Could you have created a “dirty cap table?”

Oh, I know. When you started the business, you took investments from friends and family in small amounts just to get you started.  Of course, that worked at the time.  But…

Enter the need for larger investments

When you seek professional investors, whether organized angels or venture capitalists, one of the early questions you are asked is “How have you financed the business so far?”  Investors love to see entrepreneurs who have used their own money to ignite their businesses.  But often, entrepreneurs turn to others for initial capital. Describing that capital using the phrase “friends, family and fools,” or “FFF,” has become as common as to be just plain trite.

Crowd sourcing as a tool

More recently, “crowd sourcing” has become one more way to finance a business, whether by forming a single investment vehicle (“”) or non-equity financing (“”)  These are newer ways to find relatively small amounts using these Internet tools and combining groups of many investors at a small amount per investment.

What would the SEC say about your investors?

[Email readers, continue here…] The problem with taking friends and family money rests in the legality of taking money from non-accredited investors, people who do not meet the SEC standard for making non-public company investments.  Currently that standard requires a minimum of $200,000 in annual income or over one million in net assets, including the value of the investor’s principal residence.  Since many small investors in a young business do not meet that standard, there is a chance that the company has taken money that it should not have taken, according to SEC rules.

An important exemption

There is an exemption for members of the entrepreneur’s family and in some cases for close friends with intimate knowledge of the entrepreneur and of the plan and, of course, for employees of the company.  It is worth checking with an attorney to see if such investors are truly exempt.

Does creating a PPM mitigate the risk?

Some small companies work to create “private placement memorandums,” attempting to protect themselves against this problem, couching the proposed investment in legal language stating the risks involved in making the investment.  The PPM does nothing to mitigate that problem when the investor is not accredited.

To compound the problem, often stock is issued by the entrepreneur without filing any report of such issuance with the state of issue.

The risk of the “dirty cap table”

The sum of these problems is that a disaffected investor can sue the entrepreneur or the entrepreneur’s company for a rescission of the investment and return of the money invested if the money was taken improperly, especially when the business has failed and the investment lost, putting the entrepreneur at risk for the loss of additional personal assets.

And the cure…

The cure for this, when professional investors enter the picture, is for the company to craft a “rescission offering” to those shareholders who invested illegally, offering to repurchase their shares at full value invested.  This is sometimes difficult since it often happens just at the time a company needs new money most and is in the process of seeking that money for growth.  If a previous investor does not accept a rescission offer, there is some insulation provided to the company against a future lawsuit by that investor.

How this could affect the future for you

So, plan to take money only from qualified investors. Check with your attorney if there is any doubt.  The risks of a problem rise with unmet investor expectations, and fade with success.  But sometimes, such behavior will cause a subsequent angel or venture capitalist to pass on an otherwise good opportunity, and that would be a shame, one that could have been avoided by diligent process in the early investment cycle.

Posted in Ignition! Starting up, Raising money | 3 Comments

Would you sign a personal guarantee if you have investors?

It’s a fact of life that a banker, lender or lessor will ask for a personal guarantee from the founder or entrepreneur most every time. But what if you’ve diluted your interest from 100% to something less than 50%?

Should your investors expect you to carry 100% of the risk?

The short answer is “yes.”  Seems unfair, doesn’t it?

To most lenders, the guarantee is still a requirement, putting the entrepreneur in a position of additional risk that is not spread among the shareholders.

Recently, one of my companies offered the founder with a 20% remaining interest after several rounds a reward for signing two large personal guarantees necessary to grow the business – in the form of a warrant to purchase common shares at today’s common share price.  A win-win for the investor and entrepreneur assuming the company does grow and have a liquidity event someday.

The eye-opening process of borrowing for a small business

Starting and running a small or growing business can be a challenge to the most confident and optimistic entrepreneur.  And the process of borrowing money or financing asset purchases can be an eye-opener for those who are not used to today’s lender and seller aversion to grant easy credit.

