The Attorney – Friend or Foe? (VentureCapital Magazine Special Edition "Startup 2010", October 2009)

How to assess attorneys in the context of VC-financed start-ups

Midwife, surgeon, gravedigger – it’s a cliché to say that no matter what happens the lawyer always makes a buck. But how can you utilize an attorney’s services and of what kind of cloth should he or she be cut to generate the maximum benefit in the delicate interplay between start-up company and investors? Which attributes do attorneys possess, and how do they use them to influence the various situations a start-up faces?


Characteristics of attorneys, and the types it would be better to avoid:

IT affinity
There are lawyers that would rather hear themselves shout than use headsets for long conferences because that’s something a secretary uses (and is therefore beneath them!). Worse yet, there are still some who refuse to create any documents at all. They’d rather dictate them, so while a number of people wait for a new draft of an agreement, for example, the administrative assistant plows ahead, blithely making mistakes in the transfer, or hasn’t even begun typing it up, because it’s already time to call it a day.

Expert understanding of economics
Indispensable, because difficult legal issues must always be viewed in context: what is the upside, what is the downside?

VC experience
Term sheet negotiation, first VC round – the clever attorney experienced in VC dealings will explain to the client that the particular structure of a term sheet in the VC environment is normal and that one can only tweak a very few parameters such as valuation or liquidation preference, AND that none of that plays a very important role because a start-up will not become successful based on terms. A run-of-the-mill attorney, on the other hand, will explain to you that those are American customs whose “wild West” nature goes against all manner of social justice.

Specialization
The lawyer specializing in labor law, for example, typically is far too far removed from the start-up context. To make the interaction as efficient as possible in this area, it’s best to have your main contact in the law office, who also understands your context, speak to the specialist.

Office size
It is advantageous if the law office is not just a two-person operation. With a bigger office, specialties are at hand, shortfalls can be compensated for, and an international network is in place. The disadvantages are subtler. Attorneys that are not partners or who are not just on their way to becoming partners may have checked out mentally, and a situation like that naturally will have a huge impact on their commitment. In larger offices, an increase in overhead and a much more complicated workflow can be observed. A senior partner delegates to a less senior partner who completes the work, which means that two people are always involved in the calls, and the contact function is always delegated to the less senior partner, who either doesn’t have decision-making capability, or who has to correct whatever has been said later. Double billing in such cases should always be rejected!

Billing granularity
Some offices charge in 15-minute increments and even factor in the assistance of paralegals. Don’t accept that. If possible, work out a flat rate for a clearly defined volume of work.

Internationality
In negotiations, the Chinese are a completely different breed. How is a lawyer going to handle that if he or she has only ever had experience with European counterparts?

Intellectualism
Very important, especially in the start-up’s early phase: keeping a certain amount of chaos regarding the unestablished in mind, yet not neglecting novel products and complex IPR configurations and the future exit positioning associated with them – many lawyers have pursued an advanced degree for just such a situation.

Emotional intelligence
Highly conducive to monitoring negotiations and depolarization, unfortunately, this attribute is often in opposition to high intellectualism.

Integrity
One lawyer receives a mandate to build up a strong counter-argument during a shareholder negotiation, but crumbles and merely responds with “Yes, sir,” and, “No, sir” at the first sign of resistance. The same lawyer is asked only to provide legal explanations during negotiations between the VC and the founder, and at the first opportunity verbally strikes out at the founder. Assessment: no integrity!

Pragmatism
Solutions that are too broad, that try to consider even the most improbable risk, are nothing but costly. The more detailed the regulations, the more potential gaps in the details.

Personal responsibility
Attorneys tend to be only “subcontractors”; a tight rein should be kept on them!
 
Composure
If mistakes occur for which the lawyers are responsible, calm attorneys will respond pragmatically by looking forward, while the volatile ones begin to panic, start to make excuses for themselves, waste your time, and in extreme cases, flatly refuse to find a solution.

Conclusion
Before you decide in favor of legal backing for your start-up, ask to have example cases explained, check references and use the above checklist to determine what you can really expect from an attorney.

