I hustled down to Wilmington yesterday to see Steven Davidoff present his fascinating paper on why so many private equity deals collapsed when the market went south.  Didn't the targets negotiate binding contracts?  Steve showed how these deals evolved in ways that allowed the PE firms to walk and analyzed the contribution the legal market made to the failure of targets to lock in their purchases (the five repeat-playing firms in go privates largely represent the acquirer in these transactions). 

If Davidoff focused on the lawyering, Vice-Chancellor Leo Strine was particularly interested in the way that the financial institutions bankrolling the leveraged takeovers were able to get out of their commitments.  Both he and Davidoff then suggested where they thought private equity contracts might be reformed.  And both agreed that, like much else during this financial crisis, the evolving shakiness of the deal contracts was probably ignored because nothing failed until 2006, and the parties to these transactions were probably disinclined to worry about eventualities that surely wouldn't come to pass.

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I just started reading Creative Capital: George Doriot and the Birth of Venture Capital, on new biography by Spencer E. Ante. When I first took an interest in venture capital, I read a fair amount about American Research and Development (ARD), the firm that Doriot made famous. In the Introduction, Ante retells the story of ARD's landmark investment in Digital Equipment Corporation (DEC). Have you ever seen the numbers?

ARD received 70% of DEC in exchange for $70,000. When ARD sold that stake in DEC, the company was worth over $400 million.

No wonder Doriot inspired imitators.

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If you don't recognize those initials, I assume you don't pay much attention to venture capital investing. Kleiner, Perkins, Caufield, and Byers is featured in the most recent issue of Fortune in a story by Adam Lashinsky because of its investments in "Greentech" and its move away from Internet companies. The story -- entitled "Kleiner bets the farm" -- is getting a lot of play on the tech blogs because of this paragraph:

Several Valley investors who monitor startups tell me they don't bother sending Web-oriented entrepreneurs to pitch Kleiner anymore; they say the firm just doesn't seem interested. As if to prove the point, not one Kleiner partner attends the 600-person [AllThingsD].

But the main thrust of the story is that KPCB is putting all of its eggs in the Greentech basket. This comes from an unidentified KPCB investor: "I hope to God they're right.... But if they're wrong it'll be the end of Kleiner Perkins."

So how risky is this move by KPCB? For a more balanced perspective on what KPCB is doing, you might want to watch KPCB partner Beth Seidenberg's presentation in the Entrepreneurial Thought Leader series at Stanford. Particularly this segment, where she explains KPCB's investment mix. About one-third of 2007 investments went to Greentech. The firm is also plowing a bunch of money into mobile technologies, which Lashinsky mentions, but the significance of this move is overwhelmed in the article by the emphasis on green. The bottom line is that KPCB isn't much interested in Web 2.0, and so far, the firm looks amazingly insightful on this point.

As for the riskiness of Greentech as a sector, does anyone really believe that this is a potential loser? Especially when KPCB has it's own in-house hype generator in Al Gore. People are ready for clean tech and KPCB is sitting pretty.

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That's Paul Kedrosky talking about this news from the National Venture Capital Association: "In the second quarter of this year not a single company backed by venture capitalists has gone public. It is the first time that has happened since 1978."

Fred Wilson takes a different view:

VCs themselves, at least this VC, have learned that a sure payday via a M&A transaction is often a better way to generate returns than the hope of a big public market payday....

Sarbanes-Oxley and other post bubble, post Enron regulations have certainly made it harder to be a public company here in the US. I know every time I sign a 10K or 10Q, my hand shakes a little. Honestly, it takes a very big opportunity to make me want to be a significant shareholder or a director of a public company. The risks and hassles are just so big....

We've had three exits to date in our first USV fund and none have been IPOs. I think we can generate the returns we need to produce to satisfy our investors without a single public offering in our fund.

Despite this sentiment, Fred notes that venture capital would be different without IPOs: "It would be smaller, with fewer funds, and smaller fund sizes. And it would struggle with big bets like biotech and cleantech, and the kind of hardware oriented IT investments that generated such great returns in the 90s." So he concludes with a called for reduced regulation: "We need to let markets work and not worry so much that some people will lose money on their investments."

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Last fall I blogged about The Funded, a website on which entrepreneurs post candid reviews of their experiences with venture capitalists. Or not.

From Matt Marshall at VentureBeat:

TheFunded has been struggling with how to handle entrepreneurs who post sour grape, inaccurate — and often viciously negative — posts about venture capitalists who rejected their ideas. Is TheFunded now assisting VCs in taking down these posts?

TheFunded’s founder, Adeo Ressi, says not at all. Rather, some of the posts are being removed under duress from venture firms — with threats of litigation. "TheFunded.com is surprised to learn that venture firms are spending money entrusted to them by their own investors to silence the opinions and constructive criticism of legitimate founders and CEOs," he wrote in a statement.

Matt provides lots of interesting examples.

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In 1998, I published an article entitled "Venture Capital Contracting in the Information Age," in which I wrote about the potential benefits of the internet in improving the efficiency of the market for venture capitalist reputation. Nearly 10 years later, I have finally encountered a site that shows some promise along those lines: The Funded.

Of course, markets in reputation are very noisy, and some of the perils that necessarily accompany such a site (including VC hurt feelings) are described in an interesting W$J story on The Funded.

Thanks to Darian Ibrahim for the tip.

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The W$J has an article on unexpected conflicts faced by venture capitalists whose portfolio companies change course. These problems are exacerbated by intense competition for profitable business models and the increased holding periods that result from a relatively weak IPO market.

