My hypothesis that the greatest increase is between the A and B rounds bears out very clearly in the technology sector. You can also see it in the biopharma data. The cleantech data may be unreliable because the sample size is small.

The reason I have been looking at this data is that I have a couple of clients that are debating internally whether to raise a B round or try for an early exit.  While I think there are many factors to weigh in this type of decision (obviously valuation is one issue, expected size of exit is another and time to the eventual exit is yet another), these statistics are, I think, the first step in an analysis that could well lead to the conclusion that, in most cases, the best return for the entrepreneur is going to be in an early exit.

Apparently, the SEC has finally come around to the notition that net neutrality is a really important issue.  I have included three of the salient paragraphs below.

The SEC’s Division of Corporation Finance has advised Sprint Nextel Corporation and AT&T Inc. that they may not omit from their proxy materials shareholder proposals that ask the companies to publicly commit to operate their wireless broadband networks in accordance with network neutrality principles.  The staff explained that, due to the sustained public debate over the last several years about net neutrality and the Internet, and the increasing recognition that the issue raises significant policy consideration, the proposals may not be omitted in reliance on the ordinary business exclusion.

AT&T wrote that the proposal represents an attempt to repackage substantially similar proposals about its network management practices, which the staff, in the past, has concluded were excludable as ordinary business.  In AT&T’s view, the proposal would directly interfere with its network management practices and would seriously impair its ability to provide wireless broadband service to its customers.  AT&T also sought to omit the proposal under Rule 14a-8(i)(2) on the basis that it would impair the company’s ability to comply with federal wireless licensing requirements.

AT&T said the proposal cited the same reports as in a 2011 proposal and that the only substantive addition was a citation to a 2011 survey that presents statistical information similar to that presented in the January 2010 report and cited in the 2011 proposal.  AT&T challenged the notion that net neutrality has emerged as a consistent topic of widespread public debate that would reflect a significant policy issue for purposes of Rule 14a-8(i)(7).

The point is that stockholders of public companies can propose that the stockholders, at the company’s annual meeting, adopt a resolution directing the company to observe principles of net neutrality.  It will be interesting to see how many, if any, companies include this type of resolution and if any of them pass.

It does not seem to matter what the articulated reason for the loss of valuation – market conditions, ineffective management, too early to market, too late to market, technology challenges, long adoption cycles, etc. – in each case one down round leads to another.  With each successive down round the common holders (and option holders) become more and more diluted and demoralized.  Key players start to leave.  Vendors are not paid and they put the company on COD terms.  These things all slow product development and sales and also harm morale.  Eventually the CEO is replaced (perhaps the entire team) and the new team is faced with the almost impossible task of bringing Lazarus back from the dead.

If this observation is really true, even in just a majority of cases, why would anyone ever invest in a down round?  The investor would simply be throwing good money after bad. 

There seem to me to be a lot of reasons potentially at play:  The original investment thesis still seems good.  Investors and management (let alone founders) remain enamoured of the business.  Investors are not eager to admit to their limited partners that a mere 12 months or so after they put a large wad of cash into the business there is a total write off.  Investors are afraid that the next guy will pull off a miracle and make the business a success as a result of which they will look like they bailed too soon.

Well, here are some facts.  We sorted our database of venture capital transactions in New England  first by searching for companies that had follow on rounds since 2008.  We then looked at the follow on rounds to determine how many were up and how many were down.  About 71% were up and the other 29% were down.  We then searched the down rounds to see which ones had a subsequent round of financing (13%, as opposed to 49% of the up rounds).  Out of the financings that followed a down round, 30% were up, 15% were down, and the rest (55%) were even. On average the “up” rounds were up by about 56% from the down round price. 

While the sample size is relatively small, the data shows that down rounds are much less likely to be followed by another round of financing, at least within the 2-year period we’re looking at. If they are followed by another round, there’s a good chance (85%, according to our data) that it will be an even or up round.

 Assuming you made equal bets across all down rounds and only 4% of the down rounds had follow on up rounds, that 4% would have to return a lot more than 56% you to break even on the portfolio portfolion of down round securities. 

Now, among other things, this analysis does not account for (1) the possibility that some of the up rounds will improve even further over time or that some of the down rounds will return something, (2) the time value of money, or (3) a host of other factors that are of lesser importance but not of no importance.  Nonetheless, it does suggest that investors would be far better off betting on the flip of a coin than on a down round.

Parties to the Agreement

Consider who should be a party to the agreement.  Should the agreement cover “affiliates”?   The answer is probably yes.

Mutual or One-way

Consider whether the agreement should be mutual (i.e. each party is obligated to keep the other’s information confidential) or one-way (only one party discloses information and the other party is obligated to keep it confidential). 

How Broad is the Definition of Confidential Information

Usually it is very broad.  In particular note whether or not the information has to be specifically identified as confidential or whether it merely needs to be such that a reasonable person would understand that it is confidential.  Depending on the circumstances you might want to go one way or the other on this.  You may also want to identify certain specific categories of information as either confidential or non-confidential.

Is the Obligation to keep Information Confidential Clearly Stated

The agreement should expressly state that the parties (or party in the case of a one-way) must keep confidential information confidential.  An ancillary point is the standard of care which could be best efforts or reasonable efforts or the same level of effort used in the case of a party’s own information. 

Exceptions

There are a number of usual and customary exceptions to the definition of “confidential information”.  These include: (1) information that is or becomes public without a breach of the NDA, (2) information that becomes available to the recipient on a nonconfidential basis from a source not bound by an NDA that covers the relevant information, (3) information that a party knows (and can demonstrate that it knows) before entering into the NDA, (4) information independently developed by a party without the use of confidential information subject to the NDA, and (5) information required to be disclosed by law (SEC disclosure obligations for example) or judicial process (discovery in a litigation for example).  In this later case (legally compelled disclosure), there is usually a requirement of notice so that the party whose information is about to be disclosed can contest the required disclosure or seek some other protection.

Return or Destroy

There is (or should be) an obligation to return confidential information and destroy all copies at the end of the NDA.  This requirement is often coupled with a requirement that the recipient certify compliance in writing.  Also, some large companies like to retain one archival copy of whatever they get.  This is usually rationalized by arguing that they need it for the record in case of a law suit.

