A founder's blog

Founders should be CEOs

I believe founders ought to be CEOs whenever possible and that when Founders are the CEOs, the chances of success is much higher. I don't have any empirical data to support this claim but my instincts tell me that would be the case. Why? Let's breakdown the job of the CEO and compare how closely it reflects to what the founder does for a company:

Culture: The CEO defines the culture for the company. A founder should define vision for his or her start up. I would like to digress a little and define what culture means and how its defined. Culture is not a list of bullet points that are put on a slide. Culture is not taught but is learned by copying. Work ethics, how you treat people, challenging ideas, debates, hierarchy, salaries, stock options all define the culture of a company. Let me give you a few examples of how we set culture at Zimbra. A simple rule was that engineers would get offices with closed doors and if you are a management team person or someone who doesn't write code, you got a cube. You would use a couple of common rooms for calls. This worked great for us and helped engineers do their thing behind closed doors :-). Second, we decided to give full health, vision and dental benefits to spouses and children. This increased the burn but we signaled that we cared about employees. Third, we had zero tolerance for anyone losing their temper at their co-workers. A great indication of the culture of the company is whether the admins and receptionists are treated like how a member of the management team is treated. There should be no difference. Finally, I want to give one more example of culture. This has not been made public before and I am sorry if it sounds like I am bragging. But its the truth and I want people to know how we treated employees. At the end of the transaction, the 3 founders and the CTO unvested $10M to revest it again over the next 3 years rather than dip into $10M retention pool that was allocated for the four of us. This allowed us to distribute that money to employees rather than keep it for ourselves. This signaled the team that the management team and founders looked out for them. I think this whole culture thing should squarely fall on the shoulders of the founder. This is the first reason why I think founders should be CEOs.

Product Vision: The CEO defines the vision for the company. A founder should define the vision for a start up. This primarily includes product vision and what markets the company should be in and when. This vision defines your place in the market and your competitive advantages. It defines your competition. This product instinct is so crucial for successful founders. That's one reason I believe that founders should be the PMs. If your product vision is coming from a newly arrived VP of Product Management, I am very afraid for the future of the company. I am proud to say that we had 110 people and were cash flow positive when Zimbra sold to Yahoo! but didn't have a product manager in the company. The founders and our community and our customers set the product vision for the company. I will write a different post another day about how we crowd sourced product management.

Raising Capital: This is an important role a CEO plays. And I think this is an important role a founder should play. When do you raise, how much do you raise and at what price are all important things that the founder and CEO should decide. Communicating a vision and a strategy for the company's product and business to investors are central to raising $$. But raising capital is also about an emotional connection and a personal chemistry between the investor and the founders. This is why founders should be involved in fund raising and get to know their investor.

When and how to exit a company: This decision, I believe, solely rests with the founders. But if the founder is also the CEO, even better. This decision is based on data that no one but the founding team/CEO have. They are the ones who are in the trenches and they know when its time to sell and they know when the price is right. The price is different for the investors than it is for the founding team. The investors are always looking for the big exits based on pure math. The decision should be based on reality in the marketplace rather than a spreadsheet formula. The market reality is not really known to the board and investors at a deep fundamental level. Great investors always allow the founders to make the call on whether to sell a company at a particular price (no matter if the math works). I was very fortunate to have investors on my board who all voted to sell the company despite their own belief that we shouldn't have sold the company. This is what distinguishes a great investor from the rest.

Scaling the team/business: This is a common reason why CEOs are brought in to replace a founder. I want to present a counter to this. If the founder can hire great people to run sales, marketing and operations (like a COO) at the right time *and* delegate operations to someone else who understands how to scale a business, I think they can continue to focus on vision and culture of the company.

Founders should be CEOs. I know that it is idealistic and there will always be exceptions. A typical one I have seen is where the founder is uninterested in hiring the right operational leader to scale the business or doesn't want to delegate operations to the right COO or just doesn't want to deal with the unavoidable stress that comes with the role of the CEO. And I know there are many a great successful companies built with outside CEOs. I am only presenting that the role of a founder closely mimics the role of the CEO. And I would argue that the probability of success goes up dramatically when a founder is the CEO.

