Sign Up for the Focus Beta

The new software is coming along slowly. Ironically, it’s to help people focus while using the computer, and I’ve had trouble focusing throughout the development progress.

While the software isn’t just for those with ADD/ADHD, it’s been helpful for me ever since I finished a few features that help block out distractions. A few years ago I was formally diagnosed with ADD; if you know me this likely won’t surprise you.

To sign up to try the software, please click here. Your feedback can significantly influence the design and functionality, and will be helpful to anyone who adopts the software.

Private Beta

I’ve been working on something for about 6 months. The results are decent, but it’s not where I want it to be yet. It’s time for feedback!

The software is designed to help me focus. The funny thing is, it’s taken so long to get it finished because I’m having trouble focusing. With the software near completion, it’s definitely been helpful for managing my time better. Maybe it can help you too. And maybe you can give me some direction and feedback.

Please sign up for the private beta. I’ll send an email in a week with instructions for participation.

OTHER SOFTWARE LIKE THIS
There’s a lot of software for managing tasks and time. There’s even software very much like what I’m building, but it’s more big-brother software than personal productivity software.

The reason I decided to build this is that none of the software really worked well for me. As a guy who struggles with ADD, I found the other software too distracting or too cumbersome. This isn’t perfect yet, but it’s decent, and it will get a lot better in the coming months.

Thanks for helping out.

Startup Equity Allocation

I might be building a new team for the new company. While I’m a little reluctant to do so because it’s always a risk, I do miss having people I can count on and who are pulling for the work we’re doing. Teams can be great (and they can break down, as well–a subject for another post).

So a question I get from entrepreneurs is how to allocate stock. There are a lot of other posts about this, so I’m not going to do into great detail here (just Google “startup equity employees” and “Feld startup equity”). But here are a few thoughts.

  • Don’t be greedy.
  • There’s negative dilution and positive dilution. Positive dilution is when you give stock or options and are diluted as a result, but the person creates more value than the cost of the dilution. Negative dilution is when the contributor doesn’t increase the overall value of the company, or worse, hurts it.
  • Create a formula for “deferred” pay. There’s really no such thing as deferred pay. There’s pay not taken, and if it gets made up in the future, it is through bonuses, salary increase, or equity. If an employee takes less money for the same work, I value that more highly than the cash value and will give that employee more for their deferred salary in equity than the dollar value. Early on, 50% discount on equity makes sense.
  • Don’t value your own company. You have no idea how much your company is worth. It’s not a million. It’s definitely not $5 million. You don’t know until someone pays money for stock.
  • So if you don’t know, then don’t allocate shares according to number of shares, allocate based on percentage of ownership.
  • For the first 10 employees, don’t allocate less than 1% per employee, and give key employees more. If you have 3 key employees (not including founders), give them 4% each with typical 4-year vesting. That’s 12%. Of what? You have no idea, nor do they, but you’ve given them great incentive to kick ass. Let’s say the other 7 get 1%–so that’s 19%, and we’ll round up to 20% just for ease. That leaves founders with 80%.
  • Plan on dilution. You’ll get diluted by new employees, but at a slower rate than the first 10. Expect at least 20% dilution in your first round of funding, plus any friends and family money.
  • Don’t sweat the dilution. What matters are two numbers: your exit number, and your percentage of the exit. You’d rather have 10% of $50 million than 50% of $10 million, assuming it takes the same time and effort to get to both exits. But if you can get to $5 million twice as fast, take that route, because your time on Earth matters.
  • Don’t hire VPs or CEOs until you have a model that’s really working–meaning you have customers, revenue, and can sustain yourselves. Too many startups get top-heavy too soon, just to satisfy investors need for feeling safe and confident. Screw that–you know more than anyone what you’re doing (and if you don’t, you’ll find out).
  • Pay consultants equity instead of cash if you can, and give them the same deal you would give friends and family investors. If friends and family get a 30% discount on the Series A round for investing before that round closes, apply the same discount to the consultants deferred pay.
  • Cash is king. So don’t spend a lot on marketing, on lawyers, on deals, on mergers, on anything other than 1) serving customers and 2) serving customers.
  • Your equity is worthless without customers. Start every day asking how you can reach and serve customers that day, and if it’s too early to charge them, set a goal of getting 10, 20, 50 customers who will use your stuff for free. Their feedback and insight will solve a lot of problems for you and can create significant value down the road.

