What's your GHIN?

We've all heard of private or venture capital companies doing due diligence on the companies in which they are interested in investing. And we probably are convinced that these financial firms are careful enough to do due diligence on the principals of the company. But did you ever think they would check out your golf handicap? Guess what? They do!

I recently found a private equity company as part of their diligence looking up the handicap (and finding out how often they play) of the principals of the company. This could be both interesting and damaging. What if you posted scores for the past two weeks, playing 4 or 5 times a week. Are they going to think about your office attendance? And what if your handicap is a 4? Are they going to believe that you are just a casual golfer?

I doubt that anyone makes a make or break decision based upon how good a golfer one of the principals is. However, it is easy for them to look you up on GHIN.com. All they need to know is your name and your state. If you have a posted GHIN account anyone can see it.

Golfers beware! :)

Man’s Best Friend

The prevailing view in national politics is that if you want a friend in Washington, get a dog. This same axiom is true for the CEO of a venture-backed company.

Sure, while they were courting you, your venture capitalists said wonderful things about your company. They applauded your past successes. They told you of their hands-off style and how they were there to help you navigate (only) the strategic issues. They persuaded you that they brought more than money to the table. They brought their contacts, their experience, the synergy of their other portfolio companies, and of course their “brand.” But what they probably left out of the equation is that the sole reason they invested in your company is their expectation of a healthy return on their investment. In other words, they are in it for the money!

Venture capital is often a necessary evil to get you, your colleagues and your company to the next level. Often times you can’t get there without it. And in many cases it is a badge of success for an entrepreneur. Venture backed companies get more attention from the press, tend to grow faster, and, in fact it is much more likely that you will accomplish an IPO with venture backing than without.

Oh sure, you say, you always knew VC’s were in it for the money. And in fact, you’re probably in it for the money too! Otherwise, why would you be putting in those long hours, enduring the hardships of limited resources, competitive pressures and dealing with hard-to-please employees and investors. But while this may be a similarity between you and your VC, there is an important difference. While you both may be in it for the money…they are in it ONLY for the money.

You, on the other hand, may have to maintain friendships and relationships with your employees, you may have your name on the line with your angel investors, friends, or family. It is on you whom the vendors are taking their chances. And perhaps you have some desire to continue running your company. You need to make decisions that may have implications that go beyond just plain money. These “other” considerations all are part of what makes you a CEO. But your VC ultimately wants nothing to do with them.

VC’s really only care about the money. You and your company are just a vehicle to get them to their goal of a return on their investment. If something, anything extraneous, gets between them and their return, like you or your “other” considerations, you will likely find yourself alone.

If you haven’t experienced this yet, just wait until your try to raise the next round of capital. Or, you miss you numbers one time too often. Or, you are forced to sell your company at a price that is not quite what the venture guys were hoping. Or perhaps worse yet, you go through a liquidation. Then see who ends up with what’s left.

So next time you are sitting at a board meeting, and perhaps things are going well enough to let your guard down just a bit, don’t consider for an instant that they the guy next to you is your friend. Unless he’s got long furry ears and a tail, think again!

Running the Funding Marathon

So what is the right value for raising institutional (venture) capital?

As with many things, beauty is in the eye of the beholder, or in our case, value is in the wallet of the investor. Whatever the market will bear is the real value of the company. This value may and will have nothing to do with the value your angel investors paid for their stock. It will have absolutely nothing to do with the amount of work you and your team put into making your product or putting together your offering. And it certainly bears no relationship to how much the company would have to be valued so that you retain control.

Rather than focusing on the paper value of their current ownership, founders should think ahead, through as many of the "gates" as they can forecast, that stand between them and commercial success (all the way to a liquidity event). It's like a marathon, as opposed to a sprint. The leader at the mid point is not necessarily indicative of the winner at the finish line. Not all money is created equal. It may be more important to get a good value, rather than the best value, from a partner who is in it for the long haul. This may mean taking a lower valuation today in return for accelerated market entry and mind share from a partner who brings much more than just capital to the equation.

