Thanks to Atlas Venture for supporting Venture Hacks this month. This post is by Fred Destin, one of Atlas’ general partners. If you like it, check out Fred’s blog and tweets @fdestin. And if you want an intro to Atlas, send me an email. I’ll put you in touch if there’s a fit. Thanks. – Nivi
There is a behavior I witness in some first-time CEOs that I meet, not necessarily the younger and more mavericky generation, that I do not think is necessary, nor helpful. It’s an insidious but frequent tendency to let the board decide, rather than advise or approve. It goes like this…
Because VCs have blocking rights on some important decisions (approving the budget, your compensation, raising money), they are often able to wield way more power than their 20% ownership would suggest they should have. As a result, entrepreneurs often talk of coming to the board with their slides in hand, asking “what does the board want me to do?”, which is code-speak for, “I am here to ask for permission from my investors to do what I need to do.”
Entrepreneurs will present the strategy they believe in, but essentially allow the board (read: the investors) to walk straight through the carefully thought-out action plan and redesign the entire strategy in one swell meeting. The investor probably walks away feeling like he provided value and the entrepreneur now goes back to his team to explain that his investors puked over the team’s strategy and that the priorities have changed.
It’s the CEO’s fault
That may be the product of investor behavior, but I would argue this is the CEO’s fault. Nature abhors a leadership vacuum, and VCs will fill that gap if you don’t.
If you really believe in what you are doing, you come to the board telling board members what you are planning to do, taking considered advice on whether this is the right strategy, considering that advice and executing on what is, in your best judgment, the right path for the business. That’s what you are there to do. Make decisions fast, don’t fall for analysis-paralysis, trust your gut, execute and iterate. As Tim Ferriss would say, ask for forgiveness, not permission.
Why VCs shouldn’t drive strategy
Guy Kawasaki does lists all the time and it seems to work for him so I thought I would try one too: Here are the top five lighthearted reasons why VCs should not drive your strategy:
We forget 50% of what we said at the last board meeting.
We don’t know the people inside the company and hence have no clue what the team can really execute.
We meet many smart people and hence we have way too many ideas than you can possibly implement.
We are focused on the 5 year vision, yet we are focused on the quarter too — we’re confused.
We don’t need to deliver on it, you do. We come and collect when the job is done.
You want to leverage your board and you don’t want to get fired for being a solo player either. Personally I really like what my partner Jeff refers to as a culture of “champion and challenge”. I guess you have to be born in the USA to say phrases like that, but it’s spot on. If I really disagree with a strategy decision, trust me, we will have a serious discussion about it. But come and champion what you believe in, take ownership, step into the role. Ultimately, I backed you because I believe in you, and you know better.
If you like this post, check out Fred’s blog and his tweets @fdestin. If you want an intro to Atlas, send me an email. I’ll put you in touch if there’s a fit. Finally, contact me if you’re interested in supporting Venture Hacks. Thanks. – Nivi
In the second part of my interview with Eric Ries, we discuss (1) acquiring customers without launching and (2) opening up board meetings to the entire company.
At IMVU, Eric and the management opened up board meetings to the entire company. Why?
To give people the information they need to do their jobs.
To teach everyone in the company to think like the CEO.
To prevent employees from gossiping about board meetings.
I’ve synchronized the audio with some simple slides below. That’s my favorite way to consume the audio. You can also find a transcript and stand-alone audio below. Please let me know if you find the transcript useful.
Read on to learn what kind of employee Eric used to “show the door” at IMVU…
How do people find out about our product if we haven’t launched?
Nivi: And this gets to a second topic, which is you guys weren’t doing any of this really in public, because you had not launched a product, right?
Nivi: Nobody knew who you were, but people were, at the same time, were using the product, so how did you do that?
Eric: I got a question today which was something like, “I’d love to follow your advice about not having a public launch, but we need to get early beta users for our product launch. How can we do that if we are not willing to talk to bloggers? Nobody really knows who we are.”
I think a lot of people have that attitude, that without PR, you just can’t get any early customers. Again, we have got to start with, “What is the goal of early customers? Why do you want them?”
If you are charging from day one, one of the reasons you want them is you actually want to make money. You want to show that your business is viable. But even if you are not charging money, you have a need to find out whether your business is viable, whether you have that minimum viable product, whether the business model, at the end of the day, is going to work.
For that, you do need customers, and you do need to be putting customers through a product experience that will give you that information. But you don’t need a lot of customers. I think that is where people get confused.
For a big fancy launch you can get hundreds of thousands of customers to show up for one day. But for metrics analysis, generally a cohort of 100 people or 1,000 people are plenty to learn from.
If you change your goal from, “How do we get the maximum number of customers,” to, “How do we get the minimally sufficient number of customers to learn what we need to learn,” new possibilities get opened up to you.
Acquiring customers on $5 a day
Eric: For example, at IMVU, we practice the $5 a day AdWords campaign. I was the VP of marketing in those days. If I actually knew anything about marketing, I would have known not to try this. By traditional marketing standards it is considered crazy to spend only $5 a day, but we had a pretty low budget and we really were pretty frugal.
I discovered that in those days you could buy clicks for five cents a click. But to me, $5 a day meant every single day 100 human beings are coming to try my product.
If you think about that from a beta testing point of view, especially if you look back at the old days of software shipped by CD, getting 100 people to try your product is actually a lot and you can learn a lot from that. And at 100 people a day, you are in good shape, just at that tiny, tiny level.
The risks of doing that are really quite low. I think a lot of engineers have this idea that once you put your product out there in public, the investigative journalists are going to find out about it and write about it and we are going to lose control of the story. Let me tell you. You should be so lucky.