The response has been for VC firms or portfolio companies to adopt conflict-of-interest policies. Another option would be to waive the director's fiduciary duty, though this introduces additional complexity and uncertainty on the legal side, as the ability to contract out of fiduciary duty varies by form of entity and state of organization.

It's a shame that the law relating to the waiver of fiduciary obligation is not clearer because it could provide useful guidance to business people. For some more thoughts on contracting out of fiduciary duty, see the appropriate section of this article.

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Well, not quite coupons, but look at this from the W$J: "Battery [Ventures] recently decided to use some of an $850 million venture fund that was closed to new investors in 2000 to invest in companies that would generate returns not through an IPO or sale, but by issuing dividends...."

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TechStars, similar to Y Combinator, is launching this summer in Boulder.  Brad Feld has the details. 

Form of investment.  At first glance, it's an odd financial model.  Founders get up to $15,000 to start a company.  TechStars takes 5% of the common equity, with none of the special rights one associates with traditional venture capital investments.  No board seats, no liquidation preference, no redemption rights.  As Darian Ibrahim has pointed out, the contrast between the form of investment in angel funding and the usual form of VC investment is puzzling. 

Non-financial benefits.  Of course, it's really about the non-financial aspects of the deal.  The founders get some office space, server space, and spend the summer in Boulder with access to some of the best human capital in town, both through educational sessions and informal networking and advice.  The investors get to know some promising entrepreneurs, and they may have an early edge on participating in the next stage of venture financing.  (Query whether TechStars takes a right of first refusal.)  They may find talented programmers and designers to place in another portfolio company.  And, of course, you never know if one of these companies may make it big. 

For-profit philanthropy.  From the founders' perspective, this is a vast improvement on the "friends and family" round.  From the investors' perspective, it's probably better understood as "for-profit philanthropy" rather than investment.  The time commitment is impressive, and it really does seem to be motivated by a desire to give something back to the community.      

Branding?  Surprisingly, I don't see this as a branding move by the investors.  These guys are already well-known, well-connected, and well-respected in Boulder.  There is some branding going on, though:  they are branding Boulder as an attractive alternative to Silicon Valley.  If Boulder can lure a few talented twenty-something entrepreneurs away from California for the summer, I bet many of them stay.                                                                                             

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Like other businesses venture capital firms cultivate their images. Looking at VC websites, my impression is that many VC firms want to send this message: we are friendly to entrepreneurs! See, for example, Kleiner, whose front page prominently displays the following image:

The not-so-subtle message is that they are not just about money. You can see a similar message from Benchmark ("The Power of Teamwork") and Redpoint ("Partners in Innovation").

My question: can we find evidence of entrepreneur friendliness in the investment contracts? In other words, do VCs attempt to promote their brand through their deal structure? (See Vic's work on branding effects.)

In the past few days, I have been looking for examples. I was excited to hear that Benchmark refused to take anti-dilution protection prior to 2000, but when I looked at their portfolio companies' charters, I couldn't verify that story. Anyway, this is part of a paper that I am writing, and I would be quite grateful for examples.

By the way, most of the VC websites are completely mundane. These firms must be looking at each others' sites because the tile motif (each tile a portfolio company) comes up time and again. Sequoia takes the theme to the extreme, but you can also find it at Draper, North Bridge, Accel, BioAdvance, etc. Also, you will see lots of men in slacks and dress shirts with no tie, like these guys from Lightspeed ...

Or these guys from Mayfield ...

Hey! How did that woman sneak into the picture! At least she got the memo about the uniform.

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I’m interested in the interplay between public and private equity markets, and specifically whether these markets work together or whether they compete. Bernie Black and Ron Gilson have argued that they work together – that venture capital investment in private entities is dependent on the ability to exit into the public equity market by IPO. A recent NYT article, blogged by Gordon here, underscored this point, noting that venture capitalist Sevin Rosen Funds took the rare step of returning $250-$300 million in investor commitments due in part to “a terribly weak exit environment” characterized by few IPOs.

On the other hand, Don Langevoort has suggested that the public and private equity markets compete, writing that “the SEC wishes to privilege registered public offerings as the favored mechanism for significant forms of capital raising, and wants to avoid structures that allow issuers to tap large-scale sources of capital within the United States while by-passing the registration requirement.” See Donald Langevoort, Angels on the Internet: The Elusive Promise of “Technological Disintermediation” for Unregistered Offerings of Securities, 2 J. Small & Emerging Bus. L. 1, 25 (1998). He points to the SEC’s questionable ban on general solicitation in certain private placements as an example. (Bill Sjostrom also critiques the SEC on general solicitation in this paper.)

So what’s going on? Are the public and private equity markets working together, or are they at odds? My guess is that it’s a little of both. The broader question is whether the current laws (e.g., the private placement exemptions, Sarbanes-Oxley) are striking the appropriate balance between the two markets. Larry Ribstein has repeatedly criticized SOX for tipping the balance too far to the private side (see here for Larry’s SOX posts). Yet the SEC appears to be standing behind SOX, which seems to cut against the competition argument. I wonder what other laws help influence the public/private equity market balance, and how good a job they’re doing?

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Thanks to Bill Henderson, I caught up with the story about Sevin Rosen's decision to abort fundraising for its tenth venture capital fund:

"The traditional venture model seems to us to be broken," Steve Dow, a general partner at Sevin Rosen Funds, said in an interview.

VC is broken? Fred Wilson doesn't think so. Nor does  Paul Kedrosky. Om Malik suggests that this has more to do with Sevin Rosen than with venture capital generally:

Sevin Rosen’s big hits came where there was massive industry disruption. Compaq in the PC era for example, or Ciena in the optical arena. The fund missed the Internet wave, and many of their telecom investments came long after the telecom bubble was in full swing. Market timing did not play in their favor.

