Brad Feld

Category: Management

I got a fun question in my inbox recently from a long time reader of this blog.  This answer is aimed at those of you who have ever thought about going to business school.

I’m an entrepreneur, software developer, and occasional angel investor, who is thinking about going to business school. I’m looking for something new to do, either in VC or in finance more generally, and want to use business school as a way to change career direction. Since I live in the Bay area, I talked to the Stanford GSB admissions office, which recommended that I apply for their Sloan Fellows program. I did so and was recently accepted, but upon further investigation I’m a little worried because, as you may know, the Sloan program is a one-year program which results in a MS in Management rather than an MBA.  My question to you is if you think that the fact you have an MS rather than an MBA has ever closed any doors to you? If so, which ones?

Before I answer the question, I want to straighten up some facts.  I don’t have an “MS in Management.”  I actually have an SM in Management Science” (I try to clear up resume fraud wherever I go.)  When I went to MIT in the mid-1980’s, they didn’t have an MBA program.  For some reason that I can’t remember (presumably to be more true to the original latin – Scientiae Baccalaureus), MIT reverses the letters on the BS and MS degrees (so they are actually SB and SM degrees.)  In addition – MIT didn’t want to be known for giving out BA degrees, so the undergraduate degree that I have is an SB in Management Science (yeah – a bachelor of science degree.)

Now that that is cleared up, let’s go on to the question.  Five years ago, I was approached by a bright young man (ok – I was young – but he was younger) looking for advice on which business school to go to.  He had a bachelors and masters degree from Stanford.  He’d recently been accepted to both Stanford GSB and Harvard Business School.  He had been working for four or five years – first as a management consultant and then as an early employee (ultimately the director of corporate development) at a recently public company.  My answer to him was “how about neither – why don’t you come work for me instead.”  Chris did, and I don’t think he’s ever looked back.

Business school certainly has value and serves a useful purpose in this world.  However, the essence of the question points at one of the fundamental problems (and possibly misconceptions) about business school.  I’m 40.  I don’t believe that the degree I have has ever had any material impact on my “career” during the last 20 years.  I can’t think of a single situation where it came up in a conversation about anything that I was considering doing.  For a while, I obsessively corrected the “MBA” and “MS” listings that would show up on web sites and in public filings – I finally gave up because I decided it simply wasn’t relevant.  While many people wear their degrees as badges of honor on their chests, I prefer to let actions speak for themselves (and – rather than look at the badges people have, I look for the actions.)

If you want a two year break from life, go to business school.  If you want to meet a bunch of new, generally smart, and always interesting people, go to business school.  If you are a techie but like the business side of things, want to get an intellectual (and functional grounding) in business stuff, want a two year break from life, and want to meet interesting people, go to business school. But please – don’t worry about whether you are getting an SM or an MS or an MBA – that’s not what you are going for.

Recognize this will cost you $100k plus two years of opportunity cost, so make sure it’s worth it to you.  There are many careers where you generally (but not always) need the MBA badge to advance to the next level.  If you are an investment banker or a management consultant, it’ll help.  If you are looking to be a VC, it might help, but it probably won’t, as the population of people being recruited into the VC business continues to be very small.  Don’t be misguided by the idea that doors will now fly open to you since you are a newly minted MBA (or MS, or SM.)

I can’t seem to get away from the “what structure should I use to set up my business” questions.  Here’s another one that I recently got.

I am trying to help an entrepreneur set up a distributorship to take US made products (tools) to a large market in asia with a huge need. Start up costs are under $1 million (5-10 angels and insiders), with proceeds going to pay for initial inventory take downs, field sales and support, and minimal opex. We do not foresee a future liquidity event for return of capital but rather generation of cash consistent with a distributorship. Question: what is the best equity structure for this company?

Given my recent post on S-Corp’s vs. LLC’s I’d lean toward an S-Corp (assuming all the investors are US-based), but given the recent change in Section 265 of DCGL, I’d be very comfortable with an LLC.  In either case, avoid a C-Corp and the risk of double taxation given that the company will likely be paying out dividends to its shareholders.

