Posts from Startup company

Pair Up

Last night I attended a meeting/dinner of many leaders in the NYC tech sector with the folks in city hall who work on economic development. We listened to a bunch of reports. One of the most telling was from Larry Lenihan of Firstmark who is managing an early stage venture fund focused on NYC tech companies. Larry explained that many of the best opportunities that come to them don't get funding because of the lack of a technical co-founder.

NYC has a wealth of business people with domain experience in many important sectors. But they seem to be having a hard time of pairing up with technical talent to form great startup teams.

Enter Pair Up. Pair Up NYC is an effort from InSITE, a group of grad students at NYU and Columbia who help startups. They've noticed the same issue and are doing something about it. Pair Up is a matching program between people who want to do startups.

I've tweeted out the link to Pair Up a few times, but I am writing this post to let everyone know that the deadline to apply for the first Pair Up program is tomorrow, March 18th. If you are looking for a cofounder and want some help, here's where you can apply.



#NYC#VC & Technology

Storm Clouds

We have enjoyed an amazing run in the web startup and investing space over the past five or six years. In this sector of startupland, company creation is up, investment is up, there are plenty of success stories, and not all of them are based on quick flips and takeouts. There is real revenue flowing through web companies and many web startups formed in the last five or six years are operating profitably. It has been good to be a web entrepreneur and a web VC, and I think it will continue to be for quite some time.

However, there are a few storm coulds out there that we need to be watching. In particular, I think the competition for "hot" deals is making people crazy and I am seeing many more unnatural acts from investors happening. If it were just valuations rising quickly, I'd be a bit less concerned. But we are also seeing large deals ($5mm to $15mm) getting done in a few days with little or no due diligence. Investors are showing up at the first meeting with term sheets. I have never seen phases like this end nicely.

We are also seeing a massive talent war for software engineers going on in Silicon Valley and it is spilling over into other regions. The story by Mike Arrington this morning about a Google engineer is just one example. There are many more examples of poaching by companies driving up salaries, equity packages, and stay and join bonuses.

You might say, "this is good for entrepreneurs and software engineers, they are finally being valued what they are worth." Maybe. But I think both of these situations are unsustainable. And anything that is unsustainable will eventually stop happening. And when it stops happening, there will be a dislocation event that will cause people to change their behavior.

Of course if you are a VC or a HR person in a web company, you don't know when that event will happen and you have to operate your business until then. So we will see this behavior and other troubling things continue to happen for some time to come. When will it stop? Who knows? But be prepared for it to end. And when it does, things will be different. And we should all be prepared for that time.



#VC & Technology

Your Worst Enemy Is Yourself

One mistake I see startups make a lot is getting too focused on what is going on around them. They spend too much time trying to figure out what their competitors are going to do. They watch the next hot startup with jealousy and it reminds them of when they were that "shiny new thing" and they want that back.

The reality of startups is that there is so much opportunity out there that if you just focus on what is in front of you, your company will do fine. But focusing on what is in front of you means not focusing on what is going on around you. You need to put blinders on and execute. Do not let what is going on around you whipsaw your strategy and your team.

I am not suggesting that you should put your head in the sand. It is critical to know what is going on in your market. But it is equally critical to have a strategy that makes sense in the context of what is going on and execute it with purpose and pace. If you spend too much time looking over your shoulder, you will not execute well. I've seen it again and again.

So don't let all the news of the day slow you down. Don't let your competitors press releases and launch parties get inside your head. Plan, build, ship, and scale. Assess. Repeat again and again. Win.



#Uncategorized

Employee Equity: The Liquidation Overhang

We're five posts into this MBA Mondays series on Employee Equity and now we are going to start getting into details. We've laid out the basics but we are not nearly done. I am just starting to realize how complicated the issues around employee equity are. That's not good. It's like paying taxes. Everybody does it and nobody but the tax accountants understand it. Ugh.

Anyway, enough of that. Let's get into the issue of liquidation overhang.

When VC investors (and sometimes angels) invest in a startup company, they almost always buy preferred stock. In most startups, there are two classes of stock, common and preferred. The founders, employees, advisors, and sometimes the angels will typically own common stock. The investors will typically own preferred stock. The easiest way to think about this is the "sweat equity" will mostly be common and the "cash equity" will mostly be preferred.

For the sake of this post, I am going to talk about a simple plain vanilla straight preferred stock. There are all kinds of preferred stock and it can get really nasty. I am not a fan of variations on the straight preferred but they exist and they can make the situation I am going to talk about even worse.

First, a quick bit on why preferred stock exists. Lets say you start a company, bootstrap it for a year, and then raise $1mm for 10% of the company from a VC. And let's say a few months later, you are offered $8mm for the company. You decide to take the offer. If the VC bought common, he or she gets $800k back on an investment of $1mm. They lose $200k while you make $7.2mm. But if the VC buys preferred, he or she gets the option of taking their money back or the 10%. In that instance, they will take their money back and get $1mm and you will get $7mm.

In its simplest (and best) form, preferred stock is simply the option to get your negotiated ownership or your investment back, whichever is more. It is designed to protect minority investors who put up significant amounts of cash from being at the whim of the owner who controls the company and cap table.

Now that we have that out of the way, let's talk about how this can impact employee equity. Anytime the value of the company is less than the cash that has been invested, you are in a "liquidation overhang" situation. If a small amount of venture capital, let's say $5mm, has been invested in your company, it is unlikely that you will find yourself in a liquidation overhang situation. But if a ton of venture capital, say $50mm, has been invested in your company, it is a risk.

