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What entrepreneurs need to know about Founders’ Stock September 15, 2008

Posted by jeremyliew in Entrepreneur, financing, founders, start-up, startup, startups, VC, Venture Capital.
36 comments

This is a guest post by John Bautista. John is a partner in Orrick‘s Emerging Companies Group in Silicon Valley. John specializes in representing early stage companies.

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When entrepreneurs start a company, there are four things they need to know about their stock in the company:

• Vesting schedule
• Acceleration of Vesting
• Tax traps
• Potential for future liquidity

VESTING SCHEDULE

The typical vesting schedule for startup employees occurs monthly over 4 years, with the first 25% of such shares not vesting until the employee has remained with the company for at least 12 months (i.e. a one year “cliff”). Vesting stops when an employee leaves the company.

Even Founders’ stock vests. This is to overcome the “free rider” problem. Imagine if you start a company with a co-founder, but your co-founder leaves after six months, and you slog it out over the next four years before the company is sold. Most people would agree that your absentee co-founder should not be equally rewarded since he was not there for much of the hard work. Founder vesting takes care of this issue.

Even if you’re the sole founder, investors will want to see your founder’s stock vest. Your ability and experience is one of the key assets of the company. Therefore, venture capital firms, especially in the early stages of a company’s development and funding process, want to make sure that you are committed to the company long term. If you leave, the VCs also want to know that there is sufficient equity to hire the person or people who will assume your responsibilities.

However, many times vesting of founders’ shares will follow a different schedule to that of typical startup employees. First, most founder vesting is not subject to the one year cliff because founders usually have a history working with each other, and know and trust each other. In addition, most founders will start vesting of their shares from the date they actually started providing services to the company. This is possible even if you started working on the company prior to the issuance of founders’ stock or even prior to the date of incorporation of the company. As a result, at the time of company incorporation, a portion of the shares held by the founders will usually be fully vested.

This vesting is balanced by investors’ desire to keep the founders committed to the company over the long term. In Orrick’s experience, venture capitalists require that at least 75% of founders’ stock remain subject to vesting over the three or four years following the date of a Series A investment.

ACCELERATION OF VESTING

Founders often worry about what happens to the vesting of their stock in two key circumstances:

1. They are fired “without cause” (i.e. they didn’t do anything to deserve it)
2. The company gets bought.

There may be provisions for acceleration of vesting if either of these things occur (single trigger acceleration), or if they both occur (double trigger acceleration).

“Single Trigger” Acceleration is rare. VC’s do not like single trigger acceleration provisions in founders’ stock that are linked to termination of employment. They argue that equity in a startup should be earned, and if a founder’s services are terminated then the founders’ stock should not continue to vest. This is the “free rider” problem again.

In some cases founders can negotiate having a portion of their stock accelerate (usually 6-12 months of vesting) if the founder is involuntarily terminated, or leaves the company for good reason (i.e., the founder is demoted or the company’s headquarters are moved). However, under most agreements, there is no acceleration if the founder voluntarily quits or is terminated for “cause”. A 6-12 month acceleration is also usual in the event of the death or disability of a founder.

VC’s similarly do not like single trigger acceleration on company sale. They argue that it reduces the value of the company to a buyer. Acquirors typically want to retain the founders, and if the founders are already fully vested, it will be harder for them to do that. If founders and VC’s agree upon single trigger acceleration in these cases, it is usually 25-50% of the unvested shares.

“Double Trigger” Acceleration is more common. While single trigger acceleration is often contentious, most VC’s will accept some double trigger acceleration. The reason is that such acceleration does not diminish the value of the enterprise from the acquiring company’s perspective. It is arguably in the acquiring company’s control to retain the founders for a period of at least 12 months post acquisition. Therefore, it is only fair to protect the founders in the event of involuntary termination by the acquiring company. In Orrick’s experience, it is typical to see double trigger acceleration covering 50-100% of the unvested shares.

TAX TRAPS

If things go well for your company, you’ll find that its value increases over time. This would ordinarily be good news. But if you are not careful you may find that you owe taxes on the increase in value as your Founder’s stock vests, and before you have the cash to pay those taxes.
There is a way to avoid this risk by filing an “83(b) election” with the IRS within 30 days of the purchase of your Founder’s shares and paying your tax early on those shares. One of the most common mistakes I’ve encountered with founders is their failure to properly file the 83(b) election. This can have very serious effects for you, including creating future tax obligations and/or delaying a venture financing of the company.

