Equity Plans Part II – Are We There Yet?

Most of you will recognize this oft repeated question which parents have heard for years. Popularized in the movie and television show by the same name as well as the movie Shrek, it is the question that sends a chill down any parent’s spine; especially when asked by a 5-year old on a long road trip. So why do I use it here especially considering Part I of this blog cited “the time has come” from Dr. Seuss? Well as they say, timing is everything and so it is with Equity Plans as well. So let me explain.

Very few people would ask someone to marry them after just one or two dates, even if they believe that person may be the “love of their life.” Yet I deal with loads of startups where the second conversation an owner has with a key potential hire turns to sharing ownership. Worse yet, without thinking through what they are offering, many offer too much equity only to find they lack enough for others (fast forward to “The Producers” by Mel Brooks – “what percent of Springtime for Hitler do they own?”) or worse yet; that key hire does not work out.

So I spend a great deal of time fixing these issues and there is nothing enjoyable about it. Legal agreements are usually incomplete; the process turns into a he said he said deal and then there are tax consequences to muscle through. It always comes down to having a well-documented equity plan and in all cases, the company “wasn’t there yet.”

So what do I advise? Very simply, have a plan. (You can look at my blog of December 19, 2013 Equity Sharing 101 for Startups for more guidance.) Of course a good attorney is the key here and while many of the documents are somewhat “boilerplate,” you must have a handle on the key provisions. So two quick cases.

In the first, a CTO was brought into a startup, and within a month, the CEO thought enough of him to offer him 10% of the Company in “Founders’ Shares” (no vesting). The CTO was focused more on coding than job satisfaction and within a year, realized he did not want to be there anymore. Fortunately, the CTO was so focused on getting out he never considered the potential value of what he had, and he basically gave back the shares and moved on. No agreements were in place; that CEO just lucked out.

In the second case, it was a similar fact pattern except the key person granted equity had been there a bit longer and felt he had substantially contributed to the Company in the five years he was there. This was another case of an early grant of equity and no provisions for separation. There was a falling out and a “settlement” is still in process. The CEO is spending a great deal of emotional time addressing this not to mention legal and consulting bills. It is not a pretty sight.

So please consider a bit of a delay to provide time for thought to make sure “you are there” before you enter an equity plan. But once you decide, move quickly and purposefully in concluding your plan and getting it all signed and delivered.

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Change of Control – Revisited

Cardinal Ximinez: “Nobody expects the Spanish Inquisition! Our chief weapon is surprise, surprise and fear, fear and surprise. Our *two* weapons are fear and surprise, and ruthless efficiency. Our *three* weapons are fear and surprise and ruthless efficiency and an almost fanatical dedication to the pope.” – Monty Python “The Spanish Inquisition”

I have seen my fair share of situations where change in control provisions in agreements resulted in unintended consequences. Until recently, I thought their sole purpose was as the name implies and as Curly said in “City Slickers,” “One thing; just one thing.” But maybe as the Cardinal suggests, there is more than one thing. Let’s look a bit more closely.

Every smart business owner knows his most valuable assets walk out the door at the end of each day. Most owners like to retain key employees and enter into employment agreements that among other things, provide for incentives (many of which vest over a period of time) that are protected, should the owner or owners no longer be around. This standard solution is known in plain English as a “change in control” provision. What this normally provides for is the acceleration of any vesting or even liquidity provisions of any incentive provisions for the key employee in the event the current owner no longer has more than 50% (usually) of voting control in the company. Everything seems fair so far; what is the problem?

In case one, I was asked to consult with a company that had a key employee that was promised an incentive payment in the event of a change in control. That provision was triggered when the Company was sold to a “strategic” but the Company took the position that they had accepted a lower sales price in return for the key employee being offered a position with the acquirer, thus they did not owe the incentive. While both sides believed their case had merit, the ambiguity created years of turmoil until we helped to resolve it.

