Thinking Media

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

2010-02-05T09:27:00.001-05:00

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

2010-02-04T08:44:00.001-05:00

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)

2010-02-03T11:00:00.003-05:00

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

2010-02-02T11:17:00.000-05:00

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

2010-02-01T08:37:00.002-05:00

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?

2010-01-07T08:28:00.001-05:00

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

2010-01-06T09:05:00.002-05:00

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.

Every Company Participates in Social Media

2010-01-05T09:46:00.001-05:00

Prolific blogger and public relations guru Brian Solis kicked off 2010 yesterday with a post on "The Evolution of Social Media and Business." One of the great things about Brian is is his obsession with dragging the PR industry toward utilizing social media tactics as job #1. It's one of those things that's obvious to outsiders but that doesn't mean that it is easy to do...and Brian is one of the key insiders making it happen.

But, I'm in a snarky mood this morning and so I'm going to channel my inner Amanda Chapel and take issue with something Brian says in his post: "Today, there are businesses that engage in social media and those that do not." Seriously? No, every company engages in social media. Some companies may not use the shiniest new tactics of the day, but if a company has a website....if a company has a customer service department that you can send a letter to....they are participating in social media.

Why is this an important distinction? Because it's time to stop pushing social media tactics out as completely disconnected from the rest of the marketing and advertising activities that companies partake in. The desire to wall social media off from other activities is part of what is giving rise to the push for social media to prove its ROI in 2010. That's good and that's healthy. But you better believe that that ROI is going to depend on social media's impact and interplay with the rest of the organization...in other words, it will be derived from cost savings in customer service, new insights for the research department and other 'surprising' value pots....not because a Facebook Brand Page drives a bunch of new sales (and the corollary is that a decision to not invest heavily in a Facebook brand page does not mean that a brand manager is an anti-social media neanderthal).

I'm a huge believer in social media...because I see how it is an evolution of the best practices of marketing, customer service and market research. Without those historical precedents, its nothing.

C-corp is the Right Corporate Structure

2009-12-10T13:00:00.004-05:00

Occasionally the question comes up as to whether or not a start-up should be a C-corp, S-corp, LLC or partnership (there's also sole proprietorships, but no one reading this wants to be a sole proprietor). The answer, simply put, is that unless you plan on being a small business with very few shareholders forever, you should be a C-corp.

Every large corporation (that I'm aware of) is a C-corp. It is the classic corporate structure, offering protection to shareholders from creditors (known as the "corporate shield"), unlimited stockholders and preserving all tax obligations / rights to itself. A key principal of C-corps is that each class of stock should be treated equally within itself, implying that while the rights of different classes can be different and complex, analysis of a capital structure can be focused at the class level rather than needing to get to the individual shareholder level. The main criticism of C-corps is that there is double taxation of any earnings dividended out to shareholders. This is because the company pays taxes on the profits and then the shareholder pays taxes on the dividends. Since most start-ups don't pay a lot of dividends, this isn't a major concern.

S-corps are an old structure that is rarely used now. They allowed for pass-through taxation, which was a benefit for small companies whose owners were often the founders themselves and had to pay out large bonuses to avoid the double taxation issue, thereby distorting their financial results. For unprofitable start-ups, the losses can be passed through to wealthy angel investors, allowing the benefit of those losses to be realized faster than in a C-corp (where they are effectively trapped until the company becomes profitable). On the flip side, S-corps can't have VCs or even foreigners as shareholders, so it really isn't a great option for most start-ups.

Partnerships are much more flexible than corporations. Profits and losses can be allocated partner by partner as fits the needs of the partnership. On the other hand, all general partners (and there must be at least one), carry personal responsibility for the liabilities for the partnership (ie - no corporate shield). These structures are rarely logical for start-ups that need to raise successive rounds of external capital to be used in operating the business. They make much more sense for law firms, venture capital firms and other 'people-intensive' businesses where the business might cease to exist if the prinicpals were no longer involved.

