Be Nice Or Leave (Term Sheet From Hell)

Came across this great blog post by Fred Wilson.

I have found that reputation is the magnet that brings opportunities to you time and time again. I have found that being nice builds your reputation. I have found that leaving money on the table, and being generous, pays dividends.

Doing right by people is important no matter what field you’re in, but particularly in the startup space if you’re in it for the long haul, you need to take care of your stakeholders. Applies to both entrepreneurs and investors. At 8 Capita when we are making an investment decision, one of the most important considerations is whether we feel the entrepreneur(s) we are dealing with knows how to take care of his investors. A couple of months ago I received a Term Sheet From Hell from an entrepreneur that, amongst other things, included a call option for the founder (founder has the option to buy back shares from investor if things are going well) and the reimbursement of founder’s previous expenses in starting the company (which essentially means founder has zero skin in the game). Needless to say we passed on that investment, but more importantly it is a character-revealing term sheet that precluded any future engagements with the entrepreneur.

Investors are not all angels either. There are a couple of investors I avoid because of what I’ve heard about them from other investors/entrepreneurs. If I was a people person I probably would have tried interacting with these guys and make my own decision about them, but I’m not naturally sociable so it doesn’t make sense for me to spend what little time I have engaging with folks of dubious character. Which goes back to Fred Wilson’s point – being nice builds reputation, and reputation brings opportunities.

 

Problems Worth Solving

Just read a great article about how David Freidburg built and sold The Climate Corporation for $1 billion (apparently there’s only a 0.00006% chance of building a billion dollar company). Many lessons to be learnt from Freidburg’s journey, but the main takeaway for me is the importance of finding a problem worth solving. Here are some of David’s Freidburg’s thoughts on ideas and innovation:

I hear so many people saying things like, ‘Oh we can build a photo sharing app for students at Stanford!’ or ‘We can do something like X for Y!’ But just look around. There are problems in the world today that are more substantial than anything we’ve ever faced in history — and it’s not just in software, or in California, or for your peers.

When you look at the markets in the world today, you can probably break it apart market-by-market and say, ‘Here’s something fundamentally flawed with the way businesses in this market are operating.’ Ask yourself, what are they doing wrong? Beyond that, how are governments not operating efficiently? When you look at it this way, there are 100,000 different ways to break apart the opportunity that exists for you to solve the big problems of today. It might take more than a weekend in the library or on the Internet to see, but they’re there.

If information was once the grist for ideas, over the last decade it has become competition for them — we have started to prefer knowing things over thinking because knowing has more immediate value. This keeps us in a loop. It keeps us connected to our friends and our cohort, and this implies a society that no longer thinks big.

There are a lot of problems out there that can and should be solved, and not just because it’ll be great for you, but because it’ll be great for everyone. Once you have this premise — once you’ve found the right thing to do — the strategy is to first know what you don’t know, the tactic is to grind, and the value is to remember: there are plenty of places to innovate.

So before you dive into your next startup, first ask yourself if you’re working on a problem worth solving, and who you are solving it for.

Venture Capital versus Private Equity

8 Capita, the investment partnership I run with a couple of friends, plays in the VC and PE space. Couple of months ago we completed our second buy out deal, acquiring a Sydney-based expense management software company. Here are some thoughts on VC versus PE:

Valuations

Early stage (pre-revenue) startups in South-East Asia are going out at valuations upwards of $2m. In Singapore, easy access to government co-funding schemes is pushing up valuations – when a startup is raising a $500k seed round, entrepreneurs naturally push for 7 digit valuations to avoid being diluted too much. How is the valuation justified? It’s a question I often ask entrepreneurs when they tell me they are valuing their startup at $2m or whatever, and I’ve yet to come across an entrepreneur who can make a convincing case why their startup is worth a few million dollars.

In private equity, companies are usually valued based on earning multiples. 3-5 times EBIT is common. Taking a 4x multiple, a potential acquirer will offer $2m for a company making $500k a year. Assuming stable earnings going forward, the acquirer knows that he will make back what he paid for the company in four years. Earning multiples seems to me a more conservative way of valuing a company. Granted most early stage startups are not profitable and therefor cannot be valued based on earning multiples, but the point remains that it is often times hard to justify why a startup with a small user base making no money should command valuations similar to a mature software company making hundreds of thousands in profit a year.

Forward forecast

Acquisition targets in the PE space tend to be mature companies that have been around the block. Financials are relatively stable, which makes it easy to project into the future. There are of course exceptions such as distressed assets, but by and large it is relatively straightforward to do a fairly accurate 3-5 year financial projection. Early stage startups are inherently risky. It is difficult to tell whether a startup will survive the next 24 months, much less make financial forecasts with any degree of confidence.

Returns

In South-East Asia exits upwards of $15m are still relatively uncommon. So say you invested in a startup at a valuation of $2m and along the way you were diluted by new financing rounds – when the startup exits for $15m four years after your initial investment, you may end up with a 4x return on your investment. That’s decent for an early stage investment in this part of the world. In private equity, unless you’re in the business of flipping an asset to a much bigger PE firm, double digit percentage growth in the top and bottom line is probably more realistic. Or to put it another way, you have a better chance of getting a five bagger from an early stage investment than a PE deal, but the risks are significantly higher too.

People

The startup space seems to be dominated by a relatively young crowd with ambitions to change the world, or if not to at least make their first million before their thirtieth birthday. This is a sweeping statement, but startup entrepreneurs can probably be characterised by three words – young, ambitious, idealistic. The founders we meet in the PE space tend to be older (and wiser?) with more realistic expectations of their business. Often times they have been running the company for years, getting it to a steady state generating stable cashflow, and are now looking for new personal or professional challenges.

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This blogpost is not a criticism of early stage investing vis-a-vis the merits of private equity. I’m still an active early stage investor, both in a personal capacity and as a partner at 8 Capita. The point rather is that having seen the type of deals in the PE space, I am a lot more selective about the early stage startups and entrepreneurs I choose to invest in, and the valuations I’m willing to accept.