Thinking About Dilution

January 19, 2012

By: Paul A. Jones

For most entrepreneurs, dilution is an ugly word. Being diluted, after all, is about giving someone else a piece of your business. All other things being equal, that’s not a good thing. That said, for entrepreneurs that need third party risk capital to fund their business, dilution is inevitable. And (the silver lining in the dilution cloud) not always as bad as it might seem.

Entrepreneurs facing dilutive events typically have two concerns, both related to a reduction in relative ownership of the business: loss of management control and a diminished share of the “upside” if the business succeeds. Let’s look at control issues first.

Fear of losing management control to investors is something that keeps a lot of entrepreneurs up at night. Too often, though, the fear assumes that there is some magic number – usually 50% ownership – around which control pivots. Alas, it is not anything like that simple. The (possibly disturbing) fact is, an owner of the smallest fraction of a company’s equity (indeed, a creditor without any equity stake at all, though that is a matter for another blog) can have de facto control of a company’s management. And, indeed, venture capital investors with minority ownership positions almost always have substantial management control, as for example rights to prohibit strategic transactions (e.g. sale or merger of the business), limit future sales of equity, etc. well beyond those rights they would enjoy from a simple “who has the most shares” analysis. The devil, in terms of management control, is in the fine print of the deal terms, not the gross percentage of equity owned. The take home here is that control in venture backed startups is more a function of the (hopefully thoughtfully negotiated) finer points of the deal terms than simply a function of who has the bigger/majority equity interest.

As for dilution reducing an entrepreneur’s share of the upside, by definition, an equity investment involves some grant of interest in future profits and/or exit value to the investor. (For purposes of this blog, we’ll assume that the investor’s stake is commensurate with its ownership stake, though it need not be: while an investor’s ownership stake is less likely to diverge significantly from the investor’s ownership share than its control rights, such discrepancies are not uncommon, if not usually as significant.)

Now it is fair enough to say that giving a third party any stake in the ultimate equity value created by the business necessarily dilutes the interests of the prior stakeholders. But the story is more complex than that. Taking on a new investor is a priori (if not always a posteriori) a classic win-win proposition. More specifically, the investor is investing because he believes that the investment will grow in value, while the entrepreneur is accepting the investment ( and dilution) because she believes that the value of her diluted share of the post-investment equity in the business will exceed the value of her (undiluted) pre-investment equity. Unless both parties anticipate a wealth enhancing proposition, there won’t be a deal.

The win-win story is most easily understood in the context of an “up” round: that is, where the new investor pays a higher price than the prior investors. So, for example, an entrepreneur who owns say 50% of a business where the previous investor paid $1.00 per share is demonstrably wealthier if she takes on an additional investor at $2.00 per share even if doing so dilutes her ownership down to 25%. In fact, her wealth (even if not her liquidity) has been doubled (she now owns the same number of shares, each of which is worth twice what it was before the investment).

The $1.00/$2.00 example above does not mean that an entrepreneur should always accept dilution if doing so would increase her wealth. It may be that while the $2.00 offer doubles her wealth, the ownership stake she is selling is worth more than $2.00 to some other investor. What the example does illustrate, though, is that a dilutive event can also be a wealth enhancing event. Indeed, even in a down round scenario (say the price goes from $1.00 to $0.50 per share) the entrepreneur should only accept the dilutive event if she feels that her diluted ownership stake after the investment will be worth at least as much as her undiluted stake if she forgoes the investment.

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Posted by pajones1

It Takes More Than Grey Hair

December 13, 2011

By: Paul Jones

One of the more pernicious mistakes many less experienced entrepreneurs make is assuming that successful “big business” executives are as a rule well suited to managing smaller high impact businesses.  It’s a pernicious mistake because few things can derail an otherwise promising startup faster than putting the reins in the hands of a poorly suited, even if highly decorated, big company manager.  It is a mistake I once made at one of my own startups, and one that I have seen others make too many times.

There are several reasons big company executives – not all of them, but a lot of them – fail when they transition to the startup world.  Most are related to the notion that managing a startup typically involves making “bet the company” decisions more often (as often as daily, and seldom less often than monthly), with less information, in less time, and with less input from appropriately experienced colleagues, than managers of larger, more established businesses.  Another startup attribute that can flummox big company executives is a culture that places much more emphasis (and reward) on rapid identification of mistakes, and much less on assigning blame for them.  Finally, most big company executives come from a world where the risk reduction paradigm is based on diversification, while for most startups risk reduction is based on focusing limited resources on a very narrow front (albeit one that can change overnight: see above re “bet the company” decisions).

None of this is to say that good big business managers are as a rule not well suited to be good managers of startups.  The point, rather, is that the demands of the jobs – and thus the skill set for doing them well – are different in the two worlds.  Some folks can transition from one world to the other, some folks can’t. 

