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.