REALDEALS: Uli Fricke Among the 20 Most Powerful People in European Private Equity

Uli Fricke is managing partner of that rare thing: a successful early-stage German venture capital firm, investing on both sides of the Atlantic. She is also the venture representative on the Brussels Task Force, fighting hard against a EU directive that could have a devastating impact on the European venture industry unless it undergoes substantial revision.

Fricke's mission is to ensure that the end result does not strangle an asset class that has a great deal to offer an economy in recovery, and to ensure that venture's voice does not go unheard.

REALDEALS 18th August 2009

Uli Fricke is General Partner and Founder of Triangle Venture Capital Group.

Technology Start-ups – Too Much of a Risk!? (VentureCapital Magazine, Special Issue "Tech-Guide 2009")

How early-stage technology funds really have to look to be successful


It’s a topsy-turvy world: The big private equity guys are berated for being "locusts" and are supposed to be responsible for the capital market crisis, while the early-stage VCs are the “honey bees”. But apparently, the honey isn’t very sweet: Investors are still being drawn to later-stage buyouts and, with a few exceptions, are steering well clear of early- stage VCs. The official response to this situation is diverse – usually involving a petition for the massive reinforcement of the supply side, which often results in liberal "watering can" investments or special seed funds that with their administrative structures tend to be risk-averse.


So what characteristics should optimally structured early-stage VC funds have? To answer that, we first have to take stock of the early-stage technology founder scene in Germany.

Four categories of founders
We can differentiate between the four following types of founders: Internet founders, engineers, inventors and researchers. Manifold Internet founders usually forge ahead without VC funds or can maneuver around the capital market on their own. As a rule, Internet founders need very little capital anyway, because the software is available as an open source product and a lot of personal initiative can be counted on to get a business going. Engineering firms and "independent" inventors are usually too incremental, and for that reason can hardly be scaled as a self-contained business. They often do not stand much chance of survival in any form beyond that of an engineering office. Finally, technology founders who come from universities and research institutes have the greatest potential because their research results usually offer completely new solutions.

Research spin-offs and the players
A representative of a high-ranking research organization recently put it like this: “The last thing professors and their founders want to see are high-gloss bulls*&% presentations by VCs, usually from foreign parent companies, that promise them the moon.”

The reasons are obvious. For one thing, the scientists, who see themselves as intellectuals, are often put off by them, furthermore, the issues surrounding a research spin-off usually have to do with operations and product strategy, for which pure capital market lore will not be very helpful. Unfortunately, during the boom, many VCs left behind a lot of scorched earth so that today they have an image similar to that of bankers whose appearance is accompanied by clichéd expectations: a fully formulated business plan, complete team, 7-digit sales revenues, etc. But that is far from the original meaning of the venture capitalist as it is known in the USA. This role, often intended for business angels as a substitute for VCs, only works in certain circumstances due to the hobby character that many ascribe to their activity and to the fact that there are only very few business angels with truly sufficient capital (that aren’t just looking for a job for themselves). Those for whom it has worked have long since turned themselves into VCs.

What, then, do research spin-offs really need? The immediate benefit of the technology is always apparent, but massive help is needed with commercialization. In the best case, there will be a concept for addressing this issue, but usually it won’t have real answers to the questions of which customer applications the technology will offer a disruptive advantage, how the product based on the technology needs to look, and how the business model must be formulated to sell the product.

To answer these questions, as an experienced entrepreneur with the corresponding specialist expertise the VC must work together with the founders and develop product and marketing visions, but above all to define concrete steps toward their implementation. That is a very creative process that naturally must begin the very first minute the business has started and must be done during the phase when the spin-off is still malleable – by the time the second financing round is reached, it will be too late. Actively guiding this kind of a spin-off process challenges the VC, not only as an entrepreneur but also as a mentor, since the founders must accept the visions as their own and must see the VC as a co-entrepreneur – statements like, “I’m pretty satisfied with my investors, they always left me alone...” are certainly not something one hears (in the positive sense)!

