Redeye VC

Josh Kopelman

Managing Director of First Round Capital.

espite being coastally challenged (currently living in Philadelphia), Josh has been an active entrepreneur and investor in the Internet industry since its commercialization. In 1992, while he was a student at the Wharton School of the University of Pennsylvania, Josh co-founded Infonautics Corporation – an Internet information company. In 1996, Infonautics went public on the NASDAQ stock exchange.

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Monthly Archives for 2010

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Open Source Venture Financing Documents

NvcaA few weeks back, I wrote a blog post (on Bridge Loans versus Preferred Equity) that briefly mentioned the National Venture Capital Association’s Model Legal Documents for a Venture Capital financing. I am a heavy user of these documents (having found them to be tremendously valuable in our negotiation process) and thought it would be worth going into some greater detail here.

These documents were drafted to offer a "template" set of public domain model legal documents that are "fair [and] avoid bias toward the VC or the company/entrepreneur" and reflect "current practices and customs".  By providing these documents, the NVCA has made my job much easier. I routinely use the NVCA docs as the baseline for First Round Capital's term sheets.  Doing so allows me to (1) clearly communicate to entrepreneurs that I am not looking for any non-standard terms, (2) reduce the legal fees of both parties, and (3) get a deal closed much faster than I would if I had to start from scratch.  The documents also note where the East coast and West coast differ in their standard terms - a feature which has been useful as I invest bi-coastally.

A little more about the documents:

The documents were drafted by a working group of law firms and venture firms and are updated annually. You can check out the current members of the working group here.

The documents include a model Term Sheet, Stock Purchase Agreement, Certificate of Incorporation, Investor Rights Agreement, Voting Agreement, Right of First Refusal and Co-Sale Agreement, Management Rights Letter, and Model Indemnification Agreement.

An interesting comment from the NVCA site:

"Annually, our industry closes several thousand financing rounds, each consuming considerable time and effort on the part of investors, management teams and attorneys. A conservative estimate is that our industry spends some $200 million in direct legal fees annually to close private financing rounds. In an all-too-typical situation, the attorneys start with documents from a recent financing, iterate back and forth to get the documents to conform to their joint perspective on appropriate language (reflecting the specifics of the deal and general industry best practices), and all parties review numerous black-lined revisions, hoping to avoid missing important issues as the documents slowly progress to their final form. In other words, our industry on a daily basis goes through an expensive and inefficient process of "re-inventing the flat tire." By providing an industry-embraced set of model documents which can be used as a starting point in venture capital financings, it is our hope that the time and cost of financings will be greatly reduced and that all principals will be freed from the time consuming process of reviewing hundreds of pages of unfamiliar documents and instead will be able to focus on the high level issues and trade-offs of the deal at hand."

Thoughts on Swap 2.0

RecycledollarOver the last year, I've often been asked my thoughts on the re-emergence of the barter/swap business model.  I thought it might be useful to share my perspective here.


Back in the Web 1.0 days, we saw the rise and fall of the barter/swap business model with companies such as WebSwap, Switchouse, Swap.com, SwapVillage, Mr. Swap, etc).  These sites received tens of millions of dollars from well known VCs but none of them were able to gain traction or survive the fallout.  It might be my false pride, but I believe that consumers were more attracted to person-to-person fixed price sites (such as Half.com and Amazon Marketplace) where they could swap their CDs/DVDs/Books for cash. As Forbes magazine wrote in 2000: “It took humans thousands of years to emerge from the barter system. Does bringing it back online make sense?


It seems that with the emergence of Web 2.0 we now have a rush of companies looking to take up where the others left off.  Over the last few months we’ve seen the emergence of Lala, Zunafish, Barterbee along with Peerflix.com.  Further support for Om's argument that Web 2.0 is Web 1.0 all over again.  In fact, last week’s New York Times article on Zunafish looks remarkably similar to the one they ran almost six years earlier.


