Founders Friendly VCs

It would be expected that Venture Capitals (VCs) when they are defining the terms and conditions of their investments would greatly favor their interests vis-a-vis the Founders.

However, one of the guiding principles of VCs everywhere is to be Founders Friendly. This attitude can be seen for instance in Term Sheets and Investment Agreements. There is a generic disposition for issues that may arise between Founders and Investors to be resolved through consensus. In many instances there is no rule inscribed in the contracts on how to overcome a deadlock. Another example is the absence, in many instances, of a penalty clause in case of breach of contract. In some legal systems such as the Portuguese, the absence of such a clause makes it a great deal more lengthy the legal procedures if the need arises.

In part, this approach stems from the economic environment. In the last years, it has been a sellers market and VCs have adapt accordingly. Additionally, the profusion of successful Founders turned Investors, has helped VCs gain a different perspective towards Founders/Investors relationships.

In the end of the day, however, I believe the major reason for this approach resides in the realization that a VC investment to be successful has to be based in a truly cooperative relationship between Founders and Investors.

Don’t get me wrong, Investors will insist in including protective provisions against down rounds (Anti-dilution clauses) and poor Exits scenarios (liquidation preference clauses). They will also demand a Board position and approval rights in major decisions for the company. In all likelihood there will also be a Good Leaver/Bad Leaver clause to protect against Founders who leave a Startup in the middle of its journey.

Nevertheless, the Investor is also aware that the Founders are the persons better placed to make the Startup a success. Key people may be brought to help complement the Management Team, but to do these recruitments or going a step further and replace the Founders against their will is to condemn the project to failure. Therefore, Investors have to truly partner with Founders in order to keep the different interests aligned and everyone focused in growing the Startup.

In this sense, it doesn’t really make much sense for Investors to overprotect the Investment Agreement. Founders will be managing the company in its day to day operations and in all but a handful of issues, Investors will be just supporting and advising the Founders.

If a stalemate is reached, chances are that forcing the Investors will on the Founders will result poorly, and unless it’s one of those few issues that are vital for the Investor, he will give precedence to the Founders.

Nowadays with the crunch in valuations, the Founders Friendly thesis is being questioned as the market power shifts towards Investors. Although some Investors will be tempted to follow this path, I believe that in the end of the day, Investors and Founders should have a balanced relationship. Founders are not employees of the Investors, but equals in a high risk venture.

And if the project is not a success there is always the Liquidation preference provision to safeguard that whatever money can be salvaged, Investors will be the first to be compensated for their investment.

 

 

Startups need a Plan B

“The winter is coming.” In Venture Capital circles, it has become a common place to hear this phrase.

CB Insights has even created The Downround Tracker: a list of Startups that have had since 2015 a funding round or an exit with a valuation lower than the previous round of financing. At the time this post was being written there were 56 companies in this situation.

For the Shareholders of a Startup a Downround can be a traumatic experience, as it will trigger Anti-dilution provisions penalizing Founders, force Investors to acknowledge a devaluation of their shareholdings and downplay employees expectations regarding their stock options.

However, it is still a much better scenario than not being able to get funding at all. Therefore it’s very important for Founders to have a backup plan if their current funding efforts don’t succeed. Here are 5 examples of backup plans:

