Posts from 2010

The most common comment in this long and complicated MBA Mondays series on Employee Equity is the question of how much equity should you grant when you make a hire. I am going to try to address that question in this post.

First, a caveat. For your first key hires, three, five, maybe as much as ten, you will probably not be able to use any kind of formula. Getting someone to join your dream before it is much of anything is an art not a science. And the amount of equity you need to grant to accomplish these hires is also an art and most certainly not a science. However, a rule of thumb for those first few hires is that you will be granting them in terms of points of equity (ie 1%, 2%, 5%, 10%). To be clear, these are hires we are talking about, not co-founders. Co-founders are an entirely different discussion and I am not talking about them in this post.

Once you have assembled a core team that is operating the business, you need to move from art to science in terms of granting employee equity. And most importantly you need to move away from points of equity to the dollar value of equity. Giving out equity in terms of points is very expensive and you need to move away from it as soon as it is reasonable to do so.

We have developed a formula that we like to use for this purpose. I got this formula from a big compensation consulting firm. We hired them to advise a company I was on the board of that was going public a long time ago. I’ve modified it in a few places to simplify it. But it is based on a common practive in compensation consulting. And it is based on the dollar value of equity.

The first thing you do is you figure out how valuable your company is (we call this “best value”). This is NOT your 409a valuation (we call that “fair value”). This “best value” can be the valuation on the last round of financing. Or it can be a recent offer to buy your company that you turned down. Or it can be the discounted value of future cash flows. Or it can be a public market comp analysis. Whatever approach you use, it should be the value of your company that you would sell or finance your business at right now. Let’s say the number is $25mm. This is an important data point for this effort. The other important data point is the number of fully diluted shares. Let’s say that is 10mm shares outstanding.

The second thing you do is break up your org chart into brackets. There is no bracket  for the CEO and COO. Grants for CEOs and COOs should and will be made by the Board. The first bracket is the senior management team; the CFO, Chief Revenue Officer/VP Sales, Chief Marketing Officer/VP Marketing, Chief Product Officer/VP Product, CTO, VP Eng, Chief People Officer/VP HR, General Counsel, and anyone else on the senior team. The second bracket is Director level managers and key people (engineering and design superstars for sure). The third bracket are employees who are in the key functions like engineering, product, marketing, etc. And the fourth bracket are employees who are not in key functions. This could include reception, clerical employees, etc.

When you have the brackets set up, you put a multiplier next to them. There are no hard and fast rules on multipliers. You can also have many more brackets than four. I am sticking with four brackets to make this post simple. Here are our default brackets:

NOTE: The numbers below are as of 2010. They have moved a lot since then. The Senior Team numbers have moved the most. I would not recommend using these numbers or you will be below market with your employee equity grants.

Senior Team: 0.5x

Director Level: 0.25x

Key Functions: 0.1x

All Others: 0.05x

Then you multiply the employee’s base salary by the multiplier to get to a dollar value of equity. Let’s say your VP Product is making $175k per year. Then the dollar value of equity you offer them is 0.5 x $175k, which is equal to $87.5k. Let’s say a director level product person is making $125k. Then the dollar value of equity you offer them is 0.25 x $125k which is equal to $31.25k.

Then you divide the dollar value of equity by the “best value” of your business and multiply the result by the number of fully diluted shares outstanding to get the grant amount. We said that the business was worth $25mm and there are 10mm shares outstanding. So the VP Product gets an equity grant of ((87.5k/25mm)  * 10mm) which is 35k shares. And the the director level product person gets an equity grant of ((31.25k/25mm) *10mm) which is 12.5k shares.

Another, possibly simpler, way to do this is to use the current share price. You get that by dividing the best value of your company ($25mm) by the fully diluted shares outstanding (10mm). In this case, it would be $2.50 per share. Then you simply divide the dollar value of equity by the current share price. You’ll get the same numbers and it is easier to explain and understand.

The key thing is to communicate the equity grant in dollar values, not in percentage of the company. Startups should be able to dramatically increase the value of their equity over the four years a stock grant vests. We expect our companies to be able to increase in value three to five times over a four year period. So a grant with a value of $125k could be worth $400k to $600k over the time period it vests. And of course, there is always the possiblilty of a breakout that increases 10x over that time. Talking about grants in dollar values emphasizes that equity aligns interests around increasing the value of the company and makes it tangible to the employees.

When you are doing retention grants, I like to use the same formula but divide the dollar value of the retention grant by two to reflect that they are being made every two years. That means the the unvested equity at the time of the retention grant should be roughly equal to the dollar value of unvested equity at the time of the initial grant.

