Here’s a look inside a typical VC’s pipeline (a must-read for entrepreneurs) - Venture Beat

April 19, 2014 4:35 PM
Sean Jacobsohn, Emergence Capital

When I meet with entrepreneurs, I am often asked about the VC “pipeline.”

How many deals do we see? How many meetings? How often do we conduct due diligence? How many of those companies do we invest in?

I thought it would be helpful to provide visibility about the VC pipeline, while also outlining what helps a company move from an intro meeting into a closed investment.

In order to make 10 investments, the average venture capital firm reviews approximately 1,200 companies.

Leads: These 1,200 come from network introductions, conferences, in-bound inquiries, proactive efforts, portfolio company referrals, and seed investors. Of the 1,200, we find that approximately 500 lead to face-to-face meetings with someone on the investment team.
The most important factor in securing a meeting is the background of the founders. Do they have the skills and experience for the opportunity they are pursuing?
Of course, the pitch also matters: Is it concise and compelling?

In addition, most venture firms like to make sure that a company is not competitive with a current portfolio company.

Personally, the primary reason I don’t meet in person with in-bound requests is that the entrepreneur was not vetted by someone I trust.

Meetings: The average venture firm has approximately 500 face-to-face meetings each year, yet only 10 percent progress from that stage. What makes a venture firm want to dig in and spend the time required to do proper due diligence?

First, most early stage VC firms look for demonstrated product/market fit. At Emergence, we also want to confirm that the company is solving a problem that is relevant outside of Silicon Valley. Too often only customers are in the Bay Area, and they are friends of the founders, which means no proof of a real market.

One of the reasons that a meeting doesn’t go well is that the founding team will say they expect $50 million in revenue in 5 years, but they have difficulty articulating how they’ll get to their first $1million.

Due Diligence: Of these 500 meetings, a mid-sized venture firm may perform due diligence on approximately 50 companies in a year.

Due diligence consists of a product review, customer references, executive team references, financial modeling, market analysis and competitive analysis. Passionate customers who are very engaged with the product can really make a difference during due diligence.
Venture firms also look for at least 100 percent annual revenue growth in the first few years. However, often companies don’t meet short-term projections set in earlier meetings, and firms can lose confidence in their future projections.

Venture firms are also wary of high rates of churn and customer concentration.

Investments:  In a typical mid-size venture firm, the 50 companies may generate 10 investments. Why do these companies stand out? A couple items are critical, such as efficient customer acquisition and a magnetic CEO that people follow. It’s a huge red flag if former employees don’t want to work with the CEO again.

With respect to market size, at Emergence, we like to see a reasonable path to $100 million in annualized revenue. For an industry focused solution, a $300 million market size is sufficient since if they become an industry standard they can get 30 to 50 percent of the market. For a horizontal solution that solves pain points across industries, a company needs $1 billion market size, since the market leader may only get 5 to 10 percent of the market.

While it may seem that one percent represents depressing odds for a founder to secure VC funding, in reality, the process tends to help entrepreneurs refine their strategy. If the first meeting didn’t result in moving to the next phase, a good venture firm will provide specific feedback and guidance. Most venture firms stay in touch with founders they have met in the past, and it is exciting when future meetings highlight changes that have led to more traction.

Link to Original Article

Sean Jacobsohn is a venture partner at Emergence Capital Partners. He joined Emergence Capital after being an executive and advisor at portfolio companies Hightail and Doximity, respectively. In addition to being a sales and alliances executive in the technology enabled services space for 13 years, he is cofounder and co-president of the Harvard Business School Alumni Angels, the largest university-affiliated angel group in the world.

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The Right Way to Grant Equity to Your Employees

Andy Rachleff is President and CEO of Wealthfront, a software-based financial advisor. Prior to Wealthfront, Rachleff co-founded and was general partner of Benchmark Capital. He also teaches courses on technology entrepreneurship at Stanford Graduate School of Business. Follow him on Twitter @arachleff.

“The defining difference between Silicon Valley companies and almost every other industry in the U.S. is the virtually universal practice among tech companies of distributing meaningful equity (usually in the form of stock options) to ordinary employees. Before companies like Fairchild and Hewlett-Packard began the practice fifty years ago, distributing stock options to anyone other than top management was virtually unheard of. But the engineering tradition that spawned Silicon Valley was much more egalitarian than traditional corporate culture.”

