Imagine you are half-way through due diligence on your Series A round and the venture fund’s counsel realizes that you never complied with federal and state securities laws when you raised angel money. Or, imagine your early CTO hire does not have the level of experience he/she professed in the interview or on his/her resume and the company is going to lose 3 months of product development while trying to fill that position. Or, imagine that you’ve blown through $150,000 of friends and family money only to realize there are no customers for that great piece of technology you built. Talk to anyone involved in the start-up and venture community and each one will have a horror story to share about a start-up or emerging growth company. Sometimes these early blunders can be fixed, but the remedy may draw significant time and money resources at a time when you need to be building value. Other times, these blunders are a death blow – unrecoverable mistakes that sideline your once promising company for good.
Most serial entrepreneurs know how to steer clear and avoid these mistakes. Why? Because they’ve been through it already. They know the landmines and can generally avoid them. But first time entrepreneurs, although having a great concept and skills to back it up, most likely have no clue how to get started. You need to learn from other’s mistakes and avoid making them yourself. Here’s my list of the 15 most common, but avoidable, mistakes made by high growth start-ups. The goal here is to have you spending your time building value, and not wasting resources fixing what may be obvious to others.
1. Making poor early hires and not firing fast enough – I don’t have enough fingers on both hands to count the number of times I’ve seen this happen. The effect can be minimal or enormous, depending on the position, timing of hire, responsibilities, etc. Two mistakes I see most often:
- The C-level hire with an incredible resume of large company, Fortune 500-type experience, but that has absolutely “zero” start-up or emerging growth experience. Certainly, you want to hire people that have great experience. There’s no arguing that point. At the same time, however, you want to make sure that the individual can utilize their skill set in a start-up environment. Some individuals have built their careers operating under budgets stuffed with positive cash flow – the anti-thesis of a start-up environment. Never hire someone solely on the basis that listing their former employer on your pitch slides looks great or because you think the company will grow into their skill set (you may turnover a couple of individuals in their role before you reach that size); and
- The hire that claims he/she brings something strategic with them, something that will only come into the fold because of their presence in the company. I am not talking here about someone that brings a great rolodex, or a specific programming skill or the like. I am talking about someone that says they have the contacts to help you raise $3M or someone that claims they have the prior relationships to land the 10 largest clients in your target market. If someone lays claim to something so specific and strategic, and they are to receive a fulsome compensation package based on those claims, then condition some of that package on delivering on the promise. X options for X amount raised, or X options for every top 10 client you bring in that signs an agreement.
Consider the real reasons why you are making the hire and consider whether or not such individual may better serve the company at the advisory board level as they may bring significant industry contacts and the like. Otherwise, just make sure you enter the hiring process knowing the traps that exist. If you do end up hiring someone that clearly is not working out, then move on quickly. It may cost you, but not as much as it would in the long run by leaving them in place.
2. Failing to assemble the correct management team – the management team that you form is incredibly important. There are many schools of thought, but I invest in the jockey over the horse. That’s not to say that the business model and having a large market aren’t important, they are. Otherwise, you may not be able to develop the kind of return your investor is looking for. But the team is uniquely important for two reasons:
- Investors don’t want you learning on their nickel. I’ve said this before. For early stage start-ups, you want to see management teams that have some industry experience. If you are in the technology space and your Senior V.P. of Sales comes out of the steel industry, there better be a great rationale for that. Demonstrate that you have talent that knows the space; and
- A cohesive, smart management team can make lemonade out of lemons. See Mistake #13 below. You know what they say about “best laid plans”. Nothing is foolproof. But it wouldn’t be the first time that a smart management team saw a completely separate business model in the ashes. That’s why you ultimately bet on the jockey.
3. Promising portions of equity to individuals in the beginning without a plan - my stomach always turns when I meet with an entrepreneur and they tell me that they struck a great deal with one of their lead employees – he’s doing all of his/her work for 10% of the company. I can see the excitement in their eyes of having saved cash while getting their platform built. Then I ask the follow up questions that should have been asked when the deal was struck, and the mood shifts. Is this deal in writing? What kind of stock does the employee think he/she is getting? When and how is the 10% measured? Is it measured at the time of the agreement or at a later date? Is the number of shares represented by the 10% calculated on a fully diluted basis or not? Can the 10% be diluted (i.e., if that 10% translates into 500,000 shares of common stock, will those 500,000 shares represent 8% when the outside investors put their money in or does the employee expect to be issued additional shares such that he/she still owns 10% following the outside investment)? In other words, did you inadvertently agree to let them have 10% of the company forever. Persons of reason laugh at the thought that anyone could think they’ve been given such a sweetheart deal. Think again. If you’ve just hired a very opportunist employee, they may have no qualms trying to hold you to a deal many would say borders on ridiculous. Then it becomes a matter of how much you would pay to avoid litigating such an issue when you should be building your company. This is an amateur mistake that is 100% avoidable.
