Emerging Enterprise Center Blog : Boston Startup Lawyer & Attorney : Foley Hoag Law Firm : Startup Financing, Venture Capital

I attended a presentation at the Mass Technology Leadership Council a while back on the subject of measuring the effects of social media. I have been thinking about it ever since. Mostly because I sometimes wonder why I am writing a legal related blog. After all, who wants to read legal stuff? (Lawyers? Foley’s marketing department? My daughter, Megan, who reads it religiously but admits she understands little of the legal stuff? The good folks at Lexblog who host this blog?)

The speaker was K. D. Paine, whose business is consulting in this area. Without question she made many many interesting points. But, and I suspect I will make a complete hash of this, her main point was that the effectiveness of social media (such as blogs) is in fact measureable and not by counting eyeballs. Here is a link to the slides from the speech.

Her point is that the effectiveness of social media revolves around engagement. So, it does not really matter how many people read your blog or follow you on Twitter. What matters is how many of them are "engaged" and how many act on this engagement. You can have a million people hitting your site, but if none comment and none forward a link to someone who they think might have an interest, then so what? A recommendation from trusted source is far better than a random hit from a Google search. If you have engagement, you are more likely to get referrals and valuable positive buzz with people who care about your product, service or message.

There are lots of ways to measure engagement. One might be how many times you are re-Tweeted or how many comments you get or how many times your blog is cited by others. If you are staying on message and readers are commenting, citing and retweeting, they you are likely to be impacting your market in a much more direct and powerful way than with mass spamming or just mountains of passive traffic.

So measuring effectiveness begins with measuring engagement and ends with calculating an ROI from the people who took action based on the engagement.

None of this, of course, tells you how to create engagement, and that is where the magic ultimately lies. Now I am on the trail looking for insights into how engagement is created (not just how it is measured). One site that seems to be focused on this aspect of web marketing is pistachioconsulting.com. A f riend at Valley View Ventures turned me on to this site.  There is currently a guest post on "Presenting with Twitter" that has some strategies for creating engagement. I am sure there are others. I will try to note them as I find them.

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Sim Simeonov has a nice post on the subject of what is the best option vesting schedule. Options are a topic that has received a lot of attention in the blogosphere. A while back there was a lengthy discussion of options on Fred Wilson’s blog that, as I recall revolved around the need to think of option grants as percentages of the equity of the issuer (rather than in numbers of shares.  The EEC blog has many posts on options (and the related topic of restricted stock). All these posts tend to focus on some discrete aspect of options that came up in the author’s business. For a more general discussion, you can go to the Emerging Enterprise Center web site under "Ask the Start-up Lawyer." There you will find a general overview of the basics.

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I am no Peak Oil maven, but I read some commentary about it in the comments to one or another blog that I read regularly (perhaps Fred Wilson’s blog or Brad Feld’s or Don Dodge’s, I am not sure). Anyway it the issue was what the effect of peak oil would be on technology companies. Aside from placing a huge premium on all sorts of energy related technologies (that is why some massive percentage of investment is going into this space), I am not sure why technology should be affected differently from other industries. Anyway, it caused me to read a little about peak oil and the various debunkers of the peak oil theory. No surprises there. But it reminded me of something I have thought from time to time. I bet that all the peak oil theorists and their debunkers have their facts wrong. I can’t believe this is an original observation, but here is why:

In my capacity as corporate/securities lawyer, I have been watching clients, investment bankers, and others (by they way back in the days of oil and gas limited partnerships – the people who put those together) put together projections and financial statements. I don’t think any (perhaps a few) ever put together projections or financial statements in bad faith. But, whenever you put together these kinds of numbers you have to make choices. They can be totally legitimate and appropriate choices. Here is an example, in determining the net present value of a future payment, you have to pick a discount rate. This is a judgment call. Within the range of fair and proper, almost everyone errs on the side that benefits them.

I am guessing that the calculation of oil reserves is not an exact science. It involves judgment calls like the one I just described. Within the range of what is fair and proper, what kind of estimates do you think big oil is making?

My guess is that nobody knows what the world’s oil reserves really are (or even has a reasonably accurate guestimate). The same, by the way, applies to the calculation of demand. My guess is that nobody knows what the demand will be (or even has a reasonably accurate guestimate). The inaccuracies, of course, compound each other (that is my guess anyway). I would guess that the world reserves are less than anyone thinks (including OPEC). We may, or may not, find additional new and vast reserves – who knows?

