Month: June 2007

Jun 30 2007

Do Venture Capitalists Still Invest In "Old Folks?"

Q:  I and a couple of other 40-somethings have a great idea for a new Web 2.0 start-up.  Our problem is that none of us can afford to give up our day jobs to bootstrap a start-up. In fact, our Web 2.0 idea would be a direct competitor to our current employers so we cannot, in good conscience, launch the service without first leaving our respective companies.

Are VC firms, given an outstanding business plan, willing to fund firms that are (a) run by middle-aged men and women and (b) have founders (three of them) that will require high salaries (150k – 170k) because they all have families to support and mortgages to pay?

I’ve been told that VCs are only interested in people who are willing to make large personal capital investments and/or will work for free for at least a year. Is that true? Is there any hope for us middle-aged folks?

A:  (Jason).  Despite much press about how only 20-somethings can be successful entrepreneurs in a start up environment, our experience shows us that age is irrelevant.  We’ve had successes with most every age group and each can have their strengths and weaknesses, but a strong management team is a strong management team. We don’t know any good VCs that make investment decisions based on ages of the management teams. 

What’s more intriguing about your question is your salary situation and your current employer.

VCs are normally reluctant to fund ventures where the management team is looking to replace their salaries that they had at larger companies.  Cash is a scare resource in a startup.  You might want to refer to our Compensation Series on what we think about early stage compensation.  I don’t think that most VCs demand that you personally invest material amounts of cash into the business – your investment is the sweat equity and risk that you’ve taken leaving your more stable job.  Furthermore, it’s also not reasonable to ask entrepreneurs to work for free.  In any situation, you can expect to make some salary, albeit usually lower than what you are currently used to.  Again, we’d refer you to our previous postings on the subject to see what ranges we think make sense.

Lastly, the fact that you’ve developed something competitive to your current employer potentially is an issue.  Depending on your position at the current company, you may owe a duty to the employee to not develop or act in any way competitive to your employer.  Furthermore, depending upon your contract, inventions that you create might be property of the company.  This is really a fact-based situation and state law has a lot to do with the outcome as well.  You should definitely consult an attorney before leaving to pursue this new opportunity.

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Jun 28 2007

Why Don’t Venture Capitalists Invest In Real Estate?

Q: Why don’t VCs invest in real estate? I have a great idea but I can’t get past the sentence where I mention it’s a real estate deal.

A: (Jason). We don’t invest in real estate because we don’t know what we are doing in that market. Okay, that was a little glib, but it’s true. VCs don’t / shouldn’t invest in sectors and themes that they don’t understand. Outside of some folks that I know who made some shrewd residential moves with their personal properties, I’d not want to trust my money to a VC doing a pure-play real estate deal.

Our investors don’t want us in that arena either, as evidenced that most of us have a charter of what types of deals we can and cannot invest in. For instance, a VC’s partnership agreements might say that they can “invest in the domestic technology industry in companies that do not require government approvals for the sale of their products.”

In this example, the VC could invest in U.S.-based technology companies, but not in any industry where the government would have to okay the sale of their portfolio companies products. Translation: this VC can’t invest in biotech (FDA approval) and better be careful about some media deals (FCC approval), etc. The VC would, however, be able to invest in a technology company that provides solutions to the real estate industry (think Zillow.com).

There are plenty of real estate development corporations out there who can much more effectively play in this space.

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Jun 26 2007

Selling a Company: To Auction or Not Auction

Question: I’m part of a small company that has been bootstrapped and grown organically over the last 4 years. We are at the point now where large competitors are very interested in us. We are seriously considering an exit. I have two questions:

1. What do you feel about auctions versus dealing with one party? In general, do you feel that auctions always the best way to get the best deal?

2. I’ve seen numerous posts on preparing decks when seeking funding. What goes in the book when it is time to sell? Basically the same? How is the story different?

(Jason).  First of all, congratulations on the interest. It’s always nice to be loved.

I’m a big fan of auctions. It’s really important to get some market validation of any deal that you are considering. That being said there are many different types of auctions that you can run. At one extreme, you hire investment bankers and enter into a formal process whereby you test the market. If you have one large competitor that is interested, likely you’ll others interested as well.

On the other hand, if you really like the deal at hand and you are on a tight time frame, you might want to quickly survey the market yourself and have these conversations. It’s a balancing act, clearly, as some cases allow you to have time to run an auction and others don’t – you certainly don’t want to do anything that will kill your “bird in hand” deal.

Regardless if you use a banker or not, make sure someone on the team is experienced in selling the company. I’d suggest that person should be outside of the executive staff (banker, board member, etc.) because you’ll need someone to play “bad cop” and you really don’t want to have the executives (who will work for the acquirer post merger) to have to play this role. For this reason alone, it might be nice to have a banker with you regardless if you do a formal auction or not.

As for what goes into a good selling deck – it’s relatively the same as fundraising, but you might focus more on how efficiencies can be derived from the larger platform that you are considering.

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Jun 25 2007

Options, Options, and More Options

Dick Costolo (aka Ask the Wizard) has two excellent posts up titled Options Acceleration and Employee Options and Grant Size.  If you are granting options or receiving an option grant, these are both excellent posts to read.