Posted March 19, 2010

Term Sheets - Final Part

In this final installment of the anatomy of a term sheet, we will look at other clauses that a term sheet might have outside of price, option pool and preference. Here is a list of everything you might expect in a typical early stage term sheet.

Redepmtion rights: This right basically allows the investor to get their money out and leave. This is usually trigerred at some long period of time after the investment. Typically done to protect the investor from a lifestyle business that is neither putting the invested dollars to work nor returning capital.
Conversion: How does preferred stock convert into common stock in an exit scenario? Typically its a 1:1 conversion. And the conversion is automatic or optional conversion decided by the investors. Automatic conversions occur in IPO scenarios. In early stage term sheets, the auto conversion provisions for qualification of an IPO is typically not a concern.
Pro-rata and pay to play: Typically investors have a right to continue to maintain the percentage ownership in future financings at their discretion. This is their pro-rata. In certain rare cases (called "Pay to Play") a late stage investor might force an early stage guy to pay for not doing their pro-rata. i.e a late stage investor might step up and own risk of doing a round when the early stage investor backs out of their pro-rata but in return the early stage investor pays by losing their preference (as an example).
Price based Anti-Dilution Adjustments: In future financings that are down rounds (if you raise money at a valuation lower than the post of your previous rounds), these are the terms to protect the investor. Typically these terms are trigerred when there is a down round. When the anti-dilution is triggered, there is a beneficial conversion of preferred stock to common stock (maybe 1:1.2 to 1:1.3) based on formula.
1. Broad based: This is the most entrepreneurial friendly
  - Weighted average between old price and new price taken over the capitalization of the company.
  - Broad based is more favorable to the company. And is the most common/popular to see on early stage deals.
2. Narrow based: This formula for calculating the conversion is more investor friendly. Don't see it as often so won't go into it.
3. Rachet: This is an extremely investor aligned term. In this case, the ratio for anti-dilution conversion is derived directly from the down round price compared to the previous price. i.e if the $100M post goes down to $50M in the next round, the investors in the $100M round automatically get the new price (1:2 conversion).

Voting Rights: This clause is designed such that an entrepreneur needs the permission of the investor for some future events. If you choose to work with the right set of investors, they usually never exercise any of these rights and always support the founders in their decisions (on whether to sell the company or not). A good investor should never force an entrepreneurs hand. Its a losing game. Back to voting rights -- things that require investor permission are:

Sale of company
Future Financings
Change size of the board
Issue Dividends

Conditions to close: Typically a quick review of legal and finance diligence. For an A round, this should be straight forward. Typically the company counsel offers the investors their legal opinion that everything is in order. There should be no other conditions for close.

Representation and Warranties: More for M&A type term sheets. This is not relevant for an A round deal. (I have another longish post on M&A contracts coming up).

Management Rights Letter: Another thing to ignore... this clause provides the investor the cover needed to raise money from pension funds as an LP

Indemnification agreements for board members: Company protects/indemnifies the investor against personal lawsuits related to the company/products.

Expenses: Typically company pays legal bills to close the transaction. This is typically capped at some $ amount (think betweeen $20k and $30k).

Registration Rights: This talks about when an investor can sell their shares if an IPO happens. Typically its "piggybacked" ... i.e investors can sell upto 25% or so together with an IPO. This is usually over-ridden by the underwriters of the IPO. They get to dictate who can sell what and when.

Market Standoff: This term prevents shareholders from selling anything for a period of 180 days from an IPO.

Right of First Refusal: If there is a sale of common stock by employees (typically called secondaries), this term dictates that the company has the right to buy them before anyone else does. The investors have a right to purchase such common shares if the company decides not to buy it. And if both the company and the existing investors pass, can the common stock be sold in the market (secondaries).

