14 posts categorized "Equity Incentives"

Startups & Social Equity (Or, How Startups Can Effect Social Change in Ways Governments Can't)

My girlfriend and I heard Richard Wilkinson talk yesterday at the Department of Communications building on the University of Washington campus. From what I've learned in the past two days, Wilkinson is an epidemiologist, renowned for his work about how social inequality impacts the physical and mental health of a given society. His focus is on rich countries. One of Wilkinson's tenets is that we now living in developed democracies are of the first generation to experience the outer limit of the benefits of economic growth. That is, while economic growth continues to be the best way for poorer countries to improve the health and welfare of their peoples, in the rich, developed countries of the world, further economic development has no statistically measurable benefit on health, happiness or quality of life.

Instead, Wilkinson says, the health, happiness and quality of life in a rich society relate to income differences within that society. The greater the social inequality within a society, the poorer its overall health (for both the rich and poor of that society). 

Wilkinson has a standard slide presentation to make his case using graphs. "Social inequality" can be defined differently -- and from questions from the academic audience yesterday it was obvious that Wilkinson and others are conversant with more nuanced statistical methods of defining the concept -- but for purposes of his presentations to the general public (as well as for a book just published, The Spirit Level, co-authored with Kate Pickett), "social inequality" is measured by the extent of the gap in income between the top 20% and bottom 20% of a given society.

In category after category, Wilkinson asserts, rich countries with less of a gap between their rich and their poor, or, to put it in positive terms, rich countries with greater social equality, are healthier and happier. Societies that close the gap between rich and poor experience less crime, fewer teen pregnancies, fewer mental health problems, and less incidence of manifold other ills. The correlations are not simply statistically significant, he says; they are extraordinarily regular and have almost no outliers (key exception: Japan performs on all scores as a relatively equal society, in spite of unusually high gender inequality there).

Wilkinson seems concerned that his thesis could be countered by arguments that creativity and innovation might be stifled in societies that place too great a premium on equality. It's a savvy concern for someone who does not appear to be steeped in business affairs or entrepreneurialism. (I don't know the man or his background; I make this deduction from his use of business terminology, which is not idiomatic for him, even after adjusting for the fact that he is from the UK). I think Wilkinson intuitively appreciates that the case for social equality could be undermined by an argument from a kind of social Darwinianism, which would say that societies should permit social circumstances of potentially great difference or even extremes, in order that innovators might be singled out and rewarded.

That said, the chart Wilkinson produces to protect his vulnerable "flank" is not as satisfying or compelling as one might hope, though it is interesting. Here it is (courtesy of The Equality Trust, an organization associated with Wilkinson):

As an faq on the Equality Trust site puts it, "[t]here is a weak but statistically significant tendency for more equal societies to gain more patents per head than less equal ones." Query whether patent issuances are an appropriate proxy for innovation; to the extent they may be, however, the suggestion is that the US may be underutilizing its human capital.

Wilkinson in person carries himself with confidence, grace and ease, but nevertheless wears on his sleeve a sense of futility about the possibility of effecting change through government policy. At one point, he mentioned that he and his co-author have been invited to present their ideas to the cabinet of the British government on Downing Street in February, though he was (a) skeptical about how many cabinet minsters would bother to show up, and (b) convinced that politicians cannot adopt positive measures to effect change, regardless of their judgments, without a broad political mandate from their electorates. To a question from the audience about the wisdom of changing Washington State's regressive sales tax policy as a means to promote social equality, Wilkinson grudgingly acknowledged that such changes could be marginally useful; but changes of that order, Wilkinson went on to opine, are just as likely to be undone by a succeeding administration, and in any case are not basic or fundamental enough.

What would be fundamental enough? Here Wilkinson showed his cards and (wittingly or not) stepped into an arena that startuppers and their investors know and live with (and sometimes struggle with): something fundamental would occur, he said, with greater employee ownership of the businesses in which they work. In Wilkinson's terms, greater employee ownership turns the place of work from alienable property into community. (For a quote on this point that is closer to the words Wilkinson spoke yesterday, see my tweeted notes.)

I now move from the realm of Wilkinson's statistics to the subjective and the anecdotal. Although I see, and share, some ambivalence in recent years about the kind of company-wide stock option programs that were typical in the dot com era, all of us in the startup and emerging company ecosystem (founders, management teams, investors, lawyers and other advisors) routinely wrestle with setting and implementing ownership and equity incentive stakes for management and key personnel. In our subset of the economy and society, we know that the employees we want, need themselves to speak for, to identify with, the enterprises they are building. Giving the right people the appropriate stake in an enterprise will, we believe, help the enterprise succeed. I don't know how well statistics might bear out that belief. 

