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Avram Miller by the sea
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587 post pubblicati dal 2006

Tag: venture capital

  • Do VC’s Add Value in Addition to Money

    Not a Fan of Venture Capitalist

    While I am a fan of venture capital, I don’t think much of Venture Capitalists.  This may sound strange from the person that was a co-founder of what was one of the largest and most successful venture capital organizations – Intel Capital. 

    I never thought of myself as a venture capitalist.  Rather, I considered myself as an Activist Strategist.  Investing in early stage companies was a means and not the end.  The return on investment was a great benefit but growing and expanding Intel’s business was the objective.  Recently, Intel announced that it was selling off a large portion of its portfolio because their current investments were not considered strategic.  I think they are making the correct choice. 

    In my role as Vice President of Business Development and leader of the largest segment of Intel Capital, I often dealt with the venture capital industry and, in particular, many of the most prominent VC firms.  Frankly, I did not find them very strategic. Of course, there were exceptions, and some VCs were very smart, creative and even nice. Most prominent in this group was Jim Breyer, who led Accel. 

    Do VC’s Add Value in Addition to Capital

    For many years, I have pondered the question of whether VCs add value in addition to money or perhaps could they have the opposite effect.  There is no good way to answer this question. I don’t know what kind of experiment would provide the proof one way or the other.  So I have to go on my intuition and my knowledge of venture capital.  I am about to make some enemies, but frankly, my opinions no longer have an impact, and most of the today’s VCs don’t even know who I am. 

    In previous posts, I have tried to explain that the VCs are not aligned with the entrepreneur, although they love to give that impression. Now I want to take on the question of whether they provide added value. 

    Passing the ten times test

    Imagine that you are starting a new company and you need to raise money from VCs.  To get funded, they will have to think that your business has a potential to make a significant return to the investors.  In general, they will be looking at the expected value.  That means that if the there is a 10% chance that the company will return 200 times the investment, then the expected value is 20 times the investment. It is a bit more complicated than that because we also have to take into consideration to the time to get that return.  Most VCs are looking for investments that will realize a minimum of 10 times their investment. They hope that at least 20% of their investment have this kind of return.  Then they hope that they will, at least, get their money back on another 50% of investments. However, this does not mean that the founders of those new companies got a cent. 

    Based on this, they define “Investable” as companies that have the potential to return more than ten times the investment.  There is a good chance that if the company’s plan does not convince the VCs that this potential exists, they will not invest.

    Four Quadrant Model (Only one winner)

    4QuadChart.pngMost early stage companies are not worthy of investment.  For instance, the idea may not be compelling, and/or the team may not be strong enough.  So it makes sense that a good portion of the companies seeking to fund will be in the quadrant “Not investable” and “Not a Good business”.  Notice I am separating the two concepts.  Then there the companies that are “Investable” and are a “Good Business”.  There are also businesses that are “Not investable” but are a “Good Business”.  If they are not able to get funding, those companies will not happen.  Lastly, we have companies that are “Investable” but not a “Good Business”.  They will end up failing or, at least, doing poorly and will certainly not give a return on effort to the founders. 

    There are many of ways that a business can get funded but end up failing

    The company could start out with a bad business and have bad execution, but a VC still invested. This situation just results from a poor selection by the VC and is not that unusual.

    However, I think many of the companies that fail, start out as a “Not Investable” but “Good Business”, but in the process of getting funded, the VC influenced the business strategy in a way that reduces instead of improves the probably of success.  I know this is a strange concept that I am sure many will disagree with, but what I am saying is that most VCs are bad at doing their jobs. 

    As an entrepreneur, the only quadrant to be in, is clearly a company that has been a  “Good Business” and “Investable” therefore, will successful.  That is the only quadrant with a payoff.  The next best two quadrants are the two where there is no funding provided. In this case, the founders get to do something else with their lives.  The worst place is to be is in the quadrant where funding is secured, but the company fails. In this case,  the many years of hard work by the founders results in no payoff.

  • Why I am not an Angel Investor, Founder, Director or Advisor to early stage companies (except when I am)

    General wisdom about investing in early stage companies suggests that for every 10 investments,  only two companies do well. Let us assume that four of the ten return the money invested and four return nothing.  If we invested a million dollars in each we will have invested ten million dollars in total. If two of the investments return 10 times in five years and the remaining return nothing – than the average return would be 15%. But most VC firms do not do that well. The annual return for all VC firms has been 8.1% per year. The top quartile does a lot better with returns of approx. 23%. And the top 20 firms do extremely well – but that is a “hits business” to some extent.

    We are better than most.  We invest in ten startups. Two of these startups return 10 times the investment, 4 firms just return the money invested and four go under. In that case, we would have a gross return of a bit more than 25% a year. Investors do not get this because of carried interest and management fees (VC’s get 20% of the gains and 2% of the money invested as a fee which is about 10% in five years).