Of course, figuring out whether a particular big company manager can succeed in the startup world is the real trick.  On that score, I have yet to find a sure fire test.  In my experience, one good approach is, once a candidate has passed the blush test and knows a little bit about the opportunity at hand, to ask her “so, tell me, if you were to start tomorrow what would you do first?”  Look for an answer that focuses on action, not analysis.  Look for a “take charge” attitude: avoid, at all costs, a candidate that looks like a deer caught in the headlights.  Another good approach is to emphasize how, well, broke the company is, or will be soon, without new capital or new/accelerating revenue – and how little the company spends on support staff and services.

If my suggestions seem inadequate, well, they come from experience as an entrepreneur hiring my replacement as CEO.  He had all the right industry experience and networks, and the grey hair to go with it.  If only we had asked him what he would do on his first day at the office, we might have learned about his need for an Executive Assistant, and his passion for good HR policies – as, for example, a standard, monthly process for recognizing the birthdays of the various members of the team.  If we had, we might have avoided making a fatal mistake.

 

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Posted by pajones1

What’s in a Name? Protecting Your Start-Up Trademarks

September 28, 2011

By: Jeff Peterson

Most new business ventures are started around a new idea.  The business focuses on a new product, a new service, something that will set the business world alight with the new idea and creativity that the business will bring to the marketplace.  The initial focus of new companies, rightfully so, is on the development of these new products and services and how to best to commercialize them in a competitive marketplace.  Unfortunately, businesses often tend to neglect another key aspect of their company’s property, namely, the intellectual property they have in the name of their company or products themselves.  Oftentimes, the initial inquiry around a new company’s name in today’s markets is whether the domain name is available for the name.  Companies often fail to do more in-depth trademark clearance searches on both the company name and any new product names which will be used in the marketplace.  Just because a domain name is available for use does not mean the company is free to use that name as the name of their business and/or their products.  Other parties may have trademark rights in that name, even if they do not have the domain name registered.  Selecting a trade name for a new company that is both available and strongly protectable can lead to an invaluable asset for the company as it grows in the marketplace.  If a new company does not do the appropriate due diligence on the selection of their name it can lead to painful and expensive name changes of either the company and/or products down the road if problems arise. 

Choosing a name
Oftentimes, a new company will choose a name which is somewhat descriptive of the new goods and services that they will bring to market.  For instance, “Quality Lenses”, or “Optic Technologies” may provide the commercial impression to consumers that the company is related to optical lenses but the marks themselves are so descriptive that any proprietary enforceability around such trademarks would be relatively weak.  This is because, in general, descriptive marks are not available for trademark protection.  Only when a mark has  been used for a long period of time and acquired so-called “secondary meaning” will courts find that descriptive marks, i.e., marks which describe a characteristic of the product or services, are afforded trademark protection.  The term “secondary meaning” stands for the principle that even though the mark is descriptive, the mark has been so widely used for such a long period of time that consumers recognize that the mark has another meaning beside the descriptive one, namely, it is an indicator of a specific source for the good or service associated with the mark.  Therefore, some of the best marks for choice of the name are fanciful or arbitrary marks that do not relate to the product or good themselves.  “Apple” for instance has nothing to do with computers or electronics.  Another good choice for a mark would be a mark that is suggestive of the good or service associated with it.  “Greyhound” for bus transportation is suggestive because a consumer may envision that the bus travels as fast as a greyhound dog.  Selecting a mark that is either arbitrary, fanciful or suggestive, but is not directly descriptive, can provide a business name or product name in which a company can strongly enforce if any competitors enter the marketplace using the same or similar brand.

Clearing the proposed name
It is important for any new company to make sure that the proposed name they are choosing to do business as is free and clear to use.  This clearance must not only be considered for the goods and services the business is planning on offering immediately but for any future expansions either in goods or services and/or geographical areas that the business is planning on expanding to in the future.  Certainly, checking domain name and corporate name availability at the corporate name registration level is appropriate.  Additionally, a company should make sure no other state trademark registrations or federal trademark registrations have been filed or registered on the same or similar mark.  Additionally, a search should be done to determine if any local businesses in the geographic area the company is operating in have been conducting business or offering products using the same or similar mark.  If such pre-existing companies have been conducting business under the same or similar mark, they may have common-law protection for the mark, even if they don’t have a trademark registration.  Working with legal counsel to perform a legal clearance search of the names is something that should strongly be considered by any new company to make sure that their proposed business and product names are available for use. 

