The Stages of an Early Stage Company and How to Think About the One Thing VCs Say Even More Often Than “No”

There’s going to be a second ‘Secret Math of Venture Capital’ post, but first I’m going to cover the stages that early stage companies progress through. Where you are in this evolution defines how much capital you can raise and the valuation that you’ll get.

Be warned: nothing below is profound. It’s even obvious. But that doesn’t mean entrepreneurs are conscious of it. We get so passionately obsessed with our vision and how we’re changing the world that we forget that the reality isn’t always keeping up. The entrepreneur who can remain aware of these stages and rationally pinpoint where the company is in its evolution is going to simplify the capital-raising process. It will change who you approach and what you expect.    

The stages are roughly as follows:

• Idea & Commitment: Ideas that have a committed entrepreneur behind them have value. If you can write it on a piece of paper and get other people excited about it, especially people with money, you’ve reached stage 1.
• Product:  The next big stage is a working product. You may, or may not, be able to do this without funding. If it’s a relatively simple consumer facing website, you probably should get it live without raising capital. If it’s a new electric car, you might line up component suppliers and other elements but you probably won’t be able to build the car.
• Revenue: Revenue may sound synonymous with the product, but it’s not at all. Building a product proves that you can execute (some people can not, some people can only talk). Building a product proves that it the thing can do what you said it would do. Generating revenue means that someone values what you do. That’s fundamentally different and very interesting. Lots of time is spent by venture capitalists understanding why people are paying for a new service & whether or not that’s likely to continue.
• Scalability and Profitability: After you start to generate revenue, the obvious next step is to grow and to grow quickly. You’re now leaving “early stage” and entering “growth stage.” Here the questions are all about how big and how profitable. You can definitely generate revenue if you buy Cokes for a dollar and resell them for $.50. But you can’t make a business out of it.

So what’s the one thing VCs say more than no? Something along the lines of, “Come back to me when….” It’s often just a softer way of saying, “no” but it can imply a respectful question about what stage you’re at. BTW, even though I’m an entrepreneur, I’m speaking with some authority here: I was a VC for four years and I probably said “come back to me when” over 1,000 times. I said it in my sleep. Cosmic justice ensured I heard it back 1,000 times when I moved to the other side of the table….

It’s a reflexive, loser comment but you should anticipate it & you should build off of it. Some ways to reply: “And what will that show?” “If we do that, will we be in the sweet spot of where you like to invest?” “Is that the only thing you think is left for us to reach y stage?” Or, if you’re feeling to moment is right to give a little back, try “and then what?” 

The Secret Math of Venture Capital and Valuations

Whenever an entrepreneur asks me for guidance I always say, “absolutely, but please read my blog first so you know how I see the world and then we can build from there.” I’m sure it’s incredibly annoying to them, but if I didn’t do it, well, then I wouldn’t have any readers at all. Honestly, my mom doesn’t even read the blog.

Anyway lately I’ve been explaining the secret math of venture capital a lot and I started thinking, “my god, didn’t I write about this? Why is everyone so interested in this?” I went back and sure enough the blog post, “How to Value Your Venture Capital Round” is a complete cop-out. I didn’t cover it at all. So be prepared to be wowed and amazed. This is the post that will change your life.

Pre-Money and Post-Money

As always, let’s start with the basics. When people talk about their valuation relative to a round of capital, you have to clarify whether they are talking PRE-money or POST-money. I tend to always think in terms of pre-money; any numbers disclosed publicly are probably post-money. What’s the difference? It’s easy. Pre-money is what the company is worth before the round closes. Post-money is simply the pre-money + the invested capital.

So let’s say the pre-money is $2 mil and the new investors agree to put in $1mil. The post-money will be $3mil. Two side notes that will help you keep up when firing numbers back and forth with potential investors:

• the price per share stays the same. So if in our example initially there are 4 mil shares outstanding, that means that on a pre-money basis, the shares are worth $.50. The new investors will buy their shares for that exact price, meaning they will get 2 mil new shares. At the end there will be 6 mil shares outstanding. $3mil post / 6 mil shares = $.50. Capital raising itself neither creates nor destroys value
• always calculate ownership off the post money. Here, new investors put in $1mil. The post-money is $3mil. Their stake is therefore 33%.

So, when a potential investor says, “I’ll value you at $2mil” make sure to listen for “pre-money” on the back of that. If they don’t clarify, it is neither tacky nor pretentious to say, “I assume you mean pre?”