IMVU was a top 1,000 website in the whole world before it got any press whatsoever. We were making millions of dollars a year. The press was writing about newly funded, venture backed competitors that had no traction whatsoever; because those were the guys sending them press releases.
It was frustrating, and psychologically you want to have that cover story on WIRED that you can send home to mom, but you know what? We did not start this company to have good vanity covers printed about you in the press. We were there to serve customers and serve them well.
Running experiments under a different brand name
Nivi: How do I run experiments, if I already accidentally got that TechCrunch article and I…?
Eric: Yeah, I am sorry. You are not doomed, but you are going to have to go waste energy later cleaning up the positioning that you put in that article, which is undoubtedly wrong.
Nivi: Right. There is that aspect of it, but do you think you should, just basically pretend that article never existed, or do you run tests under a different brand name?
Eric: That is not a bad idea. Especially on the iPhone, I see this because of Apple’s stringent release process where there is this huge delay before you can actually bring things to market.
And also because people want to get into the top 25. That is where all the action is in the Apps store. There is a lot of competition to make sure that on the day you launch your app you get all the right coverage lined up and all the stuff happening.
People feel like they don’t want to do a bad launch under their real brand name, because that will harm their ability to do the proper launch later and get to the top 25.
But there is no law that says you can only bring out products under one brand name. I strongly, recommend that to people if you are very concerned about your precious brand. I think most startups are way too concerned about the power of their brand. They should be so lucky to get some kind of brand going.
Even still, bring it out under a terrible name. I specifically recommend people bringing products out under brand names that they hate so that they won’t ever be tempted to make that into their real official brand name and then become afraid to experiment with it.
You have got to be bringing products out under a brand that you feel comfortable experimenting in. Then once you find the right formula, there are two possibilities.
Either you will be able to port that product over to your new brand name and it will be great, or the product concept you brought up under that bad brand name will be so powerful, you just can’t get people away from it.
It is too sticky and you are stuck with it. But congratulations! You are successful! Is it really so bad that you personally don’t like the brand if customers do like it? I think it is not so bad.
Running pricing experiments in public
Nivi: A friend of ours has a popular subscription based product that they don’t charge for and now they want to start charging for parts of it for the premium model, and they want to find the optimal pricing strategy. How can they run those experiments in public and in secret? What would you suggest to them?
Eric: I would actually not be afraid to run them in public. It is hard for people who are afraid of what the worst possible thing that could happen is, to do this. But I think it is good to just try it and get over it.
What happens is, it is true that customers don’t generally like the idea that one customer got charged one price for something that somebody else got charged a different price for the same item. So there is some risk when you do different pricing offers in a split test.
But in my experience, there are two mitigating factors that make it not so bad. The first is it is actually incredibly difficult for most customers to figure out that is happening, especially if you only do it in a limited time window.
For example, I am going to tell you a story that may not seem related, but bear with me. When we were at there.com, the virtual world company, we would do a lot of QA. That was a heavy QA company.
For hours every day we had QA testers sitting in a lab together running the virtual world software and testing to make sure that it worked. I remember one day getting called in to see about…
There was one tester. They were around a physical corner from each other. So you couldn’t see each other, but they were not more than 20 feet away. They were both engaged in this activity.
The guy called me down and he said, “I am in this dune buggy riding around with somebody in the virtual world and we are seeing this glitch. We are not seeing the same thing. Something is not right.” They were calling back and forth, trying to pin down what it was.
I remember sitting there really confused about what the problem was, because it looked like the two of them were sitting there in the dune buggy and everything was fine.
I walk around the corner to the other guy. I talk to him about what the problem is. I look at his screen. On his screen, he and the other guy are engaged in a paintball match. They are not in a dune buggy at all.
He was almost a mile physically distant in the virtual world from where the other guy was, yet their conversation was perfectly consistent to them and it never occurred to anybody to ask, “Wait. What planet are you on in this time that we are comparing notes?”
They had no clue that this was happening. I think, we totally tend to underestimate just how powerful the pull of what you see is to most people. They basically can’t imagine the world, any other way than the way that it is.
Entrepreneurs don’t have that problem, so a lot of times they don’t grasp what is true for customers. It is actually very unusual for the customers to go onto a forum and post, “Here are all the offers that I am being offered and exactly what I see. Does anybody else see the same thing?” Our natural assumption is that everybody else sees the same thing.
So you are not totally likely to get caught. That is a mitigating factor. It is actually not as bad as you think when you do get caught, because don’t forget; you have the power of the apology, especially as a startup.
If you screw up… You are going to screw up all the time. If you are a customer of a startup, your general experience is, “These guys are constantly screwing up.” What customers care more about than whether you screw up or not, is how you treat them when you do screw up.
They care that you listen to them and take them seriously more than if you always get it right. If they want to work with a company that always gets it right, they will go work with some premium giant company that really has a very carefully constructed customer experience.
If you get caught doing this thing, you can always say, “We are so sorry. We were experimenting with this pricing. We didn’t mean for this to treat anyone unfairly. And if anyone was treated unfairly, we have gone back in the records and we are going to give them all double the money back for the thing that happened,” or whatever you have to do to make it right.
That is OK! It is really not that bad. What happens then is people say, “Wow. These guys are serious about making sure that we get treated fairly.” Meanwhile, you get to keep experimenting.
Opening board meetings to the entire company
Nivi: Yeah. You have talked a couple times on your blog about how you opened the board meetings up to the entire company and the positive benefits of that, and people’s perceptions of negative benefits.
Eric: Yeah. Well this is not something that a lot of companies adopt. This is considered pretty crazy.
I don’t know if it’s that most people are actually afraid of giving the whole company information they need to do their job, because it might lead them to judge the top management harshly, but people judge you harshly whether you give them the information or not, from my point of view.
