by Dick Costolo

Brad and Jason have a great post up over on Ask The VC regarding the often asked first-time entrepreneur question How many shares should I create for my new company?. This is directly related to a couple of questions I've gotten lately from employees considering offers from startups that go like this (i'm combining a couple different lines of questioning into one set here):

I'm considering joining a startup that completed an A round financing. They have offered me options, and I'd like to understand the relative size of the options offer, so I've asked them about their pre and post-money valuation on the A round (which will tell me how much of of the company is owned by the investors already), and expected dilution in my equity as a result of a next round of financing. The company has not wanted to answer any of the questions in quantitative specifics, but responds qualitatively with "a good valuation" and "not much dilution". Is this reasonable? I will know the current valuation if I knew the exercise price and multiply it by total outstanding stock,right?

There are a bunch of things to say here. First, go read Brad and Jason's response to the "how many shares" question. Back already? Such a fast reader you are. Ok, let's dive into this set of questions in not necessarily any particular order.

The first question you really want answered when you're receiving an offer like this from a private company, and it's a question the company should be prepared to answer, is "what is the total number of authorized shares". If you are offered 100 options in the company, it doesn't really matter whether the company's valuation is 5 or 500 million dollars (if the company's public, all this is moot obviously. There are loads of mechanisms for valuing options in publicly traded companies). You don't really know anything about the size of your grant unless you know the total number of authorized shares, and they should be willing to let you know that information so you can determine the relative size of the grant. Without that information, the offer only amounts to "some options".

The valuation numbers are probably not going to be answered by a private company (they have multiple reasons not to go around touting the financed value of the company, not the least of which is employees claiming two years later that 'you told me the company was worth 50 million dollars'), but again, the answers to the valuation questions are secondary in my mind to the size of your grant. The first thing you really want to know is "what percent of the total authorized shares am I being offered".

In any case, you will not know the current valuation by multiplying the exercise price by the total outstanding shares. The options you are being offered are almost definitely options to purchase common stock. The investors on an institutional A round financing almost certainly have purchased preferred stock. Since the preferred stock is paid out in preference to the common stock on any liquidity event, the common stock is probably valued at a significant discount to the preferred stock. So that calculation isn't going to help you.

Once you know the percentage of authorized shares you've been offered, and you know the company's executed a 5 million dollar A round financing, how do you calculate the probable value of your options? The short answer is "you don't" or "the current value is around zero, subject to change", take your pick. The long answer is that your options aren't worth what a VC was willing to pay for their equivalent number in preferred stock. Your options are only going to be worth what somebody is ultimately willing to pay for common stock at some point in the future, and that price is only going to be determined on an IPO or sale of the company. Just like the founders, you need to decide whether you think your percentage of shares is going to be worth some potentially meaningful amount if the company is successful in the market. The only thing you can try to know with certainty is your percentage interest in the company against which you might guestimate reasonable comparable exits in the market and calculate your percentage interest in that exit, but even here, you are subject to unknown and potentially unknowable amounts of future dilution, preference multiples (in which the investors get 2x or 3x or more their investment back before any remainder is distributed to common), etc. A question you might ask the company vis-a-vis your percentage interest is whether the existing investors have any preference multiples (because this has the potential effect of reducing the common's interest in the company on a liquidity event), but again, even if the company answers this question with total transparency, it could be very challenging for you to understand or measure the implications to any reasonable degree.

The follow-on financing dilution question is important. Too few people understand the implications of follow-on equity financings, which is that everybody (probably including the existing investors if they don't invest in this round) gets diluted on any further equity financing. The trouble with specifics around this line of questioning is that the company isn't likely to have very concrete answers as to what future financings might mean for equity dilution, even if the market's supply/demand continues to function exactly the same as the present environment. One way of at least getting a sense of the magnitude/timing of potential dilution is to ask questions that help you understand how long the current financing is expected to last.

The bottom line for potential employees is that future dilution is going to be very hard to gauge, you just need to understand that the closer you are to startup mode, the more likelihood there is of significant dilution, for you and the founders and everybody else. The company should be willing to help you understand your current percentage interest in the company and some qualitative measure of the likelihood of future dilution. Beyond that, you're in the "leap of faith" pool with everybody else. If the company is unwilling to let you know what 100 shares equates to in terms of percentage interest in the company, I'd say that's a warning sign and you should ask lots more questions.

by Guy Kawasaki

My buddy at Redfin, Glenn Kelman, decided he wanted to bare his financial soul so that other entrepreneurs could get greater insight into the witchcraft called financial modeling. In this two-part posting, he reveals his numbers and his lessons. They are eye-opening for most entrepreneurs.