Limitation on Use

Very important.  These agreements should expressly limit the right of parties to use the confidential information they receive to the purpose for which it is delivered: for example, to decide whether or not to proceed with a particular transaction.  So, the agreement should say that the confidential information may only be used for the specified purpose.  If it does not say this, it may turn out that parties use the information for other purposes, such as advancing their own R&D.

Ownership etc.

The NDA should make it expressly and clear that no license or other rights to the confidential information is conveyed.  In a sense, this is part of the limitation on use, but is often stated separately as well.  Similarly, these agreements often state that no joint venture or other entity is formed and that neither party can act for the other in any respect.

Term and Termination

NDAs can be for a stated term (months or years) or they can be perpetual.  The argument for a stated term of years is that at some point the information is old and cold and the parties should be able to stop worrying about their obligations under the agreement.  In any event, the disclosing party should be concerned to make the term long enough so that the information is no longer likely to have value as a result of being confidential when the agreement expires.

With respect to termination, the termination of the agreement should not terminate the obligations of confidentiality and non-use.  The termination provision should expressly state that these obligations survive an otherwise general termination of the agreement.

Equitable Relief

These agreements often state that injunctive relief (a court order prohibiting a disclosure) is an available remedy.  Some companies want an agreement that such relief is automatically available, while others will only agree that the discloser has the right to seek an injunction.    

Governing Law and Venue

There is a distinction between the jurisdiction whose law will govern the contract and where suits may be brought.  I won’t comment on governing law, except to say that your lawyer may have an opinion about it and that in general all U.S. jurisdictions will enforce your garden variety NDA (that is plain vanilla ones).  What about NDAs with odd, different or peculiar provisions – who knows, it will depend on the provision.

Venue is more interesting.  At issue is where cases may be brought.  If you are in Boston, having to enforce your rights in Alaska is likely to be inconvenient and expensive.  Consider that when you agree to a specific venue.

Unusual Provisions

The foregoing list of provisions and comments is by no means exhaustive.  But, if you are presented with an NDA that raises any questions for you, consult your lawyer.  Just because someone from a big company (even a household name company) says “this is our standard NDA” does not mean that it is either standard or, even if it is their standard, that it does not have odd, different and perhaps pernicious provisions. 

Just to give you a flavor, here are a couple of provisions that I consider odd, that I have recently run across:

In a supposedly mutual NDA, I found the following “XXX agrees to use YYY’s Confidential Information for the sole purpose of evaluation or as otherwise agreed upon in writing by YYY.”  This provision looks fine except that YYY never agrees to limit its use of XXX’s confidential information. 

Here is another provision: “This NDA may not be assigned by either party by any means, including without limitation, by operation of law or merger, without the prior written consent of the other party.”  We all get that one can’t just transfer an NDA, but but what happens when you go to sell your business?  Did you just unwittingly make the other party’s consent a precondition to a sale of your business. 

Beware of limitations of liability provisions in NDAs.  Some pro-recipient NDAs include a disclaimer of indirect and consequential damages.  The problem is that almost all of the damages that would arise from misuse of confidential information are indirect or consequential. If the recipient breaches the NDA, it would probably argue that it can be liable only for injunctive relief, but not for damages.  While I have my doubts about the enforceability of a disclaimer of this nature, there is certainly a risk that it results in a fairly toothless NDA from the discloser’s perspective.

Occasionally, an NDA will include provisions which may allow the discloser of information to claim ownership of the IP rights in any modifications that the recipient makes to that information.  These provisions may be hidden in the definition of “Confidential Information”, which is one reason not to gloss over that provision, even if the beginning of the paragraph reads like a laundry list of every type of information and technology that the drafter could think of.

 SOPA is obviously a huge issue these days.  Whether there is more panic than is merited is not clear to me.  But this is not a post about SOPA; it is a post about Quora. 

I was curious about what people were saying about SOPA, so I decided to check out the questions and answers in Quora.  Now, I know there are a million things out there on SOPA and probably anyone interested would read about it elsewhere. 

Having said that, the Quora activity seemed meager, to say the least.  For example, 13 people are following the question What is the Stop Online Piracy Act (SOPA)?  Looking at related questions, the numbers seem to go down from there. 

My initial (and continuing) reaction to Quora is that it is a great way to cluster commentary and opinion around topics.  I wonder though if it is not losing steam/market share.  If this is the case, and I suspect that it is, there are probably several reasons for it. 

One reason might be that Quora is not really all that easy to use.  Like many techie things, it sometimes seems as though the technology stands between the user and the use.  Here is a post from Semil Shah (on Quora)that touches on this issue.  His first point:  Make it easier for Quora users to ask questions, especially on the mobile app, goes to the heart of the matter.  If Semil Shah has this reaction, imagine the experience of a less tech savvy user.

Like many things technological, ultimate success does not depend so much on capturing the fancy of Semil Shah, Michael Lopp and other members of the tech vanguard, but on massive adoption by people for whom the site is a means not an end. 

One more thought about SOPA, old distribution and revenue models will not come roaring back into fashion because SOPA is passed.  Hollywood’s content creators will still have to change their business models as technology and social networking continues to grow up. 

What is 409A and why do you care?

409A is a section of the Internal Revenue Code that governs the tax treatment of certain options.  409A provides that an option either (1) be an option for common stock of the employer and have a per share exercise price on the date of the grant equal to or greater than the fair market value of a share of common or (2) if the option has an exercise price of less than the fair market value of a share of common stock the recipient and the issuing company suffer some pretty draconian tax consequences.  (There are other ways to comply, but relate to less usual situations, such as options that are only exercisable on a liquidity event, and I am not going into that level of detail here and now.)

What are the draconian tax consequences?

There are three particularly nasty tax consequences:  (1) The recipient of the option will have income equal to the difference between the fair market value of a share of common stock and the exercise price of the option multiplied by the number of options, at the time the option vests, even if the recipient does not exercise the option.  (2) The recipient will get to pay a surtax of 20% over and above his or her normal income tax on the option related income.  (3) For each year for which the option remains outstanding, the recipient will suffer the same nasty tax consequences with respect to any increase in the value of the common stock. 

Why on earth would the IRS create such a rule?

Consider what could happen if the issuing company were publicly traded and was issuing options with below marked exercise prices to its execs.  Need I say more?  Unfortunately, 409A applies to all companies – not solely public ones.

