Why I sold my startup, Sparkbuy, to Google

Shortly after the sale closed, John Cook interviewed me about the experience.  He did a great job of transcribing all of my verbal gems, like “Maybe that is an economic way of looking at it, or something that I am unfamiliar with.”  I’m not even sure what that means.

It was the best I could muster in the middle of a crazy, exciting, wild time.  But looking back, I realize that there’s an important question there and I didn’t do it justice.  Selling a company can be a very lonely decision, so I want to revisit John’s question and share my thinking with others who might be making the call.

It was a great deal for the shareholders

Most VCs don’t care how long your company takes to show a return – they don’t get to re-invest proceeds of their deals, so if you exit early, the money sits in a bank account earning interest for years instead of contributing to their returns.  Since my investors were angels, they would look at the exit on a time-adjusted return basis.  Or put simply, if I could give them back their capital plus a great return in just six months, that could be a terrific outcome.

It was our #1 choice of acquirer

Most startups are acquired.  Actually, most startups fail – but of those that are successful, most are acquired.  Given that an acquisition was, one way or another, the most likely outcome for Sparkbuy, I compared Google to a list of about a dozen other potential acquirers.  They were at the top of my list.  If was going to go to work for The Man, I was more excited about The Man being Google than anyone else.  The employees (both of them!) felt similarly.  Even the investors appreciated the bragging rights of having a portfolio company sell to Google.
Further, the people who I would be working with were amazing.  Scott Silver has always been one of my engineering leadership idols.  After trying to recruit Phil Bogle to Ontela I knew I wanted to find a way to work with him.  While I’ve never been excited about having a boss again, Nick Fox was someone I actually knew I’d enjoy working with and learning from.

I was excited about pursuing the Sparkbuy vision at “Google-scale”

The Sparkbuy product was launched out of a personal frustration with consumer electronics shopping, but the problem is much broader.  It’s just hard to find reliable, accurate, unbiased, quantitative information about products.  Search engines favor old prose over fresh data.  Sparkbuy was about helping consumers make better decisions.

The team I’m working on now is taking that opportunity to the next level.  With business development resources, the Google brand, Fortune-100 budgets, and an appetite for giant risks, we can tackle problems at a broader scale than ever before – making consumer purchasing easier, better informed, safer, and faster.

Working a real job sounded like a good idea for a while

After eight years at startups, the idea of pulling a steady paycheck for a few years was seductive.  Some personal events, while ultimately amounting to nothing, made me feel like having great health insurance wasn’t a bad idea either.  (Soapbox sidebar: health insurance reform is key to promoting entrepreneurialism and small businesses in this country!)  I loved the idea of keeping a more regular schedule, and spending a bit more time with my family.

The money was life-changing

While I’m not in the position of my good friend Rand, who’s gone on the record saying that his life savings is $25,000, I was not previously wealthy.  The Ontela/Photobucket merger was a spectacular deal for all parties involved, and I didn’t take any cash of the table – I’m still 100% invested in Photobucket.  That means the Google sale accomplished three lifelong goals for me: allowing me to set aside enough to pay for my twin toddlers’ college educations, funding my wife and my retirement account, and giving us a financial cushion that means I’ll never have to work at a job I don’t love. It also meant that, overnight, I can pay some karma forward and start investing in startups that I’m excited about (more on that soon).

I get to swing for the fences

Some people are wired for the “billion dollars is cool” kind of risk that folks love to write articles about.  I wasn’t, at least not until I figured out the aforementioned three problems.  At least I was in good company, though – my new great-grand-boss, Larry, famously tried to sell Google for $1mm and failed.

But this lets me play the Shawn Parker game without regrets.  When I start my next company, I can swing for the fences.  Or self-fund it and do something that I love, without worrying about maximizing shareholder value.  Which brings us to…

The company was in a great position to raise money, but I didn’t want to

As the CEO of a startup, I’m dedicated to pursuing value for the investors who’ve extended me their trust.  One of the primary inputs to my decision making is how best to create value for shareholders over the life of the company – it’s not the only consideration in decision making, but it’s a big one.

One of the reasons I founded Sparkbuy was that I was excited to try a different way of building a company.  While I was at the helm of Ontela (now Photobucket), we raised over $30mm.  That’s a ridiculous amount of money.  We had a lot of fun and accomplished some amazing things along the way.  I worked with a team of fantastic people and was never happier than when I was going in to work to spend time with them.  If I had it to do over, I’d do it the same.

But I find there’s two type of people in the world – those who like refining one thing over and over and getting really good at it, and those who like trying new things.  You can guess which category I fall in to.  I wanted to try something different – a smaller raise ($1mm), angels instead of large VCs, and growing organically based on revenue.  That’s what I did with Sparkbuy, and it was a good decision when I made it.

But markets continued to heat up to a fiery glow.  The valuation of comparables in our space was shooting through the roof.  Competitors were raising rounds in the double-digit millions.  It was becoming increasingly clear to me that the best strategic decision for the company was to raise a large financing round at a lofty valuation and grow like crazy – but I wasn’t particularly excited about doing that.  In other words, what I thought was best for the company wasn’t what I, selfishly, wanted to do.

