Emerging Enterprise Center Blog - Commentary and Analysis For Entrepreneurs and Startups

Listen carefully when a lawyer says, “You’ve got an argument” or “we could argue that …” followed by some convoluted reasoning. This phrase could mean that your position is a loser but that he might be able to stir up some controversy and make life a little difficult for the other side. It may also mean that your lawyer hasn’t got the stones to give you the bad news. Lawyers know that clients have a tendency to take comfort in these words. To clients these words seem to translate into something like “if we say this the other side will capitulate.” But, your lawyer takes comfort in the fact that he has not given you any assurance of the outcome. What this phrase specifically does not mean is that the argument has any merit. In fact, I think it is most used when the argument has no merit. I am overstating the case, of course, but often what happens is a mutual self-deception. 

A while back, I had the job of giving a client the bad news that a contract simply did not provide for the license of certain software products. My client pointed to some language in the contract and said “but we could argue that …” and followed it with an interpretation of some words that defied common sense. Well, the other side can read the contract too, and they can find something they can argue too. This client proceeded to argue with his licensor and got nowhere. From this he concluded that the licensor was either a fool or a knave, since his argument should have worked on any sensible person. But, what he did not end up with was the license. Would he have done better without the self-deception? Who knows? But you have to believe that on average, you are better off understanding the real situation than placing your hopes on some half baked theory.

An argument is a fine thing, but don’t count on defeating your opponent with some Byzantine argument. In any negotiation or litigation, the best ally you can have is good commercial economics. Failing that a simple, easy to state, common sense reason that a thirteen year old could understand will hold you in good stead. 

I have been out of the country and not watching the blog scene as carefully as I should, but as I sit here in Beijing waiting for my delayed flight, a friend has brought two postings to my attention, and they are both good posts.

Data on the startup/venture industry:

Techcrunch has posted its exec summary (or a portion thereof) for its first year in review.  In an industry where good data (let alone information) is hard to come by, this promises to be a welcome new source.  Congratulations. 

With respect to antidilution:

Fred Wilson has a post on "Founder Dilution -- How Much is Normal."  It is followed by something like 62+ comments almost all of which are worth the read if dilution concerns you.  There are also a number of links that may also be of interest. 

In the context of venture financed technology companies, a one year post employment noncompete is standard stuff, at least here in Massachusetts. California, famously, passed a statute making employment related noncompete agreements illegal in that state. That statute has led to a few sticky issues for companies that start out in other states, such as Massachusetts, and then open operations in California. For example, what do you do when you have a long standing Massachusetts employee and you relo him or her to California? Or, what about requiring some employees to sign noncompetes and not others? By the way, California permits nonsolicitation agreements, nonhire agreements, confidentiality agreements and the like. So, how significant is it really that you can’t have a traditional noncompete? Acutally, I am heading down the wrong path California noncompetes, blue sky laws and etc. are going to be the topic for another day.

I recently met with the first employee of a start up client (located here in Massachusetts) who told me, quite sincerely, that he was unwilling to sign a noncompete because he objected to them on philosophical grounds. While I can imagine a lively debate on this subject, it would be completely impractical. Professional investors will require all employees (especially key technical people) to sign them or they wont invest. Savvy founders know this and, whatever their private thoughts may be, will insist that their employees sign standard forms of noncompete (ditto invention agreements and confidentiality agreements). If you are of the philosophical persuasion that noncompetes are a bad idea, that is fine; don’t let it get in the way of your signing one.

