(Based on a talk for MAP)
“Will’s voice dropped. “Everyone makes mistakes, Jem.” “Yes,” said Jem. “You just make more of them than most people.” “You hurt everyone,” said Jem. “Everyone whose life you touch.” “Not you,” Will whispered. “I hurt everyone but you. I never meant to hurt you.” Jem put his hands up, pressing his palms against his eyes. “You can’t never forgive me,” Will said in disbelief, hearing the panic tinging his own voice. “I’d be –” “Alone?” Jem lowered his hand, but he was smiling now, crookedly. “And whose fault is that?”
– Cassandra Clare, Clockwork Prince
“But what if I make a mistake?’ Will asked. Gilan threw back his head and laughed. ‘A mistake? One mistake? You should be so lucky. You’ll make dozens! I made four or five on my first day alone! Of course you’ll make mistakes. Just don’t make any of them twice. If you do mess things up, don’t try to hide it. Don’t try to rationalize it. Recognize it and admit it and learn from it. We never stop learning, none of us. Smart people learn from their mistakes. But the real sharp ones learn from the mistakes of others.”
– John Flanagan, Erak’s Ransom
In medicine, one of the most interesting and widely used metrics to judge the health of a medical system is – rate of preventable death. It’s the number of patients who die from things that were easy to prevent and is in a sense the very essence of a tragedy. Because it means people died from things that shouldn’t have killed them. Thus implementing small fixes can save a lot of lives and have a disproportionately huge upside, similarly to how merely washing their hands in between surgeries, doctors could reduce patient deaths by as much as 40%.
9 out of every 10 startups fail. There are a number of reasons, probably too many to mention. But a lot of failures are easily avoided and with small fixes can be avoided altogether. The results from a small change can be amazing. Simply by avoiding or fixing major causes of preventable startup failure can drastically improve the probability of a company succeeding.
If you can reduce the failure rate from 9 out of 10, to 8 out of 10. You have one extra big company being created. And that has a big impact on everything around it. It’s like the old conversion parable. Increasing a website’s conversion rate from 1% to 2%, only a 1% increase, results in double the amount of sales.
Most of the reasons for failure happen at the formation of the company. The train gets derailed often while it is still in the station. And so that can be the best time to help it, before it’s even started growing. From the perspective of an investor, helping a company succeed before it’s started growing can be a waste of time because it takes a lot more effort to do. Like trying to push a stationary car – once the car has started moving, it becomes much easier.
In the earliest stages I think they should stop trying to help startups succeed and to instead help startups to not fail. They’re two very different things that are semantically similar. The latter I think is way easier but lots of people seem caught up in the former. It’s like shifting gears. Before a company has started growing, it’s better to help it not fail. After a company has started growing, you shift gears and try to help it succeed as quickly as possible.
Growing companies can also fail. But they fail for different reasons. And those reasons are much more difficult to diagnose and fix. They are more in the realm of having a product people love but unsuccessfully finding a business model. It’s easier to focus on pre-growth companies and helping them to not fail.
Especially when the failure is largely the fault of the founders. They make mistakes and the company dies. At the early stages, no startup ever fails because of a bad market or lack of profitability, it is because of a bad founder. Great founders can make those restraints work in their favour or move away from them entirely.
Founder issues are the great oxymoron of the startup world. They are simultaneously the most common cause of startup failure and also something entrepreneurs and investors nearly universally agree is a must have when creating a startup. Founders are like the engines of their business so problems between them are like a car stalling, resulting in the company quickly losing all forward momentum.
One of the easiest ways of fixing this is to institute early founder contracts. Contracts between founders describing what each person gets, what the company is doing, what their roles are, what their goals are. This doesn’t even need to be a hard contract. It can just be a document that says it all.
Too few founders have the difficult conversations early on and so invariably problems begin to surface later down the line. Unfortunately, differences of opinion do happen and for small differences it’s easier for one founder to sacrifice whatever it is they want in the name of the business.
If writing it down or having a contract doesn’t fix or surface most problems from the get go. Then it’s almost not worth starting a company with this person. These can be anything from; the founders have different ideas for the company, one founder wants more equity than the other, wants to be CEO, wants certain roles the other wants, an early exit, different levels of commitment, one wants to be part time, to put in less effort or money into the business etc etc. Most occur due to some proposed disparity between the founders.
