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More on LLCs

March 29, 2009

Two days ago, I lamented about how much of a pain LLCs can be for investors. The comments were lively.

Many people pointed out the “double taxation” issue involved with C corporations. C Corporations pay taxes and then when money is removed from the corporation to the investors or founders, another round of taxes is imposed. On the surface, this is a good argument for an LLC but it turns out to not have much of an impact in reality much of the time.

The other issue that people pointed out is that valuable losses can be passed through to the personal taxes of the investors and founders with an LLC. While this is also true under ideal circumstances, it turns out to not be true at all in most common cases.

Victor Fleischer reached out to me by email with a thorough research paper called “The Rational Exuberance of Structuring Venture Capital Startups” he had written on this very topic in 2003. I found it to be very educational and I think you will too. It’s absolutely worth a full read (10 minutes or so) - and it’s not as long as it looks because there are many detailed footnotes and supporting references.

Here’s the gist of his paper as I read it. Many observers of the venture capital industry believe that VCs ignore LLCs primarily because C corporations are the devil they know, and secondarily because they’re focused on gains only and are not typically major participants in losses (since they are investing other peoples money and not their own, primarily). This paper goes a long way towards showing why professional investors prefer C corporations and includes many potential surprises such as:

  • Tax losses are often not as valuable as they seem on paper as tax rules prohibit many investors (and entrepreneurs) from capturing the full benefit of the losses.
  • Corporations are less complex than partnerships. “Friction” costs associated with LLCs may make legal costs substantially higher over time for LLCs.
  • Gains are taxed more favorably when companies are organized as C corporations from the beginning (vs converting late, if that is even legally possible).
  • Employee compensation issues are much more complex with an LLC than a corporation. This can cost more and can devalue “options” equivalents coming from LLCs.

In short, at least in my mind, much of the argument for LLCs as being more tax efficient ends up being an illusion and only true “on paper.”

I hope that this starts another big argument. Blogging is for learning, and your comments and participation are really helping me learn. I thank you for that.

Keep in mind the paper is a little old and some tax laws may have changed in the interim. As always, consult your attorney and accountant as I’m no tax lawyer.

Incidentally, Victor is returning to CU as an Associate Professor at the law school this June! I’m glad to welcome him back to Boulder after he spent the last few years at the University of Illinois College of Law. I’m excited that he’ll be an asset to the local entrepreneurial community once again.

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Look beyond the valuation

February 7, 2009

I received this question today via email:

… I am a young entrepreneur… I am currently involved in a… start up… We are currently in the process of raising a friends and family round of funding, and right now we are struggling with the valuation. I am looking at the TechStars framework (a $300,000 post-money, if my math is right) because it appears outwardly that we are at a similar stage of business development compared to the TechStars companies. However, I would like to confirm with you what stage a typical company is when they apply for TechStars? We currently have a BETA test version of our website up with 1700 members, and we pull about 2000 uniques per month. I am wondering if we are on par with a 300K post-money?

I’ll come at this answer two different ways. First, I’ll address the flawed thinking inherent in simply comparing your company to another known data point based solely upon valuation. Second, I’ll address the question of how to think about and possibly determine a fair valuation, especially in the peculiar context of a friends and family round.

TechStars is providing much more than just money. It’s providing access to extensive mentorship, a very large network, a community of startups, office space, legal work and other free services, a platform for credibility, and access and opportunity with literally hundreds of investors. It’s unlikely that friends and family will bring the same resources to bear. It’s more likely that they’re simply bringing money. Clearly, it’s not going to be an apples to apples comparison. So in order to compare a TechStars valuation to a friends and family valuation, you first need to somehow determine the value of all of the things that TechStars brings to the table. Unfortunately, this is not easy to do. The value is in the eye of the beholder. But clearly, a simple comparison is flawed thinking.

More broadly, the lesson here is that you can’t simply compare valuations in any context. Valuations tell only a small part of the story. “When” matters: Consider the average startup valuation a year ago vs. today. “Who” matters: Consider Bill Gates doing his next startup that is exactly like yours, vs you doing it. Or consider who the investors are. Investors who bring more to the table might well deserve a lower valuation. Even “Where” matters: The same startup in Silicon Valley is probably going to draw a higher valuation than if it were located in rural Iowa.

