Why is Fred Wilson (USV) excoriating convertible notes and SAFEs that finance early stage companies?


Cuban CurrencyIn a recent blog, Fred Wilson concluded that early stage investors and founders would be better off being financed directly with equity in its early stages rather than through convertible notes or, the recent Silicon Valley hybrid, the SAFE. http://avc.com/2017/03/convertible-and-safe-notes/?utm_source=dlvr.it&utm_medium=twitter  Both instruments delay the transfer and value of equity until a later date.  True enough, debates about later stage dilutions and valuations arise. Rather someone has forgotten how notes, convertible notes, and equity play a role in risks, return, liquidation rights, and dilution.

First year business school finance paradigm states that the cost of capital is far less for debt as opposed to equity for shareholders.  Much of this makes sense: founders prefer to get capital without dilution.  Another incentive comes from investors, who are only looking for a decent return, know that debt is on the top of the food chain of liquidation rights.  (What this means is that if the company were in bankruptcy, the debt holders get preferential treatment over shareholders.  And more compelling is that all debt holders – from banks to other noteholders – can get a piece of the pie to be repaid.  And, if there is anything leftover, the shareholders receive the crumbs.)

Now, in terms of bank debt, I have witnessed that the financing institutions delve into substantial negotiations to establish the pecking liquidation order of the debt being issued. There can be as 4-5 tranches of debt instruments, each with different liquidation preferences.  Hence banking institutions are particularly sensitive to where they stand in the event of a company’s liquidation.

Then came the convertible note: it is a hybrid debt instrument that can be converted to equity. That gave the financier the option to protect himself during the early stages of the company and, if the company prospects look excellent, the note can be converted into equity at some predetermined value. But what is the value being criticized by Mr. Wilson. There can be so many hallmark events that can impact any equity’s valuation.  And sometimes the conversion is precipitated by the needs of the company based on the dilution aversion and financial status.

A year ago, an investor colleague made a convertible note investment for a Colorado company for about $50k.  I asked him why he did it and he stated the company promised an interest rate of 8%, an interest rate much higher than sitting idle in a savings account.  I commented that he could have achieved such returns with a far less risky investment in junk bonds – companies with track records. But investments in that area tend to be more complex and advanced for some investors. Rather, the Colorado company was an early stage startup with apparent, positive prospects in RFID technologies.  However, after a year, the company never reached the cash flow it projected and exhausted its capital through its operations. It decided to convert those notes into equity. From a quick glance at their financials, the company didn’t have the cash to pay back the noteholders after their notes reached maturity. In other words, it had no other option other than to convert the notes or renew them.

From its short history, this Colorado company needed the least expensive capital to sustain its operations. It marketed promissory notes, which could be converted into equity. When early stage companies cannot get bank loans, it peddles “paper”, namely, debt instruments. Even publicly traded companies seek debt financing through the markets as an alternative to issuing more stock – which would depress their value – or bank debt. (Today’s financial markets contain the level of sophistication to trade billions of dollars of notes, even junk bonds, to satisfy any investor’s appetite for risks and returns. I myself developed the creation of bank debt securitization with TD that churned about US$2 billion a month. So any type of debt market can be created overnight.)

What convertible notes offer is an upside to just receiving fixed/variable interest rates for capital. And like anything else that deals with equity, it has its risks – dilution, swings in valuations, and changes in liquidation rights. So, regardless of what Mr. Wilson feels, I don’t foresee substantial changes in how startups get financed.

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Why is IP valuable?


I recall inquiring a new client that essentially seem to be a software consulting firm whether it had IP (“intellectual property”) and whether it retained such IP when providing software consulting services to their clients.  Its CEO replied in the affirmative.  However, when I began to do my due diligence, I noted that the IP was non-existent.  Maybe there was a misunderstanding. Yet, not having IP severely impacts the valuation of this type of company, I concluded.

As I have related to someone else, if it is not “written somewhere”, it does not exist.  That is tvaluationrue for IP.  IP must be registered or secured somehow by notices or security. There are 2 major categories of IP  — that IP which is registered and notified as being protected through registration, and that IP that has notification but held as trade secret.

For the first category, we all know about patents. There are fairly well understood rules regarding patents that include vetting and registration.  In other words, if not properly registered, the IP is not protected. There is some form of notification, “patent pending”, to offer some notice of the process.  I certainly did not see any such notification from this client.

Then there are the registrations for trademarks and copyrights. The former has an approval process as well during registration, and, when in process, there is a form of notification on any mark. Copyrights can be filed and require notification by the ubiquitous “©” symbol.  Again, did I see any such marks or copyrights for this client, the answer is still negative.