If I hadn’t sold, I would have raised money, and I didn’t really want to do that.

It was time to spin up a B2B strategy

Much as Sparkbuy’s direct-to-consumer website was winning rave reviews from users, there was new and substantial interest was on the part of other companies.  We were getting offers to do long-term deals with Fortune 500 companies that would generate huge revenues over a period of years.  Of course, pursuing those would have required raising a bunch more money.  Once again, this was what I did at Ontela; and once again, while it was fun, I wasn’t excited about pivoting Sparkbuy in that direction.

The biggest risk was still ahead of us

The bigggest challenge for any consumer startup is how to profitably acquire customers.  We knew from the start that this was the largest risk factor for Sparkbuy, and with the launch of our beta (a month before the sale), we were just starting to dig in to this problem.  I had a list a mile long of initiatives to drive profitable growth, but in the end all you can do is experiment and iterate, and it can take a long time to find the magic.  Our value as a company wouldn’t hit a new inflection point until we solved this problem, and it was a long ways off.

To sum it all up

Some of my investors were overjoyed.  Some of them were sad that Sparkbuy would never grow in to its own.  I’ve been called a sellout, and people have told me that I epitomize what’s wrong with entrepreneurs outside the valley.

It’s all cool.

I don’t claim my decisions are right for any other company, or anyone else.  This was not the hardest decision I’ve ever made.  It wasn’t even in the top 10.  There were a lot of moving parts, but at the end, it was simple.  Google hit my “life changing” number, provided a great return for my investors, gave me and my coworkers terrific jobs, and made it all happen six months from the day we were incorporated.  I’ll have other companies some day, and I’ll play them differently.  Your decision, should you be called on to make it, may be quite different – but I hope it leaves you feeling as lucky as mine has!

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Open letter to Mike Arrington: Please stop investing in startups

Hi Mike,

I’m one of your customers.

We don’t really know each other. We’ve chatted at a few events, you’ve covered some of my antics, but I’m mostly just a guy who reads TechCrunch a lot. I find it’s a pretty good place to see what’s important in the industry. And you and your team do some damn fine reporting on things the world wouldn’t know about otherwise.

I am product guy, not a media critic. But I’m a big believer that economic incentives shape behaviors in subtle and unmeasurable ways. And I think your decision to make investments in startups is going to make TechCrunch a worse product.

I can’t tell you exactly how. Are you going to be a little more likely to ignore competitors to your companies? Cover them, even when they’re not newsworthy, to show you’re not biased? Feel compelled to pull or throw punches, either to support or prove you’re independent of the companies you deal with?

I don’t know. But I think it’s going to happen, it’ll be subtle, and it’ll make TechCrunch worse.

I’m not making demands or threatening to leave. Just making a request, from one product guy to another: journalistic independence is a great feature. Please don’t cut it.

Best wishes,

Dan Shapiro

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The only wrong answer is 50/50: Calculating the cofounder equity split

(Note: there are great conversations about this article happening at Geekwire and Hacker News)

The question of equity brings out the most fundamental differences, perceptions, and values in an aspiring startup.  In fact the equity question, more than any other, may strangle a young company before it can even get started.  And that’s a damn good thing.

But before we get in to that…

Who’s a founder?

Facial hair alone proves insufficient to determine founder status

As straightforward as this question sounds, it’s a tricky matter.  The founder moniker is black and white, but the situations are all shades of gray.  Setting aside the philosophical question and focusing on the more useful economic one, though, there is a simple approach: founders are people who take a very particular kind of risk.

There are, quite roughly, three stages in every company’s life:

1.  Founding.  The only money the company has is what you put in.  You are getting no money out of the company.  The company will probably fail, and you will lose all the money you put in, plus the lost salary, plus you have to find a new job.

2.  Startup.  The company has money, either from investors or from revenue, and they give you some of that money every month.  Your salary is less than what you’d get at a big company.  50/50 the company fails and you have to find a new job, plus you’ve lost the difference between your startup salary and the BigCo salary.

3. Real company.  You get “market” salary.  It’s unlikely the company fails, and if it does, your downside is limited to  unemployment.

The rule is this: if you’re working for a company that’s so young it can’t pay you, you’re a founder.  If you are drawing a salary on your first day at work, you’re not.

What’s a founder worth?

A founder is defined by the inability of their company to pay them (or anyone else) for anything.  A founder’s primary job, then, is to get their company some money – either by raising investment or by generating revenue.  So a founder is valued by two things:

1) Their contribution

2) The market

The first of these is fair.  The second is  economics.  Both are essential.

And now, the formula

Of course, there can be no right answer – but this one’s not so terribly wrong.  To start out with, give every founder 100 shares.

Somebody’s got to get things started (5%)

Some startups are born running, with all founders on board from the beginning.  But others come from one leader who recruits the others.  You may or may not take the CEO title, but if you’re the one who rounded up the cofounders and talked everyone in to getting things done, add 5% to your holdings.  If you were previously 100/100/100, you’re now 105/100/100.

