We also have a great panel coming up next Thursday night, Jan. 17, on “How Investors Are Increasing Their Returns Through Collaboration and Technology”.   This is another joint event between HBS Angels of NY and the HBS Club of New York.

I hope you can join us Thursday night at a joint event of the Harvard Business School Angels of New York and the Harvard Business School Club of New York, on "How Top Venture Capitalists Create (and Sometimes Destroy) Portfolio Company Value".  I'll briefly discuss my research study on this topic, and then we'll have an all-star panel speaking.

Christopher Fralic is a Managing Partner at First Round Capital’s New York office, and has focused on a number of the firm’s investments in Advertising Technology, Social Media, Ecommerce, Gaming, Mobile and more.  Mr. Fralic has 25 years of technology industry experience, with significant Internet business development roles since 1996.  Prior to joining First Round in early 2006, Mr. Fralic was VP of Business Development at social bookmarking and tagging company del.icio.us through the Yahoo! acquisition.  Mr. Fralic was also one of the early employees and VP of Business Development at Half.com starting in 1999, and after the eBay acquisition, spent six years with eBay in a variety of entertainment, business development, and media roles.  Mr. Fralic earned his BS in Finance from Villanova University and his MBA from St. Joseph's University in Philadelphia.  You can reach Chris at www.nothingtosay.com and @ChrisFRC.

Dave Tisch is Founder and Managing Director of TechStars in NYC and is an angel investor through the BoxGroup.  BoxGroup is an investor in companies like Boxee, Flavors.me, Goodsie, fab.com, art.sy, Coursekit, Skillshare, GroupMe, DataMinr and many more.  You can reach Mr. Tisch at Tisch@techstars.com and @davetisch.

This is the third of three blog posts on financial modeling for startups.  The first was on best practices in building financial models, and the second was a template financial model for a startup.

I’ve often found it helpful to have on hand a simple model showing the impact of each financing stages on all team members, suitable for sharing with everyone in the company.  I couldn’t find one online, so I built it.

Download the Startup Options Valuation model here.

In particular, this model is designed to help all team members understand the impact of dilution on their options.  It’s very powerful to have a model that you can email to everyone in the firm, because then everyone sees clearly that you’re communicating the exact same message to the whole team (including outside consultants and the advisory board, if any).  Such a model is particularly helpful for those founders looking for a co-founder or key employee.

While working on my most recent startup, Navon Partners, we were fortunate to have Raul Trevino, a star former Citi investment banker and Columbia MBA, interning with us.  Like me, he had the pleasure/pain of being trained as an investment banking analyst.  Since he graduated, he’s now Founder and CEO of a Latin America-focused based startup, Participa.me (“I participate”).  He wrote the following guest blog post, and worked closely with me to develop this financial model.  We had a simple balance sheet by financing round model in our earlier master template financial model, but this model is more suitable for use in employment negotiations.

Enter Raul:

This capital table startup options valuation model was created with the purpose of valuing options for an illiquid, early-stage start-up. It is particularly valuable for founders because it allows them (and their employees) to assess equity compensation in the form of options paid out to founding team members and other key employees. To illustrate dilution effects, we show a couple of investment rounds (angel and VC) as well as employee option increments at different stages.

In my previous life as an investment banking analyst at Citi (Latin America industrials group), we used to spend hours deriving the appropriate weighted average cost of capital (WACC) for a particular company. We used to take medians and means of unlevered betas of different subsets of comparable companies. Daily updates of the risk-free rates and corporate bond spreads were mandatory, even if the movement from one day to the other consisted of only a couple of basis points.

In banking, a lot of my time was spent on modeling cash flows. Projections were based on dozens of operational assumptions related to pricing, production, marketing spend, etc. Market assumptions including market share and macroeconomic data were also in order. Finally, financial assumptions such as capital structure and taxes had to be considered. After capturing all of these assumptions into the model, we had to do sensitivities on the dozen or so that were most important.

In the discounted cash flow (“DCF”) methodology, the terminal value carries a lot of weight and can make up to 70% (or in some cases more) of the total value of the firm. Needless to say, a lot of time and analytics was dedicated to the terminal value.

Given all the tweaks and adjustments involved in calculating the overall value of a standalone firm, one can only imagine the wide range of valuations that we came up with. In the end, we presented the results that made the most sense to our senior bankers and to our clients. As I heard David Teten once say “if you torture the data enough, it’ll confess”.

Valuing startups is a far fuzzier process.  In particular, most valuations are negotiated rather than derived from any real numbers, like a cash flow.    This space is very different from what I had learned in investment banking.  When I interned at Navon Partners last summer, I was both surprised and humbled when I realized that I did not know the first thing about valuing start-ups.   Vinicius Vacanti and Jim Moran of Yipit had the same experience .  Projecting cash flows with any sort of accuracy is difficult at best; the WACC becomes the investor’s required return, and the terminal value is anyone’s best guess.

To bring the case in point to life, I will introduce my startup, Participa.me. Participa.me is an online marketplace of qualified freelancers focused on Latin America (initially Mexico, my native country). To the best of my knowledge, there are no direct competitors in Mexico or Latin America.

For my start-up, I built a very robust operational and financial model with a detailed revenue build up and a validated cost structure. Despite having confidence in my financial projections, I am realistic enough to admit that at this stage (pre-revenues) and with no real comps, it may be hard for potential investors to believe them.  (I’m hopeful that they will change their minds soon enough after getting some external validation from potential customers!).

The valuation method I discuss here is how people (other than friends, family and fools) really invest in early stage companies. Compared the DCF methodology, it is quite simple and is based on one thing: returns, based on a range of possible outcomes.  Each fund or individual investor has a hurdle rate and based on that they choose whether they want to invest or not.

By definition, IRR is calculated using amount invested, amount received at some point in the future, and time passed between the two cash flows. When an investor looks at a company, he projects himself into the future and calculates the value of the company at that point in time. Based on his ownership share of the company at that point (most likely a diluted percentage), he figures out his take-home amount. Couple with his personal hurdle rate and take-home amount, he figures out what his post-money share of the company must be today, in order for him to make that personal hurdle rate. To illustrate the VC method with real numbers, let’s walk through the attached model for valuing start-ups.

