Month: May 2007
As we continue our series on Compensation, let’s look at some recent compensation trends. In general, while compensation is on the rise, the rate of increase slowed between 2005 and 2006. Founder compensation (in whatever role they play) is rising faster than non-founder compensation. There are some theories on this including (a) founders are becoming more savvy about their compensation packages and (b) there is increased competition between VCs for good deals and one way to win deals and keep founders happy is to pay them more (as Brad’s 18 year old niece likes to say – “well duh!”).
Non-founder CEO compensation has been fairly consistent for the past three years while founder CEO comp is up. As companies mature, these numbers tend to converge, although in general non-founder CEO’s make more cash comp – usually because they have significantly less equity – than founder CEO’s.
Comp for financial executives – both founder and non-founder – is on the rise. Double digit increases in cash and equity compensation for the past three years is not irregular.
Engineering and technical executives have seen a small rise in cash comp over the past couple of years, but equity has remained relatively stable.
Sales executive compensation has remained relatively flat. That being said, our experience is that they are making more incentive and commission compensation which follows the general macro economic uptick the U.S. has seen the past couple of years.
Marketing and business development executives have seen a steady increase in compensation over the past couple of years. Cash comp is up in the low double digits and equity about the same. With companies generally performing better than in past years, they are spending more on marketing and business development functions, as opposed to fulfilling these roles with a combination of the CEO and sales.
One other trend is the apperance of the “management carve out.” Given the recent past of tough times for start ups and dilutive / recap financings, many companies were left in a position whereby the management and employees did not own sufficient equity in the company to keep them motivated. In some cases, they owned plenty of equity, but due to large amounts of capital raised and the VC’s liquidation preferences, their equity was out of the money in any reasonable liquidation scenario. To solve this issue, investors and management developed the concept of “management carve outs” whereby the employees would receive a certain percentage of proceeds on a liquidation event (usually 5-10%) on top of anything they would receive for their equity. In essence, these employees were receiving a liquidation preference that sat along the liquidation preferences held by investors. As general economic conditions improve, these are becoming less common, but are still a valuable tool to keep management and employees incentivized.
Q: Have you experienced a company which grows along nicely, but does not offer a liquidity event? In the funding agreement, there is a clause for redemption rights. Is this used so that the VC can get out of the investment?
A: (Jason). Yes, we’ve experienced companies growing nicely without liquidity events. And yes, we usually request redemption rights in our deals. That being said, we’ve not exercised them.
(For a primer on redemption rights, see our prior post)
So why ask for them? Theoretically, one can come up with a situation where a fund is late in life (funds are usually 10-12 years in term), you have a nice company, but no liquidity. In this event, it’s nice to have an “out” to get liquidity, or to have some leverage to have some control on the situation. That being said, redemption rights are pretty benign. They look scary, but I would hazard to guess that few VCs, if any, have ever actually used them.
I’d equate redemption rights similarly to registration rights: VCs rarely use them, but if you need them and didn’t ask for them, you are a chump.
Q: When performing diligence on a new investment I will dig through management’s projections. Even though I am a finance guy I try to understand the costs associated with the software development. Probably needless to say, I have been burned by cost overruns quite a few times. The Companies burn through our cash on development and don’t have enough left over to actually run the business. Do you have any suggestions (for both managements and investors) on how to better budget for these costs.
A: (Brad) I’m going to assume you are talking about an early stage company (pre-product, pre-revenue.) As someone who has been involved in creating a number of software products, they always take longer and cost more than budgeted. In addition, the revenue ramp almost always starts later than planned and isn’t as steep as expected.
I have come to simply not believe any early stage projections. Rather than worry about financial model, I use a zero-revenue based budgeting approach to figure out the appropriate staffing level / burn rate for a company at different phases of development. Early on, I encourage the entrepreneur to manage his spending so that he has enough time to get to the next “value point” in the business (whatever “value point” means – it’s different from company to company – but it usually means the next time at which you can logically raise more money.)
