Rick Segal has today's great post up titled From the Trenches: OS Who?  In addition to being enlightening, it's hilarious.  He's also got some hints about where OS/2 is heading. 

Fred Wilson has another excellent post up titled Venture Fund Economics: When One Deal Returns The Fund.  He continues his expose on how VC funds work and builds his thoughts in this post around the statement:

"Every really good venture fund I have been involved in or have witnessed has had one or more investments that paid off so large that one deal single handedly returned the entire fund."

I've been a partner in several venture funds and am or have have been an investor (LP) in around 25 VC funds since 1995.  I reach the same conclusion as Fred on slightly different data - every successful venture fund that I've been a part of in any way has had at least one deal that effectively returned the fund (I'm changing the assertion a little as I'm including the funds where there were several deals that each returned at least 75% of the fund.)

In 100% of the cases where there wasn't at least a deal that returned 75% of the fund, the fund was a loser.  I can't think of case that I've been involved in or seen the data from a situation where this hasn't been true (I'm sure this is at least one case, but my assertion would be that it's an outlier.) 

Fred explains it well, but the meta-message is that you have to have at least one home run in a venture fund (where home run is defined as returning at least 75% of the fund) to have a successful fund.  For tech VC funds, this is relatively easy to get your mind around for funds under about $300m.  Once you start getting into higher numbers (say - $1 billion funds), you quickly realize that to return $750m on one deal, you have to own 20% of a company with a value over $4 billion at the time you exit.  That doesn't happen very often.

Fred's conclusion is also right on the money as it's not about just stepping up to the plate and swinging for the fence.

Some will read this and suggest that our business is all about swinging for the fences. But I don't think so. There are hitters in baseball, the best hitters in fact, that hit balls out of the park when they are just trying to make good contact. That's how you have to do it in the venture business. You try to make 20 great investments and you work with them closely in hopes that four years in you have six or seven that have home run potential, and after ten years, you maybe hit one or two out of the park. If you try to hit every one out of the park day one, you'll strike out way too much and the fund won't work out very well.

Fred is doing a superb job with this series.  If you aren't already a subscriber to his blog, what are you waiting for?

Fred Wilson has another post on Venture Fund Returns titled Gross and Net Returns.  AsktheVC would like to formally thank Fred for doing our work for us, as we periodically get questions about how VC funds work and to this point have not written posts nearly as detailed as Fred's.

Today's great post if by Fred Wilson titled titled Venture Fund Economics. 

"When I write about venture fund returns, there are always comments and questions that lead me to believe that the economics of a venture fund are not well understood. And since most of the readers and commenters on this blog are people who work in the startup ecosystem, I think its important that the economics are better understood. So I am planning on some posts on this topic in the coming weeks."

This appears to be the first of several posts Fred's planning to write on this topic. I'll try to remember to point them out when they appear.

Q: When we talk about the equity percentage numbers for those directors and other early participants, are these numbers based on the total number of shares prior to a funding event or does the base share number include those allocated for investors as well? As the shares for future investors are hard to predict, I assumed that the percentage numbers we talk about here are before any dilutions, is that right?

A: (Brad) The answer is "it depends."  When we have written about equity and compensation in previous posts, we've tried to provide some context for the stage of the company.  When we've done this, you should assume that this does not include future dilution from other rounds of investment.

However, there are no absolute guidelines.  For example, when you bring on an outside board director, whether it is at the Series A or the Series D, the stock option grant is usually in the 0.25% to 1.0% range.  While this is a wide range (see - there are no real rules) it gets more complex when a director has been with the company for a while and taken dilution from subsequent financings.  For example, assume a director joins at the Series A and gets a grant for 1% vesting over four years.  Three years later, the company has raised $30m and the directors grant now represents 0.3% of the company.  In some cases, the director would get an additional option grant to increase his ownership percentage (say - back up to 0.5%); in others he wouldn't.  This is a function of the board, the investors, the entrepreneurs - all based on their view and assessment of the director's contribution.

The same is true for employees.  Most employees will take the same dilution the founders take with subsequent financings.  This is relatively easy to deal with in the success case because the dilution is less significant and the value of the equity continues to increase.  However, in cases where the dilution is significant (e.g. a down round financing) employees need an "option refresh" - this is usually negotiated in the context of one of the financings.  In addition, as employees start to reach the point where their equity is fully vested (as they've been at the company for four or five years) there is often a refresh option grant.

There's no simple answer.  And - any numbers we put on this blog are merely guidelines.  You mileage will vary dramatically with the situation.

Q: Your site talks a lot about VCs investing into companies but I can't find any information online (even on the VCs websites) about how VCs solicit investors to their funds.

I want to invest with a VC but I don't know what is the minimum VCs accept. Who in the firm should I contact to invest? What kind of terms should I expect? What kind of returns does an investor normally expect? How soon would I get my money back with the profit? Would I be in a position to make demands and say "I want a fourth of my investments to go to XYZ company that is looking for VC funding"? etc.

A:  (Jason) Most venture firms do not take individuals as investors unless they have a pre-existing relationship with them.  Most VC investors are institutions, endowments, pension funds and other corporate entities that professionally and regularly invest in VC funds  As an individual, your best way of investing is either through high net worth family office organizations or through your financial broker, if they participate in these types of offerings.  Because of this, and because of securities laws that I won't bore you with, you'll never find information on VC websites on how to invest. 