— Steven Johnson, The Peer Society

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The equity culture among young technology companies is almost universal. When implemented properly, broad employee ownership within a company can:

• Align the risk and reward of employees betting on an unproven company.
• Reward long-term value creation and thinking by employees.
• Encourage employees to think about the company’s holistic success.

Unfortunately, despite decades of experience building new hire option plans, many startups still fail to put in place an equity compensation plan that adequately rewards long term employees over time.

When I was a venture capitalist, I noticed companies that seldom lost employees due to recruitment had a lot in common. Sure they offered challenging and inspiring work environments sought by top-tier talent. But you might be surprised to learn they all rewarded outstanding performance through the issuance of additional stock options (or as is now the case, RSUs) in a similar way. 

The Wealthfront Equity Plan

Based on my observations, I created an equity allocation plan that I encouraged all my portfolios to adopt. It worked so well that executives and my fellow board members usually brought my plan with them when they got involved with other companies. Over the years, I am proud to say that hundreds of companies, including Equinix, Juniper Networks and Opsware, adopted this plan because it just made sense.  

Not surprisingly, we’ve put this plan in place at Wealthfront. 

How It Works

The Wealthfront Equity Plan is designed to specifically handle the four most important cases for granting equity to employees. Each year, you create a new option pool that addresses the following needs:

1. New Hires: These grants are used to hire new employees at market levels.
2. Promotion: These grants are intended to reward employees who have been promoted. Promotion grants should bring the recipient up to the level you would hire her at today for her new position.
3. Outstanding Performance: These grants, made once each year, are only intended for your top 10% to 20% of employees who truly distinguished themselves on the basis of amazing accomplishments over the past year. Individual performance grants should represent 50% of what you would hire that person at for their position today. This pool should be reserved for non-executives.
4. Evergreen: These grants, which are appropriate for all employees, start at an employee’s 2½-year anniversary and continue every year thereafter. The idea is you don’t want to wait until the employee’s initial grant has been fully vested to give a new grant because by that time the employee will evaluate new opportunities. Annual evergreen grants should equal 25% of what that employee would receive if she were hired for her same position today. Giving 25% of the market rate for a position each year, rather than a lump sum grant that covers the next four years, will smooth out the vesting process so the employee never reaches a cliff. As I said before, cliffs cause people to raise their heads to consider alternatives and should be avoided at all costs.

The Key: Consistent, Early Evergreen Grants

Most companies put considerable effort into the size of their equity grants for new hires. It’s rare these days to find new hires that haven’t used a tool, like the Wealthfront Start-Up Salary & Equity Compensation Tool, to determine the appropriate amount of salary & equity to expect for a given position.

Fewer companies, especially young ones, put significant effort into thinking about follow-on grants. If you tell your employees to “think like an owner,” then you need to consistently align equity with their contribution to the success of the company.

Evergreen grants are the most common area where technology startups fail to invest time until far too late in their development.

“The average tenure for most technology employees is two to three years, and waiting until your first employees hit year four is just too late.”

Instead of an ad-hoc process, the Wealthfront Equity Plan offers a transparent, consistent and fair program of equity grants that employees can build into their long-term expectations. As a result, not only do you avoid cliffs, but you also tie both long-term tenure and contribution to their ownership stake. The best part is that, as your company grows, you always grant stock in proportion to what is fair today rather than in proportion to their original grant.

What About Dilution?

Based on our calculations, the Wealthfront Equity Plan should result in approximately 3.5% to 5% annual dilution assuming no executives need to be hired. (Please see our Slideshare presentation for the details of how to allocate stock for a 50-person private company). As a point of reference, most public technology companies increase their option pools by 4% to 5% per year, so the proposed dilution is well within the reasonable range.

The Wealthfront Equity Plan might result in 0.5% to 1% extra annual dilution relative to less generous plans. One way to think about the trade-off is to ask yourself, if you’re a stockholder, would you rather be assured of retaining a much higher percentage of your key employees and own 97% of what you would have owned without the Wealthfront plan over your four-year vesting period (4x the mid-point of 0.5% to 1%), or deal with the risk of losing valued team members and not suffer the additional dilution? I would take the extra dilution 11 times out of 10.