Financial Model

The good news for us engineers (me, by academic training) that favor science over art in valuation is that there is real data out there to justify the returns that angel investors seek. According to the Kauffman study “Returns of Angel Investors in Groups”, the mean IRR of angel investments hovered around 27% as of November 2007.

As a classic VC rule of thumb, according to John Frankel of ff Venture Capital and others, a third of startups are zero's, a third are boring, and the remaining third are where the returns are.  If a third of those, or about 10% of the portfolio, work out then you have home-run returns.  The bottom line is that that the top 10% of deals provide 90% or so of the returns.   (David Teten: John points out that at ff Venture Capital, we invest heavily in our winners as they start to pull away from the pack, so that even if a third of our companies fail it is not a third of our capital.)

Based on these estimates from some domain experts, we built the attached model to figure out how much a startup at its earliest stage could potentially be worth at exit based on different capitalization rounds and how much could the payout be for a founding partner.

If you have any comments or questions, please enter your comments at the bottom of this blog post.

Download the Startup Options Valuation model here.

Photo credit: dierken

I’m kicking off a new series on this blog: detailed notes on events of interest to the investing and technology community.  Conrad Wadowski, Business Development at Xamtech, is initiating  with his detailed notes on the inaugural panel of the new Enterprise Tech Meetup.  Livestream video here.

-----------------------------

In startup land, consumer internet startups have gotten quite a bit of media attention. But if you're not interested in the idea of building the next great dating app, there's always the option to turn to the $230b B2B market for pain points to solve.

As companies like box.net, which just raised $50 million, stimulate the imagination of entrepreneurs, corporations are also making an effort to start conversations with early-stage companies.

Given the mutual need, a group of organizers in the greater New York area (myself included) have launched a meet up called Enterprise Technology Innovation that's designed to connect enterprise entrepreneurs with a panel of corporate executives.

Our inaugural event, "Corporations speak: How I think about buying your startup" was live streamed on September 28th from the Cooley office.

Panel:

Moderator: Safa Sadeghpour, McKinsey

Fionna Dodd Simmonds, VP M&A, American Express

Bill Taranto, Managing Director, Global Health Innovation Fund, Merck

Greg Merkle, VP Product Strategy, Corporate Markets, Dow Jones

Michael Monson, Senior VP of Performance & Innovation, Visiting Nurse Service of NY

Ben Boissevain, Managing Partner, Agile Equity

--

Safa Sadeghpour: Through my other life working at McKinsey, I realized there are some real challenges for corporations working on ideas internally. Someone once said there is no monopoly on great ideas. I noticed a lot of passionate and driven people that have had difficulties reaching out to corporations so I thought, let's create an interface to connect the two. While there are a million exciting events for consumer oriented companies, in New York there aren't any for the enterprise, so we started this.

For our first event we wanted to start from the backend. I want to ask about what you see as new trends in the M&A world. Secondly, what makes a startup attractive for acquisition? Is it sectors, stages, geographies, or is it a revenue or growth issue? Thirdly, from your experience what are the big deal breakers?

Fionna Dodd Simmonds, VP M&A, American Express

What are the current trends in start up M&A?

• The point of sale is being revolutionized. 10 years from now you won't use a piece of plastic with a number on it. We're looking for anything having to do that that next step. Of course no one really knows the next step so we dabble in different types of companies to have a foot in the door when we find out the company actually is the next best thing.
• Another is understanding social or behavioral information. Understanding the reason customers transact the way they do through social data. When you use your card, the issuer can typically see where you spend, what time you spent and how much you spend. Having this data can help create value for merchants. The information can then be tied into loyalty programs in a point of sale coupon or deal.
• Any technology that helps us gather data or data analytics is important as we try to understand how customers spend and how we can get them to spend more.
• Emerging markets is hot. US consumer tend to be behind the curve in terms of using their cell phones to transact, whereas Asia is probably ahead of the curve.
• India and China are also significant focuses given the sheer number of people that are unbanked and use their cell phones for many other things such as paying utility bills, transferring money. Being able to tap into that network, and get to those countries logistically isn't easy because of regulatory concerns, and is also very much a hot area for us.

What makes a start up attractive for acquisition?

• This is really the difference between pre-revenue, pre-EBITDA versus EBITDA.
• A lot of times we're looking at companies that are profitable, that have PTI, but these companies are incredibly expensive and so I think that there is a general sense that there tends to be inflated valuations in the sectors we're currently looking at.
• Cost is a very big issue. We're willing to pay for something that's good, but I think there is a general sense that valuations keep going up and up, and we're wondering is that bubble going to burst?
• Companies that have open APIs where you encourage developer community use are interesting for us. One topic we weigh is investment versus acquisition. We can use an investment to get our foot in the door as opposed to doing an outright acquisition.
• IP is actually really important for us. Do you have any patents that are really interesting and that are defensible? We look at IP, which is one of the first questions I'll ask a startup. Are you in the patent process, is there something that differentiates you and that you'd be willing to get a patent for?
• I think a lot of times, even if we're looking at a company that's pre-revenue and the technology is good, but maybe something that we wouldn't want to acquire -- what kind of talent is behind that? And how would they do at American Express? We've looked at acquisitions purely for talent but we have to balance that because we're a large company. I've got into some start up meetings where you're in a tiny room and it's great -- you have people innovating and creating new products, and if you want to do something you hit enter and it happens. At American Express, 17 people have to sign off on hitting the enter button. We don't want to stifle that innovation, so there's a balance, and that's something we consider when acquiring talent.
• We also think about what type of product development pipeline you have for the next 6-18 months. Overall revenue, let's be honest, EBITDA and PTI are important. It's great to have it, it's great to make money, but it's not a deal breaker. A lot of companies that we look at are very small, but have great technology. If we were able to take that and feed it out to our network, we could provide a lot of value.

What are the deal breakers?

