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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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Financial Literacy

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I’m stunned by the lack of financial literacy of so many people in so many contexts. The commentary by politicians, economists, and the media on the European debt crisis and the US debt ceiling dynamics is appalling. The general media and blogosphere commentary on the financials of high growth companies, especially those who have either recently gone public or filed their S-1′s, range from perplexing to just plain incorrect. And more and more entrepreneurs who I’m exposed to who are presenting their companies for financing have a complete lack of understanding of their financials – both current and projected. Of course, some of my fellow board members don’t understand how to read financial statements either, which doesn’t help matters much.

Fred Wilson took on some of this with his awesome MBA Mondays series, including several great posts around financial statements that every entrepreneur should go read right now:

In my experience there are four specific things that people struggle with.

  1. An inability to read the Balance Sheet, P&L, and Cash Flow statements.
  2. A lack of understanding of how the Balance Sheet, P&L, and Cash Flow statements fit together.
  3. A lack of understanding how non-accounting metrics (e.g. bookings) impact the financial statements.
  4. A lack of understanding of GAAP (Generally Accepted Accounting Principles) and how to use the financial statements to help normalize out all the weird things GAAP makes you do.

I used to think it was all a GAAP problem. GAAP is complicated, continuously evolving and changing, and often creates more ambiguity that it resolves. But unless you actually understand how to read a financial statement, GAAP doesn’t even come into play. And by financial statement, I don’t just mean the income statement (or P&L) – I mean the income statement, balance sheet, and cash flow statement, along with understanding how they interact with each other.

If you understand how to read the financial statements, then you can start to solve for the GAAP challenges. You’ll be able to understand things like the implications of deferred revenue on cash flow, stock option expense on net income, and the actual equity dynamics of the balance sheet.

While there are so many things about this that I fantasize about (e.g. “the media would actually learn this stuff” and “accountants would make GAAP simpler and clearer vs. more complex”) the only thing that really matters in my world is that entrepreneurs understand how to think about this stuff. So, in the spirit of Fred’s MBA Mondays series, I’m going to write a series of posts that describe how my brain processes the financial statements of a typical high growth company with a goal of adding on to the great base that Fred has created.

I’m open for suggestions as to whether I should take on one that is newly public (e.g. the S-1 and historical financials are available), or a private company (I’m open to volunteers, although it’ll mean you are publishing your financials – at least at this moment in time.) If you’ve got suggestions or want to volunteer, just leave a comment.

Failing Fast at Standardized Seed Deal Documents

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While some people hate the phrase “failing fast”, I find it instructive when it’s used to signify that one isn’t going to pursue a particular path in the context of a larger set of activities.  A few weeks ago, I wrote a post about The Proliferation of Standardized Seed Financing Documents. It generated several hundred email responses and a handful of phone calls.  A week or so later, my partner Jason Mendelson wrote a post titled Why There Will Never be a Standard Set of Seed Documents. I’ve concluded that Jason is right so rather than torture myself, I’m failing fast with regard to trying to help create a set of standardized seed documents.

Since I received so many private responses to the original post, I thought I’d summarize them here by type of respondent.

Lawyers: By far the largest numbers of responses were from lawyers offering to help (thanks!)  I didn’t count them up, but I got well over 100 emails from all over the US.  In many cases, the lawyer offered to come to the meeting, share their seed documentation, and work to make sure that seed documents were complete and acceptable to their firm.  The vast majority of lawyers provided solid background on all the seed investment work they had done.  Several weighed in with their views of the potential issues, often sighting the NVCA standard document process which everyone seemed to refer to as some version of “a mess.”  A few made sure to remind me that east coast lawyers needed to be involved or the docs wouldn’t work on the east coast.  A few brave ones told me why I was destined to fail but wished me luck anyway.  Fortunately, due to the magic of Gist, I now have contact information for a whole bunch of lawyers I didn’t know before.

