MBA Mondays - Leanpub

MBA Mondays Fred Wilson

This is a Leanpub book which is for sale at http://leanpub.com. Leanpub helps you connect with readers and sell your ebook, while you’re writing it and after it’s done.

TABLE OF CONTENTS

Preface

1

ROI and Net Present Value

3

How to Calculate a Return on Investment

3

The Present Value of Future Cash Flows The Time Value of Money Compounding Interest

7 11

Corporate Entities Corporate Entities

Accounting

19

21

21

The Profit and Loss Statement The Balance Sheet Cash Flow

15

15

Piercing the Corporate Veil

Accounting

5

24

28

34

Analyzing Financial Statements

38

Business, Metrics and Pricing Key Business Metrics

43

43

Price: Why Lower Isn't Always Better

45

Projections, Budgeting and Forecasting Projections, Budgeting and Forecasting Scenarios

49

47

47

Budgeting in a Small Early Stage Company Budgeting in a Growing Company

55

Budgeting in a Large Company Forecasting

58

60

Risk and Return Risk and Return

63

63

Diversification Hedging

65

68

Currency Risk in a Business

70

Purchasing Power Parity

73

Business Costs

77

Opportunity Costs Sunk Costs

77

78

Off Balance Sheet Liabilities

Valuation

80

83

Enterprise Value and Market Value Bookings Vs. Revenues Vs. Collections

Commission Plans Commission Plans

What a CEO Does

95

91

91

What a CEO Does, Continued

Outsourcing

87

87

What a CEO Does

Outsourcing

52

95

92

83 85

Outsourcing Vs. Offshoring

97

Employee Equity

101

Employee Equity

101

Employee Equity: Dilution

103

Employee Equity: Appreciation Employee Equity: Options

106

107

Employee Equity: The Liquidation Overhang Employee Equity: The Option Strike Price Employee Equity: Restricted Stock and RSUs Employee Equity: Vesting

M&A Fundamentals

128

Buying and Selling Assets

117

122

Mergers and Acquisitions 127

114

119

Employee Equity: How Much?

Acquisition Finance

111

130

127

Preface 1

MBA Mondays is written by Fred Wilson , and licensed under the 2 Creative Commons Attribution 3.0 license. For details, see this post .

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http://www.avc.com/a_vc/about.html http://www.avc.com/a_vc/2011/02/mba-mondays-everywhere.html

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How to Calculate a Return on Investment 1

The Gotham Gal and I make a fair number of non-tech angel investments. Things like media, food products, restaurants, music, local real estate, local businesses. In these investments we are usually backing an entrepreneur we've gotten to know who delivers products to the market that we use and love. The Gotham Gal runs this part of our investment portfolio with some involvement by me. As I look over the business plans and projections that these entrepreneurs share with us, one thing I constantly see is a lack of sophistication in calculating the investor's return. Here's the typical presentation I see:

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The entrepreneur needs $400k to start the business, believes he/she can return to the investors $100k per year, and therefore will generate a 25% return on investment. That is correct if the business lasts forever and produces $100k for the investors year after year after year.

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http://www.gothamgal.com/ http://www.avc.com/.a/6a00d83451b2c969e20120a80a233a970b-pi

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But many businesses, probably most businesses, have a finite life. A restaurant may have a few good years but then lose its clientele and go out of business. A media product might do well for a decade but then lose its way and fold. And most businesses are unlikely to produce exactly $100k every year to the investors. Some businesses will grow the profits year after year. Others might see the profits decline as the business matures and heads out of business. So the proper way to calculate a return is using the "cash flow method". Here's how you do it. 1) Get a spreadsheet, excel will do, although increasingly I recommend 3 google docs spreadsheet because it's simpler to share with others. 2) Lay out along a single row a number of years. I would suggest ten years to start. 3) In the first year show the total investment required as a negative number (because the investors are sending their money to you). 4) In the first through tenth years, show the returns to the investors (after your share). This should be a positive number. 5) Then add those two rows together to get a "net cash flow" number. 6) Sum up the totals of all ten years to get total money in, total money back, and net profit. 7) Then calculate two numbers. The "multiple" is the total money back divided by the total money in. And then using the "IRR" function, calculate an annual return number. Here's what it should look like:

3

http://docs.google.com

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Here's a link to google docs where I've posted this example . It is public so everyone can play around with it and see how the formulas work. It's worth looking for a minute at the theoretical example. The investors put in $400k, get $100k back for four years in a row (which gets them their money back), but then the business declines and eventually goes out of business in its seventh year. The annual rate of return on the $400k turns out to be 14% and the total multiple is 1.3x. That's not a bad outcome for a personal investment in a local business you want to support. It sure beats the returns you'll get on a money market fund. But it is not a 25% return and should not be marketed as such. I hope this helps. You don't need to get a finance MBA to be able to do this kind of thing. It's actually not that hard once you do it a few times.

The Present Value of Future Cash Flows 1

My friend Pravin sent me an email last week after my "How To 2 Calculate A Return On Investment" post. He said:

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http://www.avc.com/.a/6a00d83451b2c969e20120a80a29da970b-pi http://spreadsheets.google.com/ccc?key=0AvqoGGDowi93dGZmZUp3RVFrZGpxRHZfazJwZWhmRlE&hl=en http://twitter.com/pravinsathe 2 http://www.avc.com/a_vc/2010/01/how-to-calculate-a-return-on-investment.html 5 1


6

I wish there was a class that I could take that would teach me how to properly research stocks/companies for investment purposes and how that could be made into a private tutoring business. It'd be for people like me, people who didn't go to school for business but still are interested in understanding all the jargon, methods of investing, etc and how to apply it to a buy and hold strategy. Pravin then went on to say that the post I wrote was exactly the kind of thing he was looking for and that he'd like to see me do more of it. So with that preface, I'd like to announce a new series here at AVC. I'm calling it "MBA Mondays". Every monday I'll write a post that is about a topic I learned in business school. I'll keep it dead simple (many people thought my ROI post last week was too simple). And I'll try to connect it to some real world experience.

I'll start with the topic Pravin wanted some help with: how to value stocks, what they are worth today, and what they could be worth in the future. This topic will take weeks of MBA Mondays to work through but we'll start with a fundamental concept, the present value of future cash flows. I was taught, and I believe with all my head and heart, that companies are worth the "present value" of "future cash flows". What that means is if you could know with certainty the exact amount of cash earnings that the company will produce from now until eternity, you could lay those cash flows out and then using some interest rate that reflects the time value of money, you could calculate what you'd pay today for those future cash flows. Let's make it really simple. You want to buy the apartment next to you for investment purposes. It rents for $1000/month. It costs $200/month to maintain. So it produces $800/month of "cash flow". Let's leave aside inflation, rent increases, cost increases, etc and assume for this post that it will always produce $800/month of cash flow.

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And let's say that you will accept a 10% annual return on your investment. There are a multitude of reasons why you'll accept different interest rates for different investments, but we'll just use 10% for this one. Once you know the cash flow ($800/month) and the interest rate (also called the "discount rate"), you can calculate present value. And this example is as easy as it gets because the cash flow doesn't change and the interest rate is 10%. The annual cash flow is $9,600 (12 x $800) and if you want to earn 10% on your money every year, you can pay $96,000 for the apartment. In order to check the math, let's calculate 10% of $96,000. That's $9,600 per year. In practice, it is never this simple. Cash flows will vary year after year. You'll have to lay them out in a spreadsheet and do a present value analysis. We'll do that next week. But it is the principle here that is important. Companies (and other investments) are worth the "present value" of all the cash you'll earn from them in the future. You can't just add up all that cash because a dollar tomorrow (or ten years from now) is worth less than a dollar you have in your pocket. So you need to "discount" the future cash flows by an acceptable rate of interest. That basic concept is the bedrock of all valuation concepts in finance. It can get incredibly complex, way beyond my ability to calculate or even explain. But you have to understand this concept before you can go further. I hope you do. Next week we'll look at using spreadsheets to calculate present values.

The Time Value of Money It's Monday, time for MBA Mondays.


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Last week, I posted about The Present Value Of 2 Future3 Cash 1 Flows and in the comments Pascal-Emmanuel Gobry wrote : That being said, before even covering NPV, I would have first talked about the time value of money. To me, time value of money is one of the top 3 concepts that blew my mind in business school and that should be common knowledge. When you think about it, all of finance, but also much of business, is underpinned by that. Once you understand time value of money, you understand opportunity costs, you understand sunk costs, you just view the world in a whole different light. PEG is right. We have to talk about the Time Value Of Money and it was a mistake to dive into concepts like Present Value and Discount Rates before doing that. So we'll hit the rewind button and go back to the start. Here it goes. Money today is generally worth more than money tomorrow. As another commenter to last week's post put it "you can't buy beer tonight with next year's earnings". Money in your pocket, cash in hand, is worth more than cash that you don't actually have in hand. If you think about it that simply, everyone can agree that they'd rather have the cash in hand than the promise of the same amount at some later day. And interest rates are used to calculate exactly how much more the money is worth today than tomorrow. Let's say that you'd take $900 today instead of $1000 exactly a year from now. That means you'd accept a 11.1% "discount rate" on that transaction. I calculated that as follows: 1) I calculated how much of a "discount" you would take in order to get the money today versus next year. That is $1000 less $900, or $100

1

http://www.avc.com/a_vc/2010/01/valuing-stocks-today-and-tomorrow.html http://twitter.com/pegobry http://www.avc.com/a_vc/2010/01/valuing-stocks-today-and-tomorrow.html#comment-32276641

2 3

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2) I then divided the discount by the amount you'd take today. That is $100/$900, which is 11.1%. This transaction could be modeled out the other way. Let's say you are willing to loan a friend $900 and you agree that he'll pay you an interest rate of 11.1%. You multiply $900 times 11.1%, you get $100 of total interest, and add that to the $900 and calculate that he'll pay you back $1000 a year from now. As you can tell from the way I talked about them, interest rates and discount rates are generally the same thing. There are technical differences, but both represent a rate of increase in the time value of money. So if the interest rate describes the time value of money, then the higher it is, the more valuable money is in your hands and the less valuable money is down the road. There are multiple reasons that money can be more valuable today than tomorrow. Let's talk about two of them. 1) Inflation - This is a complicated topic that we are not going to get into in detail here. But I need to at least mention it. When prices of things rise faster than they should, we call that inflation. It can be caused by a number of things, most often when the supply of money is rising faster than is sustainable. But the important thing to note is that if a house that costs $100,000 today is going to cost $120,000 next year, that represents 20% inflation and you'd want to earn 20% on your money every year to compensate you for that inflation. You'd want a 20% interest rate on your cash to be compensated for that inflation. 2) Risk - If your money is in a federally guaranteed bank deposit for a year, you might accept 2% interest on it. If it is invested in your friend's startup, you might want a double on your money in a year. Why the difference between a 2% interest rate and a 100% interest rate? Risk. You know you are getting the money in the bank back. You are pretty sure you aren't getting the money back that you invested in your friend's startup and want to get a lot back if it works out.


10

So let's deconstruct interest rates a bit to parse these different reasons out of them. Let's say the current rate of interest on a one year treasury bill (a note sold by the US Gov't that is federally guaranteed) is paying a rate of interest of 3%. That is an important rate to pay attention to. Because it is a one year interest rate on a risk free instrument (assuming that the US Gov't is solvent and always will be). We will assume for now that is true. So the "risk free rate" is 3%. That is the rate that the "market" says we should be accepting for a one year instrument with no risk. Now let's take inflation into account. If the Consumer Price Index (the CPI) says that costs are rising 2.5% year over year, then we can say that the one year inflation rate is 2.5%. It can get a lot more complicated than this, but many real estate leases use the CPI so we can use it too. If you subtract the inflation rate from the risk free rate, you get something called the "real interest rate". In our example, that would be 0.5% (3% minus 2.5%). And we call the 3% rate, the "nominal rate". Now let's take risk into account. Let's say you can find a corporate bond in the bond market that is coming due next year and will pay $1000 and it is trading for $900 right now. We know from the example that we started with that it is "paying" a discount rate of 11.1% for the next year. If we subtract the 3% risk free rate of interest from the 11.1%, we can determine that market is demanding a "risk premium" of 8.1% over the risk free rate for this bond. That means that not everyone thinks that this company is going to be able to pay back the bond in full, but most people do. Ok, so hopefully you'll see that interest rates and discount rates have components to them. In its simplest form, and interest rate is composed of the risk free rate plus an inflation premium plus a risk premium. In our examples, the risk free "real" interest rate is 0.5%, the inflation premium is 2.5%, and the risk premium on the corporate bond is 8.1%. Add all of those together, and you get the 11.1% rate that is the discount rate the corporate bond trades at in the markets.

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Which leads me to my final point. Markets set rates. Banks don't and governments don't. Banks and governments certainly impact rates and governments can do a lot to impact rates and they do all the time. But at the end of the day it is you and me and it is the traders, both speculators and hedgers, who determine how much of a discount we'll accept to get our money now and how much interest we'll want to wait another year. It is the sum total of all of these transactions that create the market and the market sets rates and they change every second and always will (at least in a capitalist system). That was tough to do in a blog post. It's a very simple concept but very powerful and as Pascal-Emmanuel said, it is fundamental to all of finance. I hope I explained it well. It's important to understand this one.

Compounding Interest It's time for MBA Mondays again. For the third week in a row, the topic of the post has been suggested by a reader. Last week, Elia Freedman wrote:

"A suggestion for your next post. The logical follow-on is to explain the second half of the TVM (time value of money), which is compounding interest." Before I address the issue of compounding interest, I'd like to recognize two things about the MBA Monday series. The first is that each post has a very rich comment thread attached to it. If you are seriously interested in learning this stuff, you would be well served to take the time to read the comments and the replies to them, including mine. The second is that the readers are building the curriculum for me. Each post has resulted in at least one suggestion for the next week's


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post. I dove into MBA Mondays without thinking through the logical progression of topics. At this point, I'm just going to run with whatever people suggest and try to assemble it on the fly. It's working well so far. So if you have a suggestion for next week's topic, or any topic, please leave a comment. Last week, I described interest as the rate of change in the time value of money. And we broke interest rates down into the real rate, the inflation factor, and the risk factor. And we calculated that if you invested $900 today at an 11.1% rate of interest, you'd end up with $1000 a year from now. But what happens if you wait a few years to get your money back and receive annual interest payments along the way? Let's say you invest the same $900, receive $100 each year for four years, and then in the last year, you receive $1000 (your $900 back plus the final year's $100 interest payment). There are two scenarios here and they depend on what you do with the annual interest payments. In the first scenario, you pocket the cash and do something else with it. In that scenario, you will realize the 11.1% rate of interest that you would have realized had you taken the $1000 one year later. It's basically the same deal, just with a longer time horizon. And your total proceeds on your $900 investment are $1400 (your $900 return of "principal" plus five $100 interest payments). In the second scenario, you reinvest the interest payments at 11.1% each year and take a final payment in year five. If you reinvest each interest payment at 11.1% interest, at the end of year five, you will receive $1524 as your final payment. Notice that the total proceeds in this scenario are $124 higher than in the other scenario. That is because you reinvested the interest payments instead of pocketing them.

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Both scenarios produce a "rate of return" of 11.1%. If you look at this 1 google spreadsheet , you can see how these two scenarios map out. And you can see the calculation of total profit and "internal rate of return". The fact that you make a larger profit on one versus the other at the same "rate of interest" shows the power of compounding interest. It really helps if you reinvest your interest payments instead of pocketing them. While $124 over five years doesn't seem like much, let's look at the power of compounding interest over a longer horizon. Let's say you inherit $100,000 around the time you graduate from college. Instead of spending it on something, you decide to invest it for your retirement 45 years later. If you invest it at the 11.1% rate of interest that we've been using, the differences between pocketing the $11,100 you'd get each year and reinvesting it are HUGE. If you pocket the $11,000 of interest each year, you will receive $599,500 on your $100,000 investment over 45 years. But if you reinvest the $11,000 of interest each year at 11.1% interest, you will receive $11.4 million dollars when you retire. That's right. $11.4 million dollars versus $599,500. That is the power of compounding interest over a long period of time. You can see how this models out in this google spreadsheet (sheets 2 two and three) . Now let's tie this issue to startups and venture capital. Venture capital investments are often held for a fairly long time. I am currently serving on several boards of companies that my prior firm, Flatiron Partners, invested in during 1999 and 2000. Our hold periods for these investments are into their second decade. Of course not every venture capital investment lasts a decade or more. But the average hold period for a venture capital investment tends to be about seven or eight years.

1

http://spreadsheets.google.com/ccc?key=0AvqoGGDowi93dDdFc0dCRGlBc0FFSV9zb3dYZllpSFE&hl=en http://spreadsheets.google.com/ccc?key=0AvqoGGDowi93dDdFc0dCRGlBc0FFSV9zb3dYZllpSFE&hl=en

2


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And during those seven to eight years, there are no annual interest payments. So when you calculate the rate of return on the investment, the spreadsheet looks like this. It's a compound interest situation. If you go back to the $100,000 over 45 years example, you'll see that a return of 114x your money over 45 years produces the same "return" as 6x your money with annual interest payments. The differences are not as great over seven or eight years but they are made greater by virtue of the fact that VCs seek to make 40-50% annual rates of return on their capital. If you read last week's post, you'll know that comes from the risk factor involved. The more risk an investment has, the higher rate of return an investor will require on their money in a successful outcome. If you want to generate a 50% rate of return compounded over eight years on $100,000, you will need to return $2.562 million, or 25.6x 3 your investment. See this google spreadsheet (sheet 4) for the details. The good news is that most venture capital investments are made over time, not all at once in the first year. So the "hold periods" on the later rounds are not as long and make this math a bit easier on everyone involved (maybe a topic for next week or some other time?). But as you can see, compounding interest over any length of time increases significantly the amount of money you need to return in order to pay the same rate of return as a security with annual interest payments. There are two big takeaways here. The first is if you are an investor, you should reinvest your interest payments instead of spending them. It makes a huge difference on the outcome of your investment. The second is if you are an entrepreneur, you should take as little money as you can at the start and always understand that your investors are seeking a return and that the time value of money compounds and makes your job as the producer of that return particularly hard.

