Tips for Startup Companiesby Philip Greenspun; created February 2006, updated February 2011
The author of this article has started about six companies over the years with collective and cumulative revenues approaching $100 million. He has been a board member and advisor to young companies in software, materials science, and electronic hardware. Here are some tips for young people starting companies.
Having rich parents is great. In fact, it is the best and surest way to get rich in these United States. Unfortunately, having a low cost of capital is no guarantee of success because, as formerly poor countries have become ridiculously rich, capital has become very cheap. Your competitors can probably get a home equity loan at 6 percent on their McMansions. How much cheaper can your cost of capital possibly be?
The most reliable source of supranormal profits is superior knowledge of one kind of customer (Way #3). Ideally this will be the kind of customer that larger companies are overlooking. The founders of SAP, for example, were employees of IBM Germany for many years and got exposed to the accounting challenges of large manufacturers. When they quit IBM, they were among the best situated programmers in the world to build an accounting system for manufacturing companies. It is not because these guys were the world's best programmers that SAP is today bringing in $10 billion per year in revenue and has a market capitalization of $60 billion. It is because these guys were the best programmers who understood the problems of their customers.
If you don't understand customers, consider taking a customer-facing job (think "sales engineer" or "product manager" rather than "cubicle-dwelling system internals programmer") at a company that already has the kind of customers you think constitute an attractive market. Once you've figured out what the customers need, quit and start your own company.
Another issue is that, if you raise a lot of money, the investors will eventually come looking for a return on their investment. One of my flying buddies was tapped to be CEO of a company that had raised $40 million to build an obscure scientific instrument. After one year he told the investors that the market was limited to a handful of military agencies and that they would likely never get a return on their investment. The venture capitalists fired him in hopes of getting a better answer from another manager. They never did and the company, while it did not go bankrupt, never provided a return to the investors.
Unfortunately, most venture capitalists don't like to take risks. They don't know how to evaluate products, technologies, people, or markets. So they don't want to fund a company until it has significant revenue. I.e., they only want to fund a company that is already worth a lot.
Suppose that you own the kind of company that is attractive to venture capitalists. You have $10 million in revenue, of which $1.5 million is profit. You could simply move $1.5 million into your personal checking account every year, but instead have chosen to reinvest the profits in your growing business. You are feeling a little tight on capital and worry that if one of your competitors, flush with venture capital or money from a public stock offering, gets intelligent and efficient, you could be snuffed out. But you aren't that worried because you own an enterprise that is probably worth at least $10-20 million. You are a multi-millionaire!
Suppose that you decide to take venture capital. The VCs value your company at $25 million right now and put in $10 million for a minority share. Buried somewhere deep in the notebooks of legal documents that closed your deal will be something about "participation rights" for the preferred shareholders (the VCs). Basically it says that if the company is ever sold, the first $10 million goes to the preferred shareholders (them) and then the rest of the sale price is divided up among preferred and common shareholders (you) according to percentage of ownership. Some VCs get a little more aggressive on their participation rights and add a 10 percent annual interest. So if the company sells five years later they'd be guaranteed the first $15 million or so.
Now imagine that the strong economy that enabled you to grow to $10 million in revenue on your small initial investment begins to falter. Customers are deferring purchases. Perhaps the whole market segment is shrinking and becoming unattractive to investors. Your revenue is down to $5 million per year. Profits are down. Your entire enterprise is only worth about $5 million now (1X revenue isn't uncommon for a private company in a boring market).
If you had not taken venture capital, you are still a rich person. You own something worth $5 million. It was better a few years ago, when you owned something worth $10-20 million, but you can still afford a Robinson R44 helicopter and to hang out at the local airport with radiologists and gynecologists.
If you had taken venture capital, however, your commmon shares are now worthless. It is very unlikely that your company will ever be worth more than the $10 million that was invested by the preferreds and therefore all that you will ever get out of this company is your salary. You are a wage slave even if you don't realize it yet.
How can you cut down your risk? One obvious approach is to steer clear of venture capital and grow your company a little more slowly. Anything more than 25 percent annual growth tends to be chaotic. A less obvious approach is to insist that the venture capitalists buy some of your common shares at the time of the investment. There are a lot of venture capitalists and not too many good companies. If your company is attractive, you can probably find a firm that will agree to put $10 million into the company and, say, $3 million into your pocket. Then if the enterprise stumbles and ends up being sold for, say, $9 million, you won't feel like a total idiot.