Protecting the trademarks
Once a company has selected their business and product names, and have cleared them in a search, the next step is for the company to decide how to protect their new brands.  Fortunately, unlike patent protection, some level of trademark protection is available without undertaking any additional legal filings or expenses.  Just the mere act of using a business or product name in public, in association with marketing goods or services, is enough to obtain common law trademark protection for the mark.  Common law trademark protection is a right under state law and gives a company proprietary rights to prevent others from using the same or similar mark in the same geographical areas that the company uses the mark.  Obviously, the weakness of common law protection is that the protection would only encompass the geographical areas that a company has actually done business in.  In order to obtain more robust protection, a company can register their trademark with either the state or the federal government.  The rights granted with state trademarks vary from state to state, but generally provide the registrant similar protection to common law protection.  Federal trademark registration, however, gives presumptive nationwide rights in the use of a company’s trademark once it is registered.  Once a trademark has been registered with the United States Patent and Trademark Office the owner of the registration is, with few exceptions, the only one who may use the mark in the United States in conjunction with the goods and services for which it is registered for.  Trademark registration may be applied for at any time – even before the mark is in use.  This allows the company to reserve rights to the mark before the associated company name or product is introduced.  Before a final registration can be secured, however, the mark must pass through the registration process and be used.  The registration process can take upwards of eighteen months.  If a new company has enough financial resources it is always a good idea to try to establish a federal trademark registration at least in the company’s name to provide ample opportunities for that company to expand on a nationwide basis while preserving their right to use the mark and enforce it against other parties.

Best practices
No matter how small a new business is, they should always take the time to perform a clearance search in some aspect of the business name to make sure that there are no overlapping domain names or trademarks which would place restrictions upon how the company gets to use its name in commerce.  By performing a clearance search and picking a strong distinctive name, a new company should not run into any major issues which prevent them from using their brand in the future and will provide adequate protection to prevent others from using any brands developed by the company.  No company ever wants to have to change its business name and being forced to change something as important as the company’s name or the name brands of that company can easily spell the end of a new business.

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Posted by jdpeterson2

Navigating Wisconsin State Income Tax Credit Incentives

September 14, 2011

By: Hamang B. Patel

A business executive can be excused for not knowing which of the various state income tax credit incentives is appropriate for his or her company.  At first blush, the various tax incentives all seem to be similar.  The following summarizes the various income tax incentives available to a company to expand operations in Wisconsin, and explains how a company would want to choose from among these programs.

Four Main Programs
There are four Wisconsin income tax incentives available to companies that seek to expand activities inWisconsin, which are the following: 

1.         Economic Development Tax Credits;

2.         Jobs Tax Credits;

3.         Relocation Tax Credits; and

4.         Enterprise Zone Tax Credits.

Many business owners are familiar with the Wisconsin Angel Investment Tax Credits (commonly known as “Act 255 Credits” after the statute creating the program several years ago) and the Early State Seed Investment Tax Credits.  A key thing to remember is that these two investment tax credit programs provide tax credits to investors seeking to invest in a company, which is a good way to assist a company to raise capital from investors.  However, these two programs don’t directly provide tax incentives to the company itself. 

There are also other tax credit programs that are specific to certain industries (e.g., credits for dairy, meat processing, food processing, woody biomass, film production manufacturing, etc.).  For the moment, let’s focus on the four major programs described above that can directly incentivize a company’s expansion plans without regard to industry type.

Economic Development Tax Credits
In 2009, Wisconsin(recognizing that simplicity is welcome in the business community) condensed five overlapping tax credit programs into the Economic Development Tax Credit program. This program provides a nonrefundable state income tax credit for certain types of economic development projects.  This program provides tax credits for companies that: (i) create jobs, (ii) invest in equipment or real estate, and/or (iii) train employees.  For job creation, the credit ranges from $3,000 to $7,000 per job depending on the salary paid to the full-time employee.  For capital investment, the credit can be up to 3% of the investment in equipment and 5% of the investment in real property.  A credit for employee training is up to 50% of the training costs.  These credits are typically less $3M per company, unless special approval is provided by the state.  In 2011, the state increased the aggregate amount of tax credits that may be allocated to all applicants by $25M.  Further information is available here. 

Jobs Tax Credits
Available for the first time last year, Wisconsinprovides a refundable state income tax credit specifically for creating jobs in Wisconsin pursuant to the Jobs Tax Credit program.  The credits are up to 10% of new full-time employee wages.  New jobs must pay annual wages of at least $20,000 ($30,000 depending on the classification of the county or city) but not more than $100,000.  The total amount of these credits available to all applicants per year is $5M.   Further information is available here . 

Relocation Tax Credits
In 2011, Wisconsincreated a new nonrefundable state income tax credit known as the Relocation Tax Credits program.  These credits are available for a company that moves at least 51% of its workforce payroll or at least $200,000 of wages toWisconsin from another state or country.  The credit equals the company’s totalWisconsin income tax liability (after taking into account all other credits, deductions and exclusions).  The credit can be claimed for two consecutive years, beginning in the year the business relocates toWisconsin. 