The easy solution when entrepreneurs have controlling interest

[Email readers continue here…]  Most any entrepreneur with a clean credit record can obtain a bank card with a $50,000 limit, if s/he is willing to give a personal guarantee and has enough assets to back the promise it contains.  As the amounts get higher or as banks get into the picture, the negotiation around a personal guarantee becomes more of an issue with the lender and the entrepreneur.  As a rule of thumb, a company with a majority owner in control will be required to provide such a guarantee for most any borrowing of significant size in relation to assets.

Some thoughts on elimination of personal guarantees

All entrepreneurs assume risk when starting and growing a business.  It is only smart to consider ways to mitigate risks when opportunities to do so arise.  Approach your banker when times are good and discuss whether the increased collateral from growth is enough to eliminate the guarantee.  Approach your co-investors to negotiate some mitigation of personal risk, such as a backup guarantee in return for warrants.  Consider approaching another bank or lender with your increased strength and negotiate a “take-out” loan that eliminates the original lender without requiring a personal guarantee.

Most of all, keep your line of credit clean.  Communicate with your lender if a payment is going to be late.  And of course, here’s that old adage: “Never run out of cash.”

Posted in Ignition! Starting up, Protecting the business, Raising money | 2 Comments

Oh, go ahead and ask for a five-million-dollar investment in your startup.

I cannot tell you how many times I have seen executive summaries of business plans in which the entrepreneur seeks $5,000,000 to build the business.

Four reasons you should reconsider.

First, few startups can use that much money today with all the virtual services available and increasingly inexpensive methods of development, prototyping and marketing. Second, almost no professional investor will consider putting that much into a startup until there is proof of market demand, product viability or some other mitigation of failure.

Third (if you’re keeping score), it is not wise to dilute the founder’s ownership greatly in the first round of financing.  The investors want a motivated entrepreneur, and it is certainly more difficult to motivate a twenty percent owner than a sixty percent owner.

Fourth, there is the matter of control.  Entrepreneurs have a vision for what and how to create and build a great business.  Giving control over that vision to others early on often dilutes the vision and is a disincentive to the entrepreneur.

How does this comport with “skin in the game?”

[Email readers, continue here…] Professional investors love to see companies where the first round of financing came from the entrepreneur, showing “skin in the game” and more motivation to succeed because of money invested as well as time and creativity.

There are so many resources for early money to validate an idea, turn it into a product and increase the value of the company before professional investors come into the picture.

A much more rational approach to starting up.

Starting with credit card debt or a personal loan and working through money from friends or family, or simply consulting to earn money for investment, entrepreneurs should consider early resources for capital to produce a prototype, do market research or start to build a team.  Once there is progress in any of these critical areas, raising professional investment is easier and the likelihood of a higher valuation makes for retention of more equity during the first important professional round.

Posted in Ignition! Starting up, Raising money | 5 Comments

Once again: Is it the jockey or the horse?

Early stage investors have been arguing over this for years.  Do they bet on the entrepreneur (jockey) or the business idea and plan (the horse)?   This is serious stuff.  If you are looking for money, this question will certainly come up in one form or another when you approach professional or organized angel or VC investors.

A more complex answer

My answer always varies as I examine each deal, sometimes deferring and passing on an investment because of an uneasy feeling about the entrepreneur, even if the business plan seems able to capture the market.  Speaking for others, I see VC investors jumping into deals knowing that soon they will push to replace the entrepreneur with a professional, experienced manager that the VC has vetted and trusts.

Sometimes there’s a real surprise after the fact

I have bet on the entrepreneurial jockey numerous times and been blind-sided by after-investment behavior that completely reversed my opinion about an entrepreneur’s ability to manage growth to breakeven.  Other times, the entrepreneur went on to assemble a great team and execute the plan as it inevitably changed again and again.

[Email readers, continue here…]  Although this debate will continue for ages, I tend to fall on the side of betting on the jockey, simply because it has been a rare business plan that did not change again and again seeking a successful model in the marketplace.  And great management can morph a company to adopt without destroying the culture of the company in the process.

What if you see a great idea but no team to execute?

