BloGiza

The Basics of Equity - Part 1: Valuation

Alongside the challenges of actually getting a company up and running, the issue of equity often becomes a key concern in the life of entrepreneurs. After all, the startup is their baby and they are hoping to be rewarded for their hard work in the end. But many new entrepreneurs may not have a full handle on how a company should be valued and how equity should be distributed. So in the next couple of posts we will examine these questions.

Recently I’ve had a number of entrepreneurs pitch their company to me followed by the question, “Do you think I can ask for a pre-money valuation of $X million?” The short answer to that is, “Yes, you can ask but that won’t be much of a factor in the actual valuation.”

When you deal with traditional industries or later-stage technological companies, you can call on a set of established measurements – such as discounted cash flows and company assets – in order to establish a valuation. These help provide investors with a valuation that is relatively objective and takes into account the current state of a company and its future prospects.

Unfortunately, early stage tech companies usually have no revenues and few real assets, so the normal tools don’t really apply. This means that the valuation for early stage companies is strongly subjective. It is influenced partially by the quality of the team and the hype surrounding the space, but much more by the immediate financial needs of the company and the investor.

What does this mean for the entrepreneur? In short, it means that the valuation of the company is based mostly on what the investors are willing to give you, which in turn is based on how much you are looking to raise.

VCs (early stage ones at least) have a set investment model which is generally based on holding a 20-25% equity stake in a company. In the case where two VCs are investing, each one will want to hold 20-25%. This dictates the valuation we are willing to consider.

Let’s put it into numbers. You are looking to raise $1 million. Your friendly VC wants to hold 25% of the company post money (in other words, after the investment). So, if we divide $1 million by 25% we get $4 million dollars post money (i.e. the $1M put in is now worth 25% of the company). If we subtract the money investment from the post-money valuation we get $3 million.

This means that your company is worth more or less $3M.

Let’s take a second example, where two VCs are involved. You want to raise $5 million from two VCs. Each will want 25%. Therefore your post-money valuation is $10 million ($5M/50%) and your pre-money valuation will be around $5M.

These figures are not set in stone. But they are the basis for negotiations. Obviously, if you have a number of investors fighting over your company, you will be able to demand a higher valuation. But this will give you a ballpark figure about what you can expect your valuation to be.

Also, it should be noted that this rule does not necessarily apply to angel investors. Angels have their own goals with regards to the revenue they will see from your company and will offer you a valuation accordingly. One well-known angel investor I know has a standard model of taking 20% of the company in return for $100K seed money. Some are less generous, others more so.

To reiterate, your valuation is directly affected by the amount you want to raise. Next time, we will tackle the issue of how much do you need to raise.

Many Communication Options = Worse Communication?

Over the last couple of months, I have developed a growing addiction to social media. Where a year ago my main channel for interaction with friends was email, followed by email and Facebook, nowadays it increasingly includes Twitter and shared links via RSS readers. Not to mention FriendFeed, which is a mélange of everything else.

However, no real framework governs all these tools. Some people you contact via email, some people you send messages to in Facebook, some people you tweet. Some people you talk to across multiple channels oftentime continuing a conversation across multiple platforms.

Which is all great in theory – more ways to communicate between people should lead to more and better communications. Except that I’m beginning to think this isn’t actually the case.

I’ve had a couple of examples in recent weeks where I’ve contacted someone on Facebook regarding some issue fully expecting the person to respond via Facebook. Except that the person doesn’t respond until days later and I realize I should have actually emailed (or, heaven’s forbid, phoned) them. 

Or, I find myself having running conversations with people via tweets and private messages on Twitter. Except that Twitter was never built to be an effective tool for two-way conversations and eventually the whole exercise gets so frustrating that I go back to email.

The explosion of social media choices does provide us with a lot more options for communications. But lacking a good framework for organizing and keeping track of these conversations, it mainly seems to increase the noise.

Sergey @ The Garage May 15

We had the honor of co-sponsoring last Thursday's Garage Geeks event in which Sergey Brin came down to Holon to pay a visit to the Garage. Several hundred people showed up (apologies to everyone who asked me for an invite last week - space was really limited) to bask in the man's Google-y glow.

