A VC, a Board, and a Lawyer

Every start-up company needs them—for funding, advice, and protection. Here’s how to pick the right ones

By Frans M. Coetzee

Editor’s Note: This is Part 2 in Frans M. Coetzee’s series “Here Be Dragons: Managing a Tech Start-up,” which discusses the pitfalls and glories of starting your own tech company.

In the first article of this series [http://www.spectrum.ieee.org/careers/
careerstemplate.jsp?ArticleId=m090204], I advocated intensive planning and preparation before bringing a tech start-up to life. Much of that initial planning will include funding. Now let’s take a closer look at funding and how it relates to your company’s future: when and how to approach a venture capitalist (VC) and how to maintain your relationship with the VC. Later in this piece, I’ll turn to two other important company resources, namely the board of directors and the lawyers.

Understanding your VC is key to ensuring that you acquire a valuable resource and not a major problem. To understand VCs is to understand their motivation, which is no more and no less than to maximize their return while reducing their financial risk. A VC does not invest with the aim of bettering society or fostering new technologies. Society may benefit from a VC’s actions, and risky young technologies may develop. But these will always be spillover effects of the VC process, not its goal. Even if its motives are obscured by initial glad-handing or an idealistic prospectus, never mistake a VC firm for a charitable foundation.

The typical VC runs a lean ship and has precious little time or expertise to investigate the technology of a company in depth. In theory, VCs could limit their risk by exhaustive investigation that would ideally identify only the winners to invest in. In practice, there are so few winners and they are so hard to identify that VCs can make double-digit returns only by holding a large slice of a large number of companies. By hitting it big on just a few successful companies, VCs can cover their losses on the dogs.

And so the VCs will want to hedge their bets with you: they need to end up owning a big slice of your company to help cover their losses on the clueless companies in which they also have invested. Therefore, do not be surprised at the ferocity with which the VCs will negotiate or at the outsized stake they will try to obtain—even in the first round. It is not unethical; it is their business model, and after all, they hold the money.

As a result, make sure you negotiate with the VC from a position of strength. You should never take VC money before you have the vast majority of your company’s technology core well planned—if possible, prototyped—and have a clear, long-term strategy for financing your company. Without these, the VCs will have the advantage—they will claim that you haven’t done your homework, so funding your company is riskier for them, and they will question any assumption not backed up by data to justify taking an even bigger stake in the company. Adequate, documented planning on your side, by contrast, shows that you have a clear idea of how the company will grow, and will leave you less vulnerable during negotiations.

SELECTING A VC is always hard for new entrepreneurs. Not all VCs are created equal. There is no simple formula for sorting them out, but the following three rules seemed to evoke particular emotional response from amongst my colleagues.

First, select the firm that you would like to have on your side when your company goes off the rails. Talk to founders of both successful and failed firms in the VC’s portfolio. Look for a firm that has a history of constructively turning around fledgling companies when they get into trouble. You do not want to be shut down at the first sign of trouble. However, the VC should also demonstrate that he or she knows when to pull the plug. You do not want to be legally bound to a “zombie” company (one that is dead for all reasonable purposes) into which the VC trickles money as your share of it wastes away.

Second, make sure the VC has enough funds to participate in later funding rounds or to make emergency cash-flow contributions. If the VC doesn’t have ready cash on hand, make sure it has contacts to larger pools of capital and a history of successfully handing off investments to these larger pools.

Third, try hard to find a VC that has invested in companies in your focus area. A colleague of mine found this out the hard way when his start-up medical device company almost collapsed because the VC fundamentally misunderstood the massive upfront investment, the relentless incremental upgrade cycle, and the unpredictable delays involved in winning U.S. Food and Drug Administration approval of medical devices. His VC fund was set up by investors used to working in the relatively straightforward world of home building. My colleague would have avoided a tremendous amount of difficulty had he used a VC that had a solid understanding of the capital-intensive medical device business.

WHEN YOU APPROACH A VC, some entrepreneurs advise that you present highly optimistic financial projections to hype the potential of your company. Some even advocate preparing two sets of financial projections: the hyped “funding” projection and the true “operating” projection.

Don’t do it. Play it straight. First, an experienced VC knows a lot more than you do about how young companies manipulate projections. If you misrepresent your company, in later funding rounds, the VCs will use your earlier, inflated projections against you. They will meticulously document the deviations and outsized claims and compare them to actual revenues and costs. Your own false figures will serve as evidence that your company exposes investors to misleading projections and increased risk. Then they will demand to own much more of the company. And your credibility and that of your management team will be shot.