Finally there is trade secret that has no registration.  Instead, any third party must be notified on every document or page, that the information or formula is protected.  Every page must warn through the appropriate label the viewer of its protected claims. Otherwise there is no protection.  Again, nothing that the client demonstrated to me showed that protection.

With regard to this client, I knew that it developed software for the telecom industry.  I also noted that it had no registered trademarks, no patents pending, or even trade secrets.  Now, in this software industry, it is hard to argue “trade secret” to coding, since software codes are designed to bring certain results and, through minor modifications, codes can be rewritten and still bring about the same results.  Code alone is not protection. Since the results are not protected, that leaves little or no room to protect code.

Now, as GC, I have invariably received notices from outside counsels from potential investors to produce “any and all IP” held by the company.  Unless I have documentary proof of the IP, I would have considerable difficulty of delivering such IP requested through due diligence by outside counsel.  And, when I fail to produce such documentation, I immediately know that it would have an impact on the valuation of the company.

All of this analysis makes common sense. Now, going back to this client. Should the client re-evaluate its claims regarding IP?  The answer is affirmative. Can it then begin to buttress its IP portfolio?  And the answer is still affirmative. Look at Apple: it continuously files for patents, marks every year. It is not only a reflection of its innovation but also its acknowledgement that the innovation needs to be protected somehow.  IP creates not only branding; it increases barriers to entry for competitors.  Hence IP adds to the valuation of the firm. So every company’s CEO must be made aware that there is no avoidance in the very request about its IP portfolio and it must be produced upon request.  That is what that every client should know.

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What the New England Patriots could have taught Theranos!


In a well-known quote by Theranos’ CEO, Elizabeth Homes, she stated that “I think that the minute that you have a backup plan, you’ve admitted that you’re not going to succeed.” Of course, we all k…

Source: What the New England Patriots could have taught Theranos!

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What the New England Patriots could have taught Theranos!


patriots2

In a well-known quote by Theranos’ CEO, Elizabeth Homes, she stated that “I think that the minute that you have a backup plan, you’ve admitted that you’re not going to succeed.” Of course, we all know what happened to her first and only plan.  Yet, granted that New England is several thousand miles away, she could have learned something from Bill Belichick, the future Hall of Fame Coach of the New England Patriots.

In American football, a team prepares for its match against the opposing team by identifying their players and nullifying them to reach a successful outcome. They stifle and frustrate the opposing team’s key quarterbacks, lead receivers and the strongest running backs.  That is their core strategy. And there are finite players circled by the defense to handle. In the case of the Atlanta Falcons, the key players were Matt Ryan and their receiver, Julio Jones.  New England essentially focused on them.  Meanwhile, the Falcons defense narrowed down their targets on the New England key receivers, Hogan and Danny Amendola.  With Rob Gronkowski out of the picture, the Falcons thought they had locked up the game by narrowing the coverage of the key New England players and relied on those defensive targets as their only strategy.

New England spotted the Falcons sole strategy and, when behind by 25 points, the Patriots adjusted their game after the second half.  They had chosen an alternate receiver, in this case, James White, to be the dominant receiver.  And, with him as their alternate, the Patriots won the 2017 Super Bowl. Who was White some football commentator asked?  Simply, the alternate strategic option not expected by the defense.  The Patriots, he recited, had a leading receiver through Hogan a couple of weeks ago.  Amendola before then.  The defense plans for those players based on the previous football matches.  The Patriots relied on another player with little or no previous exposure not anticipated by the defense.

Interestingly, a Belichick biography described that the coach’s book shelves contained every book related to football, except for one, “Art of War”, which clearly recommends modifying strategies according to the military theater. And, as everyone knows, there is not much difference between business and warfare.  If the Patriots followed Theranos’ paradigm, the results would have been the opposite. Having one solution as the only strategy can spell the death knell for any enterprise or, in this case, a football game.

Alternative execution schemes are part of classical marketing strategy. In the business school text book, “Principles of Marketing” by Philip Kotler, the author recommends the development of alternative strategies to achieve objectives.  Contingency plans are designed to encounter unexpected occurrences. They must be drafted in the business plan.  And, whenever I draft a business plan, I myself always include alternative strategies in the event that, after certain quantified objectives are not met or fail, the plan shows another approach to reach the final objectives.

Ms. Holmes should have considered an alternate plan.  What is interesting is that the investors never identified that major defect in the Theranos “only” strategy.  And the lean startup principles, well promoted throughout Silicon Valley, fail to acknowledge alternative options. What lean startup does is produce a lean product and monitor customer adoption.  Alternative plans are not in the picture in case of product failure.  And there have been many failed companies applying the lean startup principles that have cost investors hundreds of millions of dollars.

