Business School For Startups

I.
Chuµtcr J: ªWho Is" Your

Comµuny?
Corµorutc Entitics
Thc Big _: Avoiding IiuLility, Protccting Profits, Crcuting Purtncrshiµs
Common Tyµcs of Corµorutc Entitics
II.
Chuµtcr z: ªWho Arc" Your
Icudcrs?
Purt J: Whut A CEO Docs
Purt z:Thc _ Functions of u Munugcmcnt Tcum
III.
Chuµtcr _: Finuncing Oµtions for
Sturtuµs
Finuncing Oµtions
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Hyµcrink: Bcyond thc Blog
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IV.
Chuµtcr µ: Emµloycc Equity Purt J
Owncrshiµ In Thc Comµuny
Diffcrcnt Icvcls of Emµloycc Owncrshiµ
V.
Chuµtcr _: Emµloycc Equity Purt z
Oµtions
VI.
Chuµtcr 6: Emµloycc Equity Purt _
Vcsting
VII.
Chuµtcr ): Emµloycc Equity Purt
µ
How Much?
Thc Equity Formulu
VIII.
Chuµtcr 8: Accounting
Rccord Kccµing For Your Busincss
Imµortunt Accounting Princiµlcs
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IX.
Chuµtcr §: Accounting Purt J
Thc Profit und Ioss Stutcmcnt
X.
Chuµtcr Jo: Accounting Purt z
Thc Buluncc Shcct
XI.
Chuµtcr JJ: Accounting: Purt _
Thc Cush Flow Stutcmcnt
Production und Consumµtion of Cush
Simµlc Form of Cush Flow Stutcmcnt
XII.
Chuµtcr Jz: Kcy Busincss Mctrics
Dcfining A Sct Of Mctrics
E×umµlcs of Mctrics to Follow
Rcvising und Trucking Mctrics
XIII.
Chuµtcr Jµ: Sclling Your
Comµuny
Thc E×it Plun
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XIV.
Chuµtcr J_: M8A Fundumcntuls
Mcrgcrs 8 Acquisitions
Considcrution: Cush vs. Stock
Buying Asscts or thc Entirc Busincss
Cusc Studics
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µµ
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7-ca Ac¿coa
I
am a VC. I have been sínce 1986. I heíp peopíe start and buííd technoíogy
companíes. I do ít ín NYC, whích ísn't the easíest píace to buííd technoíogy
companíes, but ít's gettíng better.
I íove my work. I am the Managíng Partner of two venture capítaí fírms, Fíatíron Partners
and Uníon Square Ventures.
I aíso am a husband and a father of 3 kíds. I do that ín NYC too. And ít ísn't the easíest
píace to raíse a famííy eíther. But ít's gettíng better too. I íove my famííy more than my
work.
I aíso íove musíc, art, yoga, bíkíng, skííng, and goíf. That's a íot of ínterests for a guy who
works 70 hours a week and íoves hís famííy. But I manage to make ít work.
Check out my fuíí bíog at: www.avc.com
Book edíted by |ason Karpf.
ALout 7/c Author
Get in touch:

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66
I.
Chuµtcr J: ªWho Is"
Your Comµuny?
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))
When you start a busíness, ít ís ímportant to recogníze that ít wííí eventuaííy be somethíng
entíreíy dífferent than you.
lncorporation
Fírst off, you don't have to íncorporate to be ín busíness. There are many peopíe who run
a busíness and don't íncorporate, such as numerous seííers on Etsy
(http://www.etsy.com/). They make thíngs, seíí them, receíve the íncome, and pay the
taxes as part of theír personaí returns.
But there are three bíg reasons you'íí want to consíder íncorporatíng:
Líabíííty
Taxes
Investment
And the kínd of corporate entíty you create depends on where you want to come out on
aíí three of those factors.
I am not a íawyer or a tax advísor so íf you are píanníng on íncorporatíng, I wouíd
recommend consuítíng both before makíng any decísíons. Note that thís chapter ís
entíreíy based on U.S. íaw and does not attempt to díscuss ínternatíonaí íaw.
Corµorutc Entitics
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88
When you start a busíness, ít ís ímportant to recogníze that ít wííí eventuaííy be somethíng
entíreíy dífferent than you. You won't own aíí of ít. You won't want to be ííabíe for
everythíng that the company does. And you won't want to pay taxes on íts profíts.
Creatíng a company ís ímpíícítíy recognízíng those thíngs. It ís puttíng a buffer between
you and the busíness ín some ímportant ways.
When you create a company, you can íímít your ííabíííty for actíons of the corporatíon.
Those actíons can be for thíngs ííke bííís (caííed accounts payabíe ín accountíng paríance),
promíses made (ííke servíces to be rendered), and íawsuíts. Thís ís an íncredíbíy
ímportant concept and the reason that most íawyers advíse theír cííents to íncorporate as
soon as possíbíe. You don't want to put yourseíf and your famííy at personaí rísk for the
actívítíes you undertake ín your busíness. It's not prudent or expected ín our socíety.
Taxes are the next thíng most peopíe thínk about when íncorporatíng. There are two
basíc kínds of corporate entítíes for taxes:
Fíow-through entítíes
Taxpayíng entítíes
Fíow-through corporate entítíes don't pay taxes; they pass the íncome (and tax payíng
obíígatíon) through to the owners of the busíness. Taxpayíng entítíes pay the taxes at the
corporate íeveí and the owners have no obíígatíon for the taxes owed.
Your neíghborhood restaurant ís probabíy a fíow-through entíty. Googíe ís a taxpayíng
entíty. When you buy 100 shares of Googíe (https://www.googíe.com/), you are not goíng
to get a tax bííí for your share of theír earníngs at the end of the year.
Thc Big _: Avoiding IiuLility,
Protccting Profits, Crcuting
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§§
If you want more ínformatíon on corporatíons and taxes, go to the source-the IRS:
http://www.írs.gov/busínesses/corporatíons/índex.htmí
And then there ís ínvestment/ownershíp. Even before we taík about ínvestment, there ís
the íssue of busíness partners. Let's say you want to spíít the ownershíp of your busíness
50/50 wíth someone eíse. You have to íncorporate to create the entíty that you can co-
own. And when you want to take ínvestment, you'íí need to have a corporate entíty that
can íssue shares or membershíp ínterests ín return for the capítaí that others ínvest ín
your busíness.
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Jo Jo
LLC
For many new startups, the form of corporate entíty they choose ís caííed the LLC. It
stands for Límíted Líabíííty Company. Thís form of busíness has been around for a íong
tíme ín some countríes but became recognízed and popuíar ín the US sometíme ín the
past 25 years.
The key dístínguíshíng characterístícs of a LLC ís that you get the íímítatíon of ííabíííty of a
corporatíon, you can take ínvestment capítaí (wíth restríctíons that we'íí taík about next),
but the taxes are "fíow through". Most companíes, íncíudíng tech startups, start out as
LLCs these days. Owners ín LLC are most commoníy caííed "members" and ínvestments
or ownershíp spííts are structured ín "membershíp ínterests."
C Corporatíon
As the busíness grows and takes on more sophístícated ínvestors (ííke venture funds), ít
wííí most often convert ínto somethíng caííed a C Corporatíon. Most of the companíes you
wouíd buy stock ín on the pubííc markets are C Corporatíons. Most venture backed
companíes are C Corporatíons.
C Corporatíons províde the íímítatíon of ííabíííty, províde even more sophístícated ways to
spíít ownershíp and raíse capítaí, and most ímportantíy are "tax payíng entítíes." Once
you convert from a LLC to a C corporatíon, you as the founder or owner no íonger are
responsíbíe for payíng the taxes on your share of the íncome. The company pays those
taxes at the corporate íeveí.
There are many reasons why a venture fund or other "sophístícated ínvestors" prefer to
ínvest ín a C corporatíon over a LLC. Most venture funds requíre conversíon when they
ínvest. The fíow through of taxes ín the LLC can cause venture funds and theír ínvestors
Common Tyµcs Of Corµorutc
Entitics
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aíí sorts of tax íssues. Thís ís partícuíaríy true of venture funds wíth foreígn ínvestors. And
the governance and ownershíp structures of an LLC are not nearíy as deveíoped as a C
corporatíon.
Thís stuff can get reaííy compíícated quíckíy, but the ímportant thíng to know ís that when
your busíness ís smaíí and "cíoseíy heíd," a LLC works weíí. When ít gets bígger and the
ownershíp gets more compíícated, you'íí want to move to a C corporatíon.
S Corporatíon
A níce hybríd between the C corporatíon and the LLC ís the S corporatíon. It requíres a
símpíer ownershíp structure, basícaííy one cíass of stock and íess than 100 sharehoíders.
It ís a "fíow through entíty" and ís símpíe to set up. You cannot do as much wíth the
ownershíp structure wíth an S corporatíon as you can wíth a LLC so íf you pían to stay a
fíow through entíty for a íong períod of tíme and raíse sígnífícant capítaí, an LLC ís
probabíy better.
Límíted Partnershíp
Another entíty you míght come across ís the Límíted Partnershíp. The funds our fírm
manages are Límíted Partnershíps. And some bíg companíes, ííke Bíoomberg LP
(http://www.bíoomberg.com/), are íímíted partnershíps.
The key dífferences between a Límíted Partnershíp and LLCs and C corporatíons ínvoíve
ííabííítíes. In the íímíted partnershíp, the ínvestors have íímíted ííabíííty (ííke a LLC or C
corporatíon) but the managers (caííed Generaí Partners) do not. Límíted Partnershíps are
set up to take ín outsíde ínvestment and spíít ownershíp. And they are fíow through
entítíes.
Entrepreneurs and Investors Must Choose Corporate Entítíes Wíseíy
The ímportant thíng to remember about aíí of thís ís that íf you are startíng a busíness,
you shouíd create a corporate entíty to manage the rísk and protect you and your famííy
from ít. You shouíd start wíth somethíng símpíe and evoíve ít as the busíness needs grow
and deveíop.
As an ínvestor, you shouíd make sure you know what kínd of corporatíon you are
ínvestíng ín, you shouíd know what kínd of ííabíííty you are exposíng yourseíf to, and what
the tax obíígatíons wííí be as a resuít.
And most of aíí, get a good íawyer and tax advísor. Though they are expensíve, over tíme
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the best ones are worth theír weíght ín goíd.
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II.
Chuµtcr z: ªWho Arc"
Your Icudcrs?
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If you cannot do these three thíngs weíí, you wííí not be a great CEO.
The CEO, Chíef Executíve Offícer, ís the company´s íeader. We aíí have ímages of CEOs,
posítíve and negatíve. But ít´s ímportant to know what a CEO actuaííy does, and I´m not
taíkíng about somethíng wrítten ín an offícíaí |ob descríptíon or fancy corporate
bíography. The ííttíe íesson that foííows was not somethíng I íearned at busíness schooí. I
íearned ít from a very experíenced venture capítaííst earíy ín my post-MBA career.
I was workíng on a CEO search for one of our struggííng portfoíío companíes. We had a
bunch of them. I started ín the venture capítaí busíness |ust as the PC hardware bubbíe of
the earíy 80s was bustíng. Our portfoíío was a mess. It was a great tíme to enter the
busíness. I cíeaned up messes for my fírst few years. I íearned a íot.
One of the board members was a very experíenced VC who had been ín the busíness
around 25 years by then. I asked hím "what exactíy does a CEO do?"
He answered wíthout thínkíng:
"A CEO does oníy three thíngs."
Sets the overaíí vísíon and strategy of the company and communícates ít to aíí
stakehoíders.
Recruíts, híres, and retaíns the very best taíent for the company.