We have a very sophisticated spreadsheet that Andrew Parker built that lays all of this out for current employees and future hires. We share it with our portfolio companies but I do not want to post it here because it is very complicated and requires someone to hand hold the users. And this blog doesn’t come with end user support.

I hope this methodology makes sense to all of you and helps answer the question of “how much?”. Issuing equity to employees does not have to be an art form, particularly once the company has grown into a real business and is scaling up. Using a methodology, whether it is this one or some other one, is a good practice to promote fairness and rigor in a very important part of the compensation scheme.

I've been pretty clear as of late that I think the market for investing in web startups is getting overheated. When I talk to some people about this, they say "you should shut down and ride out the bubble on the beach." To which I say "we don't think we can time markets."

If you had a crystal ball, then doubling down when the market is ice cold and folding your hand when the market is white hot would be a great investment strategy. But nobody has a crystal ball and timing markets is a lot harder than it seems.

So I prefer to focus on pacing ourselves. What I like to say is "we should add the same number of names each year to our portfolio and put out about the same amount of cash each year." The number we try to add each year is 6-8 new portfolio companies. USV has been investing since November 2004 so we've been in business exactly six years. And we will have 37 portfolio companies soon. So that is almost exactly 6 new investments per year. We had 31 portfolio companies at year end 2009, so we've added 6 new names this year.

I don't have the cash outlay numbers handy this sunday morning but I do know that it took us four years to put the 2004 fund to work. And or current forecasts are that it will take us four years to put the 2008 fund to work. So that's a good proxy for cash outlay per year.

This strategy works particularly well in the venture capital business because we generally will make three to four investments in each company, spread out over a five to six year period. So no one investment at a "bubble valuation" will impact our average valuations across our portfolio. Said another way, we will invest in 20 to 25 companies per fund and we will have three to four investments in each company, so we will make 60 to 100 individual investments in any fund. If we spread those 60 to 100 investments over a six to eight year period, we can average out the valuation spikes and valleys.

I observed this strategy at work in the first VC firm I worked for. The partners had been investing for fifteen years when I showed up and they had evolved into this strategy and taught it to me. When I left that firm and started Flatiron Partners in 1996, Jerry and I started out with a reasonable and steady pace. It took us about three years to put our first $150mm fund to work. But when we got our second fund of $350mm in 1999, we adopted a different approach. The first mistake was to raise a much bigger fund just as the market was getting overheated. The second mistake was to put that fund to work in 18 months. We went from putting out $50mm per year to putting out $250mm per year, just as the bubble was reaching its peak. The results speak for themselves. We made greater than 5x on that first fund. Eleven years later, we will be lucky to make 2x on the $350mm second fund.

So when I look at where we are right now, it reminds me so much of 1999 and frankly it scares me. But we are not pulling back. We are sticking with our investment strategy and putting out cash and adding new names to our portfolio. But we are doing it with a very close eye on pace, both in terms of names and cash outlays. I think that is the right approach and that it will serve us well as we navigate the tricky waters we find ourselves in.

The Gotham Gal is involved in an event in late January called The Women Entrepreneur Festival. They are doing it with and at NYU's ITP program.

I love the idea of calling it a "festival." This is a celebration of women entrepreneurs. Exactly what we should be doing to showcase role models and make the point that women are just as good at starting companies as men are.

They also came up with an innovative format. They have four groups of entrepreneurs; social, media, design, and green. Each group has a bunch of women entrepreneurs and at least one male entrepreneur. In the morning each group will do "show and tell" so you can see what each of them has built. In the afternoon, the groups will go on stage again to talk about their sectors and the role that women play in them.

It's great to see ITP getting involved in something like this. ITP is one of the secrets of the NYC tech startup scene. It is a program that focuses on the intersection of design, media, technology, and communications. It is all about the things that makes NYC's startup sector special. And it was started by a women entrepreneur, Red Burns. So it makes so much sense that they are hosting a festival for women entrepreneurs.

The festival is limited to 150 participants due to space limitations. You can apply to attend here. Acceptances will be made on a rolling basis. If you are accepted, it costs $50 to attend if you are a student and $200 to attend if you are not a student.

I got some great news about the Donors Choose Campaign we are running this month here at AVC.

HP will match every dollar we donate in this campaign. They did that last year as well so this is two years in a row that we've been able to leverage HP's generosity for the benefit of teachers and students.

It's a good opportunity to remind everyone that we are focusing this year's Donors Choose campaign on math and science education for young women.

And finally, I'd like to remind everyone that all contributors to this Donors Choose campaign will be invited to a Meetup I am hosting in NYC on the evening of December 8th. Here's the giving page if you want to make a donation and come to the meetup.

