HIGH TECH START UP: The Complete How-to Handbook for Creating Successful New High Tech Companies

Book by John L Nesheim

Chapter One: Introduction to Start-Ups and Their Funding

The research on which this book is based provided a lot of data about start-ups of all kinds that use technology, from semiconductors to Internet sites. The findings include their probability of success and how they are typically organized. Let's begin with thirty-one facts about typical high-tech start-ups -- many of them contrary to popular stereotypes.

1. The chances are 6 in a million that an idea for a high-tech business eventually becomes a successful company that goes public.

2. Fewer than 20 percent of the funded start-ups go public.

3. Founder CEOs own less than 4 percent of their high-tech companies after the initial public offering. Boom periods like the early Internet years often raise that to 10% and higher.

4. Founder CEOs can expect their stock to be worth about $6.5 million if the company succeeds in going public. Boom periods like the early Internet years produce billionaires.

5. Successful venture capitalists expect to personally earn about $7 million (in addition to cash wages) over five years for each $50 million pool of capital they share in managing.

6. Business plans are typically poor and are not well received by venture capitalists.

7. "Unfair advantage" and "sustainable competitive advantage" are missing in most business plans but are considered by investors to be critical if the high-tech start-up is to have an acceptable chance of succeeding. Plans lacking such an advantage rarely receive venture funding from experienced, successful venture capitalists.

8. On the average, a venture capitalist finances only 6 out of every 1,000 business plans received each year.

9. Venture capital investors own a large 70 percent of the start-up by the time it goes public: 70 percent of hardware companies, 60% of software companies and 50% of Internet companies.

10. The personal costs of doing a start-up are high, affecting families and friends as well as individuals. Fear and burnout are common. However, many CEOs have balanced those costs with the rewards of personal and professional satisfaction and the potential financial paybacks, which can be more gratifying than the rewards of working for a large corporation.

11. Bankruptcies occur for 60 percent of the high-tech companies that succeed in getting venture capital.

12. Mergers or liquidations occur in 30 percent of start-up companies.

13. A vice president's stock is worth about $2.5 million or one third of what the CEO is worth at the time of the initial public offering. Boom periods can increase the wealth tenfold.

14. The average worth of the stock for each of the employees (not including vice presidents and other key employees) on the date of the initial public offering is about $100,000.

15. Investors in venture capital pools aim to earn in excess of 25 percent each year on their money, about 8 percent more than if they had invested in all the stocks of the companies making up the Standard & Poor's 500 company index. In boom periods they can triple their returns.

16. The 10 percent of the start-ups that succeed compensate for the other 90 percent of the poorer performing companies in the venture capitalist's investment portfolio. In essence, the successful founders are paying for the substandard performance or bankruptcies of the bad investments.

17. Cash compensation for U.S. start-up managements remains below levels offered by larger corporations in spite of the scarcity of start-up talent and tax law reductions in the United States. Technical talent is paid near or at the going rate for such employees.

18. The median annual starting salary for a founder CEO in 1990 was about $120,000. By 1998 it had risen to about $150,000. Pre-IPO cash bonuses had become common by 2000 and increased total pay to $190,000 by the time the company went public.

19. The vice president of sales in a start-up often earns more cash compensation than the CEO. This occurs when incentive compensation plans are linked to sales that exceed those of the business plan.

20. Of the start-ups that get to an initial public offering, the median company takes at least three and typically five years to get to the public offering stage. Internet and biotech companies have been able to go public based on their "stories," that is, without earning profits by the time of the initial public offering.

21. Equipment lease financing and leasing of facilities and leasehold improvements have proven to be reliable and competitively priced sources of capital to augment equity raised to finance a start-up.

22. Having as a founder a person experienced with the responsibilities as CEO greatly increases the chances of getting a start-up funded. A close second is having a complete management team ready to go to work, with experienced people for each of the key functions, including the first CEO willing to step aside for a new, experienced leader when the business begins to grow rapidly.

