Regardless of the strategy you choose – IPO, sell or stay private – the best possible outcome for your company is to “make a dent in the Universe,” as Steve Jobs would say.
While Apple was changing the way the world consumes entertainment, it was also changing the net worth of the founding team. The company has been a colossal financial success, with a split-adjusted IPO price of $2.75 and a current trading price of $449.
Twitter is another example of a brilliant idea designed to simplify the complexities of the world. Arab Spring. Occupy Wall Street. The list goes on. And while the list of life changing events took place on Twitter, the platform was able to amass enough loyal users to attract close to $1 billion in projected advertiser dollars for 2014.
The self-funded phenomenon MyFitnessPal set out to make achieving a healthy lifestyle fun and easy. They now have over 30 million dedicated users and investors banging down their door.
When your goal is to make a huge (positive) impact on society, the probability of success is higher. Whether success is defined by an IPO, a billion dollar exit or a lifetime of steady profits, your chances of getting there are greater when you build a company that is focused on delivering a life changing experience to the end user.
Now that we understand the key to building a successful company, let’s take a look at the difficult decision of IPO, sale, or hold.
The decision to go public, sell or stay private is always determined by the goals of the startup. Few companies want the pressure of becoming a public company. It requires a continued focus on meeting the expectations of the myriad of analysts who poke, prod, and report on publicly traded companies. Selling for a healthy profit is an easier exit to digest; if you don’t mind staying on for a few years to collect your earn out. And, of course, maintaining your privately held company would allow you to maintain full control of your company.
As you build your funding road map, keep your end goal in mind. If you think you might want to maintain your privately held company, you will want to steer clear of any investor who is looking for a substantial return on his or her money. Focus on investors who are willing to lend money and/or receive a percentage of future profits.
In Stiletto Network, Nancy Peretsman of Allen & Company confides that her female peers’ attempt to mentor young women had a surprising effect: “We thought the younger women would deeply benefit from the older women, but the surprise was that it definitely went both ways.”
There is much written on why young entrepreneurs should seek out wise mentors. Yet, very little has been written about the value of the mentee.
If growth is important to you, become a mentor. Interacting with technologically savvy, hungry young entrepreneurs will give you new insight and renewed focus. This population is looking at problems in new ways. They have their finger on the pulse of technology and are ready to create the next big thing.
As “seasoned” human beings we tend to get comfortable with the way our society functions. Young entrepreneurs are not in the comfort rut and are seeking new ways to disrupt the current environment. Nick D’Aloisio, the 17-year-old who sold his company, Summly, to Yahoo! for $30 million, is a prime example. The app he built at 15 years old shortens lengthy articles into reader-friendly portions of text that are easy to read on the go. I’m sure he could teach me a thing or two about the power of simplicity.
Being a mentor is the best way to expand your knowledge and constantly grow. As you teach your mentee, your mentee teaches you. I recently began mentoring by teaching entrepreneurial finance via text and online video. I knew it would be rewarding, but I had no idea that I would become the student. My students challenge traditional forms of learning and inspire me to learn new methods of interacting with them.
So, the next time a young entrepreneur reaches out for a few minutes of your time, selfishly say, “Yes!”
Oh, the lure of the VC. When they call you had better answer, right?
I get the phone call often, “VCs are calling us, what should we do?” My response is always the same, “Take the meeting. Explain where you are in the process, and never under any circumstances accept an exclusive term sheet from a one-off investor.” Well, unless you are three months behind in rent and can’t make payroll. That’s a different blog post.
Back to capital raising. The capital-raising process is a marathon, not a sprint. Entrepreneurs should prepare for the race by researching all capital sources – equity, debt, and of course the cheapest capital of all: customers’ cash. If you don’t know about crowd funding, you may be living under a rock.
Entrepreneurs need to understand their funding roadmap. Hopefully, it includes non-dilutive capital sources early in the game, and a conservative amount of dilutive capital sources as needed. When you are just starting out you don’t need VCs.
If you are too early for venture capital, don’t feel the pressure to take it. To use the staid marriage analogy, it’s similar to marrying your high school sweetheart, only to realize three years later that you haven’t reached the maturity required for a long-term commitment. You now have a mortgage, two kids and a minivan, and you’re lost.
Take time to grow up. It’s okay to say no to venture capital if your company is not mature enough. Allow your valuation to grow. Allow investors time to get to know your company. Investors love companies that are able to gain traction with non-dilutive sources of capital. And, of course, entrepreneurs love holding on to as much equity as possible.
There is a danger in letting go of too much equity too soon. You don’t want to be an Angie, you want to be a Miucca. When Angie’s List went public, Angie Hicks held only 1.8% of the company. Compare that to Miucca Prada who owned 33.2% of her company, which was enough equity to garner her multi-billionaire status at her company’s IPO. Miucca was conservative in her funding roadmap and used non-dilutive sources of capital for as long as she possibly could. Angie used extensive amounts of dilutive capital (read: venture capital) to grow her company, and she ended up losing it. I bet Angie wishes someone would have told her that she didn’t need VCs.
