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.
Q: As a rookie VC trial by fire is a great way to learn. Aside from crunching through some early deals, where are the best executive programs and crash courses for newbies to the VC world?
A: While self serving, we recommend you start with our book – Venture Deals: Be Smarter Than Your Lawyer And Venture Capitalist. In addition, there are a bunch of courses now using the book that are referenced on the web that include additional materials that are helpful.
Jason also did an excellent Crash Course on Venture Capital – the 90 minute video is below.
There is also extensive information on the National Venture Capital Association website, the four day Venture Capital Institute is entering its 38th year, and the Kauffman Fellows Program is entering their 18th year.
If you know of other web based resources, please add them in the comments.
Q: We are a Delaware C Corp registered as a Foreign Entity in Colorado our home state and we need to figure out the answers to the following questions with regards to stock certificates.
1. Who gets stock certificates issued and when?
My assumptions are that cash investments DO get certificates, warrants DO NOT.
Founders and Employees with vesting schedules DO NOT get certificates, until a portion of stock is vested.
2. Do the buy and print your own certificates follow the normal process?
3. Do private C Corps file capitalization stables with the SOS?
It’s a pretty simple answer, really. If you buy the stock, you get the certificates. So cash investors do get certificates. Warrants and options are securities that provide the holder to exercise them later by paying for the stock at a pre determined strike price. At the time of exercise, money is paid by the holder to the company for the stock subject to that warrant or option and then a certificate is issued. The options can not be exercised until vested, as you suggest.
i’m not sure what “buy and print” your own certificates mean, but there is no form that you have to follow. It just needs to be signed by the President and Secretary of the company. Furthermore, cap table are not filed anywhere. You may keep this information private.
Troy Henikoff and I had lunch a month or so ago in Chicago and the conversation turned to convertible debt. I’d recently made an offer to invest in a company Troy was an investor in and the entrepreneur and I got tangled up in the definition of pre and post money in the context of existing convertible debt. In this case there were multiple traunches of convertible debt at different valuation caps. My offer was above the highest cap, but I interpreted the way the convertible debt, and pro-rata rights associated with it, worked differently than the entrepreneur did. Given the magnitude of the convertible debt, the way the debt was handled had a significant impact on the post money valuation dynamics. Ultimately, the entrepreneur and I couldn’t narrow the gap and we didn’t end up working together.
There were no hard feelings on my side (I like the entrepreneurs a lot) but it made for an interesting and awkward discussion. Troy did a great job of processing it and wrote an important, and thoughtful blog post, titled Convertible Debt: really Bridge Loans and Equity Replacement Debt. If you are an entrepreneur who is raising, or has raised, convertible debt, I encourage you to read it carefully.
In our conversation, we talked about a nuance which Troy left out – namely that the magnitude of “equity replacement debt” matters a lot. If it’s a small amount (say – $300k or less) this issue isn’t that severe. But once it gets up to $1m or more, the problem often appears in a big way. My partner Seth covered this nicely in his post That convert you raised last year is a part of your cap table.
All of those convertible debt rounds that happened in 2010, 2011, and 2012 – including a bunch of uncapped ones – are now turning into either equity rounds or unhappy situations. The more everyone on both sides understands the dynamics, the more effective the future financings, including the future convertible debt rounds, will be.
My long time friend and favorite Seattle VC Greg Gottesman has started blogging. Greg’s a great writer and super thoughtful investor so I expect his blog will be one to read and comment on. It’s certainly going to be in my daily blogroll.
Greg and I are currently on the boards of Cheezburger and Startup Weekend together. We had several shared investments over the years including both good and bad ones. I’ve always had deep respect for how Greg thinks, works, and acts. Plus, I just love hanging out with him.
Greg was half of the motive force behind bringing TechStars to Seattle. He and Andy Sack, the TechStars Managing Director, literally made it happen. Greg’s been an awesome partner in the TechStars journey and completely embraces the mentorship model and the notion of “give before you get.”
Greg – welcome to the blogosphere. It’s never too late to join.
Q: What costs are considered reimbursable to the founder of a start-up company? More specifically, if the founder has been boot-strapping his company since inception, and he agrees to a series a term sheet with a VC firm, are the operational costs incurred by the founder between this time and the closing of the round reimbursable to the founder? For example: The founder of a consumer product company and a VC firm agree to a term sheet in July. The round doesn’t close until October or November due to raising additional capital for the round, attorney delays, etc. In the interim, the founder continues to self-fund the day-to-day operations of the business – packaging design, inventory, PR firm, etc. What expenses can the founder expect – if any – to get paid back out of the series a funding?
This varies widely and is fundamentally a negotiation between the new investors and the founders who have incurred the expenses. The four variables are:
- Amount of expenses
- Amount of funding being raised
- How the expenses have been accounted for
- Attitude / style of the investor
As the amount of expenses increases, the willingness of the investor to reimburse for any of them decreases. This is directly linked to the amount of funding being raised. For example, if $1m is being raised and the expenses are $50k, an investor will likely be ok with 5% of the funding getting paid back to reimburse the founders. However, if $1m is being raised and the expenses are $500k, it’s unlikely that an investor will be ok with 50% of the proceeds going to paying founders back for expenses that have already been incurred.
How the expenses have been accounted for also matters a little, if only for optics. If it has been treated as debt advanced to the company by the founders and is documented in an arms length transaction, it sometimes has more impact on the investors. The issues of amounts far outweighs the structural issues, but the structural issues sometimes signal that there was an intent to see the money get paid back at the close of the financing.
Finally, the attitude and style of the investor matters the most. Some investors are adamantly opposed to the idea of paying the founders back any expenses and view this simply as contributed capital to the business. Other investors will view this as part of the investment required by the founders to justify the pre-money valuation. Other investors will simply not want any of their new investment to pay for past expenses. In contrast, you’ll run across other investors who are more flexible, or who are happy to get a little more money into the company at what they believe is a relatively low valuation.
Ultimately, there is no rule – it’s just part of the negotiation.
Dave McClure has a great post up today titled VC Evolution: Physician, Scale Thyself. It’s a long ramble, as is Dave’s style, on a bunch of issues around the evolution of how VC works and scales. I’m an investor in Dave’s fund and have believed in him from the beginning so it’s cool to see him continue to push the edge of things.