Seven Pitfalls for Entrepreneurs and How to
From Peter Stern, a founder of OFEFI moved to NYC twenty years ago to create a company around a new idea, something audacious, and I had no reason to think it would result in anything other than life-crushing failure. Despite everything we did wrong and a healthy dose of bad luck, it worked out rather well. We changed the world for the better, or so it seemed at the time, and made some money doing it...Read more»
Is OFEF the Best Way to Fund Your Startup?
From Peter Stern, a founder of OFEF
CMU’s Open Field Entrepreneur Fund, otherwise known as OFEF, was conceived as a way to help CMU alumni entrepreneurs. Jon Kaplan and I felt that CMU had great students, fostered incredible ideas, but lacked the startup ecosystem found in the vicinity of MIT, Stanford, and other top business and engineering schools. We felt that CMU alumni could achieve more, for themselves, for the economy, and for society, through their own efforts rather than “just getting a job.” How could we foster that? Jon felt that by adding to the pool of investment opportunities associated with CMU innovators, more startups might be fostered by CMU alumni. So Jon raised some money and created OFEF.
The idea behind OFEF is simple: create an evergreen fund that invests in startups that are founded by CMU alumni, and create a network of mentor-alumni to help these startups.
Of course, every simple idea gets complicated once you start implementing it. What is the definition of “founded by”? The answer is too complicated to put here. Who is eligible? Answer: someone who received a degree from CMU within the last 5 years. You also need to demonstrate that you can execute your idea (full-time commitment, ability to create a cogent plan, etc…) and raise some matching funds from an entity other than OFEF.
Unlike a VC or anything else I have heard of called a “fund”, OFEF does not exclude applicants based on ideas, market size, investment appeal, or the like. You must create a potentially profit-yielding entity, something that is incorporated. Non-profits are not eligible, nor are real-estate holding companies, etc… You can’t be trying to break any physical laws, but other than perpetual motion machines or Feynman ratchets anything goes. Laser toothbrush? Sure. Backyard bone-mapping software for dog owners? Probably. Drug delivery via mosquitos? You bet.
We want to help you with a bit of entrepreneur-friendly seed financing. Making the idea work is your problem.
From the beginning we needed to create an investment mechanism that matched OFEF’s purpose. Simple, low-cost financing that set the applicant on the best trajectory for success. We decided to use a fairly standard convertible note, widely used by early stage investors. A convertible note is simple a loan that converts into stock at some point in the future. It offers the investor no control, and there is no need to discuss the value of the investment, as that is determined at the time of conversion. I recommend Feld/Mendelson’s book “Venture Deals" for anyone wishing to understand how all this investment stuff works. They took the time to write down everything that I had to learn the hard way. They offer some thoughtful pros and cons on convertible notes. Brian Cohen is passionately against convertible notes, as I learned on a recent car ride through the Holland Tunnel at rush hour, but I have yet to read his book "What Every Angel Investor Wants You to Know".
If you decide convertible notes are not for your, then unfortunately OFEF is not for you either. I personally have found convertible notes extremely beneficial for both my angel portfolio and my own startups. For reason obvious and not-so-obvious, all OFEF companies have to use the same convertible note.
The OFEF note has some particulars that may or may not be right for your startup. We want every OFEF applicant to understand how this investment works before you apply. So, assuming you have already read Venture Deals, let me explain some details you should think about:
Timing: You need to have a plan for where your company will be in a year. We want you to move fast. We want you to be working hard to get your startup to the next level within a year, so OFEF has the option of converting the note in one year. This means that you should plan on having a conversion event, i.e., a larger funding event at a specific price, in the time frame. If you don’t have some other fund-raising event, OFEF can convert the note into common stock of your company, taking 5% for its initial $50K. This implies that after one year, your company has a value of $1 million dollars, which leads us to the next detail…
Evaluation: if after one year nothing has happened on the fundraising front, the OFEF note implies your company is worth one million dollars. Depending on what you are working, on this might be desirable. Many early-stage tech ventures, however, strive to be worth more than that in a year, as incredible as that may sound, and a million dollar implied cap is too low. Some founders feel this will impair their ability to fundraise after a year. This idea is debatable, but I already gave you some reading to convey the debate. OFEF is not going to negotiate the value of your new company. If you are the next big thing, and your company will be worth billions by next year, that is wonderful, and OFEF is not right for you. Understand this, though: we want you to raise money at a higher evaluation than the implied value in the OFEF note. OFEF is just a start. Our $50k is not going to get a serious venture very far. We want you to take our $50k, match it with someone else’s $50k, and get started creating something that is so fabulous that serious investors are crushing your desk with piles of term sheets in a quarter or two. Or, to pick a more modern metaphor, crashing your mail server. If that doesn’t happen, though, OFEF may own 5% of your company and create an implied evaluation of your company.
Control: Unlike many venture capital deals, OFEF does not want any control of your startup. We would like to give you access to our mentor network, we want to help you, but we do not want to be on your board, or to hold voting stock. If you ask us to be on your board we will decline. We won’t even offer advice on who should be on your board. However, we do think you should have a board, and that your board should not just be you and your co-founders, but include at least one outsider, i.e. someone who doesn’t work at your startup. In the OFEF note there is a requirement that within 60 days you will form a board with at least one outsider. For first-time entrepreneurs, forming a real board sounds intimidating, but it is simply invaluable. Serial entrepreneurs already have a board before they even apply, so this is never a concern for them. If you are serious enough to think about applying for OFEF, you should already be thinking about who you want on your board.
We created OFEF to be the most entrepreneur-friendly fundraising experience possible, and I think we have succeeded. It sure beats any fundraising Jon or I have ever done. Its not perfect for everyone, and we want everyone to make the best decision from their own perspective.
If you are a CMU alum, having received a degree within the last 5 years, and you have been dreaming of creating a startup, consider applying for OFEF. We look forward to your application!