In the second situation, an acquirer had issued an LOI for the purchase of one of my clients. During due diligence, they realized that the resulting change of control provisions would substantially “enrich the lives” of all the key management members, and they were sufficiently concerned with their motivation after the deal that they almost walked away. Fortunately, a solution was crafted which all found acceptable.

So just when I thought the key provision in an employment agreement with an incentive was a change in control, I have come to realize that it should be accompanied by a well-defined “continued employment” provision so both the team member and the company do not suffer unintended consequences when there is a change in control. Negotiating them at the start when both sides are not under the pressure of an impending transaction is also very helpful. I am starting to see these provisions in some recent transactions and strongly encourage their use. As the Cardinal said, the two key provisions are…

Non-Voting Shares – An Elegant Solution

Clark Griswold, Sr.: “It’s a beaut, Clark; it’s a beaut” – dialogue from Christmas Vacation

I am often confronted with a somewhat difficult ownership issue that can usually be addressed by what is a relatively straightforward solution; namely the proper use of non-voting shares in a succession plan.  I am surprised that I do not see this technique more often and I have come to believe that it is somewhat misunderstood, so I thought it might be worthwhile to offer some clarification.

My history with this issue started with a consultation I had a number of years ago with a very frustrated sibling (Brother A.)  His father had owned 100% of their company and although he consulted with others during his business life, all knew Dad was in charge and he made all the tough calls.  Unfortunately, the father had passed away a year earlier and wanting to treat his two sons fairly, he left half the company to “A” and half to the other sibling (Brother B).  Unfortunately, “B” had never been involved in the business while “A” had been there for 20 years and had been through a pretty decent succession planning process.  So, what was the issue?  Well, “B” started to exercise his new found rights as a 50% shareholder creating confusion and turmoil in the organization which started to manifest itself in quality issues, turnover of key personnel and declining profitability. “A” believed that without addressing this issue, the Company would get into deep trouble.

So, I undertook a small consulting project to address this and quickly realized that “B” felt his role was uncertain and undefined, but thought he was doing what was right to contribute his expertise as a half owner.  While “B” was perfectly content with his economic interest, he felt he should contribute to help the business he owned with “A” but he just did not know how.  We objectively considered the skill sets required to run the business and “B” realized his were not a match.  He did not understand what his role should be and we established some corporate governance that defined the roles of “A” and “B”.  We also (with the help of legal counsel) outlined how both could maintain their economic interest while allowing the business to carry on.  So, in the end, we converted “B’s” shares to non-voting and all turned out well.
The message here is that one should consider using non-voting shares anytime there is going to be ownership change (other than by investment) resulting in the transfer of ownership to a party not actively involved in the business.  This allows the economic distribution goals to be met while allowing the “management” of the business to carry on.  Please keep in mind that one always has to consider the corporate governance/control aspects of stock ownership when reaching conclusions here.  It would have been a beaut to have had the non-voting technique in place to avoid some of the angst for both of these brothers.

 

How to Avoid Fundraising Woes (Hopefully!)

“The hurrier I go; the behinder I get” – quote by Lewis Carroll

I talk to so many startups that struggle with fundraising that at times it is really heartbreaking.  Well-intentioned and motivated entrepreneurs seem to get their dreams crushed by turn-downs and wasted meetings. While I have been advising startups for more years than I care to remember, I promise to find financing.  So, a quick story on that point.
It was a number of years ago and I was working with a company that had pioneered some really groundbreaking voice recognition technology.  They were making the rounds with investors and having a bad time of it. They approached me and I thought it fortunate that I knew an investor who understood this space.  We worked on refining their approach and they had their meeting.  They were told at the end of the meeting that both their team and technology were really top-notch, but the investor already had a voice recognition investment and wanted to diversify.  Once I heard this, I decided I did not have enough time in the day to get inside the mind of all the investors out there and thus, my no promises on funding pledge.
So what are the three things I find are major contributors to fundraising woes:

The first is clearly the lack of a sustainable business model.  Your solution must address a real problem (see my blog “Are You Selling Aspirin or Vitamins?) and be elegant in its simplicity.  Making it too complex to use is a no–no as is the model which will rely on advertising (eyeballs) to generate revenue.  If it takes three slides to describe your model or it requires too many revenue streams, it will not work with many investors who have come to appreciate the fine art of simplicity.  For you older folks, this in my opinion is why Excel endured and VisiCalc did not.

