Category Archives: Venture Capital

My Appearance on the Private Equity Funcast

Who else but my old friend Jim Milbery, a founding partner at ParkerGale, could come up with a podcast called the Private Equity Funcast, complete with its own jingle and with a Thunderbirds-inspired opening?

Jim and I worked together at Ingres back in the — well “pre-Chernobyl” as Jim likes to put it.   When we met, he was a pre-sales engineer and I was a technical support rep.  We’ve each spent over 25 years in enterprise software, in mixed roles that involve both technology and sales & marketing (S&M).  Jim went on to write a great book, Making the Technical Sale.  I went on to create Kellblog.  He’s spent most of his recent career in private equity (PE) land; I’ve spent most of mine in venture capital (VC) land.

With a little more time on my hands these days, I had the chance to re-connect with Jim so when I was in Chicago recently we sat down at ParkerGale’s “intergalactic headquarters” for a pretty broad-ranging conversation about a recent blog post I wrote (Things to Avoid in Selecting an Executive Job at a Startup) along with a lot of banter about the differences between PE-land and VC-land.

Unlike most podcasts, which tend to be either lectures or interviews, this was a real conversation and a fun one. While I’m not sure I like the misparsing potential of their chosen title, Things To Avoid in Selecting an Executive Job with Dave Kellogg, I’ll assume the best.  Topics we covered during the fifty-minute conversation:

  • The pros and cons of CEOs who want to get the band back together.
  • Pros and cons of hiring people who have only worked at big, successful companies and/or who have only sailed in fair weather.
  • The downsides of joining a company that immediately needs to raise money.
  • How CMOs should avoid the tendency to measure their importance by the size of their budget.
  • Should companies hire those who “stretch down” or those who “punch above their weight”?
  • The importance of key internal customer relationships (e.g., the number-one cause of death for the CMO is the CRO) and how that should affect the order of your hires when building a team.
  • Feature-addicted founders and product managers (PMs), technical debt, and the importance of “Trust Releases.”
  • Pivoting vs. “traveling” when it comes to startup strategy.
  • The concept of Bowling Alleys within Bowling Alleys, which we both seem to have invented in parallel.  (Freaky.)
  • The difference between knocking down adjacent markets (i.e., “bowling pins”) and pivots.
  • Corporate amnesia as companies grow and surprisingly fail at things they used to know how to do (e.g., they forget how to launch new products).
  • My concept of reps opening new markets with only a telephone, a machete, and a low quota.
  • My pet peeve #7: salespeople who say it’s impossible to sell into an industry where the founders managed already to land 3-5 customers.
  • The difference between, in Geoffrey Moore terms, gorillas and chimps.
  • How there are riches in the niches when it comes market focus.
  • How feature differentiation can end up a painful axe battle between vendors.
  • Thoughts on working for first-time, non-founder CEOs in both the PE and VC context.
  • The difference between approval and accountability, both in formulating and executing the plan.

Here are some other episodes of the Private Equity Funcast that I found interesting:

So my two favorite podcasts are now The Twenty Minute VC on the venture side and The Private Equity Funcast on the PE side.  Check them both out!

Thanks for having me on the show, Jim, and it was a pleasure speaking with you.

Avoiding the Ten-Year Stock Option Trap (and Other Stock-Option Considerations)

I’ve increasingly spoken to startup employees who find themselves in a difficult trap.  Let’s demonstrate it via an example:

Say you joined a startup in September 2009 as an early employee and immediately received a stock-option grant of 400,000 shares with a strike price of $0.10 when you joined.  The company, while having experienced some ups and downs over the years, has done very well.  At its last 409a valuation, the common stock was valued at $10/share [1].  You feel great; after all, you’re a paper millionaire, with an option worth about $4M [2].

What could possibly be the problem in this seemingly great situation?  Well, sometime in the next 45 days that stock-option is going to vaporize and become worthless.  

More scarily, what needs to happen for that option to become worthless?  Absolutely nothing.  Nobody has to say or do anything.  No notices need to be sent.  Sometime in the next 45 days that option will silently cease to exist [3].  If the company gets acquired two years later at $20/share and you’re expecting an $8M payout you’re going to be rudely surprised to find you get nothing.

The Silent Killer
What happened?  What is this silent killer of stock option value?  Expiration.  The option expired ten years after its grant date.

The vast majority of Silicon Valley stock option plans feature options that expire after ten years.   In this example, your option was granted in September 2009 which means that by October 1, 2019 that option will be expired.  And the really scary part is that nobody needs to tell you it’s about to happen.

While some companies are undoubtedly more proactive than others in both helping employees avoid getting into this situation and warning them as it approaches, in the end, it’s up to you to make sure you don’t get caught in this trap.  Technically, the company doesn’t need to say or do anything.  And – to be clear — because it’s a relatively new phenomenon in Silicon Valley the company may not even have noticed it’s happening and, even if it does, it may remain silent because it doesn’t really have any good remediation options.  It’s a tough situation on both sides because there are no easy wands that anyone can wave to fix this.

If you think you should stop reading here because you’re only at year two of your vesting, don’t.  If you resign (and/or get fired) from your job your stock options will typically expire in just 90 days, so you’ll be facing these same issues — just on a greatly shortened timeframe.

Who Is The Evil Genius Who Set This Up?
None.  There is no evil genius.  It’s simply an unwelcome artifact of Silicon Valley history.  In olden days it took about 4 years for a startup to hit a liquidity event [4] [5].  That’s why stock options vest over 4 years.  It’s also why they expire after 10 years.  All options need to have an expiration date and back in the day, 10 years approximated infinity [6].

As employees, we benefit from the artifact of 4-year-vesting.  However, if we’re not paying attention, we can get crushed by the artifact of 10-year expiration.

What Can I Do About It?
First, this is a tough situation and you may have few or no good options.

Second, I’m not a financial advisor [7]; you’ll need to see your financial and/or tax advisors to figure this out.  In this post, I’ll walk through what I see as some of your options – which will itself demonstrate the problem.