Let's keep going on the $50mm example. It comes time to sell the company. The VCs own 75% of the Company for their $50mm. The founders own 10%. And the employees own 15%. A sale offer comes and it is for $55mm. The employees do the math and multiply 15% times $55mm and figure they are in for a $8mm payday. They start planning a party.

But that's not how the math works. The VCs are going to choose to take their money back in this situation because 75% of $55mm is roughly $41mm, less than their cash invested of $50mm. So the remaining $5mm is going to get split between the founders and employees. The investors are now "out of the cap table" so the final $5mm gets split between the founders and the employees in proportion to their ownership. The employees get 60% of the remaining $5mm, or $3mm. The party is cancelled.

This story is even worse if the company that has $50mm of investment is sold for $30mm, or $40mm, or even $50mm. In those scenarios, the employee's equity is worthless.

I know this is complicated. So let's go back to the basics. If your company has a lot of "liquidation preference" built up over the years, and if you think it is not worth that amount in a sale situation, your company is in a liquidation overhang situation and your employee equity is not worth anything at this very moment.

You can grow out of a liqudation overhang situation. If this hypothetical company we are talking about decided not to sell for $55mm and instead grew for a few more years and ends up getting sold for $100mm, then the liquidation overhang will clear (at at sale price of $65mm) and the employees will get $15mm in the sale for $100mm.

So being in a liquidation overhang situation doesn't mean you are screwed. It just means your equity isn't worth anything right now and the value of the company has to grow in order for your equity to be worthwhile. But it also means that a sale of the company during the liquidation overhang period will not be good for the employees. As JLM would say "you won't be going to the pay window."

This issue is front and center in the minds of many employees who worked in tech companies in the late 90s and early part of the 2000s. The vast majority of companies built during that period raised too much money too early and built up large liquidation preferences. Many of them were sold for less than the liquidation preference and the investors lost money on their investments and the employees got nothing. That has hurt the value of employee equity in the minds of many.

We are in a different place in the tech startup world these days. Many of our companies have raised less than $10mm in total investment capital. And the ones that have raised a lot more, like Zynga, Twitter, and Etsy, have enterprise values that are 10x the lquidation preferences (or more). This is the gift of web economics. It doesn't take as much investment capital to build a web company anymore. That has made investing in web companies better. And it has made being an employee equity holder in web companies better.

But liquidation overhangs still do exist and when you are offered a job in a startup where equity is being offered, it is worth asking a few simple questions. You need to know how many options you are being offered. You need to know where the company thinks the strike price will come in at (they can't promise you an exact price). You need to know how many shares are outstanding in total so you can determine the percentage ownership you are being offered and the implied valuation of the strike price. And finally, you need to know how much total capital has been invested in the company to date so you can decide if there is a liquidation overhang situation.

Just because there is a liquidation overhang doesn't mean you shouldn't take the job. But it's a data point and an important one in valuing the equity you are being offfered. Figure this stuff out going into the job. Because standing at the pay window and finding out there's no check for you is painful. Don't let that happen to you if you can help it.



#MBA Mondays

Startups Get Hit By Shrapnel In The Banking Bill

There is a big banking reform bill working its way through the Senate right now. It is sponsored by Chris Dodd, Chairman of the Senate Banking Committee. It has a long name I can't remember, so I'll call it the Dodd Banking Bill.

What does a bill attempting to regulate the banking industry have to do with startups? Well unfortunately, it contains two provisions that are quite problematic and hurtful to entrepreneurs and startups. They are:

1) Changing the definition of a "qualified investor" in angel and venture deals. Not just anyone can invest in a startup company. You have to be a qualified investor. A qualified investor is currently defined as anyone with a net worth of over $1mm or net income of over $250k. Dodd's bill would increase that to $2.3mm and $450k respectively. And then index those numbers to inflation.

2) Eliminate the existing federal pre-emption over state regulation of "accredited offerings." Angel and venture financings could be regulated state by state creating a fairly burdensome set of rules  and regulations that each financing would need to be subject to. Currently there is a federal pre-emption that makes getting these kinds of deals done fairly easy.

I have no idea why either of these provisions ended up in a bill designed to regulate the banking industry. Entrepreneurs and startups don't use banks to finance them. They get their initial capital from angel investors and then VCs as they grow. This system works well, did not blow up in 2008, and is not in need of reform of the type Dodd wants to throw at us.

In fact, what we need is to eliminate all accredited investor requirements for small investments of up to $25k. Why does someone have to be a millionaire to invest in a friend's startup? I understand that we don't want someone mortgaging their home, or betting their entire life's savings on a startup. But for a small amount, like $25k, we should not be regulating angel investing.

My dad sent me an email the other day pointing out a news story about an incubator in Texas that was cranking out startups and creating jobs. He told me that he believes that the work entrepreneurs and the people who work with them (ie me) are doing is incredibly important to the health of our economy. He's right and we need to explain that to Chris Dodd and his friends in the Senate. If they are going to reform accredited investor regulations, they should liberalize them, not constrain them further.

I'll get on the phone and call my Senators and Representatives. Hopefully you'll do the same. This is nonsense.

UPDATE: Irene left these details in the comments which will be helpful when you contact your representatives:

The section numbers in question are Sec. 412 for accredited investors and Sec. 926 for federal pre-emption or Reg D.

Link to pdf of bill: http://bit.ly/duxjSr

Link to TechFlash article with more info on possible influences: http://bit.ly/96uuEx

UPDATE #2: Dan Primack of PE Hub has just posted that congress is listening to all the uproar over this. Maybe we'll get to keep things the way they are. But I am still going to make the case that we need an exclusion for small investments made by non-qualified investors.

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#Politics#VC & Technology