24 August 2009

In Search Of...The Ideal Term Sheet

Continuing with our discussion on term sheets (see "Some Thoughts on Term Sheets" and "Closing Term Sheets Quickly"), today a new "plain vanilla" term sheet was published by Adeo Ressi of TheFunded.com.

You can download it on docstoc here.

It is very basic (a good thing) and entrepreneur-friendly. Whether you'll be able to get a VC to actually use it is another question altogether...when the economy is tough and funding purse-strings tighten, investors will often seek to include various onerous terms to help mitigate their downside risk. Anyway, it's useful as a starting point for discussions.

Rather than comment on it directly, I am re-publishing sections from a post on TechCrunch:

"The key terms include the elimination of participation with preferred stock, a 1x liquidation preference, and single trigger vesting acceleration on acquisition.

What this means: VCs try to increase returns by asking for large liquidation preferences. A 3x liquidation preference, for example, means the VC gets to take out 3 times his/her initial investment before founders and employees get anything. So if you raise $10 million at a 3x liquidation preference and then sell for $25 million, founders and emplyees get nothing. With a 1x liquidation preference, the VC is only able to get the initial investment back before others take their share.

More importantly, participation is eliminated. VCs often ask for this. What it means: Participation rights means the VC gets to take a pro-rata share of money in a sale even after the liquidity preference. With it eliminated, the VC has to choose - either take their 1x liquidation preference or convert and share with common pro rata. For any large deal, they will convert and be treated like the founders and employees.

The single trigger vesting provision is also important. VCs like to keep their founders locked up so they have to keep working even after an acquisition. The provision, called double-trigger acceleration, usually requires a sale followed by a firing without cause. VCs want this because it’s easier to sell a company if the founders are locked into staying on. Founders don’t like it because it sucks.

Most importantly, though, is the cost savings. VCs really need to move to a deal structure that doesn’t burn up so much lawyer time negotiating provisions that are almost never used. I could write 10 posts on how this nonsense works, and may in the future. A term sheet like this can be closed with $10k - $20k in legal fees. When you’re only raising $1 million, that’s a big deal."

More on Seed Stage Terms
One more link while we're on the topic-- here is a new post from Caine Moss, an attorney at WSGR, on the changing face of early stage investing. He explores the difference between terms at the Series A stage and at the seed or "Series 1" stage. The main takeaway is that terms will differ, and entrepreneurs should avoid deals where Series A terms are used for a seed financing.

10 August 2009

The Business Plan is Dead; Long Live the Business Plan!

Recently, there has been some heated debate in the web startup world about whether developing a business plan is really necessary. The main arguments are that: a) VCs don’t read them; and, b) a founder’s time is better spent writing code.

Optional if Your "Business" is Really a "Project"
For many firms in the Web 2.0 space, I would agree—to a point. If you are able to code a web site or develop an iPhone app or Facebook widget over a long weekend, it is very efficient to just throw it out to the universe and see if it sticks. In short, many web startups are more akin to a project than an actual business, and given the minimal amount of time and expense it takes to develop such concepts, it makes more sense to try out a lot of different experiments, vs. planning out a solid strategy.

I'll use Guy Kawasaki as an example of this approach. He famously launched Truemors.com for about $12k in development costs, and at a recent NewTech Meetup, he claimed his latest project, AllTop.com, cost about $100k to develop. He used low-cost tools like MySQL and PHP, and he uses sites like Facebook and Twitter (along with his considerable personal blog and 'brand') as platforms for promotion.

Further, for many web businesses the business model is already more or less built in: get some traffic, serve up Google ads, and then layer on a few other revenue streams as your user base ramps. There is no need for a marketing plan—assuming the team knows a bit about SEO and social media. There is no need for a hiring plan, since these ‘business projects’ can be built and scaled with a small team of developers.

Critical for Everyone Else
However, for all other startups—i.e., any business with an element of complexity to it—I would argue that writing a business plan remains a very valuable exercise, even in the digital world.
It’s as simple as this—drafting a business plan forces you to think things through in advance—i.e., work out a plan—before sinking your money, or even more importantly, your time into something.

Granted, as founder of VentureArchetypes LLC (www.venturearchetypes.com) I am not an unbiased observer in this debate. In fact, I make a decent portion of my living helping startups develop their business strategies, and we use the business plan as the framework for this activity. It is a very creative, logical, and process-driven approach to thinking through the various elements that will make your business a success.

From a high level view, here is a brief summary of our approach:

Market Opportunity
We start with the big picture—identifying the market opportunity, size of the addressable market, and trends that can be exploited. Why is now the right time to start this business? Timing can be everything, and we want to make the case that the market and the technological underpinnings are ready for your vision. History books are filled with startups that got the timing right—look at Skype, Facebook, and YouTube as just a few of many examples. None were the first in their category, nor were they the last—but they nailed the timing.