 The Secret Math

OK, now that we’ve got the lingo, let’s get to the good stuff. What entrepreneurs always want to know – essentially – is what is the pre they should be asking for? But I’m here to tell you that it’s the wrong question to ask. The question is how much capital do you think you can raise.

What?  The key insight is that in every round you raise, the new investors are going to want to own somewhere between 20 and 50% of the company. And the heart of the range is where the real action is at….30 – 35%. The bottom line is that you’re giving up a chunk of your company.  Just accept it. It’s actually easier for most VCs and angels to write bigger checks then change the model and start accepting lower stakes.

So your true motivation as an entrepreneur is to get as much money in each of those rounds as you can and minimize your dilution by raising fewer rounds, not by maximizing the valuation in each round. Although – note – by maximizing capital in exchange for that 35%, you will also maximize the pre-money. So then, what’s the difference? The difference is that if you approach it as I’m suggesting, you’ll use different language that’s less “fixed pie” and more in line with the investors’ interests.

In another post, I’ll write about stages of development and what that typically means for how much capital you can raise at each.

Before I close, though, let me point out that Fred Wilson at Union Square – who many people believe to be the hottest investor on the planet at the moment – has explicitly said he doesn’t agree with the traditional model of, “get 35% in every round.” He’d rather write smaller checks for smaller stakes that leave managers with more ownership and less of his capital to burn through. Without a doubt, this has helped Fred become an owner of great start-ups like etsy and twitter. Maybe that’s the future of venture capital. But for now, I think you’re pretty safe following my guidance when Fred’s not in the room. 

How Should You Think About Your Options (Stock Options, That Is)

After finishing the post on anti-dilution, it occurred to me that maybe I had the cart before the horse since I’ve never really discussed the basic mechanics of option grants. Since the blog is targeted at senior managers, I should note that this post is for a more general audience. My further ulterior motive is that I’ve got a presentation coming up on this topic and this will help me arrange my thoughts.

So the first thing that seems pretty important to point out is that stock options, at least in the technology world, are remarkably standard. You don’t need to spend a whole lot of time trying to figure out whether or not your company has a better option plan than another company…they are pretty much all the same. Which is NOT to say that you don’t need to worry about the details. You absolutely do. As you’ll soon see, it is not always easy to recognize value from an option grant.

First let’s cover the basics, including why plans are so similar: 1) VCs have worked to standardize governance documents across portfolio companies and option plans have fallen into this vortex, and – this is the more important one – 2) in order for grants to qualify for favorable tax treatment, they need to conform to certain guidelines. When those guidelines are met, the grants are called “Incentive Stock Options” or “ISOs.” Those guidelines drive uniformity.

Three basic concepts tell you most of what you need to know about the mechanics of option grants:

• Strike price: the strike price is the price you will pay, per share, when you exercise your grant (i.e. – buy the underlying shares). The option only has value if the value of the shares exceeds the strike price. In order to be an ISO, the strike price needs to be at the fair market value for the stock on the day of the grant. This may come as a surprise to you…your manager may have suggested to you that the stock was worth more than the strike price. Generally, what’s happening is that they are comparing the price of the company’s preferred stock (what the VCs buy) with the price of the common stock (what your option converts into). Why would VCs pay a higher price for their stock than you pay? Because they get additional rights. Should you care? No. You are going to exercise your grant and probably sell your stock relatively quickly so those extra rights are not valuable to you. There is a bit of a sleight of hand going on here that is part of the magic of options.
• Vesting schedule: Almost all employee grants have what is called a 4/1 vesting schedule. This means that the grants vest over 4 years with a 1 year cliff. The cliff means that nothing vests until you get to the first year anniversary of the grant. Why? Because it is very annoying to have to fire someone or have them quit in the first year. The idea of having itinerant workers become shareholders is excruciatingly painful to managers. Once over this threshold, the rest of the grant will usually vest quarterly or sometimes monthly.
• Expiration Date: Most employee grants expire either seven or ten years after the grant date. Generally, this is irrelevant. Something else will happen in the intervening period, including: a) there’s a liquidity event which causes you to exercise, b) you leave, which forces you to make a decision on exercising, c) the company fails or is sold at a low price, leaving the option worthless.