Third, short timeframes are not your friend.  If you see this problem coming I recommend you start thinking hard about it at least 12 months in advance; when you’re down to 30 days left your available choices may be extremely limited.

Here are some of your available options for handling this situation.

1. Exercise the stock-option before it expires. You’ll need to find $40K to pay the company for the exercise, but that’s not the hard part.  Because the fair market value (FMV) of the stock is $10/share you’re going to face a tax bill of somewhere between $1.1M and $1.9M on the exercise, even if you hold the stock (i.e., you don’t sell it) [8].  This is, in fact, the problem statement.

2. Exercise the option before it expires and sell enough to a third-party to pay the tax bill. This means, if you’re selling in the private market (e.g., EquityZen, Sharespost) at the FMV of $10, that you exercise 400K shares and then sell about 150K of them to cover your tax bill [9] [10A].  That leaves you holding 250K shares of stock.  This, however, requires (a) the existence of such a market and/or your ability to independently find a buyer, (b) the stock to be not restricted from you selling it without company approval (or the company granting such approval), and (c) you paying I’d guess $10K or more in legal and/or other transaction fees to make it happen [10].

3. Exercise the option with the support of a specialist fund (e.g,. ESOfund) that cuts rather exotic deals to solve this and related problems [10A]. For example, one of these (typically very boutique) funds might say:  “I’ll give you the cash both for the exercise and to pay your tax bill, if you give me the shares.  When we eventually sell them, I’ll keep 100% of proceeds until I get my money back, 50% until I get 3x my money back, and 25% after that [11].”  These funds are hard to find and the deals can be very hard to understand.  Legal bills can rack up quickly.  And you’ll need to be a major shareholder; no one wants to do a lot of complex work for 2K shares. 

4. Use a company liquidity program, if offered, to avoid getting into the situation.  Some companies periodically offer employees the right to sell shares in order to demonstrate to everyone that liquidity is possible.  Don’t be so busy doing your job that you forget to consider these programs.  While you may think the valuations offered are too low, if there is no secondary market for the stock and/or the company restricts selling the stock after its purchase, you may have no choice but to use such a program.  It’s a far better deal than letting the options expire worthless.

5. Live in Belgium. I believe Belgium has a great law whereby you pay a modest tax at the time you receive a stock option grant and then no tax on either exercise or sale [12].  I’m telling you this not to encourage you to start learning to enjoy moules frites and making immediate plans to move to Brussels (it’s probably too late) — but to remind my international readers that I’m writing from a US point of view and that stock option taxation, in particular, varies a lot from country to country.  If you happen to live in Belgium and the law hasn’t changed, it’s a particularly good place to get stock-options in early-stage startups.   But the main point is to be sure you understand the law of your country before making any plans or decisions when it comes to stock options (or any other tax matter).

6. Avoid the problem in the first place via an early-exercise with section 83b election. Some companies will allow you to exercise your options before they vest by effectively reversing the stock option – you pay the exercise price, the company gives you the shares, and the company retains a right to buy back the shares from you (at the exercise price) which declines by 1/48th per month over four years.  In addition, if you file a section 83b election within 30 days (and the grant was not in-the-money) then you pay no tax at exercise time and incur tax liability only when you eventually sell the shares, which if it’s more than a year away, results in long-term capital gains tax treatment [13].  Wow, this sounds awesome – and it is.

What’s the downside?  (a) Ideally, you need to do this up-front so it’s not necessarily a good solution if you’re in year three, (b) you need enough money to pay the exercise price which typically works well at early-stage startups (400K shares at $0.01/share = $4K) and a lot less well at later stage ones (100K shares at $5/share = $500K), (c) if the company gets in trouble [14] your common stock could well end up worthless and you won’t get your money back – you are effectively destroying the option-value of your option by exercising it, (d) if you don’t file your section 83b in a timely manner and/or lose your records of having filed it you could end up in a very bad position tax-wise [15].

7. Mitigate the problem via regular exercises along the way (laddered). While I don’t think this is a great strategy, it’s simple to understand, and mixes preserving option value while periodically exercising (and incurring taxes) along the way – so it’s going to be expensive to execute; but nevertheless way less expensive than a forced exercise in year 10.  The two nice things about this strategy are (a) you shouldn’t need company approval to execute it and (b) you can stop along the way and still own some of your options — it only gets very expensive in years 3 and 4.  Here’s a spreadsheet to show it (including some comments not in the image below) which you can download here.

ladder vs. panic

Of course, you may find other strategies, proactive companies may offer programs with other strategies, you might be able to execute a derivative of one of these strategies (e.g., number 3 with a rich uncle), and you can combine the above strategies (e.g., laddering plus early-exercise) as you see and your financial and tax advisors see fit.

I should note that later-stage startups may offer restricted stock units (RSUs) instead of options.  Though some of the same principles can apply (e.g., section 83b elections also relate to RSUs), RSUs work differently than stock options and bring different complexity which is beyond our current scope.

In this post, I’ve alerted you to the ten-year stock option expiration trap and given you a few ideas on how to avoid it.  Moreover, remember that if you resign (or get terminated) that this distant ten-year expiration problem becomes a 90-day problem.  Finally, I’ll point you to my favorite book on this subject (which covers both stock-options and RSUs), Consider Your Options 2019, and which has a nice website as well.

Remember to always talk to your financial and tax advisors before making key decisions about equity-based compensation.

# # #

Notes

[1]  Most private startups get an annual 409a valuation once a year to establish the fair market value (FMV) of their common stock so they can appropriately set the strike price on newly granted stock options, without being accused of granting in-the-money options (as some companies were accused of doing during the dot-com bubble).  409a valuations are always lower than “headline valuations” that companies often announce as part of financing rounds, because headline valuations take the price of a newly issued preferred share and multiply it by the entire share pool (common and preferred).  409a valuations first value the business overall, then subtract any debt, and then subtract the value of “preference stack” in arriving at a value for common stock in aggregate, and then per-share.  Because (a) of how they are calculated, (b) various valuation methodologies produce ranges, and (c) there is a general desire to preserve a low common stock price for as long as possible, 409a valuations not only differ from headline valuations (which are arguably calculated incorrectly) but they tend to produce a low-side estimate for the value of the common.