Drag Along: This term is used to dissuade strategic investors from stopping a sale to a competitor. It forces the minority preferred owners to vote alongside the majority. This can also be used to prevent an ex-founder from blocking a sale of the company. Entrepreneurs/Founders who are current can protect themselves from being forced by adding a couple of exceptions like:

The board has to unanimously agree as well.
A majority of the common holders have to agree to the sale as well

Standstill Agreement: Again this is used when a strategic investor gets involved. It forces the strategic investor to "stand still" - i.e to not try and buy more of the company (either via secondaries - i.e buying common shares from employees) to gain control of the company.

Publicity: Whether you can talk about the terms of the deal publicly or not.

Finally "No Shop": After the term sheet is signed and before its closed, the founders agree to not further shop the deal.

That is pretty much everything you can expect to see in a typical term sheet for an early stage investment in a high tech company.

Posted January 20, 2010

Term Sheets Continued

Sorry about the long delay between posts. I really want to get this series over with so I can write about other things .... In this post, I'll talk about the preference terms you can expect to see in a basic series A term sheet.

Liquidation Preference: This is a term that you see in many term sheets. And a lot of people talk argue about what the preference ought to be. In early stage series A deals, most good venture firms do not have any preference. A preference is a term that gets the investor an unfair share of the exit value in certain scenarios (typically when the exit is not huge). The key thing to understand here is that with a preference investors have a choice of either converting their preferred shares to common - in which case they get paid based on what percentage of the company they own (if exit is big enough) OR they can exercise a preference - i.e if their ownership doesn't give them the returns they expect they can dictate that they want 2x or 3x returns before any of the common stock holders are paid out. Let's take an example to make things clear. Let's say an entrepreneur raises $20M on a $80M pre-money and gives away 20% of the company at a $100M post. Then let's assume that the company exits at $50M at some future date. Here are the different preference scenarios:

1. Simple - Non Participating Preferred: This is the most entrepreneur friendly and what you should expect in an A round deal. The most entrepreneurial friendly terms is a simple 1x preference.

In this case, the investor has one of two choices:

Choose to not convert your preferred stock to common and get exactly the $$s you put in back for a 1x preference. The rest is distributed to the common stock holders (founders/employees) per ownership structure. In the example above, you pay $20M (in a 1x preference) back to the investor and then distribute the rest of the $30M of the exit equally among common holders.
Investors can choose to convert to common and get 20% of the outcome. In the example above it doesn't make sense for an investor to choose this option because 20% of a $50M outcome is only $10M and so its better for them to just take the money they put in out ($20M)

2. Participating Preferred: This is not an entrepreneur friendly term. In this scenario, the investor can get their money back and still participate in their ownership structure in certain scenarios. Typically this term has a capped upside for the investor in certain cases. Assume that there is a term sheet with a 2x participating preferred cap. Let's continue with the example above. The investor has 2 choices in a $50M exit scenario

Get the invested $20M back and then participate as a 20% owner in the rest of the $30M value (netting another $6M) capped at $40M total return.
Or convert to common as above and get 20% of $50M which is not what the investor would choose to do in this case.

Entrepreneurs should always strive for a simple 1x preference for a series A deal. Good investors should always be aligned with that. Series B and Series C term sheets should typically "follow" the A terms if the company is doing well. "Pari Passu" is a term that is used in follow on term sheets to indicate that the investors in the later rounds and the early A round investor are treated equally for preference. Sometimes later rounds have the "seniority" instead of "Pari Passu". In this case the later stage investor first gets their money out first, then the A round investor gets their money out (if available!).

There are a dozen more terms in a term sheet that is worth looking at. I will quickly discuss all of them in my next post and hopefully that post will be right around the corner.

Posted January 12, 2010

Anatomy of a Term Sheet - Part 1

I have been asked by many entrepreneurs over the last couple of years about term sheets and the different nuances that they should look out for. Here is the first part of posts on what the different things in a term sheet mean and what you should look out for.

