Articles by Tim Berry

If They Ask You to Judge a Business Plan Competition, Say Yes

I’ve had the pleasure of judging several dozen real business pitches in the past six weeks. Some were pitches for angel investment at the Willamette Angel Conference, an angel group in Oregon. More to the point, others were for the University of Oregon New Venture Competition, the Rice University Business Plan Competition, and the University of Texas’ Venture Labs competition.

The three business plan competitions I participated in were all MBA-level contests organized by the entrepreneurship-related faculties at the three schools. They all invited startups from dozens of different schools, including several from other countries.

Judges read business plans first, then hear the pitches, then ask questions, and vote for winners. If you’re an angel investor you’re familiar with what works and doesn’t, you’re interested in startups, and you’ll enjoy judging in one of these competitions. You see some great plans and smart people.

Unlike the old days of the early business plan competitions — University of Texas’ Moot Corp was the first, in 1984 — these are no longer academic exercises. These are mostly startups that will launch. Teams that competed in just the three contests I mention here in the last 10 years have raised close to a billion dollars in venture money between them. For example, Auditude, the 2005 winner of both Texas contests, was purchased in 2009 by Adobe for $120 million.

And the entrants come from all over. A Thai company tied for first place in the University of Oregon competition last month, and an Indian company just won the University of Texas competition last weekend. A British company and several other Thai companies got into the finals of these three.

And judges are a mix of venture capitalists, angel investors, and successful entrepreneurs. So if you are one of those, then I recommend you check with local universities or with bizplancompetitions.com to see what competitions take place close to you.

(Image courtesy of Rice Business Plan Competition)

Invested Interests

True Story: Why We Turned This Deal Down

This is about a deal my angel group turned down.

Tim Berry Good Investment Good Startups Venn Diagram

The software looks excellent. I wanted to use it immediately. There’s urgent and widespread market need. It’s obviously proprietary too. It’s a crowded noisy market, but it feels like this one has a real shot at it. Furthermore, the entrepreneur behind it is proven. The software grew out of the needs of a successful professional service business. There’s relatively low risk of failure.

So why did we turn it down? Because this one doesn’t need our investment. It’s quite possibly better off growing on its own bouyed by the resources of that professional service company. The entrepreneur could get it past cash flow break-even and continue growing so it would never look back.

We don’t want to end up with a minority share of a company that has no incentive to exit. Not all good businesses are good investments.

Invested Interests

The Right Way to Not Pay Yourself

Today I received an email asking me to clarify what I wrote last month in Why sweat equity often stinks. The person quoted the sentence in italics below and asked “what does that mean, exactly?” I’m including the whole point because the context helps:

Founders work for less than fair value and record the difference between actual pay and fair value as owed to founders, a liability on the balance sheet. This has the advantage of recording real expenses into the financials, so I like it. But founders asking for outside investment should expect to capitalize that and swallow the liability. You can’t use founders’ labor to justify the valuation ask, and then turn around and get it paid too. You know: cakes and eating?

So here’s a true story, an actual case, one I know very well because it was my money and my sweat equity. While I was bootstrapping Palo Alto Software I couldn’t afford to pay myself what I was worth. But I didn’t pretend I wasn’t an expense. I practiced what I preach by recording the market value of my work, month by month, as an expense called unpaid Tim salary. And I balanced every month’s entry into expenses (a debit) with a corresponding entry to liabilities (a credit).

(By the way, important warning: I didn’t report my unpaid compensation as an expense for tax purposes. You can’t deduct compensation to yourself unless it’s paid; and when it’s paid, you have to pay payroll taxes. This is not trivial.)

(Oh, and a disclaimer: I’m neither attorney nor CPA. I don’t give tax advice, accounting advice, or legal advice. I’m just telling you a true story.)

As time went by, I accumulated an interest-free liability that was a serious amount of money, more than six figures, as debt owed to me. And that still on the books years later when I brought in venture capital money.

When that turned up in due diligence, my investors said:

Tim, that’s not going to fly. If we’re investing, you have to swallow that. Capitalize it. Take it off the books.

And so we did. The money owed to me became another version of sweat equity. It was in the valuation we negotiated with the investors. It disappeared. It was never paid.