Just give them the information! Your pathetic attempts to hide what’s happening don’t fool anybody.
Having been on both sides of that divide, I can tell you I never felt like I was being successfully fooled. And if you do manage to fool me for a limited time, I’m awfully pissed. My point of view is: you want people to have the maximum information possible.
You need to do it in a trust-building way. You’ve got to make sure the people you’re giving it to understand what they can and can’t do with that information, and they understand that they need to keep company secrets confidential.
If you don’t trust your employees to keep company secrets confidential, you’ve got bigger problems and you should go address those problems first.
There is some board business that has to be done in secret for legal reasons, so it’s not true that absolutely every meeting that any time ever happened at the board level is open to the public.
Employees have critical things to say in board meetings
Eric: But the interesting part about board meetings is the strategy conversation where you present progress, show data, and you make discussions about what should happen next. And that’s the part of the meeting I strongly recommend people open up to their employees.
What we did is we actually had a board of advisors and then a board of directors that was a subset of those advisors. We would convene the full set, advisors and board, at nine o’clock in the morning and we would have a maybe two-hour strategy conversation followed by maybe a half-hour or one-hour private board meeting.
For the strategy conversation the rule was: every employee can attend. We did this up until we were a 50- or 60-person company. We actually, physically crammed everybody into one room, and we had the employees sit around in as much seating as we could fit and the board members would sit at the big table.
It wasn’t a free-for-all, most of the employees were encouraged to listen, not to speak. But every once in a while the rule was that if someone had something they really needed to say, they could be recognized by the CEO and say their piece.
It was amazing. We would, occasionally have a board meeting where we would have a moment, where there would be data we were presenting to the board, and it would indicate that on a certain day, a certain metric went up and that was due to us launching that feature that day, or whatever our interpretation of what that data meant.
And not an insignificant number of times we would have an employee raise their hand and say, “Excuse me, but do you also realize that something else happened on that day?” Yada, yada, yada.
And occasionally, I’d be the one presenting! On the one hand, I’m really embarrassed. So I’m like, “No, I didn’t realize that.” This is a critical thing about running my own business I didn’t know.
But once I got over my personal embarrassment, what you would find is the board loved it! They’re like, “Thank God that guy was sitting in the room and could enlighten us about that. That changes our interpretation of what this means.”
And quite a few times I think we saved ourselves months of work by coming to a realization of something way earlier than we would have, because the right guy happened to be sitting in the room.
And yeah, occasionally you had an employee who’d make an off-color comment or say something that really shouldn’t have been said in front of the board, but people learn from those experiences. Most of the time most people had really substantive conversations.
Nivi: Did you ever get in a situation where some of the employees were like, “I don’t even care about these board meetings. I don’t even want to go?”
Eric: Yes, yes! We eventually had people who on occasion would beg me not to have to go to the meeting. And we eventually made them voluntary. For a while I was really rigorous, I said, “No, everyone has to be there. If I have to be at the meeting, you have to be at the meeting. Why do you think I’m any more privileged or unprivileged than you?”
Yeah, because board meetings are actually pretty boring. But when people are outside the room looking in — and you know most conference rooms have some form of glass — people can see what’s going on. They’ll come up with an excuse to walk by, kind of peek in. They will make up whatever crazy conspiracy theories are consistent with the data if they’re not there.
An, in my point of view, that’s such a source of waste: people gossip and there’s rumors and people don’t know. Let them be in the room, let them see how boring and mundane most board meetings are. So that for the occasional one where something actually interesting gets decided, let them be there to hear it themselves.
Everybody in the company has the ability to understand what everybody else in the company has to understand
Eric: There are some costs, definitely some down sides to doing it. One which took us by surprise was that, people can occasionally get confused about who’s in charge, we did occasionally have people — some board member would say, “You guys should really build feature X.”
Board members occasionally would just spout off about what’s randomly on their mind, and occasionally you’d have an employee get confused that that means the company is now going to go do feature X because board member so-and-so said so.
And that was actually good practice for us, to be a constant reminder that no matter who you are, no matter what it says on your business card, nobody gets to decide randomly that the company’s going to do feature X. Right? I don’t care if you’re the CEO or the lowliest person, we’re going to have a reasoned and considered process for deciding what to do.
Nivi: And it’s a learning opportunity.
Eric: It’s always a learning opportunity. The other thing that was hard for me personally was it’s hard to have your people who work for you see you be criticized in public. That was not fun.
Nivi: Hard for whom?
Eric: Well, it’s hard for me. My emotional reaction was like, “Wait a minute! I’m doing the best I can and now you’ve got to watch me get smacked around because I screwed something up.” But once I got over my personal emotional response to it, it was wonderful.
Because it humanized me to the people who worked for me — they got to see, “Oh, I see the pressure that he’s under” — but more importantly, when I needed something from somebody for the purposes of presenting to the board I could go to them and say, “Do you remember what happened the last time I didn’t have the right answers to these questions or I had shoddy this? You’re really going to send me in there with this? Come on, you’ve got to help me out!”
So it made us collaborators in creating solutions for the board rather than I’m constantly asking them for stuff and they don’t know why.
And I think, get over your own infallibility. We all make mistakes and it’s better for people to see what the real stuff is.
Nivi: I think you wrote about this on your site, basically the assumption is that everybody in the company has the ability to understand what everybody else in the company has to understand.
Eric: That’s right.
Nivi: The assumption is I have the ability to understand what the CEO has to understand.
Eric: That’s right. And that makes people uncomfortable, because sometimes we would say, “You have the obligation to understand what the CEO’s going through right now, because it’s going to impact the way you do your job.”
