Post Category → Venture Capital

Your Best Advisors: Experienced Founders

TL;DR Nutshell: While great advice for a founder team can come from all kinds of sources, nothing comes close to matching the value of advice from other founders (preferably local ones) who have been through the exact same fire themselves, and made it to the other side.

Related Reading:

Suddenly, everyone who just shows up to school gets a participation trophy, every lawyer with small clients is a ‘startup lawyer,’ and everyone who can pull a few strings is a startup ‘advisor’ or ‘mentor.’ While there are truly great advisors/mentors out there, I see founders constantly wasting time, equity, and in some cases money on people who have very little substantive value to deliver to an early-stage technology company.

While the above-linked post gets more in-depth into the source of the problem, this one is about one specific type of ‘advisor’ that every single founder team should have: other experienced founders; specifically founders who have gone through a successful fundraising process, dealt with the nuances of founder-investor relations (preferably with the same/similar types of investors), and either achieved an exit, failed (you can get great advice from people who failed), or are still going strong.

Cut Through the PR

Given how easy it is to orchestrate personal branding and online PR that obscures the truth, every founder team needs people to talk to, privately and confidentially, to get direct, relevant, unvarnished advice; the kind that doesn’t make it onto twitter or blog posts. And there’s no better place to find that advice than experienced founders. 

Want to know what it’s actually like to work with a lawyer? You don’t ask other lawyers, or google, or other people in the market who know her; you ask her clients. Want to know what it’s actually like to work with a specific VC? You don’t ask twitter, or angel investors, or people who run accelerators. You ask their portfolio companies. And more specifically, within those companies you don’t ask the CEO put in place at the first large round and who managed to negotiate the ‘founder’ title for himself; you ask the original founder team that took the first check.

I can’t tell you how often founders will ask the wrong people about a lawyer, a VC, an accelerator, or some other service provider, and then get a complete 180 degree, unvarnished perspective when they ask, off the record, the direct ‘users’ of those people. That’s how you find out that the X lawyer who is ‘extremely well respected and well-known’ happens to take a week to respond to founder e-mails; or that Y ‘well-connected’ VC uses shady tactics to coerce founders into accepting unfair terms. You won’t get it from twitter. And you won’t get it from people who didn’t sit directly in the founder chair. 

There is a world of difference between talking to people who know about the challenges of being a founder v. those who lived them.

Finding Experienced Founders

Don’t expect seasoned founders to be running around town doing free office hours for random founder teams with an idea and hope. They’re not mother teresa. They’re sought-after, extremely busy people, and expect to have their time respected just like anyone else. So hustle to connect with them just like how you hustle to connect with other important people. Meetups, LinkedIn, Twitter, Accelerator Alumni Networks, etc. While I have serious reservations about lawyers connecting clients directly to investors, I think great VC lawyers are excellent connectors to experienced founder teams, as long as the ‘intro request’ makes sense.

But you can know that most excellent founder CEOs I know, even the ‘tougher’ ones, have a special, soft place in their heart for other founder CEOs fighting the same fight. Despite the fact that their advice is probably some of the most valuable you’ll ever find, they’re often the last people to ask for ‘advisor equity’ in exchange for their advice. Although that doesn’t mean you shouldn’t voluntarily offer it to them.

In short, very very few founder teams can make it very far purely on their own judgment. They need independent advisors to consult with on relevant issues. But most advisors don’t have first-hand knowledge of the core challenges of being a founder, and therefore aren’t qualified to advise on those issues. That knowledge lies with experienced founders. Find them.

Founder Compensation: Cash, Equity, Liquidity

TL;DR: Before investor money shows up, founders should pay themselves very little, if anything. As the company reaches milestones, including fundraising milestones, founder compensation increases as a % of market comp, although it rarely reaches full ‘market’ until a Series B/C or later. As a general matter, investors want founders (i) focused on the long-term success of the company’s stock and not on a lofty cash compensation arrangement, but (ii) also comfortable enough financially to pay their bills and not be distracted by financial worries.

Background Reading:

As with many things, how different parties assess and calculate appropriate founder compensation is far more of an art than a science.  One thing to keep in mind is that all comp numbers at each stage are heavily influenced by (i) location and cost of living, (ii) industry, and (iii) life circumstances of the founders.  Older founders with families tend to have slightly higher salaries than younger single founders. The same goes for founders in more expensive cities, and for founders in industries (like biotech, energy) where the founder team is made up of seasoned executives that have taken very large pay cuts to join the venture.

