What Not To Say In a Business Plan

Guest Post by: Barry Moltz

The following is an excerpt from his e-book entitled, Growing Through Rants and Raves. Barry Moltz is also the writer of a book entitled You Have to Be a Little Crazy, which delivers irreverent, straight talk about the complex intersection of start-up business, financial health, physical well-being, spiritual wholeness and family life. This title and other publications by Barry can be viewed at his website, http://www.barrymoltz.com.

Sometimes I find that the company’s founder is so far ‘outside the box’ that they ‘stretch the envelope.’ As an angel investor, I review more than 500 business plans each year. Unfortunately, many are so riddled with economy lingo, business jargon and clichés, that they do not communicate any real business value. In my opinion, terminology, such as disintermediation, sweet spot, ASP, best of breed, and win-win should be outlawed for the next 100 years. For building a real business, these terms are meaningless. Another challenge when reviewing business plans is that the introductory sentences sometimes stretch for an entire paragraph as the entrepreneur looks for that all-encompassing way to describe their business. Forget it! There isn’t one. Many times I want to strangle the writer to simply tell me what they do in five words or less. Poor choice of words: This business makes mechanical gasoline fueled devices, used for transportation, more efficient by periodically sending them through an applied for patent machine to loosen the terra firma from these vehicles to make them more conducive at performing their task. Solid choice of words: We run a car wash. Another frequently used practice is to create a business plan using template software or by working from an existing plan. I do not recommend this practice and like to refer to William Sahlman in his Harvard Business case study “Some Thoughts on Business Plans.” This case study has continuously inspired me to see beyond clichés and catchphrases and better interpret misleading statements within business plans.

If the plan says: “Our numbers are conservative.” I read: “I know I better show a growing profitable company. This is my best-case scenario. Is it good enough?” Since all numbers are based on assumptions, projections in business plans are by their very nature a guess and are not conservative.

If the plan says: “We’ll give you a 100 percent internal rate of return on your money.” I read: “If everything goes perfectly right, the planets align, and we get lucky, you might get your money back. Actually, we have no idea if this idea will even work.” No one can predict what an investor’s return will be. Let them decide.

If the plan says: “We project a 10 percent margin.” I read: “We kept the same assumptions that the business plan software template came with and did not change a thing. Should we make any changes?” Ensure you have developed your financial projections from the ground up.

If the plan says: “We only need a 5 percent market share to make our conservative projections.” I read: “We were too lazy to figure out exactly how our business will ramp up.” Know what it will cost to acquire customers. Gaining 5 percent market share is not an easy task in a large market.

If the plan says: “Customers really need our product.” I read: ” We haven’t yet asked anyone to pay for it.” or “All our current customers are our relatives” or “We paid for an expensive survey and the people we interviewed said they needed our product.” The definition of a business is when people pay you money to solve their problems. This is the only way to prove people “need it.”

If the plan says: “We have no competition.” I read: Actually … I stop reading the plan. Always beware of entrepreneurs that claim they have no competitors. If they are right, it’s a problem and if they are wrong, it is also a problem. Every business has competitors or else there is a current solution to this customer need. If there are no competitors for what the entrepreneur wants to do, there is a good chance there also is no business. So what should an entrepreneur do? Write the plan in plain and proper English. Please understand that the reader comes to the plan with no knowledge of your business. No fancy words, clichés or graphs will make them want to invest. Understand every part of your plan and be able to defend it. Use your own passion to describe your plan. Make your plan your own.

The 11 things that matter in a business plan:

  • What problem exists that your business is trying to solve. Where is the pain?
  • What does it cost to solve that problem now? How deep and compelling is the pain?
  • What solutions does your business have that solve this problem?
  • What will the customer pay you to solve this problem? How solving this problem will make the company a lot of money.
  • What alliances can you leverage with other companies to help your company?
  • How big can this business get if given the right capital?
  • How much cash do you need to find a path to profitability?
  • How the skills of your management team, their domain knowledge, and track record of execution will make this happen.

Please remember, the business plan is basically an “argument” where you need to state the problem and pain, then provide your solution with supporting data and analogies.