I do know, however, that tech entrepreneurs who start new companies, in this century, do so not so much to pay themselves bank executive-like salaries but instead primarily out of a desire to live more authentically. Those who found ventures after working for years or decades at a larger enterprise are especially adamant about finding in work the means to fulfill that ambition, to change themselves and others around them, and sometimes, yes, to change the economy or the world. It can get very, very personal; startupers who are parents come to understand how imperative it is to model for their children a way to live well and purposefully, to refuse to mark time in an unsatisfying relationship with one's work. 

So something about what Wilkinson says resonates deeply. If he is suggesting that a kind of social vitality is borne of widespread engagement in a shared enterprise, he is saying something we already know to be true. There remain implications to be worked out.

The VC Carry as an Executive Compensation Model for Wall Street

In the course of a talk yesterday at Reed College, J. Bradford DeLong, UC Berkeley economist and blogger extraordinaire, made (what I took to be complimentary, if incidental) references to two practices of venture capital financiers: their avoidance of leverage; and their method of compensating themselves.


DeLong's talk, "Financial Crisis & the Macroeconomy, 1825-Present," surveyed common patterns of financial panics caused by bankers over the last couple hundred years, together with the responses of governments and central banks. A common denominator of such meltdowns is an excessive use of leverage. Thus it is, explained DeLong, that although four times as many dollars were lost in the dot com crash at the beginning of this century than have been lost in bad mortgages in the current sub-prime crisis, we did not fear the onset of a depression then as we do now. The difference is that the dollars lost then were not borrowed, and so the losses stopped with those who had invested in tech companies and the funds that invested in tech companies.

As for prescriptions to better align executive compensation on Wall Street with prudent risk-taking, DeLong suggested that Wall Street use the model of venture capitalists from Silicon Valley: put the compensation in the form of a carried interest, that only pays out if the company does well for its other stakeholders over a longer time horizon. This model, DeLong seemed delighted to state twice in his talk, would turn all ambitious 35 year old investment bankers into their firms' best risk managers.

How long is "long term" enough? Initially, DeLong seemed to say yesterday that executives' compensation should be tied to the fates of their companies over a 15 to 20 year time frame; this may be his best judgment for policy, even if it varies from the time frame that his venture capital industry analogy would suggest. Later in the talk, though, I thought I heard DeLong say 10 (or 10-plus) years was an appropriate period of measure.

Contrast this with the approach of the Treasury Department's special master for executive compensation, Ken Feinberg, who according to Time is looking to get executives of bailed-out financial firms to think three or four years down the road:

In the end, he made more changes to the way executives get paid than to how much. . . . Gone are year-end payouts and AIG-style guaranteed retention awards. Instead, he devised . . . something he calls salary stock. Each pay period, the executives at Bank of America, GM and the other firms will get awards of stock along with their regular paychecks. The checks can be cashed immediately, but the executives may not sell the stock for up to four years. Also, bonuses are paid in restricted stock, which must be held for at least three years and may be sold only after the firm has repaid what it owes taxpayers. The result is that in most cases, much of what the executives will get paid — in some instances, nearly 95% — will be in long-term stock grants.

If fifteen to 20 years seems too long, three to four years doesn't seem quite long enough. Then again, four years is a tried and true vesting period under employee stock option plans.

[Although not my subject here, I should point out that DeLong's talk had a sober thesis about the prospects for (non-executive) employment generally: although we are "almost surely" not going to be facing another Great Depression, or even a Japanese-style "lost decade," we have seen the "employment to population ratio" enter a free fall, and, according to DeLong, the US economy is unlikely to rebalance to historical employment rates for years to come.]

Should Web Entrepreneurs Hang on to Their Companies?

Chris Matthews said something on his Hardball TV show last night that I found disarming. The set up is what makes the payoff satisfying, so I’ll quote his entire lead-in to a particular segment of the show:

"We all studied in school, those of us who took economics, the Marxist theory. It‘s called the labor theory of value. You get paid for your labor, and there shouldn‘t be any extra money made. Now, of course, we have all gone beyond that with neoclassical economics. And we say, no, there ought to be some money for entrepreneurial — entrepreneurialism. If a guy or a woman starts a company, they risk money, they risk most of their lives to get a company going, whether it‘s a laundry or it‘s a big bank, whatever it is. They deserve to make a big profit and live better than anybody else. That‘s the way the system works. But these guys who make money off money...is that necessary? I mean, I have got [to] like anybody you can think of, whether it‘s Iacocca, Spielberg, anybody who makes something, whether it‘s a movie or it‘s a car, you say, great, he ought to make money. But this money that is being made just off of money, is it necessary for our system to have people that make [money off of money] — and, by the way, are the entrepreneurs losing the money that they should be getting from this money?" 