3

http://spreadsheets.google.com/ccc?key=0AvqoGGDowi93dDdFc0dCRGlBc0FFSV9zb3dYZllpSFE&hl=en

Corporate Entities

Corporate Entities I'm taking a turn on MBA Mondays today. We are moving past the concepts of interest and time value of money and moving into the world of corporations. Today, I'd like to talk about what kinds of entities you might encounter in the world of business. First off, you don't have to incorporate to be in business. There are many people who run a business and don't 1incorporate. A good example of this are many of the sellers on Etsy . They make things, sell them, receive the income, and pay the taxes as part of their personal returns. But there are three big reasons you'll want to consider incorporating; liability, taxes, and investment. And the kind of corporate entity you create depends on where you want to come out on all three of those factors. I'd like to say at this point that I am not a lawyer or a tax advisor and that if you are planning on incorporating, I would recommend consulting both before making any decisions. I hope that we'll get both lawyers and tax advisors commenting on this post and adding to the discussion of these issues. I'll also say that this post is entirely based on US law and that it does not attempt to discuss international law. With that said, here goes. When you start a business, it is important to recognize that it will eventually be something entirely different than you. You won't own all of it. You won't want to be liable for everything that the company does. And you won't want to pay taxes on its profits. 1

http://www.etsy.com/

Corporate Entities

16

Creating a company is implicitly recognizing those things. It is putting a buffer between you and the business in some important ways. Let's talk first about liability. When you create a company, you can limit your liability for actions of the corporation. Those actions can be for things like bills (called accounts payable in accounting parlance), promises made (like services to be rendered), and lawsuits. This is an incredibly important concept and the reason that most lawyers advise their clients to incorporate as soon as possible. You don't want to put yourself and your family at personal risk for the activities you undertake in your business. It's not prudent or expected in our society. Taxes are the next thing most people think about when incorporating. There are two basic kinds of corporate entities for taxes; "flow through entities" and "tax paying entities." Here is the difference. Flow through corporate entities don't pay taxes, they pass the income (and tax paying obligation) through to the owners of the business. Tax paying entities pay the taxes at the corporate level and the owners have no obligation for the taxes owed. Your neighborhood restaurant is probably a "flow through entity." Google is a tax paying entity. When you buy 100 shares of Google, you are not going to get a tax bill for your share of their earnings at the end of the year. And then there is investment/ownership. Even before we talk about investment, there is the issue of business partners. Let's say you want to split the ownership of your business 50/50 with someone else. You have to incorporate to create the entity that you can co-own. And when you want to take investment, you'll need to have a corporate entity that can issue shares or membership interests in return for the capital that others invest in your business. So now that we've talked about the three major considerations, let's talk about the different kinds of entities you will come across. For many new startups, the form of corporate entity they choose is 2 called the LLC. It stands for Limited Liability Company . This form of business has been around for a long time in some countries but be2

http://en.wikipedia.org/wiki/Limited_liability_company

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Corporate Entities

came recognized and popular in the US sometime in the past 25 years. The key distinguishing characteristics of a LLC is that you get the limitation of liability of a corporation, you can take investment capital (with restrictions that we'll talk about next), but the taxes are "flow through". Most companies, including tech startups, start out as LLCs these days. Owners in LLC are most commonly called "members" and investments or ownership splits are structured in "membership interests." As the business grows and takes on more sophisticated investors (like venture funds), it will most often convert into something called a C 3 Corporation . Most of the companies you would buy stock in on the public markets (Google, Apple, GE, etc) are C Corporations. Most venture backed companies are C Corporations. C Corporations provide the limitation of liability, provide even more sophisticated ways to split ownership and raise capital, and most importantly are "tax paying entities." Once you convert from a LLC to a C corporation, you as the founder or owner no longer are responsible for paying the taxes on your share of the income. The company pays those taxes at the corporate level. There are many reasons why a venture fund or other "sophisticated investors" prefer to invest in a C corporation over a LLC. Most venture funds require conversion when they invest. The flow through of taxes in the LLC can cause venture funds and their investors all sorts of tax issues. This is particularly true of venture funds with foreign investors. And the governance and ownership structures of an LLC are not nearly as developed as a C corporation. This stuff can get really complicated quickly, but the important thing to know is that when your business is small and "closely held" a LLC works well. When it gets bigger and the ownership gets more complicated, you'll want to move to a C corporation. A nice4 hybrid between the C corporation and the LLC is the S corporation . It requires a simpler ownership structure, basically one class of stock and less than 100 shareholders. It is a "flow through entity" 3

http://en.wikipedia.org/wiki/C_corporation http://en.wikipedia.org/wiki/S_corporation

4

Corporate Entities

18

and is simple to set up. You cannot do as much with the ownership structure with an S corporation as you can with a LLC so if you plan to stay a flow through entity for a long period of time and raise significant capital, an LLC is probably better. 5

Another entity you might come across is the Limited Partnership . The funds our firm manages are Limited Partnerships. And some big companies, like Bloomberg LP, are limited partnerships. The key differences between a Limited Partnership and LLCs and C corporations are around liabilities. In the limited partnership, the investors have limited liability (like a LLC or C corporation) but the managers (called General Partners) do not. Limited Partnerships are set up to take in outside investment and split ownership. And they are flow through entities. There are many other forms of corporate ownership but these three are among the most common and show how the three big issues of liability, ownership, and taxes are handled differently in each. The important thing to remember about all of this is that if you are starting a business, you should create a corporate entity to manage the risk and protect you and your family from it. You should start with something simple and evolve it as the business needs grow and develop. As an investor, you should make sure you know what kind of corporation you are investing in, you should know what kind of liability you are exposing yourself to, and what the tax obligations will be as a result. And most of all, get a good lawyer and tax advisor. Though they are expensive, over time the best ones are worth their weight in gold.

5

http://en.wikipedia.org/wiki/Limited_partnership

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Corporate Entities

Piercing the Corporate Veil Yet another1 MBA Monday topic comes from the comments of last week's post . This series is turning into a conversation which makes me very pleased. 2

Mr Shawn Yeager said : As a recovering lawyer, and a serial entrepreneur, I constantly have associates, friends, and family coming to me for advice on formation issues (amongst other things). I think your high level overview leaves out something that always comes as a surprise to these people: the concept of "Piercing the Corporate Veil" of liability protection.

I said last week that forming a company is the best way to "putting a buffer between you and the business." But as Shawn and others point out in last week's comment thread, you can't just pretend to be a business, you have to be a business. "Being a business" means separating your personal and business records, separating your personal and business bank accounts, treating the business as a real entity, having board meetings, taking board minutes, doing major activities via board resolutions, following "due process." If you don't behave as a real business, you could find yourself in a situation where someone, most commonly someone who is suing your business, can come after you (and your business partners) personally. And then you are going to say "but what about the liability limitation the business provides?" It may not be there for you.

1

http://www.avc.com/a_vc/2010/02/corporate-entity.html http://www.avc.com/a_vc/2010/02/corporate-entity.html#comment-36092343

2

Corporate Entities

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That's called "piercing the corporate veil". And you should take that threat seriously. So once you create a company, treat it seriously, follow the rules, and do it right. Once again, if you have a good lawyer, he or she will lay this all out for you and even give you many of the tools to do this stuff right.

Accounting

Accounting I'm making up the curriculum for MBA Mondays on the fly. The end game is to lay out how to look a businesses, value it, and invest in it. We started with the time value of money and interest rates, we then talked about the corporate entity. Now I want to talk about how to keep track of the money in a company. That is called accounting. This will be a multi-post effort and will include posts on cash flow, profit and loss, balance sheets, GAAP accounting, audits, and financial statement analysis. But before we can get to those issues, we need to start with the basics of accounting. Accounting is keeping track of the money in a company. It's critical to keep good books and records for a business, no matter how small it is. I'm not going to lay out exactly how to do that, but I am going to discuss a few important principals. The first important principal is every financial transaction of a company needs to be recorded. This process has been made much easier with the advent of accounting software. For most startups, 1 Quickbooks will do in the beginning. As the company grows, the choice of accounting software will become more complicated, but by then you will have hired a financial team that can make those choices. The recording of financial transactions is not an art. It is a science and a well understood science. It revolves around the twin concepts of a "chart of accounts" and "double entry accounting." Let's start with the chart of accounts. The accounting books of a company start with a chart of accounts. There are two kinds of accounts; income/expense accounts and as1

http://quickbooks.intuit.com/

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set/liability accounts. The chart of accounts includes all of them. Income and expense accounts represent money coming into and out of a business. Asset and liability accounts represent money that is contained in the business or owed by the business. Advertising revenue that you receive from Google Adsense would be an income account. The salary expense of a developer you hire would be an expense account. Your cash in your bank account would be an asset account. The money you owe on your company credit card would be called "accounts payable" and would be a liability. When you initially set up your chart of accounts, the balance in each and every account is zero. As you start entering financial transactions in your accounting software, the balances of the accounts goes up or possibly down. The concept of double entry accounting is important to understand. Each financial transaction has two sides to it and you need both of them to record the transaction. Let's go back to that Adsense revenue example. You receive a check in the mail from Google. You deposit the check at the bank. The accounting double entry is you record an increase in the cash asset account on the balance sheet and a corresponding equal increase in the advertising revenue account. When you pay the credit card bill, you would record a decrease in the cash asset account on the balance sheet and a decrease in the "accounts payable" account on the balance sheet. These accounting entries can get very complicated with many accounts involved in a single recorded transaction, but no matter how complicated the entries get the two sides of the financial transaction always have to add up to the same amount. The entry must balance out. That is the science of accounting. Since the objective of MBA Mondays is not to turn you all into accountants, I'll stop there, but I hope everyone understands what a chart of accounts and an accounting entry is now. Once you have a chart of accounts and have recorded financial transactions in it, you can produce reports. These reports are simply

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the balances in various accounts or alternatively the changes in the balances over a period of time. The next three posts are going to be about the three most common reports;

• the profit and loss statement which is a report of the changes in the income and expense accounts over a certain period of time (month and year being the most common) • the balance sheet which is a report of the balances all all asset and liability accounts at a certain point in time • the cash flow statement which is report of the changes in all of the accounts (income/expense and asset/liability) in order to determine how much cash the business is producing or consuming over a certain period of time (month and year being the most common) If you have a company, you must have financial records for it. And they must be accurate and up to date. I do not recommend doing this yourself. I recommend hiring a part-time bookkeeper to maintain your financial records at the start. A good one will save you all sorts of headaches. As your company grows, eventually you will need a full time accounting person, then several, and at some point your finance organization could be quite large. There is always a temptation to skimp on this part of the business. It's not a core part of most businesses and is often not valued by tech entrepreneurs. But please don't skimp on this. Do it right and well. And hire good people to do the accounting work for your company. It will pay huge dividends in the long run.

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The Profit and Loss Statement Today on MBA Mondays we are going to talk about one of the most important things in business, the profit and loss statement (also known as the P&L). 1

Picking up from the accounting post last week, there are two kinds of accounting entries; those that describe money coming into and out of your business, and money that is contained in your business. The P&L deals with the first category. A profit and loss statement is a report of the changes in the income and expense accounts over a set period of time. The most common periods of time are months, quarters, and years, although you can produce a P&L report for any period. 2

Here is a profit and loss statement for the past four years for Google . 3 I got it from their annual report (10k). I know it is too small on this page to read, but if you click on the image, it will load much larger in a new tab.

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http://www.avc.com/a_vc/2010/03/accounting.html http://www.tracked.com/company/google/ http://sec.gov/Archives/edgar/data/1288776/000119312510030774/d10k.htm 4 http://www.avc.com/.a/6a00d83451b2c969e201310fa0e6cd970c-pi 2 3

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The top line of profit and loss statements is revenue (that's why you'll often hear revenue referred to as "the top line"). Revenue is the total amount of money you've earned coming into your business over a set period of time. It is NOT the total amount of cash coming into your business. Cash can come into your business for a variety of reasons, like financings, advance payments for services to be rendered in the future, payments of invoices sent months ago. There is a very important, but highly technical, concept called revenue recognition. Revenue recognition determines how much revenue you will put on your accounting statements in a specific time period. For a startup company, revenue recognition is not normally difficult. If you sell something, your revenue is the price at which you sold the item and it is recognized in the period in which the item was sold. If you sell advertising, revenue is the price at which you sold the advertising and it is recognized in the period in which the advertising actually ran on your media property. If you provide a subscription service, your revenue in any period will be the amount of the subscription that was provided in that period. This leads to another important concept called "accrual accounting." When many people start keeping books, they simply record cash received for services rendered as revenue. And they record the bills they pay as expenses. This is called "cash accounting" and is the way most of us keep our personal books and records. But a business is not supposed to keep books this way. It is supposed to use the concept of accrual accounting. Let's say you hire a contract developer to build your iPhone app. And your deal with him is you'll pay him $30,000 to deliver it to you. And let's say it takes him three months to build it. At the end of the three months you pay him the $30,000. In cash accounting, in month three you would record an expense of $30,000. But in accrual accounting, each month you'd record an expense of $10,000 and because you aren't actually paying the developer the cash yet, you charge the $10,000 each month to a balance sheet account called Accrued Expenses. Then when you pay the bill, you don't touch the P&L, its simply a balance

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sheet entry that reduces Cash and reduces Accrued Expenses by $30,000. The point of accrual accounting is to perfectly match the revenues and expenses to the time period in which they actually happen, not when the payments are made or received. With that in mind, let's look at the second part of the P&L, the expense section. In the Google P&L above, expenses are broken out into several categories; cost of revenues, R&D, sales and marketing, and general and administration. You'll note that in 2005, there was also a contribution to the Google Foundation, but that only happened once, in 2005. The presentation Google uses is quite common. One difference you will often see is the cost of revenues applied directly against the revenues and a calculation of a net amount of revenues minus cost of revenues, which is called gross margin. I prefer that gross margin be broken out as it is a really important number. Some businesses have very high costs of revenue and very low gross margins. And example would be a retailer, particularly a low price retailer. The gross margins of a discount retailer could be as low as 25%. Google's gross margin in 2009 was roughly $14.9bn (revenue of $23.7bn minus cost of revenues of $8.8bn). The way gross margin is most often shown is as a percent of revenues so in 2009 Google's gross margin was 63% (14.9bn divided by 23.7). I prefer to invest in high gross margin businesses because they have a lot of money left after making a sale to pay for the other costs of the business, thereby providing resources to grow the business without needing more financing. It is also much easier to get a high gross margin business profitable. The other reason to break out "cost of revenues" is that it will most likely increase with revenues whereas the other expenses may not. The non cost of revenues expenses are sometimes referred to as "overhead". They are the costs of operating the business even if you have no revenue. They are also sometimes referred to as the "fixed costs" of the business. But in a startup, they are hardly fixed. These expenses, in Google's categorization scheme, are R&D, sales and

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marketing, and general/admin. In layman's terms, they are the costs of making the product, the costs of selling the product, and the cost of running the business. The most interesting line in the P&L to me is the next one, "Income From Operations" also known as "Operating Income." Income From Operations is equal to revenue minus expenses. If "Income From Operations" is a positive number, then your base business is profitable. If it is a negative number, you are losing money. This is a critical number because if you are making money, you can grow your business without needing help from anyone else. Your business is sustainable. If you are not making money, you will need to finance your business in some way to keep it going. Your business is unsustainable on its own. The line items after "Income From Operations" are the additional expenses that aren't directly related to your core business. They include interest income (from your cash balances), interest expense (from any debt the business has), and taxes owed (federal, state, local, and possibly international). These expenses are important because they are real costs of the business. But I don't pay as much attention to them because interest income and expense can be changed by making changes to the balance sheet and taxes are generally only paid when a business is profitable. When you deduct the interest and taxes from Income From Operations, you get to the final number on the P&L, called Net Income. I started this post off by saying that the P&L is "one of the most important things in business." I am serious about that. Every business needs to look at its P&L regularly and I am a big fan of sharing the P&L with the entire company. It is a simple snapshot of the health of a business. I like to look at a "trended P&L" most of all. The Google P&L that I showed above is a "trended P&L" in that it shows the trends in revenues, expenses, and profits over five years. For startup companies, I prefer to look at a trended P&L of monthly statements, usually over a twelve month period. That presentation shows how revenues are

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increasing (hopefully) and how expenses are increasing (hopefully less than revenues). The trended monthly P&L is a great way to look at a business and see what is going on financially. I'll end this post with a nod to everyone who commented last week that numbers don't tell you everything about a business. That is very true. A P&L can only tell you so much about a business. It won't tell you if the product is good and getting better. It won't tell you how the morale of the company is. It won't tell you if the management team is executing well. And it won't tell you if the company has the right long term strategy. Actually it will tell you all of that but after it is too late to do anything about it. So as important as the P&L is, it is only one data point you can use in analyzing a business. It's a good place to start. But you have to get beyond the numbers if you really want to know what is going on.

The Balance Sheet Today on MBA Mondays we are going to talk about the Balance Sheet. The Balance Sheet shows how much capital you have built up in your business. 1

If you go back to my post on Accounting , you will recall that there are two kinds of accounts in a company's chart of accounts; revenue and expense accounts and asset and liability accounts. 2

Last week we talked about the Profit and Loss statement which is a report of the revenue and expense accounts. The Balance Sheet is a report of the asset and liability accounts. Assets are things you own in your business, like cash, capital equipment, and money that is owed to you for products and services you have de1

http://www.avc.com/a_vc/2010/03/accounting.html http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html

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livered to customers. Liabilities are obligations of the business, like bills you have yet to pay, money you have borrowed from a bank or investors. Here is Google's balance sheet as of 12/31/2009:

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3

Let's start from the top and work our way down. 3

http://www.avc.com/.a/6a00d83451b2c969e201310fc99f39970c-pi

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The top line, cash, is the single most important item on the balance sheet. Cash is the fuel of a business. If you run out of cash, you are in big trouble unless there is a "filling station" nearby that is willing to fund your business. Alan Shugart, founder of Seagate and a few other disk drive companies, famously said "cash is more important than your mother." That's how important cash is and you never want to get into a situation where you run out of it. The second line, short term investments, is basically additional cash. Most startups won't have this line item on their balance sheet. But when you are Google and are sitting on $24bn of cash and short term investments, it makes sense to invest some of your cash in "short term instruments". Hopefully for Google and its shareholders, these investments are safe, liquid, and are at very minimal risk of loss. The next line is "accounts receivable". Google calls it "net receivables' because they are netting out money some of their partners owe them. I don't really know why they are doing it that way. But for most companies, this line item is called Accounts Receivable and it is the total amount of money owed to the business for products and services that have been delivered but have not been collected. It's the money your customers owe your business. If this number gets really big relative to revenues (for example if it represents more than three months of revenues) then you know something is wrong with the business. We'll talk more about that in an upcoming post about financial statement analysis. I'm only going to cover the big line items in this balance sheet. So the next line item to look at is called Total Current Assets. That's the amount of assets that you can turn into cash fairly quickly. It is often considered a measure of the "liquidity of the business." The next set of assets are "long term assets" that cannot be turned into cash easily. I'll mention three of them. Long Term Investments are probably Google's minority investments in venture stage companies and other such things. The most important long term asset is "Property Plant and Equipment" which is the cost of your capital equipment. For the companies we typically invest in, this number is not large

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unless they rack their own servers. Google of course does just that and has spent $4.8bn to date (net of depreciation) on its "factory". Depreciation is the annual cost of writing down the value of your property plant and equipment. It appears as a line in the profit and loss statement. The final long term asset I'll mention is Goodwill. This is a hard one to explain. But I'll try. When you purchase a business, like YouTube, for more than it's "book value" you must record the difference as Goodwill. Google has paid up for a bunch of businesses, like YouTube and Doubleclick, and it's Goodwill is a large number, currently $4.9bn. If you think that the value of any of the businesses you have acquired has gone down, you can write off some or all of that Goodwill. That will create a large one time expense on your profit and loss statement. After cash, I believe the liability section of the balance sheet is the most important section. It shows the businesses' debts. And the other thing that can put you out of business aside from running out of cash is inability to pay your debts. That is called bankruptcy. Of course, running out of cash is one reason you may not be able to pay your debts. But many companies go bankrupt with huge amounts of cash on their books. So it is critical to understand a company's debts. The main current liabilities are accounts payable and accrued expenses. Since we don't see any accrued expenses on Google's balance sheet I assume they are lumping the two together under accounts payable. They are closely related. Both represent expenses of the business that have yet to be paid. The difference is that accounts payable are for bills the company receives from other businesses. And accrued expenses are accounting entries a company makes in anticipation of being billed. A good example of an accounts payable is a legal bill you have not paid. A good example of an accrued expense is employee benefits that you have not yet been billed for that you accrue for each month. If you compare Current Liabilities to Current Assets, you'll get a sense of how tight a company is operating. Google's current assets are $29bn and its current liabilities are $2.7bn. It's good to be Google, they are

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not sweating it. Many of our portfolio companies operate with these numbers close to equal. They are sweating it. Non current liabilities are mostly long term debt of the business. The amount of debt is interesting for sure. If it is very large compared to the total assets of the business its a reason to be concerned. But its even more important to dig into the term of the long term debt and find out when it is coming due and other important factors. You won't find that on the balance sheet. You'll need to get the footnotes of the financial statements to do that. Again, we'll talk more about that in a future post on financial statement analysis. The next section of the balance sheet is called Stockholders Equity. This includes two categories of "equity". The first is the amount that equity investors, from VCs to public shareholders, have invested in the business. The second is the amount of earnings that have been retained in the business over the years. I'm not entirely sure how Google breaks out the two on it's balance sheet so we'll just talk about the total for now. Google's total stockholders equity is $36bn. That is also called the "book value" of the business. The cool thing about a balance sheet is it has to balance out. Total Assets must equal Total Liabilities plus Stockholders Equity. In Google's case, total assets are $40.5bn. Total Liabilities are $4.5bn. If you subtract the liabilities from the assets, you get $36bn, which is the amount of stockholders equity. We'll talk about cash flow statements next week and the fact that a balance sheet has to balance can be very helpful in analyzing and projecting out the cash flow of a business. In summary, the Balance Sheet shows the value of all the capital that a business has built up over the years. The most important numbers in it are cash and liabilities. Always pay attention to those numbers. I almost never look at a profit and loss statement without also looking at a balance sheet. They really should be considered together as they are two sides of the same coin.

