What’s a Fair 409A Discount?

Quick note: I’m not your lawyer. I’m not giving legal advice in this post.

Back in the olden days of venture capital, company boards had wide discretion in pricing company options. As is true today, there was a requirement that options be priced at or above the “fair market value” of the underlying stock (otherwise there would be tax consequences to the optionee and sometimes to the company as well). However the board could determine what that fair market value was and, generally speaking, there wasn’t a practical way that these valuations could be challenged. Most boards did some level of work to determine the FMV of a company’s stock but generally options were priced between 10% and 15% of a company’s then preferred price (because common equity sits behind preferred equity there is typically a discount applied to the FMV of common stock to account for this “overhang”). It was and is imprecise science but – at least in the case of venture backed startups – there wasn’t much harm in an option being priced low. It was a benefit to employees and a slight value transfer from equity holders to option holders (generally speaking in M&A transactions the value of the aggregate option exercise ends up allocated across the rest of the cap table). In a funny way it also benefitted the IRS in terms of tax collections as employees were taxed on the spread between the option and the value of the stock on exit and since these shares were typically exercised at the time of an exit were subject to short term capital gains. Higher strike prices distributes proceeds away from short term gain tax to equity holders who more typically are paying long term gains on the value that was shifted (I’m skipping a huge amount of nuance and detail here but the above is a general representation of how things work).

This all changed on January 1, 2005 when the IRS proposed new rules for the treatment of deferred compensation, including employee stock options (here’s the initial announcement; the code section was finalized in April 2007 – side note, there was a ridiculous interim period when the rules had been proposed but were incomplete and subject to final comment and approval; during that time companies were still expected to comply with the new rules, however the IRS conveniently only gave us until 12/31/05 – almost 18 months before the rules were finalized – to get it all right). Code Section 409A covered a lot of ground related to deferred compensation (and was generally thought to be the result of some of Enron’s business practices, although I think the IRS had in mind a number of different ways companies were structuring deferred comp arrangements that they felt underpriced the market and therefore resulted in immediate – but untaxed – gain to employees).

For startups it meant that for all practical purposes companies would have to hire an outside valuation firm to conduct a 3rd party, arm’s length analysis of the fair market value of a company’s common stock (boards were still free to make their own determination but doing so involved risks that effectively all professional investors determined were too great to take on). Over night a cottage industry was created to conduct these valuations. At the time, the cost of each of these valuations ran between $10,000 and $15,000 annually for each company. These costs have come down a lot since then, and the rules have been tweaked a bit but the overall 409A framework still is as it was when originally adopted – companies must hire a 3rd party to value their stock each year. These reports are generally quite lengthy and not always particularly comprehensible to non-finance professionals. So the rule of thumb is still to consider the FMV of common as a % of the preferred price – at least as a sanity check to the larger valuation exercise.

So what should this discount be? I thought it would be worth taking a look at the data across the Foundry portfolio. A number of factors go into the calculation and I assumed that the FMV of common as a % of preferred would vary both by company stage and by the time between the valuation and the last financing round. Specifically I assumed that the longer period of time between a financing and the valuation, the less the gap would be between preferred and common. Similarly I assumed that later stage companies would also show a smaller gap. I was wrong. From the data we collected, there was relatively little variance between company stage or time to last financing and 409A discount to common. There’s a little noise in a few spots in the data (due to small numbers of samples in certain categories) but the numbers were pretty concentrated around the average of 36% of the last preferred round no matter how you slice it. So 30%-40% is the range. Interesting…

Different vs. More

I’ve had this conversation with a number of founders recently and thought I’d post something here about it in the hopes that others see it/resonate with it as well.

In the world of startups we often talk about “more”. More funding. More sales. More efficiency. More. More. More. And, of course, there are plenty of times when “more” is appropriate. When something is working, and working efficiently, doing more of it is often the right call.

That said, often times “more” isn’t the right answer at all. And focusing on it obscures the need for the real answer: “different”. This should be intuitive but in my experience often gets missed (either in its entirety or at least in part) as companies scale. Just ask any CEO who has scaled a business from 50 to 100 people (or from 100 to 200 people; etc, etc).

At 50 people all you’re thinking about is how can you do more of the things that are working. This myopic focus after all is likely an important part of the success that got you from 1 to 50 people in the first place. But that’s actually not how scale works at a business – especially in the growth phases. From there you need to consider a cycle of change that fluctuates between doing things differently – then doing more of it – then doing things differently again. This might mean reorganizing key functional areas of your business. It might mean bringing in more senior managers in a few key departments. It may involve shifting around where certain functions report up to. It might mean rethinking a product strategy or changing product tiering or pricing. It almost certainly means rethinking as a business leader how you function as a manager.

