I have posted a few times on management carve out plans (back in February 2011 and November 2011; wow, time flies!!).
Our portfolio companies routinely adopt carve out plans when the founders/employees equity values are not likely to provide enough incentive to get a company to an exit. This typically results when the company has raised a lot of money and the preferred stock liquidation preference would absorb an out sized portion of the exit proceeds. It can also result from straight forward dilution. Regardless, I am a big fan of carve out plans. There is just no way to get a good exit without a motivated management team and employee base.
Some great carve out plan materials were recently shared with me so I thought best to “memorialize” them in a blog post. Law firms often make startup “legal issues” materials available to help management teams better understand the startup landscape. So, thanks to Fenwick & West for putting these together. The first (Carving Up the Pie Using Change in Control Carve-Out Plans to Incentiviz… ) is a very well written memo on carve out plans in general. The second (Liquidity_Bonus_Plan_-_Board_Meeting_Slides) is a power point presentation that a startup board might review when adopting a plan. I am not giving legal advice……
Have a great weekend.
Howard Morgan (co-founder of First Round Capital and currently chairman of B Capital) spoke at Cornell this past Wednesday. Howard received his PhD from Cornell in operations research in 1968 (I was 3 years old!). He has a wonderful experience set (see this Cornell article).
I have seen Howard speak a bunch of times, and I enjoyed this recent one the best. He gave some really interesting data driven insights on VC and startups, like that timing is the #1 factor in startup company success, with team being the #2 factor. So…..the element of luck is huge as timing is often a factor of luck. I have seen many companies that have almost failed, then struggled to survive for a few years and then hit it out of the park as the market ultimately caught up to the company’s product offering. Timing, timing, timing! Howard noted that his idealab co-founder Bill Gross gave a super and short TED talk on this topic. Worth watching.
On the non-data driven insights, Howard mentioned a few times that that his personal relationships with startup management teams is one factor that drives him to keep being a VC. He simply enjoys the interactions and working relationships. We have all heard that the management teams are crucial to success – execution is king and only a good management team can execute. But taking this to the level of personal relationships is pretty interesting.
It boils down personal chemistry. For Howard, if he does not see himself developing a positive working and personal relationship with the startup management team then an investment won’t happen. I completely agree. And I have to admit that this factor has not always been #1 on my decision list. It should be. And will be.
The startup team/investor relationship is a long one. Often 10 years or more. Make it worth the effort.
It is highly typical for a startup to have small investors on its cap table. Founders often raise money from friends and family and other angels. That is all well and good….and 100% normal. Without friends and family and angels there would not be many companies for VCs to look at!
The treatment of the friends, family and angels (FFA) as the startup matures and raises larger rounds of financing over time is interesting. And sometimes founders want to protect the financial interests of FFAs. This is completely understandable but not always possible. Here is a quick guide.
- If FFAs only invest at the beginning and do not make any follow on investments as the company raises more $$ then the only real way FFAs make money when the company is ultimately sold is if the company keeps raising future rounds at higher and higher valuations (and IPO exit may provide upside if the stock price increases over time after the IPO). In this situation, the FFAs are diluted from an ownership percentage, but enhanced economically. In short, they own a smaller piece of a larger valuation pie. In my experience, this works about 1 out of 20 times. So not very good odds. Startups often get stuck, restart, pivot/change/move, etc., causing valuation bumps. Or the economy tanks or stock market tanks moving valuations down at inopportune times for the startup.
- So, the best thing for FFAs is to continue to invest, particularly in down rounds (where the price per share is lower than previous round). When asked, I always give the same advice: if you are investing $1 today, reserve $2 for future rounds because you never know what is going to happen.
- If FFAs do not continue to invest and the company hits bumps (again – this is the norm), then the company ends up with unhappy FFAs and the founders feel responsible (understandably so). The weight of this responsibility is very real.
So, do VCs care about the FFAs? Sure, we care about prior investors. We have even done deals where we come in for a Series A or Series Seed at a valuation LOWER than what the FFAs paid, and then literally convert the FFAs investment to the lower valuation security to protect them. Personally, I like everyone to be on the same page starting out.