• Other than price, operating illegally is actually a big deal breaker. You laugh, but there are a lot of companies that are very small and you can fly under the radar. Maybe you need a license to do something and no one really knows you exist yet. In the financial services industry, you have anti-money laundering and government all over that. Another aspect is succession liability, if we bought it would we still be on the hook?
• Lax KYC or AML standards, know your customer or anti-money laundering for American Express, very important. When you're dealing with transferring money. For example mobile payments has money laundering written all over it, so you have to have good procedures in place to ensure that this doesn't happen. It does' t need to be American Express standards, we understand you're not Amex, but having some processes in place and making an effort is very helpful. Because if not, the cost of getting a company up to speed to where we need it to be is incredibly high.
• Also, an ability to integrate with a bank holding company regulations. This is an American Express specific issue. We are a banking holding company, and because of that, if we own greater than roughly 10% of a company, this may have changed to 5%, but roughly 10% then we have to push out all of our bank holding regulations on that sub regardless of we having a non-voting stake. It doesn't matter, we're still controlled for BHC purposes. Being able to understand how a company can adapt to that. And this is something we usually discuss in negotiations, but the ability to institute those practices is important.
• Finally, one key thing we think about is how do you balance the cost of acquiring a company versus building it ourselves internally. This is a big decision and argument I have to make internally. Why should we go out and spend X number of times EBITDA to buy this company, when we could spend Y dollars to do it internally, and yet it will take 8 months. Where is that trade-off, what's the time to market?

Ben Boissevain, Managing Partner, Agile Equity

What are the current trends in start up M&A?

• Seeing a lot of cross border activity. China's active, India is certainly active. They still see the US as a hotbed of innovation.
• For enterprise IT, cloud is certainly hot, Verizon just bought CloudSwitch. Verizon is a multi-billion dollar company, so everyone is looking at the cloud and figuring out what to do. Also, mobile.

What makes a start up attractive for acquisition?

• As a general statement corporate america has spent four years cutting their R&D budgets and are looking for growth and innovation.
• If you're a startup with revenue, growth and believable milestones, you can become very attractive.
• Another key in early-stage cloud and mobile is talent acquisition. It helps to study the company buying you and it helps to create competition with potential buyers.

What are the deal breakers?

• We've seen deal breakers where the CEO of the talent acquisition doesn't want to stay with the company afterwards. I've also seen it where the seller wants a 1-year term and the buyer wants a 3-year. As management it's better to be upfront about this.
• Financials are also important. You don't have to be audited by E&Y, but you should have your financial house in order. A regional accountant can be enough to look at your financials and make sure you're GAAP compliant.
• Groupon modified their S-1 for the third time and their revenue went down by half. This is because they were booking the money they had to pay to merchants later on as revenue.

Bill Taranto, Managing Director, Global Health Innovation Fund, Merck

• Runs a $250M fund. Doesn't invest in compounds, molecules or traditional products and isn't trying to sell more Merck products. Rather, I try to invest in companies that serve a broad set of clients, even competitors in the healthcare space.

What are the current trends in start up M&A?

• Technology is the fundamental driver of the future of healthcare beyond the pill. What makes up the healthcare market is pay, provider, clinical, regulatory and employer -- the one asset that links each is data. Data is the currency that will be used to transact in the future. All healthcare is driven by outcomes and this is driven by data.
• One component is about access, aggregation, integration, analytics. We have to understand what the patient wants, what the physician wants and how that drives value.
• In terms of investments, we like to see our investments data enabled. Do they capture data, or can they do something with data? You often may hear about data such as electronic medical records, lab data, claims data -- that's a commodity, I can buy that from anyone, this is meaningless.
• What's happening is the creation of new longitudinal data in new service industries that tech is supporting. For example, a remote monitoring company. Who owns that data, how do you get access to that data? Then how do you turn that data into something valuable if you're monitoring a stroke or heart attack victim?
• Another theme is the power of the patient. We're seeing healthcare reach beyond the four walls of the hospital and/or physician office. The home health market is projected to be over $350B in 2020. This will all be enabled by technology. How do we move healthcare to the place where the patient wants it? And then how do you turn it into something of value? This is a tremendous market with high reimbursement.
• Another trend is you hear about personalized medicine. The problem is there isn't something that you'll be able to take that cures you immediately -- this type of technology is 10 to 15 to 20 years away. Just because they've done genome sequencing doesn't mean they know what to do with this.
• When we talk about personalized medicine we talk about how do you affect workflow? Right physician, right place, right medicine, right diagnosis, right treatment, right service around it -- you can do this through the right use of technology.
• Regarding emerging markets, we certainly want to be global. We want to invest globally and we want to be sure our investments can be used globally.

What makes a start up attractive for acquisition?

• Price has a large role, but we think in terms of platform. We want something to be broad based. Many entrepreneurs think very narrowly about a widget, but we want to go beyond this. An example might be diagnostics. Instead of just a one off, we think, can a company do multiple diagnoses?
• Another example is monitoring. We don't care about the device, we care about the platform. Multiple devices, being able to go anywhere and monitor anything.
• Transferrable, we want to go to the emerging markets. The US is the highest paying reimburser in the world. The problem is nothing is transferrable to outside the US. If I can do something at an attractive price point in India or China, that's easy to bring back to the US or anywhere in the world, and that's a big business.

What are the deal breakers?

• Healthcare is extremely complex. Most don't understand regulatory pathways and how to get approval for reimbursement and how to get clinical validation. What we find is that entrepreneurs get so focused on a particular widget that they forget how they will be reimbursed, whether it's out of pocket or through a provider or payer. There has to be some type of FDA approval to get yourself to market. You don't have to get approval yet, just a pathway how to get approval.
• Data enabled. We want all of our investments or acquisition to have a data component.
• Talent. If you don't understand healthcare then you're not going to make a good investment because we're going to have to come in and do it for you. We make pills and sell vaccines -- we don't create remote monitoring or technology companies -- so Merck's goal is not to take over the company. We actually want to set up the company as a separate LLC under the Merck umbrella and keep the talent that's there. We're very interested in not only your understanding of healthcare, but also the business of healthcare.
• The whole goal for Merck is to drive EPS and revenue. We want to use the power of Merck to help it grow to a point were it's actually meaningful. We're a $46B company, and $1M is revenue from a company isn't interesting in the grand scheme. We're looking to see how we drive additional revenue with portfolio companies that is helpful to Merck.

