Altgate

Topics Covered On This Blog (So Far)

Once again, here is a list of some of the more popular posts on this blog:

Raising Capital:

The Science & Art of Term Sheet Negotiation
Dating...er...Fundraising Etiquette
How to Get Introduced to VCs
How To Raise Money From VCs
Top 10 Tips For Entrepreneurs Pitching VCs
Venture Debt For Startups
How Not To Select A VC
What To Expect In Due Diligence

On Startups:

Board Management Tips For Startup CEOs
What To Include In A Board Package
Founder / CEO Succession
How To Pitch The Press
Hiring Your First Salesperson
10 Things To Consider Before Joining a Startup
Interview with Professor Noam Wasserman
'Tis The Season To Change The CEO
Sales Learning Curve
Sales is a Science, Not an Art
Startup Compensation
More on Startup Equity Compensation
Equity Compensation Strategy
Startup Entertainment
It's Lonely at the Top?

Industry Commentary:

Death of Headhunting
I Need a Social Network Aggregator!
Overjustification Effect and Web 2.0
Plaxo 3.0
The Future of Job Recruiting?
Mobile Posse Launches Idle Screen Advertising
On Wikipedia Fraud

Personal Commentary:

U of M Solar Car Team Crashes; Earns Moral Victory
U of M Solar Car Team Unveils New Technology
2007 University of Michigan Solar Car Team
Alternative Energy No Longer Just For Tree Huggers
Just When You Thought You Were A Good Dad
I want That Job!

2007 IT Startup Compensation Study

The latest edition (2007) of this valuable resource is out.  With a few years of tracking these data, as expected, there aren't many big changes from 2006.  The average base salary across all positions surveyed increased about 5% over the previous year and the cash bonus (as a percent of base salary) remained about the same.  There is still a "founder discount" in terms of cash compensation. 

There were a couple of new questions that highligt some interesting points including a question about target cash bonus (versus actual bonus paid).  It turns out that the actual bonus was about 2/3 of target when averaged across all positions--the implication being that on average startups deliver about 2/3 of what they claim. 

The other interesting point is regarding recruiting where investors source less than 20% of new executive hires which is not a great testament (on average) to the "value add" of venture investors.

The one issue not addressed (yet) in this study is the "first time discount" which is hard to quantify in a survey but is very much there in reality, i.e. a first time CEO gets a significant discount as does a director stepping up to a VP job, etc.  Who knows, maybe we'll see that in the 2008 report!

What A Coincidence!

So earlier today I did a blog post on Simulscribe and their voicemail-to-text service, and not 10 hours later I get an email from Vonage saying I've been selected for a free trial of their new "Visual Voicemail" service (essentially the same thing but for my home phone).  Weird.

Cool Vmail-to-Text Service

I recently signed up for a service by SimulScribe that converts voicemail messages left on my cell phone into email (with an audio file as an attachment).  It's great for those situations when I'm in a meeting and can't answer the phone (but do have time to look at my email).  Apparently the way it works is that the messages are shot off to some call center in India or China, transcribed and sent back.  There might actually be some voice recognition software in the middle there somewhere, but either way it's all transparent to the end user.  It takes only a few minutes to sign up (surprising given how Byzantine the carriers can be) and you don't have to change anything on your end or on the end of the folks leaving a message.  My only beef with the service is that the delay between the phone call and the email could be shorter (sometimes it's 10-15 minutes) and the service is a bit over priced for what you get, but overall I love it!

How To Raise Money From VCs

This guy is funny!  He's the Gary Snoman of 2008!  There are a lot of nuggets here on raising VC...my favorite is #3, "when VCs understand something they like to say that it'll never work [so] the less understandable you are the more attractive you are!"

Q&A With Dee DiPietro on Startup Compensation

In a previous post I mentioned Dee DiPietro, CEO of Advanced HR, who is a seasoned startup compensation expert. Well, over the past couple of weeks, I've had the opportunity to have an email Q&A session that I put together here on the topic of equity compensation philosophy in startups.

FN: What philosophies have you seen work in terms of how to use equity to compensate employees?

DiPietro: Although compensating at the 75th percentile of equity is always a great practice, the key to a successful equity program is communication versus any one particular strategy. I have seen many lucrative programs that were marginally effective (read as employee discontent and turnover) due to a lack of communication to employees – resulting in a lack of belief about potential value or position against the market. In the absence of information, people tend to construct their own information which is typically not the same information as the company beliefs. A second key to a successful program is hiring the right people for the right stage of company development. Early stage employees that are comfortable with a larger equity stake and higher risk may not always be a long term fit for the later stage company. Conversely, more risk-adverse people do not typically value equity compensation as highly and opt for a later stage package with a larger cash component. This does not mean that salaries are significantly reduced in private companies as was typical prior to the late 1990s but rather positioning in the market and the size of cash bonus provided.

