Archive for the ‘Exits’ Category

Do VC’s Guess The Exit At The Beginning?

Question: You often hear to leave out the possible exit scenario when you pitch. Brad states that its because its usually wrong. I suspect most VC’s discuss likely exits with their partners before making an investment, what percent of the time do you guys generally "guess" the exit on the front side of the investment?

A: (Brad): I’m going to answer this from an early stage VC perspective.  I’ve never been a later stage VC nor have I been a buyout guy, so I won’t try to answer for people doing those types of investments. 

Back in prehistoric times when there was a tech IPO market, early stage VC’s used to want entrepreneurs to answer the question "Is your companies destined to exit via M&A or an IPO."  I’ve always thought this was a stupid question, as the answer is "I’ll take either one!"  As homo sapiens evolved, the argument about M&A or IPO raged on fiercely.  Pre-Internet bubble, many VC firms (including mine) would often do extensive exit analyses upon each investment round, building complex models stacked on top of detailed assumptions about the future performance of the company, the future multiples in the market, and a range of execution of the company from "flawless" to "pretty good."  These analyses usually had an IRR result and a cash on cash return result for each potential outcome.

Almost all of these analyses are total baloney.  I suppose they give some people comfort that they basing their investment decision on sound economic analysis, but since there are so many variables that are outside anyone’s control, they tend to be meaningless.  In addition, almost all of these analyses (at least the ones I’ve been exposed to, including many from other VC firms), have incredible bias in their assumptions which help support either (a) an affirmative decision to make the investment or (b) a justification for a particular valuation range.

In 2001, the IPO vs. M&A debate cooled for a while when the IPO market vaporized.  It emerged again briefly in 2004 and 2005 with a new wave of IPOs, but almost anyone that had an exit in the 2004 – 2007 time frame preferred cash from an M&A transaction to IPO stock (with a few notable exceptions, such as Google.) 

VCs fantasize about the day a vibrant small and mid-cap tech IPO market will once again exist.  Let’s hope this fantasy becomes a reality.  In the mean time, I expect more and more people – especially if they’ve read Nicholas Taleb’s Fooled By Randomness and The Black Swan – will realize that making early stage VC investment decisions based on complex forecasting exercises is – well – foolish.

Do Venture Capitalists Fund A Company With An Intent To Steal It?

Q: My client is looking for a 5 million dollar investment from a VC firm. What can he do to protect himself if he is worried that the VCs will acquire the rights to his product and then try to fire him and keep those rights? Does this happen often?

In addition, he anticipates that the new entity will generate tax losses in the early years and wants to share them with the VC. What can he do here? Finally, he would like to be able to force the venture to buy back his shares if after 5 years the company is still private. Can any of these things be done?

A: (Jason) Reputable VCs don’t engage in this type of behavior – funding and then stealing a company.  For one, it’s not a repeatable model.  If a VC acted this way, they wouldn’t have any deal flow to consummate future deals.  More importantly, VCs invest in folks to run companies – we have no interest in running your company for you, as we have other investments that we monitor. 

Also remember that VCs don’t acquire any rights to your product, they simply invest in the company that owns the rights, presumably.  So the corporate entity is what controls the rights, not any particular person.  If you question is how many CEOs leave the employ the company that they’ve created and raised money for, it’s a relatively small number.  More interestingly, the vast majority of CEOs that leave companies do it by their election, not that of the VCs.  Many CEOs are serial entrepreneurs and prefer starting companies, not running them after they become larger and more successful.

To answer your other couple of questions, neither of these will work.  Since you will have to incorporate your entity as a c-corp, these loses won’t flow through to the VCs and even if they did, VCs can’t use these types of loses.  As for the VC buy back – forget about it.  That’s a non-starter.  If I fund a company and can’t get liquidity, the founder certainly doesn’t have the right to get me to put even more money in to buy him/her out.

Will A Talented Entrepreneur Make $1m From His Startup?

Q: In your experience, what are the chances a talented entrepreneur will make $1M from his startup? (And no, I don’t mean making $150K/year for 6 years and 8 months. :)

A: (Brad): I have no clue as it depends on many different inputs as to be an impossible question to answer simply (e.g. you need to know a lot more to determine anything that resembles an accurate analysis of the potential outcome.  However, this is a thought provoking question which I’ll answer a different way then intended. 