There were numerous IP telephony companies before Skype, and several video sharing attempts before YouTube, but bandwidth limitations in the early days of the web were serious constraints. In contrast, by the time Skype and Youtube emerged, broadband was widespread and P2P sharing technology had matured to the point where both firms were able to deliver a quality user experience. The same holds with Facebook— by the time FB launched, consumers were accustomed to building online networks of friends, and the scaling issues that had plagued earlier attempts like Friendster had been (mostly) overcome.

Customer Needs
Once we’ve made a case for the market opportunity, we drill down into our target customers—their needs and pains, how they are solving problems today, how they go about making purchasing decisions, etc. Again, the list is long of companies that have been able to truly get ‘inside the heads’ of their constituents, and to deeply understand what they want—eBay, Amazon, Google, and so forth.

Product Solution and Competitive Environment
Next we map out the company’s product roadmap, and show our plans for attacking the problem by doing something radically different that provides real value to customers. This is where we paint the picture of our big, audacious goals (note: investors love to back game-changing technology companies, not ones who are building a slightly better mousetrap). We plan out our roadmap in the context of the competitive landscape; a deep dive into the competition can often uncover both pitfalls and new opportunities that can be exploited.

Launch and Operations
Next we get into our launch and operations plans—the tactical, nitty-gritty details that explain what we actually need to do to get to market and scale the company. Are we outsourcing development to India, or building everything in house? Are we buying a floor full of servers, or hosting our service at Rackspace or 'in the cloud' using Amazon Web Services? Particularly at the seed or angel round, it’s important to show you have more than just a good idea—you have a workable launch plan and realistic expectations of how you will (judiciously) spend their money.

Marketing and Sales
Next, we synch our launch strategy with a solid marketing and sales plan. Here, we revisit our target customers and figure out the best ways to reach them in a cost effective manner. This topic calls for a good deal of creativity, as it encompasses things like branding, positioning, taglines, pricing and business model options. It also touches on clever ways of getting press and blogger coverage or on building viral hooks into the product. Our goal here is to not only gain ‘buzz’ and mindshare in the market, but to convert awareness into actual, paying sales. (To note, understanding the sales cycle is often overlooked with new companies.)

Team and Hiring
We also spend a decent amount of time elaborating on the “who” – who is on the team now and what value do they bring, and who will be needed to make this vision happen (in the form of a hiring plan). This involves a fair bit of navel gazing, and helps us both figure out our strengths, as well as identify what human-capital gaps we need to fill.

Finally, we “tell the story in numbers” by mapping out our costs and revenue sources in the form of a financial forecast. This can be very insightful, as it shows how much money we can potentially make, and perhaps more importantly, how much it will cost to get the business off the ground (aka net negative cash flow until break even). A good model can help you demonstrate credibility to investors—it shows that you really understand the economics of your business. Further, since it’s chronological, the model is also a great tool for setting specific goals to keep the business moving forward aggressively.

Now let’s recap the objections to drafting a business plan:
  • Investors never read them: This is a true statement; most VCs will never actually sit down and read your entire plan. At best, they may read the bios and flip through a few sections. However, drafting a plan forces you to think through the key elements of your business that investors will drill you on—hard. Further, the business plan is a great framework to lay out your ideas, from which you can then condense the “best stuff” into a very succinct pitch deck and executive summary (which are two docs that do get read, very closely). (Postscript: to see what investors want to know, visit Seqouia Capital’s web page on the business plan: http://www.sequoiacap.com/ideas/)
  • Writing code is a better use of your time—aka “it takes too long to write a plan”: Apart from very basic and experimental ‘web projects’ described earlier, I would argue that the process of drafting a plan is worth the effort—I’ve seen the positive results time and time again. It gets the founders aligned in the same direction, around a common vision. It creates a roadmap for execution, ideally with milestones for each team member-- i.e., by mapping out what you’re going to do, it gives you a structure to hold people accountable for doing it. This in turn helps set expectations and responsibilities, and reduces ambiguity—and in a startup, ambiguity = death.
Planning out your business just makes good economic sense, too. After all, it’s a helluva lot cheaper to think through your actions in advance, vs. wading into the market without a compass and feeling your way around—the 'ready, fire, aim' method. It can get very expensive if you suddenly find you need to rewrite a bunch of code or totally revise your marketing plan because it was ill-conceived from the beginning. This is how startup CEOs get fired by their VCs.

It's All About Process (and a short written doc)
In a nutshell, writing a business plan—wait, let me rephrase that—engaging in the process of developing a business plan—is still a very valid and valuable exercise for 99% of startups. It can save a lot of costs and frustrations that result by doing things the hard way, and a good plan doesn’t need to be exhaustive; indeed, many of the best plans are 10 to 15 pages in length, not a 50 page academic tome.

After all, a shorter business plan, by definition, creates focus, which is always critical at resource-constrained startups. A shorter plan is also easier to revise and update as the business evolves-- we use the term 'living document'-- which provides you with an ongoing tool for managing your business and getting things done.

UPDATE: Here is an excellent post from Martin Zwilling on why good business plans are so important (and so rare). Recommended.

The Business Plan Is Dead; Long Live The Business Plan!