Posts from MBA Mondays

Litigation

Litigation is something I try to avoid. It is way better to work out differences by sitting down and negotiating a reasonable deal for both parties.

But litigation is a fact of life in business. You cannot avoid it all of the time. Companies and people will sue you even when you have done nothing wrong. So you need to have a framework for thinking about litigation.

Here are some of the things I have learned over the years:

1/ Litigation is expensive and can go on for a very long time. There is no sense of urgency in litigation. You can easily spend more money litigating than settling. If you can settle for less than the likely litigation expense, even if you have done nothing wrong, it is usually better to hold your nose and do that.

There are some people who argue that regularly settling for less than litigation costs will give you a reputation as someone who does that and it will make you a target for lawsuits, often baseless ones. I understand that argument, but I still think settling for less than likely litigation costs is generally the right approach. 

2/ You can lose in litigation even when you have done nothing wrong. I have a friend who is a litigator and he advised me a long time ago that “assume you have a 50/50 chance of losing, no matter how strong your case is, and then you will tend to make the right business decisions.” His point is that you should not fall back on the comfort of a “strong case.” Life is not fair. You can lose when you should win. Plan for that.

3/ Litigation expense is leverage in litigation. Early on at USV, we ended up in some minor litigation. We spent a lot of money on discovery and the other side figured out how to spend very little. We got very far over our skis on the case and we ended up settling on very favorable terms for the other side. We let the other side use expense to their favor. I promised myself I would never do that again. But I see companies we work with do that all the time. It is very easy to want to “lawyer up and fight” and often that is not the best strategy. It can be better to do the rope-a-dope and let the other side spend all of their money and get over their skis.

4/ There are times when you have to fight even if you can settle. If settling a case would materially harm your business, to the point that you would have a hard time operating it, then you must fight. These are existential cases. They are very rare, but they do come along once or twice in a career. When one like this comes along, “lawyer up and fight” is the right strategy and you should amass the best legal team money can buy and you must do everything you can to win. Figuring out when something is existential is the key. Often things feel existential when they are not. That is where the mistakes are often made.

5/ There are lawyers who are great business advisors. I like the term consigliere for them. And there are lawyers who are great litigators. Make sure you have both of them working for you in a litigation. If you can get a consigliere in your company as your General Counsel, you will be way better off in litigation. If you can’t afford that, have one on your board or in your life. The consigliere will help you manage the business side of the litigation and the litigator will manage the legal side of the litigation. It is hard for a business person to manage a litigation without a lawyer at your side.

Those are few of the things I have learned over the years. But my first rule of thumb is to avoid litigation if you can. It really sucks.

PS – I realized after re-reading this post that I left out something very important. Arbitration is an excellent replacement for litigation. Think of it as “litigation light.” It is very important to have arbitration clauses in your everyday contracts (employment, construction, sale of software, provision of service, etc). Arbitration clauses require arbitration in lieu of full blown litigation in the event that there is a dispute over the contract. Arbitration is like litigation in that you can lose even though you did nothing wrong, but it will cost you a lot less time and money to reach a resolution and if you lose, the damages are often a lot more reasonable.

The Employee Equity Project

In the fall of 2010, I wrote a series of nine blog posts about Employee Equity as part of MBA Mondays.

You can read all of them at the links below:

Most of what is in those posts remains valid today.

But the final post, How Much, is very much out of date as the talent market has moved in favor of employees a lot in the past eight years.

That has been particularly true of the top executives and some key talent categories.

Most of the movement has been on the equity side of the comp package.

The How Much post is one of the top posts on AVC.

Though I wrote it 7 1/2 years ago, it was the seventh most popular post on AVC (sixth if you don’t count the home page) in the last year with almost 10k page views.

So I have been concerned that this blog (aka me) is spewing out of date information to a lot of people every day.

And so we are on a mission to fix that.

I have enlisted my colleagues Bethany and Zach on this project and this is what we in the process of doing:

We have collected data on employee equity grants from USV portfolio companies. Many of our portfolio companies use a reporting tool called Advanced HR and through it, we have been able to access anonymized data on every grant that these participating companies have made. Since these are our portfolio companies, we know what their equity is valued at and what it has been valued at over the years. We also understand the context behind many of the outlier grants.