What can I do to avoid the bad tax consequence?

Issue your options with an exercise price equal to or greater than the fair market value of the underlying shares.

How do I know what the fair market value of a share of my privately held technology start-up is?

Here are some ways to price your options:

(1) You can take a guess at the fair market value.  If you guess wrong you are toast.  And, by the way, your guess will be judged with 20/20 hindsight by the IRS.  So, that does not seem like a good solution.

(2) If there is a recent actual arms-length transaction in which common stock was sold, then you have price.  Note that I said “actual,” “recent,” and “arms-length.”  The fact that your lawyer took a few shares a year ago in consideration of an old invoice won’t cut it. 

(3) If you have a financially sophisticated person on your board (or as your CFO), and your company has been in business fewer than 10 years, 409A provides that such person can perform a valuation. 

(4) You can pay an outside appraiser to perform a valuation.   Most (all?), of my clients who have professional money invested in them end up doing this.  It is a toll and it is unfortunate that you have this cost, but that is you tax dollars at work. 

Like my entrepreneur friend, you can want to price options at $.03 but if you sold common stock last week  in an arms-length transaction for $.30 per share, don’t do it.

Sometimes it seems like all clients have the same issue at once.  One series of issues that seems to be among the popular issues du jour is what to do to secure domain names and corporate names.  Needless to say, this should also dovetail with securing appropriate trademarks. 

Here are some strategies you can consider when registering domain names:

1. Register with the most popular top-level domains. Obviously, .com domains are the most popular by far, followed by .net and .org. You might also register domain names in the .biz registry, and in the .info, and .us registries. The Columbian registry (.co) is also making a big push to be an alternate .com (though it’s not clear it has much traction yet), so you might consider that as well.

2. You might consider registering some of the popular country-code top-level domains such as .co.uk, .ca, .asia, .de, .cn, .eu, .jp, and so forth, and country domains for any country where you expect to have significant business activity.

3. You might consider applying to register a “non-resolving” (inactive) .xxx domain name once they become available on December 6, 2011, or if you already owned a trademark registration prior to September 1, 2011, you may be able to take advantage of the cost-effective .xxx “Sunrise B,” which allows trademark owners to block a domain name for at least ten years for a one-time fee.  See http://www.icmregistry.com/launch/general-availability/.  Josh Jarvis, one of my colleagues writes a blog on trademarks, copyrights and related matters, and you might check his blog out for more on these topics.

4.  To protect against competitors and cybersquatters, you may wish to “defensively” register certain variations of "yourdomainname"  in at least the most popular domains (.com, .net, and .org). Some tricks used by competitors and cybersquatters include:

a. Changing singular to plural, or vice-versa.

b. Common misspellings or spelling variations -- e.g., using “z” instead of “s”.

c. Hyphens in obvious phrase breaks -- e.g., “soft-boiled.com.”

c. Typos -- e.g., sofboiled.com (missing letter) or substituting “d” for “s” or vice versa because it’s adjacent on keyboards

5. To protect against disgruntled customers or unscrupulous competitors, you may wish to “defensively” register so-called “gripe” domain names, at least in the most popular domains (.com, .net, and .org).  Ever popular creative favorites among the disgruntled are “Sucks” (e.g., softboiledsucks.com) which is by far the most popular of these, though other obvious four letter words are used.

Generally, it’s easy to get carried away -- it’s simply not possible to capture every possible misspelling, typo, or gripe variation in a single top-level domain, let alone multiple top-level domains. This is especially the case where the number of top-level domains is expected to increase exponentially over the next few years. The key is to get the most obvious and most likely suspects, at least in the .com registry if nowhere else. Keep in mind that you may have legal recourse available in the event of future bad-faith cybersquatting.

With respect to corporate names, as with domain names, you can't, as a practical matter, get every similar name in every relevant jurisdiction, but again you should think defensively and get whatever makes common sense in Delaware.  You might consider, but I also think it may be going too far, other big jurisdictions such as New York, California, Texas, and Mass.  Getting the corporate name, really means forming a corporation (even if it is an inactive shell) in the relevant jurisdiction.

Here is what my partner, Dave Pierson, had to say about Q1 activity, “The total number of New England Series A transactions dropped 46% from Q4 …. The total number of New Englsnd Series B and Later round transactions during Q1 decreased 21% from Q4…”

Fenwick had similar observations.  Fenwick had this to say, “Venture capitalists invested $6.4 billion in 661 deals in the U.S. in 1Q11, compared to $7.6 billion in 735 deals reported in January 2011 for 4Q10, according to Dow Jones VentureSource (“VentureSource”). Although this represents a 16% decline in dollars and a 10% decline in deal volume from 4Q10, the 1Q11 results were generally flat with the average of $6.6 billion raised per quarter in 2010.”

All I can say is that either Foley Hoag is lucky or the venture world took off in Q2.

Here is the open question, given the turmoil in the public markets, will I have written plenty of new posts and be lamenting the amount of time available for such pursuits?

Without further adieu, below is the same table I produce each quarter.  This is, of course, a table reflecting Q1 activity.

There is no surprise in these numbers.  They have followed a consistent pattern from quarter to quarter for as long as I have been tracking them.  Note the greater frequency of dividends and redemption provisions in New England deals.  Having wondered about why there is not convergence on terms, given that so many of the leading venture firms do deals on both coasts and having asked a number of people in the business about it, I have come to the conclusion that it the divergence in these terms reflects a basic cultural bias.  New England just has more of a lender mentality than the Valley.

My blogger friends (and the firm’s blogger consultants), indeed, it seems the entire blogosphere seems to agree that blogs are not really an optimal publication platform for dissemination of pure content.  I take that to mean that putting law review articles (or any substantive articles on legal (or other) topics) is really not what blogs are “about.”  

Instead, blogs are supposed to be pithy comments on other people’s posts (or perhaps some other thing going on in the real or virtual world).  Hence the prevalence of blog posts that begin with some reference like, “Harry has a great post about his date with Sally….”  Harry’s post, it turns out, is likely to be some observatlon about something Sally wrote on her blog.  Sally’s blog, in turn, refers to Tom and Dick….

So, the consultants appear to say, blog posts should be pithy comments about pithy comments.