[2] And maybe a lot more than that because many private, hot-company stocks sometimes trade well above the 409a value in secondary markets.  In fact, in many cases it trades a little or no discount to the price of the last preferred round, and in some cases above it which, unless a lot of time has passed since the last round, strikes me as kind of crazy.

[3] That is, in the 45 days after August 15, 2019 – the day I wrote the post.

[4] For example, Business Objects was founded in 1990 and went public in 1994.

[5] If Silicon Valley were reinvented today, options would probably vest over 12 years, because that’s about how long it takes to get to an IPO.  However, that’s unlikely to happen as the ten years is the maximum duration under law for an ISO option.  This isn’t a VC-change kind of thing; it’s a write your Congressional Representative sort of thing.

[6] The definition of a (call) stock option is the right to buy N shares at price P by date D.  Expiration dates are inherent to options.

[7] See disclaimers in my FAQ and terms of use.

[8] Math is approximate.  On the low side, I’m assuming it’s an ISO option and the tax is all AMT at 28% and you’re in a tax-free state.  On the high side, I’m assuming it’s an NQ option, and a combined marginal rate of 49%.  See your tax professional for your situation.  The main point here:  it can be a huge number.

[9] Bear in mind, per earlier comments, the FMV tends to run on the low side and particularly for red-hot companies, prices in the secondary market can be well above the FMV, e.g., in this case, let’s say $20.  While this will help you on the sale side (you’ll need to sell half as many shares), it could bite you on the tax calculation because you’ll simultaneously be arguing that the stock is worth $10 for tax calculation purposes while actually selling it for $20.  See your tax professional.  Good luck.

[10] I’ve seen and/or heard of cases where companies charge a $5K administrative fee for people selling shares in this manner.  Some companies like it and make it easy.  Some don’t and make it anywhere from hard to impossible.

[10A] There is zero endorsement of any vendor or fund mentioned here.  I provide examples simply to make things concrete in terms of classification.

[11] This is a somewhat flawed representation of such deals, but you get the idea.  The fund effectively becomes your partner in owning the stock.  These can be expensive deals, but for the stock-optionee some value is better than none, which is what they will have once the option expires.

[12] This works particularly well for early-stage startups because I believe you pay a tax of either 9% or 18% of the aggregate value (shares x strike price) of the option at grant time, and the shares are worth next to nothing.  (It works less well if you get a grant of 100K shares valued at $100/share.)

[13] You must, must, must see your tax advisor on this.  You have only 30 days to file an election and if you don’t, you lose the benefits of this approach and can put yourself in a very bad situation.

[14] And trouble doesn’t have to mean bankruptcy.  It simply means any situation where the sale price of the company is less than the sum of debt to be repaid plus the preference stack.  In these situations, the common stock becomes worthless.  Note to the wise:  while it’s often the case, you cannot assume the preference stack is simply the amount VCs have invested in preferred stock.  In some cases, you have multiple liquidation preferences where VCs (or PEs) get 1.5x to 2.0x their investment back before the common gets anything.

[15] See [13].   I won’t go into the details of what happens because it’s complicated, but if you are going to go the section 83b route, you need to file within 30 days and keep very good records that you did.  You remember when people went bankrupt on AMT taxes due to buying-and-holding ISO options in Bubble 1.0?  You could end up rekt in a similar way if you get this wrong.

Good CEO Habits: Proactively Update Your Board at the End of Every Quarter

I am surprised by how many startup CEOs leave the board hanging at the end of the quarter.  As a CEO my rule of thumb was that if a board member ever asked me about the quarter then I’d failed in being sufficiently proactive in communications.  In tight quarters I’d send a revised forecast about a week before the end of the quarter — hoping to pre-empt a lot of “how’s it going” pings.

And every quarter I would send an update within 24 hours of the quarter-end.  In fact, if we’d effectively closed-out all material opportunities before quarter-end, I’d send it out before the quarter was technically even over.

Why should you do this?

  • It’s a good habit.  Nobody wants to wait 3 weeks until the post-quarter board meeting to know what happened.
  • It shows discipline.  I think boards like disciplined CEOs (and CFOs) who run companies where the trains run on time.
  • It pre-empts one-of emails and phone calls.  It’s probably less work, not more, to send a quick standard end-of-quarter update that includes what you do know (e.g., bookings) but not what you don’t (e.g., expenses because accounting hasn’t closed the quarter yet).

What form should this update take?  I’d start with the board sales forecast template that I’ve already written about here.  (And I’d change Forecast to Actual and drop the Best Case and Pipeline Analysis.)

how-to-present-forecast-2.jpg

Since cash is oxygen at a start-up, I’d add a line about forecast cash flows, making sure they know the numbers are preliminary, with final numbers to follow at the upcoming board meeting.  I might add a little color on the quarter as well.

Here’s an example of a good end-of-quarter board update.

Dear Board,

Just a quick note to give you an update on the quarter at GreatCo.  We beat new ARR plan by $200K (landing at $1,700K vs. plan of $1,500K) and grew new ARR YoY by 42%.  We came in slightly under on churn ARR, landing at $175K vs. a plan of $200K.  The result is we ended the quarter $225K ahead of plan on ending ARR at $11,546K, with YoY growth of 58%.

Cash burn from operations is preliminarily forecast to be $240K ahead of plan at $2,250K and ending cash is just about at-plan of $10,125K (we were a little behind in 1Q and 2Q has caught us back up).

We had some great competitive wins against BadCo and WorseCo — I’m particularly happy to report that we won the Alpha Systems deal (that we discussed in detail at the last meeting) against BadCo for $275K.  Sarah will tell us how we turned that one around at the upcoming board meeting.

