05/11/99 RMIUG Meeting Minutes - Financing Net startups: VC's, Angels and Platinum Cards

Dan Murray called the Rocky Mountain Internet Users Group meeting to order at 7:00 p.m. About 90 people were in attendance.

***IMPORTANT: Please note the July meeting on "Changes in DNS/BIND and Internet Domain Registration" will be on the *3rd* Tuesday of the month, July 20th at NCAR.***

Dan then opened the meeting to announcements from the floor:

- The Denver Metro Super Computer Show and Sale occurs every other month at the Jefferson County Fairgrounds, 6th and Indiana St. in Golden. You can buy, sell, trade, and network, with vendor tables costing $25. For more info call (303) 530-0685, or http://www.users.uswest.net/~savitt/show.htm

- John Meier (john@freshtech.com) announced that Freshwater Software is looking for a Senior Software Engineer to join this growing and profitable Boulder startup. See http://www.freshtech.com/job.htm

- Colson-Quinn, a Boulder law firm, announced the list of Colorado funding sources for entrepreneurs on its web site at http://www.colsonquinn.com. The list identifies venture capital firms active in Colorado and contains practical articles on fund raising. Colson-Quinn's practice is devoted to helping technology companies, especially small to medium sized, start and grow their business. Colson-Quinn's web page provides periodic updates of technology news, as well as a resource guide for Colorado technology businesses. If you have any questions or need further information, please contact Joyce Colson at joyce@colsonquinn.com or Rob Quinn at rob@colsonquinn.com.

- Darren Powderly of TEKSystems (dpowderl@teksystems.com) announced that there are job openings with his company. He described TEKsystems as a technical service provider. Due to their rapid growth, they are constantly in need of technical professionals with information systems skills at all levels. Contact information: http://www.teksystems.com/ or (303) 412-2721

- Joey Manley (thejoes@sprynet.com), founding director of Free Speech Internet Television announced the formation of a group interested in streaming media technologies for business or personal use. Contact Joey for more information.

- Dan thanked Mike Benson (mbenson@ecassociates.com), Senior Business Analyst with Electronic Commerce Associates for volunteering to take the meeting minutes.

Our first speaker was Marcia Schirmer (mschirmer@earthlink.net), who is President of the Colorado Capital Alliance Inc., a Colorado-based angel network that provides efficient and confidential connections between angel investors seeking opportunities and high growth companies seeking capital.

Marcia started by saying there is a paradigm shift happening. So-called gazelle companies in the Internet space are growing with unprecedented speed and angel investors don't have a historical reference for this.

Colorado Capital Alliance is non-profit, and provides a matching service through a proprietary database. There is an application process that looks for mutuality of preferences between investors and entrepreneurs. Anonymity is maintained for angels until they choose to be known. CCA also offer publications as the organization is also focused on educating angels. In addition, they offer investor seminars (typically 20 to 40 investors in the room). Angels like to invest in groups, share the risk and due diligence efforts, and share expertise. CCA has a book that explains how the process works. The organization has placed $4.3 million in the first two years, and Marcia is aware of 12 deals getting funded. They see a variety of deals that could be characterized as no's, maybes and yes's.

CEO's seem to be looking for money all the time, and you can waste time And money doing this. CCA's database contains angels from all over the country.

The investors: - Interested in all stages - 82% expect a role in the venture - Range of investment from $50K up to over $1 million - (Bill Gates is the largest angel of all, and has a slightly higher range ;-) - 18 of 20 investments don't produce a positive return - 2 years ago had no Internet interest - now it's one of the strongest areas -Cost of investing for angels is very high (due diligence - patent attorneys for example)

The entrepreneurs: - Services companies, telecom, computers, Internet, manufacturing. - 31% seed, 46% early stage, 23% mid-stage or established - 56% have sales

More facts and figures: - Equity stakes depend on the risk of the investment - Average national VC investment is now $5 million - "Band of angels" in California is a example of a well-known "informal" Angel network - Garage.com is another Angel matching service on the web and is for-profit - Again, the investors like to invest together

