Thursday, September 19, 2013

Early Stage Start Up Due Diligence - The Philosophy Part

Early Stage Start Up Due Diligence - The Philosophy Part

I recently gave a talk to Empire Angels on the subject of early stage investor due diligence, thanks to a kind invitation from Graham Gullans and Christina Bechhold. Graham and Christina are doing a great job establishing a thriving group of New York based young professionals interested in angel investing, hence bringing more diversity and energy to the NYC early stage ecosystem.

I think I surprised them by spending a fair amount of time framing the issue of "what to do" rather than getting straight into a "traditional" check list of steps to things "to do".

I set out to emphasize what, in my view, is the appropriate stance investors should adopt as the undertake due diligence being mindful of the different situations of the players on each side of the table. Those players being:

1)   The buyer of the equity – that would be the angel or VC investor

2) The seller of the equity – technically that would be the company although it amounts pretty much to the entrepreneur/founder(s)

I laid out the different stakes of these two players as follows:

A. What does investing mean for the buyer?

Across large sample sizes angel investing is an activity that generates returns in the +/-20%/year range. Indeed a Kauffman Foundation study pointed to 27%/year returns for angels investing in groups. That equates to returns that are pretty reasonably commensurate with the risk assumed ... on average. The Capital Asset Pricing Model gets it right!

We also know that any individual angel investment is very "risky" due to power law or asymmetric returns involved in early stage investing. ie each individual investment has, other things being equal a high probability of total loss (maybe 40%), a high probability of only modest positive returns on cash invested (maybe another 40%) and that the outcomes that generate that attractive aggregate +/-20% annual return come from the outsized gains on less than 20% of all investments. Indeed there is a power law within the power law. For example approx. the majority of ALL VC returns in 2012 came from one single investment, Facebook!

Of course the financial experts at Empire Angels were well aware than most that this risk can be mitigated by diversification. But, as I pointed out, the degree of diversification required is impractical for all but a very few angels. As David S Rose, CEO of Gust and Chairman Emeritus of The New York Angels, noted in one of posts that make up his prolific Quora record

Several studies and mathematical simulations have shown that it takes investing the same amount of money consistently into at least 20-25 companies before your returns begin to approach the typical return of over 20% for professional, active angel investing. 

So clearly early stage investing is risky in terms of your likely return profile. And mathematically that means that with anything less than well into a double digit number of investments the most likely outcome for an angle investor is the loss of most all of their capital! Ouch.

But this creates a paradox, as I pointed out to Empire. Armed with that knowledge, any rational angel (VCs are somewhat different here because they are investing other people's money for the most part) should only invest money she/he can afford to lose – and lose totally. ie it can "all go to zero" but the angel's lifestyle is unchanged.

Bottom Line: For the rational angel, while their is evident investment risk in this "asset class", there should be zero lifestyle risk ... assuming they only put money to work they can afford to say goodbye to without pain. (i.e. no need to cancel your next vacation, cut down on your restaurant visits or whatever!)

B. What does founding and taking outside investment mean for the seller?

The sellers, the entrepreneurs, are the even more extreme side of these asymmetric returns. The most likely outcome is … they lose "everything" So all the savings they put in to bootstrap the company, maybe the money from the sale of their house, the years of sweat equity and regular earnings forgone. So a big direct financial cost, indeed opportunity cost . (As Noam Wasserman points out in his excellent book, The Founders Dilemmas, rational founders ... will not found! Because the evidence suggests they will be better off getting a salaried job somewhere.)

Bottom Line: A pretty meaningful (and adverse) asymmetry for founders/entrepreneurs in terms of their most likely lifestyle outcome.

The Take Away

So given A+B what, I asked the Empire Angels, is the implication for all us investors as it relates to due diligence?

My point was this: 
"If you take one thought away from tonight I would like it to be this - 
You need to recognize who is taking the real risk here and treat them with commensurate respect."

That does not mean that you leave the entrepreneurs alone and don't impose on their time to conduct due diligence. Indeed the Kauffman study I cited above makes it clear that, for the investor, due diligence improves outcomes:

Investors experienced better returns in the deals where they exercised more due diligence. Sixty-five percent of the exits with below-average time spent on due diligence reported a return that was less than their original investment. Losses occurred in only 45 percent of the deals where investors did above-average due diligence.

Rather, as a practical matter, RESPECT to me in this context means undertaking your investment due diligence with the following three thoughts top of mind:

1   1. Being super sensitive to the entrepreneurs time and not sucking them into your own time wasting analysis paralysis that might be an interesting intellectual exercise for YOU but might kill their ability to execute their business. As I noted to Empire: they have no staff, no admins to hunt stuff down for them; they have incomplete data; heck they probably aren’t drawing a salary.

