On today’s episode, we have Scott Orn on the show. Scott runs Operations at Kruze Consulting, a fast-growing Startup CFO Consulting firm that works with over 160 startup clients. Kruze is based in San Francisco with clients in the Bay Area, Los Angeles and New York. In addition to his Operations responsibilities, Scott runs the Venture Debt Consulting practice at Kruze.
In his spare time, Scott publishes the Founders & Friends Podcast, which interviews Startup CEO’s, Investors and other service providers in the startup ecosystem.
Before Kruze Consulting, Scott was a Partner at Lighthouse Capital, a private debt fund that lends to startups. In addition, Scott ran Community Products at Callisto Media. Prior to joining Lighthouse, Scott spent three years in Technology Mergers & Acquisitions at Hambrecht & Quist which was later acquired by JPMorgan Chase.
Scott has an MBA from Kellogg, and an undergraduate business degree from CAL Berkeley. He also has a CFA and has passed the Series 7.
In this episode, you’ll learn:
- How do companies get into trouble by having sloppy financials?
- What are common tax mistakes that startups make?
- When should a company bring in a CFO consultant?
- What are some stories from Venture Debt Consulting with startups?
- What is it like to grow a company while at the same time becoming a new parent?
Connect with Scott Orn
- Connect with Scott on LinkedIn and Twitter.
- Kruze Consulting
- Founders & Friends Podcast
https://linktr.ee/ShawnflynnSV
- Shawn Flynn’s Twitter Account
- Shawn Flynn’s LinkedIn Account
- Silicon Valley LinkedIn Group Account
- Shawn Flynn’s Facebook Account
Pre Intro (00:00)
You’re listening to the Silicon Valley podcast on this week’s episode of Silicon Valley.
We sit down with Scott Orn, who runs operations at Cruz Consulting, a fast-growing startup CFO consultant firm that works with over 160 startup clients here in Silicon Valley. Scott also runs the venture that consulting practice at Cruz. Before Cruz consultant Scott was a partner at Lighthouse Capital. In addition, Scott runs community products at Calisto media. On today’s show, we talk about how do companies get into trouble by having sloppy financials? What are common tax mistakes that startups make? When should a company bring a CFO consultant in? Stories from venture debt consulting with startups. And what’s it like to grow company while at the same time becoming a new parent? This is much more today’s episode.
Intro (00:45)
Welcome to the Silicon Valley podcast with your host Shawn Flynn, who interviews famous entrepreneurs, venture capitalists and leaders in tech. Learn their secrets and see Tomorrow’s World Today.
Shawn Flynn (1:03)
Scott, thank you for taking the time today to be on Silicon Valley.
Scott Orn
Thanks. It’s been a blast getting to know you and I’m excited to tape the new podcast.
Shawn Flynn (01:11)
Scott, tell me a little bit about your career up into this point.
Scott Orn
I started my career in 99, which is 20 years ago, which is makes me pause for a second. But I did tech M&A for three years at Hambrick EnQuest, which acquired by J.P. Morgan. And they really kind of the godfather of Silicon Valley Tech IPO and M&A like they took Gentech public and Apple public and Netscape public. And I worked on some really great deals there meant a lot of great people. And then I went to a place called Lighthouse Capital, which is a venture capital fund that lends money and takes equity alongside that. So, kind of unintuitive, weird business model, but actually really worked. And I worked from analyst to partner, did about one hundred million dollars of the deals that I sourced like Angie’s List and Upwork and possible foods and screen Lilly and had a great run there. And then I watched my wife was doing my shoes, was actually my girlfriend at the time, she had started an accounting and tax firm for startups, is called Kruse Consulting. And I watched her from day one. She had been a Deloitte tax CPA and a controller startup, but she got the 60 clients by herself. And I was like, oh my gosh. It’s kind of like when the rules of life as you want to either found something if you can or get behind a really strong founder. And so, I did Number two, which is get behind a really strong founder. So, I joined her as the third person. And now five years later, we are 70 people big at the Kruse. We have 220 clients, all startups. It’s been a great run. And now I feel like I’m probably like you. How you’re just kind of maturing as a professional and really kind of have, like, your full complement of knowledge plus experience. You’re kind of hitting your prime. That’s how I feel right now.
Shawn Flynn (02:41)
Thank you for aging me right there. But Kruse consultant, its CFO consultant firm. What do companies start to utilize?
Scott Orn
They use us. The classic is two people and a seed round, maybe 500K, a million dollars, two million dollars. And they’ll find us, and they know that they need to set their systems up like payroll benefits, accounting, bill pay, all that stuff. And they also want to make sure all their taxes are taken care of. And these are the founders are really thinking ahead of the professional founders because they know once they take VC money, VC wants compliance. They need to know what you’re spending your money on? how long it’s going to last? And they also don’t want you to, like, mess up your taxes or let your Delaware franchise tax go long and also and lose your corporation status. Things like that. So, VC kind of exert a positive pressure on the startups to be in compliance and do things the right way. And so that’s why most companies come to us is like a two or three-person company. We do get a lot of like series A, Series B slightly later, stage 20, 25 people companies. So, it’s probably 75 percent or seed, 25 percent are A and B, but those seed companies grow over time. And we typically work with them for like four years. So, all suddenly in the blink of an eye. Next thing you know, this company that came to you is two people. All suddenly has one hundred employees and there’s one hundred and fifty, and that’s two hundred. And they’ve hired a CFO and a V.P. of finance. And we’re transitioning to their kind of in-house accounting and finance. But it’s a really rewarding journey to be on these companies because, you know, like, oh, my gosh, this person three years ago had really no idea what they’re building. They just had to look a little dream on a napkin they’d written out. And also, now they’re employing one hundred and fifty employees and changing the world’s really cool.