You spend the best years of your life building your company, shouldn’t you be able to enjoy the rewards when you exit? I think so.
There is no sure-fire way to prevent failure, but one can always fail smarter. Entrepreneurs fail smarter by understanding the basics of their term sheet, understanding how much capital is needed, and having an exit plan.
Term sheets. In the exhilaration of securing capital, many first-time entrepreneurs fail to read, and understand, the language around liquidation. All smart entrepreneurs know to seek legal counsel prior to signing off on a term sheet. However, even those who do understand the terms, tend to visualize a profitable exit; in which even the least entrepreneur-friendly terms are digestible. Unfortunately, not all companies liquidate at a profit. In the event that there is a fire sale, entrepreneurs can feel a deeper burn if they neglect to properly negotiate the language in their term sheet.
A common mistake first time entrepreneurs make is failing to fully understand the events that could potentially occur during the sale of their company.
Liquidation Preference. Liquidation preference dictates how the proceeds of a sale will be distributed.
“In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).”
Tip: Most investors will request a liquidation preference of 1x. If your liquidation preference is substantially higher, this is a red flag.
Participation. An entrepreneur needs to understand participation. There are three varieties: Full participation, capped participation and non-participating.
Fully participating stock will share in the liquidation proceeds on a pro rata basis with common, after payment of the liquidation preference.
Capped participation indicates that the stock will share in the liquidation proceeds on a pro rata basis until a certain multiple return is reached. Non-participating would not participate at all.
Tip: Some investors will request fully participating stock. Be mindful of how this will affect your proceeds during the liquidation.
Redemption Clause. The redemption clause puts a finite number of years on the investment’s life. This is enacted to protect the investor and provide a guaranteed exit.
“Redemption at Option of Investors: At the election of the holders of at least majority of the Series A Preferred, the Company shall redeem the outstanding Series A Preferred in three annual installments beginning on the [fifth] anniversary of the Closing. Such redemptions shall be at a purchase price equal to [x] times the Original Purchase Price plus declared and unpaid dividends.”
Tip: Most investors do not enforce redemption, however, it is used in some term sheets. Discuss this with your investor and understand the ramifications.
It’s important to work with an attorney who will educate you on these terms and make certain that you understand what you are signing.
Not understanding these basic terms could leave a first-time entrepreneur in for a shock when it comes time to wind down their company.
Capital. Most entrepreneurs dread building and maintaining financial models. Unfortunately, the number one reason companies fail is that they run out of capital. Know your numbers.
All first time entrepreneurs should have a general understanding of their revenue model (how money is coming into the company) and their financial model (how money flows through the company).
When entrepreneurs take the time to create a financial model and track their cash flow, they are in a better position to detect a crisis and re-position for a downturn. This will assist them if they need to pivot or exit the company.
Entrepreneurs can protect themselves in a future crisis by establishing limits. For instance, entrepreneurs can set a baseline of capital (3 months worth of salary, operating expenses, and legal expense) as the point in time that they need to seriously consider winding down and looking for a buyer.
Tip: Budget for a worst case scenario. Most entrepreneurs build out a financial plan based on one scenario only. This creates a blind spot for operations.
Exit. Another mistake entrepreneurs make is failing to attach an exit strategy to the worst case scenario. They typically have an exit strategy based on their best case. For example, if we reach $100 million in annual sales, we could potentially sell to these top five companies.
Entrepreneurs who fail to create a worst case exit strategy miss out on opportunities for asset sales, liquidations, and other sales strategies that are employed when a company is failing.
Tip: Prepare for the worst and you will come out on top of any exit.
1) They don’t create a capitalization table (commonly referred to as a cap table).
A cap table provides clarity around ownership. It will assist entrepreneurs in understanding the effects of issuing too much equity too soon. Too often, I see entrepreneurs freely giving away equity as compensation without realizing the extent of dilution they are causing.
It is normal to provide 1 percent to 2 percent of your company’s equity to an advisor who is willing to vest over a set time period of 6 to 12 months in exchange. The rationale behind vesting the shares is that you want to make sure this individual is performing activities that will enhance your company’s growth. As an advisor, I take equity in companies and specify that it will vest on a monthly basis as long as the contract is active, which is typically four to six months.
The problem I see often is when entrepreneurs dole out 5 percent or more to each person who provides ancillary services. If you give an accountant 5 percent of your company’s equity in exchange for an audit, you are diluting the company in exchange for a service that does not enhance your company’s growth.
Tip: Create a cap table and barter or pay cash for services that do not provide ongoing value to your company.
2) They don’t integrate their option pool with their hiring plan.
An option pool sets aside equity for future hires. Once the cap table is in place, the entrepreneur can start to develop their option pool. Of course, all smart entrepreneurs know to develop a financial model that details their hiring needs on a monthly basis for the next 24 months. This, in turn, provides guidance for the option pool.