That being said, there are a number of board directors who think that is too much dilution for a company to absorb. A few months ago, a fellow I recruited as CEO to two of my Benchmark portfolio companies told me he never appreciated the value of the Wealthfront Equity Plan until he joined a board where the board members were too cheap to do the right thing for their employees. Needless to say, he implemented the Wealthfront Equity Plan when he started his own company.

Investors and employees make much more money by increasing the size of the pie rather than their share of the pie. The only reason not to implement the Wealthfront Equity Plan is greed, and greed seldom leads to a good outcome.

An Equity Plan that Works for Employers & Employees

One final observation about companies that successfully retain employees: They usually create a culture that treats options as something dear that aren't offered as an alternative to a cash bonus. They encourage employees to think about increasing the value of their options through accomplishment rather than asking for more upon completion of a task. It has been my experience that companies granting options for completion of milestones seldom build a culture that values equity — and therefore suffer greater turnover. 

A well-designed equity allocation plan works for both the employer and the employees. The Wealthfront Equity Plan creates a tremendous incentive for people to stay at a company without costing the employer too much. That’s the kind of win-win to which we should all aspire.

Read more: http://firstround.com/article/The-Right-Way-to-Grant-Equity-to-Your-Employees#ixzz2qJ7BLaAA

It’s time to rethink startup equity

By Jay Adelson, Opsmatic

Nov. 13, 2013 - 8:00 AM PST

photo: Shutterstock / AnatolyM

Summary: For a place that prides itself on disrupting tradition, Silicon Valley is still using a pretty traditional method for compensating startup hires and employees with stock. Here’s another idea.

Change is the only constant in life and this is especially true in Silicon Valley. We live in a time of constant change and rebirth, which we optimists think is for the better. One thing hasn’t changed: How Silicon Valley companies — especially startups — use stock to compensate and incentivize their employees.

Traditional stock options are failing to create the ownership culture we want from employees and it’s killing our ability to build companies for long-term success.

For employees, a one-year term ending on the vesting cliff date is increasingly common. This leaves a big hole in the team and the cost to hire a replacement is significant. We all want to eliminate bad matches sooner, but it’s no surprise so many employees wait for the equity. Having more non-employee equity holders causes resentment among current employees doing the hard work to create stock value.
On the other side of the equation, founders and investors are increasingly tight-fisted with company ownership, allocating smaller stock pools to employees — most of which are eaten up by very early hires, rock stars or senior execs — leaving very small amounts for later hires, which does little to nurture their commitment to the company.

I’ve been involved with startups for a long time and have seen these patterns over and over. After working at a number of startups, I co-founded Equinix in 1998, Revision3 in 2005 and was the chief executive of Digg, Revision3 and SimpleGeo. I’ve also been an active advisor to several early-stage startups. After nearly twenty years of using the same recipe for employee equity, I’m taking a new approach at my new startup, Opsmatic. We are sharing equity in a new way, one we believe builds a true ownership culture that will be a key to our success.

I’ll explain more later, but in addition to a traditional stock option grant, we’re offering our first fifteen employees, or however fewer it takes to get to the next financing, an equal share of 15 percent of the company, which they will receive if they stay with the company through a liquidity event.
Why do this? We are focused on attracting and retaining the best possible team over the long term. Our employees are key to our success, and we are determined to change their (and our) behavior to avoid the downsides of the traditional approach to stock allocation. As I talk to CEOs, I’ve uncovered some of the causes of these patterns.

Employee behavior

Burned by booms and busts, employees often look to maximize their compensation up front, hopping from company to company in an attempt to scale compensation or title. Most stock options have a one-year cliff; if they leave at that point, they can purchase 25 percent of their equity with no further commitment to the company, giving them the ability to diversify their equity portfolio and reduce risk.

The rise of secondary markets has complicated matters and created a pervasive myth that employees can sell their stock early. While private stock sales are available to a minority of high-value, successful companies that support these transactions, it’s not an option for most early companies. According to SecondMarket’s 2012 data, the median number of employees for companies with private stock transactions was 347 with an age of seven years and a market cap of $569.5M, and 66 percent of transactions were made by existing employees, not former employees.