My theory is that people who are making big bets on new enery technologies are going to get a pleasant surprise. (Although the rest of us may not find it so pleasant.)

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I just read Don Dodge's post on Google's goal setting.  It strikes me that what works in one environment will not work in another.  For every formula that drives human behavior there is an equal and opposite formula that works for someone else.  In this case the perfect is the enemy of the good might be the equal and opposite formula.  But, I think T.S. Eliot had the last word when he described literary criticism.  He said, "the only method is to be very intelligent."  To expand this concept, the only method is to be talented and driven.  I certainly agree that some organizations bring out the best in people, but in the end it is the people not the formulas.  In all fairness to Don Dodge, he kinda comes to this point in his post.  Another blog that often (always?) has something enlightening to say on people managment is Rands. 

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My 17 year old son brought home the following list of the top 10 wealthiest countries based on GDP per capita:

10. Ireland

9. United States ($47,500)

8. Brunei

7. Singapore

6. Kuwait

5. Norway

4. Bermuda

3. Luxembourg

2. Qatar

1. Liechtenstein ($118,000)

Basically, you got tiny countries (Ireland has 6.2 million people, Singapore has 5 million, Norway has 4.8 million plus tons of oil), tax havens, oil producers, and the United States. I don’t know, but I am guessing that the next 20 would include Japan, Germany, France etc. I am also guessing that if you put together the list of the "next" 20 countries in 1970 (or perhaps 1870) it would not be much different.

He also brought home a list of the bottom 40 countries based on GDP per capita. It is basically sub Saharan Africa (with some exceptions, South Africa, and some add ins Afghanistan, Haiti, Burma etc.). At the bottom was Zimbabwe with a per capita GDP of $200. I am making three final guesses (1) if you put this list together in 1970, it would not be much different, (2) if you put this list together (assuming one could) in 1870 or 1670 it would not be much different, and (3) that the spread between the lowest and the highest per capita GDP has done nothing but increase.

With the possible exception (depending upon when you measure) of the United States and the Asian countries (Japan, Korea others?), the countries that have really cracked the top group are, generally speaking, oil rich countries with tiny populations. (Where are Nigeria and Venezuela?)

Oil is going to become less valuable over time. Yes, the price per barrel will increase (and increase dramatically as world supplies dry up and become harder and harder to exploit), but other sources of energy will have to be developed. Certainly our children, and probably anyone who reads this post, will live to see the day when today’s oil powerhouse countries will resemble Lichtenstein – rich but so what? Sustained wealth and influence does not come so much from cashing in the winning lottery ticket in the natural resources game but rather from constant innovation.

So, here is one final guess, if you take this measurement again in 2070, the U.S. will still be near the top of the list.

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I like Don Dodge’s predictions for 2010, it seems as if we are about to enter the brave new world of mobile everything (commerce, computing, internet whatever), but I have been trying to figure out what bugs me about the predictions. I finally got it. Here is the answer. I was recently reminded of the scene in Star Wars when R2D2 plugs into the Death Star and turns off the trash compactor. In the brave new world of the future interoperability will be seamless. Think about all the devices we have (and shortly will have: the Android, the new Apple "pad" is that is what it will be, mp3 players etc.). Think about all the services (Pandora, Twitter, GPS directions etc.). My prediction is that 2010 will be another year of technology chaos demonstrating that we are still in the infancy of the technological age.

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Marc Theermann has this to say about the acquisition of Quattro by Apple,

If I hear another quote that contains any part of the “year of mobile” sentence I will jump out of a high window. Just like the “local Starbuck coupon” example it is heavily overused, and profoundly misunderstood. The reality is that mobile advertising died today. Not because consumers will not use it, or because advertisers will not spend money. Quite the opposite. Mobile advertising will be huge. However, with the acquisition of Quattro, the pure mobile advertising industry died. As a result, there might never be “a year of mobile”. From now on, mobile advertising will become another check box in the interactive/online advertising budget. Tom Burgess, Omar and Andy have done everything right: they brought our industry to the point that it should be — But the harsh reality is: “the year of mobile” coincides with the year that mobile died (as a stand alone industry).

While Marc clearly thinks this is a regrettable event, with the continuing convergence of mobile, desktop, pads and whatever else comes along, I wonder if it was probably inevitable.

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Once again the year end numbers are out and the ritual wringing of hands has started. As is often the case, Fred Wilson has a clear point in his post The Venture Diet is Working. His basic point, which many others have also made, is that there is too much money floating around the venture industry and that this excessive amount of money drives down industry returns. If there is less money invested in any given period, presumably it will go to the better deals (generally speaking) and will ultimately provide better returns. You can’t argue with that proposition. It is economics 101.