I have to get back to coding. Last year I started a book, and I’ll include a lot more about equity in that and make it available here. Regardless, the overall message here is to have an abundance mentality, and positively incent your employees to find and serve customers extremely well.

Strategic vs. Linear Acquisitions

Acquisitions are up from the same time last year, mostly because the economy had everybody holding their collective breath while they figured out how and where the failure of the economic system would kick them and how hard.

The exhalation started sometime in Spring and is about to accelerate–it’s a perfect time for companies with cash reserves to pick up strategic targets. A friend on the West Coast has advised a few recent acquisitions, and his update got me thinking about it.

Note: These views are from an industry observer–I might have some of this wrong, but this is my take. The M&A experts will likely want to pipe in with adjustments and other perspectives.

So what makes an acquisition strategic?

Typically, a company is acquired by a complementary company for its team, its products, the revenue from those products, and its profitability (EBITDA).

Profitability is an obvious reason; take a company’s price/earnings ratio, add profit to it, and the stock price will likely increase. A company with $5 million in profit annually buys a company with $500k of profit and similar cost profile, and its market capitalization (and stock price, of course) should increase by 10% on the merits of increased profit alone.

But that’s a linear acquisition.

A strategic acquisition is one where the combination of the assets and activities of the target company increase the value of the acquiring company on a non-linear, upward basis. That is, the buyer gets more than they paid for, with an eye toward long-term growth enabled and accelerated by the acquired company.

In the software industry, a strategic acquisition contains these elements:

  • The target brings specific technology that enhances core product offerings
  • The target brings products and platform that have modest, demonstrated support from third-party developers, which in turn act as an external sales force because of the dependency on target’s platform
  • The target’s platform enables external value creation for the target’s product lines
  • The target’s platform enables external value creation for the acquirer’s product lines
  • The target’s products generate immediate revenue and profitability when introduced to acquirer’s existing customers, channels, and distribution partners
  • The target’s products and platform give reasons for existing customers to stay with acquirer, saving potential lost revenue.

The financial difference between a typical, linear acquisition and a strategic one is typically one of significant multiples. In the example above, the acquiring company increases in value on a 1:1 basis, with profit as the driver.

But for strategic acquisitions, the multiples range from 5 times revenue to up to 100 times revenue—there’s really no cap on strategic value, just the eye of the beholder. If Microsoft (as an example) views their strategic need as

  • something to add tens of thousands of external salespeople (developers, companies, evangelists, etc)
  • something to increase the revenue per customer
  • something to counter competitive moves by Salesforce, Intuit, Sage, etc
  • something to rapidly address a specific need of its customer base

…then they are willing to pay something greater than a linear factor, because they believe that the acquisition can catalyze exponential growth and strengthen their hold on their existing market.

This was the case recently with Intuit’s acquisition of Mint.com for $170 million. For Intuit, though, it signaled a sea change at the company when it replaced the Quicken team with the Mint team.

It doesn’t always work out though. Ebay bought Skype, then sold it. They didn’t make strategic use of Skype, and it hurt both them and Skype. So they’ve sold Skype. Sun bought Cobalt Networks, and then dropped 97% in value (that hurt) because of the bursting bubble–not just the dotcom bubble, but the Y2k IT replacement bubble.

Stay away from the linear acquisition. Yes, it’s important to generate revenue and profitability–absolutely. That should be a factor for what’s possible. But consider the list of strategic angles above.

And never go it alone–hire an M&A firm with experience in your sector, and don’t cap their % (5% to 7% is typical if they are doing the shopping). It’s rare that a management team is good enough and experienced enough  to do better than a decent M&A team can do–plus it’s a ton of work.

I hope that helps someone out there. And M&A folks–start correcting…

Startup Valuation & Early Stage Deals

I’m going through the exercise of creating a deal document in anticipation of raising investment. In the past, I’ve used the convertible note with kickers for early risk as a way to simplify raising money without having to set a value for the company. The note simply converts into the first VC round, with a discount (20 to 50% is reasonable depending on timing, stage, etc) on the VC price.

This time around I’m going to set a valuation, though, and put a stake in the ground. The reason for this is initial valuation is relatively arbitrary; what matters is the percentage of ownership at the exit. 20% of a company at entrance  is meaningless at exit if there are liquidation preferences, and the sale is for less than any cap on the preferences.

