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Chapter One: Introduction to Start-Ups and Their Funding
The research on which this book is based provided a lot of data about start-ups of all kinds that use technology, from semiconductors to Internet sites. The findings include their probability of success and how they are typically organized. Let's begin with thirty-one facts about typical high-tech start-ups -- many of them contrary to popular stereotypes.
1. The chances are 6 in a million that an idea for a high-tech business eventually becomes a successful company that goes public.
2. Fewer than 20 percent of the funded start-ups go public.
3. Founder CEOs own less than 4 percent of their high-tech companies after the initial public offering. Boom periods like the early Internet years often raise that to 10% and higher.
4. Founder CEOs can expect their stock to be worth about $6.5 million if the company succeeds in going public. Boom periods like the early Internet years produce billionaires.
5. Successful venture capitalists expect to personally earn about $7 million (in addition to cash wages) over five years for each $50 million pool of capital they share in managing.
6. Business plans are typically poor and are not well received by venture capitalists.
7. "Unfair advantage" and "sustainable competitive advantage" are missing in most business plans but are considered by investors to be critical if the high-tech start-up is to have an acceptable chance of succeeding. Plans lacking such an advantage rarely receive venture funding from experienced, successful venture capitalists.
8. On the average, a venture capitalist finances only 6 out of every 1,000 business plans received each year.
9. Venture capital investors own a large 70 percent of the start-up by the time it goes public: 70 percent of hardware companies, 60% of software companies and 50% of Internet companies.
10. The personal costs of doing a start-up are high, affecting families and friends as well as individuals. Fear and burnout are common. However, many CEOs have balanced those costs with the rewards of personal and professional satisfaction and the potential financial paybacks, which can be more gratifying than the rewards of working for a large corporation.
11. Bankruptcies occur for 60 percent of the high-tech companies that succeed in getting venture capital.
12. Mergers or liquidations occur in 30 percent of start-up companies.
13. A vice president's stock is worth about $2.5 million or one third of what the CEO is worth at the time of the initial public offering. Boom periods can increase the wealth tenfold.
14. The average worth of the stock for each of the employees (not including vice presidents and other key employees) on the date of the initial public offering is about $100,000.
15. Investors in venture capital pools aim to earn in excess of 25 percent each year on their money, about 8 percent more than if they had invested in all the stocks of the companies making up the Standard & Poor's 500 company index. In boom periods they can triple their returns.
16. The 10 percent of the start-ups that succeed compensate for the other 90 percent of the poorer performing companies in the venture capitalist's investment portfolio. In essence, the successful founders are paying for the substandard performance or bankruptcies of the bad investments.
17. Cash compensation for U.S. start-up managements remains below levels offered by larger corporations in spite of the scarcity of start-up talent and tax law reductions in the United States. Technical talent is paid near or at the going rate for such employees.
18. The median annual starting salary for a founder CEO in 1990 was about $120,000. By 1998 it had risen to about $150,000. Pre-IPO cash bonuses had become common by 2000 and increased total pay to $190,000 by the time the company went public.
19. The vice president of sales in a start-up often earns more cash compensation than the CEO. This occurs when incentive compensation plans are linked to sales that exceed those of the business plan.
20. Of the start-ups that get to an initial public offering, the median company takes at least three and typically five years to get to the public offering stage. Internet and biotech companies have been able to go public based on their "stories," that is, without earning profits by the time of the initial public offering.
21. Equipment lease financing and leasing of facilities and leasehold improvements have proven to be reliable and competitively priced sources of capital to augment equity raised to finance a start-up.
22. Having as a founder a person experienced with the responsibilities as CEO greatly increases the chances of getting a start-up funded. A close second is having a complete management team ready to go to work, with experienced people for each of the key functions, including the first CEO willing to step aside for a new, experienced leader when the business begins to grow rapidly.
23. About $100 billion is committed to pools of venture capital. It is managed by more than 2000 actively venturing individuals in over 500 firms, mostly in the United States, mainly in Silicon Valley, with a few in Europe and Asia.