LLCs are a new structure (circa 1990) that combined the pass-through capability of S-corps and partnerships but retaining the corporate shield of a C-corp. However, once set, the structure is relatively inflexible and major changes can trigger the wind-down of the LLC. They are appealing to some angel investors but VCs can not take advantage of the pass-through losses.

The initial holding entity for Expo was an LLC because the paperwork can be very simple and cheap to file. However, as soon as we brought in the first external financing, we created a C-corp which bought all of the assets of the LLC and in return gave all of the common stock of the C-corp to the LLC. Because there was no value in the company, this was a tax-efficient and relatively simple transition.

Last but not least, you should probably register your C-corp in Delaware. The costs are low and all lawyers are familiar with the rules and standards in Delaware...Delaware law is the "english language" of the corporate world. No, you never have to go there.

Although this was all based on personal experience, I did do some fact checking on this very helpful page on all business structures from H&R Block and suggest you check it out as well.

Basic Securities and Structural Elements in a Venture Backed Capital Structure

2009-12-09T09:30:00.000-05:00

On May 30, 2007 I published a post called How to Value Your Angel Round on how to think through valuation for your first external financing. In that post, I promised that the next post would be a basic explanation of capital structure concepts for start-ups. Well, I lied. Although we've talked around some of the issues from time to time, we've never really covered these concepts as promised. But today is the day!

Last bit of wind-up, I'm only going to cover securities appropriate in a C-corp. The next post (I promise! I already wrote it...I just have to push publish!!) will cover why you should choose a C-corp.

Every C-corp starts with common stock. Common stock defines the basic "unit" of a share. Convertible securities given to some investors generally convert into common shares. Employee options are exercised for common shares. Common shareholders as a class have rights, such as being able to elect some or all of the directors of the corporation and to vote on certain other matters. Many shareholder votes occur as if all convertible securities had already been converted (but optionholders generally cannot vote until they have exercised their options).

When public companies raise "equity" capital, they are generally selling common stock. In fact, when a public company sells preferred stock or convertible stock, much of the valuation is based on the debt components of those securities (ie - the interest or dividend promise and the high likelihood of the preservation of the capital invested). It's very different for private companies.

As I've written elsewhere, I think all investors in start-ups should get preferred stock. This is because the preferred security holders will not convert their shares to common unless they are "in the money" (ie - above the price they invested at). Otherwise, they have the right to request the return of their capital (or more, as we'll soon see) before other shareholders can take any proceeds from a transaction (as a side note, this has the effect of driving down the effective share price other shareholders receive).

Before we get to those "or more" situations, there's one more important point. Most start-ups raise more than one round of preferred capital. Typically, each round is senior to the prior rounds. So, in a sale of the company, the most recent round gets first 'dibs'. If the most recent capital raise was, for example, $5mil and the company is sold for $7mil, the most recent investors would get their $5mil back and all other shareholders would share in the remaining $2mil (most likely to go entirely to the round immediately prior unless it was smaller than $2mil).

OK, but how can preferred shareholders attempt to "guarantee" getting even more than their capital back? These are called sweeteners and they come in several varieties, but they all have the same basic purpose, which is to enhance returns. There are:
1. cumulating dividends: typically, preferred dividends in a start-up aren't paid out as cash, but rather they accumulate on the preference. If the ultimate proceeds from a transaction exceeds the preference plus the accumulated dividends, then the dividends are of no effect. However, they do increase the "preference stack" by the amount of the dividends each year, usually 6 - 10%
2. multiple preferences: just like it sounds, in these cases the preferred shareholders have a right to a multiple of their capital before common or other shareholders are eligible for proceeds. This is less common and when used, generally it will be a 2x but have heard of 3x.
3. participations: this one sounds nice and benign, but its a strong one...a participation means that the preferred holder gets their capital back and then still gets the benefit of their full converted ownership. Although in some cases it wouldn't give the preferred holder economics as attractive as a 2x preference, the challenge is that no matter how well the company does, the fact that this capital has to come out off the top reduces the return for all other shareholders. There are even cases of multiple participations which make me wonder if the managers of those companies knew what they were signing.