Often we see founders falling prey to early angel investors "bidding up" the value of their companies during several cash calls in an effort to increase their short term valuations. While this may "feel good" at the moment, it could become a critical obstacle to their long term success. Founders should understand that it will be VERY DIFFICULT to later get an early investor to digest a crammed down valuation if these angel values were artificially inflated.

Here's an example: A plastics company in upstate NY purchases some very interesting patents from a large industrial conglomerate who doesn't view them as critical. They raise angel capital to begin to prototype this product. They run out of cash. Management either knew or should have known they would need more cash. They go back to their investors needing more capital. The investors agree, perhaps they bring in a few of their friends in this round, but only at a newly established higher value. This continues for several more years. By this time the company has yet to commercialize its product, yet the valuation is now in the double digit millions - based almost entirely upon the angel investors bidding against themselves to increase the value and to feel good that their investment is increasing in value. Has this higher valuation helped them?

Absolutely not!

They are now getting closer to being able to commercialize the product. They need sales and marketing funding, they need production facilities, they are ready for their launch. This requires capital in excess of anything they have raised in the past. So they seek out institutional investors. In fact as they become a bit more desperate, they also seek a strategic buyer. There are several interested acquirors - but they each in turn demur due to the demanded valuations. Ultimately there is interest from institutional investors (bigger fool theory in play here?), they can't justify the lofty valuations the angels' fictions have created! But the company needs the capital. And voila - cram down occurs. Founders get squeezed (out completely in this case). Early investors get burned. Later investors get fried! And company's prospects for success are still in doubt. But the founders felt great at these lofty values, that is at least until ... they got dumped!

What could have happened?

With some foresight, the founders might have begun to understand that the only real valuation that matters is the one just before they cash out. Restricting their fund raising rounds to smaller increases (or sideways) in value that were commensurate with their market progress, might have enabled them to keep the valuations in line and then be able to raise capital from institutions at an appropriate rate. Or, it might have enabled them to cash out in a sale to a competitor at a valuation they could stomach.

This vortex of capital raising can stymie the progress of even the most promising venture. So beware when you hear yourself remarking about how the world doesn't get your value proposition! The "best" valuation you can have for your company, may not be the one that momentarily makes you currently feel the richest.

Your Money or Your Life?

When is the right time and at what is the right valuation to seek outside funding? Founders and entrepreneurs constantly quip that the world (that is everyone outside of their four walls) does not understand their true valuation. Obviously, they know something that everyone else doesn't. (But do they?) And as such, entrepreneurs often wait, sometimes too late, to raise funds.

Sometimes waiting is exactly the right thing to do. If the product is not yet complete, the value proposition for the outside world has not yet been proven, or if the claims the company is making are just not yet credible to the financial community, this can be the appropriate move - assuming the company has the wherewithall to survive. But founders and entrepreneurs should be wary of continuing to push that rock by themselves for a bit too long and the implications that their "slow" pace of progress will have on their competitive strength.

Sometimes getting to market first is just not enough! The market is strewn with dead companies who introduced the next great thing to the market, only to bowled over by a better heeled competitor who follows in their path. Getting there first is part of the battle, having the resources to execute, to capture market and mind share, is a critical hurdle that must be overcome to be a commercial success.

The savvy entrepreneur should understand that having the appropriate resources at just the right time (no earlier - but certainly no later) is critical for maximizing the value of their opportunity. If your product or service is ready to be launched, but you delay due to perceived poor valuations, you may in fact be giving up much more value to the market than the lower-than-expected valuation costs you. If you miss a market opportunity, or enable a competitor to impinge upon your market space, or create noise or confusion in the market, you may just find that you have diminished the value of your creation beyond repair.

Slicing up the Pie

One of the toughest moments for a new founder/CEO is when she realizes that success requires she begin to slice up the pie. Sometimes this happens first when its time to attract or compensate early employees - not all of whom are willing to take severe pay cuts without something in return. Or sometimes her first encounter is when it's time to raise some outside capital. But how big should the slices be? And how many of them should be cut? And what does this term dilution that people keep throwing around really mean?

The "pie" analogy is often used to describe the cutting and serving of slices of the business often in return for something of value. Whether this is a pizza, lemon meringue, or other category is not necessarily the relevant question. Venture capitalists will talk about "increasing the size of the pie" - usually about the time they are angling to cut themselves an oversize slice. And founders are often times seen giving out big servings to their original founding team without thinking through how many her pie will feed.

