The following is a memo that David Henke wrote in 1998. It was a formative article for me and has helped me make serious decisions about my career and where I chose to work. I asked him if I could reproduce it, since I couldn't find it online, and he obliged. Here's what he had to say about it...

I wrote this memo in 1998 for engineers leaving Silicon Graphics to the internal newsgroup sgi.bad.attitude. Naturally it leaked to the Internet where I received thousands of emails like:

1. I read your memo and did not join the startup.
2. I joined the startup even though I read your memo.
3. I wished I had read the memo before I joined the startup.

It's a pleasure to have his permission to post it. I've edited it lightly for formatting. Please enjoy! - Bill

I. Introduction

I have given the following speech many times, very often in a re-recruiting effort for engineers in my current company. I have founded two software startup companies, one mildly successful, and one a disappointment. As with any advice from any one but your Mother, take it or leave it.

Buena Suerte -- David Henke

II. What the Venture Capitalists Are Looking For, so Should you

1. People
2. Technology
3. Market
4. Financing

If there is a red flag in ANY of the above categories, forget it.

1. People

a) If your gut (or someone you trust) tells you that ANY ONE of the Founders is a bozo, forget it and walk away. They will take you and the company down.

b) Also, look at the track record of the Founders. If there is a history of failed startups, walk away. I was asked to join a startup where one of the founders had been in 5 previous failed attempts. I sense a pattern here. Some people believe you learn from your mistakes. I believe you learn from your successes, and successful people try to apply successful techniques to tackle problems in other domains. In a startup, there are thousand ways to fail, and only a few ways to succeed. Even if I learn from my previous mistakes, there are still a lot of ways to fail, and only a few ways to succeed.

2. Technology

a) The technology must be viable to build your solution. There are numerous cases where the "product" is ahead of its time. A good example was Gene Amdahl trying to build "wafer-scale-integration" at Trilogy, a $100 Million drop in the proverbial bit-bucket.

b) Also note that the word "product" is quoted above. You are typically NOT selling technology, you are selling products and services == solutions. Many people do NOT understand this distinction. I didn't. Customers DO.

c) Also, make sure you have a technology edge, that is either patentable or very hard to duplicate. Too often it is not the first one in the game, but a follower who does a better job at building or marketing the product. Visicalc was the first spreadsheet, but Lotus was the one that cornered the market. MANY Internet businesses have low cost of entry, but can also be duplicated in a short amount of time. How many search engine companies are there? How many yellow page directory services companies are there? How many of these will survive in the long term? When your technological edge evaporates, it comes down to marketing and branding.

3. Market

a) While seemingly obvious, knowing and understanding your market/customer base has baffled numerous ventures over time. A good example was pen-top computing, where millions were poured down the drain, and no customers were willing to pony up. "Momenta" (remember them) had people, technology and plenty of financing (40 Million), but no market.Today, many of the Internet startups face the SAME dilemma. They are rushing to the mines looking for gold. Most will drop out along the way.

b) Competition. What is different about this company and its competitors? The classic line you will hear is, "We have no competitors." Do not believe this. Only Microsoft has no competitors. Venture capitalists perform "due diligence". So should you.

4. Financing.

You want to make sure you have enough money/resources to build AND market your solution. Many companies have gone down simply due to lack of funds. Another common problem is the unexpected second, third, or bridge financing which keeps your company afloat, but typically comes at a high dilution factor. This is never good for your morale. Make sure you know, up front, the financing AND business plan. For example,

a) How much money does the company have in the bank today? b) What is the burn rate (rate at which company spends per month)? c) What is the revenue model? d) When will the company run out of money? e) When will the company break even? f) When will the company be profitable? g) Will there be a second round of financing? h) What is the valuation of the company today? i) What is the valuation of the company on the next financing?

