Montreal Start Up

In part II of this series, I argued that it has become so cheap to launch a Beta Web service, that VC level funding is no longer required. This changes the game somewhat in regards to product development and exit strategies.

Today, students can throw together a basic service over the course of a few weekends and run it from the family basement over a DSL line. Why bother then with market research when you can field test ideas this quickly and cheaply. Have an idea? Build it, throw it out there and repeat until one of them gains traction.

Paul Graham was one of the first to grasp this new reality and put it to the test with his Y-Combinator. The recipe is simple: give small amounts of seed money to bright kids, provide top tier mentors and see what they produce. I think it’s still a bit early to call, but the fact that there are now TechStars in Denver, YEurope in Vienna and SeedCamp in London would seem to indicate that the idea has legs.

So, founders can test their ideas cheaply, but once they start to gain traction, they still need to scale the business and that requires money. This is where VCs come in. They have the resources and expertise to accelerate a startup’s growth. In the nineties, in order to get an exit, the company would go through several rounds of financing, cranking up the valuation (and hype!) each time, before going public. Today, however, IPOs are out of favour (at least until Facebook goes public and makes a bundle for its investors), so VCs try to sell the company instead, once they’ve pumped its value up to a respectable level.

Now if you are a big Internet or media player and you have the opportunity to buy a promising startup, when would you rather do it: when they first demo their Beta service or after their Series C round when they have a valuation in the ten’s of millions? Obviously, if you believe in the company, acquiring it early on before its valuation rises too much is ideal. But that will be difficult if the company has taken money from a VC fund, because VC money always comes with special privileges, such as the right to block the sale of the company. While selling the startup after a successful Beta might provide a quick 3x return on their money, the VCs are aiming for the homerun, so they will often block the sale and take their chances growing the business. If the founders bootstrapped their launch or used Angel money, then they get to decide whether they want to (a) cash out quickly, (b) build a business that grows organically or (c) take VC money and go for the gold.

Call it a lack of ambition in today’s youth if you will, but it seems that many young founders are quite willing to exchange 12-18 months’ worth of effort for a couple of million dollars… and so is Google.

Google started by inviting founders to come pitch to them. This gave Google the opportunity to acquire promising startups before the VCs got involved and pumped up the valuation. Their acquisition of Zenter is a prime example of this: Zenter went from seed to exit without even bothering to build a business in between! Google has now taken it further and is providing seed funding for developers that want to build upon their Gadget platform (Google Gadget Ventures). Other big players have also adopted this strategy; Conde Nast’s acquisition of Reddit is a perfect example. In a world where Web startups can sell themselves after taking only a few $100k in financing, what role remains for traditional VCs?

Some VC funds have started to adapt to the new reality of Web startup financing. The best-known example is probably Charles River Ventures’ Quick Start program. Looking at the amounts involved and deal structure (up to $250K as a convertible loan) the program clearly aims to compete with Angel money. It also includes the right to fund 50% of an eventual A round. Another VC Fund, Union Square Ventures, have adjusted to smaller deal sizes, but admit they aren’t staffed to go as low as the CRV Quick Start program.

Other firms are trying to do smaller deals than in the past, but haven’t changed the structure of the deal; this is often awkward for everyone involved. The VCs have to deal with high overhead for small deals and the larger number of deals causes the resource squeeze discussed in part I of this series. As for the entrepreneurs, those that we’ve spoken to recently, say they feel pressured into taking more money than they need and find the terms overly restrictive for a seed round.

So what do you think? In a city with limited angel activity, how should entrepreneurs proceed? What should local VCs be doing?

In the previous post, we looked at how constraints on the GPs’ time and the need to invest large amounts of capital makes it difficult for VC funds to do small funding rounds. This wasn’t a problem for Web 1.0 so what has changed?

During the Dotcom bubble, the Web was new and shiny; new to consumers and investors, but also to developers and engineers. The network guys laid fibre as fast as they could, the IT gals racked ever more servers in data centres that sprouted like mushrooms and the developers cobbled together servers and applications using java, perl, cgi scripts and anything else they could get their hands on. It was all very expensive, but money was seldom a problem. Then the bubble burst.

