The Importance of Boards

I have written quite a few posts on the topic of Boards of Directors.  Just put in “board of directors” into the search bar.  As a quick review, it is the Board of Directors or “Board” that literally by law makes all critical decisions for the company.  The Board has to vote on issuing stock, approving the annual budget, setting the company’s strategy, changing the company’s by-laws and certificate of incorporation, selling the company, merging with another company, hiring officers like the CEO, shutting the company down, etc.  The list goes on and on.  Good corporate governance is critical at startups and other companies alike!

The importance of the Board is why institutional investors (like VCs) often get a seat on the Board after an investment.  The Board discusses and agrees on strategy.  Discussion is critical.  But don’t be fooled, there is an element of control as investors want a say in critical decisions.  This is pretty natural if you think about.  VCs typically do not want to control the board vote, they just want a seat at the decision table.

When CVF invests we often take a board seat (probably 95% of the time) and when we don’t we take an observer seat (5% of the time).  If the board is already large and we are coming into the company later in its stage of growth, then an observer seat might be fine.

One situation is really scary though.  Sometimes at the seed stage, the company founder insists that he/she be the only board member and that once more financing is raised that the board composition will be normalized (code word for “adding more members”).  From my perspective, this is typically a sign of paranoia.  

I have now done 2 deals where there has been a lead investor (not CVF) who did not mind the “founder as sole board member” trap.  We followed in line with the lead investor and went along with the structure.  This was a HUGE mistake that I will never make again.  Both companies have since failed for different reasons:  one had no product market fit after 3 years of trying.  And one gave up prematurely.  Regardless, had there been an actual board of directors with 2 or 3 members I am pretty confident that the end result would have been better.

Never again.

State of Startups 2016

First Round Capital just released its State of Startups 2016.  It is chock full of interesting stuff!  No need for me to recap it here.  Just view it for yourself.  Here is the link.  Thanks!

PS:  2 prominent team members at First Round Capital are Cornellians (Bill Trenchard and Howard Morgan)!

Calling BS

Vanity Fair recently published a expose on Theranos.  It is worth reading.  Like a mini “page turner” novel.

It reminded me of one of my personal themes in investing:  “if you don’t understand the technology then don’t invest.”  The understanding can definitely be acquired.  In fact, I rarely understand the technology when we first meet with a company.  But over our months of due diligence the understanding grows.  And sometimes my partners’ understanding is a good proxy.  BTW, understanding does not mean being an expert.

So, how about these words that Vanity Fair wrote about Elizabeth Holmes, the CEO of Theranos:  “She took the money on the condition that she would not divulge to investors how her technology actually worked, and that she had final say and control over every aspect of her company.”   All I can say is OMG.   Are you kidding me?  Who would invest into a black hole and control freak?  Not sure what else to say.  Granted that this is all hearsay.  I have no proof that this is what actually happened.  All I will say is that if you get whiffs of this type of attitude you should run the other way.   And now that I think about it more, we actually did get caught in a similar situation once, but by no means as blatant.  It is not working out well!!

The Vanity Fair article also offered up an interesting synopsis of venture capital:

“It generally works like this: the venture capitalists (who are mostly white men) don’t really know what they’re doing with any certainty—it’s impossible, after all, to truly predict the next big thing—so they bet a little bit on every company that they can with the hope that one of them hits it big. The entrepreneurs (also mostly white men) often work on a lot of meaningless stuff, like using code to deliver frozen yogurt more expeditiously or apps that let you say “Yo!” (and only “Yo!”) to your friends. The entrepreneurs generally glorify their efforts by saying that their innovation could change the world, which tends to appease the venture capitalists, because they can also pretend they’re not there only to make money. And this also helps seduce the tech press (also largely comprised of white men), which is often ready to play a game of access in exchange for a few more page views of their story about the company that is trying to change the world by getting frozen yogurt to customers more expeditiously. The financial rewards speak for themselves. Silicon Valley, which is 50 square miles, has created more wealth than any place in human history. In the end, it isn’t in anyone’s interest to call bullshit.”

My reaction that synopsis, which definitely made me chuckle:

  1.  The white men comments are true.  Change is happening at a slow pace.
  2. Good VCs typically do know what they are doing, but some are so full of themselves that they come across as very pompous.  But most VCs I deal with are good people with lots of brain power.
  3. Most companies I see are not working on meaningless stuff.  But we focus on upstate NY!!
  4. There is nothing wrong with a “Change the World” CEO as long as they are realistic and focus on building a big company that will make money.
  5. VC is definitely about making money.
  6. It is in EVERYONE’S interest to call bullshit.  Please do just that all the time!