Personally, I’m a fan of equal founder ownership. Where every founder owns an equal stake in the business. The only exception is if one founder has put in a lot more time, money or resources into it. If one founder has worked on a company for years before the other joins or puts in their life savings while the other doesn’t, then they deserve a greater equity stake.
Whenever founders have a big fight and they are on the verge of walking away. The collateral damage is frequently the company finances and the target, like vultures fighting over the scraps, nearly always becomes the company bank account. An easy means of fixing this are for all founders to be signatories on the bank accounts in a way so that major withdrawals can’t be done without all signatures.
Or if there is a lead founder who is much more committed than the others, they should be the only ones with access to them. Whoever controls the money will invariably control the company, and if a founder walks away, the others can still make it succeed.
A near universal mistake founders make is hiring. Nobody gets hiring right but it is very easy to get very very wrong. There are two types of mistakes when it comes to recruiting. One is hiring the wrong people. The other is hiring the right people, but too soon, burning through a startups money prematurely. Salaries are the least productive way of spending money in an early stage company.
The official cause of most startup failure is running out of money and often the leading indicator of this is a startup that hires too quickly, draining the companies money prematurely. One interesting hack for this is by not hiring anybody and instead using lots of contractors or giving large parcels of early equity instead of a large salary. One of the worst ways to hire a contractor is per hour. Always have fixed fees for certain milestones. This will save so much pain in the long run it’s almost not worth ever engaging someone per hour. Even services like law firms or accountants.
There is a reverse correlation here where the best startups I know use equity as the incentive, not a salary. And the worst use a salary, not equity. Founders who are selfish with a few percent of equity in the earliest stages of a business are people I nearly universally don’t like working with it. If a person cannot see the very direct benefit of making everyone aligned and vested in the success of a business in the early stages, then they clearly don’t have the foresight to build a lasting successful company.
The most important thing is making money last a long time. So anything that would cause you to spend a large amount of your cash is something you should avoid doing at all costs. Hiring people is the fastest way of spending money. The reason people hire lots of people is because it feels good. They see large companies and society defining a successful company by the number of employees they have. There will be a time for hiring lots of people but that time is not at the beginning.
What should you do with your savings or when an investor writes you a cheque? The answer: don’t spend it. Put it in a bank account and make it last as long as possible. That one change will make the company last longer and improve your odds of succeeding tenfold. If you’re a startup with say $50k-$100k in a bank account that has the choice between paying your own living expenses for 3 years or hiring 2 people for 1 year.
Always go with the former. But too many startups choose the latter. They think by hiring people, they’ll get to their goals faster but empirically they are more likely to succeed by drawing out the life of their company. Giving it a better chance at reaching profitability and then reinvesting the profits to grow. That same company will have 3 years of runway instead of 1 year.
How do you know when you should be hiring? A good rule of thumb is: you’ll know. Because the company will be growing so quickly that you physically can’t keep up with the workload without bringing on more people. That’s when you know you should start hiring. And you should avoid hiring as much as you can. The key word is need. Only hire people when you absolutely need to.
But if you just feel like you want to hire or you’re a company in a medical field or hard science or one that isn’t growing quickly, then I once heard you shouldn’t hire a person unless you can afford to hire 3 of them. So for every 3 people you can afford to hire, only hire 1 person.
The reason is because each new employee increases your costs and if your revenues aren’t growing fast enough to match that cost, then you’re headed in a downward trajectory. Hiring is not a necessity the same way web servers or technology are for an internet startup. It is a luxury in the way that it eases your workload. Whatever the case, hiring should be done with extreme caution. There is almost an unlimited number of people a startup could hire. In fact, if it becomes a huge success, you could end up needing to hire thousands of people.
Hiring the wrong people is a problem that is so easy to fix that it almost amuses me when someone gets it wrong. The answer is: Calling references. So few people practice this but it will identify a bad hire almost every time. This is so important that it’s worth writing again. Calling references. Always call references. The utility of practicing this always outweighs the possible cost of not doing it. Especially if that cost can kill your company.
In fact you can make a prediction. Startups that make consecutive bad hires are going to fail. It is very difficult to come back from early bad hires because it sets the DNA and culture of the company off on the wrong foot. I once saw a company that had a functioning product, lots of users and revenues. They made their first developer hire who introduced so many bugs, it postponed their product development by 6 months and increased their churn by 20%. The founders didn’t even realise until it was too late.
