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what’s the real deal?
financing ideas to IPO

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Audience Member:  A Ouija board?

Jeff:  Yes, and it’s irritating, too.  One of the rules you learn with VCs is that you have to be absolutely confident that your pre-money value now is $1.7 million.  Why?  For all the analytical reasons discussed in your business plan.  You are making it up.  He knows it.  You know it.  You just have to act like you are not making it up.  I swear.  There is no magic to it.  Everybody makes it up.

          So I'm going to pick a number so that the math is easy, like a million bucks.  [He enters $1 million in the “Post-Money Value” under the “Startup” column.]  When you absolutely are a startup, your pre-money valuation is zero because there's nothing there.  The founders will come along and put in some money, so we'll have a “raise,” which I'm going to call for this purpose $10,000, because that's what we came up with in my company and I was broke so that's a nice, low number.

          You issue shares.  Let's say a million of them because you are the founders.  You get it as cheap as you want.  Now you have that post-money valuation of a million dollars just because you decided to pick a number.  This is the easy part, the part you do with a lawyer.  You and your partners go to a lawyer and say, “I want a bunch of shares.  I'd like to issue a million, and we are going to pay $10,000 for them.”  So the share price is . . . uh-oh, I'm going to have to do math . . . the share price is a penny a share.  Anybody missing this?  Is this all logical?

          There is a number of shares which are . . . I always get this backwards . . . outstanding or issued.  Is there a lawyer here?  Which is the big number that you haven't given to anybody and which is the small one?  You probably “authorize” for this enterprise five million shares, maybe 10 million.  In fact, here's a new trick that is really sleazy but very popular.  When you are starting a company, potential employees will walk in and say, “Hey, great job!  I realize I'm going to have to work for dirt, so how many shares do I get?”  We did our start with 5,000 shares, so we gave our first key employee 500 shares.  He laughed.  We had to explain to him why it was such a great percentage.  Now, a lot of people have decided, “Forget that; I'm issuing 100 million shares.”  They get Joe Junior Engineer coming in and they say, “Well, it's only $10 an hour but you get 50,000 shares.  Joe thinks, “Excellent!”  He goes home and says, “That crummy job across town only offered 1,000 shares, but here I got 10,000.”

          It's like being paid in nickels instead of dollars.  Does everybody understand clearly that a share doesn't mean squat.  A share represents a percentage of a total company, so the two things that matter are what's the whole company worth and how many shares are there.  If there are a hundred million shares and you want to give somebody 1%, you can give them a million shares.  If you have 1,000 shares and you give them 1%, it's 10.  Some of the most brilliant engineers are too freaking stupid to do the math.  I spent 15 years telling people, “No, no, let me explain.  You are selling your house, I'll give you one million nickels.”  People do that with shares.  They don’t do the math.  Companies were getting turned down by people who wanted 50,000 shares for a management position, so they went back to the board, did a little trick and said, “How about a million shares?”  The people said, “Excellent!  I'm on board.”

          This introduced to them the concept of the reverse split.  Let's say you have a dollar-valued company and there are 20 shares outstanding.  Each share is worth a nickel, right?  In a split, let's say a 5-to-1 split, there are now 100 shares each worth a penny.  A reverse split?  Boo, hiss.  Let's say it’s a 20-to-1 reverse split.  If you have a million shares today, tomorrow you have 50,000.  Okay?  I can't stress to you enough how important it is to recognize that the number of shares is meaningless.  You don't want 100 dollars for your car?  Okay, I'll give you 10,000 pennies for it.  It's really important to understand this distinction, and it's really hard to explain to employees.  Discuss with your lawyer why you shouldn't have more shares, but you are going to get beaten by the guy who does this trick.  At least in this area, for some reason, people are just stupider than they have any right to be.  Worse, if you are going public, you can't talk about it.  Employees get upset because there’s going to be a split after going public.  They don’t understand that if they have 10,000 shares at $100 apiece, after the split they will have 20,000 shares at $50 apiece.  “Is it going to affect my options?”  No, they all split.  There are smart people who don’t understand this, but the lawyers say you can’t hold a class on it because you’d be making forward-looking statements.  At least a lot more people understand it now than did five years ago.  Then, it was a really huge mystery.


angels with filthy lucre

          Moving on, at startup the founders' ownership share is still 100%.  [He begins working on the next column in the chart.]  Now, an angel investor walks in and says, “Hey, nice company.  What's it worth?”

          “A million bucks.”

          “How much money are you looking for?”

          “We need $300,000 to get the product to prototype,” or whatever the next logical step is.

          You have a pre-money valuation of a million bucks and you want to try to raise $300,000.  You are going to issue 300,000 shares for that so the share price has gone from a penny to a dollar.  Anybody want to guess what the post-money is?  Pre-money plus money equals post-money.  How easy is that?  It's like “a pints a pound the whole world round.”