Part I: Numbers

Startups face one primary challenge: To never run out of cash. So when projecting costs, we heeded Guy's advice that "the three most powerful words you can utter at a board meeting are, 'We beat projections.'" This convinced us to develop the worst possible financial model that could still be used to raise money.

We're glad we did. True underachievers, we've performed at or just a bit better than this worst-possible plan almost every month, raising revenue projections only when forced to in December 2006. We've been able to stick to our plan mostly because absurd assumptions in opposite directions cancelled one another out. As the real estate market tanks, we may not be so lucky in the future.

When first putting together our financial model, we looked online to calibrate spending assumptions. So many people have blown venture capital, we thought, there must be a manual somewhere on how to do it, at what rate, avoiding which follies. We couldn't find anything. So we took some wild guesses and figured we'd see how they turned out. And now two years later to the day that we built our first model, here are the projections and actual results. Hopefully, you can learn from our experiences.

Rent, Per Employee, Per Month

Redfin Model: $250. Actual Redfin Cost (Last Month): $336

Our actual costs are high because we just moved last month into an office with room to grow, which seems to happen every eighteen months. When people were sitting in hallways at the old space, we were paying about $200 per employee, per month. Class B space on well-traveled mass transit lines is roughly $20 per square foot per year in Seattle, $30 in the Bay Area. You need 165-200 square feet per person or more.

At the extremes, Adobe supposedly allocates 435 square feet per person while Yahoo! allocates 220 square feet per person. The startup cult of cramming people into small spaces is counter-productive: people are what's really expensive, not space. The cost Redfin really didn't anticipate was for tenant improvements which you mostly have to fund yourself when signing sub-three-year leases. In September, we spent more than $100,000 to add private offices for our engineers on the hope that our current office will last us longer. It was probably too much money.

Initial Per-Employee Equipment Cost

Redfin Model: $6,500. Actual Redfin Cost: $5,700

Computers, 20" monitors, Ikea desk, decent chair, VOIP telephone, and cell phones for field employees. Our first phone system came from Craigslist, and we had to upgrade after a year.

Monthly Benefits, Per-Employee

Redfin Model: $600. Actual Redfin Cost: $471

Redfin benefits are competitive, but many employees are Seattle-based. Costs are 10% higher in California.

Annual Payroll Tax

Redfin Model: 12.5%. Actual Cost: 8.5%

We added 4% here to our plan, just to pad per-employee costs. In ways you can't anticipate, people cost money. Payroll taxes are the same nationwide. California's state payroll tax is, for example, negligible.

Quarterly Bonus Payout, as a % of the Total Possible

Redfin Model: 85%. Actual Cost: ~85%

We pay quarterly bonuses, mostly based on customer satisfaction objectives. Maintaining discipline on bonus payouts has been difficult. When business booms, everyone wants to be paid for it, even if you haven't yet turned a profit.

Annual Payroll Increase for Existing Employees

Redfin Model: 6%. Actual Cost: ——-

We can't disclose actual costs here, but they were higher than planned. When we set the plan, many employees were being paid below-market rates, which is not uncommon for startups; as a startup raises more capital and people go into their second year of sucking it up, you have to pay the piper at the employees' annual review.

Percentage of Candidates for Which Redfin Paid a Recruiting Fee

Redfin Model: 35%. Actual Percentage: 20%

If you can't build an engineering team through your own network, recruiting fees can become a significant expense at an early stage. Most of the folks Redfin paid a recruiting fee to hire still came through our own employees who got a $2,000 bonus for every recruit they bring on board.

I assumed colleagues would encourage friends to apply to Redfin without a fee, but for $2,000, people start nagging their cousin's friend's wife to apply. We saw an immediate increase in candidates. The occasional party, done on the cheap with kegs and pizza, has also worked well for us.

For Employees Recruited for a Fee, the Recruiting Fee as Percentage of Annual Salary

Redfin Model: 20%. Actual Cost: 4.5%

Because we want top-of-the-stack candidates, we do pay 20% to professional headhunters, but most recruits only required a $2,000 employee referral bonus. We've also experimented with in-house recruiters working on an hourly wage, but they tend to focus on managing the hiring process rather than adding candidates to the pipeline.

What really wrecks the budget is a retained search for executives ($30,000 - $50,000), a cost we didn't even include in our calculations above. A retained search as an agreement to work exclusively with one search firm is reasonable, but we recommend negotiating aggressively to defer most payment until placement.

