9. Valuation p2, Ethics & Midwest Venture (Jeffrey Carter)

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Jeffrey Carter (part 2) where we finish the discussion on Valuation and also address ethics, and the Midwest Venture Environment.

Itunes:  http://bit.ly/1qL2Uce


Direct-audio:  http://bit.ly/1s1sebY


SoundCloud:  http://bit.ly/1HnmAez

Guest Links:

Key Takeaways:

I wanted to highlight a few quotes:

1- On communities: “Communities are not built by politicians, they’re not built by investors, they’re built by entrepreneurs. They lead the community, the build the community. They’re taking most of the risk and they’re doing the dirty work.”

2- On advice to new investors: “Get your hands dirty. Don’t be afraid. As a trader you can paper trade, but it’s not the same thing. If you want to angel invest, the best thing to do is make some investments, because it helps you learn.”

3- On successful angel investing: “Angels don’t do well as a lone-wolf. They do better in packs. You can get picked-off in later rounds by VCs if you’re a lone wolf. You can get watered out of a cap table. You’re better off in a pack.” The last thing I wanted to recap had to do with Exit values. While Jeff’s example, was specific to the midwest, I don’t think it matters where you are, if you are investing in startups that have modest exit potential. So, if you’re investing in a company where your top exit value will be $50-80M… you can’t take VC money and you really can’t even involve VCs. Need to look at investing and exits in a different way. Jeff mentioned that John Huston, current head of the ACA, has an approach to do this… so we will have to get him on the show to fill us in on it.