Greg Merkle, VP Product Strategy, Corporate Markets, Dow Jones

• Traditionally Dow Jones is a publisher, but I run corporate markets or the B2B side. While we are traditional publishers that create content such as WSJ, Dow Jones Newswire, Barrons, there is also another side called Factiva that has a heritage going back to 1977 with Dow Jones news retrieval.
• We were one of the first search engines around. Pre-internet so an interesting place to be. We now provide business intelligence tools to corporations by aggregating 38,000 sources.  Instead of crawling or scraping, we typically license content from publishers and pay out royalties.
• We take all those sources and reduce them to a single form of XML and we tag and code it. We categorize by industry, subject, region etc. and now we have a billion article archive. The idea is that you can mine this information. It is all updated by the minute and we have content in 22 languages.
• We serve consultancies, financial institutions, banks, insurance, hedge funds, small companies, healthcare, retail, etc.

What are the current trends in start up M&A?

• The five basic capabilities are searching, alerting, monitoring, analytics, sharing and dissemination, the last two being the hotbed.
• Getting close to the customer and understanding what they do is important to us and critical to our success.
• There is also influence of social tools that are now coming to the enterprise. Think of the enterprise as the next frontier of consumer-like behavior.
• Because as a larger company we can just as easily hurt innovation, what I try to focus on is building an internal innovation center like an agency. The areas I'm focusing on right now is customer intimacy -- we're working directly with consultancies as an example to find out how they work.
• These large enterprises can't seem to build their own tools and are looking for partnerships. In many cases there are gaps in terms of the workflow that they are trying to achieve such as sharing and collaboration. Something as simple as moving document around -- and while we have Microsoft SharePoint and LotusNotes, we've seen lightweight tools such as Dropbox or box.net that address mobility and workflow pain points.
• We're also looking at building rich intelligence tools. Going beyond the search box and into rich monitoring views. We hear about big data. Everything can be measured now. How can I correlate news and the events that are happening now with my hypotheses and analysis? How can I bring that in an actionable dashboard? We're actually dovetailing into a knowledge management strategy that is so far from where we were even a decade ago in terms of information retrieval.
• Big data is a trend, cloud based services is a trend. Also, globalization -- with many major corporations having operating centers around the world there is a need to mine data in different languages and normalize it.

What makes a start up attractive for acquisition?

• Talent for acquisitions is important in the mobile space such as HTML5 and iOS5 early adopters. It's easier to lease talent, partner or acquire it.
• Build versus buy are some of the challenging decisions we have to make. Many of the partners we work with are able to come to market much quicker.

What are the deal breakers?

• IP, copyright issues. Are you violating any? Valuation. You want to keep that founding talent on board -- after all, you're buying skills.

Michael Monson, Senior VP of Performance & Innovation, Visiting Nurse Service of NY

• Nation's largest non-profit home based healthcare company. We do $1.3B in revenue and serve the New York metro area. We're both a payer and provider -- roughly equally split. We have a large payer business that's focused on keeping people in their homes. Also as a provider we do home care, hospice services  in people's homes, focused mostly on the frail and elderly.
• I run our corporate strategy group as well as our innovation office. This is a cross between a venture arm and a development arm. My job is to be on the market place looking for healthcare companies that can provide improved care and outcomes or decrease our cost structure

What are the current trends in start up M&A?

• There is a lot of money in health IT and home health. As a result of this, the valuations in the space have gone up and there are more strategics at play. In the last year Aetna bought Medicity. This type of deal is beyond what most vcs or private equity companies would have been able to pay.
• Behavioral science is also very interesting from a healthcare perspective. People make bad decisions. You would think a diabetic in bad condition would be more compliant about their diet, but shockingly they're often not. We're very interested in companies that allow people to overcome these humps. This is an emerging space and has a lot of promise.
• We are also very interested in informatics, big data, natural language processing which is exciting for the provider space. It would be easier to have a clinician adopt a system where they can take notes the same way they always have and information could simply be sucked out. We're also interested in companies that focus on medication compliance. Many patients simply don't comply and there are a number of new tools that help people with this. Also how do you create an environment that allows you to stay in your home safely and at a reasonable cost.
• Productivity enhancement is another area in healthcare that is a critical factor. If we don't use our scarcest resource, our clinician resource, healthcare costs are going to continue to skyrocket. Clinicians are doing tasks they shouldn't be doing or are not using the skills they have.

What are the deal breakers?

• If building something for mobile you need FDA approval and HIPPA compliance. Engineers build great technologies, but because they haven't spent time studying the customer or consumer, no one may want to use it.
• Many times entrepreneurs haven't tested their products. If you've built something for the home, it needs to be able to work in many different settings.

Q&A

Safa Sadeghpour: When you think about a company, how much value is placed on a product versus validating a market and revenue?

Ben Boissevain: It's more challenging to sell a company that's just a technology. Proving revenue is important, but look at who's buying whom. Smartest client I've ever had, kept a log of who's buying whom and was sold for 14X revenue with only one product.

Bill Taranto: It's good to talk about how broad you can go with your business, and creating a platform -- being able to map out where the business can go. For the most part you'll get a valuation on a single line of business as well as the comps around that.

Safa Sadeghpour: How do you think about equity participation versus acquisition?

Fionna Simmonds: There is no easy answer. Minority investments are hard for us, so the default would be -- is there some sort of partnership or operating agreement we can do, or otherwise acquire it. Sometimes however, start ups have a particular culture and if we feel that is best left alone, incorporating them under the AMEX umbrella is not the best bet. Typically we are not a financial investor, our goal is find out how can we add value and capitalize on that value. Also for an acquisition, is this a technology we want to own outright?

Safa Sadeghpour: Pharmacos have expanded, but there hasn't been that big play by health IT. When do you see this happening?

Bill Taranto: If you look where the industry is going, it's going to happen and fast. The traditional pharmaceutical company is really good at clinical informatics, what we lack is post-market informatics which is where reimbursement occurs.

We know how to get reimbursement for pills, vaccine and consumer products, but when you start to talk about remote monitoring or creating efficiencies in the market, it's all enabled by IT. For us to survive we have to invest in infrastructure and health IT. We're looking at Merck, but also the industry -- how do we help the industry better manage data. Every big pharma company has an informatics strategy right now.

Safa Sadeghpour: I hear about two trends in the market. One is a flight to safety and the other increased valuations of early-stage companies. These seem to be pointed in opposite directions.

