Month: December 2005
Amazingly, I’ve lived in Colorado for 10 years and haven’t ever gone snowshoeing. Since I lost my Pilates virginity this week, I figured I’d try a second kind of cross-training in two days. Dave Jilk took me up Long’s Peak Trail to try to get above treeline. I strapped on my brand new MSR Denali Ascent Snowshoe (awesome snowshoes) and took off after Dave. I settled into a groove in about 30 minutes – it was a completely different motion than trail running or hiking (if you’ve ever snowshoed, then you know what I mean when I say “hip flexors of the world unite.”)
We ultimately got up to about 10750 feet before we were overwhelmed by 80+ mph gusts, the complete inability to see anything, and brutal cold bursts. We didn’t quite make treeline, but we still got wild views of Meeker and Twin Sisters. We turned around and hoofed it back, happy to be going downhill and get out of the wind. We celebrated our success with a stop on our way home at Royal Wok in Lyons for some spectacularly appropriate chinese food in the middle of nowhere.
Enough cross-training – time to go for my run – although it won’t be the long one that I had planned because my entire body is sore and tired in weird places from the past two days (I ran on Pilates day also, so that probably added to my general feeling of overwhelming physical fatigue.)
In the spirit of the New Year, I’m trying to blog the questions that I’m getting that I think could have broad interest. Here’s another one. Remember – I’m not a lawyer so this isn’t legal advice.
I have a question regarding the valuation of a startup I’m in and when it takes affect. When I joined the startup in 2004, I was granted options at $.10 each. In Oct ’05, we received a term sheet as part our financing efforts which valued the shares at a multiple to the $.10. We ultimately didn’t sign for various reasons. I have 2 questions related to this.
a) Does the event of receiving a term sheet automatically trigger a new price for the options based upon the valuation in the term sheet even if it isn’t signed? While a 409A valuation expert might take into consideration an unsigned term sheet as part of their valuation analysis (similar to them taking into consideration an offer to acquire the company at a certain price), this won’t necessarily trigger a new price for common stock (presumably the stock underlying the options – equal to the option strike price.) It’s likely the the new investment would have been preferred stock with some additional characteristics (liquidation preference, participation, dividends) that would cause the preferred stock to have a higher price than common stock. As a result, at the minimum, one has to take into consideration the capital structure of the company when determining the price for the stock options. It’s even conceivable – based on a formal valuation analysis – that the appraised value of the common stock might be less than $0.10 due to the new proposed capital structure, even though the per share price of the preferred stock that was proposed was a multiple to the $0.10.
b) Given there was lots of pre-work to come up with the pre-money valuation, when would this pre-money valuation take effect? Since the proposed investment was never consummated, this pre-money valuation doesn’t really ever take effect. It’s merely one data point in the determination of value under 409A (and – in my opinion – a relatively weak one since the deal didn’t occur).
For the lawyers and 409A valuation experts out there lurking, I encourage you to comments on / add to posts like these.
Every good marathoner knows he should cross-train. Most of the ones I know struggle with “cramming it in” as marathon training already consumes at least ten hours a week. Triathletes have it easy since they are already running, biking, and swimming (although they should cross-train away from these three also.) But – I’m a marathoner – not a triathlete – so I carry a special cross-training burden.
My wife Amy is a yoga fanatic. While I love Shivasina, I have trouble keeping up with most yoga, especially Ashtanga Yoga. At the encouragement of Dave Jilk, I’ve done Bikram Yoga on and off for the last few years and – while it’s been helpful – I find the 90 minute sessions a little long (30 minutes, to be precise) and I’ve gotten bored of the rigidity of the practice.
Amy has suggested for a while that I try Pilates. Wendy Lea has become completely addicted to Pilates and has been raving about it for the past year. The Pilates equipment (a “reformer”) looks like something a mad scientist created. I figured “what the hell” and decided to try it yesterday.