4. Failing to properly structure founder shares - once you’ve decided who the founders are going to be, you’ll need to structure your founder shares. Founder shares embody the concept that if a founder receives all of their shares upfront, fully vested, then there’s no incentive to stick around and help build the company. That founder could walk one day, keep all of their shares and piggyback on the hard work of the remaining founders. Founder shares usually vest over a period of time and are issued as restrictive stock grants. By way of example, a founder may be issued a restrictive stock grant of 400,000 shares of common stock, vesting annually/monthly/quarterly over 4 years. If the founder stays for the full 4 years, he/she keeps all 400,000 shares. If the shares vested annually and the founder leaves 2 1/2 years later, they keep 200,000 shares (the company usually buys back the remaining 200,000 shares at the same price the founder paid for them). If they are fired for cause, it is possible that they could lose all of the shares. If there is just one founder, there is really no issue until such time that the company seeks to raise outside capital. At that time, the investors may insist that the founder put some of their shares on a vesting schedule – again, to align both founder’s and investor’s incentives. If there are multiple founders, then this is something that should be put in place at formation. For some further info, see both of these articles from Mark Suster regarding Founder Prenups and Founder Vesting.
5. Picking the wrong type of entity and structuring early ownership 50/50 – see my earlier posts regarding picking the right type of entity and the difference between entities. In my humble opinion, if you plan on seeking outside investors, then go with the corporate structure. You avoid the whole issue of VC funds requiring blocking entities (a result of some of their limited partners being non-profit companies) and the possible need (and accompanying cost and time) to convert your limited liability company to a corporation at a later date. In terms of how you structure ownership, if there are two founders then find some difference between yourselves to rationalize one person taking 51% of the ownership. 50/50 deals, absent some complicated deadlock breaking provisions, simply result in a standoff the minute the founders disagree. In order to make the 51/49 split more palatable, you can give the 49% owner comfort that he/she will have a say in material decisions (e.g., taking on debt, sale of the company, major hires, etc.) by giving the 49% holder certain protective provisions (i.e., the need to obtain their consent in order to approve these material decisions). If you do provide protective provisions, then make sure you look at them in the totality. You don’t want the exception to become the rule and end up in a 50/50 situation inadvertently.
6. Failing to consult experienced advisors at the beginning – many of the mistakes in this post could be avoided by simply hiring experienced start-up and emerging growth attorneys and accountants from the very beginning. See my earlier post regarding hiring start-up counsel. First time entrepreneurs may balk at this, serial entrepreneurs do not. Serial entrepreneurs know that they will save time and money resources (far in excess than they would have saved in reduced fees by going with inexperienced counsel) in the long run because they eliminate the clean-up necessitated by lawyers that don’t know what they are doing in this space. Hiring experienced counsel doesn’t mean the big price tag it used to mean. Contrary to many years ago, the marketplace has many start-up and emerging growth experienced attorneys at reasonable rates (see my earlier post on the changing law firm market).
7. Not having a clear business plan – the mantra here is focus, focus, focus. If you try to become all things to all people, you will likely end up being nothing to nobody. Investors back business plans that are clear and show some rational path to acceptable returns. I would advise having your attorneys and accountants also review your plan. If you are following my suggestion in Mistake #6 above, those attorneys and accountants see many plans and can provide helpful comments to improve and refine it.
8. Raising too much or too little money – raise too much money and you may have just bought yourself complacency (along with many of the other mistakes in this post). Too much money allows for making poor early hires (Mistake #1 above), consulting experienced but not cost-effective counsel (Mistake #6 above), losing direction (Mistake #7 above) and spending endlessly or needlessly (Mistake #11 below). Raise too little money and your runway may be cut short before you launch your product or have built enough to support raising additional funds. Planning and projections are the name of the game here. You need to look into the future as best you can and consider how much money you will need to reach the next fundraising stage.
9. Failing to properly document early agreements – there are early internal agreements to think about, and that experienced counsel can help you prepare, such as (i) shareholders’ agreements between the founders, (ii) founder share agreements and possible 83(b) elections, (iii) non-competition, non-solicitation, confidentiality and invention assignment agreements for employees (these are critical, particularly for employees that are building your product, as you might not own what they develop without them), and (iv) proper equity compensation plans (i.e., stock option plans), and option grant agreements. There are also early external agreements such as customer contracts, service agreements, licensing agreements, office leases and the like that need to be prepared. I’ve seen scenarios where early stage start-ups leveraged the existence of early customer contracts, but due diligence by VC funds later uncovered that those contracts were not as strong as previously thought. Use of experienced counsel early on will provide some assurance that the contracts contain the appropriate protections.