This resonated with something a friend, a veteran venture investor, told me a couple months ago. I won’t convey what he said nearly as precisely as I nailed the Chris Matthews’ quote (thanks to the show’s transcript), but my friend said something like this:

“Wall Street’s pitch to the entrepreneur for the last fifty years has been: you go build your business and operate it and make it valuable. Once you’ve done that, sell it, liquidate it, and turn the cash over to us; we will diversify your wealth, spread it around, extend it, because we know how to do that really well and you don’t. Your money is not only safe with us, it’s safer with us than it would be if you stayed in the game running a business somewhere out there in the middle of America.”

And the Great Recession has put the lie to that pitch, my friend said. From here on out, I’m re-constructing more than paraphrasing:

"Those who bought the Wall Street pitch have lost forty to sixty percent of their wealth. And so it will become clear once again that the way to gain wealth, keep it and expand it is to do it the way the robber barons of the 19th Century did it — by owning and controlling operating businesses. It’s fine to hire others to come in and manage them, but if you want to keep your wealth, you have to own businesses that turn on the lights (real or virtual) every day. Diversification doesn’t mean stocks and bonds, it means owning and operating several or many different businesses. This is also the best hedge against inflation, because you will always be paid in the current currency; and you won’t be having Wall Street taking its cut, coming and going, up years and down."

This is well and good for tycoons and would-be tycoons, but most entrepreneurs I work with still need liquidity because, first and foremost, they are restless; having succeeded, or failed, or succeeded-and-failed-at-the-same-time with a given venture, they will invariably, at some point, need to move on to the next thing.

Can you pull some liquidity from your venture, keep running it, and hire management into it while you go focus on the next one? This is a model that I think we may see play out here in the next few years:  the serial entrepreneur who stays a shareholder, and perhaps a board member, as he hands off the day to day operational responsibility, and draws cash from one business to seed the next one. This may be a model that is unique to software, social networking and other Internet-oriented ventures, however. This may be a byproduct, a benefit, of those who’ve learned to bootstrap during the Great Recession.

Regulation of VCs: What's the Impact on Startups & Emerging Companies?

The Treasury Department's whitepaper on financial regulatory reform, released last week, includes a proposal to require venture capitalists to register with the SEC as investment advisers.  VC industry reaction has been negative.  My buddy Joe Wallin thinks such reforms could impair the flow of capital to startups.

Here exactly is what the Treasury Department proposes, at page 37 of the whitepaper:

All advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed some modest threshold should be required to register with the SEC under the Investment Advisers Act. The advisers should be required to report information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability.

Many professionals who manage other peoples' money already register with the SEC as investment advisers.  As I've noted before in this blog, it seems prudent to eliminate gaps in coverage in the overall regulation of financial products.  RIAs (registered investment advisers) I've communicated with in recent days -- professionals who are registered with the SEC and are very active in financing startups -- have told me they don't see why VCs should object to similar registration.

At the same time, one RIA cautioned that certain reporting requirements that now apply to RIAs might, if extended to VCs in certain ways, have negative effects on startups.  This person noted that RIAs have to disclose all investment entities that they manage, and state current valuations.  Were such regulations extended to VCs and construed to require valuations of startup companies within a given VC portfolio, startups and emerging companies could be harmed.

At this point, I haven't seen a Treasury proposal for periodic valuations of VC portfolio companies.  It does not seem to be a feature of what the government proposed last week.  Below is an excerpt from further discussion in the Treasury whitepaper, also on page 37, describing recordkeeping and reporting requirements for VC (and other) funds.

We further propose that all investment funds advised by an SEC-registered investment adviser should be subject to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; and regulatory reporting requirements. The SEC should conduct regular, periodic examinations of such funds to monitor compliance with these requirements. Some of those requirements may vary across the different types of private pools. The regulatory reporting requirements for such funds should require reporting on a confidential basis of the amount of assets under management, borrowings, off-balance sheet exposures, and other information necessary to assess whether the fund or fund family is so large, highly leveraged, or interconnected that it poses a threat to financial stability. The SEC should share the reports that it receives from the funds with the Federal Reserve. The Federal Reserve should determine whether any of the funds or fund families meets the Tier 1 FHC criteria. If so, those funds should be supervised and regulated as Tier 1 FHCs.