Agreed. The sky is not falling.

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This email arrived in my box earlier today:

From: Mr [Name Withheld]
Subject: Exit strategy

Dear Dr. Smith

We are a venture capitalist in Iran having 3 years experience by investing in 23 start up companies up to 3 million dollars. we plan to work on your paper named "the exit structue of venture capital" in order to improve our exit strategy. I would really thank you so much if help us know more about your ideas and papers in this regard and the way we could use your papre properly.

Best regards,

[Name withheld]

Venture capitalists in Iran? I wondered whether this were a personalized version of the Nigerian email scam. Lisa suggested that I might be the exit strategy!

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Venture money is not fungible. Check out SiliconBeat on Crescendo Ventures:

More significant to entrepreneurs in Silicon Valley is if Crescendo, desperate to save itself, will be forced to swing wildly for the fences on its last pitch. When the pressure is great, bad decisions can be made. A firm can push one of its companies to sell out, when waiting might be preferable for the company. Crescendo's is a situation many firms are finding themselves in. They may or may not do the right thing. But if you're juggling which firm to take cash from, take it from someone who doesn't have two strikes.

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Gordon posted recently on "Law and Entrepreneurship," a field that I think we're all still trying to define clearly.  Gordon is focused, quite sensibly, on the way that legal organizations help entrepreneurs develop an idea into an organization with a commercially viable idea, whether it be through a VC-backed start-up, university tech transfer, internal corporate R&D, a strategic alliance, etc.  This fall I'll be teaching a class in this area for the first time.  While I very much share Gordon's interest in this research agenda, I wonder if I might shift the discussion a bit and ask if anyone has thoughts about teaching this subject. 

What's the best way to teach a course in this area?  I've looked at a few syllabi from classes in entrepreneurship or venture capital at various schools, and they tend to focus on the classic stages of a tech start-up, from initial funding (perhaps angel funding), to VC funding, to IPO or other acquisition/exit.  There's a lot to be said for this format.  But looking at these syllabi, I can't figure out how they're conceptually organized.  And I'm afraid my students will have the same struggle.  In my experience, having clear themes makes it much easier for students to retain what they learn in the long-run.  It's what distinguishes a law school course from a CLE seminar.

So I wonder if the classic focus on tech entrepreneurship and venture capital is the right way to go.  From the point of view of training lawyers, is there a better way to conceptually organize the course?  In my research in the area, I've noticed certain elements of legal organization that seem to recur, again and again and again, like a chorus.  (E.g. regulatory exemptions from tax, securities, ERISA, two-and-twenty comp structure, incomplete contracts and unenforced/unenforceable contractual rights ...)  When you look at these elements, a VC-backed startup has more in common with the portfolio company of a private equity fund than it does with other new businesses. 

So with that in mind, I'm considering making private investment funds, rather than entrepreneurship per se, the central focus.  I'm tentatively organizing it around the following key ideas:

1.  The source of investment capital differs from other areas of finance, creating unique opportunities for regulatory flexibility (and some unique concerns). 

2.  Conditions of extreme uncertainty and risk require active intermediaries (VCs and private equity professionals) to source and monitor investments.

3.  The pressure for rapid exit affects the design of the legal infrastructure employed at the portfolio company level.

4.  Reputation often replaces or supplements contractual solutions.

(Some readers may notice that in this course design I'm borrowing pretty heavily from Ron Gilson's research, though I'm adding my own regulatory focus to his transactional focus.) 

The course would, broadly speaking, work from the top of the organizational structure downwards, starting with the investors.  We'll touch on portfolio design, ERISA, securities exemptions, UBIT, and tax.  Next will come fund organization, including the 40 Act exemptions and the "Two and Twenty" compensation structure.  Only then do we get to portfolio company design, with choice of entity, board organization, form of investment, and so on. 

Does this course structure work?  If not, then what is it, exactly, that makes a course in "Law and Entrepreneurship", "Entrepreneurial Finance", "Venture Capital", or "Venture Capital and Private Equity" a worthwhile part of the curriculum?  What's the best way to distinguish it from other corporate/transactional courses? 

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Peter Rip is bothered by the question, "What's your business model?":

The reason the question "what's your business model?" bothers me it that the inquirer often judges the answer based on its parsimony, as though simple is prima facie evidence of good.  Occam’s razor applied to business strategy. 

I myself will sometimes ask others the question, but I use it to test for complexity, not simplicity.  I use it as a Rorschach to see how deeply the respondent has thought about the market and which aspects of the business appear most salient to him or her. 

Peter seems to be confusing two distinct concepts: simplicity and simplism. The ability to communicate complex ideas simply is a mark of genius, but oversimplification suggests lack of depth.

The companion of oversimplification is excessive complexity, which may not signal lack of depth, but is indicative of muddled thinking. Consider the chart that Peter "sat down and drew" to illustrate the complexity of business plans:

Peter refers to the chart as a "checklist," so why make a chart out of it? The spatial organization -- ten aspects of business plans organized around a box labeled "Business Model Levers to Impact Return on Equity" -- has no significance whatsoever. I strongly suspect that Peter could refine the chart to make it more meaningful, but that would take lots of time. And if he were attempting to communicate effectively, I suspect the chart would become simpler, not more complex. (Of course, it is possible that this chart was not designed to teach, but rather to illustrate the complexity of business plans. In that case, the chart had darn well better be complex!)

HT Brad Feld.

P.S. Did you notice Peter's use of "impact" as a verb? You can read my thoughts about that here.