Enterprise Zone Tax Credits
In 2011, Wisconsinexpanded the Enterprise Zone Tax Credit program to allow up to 20 “zones” (up from the existing 12 zones).  The zones are created at the discretion of the Wisconsin Economic Development Corporation (the “EDC”), taking into account the area’s economic need.  Although not self-evident from the statutes, in practice a “zone” has been the area around a particular company’s facilities rather than a broad area.  So in practice, this program should be thought of as an incentive for a particular company’s expansion plans.  A company receiving these credits should make a significant investment in jobs and/or capital.  Our discussions with EDC staff suggests that projects that would receive these credits are for those that create or retain 800-1,000 jobs in Wisconsin and/or invest $80M – $100M of capital investment.  Several refundable state income tax credits are available under this program.  For job creation or retention, the credit is up to 7% of wages in excess of $20,000 ($30,000 depending on the classification of the county or city).  For job training, the credit is up to 100% of the training costs.  For capital investment, the credit is up to 10% of expenditures.  A final credit is equal to 1% of purchases of goods or services fromWisconsin suppliers.

Certification
To obtain any of the credits described above, a company needs to get certification from the EDC prior to starting the job creation or capital investment upon which the credits will be computed.  Certification is a competitive process and depends on the allocation constraints of the EDC (i.e., how much of the limited credits remain available).  Our experience with the EDC is that certification for a credit also depends on the quality of jobs created (i.e., whether the jobs are low-wage or transitory) and, for nonrefundable credits, whether the company has taxable income to use such credits.  The EDC has also told us that while there is no statutory prohibition against double dipping to obtain multiple credits, the EDC would never in practice certify a company to receive multiple credits for doing the same thing.  For example, the EDC wouldn’t certify a company to receive the Jobs Credit and the Economic Development Credit for creating the same jobs.  On the other hand, the EDC has told us that it might be possible for a company on a case by case basis to be certified, to get the Jobs Tax Credits for creating jobs and also to be certified to receive the Economic Development Tax Credits for other activities (e.g., capital investment or employee training). 

Choosing Among Programs
The EDC will ultimately choose among the above described incentives that are available/offered to a company.  Nonetheless, a company would need to know which incentive to push for.  The following lists some of the factors that should be taken into consideration from the perspective of the company.

1.         Tax Appetite.  The obvious difference among these programs is that the Jobs Tax Credit program and the Enterprise Zone Tax Credit program provide for refundable credits.  Thus, if a company doesn’t have taxableWisconsin income that can be offset by these credits, the state will literally send a check in the mail to the company for the unused portion.  In contrast, the Economic Development Tax Credit program and the Relocation Tax Credit program offer nonrefundable credits.  If the company doesn’t have taxableWisconsin income that can absorb the credit, it would have a preference for the Jobs Tax Credit or Enterprise Zone Tax Credit.

2.         Size of Project.  Based on our discussions with EDC staff, the Enterprise Zone Tax Credits is not for small projects.  Thus, unless a company is planning a major job creation or capital investment program, the company is unlikely to be certified to receive Enterprise Zone Tax Credits. 

3.         Quality of Wages.  For some programs, the level of wages for new jobs created must be above a certain threshold (e.g., Jobs Tax Credit and Enterprise Zone Tax Credit programs) due to statutory requirements.  Unless the expected jobs exceed this threshold, such programs can be disregarded.  For the Economic Development Tax Credit program, which allows tax credit solely due to capital investment activities, our experience is that if the jobs resulting from or saved by the capital investment are not well paying jobs (e.g., migrant workers earning minimum wage), then the EDC is unlikely to certify the program for credits.

The economic value of these tax credit incentives can be powerful.  A company considering a business expansion would be advised to spend some time evaluating the various state incentives and contacting the EDC to see if any of these incentives are available.

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Posted by hamangpatel

Serious Patent News: Some Good, Some Not So

September 7, 2011

By: Paul Jones

Any day now, the Senate will likely pass the America Invents Act, with the President’s signature promised shortly thereafter.  The Act will make the most sweeping changes to United States patent law since at least 1952.  By moving the United States from a “first to invent” patent paradigm to a “first to file” paradigm it will align the country with the vast majority of other nations, and will most likely substantially reduce costs associated with documenting and litigating “who thought of it first” questions.  It will also likely impede the formation and growth of innovative technology-driven startups in the United States. Whether that is a good trade off is something reasonable folks can disagree on.

The new “first to file” paradigm has some undeniable advantages; advantages that to some extent will have their most positive impact on smaller entrepreneurial innovators.  Historically, and I can attest to this from personal experience over 25 years of working with emerging technology businesses, the detailed record keeping programs associated with the first to invent paradigm trip up startups and smaller firms more often than they trip up the big players.  And even when a small firm has a plausible “first to invent” case, it often lacks the financial and other resources to make it effectively.

So much for the plusses of the new first to file paradigm. 

