I attended a venture finance event a while back in Palo Alto, which was put on DLA Piper. They had a nice segment on legal aspects of venture finance and law.

While this post is geared towards the investor, venture capitalist and angel, if you’re an entrepreneur, you will obviously gain value from understanding this overall concept.

Calculation of Number of Shares To Be Offered to Existing Investors Pursuant to Preemptive Rights:

To determine the number of shares to be offered to a current shareholder pursuant to preemptive rights to maintain ownership percentage, you must first determine the basis on which the calculation of the holder’s ownership is to be made {e.g., fully diluted including all options in pool, fully diluted excluding ungranted options, based on shares actually outstanding [on an as-converted basis], including warrants, etc.).

In a venture-backed company, these rights typically will be contractural rather than statutory {i.e., pursuant to the company’s charter or state incorporation laws). The calculation of statutory preemptive rights will vary depending on the law of the state of incorporation.

The actual number of shares to be offered to existing investors pursuant to preemptive rights is the difference between the aggregate offering size and the shares to be offered to new investors.

To calculate the aggregate offering size, use a standard “gross up” calculation by dividing the number of shares being offered to new investors other than the holder(s) with preemptive rights by a fraction which is (1 – [the holder's percentage ownership of the company after making the determination above]). For example, if the company proposes to offer 8,000,000 shares to new investors prior to the offering the existing investor with preemptive rights owns 5% (or .05) of the company then the existing investor would have the right to purchase the following number of shares:

Aggregate Offering:

8,000,000/(1 – 0.05) = 8,000,000/(0.95) = 8,421,053

Offering to Existing Investor: 8,421,053 – 8,000,000 = 421,053

[You can view more resources, guides and helpful documents here...]

As you probably know, a wiki is an unusual communication mechanism that enables the organization of contributions to be edited in addition to the content itself. The current VC model is closed and to VC’s, their process cannot be edited. Each VC is running on a different program. To counteract this, I wrote about the idea of a Wiki Fund a while back (link here).

Unlike the current venture capital model, the Wiki Fund proposes to open up these lines of communication. Essentially, creating a Stock Market For Startups.

In the past couple of months, I’m excited to tell you that this idea has become reality. The space is shaking up; the venture capital model is changing. I’m sure you have opinions on this, as well. Is a stock market for startups really safe? Should the vc model change?

Share your thoughts below in the following poll:



It seems that every other day there’s a new story that surfaces regarding the venture capital model. The argument can range from the completely pessimistic point: “Venture capital is dead,” to an optimistic look, “Venture capital isn’t dead, entrepreneurs just aren’t performing.” Usually the optimistic view is hammered with data and angry individuals declaring this view absurd. Really, no one knows what’s going to happen. However, there are some stealth and early stage models soon to be released that will forever change the venture capital model as we know it. One in particular, is launching a model quite similar to the wiki fund, an idea I wrote about months ago.

Would you like to test the cutting edge, new model for venture capital? A stealth venture is now accepting test users. You can sign up below:
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The most level-headed perspectives have actually come from venture capitalists. Fred Wilson, for example, has communicated the disenchantment held by his limited partners to the world.

In the end, venture capitalists are finally understanding that there’s not only a problem, but that it’s not just the economy to blame for it. Basically, we’re at the foot of the mountain named, “Change.”

Never waste a good crisis. A number of VCs compare today’s environment to tech’s nuclear winter in 2000. But in the last such “winter,” digital media and the Chinese market emerged and entrepreneurs seized upon tough times to start their businesses. Today, we are on the cusp of the next wave of disruptive technologies with next-generation Internet platforms driven by SNS and online games. The cleantech sector provides upside for renewable energy, efficiency and natural resource management, and VC-backed technologies including water disinfection, solar panels, gridscale storage or solid state discs can play a key role. Lastly, a rising middle class in developing countries will fuel excitement and adoption of transformative technologies. Now is one of the best
periods in the VC industry to invest.

