Firing someone: If you are successful, at some point you are going to have to do it.

Posted by Dave Broadwin on October 24, 2012

I can’t say how often I have been called the first time an entrepreneur has to fire someone.  BTW, I get that call from seasoned execs as well.  Nobody likes to do it and everyone is nervous that they will mess up in light of all the applicable rules. 

One of my partners, Jonathan Keselenko, who practices in the Employment area, developed a nice simple termination checklist that I have found useful.  One thing about this list is that it applies to situations where the employee is an “employee at will.” If there is an employment contract, you will also need to review the contract to make sure you meet its requirements as well.  Here is the list, with some additions from me:

EMPLOYMENT TERMINATION CHECKLIST

 

  • Have a good reason for the termination, and make sure that the reason is consistent with the documentation.
  • Provide the employee with a truthful explanation for the decision.  For example, if the employee is being terminated for poor performance, do not characterize the termination as a layoff.
  • Don’t be gratuitously cruel.  You should inform the employee of the reason for the termination, but you do not need to convince him that you are right or win a debate.
  • Conduct the termination in a private and respectful way.
  • If you any concerns about litigation, two people from the company should be present at the termination meeting, and both should take detailed notes.
  • Pay: be prepared to pay all compensation due, including unused but accrued vacation pay.
  • Explain that the employee will receive notice about continuing group health coverage under the Comprehensive Omnibus Budget Reconciliation Act of 1985 (“COBRA”).  Explain that all other benefits will cease as of the termination date.
  • Provide state-issued information about filing for unemployment, even if you think the employee is not eligible.
  • Collect all company property from the employee.  Consider having the employee sign an acknowledgement form that he has returned everything.
  • Allow the employee to collect any personal belongings before leaving the work premises.
  • Block the employee’s access to the Company’s premises and electronic access to the Company’s computer systems and email.
  • If the employee is listed on your company website, remove him from the site.
  • Remind the employee of any restrictive covenants (by this I mean noncompetes, nonsolicits, confidentiality and inventions agreements) and provide an additional copy.
  • Think about how you intend to communicate the employee’s departure to customers and other employees, if at all.  Who needs to know and why?  Make sure you have a legitimate business reason for the communication.
  • Think about whether you are willing to give the employee a reference. 
  • Inform the employee about options that may be exercised (or restricted stock that may be repurchased by the Company).  Be prepared to repurchase restricted stock (if you intend to).  The repurchase agreement may not be “self-executing” with the result that you may have a time frame for acting.

Dealing with Preferences

Posted by Dave Broadwin on September 07, 2012

The outcomes of negotiations around preferences never seem to have a compelling logic.  Under a particular set of circumstances is there a compelling reason why the A and B should be equal (pari passu, as lawyers like to say) in the preference stack or one (usually the B) should be ahead of the A?  It seems to me to be more determined by how eager to invest the new money is (or how desperate to get a next round the old money is).  This “you get what you negotiate” situation probably accounts for why there are a wide range of provisions out there. 

Having said that, there do seem to be some broad buckets that the outcomes fall into.

An Up-Round Scenario

Let’s look at a situation in which the B comes in at a significant increase in valuation compared to the A.  In this situation, the valuation of the company starts off at a point higher than that aggregate of the existing preferences.  If the company were to be sold in the following nanosecond, the B would get its money back and the A would get its money plus, perhaps, some return.  The same result would obtain if the valuation increased over time. 

If, however, the valuation declines over time, and the company is later sold for a valuation below that at which the B invested, then all investors would be at risk of not getting their investment capital back.  If the B is equal to (or – God forbid – below) the A in the preference stack, the B would, in effect, be funding the A’s preference.  For example, if the company were sold at a down valuation shortly after the investment, the A might likely be paid in full and the B might likely receive a reduced return – in effect the B’s money would have gone to pay the A.  New investors (the B in our example) are very unlikely to be willing to do this, unless they are truly eager to get into the deal. 

For this reason, the most typical arrangements in up rounds are for the new money to either have a priority over the old money or to be equal to the old money in the so-called preference stack.

A Down-Round Scenario

Now, let’s consider a situation in which the B comes in at a significant decrease in valuation from the A round – a down round.  For the reason described above, it is hard to imagine that in this scenario, the B would agree to be anywhere other than at the top of the preference stack.  So, let’s assume that is a given. 

