Oct14th
Sunday, October 14th, 2007
David:
This Memorandum is confidential unless you decide to share it with others.
With your permission I am writing to cover several related topics; namely (i) what I consider to be the strengths and weaknesses of the company with an emphasis on how an investor candidate will likely look at the company, (ii) a recommended structure to use with investors, (iii) the importance of having a Plan B, and (iv) approaching Chinese companies you will meet on the trip who may be interested in investing for equity, as opposed to acquiring fractional interests,
1. Strengths and Weaknesses of the Company as Perceived by Potential Investors.
First the Strengths:
(a) Your commitment of funds and the significant amount thereof.
(b) Your vision as to the importance of bringing some manufacturing back home.
(c) Your insight into the fractional ownership concept.
(d) The attractiveness of the franchise concept to be sold to engineering design firms.
(e) The prospect of expanding the manufacturing options.
(f) Branding the company’s name as a name that carries economic value.
(g) The pending patent.
(h) The possibility of a strategic relationship with industry players.
(i) The prospect of doing business with Chinese manufacturers.
(j) The collegiality of your employees.
(k) Preliminary plans to acquire other companies from related fields.
(l) Your success with your previous company, although it was in a different industry.
(m) An anticipated ‘exit strategy’ based on the possibility of being acquired.
(n) This list is not intended to be complete.
Second, the Weaknesses:
(a) The lack of a significant number of customers to date for the business concept.
(b) A shop floor that is underwhelming due to a scarcity of customers.
(c) Financial forecasts that show the company to be in the low-margin manufacturing sector (net income after taxes of less than 10% of gross sales), as opposed to having found a way to break the mold, so to speak, and create a new economic model, one that shows that customers will pay more than industry prices.
(d) Present uncertainty as to the correct direction for the company to pursue, whether China will be a ‘good partner’ or not, and what happens if the business plan and the revenue forecasts do not materialize.
(e) The age of the team, and without someone from the industry who is the CEO and a ‘stud.’
(f) Lack of a board of directors, or of advisory board members (as of the moment), that otherwise shows the strength of its outsiders.
(g) Need for a ‘Plan B’ that can assuage investors’ need to feel safe with their investment.
(h) Unlikelihood that a lead investor will emerge from conventional sources
such as aligned companies, venture capital funds or other categories.
(i) The geographic location of the company, which is too far from the airport to make it convenient for out of the area investors to schedule one day meetings at the company’s offices.
(j) Some personal health issues that may affect you and in turn potential investors’ comfort.
(k) This list is not intended to be complete.
2. Choices, Best Scenarios and the Alternatives Regarding Funding.
Using a balance scale, and trying to imagine all of the items listed under “Strengths” on one end and all of those listed under “Weaknesses” sitting on the other end, it is my conclusion that we should give unbiased attention to whether we can successfully raise the intended $4M before the middle of December. To do so we may have to be creative in the areas of the structure of the investment, with an emphasis on enhancing the return to the investors.
If after we have worked through all these issues we are not prepared to bet the farm on the likelihood that investors will sign up, and quickly, we should begin the process now to identify possible acquirers of the company. Between just us, this will be known as Plan B.
Due to the upcoming trip to China and the time constraints when the management team is out of the office, we have a challenge in fitting in presentations to potential investors when everyone is around. This only makes it more critical to know what we are doing with respect to the terms of an offering, where there is flexibility and how do we get someone with credibility to be a lead investor.
It may be necessary to focus on potential investors who reside nearby, or those who have other connections to the company and/or its team, and leave out of the equation any potential investors who live elsewhere or who do not have any pre-existing connection to the company and/or its team. Furthermore, it is unlikely that we can attract venture capital funds, even if we were willing to live with their onerous conditions. The economic model does not have the ‘big win’ kind of numbers, without gross speculation on our part, to convince them that this fits their portfolio requirements.
To that end, John, your financial analyst and manager of some of your personal investments, may be an important link to possible investors. Can he recommend, or at least offer to show the Business Plan to some of his clients without violating any rules or disciplines? He will have to make a disclosure of his relationship with you. If he can help and is willing to do so, perhaps the company can compensate him when he brings investors in. If so, we should start the process with him immediately.
All of the above is written with an eye on the calendar. If it was six months ago, the trip to China was behind us, and the franchise plan was well accepted by engineers and design firms, then we would have a different story to present. Time is of the essence. And getting behind the ‘8 ball’ is not allowed to happen.
