Pay-to-Play

I think the pay-to-play provision is described well enough in Wikipedia, that says,

Pay to Play is a provision in a corporation’s charter documents (usually inserted as part of a preferred stock financing) that requires stockholders to participate in subsequent stock offerings in order to benefit from certain antidilution protections. If the stockholder does not purchase his or her pro rata share in the subsequent offering, then the stockholder loses the benefit(s) of the antidilution provisions.

As we see, with the provision, the investor may have the right to plugged in the subsequant deal with the prescribed portion. It’s important especially in down round, for the investor who has the shares of Series A Preferred can get more preferred stock in lower price.

If the provision is exerted, the securities would be converted automatically to a series of preferred stock. On the other hand, when it fails they will be converted to a common stock resulting in the loss of all preferential rights – antidilution protection, liquidation preference, Board seat and so on.

This is the second round to cover up the terms in term sheet. The main subject is about liquidation preference, which is concerned with the division of the value when liquidity event – the sale of the company or the majority of the assets – occurs. Notice that liquidation preference is not about control, but utterly about money. It consists of two parts – the actual preference and participation.

Actual Preference

The actual preference is specified with the number which is the multiple of the original investment per share to be returned to investors in preference to the common stock holders. For example, if a series A investor invests $10m with 2x preference, then he will receive $20m in return when the company is sold. Occasionally the number goes higher than 1x, but in most case it is set to 1x.

Participation

Participation is another significant term in liquidation preference. It determines how the money shall be divided and delivered to investors. There are three options in participation.

• Non-participating: It is easy to calculate. In non-participating, the investor gets the pro rata amount of investment. For example, if the sale price is $100m and the investor has 40% of equity with $20m of original price, then the investor will get $40m, or 40% of $100m.
• Participating: Participating increases complexity on the event, yet the concept is simple. The investor may get the original investment price first, and then do calculation with the rest of the money. In the above example, in participating, the investor takes $20m – the original invement price – first and takes 40% of the rest of money, which is $32m or 40% of $80m. So the investor takes $52m in total.
• Participating with cap: Capped participation is a condition statement which indicates that a certain multiple return shall be reached. When the preferred doesn’t reach the cap, the fully participation is applied. See the example again, assuming that the contract is in participating with a 3x cap. As the return ($40m) doesn’t reach the cap ($20m x 3 or $60m), the result would be the same as the participating case. If the purchase price goes up to $200m that it makes better than 3x, the participation doesn’t happen.

Participation makes the deal more complicated because the other fundraising may follow up inevitably. Thus, it’s always better to simplify the liquidation preference especially in early days of business. That is, the entrepreneurs should choose the non-participating option for the future deal.

Term sheet is the primary sentences for the start-ups as they need money from investors. And not to be confused or sneaked by VCs(venture capitalists), the entrepreneurs should keep the terms fully understood. So I share the description of the terms in a series so that the beginners can get the overall terms of term sheet. Today, we’ll see the price and option pool.

Price

Price is the very basic unit of the deal as it is a measure of the valuation of the company. To get into the notion, we need to understand the terms ‘premoney’ and ‘postmoney’ because the investors’ mentioning the valuation would determine the actual value of the company. Premoney, usually called  ’pre’ in short, is the valuation before the investment whereas the postmoney is the valuation including the investment amount.

Let’s see an example. If a VC says, “I will invest $5m at a valuation of $20m,” it usually means the postmoney valuation. As a result, the investor will get 25% of equity – $5m portion of $20m. On the contrary, when the VC clarifies the valuation as premoney, then the VC gets 20% – $5m of total $25m postmoney. So do the math before talking about the price.

Option Pool

There’s one more thing to consider: option pool. Option pool is the equity reserved to compensate the employees, so it is also called as the employee pool. It is important because the entrepreneurs’ share would decrease relative to the increment of the option pool. In the above example of postmoney valuation, suppose that the entrepreneur sets the option pool to 10%. Then what if the VC requests to scale it up to 20%? The VC’s portion doesn’t change though, the founder would hold reduced portion of share, which is 65%, 10% less than the original portion if the request is accepted. Thus, the option pool should be considered if the VC tries to touch this.

