Saturday, May 20, 2006

Two contrasting views on exit strategies

Matt Inglot went to the Infusion Angels seminar -- I assume the one organized by the Entrepreneurs' Association on Wednesday in Waterloo -- and has written a very good summary of the talk. I wasn't there, but I had lunch with the Infusion guys in March and ran into them again on Thursday during the official opening of the Accelerator Centre. Infusion Angels is a new division of Infusion Development, a company based in New York and Toronto that is filled with UW grads and is now coming back to the area in hopes of funding the launch of a few startups a year here.

Matt says the Infusion presentation emphasized that the number one point that a VC wants to see covered in a pitch is exit strategy.

Which is interesting, and a little ironic, given what was said the day before the Infusion talk -- on Tuesday -- at a presentation hosted by WatStart by Derek Smyth, partner at Toronto-based VC EdgeStone Capital Partners.

Derek, who was a successful tech entrepreneur before becoming a VC, said that exit strategies are over-emphasized in business plans, and that when he and his partners make their case internally to invest in a company, exit strategy is a small consideration -- perhaps comprising a few sentences in the document they prepare for the other partners.

I won't pit the two comments against each other -- maybe if I had been at the Infusion talk and heard everything in context I would have interpreted it differently than Matt did (or not) -- but exit strategy is certainly not the main point you have to communicate to a VC. Market need, business model, and scalability all trump exit strategy by a wide margin.

Not that exit is immaterial -- I can think of one business plan I wrote where I thought the section on exit strategy was quite compelling. There were a couple of multinational companies that were snapping up -- by the dozens each year -- smaller companies in the market space being targetted by the company I was working with. I certainly made sure that this was outlined in the plan, and probably gave myself a virtual high-five when it was done. Unfortunately, this company had what may have been the most convoluted business model I've ever seen (despite my efforts to get them to change it) and the greatest potential exit strategy in the world can't overcome a business model where you can't figure out how anyone is going to make money.

In most cases, I wouldn't spend a lot of time at a seed stage worrying about exit strategy. It's good to present some plausible possibilities -- companies that you think might acquire you, and why. But it's not going to be the biggest hurdle you'll have to clear.

(Thanks to Ken Dyck for the link to Matt's blog.)

Thursday, May 18, 2006

Life after SCOTUS eBay ruling for "patent trolls"

My next column in Rex magazine -- coming out later this month -- is about patents and the RIM-NTP battle that became the most widely covered Waterloo Region business news story of all-time.

RIM's patent misfortunes have helped stir up an angry rabble demanding that something be done about patent trolls. Nobody knows exactly what a patent troll is -- from context, the only definition I can infer in many cases is "someone who holds a patent that we don't think should be enforced" -- but these days they seem to be ranked somewhere near steroid-using athletes on the most-despised list.

They're so hated that many wishful-thinking folks were eager to interpret a U.S. Supreme Court ruling earlier this week as a slam-dunk victory over the trolls. "Supreme Court buries patent trolls," proclaimed a Forbes headline.

Whatever patent trolls are, I'm sure they weren't pleased by the court's decision, but don't be fooled by reports of their interment.

The specific case that the Supreme Court heard was between eBay and MercExchange, largely over the buy-it-now button that eBay uses and MercExchange (and the U.S. Patent and Trademark Office) says it has patented.

Following the ruling, eBay is still on the hook for infringing on the MercExchange patents, it's still facing the uncertainty of whether a judge will impose an injunction, and it still has to pay MercExchange the full award previously determined by the courts -- tens of millions of dollars -- plus ongoing royalties. About the only thing that changed is that the likelihood of an injunction being ordered is now less than near-certainty. How much less? We don't know.

Four of the nine justices attached their names to an opinion that was sensitive to the issue of patent trolls and seemed to imply that entities that "use patents not as a basis for producing and selling goods but, instead, primarily for obtaining licensing fees" may be less entitled to an injunction than other patent holders.

The problem is, if that's their definition of a troll, then many university professors and individual inventors would have to be placed in that category. And it's a surprising definition because Supreme Court justices would have to know that holding a patent on an innovation doesn't entitle you to manufacture and sell it. For example, implementing your patent may require other patents which you do not own. If you can't license them, then you won't be able to manufacture products that incorporate your patent.

While it may seem preposterous that a non-operational entity like NTP can threaten the business of a multibillion-dollar corporation like RIM in its biggest market, I suspect that reforms that try to target trolls directly will fail.

Despite all the analysis and commentary that's been published on patent reform, no one has come up with a proposal that would clearly be an improvement on the current system. As bad as things seem to be now, they could be even worse under some of the reforms that have been suggested.

Wednesday, May 10, 2006

Getting more by giving up more

Rick Segal mentions the odious practice of some VCs to insist on participating preferred shares when they make an investment. As he explains, it can drive a wedge between the interests of investors and entrepreneurs, and leave company founders with little financial motivation to make a company successful (unless it can be a home run on a Barry Bonds scale).

As a VC, Rick says he will typically ask for non-participating preferred shares, which are much more reasonable. Tech Capital Partners in Waterloo goes a step further and will make an investment in exchange for common shares. There aren't many VCs who will do that, but for an entrepreneur it is usually ideal. You and your VC both own the exact same stock and will share the same reward down the road.

