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

Last week Fred Wilson and I had a good back-and-forth going via comments on his post about venture capital returns . I’ve been thinking more about what I wrote concerning the proper measurement period for calculating returns and I thought I should follow up to Fred’s last reply . So, here are a couple of thoughts: (1) No matter how you calculate returns, an actual improvement will help the industry. The internal revenue code (IRC) is biased against venture capital investment in a material way. One change in the IRC would have a material impact on venture returns. More below. (2) I’m no accountant, but I believe LPs in venture funds have to account for their investments as a liability from the time they agree to invest. (3) Maybe, LPs in VC funds have sophisticated models anticipating calls etc. But that may be more scary than good.

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Here is a link to an article about option repricing. Intel and other big public tech companies are doing it. Options are supposed to provide employees with an incentive to improve results and thereby increase stock value. In a sense, they align the employee interests with the stockholder interests. On the one hand, underwater option provide little (maybe no) incentive to employees. On the other hand, if you reprice downward when there is a market decline, you protect employees from the downside risk in a way that you don’t (and can’t) protect common stockholders. You can pick your poison.

The nature of the law business is that pretty much each attorney is an individual contributor. You do the work clients need when they need it. If clients have conflicting needs, it is mostly up to you to prioritize and manage your own way through it. Sometimes you work on large matters, IPOs (when there used to be such things) and mergers being examples, and you have to coordinate with a group. But, generally, you are the master of your day, your week, your month and your year. When we opened the EEC things changed a lot. We changed the model to some extent and now there are a lot of projects that have to be done by many people over many months (even years). Just saying, “the client needs it ASAP” doesn’t help. When, exactly, is ASAP?

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Sometimes practical reality and legal niceties collide like trains guided by Chas Adams. Here is a typical situation that must happen on a daily basis somewhere: I recently had a start up client call up and say that he wants to issue options to a new employee. The company was founded a couple of months ago, founder shares were issued, IP was contributed, options were offered, new guy was hired, client wants to know how to price the options. Enter Section 409A of the Internal Revenue Code which provides that the options must have an exercise price not less than the fair market value of the stock and fair market value be determined “by the reasonable application of a reasonable valuation method.”

Client: “OK, you’re my lawyer, how do I do that?”

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To a large extent, but not exclusively, whether to be a “C” corporation or an “S” corporation or a limited liability company (and “LLC”) is a tax issue. LLCs and “S” corporations are so-called pass-through entities. That is to say that the entity itself is not taxable; its tax attributes (profits and losses) are passed through to the owners of the entity, and they pay tax in accordance with their particular tax situation (often at the highest marginal rate for individuals – assuming they are well-to-do). (Most LLCs and “S” corporations distribute cash to enable their owners to pay these owner-level taxes.)   Distributions or dividends that an LLC or “S” corporation pays to its owners are then free of a second level of tax.  Profits of a “C” corporation, on the other hand, are subject to double tax: first, the entity itself is taxed, and the shareholders are taxed on any dividends paid to them.

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Dan Frommer of Silicon Alley has noteworthy a post on start ups merging with each other.  It can't make sense for many start ups to merge with each other.  They are already stretched just keeping themselves going and executing on their own plans.  So, they are unlikely to have the bandwidth to take on a second project.  Hence there will be few synergies and fewer savings.  Unless the two start ups are more fundable when put together than they are apart, something is going to get mothballed.  This strategy suggests that one (maybe both) parties can't find a buyer, even in a distress sale.  Dan Frommer notes that Google "is waiting to buy companies until prices come down."  I wonder if  this strategy isn't just aimed at preserving or enhancing some value for a distress sale in the coming months.  if it is, I don't think we will see a lot of this activity because sellers have to have more options with a single product than trying to find a buyer (who may or may not) see the synergies of the two start ups together.  Presumably a buyer could put them both together itself if it was so inclined.

What are you seeing? People seem to be asking each other this question with increasing frequency. I attended a board meeting for a client who will need to be doing a financing in the next few months, and that was the one question everyone wanted to have the answer to. There is no good answer to this question because no one is seeing anything. We all have random data points. So, here is my answer:

Prepare to be horrified. Funded companies that are doing well and controlling their burn, are getting appalling down valuations from potential new investors. These valuations are often below the original “A” round valuation. Imagine meeting your milestones, controlling your burn and going from $80 million to $10 million on valuation. This is if you are lucky enough to get an offer of investment. Most of what I am seeing is people doing a bunch of diligence and then declining politely.

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There must be millions of NDAs out there. How controversial can they be? One of my clients and I recently put together a form of NDA that was specifically designed to be easy to sign. We made it simple, one page; we took out a lot of the legal boilerplate; we did not take any aggressive positions (tried to make it completely evenhanded). 

So far, she has sent it to two companies and neither has signed it. In one case, we got back a revised draft that, in effect, put back all the provisions we took out. All but one of these “new provisions” are favorable to my client. So, we plan to agree to them. One example is they lengthened the duration of the NDA. 

Why would they do this? Who knows? The ways of lawyers are often mysterious. One lesson might be don’t bother trying to short cut the process because there is a good chance that your short cut will make for a long delay.

A couple of things to be aware of in NDA:. First, the duration – should it be infinite or for a stated number of years or some other period (and if for a specified period how long)?  At a minimum it should be long enough to protect confidential information for however long you think it will have value as a result of being confidential. Second, identification of what is and what is not confidential. Does the stuff have to be physically marked confidential or is it enough that one should know (or something in between)? Third, when does stuff cease to be confidential? When it enters the public domain? When it is generally known? Consider also what state you want to enforce the NDA in. There is a lot more that goes into these agreements, but if you think through these items, you have a good start.