Naive entrepreneurs fail to protect their equity and exit poor; with Jotham Stein

Welcome to this episode of The Unnoticed Entrepreneur. Today, I'm delighted to have Jotham Stein joining me all the way from Southern California. Jotham, welcome to the show.

Thanks for having me on your show, Jim. And I should say I'm in Northern California since I live south of San Francisco, right near Silicon Valley. Although the geography person would say we're in mid-state of California, but here in California, you say Northern California.

Okay. Northern California. And as long as you stay safe from all those fires and you and I are going to talk about Not only getting noticed like an entrepreneur, but how to protect yourself as an entrepreneur. And you've got a book, How to Negotiate Like a CEO. So, Joachim, tell us, how can an entrepreneur protect themselves so they get to keep the company that they're building?

So the first thing they need to know is the language of investors or who they're doing contracting with. So they have full information. And what I find is many entrepreneurs don't have that information. They're wonderful at what they're doing, what they're creating, and they're 100% focused on what they're creating, but they don't understand the language as, let's say, investors, or if they're starting out with co-founders, what they need in their contracts to protect themselves going forward so they don't get forced out of their own company. And the next question is who they're talking about. Are they talking about protecting themselves against an angel investor or with respect to a co-founder or like an institutional investor, a venture capitalist or private equity individual? Each of those people, you need to know the language. that they use and what their interests are and what they want to do to put themselves in a position of being able to have control over you, the founder, and you don't want that. So you need to know what their interests are so you can negotiate and have a contract, which I call a professional prenuptial agreement to protect you, the founder. So you stay in control of your company.

Well, so you make a really interesting point here that as an entrepreneur, you think about, you know, raising money as being liberating. But actually, Jotham, you're raising the specter of some sort of danger that you're building a company for someone else. So let's go through some of the elements of that prenup that you've mentioned, if we can, to start with.

So the first thing you have to do is you're going to get an LOI at some point as an entrepreneur, a letter of intent typically. And one of the things that you need to know about is how many board seats does your investor want? Because your company typically is controlled by the number of board members. You want to keep those board members under your control and the investor at some point wants to take control of the board, because once he or she takes control of the board as an investor, they can then fire you as the founder. So that's the first thing you need to know. Second is you need to know is what capital are you giving up? What percentage of the company are you giving up? Third, are there going to be liquidation preferences? That's a fancy term for what the investors take back if they sell your company or your company exits before you get anything. And then the relationships you have with your own company, you probably want to put in place a strong employment agreement for yourself, the founder. Even though you're running the company and control the board, because at some point, if you lose control or something goes wrong, you want to have a clean exit where you protect your equity. So you have all your equity when you leave, and also you get severance or separation pay so you can transition to the next thing in your life, which could be working for another company, could be starting a new company, whatever it is. And all of those things you need to know, and they all have language. They have words behind them and they have contracts behind them.

So, Jotham, you know, you've introduced a whole new dictionary of vocabulary there. I know it's context sensitive and every deal is different, but there must be some sort of key takeaway tips that I know you've got in your book, which we will of course put in the show notes, but can you give us some top line things that entrepreneurs, people like myself should really be thinking about before they go into a deal?