If the goal of a talented entrepreneur is to make $1m from a startup, he should consider getting a job that makes $150k / year for 6 years and 8 months. Whenever I meet an entrepreneur that is focused on a specific economic outcome, I lower his chance of success because I think he’s focused on the wrong thing.  By definition, an entrepreneur should be striving for a significant economic payoff.  Yet the economic uncertainty of entrepreneurship is so high and the range of outcomes so broad that an entrepreneur just has to believe that if he nails it, good financial things will happen.

The direct tradeoff between a specific financial outcome ($1m) and a salary over time ($150k * 6.667 years) doesn’t really capture the essence of the financial trade in entrepreneurship.  In a success case, the $1m could turn into $10m, $100m, or even more.  Or $0.  The $150k * 6.667 is still going to be $1m.  Which would you rather have ?  (a) 0 < x < $100m+ or (b) $1m < x < $2m?  If (a) you are an entrepreneur.  If (b) you should stick with your day job.

Can You Conduct A Confidential Venture Capital Job Search?

Q:  I am part of the founding management team of a start-up. We are backed by a few well known VC’s. While I think the prospects of the company are good, I am entertaining the thought of moving into venture capital.

I have a number of contacts in the venture capital community from grad school and from raising funds for my current company. I want to parlay these contacts into a venture job, but I am worried about the confidentiality of the job searching process. I am particularly concerned about:

1) Alerting my current investors and co-founders what I am up to; and

2) Making future fund raising efforts for my current company awkward, should I be unsuccessful in my search.

With that as context, here are my questions:

Should I be worried about VC’s keeping a job-related discussion with me confidential?  The firms I would speak to would be reputable firms, but my impression is that VC’s love to share little nuggets of inside information with each other.

If I should be worried about confidentiality, what steps can I take to lower my risk?

A:  (Jason)  You should be worried about word getting around.  I don’t think VC’s are any more likely to talk than if you were looking for a new CEO position at another company, but word tends to travel.  Plus, if you are really trying to get a job at one of the VC’s you speak to, they are going to need to do extensive background checks into you and this would include VC’s on your current company’s board.

Your concerns are genuine that if word gets out it will make life for you and your current company more difficult. 

I wrote a prior post that is tangentially relevant, here.

How Can You Replace the CEO of a Struggling Angel-Funded Company?

Question: I own shares in a company in a 5 year old private company. The company to date has raised its capital through a series of convertible notes and warrants. The company has failed to gain traction over the past few years and the CEO needs to be replaced. Do any of the debt and shareholders have any recourse? Any suggestions?

(Jason) This is a meaty question, but without more background it’s hard to give you a definitive answer. The “easy” answer is that you should look to the provisions in the debt instruments that the company issued to see if they are callable. If the debt holders agree that the CEO needs to be replaced and the debt can be called, then (even if the company cannot pay the loans back), you might have the leverage to make the change. Either that, or you can shut the company down.

One more thing to consider: who is on the board? The board can replace the CEO at any time. If the board still supports the CEO, then you really only can threaten to call your loan.

In general, it’s very difficult for a debt holder or shareholder to be able to replace the CEO. Their only recourse normally is leverage they have as stakeholders.

Keep in mind the above is the “lawyer” answer. The “business” answer is that you can rarely forcibly remove a CEO – either you have the support of the board, the employees etc. and most likely the CEO doesn’t want to stay around, or you don’t. If you don’t have this widespread support, changing out the CEO is probably not going to help turn the company around. CEO transitions are hard enough, especially if the majority of the company isn’t supportive.

What Do Venture Capitalists Think About Founders Looking For A New CEO?

Q: You (VC guy) are thinking about making an investment in a new company. The founder(s) relay to you that they are interested in finding a new CEO once the VC money comes in. As a VC, would it make you more or less confident in the founders?

First of all, it’s great when founders in a potential portfolio company are completely honest and transparent. These types of issues should definitely be raised pre-funding and conversations like this make VCs more confident in their prospective management team.

Assuming that the business needs another CEO to take the company to the next level post funding, it’s great that you realize this and are amenable to the change. There are plenty of stories of founders and VCs disagreeing on who should run the company and it is not a pleasant situation. Having a realistic view of your strengths and weakness is a good thing.