FN: What’s your view on option refreshes?  When do they work and when not? 

DiPietro: Option refreshes are now a critical part of an equity program due to changes in acceptable metrics for private companies to achieve before an [exit]. Up through 2000 when a typical path to an [exit] was about 4 years, a refresh program was not conventional in privately held, venture backed companies – although I personally found this practice a bit short-sighted for retention after an IPO or sale. Now that the models for development have changed to larger revenues with typical development times of 5 – 6 years, a four-year grant without refresh is not an effective retention tool. Most companies wait until vesting is at least 75% or three years complete before implementing a refresh program and this practice puts the company in a reactive versus proactive position. At this point, the early technical team is seriously considering diversification, especially in light of a lack of information about refresh practices. So, for each person who gets an offer from a public company, the thought process goes like this: I am valuable but not critical to success so they can replace me, the company will go on and my stock will be worth something. I will get a sign on bonus and have two weeks of vacation that will need to be paid so I have enough cash to exercise options the 80% of my options that are vested. I will get an increase in base salary of 10-15% and I will get an annual cash bonus of 20% so I will have paid options in a private company with potential upside and a cash package from a more stable public company. In successful schemes I have developed, companies do not wait as long to implement refresh programs but there were difficult choices to be made and communicated to the board. The primary factor in developing an effective compensation program which includes refresh is the competitive stance required for the labor market in which you are competing for your talent.

FN: Is there really a cash-equity tradeoff?

DiPietro: At the executive level where there is a larger amount of equity being given, most definitely. Data typically shows a 20-25% reduction in exec comp compared to small market cap companies. For a few early hires who get a larger equity stake, quite possibly more. But for most positions, no. A company is lucky to be able to use equity to offset bonus for some period of time.

FN: It seems that use of equity ebbs and flows, where is it now and what’s the outlook?

DiPietro: The changing practices in public companies will make use of equity for staff level positions more strategic and less prevalent as many have focused changes necessitated to address equity spend and dilution issues on the staff level grants versus executive. However, the use of cash has increased significantly to offset these changes. In response, privately held companies will need to determine the best use of their available compensation elements to compete effectively. In consideration, one might wonder what this will do to current investment models and the decisions boards will make when faced with increased cash spending resulting in a delay of liquidity versus increased option pools resulting in reduced investment return.

Quote Of The Day

A few days ago I was talking with a VC about the attributes of successful founder/CEOs.  When describing one of the better performing companies/CEOs in his portfolio he said, "She always delivers on the numbers...not because that's what I want, but because she thinks that is how she'll get rich."

Point being that entrepreneurial success is driven by vision and conviction and not by following directions.

The Science & Art of Term Sheet Negotiation

By the time I was in the 9th grade, I had been playing chess for a few years (as in I knew the rules) but I didn't play seriously and more often than not I lost.  Then one day at the library (remember, pre-internet) I happened to find a book on chess.  So I read the book and almost overnight I became one of the chess "stars" in high school.  In one of the funnier incidents, I started playing chess during lunch hour and was "hustling" money which on one occasion resulted in a kid pulling a knife on me after I relieved him of a few bucks.  True story.

What was it in that book that allowed me to take advantage of the situation?  Well, there was a lot of basic stuff, some general rules and even some strategy, however, the most useful bit of information, initially, was a table on the relative value of pieces.  You know, a pawn is worth 1, a knight/bishop 3, rook 5, a queen 9 and the king "infinite" unless it's the endgame then it's more like a 4.  Experienced players have a "feel" for this from many games played and they can also break the "rules" by, for example, sacrificing a queen for a rook to get better position.  But these are all things learned from experience and best not tried by a novice.  If you are new to the game, you have no idea.  When you are starting out, having some rules of thumb can make all the difference between winning and getting hustled.

What does this have to do with negotiating term sheets?  Well, I think a lot of newbies get hustled when negotiating term sheets because they don't know the relative importance of the various terms.  Have you heard the joke about the VC who says, "I'll let you pick the pre money valuation if I get to pick the terms?"  My goal here is to provide a framework that gives relative value of various terms on a term sheet and allows you to compare them on two dimensions: economics and control (or as my friend Noam Wasserman likes to say, "rich" versus "king").  In the same way that a chess grand master doesn't need rules of thumb from someone else, if you're a seasoned negotiator of term sheets then this is probably equally useless.  And no, this is not based on any academic or scientific study.  It's based on my own experience and, more importantly, that of a few other experts like Dave Kimelberg (Softbank's GC). 

