Category: Ventures & Entrepreneurship

Will Hsu has an interesting post on the jockeying and balancing that goes on between the outside financiers and founders (with respect to equity).

In a related area, I’ve sometimes been disturbed (not so much by the legal foundation) with respect to the "protections" for angel investors, non-founders, and early-in-the-game employees that get squeezed by later rounds of capital. Sometimes it seems like that the only real protection that these folks have come down to the integrity of the CEO, board members, and new investors in respecting what hard money (e.g., angel money) and hard sweat the employees have put in (for perhaps, very low wages). And where does the fiduciary responsibility of the board members fit with non-founders?

If you buy into my into my concept that it is impossible (or very hard) to provide legal protection to non-founders via investment rights agreements, etc., and if you further agree that board governance may be a little loose on obligations to non-founder employees, consider where the onus stands.

Update (8/18/05): BTW – in the case of non-founders I am conceptually all for performance-related structures, but the mechanics in today’s world seem very difficult to execute. Always interesting to search for new practices.

On Fridays I tend to get a little more free-form with my thought, so I thought I’d reflect on professional choices that people make through a recruiting situation I encountered with a venture capital firm. This post should not be construed as either a right way or wrong way to either be interviewed or conduct an interview. It focuses on how one weighs one’s principles in tough situations.

Eight years ago I was approached by an executive recruiter retained by one of the top one to five venture capital firms in the Valley for an associate position in the telcom space. Associate positions are basically the entry point for MBAs – it is the lowest partner-level track position within a VC firm. Apparently one of the partners had gotten my resume from another VC and passed it to the recruiter.

As relayed by the recruiter, the partner was attracted to my engineering and business background, focus on telcom in the production, operations, and standards areas, and my involvement with start-ups. The era was pre-bubble, and at a time when technologies like DSL, cable modems, advanced switching, and broadband services had not spread as widely as today (where many people have home networking setups, etc.).

During the interview, the recruiter also liked my ability to bridge the interface between technology and business worlds. It’s an important aspect of venture capital, because at some point a VC has to cut through all the mumbo-jumbo tech stuff and figure out whether the venture is going to make any money for the investors in the venture fund.

But this is a point where the interview not only went very right but also went very wrong.

What the recruiter said to me was something to the effect of this, "You know what’s wrong with you. All this stuff is nice, but the only thing in common that the partners in this [venture] firm have is that they personally want to get f*** filthy rich. I’ve known these guys for a long time, and there’s no other common thread."

Subsequent to the interview, I received some follow-on invitation and informational material about the venture fund. The fund had served as the fuel for X% of the tech capital market, etc. Pre-MBA, I had just come out of the market with a salary in the mid 50s to 60s. The letter in the packet said that in five years I could be making high seven figure earnings. This is not the even the type of lure that management consulting and investment banking firms use at b-schools.

What immediately jumped into my mind was what the recruiter said … "personally want to get f*** filthy rich".

The venture capital area excites me.
Entrepreneurism is great.
I get charged by technology.
I get charged by business.
I get charged by being entrusted by parties to protect and maximize their interests.
I hate to lose.
Of course I am interested in maximizing personal earnings potential.
But I didn’t like the underlying principle that this recruiter was focused on, which was to the effect of make yourself rich and the rest will come.
It was a cart before the horse kind of thing.

While perhaps not representative of the venture partnership, I figured I had better things to focus on. Certain principles matter to me.

In a prior comment, Kisalaya asked if I would share some thoughts about US venture capital in a way that might provide some insights as to where one might look for macroeconomic levers in how venture funded companies develop within other geographies (e.g., in India).

Let me preface this by saying that I am not a venture capitalist, although I tend to be about small businesses, privately-held companies, venture capital- and angel-financed businesses as a matter of appetite.

From my experience at business school at the University of Chicago as related to the distribution of venture capital and entrepreneurial activities, the first thing that jumps out at me in the United States is that Silicon Valley and Route 128 (Boston) have the highest concentrations of venture capital and venture financed businesses. Areas like my former hometown of Chicago and current hometown in Dallas have sometimes been referred to as the desert wasteland of venture capital. Fewer early-stage venture firms, more mezzanine firms, etc. … this tends to be the makeup in the Midwest.