We have to capture the moment and not worry about negative ‘what if’ events could happen. Time is of the essence, and I apologize if this is a repeat.
3. Proposed Structure for the Investment.
Based on the foregoing, I suggest that you consider approving an investment package that has some incentives you may not otherwise be in favor of. These are as follows:
a) Create a strong preferential schedule for paying the investors back sooner than you will recoup your investment. To do this, consider the following. Give these investors a disproportionate return, not in alignment with their percentage of equity ownership. To this end, how about a structure that says the investors will be paid 60% of the company’s net after tax income until they have recovered 100% of their investment?
Incidentally, if the company is reorganized as a limited liability company, as opposed to a C corporation, it would avoid double taxation. As an LLC federal income taxes only apply on funds when distributed to the equity holders. There is no tax on the income at the LLC level, unlike the liability for taxes on a C corporation on its net income, and then taxes are also levied on the distributions/dividends to its shareholders.
b) Let’s consider using Convertible Promissory Notes rather that try to sell Preferred Shares at this time. The Notes will carry say interest at 8% per annum, and be due and payable after 24 months. Furthermore after two years the company can make a demand that the Notes be converted at a set price per share. The conversion will equate to 33% of the then outstanding equity of the company. The Notes would automatically convert into Class A Preferred Shares (with the preferences as shown below) if the company is acquired (or goes public).
c) There will not be an escrow requirement for the proceeds received from investors if we can keep it out. Otherwise we can offer to escrow the first $2Million and then the escrow goes away.
d) Following conversion of the Notes, the holders thereof will have anti-dilution rights as long as the Notes are outstanding. After that they will have a right of first refusal to invest whenever the company elects to sell additional shares so that they can protect their percentages of equity ownership.
e) If the holders of a majority of the Notes elect to convert at the two-year date, then all holders shall be required to convert their Notes.
f) In the event of a liquidation event after the Notes have been converted, the holders will have a preferential right, before any monies are paid to any other classes of shareholders, to be paid an amount, which when added to the monies previously paid from the annual net after tax income of the company, that together are equal to the amount of their original investment.
g) The company will not hold any redemption rights.
h) The board of the company will have at five directors. As an added inducement I recommend that the investors, as a group, be entitled to designate two members of the board, subject to approval of those nominees by the company. You and two others, selected by you, will be the balance of the board members.
i) If for any reason the investors have not recovered their entire investment within three years, they would be entitled to designate a third director and the board remains at five members.
j) Agree to hold equity-holder meetings at least once a quarter and to provide annual financial statements and quarterly un-audited financial statements and reports.
4. Rationality Behind Proposed Structure.
The purpose in suggesting these clauses and terms is to give investors a sense of safety without indicating that the company has concerns in these areas. Also, I should add that in the presentations we need, at the outset, to establish that the company is just beginning to look for investors. The purpose of this is to convey a dual sense of opportunity; namely that they are getting a first look and that you have not been turned down by other possible investors.
There is a thin line between selling an investment and showing an investment. We must be showing, not selling.
5. Capture the Audience.
Another point to make is to create in the meeting a quick sense of mutuality. Body language from those in the room, or what and when they say something is also a harbinger of how they are looking at the opportunity to write a check. It stands out like a sore thumb, hopefully one that is pointing up. The surest way to make this connection from the outset of the meeting is to find something that is common to those hearing the presentation and those making it. It could be backgrounds in manufacturing, schools attended, where they live in the area, who else they know, etc. Hitting on one of these links, or others is very important.
Whoever is presenting, at any part of the presentation, should not get lost in what they have to say. They need to be on the look out for what is being said by the attendees, how they are engaging, whether they are leaning forward or sitting apart from the others in the room. It also helps to have as much GQ on each of the persons in the room beforehand so that we can address those interests and questions before they are asked.
Venture capitalists like to see “Mo” meaning momentum. Rather than getting bogged down in too much detail early on we should begin the meeting with the latest momentum for the company. Numbers can be boring but news suggests that the company is on to something. Stories from recent trips, unanticipated calls from potentially significant customers, etc., are very good indicators of “Mo.”
