No immunity: Start-ups and litigation

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I long thought that litigation was the exclusive domain of lawyers, large companies and criminals. Who would want to pick on a poor, helpless start-up? The reality is, sadly, that our litigious society has entered the domain of the early stage company.

Legal Battlefronts

The disgruntled “friend,” collaborator or employee

I sometimes call this the “Social Network effect” after the Facebook movie. Usually, the litigant feels slighted and entitled to equity or cash. These cases are especially challenging because they become personal, rather than rational. The biggest sticking issue is equity, because often the litigant is seeking equity for some early collaboration (perhaps classmates that brainstormed an idea in their dorm room). While its generally understood that equity is for one’s forward-looking contributions, this principle can be hard to establish in a jury trial. This makes these cases especially tricky even when the company is 100% in the right. This should be a reminder to all founders to get stock allocations set and locked in the beginning to avoid future disagreements.

IP litigation

Perhaps inspired by patent trolls, I’ve seen an increasing number of larger companies sue any or all upstarts that threaten its core business. Given the number of very generic patents that have been issued over the past decade (many in software), it has become increasingly easy to demonstrate some sort of violation, especially to a less-than-sophisticated judicial system.

Smaller companies generally have only one product to sell, and without the ability to sell that product, have no business. Furthermore, most start-ups cannot afford the distraction and therefore, most boards advocate settling cases sooner than later.

Innovation ahead of regulation

This type of litigation is in the press seemingly everyday. Uber, a portfolio company, and Aereo are well-documented examples where municipalities or other groups sue the company for violation of certain regulations. The reality is that most regulation hadn’t taken into account the existence of new technologies (as in Uber or Aereo). Instead, protectionist politicians that wield significant influence try to shut down these new services before regulation catches up to innovation.

Selecting Counsel

Representation selection signals to the other side a great deal about your view of the case. For example, if the start-up hires a large firm, the other party knows that high rates are being paid and thus may believe a higher settlement is likely.  That said, if the start-up is fighting “bet the company” litigation, its advisable to use a big firm despite the signaling risks.

On the other hand, if you’re fighting a lawsuit that is a nuisance but doesn’t jeopardize the very being of the company, its advisable to use a smaller, less expensive firm. Remember that investor dollars are being used to fund litigation, which is among the worst ways an investor (or an entrepreneur) can envision spending his/her company’s capital.

Budgets

I’ve seen our companies spend tens of thousands to over a million dollars in legal fees. Each case is unique, but my experience has been that the vast majority of cases settle close to the trial date. In these cases, generally hundreds of thousands have been spent. This isn’t altogether surprising given that it takes time for both parties to realign their expectations. If a case does go to trial, the costs almost certainly will be at or north of $1M for all fees leading up to and including trial.

Venture investors are increasingly familiar with litigation. The start-up founder/CEO needs to be transparent about the situation and the facts, and keep the Board closely updated on the process. Unfortunately, the wheels of justice turn slowly and often the biggest expense paid by the company is the time and distraction.

Yes, the goal posts keep moving

 

Goal post

It was one of my least favorite aspects of raising money. Time and time again I would ask VCs to articulate what metrics would be required to close funding. Inevitably I’d be left unsatisfied and wonder, “why does it feel like the goal posts keep moving?”

The answer has come into focus now that I’m on the venture side and it’s unsatisfying and simple. They are moving.

No such thing as hard metrics

Some investors might say I’d need to see “x” pre-orders for a hardware start-up, “y” downloads for a mobile app, and “z” revenue for an e-commerce company. Yet, such a formula is misleading to entrepreneurs (and bad investing). There are no precise metrics for getting funding, given how many intangibles go into building start-ups. Much like applying for college, kids with lower SAT scores get accepted to better schools and vice versa.

The venture market is more like the stock market than you think

We often think of the venture market in very different terms than the stock market. It feels like a cottage industry, more like the local real estate market than the broad securities exchange. The reality is that investor behavior is more similar than different. Macroeconomic factors impact the venture market – increasing stock values, economic data and even political conflict has an impact on capital raising for start-ups. Like the stock market, the venture market ebbs and flows.

Investors are influenced by their portfolio & deal flow

Let’s say you’re an e-commerce company doing $25K in monthly sales when you first sit down with a VC. The investor seems enthusiastic about the company. You come back a few months later doing 4x the sales looking to close the funding. Instead, the VC seems much less enthusiastic than the first meeting. What happened? It was a 4X!