Entrepreneurs: The next largest number of respondents were entrepreneurs.  I think all of them cheered me on, told me how much they hated paying lawyers for their seed documents, and asked if there was some way to reduce everything to a few standard pages, not unlike a mortgage document.  A few told me “don’t include lawyer X in the process – he charged me $70,000 for my seed deal” and a few suggested that lawyers should have to use paper and crayons instead of word processors.  Several asked if I’d be interested in funding their companies.  All demonstrated a sense of humor about the situation.

VCs: The VC comments came in a few different flavors.  A few said “I don’t see the problem – it’s fine having multiple seed documents.”  Another reminded me that “great is the enemy of good” (although the real, and more relevant quote is “The perfect is the enemy of the good”) and the existing forms floating around are “very good – much better than they used to be.”  Another suggested that none of the standard docs worked for him, but he was perfectly happy to sign the forms from Law Firm Z without any modification.  Several asked me whether I was still watching 24 (yes, I will watch it to the bitter end.)  I received private emails from each of my partners containing a slightly different version of “are you out of your fucking mind?”

LPs: I only had one email from an LP.  It was a short one.  “Don’t waste your time on this.”

After pondering all of this, I realized that I was both trying to solve a problem that didn’t really want to be solved while at the same time falling into a common trap of working on something that, while on the surface seems like a good idea, isn’t really my issue to solve, at least not in this way.  As many of you know, the issue is not only the term sheet, but also the underlying documents supporting the deal.  I think this is a nuance that is often missed, as the seed docs need to be robust enough to easily support a next round financing (Series A or Series B) since the seed financing is rarely the last one.  So, while a simple term sheet might be able to be agreed on, I realized that getting the actual docs agreed on would be a miserable, and likely impossible, thing to try to deal with.

Hence my failing fast.  While in theory this might be a great idea, I’ve concluded that I can’t be successful at this.  There are plenty of people – namely all the lawyers that work with startups – that have a much greater incentive than I do to get this right, be efficient for the entrepreneurs they work with, and be cost-effective for the companies they bill.  So, I’m going to leave it to them.

The Proliferation of Standardized Seed Financing Documents

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As of today’s announcement that Ted Wang at Fenwick & West has collaborated with a group of bay area early stage VC’s and angel investors to create the Series Seed Documents we now have – at my count – four different standardized seed financing documents floating around the industry.

Many smart and capable people have either worked on these various docs on signed on as supporters.  However, until there is one standardized set of documents that everyone – especially the various law firms agree on – I don’t expect there to really be a standardized set of seed financing documents.  I wrote about this in my post The Challenge of The Ideal First Round Term Sheet.

Rather than whine about it, after reading the PEHub article Marc Andreessen on “Series Seed Documents,” and Why VCs Should Start Using Them I’ve decided to try to get a handful of lawyers in a room and try to come out with one set of documents.  This might be a futile effort, which will prove the point that it’s impossible to create one standard set of documents.  But – I’m an optimist, so I’m going to plan for a good outcome.

I’ll proactively reaching out to the appropriate folks at Cooley, WSGR, and Fenwick & West to organize a one day session, with laptops, somewhere in the bay area.  I’ll include a handful of early stage investors (both VCs and angels) in this effort.  My goal will be to finish the day with a truly standardized set of seed documents that all of the firms agree to use.  Then we’ll open source these and evangelize them across the startup world, at least in the US.

If you are an attorney at a major national or regional law firm that works with startup companies, please email me if you are interested in participating.  If you are a VC or angel investor that supports this effort – same drill (email me).  Let’s end this madness (which I’ve been dealing with for 16 years and an angel and VC investor) once and for all – the entrepreneurs who we work with deserve better from us.

Have You Used Our Term Sheet Series In A Course?

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Over the years my partner Jason Mendelson and I have heard from numerous people that they’ve been exposed to our Venture Capital Term Sheet Series as reference material in a college course.  We are delighted by this and whenever we’ve been asked, we’ve always said (and will continue to always say) “with our blessing.”  However, we haven’t kept track of any of this over the year and have a few ideas for things we can do to update the material now that five years have passed.