6. The China Investment Question.
The Ambassador clearly was pushing the proposition that companies in China may want to become investors in the company. I am recommending that before you and the team gets on that plane that a plan is agreed on as to how this will be handled. So much in China hinges on relationships and culture. It may be important from both of those points to give this careful consideration. If the company has no interest in selling any shares to a Chinese company they will, I believe, take it to mean that we do not see them as being worthy. Based on my belief, I see an opportunity to create a genuine interest on their part the more you and the team engage with your hosts. If it makes business sense to have Chinese companies using the company’s facilities for US customers who need rapid prototyping, then it should also make sense for the Chinese companies to acquire some ownership in the company. The amount of ownership, of course, has to be attractive to them but not a threat to the company or its mission (unless they want to pay an Emperor’s ransom).
If this was my company and my chance to interact with Chinese manufacturers who have the capital to become good investors, I would entertain them and the possibility of working something out. Excuse my openness but I know how well Jin can work with them and if you ask him to explain the idea he will do it.
7. Conclusion.
If it was not for the time constraint and the time of the year, things could be easier with respect to the raising capital. I am very mindful of your commitment to the company and will stay very pro-active with you so that you can rest any worries you have. Call me anytime, day or night. I will travel to the company, participate in presentations and keep providing my best advice, whenever asked.
I look forward to hearing your comments, questions and any criticism. Following those we can advance the fund raising process.
Jacques Nichols (c) September 2007
Posted in Business, Business Coaching, China, Finance, Money, Venture Capital | No Comments »
Print This Post
Email This Post
Oct14th
Sunday, October 14th, 2007
Allow me to write an important historical footnote, insofar as Oregon is concerned. The first venture capital backed investment in the history of Oregon was in 1971 when Floating Point Systems raised $1 Million for ten percent of the company (that would still be a good deal today for most start-up companies). The funds were provided by Greylock Management, Fidelity Ventures and Sutter Hill. Norm Winningstad, the President, (there were no CEO’s in the 1960’s and 70’s) called to introduce himself and said he would like to hire me as a special counsel for the company in connection with a venture capital investment. He had been to an AEA Conference in Monterey, CA and, as I soon learned, had excited these funds and they were about to come to town.
To conclude this historical note, the attorneys in New York made a typo in their confirming letter when the attorney wrote that the funds would invest $1.1 Million for ten percent. I brought this $100,000.00 error to Norm’s attention but was advised to say nothing and let them catch it. When Bob Newton, then the Treasurer and CFO for Floating Point, and I walked into the conference room for the closing and saw three checks on the table we saw that they had not caught the error. Score one for Oregon vs. The Big Apple. In any case, I think those venture funds made more than 10X on their investment in Floating Point.
My first connection to Silicon Valley and Sand Hill Road in Menlo Park, CA (there’s a Sand Hill Road in Las Vegas too) was an undergraduate degree from Stanford University and a degree from Stanford Law School. But those were received in 1959 and 1961, respectively when there was no Silicon Valley at that time, let alone the Sand Hill Road that everyone knew about. I first had to go to Portland, Oregon and establish a law practice with start-ups and early stage companies before I had connections to the Valley.
On a couple of occasions during the late 1970’s Peter Crisp, the Managing Partner of Venrock, sat in the conference room at my law firm. In 1984 Dick Kramlich, a founding partner of New Enterprise Associates, sat in that same room. If you had only two draws to make in a game of venture capital poker, those two gentlemen stood a very good chance of seeing to it that you won every hand.
From those meetings and the offer of friendship from Peter and Dick I gained an immeasurable amount of respect for both of them and the way they represented the Venture Capital industry, (as it was practiced at that time). Although I was in Oregon, I knew I would be associated with them and this industry for a long time.
Other stalwarts from that august society also sat in that conference room. Charlie Waite from Greylock, Management, Grant Inman from Hambrecht & Quist, Vince Prothro on behalf of NEA, David Hathaway from Venrock and Paul Wythes from Sutter Hill were there too. On trips to the Valley I was introduced to Burt McMurtry of Technology Venture Investors (the only fund that invested in Microsoft) and other funds who had offices in the Valley.
I met a founding partner of US Venture Partners when he came to Portland to consider investing in a client, Avia, a footwear company. After we got acquainted he asked if I would be interested in managing a Portland office for their firm. NEA, on a couple of occasions brought up a similar possibility. At another time Jean Deleage from Burr, Egan and Deleage’s San Francisco office and his partners from Boston invited me to meet them in New York to discuss the same topic. While the possibility of joining a venture capital fund was enticing, I knew how distant, in many ways, Portland was from Silicon Valley and I did not pursue these discussions further. While I was fascinated with these possibilities, I kept seeing myself as a Maytag repairman, waiting for a return call from the home office.