Perhaps one of the e-commerce companies in the portfolio hit hard times and that colors the investor’s view. Or, maybe a new opportunity surfaced in the meantime that makes your company appear less attractive on a relative basis. None of these reasons are rational, but nonetheless impact the investment decision.

So what’s an entrepreneur to do?

One of my trusted mentors, Jeff Bussgang, said to me “VCs are in the extrapolation business.” It’s sage advice. Rather than focus on individual data points, the entrepreneur must generate data that demonstrates an upward trajectory of the business. Unfortunately, the x and y coordinates of these points are not obvious.

I discourage entrepreneurs from asking VCs to articulate metrics that will trigger funding. Instead, think about the risks of the business and identify the metrics that best address those risks. Don’t look to VCs to lay out a path for funding. Instead, knock down the risks you see and frame those metrics as the ones the prospective investor should care about.

Venture Debt: The third rail of venture financing

I’ve taken venture debt in all three of my start-ups. Additionally, many of our portfolio companies have taken some or are in the process of doing so. No doubt it’s a frothy market for debt. Nonetheless, when I polled others I respect, I heard everything from an unwillingess to comment  to outright dislike. Why is venture debt the third rail of venture financing?

A couple of years ago Fred Wilson wrote a post stating his view that debt is not appropriate for an early stage start-up. The primary argument was that venture-backed start-ups who have no current means of paying it off shouldn’t take on debt.

I, however, frequently encourage debt despite that most venture folks share Fred’s view. Some VCs argue that the start-up is riding on the VC as the financial backstop. This is true. In fact, most debt funds are only willing to finance companies backed by top tier, well-known funds. For the entrepreneur, this is another good reason for the start-up founder to get capital from such a fund! Secondly, the price of debt, often over 10%, takes into account this default risk. If the company defaults, ultimately the company reverts to the debt holders. These investors know what they’re getting into and have generally shown decent returns because most of their portfolio gets further equity capital.

Another counterargument to venture debt is that it can spook prospective investors in future rounds. There’s certainly merit to this argument. However, what the argument fails to consider is that founders need runway above all else. In my experience, the debt enabled my team to achieve the milestones we needed to raise more capital.

Investors are either buyers or sellers. Most investors put in equity dollars and want to see meaningful traction before further investment. When companies are going sideways or the trajectory isn’t obvious, debt is often the lowest cost way to extend runway. When I was a CEO/founder, I would ask my investors, will you put in money at the debt terms? The answer was always “no” and investors acquiesced.

Venture debt does have a dark side. When things start to go wrong, as one CEO said to me, debt can exacerbate decline. Servicing the debt can be costly to the burn and may make it harder to exit (typically on “soft landings”) because prospective acquirers don’t want to pay off the loan. That said, I’m a believer that the entrepreneur needs to “play to win” and as a result it’s beneficial for the CEO to get debt early, when it’s still possible to get it.

Venture debt is a case by case decision. By no means would I advocate it in all cases. The amount of debt borrowed, whether it’s drawn down immediately or not, and the terms are extremely important to consider when deciding to take it on.

 

The Business Plan Competition Deconstructed

Nowadays, nearly every school runs one. Last week I judged the NYU Business Plan competition with Fred Wilson, Dave Tisch, David Aronoff and Geoff Smith. It was an exciting event packed with four great finalists. Having sat on both sides of such competitions, I think their purpose is often misunderstood.

Business plan competitions are imperfect and artificial. By their very nature, they are academic exercises.  Sure, the goal is ultimately to start a business but the reality is that this is the exception not the rule. In my experience, at Brontes, we started a business after coming in second at the MIT $50K, however, it was based on a completely different business plan.

The competitions are great forcing mechanisms for bringing teams together around a business thesis. They place deadlines in submitting executive summaries, slide decks and, still, the nearly extinct longform business plan. Most entrepreneurial teams need some amount of structure, and for this, the competitions are useful. They encourage the team to debate ideas like which market to focus on, whom will be named CEO, CTO and how to finance the business. These are worthwhile conversations and are educational whether or not the company is founded.

The competitions are a great way for a team to build its network. Most competitions attract a fairly prominent set of faculty, industry folks and venture capitalists (myself excluded!). The feedback I heard on the panel at NYU last week was constructive and simulated the entrepreneur’s experience pitching his/her business to a VC. The savvy entrepreneur will keep track of the judges as a way back in the door for future conversations.

Despite these benefits, many participants have unreasonable expectations about the competition. The prize money may woo some, frequently academic-minded teams, in the way that government grants are viewed as easy money (but isn’t really). None of these competitions provide enough prize money to fund a venture at any level. Additionally, often the prizes have strings attached. For example, many offer free legal services for a period of time. In those cases the services are great, until the founding team feels locked into a firm or partner they don’t like.

