Every once in a while, I’m reminded just how harmful overlawyering can be.  I just finished preparing an operating agreement for 3 partners in a new venture.  They have a promising startup with a couple hundred thousand in seed capital, seeking to raise maybe a half million more to fund their initial operations.  I worked with them to prepare a detailed operating agreement, standard founder intellectual property (IP) assignments, and consulting agreements to govern their go forward work for the company.  That’s about all they need at this nascent stage.

All was good until one of the partners decided it would be a good idea to have their personal counsel look over the documents to protect their personal interest.  (After all, I’m company counsel, not founder counsel.)  Unfortunately for the company, founder’s counsel is what I’ll call an “Overlawyer”.  Next thing you know, I have a seven page memo of comments on the operating agreement.  And that’s not counting the four page tax memo that followed.   Or the three separate counsel phone calls I fielded on a completely standard founder IP assignment.

Mind you, most of the memo was written by a third year associate in his vast business experience (nice guy though, kind of sad to see him indoctrinated).  It was then reviewed by a senior corporate partner, and I’d estimate the combined hourly rate of these two lawyers at about $1,000 per hour.  Needless to say, many hours and thousands of dollars later, we are all “agreed”.  About 15 minutes’ worth of the input from Overlawfirm’s tax counsel was helpful.  Aside from that, what do I think was improved in partner’s “deal” as a result of their hiring Overlawyer to represent their interests?  Zero. Nada. Zilch.  The company will function exactly the same as it would have otherwise.

So everybody talks (complains) about the cost of Overlawyers in terms of dollars.  And the financial cost is ridiculous, no doubt.  But people rarely talk about the nonmonetary costs of an Overlawyer approach, which in my book are just as, or even more, detrimental to an entrepreneurial venture.  In the current founder situation, Overlawyer scared its founder client into worrying that certain benign document provisions were detrimental to founder (and somehow only to founder—odd, since they applied to all the founders equally).  That needlessly instilled in Overlawyer’s founder a certain degree of mistrust in both company counsel and in founder’s partners.  That’s a crying shame, because we all will be working together for years to come to build the business, and that’s not the right way to kick it off.

Worse, the business partners have just spent weeks negotiating with one another, rather than working together to advance the business.  The other partners who didn’t hire separate counsel were frustrated by the delay, and they aren’t happy that their partner sought out special protections for themselves rather than just doing what’s best for the company like everybody else.  These things take a toll on founder relations.

Finally, by incessantly prioritizing individual founder interest before the company’s operations, Overlawyer missed the forest for the trees.  Had I not put my foot down, founder would not have properly assigned their IP to the company, and the company’s decision making processes would have been held hostage to founder.  That would have made the company less investable, less functional, and quite likely, less successful.  Ultimately, what serves the founder’s financial interest in the startup context is a well functioning company, and that is a fundamental business truth that remarkably few Overlawyers grasp.

I’d like to say that this experience was unique, but it’s not.  While of course there are Overlawyers at firms of all sizes, I find almost an inverse relationship between the size of the law firm, and how prone they are to utter nonsense like the above.   There are structural reasons for this.  Many lawyers at big Overlawfirms have never done anything in their professional careers but practice law, and as a consequence have little ability to distinguish between salient business risks and theoretical legal issues.  Every business lawyer I’ve ever met likes to claim that he or she is a “practical lawyer,” and 90% of them are full of crap.  The inefficient approach is also inherent in the internal Overlawfirm financial model, which relies on leveraging young, inexperienced associates to enhance revenues at the top of the law firm pyramid.  Indeed, Overlawfirm’s business model depends on its lack of restraint; if every hour is billable, every issue, whether important or not, is revenue.