As my law practice I was approached by numerous local companies asking for introductions to the funds I knew. In the fall of 1982 I quickly formed a company and called it Capital Bankers so that I, and two friends, could show up with business cards at the American Electronics Association show in Monterey, CA. I had heard about this gathering and I had an idea. It was confirmed as I sat through the various presentations. Oregon, and the Northwest, in fact had high tech companies that were equally interesting as the companies from California that presented at the AEA show. So, why not stage our own version of the AEA show?
I took up the reins to prove my convictions. In the period of December 1982 through November 1983 I organized and headed up the Northwest Financial Symposium. At the first event in Portland 66 venture funds attended and most had not been to Portland before. A hand-selected cast of 31 local companies presented and most of them attracted attention for one or more of the funds in attendance.
Within this ‘82-‘83 timeframe the event was held a second time in Portland and once each in Seattle, Phoenix and Calgary, Alberta, Canada. Although I was no longer involved with the Symposium after 1983 it had a continuous run of 11 years in Portland, and I believe in Seattle too.
More and more I found myself being drawn into the world of venture capital. In 1984 the VC bug bit me hard and I decided to leave the practice of law and jump in feet first. I become the Managing General Partner of what I named First Source Capital Fund. Later on I had a silkscreen company print up some T-shirts with a tag line that said: The Venture Fund With The Silent “D” The shirt was my retort to another VC’s comment that this work was not fun.
First Source was a general partnership with a Fortune 200 company that was in the timber products industry. They agreed to provide the capital and I was responsible for finding the companies in which to invest. At that time interest rates were north of 15% and home building was in a slump. The company thought that by emphasizing the new world of venture capital their shareholders would stay the course. Unfortunately for me they only provided money for three years, instead of the agreed-upon ten years. By then the period of high interest rates had passed.
The funding company lost its way and its character when they opted to break the partnership agreement and take the entire portfolio of investments in six companies and to cut me out of my 15% share of future gains. : -( And to know the rest of that story you will have to read my forthcoming book with the co-titles: WHO THE HELL SIGNED ME UP FOR THIS CLASS? and IF YOU WANT TO SEE GOD’S FOOTPRINT, CHECK YOUR BUTT!
One of the investments First Source made, in addition to two others that made money, was in FLIR Systems, Inc. for $8.1 Million. I will never forget signing that check. The fund acquired 40% of FLIR and in 1994 it went public. Ten years later FLIR had a market cap in excess of $3Billion. Besides the obvious math lesson as to what the value of my share of the gains would have been worth, the most painful lesson I learned was to know your partners. I had also failed to heed a warning from Dick who knew the CEO of the funding partner. He said the CEO could not be trusted and for me not to enter into the partnership.
That is also the No. 1 lesson to learn for any company that sets out to attract investors: Find where is the trust factor on the investor’s scale and your scale. Do they align? Can they be trusted? Can you be trusted? Does their word equal their bond, or are you going into bondage?
To tell more of the story about the start of First Source the same day that the funding company agreed to provide $100 Million over ten years they said it was subject to one requirement, namely that they would be the only investor. Just hours earlier the Secretary of State for Oregon had offered to invest $25 Million from state funds. Calling him back and declining his kind offer was a one of a kind experience for me. In the 1980’s even a venture fund in the Valley with $25 Million in committed capital was considered to be a player, let alone one with $100 Million.
At least I got one good memento from the partnership. Chuck Yeager, the first pilot to break the sound barrier, was on the board of the timber company and he gave me two framed pictures of him with his airplanes. I have since given them to my son. Feeling that reciprocity was a good idea, years later I gave a John Clymer print to the CEO of the timber company. It showed two hunters huddled near a fire while a venison meal was cooking. In the night background the yellow eyes of a pack of wolves starred at them. He owned a hunting lodge and I thought this would be appropriately hung on a wall. He sent me a thank-you note yet I wondered if he got the hidden meaning of my gift. I may have been dead meat after he terminated the partnership, but maybe there were wolves out there now he had to watch out for? A couple of years earlier he had been removed by his hand-picked board.
