Note: This post also published at NextView’s blog for seed stage companies The View From Seed.
The startup ecosystem is often full of hyperbole, which is perfectly understandable when you think about it. A population of founders, employees, investors, advisors, and others all aligned in trying to build large disruptive businesses is naturally prone to lofty, even over-the-top language.
But the reality of tech entrepreneurship is that not everyone is “killing it,” and certainly not all of the time.
Not every startup is going to “crush” their original milestones and financial projections.
Not every round of funding is closed at a “monster” valuation.
And even acquisitions painted as successes may look very different below the (typically confidential) surface.
This has very real consequences that founders should consider — both for their relationships with investors and for the success of their current and future ventures (and therefore the many people likely tied to these ventures).
The Power of Perception
I saw this firsthand with my own experience as an early PayPal employee. PayPal ultimately became a very successful company. We went public in 2002 and eBay bought the company later that year for over $1.5 billion. Today, PayPal is poised to become a very large standalone company again.
But during the year 2000, we went through three different CEOs, fraud nearly killed the company, our revenue was negligible and unproven, and at our worst point, the company was burning well over $10 million a month — A MONTH!
As a VC investor, I’ve seen numerous other companies face challenges too — both in businesses that were ultimately successful and those that ultimately failed.
Our industry is so enmeshed in TechCrunch headlines, the Twitterverse, and offline chatter at networking events that it’s easy to believe that everyone else is killing it. This is the vernacular of today’s startup ecosystem, for better or worse.
But here’s the very troubling byproduct of this: I’ve met plenty of entrepreneurs who, surrounded by this hype, find it hard to manage when their own startup hits challenges, which are inevitable in any startup (even successful ones like PayPal). If you perceive everyone to be “killing it,” then it’s nearly impossible to speak up as the “only” person that isn’t.
How can we put things into context? And when and how should founders communicate challenges with their employees, investors, or other stakeholders?
Since this hyperbolic culture can and does prevent founders from seeking help — despite all founders needing it at some point or another — these questions are actually worth answering today.
It seems simple, but the first step is being honest with yourself as a founder, and being honest with your co-founders. Don’t shrug off poor sales or user growth, a dysfunctional team, a wave of bad PR, or other challenges confronting the business. If you’re in denial, it’s hard to overcome any challenge.
Then, it’s time to speak up and work past your challenges.
Communicating with Your Team
While there’s no precise formula for when and how to share challenges with your employees, given how varied each situation can be, I’d recommend the following guidelines to do so:
1. Do No Harm
Unfortunately, some startup CEOs convey perpetual crisis mode to their team. Every small issue is portrayed as a firestorm, real or not, and the steady stream of scary news can easily distract employees from both their day to day execution and the company’s long term goals. Know the difference between being honest with your team versus sowing unnecessary panic.
2. Frame the Solution and Involve Your Team
In addition to being candid about the challenges facing the company, talk with your employees about what the possible solutions may be and how they’re likely to be involved.
3. Don’t Blindside Them
As a startup exec or employee, one of the toughest things to experience is for your CEO to share bad news in a way that blindsides you. Folks can feel taken by surprise when they suddenly hear about things that they never expected or (more commonly) that a CEO let fester for a long time in secret. Odds are good that at least some folks on your team already know or suspect when challenges hit the company, so hiding stuff is usually counterproductive.
Communicating with Investors
Some of the same principles apply when sharing difficulties with investors, but the nature of the relationship is obviously different.
A few guidelines that might help when communicating challenges to your board and investors:
1. Be Direct
I find both the challenge at hand and the long term relationship work best when CEOs communicate challenges directly and promptly with their investors. Most good VCs will seek to help and advise where possible, and founders who put off sharing bad news or beat around the bush only frustrate others and reduce the amount of time they can work together towards a positive solution.
2. Communicate Challenges 1-on-1
Difficulties are easier to communicate privately with your board members or key investors. The topic may be revisited later in group settings like a board meeting, but breaking bad news should almost always be done 1-on-1 where possible. This helps mitigate the risk of groupthink or “pile-on-the-CEO” discussion … which benefits no one.