23. About $100 billion is committed to pools of venture capital. It is managed by more than 2000 actively venturing individuals in over 500 firms, mostly in the United States, mainly in Silicon Valley, with a few in Europe and Asia.

24. The intensity of competition between venture capital firms has swung back and forth. It favored the entrepreneur at the height of the boom days of the personal computer, biotech, and Internet eras. However, whatever the trend, venture capitalists still end up owning the vast majority of the stock of a start-up, typically in excess of two-thirds of the company.

25. Mergers and acquisitions of start-ups increase when the market for initial public offerings cools off and when initial public offering valuations are historically very high.

26. Investors' interests in new issues rises and falls depending on the interest of institutional investors in the stocks of public companies traded over the counter, as well as in blue chip stocks traded on the New York Stock Exchange. In general, windows for IPOs open and close, based on whether there is a hot market for stocks in general. E*Trade and other Internet era financial service firms have brought access to IPO offerings to the general public. By 2000, "day traders" were a factor in moving stock prices.

27. Pricing of private rounds of venture capital by investors follows the same financial guidelines and measurements used to price securities of publicly traded companies. Investors translate risks and rewards into acceptable levels of expected return on investment, which becomes the basis for the dilution of founders' shares.

28. Competition for the shares of a start-up is the best way to increase its valuation and to reduce dilution for founders. Competition is enhanced by careful planning of the strategy for the capital-raising campaign. However, such deliberate planning is noticeably absent among founders of high-tech companies, especially those started by engineers.

29. Venture boom-to-bust cycles have become a way of life. The boom times of the personal computer of the 1980s ended. Biotech arrived and ended. The Internet boom arrived in the 1990s. These caused wide swings in the financial return on portfolios of venture capital firms. Many firms failed and closed their doors, leaving nothing to their investors. Other venture firms survived and some thrived. This resulted in a hierarchy of venture firms, interrelated deal-making ("deal flow"), and politics. Portfolio returns have dropped as low as single digit ROIs and a few have risen above the 60 percent range.

30. Mixed sources of venture funding have become a way of life. As a number of venture firms died out, a need and opportunity was created for funds from other sources. One new source of venture funds is large public corporations whose business development leaders became very active in the Internet boom. There continues to be funding from non-American sources. Angel investors grew and were prominent in the early years of the Internet. Friends and family funding, as well as bootstrap funding, has continued since the earliest days.

31. Internal start-ups within established corporations are now a frequent phenomenon; they have allowed emerging growth companies to sponsor an entrepreneurial spirit while retaining an uninterrupted focus on the parent company's bread-and-butter business. For internal start-ups to be successful, special attention must be paid to the unique characteristics of such new enterprises, particularly freedom and compensation.

Critical Issues

There are a number of key economic forces driving the venture capital funding of high-tech business.

• ROI -- return on investment -- drives the start-up business. It is measured in two ways: (1) A crude measure is that of how many times the value of one share invested rises by the time the initial public offering is over. This is called the "multiple." (2) A more sophisticated measure -- the only number that really counts -- is the annual compounded return, or percent per annum (p.a.), that the general partners in the venture capital firm return to the limited partners, pension funds, university endowments, and so on. To put it another way, how long the limited partners had to wait for the multiple to be returned determines the true percent annual ROI.
  
  
• Cash flow (the "burn rate") is what is managed. All the accounting in the world does not matter to the founder who is struggling to meet payroll while launching the start-up's first products into a very competitive jungle.
  
  
• The IPO (initial product offering) is the holy grail. Everyone has their eyes on that final goal. Mergers stand a poor second in attraction, because companies can generally negotiate higher valuations for a public issue.
  
  
• Liquidity ("exit strategy") is everything for the VCs (venture capitalists). Anyone inhibiting attainment of liquidity quickly learns why VCs have earned a reputation as "vulture capitalists." A business plan must have an acceptable "exit strategy" that converts the investors' shares into cash.
  