After First Source ceased operating I stayed connected to the world of start-ups and venture capital either as an attorney, an advisor or as a source of introductions to angel investors. Still I’ve wanted to return to that world, albeit in a different form, and certainly not as a wolf. I sought something that was similar in many ways but very different when it came to offering more than money to start-up and early stage companies. That something required to first looked to find if the entrepreneur had a heart or only a desire to be rich, and then I looked to see if the money men ever had a heart.
Thinking as often as I did about this subject, I concluded that destiny had its own clock and I couldn’t advance the hands any faster than they were programmed to move. Now, at last, those hands are in sync with a special source of funds that I have been working on for the past two years. However, it will remain in stealth mode, as I have learned that some things are best left unsaid.
I also had a great friend and executive recruiter who knew the Valley well. His name was Bill Tholke and he lived there since the late 60’s. Everyone knew Bill and his great Irish tenor voice as well as his love of telling good jokes. He ran all the search assignments for companies in which First Source invested. Bill passed away in 2005 and at the time he was a partner with Boardroom Consultants in New York with an office in Palo Alto. He often invited me to visit him in New York, or in Palo Alto, where I met John Atalla Ph.D., who previously worked at H-P Labs, and other founders of Valley companies. Some day I’ll tell the story of when Bill and John sat in that same conference room at my office in Portland and what Bill said to John who had a month earlier had missed the Christmas Party for the Atalla Corporation. Bill was on the board and with his wife attended the party. The punch line from Bill brought the three of us to hysterics.
One day while having lunch with Bill at the famous Sun Deck Restaurant on Sand Hill Road I went out to the rental car to pick up something and as I got to the front door I had the special privilege of holding it open for Bill Walsh, the revered coach of Stanford and the San Francisco 49ers. I said something about Stanford, he acknowledged it, and we passed like ships in the night. What was Bill doing there, was he being invited to hear one of those presentations where a deal is struck on the back of a napkin?
Portland Oregon has never been on the beaten track for VC’s, whether from CA or NY. So what goes? Why did Peter Crisp, Dick Kramlich and the others come to Portland? The answer is that I was fortunate to have clients for my law practice like Floating Point Systems, Mentor Graphics, Lattice Semiconductor, AVIA Group Int’l and others. They were the reasons these visits took place. Also I had been the attorney for the original investors in NIKE, Inc. and some of them invested in other companies I represented.
The visit by Dick to Portland in 1984 was at his invitation. I had previously attended NEA Annual Meetings with its limited partners in Dallas and San Francisco. Dick called to ask if I would make some introductions to potential investors for NEA. He was raising money for one of the early NEA funds. I was most pleased to do so. I soon arranged meetings with representatives of the Meyer Memorial Trust (the largest foundation in Oregon) and the State of Oregon’s Public Employees’ Retirement Fund.
Roger Meier, the single-handed chairman of the board of trustees of the State Fund, reluctantly agreed to attend the meeting. But that was Roger’s style, no matter who wanted some of his time.
Dick sat to my left and Roger sat across from me. Gerry Pratt, a good friend and a trustee for the Meyer Trust sat next to Roger. Dick started his presentation but Roger could not wait until he was finished. Instead he interrupted and said that he had just read that week’s Time Magazine article that was all about venture capital and he mentioned that Arthur Rock, who was on the cover, was someone he would prefer to be meeting today. Dick, without a hint of a smile on hearing Roger’s challenge, simply said: “I had lunch with Art yesterday; I used to be his partner.” I am temped to add an exclamation point at the end of the preceding sentence but Dick didn’t when he spoke, so I’ll let the urge pass.
Safe to say, Roger was impressed with what Dick said and invited him to make a presentation to the full board of PERS. Gerry then invited Dick to come to the Trust’s offices. NEA secured, as a result of that trip, at least $10 Million from the State of Oregon’s Fund and $5Million from the Trust. Hopefully both entities continued to participate in every succeeding NEA fund. If they did the ROI on their invested dollars is among the best in the country from VC firms. Gerry still goes to NEA’s Annual Meetings and I doubt he would ever pass that duty on to someone else. In the mid-1980’s Gerry said that he had designated me as his successor Trustee. I should ask him sometime if it is still written that way.
Peter Crisp came to my attention and me to his, when Brooks Ragen, who was two years ahead of me at Stanford Law School, dropped into my office when he was in Portland to visit his family. After law school he moved to Seattle where he was an investment banker. He later formed Ragen McKenzie. When Brooks asked how I was doing, I mentioned that I had a number of start-up companies as clients. He immediately reached for the phone on my desk and dialed Peter’s number. Peter and Brooks had been undergraduate classmates at Yale. When Peter answered, Brooks passed the phone over to me.
