Tag Archives: preferences

Dilemmas of Founders

HartebeestsIf you are considering starting a company, or if you have recently started a company, an essential item for your reading list is Noam Wasserman’s The Founder’s Dilemmas. Based on years of solid research and experience, this book surveys many of the biggest problems facing founders of high growth start-ups. I want to share with you some of the thorniest of those problems here. But please don’t take my word for it. Buy the book for the complete story [No, I don’t get a commission].

1. Career Dilemma

You are currently employed and earn a comfortable salary. You have a great idea for a new start-up. How do you determine what to do?

If you stay with your current job, you maintain the security of a paycheck but likely give up the dream of starting a company, spreading your wings, and perhaps “getting rich.” Most investors will not invest in a startup without the founders/officers demonstrating a significant level of commitment, and that means “quitting your day job.”

If you quit your day job, you have the chance to make it big, but you give up the security of a paycheck. Can you afford to do that? Most start-ups cannot afford to pay the founders a salary for the first few years, so you need to have a significant enough nest egg put away to afford a few years of financial drought.

2. Co-Founders with Complementary Skills

Often entrepreneurs co-found companies with others who have very similar backgrounds as themselves. The advantage of this is you all speak the same language. The problem is that starting a company requires a diverse set of skills: technology, marketing, sales, financial, legal, and so on.

The best teams tend to ones that combine diverse skills and diverse personalities.

3. Title for the Founder

Many individual founders believe that they should lead their companies with a title such as CEO. Derived from Wasserman, the figure on the right shows the starting role that the “idea person” serves in start-ups. Although the initial idea person may be the perfect CEO for the start-up due to commitment and passion, the skills required for leading the company through long-term growth may not be present. Only 75% of founder-CEOs are still in the CEO position by the time of the first external investment round, and only 39% are still in that role by the time of the fourth round.

4. Who is in Charge?

Most start-ups have a single individual who serves as leader; s/he could have any
of a variety of titles; chief executive officer, president, and chief operating officer are typical. This individual reports to the board of directors. If you are considering having nobody in charge, or having two or more co-presidents in charge, think again. Tough times will come. And when those tough times arrive, somebody needs to make the tough decisions. The movie, Startup.com, exposes many start-up problems, not the least of which is what happens to relationships when one of two co-founders thinks they are “co-CEOs.”

5. Liquidation Multiples

When investors purchase preferred stock, they typical ask for (and receive) a liquidation preference, which specifies what multiple of their purchase price they will receive upon a liquidity event prior to general distribution of the remaining funds to all shareholders. I described some of the problems related to liquidation preferences in an earlier blog called Liquidation Preference and Avoiding Dilution.

According to Wasserman, Series A investors in 78% of all start-ups that raised external investments had a liquidation multiple of 1; 9% had a liquidation multiple of 1.1 to 2; 5% had a liquidation multiple of 2.1 to 3; and 8% had a liquidation multiple of greater than 3.

The dilemma is: Do you accept an investment whose terms include high liquidation preferences even though it in effect makes earlier investors’ return nil [and significantly dilutes the founders], or do you turn down the investment hoping for better terms from another investor?

If you accept the terms, you have thrown your earlier investors under the bus. If you refuse the terms, you may be throwing the entire company under the bus. Therein lays the dilemma.

6. External vs. Internal Boards

If you have a board of directors composed of the inner circle, e.g., co-founders and/or fellow officers, you can make decisions with your co-leaders and know they will be endorsed by the board. But now you have no “sounding board.” You have no independent thinkers. You have no checks and balances. The primary reason for a board should be to hear other opinions.

7. Control vs. Wealth

In an earlier blog called You Are Not Your Company, I described the problem founders have of trying to control their companies vs. distributing ownership and creating a much bigger pie to share among more mouths.

8. Compensation

Should officers of the company (and in fact all employees) receive cash compensation equal to what they would receive at a non-start-up company? Should they receive stock options as an incentive to join the company? Should they receive stock options in lieu of cash compensation? What is the right balance among these three?