24. The intensity of competition between venture capital firms has swung back and forth. It favored the entrepreneur at the height of the boom days of the personal computer, biotech, and Internet eras. However, whatever the trend, venture capitalists still end up owning the vast majority of the stock of a start-up, typically in excess of two-thirds of the company.
25. Mergers and acquisitions of start-ups increase when the market for initial public offerings cools off and when initial public offering valuations are historically very high.
26. Investors' interests in new issues rises and falls depending on the interest of institutional investors in the stocks of public companies traded over the counter, as well as in blue chip stocks traded on the New York Stock Exchange. In general, windows for IPOs open and close, based on whether there is a hot market for stocks in general. E*Trade and other Internet era financial service firms have brought access to IPO offerings to the general public. By 2000, "day traders" were a factor in moving stock prices.
27. Pricing of private rounds of venture capital by investors follows the same financial guidelines and measurements used to price securities of publicly traded companies. Investors translate risks and rewards into acceptable levels of expected return on investment, which becomes the basis for the dilution of founders' shares.
28. Competition for the shares of a start-up is the best way to increase its valuation and to reduce dilution for founders. Competition is enhanced by careful planning of the strategy for the capital-raising campaign. However, such deliberate planning is noticeably absent among founders of high-tech companies, especially those started by engineers.
29. Venture boom-to-bust cycles have become a way of life. The boom times of the personal computer of the 1980s ended. Biotech arrived and ended. The Internet boom arrived in the 1990s. These caused wide swings in the financial return on portfolios of venture capital firms. Many firms failed and closed their doors, leaving nothing to their investors. Other venture firms survived and some thrived. This resulted in a hierarchy of venture firms, interrelated deal-making ("deal flow"), and politics. Portfolio returns have dropped as low as single digit ROIs and a few have risen above the 60 percent range.
30. Mixed sources of venture funding have become a way of life. As a number of venture firms died out, a need and opportunity was created for funds from other sources. One new source of venture funds is large public corporations whose business development leaders became very active in the Internet boom. There continues to be funding from non-American sources. Angel investors grew and were prominent in the early years of the Internet. Friends and family funding, as well as bootstrap funding, has continued since the earliest days.
31. Internal start-ups within established corporations are now a frequent phenomenon; they have allowed emerging growth companies to sponsor an entrepreneurial spirit while retaining an uninterrupted focus on the parent company's bread-and-butter business. For internal start-ups to be successful, special attention must be paid to the unique characteristics of such new enterprises, particularly freedom and compensation.
There are a number of key economic forces driving the venture capital funding of high-tech business.
- ROI -- return on investment -- drives the start-up business. It is measured in two ways: (1) A crude measure is that of how many times the value of one share invested rises by the time the initial public offering is over. This is called the "multiple." (2) A more sophisticated measure -- the only number that really counts -- is the annual compounded return, or percent per annum (p.a.), that the general partners in the venture capital firm return to the limited partners, pension funds, university endowments, and so on. To put it another way, how long the limited partners had to wait for the multiple to be returned determines the true percent annual ROI.
- Cash flow (the "burn rate") is what is managed. All the accounting in the world does not matter to the founder who is struggling to meet payroll while launching the start-up's first products into a very competitive jungle.
- The IPO (initial product offering) is the holy grail. Everyone has their eyes on that final goal. Mergers stand a poor second in attraction, because companies can generally negotiate higher valuations for a public issue.
- Liquidity ("exit strategy") is everything for the VCs (venture capitalists). Anyone inhibiting attainment of liquidity quickly learns why VCs have earned a reputation as "vulture capitalists." A business plan must have an acceptable "exit strategy" that converts the investors' shares into cash.
Those are the economic laws that govern a start-up. The CEO who understands them will win more often and will survive to savor the grand IPO day.
Venture capitalists are driven by competing venture firms to maximize their return on investment. The general partners share in about 20 percent of the profits of a pool of money provided primarily by huge institutional funds, such as pension plans for Fortune 100 megagiants and billion-dollar university endowment pools.
If VCs earn a high enough ROI on their first pool of institutional funds, they will have a chance to bid for more. They are competing against the alternatives -- such as the stock and bond markets -- that are open to institutions. The economic and business factors that drive stocks and bonds also drive the VCs, and therefore must drive the start-up CEO.