I’ll explain. (The numbers I’m putting forward are not for my startup–they just make the math easier.).

Say I’m raising $400k, at a post-money valuation of $2 million, ($1.6 pre-money value plus $400k),  with typical downside protection; the first money out of any deal goes to investors. This is called a 1x “liquidation preference”–you get your money back in the case of a sale greater than the amount invested.

We will add to this “participation”, which means investors will first get their money back, then receive their full percentage of the remainder as well.

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EXAMPLES

Low Exit

In the event of an exit of, say, $500,000, with $400k invested, investors get their  $400k back, plus 20% of the remainder, or $20,000. Not a great return, but not a loss, either. Better than the 2008 Dow, anyway!

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Loss

In the case of a $200k exit, they get $200k and call it a day–a loss of 50%.

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Flat

In the case of a sale at $2.4 million, investors get their original $400k, leaving 2.0 million, and then 20% of the remainder, or $400,000, for a total of $800,000 , or 30%. So 20% becomes 30% on the exit–not a bad deal for investors.  Common (founders, employees), split $1,600,000. Not great, especially if it’s after 4 years of work. But it beats working for the man.

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Capped

Say the participation cap is at $4 million, so any sale over that removes the preference. At $4 million, this means straight percentage return–20%, or $800,000, a 100% gain.

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What’ s interesting is that it’s in the investors interest for the lower sale of $2.4 million, which provides a 3x return, than on the higher sale of $4 million, which provides a 2x return. While there are ways to smooth this out, it’s not really worth the complexity at that level of exit.

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Ideal

The ideal situation would be to sell the company for a much larger amount–say $8 million. Everyone makes their pro rata amount because the preference is capped and  goes away at $4 million, so it would be a straight 20% to investors: $1.6 million, or 4x their investment. (I’m leaving out accrued interest; most deals carry 8% annual interest until exit, which mitigates risk for the investors but can really nail Common if the startup gets long in the tooth. It’s another incentive to do well quickly).

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The challenge is to create real value over time so that the exit is good for investors and good for employees and founders. The tradeoff with taking investment of this type isn’t terrible: you get the chance to build your startup, and if you do a great job, it will pay off for everyone in the end.  If you don’t get it to a decent value, then at least you’ve taken the shot and haven’t gone bankrupt doing it.

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Remember to take a salary; I went without one for 5 years with Mission Research (I could afford to at the time), and while I received some additional stock for it, it wasn’t close to the amount of time I put in or my market value as a startup CEO. But that was a trade-off I accepted at the time, and I have no regrets about it–it’s a solid company and I’m proud to have started it. But the message is this: don’t forget to take care of yourself–at least the basics.

Pricing Employee Options

A startup I advise on occasion just repriced employee options 50% higher, while pricing preferred shares lower. On the face of it, it seems skewed, but when you really look at it, it’s very skewed. Here’s why.

Let’s say employee options are priced at .15 cents, and preferred is at .40 cents.  We’ll say there are 10 million shares, so that puts the value at around $4 million.

But there is $3 million invested, and the liquidation preferences are set at 2x, so Common won’t see anything for any sale of the company under $6 million, and won’t see the same price per share as Preferred until $12 million.

So Common = zero for anything under $6 million. And the current value as determined by the preferred share price is $4 million. So Common shares and option pricing should be not much more than zero.

Pricing options has gotten more complex since the introduction of 409A (See Brad Feld’s posts about that here). But common sense tells us that you can’t assign zero value to Common shares through liquidation preferences, and then charge $.15 per Common option. And that’s without getting into more esoteric and nuanced about the superiority of Preferred shares to Common, or situational arguments.

Employee options have nowhere near the value of Preferred, which supports my argument that VCs tend to value their own capital over the people designated to make that capital much more valuable, as reflected in the deal terms.

If you have any insights into this, please post in the comments.

New Startup: Sizing & Funding It

I’ve been working in stealth mode for the past two and a half months on new software that I hope will really help people. The closed beta starts sometime next week. I’ll announce the software here and hope you’ll give it  a try.

A question I’ve been pondering is something familiar to founders: should I raise money, how much should I raise, and what on what terms?

After starting three technology companies, two music companies, and a consulting business, I’m working on creating a worksheet to evaluate a number of things about how I’ll build this one.

