Monthly Archives: April 2011

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April 30, 2011

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Free Riding is a Serious Problem

Hypo:  3 co-founders start a business with Joe initially owning 35%, Lisa initially owning 35% and Steve initially owning 30%.  Joe is CEO/Leader, Lisa is tech/science and Steve handles finance and marketing.  For purposes of this post, the roles are actually irrelevant.

Lisa came up with the core idea and the 3 of them form the business and create a legal entity (corporation typically).  Exciting times all around.

One of my biggest concerns in this incredibly common situation is protecting each founder from the other founders’ free riding.  I call this the “Pig on a Motorcycle” problem.  Specifically, you don’t want one founder to leave the business (for any reason) with his/her full equity slug and simply thereafter benefit (i.e., ride around on a motorcycle) from the hard work of the continuing founders.  Here is an illustration to drive the point home:

The only way to truly protect the founders from each other in this situation is by making sure that the equity owned by the founders reverse vests.  The typical vesting period would be 3 years.  Think of reverse vesting as each founder owning their shares outright, but with a risk of forfeiture of any unvested portion if they leave the company prior to the vesting period expiring.   Things to consider:

1.  How long is vesting period?  As I just stated, typical would be 3 years, but this is negotiable among the founders.  I would not recommend less than 2 years.  Longer is better, and I have seen 4 years used often.

2.  What are the vesting increments?  I recommend vesting monthly over the vesting period.   So, if the period is 36 months, and the founder leaves after month 11, he would be 11/36s vested and would forfeit 25/36s of his shares.

3.  How does the forfeiture actually work?  It is typically stated that unvested shares are subject to a right of repurchase by the company and continuing founders at a price equal to that originally paid for the stock.  And, what is that original price?  Typically ZERO.   Do not unintentionally get caught in the trap of having the repurchase price equal to fair market value on the date of repurchase.  That can be disastrous and defeats the whole point of the vesting.

4.  What happens if there is a change of control (think sale of company) prior to the expiration of the vesting period?  If written properly, a change of control has no impact on the vesting because, unlike a stock option, the founders own their shares outright.  The change of control does not cause any forfeitures and they each get their stated share of the sale proceeds.

5.  Should the forfeiture be tied to the cause of the founder leaving?  In my mind the answer is absolutely NOT.   I don’t care if the founder was fired without cause; I don’t care if the founder became disabled; I don’t care if the founder died.  Ok, obviously I care about these things from a human compassion standpoint.   I don’t care if the founder quits and goes to work at another company or decides to quit to stay home to take care of the kids.  I don’t care if the termination is voluntary (as in “I quit) or involuntary (as in “you are fired”).  The point, however, is that the vesting should be designed specifically to enable the continuing shareholders to show someone the door and always avoid the free riding problem.  Plain and simple.

6.  Is there cliff vesting?  Cliff vesting (for example, the first year of vesting does not occur until the actual passage of 12 months and thereafter vesting is monthly) is not that common for the vesting of founders stock.  I don’t recommend it.

7.  Does this post have anything to do with venture capitalists requiring requiring reverse vesting of founders’ shares?  Not much at all.  I am really focusing on protecting founders from each other right from the get go.  One benefit of putting in place the founders’ vesting right away is that sometimes VCs will just go along with the existing schedule and not impose additional vesting time periods (no guaranty of course).

Happy to answer any questions on this critical topic.  I will likely do another post on some exceptions to imposing vesting on all founders.

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April 26, 2011

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Startup Life

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100 Rules for Being an Entrepreneur

Ok, here is another repost.  James Altucher is also a Cornell alum (so part of the Ithaca family).   Here is Jame’s post from April 25th titled “100 Rules for Being an Entrepreneur”.  It is great and includes, yes, some pictures.

Enjoy:  http://www.jamesaltucher.com/2011/04/the-100-rules-for-being-an-entrepreneur/.

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April 26, 2011

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Dealing with VCs, Public Service Announcements, Startup Life

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Short and Sweet – Tips for Getting into the VC Queue

When I come across another startup/VC blogger that I like, I like to share it.  Startup Professional Musings (see http://blog.startupprofessionals.com) falls into this category. It is written by Martin Zwilling.  He sticks to the short and sweet theme and has a very educational approach, which I think most readers probably appreciate.

His April 24th post (see http://blog.startupprofessionals.com/2011/04/startups-with-real-revenue-can-get.html) talks about getting into the VC queue.   My favorite line is: “Create an investment-grade business plan.”  It is my favorite because he then defines the business plan to be an executive summary, investor presentation and financial model.  Note what is absent – a written full business plan.  

I agree completely with this approach.  Note Zwilling’s click offs to each of the 3 parts as well.   The 3 parts completely cover what is in a full written plan.  The problem with a full plan is that many/most VCs have difficulty reading them due to lack of time.  The well voiced over presentation is worth its weight in gold.  And the financial model must be fully synced up to the presentation.  They both need to tell a consistent story (we all know things will change going forward).  

So, start telling!

