Posts from entrepreneurship

The Finance Function: Looking Back And Looking Forward

High growth companies need to have a strong finance function. You can’t drive a car (or a plane) without some instrumentation. Most importantly, you need to know when you are going to run out of gas (or electricity).

The mission critical things that must be done in the finance function are mostly accounting related functions; pay bills, make payroll, keep track of expenses, maintain the books and records of the company. These are “must dos” and you need a person who has an accounting background to do most of them. But these are all “looking back” functions in the way I think about the finance function.

What is even more important in a high growth situation is the ability to look forward, to project, and to make sure that the company doesn’t run out of money.

In order to look forward, you need to know where you are, and that requires a solid baseline derived from looking back. So one feeds the other. But they are different.

Looking forward requires modeling and it requires the ability to anticipate. An example of this is “we are going to get a big order from a new customer next month, let’s put that revenue into the model.” But if you don’t anticipate that it may take up to ninety (or more) days to collect that revenue, then you have messed up the modeling and that is the sort of rookie error that could lead to an unexpected cash crisis.

There are many reasons why a company needs a forward looking projection to run the business but avoiding the unexpected cash crisis is number on on that list in my view.

In my experience, the people who are strong at the looking back function are often not strong at the looking forward function. You may need different people to do these roles. In a large company, there are entirely different departments that do these functions. There is an accounting department and there is a financial planning department (often called FP&A).

If you are a small company and have limited resources, you will often attempt to get both the look back and the look forward from the same person. If you aren’t getting what you want in doing that, don’t be surprised. I would rather see a small company outsource the accounting work and staff for the planning/modeling work. Accounting is a bit of a commodity, many people can do it well. Seeing the future from around the corner is most definitely not commodity and if you have someone who can do that well, hold on to them, pay them well, and make sure they are happy and rewarded in the job.

Because looking forward is really where it is at in the finance function at the end of the day. That’s where the good stuff and the bad stuff mostly happen. And when it is done well, it is a thing of beauty.

The Diverse Syndicate

Startups are generally not funded by just one investor. They are usually funded by a collection of investors; the angel syndicate, followed by the seed syndicate, followed by the VC syndicate.

This gives the founder the opportunity to gain insights and advice from a group of people versus just one.

I was sitting next to a VC last night who brought up the age old question – operator vs investor? She is a successful early stage investor who has never been an operator.

My answer to her question was “both.”

Yes it is fantastic to have people in the syndicate who have been or maybe still are operators. They will be able to help you with all sorts of management issues.

But it is equally important to have the investor mindset in your syndicate. Investors tend to be very attuned to financial issues like burn rate, when to raise, from whom, etc. They also understand market positioning, strategy, and similar stuff very well.

While you are at it building a diverse investor syndicate, try to get women, minorities, and other forms of diversity into your syndicate.

Treat building an investor syndicate like building a management team. What you want is a lot of differing strengths not a bunch of the same strengths.

The Hidden Cost Of Extending Option Exercise Periods

Many people in startup land believe that the answer to the challenges around forcing departing employees to exercise vested options is to simply extend the option exercise period to the maximum (ten years) allowed by the IRS.

It certainly is one of the techniques that are available to companies and one that a number of our portfolio companies have adopted. Another option, and one that I prefer, is for a market to develop around financing these option exercises (and the taxes owed) when employees depart.

However, if you are thinking about extending the option exercise period for departing employees, you should understand that it will cost your company something.

Here is why:

Options are worth more than the spread between the strike price (the exercise price) and what the stock is actually worth. They have additional value related to the potential for the stock price to appreciate more over the life of the term of the option.

There is a formula that options traders (and companies that issue options) use to value options. It is called the Black-Scholes formula.

If you click on that link, you will quickly realize that the math used in the Black-Scholes formula can be complicated. But fortunately, there is a neat little web app that I frequently use to estimate the value of an option. It is here.

So let’s say that your company is issuing options at $1/share (your 409a) but your most recent financing was done at $2/share. Then a four year stock option is worth roughly $1.25/share.

If, on the other hand, you offer a ten year option exercise period to your employees, the value of the option rises to $1.52/share, reflecting the longer period of time that the stock could appreciate over.

That is a 20% increase in the cost of issuing stock options. You could mitigate that by reducing the number of options you issue to incoming employees by 20% but that might make your equity comp offers less attractive to the “market” because incoming employees won’t value the longer exercise periods appropriately.

Stock based compensation costs are real costs even though many in startup land think of options as “free” because they don’t cost cash. The accounting profession has attempted to estimate these costs and companies do put stock based compensation costs on their income statements. If you go with ten year exercise periods instead of four year exercise periods, expect those expenses to go up significantly. Twenty percent is just the amount in my example. It could be larger, possibly as high as fifty percent (or more) if your exercise price is a lot closer to the current value of your stock.

This extra value of a ten year stock option versus a four year option is known as “overhang” by investors. It is the cost of carrying a group of people who have a call option on your stock but don’t have to pay for it for a long period of time. Generally speaking investors don’t like a lot of overhang in a stock.