On a less cynical note, there are many honorable Overlawyers who are not trying to churn billable hours.  They truly (but falsely) believe that they best serve their clients’ interest by advocating for them in this way.  I would like to see law firms teach their corporate attorneys that their number one goal is to facilitate their clients’ businesses, while acting ethically and protecting against undue (not all) risk.  Instead, big Overlawfirms tend to drill into their attorneys that their number one priority is to avoid missing anything, always turn over every stone, never make a mistake.  Risk avoidance at all costs.  This leads Overlawfirms to the conclusion that overlawyering is good lawyering.  It’s not.  And it can be fatal to an entrepreneurial venture.  Whereas Overlawyers seek to avoid risk at all cost, the very essence of all business, and most certainly venture backed business, is calculated risk taking.   Shy away from too much risk, and you choke the opportunity.

The Overlawfirm model is broken, period.  It works for few businesses at all, and almost never for entrepreneurial companies that must be nimble, practical and cost-efficient in their operations.  Entrepreneurs, if you find yourself with an Overlawyer, overfire.

Seeing last week’s Venture Capital Dispatch in the online Wall Street Journal, When Venture Capitalists Let One Slip Away, reminded me of Jim Armstrong’s (Clearstone Venture Partners) comment last year about false negatives. “You can afford to have a false positive; you can afford to invest in things and fail, but because the big ones are so rare, you cannot afford a false negative. You cannot afford to be looking the wrong way.”

Some VCs, like Bessemer and their Anti-Portfolio, list their best false negatives on their website. As Bessemer puts it, “Whatever the reason, we would like to honor these companies, whose phenomenal success inspires us in our ongoing endeavors to build growing businesses. Or, to put it another way: if we had invested in any of these companies, we might not still be working.”

If you think VCs and Angels have had some of the biggest investment oversights, here are some of the bigger and more amusing ones from outside the VC community:

“We don’t like their sound. Groups of guitars are on the way out…You really should stick to selling records in Liverpool. Electric guitars are now old hat. (Mike Smith, Decca A&R manager, turning down the Beatles in 1962)

“There is no reason anyone would want a computer in their home.” (Ken Olson, president of Digital Equipment Corp. in 1977)

“You ain’t goin’ nowhere son. You ought to go back to drivin’ a truck” (Jim Denny, manager of the Grand Ole Opry when he fired Elvis in 1954)

“You’d better learn secreatarial work or else get married” (Emmiline Snively, director of Blue Book Modeling Agency to Marilyn Monroe in 1955

“Rembrandt is not to be compared in the painting of character with our extraordinarily gifted English artist Mr. Rippingille.” (John Hunt, 19th-century art critic, on Rembrandt)

“You’ll sink, not like a lead balloon, but even faster, like a lead zeppelin.” (Keith Moon, drummer of the Who, when Led Zeppelin was forming)

“(His) compositions are deprived of beauty, of harmony, and of clarity of melody.” (German music critic in1737 about Johann Sebastian Bach)

“Far too noisy, my dear Mozart. Far too many notes.” (Emperor Ferdinand of Austria after a performance of Mozart’s Marriage of Figaro in 1786

These examples should give you a pretty good idea why Angels and VCs don’t typically invest in music, movies or other forms of content.

Over the last few years I’ve written extensively on strategic exits and encouraged Angel investors to concentrate their investments where a strategic exit is highly likely.  I have focused on strategic value investments as I have found convincing evidence to show that these have higher ROI, shorter investment periods and lower execution risks. I have observed that more Angels are now discussing strategic exits, but find that there’s some confusion as to exactly what is a strategic exit.

I don’t believe there’s any confusion that a strategic exit does not occur where a single individual buys a business to manage it themselves. There are no benefits which accrue to the buyer beyond the boundary of the firm. Any return the buyer receives on their investment must come from the revenues and profits generated by the assets and capabilities of the acquired business. However, we would anticipate that a smart buyer would bring additional knowledge, funding, networks and experience to the business thus improving the return on the investment. In fact, knowing they could generate higher profits from the business through their own contribution, they may be prepared to bid higher for the right to acquire it. This is clearly a financial acquisition rather than a strategic acquisition. Therefore, the sale is a financial exit.
On the other hand, a business which is bought solely for its IP by a corporation and which has no revenue history or sales capability and will never be managed as a stand alone entity is a strategic acquisition. The buyer anticipates bringing the acquired IP into their own organization and leveraging their extensive capabilities, funding and distribution channels to generate new revenue. This would be strategic sale.