How will the B feel about the A keeping any preference? 

The debate will center around how much, if any, of its preference the A should keep.  To focus the issue, let’s assume that there was a really large A round (more likely there have been several early rounds and the new round is the D) and the old preferences add up to a large number, say $50 million.  If the B invested, say $10 million and the A keeps all of its preference, then the company would have to be sold for more than $60 million for the B to start to see a return on its investment (not taking into account anything for the common).  No new investor will agree to that structure in a down round situation.

So, the question is: What happens to the A? 

When the A does not participate

In a down round where the A does not participate in a meaningful way in the new investment, the A holders have very little leverage.  Their bargaining position consists of either holding the deal up altogether, at the risk of watching their entire investment disappear or making a huge concession to the B. 

When all the A participate in an inside round

When all the A participate (without an outside investor), then the question becomes how much can reasonably be stacked on top of the common (typically meaning management’s options) before there is just no incentive for management to stay with the company.  If it is necessary to reduce the aggregate preference that is stacked on top of the common, they can go ahead and do so by amending the A.  In the alternative in a case where there is significant common ownership by persons no longer with the company, the investors may leave the preferences in place but create a management incentive plan that carves out some portion of exit proceeds to be distributed to management.  (This, of course, has its own complexity.  If management has an incentive plan that sits on top of the preference stack, it can affect management’s motivations.  Which suggests another blog topic:  How to structure management incentive plans to properly align management’s motivations, a topic for another day.)

The Cram down and the Pull-Through: when some, but not all, of the A participate

When some of the A participate and some do not, the negotiation can get interesting.  The ones that participate (particularly if they lead and comprise substantially all of the B round) will be in a pretty strong position to hold onto their position in the preference stack.  But, free riding by the non- participating A investors will be anathema to the participating investors. 

Often the result of this situation is the pure cram down.  The non-participating A investors end up converted into common stock (sometimes a pay-to-play is used to convert them into a preferred “lite”). 

Sometimes, however, the new investors are willing to leave the non-participating investors with some preference over the common (and presumably over the profit potential to (as opposed to the return of invested amounts) the participating investors).  Having observed this dynamic on a variety of occasions, I can’t say that I have seen any pattern to when it arises.  One situation that seems to have some logic to it is when some of the A round investors were the sorts of angel and early stage investors whom nobody expected to see invest in later rounds.  Another situation that I have seen arise is when some of the early round investors were brought in by the larger VC investors or are persons with whom the larger VC investors have ongoing relationships.

In these situations, you sometimes see a so-called “pull through”.  It works like this:  for every $XX of B that an existing investor buys, he gets to convert some number of shares of A into shares of B.  In this arrangement, the B is ahead of the A in the preference stack. 

Final Thought

The negotiation of all this is usually done among the investors and away from the sight of the company and management.  Actually, it may be even more arbitrary than that suggests.  It is often discussed among a small “inner” group of investors, who try and guess what they think it will take to get the deal done.  When they finally come out with the offer, it is often a self-fulfilling prophecy.  They are often so invested in the solution they propose that it is impossible to get them off it, with the result that it becomes their offer or nothing.

However, how the preference stack works can affect exits.  At certain price ranges some investors at the top of the stack will get a return (or perhaps their bait back) while others will get nothing.  As a result, there may be very different opinions around when and at what price investors will support an exit. 

Redemption and Misunderstanding

Posted by Dave Broadwin on August 12, 2012

I recently ran into this situation around a very standard redemption provision.

About a year after the initial close, my client went to raise a medium sized extension round.  They found a lead for the extension and everything went well.  After some negotiation, we got to the last issue in the term sheet: redemption.  The investor insisted that its redemption right be timed four years out to coincide with the redemption for the initial investment.  The company, of course, insisted that redemption start at five years.  They quickly reached impasse. 

The CFO then asked me what to do.  He sent along an email from the investor who explained carefully and reasonably that he did not want to be behind the initial investors. 

I then sent an email to the group stating that our understanding was that all preferred would have the same redemption schedule – beginning five years after the extension closing not four years. 

Needless to say, that closed the gap.  The point is, I think, that there never was a gap. 