One tangential thing to note: we’ve had plenty of situations where founders brought up this issue and we believed that they were actually the best person to run the company. What was really needed was an augmented management team to help support the founder / CEO. The other day I was in a meeting with a former CEO of a large Silicon Valley success story who is now a full-time investor. He had a great quote: “I love backing first time CEOs because they don’t know what they can’t do and never limit themselves.” So before you decide completely that you aren’t the one to run the company, decide whether or not additional management team support might change your mind.

What Do Venture Capitalists Think About Founders Leaving and Starting New Businesses?

Question: I founded a hardware startup in 2000. We have not had an exit yet, but it’s been successful. We have 9 VCs who invested in us and 4 are on the board. I am thinking about starting another company, because the idea is worth it. What would be the VCs point of view on this? (at least if that was you?)

Our Take: Assuming that you are still working for your current business, this is probably a bad idea. Venture Capitalists don’t just invest in ideas and companies, but also people. In other words, they’ve put their money in you. If you decide to leave and start a new business right away, my guess is that most VCs would feel abandoned and it would not reflect well on you when you try to raise money for your new venture.

That being said, if you are at a point with your first company where it’s a natural time for you to move on, then you may be able to make a graceful exit. Whatever you do, be honest with your board – you usually only get one chance at a good reputation. If your heart is no longer in the company, you need to let those around you know, because invariably it will affect your future chance of success.

How Is Intellectual Property Split Between Separating Founders?

Question: What happens if two founders hit a crossroads and they are not able to agree on the strategic direction of the company prior to institutional funding and decide to separate? Is there an easy way to split the company at this point given that there are no hard assets? What rights does each party have to the intellectual property in the company? Is it based on what they contributed or the current equity distribution? If it’s based on the current equity distribution then is it possible to value the intellectual property piece-by-piece?

Our Take: There is no easy answer to your question. Absent an agreement up front about how a divorce affects the IP ownership rights, there is no standard method for determining who owns what. Yes, you both can go out and hire lawyers and they can charge you several hundred dollars per hour to advise you on strategies and arguments of why “you own X and your former partner Y,” but at the end of the day, this will just land you in court and years away from a definitive answer. By the time everything is settled, your opportunity to exploit your IP will most likely have passed.

If you divorce is acrimonious, each of you could claim to own 100% of the IP. Regardless of who actually developed what, or what the ownership of the company is, it’s easy for each of you to say “we both own 100% of the IP,” either severally or jointly.

Bottom line, you have a strong incentive (as does your former partner) to settle this amicably, otherwise, you both are going to be worse off.

Now before the lawyers out there chime in on what could have been done up front (e.g. drafting corporate documents that clearly define who owns what, who has the power to fire whom and take control of the company, etc.) it’s in my experience that few, if any, founders want to rack up legal fees ahead of time to protect against this situation. With 20/20 hindsight, anything is possible, but in reality, I can’t think of any company that has fully thought out this scenario and planned for this contingency when forming the company from the onset.

What To Do With An Alcoholic Business Partner

Question:  We have recently discovered that our business partner is an alcoholic.  He is integral to our business and we need to find him help.  He’s been to a couple of AA meetings, but doesn’t like the “atmosphere.”  Any recommendations?  I don’t expect you to provide recommendations for treatment facilities. However I am interested in knowing how an entrepreneur should handle a situation in which s/he feels that in the best interests of the company, a key partner/executive/investor should exit or transition into another role for whatever reason. What evaluation process should the entrepreneur go through before making a final decision? How do you recommend the entrepreneur approach that person and with what type of exit or transition strategy?


Our Take:  This is a very unfortunate and sensitive matter.  Besides the personal issues, there are also business and legal considerations to address and we can not urge you strongly enough to speak to your lawyer, as state law can drastically change your options.  Normally, either Brad or I answer questions posed to us, but for this post, both of us will respond, Brad highlighting the business side and Jason addressing the legal.