It is the direction of the benefit that determines what type of sale occurs. If the benefits of the acquisition are to be generated from within the acquired firm, even if the buyer puts additional resources into it, this is a financial sale. So even if the buyer provides trademarks, IP, new processes, new management, additional funding or excess demand to improve the performance of the acquired firm, it still remains a financial acquisition. The return on their investment is received solely through the performance of the acquired firm.

We might also argue that costs which are outsourced to the buyer, such as head office and services costs, do make a difference to the profitability of the acquired firm but this hardly makes it strategic. The acquired business still operates substantially as a stand alone entity from a product/market interface and the ROI must be generated through its revenue stream.

Moving to a different scenario, I would classify any acquisition as generating strategic value for the buyer if the buyer’s revenue, separate from that generated by the acquisition itself, was either protected (threat mitigation) or enhanced (opportunity exploitation) by the acquisition. Any situation where assets or capabilities are passed to the buyer to exploit within the buyer’s organization and which changes the buyer’s future prospects should be considered as a strategic value acquisition.

There are situations where the acquired business continues in operation, improved or not, with assets and capabilities passed back to the buyer’s organization. This would still be a strategic acquisition as additional benefits are being derived by the buyer beyond those which can be generated within the acquired firm.

This classification is critical for preparing a business for sale. A business which achieves its highest value on sale through its own revenue and profit potential needs to be structured for a financial sale. The bulk of the sale preparation effort needs to be put into revenue and profit growth, risk reduction and identifying growth potential which the buyer can execute on within the business. Any marginal strategic value or buyer synergies enhances the potential sale price but the major thrust of the sale preparation strategy remains with revenue and profit growth.

Alternatively, a business which achieves its highest value on sale by providing a large corporation with a means of mitigating a significant revenue threat or exploiting a major revenue opportunity through the transfer of acquired assets or capabilities, should be prepared for a strategic sale. The value of the strategic acquisition to the buyer is mostly determined by the size of the threat or opportunity within the buyer’s organization and not by the revenue and profit generating power of the acquired firm. In this case, the existing or even potential revenue and profit/loss of the acquired firm may be entirely irrelevant in determining what the business is worth to the buyer. You would prepare a strategic sale by concentrating resources on ensuring that your strategic assets and capabilities are structured so that the buyer can rapidly exploit them within their own organization.

We should not confuse the source and size of the value generated with the price paid to the sellers. The sale price achieved often has much more to do with positioning, preparation, negotiation and competitive tension in the deal. Any high growth potential firm suited to a financial sale, if handled effectively, can easily achieve 3 to 5 times a conventional (EBIT multiple) sale value. On the other hand, a venture suited to a strategic sale can often achieve a sale price equal to 20 to 100 times their net asset or revenue values.

A premium on sale to a corporation may be due to the inherent potential in the acquired business rather than synergistic or strategic benefits accruing to the buyer. Just because a corporation buys a business at a premium over the industry norm EBIT multiple does not make it a strategic acquisition. Rather it is only where additional benefits are achieved outside the boundaries of the acquired firm which determines it is a strategic acquisition and thus a strategic exit for the sellers.

On Thursday (10/22) this week, join us for a full day of worthwhile events in Altadena at Tech Week. The morning’s session features a Cleantech program, moderated by Ben Kuo of SocalTECH.com. Along with Ben’s program, there’s a great keynote presentation by Barbara McQuiston of DARPA and a couple of panels featuring Wired Magazine reporters.  [Shameless Self-Promotion Alert]…The last program of the day is the annual Pasadena Angels program on the state of Angel and Venture Capital in Southern California. We’ll have a great group of panelists (no immodesty here, since I’m just the moderator) that afternoon, and I’ll provide some comments and feedback from the event in my next post.

