Cornell Tech celebrated a historic milestone today with the dedication of its new campus on Roosevelt Island in New York City. A collaboration of Cornell University (yes, my law school) and The Technion – Israel Institute of Technology, the 12 acre applied science and engineering campus is one of the most significant additions to the NYC landscape in the last several decades and will help solidify the City’s claim as the number two technology hub behind only Silicon Valley.

Hard to believe it’s been six years since the splashy news conference in which Cornell and The Technion were introduced as the winners of what had become a grueling competition for who would build the new campus. That announcement was itself the culmination of a strategic process that started in 2008, when a study commissioned by then Mayor Bloomberg determined that the best opportunity to replace the thousands of jobs lost in New York City in the financial crisis was in the technology sector through the creation of startup incubators, accelerators and investment funds, and that the success of these initiatives depended on the recruitment and retention of talent. In response to the study’s recommendations, Mayor Bloomberg launched a competition to build an applied science campus in New York City with a focus on entrepreneurship and job creation, with the winner to receive $100 million (a mere fraction of the ultimate cost which turned out to be in the billions) and free land.

As would be expected, the campus has some of the most environmentally friendly and energy efficient buildings in the world.  And as Technion President Peretz Lavie said to me, “the campus is the most beautiful I have ever seen”.  High praise.

Cornell Tech’s mission is to create “pioneering leaders and technologies for the digital age, through research, technology commercialization, and graduate-level education at the professional masters, doctoral and postdoctoral levels.” The campus will undoubtedly have an enormous impact on the innovation ecosystem in the New York City area. It will serve as a tremendous pipeline for high end technology talent. Most tech startup founders would say that their single biggest challenge is recruiting and retaining talent. Many Cornell Tech graduates will be recruited into existing startups. Others will join big tech companies. Many others will be founders themselves, and it’s predicted that there will be 600 spinouts from the campus over the next three decades. Over 30 startups have spun out already in the digital technology space, spanning consumer applications, devices, medical, media and communications.

This is just the first stage of development of the campus, which is not expected to be completed until 2043. The current faculty of 30 tenured and 60 overall is expected to grow to four times as big, and the plan is to expand the student body, currently 300, to up to as many as 2,500.

The dedication ceremony can be viewed here.  And here‘s a cool interactive 360° presentation.

On March 22, the Subcommittee on Capital Markets, Securities, and Investment of the Financial Services Committee conducted a hearing entitled “The JOBS Act at Five: Examining Its Impact and Ensuring the Competitiveness of the U.S. Capital Markets”, focusing on the impact of JOBS Act at 5the JOBS Act on the U.S. capital markets and its effect on capital formation, job creation and economic growth. The archived webcast of the hearing can be found here. Most people won’t have the patience to sit through two hours and 44 minutes of testimony (although the running national debt scoreboard on the right side of the home page showing in real time the national debt increasing by $100,000 every three seconds, and by $1 million every 30 seconds, etc., is eyepopping). At the risk of being accused of having too much time on my hands, but as an act of community service, I watched the hearing (or at least most of it) and will offer some takeaways.

Raymond Keating, Chief Economist of the Small Business & Entrepreneurship Council, testified about some disturbing trends in angel and VC investment. The value and number of angel deals is down from pre-recession levels.  VC investment showed the most life but a decline in raymond keating2016 is troubling. So what’s going on?  Keating believes it’s about reduced levels of entrepreneurship stemming in large part from regulatory burdens that limit entrepreneurs’ access to capital and investors’ freedom to make investments in entrepreneurial ventures. He also testified on the need for further reform, particularly in Regulation Crowdfunding under Title III which allows companies for the first time to raise capital from anyone, not just accredited investors, without filing a registration statement with the SEC, and identified the following reform targets:

  • Issuer Cap. Currently, issuers are capped at $1 million during any rolling twelve-month period. There’s been a push to increase that cap, perhaps to $5 million.
  • Investor Cap. Currently, investors with annual income or net worth of less than $100,000 are limited during a 12-month period to the greater of $2,000 or 5% of the lesser of annual income or net worth, and if both annual income and net worth exceed $100,000, then the limit is 10% of the lesser of income or net worth. The proposal here would be to change the application of the cap from the lower of annual income or net worth to the higher of annual income or net worth.
  • Funding Portal Liability. Currently, funding portals can be held liable for material misstatements and omissions by issuers. That poses tremendous and arguably unfair risk to funding portals and may deter funding portals from getting in the business in the first place. The proposal here would be that a funding portal should not be held liable for material misstatements and omissions by an issuer, unless the portal itself is guilty of fraud or negligence. Such a safe harbor for online platforms would be similar to the protection that traditional broker dealers have enjoyed for decades. A funding platform is just a technology-enabled way for entrepreneurs to connect with investors, and they don’t have the domain expertise of issuers and can’t verify the accuracy of all statements made by issuers.  Part of the role of the crowd in crowdfunding is to scrutinize an issuer, a role that should remain with the investors, not with the platform.
  • Syndicated Investments. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors to invest in a special purpose vehicle whose only purpose is to invest in the operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field.
  • $25 Million Asset Registration Trigger.  Under current rules, any Regulation CF funded company that crosses a $25 million asset threshold would be required to register under the Securities Exchange Act and become an SEC reporting company. Seems inconsistent with the spirit of Regulation Crowdfunding, which for the first time allows companies to offer securities to the public without registering with the SEC.

As to the continuing challenge for companies to go and remain public, Thomas Quaadman, Vice President of the U.S. Chamber of Commerce, testified that the public markets are in worse shape today than they were five years ago and that we have fewer than half the public companies quaadmantoday than we had in 1996, a number that has decreased in 19 of the last 20 years. Mr. Quaadman blamed this in part on an antiquated disclosure regime that is increasingly used to embarrass companies rather than provide decision useful information to investors. In order to rebalance the system and reverse the negative trend, he suggested a numbere of reform measures the SEC and Congress should undertake. The disclosure effectiveness proposal should be a top priority for the SEC to bring the disclosure regime into the 21st century. We need proxy advisory firm reform that brings transparency, accountability and oversight to proxy advisory firms. Also, there should be recognition that capital formation and corporate governance are inextricably linked and there should be reform of the shareholder proposal process under Rule 14a-8.

Lane Becker, Former CEO of Get Satisfaction
Lane Becker, Former CEO of Get Satisfaction

The Founder of a $50 Million Startup Just Sold His Company — And He Didn’t Make a Dime”.  Such was the provocative headline of the Business Insider article last year reporting the sad tale of young entrepreneur Lane Becker and how he and his management team received none of the acquisition proceeds on the sale of Get Satisfaction, the company Becker founded.  Becker’s fate was not anomalous, and happens when the cumulative liquidation preference amount payable to investors exceeds the value of the company itself.  In this blog post, I’ll briefly explain the liquidation preference overhang phenomenon and discuss how to keep founders and key employees incentivized with a carveout arrangement.

Liquidation preference is a key term negotiated in venture and even seed stage investments. It’s the amount of money the preferred stockholders are contractually entitled to receive off the top on a sale of the company before the common stockholders receive anything.  The common stockholders receive only the balance after the liquidation preference is paid, and if the liquidation preference has a participating feature, the preferred stockholders also participate pro rata in that balance on an as-converted basis.

I have previously blogged here and here about how entrepreneurs often are too fixated on valuation and tend to overlook at their peril the impact that liquidation preference can have on the value of the entrepreneurs’ equity stake. A rich valuation could be completely undercut by a heavy liquidation preference stack.  For example, suppose an investor is proposing to invest $20 million at a pre-money valuation of $60 million for Series B preferred stock constituting 25% of the total equity on an as converted fully-diluted basis and includes a 2x liquidation preference.  The founder is giddy about the $60 million pre-money valuation and takes the deal.  The company had previously raised $10 million in a Series A round where the Series A had a 1x liquidation preference.  Two years after the Series B, the company is sputtering, challenged by competitors and investors and management alike believe the company may only be valued at $40 million, $10 million below the cumulative liquidation preference of $50 million (2 x $20,000,000 (Series B) + 1 x $10,000,000 (Series A)).  Founders’ and management’s common shares are essentially worthless and, consequently, they have little or no incentive to work hard and help the company succeed.