Makes sure there ís aíways enough cash ín the bank.
I asked, "Is that ít?"
He repííed that the CEO shouíd deíegate aíí other tasks to hís or her team.
I've thought about that advíce so often over the years. I evaíuate CEOs on these three
metrícs aíí the tíme. I've íearned that great CEOs can and often wííí do a íot more than
these three thíngs. And that ís OK.
Purt J: Whut A CEO Docs
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But I have aíso íearned that íf you cannot do these three thíngs weíí, you wííí not be a
great CEO.
It ís aímost 25 years sínce I got thís advíce. And now I am passíng ít on. It has served me
very weíí over the years.
Matt Blumberg, CEO of our portfolio company Return Path
(http://www.returnpath.net/) offers the following additional insight on what a
CEO does:
Fírst, three coroííaríes - one for each of the three responsíbííítíes outííned above:
Setting vision and strategy are key.but ín order to do that, the CEO must
remember the príncípíe of NIHITO (Nothíng Interestíng Happens ín the Offíce) and must
spend tíme ín-market. Get to know competítors weíí. Spend tíme wíth customers and
channeí partners. Actíveíy work índustry assocíatíons. Waík the fíoor at conferences.
Understand what the substítute products are (not |ust dírect competítíon).
Recruiting and retaining top talent are pay-to-play.but you have to go weíí
beyond the standards and basícs here. You have to be personaííy ínvoíved ín as much of
the process as you can - ít´s not about deíegatíng ít to HR. I fínd that fosteríng aíí-hands
engagement ís a CEO-íed ínítíatíve. Reguíaríy conduct random roundtabíes of 6-10
empíoyees. Send your Board reports to ALL (redact what you must) and make your aíí-
hands meetíngs O&A ínstead of status updates. Hoíd a CEO Councíí every tíme you have
a tough decísíon to make and want a cross-sectíon of opíníons.
Making sure there's enough cash in the bank keeps the lights on.but managíng
a handfuí of fínancíaí metrícs ín concert wíth each other ís what reaííy makes the engíne
hum. A íot of cash wíth a íot of debt ís a poor posítíon to be ín. Lookíng at recognízed
revenue when you reaííy need to focus on bookíngs ís shortsíghted. Managíng operatíng
íosses as your burn/runway proxy when you have huge íoomíng CapEx needs ís a
probíem.
Second, three behavíors a CEO has to embody ín order to be successfuí - thís goes
beyond the |ob descríptíon ínto key competencíes.
Don't be a bottleneck. You don´t have to be an Inbox-Zero nut, but you do need to
make sure you don´t have peopíe ín the company chronícaííy waítíng on you before they
can take theír next actíons on pro|ects. Otherwíse, you íose aíí the íeverage you have ín
híríng a team.
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Run great meetings. Meetíngs are a company´s most expensíve endeavors. 10 peopíe
around a tabíe for an hour ís a íot of saíary expense! Make sure your meetíngs are as
short as possíbíe, as actíonabíe as possíbíe, and as ínterestíng as possíbíe. Don´t hoíd a
meetíng when an emaíí or 5-mínute recorded message wííí suffíce. Don´t hoíd a weekíy
standíng meetíng when ít can be bíweekíy. Vary the tempo of your meetíngs to match
theír purpose - the same staff group can have a weekíy wíth one agenda, a monthíy wíth
a dífferent agenda, and a quarteríy wíth a dífferent agenda.
Keep yourself fresh. |oín a CEO peer group. Work wíth an executíve coach. Read
busíness ííterature (bíogs, books, magazínes) ííke mad and appíy your íearníngs. Exercíse
reguíaríy. Don´t negíect your famííy or your hobbíes. Keep the buík of your weekends,
and at íeast one two-week vacatíon each year, sacrosanct and unpíugged.
There are a mííííon other thíngs to do, or that you need to do weíí.but thís ís a good
startíng poínt for success.
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CEO Matt Blumberg offers more leadership insight. Here he describes what a
management team does by identifying their 3 key functions:
After a quarteríy Return Path exec team offsíte, my team and I were rehashíng the day´s
conversatíon over dínner. Was ít a good day or a bad day? An upper or a downer? We
concíuded that the day was as ít shouíd have been - a good míx of what I wííí now
artícuíate as the three maín functíons of a management team. Here they are wíth some
coíor:
Create an envíronment for success: Do peopíe ííke to come to work every day? When
they get there, do they know what they´re supposed to do, and how ít connects to the
company´s míssíon? Are peopíe íearníng and growíng? Are you buíídíng an enduríng
organízatíon beyond you as a íeader?
Níp probíems ín the bud, or prevent them entíreíy: Are you spendíng enough tíme
thínkíng about your busíness´s vuínerabííítíes? Do you go ínto a dark cave of paranoía
once ín a whííe and make sure you´re cognízant of aíí the maín potentíaí threats to
your ííveííhood? What can you do to spot smoke as an earíy warníng detectíon of fíre?
Expíoít bíg opportunítíes: Do you know the top 5 thíngs that wííí make your company
successfuí? Are you constantíy on the íookout for sígns that ít´s tíme to ínvest more
heavííy ín them? Are you nímbíe enough to make those ínvestments when the tíme ís
ríght.and have you deveíoped the ínteííectuaí or ínfrastructuraí underpínníngs to
make those ínvestments matter?
I´m not sure there´s any order or weíghtíng to these, at íeast not over the íong hauí.
I may be míssíng some huge swaths of terrítory as a resuít of where our company and
our team are at thís partícuíar moment ín tíme. But after readíng thís over a few tímes, ít
feeís ríght on a more enduríng basís.
Purt z:Thc _ Functions Of A
Munugcmcnt Tcum
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III.
Chuµtcr _: Finuncing
Oµtions for Sturtuµs
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Startíng a company ís more art than scíence.
Thís foííowíng ííst ís roughíy ín chronoíogícaí order of how a smaíí company míght avaíí
ítseíf of the varíous fínancíng optíons, but there are aíways exceptíons. Startíng a
company ís more art than scíence.
Fríends and Famííy
Contests/Prízes/Acceíerator Programs
Government Grants
Customer Fínancíng
Vendor Fínancíng
Convertíbíe Debt
Preferred Stock
Venture Debt
Capítaí Equípment Loans & Leases
Brídge Loans
Workíng Capítaí Fínancíng
Friends and Family
Fríends and famííy fínancíng ís popuíar because ít ís easy to get a hearíng from the
peopíe who know you best and they are posítíveíy íncííned to say yes. But there are some
negatíves as weíí. It's tough to know how to príce and structure an ínvestment where the
ínvestors are cíose fríends or famííy. You don't want to take advantage of them and they
may not be sophístícated enough to know what ís a good deaí and what ís a bad deaí.
Make Sure Fríends and Famííy Know the Rísks
Probabíy the tríckíest part of fríends and famííy fínancíng ís that you reaííy don't want to
íose money that fríends and famííy have ínvested wíth you. And most startups faíí so the
chances that wííí happen are hígh. I wouíd encourage entrepreneurs who take fundíng
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from fríends and famííy to be very cíear about the rísks and downsíde. I wouíd aíso
suggest oníy takíng capítaí from fríends and famííy members who can afford to íose the
ínvestment.
Díscount Notes: The Best Approach for Fríends and Famííy
Convertíbíe notes are recommended fríends and famííy fínancíngs wíth a díscount and a
cap on the vaíuatíon. That way you don't have to worry about how to príce the
ínvestment. A 20-25% díscount from the next round ís appropríate. Whííe the vaíuatíon
cap ís goíng to vary dependíng on the síze of the raíse and the síze of the opportuníty, I'd
suggest a cap that gíves the fríends and famííy around 10% of the busíness íf thíngs work
out.
Contests}Prizes}Accelerator Programs
Thís ís a group of optíon that has become a íot more avaííabíe to entrepreneurs ín recent
years. There are so many programs out there that target entrepreneurs where the
wínner(s) ís/are awarded cash prízes or smaíí equíty ínvestments.
Acceíerator Programs
Acceíerator programs wííí requíre you and your foundíng team to reíocate to a set
íocatíon for around three months and partícípate ín a program. The equíty ínvestment
varíes but ís generaííy ín the range of $25,000 to $30,000. The equíty you wííí gíve up for
thís cash ís usuaííy ín the range of 5-6%. The bíggest vaíue comes from the mentoríng
and the opportuníty to pítch to a íarge group of angeí ínvestors on the íast day of the
program.
Y Combínator ís a píoneer acceíerator: http://ycombínator.com/
Contests and Prízes
Contests and prízes have been around for a íot íonger but there has aíso been an
expíosíon of them ín recent years. One of my favoríte ís the NYC Bíg Apps contest
(http://2011.nycbígapps.com/) where deveíopers compete to buííd the best app that uses
data from the NYC open data pro|ect. The wínníng team gets a príze of $40,000 wíth no
equíty dííutíon. The wínners of NYC Bíg Apps the past two years have gone on to create
reaí busínesses wíth fundíng and user tractíon.
You are not ííkeíy to fund your busíness aíí the way to cash fíow breakeven on the money
you get from an acceíerator program or wínníng a contest (aíthough I'm sure someone
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has done ít). It can gíve you the money (and connectíons) you need to get goíng and get
somewhere and set yourseíf up for the next fundíng source.
Government Grants
Governments wííí províde capítaí for startups
(http://www.grants.gov/aboutgrants/eíígíbíííty.|sp) and I've seen many entrepreneurs over
the years take advantage of thís form of fínancíng. The grants are usuaííy "free money"
ín the sense that they do not need to be paíd back and they don't cost any equíty.
But nothíng ín íífe ís free. You do pay for thís money ín ways that may not be ín your
ínterest. The appíícatíon process ís usuaííy íong, ínvoíved, and dístractíng. And sometímes
the grants come wíth stríngs attached; you can't move, you have to use ít for a specífíc
purpose, you have to híre a certaín number of peopíe wíth ít, etc, etc.
Not a Fínancíaí Sííver Buííet
I'm not a fan of thís form of fínancíng. Fírst, ín príncípíe I thínk that government ought to
stay out of the busíness of píckíng wínners and íet the market do that. But more
practícaííy, I've never seen an entrepreneur change the outcome of theír startup wíth
government money. It ís never enough to reaííy move the needíe and the stríngs that are
attached usuaííy make ít unínterestíng to me.
Customer Financing
Customers are a great way to fínance a busíness for many reasons. Fírst, customer
fínancíng ís typícaííy non dííutíve. Customers aíso heíp you fít your product to the market
and heíp debug and ímprove the quaííty of the product.
How Customers Can Further Product Deveíopment
The most common way customer fínancíng ís done ís you seíí the customer on the
product before you've buíít ít or before you've fíníshed ít. The customer puts up the
money to buííd the product or fínísh the product and becomes your fírst customer. An
earíy customer míght ask for some excíusívíty on the product, but most of the tíme the
earíy customer símpíy wants the product from you and nothíng more.
Límítatíons of Customer Fínancíng
It ísn´t aíways possíbíe to fínd a customer who wííí put up money ín advance of the
product beíng compíete and ready to use. It takes great saíesmanshíp to convínce a
customer to buy somethíng from you that ísn't buíít or ísn't fíníshed. But even íf you can
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convínce a customer to do thís, there are some negatíves.
Buíídíng a product expíícítíy for one customer often makes ít íess appíícabíe to the market
as a whoíe. An earíy customer who provídes fundíng to buííd your product wííí want the
product taííored specífícaííy for íts needs.
Second, you rísk buíídíng a "fee for servíces cuíture" ín your company wíth thís approach.