Finally, I did want to point out — given the concerns about sales hiring — that we ended the quarter with 12 quota-carrying reps (QCRs), only 1 behind plan. Sarah and Marty did a great job helping us catch almost all the way back up to plan.  That said, we’re still having trouble hiring machine-learning engineers and are nearly 5 heads behind plan to-date.  Ron and Marty will update the board on our plans to fix that at the meeting.

Overall, we feel great about the quarter and I look forward to seeing everyone in a few weeks.  Thanks, as always, for your support.

[Table with Numbers]

Cheers/Dave

# # #

Stopping Inception Churn: The Prospective Customer Success Review

I think for many sales-aggressive enterprise SaaS startups, a fair amount of churn actually happens at inception.  For example, back in 2013, shortly after I joined Host Analytics, I discovered that there were a number of deals that sales had signed with customers that our professional services (PS) team had flat out refused to implement.  (Huh?)  Sales being sales, they found partners willing to do the implementations and simply rode over the objections of our quite qualified PS team.

When I asked our generally sales-supportive PS team why they refused to do these implementations, they said, “because there was a 0% chance that the customer could be successful.”  And they, of course, were right.  100% of those customers failed in implementation and 100% of them churned.

I call this “inception churn,” because it’s churn that’s effectively built-in from inception — the customer is sent, along with a partner, on a doomed journey to solve a problem that the system was never designed to solve.  Sales may be in optimistic denial.  Pre-sales consulting knows deep down that there’s a problem, but doesn’t want to admit it — after all, they usually work in the Sales team. Professional services can see the upcoming trainwreck but doesn’t know how to stop it so they are either forced to try and catch the falling anvil or, better yet, duck out and a let partner — particularly a new one who doesn’t know any better — try to do so themselves.

In startups that are largely driven by short-term, sales-oriented metrics, there will always be the temptation to take a high-risk deal today, live to fight another day, and hope that someone can make it work before it renews.  This problem is compounded when customers sign two- or three-year deals [1] because the eventual day of reckoning is pushed into the distant future, perhaps beyond the mean survival expectation of the chief revenue officer (CRO) [2].

Quality startups simply cannot allow these deals to happen:

  • They burn money because you don’t earn back your CAC.  If your customer acquisition cost ratio is 1.5 and your gross margins are 75%, it takes you two years simply to breakeven on the cost of sale.  When a 100-unit customer fails to renew after one year, you spent 175 units [3], receive 100 units, and thus have lost 75 units on the transaction — not even looking at G&A costs.
  • They burn money in professional services.  Let’s say your PS can’t refuse to the implementation.  You take a 100-unit customer, sell them 75 units of PS to do the implementation, probably spend 150 units of PS trying to get the doomed project to succeed, eventually fail, and lose another 75 units in PS.  (And that’s only if they actually pay you for the first 75.)  So on a 100-unit sale, you are now down 150 to 225 units.
  • They destroy your reputation in the market. SaaS startup markets are small.  Even if the eventual TAM is large, the early market is small in the sense that you are probably selling to a close-knit group of professionals, all in the same geography, all doing the same job.  They read the same blogs.  They talk to the same analysts and consultants.  They meet each other at periodic conferences and cocktail parties.  You burn one of these people and they’re going to tell their friends — either via these old-school methods over drinks or via more modern methods such as social media platforms (e.g., Twitter) or software review sites (e.g., G2).
  • They burn out your professional services and customer success teams. Your PS consultants get burned out trying to make the system do something they know it wasn’t designed to do.  Your customer success managers (CSMs) get tired of being handed customers who are DOA (dead on arrival) where there’s virtually zero chance of avoiding churn.
  • They wreck your SaaS metrics and put future financings in danger. These deals drive up your churn rate, reduce your expansion rate, and reduce your customer lifetime value.  If you mix enough of them into an otherwise-healthy SaaS business, it starts looking sick real fast.

So what can we do about all this?  Clearly, some sort of check-and-balance is needed, but what?

  • Pay salespeople on the renewal, so they care if the customer is successful?  Maybe this could work, but most companies want to keep salespeople focused on new sales.
  • Pay the CRO on renewal, so he/she keeps an honest eye on sales and sales management?  This might help, but again, if a CRO is missing new sales targets, he/she is probably in a lot more trouble than missing renewals — especially if he/she can pin the renewal failures on the product, professional services, or partners.
  • Separate the CRO and CCO (Chief Customer Officer) jobs as two independent direct reports to the CEO.  I am a big believer in this because now you have a powerful, independent voice representing customer success and renewals outside of the sales team.  This is a great structure, but it only tells you about the problems after, sometimes quarters or years after, they occur.  You need a process that tells you about them before they occur.

The Prospective Customer Success Review Committee
Detecting and stopping inception churn is hard, because there is so much pressure on new sales in startups and I’m proposing to literally create the normally fictitious “sales prevention team” — which is how sales sometimes refers to corporate in general, making corporate the butt of many jokes.  More precisely, however, I’m saying to create the bad sales prevention team.

To do so, I’m taking an idea from Japanese manufacturing, the Andon Cord, and attaching a committee to it [4].  The Andon Cord is a cord that runs the length of an assembly line that gives the power to anyone working along the line to stop it in order to address problems.  If you see a car where the dashboard is not properly installed, rather than letting it just move down the line, you can pull the cord, stop the line, and get the problem fixed upstream, rather than hoping QA finds it later or shipping a defective product to a customer.

To prevent inception churn, we need two things:

  • A group of people who can look holistically at a high-risk deal and decide if it’s worth taking.  I call that group the Prospective Customer Success Review Committee (the PCSRC).  It should have high-level members from sales, presales, professional services, customer success, and finance.
  • And a means of flagging a deal for review by that committee — that’s the Andon Cord idea.  You need to let everyone who works on deals know that there is a mechanism (e.g., an email list, a field in SFDC) by which they can flag a deal for PCSRC review.  Your typical flaggers will be in either pre-sales or post-sales consulting.