All of these new sites are looking to build a barter/swap-based business model.  However, the Web 2.0 barter sites represent a meaningful advance from the Web 1.0 barter sites.  Rather than force users to conduct a two-way swap (ie, User A has something that User B wants AND user B has something that User A wants) they’ve introduced a point system (or alternate form of currency) to allow users to conduct one-way swaps (ie, User A gives something to User B for 4 points – and User B can get something from user C for those points).  Users pay a standard fee (typically $1) to make a trade.


The currency/point model is a significant improvement.  Users can now get something without having to find someone who wants something from them.  Recent blog posts have compared the efficacy of this new model to the cost of buying/selling used goods.  However, I’m still not convinced that a swap/barter marketplace is as effective as a cash marketplace. 


I spent some time tonight looking at the currency value of DVD’s on Peerflix.  Specifically, I compared the used price of several DVDs on Half.com to their Peerbux price – and found the values to be highly disproportional.  (I chose Half.com since it is a liquid marketplace that places a dollar value on used DVD’s – and since I founded it – but the analysis holds in Amazon Marketplace as well)


For example, you can get both the Fourth and Fifth Season of the Sopranos on Peerflix for 10 Peerbux each.  However, on Half.com you can currently buy the Fourth Season for $29.99 and the Fifth Season for $38.00.   That means that there is an eight dollar price difference between two DVDs worth the same number of Peerbux.  So a user who gives away their Fifth Season Sopranos for 10 Peerbux is not just paying a $1 swap fee – they are leaving another $8 on the table.  Moreover, Peerflix users can buy Peerbux for $5 each.  So, if you wanted to get the Fourth Season of the Sopranos on Peerflix by purchasing Peerbux, you’d be paying $50 – or $20 over market value. Badda bing!


I selected a total a ten DVDs and then computed the implied cash value of a Peerbuck (by dividing the price on Half.com by the price in Peerbux).

Peerbux_2








I was surprised to see that the price of 1 Peerbuck ranged from $0.95 all the way to $9.30. This has two consequences. First, it creates a “winner” and a “loser” in every trade. In a true marketplace, both sides of the transaction get a fair deal.  However, if you “sold” your copy of 24 (Season Two) or Murder by Death on Peerflix you did not get as good as deal as someone who “sold” their Lord of the Rings or Bad News Bears.  By using a point system instead of real dollars, these marketplaces hide the true cost of the trade -- and are always putting 50% of their users at a financial disadvantage.


Second, people will want to keep the good DVDs they have, while they're willing to trade the bad ones (via Techdirt).  This creates a real arbitrage opportunity. I went on Peerflix and listed several of the low value items for trade (Lord of the Rings, The Terminal, Sopranos Fourth Season, Bad News Bears). If I get an order, I’ll go to Half.com and have the DVD’s shipped to the Peerflix customer…then I’ll use my new Peerbux to buy Murder by Death or 24 (Second Season) – and then sell those on Half.com. It should be an interesting experiment – I’ll keep you informed…

No Surprises...

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You missed your sales forecast.  Your CTO quit. You lost a big sales prospect.  You didn't get the term sheet you were expecting.  Your web site has been down for hours.


What do you do?

 

All entrepreneurs know that running a startup company has its ups and downs.  However, how a CEO handles the downs is very important.  If there's one thing I've learned, its that a CEO needs to share the bad news with investors just as fast as they share the good news.

 

I'm a big believer in creating transparency between a CEO and his board of directors.  At Half.com, we created an automated email to summarize our daily sales numbers.  In addition to sending it internally to management, we also sent it our board members.  No one expected them to track our sales on a daily basis (that was my job), but by providing them with the constant flow of information, they were able to make better suggestions/recommendations when asked.  (That's the same reason why Jingle Networks distributes a daily email summarizing call volume to 1-800-FREE411).