You know. For kids.

Ideas are precious, but dwarfed by execution (5%)

It’s a lie to say that ideas are worthless and execution is everything… but it’s not too far from the truth, either.  If you’re the founder who brought the original concept to the table, increase your share holdings by 5% (so if you had 105 before, you now have 110.25) Note that if the idea is implemented, or patented, or otherwise has some execution behind it, then…

The first step is the hardest (5%-25%)

Creating a difficult-to-replicate beachhead can give a fledgling company direction and credibility.  It can help with revenue and with financing.  If you bring a concrete start to the table – a critical, filed patent (not a provisional), a compelling demo, an early version of the product that isn’t quite there yet, or something else that means much of the work towards financing or revenue is already done – you get a boost of 5%-25%.  The key variation here is, “How much closer does this get us to revenue or financing?”

CEO gets more (5%)

Common situation: the split is 50/50 so that neither party controls the company.

Well, if you don’t trust your CEO with the majority of shares, you’re founding the company with the wrong person.  Market rate for a great CEO is higher than market rate for a great CTO, so the CEO job gets a bit more equity.  This isn’t fair – the work isn’t easier or anything – but it does reflect some market realities.

Fulltime commitment is expensive (200%)

If you’re working fulltime while your cofounders are working part time, you’re the pig. You’re working more, and you’re risking a lot more if the project fails.  Furthermore, part-time cofounders are a big minus to someone considering an investment.   Their equivocating will be expensive.  Add 200% to the shareholdings of all the fulltimers.

Reputation is the most precious asset of all (50%-500%+)

If your goal is to get investment, some people make that much easier.  If you’re a first-time entrepreneur partnering with someone who’s successfully raised VC dollars, that person is a lot more investable than you are.  In the extreme, some entrepreneurs are so “investable” that their involvement is a guarantee of raising funds.  (It’s easy to identify them: ask the investors who know them best “would you back them no matter what they do.”  If the answer is “yes”, then they are that kind of super.)   These super-preneurs essentially remove all the risk of the “founding” stage, so you should expect that they get the lion’s share of the equity from this stage.

This point doesn’t apply to most founding teams, but when it does, expect the super-preneur to take 50%-500% or more, depending on just how much more significant their reputation is than their cofounders.

Treat cash like an investment (varies%)

Ideally, each investor contributes an equal amount to the company.  That, plus their labor, earns them their “founder shares”.  It’s possible, though, that one founder may put in significantly more.  The price for that is high, since it’s the earliest, riskiest investment.  That founder will get more equity; to determine how much, talk to a good startup attorney about a reasonable value for your company and work from there.  For example, they might say that your company could reasonably be valued at $450,000 for investment purposes, so a $50,000 investment would merit an additional 10%.

There are more structured ways to do this, ranging from revolving credit lines with interest and warrants to convertible debt that converts in to common shares.  But these all mean increased legal bills and, more importantly, complex cap tables – something that can scare off outside investment.

The final accounting

At this point,  you’ll have something like 200/150/250.  Just add up the shares (600, in this example) and divide each person’s holdings by that number to get their ownership: 33%, 25%, 42%.

If you have equal shares, you did it wrong

A couple of years ago I was asked to give a talk at a continuing education series for attorneys.  I asked to see the class list, and opposing counsel for a deal I was working on was being there, so I figured it was probably a good idea to do it.

I asked them what to talk about, and they helpfully replied “startups”. I pressed for more detail. “You mean like generic startup experiences?  Legal issues startups face? Advice for attorneys?”

“Yes, exactly like that!” came the enthusiastic reply.

Clear direction in hand, I started musing on the early days of Ontela.  Our company started as just two of us, Charles Zapata and I, brainstorming in a basement.  We covered a ton of ground – generating a million ideas an hour, each better than the last, on everything from business concepts to core values to better ways to file expense accounts.  No matter what came up, we either agreed, or quickly resolved our differences.  Life was good.  We split the equity 50/50.

It wasn’t until six months later, when we’d quit our jobs and committed our savings, that we nearly destroyed the company with our first real argument.

The advice I gave the lawyers was this: “The most common cause of startup death is founders who can’t resolve their differences.  Nobody hears about it; they just pack up and go home before the company ever had a chance.  If there’s one thing you can do to help your clients – really help them – it’s to get the hard questions on the table early and help them work through them together.”

Mark Suster talks a bit about this in this four minute video clip about “the co-founder mythology“.

Solomon was unavailable

50/50 isn’t a business decision, it’s a compromise

You need to get used to hard questions.  You need to get used to trusting each other.  You need to get used to the idea that you’re not all equal.  You need to have the difficult discussions about responsibilities, contributions, roles, and compensation.  You need to do  it before you make commitments to investors and employees.  And if you find that the only way you can get a decision made is by compromising – then you need to stop now, before the price of failure climbs higher.

There’s no way around it – you’re going to have to split the baby, but it doesn’t require the wisdom of Solomon to get it right.  Take your time, keep a level head, and remember: this is just the first of the decisions you’ll be making together for the rest of your company’s life!