Interesting post on Jason Calcanis’ blog this week (also picked up by Ben Kuo and SocalTECH) with further thoughts on Angel groups charging startup companies to pitch. All of his posts on the topic are not only good reading, but accurately describe what goes on within some Angel groups (e.g., These pay-for-play scams remind me of the “modeling agencies” that charge people for representation, acting lessons and to have their headshots done.). Although I’ve written on this topic and share Jason’s ire,  I’m not yet at the point of ‘jihad’ (crusade maybe) or calling out particular Angel groups. Other than what Jason and I have already mentioned, the only other advice I can give is beware of for-profit angel groups based on a franchise model–as those are typically the ones that charge companies. If they don’t make money the old fashioned way and exclusively through investment returns, then they aren’t worth talking to.

As I was writing another installment on what the Pasadena Angels look for in company pitches, I came across a good post from Steve Blank about sufficiently understanding your customer and target markets and decided to use that instead. Steve’s observations are pretty representative of what we regularly see when companies pitch.

Lastly, Jeff Sheldon, a longtime member of the Pasadena Angels and well respected IP attorney and litigator put together a good reference on Patenting Inventions.

Have a great weekend. Patenting Inventions

I recently reviewed a set of investment ready criteria published by a respected Angel Group (not the Pasadena Angels). All the usual factors were there–what problem was being sold, the extent of competitive advantage, the experience of the management team, size of market, etc.  You could quickly infer from the questions that the objective was to find a high growth potential venture to invest in. No doubt the intention was to fund the company,  establish a market position, grow market share and then somehow harvest the venture. What I found remarkable was that the question of possible exit path wasn’t on the list.

Perhaps I shouldn’t be that surprised.  I recall conducting a study 5 years ago when I and a colleague reviewed several hundred VC websites to ascertain the extent to which exit strategies were discussed or requested in investment proposals. Even then I was surprised to discover that over half the sites had no mention of exits and not one had an explanation of the various forms of exit and an indication of what information the VC firm would like to see on the proposed exit strategy. Five years on and I had hoped that we would have gained a much better appreciation of the importance of the exit to the investment evaluation.  It seems I was wrong.

What I find distressing is that we still seem to be locked into a business concept from the 70’s and 80’s where the dominant VC model was to grow a business to a point where it could be taken to an IPO.  In those days the pent up demand for hardware and software meant that any reasonable product could fuel significant growth so an IPO was a real possibility.  Then along came the internet boom followed by the biotech boom and that simply reinforced the conventional wisdom. However, it is very clear now that the days of easy IPOs are gone and so is the conventional VC model.

In the present environment our liquidity options now are very limited, basically the best and most likely path is a trade sale.  If that is the case, then why are we still fixated on building out the business. Surely the question we need to ask is – what form of trade sale is the best harvest option for this venture?  Only then can we deal with the other criteria. Is it not the case that the exit method drives the development of the business?

Before we get tied up in legal and financial due diligence we should be working out the exit. We should be ascertaining how the venture will create value and what type of acquirer wants what they have?  Since there is a fundamental difference between a trade sale based on inherent revenue and profit generation from one based on exploiting an underlying patent or other form of IP, these are critical to an evaluation of whether the venture can be prepared for sale.

Asking about market share, distribution channels, management experience, R&D pipeline and so on, before ascertaining the exit path is clearly asking the wrong questions.

With everyone facing budget cuts, does it still pay to go to major industry tradeshows?  I am returning from one of my industry’s biggest, and the answer is an emphatic “Yes”.

We were going to a major trade show that drew more than 4000 attendees in better years, and were concerned by reports that many friends and clients that attended in prior years were not going in 2009.  Attendance was down to 2000+, but our sales productivity was high, in spite of the reduced numbers.

Why?  The pattern was clear:  companies cut their delegations in half, sending only the key decision makers.  All of the junior staff that normally attended were left home, so we could focus on the right individuals more easily.  As a bonus, the weaker competitors were also gone.  We had our best show ever, hands down.

What were the lessons learned?

