Who Drives the Startup Train?
May 1, 2016: Wednesday night I was grateful to be invited to Andrews Kurth in downtown Austin to be a mentor for the McCombs MBA “Venture Fellows.” There were six teams working from a very detailed case presentation provided by the AK lawyers. In my room we had three Fellows playing their assigned roles per the case script and duking out matters of ownership percentages, titles, founder stock vesting, an already messy cap table, and assorted IP landmines. It was a fairly typical story of a startup that more or less “happens” without much thought given to the legal foundation and longer term financing considerations.
Our three Fellows were good thespians and readily adopted their assigned personas. Since the campus carry law doesn’t take effect until August 1 at UT Austin, I presumed none of them were packing and that it was safe for them to be a bit belligerent in their discussion.
I’ve done this gig before and find it to be a great learning experience. It draws a solid collection of mentors, including active investors and entrepreneurs in the midst of dealing with real-life issues along the lines of the case at hand.
If you are hatching a startup and don’t want to be fodder for a future case study like this, may I offer my opinions on some of the topics raised:
1. Don’t scrimp on legal services from the outset. Most top law firms that work on angel or venture backed deals have easy plans to help startups get under way. They’ll generally take a fee haircut on ones they find promising in hopes they will have a reasonable hit rate of successes. Some very good long-term clients can be incubated that way, and any client with no previous startup experience will be more likely to avoid the pitfalls that make for juicy case studies later. If you’re the startup leader and not a lawyer by training, you’re better off doing what you do well and letting the lawyers keep your deal clean.
2. Address the personal issues early. I learned long ago that people get along great when the values are hypothetical, but when there are investor dollars at hand and things start getting real, they suddenly value themselves much more highly. It’s far better to arm wrestle at the outset over who gets what percentage of the founders’ shares and how or if those vest and who will hold which titles. The AK case had issues of fuzzy IP coming across from one of the founders, loans from another, and undocumented work-for-hire from the third. All those made for good discussion but made it impossible to create a simple division into thirds, for example. Everyone had some baggage at the table. However, there were only three of them, and they (or their characters) all appeared to be needed. I pointed out that a startup team looks more like a team when at least three players are included. They really had to find a way to get organized happily in a fair arrangement or risk falling below the critical mass needed to do anything of consequence. And, they obviously had to be unified among themselves before investors start messing with their roles and respective percentages or bringing in some of their own bench players to eat up the equity. The last thing investors want to do is cleanup work, and the last thing you as an entrepreneur should want is to have investors even see anything that obviously needs cleaning. It’s hard enough to get a deal done when everything is nicely buttoned up in advance, so never let your own sloppiness make it even more difficult.
3. The devil is in the vesting schedule. I learned from the mentor comments that it is in vogue now to stretch out vesting periods to 5 years because it takes that long for a startup to cross the chasm. And, a one-year cliff usually accompanies that, so that any early departs take zero equity with them. Investors are paying very close attention to handcuffing founders long enough to get the job done. However, an investor once offered me a vesting schedule for the founders’ equity I already owned, and I was insulted. In that instance we had already built a product and were in business, and I felt all of our team had earned what they then owned. That was not a deal breaker, fortunately, and that was the company we eventually sold to Rupert Murdoch’s News Corp. I advised the Fellows to have a cap table with some earned founders shares, fully vested but subject to a typical shareholders’ agreement with buy-back provisions, and then pile on some options with whatever vesting rules they agreed and to which their investors would also likely agree. It’s darn nice to tell your spouse that, even though your family is going to have to live on noodles for a few years, you have in hand a stock certificate that represents great wealth at the end. You don’t want to be appending: “but there’s a cliff.” On balance, however, I suppose your influence over vesting provisions is purely a function of how much bargaining power you have over investors looking at your deal.
4. Someone has to be the driver of the startup train. Even if three founders all bring important skills to the table, startups generally shouldn’t be run by consensus. One person has to stick out his or her neck, make the tough calls and be held accountable for the progress of the venture. That person has to maintain the team’s buy-in of the overall plan and keep them marching abreast toward whatever objectives have been set. There needs to be an “I” in team for this purpose. Investors, signature customers, and strategic partners want to know the buck stops somewhere. There will be unpopular decisions to be made. Over time people will have to be excused from the organization when it surpasses their temperaments or skill sets, and new strengths will have to be attracted to the company. Yes you may have team interviews and share your collective assessment of a potential colleague; that’s good. But, in the end, if you are the CEO, you are the only Super Delegate who gets to vote on many important matters.
I hope those tidbits will help you chug on down the line a bit faster.
<Strasburg Railroad, 2010, Klaus Nahr via Wikimedia Commons.>