Where do you find good hires? The best method I’ve heard is the Paypal method. The early Paypal recruits were all given large amounts of equity, a lot of responsibility and were the smartest people the founders themselves knew. After they hired someone, they would ask the new hire to go and recruit the 3 smartest people they knew and so on and so on. But always call references.
One of my favourite things to do when calling references and figuring out whether someone is amazing is something Scott Cook from INTUIT advocates. When asking about someone, to get a really clear picture, ask a person to rate the employee out of 10. When they give an answer, usually a 7 or 8, you ask why that person isn’t a 10? That question will tell you all the hidden details and problems later to surface. It will also identify the ways the person will grow best and what their weaknesses are much faster than directly asking about them.
Spending (Investor) Money
There are two types of investors. One type accelerates the growth of the company. So they’ve figured out how to succeed and just need to get there faster. The other type provides for the founders to survive until they’ve figured out how to make the company succeed. In a perfect world they would be the same but so often aren’t and have different priorities. Make sure you know which type they are before raising money from one.
I was out to dinner once with a venture capitalist who’d made an angel investment in the company of a colleague. It looked like it was going to fail. They’d run out of cash. The investor complained that the founder was paying himself an executive level salary with all of his kids in fancy private schools while the company slowly died. The investor was effectively paying for the private schooling for the founders kids. This might sound mean but it is an unfortunate reality. Investors hate paying founders large salaries. Because it’s money taken away from the growth of a company.
Every investor knows what $200k worth of ads can do for the growth of a company, but when that goes to a founder or executive instead leaves a bad taste in the mouth. It’s the kind of thing no one will admit publicly but is something every investor thinks about. You should be spending money just to survive and get by until the company starts succeeding or on things that will improve the outcome of the business. Not to live lavishly. Frugality is the best friend of an entrepreneur.
This doesn’t just apply to investor money. It applies to spending money in general. Don’t do it. The first thing that happens when you start a business is a number of people start becoming your friend and trying to charge you for things that you will be convinced you need. Software developers, logo designers, business planners, sales people etc etc. This is a mistake. Money is oxygen and the worst way to use up what little oxygen you have is by giving it to other people.
It’s not uncommon to see inexperienced founders invest $20k – $50k of their own savings into a business and one of the first things they do is blow tens of thousands of that on web developers, designers, slidedecks and business plans just to be in the position where they even have a product. This is ludicrous. You should be doing everything yourself and valuing your time at zero.
If the tradeoff is spending 3 hours designing a logo or paying someone $200, spend the time and do it yourself. The only exception is if you have a demanding high paying job and are using the salary to bootstap the business on the side. If you are going to use service providers, try your best to pay for things using equity. If the logo designer really does think your company will be successful, they’ll take 2% of the company over that $200 anyway.
If you have the option of paying for something with cash or with equity, almost always take the equity. Especially in the early stages where the odds of the equity ending up being worth anything is next to infinitesimal anyway. It always angers me seeing founders in the early stages of a business being selfish with equity.
The number of times I’ve seen a greedy founder not give a few percent of a business to someone who helped them early on just frustrates me. It’s like they don’t understand that by being the kind of person who does this is, is very likely to cause the startup to fail anyway. Talented people don’t want to help or work with people who aren’t generous. And generosity in startups is usually always rewarded handsomely.
Playing Startup. Not Being Persistent. Giving Up
What a startup does is challenge the status quo of the world. The world doesn’t want you to succeed because people like what is familiar to them and want to do things the way they always have. You’re trying to change that. You want to change their default settings. So you have to be a force that is capable of changing people’s behaviour. It means you have to never give up. Giving up is the only way you lose in the startup game.
What not giving up translates to in practice is being persistent. If you are ever going to call someone. Call twice. The first time they’ll probably miss your call anyway. Always call twice. Followup from meetings with an email. If they don’t respond, email again. If you get an email, reply quickly. Always reply to emails quickly. Reply to any message you’re sent quickly. You want to be so frustratingly persistent that a person can’t help but to notice and be impressed by you.
In the art world. This thing happens when a promising performer gets shown to the public, critics, producers and agents too soon. They dismiss the rawness of it. So when later they emerge, it makes it more difficult for the artist to succeed because the important people already have their first opinions formed which are hard to change. The best advice given to young artists is to polish their craft and work as hard as they can in secret. So that when they finally release, it’s leagues ahead of anything else and is already the best.