Venture Money Surge Leads to Problems
Venture capital partnerships have been a successful way of investing institutional money over long periods of time (ten to twelve years) for at first a limited number of investors. But with success, more money and more investors have followed. This in turn has led to serious competition between pools of venture capital. Since the surge of funds began in 1984, there has been a dramatic alteration of the risk-reward ratio for high-tech start-ups.
The Venture Capital Journal reported that during the ten years since 1977 the total of annual additions to venture capital partnership pools rose fifteen times, from a rate of about $200 million per year to more than $3 billion annually. This produced an excess of available venture capital and failures by many venture firms, which was followed by recovery, the arrival of the Internet start-ups, and more than $6 billion invested per year in the 1990s.
The $40 billion venture pool of the 1980s grew rapidly the following decade. By 2000, the venture capital pool was estimated by some to measure nearly $1 trillion, certainly $100 billion. The firms representing the pool continue to be flooded with business plans. Such increases intensify the simultaneous competition among start-ups that aim their technology at the same new perceived market opportunities. One example was the personal computer disk drive business, which boomed in 1984 and then went bust along with many start-ups. Another example is the minisupercomputer market; Convex and Alliant made it to IPO, but veteran venture capitalist partners say that another dozen companies or so were floating around at the same time the managers of those two founding groups were knocking on doors seeking seed rounds of venture capital. Internet start-up plans have flooded venture firms since 1995. In 1995, Forbes magazine reported that at least thirteen business plans were circulating in Silicon Valley the same month to do the same thing: sell pet food and products over the Internet.
Another effect of the success of venture capital investing is that big corporations have vastly improved their ability to see, decide, and act on new market opportunities. The giants have learned to invest their own "corporate venture capital." Since 1981, the number of acquisitions of venture-backed companies has more than tripled. And pioneering leaders of established public high-tech companies have invented a new form of internal venture capitalism dubbed "internal start-ups" or "start-ins." These have created successful new enterprises, attracted top managers, and proved to be successful in competing for already scarce high-tech talent.
Result: Dilution, More Risk, Less Stock, Lots of Work
All of the forces just mentioned have increased the risk of failure of a high-tech start-up. Few if any other trends have emerged to offset this increased risk. Accordingly, investors have been following a trend of requiring higher and higher returns on the monies they have invested on behalf of their institutional clients. This means that less wealth is available to be shared by the founder and employees.
In modern portfolio terms, these trends have raised the cost of capital for the start-up. In more ordinary parlance, the founders have to give up a lot more of their companies today than they used to. Boom times appear to favor the founders, but over time the investors own the largest portion of the start-ups. In the 1970s it was not uncommon for investors to be in the minority. In the boom days of the 1980s start-ups such as Altos, Ashton-Tate, Microsoft, and Televideo went into business and retained 80 percent or more of their stock for employees and founders. After the bust of the 1980s, investors became the largest percentage owners. The explosion of Internet start-up deals in the boom time of the 1990s appears to have again changed the trend. Start-ups like Netscape and Yahoo went public very quickly, in less than three years, with investors owning less than 50 percent. Like the biotech boom days, some say the Internet IPOs were in essence a case of the public funding venture capital deals. With fewer employees, the founders ended up owning a larger portion of the company in the race to go IPO as soon as possible to fund the high cash burn rate of money-losing Internet start-ups.
The amount of stock given up by founders is spelled out in Chapter 7 in more detail. Research of Securities and Exchange Commission (SEC) documents by Saratoga Venture Finance revealed that, over the long term, CEO founders should expect to get to IPO owning not much more than 3 percent of their companies. That share of stock will be worth about $6.5 million at that time. They will have to work very hard for four to five years or more, and must have a lot of good fortune and big breaks to be able to cash all their chips in within two years after the IPO. Three years to IPO is rare, five is more common. And few get there.
Is a start-up worth the personal cost required? That is among the key issues for the CEO considering a start-up and is discussed in Chapter 8.