Most importantly, the winners of the competition are not branded as future IPOs in the minds of investors. Similarly, those that don’t win are not destined to fail. My experience at both Brontes and Sample6 is that the results of a competition never come up in any VC discussions.

The most valuable part is getting the team together, practicing the pitch and getting feedback from judges. The competition is a low risk practice run for crafting a business pitch. Used for this purpose, it’s a valuable exercise.

Paper Money: Personal finance for entrepreneurs

In 1999, my internet start-up was valued at nearly $100M. I thought I had it made. Like many of my contemporaries at the time, I rented a nice apartment near the beach and spent more money going out. I momentarily day-dreamed that I’d be ringing the NASDAQ opening bell.

It didn’t end up that way and when that world came crashing down in 2001, I ended up with less than $10K to my name. I learned the hard way that paper wealth doesn’t pay bills. I was forced to re-think how to think about finances, risk and exits.

Personal burn rate

For the scrappy entrepreneur, budgeting and saving is complicated. Many entrepreneurs are living paycheck to paycheck, or in debt. Early stage founders can make $60K or less.

The key is to live conservatively and maintain a low personal burn rate. Married entrepreneurs often deliberately diversify income streams whereby one pursues the entrepreneurial route while a spouse takes a lower-risk, steady-paying job.  As a career entrepreneur, I’ve never owned a home, avoided lavish spending and invest conservatively. While others may think I’m cheap, I’m acutely aware that a big win is by no means guaranteed. Though I’ve had a previous exit, I’m very protective of my savings.

The equity/cash trade-off

My father, an attorney, would say “every hour I’m not working, I’m not earning.” Unlike high cash-paying jobs like those on Wall Street or in consulting, the entrepreneur must be at ease that it is a conscious ownership/cash trade-off. One’s equity interest in their start-up often is their savings.

Start-ups are, inherently, hit driven businesses. The entrepreneur has significant earnings volatility, yet greater upside. The shares one aggregates over his/her career may be worth nothing or millions of dollars, but this often takes years to find out.  I advise young entrepreneurs to take a longer term, multi-venture perspective and to diversify the types of opportunities they pursue. In a sense, you’re your own career venture capitalist.

Risk tolerance and exits

Most entrepreneurs set out to build the billion-dollar business. Somewhere along the way they realize that it isn’t in the cards. Sometimes there’s an opportunity to sell the business and make good, potentially life changing, money. I’ve long believed in staging risk and preserving exit options along the way.  Too many entrepreneurs, tempted by the ability to raise lots of venture capital, ended up with smaller returns than if they had sold earlier (perhaps my mistake at Handshake.com). I encourage founders to talk openly with their teams, investors and families about risk/return throughout the journey.  Always believe you’re out to change the world, and build the next great big company. Just don’t spend like it.

 

Moving into the (seemingly hip) start-up world …

Consultants, bankers, big company folks and family members are making the move into the start-up world. I think this trend is here to stay. Nonetheless, the decision shouldn’t be taken lightly (or motivated solely by extrapolating off Instagram like outcomes). Here’s what I’ve said to those that have asked for advice…

It’s not about managing your career; it’s about building a business

Many traditional business jobs are individual focused. The emphasis is on individual returns, meeting sales targets, or getting a promotion. As a result, the incentive structure in that environment is quite different than the start-up. Candidates I’ve interviewed over the years have “managed upward” well but are poor fits for the flat, team-based nature of the tech start-up. In the start-up, the individual is de-emphasized and the collective team’s ability to deliver a product to the end-market is key.

Leverage what you know

Wall St, for one, is seeing migration given the reduction of opportunities and shrinking bonuses. Anecdotally, I know a good number of folks looking to transition out of finance. In these cases, I encourage people to leverage their “learnings” in the sector. Financial services technology is a great sandbox in which to play (is the Bloomberg terminal the last breakthrough!?). Those with first-hand knowledge of the pain points are likely to be most successful. The same holds true for healthcare and other more traditional industries ripe for disruption.

Find a good partner

I give this advice to everyone I speak to who is trying to start a new business. The key to entrepreneurial success, like any good relationship, is to find a good partner. It’s not about someone you want to have a beer with every night (though that helps), but about someone with complementary skills and a passion for making the venture succeed. It’s also best to “date before you get married” when picking a business partner.  When I look at founding teams as potential investments for Founder Collective, I insist on meeting the entire founding team, not just the CEO.