– Dixon Doll, co-founder and general partner, DCM Partners

This change is something that we are capable of implementing immediately. At the foundation of this change will sit technology; and this will occur whether from a web 2.0 perspective (people at the center of technology), or a software perspective (simulation and quantitative analysis). The competitive pressures to bring the changes about all are in place. The only thing that will force the change will be results; that is, venture capital as an asset class must underwhelm limited partners to the point where they ditch the asset class completely. This is happening now.

Already, venture capitalists are shifting the focus of their investment strategy to later-stage companies and existing portfolio companies (Graph 1). This can be attributed to many factors, not the least of which is overcapitalization. While the venture capital industry was arguably already overcapitalized, the economic downturn has drastically restricted exits, further increasing overcapitalization. This and investor pressure has led to venture capitalists focusing on later-stage deals to realize quicker and more reliable returns over a shorter time span. Additionally, it is much more cost-effective for venture capitalists to focus on fewer, larger deals instead of numerous smaller deals. The statistics speak for themselves- even though 53% of venture capitalists in America think “it is currently a ‘terrific’ time to invest in promising entrepreneurial companies” (42% think it’s a “fair” time to, and 4% think “awful”), there is a dramatic shift of focus away from early-stage companies (graph 1).

The average $25 billion injection in capital in the venture capital asset class is fading. The willingness, in the late 1990s, to finance risky ventures is finally coming to an end; the funds that were known as the “dot-com” era funds will be releasing their return performance over the course of this next year.

The Basics of Venture Capital

The articles popping up lately presuppose that the reader understands the structure of venture capital. Except for the incubators that have surfaced recently like Y-Combinator, almost all VC funds are organized as limited partnerships. Currently, there are well over 1,000 funds in existence in the US, and a smaller number of others internationally. Of course, some of the U.S. headquartered funds invest internationally. Most funds have a life of 10 years. Over the course of these 10 years, the fund undergoes various cycles: (i) generating dealflow, (ii) investing, (iii) mentoring/monitoring, (iv) board level oversight, (v) harvesting (which means reaping the rewards of the capital invested).

From a legal perspective, the fund’s manager is a separate entity-it’s a venture capital organization that simply manages venture funds that it creates for itself. The members of the managing organization (venture capitalists) manage the fund as it enters different stages in the life-cycle. If the venture capitalist is a senior partner, he or she is simultaneously focused on raising an additional fund -it’s how they stay in business. It’s a very basic principle of diversification–the more funds you have the more stability you have. It’s fair to say that many VC’s focus on how they can raise the next fund, rather than focus on squeezing the most out of their current fund.

This year and next should be an attractive time to make new venture investments. The pace of technological change continues to accelerate and there is no shortage of great entrepreneurial ideas. Yet many of the sources for funding away from institutional venture capital have shrunk dramatically. Angel investors, corporate investors and hedge funds have all cut back or disappeared. Entrepreneurs are realistic about what kinds of venture deals can be done in this environment. So we feel there is now a great opportunity for venture capital firms to back great teams building leading technology companies.

– Sandy Miller, general partner, Institutional Venture Partners (IVP)

A Look at The Internet Bubble and How It Changed Venture Capitalists’ Philosophy

Put simply, the internet bubble was all about ideas, not about the people behind the ideas. Everyone had an idea for an internet company. You simply take an idea from the real world, and apply it to the online world. Obviously, with the “newness” of the internet, VC’s couldn’t invest in teams with a profound amount of experience in the realm. Nothing mattered except the idea. It had to be big enough to pump up, inject false hope and hopefully ride the cash-loss wave until you dished it out to the public via IPO. The best VC’s were those who could make an idea look glamorous and complete the IPO before people discovered there was no business model.

This way of generating success has slowly died out. Limited partners are waiting to get out, and VC’s are trying to simultaneously figure out how to actually invest in the space. The future of new venture financing is going to be nothing like the recent past. The pressures that venture capitalists experience are now trickling down to entrepreneurs; however, the effect it’s had has not been detrimental to the entrepreneurship sector because, well, entrepreneurs are resilient. Additionally, the cost of starting a tech company can be funded either through (i) open-source technologies, (ii) grants, or (iii) universities.