Although I've been on all sides of sweeteners (asking, getting and subject to someone else's), in a 'normal' situation I think they are fundamentally a bad idea and I think most people, even VCs, agree. Why? They create perverse incentives for managers who realize that their opportunity for upside is buried under a pile of preferred shareholder economics. Those managers are then incented to "throw for the long ball" in an attempt to catch up. Or, they may just give up entirely and start looking for the next opportunity. In either case, all of the shareholders are put at risk...including all of those sweetened preferences and the junior employees who are as interested in keeping their jobs as they are in the value of their options.

So why do all of these sweeteners exist? Well, lest it seem that I'm castigating evil investors, I think entrepreneurs have to take responsibility for the existence of sweeteners. They result from one of three circumstances:
1 - 3. Overfocus on valuation: Entrepreneurs measure their success in a capital raise primarily by the valuation they get. Investors respond to "valuation inflation" by adding sweeteners. Research shows that sweeteners occur more in boom times than in lean times. When tech is flying high, entrepreneurs convince themselves that they need a big "sticker price". VCs will give in but will insist on sweeteners that seem innocuous at the time but can end up destroying the company. In my view, the smart entrepreneur takes a lower valuation and keeps everyone's interests aligned.
4. Ignorance of implications: We'll assume that managers are all properly advised by their counsel as to the mechanics of these structures. But even that doesn't mean that managers are thinking through all of the implications. Remove rose colored glasses, replace with gimlet eye and do the math on various scenarios / outcomes and the implications will literally jump off the page.
5. Desperation: There is a 3rd alternative and while it sounds the worst, it's at least the most honorable. If, as a manager, you have a situation where there's only one capital source and they know it, you may not have much of a choice. Still, my advice would be to trade down on valuation as far as possible (I'll write later on anti-dilution issues which could come into play here) and minimize the sweeteners. It's painful, but a lower value tends to clean the slate, clarify everyone's situation and allow the company to develop organically as it should.

HGTV & Lowes Cross the Chasm

2009-12-08T09:36:00.003-05:00

As you might have noticed the sub-title of this blog is, "The Collision of Commerce & Media". The premise - even three years ago - was that the boundaries between advertising and editorial were falling due to the de facto incursion of manufacturers and retailers into the world of media, primarily through the existence of their websites.

This evolution - arguably revolution - has been obscured by the larger enthusiasm over "social media" but it hasn't been lost on companies like Scripps, who I believe tried to stem the tide through initiatives like owning their own home shopping network & getting into merchandising. Unfortunately, at least of those initiatives were unsuccessful and so there's been an uncomfortable peace where a kraftfoods.com can be a reasonable competitor to Food Networks' websites and one finds oneself in the situation where your advertisers are also your competitors. In other words, yet another factor conspiring against and eroding traditional media's business model.

Which is why I think it's great news to see a deal like the one described in AdAge today where HGTV and Lowe's have gotten together. The most insightful quote to me was the one where John Dailey, HGTV's VP of Ad Sales bluntly acknowledged the reality: "They [Lowe's] view themselves as a media platform, safe to say, and, yes, we certainly do too." Kudos to Scripps for recognizing that and being willing to play it out.

PS - There's some subtext in the article about how the deal allows everyone to "talk to the consumer" more efficiently that's pretty weak (unless we're supposed to read 'talk AT the consumer'), but let's charitably chalk that up to all parties - including the reporter - being afraid to write an entire article without paying tribute to the forces of social media. But that's a story for another day.

Launching ‘Kitchen Table Conversations’ …a new research platform

2009-12-07T08:57:00.004-05:00

Had a little hiatus from blogging, but I’m back with an exciting announcement! We’re launching a new product today. It’s a video research product that sits between the world of focus groups and ethnographies. The core of the product is that companies and agencies have been coming to us with research projects and we tap, on a demographically targeted basis, the appropriate members of our community who film themselves engaging in the behaviors the researchers are interested in & answering questions.