There is no right answer. However, the decision is affected significantly by the amount of cash the company has (and this is affected by the desire to attract investors and/or the desire to time investments based on company valuation) and the amount of control that the founders demand or are comfortable with sharing.

9. How Long Should Vesting Be

When options are granted or stocks are sold to employees with reverse vesting, how long should the vesting period be?

On one hand, a long vesting period sounds like an incentive for the individual to stay with the company for that long period of time.

On the other hand, a long period of vesting could also cause a frustrated individual to say “I can’t wait that long; I might as well leave now.” The table on the right, from Wasserman, shows how long the vesting period is in start-up companies for founder CEOs vs. non-founder CEOs.

In summary

Starting a company is not for the faint of heart. Fortunately books like Wasserman’s Founder’s Dilemmas exist to guide you through the tough times.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?

Photo of fighting male hartebeests by Filip Lachowski (Creative Commons)

Should you sell investors common or preferred shares?

Photo PreferredPhoto CommonIn most start-ups, founders’ shares are common.  Subsequent investment rounds tend to sell preferred shares to investors, but some start-ups sell common shares to investors.

Why offer preferred shares to investors?

The reason for offering preferred shares to investors is that insiders (like founders and officers) have a huge amount of control over the success or failure of the company whereas outside investors have so little control.

The preferences that come with preferred shares lessen that almost intolerable level of risk.  These preferences reduce risk for their owners, and generally fall into two categories. The categories are downside insurance and upside insurance.

What are “downside insurance” preferences?

Downside insurance preferences provide owners with protections in case the company does not do particularly well. Two examples are liquidation rights and anti-dilution rights.

  1. Liquidation rights give the preferred shareholders a multiple of their initial investment back before a general distribution of the proceeds of a liquidity event. Say the investors purchase their shares for $600,000 and they negotiate 2x liquidation rights.

    A few years later, the company is acquired for $4,000,000.The preferred shareholders would receive 2x their initial investment, i.e., $1,200,000, and then the remaining $2,800,000 would be divided pro rata among all shareholders (including these same preferred shareholders).

  2. Anti-dilution rights give the preferred shareholders a “guaranteed best price” on their share purchase. The preference kicks in only if the company ever sells shares at a future date at a price lower than the current offering.

    Say the investors purchase 300,000 at $2 per share (for $600,000) and negotiate anti-dilution rights.

    A year later, the company has run into difficulties and is forced to sell shares at $1 per share in order to attract investors.

    If they succeed in raising this follow-on round, they will have to issue 300,000 additional shares at no cost to the original preferred shareholders (the ones who had the anti-dilution rights); this has the effect of retroactively selling them 600,000 shares at $600,000, so they actually ended up paying the better price of $1 per share.

What are “upside insurance” preferences?

Upside insurance preferences provide owners with some additional benefits in case the company does extremely well. Two examples are registration rights and warrants.

  1. Registration rights allow preferred shareholders to sell their shares at the time of the initial public offering.
  2. Warrants allow preferred shareholders to purchase additional shares at the current price. Say the investors purchase 300,000 at $2 per share (for $600,000) and negotiate a warrant to purchase an additional 100,000 shares at $2 per share.

    A year later, the company is doing poorly; the preferred shareholders will not choose to exercise their warrant.

    However, if a year later, the company is doing very well, and the shares are now worth $5, the preferred shareholders may choose to exercise their warrant and purchase the additional shares

In Summary

Some first time entrepreneurs avoid selling preferred shares to investors out of fear that they should not sell something “more valuable” than what they, the founders, own. However, most founders become officers and thus have almost complete control over the company’s success or demise, while outside investors have very little power to influence the success of the company.

Outside investors deserve some ability to reduce their risk and share in the upside. And the only way for them to do that is to negotiate the preferences that go with preferred shares.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will You New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

WYNSUMM CoverIf you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?