August 18, 2010 by dan.

Having served on more than my share of boards, and often on the comp committee, I am often asked about the following situation:

• A company has taken quite a bit of investment, usually from institutions and angels.
• The deal that was struck has a liquidation preference (if you don’t know what this means, you should educate yourself). Good terms for companies meeting their goals are 1x participating preferred (sometimes capped); bad terms are 2x to 3x and usually granted when a company is in trouble and needs to raise money.
• Acquisition seems like the best alternative, but the offers are for less than the liquidation preference (or not much more than the preference).

In this case, the common stock and options are essentially worthless. The founders, employees, and others who bet on the upside find themselves in the position of having worked for little-to-no upside (or in the case of board members or consultants who took options – nothing!).

What is the board to do?

Here is my perspective:

• Recognize that management did not deliver the value that was promised when the money was taken. It is not fair to give management a great return, while investors lose money.
• On the other hand, it was management’s sweat that got the company to exit. This needs to be rewarded.
• The board should try, as a first priority, to ensure that management gets a good deal from the acquiring company. This is good for the acquirer and allows the proceeds to go to investors.
• If a carve out is necessary, I believe that it should be graduated (like a graduated income tax). In that way, as the investors do better, management increasingly does better. This aligns incentives. For example, if the liquidation preference is $10M and the acquisition will be in the range of $5-15M, the carve out might look like this:
  • 5% of proceeds for the first $5M (which is $250k at $5M)
  • Between 5-10M, $250k plus 7.5% of the amount over $5M, which is $375k at 10M
  • $875k plus 10% (plus the value of their stock, which is now in the money) for any amount over $10M
• This seems to give both aligned incentives and balance the reward for management with the need to get investors their money back.

Of course, all of this looks much better when the company sells for a lot more than was invested!

Posted in Company behavior, Startups, Boards, Investment Terms, Angel Investing | No Comments »

August 18, 2010 by dan.

Over the last several weeks, I have had a series of experiences where boards have not represented the interests of shareholders. Why? Kindly, you would say inexperience or lack of knowledge. Less kindly – incompetence. Or even less kindly – greed.

In one case, the board, without any form of communication about the company’s status or consultation to the vast majority of shareholders, in short order (1) forced a “pay-to-play round” led by two institutional investors; (b) granted the CEO and other senior managers a HUGE carve out (despite several years of missed targets and poor performance); and (c) negotiated a quick sale of the company where the winners were the management (who got the carve out and a bonus from the acquiring company) and the institutions that forced the pay to play. This was done by a board that was incredibly conflicted, but counted on the fact that the angel investors in the deal (there were about 30 of us) wouldn’t take any action. Payout to the angel shareowners - $0. That’s right – nothing. This is egregious, but not uncommon.

Angels need to be willing to take better actions to protect their investments.

1. We must be willing to band together. I am working with several attorneys and the Alliance of Angels to create an LLC that can be used to aggregate our investments in a company. In this way, we will in aggregate be a “major shareholder” in the startup and get rights and privileges commensurate with a VC. This will add a small expense to our investing and require some overhead, but it should be worthwhile. And the company should love this, since this will be one shareholder instead of many.
2. We need to insist on a board seat and assign one of our members with sufficient experience to take that seat.
3. We must insist that our CEOs communicate, communicate, communicate. I get frustrated with a CEO that has bad news and decides not to share it until there is good news. Often the only communication is one from the law firm representing the startup and usually that is really bad news. Funny how the CEO was quite communicative while raising money from us. Boards need to step up and make sure that their CEOs treat their investors with the respect that they have earned by investing in the company.
4. Boards must represent shareholders in holding management accountable. I’m not saying be obnoxious. But, if you hired a contractor to fix your house and they didn’t do the work they contracted for, you wouldn’t pay them the full amount. Why do boards feel it is OK for a team to miss on their execution and then reward them? Boards need to step up.
5. Carve outs need to be measured. I understand that an acquisition can only occur with a willing management team (and a willing board). If there is a large liquidation preference overhang, (as there often is) management’s stock might all be under water. There is a need to take action to make sure that rewards are balanced. Boards need to be proactive in this. I will be posting a separate blog on my assessment of best practices on this.

So.. investors need to insist that board really do represent them and not allow them to take the easy way out, create conflicts of interest, or have investors take it on the chin. Boards – step up!