And, the occasional pithy comment is probably a good idea, but when I look at the statistical data concerning this blog and I consider which posts seem to have generated interest and which have not, the numbers (meager as they are) support a completely different notion. 

Readers want content more than conversation – at least as much as conversation.

I am, for example, under the impression that Fred Wilson was very successful with MBA Mondays.  (Now, his entire blog is a huge success.)

Switching gears, Prithvi has told me on many occasions that the content posts I have done in the past are more geared for consumption by lawyers than by entrepreneurs. 

So, I am going to try and take a trick from Fred’s book and apply Prithvi’s advice and write a series of posts (I will try for weekly) that will be both substantive and usable by entrepreneurs.  The posts will be checklists for things that are legal in nature.  The idea is to put the entrepreneur in a position to think about whether he or she has covered everything he or she needs to cover in a document or deal. 

Of course, the usual caveats about how this is not legal advice and does not create a lawyer client relationship etc. apply. 

I thought I would tackle seed preferred term sheets first.  Although these can vary from one pagers to 5 pagers (or more), for the purpose of creating a checklist, I am going with the longish form.  After all, it is the purpose of a checklist to be over inclusive.  Also, I have linked each of the terms (and some other items) to the glossary defining these terms on the EEC microsite and, where it seemed relevant, to my blog. 

Please send me thoughts on the checklist.  If the checklists seem useful (or popular) I will post them on their own site on an easy to use open source basis.

Here goes:

At the risk of fighting the last war, I am going to come back to idea (and in some cases reality) of “standard” open source seed preferred documents. 

To be clear: 

(1) A note that converts at a discount into the next round of equity financing is probably the best deal an entrepreneur can hope to get.  Now he or she may not be able to actually get such a deal (and certainly won’t get it from many VC investors).  Why is this the best deal an entrepreneur can hope to get?  Because it limits the investor’s upside.  Why do VC (and other) investors hate these notes?  Because the notes limit their upside.

(2)  A convertible note with a cap may be the worst deal an entrepreneur can get.  Why?  Because, she is selling equity at the lower of two prices.  One price is a fixed valuation and the other is something less.  If you are going to set a valuation, you might as well just take that.

(3)  The seed preferred is probably the investor’s best friend because it sets a valuation on the closing date.  And, it starts the capital gains clock ticking so that in the case of an early exit, there is some hope for capital gains tax treatment.

It is hard to object to a fair valuation.  Of course, if it is fair, then so be it.  Unfortunately, experience suggests that valuations at the seed stage are chronically too low, with the result that after the first VC round, founder equity is diluted to the point where it is hard to see how (in the absence of a spectacular exit) the founder pay day will be all that good.

Of course, the black magic of valuation is the special provenance of VCs.  So that last paragraph was just an observation from the peanut gallery.  Unfortunately, I have seen this show more than a few times, and it doesn’t change much over time.

But here is one that is more in the provenance of lawyers:  Sometimes seed preferred docs carry in them the germ of a most favored nation clause.  That is the clause that says something like:  The Series Seed will be given the same rights as the next series of Preferred Stock (with appropriate adjustments for economic terms). 

In effect, your seed investor has gotten today’s valuation (the low one) and tomorrow’s terms (the good ones that the VCs negotiate).  If you are an entrepreneur and you believe, as I am told some people do, that investment negotiations sometimes involve a trade off between price and terms, then you just lost on two counts.

Ah, but what did you get?  A nice, simple, clean deal (that give the investor what he wants low price and good terms) at a low transaction cost (whatever fixed fee you agree to with the lawyers).

Unfortunately, many seed investors won’t stop at a simple deal.  They have loads of their own requirements.  But that will be the subject of another post.

But when our client SCVNGR asked if we’d be interested in participating in one of their groundbreaking new LevelUp promotions, we jumped at the opportunity. LevelUp is SCVNGR’s exciting new pilot for building customer loyalty by combining online daily deals and location-based gaming mechanics.

Here’s how it works. LevelUp works with merchants to create the best deals in your city – say, a special on burritos, rock climbing, or fitness centers. Each business has three levels of deals - Level 1, Level 2 and Level 3. Buying Level 1 not only gives you a great discount, but it automatically “unlocks” Level 2, allowing you to “level up” to a great deal for a second visit. If after the second visit you like what you’re experiencing, you can “level up” again and get a third great deal.

We think this is genius, and we wanted to be a part of the fun. Although LevelUp is usually retail-focused, we worked with SCVNGR to create “LevelUp Your Startup,” a special LevelUp deal for entrepreneurs with great ideas who could use discounted legal and accounting advice as well as coveted access to premier investors.  As part of Level 1, Foley Hoag attorneys will meet with entrepreneurs to help get their companies incorporated with a startup legal package.  Entrepreneurs who buy Level 1 will unlock Level 2, which includes a startup accounting package. Buying Level 2 unlocks Level 3, where top-notch investors like Rich Miner from Google Ventures, Alex Taussig from Highland Capital Partners and folks from Common Angels, Robin Hood Ventures and Dreamit Ventures will take the entrepreneurs out to lunch and hear their pitch.

LevelUp Your Startup launched on April 5th. We offered 10 startups $2,800 worth of legal services for $250 (no, there’s no comma missing there). What’s more, a share of the proceeds of this promotion goes to support a very deserving organization: MassChallenge.  Within about an hour, the deals had sold out.  

Given the numbers involved, it’s probably obvious that in the case of this LevelUp our goal was not necessarily to make money.  Instead, we wanted to be part of a great team and show how an awesome new program could be used to foster our local entrepreneurial ecosystem and help new businesses get off on the right path.  By every measure, LevelUp Your Startup has been a huge success for Foley Hoag, SCVNGR, our new entrepreneurial clients, and MassChallenge.  I think this is where I yell “Woot!”

Now to the matter at hand: We were retained by an investor leading a $1mm seed preferred type financing for a start-up digital media company. The investor will end up with around 20% of the company after close. The company is pretty hot and the entrepreneur is already a one time winner in the space. The entrepreneur is a huge Fred Wilson fan and can’t imagine how costs could exceed $5K for this deal.

In an effort to control costs, once the investment got passed the “term sheet” (and I use that phrase loosely) stage, the entrepreneur insisted that he would only make and take comments in the form of tweets. Our client agreed to this.

The deal went into hyperdrive as soon as the tweets started to fly, with tweets like:

            “Always get 6% cumulative dividends but only paid on liquidation”

            “why?”