Fortunately, over the years, I’ve developed a number of work-arounds (depending on the circumstances) and we can many times find a solution that puts the founder back in the same position had the 83(b) election been properly filed. Nevertheless, this is one of the first things that your lawyer should check for you.

Of course, you’ll still owe tax at the time of sale of the shares if you make money on the sale. But by then, I’m sure you’ll be able and happy to pay!

POTENTIAL FOR FUTURE LIQUIDITY

Founders’ stock is almost always common stock because VC’s purchase preferred stock with rights and preferences superior to the common stock. However, recently my law firm (Orrick, Herrington & Sutcliffe LLP) has created a new security for founders which we call “Founders’ Preferred” which enables founders to hold some of their shares in the form of preferred stock. This allows them to sell some of their stock prior to an IPO or company sale.

The “Founders’ Preferred” is a special class of stock that founders can convert into any series of preferred stock sold by the company to VC’s in a future round of financing. The founders would only choose to convert these shares when they plan to sell those shares to VC’s or other investors in that round of financing. This special class of stock is convertible into the future series of preferred stock on a share for share basis. Except for this conversion feature, this class of stock is identical to common stock.

The benefit to you is that you are able to sell your shares at the price of the future preferred round. This avoids multiple problems associated with founders attempting to sell common stock to preferred investors at the preferred stock price.

Furthermore, the benefit to the preferred investors is that they can purchase preferred stock from the founder as opposed to common stock.

“Founders’ Preferred” can usually only be implemented at the time of the first issuance of shares to founders. Therefore, it is important to address the advantages and disadvantages of issuing “Founders’ Preferred” at the time of company formation. I normally recommend for founders who want to implement “Founders’ Preferred” that such shares cover between 10-25% of their total holdings, the remainder being in the form of common stock. The issuance of “Founders’ Preferred” remains a new development in company formation structures. Therefore, it’s important to consult legal counsel before putting this special class of stock into effect.

Many VCs do not like to see Founders’ Preferred in a capital structure.

CONCLUSIONS

As discussed above, there are a number of issues to address when issuing founders’ stock. In addition to business terms associated with the appropriate vesting schedule and acceleration of vesting provisions, founders need to be navigate important legal and tax considerations. My advice to founders is to make sure to “get it right” the first time. Although here are many companies on the web that specialize in helping founders by offering forms for setting up companies, it is important that founders get the right business and legal advice, and not just use pre-packaged forms.

This advice should begin at the time of company formation. A little bit of advice can go a long way!

How to interview key hires II: Behavioral interviewing September 10, 2008

Posted by jeremyliew in hiring, HR, interviewing, start-up, startup, startups.
2 comments

Recently I posted about how to interview key hires, focusing on the three areas to test a potential hire on:

1. Technical Skills
2. Cultural Fit
3. Performance Skills

Technical skills and cultural fit are relatively easy to interview for (although you may need to borrow advisers or friends with the technical skills of the function that you are hiring for to help you with the interviewing).

Performance skills tell you how well they can do a job. These include characteristics such as attention to detail, problem solving, initiative, leadership and team work. I have found that behavioral interviewing is the best way to test for performance skills. From SUNY Brockport:

Behavioral interviewing is a style of interviewing that was developed in the 1970’s by industrial psychologists. Behavioral interviewing asserts that “the most accurate predictor of future performance is past performance in a similar situation.”… Behavioral interviewing emphasizes past performance and behaviors.

First and foremost, it is important that you and your co-founders and other key leaders in the company agree on what performance skills you are testing for. While ideally you would like all your key hires to be great at everything, there are likely a set of 3-5 performance skills that are critical. For example, someone in a sales role might need to have a strong customer focus, an ability to influence and persuade, experience negotiating and good relationship management skills. A product manager might need to have high attention to detail, product vision, skills in working across functions and expertise at planning and prioritizing. Agree on what performance skills are important in advance.