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April 20, 2011

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Board of Directors, Dealing with VCs, Management, Startup Life

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3 Up / 3 Down

I was talking with one of the CEOs that we work with the other day about the “weekly update”.  See https://ithacavc.wordpress.com/2011/02/28/the-weekly-update/.  This post presents a variant to it.  Don’t get me wrong, I still love to get weekly updates and still love the purposes they serve.  The critical purpose on top of my mind this morning is “unity”, as in getting the entire team unified on an ongoing basis.  The team is not just the board, but the whole management team as well.  I encourage CEOs to send their weekly updates to their management teams (sometimes editing is necessary, but not often).  The “unity” purpose falls under “amazing communication tool” that I wrote about in my earlier post.

3 Up / 3 Down is a variant of the weekly update (perhaps call it the little sibling – not quite as mature as big brother or sister).  In total it might be 6 sentences (yes, even a recovering lawyer like me can do that math).  On Sunday night, as a way to start off the week with a unifying message to the team, I am suggesting that CEOs (or other person in charge of the update though typically it is the CEO) who have been unable to write a full one page update (and the best updates are not longer than one page IMO), simply write down the 3 things that make them feel up and the 3 things that make them feel down…….and then press “send”.   Obviously the points should relate to the business.  And my guess is that this should take between 5 and 10 minutes max.  Once sent, the board of directors will know what is on the CEO’s mind, the management team will know as well and the CEO will be building unity (among other things).

Now that I have suggested this, I am going to start doing it by sending my 3 Up/3 Down to my venture fund partners.

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April 17, 2011

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Public Service Announcements

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Do the Right Thing

This past Thursday and Friday was the Entrepreneurship@Cornell Celebration (see http://entrepreneurship.cornell.edu/activities/celebration/2011).  It was a fabulous event.  During the Celebration, the 2011 Cornell Entrepreneur of the Year was honored.  Harris Rosen was the honoree (see http://www.news.cornell.edu/stories/Jan11/CEY2011.html).  Mr. Rosen’s life story is truly one of the most inspirational tales I have ever heard.  He summed it up with “Do the Right Thing”.

Before I try to tell you Rosen’s story in blog fashion, the saying “Do the Right Thing” has infiltrated my house before though in a different context.  I use it with my kids (ages 5 and 9) when trying to get them to treat each other nicely.  For example, if the 9 year old has some candy and the 5 year old asks for some, the 9 year has a choice:  don’t share or “Do the Right Thing”.  If she does the right thing, she now knows the benefits.  If she does not, then I usually find some other way or rewarding the 5 year old for his sister’s not stepping up and doing the right thing.   Life lesson turned into a family dynamic game.

So, back to Rosen.  He grew up in the slums of NYC during WW II.  Very poor and his parents never graduated from high school.  One day when he was about 9 or 10, Rosen and his brother were playing in the street when a tour bus stopped.  Looking at the Rosen boys, one well-to-do lady said to her friend, “so, that is how they live.”  Rosen went home and asked his mom what the lady’s words meant, and she explained.  She further explained that the only way out of the slum was education.  From that point on, Rosen and his brother took school seriously.  Both graduated from high school and Harris was accepted into Cornell (in the School of Hotel Administration).  After college, he worked a few jobs, served some military time and eventually ended up at Disney.  In 1974 he was fired from Disney for challenging his bosses and that year purchased his first hotel (a Quality Inn) in Florida.

I am leaving some details out.   He built his hotel properties to multiple resorts with over 6,000 beds.  He has never levered a property and so has a competitive advantage during economic down cycles.  In the early 1990s, Rosen had an epiphany, and realized that it was time to start giving back.  Note that by this time he had already started to provide all his employees (over 2,000) with full health care coverage (I believe completely self insured) with a maximum out of pocket expense for any employee of $1,000 ($500 for each of the 2 first years).  Rosen’s hotels have incredibly low employee turn over.  I should mention that he does not allow any of his employees to smoke.  Drug tests are used to detect nicotine, and any offender is given 6 months of treatment (employee’s choice of treatment) to quit.  Rosen has only lost 2 employees to the no smoking rule.

The epiphany materialized itself by Rosen “adopting” a section of Orlando, FL called Tangelo Park in the early 1990s.  TP was a run down, drug infested section of town.  Rosen literally went to the town governing body and offered free day care for all kids prior to kindergarten and then free tuition at any Florida state college for anyone from Tangelo Park graduating from high school.   Since then, the high school graduation rate for Tangelo Park has gone to 100%.   No, that is not a typo.

This is Mr. Rosen’s way of, to use his words, “Doing the Right Thing”.   His message was simple:  the more you have the more you need to give back.

Mr. Rosen told his story via a moderated discussion with a former Cornell president on Thursday afternoon.  The audience of about 600 was completely enraptured.  There were inspired tears and huge ovations.  It was truly awesome to hear his story first hand.  Rosen is so humble that he is actually very uncomfortable in front of large audiences.  This made the presentation even more heart felt.

Do the Right Thing.