Here are a few examples of how we’ve been using it for JWT, AdAge, the National Retail Federation (NRF), Shop.org and others:

Below is an embedded video of research supporting JWT and AdAge’s Rise of the Real Mom White Paper
Client research on morning routines
Two videos supporting JWT’s AnxietyIndex blog, one focused on general sentiments and the other on the media’s impact on people’s perceptions.

Based on these and other “trial use cases” we believe this is a disruptive technology that can ultimately change how qualitative research is done. In the meantime, we anticipate a lot of experimentation because it’s so affordable that ethnographers can use it as a precursor program to full ethnography studies and agencies can use it to support new client pitches without breaking the bank.

As a last note, I’d like to thank both Mark Truss at JWT and Earl Wilcox at Plannerzone. They both played critical roles in the ideation and evolution of the product. Earl will continue to be involved as an insights resource for clients who want that additional support & Mark we think will become one of the biggest clients of the service!

Here’s a link to our press release on the launch of Kitchen Table Conversations.

Tide.com Social Media Case Study

2009-10-15T13:15:00.004-04:00

Tide.com has a forums area of their website that's relatively active. No really big news there...but after reading through one particular thread about Tide Discontinuing the Simple Pleasures scented line, I had to blog about it. Essentially, this is the promise of social media. Over a period of months, a group of 45 incredibly passionate users piled up comments about this discontinued line of detergent creating a tsunami of Influence Instances.

Right from the beginning, P&G Mandy Earnshaw (go Mandy, amazing!) was right there with them offering sympathy and alternatives. However, despite her pretty definitive early posts the community (if we can call it that) keeps building steam. No spoilers here though, you gotta' go read the thread for the cliffhanger ending.

When you see this thread, you'll appreciate that social networking hubs - great as they are - are not the ultimate repositories for this kind of dialogue (yes, I appreciate that maybe some day the dialogue takes place in a 'destinationless' kind of way, but nevertheless). Probably not even ecommerce sites. Brand sites are. The engagement, recall & humanizing of the Tide brand from this one thread is simply off the charts.

Kudos also to getsatisfaction who is powering the forum (coincidentally, Dave Knox mentioned getsat yesterday in a very good, even if he forgot to mention Expo, post on what great content sites should feature). As an early board member at PlanetFeedback a decade ago, this is the realization of a vision a long time in the making.

Moving Past The Honeymoon, Consumers and Brands Now in a Committed Relationship

2009-10-14T13:23:00.005-04:00

eConsultancy came out with a survey yesterday on how unhappy customers are increasingly using social media to voice their complaints.

Here's a good little slideshow from the article:
Brands beware: the social media backlash

View more presentations from Dave Ewart.

While stories about consumers new-found power and ability to 'bite back' -- with The Consumerist leading the charge and even adopting that tagline -- never went away entirely, this is first story I can remember in a long time that quantitatively suggested an increase in consumer complaints through social media (read: the internet) versus focusing on how positive most consumers are in their product commentary.

Which makes it worthwhile to take a trip down memory lane: how did it come to be that for so many years it was news that consumers actually like the products they use?

If you go back only 10 years ago, customer service, consumer engagement, feedback...these were all bad words with negative connotations. The only time a company heard from its consumers was when they called the customer service department and anyone willing to cross that hurdle (oh, and there were major hurdles even beyond dialing an 800 number) clearly wasn't calling to say, 'thanks for the great job!'

It was so accepted that consumer engagement was a negative experience that social media guru Pete Blackshaw started a company in 1999 called "PlanetFeedback" (which I was lucky enough to sit on the board of). Read that name again slowly and think about it. Now translate it: "a world of people bitching about everything." No wonder we had trouble selling subscriptions to F500 clients.