Would I do that — keep track of unpaid salaries — again? Yes. Would I recommend you do it? Yes. It gives a better picture of real expenses, break-even, and so forth. It might be useful for some future close-in negotiation with partners, people close to you, perhaps divorce court or inheritance tax. But investors won’t want to pay it back.

That’s what I meant. I hope that clears that up

Invested Interests

How We Do the Due Diligence for Our Angel Investment Group

Bill Payne had an excellent post here a few weeks ago, Raising Your Hand as Due Diligence Lead for Angel Groups, which starts with a this:

Through Rob Wiltbank’s ground-breaking study in 2007, angels in groups learned that collective due diligence on new deals really pays off. The 538 angels included in this study enjoyed 2.6X returns over the life of their investments. However, for deals on which collective due diligence totally less than 20 hours, returns were only 1.1X. But, deals on which angel put in over 40 hours of due diligence (the top quartile) returned 7.1X to angel investors. Due diligence clearly makes a big difference for angel investors.

With this post I’d like to add some experience on what due diligence means for the angel group I’m a member of (the Willamette Angel Conference, in Oregon). I want to share what, when, and how we do it. I’m not suggesting that our way is the right way or better, but merely that it might be helpful to others. Our group links the investment to an annual event organized by the local chamber of commerce. That gives us some community benefits, like the awareness that angel investment is available and happens in our community. It also ties us to an annual schedule.

We announce our investment event months in advance, we clarify its bias for Oregon startups, and we set a deadline for submissions. About 40 startups enter.
We use gust.com to collect our entrants. The post their info. Our members join and get access to the site.
We use the gust.com ratings platform, each of us individually, to rate the 40 companies based on the information they posted.
In a first meeting we decide which of the 40 companies we want to contact for more information. Our members call and ask and organize what they get.
In our second meeting a week later we share the information gathered from the companies we contacted, review the information posted, and decide on a select group to move forward into more serious due diligence. The target number is 12. The number can vary from year to year, depending on the quality of the submissions and other factors. We assign due diligence teams of 3 or more member investors.
Over the following 5 weeks we invite the top 12 or so to our meetings, listen to pitches, ask questions, and meet with them offline, read business plans, talk to advisors and investors and customers if they have them. The due diligence teams report back to the group.
We then name finalist companies — the target is five — and due another round of due diligence. They pitch again, we shuffle the teams, we read more, call more people, and look deeper. The teams report back to the group.
The last day is an event, organized and hosted by local chambers of commerce, with an audience of several hundred people who pay to get in. The finalists pitch. We vote and select our investment.

I hope you find these details helpful. I’ve left out dates and some details on purpose. We do keep all due diligence and deliberations strictly confidential, but the process itself is not.

(Image: KendyTV on photobucket)

Invested Interests

Why Sweat Equity Often Stinks

Somebody asked for standard boilerplate for sweat equity via the ask-me page on my website.

I am looking for a contract template which states an agreement for services in exchange for equity. I was hoping that you would have a template that you can share.

That’s not going to happen. Fundamental sweat equity is beautifully, blisteringly clear, and real. And needs no template or contract. And most other sweat equity is full of potential problems, misunderstandings, and disappointments.

Real sweat equity

Real sweat equity is solid. It doesn’t take documentation; it’s as basic as walking forward. You start your company, create something from nothing, grow it, and the sweat equity value is simple and obvious. For every company owned by its founder(s), sweat equity is a simple formula

valuation
– compensation taken
—————————————————-
sweat equity

This is the way of the startup world, for the most part. Real life. Be careful, though, as you develop the business, not to underestimate real expenses and overstate profits by ignoring the fair value of the founder’s work. That messes up the analysis.

When I read business plans as a potential investor, I expect the founders to include the value of their work in the valuation. I don’t like it when they promise to work for less than fair value in the future, because that puts pressure on the system. Sometimes those sacrifices blow up on the company at bad moments. I like a business that can afford to pay everybody working there, including founders. And if the numbers work, the future prospects are good, then that can be part of what investment funds are used for.

And I hate seeing liabilities on the balance sheet (see point 3, below) that track back to unpaid compensation for founders. Your valuation is your compensation.

