The Founders' Pie

A reader of this blog referred me to this article about a Founders' Pie Calculator as a way to add some science to splitting up the founding pie. While this method is also still an estimate, it does require that the founders put some tangible thought behind relative values brought to the organization and it does bode well for future sound decision making.

Make Yourself Dispensible

Where would your company be without you? Better off?

Most Founders don't even consider where their companies would be without them. In fact, founder organizations often require intimate and frequent communications with the founder. This is the natural result of a driven founder with intimate knowledge of the marketplace and the solution being produced . Founders tend to take few vacations that allow them to become untethered from the organizations they created. Founders make many (most) of the critical decisions for their companies. Founders hire people who execute on the founder's decisions - usually not decision makers themselves.

But have you ever thought about whether this is bad or good for your company? While it may feel good to the founder - no decision gets made by some bumble head who doesn't know as much as the founder - and it may make the early stages of a company function efficiently - no bureaucracy, in the long run this poses an undue constraint on the organization as it grows beyond double digits of employees.

Founder decision making is just like the days of time sharing computers. For those of you who are not old enough to remember, time sharing computers gave multiple people access to a single computing resource (usually connected via a slow dial up line and acoustic coupled modem) by slicing the time the processor was dedicated to each individual task. Usually this was done fast enough to make the user believe she had unfettered access to the computing resource. However, when enough people tried to access the computer all at the same time, the response times suffered. (We actually are spoiled now - we accepted these delays as normal - such lack of responsiveness even under the best of conditions would not be acceptable today.)

Similarly, as the load increases on the founder with more and more employees clamouring for access to the founder, decisions get slower and slower - sooner or later bringing the organization to its knees.

It is the unique founder who "gets this" (before her board steps in) and begins to decentralize decision making. Often founders feel uncomfortable taking this step - allowing the bumble heads to make the decisions. They are too used to being the "go to" person for all major issues that anything short of that leaves them numb. But as soon as a founder realizes that she can hire smart people and permit them to make some of their own decisions, the organization gains a whole other level of potential and cycle times can begin to reduce.

So next time you revel in the idea of your indispensability - think again! Maybe you need a vacation?

Vote with Your Feet

Ever been in an organization where after a change event occurs there is a constant back channel discussion about how the sky is falling? Ever participated in one of those conversations? Come on now, be honest!

There really is only a binary decision that needs to be made when experiencing a change event: either embrace the change or vote with your feet - that is get out if you don't like it.

Change is often accompanied by the unknown. It's human nature to expect the worst under conditions of change. So in the organizations I've led, I always suggest the following approach.

1) Give change a chance. Often times people react immediately to change. For all they know the change might be good or might enhance their career opportunities. So unless change hits you directly between the eyes (like in the case of being laid off due to a change), wait with a positive (or at least neutral) attitude to determine whether or not the change that is occuring is something you can live with.

2) Once you determine that you don't like the change (and you've at least given it a chance) vote with your feet. Get out. Or at least start the process for finding a new opportunity.

All too often employees choose a third path which is to stay and complain. When you stay and complain, you've got no one to fault but yourself. Complaints feed upon themselves. They foster an environment of resentment. And they don't lead to any positive results - either for the individual or the organization.

So either embrace the change ..... or vote with your feet!

Earnouts are for Sissies

The ultimate founder transition - when the time comes for a founder to sell his or her "baby" - the highest hurdle encountered is often the PRICE. Buyers and sellers may find that there is a large gulf between the realistic value for the company and the price the seller is willing to take. Whether this is due to asymmetric information, scarcity, or the psychology of a founder expecting their kid (like in Lake Wobegon) always being better than average, it does create an obstacle to completing the transaction.

All too often, this gulf is bridged with a mechanism commonly called an earnout. An earnout is simply a way to pay less money today and (perhaps) more money in the future, based upon "proving" the value is actually higher than it appears today. How do you prove it? Typically, by increasing revenue, earnings, or the accomplishment of prescribed milestones.

So the seller agrees to take less cash today with the promise of a future upside (sounds very entrepreneurial) and the buyer agrees to pay what she believes to be the value today and something in the future if certain conditions are met. In theory, this appears to be a sound compromise. In practice, it often becomes a contentious and inexact computation.

So, if they appear so promising, why don't earnouts work?

Less than obvious to the innocent bystander is the fact that an earnout is used to paper over a disagreement. Like any good, long term relationship, a firm foundation of understanding, trust, and agreement is required to perpetuate the relationship. One founded on a disagreement is an indication of the quality of its construction.

