“By failing to prepare, you are preparing to fail.” Wise words from Benjamin Franklin.
From day one most Israeli entrepreneurs are already looking for their exit. Unfortunately they are not always prepared and preparation is the key.
In order to protect your technology, to appear professional and to attract investors you should have all your ducks in a row from the get-go. Know your strengths and know your weaknesses, and importantly how to spin those weaknesses to minimize their effect on your valuation.
Many entrepreneurs have tried to convince me that a founders’ agreement is unnecessary. They are friends. There is trust and mutual interest. If only that was enough. You need a framework agreement to:
(a) Manage Expectations — Everyone should be on the same page. You should clarify who will fill each role, how much time and resources each party will dedicate to the venture and how decisions will be made.
(b) Exclusivity — You should commit to pursue the idea together, preventing one of the founders running off and making a competitive, and heaven forbid better, product or service.
(c) Intellectual Property — The technology should belong to the venture and be duly assigned by all the founders.
(d) Equity — It is important to clearly divide the interest in the venture among yourselves, and to tie each founder’s equity to their contribution. Say you split the shares between three founders equally. Six months later one of the founders receives an offer he simply cannot refuse from Google and walks away with a third of your company, having not written his part of the code. If you had agreed on a reverse vesting mechanism he would have to return some of his shares; a more just outcome. Investors want to see that the founders have skin in the game and will likely ask for such mechanism to be adopted later.
A simple founders’ agreement will prepare you for your first rounds of financing. It will allow you to justify the initial equity allocation and avoid the hassle of negotiating and procuring last minute IP assignment letters, non compete agreements and reverse vesting undertakings from your co- founders – who may no longer be involved in the venture.
Dirty Cap Tables
Keep your cap tables clean. It can be easier to first raise funds via a FFF round (friends, family and fools) but this can lead to numerous small shareholders. You should already be thinking long term and strategically. VC’s prefer not to deal with a plethora of shareholders as it delays decision making and can make obtaining consents arduous. At a minimum, small shareholders should be asked to sign voting proxies with their co-investors.
I understand that at the beginning it is tempting to offer service providers equity in lieu of cash, and service providers are willing to take the risk – they heard of the graffiti artist who painted Facebook’s first office for stock which rocketed in value to $200 million. However this should be avoided where possible to avoid overpopulated cap tables.
When issuing equity for services you also inadvertently set the valuation of your company. You engage a programmer to design your UX and UI for which he would typically charge USD 10,000 but instead you give him 3% equity. You have just valued your company at USD 333,333 and you will need to justify a higher valuation to any pre-seed investor or angel. If you are going to give equity for labour, ensure your agreement is in writing and finalized before the work actually commences and to the extent possible tie the shares to clearly defined milestones.
You want to be prepared with a nice clean, clear and up to date cap table when your investors ask.
Choose your financial sources wisely. The National Technological Innovation Authority (NTIA – previously the Office of the Chief Scientist) offers favourable grants to Israeli start-ups, however there are strings attached in the form of restrictions of transfer of IP and manufacturing abroad. If your venture involves hardware which would be cheaper to manufacture in the Far East, the NTIA may not be the right source for you.
Research the people, funds or corporations that can bring added value to your company and open doors for you. Appeal to their interests. If you are developing a tool for monitoring insulin levels look for those that invest in the field of MediTech and Life Sciences or who have a personal interest in diabetes. A little focused research will help narrow your search and hopefully save you pitching to the wrong audience.
Practice, practice, practice. You have seven seconds to make a first impression and first impressions stick. Start by identifying the problem and then move on to how your product solves it. Be thorough but concise. VC’s like growth, so time your pitch so you can demonstrate progress. Remember investors are not your customer. You may be bursting with pride with your product and your revolutionary algorithms but the investor wants to know how this translates financially. They want to know your business model, to see a considered 12 month business plan, your CAC (cost to acquire customers) and CLV (customer lifetime value). They want to know your real market segment. To give a crude example, if you have developed a new healthy lifestyle app your market is not everyone with a smartphone, but a more limited (and probably health conscious) segment. You need to do your homework.
At various stages of your venture you will contract with service providers, suppliers, customers etc. Typically, contracting parties like to know who they are in bed with and commercial terms are effected by personal relationships. Accordingly, contracts often include non assignment and change of control clauses. In layman’s terms, if you transfer the agreement to a third party or sell the company to a third party the counter party will have the right to terminate. (Note that the Israeli Transfer of Obligations Law (1969) provides that where a contract is silent, a contractual right may be assigned by one party without the consent of the other, however a contractual obligation cannot.) At inception you do not know what your exit will be, whether you will sell your technology or your company, so from early on you should be negotiating to ensure that your material contracts allow for either exit. A little advance preparation will help avoid the uncertainty that may ensue when your buyer conditions your exit on the consent of your material suppliers or customers.
Contracts and understandings should always be in writing and kept in an orderly fashion. When an investor performs due diligence, he wants to see a healthy company. You do not want to have to buy time and delay investments while you scramble to put oral agreements in writing and negotiate consents and waivers.
Bring Along Rights
The Israel Companies Law 1999 provides that if 80% of the company’s shareholders approve an exit, such exit will be binding on the remaining shareholders. Essentially this means that you can compel a minority shareholder to sell his shares even if he does not want to. This stops minority shareholders vetoing a sale or worse using their veto as leverage to gain something from you. It is not uncommon however for companies to adopt lower thresholds in their corporate documents and I would advise the same. Agreeing to a 70% threshold now will make approving a sale in the future easier; particularly if you have many small shareholders.
Finally, consult with experts. Do not risk your precious exit with inexperienced advisers. Remember Red Adair’s words:
“If you think it’s expensive to hire a professional to do the job, wait until you hire an amateur.”