Sergey actually stayed for quite a while, close to two hours. At first, he seemed a little surprised at the rock-star reception he got. Either that or the poor guy was just trying to eat something while everyone mobbed him. But later in the evening, after some presentations by the Garage crew, he got up on stage to give a little talk and answer questions.

The Q&A session was also surprisingly lengthy. (Ayelet Noff has posted a video of most of it which you can find here). I'd be lying if I said that we heard some earth-shattering revelations from Sergey, but here are a few of the more interesting tidbits:

• When asked where Google is focusing its attention these days, Sergey mentioned both Android and RE>C (Renewable Energy Cheaper than Coal), Google's cleantech initiative. I'm actually kind of thrilled to hear this. Along with the proliferation of the iPhone and similar devices, the rise of Android may finally help launch mobile Internet as a mainstream application. Google is one of the few companies that can leverage its size and prominence to introduce new standards and paradigms for the mobile world, so all the power to them. And although Sergey claimed rather politically that Google and Apple are not competitors here, it will be interesting to see how the dynamic plays out.

• Someone asked Sergey if Google was planning on buying Yahoo, which led him to tell the story of the first time the two companies met. In his telling, it was in late '96 or early '97. He and Larry had put together a small company already and approached David Filo with an offer: Give us a couple of million dollars and we'll develop a good search engine for you. Yahoo passed on the offer. In retrospect, Sergey says he understands what Yahoo was thinking -- a couple of crazy kids with an idea come to you asking for a lot of money and it seems a bit ridiculous. But from such events is history created.

• Charmingly, Sergey brought along his parents. Which led Yossi Vardi, who helped bring Sergey to Israel, to point out that in the eyes of Sergey's mother, despite the fact the guy has gazillions of dollars he still hasn't finished his PhD. Sergey says that he plans to finish the doctorate one day.
  
  Now, being that we are all a bunch of provincials, someone had to ask when Sergey is planning on making aliyah. To which, a number of people in the audience shouted "after he finishes the PhD."

• Google's "70/20/10 rule" -- 70 percent of focus on the core business, 20 percent on ancillary businesses, and 10 percent anything-goes projects -- seems to actually track in real life.

• Sergey's favorite application -- Panoramio, an application over Google Earth which shows you pictures from any given place. Which is kind of like Flickr's geotagging feature that no one seems to use.

In short, an interesting evening and a chance to catch a bit of the magic. More on the event can be found here.

SemantiNet gets Scobleized

During his recent visit to Israel, Robert Scoble interviewed Tal Keinan, CEO of SemantiNet. SemantiNet is one of Giza's very promising Internet companies. In the video, Tal provides a demonstration of what they do:

SemantiNet will be launching its first product into beta soon.

A few harsh words about the local Internet

Let’s talk about our local, homegrown Internet scene.

For those of you who might not know, Israel has over the last decade and a half developed its own Hebrew-speaking Internet industry complete with Hebrew-language portals, news sites, social networks, blogs, e-commerce, and marketplaces.

By and large, everyone in Israeli high tech (the main, overseas-facing high tech industry anyway) ignores the local Israeli Internet. The world of .il seems uninteresting and irrelevant. I have often attempted to buck the trend and gone off spelunking into the Hebrew Internet looking for undiscovered gems. Just as often, I have come back disappointed and I think I am now about to give up altogether.

The latest impetus came a few weeks ago at the Comvention. As with every year, it was a two-day event. The first day featured talks held in English with numerous guests from overseas. The second was conducted in Hebrew and focused on the local Israel-centered industry.

Very few of my colleagues showed up on the second day. In fact, very few people I knew showed up on the second day, even though the convention center was packed. I would estimate that the overlap in the crows between the two days was less than 10 percent. And this is but one indication of the problem at hand. Simply put, the local Israel-facing Internet is small, provincial, disconnected from the outside world, and two or three years behind everybody else.

One of the panels on the second day of the Comvention was entitled “The Israeli Internet – Sleeping Beauty?” To which Gadi Shimshon, a prominent local Internet pioneer, snorted, “Sleeping Beauty? More like a fuggo in a coma.”

