I’m sure I have to pay someone to put this up on my blog legally. 

Thanks njschock – nice use of the for:bfeld del.icio.us tag.

This just in from Matt Blumberg, a CEO of one of my portfolio companies that is enjoying pondering what to do about 409A.

She’s real fine?
Or tile cleaning fluid?
No – IRS mess.

IRS Regulation 409A really sucks. While I’m probably now on some audit watch list as a result of speaking my mind, there really isn’t any other way to state it. Jason Mendelson and I were bitching about this today as we pondered how to deal with it and decided that we might as well try to constructively air our thoughts (and help educate our entrepreneurial and venture brethern on some of the issues) via a 409A Series (similar to our Term Sheet and Letter of Intent series). Remember – we aren’t lawyers (ok – Jason is…) and this isn’t legal advice – just the thoughts and opinions of two guys dealing with this stuff everyday. 

In case you missed it, proposed IRS Regulation 409A, dealing with deferred compensation, is making everyone in the startup community run around like chickens with their heads cut off. It’s a broad regulation, but in a nutshell, for private companies it redefines the way companies determine fair market value in granting stock options. In the “old days” (before I was 40 years old) the board would spend time and make a good faith determination what the fair market value was and grant options. Now, companies must formally value their common stock options (by one of two prescribed methods that we’ll get to later) or risk the penalties should they be wrong with their option pricing. Please note that this regulation also affects public companies, venture capitalists, severance contracts, any sort of deferred compensation, etc., but we’re only going to focus on the private company option pricing nightmare.

Because everyone likes the punch line, the simple answer to “what are the penalties?” is this: The penalty for undervaluing options is that the option holder gets taxed at normal income rates on the “spread” (difference between the grant strike price and what the IRS deems the “correct” value) as if it was income given to him by the company PLUS an additional 20% tax on top of this in further penalties. Furthermore, the company gets penalized on withholdings it should have made on this additional “income” it provided to the employee. 

But wait, it gets better. Did we mention that these are only proposed regs, but the IRS says everyone must comply with them immediately as if they will be adopted and oh yeah…. they’re retroactive also and any stock option that still has vesting left as of January 1, 2005 is subject to the regs. Yes, if you granted or received an option in mid-2001 with typical 4 year vesting, congratulations, you are subject to 409A.

Basically, everyone involved gets fucked. 

Interested? Scared? Reconsidering a new career as a 409A valuation expert? In this series we’ll take your through some detail on the joys of 409A. If you are a masochist and want some good reading, Cooley Godward has a good overview online as does O’Melveny & Myers.

In the mean time, sleep well.  While we wish we could spray some Formula 409 on this and make it go away, we know the value of facing reality and will provide some addition information in our next post.

Fred Wilson has an awesome blog on The VC’s Customer.  The first few sentences summarize the post.

Many of the people I know in the venture capital business think their customers are their investors, called LPs in the industry vernacular. I’ve always thought that was dead wrong.  The entrepreneur is the customer and the LP is the shareholder. That’s the only way to think about the venture capital business that makes sense to me.

I agree 100% with Fred’s perspective on this.  Both my shareholders (my LPs) and my customers (the entrepreneurs) are critical to my business.  But I (and Fred) think it’s important to be clear on which is which.

Well – it’s about 20 days after the end of the quarter and the Ernst & Young / Venture One survey of venture capital funding is out and the Denver Post and Rocky Mountain News feel compelled to comment on it.  I really like Roger Fillion who wrote the RMN article (I don’t know Will Shanley who wrote the Denver Post article), but as I said to Ross Wehner from the Denver Post last quarter, “Who Gives A Fuck?”

Whether the data is right or not, the conclusions are misleading.  Both articles assert that the market for VC investment in Colorado has “grown” over 2004 and that it – according to local VCs – “has definitely gotten stronger.”  But – no one really digs into the data beyond suggesting that through Q3 Colorado firms have raised $469.2m vs. $386.8m in 2004 and that in Q305 Colorado firms raised $131.7m vs. $107.8m in Q304. 

As I suggested last quarter, one deal – Webroot – raised $108m – and most of that was to buy out the founders (is this a VC deal or a private equity deal done by VC firms?).  This quarter, one deal – Replidyne – raised $62.5m – in a well executed late stage deal.  If you leave Replidyne in (it is a VC deal, albeit one that skews the numbers) but take Webroot out, Colorado is actually at $361.2 through Q305, behind 2004!  Interestingly, in the quarter, Colorado saw 13 deals in Q305 and 13 deals in Q304 – that seems equivalent to me (although my logic is rusty: 13=13 is true, correct?)

It’s all about how you analyze the numbers and – in the rush to simply publish that “things are good” or “things are bad” – the papers do everyone a disservice by not really digging into the actual data.  I’d love to see the full list of fundings in Q305 in the articles on the web compared to Q304 with some thoughtful analysis of what is actually going on in the market.  As a local player, it feels “about the same” to me as last year, although I spent two thirds of Q3 in Alaska and the balance of it on the road so I’m a lousy data point also.

