Portland Startup Tax – Bad Investor Behavior

I want to wrap up the discussion about the Portland “startup tax” with a focus on Portland investors. My last post outlined mistakes Portland entrepreneurs often make. Now I want to focus on bad investor behavior.

Most investors I’ve met in Portland have a horror story about getting stuck in a company that ends up going nowhere. Or, being in a growing company but getting washed out on a later round.  This has lead to a number of investor behaviors that often prevent good companies from getting access to growth capital.

Early stage Silicon Valley investors have developed entrepreneurial friendly investing behaviors that coupled with lean startup methodologies have proved extremely successful. Many of Portland’s bad investment habits hobble Portland entrepreneurs and add to the Portland startup tax. Here are a few practices Portland investors need to adopt to lower the tax.

Quick Diligence

Too many Portland investors see virtue in time consuming comprehensive diligence. Traditional business diligence looses its relevance with nimble, agile and lean early stage startups. Scouring existing financials and forecasts has limited relevance in a lean startup that depends on speed and agility. Plus the distraction to the founding team is costly.

Investors should invest in areas in which they have knowledge and are comfortable. It’s most productive to limit early diligence to the market space and the team. Most oving quickly and helping founders focus on the business.

Fund Fast

Many Portland investors are drawn to contingent funding. Forcing entrepreneurs to find additional funds is too often viewed as a test that lowers risk. I’ve seen several instances when entrepreneurs tie themselves up for months trying to find additional investment dollars so they can take down contingent investments. Rather than test, this can kill a company by exhausting entrepreneurs and delaying execution. If a company needs more money that an investor can supply than the investors should do their share to syndicate the deal.

Set Reasonable Valuations and Caps

Portland investors often force low valuations because they can. But, this can be counter-productive. Too much early low valuation money crowds a cap table scaring off later stage capital. Later rounds that leave the founders with too little ownership increase the execution risk (by demotivating and distracting the founders), limiting the upside for everyone. In Portland, this often drives early sales of companies even when they have tremendous growth potential.

Forcing low caps on notes is the same as setting too low a valuation. The idea of a note is to avoid pricing a round before there’s enough business to value. Investors should either use a note as intended – a quick lightweight way to bridge a company forward (with discounts and interest as the incentive). Or, they should price a Series Seed round. The cap should merely protect an investor from not appropriately participating in extraordinary appreciation. A note with a low cap can either telegraph a low valuation for a subsequent round or scare off investors with a inappropriate differential in share price.

Keep Terms Simple

Funding terms only get worse in subsequent rounds. Early multiples of participation, ratchets, anti-dilution ratchets and other onerous terms rarely ever go away. And although they may seem to favor investors, they can encumber companies and compromise the ability to raise needed capital and restrict strategic options. Early investors are most successful when they align their interests with the entrepreneur’s.

Portland’s seed and angel investors need to better partner with entrepreneurs. Putting a company in a position to find the best future investors optimizes returns for everyone. All behavior that slows a company, or attempts to protect the early investor from the entrepreneur essentially increases the Portland startup tax and limits everyone’s upside.

The Portland Startup Tax – Bad Entrepreneur Behavior

Last week at Immix Law Group’s PowerUp Event on fund raising we discussed the Portland “startup tax” that local entrepreneurs pay when raising capital. My last post looked at the tax entrepreneurs pay due to lack of local capital. Now I want to look at bad entrepreneurial behavior that makes building well-funded scalable businesses harder. Too often Portlanders get in their own way.

Growth capital is looking for companies that can scale to a big exit. To attract capital, companies need to structure for investment and scale from the beginning. There are several best practices often missed by Portland Entrepreneurs:

Delaware C Corp

Half the early Portland startups I see who are looking for early funding are Oregon LLCs. Another third are S Corps. When raising money, optics is important. An LLC communicates that you’re not sure what you want to be when you grow up. An S Corp is even worse. Oregon needs to get past a well-deserved reputation for no-growth life style companies. An S Corp tells me the entrepreneur is running the company to maximize their personal tax benefits. A C Corp, in Delaware provides the optimal accommodation and protection for investors. It says from the beginning that you are in it to grow a big company and make money for all involved.

Get Lawyers and Accountants that work with Silicon Valley VCs

There are well established, hard won “rules” for high-growth startups; best practices that have evolved over decades. Some corporate lawyers are fluent in this game. Unlike many legal situations, they know optimizing their client’s position means staying within norms and providing balanced documents; not trying for client advantage in the short term. It means playing for a five to ten year growth curve. I’ve had multiple capital raises where we minimized cost by convincing the investors to go bare and just use company lawyers in drafting and executing documents. This was possible because they trusted the lawyers were operating within comfortable norms.

Entrepreneurs can easily get up to speed on the High Tech Growth game through blogs and sites that lay out best practices and model legal agreements. Portland has several Law firms facile with Silicon Valley Venture investing. If you want access to VC capital use one of these firms. In fact, they generally charge very little (if anything) to get a company set up and on this path because they understand the cost of early money and how large potential fees will be when a company finds scale successfully.

Structure your Cap Table by working backwards from your exit

An entrepreneur building a $100 million plus company should be able to layout what the company cap table looks like at $100 million: founders shares, a couple rounds of financing, employee options, a few shares for advisers, and warrants for banking and other partnerships. An entrepreneur that lets a Seed or Series A valuation be driven solely on a handful of beta customers and a MVP is not setting up for growth. Early validation and traction should be accompanied with a vision for a large addressable market and a credible plan for scale.

More than once I have found myself as an early investor in a Portland startup struggling to find capital because of a cap table messed up with low valuation early financings.

Vesting for all Founders shares

Founders and investors need protection against a founder or early employee leaving and taking too many shares. Four year vesting ensures everyone is in it for the long hall and if there isn’t a fit, the company can recover shares to adjust. Starting a four-year vesting day one protects the founders, communicates the right thing to investors and prevents a painful reset of the vesting clock later.

Intellectual Property discipline from day zero

Track every line of code from day one. Establish proprietary rights agreements with every contributor. Track open source licenses carefully. Getting IP assignments after the fact is always hard and expensive. Take it seriously and behave like your effort is valuable from the beginning. This makes it far easier for an investor (or acquirer) to take it seriously and value it later on.

Too often Portland entrepreneurs don’t do these out of ignorance or neglect. You already have to explain to potential investors why you’re in Portland and how they can make money here. Showing you understand drill can minimize a painful Portland startup tax.