Monday, January 25, 2010

Institutional vs. "Friends & Family" Investors

Part 3 of a 3 part series on surviving the funding transition

In this final post of the series, we discuss the difference between a friends and family ("F&F") vs. an institutional* (i.e. VC) investor and what this means for a founder/CEO.  We'll start by looking at what the startup world looks like from the VC's side.

How Venture Capital Firms Work
Venture capital firms are usually structured as limited liability partnerships.  The VC firm raises money from limited partners (i.e. wealthy individuals, pension funds, etc. who put in money but are  not actively involved in the firm's management) which are collected into a fund.  The proceeds of the fund are then invested by the general partners in a portfolio of startup companies for typically 5-7 years.

During this time it is expected that some of the startups will have some liquidity event like an IPO (initial public offering) or a strategic sale (i.e. company gets sold to a corporate buyer) while others will fail.  Ideally, the proceeds from the successful liquidity events will exceed the losses from the failures and the VCs will be able to return the invested capital plus gains back to the limited partners at the end of the fund's life.  This means:
  • VCs have a fiduciary duty to protect the interests of their limited partners - This means that they are legal caretakers of their investor's money and must take all reasonable care to protect it.  They must perform due diligence on prospective portfolio companies, negotiate hard for the most favorable terms for their investors, and will use 3rd party experts to provide independent opinions to support the firm's investment decisions.  If they sit on your board, while they will have a director's duty to do what's best for the company, it will be with respect to what's best for the shareholders (not management, employees, or any other stakeholder).
  • VCs are professionals - They have the resources to conduct sophisticated financial, strategic, and legal due diligence of the business.  Unlike F&F investors, they will read the operating agreements, contracts, analyze the financials, cross-check market assumptions, and attempt to ferret out any non-compliance issues that could come back and bite the company and - more importantly - them.  They will require portfolio companies to have financial controls, insurances, and legal compliance procedures.  They will be sensitive to the fact that if one of their portfolio companies gets embroiled in a lawsuit, they are the deep pockets that a plaintiff will pursue.
  • VCs must exit their investment within a fixed time frame - VCs will expect their portfolio companies to make active progress towards a liquidity event.  Their money is not meant to be in forever.
  • Most VCs are not operational - Therefore, they will seek to maintain leverage by ensuring alignment of management incentives with those of shareholders.  They will look askance at any attempt by management and employees to reap returns before the investors (e.g. cash bonuses before the company is cash break even).  They will look favorably at anything that shows management  has "skin in the game" which to a VC means your heart and soul.
Implications for Founder/CEOs
So what does this mean for a founder/CEO?
  • First impressions start in due diligence - The first time a VC will see you in action will be during due diligence.  A smooth process will leave a favorable impression of your team's ability to execute (always a concern for an investor); a rocky process just the opposite.  Prior to seeking funding, it is a good idea to get your house in order, particularly with respect to legal compliance issues.  It's one thing not to have general liability insurance because you were preserving cash.  It's quite another not to have filed your tax returns for the past three years.
  • Your board will (likely) be professionalized - VCs are likely to insist on one or two board seats as a condition of their investment and want the board to be structured in accordance with good corporate governance practices.  This likely means a VC director, one or two independent directors (often recommended by the VC), and limiting management directors to just the CEO.  F&F directors, unless they possess some unique skill set (i.e. your cousin on your board is Marc Andreesen) will likely be dropped.
  • You are now a fiduciary - Actually if you have F&F investors, you already are.  But your F&F board probably wasn't in the habit of reminding you of your duty to shareholders at every meeting (if you even had live board meetings).  Your VC directors will.  It is a good idea to agree on and establish upfront a regular mechanism for keeping your board informed.
  • Your relationship with your board is based solely on your future expected performance - You continued tenure at the company is not based on what you've done for the company in the past or even on how you are performing now.  The only thing that matters is how you're expected to perform in the future. And expect tolerance for under performance to drop significantly about 18-24 months before the targeted exit date.  For an excellent elaboration on this point, read this post by Steve Blank.
  • Assume that any advice from your VC board member is skewed towards the interest of shareholders - And as discussed in the last post, this is not always the same as what's best for the company.  You are the pivot point for balancing off the various stakeholder's interests for the good of the company.  While your VC board members will be clear about the tangible, short term, measurables of your business, only you can factor in the intangible, long term, unmeasurables.
  • Learn to distinguish between advice, demands, and decisions - Advice and demands are opinions.  They are not decisions.  This fact often gets lost in debate, particularly when consensus is reached.  Consensus is also not necessarily a decision.  Board decisions should be confirmed by formal vote and resolution.  If in doubt, explicitly ask if a consensus opinion board is really meant to be a decision requiring a formal vote.
Overall, the toughest part of the transition for a founder/CEO is going from being the final decision maker answerable to no one to having a boss again - the board.  It may no longer be clear where the line is as to when you should continue to just make the decision and move forward vs. when you should seek board consent.

