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Repurchase agreements: what you should know before you sign May 7, 2010

Posted by Simeon Simeonov in VC, Venture Capital, startups.
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This is the second guest post from Dave Broadwin, head of the Emerging Enterpise Center at Foley Hoag LLP, in the area of founding agreements. Part one is on vesting and the other related posts are on improving the performance of founding teams, founder agreements and strategies for dealing with poorly performing co-founders.

Back by request, a post on repurchase rights and related concepts.  These concepts pertain more to companies that are not venture financed than to companies that are venture financed.  Why?  Because when VCs invest, they cover off all these concepts in their basic investment docs.

The issue sets up like this:  You and three friends (Mark, Luke and John) decide to form a company to found a new social network.  You have checked out what Sim Simeonov has to say about vesting, so you figure you have it knocked – until you go talk to your lawyer.

The first words out of his mouth are, “Well Matthew, what if Mark, Luke or John leaves the company and goes to the dark side?  What if one of them becomes disabled or dies or gets a divorce or goes bankrupt?  You might find yourself with a partner you don’t want.”

There are a number of ways of dealing with these issues.  They begin with transfer restrictions, move on to repurchase rights and obligations, go through a process for determining the purchase price and end up with an agreement around payment terms.  So let’s take the tour.

The tour is all about how to anticipate and prepare for the situation in which one of your co-founders leaves the business.  The far more common situation is that the founders come to a parting of the ways or they need to reallocate equity for reasons of nonperformance or noninvolvement and there is no agreement in place.  So, first a few words about that.

Equity Reallocation Without an Agreement

In my last guest post, I suggested that perhaps you would need a prescription for Nexium in these circumstances.  I repeat my suggestion.

In the absence of an agreement, you are going to have either a negotiation or you are going to have to dilute the departing or non-performing founder (or consultant or whatever).  It is hard to imagine a circumstance in which a negotiated result is not going to serve you best over time.  So, unless something about the situation or your lawyer’s advice dictates otherwise, your best course of action may be to have a come-to-Jesus meeting with the other person and explain what you want (i.e. a give up of equity either in the form of a simple contribution back to the company or a sale at some low price) and why it makes sense for the company as a whole and, therefore, for the other person as a shareholder.  If that works, go for a release while you are at it.  Your lawyer can help you with that too.

If the negotiated route does not work, you are going to be looking for ways to dilute the former founder.  Anything you might do here is fraught with potential corporate law and tax law consequences.  You should not start issuing shares or options without legal advice.  Just to make the point, if you issue yourself a bunch of shares, that could be taxable income.  Also, issuing shares at less than fair market value could be a breach of the fiduciary duty of directors and could expose them to a lawsuit from the disgruntled party.

All this, of course, argues that you should be prepared lest you end up in founder Purgatory or worse founder Hell.  So, now at long last, the tour:

Transfer Restrictions

Most stockholder agreements begin with the same basic commandment, thou shalt not “sell, assign, gift, loan, pledge, mortgage, hypothecate (that one sounds ominous), distribute, encumber, or otherwise transfer or dispose of “ thy shares, unless … There are really two points here.  First, you really can’t sell (etc.) your shares to anybody under any circumstances.  Second, is the stuff that follows the word “unless.”

“Unless” is usually followed by a variety of exceptions to the principle of no sale.  These exceptions include some, or all, of the following:  (1) pursuant to a bona fide purchase offer from an arms-length third party after first providing the company and/or the other stockholders a right of first refusal, (2) pursuant to bona fide estate planning (with the proviso that the recipients remain subject to the basic transfer restriction), (3) upon death or disability, (4) pursuant to a divorce decree or (5) upon bankruptcy.

Think about it this way:

Mark can sell his shares to Satan, but only after giving the company and the other Apostles a chance to buy them (usually on the same terms and conditions as offered by Satan).  Sometimes you see flat out prohibitions on sales to competitors.

Luke can put his shares in a trust for anyone he begets, but if he does that, the begotten can’t make further transfers unless they comply with the basic transfer restrictions.  Same result if Luke dies or becomes disabled and the shares go to some trust or other.

If John gets a divorce, then the shares can be transferred by court order in the divorce.  There is not much you can do about that, except get the spouse so sign something beforehand or provide for repurchase by the company and the other stockholders pursuant to some fair valuation.  Similar issue if John goes bankrupt (only the bankruptcy court has even more control than a divorce court).

Repurchase Rights and Repurchase Obligations

A departing stockholder may be required to sell and/or the surviving stockholders may be required to buy the stock of the departing stockholder.  This type of arrangement has the following results:

  • It may provide liquidity to the departed, depending on the price per share
  • It permits the surviving to retain 100% of the ownership
  • It prevents undesirables from becoming stockholders

You can also mix and match.  Under some circumstances you may want repurchases to be mandatory and not under others.  For example, stockholders often want repurchases to be mandatory upon death or disability because they foresee the need for liquidity.  Sometimes they want the right to be optional in the case of a sale to a third party because they don’t want the company (or themselves) to be obliged to make a payment they can’t afford but they need the security that they can prevent a sale to a competitor.  You want to consider the needs of the company and the stockholders to decide what works for you.

What is the Purchase Price?

There are probably as many ways of setting a price as there are people wanting to set one.  However, there are some that can be described as typical or usual.  In any event, they are more common than others.  These are (1) in the case of rights of first refusal, the price set by a bona fide third party offeror, (2) formula pricing, (3) appraisal, and (4) the mutual option method.  Sim has pointed out to me that he sometimes sees 409(A) valuations used to determine fair market value in shareholder agreements that apply to many shareholders.  While I can’t say that I have seen this done, I can see that it could have great appeal.  You will have an objective third party valuation.  However, these valuations sometimes seem low.  So, representing a senior exec, I might go for something else.