Some say we’re on the brink of seeing venture capital transition from an art to a science. However, this really isn’t the answer at all. If it did transition down that path, we’d just be counting down until the next Long-Term Capital Management fiasco. The transition venture capital needs to go through is one in which: (i) value-based investing is given emphasis, and (ii) people are at the center of the next revolution.

This is an easy prediction to make. Anyone can predict change in any sector; however, the nature of that change is what will be most interesting. Touching briefly on the art and science argument again, the major point is that venture capital in the 90′s was an art: where one individual valued assets based on subjective matters of personal taste. Many say the science component will come into play with increased insight into valuations; however, this never has been, or never will be, the answer.

The core problem with the late ‘90′s model was the singular decision-making that sat at its foundation: one investor making a decision on behalf of millions of dollars in limited partner money. The world has grown, and technology now easily allows many individuals to collaborate and build information. Already, microlending is quickly becoming a mainstream source of financing. According to the research firm Celent, the nascent peer-2-peer lending market has grown from $0.6 billion in 2006 to a projected $5.8 billion in 2010. If everyone had the opportunity to invest in startups as they now do with loans, a similar explosion of market growth would take place- there is approximately $50 billion in annual US seed-stage and early-stage financing requirements, of which VCs have provided a rough $5 billion annually for the last 7 years. A plural nature will be the future of venture capital.

http://nvca-chartbox.ichartsbusiness.com/

The Last Capital Transformation

In 1952, for the first-time ever, a theory of valuing very risky financial assets was introduced. The capital markets were never the same. Portfolio theory, as it came to be called, was unleashed by Harry Markowitz in a revolutionary article. And yes, it was very academic. After this, many practices and theories erupted that took theory and science within the financial realm to the next level. The problem was, they lost focus on what makes a sound investment as the fundamental aspect was lost in the hype: value investing.

At the center of portfolio theory sits the concept of diversification. Diversification is the process of investing small amounts in many risky assets rather than investing a large amount of capital in a few. However, it also lowers the rate of return that investors seek for investing in risky assets.

With portfolio investing as a tool for managing risk, professional asset managers compete aggressively for a few basis points of enhanced yield. A basis point is one one-hundredth of a percent–one penny per year on an investment of $100. Asset managers’ pursuits of basis points are responsible for:

* Growth of the small-cap public equity market
* Securitization of mortgage portfolios and a variety of debt instruments
* And growth of the international equity capital markets

In every case where portfolio investing has transformed a portion of the capital market, it has driven rates of return down. The same is true of the venture capital sector.

The Concept of Capital Commitments

A commitment is a promise by a limited partner to provide capital when called upon to do so by the fund’s general partner. Many think that venture capitalists have money in the bank account, ready to cut the check. This isn’t the case. They simply have the power to call up a large institution like Calpers requesting a million dollars. The reason it’s set up this way is partly due to safety and partly due to debt/leverage. The reason why venture capitalists don’t solicit us to invest in their fund is because it would simply take too long-additionally, the everyday investor wouldn’t be able to commit one lump sum of $150 million. Really, it’s about laziness. It’s easier to go to convince one huge pot of money, compared to many micro-pots of money. Still, you’re probably invested in a venture capital fund, without even knowing it. Your pension fund may be investing your money for you. You’re an indirect venture capitalist.

This structure did not become “the way” of structuring venture capital until 1979. Before then, SBIC’s (Small Business Investment Companies) dominated the field through subsidized loans to cash-generating small businesses.

In 1979, a change in U.S. federal law enabled institutional asset managers like pension funds and endowments to invest in illiquid assets, including VC funds. These entities that invest in VC funds are investors who easily can tolerate illiquidity. They can hold investments for several years waiting for an appropriate opportunity to sell. Such investors do not need much inducement to encourage them to invest in VC. This 1979 regulatory change is the same one that enabled fund managers to invest in small firms, securitized debt, and international equities.

With regard to illiquid assets, because of portfolio investing, even a slight differential in expected returns, compared to returns on liquid assets, is sufficient to attract capital. Portfolio investing, in fact, argues for some investment in VC even with no differential return or a slight negative. Nonetheless, returns to VC investing have been attractive.

