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
Note: This is Part 2 in Frans M. Coetzee’s series “Here
Be Dragons: Managing a Tech Start-up,” which discusses the
glories of starting your own tech company.
the first article of this series [http://www.spectrum.ieee.org/careers/
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
resources, namely the board of directors and the lawyers.
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
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
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
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.
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
it would be or you will pay the price in future funding rounds.
Remember that what you promise is not as important as delivering
Competent VCs are not looking for phenomenal results up-front:
they are looking for a predictable and disciplined company, which
a company that doesn’t miss its deliverables.
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
and sucked up by the sales department, even the most productive
team will look lazy and overpaid. And when times are tough and
the VCs force you to cut your staff, those hidden costs could
the VCs to think they have cut just half your development staff,
when in fact no one may be left.
raise too little cash. A rule of thumb says you should try to raise
percent more money than you think you need. This buffer is crucial
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
VCs if your first tier VCs decide to write off an investment
with such a poor management team. Dilution in emergency rounds
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
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.
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.
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
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.