Sure. Protecting your control over the company. So that's typically the board of directors. The investors want to take as many board seats as they can, because once they get control of the board, they can kick you out or do what they want. They don't have to listen to you as the founder. As they're building the company, if you want to do X, investors want to do Y, the board says we're doing Y, you lose. The board says we're kicking you out, you lose. So that's number one. Number 2 is protecting your equity. Equity is another word for stock or stock options, restricted stock. So in the United States, most individuals, if they're in a C corp, They have common stock. You guys in the UK call it ordinary shares. I think that's the same in Australia, ordinary shares and different places in the world. It's the same though. Investors, when they put in money, you have to be concerned with what they call liquidation preferences. So using $1 million as an example, investor puts in $1 million. They often say the contracts that you have to read, because you're going to have to read all the contracts, they could say we get the first million off the top. And no matter what you sell the company for, what you do, we get the first million. That's what it might say. But what happens if the contract says, well, we want double participating or double participating preferred as an example. And so they get 2 times, they get $2 million off the top and so forth. So if you raise a lot of money and your company isn't doing so well, you need to protect yourself against these liquidation preferences. Third, you should have an employment agreement with your own company. Even though you're the founder, even though it's your company, you know, you have various relationships with your company. One is an employment relationship. Another is an officer of the company. A third is a board member. And so you should have an employment relationship with the company that sets out all your protections. And so, for example, equity protections is one I was describing before. The founder or the entrepreneur, when they put that million dollars in or whatever it is, $5 million, $10 million, they say to you, Okay, well, you have to have skin in the game. Let's take your shares and start revesting them, meaning you have to work over time for those shares. And let's say 4 years, they say, we're taking back all your shares and we're going to vest them over 4 years. Well, what happens if you get fired after 2 years? You lose half your equity that you just had as a founder. But if you have an employment agreement in place that says, okay, if you fire me for any reason or no reason except for cause, and you strictly define cause, I keep all my equity. The fancy term for that is accelerating your equity, then you're okay, at least to the extent that you have what you started out with. So those things are all important. There are many others that I discuss in the book. I could go on and on for hours about this, but first of all, you need to know what it is you need to protect yourself against, which unfortunately entrepreneurs don't until they've been mistreated or to use the California colloquial, screwed once before, and then they don't let it happen again. That's why my book describes all of these things that you should know the language. And then after you know what it is, you need to be able to Talk about it. And if you have any leverage at all, then even if it's outside your personal comfort zone, you have to enter into contracts, negotiate, bring up the terms, socialize the terms, negotiate the contract, and then sign a contract with your investors, your board, your company to protect yourself.

Right. So that's fascinating. So all of this protection work, is this done before the negotiation around pricing or is it done You know, after the money's come into the company, Jotham, give us some ideas as well, because it seems as though many entrepreneurs, myself included, I raised money from a VC back in 1998 in Singapore. You know, I was so frankly so desperate for the cash that some of these terms, I'm sure I was guilty of not certainly reading or understanding fully. So at what stage in the negotiation Should these be taken seriously?

So I'll just step back and say, not everybody can negotiate because they have no leverage. They're so desperate for cash that they'll give up everything, including their own company. And the key of reading my book and understanding all the language is, listen, if you have no leverage, at least you go in with your eyes wide open. And if you have multiple investors and no leverage, you try to pick the one that'll do the best for you. Because I can tell you many times investors invest knowing that they're going to get rid of a founder. Or management team. But going back to the question, so there's a difference of opinion I have sometimes with my colleagues. I believe that when you start out with your company, when you found it, you should enter into these protective agreements, even though you're voting as the only member of the company or, you know, in control of the company, you're voting on your own agreements to protect yourself, both your equity as well as your severance. Because I believe you're stronger when you say do a Series A round of investing or a Series B round of investing with institutional investors. You can always negotiate off what you have. And I believe it's much more difficult to negotiate just as a sort of psychological business matter once an investor comes in with an LOI and then you're putting in place your protective agreements. Now, for the most part, now I have to say, I have colleagues who believe just the opposite. Don't waste your time in the beginning when you control the company. You know, when you get a sophisticated institutional investor, then you start negotiating and they understand. I just have a difference of opinion. It's strong. But, you know, sometimes with entrepreneurs, I have my colleagues speak to that as well. So they get to hear both sides of the spectrum and they can decide for themselves.

Right. It sounds like it's really prudent to have all those things in place, especially if you're not the sole founder as well, Jotham, because what you're also describing are all the different dynamics that can take place if the business goes well or goes badly. It sounds as though one of the things you've also identified Is that not all investors are the same? Can you just talk us through a little bit about how you think entrepreneurs can target and communicate with the right kind of investor? Because you've identified the fact that they're not all there necessarily to help the investor or the entrepreneur get rich.

