blog.payne.org

If you’re thinking about raising money, you may have some friends that want to co-invest.  Or, you may have a few folks that you want to recruit as investors.

A carefully chosen set of individual investors can be really helpful at various company stages.  They can be mini-advisors, providing help at key junctures:  funding, acquisition, strategy, etc.  Also, a commitment from “rock star” individuals can give you some additional credibility in raising the main funding round.

If you’re thinking about individuals, it’s important to build it into VC discussion from the beginning.  When you’re talking about the size of the round, you should say you intend carve out x% or $y of the Series A for individuals.  (Adding individuals at the end of the process is a pain.  I just went through this for a company I recently co-founded:  the resulting cap-table jostling is energy that should be spent elsewhere. )

Other things to keep in mind:

• $25k to $100k is a typical individual investor amount.
• Individuals may have to be accredited investors ($1m net worth).  Check with your attorney.
• Figure out how any pay-to-play provisions will apply to individuals.  Will they have to participate in future funding rounds?
• Your investor may take some time to figure out if s/he can invest.  Individuals at venture firms, law firms, and large companies may have to get approval that your company isn’t conflicted with their existing business.

Finally, get all of the details to the attorneys well before closing, including entity names (many individuals invest through an LLC or a estate planning trust).  Nothing kills the excitement of closing a round of funding like a holdup from a $25k investor.

I met a small group of entrepreneurs a year or two back that had built a social networking site. I asked them, “how is the better/different than MySpace, which is already dominating?”

They said, “Our design is more scalable.”

I paused, and said, “You’re pretty far away from earning the right to have a scalability challenge.”

The problem was that they had worked on a down-the-road problem (scalability) taking energy from the immediate problem (getting users). It’s a common way to fail in startups (I’ve done it myself): spending too much time solving future problems, instead of solving the “now” problems.

I have a number of entrepreneur friends that have become VCs. We’re all optimizing different factors in our own lives and careers, but I just don’t get it.

In case anyone’s not paying attention, the venture capital business is not in great shape right now.  Returns (relative to risk and other asset classes) aren’t that good.  There are too many funds, VCs, and dollars chasing too few deals.  Good projects are highly competitive, with VCs spending a lot of time trying to sell some differentiation and paying too much on bid-up deals.  Large funds are struggling with how to participate in small-capital projects.

I have a lot of VC friends:  they’re all working harder than they’ve ever worked before, and are likely making less money than they’ve ever made.

I think part of the attraction is based on out-dated romantic notions.  Back in the 90s, VC was THE career-capping move for an entrepreneur.  “Venture capital” would be the last job you ever had, and you were making a lot of money and not working very hard.  (In 1999, it felt like the VC weekend started at 4pm on Thursday.)

(If I ever join the dark side, feel free to remind me of this note.)

Today’s practical startup tip:  4×8 “showerboard” panels (available from Home Depot and Lowe’s, $10-$15/sheet) are a great option for large cheap whiteboards.  Test erasability before you buy; here are the details.

If money is less of an object, take a look at dry erase wallpaper.

One of the biggest pieces of advice I give entrepreneurs: find an good attorney with experience in startup financing. Do not use your uncle’s friend who’s been doing family law for the past 30 years.

Your investors will have great attorneys, and you need someone who can skillfully represent your interests. Find someone who’s more than a corporate law mechanic, that can contribute business advice during investor negotiations. A good attorney will be able to suggest deal terms, based on their experience with other deals (or even deals with your investors).

Ideally, you can find someone that does nothing but startup financings. Here’s a great list of lawyers with the right kind of experience. (This is the group that worked on the National Venture Capital Association’s Model financing documents.)

When interviewing folks for new startup projects, I frequently get asked “are you planning to go public?”

I find this question very annoying, but I’m not exactly sure why.  I think it has to do with goals:  an IPO is a more of a milestone than a goal.  Asking this question feels like asking a soldier about to go off to war, “are you planning on winning a medal?”

The real goal (if you’ve got investors) is to build a valuable company.  If you do that well, all of the right options (acquisition, IPO, etc.) will follow.

Following up on my exit analysis blog post, Steve Kane brings up a great comment point:  entrepreneurs should clearly understand how exit proceeds would be allocated.

Participating stock structures can be complicated (e.g. “participating preferred with a 2x multiple and 3x cap“), and they can route a surprising chunk of the exit proceeds away from the common stockholders and to the investors.  In many deals, a 1% common shareholder gets nowhere near $1m in a $100m exit.

Cutting through the complexity is easy:  make a payoff table showing what each share class gets for a range of acquisition cases (say, in $5m increments), then graph it.   If you’re contemplating a few options, you should be able to clearly see the difference in return at various price points.

If you’re considering a term sheet and don’t understand (or like) what you see, send your graph to your investor:  “is this what you meant?“

I’ve done advisory projects that have included common stock as part of the compensation. And I’ve learned the hard way that the common stockholders are the last to get paid, and it’s even worse if you’re not an employee.

Every company goes through ups and downs. Even successful companies may have a “down round” along the way, where the existing stockholders get crammed down by investors (existing and/or new). The usual mechanism for this is anti-dilution protection, which protects existing investors if there’s ever a follow-on round at a lower valuation. Or, if the company is in a really tough spot, a new investor will insist existing investors convert their preferred stock to common, before investing at some rock-bottom valuation.

The net effect is that common stock holders take a massive dilution hit (say, like 95%). Now, the investors realize that employees need meaningful ownership, so they will “re-up” everyone with grants to get to a reasonable percentage. This ownership may be more or less than the pre-dilution percentage, based on how important the company feels the employee’s contribution is. The re-ups almost always start vesting over again, so the founders (vs the developer that was hired a month ago) get hit the hardest — their clock is reset.

And if you’re a non-employee, you’re totally screwed. I’ve never seen a company re-up anyone who’s not integral to things going forward (and you can’t blame them).

There’s nothing you do about this, other than to factor it into your thinking about stock compensation for a consulting or advisory project.

For entrepreneurs pitching investors: make sure you’ve included “exit” thinking.

I see a lot of entrepreneur plans with the usual stuff on how the product/service will be developed, how it will be marketed, how much capital is needed, and how the business will grow. The frequently missing item is the exit analysis: is there a plausible path for $1 invested to be worth $10?

Investors invest to generate a return. You can build a business with the greatest {revenue|users|uniques|units sold|subscribers} in the world, but if it’s not valuable, it doesn’t matter. Some basic exit analysis against comparables (public companies, acquisitions of similar companies, funding rounds) may surface investment flaws, such as: low-margins, poor scalability (e.g. many services-centric businesses), and capital inefficiencies (e.g. $50m needed to make a company worth $100m).

Avoid the embarrassment in the VC conference room: do your exit analysis homework.

There’s an entrepreneurial lesson in the current Facebook dustup:  hubris can quickly lead to trouble.

There’s a fine line between confidence and arrogance.  Confident companies know what they’re going to do, and they do it.  Arrogant companies take it a step further and make it about proving something.

Arrogance is trouble because it kills the fan base.  Companies and entrepreneurs, like sports teams and rock bands, need fans to be successful.  Even famously arrogant companies like Google and Wal-Mart treat their user-customers well, and when they mess up, they usually attempt to make it right.

Facebook is in the middle of pissing off all the fans.