 

With the growth of ASP-based management tools, there are now even easier ways to share information with investors.  Several of my portfolio companies have created accounts on Salesforce.com for Board Members with a customized BOD dashboard to provide a "30,000 foot view" of the pipeline.  Other companies have created accounts on Google Analytics so that board members can access traffic stats in real time.

 

By providing open access to information sources there are a number of benefits:

  • It eliminates surprises. By providing a continual stream of information, the board should never be surprised.

  • It makes board meetings much more productive.  Rather than spend a lot of time presenting the raw data, the CEO can now provide interpretation and analysis of data -- they can put the numbers in context.
  • It allows board members to make more meaningful suggestions.  Different board members have different skills. Some are strong at enterprise sales -- and by tracking a sales pipeline over time they might be able to identify areas for improvement in the sales cycle.  I personally am stronger at online consumer marketing -- and feel that by having access to website traffic reporting I can ask better questions and make better recommendations. 

 

Sharing data with a board does not mean that you are sharing control. Rather, I believe that an informed and knowledgeable board will be less intrusive (and more hands-off) than a board that is in the dark. (That said, a CEO should clearly set expectations that they are not looking to get the "why are Tuesday's sales 2% lower than Monday's sales" phone call. )

 

Too many CEO's try to hide their bad news and setbacks -- they stick it in the fifth paragraph of a six paragraph email.  I get extremely uncomfortable with that approach. It forces the investor into the role of detective -- constantly on the look out for hidden clues. 

 

Just last week I received an email from a portfolio company CEO with the subject line "Bad news. XXXX is reversing his previous agreement to fund us." While no investor likes to receive bad news, I must say that I was impressed by the way the CEO handled it.  He communicated the news clearly and boldly.

 

All CEOs can be sure that they will have their share of bad news. 

All good CEOs will be sure to share their bad news.

Bridge Loans vs. Preferred Equity

Handshake Over the last few years, my fund has made over 20 seed-stage investments. While we strive to be the "first money" into a company, we recognize that we typically don't provide enough capital to get a company to profitability.  So we invest with the assumption that there will be another "institutional" (or venture) round after us.    

Brad Feld recently posted a great overview highlighting the two leading structures for a pre-VC investment -- convertible notes and preferred equity.  I, like most investors, have a strong point of view on the topic -- and wanted to share my thoughts.

In general, I have a strong preference for Preferred Equity.  While there are a few circumstances where I would go with a Convertible Note (which I'll outline later), I believe that:

  • Preferred equity better aligns the interest of the Investor and the Entrepreneur.
    A typical convertible note allows an investor to convert from debt into equity at some discount to the Series A price (typically 20-40%).  I believe that this often has an unanticipated outcome -- it puts the seed-stage investor and entrepreneur on different sides of the table.  The entrepreneur wants the Series A price to be as high as possible, while the note holder wants the Series A price to be as low as possible (since the conversion price of their note will be based on the Series A price).   This misalignment of interest creates a number of problems for me.  Once I invest in a company, I would like to focus on adding as much value as possible - I want to help the company refine their strategy and business model.  I want to help them build their team. I want to introduce them to business development partners.  I want to help them generate PR.  I want to introduce them to several VCs so they can raise their next round on good terms.  However, as a note holder, there is an economic penalty for adding value -- the more I try to help the company, the more expensive my equity ultimately becomes.  In effect, I have to pay for any value I help create.  If I was an equity holder, those conflicts would not exist.  I would benefit directly from any value I help create.
  • Preferred equity prices in all of the risks facing seed-investors
    There are a number of risks facing every company - technical risk, execution risk, team risk, marketing risk, customer acceptance risk, etc.  However, I believe that the #1 risk factor facing seed investors is funding risk.  Since I know I am not giving the company enough money to get to breakeven, I need to assess the probability that they will be able to raise additional money.  In my opinion, a convertible note does not effectively price-in this funding risk.
     
