How can I reduce the risk of nuisance suits?

May 2011

"I'm starting a company that will compete with my present employer. I don't have a non-compete agreement and there's no issue of intellectual property, but investors are worried that we'll be hit with a barrage of nuisance suits. How do I convince them that this isn't a risk?"

Mike: Remember that the risk is not that you might lose a legal battle--it's whether you might be tied up in a lengthy court battle that will inflict high legal fees, create market uncertainty, and perhaps even tie up the sale of the company. Your investors have every right to see this possibility as a risk, even if the legal issues are largely groundless.

To minimize this risk, you should probably talk to your current boss about your plans. You might work out a strategic deal for your new business to target a market niche that he's not interested in exploiting. Or maybe he'll join your board or even make an investment. That should reassure other investors that he's okay with your plans, and incidentally it would be pretty compelling evidence in your favor if he did eventually take you to court.

Is it safe to sell stock with first-refusal rights?

May 2011

"A large OEM customer has offered to invest in our startup business, provided we give them a 'right of first refusal' on all future stock sales. This seems reasonable to me, but one of my partners insists that the deal will destroy our valuation when we try to raise money or sell the business in the future. Who's right?"

Mike: Your partner is right. You'll always get a premium valuation when you have at least two suitors bidding for the deal.

And even if you don't manage to attract multiple bidders or investors, the fact that your OEM customer has first refusal rights is bound to be a turnoff. Why would a potential buyer enter into acquisition discussions if they know before you could accept their offer, no matter what the price is, you had to show that offer to another company who might outbid them?

How should a startup price its stock?

November 2010

"I'm thinking about investing in a startup, but I think the founders are being unrealistic about the company's valuation. They have a couple of (very happy) customers and maybe two years of operating history, but they're basing their valuation on EBITDA calculations and public company comparables, which seems nonsensical. What would be a more realistic yardstick?"

Mike: Most common valuation methods are based on historical numbers and trends, so they don't tell you much about companies with very limited operating histories. Worse, they generally result in valuations that are so low that the founders either can't raise enough cash or else have to give up almost all their equity. It might be useful to insist that the founders show you exactly how they arrived at their proposed valuation. But in the end, your investment will have to be based largely on whether you share their vision of the company's future.

One other approach that I've seen for startups is to ignore the valuation question and treat your investment as an interest-bearing bridge loan, convertible into equity when the company raises (say) $2 million in a venture round. To reflect the fact that you invested at a riskier point in the company's growth, your investment could be priced at a discount to the $2 million round.

Should I pull the plug on non-responsive investors?

August 2010

"I've shown my business plan to several investors, and I can usually answer their questions. But one guy just asked me a tough one: What's the plan if we fail? How would you answer this?"

Mike: I've never heard this question either, but I suspect it's because investors usually prefer to back founders who have a single-minded focus on success. Investors want a team that believes passionately in the core product and market opportunity, who won't give up hope at the first obstacle.

Of course, "failure" is relative. Very, very few startups execute exactly according to their original business plan. A new product may take longer than expected to develop, buyers may reject the concept, critical staff people may walk out--a lot can happen. Savvy investors know this, and so they look for founders who can creatively reposition their original technology or quickly find a brand-new market. That's just Plan B, not failure.

Should I have a plan for failure?

May 2010

"I've shown my business plan to several investors, and I can usually answer their questions. But one guy just asked me a tough one: What's the plan if we fail? How would you answer this?"

Mike: I've never heard this question either, but I suspect it's because investors usually prefer to back founders who have a single-minded focus on success. Investors want a team that believes passionately in the core product and market opportunity, who won't give up hope at the first obstacle.

Of course, "failure" is relative. Very, very few startups execute exactly according to their original business plan. A new product may take longer than expected to develop, buyers may reject the concept, critical staff people may walk out--a lot can happen. Savvy investors know this, and so they look for founders who can creatively reposition their original technology or quickly find a brand-new market. That's just Plan B, not failure.

Is a two-year non-compete too long?

January 2010

"A potential investor group is interested in putting money into my company, but first they want several key employees to sign two-year non-compete agreements. At most, my employees say they'll sign six-month agreements. Is there a standard term for these contracts?"

Mike: The short answer is no. You and the investor group must determine what's a reasonable time period to protect the company if your employees leave to join a competitor. Unless there's a very unusual competitive situation, a two year non-compete seems excessive. Six months is more common in my experience, and you should remember that there are some states--such as California--where non-compete agreements are rarely enforced.

If your investors won't accept six months protection, you should talk with them about other ways to persuade key employees to stick around. For instance, you might offer stock options with a minimum two-year vesting period. Or you could pay a hefty deferred retention bonus (which might have to come out of your pocket, if you want to make the deal work). However, you should also be prepared to walk away from these investors if they refuse to be flexible on this one issue. They may not be the right partners to help you grow your company.

How can I organize investor documents?

November 2009

"I'm setting up a new company, and there are all kinds of documents that our investors want to see--articles of incorporation, by laws, minutes, contracts, employment offers, financials, on and on. Many of these documents have gone through several revision cycles, so we waste a lot of time making sure everyone is working with the latest versions. Help!"

Mike: Set up a "virtual data room" on the Web, with password protection. Create a good table of contents with links to the latest versions of each document (and perhaps include archival copies of earlier versions, with dates). Whenever you add a new document, send out an e-mail blast to all your investors and corporate officers.

If you can handle a little more technology, you might also provide a download record that tracks who has accessed or downloaded each document. Your investors will be grateful that you're not wasting their time (or yours) trying to figure out who's missing the minutes for last month's board meeting.

Do business plan awards mean anything?

November 2009

"One of my angel investors has urged me to compete in a business plan competition. If we do well, will this credential help us with larger investors? I'm skeptical."

Mike: I don't think the credential by itself will have much impact on investors. But these competitions are a great way to fine tune your presentation and improve your public speaking skills.

You'll probably get some good feedback, too, since the judges are usually investors or entrepreneurs themselves. They'll ask the same questions that you'll hear from a venture firm or angel group--is there a big upside opportunity, how solid is the management team, is the market well defined? In fact, I was at a business plan contest recently where the judges picked a winner--a pharmaceutical startup--that fit these criteria so perfectly that investors were coming on board even before the competition was over.

What questions are off limits to investors?

September 2009

"I've been talking with a venture firm about funding, and now they've asked me to undergo a comprehensive physical exam. I hesitate because I have a minor medical condition I'd rather not disclose. Advice?

Mike: The medical condition may be minor, but your refusal to take a physical will raise a huge red flag for your investors. They certainly don't want to put money into a company whose chief executive might have a serious medical problem. They want assurances about your health precisely because an unhealthy boss is a major risk factor for a startup.

But that's just common sense. My guess is that you're more concerned about confidentiality--you don't want the investors to gossip about something you feel should be very private. If that's the case, tell your investors that you're happy to have their doctor check you out, but he should only report significant health issues that affect your fitness for the job. That should satisfy everyone.