Once a short list of performance skills has been created, each interviewer should develop a different question to ask the candidate about this performance skill. These questions should focus on asking about specific past experiences and outcomes. For example, if the performance skill being tested was initiative, questions [and interpretive guides] could include (with a credit to Novation’s SkilAnalyzer):

Tell me about a situation in which you aggressively capitalized on an opportunity and converted something ordinary into something special. [Did the candidate put a unique twist on a routine situation to yield positive results? Was there an accomplishment of little magnitude or that should have been expected of anyone in that situation?]

Describe something you’ve done that shows how you can respond to situations as they arise without supervision. [Did the candidate take reasonable and quick action with an appropriate amount of information or research, warranting the independence? Was there use of authority inappropriately, excess procrastination, or a bad decision?]

Think of a slim sales lead that you converted into a big sale. How did you do it? [Did the candidate follow up on a lead that offered little chance of success, and move it to a success level that justified the effort? Was there a trivial effort, possibly with insignificant rewards?]

Described a time when you voluntarily undertook a special project above and beyond your normal responsibilities. [Did the candidate volunteer for a task despite an already full workload and succeed without undue compromise to other responsibilities? Was there an insignificant addition, or sacrifice of other areas?]

Many people have good ideas, but few act on them. Tell me how you’ve transformed a good idea into a productive business outcome. [Did the candidate generate a meaningful action plan to bring the idea to reality? Was there a haphazard, unrealistic, unproductive transformation?]

Tell me about a time when you anticipated an opportunity or problem and were ready for it when it happened. [Did the candidate prepare an approach that would be ready to launch upon the event’s occurrence? Was there a slow trial-and-error response to the event, and resulting in only modest benefits?]

For these or any other questions that you ask, make sure that you keep the candidate talking about a single, specific instance that occurred in the past. Don’t let a candidate talk about generalities (“I always like to …”), or about how they would react (“If I got a sales lead like that I would…”). You are looking for a simple structure: Situation; Action; Outcome. Make sure that you get all three in detail.

Probe carefully to understand who was involved in decisions and what was the candidates work versus the work of people around them. Press on any instance of “we” to see what exactly the candidate did, versus what her team mates, reports or boss did. And make sure you know what impact their actions had, whether positive or negative, major or minor.

It is hard to make up stories about past experiences. That is why behavioral interviewing works so well. You’ll be surprised just how much a candidate will tell you, and how much it tells you about them, when you follow this approach.

Being wise versus being smart September 4, 2008

Posted by jeremyliew in Entrepreneur, start-up, startup.
5 comments

Great post today from Sim Simeonov about being wise vs being smart that I’ll quote in its entirety since it is so short:

There is a set of interrelated concepts I’m fond of reminding entrepreneurs about but I’ve never found a really good way to summarize them into a sentence that conveys the right meaning and tone. Here are various renditions:

* Be different, not best
* Do less, not more
* Go around a wall, not through it
* It is better to figure out how not to have to solve a problem as opposed to having to solve the problem.

A while back I was talking to my friends at Kaltura about this and CEO Ron Yekutiel told me about a saying he’d heard about the difference between smart and wise people.

The difference between a smart person and a wise person is that a wise person knows how not to get into situations that a smart person knows how to get out of.

It will be harder to raise Venture Debt for a while. August 27, 2008

Posted by jeremyliew in financing, start-up, startup, startups, venture debt.
4 comments

Many startups use venture debt to extend their runway beyond the capital that they raised from venture capital investments directly into the company. David Hornik wrote a good overview of venture debt a few years ago, all of which is still relevant today.

Some things have changed since then however. The WSJ reports today on how tightening credit markets are hitting venture debt firms

Providers of loans to start-up and other venture-backed companies are feeling the pinch of the credit problems plaguing Wall Street.

venturewireThe latest is publicly traded venture debt provider Hercules Technology Growth Capital, which on Monday said it secured a $50 million line of credit from Wells Fargo–much smaller than the $250 million in available credit it secured from Citigroup and Deutsche Bank last year. “We’ve been in discussions, and continue to be in discussions [with Citigroup and Deutsche Bank] about continuing the existing facility, but their appetite to expand the facility we have with them is somewhat limited,” said Scott Harvey, Hercules Technology’s chief legal officer…

…Harvey said $50 million is adequate to meet the firm’s needs, and Hercules won’t be looking to add to the facility for at least another three months, but could raise as much as $300 million over the next two years….