Similar advice is applicable to startups. In the words of Doug Leone, investor at Sequoia Capital, “the two things a startup needs more than anything else are speed and stealth. They should lock themselves in a room, tell nobody what they’re working on and run like a son of gun. By the time people find out what they’re doing, they’re already so far ahead.”
A lot of founders prefer to go through the motions of starting a company instead of actually starting one. They read tech news, go to meetups and speak to everyone they can about their company without actually working on it and making progress and getting customers or users. This is a mistake.
Often they’ve started the company because they wanted to do a startup rather than because they want to create something important or have a problem they wanted to create a company around solving. You’ll see it because every 3 years they’ll be working on something new that is based on some new tech trend so won’t receive any of the compounding benefits on their time if they worked on something genuinely important to them.
Too often founders get disillusioned with their own companies. They start it, make some progress and then give up when it gets hard. They enjoy the intellectually satisfying task of brainstorming ideas and creating new things but don’t like the monotonous task of growing it or getting customers. Running a company is actually rather dull. The excitement fades quickly.
Most of the value creating activities in a company, like getting customers, are in fact the most boring. It means succeeding in building a company, contrary to popular belief, is really boring. You have to persevere and force yourself to complete boring tasks. But that is the only way to accomplish anything.
The founder started a company because it seemed exciting, but then when their business starts to succeed and resemble just a normal company, not this magical startup thing, they get bored and move onto something else. The business then plateaus and starts to fail. As the saying goes, when the going gets tough, the tough get going.
Another form of getting distracted is when you think you’re doing work but aren’t. When you start going to conferences, giving talks, writing blog posts, getting coffees with investors and entrepreneurs et al. These all seem like value creating activities. They are. Just not for the company you’re working on. They’re peripherally value creating but they don’t make your company succeed any faster, the opposite is more likely.
This problem is easily fixed by having one core heuristic that you measure and focus on. This metric should be important for your business and you ignore everything except this. It could be how much revenue is coming in. How many customers there are. How frequently the product is used. How many products are being sold etc etc. It’s really important to have this metric. It becomes like the guiding light through the storm. Something to keep the ship aligned and moving in the right direction. Not having one is an easy way to go astray.
Creating a successful startup is one of the most difficult things you can do. It tests your fortitude, resilience and determination. And will lay havoc to your finances, emotions, relationships and mental health. It’s common to become demoralised because it is being faced with near constant amounts of rejection. But it is rejection whilst also being under pressure. That is the hardest part. Picking yourself back up after being put down again and again and finding motivation to keep going.
Customers won’t buy your product, investors will say no, family will tell you to do safer things, people won’t understand what you’re doing, no one will give you any money. Being rejected feels awful and startups are a field where that is the default. It’s like asking someone you have a crush on out on a date only to be turned down, but over and over again, every day for years until that internal sick feeling goes away.
It’s not something that should be embarked upon without careful consideration and likewise is not for the faint of heart. People starting companies without being committed to it are doomed to fail from the onset. A personal test I have, is if someone isn’t willing to spend 3 years doing something, then they shouldn’t do it.
The other side of the coin is when promising startups release a product and get taken apart too soon. It’ll happen when experienced advisors or industry experts or the media will tell them what to do and they’ll change themselves to fit the advice. Most founders are probably better of sticking to their guns and being wrong than allowing bad advice to influence their decisions. The problem is figuring out what is good and bad advice.
That doesn’t mean founders shouldn’t listen to advice. But there is a healthy balance between listening to other people and listening to yourself. Many a path has been undone by a stubborn founder not listening to the experiences of another person. Could you imagine how Luke Skywalker would have learned the Force if he didn’t listen to Yoda?
Becoming Distracted. Burning Out
Another indicator is getting distracted or moving slowly. Distraction can be the death of a young company. The way it happens is someone starts a company on the side while they’re studying or have a job. Then they take on more things; life events happen, they get a girlfriend or boyfriend, have a child, join a club, start a new project etc until next thing you know, they have too much going on and don’t have enough time to work on the company.
Startups are a different kind of work than what people become used to growing up. During schooling, you get given work and a deadline and you just have to complete it before that deadline. It’s even common for people to leave assignments to the last minute and do only the amount needed to get by. In a job, you get given work and have to get it done or you get fired. A startup isn’t like that.