Founder behavior

Founders and CEOs typically distribute equity in a long tail, most of which goes to very early employees after a first financing, leaving increasingly smaller amounts for later hires. This does not build a sense of shared ownership.

The rationale I hear is that early employees take more risk around an uncertain future, so they should get higher compensation. Lately, in conversations, I surprisingly found that people joining later often feel they are taking a larger risk around getting paid!

This may seem backward, but upon reflection, there’s always the non-trivial chance of the next round not happening or revenue not coming in before cash is burned away. A fresh, recently funded startup has more money in the bank and has made fewer execution errors, so risk is a matter of perspective.
To make matters worse, I’ve talked to dozens of founders who confirmed that in retrospect, there was little correlation between the distribution of stock options and the actual value the employee brought to the company. Independent of contribution, the larger option packages are dolled out to super early employees (or co-founders) and rock stars.

A rock star hire is a hire in which founders and CEOs pay above market rates for someone they deem super-critical. Maybe you’re developing software and would benefit from someone who is famous for inventing the concept. Perhaps you need to build a new sales force, so you go after a famously successful head of sales veteran from another company. Maybe you want to recruit new talent, so you hire someone that new employees would kill to work with.

Rock stars are typically fought over, so equity distribution increases due to competition, giving these employees a larger share. Nevertheless, years later, post exit, often the unsung heroes — like employee number fifteen — weren’t benefiting in a way that reflected their contribution. As far as I’m concerned, when combined with the long-tail distribution, this is not the best way to motivate employees or engender team loyalty.

The details of our approach

To address these issues, we’ve created a new approach to equity called the Dynamic Stock Pool (DSP).
This pool is designed to be a long-term incentive, encouraging loyalty and reinforcing that we will win or lose as a team. While each of our employees will get a traditional stock option grant, the majority of Opsmatic’s employee stock — 15 percent of the company — is allocated to the DSP.

The DSP pool is egalitarian, shared equally amongst the first fifteen employees we hire. So it’s a rich incentive at 1 percent of the company (before any future dilution). Typically, equity numbers of that level are reserved for VPs, CxOs and rock stars, so this is a significantly more generous offer than most early hires receive, particularly outside of management or founders.

However, here’s the catch: The stock in this pool is only distributed to employees who remain at the company through a liquidity event, such as an IPO or acquisition. If you leave before then, you don’t get any of your DSP shares — so this is truly an incentive to play for the long-term. In fact, the employees who stay through the liquidity event continue to share equally in the pool. For example, if only five of the first fifteen employees remain, each would receive 3 percent (pre-dilution).

What about…

Clearly this is different from how things have been done since companies started handing out stock options, so of course it raises a few questions.

Some feel that varying skills and experience merit differential grants. Beyond accompanying salary differences, we also have a traditional option pool to address a legitimate reason to give one employee more than another. Another challenge involves the perception of the ‘value’ of different kinds of employees. For example, some people have asked, “What if you hire a receptionist or a janitor? Should they have as much value as a developer?” Because each employee is equally diluted in the DSP, this model creates a strong incentive to only hire critical employees. This means hiring fewer non-essential personnel and prioritizing the hiring of great, mission-critical people first. If your team truly needs a receptionist to succeed, the equity is justified. As for early departures, employees who unexpectedly leave would still have their traditional vested options, and measures are in place to prevent a manager from firing someone at the end, like a game of Survivor.

There are other edge cases we have thought of and resolved, and probably complications that arise out of the longer-term nature of this incentive. However, I spent the greater part of two years working with great attorneys closing all the legal loopholes that may arise, and I’m confident enough that I’m using Opsmatic as the first test bed for the DSP.

Of course, I welcome feedback, and I’ll definitely share what I learn as we put this new approach to work.

Jay Adelson is a serial entrepreneur, having built companies such as Equinix, Digg, Revision3 and SimpleGeo. Jay founded Opsmatic in early 2013, and currently serves as Chairman and Founder.
Featured photo courtesy Shutterstock user Shutterstock user AnatolyM

Convertible Note Insights

by Keith White

Convertible notes are all the rage in early-stage financings.  Here is our guide to convertible notes with what we’ve garnered from our experience with them.  In short, they are neither the panacea their proponents promote them as nor the blight their critics complain of.  They are a potentially useful tool that must be understood to be used properly.

