Evaluating San Diego’s Entrepreneurial Spirit

How attractive is San Diego as a place to start a company compared with the Silicon Valley? Santa Barbara? Los Angeles?

On Thursday evening the “Sweat Equity” series of seminars sponsored by San Diego’s Software Industry Council (SDSIC) brought together a distinguished panel with a venture capitalist and successful entrepreneurs answering questions, drilling into their experiences, as well as exploring perceptions they’ve developed over several years doing business in San Diego. More than 50 interested attendees with the hope and aspiration of either starting their own company, or breaking away from the corporate world with a startup, provided an enthusiastic audience to support the discussion and Q&A.

Panel members included:

  • James Adams, Moderator, Fortress Secure Payments
  • Russ Mann, Entrepreneur, Covario
  • Ted Alexander, Venture Capital, Mission Ventures
  • Allen Drennan, Entrepreneur, WiredRed

The panel tried to answer the question, through their experience, of whether or not San Diego is a good place to start a business. Starting with the question “How start up friendly is San Diego?” the panel thought the city rates a “good.” The universities around San Diego are graduating high quality workers, with a small community spirit nurturing fresh ideas and enthusiasm.

However the panel agreed that San Diego has shortfalls in the amount of investment money available less than in the Silicon Valley. Ted (the VC) cited that “last year there was around $7~10 billion in venture capital committed in the Silicon Valley vs. $1~2 billion in Southern California.” However he also added that “if you are a talented individual you can overcome the challenges.”

On the question “Do San Diego-based legal firms provide adequate support for small companies?” the panelists were all generally positive. Russ Mann gives the San Diego legal community “two thumbs up,” but Allen Drennan cautioned that his only bad experiences with San Diego law offices were when he tried to save money with cheaper representation that his company ultimately suffered.

Ted reinforced the need for good legal representation, and closed the topic by adding “San Diego legal firms are busy, but if you are willing to pay they are as good as any in the country.”

Attracting Outside Talent to San Diego

The panel tackled the question “What is the quality of CTO-level game-changers in the San Diego area?” The general consensus of the panel and attendees was that San Diego lacks high powered CTOs, and start up companies generally must go out of the area to attract the talent they need to provide the vision and technical leadership need to get a tech-sector start up off the ground.

“I am much more bullish on CEOs than on CTOs (in the San Diego area)” pointed out Russ. “Risk-taking CTOs do not like Southern California and San Diego, preferring the east coast and Silicon Valley.”

The panel discussed the idea of industry clusters. Those grouping of similar companies that normally follow one successful company in a location, and highly qualified engineers and leaders “gravitate” towards the clusters. Unfortunately San Diego does not have any strong industry clusters at the level of an El Segundo (military/industrial), Silicon Valley, Boston, or similar clusters. This makes some highly qualified people somewhat reluctant to take the risk of moving to San Diego.

Those who do find San Diego a good area to work are at a point in their life where they are interested in a better lifestyle, and the potential of a higher quality of life (as possible in Southern California).

The same opinion passed through into the question of availability skilled technical developers, where the opinion of the panel was low, concerned with both local talent, as well as difficulty attracting high quality developers to the area.

Funding SD Startups

San Diego does not appear to be friendly for funding startup companies. Ted’s company, Mission Ventures, may be the only company that is located in, and focused on the San Diego market. Ted stated “it is very difficult to build a large company in San Diego.” He continued “the reality is not every startup should get VC funding, and angels may give you a better deal or solution.”

The low confidence in getting funding in San Diego continued into 2010, with Allen quoting a San Diego Business Journal article which indicated “there is very little investment money expected in San Diego” over the next year. All members of the panel added stories about VCs and companies they know who are aggressively going after potential investments in other parts of the country, with an emphasis on Silicon Valley – but not in San Diego.

Ted tried to lift the spirit of the panel by ending the topic with “of course the right idea will always find a way to get funded.”

Comparing San Diego with other California Cities

Having visited several areas in California over the past couple of years, including San Diego, Orange County, Los Angeles, Santa Barbara, and the Silicon Valley, the differences are very clear. Enthusiasm and aggressive threshold for innovation is most visible in Northern California. Returning to the idea of clustering, it is easy to meet clusters of innovators and visionaries by simply going to a “cluster watering hole” (bar) near the tech community, such as the “Fault Line” in Santa Clara. The people you meet are fearless, unconcerned with the economy or other external factors, and just want to talk about their ideas.