Incremental Amount Paid to Contractors, as Percentage of Payroll

Redfin Model: 5%. Actual Redfin Costs: 3%

Our contractors have mostly been an in-house recruiter, a graphic designer, and a web programmer; no big-shot consultants.

Monthly Travel Costs, Per Field Employee

Redfin Model: $300. Actual Redfin Costs: $369

The $369 includes mileage for field agents who drive clients to listings as well as travel between our San Francisco and Seattle engineering offices. Your costs may be lower. Or not: on the road, some of us still stay with friends.

Monthly Telephone Costs per Field Employee

Redfin Model: $125. Actual Redfin Costs: $261

We’ve started equipping real estate agents with cellular modems, so costs are unusually high here, too.

Monthly Legal Costs

Redfin Model: $12,500. Actual Redfin Costs: $9,406

The $9,406 per month excludes legal costs for a round of financing, usually about $50,000 for company counsel and investors' counsel (more late stage, less early stage). We have saved money by dividing the monthly work between a more-expensive tech-focused firm (Orrick, very good) for board resolutions, minutes and stock administration and a general corporate practice (Lasher, also quite good) for employment and real estate law.

We also handle on our own most of the repetitive paperwork like option grants and, perhaps unwisely, vendor contracts. We don't spend much on patents. Incidentally, we pay a service $14,000 per year to set a quarterly price for our stock options. This is a cost that we didn't anticipate and didn't project as part of our legal costs.

Annual Accounting Costs

Redfin Model: $45,000. Actual Redfin Costs: $32,912

Once you've raised money, your investors will want a year-end audit of financial statements. This can be done for less money when the business is small and if you keep your books in good order, but we commissioned our first audit only after Redfin had generated over $1 million in revenues. Your accounting expenses will also be a bit higher (and your payroll significantly lower) if you can hire a book-keeper to come in twice a month to pay your bills, which makes sense for the first year or two until you need someone permanent.

All-Company Meeting Cost, Per-Meeting, Per-Employee

Redfin Model: $350. Actual Redfin Cost: $560

Almost half of Redfin works outside of Seattle, so our meeting costs are unusually high. But we can't avoid meeting at least once a year, which is a significant expense that we forgot to plan for in our original model.

There are of course all sorts of other costs that are unique to our business as an online real estate broker: how much we spend to attract a home-buyer to our site, for example, or what it costs to sell a listing. What you see here are just the costs common to every startup.

And now, looking this over, I worry at every turn that we've spent too much money. When I first worked at a venture-backed company, someone told me that Sequoia liked to see entrepreneurs "dive in the toilet for nickels." I'm not even sure that's true, but it was an image that always stayed with me. At the time it was actually comforting. I couldn't do anything else right but, thinking about the toilet and the nickels, I said to myself, "This, I can do."

Part II: Lessons

Here are a few other tips for building a financial model:

1. Focus on headcount. Outside of marketing programs, the basis for all cost in Internet software is headcount. Just figure out whom you'll hire and how much you'll pay and you can't go far wrong.

2. Plan slow, run fast. The most likely scenario is that you won't be able to hire engineers fast enough, and that revenues will come more slowly too. Investors expect their money to drive artificially accelerated growth rates, but signing up for that sometimes just blows a company up before you've had a chance to figure everything out. At least in the financial model, give yourself as much time to grow as you can.

3. Run top-down sanity-checks. To estimate what a company is likely to spend each year, try doubling the average salary and multiplying it by the number of employees. A 100-person company might spend as much as $15 million per year.

4. Forget economies of scale. The biggest whopper is that a business will magically become more efficient as it grows. If you really believe this, just walk into the headquarters of Amazon or eBay. Bureaucracies grow. Salaries float away. Straining to make a model work, I always forget that per-employee costs rise every year.

5. Admit that revenues are a mystery. If you don't have any revenues yet, you can't say what they'll be. The point of a model is to prove you can make money if people buy your product, not to insist that they will. By developing different scenarios based on different levels of demand, you can later calibrate hiring and spending according to which scenario fits reality best.

6. Build from building blocks. Nearly every model is the sum of smaller units. In Redfin's case, our unit is a market like the San Diego real estate market, which we plan to grow to a certain size in a certain number of months, hopefully returning a certain amount of profit to the overall business. We can then gauge whether the model works by just looking at whether San Diego works, and then asking, "Now what if we had twenty San Diegos?" For another company, it may be a user-created website, with so many page-views and so many ads, or it may be the productivity of a single salesperson, with a million dollars in quota per year.