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I've ranted about bad PowerPoint before.  I just came across Guy Kawasaki's 10/20/30 Rule of PowerPoint, sage advice for entrepreneurs pitching their new new thing to VCs.  10 slides max, 20 minutes max, 30-point font minimum.  On using too small a font:

The reason people use a small font is twofold: first, that they don’t know their material well enough; second, they think that more text is more convincing. Total bozosity. Force yourself to use no font smaller than thirty points. I guarantee it will make your presentations better because it requires you to find the most salient points and to know how to explain them well. If “thirty points,” is too dogmatic, the I offer you an algorithm: find out the age of the oldest person in your audience and divide it by two. That’s your optimal font size.

Incidentally, the banner to Guy's blog contains this pithy definition:

Blogger. n. Someone with nothing to say writing for someone with nothing to do.

He doesn't mean me, right?

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Catching up after Law & Society, I notice a post from last Friday by Fred Wilson, responding to this email from a reader:

Our startup company recently started seeking funding and the first firm we presented to has shown some interest. However, they have now sent us a Due Diligence Agreement and are requesting a "one time good faith due diligence payment of $9,000".

Is it standard industry practice to charge the entrepreneur a fee for the due diligence? We are obviously short on cash - paying $9k to every VC who shows an interest in us sounds counterproductive.

Fred's response:

I believe most high quality venture capital firms would not request a due diligence fee as part of signing a term sheet. Most VC firms are paid a management fee by their investors that is designed to cover the basic due diligence efforts.

However, if there is some particular diligence issue that is not usual, like a dicey patent situation, some arcane tax issue, a lawsuit, some highly technical diligence that requires an expert to weigh in, I have seen and have even asked the company to cover those costs out of the proceeds of the financing.

Also, most VC firms ask the companies to pay the legal expenses associated with closing the transaction. Those fees are often taken out of the proceeds of the financing. I know of a few entrepreneurs, like my friend Steve, who find that very distateful and I certainly understand why, but it is customary and has been the industry practice for years.

Lots of good comments over there, too.

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Brad Feld discusses a "Compelled Sale Right," which he found in a term sheet that recently crossed his desk.

Corporate lawyers are familiar with the doctrine of "minority oppression," which aspires to protect minority shareholders against "squeezeouts" and other abusive tactics by majority shareholders. The "Compelled Sale Right" turns the tables, allowing a minority shareholder (in this case, as low as 10%) to sell the company over the objections of the majority shareholders.

The minority investor has to wait seven years before the provision is active, but still ... I have never seen a provision quite like this one.

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Nerd/Programmer/VC Paul Graham has posted an essay, How to Be Silicon Valley.  (HT to Phil Weiser.)  Graham argues that you only need two kinds of people to create a technology hub: rich people and nerds.  If you don't have enough nerds, you'll need a great university to attract them.  Graham continues:

However, merely creating a new university would not be enough to start a silicon valley. The university is just the seed.  It has to be planted in the right soil, or it won't germinate.  Plant it in the wrong place, and you just create Carnegie-Mellon.

To spawn startups, your university has to be in a town that has attractions other than the university.  It has to be a place where investors want to live, and students want to stay after they graduate.

You need a town with personality to draw in the rich folks and prevent brain drain.  Graham cites Boulder and Portland as the two most promising cities-with-personality, but he notes that the existing universities in those two towns aren't great (i.e. not the caliber of Stanford and Berkeley.)  I haven't been to Madison, but I suspect it would be in the running too from what I've heard (and seen on Althouse).

I largely agree with his analysis, and I'd argue that the "limiting reagent" to startup growth in Boulder is the cramped budget of the university.  So my question is this.  How, exactly, do you convince the good folks of the state of Colorado  (or Oregon or Wisconsin) to pour money into the university when the technology hub benefits -- esp. in the first few years -- would be concentrated in Boulder (or Portland or Madison)?  Or is additional university-private sector collaboration the key?

In any event, Graham certainly understands the geographic preferences of nerds:

Most nerds like quieter pleasures.  They like cafes instead of clubs; used bookshops instead of fashionable clothing shops; hiking instead of dancing; sunlight instead of tall buildings.  A nerd's idea of paradise is Berkeley or Boulder.

Hard to argue with that.

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The Fulton County Daily Report has an article about a drafting error that has caused Alston & Bird to be sued for malpractice.  Here's the nutshell:  a consortium of venture capitalists (including Mellon Ventures and GE Capital Equity Investments) wanted to invest a little over $16 million in a company called SecureWorks, Inc. in exchange for C series preferred.  This series would have a preference in liquidation, including acquisitions, mergers, etc.  The B series were to receive tag-along rights so that if the C series sold to a third party, then the B series could also sell; however, these rights don't apply to liquidation, including acquisitions, mergers, etc.  Sounds good.  Except that the B series rights were cut and pasted from another section so that the rights would be triggered in case of liquidation, etc.  Oops. 

The parties seemed to have discovered this problem in 2002, and in 2004 the consortium filed a declaratory suit to figure out how to solve the impasse.  One can surmise that efforts to amend the documents were not fruitful.  The investors stated in their complaint that the language would frustrate any future acquisiton or investment by third parties because of the prospect of a lawsuit over the language.  The declaratory suit was settled with the investors paying another $5 million in change to management to amend Series C rights.  Now those investors want $6 million from Alston & Bird.

Some questions:  If Series C has this liquidation preference, then they probably also have superior voting rights or at least a class veto over transactions.  So, presumably they would have enough leverage to get the rights amended to reflect the true negotiated deal because the Series C could hold up any new investment or liquidation, much to the founders' unhappiness.  Why was this leverage not enough?  Who held the B series and did the B series prove to be the sticklers, making hay from an unanticipated benefit?  Did the series C agree to pay the $5 plus million (in notes) because they thought that their attorneys would be the guarantors of that loss?