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Cash Flow 1

This week on MBA Mondays we are going2to talk about cash flow. A few weeks ago, in my post on Accounting , I said there were three major3 accounting statements. We’ve talked about the Income State4 ment and the Balance Sheet . The third is the Cash Flow Statement. I’ve never been that interested in the Cash Flow Statement per se. The standard form of a cash flow statement is a bit hard to comprehend in my opinion and I don’t think it does a very good job of describing the various aspects of cash flow in a business. That said, let’s start with the concept of cash flow and we’ll come back to the accounting treatment. Cash flow is the amount of cash your business either produces or consumes in a given period, typically a month, quarter, or year. You might think that is the same as the profit of the business, but that is not correct for a bunch of reasons. The profit of a business is the difference between revenues and expenses. If revenues are greater than expenses, your business is producing a profit. If expenses are greater than revenues, your business is producing a loss. But there are many examples of profitable businesses that consume cash. And there are also examples of unprofitable businesses that produce cash, at least for a period of time. Here’s why. 5

As I explained in the Income Statement post , revenues are recognized as they are earned, not necessarily when they are collected. And ex1

http://www.avc.com/a_vc/mba-mondays/ http://www.avc.com/a_vc/2010/03/accounting.html http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html 4 http://www.avc.com/a_vc/2010/03/the-balance-sheet.html 5 http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html 2 3

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penses are recognized as they are incurred, not necessarily when they are paid for. Also, some things you might think of as expenses of a business, like buying servers, are actually posted to the Balance Sheet as property of the business and then depreciated (ie expensed) over time. So if you have a business with significant hardware requirements, like a hosting business for example, you might be generating a profit on paper but the cash outlays you are making to buy servers may mean your business is cash flow negative. Another example in the opposite direction would be a software as a service business where your company gets paid a year in advance for your software subscription revenues. You collect the revenue upfront but recognize it over the course of the year. So in the month you collect the revenue from a big customer, you might be cash flow positive, but your Income Statement would show the business operating at a loss. Cash flow is really easy to calculate. It’s the difference between your cash balance at the start of whatever period you are measuring and the end of that period. Let’s say you start the year with $1mm in cash and end the year with $2mm in cash. Your cash flow for the year is positive by $1mm. If you start the year with $1mm in cash and end the year with no cash, your cash flow for the year is negative by $1mm. But as you might imagine the accounting version of the cash flow statement is not that simple. Instead of getting into the standard form, which as I said I don’t really like, let’s talk about a simpler form that gets you to mostly the same place. Let’s say you want to do a cash flow statement for the past year. You start with your Net Income number from your Income Statement for the year. Let’s say that number is $1mm of positive net income. Then you look at your Balance Sheet from the prior year and the current year. Look at the Current Assets (less cash) at the start of the year and the Current Assets (less cash) at the end of the year. If they have gone up, let’s say by $500,000, then you subtract that number

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from your Net Income. The reason you subtract the number is your business used some of your cash to increase its current assets. One typical reason for that is your Accounts Receivable went up because your customers are taking longer to pay you. Then look at your Non-Current Assets at the start of the year and the end of the year. If they have gone up, let’s say by $500k, then you also subtract that number from your Net Income. The reason is your business used some of your cash to increase its Non-Current Assets, most likely Property, Plant, and Equipment (like servers). At this point, halfway through this simplified cash flow statement, your business that had a Net Income of $1mm produced no cash because $500k of it went to current assets and $500k of it went to noncurrent assets. Liabilities work the other way. If they go up, you add the number to Net Income. Let’s start with Current Liabilities such as Accounts Payable (money you owe your suppliers, etc). If that number goes up by $250k over the course of the year, you are effectively using your suppliers to finance your business. Another reason current liabilities could go up is Deferred Revenue went up. That would mean you are effectively using your customers to finance your business (like that software as a service example earlier on in this post). Then look at Long Term Liabilities. Let’s say they went up by $500k because you borrowed $500k from the bank to purchase the servers that caused your Non-Current Assets to go up by $500k. So add that $500k to Net Income as well. Now, the simplified cash flow statement is showing $750k of positive cash flow. But we have one more section of the Balance Sheet to deal with, Stockholders Equity. For Stockholders Equity, you need to back out the current year’s net income because we started with that. Once you do that, the main reason Stockholders Equity would go up would be an equity raise. Let’s say you raised $1mm of venture capital during the year and so Stockholder’s Equity went up by $1mm. You’d add that $1mm to Net Income as well.

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So, that’s basically it. You start with $1mm of Net Income, subtract $500k of increased current assets, subtract $500k of increased noncurrent assets, add $250k of increased current liabilities, add $500k of increased long-term liabilities, and add $1mm of increased stockholders equity, and you get positive cash flow of $1.75mm. Of course, you’ll want to check this against the cash balance at the start of the year and the end of the year to make sure that in fact cash did go up by $1.75mm. If it didn’t, then you have to go back and check your math. So why would anyone want to do the cash flow statement the long way if you can simply compare cash at the start of the year and the end of the year? The answer is that doing a full-blown cash flow statement tells you a lot about where you are consuming or producing cash. And you can use that information to do something about it. Let’s say that your cash flow is weak because your accounts receivable are way too high. You can hire a dedicated collections person. You can start cutting off customers who are paying you too late. Or you can do a combination of both. Bringing down accounts receivable is a great way to improve a business’ cash flow. Let’s say you are spending a boatload on hardware to ramp up your web service’s capacity. And it is bringing your cash flow down. If you are profitable or have good financial backers, you can go to a bank and borrow against those servers. You can match non-current assets to long-term liabilities so that together they don’t impact the cash flow of your business. Let’s say your current liabilities went down over the past year by $500k. That’s a $500k reduction in your cash flow. Maybe you are paying your bills much more quickly than you did when you started the business and had no cash. You might instruct your accounting team to slow down bill payment a bit and bring it back in line with prior practices. That could help produce better cash flow. These are but a few examples of the kinds of things you can learn by doing a cash flow statement. It’s simply not enough to look at the In-

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come Statement and the Balance Sheet. You need to understand the third piece of the puzzle to see the business in its entirety. One last point and I am done with this week’s post. When you are doing projections for future years, I encourage management teams to project the income statement first, then the cash flow statement, and then end up with the balance sheet. You can make assumptions about how the line items in the Income Statement will cause the various Balance Sheet items to change (like Accounts Receivable should be equal to the past three months of revenue) and then lay all that out as a cash flow statement and then take the changes in the various items in the cash flow statement to build the Balance Sheet. I like to do that in monthly form. We’ll talk more about projections next week because I think this is a very important subject for startups and entrepreneurial management teams to wrap their heads around.

Analyzing Financial Statements This topic could be and is a full semester course at some business schools. It is a deep and rich topic that I can’t cover in one single blog post. But it is also a relatively narrow skill set at its most developed levels. If you are going to be a public equity analyst, you need to understand this stuff cold and this post will not get you there. But if you are an entrepreneur being handed financial statements from your bookkeeper or accountant or controller, then you need to be able to understand them and I’d like this post to help you do that. I’d also like this post help those of you who want to be more confident buying, holding, and selling public stocks. So that’s the perspective I will bring to this topic. In the past three weeks, we talked about the three main financial 1 2 statements, the Income Statement , the Balance Sheet , and the Cash 1

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Flow Statement . This post is going to attempt to help you figure out how to analyze them, at least at a cursory level. In general, I like to start with cash. It’s the first line item on the Balance Sheet (it could be the first several lines if you want to combine it with short term investments). Note how much cash you have or how much cash the company you are analyzing has. Remember that number. If someone asks you how much cash you have in your business, or a business you are analyzing, and you can’t answer that to the last accounting period (at least), then you failed. There is no middle ground. Cash is that important. Then look at how much cash the business had in a prior period. Last month is a good place to start but don’t end there. Look at how much cash went up or down in the past month. Then look much farther back, at least a quarter, and ideally six months and/or a year. Calculate how much cash went up or down over the period and then divide by the number of months in the period. That’s the average cash flow (or cash burn) per month. Remember that number. But that number can be misleading, particularly if you did any debt or equity financings during that period (or if you paid off any debt facilities during that period). Back out the debt and equity financings and do the same calculations of average cash flow per month. Hopefully the monthly number, the quarterly average, the six-month average, and the annual average are in the same ballpark. If they are not, something is changing in the business, either for the good or the bad and you need to dig deeper to find out what. We’ll get to that. If cash flow is positive for all periods, then you are done with cash. If it is negative, do one more thing. Divide your cash balance by the average monthly burn rate and figure out how many months of cash you have left. If you are burning cash, you need to know this number by heart as well. It is the length of your runway. For all you entrepreneurs out there, the three cash related numbers you need to be on top of are current cash balance, cash burn rate, and months of runway.

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I generally like to go to the income statement next. And I like to lay out a few periods next to each other, ideally chronologically from oldest on the left to the newest on the right. For startups and early stage companies, a 12 month trended monthly presentation of the income statement is ideal. For more mature companies, including public companies, the current quarter and the four previous quarters are best. Some people like to graph the key line items in the income statement (revenue, gross margin, operating costs, operating income) over time. That’s good if you are a visual person. I find looking at the hard numbers works better for me. Note how things are moving in the business. In a perfect world, revenues and gross margins are growing faster than operating costs, and operating income (or losses) are increasing (or decreasing) faster than both of them. That is a demonstration of the operating leverage in the business. But some early stage companies either have no revenue or are investing in the business faster than they are growing revenue. That is a sound strategy if the investments they are making are solid ones and if they have a timeline laid out during which they’ll do this. You can’t do that forever. You’ll run out of cash and go out of business. From this analysis, you may see why the business is burning cash or burning cash more quickly or less quickly. You may see why the business is growing its cash flow rapidly. I am most comfortable when the monthly operating income (or losses) of a business are roughly equal to its cash flow (or cash burn). This does not have to be the case for the business to be healthy but it means the business has a relatively simple economic architecture, which is always comforting. From Enron to Lehman Brothers, we’ve learned that complex business architectures are hard to analyze and easy to manipulate. One thing that bears mentioning here are “one time items” on the Income Statement. They4make your life harder. If you go back to the Income Statement post and look at Google’s statement, you’ll see that in the first year of their presentation Google made a one-time contribution to the Google Foundation. That depressed earnings in that 4

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period. You need to back that one time charge out for a consistent presentation, but you also need to be somewhat suspicious of onetime charges. Companies can try to bury ongoing expenses in onetime charges and inflate their earnings. You don’t see that much in startups but you do in public companies and it’s a “red flag” if a company does it too often. If the monthly operating income (after backing out one-time charges) doesn’t come close to the monthly cash burn rates, then something is going on with the balance sheet of the business. Many of these differences are normal for certain businesses. My friend Ron Schreiber told me about a software distribution business he and his partner Jordan Levy ran in the mid 80s. They would buy software from Microsoft, Lotus, and others in bulk and sell it in small quantities to mom and pop businesses. Microsoft and Lotus wanted to be paid upfront when the shipped the software but the mom and pop businesses were running on fumes and could not pay until they sold the software. So Ron’s business, called Software Distribution Services (of course), was always out of cash. In Ron’s words, they were a bank and a distribution company and weren’t getting paid for the banking part of their business. All during this time the revenue line and the operating income line was growing fast and furious as desktop software went from a niche business to a mainstream business. Eventually Ron and Jordan had to sell their business to Ingram, a large book distributor who had the financial resources to provide the “banking services”. They made a nice hit on that company, but not anything like what Microsoft and Lotus did even though they grew their topline just as fast as their suppliers. Ron and Jordan’s business was “working capital intensive.” Working capital is the non cash current assets and liabilities of the business. When they grow rapidly in relation to revenues, it means you are financing other parts of the food chain in your industry and that’s a great way to run out of cash. So if monthly income and monthly cash flow aren’t in the same ballpark, look at the changes in working capital month over month. We went over this a bit last week in preparing the cash flow statement.

Accounting

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If working capital is the culprit soaking up the cash, you need to look at two things. The first is if the revenues are real. A great way to inflate revenues is to “ship product” to people who aren’t going to pay you. A company that is doing that is operating fraudently so you don’t see it very often. But if someone is doing this, cash will be going down while profits are steady and accounts receivable are growing rapidly. I always look for that in a company that is supposed to be profitable but is sucking cash. The second is the availability of working capital financing. If a business can finance its working capital needs inexpensively, then it can operate successfully with this business model. In times when debt is flowing freely, these can be good businesses to operate. When cash is tight, they are not. The final thing to look for on the balance sheet is capex. If a business is operating profitably, and growing profits, but its capex line is growing faster than profits, it’s got the potential for problems. Hosting companies are an example of a set of companies that might be in this situation. Again, the availability of financing is the key. Local cable operators operated profitably for years with big negative cash flows because of capex. The fiancial markets like the monopolies these busineses were granted and consistently provided them with financing to buy more capex. But if that party ends, it can be painful. This post is three pages long in my editor so it’s time to stop. There is more to discuss on this topic so I’d like to know if I did this topic justice for most of you or if you’d like another post that digs a little deeper. My preference is to move on because I’m getting a bit tired of writing about accounting every Monday, but most of all I want to cover the stuff you want to learn or freshen up on. So let me know.

Business, Metrics and Pricing

Key Business Metrics The past five MBA Mondays posts have been about accounting concepts, financial statements, and related issues. I don't know about all of you, but I'm a bit tired of that stuff. So I'm moving on to something a bit different.

Every business should have a set of metrics that it tracks on a regular basis. These metrics could include some of the accounting stuff we've been talking about like cash, revenues, profits, etc but it should not be limited to those kinds of metrics. Early on when the company is developing its first product or service, those metrics might be related to product development like development resources, features completed, known bugs, etc. Once the product or service is launched, the metrics might shift to include customers, daily active users, churn, conversions from free trial to paid customer, etc. As the business grows and develops, the amount of data you can collect and publish to your team grows. If you aren't careful, you can overwhelm your team with data. It becomes very important to distill the business down to a handful of key business metrics. There are usually four to six metrics that will be sufficient to determine the overall health and growth trajectory of the business and it is best to focus the team on them.


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1

Our portfolio company Meetup has learned to focus on successful Meetup groups. Those are Meetup groups that are active, meeting regularly, have growing memberships, and are paying fees to Meetup. Meetup could focus on other data sets like monthly unique visitors, new Meetup groups, total registered users, revenues, profits, cash. They collect that data and share it with the team. But the number one thing they look at it successful Meetup groups and that has worked well for them. It is their key business metric. Sometimes the most important data on your business is the hardest 2 to collect. Twitter knows that the total number of times all tweets have been viewed each day, month, or year is a critical measure of the overall reach of the network. But because so many of those tweets are viewed on third party services, web pages, apps, etc, it is very hard to collect that data. The Company is only now starting to measure them. Most key business metrics will be drivers of revenues and growth 3 but not all of them. Etsy is focusing a lot of effort on its customer service metrics, which are a cost center not a revenue driver. But the Company knows that customer service is critical to the health of the marketplace, so customer service metrics are key business metrics for them. The management team should spend time talking about and selecting the key business metrics to focus on. They should collect the data on a regular basis, the more real-time the better in my opinion, and they should publish the key business metrics to the entire team. I do not believe it makes any sense to segment who gets to see what business metrics in a company. Sales metrics should be shared with development. Customer service metrics should be shared with finance. And so on and so forth. Some companies buy big screens and mount them on the walls around the office and publish the key business metrics on them so everyone can see them. I like that approach. But I also like sending out a regular 1

http://www.meetup.com/ http://twitter.com/ http://www.etsy.com

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email to the entire company with the key business metrics and how they are trending. And of course, I think these metrics should be shared with the Board and key investors. When you publish financial projections (a topic for the coming weeks), you should include your projections or assumptions for key business metrics in the periods for which you are projection financial performance. Many of these metrics will be drivers of your projections but they are also helpful to establish the overall progress of the business over time. It is a good idea to evaluate what your company's key business metrics should be from time to time. I like to suggest at least once a year, probably around the annual budgeting exercise (another topic for the coming week). It is expected that you will change some of these metrics every year as the business grows and develops. Don't just keep adding new ones, you should also subtract old ones that don't seem as useful anymore. Keep the total number of key business metrics you are tracking to a small enough number that most people on the team could recite them from memory. Less is more when it comes to key business metrics. Tracking key business metrics is important for a bunch of reasons, but probably the most important reason is cultural. It helps to keep everyone on the same page, aligns people across the different parts of the business, and leads to a culture of success when you see the key business metrics moving in the right direction. It's critical to celebrate when a key business metrics reaches a new and important milestone. These kinds of things seem silly to some but are incredibly important to building a strong company culture that can work together and grow rapidly.

Price: Why Lower Isn't Always Better I want to tackle the issue of forecasting and projections next in the MBA Mondays series but I don't yet have an outline in my head of


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how I am going to approach this critical subject. So I am taking a breather this week and instead will tell a story I heard from a marketing professor in business school. This professor did a lot of consulting on the side. He was known as a highly analytic marketing expert. He was asked to take on a french producer of champagne as a client. This champagne producer was trying to enter the US market but was not selling very much of their product in the US. The professor did an analysis of the "five Ps"; product, price, people, promotion, and place. He determined that the champagne was of very high quality, it was being distributed in the right places, and that the marketing investment behind it was substantial. And yet it wasn't selling very well. He did an analysis of comparable quality champagnes and determined that this particular producer was pricing his product at the very low end of the range of comparable product. So the professor's recommendation was to increase the wholesale price such that the retail price would double. The client was very nervous about the professor's recommendation but in the end did it. And the champagne started selling like crazy. They couldn't keep it in stock. The morale of this story is that price is often used as a proxy for quality by customers, particularly when the product is a luxury item. By pricing the champagne at the very low end of the range of comparable product, the producer was signaling that its product was of lower quality than the competition. And by raising the price, they signaled it was of higher quality. So when you are selling something, be it advertising, software, or something else, think carefully about how you are signaling the market with your pricing. Having the lowest price among your competition might be the right strategy but it might also be the wrong one.

Projections, Budgeting and Forecasting

Projections, Budgeting and Forecasting MBA Mondays is starting a new topic this week. It's a big one and I think we'll end up doing at least four and maybe even five posts on this topic in the coming weeks. 1

I said the following in one of my first MBA Mondays posts : companies are worth the "present value" of "future cash flows" The point being that the past doesn't matter too much when it comes to valuing companies. It's all about what is going to happen in the future. And that requires projecting the future. There is another big reason why projections matter. They are used for goal and expectation setting. Generally speaking goal setting is used to manage the team and expectation setting is used to manage the board, investors, and other important stakeholders. And finally, projections matter because they tell you what your financing needs are. It is critical to know when you will need additional financing so you can start planning and executing the process well in advance of running out of cash (I like 6 months). There are three important kinds of projections. I'll outline each of them.

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http://www.avc.com/a_vc/2010/01/valuing-stocks-today-and-tomorrow.html


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1) Projections - These are a set of numbers, both financial and operational, that you make about your business for various purposes, including raising capital. They are aspirational and are often done with a "what could be" perspective. 2) Budgets - These are a set of numbers, both financial and operational, that the management team prepares each year, usually in the fall, that outline what the company plans to achieve in the coming year. They are presented and approved by the board and the management team's compensation is often driven by them. 3) Forecasts - These are iterations of the budget that are done intrayear by the management team to indicate what is likely to occur. They reflect the fact that the actual performance is going to vary from budget (in both positive and negative ways) and it is important to know where the numbers will actually end up. Over the coming weeks, I will go through the processes companies use to project, budget, and forecast. Because I do not do this work myself, I've enlisted one of our portfolio companies to help me with these posts. 2

I've been working with Return Path for ten years now. Matt Blum3 4 berg , CEO, and Jack Sinclair , CFO and sometimes COO, have done over ten sets of projections, budgets, and forecasts for me and other investors, board members, and team members. In the process they have evolved from a raw startup to a well oiled machine. With their help, I will talk about the how three "model companies" go about projecting, budgeting, and forecasting. These companies will be 10 person, 75 person, and 150 person. These are the typical sizes of companies that I work with and are probably also the sizes of companies that most of the readers of this blog are dealing with. I'll end this post with a picture that Matt sent me last week. This is ten years worth of board books that include Return Path's projections, budgets, and forecasts. The goal of MBA Mondays in the coming 2

http://www.returnpath.net/ http://twitter.com/mattblumberg http://twitter.com/JSinclair

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weeks will be to get all of you to a place where you can create something similar.