Pete learned, I learned, we all learned that the truth was a lot more nuanced and positive. Fast forward to 2009 and what we do at EXPO. Our open-forum consumer generated content is generally so positive (by which I mean, exactly in line with text reviews across the internet) that we feature the negative reviews just so product researchers can understand whatever trade-offs - or dare I say, shortcomings - are inevitably part of the product.

So here's my relationship based analogy for the history of brands and consumers:
Phase 1, 8th grade flirting: pre-internet, consumers and brands used limited tools to flirt in a notably adolescent way. The brands preened themselves around using one way marketing and consumers, although perhaps whispering to their friends about how cute the brand was, made sure every comment directly to the brand was absolutely nasty
Phase 2, honeymoon phase: consumers started writing text reviews on the internet and low and behold after years of abuse, brands started to recognize, they love me! Gifts (contests, coupons and samples) rained from the sky & odes of love (blog posts fluffery) were written in return as the two lovers finally came together....to the point where the teacher (the FTC) decided to lay down some rules on all of this PDA
Phase 3, committed relationship: now, realizing that there's more to a real relationship than just mutual admiration, perhaps we're on the cusp of an era where consumers are starting to step up their "constructive comments." And brands are listening and taking action (more on that later this week). This is of course, is where the hardest work will be done. But it also smacks of being the most sustainable and rewarding for all parties.

Expo Looking for New Sales Talent

2009-10-13T22:03:00.002-04:00

And now a word from my sponsor J

We're expanding our salesforce. Looking to add a Sales Director in NY, Chicago, Cincinnati or Minnesota. Here's a link with all of the details: http://blog.expotv.com/job-openings-at-expo/. Best wishes to all applicants.

100,000 Facebook Fans! Now What?

2009-10-13T09:14:00.001-04:00

I'm a big fan of Texas Pete Hot Sauce (I'm from Winston-Salem, NC and as everyone from W-S knows...that's where they make Texas Pete and always have).

Texas Pete is currently doing a Facebook Fan Page promotion (got to my newsfeed...from a friend from W-S) where if they get to 100K fans, everyone gets a coupon. Woo-hoo!!! I signed up immediately. If the link doesn't take you directly there, click on the 'coupon' tab. I like the campaign, executed by The Sales Factory. It's a simple, low-engagement, obviously low cost way to get coupons in the hands of interested people.

But what I like more is what Texas Pete has done with the rest of the their fan page. There's a 'Recipes' tab. There's a 'Legend' tab. These are the things that will sustain Texas Pete's Fan Page after the coupon campaign is over (and when they need something more, we've got about 20 great video reviews of Texas Pete products). I also love how they are twittering like crazy for all of 85 followers. Hmm. I...wonder...what...the...next....campaign...will...be???

A couple of years back, it seemed like every brand was doing a 'user generated' 30 second spot campaign. One of the many problems with these campaigns was that there was no follow-up with the people who participated. Can you imagine making a commercial for a brand, losing and then never hearing from them again? Gives new meaning to being dumped & it was one of the reasons we avoided the trend.

What we're seeing now is smarter, more sustainable engagement (hard as it may be for most agencies to adjust). If you lower the barriers enough, the 'continuous steam' of user generated content opens up, even for brands. That creates infinite engagement opportunities and influence instances and that's where real insights will occur.

Finding Co-Founders

2009-10-12T12:18:00.002-04:00

As long as we're talking founders, here's a good post from TechCrunch on what to look for in co-founders

Founder Shares and Equity Distribution

2009-10-11T20:31:00.004-04:00

With the nuclear winter in financing starting to loosen up just a bit (although there's a couple of questions where I talk about some fundamental changes in the financing landscape in Michael Dunlop's interview that might make for interesting perspective), I've started getting questions about start-ups and founding companies again. I recently published a post Founders vs. Employees and now this post will address founder shares. If you just want to see all of my posts on general topics about startups and early stage financing, click the "startup" or "financing" labels to the right.