Tip of the Week: Pro-rata as a Right, Not a Privilege

Below is the “Tip of the Week” transcript from the Podcast Episode 9: Valuation, Ethics and the Midwest Venture Environment p2 (feat. Jeffrey Carter) On today's episode, Jeff talked about this concept of optionality of investing. If you remember my discussion with Chris Yeh from Episode 2, we talked about different types of funds. There can be seed funds and growth funds. Seed funds, of course, seeding businesses at an early stage. Growth funds, to invest more, in subsequent rounds, on the winners. Today Jeff talked about raising a $50-100M fund so that he'd have the ability both to seed a range of investments and also "press his winners." This is a key point that I've seen angels omit from some deals. A Key term, that one must include in a venture investment, is called "the pro-rata partcipation right." Essentially, this allows an early investor to maintain his % of ownership, by providing follow-on capital, at later stages. The reason that this is critical is b/c you can not predict your winners and you need to secure, support and benefit from the early-stage investment that you made. This can also be positive for the entrepreneur. It is a standard term, so it will not alienate VC funding at later stages. It also encourages previous investors to continue making investments in every funding cycle, which can reduce the $ amount that the founder has to raise in those rounds. Let's walk through an example. I'm not going to consider liquidation preferences, to keep things simple: (more…)Read More...
N: So let’s say you’re the investor and I’m the founder. I can’t change my track record, and I’m already married to the idea. I can’t change the round—let’s say it’s a seed-stage round. What things can I do, and what advice would you give me, to help get a better valuation? J: I think you have to educate your investor to help them see what you see, and if they don’t see it, they’re probably not a good investor for you. It’s important at any stage for the entrepreneurs to interview their investor as much as the firm is doing due diligence. They should talk to other companies to find out what kind of investor they are—if they’re passive or active, if they’re constantly emailing them; there are all kinds of different investors. If you came to me and said, “I’ve got this much capital committed at this price, and I’m not changing my idea,” I’d either have to buy it or sell it. But as an entrepreneur, I’d tell you, chances are your idea’s going to change. Your valuation’s not, but chances are you’re going to go out into the market and learn things and then it’s going to change. You can’t be married to your position and you can’t be married to your idea. N: Yeah, I had a gal the other day that was 2 months off a patent being granted and 1 month off a release, and she was trying to raise the capital now. I said, “Well, why does it benefit me to get my money in now? Let’s see some market traction, and let’s see if the patent gets granted. J: Yeah, and you should do some research with your attorney and calculate the probability of that patent being granted, and then you can calculate the valuation. If she really wants to get you in, she can give you some warrants to sweeten the deal. The one person who popped into my head when you talked about being married to an idea is Sue Khim, who’s a tremendous person and a really great entrepreneur to invest in. She came out of the University of Chicago and had a company we invested in called [inaudible], and it was a marketplace for tuition loans. She presented at some Silicon Valley thing and won the whole competition, and this guy from Social+Capital saw her and loved her. And he said, “I think your business model is wrong, but I’m willing to invest in you if you’ll throw everything out and do it,” and she did. Brilliant.org is the company, and it’s great. I’ve invested in every single round that I could—as an investor, you can only press your lowers, and luckily for me, Sue Khim finally came and looked for more capital. It’s revolutionizing the way kids do math and science together, and it’s a fantastic idea and a fantastic company, but Sue will tell you how painful it was for her to throw out everything she did and pivot. It took a lot of balls for Sue to do that, and she’ll talk about stuff like that and she’s totally transparent with you. I love that. I love talking to her about the business, because she’ll say, “These are the kind of things that we see happening.” I was talking to a guy the other day about Brilliant and I showed it to him, and he said, “Oh my God, I want to hire all those kids.” When we were talking about putting money into it at the beginning, that’s one of the things that we were talking about and all of a sudden, here’s a potential customer, and he’s talking about hiring all of these kids. You never know how these things are going to work out, but to me that one looks like it’s going to work out. N: Yeah, that’s a testament to jockeys and horses. We had George Deeb on, and we were talking about jockeys and horses. He said he’d rather have an A+ team building a B idea than a B team building an A+ idea. J: Yeah, the best companies are A+ teams with A ideas. But with Sue you just knew—the first time I ever met her was at the university club, actually. It was funny because Sue’s short and I’m 6’5”. Her partner Silas is short; he’s from Wisconsin, so I met him, and then of course we got involved with them, and they’ve just been really great. N: I saw your