Photo by Denny Müller on Unsplash
The best time to start thinking about your company’s exit is at the beginning. There are several reasons for this, the most important of which is positioning your company to be able to find funding when it needs it. Many new founders think they can just wait to see how things go; they will consider an exit when the opportunity arises. If your startup plans to raise money in the foreseeable future, you will not have the luxury of waiting and seeing.

Your company’s exit plan is a significant factor in attracting and retaining investment. Startups that are able to find money to move through the development stage and beyond usually have succeeded at a couple of things: (1) convincing investors that they will realize a return on investment (ROI) of 10x – 100x, and (2) giving investors a reasonable idea of when the expected ROI will be realized. Sure, investors like to count their money on paper as your startup grows. What they like even more is seeing actual money in the bank. Until your startup has an exit event of some type, the money in the bank part will not happen.

So what is an “exit”? In startup vernacular, the term “exit” usually means a sale of the company (or its principal assets) or an IPO (Initial Public Offering). In either transaction, the investors turn their original investment, and any appreciation, back into cash. While IPO’s are certainly buzzy, it is far more likely that a startup’s exit will come with a sale of the company.

The term “exit” is used because it refers to the time that the founders, who were the company’s first investors, and all of the other investors, exit the investment. The founders may think of an exit as leaving the company. In truth, it’s when they cash out – whether they leave or not. It’s the same with investors. They exit a company by turning the investment back into cash – hopefully, a lot more than they started with!

Your company’s business plan should always include a section on exit, even in the company’s early days. Potential investors will want to know when the cash-out comes. You will need to distill your ideas about the company’s future to arrive at an exit strategy. If you think it will be a sale of the company, what kind of sale will it be? Sale to a larger competitor? Sale to an investment group? Sale of the business’ IP or material assets? Sale to employees? Or do you think the company is likely to experience such a high rate of growth (and demand for cash) that it makes sense to “go public”?

“Going public” is shorthand for a sale of the company’s stock in a public offering. A public offering is when a company lists its stock on a stock exchange for sale to the general public. Limited liability company membership interests/units may also be sold publicly, although this is less common that public sale or corporation stock. The company “goes public” by registering a stock offering in accordance with U.S. securities laws. Those registered shares are then listed on a stock exchange, such as the New York Stock Exchange or NASDAQ, for sale to the public.

Startups usually raise money in the early days in private, not public, offerings. In a private offering, the company’s securities are sold under an exemption from registration (i.e., they are not registered). Registration is intended to be the way the company provides information to potential stock purchasers about the company’s business and financial health so that those individuals can make an informed decision about investing. Private investors acquire information about a company by doing due diligence, the results of which they combine with their investment experience to make their decision about investing. In either case, potential investors want sufficient information to evaluate the risk of the investment. When selling to the public, securities laws mandate what information must be given.

Early private investors are concerned about investment risk, but they are also driven by potential returns. Your company’s exit plan provides critical information that potential investors need to evaluate return potential. In other words, potential investors want to know up front when they can expect to cash out, which will factor into their risk-return assessment.

Investors will expect your company to support its beliefs about the company’s exit with information demonstrating that its exit projections are realistic. You may feel that mapping out an exit path for your company is pure conjecture, especially before the company has gained significant market traction. While there is some truth to that feeling, there are a variety of ways you can use available information to support your ideas about your company’s exit.

First, you can compare your company to the experience of similar companies that have gone before. If you have a ride-sharing company, for example, you may be able to compare your company to the experience of Uber or Lyft. Second, you can show transactions involving companies similar to yours, such as previous acquisitions. Last, you can illuminate the competitive landscape to show how your company’s product, service, or technology fills a hole for other companies, making your company a desirable target. In each case, your company uses real world examples to demonstrate that its exit projection is attainable.

In evaluating your company’s exit, you will also want to focus on financial considerations that may impact your exit strategy. To use Uber again as an example, one can point to Uber’s need to access significant cash to explain its choice to exit through an IPO. Uber is expecting to operate at a loss for the indefinite future, and it will need a continued infusion of cash not only to continue to grow, but to stay afloat until it realizes its end goal of deploying autonomous vehicles to transport riders. By using an IPO, Uber was able to access public markets for the huge cash investment needed to support its long-term business model. Had Uber instead projected an exit through acquisition, it would have been much harder to show that it could find an acquisition partner willing to make the large cash outlays necessary to survive until autonomous vehicles become reality. If your company has financial circumstances that will drive one kind of exit over another, those circumstances should be an integral part of your exit planning.