I know there are lots of potential problems with this.  The committee might fail to do its job and yield to pressure to always say yes.  Worse, sales can start to punish those who flag deals such that suspect deals are never flagged and/or that people feel they need an anonymous way to flag them [5].  But these are manageable problems in a healthy culture.

Moreover, simply calling the group together to talk about high-risk deals has two, potentially non-obvious, benefits:

  • In some cases, lower risk alternatives can be proposed and presented back to the customer, to get the deal more into the known success envelope.
  • In other cases, sales will simply stop working on bad deals early, knowing that they’ll likely end up in the PCSRC.  In many ways, I think this the actual success metric — the number of deals that we not only didn’t sign, but where we stopped work early, because we knew the customer had little to no chance of success.

I don’t claim to have either fully deployed or been 100% successful with this concept.  I do know we made great strides in reducing inception churn at Host and I think this was part of it.  But I’m also happy to hear your ideas on either approaching the problem from scratch and/or improving on the basic framework I’ve started here.

# # #

Notes

[1] Especially if they are prepaid.

[2] If CROs last on average only 19 to 26 months, then how much does a potentially struggling CRO actually care about a high-risk deal that’s going to renew in 24 months?

[3] 150 units in S&M to acquire them and 25 units in cost of goods sold to support their operations.

[4] I can’t claim to have gotten this idea working at more than 30-40% at Host.  For example, I’m pretty sure you could find people at the company who didn’t know about the PCSR committee or the Andon Cord idea; i.e., we never got it fully ingrained.  However, we did have success in reducing inception churn and I’m a believer that success in such matters is subtle.  We shouldn’t measure success by how many deals we reject at the meeting, but instead by how much we reduce inception churn by not signing deals that we never should have been signed.

[5] Anonymous can work if it needs to.  But I hope in your company it wouldn’t be required.

Career Decisions: What To Look For In a Software Startup

So, you’re thinking of taking a job at a startup, but are nervous about the risk, perhaps having trouble telling one from another, and unsure about knowing what’s really important in startup success.  In this post, I’ll share what I consider to be a great checklist for CXO and VP-level positions, which we’ll try to adapt a bit to be useful for all positions.

1. Great core/founding team.  Startups are about people.  We live in a founder-friendly VC era.  Thus, there is a good chance one or all of the founding team will be around, and in influential positions, for a long time.  If you’re CXO/VP-level, make sure you spend time with this team during your interviews [1] and make sure you think they are “good people” who you trust and who you’d want to work with for a long time [2].  You might well be doing so.

2. Strong investors.  In venture capital (VC) land, you should view investors as long-term partners in value creation.  Their investments give them contractual rights (e.g., board seats) and you can assume they will be around for a long time [3].  Companies need two things from their investors:  advice (e.g., the wisdom acquired from having built a dozen companies before) and money.  While good advice is always important, money is absolutely critical in today’s startup environment where a hot category can quickly evolve into a financial arms race to see which company can “buy” the most customers the fastest [4].

While I won’t do a tiering of Silicon Valley VCs here, you want to see investors with both deep pockets who can fund the company through thick (e.g., an arms race) and thin (e.g., inside rounds) and strong reputations such that other VCs are willing and eager to invest behind them in future rounds [5].

3. Newer company/technology.  I’ll give you the hint now that this is basically a list of key factors ranked by difficulty-to-change in decreasing order.  So the third hardest-to-change key factor is technology.  If you’re considering going to work at a twelve-year-old startup [6], understand that it’s very likely built on twelve-year-old technology premised on a twelve-plus-year-old architecture.  While the sales-and-marketing types will emphasize “its proven-ness” you will want to know how much technical debt there is associated with this old architecture.

Great startups are lead by strong technologists who ensure that technical debt is continuously addressed and retired via, e.g., trust releases.  Bad startups are feature addicts who pile feature upon feature atop a deteriorating architecture, creating an Augean Stables of technical debt. But even in good startups, routine debt-retirement doesn’t prevent the need for periodic re-architecture.  The best way to avoid an architectural mess of either type is to go to a newer startup, led by strong technologists, where the product is most probably built atop a modern architecture and where they definitionally cannot have accumulated a mass of technical debt [7].  

4. Clean cap table.  I once took a job at a company where a VC friend of mine said, “they have a good business, but a bad cap table.”  Since I didn’t entirely understand what he meant at the time, I took the job anyway — but, wow, do I wish I’d spent more time trying to understand the phrase “bad cap table.”

A capitalization table (aka “cap table”) is simply a list of investors, the type and amount of shares they hold, shares held by founders, shares allocated to the stock option pool, warrants held by suppliers and/or debtholders, and along with information about any debt the company has acquired.  So, strictly speaking, how could this table be inherently good or bad?   It just “is.”  Nope.  There are good cap tables and bad cap tables and here’s a partial list of things that can make a cap table bad in the eyes of a future investor.

  • Upstream investors who they don’t know and/or don’t want to work with.  That is, who holds the shares matters.
  • Ownership division that gives either the founders or employees too few shares.  Most VCs have the right to retain their percentage ownership going forward so if the company is already 60% owned by VC1 after the Series A and 20% owned by VC2 after the Series B, the new investor may believe that there simply isn’t enough to go around.  Strong VCs truly believe in founder and employee ownership and if there isn’t enough of it, they may walk from a deal.
  • ARR not commensurate with total funding.  Say a company has consumed $50M in capital but has only $5M in ARR to show for it.  Barring cases with exceptional product development entry barriers, that’s not a great ratio and most likely the result of a pivot, where the company started out on hypothesis A and then moved to hypothesis B.  From the new investor’s perspective, the company spent (and wasted) $30M on hypothesis A before switching to hypothesis B and thus has invested only $20M in its current business.  While some new investors might invest anyway, others would want some sort of recapitalization to reflect the business reality before investing.
  • Parasites, such as departed founders or incubators.  Founders A and B, aren’t going to be that excited over the long term for making money for founder C while she is off doing a new startup.  And why would a future VC want to make money for founder C, when she has already left the company [8]?  These are problems that need to be addressed from the viewpoint of a new investor.
  • Network effects among investors.  If VC1 owns 40% and VC2 owns 20% and VC2 works almost exclusively with VC1, then you can assume VC1 has control of the company.   This may not be a deal killer, but it may make a new investor wary.
  • Undesirable structure.  While VCs almost always buy preferred shares (as opposed to the common shares typically held by founders and employees), the specific preferences can vary.  New VC investors typically don’t like structure that gives preferred shares unusual preferences over the common because they worry it can demotivate employees and founders.  Such structure includes participating preferencesmultiple liquidation preferences, and redemption rights.