            “standard”

            “won’t agree to have a common vote on the drag”

             “Why?”

             “have in all our deals”

As you might imagine, with this limitation on discussion we are way under Fred Wilson’s magical $5K.

Unfortunately for my client, a well-known angel got wind of all this and tossed her hat in the ring with a convertible note. She wised the entrepreneur up to a number of things including that idea that converts are better for entrepreneurs than priced deals.

So here is my challenge:

Explain in 140 characters or less why the entrepreneur should accept any of the following:

(1) a priced deal and not a convertible deal

(2) a 6% dividend

(3) a drag without a common vote

The winner for best explanation within the 140 character limit gets free legal services from me to the extent of the positive difference, if any, between $5K and my fees at standard rates on this deal.

I have been giving some thought to Fred Wilson’s recent post, “A Challenge to Start Up Lawyers”.  His basic point is that he should be able to close an angel financing of under $1mm for legal cost of $5K.  Needless to say, this post brought out the sycophants (the Fred you are absolutely right crowd) and the deeply offended (the lawyers are worth every penny they charge crowd). 

I don’t think it is reasonable to be in either crowd.  Our firm enters into a wide variety of arrangements with start-up (and other) clients.  These arrangements are intended to reflect the needs of the client and the particulars of each situation.  We may agree with a client on fixed fees, deferrals, reduced hourly rates, premiums, blended rates – to describe just a few of the arrangements we have with various start-up clients and other clients.

But, I want to talk about the $5K for a $1mm seed preferred investment.  Let me start by separating the invoice amount from the time that needs to be put into the transaction.  In the world of hourly rates, these two things are inextricably intertwined, but they need not be.

Our firm knows, because we do many angel financings, that the result of hourly rates multiplied by the time spent is highly likely to exceed $5K.  (That does not mean that we charge more than $5K or less than the hourly rate times the hours – what we charge depends upon many factors, the most important one, of course, is any agreement we have with a client.  For example, it is not unusual for us to write off time that we feel is excessive for any reason.)

So, why are the time charges (remember not necessarily the invoiced amount) likely to exceed $5K when so many angel deals are done and the terms are so “standard?”

VCs and lawyers do tons of deals, entrepreneurs only a handful.  Investments, even (or perhaps especially) angel investments involve a lot of discussion.  By way of illustration, they may involve discussion of valuation, option pools, vesting for founders, structure (seed preferred versus convertible notes) and other items.  Note that I have not yet mentioned the actual terms of the seed preferred. 

I can just hear Fred and his army of outraged investors saying:  “But we posited that the deal would be a seed preferred on standard terms and we agreed (hypothetically) on readily available open source docs.” 

OK, but I know from experience that the entrepreneur is highly likely (near 100% of the time) to come to me and say, “Fred wants to do a priced deal, but my buddy Winston got funded with convertible notes, which is better?”  So, now we have a discussion on the merits vel non of priced deals and convertible deals.  (I know that Fred won’t do a convertible deal, but that does not mean the entrepreneur won’t ask the question.) 

So, Fred, does the time spent on the discussion of priced deals versus convertible deals count towards your $5K or not?  Well let’s tick off $500 for that discussion (in the hours times rate world) and move on.

OK, now there is some sort of email or other with the “terms”.  At this juncture, the entrepreneur wants to discuss whether the valuation is fair.  (Remember that the fact that I am a lawyer and (according to most investors) as likely to know about valuations as about paleo-anthropology will not stop the entrepreneur from asking what other clients are getting.)  The meter ticks on….

Eventually we get to the seed docs themselves.  I produce the docs at the speed of greased lightening.  Unfortunately, the entrepreneur reads them and, guess what, has intelligent questions. 

Here is a good question:  Ted Wang’s open source docs provide an MFN provision for new terms arrived at in the next equity round.  I have a client that asked at least these questions about that provision alone:  What does it mean?  Is it fair?  How might it impact my negotiations in the next round?  Does it give my angel investor a practical veto over the next round?  And the meter ticks on….

Anyway, you get my point.  It is not mere document production; it is time spent with the client.  No lawyer wants his client to sign something that the client is not comfortable with and does not understand.  It is just not good corporate hygiene.  (In fact, it might be malpractice.)

So here is one for you Fred:  Would you want your portfolio company to be using a lawyer who just says these are the standard open source docs, just sign them please?  Would you invest if you knew the entrepreneur signed on that basis?  Would you invest if the entrepreneur read the docs and did not have any questions?

Now back to the price.  Many high quality reputable firms would agree to a fixed price (perhaps $5K) – not because they believe they will be able to bring in the time at a profitable rate, but because they think of it as business development.  They may have other reasons as well.  The thing to do is to have a discussion and agree at the front end as to how the billing will be handled.  But don’t be under any illusion.  It is unlikely that rate times hours will yield $5K.

One more point is that law firms are likely to view fixed fee arrangements as loss leaders.  They are planning to get more work on which they can make a profit.  Fred’s example of the exit (where the law firm charged six figures) is an excellent case in point.  The risk, of course, is that the firm that did the early work at what is in effect a discount, does not get the more profitable back end work.  This can happen when VCs (and other advisors – most of whom know as much about legal work as they do about paleo-anthropology) come to the conclusion that the company needs a thousand lawyer national megafirm for the “important” work, and they push the client away from the start-up lawyer.  It can happen for other reasons as well, the ingrained preferences of a new CEO or CFO, the insistence of a new investor that the company use one of its “favorite” firms, or the insistence of a heavy hitting board member to the same effect.

This leads to a lose lose situation for the start-up lawyer, who will now think twice before doing the angel financing at a loss.

One problem is that sometimes parties assert that a particular provision is standard in a context that just isn’t the kind of place where it belongs.

My current bug bear is the “drag – along” -- a standard feature of venture investments.

