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A bi-weekly column with timely, relevant and possibly irreverent insight into the BC technology industry.

Something Ventured:
July 8th, 2005

By Brent Holliday
Greenstone Venture Partners


Understanding The Underlying


"You can't always get what you want,
But if you try sometime, yeah,
You just might find you get what you need!" - Rolling Stones, You Can't Always Get What You Want

We talk a lot these days about "root causes" for terror in a search for understanding of seemingly irrational and definitely horrible set of acts perpetrated by fellow human beings. Obviously, the metaphor of "root causes" comes to my mind today on the heels of another senseless act in London. But, as I was watching the news and thinking of today's column topic, I decided to look at a popular issue with start-ups (financing) the way that some people are looking at stopping the terror: understand and fix the underlying issues that foment terror as a long term solution.

There are a series of conflicts that arise in getting a company up and running in BC that may or may not be different than other regions like the Silicon Valley. One of the conflicts is how to pay the people that are starting a company that runs on a shoestring budget. The best and brightest are needed for your company to be a success. How can you pay them at or below market in cash and get them to stay? Obviously equity compensation is a part of that, along with the chance to be a part of something "insanely great" (the opportunity needs to be more exciting than working in a larger company).

Another conflict in the start-up process is how much money to raise at any given point. You need financing to get you to cash flow breakeven. Do you take a lot early on to give you cushion to get through a series of important milestones? Or do you take little chunks at slightly higher prices? Both have their drawbacks. In the first instance, you would have to give up a lot of your company to financiers to take a lot of money, given the risk. In the second instance, you are constantly in fund-raising mode which keeps you from running your business. But this conflict, in my experience, is usually defined by a poor understanding by the founders of how much money it really will take to get the company to that magical breakeven point. More on that later.

Finally, a third conflict is related to terms of financing. This is the esoteric art of coming up with deal terms that try to align everyone's interests in a financing deal, but often put four distinct groups at odds with one another (founders, stock incented employees, previous investors and current investors). I haven't seen many instances of successful companies and haven't seen any instances of unsuccessful companies get to a conclusion (an exit or liquidity event) without one or more of those groups being unhappy.

Let me explain to you that the primary "root cause" in all of these conflicts is lack of experience or immaturity of our industry here. Although it cannot be fixed by anything other than time, it is not a cause for panic or despair. Understanding this "cause" and having a little humility in dealing with one another will help everyone out a lot, over time.

Back to the conflicts. Ask yourself honestly, what do you want? Cash compensation to pay for your mortgage, car and kids? Or sacrifices on current cash income for a potential, but risky, huge payout down the road? This is an age and responsibility dependent question in a lot of cases. Young, un-attached, un-mortgaged people can afford to take lower cash, work harder and longer and go for the payout. Older people that have paid down the mortgage, have the kids grown up or in college and have made a decent wage for many years, also can try their hand at a start-up for a few years and look for the big payout. Those in the middle with cash needs and time needs for busy households, usually need the cash now.

These are universal truths, applicable to any region in North America. Culturally though, we are not the Silicon Valley and are willing to take less risk. Why? The tech industry here is about 5% of the province's output and less than 5% of its workers. Chances are you are not seeing or married to a tech industry worker and most of your friends are not in the business either. Not so in the Valley, where (excluding San Francisco) nearly 50% of the region's output is technology or defense related and 40% of the people work in the industry. Chances are that the person at home needing money to pay bills or go shopping is also a tech worker and understands the demands of your business.

As a young, but growing industry, we are more cash oriented and less interested in stock compensation. Interestingly, this fact is one of many helping attract technology companies in the Valley to locate and staff here. Our cash is cheaper than theirs and we want less stock… seems like a no-brainer to me. As more and more of your friends or people you read about on this web site hit the jackpot with stock based compensation, this ability and willingness to take on risk will seem more appealing. The real question for CEOs and investors is, "does stock compensation change behaviour and align the founders and stock incented employees better with them?" If it does, then a more mature industry will help make more successful companies, at least in part due to the willingness of all employees and founders to increase shareholder value.

Related to the point of cash compensation, in an industry whose largest cost is always its people and what it pays them, is the conflict about how much money to raise from outsiders and when to raise it? If "good" people in this region require more compensation in cash, this can increase your needs. If these same team members would come aboard for more stock-based compensation, your needs are very different. This is dramatically represented by the following example from two recent transactions in the VoIP space. Kagoor Networks was bought for US$65M by Juniper. The company raised nearly $40M from investors. Clearly, this was not a good return for some investors and, depending on stock option pricing and terms of preference by the last investors in the deal, probably not very good for the stock incented employees. Jasomi Networks (an Alberta start-up with Silicon Valley ex-pats) sold to Ditech for US$20M, which most people would assume was not even a return of capital for its investors. How could a VoIP hardware company get started and sell product for anything less than US$20M raised? Well, they raised less than $5M CDN. So, it was likely a decent return for investors who were insiders and angels. How did they do it? Stock based compensation in the first year or two by the people they brought on who could afford to be paid very little. They got "good" people for next to nothing and parlayed it into more than annual cash compensation at their market rates.