In the case of rights of first refusal, the right is always (almost always) the right to preempt the proposed purchase by a third party.  It seems inherently unfair to set the price at a number different from that which a bona fide willing third party has offered.  Enough said on this one.

Formula pricing offers the illusion of objectivity in the guise of ease of calculation.  Typical formulas are things like multiples of revenue or EBITDA or even, sometimes, book value.  Formulas can, and do, work well in situations where the company is well-established in an industry where companies typically sell on some established basis such as a multiple of EBITDA.  Having said that, this approach may not (almost certainly won’t) work for early stage companies or technology companies where there is real value in the technology.  If a company has no revenue, it will not have positive EBITDA or, frankly, any other balance sheet number that can be used in a formulaic way to set value.  But, this is not to say that the company has no value.  For example, the exclusive right to sell indulgences may not have achieved revenue, but it sure could have value.

Once you give up on formulas, the typical fall back is appraisal.  In my experience, clients like to go with a neutral knowledgeable outsider such as an investment banker to do the appraisal.  There are various methods of choosing the banker such as the parties agreeing or if they can’t agree after some amount of time, each picks one banker and the two so chosen pick a third banker who does the valuation.  This method can, of course, be expensive since the banker has to be paid.  Another possibility is that the independent directors (if there are any) pick.  I have even seen baseball arbitration used in this context.

A final method that I mention because it is used more often than I ever expect (which is not to say that it is used all that often) is the mutual option.  The way this works is that, at a stated time, either party may set a valuation and the other party may then elect to either sell at that valuation or buy at that valuation.  For example, in a simple case where there are only two founders, Luke and John, one founder, Luke, sets the valuation and the other founder, John, elects whether to be a buyer or a seller at that valuation.  If Luke sets the valuation too low, John will buy out Luke but if Luke sets the valuation too high, John will sell out to Luke.   This method pushes people to pick reasonable valuations because the risk giving away the store if they don’t.  It has other drawbacks, however, for one, it is difficult to make work if there are more than two parties.  For another, it favors the financially stronger party.  If one party can’t come up with the money to be a buyer, then they are likely to end up selling at a low valuation either because they themselves are constrained to pick low valuations or because the counter party figures it out and is artful about how they set the valuation.

In the End: Payment

In the case of rights of first refusal, usually payment must be made in the same manner as that which the third party buyer has proposed.  On occasion, however, thoughtful entrepreneurs take into account the possibility that a large sum could have to be paid in a short time frame and provide some sort of payout mechanism in the stockholder agreement.

Unlike the situation with a right of first refusal, in the case of appraisal and other valuation methods, the payment method should be set forth in the stockholders’ agreement.  Usually the stockholders agree on some portion to be paid at a closing and the rest to be paid over time.  Often the timed payment is in the form of a note that bears interest and may, or may not, be secured.

Dealing with Disputes

Needless to say, when these situations come into play, there are many opportunities for disputes.  It is hard to say anything good about disputes and how to resolve them.  Disputes among founders are almost always fraught with emotion.  This makes them very intractable.  Many people have tried to find cheap and easy ways to resolve disputes.  These ideas sometimes make it into shareholder agreements.  The typical approach is some form of non-binding mediation for some period of time followed by binding arbitration.  A lot of clients are of the view that this process will be less costly and less time consuming than a court proceeding.  They may be right, but it is really hard to know.  Also, there is the belief, which may not be correct, that arbitrators tend to compromise, compared to courts that just decide who is right and who is wrong, thereby reducing risk to all parties.  Again, this may or may not be true.  I am not aware of any objective evidence one way or the other.  Just to give you a rough sense, our firm handled litigation between founders, one of whom was a client of mine, that went all the way through a bench trial (it was tried before a judge and not a jury).  The cost for our client, who won the case in its entirety, was just under $250,000.  We handled a different case, also for one of my clients, where we hired a solo practitioner in California to handle the arbitration.  He agreed to take the case on a contingent fee basis.  Again, we won a sweeping victory.  The contingent fee lawyer got one third of $2million and this was on top of our hourly fees, which were trivial by comparison.  Keep in mind these are the costs of the winners.  There were approximately equal costs on the other side, and they both lost and paid material fees.

As you can see, my experience is that neither method, arbitration or lawsuit, is cheap or easy.  While I also believe that judges and arbitrators actually believe (and behave as if) they are in the business of delivering a just and fair result, irrational things creep into both processes and can affect the results.  For these reasons, I often advise clients that it is in their best interests to find a compromise before getting into a formal dispute resolution process.  Not to be too flip, I actually often tell clients that if everyone is equally unhappy with the result, then it was probably the right result.

One more piece of advice, and this is certainly self-serving, if you really are going to go all the way to trial (or its arbitration equivalent), don’t be penny wise and pound foolish, hire a good lawyer with experience in the type of dispute you are dealing with.  You will be dealing with enough risk; don’t add an inexperienced attorney to the mix.

As far as I know, Matthew, Mark, Luke and John are still together enjoying the fruits of their labor in heaven.  I don’t know what your chances of getting to heaven are but your chances of avoiding Hell are better if you think about and deal with founder issues at the beginning than if you don’t.

Let us know what you think in the comments or on Twitter @simeons and @broadwin.

Founder Agreements – Vesting, Vesting and more Vesting April 25, 2010

Posted by Simeon Simeonov in VC, Venture Capital, startups.
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9 comments

startup stock certificateFollowing my posts on improving the performance of founding teams, founder agreements and strategies for dealing with poorly performing co-founders, I continue to receive many emails at FastIgnite from entrepreneurs having difficulties with managing and formalizing the relationships with their co-founders. I reached out to my blogger friend Dave Broadwin, head of the Emerging Enterpise Center at Foley Hoag LLP, and invited him to provide his perspective in a series of guest posts of which this is the first. (No, it’s not legal advice.) I hope you enjoy them and follow Dave’s writing.