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Jun 24 2007

Merger and Acquisition Due Diligence – The Seriousness of the Acquirer

Part 2 of David Shanberg’s article on M&A Due Diligence.  Part 1 addressed what to expect from the due diligence process. This time David addresses “How To Be Protect Your Confidential Information While Still Moving the Process Forward.”

Potential acquirers are typically trustworthy and sincere in their intent when conducting due diligence, with making an acquisition the goal rather than gathering competitive intelligence. However, some may enter the process with both goals, and a few may actually have bad intentions.

With that in mind, there are three actions that a company can take to decrease the odds of wasting time and unnecessarily parting with sensitive information, while not overly encumbering the acquisition process:

A. Gauge the seriousness of the potential acquirer (covered below)
B. Stage the flow of information (to be covered in the next post)
C. Be on the lookout for warning signs (to be covered in a future post)

A. Gauge the seriousness of the potential acquirer

In addition to the intentions of the potential acquirer, judging their seriousness at the beginning of the process and throughout can save a target company lots of time and frustration. In my experience, frequently a company would like to make an acquisition but simply is not in a position to do so.

There are number of easy ways to test for this, including the following.

Evaluate the company’s financial ability to make an acquisition. Do they have the cash to make a cash deal? Do they already carry a large debt burden, or do they have the ability to borrow to finance the deal? In the case of a public company, it is feasible to consummate a stock deal? The company should be able to provide a clear and realistic plan on how they would structure and finance the deal.

Evaluate the means of initial contact. Was it through a senior executive or board member, or through a person with less authority? If was through an intermediary, how credible is the intermediary, and is it formally representing the company?

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Jun 24 2007

How Do You Negotiate a Carve Out With Investors?

Q:   We are in the midst of negotiating a carve out with an investor on the East Coast.  Two stumbling blocks have occurred.  The first issue is what is an appropriate option pool size and does it vary from East to West coasts?  The investor tends to believe that there are a significant differences in sizes of pools for Boston based companies vs. Bay Area-based companies. 

Secondly, we are debating whether or not it’s appropriate/acceptable for management to have a carve out and maintain participation in the ESOP should an exit be large enough to be in the money?

A:  (Jason).  Most of the compensation reports that we’ve seen, as well as evidence from our own portfolio would indicate that there are not significant differences in option pool sizes between coasts.  That being said, the range of option pools can be anywhere from 10-30%, so the there is a wide variance, but our opinion is that this is fact specific, not location biased.  It really depends on how many rounds of financing the company has consummated and, to some extent, company performance.  Recaps tend to decrease the size of the pool to the minimum amount to keep current employees properly incentivized and not much extra.

With respect to your question regarding the carve out and employee participation in the ESOP (Employee Stock Option Plan), we assume the following:

1. The company has enacted a carve out plan for employees on the assumption that a liquidation event will not properly compensate employees due to the potential size of the liquidation event and the liquidation preferences ahead of the common stock underlying the employee options.  For background on management carve out plans, see our prior post here; and

2. The employees have options / stock issued from the ESOP, which depending upon the size of the liquidation event may or may not yield any return.

The way we’ve seen management carve out plans and options mix at the time of liquidation events are fairly standard.  In short, we’ve seen a reduction in the aggregate carve out once the employee options are in the money.  Let’s create an easy mathematical example and look at two potential outcomes.

Example:

– Carve Out Plan:  10% of aggregate liquidation proceeds.

– Range of liquidation events that would return nothing to employee options / stock:  $0 to $50M dollars.  (In other words, any event that would return $0 to $50M to the company would offer no return to employees due to liquidation preferences).

– Employees would receive 20% of any amounts of consideration above $50M.

From $0 to $50M, the carve out provides 10% of proceeds to the recipients of the carve out plan.  At $50M, $5M would be the carve out.  With a $60M dollar deal, the employees would receive $2M on their options.  So what happens to the carve out?

The carve out is normally reduced – how much is a negotiation.  In some cases, it’s a dollar-for-dollar reduction.  In our case that would mean that at $50M, employees get $5M and at $60M employees would get $5M, but at $60M, the carve out piece would only be $3M, while the option payout of $2M would pick up the rest.  In this case, you’ll note there is a “flat spot” for employee return until the deal size is above $75M. 

One could argue that in order to incentivize management to maximize the value of the deal above $50M, there should be a “sharing” of the proceeds.  Instead of a dollar-for-dollar reduction, maybe it’s a 75 cents reduction for every dollar.  Again, it’s a negotiation.

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Jun 22 2007

What Is the Standard Number of Shares to Create in a New Company?

Q: This may seem rather fundamental and elementary, but I cannot seem to receive a solid answer from anyone. When filing the articles of incorporation (charter) papers for a C-Corporation, is there a strategic amount of shares to issue at a certain price per share upon incorporating, or is this irrelevant in the beginning? I am the only equity founder at this point, but will soon be raising seed funding, as well as setting aside 15%-20% equity for employee stock options. I have heard that 1,000,000 shares at .01 per share is typical. Is this anywhere near correct?

