Yearly Archives: 2007

Convertible Notes versus Preferred Equity, Part 1.5

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Oh one other quick word.
When I started dealing with term sheets in both Notes and Preferred Equity, I strove for understanding. I went in thinking that this was an orderly process and that there were standard contracts for this sort of thing.
The one thing I learned is that NOTHING IS STANDARD.
Terms are written purely on whatever the entrepreneur and the investor(s) want. Yes, there are standard things like interest rate payments or anti-dilution provisions, but as for what interest rate to pay or which type of anti-dilution provision of which there are many…all up for grabs.
So if anyone tells you their term sheet is standard in the industry, don’t believe them. Everything is negotiable, so just say, “Thanks I’ll take a look and get back to you.”
Onwards to Part II…

Convertible Notes versus Preferred Equity, Part I

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Just recently the issue of Convertible Notes vs. Preferred Equity came up with an entrepreneur. It was an interesting discussion and caused me to think deeply about both types of financing methods and why entrepreneurs and investors may or may not like either one.
In this Part I post, I describe what I’ve learned about Notes and Preferred Equity. This is by no means exhaustive or even showing that I’m an expert in this, but I choose to state what interesting information I did dig up over the many months I’ve been doing this angel investing stuff.
Characteristics of Notes:
1. They are cheap. I just heard a quote from a law firm that, after terms were set, you could close a Note at about $1000 in legal fees.
2. They are quick. You can close a Note in about 2 days, assuming everybody gets their cash transferred in. If you need cash in a hurry and the other larger financing round is going to take more time to close, then the Note can give you cash in the short term very quickly.
3. The paperwork is minimal. Only one document is required, which is expanded from the term sheet and spells out the terms of the Note in exhaustive detail. Investors sign that, the money is transferred, and you’ve got cash.
4. At early stage, many companies have little assets. Generally, for early stage startups, Notes are unsecured, meaning they are not backed by the assets of the company. So if you go under, you are really under no obligation to pay investors back.
5. It keeps options open for the next equity financing. Valuations may change and the Note doesn’t cause any potential issues with Preferred Equity ownership prior to the next round of financing.
6. Negotiation on terms is possible, increasing time and cost to close.
7. Notes, or convertible notes, are basically loans to the company. The investor doesn’t own any part of the company, and there is a promise to pay back the loan with interest. The convertible aspect means that at some point, generally when the next financing occurs, the money you invest would convert to the terms of the next financing. Sometimes it’s spelled out as to which financing it is, and sometimes it is not.
Characteristics of Preferred Equity:
1. Preferred equity holders gain actual ownership in the company.
2. It locks in a valuation for the company at time of closing.
3. They are more expensive than Notes to close. A recent quote, after terms were set, would cost about $10,000 to $20,000 in legal fees to close a Preferred round (versus the $1000 of a Note closing).
4. Preferred Equity rounds take longer to close. They may take up to 3 weeks to finalize everything (versus as little as two days for a Note).
5. There is more paperwork involved. A Note involves only the expanded Note document. A Preferred Equity round involves a Stock Purchase Agreement, Investor Rights Agreement, filing of changes in the Articles or Certificate of Incorporation, potentially a Voting Agreement, and other supporting documents and changes. After all the paperwork is signed, a Preferred Stock certificate is sent to each shareholder.
6. It will require an official board meeting resolution to approve, and recording of minutes.
7. Negotiation in terms is possible, increasing time and cost to close.
8. Preferred Equity may cause issues in further financing rounds as follow-on round investors may desire more ownership and/or control in a company and may be deterred from investing by the fact that there already are Preferred Equity owners present.
9. Preferred Equity holders get preferential treatment as defined by terms. These can be things like, in case of company liquidation, they get paid back first, or anti-dilution provisions, or special voting privileges, or the ability to select a board member to represent their interests.
In Part II, I look at Notes versus Preferred Equity from the entrepreneur point of view. Part III will look at Notes versus Preferred Equity from an investor point of view.

The First Investor Meetings!