Like Chilisoft, I won’t have co-founders, but will have a very small team that can get things done as I try to evangelize the products. I haven’t thought too much about team composition, except that there will at least three developers, focused on three different parts.

A five-member team feels about right, and more than seven feels like too many moving parts. I will need some help with marketing tasks, so it’s likely I’ll hire a generalist with some site building skills, and I’ll outsource and automate all admin, accounting, and HR stuff.

But I might not need to; it’s very possible I’ll stick with freelancers until there’s a need to do otherwise. Employees can be helpful, but until you know you have a steady stream of sustainable revenue or sufficient investment, you’re better off waiting.

So, a topic on my mind is fundraising. I’ve raised a lot of money, and have a lot of opinions about it, but here I want to focus on one question: how much is enough? If you’re pre-revenue, pre-release, it’s tough to raise from VCs, so you’re likely raising from angels, friends, and family.

I’m not very liquid at the moment, so I’m likely to raise something. I have two significant successes under my belt–ChiliSoft and Mission Research (9,000 customers, profitable and growing), so doors are open to me that aren’t open to first-time founders.

But the question is how much? For me, I just want to have enough to fund the path to product completion, tiny launch, and my own salary, which I’ll keep at maybe Sr Developer level–enough to get by and rebuild the buffer. But for how long?

I’ve developed a few business models for it, most of which depend on adoption. I think 12 months from release is enough to know whether you can get adoption and whether there’s a business there. I’m about 2 months from full release, so I’ll need about 14 months of funding, but I’ll base my calculations and number on 12 months because I have some sweat equity in it.

During that time, I’ll need about 1 full-time developer, and 1 full-time utility person–the generalist. The generalist is really key for startups, but has trouble fitting in down the road as a company specializes more. I’m a generalist, but have not needed to specialize because I’ve always stayed in leadership roles.

So I’m going to make the guess that if I want to have a full-time focused effort on this project, I’ll need 14 months of salary, plus ops costs, hosting, a little marketing, and etc. In Mission Research, I didn’t get paid for 5 years, then was paid decently for one year, and well for one year. This time around, I can’t afford to not get paid, because I’m not liquid.

So let’s say I can convince my cohorts to take $60k, and i’ll take the same. That’s $180k, to which I’ll add 30% overhead, so $240k, and then ops and marketing at maybe $5k/month. $300k to find out if there’s a there there.

So in this little exercise, I nailed the number pretty easily, based on the assumption that I can get cohorts at $60k. If I can’t get them for say less than $80k, then we add $60k to that number, or shorten the path by $60k. I won’t take less than the cohorts–I’ve been there and I can tell you that I’m willing to be the hero when needed but not by default. I have some specific cases in the past where I just ended up getting burned, and I won’t do it again.

So now the number is, well, let’s call it $360k. That’s if I want fulltime focus. Time to market is important, quality is crucial, timing is important. I can make this happen as a part-time thing, but without any guarantee for success. So I’d rather fund it.

So a pre-revenue company with a repeat successful founder might be able to get a pre-month valuation of around $1 million if the model is clear and some opportunities are already lined up. Without a track record, you might get between $500k and $750k. Even with a track record, that might be the range.

So if I’m crisp, maybe we’ll raise $300k at 900 pre, 1.2 post, for 25% of the company. To me that’s worth it, but if I could avoid that, I will.

The critical question is this: can I build a company worth more than the amount invested by the time the money runs out, and sell it or create sustainable revenue?

The answer is yes.

But if I can get it to revenue a lot faster, than the capital requirement goes down. So, what does it take to get it to sustainability?

1) Cut the costs. If I keep my expenses down, investment can be lower, % lost can be lower, and amount of revenue to get to sustainability is lower.

2) Get to revenue faster. Sell more faster. At $360k/year, we need to get to $30k/month. Now, I can get to $30k a month just selling consulting services. But building company revenue that requires adoption is tough, when the biggest obstacle to adoption is price. This is a free product, supported by sales of derivative products.