PS: Joel, you’re awesome, but I couldn’t disagree more

Joel Spolsky is one of my favorite authors.  He wrote a thoughtful piece about the same subject that reaches very different conclusions.  Here’s why his article is wrong:

• It confuses “easy” with “fair”.  If you’ve had two successful exits already while I’m doing my first startup, it’s easy but not fair to split it 50/50.  It’s fair but not easy to reach a more accurate split.
• It advocates avoiding conflict so you don’t “argue yourselves to death”.  That’s exactly the wrong approach: if you’re going to argue yourselves to death, do it now when you don’t have investors and, worse, employees (“Mom and dad are fighting again”).
• It gives too much equity to employees who are drawing salary, at the expense of the founders.  The majority of founders work without salary for companies that ultimately fail.  Employees are at least guaranteed a salary.  The difference in risk is monumental. Nivi provides a lot more detail here explaining why founders should get a lot more stock than employees.
• It doesn’t reflect market realities.  A typical Series A allocates 20% for the employees.  Joel’s model has 33% for the employees, which means just 33% for the founding team.
• IOUs are nearly worthless.  Most companies don’t succeed in raising money or getting profitable.  Of those that do, many investors will require that IOUs be waived as a precondition of investment.  A $1 IOU has an expected value of nickels.  The right solutions are either convertible debt (for investment) or equity adjustments (for anything else).
• It’s worth noting that, by the way, Joel is spot on that founder vesting is required in any cofounder situation.

Joel’s already successful.  I believe this is his first startup with cofounders and investors.  This looks like a great, idealistic set of ideas – but it’s economically unsound, and doesn’t reflect the majority of the market out there.

Note: I’ve only founded two VC-backed companies myself, so I’ve vetted this analysis with a bunch of folks to access a broader experience base and make sure I’m not out in the blackberry brambles here.  That said, a few VCs (including Fred Wilson, one of Joel’s investors) have chimed in to endorse Joel’s analysis, so perhaps he’s not so crazy either.

Thanks to Bill Bromfield, David Aronchick, Galen Ward, Joe Heitzeberg, Rand Fishkin, Sarah Novotny, and Tony Wright for providing feedback on drafts of this.  Mistakes, overly broad assertions, and incendiary observations are mine, not theirs.

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My new company, Sparkbuy, is public

Check it out at www.sparkbuy.com and see what I’ve been working on for the past 6 months or so. You can also read about it:

• The New York Times
• The Wall Street Journal’s All Things D
• Seattle’s own Geekwire

Drop me a line and let me know what you think.

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How much are startup options worth?

Startup pay kind of sucks.

This is not a well-kept secret.  A great startup with a dozen or so people will typically pay its employees about a third less than a big company.  Some will argue that that’s because of the value of the equity that startups give you.  I argue that that’s the price of doing something that’s more fun but of unproven economic value.

But regardless of why you’re doing it, there’s no question that startups ply you with ownership in the company, typically in the form of stock options.  They will argue that there’s tremendous value in those shares, more than you’ll get from a big company, but they tend to get all nervous-looking when you ask them how *much* value.  Now there’s no doubt that 1000 options on stock in a startup with 1mm shares outstanding (0.1%) has a lot more upside than 1000 options on stock in google (0.000003%).  This of course raises the simple question: what are they worth?

I’m going to give you a few tools you can use to take a swag at that value.  More importantly, I’m going to give you a checklist of key questions to pummel your potential new employers with that will simultaneously put you in a position of much greater knowledge, and making them think you’re a badass negotiator.

Note that many people would prefer you not know this stuff.  At most startups, the equity’s worth a lot less than you might imagine (as you’ll see below).  One of my favorite bloggers, Mark Suster, argues that you should just assume the equity is valueless and be pleasantly surprised if you find otherwise.  This is one of the reasons I admire Mark – he’s so good at closing candidates that before he does it, he takes on voluntary challenges.  It’s like he’s working on an xbox achievement.

Me? I want my potential new hires to know exactly what they’re getting, erring neither high nor low.  I don’t want them misled with a number that’s too big, or there’s hell to pay when they realize they’ve been had.  And I don’t want to sandbag, because closing a hire is hard enough without telling people to ignore the equity upside.  So that’s what I’m here to tell you: how to know if you’re getting a good deal from a startup.  And my secret ulterior motive is this: I usually give my employees a great deal on their equity.  That means that if they’re informed consumers, my companies’ offers look awesome compared to anything else they’re seeing.

Let’s start with the basics, which are completely misleading.  Then I’ll get to the important stuff.

The value of a whack of equity is this:

Quite simply, it’s your percent ownership times the company’s value.  Seems simple enough, but it’s totally wrong.  There’s a little reason why and a big reason.  The little reason is that the above equation describes the value of shares.  You’re probably receiving options.  An option is worth less than a share.  How much less is excruciatingly difficult to model accurately.  It’s about the same before your first financing round, but it can be a meaningful difference if your company has taken on a few subsequent rounds of capital.