And that’s only a partial list.  At the CXO level, I think you have the right to ask about the cap table, but it’s much harder for job titles below that.  So I understand that you won’t always be able to access this information, but here’s what you can do:  (1) look at Crunchbase for financial history to try and identify some of these problems yourself, and (2) try to find a VC friend and get his/her opinion on the company.  VCs, particularly those at the bigger firms, are remarkably well informed and look at lots of deals, so they can usually give you an inkling about potential problems.

5. Strong market opportunity.  I’ve always done best when the need for the product was obvious.  Best example:  Business Objects in the 1990s — data warehouses were being built and it was obvious that there were no good tools to access them.  Business Objects eventually sold for nearly $7B.  Best counter-example:  MarkLogic in the 2000s — several years after Gartner wrote a note called XML DBMS:  The Market That Never Was.  That nearly twenty-year-old company is still not liquid, though through exceptional execution it has built a nice business despite strong headwinds; but there was nothing either obvious or easy about it.  In my other direct experience, the markets for Ingres (RDBMS), Salesforce.com, and Host Analytics (cloud EPM) were obvious.  The market for Versant (ODBMS) was not.

Another test you can apply to the market is the Market Attractiveness Matrix, which positions the type of buyer vs. the need for the product.  Selling SFA to sales, e.g., would be in the most attractive category while selling soft productivity improvement tools to HR would be in the least.

mam

Finally, I also like markets where the pricing is tied to something that inherently goes up each year (e.g., number of salespeople, size of stored documents, potentially usage) as opposed to things that don’t (e.g., number of HR or FP&A people, which increases — but in a more logarithmic fashion).

6. Strongest competitor in the market.  The problem with obvious market opportunities, of course, is that they attract multiple competitors.  Thus, if you are going to enter a competitive market you want to ensure the company you’re joining is the leader in either the overall market or a specific segment of it.  Given the increasing returns of market leadership, it is quite difficult to take away first place from a leader without they themselves faltering.  Given that hope is not a strategy [9], unless a runner-up has a credible and clear plan to be first in something [10], you should avoid working at runner-up vendors.  See the note below for thoughts on how this relates to Blue Ocean Strategy [11].

7.  Known problems that you know how to fix.  I’ve worked at epic companies (e.g., Business Objects, Salesforce) and I’ve worked at strugglers that nearly clipped the tree-tops on cash (e.g., Versant) and I can assure you that all companies have problems.  That’s not the question.  The questions are (1) do they get what really matters right (see previous criteria) and (2) are the things that they get wrong both relatively easy to fix and do you know how to fix them?

Any CXO- or VP-level executive has a set of strengths that they bring to their domain and the question is less “how good are you” than “does the company need what you bring?”  For example, you wouldn’t want a sales-and-marketing CEO — no matter how good — running a company that needs a product turnaround.  The key here is to realistically match what the company (or functional department) needs relative to what you can bring.  If you’re not a CXO- or VP-level executive, you can still apply the same test — does the company’s overall and functional leadership bring what the company needs for its next level of evolution?

8. Cultural compatibility.  Sometimes you will find a great organization that meets all these criteria but, for some reason, you feel that you don’t fit in.  If that happens, I’d not pursue the opportunity because you are likely to both be miserable on a daily basis and not succeed.  Culture runs deep in both people and in companies and when it’s a not a fit, it’s very hard to fake it.  My favorite, well-documented example of this was Dan Lyons at HubSpot, detailed in his book Disrupted.  HubSpot is a great company and I’m pretty sure Dan is a great guy, but wow there was a poor fit [12].  My advice here is to go with your gut and if something feels off even when everything else is on, you should listen to it.

I know it’s very hard to find companies that meet all of these criteria, but if and when you find one, I’d jump in with both feet.  In other cases, you may need to make trade-offs, but make sure you understand them so you can go in eyes wide open.

# # #

Notes

[1] A lack of desire to spend time with you during the recruiting process should be seen as a yellow/red flag — either about you as a candidate or their perceived importance of the position.

[2] In this context, “a long time” means 5-10 years.  The mean age of high-growth SaaS IPO companies in last year’s IPO class was 14 years.

[3] While “shareholder rotations” are possible (e.g., where firm B buys out firms A’s position) they are pretty rare and typically only happen in older companies (e.g., 10 years+).

[4] In my opinion, VC a few decades back looked more like, “let’s each back 5 companies with $20M and let the best operators win” whereas today it looks more like, “let’s capitalize early and heavily on the increasing-returns effects of market leadership and stuff (i.e., foie-gras) our startups with money, knowing that the market winners will likely be those who have raised the most cash.”  Note that while there is debate about whether this strategy yields the best returns (see foie gras link), there is less debate about whether this generates large companies in the market-leader pack.

[5] As one later stage investor told me:  “we prefer to work with syndicates with whom we’ve worked before” suggesting larger firms with more deals are preferable upstream and “if it ends up not working out, we’d much rather be in the deal with a highly respected firm like Sequoia, Accel, Lightspeed, or A16Z than a firm no one has ever heard of.”  Your upstream investors have a big impact on who is willing to invest downstream.