How should early-stage VC funds really look?
The main requirement of early-stage VC funds is that they have to be at least as entrepreneurial as the founders in whom they invest. VC funds that don’t even know what fundraising is, or who call on government aid for it, have already lost – how are people who themselves cannot sell supposed to help a founder formulate a sales strategy? It is equally important that the VC team members make their own investments in the fund. A bonus is one thing, but taking responsibility for one’s own investment is another. That’s why successful early-stage VC funds are private, and the members of the operative team make the investment decisions, not some anonymous committee.

Early-stage VC investment is not a high-volume business. If a partner makes more than one new investment per year and manages more than four, something is not right. Due diligence, business strategy development, assembling the founder team, the first 100 days, three other ongoing investments and deal scouting… and we’re talking about a 60- to 80-hour workweek.

But many participants are not even aware of the baggage associated with the word “seed”. For the founders, it is a sign that a VC is interested in pre-revenue companies; for investors in VC funds, it is a reason to stay away from them. That is why it is high time we return to the original understanding of VC, by which start-ups are built up from the beginning with the entrepreneurial assistance of the VC and are under the pressure of limited means to become successful quickly and creatively. The creation of framework conditions that promote start-ups and VCs, would have a positive effect on the formation of additional private early-stage VCs. Investors in VC funds would no longer feel a need to avoid the functioning VC marketplace that results.

Q&A – Early-phase VC financing today (UniversityJournal 16.06.09)

Before and after founding a start-up, founders regularly ask whether it makes sense to seek external financing. And if so, what should that financing look like? Answers to the 10 most important questions on this subject are found below.


1. As an entrepreneur, what can I expect life to be like? It will change you – after a few years, your personal surroundings will seem to you to be narrow-minded and inflexible. But why is that? In the same period, during which your best friend has pursued a career in a corporation, you have had to solve 100 times as many problems, and have often faced existential challenges whose decisions have exacted an emotional toll that you could not have foreseen. In other words, you have an extremely steep learning curve. More than anything, it’s great fun, despite the 14-hour days on average during the first few years!

2. Where can I be with my start-up in 5 years? You can achieve revenues of between EUR 5 and 20 million, depending on the business you are in. At that point, a buyer will probably acquire you. Set high goals for yourself – but be realistic too, because the often-cited "billion dollar company" is a purely accidental phenomenon and cannot be planned.

3. How can I figure out how high my capital requirement is? You should plan as if you would be able to reach break-even at 2 million in sales within 2-3 years with one round of financing. The biggest uncertainty (with an existing Proof of Concept and a functioning R&D department) is the market launch!

4. Which investors should I consider? Make yourself a list – at the very top should be private, independent VCs that have specialized in start-ups, then business angels, followed by government development agencies and banks, assuming you can provide collateral. True entrepreneurs will accept even the second-best funds if they cannot get their first choice.

5. How do I choose the right VC for me? Above all, the "right" VC is private and independent – that will ensure that you have their undivided attention to follow the same goal and feel the same pressure that you do: to become successful and rich. But VCs are focused, too: that is, almost all of them will say they do everything, but if you look at the portfolio you will see certain concentrations. And at second glance you will be able to see where a specific VC has been particularly successful. For example, although some excellent Internet IPOs were conducted, something like technology investments weren’t successful.

6. What valuation should I accept? As disenchanting as it might sound, in the beginning it’s not an upside maximization as much as a downside minimization. Without financing you probably cannot meet the goals listed under number 2 whatsoever. That’s not only because of the investment volume but also more specifically because of the know-how of the VC as co-entrepreneur. The VC is under pressure to achieve a realistic outlook of a factor of 10 on his investment. In the case of a mid-sized corporate value of EUR 40 million paid through an M&A, for financing the VC doesn’t have the leeway to valuate your company at more than EUR 2-3 million. If a VC offers you more than that in the first round, it should be a signal to you either that the VC does not understand the business or merely needs to place some money. In either case, the VC will not have any drive to succeed with you.