He’s right I think. There are a number of dispiriting issues at play in .il:

• Attack of the Blinky Ads –The average American web site has 14 ads on it. In Israel, the average is closer to 100 (I’m not making this up). Click on any major Israeli Internet site. Now shield your eyes. You are immediately assailed by a wide variety of intrusive Flash ads, popups, video clips that start playing automatically, and every other manner of annoyance you can imagine.
  
  While annoying in and of themselves, blinky ads represent a deeper problem: the immaturity of online advertising in Israel. At the Comvention, Kfir Pravda gave an interesting talk about new trends in online video monetization. He talked about viral campaigns and interesting product placement technologies, among other things.
  
  The crowd – which was comprised mainly of ad agency employees – lapped it up. At the end of the presentation, however, a number of people stood up and said that while they would love to introduce more clever and effective advertising online, their clients the advertisers won’t hear of it. Local advertisers don’t want something new and subtle. They want the same old annoying hard-sell with the same old easily measured parameters.

• Firefox? Not here – I challenge my readers to come up with one major Hebrew-language website that renders properly in Firefox. YNet is about the only one that comes close and even then gets tripped up with embedded video. Hebrew sites don’t do Firefox. And I won’t even mention Safari or Opera, heaven forbid.
  
  To some degree, this represents very successful missionary work on the part of Microsoft which for years has actively nurtured generations of local .Net programmers. But it also indicates a real disconnect with the outside world. The main non-IE browsers now account for nearly 25% market share. But you’d never know that here. Local developers ignore alternative browsers because they never encounter anyone who uses them. It’s a closed loop.
  
  The same goes for all them fancy new Web 2.0 services such as Twitter or Digg or De.licio.us. If there isn’t a homegrown version, then nobody knows what you’re talking about nor sees the need.
• Lack of Internet culture - In general, Israel does not have a civilized Internet culture. On the one hand you have the often-hateful “talkback” environment wherein portals and content sites are shot through with ugly user-generated slander. On the other hand, you have Knesset members constantly coming up with new laws whose main purpose is to censor the Internet. Either that or demonstrate that the people in charge of the Internet in this country don’t understand how it actually works.

In short, situation not so good. Somehow, the same country that can produce Internet successes like Yedda and FoxyTunes craps out when it comes to producing homegrown fare.

So, why do I care? I focus on companies which are by definition outward-facing. So, why waste 1000 words on the irrelevancy of the local scene? Because as long as Israel cannot produce local Internet sites that are connected to the world at large, we limit the pool of talented local developers and entrepreneurs who could build the next great outward-facing Internet property.

Does anyone have any ideas what can be done?

Duck and Cover

The other day, I was talking to a friend of mine in New York who works in the financial services industry. I asked him how things were going there. His (sarcastic) answer, “Everything’s great! The dollar is strong, oil is cheap, Wall Street is looking sound, we’ve got a morally upstanding governor, and I just bought a large position in Bear Stearns. What could be better?”

Indeed, these are scary-type times for those of us in the finance world. This last month has been turbulent. The US economy is teetering at the moment, as the subprime mess starts seeping into many areas of the financial world not directly related to mortgages. At the same time, the dollar is weaker than it has been since the mid-$80s.

This last fact is especially striking when you compare the dollar to the state of the shekel. Sometime over the last couple of years, the humble shekel has transformed itself into an international monetary powerhouse. Since the beginning of the year, the dollar has lost more than 10% of its value relative to the shekel.

So, what does this mean for those of us who ply our wares in the local venture capital trade? Mostly bad news, but there may be a thin silver lining hiding in there somewhere.

The bad stuff: With the financial markets currently in a state of chaos and the US economy slipping (if not already slipped) into a recession. From our perspective, this has three main ramifications:

1. It will be very hard to exit portfolio companies in the States this year. A lot of big players will likely hold off on M&A activity while everything settles. At the same time Wall Street will also take a while to get over its jitters, meaning a rougher environment for IPOs.
   
2. Portfolio companies, especially those in the IT/Software space who sell to financial institutions are liable to miss their revenue forecasts as these institutions implement cost-cutting measures.
   Funds who have recently started fundraising may encounter problems with LPs getting cold feet.
   