article on investing in Madison tech companies today; we’ll save that for another time. You’ve mentioned a lot of resources already, but any recommended resources that you would drive investors to on the topic of valuation? J: Yeah. I think the Angel Capital Association has some great stuff there. There are some good papers out of the University of Chicago that talk about valuation, and then just blogs. There are so many VCs that blog now—Fred Wilson, Brad Feld, Mark Souster are three of the top ones that I could think of. There are so many others, and you can get a great sense of it, but you have to be active. N: So, Jeff, tell us more about what you’re up to at Hyde Park Angels and West Loop Ventures. J: Well, Hyde Park Angels is a group that has over 100 members, and we invest in Midwestern start-ups. It’s everybody’s own money; I’ve never made a dime off Hyde Park Angels from a salary perspective. I only make money if my investments do well. That was pretty disruptive at the time we started; there were a lot of brokers, and they’d call up entrepreneurs and tell them they had a network and then dial for bucks and raise $1 million, then take 6% of the million and take a 6% equity stake for doing it and the entrepreneur was off, and maybe they sat on the board and maybe not, but it didn’t matter because they performed their role of finding capital. There’s a lot of that in Chicago, and I think we disrupted it because the way we work at HPA is, if we make a million dollars, we actually write a 3% more check to cover legal and accounting costs and all the money goes to the entrepreneur. We may or may not get a board seat, but we try to help them as much as we can. With West Loop Ventures I’m attempting to do something different. It’s a fund, so I am going to make a management fee off it and a carry, but if you look in Chicago at people who do seed and Series A investing, there’s not than many funds. And they’re not big—$20 to $50 in size. There is no Union Square Ventures here, or Foundry Group. Lightbank is a $200 million fund that’s starting to do more, but it looks like, to me, they’re investing in groups that are symbiotic to Groupon. So Belly is a company that’s working really well for them; if you go into a store, you build customer loyalty. It’s the same target market as Groupon, and they can build up an ecosystem around Groupon. They don’t feel like a classic sort, like Union Square Ventures. Their strategy is to buy a bunch of Groupons, which is a great strategy. I wish I could invest in Groupon—I tried. I met Eric Lefkofsy at the University of Chicago and I said, “I just started this angel investing group; will you let us in?” And he said, “Nope.” We couldn’t invest in that one and we couldn’t invest in Braintree because they didn’t raise any money. With West Loop, what I want to do is raise $50 to $100 million so we can be in the early-stage rounds and the later-stage rounds as well, and do optionality. So with optionality you put a little bit of money in early and keep pressing your bets as you go, and the bad one’s you kill, because that’s probably going to be about 30% of your portfolio. I think that would add a lot here. If you look at other funds, they invest later with more growth capital. [Inaudible] is a great guy and I respect him because he;s done so much for the community, and his fund invests a little bit later. But they do Series C, D, E money, and that’s sometimes difficult money because you need an investor that can write big checks, and that’s what he does. But we don’t have anyone like Union Square Ventures that does it all the way through. Someone mention Drive Capital to me the other day, but they’re out of Ohio. So they may be a fund like, that but they’re only one. If you look at the Valley, there’s a lot. N: What about West Loop? J: That’s exactly the direction we’re going in, yeah. So we’re out talking to investors. What’s interesting to me is that the politicians in Illinois want a start-up community here, and in Wisconsin, Iowa, Indiana, Michigan. The mayor of Chicago has been a tremendous help to us. I’m not a democrat; I’m a Republican, and we sat next to each other on a board. We don’t see eye-to-eye on a lot of things, but you have to give him credit, because he went down to Austin and talked about Chicago. He talks about the start-up community here, and he’s a great salesman. He wants a start-up community here. You go to the funds, and a lot of them are sending their funds to the coasts. People don’t want to do it here; it’s too risky for them. If you’re going to establish a start-up ecosystem here, it’s going to be done with Midwestern venture capitalists with Midwestern funds that invest in Midwestern companies, and the successful companies that come out of that are going to continue to build the ecosystem. The guys from the outside—the coasts, and California—will come in here and cherry-pick the best options, but they’re not going to be constant forces driving the market here and really doing the hard work. They have plenty of community in Silicon Valley and New York. It’s really the civic duty of Midwestern venture funds, pension funds and corporations to put their money behind Midwestern focus funds. Instead of writing a million-dollar check to the civic opera, maybe what people should do is write that check to West Loop Ventures or another Midwestern focus fund that will create jobs and opportunities in the area. N: So you and I have talked about the ecosystem here and some of the questionable ethics. Can