Shawn Flynn (04:18)
It was interesting, you used that term professional founders. Can you talk a little bit more about your definition of a professional founder and also could you talk a little bit more if companies ever get in trouble for maybe having sloppy financials, maybe for tax reasons or anything in this growth process?
Scott Orn
Great questions. So, I use the term professional founders, meaning, like folks that are super serious. Take in an institutional investor money because again, the bar really goes up when you take institutional money. They have just a different expectation. So those bootstrap companies, you know, maybe take a little away a little while to find their way in the world until they get to that kind of like, hey, we’re going to do everything the right way, industrial strength and so, there’s a lot of founders who take money and know they’re just going to do things the industrial strength, perfectly accurate the whole way through. They’re not the people who forget to do two or three tax returns, two or three years of tax returns. We have tons of clients like that who also they take a little while to find their way and maybe were focused on building a product. But then they realized, oh, my gosh, this financial debt in the same way that, like technical debt piles up financial and tax. They’re like not doing your tax returns really messes up. And not being able to give the investors actual financials when they ask for it reflects poorly on you. And so that’s when they come to us. It’s kind of like we’re all we’re all learning as we go an entrepreneurial ecosystem. And a lot of folks just need to learn sometimes the hard way that like, hey, you got to do the stuff the right way or else they’re ramifications. And so that’s what I mean by like someone who just wants to do things professionally from the start. In terms of the answer second question. Are there people who have felt the pain of not of having sloppy financials or not doing the taxes? Absolutely. And the way you feel that pain, it stinks. It’s usually when you get an inbound interest from a VC or M&A and everyone, you know, the people who procrastinate. I’m a procrastinator, too. You think like oh I have plenty of time to do my financials and catch up later or not a huge deal if I don’t do my taxes this year. But it is a big deal. But you think you’re going to have time to repair it before it matters. But in the law of M&A and venture capital, when someone sees something they like and they want to buy or they want to invest in it, they’re going to be very direct. They’re going to come to you. They’re going to approach you. And not having your financials in shape is a really poor reflection to the VC. Put yourself like Shawn. You’re the VC here. You want to invest in my company and you’re about to give me like a five million our term sheet for a series A and I can’t even show you what I spent money on for the last two years. Right. It’s like that’s a little rough. It’s hard. And it’s not just for that. That VC that VC reports up to a partnership in that partnership has five to 10 other partners on it. And so that VC comes in and says I really like this company. I like the product. But they don’t have any kind of no financial infrastructure. It’s going to give everyone a little bit of a pause. Right. So, the nice thing is we’ve evolved to be able to handle that. So, we actually get quite a few leads from venture capitalists who are like, hey, I’m just about to put money in this company. They need some help. It’s all the usual stuff. Can you help clean them up? And so we actually use the term cleanup for doing years-worth of financials retroactively and catching everybody up, then doing all the compliance repairs, like filing a couple years of taxes, although our franchise tax Chalfont in your franchise taxes, getting them in shape, doing 1099. So the good news is all this stuff can be fixed. It just takes some time and money. And that’s where they are there for. But you never get up for another chance to make a first impression. Right. And so, whether it’s a VC or even M&A is even kind of more serious, because when someone’s going to buy your company, they’re going to give you a term sheet. And almost always, unless you have tremendous negotiating leverage like another buyer right there, that number is probably going to be you’re going to try to negotiate up a little bit. But that buyer, once they get an internship, they’re kind of like looking for reasons to reduce the number because they’re saving money. Right. By reducing them or so. Retraining based on not having accurate financials or not having financials that kind of reflect what they’ve been told about the business is a very common thing. So by not having things set up properly and accurate in real time, you’re risking a retrade, which is like the worst failing as entrepreneur, because you’ve spent years and years and years building this company and then you’re so close to an exit and all sudden the price got reduced 20 percent and If you don’t have leverage, you may have to take that. You know, you may have to accept that offer. But oftentimes they’ll use the excuse of like there’s a lot of compliance. We can’t trust the numbers. And that’s how they try to retrade the deal.
Shawn Flynn (08:73)
So, Scott, how far in advance do startups need to say they have all these problems, they want to raise funding, go back, and start cleaning up safe, I’m going to raise funding from a VC. Is it going to take me three months to clean this up before I go raise money or more, six months before I go and raise funding? How far in advance do I need to clean this up or start to clean it up So it’s all ready by the time I have that first VC meeting?
Scott Orn
So, I’ll say prevention is the best medicine. And so, like, set it up day one, like when you start getting your financing in. Then I would just actually set it up then and do set up by your system, set up your cadence of all your tax compliance. That kind of stuff. If you have procrastinated a couple of years, then you’re probably going to need three months at least. Maybe that’s probably the bare minimum to clean things up. Sometimes comes a call. No, they’ll need something like in two weeks. That’s just not doable. It’s just too much work. And you also end up making a bad selection on your service provider. If you’re in a huge hurry, because the people who have bandwidth usually are people who aren’t that busy for a reason. So, you kind of want to, like I would say, always give yourself three months. But it just kind of going back to my last answer, like you think you have three months. But like then the inbound call comes in as a surprise. It’s almost always a surprise. So, it’s better just to plan ahead and get it done right away once you raise money.
