These are reflections after attending one of the recent Startup Weekends in Toronto.
1. Investors Will Pile on and Fight Each Other to Invest in Our Startup
One budget slide assumed that the team would self-fund $5,000.00, and “investors” would pitch in $100,000.00. Investors didn’t get where they are by making stupid decisions. They will demand that you have skin in the game. One of the things I liked about one of the winners was the flat-out honesty of their budget slide. They were going to do it for under $15,000.00 in the first year, and their sources of funds were labelled as “ourselves” and “our parents.” That shows me that they live in the real world. In the initial phase of a project, expect to keep your day job or eat peanut butter and French fries for most meals.
2. We Will Just Pay People With Equity
The dangers of equity abuse could not be over-emphasized. Passing equity out like candy is the best way to close off your upside and create exciting new downsides. The downside is that any shareholder, even someone who owns 0.01%, is a minority shareholder under the law. He has a right to review your startup's financial info, and he can sue startup's directors and officers for various causes of action. It’s also an incredible headache if your startup has dozens of shareholders, who then transfer their shares to another dozens of shareholders (one of whom is a competitor who now gets to look at your finances). Then some shareholders move to Bahamas or China, and two others have died and now some shares are stuck in probate court in Vancouver. Equity abuse limits your upside because: (1) mathematically, there is less equity for you as a shareholder; and (2) the lawyers representing any potential investor will go ballistic. Not only is it an expensive gauntlet of paperwork, but it also exposes their clients to director and officer liability. Significant investors usually like to have a seat on the Board of Directors, and they cannot take a board seat if that is going to paint them as a target for disgruntled employees who are threatening to sue. So, how do you use equity wisely? First, think of equity as partnership because that is what it is. Every shareholder is your partner. To stay closely held, make sure that transfer restrictions are baked into your incorporation documents. Any sale or transfer should be automatically void unless it goes through a specific right-of-first-refusal procedure. Second, remember that shares confer partnership, only offer it to people who are on partnership track. This should be a lot like tenure track – figure out how much time you need to work with someone to decide if they are permanent or not, and then create your vesting schedule accordingly. Share options also make a lot more sense than outright shares.
3. My Lawyer/Advisor/Mentor Will Introduce Me to a Bunch of Rich Investors
Somehow the saying “Your lawyer is your first investor” has gotten mangled into “Your lawyer/accountant/mentor will be your fairy godmother.” There are no fairy godmothers. Your mentors are being very generous by giving you their time, and it would be insanely inappropriate for you to make the first move in asking for anything more than advice. It is pretty silly to think that any law firm, accounting firm, marketing firm, etc. would jeopardize its relationship with an established client by vouching for your tiny, unproven business. If you give a service provider $5,000.00, he will give you professional services in return. Some entrepreneurs believe that investors are hungry for deal flow, but if they were hungry for your stage of venture, it is pretty easy for them to show up in person to demo days like Startup Weekend. Also, from an ethical standpoint, lawyers hate it when clients do business with other clients; they get conflicted out of representing one or both of them. If a lawyer somehow hooks you up with a VC firm that it also represents, guess which side of the deal the lawyer would prefer to represent? If you both sign conflict waivers (which would permit the law firm to represent both sides), do you feel secure that your lawyer will fight for your interests exactly as zealously as the 1000x richer client? If not, will you dig in your heels and refuse to sign a conflict waiver, thereby forcing the VC firm to retain their second-choice law firm? So what does “Your lawyer is your first investor” really mean? It refers to the practice by a very few law firms, including ours, of deferring legal fees for a few very promising ventures. Our firm does not accept equity because it is a conflict of interest that muddies our role as your disinterested advisors. Our deferral policy is more stringent than many other firms, since we provide very time-intensive services to our deferred clients. Sometimes we have lost business to large law firms that defer completely. We think that those entrepreneurs have chosen unwisely - there is no free lunch. (Thought Exercise #1: If you have a lunch meeting with a potential investor, who pays for lunch?) Full deferral can mean that a law firm will talk to you at first, lightly edit one of their off-the-shelf forms, and stop taking your calls within a few months if no investor interest is in the works. Law firms are businesses, not charities, and they are going to spend expensive time of their lawyers on clients who actually pay their bills. (Thought Exercise #2: If a law firm spends time but defers fees completely until funding, but only x% of clients ever get funding, what premium do funded clients need to pay in order to subsidize the model?)
4. My Idea is Unique and I Will Patent it so Nobody Can Compete With Me Ever
First time entrepreneurs often operate under a misconception that obtaining a patent will secure them a complete monopoly on a certain market. We have seen numerous inventions and we have filed numerous patents for them in the course of our practice. We are yet to see a completely unique idea to be embodied in an invention. In all likelihood your idea is not as unique as you think it is. Was Friendster able to patent the “link up with your friends” idea? Was SixDegrees able to prevent Friendster from existing? How about MySpace? Facebook? Patent law is driven by a policy consideration to keep our economic engine running, not to give someone a gold star for being smart. If some kind of DARPANET ur-Facebook could own the idea of “link up with your friends,” our economic engine would seize up and die. Neil Gaiman says that fans often approach him with crazy offers of “I have got this fabulous idea! How about you write it and we will split the profits?” That, my friends, is not how it works. Ideas are easy; the execution is hard. The law understands this and protects ideas versus execution accordingly.