But once we invest, do we care about protecting FFAs? The short answer is that we completely believe that ALL investors (including FFAs) should have preemptive rights (just the right to invest in future rounds on a pro rata basis). And as stated above, I think they should use these rights. But if they do not use them and do not invest in future rounds then it is challenging for participating investors to be very concerned about non-participants’ dilution.
Also, note that the Board of Directors of any company owes the same fiduciary duties to all shareholders. So when faced with a choice of approving a down round (typically bad for non-participants) or seeing a company go under for lack for financing, the director’s choice is not typically difficult. It is better for all shareholders to fund the company.
Anyway, lots of interesting dynamics.
I am going to try to address a complex problem in a concise way.
Here is the big problem with investors – they dilute the founders’ ownership in the company. Is this actually a big problem? Well, that answer depends on your point of view.
Let’s cover some basics:
- It is impossible to issue stock to investors without existing shareholders (founders, employees and prior investors) being diluted.
- It is impossible to do a stock for stock business combination without existing shareholders being diluted. But now the diluted shareholders own a smaller piece of a larger pie hopefully.
- If you have issues with dilution then raising outside investment will give you heartburn every time. That is not a good situation to endure.
Given the basics, here is one key subjective data point that I always like to keep in mind: what exit value is going to make the founders happy?. The answer to this question is a function of (i) how much of the company do the founders own at time of exit and (ii) the exit value. For example, a company may sell for a relatively small amount, say $18 million. Are the founders happy? Well, if they own 50% of it they well might be. Typically, 50% ownership would mean that the company only has raised 1 or, at best, 2 rounds of equity funding. Alternatively, if the founders own only 15% then they might not be too happy with an $18 million exit. But they might be really happy with a $100 million exit.
Here is another basic truth: the more a company raises, particularly in tough times when projections are not being met, for example, the greater the likelihood of real tension between the investors and the founders. As investment dollars increase, founders ownership decreases. And if dollars are raised in challenging times then valuation and other terms will favor the investors compounding the tension. VCs deal with this situation most of the time. The “up and to the right” valuation scenario is not at all common (unfortunately!) or only comes after millions and millions of investment.
It is up to the investors and founders to acknowledge the tension, discuss it and come up with solutions that dissipate it. Often times, investors face situations where they must support a company that is going through growing pains. These are tough times for the investors and founders. It is up to the founders and investors to make sure that the founders stay motivated. But it is up to the founders to acknowledge the situation the company might be in, particularly if sub-optimal. There are ways to keep management teams motivated – additional stock option grants and management carve out plans are probably the 2 most common. But the investors and founders need to have direct face to face open and trustworthy discussion.
The motivations of founders and investors are highly predictable and usually aligned (maximize company value!), which should make the discussion easier. Luckily, the motivations are not political – I have been watching House of Cards recently…….
Sometimes it is GREAT to have a playbook. A coach loves a playbook. A teacher loves a playbook. A general contractor loves a playbook.
Well, for investors, a playbook is tricky because every investment is different. No exceptions. Never will all the key factors be the same: founders, market, product, scalability, regulatory environment, IP protection, global market forces, etc.
Yet having some “standard” questions to ask when starting to learn about a team and a company is comforting. So, yes, I am talking about “first meeting” questions.
Likewise, as a founder it is comforting to anticipate what those first meeting questions will be and good to have a general plan on how to answer them.
I read this morning a GREAT playbook on first meeting questions. It is written from the angel investor perspective, but it is a wonderful resource for founders as well.
Here is it (thanks to Tim Ferriss and Jason Calacanis).
I do have one piece of advice for founders as they answer questions in an investor meeting: be very open and honest and do not sound like a politician. Answer the questions directly and thoughtfully. If you have not quite figured something out, then say that. No beating around the bush and no BS – that will only have the opposite reaction you are hoping to get. My number one subjective factor when making an investment decision is trust.