Jul 4 2006

How An Entrepreneur Can Protect Himself Post-Funding

On this spectacular fourth of July (at least in Homer – it’s 60 degrees and not a cloud in the sky), I was enjoying disk 2 of Atlas Shrugged (I’m about 300 pages in) on my run today.  I’m deep into the section where all the competent people are quitting and walking off the playing field and the looters are ratcheting up the rules, which have the unintended consequence of destroying the world as they know it.  Hank is still fighting it out trying to hold everything together in an increasingly bleak world and Dagny is on her quest to find the inventor of the motor as she naively thinks that will solve everything.  The contrasts of the section I’m listening to lingered in my mind long after my run, especially as I pondered the state of affairs (good and bad) in our country 230 years after our birth.

When I sat back down at my computer, a question a that I got a few weeks ago from a reader jumped out at me.  The question follows:

If you are an entrepreneur leading a start-up, and you are negotiating investment with a strategic investor or VC, what are the standard or most desirable ways to protect yourself personally now that you have the potential to be fired?   Lets say they want to get rid of you in 6 months, and have the ability to do that, what type of parachute or provisions should the founder have on the front end to make sure they are covered in the event of being dismissed or benched?  Issues like whether you can be fired at all or just assigned a new role, severance salary/term and protecting your equity.  I have heard that covering yourself personally is among the most important terms to negotiate in a term sheet as the founder.    If by securing funding you are also unwittingly arranging your own personal demise, what precautions should you take. 

I might have answered this differently if it (a) wasn’t the 4th of July and (b) I hadn’t just listened to a particularly disheartening section of Atlas Shrugged.  While Jason and I covered the basics in our post on Vesting and part of our Term Sheet series, that only covers one aspect of the question – namely that of what is standard and fair in protecting your stock position.  While some VCs and entrepreneurs will try to negotiate employment agreements as part of a financing, I hate these.

If – as the entrepreneur – you are competent – it’s unlikely the premise above is valid.  Specifically, very few VCs invest in a company with the idea of firing the CEO in six months.  While many CEOs get replaced – and it’s often not pretty – it’s rarely because the new investor coming into a company thought – a priori – I want to get rid of this guy right after I invest.

As a result, I think the most effective approach for an entrepreneur is to punt completely on the employment agreement and issue of “employment protection.”  An open, direct discussion with the new investor is key – if the VC believes the entrepreneur should be playing a role other than CEO, get this out in the open in advance of the financing.  The entrepreneur should also do the leg work to understand the history of the investor – is this an investor that stands behind the entrepreneurs he funds or does he have a history of revolving door management?  When things don’t work out, how does the investor behave – is he fair and appropriate?  While you can’t always pick your investor, you certainly can know what you are getting yourself into.

I believe a combination of competence and transparency is the best approach.  If you are an excellent CEO, completely open with your investors about the good and the bad, diligent about trying to make the company successful, and completely open to feedback and constructive criticism, it’s unlikely that you’ll randomly get fired.  If the company isn’t performing, or you are struggling in your role, being open, honest, and proactive with your investors will almost always be much more effective than “employment protection.”  Occasionally you’ll run into “a bad investor” who has nefarious motives, but the world is small and life is short so this shouldn’t be that hard to figure out in advance.

While a cynical entrepreneur might paint this as an idealistic perspective, I’ve found that the real trust between the entrepreneur and investor is much more important than a legal agreement that immediately polarizes people before they’ve even started working together.