Rule 409A – Again

I first wrote about Rule 409A back in September 2011.  Here is the post, which focused mostly on how 409A valuations are used for stock option purposes.  BTW, I continue to think that as applied to private companies 409A is a terrible rule.  And I think that early stage companies should take the risk and not use 409A valuations.  As companies move to later stages and have meaningful revenues and profits then 409A valuations begin to make more sense.

I would like to add another Rule 409A thought.  Here goes:  please do NOT think that the 409A valuation has any bearing or meaningful relationship to how a VC will value your company.   Said another way, a 409A valuation is meaningless to how VCs negotiate pre-money valuations for their investments.  The 409A valuation is not based in VC reality.  Sure, you might say that VCs have warped senses of reality.  I can understand that!  Regardless, don’t dig yourself any credibility holes by trying to use the 409A valuation as a negotiating tactic.

To repeat what I wrote in my earlier post, I think that 409A valuations routinely work to the detriment of employees.  Stock options prices for startups should be as low as possible.  The government would end up collecting more tax on successful exits and the employees should be delighted to pay more tax on their larger gains!

Thanks, and enjoy the weekend.

Convertible Debt – Qualified Financing Triggers

I recently dealt with a tense situation regarding the “Qualified Financing” trigger in a standard convertible note financing.  For background, convertible debt documents typically provide that the debt will automatically convert into a future0 Qualified Financing equity round.  And that conversion is typically at a discount to the Qualified Financing equity round price.  Here is an example of actual language from a promissory note:

“Upon the closing of a Qualified Financing, the principal and accrued interest of this Note shall be converted automatically without the consent of the Holder into securities of the same class or series as are issued in the Qualified Financing. The number of securities to be issued in such conversion shall be determined by dividing the sum of the then outstanding principal amount of this Note and all accrued but unpaid interest thereon by the Conversion Price.  The “Conversion Price” means an amount equal to eighty five percent (85%) of the price per share paid by the investors in the Qualified Financing.”

It is extremely straightforward – here the discount was 15% to the Qualified Financing price.  (Sometimes, though not in this example, you will see a valuation cap built in too so that the debt holder gets the better of the discounted price of the valuation cap price. I suppose I should do a post on valuation caps too at some point.)

Here is the definition of Qualified Financing from the same promissory note:

”    “Qualified Financing” means the issuance of equity interests (or debt securities convertible into equity interests) in the Company to investors prior to the Maturity Date (as the same may be extended) in one or a series of related transactions, the principal purpose of which is to raise capital, which transaction or series of related transactions result in the Company receiving gross proceeds of not less than $700,000 (inclusive of the principal amount of the Notes that will convert into equity in connection with the consummation of the Qualified Financing).”

Typically you set the Qualified Financing trigger to be a meaningful amount of NEW equity financing so that the convertible debt is converting in a financing that will give the company some meaningful cash burn runway.  That is the whole premise behind having the conversion be automatic.  If the company is successful in raising the equity round that gives it some breathing room and runway, then the debt automatically converts and everyone is happy.  Goal accomplished.

I have used the word “typically” a few times in this post.  I am now going to use it again.  Typically, in the definition of Qualified Financing the amount of the outstanding convertible debt notes do NOT count towards achieving the Qualified Financing threshold as it is NEW cash that gives the company the breathing room and runway.  In the definition above the threshold is $700,000, which would give the company meaningful time to achieve its next set of milestones and set it up for additional capital raising if required.   Now, I hope some of you see the problem in the definition above.   It uses the word “inclusive” as opposed to “exclusive”.  I underlined “inclusive” in the definition.  In all the convertible debt deals that I have done (probably 50 or more), I have only used the word “inclusive” once.  And I honestly do not know why on that one occasion I agreed to it.  Mental lapse?  Maybe!  I actually think what happened is that when we advanced the first promissory note we were highly confident that the Qualified Financing was not far off so that including the note amount was okay because the note amount was small (like $100,000).   Well, the Qualified Financing got delayed and delayed and delayed…..and the amount of convertible debt grew and grew and grew as more debt was advanced to support the company prior to a Qualified Financing.

Ultimately, the amount of the debt approached the $700,000 Qualified Financing trigger amount.  We could not advance more than the trigger amount – that would be nonsensical and put the noteholders in a very bad spot.  The resulting conversations were awkward, but the solution was easy.   Just amend the notes to change “inclusive” to “exclusive”, which is incredibly normal anyway.

Lesson learned.