Posts from October 2010

This is the third post in an MBA Mondays series on Employee Equity. Last week I talked about Dilution. This week I am going to talk about the antidote to Dilution which is Appreciation, specifically stock price appreciation.

When you start a company, on day one the stock is basically worthless. There are some exceptions to this rule such as a spinoff company where Newco is getting some valuable assets day one. However in the vast majority of cases, the value of a startup on day one is zero.

One of the objectives of an entrepreneur is to steadily increase the value of the business and the stock price.

At some point, the Company will generate revenues and earnings and can be valued using traditional valuation metrics like discounted cash flow and earnings multiples. But early on in the life of a startup it is trickier to value the stock.

Fortunately we have a marketplace for startup equity. It is called the venture capital business. Every time a startup raises capital, there is a competition between investors and a negotiation beetween the Company and the investors. Those two processes provide a mechanism to determine stock price.

There is a growing trend to finance the ‘seed stage’ of a startup’s life with debt, specifically convertible debt. One of the reasons I am not fond of convertible debt is that it obfuscates the equity pricing process. But that’s a digression.

So between the formation time when the stock price is most likely $0.01 per share (ie zero) and the time of exit at hopefully $100/share or more, there is a progression of price appreciation along the way marked by the progress of the business, financing events, and eventually revenues and earnings which lead to financial analysis.

If you are an entrepreneur or an employee in a startup who has equity as part of your compensation, it behooves you to understand the appreciation in the value if your equity.

One thing that you need to know is that the price doesn’t always rise. There can be setbacks in the business that lead to price declines. There can be setbacks in the capital markets that make all businesses less valuable including startups.

And if course your Company could fail in which case all of the employee equity will be worthless.

In the case of a startup that becomes a successful business, the price will appreciate over time. There can be price declines or long periods of price stagnation, but if you are patient and the business succeeds, the employee equity will appreciate over the long run.

There are some specific issues that require a deeper dive, including the impact of liquidation preferences and the role of a 409a valuation. I will tackle those issues in the comings weeks.

Yesterday at Austin City Limits, I went through two batteries on my Android phone. By midnight, on our way home from a late dinner, the second battery died and the phone shut off. But at least I got a long day of heavy use out of my phone. And that was possible becuase I left the hotel with a fully charged phone and a fully charged spare battery.

Of all the limitations imposed by the iPhone, the inability to take out the battery is the one that mystifies me the most. I understand most of the other choices Apple has made even though I don't personally agree with them.

But to this day, I don't understand how anyone can use a phone that doesn't allow for the use of a spare battery. When a phone is dead, you can't be reached. And with all of the heavy data usage on a smartphone, the battery takes a pretty heavy toll. It seems to me that any credible smartphone in this day and age ought to allow for a spare battery. And yet the iconic smartphone, the one that every other smartphone looks up to, does not.

Strange.

Steven Johnson’s Where Good Ideas Come From could also be called Where Good Posts Come From. I’ve got at least a half dozen posts rumbling around in my head as a result of that book. This is one of them.

There’s a line in the book I love:

The best innovation labs are always a little bit contaminated

The line comes at the end of a section that explains how noisy signals, mutation errors, and screwups often lead to great things.

I’ve seen this in startups. If you look at our thirty something portfolio companies you will find that many of the most successful companies have been highly chaotic organizations for a significant part of their existence.

You will also find that some if the best managed and most disciplined startups have struggled.

This is not always the case. I am thinking of one portfolio company that is very focused and disciplined that is absolutely killing it.

But there is always an exception that proves the rule.

If you want to unleash more creativity in your company, you need to allow for a little contamination. It is the sand in the oyster that creates the pearl.

The post from 10gen about the Foursquare outage this week prompts me to write about the pros and cons of portfolio companies working together.

Back in the mid 90s, it was fashionable for VC firms to talk about the synergies between their companies and actively encourage the companies to work together.

At Flatiron Partners, the firm I co-founded in 1996, we did that early on. We had a portfolio company called eShare that had a web chat system they sold to websites that wanted to offer live chat.

Two of our portfolio companies, Geocities and StarMedia, became big customers of eShare. Whenever eShare let our portfolio companies down, we would get caught in the middle like a parent with two fighting children.

It was no fun and it soured me on the whole idea of encouraging our portfolio companies to work together.

Since that experience, I have taken a different posture. When one of our portfolio companies can solve a problem for another, I make the introduction. But I also make it clear to both companies that I am not going to encourage any unnatural acts and they should not factor USV's interests into their decision.