Shawn Flynn (09:50)
Do you have any examples of what a startup went to raise funding and the deal went just sour, just bad because of it?
Scott Orn
There’s a lot of like general times where like the retrade, because the financials are not accurate, or the financial model isn’t what the CEO told the other CEO over coffee. Right. Like, that’s the classic ones. Like we’re going to do ten million dollars in revenue next year. And then and that’s the CEO telling the acquiring CEO, the acquiring CEO gets really fired up because everyone wants a fast-growing acquisition. But then the numbers come over and it’s seven instead of 10. And that’s the projection. So, like it gives in the acquiring CEO pause because remember when the acquiring CEO is signing up to buy this company, the acquiring CEO is putting their name on the line with the board. And if this doesn’t work out, they’re going to be in trouble, potentially even fired. There’s usually like a line manager or product manager who’s also like a business manager signing off on this because they think that this acquisition is going to really goose their group or their revenue. And so that person is if the company is once they’re bought. If that company underperforms on the financials, they may even have to do layoffs like they may have to get rid of their people in sympathy for this acquisition they signed up for. Right. So, like, no one wants to take burn on. That’s not predictable. No one wants to take a company or buy a company that isn’t performing. And so, these projections and these reliable financials are like super-duper important. Those are like kind of generals. I do have some really awesome stories of like minor. Is one company that they needed a bunch of tax compliance and they thought we were too expensive. And so, they’re like, no, I am going to do something else. And then two months later, the CEO called Vanessa, my wife, and our founder, like at five o’clock in the day and said I just got a term sheet from VC they ran a compliance check on us.
And it turns out we’ve lost our Delaware Corporation status, which is like the most basic thing. And so, the VC fund fine was like a top tier Sandhill Road VC fund, if I’m not going to name them. But like, can you imagine that that VC. It was named on a term sheet. And he’s like, we need to get all this fixed right away. And we’re like, we can’t fix it that fast. It’s like exactly your question. Right? Like, we cannot fix it in a week or two weeks. It’s impossible to do. And so that was a great moment for that CEO. And I think that company actually gone on to be successful. But it was like talking about getting religion and really kind of believing what you need to do and do things professionally. That was the moment for that CEO.
Shawn Flynn (12:07)
When something like that happens, whose fault is it on the team that they completely forgot to renew their Delaware’s or C-Corp.
Scott Orn
If they don’t have someone who’s doing this work for them, then it’s the CEOs. Because the CEO made the decision not to hire someone. In this case, it was the CEO decided he didn’t want to spend the money. And that was a decision he made. And that’s kind of like the role of a CEO to start up or any company is capital allocation. You’re making decisions all day long on what you want to spend money on and what you don’t want to spend money on. And so, it was his responsibility and he is going to have to tell VC that they lost their corporate status, When you lose your corporate status, like you don’t have a trademark anymore, you don’t. You know, it’s like a big deal. So, but anyways, yeah, it’s almost always the CEO’s responsibility.
Shawn Flynn (12:51)
So, companies, you know, normally either accelerated or dive bombing or at least it’s kind of how it seems in the startup world when they’re dive bombing is that when they’re typically missing their taxes? And how much more does this accelerate the problem?
Scott Orn
You know, it’s actually more missing your taxes, more of a symptom than a cause, I would say it’s a signal that there’s not enough institutional control and emphasis put on like having a healthy organization and healthy culture. So, when I see companies that are doing that, I know they need to make a cultural shift. A company Dive-bombing is usually dive-bombing because it raised a lot of money and the dogs are not eating the dog food. Or maybe they grew too fast, like you’re seeing with a lot of the soft bank companies right now. Like, they just they took something and tried to hyperscale it in a way that just wasn’t going to work, or it didn’t work. And so, there’s a lot of there’s a lot of money has been wasted. And so those companies usually probably had pretty good institutional control before, but then they tried to go to another level of growth and they couldn’t handle it, like the organization could not handle growing that fast and absorbing that much capital. So that’s kind of like the company, you have to kind of be careful what you ask for in terms of raising too much money and growing really fast, because most companies cannot handle that. It’s rare to have a Facebook that can actually like Mark Zuckerberg, how that plays together with tape. But he did it. Now they’re incredible. There are not too many companies that can absorb that. But one symptom of not having strong organizational control and culture is like really missing your financials or missing your projections or not doing your taxes, things like that.
Shawn Flynn (14:23)
Can you talk a little bit about what venture debt is and maybe some advice or best practices in that area?
