The title to this blog (or this slice of pie) is a quote by a New York City Wall Street investment banker more influential professionally to me than the many law and business graduate school tools in my professional career. This quote really impacts on how one hires both internally (senior managers and employees) and externally (service providers). It can have considerable influence on the ability to finance a startup. It can influence the durability of the company. And I do believe that it is a key to success for all fast growth companies.
Let’s see why that quote originated and why this banker made that comment at a meeting. The situation was a telecommunications startup that needed to raise hundreds of millions of dollars on Wall Street to deploy its network. The whole startup team had experience in the telecom industry, but the banker remarked that not one member had ever managed a company valued over $100 million. That could be a fatal weakness that would discourage any potential investor. The only solution was to bring a senior manager with that experience and the team had to be amenable in granting sufficient stock options to attract the senior executive on board. Otherwise, the management team might own the equity of a valueless company since it will fail to attract investors without that key, seasoned manager. Hence he raised that 10% rule.
The banker also added this comment to the founder. Even though the founder would play a secondary role in this startup, he will later on no longer need this executive “straw man” after the success of this venture, as he now has the experience under his belt. So he suggested that the founder will gain more in the long run by bringing in the seasoned manager.
I have observed many startups that should follow this banker’s advice, once one sees the many applications of this rule. Recently, I observed a 100% guy, who is avoiding in outsourcing his work to skilled experts. The founder/CEO, without a team, who had developed an interesting visual recognition technology in California, decided to file his provisional patent on his own, without employing patent counsel. True, he retains 100% of capital, but smart investors would question whether that provisional filing has any merits. The investor expects a third party to confirm the value of that patent. Filing your own provisional can imply a very partial bias. Yes, he saved thousands of dollars in not hiring an outside legal advisor, but will he attract millions of dollars in investments later on?
In another situation, I met a very reputable, brilliant physicist from University of Maryland, with substantial patents on optics being applied to a specific startup. His whole previous professional experience has been in academics. Because of that, I recommended to the investment team that, although the technology had considerable merits, the founder-physicist had no private enterprise experience. The startup would need an experienced private sector manager. Instead, the founder found a local investment firm to ante up $10 million that would also allow him to be President and CEO. He spent millions constructing a “clean room” rather than leasing one. He hired a fulltime General Counsel, when the legal transactions were few and far in between. He exhausted those funds in a year without a viable product, and he then returned to academics. In other words, he kept 100% of nothing. Had he allowed a professional manager to work alongside, he would have had a viable percentage of the company.
Another example of the 10% rule is promising ISO equity to the management team and delivering on that promise. For example, one founder created an LLC for this health food enterprise and he intended to pay out equity by units to attract managers with underlying salary base. He actually suggested to me to join that team, and he needed my personal rolodex and professional recommendations for the marketing and packaging strategy. Meanwhile, the so called units never materialized. I have witnessed too many ISO promises that are never awarded or awarded far less than verbally promised. True, legally speaking, no one can enforce anything until it is in writing. And that employee undertakes a legal risk by beginning employment without the ISO being defined. (There is a saying: “Bulls**t walks, money talks”) But I see a very avaricious founder trying to keep as much equity to himself. In this specific instance, he should have awarded the units to the prospective managers – the “money talks”. And his team, if already destabilized by being short changed, will search for other opportunities with other companies when the opportunities arise. Yes, the founder keeps more shares, but what will be their value if his team evaporates?
I have used the American football analogy before and the 10% rule applies to one football tenet: each member of the 11 players play a critical role in winning. One player, even the QB, cannot win the game. Each player plays for the other teammates. And a company is made up of a team of managers, not one individual. In the realm of business, it makes sense to compensate every member of the team. In fact, in the real world of football, Tom Brady rewards his offensive line with Rolex watches or cars every year. He clearly understands that he cannot win the game without his offensive line. I wish that many entrepreneurs learn from Tom Brady or the NYC investment banker. The point here is winning, while avarice might play a barrier to that success.