In my view there are 12 important terms on a typical Series A / B term sheet.  Yes there are other terms and yes sometimes they are important, but if you go with the thesis of keep it simple, then 12 is the magic number.  In terms of rating, the rich/king differentiation is important as different people are after different things so depending upon your motivation you may be inclined to pay more attention to one column than the other.  So without further adieu, below is a table showing them as well as the relative importance:

Term	Rich	King
1. Investment / price	10	-
2. Board of directors	-	8
3. Option pool refresh	10	-
4. Preemptive rights	1	3
5. Andi-dilution protection	5	-
6. Registration rights	1	1
7. Drag along rights	1	5
8. Right of first refusal / co-sale	5	-
9. Dividend right	5	-
10. Liquidation preference	7	-
11. Protective provisions	-	8
12. Redemption	1	-

Here a 10 means it is really important to get as favorable a result as possible on this term, a 1 means it is not so important and a "-" means it doesn't apply (i.e. a zero).  The cool thing about having something like this is you can use it as a tool to compare term sheets (provided you can determine how favorable or unfavorable each individual term is...more on that below). 

The next part of this post is to provide a range of typical results for each term which will give you a means to rank each term in each term sheet with a "1,3 or 5" where 1 is "unfavorable", 3 is "fair" and 5 is "favorable."  If you aren't already familiar with the terms in a term sheet, you should check out the model term sheet (basically a template) put together by the National Venture Capital Association.  They have other model agreements too, but you will see with the term sheet that they include various options, some discussed here.  Below is a scale for each of the 12 key terms across the two dimensions:

1. Investment/price.  I think there are two ways you can rank price.  One is to rate it relative to your expectation and another is to rate it relative to similar companies (in terms of stage, geography, sector, etc.).  If you don't have comparables, you can fairly easily get them, for example Dow Jones puts out a quarterly survey of VC deal terms which includes pre-money valuation (send me an email if you want a copy).  If you're less than 80% of your benchmark, that's probably unfavorable, if you are within +/- 20% than that's fair and if you're over 120%, then it's favorable.
2. Board of directors.  This term comes down to simple math.  If you give up and don't have control of the board, that's unfavorable, if it's tied, call it fair and if you control it, that is quite favorable.  BTW, the reason I didn't rate the board control a "10" on the "king" scale is because even when you give up control, your board members are bound by fiduciary obligations to the firm, i.e. they can't do whatever they want.
3. Option pool refresh.  Often time this will show up as a separate term in the term sheet, however it is actually just another bite at the apple in terms of price.  Traditionally there is a refresh pre-deal so that after the round the company can execute on its hiring plan without needing to expand the pool for 12-18 months.  You will have to develop your hiring budget if you haven't already.  Given that benchmark and your hiring equity budget, I'd say less than 12 months is favorable, 12-18 months is fair and more than 18 months is unfavorable.
4. Preemptive rights.  As you know, preemptive rights give your investor the right to invest in future rounds.  This is of moderate economic value, however you are giving up some control of future financings.  There is remarkably little variation in how this term gets negotiated, probably because of its relatively low importance in the grand scheme.  I'm told the only area that gets negotiated is whether the investor has an "overallotment right" whereby they can take a portion or all of the pro rata of another investor in the same series who didn't participate.  That said, unless something unusual is in your term sheet, it's probably a 1 for rich and 3 for king.
5. Anti-dilution protection.  Anti-dilution is a pretty important economic term.  In terms of the range of possibilities, no anti-dilution would be a 5, broad-based weighted average would be a 3 and full-ratchet would be a 1.  I think the vast majority of deals end up as broad-based weighted average.  Very few deals avoid it altogether, but it can be done, particularly in later stage or very hot deals.
6. Registration rights.  Reg rights have some economic value and in theory you do give up some control, but in reality they're close to worthless.  You can push on these and most investors will give in when pressed. You can negotiate when the right kicks in and cutbacks.  But bear in mind that investors will love it if you waste time negotiating this because it is not an important term.  Unless something unusual is going on, I'd rate this a 1 on both dimensions.
7. Drag along rights.  Most deals include drag along rights and like many of the other terms, the key is in the voting thresholds.  I rated this a 1/5 on the rich/king scale.  In terms of economics the issue is with regard to a sale of the company where the preferred stock, because of special rights, is indifferent to a deal that would be better for Common.  However, the bigger issue is on the control side of the equation where you could get dragged into a sale that you don't want to do.  So in terms of rating both the economic and control sides, I would say that if the thresholds are such that a single investor can unilateral drag along, that's a 1, if it takes 2 or more investors that's a 3 and if it takes investors plus either a neutral party or Common (you) then it's a 5.
8. Right of first refusal / co-sale.  I rated this a 5 because this is essentially a "lock-up" on the founders stock which seriously affects liquidity and thus value.  It doesn't really affect control issues.  If you read the actual section of the stock purchase agreement that describes this term it's several pages of bureaucratic procedures for a sale that in the real world you can't imagine ever occurring (which they don't).  As a result, the only real counter party for selling common stock is the other investors or the company with the investors approval and they're all quite likely to low ball.  Unfortunately, I've never heard of avoiding this term completely, so in terms of how to rate it, I'd say that if you can negotiate a right to sell some portion (say 20% on an annual basis) you're at a 5 otherwise if it's a standard lockup then you're at 3.
9. Dividend right.  I rate this a 5 on the economic scale.  In terms of the range, there is no dividend which is a 5, then there is a simple interest dividend which I'd say is a 3 and a 1 would be a compounding dividend.  For some reason, the dividend rate has been 8% ever since I've seen term sheets.  You can negotiate the rate, but the bigger battle is whether you pay a dividend and how the rate compounds. 
10. Liquidation preference.  This is a very important economic term that doesn't have any importance in terms of control.  The issue here is during a sale, how do investors get paid out.  I'd say about 1/3 of deals have a preference at 1X but no participation, another 1/3 have a preference with a cap and participation and the balance a preference with no cap plus participation and that's pretty much how I'd rate it, i.e. 5 for 1X preference/no participation, 3 if with a cap in the 2-4X range and 1 if with no cap and participation.
11. Protective provisions.  This is very important from a control perspective but not so economically.  While there are a ton of these protective provisions, the key ones relate to sale/merger of the company and future rounds of financing.  As with other control rights, the key is in the voting thresholds so I'd assess this the same as 7 (drag along rights).
12. Redemption.  Finally, we get to number twelve, redemption rights.  This is an almost worthless economic right.  I've never seen or heard of this being exercised and most investors will acquiesce if you push on this.  Unless you see something unusual, I'd rate this a 3.