Successful businesses, in my experience, are continually looking for ways to rethink how they operate and aren’t afraid to make meaningful changes – even to things that appear to be working – with an eye towards how “different” can actually be of greater impact than “more”.

How to Build a Better Network

A few notes before I jump into this. First, I realized in running through several drafts of this post that it can be hard to talk about networking without coming across as a bit cold or transactional in how one approaches relationships. I hope the note below doesn’t come off that way – my aim was to talk about something that I really care deeply about and offer some ideas for how to strengthen and deepen the working relationships in your life. Secondly, I’d like to thank Patrick (who I reference below) for his review and feedback of several drafts of this post – it was very much appreciated (and needed).

While we live in a hyper-connected world, how deep do those connections really run? And how do we better cultivate those relationships? It’s easy to pay lip service to our networks, but for me and for many of the readers of this blog our networks – the relationships we maintain with our peers and our contacts – are central to our lives (and here I’m purposely blurring the lines between business and personal, as many of the relationships we maintain do the same). I’m deliberate about how I maintain these relationships and wanted to share some thoughts/ideas on how to better maintain one’s network. I’d like to give credit here to Patrick from MindMaven, who helped me hone these skills and who has been a voice in my ear for the past year keeping me honest about making sure I care and tend to my network.

Make relationship building a priority. I’m often thinking about ways to be more connected to people in ways that are both authentic and meaningful. Relationship building is important to me and rather than let it happen by accident I regularly look for ways to deepen the relationships I have with friends and colleagues. The point I’m making is that being authentic and meaningful doesn’t always have to equate to a lot of work and effort. I actually believe that many people fear the effort they avoid it completely (I’d actually say that most people do). However there are ways in which you can deliver authentic and meaningful experiences to your network that do not cost you too much time and effort.

By making relationship building a priority you will develop habits around it. For example, one important habit I’ve developed is not letting things pass me by that are clear and obvious touch-points with someone I care about. I’ve found that a simple “saw this article about your company and it made me think of you” or “saw your quote here and I found it really insightful” or “saw this on Twitter and thought I’d share it with you” is extremely powerful. Plus it’s authentic. When I see someone I know has raised money, or been featured somewhere, it makes me happy. But instead of letting that thought pass, I take a minute to write a quick email to tell them that. The key here is to not let the moment pass or try to remember to do it later – when you are in the moment, the likelihood of actually doing it is much higher. At the time you see something that reminds you of someone, take 30 seconds and tell them that. It doesn’t take much time to send that message but it shows that you genuinely care about the relationship. The reason why this is so powerful is that it creates interactions that are relevant but where you are not asking for anything. It separates you from the transactional nature of asking for a favor from someone you haven’t talked to in a while. Investing in relationships on an ongoing basis create stronger bonds and if there does come a time when you’re asking something of someone in your network it feels more natural and less transactional.

Tools to help. At the end of the day, tools help but don’t take the place of actual work. In the tech industry we often try to rely on tools as the solution to our challenges when we identify a problem. That is rarely the right answer. Better is to figure out the habits we need to establish and use tools to reinforce or take friction out of those habits. With that as an important preamble to this section, I have found many tools that help me do that…Organizing this activity is important – there’s so much information flowing at each of us, it’s easy to miss stuff. Developing a tool-set to support your networking and engagement work doesn’t have to be particularly complicated  – for me it’s Tweetdeck to manage various groups on twitter; Feedly to manage the blogs I read; Accompany to help track news mentions of people in my network; and Contactually, which I describe in more detail below, to organize my network and keep track of who I’m connecting with. They all help me stay on top of what’s going on and allow me to gather data on my network to I don’t have to search out news and updates – those updates come to me.

A personal touch matters. I have terrible handwriting so this doesn’t come easy to me, but I have nice card stock that has my name on it with envelopes with a printed return address and I regularly use this to send notes out to people I’ve met with or who have helped me out in some way. A trick I’ve found is to use a sharpie – it slows me down and forces me to write more clearly (not my strong suit, as I said). The note doesn’t have to be a long one – the point is that I’m taking the time to write something personal, address and stamp it. Emails are great, but I don’t like to miss the chance to send someone a personal note of thanks.

