Venture capital is not broken. But it could use an alternate incentive structure.

February 19th, 2009  Comments

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Summary
Much of the “venture capital is dead / broken” cacophony focuses on how most angel and venture capital investors have been unable to adapt their investment and operational models to fit the new economics available to many entrepreneurs. Perhaps we just need an alternate investment structure to align incentives and economic models.

Not a replacement, but an alternative for some situations. Instead of accepting what is, let’s think about what could be.

Feedback Requested: A Flexible Structure for Partnering with Entrepreneurs

Conversations around the best structures for pre-venture capital Series A investments often focus on convertible debt and preferred equity. It’s not a simple question: the “best” structure really depends on the specific situation and often comes down to a value judgment over which structure is more “fair” or “easy”.

Structures create incentives; perhaps what the venture industry needs is an alternate model to align incentives and economic models.

In response to a couple business opportunities I’ve been evaluating, I’ve been playing around with some ideas for an investment and compensation structure that could work for the type of fluid investor, consultant and entrepreneurs partnering relationships that new organizational and economic models are making more possible and more common.

Goals

  • The fundamental problem: how can investors and consultants help entrepreneurs start businesses and get fairly compensated for the value they create?
  • Establish the rules and create more interactions: what’s the hardest problem in starting a new venture? What decisions need to be made in the beginning?
  • Create structures that enable flexibility, create more intermediate decisions and tie payments to actions, not to negotiations.
  • Allow consultants and investors to contribute as needed to help entrepreneurs.

Structure
The structure has two key parts to create compensation and investment agreements for investors / consultants and entrepreneurs:

1) Compensation: Convertible Preferred Shares granted under a Kudos Model.

  • Convertible Non-Participating Preferred Shares.
  • Granted by the entrepreneur to the consultant / investor under a version of a Kudos Model: the entrepreneur selects the number of shares to grant every three months based on their estimate of the value created over the past three months. The entrepreneur cannot retract granted shares.
  • Shares are priced at $X per share (price TBD: set at same for all shares).
  • Share holder holds the decision to convert (portion or all) of shares to 1) Equity at next qualified investment round or 2) Convertible Debt at any time under the terms in the instrument detailed below.
  • Shares are convertible at 1:1 ratio for shares bought by the next investor at the next round (common, preferred or whatever form of equity negotiated).
  • “Next round” traditional VC sets the pricing and terms of the shares.
  • The shares vest immediately.
  • Cash compensation: the holder of the shares holds the option to be paid cash compensation whenever the company reports a cash flow positive month (or whenever the entrepreneur draws cash from the business), commensurate with the share holder’s % equity ownership of the company. Repayment will reduce the amount of Preferred Stock held by the Consultant / Investor. E.g. if the preferred stock holder owns 10% of the granted shares in the overall company, whenever the entrepreneur draws cash compensation from the business the preferred stock holder will be paid 10% of the cash compensation.

2) Investment: Convertible Debt

  • Consultant / investor invests capital into the business through a convertible note.
  • Note carries an interest rate of 10%. Interest is not paid as cash but is added to the contributed capital in the note.
  • Multiple closings: the note is “open” for continued investment for one year from date of issue. This is so that the investor can continue to gauge progress and invest money into the business depending on capital needs and continued interest and commitment to the business.
  • The note converts at a discount to the conversion price on the next round. The discount will be a maximum of 25% (five percent per month, depending on how long it takes to close the financing, up to the maximum) off of the per share price.
  • Debt repayment: the holder of the convertible debt holds the option to be repaid portions of the debt whenever the company reports a cash flow positive month (or whenever the entrepreneur draws cash from the business). Repayment will be X% of the positive cash flow or X% of the cash flow drawn by the entrepreneur (% TBD, to be negotiated).
  • No personal guarantee of the note by the entrepreneur.
  • Weighted average anti-dilution protection.
  • Investor holds the right to participate equally (pro-rata) in further investment rounds under the same terms as the next investors.
  • Basic protective provisions: no pre-payment of the note by the Entrepreneur, pre-specified payment if there is a change of control prior to a venture round, and a cap on the amount of additional debt a company can take.

Other Terms:

  • Financial statements: entrepreneur is required to send a monthly CEO update; unaudited financial statements available upon request.

Starting the conversation…

  • A little confusing? Perhaps.

    As you think through the terms and the necessary improvements, consider one of my basic thoughts: How can we let continuous interactions and decisions, rather than scheduled commitments, determine the flow of attention, talent, time and capital? How can we introduce elements of game theory into our investment and operating structures?

  • Valuation: Why aren’t the convertible shares or the convertible debt properly priced to a % ownership of the company at the time of grant or issuance?