Extenuating circumstances become the rule, not the exception. Once merged together, decision making on issues that may impact the trigger criteria may fall under the control of the buyer. While reputable buyers may not purposefully "game" the system to ensure that triggers are not met, they may in fact find that it is in the interests of the now "greater good" for the business to be run in a way that no longer hits those triggers. And guess who is making those calls now? Usually, it is not the seller - who has the vested interested in hitting those targets.

Who determines the payout? Sellers should understand that once a transaction is completed, the "golden rule" controls. (The "golden rule" is usually understood to be - he who holds the gold, makes the rules!) Buyers will make the determination as to when and if additional payouts occur. While agreements may be carefully crafted by expensive and sometimes even competent counsel, in practice it just may not be clear whether or not the trigger criteria has been met, several years into the future - especially if in between, the game has changed.

History has shown that earnouts don't always get paid out at the times or at the values that the seller had expected.

So should a Seller just say no? The realistic answer is no (I think that is a double negative!). Earnouts are ok to use as a seller if the expectation is clearly set that this portion of the potential purchase price is just gravy (or icing on the cake if you like that analogy better). Negotiating a purchase price that is "acceptable" even if the earnout is not paid, and accepting the earnout as a potential extra to the deal, will lead to a much sounder future relationship.

Of course if you are buyer - Earnouts are great!

Cheating - or Postmodern Learning

I was absolutely amazed to read the commentary in Business Week, May 14, 2007 p. 42 from Michelle Conlin on the Cheating scandal at Duke's Business School. Can there really be a question here of whether these graduate business students, who in complete disregard of all ethical and statutory standards of this prestigious business school, did something WRONG by collaborating (CHEATING) on a take home exam?

I too am a fan of open source, collaboration and the idea that capturing the participation of customers and employees is required in this new 21st century competitive environment. But to write off this cheating scandal based upon the "mixed signals" society is giving to these students, is tantamount to explaining away Enron's criminal activities as just doing what everyone else was doing. The idea that email, instant messaging, and the iPod has somehow created a society in which cheating is de rigueur is just plain misguided! Michelle, if you don't believe that these students thought they were doing something wrong, then I suggest you think again!

How can a publication like Business Week publish such garbage and even allow the thought that this behavior should be condoned as a plausible argument? Haven't we had enough of our fair share of misguided business, political and religious leaders provide a large enough pool of miscreants to make us all uncomfortable with the role models our society has created?

This argument that "one can understand the confusion" that somehow cheating on an exam should be written off as postmodern learning is not "food for thought" as Michelle portrays it, this is our corrupt view of the lowest level that our standards have ever achieved. Business Week should know better!

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.

Founder Forecasts

Having recently spent a substantial amount of time reviewing new business opportunities, I'm beginning to realize just how hard it is to come to agreement on the value of an early stage company. I had thought that this would be challenging, and certainly it has been. However, I continue to be surprised by the metrics (or lack thereof) that are offered by founders and the shaky foundations for their logic. So below is my advice to founder-types on what they should avoid when trying to negotiate the worth of their progeny with any outside investor.

First Lesson - You can't use discounted cash flow analysis as a method to measure value when there are no cash flows. Almost every time a valuation discussion with a founder begins, someone whips out a discounted cash flow analysis. I guess business schools all teach some version of DCF. and perhaps business incubators perpetuate this teaching by suggesting it to budding companies. But the DCF method for valuing a business was based upon "predictable" cash flows. Without predictable cash flows, applying mathematics to speculation does not make the result any more real. And, increasing the discount rate to account for the "risk" that these cash flows may not occur, while better, still results in factoring a mathematical formula against a speculative occurrence - still not helping the result to become any more real.

Lesson Two - One or Two Customers does not a trend make. As Abraham Lincoln once said: "you can fool some of the people all of the time." And this is often just the case. Or at least you haven't yet proven that your idea has widespread appeal. Extrapolating value from the first few customers to anticipate broad market acceptance is at best optimistic or at least premature. In mathematical terms, you need a set of points, not just the first few, to spot a trend. Early adopters are just that. Market acceptance occurs as Geoff Moore would describe, when you cross the chasm, when real customers purchase products as a matter of course, not as a pioneer. Anything less may be an indication of future opportunity, but certainly not proof.

Lesson Three - You can't pay your bills by trying to cash in on someones interest in your solution. I can't tell you how many times a founder has told me that things are going great because several potential customers, partners, venture capitalists, angel investors, (you can fill in the noun here) has told them how "interested" they are in taking the next step. I can't speak for everyone here, but it seems like a very American personality trait to use the word "interest" to mean "please leave now since I have a lot of other things to do and I would rather not tell you how I really feel about what you are trying to convince me of." If you don't believe me, try being a bit cynical next time someone tells you how interested they are in what you are pitching. But even more important, interest (even if real) is a long way from cash in the bank. Founders by nature are optimistic. But they need to gain a healthy does of cynicism and perhaps an objective sales process, before they can begin to value the "interest" they are receiving.