…Hercules, which has made about $1.3 billion in commitments to life science and technology companies since its inception in 2003, isn’t alone. This month, Western Technology Investment disclosed that its $125 million credit facility is being pulled by J.P. Morgan Chase and Deutsche Bank. “This is not isolated to us or our industry. Basically, the banks are unwinding the lending process,” said Ron Swenson, Western Technology’s chief executive.

Western Technology still has $220 million in equity remaining in its twelfth and most recent fund, which closed in February 2007.

This tightening in credit will hit some venture debt lenders harder than others. Lenders who can fund venture debt from deposits (e.g. SVB, Comerica) or who do not themselves leverage their equity to make more loans will not be as affected. However, it is likely that all lenders will be more cautious. Additionally, as some firms will have less “dry powder” with which to lend, there will likely be less competition for venture debt providers, meaning that terms for venture debt may get less attractive to startups for a little while.

How to interview key hires August 25, 2008

Posted by jeremyliew in hiring, HR, interviewing, start-up, startup, startups.
6 comments

Startup founders often need to hire people into areas that they don’t know anything about. This can be a technical founder hiring a VP marketing, a business development founder hiring a VP Engineering, or a product management founder hiring a VP Ad Sales. Often these hires are some of the most importantthat a company makes as they fill the holes in a founding management team.

There are three things that you should test a potential hire for:

1. Technical Skills
2. Cultural Fit
3. Performance Skills

Technical Skills: These are the skills strictly required to do the job. They are typically based on training or past experience. Examples include ability to program in Ruby on Rails, ability to run an Search Engine Marketing campaign, ability to sell 6 figure ad deals to movie studios etc. Resumes provide a good first screen for technical skills.

If you do not know anything about the field of the candidate that you’re hiring, your ability to discern their level of technical skills is limited. You should have a domain expert (who does not need to be an employee of the company – advisers, investors and friends can fill this role) interview your candidate to make sure that their expertise matches their resume. Having more junior employees within that function interview the candidate (ie having the team interview the boss) can be helpful but is not always enough. Often more junior employees don’t fully appreciate the full scope of their bosses’ jobs.

Cultural Fit: Companies are groups of people, and all groups of people have culture. This can include styles and modes of communication, work norms, modes of decision making and many other elements that can be difficult to define. Any team members can interview a candidate for cultural fit.

You have to be careful not to let “cultural fit” become a code word for suppressing diversity. The key question to ask is not, “Is this person different from the norms of our company culture?”, but “Could this person be effective in their job given the norms of our company culture?”. For example, consider a startup comprised only of recent engineering graduates with a norm of getting to work around noon and working until 3am, that is considering hiring a VP of Marketing who has to leave the office at 5pm to pick up her kids from daycare. It isn’t reasonable to ask if the VP Marketing will be in the office at midnight. It is reasonable to ask if the VP Marketing will be able to do all the required communication and coordination with the engineering team during the five hours that they will both be in the office together.

Performance Skills: Whereas Technical skills tell you if a person can do a job, Performance skills tell you how well they can do a job. These include characteristics such as attention to detail, problem solving, initiative, leadership and team work. Anybody can interview a candidate for these characteristics. However, there is a trick to doing this effectively. Asking someone “how tolerant are you of ambiguity?” is not a good differentiator. One of the most effective techniques I have come across is called behavioral interviewing. When I was GM of Netscape I put my entire team through the Skill Analyzer training from Novations to learn this technique of interviewing. I thought it was extremely helpful in creating a structured, standardized interviewing process.

Later I’ll talk about some of the key elements of Behavioral Interviewing.

How to capture your user value proposition August 4, 2008

Posted by jeremyliew in marketing, start-up, startup, startups.
9 comments

In the past I’ve written about encapsulating your business plan for potential investors in an executive summary, or even more succinctly as a high concept startup pitch. This is helpful for communicating to angel investors and VCs, but it doesn’t help you communicate to new and potential users of your product why they should try your site.