Posted in Startups, Company behavior, Rip-offs, Boards, Investment Terms, Alliance of Angels, Angel Investing | No Comments »

June 28, 2010 by dan.

A number of years, I joined the board of the Humane Society for Seattle and King County (www.seattlehumane.org), a local non-profit that runs an animal shelter, adoption facility, and does veterinary services for the animals in our care. For those that believe in animal welfare as I do, you will easily understand how an organization of this type can attract experience and well meaning board members.

Shortly after joining the board, I began to try to study and make sense of our metrics – especially euthanasia numbers. I well understood that not every animal was “adoptable,” some were too sick to be saved or had behavioral problems that made them unsafe to be in a house with either other pets or small children. But the numbers just didn’t make sense to me. So, along with the support of other board members, I began to ask for more details on the metrics, drilling to the next level of numbers. What emerged was a picture of management controls and lack of consistent strategy that meshed with the desires of the board. As a result, the board changed management first on an interim and then permanent basis. And, we established a goal that “no adoptable animal in our care would ever run out of time or space.”

Over the course of a few months, we focused on a metric that matched that goal (it’s called the Asilomar Live Save Rate) and have been successful in maintaining that metric at a level that qualifies us as a so-called “no kill” shelter for several years since. And then we were able to go to important, but secondary, metrics (e.g length of stay until adoption) that improved our operations and the care we gave our animal guests. I am proud of these accomplishments, but it has caused me to reflect on the importance of goals, strategy, and leadership in a more general sense.

In both the non-profit and start-up worlds (some claim many of my startups are non-profits! J), understanding your goals is a critical element in success. Goals must be meaningful to the organization and actionable. And have corresponding metrics that match those goals.

This seems simple, but in several of my companies, this has proved exceeding difficult. Many metrics follow results by too wide a gap to be actionable. In many cases, revenue is such a metric. But in almost every case, there are a handful of “value drivers,” those metrics that truly derive the value and health of the business. For example, in a telecoms consumer services business (like one a ran earlier in my career), the key value drivers were, (1) cost of customer acquisition; (2) average revenue per customer; and (3) churn. For each business type, these will be different.

The power of setting a good goal, understanding your value drivers/metrics, and having a strategy to maximize those value drivers and fulfill the goal is the path to success.

Posted in Seattle Humane, Company behavior, Boards | No Comments »

December 27, 2009 by dan.

Startup companies need good boards. But they often don’t have them.

There are many reasons. First, there really aren’t that many experienced people willing to serve on a startup company boards. And those that are experienced, skilled, and bring a lot of value, generally want to be compensated, which startups can’t really afford.

VCs will serve on boards, but generally when their fund owns 15% or more of the company, so their compensation comes from the fund and the upside from a huge amount of stock.

In contrast, individual angel investors usually only own a very small (<2%) of a company and there is no ready mechanism for their co-investors to compensation.

So.. what makes a good board member? Many startup CEOs believe that the most important factor in choosing a board member is industry experience. I disagree. Industry experience is valuable on an advisory board, but needs to be resident in the company. Some degree of industry experience is, of course, beneficial. But, the following experience is more important on a board:

• Experience on other boards for high-growth companies;
• Having been through financings of various sorts;
• Experience in acquisitions and IPOs to understand the inflection points and needed metrics;
• A good rolodex relevant to the company;
• Good chemistry with the CEO and other board members; and
• A willingness to be direct and outspoken about the company, even if that position is unpopular with management and the board.

To get good board members, a startup company must be willing to compensate board members (as they do management). I’ve spoken with a number of angels and angel groups around the US and found that board stock compensation seems to vary widely. On the West Coast (primarily the Bay Area) and Boston, compensation seems to follow the VC model – no additional compensation is required. However, in much of the rest of the country, options are generally routinely given.

I’d recommend the following package for a pre-A round company: 1% of fully diluted stock, vesting over no more than 2 years. Shorter vesting is generally a very good idea for board members in order to make sure that board members don’t try to act to save their board position rather than do what is right for the company. Of course, if the company is already financed and has suffered the dilution to do so, then the percentage would be less.

I believe that the Angel Capital Association, the Kauffman Foundation, and/or a university business school should conduct a survey on this.

Posted in Boards, Angel Investing, Investments, VC | No Comments »