Peter had not been to Portland before but said the companies sounded interesting and that he’d fly out for a series of introductory meetings. I learned more from watching Peter in those initial meetings about venture capital and how it was practiced than I learned from anyone else. Two stories from Peter’s trips demonstrate how venture capital was pioneered years ago.
One of these lessons took place at a software company’s offices in Beaverton, OR. The founder was so excited to have some one connected to the Rockefellers in his office that he could hardly contain himself. When he asked Peter for his card he was told: “I don’t have any with me. Peter practiced venture capital without fanfare. He did not give his business card away to just anyone. First they had to show him who they were. Later in that meeting he reached across to a grab a sheet from the yellow pad that the founder had been writing on and filled out his phone number in New York.
During the same meeting Peter made a point that was another lesson. As the founder became more and more convinced that his company had to be perfect for Venrock Peter listened and then said: “My job is like working at a railroad station. As I look out onto the tracks I see a string of cars that seems to go on for miles. Yours happens to be the one that for now is right outside the window. I may pass on your company and miss a terrific investment, but there are so many more cars that have yet to go past this window that it will be OK with me if we miss this one.”
Another story, with an obvious lesson, came during a dinner Peter and I had one evening with the founder of a medical products company. He was the only one of the six companies on our schedule that heard the magic words from Peter: “I’d like you to come to New York to meet my partners.” That’s all it took, one dinner and the door was wide open. Unfortunately my client, Richard Flora, made the mistake of being a wise-guy and said (after too much to drink): “Why the hell do I need the Rockefellers?” I kicked him on his chinbone but Peter let the humor pass and repeated the invitation. Instead of accepting the invitation Richard sold the company to Pfizer only to later wish he hadn’t.
To continue with my brand of insight into how this industry operated, another venture capital story with a lesson, comes to mind. In 1985 a group of NEA partners visited companies in different localities across the country. Portland was on their list. Neal Bond and Frank Bonsal were the lead partners on the trip. Trusting in my judgment, they had not asked beforehand which companies we would visit. When I pulled up my van at the first company’s parking lot someone sitting in the back asked if Fred Adler was an investor in this company. I said I believed he was, although the company was not a client of my office. The next words I heard were: “Drive on to the next appointment; we are not going in.” That was lesson number three: Don’t try to force a marriage between various funds.
Unfortunately I did not learn that lesson well. In 1987, and after the termination of First Source Capital Fund, I arranged for a meeting at Burr Egan & Deleage in San Francisco. Jean Deleage had offered to introduce me to some of their limited partners who may be interested in investing in a new fund in Portland. A third person who I had invited to the meeting immediately brought up the name of Patricof & Co. from New York. As soon as Jean heard that piece of information he said he could make a couple of recommendations as to where we might want to go for dinner, but he would not be joining us. There went about $40 Million and the possible successor fund to First Source died.
Portland is also not without connections, some of which are remarkably similar to those that have worked in the Valley. When you read the history of Kleiner Perkins, the ultra successful venture fund in Menlo Park, you learn that Henry Hillman, Sr. was their first investor. Henry Hillman, Jr. and I met here in Portland after I had guaranteed a $250,000 bank line of credit for AVIA. I did this because I could not allow an investment banker to do so and in consideration thereof he demand 40% of the company. For my good deed the founder sent me a collector’s duck call from Eddie Bauer and a few shares of common stock. Actually I did very well when I sold the shares in a gray market before Reebok bought the company. Henry once told me that his family made more money from the first four investments made by Kleiner Perkins than they did from the next 200. Genetech was one of those investments, along with Apple.
Henry also said that with venture investing the big unknown is whether ‘Luck’ will make an appearance. When he invested the bank cancelled the guarantee I had signed for the company’s line of credit.
Sorry if I can’t stop telling these venture capital-related stories. And speaking of Apple, or in this case the Big Apple, the meeting with Jean Deleage and his partners as mentioned above took place in the Helmsley Hotel in Manhattan. On entering a spectacular French provincial restaurant on the mezzanine level one of Jean’s partners said, as he pointed to the ornate ceiling overhead: “Jean, this reminds me of your home in California.” Jean took a moment to look upward and then, being a true Frenchman, and with a delightful accent said: “No, my ceilings . . . zey are a bit higher.” Touché.