I hope we can get a representative from HP to attend the Meetup.

I had the pleasure of watching John Battelle interview Evan Williams to wrap the Web2 conference yesterday. John's a great interviewer and it was a memorable talk. But the thing that stayed with me through the night and was on my mind as I woke up this morning was this part, as transcribed by Matthew Ingram.

Williams — who founded Blogger and later sold it to Google — said that “lowering the barrier to publishing” has been something he has spent most of his career on, and this is because he believes that “the open exchange of information has a positive effect on the world — it’s not all positive, but net-net it is positive.” With Twitter, he said, “we’ve lowered the barriers to publishing almost as far as they can go,” and that is good because if there are “more voices and more ways to find the truth, then the truth will be available to more people — I think this is what the Internet empowers [but] society has not fully realized what this means.”

When I started blogging back in 2003, I would tell everyone how awesome it was. A common refrain back then was "not everyone should have a printing press." I didn't agree then and I don't agree now. Everyone should have a printing press and should use it as often as they see fit. Through things like RSS and Twitter's follow model, we can subscribe to the voices we want to hear regularly. And through things like reblog and retweet, the voices we don't subscribe to can get into our readers, dashboards, and timelines.

If I look back at my core investment thesis over the past five years, it is this single idea, that everyone has a voice on the Internet, that is central to it. And as Ev said, society has not fully realized what this means. But it's getting there, quickly.

This was a lot of fun. I got to share the stage with John Doerr, someone I've admired and respected for many years, and John Heilemann, who never ceases to entertain and educate me.

Here's the video. It's pretty long. Just shy of forty minutes.

Bill Gurley penned a fantastic post about IPOs yesterday. Go read it.

Bill presents a very compelling case that IPOs still have a role to play in the startup ecosystem and he also puts forth some strong data suggesting that the IPO market is coming back and good companies are taking advantage of it.

But my favorite part is his counterargument to the point that Wall Street forces entrepreneurs and managers to run their companies with a short term focus (an issue I've long been concerned about). Bill writes:

One recent argument knocking the IPO is as follows: Wall Street is too short-term focused, and that if you want to run your company for the long-term you should remain private. There are three great reasons that this “can’t focus on the long term” argument falls short — Jeff Bezos, Marc Benioff, and Reed Hastings. All three of these amazing entrepreneurs turned CEOs took their company public on a standard IPO time frame. They also all three conveyed to Wall Street that they would postpone short-term earnings results in order to chase a greater long-term objectives and ambitions. The intelligent mutual fund investors that were swayed by their convincing arguments (there were many) were handsomely rewarded. Furthermore, Bezos, Benioff, and Hastings all three used “being public” as a bully-pulpit to tell their version of their industry’s story, thereby aiding their advantage. If you are unconvinced go ask Steve Riggio, Tom Siebel, or Blockbuter CEO Jim Keyes.

Back in the late 90s, my prior firm had somewhere between a dozen and two dozen IPOs out of a portfolio of 50 some names. Many of those IPOs ended badly as the companies failed and were sold for way less than the offering price. That experience taught me a great deal and as Bill notes in his post, I've been bearish on IPOs since then.

However, even in my most bearish posts on the topic, I've always said that the best 10% of venture backed companies ought to at least consider an IPO. If you are operating a business with the potential of a Netflix, an Amazon, or a Salesforce, then you are in a different league and the IPO should be in your playbook. Whether you actually call that play is another story, but it needs to be there.

We have close to forty portfolio companies now and I can easily count four of them that someday will make great public companies. In my view, you need to be able to say yes to all of the following questions to have a great public company:

1) Market Leader

2) Sustainably Profitable

3) Strong Top Line Growth For As Far As You Can See

4) Strong Management Team With Public Company Experience In The Key Places

5) A Willingness To Build The Company Without Regard To Short Term Stock Price Movements

6) The Ability To Credibly Trade At A Billion Dollars of Market Cap Or More

If you have a company that fits that bill, then you should absolutely be thinking about an IPO. But if you don't, then you should think about some other approaches to exit, most likely M&A to a strategic or financial buyer. You may also want to consider secondary sales to provide liquidity while the company continues to build toward an IPO or a sale.

Bill's post is well timed. The startup sector is on an upswing and there are quite a few really strong businesses out there sitting in venture capital portfolios. If those companies and the VCs behind them are careful and thoughtful about going public, and if only the best companies choose that route, we could see a healthy and vibrant IPO market for startups reappear in the coming years.

We had a bunch of questions about vesting in the comments to last week’s MBA Mondays post. So this post is going to be about vesting.

