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Monday, December 12, 2011

Startup Saturday Bangalore - December-2011 - Should you spend your money or someone else's?

After hearing a lot about Headstart.in and Startup Saturdays and after having read a lot about startup communities and their importance in various blogs (including Paul Graham's) I attended this month's Bangalore edition of Startup Saturday. I must say that I totally loved it and am really sad that I did not attend it earlier. Well, better late than never.

This edition's broad focus was on funding and equity distribution. Here is a link to the event description page. We had Suresh from Telibrahma and Sujai from Sloka Telecom sharing their experience and some of the nitty-gritties associated with securing funding for your startup and managing equity and stakes. Here are a few things that I grasped and managed to remember.

For those in a hurry, there is a tl;dr section at the bottom. I know your time is precious and I blabber a lot. :)
  1. Start your company with an exit clause in the agreement with your partner

    Suresh pretty much started the discussion with this point. When you start your company decide first off what the founders are going to do with their share of equity in case they leave the company. You might be thinking that it is such a negative thing to start with, but Suresh made it clear enough that it is essential, irrespective it's positive or negative influence. The rationale is that things look very good at the beginning and everyone is absolutely positive and hopeful, but it is very likely that not all founders will share the same amount of enthusiasm and hope as time passes by. Reasons could be various, but it can just happen. One of the founders might just want to move out at some point. Such an event shouldn't derail your company/organization. This is why it is better (and pretty much essential) to have an exit clause in the initial agreement. The specifics can be anything. You might choose to compensate the person moving out based on the amount of years he/she has put in or the initial investment they came in with or whatever. Just be sure that it is there in black and white in an unambiguous way. You do not want a member of your founding team going out shouting, bringing the morale of the team down, now do you?

  2. Do not hesitate to talk about money and stake. Finalize it ASAP

    This is sort of a follow-up point to the previous one. Whenever a startup is formed by a group of people, which is very common, specifically by a group of friends, which is even more common, there can be some stigma about discussions around stake and percentages. There might be one or two members who feel that talking about such things very early is a sign of lack of trust and is not really a good way to start with. As Sujai and Suresh said, this isn't really so. It is always better to finalize these matters at the earliest, no matter how delicate they are. In fact you should do it at the earliest because they are delicate. You do not want to be dealing with them in a crunch situation, which might just worsen the case. So act mature and deal with it, of course in a fair way.

  3. Term sheets are very flexible. Use it to achieve a common ground during negotiation

    It is very common to come up with valuations vastly different from the investor's when you are trying to raise money. In some cases it can be so vast that the middle ground itself is unacceptably far for both the entrepreneur and the investor. For example when raising very early stage funding from an angel investor you might value your company at $1 Million, because you think your idea is kickass and totally innovative and you seem to have a perfect plan. OTOH, the investor values your company at nothing more than $100K, because all you have is an idea and your own expertise/experience. The average of the two numbers is just not acceptable to both of you. But both you and the investor might like each other (the frequency just matches) and you want money and the investor wants to invest. In such a case you can use the term sheet to achieve middle ground. You can tell the investor to give you money at your valuation, and say after a year or two when you go for a bigger round of funding with $5M or $10M valuation, the angel investor will get some perk - like he gets shares at a discount or he gets an outright payout (like interest or dividend on what he invests now) or whatever. But if you fail to reach that goal within the stipulated time, then the angel investor will get some more stake to match "his" initial valuation.

    This is just an example and terms can be anything that you can negotiate for. The idea is that if there is a good match between the entrepreneur and the investor, then the deal should not fall through just because of  differences in valuation. This of course doesn't mean that you should accept money at any crappy valuation that an angel or a VC is throwing at you. See the next point. Also you should not expect investors to put in money at insane valuations just because you got a very innovative product. Be reasonable.

    If you are new to Term Sheets check out this and this.

  4.  It's a good deal only when both parties are happy

    Often entrepreneurs think that investors are out there to squeeze everything they can from the founders and that one has to be very cautious when dealing with investors. What both Suresh and Sujai said was that a good investor will make sure that the founders will get a good deal, even in cases when all that the founders (typically engineers) know about finance is addition and subtraction. The reason is that, if the VC "tricks" the founders into shelling out a lot of equity for a small sum of money, it is very likely that the founders will lose the motivation to keep going. If all that they own (collectively) is something like 20% or 30% they will soon feel like they are slogging for the investor and there is nothing in there for themselves. This is the worst thing that can happen to a startup. If the founders themselves are not motivated enough, the startup will come to a screeching halt in no time. Alternately, another "good" investor might come along and woo the founders away to form a new company where they really have sizable stake and actually feel like "founders". So both entrepreneurs and investors should go home happy after a deal. If you are not happy with the deal it's better you walk away. Sujai even went on to say that it's better not to deal with investors whom you don't think you can work with without two strips of aspirin, even when the valuation is close to what you want or even more. It's just not worth the headache it will eventually generate. But if your company is dying and you are absolutely in need of cash, then it's a different situation altogether.