Prior to being acquired, Get Satisfaction was reported to have raised $10 million in a Series B round at a pre-money valuation of $50 million, bringing the total amount raised to $21 million. The purchase price of the acquisition was not disclosed, but it must have been less than $21 million for management to have been washed out (assuming a 1x liquidation preference).

In Lane Becker’s case, he had been terminated as CEO a few years prior to the acquisition of Get Satisfaction, which could happen when founders negotiate away control of their company. But what happens in the more typical scenario when founders are still the CEO or otherwise are employed by and managing the company at a time when the liquidation overhang looms, i.e., when the aggregate liquidation preference amounts exceed the company’s valuation?  What incentive does the common stock holding management team have to stick it out?  Cash compensation will rarely get management satisfaction (pun intended), either because startups seldom have the cash to do so or because cash compensation was never a motivating factor for key employees to begin with.  By joining a startup, talented employees typically sacrifice higher cash compensation they could earn with more established companies in favor of the upside potential that comes with equity they receive in the startup.  Hence, the drill would be to come up with a mechanism that simulates the upside potential of equity without that upside being negated by the liquidation preference overhang.

That mechanism is a bonus or carve-out plan that provides for a payout to carveouteligible employees upon a sale of the company or other liquidity events identified in the plan. A typical plan sets aside a pool of money whose amount is determined based upon a certain percentage of acquisition proceeds.  A well drafted plan would address certain issues related to calculating the proceeds upon which the payout is determined, such as assumption of debt by the purchaser, deferred payments, earnouts and contingent payments.  The relevant percentage may also be on a sliding scale, e.g., 3% on the first $100 million, 5% on the next $50 million and 7% on amounts exceeding $150 million.

Inasmuch as these plans are intended to provide value to common stockholders when the common is worthless, plans could (or should) consider the value of the common (i.e., when the purchase price exceeds the liquidation preference amount) as an offset to payouts and also set a ceiling on payouts. The plan could be structured either as a quasi-contractual commitment by the company in the form of a benefit plan or as a special class of common stock that would be issued to founders and key employees that would be pari passu with the preferred but have a separately calculated payout formula upon the sale of the company.

It’s never easy to take an entire business day out of the office, but the annual Cornell Entrepreneurship Summit is well worth it.  The 2014 edition, dubbed “Beyond the Horizon”, was no exception.  One thing that struck me about this year’s summit was that, unlike previous years, none of the entrepreneur speakers were Cornell alums, demonstrating that the summit has evolved from a Cornell entrepreneurship event to a Cornell event about entrepreneurship.  As to the speakers, here are some of the more memorable and meaningful takeaways for me.

Skybox CEO Tom Ingersoll
How did a startup succeed in creating a real-time Google-Earth?  Skybox Imaging CEO Tom Ingersoll asked the audience, “Have you looked at your house on Google Earth? Disappointed it was two years old?” Because satellites are so expensive to build and launch, most of the pictures that we see are of poor quality and years out of date. Until now. Skybox knew that real-time satellite imaging would require dozens of satellites, a prohibitively expensive endeavor with the cost of a single satellite being around $850 million.  So Skybox needed to find a way to build satellites for a fraction of that, and created a lightweight, nimble satellite in-house for about $10 million.  Ingersoll insisted that the key to Skybox’s success is in execution, and evoked the line mostly attributed to Thomas Edison (also a favorite of Steve Jobs):  “Vision without execution is hallucination”.  Ingersoll said that another key to Skybox’s success is that it has had a patient board of directors, which enabled Skybox to say “no” to Google twice, before finally agreeing to be acquired earlier this year.

If a company offered its employees unlimited vacation time, would anyone show up to work?  Return Path CEO Matt Blumberg revealed that when his company instituted that policy it experienced no higher vacation rates.   The author of “Start-Up CEO” said that his employees are encouraged to take as much time off as they can while maintaining high performance and achieving milestones.  “We don’t count the hours they work, so why should we count the hours they don’t?”