The best way to strike this balance is to view your shareholders as co-owners, which they in fact are.  While the board is technically your boss, as founder/CEO and a shareholder in your own right, you cannot act as an employee manager.  Not even your board wants this.  The VCs invested in your company because of what you and your team created under your leadership.  They still want and need you to lead.

* Throughout this post, I use "VC" as synonomous with "institutional investor."  In reality, institutional investors can also be private equity or angel funds.  I use venture capitalists as representative of institutional investors because they are the ones most likely to be engaged with early stage startups.

Monday, January 18, 2010

Stakeholders Run Amuck!

Part 2 of a 3 part series on surviving the funding transition

In last week's post Startups and Stakeholders, we started to address the question of how a new founder/CEO can prepare themselves for the transition from leading a "friends and family" backed startup to one with institutional investors.  We described how a company is comprised of six core stakeholders - shareholders, managers, employees, suppliers, community, and customers - each receiving economic value from the company differently.  Unfortunately, this difference can lead to conflicts of interest, particularly with respect to dividing up the economic value.  And to some degree, it's a zero sum game;  what goes into one stakeholder's pocket comes out of another's.

So what happens when a stakeholder's claim on a company's economic value gets out of whack?  In the worst case, the death of the company.
  • Shareholders - Because shareholders have the legal authority as owners to set direction and hire/fire management, they can drive action that maximizes short term shareholder value and profits.  But this can mean cutting employee headcount and wages, squeezing suppliers, creative tax sheltering, sacrificing product quality, or raising prices to customers.  Remember "Chainsaw" Al Dunlop?  Before the Sunbeam debacle caught up with him, he was the darling of Wall Street and champion of the view that the primary goal of business is to make money for its shareholders.  As CEO of Scott Paper, by drastically cutting the workforce and closing factories, he improved profitability at Scott, subsequently sold the company to Kimberly-Clark and became a hero to Scott Paper's shareholders.  What the downsized employees thought of him was quite different.  In a venture backed startup, the pressure for short term profits can arise as the company approaches its target exit date, typically around year 5 after funding, especially if the company is lagging on its plan.
  • Managers - Think AIG, the recent sub-prime mortgage led meltdown of U.S. banks and the billions in bonuses "earned" by the executives at these banks, banks that would no longer exist if it weren't for a taxpayer bailout.  Who paid?  The shareholders whose stock value plunged, the employees and suppliers who lost their jobs, and the communities which will be suffering the collateral damage from shattered local economies for years to come.  Enough said.
  • Employees - Think inflexible union work rules, rich pension plans, and wage rates that, along with poor management, helped drive GM and U.S. Steel into bankruptcy.  Also, remember those great dotcom parties in 1999?  Great fun and great lifestyle...until the shareholders' money ran out.
  • Suppliers - As long as cash is sufficient, suppliers generally can't force a disproportionate receipt of economic value.  But when cash is short, it's a different story.  Suppliers can force a company into court or bankruptcy to collect debts owed even if this means destroying the company.  One could make the case that the leading cause of startup death (next to lack of customers) is when suppliers refuse to extend products and services the business needs to keep going in the absence of cash.
  • Community - Want to boost local employment?  Require local resident hiring quotas.  Need more community services?  Just raise taxes.  Hate large billboards?  Impose new zoning restrictions.  Hey, why are all the car dealer's leaving Palo Alto?  Why did sales tax revenues just drop 10%?  We need a new business license tax!
  • Customers - How is this possible?  Are you a Twitter fan?  When's the last time you paid to use the service?  When are you ever planning to pay for the service? I'm sure the folks at Benchmark Capital and Institutional Venture Partners would like to know...before their money runs out.
So how can a CEO decide what the proper balance between stakeholders should be?  Some guidelines and examples:
  1. Define what kind of company you want to be.  Rank your stakeholders in order of fit to your mission.
  2. Determine the importance of each stakeholder's contribution to your company and rank accordingly.  Cross-check this against the first list.
  3. Prioritize.  No ties allowed.  If you're having trouble breaking ties, play out some scenarios where the tied stakeholders would be in conflict and ask yourself how you would resolve it and why.  Some examples:
    • 5% price hike to customers vs. no salary increases for employees
    • Profit share bonus to employees vs. dividend distribution to shareholders
    • Slowing payments to suppliers to enable installment payments from customers
    • Employee layoffs to hit profit targets enabling  management bonuses
  1. Determine the line you won't cross for each stakeholder. This might take the form of a trigger (e.g. no management bonuses in a year where there is a layoff >5% of the workforce) or a number (e.g. no supplier payments >90 days).
In practice, I've found that shareholders, customers, and employees are the big three stakeholders with managers grouped with employees.  Here are some examples of how some well known companies prioritize stakeholders:
  • Customers 1st - Johnson & Johnson's Credo and its application by CEO Jim Burke to the Tylenol recall is the best known case.  J&J explicitly ranks customers (doctors, nurses, parents) first followed by suppliers, employees, community.  Shareholders are ranked last with the Credo explicitly calling out a "fair return" not a maximized one.
  • Employees 1st - Southwest Airlines' mission statement focuses on employees.  Their reasoning?  Happy employees lead to happy customers from which profits flow.
  • Shareholders 1st - As you might expect, many financial services firms place their shareholders first.  KKR, a private equity firm, is one example.  Surprisingly (perhaps), one that does not is Goldman Sachs.  They place customers first.
  • Community 1st - Most groups placing community first are humanitarian or charitable groups (e.g. the Red Cross) and newspapers.
  • Suppliers 1st - I've yet to find a case where suppliers are placed first.  If you should come across one, let me know!
As you might expect, determining how to balance stakeholder demands takes time and evolves as you are forced to make the real life tradeoffs.