Also, doesn't anyone read documents?  I know that waterfall provisions can be very complex (our project finance documents had extremely complicated waterfall provisions), but that should mean that someone would be reading them -- client and attorney.

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Kirk Stark points me to H.R. 5198: The Access to Capital for Entrepreneurs Act of 2006. 

I don't know if it's a serious proposal or not.  And I haven't worked through all of the mechanics --there's lots of attribution/look-thru rules (fun!) and the like.  But even before getting into any of that, it's worth considering whether venture capital even needs a subsidy or if this is the right way to do it. 

The House bill subsidizes venture capital by targeting "angel investors."  It's a 25% tax credit for accredited investors (as defined by the securities laws) who invest in small businesses.  Although the tax credit is capped, it would also have the effect of subsidizing VCs who make larger investments, albeit to a lesser extent than angels. 

A few problems jump out at me. 

Venture Capital Overhang.  For one thing, if there's a shortage in venture capital, it's a shortage of great entrepreneurs, not a shortage of capital. 

Subsidizing Investors vs. Founders.  One could argue that the tax credit gets to the same result.  The idea would be that the tax credit will increase the amount of VC investment, lowering the cost of capital for entrepreneurs. Engineers and other innovators, seeing the opportunity to get better terms from angels and VCs, will be more likely to quit their jobs at Microsoft and Google and start their own companies.  (Cf. the low income housing credit, which is designed to create more housing, not to increase returns for investors.)  But if the point is to convince innovators to become founders, doesn't it make more sense to subsidize founders directly?  Adjusting the capital gains rate for founders would be the more direct route. 

Tax Credit vs. Cap Gains Rate.  Adjusting the capital gains rate also has the benefit of limiting the tax break to successful companies; an investment tax credit rewards mediocre and slow-growth businesses as well.  Not all small businesses create jobs.  What we really want to subsidize is the next Apple or Ebay.  This bill also subsidizes the new dry cleaner that puts another dry cleaner down the block out of business.  And it encourages established, slow-growth small companies to recapitalize by extracting some cash and seeking out new equity capital that could get the tax credit.  The only jobs created are for tax lawyers. 

Occam's Razor.  Maybe I'm overthinking all of this.  Occam would suggest that it's just a giveaway to rich guys (aka accredited investors) who are making these investments anyway. 

In any event, I don't mean to sound anti-small business.  The topic of subsidizing venture capital is ultimately where my tax research agenda is headed -- see, e.g., here, here and here.  I'm tentatively in favor of subsidizing venture capital, if (big if) we can design the subsidy well.  If we're going to subsidize venture capital, it's better to do it through the tax system (where VCs choose which target companies to invest in) rather than through direct government grants (where administrators choose the targets).  But designing an effective subsidy is harder than it looks.

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Keep an eye on Sequoia Capital. The Silicon Valley-based VC firm has expanded to Israel, China, and -- as of yesterday -- India. Silicon Beat has the scoop.

The traditional story is that venture capital is local, but that story is increasingly challenged by international investments and global expansion.

I am reminded of law firms in the 1980s. The Skadden model was built on massive expansion around the globe. The Wachtell model was based on high levels of expertise in a concentrated area. When I started practicing, some people wondered whether one model would drive the other out, but both seem to have survived quite comfortably. (Though Wachtell partners make much higher profits.)

By the way, have I mentioned that Silicon Beat is my favorite business blog? It's a great read. Consistently.

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Dealbook links to an interesting NVCA survey about the relationship between CEOs and VCs.  Be sure to click through to the slides.  No big surprises; the survey tends to confirm that conflicts over exit strategy are a big tension for start-ups.  For background, see, e.g., Gordon's paper here and a new version of Jesse Fried & Miri Ganor's paper here. 

I also found an interesting tax tidbit; again, no surprise, but the survey confirms that when VCs sit on boards they take no compensation or take additional stock in exchange for services.  The exchange of services for property normally gives rise to ordinary income, but the structure of the deal allows the VCs to get taxed at capital gains rates.  In other words, despite the extensive work that VCs provide to portfolio companies, the tax code treats them as if they were sitting on their hands as passive investors. 

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There’s an interesting article in today’s New York Times (article here) about a recent lawsuit involving Wine.com and its venture capital investors. According to the article, the company’s former CEO has sued Baker Capital—one of Wine.com’s primary VC backers—over a venture capital financing that occurred in 2005. Baker initially invested in Wine.com in 2004 when it purchased $17 million of the company’s Series F preferred stock. (A separate article about the initial financing is here). Typical of VC financings, Baker obtained the right to appoint two directors to the board and it also negotiated for a variety of stockholder veto rights, including the right to veto a sale of the company.

Problems arose in 2005 when Wine.com ran short of cash. The complaint alleges that the company's management secured an acquisition offer from Liberty Media for $67.5 million, which would have resulted in all investors receiving a pay-out on their investments. The board of directors allegedly approved the Liberty offer; however, it was vetoed at the stockholder level by Baker Capital. Left with no alternative but bankruptcy, the company was then forced to accept a new financing led by Baker that resulted in significant dilution to all other investors. Baker contends that the Liberty offer was never presented formally to the board and that it “saved Wine.com by providing it with needed funding at a time when no one else would do so.”