There are also tax nuances involved that are not the scope of this article. That being said, the below is an outline of the overarching common principles that I’ve observed among companies along the various stages of their life cycle.

Pre-Seed: Cash In, Not Out.

Money in should be documented as a Founder Note or SAFE. Paying yourself a salary  at this stage makes little sense, unless there’s substantial revenue. If you need to get some money back, a small bonus upon raising a larger ($2MM+) round is sometimes kosher. 

If a startup is currently bootstrapped and not running on a sizable amount of customer revenue, paying founder salaries amounts to taking cash from one pocket and placing it in the other, while allowing the IRS to take a percentage of it. It is very rarely rational. Keep what you need to survive in your own bank account, and only fund the company with the rest.

Contributions of capital from founders beyond minimal amounts should usually be documented as a founder convertible note or SAFE (see articles above), with the expectation that it will convert later into preferred stock, providing that founder a “little extra” on the cap table and eventually in a liquidity event. It should not, however, be expected to be paid back.

However, occasionally founders will put in such a large amount of money that they really need to get some of it back much earlier than in an exit. In those instances, discussing a small ‘performance bonus’ with your seed or Series A investors can often work, as long as the amount isn’t too large of a percentage of the overall round. I’ve seen founders get a $50K ‘performance bonus’ upon raising a $2MM+ Series A, with the logic being that they were taking barely subsistence salaries for the past year and need something to help cover deferred expenses. Sometimes it works. Sometimes it doesn’t. Usually founders with personal obligations, like student loans or families to support, are able to make a more credible case for an early cash bonus. 

I would also put “Friends and Family” round territory in this category, although it depends. If you’ve raised $250K or less, which is usually what I see for F&F, paying yourself any kind of salary often doesn’t make sense. For larger F&F rounds that are meant to last for over a year, very small founder salaries can work. As a general matter, however, anyone looking to build a company without at a minimum 6-12 months of cash reserves to live off of should re-consider whether they are in the right position to start a company.

Seed / Series A: Enough to pay the bills.

Founders get paid ‘subsistence’ salaries; enough to cover expenses, but low enough to where they’re still hungry for growth. 

Once investors are on the cap table and/or the company is generating real revenue, discussions about founder salaries start to make more sense. The core principle to understand in this stage is that investors will want to avoid paying founders such high salaries that they’re no longer hungry and are just enjoying the ride. The vast majority of a founder’s long-term payout should come from their equity stake in the company, and investors want founders laser focused on turning that stake (and the investors’ stakes) into cash with a successful liquidity event.   That being said, most investors also do not want founders to be so desperate for cash that they are worried about paying their mortgage, or their kids’ schooling, which will be distracting from company matters. 

While this is an extremely rough benchmark and there are all kinds of variations, if you assume 100% as being the aggregate cash compensation of a C-level executive in a respectable, matured middle-market company in a startup’s industry and geography, seed-stage founders will often get paid 20-25% of market, and Series A founders bump up to something like 35-50%. So, as an example, if $250K is ‘market’, a seed-stage founder CEO might earn $50-60K a year, and $85K-$125K at Series A; with the universal understanding that industry, cost of living, and the personal circumstances of founders will push it in either direction.

At this stage, any discussions of founder liquidity (taking some money off the table via a secondary sale) will be non-starters, and even send a negative signal to investors that the founder isn’t as bullish as he/she should be on the company’s long-term prospects. If a founder needs more money (often family circumstances), cash comp, like a special bonus, should be the focus.

Series B/C and Beyond: Edging Toward “Market” Comp, Liquidity

Now we’re running a real enterprise, with the market compensation to prove it. 

It’s at true “growth” rounds when cash compensation starts to edge closer to ‘market,’ and when discussions about some small founder liquidity start to make more sense.  A ‘growth round’ would generally mean that the company has found strong product-market fit, growth is going strong, and they just need gasoline (cash) to propel the rocket ship. At this stage, founder cash comp would usually be closer to 75-100% of market for the founders’ position in the company, which may still be C-level, but might not be. See: Rich v. King: The (Core) Founder’s Dilemma.

A dynamic that starts to arise at the growth stage of a company is the feeling among a founder team (and, frankly, their spouses and families), that even though the company hasn’t exited yet, they’ve ‘made it.’ They’ve made it through the sleepless nights, the chaotic weekends, and the strained personal lives, and have built something with sustainable, sizable market value… but the ‘big pay day’ may still be years away.