Scott Orn
Yes, venture debt is a complement to venture capital equity. And so, the typical use case is a startup will go out and raise five million or ten million dollars in equity in preferred shares. And so those investors have put in money that doesn’t need to be paid back its equity. They own part of the company and a nice little complement that would be getting a little bit of extra money in the form of debt because it’s less dilutive to help lengthen the company’s runway. In the startup world, you’re all about hitting your milestones. So, when you pitch VC, you’re probably saying, hey, 18 to 24 months, I’m going to hit X, Y and Z milestones. So, for a SaaS company, you might be 10 paying customers for a consumer company. It might be a million users or something like that. There’s something that everyone’s going to look at and decide that this company is worth funding and the in the next venture capitalist are going to come in. Well, not hitting your milestones is really, really painful because the insiders have to keep funding the company, which they don’t want to do, or they may just throw up their hands and say, I’m not going to fund the company more. And it goes out of business. Right. So, if you’re a savvy entrepreneur and savvy VC, having a little bit of extra runway, a little cushion or insurance policy and the foreign venture, that’s pretty powerful. And typically, the terms on venture debt, there’s kind of two buckets of venture debt. But usually it’s you give up a little tiny bit of equity, like 25 basis points or 50 basis points in the company. So, kind of what you’d give like a director level employee at your company. So not a lot. And then you’re agreeing to pay interest and principal back over time to get the lender back their money into driver interest return from the lender. The lenders excited because if this turns out to be a Facebook or a really big one, then that equity, even though it’s not a lot, is going to be really, really valuable. So that the firm that did Facebook, WTI, I think made two or three hundred million dollars on two million-dollar loans, but that equity kick was so high that it made it made their fund. And so, there’s lots of stories like that. Google Juniper. We’ve done some at Light House, did some really huge ones, is really awesome. But you also are sometimes going to lose money as a lender because not all startups hit their milestones. Not all companies can actually raise an extra. So, some of those equity pops are also going to offset losses. But from a founder’s perspective, the great thing about it is it’s less dilutive than equity. You probably sold 20 percent of your company to get whatever amount of capital you just raise in equity. This you’re selling 25 basis points or 50 basis points. So very, very small amount. But you are trading off. The lender will have the senior lien on the company, so they get all their money out first before the investors get their money out and in before the common starts participating. And they’re going to just be a little bit less flexible than an equity investor would be. But and all in all, I recommend that companies do venture debt. And we can talk about some of the ratios. They should think about some pricing if you like.
Shawn Flynn (17:12)
Yeah, actually, I would like to tell you about that, but I’d also like to ask if they’re in first position with the league. What is the lean on? Is it on IP? Because a startup probably wouldn’t have many assets.
Scott Orn
That’s an awesome question. And you’re exactly right. Start-Up doesn’t have that many assets, but they are developing something interesting, intellectual property wise. And so, you will typically get a lean on all the assets. Sometimes the startups negotiate a what’s called the negative pledge, lean on the IP, meaning the lender doesn’t have the lean on the IP. But no one does. And so, it’s a little bit of inside baseball here. But when there is an asset that doesn’t have a direct lean on it, like IP in this situation, then when there’s a liquidation of a company and that company’s assets, all the creditors participate in the proceeds of that specific asset when they lean on it in a pro-rata way. So, say lender has two million dollars outstanding. And there’s another two hundred thousand dollars of payables like the gardener and the accounting firm and the bakery down the street that does the weekly cupcakes and whatever else you can think of that you might owe money as a company. Well, the total pool of unsecured creditor claims then would be 2.2 million dollars, two million plus the two thousand unsecured. And then that means that the lenders, the venture lenders would participate on a 10 to 11 percent rate, 10 to 11 ratios of the proceeds. So essentially every nine dollars out of every 10 on the proceeds that IP would actually go to the lender, even though they weren’t secured in that specific asset, because they’re going to be the biggest lender in the company by a lot Usually they’re still going to get most of the proceeds on an intellectual property. This is one of those ones where it’s like a lot easier when you’re looking at a spreadsheet and you can actually just see the numbers. But the big takeaway is the venture lender is going to benefit the most and by far the most from any liquidation of the assets far beyond any other creditor. And until the venture lender is actually paid back, the venture capitalists in their preferred equity and the common, which is usually the management team, the founders are not going to participate at all. So, you’ve got to clear that debt. But if you sell your company for five million, but you only you have five million dollars of venture debt outstanding, then the equity folks and the common equity are not going to get anything.
Shawn Flynn (19:27)
So then to go out to these banks and get the venture debt. Does the founder need board approval to go out and get venture debt? Or what do the VC think of this process?
Scott Orn
Great question. So, you do need board approval. You kind of want to be like a savvy CEO, right? You don’t want to just spring it on him at a board meeting. You’re going to start like kind of sanity checking this in the lead up to doing it. Like all good things, you know, you want to kind of presell it. And so probably when the rounds coming together, the equity round, you’re going to say to your Ventry couple, hey, do you mind if I get a couple million dollars’ worth of debt?
And as long as you’re asking for a reasonable amount. Meaning you’re not over leveraging the company, then the venture capitals are usually saying yes, because they can understand that a little bit of debt is actually pretty helpful because it extends the runway where the VCs don’t like it. And where they feel and I feel that companies get in trouble, is going to take too much debt. So sometimes I’ve sat in meetings where the fact that lender or even when I was a lender would ask, how much debt do you want? And the entrepreneur would say, as much as you’ll give me, which is like the most negative signal you could ever do. Now the entrepreneur and their head are thinking, this is my bet. I bet my life on this company, you know, not literally, but like the last five years of my life. So, like, if it goes to zero, I don’t really care. They want to maximize their upside and maximize the amount of runway they have. But that’s not like a really great way to signal to your partners, both the VCs and your lenders. And so, I always recommend something like 20 to 40 percent debt to equity ratio, meaning if you raise a five million dollar around probably two million dollars of debt is the right number for you. And there’s another kind of way of thinking about this, which is you really only want your debt to be worth three to six months of cash runway. So, if you start depending on the debt too much, it’s another signal that you’re over leveraging and all sudden you’re relying on lenders to not do anything funny or not kind of throw a wrench in the company. And so, you don’t want to rely too long on that. You don’t want, like a year’s worth of debt. And so, the cool thing about it is most companies raise 24 months of equity capital. And so, three to six months of debt runway would be basically equivalent to 20, 25 percent equity or debt equity ratio. So, by not over leveraged and company, you’re still maintaining control. The equity investors can always put more money in so that if something goes wrong, they can keep it going. When the comes over leveraged awesome equity investors don’t want to put more money in because they know that they pour money in. It’s just going to pay the lenders back. And so, you end up by over leveraging. You think you’re doing you think you’re being smart and optimizing your outcome as an entrepreneur, but you’re actually shortening your outcome because if anything goes wrong, there’s no slack. There’s no way for people to help you out. You just kind of in it. And so that’s why that 25 to 40 percent kind of debt equity ratio makes a lot of sense.