And, one more bit of wisdom. When I first heard the word ‘nanosecond’ in 1981 from Raul Sud, the founder of Lattice Semiconductor, I immediately decided it also defined the length of time it took an investor to go from being an optimist to being a pessimist, or maybe it is the other way around if the investor is a cheerleader at heart.
A final story . . . for now. In its original cardboard tube alongside my desk is a full-size movie poster in color with a caricature of me, ala Marlon Brando from the Godfather movie. Years ago I was dubbed the ‘Godfather of Start-Ups’ (it only applied in Oregon). Ray Nelson, the founder of Flying Rhinoceros, a local animation studio, presented the poster as a surprise. I love it but for various reasons have left it in the tube. A tag line at the bottom says: “It ain’t no picnic getting you’se guys de bucks.” One of these days I’ll take it to a framing store and find an appropriate wall to hang it on.
LEARNING ABOUT VULTURE CAPITAL
In 2005 I learned first-hand what vulture capital was all about. Peter and Dick would have never treated a company that way, or its original investors, let alone care only about making money. Once I had the experience of seeing how vulture capital operates I began casting about for a new and different term to signify the type of capital that would serve the mutual interests of investors and portfolio companies. I believe that an investment is an inter-dependent partnership between the investors, the entrepreneur and early seed investors. My first attempt was to coin the term: “Harmonic Capital.” Again loving to write, I wrote a tag line. It said: “Finding the Perfect Balance between the Pitch and the Note.”
The more I thought about what I had heard in that 2005 meeting I decided that ‘vulture’ was not an appropriate enough word, so I gave that kind of capital another ‘V’ word. Hint; it comes in a jar. What made that meeting so heinous was not just a requirement that the fund’s moneys hold a 4X preferential right for return on its money before any returns would be paid to the earlier investors (including myself), but it was how they practiced the art of deceit. The investors that I brought in when the company was formed purchased their Class A Preferred Shares at a price of $0.50 per share. When the funds that invested as a second round came in the transaction was structured as Convertible Debt and their monies were to be converted at $0.67 per share.
That price was all right, however, they did not convert the Notes when they became due. Instead since they controlled the board and removed the original CEO and appointed their own CEO. They waited two years before calling an Annual Shareholders Meeting. When a Notice of a Shareholders’ Meeting was sent out it called for a meeting in just ten days. Tucked away in the accompanying material was a proposal to convert $8.8 Million in Notes, plus $4 Million in additional loans, not at the specified $0.67 per share, but at, can you believe this, $0.04 per share!
I challenged their attempt to reorganize the capital structure of the company in this way but just before the meeting I learned they had strong-armed the founder/employees who held the majority of the common shares to vote for this plan or be fired. With control over the number of shares required to vote for their proposal, all I could do was leave my thoughts in the room. To do so I told the VC’s and the other shareholders in the room a story from FLIR early history and how I helped raise $2,500,000.
A close friend of mine, Chuck Wiper, who had been a B-17 pilot in World War II and who said he wished that FLIR’s infra-red camera had been on his plane before it crashed, invested $1.25 Million on the spot when I asked him to invest. He called me a couple of days later to ask why a Seattle venture capital fund needed an extra month to do due diligence before they would write a matching check. He added: By he way, I just went to the Post Office and mailed you another check for $1.25 Million. Then he added: “Please do me a favor and call that fund and tell them you just got some ‘Screw-you’ money!”
Chuck was also an investor in NIKE, Oregon’s all-time most successful investment. If you had invested $20,000 today you’re your NIKE shares are worth over $400 Million and your annual dividend exceeds $4 Million. No, I did not take any of my fees and buy some of those shares after I was offered the chance to do so.
Spoken as it was in full living color, that display of such a vitriolic form of venture capital led me to continue to seek an alternative funding classification. It had to be one that for ever more separates itself from all the other ‘v’ words I’ve heard or used. Thus I created the term ‘Virtuous Capital.’
The present terms and conditions in a VC-written term sheet are as much fun as catching your tie or shoelaces in an elevator door. They focus on cram-downs, perpetual anti-dilution, 4X or greater preferential rights, and not to mention a VC dominated and one-sided board, their hand-picked management, and the upcoming nightmare of trying to find satisfactory dates and times for future board meetings that meet the VC’s schedules, never management’s.