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Scenarios 1

In last week's MBA Mondays , I introduced the topic that we'll be focused on for the next month or so; projections, budgeting, and forecasting. In that post, I described projecting as a "what if" exercise that is done at a higher level of abstraction than the budgeting and forecasting exercises. I said this about projections: These are a set of numbers, both financial and operational, that you make about your business for various purposes, including raising capital. They are aspirational and are often done with a "what could be" perspective. Since projections are not budgets and are much more "big picture" exercises, it is important to use a scenario driven approach to them. I generally like three scenarios; best case, base case, and worst case. But you could do as many scenarios as you like. It's not the results that matter so much, it's the process and the learning that comes from the projections exercise. 5

http://www.avc.com/.a/6a00d83451b2c969e20133ecf5a9ae970b-pi http://www.avc.com/a_vc/2010/04/projections-budgeting-and-forecasting.html

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If you build your projections with a detailed set of assumptions and if you can assign probabilities to each assumption, you could easily do a monte carlo simulation in which literally thousands, or tens of thousands, of scenarios are run and the outcomes are charted on a bell curve. I don't recommend doing projections this way, but my point is simply that the number of scenarios is not important, it's the process by which you determine the key drivers of the business, the assumptions about them, and the probabilities associated with them. A few weeks ago on MBA Mondays we talked about key business 2 metrics . It is very important to identify your key business metrics before you do projections. These key business metrics will drive your projections and your assumptions about how these metrics will develop over time will determine how your scenarios play out. Let's get specific here. I'll assume we are operating a software business and we are selling the software as a service over the internet using a freemium model. Everyone can use a lightweight version of the software for free, but to get the fully featured version the user must pay $9.95 per month. So here are some of the key business metrics you might use in projecting the business; productivity of the engineering team, feature release cycle, current outstanding known software bugs, total users, new free users per month, conversion rate from free to paid, marketing dollars invested per new free user, marketing dollars invested per new paid user; customer support incidents per day; cost to close a customer support incident. These are just examples of key business metrics you can use. Every business will have a different set. The next step is to lay all of these metrics out in a spreadsheet and make assumptions about them. As I said, I like three assumptions, best case, base case, and worst case. Best case is not the best it could ever be but best you think it will ever be. Base case is what you genuinely expect it to be. And worst case should be the worst it could ever be. Worst case is really important. This is your nightmare scenario. You then calculate your costs and revenues as a function of these metrics. There are some expenses that will not vary bases on the as2

http://www.avc.com/a_vc/2010/04/key-business-metrics.html

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sumptions. Rent is a good example of that in the short term. But over time, rent will move up if you need to hire like crazy. I would go out at least three years in a projections exercise. Some people like to go out five years. I've even seen ten year projections. I don't think any technology driven business can project out ten years. I am not even sure about five years. I believe three years is ideal. Getting the assumptions right and building up to a full blown projec3 ted profit and loss statement is an iterative process. You will not get it right the first time. But if you build the spreadsheet correctly the iterating process is not too painful. Do not do this exercise all by yourself. It should be done by a team of people. If you are a one person company right now, then show the results to friends, advisors, potential investors. Get feedback on your key business metrics, assumptions, and results. Think about the results. Do they make sense? Are they achievable? In last week's comment thread we got into a conversation about "top down" vs "bottom up" analysis. Top down is when you say "the market size is $1bn, we can get 10% of it, so we'll be a $100mm business." I think top driven analysis is not very rigorous and likely to produce bad answers .The kind of projection work I've been talking about in this post is "bottom up" and is based on what can actually be achieved. However, it is often best to take the results of a bottom up analysis and do a reality check using a top down analysis. So when your best case scenario has your business at $100mm in revenues in year three, do yourself a favor and do a top down reality check on that. No matter how rigorous the projections process is, if the results are not believable then the whole exercise will have been wasted. Most entrepreneurs do projections as part of a financing process. And it is a good idea to have projections for your business when you go out to raise money. But I would advise entrepreneurs to do projections for themselves too. It is a good idea to have some idea of what you are

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building to. Make sure it is not a waste of time for you and the team your recruit to join you. It is true that most great tech businesses, possibly all businesses, are 4 initially built to "scratch an itch." But once you get past the "I built this because I wanted it" and when you find yourself hiring people, raising capital, renting space, it's time to think about what you are doing as a business and having solid projections and a few scenarios is a really good way to do that.

Budgeting in a Small Early Stage Company Today and for the next two weeks, we are going to talk about budgeting on MBA Mondays. Since the budgeting process works differently in companies of various sizes, we are going to focus on three company sizes; 10 people, 75 people, and 150 people. Today we will talk about the 10 person company scenario. 1

As I said in a previous post , I have been working with Matt Blumberg and Jack Sinclair, CEO and COO/CFO of our portfolio company Re2 turn Path on these budgeting posts. I have been involved with Return Path for ten years now and I've watched Matt and Jack run excellent budgeting processes and so we are getting the benefit of their work and learning in these posts. 3

Last week we talked about projections . It is important to run a projections process before you turn to budgeting. Think of budgeting as a refinement of the projections process where the goal is to predict what is going to happen in a particular calendar year.

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http://www.paulgraham.com/organic.html http://www.avc.com/a_vc/2010/04/projections-budgeting-and-forecasting.html http://www.returnpath.net/ 3 http://www.avc.com/a_vc/2010/05/scenarios.html 1 2

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I believe that budgeting should be done on a yearly basis. If you want to start budgeting and you are in the middle of the year, that is fine. Just budget for the rest of the year and then do your first full year budget in the late fall. The late fall is budgeting time. October and November are the best months to do it. If you have a board, you should be able to present your budget for the next year to the full board in December so they can approve it before the year starts. If you don't have a board, then you should be able to lock into a budget with your team in December. The budgeting process starts with a financial model. If you have done projections, then you should have a financial model already4 built. If haven't done projections, then go back to the projections post , follow the directions, and do some projections. Then come back and read this post. The first step in budgeting is to review the key business metrics and lock them down based on what is realistic for the next year. Be very realistic. A good budget is a conservative budget. In a ten person company, the budgeting process can be done by a couple of the senior managers, typically the CEO and the most financially savvy of the other team members. These two people can run the process all by themselves without any input from the rest of the team. That will change quickly as the company grows, but in a very small company you do not need to involve the entire team in budgeting. If the company is pre-revenue as many 10 person companies are, then the focus will be on hiring and people costs. And the budgeting process will largely be about spending and how many people the company can hire and how much money the company can spend and how long its cash will last before needing another round of funding. If the company has revenues, they will not likely be large yet at 10 people, so the revenue forecast will be a bit tricky. In the first few years of revenue generation, the revenue model changes a lot and the drivers of it change too. I would encourage everyone to be conservat4

http://www.avc.com/a_vc/2010/05/scenarios.html


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ive about revenue budgeting early in a company's life. Most budgets are missed because revenue does not come in as planned. Make sure to include a cash line item in your budget. Most budgets are done as profit and loss statements which is how they should be done. But you should back into a cash projection based on the profit and loss numbers and include that line item in your budget.5 If this is new material to you,7 go back to my posts on profit and loss , balance 6 sheet , and cash flow to see how these three statements work together. Once the budget has been locked down and approved by the board and/or by the senior team, you should share the budget with your entire company. Some executives don't like to share the entire line by line budget with the team and I can understand that. Some executives don't like to show a cash line that runs out with the team and I also understand that. But you should at least show the key business metrics and some of the most important line items in the budget with the entire company. This will be their roadmap for the next year and it is important that they understand it if they are going to be expected to help you deliver it. All that said, I favor being as transparent as you can possibly be with your company. It is hard to hide information from the company. The important information leaks out eventually and if and when it does, you won't be there to provide context. So the more information you provide, the better off you will be. Once you have a budget, you need to measure yourself against it. Each month report the actual numbers versus the budget and track how you are doing against each key business metric and line item in the budget. At some point during the year, you may want to do a reforecast. We will talk about that exercise in a few weeks. Next week we will talk about how this process changes as you grow to 75 people. It a very different process at that point.

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http://www.avc.com/a_vc/2010/03/the-profit-and-loss-statement.html http://www.avc.com/a_vc/2010/03/the-balance-sheet.html http://www.avc.com/a_vc/2010/03/cash-flow.html

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Budgeting in a Growing Company I failed to post a MBA Mondays post last monday. Sorry about that. I had something else on my mind when I woke up, wrote about that, and didn't realize that it was monday and I was supposed to do an MBA Mondays post until late in the afternoon. So we are now picking up from where we left off two weeks ago. Which is in the middle of a four to six post series on projections,1 budgeting, and forecasting. We covered budgeting in a small company two weeks ago. We are now going to talk about what happens to the budgeting process once revenues start coming in, headcount gets to between 50 and 100 employees, and you are now a full fledged high growth business. Once you have real revenues, 50+ employees, and a real business, you should have a full time finance person on your team. It could be a CFO or it could be a VP Finance. There are tradeoffs between the two. If you think you are going to be an independent company for a long time that will go public or do a large number of private financings and M&A transactions, then you will want a CFO. If you plan to keep the business simple and head for the exits within a few years, a VP Finance should be fine. I should do a post on the difference between a CFO and a VP Finance and I will, but this is not the time for it. So your budgeting process should start with your lead finance person. He or she should run the process with you as their partner. Your budgeting team should also include the leader of your sales or revenue operation and your head of engineering or tech ops if you have one. The way I like to think of these two people is the person who "owns" revenues and the person who "owns" capex. This group is sufficient to run a budgeting process in a 50 to 100 employee company.

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http://www.avc.com/a_vc/2010/05/budgeting-in-a-small-early-stage-company.html


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There are three inputs to the budgeting process in a company of this size; a detailed revenue plan/model, a comprehensive cost model including headcount, and a set of key performance indicators (KPIs). Start with the revenue plan/model and do it bottoms up (meaning identify where the revenue is going to come from and how much of it you are going to be able to pull in during the year). The sales leader will give you a plan that he or she thinks they can hit. Dial it back. As much as I love sales leaders, they are optimists. Very few of them can properly estimate revenue in a high growth relatively early stage company. I believe they generally do a good job of identifying where the revenue will come from but a poor job of estimating how much of it will come in during your time frame. Things always take longer. So dial the sales leader's numbers back. Then once you have a set of revenue numbers, lay out all the KPIs that it will take to hit them. What is needed from the product team? What is needed from the engineering team? What is needed from the bus dev team? What is needed from marketing, customer service, HR, etc? The KPIs are the glue between the top line model and the cost model. Spend a lot of time on this part of the process. Going from KPIs to a comprehensive cost model is not that hard, especially for a seasoned finance person. The key is being comprehensive. If you are growing headcount aggressively, will your current space be sufficient? If not, you'll need numbers for more space. Things like legal and recruiting costs really start to pile up at this stage. They may not be very large in your historical financials. Plan for them and budge them. And make sure to budget for capex costs. Some companies rent their capex via leases or managed hosting. If you do this, your capex will show up in your operating costs. Some companies acquire their capex with cash. If you do this, your capex will show up on your balance sheet. Either way, capex can eat up a lot of cash. So budget for it correctly and make sure your engineering or tech ops leader is held accountable to the capex budget.

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In my last post on this topic, I said that budgeting time is October and November so that the board can approve it in December. That is generally true for a 10 person company but not for a 50 to 100 person company. I like to see budgeting start in September for a company of this size and I like to see the Board look at the budget in November. That way if there is a disconnect between management and the Board, another revision to the process can occur before the year starts on Jan 1st. The budget is not just for the Board. It is first and foremost for the team. So make sure to share the budget with the team and make sure they are all bought into it. If they are uneasy about it, listen to them and don't force a plan on the team that they do not think they can hit. A company at this stage will have a senior team and they should be accountable to the budget. They may even have incentive comp associated with the budget goals. I like to see the entire senior team participate in the budget presentation to the Board. I like all of them to talk to their parts of the budget. That shows they understand it, they have bought into it, and they are behind it. To be brutally honest, very few budgets are met in companies of this size. These businesses are still very much in flux and things change a lot during a year. But I still believe in the value of doing budgets. The process is incredibly helpful in establishing what can be done and what can't be done. It focuses the mind and the company. And if you realize half way through the year that you are not going to meet your budget, you can and should do a forecast. We'll talk about that in a few weeks. Next up is budgeting in a 150+ person company. We'll do that next Monday assuming I don't have another brain fade.


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Budgeting in a Large Company 1

Last week we talked about budgeting in a growing company . I defined that as a company between 50 and 100 employees. Today we are going to wrap up the budgeting series by talking about what happens to the process when you get to be a "big company." The context for the whole of this MBA Mondays series of posts is the world of entrepreneurial startups so "big company" means 150 employees or more to me. The biggest companies that I actively work with are between 150 employees and 1000 employees. Once they get bigger than that, they are beyond my ability to comprehend them and help them. The process of budgeting in a large company doesn't differ that much from a growing company. If you haven't read that post, please go back 2 and read it . The budgeting process is still led by the financial leader of the company (VP Finance or CFO but by this stage you are likely to have a CFO) and the CEO. But the team that runs the budgeting process now includes the entire senior team. That is because each senior team member has control over a meaningful team and piece of the business. So you have to get them all involved in the budgeting process. It's also increasingly likely that your revenues are coming from a number of lines of business so you will want to do a more detailed revenue forecast with attention to each segment of revenue. Your sales leader will still be responsible for the revenue forecast, but he or she will need help from the finance leader and often from other senior team members to put the revenue forecast together. You will continue to use KPIs as a bridge between the revenue budget and the cost budget, but the creation of the KPIs and the forecast of them is now driven by the entire senior team. As I said in last week's

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post, this is the most important part of the budgeting process so make sure to give the senior team ample time to get the KPIs right. Cost budgeting in a large company is a much more exhaustive process. The cost budget has a lot more detail and input into it. It is an iterative process where each senior team member brings a cost budget from his or her team and the finance leader integrates it all together and then negotiates with the senior team members to get the numbers where they need to be. This is where entrepreneurial budgeting starts to feel like big company budgeting. One thing that many companies start doing at this stage is benchmarking their budget numbers versus others in their industry sector. This is mostly done with public company numbers since getting detailed financials on privately held companies is difficult. It is helpful to look at what your competitors or similar companies are spending as a percent of revenues on the various parts of the business. And it is helpful to look at how profitable their businesses are versus yours. As you can see, the primary difference between the budgeting process in a growing company and a large company is the amount of involvement, interaction, and iteration among the senior team. This all takes time. So start the budgeting process by labor day, if not a bit sooner. It will take three months to do this right. You'll want your budget ready for a board review in mid to late November so there is time to do one more iteration before year end if that is necessary. The budgeting process is really critical in a large company. It forces the company to make highly informed decisions about investments and resource allocation and it creates company wide discipline around hitting goals. I have never seen a company of 150 employees or more operate functionally without a strong budget process. 3

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I'd like to again thank Matt Blumberg and Jack Sinclair of our 5 portfolio company Return Path for their help with these budgeting posts. I have watched them go through all of the various stages over 3

http://twitter.com/mattblumberg http://twitter.com/jsinclair http://returnpath.net/

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the years and their planning and budgeting has been stellar. Their insights were invaluable to me in putting the "how to" parts of these posts together. Next week we'll talk about what happens when the reality starts diverging from the budget - forecasting.

Forecasting 1

This is the final post in a long MBA Mondays series on projections, budgets, and forecasts. Today we will talk about what happens when reality starts to differ from what you've budgeted - you re-forecast. Let's go back to the framework I laid out at the start of this series. Projections are long-term high level efforts to establish the scope of the opportunity. Budgets are an effort to establish an operating framework for the coming year. And forecasts are done intra-year to establish what is likely to happen. As someone said in the comments, it's "long term, short term, and real-time." Forecasts are typically done mid-year but they can and should be done whenever the actual performance differs significantly from what was budgeted. Forecasts are not an attempt to throw out the budget. The company should continue to measure itself and report against the budget. The forecast should exist beside the budget and show what management thinks is likely to happen. Forecasts are important for a variety of reasons but first and foremost you want to know where your cash balances will actually be. And you'll want to know where you will be on your revenue growth trajectory. If you are planning on doing a financing, forecasts are important because they will give you an indication of what the metrics investors will be using when they offer you terms for a financing.

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The process of doing a forecast is not very hard. You simply take the model you used for budgeting and put new numbers in for revenues and costs. The way most forecasts go down is the revenues are taken down to reflect slower sales growth. Then management looks at the costs in the budget. In some cases, costs are not adjusted because management feels that they need to continue to invest in the business. But in many cases, costs are adjusted down somewhat to reflect a desire to conserve cash. Either way, you'll have a new set of numbers for the months ahead. You combine these new sets of numbers for the coming months with the actual results for the months that have already happened and you have your forecast. Once you do a forecast, it is a good idea to keep updating it as the year develops. If you do a forecast at mid-year and by the fall that forecast is off, do another forecast. The forecast is not another budget you have to try to meet. It is an attempt to estimate actual results. So keep adjusting the forecast in an attempt to nail it. As you get into the fall, you will start budgeting for the next year. Use the learning that came from the forecasting exercise to make next year's budget better. Think of budgets and forecasts as agile financial management. The budget is the annual release and the forecasts are the iterations based on feedback. So that's it. We are now done with projections, budgeting, and forecasting. Next week we'll tackle a new topic.

Risk and Return

Risk and Return One of the most fundamental concepts in finance is that risk and return are correlated. We touched on this a tiny bit in one of the early 1 MBA Mondays posts . But I'd like to dig a bit deeper on this concept today. 2

Here's a chart I found on the Internet (where else?) that shows a bunch of portfolios of financial assets plotted on chart.

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As you can see portfolio 4 has the lowest risk and the lowest return. Portfolio 10 has the highest risk and the highest return. While you can't draw a straight line between all of them, meaning that risk and 1

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return aren't always perfectly correlated, you can see that there is a direct relationship between risk and return. This makes sense if you think about it. We don't expect to make much interest on bank deposits that are guaranteed by the federal government (although maybe we should). But we do expect to make a big return on an investment in a startup company. There is a formula well known to finance students called the Capital 4 Asset Pricing Model which describes the relationship between risk and return. This model says that: Expected Return On An Asset = Risk Free Rate + Beta (Expect Market Return - Risk Free Rate) I don't want to dig too deeply into this model, click on the link on the model above to go to WIkipedia for a deeper dive. But I do want to talk a bit about the formula to extract the notion of risk and return. The formula says your expected return on an asset (bank account, bond, stock, venture deal, real estate deal) is equal to the risk free rate (treasury bills or an insured bank account) plus a coefficient (called Beta) times the "market premium." Basically the formula says the more risk you take (Beta) the more return you will get. You may have heard this term Beta in popular speak. "That's a high beta 5stock" is a common refrain. It means that it is a risky asset. Beta (another Wikipedia link) is a quantitative measure of risk. It's formula is: Covariance (asset, portfolio)/Variance (portfolio) I've probably lost most everyone who isn't a math/stats geek by now. In an attempt to get you all back, Beta is a measure of volatility. The more an asset's returns move around in ways that are driven by the underlying market (the covariance), the higher the Beta and the risk will be. 4

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So, when you think about returns, think about them in the context of risk. You can get to higher returns by taking on higher risk. And to some degree we should. It doesn't make sense for a young person to put all of their savings in a bank account unless they will need them soon. Because they can make a greater return by putting them into something where there is more risk. But we must also understand that risk means risk of loss, either partial or in some cases total loss. Markets get out of whack sometimes. The tech stock market got out of whack in the late 90s. The subprime mortgage market got out of whack in the middle of the last decade. When you invest in those kinds of markets, you are taking on a lot of risk. Markets that go up will at some point come down. So if you go out on the risk/reward curve in search of higher returns, understand that you are taking on more risk. That means risk of loss. Next week we will talk about diversification. One of my favorite risk mitigation strategies.

Diversification I was talking to a friend over the weekend and he told me a story about a person he knows who made hundreds of millions of dollars of net worth in his career and then lost it all. I asked my friend how that could happen. He said "he made a lot of risky bets and none of them worked out." I don't get how anyone could do that to be honest. I don't understand how someone gives Madoff all of their money to manage for them. When someone has very little to lose, I totally get betting it all and going for it. But when you have accumulated a nest egg or more, you must be diversified in your investments and assets. You cannot put all of your eggs in one basket.

