Month: January 2013
Reid Hoffman, founder / executive chairman of LinkedIn and partner at Greylock has started blogging. Well – he’s started writing long form essays on a blog that my understanding is will come out about once a month.
The first post is If, Why, and How Founders Should Hire a “Professional” CEO. It is outstanding and I expect Reid’s blog should be on your must read list. My only complaint is there are no comments open – I’d encourage Reid to engage with people reading this, rather than just lecture to us!
Q: When building a financial projection model for a pitch to VC’s, should you include future rounds of funding in the model or simply show what measurable goal you are trying to achieve with the current round you are seeking?
A (Brad): It depends on the stage of the company. But first, it’s important to understand how a VC is going to look at your projections in the first place.
- Early and pre-revenue: Investors are going to be most interested in your near term burn rate and how long their money is going to last. Focus on putting this information front and center – don’t hide it. Recognize that your revenue is totally speculative so the “base case” is going to be zero revenue.
- First product in the market, < $100k / month of revenue: Revenue matters here and the projections out into the second and third year will give a good indication of how you are thinking about the ramp of your business. However, if your revenue is modest, a smart investor is going to look at your gross margin also. If you are a recurring revenue business, the month-over-month growth – both of revenue and gross margin, is going to be important.
- Meaningful revenue, > $1m / quarter: You have entered the zone in which you have a real business and likely can have a credible growth plan out three or more years.
Now, in every case, a VC is going to be interested in how long the current round of financing is going to last. In early cases, they are going to focus on cash / monthly-burn-rate. In later cases, they will factor in some amount of revenue and gross margin projection, but likely discount both, viewing you as being overly optimistic on revenue as well as the gross margin percentage.
Then, building off of this, they will be interested in how much additional money you think you will need to get cash flow positive. They’ll calibrate this against whatever your current plan is. The earlier the life of your company, the more skeptical the VC will be of any projections of revenue, and any time horizon greater than one year.
Update: I just noticed a twitter comment that said “I would suggest that it should take you up to their expected exit as that is most definitely their primary concern.” While some investors may ask for this, it’s the exception as most rational investors will want to understand what it takes to be cash flow positive. It’s impossible to predict the exit as there are too many variables at play, including the notion that you can’t force an exit. However, you can run a business indefinitely without additional financing if you are cash flow positive. So I’d assert that showing the plan getting to cash flow positive is much more important than showing the plan getting to an exit.
Q: On page 105 of the second edition of Venture Deals under Debt Conversion Mechanics, you state: “Therefore, having outstanding debt (that doesn’t convert) can be a bad thing if an entrepreneur ever gets sideways with one of the debt holders”. I infer this to mean that convertible debt cannot bring about the same bad results. Is that correct? How can the company trip conversion so that debt holders cannot enforce these bad results?
A (Jason): Convertible debt only automatically converts (normally) under two circumstances: One, the company completes a financing of X amount or two, the debt holder elects to convert. We’ve never seen convertible debt where the company can unilaterally convert the debt, thus the caution around getting sideways with a debt holder.
Q: What is the best path to take if a VC which has invested in my company closes down, but we have not exited and are still operating profitably ? What happens to the LLC entity that was formed at the time of investment? Do we ask the VC for our shares back or buy them back at a discount?
A (Brad): First, you need to understand what actually happened to your VC firm. There are lots of specific points in time to consider. Let’s start with two magic milestones – year 5 and year 10.
1. The VC is outside their five year investment period. Most VC funds have a five year investment period. This is the time frame in which they can make investments in new companies (those that they haven’t already invested in.) However, most funds last 10+ years and can be extended for many more years. In this case, even if a fund is outside of its investment period, it can still make follow on investments in your company.
2. The VC is outside their ten year fund period. As mentioned above, most funds last for 10 years. However, they often have two, one-year automatic extensions, resulting in a 12 year life. Beyond 12 years, the fund can continue to be extended to operate with approval from the fund’s investors (the LPs). Many funds end up operating for 15 – 20 years.
Now, in each of these cases, you’ll have two situations – the VC firm has raised a new fund or it’s hasn’t. If it has, then the firm itself is still “in business” even if the fund that has invested in your company is getting older. If the firm has raised a new fund in either case, then you have nothing to worry about. However, if the firm hasn’t raised a new fund by year ten, it’s like to be considered a zombie firm.