Next, approach the right investors.  For established companies seeking to expand, there are various sources of funds, from cash-flow lines of credit to asset-based loans to private equity and subordinated debt.  Financing 101 says match the financing need with the proper source.  It is the same for emerging growth companies.  Seed money is not venture money – getting a VC to get interested in your pre-revenue startup is an impossible mountain to climb.  Focus your efforts to match your stage of development with your financing source.

Finally, make sure your market is big enough.  I just reviewed a pitch deck for a “commission type” model.  All the market size data was based on gross sales which really exaggerated the market opportunity as certain sales in that space did not involve a commission.  If a CPA like me realizes that point, so will an investor.  Stay relevant and make sure there really is a big enough market.

So, if you want to avoid running around in circles as you undertake your rounds with investors, please keep these ideas in mind.  It may not result in success but at least it may keep you from spinning your wheels.  Good luck.

Is Your Business Model Sound?

“If it’s a penny for your thoughts and you put in your two cents worth, then someone, somewhere is making a penny.”  – quote from Steven Wright.
I love to listen to entrepreneurs and advisors talk about the value of a new venture.  Even more enlightening to me is the discussion that centers around the proposed business model.  Of particular interest is when the conversation moves to potential funding and the steps one must take to be successful at this difficult task.  One slant I have heard a number of times is a common theme about the difference in approach between West Coast and East Coast investors. There seems to be a pretty consistent “myth” which goes something along the lines of “West Coast investors are more likely to invest in an idea / concept whereas those on the East Coast want to see models and projections.”  It almost comes across as requiring you to develop a viable business model for those on the East Coast but you can “coalesce the vapors of human experience into a viable and meaningful comprehension” to win over West Coast money. (My thanks to Mel Brook’s character, Comicus, from History of the World; Part I for this quote.)

Well, I hate to bust this myth but I believe nothing can be further from the truth. Trust me, unless an investor is totally in love with either your management team or the social cause you are touting, you need a viable business model to obtain meaningful financing. Now some of the models I hear touted sound a bit like this quote from Stephen Wright – they appear to be based on the belief that “there has to be money in there somewhere.”  While this might be true, investors look for you to show them the map and tell them where.

When some talk about their model, I still hear about the number of “eyeballs” a site will attract and the resulting impact of generating advertising revenue. This isn’t Warby Parker – – I am not discouraging this approach but you have to consider how many uses FB had to get to before it could generate meaningful ad revenue. Though they may convey it at different times in the evolution of an early stage company, the message from investors from both Coasts is always the same – – the more pain your product / service eases and the easier it is to use, the more people will pay; and if it is better yet if that payment happens at the time of a purchase (like a transaction fee.) They invest in aspirins not vitamins (see my earlier blog on this.)

So a word to the wise; while I would certainly agree that I have seen some West Coast investors fund companies earlier in their life cycle, I would not extend this to include the concept that there was not a solid business model behind that decision. Earlier involvement does not translate into the fact that they will fund a concept without a business model.  Stay focused on that solid business model no matter where your target investors reside.

Family Office- An Alternative Path

“Yes, there are two paths but in the long run, there’s still time to change the road you’re on” – lyrics from Stairway to Heaven by Led Zeppelin

While they have been around for years, family offices are gaining in popularity as a new generation of entrepreneurs that are coming into wealth are finding this vehicle an excellent way to carry on their legacy. There are now a number of family office organizations and education sessions as well as a growing group of service providers dedicated to this industry.  But, what is a family office, why form one and how can it work for me?