In a startup environment you create your own work and the more work you do the better grade you get, in the sense that the company does better. By picking the wrong work, you can both seem to be getting a lot done and also not be getting anywhere. A hack to this is just to do things immediately.
By prioritising tasks immediately, you act as a forcing function and are making your company succeed. You become a sieve for filtering out unproductive activity just because you’re getting both done at an accelerated rate. There is always something incredible about someone who seems to get a lot done and also does it soon. While it’s very frustrating to work with a company that seems to take forever to get anything done.
A good measure of this is speed and both of these go hand in hand. If a company is moving slowly and not making progress, sometimes it’s better to just quit and move on. The company becomes a dead weight. However if a founder is distracted with lots of projects and the company is also making huge leaps of progress, then there may not be anything wrong but might lead to burnout.
Burnout is a common and avoidable cause of failure. Too much of a good thing can be a bad thing. It’s when a founder is working on their company so much they develop mental health problems. The founder is doing “too much” work. The fix is simply having a good work life balance and great relationships. There is more to life than a company and many many more important things than making a startup succeed. It’s healthy to stop working and go out and smell the roses.
Society glorifies people who sacrifice themselves to build great things. Society is wrong. Being a workaholic is the classic stereotype of the Disney villain which should say everything there is to know. For your own sanity and stability, it’s better in this one regard to spend time doing other things and with people you like. Think of it as an investment in happiness. You are diversifying your portfolio of things that make you happy and investing your time in more than just one of them, the startup.
Thinking Too Small
If everything goes right for this company, how big can it get? Can it go public? Can it become the leader in a category? If there is a shortage of anything in this world it’s ambition. And startups without ambition are ineffectual at their prime objective of wealth creation. It’s like starting something that could be huge but not wanting it to be.
An example is founders who are focused on small exits and becoming rich instead of creating value. I think every startup should begin with the goal of local optimisations, travelling up a curve towards a global maximum. That they should do what is right in the short term, so long as it is travelling in the direction of – if this company were to get as big as it could, what would it look like?
The reason this is a bad thing is because you start to think like a small company. That is the kiss of death. Because if you think like a small company, then you’ll act like one and will always be a small company. The aim is to be a small company that thinks of itself as on its way to being a big one. So decisions are made in the vein of will this help us become bigger?
My mother started a small business once. It was popular and had loyal customers but also many problems. She would justify all the things going wrong as it was “just a small business” and a project for her. And so when it eventually failed, it wasn’t a surprise to anyone but her.
Growth is actually terrifying. It is easier to have sympathy with small ideas because big ones are scary. They make you question yourself inertly. Real success is less affable than it is grotesque. Because it is so far beyond the realms of what people can even visualise or imagine. It’s like trying to put a big number in perspective. You’ll never truly appreciate how big it really is.
That’s why it is so corrupting. Success is having the financial ability to end particular diseases or move a species from one planet to the next. With great power comes great responsibility and most people buckle under the weight of it. They choose the easy option and do stupid things with their wealth like buying fast cars, big houses and lots of stuff instead of chasing down a big idea. It’s why so frequently successful people are awful ones. They develop an insular view of the world and their place in it which is always in relation to the fixed point of their success. It becomes a funnel for how they see things.
Granted, ambition should not be mistaken for overconfidence or arrogance. This too can be destructive but mostly because nobody likes someone with an inflated ego. Everyone has come across people who thought they were fantastic but in reality were mediocre. Frequently these people are obtuse, averse to change and do not learn – their ego becomes a blindfold or lead weight for their own companies.
Like Ancient Greek myths, the sin of hubris ends up being the downfall of the very same founder who thinks it is their strength. One way to mitigate this is to learn pretty much everything there is to know about a field. Frequently arrogance simply comes from ignorance. Knowledge has a habit of making you realise how little you know.
Some people just plain suck. There are people who just feel that being dishonest, doing the wrong thing, lying, stealing, cheating and exploiting people is how to get ahead in this world. They should be avoided at all costs. There is no real remedy except not going into business with a person like that in the first place. If you do go into business, it’s probably going to end badly and you should quit while ahead.
A great way to avoid this is simply to have a culture of transparency. No one will ever do bad things while a spotlight is on them. And if a person is transparent, you’ll usually find there’s nothing worth worrying about. It’s lack of transparency that is the danger sign. You’d be hard pressed to find a situation where more transparency results in a worse outcome. But obscuring the truth or hiding things is nearly always a recipe for disaster.