- There are more than 2 million angels in the country (only 250,000 are investing) - They invest $20 billion annually - 300,000 plus companies are looking for money - Angels look for companies that have strong management - If lacking solid management team, they won't invest - they need to believe in the founder and have a gut feel - People invest in people

- The percent of VC investments going into Internet investments is rising sharply - Expect to spend 6 months to a year to prepare to seek funding from angels - Angels invest close to home (within a half-day drive) - Sources (how to find angels): at accounting firms, legal firms, banks (in that order) , and through angel networks - Beware of shopping a deal too early - people remember deals that are shopped around too much too long

- Due diligence is a 2-way street- (it's OK to ask for info/references on the investor) - This is a marriage - "blind date" analogy "do as much due diligence as you can" - Only 1% of companies seeking capital are considered as high-growth potential - 40% to 100% return per year is aggressive - Internet companies are growing extremely quickly - great returns are there...

- Trend: more experienced entrepreneurs now in Internet deals (also more novices) - The wealth creation has attracted many to Internet deals - Investors look for entrepreneurs who can move quickly, staff up, anticipate, and move through transitional stages of evolution - More people are now interested in investing - Big issue for the entrepreneurs: Are you prepared? Be ready to answer the phone call

- Entrepreneurs should talk to the investor from the investor's point of view - Investor asks: "what are you offering?" (valuation is important) - Rule of thumb - you'll spend 5% of the capital before you ever get it - Don't present valuations that are sky high - "You never have enough money" "you'll always be looking for money" After you figure out what you need, double it

- Show that you're prepared to deploy the capital - (as an example: 40% for marketing, 60% for operations) - Don't think in terms of "giving away" a % of your company - if it works, everyone will be happy - Be clear on your exit strategy - have something more than: "we'll do an IPO" - You can source funds in other ways while you're looking for angel capital - SBA money, "layered financing" , adding strategic partners is good, contracts are good, etc. - "There's a lot of money out there"

Q&A Q. What about the stratospheric valuations? How does it affect early rounds? A. This is unclear - people have been saying for years that Internet Valuations are too high. Timeframes are getting compressed - 5 years has now been reduced down to perhaps 3 years or less. Depends on the markets, how fast is the market developing?

Q: What's the dark side of angel investing? A. If they cold call, hang up. Watch out for scams. There are a lot of vultures out there. Beware of brokers who want to take money up-front to get you in front of angels...not all are reputable

Q: How do you get paid? A. CCA is funded through its product sales and fees, service fees, and sponsorships.The board has had discussions about the merits and disadvantages of being a non-profit network. (especially in light of garage.com).

Our next speaker was Bernard Hatcher (hatcherbl@cooley.com) who is an associate with national high tech law firm Cooley Godward and head of their venture capital fund practice in Colorado.

Bernard started out with some recent statistics. Of 267 total IPO's in registration, 133 of those are Internet related. Average size of investment in Internet deals is steadily climbing from 1995 - 1998, at $2.5 million, $3.5 million, $4.1 million, and $5.5 million for those years, respectively. Colorado is a secondary market for VC investments, California was at $6537 millions while Colorado came in at $543 million. In 1998, the average size of investment for venture deals in all industries was $4.1 million (a number inflated by the large size of the telecommunications deals done in Colorado).

More stats: from 1995 to 1998, there has been a trend towards more out of state investments coming into Colorado VC deals. There's a good concentration of deals here, but the valuations tend to be somewhat lower.

What are VCs looking for? Expertise, solid reputation and references of founders, great story, product/service technology excellence. Management that gets along with its investors, good understanding of deal structure, speedy exit strategy. Acquisitions are much more common for Colorado companies rather than IPOs.

Why choose VC funding? Decreases risk, strategic relationships, other value added. Possible counter arguments: possibly a lower valuation, loss of control of the venture. Valuation isn't a huge issue for small amounts of money. In general, you're likely to get a higher valuation from an angel than a VC.