For me, the most interesting aspect of the story is that the dispute actually reached the courts. For years, the conventional wisdom has been that the VC industry is too small and well-connected to permit opportunistic behavior by either VCs or founders. Take, for instance, the following statement by VC-gurus Josh Lerner and Paul Gompers of Harvard Business School:

“[W]hile the controls that venture capitalists demand may be essential, they also create the potential for abuse. A venture capitalist’s reputation for fairness is the only assurance an entrepreneur has of being treated with respect. Established venture groups typically care deeply about their reputation for treating entrepreneurs fairly and openly.” PAUL GOMPERS AND JOSH LERNER, THE MONEY OF INVENTION: HOW VENTURE CAPITAL CRATES NEW WEALTH 12 (2001).

Cases such as Wine.com indicate that the traditional reputational markets in the VC industry may be breaking down. In fact, the case is one of a number of recent founders-vs.-VC lawsuits that have begun to pop up (e.g,. similar suits have been filed against the VC backers of epinions.com and Nishan Systems). Why might this be happening? I think the primary answer lies in the fact that the VC industry isn’t the same as it used to be. Reputational sanctions for opportunistic behavior are strongest in settings involving close-knit communities. The significant growth of the VC industry over the past decade makes it unlikely that the VC community resembles those communities where norm-based reputational sanctions have displaced legal sanctions. For instance, the membership of the National Venture Capital Association has grown from 87 firms in 1980 to over 900 firms in 2003 with over 9,000 investment principals. Add to this the difficulty of proving a “bad act” worthy of reputational sanction (did Baker’s financing “save” the company or oppress it?), and I think it becomes evident that reputation probably plays less of a role in the VC market today than it did in the past.

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Many thanks to Gordon, Christine and Vic for inviting me to guest-blog at the Conglomerate. As Gordon notes, one of my primary areas of interest is venture capital/private equity--a topic that gets quite a bit of attention around here. Accordingly, I’d like to begin by addressing a recent issue that has arisen in the private equity world, curtsey of the State of Illinois.

In May 2005, the Illinois General Assembly passed (with overwhelming support) S.B. 23, a bill that requires state and local pension funds to divest themselves by July 2007 of any investments in financial institutions that do business with or in Sudan. To ensure compliance with this requirement, all Illinois pension funds investing in managed investment funds (such as private equity funds) must receive certifications from fund managers that no fund assets are invested in a “forbidden entity” (generally defined to be any agency of the Sudanese government or a company doing substantial business in Sudan). Private equity funds receiving Illinois money must also receive certifications from each portfolio company that the company does not do business in Sudan. The legislation was prompted by the ongoing genocide in the Darfur region of Sudan, which represents a tragedy of extraordinary proportions. S.B. 23 was signed into law (Public Act 94-0079) on June 27, 2005 and took effect on January 27, 2006. You can find the statute here.

Notwithstanding the admirable intentions of the Illinois legislature, the effect of this legislation on Illinois’ private equity investments has troubling implications for the state’s pensioners. As a number of sources of have noted (see e.g., here and here), many top performing private equity funds have already begun to refuse investments from Illinois pension funds rather than accept the additional burden of complying with the statutory requirements. This is not because these private equity funds invest in Sudan or because the statutory requirements are especially onerous. Rather, it is because these funds tend to be oversubscribed when they are formed and can pick and choose their investors as they see fit. As this blog has previously noted, private equity funds are already concerned with the additional disclosure burden of having public pension fund investors, and the Illinois legislation seems to be viewed by many private equity investors as simply one more reason to stay clear of “public” money.

Of course, one might argue that public pension funds have no business investing in “risky” private equity anyway, so being shut out of private equity funds is entirely appropriate. But I think the evidence is now pretty clear that private equity investments represent an important asset class in creating an efficient investment portfolio, particularly for pension funds facing significant fund out-flows in the years ahead. Moreover, there is considerable evidence that positive returns on private equity investments are closely linked with having access to the historically top-performing private equity shops. If Illinois pension funds are shut out of the top-tier private equity funds, their private equity returns will almost certainly suffer.

While I support the goal of this legislation, I fear it will have unintended consequences for the Illinois pensioners who had little say in whether they would be willing to subsidize it. More generally, it causes me to wonder whether using pension fund assets to pursue this type of social policy is consistent with the prudent investor standard that governs pension plan fiduciaries.

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I'm presenting my "Two and Twenty" paper today at UCLA on the taxation of partnership profits in private equity.  I argue that the status quo gives VCs and private equity fund managers an unwarranted opportunity to defer income and convert their labor income into capital gain, and I argue for reform. 

This article suggests the UK tax authorities have the same idea.  The mobility of capital will make it difficult for reform proposals, including my own, to succeed politically.

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Venture capital is Gordon's specialty, but my colleague Eric Goldman forwarded me this Mercury News article about what may be a growing trend of founders suing the venture capital firms that ate their start-up.  In one suit that is described there, the founders of Wine.com are suing their VC firm, who initially did not hold the majority of the shares outstanding, but did effectively control the firm due to certain control provisions including veto power.  Last year, the firm vetoed an acquisition by Liberty Media for $4/share, only to then vote to issue stock this year at 62 cents a share, diluting all classes but their own and gaining majority control.  The plaintiffs are claiming that Delaware law would impose a fiduciary duty on the controlling shareholder in these non-conflicting transactions, so we'll see how that works for them.  I would suspect that the court would say that the founders should have thought about all this when they contractually gave away the farm at the beginning, but we'll see. 