Know your network. Being proactive about your network doesn’t happen by accident but it also doesn’t happen if you’re not deliberate about who is in your network in the first place. Most of us manage this in our heads, which is a mistake. I’ve played around with a few different tools for this and the one I rely the most on is Contactually. This platform integrates with my email and allows me to track how often I’m interacting with my network (over email and twitter at least) and, most importantly, set reminders and goals for how often I want to connect with people in different parts of my network. I’m not a slave to Contactually – I don’t reach out to people for no reason just because Contactually tells me it’s been too long, for example – but I do use it to make sure that I know how frequently I’m interacting with people in my network and to set reminders for myself to stay on top of my contacts.

Ultimately all of this comes down to care and feeding. Your network is in some ways a living, breathing organism. Yet most of us treat it like it’s static and exists when and as we need it. But networks need work and you’ll find you get out of them what you put into them.

What’s The Optimal Portfolio Strategy for a Venture Fund?

Last year I wrote a few posts (here and here) that talked about how skewed venture returns were. The key take-away graphic from that post is below – outsized returns on venture investments are rare. Much rarer than most people realize.

A key question my post didn’t consider was what the ideal venture portfolio might look like in the face of these data. 

Steve Crossan took a stab at modeling the answer to that question using the data from my Outcomes post. It’s an interesting read – you can see his full analysis here. Interestingly, we pondered this exact question at the very start of Foundry Group. Nassim Taleb’s book, The Black Swan had just come out and we decided to read the book and discuss its implications for the venture firm we were about to start in late 2006. I imagine many of you have read the book (if not, I’d highly recommend it) – the basic premise is that humans do a poor job of understanding the likelihood of unusual or improbable events.Black swans are rare but just because you’ve personally never seen one doesn’t mean they don’t exist. Compounding this error, humans are also poor at understanding the causes of these unlikely events after they take place (we misattribute their causes and as a result continue to make poor judgements about their likelihood of reoccurrence).

The robust dinner conversation we had back in 2006 essentially asked the question: “If venture outcomes are Black Swans, what does the optimal venture portfolio construction look like?” Steve asked a similar question in his analysis, which tries to use a simulation model (actually thousands of them) to construct hypothetical portfolios to see what the resulting returns look like. We obviously didn’t have the benefit of the data that my original Outcomes post relied on, but having already been in the venture industry for a while we knew that venture outcomes were relatively rare. In the end, we came to some similar conclusions as Steve did on one end of the portfolio construction scale but our views diverge as the portfolio size gets larger – more on that below.

It’s clear from the data (and from common sense) that every venture firm needs to place enough bets to expose themselves to outsized successful companies. With a small number of investments your chance of a winner is too small and your bets are too concentrated. That’s true no matter the size fund you’re investing (I’m referring to early stage funds here but a version of this is true even for larger, later stage funds; although a higher level of  concentration in later stage funds is actually helpful). This is similar to the advice I give to angel investors as well. Diversification is clearly important in venture investing – you can see that from in the graph below from the steep slope on the left side of the graph (which shows on average very poor return multiples for funds that have a small number of portfolio companies).

But is too much diversification a bad thing? Here’s where I think math fails practical reality. Given the rarity of outsized returns (the data from my original post surprised many) a purely theoretical model such as the one Steve ran suggests that the optimal strategy to exposure yourself to outsized outcomes almost has no cap on the number of companies one should invest in (again see the 2nd graph – the slope flattens, but still rising, as the number of companies increases). I think we intuitively understood this back in 2006 and the cruz of our debate centered around just how diversified should a portfolio like ours be. On the one hand there is clearly some benefit to being exposed to a large number of companies. On the other hand it’s not practical to manage that many relationships and we believed there was benefit to knowing which businesses to continue to support and which ones not to. Additionally there is benefit to concentrating ownership in your best performing portfolio companies – something a firm can’t do if it’s spread too thin. It’s a discussion we continued to have throughout the history of Foundry, in our case settling on ~ 30 companies per fund (each of our early stage funds is $232M in size). We felt like that struck the right balance of capacity, ability to concentrate ownership, ability to continue to back “winners” and, frankly, the kind of relationships we wanted to have with our portfolio.

