« "Managing" Your Board of Directors | Main | More on "Tough Questions" »

July 04, 2005

Some Tough Questions You Should Ask

If you want to raise money from VC’s, here’s a really tough, really important question you ought to ask yourself very early in the process: “How many co-founders should I have?” Having the wrong “answer” to this question can make your life difficult in some subtle (and odd) ways. Plus, unlike some miscalculations, here the wrong answer hurts only the founders, not the VC or later employees. Here’s how to look for the right answer.

Although entrepreneurs are motivated by things in addition to money, money’s important to everyone I’ve ever met trying to start a company. Monetary rewards in a startup, as everyone knows, ultimately derive from ownership of stock (not salaries or bonuses). Since there can never be more than 100% of the founders’ stock available for allocation, every co-founder should focus on ensuring that the allocation best matches the realistic, expected contributions of each founder to the success of the Company. 

In Silicon Valley (assume it’s the same in other startup regions), “founders” have a bunch of iconic attributes, some good, some bad.

Although we don’t, we should have a statue dedicated to “The Startup Founder” prominently displayed somewhere in Silicon Valley. Founders are passionate about their businesses, and will run through brick walls to make them succeed. In large part, Silicon Valley’s success is attributable to this passion and “never-say-die” attitude.

That’s the good part. 

Founders are also “expensive” in terms of equity (usually, and sometimes even rightfully, to reward them for taking the risk in joining a startup). Founders are harder than normal employees to transition out of the Company (not legally, just emotionally: “How can we fire Joe? He’s a founder.) Just like most people (including VC’s), founders usually have skills and experiences that are narrower than they, themselves, believe (even sincerely). And finally, founders don’t always pick their co-founders with a beady, cold-eyed, highly calculating gaze with a tough-minded focus on who can actually make the biggest contribution to the Company. Often, co-founders are picked because they are friends, or like-minded, or “great people, the kind you’d pick if you were in a foxhole under fire”. 

That’s the bad part. 

Let me illustrate the problem with a hypothetical (though not uncommon) four-person startup. 

Four friends decide to start a new company. After some jockeying (since they’re “peers” at their current company), they finally settle on the following titles, roles and percentages of the equity: (1) President and CEO (35%), (2) VP Marketing (25%), (3) VP Engineering (25%) and (4) VP Finance/CFO (15%).

To them, it seems logical to have these four (eventually) important business functions covered by the founding team. Moreover, these responsibilities roughly match their (perceived) skills and experiences, although none of them has ever had a title higher than Director, and none has ever had general management experience (i.e., responsibility for a complete P&L). 

They work hard on their business plan and actually come up with a very interesting idea. 

Having studied the “Ten Commandments for Entrepreneurs” at www.allensblog.typepad.com and mastered its lessons (sorry, had to do it), off they go to Sand Hill Road.

Because the idea’s interesting, they quickly arrange several first meetings at top-tier VC firms, but receive no call-backs. They know that the odds of getting VC financing are low, but can’t figure out why they are having no success at all. Without exception, their first meetings have been energetic and enthusiastic – and no one has pointed out any blind spots in their planning or preparation. 

As it turns out, the VC’s actually liked their idea a lot. The VC’s also actually liked two of the four founders (marketing and engineering) a lot, although no VC they met believed that either of them was ready for a “real” VP role. Unfortunately, when asked, the marketing founder and the engineering founder were defensive about deserving “their chance to step up to the VP level”. That paled, however, in comparison to the defensiveness of the CEO when questioned about his future role in the Company. Finally, the CFO couldn’t really describe what kinds of CFO-like duties he would perform for the first two years. Every duty he did describe could be done by a competent, high-level office manager. 

Spotted the problem….? 

Actually, there are several: (1) the CEO and CFO, who owned 50% of the founders’ stock, were not appropriate for their roles, (2) neither of the “continuing” founders was really ready for a VP role (and was defensive about the issue) and, though less importantly, (3) no startup needs a VP Finance/CFO. 

From the VC’s perspective, this is a deeply “broken” situation, despite the interesting business idea. And since the “broken-ness” involves founders (with all the iconic complexity that entails), “fixing” the situation involves some really hard work and tough decisions. Given the tensions (and lurid myths) that surround VC’s replacing founders, any VC with decent deal flow will simply move on to some other interesting startup that doesn’t have these problems. 

What’s the big deal? 

First, it is extremely difficult to transition a founder out of “their” company. Moreover, as hard as it is for the Board of Directors to make such a transition, it’s virtually impossible for the other, continuing co-founders to do it. After all, they were friends and “peers” who took a huge risk together, as well as a blood oath: “All for One and One for All!”. 