Some companíes buííd products for customers for a fee. Other companíes buííd products
and seíí them "as ís" to customers. The íatter ís the scaíabíe modeí for buíídíng vaíuabíe
companíes.
Customer fínancíng ís much more díffícuít, íf not ímpossíbíe, ín consumer-facíng servíces.
It ís much more appíícabíe ín busíness-facíng servíces.
Vendor Financing
The more capítaí íntensíve your startup ís, the more you can and shouíd thínk about
vendor fínancíng. Two reasonabíy common exampíes ín the woríd of tech startups are
equípment fínancíng and deveíopment for equíty.
Equípment fínancíng ís when a vendor of capítaí equípment, ííke servers, agrees to seíí
you theír product and takes a íoan or a íease ínstead of cash. Deveíopment for equíty ís
when a thírd party deveíopment fírm buííds somethíng for you and takes equíty ín your
busíness (or íess commoníy, a íoan) ín return for the deveíopment servíces.
In the bíotech and cíeantech sectors, vendor fínancíng ís more common. These sectors
have íarge capítaí equípment requírements and íarge thírd party servíces requírements.
There ís a íot of money íaíd out to thírd party vendors on the way to cash breakeven and
therefore a much greater opportuníty to have those vendors fínance the busíness.
Convertible Debt
Convertíbíe debt (aíso known as convertíbíe íoans or convertíbíe notes) ís when a
company borrows money from an ínvestor or a group of ínvestors and the íntentíon of
both the ínvestors and the company ís to convert the debt to equíty at some íater date.
Such fínancíng can íncíude compensatíon ín the form of a díscount or a warrant and a
cap on the vaíuatíon at whích the debt wííí convert.
There are a number of reasons why the ínvestors and/or the company wouíd prefer to
íssue debt ínstead of equíty and convert the debt to equíty at a íater date. If the company
beííeves íts equíty wííí be worth more at a íater date, then ít wííí dííute íess by íssuíng debt
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and convertíng ít íater. It ís aíso true that the transactíon costs, mostíy íegaí fees, are
usuaííy íess when íssuíng debt vs. equíty.
For ínvestors, the preference for debt vs. equíty ís íess cíear. Sometímes ínvestors are so
eager to get the opportuníty to ínvest ín a company that they wííí put theír money ínto a
convertíbíe note and íet the next round ínvestors set the príce. They beííeve that íf they
ínsísted on settíng a príce now, the company wouíd símpíy not take theír money.
Sometímes ínvestors beííeve that the compensatíon, ín the form of a warrant or a
díscount, ís suffícíentíy vaíuabíe that ít offsets the vaíue of takíng debt vs. equíty.
Fríends and famííy rounds (see prevíous) are often done vía convertíbíe debt. It makes
sense that fríends and famííy wouíd not want to enter ínto a hardbaíí negotíatíon wíth a
founder and wouíd prefer to íet the príce díscussíon happen when professíonaí ínvestors
enter the equatíon.
Warrants, Díscounts and Caps
The typícaí forms of compensatíon for makíng a convertíbíe íoan are warrants or a
díscount.
In the typícaí convertíbíe note, the warrant wííí be an optíon for whatever securíty ís soíd
ín the next round. The warrant ís most often expressed ín terms of "warrant coverage
percentage." For exampíe "20% warrant coverage" means you take the síze of the
convertíbíe note, say $1mm, muítípíy ít by 20%, whích gets you to $200,000, and the
warrant wííí be for $200,000 of addítíonaí securítíes ín the next round.
A díscount ís símpíer to understand but often more compíícated to execute. A díscount
wííí aíso be expressed ín terms of a percentage. The most common díscounts are 20%
and 25%. The díscount ís the amount of reductíon ín príce the convertíbíe íoan hoíders
wííí get when they convert ín the next round.
Convertíbíe notes aíso typícaííy have some cap on the vaíuatíon at whích they can
convert. That cap ís anywhere from the current vaíuatíon (not very common) to a
muítípíe of the current vaíuatíon. Recentíy we are startíng to see uncapped convertíbíe
notes. These notes have no cap on the vaíuatíon at whích they can convert.
When Convertíbíe Debt Makes Sense
Startups typícaííy thínk about raísíng capítaí vía convertíbíe debt earíy on ín the íífe of a
startup. They want to move fast, keep transactíon costs íow, and they are often deaííng
wíth a syndícate of angeí ínvestors and ít ís easíer to get the round done wíth a
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convertíbíe note than a seed or seríes A round.
However, íater on ín a company's íífe convertíbíe debt can make more sense. A few years
ago, we had a portfoíío company that was píanníng on an exít ín a year to two years and
needed one íast round of fínancíng to get there. They taíked to VCs and fígured out how
much dííutíon they wouíd take for a $7mm to $10mm raíse.
Then they went to Sííícon Vaííey Bank and taíked to the venture debt group. In the end,
they raísed $7.5mm of venture debt, íssued SVB some warrants as compensatíon for
makíng the íoan, and buíít the company for another year, soíd ít, and díd much better ín
the end because they avoíded the dííutíon of the íast round.
Preferred Stock
Preferred stock ís a cíass of stock that provídes certaín ríghts, prívííeges, and preferences
to ínvestors. Compared to common stock, whích ís normaííy heíd by the founders, ít ís a
superíor securíty. Aímost aíí venture capítaí fírms and many angeí and seed ínvestors wííí
requíre the company they are ínvestíng ín to íssue them preferred stock.
Líquídatíon Preferences
Preferred stock takes íts name from a crítícaí feature of preferred stock caííed ííquídatíon
preference. Líquídatíon preference means that ín a saíe (or ííquídatíon) of the company,
the preferred stock hoíders wííí have the optíon of takíng theír cost out or sharíng ín the
proceeds wíth the founders as common stock hoíders. What thís means ís that íf the
vaíue of the saíe of the company ís beíow the vaíuatíon the preferred ínvestors paíd, then
they wííí get theír money back.
Investor Ríghts and Prívííeges
There are a number of ímportant ríghts and prívííeges that ínvestors secure vía a
preferred stock purchase, íncíudíng:
A ríght to a board seat
Informatíon ríghts
A ríght to partícípate ín future rounds to protect theír ownershíp percentage (caííed a
pro-rata ríght)
A ríght to purchase any common stock that míght come onto the market (caííed a
ríght of fírst refusaí)
A ríght to partícípate aíongsíde any common stock that míght get soíd (caííed a co-saíe
ríght)
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An ad|ustment ín the purchase príce to refíect saíes of stock at íower príces (caííed an
antí-dííutíon ríght)
Negotíate Preferred Stock Carefuííy
As a wíse man ííkes to say, "In íífe you don't get what you deserve, you get what you
negotíate." When you are preparíng to seíí preferred stock to ínvestors, make ít a poínt to
famíííaríze yourseíf wíth aíí the ímportant terms, what they mean (both to you and your
company), and what an "entrepreneur fríendíy" deaí íooks ííke.
Then go get a good investor for you and your company. It heíps to have some
íeverage and íeverage ín fínancíngs means muítípíe ínvestors at the tabíe. So when you
are deaííng wíth sophístícated ínvestors, make sure you have optíons and make sure you
understand the key íssues and don't settíe for a bad deaí.
Preferred stock doesn't have to be a bad deaí for entrepreneurs. It can be a wín/wín for
both sídes. But you have to work at thís part of your busíness |ust ííke you do at the other
parts.
Venture Debt
If there were two words íess ííkeíy to be found together, ít wouíd be venture and debt.
Startups are not credít worthy enterpríses. They have ííttíe to no assets and no cash fíow.
Equíty ís the appropríate way to fínance startups.
However, there ís a íarge, growíng, and víbrant market for somethíng caííed Venture
Debt. It ís índeed debt, íargeíy províded by a number of banks and fínance companíes
who specíaííze ín thís market. The foííowíng are components of venture debt:
The term: how íong you have to pay back the íoan. Three years ís the typícaí term
for Venture Debt.
lnterest only: you pay the ínterest on the íoan each month but you don't pay the
íoan down each month.
Balloon payment: you pay the íoan amount ín fuíí when the term expíres.
Warrants: ííke optíons, you get the ríght to buy equíty at a fíxed príce for a períod of
tíme, usuaííy fíve or ten years.
Equity kicker: an equíty component to the deaí to goose the returns.
Eíígíbíííty for Venture Debt
Venture Debt ís avaííabíe íargeíy to companíes that have secured at íeast one round of
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venture capítaí fínancíng by a recognízed venture capítaí fírm or syndícate of venture
capítaí fírms. It ís aíso avaííabíe to more deveíoped startups that are credít worthy by
vírtue of sígnífícant assets or cash fíow.
When banks íssue venture debt, they are not íoaníng agaínst the credít worthíness of the
startups; they are íoaníng agaínst the credítworthíness of the venture capítaí fírm or
syndícate. The banks are bettíng the VCs wííí keep fundíng the company weíí past the
term of the venture debt íoan.
When Venture Debt Makes Sense
If an earíy stage company ís gettíng the money because of the credít worthíness of my
fírm and the other fírms ín the deaí, then I'd rather be puttíng more equíty ín ínstead and
gettíng paíd for my capítaí at rísk.
I am a bíg fan of venture debt íate ín the íífe of the startup. It can be a brídge to a saíe or
a brídge to an IPO or can be used to fund an acquísítíon or some other vaíue enhancíng
transactíon. It ís smart to use debt vs. equíty when you can absoíuteíy pay the debt back.
Capital Equipment Loans and Leases
Equíty capítaí ís expensíve. Every tíme you do a raíse, you dííute. It makes sense to íook
for píaces where you can use other íess expensíve forms of capítaí to fund growth.
Capítaí equípment provídes an opportuníty for debt fínancíng because you can borrow
agaínst the equípment.
Capítaí Equípment Loans
Capítaí equípment íoans are íoans made by banks and fínance companíes to províde a
company the funds to aquíre the capítaí equípment. The company owns the servers,
computers, etc and puts them on íts books. The company aíso has a íoan obíígatíon on íts
books to the bank or fínance company.
The íoan ís coííateraíízed meaníng that íf the company defauíts on the íoan, the bank or
fínance company can come take the equípment. The equípment ís the securíty for the
íoan. These íoans are usuaííy seíf amortízíng term íoans of around 3 years and carry
ínterest rates of between 6% and 12% dependíng on the fínancíaí profííe of the borrower.
Capítaí Equípment Leases
Leases are a fínancíng tooí used by the manufacturers of equípment (and sometímes by
banks and fínance companíes too). Let´s say you want to purchase a bunch of servers to
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run your web appíícatíon. The server company can íease the servers to your company
ínstead of seíííng them to you. Under a typícaí íease deaí, you wííí pay the íessor a fíxed
monthíy amount for a fíxed term, typícaííy three or four years.
At the end of the term, your company wííí have the optíon to buy the servers for a
nomínaí amount or gíve them back to the íessor. Some íeases wííí be capítaíízed and end
up on your books and íook a íot ííke capítaí equípment íoans. Other íeases wííí not end up
on your books and wííí íook more ííke rentíng an offíce.
Advantages of Capítaí Equípment Loans and Leases
In both cases, you are gettíng capítaí you need to fínance growth wíthout dííutíng. And the
prímary reason for that ís the equípment ítseíf provídes the securíty for the íoan, not your
company, whích ís ííkeíy not credít worthy.
The rísks and rewards are weíí aíígned for both the íender and the borrower and ít makes
sense for both partíes to do these transactíons. Don't use your precíous funds raísed ín
dííutíve equíty rounds to buy servers and other capítaí equípment. Go see a bank, fínance
company, or manufacturer about a fínancíng arrangement.