    Establishing valuation at this stage really isn’t worth it. The intention is to push the valuation decision to when all parties have more information.

  • Can’t the entrepreneur choose to “underpay” the consultant / investor by not granting enough shares?

    Yes, but that will make the working relationship pretty short, and that’s probably not in anyone’s interest.

  • What if the entrepreneur will never be able to sell the business or achieve a qualified investment?

    The consultant / investor has the continuing option to take cash or hold shares; if the business turns out to be a cash-flow based business, then the consultant / investor will want to convert their ownership into whichever instrument maximizes their return.

    Yes, that means the investment may turn out to just be a loan.

  • Keeping an accurate share register is very, very important to track the conversion options and current shares / debt structure.

    No question. And while this is a bit more complex, is it anything more than a couple extra lines in our Excel models?

  • Why are the grant timelines set for every three months? Why don’t the grants only occur at investment rounds?

    Because for some “lifestyle” startups there may never be qualified investment rounds; the economic models simply won’t fit. Why three months? No particular reason, open for ideas.

  • This is way more complex than the typical convertible debt or preferred equity structure; investors, entrepreneurs and lawyers understand those agreements and this type of agreement will create large legal costs for investors and entrepreneurs. Legal agreements are already too large of a transaction cost (time, money and focus) in starting businesses.

    Really? Seriously? We are nowhere close to a set of industry standard documents. A huge variety of structural decisions, terms and clauses are negotiated on a case-by-case basis. Legal fees are a pretty hefty transaction cost in raising capital and and creating option / equity structures. Is this really that much harder to structure?

    The goal of this idea is to create a standard structure and a set of interactions and less-standard decisions after the agreements are signed and the business starts, instead of focusing on the decisions before the business starts. Legal agreements are important; let’s help figure out ways to get them done sooner and quicker to let people start creating businesses.

    In addition, this structure effectively “punts” on many decisions and pushes the negotiations over pricing and other terms to the next investors, the next round or the later stages of the company, at which point the entrepreneurs and investors will be in better position to pay the necessary transaction costs and additional investors will be involved to help set terms.

  • We (investor and entrepreneur) know exactly how we’re going to work together, how we’re going to balance our time and capital contributions and how the business will make money for both of us.

    If you know all of that, awesome.

    But there’s a good chance you don’t, and a better chance you’ll be wrong.

    Why create a structure that won’t allow you to adapt and change your relationship, time commitments and capital contributions over time?

Disclaimers

  • It’s not meant to work for all situations. It probably won’t work for traditional angels or venture capital investors: in my mind it is best suited for the $0 to $100K “friends and family” pre-seed stages. But more importantly, it might work for consultants / investors and entrepreneurs that need a flexible, multi-facted, non-priced investment and compensation model to fit their fluid organizational model and “the great unknowns” of the future for their businesses.
  • I’m not an expert. I’m not a VC. I’m not even an entrepreneur, really. But by sitting in the middle I see a both sides to similar arguments. I’m trying to imagine something different. Maybe I’m wrong: I’m fine with that, but I’m interested in learning why I’m wrong.
  • This is not fully baked; it’s lacking many necessary terms, covenants, warranties and representations; I haven’t introduced the “Qualified IPO” concept,or “drag-along” rights and protective provisions on sale, I’m not sure about the nature of the convertible shares and liquidation preferences (participating? preferred or common?), maximum conversion clause, there are decisions to make on share vesting schedule, anti-dilution, Board of Directors, tax implications, etc… I’m looking for the discussion to help flesh out the details, point out holes and hopefully add new ideas that may help investors, consultants and entrepreneurs.

Inspirations and Resources:

Updated: Mentioned in the Wall Street Journal online Venture Dispatch column The Daily Start-Up.

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By Taylor Davidson. Posted February 19th, 2009. Category: Financial and Business Models for New Opportunities, Venture Capital for Everyone   Comments

SIMILAR THOUGHTS

  • Taylor,

    Great post. I love your articulation of the fundamental problem (which absolutely exists):

    ". . . how can investors and consultants help entrepreneurs start businesses and get fairly compensated for the value they create?"

    Your third goal also jumps out at me:

    "Create structures that enable flexibility, create more intermediate decisions and tie payments to actions, not to negotiations."

    And your proposed solutions have got me really thinking about what it would take to create a contract to support these goals.

    You've hit on such an important issue. Starting-up a business is inherently uncertain, but the potential value is the natural counter-balance, so how do we share the risk and rewards of the germination phase given different types and amounts of investment?

