Maybe it’s the author of the piece trying to make something out of nothing, but the article reads as if Prof. Stout simply knows what’s best for corporations, individual shareholders, and institutional investors. While it’s not uncommon to see academics pronounce superior judgment, Prof. Stout acknowledges the power of the board to control a corporation. A misstatement of law then intrudes, and this is where the article turns south in terms of quality: the board’s fiduciary duty to shareholders (a phrase not even mentioned in the article) to exercise their business judgment  is transformed, without support, into an obligation to create short-term increases in the stock price. Beyond being incorrect (that’s not what the law says at all except in the general scenario where the board has determined to sell the company and is then obligated to search for the highest price), there’s no real proof that that’s even what management and boards are doing in the first place. (That’s about four long posts’ worth of explanation foreshadowed right there.)

Instead, what this article really does is communicate Prof. Stout’s opinions about practices she doesn’t like.

1. She says that tying executive compensation to share performance is bad; executives should get bonuses instead.

2. She thinks that hedge funds (a convenient and irrelevant foil) engage in lots of “zero-sum” trading.

3. She thinks that too many investors have a short-term perspective.

Separate from the notion that there are plenty of companies that take different approaches to these issues is the idea that Prof. Stout can certainly buy corporate control in the market and make long-term decisions instead. If that’s all it takes, she should make outsized returns. 

As with many academics, the solution is too quickly “you do as I say” rather than “let me do what I say and see what happens.” For each of these described problems, there are counter-examples and reasons for doing business a certain way. Google’s founders, in one well-known example, structured the company’s cap table to preserve their ability, consistent with their fiduciary duties under state law, to make long-term decisions that might have negative short-term consequences. Private equity funds take companies off the public market when investors disfavor short-term negative results as a price for long-term investments. 

If compensating executives differently is so easy and so obviously “right” that boards should be prevented from any other system (and there have been bonus structures in the past, obviously), then perhaps the way to actually prove this theory is by doing compensation consulting and basing the fee on results. I wonder whether Prof. Stout would reject stock-based compensation to share in any value increase to the company. Money plays no favorites; the market will respond to the results.

Nothing about the concept of shareholder value dictates any particular executive compensation scheme; nothing about fiduciary duties requires boards to focus on quarterly results. Whether some do, perhaps even unwisely, has little to say about the wisdom of requiring boards to act in any specific way.

(Conflicts of interest: Rick went to Cornell Law, Class of 1997. Mike went to Cornell’s Johnson Graduate School of Management, Class of 1999.)

What we’ve found though, is that just as typos are the not the biggest problem with written work, it is weak  or sloppy analysis that is the real problem in many more spreadsheets.

Spreadsheets, like sentences and paragraphs, communicate ideas. In a financial model for a startup, the ideas include overt and hidden assumptions about major variables, such as length of a sales cycle and the salary requirements for a software engineer. But a model also communicates a vision of how the various assumptions fit together and becomes a representation of how the business functions just as clearly as any flowchart or business process diagram.

We’ve reviewed hundreds, maybe thousands of financial models. Many are constructed correctly, in that the cells match up and the formulas do what they say. But those same spreadsheets fail at the task of communicating the business model — how the company takes capital and employs it to bring in revenue, capture gross margins, and operates the business in such a way as to produce positive cash flow.

No, the real risk in your spreadsheets is that they correctly answer the wrong questions.

Conveniently, we said this over three years ago in describing the data needed to create alternative fee structures.

Some corporate clients have enough legal liability of their own that they can do the analysis internally: an auto manufacturer’s finance arm can address auto loan defaults, for example, as can almost any company with a large volume of litigation, such as an insurance company. There’s likely to be enough data that reasonable connections could be drawn between various attributes of each case (amount at stake, jurisdiction, age of account, and similar items, many of which are related to the underwriting process in the first instance) and the ultimate legal fees and result (productivity: comparing input and output).

But for many corporate clients, they are only infrequent participants in litigation, and thus they turn to outside law firms on the cost question for the same reason they turn to those firms on the legal specialty question: volume of work for an outside lawyer is almost always higher than for a comparable in-house lawyer. I worked on more IPOs in two years as a corporate associate than most GCs would work on in a lifetime at a company (most companies only go public once!).

So law firms have the possibility of interpreting their data to find the answers, but there are a few major hurdles.