III. Venture capitalists

1. Clearly these people are a different breed. They drive expensive cars, spend other people's money, and can destroy your dreams in a microsecond. On the other hand, they have the money, and hopefully much more.
2. Like any other group, there are good ones and bad ones.
   a) Never partner with a venture firm that ONLY wants to invest money.
   The only exception to this rule is you are SURE that is ALL you need from them, AND you can cut a much better deal.
   b) A good venture capitalist will help you:
   • open the door to potential customers
   • help you create strategic partnerships
   • help you find senior management
3. Its not what you know, but who you know. This is clearly a "good ole boy's network." It HELPS to know someone. These guys must wade through hundreds of business plans. Do not go in the front door. Use the back.
4. They talk to each other. NDA's (non-disclosure-agreements) do not prevent them from talking. Only greed can do that. The only reason a venture capitalist will keep his mouth shut is if you are a HOT ticket and YOU are the best vehicle for delivery. Do not trust these people.
5. All venture capitalists care about is ROI (return on investment). Their favorite trade-off is risk/reward.
6. If you are joining a startup, ask if you can talk to the senior investors/venture capitalists. Be sure to ask them the following:
   • What are the biggest risks facing this company?
   • What attracted you to this startup?
   • What is YOUR expected outcome?
   • What have you done beyond financing to insure the success of this company?
   • What are the financing plans?

IV. Outcomes

What is the expected outcome of the company?

1. Privately held company
2. IPO
3. Acquisition/merger

Ask the founders about THEIR desired outcome. You will learn a lot about their motivation in the answer. Some want to build a long-lasting enterprise with quality products and services. Some want in and out with as much financial return as possible in as short a time as possible.

Some want to have fun (I will go into this later). Make sure your goals are aligned with their goals. Otherwise, they may attain their goals while you are left holding the bag.

V. Why Are You Joining a startup?

1. Stock Equity

It amazes me that engineers with the ability to build complex systems can be so bamboozled when it comes to "stock equity" in a startup. So, here it is. I will offer you 50000 shares in my new company. I am hoping we go IPO in two years at 20 dollars a share. You're a "smart" engineer. You figure 50000 shares * $20/share. WOW! ONE MILLION DOLLARS. I'm a millionaire. Where do I sign?

Calm down.

Take a breath.

Start asking questions.

a) What percentage of the company does 50000 shares represent today? b) What is the value of the company today? c) What expected dilution will I see in my percentage in the next financing? d) What is the expected valuation of the company in the next financing? e) What is the vesting period for my stock? At what price?

Another interesting discussion revolves around the proverbial IPO price of the company. When the Founders offer you 1/2 of 1 percent, and then tell you the company will go public at 200 Million dollars, they did NOT pick that IPO price out of a hat. They know you will multiply .5% times the 200 Million and come away with that magic number again, 1 Million dollars.

Here is what YOU need to do.

Perform an expected value calculation on possible outcomes for the company.

Break down possible outcomes by percentage and valuation, multiple them out, add them up, and that is the expected value for the company. (The percentages should add up to 100%). Then multiply THAT result by your percentage to see what YOUR expected value is.

Wait!

Be sure to halve that number, because you will undoubtedly be diluted by at least a factor of 2. In my first company, I started out with 17.0%, and ended up with 0.75%, a 22.66 dilution factor. Clearly not the desired outcome. Finally, don't forget the "WHEN" factor in your equation. Will you get your windfall in 6 months, 1 year, 2 years? Depending on inflation and expected returns on investment, being given X dollars today has a significantly higher present value than X dollars given to you two years from now (assuming you don't drop it at the craps table).

Here is an example of an expected value calculation. Your mileage may vary.

Okay, now your expected value for the company is 43.5M (M=Million), not the 200M the startup President was quoting you. You were given 1/2 of 1 percent which got diluted by a factor of 2. So YOUR expected value is 43.5M * .0025 = .108M.

One more thing -- don't forget that you will be taxed on the sale of this stock. So after taxes, assuming you hold out for long term capital gains tax at 28%, that's a whopping .72 * 108K = 78 thousand dollars. Wait a minute, that's 78 thousand dollars after 4 years of vesting, not the 1 million dollars you were "promised" during your negotiation.

What happened?