The term sheet should identify "deal killers" and is non-binding generally with exceptions. This document defines valuation, the terms around the exit, etc.

Some successful entrepreneurs, such as Pete Estler who hit big with Matchlogic, are out funding new start-ups as angel investors.

Why are there 2 classes of stock? Investor protections and preferences, valuation and accounting consequence of common stock. Options to employees can be offered at a very low price (well below preferred shares) - there are accounting treatments to handle this: 10% off historically, now - it can be a lot more extreme, like 20-to-1.

Some deal terms: Liquidation preference - the VCs get their money out first Participating preferred - preferred gets paid first, then they participate in the payout of the rest Non-Participating Preferred - preferred stock gets paid a multiple of the issue price (3X or 4X), then that's all they get. Note - in some cases, the investor will actually be better off if they convert to common (and therefore participate) (they usually have conversion rights)

More deal terms: Dividends - very rare (exception - sometimes affects conversion ratio) Preferred stock provisions - redemption right (redemption of preferred) what the investor is saying is that they want leverage --- to put their stock on you as the entrepreneur. Generally not a good thing for the entrepreneur, it's usually a leverage issue (provides an incentive to seek liquidity) Anti-dilution protection: ratchet - first investor gets same valuation as the next round (not always a bad thing for the entrepreneur), weighted average (narrow vs. broad based), pay to play - forces each investor in the syndicate to participate in each round (lead investors like it, entrepreneurs like it but its cumbersome and rarely used), anticipated dilutive cheap stock issuances (employee stock financing warrants, corporate partner stock) are typically excepted from antidilution protection.

Preferred stock conversion: negotiated points include: IPO of minimum size and price per share, vote of x% of preferred, voluntary conversion Voting rights - negotiated points: election of board, preferred votes separately on organic changes and certain other specified actions It's key who at the VC fund is on the board - very important because that's where the decisions are made Registration rights - demand, piggy-back, share cut-backs/limitations - this is highly negotiated, rarely exercised Other agreements - Investors have first refusal rights on sales by other parties, Investors have co-sale rights on sales by major holders, newly imposed vesting schedules (vesting periods 3-to-5 years typically)

Q&A Q: I'm surprised by emphasis on preferred shares - is it non-voting? A: It's voting preferred. Investors want control of liquidity, want control of who's on the board

Q: What was the valuation of 3X or 4X? A: That's a liquidation preference - entrepreneurs can limit the VC's total return to 4X. VC's are looking for 10X deals, would like to get it in 2 years if possible. There are some amazing deals: MatchLogic's multiple was reportedly 23X in about 9 months. The founders did really well! Another incredible one was Rhythms the return on a $2 million investment was about $1 billion

Our third speaker was Perry Evans (pevans@netignite.com), who is President & CEO of netIgnite Incorporated. Perry was previously founder and President of the MapQuest Publishing Group, where he created one of the web's most prominent consumer brands and one of the most widely licensed business services on the Internet. (MapQuest.com just went public on 5-4-99, NASDAQ: MQST).

Perry has been working with VC-led companies for 12 years. They're pretty predictable, they're in it for the return, they have the capital...and you absolutely need the capital. But, angels can be very different from one another - some are just like the VC's... others are not very sophisticated.

The pace of change for financing Internet ventures has increased - the level of investment is much larger, you've gotta think big! In Perry's most recent venture, he spent 3 or 4 months on the business plan, and closed a deal that was 3-4 times the capital he went looking for, through strategic capital from an existing public web company, OSS.

A few things to focus on: - Sanity check your business concept fully (the investors come at it from a risk management perspective) - Focus on competitive positioning - assume there are 3 or 4 others doing exactly what you're doing - Successfully raising money and failing is the most unfortunate experience you could have, be ready to really implement - Have a strong execution plan behind the deal

Perry discussed how it always amazes him how many Internet entrepreneurs are out there working on the same things. It's good practice to always assume that other companies you don't know about are building something similar to your own plan.