Shawn Flynn (22:10)
And then what type of interests is being paid on this debt?
Scott Orn
Another great question. This is awesome. So, there’s two buckets of lenders, there is banks and there are fund lenders. And so, the world kind of individual dividing into those two categories. So, banks are like Silicon Valley Bank, Bridge Bank, Park West, which used to be square one. And so, they’re ballgame. The game they play is they already hold your deposits like you have your cash in the bank. And so, they have a very low cost of funds like banks. Like what was the last interest rate you got on your checking account?
Shawn Flynn (22:44)
Probably zero. Probably zero.
Scott Orn
Exactly. Exactly. And so, their cost of funds is zero, which is a pretty awesome business to be in. So, for them to charge five or six percent interest rate, that means they’re making essentially before they lose money, anything with that, they’re making five or six percent like net. That’s awesome. Now, the other thing that’s powerful about controlling your deposits, your cash, is that there’s a term in lending which is called the right of offset. And basically, what it does is it lets a bank say, hey, we have five million dollars of your money in our accounts and you owe us five million dollars. So, we’re just going to offset that and we’re clean. We’re clear now as a startup, that’s like the worst thing of all time, because all of a sudden, all your million dollars is disappeared. But banks have the ability to do that if things go bad. Now, they wouldn’t be able to do that unless you are in a default stage, meaning you violated the terms of your loan. But the other thing that banks do is they put in terms like mature adverse change or investor abandonment. And they both kind of mean like if something changes in the company and the investor is not supportive, then that is a defensive default and then they can move to fixing things. And so, like a simple matter of a change might be, your CEO gets fired or the board withdraws or even I’ve even seen it. I don’t agree with this, but I’ve seen lenders changes when the market changes or goes down a lot. And so all sudden, the loan is effectively getting called at the wrong time for you as a startup the worst time. Investor abandonment clauses is pretty close to that. But it basically says if we call Shawn your investors and ask if they’re going to put more money in and they say no, then they are not supporting the company. And is an event of default. They have to put more money in when we ask them. And of course, you can kind of imagine the bank is only going to do that call when you’re running low on cash and spending their money. Like, if they give you five-million-dollar loan and you’re at a three million cash balance, so use that two of their million already. That’s when they’re going to make that call because they don’t want to lose more money.
They want to make sure the investors kind of top up the company if your investors don’t follow through. That denies the event of default. And then they can go about doing things like forcing you to sell the company or out of offset whatever. Now, banks don’t do that lightly. That’s a pretty serious thing for them to do because it hurts their reputation in the community. But they also don’t want to lose money. They’re federally regulated. So, for them, lose money is a really big deal. So, with all that said, you might say, why would I ever take money from a bank? Well, it’s really inexpensive. Of five or six percent interest rate with a little bit of warrants is like an incredible deal. You know, this is a money losing startup that’s borrowing like at what’s close to a mortgage. And so, it’s a really great deal. So sometimes when a company doesn’t really need a ton of money, I’ll recommend they take money from the bank because it’s not as reliable as taking money from a fund, which I’ll explain in a second. But it’s really cheap and it’s really good for dressing up your balance sheet and just giving you, like, a sense of comfort. So that’s the banks who lend money. Second category is fund lenders, which is what I used to work at Lighthouse. And there’s other ones like WTI. There’s a lot of fun lenders. They say, hey, I’m going to give a startup really flexible capital. I’m not going to have a mature over change clause. I’m not going to have an investor abandonment clause. So, you can actually use this money. Shawn.com the hottest startup around, can you use this money. Right. So, you’re like, great. I can actually reliably hire engineers and spend money on marketing. And I know the lan is not going to get called on me at the worst possible time. But the catch is they need to drive a much higher return. And so, because they’re investors, they don’t have the deposit base that’s federally regulated like a bank does. So, their investors are like ours are like M.I.T. and Clippers and varieties and pension fund, big, big pension funds or endowments that want a really nice return. And so typically, they’ll be somewhere around 11 or 12 percent interest rates. So, contrast, that’s about double as expensive as a bank. And they’ll ask for more warrants. They will ask for like 50 basis points to 75 basis points of company. But again, you can reliably spend this money. So sometimes I say this is I literally give this exact kind of speech to entrepreneurs. And I say, you kind of have to decide, are you someone who like shopping at Target, which makes great products at a very low cost. Or do you want to shop at Nordstrom’s where you’re willing to pay up. But you get a really nice jacket and you look great in it. And you can walk around town, you can rely on that jacket. And so that is the decision startup founders make. Typically, when a company really needs the money is really going to rely on it, I’ll recommend they go work with a fund.