And before a would-be founder can answer the personal questions, he or she must focus on another question: "How should I plan and control the venture capital formation process, from seed through multiround financing to IPO, so that I have an unfair advantage in getting the funds I need in order to succeed?"
The Everlasting Process of Raising Capital and Other Stresses
The entrepreneur must realize that the process of raising venture capital never ends. From the first to the last of the fourteen stages of the venture capital formation process described in detail in Chapter 3, the CEO is continuously occupied with problems of how to raise needed capital. Experienced start-up staff members of both successful and unsuccessful companies said the same thing: "You never have enough money, things always take twice as long to do as you think, and there is never enough time to stop raising capital while you focus on running the company."
Analysis of more than 300 start-ups since 1981 revealed the extra strains put on a CEO. Stress begins with the wide range of outside professionals -- twenty categories can be cited -- with whom the CEO must be in continuous contact, beginning almost immediately upon launch of the new enterprise. This puts a new kind of pressure on managers whose careers have typically been strictly "insider" executives. Such leaders are usually not experienced at dealing with lawyers, board members, bankers, leasing companies, landlords, Wall Street, and shareholders. Extra stress is added in boom times when investors and intense competition push the founder to run faster to the IPO in order to retain the "first mover advantage." More stress is added to the lives of founders who have never managed much if anything before in their lives. They are subject to extra pressures of "learning-on-the-fly" and how to deal with advice (what one wag called "adult supervision") from board members, venture capitalists, and others.
Sources of Capital
The sources of venture capital are varied and often colorful and creative. For example:
- "Bootstraps" like eBay, of San Jose, California, get their first funds from personal savings and friends and relatives.
- "Angels" get start-ups rolling with their own seed money and hands-on help preparing for next-round funding from venture capitalists.
- "49er" start-ups like Netscape get seed money from their wealthy friends and founders (Jim Clark, prior founder of Silicon Graphics).
- "Classics" like Exodus Communications of Santa Clara, California, raise their monies from the usual VC gang at 3000 Sand Hill Road in Menlo Park, California, and other centers of venture capital such as those in Boston, New York, Dallas, Minneapolis, Denver, Seattle, and Los Angeles.
- "Creative" start-ups like Chips and Technologies and Worlds of Wonder get money from suppliers, landlords, and business partners who are acquainted with their skills as managers.
- "Hybrid" start-ups like AirFlash of Redwood City, California, get seed money from a mixture of angels, venture firms, and corporations like Intel and Lucent.
There are other unconventional sources of funding. Equipment lease firms provide substantial funds to augment equity capital of high-tech start-ups, and wealthy individuals continue to emerge as supporters of start-ups. Megabuck luminaries like Ross Perot are called professional "angels," and independently wealthy founders of start-ups are angels dubbed "49ers" -- a term harking back to the gold rush successes in California in the 1849 era. Both represent unofficial pools of funds that go to work backing start-ups.
And the creative list goes on and on. Later in this book we will provide lists of venture capital sources.
More important than lists are techniques for planning and negotiating with money managers who are responsible for investing venture capital. Details are provided in case studies in later chapters.
Some Findings About Rewards and Risks
Saratoga Venture Finance has carefully dissected the prospectuses of IPOs to extract the facts on the ownership, ROI, and sharing of the wealth among famous high-tech start-ups.
We found that CEO wages ranged widely, from base salaries of $65,000 per year to $230,000. The median in the nineties was about $150,000 for base salary plus significant bonuses prior to IPO. The trend is for cash compensation to rise as the number of start-ups grows and thus makes good management scarce. A good resource is advanced-hr.com, which publishes stock and pay compensation for venture-backed start-ups.
Investors dominate ownership; their proportion often exceeded 70 percent just before the IPO. There was no correlation between percent sold to investors versus the amount of capital raised. Boom to bust cycles greatly alter the ownership portions.
Return on investment of famous VC firms was slashed at the end of the 1980s after the shakeout following the personal computer-era boom. It became tough to repeatedly earn the 50 percent annual "slam dunk" of the boom days of 1978-1983. Kleiner Perkins and a few others managed partnership pools in the better days that returned nearly 65 percent p.a. In 1987 a portfolio return in excess of 25 percent p.a. would be among the top performers, according to private sources we polled, and average returns were around 17 percent p.a.