An even bigger problem is believing your own hype and ending up with the VC’s allocating you a small piece of the hypothetically large pie. If you firmly believe you are building a US $100 million revenue company, you may be satisfied owning just 5 percent of the company. But that satisfaction may disappear if the company can realistically make it only to the $10 million mark.

Mistakes, even honest ones, will end up costing you more. Say you err in your cash-flow estimate, which forces you to go back to your investors for an emergency round of funding; your already small stake will dwindle even further. In our example, your ownership could easily drop so far below 5 percent that only meeting the $100 million mark could make the stress and loss of personal time entailed in start-up life even marginally worthwhile.

Here are some common funding mistakes to avoid:

• Do not set overly ambitious deliverables. For example, if you say an important strategic alliance is in the bag, it had better be in place when you said it would be or you will pay the price in future funding rounds. Remember that what you promise is not as important as delivering on that promise. Competent VCs are not looking for phenomenal results up-front: they are looking for a predictable and disciplined company, which means a company that doesn’t miss its deliverables.

• Beware projected revenue inflation. In fact, you should slightly underestimate your revenues. In the eyes of a VC, every revenue target you make, even if only a penny, is good. Every target you miss, on the other hand, is bad, operationally and strategically, and gives the VCs the opportunity to stick it to you in subsequent funding rounds and take more of your company away from you.

• Never let the chief financial officer hide operational costs in the development budget. This temptation to hide costs can be greatest during fund-raising. VCs rightly view a product that doesn’t generate enough revenue in its first year to cover its operations as a stinker. But, if half of the research and development budget is in fact silently diverted and sucked up by the sales department, even the most productive R&D team will look lazy and overpaid. And when times are tough and the VCs force you to cut your staff, those hidden costs could easily cause the VCs to think they have cut just half your development staff, when in fact no one may be left.

• Don’t raise too little cash. A rule of thumb says you should try to raise 50 percent more money than you think you need. This buffer is crucial since follow-up rounds invariably take more time than expected, and unforeseen operational problems always swallow up cash. The biggest danger to a start-up is to have an emergency funding round where you have to take in money on any terms just to meet payroll. You could easily face some unsavory VCs if your first tier VCs decide to write off an investment with such a poor management team. Dilution in emergency rounds is brutal, and you frequently lose control of the company. One of the best times to raise money is at the start, when your prototype and idea still seem unbelievably cool. If at all possible, during first-round funding, lock in follow-up rounds and commitments for later short-term, emergency loans against future revenues and milestones.

Once the money comes in the door, do not forget about the VCs. The first block of cash typically covers no more than one year of operation. Even if you’ve already lined up funding beyond that stage, you’ll still need to wrestle the check from the VCs, at which time they will take another look at what you’ve been up to. To avoid any surprises when you approach the VCs for another cash transfusion, keep them up to date, and when they visit your company, be organized.

Remember, VCs have only a small amount of time to spend on any one company. But while VCs may not fully understand the business, they will be finely attuned to the tone of the operation. Financials that do not match across different spreadsheets, sales staff that fail the “elevator pitch” (meaning they are unable to describe what your product is all about in the time it takes to take a short elevator ride), and demonstrations that fail in the boardroom have all caused major funding problems for start-ups. In short, your best protection against the vagaries of the capital marketplace is to run a disciplined company.

BEFORE YOU LINE UP A VC, it pays to consider carefully your board of directors. The best advice I’ve ever received on this matter was from a high-ranking and battle-hardened corporate veteran. When I expressed amazement at his involvement in a small company such as ours, he responded, “The zeros do not matter.” Simply put, a small company need not and should not settle for small-time board members. Executives from highly esteemed companies will gladly agree to serve on a well-run and interesting start-up’s board, for free or for a few stock options. These executives know that small companies are usually refreshing hotbeds for new ideas, that decisions produce almost instantaneous change, that problems are much more clear-cut than in large companies, and that enthusiasm is everywhere.

Do not hand out board seats to friends unless you have a clear business reason for doing so. Every member should do at least one useful thing for the company, be it snaring a major customer, getting cash in the door, or offering technological insight and expertise. Get the best board you can. Your choice of board members will reveal a lot about your company’s managerial “maturity” to the VCs.

To get the most out of your board, interview each board member, and remain up to date on their business connections. Make sure they are well informed and that each one has a one-page “pitch sheet” for your company. While it is tempting for small companies to schedule board meetings ad hoc and report verbally, do not fall into this trap. Invest time up-front to put together a template board report that contains not only financials, but also sections on customer acquisitions and problems, technology progress, and needs and risks.