1. Consider other kind of Investors: if your preferred Investors don’t show an interest in your Startup, consider other options both in a geographic point of view, as well as in the type of Investor. Crowdfunding, Business Angels or Corporate VCs are just some other options to traditional VCs;
2. Work your current Investors: current Investors would rather participate in the new funding round only in the pro rata of their current shareholding. However, if new investors are nowhere to be found, they may consider doing a bridge round and make an advancement on the pro rata investment of the new funding round;
3. Reduce your burn rate and if possible break-even: to reduce a Startup’s burn rate and risk lose momentum is a complete anathema to many. In normal circunstances I agree with this assessment, however if there is no more funding to be had, Founders should follow this course of action to avoid having to liquidate their Startup;
4. Sell the Startup: look into the close relationships you were able to build with large players (suppliers, customers, distributors) in which they validated for their own use the Startups value proposition and see if they have interest in an investment or in an acquisition. Aside from these already established relationships, the market where the Startup operates should be mapped to see who else might be interested and has the funds to do it. There are several possibilities ranging from selling the company as whole, to specific assets, to an equihire in which what is being bought is basically the dev team;
5. Liquidate the Startup: when everything else fails, an orderly liquidation of the Startup is the best course of action. Please bear in mind that the failure of a Startup is the most likely outcome of such a venture and should not be seen as the Founders falling in disgrace. Nevertheless, things should be done properly in order to avoid an insolvency process and the consequences arising from debts namely to the Tax Authorities and Social Security.

In conclusion, I strongly believe that Founders should have at all times a backup plan in case they aren’t able to raise the funding round they wish for. In the current economic climate this Plan B is even more important. The last thing a Founder should do is spend the last cent waiting for a miraculous turn of events and then be saddled with debts that he will have to pay from his own pocket.

Full-time Founders!

Kind of a redundant headline, right? If you have a tech based startup and you believe it has the potential to become a unicorn, why on earth would you treat it as a hobby and work on it as a part-time job?

Well, the number one reason is when Founders need to earn money in another job to pay for their personal expenses, as well as to pay for the costs of the startup. That is also one reason why there is so many tech entrepreneurs coming out directly of universities. They don’t have a house to pay or a family to support. Therefore and with low personal “fixed” costs and some financial help from family, it’s easier for them to bootstrap the Startup to the point where Business Angels and/or Venture Capital firms take an interest on the project and invest in it.

Older Founders usually have higher personal expenses, as well as higher opportunity costs (such as a high salary and a corporate career). As a plus, they may have enough money reserves to bootstrap for themselves the Startup. Even if there is an investment from a VC and in the early stages of a Startup, the Founders’ salaries will never be as high as it could be if they worked for a big corporation. This investment that Founders make in the Startup will come to fruition at the moment of an IPO or Trade-Sale, when they sell their sizable chunk of the Startups’ share capital.

Sometimes, however, Founders want to do it all. They manage the Startup and on the side they do other work (consultancy, freelance work, teaching), with various degrees of time devoted to the Startup. Before a BA or a VC investment, such a situation might be understandable, given that Founders may not have enough money to sustain themselves or/and the Startup. With BA or VC funding, the norm is for Founders to spend 100% of their time working in the Startup, as the funds raised should have taken into consideration the need to pay a salary to the Founders. Some Founders, however, find these salaries not to be enough and insist in maintaining other professional endeavors.

In my opinion, part-time Founders are not compatible with the challenges and the need for speed in growing a Startup. Competition is high in virtually all markets and no matter the competitive advantage, if the Founders are sharing their time between various activities, the execution won’t be good enough to succeed in top tier markets. Being a Founder is a 24 hours, 7 days a week, work and even so, chances are that the Startup will not succeed. If Founders aren’t able to devote themselves 100% to the Startup, the probability of success will decrease even further into the realm of an unlikely event.

 

 

 

Don’t waste a Board Meeting!

Building a successful Startup is an incredibly tough job. Therefore, Founders should leverage all the resources they have access to.

When a Venture Capital firm invests in a Startup, a special focus is given in building a good Board of Directors. In a Seed and Series A stage, the Board of Directors is usually composed of 3 to 5 members, with 1 to 2 Founders, an equal number of Investors and finally an Independent Board Member.