Santa Barbara has a very enthusiastic community, but tend to be more interested in the business side of their future rather than working out strategies on how their ideas could be realized, and find a way to change the world.

As a great place to live, it is impossible to beat Southern California. As a place to build a company, the Silicon Valley offers a pool of talent, better access to funding, well-defined technology clusters, and a buzz of excitement that is not easily located in other locations. On a personal note, I have been searching for the buzz in the OC, San Diego, Long Beach, and other areas of LA, but have to finally admit the buzz is much stronger in Northern California.

We can change that, but the process requires a major shift in the local city governments, financial community, and aging business leadership to re-engineer Southern California as a valid competitor to the Silicon Valley. With notable exceptions such as Qualcomm, Boeing, Northrup, and some bio-tech leaders, it is hard to argue the percentages.

Los Angeles and Southern California provide a great environment for manufacturing, logistics, entertainment, and other operations-oriented industries. But for today, the burden is on the south to provide an environment that will spawn the next Google, Cisco, HP, National Semiconductor, or Apple.

John Savageau, Long Beach

Sweat Equity in San Diego – Starting Up at the SDSIC Entrepreneur’s Forum

More than 90% of startup companies around San Diego compensate the founders and senior staff with stock options, grants, or restricted stock” advises Mike Kinkelaar, Partner at Procopio, a San Diego Law Firm.

Mike joined three other panelists discussing “Sweat Equity” and senior management compensation at the San Diego Software Industry Council’s Entrepreneur’s Forum Thursday evening in San Diego (SDSIC).

Sweat Equity in the StartupSweat equity refers to “the efforts of executives or other shareholders into a company. This does not include money that is put into a business, which is financial equity. It is the time and knowledge that an individual or a group of individuals put into a business to make a result.” (BusinessFinance.Com)

The panelists represented a very diverse group including lawyers, a couple of serial entrepreneurs, and a CPA who was very familiar with assisting start up companies and their executive compensation plans. Those members were:

  • Joe Perohit, serial entrepreneur and CEO of EcoLayers
  • Mike Kinkelaar, partner at Procopio
  • Daniel Cunningham, serial entrepreneur and CEO at DPC Corporation
  • Timothy Willis, CPA at Mayer, Hoffman, and McCann P.C.

Who deserves Sweat Equity Compensation?

The panel discussed this is great detail during their panel discussion, as well as during the Q&A session following their panel remarks. After a bit of debate, the panel and attendees finally settled on the following model for sweat equity compensation (SEC):

  • Those who contribute to the company in early stages who are willing to accept ownership and shares in the company rather than pure cash compensation
  • Avoid SEC grants or compensation for mercenaries, or those who may leave the company as soon as their shares are vested (Joe)
  • Those senior people who are already financially stable, and will be able to stick out the early phases of the company without a desperate need for cash (Mike)
  • Younger people, newlyweds, new home owners, YUPPIES with expensive tastes in cars, etc., are not generally good candidates for high levels of sweat equity, as they will have a need for higher levels of cash, and will probably not be able to stay in a startup for a long period of time while waiting out the valuation of their potential stock shares
  • Those who offer a very unique contribution to the startup company. This could include engineers with the intellectual property needed for the company’s product, or those who are needed for the founders to go to investment bankers and the market for additional development funding

Understanding the Types of Startup Sweat Equity Compensation

The panel introduced and discussed four major types of SEC, and went into a bit of detail on the descriptions of each. While there are obviously clear legal and financial descriptions available for each category of SEC, it was refreshing to hear the panel paraphrase those categories.

  • Stock/ownership grants. This is really straight ownership of the company. Each stock grant has value, and presents a voting right for the company. This should only be considered for the founders, and possibly one or two C-Level executives. Grants are considered as income to the IRS and state.
  • Stock options. Given more freely to employees. Most often these are incentive grants, either allocated as a signing bonus, or as additional compensation for better performance. Vesting period is normally around 2 years, at which point the employee is eligible to purchase ownership in the company.
  • Warrants. Normally only issued to financiers and banks – not recommended for employees or senior management. This is legally considered a form of stock option.
  • Non-Incentive Stock Options. This is more on the line of friends and family options, and given to those who would not normally receive an option based on performance or other incentives.