As part of the VC Advisory Board for Microsoft’s Emerging Business Technology group, I like to say that I work for Microsoft three days a year (this is how often the EBT VC Advisory Board meets).  We have a meeting coming up this week and – as I get ready to trek up to Redmond – I was pondering the meeting agenda when I came across Dan’l Lewin’s (who runs EBT) recent post titled “Should Microsoft Invest in Startups?” 

I have huge regard for Dan’l and have always really enjoyed working with him.  While I’m not a Microsoft shill, many of the companies that I’ve been involved in – going back to the very first company that I started – have had “deep and meaningful” relationships with Microsoft.  While I’ve been on the wrong end of things with them at times, the benefits of the relationship have far outweighed the costs.  Today, Microsoft is a huge place and understanding how to navigate them, work with them, and be effective is non-trivial.  Dan’l and his team do a great job of helping VCs and VC-backed companies – it’s rewarding to see some of the ideas and philosophy that we bandy around in our Advisory Board meetings come out in Dan’ls public thoughts.

When I was a child, I had a fleeting glimpse of my future.  My mother used to tell me to “pay attention” as my brain wandered off to something else. Little did I know that – according to Dave and Seth – I was training for my current gig. 

My training went so well that when Amy says, “Brad, have you been listening to me?” I can repeat back the last few sentences that she’d said. This continues to be one of my favorite marital party tricks.

Pascal Levensohn just put up a teaser post about his upcoming white paper addressing venture governance and the CEO succession challenge.  I’ve referred to this paper in the last two posts I wrote on signs that a board should consider replacing the CEO and talking to fellow directors about replacing a CEO.

I recently posted about the signs that a board should consider replacing the CEO.  My partner Heidi Roizen came up with these as her answer to a question posed by Pascal Levensohn for a new paper that he is writing on the “Ten Signs That It’s Time to Make A CEO Change in A Venture Backed Company.” 

Pascal asked two questions in his interview request.  The first, which I addressed in the other post, was “What are the five most important signal indicators to you that it’s time to replace the CEO of one of your portfolio companies?” The second question was “When you have approached your fellow directors to tell them that you think the current CEO needs to be replaced, what has been the most difficult thing you have had to address in convincing them to support your position?”  As with the previous post, I’ve started with Heidi’s response and edited freely.

Before I dig in, recognize that none of this is easy stuff, for the VC, the CEO, or the board.  So – my comments below are from a VCs perspective and are not intended to be “balanced.”  Rather – I’m trying to give a feeling for what the underlying issues are, what is “good” vs. “bad” behavior, and to address one way to think about this.  I’ve been involved in many situations where a CEO had to be replaced – they fall into two categories “it ends happy” and “it ends unhappy” – I really haven’t had anything “in-between.” 

Interestingly, in many situations the other board members have arrived at the same conclusion that the CEO needs to be replaced.  However, individual directors tend to come to this conclusion on different time frames depending on their personalities, their level of engagement in the company, and their comfort level (or lack thereof) with CEO level confrontation.

The biggest point of resistance among directors is that there is never a “good” time to replace a CEO.  Startups are fragile things and CEO changes rattle customers, employees, VCs, VC’s partners, vendors, parents, children, and pets.  As a result there are often holdouts on the board who want to limp along and avoid dealing with the issue, particularly if there is a “transaction” looming such as a large customer opportunity, another financing, or an M&A deal.  My experience indicates that it is never a good idea to limp along.

Replacing a CEO can be the hardest work a board has to do.  Once the decision is made, you (you – in this case – refers generally to “the board”) have to start by dealing with the issue directly with the CEO.  You have to fire them and then figure out what the transition plan is going to look like (never fun after you’ve fired someone, especially if they don’t think they deserve to be fired, act irrationally, throw things at you, immediately call their lawyer, or simply walk away.)  You then have to articulate what you are looking for in a new CEO.  You have to figure out how to keep the company operational in the interim, both at an executive level as well as across the entire company. If you decide to use a recruiter, you have to find them, spend time bringing that person up to speed, go through interviews, reach consensus, then land someone, and deal with not only their comp but the repercussions on all the other comp and equity holdings among management.   Oh – and most capable new CEOs want to make sure the company has enough capital to insure that it is successful, which often means providing a new financing as part of bringing a new CEO on board.

Some VCs devolve into non-constructive behavior when faced with a CEO that is not performing.  Rather than addressing the issue directly, the VC becomes angry and hostile to the CEO, asks for irrelevant data / meetings / homework assignments from the CEO, and behaves in a surly, unproductive manner at the board meetings, bitching about the CEO in private to other directors, and generally being passive aggressive about the situation.

A wise and extremely successful VC (let’s call him Yoda) once said, “Every morning when you get up, think about your company’s CEO and decide whether you are going to support him or not.  If you are going to support him, do everything in your power to help him make your company successful.  If you are not going to support him, then replace him.”  By saying “help him make the company successful”, I don’t mean that the VC should be only a cheerleader, but that she should include lots of tough love type stuff that may not necessarily feel like support at the time. 

While this sounds simple, I often see VCs become “just another problem” for the CEO. This is a lousy situation.  I’ve personally evolved a very simplistic point of view, which I describe as “I support the CEO’s of my portfolio companies 100%, until the moment I don’t, at which point I act on it.”   With this lens on, I can spend all of my time “working for” the CEO, rather than having the CEO feel like he works for me.