Some people would say, “I just want to sit in my narrow corner, do my little thing, and I don’t want to worry about what the company strategy is.” And we would show those people the door. We were really serious about that.
You really needed to have people who were… they didn’t have to be good at it! We weren’t asking them to be good at the CEO’s job, but we are asking them to understand why is the CEO making the decisions that he’s making. Because they’re going to have to make CEO-level decisions sometimes.
Sometimes the actions that have the biggest impact on the company’s performance are taken by people at the line employee level. They may not realize it’s going to have that big impact, but they are going to make those decisions. By the time the CEO finds out about it, sometimes it’s way too late to do anything about it.
We sure hope that the guy at the line level understands what the company strategy is and how his decisions impact, at least the best that he can.
Nivi: Yeah, I think maybe their decisions impact the company more than the CEO in the sense that if the CEO doesn’t come in to work, who cares? The company proceeds, but if the team doesn’t come in to work nothing happens.
Eric: OK, let me tell you: when the community manager takes a day off, you can have serious, serious meltdowns in the community if it happens to be the wrong day. That can have major impacts on the company.
Should we share bad news with employees?
Eric: I’ll say one more thing because this is a real effect that people are afraid of, which is that if you give people information about how a company’s doing, it can impact morale negatively. Sometime the company’s not doing well.
It makes some people have this idea that part of your job as a manager is to shield people from bad news or shield them from chaos. Because it’s not fair to them to have them have to do their job and also be confused about how the company’s doing. I just think that’s a really paternalistic attitude that we just need to let go as an industry.
If you want people to believe you when you tell them the good news, you have to sometimes tell them bad news. Otherwise, you have no credibility. And when there’s bad news to be shared, yes, it negatively impacts morale. But for a good reason, because things aren’t going well and we now need to rally the company around the fact that we need to change what we’re doing.
And there’s nothing like actually seeing the board say, “You guys have a major crisis on your hands that you have not yet understood,” to get everyone in the company saying, “We’re alarmed. We need to do something about it.”
That can cause some chaos, and that can be disruptive, but if you build trust and rapport with your employees then what you could do is you can sit everybody down for an analysis meeting after the board, which we would always do, and say, “OK, let’s talk about what we heard and what does it mean for the company,” and let people share their perspectives.
Let people say stuff like, “This says to me we need to cancel all our projects and completely retool.”
You need to get that idea out in the open because when somebody thinks that, you don’t want them to just unilaterally go execute on that plan! You want the opportunity to tell them and everybody else who didn’t have the courage to say the same thing: “No, we’re not retooling, but we are going to make some adjustments and here’s how we think about it, here’s what we’re going to do about it and here’s what’s going to happen.” That was pretty powerful.
Summary: Control is a one way street that runs towards investors. Control doesn’t run backwards toward founders or common stockholders. In each round of financing, the percentage of investor board seats goes up (or stays the same). Once the investors have more board seats than the common, you’ve lost control of the board and you’re never getting it back. Your best bet is to be stingy with board seats and hope you never have to raise a round without good leverage.
An interesting idea came up in a meeting with Mike Speiser last week:
Control is a one way street.
In startups, control is a one way street that runs towards investors. Control doesn’t run backwards toward founders or common stockholders (unless you create dual-class stock when you IPO).
Types of control.
Here’s how control shifts to investors with each round of financing:
The Board: In each round of financing, the percentage of investor board seats goes up (or stays the same). And the percentage of common board seats goes down (or stays the same). In each round, the common can only hope to maintain their percentage of board seats.
Protective Provisions and Class votes: In each round of financing, the number of investors who participate in protective provisions and class votes goes up (or stays the same). That means you’ll have to ask more investors for their consent to do things like sell the company.
Shareholders: In each round of financing, the percentage of company shares held by investors goes up (obviously).
Class votes, shareholder votes, and the exercise of protective provisions are rare compared to board actions. The board meets about once a month to approve management decisions—so let’s take a closer look at the board.
Here’s an example of how board control shifts to investors with each round:
Founding: The founders have all the board seats. Let’s say the board consists of 2 founders.
Seed: The founders keep all the board seats.
Series A: The investors gain two board seats, an independent joins the board, and the founders don’t gain any board seats. Let’s say the board is now 2 investors, 2 founders, and 1 independent.
Series B: The company has a tough time raising money so the investors gain one more board seat but the founders don’t. The board is now 3 investors, 1 independent, and 2 founders. The investors now control the board.
In each round of financing, the percentage of common board seats stayed the same or went down. Don’t count independent directors when you’re calculating the percentage of common board seats—you don’t know how the independent director will vote.
Facts about investor board seats.
Here are some facts to consider when you’re giving board seats to investors:
In every round of financing, you will have to give board seats to investors. (There are two exceptions: (1) many seed rounds don’t give board seats to investors, and (2) some later-stage rounds don’t give board seats to investors if the company has a lot of leverage or the new investor has a lot of experience following an existing investor.)
If you give a board seat to an investor, you’re never getting that board seat back.
Every time the percentage of common board seats goes down, you’re stepping towards losing control of the board. (Don’t count independents when you’re calculating the percentage of common board seats.)
If you ever raise a round with poor leverage, the investors will gain control of the board.
Once the investors have more board seats than the common, you’ve lost control of the board and you’re never getting it back.
How to structure your board.
Your best bet is to be stingy with board seats and hope you never have to raise a round without good leverage:
Build a great company with good traction so you have a lot of leverage when you raise money.
Create a board that reflects the ownership of the company. Some investors argue that a board that has an equal number of investor seats and common seats (not counting independents) is “balanced”. But this board is actually “investor-leaning”. In bad times, investors will take over this board. But, in good times, the common doesn’t take over the board.