Are You Accredited?

Mar 21, 2006
Category Management

Jason and I have mentioned accredited investors several times in various postings on this blog.  However, after I received the following question, I realized we had never talked about why non-accredited investors are an issue for a company.  The question I received follows:

Do you have any stories or insight into the dangers of non-accredited investors? I’m currently attempting to work out a messy deal where some of the original (and potentially very unhappy) investors come in all flavors – sophisticated and accredited, unsophisticated and accredited, sophisticated and unaccredited, and of course, unsophisticated and unaccredited.  I’d love to see a post on the subject in your blog, should you have the insight and interest.

For those of you that don’t know what an accredited investor is, the SEC provides a very clear definition.  In general, unaccredited investors can pose a number of problems.  You’ll have to ask your lawyer for the nitty gritty, but we’ll cover the three major points in this post. 

First, have you done a proper private placement?  One has to jump through many more hoops to sell securities to unaccredited investors.  Many times, what appears to have been done correctly, later turns out to have been done poorly or incorrectly.  This is particularly troubling because at any time, these unaccredited investors have the right to rescind their investment in the company.  This is a ticking time bomb that can explode, especially if the company is underperforming.  It’s a very dangerous thing to have investors around that can unravel a deal with 20/20 hindsight.  Let’s assume, however that your lawyers got it right, which leads us to the next issue.

What happens on an acquisition?  Regardless if the placement was done correctly to the unaccredited investors, an acquisition of the company could pose big problems.  Take the case where a private company acquires the company for stock.  Handling the unaccredited investors can be extremely difficult.  The unaccredited investors need a purchase representative to trade their stock for the acquiring company stock, or the stock needs to be registered or subject to fairness hearings.  Alternatively, the buyer will insist that they don’t want unaccredited investors holding stock in their company, in which case the seller needs to come up with cash to buy out the unaccredited investors. We’ve seen cases where the buyer completely refused to deal with the unaccredited investors and the accredited investors on the seller’s side had to invest new cash in the company to buy out the unaccredited investors.  Public company acquisitions can present similar problems if the stock being issued in the acquisition is not registered.  Basically, your garden variety mess.

Finally by nature, unaccredited investors are generally unsophisticated.  This might be the most concerning issue of having unaccredited investors into your company.  By nature, they are less experienced in these types of investments and have less money to invest than others.  What you normally get are more skittish investors whose emotions rise and fall with every piece of good or bad news from the company.  When things turn bad, “unsophisticated investors” – who often didn’t realize that they could lose 100% of their investor – become irrational or hostile, in an already difficult situation for the company (i.e. the company is failing.)

Now – just because an investor is accredited doesn’t mean he is sophisticated.  The basic message is always the same – know who your investors are and what their past behavior has been like, especially in difficult circumstances.  However, especially in early stage companies, try to insure that all of your investors are accredited and – if some aren’t – that your lawyer has done a proper private placement to eliminate any issues associated with the actual financing.

I received the following question last week. It’s a good one – very chewy – and my answer is given from my frame of reference (e.g. a managing partner in a large VC fund).  Consequently, I’m not sure that my answer is either generally correct or abstractable to all situations. How’s that for a hedge? The question is:

Do you agree or disagree with the following scenario as a firm basis for Web 2.0 ventures: Raise $2 to $6 million to be spent over a two to three year period, with an exit of a $20 to $50 million sale to one of the GEMAYANI’s. Would you adjust those numbers significantly, as a general thesis? Is such a venture model an attractive VC proposition, by definition, or maybe merely acceptable in the absence of a more traditional, larger-scale exit (say, raising $4 to $16 million with a $80 to $300 million exit after 4 to 7 years)? What model has the most appeal to you these days? Ultimately, it’s a question of what entrepreneurs should be shooting for. Implicit here is the question of whether Web 2.0 is a short-term window which may close in less than two to three years.