Note: These points are listed roughly from beginner to advanced, so experts might want to read bottom-to-top. 

• A convertible note combines features of a loan or debt, typically interest and priority in a default, with the ability to convert into equity, giving greater financial upside to the investor if the firm flourishes. 
• Startups typically defer the interest rather than pay it in cash, meaning it gets added to the value the noteholders will convert.
• Notes often include “discounts,” the ability to convert to equity at a lower price than subsequent investors in the next round.  We sometimes hear subsequent investors grumbling about this but we think that’s unreasonable since the noteholders invested earlier and earlier investors deserve more upside.
• In big corporations, the conversion feature is usually considered a fallback option, but with startups conversion is expected because it’s hoped the company value will increase dramatically.
• If you issue equity, you generally give all investors the same terms for legal and expectational reasons.  Notes can give the flexibility of offering different terms to different investors.  However, the same feat can be accomplished with equity through warrants.  We can show you how.

Valuation Caps

•  Startups often offer convertible notes with valuation “caps,” which allow a note investor to gain value for company growth between the purchase of the note and its conversion in the next round.  If the note has no cap, the investor would only benefit from growth AFTER conversion.
• People often hear “cap” and think the return is capped, but in fact it’s the dilution that’s capped.  This means a cap favors the investor, not the founders. 
• An example:  If an investor invests in a convertible note with a $4M cap and the firm is subsequently valued at $8M, the investor has doubled their money.
• Don’t confuse the “cap” in a valuation cap with the “cap” in the “cap table.”  In the former, cap means limit.  In the latter it is short for “capitalization.”
• Convertible notes with caps can give investors high, equity-like upside with low, debt-like downside.

Potential Misconceptions

•  Many notes are described as having a valuation cap AND a discount.  This is grammatically imprecise.  When converting to equity, most deals apply a cap OR a discount, whichever is better for the INVESTOR.  We can show you how to calculate which applies.  Generally, the higher the valuation at conversion, the stronger the case for applying the cap.  It’s analogous to the “make-or-buy” problem you may have seen in business or economics class.
• Some say convertible notes are faster & easier to negotiate than priced equity offerings.  We consider this “sort of true.”

−  The initial paperwork can be easier since noteholders usually don’t get ownership rights like board seats and voting rights, which are complicated terms to negotiate.

−  Notes avoid having to set a valuation on the company, essentially “punting” that until the next round.

But…

−  Reasonable professionals can often negotiate valuation & terms quickly in an equity offering, mitigating notes’ advantage.

−  Notes have other terms to negotiate like interest, caps, discounts, maturity dates and conversion terms.

−  A valuation cap acts like an implied valuation if triggered, so if a cap is offered you still have to think about valuation.

−  Tracking the accumulation of interest can mean more paperwork later, especially if you offer different investors different terms.

Still…

·   Issuing notes means you don’t have to create a valuation for tax purposes, which is required in an equity offering.

Important But Often Overlooked Elements

• In a down-round, the face value of notes doesn’t decline with the value of the company, so they act like “full ratchet anti-dilution” clauses.  If there’s a discount, it may still apply and notes are even more dilutive.  Expensive capital in these cases.
• Notes typically have maturity dates.  If a firm can’t raise another round before maturity to force conversion, they technically have to pay back the loan (and interest) with cash, often causing a default.  In reality the company tries to renegotiate, but that’s no fun and success is uncertain. This maturity problem is exacerbated by the development of the Series A crunch, where many firms get seed funding but can’t get Series A funding because VCs are now preferring bigger deals (Series B+).
• If a note converts into a class of equity with a liquidation preference, the noteholder gets that preference too.  For example, investing $500K in a note with a $4M cap and converting into equity with a 1x participating preference at an $8M valuation means a noteholder quadruples their money in a liquidation (doubling once due the the cap and doubling again due to the preference).
•  Note terms are often expressed as price-per-share in calculations & contracts.  If you find that confusing, try calculating percentage ownership and investment value first.  Many clients find that more intuitive.  We can show you how.

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