Bridge Loans
Brídge íoans are so caííed because they are a "brídge" to somethíng eíse. They are short-
term íoans íntended to fund a company to an antícípated event ín the future. Bíg banks
wííí often brídge companíes to transactíons they are puttíng together for them. Reaí
estate transactíons are often brídged to a cíosíng.
The Rísk of Brídge Loans
Most brídge íoans ín the startup woríd are made to money íosíng companíes that are
goíng to run out of funds before they can cíose a fínancíng or saíe transactíon. These are
very rísky íoans that wííí not get paíd back uníess a transactíon happens and often the
transactíons that are requíred don't happen.
When makíng a brídge íoan, ít ís crítícaí that the síze of the íoan be suffícíent to get to the
transactíon you are brídgíng to. You want the brídge to be íong enough to cross the ríver.
So íf you thínk you need three months to seíí the company or get a fínancíng done, get síx
months of burn ín your brídge.
Typícaí Terms and Rates
The íoan wííí be secured by aíí the assets of the busíness that can be píedged. If there ís
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The íoan wííí be secured by aíí the assets of the busíness that can be píedged. If there ís
exístíng bank debt or equípment fínancíng, the brídge wííí be subordínate to those íoans.
And you wííí need the bank's cooperatíon gettíng a brídge done íf there ís a bank ínvoíved.
Sometímes that ís not easy.
The íoan wííí carry an ínterest rate of between 6% and 12% dependíng on the current
rate envíronment and wííí have warrant coverage or a díscount. Brídge íoans are a
specíaíízed form of convertíbíe debt.
A Reaííty for Startups
In summary, brídge íoans are common ín aíí busínesses. For startup ínvestors, brídge
íoans ín the aggregate are a poor performíng ínvestment and as an índustry, we dísííke
makíng them. But ííke aíí of the tooís at our dísposaí ín the statup woríd, brídge íoans are
a reaííty of our ííves.
Working Capital Financing
Workíng capítaí fínancíng reííes on a company's baíance sheet to support the íoan so
understandíng how a baíance sheet works ís ímportant to understandíng workíng capítaí
fínancíng.
When Workíng Capítaí Fínancíng May Be Necessary
Workíng capítaí ís equaí to current assets mínus current ííabííítíes. In íayman's terms,
workíng capítaí ís what your customers owe you píus any ínventory you have buíít up
mínus what you owe your suppííers and empíoyees. Workíng capítaí aíso íncíudes any
cash you have ín the bank. When a busíness ís makíng píenty of money on paper but
can't manage íts cash needs, ít has a workíng capítaí íssue. And the faster a company
grows, the worse ít can get.
How Banks Issue Workíng Capítaí Fínancíng
Banks and fínance companíes wííí íoan companíes, partícuíaríy profítabíe companíes, the
money they need to purchase ínventory and waít to get paíd by theír customers. Banks
wííí reíy on the purchase orders on hand and the actuaí vaíue of the ínventory that the
company has ín stock to backup the íoan. They wííí aíso take ínto account the money the
company owes íts suppííers and empíoyees ín determíníng exactíy how much capítaí to
íoan the company.
Most workíng capítaí fínancíng has buíít ín cushíons. Banks wííí typícaííy íoan 50-75% on
the doííar of workíng capítaí, íncreasíng the síze of the íoans they make as workíng capítaí
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grows. These are aíí short-term íoans because the ínventory eventuaííy gets soíd and the
customers eventuaííy pay. A typícaí way these íoans are structured are íínes of credít and
revoívers meaníng that as the money comes back ínto the busíness, the íoans get repaíd,
but the totaí amount avaííabíe under the íoan stays the same so the company can |ust
borrow ít back when ít needs the money agaín.
For companíes that are partícuíaríy shaky, there ís a techníque known as "factoríng"
where the bank actuaííy takes the amounts of money due from the customers as
coííateraí and gets paíd dírectíy by the customers and then remíts the extra amounts to
the company. The bank essentíaííy becomes the accounts receívabíe department of the
company.
A Smart and Necessary Choíce
Even a software-based busíness can buííd up a íot of workíng capítaí. It usuaííy resuíts
from the company havíng to pay íts obíígatíons much faster than íts customers are
payíng the company. If you have customers that pay ín 90 days and you are growíng
revenues quíckíy, then you can fínd yourseíf ín a ma|or cash squeeze. Workíng capítaí
fínancíng ís a great way to manage that kínd of cash squeeze.
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When you |oín a startup, you have the expectatíon of gettíng some ownershíp ín the
company.
One of the defíníng characterístícs of startup cuíture ís employee ownership. Many
íarge companíes províde empíoyee ownershíp so thís ís not uníque to startup cuíture. But
when you |oín a startup, you have the expectatíon of gettíng some ownershíp ín the
company and íf the company ís successfuí and ís soíd or taken pubííc, that you wííí share
ín the gaíns that resuít.
Empíoyee ownershíp ís an ímportant part of startup cuíture. It reínforces that everyone ís
on the team, everyone ís sharíng ín the gaíns, and everyone ís a sharehoíder. I can't thínk
of a company that has come to pítch us that has not had an empíoyee equíty pían. And I
can't thínk of a term sheet that we have íssued that dídn't have a specífíc provísíon for
empíoyee equíty. It ís símpíy a fundamentaí part of the startup game.
Read thís Harvard Busíness Revíew artícíe on the ímportance of empíoyee equíty to a
company´s íong-term success: http://hbr.org/2005/06/every-empíoyee-an-owner-
reaííy/ar/1.
Owncrshiµ In Thc Comµuny
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Whííe empíoyee equíty ís "standard" ín the startup busíness, the íeveís of empíoyee
ownershíp vary quíte a bít from company to company. There are a varíety of reasons.
Geography matters. Empíoyee ownershíp íeveís are hígher ín weíí deveíoped startup
cuítures ííke the Bay Area, Boston, and NYC. They are íower ín íess-deveíoped startup
communítíes. Engíneeríng heavy startups wííí tend to have hígher íeveís of empíoyee
ownershíp than servíces and medía companíes.
If the founders are the top managers ín the company, then the typícaí "non founder
empíoyee ownershíp" wííí tend to be between 10% and 20%. If the founders have íargeíy
íeft the company, then "non founder empíoyee ownershíp" wííí be cíoser to 20% and
couíd be a bít hígher. The peopíe provídíng the "sweat equíty" typícaííy get 20% of the
gaíns ín our busíness (at USV we get 20%) and they shouíd get at íeast that ín the
companíes we back. I say "at íeast" because the founders are often stííí provídíng "sweat
equíty" and they can own much more than 20%.
Prímary Forms of Empíoyee Equíty
There are 4 prímary ways to íssue empíoyee equíty ín startups:
1.) Founder stock. Thís ís the stock that founders íssue to themseíves when they form
the company. It can aíso íncíude stock íssued to earíy team members. Founder stock has
specíaí vestíng provísíons among the founders so that one or more of them doesn't íeave
earíy and keep aíí of theír stock. Those vestíng provísíons are extended to the ínvestors
once capítaí ís ínvested ín the busíness. Founder stock wííí typícaííy be common stock and
ít wííí be owned by the founders sub|ect to vestíng provísíons.
2.) Restricted stock. Thís ís common stock that ís íssued to eíther earíy empíoyees or
top executíves that are híred ínto the company faíríy earíy ín a company's íífe. Restrícted
Diffcrcnt Icvcls Of Emµloycc
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stock wííí have vestíng provísíons that are ídentícaí to standard empíoyee optíon píans
(typícaííy 4 years but sometímes 3 years).
The dífference between restrícted stock and optíons ís that the empíoyee owns the
shares from the day of íssuance and can get capítaí gaíns treatment on the saíe of the
stock íf ít ís heíd for one year or more. Issuíng restrícted stock to an empíoyee tríggers
ímmedíate taxabíe íncome to the recípíent. It can be very expensíve to the recípíent and
therefore ít ís oníy done very earíy when the stock ís not worth much or when a seníor
executíve ís híred who can handíe the tax íssues.
3.) Options. Thís ís by far the most common form of empíoyee equíty íssued ín startup
companíes. The stock optíon ís a ríght íssued to an empíoyee to purchase common stock
at some poínt ín the future at a set príce. The "set príce" ís caííed the "stríke príce."
4.) Restricted Stock Units. Known as RSUs, these securítíes are reíatíveíy new ín the
startup busíness. They were created to fíx íssues wíth optíons and restrícted stock and
have characterístícs of both. A RSU ís a promíse to íssue common stock once the vestíng
provísíons have been satísfíed. The vestíng provísíons can íncíude a ííquídíty event. So
when you are gettíng an RSU, you are gettíng somethíng that feeís ííke an optíon but
there ís no stríke príce. When you get the shares, you wííí own them outríght but míght
not get them for a whííe.
l implore all of you entrepreneurs to hire an experienced startup
lawyer. Empíoyee equíty íssues are trícky. You can and wííí make a bunch of expensíve
místakes wíth empíoyee equíty uníess you have the ríght counseí. There are píenty of íaw
fírms and íawyers who specíaííze ín startups and you shouíd have one of them at your
síde when you are settíng up your company and throughout íts íífe.
For deeper detaíí on equíty, read these bíog posts:
Employee Equity: Dilution
http://mba-mondays.pandamían.com/empíoyee-equíty-dííutíon/
Employee Equity: Appreciation
http://mba-mondays.pandamían.com/empíoyee-equíty-apprecíatíon/
Employee Equity: The Liquidation Overhang
http://mba-mondays.pandamían.com/empíoyee-equíty-the-ííquídatíon-overhang/
Employee Equity: The Option Strike Price
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http://mba-mondays.pandamían.com/empíoyee-equíty-the-optíon-stríke-príce/
Employee Equity: Restricted Stock and RSUs
http://mba-mondays.pandamían.com/empíoyee-equíty-restrícted-stock-and-rsus/
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If you are |oíníng a startup, you are most ííkeíy goíng to receíve stock optíons as part of
your compensatíon.
A stock optíon ís a securíty whích gíves the hoíder the ríght to purchase stock (usuaííy
common stock) at a set príce (caííed the stríke príce) for a fíxed períod of tíme. Stock
optíons are the most common form of empíoyee equíty and are used as part of
empíoyee compensatíon packages ín most technoíogy startups.
If you are a founder, you are most ííkeíy goíng to use stock optíons to attract and retaín
your empíoyees. If you are |oíníng a startup, you are most ííkeíy goíng to receíve stock
optíons as part of your compensatíon. Thís post ís an attempt to expíaín how optíons work
and make them a bít easíer to understand.
The Tax Advantages of Optíons
Stock has a vaíue. If your company ís gívíng out stock as part of the compensatíon pían,
you´d be deííveríng somethíng of vaíue to your empíoyees and they wouíd have to pay
taxes on ít |ust ííke they pay taxes on the cash compensatíon you pay them.
Let´s say that the common stock ín your company ís worth $1/share. And íet´s say you
gíve 10,000 shares to every software engíneer you híre. Then each software engíneer
wouíd be gettíng $10,000 of compensatíon and they wouíd have to pay taxes on ít.
But íf thís ís stock ín an earíy stage company, the stock ís not ííquíd; ít can´t be soíd ríght
now. So your empíoyees are gettíng somethíng they can´t turn ínto cash ríght away but
they have to pay roughíy $4,000 ín taxes as a resuít of gettíng ít. That´s not good and
that´s why optíons are the preferred compensatíon method.
If your common stock ís worth $1/share and you íssue someone an optíon to purchase
your common stock wíth a stríke príce of $1/share, then at that very moment ín tíme,
that optíon has no exercíse vaíue. It ís "at the money" as they say on Waíí Street.