3) pursue multiple sources of revenue early on until adoption. Here are some ideas I’m kicking around:

  • freemium–free plus premium. The free part is easy. Defining the line between free and paid features is a challenge.
  • Heroes Subscription–basically ask super users to support you with a monthly subscription that entitles them to direct interaction, early news, lifelong benefits of some sort, and a list of satisfying benefits. I’m not good at defining those, so I have some research there. But I like the idea, and know people who would do this. At $20/month, it would take 1500 subscribers to float us. Doesn’t feel realistic, but I think the product will inspire that kind of support. I hope.
  • Data Exclusivity for 1 year. The primary model will likely be selling data, reports, analysis, etc. It’s possible to enlist a large company that cares about the kind of data we’ll be generating to fund it as a research project;i.e. have your customers fund you.
  • etc

If the post-money valuation is $1.2 million (optimistic or not), then one percent is $12,000. So for each $12,000 of revenue we can generate or cost we can cut, we get 1% less dilution. Sell the company for 20 times the first round, and you’ve left $240,000 per 1% on the table. If that’ s not incentive to cut costs and generate revenue…

The place you don’t want to get to is running out of money while the opportunity is still green and growing but not producing. Been there, too, many times, and it sucks for everyone.

I’ll keep thinking about this out loud here as I get closer to deciding on my path.

Raising Capital: Liquidation Preferences

One of the “standard” terms in VC term sheets is the liquidation preference. Google it, learn it, love to hate it and learn to live with it, because it’s unlikely you’ll get a deal without it. I call it the “have-your-cake-and-eat-it-too clause for VCs”.

Here’s how it works (or, How 20% becomes 28% without even trying).

Let’s say you raise $1 million from a VC at a miraculous $4 million pre-money valuation. Your post-money valuation is $5 million, and the VC stake is 20%. The next week you sell the company for $10 million (because you’re so amazing). How much does the VC get?

$2 million. Wrong! Yes, but 20% of $10 million is $2 million, right?

Well, yes and no. The liquidation preference means that the investor gets the$1 million back first, leaving you with $9 million, and then you take 20% in addition to the initial investment, making it $2.8 million total, or 28%.

So instead of merely doubling its money, the VC firm has almost tripled its money, with 180% return.  And that’s only if you have negotiated a 1x liquidation preference; 2x and above are back in fashion given the economic collapse and the pound of flesh investors are trying to extract from their portfolio.

If you have a 2x liquidation preference, the VC gets $2 million, then 20% of the remaining $8 million, for a total of $3.6 million or 36% of the deal, leaving you with $6.4 million, just $2.4 million more than your pre-money valuation and only $1.4 million more than your post-money valuation. In fact, the VC gets the bulk of the gain in that case.

So before you sign the deal, you might want to consider whether it’s worth it, because you could perhaps as easily (it’s not guaranteed) sell the company for $7 million and do better than if you sell for $10 million with VC on board.

So why do liquidation preferences exist?

Primarily, this term is designed to give the venture firm downside protection. Let’s say you sell for $2 million and your liquidation preference is just 1x. The VC firm gets its $1 million, plus 20% for a total of $1.2 million, leaving other shareholders with $800,000 to be distributed. They’ve still made 20%.

If you sell for $500,000, though, you get nothing, the VC gets $500,000, and has lost 50%.

I’ve always been ok with liquidation preferences as a downside protection, but I don’t like it when venture firms get the preference when they are already getting a positive return on investment that matches their internal targets.

I’m guessing the term was introduced for downside protection, but somewhere it turned into a nice bonus for the VC firms and nobody challenged it, so it became standard. I ‘m not a fan of standard.

WHAT CAN YOU DO?
Accept the terms, but limit participation to a certain level. Set a limit where the liquidation preference goes away–if the sale is greater than $10 million, they can choose the preference or the percentage, but not both. They will not likely agree to that number (my numbers here are arbitrary), because they want you to have extra incentive to push the number as high as possible.

So how much is enough? Well, first of all, if you only have one firm pushing a term sheet at you, you don’t have a lot of strength to negotiate besides your ability to appeal to their belief in you and their reasonableness. When you talk about any term, suggest an alternative and say it’s “fair and reasonable”–nobody likes to be considered unfair and unreasonable. But make sure the alternative matches the rhetoric.

Id’ say doubling their money is reasonable. They’ll disagree. Suggest an exit level that is 3X the post-money valuation (Keep in mind I’m not saying a 3x liquidation preference, but a 3x post-money exit. The difference is huge).

Liquidation preferences aren’t likely to go away, and it’s unlikely you’ll negotiate them away. But you can contain them in a way that feels to both you and the VC that your interests are aligned.

Please comment on this if you have other insights, questions, corrections, or challenges.