So we have been normalizing the data and bucketing it and looking at distribution curves and understanding it.

We are mostly through all of this work and it is my hope we can publish the data before the middle of May.

As part of that, I will rewrite the How Much post and I will go back and edit the original post with an update section at the end clarifying that the data has changed (a lot).

We also plan to publish a calculator that will help a founder/CEO/HR team understand how to use the numbers we are going to publish.

So stay tuned for this update. It has been a fair bit of work to do this update right and we are excited to get the data out there so all of you can use it.

From The Archives: Convertible Debt

I wrote this in July 2011, as a part of an MBA Mondays series on financing structures:

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MBA Mondays are back after a one week hiatus. Today we are going to talk about convertible debt. Convertible debt can also be called convertible loans or convertible notes. For the purposes of this post, these three terms will be interchangeable.

Convertible debt is when a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made. Sometimes there is compensation in the form of a discount or a warrant. Other times there is not. Sometimes there is a cap on the valuation at which the debt will convert. Other times there is not.

There are a number of reasons why the investors and/or the company would prefer to issue debt instead of equity and convert the debt to equity at a later date. For the company, the reasons are clearer. If the company believes its equity will be worth more at a later date, then it will dilute less by issuing debt and converting it later. It is also true that the transaction costs, mostly legal fees, are usually less when issuing debt vs equity.

For investors, the preference for debt vs equity is less clear. Sometimes investors are so eager to get the opportunity to invest in a company that they will put their money into a convertible note and let the next round investors set the price. They believe that if they insisted on setting a price now, the company would simply not take their money. Sometimes investors believe that the compensation, in the form of a warrant or a discount, is sufficiently valuable that it offsets the value of taking debt vs equity. Finally, debt is senior to equity in a liquidation so there is some additional security in taking a debt position in a company vs an equity position. For early stage startups, however, this is not particularly valuable. If a startup fails, there is often little or no liquidation value.

Friends and family rounds, which we discussed earlier in this series, are often done via convertible debt. It makes sense that friends and family would not want to enter into a hardball negotiation with a founder and would prefer to let the price discussion happen when professional investors enter the equation.

The typical forms of compensation for making a convertible loan are warrants or a discount.

Warrants are another form of an option. They are very similar to options. In the typical convertible note, the Warrant will be an option for whatever security is sold in the next round. The Warrant is most often expressed in terms of “warrant coverage percentage.” For example “20% warrant coverage” means you take the size of the convertible note, say $1mm, multiply it by 20%, which gets you to $200,000, and the Warrant will be for $200,000 of additional securities in the next round. Just to complete this example, let’s say the next round is for $4mm. Then the total size of the next round will be $5.2mm ($4mm of new money plus $1mm of the convertible note plus a Warrant for another $200k). The total cost of the convertible loan is $1.2mm of dilution at the next round price for $1mm of cash.

A discount is simpler to understand but often more complicated to execute. A discount will also be expressed in terms of a percentage. The most common discounts are 20% and 25%. The discount is the amount of reduction in price the convertible loan holders will get when they convert in the next round. Let’s use the same example as before and use a 20% discount. The company raised $4mm of new cash and the convertible loan holders will get $1.25mm of equity in the round for converting their $1mm loan ($1mm divided by .8 equals $1.25mm). Said another way $1mm is a 20% discount to $1.25mm.

Convertible notes also typically have some cap on the valuation they can convert at. That cap is anywhere from the current valuation (not very common) to a multiple of the current valuation. Recently we are starting to see uncapped convertible notes. These notes have no cap on the valuation they can convert at.

Startups typically think about raising capital via convertible debt early on in the life of a startup. They want to move fast, keep transaction costs low, and they are often dealing with a syndicate of angel investors and it is easier to get the round done with a convertible note than a seed or series A round. While these are all good reasons to consider convertible debt, I am not a big fan of it at this stage in a company’s life. I believe it is good practice to set the value of the equity early on and start the process of increasing it round after round after round. I also do not like to purchase or own convertible debt myself. I want to know how much of a company I’ve purchased and I do not like taking equity risk and getting debt returns.