That said, I imagine there’s an argument to be made that 30 is still too concentrated for a fund of our size – we debated this vigorously back in 2006 and still talk about optimal portfolio construction regularly. Certainly there are examples of funds like ours that invest in more (or in some cases far more) companies than we do (FirstRound Capital comes to mind as does True Ventures). And, of course, there are many examples of similarly sized funds that have the same or even greater concentration than our model. I’d also note that the earlier stage a fund invests the less concentrated I think it should be – the earlier the investment the larger the distribution of outcomes. And similarly, the smaller a fund is the less concentrated it should be as well – lacking the ability to continue to invest across rounds (and therefore to meaningfully concentrate ownership in clear winners) the more diversified the initial investment set should be.

As a student of venture math, I love these sorts of questions. I’m sure we’ll be debating them for years and years to come.

 

You May Have Too Many VCs On Your Board

Those that have followed my blog for any period of time know that I love the data that my friends at Correlation Ventures gather and write about (for example the data behind my post Venture Outcomes are Even More Skewed Than You Think or IPO or M&A). Today they released some data on the correlation between the number of venture board members around the boardroom table and the success of venture funded businesses which I thought was pretty illuminating and which confirmed a long held suspicion of mine.

I haven’t counted exactly but I’ve been on dozens and dozens of venture funded boards in the almost 20 years I’ve been a venture investor. Some have been fantastic. Some have been dysfunctional. Most have been somewhere in between. I’ve had the experience of being the sole venture board member. I’ve also been on boards as large as 15 or more when you include not just the board members but also the board observers, associates and others that regularly attend board meetings. I’ve often wondered what the optimal number of venture board members is and have regularly cautioned CEOs and founders against adding too many; and especially adding too many too early in the life of a company.

Today, Correlation answered this question empirically in a fantastic analysis that plots the correlation between the number of VC board members and the ultimate success of a business. They’ve controlled for factors beyond this variable and from their analysis we can draw pretty clear conclusions about how many board members is too many.

There’s plenty to talk about here, but the shape of the graph pretty much tells the story. There’s value to having VCs on your board. In fact, there’s value (or at least a correlation with success) to having multiple VCs on your board. But this value diminishes – and does so rapidly – as you add too many. This certainly matches to my experience. It’s almost always helpful to have a few experienced investment voices around the table. But having too many becomes hard to manage and leads not just to conflicting advice, but I’d suspect to CEOs and management teams spending too much of their time on board management and not enough on the business itself. It’s important to note here that the skew on the right tail of this graph was not due to investment stage (which was my first thought when I saw the graph) – Correlation controlled for that, as well as sector, time period, etc. and found that the correlation holds – companies with more than 3 investor board members performed worse than those with 3 or fewer.

I think it’s important to point out here that, at least in my experience, that having too many VCs around the table is bad for companies even if those VCs are good, helpful, competent people. I say this not just for the benefit of my peers who are reading this and with whom I sit on a board with more than 3 venture investors. I say it because I’m trying to emphasize that different board members bring different skill sets to a company and a board. And while VCs certainly come from many different backgrounds, I think the real issue here is that their skill set and points of view are over quite overlapping. They also tend to have a very loud voice in a board room because, despite being fiduciaries of all shareholders, they also represent typically the largest owners (and funders) of a business. Better boards are more diversified. Actually I said that backwards – more diversified boards are better boards. The research clearly shows this. This is true across all types of diversity (background, experience, gender, race, etc.) and ultimately having too much of a concentration of VCs on your board is a type of lack of diversity that creates poor boardroom dynamics and negatively effects businesses.

Now you have the data. It may be time to have some hard conversations with your investors…

 

 

 

 

 

The Changing Venture Market In 3 Images

Want to visualize how the venture funding market is changing? Look no further than these 3 slides (from a presentation put together by our friends at Greenspring). I don’t think much commentary is needed here.

  • Average round size at Series A is increasing dramatically.
  • Venture is being increasingly driven by large rounds (especially at the later stages – this is significantly skewing the overall funding numbers that are being reported).
  • IPOs are the new Unicorns (they’re becoming more scarce than their $1BN valued cousins)

What does it mean to be an “executive”

We have active and lively Foundry CEO and Portfolio Executives email lists. They are among the things that I love the most about the community we’re creating at Foundry. I love watching execs across the portfolio (who refer to each other as “Foundry cousins”) help each other out and share ideas. It’s an important reminder that great companies are created not by solo, heroic efforts, but by the collective force of entire communities.

Recently a CEO sent around the following question: what defines an executive (who reports to a CEO)? — especially as different from “a regular manager”. I thought a number of the responses were great and wanted to share them here so they can benefit companies beyond the Foundry portfolio.