As for your ability to control terms or designate investment particulars, this probably won't happen.  The large institutions that invest in funds drive terms, not individuals, so if you do decide to invest, you'll piggyback off the terms the VC fund and it's largest investors negotiate. 

Q: It seems that the venture community is dominated by a very few large names (Kleiner, Sequoia, etc.).  If I don’t get funded from one of those firms, is my company toast?

A: (Jason)  Nope!  While Kleiner and Sequoia deserve their great reputations, the list of successful venture backed companies that had syndicates that didn’t include either Kleiner or Sequoia is extremely long.   While having a great VC firm as an investor is often very helpful, the idea that you are “toast” if you don’t have an investment from one of them in nonsense. 

The real key is finding a partner at one of these firms who understands your business and whom you think you’ll have a great working relationship with.

Q:  My company is backed by VC firm to whom we also pay a $2k/month "consulting fee." We have raised approximately $2MM from them in a Series A. Is that type of consulting payment typical in an early stage venture?

A:  (Jason)  I want to vomit again.  We received this question just a  few short days after posting that entrepreneurs should NOT pay their lawyers for introductions to VCs and how scummy of a practice that was.

Now today, we get this question.  This is even worse.  The answer is NO.  Companies should never pay their VCs consulting fees, board attendance fees, or any type of fees related to their involvement in their company.  I've never worked with a reputable VC firm that charges their companies to help them succeed.

As a venture capitalist, we are paid a management fee by our investors that is our "salary" and we receive a percentage of the profits (called "carry") on our fund.  We don't get paid to sit on boards and certainly it is not appropriate for them to "round trip" your investment capital by paying themselves part of it. I would wager to guess if their investors knew they were doing this that the investors would revolt.

I'm sorry to report, but not only is this not typical, it's unheard of in the venture world when dealing with reputable folks.

(Note, private equity is a totally different matter and fees are commonplace, but it's a totally different model)

Q: From my limited perspective, venture debt in proximity to an A round seems awfully premature -- restrictive debt coverage ratios, warrant coverage on preferred terms, etc -- yet there seems to be an awful lot of venture debt investors out there who essentially have no response to these concerns but want me to take their money anyway. Hence my question: if such financing really is premature and potentially limits the options for a startup, why should an early stage company take it?

A: (Brad) From a tech entrepreneurs perspective, there are two types of banks in the world.  Those that understand tech entrepreneurship and those that don't.  Those that do - such as Silicon Valley Bank and Square 1 Bank - have good early stage venture debt programs.  Those that don't either simply don't have a venture debt program or have transient ones that come and go with the market.

Let's assume we are dealing with a credible bank in the context of venture debt. These banks have venture debt programs that are largely based on their relationships with the VC firms involved.  The ultimate goal of the bank is the long term relationship with the company - they are willing to extend debt on relatively inexpensive terms if they believe the equity participants (the VCs) are going to be supportive of the company beyond the Series A.

Now, the price of admission for this for the bank - and for the banking relationship - is to extend debt terms as part of a banking package.  This package will have all the expected banking services, but will also include either an unrestricted debt line (usually somewhere between $1m and $2m) and an asset-based line (usually up to $1m).  This debt package will have straightforward terms, including relatively light warrant coverage so the bank can get some upside in the success scenario.

The bank is doing this because it believes the VCs will continue to finance the company beyond the Series A.  This debt will typically give the company one or two quarters of additional runway to make progress which can be very helpful in the context of some early stage companies. 

One thing to be cautious of is a debt package that you can't actually use.  Many proposals have covenants in them that essentially require there to be an equivalent amount of money in the bank as the debt being borrowed - this is obviously useless.  However, I continue to be endlessly entertained by the proposals like this that I see.

Q: My lawyer is asking for a "success fee" for a referral to a potential investor in my business. Since he'll be doing the legal work, he's offered to charge only 3% on the amount funded (solely from this one contact) as opposed to a 5% that a typical investment banker would charge (even though he's not an investment banker himself).

As this is the first venture I'm actually raising capital for, I am simply unfamiliar with this practice in the legal world. Is this a common industry-wide practice? Should I be wary of this offer? Although I don't feel like he is trying to take advantage of me in any way, it does feel a bit like he's trying to double-dip.

A: (Jason)  Without sounding too unprofessional, I want to vomit.  This is egregious behavior by your lawyer and you should not accept paying ANYTHING to him for introducing you to potential investors.

First of all, it's part of a lawyer's job to introduce you to any investor contacts he may have.  If you get funded, he gets paid and gets to bill you throughout the lifetime of your company.  If you don't think he is already making enough money, see my post on start-up lawyer compensation from my personal blog. 

Second, while investment banks may offer you a deal at 5% (and in my experience this can be negotiated down), individuals who find money for you (normally called "Finders") normally charge in the 1-2% range, so his quote is at least 50% too high.

Lastly, venture capitalists prefer to invest in deals without finders.  We don't like funding a company that has to pay someone part of the deal proceeds.  We want our money to be used to operate and grow the company.  You will see many VC term sheets that have provisions that specifically call out the absence of finders fees. 

So yes, your lawyer is double dipping.  And that is stating it very nicely.