In terms of negatives, any good handicapper would have to say that startups and other smaller firms are going to lose more first to file races than they win, for two reasons.  First, they often lack the technical resources to move as fast as their larger and richer competitors in terms of taking an “aha” moment to a robust patent filing.  Second, they typically lack the deep pockets and intellectual property resources of larger businesses, which also make timely, robust filings problematic.  While the net negative impact on innovation by startups and smaller firms of the first to file paradigm can be debated, I have yet to see a cogent argument that the impact will be anything but negative.

As for me, I like the certainty – at least as to ownership – of the new first to file approach, and the likely reduced operating and legal costs associated with that.  And harmonizing United States patent law with the rest of the world has some intrinsic appeal.  Time will tell, though, whether those plusses are worth the price in terms of how the change will likely impact the amount of innovation in the United States.

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Posted by pajones1

Pondering the First Mover Advantage

August 22, 2011

By: Paul Jones 

The so-called “First Mover Advantage” is one of those terms that invites both passionate devotees and passionate skeptics.  The “FMA” posits that an entrepreneur who gets to market first – with a novel technology or business model – has a sustainable competitive advantage over competitors that should predict ultimate victory.  It is a theory that explains a lot: Yahoo!, for example (or even Lycos, if you prefer).  Of course, it doesn’t explain Google quite as well.

The FMA was particularly popular in the internet bubble at the turn of the century.  In those days, convincing a venture capitalist that you had a real FMA would get an entrepreneur most of the way to a term sheet with most venture capitalists.  The term has been in and out of favor since; in when it seems to work, out when it doesn’t. 

My own thinking is that the FMA is a pretty good analytical tool in so far as it goes.  By that I mean that it is best understood as one-half of a much more instructive tool, which I will call the “First Mover with the Most Advantage” or “FMMA.”

Credit for FMMA probably goes best to Confederate Civil War General Nathan Bedford Forrest.  Forrest was a spectacularly successful cavalry general who won many victories over superior forces employing a strategy that he is famously remembered for saying was based on the notion that the force that “gets there first with the most” generally wins the battle.  That was almost always Forrest.

As applied to technology and business model innovation and success in today’s world, FMMA reminds entrepreneurs and investors that being first to market is by itself not the proverbially “sustainable unfair competitive advantage” that venture capitalists and business theorists are so fond of.  Getting to market first is quite often an unfair competitive advantage, but by itself it is not sustainable as such.  Being first to market with a new technology or business model is only a sustainable advantage if you get there with sufficient resources to capitalize on your position.

The real, but ultimately not unlimited, value of the FMMA tool can be seen in the development of the internet search engine business.  Going back to the 1990s, a number of search engines that look more or less like Google in terms of technology and core business model (Google has obviously broadened the model beyond basic search, as have its competitors, and the technology has evolved) got started, including Lycos, Infoseek, Magellan and Yahoo!.  Of these, Lycos could best stake the claim to the FMA in 1994.

But as history tells us – and the FMMA tool might have predicted – Lycos did not emerge as the winner of the first internet search war, but rather Yahoo! did.  Why?  Because Yahoo! was the first company to get to the market first with the most in terms of resources beyond basic technology and business model innovation.  Resources like superior marketing, and the most capital.  Resources that allowed Yahoo! to be the first of the first generation search engines to reach a critical mass in terms of brand recognition and value.

The Yahoo! experience tells us two things about the FMMA strategy.  First, the obvious one: that being first is not by itself enough.  You also have to be recognized and appreciated as such, and that takes another set of resources and skills, and generally lots of them.  Second, and if you keep in mind what happened to Yahoo! when Google came along, you will also see that FMMA can be a sustainable competitive advantage over time, but that as a tool it is only as durable as the management team that wields it.  It is only an advantage, not a guarantee. 

In terms of modern examples of FMMA at work, take a look at the ecoupon business, where Groupon can I think fairly lay claim to FMMA status.  It is clearly the big dog in terms of resources (brand recognition and value, as well as capital and revenues), and if the ecoupon business model has legs, Groupon would have to be the favorite to emerge as the dominant player.  But the favorite in a race still has to run the race, and run it well.  Favorite status is not a sure thing (Forrest got there first with the most and still, occasionally, came up short of victory; ditto Secretariat, the greatest thoroughbred of all time, who in fact did lose a race once).

In sum, the so-called First Mover Advantage is, for starters, incomplete.  Being first is great, but the advantage goes to the entrepreneur that gets there first with the most.  It is also an advantage that can be sustained – or not, depending on how well it is employed over time.

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Posted by pajones1

Startup Valuation: Sometimes Less is More. Part I.

August 2, 2011

By: Paul Jones

A good rule of thumb when you are selling something is to sell it to the highest bidder.  Alas, if you are an entrepreneur selling a stake in your startup company, this seemingly self-evident rule is subject to a number of exceptions, large and small.  In this first installment of a couple of blogs exploring startup world exceptions to the higher is better rule, we’ll be looking at one of the biggest and for some entrepreneurs most frustrating exception: what we’ll call the “Over Zealous Investor” exception.

