Portland Startup Tax – Bad Investor Behavior

I want to wrap up the discussion about the Portland “startup tax” with a focus on Portland investors. My last post outlined mistakes Portland entrepreneurs often make. Now I want to focus on bad investor behavior.

Most investors I’ve met in Portland have a horror story about getting stuck in a company that ends up going nowhere. Or, being in a growing company but getting washed out on a later round.  This has lead to a number of investor behaviors that often prevent good companies from getting access to growth capital.

Early stage Silicon Valley investors have developed entrepreneurial friendly investing behaviors that coupled with lean startup methodologies have proved extremely successful. Many of Portland’s bad investment habits hobble Portland entrepreneurs and add to the Portland startup tax. Here are a few practices Portland investors need to adopt to lower the tax.

Quick Diligence

Too many Portland investors see virtue in time consuming comprehensive diligence. Traditional business diligence looses its relevance with nimble, agile and lean early stage startups. Scouring existing financials and forecasts has limited relevance in a lean startup that depends on speed and agility. Plus the distraction to the founding team is costly.

Investors should invest in areas in which they have knowledge and are comfortable. It’s most productive to limit early diligence to the market space and the team. Most oving quickly and helping founders focus on the business.

Fund Fast

Many Portland investors are drawn to contingent funding. Forcing entrepreneurs to find additional funds is too often viewed as a test that lowers risk. I’ve seen several instances when entrepreneurs tie themselves up for months trying to find additional investment dollars so they can take down contingent investments. Rather than test, this can kill a company by exhausting entrepreneurs and delaying execution. If a company needs more money that an investor can supply than the investors should do their share to syndicate the deal.

Set Reasonable Valuations and Caps

Portland investors often force low valuations because they can. But, this can be counter-productive. Too much early low valuation money crowds a cap table scaring off later stage capital. Later rounds that leave the founders with too little ownership increase the execution risk (by demotivating and distracting the founders), limiting the upside for everyone. In Portland, this often drives early sales of companies even when they have tremendous growth potential.

Forcing low caps on notes is the same as setting too low a valuation. The idea of a note is to avoid pricing a round before there’s enough business to value. Investors should either use a note as intended – a quick lightweight way to bridge a company forward (with discounts and interest as the incentive). Or, they should price a Series Seed round. The cap should merely protect an investor from not appropriately participating in extraordinary appreciation. A note with a low cap can either telegraph a low valuation for a subsequent round or scare off investors with a inappropriate differential in share price.

Keep Terms Simple

Funding terms only get worse in subsequent rounds. Early multiples of participation, ratchets, anti-dilution ratchets and other onerous terms rarely ever go away. And although they may seem to favor investors, they can encumber companies and compromise the ability to raise needed capital and restrict strategic options. Early investors are most successful when they align their interests with the entrepreneur’s.

Portland’s seed and angel investors need to better partner with entrepreneurs. Putting a company in a position to find the best future investors optimizes returns for everyone. All behavior that slows a company, or attempts to protect the early investor from the entrepreneur essentially increases the Portland startup tax and limits everyone’s upside.

Taking Stock

I left my operating position in SweetSpot Diabetes Care a few months ago making this a natural time for reflection. I’m struck by how the arc of SweetSpot mirrors that of the Portland tech scene. We sold the company to Dexcom, Inc. (NASDAQ: DXCM) just over a year ago.  Dexcom has continued to invest in Portland, signing a long term lease and tripling the SweetSpot staff.

This is a great outcome for SweetSpot; its employees, investors and shareholders. We were one of several tech companies to sell in 2012, a sign that the Portland tech ecosystem has reached another level of maturity. We now need to move to the next level – a plethora of growth companies, big exits, IPOs, easier access to capital and, most importantly, local venture capital.

I moved to Portland in late 2005, but it wasn’t until 2008 that I stopped joining the flock flying south for weekdays. In 2008, it was clear Portland had the potential for a great Tech startup environment. Most notably we had an enviable influx of over educated young people. Driven by the quality of life, Portland had a burgeoning creative class, increasing ethnic diversity and growth in multiple industry segments. Most of all, Portland was, and still is, the most affordable West Coast metro. But it hadn’t seen significant Tech success since Techtronics spun out the Silicon Forest companies.

Many of us were frustrated with how hard it was to get a Tech company started, let alone built to scale. Everyone seemed to have a side project and limitless enthusiasm. Un-conferences and Legion-of-Tech events filled the calendar, but real startups were rare and funding was non-existant. SweetSpot was Adam Greene’s side project in 2009. When I joined Adam, we converted to a C Corp. But, beyond friends and family, we had to go to the Bay Area for Seed funding. We pushed hard to change things in Portland.

We pressured then Mayor Sam Adams to make money available for startups, an effort that lead to the Portland Seed Fund. Wieden and Kennedy took advantage of the excess tech talent by starting The Portland Incubator Experiment (PIE).  This provided a catalyst for startups, accelerators, incubators, and angel funding.

We now have a dozen active accelerators and incubators. These, plus independent entrepreneurs, are minting scores of viable startups every year. SweetSpot was part of over $400m in tech exits in 2012, up from less than $100m only two years earlier. We sold SweetSpot because Dexcom was a perfect match for us. Partly though, we sold because of the difficulty in raising venture capital.

There has been over $200m in venture capital invested in a half dozen Portland growth companies that are achieving significant scale. Silicon Valley is the source of virtually all this money. These investors (including Foundry, First Round, True, Sequoia, Kleiner Perkins, among others) are confident they can make significant money in Portland.

Now we’re poised to take the ecosystem to the next level. Some of these growth companies will see big exits and perhaps an IPO. It’s getting easier to get venture money, but 503 still doesn’t even show up in the nations top 25 venture capital area codes. Portland is the poster child for the Series A crunch with more than a 100 startups chasing virtually nonexistant early stage VC. Portland Tech companies will create massive amounts of wealth in the next 10 years. It’s an opportunity which needs better access to capital and that should include local money.

 

Don’t Be Fooled, VC Trends are UP not Down

Too much of the VC discussion focuses on low 10-year average returns – basically zero – and the deinvestment in Venture Capital as an asset class with the number of firms declining precipitously.

We’re at the beginning of an explosion of wealth creation from startups bringing mobile, social, cloud computing, connected things and big data to every aspect of our lives. The impact of these technologies and resultant shifts in business, commercial practices and consumer behavior is greater than that from desktop computing and the Internet. And like all swift technology adoption startups, not incumbents, will drive the change and reap the rewards.

To measure this impact, exit values are what matters. The upward trend of wealth creation is clear even before you adjust for strong countervailing factors: the over commitment of capital caused by the late 90’s exuberance; the concentration of IT spend for Y2K; and the retreat of capital from the Tech IPO market. When adjusted you see a liquidity ratio returning to 4+ and exit values trending to $80B with no top in sight.

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Mark Siegel at Menlo Ventures has it right, “this bodes well for returns going up”.