There are many other economic terms like liquidation preference, warrants, pay-to-play, vesting and antidliution in term sheet. I will compact the description of the terms into the summary as if I posted here today. Next time we’ll see the term, liquidation preference.

Suppose that you heard a news from a friend that new iPad3 design and specs are leaked. At first you may wonder it’s true or not because you know that iPad2 launch day was just a couple of weeks ago. After a while another friend tells you the same story, and then it becomes a fact. You’ll soon enter “iPad3″ into Google search bar. The point is, just 2 or more friends make you believe something.

We trust search result from Google or Wikipedia. Is that trustworthy? Many resources are on the stage but not guaranteed. And we, the irrationals, use the information for doing business. By abusing this trait maliciously, one guy can agitate the herd as the internet connects all over the world.

One good example of this is, so called, social engineering. Although the security system is completely safe technically, human is not perfect. If somebody exploits the vulnerable point of that guy who organizes the system, hacking done.

Ignoring irrational tendency is more risky than accepting the weakness. And I think being irrational is a part of risk management.

[ Dice gives us fun because it shows uncertainty. But dicey. ]

Success in business requires the satisfaction in myriads of views. But few thinks about the uncertainty, which motivates and accelerates the one. If you are not sure that the business works, you cannot affirm the employees to go on the way. And that would stuck in there. Never go further.

However, that kind of conviction is differ from the recklessness. I hope to share my opinion on how to distinguish the actual conviction from the brute courage. Please checkout the points below and reponse me for correction if needed.

• It should be sustainable. If it temporarily survives, it’s going with the temporary feeling. Intuition is quite different with the feeling that intuition is sustainable. Sustainability involves the financial
• It should be programmable. Without the programmability, the belief is just a pipe dream. It is the most difficult to figure out before kicking off the business so it needs the help from experts.
• It should require more opinions. The idea need to be shared so that you could know how other people are thinking about the issue. Maybe more possible options are not weighed just because you thought it alone.
• It should be scalable. The need in market can change. The scalability makes more flexible when the market changes. For example, people designing TV business like Google-TV should consider the usability of any other devices as well in case the future technology evolves and expands into other platforms.

Well.. lots of more things to consider. But here I suggested is the core values for business I think. And they are what I consider whenever thinking about new business. You’d rather trust your business with those equipped.

Sometimes go-getters miss that they should pertain their business. Without considering the point, the business comes to be easily in panic. People will surge in at a time (at first) and out soon after.

Then how could we take it into account?

Simulate it. Prototyping might help. Or offering to normal people would give you some responses about the business. There is bunch of ways to figure that out.

Usually good idea makes “ta-da” moment. But without sustainability, it could not aggregate the fortune. That is, it is not profitable at all.

Popularity is a different kind of matter. Popular people don’t need to be skillful. Yet many followers may tell us the reason why they are popular, those bids might not be correct. There are lots of guys who match the characteristics but are not popular.

Why, then, are they popular? It is a conundrum for marketers. They usually ask, ”We furnish a great service with no charge but people don’t use our service. What’s wrong with that?” Again, popularity is totally differ from skill.

Then how could we make something popular? Well.. there’s no magic formula but there are some prerequisite. The quality of what you serve, trust and attractiveness. Remember that two of those are emotional. Even the bad quality could give a negative effect by making people furious. Human things are one of the most difficult things to control as emotion is amorphous. Getting more skill is good. But that’s not crucial for popularity.

Otherwise, the distribution system dealing with such products gets the evolution. Now we have more elegant transportations: car, ship and aircraft. And the prevalance of internet accelerates the process.

You’d rather not miss it! Transportation and internet tech don’t belong to any categories I’ve mentioned at the top of this article. What I intended to say is that daily necessities don’t greatly depend upon its content. It is certain that consumers may prefer something to other things, though, various kinds of foods, clothes and houses are affluent and have no scarcity; that is, no innovation available in themselves.

