Tuesday, September 25, 2012

Driving Forces Behind Startups

Not all VCs are created equal, however….

It turns out my gut feeling was probably correct. A newly released research by Shikhar Ghosh, a senior lecturer at Harvard Business School, shows that almost 75%-95% of VC backed startups fail. VCs would normally say that only 30% fail and the rest simply did not bring the expected results – big difference.

I founded few VC backed companies, and although my sample group is relatively small for any statistical relevance, I have been interacting with many other entrepreneurs over the years and kept hearing the same mantra, which is “VCs suck the life of companies”.

VCs typically (in spite whatever you think when you are funded or been told) work against the company instead of what seems logical to assume. The problem is they pull in different directions so the sum of all forces zeros out, in many cases they talk about extending runway on one hand and what they mean is for the founders to work for less, while they keep sending invoices for first class flights to board meetings (true story).

There is a whole ritual in the VC process, where initially VC and founders fall in love. Later if success is slow to come, they try to force changes. If success comes too fast, they get greedy and may block an exit, or even worse, try to take over bigger parts f the company by blocking next round depleting the company cash reserves only so they can offer a bailout bridge loan in bad terms for everyone but them. This triggers a whole company-VC hate cycle, where VCs try to replace the Founder/CEO and founders try to bring other VCs to reduce the power of exiting VCs, and the cycle repeats.

However, I think the problem lies at a deeper level than that. I recently raised my hand at an event to ask a panel of investors if they can envision a scenario where they invest with no preferences, I.e. everyone in the company, founders and investors alike, will have common shares. I did not have to wait a second; all of them, without any hesitation said NO, Never. They could not even envision something like that.

[As a side note: The preferred stock held by investors has more rights and privileges than the common stock issued to Founders. The most important rights that affect badly the founder up-side, is the right of the VC (preferred shareholders) to get paid before the common stock holders. If the company is acquired, the preferred stock holders will be paid first. Then, if any money is left over, the common stock stockholders will be paid in a prorated fashion, (i.e VCs get yet another dip).

As usually defined, the amount paid to the preferred stock holders is usually a multiple of the amount invested. For example, if Series A stock is sold to first-round investors for $1/share, the preference amount for that stock is sometimes a 4X multiple of the share purchase price.

Common stockholders should care about the preference, because that preference is "ahead" of the commons in any acquisition outcome. For example, let’s assume that the company raises $5m dollars by selling 5,000,000 shares of Series A preferred stock with a 4X multiple. That means that if the company is acquired for $20m (or less), the preferred stock holders get all of the proceeds and the common stock holders get nothing. In other words no upside to the Founders for exit of less than $20M even if they own 75% of the company]

Since in my past, I happened to be a co-founder of a company that was organized with common shares (and eventually went public at NASDAQ), I can tell you that the same love-hate cycle existed even when everyone had common shares, however the fact that parties had relatively equal “power” created a balancing force. It did two things, first it enabled the founders more maneuvering space to succeed in spite the investors greed, and second it protected the one common success factor everyone forget about, and that is the Founders’ upside.

Taking the upside from the Founder strips the company from its main driving force and converts the company from a potential success to a company with large chance to fail. I believe that this survey reflects that.

I believe investors should re-examine the assumption that they must have preferred shares, and start testing scenarios where everyone has common shares and where the founders are so motivated to make thing work that they increase the chances to succeed tenfold.

If VCs will see more success, they will become less greedy, interests will start to better align between Founders and VCs and with everyone pulling in the same direction chances are that more startups will succeed. The question is now which VC will be the first to create and lead that trend.

VCs often say that like horse track gamblers, they bet on the jockey not on the horse. If I to continue that analogy, I guess placing a nice juicy carrot in front of the jokey can dramatically improve the odds of winning the race.

What do you think?

Friday, September 14, 2012

Time is Money

By: Alon Cohen EVP/CTO at Phone.com

How do you move from a few friends brainstorming on a new startup concept to actually getting the group to sit down and start working to build a company?

How do you deal with situations in which one team member already has a job and cannot devote the hours to the project that other founders can put in? What if you start and one team member gets an offer he cannot refuse from say Google? What if one member is a good salesperson or marketing person, and will only contribute later after the R&D phase? In other words, how do you divide the cake, to begin with?