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Last week on MBA Mondays, we talked about Risk and Return . I made the point that risk and return are correlated. If you want to make higher returns, you must take on higher risk. But you can mitigate that risk by diversification. And this post is about that strategy. One of 2the things most everyone learns in business school is portfolio theory (that's a wikipedia link if you want to learn more). Portfolio theory says that you can maximize return and minimize risk by building a portfolio of assets whose returns are not correlated with each other. Let's use some real life examples. Let's say you have a portfolio of stocks and all of them are tech companies. To some degree, they are all correlated. When the tech bubble blew up in March of 2000, every tech stock went down. So if you had that portfolio, your portfolio went down big. Let's say you have a portfolio that has some tech stocks, some oil stocks, some packaged goods stocks, some real estate, some bonds, and some cash in it. When the tech bubble bursts, you get hit, but your portfolio does not "blow up." That is the power of diversification at work. I have my own tech bubble story that is similar to that example. When the Gotham Gal and I moved back to NYC in the late 90s, we bought a large piece of real estate in lower manhattan from NYU. We sold a big slug of Yahoo stock that we got in the sale of Geocities to fund the purchase. And then we sold another big slug of Yahoo stock to fund a complete renovation of that real estate. Beyond those two sales, we did not get liquid on most of our internet and tech stocks because our funds were locked up on almost everything else. When the bubble burst, our net worth dropped 80% to 90%. But it could have dropped 100%. That real estate did not drop in price. It actually increased by 2.5x over the eight years we owned it. That is the power of diversification at work. Of course, we learned our lesson from that experience. We now have a fairly diversified portfolio of assets that includes venture capital 1

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investments, real estate investments, hedge funds, and municipal bonds. I am not suggesting that our mix is a good mix. I suspect we could be much more conservative and more "efficient" with our asset allocation if we hired a professional financial planner to do this work for us. But this post is not really about our portfolio construction or even about asset allocation. It is about the power of diversification as a risk mitigator. Let's talk about diversification in venture capital funds. Making "one off" early stage venture capital investments is a bad idea. The chance that you will pick a winner in early stage venture capital is about one in three. I've said many times on this blog that one third of our investments will not work out at all, one third will work but will not be interesting investments. And all of our returns will come from the one third that actually work out. If you are making "one off" early stage investments and make five or six investments over the course of a few years, you do not have enough diversification. You could easily pick five or six investments and not once get to the one third that work. We put 21 investments into our 2004 fund and I believe we will put between 20 and 25 investments into our 2008 fund. With that number of investments, we have a good chance of finding one investment that will be good enough to return the entire fund. And we have a good chance of finding another four or five investments that will return the fund again. We can handle a complete wipe out on between five and ten investments and still produce excellent returns. That is how diversification helps to manage risk in an early stage venture portfolio. So if you are building a portfolio of anything, be it financial assets or anything, make sure to fill it with things that are not too similar and not too correlated with each other. To do otherwise is not prudent.

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Hedging 1

This is the third in a series of MBA Mondays posts about risk and return. Last week we talked about diversification, my favorite form of risk mitigation. This week we are going to talk about another favorite risk mitigation method of mine - hedging. There are different types of investors in any highly developed and liquid market. There are speculators who are looking to make risky bets and you can use them to reduce your risk by taking the opposite side of those bets. Doing this is called hedging. Let's go through some real world examples. The simplest one is shorting a stock that you own. Let's say you own 1,000 shares of Apple that you bought during the 2008 market break at $75/share. The Apple shares are now at $267/share and you are worried that the iPhone 4 reception problems are going to hurt the stock in the short term. You could sell the stock, but you really don't want to. So you can short 1,000 shares of Apple for as long as you are nervous. The way shorting a stock works is someone who also owns the stock loans you the shares and you sell them. You promise to give them back the stock at some future date. You pocket the $267,000 you get from selling the Apple stock but you have a liability which is you have to give the stock back to the person or institution who loaned it to you. Fortunately, you still own the stock you originally purchased so you can always pay back the loan in the stock you own. If the stock goes down, you can use some of the $267,000 you got in the sale of stock to buy back the Apple stock at a lower price and use that to repay the loan. If the stock goes up, you are losing money on your short, but making exactly the same amount on the stock you originally bought.

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In this scenario, you have hedged your risk of the stock going down, but you are also not going to make any money if the stock goes up. It is like you sold the stock except that you still have your original stock in your possession. You are perfectly hedged except for counterparty risk, which are risks brought on by the other party to your hedging transaction. In this case, counterparty risk is pretty low. Another form of hedging involves options. There are two primary forms of options, puts and calls. A put option gives you the option of "putting" your stock to someone else at a specific price. A call option gives you the option of "calling" a stock from someone else at a specific price. Let's continue this example of Apple stock at $267/share. Instead of shorting the stock you can use options to hedge your position. The simplest form of a hedge is to buy a put to protect your downside. Let's say you want to make sure you get $250/share for your Apple stock no matter what. You can buy a put that allows you to "put" your Apple stock for $250/share until August 10th (a little more than 5 weeks) for $27. If that happens, you actually are getting $223/share because you'll get $250/share but you had to pay $27 for the call. That is the purest form of downside protection. It is expensive, but you get to keep all of the upside on the stock. And there is counterparty risk because if the person selling you the put goes out of business, they won't be there to honor the call. If you are willing to give up some upside, then a better approach is the "collar". In this trade you buy a put and sell a call. The August 10th Apple put at $250 is trading at $27 right now. To finance that cost, you can sell an Aug 10th Apple $280 call for $24. You are still out $3/share but it is must less expensive insurance. However, if the stock goes up to $280, it can get called from you. 2

I got all these option prices from the CBOE's website . These are the current prices as of Monday morning before the markets open. These prices will move around a lot, reflecting both the price of Apple stock,

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the remaining time until expiration of the option, and the volatility of the stock. If you think about the collar, it is a lot like shorting a stock you already own. You are protected if the stock goes down but you aren't going to make much if the stock goes up. When our venture capital firm finds itself with a lot of public stock that we cannot sell for one or more reasons and we want to protect ourself from downside risk, we like to use a collar. You can use traded options, like the ones I am quoting from the CBOE. Or you can get a trading desk at a major brokerage firm to create synthetic options for you. No matter what you do with collars, it is going to cost something. You are purchasing insurance and insurance has a cost. It is important to remember the counterparty risk when you are hedging. No hedge is any good if the other party to the transaction is not there to settle up. It is like buying insurance. You want to buy insurance from a highly rated carrier and you want to do hedging transactions with financially secure and stable counterparties. What constitutes that these days is another issue. In summary, when you have a large gain on your hands, think about taking some of that gain off the table by selling it and diversifying. If you can't do that for one reason or another (taxes is a common one), think about a hedging transaction.

Currency Risk in a Business I'm in europe this week, using euros for everything instead of dollars. So I thought it would be an appropriate time to talk about currency risk in a business. When you have a business that only generates revenues in your local currency, you don't have to concern yourself with the fluctuations of one currency versus another. But if you start generating revenues

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in other currencies, or if you open an office outside of your country and start generating expenses in other currencies, you will have to start thinking about currency risk. First, let's talk a little about currencies and how they fluctuate against each other. Since I'm spending euros this week, let's look at the past 120 days of price action in dollar/euro:

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So let's say that 20% of your company's revenues are euro denominated. And let's say that your business is doing $10mm a year in revenues. So about $2mm in US dollars of your revenue is in euros. And let's say that was the case at the beginning of the year. At that time, the exchange rate was about .7 euros to 1 dollar. So your business was generating 1.4mm euros in revenues. Since the start of the year, the euro has dropped and now you get .8 euros for every dollar. So if your business is still generating 1.4mm euros in revenues, that is now only $1.75mm dollars of revenue per year. You are still selling just as much in euros, but your annual revenues in dollars has dropped $250,000 in six months. That is how currency fluctuations can impact a business. Let's do the same analysis, but this time with expenses. If at the start of the year, you had $2mm in annual expenses in a euros because you have an office in europe with employees, rent, etc, then you had 1.4mm euros in annual expenses. By June of this year, those expenses have

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dropped to $1.75mm, saving your company $250,000 in annual expenses. What this example shows is the primary lesson of currency risk in business. It is ideal to have your foreign currency denominated expenses and revenues be as close to each other as possible. Because if you can do that, they are a natural hedge. If our examples are combined, and you have $2mm of revenues and $2mm of expenses in euros (a breakeven business in euros), then your profits will not be impacted by currency fluctuations. Your revenues might go up or down, but your profits will be immune. If you cannot match foreign currency denominated revenues and expenses, then you will have risk to your business. If the foreign currency revenues and/or expenses are small (measured in the millions or less), then you should not do anything about this risk. Just understand that you have the risk and live with it. But if your unmatched foreign currency denominated revenues and/or expenses are in the tens of millions of dollars or2 more, then you can hedge the risk. As I explained in last week's post , there are a number of hedging strategies that you can put in place to manage this risk. There are currency desks at the major money center banks and global brokerage firms that specialize in hedging currency risk for companies and they will be happy to put in place currency hedges for you. Hedging currency risk can get expensive, which is why I don't recommend it for small companies, but for large companies with significant currency risk, it is standard business practice and it is very common. For many entrepreneurs, currency risks are not going to be something to worry at the start of the business. But we see most of our portfolio companies start thinking about international expansion about five years into the development of their business. They open an office outside the US and start generating non dollar denominated expenses. In time, they start generating non dollar denominated revenues. At some point, these amounts become significant and the CFO has to start thinking about currency risk. If you get to that point in your 2

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business, think of it as a good sign. Something to manage for sure, but a sign that the business is on the right trajectory.

Purchasing Power Parity Continuing the international theme, we are going2to talk about Pur1 chasing Power Parity today on MBA Mondays . I learned about purchasing power parity in business school and it has always helped think about international exchange rates. The theory is far from perfect and fails miserably in many situations, but I still think the basic construct of purchasing power parity is something everyone in business should understand. The basic concept is this: a basket of goods that are traded between markets should cost the same in different markets. My favorite ex3 ample is the "Big Mac Index " which is calculated and published annu4 ally by The Economist . If a Big Mac costs $4 in the US and 3 pounds in the UK, then the proper exchange rate between the two currencies should be four dollars to three pounds which works out to be 1.33 dollars per pound. The reason I like the Big Mac index is it is simple to understand. A Big Mac is not a "basket of goods" however and a more comprehensive basket of goods is normally used to calculate purchasing power parity of different countries. That said, I will use the Big Mac index one more time to explain how purchasing power parity can be used to determine of a currency is overvalued or undervalued. This example comes from wikipedia:

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Using figures in July 2008: • the price of a Big Mac was $3.57 in the US • the price of a Big Mac was £2.29 in the United Kingdom (Britain) (Varies by region) • the implied purchasing power parity was $1.56 to £1, that is $3.57/£2.29 = 1.56 • this compares with an actual exchange rate of $2.00 to £1 at the time • [(1.56-2.00)/2.00]*100= -22% • the pound was thus overvalued against the dollar by 22% This is important to understand. If two baskets of goods should cost the same in different markets and they don't, then the implication is that one currency is overvalued relative to another and that difference will eventually unwind itself.

Let's look at China versus the US. The International Monetary Fund (IMF) estimated in 2008 that one US dollar was worth 3.8 yuan using purchasing power parity. And yet the official exchange rate at that time was one dollar for 7 yuan. That situation has not changed much. The yuan dollar exchange rate is now one dollar of 6.8 yuan. What this means is that US made goods are more expensive in China than they should be using purchasing power parity as a guide. And Chinese goods are less expensive in the US than they should be using purchasing power parity as a guide. If the dollar yuan exchange rate was allowed to move entirely with market forces, the theory of purchasing power parity says that the exchange rate should move to around 4 yuan to the dollar. Until that happens, this price discrepancy will remain. There are all sorts of problems with purchasing power parity but I will not go into them here. The basic concept makes sense to me and

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is used widely in international economics. It is worth understanding as it provides a basic framework for how currencies can and should move relatively to each other.

Business Costs

Opportunity Costs 1

We are going to turn our attention on MBA Mondays to some costs that are important to recognize in business. First up is Opportunity Cost. Opportunity Cost is the cost of not being able to do something because you are doing something else. These costs don’t end up on your income statement but they are expensive, particularly in a small business where you have very few resources. Let’s use an example. Assume you have three software engineers on your team and you commit to building a new product that ties all three of them up completely for six months. Not only do you commit to build that product, but you sell it in advance and take a deposit from your customer to fund the development. And then an even bigger opportunity comes your way. You have been invited to build a version of your product that will ship in a hot new device that a major computer company is making a big bet on. But you can’t take on that project because your team is tied up on the first project. So the cost of the first project is not only the time and salaries of the three software engineers who are working on it. It is also the lost revenues and market share you might have gotten if you had been able to work on the partnership on the new device. That is your opportunity cost. The problem with opportunity costs is that you can’t predict or measure them very well. They become painfully obvious in hindsight but not at the decision point when you need to know their magnitude.

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So what do you do about opportunity costs that are out there but you can't see or measure? That's a tough one. I like what my friend 2 3 Gretchen Rubin said on the subject : I also try to ignore opportunity costs. I can become paralyzed if I think that way too much. Someone once told me, of my alma mater, “The curse of Yale Law School is to die with your options open” – meaning, if you try to preserve every opportunity, you can’t move forward. So my advice is to understand the concept of opportunity costs, build them into you mental map, but don't focus too much on them. If you can, try to build some flexibility into your organization so you aren't completely resource constrained. That will reduce opportunity costs. But at the end of the day, you need to "move forward" in Gretchen's words and that is first and foremost what all great entrepreneurs do.

Sunk Costs 1

Today on MBA Mondays we are going to talk about another form of costs; Sunk Costs. Sunk Costs are time and money (and other resources) you have already spent on a project, investment, or some other effort. They have been sunk into the effort and most likely you cannot get them back. The important thing about sunk costs is when it comes time to make a decision about the project or investment, you should NOT factor in the sunk costs in that decision. You should treat them as gone already and make the decision based on what is in front of you in terms of costs and opportunities.

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Let's make this a bit more tangible. Let's say you have been funding a new product effort at your company. To date, you've spent six months of effort, the full-time costs of three software developers, one product manager, and much of your time and your senior team's time. Let's say all-in, you've spent $300,000 on this new product. Those costs are sunk. You've spent them and there is no easy way to get that cash back in your bank account. Now let's say this product effort is troubled. You aren't happy with the product in its current incarnation. You don't think it will work as currently constructed and envisioned. You think you can fix it, but that will take another six months with the same team and same effort of the senior team. In making the decision about going forward or killing this effort, you should not consider the $300,000 you have already sunk into the project. You should only consider the additional $300,000 you are thinking about spending going forward. The reason is that first $300,000 has been spent whether or not you kill the project. It is immaterial to the going forward decision. This is a hard thing to do. It is human nature to want to recover the sunk costs. We face this all the time in our business. When we have invested $500,000 or $5mm into a company, it is really easy to get into the mindset that we need to stick with the investment so we can get our money back. If we stop funding, then we write off the investment almost all of the time. If we keep putting money in, there is a chance the investment will work out and we'll get our money back or even a return on it. Even though I was taught about sunk costs in business school twentyfive years ago, I have had to learn this lesson the hard way. Most of the time that we make a follow-on investment defensively, to protect the capital we have already invested, that follow-on investment is marginal or outright bad. I have seen this again and again. And so we try really hard to look at every investment based on the return on the new money and not include the capital we have already invested in the decision.

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This ties back to the discussion about seed investing and treating seed investments as "options." Every investor, if they are rational, will look at the follow-on round on its own merits and not based on the capital they already have invested. But the venture capital business is a relatively small world and reputation matters as well. Those investors who make one follow-on for every ten seeds they make will get a reputation and may not see many high quality seed opportunities going forward. Our firm has followed every single seed investment we have made with another round. In most cases, those investments have been good ones. But we have made a few marginal or outright bad follow-ons. We do that for reputation value as much as anything else. We measure that value and understand that is what we are doing and we keep those reputation driven follow-ons small on purpose. When it is time to commit additional capital to an ongoing project or investment, you need to isolate the incremental investment and assess the return on that capital investment. You should not include the costs you have already sunk into the project in your math. When you do that, you make bad investment decisions.

Off Balance Sheet Liabilities In the past couple weeks we’ve talked about some costs that don’t al1 ways2appear on the income statement; opportunity costs and sunk costs . Today, I’d like to talk about some liabilities that don’t appear on the balance sheet. The technical term for them is “off balance sheet liabilities” and they are something to be very wary of as an investor. When you think about investing in a business, whether it is a public stock you can buy via Schwab, or a mature business you are acquiring with debt financing in a leveraged purchase transaction, or a growth company you are investing in, or even a young startup, you should take a close look at the balance sheet. You should see what obligations 1

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that company has built up over the years and how they compare to the company’s assets. When the liabilities are large and the assets are not and if the cash flow is weak or non-existent, then you should be extremely cautious because those liabilities can sink the company. We talked a bit about this in 4the post I did on financial statement 3 analysis and the balance sheet . But sometimes companies don’t put all of their obligations on the balance sheet. There are at times valid reasons for this, but there are times when the company is just trying to pull a fast one on the investor community. Enron is a classic business case story about this. What Enron did was create investment partnerships where they transferred assets and liabilities. But those partnerships had close ties back to Enron and at the end of the day, they did not eliminate the liabilities, they just took them off their reported balance sheet. When those partnerships blew up, Enron came crashing down. Billions were lost and executives went to jail. Even if the company you are looking to invest in is totally clean and honest, there will be likely be liabilities that are not on the balance sheet. Let’s say you are looking at investing in a company that does mobile software development for big media companies. Let’s say they have just signed a three-year contract to develop mobile apps for one of the largest media companies in the world. Let’s say they got paid upfront $1mm to do this work. That $1mm will appear on the balance sheet as deferred revenue and that is a liability. But what if the company misjudged the amount of work it will take and they will ultimately lose money on the deal? What if it will actually take them $1.5mm in costs to do this work? The $500k of losses is an additional liability but it doesn’t appear on the balance sheet anywhere. But those losses could sink the company if it is thinly capitalized. Real estate liabilities are a particularly thorny issue. Back in the early part of the last decade, right after the Internet bubble burst, I spent almost all of 2001 trying to negotiate a bunch of companies out of real estate liabilities. These companies were all growing like crazy in 1999 and 2000 and they signed five and ten year leases on big spaces (like 3

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10,000 square feet or more) with big landlords. Many of these leases had rent concessions in the first year or 18 months and when those concessions came off, the companies instantly faced the dual reality that they could not afford the leases and that they were not going to raise more money with these huge lease obligations in place. But those lease obligations were not on the balance sheets. The annual rent expenses were on the income statement, but the future lease obligations that ultimately sunk a few of these companies were only disclosed in the back of the footnotes. The footnotes are where you have to go to see these off balance sheet liabilities. If the Company is audited, then their annual financial statements will have footnotes and this kind of stuff is likely to be in there. If the company is publicly traded, it will be audited, and the footnotes will be in the 10Ks and 10Qs that the company files with the SEC. But many privately held companies, particularly early stage privately held companies, are not audited. So if you are going to invest in a company that is not audited, you need to diligence these unreported liabilities yourself. You should ask about lease obligations and any other contractual obligations the company has. Read the leases and the contracts. Understand what the company is obligated to do and how much money it will cost. Make sure those funds are in the projected cash flows. Balance sheets and income statements are important to understanding a company. But they do not tell the entire picture. They don’t tell you if the team is solid. They don’t tell you if the product is any good. They don’t tell you if the market is big. And they don’t even tell you about all the costs and they don’t tell you about all the liabilities. So you have to dig deeper and understand what is really going on before putting your capital at risk. That is called due diligence and it is critical to investing. And looking out for liabilities that aren’t reported on the financial statements is an important part of that.