Furthermore, don’t think that the answer necessarily lies in "staging", that is, creeping from one valuation round to the next higher round in small financing steps. That is a naive dream stemming from the Internet bubble that won’t get you anything except a constant preoccupation with financing rounds. Ultimately you will come to the conclusion that you haven’t been able to concentrate on your real job and therefore have not reached your goals and are standing with your back to the wall.

7. What is it like to collaborate with a VC? If you think that you’ll be left alone to "do your thing" then you should start farther down on your investor list. "Non-VCs" are more likely to leave you in peace and quiet (that is, however, only until something has gone wrong, and then things often get rather "cramped"). VCs, by contrast, will work closely with you (a weekly conference call is the rule) and will help you a) not to fall into every trap and b) to recognize every business opportunity early enough and get the maximum benefit from it.

8. Will the "Exit" for me be something like an "Exodus"? If, in the case of an M&A, you stay with the company another 1-2 years as is often called for, it won’t be in any event. Otherwise, true entrepreneurs are happy to have new challenges in which to apply and expand their newly acquired knowledge and experience.

9. What kind of impact will the present economic crisis have on me? Only a positive one – cemented economic structures are forced open by the modification or disappearance of the Opels and Arcandors of the world. Established companies are under enormous pressure to adapt, variablize expenditures and minimize costs. This will help you directly, because by definition you are more flexible and more agile, which is the prerequisite for the survival of your start-up. You are also in a much better position for recruiting qualified employees: Today, the promise of a great career and security in a traditional company are less of a given than they have ever been – that fact opens up many people’s eyes as to better opportunities in a start-up.

10. There are so many advisors out there that are all trying to tell me something different. How can I believe anything they say? Make sure you scrutinize the advisor’s motivation and skills. Both are relatively easy to assess. In the case of the administrative officer, advice about your new enterprise is certainly well intended, but just as certainly does not come out of a wealth of personal experience. VCs and entrepreneurs are on the other end of the spectrum – they speak directly from their own experience. The VCs that you talk to about financing, especially, have the same interest as you: success. But look around! There are many pathways to wealth: there is no silver bullet here!

20 Years German Private Equity and Venture Capital Association (BVK)

Germany is a great country for venture capital investors. There is a broad pool of highly educated young people, a number of publically-sponsored research projects, an unparalleled entrepreneurial spirit, and a good number of "nascent" entrepreneurs – we could be the Silicon Valley of Europe! So why are those entrepreneurs merely "nascent"?


Statistics* show that of the European fundraising activities in 2008 exactly 8.9% of all funds collected from private equity/VC companies came from Germany, Switzerland and Austria – even though the share of the German population in the EU is 16.5% and the country contributes 20% to GDP. If we assume that the VC share is much lower still, that is a poor showing indeed.

What does this phenomenon have to do with entrepreneurship? A lot – the more entrepreneurs there are in a country, the more venture capital companies there will be, for one thing because private VCs often recruit from successful entrepreneurs. In Germany, however, where the maxim is "market failure", the government feels it must get involved and function as a VC (but without adhering to a VC's investment criteria). And then everyone is ordered to be successful! Surely many good ideas would have been much more successful if the founders had had to work harder to acquire private money, and had successful examples to follow. Instead, we see ludicrous action being taken on the German VC market such as the VC branch of a state bank that had due diligence performed on a start-up by a third party (!) but never spoke directly with the CEO and then denied credit on the basis of poor economic prospects.

Just like the German research spirit, entrepreneurship has been scrutinized, and held at arm’s length, for long enough. What we really lack is a positive atmosphere, in which individual responsibility and its resulting success is predominant, and where the glass is considered half-full and not half-empty, to serve as a good example to "nascent" entrepreneurs. Achieving that is the primary task of the political system, whereupon the entrepreneurs among us can build the Silicon Valley of Europe over the next 20 years!

