Following is a question that I got from a reader of this blog on Friday.  “I have wondered about the dynamics of a restart company and how it affects employees, options and the dynamics between existing money and new money. My company took about 30MM during the boom years, did not get anywhere, and there was a restart financing round for a new product/market. However, I feel a “bad” history has an overhang even in a company’s new life. “

Since Jack Bauer got a restart last night I thought I’d take on the question today.  Restarts are a way of life in the world of VC-funded companies.  An entrepreneur starts a business.  A VC (or VCs) fund it.  Time passes.  The company gets fucked up and goes off the rails for a variety of reasons (the product doesn’t work, the market doesn’t develop, the executive team doesn’t gel, the entrepreneur gets kicked out of the company, the VCs push the company in a direction that makes no sense.)  Suddenly, a bunch of money has been invested and – while there might be something there (most notably a product or some customers) – the business has clearly stalled. The board tries to find a new investor to lead a financing or a buyer for the entire company and comes up dry.  While shutting down the company is one option, VC-backed companies often get a second (or third) life via a restart (it’s harder for most people to call the ball and declare failure then it is to put in a little more money in and keep trying.)

In a restart, some subset of the existing investors provide financing for the company.  While this can be done in conjunction with a new lead investor, in this case I’m describing the dynamics of an internally led restart.  Often this follows or is in conjunction with a change in the leadership team and a meaningful headcount and expense reduction.  In the cleanest restarts, the company is recapitalized via the new investment, reducing (or eliminating) the previous liquidation preference overhang and well as the previous equity ownership.  A “full recapitalization” (at a $0m pre-money valuation) will eliminate the value of all previous equity – this is the harshest case – typically the previous equity will receive some small share (5% – 10%) of common stock in the recapitalized entity.  There is often extensive negotiation around this since not all of the existing investors are participating in the new financing and – even though they don’t want to put any more money in – want to figure out a way to preserve some economics in the off chance that the company is ultimately successful.  This gets even more complex if the existing investors have been bridging the company with debt as some of the investors may not want to put any new money in, but want to get credit for their debt investment.  Ultimately this resolves itself because if the existing investors can’t figure out a structure that works for everyone, the company usually disappears into dust.

As part of this recap, the employees that are staying with the company will receive new options in a “refreshed” option pool that is usually between 10% and 20% of the equity of the company.  Since this is a restart, this equity also starts vesting again, although in some cases employees are given some vesting credit for previous service.

It’s kind of like Jack coming back from the dead.  Some people will think this is bad; some people will think this is good; most people will be suspicious.  While the company undeniably has an emotional overhang, a lot of companies address it by such simple things as changing their name and pretending the history doesn’t exist.  If the recap is clean (e.g. no big liquidation overhang, employees treated fairly, non-participating investors acting like big boys and girls and taking their medicine), then there probably isn’t much overhang on the restart.  If there’s a complex ownership structure with the non-participating investors and old executives hanging around trying to extract something out of their investment without continued participating, then the overhang will be meaningful.

Each restart is going to be different – as an employee, rather than default into “it’s good” or “it’s bad”, look under the hood and see if the company has a clean restart (financially and emotionally) or if it’s merely the same group of characters deceiving themselves that “a little more money will make us successful.”

I received several comments and private emails about my post on Investment Agents – Good or Bad? A colleague sent me a good follow up note adding some flesh to my comment that the ratio of charlatans to qualified agents is 100:1.  He’s asked to remain anonymous, so I thought I’d summarize his comments here – the basic message being that there are some non-trivial legal considerations for the role the placement agent plays in soliciting investors and structuring the transaction.

In general, the SEC may turn a blind-eye if the agent (or “finder”, or “banker”, “advisor”, or “scam artist”) is only working on a one-off basis and is not involved with structuring the transaction.  However, if they do it as a line of business, receive contingent compensation, or are involved with structuring transactions it can be bad news for all concerned, including increased liability for the startup if things go south.