From a generational standpoint, I thought that one of the remarks of the founders was very interesting.  The article talked about the traditional conventional wisdom of entrepreneurs not to sue VC firms and possibly get a bad reputation in the tight-knit industry, which might prevent future VC investment in future projects.  Don't bite the hand that feeds you, so to speak.  One of the founders of Wine.com explains his willingness to sue in this case:

I spent two years working 70-hour weeks, spent a tremendous amount of time to grow the business, and wake up to find two years of sacrifice, of being away from the family, has no upside to it

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Kleiner Perkins, the legendary venture capital firm, has closed Fund XII.  They've raised $600 million, and in addition to the usual IT and life sciences targets, $100 million will be targeted at so-called green technologies. 

This may just be a sort of positive branding spin on what VC firms have already been looking at for a while (e.g. fuel cells).  Or maybe they think there's been a shift in attitude, and they expect increased demand for clean energy in a few years.  Will it be consumer-led?  Forced by regulators?  Both?  Whatever it is that underlies KP's decision, I'm pretty sure it's not a decision to focus on things other than generating a high IRR for the investors.  VCs are green only when it generates green.

Fundraising must be laughably easy for KP.  The article linked above notes that the roster of institutional investors has changed much in 20 years.  And with good reason.  KP has generation some hefty returns for LPs. We may not know much about shaming, but we do know that having a good reputation is valuable.

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Tom Perkins is one of the founders of the well-known Silicon Valley venture capital firm, Kleiner Perkins Caufield & Byers. He is also the ex-husband of Danielle Steel. (They were married 17 months.) Soon, he hopes to be competing with his former wife for book sales. Perkins has written a novel entitled, "Sex and the Single Zillionaire." According to the W$J, Perkins'  partners at KP were thrilled:

The idea of Mr. Perkins penning a romance flabbergasted his colleagues at work. Some asked if he would actually put his name on it. Frank Caufield, a Kleiner Perkins co-founder, says he said, "You're kidding" when he found out what Mr. Perkins was doing. John Doerr, another Kleiner Perkins partner, says Mr. Perkins didn't ask the firm's permission to write the book. "To seek permission here is to seek denial," says Mr. Doerr.

The W$J article has some brief passages from the book, which are stomach churning. ("He could feel arousal beginning to stir in his loins. Hand in hand they returned to the stateroom.") Here is the official description from Harper Collins:

Much to his surprise, and the chagrin of his Wall Street partners, Steven Hudson, a very wealthy middle-aged widower, agrees to appear on the new reality TV show Trophy Bride. Plucked from his lonely Central Park–view penthouse and dropped into a frothy mix of stunning models, actresses, and athletes, Steven's sober life quickly veers out of control.

Lured from his self-imposed solitary existence by Jessica James, the smart and sexy producer of Trophy Bride, Steven is encouraged by the enthusiastic response of Helen, his serious-minded daughter, and Henry, his trust-fund-spoiled son. And if Henry can lend his father a hand with the TV show, and ingratiate himself with some of the gorgeous contestants to boot, how can that hurt?

Steven plays along with the TV madness to stay close to Jessie, taping "dates" on his fabulous private jet, the breathtaking slopes of Vail, and his incredible yacht -- but try as he might to stay focused on this most unusual venture, he only has eyes for her. While Jessie struggles to keep the dazzling trophy brides in line, Steven struggles to show Jessie that he's more than just a zillionaire. But with an engagement ring on her finger from her hot young fiancé, is Steven too late?

Funny, sexy, and at times deeply moving, this debut novel is sure to be read in bedrooms and boardrooms all across the nation.

There is so much that is so wrong here, it's tough to know where to focus. How about this: "this debut novel is sure to be read in ...  boardrooms"?!?

Forget the new executive compensation rules. I hereby propose that the SEC adopt a new disclosure rule, requiring any company that allows this book to be read in its boardroom to disclose that fact in an 8-K.

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My latest paper -- The Exit Structure of Venture Capital -- is now available for download on SSRN. This is the first paper based on my study of 367 venture-backed firms. Although informed by empirical data, this paper is mostly descriptive and theoretical. Another paper with a more detailed examination of the provisions is in the works.

In my view, the most important contribution of this current paper is its discussion of the board composition proposals. (See Parts I.D and I.E of the paper.) The most cited study of venture capital terms to date was done by Steven Kaplan and Per Strömberg. Steven N. Kaplan & Per Strömberg, Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts, 70 REV. ECON. STUD. 281 (2003). In that study, they describe board composition provisions in which the common stockholders and preferred stockholders must "mutually agree" to elect tie-breaking directors. This finding provided the foundation for Bill Bratton's intriguing paper. William W. Bratton, Venture Capital on the Downside: Preferred Stock and Corporate Control, 100 MICH. L. REV. 891 (2002).

Although I found such "mutual agreement" provisions in my sample, they were rare. Only 2.60% of the board composition provisions in my study include the language of "mutual agreement." Instead, most of the board composition provisions required common stockholders and preferred stockholders to vote together as a single class on tie-breaking directors. This is, of course, not the same as "mutual agreement," and I argue that this provison is part of contingent control transfer in the venture capital context.

Lots more in the paper. I hope you will take the time to read it.

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Paul Kedrosky has a nice post commenting on today's NYT story, which reported that Colin Powell was joining the legendary VC firm Kleiner Perkins.  PK notes that

Top firms like Kleiner are not resting on their laurels; they are actively working to protect their position by doing all the yucky product marketing & branding things that bring deals to the door. People scoff at this sort of thing at their peril.

I actually don't want to overplay the branding angle.  Powell brings a lot of actual non-marketing value to the table, primarily through networking ability.  It's hard to imagine anyone in the world not taking his call.  If the firm wants to bring a defense contractor into the syndicate, Powell will know who to call.  There is also, I am told, a huge market for nanotechnology in military and security-related markets.  Powell may be able to offer some specific guidance and sit on the boards of portfolio companies. 