Second, even if it can be done, it’s usually “expensive” in terms of founders’ equity. Frequently, all founders have some form of accelerated vesting (or full vesting) of their founder’s stock if they leave the Company otherwise than by voluntary resignation. In our example, if some VC had loved the business idea enough to undertake the tough job of reorganizing the founding team, the departing founders would have taken as much as 50% of the founders’ stock with them. 

It’s important to note that it is NOT the VC or angel investor who gets screwed here – it IS the continuing co-founders. How so? Think about it for a second… 

When considering an investment, any investor, whether VC, angel or otherwise, will place a pre-money valuation on the Company when they offer to invest. That’s what they think the Company’s worth, regardless of who owns the founders’ stock (a slight oversimplification). If a good chunk of the founders’ equity is in the hands of co-founders no longer with the Company (and therefore who won’t contribute to its success), it doesn’t alter the investors valuation calculation. So, the continuing founders will end up with substantially less equity than they “deserve” – but not because the VC’s were unfair. 

In fact, it can actually be worse than this for the continuing founders. If enough stock has left the Company in the hands of the departed co-founders (in our hypothetical, up to 50%), an investor may simply decide that there isn’t enough equity left to properly motivate the continuing founders (calculating what additional stock must be reserved for future hires). In this case, the top-tier VC simply moves on to an equally interesting, but less troublesome, situation. 

What would have been a better strategy for this startup? Like everything else important in life, it depends…… 

In my next post, I’m going to suggest some things for entrepreneurs to consider as they put their founding teams together. 

Hopefully, they'll help.

In the meantime, however, before you prick your fingers and take the startup company blood oath, do the tough part and carefully evaluate who is on the founding team – you owe it to each other.

July 4, 2005 | Permalink

Comments

I think your post is very valuable insight for founders. Thank you for taking the time and for being so forthright.

Posted by: Alexander Muse | Jul 4, 2005 10:56:41 PM

Very good post. Excellent topic. I couldn't agree more. Unfortunately, many entrepreneurs (including myself) learn this lesson the hard way. I'm sure in your next post you'll discuss reverse vesting of restricted stock and company buy-back provisions for founders stock (with promissory notes) should a founder leave early -- for whatever reason.

Regardless of what is suggested, it is ultimately up to co-founders to be smart about choosing their team and realistic about titles and related experience. More importantly, founders have to understand that they are shareholders first and operators second. As such, they must agree to make decisions that are best for shareholders. It benefits them more in the end.

Posted by: Clarence Wooten | Jul 5, 2005 8:01:41 AM

Great post. Thanks for putting it up.

Posted by: Marc Hedlund | Jul 5, 2005 9:06:24 AM

Excellent post. I am looking forward to the next one as well.

Posted by: Alex Krupp | Jul 5, 2005 1:27:06 PM

Allen this is such invaluable information. Thank you for each post you've made. Straight shooting advice and to the point. Yours is a no frills, just business approach to VC funding.

Posted by: Mike D. | Jul 5, 2005 7:24:50 PM

I saw most of the problems you mention here in my last startup and it's really interesting to see the analysis of it.

It can be very emotional when these problems hit the fan and can break just about any good idea.

Right now I'm working solo on my next startup sans partners until the point that I feel I really need them.

Pelle

Posted by: Pelle | Jul 7, 2005 1:40:47 AM

Just posted a response on my blog Searching for a team. Click on my name to go their directly.

Posted by: Pelle | Jul 7, 2005 1:53:24 AM

I have run into this so many times. It is a bit tricky, because everyone has a pretty high valuation of their own capabilities and worth. Usually there is one guy, maybe two that are critical - the real entrepreneurs and visionaries - and the rest are along for the ride. The sad thing is that they can bring down the whole thing - if not at the beginning, then later on. In some ways, the best thing that can happen to a weak team like this is to not get funded at all. This allows the real people in the group - the ones that won't give up - to reassess their values and try again with a stronger group.

Another side of the coin is a group starting a company and some of them leaving - with founder's stock - before things take off, due to the efforts of the guys that stuck around and took the heat. So another rule - punish the unbelievers.

Posted by: David A. Smith | Jul 7, 2005 1:38:18 PM

This post is actually a great argument why entrepreneurs should AVOID VC if they possibly can. Here the argument seems to be that when the VCs have to fire some of the founders, the ones who remain get screwed. Because it's hard to "transition" [fire] founders from "their" company [their company]. And you know what? It is! If I owwned stock as a founder and some a**hole VC decided arbitrarily that I "wasn't the guy", and "transitioned" me, and I gave up a job or had invested my savings in the venture in good faith, you bet your buttcheeks I would keep my stock! Only a fool wouldn't. After all, it was the VC that was invited in--I already OWNED my shares.