By 1990, we found that most portfolios had single-digit returns. "The turkeys hatched since 1983 have come home to roost," said one venture capitalist. Some pundits, major VC players themselves, said that there were some VC pools that lost all the investors' money by the time the partnerships were liquidated.
As 1990 arrived, along came the Internet boom and once again the ROIs jumped. By 2000, venture partners had returned to quoting 75 percent to 90 percent and higher returns on their investments!
Over the past two decades VCs have formed a vision of a "typical" portfolio of investments in start-ups. About 60 percent of the companies funded by VCs can be expected to go bankrupt. Fewer than 15 percent even get to IPO, and less than 10 percent is typical. Our database shows that 9.7 percent reach IPO. The remainder are either merged into large companies, sold off as "fire sales," or go on eternally as "zombies" -- companies too small to get to IPO and not interesting enough to sell to other companies.
These and many other details about the companies studied are shown in the Saratoga Venture Tables in Appendix A; the tables include wages, options, founders' shares, venture capitalists' multiples earned, and how much the Wall Street firms got in fees to take the start-up public.
The Personal Costs
Coping with political power plays is just one of the factors that contribute to the psychological and emotional costs of leading a start-up. There are many more, including the effects on the CEO's physical health and family. Some CEOs said they loved it anyway, while others said they hated every minute of it and would never do it again.
Some of our research in this area sharply contradicts popular myths. Here are highlights of what we found:
- Hours worked per day for start-up CEOs are long, but are no more than those worked by an aggressive manager in a growing division of a much larger public company. This surprised us, as it did most of the people we interviewed and analyzed. No one said that a start-up was less work than their last job as an employee.
- Terror is a constant companion. CEOs with experience often say "entrepreneurs should run scared." Based on our surveys, they do! Inc. magazine and other surveys and testimonials support the belief that fear of failure is a constant companion.
- Founder CEOs seldom last as employees for more than three years. This is universally lamented by all parties, including the VCs. We will discuss the reasons and cures later in this book. Silicon Valley psychologists report that few founders make it to the IPO without personal emotional trauma.
- Burnout and heart attacks, marriage problems, and divorces are no more frequent than in other high-tech jobs. Employees of start-ups may actually be a bit less prone to such problems if the CEO sets a good example of a balanced personal life, including regular exercise, enough sleep, proper diet, and time for family, friends, and spiritual matters.
- Honesty and integrity (or a lack of them) are as common as in bigger companies. Contrary to the expectations of some observers, no evidence could be found that the stress of a start-up produced a pattern of especially immoral, or moral, behavior.
It is interesting to compare the predictions made by Saratoga Venture Finance in the first edition of this book and to make observations regarding the actual outcomes:
- A shakeout of venture fund managers will continue to occur, leveling out by the mid-1990s.
This has happened and the venture industry has settled down, led by the survivors, followed by growth in the form of fresh firms formed by former partners of the leaders.
- The trends of the 1980s indicate a significant slowing of the flow of fresh funds into the earliest stages of new ventures. This will continue as surviving VCs spread their investments across all rounds of funding for new enterprises.
This occurred and continues today as venture firms pursue specialized strategies on funding different stages in the life of high-tech start-ups.
- $2 billion to $3 billion of new venture capital will become available each year, sustaining the $40 billion pool at work in 1990.
The pool stabilized at $40 billion, with new funding running at $3 billion annually until the Internet boom arrived, then doubling to more than $6 billion invested annually from a pool that had more than doubled in size.
- Some funds will never return. Others will diversify more, into low-tech and leveraged buyout investments. Offshore investing will be done by several, attempting to get away from intense U.S. venture competition. The remaining VC leaders will converge and dominate.
This is now the form of the venture community.
- Specialization of venture sources will continue: biotech, electronics, and other segments of industry and technology.
This is how the venture industry segmented until the Internet boom added electronic commerce and related Internet companies as the newest addition.