After a Down Round: Alternatives for Employee Incentive Plans

*Excerpt from VC Experts Encyclopedia of Private Equity & Venture Capital

Employee Incentive Plans for Privately-Held Companies

Despite the recent improvement in capital markets activity, many small, privately-held technology companies continue to face reduced valuations and highly dilutive financings, frequently referred to as “down rounds.” These financings can create difficulties for retention of management and other key employees who were attracted to the company in large part for the potential upside of the option or stock ownership program. When down rounds are implemented, the investors can acquire a significant percentage of the company at valuations that are lower than the valuations used for prior financing rounds. Lower valuations mean lower preferred stock values for the preferred stock issued in the down round, and as preferred stock values drop significantly, common stock values also drop, including the value of common stock options held by employees.

Consequently, reduced valuations and “down round” financings frequently cause two results: (i) substantial dilution of the common stock ownership of the company and (ii) the devaluation of the common stock, particularly in view of the increased aggregate liquidation preference of the preferred stock that comes before the common stock. The result is a company with an increasingly larger percentage being held by the holders of the preferred stock and with common stock that can be relatively worthless and unlikely to see any proceeds in the event of an acquisition in the foreseeable future.

In the face of substantial dilution of the common stock and significant devaluation in equity value, companies are faced with the difficulty of retaining key personnel and offering meaningful equity incentives. Potential solutions can be very simple (issuing additional options to counteract dilution) or quite complex (issuing a new class of stock with rights tailored to balance the concerns of both investors and employees). Intermediate solutions range from effecting a recapitalization that will result in an increase in the value of the common stock to implementing a cash bonus plan for employees that is to be paid in the event of an acquisition. Each approach has its advantages and disadvantages, and each may be appropriate depending on the circumstances of a particular company, but the more complex alternatives can offer companies greater flexibility to satisfy the competing demands of employees and investors. This article briefly reviews three of the solutions that can be implemented-the use of additional options, recapitalizations and retention plans (cash and equity based).

Granting Additional Options

The simplest solution to address the dilution of common stock is to issue additional employee stock options. For example, assume that, prior to a down round, a company had 9,000,000 shares of common and preferred stockoutstanding and the employees held options to purchase an additional 1,000,000 shares. Also assume that, in the down round, the company issued additional preferred stock that is convertible into 10,000,000 shares of common stock. On a fully-diluted basis (i.e., taking into account all options and the conversion of all preferred stock), the employees have seen the value of their options reduced from 10% of the company to 5%, or by 50%. In this case, the company might issue the employees additional options to increase their ownership percentage. It would require additional options to purchase in excess of 1,000,000 shares to return the employees to a 10% ownership position, although a smaller amount would still reduce the impact of the down round and might be enough to help entice the employees to stay.

If the common stock retains significant value, the grant of additional options can be an effective solution. It is also relatively straightforward to implement; at most, stockholder approval may be required for an increase in the optionpool. In many cases, however, the aggregate liquidation preference of the preferred stock is unlikely to leave anything for the common holders following an acquisition, particularly in the short term. In that event, the dilution of the common stock becomes less relevant – 5% of nothing is the same as 10% of nothing. Companies with this kind of common stock devaluation will need to consider more intricate solutions.

Recapitalizations

If the common stock has been effectively reduced to minimal value by the down round, a company could increase the common stock value through a recapitalization. A recapitalization can be implemented through a decrease in the liquidation preferences of the preferred stock or a conversion of some preferred stock into common stock, thereby increasing the share of the proceeds that is distributed to the common stock upon a sale of the company. This solution is conceptually straightforward and certainly effective in increasing the value of the common stock. In most cases with privately-held venture capital backed companies, however, the holders of the preferred stock are the investors who typically fund and implement the down rounds and in nearly all cases the preferred stockholders have a veto right over any recapitalization. Accordingly, implementing a recapitalization would require the consent of the affected preferred stockholders, which may be difficult to obtain, particularly because the preferred stockholders may not like the permanency of this approach. In addition, a recapitalization can be quite complicated in practice, raising significant legal, tax and accounting issues.

Retention Plans

Another approach is the implementation of a retention plan. Such plans can take a number of forms and can use cash or a new class of equity with rights designed to satisfy the interests of both the investors and employees. These solutions are more complicated, but also more flexible.