The long-run average return (based on the last 20 years) for investing in VC has been 20.3%. If we were to weight the performance by total funds invested, the percentage return would be much larger. These returns are dramatically higher than returns investors seek for investing in liquid assets (stocks and bonds). Long run, the (postwar) average return on stocks (the S&P 500) is 14.7%. VC returns have been almost 1.5 times as high.

The Bottom Line:

Venture capital is undergoing a transformation. While this certainly is not unique, and is finally recognized, we will see new, innovative models arise. Stay tuned.

Would you like to test the cutting edge, new model for venture capital? A stealth venture is now accepting test users. You can sign up below:
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There are are two types of factors that determine your success as an entrepreneur: (i) external factors, and (ii) internal factors. Of course, you can improve on both. Internal factors are more immediate; with external factors, you must put yourself in a position to experience them.

Below is a visualization of the factors, as well as their frequency [1]:

Graduation is upon us, and the masses of clueless, freshly minted graduates are flooding the dead job market.  Many individuals hope to explore the realm of technology, entrepreneurship and… well… probably venture capital.

Over a year ago, I explored the realm of getting a job in venture capital. I was disappointed. All posts and articles declared either (i) you have to be a successful entrepreneur, or (ii) you have to get a Harvard MBA. I was neither. I was just profoundly interested in venture capital (who wouldn’t be).

I wasn’t satisfied with those two routes; I went out and landed a gig briefly before discovering that entrepreneurship was more fun–once becoming a successful entrepreneur, I can’t see myself going back into the realm of VC–angel investing, perhaps–but not venture capital. It’s too slow.

Still, there’s obviously going to be young individuals, like myself once, who desperately want to work in the field of venture capital. And for you, I’ve gathered up some of the best posts on getting a job in venture capital. Enjoy:

• Seth Levine
• Ask the VC
• This is Going to Be Big
• Mr Wave
• Venture Explorer
• Fred Wilson

The following excerpt is from a special series I’m running on “Ahead of The Curve,” which documents tales and experiences from a two-year journey at the Harvard Business School. Learn more here.

As venture capital has become institionalized, the people in it have become less venturesome. Those who visited campus were overwhelmingly male and either white or Asian. Some had worked at a real company before becoming capital providers, but that was no longer necessary. Most had degrees in sicence, engineering, or business. They liked to think of themselves as renegades and rule-breakers, and yet they struck me as a hardened monoculture. when one of them took up bicycling on the weekend, they all did. If one had pale blond wood in the conference room, they all did.

In the HBS classroom, the future VCs all affected a similar manner, speaking in a measured monotone, keeping their notes in a leather portfolio, wearing chinos, tucked in dress shirts, and baseball caps. The comments they made were never surprising, sticking close to the frameworks we were taught. Whereas the bankers were often argumentative and difficult, the VCs like to affect calm under pressure. They loved to poke holes in business plans by saying things like “I’d like to see more customer data” or “Iquestion the founder’s motivation.” They enjoyed sitting in judgement and looking terribly pleased with themselves, to the point where all you wanted to do was slap them to life and demand they do something.

For a long while, many have thought there to be a sexist bias in the realm of venture capital. Racist, too? What do you think? Any experiences?

I’ve built the following list of top venture capital blogs over the past year. Obviously, these are my opinions, and the actual rank gets hairy and more irrelevant after passing the first quartile. If you’re interested in the new venture arena, this is definitely a great starting point. Enjoy:

1. http://avc.com
   
2. http://pehub.com
   
3. http://venturebeat.com
   
4. http://techcrunch.com
   
5. http://altos.typepad.com/ (Probably the most underrated venture capital blog. Ever)
   
6. http://feld.com
   
7. http://creativecapital.wordpress.com
   
8. http://www.venturehacks.com
   
9. http://thefunded.com
   
10. http://blogs.wsj.com/venturecapital/
    
11. http://vator.tv
    
12. http://reiboldt.com
    
13. http://earlystagevc.typepad.com/earlystagevc/
14. http://dondodge.typepad.com/the_next_big_thing
    
