Upside and Downside

Heidi Roizen has yet another great post this week: “How to Build a Unicorn from Scratch – and Walk Away With Nothing.” Every budding entrepreneur should read it.

Her post isn’t just about valuations and terms. It is also about thinking through downside. In frothy times, especially when equity starts to feel more valuable than cash (a condition not yet reached in New York, but which seems to have hit the SV/SF again), it is easy to focus solely on the upside. Growth, growth growth! Let’s make the business awesome! Let’s make the culture awesome! Let’s make the product awesome!

Awesomeness is indeed a desired, even necessary, goal, but you can’t forget downside protection.

What are some common examples where entrepreneurs lose their head and forget about downside?

Bizdev Deals
A common mistake in the dotcom era, which reared its head in Heidi’s post, is to do business development deals without downside protection. The startup agrees to a distribution deal of some kind and commits to certain levels of payment, but forgets to put performance metrics in place. Why does this happen? Because everyone is so focused on awesomeness! But if your partner’s performance doesn’t live up to expectations, you can get screwed. Believe me I know. In 2000, I sold my startup Ithority and took over business development at the the buyer – an Internet company that subsequently went public. I inherited a ton of these deals that promised cash in exchange for promotion or distribution. When the economy went south, I had to figure out how to re-negotiate these poorly performing deals, but the contract terms left me little leverage. It sucked – and could have easily been prevented with outs tied to metrics.

HR Issues
If you focus solely on awesome and forget the downside, you can get sloppy with employee and contractor practices. You gloss over creating clear terms for your contractors that makes it easy for you to terminate someon who isn’t working out. You don’t set up processes for managing poorly performing employees out of the business, which puts you at risk of spurious lawsuits when you finally crack and decide to fire someone. The truth is, no matter how rigorous your interviewing process is, some folks are not going to work out. Unlike big companies, startups can’t afford to let non-performing people linger.

A rising tide floats all boats, doesn’t it? Not in startup land. In each major category, there will be lots of competitors, but only 1 or 2 big winners (and sometimes none at all if the timing is wrong). When times are frothy, there is a clear temptation to think of things as a land-grab, and thus try to grab as much as you can as quickly as you can. That can lead founders to spawn multiple business initiatives in parallel, which dilutes the team and burns through cash quickly. The way to prevent that is to either 1. stay focused on one thing until you have a clear, very strong beachhead; 2. only allow yourself to look at things with very clear synergies; and/or 3. take a lean “experiment-driven” approach instead of diving in big.

Founder Vesting
Another common place for entrepreneurs to forget downside is at the founding of the company and how equity structures are put into place within the team, in particular, vesting. Many people think that they deserve ownership because they helped come up with an idea, but that’s bunk. The real work and real value is building a company. This is where vesting comes in. It says that if you leave the company too quickly (or deserve to be fired), you don’t get to keep your unvested shares. Usually vesting terms are 3 or 4 years, with a 1-year cliff. For example, for a 4-year schedule, you don’t get to keep any of your stock unless you stay for a full year, and then you get vest a monthly portion for the remaining 36 months. This is a very very good thing. Get a good startup lawyer to help you think through these structures.

Final Notes
In conclusion, dream big but don’t forget to protect yourself from the downside, not just in hunting for product-market fit, but in everything important. Remember that contracts exist in case the things that we DON’T want to happen actually happen. Sometimes they will.

Preparing for these kinds of problems isn’t being a debbie-downer. It’s good business.