However, later on in a company’s life convertible debt can make a lot of sense. A few years ago, we had a portfolio company that was planning on an exit in a year to two years and needed one last round of financing to get there. They went out and talked to VCs and figured out how much dilution they would take for a $7mm to $10mm raise. Then they went to Silicon Valley Bank and talked to the venture debt group. In the end, they raised something like $7.5mm of venture debt, issued SVB some Warrants as compensation for making the loan, and built the company for another year, sold it and did much better in the end because they avoided the dilution of the last round. This is an example of where convertible debt is really useful in the financing plan of a startup.

My guess is we will see the use of convertible debt, particularly with no compensation and no cap on valuation, wane as the current financing gold rush fizzles out. It will remain an important but less common form of early stage startup financing and will be particularly valuable in things like friends and family rounds where all parties want to defer the price negotiation. But I expect that we will see it used more commonly as companies grow and develop more sophisticated financing needs. It is a good structure when the compensation for making the loan is fair and balanced and when the debt vs equity tradeoff is useful for both the borrower and lender.

From The Archives: Retaining Your Team

I picked up a bad head cold in SF this week. It’s rainy and cold there and that got the best of me. So I’m running a post from the archives and medicating myself instead of writing today.

Retaining Your Employees

I hate to see employees leave our portfolio companies for many reasons, among them the loss of continuity and camaraderie and the knowledge of how hard everyone will have to work to replace them. Many people see churn of employees in and out of companies as a given and build a recruiting machine to deal with this reality. While building a recruiting machine is necessary in any case, I prefer to see our portfolio companies focus on building retention into their mission and culture and reducing churn as much as humanly possible.

There isn’t one secret method to retain employees but there are a few things that make a big difference.

1) Communication – the single greatest contributor to low morale is lack of communication. Employees need to know where the company is headed, what they can do to help get there, and why. You cannot overcommunicate with your team. Best practices include frequent one on ones between the managers and their team members, regular (weekly?) all hands meetings, quick standup meetings on a regular basis for the teams to communicate with each other, and a CEO who is out and about and available and not stuck in his/her office.

2) Getting the hiring process right – a lot of churn results from bad hiring. The employee is asked to leave because they are not up to the job. Or the employee leaves on their own because they don’t enjoy the job. Either way, this was a screwup on the company’s part. They got the hiring process wrong. The last MBA Mondays post(two weeks ago) was about best hiring practices. Focus on getting those right and you will make less hiring mistakes and experience less churn.

3) Culture and Fit – Employees leave because they don’t feel like they fit in. Maybe they don’t. Or maybe they just don’t know that they do fit in. Another post in this series on People was about Culture and Fit. You must spend time working on culture, hiring for it, and creating an environment that people are happy working in. This is important stuff.

4) Promote from within. Create a career path for your most talented people. The best people are driven. They want to do more, develop, and earn more. If you are always hiring management from outside of the company, people will get the message that they need to leave to move up. Don’t make that mistake. Hire from within whenever possible. Take that chance on the talented person who you think is great but maybe not yet ready. Work with them to get them ready and then give them the opportunity and then help them succeed in the position. Go outside only when you truly cannot fill the position from within.

5) Assess yourself, your team, and your company. We have discussed various feedback approaches here before. There is a lot of discomfort with annual 360 feedback processes out there. There is a growing movement toward continuous feedback systems. Whatever the process you use, you must give your team the ability to deliver feedback in a safe way and get feedback that they can internalize and act upon. You must tie feedback to development goals. Feedback alone will not be enough. Build a culture where people are allowed to make mistakes, get feedback, and grow from them. I have seen this approach work many times. It helps build companies where churn rates are extremely low.

6) Pay your team well. The startup world is full of companies where the cash compensation levels are lower than market. This results from the view that the big equity grants people get when they join more than makes up for it. There are a few problems with this point of view. First, the big option grants are usually limited to the first five or ten employees and the big management positions. And second, people can’t use options to pay their rent/mortgage, send their kids to school, and go on a summer vacation with the family. Figure out what “market salaries” are for all the positions in your company and always be sure you are paying “market” or ideally above market for your employees. And review your team’s compensation regularly and give out raises regularly. This stuff matters a lot. Most everyone is financially motivated at some level and if you don’t show an interest in your team’s compensation, they won’t share an interest in yours (which is tied to the success of your company).