3. Be Decisive About the Way Forward
If you have thoughtful investors in your company, hopefully they’ll provide useful feedback about how to deal with a difficult situation. And it’s okay if you as the CEO don’t have all the answers when confronting a challenge. But you have to be prepared to map out the options of how to move the company forward, and it behooves you to have a strong recommendation and rationale for your plan.
It’s Never Easy — It’s Even Harder When Avoiding It
Facing difficulties and sharing bad news is never fun. But the reality is that not every startup is killing it, and even the ones that seem to be growing quickly aren’t actually succeeding all of the time in everything they do.
Successes may define us to others more than failures, but great entrepreneurs distinguish themselves by how they handle those situations when the chips are down.
I like to say that “there are only co-founders” — it’s extraordinarily rare for a successful business to have just a sole founder. But not all co-founders are equal in terms of title, ownership, responsibilities, and so forth. As a result, one of the trickier things co-founders tackle is determining the equity split amongst the founding group of individuals.
There’s no magic to this, and there’s no hard and fast rule. Across both the startups I’ve personally been involved in (PayPal and LinkedIn) and the startups in which I’ve been an investor, I’ve seen a broad range of co-founder equity splits.
Sometimes co-founders put off the equity split question for some time. This is often the case where there was a close personal relationship between some or all of the co-founders, as former co-workers, friends, or college roommates. If we’re all friends, we can just be comfortable with the notion that we’ll “figure it out later,” right? But delaying or avoiding the conversation often results in it being more awkward than it needs to be. Once you’re working on a project in earnest, even if it’s still at the nights-and-weekends phase, co-founders should go ahead and discuss this topic.
Additionally, you should put whatever agreement you reach to paper, even if you have not yet incorporated or had your legal counsel draw up the founder stock paperwork. For example you can type out a simple letter saying something like “We the founders of XYZ agree to the following schedule of founders equity ownership – John Doe 20%, Jane Doe 40%, Mike Doe 40%” and then have each co-founder sign, with each co-founder keeping a copy. You can then work with your law firm to formally draw up founder common stock paperwork either then or subsequently.
It’s also worth keeping in mind that regardless of how the founders’ common stock is divided, there will be future issuance of stock that will dilute the founders over the lifecycle of the company. You don’t really need to worry about how much common stock will be set aside for an employee option pool or how much preferred stock might be issued from raising future VC rounds in order to determine an equitable founder stock division. But all the co-founders should keep in mind if they own X% today, their share will likely be smaller (though still usually quite substantial) down the road.
The most successful approaches to splitting founders equity typically involve establishing a framework that all the co-founders buy into at the outset. This needn’t be some terribly complex formula that tries to do a cost accounting of everyone’s contribution to the decimal point. But they frequently capture some of the following dimensions:
1) Experience / Seniority / Role – Every founding team is different in terms of whether co-founders are peers or near peers or if there are broad disparities in terms of seniority and experience. Founding splits typically acknowledge that more senior folks or folks in C-level positions will have a larger founders’ equity percentage than more junior or staff-level co-founders.
2) Capital Investment & Sweat Equity – Sometimes some of the co-founders provide personal startup capital (hard cash) at a company’s inception, and often they will receive a larger portion of founders’ common equity as a result, rather than structuring their capital as a separate investment via preferred equity or convertible note. In other cases, some co-founders might forgo salary early on (if their personal circumstances permit) to earn an additional share of “sweat” equity. Both of these are typically reflected in the founder equity split.
For example, when we started LinkedIn at the end of 2002, each member of the founding team essentially had a couple chunks of founders’ common stock. One chunk was based on the experience level and role of the co-founder. Next, those that were forgoing some or all salary prior to Series A got an additional chunk for that. And lastly, a chunk of our CEO Reid Hoffman’s equity was attributed to the fact that he provided the initial ~$750K in seed capital for the company.
3) Prior & Ongoing Involvement – A co-founder’s equity should also be reflective of their on-going involvement in the company. For example, it’s not uncommon for there to be a couple co-founders at the inception of a company. But sometimes, for a variety of reasons, one or more of the co-founders won’t be involved on a full-time basis going forward. Those co-founders that are there for the long haul and working full-time should have a larger chunk of equity (typically multiple times that of co-founders not working full-time on the venture). Co-founder equity should have vesting periods (or lapsing repurchase rights) so if a co-founder departs substantially earlier than others, their stake in the business is accordingly smaller.