On the topic of forecasting - nobody expects your projections to be that meaningful or "guaranteed" , put a lot of focus on the business models, show other relevant examples - business plan doesn't need to be full-color or lengthy. The business plan does need to be well thought out and defensible, however, and you need to be able to execute.

You may be able to create value that has no revenue, but think through how you can monetize that - point to similar examples. CCA and garage.com are useful training wheels, but in Perry's opinion, the real angel capital deals come from personal networking (even in garage.com, most of the deals got done through personal ties...).

- Find a path to a personal network! - Investors appreciate tenacity - Naveen Jain of InfoSpace is the most intense and tenacious entrepreneur I ever met, he would not go home until he'd connected with at least 3 people. - Check out http://www.thelevator.com/ (like garage.com but east-coast based) - Colorado Internet Keiretsu ( http://wwww.cik.org ) is a good resource - Tip: Achieve a significant milestone before you go out for money - show that you can reduce risk for the investor. Excel at what you can do without money (build customers, personal networking, software prototyping). Ultimately, you clearly need the money to create real value. On the web, however, I see things shifting to what happened in markets like databases As platforms emerge, niche and service businesses will grow "on top" of these enabling platforms - and these next generation businesses won't need the huge investments to get started.

Panel Discussion (Marcia was not available for this part of the evening)

Q: Which companies are some of the Colorado Internet success stories? A: Perry: Match Logic, Rhythms, VStream, MessageMedia, BrainPlay.com, Eclectic Radio Company. Bernard: Carrier Access, e-commerce companies: NetLibrary, Requisite Technology

Q: What are the valuation models for Internet Companies? A: Bernard - I don't think there is one! Its more a negotiation, and not a rational process. Perry: tip - go to California and get somebody hooked; bring the term sheet back home, because the deals happen slower here and at lower valuations.

Q: Who invests in Colorado? (what out-of -state funds invest here) A: Hard to name names... There's a notion that Colorado is getting hotter. It depends on the strength of your business plan. You've got to go to them...can't expect them to come here.

Q: Which Colorado VC firms focus on Internet deals? A: Now they all do them. Only a few claim not to do them. The ones who have succeeded: Sequel, SOFTBANK, Boulder Ventures perhaps Perry: It's important to also talk about the round size and the stage.

Q: What else can you do besides paying advisors in equity to help the success of your venture? A: Perry - it's a tough problem. Focus on what you can do without money - at some point it's no good until you get the money - similar to the next-stage players in database, we'll see the same thing with Internet companies - deals in the future may be service based and not need as much capital.

Q: Where can we get good information on the VC business? Recommend books? A: Rockies Venture Club has a good book.

Q: Where are the barriers to entry? Describe the land-grab... A: Bernard - that's why management is so important Perry: If you're trying to be a direct consumer web business, you need to find a way to either pay a lot of money to, or to get past the gatekeepers. The portals have now struck a lot of deals, and in many markets the price to enter is huge . The notion of a consumer being free on the web - it's a fallacy - it's not that way anymore. Some "lucky examples" will emerge, but it will be the exception not the rule.

Dan thanked the speakers and audience and wrapped up the meeting with a reminder of upcoming meetings. ***IMPORTANT: The July meeting will be on the *3rd* Tuesday of the month, July 20th***

Tentative schedule of upcoming 1999 RMIUG meetings: Jul - Changes in DNS/BIND and Internet Domain Registration Sep - Tips and Tools for Web Site Development Nov - Y2K Armageddon, The Coming Internet/World Meltdown ;-)

RMIUG appreciates the ongoing support from XOR Network Engineering ( http://www.xor.com ) for administration of RMIUG's electronic discussion lists & WWW site. Thanks also to NDA ( http://www.nda.com ) for sponsorship of refreshments for our group.

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