Founders usually adopt two different attitudes regarding Board meetings:

1. Necessary Evil: Board meetings are thought of as a burden that must be endured. With this mindset, Board meetings become reporting sessions without much time being given by the Founders to strategic issues and to try and involve everyone in finding solutions to the challenges that the Startup faces. If the company evolves well, Investors will tolerate this approach and focus their energies in the portfolio companies that demand more attention. When problems arise, the frustration of not being able to help will lead to increasingly tenser meetings, with Investors pinning the blame squarely in the shoulders of the executive team.
2. Embrace the Board: Founders are humble enough to realize that if they have resources that can be used for the good of the company, it’s their duty to extract the most value possible from them. Investors and the Independent Board Member are in an unique position to offer different perspectives of the challenges as well as possible solutions that in their experience have worked in other situations.

For Board Meetings to run smoothly, Founders should prepare in advance the meetings, namely:

• Compile the slide deck with care so as to present not only the status of the company, but also to share the main challenges the Startup is facing and the remedies the Founders have envisioned. In this kind of situations, it’s important also for Founders to include enough data points about the challenges for the other Board members to be able to help;
• Share the slide deck in advance with the other Board members so that they have time to read it and to ask for additional information or clarification if need be;
• Important decisions as well as issues that the Founders anticipate that will be controversial warrant a pre-board meeting conversation with the other Board members so as to align positions and avoid stalemates in the Board meeting;
• From time to time special Board sessions should be schedule to brainstorm/discuss in depth specific issues. Investors and Founders alike are always very busy, and regular Board meetings have a lot of ground to cover. Therefore it’s more productive to have special meetings to go through specific matters.

Investors from their side, should also avoid some pitfalls, such as:

• Trying to run the company themselves: Investors are non-executive Board members who’s main role is to support and advise the Executive team. It’s very easy for Investors, specially when there is a bump in the road, to try to micro manage the CEO. It never ends well. If the Board thinks that the CEO is not up to the job, then it’s the Board duty to have him replaced;
• Transforming Board meetings into accountability sessions where most energies are spent looking at the past and pining blame for what went wrong. Don’t get me wrong, it’s important to review the past evolution, but even more relevant is to help  the Executive team overcome the challenges it’s facing. Founders for their part have the duty to present to the Board the hurdles the company is facing, as well as the steps they propose to do, to overcame them;
• Not preparing for the meeting: Investors have very tight schedules, but they have to set aside some time to at the very least read the slide deck before the meeting and adequately prepare for it. However, if Founders don’t send the information a few days in advance, they can’t expect Investors to be able to go through them thoroughly;
• Not attending the entire meeting: arriving late, interrupting constantly to answer the phone or departing before the end of the meeting doesn’t help to establish the right connection with the other Board members.

In conclusion, Board members should work together in order to maximize the chances of success of a Startup. It’s very easy for egos to hinder this cooperation. When that happens and problems arise (and they always will, even in the most successful Startup) everyone will be more focused in pinning blame, instead of working together to build a solution.

Don’t delay the Approval of the Annual Accounts!

Building a startup is a 24 hours, 7 days a week affair. Achieving product/market fit, improving traction metrics and keeping the startup funded are the top priorities.

Understandably, the closing and approval of the annual accounts comes as a red tape kind of task that most Founders see as being of little value. If the Founders don’t have any sort of training in accounting some of the concepts involved are difficult to understand and this task will slide even further down the priorities scale.

Accountants and Statutory Auditors for their part, are in this time of the year fully booked, and if the startup doesn’t pressure them to do the year-end closing, they will prioritize other customers who are more demanding.

In Portugal the annual accounts comprise the following documents:

1. Balance Sheet;
2. Profit and Loss account;
3. Cash Flow statement;
4. Statement of changes in equity;
5. Notes to the financial statements;
6. Management report;
7. Statutory Audit Report (if the company is required by law to have a Statutory Auditor);
8. Report from the Audit Committee or from the Single Auditor (if the company is required to have an Audit Committee or a Single Auditor);

Usually, the annual accounts follow the civil year, although this can be different if the company’s activity calls for it, as for instance can happen in the agriculture sector.