The big reason is something investors don’t like to talk about, but here it is: the existence of preferred, “investor” shares significantly devalues regular, common shares.

This isn’t some sort of rant: it’s basic economics.  You see, investors typically take rights when they invest that put them “in front” of regular investors.  If they invest a million bucks and the company sells for a million bucks, they get their money back and everyone else gets nothing.  It’s called a preference, and Brad has explained it much better than I can.  It has a colossal impact on the expected returns.  They also often have something called participation, meaning that after they get their money back, they continue to get returns as if they hadn’t.  And then they have a set of terms called “protective provisions” which (more Bradness) explicitly allow them to block actions that are in the best interest of the company’s shareholders, as a whole, and supported by a majority of shareholders.

Back when the IRS allowed such things, the rule of thumb was that common stock was worth one tenth as much as preferred stock.  And the “value of company” number, above, is a preferred stock number.  Yikes.

So that’s the bad news: options on common shares in a venture funded company have a pretty crappy book value.

If you thought the company was worth what the IRS does, you probably would just take Mark’s advice and ignore the equity.  But there’s other ways to look at it.

Another, quite reasonable way to consider the value of the options (or at least their value to you), is to look at what you predict they’ll be worth.  Most startups that try to sell the value of your options do this in an optimistic (some might say “false”) way.  I’ve heard the phrase “Our company just wouldn’t accept an offer of less than $500,000,000″ uttered by recruiters.  But there’s a right way as well as a wrong way.

The basic math for this one is:

that means you take your shares, divide by total shares, and multiply by what you think it’ll sell for.  Of course, nothing’s that simple.  You have to:

• Account for the possibility that the company may fail
• Consider dilution from subsequent financing rounds
• Subtract any preference
• Account for any participation
• Subtract bonus/retention/carveout packages

and a bunch of other tricks that investors (and management) can use to manipulate the return curve.  This becomes unbelievably complicated, since key factors are things like how good a negotiator your CEO is.  To try and capture all of this, I banged out a set of heuristics (definition: “statements people will argue about”) that you can use to make a crude estimate.

1. Do you believe in the company?  Really, really believe it’s going to be awesome?  Feel in your guts that it’s going to be something amazing?  90% of new companies fail, so if you don’t, then you should assume your stock is worthless, and stop here.  Also, you should go work elsewhere, because life’s too short.
2. Ask the company: “What is your expected exit range, and what comparables did you use to get there?”  (in English: how much will you sell for, and who do you use as a basis for comparison).  If you agree that this company looks like the comparables, then take the low number and divide it by 2. If they say it’s going to IPO, divide by 10 instead. This is X.
3. Ask how many rounds have been raised, and how much more they expect to raise before they exit.  Add them together, then double them, to get Y.
4. Ask if there’s a preference, and if so, what multiple.  Ask if there’s participation, and if so, is it capped.
5. Cube the preference (as in, 2 x 2 x 2).  That’s Z.
6. If there’s a capped participation, add 1 to Z.  If it’s uncapped, add 2.
7. Ask who’s on the board.  If a majority of board members are employees/founders, do nothing.  If it’s a 50/50 balance between founders and investors, add 1 to Z.  If it’s tilted towards the investors, add 2 to Z.
8. Now for the grand finale:

And that’s what they’re worth.  Here’s an example:

You’re being offered 0.1% of a great company that thinks they’ll exit for $250-500mm.  They’ve raised $5mm and expect to raise $10mm more.  Terms are 1x preference, capped participation. The board is evenly split between founders and investors.

X: 250/2=125
Y: 15*2=30
Z: 1^3+1+1=3

125-(30*3) = $35mm.

You should consider your shares to be worth 0.1% * $35mm = $35k.

I love startups.  I love it when people get rich from startups.  I want you to join a startup, and I want it to shower you with riches beyond your wildest dreams.  I want you to blow all this math out of the water.  It’s all guesstimates anyway… but it’s better than fencing left handed.

Special thanks to Dave Schappell of Teachstreet, Rand Fishkin of SEOMoz, and Tony Wright for proofreading and edits.

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What it really means to be a startup CTO

I just wrote a guest post on what it really means to be a startup company CTO over on my friend Scott Porad’s blog. Read it here.

Also… I started a new company, Sparkbuy, which I think I forgot to mention.  We’re in stealth mode but launching in just over a week.  Follow us on Twitter so you get an invitation to the private beta!

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Your secret Twitter account, isn’t

I was reviewing a student resume today.  It was quite outstanding – no hesitation about recommending the candidate highly.  If there was one thing that I could nitpick about, though, it’s that I like to see a resume that includes a bit of an online footprint.

For a developer, point me to your github or stackoverflow account.  For an MBA, let’s see a clever website you banged out that’s delivering a couple hundred bucks a month of adwords to your bank account.  For a marketing grad, show off your blog or your twitter account that may not have much in the way of useful content but still manages to have a ridiculous number of followers.