- Merger and acquisition activity will rise and fall in cycles that are the reverse of those of the U.S. stock market.
- This has happened until Internet mergers arrived and grew with the stock market boom.
- Business plan screening by VCs will remain generally quite tight. Those that best articulate the unfair advantage of the proposed business will get funded.
This remains one of the most important things a founder should know and respect.
- Extra caution by VCs will require CEOs to be better prepared for their launch strategies. A candidate with successful prior experience as a CEO will be sought after first by investors.
The experienced CEO as founder is the number one concern of venture investors. Such leaders are very scarce.
- More favor will be placed on deals with complete, first-class, experienced management teams with a long-run or "marketable" CEO in place. Inexperienced teams will find it very difficult to get money.
This is the rule; the exceptions come during boom times, such as in the Internet explosion, when "stand-in" managers are called upon to provide "adult supervision" and angels become very useful.
- Attracting as complete a start-up core team as possible will be even more essential to success.
Concept start-ups are difficult to fund; the key people should be in place on day one for technology, marketing, and management.
- Corporate venturing will continue, mostly for secondary-stage funding. And the corporations will use more "internal venturing" structures.
This is now a steady trend.
- Foreign venturing, especially from Europe and Asia, will continue and even accelerate.
Venturing from Europe and Asia is in place, but is not yet a dominant force.
- The U.S. IPO market will continue its cyclical strength, subject to ups and downs resulting from excesses and from trends in the broader equity market.
The steady growth of the U.S. stock market has fueled a record run of an uninterrupted IPO market.
- New overseas markets for IPOs, the way London was in the 1980s and Taiwan was in the 1990s, will emerge and be tested during the remainder of the decade.
This has been tested, but is still in its infancy. Europe continues to experiment with NASDAQ-type stock markets such as the Neuer Markt. Asia is working on the same.
- Intense pressures will continue from investors for an exit strategy that gets them liquid within five years of investing.
That is a rule and way of venture life.
- VCs will be delighted to invest in deals whose prospects can get investors ten times their money in five years. VCs will compete even more aggressively for cream-of-the-crop deals.
There now seems to be an annual phenomenon centered upon a small crop of "designer" start-ups in a category which the top-tier VCs all rush to fund simultaneously.
- Investment banking desires for high-tech IPOs will not abate but will result in reshuffling the rankings of the leaders in that intensely competitive business.
All of Wall Street now competes aggressively to do the best IPOs, from the smaller firms specializing in high-tech to the giant firms. Acquisitions and new e-firms have scrambled the rankings.
- Employers and giant corporations will be more predatory in legal action aimed at preserving company proprietary intellectual property and key employees.
There are now established legal guidelines to follow to stay out of trouble as a start-up.
- Tax uncertainties and trends toward more changes in accounting rules make the careful choice of a CPA firm more important in the 1990s.
Software start-ups are especially affected by fresh accounting rules.
- A greater percent of ownership will be retained by founders who deliberately plan a capital-raising campaign complete with strategy and alternative sources of venture capital.
Founders say they won more by being better prepared.
- The proportion owned by the CEO will decline a bit over the next decade as intra-VC competition wanes.
The results show this has happened. Boom times cloud that general trend.
- Venture equipment lease firms will continue to bid for financing of the better deals done by the top VC firms.
This has continued.
- CEOs will have more of an opportunity to set an example of a balanced personal life for the start-up culture, as the scarcity of qualified CEOs adds to their power.
CEOs have become even more powerful as a result of the Internet boom and scarcity of experienced talent.
Strategies and Implementation
This book presents a classic strategy for starting a high-tech company and securing multi-round financing. The case studies provided in each section were chosen carefully to reveal how the classic strategy can be modified to fit the special objectives of the founding team.
The focus of the book is on how to use ROI know-how as an anchor in developing a start-up strategy, especially for pricing each round of venture financing.
The author hopes that the information provided here will allow the CEO to spend more time doing strategic thinking and finding and improving a sustainable competitive advantage for the company's long-term well-being.
If there are fewer failures, more jobs, and better lives as a result, the author will be very satisfied.
Copyright © 1997, 2000 by John L. Nesheim