What Defines an executive? Especially as different from a manager

The biggest difference is the mental frame you start with when approaching a problem. 

A manager starts with their team and their contribution to the problem/solution. “How can marketing do better at X? What’s the impact to marketing? How can I make a business proposal to get marketing more resources to do x”)  The manager spends 90% of her time thinking about her team/department/role, and 10% of the time thinking how the whole company needs to move together to reach the next level. 

An executive thinks like the CEO first. Their first team is the whole company. They have a deep sense of the market, how the business operates together as a machine. Their particular department (even their role) is the secondary consideration. An executive spends 80% of her time thinking about what we need to accomplish as a company, and how all the teams need to work together to achieve those things, and only 20% of her time thinking about her department/role. 

_______________

An Executive:

Finds a way to success.  The (functional) buck stops here.  Most managers are used to someone above them being accountable and, therefore, not really thinking all that thoroughly through their decisions (or lack of decisions) and their impact.  Executives can’t afford that laissez faire approach.

Is a model of delegation. Are very clear on what specific objectives and decisions are being delegated, drives alignment with their colleagues about the principles that underlie those delegated tasks and decisions, gets out of the way and then neutrally assesses outcomes.

Is a model of company culture.

Coaches the coaches.  Rather than thinking as much about individual contributors’ tasks and performance, spends much more time coaching their managers on how to be great managers.

Puts company (not function) first. Knows what it will take for the company to win and is constantly in pursuit of that whether in their functional area or as an assist to another. This includes budgets – always aware of when there is a higher-priority expenditure outside their purview.

Challenges the CEO. It’s vital for every CEO to see the icebergs coming.  Each exec is a sentry and its their obligation to challenge the CEO to see potential icebergs — 10 or 20 eyes have much more clarity than two.

_______________

Six things:

1. Can they get the right people into the right roles, in every role in their area?

2. Can they put together a plan that supports the objectives of the business, then decompose it and push accountability for achievement of its component parts deep into the organization?

3. Can they establish clear and simple metrics of progress for every single employee?

4. Can they ensure that their business rhythms are set up correctly and that the right conversations are happening?

5. Can they create a culture that supports the priorities and objectives of the business?

6. Can then get everyone in the organization involved in developing the organizational narrative / the company’s understanding of itself?

__________________

And this one which was a bit broader in its answer but I thought really framed what it means to function at various levels inside an organization well.

Jr. Director (C)

They can drive results with little or no supervision and can build the tactical plan. They get stuff done via their team vs. as an individual contributor. They aren’t often focused on the higher-level strategy (the why) or surveying / understanding the market at large. They are focused on the quarter instead of the 3 – 5 year timeframe and their silo. Still requires basic coaching on management, team performance/measurement, team structure, etc. (if managing) May or may not have made their first fire in their history.

Director

D’s fulfill the above + they have opinions on building & measuring the program + creating job descriptions.They take on difficult conversations with the team, and may require some coaching. Still requires support on the plan, but less so — they may need some assistance on getting buy-in / communicating that message. They are thinking somewhat strategically, though need direction on strategic initiatives.

Sr. Director / VP

E’s need less support on building the plan, but still need a clear charter to execute on. They motivate and challenge their team and other teams in powerful ways (if a new candidate, they’ve managed teams of 5+ at any given time). Active contributors to strategic conversations. They make hard decisions and can message them (with little to no support). They require little approval / permission before making a decision.

VP

F’s set the charter, get the buy-in, and champion it across the company — not just entrepreneurial, but they are also visionary. They are a leader and actively take on mentorship of others in and outside of their team. They think at the 30K foot view. They go and figure out the vision for their program, and aren’t afraid to take ownership for it. They aren’t afraid to lose their job — they go to bat for their convictions because of the greater good of the team, and they do it with passion and with a focus on the human. They are thinking strategically about their team among others, not just their own silo — they understand most of the business, can critically evaluate areas outside their expertise, and they understand the external environment (competitors, market, etc.).

VP

All of the above. They are one of the top of their field, an expert and trusted source, as acknowledged by the community of their peers both inside and outside the company. They have a vast range of experiences that make them likely the highest quality person we could have in this role. They likely have an unfair advantage (heavy experience in the industry, personal contacts that can lead to BD deals, etc.) that makes them uniquely suited. They are a unicorn of a hire, and they are a change agent for the business at the 30K foot level.