A final step in looking at any exit analysis is to consider the health of the market on which you are relying to acquire your company. With an IPO, you will want to consider prevailing trends in the IPO market as well as the broader market. With an acquisition, you will want to look at the fiscal health of companies you identify as possible acquirors. Do these companies have uncommitted cash on the balance sheet to make such a purchase, or are they mired in debt? Do they have sufficient ongoing revenues to fund an acquisition? Have they made earlier acquisitions to add to their intellectual property portfolio or menu of products and services? If they have made acquisitions, how much did they pay for the target company and what was the likely return to the target company’s investors? Answers to these types of questions will give prospective investors confidence that your chosen exit strategy will support investors’ expected ROI.

Thinking through your exit strategy will have benefits for your company beyond the information it communicates to investors. As you research acquisitions of companies similar to yours, you will gain a more refined understanding of your market and your competitors. You will learn whether competitors are paying to acquire new or needed technology or product categories, and how these acquisitions come about. Was the acquiring company a former customer? Did the acquiring company establish an important business relationship first, such as by being a major licensee of the target’s technology? Your analysis should also identify companies that may have an interest in what your company has to offer. The acquisition patterns in your market – or lack thereof – will help you position your startup most optimally for exit, whenever that time comes.

It may seem counterintuitive at first, but understanding your company’s exit strategy will help you position your company to attract investment and, eventually, to help your investors realize a return on their investment. Investors with a track record of investing in startups are rarely looking to be long-term equity holders. Instead, they operate on a fixed time horizon, expecting that their 10x + returns will be realized within some proscribed period. If your company’s anticipated time to exit is too distant, or expected ROI is too small within investors’ preferred time horizons, investment capital may be hard to find. Understanding these facts will help you think about your company the same way investors will. This insight can be a powerful tool to help you realistically evaluate your company’s prospects and make it an attractive investment opportunity.

Is your startup sitting on a legal landmine?

Entrepreneurs have their hands full trying to get their companies off the ground. With endless demands and “to dos” and limited time, legal matters often get moved to the “when I get to it” list.

Legal services are expensive, and finding an attorney takes time. Finding the right attorney for your company, rather than just any attorney, is important, but the need to invest time and resources can be off-putting. Time-starved founders often find it easier to just put legal on the back burner. Legal needs are addressed if and when they become critical or inescapable.

There are some basic legal areas founders need to address in the early days of their companies and not avoid. Taking care of tasks in these areas will go a long way toward averting legal landmines down the road.

If your company cannot afford to hire a lawyer, you will need to be sure that whatever legal resources you use instead are the right ones, have been designed with startups in mind, and do not reflect terms negotiated to fit someone else’s business needs.

The following are the basic legal areas your startup will want to cover. The list below is not exhaustive, but it provides particular areas in which mistakes or omissions are commonly seen.

If your company has not addressed one or more of these areas, it may be sitting on a legal landmine.

1) Entity Formation: This area involves choosing the correct entity form and jurisdiction (state) of formation for your business, filing the correct forms to establish the entity, filing any qualification documents (if needed) in states other than your entity’s state of organization, adopting the “rules of the road” for running your company (bylaws, operating agreement, partnership agreement, etc.), adopting organizational resolutions of the governing body and/or shareholders/members, making appropriate tax filings, and obtaining any local licenses needed to operate the business.

2) Business and Brand Names, Trademarks and Domain Names. Your company will want to be sure that any business, product, or service name that it wants to use as a trademark is actually available for use and not already being used by someone else. Equally important, subject matter on which your company wants to seek trademark protection must be determined to be eligible for trademark protection. When researching names for trademark, also be sure the top-level domain is available.

Do not set your heart or put any money behind names that you have not cleared for trademark and/or domain name registration. As well as determining eligibility for registration, your company wants to be sure it will not be infringing others’ marks when adopting any name for use.

3) Document All Founders’ Roles, Responsibilities and Ownership. Failure to document founder roles, responsibilities and ownership can cause significant trouble down the road, especially if the company becomes successful. This documentation is also important in case a founder resigns or is asked to leave the company. Do not leave this negotiation among founders until something arises that will affect the founders’ relationship. Crisis negotiations almost always leave the company and continuing founders with less leverage than they might otherwise have had.