Another model for valuing your stock (often used in a fast growth public company), is to measure the value of your options as if you owned them, look at the growth of the company, measure the value in 4 years, and then subtract the two. For example, if you have 25000 shares of YAHOO at the option price of 80/share, this equates to 2 Million dollars of Yahoo stock (remember, you're option strike price is still 80/share so you won't make anything if you exercise and sell today).

If YAHOO grows at 20% compounded annually and your stock reflects that growth, your 25000 shares will almost double in value (do the math, (1.2 * 2M) after 1 year * 1.2 after the second year, and so on). 4 Million -- 2 Million == 2 Million looks pretty good. But this relies on a very simplistic growth to stock price equation, and does not necessarily take into account high premiums already built into the stock price.

2. To Have Fun.

I have heard this many times. I even failed a job interview because the VP of Engineering wanted me to say that "fun" was an important part of why I wanted the job. It may be true for you. It is NOT true for me. Fun is playing tennis, guitar, drinking beer, fishing, (and perhaps a few other things). Working 24 hours a day, 7 days a week, is not fun, at least not in the long run. It is simply hard work, which has its own reward.

3. To Have More Control AND Focus

No argument here. As one of a small number, you have a great deal of impact on the outcome of the company. There is usually far less politics and bureaucracy in a startup. There is simply no time to waste. You will focus your entire energy on getting your product out. There is definitely satisfaction in this type of work.

4. Does the Startup Fit Your Personality, Lifestyle, Financial Situation, and Career Goals

a) Your role. You may be asked to do many different tasks in a startup. If you like multiplexing, good! If not, this may not be for you.

b) Stress. There is always a sense of urgency. While this can be exhilarating, it is also stressful. You screw up, there may not be a second chance. Every day is an adventure, full of promise and pitfall. If you like a steady, supported environment, this is not the place for you.

c) Your time. You WILL work longer hours. You WILL spend less time with your family. It is an interesting dilemma, because you are sacrificing the present for a chance to buy your time in the future. I was offered a position recently where I thought I had a shot at 2 Million dollars. My wife asked me, "Is 2 Million worth the time TODAY away from your children". Naturally I said no to her, but in my head, well....

d) Your financial situation. If you are living paycheck to paycheck, mortgage to mortgage, this may not be the place for you. While ANY job is at risk, startup jobs are more prone to delayed paychecks, firing, lay-off, or simply going out of business. I worked for 1 year with deferred salary in my last startup. This was never recovered. Not that it mattered too much, since we paid each other 55K/year during that time.

e) Career choices. Question to ask yourself include:

• What do I want out of life/my career?
• Where do I want to be in 2, 4, 6, 10 years?
• What sacrifices will I need to pursue a startup?
• Is this the appropriate point in your career for a start-up?
• Is the chance of making money at a start-up NOW worth not waiting for a better chance in the future?
• Will the focus of the startup prevent me from staying ahead of the broader technology/market curve?
• Am I doing this for the money only?
• Will I enjoy the work itself?

f) Have you looked around. This is one that also amazes me. It is like the famous mathematical problem entitled "The Secretary Problem". You need to hire a secretary. You can interview any number you like. How many should you look at before you decide. Obviously 1 is not enough (he/she may be the worst candidate). But as obvious, 1000 is too many, far too impractical. Many people pick the first one that comes along, largely because they know someone, AND it is "better" than their current position. Remember, the startups NEED people like you. Give yourself the opportunity to "look around".

VI. Futures/Conclusion

In a follow-on, I will provide you with a handy-dandy set of metrics for "quantifying" and "researching" the various issues involved in your startup evaluation. I will attempt to help you answer questions like:

• How do you arrive at your percentages and values for your expected value calculation?
• How do you use the historical startup information to gage your new opportunity?

Unfortunately, this is a little like using the last weeks football scores to determine this weeks betting spreads.

• What is the likelihood of future financing rounds and subsequentdilutions?
• How do you find out about competitors?

I will produce a calculator/spreadsheet (Java applet, what else) to assess your chances, factoring in:

• current financing
• burn rate
• predicted delivery dates
• market ramp
• various certainty factors

I have not figured out how to factor in LUCK, but it definitely plays a role!

But when all is said and done, trust your gut and know thyself!