Cash Bonus Plan

In a cash bonus plan, the company guarantees a certain amount of money to employees in the event of an acquisition. This amount can equal a fixed sum or a percentage of the net sale proceeds, to be allocated among the employees at the time of the sale, or it can be a fixed amount per employee, determined in advance. Allocations can be based on a wide variety of parameters, enabling a high degree of flexibility. Often these plans have a limited duration (such as 12 to 24 months, or until the company raises a specified amount of additional equity).

A cash bonus plan is easy to understand, provides the employees with cash to pay any taxes that may be due and can be flexible if the allocations are not determined in advance. However, there are a number of hurdles. Many acquisitions are structured as stock-for-stock exchanges (i.e., the acquiring company issues stock as payment for the stock of the target company) because such exchanges may be eligible for tax-free treatment. A cash bonus plan may interfere with the tax-free treatment and, thus, may reduce the value of the company in the sale or may be a barrier to the transaction altogether.

A cash bonus plan can also be problematic in that it requires cash from a potential acquirer in the event there isn’t sufficient cash on hand in the target company. A mandatory cash commitment from an acquiror may also make the company less attractive as a target. Typically, a cash bonus plan can be adopted (and amended and terminated prior to an acquisition) by the board of directors, although a cash bonus plan creates an interest that may in effect be senior to the preferred stock, which requires consideration as to whether the consent of the preferred holders is required.

New Class of Equity

A stock bonus or option plan utilizing a new class of equity, although more complicated, shares many of the benefits of the cash bonus plan, but avoids some of the major disadvantages. A newly created class of equity, such as senior common stock or an employee series of preferred stock, permits the use of various combinations of rights. The new class of equity can be entitled to a fixed dollar amount, a portion of the purchase price or both. These rights can be in preference to, participating with or subordinate to any preferred holders, and the shares may be convertible into ordinary common stock at the option of the holders or upon the occurrence of certain events. Referring to our earlier example, the company might return the employees to their pre-down round position by issuing them senior common stock entitled to 10% of the consideration (up to a certain amount) in any sale of the company. Although a return of the employees to their pre-down round position may not be acceptable to the preferred stockholders and may not be necessary to keep the employees incentivized, the new class of equity can be tailored to fit whatever balance is acceptable to the investors.

This type of approach has several advantages. First, unlike a simple issuance of additional options, it gives real value to employees that were affected by a devaluation of their common stock. Second, unlike a cash bonus plan, it does not require an acquiror to put up cash when they purchase the company and the acquirer is less likely to discount the purchase price. Third, unlike a cash bonus plan, it will not affect the tax-free nature of many stock-for-stock acquisitions. Finally, it provides certainty to the participants, who know exactly what they will be entitled to receive upon a sale of the company.

The main disadvantage of creating a new class of equity, at least from the employees’ standpoint, is that the employee will either have to pay fair market value for the stock when it is issued or recognize a tax liability upon such issuance, when they may not have the cash with which to pay the taxes. This disadvantage can be partially ameliorated by the use of options for the new class of equity, rather than issuing the new equity up front, which at least allows the employee to control the timing of the tax liability by deciding when to exercise. Moreover, for many employees an option may qualify as an incentive stock option under federal tax law, thus allowing the employee to defer taxation until the sale of the underlying stock. A new class of equity will also be somewhat more difficult for most employees to understand, at least when compared to traditional common stock options.

In addition, a new class of equity adds complexity from the company’s perspective. It may raise securities and accounting issues, and shareholder approval of an amendment to the company’s charter will be required. At a minimum, it will require more elaborate documentation than some of the simpler alternatives, such as a cash bonus plan, and thus it will likely be more expensive to implement at a time when the company may be particularly sensitive to preserving its cash. A new class of equity may also result in future complications such as separate class votes or effective veto rights in certain circumstances. As with the other solutions that address the devaluation problem, there may be resistance from the existing preferred holders, whose share of the consideration upon a sale of the company would thereby be reduced.

These complexities are surmountable and companies may find that they are more than balanced by the advantages that a new class of equity provides over other solutions in addressing issues of reduced common stock valuations and dilution.

A Founder’s Guide to Making a Section 83(b) Election

Guest Post by: Kevin E. Criddle, Associate, DLA Piper

One of the more important tax decisions founders of early-stage companies will face is whether or not to make an election under Section 83(b) of the Internal Revenue Code for stock awards or other acquisitions of shares subject to vesting. By making this decision promptly upon acquiring the shares, founders can avoid missing the 83(b) filing deadline and protect themselves from significant tax consequences down the line. Below, we have set out six of the most commonly asked questions by our clients:

1) What is a Section 83(b) election?