Of all of the start-up topics I get asked about, I think founders shares must be the most common. What are founders shares? Who should get them? And, within founders shares, who should get what percentage? The key to teasing this apart is to understand that there are three distinct types of 'players' in a company's equity capitalization structure and we'll address each in turn:
1. founders
2. funders
3. employees

The fundamental insight of this post is that most of the confusion and problems in setting up a company come when these roles aren't kept distinct. Which isn't to say that one person can't actually be all three things...it's just that they are three separate roles and should be treated as such.

The core essentials of a company are an idea and common stock. A founder (or founders) has an idea, he starts the company and he owns 100% of the common stock. If the company doesn't require equity funding and its employees don't require equity incentives, the founders can continue to 100%. Otherwise, founders get diluted as they build value. We'll come back to this and the division of founding shares below.

The first place dilution usually comes from is equity funding. Although occasionally investors will take common stock, I think it's a bad idea. Capital from investors should come in as preferred stock, which keeps it senior to common stock so that investors get their money back before there is a payoff to the "intellectual" capital. As a corollary, a founder who "writes a check" should get preferred stock (or in some cases, straight debt). A founder should never get talked into allowing a capital contribution to get counted toward "sweat equity".

The grey area in this is that many founders work not just for a low salary, but for no salary at the beginning. That's generally still sweat equity. But if you actually write a check for expenses, put it in as preferred stock in the first capital raise.

Employees get options and a salary. Of any of the players, they are the most likely to effectively get anti-dilution protection, although that should never be contractual. Senior managers will get options that are measured in percents of the company (.2% to up 6% for a rock star CEO) and generally there are new grants every year or so or around the time of capital raises.

Back to founders. They don't get dilution protection...not from capital raises, not from the employee option pool. So the problems come when you have a "primary" founder (to borrow from my previous post) who comes up with the core of an idea and then wants partners. People call me up and say, "I've been asked to be a co-founder and the main guy has offered me 5%." For someone who probably at most had .5% of a company in options in the past, it sounds potentially ok. But its not. That 5% will be 1% after about 2 capital raises and an option pool...and it will be headed further south. If you read the post on founders vs. employees, you'll realize 1% isn't a good trade-off for sleepless nights, writing checks to cover payroll and the other sacrifices founders make.

How do you tell someone who just offered you 5% of a company that it isn't good enough? My advice is to put it into the appropriate context by saying, "5% implies I'm a founding employee, not a co-founder. I'm willing & ready to be a co-founder and that suggests I should start at at least be at [30% if only 2, 20% if a total of 3 founders, and so on]."

If "primary" guy balks at giving up such a large stake, make some / more of your shares subject to vesting. That should get him / her over the fear that you'll take the shares and bolt. Vesting in this case shouldn't have a cliff and should vest quarterly or monthly. Don't go overboard on this...any VC who sees that you're "open-minded" on vesting is likely to re-restrict shares for all of the founders.

That should get you started. Feel free to ask questions.

Consumer Collaboration

2009-10-10T16:02:00.003-04:00

Great blog post by Dave Knox on Consumer Collaboration

What’s the Difference Between a “Founder” and an early “Key Employee”?

2009-10-10T08:24:00.001-04:00

One of the key things entrepreneurs need to think about is their co-founders. Who’s a co-founder and who is a “key” or even “founding” employee. It’s a highly subjective topic and there are tons of opinions on it that can be found around the web. The subjectivity starts with the fact that a “founder” doesn’t have any real legal implications (unlike “directors” or “employees”). If forced to define a founder, lawyers would probably say it is an individual who was issued common shares at the business’ inception for which the received consideration was not solely monetary.

That’s still a broad definition and in our entrepreneurially-charged culture, the phrase has become an honorific. So the question of the actual role becomes personal to the company…what do you want it to imply? Let’s assume that you are the “primary” founder who conceived the animating idea. How do you decide who is a co-founder and who is an employee?