Shawn Flynn (27:05)
You’d mentioned warrants. Could you talk a little bit about that and could you also talk about the market change and get in the money called, How much information does the bank, You’d mentioned that they know about your money in the deposit. But are you also giving them quarterly financials, quarterly information? How much knowledge is the bank know of you hitting and your milestones?
Scott Orn
Let me answer that one first and then I’ll go back to work coverage. So, the bank actually gets in any lender. They get monthly financials from you. They have a pretty good pulse of what’s going on. From a pure number’s standpoint, they also do usually quarterly update calls or meeting. So, they want to hear like what’s going on, what big customers did you sign, progress if other venture capitalists have inquired about leading next round. And then they have VC relationships. And if you kind of think about game theory, the venture capitalists have big portfolios. The banks have giant portfolios. Right. There’s like three or four big startup banks in the ecosystem. And so, the venture capitalist works with the bank over and over and over again. Whereas you as a founder, you only work with a bank like on one company over like five, eight years. Right. And so, the VCs have a vested interest in keeping the lenders, the banks, and the funds excited and happy to work with them. And so, they should, if they’re taking the long view, not want to pull the wool over the banks and give them a bad deal. Now, some do because they don’t think long term and they’re kind of desperate. And we can talk about why that would happen. But for the most part, the VCs are pretty good communicators with the lenders. And so, you can imagine the lender comes and meets with you, Shawn.com, and they see your financials, they see are burning some money, but they hear great things from you. And then they go check in with the VC and the VC is like, oh, I don’t know, Shawn.com not as hot as it used to be. We’re having some problems. So that’s contradicting what you just told them. Right. So I think one of the most powerful things about Silicon Valley and also in the New York ecosystem and in China, I think this is starting develop too, where companies have a vested interest in being a good actor and telling the truth and playing by the rules, because that helps you out a lot more than trying to hide bad news from someone, whether it’s VC or lender or even a future employee. The word gets around very quickly and you become labeled. If you’re someone who’s not, like, not a good actor. So that’s how the bank knows what’s going on. Ultimately, the lenders look, they’re kind of thinking of like when you start spending their money, the money they give you that five million dollar debt deal that they gave Shawn.com, When you’re like at three million, you spent two of their million. That’s when they’re getting really nervous. They want to see you raising a new round right at that point. They’re checking with you pretty frequently.
Shawn Flynn (29:31)
Whoever owns the domain Shawn.com,
Scott Orn
you’re going to make millions.
Shawn Flynn (29:37)
Any bump in audience this month, please link back to our show.
Scott Orn
Hopefully, the publicly traded stock going through the roof on Nasdaq right now. So, warrants are another word for stock options. So, people are pretty familiar stock options because they’ll read about Bill Gates or Mark Zuckerberg and how their options are worth billions of dollars. And really all on stock option or warranties is the ability to buy stock at a later time for a set price. And so, when you join us startup an early date, you get a really low stock option price because the company is not really not worth anything. So, you might get like a dollar a share, something like that. If you are fortunate to be at one of startups, actually can do an IPO and go big or get bought for a lot of money. You might get bought for ten dollars a share, something like that. So, all of sudden, you, as a founder, you’ve made nine dollars profit per share you could have bought in. The cool thing about an option or warrant is you don’t have to buy it right away. You can wait until it’s like in the money, meaning you’ve done the IPO, or the M&A events happen. That’s when you buy it. And so, it’s a really powerful instrument in that it gives someone a lot of optionality and a lot of value in that over a portfolio. Odds are a lender is going to have a lot of good companies that actually have equity or warrants or something. So, a warrant is another word for option, but it’s basically outsiders of the company. So, people are not in place. And so, a common warrant might say, for Shawn.com again, that that five-million-dollar deal, the lender might get the ability to buy five hundred thousand shares at a dollar a share in the future over 10 years whenever they want. And so, again, if Shawn.com goes public at 10 bucks a share, while that founder founders made four and a half million dollars profit, that happens a decent amount like it’s probably I’d say five to 10 percent of the lender’s portfolio has some type of equity profit. Now, sometimes it’s one times your money sometimes is two times your money. Occasionally it’s like a hundred X or thousand X, like a Facebook.
Shawn Flynn (31:25)
And you mentioned also some VC may not be thinking long term. Talk a little bit more about that.
Scott Orn
I think the vast majority of venture capitalists do think long term, and so they’re not incentivized to burn a lender or a key partner. But sometimes there’s people who start, you know, join the venture capital industry after doing a startup or they’re just not, like indoctrinated and all the processes and kind of the culture quite yet. And so, and they may only have like two or three investments. And they’re being judged in their partnership on the success of those two or three investments. So, they don’t have the full portfolio effect because they only get to make a certain number of bets. The fund probably does 50 investments or twenty-five or 100. So, the fund itself with all the partners has a lot of diversification. There’s a pretty good odds if they’re doing their job the right way, they’re going to have three or four big winners in that. But the specific partner only has two or three or maybe four investments. And so sometimes they’re desperate to try to save a deal going bad so they can try to help get it bought or something like that. But they also cannot get money from their partnership because the partnership knows the company’s not doing very well. That would be the circumstance. And again, very rare that someone would do this, but that will be the circumstance where VC would try to get a lender to basically give a loan to a not so great company. Now, again, there’s a lot of checks and balances because even the partnership knows if that company is going to go try to get debt and they may some of the senior partners may gently encourage the VC trying to prove themselves that they shouldn’t be taking debt and a company that’s not going anywhere. That’s going to hurt the company long term. They also know that the VC funds reputation is on the line with those lenders. And so, like you can imagine, if SVB does a bunch of deals with a certain venture capital fund and they’re all dogs, they’re just going to stop lending to that funds companies. Right. So, the partners do have a longer view, are usually going to coach that oftentimes younger VC. on how to kind of be a long-term actor and make sure they do the right thing for everyone in the ecosystem. But there’s greed and there’s temptation. And for the founders, some do try to get a lender into a company that’s not going anywhere because, again, this is like a very binary bet for them on their life. Like they’ve started this company. They put a lot of blood, sweat and tears into it, which I can totally relate to. And so, they want do anything they can to save it. But usually debt that is really not going to be able to save you. There’s just not a long enough runway to fix things. You really probably need to do like a recap and take more equity at a lower valuation and kind of get it going restarted again to get it going. Give yourself a long enough timeline.