4) Ideation / IP – Sometimes a portion of founders’ equity splits are attributed to “who came up with the idea” or to actual IP that’s brought into the business at inception. For most software and internet startups, the hard IP coming in is usually isn’t an issued patent, which is obviously different for biotech or other kinds of startups. Sometimes, however, there’s an existing code base that one co-founder brings. In general, successful startups are based on execution and not an idea, so I personally attribute a pretty small portion of the co-founder equity split to this factor, though entrepreneurs sometimes use it in their frameworks.
Once you have the framework, it’s simply a matter of having the conversation and reaching an agreement. Yes, sometimes these conversations take a few sessions, and at times the conversations can be contentious. But this is one of the very few times in a startup’s life where the co-founders are playing a zero-sum game. And ultimately, no matter what split you work out, building a successful business and growing the pie of the whole company’s value is what will really matter for all the co-founders.
Most folks reading this will know that many startups were built in part with the help of venture capital. Most attention goes to tech companies ranging from Google to Genentech, but some non-tech companies like FedEx and Starbucks also raised VC early in their lives.
However, many folks probably don’t think about exactly where those VC dollars that help fund startups actually come from. So I wanted to dive a little deeper into what I call the startup capital supply chain. I’ve had a version of this post in my “drafts” folder for some time, but the confluence of three unconnected things (more on these later) prompted me to finally finish and publish it.
So where did that dollar that a given VC invested in a startup ultimately originate? Well it may be useful to illuminate this discussion with a chart.
(Click the image to view a larger version.)
Most of the dollars a VC firm invests come from outside limited partner investors (LPs). The actual partners of a VC firm (GPs) will typically invest a minimum of 1% of the total size of their fund,* though frequently this percentage is substantially higher (especially in many of the best funds).
The nature of LP investors can vary widely, but the bulk of the capital in the VC ecosystem comes from large institutions like pension funds, endowments of universities and hospitals, charitable foundations, insurance companies, very wealthy families (aka family offices), and corporations. A smaller portion of the total capital in the VC ecosystem comes from high net worth individuals. Very small funds may not have any large institutions as LP investors, just individuals, but even the largest and most established VC funds often have “sidecar” funds to enable a select group of individuals to invest in their funds (typically entrepreneurs the firm knows well).
To better understand VC capital, let’s look more closely at the various types of institutions (LPs) and their raison d’etre:
Defined-benefit (DB) pension funds are the entities which pay a fixed pension amount to retired employees of a particular organization. There remain many corporate pension funds still investing in VC, though a lot of DB pension funds in the private sector are no longer enrolling new employees. Today most corporations have 401(k) style defined contribution programs where employees pay a fixed amount and the performance of their investments determine the amount they have upon retirement.
For public sector roles, such as government employees, teachers, and firefighters, DB pension funds are still the norm, and many public pension funds still invest in VC funds (though some of these are very large entities, making scale an issue, which I’ll discuss more below).
Some VC firms have eschewed taking direct investments from public pension funds, as state laws now sometimes require these pension funds to publicly disclose information about their investments that VCs consider sensitive, confidential info, like fund-level returns or individual companies in the portfolio.
Endowments are the funds established by universities, hospitals, museums, and other non-profits to invest for the long term. The income these investments generate then help fund the operations of those organizations or capital investment (e.g. new buildings, etc).
University endowments are one of the main categories of LPs for VC funds, though there are also endowments for other kinds of organizations that are investing in venture.
Large charitable foundations like the Ford Foundation, Carnegie Corporation, Kresge Foundation, and many others invest in VC. These foundations then support other non-profits with the investment returns they generate.
Wealthy families arguably created the VC industry both directly and indirectly. Some of the oldest VC firms were essentially the direct investment arms of wealthy families like Bessemer Ventures (originally an outgrowth of the Bessemer Trust established by the Phipps family) and Venrock (originally an outgrowth of the Rockefeller family), though at this point both firms now have outside LPs that constitute the majority of their capital. Greylock’s first fund was also raised from a small handful of wealthy families primarily in the Boston area. There are different flavors of family investment offices today, some are “single family” offices which invest on behalf of one uber wealthy family and their descendants whereas others are “multi-family” that might aggregate the wealth of a number of rather wealthy but not uber wealthy families.