    This piece of wisdom also applies to equity that is given to the co-founders and early employees. Do not be very stingy is handing out equity. Remember that when you get a co-founder or when you hire someone, you and that person are making a deal too. And like every other deal this one should keep both the parties happy. If you do not give sufficient equity to keep them motivated, eventually they will have no reason to stay with you. They will all be working their asses off. You better keep them motivated. Otherwise someone nicer will come along and take them away to their company with a much better offer. Also investors do consider the equity distribution amongst co-founders and the initial team. If they find it highly distorted they will very likely refrain from investing because they are not confident that the team will stick around. This doesn't mean you give out equity like a charity program. It is good (and often necessary) that you as the founder will retain a majority stake. This brings me to the next point.

  5. There should be a LEADER  -- a MAJORITY STAKE HOLDER

    As mentioned in the second point, when a group of friends join hands to start a company, the general tendency is to distribute equity equally among themselves. For example 4 friends starting a company might end up owning 25% each. This is very very bad. Both Suresh and Sujai strongly emphasized that there should be a leader (call him/her a CEO or MD or anything) who is also a Majority Stake Holder. It is very common to hit deadlocks, get into conflicts, during product design or in cases when you have to pivot and it becomes essential that there exists a leader who can resolve these conflicts and take a decision. In the absence of a leader the conflict will persist delaying the process or decision making. Time being an essence in startups, such leader-less scenarios lead to the death of a startup, often with the people involved getting upset with each other. Some might say that they prefer to have a "flat hierarchy" and will take collective decisions. It all sounds good, but doesn't really work always. A leader doesn't mean a dictator. The leader will still invariably consult his team before taking any significant decision. Having a leader also makes interaction with outside parties easier. A customer or an investor doesn't have to deal with 3 to 4 people for the same thing. Doing the same work repeatedly is no fun for anyone (unless you are a body building freak).

  6. LEADER should act like one. He/She is the face of the company

    This is something that my manager (also a very good friend and a mentor) at a previous company explained to me when I said I want to go out and join a friend in his start up venture.
    Being a leader is not just about holding a title or exercising your superiority during a discussion/conflict. The leader will be the face of the company and is as such thought of as a reflection of the company. When investors put in their money, they invest not just in the idea or the product, but also in the people and very specifically the leader. They expect the leader to steer the company towards success. It is the leader's ability that they trust. Consequently any wrong doing on the leader's part will reflect very poorly on the whole company. Integrity is of utmost importance. For example one might feel a sense of achievement in "tricking" investors with false promises or similar things. But it will create a permanent dent in the image of the company (and also that person). Also, the leader should command respect within the company by virtue of his/her actions and thought process. So choose a wise leader, think a lot before choosing one, especially when you are choosing yourself. (Yeah, the last line is my addition :) )

  7.  You will miss your first deadline - Learn to live with it

    Almost every startup start's with a "perfect plan" and with the hope and confidence of "perfect execution" of that plan. You look at the money you have and you feel that you are good to go for a year. Then you look at the idea, discuss about the product, make a plan for the implementation, possibly meet potential customers and promise them a delivery date (mostly a very aggressive target). You then foresee that you are going to get money in 8 months or you will be able to raise good amount of money from investors in not more than 10 months. Isn't that fantastic? You are so safe..!

    But this rarely, if not never, happens in reality. Sujai spelled it out that each and everyone of us is going to miss our first deadline/target. So one has to learn to live with it, get over it and continue working towards the target. This doesn't mean that we all plan so badly. It's just that the startup environment is so dynamic. There is a lot of flux and uncertainty. It's better to come mentally prepared for shocks and than to come in overly optimistic and get bogged down by these unexpected setbacks.
  Here are the main points. If you find something interesting you can go back up and read it in full.
  1. Start your company with an exit clause in the agreement with your partner
  2. Do not hesitate to talk about money and stake. Finalize it ASAP
  3. Term sheets are very flexible. Use it to achieve a common ground during negotiation
  4. It's a good deal only when both parties are happy
  5. There should be a LEADER  -- a MAJORITY STAKE HOLDER
  6. LEADER should act like one. He/She is the face of the company
  7. You will miss your first deadline - Learn to live with it
This discussion was followed by a product demo by Saptarshi from Quikast. They are building some cool stuff. I wish them all the best.