Next week, in the final post of this series, we will focus on the difference between "friends and family" and institutional investors, and what this means for a founder/CEO.

    Monday, January 11, 2010

    Startups and Stakeholders

    Part 1 of a 3 part series on surviving the funding transition

    When I first became a CEO, one of the greater challenges I had to face was learning how to balance the conflicting demands of various stakeholders in the company.  In particular, having to deal directly with the demands of shareholders in more than just an abstract "delivering shareholder value" speech took several years.  So what relevance does this have if you're a startup CEO.

    One of the known stumbling points for a new founder/CEO is the transition from being a "friends and family" backed startup to having institutional investors (i.e. VCs). First timers often fail to understand how having professional investors can change the way a company is run.  They either continue to run it as if the new investors were the same as their "friends and family" or they become overly sensitive to the new investor's demands.  Both have the potential for disaster.

    So how can you prepare yourself and improve your ability to survive the transition?  Are there any guidelines for balancing off the competing interests of various stakeholders?

    The answer is yes.  Several frameworks exist to answer the question of rights, responsibilities, and prioritization amongst different stakeholders.  To understand how this works, we first need to understand what makes up a company.

    What is a Company?
    A company at its most basic is a legal entity created for the purpose of generating some economic value which is then shared over time by stakeholders, interested parties who contribute something to the company in exchange for a share of the economic value (i.e. money or capability).  The core stakeholders common to all companies are shareholders, managers, employees, customers, suppliers, and the community.  At the risk of oversimplification:
    • Shareholders contribute money and resources.  In exchange for risking their resources, they are the company's owners and are entitled to all the excess economic value generated by the company after obligations to other stakeholders are fulfilled.  Because they are last in line, they get to set overall direction for the company and hire/fire management.
    • Managers are agents of the shareholders responsible for day-to-day operations of the company.  They contribute management skills and know-how.  In exchange, they may receive equity, in which case they receive the value of shareholders, or wages, in which case they receive the economic value of employees.
    • Employees contribute their know-how, skills, time, and labor under the direction of managers.  The economic value they receive is wages.
    • Suppliers contribute products and services to the company in exchange for money.
    • Community is most typically represented by government, which establishes the legal and economic infrastructure (e.g. roads, schools, fire protection) shared in common.  In exchange, economic value is received in the form of taxes, jobs for community members, and charitable support for non-governmental organizations.
    • Customers contribute money in exchange for the capabilities of the company delivered in the form of products and services.  Unlike the first five stakeholders, the economic value they receive is a capability.
    Entrepreneurs create companies by figuring out how to combine the money and resources from shareholders with the know-how, skills, products, and services from managers, employees and suppliers to create something that customers will pay for with sufficient excess profits to comply with community obligations and pay the other stakeholders their share of the economic value created.