It's a hard reality, kids: there would be no VC business without entrepreneurs (although if VCs could figure out how to make money without entrepreneurs they would leap at it, just like record execs would love to make profits without dealing with rock starrs and artists, whatever they say to the contrary). I have long believed--and I have been a successful VC AND entrepreneur--that most VCs secretly/subconsciously resent entrepreneurs, and for that reason try to sideline, dilute and "transition" them ASAP. What guy in his late 40s or 50s wants to see a bunch 30 year-olds get richer than him in 36 months, with money he is managing?

Most venture capital is NOT about building long-term businesses. It is about technology speculation and fast exits at high premiums to strategic buyers or frothy IPO markets. VCs are short-termers. Entrepreneurs of quality are not.

I advise anyone and everyone I deal with to avoid VC if at all possible. It's a rigged game, and unless you have lots of experience, you will lose. They play this game every day: double-dip prefs, anti-dilution, board seats, negative control covenants, founder vesting, etcetera.

I say: go get customers, build product, choose your own team, and make your own future. Keep your equity. That is what Gates, Dell and Ellison did. (According to Allen's logic, his firm would have "transitioned" Gates (a high-strung 19 year-old), Jobs (dropout, also high strung), Dell, Ellison and countless others.)

No matter what BS the VCs sling about value-add, it's really about value grab. This blog provides better arguments than I ever could.

Entrepreneurs: it is YOUR company. Don't be suckers. Focus on the customer and on profits, and you will be heading in thee right direction. VC is a lottery game where all the odds are against you.


Posted by: sparrow on a branch | Jul 11, 2005 5:03:03 PM

Wow, Allen.

Very well written and insightful. I think it applies to ANY entrepreneurial project. Many of the deals that I have seen fail collapsed around one or more founder's quirks. These become sacred cows that nobody was willing to do anything about.

Posted by: Robert Coleman | Jul 12, 2005 5:12:58 PM

This seems to be a chicken-and-egg problem. Many VCs I have met insist that an initial management team be formed prior to a funding event; however, the "top talent" managers can rarely be attracted prior to a significant funding event. Personally, I feel it is preferable to raise capital and then get the best, most appropriate talent, rather than form a pre-capital team with "b-string" players. Any thoughts?

Posted by: Anonymous Coward | Jul 13, 2005 9:35:16 AM

Dear Mr Allen
I came across your blog recently. I really appreciate every part of it. I had corrected what u told the posting in ascending order in My blog from 1 to 10 in order .. Thats very easy even u can do that just by a simple techniwue wont take more than 2 mins..

i really want to talk to you some times, can i give you a call ..

Thanks your admirer
vijaychandran

Posted by: vijaychandran | Jul 13, 2005 2:05:30 PM

I completely understand where Allen is coming from to the extent that you're drinking the kool-aid of VC funding and buy into their playbook for building a "world class" company with "world class" executives.

That being said, bravo to Sparrow on a Branch's post. VCs in their infinite wisdom today would have in fact fired Gates, Ellison, and Jobs (in fact, they did fire Jobs and the company has only really rebounded since his return). They are looking to mitigate their risk which in many cases increases their risk substantially. I've seen it more times than the other way around.

Moreover, its not like Allen has had some big win with any of his investments, so I don't know where he gets off knowing that two of the four founders need to be replaced in his example. How do you know that after one meeting? Did you learn that at Wilson Sonsini? If so, when?

For example, is Tribe going to be more success now that Mark Pincus is gone and you've brought in the "world class" executive who ran WebSwap into the ground?

Or does Eric Schmidt actually do anything at Google? Thank God Larry and Sergey had enough control over the company not to be fired by their "world class" VCs who forced them to find a CEO. Let's be honest, Eric Schmidt has enough time to teach a class at Stanford that he never misses. Do you know any active CEO who can find that kind of time? Larry and Sergey are really running that company and last time I checked they were not so seasoned.

If VCs have some crystal ball that tells them the algorithm for replacing founders and bringing adult supervision, I don't want it. It doesn't work.

My fear is that while this blog gives people an insight into how decisions are made at second rate VCs, it is not focused on what people need to do in order to build a successful company out of nothing: building a great product, finding customers, recruiting a great team.

Allen, do you have some thoughts or best practices along those lines? I ask that sincerely.

Posted by: Vanilla Chin | Jul 19, 2005 1:58:11 PM

Great post, looking for the next one.

Posted by: Ruchit | Jul 26, 2005 4:46:07 AM

Great post.