I believe these six things (communicate, hire well, culture matters, career paths, assessment, and compensation) are the key to retention. You must focus on all of them. Just doing one of them well will not help. Measure your employee churn and see if you can improve it over time. A healthy company doesn’t churn more than five or ten percent of their employees every year. And you need to be healthy to succeed over the long run.

From The Archives: Turning Your Team

I’m on a short vacation in Utah for the next few days and so I’m going to pull an oldie but goodie out of the archives. I’ve been seeing a lot of “turning the team” in our portfolio as of late so I thought it would be good to give this a re-run.


A serial entrepreneur I know tells me “you will turn your team three times on the way from startup to a business of scale.” What he means is that the initial team will depart, replaced by another team, which in turn will be replaced by yet another team.

I have been closely involved with over 150 startups in my career and since roughly 1/3 of the startups we back get to real scale, that means I’ve seen the “startup to scale movie” over fifty times in my career and I can tell you this – my friend is right.

The people you need at your side when you are just getting started are generally not the people you will need at your side when you have five hundred or a thousand employees. Your technical co-founder who built much of your first product is not likely to be your VP Engineering when you have a couple hundred engineers. Your first salesperson who brings in your first customer is not likely to be your VP Sales. And your first community person is not likely to be your VP Marketing.

Likewise, the first VP Engineering who figured out how to manage the unwieldy team left by your technical co-founder is not likely your VP Engineering when you have five hundred engineers. Your first VP Sales who built your first sales team is not likely the person who can manage a couple hundred million dollar quota. Companies scale and the team needs to scale with it. That often means turning the team.

The “turning your team” thing probably makes sense to most people. But executing it is where things get tricky and hard. How are you going to push out the person who built the first product almost all by themselves? How are you going to push out the person who brought in the first customer? How are you going to tell the person who managed your first user community so deftly that their services are no longer needed by your company?

And when do you need to do this and in what order? It’s not like you tell your entire senior team to leave on the same day. So the execution of all of this is hard and getting the timing right is harder.

This is where serial entrepreneurs have a real leg up on first time entrepreneurs. They have seen the movie too and they played the starring role. So they know what the next scene is before it even starts. They know the tell tale signs of the company scaling faster than their team. And so they move more quickly to move the early leaders out and new leaders in. One of the signature faults of a first time founder is they are too loyal to their founding team and stick too long with them.

If it is any consolation, the founding team makes most of the money when a company becomes successful. That technical co-founder who built the first product will likely end up with tens of millions of dollars, if not a lot more, if a business they helped start gets to five hundred or a thousand people. The VP Engineering of a five hundred person company will not likely have an equity package that is worth anywhere near that much.

So I generally advise entrepreneurs to be open and honest about all of this. Tell your early team that they may not make it all the way to the finish line but they will be handsomely compensated with equity and if you are successful, they will be too. And when it is time for them to go, think about how much they brought to the company and consider vesting some or all of their unvested stock on the way out. Also think about compensating them to stick around during the transition. And always make sure they leave the company with their head high feeling like the hero that they are.

Here’s the thing. Turning a team is not the same as firing someone for weak performance. You are firing someone for doing their job too well. They killed it and in the process got your company off to a great start and growing to a scale that they themselves aren’t a great fit for. They may not be right for the job at hand, but they are a big part of the reason that the company is successful. That’s the narrative that you need to have in your mind when you turn your team.

All of this is very hard, particularly if you are doing it for the first time. So get some mentors, advisors, and board members who have lived through this before. And listen to them about this. You may not want to listen to them too much about product and market stuff. Maybe you understand that better than they do. But when it comes to scaling a management team, those who have had to do it before will generally be right about the issues you are facing with your team. So their advice and counsel is worth a lot and you should pay close attention to it.

The Bubble Question

Everywhere I go, everywhere I speak, I get asked this question. Are we in a bubble?

I’ve been getting asked that question for at least four years now. It’s hard to sustain a bubble for four years. But we are also not in a normal valuation environment for high growth tech companies and we have not been in one for a while.

Here’s how I have been answering the question.