you touch on that for the audience? J: Yeah. Chicago is a transactional city. If you really want to understand it, you should read a book called City of the Century. I grew up in the Midwest, and I learned a lot from reading that book. Don Miller’s the director of the national World War II museum, where I’m on the board, and I said “That book was fascinating,” and he said, “What did you learn?” and I said, “I learned that nothing’s changed in Chicago since, basically, 1850.” And he said, “You’re absolutely right; that’s why I wrote the book,” and he’s right, because it’s always been a transactional town. You’re not going to change Chicago, but you can make it more transactional. There are a lot of people here who just broker capital. There are a lot of companies here that put “Venture” in their names, and they’re not venture companies. Venture companies sit in the board, and they really work for their companies. If you look at a company like OCA Ventures or any other good funds in town, they’re active and they work side by dies with the entrepreneurs. I had a guy bounce a $350,000 check to me January 5th of 2013—to the company; we were going to do a deal, and he was a total scheister; he put this company in distress, and we saved it, but talk about a bad deal. There are people that go to venture events here that call themselves investors, and I’ve never seen them write a check. And then there are service providers that market themselves as investors that are just looking to milk money out of the system. I’m okay with service providers as long as they give before they get—that’s the mantra in entrepreneurship circles, “Give before you get.” So I think it’s incumbent on people with expertise, specifically the corporate community—strategists and marketing people—to go out and mentor. Buy the coffee, don’t expect anything in return, and build the community. What these other people are doing is they’re leaching off the community and they’re sapping it of resources. I had a start up who went to talk to a guy who runs a design shop in town about designing a website, and he wouldn’t have a meeting without them writing a check for $10,000. They wrote the check, left, decided not to take the deal, went upstairs and asked him for the check for $10,000, and he said no. He took $10,000 from them. He’s a scumbag; I’ll never do a deal with him again. I also hate the investors who will play entrepreneurs against each other or do all kids of research on one company and have a term sheet on another company and invest in them. David Cohen had a post that caught my eye called “Asshat VC Move #1” and one called “Asshat Angel Investor Move #1” as well. Everybody has their fair share of leeches—Silicon Valley has them, New York has them—but you have to talk about it and be transparent about it. When I was a trader at the Mercantile Exchange and there was a bad egg in the pit, we’d call them out, and eventually they were washed out of the business. You have to do the same thing with this sort of thing. N: So if we could cover any topic on venture investing in the podcast, what topic do you think should be addressed and who would you like to hear speak about it? J: That’s a very good question. I think for our community, at the state it is, there’s two topics. I would like to have a family office that avoided venture, then got into venture and had a successful investing history with it, where they discovered thing that they didn’t think were going to happen—or a wealthy individual that totally shunned it but decided to get into it and wrote a check to a fund, and their experience with that. So, a limited partner; that would be great. And then for the broader community, I think it would be great to have entrepreneurs on that have grown businesses. I think communities are not built by politicians or by venture capitalists or investors; they are built by entrepreneurs. Entrepreneurs build the community and lead the community, so they need to be held above everybody else—they’re the real kings. They take most of the risks and they do most of the dirty work. It would be great to have somebody like Andrew Mason talk about what it was like to grow Groupon the guys that grew GrubHub, or Brian Johnson to talk about not the seed or the beginning, but sort of that middle stage of the company and the problems they encountered with scaling and human resources, and what they did to overcome it. I think people like that talking about that mid-stage would be great. Right now in Chicago, there’s a lot of Series A companies out there and seed-stage companies, but we have trouble raising B round companies and there are fewer because it takes at least 20 years to build an ecosystem, and I would argue that ours got started in 2007 with Hyde Park Angels. It really got going in 20098 with Excelerate Labs, which became TechStars. When [inaudible] put us on the map with 1871, it became a sort of town hall, a cohesive centering that took us out of fragmented places. There are still some fragmented places where you can walk in, meet people, and get stuff done, so now, you can argue the Chicago ecosystem is in its growth stage. So if 2007 was the seed, 2009 was the Series A; 2011 was that point at the base of the hockey stick when you start to go up, and we’re in 2014. So in 2027 it’s going to look a lot different around here if everything breaks right for us. But we’ll be able to point to those 3 seminal moments when we started to climb up the hockey stick. And having people around who have climbed up the