4) Develop and Implement Programs to Acquire, Capture and Protect Intellectual Property. Your company’s IP acquisition begins with the transfer to the company of any core IP founders may developed prior to the establishment of the entity. As the company begins to do business, it may want to acquire IP from third parties, or it may itself develop IP. In each case, the company should have a process to acquire, capture, document and protect IP. The founders may also want to have an understanding of when the company will seek protection for IP through registration, such as with patents, trademarks or copyrights, and when it will use secrecy (trade secrets). The company’s IP strategy must extend to the company’s employees.

5) When Your Company Raises Money, Comply with Securities Laws. It is never advisable to assume that an issuance of company securities will fly under the radar or that it is automatically exempt from registration, even issuances to founders. If your company ever raises outside money from an institution, venture capitalist or other sophisticated investor, the company’s handling of issued securities will be one focus of the due diligence process. Neglect this task at your company’s peril. Unattended securities issues can cause serious financial or tax repercussions for your company – and may affect the company’s ability to raise outside money.

6) Comply with All Labor, Employment and Non-Discrimination Laws. Failure to comply with applicable labor, employment and non-discrimination laws can open up your company to fines, penalties, assessments and other financial risks. Do not assume that labor and employment compliance starts when your company hires its first employee. These laws may apply to founders working in the business as well as regular employees.

7) Plan for Executive and Employee Incentive Compensation. If your company will not have the means to pay market salaries to attract talent, you will want to think early on about setting up some type of equity compensation plan. There are legal, tax, and accounting considerations that attach to different types of equity compensation, and your company needs to understand the lay of the land with any equity compensation it issues. Some mistakes in this area cannot be rectified, and mistakes may affect the company’s future fund-raising.

With each of the above areas, it is often better to trade limited resources for expert help than to apply self-help and simply hope it’s right or assume you can fix errors later.

If your company does decide to go it alone, do your homework. Find the best resources you can, preferably those specifically designed for startups. Leverage any available legal advice you have access to, with the caveat that the person or service providing the advice actually knows the subject area. It doesn’t make a lot of sense to seek securities compliance advice from a lawyer who specializes in immigration or personal injury litigation, for example.

Startup companies have somewhat distinct legal needs, and the lawyer you trust to advise your company – even on an ad hoc basis – should be familiar with those needs.

This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact an attorney directly.

Conventional wisdom says that you can’t improve what you can’t measure. Many startup founders take this wisdom to heart, and they try to measure as many metrics as they can.  Financial metrics help a startup analyze its business model to determine when to double down, when to hold, and when to fold.

The principal job of a startup is to grow and scale. Without improvement and growth, startups fail – and they do so at an alarming rate. To paraphrase Steve Blank, a startup is an organization formed to search for a repeatable and scalable business model.  Financial metrics are like putting your cards face up on the table.  They can show solid evidence that your startup is on the right track to repeatability and scalability.  They can also help you evaluate whether your startup’s business model is sustainable.  When you know your numbers, your metrics will also allow you to “fail fast” if your company seems to be holding a pair of threes instead of a Royal Flush.

With a failure rate of close to 90% despite that fact that startups generally keep a good eye on their finances – if for no other reason than money is tight and needs are great – we have to ask, “Are startups measuring the right things?

Below are the key metrics your startup needs to measure to keep it on the right track. Tracking these metrics will ultimately tell you if your startup has a sustainable business model. These few financial metrics should be measured and updated consistently so that the founders or executive team knows at all times how the business is faring and what its prospects are.

Here are the key metrics to measure:

1)  The total cost of running your startup. Be sure to include both fixed and variable costs, and don’t forget less obvious costs like taxes (income and employment) and insurance.

You can’t figure out your runway until you know your costs.

2)  Your startup’s break-even point. Once you know the total cost of running your startup, you can figure out what level of sales revenue you need to pay those expenses. The point at which revenues equal expenses is your break-even point. Knowing your break-even point can help you figure out how much runway you are going to need.