So this deal is not just about improving the brand image of Kleiner Perkins --- though Powell undoubtedly helps that too.

For more on the importance of reputation in venture capital, see my papers here and here and here.

UPDATE:  Genuine VC has more here.  The real puzzle, he suggests, is why Powell is interested in venture at all.  It's got to be more than money.  My speculation is that Powell shares my belief that there' s something special about venture capital, the way it drives economic growth and the positive externalities of new, disruptive technologies.  The nanotechnology created to shield military personnel might be used next to protect firemen or cops, or to shield civilians from terrorist bombs.  Who knows.  So, given a choice between working for Kleiner and its exciting portfolio companies on the one hand, and working for a defense contractor on the other, the psychic benefits of working for Kleiner were higher.  Just a guess.
 

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The NYT has a nice story about "Tourist Venture Capitalists," those who cannot seem to find the good investments and wash out. Exhibit A in the story is Mitch Kapor, founder of Lotus way-back-when:

Mr. Kapor had enormous success investing for himself in barely-formed start-ups like RealNetworks and UUNet Technologies, both of which provided him with staggering payouts. Yet he did not prove to be a star the years he worked as a professional venture capitalist. "The fact that it's someone else's money you're investing, and that you're investing as part of a partnership, that was more different than I thought it would be," said Mr. Kapor, who went to work in 1999 for Accel Partners, another top venture house in Silicon Valley. "I later found out that everybody who makes the transition like I did says that."

Here is the killer stat: "Mr. Kapor failed to choose a single company that made him, his partners and their investors any money. He confesses he was 0-for-5 in the investments he made during his three years at Accel."

Yikes!The whole story is worth reading.

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The latest issue of Business Week contains this story about AzoogleAds and other firms whose founders are cashing out with venture money.

These days private equity firms are using their wads of cash to buy entrepreneurs' stock before their companies reach Wall Street. In the past five months at least eight private Internet advertising and marketing companies have completed financing rounds in which founders sold shares to such investors for millions.

I am not the only person who thinks the venture capitalists who finance such buyouts are nuts.

Steven Eskenazi, a general partner at San Francisco's WaldenVC, calls the sales of founders' shares a "very disturbing and negative trend." For one thing, founders may have little incentive to stick around after getting their windfall. "If times get tough and they have a disagreement with their board, they're going to go to the beach," Eskenazi says. In addition, if founders sell before an IPO or acquisition, it could raise questions about their confidence in the future of their companies.

For a company where this sort of financing may have had a negative effect on the IPO pricing and subsequent market performance, Business Week cites Fastclick, though that is a company with other problems.

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Fred Wilson is discussing the many conflicts inherent in venture investing. Some of these conflicts are merely uncomfortable -- "if you've been working with serial entrepreneurs for years, you find your friends starting competitve businesses" -- but others pose potential legal problems. For example, he says this about confidentiality:

When we identify an area we are interested in investing in, we try to meet with every entrpreneur working in that market.  We collect a lot of information that way.  We must and do keep that information confidential or else nobody would talk to us.  But that information has a way of coming togeter in our brains and informing how we think about markets, business models, leverage points, market entry plans, etc. And it is incredibly hard to keep all that expertise locked up inside our firm.  So we are constantly asking ourselves what is the line we cannot cross in educating others.  Very tricky stuff to say the least.

This is precisely the reason most venture capitalists do not sign confidentiality agreements.

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INSITE was fortunate to host Antoinette Schoar  from MIT over the past two days, and we had some great discussions about venture capital. Antoinette presented her paper "Smart Institutions, Foolish Choices?: The Limited Partner Performance Puzzle" (pdf) (with Josh Lerner and Wan Wang). This paper presents data on investment returns in early and late-stage venture capital, as well as in buyout funds, with some surprising results. For example, endowments earn higher returns than pension funds and insurance companies and much higher returns than banks and investment advisors. Is this just a "fund picking" story? Apparently, as none of the limited partners seems to be greatly involved in the funding of portfolio firms. Thus, the puzzle: why are some limited partners so much better at this than others?

The authors are still working this out, and I suspect the results have more than one cause. I am sure that the endowments believe that they simply are more sophisticated fund pickers than other investors, though I doubt that story. It may be a story about access, though that doesn't seem to explain everything. Politics may play a role in reducing the returns of public pension funds, though these funds do quite well incomparison with the lowly investment advisors. This is, indeed, a puzzle. And I hope the authors solve it!

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Brad Feld is turning out the analysis faster than I can link to it! I am temporarily skipping his post on pay-to-play provisions to focus on his thoughts about dividend provisions. I thought he had skipped dividends altogether because, as he observes, "many venture capitalists –- especially early stage ones -- don’t really care about dividends." This is surprising to some people, but easy enough to understand. Venture capitalists are not investing for dividends, they are investing for capital appreciation.

Nevertheless, (almost) every venture deal specifies dividend rights, and some deals have very elaborate provisions. Dividend provisions have two main functions: (1) the dividend preference requires the company to pay specified amounts to the venture investors before the common stockholders get anything, thus deterring opportunism by the entrepreneurs; and (2) a cumulative dividend provision provide extra return to the venture capitalists in the event a downside liquidation, though not without some financial and psychic costs.

Finally, here is a nice tidbit from Brad: "Mathematically, the larger the investment amount and the lower the expected exit multiple, the more the dividend matters. This is why you see dividends in private equity and buyout deals, where big money is involved (typically greater than $50m) and the expectation for return multiples on invested capital are lower."

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