When interviewing folks for new startup projects, I frequently get asked “are you planning to go public?”

I find this question very annoying, but I’m not exactly sure why.  I think it has to do with goals:  an IPO is a more of a milestone than a goal.  Asking this question feels like asking a soldier about to go off to war, “are you planning on winning a medal?”

The real goal (if you’ve got investors) is to build a valuable company.  If you do that well, all of the right options (acquisition, IPO, etc.) will follow.

Following up on my exit analysis blog post, Steve Kane brings up a great comment point:  entrepreneurs should clearly understand how exit proceeds would be allocated.

Participating stock structures can be complicated (e.g. “participating preferred with a 2x multiple and 3x cap“), and they can route a surprising chunk of the exit proceeds away from the common stockholders and to the investors.  In many deals, a 1% common shareholder gets nowhere near $1m in a $100m exit.

Cutting through the complexity is easy:  make a payoff table showing what each share class gets for a range of acquisition cases (say, in $5m increments), then graph it.   If you’re contemplating a few options, you should be able to clearly see the difference in return at various price points.

If you’re considering a term sheet and don’t understand (or like) what you see, send your graph to your investor:  “is this what you meant?“

I’ve done advisory projects that have included common stock as part of the compensation. And I’ve learned the hard way that the common stockholders are the last to get paid, and it’s even worse if you’re not an employee.

Every company goes through ups and downs. Even successful companies may have a “down round” along the way, where the existing stockholders get crammed down by investors (existing and/or new). The usual mechanism for this is anti-dilution protection, which protects existing investors if there’s ever a follow-on round at a lower valuation. Or, if the company is in a really tough spot, a new investor will insist existing investors convert their preferred stock to common, before investing at some rock-bottom valuation.

The net effect is that common stock holders take a massive dilution hit (say, like 95%). Now, the investors realize that employees need meaningful ownership, so they will “re-up” everyone with grants to get to a reasonable percentage. This ownership may be more or less than the pre-dilution percentage, based on how important the company feels the employee’s contribution is. The re-ups almost always start vesting over again, so the founders (vs the developer that was hired a month ago) get hit the hardest — their clock is reset.

And if you’re a non-employee, you’re totally screwed. I’ve never seen a company re-up anyone who’s not integral to things going forward (and you can’t blame them).

There’s nothing you do about this, other than to factor it into your thinking about stock compensation for a consulting or advisory project.

For entrepreneurs pitching investors: make sure you’ve included “exit” thinking.

I see a lot of entrepreneur plans with the usual stuff on how the product/service will be developed, how it will be marketed, how much capital is needed, and how the business will grow. The frequently missing item is the exit analysis: is there a plausible path for $1 invested to be worth $10?

Investors invest to generate a return. You can build a business with the greatest {revenue|users|uniques|units sold|subscribers} in the world, but if it’s not valuable, it doesn’t matter. Some basic exit analysis against comparables (public companies, acquisitions of similar companies, funding rounds) may surface investment flaws, such as: low-margins, poor scalability (e.g. many services-centric businesses), and capital inefficiencies (e.g. $50m needed to make a company worth $100m).

Avoid the embarrassment in the VC conference room: do your exit analysis homework.

There’s an entrepreneurial lesson in the current Facebook dustup:  hubris can quickly lead to trouble.

There’s a fine line between confidence and arrogance.  Confident companies know what they’re going to do, and they do it.  Arrogant companies take it a step further and make it about proving something.

Arrogance is trouble because it kills the fan base.  Companies and entrepreneurs, like sports teams and rock bands, need fans to be successful.  Even famously arrogant companies like Google and Wal-Mart treat their user-customers well, and when they mess up, they usually attempt to make it right.

Facebook is in the middle of pissing off all the fans.

Check out this great post from Union Square Ventures:

My friend Dick Costolo, co-founder of FeedBurner, describes a startup as the process of going down lots of dark alleys only to find that they are dead ends. Dick describes the art of a successful deal as figuring out they are dead ends quickly and trying another and another until you find the one paved with gold.