Shawn Flynn (33:58)
You talked about that taking money at a lower valuation, because from what I’ve heard, that is basically the kiss of death.
Scott Orn
It is rare right now because we have been just like that, maybe the 10 greatest years of venture capital in a very long time. And so, companies that weren’t getting funded would typically just go out of business because the VCs would have a portfolio of higher performers. They want to focus on also that founder could probably get go get a job at a senior job at high performer and get a bunch of stock options. So, the rising tide that we’ve experienced the last 10 years has made it. So, there’s way less down rounds now when times get tough and you’re kind of seeing the Softbank companies, they’re having a really hard time. Those companies are doing down rounds. So, WeWork at a down round from I think it was like 40 billion to eight billion, for example. And so, what is really happening there is like the venture capitalism, the founders were sitting around saying this is still a good business. We just got ahead of ourselves on valuation and probably spent too much money.
So, let’s save the business. It can be right sized, but with that right sizing, we can’t have the same valuation expectations that we used to have, so, there’s something called a cramdown where all those preferred shares that have, you know, that made up that 40 billion dollar valuation are typically written off almost to zero or like a penny. The new money comes in and that’s a new valuation and takes new preferred stocks that the old preferred that was written down to a penny, is also written down a common. So, it doesn’t have a liquidation preference anymore. And so, the new money kind of like gets to write the new contract and write it all from scratch and kind of clear everything up. Now, that is very, very painful for everybody, because everyone who own stock at those high preferred valuations has to take a write off in their own fund accounting. And all the employees that exercise their options in anticipation of a big win are getting written down, too. So, they’re taking a loss. So, it’s really kind of like taking your medicine is not fun to do. But in the case, WeWork like we have an office that WeWork, we love, we work. It’s a great service. The valuation was just messed up. And so, it’s a really smart thing to do in those situations. But as painful, oftentimes they’ll bring in new management because it’s really hard for the old management to kind of get their head around it and also make those cuts. So that’s what happens if we go into a period of sustained kind of evaluations not going up. And it’s not as successful in the starting reasons. You’ll start seeing a lot more of those because everyone’s alternatives have gotten worse. The VC can’t invest in as many High-Flying stocks or doesn’t have as many High-Flying companies. So, they’re going to focus, try to get those ones that are mediocre out to an exit. Founders’ can’t just go join Amazon or Google and get a time of restricted stock and make a ton of money. So, they’re going to try to make it work. And so that is symptomatic of like tough times. So, like in 08, 2010, you saw a lot of down rounds, a lot of recaps, but a lot of those guys actually did really well. They just needed more time and either reset the valuations.
Shawn Flynn (36:44)
So, before you worked at an investment bank called Lighthouse Capital. What was it like to be an investment banker?
Scott Orn
So, Lighthouse was the venture lending fund that I worked at was a venture capital fund that did debt and equity. The M&A world. I worked at Hambrick Quest that was acquired by JP Morgan and that was super fun, although I was like classic low man on totem pole. Awesome. First job out of college. And I had the privilege of working on an on a huge merger. Network Solutions, the very sign, which was like a 40-billion-dollar merger. A little bit of play money because I was on the top. I think literally to the day top of the Nasdaq in 2000 when that got announced. But I got to work with amazing manager teams. And I also got to see, like the head people at our firm, Dan Case, Paul Cleveland, David Goldman, who are just like some of the best M&A bankers you’ve ever seen in your life, work their magic. And so, I got to not just learn a bunch of skills like how to do financial forecasting and DCF and accretion dilution models and comps and things like that, but also got to see how to be a professional. And I got to sit in with them on meetings where they talked with the clients. I got to see the culture they built H and Q was a super entrepreneurial culture. People don’t usually associate investment banks with entrepreneurship, but there was a very entrepreneurial place. And so, I took that. I’ve taken that through all my jobs. And it was really I was really blessed, and I was a great start. So if you’re listening to this podcast and you’re in college or you’re starting your career, getting into a position where you can see a lot, lot of different things and work with a lot of great people, that that’s what I would focus on. It doesn’t really matter if you’re working at a company or a service provider like a bank or consulting firm. Just find somewhere where you identify with the people. We identify the culture and you’ll see a lot of stuff and then good things will happen.
Shawn Flynn (38:25)
At a more personal question. You’re a new parent now and with your wife growing this company. What’s it like? What recommendation do you have to balance that work life balance for new parents out there or people that are working with a significant other?