  • Preferred equity typically does not create liabilities for the venture round.
    The main reason I'm given when people choose convertible notes instead of equity is that "setting a valuation for a seed-round makes it challenging to get a higher valuation for a venture round." In my experience, as long as the venture round occurs more than a few months after a seed-round, this is not the case.  I have recently participated in several seed-rounds that raised much larger venture rounds at valuations that were multiples of the seed-round valuation.  Venture firms understand that the later they invest, the more progress a company makes, the more risk gets removed from the deal -- and valuations reflect that. In fact, I often see companies use the progress they've made during the interim period as a rationale for increased valuation (ie, we were worth $3M before we had a complete team, a customer pipeline, a working product -- so now we're  worth $5-7M).  This, of course, assumes that the terms for the equity are standard market terms.  (I prefer to use the National Venture Capital Association's Model Documents -which are drafted to reflect current practices and norms and  "avoid bias toward the VC or the company/entrepreneur."

 
So what are the cases when I'm OK with a convertible note? 
 

  • When a VC round is already underway or imminent.
    There are times when a company is already in talks with a number of venture firms, but wants to take some money in advance of the round.  This money often lets them make key hires or purchase necessary hardware so that they can have a stronger hand in their VC negotiations. In these cases, I'm comfortable participating in a bridge note -- provided that I am reasonably confident that a venture round will close within the next 60 days.
     
  • When I'm not expecting (or expected) to be an active investor.
    While I try to help create value for all my portfolio companies, there are sometimes circumstances where I am not the lead investor -- and am not expected to be extremely active.  These tend to be situations where I have a smaller investment and am more "reactive" than "proactive".
     
  • When the discount (or warrant) coverage increases over time.
    When I invest in a note, I prefer that the notes are structured so that the conversion discount (and/or warrant coverage) increases as time progresses.  If a company closes their venture round two months after I purchased my note, I should get less of a benefit than if takes the company eight months to raise a VC round.
     
  • When the note has some equity-like protections.
    Any bridge note should have provisions that (1) prevent the company from pre-paying the note without the approval of the noteholders (otherwise I could get redeemed for interest only without converting into the next round); (2) provide a pre-specified payment in the event of a change of control prior to a venture round (so if a company gets acquired before the note converts, the note holders get a return of X); (3) put a cap on the amount of additional debt a company can take (so you don't end up with a company that raises millions of dollars via bridge loans); and (4) provide basic protective provisions.  In addition, if I'm leading the seed-round, I also ask for a maximum conversion valuation -- so that I'm protected if the Series A valuation is dramatically higher than I expected.

This analysis is by no means comprehensive.  But in general, I believe that if an entrepreneur wants a seed-investor who can add real value, it is not productive to economically penalize that investor when they add it.  Structuring a seed-round as equity allows the investor and entrepreneur to be completely aligned and share one goal - to create as much value as possible for the company. 

Howard is blogging...

Howard Morgan, my partner in First Round Capital, has just started to blog.  Howard has been a friend, advisor and mentor to me for the last 15+ years - and I really look forward to what he has to say. 

Check it out - waytooearly.firstround.com

Early stage companies bought for high valuations

Google_2 So I log in to mybloglog.com today (a great source for tracking where your blog readers come from and where they go) - and I notice that I received three visitors from the following Google Query: "early stage companies bought for high valuations".  Nice to see that I'm the only VC to show up on the first screen of Google results ;-)

My RSS Feed

RsshqApparently some readers have been subscribing to an old version of my blog's RSS feed.  To ensure that you are receiving all new blog posts, please make sure your RSS feedreader is subscribed to http://feeds.feedburner.com/redeyevc.  I apologize for any problems this might have caused you...

Shrink a Market!

On the First Round Capital website we write that: "We love investing in technologies and business models that are able to shrink existing markets. If your company can take $5 of revenue from a competitor for every $1 you earn – let's talk!"  I’ve often been asked what we mean by that – so I thought it would be a good topic for a blog post.
 