I've a story on what can happen in a "normal startup"

2 founders (CEO & CTO) started off on 1 biz plan, then one of the founders (CEO) realized that the plan was flawed and executed a 2nd plan without the support of the CTO (the CTO did services work to bring in some revenues)- the 2nd plan worked really well.

The CEO went to VC's, got a term sheet.... and then the CTO wouldn't co-operate - he would only dilute the same as the CEO - no recognition for turning the biz around, and no recognition for the 3 grunt developers who made it happen.

The CEO walked... he couldn't sign up to building the business with a "co-founder" who was not based in the realities of startup business life.

The business failed to obtain additional funding and ceased trading

its a scary story, but one that has probably happened quite a bit

regards
Bill


Posted by: Bill Smith | Aug 5, 2005 10:47:55 AM

Assuming what Sparrow-on-a-Branch said is true and that he has been both “ … a successful VC AND entrepreneur …”, then his post is fantastic since it would be based on personal experience and insights. Otherwise, it would be like listening in on an argument on the merit between French and German when the person speaks only Chinese.

The bottom-line is that we live in a very rich society and that there is a solid middle class. So even though the country as a whole is in tremendous debt, the individuals as a people have significant net worth. For our retirement and our children, we have put our money in real estates, bonds, stock, term-life insurance, mutual funds or may be even endowment.

These are instruments that we can deploy to balance risk and reward. So VC is actually our own creation. If all consumers got together and decided that they would rather take lesser returns in exchange for lower risks, there wouldn’t be any VC’s. In fact, if we keep all of our money in cash, there wouldn’t any bankers.

VC’s are money managers no different from brokers or stock traders. We pay them a fee in exchange for professional services. They are agents and they make financial decision on our behalf. The only difference is that VC’s are agents’ agents meaning that they manage money for people who manage other people’s money.

As an instrument, VC funds have to have higher returns which mean that VC's have to take higher risks. If they don’t take higher risks, they couldn’t survive as VC’s. But unlike entrepreneurs, their passion is not in building companies; VCs’ passion should be in making money because that is the only reason that we as consumers would allow them to exist.

As a consumer, we make consumer decision. As an entrepreneur, we make investment decision. We can decide to use our own money to build companies or we could decide to use other people’s money. If we take money from VC’s, then we have to play by their rules because after all, as consumers, we are the ones who created them.

I really like Allen’s writing because I don’t believe he is telling the entrepreneurs what to do. What he is doing is telling us what the rules are. Some readers seem to think that Allen is condescending. Not at all, Allen is doing what he does because he respects entrepreneurs and as a VC, he desperately needs us.

But we don’t have to deal with the VC rules if we don’t take VC money. Not taking VC money does not mean that we cannot create great companies. Not taking VC money does mean that the Founders are in total control of their own destiny. In fact, I believe nowadays, entrepreneurs really cannot afford to take money from VC’s.

http://www.lightreading.com/document.asp?doc_id=74632

Posted by: Denny K Miu | Aug 12, 2005 5:00:55 PM

i have been there and done that as a co-founder in almost this exact situation. we had 5(!) co-founders (though one was a 5% co-founder) and when two of them departed it made things difficult for those of us who stayed for exactly the reasons outlined above.

Posted by: just.a.guy | Sep 13, 2005 2:31:21 PM

For

"As it turns out, the VC's actually liked their idea a lot. The VC's also actually liked two of the four founders (marketing and engineering) a lot, although no VC they met believed that either of them was ready for a 'real' VP role. Unfortunately, when asked, the marketing founder and the engineering founder were defensive about deserving 'their chance to step up to the VP level'. That paled, however, in comparison to the defensiveness of the CEO when questioned about his future role in the Company. Finally, the CFO couldn't really describe what kinds of CFO-like duties he would perform for the first two years. Every duty he did describe could be done by a competent, high-level office manager.

Spotted the problem?"

I have to conclude that on what is necessary for "the VP level” you are taking a common but unfortunate turn off a good road into a hopeless swamp. It sounds like you passed on a possibly good investment for a poor reason.

Sure, sometimes, perhaps too often, can interview someone and have to conclude that they will not be able to function well. It is easy to list various obvious disqualifications.

Beyond the obvious, however, the evaluations quickly descend into little more accuracy than tea leaf reading.

We can be clear on this point: If anyone, anyone at all, really knows what in any reasonably precise terms is really special and necessary and sufficient for "the VP level”, then they should immediately sequester themselves with a word whacking computer, type in their astounding knowledge in really clear and well documented terms, and submit the result to a book publisher. The result should be a best seller and, possibly, a Nobel prize in economics.