1. Prospects are will attend the best trade shows, but weaker ones are languishing.  Focus your efforts.
2. If your business generates revenues for your prospects, like ours, you will be very popular at shows.
3. Your prospects are sending only their most senior staff.  Send your best people.
4. Cut costs.  Our senior team shared rooms, and we kept our entertaining to a minimum.  Those tradeshow breakfast and lunches aren’t great, but they are free.  And you can network at the cocktail hour just as easily as you can in an expensive restaurant.
5. Frugal is the in thing.  Get rid of the corny trade show goodies, and focus on helping your prospects succeed in their business.  They will take you more seriously, and you will avoid offending with any signs of excess.

Trade shows are still a great sales asset, even in tough times.  Find the budget for the key ones in your industry, even if you have to cut back elsewhere. 

I’m off to Asia, so today’s post will be briefer than usual. Earlier today I came across an interesting post by the BBC (yes, that BBC), The Problem with PowerPoint.  Although they have a great global perspective and I listen to their Internet radio extensively, I don’t typically expect to see much coverage of our landscape. Their brief article provides some good advice for the PowerPoint junkies in our world, as well as any entrepreneurs pitching investors. It’s also a good complement to the other articles/videos on investor presentations we’ve had in earlier posts from David Rose and others.

The second article worth reading is from Mark Cuban (yes, and unfortunately that Mark Cuban). Although as a Lakers fan I don’t have a very favorable opinion of Mr. Cuban, this article provides a good example and analysis of a an email received from an entrepreneur that will eliminate any chances of getting funding and is very similar to the 4-6 emails received each week by the Pasadena Angels.

Following on the heals of last week’s post from Andrea Belz, we have another guest blogger, Bob Aholt. Bob is a Director and long-time member of the Pasadena Angels, has been investing in early stage companies for 5 years, and has been held numerous “C” level positions at private and publicly traded companies. Bob also teaches graduate level finance courses at Antioch University.

  By Bob Aholt

To set the stage, as an early stage investor, I look to invest in a “perfect storm” company.  That is, I’m looking for a great Entrepreneur, a great product and a great deal.  I’ll leave the discussion of what comprises a great idea and a great people for another post, but here I’ll give my rational behind what constitutes my version of a plausible deal.

It all centers around Return on Investment, or otherwise known as ROI.  The higher the ROI the better the investment – brilliant eh?

Now for some details.  Lets start with the definition as presented at Investopedia.com (one of my favorite resource sites).

For this conversation, I’m going to focus on gains exclusively from a sale and forgo a discussion on ROI from cash flow.  Not that it’s irrelevant or infeasible, just that early stage investments are generally more exit strategy centric.

So for an example lets assume a $500k investment in a company with a $600k pre money that professes to have an exit plan that will garner a $5m sale in 5 years.  The investor ROI on this is 355%.  [Gain = $5m *$500k/$1.1m], [Cost = $500k].   The gain divided by the cost of the investment is often referred to as the multiple.  In this case 4.55.  Typically, I hear the “multiple” referenced more than ROI in Investor presentations. Since they are derived from the same parameters, they are rather synonymous, but as the ROI calculation includes the time parameter, it’s more relevant to me.

Two other statistics that also come up are Net Present Value (NPV) and Internal Rate of Return (IRR).   Excel quants will be able to calculate these fairly simply, and in this example come to $828k (at 10%) and 35% respectively.  However, from my point of view, really only the multiple or ROI are necessary.  That’s because all these numbers are all based on a rather large set of assumptions.  That’s where I’ll turn my attention next.

Assumptions:  everyone knows how the game is played.  All Entrepreneurs say their projections (from revenue, to expenses to exit values) are conservative.  All investors feel they are, at best, an educated guess.  From what I’ve seen, and what I appreciate most, are a couple of different scenarios – best case, worst case and expected case – with the parameters and assumptions clearly laid out.  If I can buy into a plausible scenario where the exit is approximately a  400% ROI or a 5x multiple in 5 years then I’m willing to go further along in the conversation.