Now that I’ve cleared that up (I hope) and all the readers from Iowa are gone, let’s address the part of the question pertaining to coming up with a valuation for friends and family. This is really tricky, because in my experience it’s very easy to drive an extremely high valuation in these scenarios. Usually, friends and family are investing in you, and will not pay so much attention to the valuation. They’ll often trust your judgment above theirs (which is part of what makes them “non-professional investors”). Depending on all of the factors I’ve described above, typical web company startup valuations run somewhere in the $1M-$3M range, pre-money. From what little context I have from the email, I’m guessing the startup in question would be valued on the low end of that range, assuming investors wanted to do the deal in the first place. With professional investors (angels and venture capitalists) this simply turns into a negotiation. There is no magic formula - it’s simply a number that both parties can agree to. But with friends and family, given the dynamic, I generally recommend a completely different approach.

With friends and family investors, the right approach for companies that think they may want to raise more money in the future is almost always going to be to use convertible debt. Instead of issuing equity, you can simply document it as a loan to be repaid with interest potentially with a right to have their money “converted” at the next value event (funding or acquisition) based on the valuation that is assigned at that point. Often, a small discount (10-25%) will be offered so that early investor gets additional equity at that point as compared to those bringing in the new money. The benefit here is that the valuation at this next value event will typically be assigned (and negotiated) by an acquirer or by professional investors. It avoids the whole messy discussion of valuation with friends and family, and feels “fair.” The other benefit is that it’s likely that venture investors are going to want to buy out any friends and family investors when they do a large financing. Using a debt instrument makes this an easy step, while still rewarding your early friends and family investors.

Now, you may be wondering if this advice is in conflict with other advice you might have heard about “misalignment of interests”. After all, if you raise a debt round, isn’t it going to be in your investors best interests to keep your next valuation as low as possible, so that they get the maximum effect from conversion? The answer is yes, which is why I generally recommend and use preferred equity in most of the deals that I participate in. However, I’d submit to you that in the case of friends and family, they’re unlikely to take that point of view for the same reasons that they’re unlikely to push valuation as an issue in the first place. Finally, another benefit is that it’s less expensive to create legal documentation for a debt financing than for an equity financing.

In summary, I generally recommend using a debt instrument for a friends and family round. I also think that it’s critically important to look at much more than the valuation in order to truly understand any equity financing.

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Venture Capital in the Rockies presenting companies announced

February 3, 2009

I was on the selection committee for this years Venture Capital in the Rockies conference. We had some really interesting companies to choose from this year, and it took a few more conference calls than normal to get down to the final group this year. Here’s the list of companies that will present.

Hope to see you there!

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VCIR deadline approaching

December 9, 2008

The deadline to submit an application for your company to present at Venture Capital in the Rockies in early March is December 20th. Here’s my previous post on what they’re looking for. All that’s required to submit is a 4 page (or less) executive summary. Both seed stage companies (<$1M) and those seeking later stage venture capital (>$1M) are encouraged to submit.

Venture Capital in the Rockies has a demonstrated track record of introducing presenting companies to qualified capital sources.

  • VCIR presenting companies have raised over $4 billion in the last 10 years
  • Over 150 venture capitalists attended last year including nearly 50 from venture firms on the the west or east coasts

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And it holds for angel investing too

November 13, 2008

Fred Wilson’s post amplifying Jeff Nolan’s post about the “broken” VC model says about venture capital investing what I was trying to say about angel investing at Ignite Boulder. Both made the point far more eloquently than I did, even though I was given five minutes. My point at Ignite was that most (the vast majority) of angel investors will never make any money by doing it. It’s hard (and takes alot of work) to be in that group of 10-20% of angel investors who do make money.