However, Fred is looking at the supply side of the equation (i.e. the supply of money). I am not an economist (in fact I am an attorney with a graduate degree in English literature), but if you look at the demand side of the equation (entrepreneurs seeking money) you might conclude that underlying Fred’s and others’ analysis is an assumption that the rate of change along the demand curve is more or less constant. For every dollar that you take out of the venture market a somewhat consistent corresponding amount of demand increases (or to put it another way – the value of the investment dollar gets bid up in a somewhat consistent way).

I keep saying "somewhat" because I think the demand curve may be more (and sometimes less) steep at various points along the supply curve. Here is the part that I cannot "prove" or demonstrate, but I believe that the ecosystem needs a certain amount of investment activity to remain viable. In order to motivate people to pursue their entrepreneurial dreams, they have to have some hope of getting funded and, ultimately, of a cool exit. If the investment supply becomes too small, that hope may disappear and the ecosystem may not support entrepreneurial life at all. If you take enough oxygen out of the pond, the fish will die.

So, the system needs to be smaller to permit good returns to investors (or they will go away), and the system needs to be large enough to provide incentive (hope of funding), even to those who might fail. Those two points define the space of viability for the venture capital/tech entrepreneur ecosystem. The question that needs to be answered is whether that space exists at all. A second question is, if it does exist, where is it?

To me this issue also raises larger questions about the so-called venture model. From my vantage point, I see VCs investing in well conceived tight investment thesis tech companies with the plan of an M&A exit (mostly). One way to think of this (and not a particularly original way) is to observe that the buyers (Microsoft, Google, et al) are outsourcing new product development risk. That is why VC investments seem to be focused on tight investment thesis companies with a seeming clear path to an acquisition. (I can just feel the VC community pounding me with the "we want to create great companies speech," but look at what they actually do not what they say they want to do.) In part this model is driven by the ten year fund cycle. Recently, I have run across VC investments (I have two in my client portfolio), that are not driving to an exit so much as towards developing larger sustainable businesses.

While it may be that the VC diet works, it also may be that it doesn’t and something new must emerge. Either way, it is a critical issue. We need tech entrepreneurs to grow wealth and we need a way to value them and provide a handsome return to people who invest in them. If we don’t we will end up having to compete with Brazil to make Nike sneakers.

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Here is a link to a fun post (and series of comments) from Dharmesh Shah called Start-up Advice in Exactly Three Words.  I am a little late to note it because it was posted on Jan 10, but it is fun, so take a look.

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  Eric Belsley from our office had this to add on the subject of accruing but non-cumulative dividends.  More concise and to the point than my post of Wednesday.

This is a relatively unusual provision. However, it would mean that although dividends accrue daily (and thus are computed when payable on a number of days in the year to date basis), the amount of such dividends is reset to $0 at the beginning of each year.

An interesting issue is the effect of this provision on payments made in liquidation and redemption. If the liquidation and redemption sections expressly refer only to "accrued and unpaid dividends" in addition to the principal amount, the company would have an argument that the non-cumulative nature of the dividend reduces the payout attributable to the accruing dividend in these events. This argument is much weaker if the liquidation and redemption sections expressly refer to the amount defined in the accruing dividend section, without referring to it as a "dividend."

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As a general proposition, with respect to dividends in venture capital style preferred stock, there are two main choices and a third that is rarely; but not never, seen, that is easy to comprehend and then there is a fourth choice that is rarely, seen and is hard to understand, but occurs with some frequency.

You might ask, "What is it?" But, before we go and make our visit, let’s do a quick review of the dividend provisions that are more commonly seen.

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First, don’t put too much store in sales advice from a lawyer. Second, here is something I have observed more than a few times, so it seems to me that it merits mention. Every now and then I run across what seems to me to be a very compelling story. The entrepreneur has identified a pain point in the market. They have a service or a product that seems to address it elegantly. The business thesis hangs together in a very coherent and compelling way. The company has talented, energetic and committed officers and employees. Investors buy into the thesis and invest. But, somehow, for some reason after several years of trying the business is just not developing. 

I am just the lawyer. I don’t know what the problem is, but I have seen the situation before and I recognize the symptoms. Everyone involved is engaged in a collective delusion. They are all ignoring (perhaps they really don’t see it) an important fact. The emperor has no clothes. 