So there are several important considerations for how, when, why and how much, and to whom to serve from this founder's pie. Below are three common mistakes that the unwary founder may be (mis)guided to endure.

Common Slicing Mistakes

• Excessive Portion Sizes for Early Employees - Early stage companies are often run like families. Sometimes they in fact are families (see Why CEO's Fail). Close knit groups of employees come together to do the impossible. To create something extraordinary from nothing but a vision. They dream dreams of (market) power and riches beyond most of the founding team's conceptions. They work hard, often in close quarters, and form strong interpersonal bonds. Many times these bonds cause founders to mistake relationships for value. At what Venture Capitalists might consider a "weak moment" for the founder, large slices of the pie are doled out early to the founder's team.
  
  
• Using equity instead of cash to pay operational costs - in the earliest stages of a new venture, it is common for cash to be dear. There is much to get accomplished and too little cash to "pay someone" to do it. So often founders are induced to use equity (another slice of the pie) to substitute for cash. Whether this be for a bargain property lease, purchasing of equipment, or hiring a consultant, equity may be all the founder has as a currency to purchase these resources. So necessity itself is the mother of this mistake. And, although there may be little alternative than to use equity, the cautious founder should realize that while these expenses may be real, the use of equity is akin to mortgaging the future of your venture "just" to get this resource today.
  
  
• Unwilling to create slices that increase the size of the pie - the flip side of the prior error is the contrary position. There are times in the life of a new venture when resources present themselves, in the form of unique talent, critical opportunities, and cash funding. Founders sometimes find themselves unwilling to part with even a relatively small slice of the pie, even though these resources may only be fleetingly available and could materially grow the size of the pie.
  
  

So how does a founder avoid these mistakes? Some forethought about the end result and understanding a bit about dilution will certainly be helpful.

There only is One Pie to Slice

The first thing to understand when slicing up your pie is that there is only one pie to slice. Better put and despite some notable con-men to the contrary, you can only give or sell 100% of your company. That means there are a limited number of slices. Once you cut a slice out of the pie, that slice is gone. Even if the pie gets bigger (the venture gains value) that slice will grow proportionally as well.

Early stage employees may be very important to the early stages of a venture. It is common for these early stage employees to be just that: good early stage employees. They may not be capable to take the company to the next stage. They may have to be replaced by new talent at a later stage. Realizing that giving up an extraordinarily large slice of the pie early, may leave you "slice-less" later when your venture needs to attract talent that may not be willing to work for just a salary. Employees may come and go, but there only is one pie.

When you pay for current expenses using slices of equity, you also should be thoughtful about what that means at a later stage. Remembering you only have one pie, while realizing your expenses will continue forever (they are recurring), will help you to understand that you won't be able to use slices of your pie for ongoing expenses forever. Therefore if you have to use slices to pay for ongoing expenses, be sure you know when you can reverse this trend. And, while the size (value) of your pie (entity) may be small today, most people value equity based upon future value. [Our own public stock markets are really valued based upon the potential value the ownership right (shares) that you purchase. Financial types often speak about discounted cash flows - or the value of this share of the company based upon expected future results.] So if you use stock to pay for current expenses, be sensitive to this valuation process and don't sell yourself short.

Increasing the Size of the Pie

Being realistic when opportunities arise that will grow the size of your pie is equally as important as careful scrutiny of giving out early slices for employees or expenses. Your value (the size of your slice) is truly dependent upon BOTH the proportion of the piece you have for yourself AND the size of the pie. A 1/4 slice of an extra large pizza is bigger than a 1/4 slice of a personal-size pizza. Understanding what will grow your pie is critical. When angels or venture capitalists offer you cash in return for a slice of your pie, you must look at the impact that financing has on the size of your pie.

Here's a quick lesson in pre and post money valuation.

Venture capitalists speak to you about the value of your venture. They may offer you $1 million for a 33 1/3% share in your venture. To you that means your venture is worth $3 million. Once you get their money your whole pie will be $3 million sized - that's the size after they added their $1 million. By simple math - the "pre-money" size of your pie was $3 million less the $1 million they added - or $2 million.