Oµtions
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The tax íaws are wrítten ín the U.S. to províde that íf an empíoyee gets an "at the money"
optíon as part of theír compensatíon, they do not have to pay taxes on ít. The íaws have
gotten strícter ín recent years and now most companíes do somethíng caííed a 409a
vaíuatíon of theír common stock to ínsure that the stock optíons are beíng struck at faír
market vaíue.
Most stock optíons ín startups have a íong hoídíng períod. It can be fíve years and ít often
can be ten years. So íf you |oín a startup and get a fíve year optíon to purchase 10,000
shares of common stock at $1/share, you are gettíng somethíng of vaíue. But you do not
have to pay taxes on ít as íong as the stríke príce of $1/share ís "faír market vaíue" at the
tíme you get the optíon grant. That expíaíns why optíons are a great way to compensate
empíoyees.
Usíng Optíons to Attract and Retaín Taíent
Stock optíons are both an attractíon and a retentíon tooí. The retentíon happens vía a
techníque caííed "vestíng." (see foííowíng chapter for more ínformatíon) Vestíng usuaííy
happens over a 4-year term, but some companíes do use 3-year vestíng. The way vestíng
works ís your optíons don´t beíong to you ín theír entírety untíí you have vested ínto them.
If ít were to vest over 4 years, you wouíd take ownershíp of the optíon at the rate of
2,500 shares per year. Many companíes "cííff vest" the fírst year meaníng you don´t vest
ínto any shares untíí your fírst anníversary. After that most companíes vest monthíy.
The níce thíng about vestíng ís that you get the fuíí grant struck at the faír market vaíue
when you |oín and even íf that vaíue goes up a íot duríng your vestíng períod, you stííí get
that ínítíaí stríke príce. Vestíng ís much better than doíng an annuaí grant every year
whích wouíd have to be struck at the faír market vaíue at the tíme of grant.
Exercísíng an optíon ís when you actuaííy pay the stríke príce and acquíre the underíyíng
common stock. In our exampíe, you wouíd pay $10,000 and acquíre 10,000 shares of
common stock. Obvíousíy thís ís a bíg step and you don´t want to do ít ííghtíy.
There are two common tímes when you wouíd ííkeíy exercíse. The fírst ís when you are
preparíng to seíí the underíyíng common stock, mostíy ííkeíy ín connectíon wíth a saíe of
the company or some sort of ííquídíty event ííke a secondary saíe opportuníty or a pubííc
offeríng.
You míght aíso exercíse to start the cíock tíckíng on íong term capítaí gaíns treatment.
The second ís when you íeave the company. Most companíes requíre theír empíoyees to
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exercíse theír optíons wíthín a short períod after they íeave the company. Exercísíng
optíons has a number of tax consequences. Be carefuí when you exercíse optíons and get
tax advíce íf the vaíue of your optíons ís sígnífícant.
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Companíes grant stock or optíons upfront when the empíoyee ís híred and vest the stock
over a set períod of tíme.
Vestíng ís the techníque used to aííow empíoyees to earn theír equíty over tíme. You
couíd grant stock or optíons on a reguíar basís and accompíísh somethíng símííar, but
that has aíí sorts of compíícatíons and ís not ídeaí. So ínstead companíes grant stock or
optíons upfront when the empíoyee ís híred and vest the stock over a set períod of tíme.
Companíes aíso grant stock and optíons to empíoyees after they have been empíoyed for
a number of years. These are caííed retentíon grants and they aíso use vestíng.
Vestíng Scheduíes
Vestíng works a ííttíe dífferentíy for stock and optíons. In the case of optíons, you are
granted a fíxed number of optíons but they oníy become yours as you vest. In the case of
stock, you are íssued the entíre amount of stock and you technícaííy own aíí of ít but you
are sub|ect to a repurchase ríght on the unvested amount. Whííe these are sííghtíy
dífferent techníques, the effect ís the same. You earn your stock or options over a
fixed period of time.
Vestíng períods are not standard but I prefer a 4-year vest wíth a retentíon grant after 2
years of servíce. That way no empíoyee ís more than haíf vested on theír entíre equíty
posítíon. Another approach ís to go wíth a shorter vestíng períod, ííke 3 years, and do the
retentíon grants as the empíoyee becomes fuííy vested on the orígínaí grant.
I ííke that approach íess because there ís a períod of tíme when the empíoyee ís cíose to
fuííy vested on theír entíre equíty posítíon. It ís aíso true that 4-year vestíng grants tend to
be sííghtíy íarger than 3-year vestíng grants and I ííke the ídea of a íarger grant síze.
If you are an empíoyee, the thíng to focus on ís how many stock or optíons you vest ínto
every year. The síze of the grant ís ímportant but the annuaí vestíng amount ís reaííy your
equíty based compensatíon amount.
Vcsting
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Cííff Vestíng
Most vestíng scheduíes come wíth a 1-year cííff vest. That means you have to be
empíoyed for 1 fuíí year before you vest ínto any of your stock or optíons. When the fírst
year anníversary happens, you wííí vest a íump sum equaí to one year´s worth of equíty
and normaííy the vestíng scheduíe wííí be monthíy or quarteríy after that.
Cííff vestíng ís not weíí understood but ít ís very common. The reason for the 1-year cííff ís
to protect the company and íts sharehoíders (íncíudíng the empíoyees) from a bad híre
whích gets a huge grant of stock or optíons but proves to be a místake ríght away. A cííff
vest aííows the company to move the bad híre out of the company wíthout any dííutíon.
There are a coupíe thíngs about cííff vestíng worth díscussíng. Fírst, íf you are cíose to an
empíoyee´s anníversary and decíde to move them out of the company, you shouíd vest
some of theír equíty even though you are not requíred to do so.
If ít took you a year to fígure out ít was a bad híre then there ís some bíame on everyone
and ít ís |ust bad faíth to fíre someone on the cusp of a cííff vestíng event and not vest
some stock. It may have been a bad híre but a year ís a meaníngfuí amount of
empíoyment and shouíd be recognízed.
The second thíng about cííff vestíng that ís probíematíc ís íf a saíe happens duríng the fírst
year of empíoyment. I beííeve that the cííff shouíd not appíy íf the saíe happens ín the fírst
year of empíoyment. When you seíí a company, you want everyone to get to go to the
"pay wíndow" as |LM caíís ít. And so the cííff shouíd not appíy ín a saíe event.
Vestíng and Change of Controí
When a saíe event happens, your vested stock or optíons wííí become ííquíd (or at íeast
wííí be "soíd" for cash or exchanged for acquírer´s securítíes). Your unvested stock and
optíons wííí not. Many tímes the acquírer assumes the stock or optíon pían and your
unvested equíty wííí become unvested equíty ín the acquírer and wííí contínue to vest on
your estabííshed scheduíe.
So sometímes a company wííí offer acceíerated vestíng upon a change of controí to
certaín empíoyees. Thís ís not generaííy done for the everyday híre. But ít ís commoníy
done for empíoyees that are ííkeíy goíng to be extraneous ín a saíe transactíon. CFOs and
generaí counseís are good exampíes of such empíoyees.
It ís aíso true that many founders and earíy key híres negotíate for acceíeratíon upon
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change of controí. I advíse our companíes to be very carefuí about agreeíng to
acceíeratíon upon change of controí. I´ve seen these provísíons become very paínfuí and
díffícuít to deaí wíth ín saíe transactíons ín the past.
And I aíso advíse our companíes to avoíd fuíí acceíeratíon upon change of controí and to
use a "doubíe trígger." Fuíí acceíeratíon upon change of controí means aíí of your
unvested stock becomes vested. That´s generaííy a bad ídea. But an acceíeratíon of 1
year of unvested stock upon change of controí ís not a bad ídea for certaín key
empíoyees, partícuíaríy íf they are ííkeíy to be wíthout a good roíe ín the acquírer´s
organízatíon.
The doubíe trígger means two thíngs have to happen to get the acceíeratíon. The fírst ís
the change of controí. The second ís a termínatíon or a proposed roíe that ís a demotíon
(whích wouíd ííkeíy íead to the empíoyee íeavíng).
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Gettíng someone to |oín your dream before ít ís much of anythíng ís an art, not a scíence.
There ís aíways one questíons surroundíng empíoyee equíty: How much shouíd the
company gíve peopíe? For your fírst key híres, perhaps 3 to 10 peopíe, you wííí probabíy
not be abíe to use any kínd of formuía.
Gettíng someone to |oín your dream before ít ís much of anythíng ís an art, not a scíence.
And the amount of equíty you need to grant to accompíísh these híres ís aíso an art and
most certaíníy not a scíence. However, a ruíe of thumb for those fírst few híres ís that you
wííí be grantíng them ín terms of poínts of equíty (í.e., 1%, 2%, 5%, 10%). To be cíear,
these are híres we are taíkíng about, not co-founders.
Once you have assembíed a core team that ís operatíng the busíness, you need to move
from art to scíence ín terms of grantíng empíoyee equíty. And most ímportantíy you need
to move away from poínts of equíty to the doííar vaíue of equíty. Gívíng out equíty ín
terms of poínts ís very expensíve and you need to move away from ít as soon as ít ís
reasonabíe to do so.
How Much?
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You shouíd use a formuía to determíne equíty. The foííowíng formuía came from a bíg
compensatíon consuítíng fírm we híred when I was on the board of a company that was
goíng pubííc. I've modífíed ít ín a few píaces to símpíífy ít. But ít ís based on a common
practíce ín compensatíon consuítíng and the doííar vaíue of equíty.
Fírst, fígure out how vaíuabíe your company ís (we caíí thís "best value"). Thís ís NOT
your 409a vaíuatíon (we caíí that "fair value"). Thís "best vaíue" can be:
The vaíuatíon on the íast round of fínancíng
A recent offer to buy your company that you turned down
The díscounted vaíue of future cash fíows
A pubííc market comp anaíysís
Whatever approach you use, ít shouíd be the vaíue of your company that you wouíd seíí
or fínance your busíness at ríght now.
Let's say the number ís $25mm. Thís ís an ímportant data poínt for thís effort. The other
ímportant data poínt ís the number of fuííy dííuted shares. Let's say that ís 10mm shares
outstandíng.
Usíng Muítípííers to Determíne Equíty
The second thíng you do ís break up your org chart ínto brackets. There ís no bracket for
the CEO and COO. Grants for CEOs and COOs shouíd and wííí be made by the Board. The
fírst bracket ís the seníor management team; the CFO, Chíef Revenue Offícer/VP Saíes,
Chíef Marketíng Offícer/VP Marketíng, Chíef Product Offícer/VP Product, CTO, VP Eng,
Chíef Peopíe Offícer/VP HR, Generaí Counseí, and anyone eíse on the seníor team.
The second bracket ís Dírector íeveí managers and key peopíe (engíneeríng and desígn
superstars for sure). The thírd bracket íncíudes empíoyees who are ín the key functíons
ííke engíneeríng, product, marketíng, etc. And the fourth bracket íncíudes empíoyees who
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are not ín key functíons. Thís couíd íncíude receptíon, cíerícaí empíoyees, etc.
When you have the brackets set up, you put a muítípííer next to them. There are no hard
and fast ruíes on muítípííers. You can aíso have many more brackets than four. I am
stíckíng wíth four brackets to make thís símpíe. Here are our defauít brackets:
Seníor Team: 0.5x
Dírector Leveí: 0.25x
Key Functíons: 0.1x
Aíí Others: 0.05x
EÇUlTY MULTlPLlER CHART
Multiply by Yearly Salary to
Determine Equity Received
Organizational Bracket Members Equity
Multiplier
Seníor Team C-íeveí OTHER THAN CEO, COO;
executíves (SVP, VP, etc.)