Everyone wants “incentive stock options” (as such term is defined in the Internal Revenue Code) as opposed to non-qualified options, because of the potential to capture capital gains tax treatment after the exercise of the incentive stock options and the eventual sale of the underlying stock. The option holder hopes to pay capital gains tax (as opposed to income tax) on the difference between the exercise price of the option and the price at which the underlying stock is eventually sold. So, if you have options to purchase 100,000 shares the Mighty Software Corporation with an exercise price of $.20 per share when Mighty is sold to Microsoft for $2.00 per share, your hope is to realize $180,000 of profit. If you are taxed at the current long term capital gains tax rate of 15% you would pay $27,000 in tax and keep $153,000. Compare this result to paying tax at the highest marginal rate of 35%. $180,000 multiplied by .35 is $63,000. In this scenario, you keep $117,000 (or $36,000 less than if you had paid tax at the capital gains rate). 

The dirty little secret of incentive stock options is that the holder must comply with a variety of requirements under the Internal Revenue Code to actually get capital gains treatment. Among these requirements, is a holding period requirement the effect of which is to prevent the option holder from getting capital gains treatment in almost all cases. The holding period requirement is that one must hold the stock obtained upon exercise an incentive stock option for a minimum of one year in order to get capital gains treatment. In fact, you have to hold the option and the stock for a combination of two years, but at least one year has to be after exercise.

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Incorporation may seem so obvious that it hardly bears mention. Nevertheless, at the risk of being boring, you want to incorporate because: (1) if you do it right as a general proposition, you get protection from personal liability for the obligations of the business, (2) the company (or LLC or limited partnership) is a vehicle that can be financed, and (3) it greatly facilitates many mechanical aspects of the business, such as hiring people, holding assets such as IP but other assets as well. 

With respect to personal liability, as everyone knows, companies get sued for many reasons, often contractual disputes or employment related disputes.  Companies are separate legal persons (different from their owners), and companies are legal actors.  So, companies (as distinct from their owners) enter into contracts, and companies are obligated to perform those contracts.  If the counterparty to a contract is disappointed for some reason, recourse is to the company that entered into the contract, not the owner of the company.  Now, this is not the case if you don't respect the legal entitiy by doning things like keeping appropriate books and records, not commingling funds with your personal account, signing documents personally (rather than on behalf of the company -- this has to do with how signature lines appear on documents) and the like.  Also, there are certain kinds of claims (including torts) where the individual actor (in addition to the corporate actor) will have liability.  Nevertheless, by incorporating you protect yourself from many potential sources of liability.l

Financing is really a subset of dealings with third parties, but it merits its own mention.  Perhaps it is sufficient to say that no VC will write you personally a check for $XX.  These investors expect to sit on boards, own an known percentage of a company etc.  This is all achieved by investing in a corporation (or LLC or limited partnership).

A separate question is when to incorporate.  This will be the subject of another post.

I am usually a sucker for predictions about the future, especially with things having to do with the Web, and all the more so because I am particularly bad at predicting it myself. I need to admit that when I first heard about Twitter, my reaction was that it was just one too many. Things keep going in one direction until they have self-evidently gone too far, and I thought Twitter was evidence of having gone too far. But, there it was on CNN on election day. How much more mainstream can you get than the “best political team on television?”  With Wolf using Twitter and God only knows how many grandparents on Facebook, where will the social media world go next?  Well, Read Write Web has one guess as well as a number of embedded links to various social media sites that are heading off in various directions.

According to VentureWire,

A plague of layoffs touching all industries - specifically the finance and technology sectors - has opened the flood gates for entrepreneurs looking to strike out on their own at a time when jobs are scarce. Some cases are desperation, while others are an opportunity for talented executives to take the start-up plunge they always dreamed of.

Only time will tell, if there is really a large wave of new start-up activity. My entirely subjective sense is that it may never be a good time to do a start-up, but some times are worse than others. If you can bootstrap or if you have access to angel (or here is an unlikely thought) VC money, now may be a good time to start on the theory that you wont need market traction for a year or more and you can catch the next wave. If you don’t have a brilliant business plan and you expect to get professional investment, it will be very hard to find. My sense is that investors are not feeling a lot of pressure to invest right away. They are actually looking at fewer opportunities (even though there may be more out there) and they are looking longer and harder at them.