One interesting alternative for those that only perform services for private companies is the NASD Series 82 Examination Program. It’s a little known license offered by the NASD strictly for private placements. However you still need to be affiliated with a NASD firm to take the exam and transact securities.  For the legal minded among us:

“The Series 82 examination program is proposed in connection with a proposed change to NASD Rule 1032 to implement Section 203 of the Gramm-Leach-Bliley Act of 1999 (“GLBA”), which requires the NASD, as a registered securities association, to create a new limited registration category for any associated person of a member whose investment banking and securities business is limited solely to effecting sales of private securities offerings.”

Naturally this end of the capital markets is full of gray areas.  The SEC probably wouldn’t spend much time on a VC investor complaint (we’re supposed to be sophisticated after all), but if an entrepreneur takes angel – or worse – non-accredited investment – through an unregistered placement agent they could be setting themselves up for a world of hurt.

So – if you are considering hiring an agent to help you raise money, in addition to asking for a resume, list of previously completed deals, and references, you should ask for the agent’s regulatory status.  This will help you with the charlatan:legit_dude ratio.

It’s been a quiet day today as I sit in Amy’s office in downtown Boulder and get geared up for the year ahead.  My inbox is empty, my todo list is mostly empty, and my brain is clear.  There’s something really elegant about the first business day of the year which – apparently – wasn’t today but is tomorrow.

As I enjoy the sun going down over Boulder, I’ve been reflecting on my first company (Feld Technologies).  I looked at the Business Plan series to see where I had left off and – voila – the next section to talk about is The Company.  Since I’m in Boulder, land of hippies and crystals (and lots of Internet entrepreneurs, plenty of mountain bikers, and some amazing Olympic athletes) I thought this sychronicity warranted that I crank out another post on the Business Plan.

Once the setup to the business (e.g. what industry are we going to address) is out of the way, a business plan should cut to the chase and describe what the company is going to be doing in the context of the industry it is addressing.  This was short and sweet for Feld Technologies:

As a company, Feld Technologies will focus on encompassing the entire semi-custom software concept; it will use this concept to solve problems for small businesses. Because of its generic nature, the capabilities of semi-custom software covers most of the needs for business software used in small companies.

It could have been a little simpler – e.g. “we write custom software for small business and we try to be smart about it, using the “semi-custom software” idea we described earlier.”  One paragraph describing what the company is going to do doesn’t seem particularly ambitious, so we fleshed it out a little.

The Company will gain expertise in the use of various database packages. It will build up a library of reusable software, which will improve quality and efficiency in development. It will build a customer base of lead-users who will help steer the Company toward emerging trends and needs. In these ways, Feld Technologies will add a value to its products which no vendor of individual competitive products can match.

The founders will become authorities in the field of database application programming. We will use this status to develop and market numerous adjunct database products including software and literature. We will leverage our authority to become noted consultants who create computing solutions for small businesses. Finally, we will strive to make Feld Technologies a cornerstone upon which a new segment of the software industry is built – namely semi-custom software.

We were very specific and direct.  When I look back on this, the only thing we never got around to trying to do was “develop and market numerous adjunct database products including software and literature.” We never really developed a product focus – something that is very hard for a self-funded consulting firm to do, especially one run by a 25 year old and a 21 year old.

So many of the business plans that I see (and often don’t read) have endless vague generalities and extremely optimistic assertions about what the company will accomplish.  Keep it short, simple, and direct.  Don’t be afraid to have a big vision, but make sure it’s a clear one.

Another day, another question to answer that was stuck in my “answer this question on your blog” someday folder in Outlook. 