3)  Cash flow, cash flow, cash flow. Your cash flow measures cash coming in and cash going out. Positive cash flow is the lifeblood of every business. Positive cash flow means your startup has more cash coming in that it has going out. Negative cash flow is simply the reverse. Your startup needs to track actual flows, and it also needs to forecast future cash flows.

When you forecast, you determine how much will be coming in and when, what cash is going out, and how much you will have left over (if any). By looking ahead, you will be able to identify cash flow problems and plan accordingly. Cash flow forecasting also gives you a tool to evaluate the sustainability of your business model. If your startup consistently has a negative cash flow, there may be a problem with your business model.

4)  Sales and marketing efficiency. Achieving sales and marketing efficiency is one way to show that your startup has a repeatable and scalable business model. This efficiency has two main components: (1) Customer Acquisition Cost (CAC) and (2) Lifetime Value of Customer (LTV).

CAC is calculated by adding together for a specified period all costs that went into acquiring customers. This amount is then divided by the total number of customers acquired during the same period, giving you your per-customer acquisition cost.

LTV essentially measures how long a customer is expected to remain a customer of your company and how much money the customer is expected to generate over that period. While the LTV calculation itself is straightforward, LTV is a little more difficult than CAC to calculate accurately in a startup’s early days because you may have to guess at one or both numbers. The closer your guesses are to actual, the better insight you will gain about your company’s sales efficiency.

Knowing your CAC and LTV will help your startup scale at the right time – and not before. The general rule of thumb is that LTV should be at least three times CAC before a company is ready to scale. Premature scaling often leads to poor performance, even failure. Having a favorable LTV to CAC ratio also tends to indicate that a company’s business model is repeatable and sustainable.

In short, know your startup’s key financial metrics. Being able to identify problems early-on will help your startup address business model problems before they become intractable or before your startup burns through its cash reserves. Pivots only happen when problems are identified early enough that the startup still has resources to pursue the modified business model. The metrics can also help you identify when problems are intractable, allowing you to “fail fast” if your company’s business model proves not to be viable.

This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact an attorney directly.

Almost every entrepreneur will wrestle early-on with a non-disclosure agreement. Sometimes, it is the entrepreneur herself or himself wielding the NDA; sometimes, it will be a potential business partner or supplier. New entrepreneurs just making their first foray into business sometimes seize on NDAs as the attainment of something desirable – as though having an NDA validates their business idea or product, showing that the entrepreneur actually has something to protect. This idea may miss the mark. Instead, the entrepreneur should determine what he or she has that not only is non-public, but that has true economic value. The entrepreneur should understand the reason she or he will be disclosing confidential information, what benefits arise from disclosure, and how the receiving party intends to use it. Finally, the entrepreneur must understand the sensitivity of the information disclosed and how to best protect it in the hands of the receiving party.

To get a couple of things out of the way, let’s look at a few things around which there seems to be much confusion. First, ideas by themselves are virtually worthless. All of us have thousands of ideas each day. Ideas are not protectible as such. Truly, most ideas are not unique. What is unique is the ability to take an idea and realize it in the form of an invention, product, service or sustainable business. Second, you cannot protect something with an NDA that is already public, whether in a protected way (such as, under patent or copyright) or as part of the public domain. New entrepreneurs sometimes fail to look at the marketplace to determine if what they are doing is truly new and, more importantly, non-public. A quick look at the database of issued patents can provide insight as to the novelty of a new invention, for example, or a survey of similar businesses’ products and services can give perspective on whether a product or service is actually new.

If the information you are trying to protect with an NDA contains subject matter on which you intend to seek patent protection, disclosing the information under an NDA may not be the best strategy. You may want to file a patent application first, whether on a regular or provisional basis, before disclosing the information to third parties. The patent filing will help to prevent misappropriation or misuse of your valuable information and to forestall competing claims of inventorship from a receiving party. If your company has come up with a fantastic new brand for your company, product or service, it may be safer and more efficient to purchase the top-level domain or file a trademark application than to disclose the unprotected information under an NDA.

There is one truth always to keep in mind about secrets: Once revealed, a secret cannot be untold. The recipient’s memory cannot be erased. The risks of disclosure should always be weighed before the disclosure is made. NDAs are not always water-tight, and poorly-drafted NDAs are legion.