For your Board of Directors you need folks who are actual business people. A business person is one who has held profit-and-loss responsibility ("P&L" on their resume). P&L responsibility means that the person was in a position to determine the total profit earned by a company or a division and received compensation based on that profit, not based on what his or her manager thought.
Better someone who was the manager of a McDonald's restaurant or a roadside shop in Hyderabad than an impressive former management consultant or middle manager from a big company. The Board makes important decisions and the directors need to have an intuitive feeling for what is going to make the customers happy and get them to keep coming back and paying. Membership on the Board should be limited to those who have founded companies, run companies, or held P&L responsibility in a division of a larger company.
It is always easy to hire more of the kind of stars that you already have. A company that revolves around great salespeople and has a few on board already will find it easy to hire more great salespeople. A company that revolves around Stanford-educated superstar engineers will find it easy to hire more Stanford-educated superstar engineers. Just because the smartest guy you knew from grad school wants to work with you at your new company, don't be deceived into thinking that a competent manager will find your enterprise attractive. Business people will approach you wanting to get involved. Mostly these will be older guys who were discarded by their Fortune 500 employers and maybe some young guys who couldn't get jobs at GE.
Larry and Sergei had to run Google, the fastest growing company in the history of the world, themselves for about three years before it was successful enough to attract a competent CEO. Bill Gates ran Microsoft for more than twenty years before his successor, Steve Ballmer, who had worked at Microsoft nearly the entire time, was adequately trained to take over the reins.
For an organization with tremendous institutional history and stability, bringing in an outsider at the top might be the only way to effect some needed change. That's why you sometimes see the Fortune 500 bringing in outsiders and the American people often vote for an outside CEO to head up the Federal Government. An organization that has been recently and rapidly assembled, however, is very fragile and bringing in an outside CEO is tremendously risky. Much better to copy Bill Gates and bring in a COO then promote him or her to CEO when the individual has learned enough about the organization and vice versa.
Be wary whenever interviewing someone who isn't like you. You probably don't know how to evaluate them. They probably aren't very good, otherwise they wouldn't be interested in your tiny little enterprise. Use your network of Board members and top business executives to evaluate management candidates rather than relying on your own judgement and enthusiasm.
"An entrepreneur is someone who starts a company in which he/she would never work and if they did, would promptly be fired." -- Bill Abernathy, in The Sin of WagesA friend who went through the MIT Sloan MBA program said that the one good book on management techniques that he was assigned there is Bringing out the Best in People, by Aubrey C. Daniels. Let me try to summarize this book:
What kind of interview questions can you ask to sort through the remarkable achievers who apply? Don't ask them what they've done; ask them what they would do in a hypothetical [or in your current] situation. You want to see how the applicants think, not help them relive the glory of their past achievements. Ask them to do some homework before coming in. Give them a real business or technical problem that you're facing and ask for a plan towards a solution.
A "work made for hire" is--Do you see software on that list? Neither does Jim Gatto, one of the country's preeminent software attorneys (see his paper on this subject). If you're a startup, you probably can't afford to hire Jim, so just make sure that you get an explicit assignment of copyright from anyone you hire to write software. For a model, you can very likely cut and paste from the employee agreement of any big tech company.
(1) a work prepared by an employee within the scope of his or her employment; or
(2) a work specially ordered or commissioned for use as a contribution to a collective work, as a part of a motion picture or other audiovisual work, as a translation, as a supplementary work, as a compilation, as an instructional text, as a test, as answer material for a test, or as an atlas, if the parties expressly agree in a written instrument signed by them that the work shall be considered a work made for hire. For the purpose of the foregoing sentence, a "supplementary work" is a work prepared for publication as a secondary adjunct to a work by another author for the purpose of introducing, concluding, illustrating, explaining, revising, commenting upon, or assisting in the use of the other work, such as forewords, afterwords, pictorial illustrations, maps, charts, tables, editorial notes, musical arrangements, answer material for tests, bibliographies, appendixes, and indexes, and an "instructional text" is a literary, pictorial, or graphic work prepared for publication and with the purpose of use in systematic instructional activities.
I asked whether the guy had done anything unethical or irresponsible. No. In fact, he had tried his hardest, according to the founders. "You guys are going to run out of money in three months," I offered. "You don't need any other reason to cut payroll. Just say 'We're sorry, but we need to lay off anyone who isn't directly involved in product development'. As for the stock, why not give him what has vested proportionally and ignore the one-year cliff? The stock might be worthless in three months if we don't raise the next round of funding." I reminded the other board members that the ex-employee, if treated fairly, might still be an advocate for the company.