A few got rich during the bubble, many lost plenty, but the money spent on infrastructure was not lost. The Telecom upstarts may have gone bankrupt building data centres and laying all that dark fibre, but their assets were bought up for pennies on the dollar, and so today, hosting is cheap. Between Moore’s law and the FOSS movement, server hardware and software is inexpensive and powerful. As far as tools go, what can I say; we’ve come a long way since applets! The collective knowledge gained from more than a dozen years of developing for the Web has led to the development of increasingly sophisticated tools and methodologies. Ruby on Rails, Django, TurboGears, AJAX, Agile development, MVC, REST and countless software libraries come to mind.

As a result, it is much, much cheaper to launch a Web service today than it was a decade ago. It has become so cheap in fact, that today’s seed rounds are often below the minimum amounts VC funds are willing to invest.

Next up: the new players on the Web startup funding scene and how the VCs are responding.

From what I’ve been reading over the last 18 months, as well as what I’ve been hearing from people trying to do deals, both here and in the U.S., I get the feeling that the Venture Capital market is changing. I’m going to spread this out over several posts, beginning with this one, a re-cap on the basics of VC funds. Now, I’m going to greatly over-simplify here, but bear with me, as I don’t really want to write a treatise on venture capital, but rather get to the discussion on how the startup funding market seems to be evolving.

A Venture Capital (VC) fund is created when a number of investors, called Limited Partners (LPs), agree to pool their money in a fund for a certain period of time. The purpose of the fund is to invest in new business ventures, which in the tech community we usually call startups. Actually, I much prefer the French name for venture capital – capital de risque – or risk capital, because that is really what VC funds do: high risk investment with potentially high returns. Now the people actually managing the fund are called General Partners (GPs) and the way they are compensated is what we are interested in. The GPs take a cut of the assets under management to cover their expenses and as salary. These management fees are typically in the 2-3% per year range. This is nice, but there is little incentive for the GPs to get out of bed, as they collect these fees whether they make any investments or not. So, in addition to the management fees, the GPs get a share of the carried interest, or carry. When the fund is dissolved, the LPs get back what they originally put in, the GPs get 20-25% of the remaining funds and then the rest is distributed to the LPs on a pro rata basis. So the more money the fund makes, the more the GPs’ carry is worth. Think of it as performance based pay.

Let’s look at a simple example. John and Daniel decide to raise a VC fund. They manage to convince a couple of financial institutions and some high net worth individuals to invest and ultimately raise $30M. As far as VC funds go, this is small potatoes by the way. Now the Limited Partners agreed to leave their money in the fund for say, 7 years. John and Daniel, as the General Partners managing the fund, will take 2% of the assets under management annually as management fees and a 20% carry when the fund is dissolved in 7 years’ time for their efforts. For those of you keeping track, that works out to $600K annually to cover expenses (office space, travel, due diligence, etc.) with whatever is left over being salary for our two GPs. Now John and Daniel being decent investors, let’s assume that the fund averages 20% growth annually over its lifetime. So after 7 years, the fund is worth roughly $107M. Subtracting the initial $30M invested, leaves us with $77M of which John and Daniel will take 20% for their efforts, or $7.7M each. Not a bad payday. The remaining $61.6 is returned to the LPs on a pro rata basis.

So the GPs are well paid, but they have to earn it, meaning the fund didn’t achieve an average annual return of 20% on its own. The GPs spent the last 7 years helping the entrepreneurs grow their companies and looking for exits, i.e. ways for the fund (and company founders) to convert its stake in the startups into cold hard cash. The classic exits are the IPO (the startup goes public and the fund sells its shares on the open market) and the acquisition (the fund sells its shares in the startup to the acquirer). In both cases the goal is to sell your shares for substantially more than you paid for them, although sometimes you are just trying to cut your losses and get out. Achieving a successful exit requires a lot of hard work (and luck!) and so most GPs cannot reasonably handle more than 6-8 investments at a time. So with a $30M fund, John and Daniel each have to manage $15M worth of investments. Assuming they each manage 8 companies simultaneously, that means the average investment will be approximately $2M. Again this is a very simplistic analysis that ignores such things as follow on rounds of funding which soak up cash but don’t add another company to the fund portfolio. The point I am trying to make, is that the GPs’ time is an important constraint on fund activities.