What this usually means is that you will have to give up a bigger piece of the company -- or at least, what seems today to be a bigger piece. That's why Tech Capital usually wants 50% of a company when making an initial investment. It sounds like a lot, especially if you have other offers that apparently ask for a much smaller percentage. But the important number isn't how much you're giving up now, but how much you'll get in the future.

Founders generally have an aversion to giving up a lot of their company. Of all the terms in a proposed financing, the percentage and the valuation are the two that grab entrepreneurs' attention. But they can be very misleading. You can create a spreadsheet and run a bunch of 'what-ifs' comparing what you'll end up with under various scenarios under common share, non-participating preferred, and participating preferred offers. Giving up what seems to be a bigger piece of your company will often actually give you a bigger return when there's money to be divided up.

Monday, May 08, 2006

Panel provides refreshing perspective on commercialization in Canada

I wasn't expecting much from the report of Canada's Expert Panel on Commercialization, published a couple of weeks ago. The group was put together by Industry Canada under the previous government, and I was anticipating yet another report full of ivory tower wonk-speak on commercialization.

Frankly, I had good reason to be skeptical. Whenever governmental groups or think tanks discuss commercialization, they usually completely miss the point that it's all about creating innovative products that succeed in the marketplace. If these groups aren't superficially discussing far-too-tidy concepts like "technology transfer" and "receptor capacity" that should have been retired from our lexicon over a decade ago, they're usually providing some useless 30,000-foot-high analysis of the wonk's favourite chimera -- Canada's productivity gap. Policy makers seem to eat that stuff up with very little critical thought.

But the Expert Panel surprised me. It integrates products and market demand into its definition of commercialization, and acknowledges that it is "fundamentally a private sector activity." It sees universities as a vital part of developing commercialization capabilities, but without making the common error of treating them as if their purpose is to create commercializable technologies.

It's a refreshing perspective, and one that I hope policy makers will listen to.

The Expert Panel's first recommendation is the creation of the Commercialization Partnership Board (CPB). We should have someone looking at these issues on a continuing basis, and the Expert Panel emphasized that the CPB must be rooted in the marketplace and led by someone from the private sector. A good proposal, as long as those principles are followed.

After that, the recommendations are divided into three categories: talent, research, and capital.

Under talent, other than proposing that Canada should do more to attract skilled people to the country (okay), the recommendations only address students and recent grads. This doesn't go deep enough into the issue. There's a wealth of people in Canada with expertise useful in commercialization, but improving access to this expertise isn't addressed in talent section of the report. The role of service providers and other entrepreneurs offering commercialization services is hardly discussed at all.

The Expert Panel wants to provide an incentive to companies to hire people with research capabilities (in science, technology, or business) -- especially firms in industries that don't commonly hire people with those skills. It proposes the creation of fellowships that would significantly underwrite the cost of hiring a student or grad. "Reduce the risk by allowing firms to 'test the waters' and discover the value ... [of] highly qualified workers" [Boy, what a pompous label that is. Does that make other employees unqualified or not-so-highly qualified?]

Students and recent grads are not commercialization experts (and so, in fact, are under-qualified workers ... maybe we should go with that tag). We hope many of them will develop that expertise over time, but it's not something you receive with your degree, or that comes from having taken a course.

The Expert Panel may be placing students and grads in an unfair position where the weight of demonstrating the value of "highly qualified workers" falls entirely on to them and their inexperienced shoulders. Students can do a lot, but when you target companies that are skeptical of the value of these employees and, therefore, require a government subsidy to pay for them, you're setting students up to fail with some unrealistic expectations of what they can achieve.

And every student or grad who gets hired by one of these companies because of the government subsidy is taken away from whatever company they would have worked for without the financial assistance. We need to see more discussion around what firms would qualify for the program and what impact this could have on those that don't.

Providing help to start-ups and small companies is at the heart of two of the three recommendations on research. (The third -- proposing the creation of a $250 million-a-year "commercialization superfund" -- isn't described in enough detail for me to comment on.)

The Expert Panel wants to help start-ups at the proof-of-concept or proof-of-principle stages, and recommends increased spending on IRAP, an Industry Canada initiative that has delivered a lot of value to early-stage companies. Good idea.

Another proposal would see the government make it easier for small companies to receive market research and marketing support -- something that is definitely needed.

In the section on capital, the Expert Panel wants to improve access to angel financing, something that has long been a challenge. It suggests the creation of government-funded community-based funds that would co-invest with angels. That could be an excellent idea, and it's similar to something I've been trying to create with Communitech (except I was looking at getting VCs to provide the funding).

I think the Expert Panel puts too much faith in angel investment networks -- which have largely been a flop in Canada, and I'm skeptical of how effective they've actually been anywhere (whenever someone does a story on angel investment groups, they always talk to the people who run one ... who amazingly always have great things to say about them. But ask entrepreneurs and VCs, and you'll get a very different view, and one that I now lean toward).

The Expert Panel would also like to see the government change the tax laws to encourage foreign investment, and wants a review of how well the Canadian VC community is meeting the needs for expansion capital.

A lot more needs to be done to refine these recommendations -- which come with a very heavy price tag of $1.1 billion a year (which means they're unlikely to be implemented anytime soon -- the new Industry Minister says he's looking forward to reviewing the recommendations). But this was a significant improvement over what we've seen in the past.

Can Windsor use a non-snub to energize a focus on innovation?

OMG, did you hear? There's a new $100 million "Innovation SuperCorridor" initiative from the province introduced in the budget...