Ben Boissevain: I think it goes back to global corporations, they've got large cash balances. What they're missing is innovation and revenue growth. Large corporations are looking for innovative companies because their revenue has been flat on a global basis. The VC and private equity communities are all relatively healthy.

Safa Sadeghpour: How do they find you and create conversations. When you’re looking for advice you get money, when you're looking for money you get advice. How do you approach this in a smart way?

Greg Merkle: The meetup is a great networking opportunity. I've found them to be incredibly fertile -- semantic web meet ups for example. There is someone like me at every major corporation and I'm actively looking for technologies and looking to invest or build. The meetup is on the leading edge and I try to be as open as possible, and will listen to anyone. You have to have an open mind. Email always works great

Michael Monson: I'm very active in health 2.0 and we've gotten a lot of opportunities through here. Every email that comes across my desk, we'll read. Even if it's something that's too early for us, we'll make introductions to venture firms to facilitate the conversation and stay in touch with the company.

( Photo courtesy of pagedooley .)

For background, we rarely see a CPA come to us with a startup idea.  As a result, we offer our portfolio companies a wide range of accounting services, including  Accounts Payable/Expenses; Accounts Receivable/Revenue; Payroll; General Ledger; Management Reporting; Annual tax and financial reporting.  In addition to relieving our companies of a time-consuming burden, this also gives us deep insight into their growth and ability to help them see upcoming issues well ahead of time.  Alex leads the four-person team that provides these services.

Enter Alex:

I am writing to tell you about two tax credits available to companies that do business in New York State.  The first credit, called the “Qualified Emerging Technology Company” tax credit, is available to companies located in New York State that are involved in “emerging technologies.”  The credit can benefit companies even if they are not yet paying taxes to New York State, because New York will refund the credit amount.  This can be a boon to your Company or your investors.  New York also enacted this year a “New York Jobs Tax Credit” that is available to companies who increase their New York employment in 2011 over 2010 levels, even if 2010 was zero.

Qualifying Emerging Technology Credit

The Qualifying Emerging Tax Credit is available to companies involved in R&D activities in information and communication technologies, among other things.  The amount that can be refunded includes the following:

• Up to $250,000 per year based on a portion of amounts paid for payroll, training, computer equipment and other items;
• $1,000 per year for each new employee hired; and
• Up to $300,000 for amounts invested in QETC companies (this credit is available to shareholders directly, but is not refundable).

 

New York Jobs Tax Credit

The New York Jobs Tax Credit is for New York companies who increase employment in 2011 over 2010 levels.  The amount of the credit equals the amount that the employees paid in individual withholding taxes.

Act Now!

If you have not taken advantage of the tax credit before, you can amend your 2008, 2009 or 2010 tax returns to do so, and New York may issue a refund to you for those prior years.  Note, however, that the credit is scheduled to expire at the end of 2011.  I am told that the Governor is engaged in discussions with the Legislature about extending the credit, but it would be wise to consider this opportunity as soon as possible.

The process can be involved and detailed.  It involves filing an application to the New York Department of Taxation and Finance to be deemed a QETC and then submitting an application each year as part of your annual tax return.   I have spoken with two CPA firms who can help in the process, and I can be available to answer any questions you may have.

(Photo courtesy Shedboy.)

I asked Rick Eaton, CFO of Hashable, to write for you a sanitized version of some of the detailed reports that Hashable provides to its investors (which includes us).  He’s provided below a template for both the cover email and the detailed report.  Rick was previously CFO of our former portfolio company Quigo, sold to AOL for >$340m, so he has a lot of insight on this topic.

THE PROBLEM WITH SPREADSHEETS AND SURPRISES IN GROUP DYNAMICS

Getting ready for a board meeting is a busy time for most startups. Often, the financial statements and slides are prepared just before an agreed upon deadline. Sometimes, despite sending the package in advance, it’s clear that some members haven’t had the time or physical venue to open and review the various attachments. They need the information in a form conducive to viewing on a mobile device. It’s also the case that some people find it easier to digest financial information when presented as text -- instead of in spreadsheets and tables.

While it’s not always practical to prepare a cover email summarizing the results, there is great value to providing a text-only cover email allowing for mobile access of the results. In the group dynamics of a board meeting, anything surprising or misunderstood can really hinder the flow and effectiveness of the team. Giving members the basics in advance and in a form that is easy to digest from a mobile device can avoid surprises and unnecessary tensions. An additional benefit is that the process and discipline of verbalizing the results also helps catch errors and forces a deeper understanding of the operations. So, if time is available to prepare a short email cover narrative about the financial results, it can tee up a more constructive exchange during the board meeting.

Here are some guidelines for things to address in such a cover note.

KEY ITEMS TO COVER:

At a minimum cover this:

1. How much cash do we have?

2. What is the current burn rate and what is expected?

3. How long will cash last? When will we need to raise more capital?

4. How many options are left in the option pool expressed as a % of fully diluted shares?

5. How many employees do we have?

6. How many employees do we expect to hire near term and will the option pool be sufficient to get us through the next capital raise?

Ideally cover this as well:

7. Revenue variances as compared with the budget and descriptions of key drivers of revenue growth or lack thereof vs. expectations set at the previous meeting

8. Try to express variances in terms of both rate and volume.

9. Gross profit or contribution profit variances with plan and key drivers.

10. Express margin impact in terms of both cost rates and volume.

For “extra credit” as you grow and gain traction, it helps to marry the financial data with operations data and provide a narrative on key performance metrics as well. This is often difficult for companies in the startup phase to do in a manner that is both efficient and meaningful, but expansion stage companies are more likely to be able to provide this and it pays dividends in making meetings productive.