0.5x
Dírector Leveí Dírectors and equívaíent managers,
engíneeríng and desígn "superstars"
0.25x
Key Functíons Engíneeríng, product, marketíng 0.1x
Aíí Others Receptíon, cíerícaí 0.05x
Then you muítípíy the empíoyee's base saíary by the muítípííer to get to a doííar vaíue of
equíty. Let's say your VP Product ís makíng $175k per year. Then the doííar vaíue of
equíty you offer them ís 0.5 x $175k, whích ís equaí to $87.5k. Let's say a dírector íeveí
product person ís makíng $125k. Then the doííar vaíue of equíty you offer them ís 0.25 x
$125k whích ís equaí to $31.25k.
Then you dívíde the doííar vaíue of equíty by the "best vaíue" of your busíness and
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muítípíy the resuít by the number of fuííy dííuted shares outstandíng to get the grant
amount. We saíd that the busíness was worth $25mm and there are 10mm shares
outstandíng. So the VP Product gets an equíty grant of ((87.5k/25mm) * 10mm) whích ís
35k shares. And the the dírector íeveí product person gets an equíty grant of
((31.25k/25mm) *10mm) whích ís 12.5k shares.
(Doííar Vaíue of Equíty)
X (Fuííy Dííuted Shares) = Grant Amount
(Best Vaíue of Busíness)
Usíng Current Share Príce to Determíne Equíty
Another, possíbíy símpíer, way to do thís ís to use the current share príce. You get that by
dívídíng the best vaíue of your company ($25mm) by the fuííy dííuted shares outstandíng
(10mm). In thís case, ít wouíd be $2.50 per share. Then you símpíy dívíde the doííar vaíue
of equíty by the current share príce. You'íí get the same numbers and ít ís easíer to
expíaín and understand.
Communícatíng Equíty
The key thíng ís to communicate the equity grant in dollar values, not in
percentage of the company. Startups shouíd be abíe to dramatícaííy íncrease the
vaíue of theír equíty over the four years a stock grant vests.
We expect our companíes to be abíe to íncrease ín vaíue three to fíve tímes over a four
year períod. So a grant wíth a vaíue of $125k couíd be worth $400k to $600k over the
tíme períod ít vests. And of course, there ís aíways the possíbíííty of a breakout that
íncreases 10x over that tíme. Taíkíng about grants ín doííar vaíues emphasízes that equíty
aíígns ínterests around íncreasíng the vaíue of the company and makes ít tangíbíe to the
empíoyees.
Use thís methodoíogy to heíp answer the questíon of "how much?" Issuíng equíty to
empíoyees does not have to be an art form, partícuíaríy once the company has grown
ínto a reaí busíness and ís scaííng up. Usíng a methodoíogy, whether ít ís thís one or some
other one, ís a good practíce to promote faírness and rígor ín a very ímportant part of the
compensatíon scheme.
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8: Accounting
8: Accounting
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It's crítícaí to keep good books and records for a busíness, no matter how smaíí ít ís.
How do you keep track of the money ín a company? It´s caííed accountíng and íncíudes
topícs such as cash fíow, profít and íoss, baíance sheets, audíts, fínancíaí statement
anaíysís, and GAAP (Generaííy Accepted Accountíng Príncípíes) accountíng. The FASB
(Fínancíaí Accountíng Standards Board) estabííshes GAAP ín the Uníted States
(http://www.fasb.org/home).
Accountíng ís keepíng track of the money ín a company. It's crítícaí to keep good books
and records for a busíness, no matter how smaíí ít ís.
Rccord Kccµing For Your Busincss
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8: Accounting
8: Accounting
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Every financial transaction of a company needs to be recorded. Thís process has
been made much easíer wíth the advent of accountíng software. For most startups,
Ouíckbooks (http://quíckbooks.íntuít.com/) wííí do ín the begínníng. As the company grows,
the choíce of accountíng software wííí become more compíícated, but by then you wííí
have híred a fínancíaí team that can make those choíces.
The recordíng of fínancíaí transactíons ís not an art. It ís a scíence and a weíí understood
scíence. It revoíves around the twín concepts of a "chart of accounts" and "doubíe entry
accountíng."
The accounting books of a company start with a chart of accounts. There are
two kínds of accounts:
Income/expense accounts
Asset/ííabíííty accounts.
The chart of accounts íncíudes aíí of them. Income and expense accounts represent
money comíng ínto and out of a busíness. Asset and ííabíííty accounts represent money
that ís contaíned ín the busíness or owed by the busíness.
Advertísíng revenue that you receíve from Googíe Adsense wouíd be an íncome account.
The saíary expense of a deveíoper you híre wouíd be an expense account. Your cash ín
your bank account wouíd be an asset account. The money you owe on your company
credít card wouíd be caííed "accounts payabíe" and wouíd be a ííabíííty.
When you ínítíaííy set up your chart of accounts, the baíance ín each and every account ís
zero. As you start enteríng fínancíaí transactíons ín your accountíng software, the
baíances of the accounts goes up or possíbíy down.
The concept of double entry accounting is important to understand. Each
fínancíaí transactíon has two sídes to ít and you need both of them to record the
Imµortunt Accounting Princiµlcs
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8: Accounting
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transactíon. Let's go back to that Adsense revenue exampíe.
You receíve a check ín the maíí from Googíe. You deposít the check at the bank. The
accountíng doubíe entry ís you record an íncrease ín the cash asset account on the
baíance sheet and a correspondíng equaí íncrease ín the advertísíng revenue account.
When you pay the credít card bííí, you wouíd record a decrease ín the cash asset account
on the baíance sheet and a decrease ín the "accounts payabíe" account on the baíance
sheet.
These accountíng entríes can get very compíícated wíth many accounts ínvoíved ín a
síngíe recorded transactíon, but no matter how compíícated the entríes get the two sídes
of the fínancíaí transactíon aíways have to add up to the same amount. The entry must
baíance out. That ís the scíence of accountíng.
Once you have a chart of accounts and have recorded fínancíaí transactíons ín ít, you can
produce reports. These reports are símpíy the baíances ín varíous accounts or
aíternatíveíy the changes ín the baíances over a períod of tíme.
Don't Skimp on Accounting
If you have a company, you must have fínancíaí records for ít. And they must be accurate
and up to date. I do not recommend doíng thís yourseíf. I recommend híríng a part-tíme
bookkeeper to maíntaín your fínancíaí records at the start. A good one wííí save you aíí
sorts of headaches. As your company grows, eventuaííy you wííí need a fuíí tíme
accountíng person, then severaí, and at some poínt your fínance organízatíon couíd be
quíte íarge.
There ís aíways a temptatíon to skímp on thís part of the busíness. It's not a core part of
most busínesses and ís often not vaíued by many entrepreneurs. But píease don't skímp
on thís. Do ít ríght and weíí. And híre good peopíe to do the accountíng work for your
company. It wííí pay huge dívídends ín the íong run.
For more ínformatíon about fínancíaí statements, vísít thís bíog post:
Analyzing Financial Statements
http://mba-mondays.pandamían.com/anaíyzíng-fínancíaí-statements/
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8: Accounting
8: Accounting
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IX.
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A report of the revenue and expense accounts.
The profít and íoss statement ís a report of the changes ín the íncome and expense
accounts over a certaín períod of tíme (month and year beíng the most common). The
most common períods of tíme are months, quarters, and years, aíthough you can
produce a P&L report for any períod.
Top Líne: Revenue
The top ííne of profít and íoss statements ís revenue (that's why you'íí often hear revenue
referred to as "the top ííne"). Revenue ís the totaí amount of money you've earned
comíng ínto your busíness over a set períod of tíme. It ís NOT the totaí amount of cash
comíng ínto your busíness. Cash can come ínto your busíness for a varíety of reasons, ííke
fínancíngs, advance payments for servíces to be rendered ín the future, payments of
ínvoíces sent months ago.
There ís a very ímportant, but híghíy technícaí, concept caííed revenue recognítíon.
Revenue recognítíon determínes how much revenue you wííí put on your accountíng
statements ín a specífíc tíme períod. For a startup company, revenue recognítíon ís not
normaííy díffícuít. If you seíí somethíng, your revenue ís the príce at whích you soíd the
ítem and ít ís recognízed ín the períod ín whích the ítem was soíd.
Accuraí Accountíng
Thís íeads to another ímportant concept caííed accruaí accountíng. When many peopíe
start keepíng books, they símpíy record cash receíved for servíces rendered as revenue.
And they record the bííís they pay as expenses. Thís ís caííed cash accountíng and ís the
way most of us keep our personaí books and records. But a busíness ís not supposed to
keep books thís way. It ís supposed to use the concept of accruaí accountíng.
Let's say you híre a contract deveíoper to buííd your íPhone app. And your deaí wíth hím
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ís you'íí pay hím $30,000 to deííver ít to you. And íet's say ít takes hím three months to
buííd ít. At the end of the three months you pay hím the $30,000. In cash accountíng, ín
month three you wouíd record an expense of $30,000.
But ín accruaí accountíng, each month you'd record an expense of $10,000 and because
you aren't actuaííy payíng the deveíoper the cash yet, you charge the $10,000 each
month to a baíance sheet account caííed Accrued Expenses. Then when you pay the bííí,
you don't touch the P&L; ít´s símpíy a baíance sheet entry that reduces Cash and reduces
Accrued Expenses by $30,000.
The poínt of accruaí accountíng ís to perfectíy match the revenues and expenses to the
tíme períod ín whích they actuaííy happen, not when the payments are made or receíved.
Expense Sectíon
Wíth that ín mínd, íet's íook at the second part of the P&L, the expense sectíon. You wííí
often see the cost of revenues appííed dírectíy agaínst the revenues and a caícuíatíon of
a net amount of revenues mínus cost of revenues, whích ís caííed gross margín.
I prefer that gross margin be broken out as ít ís a reaííy ímportant number. Some
busínesses have very hígh costs of revenue and very íow gross margíns. An exampíe
wouíd be a retaííer, partícuíaríy a íow príce retaííer. The gross margíns of a díscount
retaííer couíd be as íow as 25%.
The other reason to break out cost of revenues ís that ít wííí most ííkeíy íncrease wíth
revenues whereas the other expenses may not. The non cost of revenues expenses are
sometímes referred to as overhead. They are the costs of operatíng the busíness even íf
you have no revenue. They are aíso sometímes referred to as the fixed costs of the
busíness. But ín a startup, they are hardíy fíxed. In íayman's terms, they are the costs of
makíng the product, the costs of seíííng the product, and the cost of runníng the busíness.
Income From Operatíons
Income from operatíons ís equaí to revenue mínus expenses. If ít ís a posítíve number,
then your base busíness ís profítabíe. If ít ís a negatíve number, you are íosíng money.
Thís ís a crítícaí number because íf you are makíng money, you can grow your busíness
wíthout needíng heíp from anyone eíse. Your busíness ís sustaínabíe. If you are not
makíng money, you wííí need to fínance your busíness ín some way to keep ít goíng. Your
busíness ís unsustaínabíe on íts own.
The ííne ítems after "Income From Operatíons" are the addítíonaí expenses that aren't
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dírectíy reíated to your core busíness. They íncíude ínterest íncome (from your cash
baíances), ínterest expense (from any debt the busíness has), and taxes owed (federaí,
state, íocaí, and possíbíy ínternatíonaí). These expenses are ímportant because they are
reaí costs of the busíness.