If you find yourself doing the same thing over and over again and getting the same results and you continue to be convinced that your strategy and tactics are destined to succeed – you just can’t explain why they haven’t, consider whether or not you and your team have not fallen into a collective delusion. You need to find reality in order to address it effectively. 

Your widget is perfect. It is the best thing on the market. The competition, while well established, is lumbering and slow and expensive. But no one is buying. You need to go back over each of the facts and examine each one. Somewhere you are missing something. Here is my bet. The most basic premise is where you have gone wrong. In this widget example, I began with “your widget is perfect.” I am willing to bet that it isn’t. If there is some premise that can’t be examined, that is truly an article of faith. If the CEO keeps saying our widget is faster, and no one ever challenges that assumption, it is almost certain that that is where the problem lies. 

It may be that the problem can’t be fixed, but you might as well know it. If it can’t be fixed and the problem is fatal, at least you can move on. If it can be fixed, then you at least have a shot at it if you can identify the problem. The real world gives you feedback. What you think is nice, but it better not fly in the face of what is actually happening or you may find that you are parading down the street with no clothes.

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My last post concerning structuring to meet the needs of your financing sources, has led me to think about how to handle contracts. Businesspeople are often willing to go “skinny”. That is to say they are willing to live with contracts that are not comprehensive or rigorous. They often rely on relationships and accepted business practices (or simply trust). In many ways, this is what makes the world go around. The mere creation of a thorough carefully drawn contract that covers every (almost every) contingency and the negotiation that implies may itself be an impediment to doing business. 

A lot of the time the sales guy writes up the contract, the CFO signs off on it and the world rumbles on. If the relationship works and no third party ever has to look at it – you are fine. But, what happens when a third party gets involved. I am thinking particularly about what happens when you go to sell the business and the buyer is a Fortune 50 company (or even a Fortune 2000 company) that does not have a strong “personal” relationship with your counterparty? Or, what happens if you go to a financing source such as a name brand VC?

Family businesses (and my family used to have one, so I know) can operate at a level of informality that venture financed businesses just can’t ever get to. When IBM (or any other large buyer of companies) acquires your business, they want (need) to know that they will be inheriting the vendor and customer relationships. Assuring IBM that you and your customer have an understanding and are very simpatico just wont cut it. 

VCs get this, and they expect their portfolio companies to be set up for an exit. That means that informal arrangements (perhaps except for immaterial matters) are just not acceptable because they diminish the marketability of the portfolio company. If you are planning to get VC funding, you should assume that the VC will review your contracts (at the very least all the important ones) and a company with a squishy key contract may not be financeable (at least without an amendment to the contract).

Consider having to go from the easy squishy contract to the level of definition and tightness that IBM (or any other similar buyer) or a VC proposing a financing will want, under the pressure of a pending exit or pending financing. Your bargaining power just went out the window and your good will with the customer or vendor just went down the tubes. The moral to the story is that an ounce (or a several ounces actually) of prevention is better than an pound of cure.

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I once sat in on a meeting between a public company client and an investment banker, from whom the client wanted an underwritten offering. At one point in the conversation the CEO of my client said something like, “We intend to structure our business in accordance with the requirements of Wall Street.” Nobody twitched. But this is not going to be a post on the absurdity of taking unsound actions to appease Wall Street, it is a post about being realistic about how you cater to your financing sources. 

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David Wessel’s recent article in the Journal, “A Prozac Economy has its Costs,” asks: If we were able to invent the economic equivalent of Prozac – something that would take away the high-highs and the low-lows of our current economy (think the tech bubble of the late 90’s and the current recession) – would we elect for a prescription? Would we, given the choice between a dynamic, volatile economy with painful depressive phases, and a more mellow economy with fewer crises but a slower growth rate over the long term than its manic doppelganger, settle for a calmer existence? Though my understanding of economics is limited to my college-level macro and micro courses, from an entrepreneur’s and VC’s point of view, I think my answer would be: give me manic any day.

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My last post reminded me to come back to a theme that I address from time to time – transaction costs for small transactions. While it is true that smaller deals are not necessarily less complex than larger deals (sometimes it seems like just the opposite), you just can’t paper a $1,000,000 deal (let alone a smaller one) the way you can a $10,000,000. $40,000 is 4% of $1,000,000 – it might be a material item that eats into the money you have to put to work in your business in significant way. (By the way, I picked $40,000 randomly because it is not far off the cost of a typical Series A investment from a VC (that is the cost of one side’s lawyer).) But, there are risks in doing a less than thorough and careful job of documenting a transaction. I am sure there are many horror stories out there. Having said that, all businesses have to manage risk one way or another to preserve the value of the transaction. At the risk of stating the obvious, the best thing you can do is use an attorney experienced in representing early stage companies and hope the other side does too. The other thing you can do is be sensible about your own deal strategy – pick your battles. If you feel the need to negotiate every sentence of a document, guess what – your transaction costs will reflect that.