I’m in Toronto today speaking at Canada’s startup conference, Startup Empire. My presentation is called “Boulder, TechStars, and Why Venture Capital doesn’t have to matter.”   In general, I think that entrepreneurs put far too much weight on the availability of venture capital. Worse, they put too much mental energy into it.  I’ve been pitched many ideas over the last 3 or 4 years that always start with “get venture capital”. These business plans fundamentally depend upon venture capital (even prior to collecting underpants), causing many of them to never even get off the ground. The availability of venture capital cannot be your barometer.

My presentation in Toronto today argues that (based on raw data) it’s mathmatically 100 times harder to raise venture capital in Toronto than it is in tiny little Boulder, Colorado.  But my point is that whether your chances are 0.5% or 0.005%, does it really matter? Are you really going to focus your efforts there unless you have some of the things that improve your chances dramatically, such as a track record or a truly-world changing technology?

If you’re a first time entrepreneur with no big wins under your belt and no special relationships, it’s time to stop deluding yourself. Focus on your product and your customers, not venture capital.

Don’t let the down economy stop you from starting a business right now. That’s an excuse, and entreprenurship is about breaking through excuses. Sure, it’s hard to raise money from VCs (it always has been) and it’s also hard to raise money from angels (and it always has been) and it’s hard to build a business from the ground up (and it always has been).  It always will be, but you can do it.

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Angel Capital Summit is around the corner

November 8, 2008

The Angel Capital Summit is coming up in a few weeks. Here are some details from the organizers.

Angel Capital Summit
Hosted by Rockies Venture Club
Presented by EKS&H

Friday, November 21; 7:30am - 5:30 pm
Denver Marriott City Center, 1701 California St., downtown Denver

Opening Keynote Speaker
Denver Mayor John Hickenlooper

Lunch Keynote Speaker
Anita Burke

Town Hall Meeting
Angel Investing On The Edge
Colorado’s entrepreneurial response to the credit crisis, election, energy and sustainability.

40 Presentations for Colorado’s top entrepreneurial companies in 4 tracks throughout the day!

These are times of profound change in our economy, and entrepreneurship is the single sector in the business ecology poised to capture the opportunities that are being stirred up by these changes. You’ll also learn that you don’t have to do this alone.

Now, more than ever, our society needs a healthy entrepreneurial sector. Now, more than ever, you should attend the Angel Capital Summit, to work with the rest of us to make this a reality.

For information and registration, go to www.angelcapitalsummit.org.

As an incentive for your guests, we offering attendance at the Summit at Rockies Venture Club member rates. Please instruct guests to choose the standard “Guest Ticket - $159” on page 1 of the registration form. On page 2 of the registration form, have them enter the code “ACSIAP08″ in the Discount Code Field at the top of Page 2, then click the “Recalculate” button which will adjust their discounted price and ticket. Attendees registering for the Town Hall Meeting only will need to pay the $25 registration fee and should not enter the code.

The companies who are presenting are:

18 Principles, Inc,  3D at Depth, Affinity Telecom, Inc, Alaskan Hardgear, Allegro Multimedia dba Music Wizard Group, ApopLogic Pharmaceuticals, Inc., AppVenture, Atrato, Inc., Aubice LLC, AWhere Inc., BOCS, Cadeka Microcircuits, Center For Innovation, Metropolitan State College of Denver, Chata Biosystems, Inc., CTM Software Corporation, Del Norte Brewing, DEMAND1, FacetoFace Health, flaik Inc, Fluonic, Inc., Frontline Aerospace, Inc., GroGreen Inc, iVation LLC, JuJu Central, LLC, Lingoport, Inc., Magic Portrait, Munch Away, LLC., NanoPrint Technologies, Progressive Health Center, PROJECT C.U.R.E., Shrewd Foods, Inc., Spatial Networking, Tissue Genetics Inc., Toghers Inc., TruEffect, Inc., Two Moms in the Raw, VanDyne SuperTurbo, Inc, VarVee, LLC, VitruMed Inc., Web2Storage, WhiteDove Herbals, Inc., Xpressplay, LLC, and Zerista.

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Do you know a company that should present at VCIR Winter 09?