First, their incentives are not clearly aligned with doing the work to overcome the other hurdles. When all firms have the same problems, no one sees a pressing need to move first and invest in figuring out what they know.

Second, lawyers don’t like to be pinned down — it’s inherent in the hourly fee model: the risk of there being more work falls on the client. Since it’s the client’s lawsuit, lawyers see that as fair, and it pretty much is when the amount of work can be dictated by someone else, such as the other litigant!

Third, virtually all firms don’t collect the sort of data that might be useful to divine the cost drivers of litigation. (Insurance claims adjuster files might, but those companies can already do their own analyses.) With the need for either an upfront investment in collecting the absent data or in adopting a new process going forward, firms find it easier to use the excuse of “no data” to stick with the “I’ll give you an estimate that is really just a guess based on my own anecdotal approach.” Anecdotal evidence isn’t — and firms recognize that because they’re unwilling to adopt their own estimates created this way.

Fourth, law firms aren’t really sure yet about the risk transfer inherent in an alternative fee structure. The connection, in terms of ultimate outcome, between facts, law (which while knowable is seldom exactly known early in any given case), and lawyer skill, is fuzzy. Law firms have historically benefited from that fuzziness because excuses abound from the underlying facts (“you were always going to lose on these facts”) to the law (“there are just too many unfavorable cases”) to the process (“with this judge and this jury, it turned out to be a loss; with a different judge and jury, …”) to the client (“by trying to be cost-effective, we didn’t have enough resources available”). The rationale of “the other lawyers were smarter than us” is non-existent. But that’s what performance fees are about: betting on yourself and trying to manage the other cost factors.

We’re always looking for legal services opportunities, for corporations and law firms, to apply our approach to this alternative fee problem.

directors on compensation committees are under unprecedented pressure to define the strategy and rationale for their executive compensation decisions.

That’s funny because we’ve been reading articles, from the popular press (the WSJ told us “How to Fix Executive Compensation” just four months ago!) to financial journals, for over a decade talking about pay and performance. The topic reached a crescendo during the dot com boom as the value of stock options grew to unforeseen heights for many companies. But that, too, was just an echo of an earlier rise during the heyday of the MBO, when putting management’s “skin in the game” was part of a strategy to improve performance. More recent restricted stock grants have similar goals.

Why the NACD thought that last week was finally the time to create this guide escapes me. Consider, for starters, that all of these directors are ALREADY subject to fiduciary duties to perform their duties competently. What is the NACD saying? That companies really don’t know what they’re doing? Or that there’s a right way and everyone has been mucking it up all along? 

I’ll stick with the cynical explanation that the compensation consultant and law firm sponsors/advisors to the guide finally coughed up enough money to make it worthwhile to the NACD to pretend to solve a problem that has already been the subject of scads of actual academic research and that has already been “solved” annually by every board on which its members sit. 

Sigh.

The key issue in splitting rounds is raising enough money (including your cushion) to get you to the next major valuation-bumping milestone. That’s it — that’s the optimal number. This is a number measured using Abe Lincoln’s suspenders (just as long as they needed to be) – the amount of money should be just right, and it’s not a guessing game. More money and you’re giving away extra; less and you’re increasing your transaction costs.

Answer: The question assumes something that it also seems to indicate is not true. And that’s the clue to the right answer.

1. The founder assumes that he’ll give up more equity in a single round than in two rounds. That is only material IF the value of the company appreciates significantly in the interim.

2. But, the founders also says that the company will not be cash-flow positive until toward the end of the period (month 20 – past the middle of the second $600k round). If that’s true, then it’s much less likely that the company is going to hit the sort of major inflection point that equates to a definite material bump in valuation.

3. Why does this sound pessimistic? Because the company has been operating for 18 months and already created great amounts of value — developed a product/service offering, found customers, started a company, and now it is chipping away at execution risk and growing the company. If you as a founder have cracked the code on those earlier stage issues, the value jump between that stage, and that +800k, isn’t as likely to be all that great.

So, listen to the people who’ve seen it happen in real life: two rounds of fundraising are likely to be more burdensome than you expect; do the math on the two-tiered valuation; figure out what you as founders will get years from now from spending the time to fundraise twice to retain a little extra piece for yourselves versus spending the time on growing the business at its rate of return.

Remember, you make vastly more money by running your business than by trying to over-optimize your fundraising.