EncyclopediaMy first company, Infonautics, was an online reference and research company targeting students (mostly high school students). While I was there, I got a firsthand education on “asymmetrical competition.” In 1991, when we started Infonautics, the encyclopedia market was approximately a $1.2 Billion industry. The market leader was Britannica - with sales of approximately $650 Million, they were considered the gold standard of the encyclopedia market containing “over 44 million words” written by scholars and “more than 80 Nobel laureates”. World Book Encyclopedia was firmly ensconced in second place. Both Britannica and World Book sold hundreds of thousands of encyclopedia sets a year for over $1,000.
 

However, in 1993, the industry was permanently changed. That year Microsoft launched Encarta for $99. Encarta was initially nothing more than the poorly regarded Funk & Wagnall's Encyclopedia repackaged on a CD – but Microsoft recognized that changes in technology and production costs allowed them shift the competitive landscape. By 1996 Britannica’s sales had dropped to $325 million - about half their 1991 levels – and Britannica had laid off its famed door-to-door sales staff. And by 1996 the encyclopedia market had shrunk to less than $600M. In that year, Encarta’s US  sales were estimated at $100M.

So in just three years, leveraging a disruptive technology (CD-ROM), cost infrastructure (licensed content versus in-house editorial teams), distribution model (retail in computer stores versus a field sales force) and pricing model ($99 versus $1000), the encyclopedia market was cut in half.  More than half a billion dollars disappeared from the market.  Microsoft turned something that Britannica considered an asset (a door-to-door salesforce) into a liability. While Microsoft made $100M it shrunk the market by over $600M. For every dollar of revenue Microsoft made, it took away six dollars of revenue from their competitors. Every dollar of Microsoft’s gain caused an asymmetrical amount of pain in the marketplace. They made money by shrinking the market.

[It is also interesting to note how distruptive business models have continued to impact the encyclopedia market - anyone care to guess what Google and Wikipedia have done to Encarta sales in the last few years?]
 

5a_7At Half.com, we tried to do the same thing. We quickly learned that most readers of fiction books finished reading the book within two weeks after purchase. So we launched a very simple feature on our site. Say you purchased a John Grisham book from half.com for $15 (versus a market price of $30). Two and a half weeks later you would receive an email from Half.com offering “your money back” – users simply had to check a box and we would list their book for sale for $15. The vast majority of users would relist the book for sale -- and we found that for best selling books, we would sell the exact same copy of a book four times. That is, Buyer A would buy the book for $15, read it and sell it to Buyer B for $15, who would then read it and sell it to buyer C for $15, who would read it then sell it to Buyer D. Of course, we would take commissions from every sale – say $3 – and shipping charges – say $2 – from each sale. So for the four transactions, the out of pocket cost to the buyers would be $20. Now if half.com didn’t exist, you can assume that the books would have been purchased through traditional channels for $30 each – for a total out of pocket cost of $120. Think about it. For every $1 of sales on half.com, we took $6 away from the existing traditional channel - another example of  asymmetrical competition.
 

Free411This is the reason why I’m so excited about our recent investment in Jingle Networks. Jingle is the owner of 1-800-FREE411 – the country’s first nationwide provider of free directory assistance. Launched late last year, the 1-800-FREE411 service offers consumers a free alternative to the high cost of 411 service provided by traditional carriers. By including a ten-second advertisement before giving out a phone number, 1-800-FREE411 saves consumers on average $1.25 each time they look for a phone number from their telephone. Since American consumers use traditional 411 services 6 billion times a year, 1-800-FREE411 has the potential to shrink an $8 billion market. I believe (and hope) that as consumers shift to ad-supported directory assistance, we will take a significant share away from the entrenched carriers.

 

If you have a business that will shrink an existing market, allowing you to take $5 of revenue from a competitor for every $1 you earn, let’s talk!

 

For a great inside look at the creation of Encarta - I'd suggest "The Microsoft Way" by Randall Stross.  Just $0.75 on Half.com...