As someone looking for funding, lay out your case as to why your company will be bought for $5m in 5 years (in the above example).  As an Investor, I understand that 5 years out is an eternity for an early stage company, and the scenario has a better chance of being wrong than right, but I need to know the Entrepreneur has thought through the process and that the scenario is realistic.  Sure there’ll be adjustments, course corrections and outright changes to the business model, but my end goal is still a high ROI and I need to know the company understands that perspective.

In the financial part of a presentation, I’m also looking at the company’s validation points.  From inkling to viability my list includes:

- idea – is this all the company has at the moment
- beta – is there a proof of concept to show
- customers – is someone using the product
- sales – have the customers agreed the product has value
- gross margin – can the company make the product for less than its sold for
- operating profit – can sales cover the cost of doing business too
- positive cash flow – a going concern

If the company can present a timeline showing each of these milestones, or at least the ones that get it to the exit point, the story becomes much more plausible.

Since an investor is focused on ROI, the implication to valuation now becomes clear.  All else being equal, the lower the valuation the higher the (potential) ROI.  Using the example above, if the pre money were $1m instead of $600k, the ROI drops to 233%.

A note about subsequent raises and dilution.  If the company is going to need more capital than Angels can supply, that’s ok.  There are plenty of examples of Pasadena Angel companies that have had multiple rounds of funding and provided quite good returns to the investors.  The Entrepreneur needs only reflect the smaller ownership percentage of the initial investors in the ROI/multiple number. Usually the follow on funding is presented in a scenario where the exit amounts are higher, so mathematically, the results could be a wash.  Again, for me transparency, plausibility and clear assumptions are most critical to persuading.

So to sum it all up, an investor’s ROI depends on three things: exit price, the length of time to the exit and the percent of the exit received by the investor.  The first two – sale price and duration – are heavily influenced by the quality of the idea and the people executing (not to mention luck).  Valuation (and any subsequent raises) are casual to the percent of the sale received by the investor.  And valuation is the only variable in this equation that can be controlled at the time of investment – that’s why it becomes such a critical negotiation point.

Hypothetical Example
THE RAISE
Investment    $500,000
Pre Money    $600,000
Post Money    $1,100,000

OWNERSHIP
Founders    55%
Investors    45%

EXIT
Sale Price    $5,000,000
Time    5 years

INVESTOR RATIOS
ROI    355%
Multiple    4.55x
IRR    35%
NPV @ 10%    $828,000

From time to time we have posts from local members of the startup community that provide some great advice from a different perspective. Today’s post is from Dr. Andrea Belz, a long-time member of the Pasadena Angels, a local consultant and one of the brightest people I know (a CalTech PhD–what more can you say).  Although Andrea provides five simple questions to ask when commercializing university technology, these can also be applied to most startups—whether they get their start in academe or not.

     By Andrea Belz

Many entrepreneurs approach Angel groups and VCs with novel technologies and strong technical teams.  Unfortunately, they often “forget” to conduct any marketing research, mainly because they don’t understand how to do it.  Even worse, technical teams with strong resumes may attract plenty of funding, but eventually they may hit the wall (at investors’ expense) once everyone realizes that there is an interesting technology but no interest from the outside world.

This problem can be especially acute when the local community includes a strong research institution interested in technology commercialization.  People often underestimate the gap between the technology’s readiness to exit the university or research laboratory and its readiness for market.  This gap often takes five years to overcome.   Furthermore, technologists almost always underestimate the difficulty in selling anything – the hardest challenge in almost any organization is to get someone to write the first check.

Entrepreneurs should be sure to ask themselves a few key questions before pursuing a plan to commercialize technology, particularly with investors.  Investors can use these questions as a guide to the entrepreneur’s “coachability”.

1. Have you spoken with anyone that might be an end user of the product and lived in their world for a day?
2. Have you listened seriously to his/her feedback without foolishly discarding it (“They just don’t get it”)?
3. Do you tell people about your technology or about the benefits?  In other words, do you sell the drill or the hole?
4. Can you estimate the size of your market and have you found “low-hanging fruit”?
5. If the low-hanging fruit is not the first application you considered, are you willing to shift direction?