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A potentially scary moment is when you get into your first investor presentations. One of my startups is doing that right now. So before the meetings, I tend to send lots of comments to prepare them. Here are some of them:
1. You will be presenting a term sheet. Most VCs will present their own and I am sure it will be investor friendly. See item 2 below.
2. VCs may tempt you by closing quickly and shoving a term sheet in your face, hoping that the positivity and amount of money will sway you into signing right now to get the money. See item 3 and 4 below. My advice is to never sign anything especially in the emotional euphoria of a positive meeting. I would shop around first and make them compete against each other if possible on terms.
3. Always be ready to say ‘Let me think about it.’ Don’t accept anything too quickly.
4. Don’t let desperation cloud judgment. Ever. And it’s corollary (see item 2 above), don’t let euphoria cloud your judgment either!
5. There may come the option to skip the note if a VC you like wants to close quickly. Be ready to address this as an option, and hopefully a positive result for both you, the VCs, and us angels. By positive I mean that we all invest in and get stakes in the series A. Negative results would mean us angels may get squeezed out.
6. Make the note close between 250K and 400K. Keep the option open to close sooner if you think it’s a good idea, or to extend fund raising to grab the extra 150k for a total of 400k. Don’t just close on 250k if you think you’ve got it. You may be able to get the full 400k if you work a little harder and a little more time. Remember item 3 above.
7. VCs may want part of the note. Especially if you’re giving a discount. They may demand to write into the note the right of first refusal to invest in the series A of some percentage. I would recommend not letting them do the full amount, but say up to some percentage like 50%.
8. VCs may attempt to squeeze us angels out to gain a higher percentage of ownership of the company. Being an angel, I will only ask that you do not let this happen for our sake.
9. VCs may demand a board seat. This is probably ok, but make sure you select the board member VERY CAREFULLY. You should get along with this person, like them, and want to work with them. Getting rid of a board member is not like firing an employee. You will be stuck with this person for a long time. Choose carefully and wisely.
10. VCs will undoubtedly ask for a huge percentage of the company. I would only say that a smart VC should never un-incentivize an entrepreneur by taking huge stakes in the company and dropping the entrepreneurs ownership to near nothing. It’s a dumb move and unnecessary. I would say you could get away with 25-40% depending on the situation.
11. VCs may like the idea so much they want to give you more money. Be also very careful of taking too much money. It will affect valuations, ownership percentages, and also exit strategies. Now venture funds are huge with cash; they want to deploy more whenever possible. Don’t let them tempt you into taking too much!
Other stuff:
1. Be prepared for the due diligence process. It involves getting a huge amount of paperwork delivered to potential investors. Get it all organized and ready to go now, and thankfully you haven’t been in operation very long or else the paperwork could be immense.
It’s always an exciting process to present your ideas and business to potential investors. It is unfortunate that there are so many sharks out there and trying to not get eaten is the name of the game.

VoxPop Goes Live with Oscars Game, Yankees Decade of Dominance

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One of the coolest things I’ve seen is when one of my startups gets their first site or application up and running. VoxPop has been busting their butts getting their first two promotions up:
EW.com Presents the 79th Annual Academy Awards: Pick the Winners
WCBS Newsradio 880 Presents the Yankees Decade of Dominance Tournament
Incredibly well done and designed. Their contest engine is working nicely and the front end design is beautiful. Check them out and enjoy!
Learn more about VoxPop on their site…