[6] Quip:  what do you call a twelve-year-old startup?  Answer:  a small business.  (Unless, of course, it’s high-growth and within striking distance of an IPO.)

[7] I would argue, generally, that newer startups tend to be built with newer business model assumptions as well.  So picking a newer company tends to ensure both modern architecture and contemporary thought on the business model.  For example, it’s hard to find a five-year-old enterprise software company built on an on-premises, perpetual license business model.

[8] Or, if an incubator makes itself a virtual cofounder in terms of common stock holdings in return for its incubation services.

[9] i.e., hoping the other company screws up.

[10] Either a segment or a segment that they believe will grow larger than today’s overall market.

[11] I feel obliged to mention that not all non-obvious market opportunities are bad.  As a big fan of Blue Ocean Strategy, I’d argue that the best market opportunities are semi-obvious — i.e., obvious enough that once you dig deeper and understand the story that they are attractive, but not so obvious that they attract a dozen ocean-reddening competitors.  Of recent enterprise software companies, I’d say Anaplan is the best example of Blue Ocean Strategy via its (emergent) strategy to take classic financial planning technology (hypercubes) and focus on sales planning in its early years.

[12] Note that I am not saying HubSpot is a perfect company and we can argue at great length (or more likely, quite briefly) about the strengths and weaknesses in typical Silicon Valley cultures.  And that’s all interesting academic debate about how things should be.  What I am saying is that when it comes to you, personally, for a job, why make yourself miserable by joining an organization where you know up-front that you don’t fit in?

Appearance on the Twenty Minute VC: Financing Thoughts, The Private Equity Sales Process, and More

Today famed venture capital podcaster and now venture capitalist at StrideVC, Harry Stebbings, released a new episode of the Twenty Minute VC podcast with me as his guest.  (iTunes version here.)

dk harry 500

Harry’s interview was broad-ranging, covering a number of topics including:

  • Financing lessons I’ve learned during prior bubble periods and, perhaps more importantly, bubble bursts.
  • The three basic types of exits available today:  strategic acquirer, old-school private equity (PE) squeeze play, and new-school PE growth and/or platform play.
  • A process view of exiting a company via a PE-led sales process, including discussion of the confidential information memorandum (CIM), indications of interest (IOIs), management meetings, overlaying strategic acquirers into the process, and the somewhat non-obvious final selection criteria.

The Soundcloud version, available via any browser is here.  The iTunes version is here.  Regardless of whether you are interested in the topics featured in this episode, I highly recommend Harry’s podcast and listen to it myself during my walking and/or driving time.

Oh, and if you like the content in this episode, don’t miss my first appearance on the show.

 

The Market Leader Play: How to Run It, How to Respond

Business-to-business (B2B) high technology markets are all about the market and only less so about the technology.  This is primarily driven by corporate buyer conservatism — corporate buyers hate to make mistakes in purchasing technology and, if you’re going to make one, it’s far better to be in the herd with everyone else, collectively fooled, than to be out on your own having picked a runner-up or obscure vendor because you thought they were “better.”  Hence, high-technology markets have strong increasing returns on market leadership.  I learned this live, in the trenches, way back in the day at Ingres.

Uh, Dave, please stop for a second.  Thank you.  Thanks so much for coming out to visit us here at BigCo today.  Before you begin your presentation, we wanted you to know that if you simply convince us that Ingres is as good as Oracle that we’re going to chose Oracle.  In fact, I think you’re going to need to convince us that Ingres is 30% to 40% better than Oracle before we’d realistically consider buying from your company.  You may now go ahead with your presentation.

Much as I hated it on that day, what a great position for Oracle to be in!  Somehow, before the product evaluation cage-fight had even begun, Oracle walked into the cage with a 40% advantage — brought to them by their corporate marketing department, and which was all about market leadership.

Why do corporate buyers care so much about buying from market leaders?

  • Less project risk.  If everyone else is buying X, it must be good enough, certainly, to get the job done.
  • Less embarrassment risk.  If the project does fail and you’re using the leading vendor, it’s much less embarrassing than if you’re on an obscure runner-up.  (“Well, I guess they fooled us all.”) [1]
  • Bigger technology ecosystem.  In theory, market leaders have the most connectors to other systems and the most pre-integrated complementary technologies.
  • Bigger skillset ecosystem.  Trying to find someone with 2+ years of experience with, e.g., Host Analytics or Adaptive Insights is way easier than trying to find someone with 2+ years of experience with Budgeta or Jedox.  More market share means more users means you can find more skilled employees and more skilled partners.
  • Potential to go faster.  Particularly for systems with low purchase and low switching costs, there’s a temptation to bypass an evaluation altogether and just get going.  Think:  “it’s the leader, it’s $35K/year, and it’s not that hard to change — heck, let’s just try it.”

Thus, relatively small differences in perceived or actual market leadership early on can generate a series of increasing returns through which the leading vendor wins more deals because it’s the leader, becomes relatively larger and thus an even more clear leader, then wins yet a higher percentage of deals, and so on.  Life for the leader is good, as the rich get richer.  For the others, life is a series of deals fighting from behind and, as they said in Glenngarry Glenn Ross, second prize really is a set of steak knives.