Sols CEO Kegan Schouwenburg

“We went from the cobbler to standardized mass manufacturing and now today we are going to change all that with digital manufacturing”, announced Kegan Schouwenburg, CEO of Sols Systems.  Sols captures a 3-D model of a patient’s foot, makes therapeutic adjustments in a web-based app and manufactures a final product with a 3-D printer.  Schouwenburg also demonstrated the direct to consumer version of the service where a customer can scan his or her own foot with a smartphone and order a custom fit insert.  “One super cool thing about digital manufacturing: no waste”, Schouwenburg said.

Despite recent mega-exits like WhatsApp, Tumblr and Waze, billion-dollar exits are rare, so much so that they’ve been designated the name of a mythical creature, a unicorn.  Every VC chases them.  “Birthing a unicorn is hard”, proclaimed CB Insights CEO Anand Sanwal.  Sanwal’s data shows that only one percent of exits are unicorns, while 72% are below $200 million.  Sanwal said that we may not be in a bubble yet, but valuations are “frothy”.  Although billion dollar valuations require lots of capital raising, some of the recent unicorns raised money late at higher valuations, or never, including Shutterstock and former Cornell Entrepreneurship Summit presenter Wayfair, and Anand said that “these are the companies we should celebrate”.

Building  a successful startup is challenging.  But the chances of success could be greatly enhanced through participation in a startup accelerator program.  Entrepreneurially minded universities and research institutions have run incubators on or near campus where startups receive office space, shared facilities and services, but no capital.  Over the last several years, a new breed of startup incubator has emerged, commonly referred to as a startup accelerator, which combines space and back-office services with hands-on mentoring, access to valuable  networks and seed money.  The money is not free of course, but rather provided in exchange for a small amount of equity in the company, sometimes in shares and sometimes as a convertible note priced at or discounted to the next round of funding.  Another distinguishing feature of accelerators is the intensive duration of their program, typically three months rather than the multiple year model of the traditional incubator.  Admission has become enormously competitive, with the top accelerators accepting as few as only 1% of applicants.  It’s harder to get admitted to some of these programs than it is to an Ivy League business school.

Incubators

Accelerators 

Duration: Long term: multiple years Intensive: 3-4 months
Funding: None Seed money for some equity
Mentoring: Limited; no formal program Strong ongoing program
Investor   Access: None Demo days
Admission: Less competitive Extremely competitive

The first modern accelerator was Y Combinator, formed by entrepreneur Paul Graham in 2005 after selling his startup Viaweb to Yahoo for $49 million a few years earlier.  Since its inception, YC  has helped launch over 600 companies, including multibillion dollar startups Dropbox, a cloud storage and sharing company reportedly valued at $10 billion, and Airbnb, an on-line booking service for short-term stays at private residences also reportedly valued at $10 billion.  The startups in the YC program move to Silicon Valley for three months, during which the mentors work intensively with them to get the companies into shape and refine their pitch to investors.  Each cycle culminates in Demo Day, where the startups present their business plans to a carefully selected, invite-only audience of investors.  In exchange for 7% of the equity, YC provides each startup with $120,000, a portion of which comes from a fund YC manages which has limited partners.

Another nationally known accelerator is Techstars, which runs programs in seven major startup cities: Boston, Boulder, Chicago, New York City, Seattle, London, and Austin.  It boasts as its mentors such startup superstars as Foundrey Group Managing Director Brad Feld, Union Square Ventures Partner Fred Wilson and Twitter CEO Dick Costolo.  Techstars’ website offers a helpful set of practical ground rules for the application process that entrepreneurs violate at their peril.  For example, entrepreneurs should not apply and then immediately email Techstar’s mentors.  According to the website, doing so in order to try to influence the mentors before being accepted into the program will hurt the entrepreneur because the mentors will complain about it. Entrepreneurs should also not visit Techstars’ offices without an appointment because it’s “not a good example of persistence … and it will negatively influence [the] application”.