Guardian Angel

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The other week one of my entrepreneurs jokingly referred to me not just as an angel (as in angel investor) but as a guardian angel. I laughed.
But it’s also got some real serious undertones.
The more I meet entrepreneurs, the more I realize that there are real BIG holes in their knowledge. This is even more apparent with first time entrepreneurs. Even I had big holes in my knowledge base regarding investing and startups when I started David Shen Ventures, LLC.
How did I learn? I tried to find people to sit with me and talk with me. But so many of them are all busy and I also found out that a coffee or lunch is just not enough time to go through everything and have it sink in. I tried looking for books, but many were too generic to be useful. I did find a series of really expensive books on venture funds but they were very complex to read and took a while to figure out what they were talking about.
I eventually paid my lawyer for about 1.5 hours to sit down with me and go through some example financing docs. I made notes on these complex term sheets and other paperwork and then I could go back later and review what I had heard and written down. One funny thing was that when I met with my lawyer, he actually brought on another lawyer whom he partners with in financial deals. He was probably the most conservative, worst-case-scenario lawyer I had ever met; I almost quailed at giving my money to anyone after talking to him! But I also learned that early stage startup investing is not for the risk averse and that you can’t get the same security as for other more established companies in later stages. Still, that 1.5 hours was not enough time to let everything sink in, but I had a better base to draw from.
Then I started reading some blogs about venture funds. I especially like Josh Kopelman’s blog and I find his posts about investing in general to be really informative. This brought more knowledge in but still didn’t complete the picture.
It was when I started doing a few angel investments when I really started to hit my stride. Arguing for terms was one of the best ways to firm up in my mind what risks there were in a particular deal. So many details all intertwined: valuation now and in the future to achieve a given return, percentage company owned, future return, squash prevention (or preventing dilution), notes versus preferred series. I always carry a calculator with big buttons with me at all times to punch in numbers and make sure my mental calculations are correct. I am getting more and more proficient and arguing from at least the point of view of a knowledgeable angel investor.
Now think about the new entrepreneur. Not much cash. No exposure to the financing world for the first-timers. I was willing to pay for some of my education with my lawyer (I just thought of it as educational expense) but others can’t afford that. So what do they do? Where do they find help?
As advisor, I feel compelled to help them. And I don’t mind as many meetings as it takes to get them educated. With this particular entrepreneur, I have had meetings weekly, many email exchanges, and also sat in with them on presentations. We talk about everything. The presentation, what to talk about, financing strategies, the usual company strategy stuff that I advise on (product, user experience, advertising, etc.), everything.
Before presentations, I email them for things to watch out for, and remind them to mention this and that. Post-meeting I email them again and give them one person’s objective view on how it went. We go over the financing strategy and explain to them some of the details that are hard to understand if you haven’t done it yet. I give them strategic advice on the pros and cons of doing financing one way or another, and how investors will react to certain terms. I give them example term sheets and show them what terms can look like, and what investors like and don’t like and why.
I make myself available to them because I know there is no one else that is willing to spend that much time with them. And while I give them information, I try not to make the decisions for them; I make sure they have as much information as possible so they can make an informed decision and not one that has blind spots.
So from angel (investor), I became guardian angel. I keep them out of trouble as much as possible and in many cases I’m the only guy doing it.
How ridiculous is that. In our world, we seem to have major problems finding mentors who will give their time and expertise to others. If you don’t have the connections and relations, then it gets even that much harder to find someone who is willing to help you. I for one hope to change that with my entrepreneurs. It is my belief that whatever knowledge I give them will give them a greater advantage over other companies who are still in the dark.

Yet Another Startup: Thank God for IKEA

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Yet another startup setting up in San Francisco offices. A nice space right near the CalTrain station!

I think that SF startups would have a hard time finding furnishings if it wasn’t for IKEA being so close by. It’s so cheap to outfit an entire office! They really exemplify the concept of disposable furniture; if it breaks, you just go buy another one. When you’re done, you can just toss it.