What if you were the investor and someone walked into your office handing you a business plan executive summary that floored you with its brilliance?  And what if that person admitted immediately that he or she had no team and was not the person to take this plan to market?  Would you, as an investor, plow money into the plan and help to incubate the idea into a real enterprise?  I would not, nor would most all of those I co-invest with.  There are millions of great plans that failed over the years for want of a great management team.  And I am sure there are many, many average plans that developed into great companies with the help of a great team.

Concentrate on a world class team

So, if you are one of the entrepreneurs without experience or ability to take your great plan to market, admit this early and form a team that investors can trust to do this, personally stepping into a position that fits your core skills, be it marketing, sales, development, or other areas required by a young company.

It would be refreshing as an investor to meet an entrepreneur with a great plan and a pre-formed management team fronted by the strongest possible leader, even if the entrepreneur offers to take a back seat in order to make the vision a grand reality.

Posted in Depending upon others, Ignition! Starting up, Surrounding yourself with talent | 4 Comments

Can you become a master negotiator?

Think you don’t use negotiation most every day of your life?

From the time we learn to manipulate our parents from the crib to today, we learn to negotiate to obtain our wants and needs.  As we grow, we negotiate constantly with our parents, then with our peers.  As we enter the business world, we negotiate with our bosses and our subordinates.  We negotiate with our suppliers, customers, investors, and even our auditors. At home, we certainly negotiate with our spouses or significant others.

Learning and practicing the art of negotiation

If we are constantly negotiating to obtain an advantage or just a win-win attempt at parity, we should try to learn and then practice the art of negotiation (although I prefer to think of it as a science then delivered in its final form as art.)

It could be as simple as reading the right book

Because I believe that negotiation is so important to our success in the business and in the social world, I re-read my favorite book on the subject again every couple of years, just to keep myself aware and sharp using the tools and techniques so important to a successful negotiation.  The book, You Can Negotiate Anything, by Herb Cohn was first published in 1980 and is available today as the best and easiest to read of all the books on the subject.  I implore you to read this book and internalize the three crucial variables, the many styles of negotiation, and the fourteen powers you can call upon or recognize when used by others in a negotiation.

Removing the emotion from a negotiation

[Email readers, continue here…] Over the years, I have been delegated by more than several entrepreneurs and boards to negotiate critical agreements, sometimes to sell the company or merge it with another.  I was selected because I did not have an emotional stake in the outcome as did the entrepreneur, or the continuing relationship with a buyer as would others in management who might remain after the sale.  With that freedom, I was able to use the tools of negotiation to achieve a result better than if I worried each moment about disrupting the deal when making each move and countermove.  There is a lesson there, one the same Herb Cohn quoted in a later book, in which he entreated his readers to negotiate with care, but “not that much care” as to lose perspective.

A story of a big win-win

I recall one such instance, when delegated to be the lead in negotiating a sale of a company on whose board I sat, I asked the entrepreneur to name his expected price in an ideal sale, which he did immediately as if he’d been thinking of this for some time.  Surprising him and the rest of the board, I asked him to go home and not to attend the negotiation session set for that evening at a local hotel, promising to call him immediately with the outcome.  I am sure he worried over losing control of his most important business negotiation ever, but he did cede the task to me (and another board member).

Doing your homework before the event

Doing my homework ahead of time, using one of Herb Cohn’s principles (please read the book), at the start of the negotiation I placed a paper in front of the negotiator representing the intended buyer, showing how our company would be accretive to their public company valuation, properly valuing our purchase at three times the ideal amount as stated by our entrepreneur-CEO.  The buyer looked over the numbers for a few minutes, recognizing the accuracy of my statement from his due diligence and knowledge of his own financials.  In a sincere response so transparent as to be an obvious truth, he stated, “Oh, but I only have authority from the Board to offer two-thirds of that” which of course was twice our entrepreneur’s the asking price.

And a successful outcome

After forty-five minutes of further negotiation, we walked from the room with an agreement to sell the company for cash at twice the asking price.  And as the entrepreneur still tells the story, we two board members walk on water for having delivered such great results.  In fact, we had done our homework, presented a logical case, and created a win-win by leaving enough value for the buyer to add to its market capitalization as well as doubling our sales price.