I don't pay as much attentíon to the expenses above because ínterest íncome and
expense can be changed by makíng changes to the baíance sheet and taxes are
generaííy oníy paíd when a busíness ís profítabíe. When you deduct the ínterest and taxes
from Income From Operatíons, you get to the fínaí number on the P&L, caííed Net
Income.
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A report of the asset and ííabíííty accounts.
The baíance sheet ís report of the baíances aíí asset and ííabíííty accounts at a certaín
poínt ín tíme. It shows how much capítaí you have buíít up ín your busíness. There are two
kínds of accounts ín a company's chart of accounts; revenue and expense accounts and
asset and ííabíííty accounts.
The Profit and Loss statement (see prevíous) ís a report of the revenue and expense
accounts. The Baíance Sheet ís a report of the asset and ííabíííty accounts. Assets are
thíngs you own ín your busíness, ííke cash, capítaí equípment, and money that ís owed to
you for products and servíces you have deíívered to customers. Líabííítíes are obíígatíons
of the busíness, ííke bííís you have yet to pay, money you have borrowed from a bank or
ínvestors.
Top Líne: Cash
The top ííne, cash, ís the síngíe most ímportant ítem on the baíance sheet. Cash ís the fueí
of a busíness. If you run out of cash, you are ín bíg troubíe uníess there ís a "fííííng
statíon" nearby that ís wííííng to fund your busíness. Aían Shugart, founder of
Seagate (http://www.seagate.com/www/en-us/) and a few other dísk dríve companíes,
famousíy saíd "cash ís more ímportant than your mother." That's how ímportant cash ís
and you never want to get ínto a sítuatíon where you run out of ít.
The second ííne, short term ínvestments, ís basícaííy addítíonaí cash. Most startups won't
have thís ííne ítem on theír baíance sheet. But when you are Googíe and are síttíng on
muítípíe bííííons of cash and short term ínvestments, ít makes sense to ínvest some of
your cash ín "short term ínstruments." Hopefuííy for Googíe and íts sharehoíders, these
ínvestments are safe, ííquíd, and are at very mínímaí rísk of íoss.
Accounts Receívabíe
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The next ííne ís "accounts receívabíe," the totaí amount of money owed to the busíness
for products and servíces that have been deíívered but have not been coííected. It's the
money your customers owe your busíness. If thís number gets reaííy bíg reíatíve to
revenues (for exampíe íf ít represents more than three months of revenues) then you
know somethíng ís wrong wíth the busíness.
Totaí Current Assets
Totaí current assets ís the amount of assets that you can turn ínto cash faíríy quíckíy. It ís
often consídered a measure of the "ííquídíty of the busíness."
The next set of assets ís "íong term assets" that cannot be turned ínto cash easííy. Three
exampíes are "íong term ínvestments," "property píant and equípment," and "goodwííí,"
an íntangíbíe asset refíectíng the strength of the brand, good reíatíons wíth customers
and empíoyees, and propríetary systems and patents.
Líabííítíes
After cash, the ííabíííty sectíon of the baíance sheet ís the most ímportant sectíon. It
shows the busínesses' debts. And the other thíng that can put you out of busíness asíde
from runníng out of cash ís ínabíííty to pay your debts. That ís caííed bankruptcy. Of
course, runníng out of cash ís one reason you may not be abíe to pay your debts. But
many companíes go bankrupt wíth huge amounts of cash on theír books. So ít ís crítícaí to
understand a company's debts.
The maín current ííabííítíes are accounts payabíe and accrued expenses. Both represent
expenses of the busíness that have yet to be paíd. Accounts payabíe are for bííís the
company receíves from other busínesses. Accrued expenses are accountíng entríes a
company makes ín antícípatíon of beíng bíííed. A good exampíe of an accounts payabíe ís
a íegaí bííí you have not paíd. A good exampíe of an accrued expense ís empíoyee
benefíts that you have not yet been bíííed for that you accrue for each month.
If you compare Current Líabííítíes to Current Assets, you'íí get a sense of how tíght a
company ís operatíng. Many companíes operate wíth these numbers cíose to equaí. They
are sweatíng ít.
Non-current ííabííítíes are mostíy íong term debt of the busíness. The amount of debt ís
ínterestíng for sure. If ít ís very íarge compared to the totaí assets of the busíness íts a
reason to be concerned. But íts even more ímportant to díg ínto the term of the íong
term debt and fínd out when ít ís comíng due and other ímportant factors. You won't fínd
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that on the baíance sheet. You'íí need to get the footnotes of the fínancíaí statements to
do that. Agaín, we'íí taík more about that ín a future post on fínancíaí statement anaíysís.
Stockhoíder Equíty
Stockhoíder Equíty íncíudes two categoríes of "equíty." The fírst ís the amount that equíty
ínvestors, from VCs to pubííc sharehoíders, have ínvested ín the busíness. The second ís
the amount of earníngs that have been retaíned ín the busíness over the years.
Stockhoíder equíty ís aíso caííed the "book vaíue" of the busíness.
The cooí thíng about a baíance sheet ís ít has to baíance out. Totaí Assets must equaí
Totaí Líabííítíes píus Stockhoíders Equíty.
In summary, the Baíance Sheet shows the vaíue of aíí the capítaí that a busíness has buíít
up over the years. The most ímportant numbers ín ít are cash and ííabííítíes. Aíways pay
attentíon to those numbers. I aímost never íook at a profít and íoss statement wíthout
aíso íookíng at a baíance sheet. They reaííy shouíd be consídered together as they are
two sídes of the same coín.
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XI.
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Cash fíow ís reaííy easy to caícuíate.
The cash fíow statement ís a report of the changes ín aíí of the accounts
(íncome/expense and asset/ííabíííty) ín order to determíne how much cash the busíness ís
producíng or consumíng over a certaín períod of tíme (month and year beíng the most
common).
Cash fíow ís the amount of cash your busíness eíther produces or consumes ín a gíven
períod, typícaííy a month, quarter, or year. You míght thínk that ís the same as the profít
of the busíness, but that ís not correct for a bunch of reasons.
The profít of a busíness ís the dífference between revenues and expenses. If revenues
are greater than expenses, your busíness ís producíng a profít. If expenses are greater
than revenues, your busíness ís producíng a íoss.
But there are many exampíes of profítabíe busínesses that consume cash. And there are
aíso exampíes of unprofítabíe busínesses that produce cash, at íeast for a períod of tíme.
Thc Cush Flow Stutcmcnt
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Revenues are recognízed as they are earned, not necessarííy when they are coííected.
And expenses are recognízed as they are íncurred, not necessarííy when they are paíd
for. Aíso, some thíngs you míght thínk of as expenses of a busíness, ííke buyíng servers,
are actuaííy posted to the Baíance Sheet as property of the busíness and then
deprecíated (í.e., expensed) over tíme.
So íf you have a busíness wíth sígnífícant hardware requírements, ííke a hostíng busíness
for exampíe, you míght be generatíng a profít on paper but the cash outíays you are
makíng to buy servers may mean your busíness ís cash fíow negatíve.
Another exampíe ín the opposíte dírectíon wouíd be a software as a servíce busíness
where your company gets paíd a year ín advance for your software subscríptíon
revenues. You coííect the revenue upfront but recogníze ít over the course of the year. So
ín the month you coííect the revenue from a bíg customer, you míght be cash fíow
posítíve, but your Income Statement wouíd show the busíness operatíng at a íoss.
Caícuíatíng Cash Fíow
Cash fíow ís reaííy easy to caícuíate. It´s the dífference between your cash baíance at the
start of whatever períod you are measuríng and the end of that períod. Let´s say you
start the year wíth $1mm ín cash and end the year wíth $2mm ín cash. Your cash fíow for
the year ís posítíve by $1mm. If you start the year wíth $1mm ín cash and end the year
wíth no cash, your cash fíow for the year ís negatíve by $1mm.
But as you míght ímagíne the accountíng versíon of the cash fíow statement ís not that
símpíe. Instead of gettíng ínto the standard form, whích as I saíd I don´t reaííy ííke, íet´s
taík about a símpíer form that gets you to mostíy the same píace.
Production And Consumµtion Of
Cush
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Let´s say you want to do a cash fíow statement for the past year. You start wíth your Net
Income number from your Income Statement for the year. Let´s say that number ís
$1mm of posítíve net íncome.
Then you íook at your Baíance Sheet from the príor year and the current year. Look at
the Current Assets (íess cash) at the start of the year and the Current Assets (íess cash)
at the end of the year. If they have gone up, íet´s say by $500,000, then you subtract that
number from your Net Income. The reason you subtract the number ís your busíness
used some of your cash to íncrease íts current assets. One typícaí reason for that ís your
Accounts Receívabíe went up because your customers are takíng íonger to pay you.
Then íook at your Non-Current Assets at the start of the year and the end of the year. If
they have gone up, íet´s say by $500k, then you aíso subtract that number from your Net
Income. The reason ís your busíness used some of your cash to íncrease íts Non-Current
Assets, most ííkeíy Property, Píant, and Equípment (ííke servers).
At thís poínt, haífway through thís símpíífíed cash fíow statement, your busíness that had
a Net Income of $1mm produced no cash because $500k of ít went to current assets and
$500k of ít went to non-current assets.
Figuring Liabilities into the Cash Flow Statement
Líabííítíes work the other way. If they go up, you add the number to Net Income. Let´s
start wíth Current Líabííítíes such as Accounts Payabíe (money you owe your suppííers,
etc). If that number goes up by $250k over the course of the year, you are effectíveíy
usíng your suppííers to fínance your busíness. Another reason current ííabííítíes couíd go
up ís Deferred Revenue went up. That wouíd mean you are effectíveíy usíng your
customers to fínance your busíness (ííke that software as a servíce exampíe earííer on ín
thís post).
Simµlc Form Of Cush Flow
Stutcmcnt
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thís post).
Then íook at Long Term Líabííítíes. Let´s say they went up by $500k because you
borrowed $500k from the bank to purchase the servers that caused your Non-Current
Assets to go up by $500k. So add that $500k to Net Income as weíí.
Figuring Stockholder Equity into the Cash Flow Statement
Now, the símpíífíed cash fíow statement ís showíng $750k of posítíve cash fíow. But we
have one more sectíon of the Baíance Sheet to deaí wíth, Stockhoíders Equíty. For
Stockhoíders Equíty, you need to back out the current year´s net íncome because we
started wíth that. Once you do that, the maín reason Stockhoíders Equíty wouíd go up
wouíd be an equíty raíse. Let´s say you raísed $1mm of venture capítaí duríng the year
and so Stockhoíder´s Equíty went up by $1mm. You´d add that $1mm to Net Income as
weíí.
Finalizing the Cash Flow Statement
So, that´s basícaííy ít. You start wíth $1mm of Net Income, subtract $500k of íncreased
current assets, subtract $500k of íncreased non-current assets, add $250k of íncreased
current ííabííítíes, add $500k of íncreased íong-term ííabííítíes, and add $1mm of
íncreased stockhoíders equíty, and you get posítíve cash fíow of $1.75mm.
It´s símpíy not enough to íook at the Income Statement and the Baíance Sheet. You need
to understand the thírd píece of the puzzíe to see the busíness ín íts entírety. When you
are doíng pro|ectíons for future years, I encourage management teams to pro|ect the
íncome statement fírst, then the cash fíow statement, and then end up wíth the baíance
sheet.
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XII.
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Busincss Mctrics
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The management team shouíd spend tíme taíkíng about and seíectíng the key busíness
metrícs to focus on.
Every busíness shouíd have a set of metrícs that ít tracks on a reguíar basís. These
metrícs couíd íncíude accountíng íssues ííke cash, revenues, profíts, etc., but ít shouíd not
be íímíted to those kínds of metrícs.