This should not be confused and is not the same thing as a resourceful entrepreneur who does something borderline unsavoury to get ahead. When Airbnb and Uber first started, in many cities they were considered to be illegal yet they persevered anyway. Other cases are of founding executives needing to fire large quantities of staff or defaulting on bank loans to keep their businesses afloat.
The litmus test is so long as a person does the right thing and not the wrong one. It is referring to right or wrong in the sense of morality. If something seems morally wrong then it probably is. While if something seems morally right, it also probably is. The model should be the protagonist Harvey Spectre from Suits. He skirts the line to achieve his goals but never crosses it.
Not Embracing Frugality
The way this works is that the founders convince themselves that a lot of unnecessary purchases are must haves and so start buying things that do not help their companies at all and are completely irrelevant. Examples include filing patents prematurely or paying to pitch investors or attending conferences or hiring sales people before there is something worth selling. This is a sure way to burn all your cash and not have much to show for it.
The antithesis to this is not spending enough money. As the old saying goes, you have to spend money to make money, there is such a thing as being too frugal. Examples of this are a founders becoming homeless to bootstrap their startups, failing to buy essential things, not being generous or trying to pay their employees badly. Refusing to spend money scaling their company in the name of frugality is a mistake. As the old saying goes, if you pay peanuts, you’ll get chimps. Spending for good work nearly always results in positive ROI.
A corollary to this is founders not issuing stock to new employees or people who help their companies. A very wise investor once told me once that everyone who comes into contact with a company and helps it in some way should walk away a shareholder. They were perhaps exaggerating but the point is important. People who contribute to the success of a company deserve to be rewarded for it.
A healthy balance should be struck between the two extremes. You’ll find successful companies didn’t not spend money, they only spent it on things that mattered. An interesting test becomes simply holding off on expenses. If something seems like it’s absolutely needed, wait two weeks. Most of the time you’ll find it wasn’t or you think of a cheaper way of doing the same thing. Another test is if the expenditure has a return on investment. If there’s a clear path for the amount you spend to return more money than you spend, then it is worth doing.
A great example in my own company is printing shipping boxes to package products in. On the surface it seems like an unnecessary expense. However, when working out the cost of postage, buying boxes from a shipping company costs $1.75 per box, whereas printing it ourselves comes to $0.55c per box and they are branded bright red as Medicine. So for 1,000 boxes, we’re spending $550 to save $1,200. And we actually make $1.20 on postage charging the same amount. Once we’ve shipped 500 products, we’ve made back the cost of this. So it’s a great tradeoff and investment. No downside.
One of the easiest causes of preventable startup failure is getting the documents wrong. This is reasonably simple to do and is a common cause of huge problems. Most are the result of listening to bad advice or trying to overcomplicate a simple task or trying to be too clever for their own good. You often hear this as someone being given advice from a senior or experienced person, they followed it and it not only didn’t work, but created negative value.
To get the documents right. When incorporating in Delaware, you incorporate a C Corporation and then file an 83(b) tax election. The shares are issued to the founders. In Australia, you start a PTY LTD company and register for an ABN, TFN and ACN. You then register for GST after you cross gross income of $75,000.
In heavy tax parts of the world, often the answer is to do the same thing but instead of issuing the shares to the founders directly, you create a trust and issue the shares to that instead. But commonly you should hold of incorporating for as long as you can. This is one of the hardest things to fix if you get it wrong.
Terms that you need to have in your shareholder agreement or term sheet are founder vesting. A common structure for this is 4 years with a 1 year cliff and is to prevent a scenario where a founder walks away from the company owning a large amount of stock. It’s very demoralising to have a founder quit while still owning 25% of the company. Likewise an investor friendly term that is good to have is pro-rata rights. It’s the ability for an investor to be able to put more money into a company if they choose, to offset dilution.
When raising money, you can either raise it at a fixed valuation or do a convertible note or equity agreement. A fixed valuation is fairly straightforward, both parties argue over what the company is worth and could be worth in the future, how much money they will put in and then agree on that. Convertible notes are when the investor gives the company money for an amount of stock that will be priced in the future at a certain date or the next time the startup raises money.