Since we negotiate daily for things large and small, wouldn’t it be high on your list to learn to use the tools and be aware of the elements of a great negotiation?

Posted in Growth!, Positioning | 7 Comments

Non-competes, gray areas, and salvaging a failed purchase

Last week we introduced the subject of non-compete agreements.  Let’s dive a little deeper and present some “gray area” scenarios to consider.  Then we’ll address the success or failure of the buyer with your product…

First the obvious case in point

What if you are the seller of a previous business or shares amounting to more than an insignificant percentage of a previous business?  Certainly, the buyer’s asset purchase documents included a non-compete clause, usually valid for two years from the date of the closing.  And because there was consideration paid to you in the sale, that clause is binding upon you and is effective almost everywhere.

Now we add complexity to the issue: bankruptcy of the buyer

Well, what if the buyer is now bankrupt?  That does nothing to regain your right to its purchased information.  The estate of the bankrupt company retains and can resell those rights into the infinite future.  (Patents expire after 14 or 20 years – depending upon type – and publicly disclosed patent information is no longer subject to your original agreements after that expiration, as long as you use only the publicly disclosed information as filed within the patents themselves.)

Abandonment of your product line or your later new inventions

What if the buyer abandons your previous product?  That does not change their purchased rights to it.  What if you invent a substantial enhancement or change to the product?  As long as you did not use patented processes or trade secret material from your previous company, you should be protected, but you might be prepared for a fight.

After the non-compete expires

[Email readers, continue here…]  How about after the two-year limitation in your non-compete agreement?  Just separate confidentiality from non-compete, and obey the confidentiality clauses, which do not expire.  The non-compete agreement does expire when stated.

But watch it. Some clever buyers try to slip in an unlimited non-compete, and some courts have upheld this.  And there are gray areas for former key employees who signed a non-compete with a limited life as part of the sale but remained on with the buyer for some time thereafter. Does the non-compete start anew upon the departure of each continuing employee?  Courts tend to apply only the reasonableness standard to these gray area cases, looking to see how much the person now competing gained from the original sale.

The safest advice is to avoid using any materials from the previous company, and compete only after the expiration of any written agreements or clauses signed with the buyer.

About starting over or repurchasing your business

Many entrepreneurs have new and better ideas for a similar product and wait out the non-compete by watching the clock.  Others find opportunity in repurchasing rights to your product from the buyer who has been disillusioned by low sales from your product, or distracted by taking an alternate strategic path during those years.

If you are one of those watching the buyer’s success or failure with your baby over those first years, you will need to decide if you could revitalize the wayward business, or start over with a new, better product with non-obvious advances and without using any of the technology from your previous product.  Many have done one or the other with great success, but only after analyzing the lessons from failures by the buyer.

Posted in Depending upon others, Protecting the business, The liquidity event and beyond | Leave a comment

What about your previous company non-compete?

Entrepreneurs tend to remain in the business niche they know best.  Usually that means one they once or recently spent time in as an employee or manager within a company where they had little or no ownership.

Are you one of those?

Some of these entrepreneurs starting a new company are alumni from companies that would be a competitor to the enterprise being created or joined.  And some are former selling shareholders of just those businesses.

Rules about non-compete agreements 

So, what are the rules about those pesky non-compete agreements signed upon your discharge, or upon the sale of your previous company?

The good news is that if you were not a significant (usually 5% or more) selling shareholder of a previous company, most states specifically exempt non-compete agreements signed between companies and their employees or minority shareholders.  In that case, you must worry only about information and trade secrets taken from the previous company which are both certainly subject to protection by almost all laws and courts.

The obvious admonition

 [Email readers, continue here…]  So, to you and to everyone: do not take customer lists, design documents or any document considered a trade secret from any previous employer or previous consulting customer.  Digital or analog!

Yes, some companies were sloppy and did not have you sign a confidentiality agreement, but that procedural slip-up does not protect you from their legal wrath.  Further, there is no expiration date on these poisoned documents. You cannot complain that the document or information in question is more than five years or two employers old.