hockey stick and can describe will help other people as they climb up the hockey stick. N: Well, I hope you can help accelerate that growth with West Loop Ventures. J: Yeah, I’ve got to raise the money first. N: Yeah, that’s always a challenge, right? So for someone who’s new to start-up investing—and you’ve got many of those who are joining your group—what advice would you give? J: I think the first thing is to get your hands dirty—don’t be afraid. As a trader you can paper trade; it’s not the same as having real money on the line. Make some investments, because if you want to angel invest, the best thing to do is to make some investments; it helps you learn. The other thing you want to do is watch your capital. Don’t write a check for $100,000. Write a check for $10,000, because the risk that you take is less, but what you learn is them same, and you’re less emotional about it. Angels don’t do well as lone wolves; they do much better in packs. You can get picked off in later rounds by VCs if you’re a lone wolf; you can get watered out of a cap table—there’s all kinds of things that can happen. You’re better off in a pack. At HPA we’re not taking more members right now, but West Suburban Angels in the western suburbs have started up; Cornerstone Angels is another one. If you’re associated with Notre Dame, they have a great angel group that I helped get up and running, and if you don’t want to join any of those, start your own. Harvard also has an angel group. But you can start your own. It’s challenging, but there are resources to help you, and there’s no law against more angel groups. In fact, more angel groups is good for the Midwest, because the more seed capital we have that goes to work, the more chances of it being invested in later-stage companies that are going to be blowouts. From Ohio TechAngels, John Huston—who wears a bow tie—has come up with strategies for angel investors not to use VC. So all the money that’s on the table at the beginning is all the money that needs to go in later, and those people are committed to writing checks at later rounds to make that company succeed. N: So they’ve got that growth capital built in. J: They’ve got it all built in, and they have a heart-to-heart with the entrepreneur about what kind of company they’re investing in and where it’s going to go, and they have a clear idea of when it’s going to exit, and what for. And his argument is, if I look at the state of Wisconsin or Ohio, how many billion-dollar exits have there been from a seed-stage start-up in those states? Zero, that’s how many. N: It’s like Aileen Lee’s article on “Unicorns,” as she termed it. J: Yeah, it’s like a .0067 chance. But how many 100 million-dollar exits have they had? Zero. And then it’s, how many local Ohio companies—so, out of Columbus, Cincinnati, Cleveland, Akron, Dayton—have bought a start-up for more that $100 million? Zero. So that really changes the game when you’re an angel investor, because if I know that my exit’s only going to be $15 or $20 million, that changes the valuation from the beginning—which is another thing you have to talk about with valuation. It also changes my entire investing strategy, because I can’t take VC money. I can’t even involve money, because the VCs can’t make money if they invest at a $10 million valuation and it sells for $50 million. That’s nice, but that’s just beer money for them. They need 3x return so that they can raise their next fund. A $50 million exit’s not going to do it for them, and they can’t write a check for $100,000. It’s just too small. They need to write a check of half a million dollars. N: Gotta put that money to work. J: Right, because of the risk-reward and because of all the metrics. It’s a very different way to look at investing. He’d be a good guy to have on, too, John Huston. He’d be a very interesting guy to talk to. N: I wish I had connected with you earlier. The first two deals we closed were each 50k, and we probably could’ve taken less risk and moved that money to more places. But I’m happy with how those are working out, and I’m a member of Cornerstone, so I had Michael on the show. J: Oh, good. Mike and Larry are great. Believe me, I took lumps big-time early and learned a lot. It’s not easy. If it were easy, everybody could do it. N: Sure. Well, hopefully we can help that with the show here and get folks like you on to provide some great advice. So, Jeff, what’s the best way for listeners to connect with you? J: I’m at my blog, pointsandfigures.com. You can just email me through the blog. I’m on Twitter, and my handle in @pointsandfigures, so you can follow me on Twitter; I interact with people there. I’m on Facebook; I’m on LinkedIn; I’m on Pinterest, believe it or not, and another place that I’ve been doing a lot lately is Tumblr, and my blog is different. It’s called pointsnandfigures, because when I typed it in I mis-typed it and didn’t catch it. I post stuff there and interact there. The reason I got into social media was that so many of these companies are using it, and if you don’t use it and learn about it, how are you going to advise someone about it and ascertain whether it’s useful for them? Two books that you can read on social media are Groundswell and World Wide Rave, which will give you a basic education in it. N: Okay, his Twitter handle is @pointsandfigures, the blog is pointsandfigures.com, and his Tumblr blog is pointsnandfigures.tumblr.com. Jeff, it’s been a huge pleasure having you, and I hope to connect again soon. J: Okay; thanks, Nick.