15. http://paul.kedrosky.com
    
16. http://redeye.firstround.com
    
17. http://www.thisisgoingtobebig.com/
    
18. http://whohastimeforthis.blogspot.com/
    
19. http://www.unionsquareventures.com/
    
20. http://www.ocvcblog.com
    
21. http://www.venturewoods.org/
    
22. http://www.askthevc.com/blog
    
23. http://www.markpeterdavis.com/getventure/
    
24. http://dealarchitect.typepad.com/deal_architect/
    
25. http://bostonvcblog.typepad.com/vc/
    
26. http://www.vccafe.com
    
27. http://ventureblog.com/
    
28. http://lsvp.wordpress.com/
    
29. http://www.sethlevine.com/blog/
    
30. http://www.freddestin.com/blog/
    
31. http://www.vcconfidential.com
    
32. http://www.adventurista.com/
    
33. http://dontgosouth.wordpress.com/
    
34. http://www.unstructuredventures.com/uv/
    
35. http://www.mvmpartners.com/blog
    
36. http://babblingvc.typepad.com/pjozefak
    
37. http://www.allantyoung.com
    
38. http://due-diligence.typepad.com/blog/
    
39. http://jeffnolan.com/wp/
    
40. http://www.beyondvc.com/
    
41. http://blog.socaltech.com
    
42. http://www.thefrankpetersshow.com
    
43. http://www.xconomy.com/
    
44. http://www.purevc.com/pure_vc/
    
45. http://continuations.com/
    
46. http://wildrumpus.typepad.com/mediavc/
    
47. http://ricksegal.typepad.com/pmv/
    
48. http://southeastvc.blogs.com/southeast_vc/
    
49. http://www.alsop-louie.com/
    
50. http://www.lp2dot0.com/
    
51. http://www.christine.net/
    
52. http://vcmike.wordpress.com
    
53. http://baris.typepad.com/
    
54. http://vcinme.typepad.com/vc/
    
55. http://www.greentechmedia.com/cleantech-investing/
    
56. http://blog.irvingwb.com/blog/
    
57. http://www.pascalsview.com/
    
58. http://allensblog.typepad.com/
    
59. http://waytooearly.firstround.com/
    
60. http://cracking-the-code.blogspot.com/
    
61. http://www.kitevc.blogspot.com/
    
62. http://www.wasatchgirl.com/
    
63. http://www.vcball.com/
    
64. http://dealbook.blogs.nytimes.com
    
65. http://nothingventurednothinggained.blogspot.com/
    
66. http://ventureagain.blogspot.com/
    
67. http://www.floridaventureblog.com
    
68. http://www.unstructuredventures.com/uv
    
69. http://vcratings.thedealblogs.com
    
70. http://www.vcrants.com
    
71. http://vcinjerusalem.typepad.com/vcinjerusalem
    
72. http://commonangels.wordpress.com
73. http://azeemazhar.com/
74. http://www.altgate.com/blog
    
75. http://www.jasonmendelson.com/blog
    

Did I miss any obvious or up-and-coming ones?

Or perhaps there’s an unfair rank? (don’t lose sleep)

Let me know below!

Update 1 (August 2009):

Here are two new, up-and-coming venture capital blogs (found out through the comments):

1. http://bothsidesofthetable.com/ – This one seems promising. The author, Mark Suster, is a 2x entrepreneur who grinded it out and had some success before joining the VC ranks.
2. http://seeingeyetoeye.wordpress.com/ – Also keep an eye out for this one. Mark Suster mentioned this one (see below). The first post I read, “Markets vs. Teams” is damn good. Make sure and check it out.
3. http://abejma.blogspot.com/ — A unique one delivered by John Abraham. In his own words he’s, “A very successful longtime computer scientist and venture capitalist, educator at world-class institutions and such, I have many interests including what is going on now, technology, magic and such.” Check it out.
4. http://www.shareholderrep.com/blog — “It’s about the issues involved in mergers between acquirers and VC-backed companies.”
5. http://www.ansanelli.com/blog/