As the busíness grows and deveíops, the amount of data you can coííect and pubíísh to
your team grows. If you aren't carefuí, you can overwheím your team wíth data.
It becomes very ímportant to dístííí the busíness down to a handfuí of key busíness
metrícs. There are usually four to six metrics that wííí determíne the overaíí heaíth
and growth tra|ectory of the busíness.
Potentíaí metrícs íncíude:
Pre-Launch}Early Stage:
Deveíopment resources
Features compíeted
Known bugs
Post-Launch:
Customers
Daííy actíve users
Churn
Conversíons from free tríaí to paíd customer
Dcfining A Sct Of Mctrics
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Our portfoíío company Meetup (http://www.meetup.com/) has íearned to focus on
successfuí Meetup groups. Those are Meetup groups that are actíve, meetíng reguíaríy,
have growíng membershíps, and are payíng fees to the company. Meetup can focus on
other data sets ííke monthíy uníque vísítors, new Meetup groups, totaí regístered users,
revenues, profíts, and cash. They coííect that data and share ít wíth the team. But the
number one thíng they íook at ít successfuí Meetup groups and that has worked weíí for
them. It ís theír key busíness metríc.
Sometímes the most ímportant data on your busíness ís the hardest to coííect. Twítter
(https://twítter.com/) knows that the totaí number of tímes aíí tweets have been víewed
each day, month, or year ís a crítícaí measure of the overaíí reach of the network. But
because so many of those tweets are víewed on thírd party servíces, web pages, apps,
etc, ít ís very hard to coííect that data. The company ís oníy now startíng to measure
them.
Most key busíness metrícs wííí be drívers of revenues and growth but not aíí of them.
Etsy (http://www.etsy.com/) ís focusíng a íot of effort on íts customer servíce metrícs,
whích are a cost center not a revenue dríver. But the company knows that customer
servíce ís crítícaí to the heaíth of the marketpíace, so customer servíce metrícs are key
busíness metrícs for them.
Communicating Metrics Within Your Company
The management team shouíd spend tíme taíkíng about and seíectíng the key busíness
metrícs to focus on. They shouíd coííect the data on a reguíar basís, the more reaí-tíme
the better ín my opíníon, and they shouíd pubíísh the key busíness metrícs to the entíre
team.
I do not beííeve ít makes any sense to segment who gets to see what busíness metrícs ín
a company. Saíes metrícs shouíd be shared wíth deveíopment. Customer servíce metrícs
shouíd be shared wíth fínance. And so on and so forth.
E×umµlcs Of Mctrics To Follow
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Some companíes buy bíg screens and mount them on the waíís around the offíce and
pubíísh the key busíness metrícs on them so everyone can see them. I ííke that approach.
But I aíso ííke sendíng out a reguíar emaíí to the entíre company wíth the key busíness
metrícs and how they are trendíng. And of course, I thínk these metrícs shouíd be shared
wíth the Board and key ínvestors.
When you pubíísh fínancíaí pro|ectíons (a topíc for the comíng weeks), you shouíd íncíude
your pro|ectíons or assumptíons for key busíness metrícs ín the períods for whích you are
pro|ectíon fínancíaí performance. Many of these metrícs wííí be drívers of your pro|ectíons
but they are aíso heípfuí to estabíísh the overaíí progress of the busíness over tíme.
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It ís a good ídea to evaíuate what your company's key busíness metrícs shouíd be from
tíme to tíme. I ííke to suggest at íeast once a year, probabíy around the annuaí budgetíng
exercíse (another topíc for the comíng week). It ís expected that you wííí change some of
these metrícs every year as the busíness grows and deveíops. Don't |ust keep addíng new
ones; you shouíd aíso subtract oíd ones that don't seem as usefuí anymore. Keep the totaí
number of key busíness metrícs you are trackíng to a smaíí enough number that most
peopíe on the team couíd recíte them from memory. Less ís more when ít comes to key
busíness metrícs.
Trackíng key busíness metrícs ís ímportant for many reasons, but probabíy the most
ímportant reason ís cuíturaí. It heíps to keep everyone on the same page, aíígns peopíe
across the dífferent parts of the busíness, and íeads to a cuíture of success when you see
the key busíness metrícs movíng ín the ríght dírectíon. It's crítícaí to ceíebrate when a key
busíness metrícs reaches a new and ímportant mííestone. These kínds of thíngs seem síííy
to some but are íncredíbíy ímportant to buíídíng a strong company cuíture that can work
together and grow rapídíy.
Rcvising And Trucking Mctrics
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Your Comµuny
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A protracted saíe transactíon can be very harmfuí to the busíness and íts stakehoíders.
The exít pían. It typícaííy means seíííng your company. The key íssues for you, your
ínvestors, and your board to consíder are:
Príce
Consíderatíon
Reps, Warrantíes, and Escrow
Integratíon pían
Stay packages
Governmentaí approvaís
Breakup fees
Tímíng
Price ís the amount the buyer wííí pay for the busíness. It ís the most ímportant íssue and
aíso the símpíest.
Consideration ís the mechanísm the buyer wííí use to deííver the purchase príce. The
símpíest form of consíderatíon ís cash ín your íocaí currency. That ís aíso the most
common form of consíderatíon. Another common form of consíderatíon ís the acquírer's
stock. That couíd be pubíícíy traded ííquíd stock or ít couíd be ííííquíd prívate company
stock. Buyers can aíso pay wíth debt obíígatíons, earn out píans, and a host of other
esoteríc and íess common forms of consíderatíon.
Reps and Warranties are the íegaí promíses and obíígatíons you wííí take on as a seííer.
A portíon of the purchase príce ís usuaííy heíd back and escrowed for some períod of tíme
to backstop the reps and warrantíes. The escrow ís usuaííy a percentage of the
purchase príce. Ten percent ís common but I've seen as ííttíe as 5% and as hígh as 25%.
The integration plan ís the way the buyer píans to operate your busíness post
acquísítíon. Many seííers don't thínk thís matters too much but I thínk ít ís crítícaí. If you
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thínk about the ínterests of aíí the stakehoíders ín the busíness, not |ust the sharehoíders,
then the íntegratíon pían becomes a very ímportant part of the overaíí deaí.
Stay packages are compensatíon píans put together by the buyer for your team. There
may even be a stay package for you íf the buyer wants you to stíck around and most of
the tíme they shouíd. These packages are a combínatíon of cash and stock that vests
over a stay períod. It ís common that some of the consíderatíon may be appííed to stay
packages, partícuíaríy unvested empíoyee stock ín your company.
Government approvals ínvoíve requírements by the government, and not |ust your
country's government, to approve the saíe. Thís ís not common for smaíí deaís. Anythíng
sub $100mm wouíd be very unííkeíy to requíre governmentaí approvaís. Reaííy bíg deaís,
ííke bííííon-doííar píus transactíons, often run ínto these íssues. Powerfuí companíes that
the government worríes may have monopoíístíc propertíes wííí usuaííy face governmentaí
approvaís for theír acquísítíons.
Breakup fees are what the buyer may have to pay íf your busíness wííí face negatíve
consequences íf the saíe ís announced and then does not cíose. Most buyers wííí resíst
agreeíng to breakup fees but they do exíst ín many deaís, partícuíaríy very íarge deaís.
Timing ís another ímportant íssue that many seííers don't focus on. Saíe transactíons are
very dístractíng for the seníor team and often for the entíre team. A protracted saíe
transactíon can be very harmfuí to the busíness and íts stakehoíders. You can put tíme
commítments ínto the íetter of íntent to seíí the company and you can expect the buyer
to ííve up to them.
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Fundumcntuls
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Acquísítíons are much more common and much better.
As the term M&A suggests, there are two types of deaís, mergers and acquísítíons.
Acquísítíons are more common; ít ís when one company ís takíng controí of the other. A
merger ís when two ííke-sízed busínesses combíne. An exampíe of a merger ís the
AOL/Tíme Warner busíness combínatíon ten years ago. I am not a fan of mergers. I
beííeve ít ís way better when one company ís takíng controí of the other. At íeast then you
know who ís ín charge. Mergers are very compíícated to puíí off organízatíonaííy.
I have done a few mergers ín the startup woríd. The best exampíe ís Return Path and
Verípost whích merged ín 2002. The two companíes started at about the same tíme, both
got venture fundíng, and buíít aímost ídentícaí busínesses. They were beatíng each other
up ín the market and gettíng nowhere quíckíy. The management teams knew each other
and the VCs (Brad Feíd and yours truíy) knew each other. We fínaííy decíded to put the
two companíes together ín a merger. It worked because we decíded that Return Path's
CEO wouíd run the combíned companíes and because Verípost's CEO was fuííy supportíve
of that decísíon. Even so, ít was not easy to execute.
Acquísítíons are much more common and I beííeve much better. Most of the deaís you
can thínk of ín startup-íand are acquísítíons. A íarger company ís acquíríng a smaííer
company and takíng controí of ít.
Mcrgcrs 8 Acquisitions
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The next dístínctíon that matters a íot ís how the consíderatíon ís paíd. The most common
forms of payment are cash and stock. In fact, you'íí often hear corporate deveíopment
peopíe say "ít's a stock deaí" or "ít's a cash deaí." Companíes can pay wíth other
consíderatíon as weíí. Debt ís sometímes used as consíderatíon, for exampíe. But ín
startup-íand, you'íí mostíy see stock and cash.
Most peopíe thínk cash ís preferabíe. If you are seíííng your company, you want to know
how much you are gettíng for ít. And wíth cash, that ís cíear as crystaí. Wíth stock you are
símpíy tradíng stock ín your own company, whích you controí, for stock ín someone eíse's
company, whích you don't controí.
However, over the years ín maybe a hundred deaís now I have made more money ín
stock-based deaís wíth the acquírer's stock than I have íost ín acquírer's stock. I don't
know íf that ís |ust my good fortune or not. But I certaíníy have had the experíence of
takíng stock ín an acquísítíon and havíng that stock crumbíe and íose ít aíí. So íf you are
doíng a stock-based deaí, make sure you do your homework on the company and íts
stock.
Considcrution: Cush Vs. Stock
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Typícaííy the purchaser can eíther buy assets or buy the company (vía íts stock). If you
are seíííng your company, you'íí generaííy want to seíí the entíre company and thus aíí of
íts stock to the buyer. The buyer may not want to entíre company and may suggest that ít
wants to do an "asset deaí" whích means ít cherry pícks what ít wants and íeaves you
hoídíng the bag on the unwanted assets and some or aíí of the ííabííítíes.
For obvíous reasons, fíre saíes are often done as asset deaís. Heaíthy companíes wíth
bríght futures are not often purchased ín asset deaís. They aímost aíways seíí the entíre
company ín a stock deaí. If you are seíííng your company you shouíd try very hard to do a
stock deaí for the entíre company.
For more ínformatíon on M&A, vísít thís bíog posts:
Buying Asscts Or Thc Entirc
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M&A Case Studies: ChiliSoft
http://mba-mondays.pandamían.com/ma-case-studíes-chííísoft/
M&A Case Studies: WhatCounts
http://mba-mondays.pandamían.com/ma-case-studíes-whatcounts/
M&A Case Studies: WhatCounts Sales Process
http://mba-mondays.pandamían.com/ma-case-studíes-whatcounts-saíe-process/
M&A Case Studies: Feedburner
http://mba-mondays.pandamían.com/ma-case-studíes-feedburner/
M&A lssues: The lntegration Plan
http://mba-mondays.pandamían.com/ma-íssues-the-íntegratíon-pían/
Cusc Studics
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