Now from the GPs’ perspective, because both the management fees and the carry are a percentage of the assets under management, the bigger the fund, the better (actually, it’s the ratio of fund size to the number of partners, but you get the idea). Bigger funds mean, each GP has more money to invest, but there are still only 24 hours in a day, so each investment now has to be bigger. This is why, entrepreneurs looking for seed level funding regularly get turned down by VCs with plenty of cash to invest. Take John and Daniel. They may like an idea and the team behind it, but if they start investing in $200K chunks, each one of them is going to end up sitting on 75 boards! Spread that thin, they won’t be able to really help any of the startups, which greatly decreases the chance of succesful exits for the fund.

Traditionally, seed funding comes from friends and family (“Love money”) or angel investors. Seed funding allows an idea to be explored, a prototype to be built or the launch of a beta version of a service. Once the kinks have been worked out and a company is ready to ramp up its offering, that’s when the VCs usually step in. They provide the resources to dramatically accelerate a business’ growth. So in a healthy investment environment, you have angels speculating and VCs accelerating and, in later funding rounds, consolidating through mergers and acquisitions. Now if you are an entrepreneur in Montreal, you know that raising seed funding is tough, because there are few angels in the city and most aren’t very active. This is one of the things that Montreal Start Up (MSU) is trying to change by the way. For those of you who haven’t heard already, MSU is putting together a fund that will provide seed level funding for local technology entrepreneurs. We are also working with local angel groups to see how we can help them do more deals. Expect an announcement early this autumn.

Avis aux entrepreneurs, le Centre d’entreprises et d’innovation de Montréal (CEIM) tiendra une séance d’information sur les différents programmes d’aide gouvernementale le 6 juin. Plus d’infos ici.

Aussi, ce mercredi, le réseau inter logiQ tiendra un évènement de réseautage pour anges, investisseurs et entrepreneurs à la recherche de capitaux, le Rendez-vous financement.

Cette semaine MSU a participé pour la première fois à une rencontre du chapitre Québécois du National Angels Organisation. Ce groupe d’anges financiers se rencontre deux ou trois fois par année pour réseauter et écouter des pitch d’entrepreneurs. (Pour ceux que ça intéresse, quatre entreprises ont présenté: une dans l’industrie manufacturière, une autre développe un logiciel de gestion pour les PME et les deux dernières sont des Internet play. Ils ont 10 minutes pour présenter, suivi de 5 minutes pour répondre aux questions. Les neuf premières acétates doivent suivre un format fixe; s’il reste du temps, l’entreprise peux rajouter d’autres acétates)

Les entreprises qui présentent doivent être parrainées par un membre du groupe, c’est à dire, un des anges doît trouver l’opportunité d’investissement assez intéressante pour y associer son nom. Etant donné que l’ange risque sa crédibilité auprès de ses pairs, les entreprises et les présentations sont typiquement de qualité. Pour cette première participation, MSU a parrainé Praized Media, un startup local qui a, selon nous, beaucoup de potentiel.

J’ai bien apprécié les gens, autant les entrepreneurs que les anges, que j’ ai rencontré à cette soirée, mais je dois admettre avoir été surpris par une chose que j’y ai apprise: depuis quatre ans, des deux douzaines d’entreprises qui ont présenté, seulement deux ont reçu du financement du groupe. On s’entend que ce n’est pas le seul groupe d’anges financiers à Montréal, ni même le plus actif, mais deux investissements en quatre ans ça illustre bien à quel point obtenir du financement de démarrage est difficile à Montréal.

Generally speaking I have never viewed grants as a particularly effective way of generating entrepreneurism. Firstly, decisions on awarding a grant are often more political than commercial, secondly, they do not have the desired effect of increasing the number of people to whom the entrepreneur is accountable and thirdly, they do not generate a new source of interested parties who are willing to invest their resources in aiding the entrepreneur’s business.

A grant is appropriate for “projects” that will provide a non-commercial benefit to the community as a whole, but not where there is a commercial benefit to be gained by individual shareholders. I wouldn’t regard the prizes awarded at events such as Les Anges Financier as “grants”;the amount of money is so small (approximately $5K) that it has no material impact whatsoever on the growth of the business. These prizes are much more about PR for the company.

