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Due Diligence Comes Before Joining a Startup
This week a friend of mine was offered a chance to work for an exciting startup in the consumer packaged goods industry (think food and beverages). He wanted to know what he should ask before accepting the offer, which was a below-market salary in exchange for equity ownership in the company. Oftentimes this equity ownership comes in the form of stock options. I’ll write about that later. In this case, he was being asked to join a Limited Liability Company (LLC).
So here’s some of the advice I shared with him:
- As an LLC, there is no stock, there are only units. Properly structured LLC’s have an operating agreement explaining how the units behave, so you might ask to see that.
- LLC’s may be have classes of units, and their distribution may be arbitrary (i.e., unfair) so you need to read the operating agreement to learn whether or how you can be diluted or underprivileged.
- Having experienced a motivation misalignment before, I would try to find out whether the folks running the company are motivated more by wealth or more by control. I’m wealth-motivated, so whatever produces the greatest long-term value is what I want to do. In the past I’ve worked for control motivated folks, and we often disagreed about what to do.
- Business owners acting in their own best interest should only use ownership as a form of currency when the ownership is being over-valued by the employee or deal partner. Options and units can be great examples of this. Give out an “eye-popping” amount to employees (“Oh, that sounds like a lot!”) and hope they don’t realize what it’s actually worth. Be wary. Specifically, for an LLC you want to see that operating agreement to know how many units there are, how many you’ll get, and how new units will be created.
- I’d ask to see financial statements. If the company is a going-concern with a history of profitability, your units are absolutely taxable, and the valuation could be performed by an expert or by me or someone else. Regardless of who values the company, the IRS always retains the right to disagree.
- If they are a going-concern with a history of profitability, or else if the founders have done this successfully before, I’d be highly inclined to find a way to take the ownership. You can live very comfortably on a corporate salary, but you can be “set for life” if you hit it big with a young company that you purchased with your labor when it was worth very little.
- If they’re a loosey-goosey operation, they may flinch at showing you their underwear drawer: they may not have an operating agreement or financials. If that’s the case, I’d be highly inclined to take all or most of the compensation in cash at market rates, rather than equity. Remember that most startups fail, and if it’s not your baby, you need to make a living from it.
So that’s some food for thought beyond the global picture, which is “what is the business, does it make sense to me, etc.” Keep an eye out for your own interests, and you’ll make a good decision.
For further reading, I suggest
- Noam Wasserman’s “The Founder’s Dilemmas”
Financial Figuring for Landlords: Working Capital
What will you do if that old roof floods your top floor apartment, or if a cast iron drain pipe cracks just as you’re paying for bedbug extermination? What if the jobs cost $10,000? Do you call up your regular contractor and cut a check without batting an eyelash, or is this is a crisis necessitating soul searching, an emergency loan, or perhaps even a brave attempt at “deferred maintenance”? If you couldn’t afford a $10,000 emergency repair, you’d be in good company. Most small time property owners have a shortage of operating cash. But you can do better.
For large, established companies, there’s a test used to evaluate their ability to survive a “disaster” scenario. It’s called “the acid test.” The phrase comes from bygone days when gold was authenticated by dropping acid onto it. Gold won’t react, so if it’s “good as gold,” the acid has no effect. For businesses, “passing the acid test” usually means having enough liquid cash to cover more than an entire year’s expenses. That’s a heavy burden for a rental property, but if you manage that way, you can have some measure of peace of mind.
You can calculate the “acid test ratio” for your property by adding all your cash accounts for the business and dividing by all your liabilities for the next year. Your liabilities include the total of all interest, all insurance premiums, all real estate taxes, and all expected repairs. Suppose you have $12,000 set aside in the property’s rainy day fund. Suppose each month you pay $800 in interest, $300 in insurance, $300 in taxes, and $200 in repairs. All those expenses, times 12 months in a year, means you have liabilities of $19,200. Your $12,000 in cash divided by your $19,200 in liabilities means you have an “acid test ratio” of 0.625. A typical publicly traded manufacturing company has an acid test ratio of 1.25 to 1.5, more than double.
Now I’ve spoken with landlords about this, and most express shock and dismay that they should have to keep so much cash set aside. With monthly income guaranteed by leases, you might reasonably use another test, called “the quick ratio,” which lets you count receivables as “cash” because you’ll get them quickly. We can calculate this using the example above. If your tenants are obliged to pay $1,000/mo for the remaining nine months on their lease, you get to add another $9,000 in “cash.” Now $12,000 cash plus $9,000 receivables = $21,000. Divide this by $19,200 and your quick ratio is greater than one, just where you want to be. But be honest and don’t count month-to-month’s at face value. And if you’re dealing with tenants who might be headed for eviction or non-renewal, don’t count a full year of their lease at face value, either.