Valuation

Enterprise Value and Market Value Last week I mentioned that sometimes I am at a 2loss for something 1 to post about on MBA Mondays . Andrew Parker , who got his MBA at Union Square Ventures3 (largely self taught) from 2006 to 2010, suggested in the comments that I post about the differences between Enterprise Value and Market Value. It was a good suggestion and so here goes. The Equity Market Value (which I will refer to as Market Value for the rest of this post) is the total number of shares outstanding times the current market price for a share of stock. To make this post simple, we will focus only on public companies with one class of stock. The Market Value is the price you are paying for the entire company when you buy a stock. 4

Let's use Open Table , a recent public company as our real world example in this post. Open Table (ticker OPEN) closed on Friday at $48.19 and has5 a "market value" of $1.1bn according to this page on 6 Tracked.com . According to Google Finance , Open Table has 22.77 million shares outstanding. So to check the market value calculation on Tracked.com, let's multiply the market price of $48.19 by the shares outstanding of 22.75 million. My desktop calculator tells me that is $1.096 billion. So if you purchase Open Table stock today, you are effectively paying $1.1bn for the company. But Open Table has $70 million of cash and has $11.6 million of short term debt outstanding. So if you paid $1.1bn 1

http://www.avc.com/a_vc/mba-mondays/ http://twitter.com/andrewparker http://www.avc.com/a_vc/2010/08/the.html#comment-65842545 4 http://www.tracked.com/company/open-table/ 5 http://www.tracked.com/company/open-table/ 6 http://www.google.com/finance?q=NASDAQ%3AOPEN 2 3

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for the company (as would be the case if your company purchased Open Table), then you would be getting $70 million of cash and a debt obligation of $11.6 million. So the Enterprise Value of Open Table, meaning the value of the business without any cash or debt, is a bit less than $1.1bn. To get the Enterprise Value, you calculate the Market Value and then subtract cash and add debt. When we do that, we find that Open Table currently has an Enterprise Value of $1.038bn. Not much difference in percentage, but almost $60mm in difference in dollars. There are some companies that have a lot of cash or a lot of debt relative to their Market Values and in those cases it is really important to do this calculation to get to Enterprise Value. We do a lot of valuation analysis on our portfolio companies, particularly the ones with a lot of revenues and profits. We do them mostly for our accountants as part of something called FAS 157 or "mark to market accounting". I am not a fan of FAS 157 and I've blogged about 7 it here before . But regardless of whether or not I think "mark to market" is the right way to value a venture portfolio (I do not), it is the current practice and we need to do it. When we do valuations, we often use public market comps to get "market revenue and profit multiples" and then we apply them to our portfolio companies. When you do this work, it is critical to use the Enterprise Values to get the multiples. Then when you apply the multiples to the target company, again you need to get an Enterprise Value and then work back to get Market Values. If you use Market Values to calculate multiples, you may end up with some really screwy numbers for businesses with a lot of cash or a lot of debt. So use Enterprise Values when you are doing valuations and calculating multiples.

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Bookings Vs. Revenues Vs. Collections 1

A reader suggested this topic for MBA Mondays . It is a good one. When a customer commits to spend money with your company, that is a “booking”. A booking is often tied to some form of contract between your company and the customer. The contract can be simple or very complicated. And some bookings do happen without a contract. Examples of these contracts with customers include an insertion order in advertising, a license agreement in enterprise software, and a subscription agreement in “software as a service” businesses. Revenue happens when the service is actually provided. In the case of advertising, the revenue is recognized as the ads are run. In the case of licensed software, the revenue is recognized when the software is delivered and accepted by the customer. In the case of a subscription agreement, the revenue is most often recognized ratably over the life of the subscription. The customer’s cash shows up in your company’s bank account when it is collected. That can happen at the time of booking the business (as is typical in subscription businesses), or it can happen at the time of revenue recognition (as it typical in ecommerce), or it can happen a long time after revenue recognition (as it typical in advertising). It is important to track all three of these metrics very closely. You want to know how much revenue your company has booked, you want to know what your monthly revenues are, and you want to know how much revenue you have collected, and most importantly, how much you have not yet collected (that is called Accounts Receivable). It is also possible to collect cash at the time of booking in advance of when the revenues will be realized. That is called deferred revenue and it is a liability because delivery of the revenue is an obligation of 1


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the company. Many companies have four revenue oriented items they track; bookings, deferred revenues, revenues, and collections. An interesting metric that many analysts and financial managers track is the book to bill ratio. You get that by dividing monthly (or weekly or quarterly) bookings by the revenues in the same period. If bookings are lower than revenues, that can be a negative sign. If bookings are a lot higher than revenues, that can be a positive sign. But it can also mean that your company is having a hard time getting revenue realized. In some industries, not all bookings turn into revenues. In the advertising business, for example, it is often the case that not all the booked business can be delivered (and thus recognized as revenue). This is a big issue in highly targeted advertising businesses. If you have such a business, it is important to track your yield which is the percentage of booked revenue that you actually deliver in a given period. I like to think of the bookings to billings to collections as the way revenues “flow” through the business. And since revenues are the life blood of any business, it is important to understand your company’s specific flow and measure it along the way.

Commission Plans

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Last week's2 MBA Mondays post about Bookings, Revenues, and Collections generated a number of comments and questions about sales commission plans. So I decided to ask my friend and AVC com3 munity member Jim Keenan to write a guest post on the topic. Jim's 4 blog, A Sales Guy , is a great read for those who want to get into the mind of a sales leader. So with that intro, here are Jim's high level thoughts on setting up commission plans. I know the discussion on this post is going to be a good one. So make sure to click on the comments link and if you are so inclined, please let us know what you think on this topic. -----

I get asked a lot how to build a good commission plan. I give the same answer every time. Keep it simple and align it with company goals. It amazes me how often companies screw this up. Sales people are coin operated. Tell them they get a buck if they go get a rock, you'll get a rock, a whole lot of rocks. Tell them they get two bucks for red rocks, you'll get a lot of red rocks, but fewer rocks in general.

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Sales people don't hear what you say; they hear what you pay! Commission plans need to do two things; motivate sales people and sell product. They should align what you say, with what you pay. The killer commission plan starts with two critical questions; 1) What do you want to sell? 2) How do you want the sales team to behave? Commission plans drive behavior, get it wrong or don't align commission incentives with the company’s goals you’ll get everything you don’t want and little of what you do want. What do you want to sell? Do you want to sell your existing products or your new products? Do you want to sell your services or your software? Do you want more revenue or higher margin? Answering these questions up front matters. Whatever you put in your commission plan you WILL get. Build your plan for what you want to sell. How do you want the team to behave? Do you want new accounts and new business or more business from existing accounts? If you want new accounts pay for hunting, if you want them to work the accounts you already have, then pay for farming. What ever you pay for you WILL get. Build your plan for how you want the team to act. The key is to sit down with finance, product and marketing with the 5 budget in hand and ask the questions; what do we need to sell by the end of the year? Where do we need the business to be? How much revenue do we need? How much margin do we want? How many new customers do we need? How much growth are we looking for? How do we define success at the end of the year? Once these questions are answered, incent the sales team to do exactly that. What ever you pay for you will get.

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Once the incentives have been nailed and properly aligned, make the plan dead, stupid, simple. Don’t overcomplicate it. Don’t try to be sophisticated, creating fancy algorithms and fancy spreadsheets filled with if/thens. Make the plan "simple stupid." A plan is simple stupid if a sales person knows exactly what they will be paid on a deal without looking it up. Simple plans motivate sales teams. They know what their deals are worth and chase them accordingly. Complicated plans de-motivate. When sales doesn’t know how much they will get paid on a deal, motivation is nipped. Make sure it’s easy for sales to figure out what they get paid on a deal by deal basis. In addition to being dead, stupid, simple, all plans must have accelerators. Don’t be greedy. Don’t look to cap sales earnings. If they are selling more, pay them more. Accelerators are when more commission is paid for a deal after a certain threshold is met, usually quota. Finally, AND most important, once the plan is done DON'T MESS WITH IT. Nothing is more detrimental to a sales environment than changing the commission plan on the fly. You have to live with what you have. Commission plans are the lifeblood of a sales team. Get them right; start counting the money. Get them wrong; it’ll be a long year. Remember; Sales people don’t hear what you say, they hear what you pay . . . so pay right.

What a CEO Does

What a CEO Does 1

I am posting this as a MBA Mondays post. But I did not learn this little lesson at business school. I learned it from a very experienced venture capitalist early in my post-MBA career. I was working on a CEO search for one of our struggling portfolio comapnies. We had a bunch of them. I started in the venture capital business just as the PC hardware bubble of the early 80s was busting. Our portfolio was a mess. It was a great time to enter the business. I cleaned up messes for my first few years. I learned a lot. Anyway back to the CEO search. One of the board members was a very experienced VC who had been in the business around 25 years by then. I asked him "what exactly does a CEO do?" He answered without thinking: A CEO does only three things. Sets the overall vision and strategy of the company and communicates it to all stakeholders. Recruits, hires, and retains the very best talent for the company. Makes sure there is always enough cash in the bank. I asked, "Is that it?" He replied that the CEO should delegate all other tasks to his or her team.

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I've thought about that advice so often over the years. I evaluate CEOs on these three metrics all the time. I've learned that great CEOs can and often will do a lot more than these three things. And that is OK. But I have also learned that if you cannot do these three things well, you will not be a great CEO. It is almost 25 years since I got this advice. And now I am passing it on. It has served me very well over the years.

What a CEO Does, Continued 1

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Last week's MBA Mondays post on What A CEO Does was a huge 3 hit. Matt Blumberg , who is one of the finest CEOs I've had the 4 pleasure5 of working with, wrote a follow-up post on the topic for his blog . I asked him if I could run it as a guest post here on MBA Mondays and he agreed. So, here's a bit more on What A CEO Does: ---What Does a CEO Do, Anyway? Fred has a great post up last week in his MBA Mondays series caled “What a CEO Does.“ His three things are set vision/strategy and communicate broadly, recruit/hire/retain top talent, and make sure there’s enough cash in the bank. It’s great advice. These three are core job responsibilities of any CEO, probably of any company, any size. I’d like to build on that premise by adding two other dimensions to the list. 1

http://www.avc.com/a_vc/mba-mondays/ http://www.avc.com/a_vc/2010/08/what-a-ceo-does.html http://twitter.com/mattblumberg 4 http://www.onlyonceblog.com/2010/09/what-does-a-ceo-do-anyway 5 http://onlyonce.blogs.com/ 2 3

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First, three corollaries – one for each of the three responsibilities Fred outlines. • Setting vision and strategy are key…but in order to do that, the CEO must remember the principle of NIHITO (Nothing Interesting Happens in the Office) and must spend time in-market. Get to know competitors well. Spend time with customers and channel partners. Actively work industry associations. Walk the floor at conferences. Understand what the substitute products are (not just direct competition). • Recruiting and retaining top talent are pay-to-play…but you have to go well beyond the standards and basics here. You have to be personally involved in as much of the process as you can – it’s not about delegating it to HR. I find that fostering all-hands engagement is a CEO-led initiative. Regularly conduct random roundtables of 610 employees. Send your Board reports to ALL (redact what you must) and make your all-hands meetings Q&A instead of status updates. Hold a CEO Council every time you have a tough decision to make and want a cross-section of opinions. • Making sure there’s enough cash in the bank keeps the lights on…but managing a handful of financial metrics in concert with each other is what really makes the engine hum. A lot of cash with a lot of debt is a poor position to be in. Looking at recognized revenue when you really need to focus on bookings is shortsighted. Managing operating losses as your burn/runway proxy when you have huge looming CapEx needs is a problem. Second, three behaviors a CEO has to embody in order to be successful – this goes beyond the job description into key competencies. • Don’t be a bottleneck. You don’t have to be an Inbox-Zero nut, but you do need to make sure you don’t have people in the company chronically waiting on you before they can take their next actions on projects. Otherwise, you lose all the leverage you have in hiring a team.

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• Run great meetings. Meetings are a company’s most expensive endeavors. 10 people around a table for an hour is a lot of salary expense! Make sure your meetings are as short as possible, as actionable as possible, and as interesting as possible. Don’t hold a meeting when an email or 5-minute recorded message will suffice. Don’t hold a weekly standing meeting when it can be biweekly. Vary the tempo of your meetings to match their purpose – the same staff group can have a weekly with one agenda, a monthly with a different agenda, and a quarterly with a different agenda. • Keep yourself fresh…Join a CEO peer group. Work with an executive coach. Read business literature (blogs, books, magazines) like mad and apply your learnings. Exercise regularly. Don’t neglect your family or your hobbies. Keep the bulk of your weekends, and at least one two-week vacation each year, sacrosanct and unplugged. There are a million other things to do, or that you need to do well…but this is a good starting point for success.

Outsourcing

Outsourcing This MBA Mondays topic was suggested by Aviah Laor, a regular member of this community. I'll start this post by describing outsourcing and explain why companies do it. Then I'll talk about outsourcing in the context of startups. Outsourcing is when a company hires another company to perform 1 certain functions. Wikipedia defines it as "contracting to third parties." The term has become synonomous with the transfer of labor/work overseas, but outsourcing is not geographically defined. You can outsource work to the company across the hall. The two primary reasons one company will outsource work to another company are cost and skill set. The third party outsourcing company can provide the required work at either lower cost or higher quality or possibly both. Sometimes time is also a factor. It is often the case than an outsourcing company can get the job done faster. All kinds of business functions can be outsourced. I have seen almost every part of a business outsourced at one time or another. But the most common things that companies outsource are software engineering, data entry/data hygiene, customer service, tech support, and financial record keeping/reporting. Startups are among the most active outsourcers. It makes sense. Typically the founding team has skills in one or two areas and doesn't have the entire set of skills to launch a business. So they outsource the tasks they don't have the expertise in. This can be a good thing but can also be a bad thing. 1

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Specifically, I think it is always a bad thing for the founding team of a software company to outsource software development. We see this a lot. A team will come into our office and pitch us. When I ask how many people they have, they say "this is all of us". Then I say, "who is writing code?" And they say, "we've hired a company to do that for us." That is a very disappointing moment for me because it means we almost certainly won't invest in that team. We believe that software companies must own their most important capability themselves and that is the ability to produce their product in house. The founding team of a software company should have a strong product manager on it (often that is the founder) and should have at least several strong software developers on it who can write most of the code. It does make sense to outsource some parts of software engineering from time to time. A common thing we've been seeing recently is outsourcing the development of a blackbbery app or some other kind of mobile app. Right now, that is still a fairly nascent skill set but we are also advising most of our portfolio companies to bring individuals in house to do that work because it appears that mobile app development will be a key skill set for our portfolio companies for some time to come. It is tempting for startups to want to outsource customer service and tech support because these are labor intensive activities that can be fairly easily outsourced to a call center, either in the US or even outside the US. At some point, most companies will outsource some of all of this work. But we do not believe startups should outsource this work until they are "all grown up" (whatever that means). Customer service and tech support are the best way for startups to talk to their customers. Sometimes it is the only way startups get to talk to their customers. And customer feedback is so very important to startups so it is critical for them to do this work in house. Data input and data hygiene is one area that we do think startups can and should outsource. This is not strategic for most startups and is often costly and time consuming work that can be easily outsourced.

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The function that most startups outsource in the beginning is financial record keeping and reporting. And that makes sense. Accounting and bookkeeping is a specific skill that most founders don't have. By outsourcing it, you make sure your books and records are kept accurately and up to date. I am a fan of outsourcing in general. I believe companies should develop those skills and functions that are their core competency and outsource the skills and functions that are not. I believe that the US should invest in outsourcing instead of demonizing it. I believe there is a lot of opportunity for economically weak regions of the US to use outsourcing to build their economies and grow. But for startups, outsourcing is a tricky issue. You should not outsource those things that are core competencies or critical feedback points. If you don't have the skills on your founding team to do that work, go find people who do and either hire them or bring them onto the founding team.

Outsourcing Vs. Offshoring 1

A lot of the 2discussion about last week’s MBA Mondays post on Outsourcing was about the differences between outsourcing locally and outsourcing outside your home country. A popular term for the latter approach is offshoring. The advent of modern electronic communications has allowed companies to efficiently source and manage labor all around the globe. This is one of the megatrends, if not the megatrend, of the current economic period we are living in.

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But just because you can use labor halfway around the world doesn’t mean you should. This post is about the pros and cons of offshoring from my perspective. On the plus side, offshoring often offers considerable cost savings. Labor costs in emerging markets are often a fraction of the labor costs in the developed world. And you can often tap into highly educated and skilled labor pools. We have companies in our portfolio that have built world class engineering teams in places like Belarus, Solvenia, and India. These teams cost less and often produce amazing work. AVC community member Ken Berger has been involved in building 3 a strong team of ruby engineers in Vietnam . I have no doubt that team can do excellent work at a fraction of the cost of a team of ruby engineers in San Francisco or New York. On the negative side, there are significant communication and management issues that arise when you have a team working half way around the world for you. Yes, you can Skype, IRC, Twitter, and IM all day long with your remote team. But often they want to be asleep when you want to be awake. Israeli tech teams are well known for their participation in critical product/tech meetings with their US counterparts in the wee hours of the morning. They might be in the meetings, but you have to wonder if they are at their best. But as problematic as the communications issues are, the management issues are even harder. You can outsource the management issues by hiring a firm to do your work for you. I am not a big fan of that ap4 proach, particularly for startups. As I outlined in my post last week , I believe startups need to directly employ the people doing the most critical tasks. And for a startup, that includes things that are commonly offshored like software engineering and customer support. And even if you outsource the management to an offshore firm, you will have to manage that firm. And managing vendors is often harder than managing employees.

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I have observed that hiring a local manager for a remote team is often the hardest thing to do. And you need a strong manager in place in your remote location if you are going to be successful. A weak manager of a remote team is almost always a disaster for your company. It causes delays and management messes that you will have to clean up. The most reliable technique I have observed is to ask a trusted and experienced team member to go overseas and launch/manage the remote team. That is a big ask and often is not possible. But if you can make that work, it has the highest probability of success. The companies in our portfolio that have done the best job with teams located in other parts of the world have had founders who came from those places or founders who spent significant time in those locations. They are able to source high quality talent and manage them, sometimes even remotely due to their familiarity with the people, place, and culture. Speaking of culture, you can’t overemphasize what a big deal it is having multiple cultures in your company. Some cultures take it easy in the summer and work hard in the winter. Some cultures have different approaches to gender in the workplace. Some cultures value respect more than money. Some cultures value money more than respect. Multiple cultures can often create tensions between offices and teams. Managing all of this is hard and I have not seen many do it exceptionally well. But I have also observed that as this kind of organization structure gets more common, entrepreneurs and managers are getting better at handling cultural complexity. The single most important thing you can do is get everyone, at least all the senior team members of the company, across all geographies, together on a regular basis. And I think it is not a good idea to always have the remote offices come to the home office. The home office needs to travel to the remote offices too. As I said at the start of this post, being able to source and manage talent all across the globe may be the signature megatrend of the current economic period. It has far reaching consequences for companies of all shapes and sizes. For startups, it offers lower costs and at times ac-

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cess to excellent skills and talent. But it comes with great challenges and you should not undertake an offshoring exercise lightly.