Some time ago Sim Simeonov asked me to write a guest post on the subject of founder agreements.  For one reason or another it has taken a long time to get it done.  In part this is because I broke my leg skiing and in part it is because the number of founders walking through our doors these days seems to be on the rise.  So the very issues that Sim wanted me to write about have been taking up my time.

As Sim has pointed out in his two prior posts (Ten Rules for Better Founding Teams and Startup Founder Agreements), there are a lot of different types of contracts that founders have to enter into in the course of starting up a business.  Most of them, though, don’t give lawyers a lot of heartburn.  That is not to suggest that they are not important or that you should not pay attention to them, but from a lawyer’s point of view, there is not usually, a lot of controversy around NDAs and the like.  Having said that, Sim has mentioned that he routinely asks for changes in standard forms of NDA in the areas of information management, protection, destruction and return of information.  While it is true that most companies are very reluctant to make changes in employment related NDA (and other) forms which they ask all their employees to sign, it is also true that with the rise of the cloud and other factors, these forms may be at odds with the way information is actually handled.  If you have a legitimate point, most tech companies will hear it – so don’t be shy.

The shoals upon which founders founder, seems to me to be first and foremost, the allocation of equity among co-founders, and secondarily the use of equity to pay consultants and other people providing services in the early stages of the business.

I have said this elsewhere, but it almost seems like a rite of passage that founders give away too much equity to someone who later does not perform (and, often, who leaves the business to pursue some other job and wants to keep the equity).  Somehow you then have to get the toothpaste back in the tube.  This can be an ugly process.

Here is a very typical (perhaps I should say archetypal) fact pattern:  Sally wants to start a web based company.  She needs some coding done for her web page.  She meets Harry.  Harry is out of work (having been laid off from MondoHuge Software, Inc.).  Harry, who seems like a charming fellow, has the time and, apparently, the skills that Sally needs.  Moreover, Harry professes to have had his fill of big companies and is ready to launch an exciting new start-up.  So, for a mere 25% of the equity, Harry agrees to do all the coding and have the beta ready in six months.

Sally and Harry enter into an agreement (in the form of a letter that Sally sends to Harry without running it past her attorney, Clarence Darrow).  The letter says something to the effect of Harry will be in charge of software development and will be issued 25% of the common stock right away.  The letter says nothing about performance expectations or what happens if they are not met.  The performance expectations are all in Sally’s mind.  Sally never considers what might happen if Harry does not perform, let alone what might happen if he leaves the company.

Harry is issued a nice shiny new stock certificate.  Everything is cool for about two months.  Then Harry, who unbeknownst to Sally has been looking for a job all along, gets a job offer from Ginormous Software Corp.  He takes the job and tells Sally that he is moving to the west coast to run Ginormous’ new Flash division.

It turns out that Harry only wrote a few lines of code and is not planning to give back the stock, which he feels is his (since he is a co-founder).  Sally then calls Clarence ”How do I get the stock back?”  Although he uses other words, Clarence is thinking “I hope you are taking the little purple pill because heartburn is about to become a part of your life.”

Since an ounce of prevention is worth a pound of cure, I am not going to write about how to negotiate with Harry under these conditions, rather I am going to write about the things you can do to avoid walking a mile (more like 40 miles) in Sally’s shoes.

To paraphrase the famous line from The Graduate “I have one word for you “vesting.’”

Sim has a lot of great things to say about vesting, but here is my take on it:

Every member of the team should be subject to vesting. Unless you are planning to go it alone, in which case who cares, every member of the team should be subject to some form of appropriate vesting.  Consider the divorce rate among practicing Catholics, and they are expecting to suffer eternal damnation if they break up.  Breaking up may be hard to do, but people do it a lot.  Like the Boy Scouts, Be Prepared, in case it happens to you.  If Sally had followed this policy, no matter how sure she thought she was about Harry, she would have been OK when he bolted.

Consider this, if Harry leaves with a big chunk of equity and won’t give all (or some) back, you are going to have to figure out how to dilute his position.  This means getting more stock into the hands of the remaining productive team members.  This topic is beyond the scope of this post, but you probably can’t just give everyone (other than Harry) a pile of new shares.  If you did, then everyone is likely to have phantom income equal to the value of the new pile of shares.  So, you have to consider options (which have other drawbacks).  You also have to consider the impact on your investors, if any, and what rights they have in connection with your issuance of shares and options.  Fixing the capitalization once the shares are issued and vested is hard to do.

Vesting should be part of an express agreement between the stockholder and the Company. No handshakes, vague understandings, or oblique references in emails, unless you plan to become part of AstraZeneca’s cash flow (they make the little purple pill).  Vesting can be made a part of a stockholder agreement signed by all stockholders.  One drawback of the collective approach is that it may be cumbersome or a diplomatic challenge to have different vesting schedules and arrangements for different stockholders.  Vesting can also be set forth (to use a lawyerly turn of phrase) in individual agreements.  This approach makes it easier to strike different deals with different people for whom different considerations might apply.  If Sally had a written agreement with Harry, she would not be looking for a scrip for the purple pill.

Immediate vesting is a bad idea.  By this I mean that all stock vests upon issuance.  The day after formation Harry gets to (a) keep all 25% and (b) leave for greener pastures.  Having said that, some level of immediate vesting is often appropriate.  For example, if the founders have been working part time for six months pulling the business together in their garage and they have real sweat in the business, a recognition of that contribution may be entirely appropriate.  This does not mean that everything should be fully vested right away.  Another common situation is when someone puts in actual money (in addition to sweat equity).  Stock that is bought and paid for probably should not be subject to vesting.