Lesson Four - While selling the first few of anything may be difficult, it doesn't mean your organization will be capable of selling a sufficient quantity to become profitable. I recently became enamoured with an early stage company and its solution. I spent a good amount of time investigating how the company was selling its solution. What I found was that the direct cost of sales and implementation was something in the range of 10X or more the gross revenue the company would receive from this customer (who had shown interest - see lesson Three). But just like the businessman in the well told joke, I was told, don't worry about the cost, we will make it up in volume. Well, really what I was told was that these were just early sales and in the future this would be much easier and cheaper. While I agreed that there were some very clear ways to reduce the cost of sale, there was no real plan for doing so. No one had thought through how they were ultimately going to deliver this solution at a profit. And while early cash flows and even beginning profits are interesting and necessary, unless the company is capable of generating some kind of real gross margin on its solutions, this is no place for an outside investor.

Lesson Five - Sometimes you have to give up more than you would like to get your idea to market quickly enough. I've run into several situations with founders who need to raise capital, but they only want to raise a small amount because too much will be too dilutive to their early investors and themselves. I always approach these situations with admiration. I too would want to not give up any more equity than necessary if I had a early stage company that I believed was quite promising. However, don't let dilution blind you to market reality. If your idea is good, then get it to market. If your idea is completely protectable - i.e., you got an encompassing and defensible patent that will be difficult to work around - you might be able to ignore this lesson. For everyone else, if you slowly inch your way into the market, and it is in fact a good idea that you have, as soon as you have proven sufficient viability, you have opened the door for someone with more capitalization and more resources to steal this market from you. Taking market share early is often the best tactic. To borrow and idea from a seminal marketing book Positioning authored by Ries and Trout: getting to market first is important, but getting there firstest with the mostest (big presence and share) is critical. In today's global market, you can be sure there is someone somewhere who is waiting to pounce. If your slow path to market risks someone taking over leadership ahead of you, it would likely behoove you to take the larger-than-you-would-prefer dilution, and ramp up your plans early.

So how does this help you come up with a mutually acceptable valuation? My advice is be honest. Most investors (with some notable exceptions) do not want to steal your business from you. Usually, it is more important to have you completely engaged in the business, than it is for the investor to get your equity at a bargain price. Investors like to have rational conversations with factual underpinnings. They often are enthused when they hear some healthy skepticism in their conversations with founders. If you can run the business and grow it fast enough without asking for any outside funding then do it! But if your business model requires that you capture market share and ramp up sales more quickly than your personal capital requires, then understand that being realistic may be just the ticket you need to capturing a share of the investors wallet.

Sticking around too long?

I recently was referred to a blog post on Fred Wilson's Musings of a VC in NYC. Fred suggests that keeping a founder around post his replacement - moving "up" as he calls it - is an important positive development. I think Fred may not realize that while it may have positive implications for the right personality founder, it may pose some significant issues for the hired gun CEO who steps into a position which perhaps may have been previously filled by a "legend." Forcing a newly hired gun CEO to operate in the shadow of a large personality who has accomplished the impossible of starting and building a substantial company from scratch, while someone remains to look over his shoulder, can be an undue burden that hinders rather than helps the company. The fact that many founders return to their old jobs years later may not be as good a prescription as Fred leaves us to believe.

Good CEO's are not puppets. Moving the founder "up" to become the puppeteer to manipulate his strings (unfortunately what it appears happens with some founders who stick around), is likely not what you hired his successor for. When change is required (which often is the reason for replacing the founder to begin with) keeping the old guard around and still "in charge" as Chairman, can be a sea anchor on the successor's ability to implement change. It is a unique founder for sure who does not try to perpetuate their own ideas even when moved out of the CEO role.

Witness what may go down in history as one of the best performed transitions (albeit not of a founder, but the analogy certainly still holds) with Jack Welch giving way to Jeff Immelt. Jack carefully picked his successor after years of scrutiny (may be a big lesson there too on the care taken to select the successor - See my posting on Try Before you Buy) and then left the company entirely, in order to enable Immelt to do the right thing and not be encumbered by Jack's legacy. Jack clearly was quite a successful CEO. By all rights he could have stuck around and "helped" Jeff transition the company into its next stage. Instead, Jack felt it necessary to get out of the way. In fact, Immelt undid many of the well worn strategies that made GE successful during the Jack Welch era. But Jack was smart enough to realize that change was necessary and chose a capable successor, gave him the keys and waved him goodbye.

Is Jack available if Jeff needs him? Sure! But he is careful not to have his shadow restrict the vision that Immelt requires to take the company to the next level.

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.