11. There are many important metrics. A sampling of this information for two different business types appears below.

I. Subscription revenue business - key metrics for customers:

Revenue per customer

Cost per customer

Contribution profit per customer

Cost to acquire a customer

Average life of a customer

Churn rate

Lifetime value of a customer

II. Advertising revenue with a sales-team driven business

Number of customers active during the period

Revenue per customer

A narrative on the health of the sales pipeline

Revenue per sales person

Quotas assigned to sales personnel

Number of sales people on track to make quota

Progress of new sales personnel towards making quota

Commission expense as a percent of revenue and gross profit

FINANCIAL RESULTS COVER EMAIL TEMPLATE FOR A PRE-REVENUE COMPANY

(BOARD MEETING 3 WEEKS AFTER MONTH)

YEAR-TO-DATE EBITDA AND CASH

On a year-to-date basis through MONTH, YEAR, we posted an EBITDA loss of ($XXX), which is $XX or X.X% favorable to the budgeted EBITDA YTD loss of ($XXX). We averaged XX.X FTE's (full-time equivalent employees) during the X months ended MONTH, as compared with a budgeted average of XX.X FTEs, and this accounts for most of the favorable EBITDA variance. Our average FTE has cost us about $XX.X per month during this period.  Notably however, this average declined in MONTH to approximately $XX.X, largely as a result of a savings from switching health insurance providers. Our cash balance at the end of MONTH stands at $XXX, approximately $XXX favorable to budget.

MONTH EBITDA

For the month of MONTH, we posted an EBITDA loss of ($XXX), which is $XXX favorable to the budgeted loss of ($XXX). The favorable variance is principally attributable to running with lower FTEs at a relatively lower cost per FTE and from lower marketing activities. We ended MONTH with XX full-time employees, which was lower than our budget of XX employees. Our EBITDA loss in the MONTH of ($XXX) compares favorably with an EBITDA loss of ($XXX) in MONTH-1, ($XXX) in MONTH-2, and ($XXX) in MONTH-3.

EBITDA EXPECTATIONS

We expect, as compared to the budget, to continue with a lower number of FTEs on average and lower benefit costs. We expect to [INVEST MORE OR LESS IN MARKETING]. Accordingly, we expect to see the monthly EBITDA loss in the ($XXX) range in MONTH+1 and then [INCREASING OR DECREASING] to the ($XXX) range as we INVEST MORE OR LESS IN MARKETING and add X FTEs in the next fiscal quarter. There is an additional one-time expense projected for the month of December of approximately $XX, cushioning [A ONE TIME EXPENSE]. We expect to post an EBITDA loss for the year that is over $XXX favorable to budget. Naturally, this view is subject to change depending upon opportunities that may arise.

REGISTERED USERS

We ended the month of MONTH with approximately XXX registered user accounts, up from XXX registered user accounts at the end of MONTH-1 and up from XXX at MONTH-4. The increased growth rate in registered accounts during MONTH was primarily attributed to [REASON]. We had been averaging XXX signups per day in MONTH prior to [REASON]. We averaged about XXX signups per day after [REASON]. For the first 14 days in MONTH+1 we averaged XXX signups per day as a result of [REASON]. We ended with XXX registered accounts on the 14^th day of MONTH+1. We expect the daily signups to [INCREASE, DECREASE, OR REMAIN CONSISTENT] as compared with this experience rate.

USER ACTIVITY

On a trailing 30-day basis, we’re seeing about XX% of our registered users as active. This percentage rose to the XX%-XX% range towards the end of MONTH and through the first two weeks of MONTH+1, buffeted by [REASON]. We’re seeing about XX% of our registered users as active on a daily basis.

OPERATING EXPENSES

For the month of MONTH, employee compensation, bonus accruals, taxes, and benefits totaled $XXX, accounting for XX% of our EBITDA loss of ($XXX). Contractors, another way to pay for personnel, were $XX or XX% of cash expenses. So, XX% of our cash expenses went for labor.

Our next largest item remains the $XXX per month we spend on IT/operations, comprising XX% of cash expenses. We made an improvement in MONTH that [REASON] should save us $XXX per month going forward.

Occupancy was $XXX during the month of MONTH and represents XX% of monthly cash expenses. It's largely fixed. We held sales & marketing expenses to $XXX in MONTH or XX% of cash expenses, as compared with a budget of $XXX. G&A expenses were at about $XXX, or XX% of monthly cash expenses, largely because of lower XXXXX expenses. We expect this trend to continue for several months.

CASH AND LIQUIDITY

We expect to end the year with a cash balance of $XXX, which is $XXX favorable to budget – and continue to expect that cash balance to get us through MONTH, YEAR, targeting a financing by early [SEASON].

Our equipment financing debt balance stands at $XXX as of the end of MONTH. We expect that payments for debt service of $XXX per month will continue to bring the debt balance down to about $XXX at the end of the fiscal year. We have $XXX available for additional borrowings under our credit facility, subject to our [MOST RESTRICTIVE COVENANT].

The attached model shows our projections on a monthly basis through the end of the fiscal year. In making our projections beyond the end of the fiscal year, we’re assuming we adjust the then expected normal monthly EBITDA loss of $XXX as follows:  $XXX for annual bonus payments and taxes to be made in February 2012; $XXX in incremental marketing; $XXX to settle the debt balance; $XXX for a month’s trailing non-payroll cash liabilities; $XXX in capex and $XXX per month in cushion on the monthly burn estimate. Naturally, if things change and we hire more headcount, the burn will be higher and the runway will be shorter – probably by about $XX per month per incremental FTE (fully loaded).

OPTION POOL

There is currently XX% available for grant in the pre-approved employee stock option pool. Our targeted headcount additions suggest the pool should last us until [MONTH, YEAR].

Please feel free to call with any questions you may have.

------------------------------------------------------------

For Revenue Generating Company, add:

REVENUES

Revenues for the X months ended MONTH, YEAR were $XXX, favorable by XX% to budgeted revenues of $XXX. Revenues of $XXX in the month of MONTH were also favorable, by XX%, to budgeted MONTH revenues of $XXX. The revenue trend for the last several months is: MONTH-1 $XXXX, MONTH-2, $XXX, MONTH-3 $XXX and MONTH-4 $XXX.

Driving the increase in revenues on a year-to-date basis and in MONTH is a combination of [Rate and Volume]. Average price was XX% higher than expected. Both average deal size and number of deals has been higher as well. Average deal size was $XXX as compared with a budget of $XXX and we were running XX deals as compared with a budgeted number of XX deals. We expect this trend to continue for the next several months and are taking up our projections accordingly.