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Seed and angel investments often come in the form of convertible notes – often notes that are convertible into some future round of equity investment at a discount to the valuation at the time of conversion. They have other terms as well such as interest rates, maturity dates, prepayment premiums in the event of an early sale of the business, waiver of certain debtor protections etc. These all may form the focus of future posts. I want to focus on what, if any, influence seed/angel investors who invest in these types of notes want (or get) concerning the terms of the equity into which they are planning to convert.

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The Dow Jones webinar I did with David Bell (Fenwick & West), Sarah Reed (Charles River Ventures), and Lizette Perez-Deisboeck (Battery Ventures) has provided me with a lot of eye catching numbers. I will comment on the VC fundraising numbers in this post (and maybe some others in the future).

According to Dow Jones, VC fundraising by venture funds has risen steadily, from a low of $10.3 billion in 2003, to a recent high of $41.0 billion in 2007. I say recent because in 2000 the raise was $82.3 billion. Year to date numbers for 2009 show a total raise of $8.1 billion. There is still a month to go, and maybe a fund or two will have a closing in December, but this looks like an historic low.

Based on a discussion over lunch with Rick Grinnell of Fairhaven, I believe that there will be an unusually high number of big "A" list funds that will be looking to raise new funds in 2010. In some ways this makes 2010 the year to watch. If a large number of strong players are in the market and the amount raised does not spike up it may reflect that a new, lower, equilibrium has been reached in the market. In effect, 2010 may well tell us how much smaller the venture world will become for the next half decade.

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Should you jump on a plane to look for money on the west coast?

Last Friday David Bell (from Fenwick & West), Sarah Reed (Charles River Ventures), Lizette Perez-Deisboeck (Battery Ventures) and I were the panel for a Dow Jones sponsored Webinar on the subject of "The Evolving Venture Term Sheet: What VCs & Execs Must Do To Secure the Best Deal." This Webinar was built around the deal statistics published by Fenwick (a west coast law firm) and Foley (an east coast law firm). As you might expect, the numbers appear to confirm that there are some identifiable differences in practices between the west and the east.

David Bell summed it up better than I can, and I know I can’t now recreate his exact words, but the gist of what he said was that activity and valuations are picking up on the west coast sooner than on the east coast and that deal terms are slightly better on the west coast than on the east coast. In essence, the east coast lags the west coast a little bit in good times and bad. So, in bad times terms are a little less draconian on the west coast than on the east coast, and in good times terms are a little better on the west coast than on the east coast.

This observation is, I think consistent with the statistics gathered by Fenwick and by Foley. It is also consistent with anecdotal information. On the west coast there are more deals with stronger valuations than on the east coast. Also, one the west coast there are relatively fewer deals with terms like a 1x preference and full participation. It is not that there are wildly different practices, but there does seem to be a small but consistent difference.

This persistent difference seems all the more odd because the VCs (who presumably drive all this) do deals on both coasts. Battery and Charles River both have offices in Waltham and Palo Alto. It is hard to account for this difference. One facile answer is to say that it is cultural. But, that seems too easy. Also, I would think that if this were the case, west coast firms would bring their attitudes east and grab lots of good deals. Perhaps it has to do with the relative mix of industries – the east having a relatively higher percentage of biotech and life science. Biotech being relatively more expensive and requiring a relatively longer investment horizon than, say, IT, might breed more conservative practices.

While I don’t really know, I am guessing that the explanation is more along the lines of some economic factor than a purely cultural one. I think getting a west coast VC into your mix is probably a good thing, but I would not stop looking for investors in Boston.

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Entrepreneurs are risk takers; lawyers risk managers. An inherent tension exists. Take too much risk or over-manage the risk and the results can range from unsatisfactory to disastrous. However, in every venture, there are manageable risks and uncontrollable risks. The trick is to realize which is which and deal with them accordingly. I have met some smart, innovative first-time entrepreneurs with thought-provoking business plans that illustrate foresight and a nuanced understanding of market forces. However, more often than not, these very same entrepreneurs are more than willing to lump all their risks in the “uncontrollable” category.

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