Everything else

However, a lot of so-called sweat equity isn’t solid; it’s like folded paper, easy to rip or crush, not reliable. Some examples:

Peanuts-and-promises sweat equity: Ralph hires Mary for a lot less than she’d be worth on the market, and a lot less than what it would cost him to get a market-value employee to do what Mary does. Time passes. Mary works. She thinks she owns 50% of the business. But nothing is written. The business takes off. Mary wants her share but now she’s asking, as a supplicant. Her share is whatever Ralph decides is fair. Ugly, but it happens a lot.
Salary-plus-shares sweat equity: This is way better than the peanuts and promises. There’s a formula and some specific numbers to it. Both sides negotiate the mix between money and shares. However, shares are just one number in a calculation that depends on two numbers; percent ownership is another simple formula:
shares/total shares outstanding = ownership%

Way too often people dangle shares as reward, without specifying total shares outstanding. It becomes another misunderstanding and disappointment waiting to happen.
Temporary-and-will-be-capitalized sweat equity: Founders work for less than fair value and record the difference between actual pay and fair value as owed to founders, a liability on the balance sheet. This has the advantage of recording real expenses into the financials, so I like it. But founders asking for outside investment should expect to capitalize that and swallow the liability. You can’t use founders’ labor to justify the valuation ask, and then turn around and get it paid too. You know: cakes and eating?
Plain exploitative BS sweat equity: It happens all the time. Whenever startup founders just get together and start working, without really agreeing on who owns how much, and who does what for how much, there’s a 90% or more chance somebody is going to end up shafted, feeling they’ve contributed more than their share and got less than their share back. I hate hearing about this. “You’re an owner” and “we’re partners” and “sure, I’ll take care of you” are incredibly powerful lures used way too often to get more work for less ownership and less money.

Pivotal Moments

Big Obvious Failure is Better Than Long Slow Lack of Success

Steve Blank has a good post today called Failure and Redemption, which he introduces with this:

We give abundant advice to founders about how to make startups succeed yet we offer few models about dealing with failure. So here’s mine.

Steve’s experience was Rocket Science Games, which raised $35 million and a cover story in Wired Magazine before failing. He writes about shock, denial, anger, blame, depression, acceptance, and, finally, insight.

At least it was clear and present failure. Very visible failure with the big raise, big press, and then the big crash at the end.

Not one of those much-more-common long drawn-out failures that end up taking years of slow quicksand-like decline. Lots of smaller raises, pivots, restructuring, clinging to hope, and frustration. With no real path to success but no exit either.

Not having the option of continuing can be a blessing. Take the write-off, swallow hard, and do something else. Persistence and perseverance can be overrated.

Invested Interests

What? Avoiding Undue Diligence? Seriously?

I suspect this is one of those provocative posts that gets misquoted, misaligned and misunderstood, and definitely not to be taken at face value. Still, read Avoiding Undue Diligence: My Strange Approach To Angel Investing, in which Dharmesh Shah argues against due diligence in angel investment.

Dharmesh Shah on Avoiding Undue Diligence

I don’t subscribe to the idea in the title. And I’m familiar with Robert Wiltbank’s exhaustive research on angel investment — as in this summary in TechCrunch — that shows a serious correlation between more hours of due diligence and higher incidence of successful exists.

Still, Dharmesh’ refreshingly contrarian, and unabashedly honest, analysis is worth a good read. And the comments are lively too.

Furthermore, I’m really intrigued with this quote near the bottom:

There’s no such thing as too many companies starting up. But, there is such a thing as not enough companies shutting down.

Now there’s a thought worth following up.

Blog

Thoughts on startups by investors that fund them & entrepreneurs that run them

Tim Berry

Articles by Tim Berry

If They Ask You to Judge a Business Plan Competition, Say Yes

True Story: Why We Turned This Deal Down

The Right Way to Not Pay Yourself

How We Do the Due Diligence for Our Angel Investment Group

Why Sweat Equity Often Stinks

Big Obvious Failure is Better Than Long Slow Lack of Success

What? Avoiding Undue Diligence? Seriously?

Get Gust by Email