Brad’s Take: I am no expert on alcoholism.  However, I have had several friends that either became alcoholics or drug addicts.  In each case, their addiction dramatically decreased their ability to function in a business context over a period of time until it reached a point where they had a meaningful negative impact on the business they were involved in.  These were both tragic situations – there were deep personal relationships that were shattered as a result of the stress, tension, and dynamics of the relationships around the addiction.  As a result I only know one way to deal with this in a business context – head on and directly.  As a human, I believe I am responsible for my actions and you are responsible for your actions.  All actions have implications and part of being a person, being business partners, and being friends is that you have to deal with the implications of your respective actions.  While your personal philosophy may be different than mine, I felt the only way to answer this question from a business perspective was to start with my philosophical frame of reference.


If you share my perspective, I’d recommend having a direct and very difficult conversation with your partner.  I’d do it in a non-confrontational manner – in a comfortable setting – with the backdrop of your fundamental concerns. In this case, it appears that your partner acknowledges his addiction, which is a great start.  I’d offer any and all help I could – and be as flexible as possible – within the context of reasonableness – to help him find help.  If AA doesn’t work for him, I’d help him find alternative programs, including such things as therapy and in-patient treatment for addictions.  But I’d insist that he address the issue as a part of staying involved with the business.  If he was unwilling to do this and his addiction impaired his ability to be effective, I’d immediately confront the issue of him departing the business if he was unwilling to address the issue and get help.  I would not be judgemental in any way – in fact I’d acknowledge that I wanted to do everything in my power to be supportive and helpful – but insist on dealing with it in the context of the business.  In my experience, one of the most challenging things for someone that has an addiction to deal with are limits on their behavior, especially in the context of the addiction.  While it sucks to have to be the person that draws the lines in the sand in a situation like this, it’s often necessary.


Jason’s Take:  I agree with everything that Brad has said. Unfortunately, if things don’t work out, you may have to consider firing your partner. Depending on where your business resides, you may or may not be able to terminate someone with a substance abuse problem.  In some states, you have to allow the person to seek treatment for 30-90 days and hold their position open while they are gone.  In the case of a key employee, it can be really tough on a young business to have this person absent from the company and to not have the option to replace them.  Even after this treatment period, you then have to give them some reasonable time to re-integrate into the business.  If you terminate the individual following treatment, one must always be aware of the potential “retaliatory firing” lawsuit.  This is a state-by-state analysis.  In some states, you can still fire a person for any reason.


Do note however, that a person with a substance abuse problem can waive their right to seek treatment and instead accept the termination and sign a release.  Obviously, there will be a price tag attached to this.
As for an “evaluation process” I’d suggest one of two polar opposites:  document everything, have multiple people in each conversation, put the person on notice, offer assistance, etc., or document nothing.   The “everything” approach will build the best record and in the event of a lawsuit, hopefully you can prove that you jumped through all the hoops and that the termination wasn’t an unjust termination.  The “nothing” approach is more akin to sweeping things under the rug.  This would play well if you think you can get a signed release at a reasonable price.

How Do You Deal with Founders Stock When Some of the Founders Leave the Company Early?

Question:  I have seen two pre-funding startups that have had 1 of 2 and 2 of 3 of the original founders quit. Neither of these companies had founder buy-sell agreements.  In the latter case, the 3 founders had split the company equally which means 66.7% of the ownership is now outside and passive.

Fortunately, they realize that this is a non-starter when the current company reaches a point (soon) of funding and are willing to give back significant ownership.  What is the best mechanism for the company (C Corp) to absorb enough of the outside founders’ shares without serious tax ramifications?

Our Take: There are three ways that we’ve seen this work. In any of these scenarios, there are important legal considerations / risks to consider. Please consult your lawyer.

1. Recapitalization of Stock. Chances are if the founder left, the company wasn’t white hot. In fact, our bet is the company isn’t doing well at all. Someone could put in a bit of money and recap the whole company washing people out to what they should have, then grant new options (that can be partially vested on day one) to those who are left.

2. Company tender. The board of the company determines the FMV of the company and then company buys back for FMV. Again, assuming the company isn’t super hot, the spread should be little or even negative.

3. Company buyback and release. The company could buy back the stock for $X in exchange for the founder shares coming back into the company and a release. Make it a release of potential claims. The company pays cash for the stock. Whatever the spread on the stock is, can be expensed by the company as a payment to protect business reputation.