Management Carve Out Plans

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.

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Its all about the relationships…..

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.

Dilution and Investors and Tension

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:

  1.  It is impossible to issue stock to investors without existing shareholders (founders, employees and prior investors) being diluted.
  2.  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.
  3.  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…….

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.

Answering the question “What do I need to know about investing in a startup?”

Once in a while I get the question “What do I need to know about investing in a startup?”   The context is typically where Friend A has asked Friend B to invest in Friend A’s startup business.  Then Friend B asks me the question.  This happens multiple times a year.

It is a fair question.  And one that is hard to answer definitively.  But, here are some basic things that I would recommend to Friend B to start with:

  1.  How much is Friend A looking to raise in total?  Let’s pretend the target raise is $750,000.
  2.  Is there a minimum amount needed to “close” the round of financing.  This is a critical question.  If Friend B wants to invest $25,000, then there better be some larger minimum amount going into to the company at the first closing.  If Friend A took $25,000 from Friend B and nothing else, then Friend B has most likely just flushed $$ down the toilet.  The company will be out of business as soon as the $25,000 is spent.  So, in this made up scenario, Friend B should insist on a minimum closing amount that gives Friend A’s company at least 6 months (and ideally longer) of runway.
  3. Can Friend A produce a projection model?  Does the projection model make sense?  Does the projection model actually show how the funds being raised will be spent (in other words an understandable “use of proceeds”)?   We all know that startup projections are essentially best guesses, but the model needs to tell a realistic narrative.
  4. Why type of legal entity does Friend A have set up?  Typically will be either a corporation or LLC.  BTW, I have a strong bias towards corporations when it comes to startups raising $$.
  5.  What type of security is being sold?  Typically will either be convertible debt or preferred stock (Series Seed or Series A).  And does Friend B understand the terms of the security and the deal?
  6. Does Friend B know much about Friend A’s business and does Friend B truly trust Friend A?
  7.  Finally, is Friend B ready to lose $25,000?  Key question!

This is literally the tip of the iceberg.  Please add your thoughts in the comments.   Thanks.