Yet focusing a little deeper on one phenomena may be instructive, and it has been researched a bit in universities at a more rigorous and statistical level (I cannot find the studies offhand, so this is off the top of my head – if anyone can confirm, great). The phenomena is this: Silicon Valley tends to swamp Route 128 in terms of the amount of capital and venture financed businesses. 

On the surface, this is perplexing as to why this is so. Both of the areas have large talent pools. They also both have good universities (e.g., Harvard, MIT, Stanford, Berkeley) very proximate to the center of activity. Both areas also have partnerships between industry and academia. Both also have capital investment infrastructure.

The way this discrepancy has been explained to me is that the employee-friendly laws of California over Boston have some of the biggest effects on the difference (in addition to the more litigious stances in Massachusetts). Non-competition clauses as part of employment agreements are much, much harder to enforce in California. As net result of legal differences, the network effects of a much more mobile workforce creates an environment that may be much more "entrepreneurial-friendly" in a sense.

Anecdotally from my own experiences with start-ups, when considering legal infrastructure documents (e.g., stock option plans) for areas like California, Illinois, and Germany, the California forms of agreements seem to be much more employee-friendly as a general rule too. Things like employee-friendly stock repurchase agreement and accelerated vesting clauses come to mind as being things that have become norms in California, but not necessarily in other parts of the country and perhaps not other areas of the world. While stock options did lose a lot of weight in the bubble, and thus leveling the playing field from a stock option differential perspective, things will start to open up again as the IPO and capital markets open up.

California is a very employee-friendly place (perhaps aside from housing costs …) from my perspective. Although this may be shooting a little low, if the unemployment security filing regulations for employers is any example, I’ve found the filings for CA employees to be the most burdensome of any of the states I’ve filed for. That type of structure protects the employee as well at the cost of higher administration for the employers.

Stepping back a bit, I suppose other things to look at that could influence venture capital activity:

• how do the venture capitalists get liquid (what are the mechanics of getting to the public markets)
• industry variations due to local geography (e.g., Chicago does not have as much high-tech)
• talent pool for management (aside from just line workers)
• proximity of capital to ventures (VC have historically invested closer to where they are located than farther away [because of deal management and deal sourcing concerns])
• exchange rates (can the VCs both make enough money and invest enough money relative to the pre-money valuations of the companies and size of fund they are working)

Other than the fourth bullet point above, I’ve not seen any academic research on the topics. Not to say it isn’t there or that it couldn’t be researched more rigorously, I just haven’t seen it.

Internationally, other areas to study that come to mind may be Japan and some of its protectionist policies in the past surrounding electronics. China, in terms of of the recent transfer of wealth to entrepreneurs by the giving away of state property, is also noteworthy.

Other areas to look at may be New York and Colorado in terms of venture capital (especially since Fred Wilson and Brad Feld are prominent VC bloggers in those respective geographies). I’m less familiar with those areas of the US, but what comes to my mind readily is that Colorado made some good telecom modernization investments in the mid- to late-90s. New York is the home of a lot of publishers, advertising, etc. firms. New York City doesn’t have much in the way of financial markets though, right?

Update (Sept. 2005): Venture capitalist Fred Wilson focuses in on a special area of this post.

I participate in a group of about 50-60 CFOs that focuses on the software sector, finance, and operational issues. Participants range from sole proprietorship consultants to CFOs in public companies and venture-backed Series A-ZZ firms. Online inquiries by group members can be restricted to an intranet-based discussion (potentially using a group blogging service down the road).

When working for ventures, you need to try to leverage informal networks as much as possible (including using counsel). As examples of the high-quality things that the peer group can help you get data points on (sort of a "wisdom of the crowds" thing provided that you watch out for biases), here are two results polls related to:

1. pricing of underwater options
2. whether VPs, CXOs, etc. can be contractors

• Most people who have dealt with this historically have chosen to cancel underwater options and reissue them in 6 months and 1 day.  This was the cleanest solution that avoided triggering variable accounting.  Employees are "naked" for 6 months, but good communications plans help avoid any associated morale issues.
• After further research, [CFO] found a very interesting solution working with [deleted] auditors – a new alternative that leverages the changing regulations around expensing stock options.  There is no such thing as variable accounting if you adopt FAS 123R – Expensing Stock Options, which all private companies need to do by 2006 [deleted].  In essence, if the company adopts FAS 123R now, it can reprice the underwater options immediately.  The company simply needs to recognize an expense for the delta in value of the options (via Black-Scholes) caused by the repricing, and expense it over the remaining vesting period of the options. 
• To make a long story short, the company will solve the problem by adopting FAS 123R six months before it otherwise would have done so.  There may be some administrative pain to being on the cutting edge of implementing this, but the company avoids a lot of overhead and administration for education seminars and general employee confusion.  Accounting absorbs some pain sooner than it would inevitably face, but the rest of the organization gets to focus on business execution.