The entrepreneur will look to the hiring needs of the company for the next 24 months. If they are raising outside capital, they will structure their option pool around the next funding event. In other words, they will create an option pool that will last up until their next funding round. Each subsequent round will have an adjusted option pool.
Here’s an example:
Six months ago, I seeded my company through a crowd funding campaign. Today, I want to raise $3 million, which will take me through to the next financing round, which I anticipate will occur in 18 months. Therefore, I create an option pool that covers all applicable hires within the 18-month time frame.
I use the following schedule for guidance:
C Level (CEO/CTO/CMO) 2% to 10%
Vice President 1% to 2%
Director .5% to 1%
Executive .5% to 1%
Your option plan will vary depending on the characteristics of your company. If you have a non-tech company that is highly focused on selling a non-tech product or service to your target audience, your CMO may warrant a higher percentage of options than your CTO. In other words, ask yourself how critical each role is and award the role accordingly. The more critical the hire, the higher the percentage of the option pool.
Tip: Create an option pool based on your company’s hiring and fundraising needs.
3) They don’t get legal guidance when negotiating the equity in their term sheet.
One common point of contention is an investor who inserts the option pool into the pre-money valuation. This may seem like a minor issue, but it dilutes the valuation of the company.
Here’s an example:
A company has a pre money valuation of $15,000,000.
An investor agrees to invest $5,000,000, which creates a post money valuation of $20,000,000 (pre money valuation + investment = post money valuation). However, the investor stipulates that 10 percent of the fully diluted shares will be set aside for the option pool. This 10 percent option pool represents $2,000,000 (10 percent x $20,000,000). Your valuation has gone from $15,000,000 to $13,000,000, as the $2,000,000 worth of stock has been set aside for future hires.
This can be remedied by asking for an increase in valuation. Most investors are amenable to the increase in valuation as they know that the option pool is a sensitive issue.
Tip: Always seek legal advice when negotiating a term sheet. Understand how each term in your term sheet affects your company.
In summary, entrepreneurs should pay close attention to the equity in their company. It is a finite source and should be distributed with the utmost care. Your option pool will be critical in attracting top talent, so you will want those working with you incentivized accordingly. Last, but not least, an ounce of prevention is worth a pound of cure. Always seek legal advice before signing off on any investment.
Watch this 8 minute video and download the free cap table:
Still have questions about equity? Watch the September Office Hours for a discussion on valuation caps, common vs. private, and dilution — http://www.spreecast.com/events/lean-finance-for-startups92013
I read an interesting blog post recently titled, Why Early-Stage VCs Should Be Careful About Intros from Bankers (update: he has since back peddled on the title). The author, Mark Suster, posits that entrepreneurs should carry the full weight of executing a successful capital raise and steer clear of “bankers.” Below are a few key issues that came out of the article.
“Bankers” are known to fight hard for their clients. Mark notes the typical, “We’re expecting 3 other offers, so move fast” and “You’ll have to top “x” price to win this deal” can be annoying to investors. It’s true that bankers have access to various capital sources – hedge funds, family offices, etc. – and will use this as a bargaining chip for entrepreneurs. This is a good thing.
One key issue that was not mentioned in the article, is the one sided valuation. When a “banker” type is not involved, the investor has full control over the valuation. An investor could tell an entrepreneur that their company is worth only a fraction of its true value and the entrepreneur has no way of knowing if it is or isn’t. This brings me to one of the most important reasons to have a “banker” type on your team. A “banker” will pull the data you need to back up a healthy valuation. Most early-stage entrepreneurs do not have time or money to research acquisitions and financing rounds to pull together valuation data.
Another point that Mark makes:
“And given how easy it is to meet VCs through introductions I also wonder what’s wrong with your startup teams that given the unprecedented amount of transparency and access now in our industry – why they chose to hire a banker.”
I agree, wholeheartedly, that it is easy for entrepreneurs to meet investors these days. If an entrepreneur is not willing to do any of the work needed to find investors, this is a huge read flag. Any entrepreneur who expects to hand off 100% of the process to a “banker” is not a true entrepreneur. A true entrepreneur is willing to do everything they can to get the deal done, yet smart enough to get assistance to carry the load.
How to Find Investors breaks down the process of finding investors. If an entrepreneur wants to raise money fast, they should be willing to network to ensure that they are casting the widest net possible. When an entrepreneur believes passionately in his or her vision and shares it with their network, they will attract the right investors.
The Rock Star you need to recruit is you.
There is nothing wrong with recruiting a “banker” type to help you research the market, build a financial model, defend your valuation, and assist you with your investor selection and investor pitch. But in the end, the investor is evaluating you as a person. Can you lead your team? Do you have conviction in your ideas while remaining open to new ideas? Do you enthusiastically accept criticism and view it as an opportunity to learn and grow? If you answered yes to all of these questions, you are the Rock Star that you need.
Are you raising capital and hitting a brick wall? Leave a comment below or send me a tweet for feedback on how you can fine tune your approach.