Then, when something goes awry, and it often does, we are not caught in the middle.
Even with this approach, it can be very painful to watch two of our portfolio companies struggle with a business partnership. I know my partner Albert had a bad day earlier this week when 10gen and Foursquare were scrambling to get Foursquare back up.

There are plenty of times when it makes sense for portfolio companies to work together. Most of our portfolio uses Return Path's email deliverability service. Many use MongoDB. A growing number use Twilio. I think all use Twitter and many use Tumblr. But hopefully they've all made those decisions themselves without any pressure (real or perceived) from USV.

We do encourage our portfolio companies to share space. And many do that. I think a lot of good comes from idea sharing, networking, and relationship building. If that leads to business partnerships then great, but it doesn't need to in order to be valuable to both parties.

So in summary, I strongly believe that VCs need to go easy on portfolio synergy. When it happens naturally it is usually a good thing. But it should not be forced in any way.

I'm running a video this morning in lieu of a post. Here's a quick (~4min) video that Mathew Ingram did with me yesterday during my visit to Toronto.

Commenter supreme JLM noted in a comment on Monday that he was once ripped off of a $2mm payday by a person he worked for. He took the hit, went away for a month, came back and started working for himself. Its an inspiring story from an inspiring guy.

And by the way, the person who screwed JLM out of his money went broke.

That story reminded me that there are takers and makers in this world. Takers make their money by taking from others. They are usually bad business people and their careers often end in failure.

Makers build things. They create value for society, their employees, their shareholders, and themselves.

Be a maker and stay far away from takers.

I don't like to say "I told you so." It's not nice.

But I feel it a lot. And my greatest I Told You So moments are with my kids.

Yesterday I saw that my oldest daughter is moving her photoblog to Tumblr. When she first set up her photoblog on Blogger, it killed me. I said, "why not Tumblr?" She said, "I like the way Blogger looks." Now she is moving to Tumblr. Yesss.

This past weekend my son and I were on the couch in the family rooom watching football. He picked up his iPhone and checked his Twitter. Big smile. I tried so hard to get my kids to use Twitter. But it was always "Facebook is better for me dad."  But the football players Josh loves aren't on Facebook, they are on Twitter. So he uses Twitter to follow them. Yess.

For years I tried to get my girls to shop on Etsy. They just didn't get it. Then last spring my daughter came home from college and told me that she was "addicted to Etsy." Turns out that she thinks Etsy is the best vintage store on the web. Yesss.

I care a lot about what my kids do. Because they are my best panel/focus group. We've made a bunch of investments in companies they don't use and don't understand. But over time they have adopted many of them. Of course, some of that may have to do with my incessant advocacy of the services we invest in. But I think that actually hurts me in the short run. Most teenagers don't want to be associated with stuff their parents like.

But I am proud to say that my kids have come around to many of the services we invest in over time. And when it happens, I am so tempted to say "I told you so." But I don't. I just bite my lip and smile. 

Last week I kicked off my MBA Mondays series on Employee Equity. Today I am going to talk about one of the most important things you need to understand about employee equity; it is likely to be diluted over time.

When you start a company, you and your founders own 100% of the company. That is usually in the form of founders stock. If you never raise any outside capital and you never give any stock away to employees or others, then you can keep all of that equity for yourself. It happens a lot in small businesses. But in high growth tech companies like the kind I work with, it is very rare to see the founders keep 100% of the business.

The typical dilution path for founders and other holders of employee equity goes like this:

1) Founders start company and own 100% of the business in founders stock

2) Founders issue 5-10% of the company to the early employees they hire. This can be done in options but is often done in the form of restricted stock. Sometimes they even use "founders stock" for these hires. Let's use 7.5% for our rolling dilution calculation. At this point the founders own 92.5% of the company and the employees own 7.5%.

3) A seed/angel round is done. These early investors acquire 5-20% of the business in return for supplying seed capital. Let' use 10% for our rolling dilution calcuation. Now the founders own 83.25% of the company (92.5% times 90%), the employees own 6.75% (7.5% times 90%), and the investors own 10%.

4) A venture round is done. The VCs negotiate for 20% of the company and require an option pool of 10% after the investment be established and put into the "pre money valuation". That means the dilution from the option pool is taken before the VC investment. There are two diluting events going on here. Let's walk through them both.