7. Take out "hope." Think about what is most likely to happen, so that a bookie would say you're as likely to out-perform the plan as under-perform it. Generally speaking, "hope" is not a strategy.

8. Flag your assumptions. Rather than burying your assumptions in Excel formulae, call them out in a separate tab of the workbook, so that you have a control panel for adjusting the model. This is especially important if you plan to share your model with potential investors.

9. Hit $100 million in revenues within five years. The premise of most venture investments is the possibility of generating ten-fold returns in five to seven years, which is hard to do if you spend $5 million to build a $25 million company.

10. Keep market-share under 20%. Most startups reach a jillion in projected revenues by assuming that the business grows by leaps and bounds for five years. Since there's a natural limit on growth, be ready for the question: "What would your market-share be in year five?" If it's over 20%, take the jillion-dollar projection down a notch. Even a hit like iPod doesn't have 20% market-share. You'll be lucky to come close to 20% of any market.

So these are our costs, and that's our advice. What's your take? We'd love to see how our costs compare to other startups'; please leave a comment and let us know where your numbers differ from ours, especially in markets outside the U.S. We could also post a sanitized version of our financial model, if enough people ask for it to make it worth the trouble.

(Thanks to Redfin's Chris Roske, Chris Neitzert, Matt Goyer and Angela Cough for their help with the numbers in this post.)

by Todd Jaquez-Fissori

Over the last ten years I have probably written or been a party to well over 100 term sheets, all flavors and varieties from simple straightforward Series A deals to recap rounds and costly later stage deals. As an entrepreneur you will find the fair, the normal, the obscure, and the downright strange like accruing dividends that increase exponentially over time and ten layers of preferred stock with 3x liquidation off the top. 

Hopefully, one of two things will happen for you.  You will find yourself with several termsheets or even better one fully committed and filled out termsheet from a fair and reasonable partner who understands this is a marriage of equals.  If we (as VCs) do our job right you will be the superstars and we are merely stagehands.  So much time is spent on termsheets and terms and what to look for that sometimes we forget what this business is really about-People. 

Let's focus on what you should look for BEFORE you get a new termsheet:

1) What funds are you considering?

Build a job description or position requirement just like one might for a CEO.  List all the qualities you want and you need to succeed.  Consider them as you would any important long term partner.  Funds are all different--different focus areas, sweet spots, stages of investment preference.  You can make a checklist to help narrow your search to a relevant set of potential venture capitalists.  Key things to consider include—what amount of capital are you raising? Is this your first round?  What technology area are you in and does it match with what the VC fund has done before.  There is a big difference between late stage and early stage investors and what they like and what they offer.  The best thing you can do is spend time on upfront research as it will save you lots of time and pain late. 

2) What do they bring to the table?

Sure it is nice if a VC brings their check book to the party but what else can they offer?  Look for successful funds that have connections into the industry that you want to enter.  Sometimes these relationships could be from existing LPs that are in the fund or maybe because the firm has done a few deals in a given space and has experience work with your potential future customers.  Consider strategic funds as well.  This means funds that are tied to a larger corporation. 

This usually means they have direct access to what the company’s needs and wants are as well as they will have contacts at other companies and strategics that might help you.  However, do you homework as Corp Funds are not all created equal just like traditional VC funds.  Another question to ask is how do they operate?  It is important to understand the partner dynamics meaning which partner runs the fund. This will tell you who is really in control. Fund lifecycle can be important as well; maybe they won't be around in 2 years when you need more money.  Make sure to ask.  You also need a lead fund that can write you a termsheet and help you find other VC partners for the deal.  This will save you a lot of time.  Just beware that some funds like to give out termsheets as if they were free gifts without doing any diligence.  These termsheets are meaningless, avoid them.

3) What GP are you working with?

You are entering a marriage not with a fund but with a Partner.  Make sure you know who you are getting as sometimes changes are made at the last minute.  Some GPs are very busy with lots of board seats (over 10 is extreme) and can't always focus on helping you.  Just make sure you get what you want.  They all have different styles and backgrounds.  Do you want the easy to get along guy, the financial wizard, the ex-consultant, the operator, or the VC who has seen it all over the last 10 or 20 years- it is your choice.  Find someone who will push you, ask you hard questions, make you reconsider your actions, and who will drive you to excel even more.  The person that you will respect, hate sometimes, but you are always happy to see them at the board meetings.  That is who you want as an investor and board member.

by Tim Keane

Investors love entrepreneurs who understand their business model, and can describe it accurately.  And when they meet entrepreneurs that can't, it is often a sign that the management team needs strengthening - at a minimum.