GROSS PROFIT AND MARGIN

Gross profit for the X months ended MONTH, YEAR was $XXX, favorable by XX% to budgeted gross profit of $XXX. The additional volume was the key driver of the favorable variance as expected costs per deal were higher than anticipated. We believe the reason for the higher costs resulted from [DESCRIBE REASON]. Our margins suffered slightly by XX points as a result of this with gross margin coming in at XX%, as compared to budget of YY%. We expect this trend to continue for the next several months as well. We are [DESCRIBE PLAN] to address this margin pressure.

(Image via CrunchBase)

One attendee, a partner at a Silicon Valley VC, recently attended the demo day of a major Silicon Valley accelerator.  He observed that ER far surpassed “the accelerator who shall not be named” in two areas specifically: the slickness of the pitching companies' marketing, including some very professional videos; and the focus and thought that had gone into the business models of the companies.
Complimenting a tech startup on marketing is a bit of a backhanded compliment, but they’ll take it.

Thanks to our intern Raffi Sapire for her detailed notes below, with some of my thoughts inserted:

Centzy- comparison-shopping for local services

• Less than 25% of local businesses post their prices online, so as consumers we are presented with a challenge when trying to find the cheapest place to get a service.
• On Centzy, you are able to search for a service such as a haircut or oil change, and the results are sortable by price, quality, and distance. Thus, you can find the best and cheapest option within your price range that is near by.
• Unlike other sites, Centzy focuses on everyday services under $100, which they estimate to be a $350Bn market.
• There is also an app in beta.
• Scalable- 15k up front to launch in a new city
• Revenue: long term is lead gen and booking companies. Immediate is ads and citygrid media.
• Achieves $0.40 per click, $4 per lead and $10-$25 per booking

Buzztable- mobile CRM

• Mobile CRM increases customer retention.
• It’s estimated that 80-90% is spent on customer acquisition. This is 7-10x more costly than keeping current customers.
• Restaurants pay a fee to use the CRM tool, and they enter customers cell phone information and text them when their table is ready. This way they are able to collect information about their customers and even offer them a free drink for next time via text.
• They have launched this app at over 4 restaurants and found that 91% give numbers during peak hours.
• Rev= SaaS platform fee.

Web Thrift Store- Online peer-to-peer market

• We all have items in our house that we don’t need and would be happy to donate to charity.
• EBay moves 60Bn but eBay makes it increasingly difficult for people to sell stuff (over 30 steps to posting something on the site!)
• Seller chooses a charity (they have partnerships with four major charities). The seller posts their items online, and when someone has requested to purchase it the seller receives a box and label in the mail. The money the buyer uses goes to charity.
• DT: my concern—this is a lot of work for items which many people will just as easily throw away.

Pricing Engine

• Create free account, import data, receive insights on what they can do to improve
• They make money off of free users. Cost is <$1 per user. Get $70 LTV. Spend <10 customer acquisition.
• Pay per click. Content strategy marketing.
• Raising $750k seed round.

Parking Panda

• Parking is expensive. Go online and rent your space out.
• $20B in parking in the US last year. At a single Ravens game, the team collects $750k from parking.
• 20% transaction fee.
• Driver is charged no fee beyond cost of parking space
• 2 weeks, 117 cars.
• $750k to expand into new cities.

Public Stuff- service request management system

• When there is a pothole, a fallen tree, how to report these issues? Who do you report it to?
• NYC spends $25mm to operate 311.
• Receive, track and assign requests.
• 92% of cities are not using any mobile systems.
• Suite hosted online, portal, CRM and mobile. It hits a backend CRM system.
• License the CRM to customers. The backend system houses all data, which leads to savings.
• $9 to close a request using cities current phone methods. Using Public Stuff costs $0.44
• Submitted per account.
• The system plays for itself within first month of operation.
• Sales and outreach.
• On average, 2-4 months to close a deal. All online.
• In 35+ cities.
• Addressable market of 3.2b internationally.
• Also can be used for facility management companies in the US of 5.3bn dollars.
• Competition charges 210k. They charge 3-40k.
• DT: Impressive wins, but a long sales cycle.

NumberFire - the next generation sports analytics platform.

• Sound actionable analytics for fantasy football owners to make the most educated and analytical decisions they can
• People spend 9hrs/wk on fantasy football.
• $5Bn market in fantasy sports.
• Also could sell data to managers
• The have closed 400k, are raising 750k

LetGive - the first open giving platform.

• 8% of $212bn were made online for charity.
• You can donate to a charity online but these are destination sites you must purposefully go to.
• It provides a platform that connects developers, charities, and consumers.
• Every day, 560 apps are submitted to app store. Crowded marketplace. Differentiate your app by making it also a fundraising vehicle
• Revenue derived from 20% fee on all transactions processed through platform
• 3k downloads and 15k using it.
• City harvest are releasing a mobile restaurant guide. Leave a tip for city harvest in the process.
• Raising funding to build 100 additional apps, 50 partnerships with charities

BespokePost – subscription service for products men want

• Similar to birchbox for men except with “mancessories,” food & drink, and things for home and office
• Chance to access this targeted market (men aged 20-35 who like nice things but don’t want to go shopping) is very valuable.
• $40 per box and it has accessories.
• Scale, increase customer marketing for 500k
• DT: I’m skeptical of this.  It doesn’t have the low COGS of Birchbox, and then it becomes the low-margin distribution business.

Sitesimon – find the content you’ve been missing.

• Push content to people to make good recommendations based on where people have been going.
• 27mm pages shared daily. 60K new websites created daily.
• The average person views about 85 pages daily. It privately analyzes who you browse.
• Seamlessly integrates into browser.
• Content discovery should be effortless and personalized.

If you are a student anywhere in the world seriously interested in venture capital, angel investing, and/or entrepreneurship, please consider working with us on your research papers.  We're obsessed with research and data, and have a number of research topics we'd love to dig into with the right student partners.

If you are highly qualified and your research is pertinent to our work, we can help provide you with research materials, guidance, introductions to interviewees and other experts, and access to unique data sets. If your research results are high quality, we'll also help you publicize and potentially publish your final research paper. We have relationships with many of the leading finance media which have published our own research.

To learn more, contact us with: your proposed research topics; the full resumes of your team members; the course for which you are writing the paper; your professor's name and website; timeline; and your targeted deliverable (length, format, etc.). We cannot respond to inquiries which do not provide all of this information. We prefer to work with graduate students (MBA/PhD/etc.), but are open to exceptional ambitious undergraduates also.  We have a strong preference for team projects as opposed to individual projects.