It’s at this stage that a spouse might ask a question like, “So… you’ve been at this 5 years and your company just raised $20MM. Why can we still not afford to buy that house I told you about?” Those types of thoughts, which are often not unreasonable, prompt discussions about founder liquidity; meaning the sale of a portion of a founders’ common stock for cash beyond an amount that would be reasonable as a cash compensation package directly from the company.

Some VCs, when prompted by a founder looking to take a little money off the table, will respond bluntly, “absolutely not.” The logic being the conventional “I want you to be hungry” mindset. Over the past few years a counterpoint to that perspective has emerged that is reflected in It All Changes When the Founder Drives a Porsche and Some Thoughts on Founder Liquidity. The logic goes something like this:

  • Once a founder has built demonstrable enterprise value and their equity stake represents a life-changing amount of money, personal psychology and (often) family dynamics can lead them to become impatient toward converting that stake into cash;
  • This impatience can lead founders to become overly conservative in company decisions, edging toward smaller, but earlier exits (early acquisition), when a little more patience and longer horizon could achieve a significantly larger outcome (larger acquisition, IPO);
  • Therefore, allowing founders a small amount of liquidity in growth stage – enough to bring something significant home to their spouses/families/friends to reflect their achievement and calm the financial impatience, but not enough to take their eyes off the much larger pot at the end of the rainbow – can maximize the value of the company, and the eventual payout to investors, in the long run. 

You’ll still often run into both the “keep them hungry” and “let them take a little off the table” mindsets within a single cap table, but I would say the latter view, that some founder liquidity (think 5-10% of their stake) in true growth rounds can push founders to achieve bigger exits, is winning out. It depends a lot on the context, and on the particular investors.

So to summarize, while there are wide variations in the market, some reasonable, rough guidelines for founder comp are:

Pre-Seed / F&F: All equity, minimal or no cash comp, liquidity impossible.

Seed: 20-25% of market cash comp, liquidity impossible.

Series A: 35-50% of market cash comp, don’t ask about liquidity.

Series B-C+: 75-100% of market cash comp, small liquidity possible in right circumstances.

Did you get a “good” valuation?

TL;DR: What a “good” valuation is depends highly on context: geography, industry, timing, size, team experience, value-add of money, control terms, and a dozen other variables. Be careful using very fuzzy guidelines/statistics, or anecdotes, for assessing whether you got a good deal. The best valuation for your company is ultimately the one that closes.

VC lawyers get asked all the time by their clients to judge whether their financing terms are good, fair, etc; especially valuation. And that’s for good reason. There are very few players in ecosystems who see enough volume and breadth of deals to provide a truly informed assessment of a financing’s terms. Executives have usually only seen their own companies. Accelerators see only their cohort’s. Most advisors/mentors have even more limited visibility.

But VC lawyers/firms with well-established practices see deals that cross geographic, industry, stage, etc. boundaries.  In addition to a firm’s internal deal flow, there are third-party resources that can be subscribed to with data on VC valuations across the country and the world. Those resources tend to be expensive (5-figure annual subscriptions), and only firms with deep VC practices will pay for them. Given how much you’ll be relying on your lawyers for advice on your financing terms (for the above-mentioned reasons), ensuring that they are objective (and not biased in favor of your investors) is crucial. 

The above all being said, founders should understand that determining valuation at the early stages of a company (seed, Series A, B) is far far more an art than a science. It is for the investor making the investment, and it is for the people judging whether the terms are “good.” That’s why relying on broad metrics like “median Series A valuation is X” is problematic; there are simply too many variables for each company that could justify deviating from the median, in either direction (lower or higher).

What some people call a seed round, others might call a Series A. Some companies raise a Series A very early on in their company’s history because the nature of their product requires serious capital expense to even get to early milestones. Other companies bootstrap for a decade and only use a Series A as true growth capital (the way others would use a Series C or D). I saw a $150MM ‘Series A’ once. I’ve also seen $500K ‘Series A’s. And everything in between as well. So whenever someone asks me “what’s a good Seed or Series A valuation?” the answer has to start out with: “it depends.” 

Below is a break-down of the mental analysis that I might use in assessing a company’s valuation. Remember, it is an art, not a science. There are widely varying opinions here, and this is just one of them. Consider it a set of suggested guidelines, not rules.