All of that said, employees are the ones who create value for shareholders. They need to be compensated for that. And I am a fan of both cash compensation and stock based compensation. I like to see the employees of our portfolio companies well compensated in stock. That has a cost and everyone should be well aware of what it is. Longer exercise periods increase that cost. I would rather put more stock in the hands of the employees of our portfolio companies than give them longer exercise periods. But regardless of where one comes out on that tradeoff, it is important to recognize that it is a tradeoff. There are no free lunches, not even in stock option exercise periods.

Audio Of The Week: Ayah Bdeir

I wrote a bit last Monday about the 60 Minutes piece last Sunday night about getting to gender equity in STEM education. My message in that blog post was that there are many innovators in this sector and not everyone will get the credit they are due.

Ayah Bdeir, who was left on the cutting room floor on that 60 Minutes piece, had a different message and one that I understand and appreciate.

Ayah is awesome and I want to shine a light on her and her work and there is no better way to do that than to repost her conversation with The Gotham Gal from last year.

Progress Is Ugly

I walked out of my house in LA this morning and was greeted with this sight:

I thought “ugh” and debated picking it up and putting it where it belongs.

I am all for progress and understand that there are costs and benefits with everything.

This post explains how electric scooters can and likely will result in massive reductions in carbon emissions (and that Steve Jobs was a big fan of electric scooters).

With that electricity subtracted, the net amount of mitigated carbon equals 17,130 metric tons. Let’s reduce this number by 20% for people who would have walked and for chargers picking up scooters in their cars. Now we’re looking at a total amount of 13,700 metric tons of CO2 mitigated by not driving a car.That’s the equivalent of taking 105,000 cars off the roads around the world, each day.

https://medium.com/cleantech-rising/the-environmental-impact-of-electric-scooters-8da806939a32

That is a big deal. It is really hard for me to be against electric scooters when I see people riding them to work instead of driving or being driven in cars.

But the way electric scooters have been rolled out here on the west side of LA leaves a lot to be desired. I have counted at least five suppliers of electric scooters in my neighborhood. There seems to be no limit on new entrants. And the big product market fit innovation that unlocked electric scooters, the dockless network (which I’ve been a fan of on this blog), is also the cause of much of the “ugliness” of them.

I have no doubt that the electric scooter providers will innovate on the model and the product and figure out how to alleviate many or possibly all of this ugliness over time. But until then we will be picking up scooters from our lawns and sidewalks.

It is no wonder that large swaths of society are getting tired of tech companies, startups, and disruption and are starting to say “no mas.” We in startup land have learned that the winners beg for forgiveness instead of ask for permission. And you won’t find a bigger fan of and promoter of permission-less innovation than me and my colleagues at USV.

If we wait for those in power to grant permission to innovate we won’t get anywhere. Most everyone understands that.

So we end up with ugliness. And that is a big challenge for innovators. Can we innovate a little more beautifully? I don’t know but I hope that we can try. If we don’t, we will see even more backlash than we are seeing now.

How To Be A Good Board Member

Mark Suster wrote a post this weekend laying out some rules for being a good board member before the meeting, in the meeting, and outside of the meeting. It is a very good list. I particularly like his rules for outside of the board meeting and agree with him that is the most important part of being a board member.

I try to follow these rules except “let others speak.” That is a joke but I am known for taking up a lot of airtime in meetings, not only board meetings. It is something I’ve been working on for thirty-five years and something I expect I will be working on for the rest of my life. I just get so into it and can’t help myself.

Which leads me to my rule for being a good board member.

It comes down to one word.

Care.

If you care, really care, deeply care, like the way a parent cares for a child, you will be a good board member.

Of course, you have to do a lot of work; preparation work, people time, relationship work, reading, studying, etc to be good at this job.

But all that comes easy if you just deeply care about the company, the people running it, and everybody in and around it.

The “Doubling Model” For Fundraising

I was talking to a friend this past week who is looking at an early stage company and trying to figure out how to value it.

He pointed to a similar company that has a public market cap of $250mm.

I asked him how many rounds of financing or how many major milestones does this early stage business need to accomplish before it can get to the same place the similar publicly traded company is at.

He said he thought it was going to take three big steps after this financing to get there.

So I said, “it is worth roughly $30mm after this round.”

He said “how did you determine that?”

I said “If you assume the value will double from round to round or milestone to milestone, and after three more of those it will be worth $250mm, then it should be worth $30mm after this one.”

I then said “work back from $250mm, to $125mm, to $62mm to $31mm.”

I call this the doubling model and I’ve used it as a framework for thinking about value appreciation in startup financing for over thirty years.

Here is a simple spreadsheet that shows how this works. It does not include the impact of employee equity grants in it so the numbers would change a bit if I added that. Assume the employees would own 20% of the company at exit.


This is just a framework, nothing more.