“One investor with whom I met on my [China] trip described a recent situation in which he funded an entrepreneur, only to have that entrepreneur turn around and leave for business school months later. The entrepreneur assured the investor that he would be better situated to make the business a success after the two years of school. The investor had no recourse as his money left the country with the entrepreneur.
“In another instance, an investor backed an entrepreneur in a business that thereafter appeared to be failing. However, a couple years later when the same company started thriving, the entrepreneur informed the investor that it was not the company he had backed. The investor was incredulous. He told the entrepreneur that it was the very same company with the same team and even the same name. The entrepreneur assured the investor that it was, in fact, a different company and that he had not invested in this successful company, his investment was in the previous failed venture. Despite the obvious deception, the investor told me that he again had no legal recourse.
“…the legal structures needed to support a vibrant startup economy [in China] are, at best, embryonic. Neither entrepreneurs nor investors are particularly well protected by the Chinese legal system.”
Investors trust, but verify.
Investors trust the entrepreneurs they back. They wouldn’t invest if they didn’t. Their trust is an expectation that entrepreneurs will:
Do what they say they’re going to do in anticipated situations.
Consider the investor’s interests in unanticipated situations.
Investors have been playing this game long enough to anticipate certain situations. So they use contracts and courts to enforce their expectations in those situations:
Investors trust entrepreneurs to stay at the company for 4 years, and they verify it with a vesting schedule.
Investors trust entrepreneurs to pay the investors first when the company exits, and they verify it with a liquidation preference.
Investors have been playing this game long enough to also know that you can’t anticipate every situation. So they use control to dispose the company towards the investor’s interests in unanticipated situations.
Verify your expectations.
China doesn’t seem to have a legal system that lets investors and entrepreneurs verify their expectations. They have trust, but no verification.
But U.S. investors can trust and verify. And you should do the same—with the same tools investors use: contracts and control.
Summary: Smart money is money plus the promise of help that’s worth paying for, dumb money is money plus hidden harm, and mostly money is mostly money. Weed out the dumb money with diligence. Evaluate supposedly smart money with the smart money test. Finally, assume your investors are mostly money: unbundle money and value-add to get money on the best terms possible and value-add on the best terms possible.
If smart money is money plus the promise of help that’s worth paying for, then dumb money is money plus hidden harm, and mostly money is mostly money. All three provide what entrepreneurs primarily want from investors: money.
Avoid dumb money: you don’t hire harmful people—so don’t marry them for the life of the company either.
Most investors are mostly money but very few of them act like their primary contribution is capital. They spend too much time selling you on their value-add and not enough time getting you a quick yes or no.
Smart money is rare—after all, would you work with most investors if they didn’t bring a piggy bank? Also, too many investors think the “smart” in smart money means “we know how to run your business better than you.”
Weed out the dumb money with diligence.
Don’t assume any investor won’t be harmful. Do the diligence to prove otherwise:
Do you trust him?
Will he provide his pro rata in the next round? (Not so important for seed funds and angels.)
Will he support you if the company is going sideways?
Does he have impeccable references?
Does he want control?
When it comes time to sell the company, will he let you?
Will he let you expand the option pool to hire someone great?
Does he want to replace you as CEO?
Will he try to merge you with a dying company from his portfolio?
Do you want to marry him for the life of the company?
Is he committed to investing in startups and does he have a reputation to protect in the startup world?
Evaluate supposedly smart money with the smart money test.
After you’ve weeded out the dumb money, do the smart money test on everybody else:
Would you add the investor to your board of directors (or advisors) if he didn’t come with money?
If the answer is no, he is mostly money (see below). If the answer is yes, subtract some dilution from his investment since he’s eliminating the cost of a value-add director or advisor. You’re paying for the smart money investor—with his own money!
A smart money investor can be very valuable because he is good enough to be an advisor or board member and he owns enough to really care about the company in good times and bad times. An advisor or independent director won’t own enough of the company to really care if the company is in trouble—his career isn’t on the line like an investor’s.
But! If the investor you thought was smart doesn’t add value, you can’t fire him like an advisor or director and get your money back. You can only hope to ignore him. Which is why it is safer to…
Assume your investors are mostly money.
Whether you raise smart money or mostly money, you should raise money as if your investors were mostly money. In other words, unbundle money and value-add. Get money on the best terms possible and get value-add on the best terms possible.
You can buy advice and introductions for 1/10th of the price that most investors charge. An investor will buy 15–30% of your company. An advisor or independent director will require 0.25–2.5% of your company with a vesting schedule of 2–4 years.
An advisor or independent director will be hand-picked from the population of planet Earth. He should be more effective than someone picked from the vast pool of investors who want to invest in your company.
He will own common stock, unlike an investor who owns preferred stock with additional rights.
And he won’t have conflicting responsibilities to his venture firm, other venture firms, or limited partners.
Money-add first, value-add second.
Value-add is great but it comes after money-add. First, find a money-add investor who will make an investment decision quickly, who is humble and trustworthy, who will treat you like a peer, who shares your vision, and is betting on you, not the market.
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Valuation is temporary, control is forever. For example, the valuation of your company is irrelevant if the board terminates you and you lose your unvested stock.
The easiest way to maintain control of a startup is to create good alternatives while you’re raising money. If you’re not willing to walk away from a deal, you won’t get a good deal. Great alternatives make it easy to walk away.
Create alternatives by focusing on fund-raising: pitch and negotiate with all of your prospective investors at once. This may seem obvious but entrepreneurs often meet investors one-after-another, instead of all-at-once.