Resolving all that from the get-go is essential, but is usually awkward for first-time entrepreneurs. Many times a no solution prevents good things from happening or good ideas from coming to fruition. Venture capitalists often say that they mostly invest in a management team.  Accordingly, a group of founders that have these issues resolved will be more attractive to investors.

To start, one must look at least on three periods: the periods before funding, during funding, and after funding, i.e., when an investor decides not to invest anymore, for some reason, and the founder is left stranded with the rent and salaries to pay.

Say you, the entrepreneur, have an angel investor or start working with an incubator for a defined period. The incubator or the investor stops investing, while you are willing to continue to work on the project on your own time until funding or revenue comes along. Will the incubator get to keep all the equity they initially received? How would you be compensated for the work you did during the post-incubator or post-funding period?

Existing solutions do not favor the entrepreneur, and usually, the only situation in which you can recover some equity when things change is if a team member quits. In that case, you might recover some equity only if the company, upon funding, agreed on a “reverse vesting” mechanism. (Generally speaking, I like the reverse vesting mechanism).

I was thinking about the startup bootstrap problem in over the years, and again recently, particularly in my role as a mentor with the TechLaunch program in NJ and ffVC in NY. It seems that there is a need for a simple method that can help individuals to resolve some of those common problems that emerge when you start a company.

The concept I came up with is based on the fundamental axiom (sometimes forgotten by some investors after the funding is done) that “Time is Money,” and, in our case, time and talent are money.  The concept is as follows:

You define (agree on) the value of each hour of work invested by a team member, like say, a discounted, $50/hour.

When the group starts the project, usually working with no salaries, each participant logs the time invested, like money, based on the agreed-upon conversion rate. If a member needs to put some money into the company for anything, you will log that as dollars.

For instance, if one person invested 100 Hours + $10,000 (that is 100*$50 + $10,000, or $15,000) and say the other partner invested only $15,000 (with no work), the two investments are deemed equal (theoretically, with no official share distribution yet). When another person joins, he or she starts accumulating their own share in the same way. If the investment goes to pay anyone a salary, then no hours will be logged for that paid individual.

Now, say that the bunch created an application that sells nicely on the App Store. Any revenue left to distribute will be split based on the percentage “invested” by the partners. This process nicely solves the situation where one person leaves the project for some reason. The others, which continue, gain a larger share since the relative share of those who left diminishes over time unless they continue to contribute.

As you move to the funding phase, the key is to get investors or an incubator to agree to accept that principal and keep that process going when, or in case, they stop investing. Say the founders decide to keep working with no pay after the funding ended, or until the next round is secured—the contributing founders keep counting hours, which will be regarded as if they invested more money as part of the last round.

Clearly, after an investment, the rate of gaining back equity by the founders might not be the same as the rate at the beginning stage, (since the company now has a post-money valuation) but that might serve the investors well, since, in spite the fact that they might lose some relative equity at some rate, they will still be in the game for an upside in the event the startup makes it. It is also acceptable that each working individual’s investment rate will now be defined based on the salary they received during the time the company was funded. Without that founder’s compensation, most startups will disintegrate when the funding ends.

Angel investors and incubators might be smart to accept these terms. Those terms provide the founders with an incentive to keep working on the project, and can also prevent unwanted friction as you move forward.

I asked myself if those investing hard-earned money should have some sort of preferred compensation in case of distribution of revenue. Eventually, I concluded that time plus talent should be treated just the same as money. In much the same way that the investor risks wealth (and, in most cases, not even his own), the founder risks his or her future and misses on potential earnings. Hence, in my eyes, the two parties bear a similar risk.

While talking to David Teten, a partner at ffVC, he recalled that he successfully used a similar model at his prior startup, Navon Partners.  There, he calculated the vesting on a daily basis instead of an hourly basis. As he put it, “it’s sometimes annoying to track activity by the hour.”

There may also be tax ramifications to a founder who earns equity through providing services.  I urge you to consult with your accountant or attorney to be sure you avoid any tax landmines.

What do you think of this structure?  Have you used a system like this yourself?  What challenges have you encountered?

Editor note: the views & opinions expressed herein are those of the contributor and do not necessarily reflect the opinions & views of ff Venture Capital.