Well the “drag” is standard in venture investments because VCs typically own a controlling interest in the companies they invest in and they want to have more or less unfettered freedom to exit without regard to the structure of the exit.  Here is the pure case:

VC owns 60% (or more) of the voting stock of EasyTech, Inc..  VC wants to be able to force an exit and is concerned that for some unforeseen and unforeseeable reason, the exit may have to be structured as a direct to stockholder transaction.  That is to say the buyer may need to acquire the stock of Easy directly from the stockholders rather than through a merger (as is mostly done).  This means that each stockholder will have to make his or her own decision and, if there is a holdout, it might queer the deal.  So, the VC wants to be able to deliver all the shares (or almost all – not going to get into why not 100% at this time).  The drag is a contract that permits him or her to do just that, if certain conditions are met.  Those conditions are typically (1) board approval of the transaction and (2) approval of the holder of a majority of the preferred stock.  In effect, the holders of common stock are required to sell – it does not matter what they think.

Well, this makes sense in the context described above.  When the majority wants to sell why should the minority be able to hold them up, and why should it matter what form the transaction takes?  That is why the drag is standard in these deals.

But, what about other contexts?  Should an angel investor acquiring just 20% of the stock of a company have the same right to drag the holders of 80% of the stock as a VC who owns 60% of the stock?  There are a lot of angel investors meeting this general description who present this type of drag as a standard provision, and there are a lot of entrepreneurs who simply accept it without further consideration. 

So here are some things to consider.

First, the pure case (where the VC owns a majority):  Why is the board part of this at all:  From the director point of view it puts pressure on the directors to be extra careful from a fiduciary duty perspective because the only protection for the common stock is board approval.  So, in theory, at least, the board may become subject to attack from a common holder who thinks the deal was not “good enough.”  Remember, the board, in this context, is likely to be dominated by representatives of the VCs and the deal may be a direct to stockholder deal that might not otherwise require a board vote.  Why would a VC want this situation?  In the pure case, it might make sense to have the drag be a contract between the preferred holders and the common holders and not involve the board.

Second, the minority investor case:  Is it really the expectation of the majority that the minority can drag them into a sale they don’t want?  I don’t think most entrepreneurs think that when they take on an angel (even a professional angel group) for a minority investment that the angel will have the legal authority to sell the business out from under the majority.  So, in this case, it seems to me that the drag should require some vote of the common as well as the preferred – assuming it should exist at all.  The argument for a drag that requires a common and a preferred vote in this context is that the collective majority should not be able to be held up by a pain in the ass minority stockholder.  This type of drag is sometimes referred to as a “housekeeping drag” , and it makes a lot of sense to me, in the angel investment context.  Again, putting the board in the middle seems to me to invite a potential problem for the directors.  I wonder if it is not more consistent with the expectations of the parties that the drag be a purely contractual arrangement among stockholders and not subject to someone’s interpretation of their fiduciary duties.

Another question is whether the majority should not be able to drag the investor.  It seems highly unlikely than any investor would agree to such a thing on the grounds that they do not want to create a perverse incentive to sell early.

So, when would you put the board in the middle?  How about when the drag becomes a bone of contention in a negotiation and you need some compromise to get over the issue?

For a variety of reasons, drag-along provisions don’t tend to get a lot of thought.  They are often treated as standard or boilerplate with results that sometimes don’t really fit the situation.

As I have done each quarter for some time, this blog presents a comparison of the published statistics relating to venture deals from my firm, Foley Hoag LLP, and the west coast firm, Fenwick & West LLP.  This time I am not including Cooley LLP because their year end edition has not yet been published. 

Here are some general thoughts:

Foley Hoag, in our publication Venture Perspectives, reported on a total of 46 deals in New England.  Fenwick reported on 95 deals in the Valley.  This puts the New England market at about half the size of the Silicon Valley market  -- entirely consistent with historical norms (at least for so long as I have been observing the scene).  The new comer, of course, is New York, where, according to Crain’s New York business.com, there were 51 financings in Q4 in New York in the following industries 20 in software, 17 in media and 14 in IT (for sure there were other in other industries). 

On the one hand, this might suggest that New England is losing ground to NYC.  On the other hand, it suggests that the north east (New England plus New York) is now as big a market as the Valley and is probably growing faster given the velocity in NYC.  (I can hear the Valley folks saying you’ve gotta include Seattle and San Diego – whatever.  If that is where they take it, they have in effect conceded the point.)

Even more interesting, is that most of the New York deals are software, digital media and IT related.  Based on anecdotal evidence there were a significant number of digital media deals in New England (unfortunately, our survey lumps media in with software so I don’t have precise number).  According to Fenwick, the most active sectors in the Valley were software followed by cleantech and hardware then came internet and media followed last by biotech.

If I had to pick something hot today, it would be internet and digital media – and the epicenter is not in the Valley!  The reasons for this are almost certainly that the advertising industry is headquartered in New York, there are lots of digital and data infrastructure companies in New England, and there is lots of money in New England and New York to fund these businesses.  It is efficient to be near the relevant infrastructure (the advertising world).  Apologies to Nivi and all the other “you have to move to the Valley” proponents, but if you are working on a digital media company – don’t relo to the Valley quite yet.

So, with that as a background, below is my usual table comparing actual deal terms.

Comparison of Terms for Q4 2010 Venture Deals from Foley Hoag and Fenwick & West

(some percentages are approximate)

It pains me every time I write this, but there is a persistent and consistent difference in terms between New England and Valley deals.  Look at cumulative dividends and redemption.  The numbers are consistent quarter after quarter.  At least as to these terms (and painful as it is to admit, I suspect as to others), entrepreneurs get a better deal in the Valley than they do in New England.

There is just too much out there – snow and blogs.

Finally, here is something that actually might be helpful.  Larry Cheng has published his 2011 directory of top VC blogs.  Here is the link.  His directory lists 149 VC, seed etc. blogs.  The top ones are ranked by number of monthly uniques in Q4.  Thank you Larry. 

But, who is really going to read all those blogs?  No one.

This kind of crowding happens just before a shakeout.  We are in the bubble before the burst.  Think .com in 1999 or tulips in 1624.  Whatever all these VCs think they are getting from all the blogging, the returns will not be there for almost all of them. 

Here are two predictions:

• Many will soon stop blogging (and by soon I mean 24 months). 

• Some will find nitches in industry or other verticles.

Blogging is on the verge of becoming a mature industry with a relatively small number of established players who express the mainstream opinions for the Venture industry, and they will be enough.  Blogging will soon be old and stodgy – my god even lawyers are doing it.  The wave of accountant bloggers can’t be too far behind. 