Emphasis added.  By my reading, it looks as though the Treasury is contemplating that reporting requirements will differ for different kinds of investment pools (e.g., hedge funds and VC funds might report differently), and that information about "assets under management," where required, might be reported on a confidential basis.

The National Venture Capital Association argues that venture capitalists should be altogether exempt from new regulation because the industry as a whole is too insignificant to possibly pose a systemic threat to the financial system.  The NVCA's position is that Form D filings (the same kind of filings startups and emerging companies make for private offerings) made by VCs in the course of fund formation represent appropriate and adequate regulation.

My opinion is that VCs and the startup community should focus, not on opposing regulatory reform altogether, but on making the case that a VC's registration and reporting should not encompass detailed information about its funds' portfolio companies.  There is still time to draw the right lines in this debate; startups and emerging companies, and not financial investment professionals, need the shielding.

Pricing Stock Options: Who’s Doing 409A Valuations These Days?

Let’s start with the assumption that we all agree startup technology companies should set the exercise price for stock options at fair market value (“FMV”).  There are board fiduciary, investor sensitivity, employee fairness and company morale reasons for this.  But the main reason we all aim for FMV--and the main reason we need to get FMV right--is to avoid tax problems.  We don’t want the issuing company or the option recipient to face higher rates, earlier or phantom tax recognition events, or stiff penalties.  Any of the foregoing parade of horribles can occur when options are priced at less than FMV.

In recent years, a prevailing practice has been to engage a professional appraiser to give a "409A valuation” of the company's currency for stock options (almost always voting common stock).  The practice arose in response to some proposed Treasury regulations, now final, that created a "safe harbor" against possible adverse tax consequences and penalties in certain situations where stock options might be found to have not been priced at FMV.  (Fenwick and West attorney Tahir J. Naim has written a superbly concise summary of these “409A “requirements.)  In response to these IRS regulations—even before they became final—a cottage industry of "409A appraisers" sprung up; prices charged were initially cheaper than those of traditional valuation experts, but crept up as most of the startup tech industry followed the practice.

Industry practice is currently in flux right now.  Generally speaking, early stage companies that are not venture backed are by and large not hiring independent valuation firms and instead are determining FMV in other ways.  Venture backed companies, on the other hand, still appear to seek the extra comfort of an outside appraisal (depending on your point of view, this reflects an appropriately professional prudence, little different than insisting a startup purchase D&O insurance; or else it reflects an aversion to exposure of firm members who would appear to be qualified, under 409A, as persons “with significant knowledge and experience” at valuations). 

As Davis Wright attorney Joe Wallin points out on his firm’s startup blog, third party appraisals are not required.  At the same time, a formal valuation may be better at shifting the burden to the IRS to prove that a particular valuation is not reasonable.  Prices for such appraisals, at least from the “cottage industry” shops and programs, have come down now, within a range of from $3000 to $7000 (some of these providers will commit to doing annual updates at a lower rate).  That’s still a lot for most startups to spend these days.  And there’s also a question as to whether some investors will respect valuations from some of the lower end providers.

On the other hand, for companies that lack internal resources (either from within management, or among members of their board of directors or advisors willing to take on the task) to perform a FMV analysis, it may make sense to “outsource” the job.  And once companies have significant revenue, or any kind of recurring profit, it strikes me that a reasonably priced outside appraisal begins to make much more sense.

I’ve sought and gotten feedback from several trusted colleagues and former colleagues on this point in recent days.  Here is a quote that basically sums it all up; this from a very experienced CFO I have worked with at two companies:

“I think the scattergram of board/company philosophies re: 409A compliance is pretty scattered.  My experience continues to be that “higher” profile VC firms (certainly those with Sand Hill Road addresses) have a lower risk tolerance and greater desire to go by the book – annual valuations with periodic interim updates – than the lower profile VC firms.  The big boys don’t care what it costs, and have a relatively short list of valuation providers that they’re comfortable with.  Same dynamic with law firms, although more lawyer vs. firm centric.  That said, compared to two years ago (and even a year) I think the focus is off this issue and onto other more pressing business issues by virtue of the passage of time.”.

Aligning Management and Investor Incentives

    In bullet form below are some quick observations, here at the end of Q1 2009, on how different ventures in the “emerging company” category are dealing with the problem of management perceiving no equity upside to their efforts (and I’m not really discussing founders or startups here; that is another topic).  The common problem, to state it succinctly, is that current funding rounds are so dilutive, liquidation preferences are so high, and M&A values are currently perceived to be so modest, that only the investors (or the last round in) appear to have the prospect for positive returns.