Focusing on fund-raising creates the scarcity and social proof that close deals. Focus also yields a quick yes or no from investors so entrepreneurs can avoid perpetually raising capital.
Q: What’s the biggest mistake VCs make?
The biggest opportunity for venture firms is differentiation. VCs compete for deals, and differentiation is the only way to compete.
Most firms offer the same product: a bundle of money plus the promise of value-add. And the few firms that are differentiated don’t communicate their differentiation to entrepreneurs. Y Combinator is an example of differentiated capital with excellent marketing communications.
Venture firms that thrive by investing in game-changing businesses have barely begun to differentiate themselves, let alone changed the rules of their own game.
Summary: Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. They protect the preferred, who are minority shareholders, from unfair actions by the common majority. However, the preferred shouldn’t use protective provisions to serve their other interests.
Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. Roughly, they state that
“The Company requires the consent of the holders of at least X% of the Company’s Series A Preferred to (i) effect a sale or merger of the company, (ii) sell Series B Preferred with rights senior to or on parity with the Series A, (iii) et cetera…”
To understand why investors want protective provisions, you first need to understand how the preferred and common classes control the company.
The board mostly controls the company.
The common and preferred classes control the company through
Board seats, which require each board member to serve the interests of the company as a whole. Board members cannot simply serve the interests of their particular class of stock.
Shareholder votes, where the preferred vote as if they held common shares. In legal-speak, the preferred vote on an as-converted-to-common basis. The preferred usually gets one as-converted-to-common share for each of their preferred shares. The preferred and common use shareholder votes to serve their own interests.
Class votes, which require a majority of the preferred and a majority of the common. We will cover this mind-numbing topic in a future hack. The preferred and common use class votes to serve their own interests.
Protective provisions, which allow the preferred to veto certain actions, such as selling the company or raising capital. In some companies, each series (Series A, Series B…) has their own protective provisions. In other companies, all of the series exercise their protective provisions as a class.
After the common and preferred classes select their representatives on the board, the board takes it from there. The board, not the shareholders, usually approve management decisions. (We previously showed you how to hack the allocation of seats on the board.)
However, some major actions require shareholder votes and class votes in addition to board votes. For example, Delaware corporations require a shareholder vote to sell the company or raise money.
Protective provisions protect the preferred minority from the common majority.
The preferred usually owns 20%-40% of the company after the Series A. If the common is united, the preferred can’t influence shareholder votes—they don’t own enough shares. Nor can they influence board votes if a united common controls the board (e.g., the board consists of two common seats, one preferred seat, and no independents).
If the common controls a Delaware corporation’s stock and board, the preferred need protective provisions to stop the common from:
Selling the company to the founder’s cousin for $1 and wiping out the preferred stock.
Selling $1M of the founder’s shares to the company so he can get a great haircut.
Issuing a bazillion shares to the founders and diluting the preferred to nothingness.
Protective provisions protect the Series A minority from unfair actions by the common majority. That’s why they’re called protective provisions. In future rounds, protective provisions can also protect each series of preferred stock from the other series of preferred stock.
Investors argue that protective provisions encourage good governance.
Some investors claim that they need protective provisions because they can’t use their board seat to serve their own interests. They correctly argue that board members have to serve the interests of the company as a whole, not the interests of their class of stock.
These investors will claim that protective provisions let them serve their interests as investors, so they can serve the interests of the company through their board seat:
Say the company receives an offer to acquire the business. Management thinks it’s in the company’s interest to sell. The board defers to management since management is doing a good job running the company. But the investors think the company is the home run in their portfolio—they don’t want to sell the company now. So the investors use their board seat to vote for the sale and use their protective provisions to veto the sale.
Investors should use protective provisions to protect themselves, not to serve their interests.
We don’t agree that investors need protective provisions to serve on the board without succumbing to their own interests.
In fact, any investor who makes that argument is raising a big red flag. They’re implying that they can’t fulfill their duty as board members without additional veto powers. They’re implying that the interests of their fund can outweigh the interests of the company.
Your response to this argument goes like this:
“I don’t think you mean that you can’t serve the interests of the company without these additional protective provisions. I’m sure you will use your board seat to do the right thing for the company, always.
“You control the company through (1) board votes where you serve the interest of the company and (2) share and class votes where you serve your own interests.
“Protective provisions protect you against the common majority. But they’re not a tool to serve the interests of your fund at the expense of the company.”
We would rather have an “evil” investor who uses his board seat to serve his interests, than an investor who planned to use protective provisions to do anything other than protect himself. At least the “evil” investor’s power as a board member is in proportion to his share of board seats—his protective provisions give him a blanket veto that is wildly out of proportion with his ownership of stock and allocation of board seats!
The next few hacks will show you how to attenuate the protective provisions, reduce this mis-alignment, and leave enough protective provisions in place to protect the preferred.
Summary: Convertible debt is often the best choice for a seed round. It is convenient, cheap, and quick. It lets you close the financing quickly and turn your focus back to your customers—that’s good for the company and its investors.
When your business is very young, raising a seed financing ($50K-$500K) via convertible debt is a great alternative to selling equity. Convertible debt is also known as a bridge loan since it ‘bridges’ the company to its next financing.
Convertible debt (debt for short) is not like getting a loan from a bank. A bank expects to get its loan back. With convertible debt, the lender and your company both expect to convert the debt into equity when you close the Series A. Read Yokum Taku’s series on convertible debt for a primer on this lovely financial instrument.
Seed stage debt rounds are much simpler than equity rounds, especially if your investors are angels. There isn’t a lot to hack in these agreements. You need to be more careful if you raise debt from venture capitalists, but a debt financing with a VC is still much simpler than an equity financing with a VC.