Employee Equity

Employee Equity One of the topics I get asked about most on MBA Mondays is "options." But options are only one form of employee equity. I am going to do a series of posts on this topic over the next month of MBA Mondays. I will start by laying out the logic for employee equity, going over some target ownership levels, and describing the various securities you can use to issue employee equity. One of the defining characteristics of startup culture is employee ownership. Many large companies provide employee ownership so this is not unique to startup culture. But when you join a startup, you have the expectation of getting some ownership in the company and if the company is successful and is sold or taken public, that you will share in the gains that result. Employee ownership is such an important part of startup culture. It reinforces that everyone is on the team, everyone is sharing in the gains, and everyone is a shareholder. I can't think of a company that has come to pitch us that has not had an employee equity plan. And I can't think of a term sheet that we have issued that didn't have a specific provision for employee equity. It is simply a fundamental part of the startup game. While employee equity is "standard" in the startup business, the levels of employee ownership vary quite a bit from company to company. There are a variety of reasons. Geography matters. Employee ownership levels are higher in well developed startup cultures like the bay area, boston, and NYC. They are lower in less developed startup communities. Engineering heavy startups will tend to have higher levels of employee ownership than services and media companies. I am not suggesting that is right or fair, but it is what I have seen. And

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if the founders are the top managers in a company, the level of "non founder employee ownership" will be lower. If the founders are largely gone from a company, the levels of "non founder employee ownership" will be higher. If the founders are the top managers in the company, then the typical "non founder employee ownership" will tend to be between 10% and 20%. If the founders have largely left the company, then "non founder employee ownership" will be closer to 20% and could be a bit higher. I like the 20% number as a target if for no other reason than it maps well to the VC business. The people providing the "sweat equity" typcally get 20% of the gains in our business (at USV we get 20%) and they should get at least that in the companies we back. I say "at least" because the founders are often still providing "sweat equity" and they can own much more than 20%. There are four primary ways to issue employee equity in startups: - Founder stock. This is the stock that founders issue to themselves when they form the company. It can also include stock issued to early team members. Founder stock has special vesting provisions among the founders so that one or more of them doesn't leave early and keep all of their stock. Those vesting provisions are extended to the investors once capital is invested in the business. Founder stock will typically be common stock and it will be owned by the founders subject to vesting provisions. - Restricted stock. This is common stock that is issued to either early employees or top executives that are hired into the company fairly early in a company's life. Restricted stock will have vesting provisions that are identical to standard employee option plans (typcially four years but sometimes three years). The difference between restricted stock and options is that the employee owns the shares from the day of issuance and can get capital gains treatment on the sale of the stock if it is held for one year or more. But issuing restricted stock to an employee triggers immediate taxable income to the recipient so it can be very expensive to the recipient and therefore it is only done very

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early when the stock is not worth much or when a senior executive is hired who can handle the tax issues. - Options. This is by far the most common form of employee equity issued in startup companies. The stock option is a right issued to an employee to purchase common stock at some point in the future at a set price. The "set price" is called the "strike price." I am going to do at least one and probably several ful MBA Mondays posts on options so I am not going to say much more now. - Restricted Stock Units. Knows as RSUs, these securities are relatively new in the startup business. They were created to fix issues with options and restricted stock and have characteristics of both. A RSU is a promise to issue common stock once the vesting provisions have been satisfied. The vesting provisions can include a liquidity event. So when you are getting an RSU, you are getting something that feels like an option but there is no strike price. When you get the shares, you will own them outright. But you might not get them for a while. I will end this post by imploring all of you entrepreneurs to hire an experienced startup lawyer. Employee equity issues are tricky. You can and will make a bunch of expensive mistakes with employee equity unless you have the right counsel. There are plenty of law firms and lawyers who specialize in startups and you should have one of them at your side when you are setting up your company and throughout its life. That is true for a lot of reasons, but employee equity is one of the most important ones.

Employee Equity: Dilution 1

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need to understand about employee equity; it is likely to be diluted over time. When you start a company, you and your founders own 100% of the company. That is usually in the form of founders stock. If you never raise any outside capital and you never give any stock away to employees or others, then you can keep all of that equity for yourself. It happens a lot in small businesses. But in high growth tech companies like the kind I work with, it is very rare to see the founders keep 100% of the business. The typical dilution path for founders and other holders of employee equity goes like this: 1) Founders start company and own 100% of the business in founders stock 2) Founders issue 5-10% of the company to the early employees they hire. This can be done in options but is often done in the form of restricted stock. Sometimes they even use "founders stock" for these hires. Let's use 7.5% for our rolling dilution calculation. At this point the founders own 92.5% of the company and the employees own 7.5%. 3) A seed/angel round is done. These early investors acquire 5-20% of the business in return for supplying seed capital. Let' use 10% for our rolling dilution calcuation. Now the founders own 83.25% of the company (92.5% times 90%), the employees own 6.75% (7.5% times 90%), and the investors own 10%. 4) A venture round is done. The VCs negotiate for 20% of the company and require an option pool of 10% after the investment be established and put into the "pre money valuation". That means the dilution from the option pool is taken before the VC investment. There are two diluting events going on here. Let's walk through them both. When the 10% option pool is set up, everyone is diluted 12.5% because the option pool has to be 10% after the investment so it is 12.5% before the investment. So the founders now own 72.8% (83.25% times 87.5%),

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the seed investors own 8.75% (10% times 87.5%), and the employees now own 18.4% (6.8% times 87.5% plus 12.5%). When the VC investment closes, everyone is diluted 20%. So the founders now own 58.3% (72.8% times 80%), the seed investors own 7% (8.75% times 80%), the VCs own 20%, and the employees own 14.7% (18.4% times 80%). Of that 14.7%, the new pool represents 10%. 5) Another venture round is done with an option pool refresh to keep the option pool at 10%. See the spreadsheet below to see how the dilution works in this round (and all previous rounds). By the time that the second VC round is done, the founders have been diluted from 100% to 42.1%, the early employees have been diluted from 7.5% to 3.4%, and the seed investors have been diluted from 10% to 5.1%.

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I've uploaded this spreadsheet to google docs so all of you can look at it and play with it. If anyone finds any errors in it, please let me know and I'll fix them. This rolling dilution calculation is just an example. If you have diluted more than that, don't get upset. Most founders end up with less than 42% after rounds of financing and employee grants. The point of this exercise is not to lock down onto some magic formula. Every company will be different. It is simply to lay out how dilution works for everyone in the cap table. Here is the bottom line. If you are the first shareholder, you will take the most dilution. The earlier you join and invest in the company, 3

http://www.avc.com/.a/6a00d83451b2c969e2013487f4abe4970c-pi https://spreadsheets.google.com/ccc?key=0AvqoGGDowi93dHdOWG5aMDNNVDJ4d2FqeXlFcWJCUFE&hl=en

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the more you will be diluted. Dilution is a fact of life as a shareholder in a startup. Even after the company becomes profitable and there is no more financing related dilution, you will get diluted by ongoing option pool refreshes and M&A activity. When you are issued employee equity, be prepared for dilution. It is not a bad thing. It is a normal part of the value creation exercise that a startup is. But you need to understand it and be comfortable with it. I hope this post has helped with that.

Employee Equity: Appreciation This is the third post in an MBA Mondays series on Employee Equity. Last week I talked about Dilution. This week I am going to talk about the antidote to Dilution which is Appreciation, specifically stock price appreciation. When you start a company, on day one the stock is basically worthless. There are some exceptions to this rule such as a spinoff company where Newco is getting some valuable assets day one. However in the vast majority of cases, the value of a startup on day one is zero. One of the objectives of an entrepreneur is to steadily increase the value of the business and the stock price. At some point, the Company will generate revenues and earnings and can be valued using traditional valuation metrics like discounted cash flow and earnings multiples. But early on in the life of a startup it is trickier to value the stock. Fortunately we have a marketplace for startup equity. It is called the venture capital business. Every time a startup raises capital, there is a competition between investors and a negotiation beetween the Company and the investors. Those two processes provide a mechanism to determine stock price.

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There is a growing trend to finance the 'seed stage' of a startup's life with debt, specifically convertible debt. One of the reasons I am not fond of convertible debt is that it obfuscates the equity pricing process. But that's a digression. So between the formation time when the stock price is most likely $0.01 per share (ie zero) and the time of exit at hopefully $100/share or more, there is a progression of price appreciation along the way marked by the progress of the business, financing events, and eventually revenues and earnings which lead to financial analysis. If you are an entrepreneur or an employee in a startup who has equity as part of your compensation, it behooves you to understand the appreciation in the value if your equity. One thing that you need to know is that the price doesn't always rise. There can be setbacks in the business that lead to price declines. There can be setbacks in the capital markets that make all businesses less valuable including startups. And if course your Company could fail in which case all of the employee equity will be worthless. In the case of a startup that becomes a successful business, the price will appreciate over time. There can be price declines or long periods of price stagnation, but if you are patient and the business succeeds, the employee equity will appreciate over the long run. There are some specific issues that require a deeper dive, including the impact of liquidation preferences and the role of a 409a valuation. I will tackle those issues in the comings weeks.

Employee Equity: Options A stock option is a security which gives the holder the right to purchase stock (usually common stock) at a set price (called the strike

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price) for a fixed period of time. Stock options are the most common form of employee equity and are used as part of employee compensation packages in most technology startups. If you are a founder, you are most likely going to use stock options to attract and retain your employees. If you are joining a startup, you are most likely going to receive stock options as part of your compensation. This post is an attempt to explain how options work and make them a bit easier to understand. Stock has a value. Last week we talked about how the value is usually zero at the start of a company and how the value appreciates over the life of the company. If your company is giving out stock as part of the compensation plan, you’d be delivering something of value to your employees and they would have to pay taxes on it just like they pay taxes on the cash compensation you pay them. Let’s run through an example to make this clear. Let’s say that the common stock in your company is worth $1/share. And let’s say you give 10,000 shares to every software engineer you hire. Then each software engineer would be getting $10,000 of compensation and they would have to pay taxes on it. But if this is stock in an early stage company, the stock is not liquid, it can’t be sold right now. So your employees are getting something they can’t turn into cash right away but they have to pay roughly $4,000 in taxes as a result of getting it. That’s not good and that’s why options are the preferred compensation method. If your common stock is worth $1/share and you issue someone an option to purchase your common stock with a strike price of $1/share, then at that very moment in time, that option has no exercise value. It is “at the money” as they say on Wall Street. The tax laws are written in the US to provide that if an employee gets an “at the money” option as part of their compensation, they do not have to pay taxes on it. The laws have gotten stricter in recent years and now most companies do something called a 409a valuation of their common stock to insure that the stock options are being struck at fair market value. I will do a separate post on 409a valuations because this is a big and important issue. But for now, I think it is best to simply say that companies issue

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options “at the money” to avoid generating income to their employees that would require them to pay taxes on the grant. Those of you who understand option theory and even those of you who understand probabilities surely realize that an “at the money” option actually has real value. There is a very big business on Wall Street valuing these options and trading them. If you go look at the prices of publicly traded options, you will see that “at the money” options have value. And the longer the option term, the more value they have. That is because there is a chance that the stock will appreciate and the option will become “in the money”. But if the stock does not appreciate, and most importantly if the stock goes down, the option holder does not lose money. The higher the chance that the option becomes “in the money”, the more valuable the option becomes. I am not going to get into the math and science of option theory, but it is important to understand that “at the money” options are actually worth something, and that they can be very valuable if the holding period is long. Most stock options in startups have a long holding period. It can be five years and it often can be ten years. So if you join a startup and get a five year option to purchase 10,000 shares of common stock at $1/share, you are getting something of value. But you do not have to pay taxes on it as long as the strike price of $1/share is “fair market value” at the time you get the option grant. That explains why options are a great way to compensate employees. You issue them something of value and they don’t have to pay taxes on it at the time of issuance. I’m going to talk about two more things and then end this post. Those two things are vesting and exercise. I will address more issues that impact options in future posts in this series. Stock options are both an attraction and a retention tool. The retention happens via a technique called “vesting”. Vesting usually happens over a four year term, but some companies do use three year vesting. The way vesting works is your options don’t belong to you in their entirety until you have vested into them. Let’s look at that 10,000 share grant. If it were to vest over four years, you would take owner-

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ship of the option at the rate of 2,500 shares per year. Many companies “cliff vest” the first year meaning you don’t vest into any shares until your first anniversary. After that most companies vest monthly. The nice thing about vesting is that you get the full grant struck at the fair market value when you join and even if that value goes up a lot during your vesting period, you still get that initial strike price. Vesting is much better than doing an annual grant every year which would have to be struck at the fair market value at the time of grant. Exercising an option is when you actually pay the strike price and acquire the underlying common stock. In our example, you would pay $10,000 and acquire 10,000 shares of common stock. Obviously this is a big step and you don’t want to do it lightly. There are two common times when you would likely exercise. The first is when you are preparing to sell the underlying common stock, mostly likely in connection with a sale of the company or some sort of liquidity event like a secondary sale opportunity or a public offering. You might also exercise to start the clock ticking on long term capital gains treatment. The second is when you leave the company. Most companies require their employees to exercise their options within a short period after they leave the company. Exercising options has a number of tax consequences. I will address them in a future blog post. Be careful when you exercise options and get tax advice if the value of your options is significant. That's it for now. Employee equity is a complicated subject and I am now realizing I may end up doing a couple months worth of MBA Mondays on this topic. And options are just a part of this topic and they are equally complicated. I'll be back next Monday with more on these topics.

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Employee Equity: The Liquidation Overhang 1

We're five posts into this MBA Mondays series on Employee Equity and now we are going to start getting into details. We've laid out the basics but we are not nearly done. I am just starting to realize how complicated the issues around employee equity are. That's not good. It's like paying taxes. Everybody does it and nobody but the tax accountants understand it. Ugh. Anyway, enough of that. Let's get into the issue of liquidation overhang. When VC investors (and sometimes angels) invest in a startup company, they almost always buy preferred stock. In most startups, there are two classes of stock, common and preferred. The founders, employees, advisors, and sometimes the angels will typically own common stock. The investors will typically own preferred stock. The easiest way to think about this is the "sweat equity" will mostly be common and the "cash equity" will mostly be preferred. For the sake of this post, I am going to talk about a simple plain vanilla straight preferred stock. There are all kinds of preferred stock and it can get really nasty. I am not a fan of variations on the straight preferred but they exist and they can make the situation I am going to talk about even worse. First, a quick bit on why preferred stock exists. Lets say you start a company, bootstrap it for a year, and then raise $1mm for 10% of the company from a VC. And let's say a few months later, you are offered $8mm for the company. You decide to take the offer. If the VC bought common, he or she gets $800k back on an investment of $1mm. They lose $200k while you make $7.2mm. But if the VC buys preferred, he or she gets the option of taking their money back or the 10%. In that 1


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instance, they will take their money back and get $1mm and you will get $7mm. In its simplest (and best) form, preferred stock is simply the option to get your negotiated ownership or your investment back, whichever is more. It is designed to protect minority investors who put up significant amounts of cash from being at the whim of the owner who controls the company and cap table. Now that we have that out of the way, let's talk about how this can impact employee equity. Anytime the value of the company is less than the cash that has been invested, you are in a "liquidation overhang" situation. If a small amount of venture capital, let's say $5mm, has been invested in your company, it is unlikely that you will find yourself in a liquidation overhang situation. But if a ton of venture capital, say $50mm, has been invested in your company, it is a risk. Let's keep going on the $50mm example. It comes time to sell the company. The VCs own 75% of the Company for their $50mm. The founders own 10%. And the employees own 15%. A sale offer comes and it is for $55mm. The employees do the math and multiply 15% times $55mm and figure they are in for a $8mm payday. They start planning a party. But that's not how the math works. The VCs are going to choose to take their money back in this situation because 75% of $55mm is roughly $41mm, less than their cash invested of $50mm. So the remaining $5mm is going to get split between the founders and employees. The investors are now "out of the cap table" so the final $5mm gets split between the founders and the employees in proportion to their ownership. The employees get 60% of the remaining $5mm, or $3mm. The party is cancelled. This story is even worse if the company that has $50mm of investment is sold for $30mm, or $40mm, or even $50mm. In those scenarios, the employee's equity is worthless. I know this is complicated. So let's go back to the basics. If your company has a lot of "liquidation preference" built up over the years, and

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if you think it is not worth that amount in a sale situation, your company is in a liquidation overhang situation and your employee equity is not worth anything at this very moment. You can grow out of a liqudation overhang situation. If this hypothetical company we are talking about decided not to sell for $55mm and instead grew for a few more years and ends up getting sold for $100mm, then the liquidation overhang will clear (at at sale price of $65mm) and the employees will get $15mm in the sale for $100mm. So being in a liquidation overhang situation doesn't mean you are screwed. It just means your equity isn't worth anything right now and the value of the company has to grow in order for your equity to be worthwhile. But it also means that a sale of the company during the liquidation overhang period will not be good for the employees. As JLM would say "you won't be going to the pay window." This issue is front and center in the minds of many employees who worked in tech companies in the late 90s and early part of the 2000s. The vast majority of companies built during that period raised too much money too early and built up large liquidation preferences. Many of them were sold for less than the liquidation preference and the investors lost money on their investments and the employees got nothing. That has hurt the value of employee equity in the minds of many. We are in a different place in the tech startup world these days. Many of our companies have raised less than $10mm in total investment capital. And the ones that have raised a lot more, like Zynga, Twitter, and Etsy, have enterprise values that are 10x the lquidation preferences (or more). This is the gift of web economics. It doesn't take as much investment capital to build a web company anymore. That has made investing in web companies better. And it has made being an employee equity holder in web companies better. But liquidation overhangs still do exist and when you are offered a job in a startup where equity is being offered, it is worth asking a few simple questions. You need to know how many options you are being offered. You need to know where the company thinks the strike price

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will come in at (they can't promise you an exact price). You need to know how many shares are outstanding in total so you can determine the percentage ownership you are being offered and the implied valuation of the strike price. And finally, you need to know how much total capital has been invested in the company to date so you can decide if there is a liquidation overhang situation. Just because there is a liquidation overhang doesn't mean you shouldn't take the job. But it's a data point and an important one in valuing the equity you are being offfered. Figure this stuff out going into the job. Because standing at the pay window and finding out there's no check for you is painful. Don't let that happen to you if you can help it.

Employee Equity: The Option Strike Price 1

A few weeks back we talked about stock options in some detail. I explained that the strike price of an option is the price per share you will pay when you exercise the option and buy the underlying common stock. And I explained that the company is required to strike employee options at the fair market value of the company at the time the option is granted. The Board has the obligation to determine fair market value for the purposes of issuing options. For many years, Boards would do this without any third party input. They would just discuss it on a regular basis and set a new price from time to time. This led to some cases of abuse where Boards set the strike price artificially low in order to make their company's options more attractive to potential employees. I sat on many Boards during this time and I can tell you that there was always a tension between keeping the strike price low and living up to our obligation to reflect the fair market value of the company. It was not a perfect system but it was a decent system. 1

http://www.avc.com/a_vc/2010/10/employee-equity-options.html

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About five years ago, the IRS got involved and issued a rule called 2 409a . The IRS looks at options as deferred compensation and will deem options as taxable compensation if they don't follow very specific rules. Due to rampant abuse of the deferred compensation practices in the late 90s and early part of the last decade, the IRS decided to change some rules and and thus we got 409a. The 409a ruling is very broad and deals with many forms of deferred compensation. And it directly addresses the setting of strike prices. 409a puts some real teeth into the Board's obligations to strike options at fair market value. If the strike prices are too low, the IRS will deem the options to be current income and will seek to collect income taxes upon issuance. Not only will the employee have tax obligations at the time of grant, but the company will have withholding obligations. In order to avoid all of this, the Board must document and prove that the strike price is fair market value. Most importantly, 409a allows the Board to use a third party valuation firm to advise and recommend a fair market value. As you might expect, 409a has given rise to a new industry. There are now many valuation firms that derive all or most of their income doing valuations on private companies so that Boards can feel comfortable granting options without tax risk to the employees and the company. This valuation report from a third party firm is called a 409a valuation. The vast majority of privately held companies now do 409a valuations at least once a year. And many do them on a more frequent basis. When your company grants options, or if you are an employee and are getting an option grant, the strike price will most likely be set by a third party valuation firm. You'd think this system would be better. Certainly the IRS thinks it is better. But in my experience, nothing has really changed except that companies are paying $5000 to $25,000 per year to consultants to value their companies. There is still pressure on the companies to keep the prices low so that their options are attractive to new employ2

http://en.wikipedia.org/wiki/Internal_Revenue_Code_section_409A

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ees. And that pressure gets transferred to the 409a valuation firms. And any time someone is being paid to do something, you have to question how objective the result is. I look at the fees our companies pay to 409a valuation firms as the cost of continuing to issue options at attractive prices. It is the law and we comply. Not much has really changed. There is one thing that has changed and it relates to timing of grants. It used to be that the Board could exercise a fair bit of "judgement" around the timing of grants and financing events. If you had a big hire and a financing planned, the Board could set fair market value, get the hire made, and then do the financing. Now that is so much harder to do. It takes time and money to get a 409a valuation done. Most companies will do a new one after they conclude a financing. And most lawyers will advise a company to put a moratorium on option grants for some time leading up and through a financing and do all the grants post financing and post the new 409a. This has led to a bunch of situations in my personal portfolio when a new employee got "screwed" by a big up round. It behooves the Board and management to be really strategic around big hires and financing events to avoid these situations. And even with the best planning, you will run into problems with this. If the company you are joining is early in its development, the strike price will likely be low and you don't have to pay too much attention to it. But as the company develops, the strike price will rise and it willl become more important. If the Company is a "high flyer" and is headed to a big exit or IPO, pay a lot of attention to the strike price. A low strike price can be worth a lot of money in a company where the value is rising quickly. In such a situation, if there has been a recent 409a valuation, you are likely in a good situation. If the company is a high flyer and is overdue for a 409a valuation, you need to be particularly careful. This whole area of option strike prices is complicated and full of problems for boards and employees. It has led to a growing trend away from options and toward restriced stock units (RSUs). We'll talk about them next week.