Update 2: October 31, 2009

1. http://www.cdixon.org/

There are seven main steps you must undergo if you want to form a venture capital fund:

1. Create an LLC entity that will manage the fund (Example: Kleiner Perkins, LLC)
2. Create a Limited Partnership for the fund (Example: Kleiner Seed Fund I, L.P.)
3. Create a Private Placement Memorandum: Have either yourself, or an attorney, draft a private placement memorandum. With attorneys, these can be priced well over $3,000. Some attorneys even charge $20,000. However, you can also have one done for yourself, using this template for much less: here
4. Have your potential investors complete The Investor Questionnaire
5. Have your potential investors read and sign the subscription agreement
6. Have your potential investors sign a Letter of Intent
7. Have your potential investors return the letter of intent and subscription agreement (The close)

You must also have a compelling presentation, which I recommend using the philosophy from the guys of venture hacks here (obviously, tailor it to limited partners/vc fund-raising), and a set of vetting protocol in place. Finally, and most important, you must have a unique and compelling story that makes others want to invest in you.

When I come across a great blog post, I attempt delay any thoughts on it immediately. Instead, I print the article out, read classic investment books, observe the market, reflect on it, and then I post my thoughts.

So I’ve had the chance to apply this methodology with Fred Wilson’s post recently regarding venture capital as an asset class.

He notes that one of his limited partners has declared the asset class to generate a return around 9%

Why would anyone want to invest in such a risky asset class with such an underwhelming rate of return?

Upon reflection, this really isn’t anything to be surprised about. Many people view the holding period of venture capital investments as 10 years. In reality it’s much shorter than that. I’d say 4-7 years. On average, 5 years. Why? Investments are made over time, not instantly.

Regression to the mean:

Regression to the mean is the historical occurrence of the market overreacting to short-term news and then under-reacting while awaiting new short term news. This pretty much sums up the dot-com era and what we’re in right now.

A while back, Morningstar published a report on the performance of different types of funds over a five year period:

5 years to March 1989

• International stocks: 20.6%
• Income: 14.3%
• Growth and income: 14.2%
• Growth: 13.3%
• Small company: 10.3%
• Aggressive growth: 8.9%
• Average 13.9%

5 years to March 1994

• International stocks: 9.4%
• Income: 11.2%
• Growth and income: 11.9%
• Growth: 13.9%
• Small company: 15.9%
• Aggressive growth: 16.1%
• Average: 13.1%

This is a perfect example: as you can see, the three groups that dominated in the first segment did worse than average in the second.

I believe we’re experiencing the same occurrence in the venture sector.

So what does this mean?

Bottom line: as a long-term asset class, venture capital is nothing special, really. On average it performs much like any other asset class; however, it has much more risk flowing through its veins. Perhaps, way back in 1953, Georges Doriot, the founder of venture capital, was correct when he declared, “venture capital is not fashionable anymore.”

If you’ve been in the valley lately, you can hear the grumbling. The good ‘ol boys are wondering whether or not Obama will change sacred characteristics of the venture capital model–like *gasp* requiring funds to be transparent.

Obama’s budget plan already signals changes in tax policy. And new fears were raised by Treasury Secretary Timothy Geithner’s statement Thursday that advisers to venture capital funds, private equity firms and hedge funds should for the first time be required to register with the Securities and Exchange Commission and file reports to enable the government to assess whether the funds “individually or collectively pose a threat to financial stability.” Venture capitalists are apprehensive about changes to their model.

“You mean a model where, in the last twenty years, 11 of the funds generated 70% of the returns is flawed?”

Obviously…

One particular fear of the VC community was captured in a blog posting by Benchmark Capital partner Bill Gurley, in the form of an open letter to Geithner: “Depending on the regulation, this could require VCs to disclose specific metrics about the private companies in which they have invested, robbing these companies of one of the key benefits of being private,” he wrote.

Essentially, he’s saying that Facebook, a private-company with half a billion in investor capital, would be obligated to disclose that they’ve been losing money.

How absurd. I hope this never happens [/sarcasm off].