However much money you choose to set aside, the moral here is that large, established businesses set aside a lot of money for rainy days. As a small business, perhaps with limited credit, it’s important for you to do so, as well, and to keep that money allocated separately as a rainy day fund. You’ll be able to weather any storm if you do.
Hiring Employees, Bosses, and Customers: Part One of Three, Employees
A wise person once said, “You must judge people, because the wrong man can kill you.” Hyperbole aside, the meaning is well met. You really want to get to know someone before you enter a relationship with them, be it as their supervisor, their subordinate, or sometimes even their provider.
In each of these scenarios you want to view the process as a sharply narrowing funnel, where subsequent stages are reached only if the lower-cost, earlier stages check out. Today I’m going to look at hiring employees, and later I’ll share some thoughts about picking the right boss and customers (yes, sometimes you get to choose).
Employees
Hiring employees is easy if you go about it right, but it can go horribly wrong and consume a lot of time if you put the cart before the horse. Here are the steps I recommend:
- Say in your job posting what you’re actually looking for.
- For instance, if you really won’t consider someone without a certain degree, don’t pretend to be more open-minded than you are. Say so. Just be careful that you don’t overspecify (this applies especially to corporate HR departments using bots to screen 25,000 resumes to zero).
- The goal here is to have a large number of people self-select out of the process, before you even know about it.
- Caveat: If you have more than 15 employees, it is illegal to inquire about the following:
- Race, gender, religion, family status, disabilities, and
- Ethnic background, and
- Country of origin (ask if they’re authorized to work in the US instead), per http://www.dol.gov/oasam/regs/statutes/2000e-16.htm
- Sexual orientation, per http://en.wikipedia.org/wiki/Employment_Non-Discrimination_Act
- Military service, per http://fhp.osd.mil/pdfs/userra.pdf
- Marital status, per http://www.unmarriedamerica.org/ms-statutes.htm
- Age, depending on whether they’re a contractor or not:
- If you treat everyone equally, you can ask about height, weight, club membership, or being a minor, per http://www.dol.gov/compliance/guide/childlbr.htm
- Caveat: If you have more than 50 employees and government contracts greater than $50,000, you also need an affirmative action plan.
- For most professional jobs, take both resumes and cover letters.
- Read them in small batches so you get into the mindset.
- Fill out a score sheet of your own design with each one.
- If they scored too low to be viable, make a note and put their materials aside.
- Use the telephone.
- Use email to invite high scorers to a low-key phone call. “Would you be available for a chat sometime Friday afternoon?”
- Beforehand, create a prompt sheet to remind you which key areas you want to hit upon.
- When the time comes, call them from a quiet place. “Hi, this is So-and-So from Acme Co. calling for What’s-Your-Name.”
- Small talk goes a long way towards getting the conversation going smoothly. Prepare to talk about something banal, like the weather, just to get them going. Ask them how their day’s been going so far.
- If the interview starts out shakey, try to keep them talking for at least 15 minutes. Especially with inexperienced hires, sometimes people need a lot of time to get their best foot forward.
- Ask open-ended questions from your prompt sheet, trying to fit them naturally into a conversation, rather than announcing stiffly that you “will now proceed to question three.”
- If your phone call reveals problems, make a note and put their materials aside.
- If their job is very technical, have a technical person speak with them a second time.
- Give up to an hour, if need be. Have the technical person use their own prompt sheet to hit all the key areas.
- If the technical call reveals problems, make a note and put their materials aside.
- Assuming the phone calls went well, arrange an on-site.
- These are hugely expensive. You’ll spend a couple of hours with them, give them a tour, and interrupt their day, yours, and your coworkers’. Do this only if you expect it will work out.
- Use the time on-site to test what they’re going to be doing. Ask them to prepare a presentation in advance, or draft something in CAD the day-of, or talk about accounting. Ask them to do anything within reason that will give you an idea of whether they’ll work well.
- Debrief with the team soon afterwards. Invite all employees who met the interviewee to the same debrief, regardless of their position in the company.
- As the hiring supervisor or HR person who brought them in, you’re probably still in favor of their getting an offer. Tell the group if this is no longer the case, and why.
- Assuming you’re still in favor, you must play Devil’s Advocate to ferret out the reasons why this person won’t work for the rest of the team.
- Communicate quickly.
- The best folks don’t wait around. If you want to give an offer, don’t wait, give an offer.
- If you’ve decided they’re not a fit, wait a day to give it due consideration and then say so in so many words. Don’t offer suggestions for improvement unless they ask.