A term sheet is a letter of intent for a proposed investment in your company. It is a promise to do a deal that is signed by the founders and the investors. It is very rare for people to sign a term sheet and go back on it. Both parties work hard towards a "close". A close is when money hits the bank and the word hits the press about your investment. Typically its about 3-6 weeks depending on the stage of the company. Between signing of a term sheet and a close legal diligence is done and closing matters are dealt with. For early stage companies, this diligence is very light. It becomes more involved in later rounds. Typically legal diligence involves making sure that everything is represented well and both parties understand what the IP involved is, who owns it, employee legal matters, founder salary, making sure that there is no lawsuit or overhanging contractual agreement (with customers, with previous employers, with current employees) that could affect the company. Its mostly lawyers making their living! It is very important that a signed term sheet closes. It becomes very ugly when a term sheet doesn't close for all parties involved. For the investor, its a reputation issue. VCs want to be seen as being good for their word and that their reputation is not tainted by a term sheet that isn't closed. For founders, going back to raise money from investors when a term sheet collapses is doubly hard. So it is very important that the *most* salient terms of a deal are nailed at the term sheet stage rather than at the close stage especially from the founders point of view. Here are some important terms to look out for:

Price: This is an obvious one. Investors infuse cash into the company in return for an equity stake.. The pre-money valuation is what the value of your company is before the cash infusion. The post money valuation is what the company is worth after the cash infusion. The post-money valuation is simply the pre-money valuation plus the total amount of money raised. If you divide the capital raised by the post-money valuation, you get the equity stake you have given away to the investors (otherwise known as the dilution). Here is an example: when you raise "3 on 6" (investor speak for what the amount raised is and what the pre-money is) - it means you are raising $3M as an investment round on a $6M pre-money valuation. The post-money valuation is $9M and you have given away 33% of the company (3 divided by 9). If there are 2 investors each investing $2M and your pre-money is $6M you have a "4 on 6" situation. Here your pre-money is $6M, your raise is $4M and your post-money is $10M. You have given away 40% of your company (4 divided by 10).

Pool: This is a tricky one. You can think of the option pool as the number of shares you reserve for future employees. This is the pool you reserve *before* the investment comes in. Since its before the investment comes in, the new investor is not diluted by this reserve pool. So its in the best interest of the new investor to have this pool be as large as possible. And its in the founders best interest to have this pool as small as possible. Why is that the case? Because if you run out of shares in the option pool after the investment, the board typically issues more shares and dilutes everyone equally (including the new investor) while the new investor is not diluted at all no matter how large the reserve option pool is (since its a reservation before the investor comes in). Let's look at a quick example. In the example of 6 on 4, founders own 40% and the new investor owns 60%. However, if there is a 20% option pool, then the founders own 20%, the future employees own 20% and the investor continues to own 60%. To make this example work, let's say there were a total of 10M shares in the company. This is the fully diluted number. 6M is owned by the new investor, 2M are owned by the founders and 2M is reserved for the "option pool". Now let's say the company is sold for $100M the day after the investment closes. In this example, there are no new employees and so the option pool of 2M shares that have not been issued to anyone at all. So it in effect "disappears" into ether. There are only 8M shares issued. 6M are owned by the investors and 2M by the founders. As you can tell -- 75% of the issued shares are owned by the investors and 25% of the issued shares are owned by the founders. So the investors make $75M and the founders make $25M of the $100M pie. Well --- that's a bit of magic isn't it? In this example, the investors owned 60% of the fully diluted number of shares (including the option pool) but owned 75% of the issued shares. In any acquisition scenario, the unissued shares disappear. In reality, new employees are always hired and so some of the unissued shares get issued. If all goes well, the number of shares issued to new employee hires is close to the number of shares reserved in the option pool. In this case, the math works right. If there is an acquisition of $100M after the entire 20% pool has been issued to new employees, the math works like this: $60M to the investors, $20M to the founders and $20M to the new employees hired after the investment. Fred Wilson treated this topic well in his post here.

