Repurchase agreements: what you should know before you sign May 7, 2010
Posted by Simeon Simeonov in VC, Venture Capital, startups.Tags: entrepreneurship, startups, Venture Capital, founder agreements, repurchase agreement, right of first refusal, ROFR, transfer restrictions
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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.Tags: entrepreneurship, startups, Venture Capital, VC, vesting, founder agreements, Dave Broadwin
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Following 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.
Personality test for entrepreneurs November 16, 2009
Posted by Simeon Simeonov in VC, Venture Capital, startups.Tags: financing, personality test, Series A, startups, Venture Capital
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I’ve had several interesting conversation following the article on negotiating a better series A deal. Entrepreneurs write and ask for advice on a specific situation. Unfortunately, it’s really hard to give specific advice in these cases without a fair amount of additional information. There are too many variables and a lot depends on the goals of the entrepreneur.
I wish there was a standard questionnaire, like one of those pop psych personality tests, that entrepreneurs can fill out to get the background information out. However, I’m not interested in whether someone wants to be an entrepreneur (they are rarely talking to me if they are not entrepreneurs already). I’m more interested in what they consider a success, what type of company they want to build, the impact they want to create, etc.
Here is some of what I’ve found.
Have you found a test you’ve liked? Have you seen a test that goes after what I’m interested in?
Comparing term sheets July 15, 2009
Posted by Simeon Simeonov in VC, Venture Capital, startups.Tags: financings, startups, VC, Venture Capital
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Jeff Bussgang did a guest post on PEHub on the topic of how entrepreneurs should look at and compare competing term sheets.
Jeff correctly points out that the pre-money valuation of the company is not what entrepreneurs should focus on exclusively because the pre-money includes an option pool, which is under board control. Instead, he suggests that entrepreneurs should look at “the promote” which is the ownership of the founders * the post money as an indication of how good a deal they got. In his example he compares a 6 on 7 offer with a 20% pool with a 6 on 9 offer with a 30% pool. The promote in the first case is $4.4M (34% of 13M post) and in the second it is $4.5M (30% of $15M post).
This all makes sense–focusing on ownership as opposed to pre-money valuation is important but I disagree that “the promote” is the key financial metric to focus on when comparing term sheets. The main reason for this is the obvoious but often forgotten point that nobody makes money on a financing (in early stage financings it is extremely rare for founders to be able to take some cash out). Therefore, what really matters is the value of the stake that founders are going to have at exit.
Typically, if things go OK, that’s ownership-at-exit * exit-value. Exit value depends on too many things to be predictable. However, the ownership at exit can be predicted to an extent. In a typical technology startup, on average, founders will experience 45-65% dilution before exit. That’s quite a range. Here are some rules of thumb related to financings for how to end up on the lower end of the dilution scale:
- Have large option pools–they protect everyone from dilution. If you take a term sheet with an artificially small option pool, it will have to be increased in the future and your ownership will be diluted. To take Jeff’s specific example, the second deal 6 on 9 with 30% pool is noticeably better than the 6 on 7 deal with the 20% pool even though the promotes are nearly identical because the extra 10% in the pool are insurance against another 10% dilution. In short, don’t get into deals because you feel you’ll own more of the company only to find out that you get further diluted in the future through option pool increases.
- Raise more capital and don’t spend it faster. In well-managed companies, there is a correlation between the amount of capital that is raised and the amount of progress that’s made, which, hopefully, results in an increase in pre-money valuation for the next financing round and hence less founder dilution. Even if they put just a little bit of money into your company, VCs will own rights that essentially give them substantial control over future financings. Don’t accept a deal just because you’ll own a lot after this round. You have to think about follow-on financings also.
- Pick the VCs carefully. Some firms and partners have much better brands and, other things being equal, are more likely to help you get great terms on a follow-on financing. However, there are circumstances where the VCs on your board don’t really have a great incentive to help you get a great price. The reasons are too complex to summarize here.
I advise every founder and startup CEO to have a good spreadsheet showing how every major shareholder is impacted in various financing and exit scenarios. When you put things down to numbers, it becomes much easier to understand why it is rational for certain parties to behave in certain ways.
As for comparing across competing term sheets, there is no single financial metric to focus on. You have to think about the overall financing model for getting to exit.
For the MIT 100K Participants: Executive Summaries February 11, 2009
Posted by Simeon Simeonov in VC, Venture Capital, startups.Tags: entrepreneurship, MIT 100K, startups, VC, Venture Capital
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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.
Should VCs Bet on the Idea or the Team? June 9, 2008
Posted by Simeon Simeonov in Polaris Venture Partners, VC, Venture Capital, startups.Tags: startups, VC, Venture Capital
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My partner Bryce Youngren pointed me to some research by Chicago GSB Professor Steven Kaplan who tackles the perennial question of whether one should bet on the jockey or the horse. The presentation, although meandering, does have some good data in it. Prof. Kaplan’s methodology is not perfect–his sample is biased to companies that have gone public but the rest of the analysis is thorough.
In the end, Prof. Kaplan concludes that at the margin one should invest in the idea and not the team, partly because a team can be augmented/improved while an idea is much harder to adapt. I would agree with this in general. One of the major values of a good investor is helping grow the team. I would, however, add a couple of caveats:
- Life is too short to back poor teams, no matter how good an idea is.
- Ideas are easily changed when a company is small and has little inertia. When there are just a couple of founders sitting around a table and the idea is on a beer-soaked napkin almost anything can change. The bigger the company gets, the more inertia it picks up and the harder it is to change what the company is about.
The best part about reading the presentation was discovering a wonderful quote from Warren Buffet:
When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.
I am an atypical VC. I specialize in partnering with entrepreneurs to help them create new startups. First and foremost, I look for ideas that can lead to very scalable businesses with solid economics. We work closely together for weeks or months tuning the idea. If the entrepreneur I’m working with can be a great startup CEO, that’s wonderful. If not, we jointly go out and recruit one.