- Keep records.
- If, heavens forbid, your hiring practices are called into question, you want to be able to pull up a document indicating that you’ve done nothing immoral or illegal.
- Review how many folks you screened at each step, and whether there were any expensive surprises toward the end of the process. Try to avoid those by rewriting the prompt sheets for next time.
You can adapt this process to suit your own business. And remember that the goal in this rigor is ultimately to save yourself time by weeding out candidates who won’t do and by getting quickly and fairly to the next great addition to your team.
For further reading, I recommend:
- Endurance, Shackleton’s Incredible Voyage by Alfred Lansing. A short section describes how Shackleton could size someone up after a few minutes, and the rest of the traumatic voyage proves that some people like Shackleton are superlatively good judges of character. For the rest of us, let’s use the funnel process.
- Winning by Jack Welch, for the “four E’s and a P” metric used to evaluate future leaders.
Miracle on 1st Street SE
Imagine that you are the proud manager of the only company that provides food to the people who live in a large area around your plant. Your CFO comes to you for the quarterly update and for the first time in a long time it’s good news. He shows you the graph below:
“We haven’t made money in ten years. If we do nothing, we’ll be on forecast 1, still losing money, but the bleeding is slowing down. We’re going to get through it. We’re lucky that the cost savings and price increases we put in place over the last ten years have set us on that path, because sales and operations are demanding even lower prices and bigger budgets. If we were going to give them what they wanted, we’d be on forecast 2 and still hemorrhaging cash.”
You think about it for a second and ask your CFO, “What does our balance sheet look like?”
He pulls out a copy of the balance sheet and hands it across your desk:
“Oh, hmm, ” you say. “I see our shareholders are in the red by about $15 trillion. God love ’em, they do support us. Let’s give sales and operations what they’re asking for.”
Your CFO should be shocked, but by now he’s totally resigned to your insane management of the company. “Okay,” he says, “I’ll call up our overseas competitors and get additional funds.”
You reassure your CFO, saying, “Don’t worry, they know we’re the only company providing food here. If they need us to pay off the debt, they’ll let us know, and we’ll just raise prices. Our customers will have to pay it. But let’s try to avoid that, okay? Also, call some emergency meetings with sales and operations. Make them work through the holidays to make sure we get onto forecast 2.”
You might think you’d be insane to run a company this way, but oddly enough, this is exactly what we’re doing to ourselves in the United States. See, for instance,
Positivity
Today I was at a management meeting to solve some specific problems, and at the end of the meeting, as often happens, we allowed for some off-topic suggestions and comments. (People should have a chance to say what’s on their mind.) One of the managers recommended that we devote some time during our “all hands” meeting to let attendees get up to a microphone and share something that they’ve learned recently, maybe just for a minute, just quickly, and then they’d sit back down. Call it a “Member Minute.” I thought that was a great idea. I’m often coming across random tidbits that I’d like to share with folks, and I think I could contribute something in less than a minute to the general audience.
Another manager also liked the idea, and they supported it by saying so and then launching into their latest gripe. They said that there was a “major problem” negatively affecting them, and “get this” there was no solution yet, and they wanted everyone else in the business to know about it. Fortunately the manager who suggested the “Member Minute” thanked the griper for their support and then emphasized their vision for the sharing of positive messages.
As problem fixers, we often want to focus on the problem, and among a friendly audience, sometimes we want to vent a little. There can be a place for venting to a group, and there absolutely is a need to talk about problems. But negativity is ultimately an organization killer: no one wants to hang around a sourpuss, and not only that, even if people don’t shut down or leave, your group’s ability to perform towards a positive outcome will be greatly diminished.
Ever been in the grocery store looking for something? Ever notice how much faster you can find it if you think about what you’re looking for, if you envision its color or its shape or a word on the box? And if they change the branding, notice how you can’t find it? The same can be said about your work. Envision a positive outcome and all your abilities converge towards it. Envision a quagmire and that’s where you end up wallowing.
As managers, we can coach or remove team members that are a drag to work with. For everyone else, especially in volunteer organizations, we need to check ourselves and others:
- Recognize that habitual negativity is career-threatening and organization killing.
- End a gripe with a suggested solution and always always (even if there is no suggested solution) offer to take suggestions or advice from others.
- Try to “break frames” and get people thinking differently with jokes or humor. (More on this later; never use sarcasm.)
- Watch your tone and use words that are even-handed or fair-minded. If the situation is more gray than black-and-white, this leaves people open to possibilities and makes it easier for them to help you.
It’s true, your attitude determines your altitude. Aim high.