By nature of their business, insurance companies end up with very large pools of assets that they can then invest and use to pay out claims over the long term. A number of life insurance companies and a small handful of P&C insurers are active LPs in VC, though in general the overwhelming bulk of insurance companies’ assets are held in liquid investments.
A handful of large corporations actively invest in VC funds themselves. This typically has a dual purpose: generate a return on the company’s cash while also gaining insight into new startups and technologies that may be of strategic interest to the corporation.
As a result, most Fortune 500 companies aren’t investing in VC, typically only tech and healthcare ones, and some obviously have their own VC arms (e.g. Google, Intel Capital). So there are a handful of VC firms that get a large portion of their capital from corporations, but in general corporations are a small fraction of the overall capital in the VC asset class.
Why They’d Invest Indirectly in VC
Many large institutions from the list above invest directly in VC funds, but others from the same categories will invest indirectly through a range of different intermediaries.
Typically, there are four basic reasons why an organization would invest indirectly.
The first is a staff constraint. Some institutional investors simply aren’t big enough to have in-house employees to vet and manage a portfolio of VC funds. The definition of “big enough” varies widely but, generally speaking, entities that manage less than $1 billion in assets will often go the indirect route.
Next is access – some institutions may have staff but lack the robust network of relationships with the best VC firms to get access to their funds. The best VC firms have a large surplus of LP demand relative to their fund size, so a good intermediary may enable an institution to invest in higher quality VC funds than they would otherwise be able to do directly.
The third reason is less in the hands of these institutional investors, and that’s governance. In some cases, the rules governing how an institution manages its capital may actually require the institution to seek an outside third party’s advice when making specialized investments in “alternative” asset classes like VC.
Lastly, there’s the issue of scale. LPs typically seek to invest in a portfolio of several VC funds, not just a single firm. If you’re a comparatively small investor, you might be better off putting $5-10 million into a pooled vehicle that’s invested in a number of VC funds rather than putting it all just in a single fund. Similarly, large institutions with tens or hundreds of billions in assets such as the largest public pension funds (e.g. CalPERS, CalSTRS) or sovereign wealth funds (e.g. Singapore’s GIC or Temasek) may find it advantageous to make a single $500 million investment in a pooled vehicle rather than try to find many good VC funds to invest comparatively small (for them) amounts in.
What Are These Intermediaries?
There’s a wide range of intermediaries for venture capital and private equity investment, each with its own structure and business model. The main ones include:
Fund of Funds (FoFs)
FoFs take capital from institutions, wealthy families, and others, and then invest it in a basket of underlying VC funds. FoFs are typically structured as limited partnerships similar to a VC fund itself, and they typically charge an annual management fee and carried interest on profits – again just like the underlying VC funds in which they invest. Because of that structure, an investor in FoFs will end up paying more in fees and carry than if they invested directly in VC funds, but the benefits of access, scale, and staff often outweigh the costs for some potential LPs.
FoFs are typically a “blind pool” in that the people running the FoF have full discretion over which underlying VC funds they invest in, and so the investors in FoFs don’t know up front exactly which funds this will be (though they can look back at the VCs a FoF has invested in previously as a guide).
Advisory can mean a great many things in the VC LP world — there are lots of flavors of “advisory” firms. In general however, they can all be categorized based on discretion and specialization.
Some advisory firms have discretion over the assets they manage, meaning if LP X gives Advisory Firm A money to invest, then Advisory Firm A gets to pick and choose their VC fund investments. Other advisory firms are “non-discretionary,” meaning they vet VC firms and/or make recommendations to an LP, but ultimately the LP decides whether or not to invest in a particular firm. In addition, some advisory firms are highly specialized and just manage assets to invest in VC funds, whereas others advise on a broad array of assets ranging from VC/private equity to hedge funds to public stocks/bonds and so on.
What prompted me to think about this now?