Time based vesting is often a good idea.  Time based vesting means that stock vests with the passage of time.  A very common scheme used in venture financed companies is four year vesting.  This typically has a one year cliff (after one year 25% is vested) and then three additional years during which stock (or options as is often the case in venture financed companies) vests ratable on a monthly or quarterly basis.  Companies that are not (or not yet) venture financed, often choose time based vesting in which stock vests ratable over three or four years beginning right away.  With this scheme, when Harry left to work for Ginormous, he would only have two months of vesting (way less than 25%).  One issue with time based vesting is that it does not take performance into account.  Often founders are reluctant to let people go, with the result that they time vest way longer than they should and they don’t deliver.

Milestone vesting is often a good idea.  With milestone vesting, stock vests upon achievement of stated milestones.  By way of example, 25% might vest upon shipment of beta with more vesting on final shipment and more on V2.0.  If Harry had agreed to milestone vesting, he would be leaving all his stock behind, which is probably the right outcome in the little morality play that this post is based upon.  One of the issues with milestone vesting is, of course, how clearly defined are the milestones.  If there is ambiguity around whether or not milestones have been reached then there can be disputes around that.  For example, if Harry is going to vest 25% on shipment of beta, maybe Harry will ship beta before it is really ready.  The only way to handle this issue that I have ever felt good about is to have very clear and unambiguous milestones.  The CEO of one of my clients has milestone vesting tied to specific revenue levels.  Now, you might think you either have the revenue or you don’t, but you can grow revenue by dropping price (and margin).  That is not what the board had in mind.  Now, in my client’s case it is working out because the CEO is not playing games, but not everyone could resist the temptation. Keep in mind, the company can play games too.  Unless you can find some measure that is truly clear and unambiguous, you reach a point where trust has to enter into the equation.  BTW, milestone vesting is also good for consultants and certain service providers.

Note that VCs usually insist on imposing vesting on founders in early stage investments (Series A).  Depending on a variety of factors a common approach is to let the founders have 25% to 50% fully vested and have the rest time vest over three years.  VCs see a lot more situations than you ever will.  There is a reason why they do this, even while they believe enough in the founder to invest millions.  Learn from them grasshopper.

Negotiation when you let someone go is the norm.  I have noted that often underperformers stay too long.  When you finally get around to terminating Harry, it could be before the cliff (assuming you have one) or after.  Particularly before the cliff (but it could be at any time) Harry is going to want to hang on to some options.  You should be aware that options are contracts, and like any contract, the option terms can be changed by agreement of the parties.  Option plans typically provide that an employee who is terminated, other than for cause, will have a period of time (usually 60 or 90 days) after termination to exercise vested options.  This means there must be some vested options and the employee has to be ready to stroke a check.  Sometimes neither is the case.  Rank and file employees typically have to live with the plan, whatever it says, but “senior” people often negotiate for some vesting and for a longer period of time to exercise.  I have not noticed that there is any standard length of time but perhaps a year is common for additional time to exercise.  Typically, the employee is looking for enough time for the company to reach some new valuation that will give the employee clarity as to the wisdom of exercising.  Also, with respect to the amount of vesting I have not noticed any “standards” – the senior employee gets what he or she negotiates.  My experience is that employees ask for the cliff (in a pre-cliff termination) and some portion of the remaining in a post-cliff termination.  Usually the company is willing to do something in a termination (other than for cause) and the negotiating space is not that great, so it is readily compromised.

Your board must approve option grants and changes to option terms.  This may be a technical point, but all option grants (including those promised to new employees when the come on board) and all changes to the terms of options (for example the negotiated changes that might happen on departure of a senior employee) must be approved by your board of directors.  The Delaware law reason for this is that you are, in effect, proposing to issue stock and that is the right of the board of directors.  For this reason, option grants in offer letters are often conditioned on board approval.  You must make sure you understand what your board will approve before you make offers.  Otherwise you could be embarrassed or worse.  From the employee’s perspective, you should get some assurance that the option grant will be considered by the board at its next meeting.  You might also want to get some assurance from whomever you are negotiating with that he or she has at least discussed the proposed grant with key board members and they are OK with it.

Once in a very dark blue moon, the bad thing happens: an employee or consultant is promised options subject to board approval and the board does not approve.  Consultants rarely protect themselves from this sort of thing.  I am not sure why – perhaps because they feel it is not diplomatic to suggest that they are not comfortable that the founder or CEO hiring them is not in sync with her board.  In any event, if you think you might find yourself in that position, you might suggest some alternative compensation that is not subject to board approval.  For example, in some cases CEOs have the authority to commit to signing bonuses.

As if that is not enough, investors (and this is absolutely true of VCs) negotiate for and obtain contractual restrictions on the issuance of options and the vesting and other terms upon which they can be issued.  Your grants must comply with your contractual agreements or you have to get a waiver from your investors.

The Internal Revenue Code will also have something to say about your grants.  I don’t want to go too far afield with tax stuff about qualified and nonqualified options, but I do want to note that Section 409(A) of the Internal Revenue Code has the practical effect of requiring that option grants be issued with an exercise price that is equal to or greater than fair market value on the date of grant.  If this stuff is of interest to you, check out Options and 409(A) – Sometimes the Law is an Ass.

Finally, and I hesitate to mention this because I am a lawyer and it will sound self-serving, but don’t be penny wise and pound foolish.  Consult with Clarence; have him review (preferably actually draft) the stockholder agreement.  It may be a sad life, but it is what he lives for.   In addition, he, like the VCs, sees a lot more deals than you ever will.