It doesn’t make sense to have different redemption dates for different series.  The result of such an arrangement is that one series is in danger of funding out another series.  No investor should ever agree to such an arrangement.  Also, as time passes and new investments are made the issuer is not going to want to be in a position to have to spend money to buy out investors rather than fund its business.

Redemption itself is not all that common a practice.  It appears in only a small percentage of west coast deals and only about half (somewhat more than that actually) of New England deals.  It is a rarely used provision.  I can’t say never but ask a few practitioners how often they have seen it used.  I bet the answer is almost never.  I bet several will say they have never themselves seen it used in their practice.  The fact that it is a rarely used provision makes it an easy give.  This, I believe, is the reason why it is a minority provision on the west coast.

If you are going to have it, however, you probably want to make sure it really works.  Investors in Thoughtworks, tired to use their redemption provision and discovered that the then usual and customary language about how redemption was subject to the board’s discretion around availability of capital.  The NVCA form has addressed this issue and created a redemption provision that actually works.

Options: What your board members want to know and how not to keep employees waiting for options

Posted by Dave Broadwin on August 02, 2012

Option grants are usually a non-issue at the typical board meeting.  During the financial presentation the CFO flashes a slide with the following information:

  • Size of the option pool
  • Number of options that have been granted
  • Number of options remaining and available for future grant
  • Names of employees and numbers of options proposed to be granted at the particular meeting, if any
  • Exercise price

The directors often have a couple of questions about who is getting how many and why and whether the remaining options will be sufficient for planned hires etc.  After a brief discussion, the grants are approved.  Good housekeeping suggests that there be a brief presentation of the status of the option plan at each board meeting whether or not you are asking for specific grants – just to keep the board current.

BTW: after the approval, the CFO typically completes the actual option grant forms, they are then signed by the CEO (sometimes the CFO) and distributed to the employees.

Sounds simple, until you don’t do it, and you want to ask for approval of option grants.

If you don’t do it (and by “it” I mean prepare a slide with all the relevant information) regularly (and by “regularly”, I mean at each board meeting), an alert board member is likely to be annoyed and have a lot of questions, when you do ask for approval of grants.  While it may seem like a small amount of information to convey and absorb to you, this is likely to be because you have thought about it in connection with determining what grants to ask for.  To your board member it is likely a matter of first (or at least not recent) impression.  No matter how much you try to explain it, the director is likely to ask for better information, time to consider and then decide to take it up at the next meeting.

You, of course, will be embarrassed because you will have promised grants to various people and will then have to explain that they won’t get the grants until the next board meeting.

Before you get steamed at the board member, here are a few things that are likely to be running through his or her mind (remember they are not on top of the facts because you have not been reminding them regularly):

  • What percentage of the fully diluted is the pool?
  • Has the percentage of the fully diluted represented by the pool changed due to recent issuances?
  • What is the exercise price?
  • Do we need a 409(A) valuation?  Do we need an update of our old 409(A) valuation?
  • How much of the option pool has been used up?
  • What planned hires do we have, and how many options will we need for them?
  • Will we have to increase the pool, and how much will that dilute the investors?
  • Is there acceleration on an exit? 
  • Is there a double trigger?
  • Why am I being put in the position of being the bad guy and delaying grants to employees when the CFO should have a slide with all this in the board package?

These and other questions are likely to come at you rapid fire.  No matter how crisp your answers, at some point your director is going to say something along the lines of “I am not prepared to decide on this now, let’s put it over to our next meeting.” 

Once those words are spoken, the likelihood of anyone saying, “nope, we have to decide now…” is vanishingly small.  Furthermore, can you imagine a director’s reaction if you said that? 

So, guess what, your employees are going to be waiting until the next board meeting.

Compensation at Startups

Posted by Dave Broadwin on July 02, 2012

I am asked all the time about compensation.  How much should I pay my CFO?  My CEO?   My… you fill in the blank. 

The problem is that we are all prisoners of our own experience.  I have represented a lot of technology startups over the years, but it is still not a representative sample.  Time is also a factor the “going rate” (if there can be said to be such a thing) was different ten years ago that it is today. 

Perhaps some of the larger more active VC funds can get a representative current sample by looking at their existing portfolio companies.  But, most people really need industry data. 