When the 10% option pool is set up, everyone is diluted 12.5% because the option pool has to be 10% after the investment so it is 12.5% before the investment. So the founders now own 72.8% (83.25% times 87.5%), the seed investors own 8.75% (10% times 87.5%), and the employees now own 18.4% (6.8% times 87.5% plus 12.5%).

When the VC investment closes, everyone is diluted 20%. So the founders now own 58.3% (72.8% times 80%), the seed investors own 7% (8.75% times 80%), the VCs own 20%, and the employees own 14.7% (18.4% times 80%). Of that 14.7%, the new pool represents 10%.

5) Another venture round is done with an option pool refresh to keep the option pool at 10%. See the spreadsheet below to see how the dilution works in this round (and all previous rounds). By the time that the second VC round is done, the founders have been diluted from 100% to 42.1%, the early employees have been diluted from 7.5% to 3.4%, and the seed investors have been diluted from 10% to 5.1%.

I've uploaded this spreadsheet to google docs so all of you can look at it and play with it. If anyone finds any errors in it, please let me know and I'll fix them.

This rolling dilution calculation is just an example. If you have diluted more than that, don't get upset. Most founders end up with less than 42% after rounds of financing and employee grants. The point of this exercise is not to lock down onto some magic formula. Every company will be different. It is simply to lay out how dilution works for everyone in the cap table.

Here is the bottom line. If you are the first shareholder, you will take the most dilution. The earlier you join and invest in the company, the more you will be diluted. Dilution is a fact of life as a shareholder in a startup. Even after the company becomes profitable and there is no more financing related dilution, you will get diluted by ongoing option pool refreshes and M&A activity.

When you are issued employee equity, be prepared for dilution. It is not a bad thing. It is a normal part of the value creation exercise that a startup is. But you need to understand it and be comfortable with it. I hope this post has helped with that.

I've written about this in the past. One of the best ways to get smarter and better at something is to do frequent postmortems after bad decisions. We do it in our firm. When we screw something up, we go back and analyze why it happened, what we did wrong, and what we could have done better. It is incredibly useful.

In the history of our firm, to date we have had only one service fail and shut down. That is Wesabe. And this past week, Wesabe's founder and CEO, Marc Hedlund, did a postmortem on what went wrong. Here are some quotes from Marc's post:

I took over as CEO and led the company without a formal peer for the final two years. All that adds up to me having absolutely no one to blame for Wesabe's failure but myself, and as a result I can't now nor could ever be dispassionate in thinking about what happened.

Between the worse data aggregation method and the much higher amount of work Wesabe made you do, it was far easier to have a good experience on Mint, and that good experience came far more quickly. Everything I've mentioned — not being dependent on a single source provider, preserving users' privacy, helping users actually make positive change in their financial lives — all of those things are great, rational reasons to pursue what we pursued. But none of them matter if the product is harder to use, since most people simply won't care enough or get enough benefit from long-term features if a shorter-term alternative is available.

Can you succeed where we failed? Please do — the problems are absolutely huge and the help consumers have is absolutely abysmal. Learn from the above and go help people (after making them immediately happy, first).

I selected those three quotes for reasons. The first quote is great because Marc is taking full responsibility for the company's failure. In fact, it was not entirely his failure. It was the failure of everyone who was involved including the board and investors. But one secret to good postmortems is not blaming others. When you start by blaming others, you don't get to the truth.

The second quote is the money quote. The first and most important thing about a product is making it easy to use and easy to get value right "out of the box." Wesabe did not do that very well and as a result it could not achieve its loftier goals.

The third quote is my favorite. Marc says "we didn't solve this problem" and suggests that it is still a wide open opportunity and that entrepreneurs should learn from Wesabe's mistakes and go for it. I love that and agree with it.

I do not take much satisfaction from the fact that only one service we have backed in the past seven years has failed. Either we are not taking enough risk or we are destined for more failures. I think it is the latter. And when we fail, I hope that we talk openly and honestly about the failures. It is the right thing to do.

I applaud Marc's courage and honesty in writing this post. I encouraged him to do it a while back and he did it. Bravo Marc.

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• Wesabe Co-founder Explains Why They Lost To Mint, Blames Himself (techcrunch.com)
• Required reading: A startup founder explains why his company failed while the competitor succeeded (RexBlog.com)
• How Does One Startup Defeat Another? (readwriteweb.com)
• The real reason "Wesabe lost" (to Mint) (davidglarson.com)