          The founders now own . . . have I done the math right?  This is why I wrote this down.  I usually do it off the top of my head, but by the third column I always need a calculator and it gets ugly.  The founders now own 77% of the company.

          This is where a lot of people get into trouble.  This is an angel round.  The founders worry about this number¾unnaturally if you ask me.  Somebody wrote a book once and left it in a public bathroom that said never to go under 51%.  Nobody has been able to track down who wrote this book, but the guy ought to be taken out and shot because this is what people all get upset about.  You now have a company with $300,000 bucks that can get to the next stage.  Your one million shares as founders are now worth $1 million, up from $10,000.  This is really, really good.  Entrepreneurs who get upset about this, and, if it's one of you in this room, get therapy or something because you are going to have to get over it.  “Oh my gosh, I only own 77% of my company now!  It's not fair!”


          You raised money.  You can't raise money without giving away part of your company.

          I use an analogy, I hope this isn't off color, but I don't work for anybody so it doesn't matter.  Everybody wants grandkids, but nobody wants some guy sleeping with their daughter.  This is exactly one of those situations.  “Yes, I would like some money, but what do you mean you want part of my company?”  That's how it works.  If you want to raise money and not give away any of your company, the Commonwealth of Virginia runs a lottery.  I suggest you buy tickets.  They will not ask for equity; they will just give you money.  It's a longer shot than raising VC money, but you won't have to give anything away.

          You are going to have to give it away.

          The next step, probably, is that you are going to get a venture capitalist involved, and this is where it gets exciting.  Again we reach into our ear and come up with a pre-money valuation.  What do we want to be worth for the VCs?  $10 million.  Why not?  In the creepy period of the last few years, these numbers tended to be based on calculating what you think you are going to need, then adding a zero.  You were getting insane numbers.  We were going to VCs and saying, “We have this really profitable plan.  In four months we can be profitable.  Everybody has done it before.  We are looking for $2 million.”  They were saying, “Sorry, I only put in $20 million.  You get, "Hold on a second.  Hi, Mr. Osborn.  Glad to meet you, we are going to give you 20 million bucks.”  Excellent!

          I'm suggesting to you now that one of the things that might have changed is that the zeros might be coming off instead of being added.  Seriously.  If you are getting advice saying ask for more money, that might be a little dated.  You might want to reconsider it.

          So we say we are worth $10 million and we need a big $5 million, so the raise is $5 million. Woo-hoo, we are talking serious coin here.  Yee-ha, we are all going to be rich.  Let's call the share price five bucks.  Why?  Because there are lots of numbers in our ear and we are still pulling them out.  That means the shares we issue . . . gee, how many $5 shares to raise $5 million?  A million.  Come on, be confident.  You folks are trying to start companies and you can't even give an answer.  The post-money valuation now is $11.5 million.  We are saying it's worth $10 million; we are getting $5 million for it in this round; we are issuing an additional one million shares.  Where it had 1.3 million shares before, it now it has 2.3 million.  To get the valuation, you just multiply how many shares outstanding by the dollars per share.  See, this is complicated.  I'm being a little reassured that this isn't all that simple.  Fortunately, this is the last column I need to do to make my point, which is that it drops the founders down to about 44% ownership.

          The bottom line is that after doing just a couple of fairly normal rounds, the ownership of the founders tends to dip under 50% real easily, and this is just the first VC round.  Next, and I'm not even going to try to add it up here, is to add a 20% pool of employee options, which is almost half a million shares and further dilutes the founders’ percentage down well into the 30s.  What amazes me is how many people start a company thinking, “Raising money is going to be great.  They are giving us money!  It’s terrific!”  Then they get to the first VC term sheet, see what their percentage is and say, “Wait a minute!  What is this crap?”  Well, this is where you are headed, if you start raising money.  If you do it successfully and you need more than a round or so, you are going to end up down here.  If you want the grandkid, you’d better figure out up front that some guy is going to have to do something with your daughter that you don't like. Just figure it out up front, okay?

          The basic idea is that you should be comfortable with what you think your company is worth, how many shares you have and how much money you are going for.  This is really fairly simple.  You can find an expanded version of this template at our site, along with some other tools.  You need to know what this looks like so that when a term sheet or financing offer shows up, you are not scratching your head saying, “Gee, what's this?”  You know that feeling you have at the car dealership?  You think you’ve come up with a real clever idea, well, Moe, on the car dealer’s floor, has answered that question 600 times this week.  You are never going to outtalk him and you are never going to outthink him because that's what he does.  If you think Moe’s smart, well, he went to high school.  The VCs all went to Yale and to Harvard Business School.  They are really smart.  They are really arrogant and they can play Scrabble on an HP 12C financial calculator.  They figured out your ROI on hair growth because you walked in the room and they got bored.  If you don't know these numbers cold, they can do anything to you they want.