It was the confluence of three unconnected things. First I read Semil Shah’s post reflecting on a recent GP/LP summit he attended. I was at the same event and Semil’s thoughts on “A dollar travels far before it reaches a founder” were spot on, but I wanted to elaborate a little more. Secondly we had our annual meeting with our NextView LPs the other week so some of this stuff was top of mind for me. Lastly I saw this tweet from Sequoia the other week, which put a spotlight on some of their LPs and why Sequoia’s exceptional returns over the decades have helped enrich non-profit causes.
Does any of this matter to entrepreneurs seeking investment from VCs?
I originally wanted to write this post to shed a little more light on how the supply chain of VC/startup capital actually works. I thought it might be useful, particular to entrepreneurs who may know a good bit about the VC business but perhaps not to this level of detail about where the dollars actually come from and how they get there. But it also got me thinking about Sequoia’s great causes microsite there. Do entrepreneurs actually care where the VCs they seek investment from get their funding? Should they care?
Anecdotally, I don’t think most entrepreneurs really care about this and personally I’m not sure they should. I believe great entrepreneurs do (and should) seek capital from VCs they think will be great long-term, value added investment partners. Whether that VCs success benefits this LP or that LP in the long run doesn’t really matter. I don’t believe that non-profit LPs (e.g. endowments, foundations) are morally superior to for-profit LPs (e.g. family offices or insurance companies or corporations). I don’t think one can even parse non-profit LPs… is it morally superior to build a new cafeteria for Harvard undergrads (by growing the Harvard endowment) or to ensure a secure retirement for public school teachers (by growing CalSTRS pension fund) or to construct a new exhibit at the Air & Space Museum (by growing the Smithsonian’s endowment)?
At the end of the day finding a great long-term investment partner is what it’s all about for entrepreneurs. The definition of “great VC” will be situation specific… it might mean a VC that has a specific stage/sector focus, it might mean a well-regarded firm brand, it might mean a specific GP who has highly relevant experience, etc. I applaud Sequoia’s transparency about their non-profit LPs, but many entrepreneurs will continue to choose Sequoia because it’s a great firm that has backed exceptional companies… not because of where there LP capital comes from.
* The 1% GP contribution is a statutory minimum for the legal & tax structure of most VC funds. Again a lot of funds have the GPs investing substantially more than 1% of the fund.
eBay announced today plans to separate itself into two companies, one the core eBay marketplace business and the other is the PayPal payments business. This is a move that’s been contemplated by folks both inside the company and outside for many years. Recently prominent activist shareholders have also been “encouraging” eBay management to spin off PayPal as a way to maximize shareholder value.
First let me say that it’s made a lot of sense for the two companies to be a combined entity over the last 12 years. When we sold PayPal to eBay in 2002 we had just gone public earlier that year. The business was strong and profitable (>$100M revenue, gross margins 50%+), but PayPal also faced challenges… diversifying beyond eBay sellers (many sell both on and off eBay), increased regulation, continued international expansion, etc. Being part of eBay helped PayPal tackle all of these things, plus it allowed PayPal to continue capturing payment share within eBay (today >70% of all eBay transactions closed with PayPal). eBay’s marketplace cashflows also provided capital to grow the PayPal business.
We had an immensely talented and entrepreneurial team at PayPal which famously went on to build many other businesses (the PayPal mafia). But in all candor it’s not obvious that we would have been best positioned to build PayPal as a public company for a decade. The payments landscape was different back then… Visa and MasterCard were not-for-profit consortiums owned and controlled by the largest banks. The “smartphone” consisted of Palm Treos and early Blackberries.
So all in all, eBay’s acquisition of PayPal was good for PayPal and great for eBay and the two as a combined entity made a lot of sense for a long time. But for PayPal to maximize it’s potential as a payments platform the company must be unshackled by eBay. Today’s payments landscape is far more dynamic… Visa and MasterCard are publicly traded companies themselves. As incumbents they’re still not terribly forward thinking, but they’re more innovative today than they were a decade ago. There are obviously other companies that have attempted and largely failed to build meaningful payments businesses (e.g. Google, Amazon) and now others like Apple that will try. Crypto currencies are still in their infancy but regardless of whether Bitcoin ever becomes a widespread medium of exchange, the blockchain has significant potential to change the way transactions are conducted and how counterparties interact.