So, here is a web site CompStudy that looks like it may fill the data gap, and you can get their data.  Below are two paragraphs taken from the CompStudy site.

The CompStudy surveys focus on private companies in the Technology and Life Sciences industries. We have conducted these surveys annually since 2000. (I collaborate on the surveys with Ernst & Young, law firm WilmerHale, and executive-search firm Park Square.) Last year, more than 800 private startups participated, giving us an extremely detailed dataset to help you understand the market for executive talent. The first decade of CompStudy surveys – which included almost 10,000 founders from 3,600 startups – served as the data backbone of my book, The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup.

As in past years, survey participants will receive free access to our sophisticated reporting/analysis website, including salaries, bonuses, and equity holdings for C-level and VP-level executives. To qualify for the free access, please complete the questionnaire by June 30th, 2012

If this survey lives up to its promise, it will be very useful.

I can’t help but note that a similar phenomena sort of exists (that is lack of actual data) with respect to other aspects of startups: for example, terms and valuation. 

Now, for some of this data you can go to our publication Perspectives (that covers New England, and shortly New York as well) or a similar publication from Fenwick & West (that covers the valley).  But although we (and I believe Fenwick) track every VC financing in our region, we don’t publish everything we know (I don’t believe Fenwick does either – although I have never discussed this with any of their attorneys).

So, when you hear someone say market is …..  You are probably hearing their subjective impression and, human nature being what it is, an impression designed to support the speaker’s agenda – good, bad or indifferent.

409A Déjà vu all over again

Posted by Dave Broadwin on June 19, 2012

With apologies to my favorite American philosoper, last week I participated as a panelist in a webinar on the topic of 409A.  The panel was sponsored by the good folks at Corporate Focus (which provides a great service that many law firms and companies use) for tracking stock and options.  They asked me along with Channing Hamlet from the appraisal firm of Cabrillo Advisors and Ed Sullivan from KPMG to talk briefly on a couple of 409A topics.  In addition, there was some Q and A at the end.  Below is a video of the webinar. 

Aside from yet again reviewing the significance of 409A and why startups should care about it, this webinar brought together a variety of perspectives on 409A in one place.  So, for example, by listening to it you can get a good sense of how the apraisal process works, how often you have to do it and so on. 

My favorite moment came in the Q&A when someone asked what to do if they had been issuing large numbers of options with exercise prices far below market over long periods of time.  I suspect that this situation may not be so uncommon.

Anyway here is the video:

Founder Vesting

Posted by Dave Broadwin on June 05, 2012

A couple of quick observations resulting from a quick read of a “standard” founder vesting agreement. 

(1)  Be wary of “standard.”  There are some items legal things that are truly “standard” but not as many as some lawyers may imply. 

(2)  You can under most circumstances get some up front vesting from VC type investors.  My experience is that for many startups in which the founders have invested some sweat, investors will give you some credit in the form of fully vested stock.  So, a typical arrangement (again depending on the facts) might be 10% to 25% fully vested at the Series Seed (or Series A, as the case may be) closing with the remaining amount vesting ratable on a monthly basis over three years.

(3)  The notion of a “cliff” seems out of place for founders who have been working on a startup for some months (or longer).

(4)  I see a lot of so-called double triggers (as opposed to full acceleration upon a sale).  So, sometimes you see everything that is unvested vest upon a sale (a liquidity event other than an IPO).  More often, however, I see something along the lines of half of the unvested vests with the remainder subject to the “old” vesting schedule provided that (and here is the second trigger) if the founder is terminated by the acquirer in the liquidity event (or the founder quits for good reason) within some agree upon time after the liquidity event (say six months, but sometimes more) then the remainder vests. 

(5)  Vesting stops when the founder ceases to work for the company.  The notion that unvested shares might vest immediately upon termination other than for cause has some appeal to founders, for obvious reasons, but you may need to come to a parting of the ways with one of your co-founders.  If you do, that fully vested block of shares (typically a big percentage of the common stock) may loom very large.

New York and New England Q1 Venture Statistics -- a quick preview

Posted by Dave Broadwin on May 23, 2012

We are about to publish our first review of New York transactions.  Here is the sneak preview: 

With respect to series A deals, New York and New England each had 22 deals in Q1.  According to us, there were 223 series A deals nationally.  So, NY and NE collectively represented approximately 20% of the national market.