    The Competing Interests of Stakeholders
    Unfortunately, while all stakeholders recognize that they have a common vested interest in seeing the company thrive, because they receive value from the company differently, this leads to conflicts of interest with respect to (1) how much of the economic value they should receive and (2) their precedence in receiving that value.  Obviously, everyone would like to be first in line for the biggest share.

    In the U.S. at least, by law and as embodied in generally accepted accounting principles (GAAP), precedence is captured on the right side (liabilities + equity) of the balance sheet, which lists the sources of capital.  Again at the risk of oversimplification, moving from top to bottom the precedence order is:
    1. Community - If you don't believe this comes first, try not paying your taxes.  The law supports this; the limited liability protection extended to corporations, LLCs, and LLPs does not extend to non-payment of taxes.
    2. Employees - Labor laws exist to protect employees from unpaid and unfair wage practices.  And because the government collects payroll and income taxes, they have a vested interest in making this priority #2.  Again, the law supports this;  certain violations of wage and hour laws as well as non-payment of payroll taxes are exempt from limited liability protection.
    3. Customers, Suppliers - Note that customer prepaid obligations and accounts payables are at the top of the current liabilities list.
    4. Shareholders - Only after all liability holders are paid off do equity holders receive their share of a company's economic value.  But while liability holders receive an amount fixed by contract or percentage (e.g. taxes), there is no cap to what equity holders can receive.
    To the degree which management's economic value is received as wages vs. equity, their interests receive treatment as either employee or shareholder's respectively.

    Given that precedence is fairly well defined, the main conflict between stakeholders centers around how much economic value to allot to each stakeholder.  Managing these tradeoffs ultimately falls to the CEO.

    Next week, we'll look at what happens when the demands of a stakeholder are out of balance with the rest.  The following week, we'll conclude by focusing on the difference between "friends and family" and institutional investors, and what this means for a founder/CEO.

    Monday, January 4, 2010

    The Job of a Small Company CEO

    For some reason, in the past month, I've had several people ask me what's involved with being a small company CEO.  Then last week, the same question came up on a startup discussion group I subscribe to,  Apparently a few people found my answer helpful, so I've posted it here.

    Having been CEO of several small tech companies in Silicon Valley, here is a summary of what I've found the job to be:
    • The CEO's #1 job is to empower his/her team to do the job that needs to be done. It is the CEO's job to put energy into the business.
    • The CEO is responsible for drawing out, synthesizing, and articulating the vision for the company both internal and external. This is not necessarily the same thing as creating the vision.
    • The CEO is responsible for creating a culture that is high integrity, high performance, but humane. Balancing these three is tougher than it looks.
    • When it comes to raising money, key customers and key partners, the CEO is the top salesperson and representative of the company. By virtue of your position, especially to investors, you are the face of the company.
    • The CEO is responsible for ensuring the company has a coherent strategy for winning in the marketplace and that the company is executing. At the startup level that means ensuring that the company creates a business model that works and understands how to acquire customers.
      So what skills does it take?
      • You should be able to pick people. Get this right, and a lot of issues go away.
      • You need to be an effective communicator of your ideas.
      • You need to be able to empathize with people and be able to put yourself in their shoes.
      • You need to have the guts to stick with your ethical values (just look around to see what happens when CEOs don't have this).
      • You need to have the ability to face the facts as they are, not as you wish them to be.
        What you don't need:
        • Brilliance - you don't need to know everything or be the most knowledgeable person in the room. In fact, this can actually be a handicap, if it stifles the willingness of your people to present views that might be contrary to yours. I've found that people spend a lot of time trying to "read the CEO". You have to create a safe environment for people to put forth their true opinions even to the point of playing dumb.
        • Charisma - I know a lot of plain vanilla, even dull CEOs who are nevertheless very effective. We can't all be Steve Jobs. CEOs come in many flavors.
        Best of luck to all of you who are or are about to assume the mantel of a small company CEO.