There are many other arrangements among founders having to do with stock and what happens if the founders come to a parting of the ways.  These include things like transfer restrictions, puts, calls, repurchase rights, mutual options and the various methods of valuation that go along with buying and selling stock.  These are beyond the scope of this post.  Also, they don’t typically apply to venture financed companies.  But, if there is sufficient indication of interest, I will write another post covering those items.

There will be more posts in Dave’s series on my blog. Let us know what you think in the comments or on Twitter @simeons and @broadwin.

Picking the ideal market size for a startup April 12, 2010

Posted by Simeon Simeonov in startups.
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1 comment so far

There may be some argument about this but I’ve read in a number of places that the fastest high-tech company to reach $1B in revenue was BEA Systems. How did they do it? They got big backers: a private equity firm called Warburg Pincus (incidentally, the firm behind Better Advertising, a company co-founded last year). BEA raised a lot of money. The first round was $26M. Upon launching they acquired several existing companies/products in quick succession: Information Management, Independence Technologies and Tuxedo. Later on they acquired WebLogic and many others. There is one other small detail: it was Bubble 1.0, the dawn of the Web. With all that cash, acquisitions and an environment where customers spent indiscriminately, it took them nearly six years to get to a $1B in revenue.

Look at it another way. Say your startup had $1M in revenue last year. It would take you five years of about 400% Y/Y growth to get to a billion. Well, you say, I don’t need to own the entire market, just be the gorilla. OK, to get to 30% of the market or $300M you’ll need over 300% Y/Y growth. To get “just” to $100M in five years takes 250% Y/Y growth starting from a million.

Statistically speaking, your startup is unlikely to grow this fast. And, statistically speaking, if you go about your business aiming to repeat the trajectories of outliers, such as BEA, you’ll end up in the dead pool.

The best early-stage entrepreneurs don’t care much about billion-dollar markets described by generic, fuzzy terms such as display advertising or consumer financial services. To them, such a market definition is an abstract notion, a vision to aim at, something to sell to investors and analysts. Investors and analysts love talking about multi-billion-dollar markets because it is easy to pontificate about the distant future using imprecise language. It requires but a vague understanding of technology, industry and customers.

What the best early stage entrepreneurs care deeply about are small, precisely-defined markets their companies can dominate. Very early on, they care about the one such market they will go after. They know that the antidote to being mediocre at many things is smart, pragmatic focus. In a startup, this automatically means not doing much and not caring much about a lot of things, such as the $123,456,789 of market opportunity your company is not going to go after this year while it’s tackling the precisely-defined market it cares about.

How big should your market be this year? Here is a simple way to guess at this:

  1. Take the important leadership metric (revenue, users, etc.) for your business.
  2. Decide where you want to drive this metric to in the next twelve months (M).
  3. Pick the smallest percentage (P) such that, if your company owned that much of the metric, you’d be the undisputed leader.
  4. The market size is about M/P.

For example, you are aiming at a monthly subscription run rate of $500K/mo in a year. In your market being the leader means owning 50% of the market. For your company to be doing $500K/mo ($6M/yr) in subscriptions with 50% market share, it must be operating in a market that is about $12M in a year.

Seems small, no? Just like any one gold mine may be small in proportion to the gold reserves in an entire mountain. More on this line of thinking in Geoffrey Moore’s and Steve Blank’s work.

What if you find (or think you have found) a much larger, homogeneous market where you have good product/market fit? Well, you can do one of three things:

  1. You can tighten your market definition. If you don’t know how to pick, make some hypotheses and test them. You are likely to find a sub-segment where you have lower cost of customer acquisition (COCA) and perhaps higher lifetime value (LTV) because of better product-market fit.
  2. You can consider ways of boosting the growth rate of the company, easing the critical constraints: hiring more people, raising more capital, partnering with or acquiring companies, etc. You’ll do this because you want to have a dominant share of this market.
  3. You can choose to not own a dominant share of the market. The question then is, who will?

Startup Founder Agreements February 22, 2010

Posted by Simeon Simeonov in VC, Venture Capital, startups.
Tags: , , , , ,
14 comments

I have been thinking a lot recently about how to apply agile development principles to investing and key aspects of startup development such as team building. That’s also the thread connecting my two recent posts on VentureHacks. Both stem from the agile principle of delaying decisions until the last responsible moment. The first post is about agile startup fundraising. The follow-on post is about agile startup team building. If you’ve read and liked these posts, let others know.

The same question came up a few times in different forms in the comments to the second post:

@Nivi

Simeon, can you tell us how you structure ownership and control so you can fire your co-founders if necessary?

This is a complex topic that has a business and legal side to it. I’m no lawyer, so I’ll look at things from a business perspective. I will mention legal terms and example language for illustration purposes only—for details, consult a lawyer. This isn’t just CYA. There are a lot of possibilities and variations that need to be thought through and for that you need legal and tax advice.

This post addresses the lifecycle of founder agreements and the key compensation and control parameters in them. A companion post suggests ten rules for building better founding teams.