It makes good sense not to be in a position to be accused, let alone guilty of taking gray or bright red “borrowed” digital files or documents from a previous employer.  We all have enough worries in our business lives not to be threatened by an emotional, upset previous employer.

Posted in Protecting the business | 1 Comment

What would you do if told to “fail fast?”

Here’s a question that should strike close to home. Professional investors like to quote this mantra to anyone who will listen.  “Fail fast,” they say. But what if you believe so strongly in your budding enterprise that this seems to be the most ill-advised directive you’ve ever heard?

So here are some rules that might make it clearer for you and for those who so easily quote the mantra.

Rules to consider as tests of early success.

With the first round of funding, there should be agreed-upon milestones to be achieved.  If they are not achieved within the expected time, the reasons must be analyzed by you and by your board and acted upon to avoid loss of capital beyond plan or expectation.

If you discover and become convinced that your vision is flawed, or the product impossible to create within cost and time expectations, or the demand impossible to quantify, or revenues never close to plan, then it would certainly be time to rethink the plan and product.

Could you pivot to save the company?

Could you and your team pivot if given the time and runway to do that?  Would that restart the clock, putting even more pressure upon you to perform?  Your investors know that an excellent management team is perhaps the greatest asset for any company – because it is just this team that has historically been able to make a drastic alteration of the plan, ultimately making a failing vision into a wildly successful one.

[Email readers, continue here…]  But if neither great management nor your vision for the product shows real signs of success in the market, then it may surely be time to listen to the investors and perhaps the board. Fail fast! Reduce further expenditures of remaining capital and protect the assets purchased with the original investment.

A personal story of failing fast

My favorite story of a fast failure was of a technology incubator started in the year 2000 with optimistic money from several angel investors, including me.  Within a month after the tech crash, the founder of the incubator decided that it made no sense to incubate companies that were not likely to receive new investments soon following incubation in the winter-of-cash that followed the tech crash.  He volunteered to close the incubator and he returned 96% of our investments to all of us angel investors.  (That return proved to be the best investment return any of us saw in the several years that followed.)

Is it the end of your entrepreneurial world to fail quickly?

Half of all professionally managed venture capital or angel investments fail.  There should be no shame to the entrepreneur in admitting such a failure.  Some angel and VC investors will give special credit to those entrepreneurs who have experienced failures when investing in their next effort.  The lessons learned are difficult to teach and are great assets in the next effort.

There is little shame and quite a reputation boost in acknowledging a failing plan and “failing fast.”

Posted in Finding your ideal niche, Ignition! Starting up, Protecting the business | 4 Comments

Investors, your board, and you: Who controls strategy?

You’re building a company from your vision and a passion, and lots of people are going to tell you that you have this or that wrong, and that it just won’t work.

Business plans rarely survive market contact

The truth is that very, very few early business plans survive in a form completely recognizable when looking back a few years.  But even with massive changes, the vision and passion usually don’t diminish in the process of morphing a business plan into a profitable business.

Are investors smarter than you?

Investors will invariably try to tell you that they know much more about the “how to” than you do, and that you should listen to them.  And because you need their money, the temptation is to listen a bit too well, and take all of the advice thrown at you during your presentations and during due diligence and finally from the vantage point of a board seat.  A good entrepreneur-turned-CEO listens, takes it all in, responds with reason, and stands up for what s/he believes for the parts that matter most.  It is good to listen.  And it is better to assimilate the best suggestions into your cake as you bake it.

How to respond to “change the course” suggestions

[Email readers, continue here…]  But there is a limit, a point where your gut is more important than your ear.  If you reach that point with suggestions from these people trying to help, think carefully about how to respond, whether with facts, instinct or support from others.  Make your case for staying the course.  Remember the same passion you demonstrated when you first attracted these well-meaning helpers.  And push back.  Some investors may drop out if you are in the pre-funding stage. But they are not the ones whose support you would later want.  Some board members may show dismay.  But most often, a good case made with passion wins the day and unites the group to move forward.