    If we had a new type of contract, as you're suggesting, to allow a consultant or freelancer to "invest" in the company with services as well as allow others to make small seed investments in such a way that they could be compensated as the business matured and revealed itself, that allowed them to ante up or cash out or trade that value horizontally (other investors at their "level") or vertically (with angel or VC investments), then it would allow for a lot of tinkering and innovation that's not happening now.

    I want it! :)

    There must be some kind of cash/debt/equity structure, some of which I'm sure is contained in your post, that can make it a reality.

    Look forward to your next post on this topic.
  • Taylor,

    Some very good thoughts here. A few points to add to the discussion:

    1.) You're touching on a real issue. The small businesses that need consulting help cannot afford to pay for it in most cases. As an outside expert, how do you get paid? And how do you get rewarded for taking risk + adding value early on?

    2.) Any security that converts into the same securities as the next institutional investor won't fly. VCs have many control provisions exclusive to their class of Pref shares. They like to keep things clean by limiting ownership of those shares to themselves.

    3.) Early on, I think consultants have one foot in the company, one foot out. They're sort of part of the company. They need some cash to keep the lights on and other cash or shares. Those shares should be common and should be fully vested. That does mean more frequent grants. No point giving options with 4 year vesting because if the startup does its job right, it will have outgrown the consultant.

    Look forward to seeing what others have to say about this.
    Mark
  • Mark, thanks for taking the time to think about the ideas and the goals...

    1) Are those questions rhetorical or directed to my own business model? Honestly, I'm trying to test new models like this with prospective clients. Trying to sell services to people that a) don't value it and b) don't have the money to pay is a bad business model; yet the services are valuable. The problem is that the contracts and standard agreements the industry has in place simply don't allow for enough value exchange (i.e. help).

    It's hard (impossible?) to measure and allocate value before it's created: what could happen if we created contracts that tied payments to actions instead of negotiations?

    2) Conversion: I'm aware of the preference; but is it because of structural incentives or because it's just "not how it's done"?

    3) I agree a cash + shares model is better; it wouldn't be a stretch to adopt my outline to include a simple hourly / monthly retainer rate. I thought about the share vesting schedules and came to the same conclusion; if the shares are meant to be compensation, then they really should vest immediately.

    The alternative, of course, would be to adopt some vesting schedule (either the "cliff" method or the 50% linearly / 50% equity event), forcing the entrepreneur to grant more shares than they would under an immediate vesting schedule. Depends on the extent of relationship; food for thought, but probably less applicable.

    I also thought about the preferred / common choice: wasn't really sure so figured I'd throw it out there to gauge the responses :)

    The interesting thing is what if a consultant also wants to contribute cash to the business? How should their "investment" be handled? How to we value cash and time contributions?
  • Taylor, Sorry for the delay. Responses:

    1.) Both.
    2.) Also both. VCs operate under the golden rule. He who has the gold makes the rules. They're hard to get to change habits. Also, since they actually pay real money at a higher price for their shares they don't want other people getting the same class of shares for free.

    I don't have one silver bullet answer to the issues here. Will keep thinking about it though
  • Yep: and that's why I don't want to change existing VCs, but create the opportunity / structure for a different class of non-traditional VCs.
  • Glad that you find the Startup Company Lawyer site helpful -- I don't know if I'd really spend a "day or two or ten" reading ...

    1. Compensation - Not sure what you are describing, but if it is issuing a security for "free," then it results in tax to the recipient (and the recipient does not receive cash to pay the tax). There are various other tax issues here -- but the fact pattern is like an "issue spotter" law school exam.

    2. Convertible debt - I don't think that there is anything "new" about what you have described. Some of the terms are not standard, but not "fatally" non-standard. The concept of weighted average anti-dilution protection does not make sense in the context of convertible debt. The eventual underlying security may have anti-dilution protection, however.
  • Startup Company Lawyer is definitely worth a day or two of reading :)

    Agreed: there's nothing really new in the convertible debt structure. I'm more curious if the combination of the two instruments (and the ability to trade between instruments) is new, valuable or meaningful to entrepreneurs, consultants and investors.

    Thank you for the pointers on the dilution protection and the tax implications. I'll admit that I'm not an expert at the details in the structures: trying to think about the frameworks first...

    What would be a better way to issue securities for compensation?
  • A stock option is a more tax efficient way to issue equity for compensation. A consultant probably has some theoretical income based on the intrinsic value of the option, but that is typically mininal.
  • Agreed: but wouldn't it be harder to trade "ownership" between the two options (debt and equity) if the equity was structured as an option?