At some point revenue starts to happen. Or a bigger financing is raised. In either case, spending can be increased, but in a measured way to get to the next value point.
The biggest mistake I see is adhering to the entire budget assuming a revenue ramp. Early stage companies have complete control over their spending; they have very little control over their revenue. Most companies I’ve worked with have no trouble making their expense plan. These same companies almost never make their revenue plan in the early days of a company. So – manage the expense / cash side of the equation and lag your increase in spending behind the actual revenue generated.
Don’t forget to focus on gross margin. If you have a pure software product, $1 of revenue is almost $1 of incremental cash you have to spend. However, if your real gross margin is only 50% (because of services, cost of sales, equipment, installation, hosting), you only have an incremental $0.50 to spend for each $1m of revenue.
Q: I’m involved in a start up where we’ve made a lot of progress. We’re currently in our coding stage but there are a lot of undefined areas as far as usability and layout are concerned. A few of the team members strongly believe its necessary to get professional help from experienced designers on usability and get competitive analysis on our design and brand image. I, on the other hand, feel its not necessary at this stage and these can be accomplished once we close our Series A round. Specifically my question is, how important is brand image at this stage in development?
A: (Brad) Anyone that knows me knows that I’m not a fan of “classically defined textbook marketing.” “Brand image” can fit in that category – or not – depending how you approach it. If you “get professional help from experienced designers on usability and get competitive analysis on our design and brand image” you are engaging in a set of activities that I think are a complete waste of time and money “pre Series A.”
Instead, develop your own brand, image, and style that is consistent with the company you are creating. Let it come from you – rather than an “experienced” consultant. A great example of this is Dogster, a company I have an angel investment in. No one is going to award the Dogster website the “most beautiful website in the world” award, but it has style. Dogs (and dog owners) appear to love it (based on their traffic growth) and it is definitely “dog freaks crossed with computer geeks.”
Once you’ve raised a Series A and have plenty of cash in the bank, feel free to hire expensive consultants to help you take your brand image to the next stage. Or not. But don’t spend your precious seed stage dollars on it.
Q: What is the typical and expected burn rate of the funds raised from a seed round before proceeding with the Series A round? I know this time-frame will vary from case to case, obviously, but with a typical internet start-up, is there an average or expected burn rate of the seed round funds before achieving the milestones needed to raise VC financing? 6 months, 12 months, 18 months?
A: (Brad) 12 months is a typical target. You want to give yourself enough time to make real progress and still have time to pull together a financing. You should plan to have to spend six months to raise your Series A round, which gives you six months of heads down work and six months of work + fundraising.
Q: On average, what percentage of a company does the “typical” entrepreneur own by the time of a “successful” exit? Obviously, huge YMMW, but what’s a reasonable expectation, say, assuming two founders, middle-of-the-road terms from investors, two or three rounds of funding, and an acquisition? Or is the range so broad as to be meaningless? If so, what’s a reasonable upper bound?
A: (Brad) The short answer is “the range is so broad as to be meaningless.” I love questions that don’t have precise answers, and this is a classic one. I’ve been involved in companies where the founder equity (sum of all equity the founders have at exit) ranges from less than 5% to greater than 90%. That’s a pretty big range.
If you assume the law of large numbers, you end up with a normal curve. Without doing a detailed analysis, most of the deals I’ve been involved with where there are two founders, middle-of-the-road-terms, and two / three rounds of funding result in a tighter range – probably in the 20% – 40% range. Again – it’s a normal curve so you’ll get higher and lower cases.
As part of your offer, there will likely be an equity component (if there isn’t, your first question after receiving the offer should be “so – what equity are you offering me as part of this package?”) The equity component will either be a grant of stock options or restricted stock – both with some sort of vesting component. If you’ve been employed by a startup before, you are probably aware of the concept of vesting; if not, take a look at our description of vesting in our Term Sheet series.