I took a private lesson at Flatiron Athletic Club. I had an awesome time. It helped that my teacher was great, but I was completely intrigued by the assistance the reformer gives you. There’s a lot of physics going on that help achieve the second order goal of “body mind connection” (e.g. a nerd gets to think a lot about what he’s doing.) I’ve got three more private lessons before I’m “allowed” to take a class – we’ll see how I feel about this in a few weeks. In the mean time, I had a new life experience yesterday (e.g. Pilates) and got some cross-training in.
Over the past year, I’ve regularly gotten questions via email on venture capital and entrepreneurship from readers of this blog. I always try to respond. A number of these questions were easily bloggable but for some reason I fell into a default mode of responding to the email rather than writing a thoughtful post. I’ve decided that – going forward – I’d try to be more diligent about posting my responses to these questions (which I encourage) as well as commenting on questions in comments (I was very inconsistent about that this year.) One can always improve, right?
The question I woke up to today was “I browsed your site today looking for a clue on how VC regard entrepreneurs who have engaged an investment agent to assist them with raising capital. It’s a decision I’m considering, because getting an agent to represent us will free up more of my time to focus on execution. My fear though is that an agent will either get in the way of a deal, or just be viewed negatively by VC (agents will probably work harder than entrepreneurs to raise the valuation by encouraging competition among VC for the deal etc).”
To answer this question, I have to segment this into “early stage VCs” and “later stage investors (including VCs)”. Many early stage VCs – especially those that are in saturated geographies and see a lot of deal flow – don’t pay much attention to deals that are promoted by an “investment agent.” I know a number of folks who simply “hit delete” on an email (the virtual equivalent to tossing the physical PPM – the document most agents insist on putting together – in the trash.) In the early stages, the entrepreneur is by far the best fundraiser for his company and there is a knee jerk negative reaction by many VCs against early stage deals that “require” an agent. At the early stage, an entrepreneur is much better served by finding an advisor (or set of advisors) or angel investor that has good VC connections and fundraising experience who can get actively involved in the company as advisor, board member, consultant, or even chairman.
Later stage companies and larger capital raises are a different story. The universe of later stage investors is very dynamic – consisting of corporate (strategic) investors, high net worth individuals, private equity firms, and hedge funds – in addition to later stage VC firms. Many firms enter and exit the market regularly for a variety of reasons (e.g. a number of hedge funds have recently started doing what traditionally look like late stage / mezzanine VC deals). An agent who is active at raising later stage capital will typically have some relationships with folks currently in the market, can run the drill of identifying the primary suspects for the entrepreneur, and can help manage what is typically a more complicated and less structured financing process (e.g. there often isn’t a clear lead investor in a later stage deal.)
As with anyone that you engage to help you with your company, doing your own due diligence and background check on the agent you are considering using is critical. The ratio of charlatans to qualified agents is probably 100:1 – the vast majority of folks that claim to be able to help companies raise capital are pretty useless. The diligence process is easy – ask for a complete list of successful and unsuccessful deals the agent has done in the past 12 months and then dig in to the details of the list, talking to the principals involved in the transaction (including the lead investors that agent brought to the table) to see how much impact the agent had on the deal.
Finally, don’t make the false assumption that an agent will “free up more of your time to focus on execution.” This isn’t going to happen – if the agent is good he will help with the process, but the entrepreneur will still be on the front line of the fundraising activity. Any new investor is going to want to hear directly from you. For the period of time that you are raising capital, this should be your primary mission in life (to raise the money you need to continue to run your business) – no one will (or can) do it better than the entrepreneur. Your lawyers, agent, and others will help, but the burden of the financing will almost always be yours.
I sat stunned this morning as I read that AT&T (the “new name” for SBC) is going to spend $1 billion on a branding campaign.
For that? Now, I’m well known for hating money wasted on marketing, but $1 billion for that? You’ve got to be fucking kidding me. I can imagine about 1 billion better uses for the money. Apparently, they’ve spent lots of high powered marketing energy (and money, I expect) replacing the “Reach out and touch someone” slogan with “Your world, delivered.” Excellent. If I’d been on the “branding committee”, I would have recommended “We Suck Less.”