I learned in business school that the multiple of earnings one should pay for a business is roughly the inverse of interest rates. The reason for that is if you buy a business that makes $10mm a year and pay $100mm for it, then you are effectively getting a yield on your investment of 10% (annual earnings/purchase price). This math is terribly simplistic but fine for the purposes of this post. If interest rates are 5% instead of 10%, then you would pay $200mm for the business ($10mm/$200mm = 5%). So the math here is interest rates = annual earnings/purchase price. Again this is very simplistic because it does not deal with the important questions of what interest rate you use, how you deal with earnings that are growing or declining, and a host of other issues. But at the end of the day, this math [annual earnings/purchase price = yield] is fundamental and everything about asset values, capital markets, and valuations stems from it.

Since the financial crisis of 2008, policy makers in the developed world have kept interest rates at or near zero. They have flooded the market with cheap money in an attempt to heal the wounds (losses) of the financial crisis and incent business owners to invest and grow their businesses. That has not worked particularly well but it has worked a bit. Though their words have changed in recent years, their actions have not changed very much. We still are in a policy framework where money is cheap and interest rates are near zero.

If you go back and apply the formula [yield = earnings/purchase price] and use zero for yield/interest rate, then one would pay an infinite amount for an earning stream. Of course that doesn’t make sense and it has not happened. But valuations are at extreme levels because you cannot get a decent return on your money doing anything else.

At some point this will change. The yield on the 30 year treasury yield has been sub 5% since the financial crisis. If (when?) it gets back to the 6-8% range where it was for most of the 1990s, we will be in a different place. Here’s a 40 year history of the 30-year treasury yield. You can see that we have been in a very low rate environment for a while now.

30 year treasury yield

The other thing we have noticed is that this low rate environment has caused asset value/earnings ratios to be non-linear. What you normally see is the value/earnings ratio grows linearly with earnings growth rates. If earnings are growing 20% per year you get a value/earnings ratio of X. If earnings are growing 40% per year, you get a value/earnings ratio of 2x. But what we are seeing is you get something that looks more exponential than linear when you start modeling this out at higher earnings growth rates. When earnings growth rates get to 50-100% per year and look like they can continue to grow at that rate for a number of years, you get value/earnings ratios that are eye popping. It seems that investors are so starved for returns that they are willing to pay that much more for earnings that can grow quickly.

It is the combination of these two factors, which are really just one factor (cheap money/low rates), that is the root cause of the valuation environment we are in. And the answer to when/if it will end comes down to when/if the global economy starts growing more rapidly and sucking up the excess liquidity and policy makers start tightening up the easy money regime.

I have no idea when and if that will happen. But until it does, I believe we will continue to see eye popping EBITDA multiples for high growth tech companies. And those tech companies with eye popping EBITDA multiples will use their highly valued stock to purchase other high growth tech business and strategic assets at eye popping valuations.

It’s been a good time to be in the VC and startup business and I think it will continue to be as long as the global economy is weak and rates are low.

Taking To Dos and Moving Up The Y Axis

I chromecasted the kitchen laptop to our family room TV yesterday morning and watched the entire Sarah Lacy interview with Dick Costolo. Yes, I had posted it as the video of the week without watching it in its entirety. But I knew it would be good. And it was. All two plus hours of it.

Dick has this management framework that I've heard him talk about before. He and Sarah talked about it in the Pando talk. It goes something like this:

If you think about what you are trying to accomplish in a meeting with someone you are managing and you plot the following:

one the x axis – whether you clearly communicated the issue to the person

on the y axis – whether they walk out of the meeting happy or mad at you

Dick's point is you want to optimize for the x axis, clear and crisp communication, and not worry too much about the y axis.

In his talk with Sarah, they talked about meetings that "move up the y axis". Dick put it this way.

In delivering difficult news to the person, you start trying to make them feel better. The next thing you know "you are taking to dos and moving up the y axis and you are going to spend all afternoon on those to dos you took".

Dick's meta point here is your job as a manager is to give people direction not to make them feel good. And if you, in an effort to make them happier, take on a bunch of work that you shouldn't, you will be less effective too.

As Sarah put it, "don't move up the y axis". It's good management advice and I thought I would share it with everyone who did not watch the whole video on this MBA Monday.

Employee Equity

Longtime readers will know this is a topic near and dear to my heart. I did a whole MBA Mondays series on this topic and I followed that up with a Skillshare class on the topic.