Terms that should be avoided are a high liquidation preference. Probably any number above 2 should be treated with caution. Likewise convertible notes that contain a high interest rate or that convert too early, after only 12-18 months, or contain a low cap of below $1 million dollars. Some investors use these to sneakily buy more stock in the company then they’d agreed on in an otherwise benign term sheet. You can figure out the optimal scenario by having the converse of the above.
Participating preferences should be avoided at all costs, preferred stock should always be non-participating. This is perhaps the most un-founder friendly term. If that term is there then you should walk in the other direction. Other unfriendly terms are veto rights which give investors the ability to prevent an acquisition if a company receives a buyout offer and redemption rights which is the ability for investors to force the company to buy out their shares after a certain period of time.
When all of the terms are agreed on, a super common mistake here is giving away board seats too easily. It doesn’t matter who owns the shares, the people who control the board control the direction of a company. A common rule of thumb is to give away one board seat at every major round of financing, no more than that. And in early financing rounds to not give any away altogether. If an investor really wants to help and give advice, they should join an advisory board. Not the actual one.
When the documents are all right, a common mistake is not issuing a large number of shares. It’s commonly advised to issue millions of shares with each share valued at $0.01c. If you ever plan on raising money, this is one of the most important things to be done.
A rule of thumb when incorporating is you issue 1 million shares total, with each share worth $0.01 cents, valuing the entire company at around $10,000.
The reason you issue a large number of shares is to have sale-ability. Having a large number of shares is important if the business ever plans to be big enough to raise outside capital or list on a stock exchange. You need enough shares outstanding to be able to issue lots of new shares without significantly diluting yourself and you need enough shares for lots of people to be able to trade them.
This is contrary advice to most small business accountants and lawyers who encourage people to only incorporate with a small number of shares which is common for restaurants or small service firms. But for a high growth technology company it is not appropriate. The reason the shares are issued at $0.01 cents is due to tax reasons. If each share value was high at the point of issue, you would run into tax problems.
There are stories of founders issuing small numbers of shares, and when they brought on investors were diluted into a low ownership stake. The most famous is probably the Wizards of the Coast founders who issued new shares to investors without issuing enough for themselves and got diluted by a lot. They got the documents wrong and the reward from all their hard work building a company was reduced to much less than it should have been. And they even had a lawyer accountant do their paperwork. Just not a startup variant.
Accountants and lawyers can be very wrong. Mostly because they’re not used to seeing companies that fit the mold of a high growth startup. You should see a startup specific accountant or lawyer. Common examples are when lawyers recommend incorporating a startup with the wrong corporate structure or with only a small number of shares; or accountants structuring companies in complicated ways to minimise taxes.
As Charlie Munger once said, “In terms of business mistakes that I’ve seen over a long lifetime, I would say that trying to minimise taxes too much is one of the great standard causes of really dumb mistakes. I see terrible mistakes from people being overly motivated by tax considerations.”
Don’t focus on downside mitigation but upside maximisation. Making the company succeed as big as it can, not how to salvage the pieces if it doesn’t. Spending money in the early days of a startup trying to avoid taxes is like preparing for winning the lottery, something that may never happen, so time and money spent doing so is a waste. Pick a structure that works and go with it.
Bad Projections. Unrealistic Budgets
I’ve never heard of a company that went exactly to plan. But nobody seems to plot bad outcomes into their plans. Unforeseen costs, huge product delays, lower earnings than expected, longer sales cycles, less user satisfaction, more iteration than was thought needed, higher churn, more taxes, and so on and so on.
They start the startup, make a budget but then overestimate their earnings and underestimate their costs. The next thing that happens is all of a sudden they’re about to die and it’s as if they never realised it sneaking up on them the whole time. All numbers should have a common sense check. Sanity check everything. The cost of an employee is not just their salary. The cost of an office is not just the rent and furnishings. Taxes are always higher than what you think they’ll be.
It’s especially common when someone calculates the numbers and thinks an opportunity is great. But when you dive into the numbers, what they thought was great will only turn out to be so if the optimal scenario happens. Which is astonishingly rare. Startups are more like bad thing magnets. Bad things always seem to happen to them. And not factoring in bad things is like a professional sailor not factoring in the wind speed and direction changes.