Of the more frustrating experiences of my 25 years in and around venture capital, among the most frustrating is the otherwise interesting deal that prices itself out of the capital markets.  It goes something like this.  A usually less sophisticated entrepreneur with an at least fundable idea but little else finds some usually even less experienced investor willing to buy in at some outrageous price.  Like, say (you can’t make this stuff up) $100 million pre-money for a somewhat generic IT idea.  The entrepreneur takes the money, uses it more or less wisely, and through hard work and determination gets the company to the “next stage” where it needs more funds – but is now worth, in the minds of more sophisticated investors, say, $2-5 million on a pre-money basis. 

Or would be worth $2-5 million but for the fact that the over zealous investors already in the deal paid $100 million.  With that baggage, it isn’t worth the paper the entrepreneur’s new PowerPoint presentation is printed on. 

Now you might think that the losers here are the over zealous investors who overpaid, and you would be right.  But so, too, is the entrepreneur, who can’t raise more money because she took too high a price early on.  And so, even, are the investors who would be very interested in the deal at a $2-5 million admission price.  It turns out, in practice, that the initial investment was such a good deal for the entrepreneur that … everyone ends up with nothing.  Thus the Over Zealous Investor exception: an entrepreneur who lets less sophisticated investors pay a scary high price for a deal runs a very high risk that when more money is needed no one (unless the initial folks want to poney up) with any brains is going to provide it.

In this situation the “sell to the highest bidder” rule led the entrepreneur astray because it brought a bunch of people in to the company as shareholders who (i) clearly (consider the price they offered) had no business making the kind of early stage high risk investment they made, and (ii) probably are the kind of people who would make good plaintiffs if the company and some group of new, smarter investors made a success of the business – albeit one that would almost certainly not, in retrospect, justify the early investors’ $100 million valuation.  To put a finer point on it, no sophisticated investor is going to come in and wash out the prior investors and – management has to remain incented – jack up the shareholdings of the founder and/or management team for the simple reason that if they do that they are inviting the wrath of the earlier investors.  Such wrath often taking the form of an expensive, time and energy-wasting lawsuit of uncertain outcome.  As I have heard at least one top tier investor say about a company with a Over Zealous Investor problem, “I wish we could do this deal, but life is too short, and, as you know, there are too many other fish in the ocean.”

So, if you are an entrepreneur with a good, fundable idea, the first exception to the “sell to the highest bidder” rule of thumb is “don’t sell if the price offered doesn’t pass the blush test” (which is to say, could you look a judge in the eye and say the price was reasonable without blushing).  When you break the Over Zealous Investor rule you all but eliminate bringing in smart money down the road.

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Posted by pajones1

Entrepreneurs, Investors and Board Meetings: What’s the Right Balance for Start-Up Companies?

June 7, 2011

By Paul A. Jones

Meetings are seldom fun, and board meetings are no exception. Moreover, meetings have a mostly deserved reputation for being unproductive wastes of time and talent. Still, some meetings – including board meetings – can’t be avoided, even by the most social-network enabled start-up entrepreneurs and their investors. So, given that board meetings are going to be with us whether we like them or not, let’s look today at the question of how often should you have them. I’ll talk about board meeting preparation and content in a later post.

While generalizations in this area can be problematic, my own view – based on having been both an entrepreneur and an investor in start-up technology businesses, as well as a counselor to such entrepreneurs and investors – is that most early-stage, tech-driven business should, at least for the first year post-funding, hold regular board meetings on a monthly basis, and that board members within a couple of hours drive time to the company should make every effort to attend in person.

Now, monthly meetings may seem like overkill, particularly if, like me, you dread attending formal meetings, and think of the start-ups anti-meeting culture as one of the things that give entrepreneurial firms a leg up on their more established and bureaucratic companies (most of which hold board meetings no more often than quarterly, or maybe bi-monthly). So, what gives? Why should entrepreneurs who are rightly skeptical of meetings generally want to have more board meetings than their more established competitors?

Several things come to mind. One is the fast-pace of start-up living. Start-ups can – and do – move faster than more established firms. Internal developments, product development, for example, is less predictable in terms of both substance and timing. And even if the external market doesn’t change faster for the start-up than for the more established company, the impact of those changes is often greater on the start-up, and beyond that start-ups are usually on a steeper market knowledge learning curve than the more established players. In short, time is even more of the essence for start-up than for more established companies, and that is one reason start-up boards should as a rule meet more often than boards of later stage companies.