    So what does this mean to the different parties?

    Founders
    First of all, remember that only 20% of companies ever really succeed. While 40% will return the capital invested – because of the difference between Preferred Shares (which is what investors get and Common shares which are what founders, employees, directors and advisors) only investors get money from the 40% that return the capital invested. That means 80% of company founders get nothing.

    Yes, the entrepreneurs have the same statistical expected value but since they do not have a portfolio, they are only able to make one bet and the chances are very high that this will not be a good bet. Most founders don’t understand this. And even when you explain it to them, they don’t care because they believe that it does not apply to them because their idea is so wonderful, their talent is so great that they are going to be a success, no matter what. 

    Employees
    Normally, you can only have one job at a time. It is easier for employees to jump ship than founders – so their odds of getting some payoff might actually be higher although the amount of payoff would be much smaller. Most employees get stock options that have provisions in them that can easily result in the employee working for years and then getting fired or leaving without the ability to exercise their options. When an employee takes a salary cut to get stock in a company, they too are making an investment but on terms far worse than the VCs.

    Generally, employees don’t understand stock options. Smart companies create large amounts of stock with low value so they can give employees big numbers. For example, I start a company and set its value at ten million dollars and create ten million shares. Each share has a value of one dollar. Now the company wants to issue an employee a stock option for 0.1% of the company. That employee is offered 10,000 options. However, if I set up the company with 100 million shares at $0.10 per share I could offer the employee 100,000 shares. Many times employees with go with the higher number of options if they are considering two competing offers even though they are worth the same. Often,  companies will not tell employees how many shares are outstanding or the value of the preferred shares that investors are getting. These are critical pieces of information in evaluating the value of the offer. For instance, an employee is being given the option to buying 0.1% of a company worth $10 million dollars. Investors were able to buy the same number of shares for $100,000. The employee may have taken a salary cut of $20,000 over five years or $100,000 for a 20% chance that he will get $100,000 which has an expected value of $20,000. None of this takes into consideration the kind of dilutions that result from the company raising additional money along the way.

    Board Members and Advisors
    This is more complicated because it really depends on how much time one has to put in. If a board member gets 0.5% of a company worth $10 million, the member is getting the value of $50,000. If if it vests of 4 years, that is $12,500 a year. In other words, the board member could have bought that stock for $50,000 and never had to show up at a meeting. There is, of course, a big range of values for companies. Things look a lot different if the company is worth $100 million when the options are granted, but the amount of stock as a percentage typically declines as the value of the company increases.

    Advisors to companies get very small amounts of stock ranging from 0.2% to 0.05%. But if all one is doing is lending their name to the company as kind of an endorsement, taking a call every now and then and answering a few email or making a few introductions, it might be ok.

    However, we have got to get back to the issue of having a portfolio. It is hard to be a board member of ten companies or even to be an advisor for ten companies. So keep in mind, you only have a 20% chance of getting anything. Also, the is, of course, a variation in the returns so even if you were in ten companies, you might get nothing or get more than projected.

    Preferred Stock Versus Common Stock
    I am treating all the stock the same in this discussion, but it is really not. Common Stock may start out having a value that is about 10% of the value of the preferred shares issued to investors. Eventually, they are worth the same in a successful liquidity.

    Angel Investors
    Angel Investors usually invest at an earlier stage than Venture Capitalists. In doing so, they are taking more risk for potentially more reward. Since they are investing directly, they do not have to pay carried interest or management fees. Returns for Angel Investors are better on average than VCs which I personally find surprising since I think most angle investors don’t know what they are doing. However, it is important to have a portfolio because otherwise, the probably of any one investment paying off is small. It appears that Angel Investors have to have at least six investments to have a reasonable probably of getting their money back.

    So What About Me
    I try not to invest in early-stage companies. I like to say “that I made my money in tech and I don’t want to lose it there” but it is really how I feel. When I left Intel in April of 1999, I started making angel investments (I could not do that when I was one of the leaders of Intel Capital). I made about 20 investments in about a year before the bubble burst. Of all those investments everyone failed with the exception of one that managed to go public. Fortunately, I sold all my stock in that company as soon as I could and it more than made up for the other 19 failures.

    I only invest in early stage companies when I am either an advisor or a board member. There are only a few exceptions when I found the opportunity extremely compelling both in terms of the company’s prospects and the valuation and terms of the investment. I also have to feel that my own efforts will result in a major increase in the value of the business.

    My “ask” as an advisor or board member is about ten times the normal amount But that is because I am in demand so I keep raising my prices. It is also what I think makes sense considering the financial calculation I use to determine the value of the offer. I always ask myself, how much would I have to pay to own these shares.