     2. Getting to YES on NO as quickly as you can

     3. Communication directly and honestly why your answer is NO, if that is where you end up.

So a key issue you face as an early stage investor doing due diligence is a question of balance. There is no right answer to that, but in my view a little (no in this case a large amount of) respect goes a long way.

Saturday, September 7, 2013

StartUps and Wall Street: Common Imperatives

StartUps and Wall Street: Common Imperatives 

Thinking with Roseanna DeMaria

I had a lively conversation with my friend and former colleague Roseanna DeMaria this week. Roseanna is an expert in organizational design and transformation, a top leadership coach and a passionate educator. So always thinking and learning. (You can see her talk about leadership and learning in this interview with Russell Sarder: Click for Video). Roseanna is a colleague from the pre-credit crisis days of Wall Street, like me she is a former Merrill Lyncher. (And by the way, watch out, she started honing her people judgement skills as a prosecutor!)

Driving value creation - and the startup mindset

Everyone knows that the value proposition for people and businesses is critical for success. As Roseanna noted, it exists on many levels: 
a) the value created by the business model itself 
b) the value delivered by the talent running the business and 
c) how the culture or DNA of the business fosters a mindset around its value creation. These three are usually inextricably interwoven and driven by the leadership of the business - in a startup context that most always means the founders. These founders/leaders determine how the business performs and how the people in it perform. Value creation takes no prisoners in any business, least of all a highly resource constrained startup. Consequently, in the start up context, it is very dangerous for founders/leaders to "miss" the fundamental concept of value creation and the three levels cited above. Get it wrong and your start up is simply, excuse the pun, a nonstarter.

Wall Street and start up imperative similarities

While discussing these issues we compared our work with early stage companies in the B2B space against our previous Wall Street experiences. We concluded that many of the imperatives we were driven in our own Wall Street careers seemed to translate very well to start up land. Indeed Roseanna (ever the creative one) coined the term: "Wall Street Ready start up".  Not a company ready for or headed towards Wall Street for an IPO (although many might aspire to be). Rather a startup that has a clear understanding of value creation, and with it an exceptional level of competitive drive/focus, combined with a sheer will to win that elevates its chance of success in what is a very long odds game.

So what makes a startup "Wall Street Ready"? 

ie What are the characteristics of a startup with a B2B product/service that operationalize these drivers of value creation? We identified three:

1. Urgency, urgency
2. Customers are priority #1,2,3 
3. Be the Wizard/ess of Oz

1. Urgency, urgency

Startups have no time for bullshit, professional or personal. You just get things done ... bulldozing through, or weaving around, constraints to drive the business forward. It means setting tough targets and deadlines and holding everyone accountable to them, not least the founders. For all its faults, so gravely exposed in the financial crisis, an intense sense of urgency was always a hallmark of Wall Street for me. In my case lived intensely as a sell side analyst. You were only as good as you last idea and had to move like crazy to create and deliver the next one in a timely manner in an environment where information to generate those ideas was widely available and the number of other smart and hard working folks trying to do the same thing was a constant source of pressure. 

2. Customers are priority #1,2,3 

Ultimately customers are all that matter. In a B2B/enterprise context validation (and survival) is much more a function of getting entities often much larger than yours to pay hard cash for something that they have been persuaded adds value to their business. Which means customers always come first: you listen like crazy, respond, iterate and treat the ones you have signed contracts with like gold. As the saying goes, startups fail for one reason ... they run out of money. So you have to drive as hard as you come to get money coming in to offset the inevitable early stage burn and de-risk he uncertainties of fund raising! The rise of the trading and proprietary risk taking culture at many Wall Street firms laid many of them low and devastated the economy five years back. Still in my view many parts of the business, especially in the more commission based equities arena (including research) and the financial advisory corporate finance side, adhered and likely still do adhere to the mantra, and do so obsessively, that the client always comes first. Dealing with the client call, the client request for a client meeting was always my number #1 priority. Wall Street Ready startups think the same way.