The standard vesting terms for a venture-backed company are typically a four-year vest with a one year cliff. For example, let’s assume you are granted an option for 10,000 shares of stock as part of your compensation package. A standard vesting plan would have you vest 25% of your options (2,500 shares) after one year (“the cliff”) and the other 7,500 monthly over the next 36 months (or 208 shares / month.) The vesting increment is usually either monthly or quarterly after the cliff period ends.
Note that “restricted stock,” while different, essentially works the same way. With restricted stock, the holder actually owns the stock, but the company has a right to repurchase should they no longer work at the company. The terms around this repurchase right “expires over time” – you can think of it as the same as vesting.
People ask about what types of acceleration we see in vesting arrangements. There are several common ones:
1. Acceleration based on prior performance: Many times a VC invests in a company whereby the founders own stock outright that prior to the VC financing is not subject to vesting. It is a pretty standard practice that the VCs will want to subject these equity holdings to a vesting schedule to incentivize the founders to stay around post financing. Normally, however a founder who has worked hard for a year to get the business off the ground will usually get a year of vesting credit. The actual amount varies – don’t expect to necessarily get vesting credit back to the day you originally thought of the idea while working at BigCo.
2. Acceleration based on termination: Often, founders and non-founder executives will negotiate a clause into their employment agreements that if they are fired without cause, their option vesting accelerates a year or so.
3. Acceleration based on an acquisition and termination: Commonly called “double trigger acceleration” this acceleration takes places when a company is bought and post acquisition, the acquirer terminates the employee within some period of time (usually within one year of the acquisition). The first “trigger” is the acquisition; the second “trigger” is the termination. It’s pretty standard practice that double trigger acceleration exists in company-wide stock option plans. Therefore, all employees at the company who are fired after an acquisition and within some time period enjoy the benefit of their options accelerating. The amount of the acceleration ranges broadly from a year to full acceleration.
4. Acceleration based on non-assumption of plan: One of common term in equity plans is the clause that accelerates all options under the plan if an acquirer doesn’t assume the option plan upon buying the company.
The other major term one see recently is the concept of a “drag along.” This is a relatively new term that’s come about in the past five years. It subjects stock holdings to a drag along, or voting proxy, whereby if the holder is no longer with the company, their shares are automatically voted (drug along, essentially) by the majority of the shareholders that are still with the company. This term became popular to ward off disgruntled shareholders who were no longer with the company.
We get a lot of questions about open source software. Today at our Boulder OpenCoffee Club meeting, we had a presentation by Doug Young regarding his thoughts on open source issues that developers face. It was a great discussion. (Unfortunately) every developer needs to keep their open source “house” in order and to that affect, I thought that I’d pass along some good links to those interested in the subject.
Doug highly recommends a book by Lawrence Rosen called “Open Source Licensing.” The very cool part is that the book is open source itself and available here for download. I took a quick look this afternoon at it and it looks great.
Another attendee this morning, Ari Newman wrote a cogent summary of this mornings highlights on his blog today. One interesting factoid that he brought to my attention was the availability of a software platform to keep track of one’s open source code. Check out OpenLogic, if you are curious.
Bottom line, know your licenses and don’t get caught surprised at the time someone performs due diligence on your company for a fundraise or acquisition.
Along the lines of our last compensation post, cash is at an extreme premium in pre-VC funded companies. In that vein, you might be presented with a situation where you “defer some of your salary” until after the first institutional financing. This means that you are theoretically earning this portion of your salary and once the financing happens, you will get it paid out in one lump sum.
Be careful about expectation setting here – while some VCs will respect this arrangement, if this deferred compensation number starts to grow, as a condition of the financing the VCs will often require some or all of the deferred comp to be converted into equity. This isn’t a horrible situation unless of course you’ve already spent your deferred comp on a new car. (Note to self – don’t by a new car until after the company is successful and you get a windfall from the sale of the business.)