For Tech Startups, the norm is for annual accounts to follow the civil year. Therefore and according to the Portuguese law the annual accounts have to be approved in a shareholders meeting until the end of March. If the company has subsidiaries there are two additional months for the accounts to be approved, so they must be approved until the end of May. This extra time is given so that the subsidiaries approve their accounts until the end of March and the mother company can then approve its own accounts which should take into consideration the accounts of its subsidiaries.

Although these deadlines are set in the law, there aren’t any penalties for companies who break it. The penalties arise only when the company doesn’t meet the deadline to fill the annual return to the Tax Authorities, which must include the annual accounts. This filling must be done until the 15th of July.

For a Startup it doesn’t make much sense to adopt an easy going approach and approve the annual accounts only in July, for the following reasons:

1. There is no need for it: Startups are small companies with few assets and liabilities, therefore their accountants and statutory auditors should have no trouble at all to do the year-end closing by the end of January, with plenty of time to schedule a shareholders meeting in the first quarter to approve the annual accounts;
2. Fundraising: Investors will ask for the annual accounts and for a Startup to not have them will look bad. It will show disorganization or even worse that there is something trying to be hidden;
3. Accountability: the approval of the annual accounts is an important moment in the life of any company, in which the Management Team presents to the shareholders the accounting record of what happened in the past year and submits itself to their judgement;

In conclusion, there is no need for a startup to delay until the second half of each year the approval of the accounts of the previous year. The accountant and the statutory auditor should be more than able to do the year-end closing by January. As the Startup grows accounts will become much more complex and the reporting needs for instance to Investors will be much more challenging, therefore it’s important to establish early on a good accounting discipline. It shouldn’t also be dismissed lightly the potential negative impact of having to justify to a potential Investor why the annual accounts aren’t still closed. Investors will always assume the worse.

 

 

 

Main differences in U.S. and Portuguese Corporate Governance practices

The growing trend of Portuguese companies establishing themselves in the U.S., be it through subsidiaries or through the famous Delaware flip, makes it important to understand the differences between U.S. and Portuguese Corporate Governance practices.

Bear in mind I’m going to focus in the most common business types used in the U.S. (C Corporation) and in Portugal (Sociedade Anónima), for a Startup being funded by a VC.

Here are the 5 main differences in the U.S. and Portuguese Corporate Governance practices:

Role: the U.S. Board of Directors doesn’t manage the company. The company’s day-to-day operations are run by the executive team, namely the CEO and the other C-Level executives. The role of the U.S. Board of Directors is to monitor and assist the Executive Team. This is to monitor their performance (in order to minimize potential agency problems) and the company’s performance. And assist them, both in strategic and operational matters, with its experience, know-how and network of contacts. In Portugal, the Board of Directors (Conselho de Administração) main role is to manage the company’s day-to-day operations. The practice however, in Portuguese VC funded companies, is to have non-executive Board members, representing the Investors, which do not manage the day-to-day operations, but are there mainly to advise and monitor the executive Board members

Composition: a U.S. Startup Board of Directors is made up of between 3 to 7 members of which 1 to 2 are executives (CEO, CFO or COO), 1 to 4 are investors depending on the company’s funding round (1-2 lead investors is the norm for seed and series A rounds, and 2 to 4 lead investors from series B round onwards. As the funding rounds progress, the early investors step down as Board Members and are replaced by the largest investors of the new rounds) and 0 to 1 independent (an independent board member is usually someone that is seen as not representing the interests of the executives nor the investors and can therefore act as a buffer or arbitrator between these parties. To strengthen this role and place the independent board member above the other parties, he is in many cases elected Chairman of the Board). Portuguese startups usually have between 3 to 5 Board Members. Independent Board Members are still not the norm, but are being increasingly nominated due to the added value in terms of know-how and network of contacts that they can bring to the table. Therefore and in most cases, the Board of Directors is composed by a majority of Founders (2 to 3) who undertake the day-to-day management of the company and a minority of Investors (1 to 2) who act as Non-executive Directors.