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Employee Equity: Restricted Stock and RSUs For the past six1weeks, we've been talking about employee equity on MBA Mondays . We've covered the basics, some specifics, and we've discussed the main form of employee equity which are stock options. Today we are going to talk about two other ways companies grant stock to employees, restricted stock and restricted stock units (RSUs). Restricted stock is fairly straight forward. The company issues common stock to the employee and puts some restrictions on the stock. The restrictions typically include a vesting schedule and some limits on how the stock can be sold once it is vested. The vesting schedule for restricted stock is typically the same vesting schedule as the company would use for stock options. I am a fan of a four year vest with a first year cliff. The sale restrictions usually include a right of first refusal on sale for the company. That means if you get an offer to buy your vested restricted stock, you need to offer it to the company at that price before you can sell it. There are often other terms associated with restricted stock but these are the two big ones. A big advantage of restricted stock is you own your stock outright and do not have to buy it with a cash outlay. It is also true that you will be eligible for long term capital gains if you hold your restricted stock for at least one year past the vesting period. There currently is a significant tax differential between long term capital gains and ordinary income so this is a big deal. The one downside to restricted stock is you have to pay income taxes on the stock grant. The stock grant will be valued at fair market value 1


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(which is likely to be the 409a valuation we discussed last week ) and you will be taxed on it. Most commonly you will be taxed upon vesting at the fair market value of the stock at that time. You can make an 3 83b election which will accelerate the tax to the time of grant and thus lock in a possibly lower valuation and lower taxes. But you take significant forfeiture risk if you make an 83b election and then don't vest in all of the stock. If you are a founder and are receiving restricted stock with nominal value (penny a share or something like that), you should do an 83b election because the total tax bill will be nominal and you do not want to take a tax hit upon vesting later on as the company becomes more valuable. This taxation issue is the reason most companies issue options instead of restricted stock. It is not attractive to most employees to get a big tax bill along with some illiquid stock they cannot sell. The two times restricted stock make sense are at formation (or shortly thereafter) when the value of the granted stock is nominal and when the recipient has sufficient means to pay the taxes and is willing to accept the tradeoff of paying taxes right up front in return for capital gains treatment upon sale. Recently, some venture backed companies have begun to issue restricted stock units (RSUs) in an attempt to get the best of stock options and restricted stock in a single security. This is a relatively new trend and the jury is still out on RSUs. Currently I am not aware of a single company in our portfolio that issues RSUs but I do know of several that may start issuing them shortly. A RSU is a promise to issue restricted stock upon the acheivement of a certain vesting schedule. It is a lot like a stock option but you do not have to exercise it. You simply get the stock like a restricted stock grant. And there is an added twist in some RSU plans that allow the recipient of an RSU to delay the receipt of the stock until the stock is liquid. Combined, these two features may remove all of the tax 2

http://www.avc.com/a_vc/2010/11/employee-equity-the-option-strike-price.html http://www.fairmark.com/execcomp/sec83b.htm

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disadvantages of restricted stock because the employee would not have a taxable event until the vesting schedule is over and possibly until the stock becomes liquid. I say "may remove all of the tax disadvantages" because I believe that the IRS has never tested the tax treatment of RSUs. Therefore RSUs are an "adventure in tax land" as one general counsel in our portfolio would say. I do not believe there is an optimal way to issue employee equity at this time. Each of the three choices; options, restricted stock, and RSUs, has benefits and detriments. I believe that options are the best understood, most tested, and most benign of the choices and thus are the most popular in our portfolio and in startupland right now. But restricted stock and RSUs are gaining ground and we are seeing more of each. I cannot predict how this will all change in the coming years. It is largely up to the IRS and so the best we can hope for is that they don't mess up what is largely a good thing right now. Employee equity is a critical factor in the success of the venture backed technology startup world. It has created significant wealth for some and has created meaningful additional compensation for many others. It aligns interests between the investors, founders, management, and employee base and it a very positive influence on this part of the economy. We strongly encourage all of our portfolio companies to be generous in their use of employee equity in their compensation plans and I believe that all of them are doing that.

Employee Equity: Vesting We had a bunch of questions about vesting in the comments to last week’s MBA Mondays post. So this post is going to be about vesting. Vesting is the technique used to allow employees to earn their equity over time. You could grant stock or options on a regular basis and accomplish something similar, but that has all sorts of complications and is not ideal. So instead companies grant stock or options upfront when the employee is hired and vest the stock over a set period of

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time. Companies also grant stock and options to employees after they have been employed for a number of years. These are called retention grants and they also use vesting. Vesting works a little differently for stock and options. In the case of options, you are granted a fixed number of options but they only become yours as you vest. In the case of stock, you are issued the entire amount of stock and you technically own all of it but you are subject to a repurchase right on the unvested amount. While these are slightly different techniques, the effect is the same. You earn your stock or options over a fixed period of time. Vesting periods are not standard but I prefer a four year vest with a retention grant after two years of service. That way no employee is more than half vested on their entire equity position. Another approach is to go with a shorter vesting period, like three years, and do the retention grants as the employee becomes fully vested on the original grant. I like that approach less because there is a period of time when the employee is close to fully vested on their entire equity position. It is also true that four year vesting grants tend to be slightly larger than three year vesting grants and I like the idea of a larger grant size. If you are an employee, the thing to focus on is how many stock or options you vest into every year. The size of the grant is important but the annual vesting amount is really your equity based compensation amount. Most vesting schedules come with a one year cliff vest. That means you have to be employed for one full year before you vest into any of your stock or options. When the first year anniversary happens, you will vest a lump sum equal to one year’s worth of equity and normally the vesting schedule will be monthly or quarterly after that. Cliff vesting is not well understood but it is very common. The reason for the one year cliff is to protect the company and its shareholders (including the employees) from a bad hire which gets a huge grant of stock or options but proves to be a mistake right away. A cliff vest

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allows the company to move the bad hire out of the company without any dilution. There are a couple things about cliff vesting worth discussing. First, if you are close to an employee’s anniversary and decide to move them out of the company, you should vest some of their equity even though you are not required to do so. If it took you a year to figure out it was a bad hire then there is some blame on everyone and it is just bad faith to fire someone on the cusp of a cliff vesting event and not vest some stock. It may have been a bad hire but a year is a meaningful amount of employment and should be recognized. The second thing about cliff vesting that is problematic is if a sale happens during the first year of employment. I believe that the cliff should not apply if the sale happens in the first year of employment. When you sell a company, you want everyone to get to go to the “pay window” as JLM calls it. And so the cliff should not apply in a sale event. And now that we are talking about a sale event, there are some important things to know about vesting upon change of control. When a sale event happens, your vested stock or options will become liquid (or at least will be “sold” for cash or exchanged for acquirer’s securities). Your unvested stock and options will not. Many times the acquirer assumes the stock or option plan and your unvested equity will become unvested equity in the acquirer and will continue to vest on your established schedule. So sometimes a company will offer accelerated vesting upon a change of control to certain employees. This is not generally done for the everyday hire. But it is commonly done for employees that are likely going to be extraneous in a sale transaction. CFOs and General Counsels are good examples of such employees. It is also true that many founders and early key hires negotiate for acceleration upon change of control. I advise our companies to be very careful about agreeing to acceleration upon change of control. I’ve seen these provisions become very painful and difficult to deal with in sale transactions in the past.

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And I also advise our companies to avoid full acceleration upon change of control and to use a “double trigger.” I will explain both. Full acceleration upon change of control means all of your unvested stock becomes vested. That’s generally a bad idea. But an acceleration of one year of unvested stock upon change of control is not a bad idea for certain key employees, particularly if they are likely to be without a good role in the acquirer’s organization. The double trigger means two things have to happen in order to get the acceleration. The first is the change of control. The second is a termination or a proposed role that is a demotion (which would likely lead to the employee leaving). I know that all of this, particularly the change of control stuff, is complicated. If there is anything I’ve come to realize from writing these employee equity posts, it is that employee equity is a complex topic with a lot of pitfalls for everyone. I hope this post has made the topic of vesting at least a little bit easier to understand. The comment threads to these MBA Mondays posts have been terrific and I am sure there is even more to be learned about vesting in the comments to this post.

Employee Equity: How Much? The most1 common comment in this long and complicated MBA Mondays series on Employee Equity is the question of how much equity should you grant when you make a hire. I am going to try to address that question in this post. First, a caveat. For your first key hires, three, five, maybe as much as ten, you will probably not be able to use any kind of formula. Getting someone to join your dream before it is much of anything is an art not a science. And the amount of equity you need to grant to accomplish these hires is also an art and most certainly not a science. However, a rule of thumb for those first few hires is that you will be 1


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granting them in terms of points of equity (ie 1%, 2%, 5%, 10%). To be clear, these are hires we are talking about, not co-founders. Cofounders are an entirely different discussion and I am not talking about them in this post. Once you have assembled a core team that is operating the business, you need to move from art to science in terms of granting employee equity. And most importantly you need to move away from points of equity to the dollar value of equity. Giving out equity in terms of points is very expensive and you need to move away from it as soon as it is reasonable to do so. We have developed a formula that we like to use for this purpose. I got this formula from a big compensation consulting firm. We hired them to advise a company I was on the board of that was going public a long time ago. I've modified it in a few places to simplify it. But it is based on a common practive in compensation consulting. And it is based on the dollar value of equity. The first thing you do is you figure out how valuable your company is (we call this "best value"). This is NOT your 409a valuation (we call that "fair value"). This "best value" can be the valuation on the last round of financing. Or it can be a recent offer to buy your company that you turned down. Or it can be the discounted value of future cash flows. Or it can be a public market comp analysis. Whatever approach you use, it should be the value of your company that you would sell or finance your business at right now. Let's say the number is $25mm. This is an important data point for this effort. The other important data point is the number of fully diluted shares. Let's say that is 10mm shares outstanding. The second thing you do is break up your org chart into brackets. There is no bracket for the CEO and COO. Grants for CEOs and COOs should and will be made by the Board. The first bracket is the senior management team; the CFO, Chief Revenue Officer/VP Sales, Chief Marketing Officer/VP Marketing, Chief Product Officer/VP Product, CTO, VP Eng, Chief People Officer/VP HR, General Counsel, and anyone else on the senior team. The second bracket is Director level

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managers and key people (engineering and design superstars for sure). The third bracket are employees who are in the key functions like engineering, product, marketing, etc. And the fourth bracket are employees who are not in key functions. This could include reception, clerical employees, etc. When you have the brackets set up, you put a multiplier next to them. There are no hard and fast rules on multipliers. You can also have many more brackets than four. I am sticking with four brackets to make this post simple. Here are our default brackets: Senior Team: 0.5x Director Level: 0.25x Key Functions: 0.1x All Others: 0.05x Then you multiply the employee's base salary by the multiplier to get to a dollar value of equity. Let's say your VP Product is making $175k per year. Then the dollar value of equity you offer them is 0.5 x $175k, which is equal to $87.5k. Let's say a director level product person is making $125k. Then the dollar value of equity you offer them is 0.25 x $125k which is equal to $31.25k. Then you divide the dollar value of equity by the "best value" of your business and multiply the result by the number of fully diluted shares outstanding to get the grant amount. We said that the business was worth $25mm and there are 10mm shares outstanding. So the VP Product gets an equity grant of ((87.5k/25mm) * 10mm) which is 35k shares. And the the director level product person gets an equity grant of ((31.25k/25mm) *10mm) which is 12.5k shares. Another, possibly simpler, way to do this is to use the current share price. You get that by dividing the best value of your company ($25mm) by the fully diluted shares outstanding (10mm). In this case, it would be $2.50 per share. Then you simply divide the dollar value

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of equity by the current share price. You'll get the same numbers and it is easier to explain and understand. The key thing is to communicate the equity grant in dollar values, not in percentage of the company. Startups should be able to dramatically increase the value of their equity over the four years a stock grant vests. We expect our companies to be able to increase in value three to five times over a four year period. So a grant with a value of $125k could be worth $400k to $600k over the time period it vests. And of course, there is always the possiblilty of a breakout that increases 10x over that time. Talking about grants in dollar values emphasizes that equity aligns interests around increasing the value of the company and makes it tangible to the employees. When you are doing retention grants, I like to use the same formula but divide the dollar value of the retention grant by two to reflect that they are being made every two years. That means the the unvested equity at the time of the retention grant should be roughly equal to the dollar value of unvested equity at the time of the initial grant. 2

We have a very sophisticated spreadsheet that Andrew Parker built that lays all of this out for current employees and future hires. We share it with our portfolio companies but I do not want to post it here because it is very complicated and requires someone to hand hold the users. And this blog doesn't come with end user support. I hope this methodology makes sense to all of you and helps answer the question of "how much?". Issuing equity to employees does not have to be an art form, particularly once the company has grown into a real business and is scaling up. Using a methodology, whether it is this one or some other one, is a good practice to promote fairness and rigor in a very important part of the compensation scheme.

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http://twitter.com/#!/andrewparker

Mergers and Acquisitions

Acquisition Finance 1

It's monday and it's time to move on from the MBA Mondays series 2 on Employee Equity . We did nine posts on employee equity and hopefully we moved the needle a bit on understanding that complicated topic. I'd like to switch topics3 now and talk about acquisition finance. The 4 other day Chris Dixon said this in a comment here at AVC : the two biggest tech companies alone (apple and google) are approaching $100B in cash that they will likely use for acquisition to support their incredibly profitable businesses The point Chris was making with that comment is there is a lot of buying power out there in the big tech companies that can be spent to buy tech startups. And he is right about that. Google has $34bn in cash. Apple has $50bn in cash and short term investments. Microsoft has $44bn in cash and short term investments. eBay and Amazon each have more than $5bn. The numbers add up to a lot of buying power out there. But just because they have the cash doesn't mean they will use it. There are a number of factors that acquirers consider before pulling the trigger on an acquisition. They look at whether the acquisition will improve or hurt earnings going forward. They look at how they will 1

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have to book the acquisition on their balance sheet. They look at how dilutive the acquisition will be to shareholders (even if it is a cash acquisition, they may need to issue employee equity for retention). And most of all, they attempt to determine how the acquisition will be recieved by their shareholders and what impact it will have on their stock price. I am calling this entire topic acquisition finance. I am not an expert on this topic but I've got a working knowledge of it and I am going to share that working knowledge with all of you over the coming weeks.

M&A Fundamentals This is the first post on the "acquisition finance" series we started last 1 week in MBA Mondays . I am going to try to lay out the basics of mergers and acquisitions in this post. Then we can move on to some details. As the term M&A suggests, there are two types of deals, mergers and acquisitions. Acquisitions are way more common. It is when one company is taking control of the other. A merger is when two like sized businesses combine. An example of a merger is the AOL/Time Warner business combination ten years ago. I am not a fan of mergers. I believe it is way better when one company is taking control of the other. At least then you know who is in charge. Mergers are very complicated to pull off organizationally. I have done a few mergers2 in the startup world. The best example is Return Path and Veripost which merged in 2002. The two companies started at about the same time, both got venture funding, and built almost identical businesses. They were beating each other up in the market and getting nowhere quickly. The management teams knew 1

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each other and the VCs (Brad Feld and yours truly) knew each other. We finally decided to put the two companies together in a merger. It 4 worked because we decided that Matt Blumberg , Return Path's CEO, would run the combined companies and because Eric Kirby, Veripost's CEO, was fully supportive of that decision. Even so, it was not easy to execute. Acquisitions are way more common and I believe way better. Most of the deals you can think of in startupland are acquisitions. A larger company is acquiring a smaller company and taking control of it. The next distinction that matters a lot is how the consideration is paid. The most common forms of payment are cash and stock. In fact, you'll often hear corporate development people say "it's a stock deal" or "it's a cash deal." Companies can pay with other consideration as well. Debt is sometimes used as consideration, for example. But in startupland, you'll mostly see stock and cash. Most people think cash is preferable. If you are selling your company, you want to know how much you are getting for it. And with cash, that is clear as crystal. With stock you are simply trading stock in your own company, which you control, for stock in someone else's company, which you don't control. However, over the years in maybe a hundred deals now I have made more money in stock based deals with the acquirer's stock than I have lost in acquirer's stock. I don't know if that is just my good fortune or not. But I certainly have had the experience of taking stock in an acquisition and having that stock crumble and lose it all. So if you are doing a stock based deal, make sure you do your homework on the company and its stock. The third and final distinction we will cover in this post is what the acquirer is purchasing. Typically the purchaser can either buy assets or buy the company (via its stock). If you are selling your company, you'll generally want to sell the entire company and thus all of its stock to the buyer. The buyer may not want to entire company and 3

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may suggest that it wants to do an "asset deal" which means it cherry picks what it wants and leaves you holding the bag on the unwanted assets and some or all of the liabilities. For obvious reasons, fire sales are often done as asset deals. Healthy companies with bright futures are not often purchased in asset deals. They almost always sell the entire company in a stock deal. If you are selling your company you should try very hard to do a stock deal for the entire company. That's it for this post. We've covered the three most important distinctions; merger or acquisition, paying with stock or cash, and buying assets or the entire business. We'll get into more detail on each of these issues and more in the coming weeks.

Buying and Selling Assets 1

MBA Mondays are back after a week hiatus. We are several posts into a series on Merger and Acquisitions. In our last post, 2we talked about the key characteristics of mergers and acquisitions . And we touched on the two kinds of purchases, the asset purchase and the company purchase. Today I’d like to talk about the asset purchase. As I said in the prior post, a buyer can either purchase the entire company or the buyer can purchase select assets and assume select liabilities. This kind of transaction is known as an asset sale. Asset sales can happen as a partial exit or a complete exit. In the partial exit, a company transfers certain assets and certain liabilities to another company in exchange for some consideration, and then continues operating as a going concern. In the complete exit, the company transfers all of the assets and liabilities that the acquirer is interested in and then winds down the company and settles all remaining liabilities and then liquidates. 1

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In the partial exit, the asset sale is a desirable transaction. It is the way that many spinoffs are done. Many companies will build or buy themselves into a diverse set of operating businesses and they ultimately realize that the business has gotten too complex to operate or too complicated to explain to investors. They can simplify their business by spinning off, selling, and otherwise exiting some, but not all, of their businesses. In the complete exit, the asset sale is often an undesirable transaction. If there is not going to be an ongoing business left after the sale transaction, it is most often best to get the purchaser to take all the assets and all the liabilities via a company purchase. The asset sale allows the purchaser to “cherry pick” the desirable assets and take on the liabilities they are comfortable with and leave the seller with undesirable assets and remaining liabilities. The seller then has to unwind what is left and liquidate the company. The seller may have to use some or all of the consideration that was given (cash or stock) for the desirable assets to settle the remaining liabilities. The seller cannot liquidate the business and take out the consideration before settling with the creditors. If the liabilities are larger than the consideration obtained, a bankruptcy or some other settlement procedure with creditors may be necessary. The asset sale may also be undesirable for tax reasons. In a company purchase, the acquirer purchases the stock from each of the stockholders and takes control of the entire business. The stockholders get a capital gain, either short term or long term depending on the length of time they held the stock. In an asset sale, the consideration goes into the seller’s company and is used to settle liabilities and wind down and liquidate. Any remaining cash after all that will be distributed out in a liquidating distribution. There may be taxes to be paid at the company level on the sale transaction which will further eat into the proceeds which can be paid out. And there is the possibility of taxation of the liquidating distribution depending on what kind of business entity the seller was operating. That is called “double taxation” and you want to avoid that in an acquisition transaction.


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There may be times when an exit is best done via an asset sale. I can imagine a set of circumstances where it might actually be desirable for a seller to do that. But those circumstances are not very common and it is generally true that if you are looking to exit a business, you want to do it via a company purchase transaction, not an asset sale transaction. If you are the acquirer however, asset purchases can be very desirable. They allow you to avoid liabilities you don’t want to take on and cherry pick the assets you want. In my experience, asset sale transactions are generally done in “fire sale” situations and company sale transactions are generally done in all other M&A transactions. At least that is how I’ve seen it done in venture backed technology companies. Next week we will talk more about the company sale transaction.