When evaluating an NDA, whether you find it on the internet, get it from the proposed recipient of your information, or have it prepared by your lawyer, you need to look at three basic things:

1)  Scope.

a.  Look at the kind of information the NDA covers. Be sure the description is broad enough to include all of the information you intend to disclose. For example, if you will disclose computer code and the NDA does not cover source and object code, software, or the like, you have a problem. If you are exploring a business deal and want all inquiries and negotiations to remain secret, your NDA needs to include that category of information.

b.  Determine if the NDA will cover a mutual exchange of information or only a disclosure from one party to the other. If your company is the disclosing party and you do not anticipate receiving confidential information from the other party, there is no need to commit to two-way confidentiality obligations.

c.  Be sure the NDA prohibits both the disclosure and use of the confidential information.

2)  Duration.

a.  Identify the period during which confidential information may be disclosed or exchanged under the NDA. Are you anticipating a one-time disclosure of information or a period of exchange? The duration of the NDA should reflect the expected disclosure activity.

b.  Determine how long the confidentiality obligation will last after the disclosure or exchange period has ended. If you are disclosing information that has rapid turnover/obsolescence, the confidentiality obligation can be fairly limited. If, however, you are disclosing trade secret information, you may want the confidentiality obligation to continue indefinitely.

3)  Standard of Confidentiality.

You will want to determine what standard applies to the receiving party’s handling of confidential information. Some NDAs provide for strict confidentiality, some provide that the information be held in circumstances comparable to those under which the recipient keeps its own confidential information, and sometimes agreements contain no standard at all. The more sensitive your information, the more you need to pay attention to these terms.

Evaluate every NDA using the above criteria.

There are other terms of note in most NDAs, but these criteria are major. If you have existing NDAs, go back and ensure that all major areas are clearly covered. If they are not, your NDA may fail you if you ever need to enforce it.

This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact an attorney directly.

Data shows that startups founded by solo entrepreneurs are more successful that those founded by entrepreneurs with one or more partners. So says an April 30, 2019 article in Inc. written by Minda Zetlin. Ms. Zetlin’s article surveys research conducted by Jason Greenberg of NYU and Ethan Mollick of the Wharton School that looked at 3,526 startup companies. The researchers found that companies with solo founders were more likely to remain in business than those with multiple founders. Companies with founder teams were able to raise more money out of the gate than solo founders, but solo-headed firms had higher revenue overall than their team-founded counterparts.

For any of you who have been around the startup world for a while, you will know that the result found by Mssrs. Greenberg and Mollick is directly contrary to the conventional wisdom spouted from all corners. Founders are encouraged to build a founder team if they want to be taken seriously. Y Combinator is very open about the fact that companies with solo founders have a much lesser chance of being accepted into the accelerator program than those with founder teams. This bias toward founder teams is also an open secret among startup investors.

Greenberg and Mollick initially looked at Kickstarter companies when doing their research. Since then, the researchers have expanded their survey to include non-Kickstarter companies. That research is ongoing, but Greenberg apparently told The Wall Street Journal that the preliminary findings from the expanded survey are consistent with the Kickstarter results.

Ms. Zetlin briefly examines in the article why companies with solo founders might do better over the long term. Lower salaries and costs, quicker decision-making, the ability to hire needed expertise and a greater tolerance for risk are all cited as reasons. The author also posits that a solo founder who makes the leap to found a startup may simply be more passionate about the product or business concept.

I found the Inc. article to be both surprising and not surprising. Most founder teams I see have one principal leader, or, at most, two strongly-committed individuals. The lead founder is, more often than not, the person who originally came up with the idea for the product or business concept. The lead founder is also the person who took the step of actually starting the company. In many team-founded startups, there often seems to be a category of “second-tier” founders who contribute to the business but who are not as instrumental as the lead founder in pushing the business forward. Could these second-tier founders be equally effective in employee roles? Possibly.

Observation seems to indicate that the solo founder model can be just as present in a team of founders. If only one of the founders is responsible for the momentum, direction and major decision-making about the company, the dynamic looks much like a solo-founder-led company. Recognizing that this dynamic exists in many team-led companies would seem to support the researchers’ conclusions that solo founders are more effective. As the researchers continue to gather data, it would be interesting to expand the study to look at the relative success of founder teams led by a dominant founder and whether these “teams” mirror the outcomes of sole-founder companies. If this is the case, the data outcomes may not be as startling on second look.

This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact an attorney directly.