    Could there be a tax-efficient way for a consultant / investor to switch their ownership between debt and equity?
  • Taylor, I like the thinking and the spirit, and at the same time am choking on the complexity. From the entrepreneur side, I see two type of help I need... the specific task stuff and the stuff that unique value that the person has to bring from all their experiences (that's the stuff we only find through collaboration). The specific stuff is stuff that I'd lean to paying for or have some form of deferred/convertible payment. The second stuff, is stuff that happens with little effort but needs the people to be able to 'hang-around' together as the venture progresses.

    So maybe, the first could be tied to any convertible debt, and the second be dealt with through friends and family/founder share allocations. Keeping to the existing agreements that exist with the company might make it easier to do. For lifestyle ventures, the friends/family allocation will more likely be a future favour or barter service.

    Great stuff... glad you keep putting this out there for conversation.
  • I agree the structure is a bit too complex, and potentially cumbersome. Perhaps it would look less complex if I didn't give some of the details behind the two instruments, details that would be better left to more minor clauses in the agreements.

    That's an interesting reformulation, and I like the tie between the two instruments and the type of work done. It's a "payment for discrete value" and "maybe you'll get something out of it for the advice you've provided" type of formulation, right?

    However, it still reflects a flow entirely from the entrepreneur's perspective: how can we create systems that allow consultants / investors to make more intermediate choices behind their own work contribution and how they want to be paid?
  • I think what I'm more getting at is a difference between the mode of
    engagement. I think there are two types (at least) at play... the type where
    something very clear is needed - and from a consultant's perspective is
    something that is generally useful and templateable/replicable. This type of
    thing needs to be operationally core and directly connected to something
    that is required by a venture or leads directly to value. It is something
    where the product will structurally look the same every time.

    The other draws on the fit of life experiences and strategic/situational
    needs of an organization. They require fit based on DNA and culture to be
    effective. What the look like could be different in every situation and are
    unique to the connection between the individual and the venture.

    Not sure if that is making sense... happy to explore further...
  • As an entrepreneur in need of investment to develop my company, I would bend myself over backwards to make investing attractive to an investor. On the other hand, there are certain things which I cannot change, such as the amount of time it takes to develop and test software. Do you have any suggestions for how to find investors who are interested in remaining vested in a company for years? Thus far I have only run into investors who want to be in and out in six months and are not interested in longer term projects regardless of growth potential.
  • Not sure what kind of investors you are talking to, but VC investors have timeframes far longer than 6 months and are indeed interested in long-term projects (3-7 years).
  • I'm going through the investment side of your model now and it seems an example will help me understand it better:

    Suppose we have a business that is a lifestyle business. The upside will come from retained earnings (eg profit sharing) and not things like IPO, acquisition, etc. I mainly looking at this as social investment; I'd like to get my investment back and a limited upside is ok with me. I'd like to be actively involved in growing the biz but not looking for outright compensation.

    As an investor, I put $10K into a biz with convertible debt at 10%.
    We agree on terms to pay down the loan out of retained earnings.
    At the end of a year, I have $11K in the biz.
    The biz generates retained earnings of $25K.
    We settle on 80% plowback and generate a dividend of $5K.
    We settle on a 50% dividend split and I take $2.5K.
    My net is $-8.5K.

    At this rate, it will take about 4 years to break even the original investment, time value considerations largely excluded.

    I proceed through the first couple years and have a loan balance of $5K. I decide to convert. It converts at a 25% discount to yield $6.6K in equity. We agree to value the company at 1x revenues. I own 6.6/250 = ~3% of the company.

    At this point, the retained earnings repayment schedule doesn't apply. My equity is only valuable when the entrepreneur shares a profit or there is a new financing event.

    Before I try to analyze it as a deal, is that basically how it would work in a simple company, single round example?
  • Sounds reasonable.

    A new financing event doesn't make the equity "valuable" (i.e. doesn't distribute cash), it merely sets a price.

    I'm curious why you would convert outside of a liquidity event; setting valuation can be a contentious negotiation for business partners.
  • You're right and that's a good point. The way I was thinking about it is this: I'm a social investor but I also want to be part of a winning team. Halfway through the loan, I see that I'm willing to take an equity stake and write off my loan because I'm forecasting the equity to be valuable one day. I want to buy shares at today's valuation. There is no liquidity event yet but I'm expecting there might be. Since the entrepreneur is paying down the loan as he goes, if there is a liquidity event after the loan is paid off, I don't profit.
  • ok. but how do you set "today's valuation"?

    perhaps instead of "Debt repayment: the holder of the convertible debt holds the option to be repaid portions of the debt whenever the company reports a cash flow positive month"

    ... it's simply holder of note holds option to be repaid... but may request to not be paid.

    this would keep the value in the note.
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