That's very true. It really is context dependent. So in other words, in multiple sort of different layers. Are you going out to raise from venture capitalists, for example? Well, let's start from the beginning. Friends and family are usually the easiest investors to work with. Also, angel investors are often the easiest to work with because they're not looking to control your company and they're early on. Friends and family often trust you as an individual, so you're not so worried. You should have contracts in place. You should have protected yourself, but that level, you don't need to be so worried. Typically, this is all general, right? Every context is different. And there are many people that have been stabbed in the back by their brother or sister or the person who stood up at the wedding. So Generally speaking, early round investors aren't going to get control because they're not going to buy enough of your company to do that. But once you start with institutional investors, so it's really context dependent. Are we talking about venture capitalists? Well, if you are, you better do your due diligence. There are certain venture capitalists that are known to meddle. They are known to fire founders, you know, immediately or very quickly. There are others that believe in management teams. This is their philosophy of investing. And they don't, they have no interest in removing people. They want the management team and that's what they're buying into. All right. So that's venture capital. Private equity is another mindset completely, and you better do your due diligence. Sometimes it's geographic based. It looks like to my sort of, this is going to be joking, but if you're dealing with a private equity principal from New York, New York City, they sometimes are the most difficult to deal with in terms of being, if you're a founder, in terms of the control that they want. I often say there's sort of like a geographic mindset there. So you better be aware of who you're dealing with and who you're working with and protect yourself against it. Now there's other kinds of investors. Sometimes your company, you're lucky enough to have strategic investors and often strategic investors, let's say potential customers, potential acquirers, big companies who are investing and hoping you grow bigger so that they can buy you at some point. Often strategics, they can invest a lot of money, a lot more than private equity or venture capitalists might be willing to do, and yet not have any interest in taking control. Zero. Because their interest is in you growing the company as the founder so they can buy it. You know, and I use an example. Let's say your company is making $20 million a year in revenue. Let's use that example. Well, their interest is in buying you at $200 million, right? And paying a lot of money, right? So they have no interest in taking control. That's a kind of strategic investor. Another might be interested in buying your company because you're making a product that works with their product. It integrates with their product. So that's why this is all context dependent, but you should do your due diligence if you have any leverage at all. Listen, if you're desperate, If you're desperate and you, if somebody comes to me and they're desperate and they don't mind losing control of the company and they know they're going to lose control. Okay. So you give them advice and you say, well, okay, you might not be there in a year. What do you want to do about that? Does it matter to you? And sometimes it matters to people and sometimes it doesn't. So everybody's different and the investors are different.

Yeah. But the consistent point though that you're making, Jotham, really well is that no matter who you are or where you're at, you must be protected along the way. But Entrepreneurs often are great at starting businesses and then at some stage will exit and maybe transition to a corporate or run that within their bigger conglomerate or the sort of career managers will come in. What's your experience about how the exiting entrepreneur can protect themselves as they seek to start to exit so that it's not, you know, being pushed, they're jumping and they've got the full parachute?

That depends. So we're talking about a true— many entrepreneurs don't want to leave their company so that entrepreneurs are different. So many companies, it's their baby, they started their company. They have no interest in, I'd say, and they get forced out. And sometimes to the detriment of the company and all the shareholders, they lose out, but sometimes to the betterment of the company, because being an entrepreneur and starting a company is completely different from the skillset is completely different from managing that company. Now, some entrepreneurs are great at both, but often they're not. So I want to give that as a background. Frankly, some of those professional managers you talk about, the MBAs of the world, they're great at managing companies. They can't start anything. Right. That's not their skillset. But if you're talking about a shrewd investor who, I mean, sorry, shrewd entrepreneur, many who've done it before and they're like, okay, I'm good at starting companies. I can't manage them. I don't want to manage them. Those kinds of entrepreneurs who then want to go start another company, call them serial entrepreneurs, of which there are many in the world and are many successful. And they don't have the ego that they have to run their own company. They're like, no, let somebody else run it. I'll do really well. I'll make the money because I own the stock in the company. Let me run the next company so somebody else can run it. That's a mindset not shared by all entrepreneurs, but those people to protect themselves on the back end, they have equity, which is their power in the company. They may stay on the board, which they often hope to do sometimes as chairman, sometimes otherwise, to give their knowledge that they have and direction that they have. And sometimes they don't stay on the board. They just keep their equity. And for them, equity meaning their stock. So for them, what they want to do is control the dilution. They don't want to be diluted out of their own company. And so there are multiple sort of ways to do that, contracting and otherwise. And there's a lot of business, you know, you're not going to be diluted in certain businesses if it's continuing to grow or it's of enough size. So again, that's sort of context dependent, but their goal in that circumstance, their goal may be to be paid as well, like for a year or 2 years so they can start their next company. So that's, they negotiate a backend separation agreement if they haven't done it on the front end, or if they have an employment agreement, they go and they talk with the board. And they say, it's time for me to move on. Why don't you just pay me out on my contract that I put in place 2 or 3 or 4 years ago? And they keep their equity, which is the key part for them. And then sometimes something else is important as well. They've negotiated. It's not always just equity and medical payments in the United States and separation pay. There could be other things that are important. And then they move on. And so those are usually friendly transactions because the investors know that this entrepreneur wants to move on. Right. If there are investors or the entrepreneur may be bringing in a professional management team. So to run the company to the next stage.