Some advanced concepts to further flesh out some scenarios:

• How do I realize value: The best way to maximize value from an option grant is to be employed at the company when a liquidity event (IPO or sale, otherwise known as an “exit”) occurs. At that point, the value of the underlying shares becomes known and you should be able to sell the shares quickly and realize the excess value. Note two reinforcing factors: a) any finance major can tell you that the value of any kind of option derives from not exercising until the last possible moment (see below for an exception), b) venture backed companies (the analysis is different for public companies) grant options to encourage you to help them reach a successful exit. Everything, even the tax laws, makes it difficult for you to realize that value if you aren’t around at the ultimate event.
• How can I enjoy favorable tax treatment: If, after you’ve exercised your option you hold the underlying shares for at least a year, the gains on those shares will be taxed at capital gains rates. Otherwise, the gains are taxed at ordinary income rates, which for now are roughly double capital gains. On the one hand, this can be economically meaningful. On the other hand, as noted above, the best way to realize value from an option is to hold it as long as possible and once you do exercise, quickly sell the stock and realize the gain. Holding the stock for any period of time exposes you to principal risk (i.e. – the money you put up to buy the stock). The intrinsic value (current price minus the strike price) may be compellingly high, but this is a dangerous game to play and you should understand the risks.
• Can I exercise if I leave my company before the liquidity event: Two things will happen on your last day of employment: a) vesting will stop, b) the clock will start ticking and you will have no more than 90 days (except in cases of death or disability) to exercise whatever has vested. The 90 days, by the way, is an IRS requirement. Your challenge will be that: a) you probably won’t know if there’s any intrinsic value unless the company has been raising capital at rising prices and b) even if that’s the case, you generally won’t know if or when a liquidity event is going to occur. In the meantime, you’ll be at the bottom of the capitalization table having paid cash for common shares with no rights (remember that from above?). In some cases, companies even put in buy-back provisions so that if the value starts to rise and an exit looks probable, they can buy back your shares at a “fair market value” price determined by the board. If it feels like the game is rigged against these types of exercises, well, it is. Regardless, I’m always surprised at the number of people who say, “I exercised my options when I left that company.” Then there’s always a pause as I wait for the rest of the story. “And I made a tidy little sum!” or “And now I’m pretty sure I’m never going to see a nickel.”

Now, I never say this, but I feel compelled to here: I’m not a lawyer and I’m not an accountant. I don’t even do my own taxes. Please do not depend on this post for legal or tax advice. The rules on options are constantly changing. Use this to make yourself smart enough to ask the right questions but consult a professional before making any decisions. 

Who Is Investing in Start-ups in New York

If you've read this blog regularly, especially the early posts, you know that my mantra is that the first capital you raise will come from someone that you already know. I still think that's absolutely gospel, but I also appreciate that it's a scary message for a lot of people. I've also started to see more "institutionalization" around early stage funding in New York and so it's becoming easier to write about sources of capital without just listing individual names and whoring out the rolodex. I've got a couple of posts in mind on the topic, but Chris Dixon's (of hunch) recent post on the Exploding New York Tech scene is a great primer on where to find the beautiful people of the New York tech scene.

Anti-Dilution and Pre-emptive Rights

Anti-dilution seems to be one of the first concepts that comes up in ‘laymen’ conversations about start-ups and early employees. I always have visions of wizened fathers giving advice to children who are about to take a job at a start-up: “make sure that they give you that anti-dilution…then they can’t screw you!!”

Yes, there is such a thing as anti-dilution clauses. The VCs get it and so why shouldn’t you get it, too? However, channeling my inner Inigo Montoya: “I don’t think that word means what you think it means.” The anti-dilution that managers tend to be asking for – because it’s the only construct of anti-dilution that makes sense around options and common stock – is, “if I get a stock grant for 1% of the company, no matter what else happens, I’ll always have 1% of the company.” Now, I’m sure that somewhere, at some time, some company (either for a Jobs-ian rock star executive or, conversely, out of sheer ignorance) has agreed to an arrangement like this. Still, I’ve never seen it. And you should know that I also believe that somewhere there are unicorns.

We've already allowed that VCs get anti-dilution protection. What is it that they are getting? The clause “anti-dilution” in investment documents is actually a form of price protection. It says that if someone later invests at a cheaper price, then the price the previous investors paid adjusts downward either to the new price (that’s called “full” anti-dilution) or to a place in-between, depending on the relative size of the new round (that’s called “weighted” anti-dilution). After giving effect to the new capital, anti-dilution clauses can result in greater ownership for the old investors, the same or less. It’s worth noting that anti-dilution clauses are also frequently waived because the new investors who have negotiated the lower price generally have lots of leverage and will say, “ahhhh…no. Anti-dilution clauses just mean the management pool is suffering the bulk of the dilution in this round and so soon we’re going to have to increase the option pool to protect management, ultimately transferring the dilution to….me.”