Here’s how I think about it: there is a legal concept called fiduciary duty, which is vested in the board of directors and requires that they take care of the company and its stakeholders. But in a start-up, typically the board will be inadequate to fulfill this role. Founders, to me, are the people who practically (although not legally) step into this void and protect the stakeholders and fight for the existence of the business.

Their commitment is so complete that they will make significant personal sacrifices with little short-term regard to their own well-being. While it may sound discriminatory, they should come to the business with personal financial wherewithal to be chronically underpaid, occasionally unpaid and sometimes to even pay payroll or a vendor. The thought of a founder leaving a company prior to funding is, to me, the equivalent of a soldier going AWOL. Why? Because even the smallest company quickly develops other stakeholders and they have almost certainly acted based on their faith in the founders. I talk more about this duty in another post, especially with regard to angel investors.

By contrast, a key employee might be more experienced or talented than a founder and they may even work harder, but (despite the best efforts of lawyers everywhere to draft employment agreements) they are not morally committed to the business in the same way. They have a right to get paid on payday and they should not be expected to ensure the viability of the entity. Note that I’m implying that issues of compensation, prestige, title and even credit can, at least theoretically, be separable from the question of ‘founders’ vs. ‘employees’. Put it this way…employees can be indispensable because of what they can do, founders are indispensable because of what they choose to do.

As noted at the top, others emphasize different things and I recommend the reader chase down multiple perspectives. I’ve seen commentary emphasizing determining who a founder is based on a person’s intellectual capacity, their willingness to work long hours, their ability to attract capital based on their experience and personal brand, making sure that the collective founders have a broad set of skills and even using the title as a recruiting tool. I’d never question the strategies other entrepreneurs have successfully applied.

My definition of a founder has meaning for me because my experience, and the experience of the entrepreneurs I advise, is that building a business is so hard that the role of “founder” typically violates personal boundaries that “employees” shouldn’t be asked to suffer through (not that every founder doesn’t owe a debt of gratitude to every employee who subjects themselves to the unavoidable sacrifices of working in a start-up environment). In my world, those violations create strong co-dependencies between founder and company that transcend legal niceties (sort of like a marriage is more than the certificate). I have a feeling that my description is a bit esoteric for anyone not living it. Maybe I should have just said, “you’ll know it when you see it.”

More thoughts on the new FTC Regs

2009-10-09T11:02:00.005-04:00

Shelly Palmer published on the new FTC regs this morning. His basic take was that it was irrelevant. A gnat in the face of a tsunami, but that all will be well because the law of large numbers will prevent anyone from changing the world by paying off a few bloggers. It's a good addition to the dialogue. So far we've got:
1. Adotas says its unenforceable because they have no one to enforce it (see previous post). Which no one's really debating
2. Eric Goldman of Santa Clara says its pre-empted by existing legislation (47 USC 230) before it even gets out of the gate
3. And Shelly effectively saying its an answer looking for a problem

Unlike Shelly, I thought the regs were actually relatively easy to read....frankly, I thought they were too simplistic, almost as if they were targeted to be read by the bloggers or other lay people themselves. On the other hand, they didn't strike me as broadly, researched well-thought out legal doctrine. Which is a bit stunning for something 30 years in the making. For example, I spent 10 minutes looking for the definition of a "network marketing program", since those seemed to be entities that the FTC was interested in. I never found a definition - again, stunning when important, non-obvious terms go undefined in a 'legal' document - but I found its first use in a footnote referring to BzzAgent's brief...apparently it was a term BzzAgent used and the FTC adopted.

Following through on that thought, it was remarkable actually how much of the statutes referred to the briefs that had been filed. Yet they didn't extensively address, to Goldman's point, other existing legislation or practice. Further evidence of this...at Expo we've already had multiple legal opinions essentially that, "this doesn't even come close to applying to what you do." Yet because its tangential and vague all at once, we *have* to think about it.