So based upon this financing offer - you used to have a $2 million pie that you had unsliced - all was yours. The VC is offering to increase the size of the pie another million larger - now $3 million. In return, they are going to take a slice that is 1/3 of the pie (1/3 of $3 million). You get to keep 2/3 of the pie or $2 million of the size.

So in this case the pre-money valuation was $2 million. The post-money valuation was $3 million. Assuming you both agreed on the $2 million pre-money valuation of your entity, the new financing was not dilutive - did not reduce the actual size of your slice. While you now only have 2/3 of the pie left, that slice increased in size sufficiently to leave you with the same amount (to eat?). While the amount of (surface area) of the slice of the pie that you still hold has neither increased nor decreased, the financing has put you in a position to continue to grow the value (size, surface area, value) of your pie into the future. You now may be in a position to stop using pie slices to pay for current expenses. You now may be in a position to attract the kind of talent you require for this stage in your venture without giving up too many large slices of what you have remaining. Overall, taking on the cash should help you continue to grow your pie beyond where you could take it yourself.

Of course you always could be happy with the size of your current pie. You always could decide that there is no need to grow the pie. Those are your decisions. But understanding and accepting that outside resources may be required to ultimately grow your pie to the size you desire, and that to do so may require you reduce the percentage of the pie that you own, will be critical to how you deal with the distribution of slices and the raising of outside capital.

Why are founders surprised?

It happens all the time. Hard working capable and uniquely qualified founder of an outside funded company is abruptly told by his board that he is no longer needed as CEO. Founder is surprised!

Most entrepreneurs know that when they accept outside funding they are now subject to a whole new level of scrutiny. Certainly they know that after several rounds of fund raising, when their ownership gets diluted down below 50%, they likely don't have sufficient voting power to override their investors. They also are very much aware, and sometimes have been directly told, that as a founder/CEO they may sometime need to be replaced. And in fact, funding agreements for VC's often include the explicit right to replace the founder CEO.

So why in so many situations that we've seen, when a CEO is told she will be replaced, is this such a startling occurrence?

In my experiences and discussions with founder CEOs I've come across several understandable rationales for this type of behavior:

1) The immortality theory - I know this happens to most founders, but it won't happen to me.

Many founders have the view that they are different from the pack. While others may suffer as less capable, they are different. They will be able to grow, scale and lead the company forever. Didn't they already start a successful company? Weren't they divisional managers leading large teams in their prior lives? This confidence in themselves is what made them great founders to start with. Unfortunately, confidence can turn to hubris, leaving the founder less aware of the reality of the situation.

2) The I'm critical to the organization theory - they wouldn't know what to do if I wasn't running the company.

Certainly in the early stages of the venture the founder is most critical to the success of the organization. But in order to grow there needs to be a knowledge transfer to a increasing number of others within the organization. Technology changes occur; existing knowledge gets outdated; other smart people join the organization. The organization matures. Other functions like marketing and sales take over for technology as the critical constraint. Often times the singular focus of the founder can insulate him from the changes going on around him.

3) The timing is wrong theory - sure I know it will happen someday. But that someday isn't today.

According to research described by Noam Wasserman in his article "Founder-CEO Succession and the Paradox of Entrepreneurial Success," Organizational Science/Vol 14, No. 2, March-April 2003., the timing for replacing the founder can often coincide with the successful completion of a prototype or commercialization of their offering. The experience of successfully meeting a milestone stands in stark comparison to the idea that the founder would be replaced... at least NOW!

So surprise it does. And the consequence of surprise often is the awkward and uncomfortable process of transitioning to a new CEO at a time when the founder is just not prepared to have their heart in the process - all things that make a tricky transition all the more delicate.

Organizations and certainly boards of directors would be well served if they ensured that they maintain high bandwidth communication with the founder, beginning well in advance of a forced transition, in order to reduce or eradicate the surprise factor and its consequences.