    In thinking about the investments of time and money, I also have to take into consideration that I can not have a large portfolio of angel investments, advisor-ships, and board positions. Therefore, I want to target a much high return.

    Finally, I will not take stock options. I want the stock to be granted, but it can be subject to a forfeiture schedule similar to vesting. This has to do with a number of factors including tax considerations (Capital Gains or even better QSBS exclusions). This also increases the expected return.

    There are better ways to invest money and time than venture investment unless you are very skilled (or, of course, lucky). I only get involved in early-stage companies for three reasons: I like the people, I think the business proposition is compelling and I feel that I can make a difference. If these things are true, I use my financial analyst to decide how much time and money would make sense. I never invest money I could not afford to lose. And I never count unrealized gains when considering my net worth.

    The Bottom Line
    Probability theory is very important when investing your money and time. If you do not understand probability distributions, you might want to. There are better ways to make money than investing time and your own money in early stage companies. But some amount of it makes sense – just don’t count on the returns.

    I personally would never be a founder of an early stage company. Thankfully, not everyone feels like I do.

    At some point, I will also explain why I am not a Venture Capitalist.

    I apologize for spelling/grammar mistakes. Hopefully, I did not make any math mistakes either. I am sure I will hear from someone if I did.

  • Born to blast

    I just came back from a three day trip to Silicon Valley.  I rarely visit Silicon Valley ever since that day in April 1999 when I turned in my badge at Intel and drove to my new home in San Francisco.  My primary reason for the trip was to see my dad who lives in Santa Clara and to visit with my eldest son and his family.  I gave my dad who is 87 some advanced lessons on how to use Facebook.  That evening I celebrated the first day of Hanukkah with two of my grandsons.  We lite the candles to celebrate an event that happened 2200 years ago in the heart of a community at has an attention span measured in milliseconds.  By the way, the next night at an Intel Alumni event (more on that later), I celebrated the second night of Hanukkah with a few Jewish friends via an iPhone app called iMennorah.
    I stayed at the Four Seasons Hotel in East Palo Alto. It was the first time in eleven years that I spent a night in Palo Alto, a town where I lived for eleven years before leaving Intel.  The Four Seasons is built in an area which had been previously called Whiskey Gulch which was al two block area located in the small part of East Palo Alto which was on the “right” side of the Freeway, i.e. the Palo Alto side.   Whiskey Gulch was named that way because in the past their was a rule in Palo Alto was dry and no alcohol could be sold.  I got involved twice with East Palo Alto. One  in the summer of 1966 when I lived there as part of a program to coach high school kids that were going to be allowed to go to Universities without having the actually grades and skills.  The second time was in 1992 when Bart Decrem started PluggedIn. East Palo Alto had one of the highest murder rates in the USA at this time.  It was a small disenfranchised enclave in the middle of the wealth and education of Silicon Valley.  Most people living in Palo Alto only thought of East Palo Alto as the place where the maids and gardeners came from.  I lived in Palo Alto by the way.  Domino’s Pizza refused to deliver in East Palo Alto.  Around 1992, I  became the first chair of the PluggedIn board and served proudly in that capacity for seven years.  We had a lot of success in up lifting the community.  We helped some of the kids start up business.  My son, Asher (now Executive Director of the Post Carbon Institute) worked with Pluggedin to create a network for the citizens of East Palo Alto called EPA.net which is still functioning.  But now part of the community we tried to build was gone and replaced with a hotel and a number of office buildings.  In fact, I had a meeting the next day  with my tax adviser and financial managers in one of those buildings.  How ironic and a bit sad.  Then I meet with the Executive Director of Accesso uguale and organization that is helping tens of millions of people in rural Asia and Africa.  I am a senior advisor to this organization.  Somehow on about five million dollars a year we can change the lives of so many people.

    I also had several meetings with old friends that are involved in high tech investing.  Speaking with my VC friends,  I heard a lot of stories about crazy valuations including companies that refused significant offers only to have go out of business  few months later. Then I read this story.   It kind of reminds me of the Gold Rush days with Sailors jumping ship to rush up to the gold fields.  Most found nothing and those that fund gold were soon separated from their tursures.  It was the people supplying the miners that made the money.

    Later that evening I went to an Intel Alumni event.   It was attended by almost 200 people many of which had been at Intel from the 70s or like me from the 80s.  Andy Grove even attended.  I moderated a panel dealing with early stage companies both from the perspective of the entrepreneur and the venture investor.  The questions we explored where what were the skills we learned at Intel that helped us as entrepreneurs are as venture investors and what were the things we did not learn at Intel that hindered us.   I plan to post on what we discussed that evening later.  But at this event where people who started young and grew old working for one company over more than 30 years in some cases.  And working for a company the changed the world.  And while I am disappointed in what happened later at Intel,  the company that is still the leading semi conductor company in the world.  What a different experience these people had to those working for the current crop of start ups.