In my mind, a "business model" reveals the structure of the profit engine that underlies the venture.  Most ventures, almost by definition, project high growth rates and substantial profits over some time frame.  In reality, the ability to estimate growth based on revenue for a new venture is low.  There are many, many variables that go into a new venture that make such predictions tenuous at best.

However, it should be relatively straightforward to build a business model that reveals how the business plans to make money.

How much will the product sell for?  (Is that price competitive in the marketplace using comparable data?  If it is a new service, what will it be displacing and therefore what should the price be, etc.) 

How much will the product cost to produce?  What other structural costs are inherent in the business?  Are they verifiable with sales, fixed, or some combination?

How much cash is needed to launch the venture and to achieve cash flow break-even?  When does the venture need the money?  (Can we invest in ranches and therefore reduce some risk as we gain knowledge?)

What are the critical elements in achieving success?  Can we test to find out if these estimates are achievable?  (Are we planning for the lowest customer acquisition cost the industry has ever seen?  And if so, what happens if we are wrong?  Are there ways to figure this out before we commit all of the resources?)

A well thought out business model can then be used to scale projections, again based on comparable experience.  However, total value of projections is vastly less important than a well planned model. 

by Pascal Levensohn

Last week in PE Hub Dan Primack reported on a recent white paper, "Should Investors Bet on the Jockey or the Horse? Evidence from the Evolution of Firms from Early Business Plans to Public Companies".  In this paper, Professors Steven N. Kaplan (University of Chicago), Berk A. Sensoy (USC), and Per Stromberg (Stockholm Institute of Financial Research) survey 50 VC-backed companies that completed IPO's in 2004.  They conclude the following:

"The results call into question the claim that "a great management team can find a good opportunity even if they have to make a huge leap from the market they currently occupy. . . . firms that go public rarely change or make a huge leap from their initial business idea or line of business.  An initial strong business, therefore, may not be sufficient, but appears to be almost necessary for a company to succeed.  On the other hand, it is common for firms to replace their founders and initial managers with new ones and still be able to go public, suggesting that VCs are regularly able to find management replacements or improvements for good businesses.  We interpret our results as indicating that, on the margin, VCs should spend more time on due diligence of the business rather than management."

The authors wisely note the limitations of their small sample size and that 44% of the companies in their survey were life sciences companies.  They also point out that they are unable to access data on companies that experienced exits through acquisition (the vast majority of VC-backed companies) because this data is unavailable.  It is unfortunate that the value of much of the academic research conducted on our field is severely limited by the lack of access to relevant data.  This is clearly the case when one reflects on the conclusions of this report.  In my view, debating this aspect of the Horse vs. Jockey argument isn't particularly useful to VCs or to entrepreneurs.

A more interesting line of related questions could begin with "Why do so few VC-backed firms succeed, period?”"  "Is it endemic to venture capital investing that roughly 10% of investments will account for the vast majority of returns?"  "Can VCs do something to improve these statistics and therefore increase the return profile of the entire industry?" 

As the authors point out, VCs do, indeed, know how to replace management teams, and this occurs quite regularly.  More importantly, the human capital side of founder and management transitions is by no means optimized in our industry. In my opinion, the absence of consistent processes in many VC-company management transitions is the Achilles heel that spells failure for many companies—and this suggests that dysfunctional personal dynamics between VCs and founders may actually lead companies with solid business models to fail.

Start-ups experience accelerating rates of change, both internally and externally, as they develop.  The convergence of changing markets, evolving product lines, and frequent employee hires and replacements in a resource-constrained environment leads to extraordinary and stress inducing rapid rates of change in fledgling companies.

Through collaborative work on identifying governance best practices, the group of VCs and other industry professionals who have formed the Working Group on Director Accountability and Board Effectiveness conclude that having process and internal controls in place allows investors and the senior management team to better identify and calibrate problems, to determine the next course of action, and to reposition the company for success.  The outcome may involve changes to the team, to the business model, or both.

Process and controls form an important framework for management self-help in decision making.  Without process, it's much easier to flounder and get caught in sub-optimal decisionmaking.

While VCs should certainly avoid investing in weak business models, in contrast to Professors Kaplan, Sensoy, and Stromberg, I would suggest that, at the margin, we should spend more time identifying and applying best practices and processes to our companies to improve our set of potential outcomes.  Assuming that we can identify strong business models, we should focus on maximizing the potential for our management teams to succeed in order to boost the VC industry's collective returns for our investors.