An Ounce of Preventive Medicine

Venture Capitalists are often the impetus for the charge of bringing on a new CEO. And almost as often, the founder/CEO is reluctant to accept the change. However, typically the founder is in no position to object. He really needs to close that round of capital! An expensive retained search ensues. The Founder studiously interviews multiple candidates. Board members, recruiter and Founder have regularly scheduled sessions to vet these candidates. Leading candidates attend second and third interviews with a selected few meeting the staff. The Founder is usually given the final veto which results in making an offer to the candidate that they feel will do the "least damage."

All too often, damage is what occurs. Several venture capitalists have somewhat jokingly stated that to save time and money they should do two searches at once - first for the transition CEO who will fail and then for his/her replacement. While I am not aware of any situation where two searches have taken place simultaneously, it is clear that making a bad hiring decision wastes not only tens of thousands of dollars of search fees and costs, the time and opportunity cost taken by the senior management team and the board to do the search, but also the months when the company founders (pun intended) while this transition CEO struggles with the duel charge of leading the company while establishing a comfort level with the Founder.

This disconnect can sew the seeds of months or years of below the surface conflict, lack of productivity, adding up to a very costly mistake. While a good process may have led to the decision to hire the "right" CEO, even the perfectly suited CEO may not succeed without sufficient advance spadework.

Experienced boards know that the process of hiring a successful transition CEO is based on much more than a good recruiting process alone. Many have found that a good fit depends even more on ensuring the Founder is clear on the roles and responsibilities of the CEO and the Founder - a task that is not as simple as it sounds.

So rather than making that expensive mistake, some preventive medicine may be in order. Here are some "commandments" that will ensure the success of your Founder Transition:

1) Before engaging in the search, get the Board, the Founder, and the senior management team together to talk about WHY a new CEO should be hired; what are the challenges that the company is or will be facing that the existing team is not alone capable of accomplishing? While board members are always busy, be sure there is at least one designated "friend" to the Founder that dedicates sufficient time and maintains a close connection to keep the Founder informed and interested in the process.

2) Discuss openly how the role of the Founder will change when the new CEO comes on board. How will other members of the management team be impacted? Be specific. Discuss roles and responsibilities that will shift from the Founder to the new CEO. Now is not the time to placate a Founder just to ensure they go along with the recruiting.

3) When engaging the recruiter, be sure he or she is aware of the special challenge that the new CEO will face in order to effectively replace the Founder. Recruiters can play an important role in ensuring a smooth process. Experienced recruiters are familiar with the potential problems in having the Founder either intentionally or not chase off potential candidates. If the recruiter is not sensitive to this issue - find another one.

4) Be sure the CEO and management team is using some type of structured interviewing process - Like Topgrading: How Leading Companies Win by Hiring, Coaching, and Keeping the Best People. (Often Founders and the management teams are not experienced in the appropriate techniques for identifying the right hire.)

5) Create a transition plan, ensuring that there is a specific plan for how the new CEO will be indoctrinated, what information needs to be transferred, who will be engaged in the process and a time line for reaching certain transition milestones. (I suggest you get the new CEO to read the book: You're in Charge--Now What? before he/she arrives for their first day at the new company.)

6) Founder and Board in advance of the selected CEO coming on board, work out the tactical details of titles (a new one for the founder), office location, support staff, etc. in order to avoid the first awkward moments of the new CEO's tenure.

7) When the new CEO comes aboard, be sure that Board members are personally present when the new CEO is introduced to show the support that the Board has for the new CEO. Hold an all employee meeting to introduce the new CEO. Be sure the CEO and Founder have coordinated their "statements" so that the company gets the message that these two are working together.

8) Reinforce this process several times with joint Founder/CEO/Board discussions, measuring progress against the transition plan.

Everyone involved in the success of the transition (recruiter, Board, CEO, management team) should know in advance that not all Founder/CEO transitions work. The founder will no doubt go through the standard "grief" cycles of shock, disbelief and anger prior to either accepting or at least convincing the board he or she has accepted the inevitable shift in his or her role.

Even with sufficient preparation, not every hire is a good one, and not every Founder is capable of sticking around while a new CEO reconfigures his/her baby. So be honest, be clear, be attentive, and be sure that the board and the Founder have a high bandwidth communication channel throughout the process.