We've listed below some of the research questions about which we'd like to learn more. We're particularly interested in working with you if you choose one of these topics for a research paper or field study.

• Analyze advantages/disadvantages of investing personally in early-stage tech companies, vs. investing in an early-stage fund.  Create checklist of criteria which could help guide decision-making around when to invest personally and when to invest in a fund.
• Research best practices of VCs and angel networks in supporting portfolio operations. Among the issues to consider: identify the right technology stack to share documents, contacts, and best practices between different operating companies.  Research correlation of investing success with the nature of VC involvement in portfolio companies.
• Research diversification in early-stage investing vs. returns.  How much diversification is optimal?  What aspects are best to diversify in (sector, stage, geography?)
• Identify best practices in being an early-stage board member. Create case studies highlighting high- and low-performing board members, and companies who do and do not effectively leverage their boards.
• Novel, demonstrably-effective techniques to predict the success/failure of startups and revenue-stage companies based on pubicly visible data (e.g., YouNoodle). Similarly, techniques to assess forthcoming needs of particular startups (e.g., which ones are best off seeking more experienced management in the coming year).  
• Research and publicize best practices in managing a virtual file server for a diverse international team.

• Execute an analysis of the leading New York-area angels, superangels, and early-stage VCs.  Evaluate number of deals, size of deals, future activity, assets under management, industries of interest, and returns. Create formal ranking.
• Compare returns of NY vs. California vs. Boston VCs.
• Analyze contribution of the New York VC community to local job creation.

• Study characteristics of the most successful Entrepreneurs in Residence.
• Research characteristics of successful angel-backed companies run by older entrepreneurs (50+).
• A study of the value that acquiring access to someone else's patent can add to a startup in a range of sectors.

• Write a guide to market mapping a new industry sector. 
• Create a systematic approach for identifying industries ripe for disruption, and disruptive companies, using the ideas in Clayton Christenson's "Innovator's Dilemma" and its followup books.  E.g., look for hated companies (AT&T, cable companies); look for the largest private companies (which may be seeking to hide their profitability).
• Analyze the most rapidly-growing open-source tools/ecosystems in order to identify entrepreneurial opportunities in those spheres. Analyze opportunities that emerged from the growth of earlier ecosystems, e.g, Ruby -->Heroku.  Identify opportunities that emerge from growth of HTML5.
• Analyze the fastest-growing companies in every significant country, and then identify if we can create a comparable company in the US market.  This is the reverse of the strategy used by many emerging market entrepreneurs copying US models that are successful.
• Identify white space on market maps: Target sectors that are not yet transformed by the internet: finance, healthcare, energy, education, etc.  

• Identify how, when, and why senior executives/time-pressed professionals are using social media, and business opportunities that emerge from the use of social media by this most influential demographic.

Photo from BillWard

We recently hosted an idea dinner on "Disruptive Companies in the Asset Management Industry". 

The most attractive industries to disrupt are highly profitable ones, and asset management is traditionally a highly profitable industry.  IMHO, the most successful disrupters in this area to date have been Vanguard (who popularized index funds) and the ETF industry.  We thought it would be interesting to brainstorm about what are the next great ideas and companies that will/can disrupt this sector, based on the ideas on Clayton Christensen's "Innovator's Dilemma".  The dinner included a cross-section of senior finance executives and experienced tech entrepreneurs.  I've attached below the notes from the dinner in slideshow format. 

For this who don't flip through the slideshow, here are the highlights:

What Do Investors Value? (What Jobs Does the Investor Want Done?)

.Returns

.Investment Team Stability

.Relationships with other investors and investment teams

.Visibility

.Capital preservation

.Job security (of the investor)

.Tax minimization

.Social welfare

.Exposure to target sector (e.g. China, commodities)

.Networking

Examples of Disruptive Innovation in Asset Management

.Index funds

.ETFs

.Structured products which minimize downside

.Investing in new asset classes: domain names (Oversee.net), equity-like student loan instruments (MyRichUncle), litigation (Law Finance), patents (RPX), etc.

.Credit Default Swaps

.Crowdsourced financing: Indiegogo/Kiva/Kickstarter

.Discount Brokerages

.Expert Networks

Examples of Sustaining Innovation in Asset Management

.Quant hedge funds

.Private company markets

.Motif Investing

-Allows exposure to investment themes (eg, "I want to invest in African oil expansion"

New Asset Classes in Which Some Are Investing

.Domain Names

.Patents

.Human Equity

.Litigation

.CDs

.Virtual Currencies

-Facebook credits

-Frequent flyer miles

-Carbon Credits

A few weeks ago, Fred Wilson discussed the role of government grants in helping launch tech companies.  Fred is not a fan and argues that evaluating and aiding early-stage companies is not a core competency of government organizations. He concludes by asking his readers to look into grant programs available for startups.

We find it hard to disagree with Fred's point of view. Nevertheless, a number of portfolio companies have asked us our thoughts on access to government finance sources, so we wanted to write a summary of options we think helpful.

Despite the fact that the grant community looks impossibly messy for a startup to navigate, a good starting place is Grants.gov, where you can find a fairly comprehensive directory of federal grants (especially SBIR-related solicitations), searchable by keyword/agency/funding-type/date. Additionally, GrantWatch seems to be the only privately-run site we came across in our research that's attempting to centralize data on funding opportunities, but its focus is on the non-profit sector, which excludes many startups. For non-federal grants, the best tactic seems to be searching for "technology grants" or "innovation grants" in connection with your local state or city, but the most reliable source of information will be your local Small Business Development Center.

From all the diversity that is government-related grants, we've squeezed out a shortlist of grant programs related to the regions and industries that most of our portfolio companies are located in (not including federal grants; see Grants.gov for that):

New York

o NYSTAR's Funding Opportunity Newsletter

o New York Grant Watch

California

o Southern California Innovation Project

o California Conservation Innovation Grant Program

Texas

o Texas Emerging Technology Fund

o Grant for Technology Opportunities Program

If you have suggestions for additional resources, please post them in the comments. Thanks to Franklin Bi for his research on this blog post.

(Photo credit: http://www.flickr.com/photos/pinksherbet/5008270549/)