Before each board meeting, the senior executives can then easily update their sections. This document provides a consistent framework and point of reference at each meeting. Finally, at the board meeting the CEO should make sure every director is given clear marching orders and assigned one task at each meeting.

Be aware that funding rounds tend to spawn new board members, as investors insist on adding their own people to the board. One way to guard against a bloated board filled with accountants is to structure the board from the beginning according to expertise, and to make use of that expertise, thereby deterring smaller investors from asking for seats for their bean counters. Technology companies, in particular, tend to have shamefully few CTOs on their boards. Even if originally there, the CTO is usually the first casualty in a board reorganization. This anti-CTO bias is, frankly, inexplicable. It’s indeed puzzling to see how companies can make informed decisions about technology road maps when no one in the room can hook up the slide projector. And yet the bias persists.

FINALLY, IN ALL YOUR NEGOTIATIONS, use your own lawyer. To avoid conflicts of interest, your company’s lawyer must be different from your VC’s lawyer. And your personal lawyer should be different from both your company’s and your VC’s.

I have personally made the mistake of thinking that since I was one of the founders of my company, my company’s lawyer represented my interests personally. This was not the case. We hired a big, Wall Street law firm that did exactly what we asked. It set up a corporate structure designed to make our company as valuable as possible. And it did so with only one, brief meeting between us and its small army of lawyers (with us anxiously watching the clock the entire time).

This firm produced the kinds of documents suited to a Fortune 500 company, including incorporated subsidiaries. Not surprisingly, we later found out that, even as company founders, we were bound hand and foot to the corporate entity the law firm spawned. Our corporation had been set up to have a life of its own, even to the extent of the founders being personally responsible for some corporation taxes. While this corporate structure did a fantastic job of bringing hungry VCs to our funding rounds, it was not what we had envisioned for our small company; nor was it what we needed. The moral: get representation that has only your interests in mind.

A good personal lawyer should be affordable and should be willing to take the time to explain the tradeoffs between your personal interests and those of the company. As a simple example, you may wish to have no penalties associated with your leaving the company; such complete freedom will, however, also ensure that no VC will invest. Somewhere between your complete freedom and the reality of funding, a compromise exists. A good lawyer will prevent you from doing such inadvisable things as joining or funding the company “while the stock details are being worked out,” or putting too much credence in verbal promises.

To give you an idea of what you may be facing, consider the following, all-too-common practices:

1. Some founders are given stock options instead of founder’s stock. Too late, these founders find that the stock underlying the options may not be sold. Furthermore, these options are subject to immediate hidden taxes and, therefore, too expensive to exercise before they expire.

2. The company is given the right to buy back stock using “company paper.” In this case, if you leave the company, the company can simply hand you what amounts to an IOU for the stock at a price largely of the company’s choosing. If the company makes it, the IOU is paid off and you lose all of the gain on the stock; and if the company fails, you are the proud owner of a worthless piece of paper.

As you can see from the above scenarios, your average real estate lawyer won’t be qualified to deal with the firms employed by VCs and other investment professionals. When the company’s interests and your interests diverge, your loss is usually a windfall for the company. Such clauses as the above can in fact make the company significantly more valuable. These facts are usually also buried in the small print somewhere in the stack of documents that you will not have time to read as your small venture is launched. If you are a founding member of a start-up, in no way can the importance of having your own, highly capable representation be overstated.

In concluding this installment, let me just note that the above cautions are not meant to induce paranoia in the budding entrepreneur, or to imply that VCs or lawyers are unethical. You have to realize, especially if you come from a technical background, that you will be an amateur playing against professionals—on their turf. Always make sure that you understand what is being proposed and that you fully understand whose interests are represented by the various players at various stages. Remember the card sharp’s admonition: “If you do not know who the sucker at the poker table is, then it is you.”

As a founder or early partner, you will be facing a long and uncertain time until the blessed liquidity event—when your company goes public or is sold—lets loose all the cash you so richly deserve. Don’t forfeit or find yourself unable to afford your earned stake because of normal business or personal events. Management gets fired—often, for good reasons and bad. And if that happens to you, your replacement will get all the credit and none of the blame for your products. The least you can do is own a chunk of the company to ease the pain when he or she succeeds because of, or in spite of, your efforts.

About the Author
After stints as a researcher at Siemens and NEC, Frans M. Coetzee in 2000 cofounded Certus International SA, a security software company, which was later acquired by GenuOne Inc. He served as CTO for both companies through August 2003 and is currently a key advisor and board member of GenuOne, which makes supply chain security products. He received a Ph.D. in electrical engineering in 1995 from Carnegie Mellon University in Pittsburgh.