I have had the chance to talk with many clients and contacts that have formed or work at a family office.  Many are founded by a patriarch or matriarch who has a successful exit from a business but still wants the family business team to work together. They pool resources to share the costs of administration of their activities but also find that longer term goals are more easily accomplished working from a larger asset base.  The old strength in numbers adage seems to ring true here.  So, just some notes on my observations about family offices:

  1. The successful ones do have structure and in many cases, that structure resembles what the previously owned family business had in place
  2. A family office requires a discipline regarding decisions such as investment vehicles, seeking another operating company opportunity or perhaps a more structured approach to philanthropic endeavors
  3. This vehicle can provide opportunities to enhance the lives of the next generation. The atmosphere is usually less hectic than the day to day crisis environment of a family run operating company so there is more time for educating and exploring alternatives.
  4. Some have told me their family office provides the opportunity to do it right. Whether it is investment strategy or philanthropy, having some resources and time allow them to develop a more successful and effective approach to their goals.

Please keep in mind, a family office is not for everyone.  Many family run businesses are full of discord, are somewhat dysfunctional and a family office will not solve those issues.  If that is the reality of your situation, everyone going their separate way may be the best solution.  There is also the concept of multi-family offices.  Some families and groups are just more organized than others and they have used these skills to offer family office services to other families.  So, if you believe you could deliver this type of service to others or you want to consider your own family office, the best place to start is to talk to some of the professionals who work in this space.  Many entrepreneurs have seller’s remorse brought on in part, I believe, by not having something to go to.  After a long career usually at one place, they have a certain emptiness when they exit a business.  Many seek a meaningful place as the next phase in their journey and while not a “be all and end all,” a family office may be an alternative to fill that void.  You might just find it is not too late to “change the road you are on.”

Exit Plan, Succession Plan, Estate Plan

“The what, the what and the what?” Dialogue from Spaceballs – by Mel Brooks

As a business matures, the owner or owners begin to dwell on the next chapter in their lives.  (For purposes of this blog, I will assume one owner.)  The preoccupation with growth and profits starts to take a second seat to retirement and perhaps their legacy.  I have seen many owners get confused by three terms which begin to get bandied about when an owner mentions he may be thinking of moving on.  So, I thought it may be helpful to provide a little primer on what these terms mean and what relevancy they may have to an owner.

I always start with the term “exit plan.”  This is the process an owner should go through if he wants to successfully transition out of his business.  This process answers two questions; “what” you want to do and “how” you are going to do it.  The owner may decide to pass his business on to others or to sell it to a third party.  In either case, there is a process for both (ours has seven steps) which helps guide the owner through one of the most important and at times difficult decisions of his life.

The second term is “succession plan” and is usually the next process.  This is the process to transition management from one generation or team to the next.  Obviously, these processes are interrelated.  I am working with an owner who is trying to execute a succession plan with his son.  He has stated that if the process is not successful (he has given it a two-year timeline) he will sell the business.  This is a fairly typical reaction but I always encourage the development of the successor level of management.  If nothing else, it serves to enhance the value of the business.

The last term is “estate planning” which is the process to transition wealth from one generation to the next.  As you might imagine, the next generation of ownership may not correlate perfectly with the next generation of management.  A great tool I use in tying these processes together is what I refer to of as the “hope” diagram.  I use three concentric circles to depict family, ownership and management.  This simple but effective tool has a way of bringing to the fore spouses of siblings and others for planning purposes.  It also helps to avoid those nasty voting control issues that can lead to business divorces (see my prior blog on this.)

I know it sounds like motherhood and apple pie, but clearly the most effective plans (which encompass all of the above) are those that involve the engagement of qualified professionals and I would strongly encourage any owner to spend the money to do so when the time to move on has come.  You will not regret it.