  • In VC-backed companies, incentive plans are proliferating that promise management teams a significant (but typically single-percentage-digit) slice of sale-of-the-company proceeds, either off the top or just prior to investors with the senior equity preference.
  • In privately-held companies,* boards are taking advantage of significantly lower valuations to make restricted stock grants to key management, looking to motivate long-term service and performance with the prospect of meaningful dividend income as businesses generate profits; early exit scenarios may still need to be addressed with VC-like change-in-control incentive plans.
  • Equity or equity-like plans in general do not go as deep into company management as they might have previously.
  • Option grants under legacy option plans remain on cap tables, but decreased valuations are not driving new rounds of grants as they would have in the 90’s.
  • Option plans remain viable for certain startups, depending somewhat on the culture and the history of the founders, but broad-based participation winds down very quickly (measured in months, perhaps, rather than years).

*Yes, I do mean to imply that VC-backed companies are not truly privately-held; more on that later, perhaps.

What, No Exit?!?

Some of you who follow my tweets have already heard me comment on a lunch I had a couple of months back, with two long-standing friends who are the savviest financial guys I know.   I went to that lunch with a mission:  to plumb their views on what the implosion in the financial markets means for entrepreneurs and companies, like my clients, who are going to need financing of one stripe or other in the natural order of scaling and expanding new ventures. 

My friends were ready for me.  In fact, they were ahead of me, far into envisioning a "next" investment paradigm.

"Bill," said Friend 47 (the age we have in common, shared also, incidentally, with the President and with George Clooney), "it's a mistake to think that what is happening now is a blip.  This recession is not a blip.  2001 was not a blip.  It's difficult for guys like you and me to see this right away, because our entire careers have taken place in one giant two-decade long blip."

"Too much," rejoined Friend S.O. (for "somewhat older"), "has been predicated on financial machinations divorced from fundamentals of operating profitable businesses."  Both he and Friend 47 went on to describe an investment paradigm that involved annual ROI, without the predicate that the investor would need or even desire a liquidity event. 

"If you invest wisely in real opportunities, manage costs and leverage efficiencies, are quick to cut off initiatives that prove not to generate returns, and you do it all in a way that returns everyone's invested capital over five to ten years, then throws off a dividend indefinitely after that . . . why would you want to sell it, unless you had another place to put the capital that would give you a better return?"  They went on to describe what they called a "partnership" model, where investors own and operate the business alongside management.  In this model, insiders are not selling the next guy on the rosy future of the business; instead, they are selling customers on the merits of the product or service.  In terms of future financing, the owners are also the only buyers for their own spin: they would only continue funding the company if they could convince themselves that the risks were merited by the potential returns.  Exits could happen, but they would be opportunistic; if strategic buyers wanted to take you out because they attributed more value to the business than the cash flow you were expecting, that might be fine.  But you would go into the business fully expecting to operate it.

In this view, someone like Madoff is not an outlier, but is instead emblematic of the normative investment paradigm of the past two decades:  the whole structure was a ponzi scheme.  In terms of tech ventures, it went like this:  angels seeded the next cool thing, hoping they wouldn't get too squashed by professional VCs who took the handoff and validated it; VCs in turn shopped the "deal" (diction betrays everything in the end, doesn't it; not the "business" but the "deal") to the mezzanine players; and then finally the company was flipped to the public, who in the hay-days of all of this were not unsuspecting so much as thrilled to be finally "let in."  With audacious (if ultimately unsustainable) use of leverage, the life-cycle was repeated for years (whole careers, even).

Friend S.O. is half way into the raising of a new fund which will look to buy businesses to operate, for the purpose of generating cash year over year.  Given the government's current attempts to pump liquidity into a frozen system, which would appear to entail the risk of hyper-inflation, this strikes me as a good hedge, from an investor's point of view:  why not have an asset that sells products or services at prices set in the denominations of future currencies?

The company founders and other early stage entrepreneurs I work with are of different minds on the implications of all of this.  Some are still highly motivated by the goal of a liquidity event, an exit that will let you mark the experience, tell the story, and maybe take some chips off the table to seed the next venture (I almost used the word "deal" there).  Others, already highly skeptical of traditional venture capital models, are warming to the idea that partnering with investors who aim to build profitable operations is sounder than committing to a pre-determined exit. 

The proof of the new paradigm's validity may be in designing equity, control and cash distribution models adequate to the task of motivating both founders and investors.  It probably won't be enough to simply desire to opt out of the "ponzi scheme" model.

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