The Power of Referrals

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Just recently, I’ve been thinking more and more about the power of referrals as applied on to Internet businesses.
Think about Digg.com. I “digg” an news article, so I hit the “digg” button and it gets tossed onto the Digg.com list. Because I “digg” it, I am essentially referring it those who subscribe to the Digg feed of news articles. In aggregation with the crowd’s opinions, as well as with some newly discovered editorial color on top of it, my referral could get sent to the those who like the Digg referral style of consuming news, as a way of uncovering interesting news.
On NYTimes.com, I just learned that they consider the number of times a story is emailed a better measure of popularity than just the number of clicks to read a story. If you think about it, calculating most popular based on clicks can have a self-fulfilling prophecy aspect to it; those on the most popular list are seen by more users who click on them more, and those stories inevitably stay on the most popular lists longer than they should. But, if you think the number of times a story is emailed, then you realize that if someone were to think this story is great, then they’re going to refer it to friends. It’s an added metric on top of how many times the story is read and helps fine tune out of self-fulfilling prophecies.
A new site I was just introduced to works on the same referral principle: downfly.com. It is a simple application which allows you to post a link on the site and it gets “passed” to your social network. Every now and then, I’ll get an email from the system that sends me links that get passed to me. As I use it more, I find it to be entertaining, a great way to discover new sites, and I also get to see what people in my network are thinking about and consider important enough to pass down their social network chain. But as I become a “passer” of links, I can’t help but think about what I’m passing and why and the ramifications of passing. I want to pass good links, not junk. I don’t want to waste peoples’ time by passing stupid links. I think about the value they’re going to get and make sure they get some from whatever site/link I’m passing them. I also can’t help but think about what they think of me as they’re receiving my link passes. That would be something interesting to implement is a feedback system that allows people to easily comment or feedback on the stuff they’re getting, as a mechanism to see if I’m doing a good job or not.
I see this referral aspect also in my advising/investing business. I see part of my job eventually is to help my early stage companies raise funding. I also see part of my job is to utilize my network to bring them valuable business partnership opportunities. But I told myself long ago that I need to build trust in my referrals to these folks. Investors don’t want to keep seeing junk from you; they’ll never take your call if you keep wasting their time with lame businesses. Potential business partners don’t want to see junk either. I think deeply about whether there is true value in a partnership with someone before I introduce them. I don’t want to make frivolous introductions, again because I want to continue building trust in my network that when I refer somebody to them, that I’m not doing that randomly, and that 10 times out of 10 it will be something they should look at.
Look at the effects of referral:
1. You the referrer have a desire to bring value to the receivers of the referrals. This altruistic notion forms the basis of the positive effects and power of referrals.
2. You think heavily on what could be interesting or valuable to them, so you’re careful at referring things to them. Thus, you as a referrer need to get to know your receivers at some level to know what could be interesting to them. If you don’t know them well, your referrals could have a negative effect on you as the referrer as your referrals could be perceived as random or junk. They may ask you to stop. Refer effectively by getting to know your receivers.
3. Successful or valuable referring can have positive effects on your reputation. It builds trust in your receivers of the referrals that you are giving them something valuable. It also builds trust in the thing you’re referring, like a website, or business opportunity, or news story. It was checked out by the referrer, whom you trust, and thus you have a tendency to trust it more too.
4. If they like your referrals, you may get value back, in the form of good referrals or otherwise. If there is some measure of how good a referrer you are, like a ratings system, you can gain in reputation in a visible way. That rating is value to referrer, as is other things.
5. Referrals can be a better measure of popularity and “this is valuable or good” based on all of the above, and helps remove self-fulfilling prophecy effects of other forms of popularity measures.
6. You refer poorly, or annoyingly, and people will shut you off. Trust is lost, and thus reputation is lowered. And also they will lose trust in the thing you refer. As an entrepreneur, make sure you get referred by someone who is trustworthy as a referrer, and not somebody who has low or potentially low trust amongst the people you’re trying to get referred to. This can be very hard to determine who is trustworthy as a referrer and who is not, so tread carefully.
7. The system which enables referring effectively can use this as a viral marketing tool to gain more customers or users.
As I think on the effects of referral, I am going to try to employ it more often in thinking on product strategy with my companies.