Let’s assume an median case where the $2m – $6m raised gets 50% of the company. In this situation, the VC firm gets half of the exit, which would result in a 5x return in the best success case and a 1.5x return in the worst success case. Of course, both of these assume the exit will occur – this only happens a small percentage of the time, so you have to risk adjust these numbers down by this amount (say 1 in 100 success case, although I’d assert given the number of startups in this domain, it’s probably 1 in 1000 right now.)  So – while the “invest $2m – $6m and return $20m – $50m is a reasonable thesis”, it’s missing the “how many times does this actually happen” multiplier.

While the exit numbers are ok, they aren’t going to move the meter on most VC funds with > $100m under management. While VCs need these kind of exits, they are typically looking for are both higher multiples and higher absolute returns, especially when you take into consideration the discount associated with the probability of success.  So – investing in this general thesis is limiting in a way that won’t be attractive for many VCs.

Now there’s been plenty of blogosphere chatter about how the VC business needs to be revolutionized, how new fund types that are motivated to invest in these outcomes should appear, and how “Advisory Capital” should play a role in all of this. All that is fine – but the second question that’s asked is the really interesting one.  What model has the most appeal to you these days? Ultimately, it’s a question of what entrepreneurs should be shooting for. Implicit here is the question of whether Web 2.0 is a short-term window which may close in less than two to three years.

I’ve always invested with the idea that I should be trying to build significant companies, rather than invest for a quick flip.  Occasionally I end up with a quick flip (and I’m always happy), but – if I see an opportunity to create something large, I’d rather go down that path.  Of course, everything is circumstantial – there is often great fit with an acquirer early in the life of a company and – when this is the case – it’s often in the best interest of all parties (entrepreneurs, buyer, VC’s, employees) sell the company and for the VC to move on (remember – a VC has a limited number of things that he can handle at any given time.)

So – the invest for a quick but modest return doesn’t appeal to me as an investment thesis.  However, I’m sure it appeals to plenty of other folks, including some VCs.  Subsequently, the real answer (from the entrepreneurs frame of reference) is to understand the investor you are working with, what his underlying economic motivation actually is, and ensure that you (the entrepreneur) are aligned before you take the investment.

As to whether Web 2.0 is a short-term window which may close in less than two to three years, I have no idea.  Ask me again in three years.  However, I expect that in three years there will still be an opportunity to create great Internet-related companies.

I received the following question earlier this week.  It’s conveniently timed, as I recently participated in two angel investments – each with one of the structures defined below.

What’s the best/preferred structure of investment money pre-VC investment. We’re in the beginnings of raising angel capital (~500k) and were wondering what, if any, considerations we should make regarding the investments to allow for VC later. Should we take convertible loans or issue straight preferred stock? What are the other options that are out there for investment structure? Is it too much of a hassle to handle future investments when there is an “angel group (say 5 doctors banded together)” versus a singular angel?

Assuming that you are planning on raising VC money some time in the future, there are two different typical structures for the first angel financing: (1) convertible debt and (2) preferred equity.

Convertible Debt: This is the easier approach of the two.  In this case, the investment is in the form of a promissory note that converts into equity on the terms of a “qualified financing” (where qualified financing typically is defined by having a minimum amount – say $1m of total investment.)  The note will either convert at a discount to the price of the qualified financing (usually in the 20% – 40% range), will have warrant coverage (usually in the 20% to 40% range), or both.  This discount and/or warrant coverage gives the angel investors some additional ownership in exchange for taking the early risk.  This note should be a real promissory note with the conversion and redemption characteristics clearly defined to protect both the investors and the entrepreneurs from any misunderstandings.

Preferred Equity: This is also known as a “light Series A” – it’s preferred stock that is similar to that a VC will get, but usually with lighter terms due to the relatively low valuation associated with it.  For a very young company, a $500k investment can receive between 25% and 50% of the equity in the company and, as a result, many of the terms associated with a typical VC investment are overkill.

While either of these work, you’ll find some angels that strongly prefer one over the other.  In addition, if you don’t believe you are going to raise additional VC money and will only be relying on additional small angel-type investments, the preferred equity approach is fairer to the investors as they’ll more clearly be participating in the upside on terms that are agreed to early in the life of the company.

