Notes to a Startup - Growing Pains

Here are a few pieces of advice I offered to a new start-up company in Vancouver in response to some questions they had about taking on outside investment. I thought it was worth sharing…

1) Regardless of whether we went with a debt (based on future earnings) model or an equity model, would we need to create an official board of directors, or can we just have an advisory board? We’d prefer the latter, so we can avoid all the governance issues.

As a private incorporated company, you are required to have a Board. Not having one doesn’t avoid governance issues – it creates them. This is actually a big deal. Running the company with proper attention to governance (regular meetings, minutes, resolutions, etc.) builds investor confidence.

Anyone making an investment in you will require it to be properly structured. This usually means a Chair and two Directors. You could be the Chair. Your co-founder could be a Director. The investor(s) will probably want to nominate the second Director.

In practical terms, the pair of you still carry the majority power on all decisions at the board level and the same at the shareholder level. The investor(s) may make it a requirement to change that somewhat in the terms of their investment. For example, they may try to get Preferred Shares with voting rights that can trump your Common Share rights.

Think of it from their perspective: they will give you a substantial chunk of cash but you have all the power to spend it any way you want including paying yourselves every penny and they have NO recourse. A big concern of theirs will be that you will create a ‘lifestyle company’ that is designed to provide you with a substantial income but that will never provide a return to the shareholders because you are not incented in any way to give them an exit or pay them a dividend.

Having this properly structured also allows you to apply for BC Small Business Venture Capital Act tax credits. Check these out:

Tax Credits

Small Business Venture Capital Act

These credits are an AMAZING way to get small/angel investors interested in your business. I can explain in more detail if you like.

2) In forming an advisory board, is there protocol/etiquette? For example, should I be asking all the major investors to be on the board? Should I be concerned if they want to invest but do not want to be on the board? (After all, we also want the brainpower, not just the cash).

You should certainly have advisors (sometimes called ‘mentors’) to help provide you guidance in running the business. These advisors should be selected for their ability to contribute expertise. If they invest, so much the better. Having a ‘silent investor’ on your advisory board is a waste of your time and the time of the other advisors.

There is some debate in the community as to the value of an advisory ‘board’. This is because some companies have filled their boards with every small investor and a bunch of people pretending to help. Boards like this are laughed at. They are sometimes an attempt to distract investors from asking for influence on the Board of Directors. It rarely works.

If you pick your advisors carefully and they regularly meet together to help you, you have an advisory board. If they work independently, they are mentors.

One big issue with advisors is compensation. These are professionals who usually expect some benefit in return for their time/expertise.

If they have invested, they may want to provide free advice to help grow the company and therefore their value. These are multi-win people to have in your company – get lots of them (assuming they offer advice that is actually helpful).

There are some advisors who want to help for altruistic reasons and don’t require compensation. This can be wonderful but you have to weigh their contribution against your expectations of their willingness to hang in with you for the long haul (5 or more years). Also, if they get no value in actually making the best decisions for the company, other factors can come into play in their advice to you and it can lead you astray at crucial times for the company.

One of the ways to reward advisors for their contributions is via stock options. You may want to consider an Employee Stock Option Plan to reward directors, advisors, executives and key employees with either stock options or restricted stock. These are not hard to set up. I can give you details if you like including recommended ratios for the different groups.

The benefit of the stock options is that they have no cost to you or the grant recipient at the time they are issued. However, they do have what can be a big cost to you in the future when you sell the company or issue dividends. Most small companies give away a bit too many options at the beginning.

Another way to compensate advisors is to obviously pay them. From this point of view, your lawyer, auditor and accountant are advisors, especially if you get some free advice along the way.

3) We keep having people ask us, “How much do you want to raise?” We’re not sure yet. That will be partly driven by the global sales/marketing strategy, and we first need advisors who have done this before to tell us how much they think that might cost. Almost all of our Biz Dev experience has been the dialing for dollars and slow, relationship building routes, but this new strategy will be vastly different, and it’s foreign terrain for us. So, should we really have those marketing costs nailed down in the business plan before we go ask for funding?