My advice was accepted. The company did raise its next round of funding. The guy who tried and failed got a small amount of stock that was diluted over time as the company needed to raise additional capital.
Bizarrely, I faced exactly the same situation five years earlier. [It is doubly bizarre, because our photo.net community in 1999 had every feature of Facebook: you could form groups, upload photos, mark other members as "interesting" and see a page showing the most recent contributions from those "interesting users" (i.e., friends). I wonder if when Facebook gets sued for patent infringement they will hunt me down as a software expert witness.]
Back in the 1990s, I created an LLC with five other people. We did not ever expect to take external investment, go public, or pay a dividend based on ownership. The company grew faster than expected, though, to the point where ownership might have been worth something. Three of the five original "partners" in the LLC had never done anything. They'd kept their day jobs or wandered off to do something else. The Facebook/Silicon Valley approach to those souls would have been to issue millions of stock options to current employees, i.e., everyone but them, and dilute their substantial ownership position to insignificance. Then they could have sued.
What I did instead was call them up and explain the situation, i.e., that despite not having done anything, on paper at least their LLC ownership interest might end up being worth a lot. Since I knew and they knew that they hadn't actually done much, would they consider selling back their shares for $10,000 or $20,000 (I forget which!)? All three agreed. They got a nice return on their original investment (less than $100). The LLC was free to convert to a C corporation, accept investment, and set itself up to go public or be acquired.
My favorite lawyers are Sam Mawn-Mahlau of Davis, Malm, and Tobias Lederberg of Lederberg Blackman. Both have extensive experience with startup companies, venture capital financing, and acquisitions.
[Big law firms are not necessarily a good choice. I took over a company for which Troutman Sanders had formerly been the counsel. The previous management team had followed standard practice and entrusted Troutman Sanders with the company's most important records: Board minutes, stock certificates, bylaws, etc. When asked, Troutman couldn't find any of these, but they did manage to dig into their accounting system and determine that we owed them money. When I called them up to object to paying for legal services given that they'd lost all of our records, they said "But we did such great work for you setting up the company." I replied, "How am I supposed to appreciate that if I can't see a copy of any of it?"]
If you're the CEO, it is your responsibility to schedule the Board meeting. I recommend that you send out anything that you're going to present in advance so that Board members can study it. You don't want anyone to be surprised in a Board meeting, even by good news. You won't get folks' best thinking unless you give them some time to reflect.
One of the main risks in a startup company is "team risk", i.e., the risk that you'll hire the wrong people for the job or that the people you have hired won't work together effectively. Your Board presentation should include indications that you are reducing team risk. If the company is small, have a chart that shows each person you've hired, what they've done, how the relationship is going.
A lot of the stuff that people show in Board meetings, such as sales pipeline and financials, should probably be available on an internal company Web site and pinned up on the walls for all employees to see. There is no reason to keep goals and performance secret. Everyone in a company should be able to see, on a daily basis, how well the company is meeting its goals. I don't like to see management present a big stack of PowerPoint slides that are imprisoned on the CEO's laptop and possibly never shown to employees. I would rather see a tour through internal Web pages or posters on the wall so that I know that there is no miscommunication within the company about goals.
What if you hire someone to do the sleazy stuff for you? Nothing could be easier. They are called investment bankers. Once a deal gets close to the point of a real offer, turn over the potential buyer to your investment banker. He or she can say "Thank you for the offer, but my obligation is to get the best price for the shareholders. I will try to get Board approval for this deal, but I will also be trying to get the best price from other bidders." The investment banker can drive a hard bargain without making the bidders feel that you welshed on a handshake deal. You might have to work with the buyer again, either through an earn-out, a service agreement, or selling them another company three years later. The investment banker can generate hard/hurt feelings without much cost to anyone.
Do you need to use an investment banker? No. It could be almost any third party. Your corporate lawyer can serve as the arbiter among the buyers/bidders. The important thing is that you don't go all the way to a handshake with a buyer. Your handshake and oral promise isn't worth anything anyway. Only the Board of Directors can vote to sell a company and they do have an obligation to get the best price for the shareholders.
Having a small business or startup business with tons of decision to make is mind bubbling brain-wreck, but I tried reading the Book Slicing pie by Mike Moyer and it all made sense, in his book he emphasized the startup equity by providing an example; also talked about splitting equity using grunt calculator and dig in to details on equity structure, founders equity, equity compensation, and differentiating your choice on salaries or equity.
-- Sean Mel, October 29, 2012