The virtue of those is that the market is stable so many restaurants, clothes shop and house distributors start up their business. Hoever, no big risk returns neither big fail nor big gain. Personally I’m not interested in this kind of market as they have no evolutionary change. If you want the change, then think about mixing those categories with other industries like web service and new delivery system. When you run the business of daily-used product, you may as well experience the whizzy matters to get an insight for expanding the business. And it will give you more gain than only delivering stable stuffs.

[ Little by little, mentos has gone ]

On the other words, the innovation itself should be evaluated regularly. I call it meta-innovation; the innovation of innovation. Surely some innovation could go to disaster. Some may not be realistic or not be profitable. There might be many exceptions which are not predictable. So the meta-innovation matters.

Meta-innovation should be shown in perspective. It’d rather see the past innovations in the view of critisicm. No compromise, no making any excuse. Such analysis would give the insight for another innovation and that could effect that much. It seems like the relation between acceleration and velocity. Velocity influences the motion of an object and acceleration pitches a little tweak toward the final object which is moving.

No wonder that there is a strategy of innovation and it is able to make something up. And the control is the main idea of meta-innovation as outpaced object is terrible sometimes. So, I suggest a cycle of innovation and meta-innovation: 3-innovations per 1-meta-innovation. Besides, the innovation should at least be conducted in every 3-month. Is it so often? My opinion about it is this: 3-month is too long to overtake the speed of change in business world. Remember, the world changes quickly than ever and there needs the acceleration on the way.

Today’s virtualization technology is brilliant. One great example is cloud computing. It reduces the cost incredibly by virtualizing physical machines to the cloud. The idea of on-demand option is a name of green for it saves electricity from power plants which uses fossil fuel and so emits carbonized materials. Manufacturing time table is simplified by adopting virtualization as well, in that way. How about online market? It virtualizes the real market on the web. That decreases the use of transporation which causes air-pollution. In the top of virtualization, there is a GREEN.

Virtualization has another effect. It cuts the total amount of task eventually. It seems like a negative one as less task cuts the workforce and somebody will lose the job. But you know? Money is also a kind of the result of virtualization. And that makes the gap between the rich and the poor though money is considered as a great invention in history. In my humble opinion, virtualization matters when it comes to the innovation. There are always pros and cons in healthy society. New idea may come from the discussion and development.

In the bottom line, virtualization is quite nice and cool. The future technology would hugely depend on the category that foreseers may already recognize the flow of. Do you have any idea on that area? Make it change the world!

How great leaders inspire action (TED)
It’s a wonderful talk about leadership. Starting with WHY-thinking is enough to inspire people including managers, employees and customers. Beyond the archetype of standard manager, leaders may innovate business and operation while the colleagues willingly participate in their journey.

Let’s think about the rule which benefits the workers like an incentive. That would motivate the workers to achieve their goal (or not). Then, how about removing the incentive? Demotivation would be the crucial return. In perspective of executives, incentive is not must-be matter but is just a tool for high-performance. This kind distinct of view on rules delivers collision sometimes.

Beneficial rules would be greeted. On the other hand, these rules cannot be ceased easily because of the effect I wrote in the middle. It does not mean that incentive-like useful rules should be eliminated. Rule-maker should be considerable for both the positive-side and the negative-side when making new rule. I’d summarize the methodology here to check out before proclaiming the rule in public.

1. List the advantages of the rule (score it from -10 to 10).
2. List the disadvantages (score it from -10 to 10) when it is suspended .
3. Let’s set advantages as A = { a1, a2, …, an } and disadvantages as D = { d1, d2, …, dn }.
4. Let’s set the weight of advantages and disadvantages as W = { w1, w2, …, wn }.
5. Calculate the total effect of advantage and disadvantage.
   That is, Ea = (A*W) / W, Ed = (D*W) / W.
6. Let P be a period of day which the effect lasts.
7. Then, check out that Ea > Ed / log(e, P) where e is a constant of periodic depreciation.

Then setting an example would help to understand. Let’s think about INCENTIVE again. Here are the lists of advantages and disadvantages with weight.