This just in – Intel also announced that they are going to do a major overhaul of their branding, replacing “Intel Inside” with “Leap ahead.” Double excellent.
Seth – the world needs you man – go save these guys from themselves.
When I saw my first demo of the World Wide Web at an MIT Athena Cluster in 1994 (it was Freshman Fishwrap – among other things – running on a very clunky version of Mosaic) I remember thinking something along the lines of “wow – this could be used for a lot of things.” Duh.
Every now and then I run into an unintended consequence of the Web. I’ve been involved in many companies that were trying to create “intended consequences” (some succeeded, some failed), but I’m intrigued when I stumble upon an unintended consequence, especially if it’s buried deep in the fabric of the mainstream.
I found one the other day. Amy and I were visiting her relatives in Hotchkiss, Colorado. Hotchkiss is in the middle of the western foothills of the Rocky Mountains, is a beautiful place, has some great running, and – while I’m probably the only jew for 50 miles – I’m always welcomed by Amy’s wonderful family at Christmas time. Amy’s uncle Mike and aunt Kathy own Weekender Sports – the local sporting goods store (need a snowmobile, ATV, fishing rod, gun, or ammo anyone?) It’s a great local store and is everything you’d expect.
I was sitting around talking with Amy’s cousin Mario who helps run the store and I asked him how business was. While the answer was “generally good”, we talked about the ups and downs of a local retail store (big city discounters, Wal*Mart, up and down days, challenging suppliers.)
One comment that Mario made that stood out was that “business is slow at the beginning of hunting season.” I pressed on this and asked him why he thought this was the case. The answer was stunningly simple – the Colorado Division of Wildlife now sells hunting and fishing licenses on the Web. Historically, if you wanted to hunt or fish in Colorado, you had to go to one of the Colorado license agents (e.g. Weekender Sports) and buy your license. This resulted in lots of traffic to the store, especially visitors from out of state who were coming to Colorado for a hunting / fishing vacation who wouldn’t otherwise go to the store. While you can still buy the license in the store, many people are opting to purchase them online since it’s better to have everything done in advance rather than have to scramble around on your first day of your trip. Of course, the unintended consequence is that visitors from out of state don’t bother stopping in at the local sporting goods store to pick up their license, and – correspondingly – don’t buy the random extra hunting and fishing gear they forgot to bring with them.
Now – there’s plenty of ongoing discussion about e-commerce and the endless shift of purchasing from stores to the Web (Amy bought almost all of her Christmas presents on the Web this year.) But – this example has an interesting effect. Think of the aggregate amount of secondary in-store purchases that won’t get made because one could get their fishing / hunting license on the Web. While you might think this is not a big deal, it clearly has impact on local merchants like Weekender Sports and is yet another e-commerce side effect that mainstream American businesses have to contend with.
This is our last post on 409A until the IRS issues more guidance or accepts some of the comments it has received during the comment period. In other words, we are “done” with 409A until sometime between tomorrow and next year. While I was hoping to get to 10 posts so I could refer to this series as “My Top 10 Thoughts On 409A” to join in with the top 10 list of 2005 meme, we only made it to 9. We hope you’ve enjoyed this series (yes – that was sarcastic.)
To wrap things up, we have a couple of questions that we are asking ourselves these days in light of 409A.
How the hell will the IRS audit this? We have no clue how this will actually play out in the real world. Is the IRS hiring a bunch of private company valuation experts? If so, they are going to have to “pay up” as there aren’t enough of these types in the private sector, much less the public sector. Or maybe these will become new members of the Homeland Security Accounting Compliance Task Force (a newly formed task force that is overseen by the Office of Civil Rights and Civil Liberties.)