3. The dollar-shekel situation presents a host of different problems for portfolio companies in Israel. This from the simple fact that they raise money in dollars but a lot of their expenses are in shekels. Which makes these currency fluctuations a big deal. Just to give an example, one of the portfolio companies I am involved with “lost” nearly NIS 750,000 shekels from the time the investment process started based on the amount they raised and the difference in the exchange rates over the last few months.

All this means that we need to help portfolio companies operate as lean as possible for the foreseeable future.

So, is there a ray of hope anywhere in here? Presumably, the new situation presents an opportunity for companies who can provide real cost savings to customers and present a compelling ROI in a relatively short time frame. As in all times of crisis, these companies can prosper.

From the VC front, all we can do is content ourselves with a bit of schadenfreude. For the past few years, as the markets soared, we VC types watched in envy as private equity and buyout funds posted huge returns. Now, as things swing the other way, we can smile to ourselves.

Explaining VC Part 5 – A few Final Thoughts

Explaining VC part 5 – Closing words

After a longer break than I expected, we come to the end of our series. We have looked at how the VC process works and I have tried to give some idea of what goes through the heads of those guys sitting across the conference table from you when you make your pitch. I’d like to close with a couple of tips and comments:

• Patience please - One of the biggest complaints we VC types hear from entrepreneurs concerns the pace at which things move in our world, especially compared to processes with angels. Yes, it does sometimes seem that we lumber along at the pace of asthmatic dinosaurs. But as I’ve attempted to show, the pace is often dictated by the process and the need to assure our investors that we’re not just plunking down their money at the racetrack. You have our apologies for this, but we do ask for a little patience.
  
• Perseverance – A well known joke says that the hardest answer to get from a VC is “yes”; the second hardest answer is “no”. Oh, how we are infamous for never giving straight-up “no”s. Instead, it’s usually a “not now”. Not now because we don’t think the concept is fully enough developed, or we want to see what kind of uptake it will have, or because the team doesn’t seem strong enough.
  
  While this is understandably frustrating to entrepreneurs, you should also look at the other side of the equation: We understand that things change very quickly in this business. Subsequently, we try to maintain ongoing contact with companies that we have passed on in the past as their situation changes.
  
  Just to give one example, we had a company come in early last year with a concept for an internet site. The idea didn’t seem fully baked, so we gave them a bit of constructive criticism and parted ways. Two months later they contacted us again. They had changed their model and suddenly they seemed a lot more interesting. We ended up giving them a seed investment.
  
  Moral of the story: even if we tell you “no”, don’t walk away mad. Update us when you have significant developments – you launch your product, you start getting users, you add people to your team. You’d be surprised how often that makes the difference.
  
• The ideal entrepreneur – Lots of startup-ists wonder what we look for in an entrepreneur. Personally, I am most impressed by people who know their stuff: they have a strong handle on the technology and the market, and can stand up to a barrage of difficult questions while maintaining a cool head. That plus real passion and devotion to the idea is the mark of a winner, IMHO.
  
• Help keep us honest – As I’ve mentioned more than once in this series, entrepreneurs have a lot of complaints regarding us money types. Some of these complaints are justified, others less so. You can find numerous forums and sites on the Web to compare notes on VCs. The most prominent (and infamous) of these is probably The Funded, where entrepreneurs gather to bitch about VCs and VCs gather to wring their hands about their image.
  
  I invite everyone to visit the site and contribute, as it helps keep us honest and improve our service. I do have one request: be fair. The fact that we didn’t get back to you with an answer (a really bad and common VC trait) is legitimate cause for complaining. The fact that we didn’t like your idea, however, doesn’t necessarily mean that we’re idiots.
  
• So, why VC? – At the end of the day, a lot of entrepreneurs will be tempted to ask, “Why should we bother with you guys?” In other words, why put themselves through a long and unpleasant investment process with a VC fund instead of just going to angels. If you are a software or semiconductor company, the answer is obvious: we’ve got deeper pockets than most angels.
  