Scott Orn
They’re both difficult. Doing it together is really, really difficult. I would say probably the most important thing, working with your like your wife or girlfriend or husband, is really about having some boundaries and being really good at communication. And so, like, for example, last night Vanessa was asking me a question at 08:40 PM about some comp stuff. And I was like, you know what? This is not a good time to be talking about work at eight forty-five p.m. but like, I totally get it because I’ve asked her questions like that at night as well. And then this morning I had a decision I had to make today early on, and it was seven forty-five drinking coffee. And so, the way I did it was, I said Hey I have a business decision to make. Can you help me make it? But if it’s if it’s too early in the morning for you and you need some more coffee, you need, we can wait a couple hours. So that was a way for her to kind of bow out gracefully and not start a fight. Now, two years ago, I would have just blasted the question to her. And then she would’ve gotten stressed out. And, you know, so like having these boundaries and asking permission to ask someone for a decision is really powerful. One of the things I really learned in last year through some coaching is asking permission when you’re going to give someone feedback is really powerful too because it really helps them get in the mode of accepting that feedback. And that’s what you want. Giving feedback is a generous act, but that generosity, your kind of hoping that the person accepts the feedback and thinks about it. And so, by asking, hey, do you have a second? Are you open to some feedback? Actually, really, really powerful. So that’s my tip for kind of navigating that. And I also think we’ve got a marriage counseling. I highly recommend going to marriage counseling, even if you’re not if you’re founders and you’re not married. You work together so much that I recommend coaching so that you can work through these kind of communication challenges that that married people have, too. So those getting those outside help is really important in terms of managing a kid. I actually don’t have like a silver bullet. I think everyone needs to get as much sleep as possible. That’s probably the single most important thing. Having some really helpful child-care people. We’re very blessed. Our nannies have a great relationship, their part time with our daughter. So, they’re like almost extensions of us and they have the same values as us, which is really helpful. But I think you also just got to kind of just buckle up and be ready for a couple of tough years and sleep deprivation. And just remember that you love each other and that the kid is more important than anything else. And making those investments in the kid’s health and happiness is pays off later.
Shawn Flynn (41:04)
But, Scott, I also have that I’ve heard in the past VC may not be interested in investing in companies that are founded by either married couple or boyfriend girlfriend. What’s kind of your opinion on this or what have you seen in the valley?
Scott Orn
You know, it’s I’ve heard that many times, too. And, of course, I totally get the reason for not wanting to invest in couples. And the reasons are, you know, it’s very stressful on the relationships with something bad can happen, the relationship that spills over the company. There’s also sometimes not enough checks and balances like your you have VC money. VC is all about, again, that peer pressure on compliance and doing things the right way. It would probably be easier to steal money or do something kind of uncouth if it’s a husband or wife. Because the checks and balances aren’t there as much. However, there’s been a lot of really successful companies that were founded by a husband-wife themed. So, must be without know. But Cisco was actually a husband, wife team like one of the largest. So, you would miss out on Cisco. And there’s a lot of other ones, like Eventbrite is a company founded by a husband and a wife team. There’s been many husband or wife teams or maybe one of them, the wife was the founder. And then the husband came in later in my situation or, you know, husband started and then the wife came in. You don’t want to miss out on those. There are so many good examples of that. So, I think the most important thing is the VC is to make sure that the founders share the same culture you do. Like all about accountability and checks and balances and everyone’s sees where this company is going and that they have resources like the coaching I was talking about and the counseling and a strong, exact team, because as a venture capitalist, you can actually help control the exact team like most venture capital firms, like my friend Glen Evans at Greylock. Like all he does all day for Greylock is recruit grant executives for their portfolio companies. This is actually a competitive advantage for a lot of the VC firms. And so, you can actually help place great executives around that couple and help, you know, magnify some of their strengths and address some of their weaknesses. So, I would say never pass on a deal. You don’t want to miss the next Cisco or the next Eventbrite. But make sure they have the right tools to be successful.
Shawn Flynn (43:06)
Scott, we got to get you on this show again, the future to talk about VC, competitive advantages, and everything else that’s going on. But if anyone wants to find out more information about you, Kruse consultant, what’s the best way to go about it?
Scott Orn
By the way, Thank you for the invitation. I’ll take you up on that. It’s been really fun. For Kruze, you can just go to Kruse consulting.com or type it into Google. I hear this Google thing’s going to be pretty big and important. It’s Kruze with a K, K R U Z E Consulting. And we’re happy to talk to anyone we focus on. Angel or VC Back Company is our Delaware C Corp. So, anyone who writes, and we’ll talk to you. And if you’re not fit for us, we will refer you to five other accounts that are fit for your kind of company. So, if you’re like an LLC or NASCAR or something that’s kind of more bootstrapped, we can just refer to get accounts for that, too.
Shawn Flynn (43:51)
Great. We’ll have all that information in the share notes. And please write a review on iTunes, give us five stars that encourages us to create more episodes like this in the future. And we want to thank Scott once again for coming on the show and look forward to all the comments and feedback. So, thank everyone.
Outro (44:09)
Thank you for listening to The Silicon Valley Podcast. To access our resources, visit us at TheSiliconValleyPodcast.com and follow our host on Twitter, Facebook, and LinkedIn @ShawnFlynnSV. This show is for entertainment purposes only and is licensed by The Investors Podcast Network. Before making any decisions, consult a professional.