Now, these zombie firms may still be operating, managing their existing investments, but not making new ones. As time passes, and a firm clearly is not going to raise another fund, most of the partners move on to other things. And this can go on for a long time as long as there is at least one partner from the VC firm still engaged in managing it.
Ultimately, we come back to your question. What if the firm actually shuts down, either because the LPs won’t continue to support additional extensions, or the remaining partner doesn’t feel like continuing to manage things. There are a few different options.
1. Distribution of shares to a liquidating trust: In this case, the equity in your company held by the VC fund now belongs to a completely passive entity that is simply going to exist until the shares become liquid, either through a sale or an IPO.
2. Distribution of the shares to the LPs: Similar to #1, but you now pick up a whole bunch of new shareholders in your company, who were there LPs of the VC fund. No one really likes this option – LPs don’t want private company shares, the companies don’t want all the new shareholders, and the VCs likely have no upside after the distribution.
3. Managed liquidity of each company: In this case, the VC will sell off each company in whatever manner he can at the point of time, either via a secondary sale to another investor, or a sale of the shares back to the company. By this point, VC funds typically have two kinds of companies in them – ones that are worth something and ones that are worth nothing. The graceful VC knows the difference and behaves appropriately. The non-graceful VC tried to squeeze blood out of rocks.
Regardless of the situation or outcome, there isn’t a simple, straightforward one. This is compounded by the complexity of VC / LP relationships, private company dynamics, and the optimism of many investors that “something good will come in the future”, more formally known as “maintaining option value.”
Q: Where can I get some good starting salary information for a SaaS startup? I need the information for CEO, CFO, CIO, CINO, Director of Sales. How much should the starting salaries vary for a startup with $5 million vs $10 million gross revenue?
A (Brad): First of all, you can find a great deal of info on structuring employee compensation right here on Ask the VC. We have posted about this topic many times in the past and have often covered specific aspects in great detail – take a look at the Compensation archive. Although many of the posts found within the archives relate to the question, the few listed below are a targeted to your question.
- What are typical compensation numbers?
- Compensation In A Very Early Stage Company
- Compensation In A Very Early State Company – Follow Up Question
The CompStudy report, written by Harvard University Professor Noam Wasserman, is also extremely good. It’s a yearly report on the current equity and cash compensation within private companies. Noam also has an excellent book related to startups (but not to compensation) titled The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup.
The numbers we list here on Ask the VC or those found within published market reports are based on average market data and should therefore be used as a general guideline. Many variables like the company’s age, current revenues, profitability, geography and others all come into play when structuring compensation packages.
Finally, I have a belief that most of these compensation studies have a frustrating survivor and reporting bias that tends to cause the numbers to be inflated. So, use them to calibrate, but not justify, your numbers.
Q: In our startup we have 4 founders, two of whom are not full time. We’ve all put in a good sum of cash thus far. The two founders with the least equity happen to be the two tech founders. Some of us feel that we made a mistake when allocating shares in the beginning – there is one founder in particular who does not do any work, and he has the second-most equity (the split goes like this: 32%, 26%, 10%, 7.5% with the rest for employees + advisors). To me, it seems like any outsider would see this as a big disparity and wonder what happened, but one of our guys (Mr. 32%) seems to think that if we can get funding, the VC will correct this wrong. I’m rather doubtful of that – what VC will want to fund a team that didn’t have the foresight to motivate the biggest contributors and keep them interested? I’m looking to convince him that we need to fix our own mistakes before pursuing funding. Am I off base?
A (Brad): You aren’t off base. Furthermore, this is a common problem and one of the reasons I strongly encourage every founding team to have four year vesting on their stock.
While some founders thinks this simply gives future investors a way to claw back equity in the future, it’s much more often the case that this protects the founders from each other, in cases like this or situations where one of the founders simply leaves.
In your case, you feel like the 32% founder doesn’t do any work. If your other two founders believe this also, the three of you should directly confront Mr. 32% right now. Don’t wait, don’t defer, don’t let more time pass. Deal with the issue – up front and directly. It’s an easy thing to solve – if you all agree (including him) that he should only have 15% of the company, then he can simply forgive (or give back – the mechanism will depend on how the company is structured) 17% of his equity. Then, each of you will end up with an increase of your pro-rata percentage of his equity.
If you have equity alignments early in your company, deal with them. Don’t let them fester.