• It will motivate people to work hard. (advantage 8, weight 6)
• It will raise the loyalty to the company. (advantage 2, weight 5)
• The expense would be increased. (advantage -4, weight 2)
• It will demotivate people if incentive has gone. (disadvantage 9, weight 6)
• They will think that the company is in a hard time and may lose their loyalty. (disadvantage 5, weight 5)
• The expense would be decreased. (disadvantage -4, weight 2)

Suppose that the incentive would affect people for 3 months. Then P = 90. Finally, the following is the result.

Ea = (a1*w1 + a2*w2 + a3*w3) / (w1 + w2 + w3) = (8*6 + 2*5 + (-4)*2) / 13 = 3.84
Ed = (d1*w1 + d2*w2 + d3*w3)/ (w1 + w2 + w3) = (9*6 + 5*5 + (-4)*2) / 13 = 5.46
Ea is bigger than Ed / log(10, P) = 5.46 / 1.95 = 2.8.
Then, this incentive should not be deprecated.

Sometimes, thinking differently guides us to a great solution. And I thought about a HR solution which looks gorgeous (and even a little quaint). The point is to reduce the number of positions and to separate payment system from the hierarchy system. The following is a kind of model.

• Grand Master Directors who get key role to determine the direction to go.
• Master Managers who share the vision of the organization and leads members.
• Member Assistant managers or senior staffs who participate in all kinds of work.
• Apprentice Staff members who support Members with their immature skills.

Peter Drucker, the pioneer of contemporary business management, said that “Rank does not confer privilege or give power. It imposes responsibility.” I totally agree with it. Too many stages will loose temper and can demotivate to be promoted. Somebody emphasized that every employees should have entrepreneurship and more horizontal relationship at work would vitalize it as they might feel that they are one of owners of enterprise.

You may urge that there’s no success from this model. Yes, it’s true. But today’s agile movement entails a very change at this moment and rapid adjustment is a great benefit in IT management. The flatter the hierarchy is, the more power the dynamic invokes. My point is that, not the model itself.

Other opponents may say that there is no incentive matter at all. But that is why I firstly said that payment system should be splitted from ranking system. The payroll cost would be increased when the member showed an incredible outcome. That is, the incentive system is required here. And that’s enough to inspire people to concentrate on their work.

Another problem would be compatibility. Most ERP systems contain HR management system and they are based-on the currently prevalent HR system. But that’s not big trouble as many ERP systems are established with flexibility. And then, how about M&A? Different hierarchy system confuses the merging process and increases the cost. In that case, substitution table would help. For example, Master with 3-year experience can be matched to Senior Manager.

Problems always exist. Focusing on efficiency may cause other problems. Then it’s time to think about the balance. Current HR model would be better? I am afraid I don’t think so. By adopting advantages of original model, this new model would be extended further. And I think it is a good try to construct new HR system because it helps to think about effectiveness in human things.

What is our purpose for existing?
Who is our target customer?
Why does anyone need what we’re selling?
If there is a need, is it enough to support a profitable business?
What were our competitors up to?
Can you reduce expenses–without harming the product?
Do we have the right leadership?
Do we have the right employees?
How will we continue to drive revenue?
How are your employees holding up?

I summarized a posting of 10 significant questions from Marc Kramer, author of five books and instructor at the Wharton School at the University of Pennsylvania and the National University of Singapore. Continuing to ask these questions would prevent the company from oblivion of the propriety and from deviation. If you want to know some more about the subject, details would be here.

Focusing on the market cannot be over-exaggerated but this fundamental principle is often forgotten. And the market should be related with customers closely. Some may urge that inner-complexity and outer-simplity would cover the problem, the distinct between the customers and the complicated technology. That is, sophisticated procedure should be hidden behind the simple interface. I totally agree and even want to advocate something more.

Human evolutional process is too slow to get in touch with the exploit of new technology area. One of the good example is 3-dimensional graphics. Myriads of people have less capacity to embrace the 3D environment even though 3D world itself looks so fantastic as the effect is similar to the real world. That’s because the world is controlled by input device rather than operation from body itself. It would be a difficult condition to manage the 3D object with such an unfamiliar way.

Again, with no professional use, simple thing is always good. But simplicity should lead itself to convenience which reduces the gap between complex process like calculation and judgement, and human brain.