The debate will continue (I have more thoughts I want to post myself on, but need more consideration) but one pretty quickly starts feeling like the bottom line was that the FTC basically just wanted to say, "Hey everybody, do the right thing because we're watching." Granted, that's not really the way governments do things and a simple press release to that effect would have engendered a lot of derision, but this alternative reality is that we're all wasting a lot of energy talking about 81 pages that doesn't hold any more water than "Hey everybody, do the right thing because we're watching."

If I stay quiet long enough, someone drags me back out into the light

2009-10-06T14:17:00.008-04:00

Michael Dunlop, the founder of IncomeDiary, tracked me down and posted a nice interview of me yesterday. Michael puts the "e" in entrepreneur and so don't waste much time reading the interview, check out everything else on his site. Thanks, Michael.

A Secondary Market for Shares in Venture Backed Companies?

2009-04-23T15:32:00.005-04:00

Both Fred Wilson and the New York Times have written about a movement toward trading illiquid tech stocks. There’s already lots of skepticism expressed in the Times but it's perhaps worthy, under the ‘raising capital’ theme of the blog to ponder whether such a market could ever come to pass.

On the one hand, as an entrepreneur, let me agree with Fred and say that, in theory, it would be great.

In practice, not going to hold my breath. We’ll get to the biggie, but let’s start small. The first issue is that it really wouldn’t help that many people. No one wants to allow founders or current employees to sell because it creates incentive problems. As for former employees, certainly no one’s really motivated to cash them out. As for the actual VCs, management has a lot of interest in not letting them sell out (unless there’s a board level war going on, but even then the negative PR is a tough trade-off) because of the implications that, at best, growth has plateaued. So who does it really help? Maybe, maybe angel investors…but again, would be surprising to see VCs endorsing something that helps others get out before they do. Which brings us to the second point….

Probably 50% of governance documentation talks about who, how & when shareholders can sell stock. For effective secondary markets to emerge, all of that boilerplate language, which has been tightened and standardized over the last 40 years of venture investing would suddenly have to start giving way. Seems unlikely. Now, jumping tracks to a more fundamental point….

You’ve got tremendous information asymmetry in these markets, far more than in other securtizable markets. Most of the shareholders are board-level insiders. As much as I might love to own a piece of Facebook in concept, do I really want to be the guy buying shares from Mark Zuckerberg? To get over that, you need far greater transparency. And where’s there is purported transparency, there is inevitably going to be….

Regulation. If you don’t believe that to be true in this day and age, I’d argue you aren’t paying attention. And if there’s transparency and regulation, well, it’s just a new-fangled public market. Maybe therein lies a clue to the real problem: the public markets themselves are broken. That’s a post for another day…

The Dominos Crisis: What’s the Big Deal?

2009-04-22T21:47:00.012-04:00

A tweet from PR handler Adam Keats of Weber Shandwick today took me to an article by folksy writer Garrison Keillor that talked about the Dominos video blow-up . Keillor’s takeaway is that it’s ‘snot a big deal’ and everyone should just relax. At some level, Garrison’s obviously right. There’s no way that video was the grossest thing uploaded to YouTube that hour, let alone day, so how on earth could it be a big deal?

Yet it is a big deal. It wasn’t news just among information desperate twitterers or the media or district attorneys, this was meaningful to hundreds of thousands, if not millions, of people. At Expo, we asked our members what they thought of the Dominos video and they told us that, yes, it was a big deal. Knowing our opinionated members, if it was no big deal, they’d tell us…no big deal. But they didn’t. Their noses were crinkled and their nausea was palpable.

So what’s the difference between a thousand Saturday Night Live gross-out skits and this video? It’s simple. It’s the brand. It’s the fact that, no matter how much we say we’re immune to advertising and branding and all that stuff, brands matter to us and they matter a lot. This wasn’t non descript cafeteria food, this was Dominos. And of course the most powerful component in restaurant branding is consistency; a consistency now marked in Dominos case with images that many of us will struggle to get out of our minds. We’d love to intellectualize it away as irrelevant, not representative, but the beauty and power of brands is that….we can’t.