Urban legends

Let’s start by dispelling some myths:

  • There is a standard founder agreement. Well, there is and there isn’t. Every major law firm and every VC firm tends to have some type of template. These templates can have meaningful variations, some of which are founder-friendly and some of which are not. Most partners, be they lawyers or VCs, tend to tweak the standard with their own language. Even if you are an experienced entrepreneur, you’ve probably only seen a few founder agreements in your life. Almost anyone can benefit from a great lawyer or an adviser who’s seen dozens of these from different law & VC firms.
  • All founders have the same agreement. Yes, it is convenient for all founder agreements to be based on the same template with the only difference being the number of shares. Don’t confuse a convenience with a requirement. In the last four companies I’ve co-founded, there were several founder agreement types. In two cases this was because of the special role I played as a part-time co-founder. In one case the CEO had a different vesting schedule because he had spent a lot more time than the rest of the founding team on the idea. In another case, for good reasons, four founders had three meaningfully different agreement types.
  • Founder status == founder agreement. Founding status can be bestowed on anyone. That’s a decision a founding team can make for many reasons. As long as the decision is public and definitive, from an external perspective there is no issue. This can be a convenient shortcut to separate someone’s status (founder) from their role (employee or contractor or advisor, etc.) and the legal documents specifying its rights & responsibilities.

Which founder agreement?

There are several critical points in a startup’s life when founder agreements are put together.

There tend to be verbal agreements between founders for a period of time before anything is put to paper. Lawyers tell me that in many cases verbal agreements are enforceable, especially if someone did work based on the verbal agreement. It helps to communicate and set expectations clearly. It also helps to have some discoverable record of the agreement. An email would do.

At some point pre-incorporation, the founding team may create a written agreement, often in the form of a letter. It outlines key points of agreement between founders around IP ownership, equity ownership, vesting, etc. The FastIgnite one is two pages. The goal of the letter is to be simple and readable so that everyone is comfortable and aligned on the main issues. Perhaps the most important paragraph is the pre-formation agreement. It requires the various parties to behave during incorporation in a way that effects the agreement. It can be something along the lines of:

Pre-Formation Agreement.  If the addressee of this letter consists of one or more individuals, rather than a business entity, the individual(s), by his (their) signature(s) below agree(s) that they will cause any business entity formed by them within 24 months of the date of this letter agreement to conduct business in the Field of Interest to enter into an agreement with me identical to this letter agreement, whereupon this agreement shall become void.  If such individuals do not form a business entity to conduct business in the Field of Interest, but instead sell or assign their developments and technology in the Field of Interest to an unrelated party, I shall be entitled to [this will vary based on the type of founder] of the net consideration received by reason of such sale or assignment.

Pre-incorporation, removing a founder is complicated primarily by the potential lack of clarity around his or her rights and obligations and hence the consequences the removal. For example, without a clear vehicle (a company) to contribute intellectual property into, a founder who walks away may mean that the future company won’t own its own IP. This is typically not a problem, unless the company becomes very valuable and the founder who walked away decides that she is owed something.

During incorporation, the couple of pages of this letter will be turned into somewhere between 20 and 50 pages of mostly boilerplate legalese. The number of separate documents may vary but they fall into two categories:

  • Those related to equity, typically a restricted stock purchase agreement (RSPA) and associated escrow and other agreements.
  • Those related to other matters: IP assignment, invention disclosure, non-solicitation, non-competition, termination, etc.

At this point, there is a precise, well-defined legal framework for resolving conflicts that can’t be addressed through other means. However, founder agreements are not set in stone and it is common for them to be tweaked by a little or a lot during the first financing by professional investors. How to handle that or avoid it altogether is something I’ll do a post on if there is interest. [more details]

Founder roles, agreements and removal strategies

Different founders contribute different assets and capabilities and can play multiple roles. Their agreements tend to reflect this and, hence, the strategies for a founding team to remove these founders differ. Note that investors have additional tools at their disposal but that’s a separate topic.

  • Employee. Compensation is a combination of cash (post funding) and common equity that is subject to vesting if professional investors are involved. There is some up-front vesting acceleration. The common number is 25% but, depending on the length of time and contributed resources, it can be up to 50%. (See my post on the best vesting schedule.) The rest of the equity typically vests monthly with no cliff for 3-5 years. Founders have rights as shareholders. They have voting rights which may entitle them to force or veto certain key decisions, e.g., hiring or firing the CEO, selling the company, raising money, etc. You need to understand the voting thresholds for key decisions and think very hard about whether you want to allow any one founder to have too much control. If you are the lead founder, this may not be an issue but it should be an issue for the founding team as a whole. Another issue to watch out for is any significant vesting acceleration on termination without cause outside of a change of control (an exit). A little bit is OK. A lot is unreasonable. Yet another issue is the price at which the company can repurchase unvested shares. To make this cheap for the company, you want the price to be the par value of the shares.
  • Investor. Founders who also invest get additional equity in the company with no vesting. Some get common equity for their investment. Smarter founders structure things such that they get preferred equity together with other investors. The smartest founders who put money in their own businesses put it through a separate preferred class of stock before other investors come in. As preferred shareholders they will have additional rights. With the right legalese, even a small shareholding can exert a huge influence and make it near impossible to remove the founder. The only way to remove their equity holding in the cap table is by buying them out or through a recapitalization of the company. In this case you have to consider whether they are common or preferred holders and, in the latter case, their anti-dilution protection, pay-to-play provisions and willingness to participate in the recap financing. A much better approach is to restructure their holding during an investment, at the point of maximum leverage.
  • Advisor. The structure depends on the nature of the advisory work. Very early on, if the equity ownership is small, the advisor equity may have no vesting. An example would be when someone gives you an idea and you run with it without their involvement. Typically, advisors tend to have shorter vesting periods (one or two years). If you like them and they have been helpful, you sign them up for another term. Sometimes, the vesting is milestone-based (upon the close of a financing) or performance-based (signing up customers, doing deals, recruiting). Advisors tend to have 100% acceleration on change of control. Typical advisory agreements have simple termination clauses. As long as that’s the case, there should be no major issues in removing an advisor founder.
  • Service provider. Like the advisor role, a service provider can do many different things. The difference is that there is some type of cash component or cash equivalent value associated with the services. There are multiple ways to handle this before the company has cash. It can be deferred, with or without interest, to be paid after a financing or once revenues start coming in. Alternatively, it can accrue into equity at some pre-defined price-per-share, usually the next round’s, perhaps with a slight discount. For example, you hire a consultant for five months at $10K/mo and then you raise $500K on $1.5M pre. For her services, the consultant will own common stock equal to $50K/$2M or 2.5% of the fully-diluted capitalization of the company. If equity compensation and vesting are aligned with how value is delivered, terminating a service provider founder should be no problem.
  • Board member. Board members differ from other parties in that they are purposefully difficult to remove. Therefore, they tend to worry less about vesting schedules. Founder directors often get the same initial acceleration as employee founders. They get 100% acceleration on change of control. Independent of shareholder rights considerations, whether it is easy or difficult to remove a founder board member depends on the rules of board composition. Be wary of board seats by entitlement. Rather than giving board seats to individuals, give them to (groups of) classes of equity and check whether the voting process doesn’t automatically give any one founder the right to be the board member. If a board member founder is not entitled to a seat, then there are various other processes described in the bylaws which may affect his removal.
  • Executive board member. Typically, the agreement is a mash-up of a board member and a service provider agreement. The usual role that fits this is a founding executive chairperson. Initial vesting typically matches employee founders. Further vesting accelerators are common, e.g., on follow-on financings or the recruitment of a CEO. The removal strategies are the same as for a board member.