Why is debt a great alternative to equity in a seed round? Convenience, suitability, control, cost, and speed.
Debt agreements are easy to understand and hard to screw up, two great benefits if you’re raising the first financing of your life.
Who knows how to determine a suitable valuation and investor rights for a seed stage company?
The company’s valuation and leverage is changing quickly as it goes from nothingness to product, users, and revenue.
The founders are unlikely to negotiate a valuation that meets their high minimum expectation since there isn’t much competition to invest in the young and risky business.
But a valuation that does meet the founder’s minimum expectations may be too high and result in a down round in the Series A. The down round leaves the founders feeling like they lost money even though the company made progress, the angels feeling like they took risk but got squashed, and the Series A investors feeling like they are dealing with unsophisticated operators.
Finally, it’s tough to reach a high Series A valuation soon after setting a low or moderate valuation in a seed round. Your Series A investors won’t want to pay a much higher share price than seed investors who bought stock just a few months ago.
Raising debt avoids setting a valuation, delays negotiating detailed investor rights, avoids the option pool shuffle, and gives the seed stage investors an upside through a discount and/or warrants.
Founders usually continue to control a company after a debt round.
They control a majority, or all, of the board seats. Debt investors, especially angels, don’t necessarily want board seats. Seed stage equity investors, especially venture capitalists, often do. Controlling the board reduces the burden of reporting to the board and diminishes the likelihood of disagreements between the board and management.
The founders also control a majority of the company’s common stock. There is no preferred stock. They can sell the company for $10M, give $2M to the debt investors, and take home $8M. Try doing that with equity investors who have preferred stock with protective provisions that allow them to veto a sale of the company. In particular, venture capitalists often have big funds and they’re looking for big returns, not $10M exits.
Finally, if you raise debt, you can create and run a profitable business that doesn’t need an ‘exit’. Angels may be happy getting a big dividend from your company every quarter, whether they bought debt or equity. Venture capitalists aren’t looking for a quarterly dividend—they need to sell or IPO a company to return a profit to their investors (their limited partners). Raising debt from VCs maintains the option of building a ‘non-exiting’ business—you can always pay their debt back when it comes due. That said, we don’t recommend taking debt from VCs with the plan of building a ‘non-exiting’ business—that’s disingenuous.
You can negotiate a debt term sheet and close the money for under $10K in legal fees. There are very few terms for the lawyers to discuss—they will barely have to modify their boilerplate documents.
Negotiating a Series A term sheet and closing it can cost $20K-$60K in legal fees. Why would you or your investors want to spend that much money on legal fees when you’re raising a $100K seed round?
Once your investors are ready to talk terms, you can negotiate a term sheet in one week and close the deal one week after that. The documents are short and simple—there isn’t much to discuss. Compare this to an equity financing which can take two weeks to negotiate and 4-6 weeks to close.
Debt is often the best choice for seed rounds.
Convertible debt is often the best instrument for a seed round. You can close the debt cheaply and quickly and then turn your focus back to your customers. That’s good for the company and its investors since speed is a major competitive advantage of a startup. If you or your investors are veering away from convenience, low cost, and speed, you are missing the point of seed stage debt!
The seed stage is the worst possible time for the founders to negotiate an equity financing. The company is nebulous, the founders are inexperienced, and the company is starved for cash and time. The team should be testing hypotheses about their business, not negotiating complicated term sheets.
Investors who market themselves as ‘business partners’ should agree that they can add a lot of value to the business by doing the financing quickly and letting the team get back to their customers.
What do you think about the benefits of debt vs. equity?
Use the comments to share your thoughts and questions on the benefits of debt vs. equity. We’ll discuss the most interesting comments in a future article.
Summary: Create a new board seat for a new CEO. Don’t give him one of the common seats.
Whether you negotiate a proportional or investor-leaning board, your term sheet will probably state that the CEO of the company must fill one of the common board seats. This may seem reasonable. One of the founders is probably the CEO and you were going to elect him to the board anyway.
Don’t accept this term. The investors are looking several moves ahead of you.
If you accept this term and hire a new CEO, he will take one of the common seats. The common shareholders will not have the right to elect that seat. If the new CEO turns out to be aligned with the investors, the new coalition of CEO + investors will control the board of directors.
A new CEO may be aligned with the investors.
A new CEO will probably be a professional manager who does a lot more business with VCs than he is likely to do with you.
VCs regularly refer the CEO to promising companies. They let him co-invest in their startups. They let him invest in their venture funds. They determine his compensation in your company. Where do you think the CEO’s loyalties lie?
Most likely, a new CEO will be aligned with the investors.
A coalition of CEO + investors can hurt the company.
A coalition of a new CEO + investors can hurt the company, founders, and employees. Consider this scenario:
The company needs to raise a Series B. Your investors discourage the new CEO from shopping around for cash because they want to invest more money in the business at a low valuation. Your investors tell you not to spend time raising cash because they will put in more money: “You should focus on building the business.” You want to shop around and raise money at a high valuation but the CEO does a half-arsed job because he knows this game.
The company ends up doing the Series B with its existing investors because that is the best offer on the table. A few months later, the CEO’s shares are “right-sized” and he is happy (“We have to pay the CEO market rate, right?”). The investors have put in more money at a low valuation and they are happy. The founders and employees have been diluted and they are wondering what just happened.
This story is not unheard of in Silicon Valley.
A new CEO may be naturally inclined to dilute you.
A new CEO can develop an antagonistic relationship with the company’s founders. Founders, like everyone else, have inadequacies as leaders and managers. Their inadequacies are usually worse than the ones the company portrayed while it was recruiting and selling the new CEO.