Even Disney is getting in on the act.  Last February, the creator of Mickey Mouse, Goofy and Donald Duck launched its first-ever startup accelerator, a three-month program pairing ten teams of entrepreneurs with mentors including  CEO Bob Iger, and giving them access to the company’s IP.  Disney’s accelerator is accepting applications through April 16, will be hosted in Los Angeles and be managed by Techstars, which has run similar corporate programs for Sprint, Barclays and Nike.

Your startup was launched only a few months ago and your co-founder has just informed you that he’s leaving.  It hits you that your co-founder just walked out the door with 50% of the equity in the company.  Oops.

Founder breakups are not uncommon, but what happens to the exiting founder’s stock will depend on whether or not the founders had agreed in advance on a vesting arrangement.  Essentially, vesting of stock means that all or a portion of it effectively gets “earned” either over time or upon achieving milestones or a combination of both.  The purpose is to align incentives: encourage founders to remain with the company and avoid the unfairness inherent in walking away with unearned equity.  The arrangement is typically effectuated with the right of the company to repurchase the individual’s unvested shares, usually at some nominal price.

Background

So if the company could be given the right to repurchase unvested shares for a nominal amount, why not just issue the shares at each vesting interval instead of issuing them all at the outset and then repurchasing shares that haven’t vested?  The answer is that issuing shares subject to vesting creates a significant tax planning opportunity for the shareholder.  Shareholders are typically better off being taxed when shares are least valuable, i.e., at or within a short period following formation.  Although shares issued under a vesting schedule are subject to a substantial risk of forfeiture and would therefore generally be taxed as they vest, shareholders can choose to be taxed at the time of issuance, i.e., when the shares are valued low, by filing a simple Section 83(b) election with the IRS.

Another reason for founders to agree to subject their shares to vesting is that VCs will typically insist on it at the time of their investment in order to incentivize founders to stay, and VCs are more likely to agree to preexisting vesting arrangements if they are reasonable.

Vesting arrangements involve several variables, each of which should be considered based upon the unique facts and circumstances of each case.  The three main variables are vesting schedules, repurchase price and acceleration.

Vesting Schedules

 Vesting schedules can be either time based, milestone based or a combination of both.  Careful consideration should be given to immediate vesting of a portion of the shares allocated to a founder to the extent that founder has made any significant pre-issuance contributions to the startup.  Vesting schedules should also be driven by founders’ expectations of their respective efforts going forward.  The most common arrangement is four-year vesting with a one-year cliff, meaning that 25% of the individual’s total share allocation vests after one year, with 1/48th of the total shares vesting every month for the next 36 months.  Of course any significant pre-issuance contribution by a founder might justify vesting a certain percentage right away.  Milestone-based vesting (e.g., some percentage of shares vest upon the development of a prototype) might be appropriate for a founder who is being relied upon to focus on development of the company’s technology.

Repurchase Price

Under any vesting arrangement, the company has the right to repurchase any shares that have not yet vested at the time of termination of employment.  The repurchase price in most vesting arrangements is some nominal amount per share (e.g., $0.0001 per share), which is intended to be the amount paid by the founder, regardless of the nature of departure.  Arguably, upon terminations by the company without “cause” or by the founder for “good reason”, the vesting agreement should provide for repurchase at fair market value at the time of repurchase as determined by the board of directors in good faith or as otherwise determined by the parties.

 Acceleration

Founders usually negotiate for accelerated vesting upon an acquisition or change of control of the company.  Investors resist this on the theory that it would make the company a less attractive acquisition candidate inasmuch as a buyer will want to know that key employees will continue to be incentivized to remain with the company at least through some transition period.  A compromise here would be something called double trigger acceleration: unvested shares would vest automatically if the founder is terminated (typically without cause) within some period of time, usually six months to one year, following a change of control.  Most acceleration provisions call for vesting of 100% of unvested shares upon the triggering event.  A better approach might be to equate the percentage of acceleration with severance.  If the individual is entitled to severance of 50% of base salary upon a termination following a change of control, perhaps the vesting of 50% of unvested shares should be accelerated.