Montreal entrepreneurs are able to take advantage of numerous development grants but it is essential that these grants are seen in context of a companies overall funding scenario:

a) Positive Scenario – an entrepreneur sees a grant as a source of “cheap” money that reduces the overall capital that needs to be raised in establishing their business.

b) Negative Scenario – an (inexperienced) entrepreneur views a grant as as an alternative to a capital raising, or worse, as a validation of the viability of their business.

EVERY decision in a business has a cost and the earlier an entrepreneur realises that the better.

MSU discutait récemment avec un des co-fondateurs d’un startup montréalais à la recherche de financement. De toutes les entreprises que nous avons rencontrées depuis deux mois, celle-ci est certainement la plus prometteuse: une équipe solide, composée d’experts dans des domaines complémentaires, avec beaucoup d’expérience et un réseau de contacts impressionnant; une idée originale qui répond à un besoin réel et un modèle d’affaire intéressant basé sur de vrais revenus plutôt que l’espoir d’être acquis. Bref, avec la quantité de capital de risque présentement disponible sur le marché, trouver du financement devrait être facile non? Eh bien, non. Le problème c’est que leurs présentations auprès d’investisseurs canadiens sont invariablement suivi de la même question: “C’est bien beau tout ça , mais pouvez-vous déposer un brevet sur quelque chose?”

Si je développe un nouveau procédé industriel je vais immédiatement faire une demande de brevet. Je ferais de même si je concevais un nouvel algorithme pour compresser de la vidéo numérique. Je reconnais l’importance des brevets en tant qu’outils défensifs et source de revenus pour une entreprise et je ne veux certainement pas entrer dans la polémique au sujet des brevets reliés au logiciels, mais si l’on veut investir dans des startups web, il faut être prêt à revoir sa façon d’évaluer les entreprises.

Dans le monde Web 2.0, mon entreprise utilise (gratuitement) les ressources d’autres sites pour transformer du contenu fourni par les utilisateurs eux-mêmes en un service utile. Suis-je une entreprise de technologie? Je n’ai rien développé, j’ai utilisé du code open source existant. Suis-je dans le secteur des médias? Peut-être, mais je ne cré, ni ne possède le contenu de mon site. Dans ce monde nouveau, les philosophies d’investissement traditionnelles ne fonctionnent souvent pas. Certains venture capitalists se sont adaptés, mais d’autres tardent à le faire. C’est pourquoi cette jeune entreprise très prometteuse cherche désormais son financement aux États-Unis.

I have been looking at the availability of seed capital for startup’s in Montreal. Although there is plenty of VC capital available at the $1-2M level, I could not find any funds available at the $50K to $250K level. This is typically the space in which Angel investors operator rather than VC’s, so I delved a bit more into available statistics for Angel investing.

The Canadian national average has Angels providing 6-9% of all Risk Capital. In Quebec in 2005 (the latest figures I could find) Angels only provided 2.5% of all Risk Capital! Are these statistics actually indicative of the real life situation?

Seed capital at this level is essential to the development of ideas and first time entrepreneurs.

In enclaves such as Silicon Valley, where there is a sizable pool of talent, an increase in seed capital leads to an increases in the pool of entrepreneurs and (in time) the number of successful companies and associated role models. In turn, these companies and role models further aide the motivation and education of a new wave of entrepreneurs that will need seed capital … a “virtuous circle”.

As Montreal’s tech entrepreneurs start to become more active (tech breakfast, barcamp, blogs etc) it is essential that they have access to Angel level funding. I’m going to start looking for it … let me know if anyone else know’s where it is !

I am new to the world of penny stocks but have been trying to educate myself on it for a few reasons.

Firstly, I invested in a company that was not a penny stock when it IPO’ed but soon became one !! (fortunately I “doubled down” and am now back in the black); secondly, one friend and one business acquaintance have recently taken companies public, one on the Bulletin Board (BB) and one via a pink sheet reverse take-over; thirdly, my interest in mortages and securitisation have lead me to a BB listed sub-prime mortgage lender that I wanted to investigate further prior to seeing whether they were worth investing any of my time or money.

My current feeling is that back door listings, penny stocks are used by companies that can’t get a serious investor interested – so they try to get money by selling a story to un-educated investors who won’t ask difficult questions. I’ve heard stories about having stock to acquire companies, but shares are very expensive currency if you really do have a solid business.

I would love to be convinced that I’m wrong. Any takers?