Friday, February 04, 2011

Who Owns The Company?

Vinod KhoslaImage via WikipediaI have been meaning to write this blog post for a while now, months, possibly over a year. Finally I am getting around to it. It has become urgent. I have a pre-launch startup.

For conventional wisdom I am going to refer to this, but later.

Mark Peter Davis: Entrepreneur's Guide To Raising Venture Capital

I do know Mark, but that is not why. And this might or might not be the best guide out there to venture capital. But I expect it to be sufficiently good to provide me with the framework of the venture capital business as it stands today. But I have made a point not to read through his posts. I want to express my thoughts before I get corrupted by conventional wisdom.

So who owns the company? Just like I have a bias for Founder CEOs, I have a bias for startups that will go IPO. And it is those two scenarios that I have in mind. So my thoughts might not resonate with startups with other kinds of exits, which ends up being most startups.

Who owns the company?

A company that will go IPO is like a rocket that ends up in space. The IPO is the ultimate exit. Just like a rocket burns through a few different fuel tanks a startup might go through a few different rounds of funding.

Let me start by stating some things I dislike.

I am absolutely opposed to the idea of a few venture capitalists and a few early team members owning equity while the rest of the team gets to work on salary alone. I am opposed to market rate salaries. Startups ought to pay below market rate salaries. Team members should not have to pay cash for their equity. They get below market rate salaries, and they get equity.

I am absolutely opposed to any outside party like a VC firm ending up with a larger percentage ownership than the team member number one. By the way, I am also opposed to using titles like Founder, Cofounder. I instead use team member one, team member number two, and so on. You still get to brag about how early you got in. But you don't draw a cut off line at team member number two, or team member three.

I am opposed to the dilution thing. If you put in 200,000 dollars in round one, and got 2% ownership - that would be 20,000 shares valued at $10 each - then that 2% should stay all the way to IPO. The dilution clause gives unnecessary negotiating power to the money people who come in later. They come in later and try to screw the people who believed in you when noone even knew you existed.

There is a tension between the entrepreneur and the VC. Ideally the entrepreneur would like to get all the money in the world without having to give out any equity at all. Ideally the VC would like to get all the equity in the world for pennies. Somewhere in the middle is the common sense meeting ground. The shady VCs mess with you. The best entrepreneurs and VCs do not struggle too much with finding that happy middle ground. They realize it is not about who gets along with who. It is about if you can build a real business. If you can build a great business and grow the pie, then everyone can go home happy. On the other hand if you are not going to meet the numbers, there is going to be pie in your face and that of everyone else.

So if you start with a small team and a great idea, and you value the company at 10 million, and you raise 200,000 by giving away 2%, that is fuel tank one. How far could you go with that money? In my case there are revenues right away. After all we are a FinTech startup.

With the investors it should be that simple. You buy 2% for 200,000 dollars in round one. We go do the work. We do great work. The valuation has now gone on to 50 million. You now get 2% for a million. We take that money and do great work. Now the valuation stands at 100 million. You can now get 5% for 5,000,000. A startup like mine is not going to need any more money after that. We will generate enough revenues and profits on our own. So we will have given away less than 10% to VCs.

I am also open to taking bank loans. Banks don't ask for equity. All they ask is if you have a real business that generates revenues and profits.

The Board seat part is tricky. Investing in my company does not automatically get you on my Board. For one, I want a really small Board. And on my Board I only want people who I would have even if they did not invest in my company. Fred Wilson, one of the leading minds in web tech, comes to mind. Vinod Khosla, the father of for profit microfinance, comes to mind. And I want one woman who knows more than anyone else about microfinance on the planet. I will fly her over for the Board meetings. She can be anywhere on the planet. Those are the only three open slots I have for outside parties. Bill Gates also had a very small Board.

I am for all members of my team getting equity, and it is forced equity. You don't have the option to get market rate salaries and no equity. If you will not accept below market rate salaries and equity, then obviously you don't value the equity, you don't believe in the company, and you obviously do not belong on my team.

Another thing is that your equity has to vest, and it goes radioactive if you leave or are asked to leave any time before the company goes IPO. Let me explain.

You come in at below market salary and equity, and your equity gets vested in two years. So if you leave or are asked to leave before those two years, you earned yourself below market rate salaries and no equity. After two years, your equity got vested. If you leave or are asked to leave after that during any time before the company goes IPO, your equity goes radioactive. Every year it loses half its value.

Ideally I would like to get the best people possible and keep them around. But you also have to make a little room for people who will either leave or you will have to ask to leave.

As for how much equity you get, there is a formula. There are two broad elements to the formula: how high up in the organization you are, how early you came in and how long you stayed. I am thinking space time.

Say there are 10 levels to the organization. The Chairperson/CEO is level 1, the Chief Loan Officer, Chief Finance Officer, Chief Operations Officer, Chief Technology Officer are level 2, and so on. The interns are probably level 10.

The company has to keep much of its ownership stake for the post-IPO phase. Some of the most interesting things happen post-IPO. If you can't raise big money and hire great people post-IPO because you burned all your fuel in the early rounds, then that will have been a sad IPO. An IPO is not the end point, it is not the end of the journey. The journey begins at the IPO. And so it is paramount that you give out as little equity as possible before that point. Think of the IPO as launch. Because it is. Everything before that was but preparation.

If you are going to give out 2% to investors in round 1, it makes no sense to give out more than 2% to the early team members in round 1. And talk in numbers of shares not percentages. Pricing the shares at $10 is a decent idea. So a company valued at 10 million has a million shares. You start with a million shares. When the company is valued at 50 million later, that $10 share has now become worth $50. Now you have five shares. And, again, there is no dilution. You are not at the mercy of the big VCs who might pop up later for you to hold onto what you earned during the early stages.

Each round is a new round and could warrant for reorganizations within the team, potentially speaking.

The idea is to take the rocket into space.

Once the company goes IPO, the SEC comes into the picture. For a few years you can't sell your stocks. There is a very good reason why not.
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