Ultimately the individual rating combined with the overall importance of each term will allow you to create a weighted average total for each term sheet on both the rich and king dimensions.  While you wouldn't want to make a decision to take an investment on this alone, it will give you a basic idea of where the strengths and weaknesses of particular term sheets lie.  It also gives some tips for negotiating.  For example, you don't want to waste your time negotiating redemption rights and attorney's fees and instead, you want to go to the core of what's important to you on the rich/king scale.

Finally, I'd love to hear feedback from folks.  How would you change the ratings?  Are their other key terms?  Feel free to comment on this post or send me email.

Startup Compensation

As I mentioned in previous posts, I've been on the hunt for some good equity compensation data for startup employees, particularly those employees beyond the top handful of executives.  Prof. Noam Wasserman conducts an annual survey of compensation in startups, which is incredibly useful, however it only covers the top 10 or so positions in each company.  Over the past month or so, I have spoken with many different companies that compile comp data a number of which purport to have equity information, but it turns out that all but one have either very thin coverage or incomplete information (for example, one firm did a survey asking how many options each position had, but failed to ask how many shares on a fully diluted basis were in the company).

The one exception I found to this is a company out in California called Advanced HR.  In fact, Noam put me on to these folks and the founder/CEO, Dee DiPietro, was kind enough to spend a couple hours talking with me and giving a demo.  The company has survey information from several hundred VC backed startups for many positions.  The data is very well organized and from my 30 minutes or so poking around, seems to have enough coverage to be useful.  If you're a startup and you contribute your company's data to the pot, then you get access to the exec comp data free and the rest of it for a nominal fee.

Here's why I think this is important.  When granting equity options, most startups use some fairly well established rules of thumb or even survey data for the top executive positions, but grants to the rest of the team are usually done with a one-size-fits all rule or some other random method and the result is that some equity is "wasted" on those who don't value it and others are demotivated by being under compensated.  I think the key is to get the equity compensation for "middle management" right, i.e. Directors and Sr. Managers.  This is where the data from Advanced HR comes in handy as they have coverage on these positions.

So my recommendation is to get as much comp data as you can when designing your equity pool and making grants.