A momentary digression: Lately, I have been experimenting with www.gist.com and www.rapportive.com.  I’m still learning to get the most out of them, but I can safely say that if you’re not using at least one of them, you’re a little bit stupider than you should be.  Don’t take it personally: this category of tool is, quite simply, synapse augmentation.  If you have it, you’re a little sharper, a little more able to connect the dots, a bit more on the ball than if you don’t.

One of their cool party tricks is a little known API capability.  Did you know you can look up someone’s user account on Facebook, Linkedin, Twitter, and elsewhere by email address?

Right.  So I didn’t google this guy (and if I did I wouldn’t have found him, since his name wasn’t anywhere on his twitter account).

I just clicked the big blue button right next to his email that linked me to the twitter account that was tied to his address.

I’ll spare you the results, but suffice it to say: if you’re building a secret Twitter account, be sure to use a secret email address for it too, OK?

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How to read a patent in 60 seconds

Someone’s claiming you’re infringing their patent!  You need to figure out how bad the situation is.

Or… your boss has asked you to take a look at an old patent you wrote, and see if someone else is infringing it.  And you have no recollection whatsoever, because it takes an average of nearly four years for a patent to be examined, so by the time anything interesting happens you’ve forgotten all about it.

Or… you’re just reading one of eighty hojillion Slashdot stories that use the title of the patent to write a “guess what obvious thing got patented” story, but you’re smart enough to know that the title isn’t actually the invention, and are curious what the real dirt’s about.

It can take hours or days to fully evaluate a patent.  When time’s short, here’s the quick and dirty way to figure out what the patent covers, usually in under a minute.

Step 1: Skip the title

The title of the patent can be just about as general as the author wants; for example, here is the the guy who patented the Tool.  It often describes the thing being improved on – not the new invention.  A patent titled “Virtual Desktop Manager” does not actually patent virtual desktops; it covers a particular set of features of a specific virtual desktop management implementation.

Step 2: Skip the drawings

Patent drawings are mostly similar to high school notebook doodles except that they cost $5,000.  They’re generally impossible to read and only indirectly have a bearing on the enforceability of the patent.  The occasional exception exists: the incredibly edifying flowchart. the drawings that look like a giant gummy bear (because the invention is, actually, a giant gummy bear) and sometimes a picture is simply worth a thousand words (particularly when that picture depicts the inventor, one Mr. Edward L. Van Halen, demonstrating proper use of his invention).

Step 3: Skip the abstract

In other fields, the abstract is your best friend: a short, direct summary of the major points of a paper.  Patent abstracts are at best meandering and hard to read, and at worst deliberately misleading (so you think you’re in the clear, do whatever you planned to do, and then get sued anyway because the abstract has no bearing on the enforceability of the patent).

Step 4: Skip the specification

Now we’re getting to the meat of the patent!  And also skipping it.  You don’t care about the background, or the field. You don’t much care about the related art.  The brief summary of the invention doesn’t tell you what’s important; the description of the drawings is generally incomprehensible (unless it’s Edward L.). And the detailed description will send you catapulting in to catalepsy, while simultaneously not separating what’s actually novel and invented from the stuff that everyone knows already.

Step 5: Find the independent claims, and read them

The claims are the only part of the patent that have any actual legal enforceability.  While they’re still a pain to read, they’re forced to be one sentence so at least they’re relatively short (modulo the occasional run-on sentences half a page long).  They can be wicked difficult to parse in detail, but a skim will get you pointed in the right direction. This page also offers a decent primer.

Step 6: Back to skipping – toss the dependent claims

Any claim that starts with “The _____ of claim _____” is essentially a refinement or detail with narrower scope than the parent claim – if you infringe the baby, you’ll infringe the daddy too.  Skipadoodle.

And that’s it!

Getting sucked in to a patent dispute is no good for any entrepreneur.  By the time it’s done, you may be able to recite 40 pages of patenteese by memory, and have learned your Markush from your Jeppson.  But if all you need is a quick summary, just cut directly to the independent claims.  You’ll be done in a minute.

Big thanks to Adam Philipp at Aeon Law (who I use and heartily recommend) for giving this article a sanity check.  Also huge thanks to Tom Huseby, who introduced me to this clever trick.

Bonus information: how the patent office reads your patent

Pretty much the same way, most of the time.  They read the independent claims, then reference the drawings, and then move to the specification if a term or concept is unclear.  If you’ve got more than a minute, you won’t do wrong by following their example.

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VC insanity, explained

…or, why VCs do what they do

(Note: this post also appeared as a guest post on Techflash)

VC behavior sometimes looks insane, but generally it’s just sound economics.  It’s crazy but true: if you know how a VC gets paid, you can pretty much read their mind.  Here’s a few examples:

VCs don’t actually seem to want to take any risk.

You’ll be forgiven for thinking that a VCs job is to take investment risk.  It’s a common misconception.  But here’s the bizarre little secret: the VC takes their biggest risk the day they close their 10-year investment fund.  That single defining moment is the absolute apogee of risk taking.  From that instant forward, the VC’s goal in life is trying to do is safely return the money they’ve taken – hopefully with lots of gravy on top – to the eager hands of their watchful LPs.