Of course there are other forms of stock, ownership, and management of those forms of equity distribution, however the above are those most commonly used as tools by startup companies to provide additional ownership incentives to owners, employees, investors, and financiers.

Setting up Your Sweat Equity Compensation Plan

All panelists were in violent agreement on a few major points. The main point is to ensure you consult with a lawyer when legally setting up your SEC plan. Mike emphasized this is not a lengthy or expensive process, as all reputable law firms have this plan on the shelf. With the number of startup companies emerging each year, law firms deal with the SEC plan as a routine part of the startup process. It is well-understood, simple if done up front in the startup process, and not difficult to understand.

Additional points made by the panel included:

  • Consult with a local small business bureau. Most cities or counties have a very good group of volunteers and professionals happy to assist startup companies with their structure and compensation planning.
  • Keep your legal documents as simple as possible.
  • Make sure your SEC documents are complete – do not defer items to a later, this will nearly always result in unforeseen tax and legal issues.
  • Set up the volume and percentages of shares allocated to grants, options, and warrants at the beginning, again even if you do not plan to allocate right away.
  • Ensure the founders and early stage recipients of SEC fully understand the compensation plan, as most problems and legal disputes with ownership and options occur with founders or senior SEC recipients who leave the company, are disgruntled, or have other issues with the founders.
  • Establish a qualified stock option plan as quickly as possible – even if you do not plan to use sweat equity compensation in the early stages. It is best to have this legal framework in place from the beginning.
  • Do not allow accelerated vesting of shares for other than founders or C-Level executives. This may result in a potential buyer finding the cost of acquisition much more expensive due to the ownership of shares becoming a higher cost to the buyer.

Some Additional Considerations Concerning Employees

Most employees do not understand the concept of stock options, grants, and taxation. Many employees do not understand items as simple as grants being considered income, and options being considered something for which you eventually will have to pay tax.

There are many people who get hung up in the percentage of a company they will own due to grants and options. They do not understand that the only value to stock ownership percentages is when the share gives you the power of vote – and that vote is only useful when it has value within the articles of incorporation, or when it is not overruled by the board of directors.

Many people still believe that percentage ownership is the highest priority, when they should understand the only value of shares is actually when you are receiving distributions (unlikely with a startup company), when you sell your vested and common stock shares, or when an equity event (sale of the company) results in a new ownership “buy back” of your shares. The only value of shares is when you sell the shares and receive cash for those shares.

Dilution of share percentage ownership in a company is normal, and expected. This will only become more apparent as the company continues to grow, receives additional investments, is acquired, or becomes a public company. In short, control by a small group of individuals will be diluted if the company is successful.

Employees must also fully understand the tax implications of all categories of SEC. many states, including California, allow the employee to either pay for the value of an option or grant up front, or defer to a later date. Many, many young employees who do not understand the concept of stock options find themselves with huge tax liabilities when their options vest. This should be explained and clear to employees up front so they do not both have a shock, as well as become disgruntled and ineefective if they are hit with a bad tax situation.

There were many more topics discussed, impossible to codify into a single blog. However a great panel, great audience, and a good use of a Thursday evening in Southern California.

The SDSIC is a great, Aggressive Organization Helping Entrepreneurs and the Tech Industry in San Diego

Silicon Valley – keep your eyes open to the south. San Diego is a very robust technology community, and organizations such as the SDSIC are focused on making it grow. There are many retirees from US and international companies settling in the great communities surrounding San Diego, and many of those successful people are starting to give back to the community through organizations such as the SDSIC.

There is a great energy in the community, with very bright people being pumped out of schools such as San Diego State University and the University of California at San Diego. Both schools have robust tech programs, and both are well-respected on a national and global scale.

Another “Well Done” to the SDSIC, thanks to the panel, and we’ll see you next time (check out the SDSIC schedule at http://www.sdsic.org/events.aspx

John Savageau, Long Beach

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