With respect to later stage transactions, there were 25 NY deals and 43 NE deals.  Again, according to us there were 368 deals nationally.  So collectively NY and NE represent about 18% of the market.

I imagine that the relatively smaller number of later stage deals in New York reflects a number of things.  One might be that the boom in NY deals is relatively recent so there may not be as many companies in the pipeline that are ready for a second or later round investment.  Another might be that the mix of investment opportunities in New York is more “capital efficient” than in NE (and maybe other places).

With respect to that later point, here is a breakdown of some categories.  We categorize deals into one of four categories technology, life science, cleantech and other. 

With respect to series A deals in NE in Q1 40% of deals were in the technology category, 14% were in life science and the rest were other.  That is there were no cleantech deals.  In NY 30% were technology and 70% were other.  There were no life science or cleantech deals.

With respect to later stage deals, in NE 37% were life science and 35% were technology.  In NY 72% were other and 16% were technology.

I suspect that most of the other deals in NY were companies with revenue models based on advertising revenue. 

All this leads to the conclusion that NY is a pretty exciting place for investors.  I predict that the upswing in NY deals will continue.  Stats over the next few quarters will tell the story.

Advice about Advisory Boards

Posted by Dave Broadwin on April 29, 2012

The question that I most frequently get asked about advisory boards is:  “How much equity should I give to a member of my advisory board?”  The answer is very little, almost certainly less than the entrepreneur is thinking about.  Perhaps some numbers would be useful here.  How about .1% (that is a tenth of a percent) to perhaps .5% -- depending upon the value to be provided.  By the way there should be vesting involved.  The vesting period should be long enough to cover the period in which you expect to be getting value from the advisor.

Having now answered (to the extent I am comfortable doing so in the absence of any specific knowledge or facts of any particular case) the only question any client ever asks about advisory boards, I hasten to note that there are a lot of other – far far better – questions that could be asked about advisory boards.  Here are a couple:  What value can I reasonably expect from a member of my advisory board?  How do I get that value?  Why do I need an advisory board at all?  How do I find good advisors?

I don’t have any objective or quantifiable information around whether and how much value start-ups derive from their advisory boards.  My gut sense, based only on my law practice, is not much.  Mostly, what start-ups get is the opportunity to name a few luminaries on a slide towards the back of their deck.  The second thing they probably get is some introductions, probably to investors. 

I am sure there are some companies and entrepreneurs that have benefited greatly from advisory boards, but I have to believe this is a small number.  Below are a couple of links to blog posts on the subject of advisory boards.  The one from venture hacks seems to me to be particularly good in that it covers a lot more than just compensation, although it also covers comp.

Venture Hacks “Everything you ever wanted to know about advisors”

Ask the VC “Are Advisory Boards Helpful?”

Ask the VC “Advisory Board Compensation”

 

Of Froth and Bubbles

Posted by Dave Broadwin on April 07, 2012

Sometimes I tend to think that bubbles are all bad.  I keep a book on my shelf titled "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay, LLD.  This book was originally published in 1841.  I read portions from time to time to remind myself that bubbles (including those in the South Sea) come and go.

Sometimes it is good to be reminded of the past -- even if you lived through it.  Here is a link to a lengthy, but thoughtful, blog post on the "bubble" of the late '90s.  Peter Thiel's Startup Class Notes.  My favorite quote from this post is "Bubbles arise when there is (1) widespread, intense belief that’s (2) not true."  This is, of course, in different words what Mr. Mackay might have said about Dutch Tulips or witches in Salem.

It seems to me that bubbles (good, bad or indifferent) airse when there is a lot of money hanging around with the result that people do irrational things with it.  The recent $646 million lottery is a good example.  As the pot got bigger the odds got smaller, but the rate at which money poured in increase.  More money chasing smaller odds?  Go figure.

Congress has just passed, and the President has just signed, a new law that is supposed to support capital raising by smaller companies.  It contains the so-called crowd-sourcing provisions that have gotten so much press.  It will be seen if this does something or nothing for small companies, but one thing it might do is send a lot of small investor money chasing every smaller odds of success.