The new CEO joins the company and naturally blames the founders for all of the existing problems in the business. Who else is there to blame? Like any new leader, he continues to blame his predecessor for the next 12 months and loses any sympathy he had for the founders. He convinces himself that he deserves more equity for his contributions even if it dilutes the founders and employees.
“These fucking founders,” he tells the investors.
“Yes, these fucking founders,” say the investors.
And on they go to find to find a mutually beneficial opportunity to right-size the CEO.
Create a new board seat for a new CEO.
These two tales of CEO-investor intrigue illustrate why a new CEO is not necessarily your friend on the board of directors. If and when you hire a new CEO, create a new board seat for him. The common board seats should always be elected by the common shareholders.
For example, adding a CEO seat to an investor-leaning board with two investors yields
2 common + 2 investors + 1 independent + 1 CEO = 6 seats
The same scenario with one investor yields
1 common + 1 investor + 1 independent + 1 CEO = 4 seats
If you want to keep an odd number of people on the board, add another independent seat too.
If you have a good BATNA, you should reject any proposal where the CEO takes one of the common board seats.
The new CEO seat maintains the board’s structure (if you’re lucky).
Your investors may argue that the new CEO seat tips the board in favor of the common stockholders since the CEO holds common stock.
If only you were so lucky.
If your investors accept the premise that the new CEO is probably aligned with them, the new seat actually tips the board in their favor. If they don’t accept this premise, they are still wrong.
First, the independent director holds common stock, but the investors do not consider his seat to tip the board in favor of the common stockholders. You should ask your investors to consistently apply the same reasoning to the new CEO seat.
Second, the CEO does not represent the common stockholders on the board; his job is to create value for all classes of stock. In fact, all of the board members have a duty to serve the interests of the company, not a duty to “serve their class of stock”.
You learn a lot about an investor’s attitude toward directorship if they imply that they represent their class of stock on the board. Investors should protect their class of stock through protective provisions, not through their board seat.
Note: This article is a term sheet hack. You may enjoy the rest of the Term Sheet Hacks.
Forces the company to raise a low-valuation Series B from existing investors by rejecting offers until the company is almost out of cash.
Merges the company with another private company and wipes out your common stock in the process.
If it isn’t obvious by now, a bad board can do lots of stupid or malicious things to make your stock or company worthless.
The board you create will be your new boss. But trying to please everyone on your board dooms you to managing board members and ignoring customers and employees. Great companies are rarely built by committee and a bad board will waste your time trying to run the company their way.
This hack will show you how to create a board of directors that you can trust even when you don’t agree with its decisions.
The board should reflect the ownership of the company.
The form of government in a company is dictatorship. The board represents the owners of the company and selects the dictator (CEO). The board then works to ensure the dictator is optimally benevolent towards the owners. Naturally, bad dictators get beheaded…
If the board represents the owners of the company, its composition should reflect the ownership of the company. Truly competitive and transparent markets, such as the public stock markets, have already reached this conclusion.
After the Series A investment has closed, the common stockholders are probably going to own most of the company. The common stockholders should therefore elect most of the board seats. Let’s assume the common stockholders own approximately 60% of the company after the Series A. If you’re taking money from two investors, the board should look like
3 common + 2 investors = 5 members.
And if you’re taking money from one investor, the board should look like
2 common + 1 investor = 3 members.
In either case, the common stock should elect its directors through plurality voting. Plurality voting enables the founders to elect all of the common seats if they control a majority of the common stock.
The sound bite you want to use in your negotiation is
“The common stock owns most of the company. Isn’t ownership the basis for determining the composition of the board? One share, one vote?”
Your investors may argue that this board structure leaves their preferred stock exposed to the machinations and malfeasance of the common board members. Your response should be
Early-stage companies with good leverage can negotiate this democratic board structure in a Series A. If your investors tell you that a democratic board is a deal-breaker and you want to move forward with them, use the fallback position: an investor-leaning board.
Don’t settle for anything less than an investor-leaning board. #
An investor-leaning board gives an equal number of seats to every class of stock, no matter how many shares that class owns. This makes no sense, but, hey! that’s venture capital! There are many future scenarios where your investors can take over this board (e.g. a down round or hiring a new CEO), but there are no realistic scenarios where the common stockholders take over this board. Hence, this board is investor-leaning.
If you end up with an investor-leaning board, get your investors to agree to create a new common seat anytime the company creates a new investor seat (e.g. for the Series B investor). This prevents the investors from taking over the board in the Series B as long as this term isn’t renegotiated.
If you have a strong BATNA, you should reject anything less than an investor-leaning board. If your prospective investors suggest anything worse, they are probably trying to take advantage of you.
Fill the independent seat with an independent party. #
Don’t let the investors control the board through the independent seat. They may suggest a big shot for the independent seat whom you can’t decline without looking like a fool.
But the big shot does a lot more business with VCs than he is likely to do with you. VCs regularly refer the big shot to promising companies. The big shot invests in various venture funds and startups that the VCs send his way. Perhaps the big shot was an entrepreneur-in-residence at the investor’s firm. Where do you think the big shot’s loyalties lie?
Most likely, the big shot will be aligned with your investors.
The simplest solution to this dilemma is to fill the independent seat before the financing. At a minimum, select someone whom you trust and has the credibility to fill the seat. The investors will have a tough time replacing this independent director if your selection is a big shot himself or if he introduced the company to the venture firm in the first place.
If you can’t select the independent director until after the financing, the simplest solution is to
Select the independent director by the unanimous consent of the board members. (Who could argue with this?)
Tell the investors that you, like them, are going to be very picky about the independent director.
Take control of the situation immediately by suggesting names for the independent director.
Note: This article is a term sheet hack. You may enjoy the rest of the Term Sheet Hacks.