Section 83(b) of the Internal Revenue Code allows founders, employees and other service providers to accelerate the time for determining taxable income on restricted stock awards or purchases subject to vesting. A Section 83(b) election is made by sending a letter (a sample form can be found here) to the Internal Revenue Service requesting to be taxed on the date the restricted stock was granted or purchased rather than on the scheduled vesting dates.

Founders that decide to make an 83(b) election need to do so promptly to ensure that they do not miss the 83(b) filing deadline. An 83(b) election must be filed with the IRS within 30 days after the grant or purchase date of the restricted stock. The last possible day for filing is calculated by counting every day (including weekends and holidays) starting with the day after the grant date.

 2) What are the benefits of an 83(b) election?

There are several reasons why filing an 83(b) election may be beneficial for a founder. Most notably, Section 83(b) of the Internal Revenue Code allows founders to accelerate the determination of taxable income on an award or purchase of restricted stock to the date it was granted rather than on the date(s) the shares vest. If the restricted stock is purchased for an amount equal to its fair market value, an 83(b) election will result in no recognition of income as of the purchase date. Additionally, an 83(b) election advances the beginning of the one-year long-term capital gain holding period, often resulting in preferential capital gain rather than ordinary tax treatment upon sale (long-term capital gain tax rates are 0, 15 and 20 percent for most taxpayers). Simply stated, an 83(b) election can result in significant tax savings under the right circumstances.

3) What happens if a founder does not file an 83(b) election?

If a Section 83(b) election is not filed by the deadline, a founder would pay taxes on restricted stock grants at each vesting date. The founder’s tax would be assessed at ordinary income rates on the amount by which the stock’s value on the vesting date exceeds the purchase price, if any. This may result in a significant tax obligation if the value of the shares has increased substantially over time.

4) What are the risks of an 83(b) election?

Despite its benefits, the 83(b) election is not without risk. Making a Section 83(b) election accelerates the date that taxable income is recognized from the vesting date to the date the restricted stock is granted or purchased. This means that if a founder makes an 83(b) election, pays taxes on income based on the fair market value of the shares on the grant date, and then later forfeits his or her shares, the founder may have paid tax on unrealized income.

5) What scenarios could make an 83(b) election more or less advantageous?

All things considered, a Section 83(b) election will likely be more (or less) advantageous for a founder in the following scenarios:

Section 83(b) Election is More Advantageous Section 83(b) Election is Less Advantageous
  • the amount of income reported at grant is small
  • the amount of income reported at grant is large
  • the stock’s growth prospects are moderate to strong
  • the stock’s growth prospects are low to moderate
  • the risk of stock forfeiture is very low
  • the risk of stock forfeiture is moderate to high

6) What are the steps to filing an 83(b) election?

To make an 83(b) election, the following steps must be completed within 30 days of the grant date:

  1. Complete a Section 83(b) election letter—a sample form can be found here.
  2. Mail the completed letter to the IRS within 30 days of your grant date:
  • Mail to the IRS Service Center where you file your tax return—the address for your IRS Service Center can be found here.
  • Preferably send the letter by certified mail and request a return receipt.
  1. Mail a copy of the completed letter to your employer.
  2. Retain one copy of the completed and filed letter for your records and retain proof of mailing.

As always, founders should consult with their tax advisors to determine how a Section 83(b) election applies to their individual circumstances.


Kevin E. Criddle, Associate, DLA Piper

Kevin Criddle’s practice focuses on securities and corporate finance, mergers and acquisitions, venture capital and private equity investments and general corporate counselling.

 

What Will VC’s Want For A Security: Common Stock? Preferred Stock? Debt? Warrants?

Written by: Joseph W. Bartlett/VC Experts Founder

As one programs any financing, as in corporate finance generally, the objective is to make 2 + 2 = 5; that is to obtain added value for the issuer. In the course of a financing, the insiders are attempting to raise the maximum amount of money for the minimum amount of equity (“equity” meaning claims on the residual values of the firm after its creditors have been satisfied). A corporation will issue at least one class of common stock because it must; many firms stop there; they pursue the simplest capital structure possible in accordance with the KISS principle (“Keep it Simple, Stupid”). However, in so doing, the corporation may close down its chances to pursue the added-value equation (2 + 2 = 5) because that equation involves matching a custom-tailored security to the taste of a given investor. The top line of the term sheet will ordinarily specify the security the VCs opt to own; the following discussion takes up the most common possibilities.