1. What was the last valuation a professional investor was willing to pay, and what progress has been made since then?

The easiest answer to “what is X worth?” is “whatever price someone was willing to pay.” While not entirely helpful in the VC context, it certainly is relevant. If you’re doing a Series A and you have institutionals who invested in a convertible note at a $5MM cap a year ago, the obvious question then is “how much progress has been made since then?” This, btw, is why it’s dangerous for companies to set their own valuations without a true market check from professional investors. Your earlier valuations will influence your later ones.

2. What city are you in?

Location. Location. Location. One of the strongest determinants of valuations is the density of startup capital in the city your company operates in; because density means competition. Silicon Valley valuations are not 2-3x those of the rest of the country because the VCs there are just nice guys who are willing to pay more. It’s a function of market competition. SV has the highest valuations. NYC follows. And then there’s the rest of the country, with variations by city. Austin valuations are generally higher than Atlanta’s, which are generally higher than Houston’s or Miami’s. General deal terms are also more company-friendly where there is more investment density.

While the entire concept of “founder friendly” investors does have an important moral/human dynamic to it, people who play in the space enough know that at some foundational level it is a form of self-interested brand differentiation. The ‘friendliest’ investors are the ones in the most competitive, transparent (reputationally) markets. Why take our money over theirs? Because we’re ‘founder friendly’… which can mean a whole lot of things; some of which are relevant, and others which are nonsense.

Yes, online networks are breaking down geographic barriers and you are seeing more capital flow between cities/states, but the data is still crystal clear that if a Silicon Valley VC is investing in an Atlanta or Austin company, they are going to want to pay something closer to Atlanta or Austin (not SV) prices. Much like all the Ex-Californians buying up Austin homes, they likely will pay slightly above the local market (and in both cases, it pisses off local buyers), but not much. 

3. How much is being raised?

Valuations can (and often do) vary widely between markets, while the actual dilution that founders absorb doesn’t vary as much. How is that? Because founders in markets with higher valuations raise larger amounts of money, and founders in markets with lower valuations raise smaller amounts of money; in each case getting the VCs/investors to their desired %. A $1MM raise at a $4MM valuation produces the same dilution as a $5MM raise at a $20MM valuation.

You should never close any round without modeling (lawyers often help here) the actual dilution you are going to absorb from the round, including any changes required to your option pool. Many investors focus first on their desired % and then back into the right valuation and round size. Smart founders should focus on %s as well. It’s not intuitive; especially if you have multiple rounds involved.

4. Who are the investors?

Value-add, known-brand institutional VCs and professional angels that will be deeply engaged in building your company after the check hits are (obviously) worth a lot more than investors who just bring money. And they will often price themselves accordingly (lower valuations). Some money is greener.

Diligencing the valuations your specific investors were willing to pay for their past investments is a smart move. Again, it still requires discussions about the differences between companies, but it can help address any statements like “we never pay more than $X MM for Series A.”

5. What are the other terms?

A $4MM valuation with a 1x non-participating liquidation preference looks very very different in an exit from a $6MM valuation with a 2x participating liquidation preference. So does a $3.5MM valuation with investors getting 1 out of 3 Board seats v. a $5MM valuation with them getting 2/3. The non-valuation terms matter. A lot. Juicing up valuations by accepting terrible ‘other’ terms gets a lot of companies in trouble. 

6. Other Business-Focused Variables

  • What are valuations within this specific industry looking like over the past 12 months?
  • What are the obvious acquirers paying for companies they buy?
  • Where is the company in terms of revenue? Revenue-multiples generally don’t have a place in early-stage, but a $25K MRR v. $300K MRR absolutely influences valuation.
  • Any serial entrepreneurs on the team? Good schools? Other de-risking signals?
  • What’s growth look like?
  • Size of market?
  • etc. etc. etc.

Obviously, multiple term sheets are a great way to have a very clear idea of where your valuation should be, but in most non-SV markets that is a privilege bestowed on a small fraction of companies.

Take-homes:

A. If your friend’s startup got X valuation for their Series A round, that can be totally irrelevant to what valuation you should get,

B. Other terms of the financing matter a lot too, as well as who is delivering them, and

C. If you have in your hand a deal that isn’t exactly at the valuation you wanted, remember that there are thousands of founders out there who got a valuation of $0.

Over-optimizing for valuation can mean under-optimizing on a host of things that matter far more for building your business. Get the best deal that you can actually get, given your business, location, and investors, and then move forward. And ignore the broad market data, particularly the Silicon Valley data, that isn’t relevant to your own company.