When I got my new IBM X41 tablet in September, I wrote a glowing review of it.  I recently was asked if I still like it – three months later I’m still loving it.  Laptops usually last me six months, so let’s see how I feel on April 1st.  Ironically, I’m not using it as a tablet much (occasionally when I’m lying on the couch reading while listening to music, I’ll flip it into tablet mode so it (a) takes up less space and (b) I can monitor my email without having to move around each time something arrives in my inbox.  However, as a standard, hardworking laptop, it’s great.

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.

My friend Larry Nelson who runs w3w3.com just put up a short interview he did with me last week.  Per Larry’s description:

Here’s some candid straight talk about access to VC capital in Colorado. Brad Feld, Managing Director of Mobius Venture Capital didn’t have much good news to talk about when w3w3.com interviewed him two and three years ago. Brad gives some specific examples and offers some interesting advice for the coming year. For some, it is going to be a very good year and others will struggle. Brad points out that mid-stage and later-stage activity is very healthy.

Have you ever made an error as a result of a formula problem in a spreadsheet.  Nope – I haven’t either <g>.  A long time friend and uber-accounting-dude Frank Lincks sent me this somewhat painful story of Eastman Kodak’s recent SEC non-reliance 8–K filing due to a spreadsheet error.  Quoting from the 8–K:

 “…the Company has concluded that the severance error that occurred in the second quarter, as described above, was primarily the result of a failure in the operation of … the existing preventive and detective controls surrounding the preparation and review of spreadsheets that include new or changed formulas. The Company has concluded that this situation constitutes a “material weakness,” as defined by the Public Company Accounting Oversight Board’s Auditing Standard No. 2. The Company believes that this material weakness will be remediated by December 31, 2005.”

Oops.

In my last post in the Business Plan series, you discovered that my first company was a “software company.”  What kind?  Even in 1987, the software industry covered a wide variety of things.  As I mentioned before, the Introduction section of a business plan should start with a general overview (“microcomputer software”) and then get specific (“database stuff”).  By the end of this section, the market segment you are targeting (in this case – “semi-custom software”) should be defined.

The early days of microcomputing were plagued by a lack of software. The hardware component of the system evolved the quickest; software developers were always playing catch-up. Support tools for software companies were limited forcing the programmer to invest a significant amount of time in developing toolboxes for use on a particular machine. As a result, software developers often sacrifice the flexibility of the applications they were developing in order to simply get them to work. This changed with the advent of the IBM PC which prompted an epidemic of fourth-generation application development languages, more commonly known as database languages. For the first time, the microcomputer software developer could focus on the issues underlying his application instead of spending all his time trying to implement the application on a particular piece of hardware.

Today, database languages are beginning to replace conventional languages within the context of application development. The trend has reached a critical mass; new database languages are emerging weekly. This outbreak of products has served to legitimize a new approach to application development.

These database programming languages can serve as a basis for a new type of application development – semi-custom software. Semi-custom software is a divergence from existing software product offerings. In a semi-custom environment, the benefits of mass-produced systems and custom software are combined. A reusable “shell” is designed for a specific industry – this is the systems component. Instead of packaging and selling only the shell, a semi-custom company modifies it to fit the client’s specific needs. Some custom software is written and integrated with mass-produced software. As a result, the customer essentially gets a software product that fits his precise needs (emulating a custom product) at a systems software price.

In 1987, “semi-customer software” was a new concept.  Database languages (or 4GLs) were becoming popular (remember dBase and .dbf files?) and were starting to incorporate mainstream programming capabilities (most notably procedural abstraction – a big deal at the time).  The things we now call “packaged applications” were going by pre-ERP TLAs such as MRP, CAD, CAM, and POS (“point-of-sale”, although most were about as good as the other use of the acronym).  We felt like there must be something in between a custom application and shrink wrapped software and decided to try to coin the phrase “semi-custom software.”  While this phrase didn’t stick, the concept ended up being very relevant and foreshadowed the packaged software revolution.

Jim Collins has an outstanding short essay titled “Lessons From A Student Of Life” as a tribute to Peter Drucker in the 11/28/05 Business Week.