Interesting to think about how the regulatory scheme, seemingly in the background, really affects the competitive landscape, much like Kickstarter is a nonstarter for startup crowdfunding in the angel/equity model. Crowdselling via kickstarter is what works well.

As an aside, does it make sense to complain about US securities laws? Maybe. Maybe they don’t do the investor protection job very well; that’s presumably a researchable problem. Maybe, of course, you remember that our laws are primarily designed to create disclosure, not safety. Dotcoms going public circa 1999 were all legitimate deals, with correctly disclosed numbers, and pages and pages of risk factors. I know, because I drafted and proofread many of those pages of risk factors myself.

The notion of whether we protect people from bad outcomes misses the point: our system isn’t designed for that. It’s designed to tell prospective investors all the material facts before they invest. Those who say that our assessment of who can and should be able to invest in non-registered securities, such as angel investments in private startups, tend to narrow the issue too much. Those who want to relax the rules often think that these “great deals” are out there and only for the rich. They forget that most of these investments do not create positive returns. And for those who argue that even further reductions(!) in the accredited investor thresholds should be implemented to increase the capital available to startups, they haven’t done the math on the differences in wealth between the original numbers and the current numbers: simply put, people who qualified as accredited investors in the past were wealthier, meaning more able to withstand the volatility and liquidity problems of unregistered investments, than those who qualify at those same wealth or income numbers today. (In other words, inflation happens.)

Angels will largely take a product risk (they bet on the product or idea and your ability to build it). “A” round investors or late-stage seed investors will take a market risk (they want to see the product, vision and maybe even the first customers, and they bet on there being a big enough market). “B” round investors usually take a scale or product market fit risk (they bet that the company can scale and that this is going to be massive).

There are other types of financial investors, and they approach deals differently, which in turn dictates what deals they’ll do. Why is this information important? Knowing how to define and describe the challenge facing your company helps you determine which investors are actually interested in hearing your story and which are not suitable.

• Banks — banks used to make money on the spread in interest rates between deposits and loans, but a much larger percentage of profits comes from fees. Banks, then, seek to aggregate and deploy capital while retaining (traditionally, within the “banking” portion of the bank) little principal risk. Securitization has moved principal risk off of bank balance sheets, helping the transition toward transaction- (and fee-) based models.
• LBO funds — LBO funds are generally focused on financial engineering, meaning they often transmute debt or equity capital into the other kind, and even working capital gets a lot of attention. Changing the capital structure of a business, “right-sizing” ROIC (return on invested capital) across divisions, segments, or products, and even divestments and acquisitions can change a company’s profile. LBO funds take the risk that other capital will be available to suit the models they’ve created and that they can provide the right investment for those other capital markets participants.
• Private equity funds — PE funds clearly span categories in the broad sense, but we think of them in this discussion as the MBO crowd. Backing a management team to buy out a company, likely taking it private, means taking on the risk of product realignment, development, or expansion when those risks are not well-suited for a public company. The fund takes on the risk that the management team has it wrong or won’t be able to execute.
• Hedge funds — Hedge funds have a variety of strategies. Other than the “we’ll do anything” model, a substantial common denominator is arbitrage. But hedge funds don’t just arbitrage price in two different markets but also across time, benchmarks (interest rates), currencies, and imperfect substitutes (commodities vs. commodity companies). That type of risk is more likely to be relevant to a company in its commercial dealings (oil shipments) than in its own financials per se.
• Mutual funds — Mutual funds aggregate vast amounts of capital for investment in public companies and similar securities. These funds effectively take risk by allocating capital to stocks, bonds, and across large sectors (domestic v. foreign, tech v. agriculture). Because of the overall size of the mutual fund industry, it’s probably not meaningful to say that the industry as a whole really takes risks on specific stocks to an extent that used to be true: trillions of dollars have to go somewhere, and mammoth widely held corporations are the place.
• Turnaround funds — These more specialized funds focus on particular types of operating risk, and sometimes related working capital risks. Some focus on pure financial operations turnarounds, others on factory operations, and others on SG&A cleanup. The risk for these funds is based on doing enough diligence before an investment to formulate a plan and staffing a portfolio company with a team that can create and execute the plan as well as adjust it successfully when things change.

Remember, too, that knowing how to describe the problems that you like to attack and solve, as an individual or team, helps you figure out where to target marketing or job search efforts.