That will be all for this post. There are a few other terms that are also important to know and consider while evaluating a term sheet. I will talk about them in my next couple of posts.

Posted December 1, 2009

This one is for the many founders

I have been using posterous for my family blog and pictures and been thrilled with it. I have been meaning to write a new blog about my experiences as an entrepreneur, CEO and, now, a VC. I have had starting trouble -- not knowing where to start and what to write about. I know that I have seen and learned a few things that could be fun (and maybe even helpful) to share. But I didn't know where to start. What would be a good first blog post?

This week, this question of what to start the blog with was answered pretty well. I had dinner with the two co-founders of a stealth startup to be launched in Q1 of next year. I believe that their launch will fundamentally change the home entertainment landscape and will win many hearts and many awards. That aside, the reason why I decided to start the blog today and start it with their story is that I am such a huge believer in the spirit, passion and conviction with which entrepreneurs do what they do.

I met the two founders at an NPO board meeting where one of them was a board member and the other worked as a volunteer. Their zeal and enthusiasm to get things done at the NPO amazed me. They were on top of things and worked relentlessly on a project for which they gained nothing but the satisfaction of reaching a goal. One day, they both quit their jobs and started working on an idea in their garage. They worked 20 hours a day, 7 days a week for 6 months building product and a prototype. That's when their financial troubles started. They told me plenty of stories of how empty their wallets were. I will only highlight a couple of salient points that detail their journey.

On their way to meet an investor, one of them runs out of gas and pulls up to fill gas. He tries each of his credit cards and it doesn't work as its all maxed out and its the same case with the other founder. Finally they call a family member who drives up to the gas station and fills gas for them so they can drive to the investor meeting. One of them finally ran out of $$ to pay rent for his 1BR condo. Its the 24th of the month and he has an eviction notice. So he decides to surf CraigsList for CS projects and finds one for iPhone apps. Well unfortunately he doesn't know Cocoa - but that doesn't stop him. He sends an email to the firm who advertised for a bid to code an iPhone app -- then goes ahead and mis-represents to them that he is an iPhone Cocoa whiz. The buyer gives him a chance to write the iPhone app for $3000. The founder insists that he gets $800 advance and the rest on delivery. He gets the advance and pays $800 for 2 weeks worth of rent, and extends his runway until then. Right after that he starts reading up on iPhone Cocoa development --- pretty soon the entrepreneur and his brain triumphs and he codes this complex iPhone app and gets paid. Soon he writes 5 more iPhone apps and makes $22k more to take care of his expenses and tide through the next couple of months while also coding his own project. By this time, a band of angels and seed investors have come together for a $1.1M round in their company. Within 3 days of the close, they hired some of the best minds out of apple and are creating an exciting app that they plan to launch early next year. I wish them the very best as they launch their product and company.

Why am I sharing all of this? First because I asked them whether I could share this. Their response was typical --- I quote: "ofcourse -- we are so proud of this experience. It gave us confidence that we could do whatever it takes. BTW when a VC asks us questions about some 5 year projection numbers - we are so cocky in our made up answers - this experience probably helped us gain more confidence in ourselves and be less worried about mundane questions. It was exciting to see the lowest of low points."

I love this story because I know this is not unique or atypical. Many entrepreneurs (me included) have it too easy --- we know people on Sand Hill road and have the history and the background to fund our companies once we hone in on a good idea. While many others, especially the first timers and the unknowns, take crazy risks and take long painful circuitous roads to get to the promised land purely fueled by their own passions and intellect. I want my first blog post to be a toast to those entrepreneurs who are first timers, unknown risk takers who are passionate about an idea and stop at nothing to achieve what they think will change the world. These are the future serial entrepreneurs and I am in awe of their passion, energy and relentless spirit. I hope they all get rewarded in some way for the conviction with which they pursue their passions! And I very much hope that I will get to work with some of them in the future.

Posted November 12, 2009

Posterous Rocks!

It really does. Can't believe how easy and simple it is. KISS always works.

Posted November 5, 2009