Whether you plan on acquiring new users through viral growth, SEO, SEM or banner advertising, the basic principles of marketing apply. You need a Value Proposition and a Call to Action. It helps a lot if your value proposition is unique so that it stands out from its competitors

I sometimes ask entrepreneurs “What would a banner ad look like for your site?”. This isn’t because I expect startups to be buying banner advertising, but because the discipline of condensing your consumer value proposition to fit into a 728 x 90 banner forces you to crystalize what is unique about your site. It forces you to focus on your value proposition in absolute terms, not relative to a competitor (“Higher quality video sharing than Youtube” doesn’t fly for example), without using any buzz words (“File class agnostic media sharing” would not make a good banner ad). Often it surfaces a key issue for startups going up against an incumbent – if your banner ad could equally apply to the leader in the space as it could to you, then you likely have a hard hill to climb to drive traffic to your new site.

Some examples might include, for Youtube “All your online video”, for Streetfire (a Lightspeed portfolio company), “Car videos for car guys”, for Hulu, “Watch your favorite TV shows online”, for Wonder how to, “Every how to video that exists”.

Mike Spieser recently gave startup marketing advice of a similar nature, focused on optimizing the vale proposition and call to action in your Google Ad Sense copy. Although he focuses more on the A:B testing aspect that Google offers to refine your value proposition (improving copy is an easy way to increase user interaction), the constraints imposed by the marketing medium still serve to distill your sites value proposition.

I’d like to hear from readers some examples of banner ad copy, whether for their own site or for various well known websites.

How to implement reporting and analytics for your startup July 30, 2008

Posted by jeremyliew in A:B testing, analytics, product management, start-up, startup, startups.
2 comments

Andrew Chen has a good post on how a startup should think about implementing analytics that I think applies to companies of all sizes and is worth reading. He notes:

In general, a philosophy on the role of analytics within a startup is:

If you’re not going to do something about it, it may not be worth measuring.

(Similarly, if you want to act to improve something, you’ll want to measure it)

Don’t build metrics that aren’t going to be part of your day-to-day operations or don’t have potential to be incorporated as such. Building reports that no one looks at is just activity without accomplishment, and is a waste of time.

He goes on:

Metrics as a “product tax”
In fact, one way to view analytics is that they are a double-digit “tax” on your product development process because of a couple things:

* It takes engineers lots of time and development effort
* It produces numbers that people argue about
* It requires machines, serious infrastructure, its own software, etc
* Fundamentally, it slows down your feature development

As a rough estimate, I’ve found that it takes between 25-40% of your resources to do analytics REALLY well. So for every 3 engineers working on product features, you’d want to put 1 just on analytics. This may seem like a ton (and it is), but it throws off indispensible knowledge that you can’t get elsewhere, like:

* Validating your assumptions
* Pinpointing bottlenecks and key problems
* Creating the ability to predict/model your business to make future decisions
* It tells you which features actually are good and what features don’t matter

I recommend reading the whole thing.

One additional piece of advice that I’ve found helpful:

1. Ask the product owners to use excel to mock up EXACTLY the reports that they would like to use, whether charts, tables, graphs, including time periods and mock data. This is way better than PRDs when it comes to reporting.
2. Go line by line through these reports with the product owners and ask them “what decision will you make with this data”. If the answer is “none” or if it is for investigation or theortical purposes rather than frequent operating decisions, cut the report out.

Happy analytics!

How Kosmix employs enterprise 2.0; a guide for other startups July 22, 2008

Posted by jeremyliew in blogs, communication, email, enterprise 2.0, enterprise infrastructure, IM, management, start-up, startup, startups, wiki.
1 comment so far

Anand Rajaraman, co-founder of Lightspeed portfolio company Kosmix, posts about how to stop email overload and break silos using wikis, blogs, and IM.

We hit the email wall at my company Kosmix recently. When we were less than 30 people, managing by email worked reasonably well. The team was small enough that everyone knew what everyone else was doing. Frequent hallway conversations reinforced relationships. However, once we crossed the 30-person mark, we noticed problems creeping in. We started hearing complaints of email overload and too many meetings. And despite the email overload and too many meetings, people still felt that there was a communication problem and a lack of visibility across teams and projects. We were straining the limits of email as the sole communications mechanism.