November 2, 2008

If you know a company that should present at Venture Capital In The Rockies Winter 2009, please let me know. We are soliciting executive summaries for the “Venture Capital in the Rockies Winter 2009 Conference” in Beaver Creek on March 3-5, 2009. If you know of promising companies in the Rocky Mountain region that intend to raise capital in the next 12 months, encourage them directly to submit their executive summaries to submissions@vcintherockies.com. The deadline for submissions is December 31st, however, the selection process and early admissions will begin in early November so it is in a company’s best interest to apply early.

Prospects for VCIR Winter 2009 should fit the following criteria:

  • A promising business that you think would be interesting to venture capital investors.
  • Expects to raise capital in 2009 and headquartered in the Rocky Mountain region: Colorado, Utah, Arizona, New Mexico, Montana, Wyoming and Idaho.
  • We are looking for companies in a range of fields including information technology, Web 2.0, clean technology, consumer media and electronics and consumer products. We will not be having a life sciences track at VCIR Winter 2009.
  • All stages will be considered—from seed level start-ups to established companies looking for growth/mezzanine capital.

The details on VCIR Winter 2009:

  • Location – The Park Hyatt at Beaver Creek
  • Dates – March 3 – 5, 2009. Cocktail reception on evening of 3rd, company presentations on 4th, and ski day on 5th.
  • Audience – Venture capital firms from the Rocky Mountain region and around the United States. Last year we had over 100 venture capitalists in attendance including 40+ from the west coast and east coast.

Here’s my coverage of last years VCIR.

If you or a representative from a promising company has any questions, please contact me.

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MIT Entrepreneur Showcase

October 23, 2008

Each year MIT has a Venture Capital Conference. This year it’s on December 6th. As part of the conference this year, 30 early stage startup companies will be selected to showcase their business to Boston’s leading venture capital investors and the MIT entrepreneurial community.

The Entrepreneur Showcase will take place from 4 - 7 pm on Saturday, December 6 , immediately following the MIT VC Conference, at the Charles Hotel in Cambridge, MA. Company applications are due November 7. More information and an application form are here.

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Colorado Angel Capital Summit is November 21st

September 19, 2008

The Colorado Angel Capital Summit is looking for interesting companies to present at this second annual event. Some good coverage from last years event can be found on Dave Taylor’s blog. I was out of the country for last years event but I plan to attend this year.

Here’s some text from the organizers:

The Summit will feature the smartest investors and the most innovative entrepreneurs in the Rocky Mountain Region, with an anticipated audience of over 500 entrepreneurs, private investors and service professionals.

To apply to present, go to angelcapitalsummit.org.  There, you will find step-by-step instructions.  The deadline to apply is Friday, October 10. There is no fee to apply.  However, once selected to present, companies will be required to submit a registration form and a $300/$350 fee (members/non-members). There will be a mandatory “pitch practice” one week before the event.

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Interview with Mark Solon on VCIR Fall

August 26, 2008

The following is an interview with Mark Solon of Highway 12 Ventures regarding VCIR Fall, which takes place Sept 9-11 in Sun Valley, Idaho.

Q. Mark, for those who don’t know you, can you introduce yourself?

I’m the founder and managing partner of Highway 12 Ventures in Boise. We’re an early-stage venture firm focused on investing in high-growth companies in the fasting growing region in the country, the mountain west. I also used to have a pretty decent curveball until ‘cuff surgery a few years ago. All I’ve got left now is a decent wrist shot in our local ice hockey beer league…

Q. What’s your relationship with VCIR?

I’ve been attending VCIR since we started Highway 12 in 2001. From my perspective, VCIR in Beaver Creek each February is the premier event in the region each year. If you’re involved in any start-up activity in this region, it’s the “must attend” event of the year.