Right. And then that's ideal, isn't it? Sort of a managed exit. Now, Jotham, you yourself are an entrepreneur. You've run your own business for over 25 years. I know now you have more business than you can manage and you've got your successful book, but how did you start? I think you've got a lovely story that you're going to share about how you got noticed At the beginning of your entrepreneurial life?

So at the beginning of building my law firm, I remember I'm in Silicon Valley. Now we have offices across the country, but I started out in Silicon Valley and I quickly recognized that there were all these entrepreneurs out there that weren't protected and didn't know the questions to ask and were frankly being cheated over and over again, forced out of their own company. So I ran an ad in a, you know, starting out, I didn't have so much money, but I ran an ad in a magazine. I'm not sure how many magazines there are. It's called The Red Herring. And I was lucky. I was able to run a quarter-page ad in this magazine. I saved my money and ran it a number of months. I talk about it in the book. And this, I was lucky because the magazine was called The Red Hanger. It was probably distributional from like San Francisco, San Francisco in the north to San Jose in the south. That's Silicon Valley. And the ad said, even CEOs get fired and listed my name and the school that I went to. And I was stunned by the number of Entrepreneurs that called and the return on that ad was amazing. And because I discovered that people, first of all, they didn't know who to talk to when they were being forced out of the company, or they were afraid to talk to their friends. They were afraid to talk to their colleagues. And so they called me up and I heard from every level, from entry-level sort of employees, because we represent everybody, all the way up to founders of companies and CEOs of companies. So would call me off of that ad. And that really got me going. I talk about it in the book. And then on the back end, at the end of the book, I talk about reincarnating yourself if you do get forced out. And one of the things I say is you are not alone. So I hope that all your listeners will buy the book so that they have the knowledge in the beginning. But if they don't, if they get forced out of their own company, there are so many founders who have been forced out of their own company and have come back or have come back successfully to start a new company. And they just do it without losing control. I have multiple clients who Now we even represent their companies because we helped them exit. And they're like, put the contracts in place that won't let me lose control of my next company. So the ad was for all those people who didn't know how to talk and didn't realize that their own colleagues might be having problems, their own friends, their own fellow entrepreneurs. Many of them have problems, but nobody likes to talk about it. And so on the back end, if it happens to you, realize you are not alone. Nobody likes to be forced out of their own company. That's a horrible, horrible experience. It's terrible from many different perspectives, you know, psychologically, emotionally, family-wise, business-wise, financially, but you can reincarnate yourself and come back strong starting a new company. And I often get calls from happy clients 6 months later saying, and I talk about this in the book, this is the best thing that ever happened to me was I got forced out because I had set myself up poorly with investors or board members or whatever. And now I'm much happier and it won't happen again to me.

Jotham Stein joining me from, I think you said the middle part of California. Your book, which is How to Negotiate Like a CEO, is available in all reputable bookstores, I'm sure.

And you can go to amazon.com and from amazon.com for sure, you can either buy the paperback and have it delivered to you. I think if you're a member of Prime, they'll, at least in the States, they'll do it the next day or 2 days later. Or you can download the Kindle version, which is their electronic version, just from the Amazon website.

Jotham, thank you so much for sharing just a slight amount of the vast knowledge and wisdom that you've got with me today and my fellow unearntest entrepreneurs. Jotham Stein joining me from California. Thank you so much.

Thank you so much for having me on your show, Jim.

You've been listening to Jotham Stein, and I will of course put all of his details in the show notes. And as always, if you like the show, do please share it and review it, and that all really helps and will Look forward to meeting you on the next show.