There are quite a few different influences on this:

the amount of money you need right now to get you to the next level in the business,
the amount you will need in the future to achieve the maximum level of market penetration you can envision,
the amount of equity you will give away in your company now and later to get the money you need (which influences valuation),
the amount of money the investors would prefer to invest at the current state of maturity of your business, etc.

Asking for too little and for too much are both difficult.

Too little and you risk not achieving the goal, investors get nervous and it gets difficult to raise the amounts you need in the future.

Too much and you give up too much equity at too low a valuation making it difficult to raise money in the future (I know this sounds strange but I can show you why it works like this).

Everyone has a different opinion. My hunch (without looking at your numbers) is that you will be looking for a Seed round of around $1M. If you can show significant market traction in the next few months i.e. while you are trying to raise the round you may be able to go for a Series A VC round of $2.5 to $4.0M and really shoot for the moon. Actually looking at the numbers may change this SIGNIFICANTLY.

In your business plan, I think you need to figure out:

The life-time value of a target customer to you expressed in revenue/year for X years.
The number of customers you think you can acquire in each of the next few years.
The expected cost to acquire a target customer. This includes the promotional costs divided by the number of customers they will influence and all the staff costs for running these programs and the customer outreach.
The expected cost to service the customer. This includes all customer support staff costs divided by the number of customers they can service.

Actually testing the incremental cost to acquire a customer (ad or direct mail costs plus apportioned staff time) will provide you HUGE benefits in figuring all of this out.

If the numbers are working out correctly, you will show that $X of investment in the marketing functions will generate $Y of profit. If Y > X by more than 50% it makes sense to grab as much money as you can (assuming you can actually build the business very quickly).

Short answer: nail the numbers and your ask will be much easier.

4) Is it better to have just one or two major investors or 10-20 smaller investors? I can see pros and cons each way, but what would be your opinion?

Smaller number of investors is better. You have fewer people to keep updated and your time is your most precious commodity.

5) In the eyes of investors, what is a reasonable salary for the CEO to take these days? My income has been well into the six figure range for more than a decade, and at my age and stage, I’m not willing to work for Ramen noodles. But I also realize that if I take a $15K/month salary (which would still be a big step back for me) then that would quickly deplete the piggy bank. So, is there sort of a generally accepted amount that most CEO’s would be taking and that most investors would accept without questioning it?

Tough one. It depends a whole bunch on how much the business is generating. If you are cash flow negative right now they will be very reluctant to pay you a full salary. I’ve heard a few investors say they won’t pay more than $120K i.e. sustenance money because they want you REALLY motivated to grow the business to a successful exit where everyone makes a fortune. Otherwise, the risk of you turning it into a lifestyle company is substantially greater and they will be very reluctant to work with you.

Think of it a bit like this: the more cash you take out of the business along the way, the less it is worth in the end because you haven’t invested that cash in leverage-able revenue generating activities. And, at exit, a dollar of profit is worth $20 or more in your pocket (based on typical exit multiples). As a retirement income vehicle, this is a huge thing because that $20 is taxed at capital gains rates, not regular income rates which makes it worth almost twice as much to you or over 40X more than the $1 of income in the end.

I’d recommend you take out the absolute minimum that you can afford to live on. From there, set up a bonus structure where if you achieve certain milestones (e.g. cash flow positive at $2M per year revenue) you get a kicker to make life a bit more fun.

Finally, because of the logic behind taking the absolute minimum you can afford to live on is so financially compelling, every dollar you need above that point decreases the amount the investor thinks you believe in your plan and are trying to hedge your bets. It can really have a negative impact on your ability to raise money.

These are good thoughts but not perfect thoughts. Please take that into account if you apply them to your situation. I’m happy to clarify them personally for you if you ask.