Q. VCIR is always a great annual event. Why was a Fall event set up for the first time this year?

After attending and participating in too many small regional venture events from 2000-2006 without the needed critical mass for success, I knew the region needed a flagship event; you know, a rising tide and all that. In 2006, I approached some of my colleagues who were members of the board of the Colorado Venture Capital Association to talk to them about the idea of expanding their footprint to become a regional association and to my pleasant surprise, they had already begun discussions about the idea. After the CVCA expanded to become the Rocky Mountain Venture Capital Association (RMVCA) in ‘06, I was asked to join that board and pleaded my case to expand VCIR to twice a year. I suggested keeping Venture in the Rockies in Beaver Creek each year given the national prestige that event had attained, but proposed adding a second VCIR event which would rotate around the rest of the region, highlighting all the other great startups in those states. For instance, each year in Idaho, we have a small handful of companies that are “venture-ready.” The problem is, we just don’t have enough of them to support a meaningful annual event on our own which would draw venture investors from outside the region. Other States like Montana, Utah and New Mexico were faced with the same challenge. Anyway, the board embraced the idea. Of course, it was like waking a sleeping baby; “you wake it, you take it.” Hence, I’m chairing the first VCIR Fall and we’re doing it in my home state of Idaho.

Q. How will the fall event be different?

We thought it was important to differentiate the two events somewhat. Venture Capital in the Rockies has always had 20-25 companies presenting with multiple tracks. Knowing that it’s going to take some time for VCIR Fall to attain the same notoriety as Venture in the Rockies, we wanted to create a more intimate feel with no tracks and everyone in the same room. Also, we’ve reduced the number of companies presenting and increased the content. We’ve got a handful a world renowned speakers. For instance, Bob Maynard – chief investment officer of PERSI will be talking about the private equity markets. Bob manages Idaho’s $11B pension and was recently named public pension manager of the year. Our keynote speaker is Wade Davis, a cultural anthropologist and explorer-in-residence at national geographic who will teach us about the effects of technology proliferation on vanishing cultures. When I saw him earlier this year, his presentation left the audience awestruck. Lastly, we’ve got senior managers from HP, Google, Yahoo and Amazon who will be speaking individually and on a panel together. However, the biggest difference will probably be the wardrobes. The overwhelming majority of folks registered have signed up for various activities the day after the conference. We expect to see more golf, mountain biking and fly-fishing outfits at the fall conference. Honestly, there may not be a more beautiful place in the world than Sun Valley, Idaho in September.

Q. Will there be two events annually going forward or is this an experiment?

The RMVCA is committed to putting on two events a year. The plan is to keep the hugely successful winter event in Beaver Creek each February and rotate the fall event throughout the region. We’ve already selected Park City, Utah for VCIR Fall ‘09 and we’re looking at places like Big Sky-Montana, Jackson Hole-Wyoming and Taos – New Mexico for future events. Lets face it, folks that have succeeded in places like Silicon Valley and Boston are flocking to this region because it’s no longer just the greatest place to live in the world, now it’s becoming the greatest place to start a company. The RMVCA firmly believes that we’re at the beginning of a wave of innovation in the region that’s going to create tremendous value for investors over the next few decades.

Q. Can you explain the transformation that VCIR has gone through from a Colorado-focused event to more of a regionally focused event?

We believe that VCIR Fall is going to showcase the rest of the region much like Venture in the Rockies did for Colorado. It’s evident to me that just expanding the CVCA to the RMVCA is already fostering a more collaborative working relationship among the regional VC’s. I know that VCIR Fall will do the same for mountain west by bringing entrepreneurs, service providers and investors together from throughout region.

Q. How is participation from out of state VCs looking?

We’re thrilled with the number of investors who have registered from outside the rockies. We’ve got VC’s registered from Boston, Silicon Valley, New York, Texas, the mid-atlantic states, Seattle, and more.

Q. What are you most looking forward to at VCIR Fall?

Personally, I love that VCIR gets us all out from behind our screens for a few days and talking about our businesses and our lives in a cool and interesting setting. The technology business seems to have less face-to-face interaction every year and I always see more business actually getting done in the weeks following an event like this. The energy from VCIR always recharges my batteries and reminds me how lucky we are to do what we do and be doing it in the mountain west.

Learn more and register to attend VCIR Fall from Sept 9-11 in Sun Valley, Idaho here. Thanks Mark!

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