Another reason start-ups should meet more often has to do with the expectations of inside and outside directors in terms of the role of the board and, most importantly, the value add expectations for outside directors and the need for time establishing good working relationships among directors, particularly between the insiders and the outsiders on the board. As noted above, things tend to move faster in the start-up world. Further, important strategic and significant operational issues tend to come up more often. And, finally, even if the financing dance went well, it is likely that it left the entrepreneur and investor(s) a little unsure about each other and, in any case, a bit up in the air in terms of what to expect from each other, in terms of information sharing and value add abilities and expectations. More regular meetings, particularly in the first year or so post-funding, can help address both of those challenges, and in the process foster better intra-board relationships and trust, as well maximize the value add of outside directors.

Finally, more regular board meetings can help a company establish and institutionalize more efficient and productive communications channels among inside and outside directors. The process of preparing for board meetings on a more regular basis – a sometimes frustrating process for senior managers with what seem like obviously more important ways to invest their time – can itself help both inside and outside directors “find their way” in terms of the appropriate timing and sharing of information about the company and it’s business and technology environment. Over time, as intra-board communications become both more routine and less formal, the regular board meeting schedule can be cut back.

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Valuation of the Company vs. Valuation of the Stock: A Venture Capital Paradox

June 3, 2011

By: Paul Jones

One of the first things entrepreneurs learn about venture capital speak is the significance and difference between pre-money valuation and post-money valuation. These are the terms that VCs use when talking about how much a company is worth before and after a round of financing. While investors in public companies tend to think of valuation in terms of how much one share of stock costs, VCs tend to think of valuation in terms of what percentage of the total ownership of the company they can buy for how much capital. So, for example, if a VC buys 1/3 of the ownership of Newco for $1.0 million, the “post-money” valuation is 3 * $1 million = $3 million and the “pre-money” valuation is $3 million – $1 million = $2 million. If say $2 million bought ¼ of the company the post would be $8 million and the pre would be $6 million.

Another thing entrepreneurs learn pretty early in the VC courtship ritual is that VCs typically get some form of “convertible preferred stock” in exchange for their capital. In the most general of terms, “Convertible Preferred” is a kind of stock that (i) has some extra rights that make it “better” than common (for example, liquidation and dividend preferences, the ability to prevent Newco from doing certain fundamental things like selling the company, etc.) and (ii) is optionally convertible into common stock by the holder at pretty much any time, and can be automatically converted in some instances (typically in connection with an exit transaction where the company is sold or completes an initial public offering at a sufficiently high price). Most often, the conversion rate is 1 to 1: that is, one share of Convertible Preferred converts in to 1 share of common. (The rate can be more or less than that, and can change over time, but neither of those facts changes the fundamentals of the analysis in this blog.)

Alas, these two concepts – pre/post-money valuation and Convertible Preferred – combine to create what looks like a valuation paradox. Let’s consider our $1 million for 1/3 ownership investment. And just to make the math simple, let’s say that the investor bought 1 million shares of Convertible Preferred for $1 each with a 1 to 1 conversion ratio, and the founders own all 2 million shares of common stock. In this situation, the post money is $3 million, right? And the 1 million preferred shares are worth $1 million, right? (Right in both cases.) So the 2 million shares of common stock must be worth $2 million, right? And each of the 2 million common shares must be worth $1, right?

Actually, in both the later cases, no. The common is not worth $1 share – how could it be worth as much per share as the Convertible Preferred, which can be converted to common at any time and has a bunch of special rights that add more value to it? If not a problem, we seem to have at least a paradox.

What is going on here? How can both the pre/post money valuation formula work AND at the same time the Convertible Preferred and Common stock have different values? Let’s try and hash that out, starting with the difference in value between the Convertible Preferred and the Common stock. As to the Convertible Preferred, the price, when it is purchased by a third party investor in an arms length transaction (in this case $1) is, by definition, the fair market value of the Convertible Preferred. Which means that the value of a Common share, at the same time, must, given that it lacks various valuable features of the Convertible Preferred, be worth something less than $1. How much less? Well, that depends. Since no one – or at least no third party in an arms length transaction is buying any at the time – it depends on what the Board of Directors, in good faith, determines it is as, for example, when it issues an option to buy such shares to an employee at what the Board says is the then fair market value of a Common share of stock.

Ok, at this point we know that a Common share is worth less than a Convertible Preferred share, and that the fair market value of the Common share is what the Board says it is. How should the Board determine the fair market value of a Common share?

In theory, the answer is simple; in practice, not so much. In theory, the board should (and any good board resolution purporting to establish the fair market value of a Common share will) “consider all relevant factors” to conclude that such value is less than the $1 value of the Convertible Preferred and more than $0. In fact, most boards will want to set a low value on the Common (to make equity incentive shares cheaper for employees and others getting shares of options on shares as an incentive to make the company succeed), but not so low as to attract the attention of the IRS, which is anxious to tax people who acquire assets, including stock, for less than it is worth.