A: (Jason) Pre-funding, it doesn’t really matter. Make sure that you have a large enough number of shares that you can give small enough awards away. In other words, if you only had 100 shares, the minimum amount that you could grant / give away is 1% of the company – probably not a great result.

Along those same lines, consider, too, what your first hires will think if they get an option grant of “10 shares.” I realize that whether I get 10 shares or 1,000,000 is irrelevant unless I know the denominator, but there are plenty of folks that I’ve seen get awfully irrational with a grant of a small amount of shares without ever asking about the total shares in the company.

Finally, consider what state of incorporation you are thinking about and what the taxes are associated with the number of shares of stock. Many states base early corporate taxation on the amount of shares authorized.

Your numbers of 1,000,000 and .01 par (which really doesn’t matter at all) seem fine, but consider the thoughts above.

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Jun 18 2007

How Can You Replace the CEO of a Struggling Angel-Funded Company?

Question: I own shares in a company in a 5 year old private company. The company to date has raised its capital through a series of convertible notes and warrants. The company has failed to gain traction over the past few years and the CEO needs to be replaced. Do any of the debt and shareholders have any recourse? Any suggestions?

(Jason) This is a meaty question, but without more background it’s hard to give you a definitive answer. The “easy” answer is that you should look to the provisions in the debt instruments that the company issued to see if they are callable. If the debt holders agree that the CEO needs to be replaced and the debt can be called, then (even if the company cannot pay the loans back), you might have the leverage to make the change. Either that, or you can shut the company down.

One more thing to consider: who is on the board? The board can replace the CEO at any time. If the board still supports the CEO, then you really only can threaten to call your loan.

In general, it’s very difficult for a debt holder or shareholder to be able to replace the CEO. Their only recourse normally is leverage they have as stakeholders.

Keep in mind the above is the “lawyer” answer. The “business” answer is that you can rarely forcibly remove a CEO – either you have the support of the board, the employees etc. and most likely the CEO doesn’t want to stay around, or you don’t. If you don’t have this widespread support, changing out the CEO is probably not going to help turn the company around. CEO transitions are hard enough, especially if the majority of the company isn’t supportive.

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Jun 16 2007

What are Supra Pro-Rata Rights?

Q: Can you explain what supra pro-rata is? It seems to be showing up in some VC term sheets now. What’s the impact on the entrepreneur? How hard should one try to negotiate it out? If a VC insists on this term, should the entrepreneur walk away?

A:  (Jason)  First of all, for those of you who want a refresher on pro rata rights, see our prior post on it here.  As for what is “supra pro-rata” it is a multiple of a 1X pro rata right.  So, if I own 10% of the preferred, I normally will have the right to buy 10% of any future securities issued by the company.  With a supra pro-rata right it is normally 1.5, 2 or 3X. In our example, a 2X supra pro rata right would allow me to buy 20% of the next round.

This isn’t a very common term, unless you are dealing with very early / seed stage financings.  You’ll see in some cases where a VC seed funds a deal with a small amount of money.  It is normally the intention of the VC to lead the first real venture round, but in order to protect itself (in case the entrepreneurs decide to take funding from someone else), the VC will ask for a supra pro rata right.  Although the seed deal doesn’t represent a lot of money, it does represent a lot of the VCs time, so they want to make sure that they can stay in the deal.

If your financing is a “regular” full blown round, then I would say this is a rare term. 

As for my advice on “walking away,” there are very few terms that I consider “walk” terms.  If you need the money and don’t have other options, get the money. 

(Because I know that I’ll get the question, if I was on the entrepreneur side, I’d walk from poor valuation, overly aggressive liquidation preferences, over bearing board and voting controls and VC board members who expect compensation to join your board). 

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Jun 13 2007

Should Entrepreneurs Be Worried About Convertible Notes as a First Financing Event?

Q:  I am looking to raise some money around an early stage business opportunity and have been instructed to raise a convertible note before doing a Series A round.

The VCs providing the convertible note would give a handshake deal to continue onto the A round should milestones be met…

Is this smart? Or should one stay away from convertible notes?

A:  (Jason)  If the VC is reputable, then you are probably okay.  We’ve done many seed / pre-Series A deals with a convertible note structure.  Other firms, like Charles River Ventures, do as well.  Let’s look at the pros and cons.

Pros:  It is much cheaper to consummate a note deal, than a financing deal, which also means it is much quicker to close.  Also, you don’t have to lock in a very low valuation today and if you do well the notes should convert into a higher valuation than they would have if you have done an equity deal.  Other cons include that you can rid yourself of the investor (if you don’t like him later) by buying out his notes – assuming you have another funder.

Cons:  Debt holders have rights that equity holders don’t – namely they can call their loan and request their money back.  This means that essentially they can shut you down if you don’t have the cash to pay them and they want out (subject, of course to the deal that you negotiate).

Make sure that the convertible notes convert automatically (not at the discretion of the VC) should the company consummate a Series A round, so that regardless if this VC is in for the long haul, anyone who funds the company can convert the original note holders to equity.

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