Mark Suster wrote a great post a few weeks ago titled The Resetting of the Startup Industry. Go read it now—I’ll wait.
For entrepreneurs, pragmatic cost cuts are always possible and often productive. Tweet This Quote
Once again, as we find ourselves in the middle of a significant public market correction, especially around technology stocks, there’s an enormous amount of noise in the system, as there always is. Much of it is very short-term focused, and like a giant tractor beam, it draws the conversation into a very short-time horizon (as in days or weeks). Rather than rational and helpful thoughts for entrepreneurs, it often brings out the schadenfreude in even the most talented people.
Mark’s post is one of the first in this cycle that I’ve seen from a VC giving clear, actionable advice. One of my favorite lines is buried in the middle:
Many companies have hired ahead of their growth rate because they had the cash to do so. In our portfolio, we generally don’t have this problem because we aren’t big fans of either (a) overfunding companies, or (b) escalating burn rates based on headcount.
Make sure you know where the capital is going to come from to fully fund your business. Tweet This Quote
But, occasionally we find ourselves in the position on the board of a company where, as you look forward, you realize you are burning more than you should be for the stage you are in.
As Mark suggests, this is a moment when you can proactively make pragmatic cuts. It will suck for a few days, but feel a lot better in the long term. But, more importantly, it’s another point Mark buries later on, which includes an awesome post of his from 2010.
I learned this lesson 127 times between 2000 and 2005. I started investing in 1994, and while there was some bumpiness in 1997 and again in 1999, the real pain happened between 2000 and 2005. I watched, participated, and suffered through every type of creative financing as companies were struggling to raise capital in this time frame.
Until you are consistently generating positive cash flow, you depend on someone else for financing. Tweet This Quote
I’ve seen every imaginable type of liquidation preference structure, pay-to-play dynamic, preferred return, ratchet, share/option bonus, option repricing, and carve out. I suffered through the next financing after implementing a complex structure, or a sale of the company, or a liquidation.
I’ve spent way too much time with lawyers, rights offerings, liquidation waterfalls, and angry/frustrated people who are calculating share ownership by class to see if they can exert pressure on an outcome they really can’t impact anyway, and certainly haven’t been constructively contributing to.
I have two simple rules for founders in my head from this experience. First, make sure you know where the capital is going to come from to fully fund your business. You might have it in the bank already. Your existing investors might be willing to provide it. Or you might need to raise it.
Entrepreneurs, keep your capital structure simple. Tweet This Quote
Until you are consistently generating positive cash flow, you depend on someone else for financing. In this kind of environment, that can be very painful, especially if you need to go find someone who isn’t already an investor in your company (e.g. your insiders require there to be an outside lead, or you need to raise much more capital than your insiders can provide).
Second, keep your capital structure simple. There are three things that will mess you up in the long run:
1. Too much liquidation preference. My simple rule of thumb is that if you’ve raised more than $25m and your liquidation preference is greater than 50% of your post-money valuation, you have too much liquidation preference. This is a little tricky in early rounds and with modest up-round financings, as you’ll often have a liquidation preference that is high relative to your overall valuation. But, as you raise more money at higher valuations, this will normalize. Then, if you end up doing a down round, it suddenly matters a lot. Don’t worry about this too much, until you do a down round. Then use the down round to clean up your preference overhang.
2. Complex liquidation preference. In an effort to keep from doing a down round, or too much of a down round, there will be tension between your old investors and your new investors (if you have them) around your new liquidation preferences. Often, there will be asymmetry between them with your new liquidation preferences having a multiple on them where they participate for a while up to a cap—or participate forever. If you don’t know what this means, welcome to the world of terms other than price suddenly mattering, which Jason and I talk about extensively in our book Venture Deals. Deal with reality as a founder as well as an investor group and avoid this complexity—just clean up your cap table instead.
3. Carveouts. After spending hours working through yet another messed up carveout I inherited from an old bubble-era deal, I realized I hated carveouts. They are almost always written in a way that doesn’t really hold up, creates misalignment, or is a negotiating anchor in an acquisition situation. When I see a carveout being proposed these days, I know there’s a liquidation preference problem.
As a founding team, the best is to work with your investors to make sure everyone is aligned for the upside case. Tweet This Quote
Mark’s post has good solutions for each of these, but as a founding team, the best is to work with your investors to make sure everyone is aligned for the upside case, rather than focused on protecting their capital in the downside case. For this, like so many other things in life, “simple is better.”
Most importantly, don’t be afraid to talk about it early, well before you have to go through another financing round.
This post originally appeared on Brad’s blog.