What will happen to the valuation reports? Given that valuation reports of private companies will contain a ton of confidential data, what will happen if an employee gets audited and requests the report to fight off the IRS? Does the company have a duty to give the report to the employee? Will the company have to expend resources and work directly with the IRS on a confidential basis? Will these reports “find” themselves out in the public? What about attorney client privilege issues? Mmm – yummy rat hole.
Will the IRS actually respond to any of the comments given to it? Jason has been active with the NVCA and the general counsel / COO group to provide comments and in addition many law firms and accounting firms are drafting their comments as well, but will this all fall on deaf ears? The idea of the internal valuation method being essentially “useless” could drastically change with the right tweaks to the regulation. We got an encouraging early Christmas present from the IRS and are hopeful for an early Easter present also.
Bottom line, have “fun” with 409A in 2006. There is a lot of noise in this area and hopefully we helped quiet some of it (or – at least made the noise more entertaining.) We’ll post periodically with updates as the proposed rules evolve.
Scott Maxwell at Insight Partners has a list of his top 10 possible New Year’s Resolutions for Emerging Growth Company CEOs. While all are good, #10 is the most important.
Perhaps the only upside to the 409A panic in the start up world has been some of the urban legends that have already popped up. Jason and I aren’t your lawyers, so don’t take this as formal advice, but if your lawyers are advising you of the following, at least ask some questions. We’ve personally heard some senior partners at big-name law firms say some crazy things regarding 409A. The following are actual quotes. We will not disclose names to protect the innocent, er.. guilty.
“ISOs (incentive stock options) are exempt from 409A, so don’t worry about it, just grant ISOs.” : This is perhaps our favorite statement. In fact, the statement is factually correct, but logically stupid. In order to qualify for ISO status, the grants must be made at fair market value or higher. Given that ISOs cannot be given to consultants, nor are most executives eligible for ISOs, no company will ever get by granting just ISOs. Since NSOs (non qualified stock options) are subject to 409A, there will be some sort of formal valuation report (whether done internally or by a third party) that will determine the fair market value of the stock, which will in turn determine the price of the ISO. In other words, 409A does affect ISOs.
“Restricted Stock is exempt from 409A, so don’t worry about it, just grant Restricted Stock.” : Another factual statement that may work for very early stage companies but just doesn’t work in reality for most companies. When a restricted stock grant is made, the award itself is a taxable event and the grantee immediately holds voting stock. Perhaps granting restricted stock awards to the first half dozen employees of a company when the valuation is extremely low works, but for any somewhat mature start up, this doesn’t make much sense. Note that Restricted Stock Units and other deferred compensations units are subject to 409A. There are some workarounds for 409A, but they are pretty dense and confusing. For example:
“Such units will not be subject to Section 409A if settled (whether in stock or cash) before the later of (i) two and one half months after the end of the employer’s fiscal year in which vesting occurred, or (ii) March 15 following the calendar year in which vesting occurred. If the units qualify as performance-based compensation under Section 409A, the holder may make an initial deferral election at any time prior to the last six months of the performance vesting period”
See, we told you so.
“Directors are personally liable for screw ups concerning 409A.” : Jason was pelted with calls on this after a name-brand firm went around telling its clients this. Frankly, we aren’t sure where this is coming from, because there is nothing specific in the regulations which say this. Our best guess is that this stems from improper withholdings that are associated with 409A blunders. Should the company undervalue its options and therefore subject the employee to income on the spread versus the true fair market value, the company should also make withholding payments to the IRS on this “income.” Traditionally, failure to properly withhold for taxes can be a personal liability of officers and directors, so perhaps this is the chain of thought that elicited this statement. In our opinion, we’d be very surprised if the IRS chose to prosecute except in the most egregious situations, so we aren’t losing any sleep over this.
While writing this, the trailer for the season premier of 24 just aired and we’d rather think about all the dudes Jack Bauer kills this year instead of 409A, so we are done with this post. Don’t worry – we’re also almost done with torturing you on 409A.