How much money will your company need to succeed? This is a difficult problem to solve at the start of your business and the previous example shows how dramatically different cash needs can be if you bootstrap, guerilla market, get cheap manufacturing and have people capable of wearing many hats by working very long hours. Oh, and they don't require a salary, but that is a very rare example indeed. But the most important factor in Jasomi and some local successes like Sierra Wireless is that the companies got the cheapest, least dilutive form of investment as fast as they could: customer revenue. Raising a $20M first round of financing to ramp up your employees and get your product to market faster, seemed like a good idea to Kagoor and its investors (who surely expected a "hit" and believed it could be worth hundreds of millions). But it didn't work out that way. There are rules of thumb for the types of business you are entering and how much money it will require over time. The biggest cash consumers are biotech companies, semiconductor companies and networking hardware companies. All need tens of millions over time, generally speaking, just in development, let alone marketing costs.

Now to the conflict. Your business plan says $5M needed, but you want to raise it in two or three rounds at higher prices to reflect less and less risk of success and minimize dilution of your stock. First, Jasomi example notwithstanding, most companies will require more than they originally think. Second, the math is different for the type of investor. Angels are happy with smaller amounts of capital and 2-4x their money in a shorter time frame. VCs are happy with larger amounts of capital and 5-7x their money by time of exit. So you have to include in your argument what you think your company can sell for in 3-5 years and in 5-7 years. If, like Jasomi, you can get $20-40M for your company in 3-5 years on less than $5M invested, angels are probably a better bet. If you think your company can sell or go public for >$50M in a longer time frame, VCs get interested.

Of course, the "root cause" of this conflict, or the exacerbation of it in founders getting frustrated with VCs not investing in them or VCs making mistakes in investing in companies that, in the end, had smaller market opportunities than hoped for, is lack of experience at recognizing where appropriate financing is available and having investors seek appropriate deals. Again, this is an immature industry still finding its feet.

Which brings us to the last conflict: deal terms. Clearly I am trying to draw all of these together as issues that affect us daily in the tech industry and this issue is also a sore point locally due to some bad times in the early part of this decade and the "root cause" I have been talking about. The best ways to avoid deal term conflicts in accepting money is to have one round of financing and everyone participates at the same terms and conditions. This rarely happens. Tying into previously mentioned conflicts, how do you know how much you will need? By taking it all in one round you get maximum dilution. Inevitably you take a small amount from angels to get started and then raise a little more. Possibly, if your opportunity is big enough, you get VCs involved.

The golden rule of equity financing any early stage company, technology or not, is that the last money in is senior, meaning it gets taken care of first. {Note: secured debt is always senior to equity no matter when it was issued. The debt holders get paid ahead of everyone but the government} This fact gets lost on a lot of founders, incented employees and angel investors. It seems counterintuitive that the investor that took the most risk would be behind those coming in with less risk. It does make some sense if the price was lower for the angels. But the money in last gets a "preference" which means that they will get paid their capital back first in most situations (after debt, employee and creditor liabilities of course). The best way to protect previous investors and align interest is for them to participate in the current round of financing to some extent. This is what VCs do on a regular basis by holding back money to participate in further rounds, keeping at least some money in the preference position. The terms associated with making the last money "most preferred" are where a lot of angst happens in our neck of the woods. As in any deal, if one or more groups of shareholders feels it is being "screwed", the deal should not happen. If the angels, for instance, do not like the terms and are not participating in the round, they should a) finance it themselves at their own terms or b) find someone else to finance the deal with better terms. The reality of an early stage market in a smaller tech centre is that there are not that many places to turn to for better terms.

The other harsh reality is that in order to raise sufficient capital to win in a market space and not get your forehead bloody by pounding it against the wall of continued fund raising, you need to accept terms and conditions that are not necessarily ideal. You are a price taker. Back to my "root cause" thesis: While it is frustrating to have someone come in after you and take a larger chunk of the company's success, it is the reality of early stage financing. Experience will help all stakeholders in our industry understand the options and accept the terms of the path that they choose. Exhibit A for this reality of accepting terms would be Sunnybrook Technologies which recently publicly announced (through a Globe and Mail article) that they have thumbed their nose at venture capital and will only seek angel financing for their display hardware company. That is their choice to make and one hopes that they fully understand the ramifications of that choice. If they have lowered their expenses through stock based incentives, have picked a business model that requires only a few million in capital investment and have a path to a $20-40M sale in the next couple of years, then they will have happy campers all around as they have clearly chosen the deal terms that match that path. However, Sunnybrook and its investors have not shown great humility in their effort to blaze their own path, which I think is a crucial part of a maturing industry. It would be nice to see others make good decisions on their path to success and not crow about it. Because you can end up eating crow. I know. I know.

In summary, the "root cause" that we need a long term view on in BC is that we are an adolescent industry just finding its stride. With more experience and more successes and failures to learn from, some of the conflicts in financing (that I think arise largely from the "root cause") will go away.

What Do You Think? Talk Back To Brent Holliday


Something Ventured
is a bi-weekly column designed to supplement the T-Net British Columbia web site with some timely, relevant and possibly irreverent insight into the industry. I hope to share some of the perspective and trends that I see in my role as a VC. The column is always followed by feedback (if its positive or constructive. I'll keep the flames to myself, thanks).

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