          These days, I sit on their side of the table and I like to help people by walking through what their shares are worth and everything else.  I have seen people get to the point where there is $5 million in it if they just sign a piece of paper, and they say, “But I don't own half the company anymore.”  It's something you need to think about up front.  If you are not interested in sharing ownership, and perhaps giving up a controlling portion, then you have to think about other ways to do it without raising money.


entrepreneur, well-heel thyself

          I'm trying to figure out where to go next with this.  I've only got a few minutes.  Would you be interested in hearing how we put together a sales organization at UUNET that became hideously fast growing and was really cheap, or how and who you approach to get through all these funding steps?  Let's hear it for the first one, the sales story.  [Scattered applause.]  Now for the raising money¾how a bill becomes a law.  [Louder applause.]  That's too bad, the first one is a lot more fun, but, yeah, I don't think they all work anymore.

          Basically, if you have a great idea, a day job and a couple of friends dumb enough to want to jump in with you, then it sort of puts you into the world of a pre-financed startup.  You are an entrepreneur if you say you are, right?  There is no licensing involved; there is no registration with the federal government.  You just wake up one day and decide you are one.  I think they ought to license them after some of the crap that's gone on lately, but they don't do it yet.

          So, once you have a really good idea, the first place to look for money is . . . ?  Yourself.  Right?  If you start a company like I did, hugely in debt with big credit card bills and a mortgage that you can't pay, a brand-new car and everything, it's going to be hard.  I would recommend not to do that.  If you are deep in debt and need a big income and everything else, do what I should have done, which is pay off the credit cards and find a rich uncle, but I guess that's kind of hard to do after the fact.

          The second group you want to look for, obviously, is family and friends.  The thing you need to be very careful about with this is that you want them to be stay friends, not become former friends.  It's a really awkward thing to hit friends up for money for something like this.  You put them in a very awkward position.  Think about it.  I don't know what the statistics are anymore, but my guess is something like . . . let's just say that well over half of the ventures that get as far as borrowing money from friends probably lose it all.  I would guess it's more like 90%, but it's got to be more than half.  Anybody know a statistic on that?  They are all lies anyway.

          Family has the same constraint.  I know a guy who crashed his company two months ago.  Mom lost the house.  His four other partners were two couples married to each other.  They got divorced; one lost custody of the kid.  Some really ugly stuff can happen if you are not prepared to do this.  Obviously, the ideal thing to do would be to put your salary in the bank and have a lot of savings¾the car's paid off, the house is paid off, the kid's college is prepaid¾but that's not likely to happen.

          You need to make sure that you have thought through what's going to happen if the bad thing happens because, by nature, entrepreneurs are optimistic and believe that everything's going to come their way.  When we went public I had zillions of dollars and I bought a Porsche; we were buying a big house.  One day, my wife stopped me from buying something, I think it was a pair of gloves.  I said “Honey, we are rich.”

          “I know, I know.”

          “Do you believe it?”


          She said, “You have been telling me since before we got married that you were going to be rich, that it was just around the corner.”  I had to get her on the phone with her mom for like an hour.  Her mom was reading from The Wall Street Journal saying, “If they think he has money, he probably does, honey.”

          It's amazing how long it takes to sink in.  You really have to believe that you are going to do it, but be able to step away from that and ask, “Is this the craziest thing I have ever done?”  I guess people do it with kids, but it would be hard.  I had no kids, thank God, just a working wife who was making enough money that at least we could eat.  You really have to think it through, because odds are it's not going to work the first time.  But if you want to do it enough, what's the first time?  UUNET was my sixth, or at least some bigger number than one, and failing one of these things really kind of hurts.

the angle on angels

          Now that you have gone through family, friends and yourself, angels are the next step.  Here's where that “I used to be a bank teller and now I'm going to be an entrepreneur” thing really starts to show up.  If you know your industry really well, then you are a known entity in it.  You can talk to people in your industry who have become successful and moved on and are funding little companies.  If you walk up to them and say, “I'm working at a dry cleaner and I want to do an outsourcing B2B play for online games,” what are the odds?  Why would somebody invest in that?  Chances are they won't.


          Where to find angels is one of the harder things that I've had people ask about.  I don't know where you find them.  We tend to invest in companies introduced by friends of friends.  I literally started this just thinking I was going to invest in friends and former employees, that was it.  It was going to be real safe, and those have all been the biggest hits.  This year, ArrowPoint made 350 times the money.  I had lunch with a former employee of mine who said, “You can invest if you want to.”   I was like, “Well, I have a checkbook.  Okay.”  The connections really, really help.  If you are walking into this cold and don't know anybody in your industry, it's going to be hard.