3. Be the Wizard/ess of Oz

In the B2C space an attractive website or a well designed app can give you instant credibility with millions. Not so B2B. A startup selling to the enterprise means you have to look and act like a (much) bigger company than you really are. You are selling, initially very much person to person, into a high level at established and often risk averse enterprises. You have to convince them that you can deliver, will support what you deliver and have a vision for your product that is compelling and aligns with their vision for their own business. And fundamentally at a personal level they must trust "you" or rather initially you the CEO. That means you need to look and act the part - sustaining your executive presence both in person and virtually. Meaning look and act the part in F2F meetings but also online personally (aka Linkedin) and corporately (aka your website and other marketing materials). It means seeking out opportunities not just to attend conferences but speak or join panels -- to look like a player not another observer. When I moved to the US in 2000, after seven years in Asia, I needed to convince long established industry experts at my buy side clients (never mind the CEOs and CFOs of major corporations at the likes of AT&T and Verizon) that I knew what I was talking about. In telecom services be it in terms of technology, regulation, market and competitive dynamics, arcane financial details - all of it. I was lucky to be at a very credible platform but still I had to find ways to project a sense of expertise that was at time frankly well ahead of what I truly possessed ... although hopefully that expertise caught up with the projected version fairly quickly!

Sunday, September 1, 2013

PS On Startup Advisory Board Contracts and Compensation

StartUp Advisory Board Feedback ... and Concerns

After my recent post on Advisory Boards I had a number of conversations with entrepreneurs who agreed (for the most part!) with my comments but were wary about what they needed to do to make it happen. Especially when it came to the sort of contacts and compensation agreements I mentioned. Sounds all very well ... but a potential time sink to set up and maintain!?

(Hat tip to Vamsi Sistla for finding this cartoon - used in his blog post on mentors/advisors at startup accelerators.)

Framing the issue: Why adopt formal Advisor agreements?

My basic point was that, as a startup moves beyond its initial boot strapped phase and has raised capital beyond FF&F, the value added by Advisors obviously benefits an increasing number of external investors. As in many other areas of its activities I noted that this seems like a good time to professionalize the relationship with Advisors and give them a stake in the company's value creation too. It creates clear alignment and allows for better definition of roles. Also it is, for what of a better word, "fair" to the Advisor. 

The questions I got focused on three topics:
1. Advisor agreements
2. Advisor compensation
3. Finding Advisors 

1. Advisor Agreements

No need to over think this! Putting in place Advisor agreements is pretty easy and standard. There are two key ones:

a) Advisor Contract
Any good start up attorney will be able to provide a basic Advisor contract. By way of publicly available version I think the Founders Space Standard AB Agreement is short and to the point while covering the key issues - which include confidentiality, non compete and expenses. It includes an Appendix covering time commitment and duties. This can be expanded and/or made more specific based on dialog between the entrepreneur the Advisor around where the Advisor can contribute most and how much time they have. The Appendix also summarizes the stock compensation terms. However these need to be separately set out and signed off in a specific stock option agreement.
b) Stock Option Agreement
The options summary in the Advisor agreement must be fleshed out in a detailed and specific and separate option agreement. This is pretty standard stuff and mostly all legal boiler plate. Again there are sample open source stock option docs you can use, and I am sure your lawyer can run one off again in a matter of minutes - so this is very simple. Here is an Orrick version: Sample Stock Option Agreement. Personally I like the idea of a one year agreement/compensation package. It allows for a meaningful but not overly onerous duration of relationship and crucially allows the CEO to re-up, or not, her/his Advisors on a time frame that makes sense for a fast moving business. (For a more general lawerly discussion of the key issues facing entrepreneurs when it comes to issuing options the "Ten Tips" guide from Walker Corporate Law is a good read.)

2. Advisor compensation

Compensating startup Advisors is of course a non cash equity business and a matter of agreement related to the magnitude of the expected benefit to the company. As such it should be tied to specific deliverables and with the options being granted on appointment and vesting over time. 

In my prior post I noted that early stage full Board members (who are not founders/VCs) typically get 1% of equity through options vesting over 3-4 years. An Advisory Board member will have less time commitment and no fiduciary responsibility. So, logically, should be paid less. How much less? I said that 0.10%/year as a start point with more depending on contribution seemed fair. That wasn't deemed especially helpful by those looking for some more specific guidance as it relates to level of commitment, services provided and the stage of their company. Filling that gap I think the Founders Institute has a very useful grid for Advisor stock compensation contained in their own model Advisor agreement: Founders Institute Advisor agreement and compensation scaleNote that they recommend a 2 year agreement so, for example their "standard performance" level at their definition of "start up stage" is 0.10%/year ... thankfully aligned with my prior math!

3. Finding Advisors

All of the above is academic unless you actually have a slate of Advisors to work with but I will deal with that separately in due course! So, I was asked, all this technical stuff is well and great but ... how do I find them! Yes, that's a big one. Big enough in fact to defer to another post.