Business professor Adam Grant, writing in the New York Times, argues that business networking activities are overrated. (Grant is the author of Give and Take, one of the rare business advice books that I have actually read. It’s worthwhile.) Formalized networking events, Grant argues, are not only uncomfortable (we knew that already), but they’re ineffectual as a means of building real professional connections. Instead of using networking to seek to achieve things, he contends, we should reverse the order and use our great achievements to build a network.
Are 409A Valuations a “Shell Game” and a “Dirty Little Secret”?
William D. Cohan, writing in the New York Times’ DealBook, characterizes the third-party valuations of private companies under Section 409A of the Internal Revenue Code as Silicon Valley’s “dirty little secret” and a “shell game.” Especially in the aftermath of the financial crisis, there has been plenty of populist rhetoric about practices in the business world, and much of that criticism has had basis in fact, but this take on 409A valuations seems awfully strained.
As described in Cohan’s article, Section 409A and the related rules require that companies obtain independent valuations in connection with their issuance of equity-based awards to employees, and failure to comply results in tax penalties. Cohan details the fact that various service providers charge significant fees to undertake these valuations, using words like “supposed” experts to make the whole enterprise seem like a racket, but the reality is that the rules do exist, and these valuations have to be done. If it was possible for just anyone to make up a valuation for a bargain-basement fee, heck, I would consider doing it as a side gig from my legal work. But the rules actually go into detail as to the required qualifications for firms providing these services. Cohan notes in the article that the SEC would not comment on these practices, but this is really more of an issue of tax law than securities law. What constrains companies and their hired valuation help from simply making up numbers out of thin air is the fact that their decisions are subject to later IRS scrutiny and sanctions.
Does It Help Startups for Founders to Cede Control?
The Wall Street Journal reports on a study finding that startups that have a founder staying on as chief executive or chairman past the first two years following inception have a significantly lower valuation, on average, than companies who replace their leadership during that period. The study’s author attempts to explain the difference in valuation by focusing on the relative attributes of founders versus executives that are brought on later. In other words, founders may have the inspiration to get the startup conceptualized and off the ground, but professional executives have a different and necessary skill set that the company needs at a later stage.
This may be part of the explanation, but it seems to me to be confusing correlation and causation. There may be a reason other than the qualities of the founders themselves that account for the different performance. One possible alternate factor is the manner in which startups are funded. Startups that receive venture capital funding are, in my experience, more likely to see a change in leadership, sometimes imposed by the venture fund as a condition to investment. On the other hand, startups that are funded by less heavy-handed capital sources (friends and family money, bank loans, etc.) are more likely to have the founders continue in their role indefinitely.
Venture capital firms can contribute far more to a company’s success other than providing new executives to replace the founders. Particularly if the firm focuses on a specific industry, the firm will have seen and invested in many similar companies and will be able to provide useful advice that would not be available to startups that rely on non-VC funding. Such expert guidance from investors could account for significant differences in company valuation. In addition, VC firms generally invest more than a startup needs to spend immediately, so the simple fact of there being more cash in the bank could lead a VC-backed startup to have a higher valuation than one that isn’t VC-funded. [Read more…]
Recent Trends in Financing Startups
The Wall Street Journal recently detailed trends in how startups are financing themselves. If you don’t have a Journal subscription, this article will likely be behind a paywall, but to sum it up, young businesses are using bank loans and home equity loans less than in the past, owing to continued cautiousness from lenders following the Great Recession. Instead, they are relying on their own savings and family loans and high interest personal credit card debt.
Bank loans to businesses still exist, but they typically require two years of business activity. This is of course no help to businesses that require a cash infusion to get started, though it can be helpful for more established businesses who want to expand their business or to smooth cash flow. Personal credit card debt is relatively easy to obtain, but the interest rates are high, and if your business fails, you’re in a far worse position than when you started.
For those who want to start a business but don’t want to potentially blow their personal savings on a venture or be stuck with high interest credit card debt, the lower risk alternative is to sell equity to outside investors. You are giving up some of your business’s upside, but receiving financing that does not immediately (or perhaps ever) need to be paid back may be worthwhile for some companies. The Journal article mentions crowdfunding as a means to obtain equity capital, and while this is a young and developing form of offering equity, it has the potential to be a common and viable method for startups to finance themselves. Even when crowdfunding does become more commonplace, it will likely still be hard for completely new businesses to receiving financing, unless the founders have already had demonstrated success with other ventures. However, there is always the possibility of friends and family equity financing to jumpstart ventures to get to the point where they can then seek financing from the crowd.
Finally, even though there are many challenges involved with fundraising for new businesses, the silver lining is that in many cases, the cost of starting a business is far less than in the past as a result of recent developments in technology and the rise of the gig economy. Taking my own business of launching a law firm, in the past, I would have had to rent expensive office space, hire an assistant and full-time attorneys, etc., all of which requires a significant initial outlay. Now, a lawyer can run a virtual firm and have work performed on a pay-as-you-go, project-by-project basis. Pretty much the only significant initial outlay is the cost of a website. Accordingly, despite the challenges in raising funds in the current environment, it’s as good a time as any to launch a business because, in many cases, less financing is required.
Startup Valuations and Plain English
Writing his usual daily roundup in Bloomberg View, Matt Levine, a former corporate attorney and investment banker who is perhaps the only person in the world who writes in a laugh-out-loud manner about securities law, raises interesting points on two unrelated topics: startup valuation and plain English writing.