Finally, I don’t think there is a difference between having “an angel group” vs. a single angel investor.  However, you should try to insure that all of your investors are accredited and – if some aren’t – make sure you understand the implications of this.

A VC friend emailed me the following question(s) a few weeks ago:

The rumor this week regarding Yahoo acquiring Digg for $30M sparked a discussion here around company valuation. The discussions revolved around the key factors in valuing an early stage web technology business and how these factors are being evaluated by investors today. For example, would Yahoo or other companies be buying the technology? Are they buying subscribers? Are they buying a brand or is it a weighting of a number of these factors? Based on what you are hearing, how would Digg, Technorati, livemarks or another consumer internet business be both evaluated and valued today?

Remember the Jedi Mind Trick that goes as follows:

Stormtrooper: Let me see your identification.
Obi-Wan: [influencing the stormtrooper’s mind] You don’t need to see his identification.
Stormtrooper: We don’t need to see his identification.
Obi-Wan: These aren’t the droids you’re looking for.
Stormtrooper: These aren’t the droids we’re looking for.
Obi-Wan: He can go about his business.
Stormtrooper: You can go about your business.
Obi-Wan: Move along.
Stormtrooper: Move along… move along.

I recommend my VC friend meditate on it.  There’s been plenty said in the blogosphere about Web 2.0 companies, the notion of “build-to-flip”, the AGILEAMY gang looking to buy early stage technologies / features to plug into their platforms, and the need to transform / reform / change venture capital to accommodate these companies.  I won’t retread those discussions here.  However, I will add two things.

This is not the real VC game: While there is a category of VC firms that is deliberately looking for companies that are planning on raising a small amount of money (< $2m) and then selling quickly to AGILEAMY, this is a game best left to angel investors.  The ratios are bad (1000 companies created for every one acquisition), the upside is too small (even 10x a $2m investment – which is probably the best you could imagine – is not worth the risk / reward ratio), and ultimately there becomes fundamental tension between the VC (who wants to build) and the entrepreneur (who wants to flip).

This is a dangerous long term approach for any VC investor: Repeat after me – “there is a very limited amount of easy money.”  There’s some – but VC firms (and successful VC investments) are not made on easy money.  It’s definitely like candy – it tastes good in the moment, but isn’t particularly filling or long lasting.  Taking a great new idea with an entrepreneurial team that wants to create something significant and trying to build a real company is what is interesting.  Unfortunately, VCs will habitually over invest in new, trendy areas.  As a result, companies that have a clever product idea but don’t have a long term vision for a business will end up with $5m to $10m in the bank and the pressure to “grow.”  However, they’ll have no where to grow to – they should be small, scrappy, underfunded companies focused on trying to beat the 1000:1 odds and end up with a flip.  Once they’ve raised $5m+, they are on a different trajectory and – if in 12 months they haven’t turned their nifty product into a business – life can get really unpleasant for everyone involved.

Fundamentally, if you are a VC, these aren’t the droids you are looking for.  The same is true for the entrepreneur – be wary of the droid you pick.

I got the following question from a reader a week ago.

A project I’m involved with is aiming to go from a team of “4 founders with a great idea and a prototype” to a full fledged online service. I believe that even at an early stage, structuring ourselves to allow for growth/investment is critical. Naturally passion for our core mission, competence, and an ability to connect with the existing team are critical. Yet compensation (with an equity component) is a big part of the equation. I want people to have a sense of ownership and our current back of the envelope structure just isn’t suited at the moment for bringing people onto the team. To avoid reinventing the wheel, is there a “best practices” template for early stage companies with respect to structure/incorporation? What’s the smartest structure for an early stage company?

There are two logical choices (S-Corp or C-Corp) and a third one (LLC) that pops up occasionally.  The best choice depends on the financing path you are ultimately planning on going down.  Rather than define each of them in-depth, I’ve linked to the Wikipedia definitions which are very good.