What’s an LP, you ask?  It’s another common misconception that VCs are investing their own money.  In fact, most of the money they invest (typically 98%+) comes from Limited Partners like college endowments, pension funds, and even the occasional individual Uncle Pennybags. Even when they invest in their own funds, it’s often just a slight of hand – cash is redirected from their management fee (their “salary”) and shuttled right in to the capital calls.  Folks who put their own dimes on the line are known as angel investors, not VCs.  Venture Capital is strictly a game of other people’s property.

So the day the fund closes is the day our friends at Hypothetical Partners have just committed to invest $135mm of other people’s money in startup companies and, ten years later, return it in spades.  That money will be spent on early stage company investments – their job from that point forward is to meet their commitments in the safest way possible.  Modern venture capital is one shining moment of derring-do taking followed by 10 years of risk mitigation.  It’s sort of like breaking a mirror.

They’re trying to make me take more money than I need.

This is a classic example of behavior that makes perfect sense to someone who understands VC economics, and no sense at all otherwise.  Consider this: average VC fund size in 2009 is about $135mm. if we give our friends at Hypothetical Partners 4 full investing partners, they’ve each got to invest about $27mm.  That doesn’t sound so bad, right?  Well if HyP is a $135mm fund, that probably means they’re investing first in Series A ($2mm) or B ($5mm), allocating a total of $10mm in either case for later funding rounds (C or more) if things go well. So doing the math, each HyP partner has to do about 3 investments from this fund.  Sounds simple – one person can probably handle 5 or 6 boards with no problems.

But this isn’t HyP’s first time around.  They’ve probably raised a few funds before – 3 would be on the low side. HyP I is probably mostly done by now, but HyP II and HyP III have companies going strong (or weak), and each partner had 3 investments in each of those funds.  So it’s very possible, even likely, that our partner may have 5 board seats already, and there are some pretty tight demands on their schedule.  Golf games may be in danger of abbreviation.

So once they finally decide that you are the least risky place to stash their funds for the next semi-decade – the more, the better.  It increases their ownership percentage meaning that they get more of the good result they think you’ll produce.  It reduces a big area of risk (running out of money). And if they invest enough, they may get themselves out of doing an investment later, which means fewer board seats, less time in due diligence, more time to see the company succeed before the fund expires, and potentially a measurable improvement to their golf handicap.

They raise big funds, but small ones perform better.

The verdict is in: Silicon Valley Bank researched hundreds of venture funds over a period of decades, and found that small funds outperform big ones (the original data is here).  Yet absent market forces forcing otherwise, VCs tend to raise enormous, ever-growing funds.  Why is this?  Isn’t it in everyone’s interest for the fund to perform better?

The answer lies in a little secret called the 2-20 rule.  It says that VCs get 20% of the fund’s profits – and 2% of the fund’s investment.  Each year.  For ten years.  Fred Wilson has laid the economics of his venture fund bare for the world to see, and it makes the point quite clear.  If HyP raises that $135mm fund, they get $2.7mm each year – enough to cover modest salaries, travel, and a nice office for the partners.  But if those same six partners raise a $500mm fund… well, let’s just say that a case could be made that their investment management skills are now of secondary importance.

They don’t appear to be particularly interested in making large amounts of money.

You’re about to pitch HyP on an outstanding plan: a virtual certainty that they will get a 100% ROI in two years.  It’s a double-your-money sure thing.

Before you can even start, they tell you – truthfully – that they’re not interested.  It’s not that they don’t believe you (although that’s probably true as well); it’s that they actually have no interest whatsoever in doubling their investment in two years.  Why?  Because their LPs want to make 9% annual returns.

You see, VCs operate within three peculiar rules:

Rule number one is that the fund is 10 years long.  They need to provide 9% returns over the course of a decade, not next year.

Rule number two is that there’s no recycling.  Once they cash out of a deal, the money goes away – never to be invested, for the rest of the decade. So your 100% return gets divided by 10 years, not by 2.

And rule number three is that those returns have to take in to account the compounding interest they would have received on both the principal and the management fees.

A little math: to get 9% per year, a hypothetical $100mm investment must increase to 100*e^(10*9%)=$246mm.  But $20mm of the principal (2%/year) goes to management fees and can’t be invested.  And the VCs get 20% of the profits (the carry).  So actually, $80mm invested needs to yield $290mm, a 3.6x return.

Suddenly you can see that your deal actually sets them back significantly (never mind the risk that the “sure thing” might not be).  When you hear that VCs aim for a 10x return, it’s not greed – it’s because if a third of their companies fail and a third just barely get them their money back, a 10x return on the winners puts them in the same place as the S&P 500!

They don’t let you sell the company, even though it’s enough to make everyone rich.

Remember that target of 10x?  Yeah, there’s another catch.  It’s not a 10x return on what they invested.  It’s 10x return on what they reserved to invest – a bigger number that takes in to account the total amount they predicted you’d need over the course of your company’s future, set aside so that they don’t come up dry during follow-on financings.  By the time your company exits, it’s probably too late to invest those reserves, so they count against you when calculating return.