High-end customers, mission-critical applications and operative pitfalls

VC expectations of medical technology deals, and how founders can utilize them for success


Let's be clear: Medical technology is not "biotech light", and is not for Web 2.0 investors who want to get a taste of a little more technology. Medical technology is complex on a number of levels; the customers are extremely demanding, applications are often matters of life or death, and the market is highly professional, in an environment of very conservative private and public contractors.

From the VC point of view, however, not all medical technology is the same. The dimensions that play a role in the evaluation of an investment case are:

1. technological complexity/depth,
2. mission-critical grade of the application,
3. footprint in the medical workflow/obstacles to a paradigm shift among users,
4. investment volume/business model,
5. existing market allocation, incremental/disruptive innovation.

The "in" technologies for VCs, for example, include drug delivery implants, active bandages, deep brain stimulation, devices that support minimally invasive procedures, miniaturized diagnostic devices, radiation detectors and combined and expanded imaging procedures (see VentureSource: First-round financings US, Il, EU since 2007).

It is critical for the assumptions of the investment case to be a thoroughly researched piece of work for the VC - but first and foremost it is the excellent practical execution of the investment case's go-to-market strategy that is sufficient for success.

Operative challenges underestimated
Often due to a lack of practical experience, founders tend to underestimate the operative challenges of product development and market launch, which are not linear but rather iterative. If the iterations then are not short and quick, the financing often disappears and/or the market disintegrates. Since many stakeholders have an influence on company development, the sources of the iterations are inherent in the medical technology business itself: Pilot users, study participants, admission authorities, and finally, market sentiment regarding one's own product initiate expensive changes. The sales rep who storms into the office of the CEO and founder late on a Friday, distraught because an important potential reference customer just jumped ship ("The competition now does 50 Watts, we can only do 30 Watts!") is a case in point. One decisive issue is the unpredictability of the feedback that must be taken into consideration by the participants. That makes the excellence of one's own processes an absolute precondition. Further specific examples are described below.

The product development manager case
Founders are often the visionaries, business developers, and/or architectural geniuses behind the technology. But they are not the development managers who are responsible for organizing the details of the development work. A competent development manager is, however, urgently needed to efficiently implement project plans, because otherwise the delays and (really, unnecessary) surprises in technical detail mount up. But be careful: The development manager shouldn't hail from the dinosaurs of the industry because they are more attuned to product maintenance, and generally cannot keep pace with the founder team.

The second source case
The product depends on a highly innovative component that is sourced from a supplier. The "second source principle" (always have one) is well known, but it is to be applied later, during ramp-up to serial production. With the first reference customers there are failures that can be attributed to these specific components. This is where things start to get bogged down: Everything is done to help the supplier to get the problem under control. A number of other suppliers are feverishly sought so that their products can be tested. But one thing is not done – the components are not directly taken control of, for example, through reverse engineering. Licensing issues would have to be considered in such a case, but there are at least ways of getting around them.

The working capital case
The classic: Complex med tech devices are a specialty business. Subcontracted components are produced in small series and have long delivery times. Expensive semi-finished parts are on stock, the financing for which the founders are loath to shell out using equity financing because it would dilute their company holdings or it simply can't be found. Banks, however, have clear restrictions as to when working capital loans can be extended. An early agreement is therefore imperative.

The first mover case
Let's say that two start-ups have competing products. Start-up 1 develops the 150% solution and Start-up 2 the 80% solution. Start-up 2 gets to market faster; it's not all perfect, but they are the first and therefore the only ones there. Start-up 1 gets to market somewhat later, but because the product development was much more involved, not everything works properly. The market, however, no longer tolerates these imperfections, especially since Start-up 2 has managed to improve its product in the intervening period – a death sentence.

The financing case
In general, it is unadvisable to live from hand to mouth, especially not as a medical technology start-up. Financing should be secured for the long term. The basic rule should apply that to concentrate on the business better, it is preferable for more shares to be released rather than entering into a new "casino round" every year, thus pushing the "virtual" share value upward. These stakes quickly lose their value because the company loses sight of its own business.