There are two things that are incredibly hard to do but are essential to building a valuable payments company. One is to build large scale consumer adoption + merchant acceptance… we did this at PayPal by piggybacking on the growth of eBay’s marketplace, and as a combined entity PayPal pushed strongly into offline payments. The most remarkable thing that PayPal achieved, and what it makes it different than pretty much every other attempt at payments innovation, has been to create a lower cost source of funding for digital transactions. We did this by getting consumers comfortable with funding via bank account (ACH) and by building innovative and robust risk management systems to deal with all the inherent limitations of ACH (not real time, no guarantee of sufficient funds, etc). We did this out of necessity back when PayPal was still a private company. Had PayPal relied solely on credit cards for funding buyers’ transactions, we would have probably failed on multiple dimensions… it would have been extraordinarily difficult to build a profitable business and the credit card associations cumbersome rules (and at times adversarial approach to PayPal) may very well have put us out of business.
The opportunity and challenge for PayPal going forward will be to take this competitive advantage and further extend the usage of PayPal into online and offline transactions. People frequently fixate on “mobile” as being the next big thing in payments… we’d all like to be able to use our smartphone as the payment token rather than a plastic rectangle with a magnetic stripe. But the grand slam opportunity isn’t simply to use a phone tied to a credit card account (as Apple Payments is attempting to do), it’s to tie a mobile app to other ubiquitous stores of value as PayPal can do with bank accounts or credit accounts (old BillMeLater). Unshackled, PayPal has a shot at this now.
GrabCAD today announced their acquisition by Stratasys (NASDAQ: SSYS). All of us at NextView extend our congratulations to founder Hardi Meybaum and the rest of the GrabCAD team. There’s a variety of coverage of it in the tech press (BetaBoston, TechCrunch), but I wanted to share the story of how we came to know the company and how the future (now past) unfolded.
I first met Hardi at the beginning of 2011 here in Cambridge. He was wrapping up GrabCAD’s participation in the Seedcamp accelerator program, and the Seedcamp startups were in the US to visit potential advisors and investors in Boston, New York, and SF. My partner Rob had also been introduced to Hardi separately by an experienced CAD exec (Mike Volpe – now Hubspot’s CMO).
I was impressed by Hardi as an entrepreneur in our first meeting there in the Seedcamp mentoring sessions. He had a clear vision of what he hoped to achieve with GrabCAD… to make collaborative CAD design easier in our connected world, where CAD engineers and product designers are more distributed.
It was still early days for the company then, at the time we invested in GrabCAD’s seed round in the spring of 2011 they had around 3,000 engineers in their community. But my partners and I saw the potential for the community to grow virally, just as LinkedIn did, and to be monetized with a variety of products built on top of this community. GrabCAD also had very high engagement in terms of the % of engineers actually sharing large, complicated CAD files in the system. CAD software is used in designing nearly every man-made product on the planet, and a substantial amount is spent per engineer on CAD software but when GrabCAD started there were few good tools for collaboration.
Hardi moved the company from his home in Estonia to Boston to be embedded in the deep CAD software ecosystem here (Solidworks – Dassault, PTC, etc) and was part of TechStars Boston’s second class. Fast forward to today and there are over 1.5 million CAD engineers and product designers using GrabCAD. That’s something like 30-40%+ of the CAD engineers in the whole world that are part of GrabCAD’s community, or using their paid products like Workbench (SaaS storage / collaboration). Companies like GE, ABB, and others are also using Workbench or have tapped the GrabCAD community for outsourced design work.
Working with Hardi as an investor has been rewarding. I saw that even first time CEOs can be very decisive… Hardi never put off important decisions, even when they might have been challenging for him personally. I got to share some of our early dashboards from LinkedIn as GrabCAD crafted their own dashboards for early viral growth. And thanks to Hardi I got to meet the President of Estonia.
Congrats again not only to Hardi but to the entire GrabCAD team. The distributed design & manufacturing revolution is still in its early innings. As part of Stratasys, who’s also acquired MakerBot and other startups, there’s a lot more to do with the GrabCAD community and platform. Onward and upward.