(from: Why Early Stage Venture Investments Fail)

This relates to my Fundamental Theory of Startups: success is about staying in business long enough to get to the third idea.

I recently got a small dividend check from a venture-funded startup.

This was unusual:  why is a startup giving out precious cash to stockholders?  It seems counter-intuitive;  the company should be (re) investing any cash into growth.

But in some cases, this move can address a real problem.  I’ve written before about the risk problems when you pair entrepreneurs (e.g. all eggs in one basket) with VCs (e.g. a whole portfolio of eggs).  For entrepreneurs with no previous exit, a startup with real traction creates a wealth concentration problem.  With 95% of her net worth tied up in the startup, the entrepreneur starts to get conservative (as she should).

This scenario is certainly a good problem to have, but is far from hypothetical:  there’s a recent unnamed but well-known startup exit, where the widely-held view is that the CEO pushed to sell out too early.  A major factor (insiders say), is the 8-figure personal outcome for the CEO — he didn’t want to risk losing that.

Unfortunately, many investors let emotions dominate, and won’t let anyone make money before they do.  A rational investor will understand founder wealth concentration.  If the company is doing well, is solidly capitalized and is cash-flow positive, it’s a reasonable idea to give entrepreneurs some diversification and re-align interests for a “go long” play.

If you want to know more about profitable selling in business read Sellers Playbook.

I just finished up stock paperwork for a new venture-funded startup. Each time I do this, I’m shocked by the complexity in stock terms. I’ve written before about the general problem of venture capital overhead, but there’s a slightly different issue here.

I think the core problem is a kind of “feature creep”. Preferred stock terms are designed to protect investors in downside scenarios. Everything some new bad thing happens, the lawyers come up with a new term that protects investors the next time around. Examples:

• Had a company go on forever (e.g. not go public, not shut down — no closure)? Let’s put in redemption rights.
• Had a co-investor bail in a later round? Let’s put in pay-to-play so they get spanked (converted to common) for not participating.
• Had an entrepreneur buried in preference resisted an exit where the commons make nothing? Let’s put in drag-along rights.
• … etc …

Stuff gets added, but never taken out. Trying to get rid of it gets responses like, “we always do things this way”.

Unfortunately, I think, entrepreneurs have to get educated, get good representation, and live with it. Two excellent resources: Brad Feld’s series on term-sheet terms, and the National Venture Capital Association’s model financing documents.

One of the problems in venture capital today is a fundamental impedance mismatch: fund sizes remain large, while capital requirements for many Internet/software deals are shrinking.

You don’t need much money anymore for many software ideas: the software stack is free, servers can be rented for $50-$100/month, and there’s cheap labor offshore. There are a lot of ideas that can be vetted for $100k to $1m.

At the same time, venture funds have grown and stayed big, driven in part by VC compensation. As I wrote in an earlier post: venture isn’t generating great returns these days, pushing VCs to make their money on fees. The larger the fund, the larger the fees.

The mismatch happens when you do the math: for a $200m fund with 4 partners, each partner needs to invest $50m. If each partner does 1-2 new deals/year, and the fund is committed over 3 years, then each investment has to be a $8-$16m commitment. (That doesn’t mean that Series A needs to be $8m, but it means that the total invested is in that range).

You can see where it is hard for many firms to do $1m investments — it’s just too small. And some of the most interesting stuff is happening “down there”!

We all know folks that made money on Bubble 1.0 that shouldn’t have and vice versa. The point: no matter what you do, sometimes you’re just lucky (or not).

Startups are calculated risks. Entrepreneurs work hard to manage all of the factors for success, but you can’t manage everything. Sometimes the low-probability, high-impact “perfect storm” happens and wipes things out. Or sometimes, the stars align in surprising ways and everything takes off.

The key, I think, is to be as relaxed as possible about it. Sometimes you do everything exactly right and it still doesn’t work out. The trouble starts when the anxiety of failure starts to creep in. When that happens, remember, it will all be OK: your spouse will still love you, and your friends will still call you back.