I once saw a company, a very successful one in the eyes of a lot of people. They’d raised millions of dollars and everyone thought they were doing amazingly well. Even they did. Everyone looked upto them. Only after sitting down with the founders for a couple of hours and going through their financials did we realise they were secretly doing terribly. Their churn was through the roof and nobody realised. So their cost of acquiring customers was about a 1/3rd what they thought it was. So they were wasting most of their marketing costs. And because of that their future earnings were about a 1/3rd what they thought it was.
You see it all the time. Particularly with companies making Excel spreadsheets. Discerning the meaning in their numbers is very difficult for optimistic founders to do when it comes to their own companies. They naturally exaggerate the upside while minimising the downside. Because they want the company to be better than it is.
You have to catch this tendency when it emerges. It’s natural, but optimism when it comes to numbers is one of the most easily avoided mistakes. It’s like laying a time bomb but not knowing how long you set the fuse for. It’s why the best financial people are often some of the most pessimistic. Because when it comes to ones finances it’s better to be cautious than exuberant because of the black swan event of you failing and losing everything.
This is not inherently bad, it’s only bad when the people running the company then act on these bad numbers. It’s particularly common when people try to judge how much money they need, how much things cost or how much money will come in. It’s better to overestimate the former two and underestimate the latter. Raise more money than you think you’ll need, assume things will be more expensive then they are and spend less money than you think you’ll earn.
For the sake of modelling a companies health, the best wisdom comes from my grandparents. When making a budget: double every expense, halve all earnings. If you always do this, you will have a healthy company. In good times you will have a huge surplus. In bad times, you will not have a huge deficit. Why? Because you planned for it in the beginning by budgeting appropriately.
It will also make a plan seem more attainable since if it can be done with half the resources, it definitely can be done with full resources. This may make the hyper growth companies grow slower because they are not spending as fast, but for the majority this will be a recipe for excellent fiscal health.
Not Keeping Records
A common mistake that comes from inexperience is not keeping track of expenses, assets, documents, finances et al. It hits people like this. The business is doing well and making money. But they aren’t keeping track of how much they’re spending and earning. Next thing the company is in serious financial trouble because they didn’t see it coming. They didn’t realise they were actually losing money hand over foot and are now in a death spiral.
Taking stock of your financial position consistently is like checking your fuel gauge while driving. It’s something you should always know but not get too hung up over. A startup should always know how much they are spending, where the money is going and how much they have left. It also stops money from being spent on unnecessary things and being wasteful. Just by seeing where it’s going will stop you from spending and will be like a gag reflex. If an emergency is oncoming, you’ll see it a mile away.
Another is not writing things down. You’ll get a big customer who agrees to buy something then pulls out at the last minute. A supplier who says they can fulfill an order but really can’t. A cofounder who agrees to do something then decides to leave. Any number of painful situations could be avoided by merely having something in a hard medium. People lose heart quickly. Contractual obligations can be a powerful motivator.
They also don’t write down how they did something or document how they got where they are. So when someone comes in they have no idea of the history of the company and end up reinventing all the wheels and fixing the same problems again. The best companies create manuals for everything they do. When they bring someone new, they just give them a manual to read. It also helps for when the company gets acquired. The acquirer needs to know how to run it.
There was a famous study done once which concluded that just by writing down goals, a person is more likely to achieve them. Similarly by writing things down, it’s more likely to happen. Not putting things in writing is also a way that charlatans can mislead people. Anyone can say what they like, but there are repercussions to go back on something in writing. This is especially important in business. There’s an old saying in law that if it wasn’t in writing, it doesn’t matter.
Founders are typically an optimistic bunch and they believe people at their word, ignoring the market realities of a person saying something and not following up on it. Putting everything in writing creates a situation where it’s hard to back out of a commitment. Especially when considering legal reasons. Most of the time it never results in legal action. But just by having that option acts as a forcing function for people to stick to their word and do the right thing. Because it means directly going against something put down in stone. It’s easy to otherwise.
As time goes by everyone forgets what they said. Conversations are remembered differently in different situations. Even after phone calls, just sending an email with dot points saying what the conversation was about can pay off years down the line when someone tries to renege on it. Get everything in writing. Write everything down. This is one of the best ways of avoiding pain.
It should be noted, avoiding these is not a guarantee of success. It might seem morose but the unfortunate reality is most are going to die anyway and very little can be done about it. People don’t want what they’re making. But it does make succeeding more likely. And if that increased likeliness makes at least one startup that would have died now succeed. Then that is a beautiful thing.