Topic #2 – Whether VPs, CXOs, etc. can be contractors (each bullet point is a snip of a selected response from peer support group participants):

• A couple of years ago I did a consulting engagement for an early-stage company on a 1099 basis and the guy who ran the company introduced me to people as "my CFO" because that’s how he viewed me and what I was doing.  However, I listed the position on my resume as "CFO (Consulting)" in the interests of accurate disclosure. If the principals involved have no objection to use of a particular title and the 1099 person is filling the role, I don’t see why not.
• Absolutely, in the past we have contracted out VP of Sales Position, albeit the person worked for us full time, however he preferred to have his consulting firm (sole proprietorship) pick up the billing and expenses.
• I also had a similar situation a few years ago.  An attorney advised me that the risk if any resided with the company as a result of an individual being held out as an officer of the company, which carries with it the presumption by outside parties dealing with the individual that the person has the usual authority associated with a company officer.  In many contract situations this is likely not the case.
• I am assuming this is a question for a resume. Guess I would look at it from a personal credibility perspective.  If I were consulting and acting as CFO, I might put CFO (consulting, acting or contract) down, but not just CFO.  If I put myself into a hiring manager’s role and asked how I would respond once I found out that it was not a direct employee position (and I would probably find out), I would probably react more favorably to the accurate representation.  The risk is getting left behind in the initial cut of the search, which will partly depend on what someone did in the role.
• We had the same type of situation with an interim CEO.  It really depends, in my opinion, on the responsibilities and authorities granted by the Board.  A title of C-O, to the outside world, implies an authority, regardless of whether the person is a W2 or 1099 employee.  That, to me, would govern whether the individual assumes the title.

Note: None of the information in this post should be construed as legal nor accounting advice. Information presented here is a summary of personal perspectives of various CFOs and finance folks.

Vincent Tang in NYC reported to me a couple pieces of news in his life that just made my week. Good news for a Friday post. First, he’s landed an analyst position with Lux Research, the research arm of Lux Capital (a venture capital firm focused on making early-stage investments in nanotechnology). Second, he’s started a blog here. Notably, he gives me credit in his post for providing him with support during his search, but I did nothing more than try to reciprocate for connections and support he extended to me.

In any case, this should be an awesome opportunity for Vincent. His opportunity reminds me of one of the well-respected niche firms in my old hometown of Chicago, First Analysis. Lux has a bit of a different wrinkle though. Should be both challenging and a lot of fun from what I can tell. Vincent is very entrepreneurial in his approach and attitude. He will go far no doubt. Congrats, Vincent!

In my past experience, I’ve worked with legal, tax, and accounting infrastructure mechanics surrounding C Corps, S Corps, proprietorships, and LLCs and the part and parcel that comes along such as articles, amendments to articles, board governance, investors rights, stock option plans and (subforms for directors, advisors, employees, etc.), interstate filings, etc. within the US. To date I’ve had little experience with international infrastructure, corporate structures, and civil codes as connected to those that work (at closer than arms-length) in the States for those international companies or may raise capital in the future within the States. Kind of obscure and not very focused, but does anyone know of good sources of information on the web related to best practices or personal experiences for such areas (e.g., mechanics on how might typical European companies expand into the US and prepare by putting in place the most optimal infrastructure for US-based stock options, capital raises, etc.)? Right now I’m just extrapolating from the control structures I’ve seen in the US …

I’ll try to share with others any general information that I learn …

Update (5/18/05, not to be construed as legal advice): Some organizational structures outside the US appear to have only common shares. Additional organizational structures may be layered in to create tiers. Not yet clear on if there are any norms on how investors rights between the organizational structures work.