Different investors have differing appetites for various combinations of risk and reward. If a given investor has a special liking for upside potential leavened with some downside protection, the investor may “pay up” for a convertible debt instrument. An investor indifferent to current returns prefers common stock. The tax law drives some preferences, since corporate investors must pay tax at full rates on interest but almost no tax on dividends. On the other hand, the issuer of the security can deduct interest payments for tax purposes–interest is paid in pre-tax dollars–but not dividends. The sum of varying preferences, according to the plan, should be such that the issuer will get more for less–more money for less equity–by playing to the varying tastes of the investing population, and, in the process, putting together specially crafted instruments, custom made as it were. A potential investor interested in “locking in” a return will want a fixed rate on debt securities instead of a variable rate; the ultimate “lock-in” occurs in a zero coupon bond, which pays, albeit not until maturity, not only interest at a fixed rate but interest on interest at a fixed rate.

As the practice of tailoring or “hybridizing” securities has become more familiar and frequent, the traditional categories can become homogenized. Preferred stock may come to look very much like common stock and debt resembles equity. In fact, the draftsmen of the Revised Model Business Corporation Act no longer distinguish between common and preferred stock. Moreover, it may be advantageous (again with a view to making 2 + 2 = 5) to work with units or bundles of securities, meaning that an investor will be offered a group of securities, one share of preferred, one debenture, one share of common, and a warrant, all in one package.

Indeed, creativity by sponsors has spawned a variety of novel “securities,” equity and debt, which have played a role in venture capital, the underlying notion being to maximize values by crafting instruments to fit the tastes of each buyer and to capture current fashions in the market. The use of “junk” or “fluffy debt has been the focus of popular attention of late; however, junk bonds debt securities which are less than investment grade and, therefore, unrated are only one species of the complex phyla of hybrid securities invented by imaginative planners. Thus, a given issuer‘s financial structure can perhaps be best envisioned by thinking in terms of layers of securities. The top layer is the most senior: usually secured debt, “true” debt in the sense that the holder is opting for security of investment and “buying” that security by accepting a conservative rate of return, a fixed interest rate, or a variable rate tied to an objective index. The bottom layer is the most junior: common stock (and if the common stock is divided into different series, the most junior series); on occasion, this level is referred to as the “high-speed equity.” The risk of a total wipeout is the greatest, but, because of the effects of leverage, so is the reward. In between are hybrids, layers of securities with differing positions, meaning differing claims on Newco‘s current cash flows and the proceeds of a sale or liquidation of the entire enterprise.

The variables open to the planners include the following:

  • a security can be denominated either debt or equity with different tax consequences to both the issuer and the holders;
  • a security may be senior, or subordinated, or both, as in senior to one level and subordinate to another (the term “subordinated” opens, in and of itself, a variety of possibilities);
  • a security may be convertible into another at a fixed or variable rate of exchange (and convertible over again, as in debt convertible into preferred stock, in turn convertible into common);
  • an equity security may contemplate some form of fixed recoupment of principal, perhaps expressed in terms of a redemption right;

Redemption can be at the option of the issuer, the holder, or both; and the issuer‘s obligations to make periodic payments with respect to a debt security can range from the simple to the exotic–monthly interest payments at a fixed rate to so-called PIK payments (payment in kind, meaning in stock versus cash) tied to the performance of a particular business segment (as in “alphabet stock”). The utility of this structure is that it gives Newco time to fulfill the promises in its pitch book.

All that said, in today’s universe, the market standard is common stock to the founder founders, plus the friends and family. The next round, with the exception noted, is convertible preferred stock. The jump balls are participating versus non-participating, cumulative dividends, etc. But the security is convertible preferred, even in the angel round, which used to be common. The exception is a convertible note in the bridge round, next round pricing. See the Buzz article, The Next Round Pricing Strategy.

For more information on Venture Capital and Private Equity, please visit VC Experts.