S-Corp: If you are not going to raise any VC or angel money, an S-Corp is the best structure as it has all the tax benefits / flexibility of a partnership – specifically a single tax structure vs. the potential for double tax structure of a C-Corp – while retaining the liability protection of a C-Corp.

C-Corp: If you are going to raise VC or angel money, a C-Corp is the best (and often required) structure.  In a VC / angel backed company, you’ll almost always end up with multiple classes of stock, which are not permitted in an S-Corp.  Since a VC / angel backed company is expected to lose money for a while (that’s why you are taking the investment in the first place!) the double taxation issues will be deferred for a while, plus it’s unlikely you’ll be distributing money out of a VC / angel backed company when you become profitable.

LLC: Often an LLC (Limited Liability Company) will substitute for an S-Corp (it has similar dynamics) although it’s much harder to effectively grant equity (membership units in the case of an LLC vs. options in an S-Corp or C-Corp – most employees understand and have had experience with options but many don’t understand membership units.)  LLC’s work really well for companies with a limited number of owners; not so well when the ownership starts to be spread among multiple people.

Based on your question, it seems like you’ll ultimately want to raise money in which case a C-Corp is probably best for you.  An established lawyer who does corporate work with early stage / VC backed companies can set this up quickly, easily, and inexpensively for you – they are often the best source for the equivalent of a “best practices template” since this is routine work and requires simple, boilerplate documents and filings.

Jeff Jarvis has a superb post up called New News: Deconstructing the newspaper

A week ago I spoke at a the Metzger Associates First Annual New Media Summit – a great example of a “local” event (local = Boulder).  It was moderated by Matt Branaugh – the Business Editor of the Daily Camera (our local paper.)  Fortunately, Matt is a good humored soul so when I asked the audience the question “how many of you read the stock tables in the newspaper” and not a single hand went up, Matt didn’t throw me out of the room when I looked at him and asked “why the fuck do you guys still print those things?”

Jeff – who knows newspapers and the newspaper business infinitely better than I do, goes through the question of “why stock tables” and much, much more in his post.

Polyphasic Sleep

Jan 16, 2006
Category Management

I got a note from an entrepreneur (Steven Livingstone) who is pondering polyphasic sleep and asked the question: I’ve just blogged something looking for advice from successful people on sleeping patterns as an entrepreneur. I haven’t read much (if anything) on this and wondered whether you have an opinion on it.

Being clueless on what polyphasic sleep meant, I was fortunately that Wikipedia exists.  Stephen’s post pointed me to Steve Pavlina’s site where he’s 80+ days into a polyphasic sleep experiment.  I was immediately intrigued because I’ve always been fascinated by sleep.  Pavlina has a bunch of great writing on this – start on his Day 60 post and go to the older diary posts.  Wacky.

I have no idea if there are sleeping patterns for successful entrepreneurs, but I do know that many successful entrepreneurs like to brag about how little they have to sleep.  As someone who loves to sleep, I usually think this is bullshit and – while I can go for three or four days on relatively little sleep, I eventually crater and need 10+ hours.  Given my fascination with sleep, I’ve ready plenty (online and offline) and my personal conclusion is that everyone has to figure out their own patterns for themselves. 

Now that I’m running marathons regularly, I accept the importance of sleep as part of my overall routine and make sure I get enough.  I love to get up early, so I’m usually up between 5 and 6 in the morning, which gives me plenty of time to catch up on email, writing, and get a run in (if I want) before the “normal day starts.”  On normal days, I’m toast by 10 pm and try hard not to operate any heavy machinery after 8 pm.  I sleep until I wake up (often 10 or 11 am) on one of the weekend days; the other is my long run day and I usually get up at 6 to have an hour or two in order to wake up, eat something, and take a crap before the run.

After pondering it, I know that polyphasic sleep is not for me – I enjoy lying in bed with Amy too much.  It’d be interesting to find out if there are any real patterns among successful entrepreneurs, although I suspect there will be too much “ego-bias” in any actual study (e.g. “I don’t need sleep”) to generate anything that’s statistically correct.