A major component of the FTC report, Protecting Consumer Privacy in an Era of Rapid Change, is the idea of consumer choice.  This is the idea that when a consumer provides a company with certain types of information, the consumer should be informed as to what that company intends to do with that information and then should be able to choose whether or not to continue the interaction.  One of the goals outlined in the FTC report is to allow “consumers the ability to make informed and meaningful choices” regarding the use of their information for data collection purposes.  The FTC further states that businesses interacting with consumers should present choices “clearly and concisely,” while offering “easy-to-use choice mechanisms.”  Exactly what is determined to constitute an informed choice in the final regulations is likely to have a significant impact on every company that is subject to these regulations.

            As the FTC notes in its report, there are many considerations to weigh in determining how to best present this choice for the consumer.  First, there is a question of when the necessary disclosure and consumer control mechanism should be presented.  In the case of a website where the company is providing retail or other service directly to the consumer, common sense tells you that the consumer should be presented with the choice mechanism at the point of sale or exchange of data.  This question becomes more complicated, however, when one considers the example of a social media service where the relationship between the consumer and the company might be ongoing, and where the nature and scope of the information being exchanged often changes over time.  In this scenario, should the consumer be continually prompted to provide consent to the use of their information?  Alternatively, should all potential exchanges of information between the consumer and the company be included in the initial disclosure and consent?      

            A second consideration for establishing the proper consumer choice mechanism is the content of the disclosure itself.  As the FTC report makes clear, the Commission staff believes that disclosures and the choices presented buried within lengthy privacy policies will not result in meaningful, informed consent by consumers.  While the Commission staff clearly prefers a simple and widely-accessible approach to providing this choice, their report provides little evidence of how they intend to apply these ideas to the varying types of consumer interaction with different websites, services and products.  For instance, how would the developer of an application used on a mobile device both clearly and accurately provide the consumer with the required disclosure when those disclosures might involve describing complicated relationships between third-parties?  Further, is it feasible to believe that a consumer who might download such an application while commuting on the subway will read the disclosures on their mobile phone and then be able to provide an informed consent?     

            Despite fact that this question of consumer choice will likely be a central element of any new regulations related to the protection of consumer privacy and the use of consumer data, the FTC’s proposals provide many more questions than answers on this issue.   One of the proposed approaches is some version of an “opt-in” or “opt-out” consent provided to consumers when they seek to engage with a particular company.  Similar to the concerns over the “Do Not Track” proposal, there is a significant possibility that this simplistic, all-or-nothing approach might encourage consumers to simply choose to “opt-out,” without much consideration to the trade offs involved with the exchange of data for the services of the company.  As consumers opt-out, companies who up to that point have relied on the use of consumer data as a way to keep the cost of their services low (or free), will likely need to raise prices on the consumer.  On the other hand, should consumers choose some sort of general “opt-in” when they purchase or begin to use a product or service, the regulations likely will not have the intended effect of increasing consumer knowledge and control over the use of their personal data.  

            As with most elements of the FTC’s report, these issues do not lend themselves to simple, blanket solutions.  As stated in its title, the purpose of this report is to protect consumer privacy; however, the framework in its current form is weighted too heavily on the side of privacy, without enough consideration for the practical implications for the businesses that provide many different products and services to consumers.  All parties would benefit from a regulatory approach that takes into account the nuanced and complex relationship between consumers and businesses in this increasingly data-driven sector of the economy. 

First-party marketing: Online retailers recommend products and services based upon consumers’ prior purchases on the website.  Offline retailers do the same and may, for example, offer frequent purchasers of diapers a coupon for baby formula at the cash register.  Some of these practices, such as where a retailer collects a consumer’s address solely to deliver a product the consumer ordered, are obvious from the context of the transaction, and therefore, the consumer’s consent to them can be inferred.

Staff proposes that first-party marketing include only the collection of data from a consumer with whom the company interacts directly for purposes of marketing to that consumer.

Basically, online behavior that is analogous to offline behavior (Macy's giving you a discount on your next purchase or taking down your address to deliver goods, etc.) is likely to be OK under the new rules, whatever they may eventually be, and, by the way, it should be.

The real rub occurs when companies start doing things that are not analogous to mainstream offline behavior, particularly when a company shares data with a third party or allows a third party to collect data about consumers visiting that company’s site.

As the FTC puts it:

If a company shares data with a third party other than a service provider acting on the company’s behalf … the company’s practices would not be considered first-party marketing and thus they would fall outside of “commonly accepted practices,” …. Similarly, if a website publisher allows a third party, other than a service provider, to collect data about consumers visiting the site, the practice would not be “commonly accepted.

The underlying rationale appears to be that the FTC believes that consumers expect, or can be inferred to expect, online business models to mimic offline business models.  If you are doing, or planning to do, something different and creative, you are likely going to have to meet a much higher regulatory burden than if you stick with the status quo. 

This regulatory framework is, of course, great for the status quo.  If you are doing regular stuff that the FTC imagines most consumers understand and expect, then you probably can keep doing it without much additional new regulatory intervention.  Hence, Amazon can keep on tracking your purchases and recommending books.  Google probably gets a bye as well.

But, what if you come up with something new.  Google was new once, although that was a long time ago in technology years.  I even remember being pleasantly surprised to receive book buying suggestions from Amazon. 

I don’t know what will come next.  The pace of technological innovation in this area is staggering.  Consider the rate at which Google, Facebook and Twitter evolved.  If you come up with something new, how expensive and time consuming will it be to get the FTC to say it is OK? 

Right now the US is, without question, the world leader in the communications/social media world because it is by far the best innovator.  This brings jobs and, by the way, money (as Google, Facebook et al expand overseas) into our economy.  Without some lower bar for innovative companies, the FTC may be putting lead weights on the wings of the goose that laid the golden egg.

The FTC and Commerce may well be hanging a giant sign on the door reading “Whatever you do, don’t innovate.”