There is nothing new here. None of these alternative choices to business execution philosophy is terribly unique. Kotler’s book is decades old.   But I don’t see it mentioned in the many business plans or pitchdecks presented in the many pitches in Northern California.  What else can be said about this myopic strategy?  Maybe there is so much capital on the San Francisco streets that speed to market under the lean startup principle is more important than considering alternative strategies. Yet, think about the Falcons-Patriots game where seconds and inches matter in an one hour game, broken up into four quarters.  Alternative strategies are part and parcel of the Patriots game. Did the alternative strategy work in such fast and precise competition?  No one can debate that. And it applies to business planning as well.

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When to hire an in-house counsel?


Someone asked the simple question of when to hire an outside counsel or attorney.  And I answered accordingly. Here, instead, I would like to quickly address of when to hire in-house counsel.  In many early stage companies, I have noted the focus to hire an in-house counsel or a general counsel.  Some motivations seem to stem from the perception that the company has full staffing to run a business. However, I tend to look at it from a bottom line approach. For that process, I refer to an old economic adage – Coase Theory of Firm, where the economist stated generally that firms or corporations internalize a process whenLawyer it is economical to do so. In the case of hiring an in-house counsel, one brings an internal counsel when it is cheaper that handing out the work to law firms.

How is that done?  One estimates the company’s average monthly legal fees and the type of work being handled and then determine which is cheaper, hiring a salaried counsel or sending the work to a law firm.  To a great degree, that analytical process comes from looking at the type of work being done.  In one example, I noted a fintech company concerned with the various financial filings for its transactions.  Since those filings were the lifeblood of the company, it could not avoid them.  As the company grew, it had to file more paperwork.  Although the forms were straightforward, they did require some legal expertise that could be handled internally faster and cheaper.

Large companies create such large legal departments that, in many ways, form a large law firm staffed by specialists. In one previous employer, the company had one lawyer whose only duty comprised of handling corporate minutes.  Another staff counsel I noted only focused on non-disclosure agreements. One attorney handled privacy matters. The bulk of the attorneys managed contractual transactions. And these attorneys worked with the various departments across the board.

In contrast, the general counsel in a startup has to wear many hats while being exposed to the many specialties not experienced working in a law firm or a large legal department.  Not only does the startup counsel manage legal matters, but could be involved with strategic issues regarding the company.  And, in my experience, I found myself more involved in international tax and accounting issues as part of the international corporate development, subject matter normally handled by the CFO.  So duties expand and become challenging.

In-house counselling can be cost effective when done right.  In one previous employer, the financial analyst remarked that the current outside legal fees ballooned to $50k a month after I left.  During my tenure, it only averaged about $5k a month and these outside counsel legal activities included substantial M&A that demanded hiring them. Just like Coase Theory of Firm pointed out, there are instances where it makes sense of internalize the legal activity.

 

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Industry Life Cycles for Startups


lifecycle-product-overview

In a recent report on Stryker, a leading medical device manufacturer, its marketing team reported that it was entering the year “on the cusp of new product cycles” and it sales grew 18% by the 4th Q and experienced 11.7% international growth. And the term, life cycle, hit my memory cells that recalled my first year marketing class.

Virtually all companies, including startups, need to concern themselves about these cycles. Businesses, old and new, face increasing competition.  Verizon, a 100 year plus old PSTN provider, sees its revenues declining just this last Q in 2016.  It struggles to look for new products to prop up its revenues.  Dropbox, a new generational digital company, is facing competition from Amazon, Google which build and manage data centers that will undercut Dropbox’s pricing. Unless Dropbox finds new products, it will also suffer revenue declines.

On the other hand, Stryker follows the textbook marketing lesson – -always get new products when the lifecycle or competition reduces the market share and product pricing. That is why Stryker is enjoying double digit growth. And, when I myself work on 3-5 year business plans, I have to think, how can I expand the list of products before initial revenues from my first product get hit? Then one has to consider the speed at which potential competitors can enter the same market. That is what Dropbox confronts today.

What is the industry life cycle?  The graph is self explanatory. And one adds the other product must be timed when the product sales dip or, to use a mathematical term, when the second derivative reaches zero.

Then, one includes a new product or a product extension.  In a medical device project I am currently drafting, I consider the new product extensions or lines to begin to be introduced within 24 months of the first product. The company must diversify products to reduce the risks to loss in its revenues when competition enters.