10. Raising early money without complying with the securities laws – no matter how you slice it or dice it, if you are selling a stake in your company then you are most likely selling a security which means you need to comply with federal and state (blue sky) securities laws. This is true starting with the issuance of founders shares all the way up to issuing stock to VC funds and beyond. The key here is to make sure that the transactions are structured in a way that you can claim an exemption to the requirement of registering the sale of the stock. It is very important that you properly structure these transactions because poorly structured transactions (i.e., those that don’t satisfy all of the requirements of an exemption) will cause significant problems down the road. They can derail future fundraising or cause the company to expend tens of thousands of dollars to later rectify. Properly structured, exemptions exist for shares issued to founders, and to employees under equity compensation plans and to VC funds. Most securities sold to outside investors are structured to comply with Rule 506 of Regulation D pursuant to the Securities Act of 1933, as amended. You will save yourself significant heartburn later on if you take the time to structure these sales correctly the first time.
11. Poor cash management and spending money on the wrong things - California Historic Landmark No. 976 – the “garage” where Bill Hewlett and Dave Packard started Hewlett-Packard in 1939. Simple beginnings for what is now a billion dollar behemoth. That garage epitomizes boot-strapping. Fast-forward to the mid-1990′s to late 1990′s, during the internet boom. Companies with only a business plan and little or no product were raising millions of dollars at hyper-inflated valuations. Many of these companies managed their cash poorly or otherwise spent their money on the wrong things. Enormous, beautiful offices and brand new furniture. Artwork. Game stations. There was seemingly no end in sight, until the whole thing imploded in mid-2000. Today’s start-ups seem to have learned some lessons from those days. You see more group-share offices, people buying used furniture off of eBay, jamming 20 employees into 4,000 square feet of Class C office space. You also see less tolerance for poor cash management. We all know “cash is king” and you really, really need to think about every dollar that goes out the door and what you are getting in return. You need to show investors you have the discipline to manage the cash to reach positive cash flow.
12. Failing to identify a market for your product/service - having and developing a product or service is one thing, but finding someone to buy it is a whole other story. Unfortunately, some entrepreneurs make the mistake of investing time and money into building the product or service before they’ve even considered who is going to buy it or how you are going to market and sell it to them (see Josh Kopelman’s article regarding customer acquisition plans). The investors that most often suffer from this mistake are the founders themselves, friends and family and, sometimes, angels. Very often it is the technical entrepreneur that may get caught up in this problem as their skill set tends to focus them on product capabilities and features and maybe not sufficiently on the need for those capabilities or features by the potential customer. The mantra here is to fail as early as possible. Try to identify what the customer wants and doesn’t want early in the process in order to reduce the amount of time and money resources focused on that feature. This mistake is not just made by early stage start-ups, as companies mature and launch new divisions and products, this mistake still ranks near the top.
13. Not being able to re-invent as you go - in the movie Heartbreak Ridge, Clint Eastwood starred as a gunnery sergeant in the U.S. Marine Corps. Anytime his soldiers would run into an obstacle or an unexpected problem, he would tell them ”improvise, adapt and overcome”. This is the perfect mantra for an early stage start-up. As I mentioned in Mistake #2 above, even the “best laid” plans run afoul and you need to be able to turn the ship on a dime and possibly take a different tack on the problem. Many say the difference between success and failure is only one factor. A capable and creative management team may be able to salvage the company by re-inventing it along the way. As the business grows, this skill set is still very useful. There were many companies that needed to re-invent themselves as of late in order to compete with some of the very capital efficient business models that currently exist.
14. Hangups on valuation rather than focusing on getting committed funds to make a successful business - I would like to thank Bob Fesnak of Fesnak and Associates for this Mistake #14. You can see my earlier post for more information on this subject. I place higher negotiating priority on liquidation preference and dilution than I do valuation. Don’t let your hangups over valuation stifle your change of closing on committed funds. Without the funds, there is no business. Read my earlier post in depth.
15. Failing to build a sustainable business around intellectual property - I would like to thank Bob Fesnak of Fesnak and Associates for this Mistake #15. It’s a classic and goes hand-in-hand with Mistake #12 above. Intellectual property is only one leg of the stool. You need all of the legs if you want the stool to stand and not wobble or fall down. The only way to monetize intellectual property is to build a sustainable business around it. This is the gap that technology transfer offices at the university level try to overcome on a daily basis. Intellectual property is created as part of the academic or research and development process and the university or professor desires to realize some value from that intellectual property. However, the university lacks the other legs to the stool and has to seek the private sector’s help to fill in the gaps. Technology transfer offices do this by partnering with entrepreneurs who can license that intellectual property and build a company around it.
You’ll find many other lists on the internet that focus on costly mistakes made early in the start-up process. For additional resources, I would point you to 25 Entrepreneurial Death Traps, by Fred Beste (Partner Emeritus at Originate Ventures). Fred is a great guy (and VC) and Originate Ventures is a great group to affiliate yourself with and to raise money from.
Thank you and I welcome your comments or questions.