A personal story to illustrate the point

I was chairman of an excellent company where I had led the deal, attracting angel investors through several rounds as the company grew to a breakeven with over four million dollars of gross revenues.  We then sought and received a venture investment from a top tier Silicon Valley VC firm, whose partner came onto the board.  After several months on the board, he spoke up. “I don’t like the niche we’re in. It will never grow enough to make this a valuable company. Forget this niche and turn the battleship. Let’s go after the Fortune 50.”  “But that’s walking away from an industry where we are #2, growing nicely and already becoming profitable,” the CEO responded.

“Don’t worry. We’ll be there in six months when you run out of money with your new R&D focus”, the VC board member replied.  The rest of the board, including myself, went along with this because, as I’ve stated often, “The last money in has the first say.”

The shocking end to the story

Can you guess the end to the story?  Six months later, the company ran out of cash, as planned, when ceasing to focus on the original niche. And the VC firm’s partners voted not to fund the restarted venture.  A good company, in a fine industry, ended up being dismantled just to repay the bank loan. No investors received anything. And the rest of us just shook our collective heads.  No one stood up to the VC board member, even though all of us heard but ignored our respective gut responses pushing back, as we remained silent.

And the lessons learned too late by the board and founder

It is years later, and the memory of that failure to push back remains fresh for me and surely for the rest of the former board members.  As chairman, I should have pushed back.  Certainly the CEO-founder had a duty to push back.  Another VC from a smaller company should have pushed back.  In retrospect, we were intimidated by the first tier VC, and half wanted to believe that he knew something we did not.

He did not.  Now, with that lesson firmly behind, I often remind members of a board when in a situation where someone on the board pushes to change the plan that the vision of the founder ignited us to bring us together.  If we believe we have a better idea, we should convince the founder and the rest of the board that we have strong beliefs that dispute the current plan.  But we should not be so loud as to drown out those other voices – you know – the ones from the gut and that of the founder’s dream.

Posted in Depending upon others, Finding your ideal niche, Positioning | 2 Comments

Missed Expectations and The Eighty Percent Acquisition Rule

Eighty percent of all businesses purchased by another company or by a new investor-operator fail to meet the stated expectations of the buyer after one year.

As with the fifty percent rule discussed last week (fifty percent of startups fail within two years), this rule is hard to find an author willing to be quoted as the source.  But it is within the range of experience by many of us professional investors, and with those who have acted as brokers, serial purchasers or consultants for acquisitions.

Why would anyone acquire a company?

With this rate of disappointment, why would anyone or any company purchase another?  The answer is that the most sophisticated buyers have experience in integrating an acquisition successfully into an enterprise and those successes are the most visible models for others to follow.  I worked with one two years ago that was exemplary in its ability to understand and integrate our selling business into its significant number of subsidiaries, and quickly create uniform dashboards and supply integration talent.

How about those less-experienced buyers?

[Email readers, continue here…]  As we move down the chain of experienced buyers, the problems of underestimation of capital, customers who drifted away from the acquired company, key employees who found the new enterprise a culture too different to endure and left, and other difficult-to-plan-for events overwhelm the majority of acquired companies, resulting in less revenue, less profit, and far less growth than forecast during the buyer’s due diligence.

Lessons to learn from the best

There are great lessons to learn from Cisco and other companies that have grown wonderfully by acquisition, understanding the need to maintain elements of the acquired company’s culture, while offering the employees retained new and attractive reasons to stay and build the combined enterprise.

And the lesson?

So, this insight is simple.  Study the literature about companies that have succeeded in their acquisitions, finding how and why such successes rose to the top twenty percent of all acquisitions when measured by the acquiring company CEO satisfaction ratings after a year. Emulate those actions that are appropriate.  Plan for surprises by keeping enough capital available to restart or re- align the acquired company after an initial problem period.

Over all, know the eighty percent rule and act carefully to protect both the acquirer and the entity acquired against failed expectations.

Posted in Protecting the business, The liquidity event and beyond | 5 Comments