The second annual Cornell Entrepreneurship Summit was held on October 11 in New York City and I was thrilled to attend.  This year, the Summit was sub-captioned “The Beginning:  From Nothing to Something”, and featured presentations from mostly Cornell entrepreneur-alums, one VC-alum and a few reps from entrepreneurship@cornell, the campus-wide program that promotes entrepreneurship education, events, commercialization and learning opportunities.

Keynote speaker Kathy Savitt, Chief Marketing Officer of Yahoo and veteran of over 100 startups, presented her “Ten Road Rules” for entrepreneurial success.  Among these were:

  • “Find Your Why”.  Identify the reason for your company’s existence – the pain you’re seeking to cure, and how you’re going to help cure it – write it down and remind yourself of it every day.
  • “Make deposits into the Cool Jar”.  Too often startups are content with simply identifying a perceived trend and following it; that would be a “Cool Jar” withdrawal.  Instead, Savitt urges entrepreneurs to innovate; that would be a “Cool Jar” deposit.
  • “Never Outsource Your Core Competencies”.  When Savitt took over as CMO in August 2012, 90% of Yahoo’s customer service personnel were overseas; today, 75% are in-house in the U.S.
  • “Fight to Stay Small as You Grow Big”.  As startups grow, the tendency is for management to get centralized and hierarchical and lose attention to detail.  Savitt pointed out that titles are less significant at Yahoo (which she refers to as the “World’s Largest Startup”), and that CEO Marissa Mayer was intimately involved in redesigning Yahoo’s logo.

Wayfair’s co-founders Niraj Shah and Steve Conine presented themselves as the “Odd Couple” of their leading online home goods retailer with 2012 sales of over $600 million.  They described their ideal employee as bright, hard working, analytical and team oriented because “these are qualities you can’t teach”.

Brian Distelburger, President and Co-Founder of Yext, encouraged entrepreneurs to “get comfortable making fast decisions with imperfect information under intense pressure”, this after immediately winning over the audience by flashing his somewhat challenged cumulative GPA across the screen at the outset of his presentation.  Yext is a market leader in location data technology.

Lux Capital Managing Partner Josh Wolfe

VC Josh Wolfe, Co-Founder and Managing Partner of Lux Capital, warned that he speaks real fast and would provide an hour’s worth of information in his allotted 20 minutes.  He overperformed.  Among the more energetic presentations of the day, Wolfe showed slides demonstrating how science fiction gadgets became the precursors of some of today’s cool technologies, and then a video featuring one of Lux Capital’s portfolio companies that seeks to place basic 3D printing capability on consumer desktops.

 

Shake Shack CEO Randy Garutti

Randy Garutti, CEO of Shake Shack, told his compelling personal story of growing up in New Jersey, leaving the East Coast after college for jobs with restaurant chains that had him skiing in Aspen and surfing in Maui before ending up in Seattle when Danny Meyer, chief executive of New York’s Union Square Hospitality Group, lured him back East.  According to Garutti, Shake Shack was a “total accident” resulting from a hot dog stand to support an art project in the park.  He said that Shake Shack borrows from the fine dining backgrounds of its management team and its locations are intended to be the “great community centers” that fast food restaurants used to be, instead of what they do now which is getting customers in and out ASAP.  The frozen custard served during the break that followed was a terrific treat.

Neal Goldman, Founder and CEO of Relationship Science, said that he always believed there should be an easier way to identify and connect with people that may be key in pursuing professional objectives, so he created RelSci, which profiles executives and dealmakers.  It does this with a database of more than two million names and a million organizations, and compiles board memberships, school backgrounds, political and charitable donations, job histories and other data points.  Goldman had a few choice words for VCs, with whom he’s had bad experiences which at least made for a couple of hilarious anecdotes.  Instead, RelSci has attracted investment from the likes of Henry Kravis and Ken Langone.

Scott Belsky, Founder of Behance and VP of Products/Community at Adobe, did a terrific job moderating.  Other entrepreneur presenters included Cheryl Swirnow, COO and Co-Founder of Sherpaa, Jessica Crolick Rolph, COO and Founding Partner of HappyBaby, and Karim Abouelnaga, CEO of Practice Makes Perfect, Inc.