          The place to find angels is in your industry.  Use every angle you have.  If you went to school with a guy whose father is rich, this is a good time to go back to him.  I don't know whether you have figured it out¾it didn't take me too many years¾but the people who become very successful usually used an angle.  “Oh, no, I want to do it on my own,” you say, “I don't want to use those others.”  Why not?  Everybody else is doing it.  Everybody else is using people they knew in school, people they met on an airplane, anything like that.  Use any personal connections you have.  I would highly recommend that this is a good time to lose the hubris and pride.  Nobody ever says to me, “Congratulations, you really hit it.  I bet you knew somebody.”  Yeah, I knew somebody.  How did I find UUNET?  I was writing a sales database on the side and they recruited me.  I kind of slipped in because everybody knows everybody who knows everybody if you're in the same industry.  I never would have found that job looking in the newspaper, and I never would have found it asking people if they hadn't been in the industry for a very long time.

          The way to find the angels is specific to everyone.  There is no book of angels.  Anybody selling you that book is a liar.  It's just too specialized.  There are investor groups you can look for, although, just between us, looking from the outside in I'm convinced that they pretty much tend to invest in things because Bob, who doesn't show up to the meetings but is a member, it's his nephew and we ought to listen to the pitch and do it.  Everybody has a scam going. You might as well figure it out up front.  If you are just Joe Nobody from outside, figure out an angle you have that nobody else does, then use it for all it's worth.

          The thing I really can't stress enough is that this is all so much easier if you are in the industry and know it, because then you know who the people and players are.  Going in cold is the hardest thing in the world.  There is such a correlation between people crashing their companies and not having known squat about their industry beforehand that I'm amazed more people don't figure it out.

          Once you get angel help, be very careful about what we call dumb money versus smart money.  Anybody here own a chain of pizza stores?  Good, then I won't insult anybody.  The dumbest money I have ever seen is from people who own chains of pizza stores in the Midwest.  The airlines must sell them cheap tickets because they come out here and want to invest in our great new startups.  They come up with terms and term sheets and offers that are, like, written in Sanskrit.  Usually, I can smell a pizza guy because they tend to hide it.  “Where are you from?  The Midwest?  What are you doing?”

          “It's family money,” they say.

          “Don’t you own pizza joints?”

          “Well, yeah.”

          The other really bad one is dry cleaners.  For some reason they throw off cash and they think they are smart because they have a lot of  money.  It's the saddest happy day in an entrepreneur's life when one of these guys gives you a couple of hundred thousand bucks.  You're going, "Score!" and don't realize that when you walk into another angel or a VC, he will look down and think, “Oh geez, it's a pizza guy!”  He’ll say, “Thanks, I can't wait to give it consideration.”  The door closes and it's in the shredder.

          Smart money is people who are in your industry, who are known and visible.  People who know people.  Other companies they funded have gone on to the next step.


where has all the seed money gone?

          Okay.  You had to raise your own money to get the company to the point that an angel could give you some more money, enough to go on so that a VC can give you even more money, enough¾the way it should work¾to go on and do a public offering.  Then the public gives you $100 million dollars and everybody is happy.  Hopefully, it becomes profitable before you run out of money and it goes away.

          What I suspect is happening now is a little disconcerting.  Fran had numbers about the percentage of seed money going in lately.  I think it's way worse than that because I think the VCs are all kind of lying to each other, which means they are lying to you.  Big surprise.

          If you raised $10,000 and you don't get your angel money, you have to go get another $10,000, right?  If you got $200,000 from your angel and you didn't get anything from the VC, you have to get $200,000 more from him, right?  You went to your VC, raised $20 million, blew through it and now there is no IPO, like there hasn't been for the last six months.  You have to go back to those guys.  They have tons of money, but they are not used to having to do that.  They wanted to put in $20 million and make $1 billion, but now they are having to go back and fund these companies again to keep them alive.

          Shannon Henry and I were having this discussion.  It's like there’s a conspiracy of silence or something, because people aren't admitting as much trouble as I think these guys are all in.  What that should tell you, as entrepreneurs, is that you should try to get off this treadmill as early as possible.  If you can do it with just your own money and never take a nickel, you own 100% of your company.  [Pointing to the chart he drew earlier.]  If you only have to do an angel round, that’s how much you own, 77%.  If this thing goes on for something like seven columns, the founders’ ownership percentage goes to a single digit, and it happens to a lot of people.  There are a lot of people with big successful companies who ended up at the IPO with, literally, 1%, 2%, 3% of their companies.  With a $10 billion IPO, who cares, but if there isn't all that much financing out there and if you want to maintain the control, you need to think about ways to do this without raising money from somebody.

      Hmmm, that breaks up the analogy because you can get a grandchild without anybody touching your daughter¾adopt.  Or have a son.


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