But I find it is very helpful in thinking about what is fair and reasonable at various stages of a companies development.

You can also scale this back. If a company only needs ~$20mm to get to positive cash flow, but only has $150mm of potential value at exit, you would get something like this:

The two big assumptions that drive this framework is that a company should always target to double valuation round to round and never dilute more than 20% per round. That minimizes dilution and also gives the existing investors the comfort and confidence that things are going roughly to plan.

If things are going great, you can take valuation up more than that from round to round, but in my experience that often catches up to you and the next round is flat as a result, which is not a great thing for anyone.

And everything is ultimately governed by the total size of the opportunity (TAM), how the market will value that at time of exit, and the capital requirements to get there. Those are the fundamental drivers of value in startup land and this framework attempts to respect them.

The Weekly Email

One of my favorite moves that I have seen founders do in the early stages of their company (think pre-seed, seed, and possibly into the Srs A stages), is the weekly email.

This can take a number of forms; a weekly email to the team, a weekly email to the investors, a weekly email to everyone, even a weekly email to yourself! It matters a bit who the audience is for the weekly email because it determines what the founder can put into the email.

But I am not sure it matters that much who the audience is. What matters more is a weekly cadence of what is on the founders mind, what happened in the last week, and what the objectives are for the coming week.

Early stage startups are hyper-changing environments. The founder needs to keep everyone aligned and on-board as he or she weaves and bobs around product market fit, the positioning of the company, the composition of the team, and a lot more. The weekly email does a good job of accomplishing that.

But more than anything, writing the weekly email is a tool for the founder to collect themselves, get grounded for the week ahead, and articulate what they and the company are doing and why.

I like Sunday evening for the timing of the weekly email best. It sets up the week to come. But any time over the weekend, or even monday morning, works fine.

If you are starting something new and want a routine that can help you get into a rhythm and stay there, consider the weekly email. It’s a great one.

Raising A SAFE Or Convertible Note In Between Rounds

A trend we’ve seen in the financing of startups in the last five years is the “SAFE between rounds” which means raising a convertible note (or SAFE) to provide more capital and runway in between financing rounds. It often comes in the form of an offer by an investor who missed the last round and doesn’t want to miss the next round.

It is a tempting offer because there is no immediate dilution from the capital and it usually converts at the next round price or a small discount to it.

Most founders look at the offer and think “why not?”

Here is why you might not want to do this.

The SAFE or convertible note can “crowd out” new investors in the next round and make it very hard to find a lead investor or any high quality investors.

Let’s do some math to show how this happens.

Let’s say you did a seed round of $1mm where you sold 15% of the company and you did a Series A of $3mm where you sold 20% of the company. Your last round valuation was $15mm post-money and you’ve now sold ~35% of the company to investors. These investors will typically have “pro-rata rights” to participate in the next round. Which means 35% of the next round will go to your existing investors.

Let’s say you hope to double your valuation on your next round and raise a Series B at $30mm pre-money or more in a year to 18 months.

Then someone comes along and offers you a $2mm convertible note or SAFE which converts into the next round. You think “free money, that sounds great.”

But if you take the note, then you have a fair bit of the next round already committed for.

Let’s say the next round is $5mm. The existing investors take 35% of $5mm (or $1.75mm), the note takes $2mm, and you are left with $1.25mm to offer a new investor. It is very hard to find a lead investor who will price the round for only $1.25mm of a $5mm round. And if that round is at $30mm pre-money, $35mm post-money, you are only offering that new investor 3.6% of the company which is not a lot.

Let’s say the next round is $7.5mm, a reasonable amount to raise at $30mm pre-money (20% dilution). The existing investors take $2.625mm, the note takes $2mm, and so you have $2.875mm to offer a new investor to lead and price the round. That is a fairly small number as well and would only purchase 7.7% of the company.

You’d have to raise a $10mm Series B before you’d be able to offer a sizable allocation to a new lead if you have 35% of the round committed to pro-rata rights and a $2mm note converting into it. And even then the new investor can only purchase ~11% of the company and the round will be 25% dilutive at $30mm pre-money.

As you can see, taking a SAFE or convertible note between rounds can make it hard to create enough of an allocation in the next round to attract a high quality lead who will price the round.

So, if taking a SAFE or convertible note between rounds is not a great idea, what should a founder do?

I like to see if the investor who wants to do the SAFE or convert is interested in catalyzing a “Series A1” where you take their money and the pro-rata (or slightly more) from the insiders and price it at a significant markup to the Series A. If they are willing to do that, it often is better for everyone to do that.

That tends to be less dilutive, creates even more runway to get to an attractive B round and it avoids the issue of crowding out money in the next round.

Mark Leslie On Entrepreneurship, Leading, and Selling

I have had the pleasure of sitting on a few higher education boards with Mark Leslie. He’s a very accomplished and wise person. I respect him a lot.

In this talk with Peter Levine, Mark talks about some of the most important concepts in starting, leading, and building companies. Listen to him. He’s knows what he’s talking about.