The strategy case
Many start-up founders dream of having independent companies with many hundreds of employees. But is that realistic? The development of a company always takes place in stages. Three to five years elapse before a technology in the medical technology field makes its first market launch and gains its first reference customers. The build-up of a global sales and service force comes later, with a new risk profile and new, considerably increased capital requirements. Forming large companies out of start-ups is still very difficult to do in Germany because there are so few investors. Here it is worth checking out alternatives early on and, for example, being sold to a major incumbent fairly soon after market launch, which helps reducing expansion risks.

Conclusion
Medical technology investments are much more complex than other software and hardware investment fields. The markets are much less forgiving and start-ups have to pull off the nearly impossible: to be as quick as the small players, and as precise and excellent as the big ones. Only a few VCs can help them in this endeavor.



* Dr. Bernd Geiger is a physicist who worked for five years at the German Cancer Research Center, a further five years at university spin-off Heidelberg Instruments (now Leica Microsystems), and subsequently spent two years with Zeiss. Triangle is currently the only VC in Germany to invest only in spin-offs originating in universities and research institutes.

Public launch financing or professional investors?

Or why it's important to make the right choice from the start

The good news is, the start-up scene is gaining momentum again, and a spirit of optimism prevails. The bad news is, even high-potential start-ups are doomed after one or two years, even though they could have generated one to two million in sales, just because they get involved with the wrong financing structure! What lies in store for start-ups, and what should they consider?

Case study: In early 2007 a financing search team introduced its company to a well-known early-phase venture capital company – the idea, from the realm of computer games, was revolutionary and promised to turn a profit very quickly. There was nascent competition in the USA, but it could not fulfill key quality criteria. Upon closer examination, however, it looked as if the lead could not be maintained forever, and that "execution" was key, that is, targeted and pragmatic product development and a quick market launch, otherwise other technologies would establish themselves in this market. The venture capitalist recognized the opportunity, and after a first phase due diligence within a few weeks prepared a termsheet that would enable the company to concentrate fully on the market introduction and development until break-even, and consequently, until the next growth phase.

The founder, however, reckoned otherwise, going with public funding that yielded only ¼ of the capital that the private VC would have contributed and at a high price, but at least the valuation would increase from the outset. Yet a half a year later, the financing round with the public investor still had not been concluded, and the employee search was proving difficult because it was hard to attract the necessary highly qualified programmers – they didn't want to venture on an undertaking with a financing period of only six months. Today the CEO (that had been required by the public investor in the meantime) has also bowed out, and the start-up is back at square one, except that a year and a half and a wealth of motivation have been wasted.


How would things have been different with a private venture capitalist?

- The biggest difference is that a start-up is financed completely until break-even is reached,* allowing the founder to concentrate on business right away, and giving both employees and customers a reliable outlook.

- Optimal assembly of the management team: When the founder team has no previous start-up or industry experience, the venture capital investor can help round out the team so that the company runs smoothly and efficiently right from the start.

- Use of "industry best practices" from the beginning: You don't have to try everything out for yourself to identify the best processes – others have already done that for you.

- Co-entrepreneurs are ideal for team players; each party contributes what they do best – you the technology and the energy to market it, the venture capital investor the experience gained from many successful and less successful start-up investments. "Hands-on" venture capitalists are your biggest supporters.

- Warning: With venture capital investors there is no "trial phase" or "light" version of a start-up during which process and focused action can be disregarded. Extra (financing) rounds cost money and stakes – why not do it right the first time?


Everything in life, of course, has a flip side, and you probably do not need venture capital financing if you think:

- you earned ample money with your last start-up,
- you won't learn very much more,
- we all need to stop and smell the roses,
- the state knows exactly how to set up start-ups, that's what the taxpayers' money is for, after all,
- that venture capital investors are "locusts" that destroy jobs,
- that 100% of a small success is better than 50% of a great success.


If you are interested in VC financing nevertheless, or wonder if you should be, send me an e-mail: b.geiger@triangle-venture.com.

*Not in biotech, where other laws apply.