At Startup Weekend, I was roundly impressed by people’s ability to execute prototypes. To balance out the energy and technical skill, however, I saw a lot of magical thinking in terms of budgets and planning. Fortunately, these are all fixable issues. Let’s get fixing — we’ll start with these four myths:
1. We’ll just pay people with equity.
I sincerely hope I’ve convinced all Startup Weekend attendees of the dangers of equity abuse. Passing equity out like candy is the best way to close off your upside and create exciting new downsides.
The downside is that any shareholder, even someone who owns 0.001%, is a minority shareholder under the law. He has a right to review your financial info, and he can sue your directors and officers for various causes of action. It’s also an incredible headache if you have dozens of shareholders, who then transfer their shares to dozens more shareholders (one of whom is a competitor who now gets to look at your finances). Then some shareholders move to Argentina or China, and two others have died and now some shares are stuck in probate court in Georgia…
Equity abuse limits your upside because (1) math-wise, there’s less equity for you and (2) the lawyers representing any potential investor will start shrieking. Not only is it an expensive gauntlet of paperwork, but it also exposes their clients to director and officer liability. Significant investors usually like to have a board seat, and they can’t take a board seat if that’s going to paint them as a target for disgruntled employees who are panting to sue.
So how do you use equity wisely? First, think of equity as partnership because that’s what it is. Every shareholder is your partner. To stay closely held, make sure that transfer restrictions are baked into your incorporation documents. Any sale or transfer should be automatically void unless it goes through a specific right-of-first-refusal procedure.
Next, remembering that shares confer partnership, only offer it to people who are on partnership track. This should be a lot like tenure track: figure out how much time you need to work with someone to decide if they are permanent or not, and then create your vesting schedule accordingly. Share options also make a lot more sense than outright shares.
2. Investors will want to pile on.
One budget slide assumed that the team would self-fund $5K , and “investors” would pitch in $100K. I didn’t buy a house during the bubble because the very existence of 5% down payments gave me chills. Likewise, investors didn’t get where they are by making stupid decisions. They will demand that you have skin in the game.
One of the things I liked about one of the winners was the flat-out honesty of their budget slide. They were going to do it for under $15K in the first year, and their sources of funds were labeled as “ourselves” and “our parents.” That shows me that they live in the real world. In the initial phase of a project, expect to keep your day job (read this first) or eat peanut butter for most meals.
3. My lawyer/advisor/mentor will introduce me to a bunch of rich investors.
Somehow the saying “Your lawyer is your first investor” has gotten mangled into “Your lawyer/accountant/mentor will be your fairy godmother.” There are no fairy godmothers. Your mentors are being very generous by giving you their time, and it would be insanely inappropriate for you to make the first move in asking for anything more than advice.
It’s pretty magical to think that any law firm, accounting firm, marketing firm, etc. would jeopardize its relationship with an established client by vouching for your tiny, unproven business. If you give a service provider $5K, she will give you professional services in return. Some entrepreneurs believe that investors are hungry for deal flow, but if they were hungry for your stage of venture, it’s pretty easy for them to show up in person to demo days like Startup Weekend.
Also, from an ethical standpoint, lawyers hate it when clients do business with other clients; we get conflicted out of representing one or both of them. If a lawyer somehow hooks you up with a VC firm that it also represents, guess which side of the deal the lawyer would prefer to represent? If you both sign conflict waivers (which would permit the law firm to represent both sides), do you feel secure that your lawyer will fight for your interests exactly as zealously as the 1000x richer client? If not, will you dig in your heels and refuse to sign a conflict waiver, thereby forcing the VC firm to hire their second-choice law firm?
So what does “Your lawyer is your first investor” really mean? It refers to the practice by a few firms, including ours, of partially deferring legal fees for a few very promising ventures. Our firm does not accept equity because it’s a conflict of interest that muddies our role as your disinterested advisors. Our deferral policy is more stringent than many other firms, since we provide very time-intensive services to our deferred clients. Sometimes we’ve lost “business” (in quotes because it’s not exactly paying business) to firms that defer completely.
We think that those ventures have chosen unwisely; there is no free lunch. Full deferral can mean that a law firm will talk to you at first, lightly edit one of their off-the-shelf forms, and stop taking your calls within a few months if no investor interest is in the works. Law firms are businesses, not charities, and they are going to spend (expensive) attorney time on clients who actually pay attorney costs. (Thought experiment: If a law firm spends time but defers fees completely until funding, but only x% of clients ever get funding, what premium do funded clients need to pay in order to subsidize the model?)
4. My idea is unique; I’ll patent it so nobody can compete with me ever.
Attendees asked us a lot of questions about patents, particularly process patents. We’re not patent attorneys (there’s a separate bar exam for that, and it generally requires an advanced degree specific to each industry). I’ll go out on a limb, however, and opine that in all likelihood your idea is not as unique as you think it is.
Was Friendster able to patent the “link up with your friends” idea? Was SixDegrees able to prevent Friendster from existing? How about MySpace? Facebook? Patent law is driven by a policy goal to keep our economic engine humming, not to give someone a gold star for being smart. If some kind of DARPANET ur-Facebook could own the idea of “link up with your friends,” America’s economic engine would seize up and die.
Neil Gaiman says that fans sometimes approach him with crazy offers of “I’ve got this fab idea! How about you write it and we’ll split the profits?” That, my friends, is not how it works. Ideas are easy; execution is hard. The law understands this and protects ideas versus execution accordingly.
In conclusion, get to work on de-magicking your business plan.
I hope I don’t sound like a crusty old curmudgeon stomping all over people’s hopes and dreams. I saw some projects at Startup Weekend that could turn into viable businesses, so I’m just trying to help people get oriented. I quit a great job at one of the best law firms in the world to co-found Clarity, so clearly I think the risk is worth it. In the end, you own what you are building, and even if the venture joins the wrong side of the statistics, nobody can ever take away the skills that you acquired in the school of hard entrepreneurship.
These are just the major points of magic that I noticed. What else did people see?