We knew something had to be done. But what? Sri Subramaniam, our head of engineering, proposed a bold restructuring of our internal communications. He led an effort that resulted in us relying less on email and more on wikis, blogs, and instant messaging. Here’s how we use these technologies everyday in running our business.

* Blogs for Status Reports
* The Wiki for Persistent Information
* Instant Messaging for Spontaneous Discussions

The effects of the communication restructuring have been immediate and very visible. They include a lot less email and almost none on weekends; better communication among people; and 360 degree visibility for every member of the Kosmix team. After we instituted these changes, everyone on the team feels more productive, more knowledgeable about the company, has more spare time to spend on things outside of work.

Anand goes into detail as to how blogs, wikis and IM are used by all employees, and how this has streamlined the communications in the company. I highly recommend reading the whole thing.

Post mortems on two failed startups from their founders July 19, 2008

Posted by jeremyliew in Entrepreneur, failure, management, start-up, startup, startups.
12 comments

Monitor110 recently shut down after raising $20m over three rounds. One of the co-founders wrote a portmortem of Monitor110, highlighting 7 mistakes that the company made:

1. The lack of a single, “the buck stops here” leader until too late in the game
2. No separation between the technology organization and the product organization
3. Too much PR, too early
4. Too much money
5. Not close enough to the customer
6. Slow to adapt to market reality
7. Disagreement on strategy both within the Company and with the Board

(found via Brad Feld)

At the other end of the spectrum is a post mortem of a bootstrapped two person startup that shut down last month after building for 1.5 years but not raising any venture capital. This founder’s lessons learned are more tactical, but no less important:

1. If your idea starts with “We’re building a platform to…” and you don’t have a billion dollars in capital, find a new idea. Now.
2. It’s a marathon, but it’s a marathon made of sprints
3. Initial conditions matter. A lot.
4. Developing in a vacuum never works.
5. Beware the chicken and the egg.
6. Prototype any 3rd-party libraries that you’ll be depending upon, before you base your product on them.
7. If you’re doing anything other than building your project and getting users, it’s premature.
8. The product will take longer than you expect. Design for the long-term.
9. People have an incentive not to crush your dreams. Take everything they say with a grain of salt.
10. Know your limitations.

(found via Brian Green)

I would recommend entrepreneurs to read both posts.

“Those who cannot remember the past, are condemned to repeat it.” — George Santayana

Looking to raise capital? Send an executive summary. June 4, 2008

Posted by jeremyliew in start-up, startup, startups, VC, Venture Capital.
4 comments

Rick Segal’s (a VC in Canada) recent post made me smile with recognition:

It’s around 2a in Toronto, midnight here in Edmonton. 260 summaries, plans, ideas, and virtual napkins are staring at me with an evil grin.

It can feel like it is hard to get a VC’s attention. I’d like to think that it isn’t because we’re bad people, and it isn’t because we’re lazy people. But we do get pitched a lot, and the ambient noise level is high. The quote above goes some way to explaining why a VC can’t give an hour to every entrepreneur who wants to meet. So what is the best way to break through the noise?

I agree with Venture Hacks’ advice on what to send an investor when they say:

Summary: An introduction captures an investor’s attention, but a great elevator pitch [executive summary] gets a meeting. The major components of the pitch are traction, product, and team.

Venture hacks goes on to advise on what not to send an investor, and I agree again:

Summary: Don’t send long business plans to investors. Don’t ask for NDAs. Don’t share information that must remain confidential.

So how do you write a good executive summary that can break through the noise? Garage.com has an excellent summary (italics mine):

The job of the executive summary is to sell, not to describe.

The executive summary is often your initial face to a potential investor, so it is critically important that you create the right first impression. Contrary to the advice in articles on the topic, you do not need to explain the entire business plan in 250 words. You need to convey its essence, and its energy. You have about 30 seconds to grab an investor’s interest. You want to be clear and compelling.

Garage.com breaks down the 9 elements of a good executive summary as follows:

1. The Grab
2. The Problem
3. The Solution
4. The Opportunity
5. Your Competitive Advantage
6. The Model
7. The Team
8. The Promise
9. The Ask

If you’re looking to raise capital, I suggest that you read the whole thing.

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