  

Those are the economic laws that govern a start-up. The CEO who understands them will win more often and will survive to savor the grand IPO day.

Venture Competition

Venture capitalists are driven by competing venture firms to maximize their return on investment. The general partners share in about 20 percent of the profits of a pool of money provided primarily by huge institutional funds, such as pension plans for Fortune 100 megagiants and billion-dollar university endowment pools.

If VCs earn a high enough ROI on their first pool of institutional funds, they will have a chance to bid for more. They are competing against the alternatives -- such as the stock and bond markets -- that are open to institutions. The economic and business factors that drive stocks and bonds also drive the VCs, and therefore must drive the start-up CEO.

Venture Money Surge Leads to Problems

Venture capital partnerships have been a successful way of investing institutional money over long periods of time (ten to twelve years) for at first a limited number of investors. But with success, more money and more investors have followed. This in turn has led to serious competition between pools of venture capital. Since the surge of funds began in 1984, there has been a dramatic alteration of the risk-reward ratio for high-tech start-ups.

The Venture Capital Journal reported that during the ten years since 1977 the total of annual additions to venture capital partnership pools rose fifteen times, from a rate of about $200 million per year to more than $3 billion annually. This produced an excess of available venture capital and failures by many venture firms, which was followed by recovery, the arrival of the Internet start-ups, and more than $6 billion invested per year in the 1990s.

The $40 billion venture pool of the 1980s grew rapidly the following decade. By 2000, the venture capital pool was estimated by some to measure nearly $1 trillion, certainly $100 billion. The firms representing the pool continue to be flooded with business plans. Such increases intensify the simultaneous competition among start-ups that aim their technology at the same new perceived market opportunities. One example was the personal computer disk drive business, which boomed in 1984 and then went bust along with many start-ups. Another example is the minisupercomputer market; Convex and Alliant made it to IPO, but veteran venture capitalist partners say that another dozen companies or so were floating around at the same time the managers of those two founding groups were knocking on doors seeking seed rounds of venture capital. Internet start-up plans have flooded venture firms since 1995. In 1995, Forbes magazine reported that at least thirteen business plans were circulating in Silicon Valley the same month to do the same thing: sell pet food and products over the Internet.

Another effect of the success of venture capital investing is that big corporations have vastly improved their ability to see, decide, and act on new market opportunities. The giants have learned to invest their own "corporate venture capital." Since 1981, the number of acquisitions of venture-backed companies has more than tripled. And pioneering leaders of established public high-tech companies have invented a new form of internal venture capitalism dubbed "internal start-ups" or "start-ins." These have created successful new enterprises, attracted top managers, and proved to be successful in competing for already scarce high-tech talent.

Result: Dilution, More Risk, Less Stock, Lots of Work

All of the forces just mentioned have increased the risk of failure of a high-tech start-up. Few if any other trends have emerged to offset this increased risk. Accordingly, investors have been following a trend of requiring higher and higher returns on the monies they have invested on behalf of their institutional clients. This means that less wealth is available to be shared by the founder and employees.

In modern portfolio terms, these trends have raised the cost of capital for the start-up. In more ordinary parlance, the founders have to give up a lot more of their companies today than they used to. Boom times appear to favor the founders, but over time the investors own the largest portion of the start-ups. In the 1970s it was not uncommon for investors to be in the minority. In the boom days of the 1980s start-ups such as Altos, Ashton-Tate, Microsoft, and Televideo went into business and retained 80 percent or more of their stock for employees and founders. After the bust of the 1980s, investors became the largest percentage owners. The explosion of Internet start-up deals in the boom time of the 1990s appears to have again changed the trend. Start-ups like Netscape and Yahoo went public very quickly, in less than three years, with investors owning less than 50 percent. Like the biotech boom days, some say the Internet IPOs were in essence a case of the public funding venture capital deals. With fewer em...