  But I’ll put the banal answer aside for a second in order to make this point: In many cases, we are learning how to act like angels. Giza’s seed-stage “Ofek” program is a good case in point. We have learned how to make relatively small, initial investments, and to do so relatively quickly. Often we invest with groups of angels.
  
  This kind of model can be found in almost all the funds here and is often used for companies in the Internet space. For the entrepreneur it gives the best of both worlds.

And so it goes. I hope this series has helped open up a bit of dialog with entrepreneurs and I encourage everyone to contact me with their ideas and complaints.

Explaining VC Part 4 – So, what are we looking for?

Thus far, we’ve looked at how the VC model works and what the investment process is. Now, we have to tackle the question that most entrepreneurs have of us, namely, “Just what is it you people are actually looking for?”

Unfortunately, I have no simple answer to this question. There are so many different factors that come into play when deciding to make a VC investment that it is impossible to generalize a rule. However, I can offer up a well-known framework for thinking: the combination of technology, market, and team.

As investors who look to put money into high-tech money with a time horizon of 5-7 years, our ideal company would have the following combination of traits:

• Technology /product– Obviously innovative, something that can lead the next generation, technology that has significant advantages over the competition, has the potential to be disruptive, and has strong IP protection.
• Market – I’ve mentioned this before, but we are looking for a product with significant market potential (theoretically in the billions), in a growing market, with proven success stories and exits.
• Team – A dedicated group of founders with passion, drive, and vision; people who have a deep understanding of the market they are operating in and have experience in similar ventures; a group of individuals who balance and complement each other.

In the real world, of course, you will find very few companies that fit the description above 100%. So, Generally speaking, you start looking for combinations. As a general rule of thumb it’s enough that a company has two out of the three components (technology, market, team) for it to start looking interesting.

Which two components are the most significant often depends on the fund you are talking to, and quite often the specific investment professional looking at your company.

As a general rule, Israeli VCs tend to emphasize team and technology. This comes as a result of Israel’s position in the world. As a small country with few national resources and a tiny local market, Israel’s biggest asset is its people and especially the Israeli talent for finding clever technical solutions to tough problems.

The fact that Israeli companies have traditionally excelled technologically more than anything else leads to a certain bias in that direction. However, over the last year I have seen more willingness by local VCs to fund companies whose strengths are less technological and more in their innovative business model and/or their target market. Giza’s investment in Koolanoo Group, which develops a Chinese social network, is one example but there have been numerous others. Internet companies have a tendency to fall into this category.

I said before that what counts is a combination of three factors. In reality, the team counts for more than the other two combined. A great team is always critical no matter if you are a technology or market play.

A great team, the thinking goes, will be able to adapt its technology or business model as market conditions change, so it doesn’t actually matter what the initial product is. And if the entrepreneur is good enough, a lot of funds have Entrepreneur-in-Residence (EIR) programs where they work together with the entrepreneur to build a company from scratch.

What makes a great team? Another difficult question. Ideally you should have one person who is very strong technologically, another who is strong on the business side and one person who can manage the operation. The team should also be able to work well together, both during the good times as well as the crisis points.

Next time: Tips for dealing with VCs

We're in The Marker

The Marker approached me a little while back and asked to republish the series on Explaining VCs for The Marker online in Hebrew.

The first installment is up and can be found here:

http://hitech.themarker.com/tmc/article.jhtml?ElementId=skita20080901_51984

The others will follow soon, as will the next installment of the series here.

The online year that was

As today is the last day of 2007, it’s a little hard to resist looking back at the past year and trying to sum it up. So, I won’t resist. Unlike last year, 2007 is hard to summarize with one handy tag such as “the year of online video” or “the year of social networks”. There was a lot of activity in a number of different areas, the rise of a major player in the social networking space, and the rise of a new form of communication.

So, herewith a few highlights IMHO of the online industry in 2007

Story of the year: The consolidation of the advertising industry
Y’all thought I was going to say Facebook, right? Now, while the rise of Facebook is certainly the most hyped story of the year, my vote for the most significant development  (not to mention the biggest source of M&A activity) is the rapid consolidation of the online advertising space.