This is why smart vendors in greenfield markets fight for the market leadership position as if their corporate lives depended on it.  Sometimes, in this game of high-stakes, winner-takes-all poker companies cross boundaries to create a perception of success and leadership that isn’t there. [2]

When run correctly — and legally — the goal of the market leader play (MLP) is to create a halo effect around the company.  So how do you run the market leader play?  It comes down to four areas:

  • Fundraising.  Get the biggest name investors [3], raise the most capital, make the most noise about the capital you’ve raised, and use the money to make a few big-name hires, all in an effort to make it clear that Sand Hill Road has thoroughly evaluated the company and its technology and chosen you to be the leader.
  • Public relations and corporate awareness. Spend a nice chunk of that capital on public relations [4].  Have the CEO speak at the conferences and be quoted or by-line articles in the right tech blogs.  Better yet, hire a ghost-writer to author a book for the CEO as part of positioning him/her as a thought leader in the space.  If applicable, market your company’s culture (which is hopefully already documented in a one-hundred slide deck).  Spend big bucks to hold the biggest user conference in the space (which of course cannot be labeled as a user conferenced but instead an industry event with its own branding).  Use billboards to make sure the Digerati and other, lesser denizens of Silicon Valley know your company’s name.  Think:  shock and awe for any lesser competitor.
  • Growth.  Spend a ton of that capital to hire the biggest sales force, wisely first building out a world-class onboarding and enablement program, and then scaling as aggressively as you can.  In enterprise software new sales = number of reps * some-constant, so let’s make sure the number of reps is growing as fast, and perhaps a little faster, than it wisely should be.  Build out channels to increase the reach of your fast-growing sales force and don’t be cheap, during a market-share grab, about how you pay them.  In the end, Rule of 40 aside, hotness in Silicon Valley is really about one thing:  growth.  So get hot by buying the most customers most quickly. [5]
  • Strategic relationships.  Develop strategic relationships with other leading and/or cool companies on the theory that leaders work with leaders.  These relationships can vary from a simple co-marketing arrangement (e.g., Host Analytics and Floqast) to strategic investments (e.g., Salesforce Ventures invests in Alation) to white label re-sale deals (e.g., NetSuite’s resales of Adaptive Insights as NetSuite Planning), and many others.  But the key is to have the most and best strategic relationships in the category.
  • Denial of differentiation.  While you should always look forward [6] when it comes to external communications, when it comes to competitive analysis keep a keen eye looking backward at your smaller competitors.  When they see you running the market leader play, they will try various moves to differentiate themselves and you must immediately deny all such attempts at differentiation by immediately blocking them.  Back in the day, Oracle did this spectacularly well — Ingres would exhaust itself pumping out new/differentiated product (e.g., Ingres/Star) only to have Oracle immediately announce a blocking product either as a pure futures announcement (e.g., Oracle 8 object handling) or a current product launch with only the thinnest technical support (e.g., Oracle/Star).  Either way, the goal is for the mind of the buyer to think “well the leading vendor now does that (or shortly will), too.”  Denying differentiation gives the customer no compelling reason to buy from a non-leader and exhausts the runners-up in increasing futile and esoteric attempts at differentiation.

So that, in a nutshell, is how creating a leader is done.  But what if, in a five-vendor race, you’re not teed up to be the leader.  You haven’t raised the most capital.  You’re not the biggest or growing the fastest.  Then what are you supposed to do to combat this seemingly air-tight play?

Responding to the Market Leadership Play
I think there are three primary strategic responses to the market leadership play.

  • Out-do.  If you are in the position to simply out-do the flashy competitor, then do it.  Enter the VC arms raise — but like any arms race you must play to win. [7]  Raise more capital than they do, build your sales force faster, get even better strategic relationships and simply out-do them.  Think:  “yes, they were on a roll for a while but we are clearly the leader now.”  Cloudera did this to Hortonworks.
  • Two-horse race.  If you can’t win via out-do, but have a strong ability to keep up [8], then reframe the situation into a two-horse race.  Think:  “no, vendor X is not the leader, this market is clearly a two-horse race.”  While most B2B technology markets converge to one leader, sometimes they converge to two (e.g., Business Objects and Cognos).  Much as in a two-rider breakaway from the peloton, number 1 and 2 can actually work together to distance themselves from the rest.  It requires a certain cooperation (or acceptance) from both vendors to do this strategy, but if you’re chasing someone playing the leadership play you can exhaust their attempts to exhaust you by keeping up at every breakaway attempt.
  • Segment leadership.  If you can’t out-do and you can’t keep up (making the market a two-horse race) then have two options:  be a runner-up in the mainstream market or a be a leader in a segment of it.  If you stay a runner-up in the mainstream market you have the chance of being acquired if the leader rebuffs acquisition attempts.  However, more often than not, when it comes to strategic M&A leaders like to acquire leaders — so a runner-up-but-get-acquired strategy is likely to backfire as you watch the leader, after rebuffing a few takeover attempts, get acquired at a 10x+ multiple.  You might argue that the acquisition of the leader creates a hole in the market which you can then fill (as acquired companies certainly do often disappear within larger acquirers), but (unless you get lucky) that process is likely to take years to unfold.  The other choice is to do an audit of your customers, your product usage, and your skills and focus back on a product or vertical segment to build sustainable leadership there.  While this doesn’t preserve horizontal M&A optionality as well as being a runner-up, it does allow you to build sustained differentiation against the leader in your wheelhouse.

# # #

Notes

[1] Or, more tritely, “no one ever got fired for buying IBM” back in the day (communicated indirectly via ads like this), which might easily translate to “no one ever got fired for buying Oracle” today.

[2] Personally, I feel that companies that I’ve competed against such as MicroStrategy, FAST Search & Transfer, and Autonomy at various points in their history all pushed too hard in order to create an aura of success and leadership.  In all three cases, litigation followed and, in a few cases, C-level executives even went to jail.

[3] Who sometimes have in-house marketing departments to help you run the play.

[4] In accordance with my rule that behind every “marketing genius” is a big marketing budget.  You might argue, in fact, that allocating such a budget the first step of the genius.

[5] And build a strong customer success and professional services team to get those customers happy so they renew.  Ending ARR growth is not just about adding new sales to the bucket, it’s about keeping what’s in the bucket renewing.

[6] That is, never “look back” by mentioning the name of a smaller competitor — as with Lot’s Wife, you might well end up a pillar of salt.

[7] If you’re not committed to raising a $100M round after they raise a $75M round in response to your $50M round, then you shouldn’t be in an arms race.  Quoting The Verdict, “we’re not paid to do our best, we’re paid to win.”  So don’t a pick fight where you can’t.

[8] This could be signalled by responding to the archrival’s $50M round with a $50M round, as opposed to a $75M.