Somehow, in Silicon Valley, many entrepreneurs and patent attorneys all believe that their products don’t require immediate extensions or innovations since the patents provide them with a virtual monopoly. In a perfect world that would be true.  But today’s world is filled with many patent lawyers, many competitors, and fast moving markets that contribute to a new innovation paranoia – to paraphrase Grove’s oft quoted remark on survival. Even Intel with its treasure troves of patents, knows that competitive concerns are paramount to financial success – even with patents. It builds huge new factories for innovative products to compete. Innovation and new product cycles are key.

So, if the company is a startup or an established company, innovation must be introduced every few years. It needs to be thought early, even when putting together an initial business plan. Investors do not want the one trick pony.  And that is what you want to avoid being – a short demonstration of one product line.

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The New Wave of Entrepreneurship by Matt Swanson, Managing Partner of Silicon Valley Software Group – Toptal


There is a multi-trillion dollar economy opening up to technology faster than ever. It has been driven by trends that have changed the nature of how entrepreneurs will be characterized going forward; specifically, industry executives will be the next wave of in-demand startup CEOs.

new wave of entrepreneurship

In April of 2007, Apple changed everything with the launch of the iPhone. It is hard to imagine that it has only been 8 years since the release of the first truly pervasive smartphone, but there is no denying its impact has been world-changing. Beyond the creation of a new dimension of industry-driven, by location-based, services (and with it, a myriad of billion dollar companies), an equally significant phenomenon emerged. By creating technology that was intuitive to the consumer masses, every person around the world started to embrace technology as more than just a work tool. Lawyers, doctors, car mechanics and people from every sector of the economy not only had a tool for productivity, but a piece of technology in their pocket they embraced as an intimate part of their lives.

Furthermore, these new consumers could now point to a standard for usable technology. Cumbersome, enterprise legal software that won’t allow a lawyer to search cases from outside the office is no longer acceptable. For those outside of the Silicon Valley silo, conversations can be heard from construction workers sitting on a lunch break saying “Wouldn’t it be nice if there was an app to …”. Unfortunately, these conversations are often too far away from Silicon Valley’s ears, which are still dominated by the talk of what will be the next WhatsApp or Instagram. Even so, a new breed of entrepreneur is emerging who see firsthand the challenges in their industry, and with that the opportunity to make a world-changing impact, and these entrepreneurs do not fit the founder archetype that many Silicon Valley investors look for.

new breed of entrepreneur

Photos from http://www.ablogtowatch.com, http://securityaffairs.co, http://geniusapp.com, and http://www.rakenapp.com

Previous decades saw similar shifts in entrepreneur characterizations. The late 90s were about Harvard MBAs applying traditional management techniques to leverage brand new Internet technologies. The “aughts” brought on the “22 year-old Stanford Computer Science” graduate applying technology to a low hanging industry. Now, in this decade, we are seeing a new wave of entrepreneurship driven by industry executives with deep product backgrounds leveraging technology to disrupt a traditionally non-tech industry.

For the past 2 years I’ve had the opportunity to see this shift firsthand as the managing partner of Silicon Valley Software Group (SVSG), a firm of CTOs focused on helping companies with their technology strategy. SVSG has seen entrepreneurs ranging from movie producers, lead singers of platinum album rock bands, travel executives, and hedge fund managers all trying to figure out how to leverage their domain expertise through technology. After a number of similar engagements, a few observations have emerged:

  • In each venture, a product-focused entrepreneur saw the adoption of technology among their peers in a particular industry and, with that, the opportunity to create a product focused on that industry.

  • None of these entrepreneurs had notable tech experience.

  • Hardly ANY of these high profile individuals had relevant connections with the Silicon Valley community.

This last observation is of particular importance!

As tunnel-visioned as Silicon Valley might be, there is a reason that it has produced so many world-changing companies.

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The combination of growth capital, multidisciplinary talent, and mentors sharing best practices around how to create hyper-growth businesses are often taken for granted by those who are part of the ecosystem. However, the disconnect between Silicon Valley natives and outsiders is shocking. Many of the companies SVSG has come across have no ability to raise strategic capital at first because their businesses are too risky when considering common pitfalls they are more likely to fall into compared with their Valley peers. Concepts as commonplace as the lean startup methodology are welcomed as sage insight to these new entrepreneurs.

What is missing for these new founders is a bridge into Silicon Valley. To date, this has been stymied by a narrow mindset from the Silicon Valley community. However, the forces of capitalism will eventually prevail and these new entrepreneurs will find their own community to center around. Keen investors will lead the herd and take advantage of existing markets ripe for change. Incubators and accelerators will emerge with a focus on entrepreneurs with deep industry experience. We are in a tech boom right now and there are countless ways to apply technology to industries that haven’t changed in decades. For those sitting in the corner office, the time has come to venture out, there are markets to disrupt

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