So – I’m writing with a simple request.  If you’ve used, or encountered, our Term Sheet series in a college (undergraduate or graduate) course or any other teaching / seminar environment, can you leave a comment below with the information (school / program / year / professor) or email me the information?

For those of you concerned about nefarious plots on our part, I assure you that we are delighted this material is out there in the public and are happy to have it freely used and passed around for all eternity.  I promise we won’t send Jack Bauer your way.

Beware the Hockey Stick in Your Budget

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We are deep in budget season as the last board meeting of the year typically includes the 2010 Budget – or at least the “2010 Draft Budget” or “2010 Budget – Draft”.  This is also known as “the joy of cramming a spreadsheet into a powerpoint presentation.”

The budgets I see generally fit into one of the following five categories.

  1. Pre-Revenue: We are pre-revenue and won’t generate revenue in 2010.
  2. First Year of Revenue: We are pre-revenue but will generate our first revenue in 2010.
  3. Growing Revenue: We are on a revenue growth curve in 2010 but will lose money every month.
  4. Becoming Profitable: We are currently losing money but will become profitable in 2010.
  5. Profitable: We are profitable every month this year.

While I’ve written about this before, it’s worth noting that “profitable” is often used to mean either EBITDA positive, Net Income positive, or Cash Flow positive.  These are three totally different things and you aren’t really in a happy profitable place until all three are true.

Of the five types of budget categories above, three (#2, #3, and #4) typically have the “hockey stick problems.”  Specifically, the revenue curve in the budget model looks like a hockey stick throughout the year with steep revenue growth in Q3 and Q4.

The hockey stick revenue helps justify additional head count and an overall ramp in expenses.  If the revenue plan is correct, this is fine.  But the revenue plan is rarely correct, especially in Q3 and Q4.  As a result, the expense base in the budget is much too high.  One of two things happen – the budget breaks (and gets ignored) or the company continues to operate on the expense budget (or some approximation of it), resulting in a much bigger loss and cash spend than forecasted at the beginning of the year.

There’s another issue – hiring is often front end loaded and the timing is somewhat unpredictable.  It’s also hard to “unhire” a month after you’ve hired someone because you are below budget.  While some people talk about people as a “variable cost”, it’s a tough variable cost to immediately turn to zero shortly after you’ve hired someone.

Each case is a little different, so let me spend some time on how I think about each one.

First Year of Revenue (#2): The problem in this case is that the company will burn through its capital faster than expected.  You can solve for this by forcing the expense budget to look like a pre-revenue budget (e.g. assume no revenue).  When revenue starts to ramp, then you rebudget, even if it’s mid-year.  Basically, discount all revenue to zero until you start generating it.

Growing Revenue (#3): This is the trickiest of the three cases.  You have revenue.  You want to spend more money to grow revenue (this is rational).  You expect revenue will grow nicely (maybe, maybe not).  In this case, I suggest you build the budget and then shift your expense plan forward by one quarter.  This delays the spending ramp by 90 days which enables you to see if you are ramping revenue as expected. I’ve rarely seen this slow down the revenue growth and, when it’s clear that revenue is ramping ahead of plan, you can always layer in some expenses explicitly ahead of plan.

Become Profitable (#4): Similar to #3, you start by lagging your expense ramp by a quarter.  Equally important, you should manage to a net cash number (cash + borrowing capacity – debt) and make sure you never fall below a threshold that is set as part of the budget process.  Once you start generating positive cash flow, you can rebudget, just like case #2.

I find that Pre-Revenue and Profitable companies typically don’t have the hockey stick problem in the budgets.  Pre-Revenue don’t by definition since they have no revenue!  Profitable companies have usually been through the cycle so many times that (a) they understand how to be realistic about revenue growth and (b) they are so happy to be profitable and self-sufficient that they err on the side of under-budgeting revenue and then expanding their expense base as they exceed plan.

Be smart – avoid the hockey stick.  Even when you are playing hockey!  It hurts when it hits you in unexpected places.

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