On Being an Advisor

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When I talk to entrepreneurs about working with them, I make it a point of saying that my business is based on the assumption that they will have a better of chance of success if I am actively helping them versus if I’m not. Therefore, if I invest in a company, I require them to make me an advisor. And yes, it’s also a form of investment protection for me since I’m watching over my money by being involved.
One might think that if I were to invest, that the advisorship wasn’t necessary. I would be tied to the company through the investment and the ownership that comes with it, and probably care greatly about the company’s progress and help when I can. In some sense it’s true.
But I have already come across cases where even though people SAY they want my help, they really don’t. They just want my money. One way to test that, besides watching my intuition about these things closely, is to see if they will sign me up as advisor.
When they do that, they need to be willing to compensate me for the advisorship. Since I deal with early stage internet companies, often pre-funding, I told myself long ago that I would not ask for cash payment like a consultant. Many people who do what I do will ask for consultant hourly fees to work with a company as an advisor. But I cannot. An early stage startup barely has cash already; to drain them of whatever little savings they may have could cripple or destroy the company. I would rather that they take that cash and build the business. In fact, I don’t think they would sign me up if I were to ask for cash. So I ask for options to equity, vesting over my term which is typically between a year to two years.
If they are willing to give up some of their options pool for me, then that is definitely a good sign that they are actively seeking my help since they are giving up some form of payment to me. It’s not 100% reliable, but there is nothing better than seeing a company give up something like cash or equity to ensure their engagement in you; they’re giving up valuable options that they could give to someone else like an employee, but instead they are giving it to me, so they better utilize me and get their money’s worth!
Being an advisor also clarifies my involvement in the eyes of outside world and within the company. I don’t want to be perceived as a bothersome investor, who keeps sticking his nose into the company’s business. With me, I’d be bugging people about product strategy, the user experience, and online advertising all day long. Without a statement of purpose like “David Shen is our advisor and he will help us in X, Y, and Z”, it becomes that much harder to communicate and reinforce why I’m hanging out with the company. I believe with that clarity comes acceptance that my advice will be given, and that they should listen. If they aren’t ok with that, then issues would come up during the advisor signup process in which case maybe it wouldn’t make sense for me to get involved with the company, if they don’t perceive my help as valuable. By the way, this has happened already.
It also clarifies in my mind what I’m supposed to do every week. If I’m signed up as advisor, I have an obligation to help them since I want to earn my options. If my term is over, then I can mentally shift and focus on the other companies whose terms are still on-going.
So is my help going to continue after the term? This part is still a bit undefined since my business is so new. A few thoughts on this:
If I’m an investor, I’ll always be around until I exit the investment. To what extent I am involved depends on the state of the company at the time of end of my advisor term.
I always tell people that by the end of my term, my goal is to teach you everything I know, help you get people in place to permanently take on what I have brought to the table, and bring on any relationships you need through my network. Generally, I think one year terms are too short to do this, but 2 years is a bit beyond the point of finishing this task. So somewhere between 1 to 2 years is where I think I’ll accomplish those goals (it’s very uncommon to do 1.5 year terms even if I think it fits my mental timeline of when I’ll finish my goals). For that reason I like 2 year terms better than 1 year, or else I think that the chance of not accomplishing those goals is high and if my advisorship does not get renewed for another year, then I’ll feel like my job with them is unfinished. So theoretically, if I do accomplish all that, then you’ll have people and relationships in place to do everything I helped you with, and only need minimal involvement from me post-advisor term.
I believe that when people see what value I have brought to them during my advisor term, that they will keep me engaged after my term ends. But I can’t keep shepherding them in their tasks; they need to be able to function effectively by themselves since I’m not an employee. And thus it’s critical that they hire great people who can do all the things I helped them with, and I will be helping with that aspect as well.
However, if they really want to lock-in my involvement post-advisor term, they should renew my advsior contract and we’ll keep going officially.
So far, being an advisor has been a rewarding experience. As I do my work, I am pretty active and aggressive at checking in and seeing opportunities and throwing ideas over to the entrepreneurs. I have found that they have really appreciated it. Anecdotely, I am finding that I am outpacing most, if not all, of the other advisors that they have brought on. I find this to be an interesting revelation. It seems to me that traditionally most advisors are only called upon very sparingly. Perhaps it’s because I’m an investor in some of these companies that I care more and want them to succeed; but I also am pretty regular in checking in with companies which are quiet at the moment.
Because of my seemingly extra effort, some of them have offered to find some way to thank me beyond what compensation we’ve agreed on. While I appreciate it, I do not expect it. The satisfaction I get in helping these entrepreneurs, seeing my help get them to success, getting caught up their energy and excitement for their company and product, being a part of the celebrations of closing their series A funding or their first $1 MM of revenue – it’s ample reward to know that I am part of that and that my help is being actively utilized, appreciated, and validation that my help is worth it.