Vesting is the technique used to allow employees to earn their equity over time. You could grant stock or options on a regular basis and accomplish something similar, but that has all sorts of complications and is not ideal. So instead companies grant stock or options upfront when the employee is hired and vest the stock over a set period of time. Companies also grant stock and options to employees after they have been employed for a number of years. These are called retention grants and they also use vesting.

Vesting works a little differently for stock and options. In the case of options, you are granted a fixed number of options but they only become yours as you vest. In the case of stock, you are issued the entire amount of stock and you technically own all of it but you are subject to a repurchase right on the unvested amount. While these are slightly different techniques, the effect is the same. You earn your stock or options over a fixed period of time.

Vesting periods are not standard but I prefer a four year vest with a retention grant after two years of service. That way no employee is more than half vested on their entire equity position. Another approach is to go with a shorter vesting period, like three years, and do the retention grants as the employee becomes fully vested on the original grant.  I like that approach less because there is a period of time when the employee is close to fully vested on their entire equity position. It is also true that four year vesting grants tend to be slightly larger than three year vesting grants and I like the idea of a larger grant size.

If you are an employee, the thing to focus on is how many stock or options you vest into every year. The size of the grant is important but the annual vesting amount is really your equity based compensation amount.

Most vesting schedules come with a one year cliff vest. That means you have to be employed for one full year before you vest into any of your stock or options. When the first year anniversary happens, you will vest a lump sum equal to one year’s worth of equity and normally the vesting schedule will be monthly or quarterly after that. Cliff vesting is not well understood but it is very common. The reason for the one year cliff is to protect the company and its shareholders (including the employees) from a bad hire which gets a huge grant of stock or options but proves to be a mistake right away. A cliff vest allows the company to move the bad hire out of the company without any dilution.

There are a couple things about cliff vesting worth discussing. First, if you are close to an employee’s anniversary and decide to move them out of the company, you should vest some of their equity even though you are not required to do so. If it took you a year to figure out it was a bad hire then there is some blame on everyone and it is just bad faith to fire someone on the cusp of a cliff vesting event and not vest some stock. It may have been a bad hire but a year is a meaningful amount of employment and should be recognized.

The second thing about cliff vesting that is problematic is if a sale happens during the first year of employment. I believe that the cliff should not apply if the sale happens in the first year of employment. When you sell a company, you want everyone to get to go to the “pay window” as JLM calls it. And so the cliff should not apply in a sale event.

And now that we are talking about a sale event, there are some important things to know about vesting upon change of control.  When a sale event happens, your vested stock or options will become liquid (or at least will be “sold” for cash or exchanged for acquirer’s securities). Your unvested stock and options will not. Many times the acquirer assumes the stock or option plan and your unvested equity will become unvested equity in the acquirer and will continue to vest on your established schedule.

So sometimes a company will offer accelerated vesting upon a change of control to certain employees. This is not generally done for the everyday hire. But it is commonly done for employees that are likely going to be extraneous in a sale transaction. CFOs and General Counsels are good examples of such employees. It is also true that many founders and early key hires negotiate for acceleration upon change of control. I advise our companies to be very careful about agreeing to acceleration upon change of control. I’ve seen these provisions become very painful and difficult to deal with in sale transactions in the past.

And I also advise our companies to avoid full acceleration upon change of control and to use a “double trigger.” I will explain both. Full acceleration upon change of control means all of your unvested stock becomes vested. That’s generally a bad idea. But an acceleration of one year of unvested stock upon change of control is not a bad idea for certain key employees, particularly if they are likely to be without a good role in the acquirer’s organization. The double trigger means two things have to happen in order to get the acceleration. The first is the change of control. The second is a termination or a proposed role that is a demotion (which would likely lead to the employee leaving).

I know that all of this, particularly the change of control stuff, is complicated. If there is anything I’ve come to realize from writing these employee equity posts, it is that employee equity is a complex topic with a lot of pitfalls for everyone. I hope this post has made the topic of vesting at least a little bit easier to understand. The comment threads to these MBA Mondays posts have been terrific and I am sure there is even more to be learned about vesting in the comments to this post.

Building web apps is not getting easier. The fragmentation of operating systems and browsers is getting worse, not better.

Here's a chart of the past thirty days of activity at AVC.com:

No OS/browser combo has more than 17% share. And there are five with more than 10% share. iPhone is about 6% and iPad is about 4%. If you go down to the next ten combos, you find a number of Android and Blackberry combinations.

Mobile OS/browser combos in total add up to about 15% of all visits and that number is up from less than 5% a year ago.

Add in the need to build mobile apps for iOS, Android, and possibly Blackberry and you've got quite a difficult environment for developers these days.