So we’ve seen that anti-dilution clauses are an imperfect tool to prevent dilution. But the idea of protecting one’s ownership stake is a concept that has definitely occurred to professional investors. And, in fact, it’s probably the most important right that investors typically have, even though its discussed far less frequently. It’s called “pre-emptive rights.” Say you own 10% of a company. Pre-emptive rights will give you the right to purchase 10% of any new offering. By so investing you will, in fact, preserve your ownership stake (almost exactly...can be some wiggle room around what's counted).

Before you jump out of your chair and scream, “so VCs do get to preserve their stake!” note that this is still a very different concept than, “I’ll always have 1%...” This is the opportunity to keep writing checks. Unfortunately, that’s a hard concept to apply to option holders for whom the major benefit is the ability to not write any checks until the end of the dance.

Given all of this, what should you ask for as a key employee at a start-up? First, understand your own preferences…are you willing to trade cash for more stock? Then, ask for as big a grant as you think available given those preferences. Ask for a reasonable amount of transparency. Very rarely do companies share their capitalization table feely, but you can generally get some sense of where the company is at. Most importantly, ask about the price, especially whenever there is a new round. The key to value creation is price appreciation. Due to the way preferences work (see this post to better understand preferences), even a big stake isn’t going to be worth anything if the price isn’t rising. 

Use of Video Fell in 2009?

Brian Solis 1^st blog of the year was really rich fodder for me. Not only did I get the “Every Company Participates” post from it, but I also want to draw off something else he cited…the Center for Marketing Research’s Finding that use of video by the Inc. 500 actually fell from 45% penetration to 36% penetration in 2009. Some other categories also fell. For example, podcasting went from 21% to 12% (seriously, who listens to podcasts? I tried. Once. What a ridiculous idea), but that video would fall so dramatically was definitely breathtaking. What does it mean? Especially what does it mean when I know that we (EXPO) had a great year and I know that other video companies also had great years.

What it means is that video is hard. As in non-trivial. As in “can’t wake up this morning and decide that we’ll do video and be done by nightfall” hard. As Jeremy Allaire said in AllThingsD and then repeated in VideoNuze, one of the themes of online video has been the thought and desire of companies to do it themselves versus partnering with the Brightcoves or EXPOs of the world. The good news (as a vendor) is that people eventually realize just how hard it is, the hard part is that it takes a while to come to that realization.

Note also the sample they analyzed: the Inc. 500 are the fastest growing private companies in the US. Do I believe that the challenges of doing great video got to be too much for 10% of that group to take on during the nuclear winter of 2009? Heck yes. Does that say much about the Fortune 500? Or even the Inc. 500 in a more longitudinal sense? No, I don’t think it says much.

Which gets us to the punchline. Which is that video isn’t going away (unlike podcasting). Seeing is believing. It isn’t a question of whether media shifts toward video, it’s merely a question of how much and what forms and formats ultimately make the most sense.

Kardashian Lawsuit: Peeing in the Twitter Punch Bowl

Good article in MediaPost this morning about a lawsuit between a "cookie diet" doctor and Kim Kardashian. In short, the good doctor is suing because Kardashian said he was lying about her being on his diet and that his diet is unhealthy. Meanwhile its not clear at all that he said she was on his diet...apparently all he did was link to an article that claimed as such. And why does she even care? Because she's getting paid to tweet about another diet that she is on.

On the one hand, I think: 'congratulations! great pr for all of you. everybody wins. how many tweets will this generate? how many people will start on both the cookie diet and kardashian's other diet today?'

On the other hand, though, is this what we've come to? This is pitiful. Celebrities are now renting out their thoughts & lawsuits are being fired back and forth in defense of shortcut diets that ethically stable doctors would reject in a heartbeat.

Twitter's great. Social media's great. But none of it means anything if there aren't standards and guidelines. I've got my libertarian streak but maybe its time to recognize that just like a free-for-all in the financial markets ended badly, so could it end badly in the "information marketplace." Consumer trust is already a preciously fleeting commodity...its time for more people to stand up and call BS on practices like paid tweeets.