Connections and Networking

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This week and the coming week I am bringing some entrepreneurs to meet with some people in my network. And the results of this week’s meetings reinforced to me the importance of connections in my line of work.
I had originally placed more emphasis on my personal skills, ie. product strategy, user experience, etc., in helping early stage internet companies. I had not thought my rolodex was strong enough to contribute in that capacity yet. But I knew as time went on, old colleagues of mine would leave Yahoo! and have ended up in some companies which I knew would prove useful to my companies. This would be a valuable asset to my business and, thus, I began a side project of networking more and getting out there as much as possible.
I also resolved to approach this networking from a slightly different perspective. There are what I would call professional networkers out there. I have found these people only network purely for business reasons. They get out there and have conversations about how they can work together and it rarely goes beyond business type conversations. I thought I would attempt my networking to have a slightly more interpersonal aspect with it. Yes, we would potentially begin with business focused discussions, but I would always leave the door open for making it not-always-business related. Who wants to keep talking about the industry anyways? Combining this with my belief that working together can be enhanced when you geniunely like hanging out with each other makes things a whole lot smoother and easier.
I am finding that as I do things for other people, that I also get some of that in return. For that, I am eternally grateful. Everybody is busy, but as I make time for others, they make time for me and my projects, like when I ask them to help me review their funding presentation.
We did just that late Friday afternoon and it was extremely fruitful. I brought one of my companies into a meeting with two guys who I thought had just amazing sense for putting creative deals together. When we left the meeting, I thought that it generated some real new possibilities that we hadn’t thought of, and now we’re going to talk about how that affects our final rev of the funding deck. If we can get some of these ideas in motion, it would certainly make our funding deck that much more attractive.
Another meeting I had was with a prominent media company exec I knew. First, I think my chances of gaining a meeting through cold calling was pretty slim. In this case, I had some history with this person and he was willing to take the meeting. It also turned out to be very good. While the person didn’t have anything specific for us, he was willing to introduce us to a person in another division who might be interested in our technology and product.
My strategy with these connections is thus:
1. I know the importance of the interpersonal aspect and thus am willing to try build relationships beyond just business.
2. I am willing to help them as much as they help me. And I won’t charge them for doing some presentations or just a meeting or coffee or two with someone they want to meet me and learn about what I do. I have always been willing to make time for any of my connections.
3. I continue to build trust with my connections.
The first area is with not bringing frivolous time-wasting proposals and startups to meet with them. I won’t do it. Everybody is so busy and time is valuable. I don’t want to setup a meeting unless I think they can really benefit from it. Thus, this maximizes the chance someone will take a meeting with me if they know that 99% of the time it will be something really cool and worth their time.
The second area is with investors. This is trickier. The number of people who claim to be fund raisers is staggering. But I think there is a problem with their business; almost all of the time, they are not investing into the companies they bring to investors. They get paid either on a percentage of successful fund raising or get paid hourly for their work. As an investor, you will never know if these are good deals or not; the person bringing them to you is getting paid no matter what! For me, I don’t want to work that way. I won’t open up my investor network unless I have put money into a company. It is the ultimate sign of confidence in a deal; you have put your own skin in the game.
Unfortunately, my investor network is the smallest out of all my networks. It’s definitely an area I’m working on now.
The third area is with introductions. There are some people who are willing to make introductions quickly. Almost too quickly. Perhaps that is a sign of trust for me. Perhaps not. But sometimes, I think it’s a bit too quick. I think they should think beyond the fact that it’s me and they know me. I think they should get to know why I want the intro, as well as the mind of the person they would be introducing me to, and then think hard on whether there should be an intro or not. Sometimes, there shouldn’t be. Or you might need to wait a while until conditions are better to ensure that there will be a successful response. Or maybe there should be an introduction yesterday.
This is in an effort to maximize value to both parties and minimize time wasted. It also helps the person who is the receiver of the introduction know that you, the introducer, aren’t making frivilous introductions and they just sit in an email inbox forever not read or responded to. My goal is to have 100% of introductions returned and matched up. If an introduction email is not responded to, I know I’m doing something wrong.
Build trust and keep building.
4. Lastly, I intend to be honest, clear, and straight-up about everything. If I can’t do something, I’ll say so. I won’t beat around the bush on that. I want people to know I mean what I say and where I stand no matter what.