The simple clear fact is that no one, no one at all, despite decades of business management book publishing experience, has more than a weak little hollow hint of a tiny clue about anything special for "the VP level”. One way to see this point is to look at people successful in "the VP level” work and extract the set of important characteristics in common -- beyond what is obvious, the set will be nearly empty. Another way to see this point is just to go to the huge collection of books that have tried to say what is needed for business management, select any two books by two different authors, compare the books, and find the points of clear agreement. There will be nearly none. This situation for books on management is in strong contrast to books on mathematics, physical science, and engineering where there is detailed agreement across broad areas of the subjects.

The evidence from real business -- FedEx, Apple, Oracle, Microsoft, Dell, Google -- is strong that what one needs to know about 'business' and 'management' for "the VP level” can be learned very quickly and that years of 'stellar professional management experience' can still lead to disaster -- e.g., losses at IBM, AT&T, GM. More generally, the shores of each major body of water in the US are dotted with yacht clubs with members who did well in business, and mostly they are owners of businesses they started and grew themselves learning 'business', 'management', and "the VP level” lessons on the way as needed. In broad areas of US society -- business, education, military -- commonly people quickly learn to do well in general management, finance, etc. for groups as large as 200 people.

A. Bechtolsheim looked at L. Page and S. Brin and saw Google; he did not see just two graduate students who may have never managed anything larger than a beer party or funds larger than their personal checkbooks and not ready for "the VP level”, much less the president and CEO level. L. Groves had managed the group that built the Pentagon and then looked at J. Oppenheimer, who may never have managed more than a few graduate students, and gave him management of the most important part of the $3 billion or so Manhattan Project. Yes, IBM management looked at W. Gates and his Micro-Soft and laughed at any suggestion that his company could be serious competition for mighty Big Blue. G. Marshall looked at D. Eisenhower, who had never managed more than a small planning group, and gave him management of the invasion of Africa and, later, the invasion of Europe.

At a high technology start-up company with fewer than a dozen employees, for some months the concentration will be on the technical work and nearly all the rest should be doable "by a competent, high-level office manager".

Some work really does have some definite and significant necessary qualifications: Playing the Beethoven violin concerto or a Beethoven piano concerto, playing one of the Bach pieces for unaccompanied cello, or being an executive chef at a three star Michelin restaurant, a heart surgeon, a Federal judge, or a research mathematician take years of difficult intense training; real world evidence is that the lessons of 'business', 'management', and "the VP level” take very little.

Yes, for centuries one of the biggest advantages of society was specialization, and one result was large organizations. Now, one of the biggest bottlenecks to progress in society is large organizations with a limited view for outsiders which leads to a difference between appearances and reality. So, we can too easily have a situation where (A) a relatively powerless hired 'professional' manager largely ignores what is good for the long term and, instead, does mostly just what looks good for the short term to outsiders but (B) a dedicated vested founder with a lot of control does what really is good for the long term and largely ignores what anything looks like for the short term to outsiders. An investor on a board with a hired CEO, at each board meeting, needs to look that animal in the mouth all the way to its tail to be sure what is being seen is long term reality instead of short term fantasy. Being confused about the qualifications for "the VP level” is a poor start on the necessary looking.

All these problems form a reason that one of the best aspects of the US -- one of the best ways around the swamps of nonsense -- is the relative ease of starting a business. In particular, one of the great current opportunities is the software business where the main capital needed can be just a personal computer which costs much less than the equipment for an auto repair shop, an auto body shop, a restaurant, or even a lunch wagon. Can help to know monotone locking protocols, Cartesian trees, extensible hashing, and more, but a broadband connection, Google, and the links there can be a terrific technical library! It can also help to know ergodic theory!

All entrepreneurs grab your ankles: Your technical knowledge, abilities, and accomplishments are nothing. All that counts is the grand magical indescribable inscrutable unsupportable ethereal wisdom of experienced marquee professional CEOs, CFOs, and marketing people selected by your Board with three helpful active hands-on venture capitalists who majored in history, never took advanced calculus, don't know a Watt from a Joule, never wrote a line of software, and deeply, profoundly, bitterly, hate, despise, and resent nerds!

Nerds: Creating value should be enough; don't let someone who believes that their study of history or some such and neglect of technical subjects gave them superior insight into human character manipulate you into handing over what you have created for no good reason!

Posted by: Norm Waite | Oct 28, 2005 1:37:06 AM

You are right on!

The amount of "startups" which fail because of founder greed and inflexibility are astronomical.

Posted by: Lowell Nicholas | Dec 14, 2006 1:49:28 PM

thankyou

Posted by: sohbet | May 7, 2007 3:46:36 AM

Post a comment