The same person can be in multiple roles and may even have multiple agreements. While there are no “best founder agreement structures,” just as there are no best vesting schedules, there are certain principles of approaching founder agreements that can be helpful in building stronger and more agile founding teams. Read the next post in the series for ideas on how to build stronger startup teams.

Let me know what you think in the comments or on Twitter @simeons.

The entrepreneur’s dilemma January 22, 2010

Posted by Simeon Simeonov in VC, Venture Capital, startups.
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“The entrepreneurs dilemma” is a term that @azeem came up with in reference to a post on how to raise money without lying to investors on VentureHacks. The point I wanted to make was that entrepreneurs often have to chose between being honest about the future and hearing “no” from investors more frequently and being overly-optimistic in their outlook. On the surface, it may seem that the latter is a net win but that’s not true. Over-promising and then under-delivering can have big negative consequences.

As with many blog posts, the comments are very interesting. Here are some highlights.

Antone Johnson

Excellent article. As a lawyer, there’s only so much wordsmithing I can do in the financing documents to protect founders from their own promises that reflect unrealistic assumptions. Of course most financing rounds never lead to litigation, but if things crash and burn, and finger-pointing and recriminations ensue, I’d rather not have excessively rosy five-year financial plans floating around as Exhibit A for the plaintiffs’ lawyers.

Denny K Miu

I think bootstrapping is very important for both entrepreneurs and for the VC’s. In my experience, the only way to have a meaningful conversation with VC’s is when we are already shipping products. I usually don’t even prepare a separate PowerPoint presentation. Instead I start the company by saying, “Let me show you how I convince customer ABC to buy our product”. Life is good after that.

GK The pertinence of forward looking sales projections depends on the stage of the business. If you raise capital from investors who pretend not to understand this, you will be setup for financial incongruity.

Consider 5 distinct business stages:
1. Incubation
2. Build Product
3. Early-Adopter Success
4. Repeatable Sales
5. Scale the business

In (1,2) sales projections are useless, the time to prepare them is wasted effort.
In (3) sales projections are presumptuous; you have yet to comprehend WHY and HOW the buyer will commit.
In (4) sales projections become essential to internal planning.

Raising capital between stages 3,4, a 1-year plan is valuable, surfacing the right questions/equations within the business, and with potential investors. A 3-5 year plan is chimerical until stage 5 and the shift preceding it.

Competing for competition’s sake November 28, 2009

Posted by Simeon Simeonov in startups.
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I don’t agree with Vivek Wadhwa that losing a business plan competition is better than winning it. However, I do think that business plan competitions force many teams to aim for the wrong target. Here is the comment I left on the TechCrunch post:

I’ve judged the MIT 100K for many years and am currently an EIR at the MIT E-Center. The biggest problem with business plan competitions is that they skew incentives. An entrepreneur’s incentive should be to build a winning business, not win a business competition. Conversely, good business plan competitions should aim to help build great companies.

The benefit of business plan competitions is that they pace a team and force it to deliver on a schedule. Many teams benefit from that process and from the feedback they receive along the way.

The biggest problem I’ve experienced as a judge is that there is no diligence process. Judges are supposed to pick winners based on the claims of the entrepreneurs alone (and a bit of face-to-face time). Without diligence, the teams have an incentive to exaggerate as there is no penalty for slight exaggeration. Judges can only react to gross exaggerations. Teams that are in touch with reality, customers and that understand the challenges involved in building successful businesses have a higher likelihood of being subtly penalized during judging when reviewed alongside folks more likely to over-promise. No, it’s not easy for judges to correct for this.

The solution is to introduce diligence as an integral part of business plan competitions. The suggestion I made to the 100K was to organize a diligence team that runs alongside teams participating in the competition. The goal of the diligence team is not to poke holes at the entrepreneurs’ dreams. It is to make the teams and the companies they want to build stronger and more likely to survive in the real world. And, yes, in the end, hopefully more deserving companies would win and there will be a higher correlation over time between companies that win and companies that succeed. Wouldn’t that be nice?

Alas, the student-organized MIT 100K competition is finding little interest inside the MIT and Sloan student bodies to participate in the diligence process.

In the end, it is the entrepreneurs that lose.