            By now, readers have seen by now the preliminary FTC Staff Report, Protecting Consumer Privacy in an Era of Rapid Change (the “FTC Report”) recommending implementation of a “Do Not Track” mechanism available to all Internet users.  The Staff envisions “a uniform and comprehensive way for consumers to choose to block online tracking and targeted advertising” accomplished by legislation or potentially through robust, enforceable self-regulation.  Media outlets have heralded the ill-defined mechanism as a simple and powerful tool to aid Internet users in their losing battle to elude an ever more complex and technologically sophisticated tracking bogeyman.  Sounds great!  “Where do I sign up?” ask the masses.  Slow down masses.  As with most sweeping government regulations, the devil is in the details.  More bedeviling is that there are no, or very few, details.  The Staff merely suggests that a “persistent browser cookie” might be the most practical means of implementing “Do Not Track.”  Serious technical and other challenges to implementation, and uncertainty as to whether legislation or “robust, enforceable self-regulation” would be sufficient are then acknowledged.

            In a nod to the FTC report, the recent Department of Commerce green paper: Commercial Data Privacy and Innovation in the Internet Economy (the “Commerce Green Paper”) asks how the Commerce Department can best “encourage the discussion and development” of technologies such as “Do Not Track.”  In general, the Commerce Green Paper reflects greater support for cooperative industry self-regulation regimes than does the FTC Report.  Commerce acknowledges that the rate at which new technologies and services develop, and the pace at which consumers form expectations about acceptable and unacceptable uses of personal information, is measured in weeks or months, while a rulemaking can take years and result in rules addressing long-since abandoned services.  As such, Commerce suggests engaging multi- stakeholder groups, and employing a “Dynamic Privacy Framework” as the best means of enabling Internet users to take advantage of “Do Not Track” in whatever form it emerges.  The Commerce Green Paper mentions in a footnote testimony that goes to the heart of what every stakeholder should have in mind:  “[A]greement on what is meant by the ‘do-not-track’ sign on, say, the user’s browser, is a . . . complex task, requiring agreement on policy and best practices among a number of players including users, advertisers, marketers, technology companies, and other intermediaries.”

         FTC states that the most practical method of providing uniform choice for online behavioral advertising would involve placing a setting similar to a persistent cookie on an Internet-user’s browser and conveying that setting to sites that the browser visits, to signal whether or not the consumer wants to be tracked or receive targeted advertisements.  “Do Not Track” boosters, media and the FTC trumpet the success of FTC’s popular and successful Do Not Call registry as a bellwether of what life in a “Do Not Track” world will look like.  Some have stated that the complexity of implementing “Do Not Track” would be similar to that involved with implementing Do Not Call. Unlike Do Not Call, however, it would be unnecessary, impossible, futile and kind of ironic for the government to set up a centrally administered database of people who have elected to take shelter under any FTC-enforced “Do Not Track” umbrella.  FTC’s envisioned “uniform and persistent choice” browser setting would instead send a universally recognized message to deactivate tracking technologies.

Although a “Do Not Track” mechanism could be simple to implement from a technical standpoint, to the extent that it takes the form of a simple on/off switch such a mechanism could amount to an innovation-stifling, business-model killing command and control regime enforced by bureaucrats.  The Commerce Department Green Paper recognizes that this is the worst-case scenario.  The Green Paper states that any “Do Not Track” mechanism needs to be colored by stakeholder input and ultimately more nuanced than simply allowing consumers to flip a switch to turn off all tracking technologies.  Commentators point out that this is because most Internet users like using the free stuff available on the Internet and are willing to pay for it by way of receiving certain targeted advertisements.  The question for stakeholders, then, becomes what constitutes “tracking” and what filter will users will be able to apply to tracking activities so as to personalize their experience? For example, a user may be happy to receive targeted marketing from businesses relevant to his profession, but opposed to the collection and sharing of any information concerning that rash he picked up in the hotel spa.  Stakes are high concerning the answer to the question of what tracking is, as countless innovative business models rely on monetizing information about Internet users in one way or another.

Do Not Track makes a lot of sense as a normative principle.  If an Internet user feels uncomfortable with a certain behavior, that user should be able to opt out of being subject to that behavior, whether the behavior is accomplished by way of a cookie, a flash cookie, or some other method either he or his browser has not learned how to fend off.  The problem is in figuring out how to attack the behavior (collecting and sharing information and Internet browsing behavior concerning that rash) without creating a bright-line rule against innovative, useful and responsible ways of collecting and using information in the context of informed consent.   Content providers use the information they collect to do lots of stuff that Snidely Whiplash would find downright mundane and in many cases benevolent (e.g., debugging and personalizing user experiences). 

“Do Not Track” is not like Do Not Call.  When the FTC bars a vinyl siding salesman from calling me at dinner, I am happy.  If FTC inadvertently prevents me from enjoying a personalized experience on Pandora, my utility will likely take a hit.  As such, FTC has proposed a system where users exercise “granular control” over their “Do Not Track” preferences, rather than a crudely fashioned on/off switch.  As technologies and uses of information advance, though, how can such granular control be exercised and enforced without ending up with a tome of regulations the size of the Internal Revenue Code?  This is where it is essential for stakeholders to provide input to FTC and the Commerce Department.  “Do Not Track” was conceived with the best intentions in mind, but I’m afraid with little thought beyond how great everyone thinks Do Not Call is and whether the technology exists to persistently block scary-sounding trackers.  Stakeholders need to give the FTC and Commerce Department some real-world perspective as to what a command and control “Do Not Track” regime would look like in practice and as to what alternatives there are for protecting Internet users’ interest in the responsible, transparent use of their data in the context of informed consent.  To these ends, FTC has asked several very important questions concerning any implementation of an enforceable “Do Not Track” regime.  Among them:

• How should a universal choice mechanism be designed for consumers to control online behavioral advertising?
• How can such a mechanism be designed so that it is clear to consumers what they are choosing and what the limitations of the choice are?
• What are the potential costs and benefits of offering a standardized uniform choice mechanism to control online behavioral advertising?
• How many consumers would likely choose to avoid receiving targeted advertising?
• How many consumers, on an absolute and percentage basis, have utilized the opt-out tools currently provided?
• What is the likely impact if large numbers of consumers elect to opt out? How would it affect online publishers and advertisers, and how would it affect consumers?
• In addition to providing the option to opt out of receiving ads completely, should a universal choice mechanism for online behavioral advertising include an option that allows consumers more granular control over the types of advertising they want to receive and the type of data they are willing to have collected about them?
• Should the concept of a universal choice mechanism be extended beyond online behavioral advertising and include, for example, behavioral advertising for mobile applications?
• If the private sector does not implement an effective uniform choice mechanism voluntarily, should the FTC recommend legislation requiring such a mechanism?