Charlie O’Donnell at First Round Capital wrote a great post called the “10 Misperceptions About Venture Capital”. Worth a quick read here. Enjoy.
Author Archives: Zach Shulman
Breaking Up Prior to Incorporation
What happens when a purported “full time” co-founder decides to scale back prior to actual incorporation of the legal entity. Let’s call this person Founder L (L for “leaving”). And let’s call the other founder Founder C (C for “continuing”). Let’s assume only 2 founders.
The situation, predictably, can be anything but harmonious. Originally, let’s say that Founder C and Founder L verbally agree (prior to formal entity formation) that the initial equity split between them would be 51% to Founder C and 49% to Founder L. They did not discuss vesting originally (a mistake). To complicate matters, each of Founder C and Founder L put in $5,000 to get the yet-to-be incorporated company off the ground (funds to order some inventory and file a provisional patent application, for example). At the time of this cash infusion Founder C and Founder L were getting along fine and Founder L was playing a meaningful role.
About 4 months or so after the initial cash infusion by each of them and the verbal agreement on how equity would ultimately be split, things start to head in the wrong direction. Founder L is not pulling his weight; he is happy to talk strategy and suggest tasks for others, but is not willing to get his hands too dirty. Founder L is the one worrying about the day to day, etc. Founder L decides to pursue a full time job. Founder C, feeling that Founder L was not worth too much to the business anyway, hires some other people. Founder C, being the agreed to majority owner of the to-be-formed entity, basically tells Founder L that there is no room for a part time founder and offers Founder L a small equity stake (5%) for past contributions and also offers to repay, when the company can afford it, his $5,000. This starts an interesting process.
Founder L’s position is that his $5,000 cash contribution at inception was an investment in the to-be-formed entity and that he is therefore entitled to a larger piece of the company (he wants 25%). No doubt that Founder L’s cash infusion was important to the non-formed company. But Founder C justifiably feels that 25% is a huge piece for $5,000. I would tend to agree with her. Regardless, unless agreement is reached, the company is now crippled and maybe dead. It is certainly not fundable with an outstanding dispute as to share ownership (I bet the early investors in Facebook had no idea about the ownership disputes there when they first invested).
This situation raises some interesting issues – very common issues unfortunately that lead to sub-optimal outcomes all the time and ruin friendships. Let’s look at some of the issues and solutions:
1. What is a good way to plan ahead for founder breakups before entity set up? The best thing to do is have a “pre-formation” written agreement that spells out who will own what, how shares will vest over time and what actually happens if someone decides to leave prior to entity formation or if the founders simply decide that they don’t want to work with each other any longer and one of them gets fired. This is particularly relevant when you have 3 or more founders and no one owns a majority as 2 can “gang” up on the other one and fire him.
2. Who is in charge prior to entity formation? The pre-formation agreement should also spell out who is in charge (acting CEO). This will typically follow the equity split so in this hypo Founder C would be in charge. If you have no majority owner, the agreement as to who is in charge is heightened in importance. Yes, everyone is pulling the same oar, but defining roles is key.
3. How much does a cash infusion actually purchase of the to-be-formed entity? My default answer is going to apply here as well – it depends on what the pre-formation agreement says. And it definitely should address this critical issue. In the hypo above, $5,000 for 25% seems really high to me as Founder L will be a serious free rider if the company is successful. Sure, he will be diluted when the company raises funds in the future, but could still end up with a meaningful stake at exit. And, agreeing that a cash infusion buys nothing outright is perfectly fine.
4. What if Founder L and Founder C don’t agree on the breakup terms? Chances are that the company is toast. Founder L will likely realize this and that would give him some bargaining power. Founder C could always form the entity and cut out Founder L completely as an equity holder, but the risk of Founder L suing is real and this risk will hamper the company’s ability to raise funds if it is disclosed. What we can hope for is that Founder L and Founder C are rational, come to terms and compromise. I doubt both will be delighted with the outcome, but the alternative is likely worse.
If this brings up additional questions for you, let me know and I will try to answer. Enjoy the rest of the weekend.
Reblog – Finance Fridays (Sayahh’s Revenue Projections)
Here is the next post in Brad Feld’s Finance Fridays. This time he talks about Sayahh’s revenue projections. Post is here.
Some interesting points:
1. It is critical to breakdown your revenue components into “digestible” segments. Brad always invests in software companies and his examples derive from that. But what about a medical device company or MEMS company. For example, if you are working on a medical device company, the revenue breakdown might show revenue coming from different channels (like hospitals, clinics, direct to patient, licensing). It is key to present in a way that truly tells your company’s story.
2. Speaking of stories, treat the revenue section of your projections as the first chapter in your company’s story book. “We will make revenue by doing X, Y and Z.” The projection model is the most critical and most underrated story telling device. If your model does not jibe with your other story elements (like a PowerPoint deck and oral presentation) you have failed to tell your story well. And you will be discredited for it…..and your fundraising will be more of a challenge.
3. Projections are never right – I am sure most of you know and expect that. I love the way Brad states this: “A skeptic might assert that it is a waste of time for a pre-customer startup to forecast revenues since they are guaranteed to be incorrect. When I look at a startup’s revenue projections, I don’t pay much attention to the actual numbers for just that reason. However, I do look at the structure of the model to see if they really understand their business and are actively tracking their key business drivers.” This goes back to having your projection model tell a story – sorry for the record skipping here (making the same point multiple times). If done correctly, it will show a solid (maybe not ultra deep) understanding of your strategy to ultimately make some jing and maybe even a positive bottom line eventually.
4. I do not consider myself a numbers guy. My corporate lawyer training did not focus on spreadsheets and my brain is not wired that way. BUT, I can easily tell when a model is good, bad or in the middle. If I can tell, then most experienced VCs can tell way better and faster. Get help with your financial models to make them sing your company’s “anthem”!
Enjoy the weekend. We are having a week of Indian Summer here in Ithaca – absolutely beautiful.
Cornell NYC Campus Competition
As you likely know from my earlier post, Cornell is responding to a RFP issued by NYC relating to building a tech campus in NYC. There are many universities competing, but it likely is coming down to Cornell and Stanford.
Please help Cornell WIN. We want to “drop” a petition on Mayor Bloomberg’s desk e-signed by 20,000 Cornell Alums expressing their support for our application. A group of alums have put together a simple way to sign an online petition. I just did this and it takes about 10 seconds. SO, if you are a Cornell alum, please click, sign and……help us WIN. And pass this along. Don’t worry about people getting it twice. Go BIG RED.
http://www.change.org/petitions/cornell-alumni-for-nycs-tech-campus
Cornell NYC Tech Campus – What is Good for Cornell is Good for NYC
I am a Cornell grad (undergrad ’87 and ’90 law) and currently teach at the Johnson School (Cornell’s business school). I love Cornell.
Cornell is responding to a massive RFP issued by NYC (Mayor Bloomberg’s office) for the establishment of a tech campus on Roosevelt Island. It is a huge undertaking. Our proposal focuses on masters of engineering degrees, a joint MEng/MBA degree and other graduate degrees. The competition seems to be coming down to Cornell vs. Stanford (which is not surprising). Our alumni base in and around NYC is Cornell’s huge asset – some 50,000 strong! We will provide mentoring to Cornell NYC startups, guest lecture in class, employ graduates, etc.
As Cornell prepares to submit its bid for this 1M+ sq ft campus, please join the grassroots effort on Twitter by following and RTing @CornellTechNYC to help influence Bloomberg in this important selection process.
Thx!
ithaca VC 