PREMISE AND VISION FOR VIRTUOUS CAPITAL
The most interesting part of Virtuous Capital is in knowing that it will not, absolutely will not, be attractive to most funds and their limited partners. Why? Because on the surface it looks like it will limit the amount of possible gains from their investment.
This concept works perfectly with Virtuous Capital. Here is the underlying model: Funds that are certified to be ‘virtuous’ are required, at the inception of an investment, to set a cap on their expected return from the investment. Future returns, if they exceed this ceiling, are required to be contributed to charities.
The more (i) equity in a company that is earmarked for, or outright granted, to selected charities, when the investment is first made, and (ii) the more of the future gains that the investing fund receives upon a liquidity event, the ultimate economic value of the company will be greater than with a typical venture/vulture capital deal.
I acknowledge that future results from investments made by funds that hold themselves out to be virtuous will confirm or disprove the preceding statement.
Speaking of this dual charitable component of Virtuous Capital is like how the word ‘dilution’ draws focus away from the primary reason a company seeks investors, namely to grow the company. Instead all they think about when they hear ‘dilution’ is how large a percentage of their company they will have to ‘give away’ to get funded. I have hit this ‘percentage reduction’ notion on the head many times in an effort to educate the audience that you cannot buy anything with a ‘percentage,’ that you need money, right? It is the anticipated growth in value of the company, thanks to the money and the wisdom from the investors that should come with it that makes the percentage retained at the time of closing rather unimportant.
I believe that funds that are certified to be ‘Virtuous’ will not only do well by doing good: They will be the funds of choice for the most promising companies with world class products and services Once companies learn about virtuous capital, such companies will seek out funds that practice the tenants of virtuous capital.
Virtuous Capital will not be its own (only) reward.
The first person to whom I mentioned the phrase ‘Virtuous Capital’ was Bill Hogan of San Jose, CA. Bill’s resume points out that he has raised over $100 Million as a CEO but the reason he got my call was that he has more recently been the CEO and a board member of Global Giving, based in Washington, DC. I knew that if anyone would ‘get’ what Virtuous Capital stood for it would be Bill. Since then he and I have talked about it numerous times and we are going to apply its principles whenever we are involved with funding companies.
I also realized that this concept of Virtuous Capital needed a special audience to test its impact and veracity. In the spring of 2007 I flew to Phoenix, AZ to attend a meeting of a company that had asked for my assistance to attract an investor. Before going to the meeting I reviewed a collection of bios about the principals of the company. One stood out. It was from John Paul Warren. If space permitted his bio should be reproduced here. Suffice to say, John Paul has an international reach as a man who has reached millions of people, yet he is an entrepreneur.
As the meeting began each of those in the room knew they would be asked to talk about themselves. John Paul sat to my right and the direction the introductions were going around the table meant that I would speak before he did. I wanted it to be the other way around. Sure enough, the founder of the company, just before I was to speak, suggested that John Paul speak next. I doubt that anyone, except for me, would have chosen to follow John Paul. He was a tough act to follow, that’s for sure, but it made sense once I began to speak.
I said that I had recently coined the term Virtuous Capital. John Paul immediately showed that he was paying attention. I continued and said that Virtuous Capital not only was about making money but it aligning itself and its portfolio companies with charitable organizations that had connections to the company’s products or services. I said that it was designed to have our cake while planning for others to eat it too.
When I finished speaking John asked me to stick around during the break. When we had the room to ourselves he said he had been praying for such a new term. He immediately offered to join me in taking the message about Virtuous Capital to the world. He has spoken to audience in 110 countries.
Virtuous Capital is a variation on Socially Responsible Capital, which focuses on public companies, while Virtuous capital focuses on start-ups and early-stage companies. More work is needed to further develop the concept and the distinctions to be found in the term, Virtuous Capital. I’ll look to Bill and John to help here.
Maybe we will call it Vir/Cap. It is also the antithesis of the term ‘Super Capitalism,’ used by Robert B. Reich in his new book by that title. The cover of his book says it all, with a string tied on the dollar sign.
Virtuous Capital can stand on its own and succeed the way venture capital was designed by the first venture capitalists over 50 years ago.
Bill Hogan John Paul and I will co-author this book. Together we plan to introduce and champion its message and mission on an international scale.
All of this will be spelled out in greater detail in the book.
Let’s begin . . .
Jacques B. Nichols © Oct.2007
Posted in Business, Finance, Money, Uncategorized, Venture Capital | 1 Comment »
Print This Post
Email This Post