During the last 12 months, Google bought out Doubleclick for $3B. Shortly thereafter, Microsoft acquired aQuantive for a staggering $6B. AOL bought out targeted ad firm Tacoda, as well as Quigo which. Yahoo acquired Blue Lithium, as well as a majority stake in Right Media. WPP bought 24/7 Real Media. And the list actually goes on.

The M&A hyperactivity in this sector is an indication of the fact that online advertising has reached a certain stage of maturity. Beyond that, the consolidation is likely to have long-term ramifications, especially in regards to the rise of Google as the behemoth of the information age as well as the development of new business models online. And that’s what makes this, at least for me, the biggest development of the year.

Phenomenon of the year: Facebook
Obviously, I couldn’t not mention Facebook which gained momentum extremely rapidly this year and became the go-to social network for those of us who aren’t musicians, 14-year-olds, or skeevy perverts. Facebook only opened itself up to the world outside the university sphere towards the end of 2006. I joined up early this year. Before long, almost every high tech-ist I knew (and many I didn’t) was on it. Lately, the sphere has expanded further and everyone, their parents, and their parents’ friends are connected. Clearly we’re on to something.

Of course, it will be interesting to see whether Facebook will be an ongoing concern for most people or just a passing fad. I like it for business purposes, as a tool for microblogging, and as the communications platform of choice for a number of my friends. On the other hand, I have a hard time answering those who complain that there’s nothing to do there. We shall see.

New technology: Microblogging
The rise of Twitter and its clones provided us with probably the only real new media form we’ve had in a few years, viz. microblogging. At first, the concept seemed a bit stupid. After all, why would I want to blog in tiny, one- or two-sentence bursts? But then you start getting into it and discover that Twittering (or updating your Facebook status, which I tend to do more) is a nice complement to blogging for those times when you have something small and/or clever to say but which doesn’t warrant an entire post. Plus, it’s the first Internet app that makes perfect sense for the mobile. It’ll be interesting to see who snaps up Twitter and for how much.

Interesting development in local tech: The renaissance of the Israeli internet scene
Three or four years ago, it seemed that the Internet industry in Israel was close to dead. During the days of the ’99-’00 bubble, the high tech scene was awash in Internet startups looking to be the next ICQ. Then the bubble burst and most of the companies went under. Worse, the VC industry was burned on the subject and it subsequently became almost impossible to get a new Internet startup funded.

As recently as two years ago I regularly had colleagues in the VC world lecturing me that Israel was incapable of producing Internet companies and, besides, these types of investments weren’t suited for VC anyway. What a difference a few years and a YouTube (and a Facebook) later make.

Once again, we are seeing dozens of new Internet companies each month. What’s more, there is a real feeling of an Internet scene here, helped along in no small part by Facebook, the work of groups like the Co.ils and the Geek Garage, and of course Jeff Pulver’s social activities. Let’s hope this continues to develop and mature.

Case of possible overhype: Online video
I’ll catch some crap from friends about this, but the online video space has become somewhat overhyped in the last year. Actually, that’s kind of unfair. What has happened is that in the post-YouTube age, online video has become ubiquitous. This has led to a lot of noise and a sense of, “Ok, what do we do now?”

Towards the end of last year, it looked like the field of mid-tail, independently produced video content (e.g. Ask a Ninja, Rocketboom, Ze Frank) would be the next big thing. As of now, that has failed to happen. There haven’t been any real breakthroughs this year. Even projects as big and as hyped as Joost have yet to take off as a mass-market application.

I still have big hopes for this sector, but it may have to wait until sometime in mid-2008.

Predictions for 2008
You’ve got to be kidding me. Only fools make predictions in this online age where what you write will forever haunt you. Still, I’ll make some safe and predictable ones for the upcoming 12 months:

• There will be a number of huge-size Internet exits that will have people scratching their heads
• The whole notion of privacy will continue to erode as Google finds out more and more about you
• Mobile internet will remain where it has for the last three or four years, i.e. tantalizingly around the corner as the Next Big Thing
• Some technology or company that you’re not thinking about will be the big story of 2008

So, for all my celebrating friends and colleagues out there, I want to extend best wishes for the new year and hope that 2008 brings health, happiness and success to us all.