The Cultural Revolution in Boston August 13, 2009

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Scott Kirsner writes about the cultural revolution in Boston and the evolving ecosystem that supports emerging entrepreneurs. He mentioned a few key resources and contributors. Two more to mention are MITX‘s work in the digital media world and MTLC‘s entrepreneurship cluster. I’m helping both with works in progress that will help the cultural transition.

IMO the transition has been happening ever since Bubble 1.0 in a less-visible manner. It was enabled by the radical lowering of the cost of development and deployment of Web-based solutions. That was important because it lowered the launch capital requirements and hence increased the pool of entrepreneurs who could launch. (Cloud computing and the bootsrapping ethos of Web 2.0 were additional accelerators.) It wasn’t until the spread of social media that the trend became more visible and allowed like-minded people to band together.

For the MIT 100K Participants: Executive Summaries February 11, 2009

Posted by Simeon Simeonov in VC, Venture Capital, startups.
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I was invited to speak tonight at the MIT 100K Web/IT track mixer but, unfortunately, I’m sick (which wouldn’t have necessarily prevented me from going) and have lost my voice (which would have made going to the event pointless). So, in exchange, here are some thoughts on the topic we were going to discuss at the event–the dreaded executive summary. I invite the 100Kers to comment liberally and we’ll get a discussion going.

Plenty has been written on how to write good exec summaries. The best article I’ve found is the one that Garage Ventures did. There is not much I can add about what needs to be in a good exec summary but I can share some “secrets” of how most VCs engage with exec summaries. Keep in mind that this is real world advice, which is not necessarily what you need to win in the BPC but then you are trying to build real startups as opposed to startups that win competitions, right?

VCs have a love/hate relationship with executive summaries. Actually, most VCs either love or hate them. Personally, I hate them. Most, even the ones by good teams, are terribly written so, statistically speaking, it’s a waste of my time to read them. If I was making an initial decline or investigate further decision on exec summaries alone, I wouldn’t have engaged with some of the great startups I know. Therefore, I prefer to look at a presentation and skip the exec summary.

Exec summaries are rarely read. They are skimmed, typically with the purpose of making a quick decline decision. Choose your words carefully. Don’t have extraneous content. Highlight key points. Use a graph or diagram, provided it would be self-explanatory to someone who knows nothing about your business. Use simple analogies that relate your technology or business model to successful companies. Be humble when you do that–VCs don’t want to see another startup which thinks its approach is analogous to Microsoft’s or Google’s or Facebook’s.

Be conscious of your goal. It is to get to the next level, ideally a face-to-face meeting. You need to sell enough to get there but no more. Don’t over-educate or over-sell. It will lead to a wordy and heavy exec summary. Avoid the common hyperbole such as “this is a $56B market” or “we have no competition.” Statements like these only make you look immature.

Be explicit about your team building goals. This advice is especially important for teams with fewer “done it before” execs. I think it would be fair to put MIT $100K team in this broad category. As a judge in previous years, I’ve been disappointed to see founding teams with too many chiefs (CEO, CFO, CTO, CSO, CMO, CPO, etc.) none of whom would be hired in those positions if the funded company were to do an executive search. VCs want to know that the founding team knows its limitations.

Tune your exec summaries for the investors you are talking to. Who said you should have only one version of the exec summary? Typically, a very early stage startup has a lot of options and its future will in some way be influenced by its investors. How you pitch to an angel group for a $500K seed investment is not how you’d pitch a VC with a $1B fund. The angel group and the large VC have different business models. They want to invest in different companies. In some cases, your company could be a fit for both, as long as you are flexible and open to the options, but your story needs to be different.

Under-promise and over-deliver. Do not make big claims in your exec summary, especially about the near future, unless you are absolutely certain you can deliver on them. For example, don’t say you’ll have a distribution deal with Large Vendor X negotiated in the next 90 days if the probability is less than 90%. You’ll likely be talking to VCs for many weeks or months. Your credibility depends on making promises and keeping them.

Good Time to be in a Startup January 10, 2009

Posted by Simeon Simeonov in startups.
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My co-founder & CEO of Plinky, Jason Shellen and Plinky advisor Vanessa Fox of Jane and Robot have been on and off the home page of CNN.com for a third day now. The article, with the slightly cheesy title “They Left The Corporate Cocoon to Blossom“, showcases several stories of entrepreneurs who left safe, well-paying jobs at large companies to start something new. Jason and Vanessa both left Google.

Staying at a large company during a recession may be safer but isn’t exactly safe nor is it full of opportunity. Large, public companies are overly influenced by the mood of public markets and hence by the macro environment. They can close or sell entire product lines or divisions. In an attempt to manage financial performance, most slow down innovation and substantially cut R&D (one of the key reasons why the quarterly focus of Wall Street isn’t great for US competitiveness).  This limits opportunities for organic growth and advancement from both an intellectual and career perspective. The prevailing philosophy is simple: first let’s stop the bleeding and then we can grow through acquisitions. When innovation and growth come back in, they come from the outside, again limiting the options for existing employees.

If you are a person whose skills are in high demand, you may be better off heading to a startup that has a couple of years of funding. Worst case, if things don’t work out and you need paycheck, you can always get a new job at a large company. During recessionary environments most large employers take the opportunity to upgrade their talent. The real question is whether you’ve forgotten how to work hard…

Embracing Students in High-Tech November 4, 2008

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Scott Kirsner looked at how trade associations in the Boston deal with student membership/participation in a recent post. I’m on the board of The Massachusetts Innovation and Technology Exchange (MITX), which he gives a B-. While I’m sure I agree with Scott’s rating system which compares apples to oranges, I am in total agreement with him that we need more focus on engaging students in and around entrepreneurial activities. In fact, this was a topic that led to a good discussion at the last MITX board meeting and we have some good ideas on how to make things better both through the work we do and through partnering with other organizations.