So I was excited to see that First Round Capital featured a blog post by Andy Rachleff on this topic yesterday. Andy was a founding partner at Benchmark and knows his way around a startup cap table. Andy included this slide deck in his post and I will reblog it here.

You will notice that Andy's plan differs a bit from my plan. But not by much. The important similarities are that Andy and I both encourage companies to not only grant equity at the start date but also on an ongoing basis so that employees' equity ownership grows as their tenure and contributions grow. This is critical.

Where Andy and I differ a bit is how to calculate how much equity should be granted. Andy suggests using market comps. I don't like doing that because 0.1% of one company can be worth a lot more or less than 0.1% of another company. I prefer to issue equity based on a multiple of current cash comp divided by the current valuation of the business. I lay that all out in my Skillshare class.

While I don't call out promotion and performance bonuses specifically in my Skillshare class, I am a big fan of both.

It is so great that folks like Andy are taking the time to lay out an approach and model to this issue. It is something literally every startup we work with struggles with. Getting it right is hard, but worth it.

Profitless Prosperity

If a Company is making huge profits this year but will not make any profits in the future, it is worthless in the eyes of an investor. But if it loses money this year and next year and may lose money for a few more years, it can still be very valuable in the eyes of an investor.

Amazon had negative net income in 2012 and pretty much zero net income this year to date. And yet it is worth $166bn in the eyes of investors.

This is because companies are worth the present value of future cash flows, not current cash flows, and certainly not past cash flows.

Amazon is not the only company that is plowing back all of its incremental profits into growing its business. This is very common for enterprise software companies as well. Salesforce has made or lost a small amount of money every year for the past four years but it has grown its revenue from $1.3bn to over $3bn in those four years. And its market value has gone from $12bn to $32bn in the same time frame. Workday hasn't made any profits in the last four years, in fact the net losses have been increasing. But the stock has doubled in the past year and the Company is now worth almost $14bn.

The lesson here is that you can't just value a company by taking its current performance into account. You really need to have a view towards its future performance. And you need to understand why the company is not currently profitable.

In the case of Amazon, it is making huge investments in warehouses and logistics to be able to continue to grow its retailing business and it is making similarly large investments in data centers to be able to continue to grow its AWS business. If Amazon did not want to continue to grow, it could stop making those investments and start generating profits. If you believe, as Amazon management does, that the future growth is going to be there for Amazon, then you ignore the current P&L and think about what a future P&L might look like. 

In the case of Salesforce and Workday, they are making huge investments in sales and marketing to secure additional customers. They are also making significant annual investments in R&D to maintain the market leadership of their existing products and bring new ones to market. If you think that Salesforce and Workday can continue to grow their revenues at or near their current growth rates, then you ignore the current P&L and think about what a future P&L might look like.

Profits are critical to the health of a business, but that doesn't mean a healthy business has to currently profitable. It needs to be able to be profitable if it wants to be and it needs to be profitable at some point in the future, at least hypothetically. So when you read that a company is losing money, don't read that as a bad thing. It could be a very good thing. It all depends on why. 

Exit Interviews

I am a big fan of exit interviews. I have learned more doing exit interviews than most other management techniques. When people are on their way out and have no fear of saying exactly what they think, you can learn a lot.

It is rare for an investor/VC to do exit interviews. I only do them in situations where there seems to be a significant problem in a portfolio company and I want to get to the bottom of it.

But if you are the CEO of a company, you should be doing exit interviews with everyone who leaves your company until your company gets to the point that it is impossible to do that. Once you pass that point, your senior team should be doing them along with you.

Here's what I like to do.

First, get a sense from the exiting employee's manager what the cause of departure was. Get the manager's take on the situation. Context is very helpful in situations like this.

Second, don't make an exit interview a witch hunt. Make it a conversation about the good and bad things about the company, the job, the people, etc. The less confrontational the exit intereview is, the more you can learn.

Finally, don't take everything that is said as gospel. There are always two sides to every situation. I like to understand both sides as well as I can. Everyone has an opinion and an agenda and its best to understand everything in that context.

Doing exit interviews is a lot like doing references. The patterns that emerge over multiple interviews are the most telling and that is what you want to be listening for. Exit interviews are a great way to get those patterns out on the table where you can see them.