Consider this: HyP invests $2mm in YouCo at a premoney valuation of $2mm, meaning they own 50% of a company worth $4mm.  Someone offers $40mm for the company.  Hallelujah!  A 10x win!  You each get $20mm!

Not so fast.  If they invested $2mm and reserved $5mm for a follow on investment, it’s probably too late to invest the other $5mm.  They’re actually getting just shy of a 3x investment on their allocated capital – not even the 3.5x they need to approach the S&P 500. No deal.  If they let you sell the company and pocket that cool $20mm, they would actually be coming out behind.  The simple economic calculation is to block the sale, and force the company to take additional investment.  Consider: if the second round is under duress, best case it’s a flat round: that means $5mm on $4mm premoney, and voila!  They own 78% of the company.  For the very same purchase price a day later, $40mm (plus $5mm for the $5mm in the bank), they now get 78% x 45mm = $35mm, or a 5x return – not 10x, but enough to clear their 3.5x requirement.

They all invest in the same things.

It makes no sense at all to invest in the fifth URL shortener, or social network, or group purchasing site.  You’re wading in to a pot of competition, and there may be more than one winner – meaning the pie gets split.  Better to invest in novelty, where you can have the field to yourself!

Sounds good, but it ignores two things: thesis risk and excuses.

You see, before a VC makes an investment, they’ve got to do a ton of background research on the market to create their investment thesis.  How big is it? How fast is it growing? Who are the competitors?  Is there a “venture scale exit” (10x ROI) here?  Now, there’s two ways to do it.  One is a lot of work.  The other involves copying your neighbors’ homework, which is usually a very poorly kept secret.  If your neighbor is someone who does a lot of work putting together their investment thesis – and on Sand Hill Road, everyone’s everyone else’s neighbor – it’s probably a lot easier to borrow their thesis and just fund something else along those same general lines.

The second reason happens when the sector blows up and everything goes sideways.  If you took the leap to invest in caffeinated soap all by yourself, good luck explaining that to one to your LPs.  But if you and everyone else thought that Push Technology would be the next big thing, well, you’ve got an excuse that hopefully gets you forgiven for having your investment explode next to 31 others.

So perhaps VCs aren’t crazy.

In fact, I’ve sat on boards with a dozen partners representing funds sizes ranging from $10m to $10bn, and there wasn’t a kook in the room.  They were smart, likable, helpful folks with an unusual job.  In fact, if there was one thing I’d say that set them apart from the average technology business person, it would probably be that they all seemed to have an outstanding grasp of advanced economics.  No surprise, then, when they act just the way their pocketbooks would predict.  Remember that next time you see otherwise-inexplicable behavior… like news reports wondering why a VC pushes aggressively for the sale of a promising portfolio company… that happens to sit in a fund that is nearing the end of its 10-year life.

And before you take money from a VC, make sure you have an open conversation about just where their money comes from and what strings they have attached.  There’s simply no way a person can surprise you if you know how to read their mind.

Disclaimer section

To keep this short and help it read well, I glossed over a lot of details.

• Some funds do allow partial recycling (re-investing proceeds from exited companies) – typical constraints are only during the first 5 years of the fund, and/or an amount equal to the management fees.
• There are some funds that have significant investment from their partners, but the standard is 1%-2%.
• I didn’t get in to capital calls, where VCs don’t get the money from their LPs until it’s needed, and the interaction between that and management fees.  I think, but I’m not sure, that the VCs don’t get their management fees unless the capital is actually invested.  I’ve also heard that at least some firms don’t get management fees after a company exits, which adds fuel to the “don’t invest in a company that will exit next year” fire.  Perhaps someone can add more information in the comments.

• Some firms build a brand out of entrepreneur-friendly behavior.

• These are generalities based on averages; the exception is the rule.  Big funds look for smaller multiples with a higher likelihood (e.g. low-risk 3x returns).  Funds near the end of their 10-year life look for companies that will exit fast.
• I’m a startup guy, not a VC.  This is all hearsay and second hand, and I hope folks who know more about this than I will chime in and correct what I’m sure are many mistakes.

And perhaps the most important point: Acting against economic interests and in favor of relationships is quite common, even the norm.  It helps deal flow, which helps fund economics, if you have a reputation as being a nice person, and… most VCs I know actually are nice people.

But… when you come across a bit of the insanity described here, try not to be too surprised.

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How to use Twitter

I’ve had a peaceful, quiet little twitter account since 2006.  Then one day, on a lark, I threw up @danshapiro up during a talk that I was giving about RC airplanes. The talk got boingboinged, and my inbox flooded with random folks following me.  (Hi!)  Ever since, I’ve had a couple of new follows a day.  Ashton, here I come.

So here’s the (blurry) algorithm I use to decide who to follow:

If you're a friend, or your followers outnumber your follows, I'll look at your page. If you don't tweet too often and at least a third of your tweets are interesting (and private exchanges with someone do not qualify), then I follow you.

So that’s my decision tree.

What’s yours?

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