In practice, there are some informal rules of thumb that tend to apply to very young and immature companies, and some explicit IRS/SEC rules that come into play for more mature companies. So, for example, a brand new startup like Newco might reasonably conclude that the value of a Common share was 1/5 the value of a Convertible Preferred share – which is to say the Common share has a fair market value of $0.20. No legal opinion is expressed here, but trust me: lots of companies have said as much without incurring the wrath of the IRS.

Ok, let’s go with $0.20. What, then, is the value of all of the stock – which is to say the value of the company? Well, there are 1 million shares of Convertible Preferred worth $1 per share, which is $1 million of value. And there are 2 million shares of Common worth $0.20 per share, which is $400,000 of value. So the total value of all the shares is … $1.4 million. Which is to say less than ½ of the post-money valuation of the company! Houston, we have a problem.

Or do we? Ok, there is a seeming paradox, but is there really a problem? I don’t think so. Because while the fair market value of the common might, at some level, seem like a more or less arbitrary determination of the Board of Directors, in fact it has to be something less than $1 in the example. And if it is anything less than $1 we will arrive at a total value of all equity that is less than the post-money valuation calculated by the VCs (and typically accepted, in normal conversation, at least, by the management/founders of Newco). The problem – perhaps a better word is artifact – is with the pre/post money concept.

And this is it. Buried in the pre/post money calculation is a very important assumption; namely that the VC post-money calculation assumes that the company will have a favorable – e.g. north of $1 per share (and probably at least 3x or more of $1 per share) – exit price when the company is sold or goes public. In which case all of the Convertible Preferred will convert into Common – and suddenly the assumption that they are worth the same amount … works.

It’s not elegant. It’s more than a little arbitrary and capricious. But it (more or less) works.

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Compensation for Directors of Startups

June 2, 2011

By: Paul Jones

One issue that comes up fairly early for most start-ups – certainly by the time of the first outside funding if not before – is how members of the Board of Directors should be compensated. Every situation is unique, but what follows is my take on the generic question.

As a preliminary matter, Directors can fall into several categories, and compensation is most often tied to those categories. Inside directors include the founders and management team. Investor Directors are those who are associated with, or themselves are, material third party investors. The classic example is a director who is appointed by and affiliated with a venture capital investor or angel investor group. A significant “lone wolf” angel investor would also fit here (more on that later). Finally, everyone else – typically people who bring industry expertise or contacts, or are mentors for the management team – is pooled together as Independent Directors. Independent Directors may have made small investments in the business, but are not significant in terms of their capital contribution.

Ok, what do all these folks get for their Board service?

Let’s start with the easy ones. Insiders typically get nothing for their service on the Board. These folks, being founders or members of the management team, are already well compensated for their service. Being on the Board is a reward (of sorts) in itself, and simply goes with the territory.

Investor Directors are more or less in the same boat. They are by definition material investors (or represent material investors) in the business and serving on Boards of portfolio companies is part of their job, just as part of the CEO’s job typically includes serving on the Board. If the investment does well, they will be amply rewarded by the people or fund they represent.

That leaves the Independent Director. The easier cases, here, are the truly independent director who is not affiliated with or representing an investor group and has made no independent investment, or has made only a token independent investment. Depending on level of experience and perceived value add, these folks may get something in the twenty-five to two hundred basis points range – something between 0.25% and 2.0% of the equity, typically vesting over two years. Beyond expense reimbursement, you should not have to pay these folks any cash compensation (beyond expenses), at least not until the company is actually generating cash in the business.

While these are good general rules, there are some common situations that sometimes don’t fit within them so easily – or at least the Director in question might think they don’t. The first of these situations, and the easiest to deal with, is the “superstar” director. For example, if Steve Jobs tells you that he is really excited about your iPhone applications company and would be willing to serve on your board of directors for a hefty chunk of equity, don’t feel bound to tell him that the most you can offer is two hundred basis points.

In my experience the most contentious Board compensation issues arise when a Director affiliated with a fund of some sort, typically a group of angels, wants an independent equity stake for serving as a Director. My own view, and I think the majority view in the major venture capital centers, is that these folks are in the Investor Director camp and should not “double dip” in terms of their equity compensation. If the angel group they are affiliated with wants to provide them with some deal specific incentive compensation they should do it by carving out a piece of the equity they purchased. That said, in tight capital markets; in places (like Wisconsin) with limited risk capital access in even good times; or in situations where the capital-affiliated director is in fact going to be an active contributor above and beyond the level expected of the typical outside director, this is an area where entrepreneurs are often either (i) forced to cave on the principles of the matter to get a deal done in the first two cases, or simply recognize the realities of the situation in the later instance. If the “independent investor” insists on compensation, try to keep it under 100 basis points.

Board compensation for start-up companies is as much art as science, and the above guidelines are just the thoughts – albeit based on 25 years in and around these deals with multiple experiences as an Inside, Independent and Investor Director – of one man. But as a starting point, I think they will serve startup companies well.

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