Sometimes being a successful Angel investor is just chalked up to luck, because for every success there are a number of failures behind it. The same can be said for entrepreneurs, success and failures come by in many ways, some planned and some that just pop up out of nowhere. In both cases we have learned that failures are nearly always due to people and relationships.
So how do you protect yourself from failure? Due diligence and vesting of stock to founders, early hires and initial partners ensures that everyone’s interests are aligned with the goal of moving a company forward.
I will illustrate this in three stories that happened over the last year, but first, what is stock vesting?
Stock vesting is a mechanism where the stock in a start-up is earned over a period of time (instead of given all at once in the beginning), by the founders, early hires and initial partners. So, if one of the founders, early hires or partners leaves the company, they only keep the stock they earned to that point (based on milestones). The remainder of the stock that they were promised stops and is taken back by the company. This ensures that stock is only issued to those who are continually providing value.
We encourage entrepreneurs to hire a talented team but be sure to vest their stock over a period of time that makes sense for the team and the company.
A typical vesting agreement is a 25% immediate stock issuance to the new hire with the remaining stock being granted over a 36 month period. If there is a monetization event then all of the stock is immediate vested. This allows the company to incentivize the talented team with ownership, while protecting themselves in case of an adverse event with an employee.
A former colleague that I had worked with in a previous life contacted me regarding a company he created. His data analytics company provides a scoring of customer needs when they purchase a certain amount of insurance. He asked that I visit with him to discuss his capital needs and capital structure.
What became clear during our conversation was not that he needed capital (he had a solid base of investors), but rather that he had an issue in the relationship with a former business partner. He went into great detail about how he and his partner had started the company and agreed on a number of operational and ownership issues. They started the company with the ownership split of 55% and 45%. The stock was distributed and the company started.
Fast forward six months, all the promises the 45% partner made and everything he was supposed to bring to the company did not materialize. When he was asked to leave the company, sadly he took his entire stake with him. There was no vesting agreement in place.
Two years and two million dollars of investment into the company later, they have brought their product to market and are making sales. The 55% owner is chatting with me about his capital structure and how he would like to take revenge on his partner and try to dilute his stock position.
After much conversation and discussion, the surviving partner decided to focus on building the business and not to focus on taking revenge on his former partner. Think of what he could have avoided – the time, effort and emotional turmoil if there was a stock vesting agreement with his partner in place.
Last year the New Mexico Angels supported a number of start-up activities; Start Up Weekend Santa Fe; Start Up Weekend Albuquerque; Albuquerque Teen Start Up Weekend, and the New Mexico Technology Showcase.
The outgrowth of this support was a number of conversations with budding entrepreneurs and with new start-up companies.
One of these companies was started by recent grads from UNM and they were focused on the idea of pushing unused service inventory via a smart phone app. In meetings with the entrepreneur we spoke about a number of issues regarding capital structure, raising funds, suggested business models, and employee compensation. Unfortunately, although really early in the process, by the time we had this conversation, the company had already been incorporated and distributed shares to a number of company founders and service providers.
Flash forward three months, one new hire had moved to California for a job, and took his shares with him. A few weeks later, the programmer who was supposed to build the app was not completing his milestones. After much encouragement, begging, and trying to make him do his job, the programmer was let go. He also had a stake the in company… and it went bye-bye with him.
Think what might have happened if the company had vested their early hires and other founders of the company. Now they have “dead stock” floating around the world out there.
The Angels were approached by a serial entrepreneur with a high-tech start up based on intellectual property from a well know technology institution. The company had already been created and the stock distributed to the founders and the principal investigators of the technology.
In reviewing the deal and the cap table, a number of issues stood out. Over 45% of the company had been distributed by the company to the principal investigators that created the technology at the technology institution. When asked what value the principal investigators were going to provide to the company; the entrepreneur stated, “technical advice… when they have time”. They were keeping their full time jobs at the technology institution and would not be hired on by the start-up company.
So the New Mexico Angels were asked to invest in a company where over 45% of the ownership in the company was not going to provide any further value to the company. (We don’t mind providing ownership to principal investigators as long as they are involved – but not half of the company!) We did not invest in this deal.
Fast forward eight months, after burning though over $400k in investment capital, the serial entrepreneur is back to the Angels presenting another round of investment. His investment proposal is to cramdown the principal investigators and the early investors, with a New Mexico Angels investment. After a quick review, the New Mexico Angels passed on the deal.
All other things considered, think about what might have happened if the serial entrepreneur have vested of the principal investigators or had given them a reasonable amount of stock for their continued involvement of the company.
In conclusion, vesting of stock in a company is a great tool to encourage at team to stay with a company while ensure that the company is protected. We believe in it and utilize it in a number of our companies.