Auditing Committee: the role of the auditing committee is similar in the U.S. and in Portugal. It’s responsible for monitoring the integrity of the financial statements and for overseeing the external auditor and regulatory compliance. In the U.S. it’s common for Startups with 5 or more Board Members to elect a subset of Board Members (usually 2 to 3) to form an Auditing Committee. The rationale being that as the company grows, these matters become sufficiently complex to demand closer scrutiny. Therefore a subset of the Board is selected to focus on these matters, freeing up the full Board meetings for discussions about the strategic and operational direction of the company. In Portugal, a recent change in the law has opened the possibility to create an Auditing Committee, which needs to have at least 3 members, who must all be Non-Executive Directors. However the Auditing Committee is still a rare occurrence in a Portuguese Startup.

Compensation Committee: in the U.S. it sets the compensation package of the CEO and often of the other executives (salary + fringe benefits + stock options) and it is also responsible for defining the objectives and assessing the performance of the executive team. As it happens in the U.S. with the Auditing Committee, the Compensation Committee is also a subset of the Board of Directors. In Portugal the compensation committee does exist in some startups, but is elected by the General Meeting of the Shareholders. Its main purpose is to approve the compensation package of the members of the Board of Directors. Whenever there isn’t a compensation committee, it’s the duty of the General Meeting of the Shareholders to approve directly the compensation for the Board of Directors.

Term of Office: U.S. Board of Directors more common election regimes are the following: i) Annual election: Board Members are elected to one-year terms or ii) Staggered board: Board Members are elected to three/four-year terms, with one-third/one-fourth of them standing for election each year; Staggered boards are used mainly as an anti-takeover provision. As to Portuguese Board of Directors term of office, Board members are usually elected for 3 or 4 years terms.

In conclusion, Portuguese Corporate Governance Law places a bigger role for the General Meeting of the Shareholders as the overseer of the company management, but that is mainly due to the fact that in Portugal the Board of Directors actually runs the company. The practice however, in VC funded companies, is to have non-executive Board members, representing the Investors, which do not manage the day-to-day operations, but are there mainly to advise and monitor the executive Board members.

In the U.S. there is a clearer separation between the role of the Board of Directors (advising and overseeing the management team) and the Management team that runs the company. Therefore, there is no need for the General Meeting of the Shareholders to have such a big role in monitoring the management of a company.

This post was originally published in LinkedIn.

5 Changes Brought about by the VC Seed Funding

At the very beginning, a startup thrives in an informality background provided by the fact that its Investors and Shareholders are usually the Founders, their families, friends and the occasional Business Angel.

When a VC invests in the company for a Seed round, a partnership is formed and Founders are no longer the only ones controlling it.

The company itself usually changes its form, from a “Sociedade por Quotas” into a “Sociedade Anónima”, due to the need of having different types of shares, a more agile framework to increase the share capital and more favorable tax conditions when selling the share capital.

Here are 5 changes that come along with the VC funding choice:

1. Management: an Independent Board Member and at least a representative from the Investor(s) will become part of the Board of Directors alongside the Founders. The Founders will still be the ones managing the day-to-day operations of the company, but the decisions about the strategic and operational direction of the company have to result from a consensus between all Board members. In some investment agreements, you may even have provisions requiring certain decisions to have the approval of the representatives of the investors. Bear in mind the Independent Board Member and the representatives of the Investors are not there only to supervise the executive management, but also to help them. For the latter to actually happen, Founders have to keep the other Board Members up-to-date regarding the key developments in the company (good and bad) and the challenges they are facing. Dropping a line in an e-mail from time to time, sharing the successes as well as the problems and not being shy to ask for help when needed are great ways to involve all the Board in what’s being done. The objective is not to have a daily reporting of everything that is happening in the company, but to establish a regular communication line with the other Board Members to receive feedback and inputs that will most probably lead to better decisions.
2. Network effect: the Startup becomes part of the VCs’ investment portfolio and will benefit from several networks the VC may provide: i) contacts the VC has access to, whether for sales introductions, other Investors or key people to be recruited; ii) other portfolio companies, both for potential sales and sharing of experiences; iii) programs and events organized by the VC to address specific challenges common to its portfolio companies, expose them to investors and help them going abroad.
3. Countdown begins again: seed funding is only another stage of the journey that hopefully will end in a Trade Sale or IPO. In two years’ time, if not before, another funding round will have to take place, otherwise the company will run out of money. Therefore, six to nine months prior to that date, a new funding roadshow will have to begin. So, Founders have one to one and a half years to grow the company to the point of being sufficiently interesting for a Series A round. And the first investors that have to be convinced to put their money in the Series A round are the current ones, because if they don’t continue to invest no outside investor will.
4. Statutory Auditor: it’s mandatory for a Sociedade Anónima to have a statutory auditor (Fiscal Único, also known as Revisor Oficial de Contas). The statutory auditor should be seen as a helping hand in ensuring the integrity of the financial statements both from an accounting and fiscal standpoints. It should be noted that technology based Startups present their own challenges in terms of invoicing and taxation, due to, for instance, the multitude of geographical origins of its customers and, in a lesser degree, suppliers. It saves money and time to correctly address these issues, not only by avoiding conflicts with the Tax Authorities, but also by preventing damaging findings in future Due Diligence processes or even indemnifications for the breach of Reps&Warranties. The statutory auditor produces at least three reports annually: i) The Relatório e Parecer do Fiscal Único, ii) The Certificação Legal de Contas and iii) The Relatório Anual sobre a Fiscalização Efectuada. The first two documents state whether the annual accounts provide an accurate picture of the economic and financial state of the company, and if not, what are the areas that are inaccurate. The Relatório Anual sobre a Fiscalização Efectuada is a more detailed report about the work performed by the statutory auditor, alerting to issues and processes that should be improved, but because they are small/immaterial, they are not discussed in the first two documents. Bear in mind the work of the statutory auditor should be performed not only at the end of the year, when the annual accounts are prepared, but all year long, so as to avoid last minute surprises that may lead to costly corrections, namely when the Tax Authorities are involved.
5. Compensation Committee: it’s becoming common practice in Startups to have a Compensation Committee elected in a Shareholders Meeting, which will set the compensation package for the Board of Directors, Statutory Auditor and for the President and Secretary of the Shareholders Meeting. Even if some of these persons are not paid at all (salary, stock options, expenses, etc…), there still has to be a minute from a compensation committee meeting stating that much. And this minute has to be delivered to the relevant authorities. It should also be pointed out, that even if a Board Member isn’t paid a salary, he may still be required to pay a minimum fee to the Portuguese Social Security (if he doesn’t receive a salary from another job). This rule applies to Portuguese and foreign Board Members. The Founders’ compensation package can be a strain in the relationship with Investors. On one hand, Founders believe that they’ve been able to grow the company into a new stage and therefore earned the right to be adequately compensated. Investors, on the other hand, see the seed stage of investment as the first of many that still have to be successfully navigated. Therefore, they don’t want the Founders comfortable with their compensation, but “hungry” to grow the company and sell it, so as to cash-in on the big Exit.

Bottom line, the Seed funding should be the beginning of a “beautiful friendship” between Founders and VCs, as it is only the start of a long journey that will last until the trade sale or IPO. Founders better take advantage of every benefit provided by the Investor, as they have an uphill battle in front of them. Involving the other Board members in the ups and downs of the project, and taking into consideration the feedback provided by them, it’s a great way for Founders to keep everyone’s interests aligned and to have a motivated partner when problems appear and have to be overcome.

This post was originally posted in LinkedIn.