Mark Suster wrote a great post yesterday titled The Resetting of the Startup Industry. Go read it now – I’ll wait.
Once again, as we find ourselves in the middle of a significant public market correction, especially around technology stocks, there’s an enormous amount of noise in the system, as there always is. Much of it is very short term focused and, like a giant tractor beam, draws the conversation into a very short time horizon (as in days or weeks). And, rather than rational and helpful thoughts for entrepreneurs, it often brings out the schadenfreude in even the most talented people.
Mark’s post is one of the first in this cycle that I’ve seen from a VC giving clear, actionable advice . One of my favorite lines in buried in the middle:
“I’ve heard enough companies say “we simply can’t cut costs or it will hurt the long-term potential of the business” to get a wry smile. We entrepreneurs have been spinning that line for decades in every boom cycle. It’s simply not true. Pragmatic cost cuts are always possible and often productive.”
Many companies have hired ahead of their growth rate because they had the cash to do so. In our portfolio, we generally don’t have this problem because we aren’t big fans of either (a) overfunding companies or (b) escalating burn rates based on headcount. But, occasionally we find ourselves in the position on the board of a company where, as you look forward, you realize you are burning more than you should be for the stage you are at. As Mark suggests, this is a moment when you can proactively make pragmatic cuts. It will suck for a few days but feel a lot better in the long term.
But, more importantly, is another point Mark buries later on, which includes an awesome post of his from 2010.
“If you need to clean up your own cap table first – while very hard to do – it will make outside funding easier”
Again, go read the post now – I’ll wait. It’s so nice there are other great VC bloggers who write this stuff so I can just point at it.
I learned this lesson 127 times between 2000 and 2005. I started investing in 1994 and while there was some bumpiness in 1997 and again in 1999, the real pain happened between 2000 and 2005. I watched, participated, and suffered through every type of creative financing as companies were struggling to raise capital in this time frame. I’ve seen every imaginable type of liquidation preference structure, pay-to-play dynamic, preferred return, ratchet, share/option bonus, option repricing, and carveout. I suffered through the next financing after implementing a complex structure, or a sale of the company, or a liquidation. I’ve spent way too much time with lawyers, rights offerings, liquidation waterfalls, and angry/frustrated people who are calculating share ownership by class to see if they can exert pressure on an outcome that they really can’t impact anyway, and certainly haven’t been constructively contributing to.
I have two simple rules for founders in my head from this experience. First, make sure you know where the capital is going to come from to fully fund your business. You might have it in the bank already. Your existing investors might be willing to provide it. Or you might need to raise it. Until you are consistently generating positive cash flow, you depend on someone else for financing. And, in this kind of environment, that can be very painful, especially if you need to go find someone who isn’t already an investor in your company (e.g. your insiders require there to be an outside lead, or you need to raise much more capital than your insiders can provide.)
Second, keep your capital structure simple. There are three things that will mess you up in the long run:
Mark’s post has good solutions for each of these, but the best is – as a founding team – to work with your investors to make sure that everyone is aligned for the upside case, rather than focused on protecting their capital in the downside case. For this, like so many other things in life, means “simple is better.” Most importantly, don’t be afraid to talk about it early, well before you have to go through another financing round.
As Finance Fridays continues, we are introducing the concept of the Cap Table. We recognize that we are still at the very early basics stage, but as we are taking a case study approach to this we feel like we have to set up all of the pieces before we get into the messy guts. Hopefully you are staying with us and finding this useful – feedback welcome!
Jane and Dick, our fearless cofounders of SayAhh, have set up an accounting system and created their first set of financial statements. This week they set out to create their cap table and hire a CTO.
The founders each have common shares that will vest over four years. The vesting schedule protects each of the co-founders in case one gets hit by a bus or decides to drop the project after a short period of time. Also, there is an important tax election called an 83(b) election that they made which allows them to recognize and pay taxes for very small income of the value of the shares. Later, if they sell, the low tax basis and capital gains tax rates result in a lower tax liability than if they didn’t file the 83(b) election.
Equity is split 55% and 45%, but where is that officially recorded? It is not in the three primary financial statements (the Balance Sheet, Profit & Loss, and Cash Flow Statement.) Rather, it gets recorded in a document called the Capitalization Table (or “Cap Table”), which shows the ownership stake each person or entity has in the business.
Below you can see Jane and Dick own 55% and 45%, respectively. As first time entrepreneurs they did not create an employee options pool; we’ll fix that in a little while.
Jane and Dick want to bring in their friend Praveena as CTO, but they don’t know how to structure the compensation. They come up with two options:
The benefit of hiring Praveena is they think they could keep more equity and control of the company. But, Praveena hails from the land of big paychecks and is not ready to leave that without considerable equity. With the funds Jane and Dick have, a big salary is not possible. Praveena wants to invest $20,000 and get 20% equity.
After several discussions (and more beer), Jane and Dick agreed with Praveena to bring her on as a cofounder where she invests $20,000 and also gets 15% equity. Praveena is just like the other two founders, where her equity will vest over 4 years. Time to update the cap table.
When you read the cap table, think of it as a series of events that add new columns to the right. Now there are two events: the initial issuance of founders common shares, and then issuing new founders common shares along with creating an options pool. In this manner, you can see both the current equity distribution of the company, as well as historically what the equity holdings looked like.
If the full pool were to be given out, the dilution is fairly significant to the founders. They would own from 55% and 45% down to 36% and 29%, but until options are exercised they are not diluted. Jane and Dick contemplated a small option pool because they had read about the risk of an option pool shuffle, but ultimately decided to make it 20% based on feedback from their friend Josh, a Boston-based venture capitalist.
Our (now three) co-founders begin building out their product. The co-founders have savings to live off of and cash will be conserved by not having any salaries. Next week we will fast forward to when they have a beta product and they build a model to pitch to investors.