Khosla Comments

Posted by Dave Broadwin on July 31, 2009

Here is a link to the Wall Street Journal blog post on Vinod Khosla’s comments at a recent conference. Mostly what Khosla has to say is interesting because he says it. To me the most interesting thing about the WSJ blog post is that Khosla did not appear to say anything remarkable (except perhaps his comment about setting aside 3 billion acres to test various energy technologies). In fact he seems to state the obvious such as “the cheapest thing ends up winning.” Well, that is a problem for investors in new energy technologies because oil continues to be cheap (or at least cheaper than the alternatives). There will be a price per barrel at which this statement will no longer be true. I don’t know what that price is, but that price is way up there (perhaps well north of $100 per barrel). I think Khosla has been credited with actually calculating that price, but a quick internet search did not yield it. Anyway, as I (and others) have pointed out before, it could be many years before oil approaches that number. This is not a reason not to pursue alternative fuels, but it is a reason to believe that the returns on investments in alternative fuels may be farther off than say investment in social media or other technologies. By the way, from a venture perspective, if the returns on funds raised today are not expected for more than ten years, VCs wont invest. So, an alternative financing method (an alternative to the customary 10 year venture fund) needs to be found for some (maybe all) of these projects.

IPOs and the Venture Model

Posted by Dave Broadwin on July 29, 2009

It is a truth universally acknowledged that investors in tech companies get the best exit valuations in IPOs. This has been accepted as axiomatic as long as I have been practicing law. As far as I can tell, when public companies get acquired the buyer usually pays a premium over the public valuation. This premium, often referred to as a control premium, suggests that there is “extra” value in not being public. If companies typically command a premium when control is sold, why are they not valued at a discount when they go public and control becomes diffuse? I can imagine a number of rationalizations for this anomaly (that companies command a premium when they go public and another premium when they go private), one is that these companies may have been public for a while and their public values may have sunk considerably from the halcyon days following the IPO.

But the point I want to get to is that you might think that selling a private company would produce a bigger premium than taking it public. The seller could jump all the way to the final control premium price. Another thought is that most venture financed companies that have gone public in the past ten years have not performed well. Obviously we are in the Great Recession, but this observation was, I think, widely thought to be true even before the Great Recession.

One possible explanation, among many, is that IPOs were hyped and sold rather than researched and bought by thoughtful investors. In other words, as Healy Jones said in his blog Startable some time ago, the public was sold a lot of stock that really did not have good investment characteristics (it was a load of crap and people lost a lot of money investing in it). Of course, there were and are a few stars (Google for one). Having said all this, it may be (perhaps certainly is) true that private buyers such as Google, Microsoft, AOL, Zimmer, etc. are just more discerning and more able to accurately value acquisition candidates than public investors.

If you agree with the thought that most of the venture backed companies that have had IPOs should not be public, then you probably agree that the IPO market should not return to pre-Great Recession norms. How much below these norms the IPO market should/will return to is impossible to tell. But, if the so-called venture model is dependent to a material extent on a robust IPO market which in turn is dependent upon investors making poor decisions, then there really is something wrong with the venture model. The venture model needs to work based upon returns obtained from sophisticated private buyers – who seem to pay less than the public.

Aligning interests

Posted by Dave Broadwin on July 27, 2009

I recently attended (actually spoke at) a training session for new hires at a major accounting firm. The speaker immediately before me was a well known partner in a prominent venture fund. In response to a question from the audience, he asserted that, although not perfectly, the basic structure of convertible preferred stock universally used in the venture industry aligns the interests of investor and entrepreneurs (management).

While I am confident that most, perhaps all venture investors, believe this to be the case, I do not think the sentiment is shared by most, or even a majority of, entrepreneurs. As I have noted in prior posts, the divergence of interests can most clearly be seen in the case of preferred stock with a preference and participation. These terms set up a situation in which the investor can make a return (not a brilliant return – but perhaps a single or maybe even a double) in an exit in which the founders and management make very little. Investors may be willing, or even eager, to sell at valuations that are real disappointments to the founders and management. Another term that can misalign interests is dividends. In a sale, investors typically get their investment plus any accrued dividends before the holders of common stock get anything.

I am not sure that the misalignment can ever be fixed. Perhaps a better way to say it is that I am not sure that alignment can ever be perfect. Having said that, the prevalence of preferred stocks with preference and participation is setting up a situation in which there will be a lot of friction between founders and management on the one hand and investors on the other hand – especially in a weak market for exits where valuations are likely to be low. We are likely to see this play out starting in about one year.

What about preference with a capped participation?

Posted by Dave Broadwin on July 22, 2009

The way capped preferences work is that in a sale of the business, the VC investor gets its investment back (a so-called 1x preference) and then participates with the common in any proceeds from the sale that exceed the preference. Imagine the fairly frequent case of a 2x or 3x capped participation. This means that the VC gets to participate until her return is 2x or 3x, as the case may be, their investment. (If the VC would get more by converting, they will simply convert.) This kind of structure helps the VC in low to intermediate return scenarios. They also really create a divergence of interest between the VC and the holder of common stock, since the VC can get an adequate return in the low to medium sale scenario and the holder of common stock can’t (in part because the money is going to the investors). In effect, there will be scenarios in which the investor is eager to sell and the holders of common stock are not.

Good Questions

Posted by Dave Broadwin on July 20, 2009

One thing that happens in the law business (I imagine any business) is that you become too familiar with the subject matter. As a result, you may start to take it for granted that your clients see the world the same way you do. This thought was sparked because I had a start up client ask a bunch of great questions about angel notes into a future financing. At Foley we deal with these kinds of angel notes all the time. For any given client, however, each note is likely to be a unique experience. Anyway, it is nice to be caught up short and look at some of the issues inherent in these notes afresh.

Basically, the client asked one of the questions I have addressed from time to time: What is normal? Are there usual and customary standards for --- you fill in the blank. She wanted "practice" guidelines for (1) What happens if there is not a future financing? (2) Are angels ever cashed out when the contemplated next financing happens? (3) Is there any way to translate the note into a percentage ownership in the company? (4) Is there a standard discount?

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Reverse Vesting and S Corporations

Posted by Dave Broadwin on July 17, 2009

I recently ran into this interesting question: If you want to use reverse vesting and take advantage of 83(b) in an S Corporation what do you do about (1) tax distributions and (2) built up after tax profits?

In the case of tax distributions, once the shares are issued, the holder will have to pay tax (to the extent that there are taxable profits) pro rata in accordance with his ownership. So, it seems logical that any distributions made to help stockholders pay this tax should also go to the holder of restricted stock on a pro rata basis. If they do not, then the holder of restricted stock will have taxable income and no cash to pay it. Moreover tax regulations require that “S” corporations make all distributions pro rata to all shareholders, including holders of restricted stock (if they have made 83(b) elections), otherwise the IRS could treat the corporation as having an impermissible second class of stock, resulting in loss of the “S” election."

Now, what about the build up of after-tax value in the corporation? A pro rata amount of that build up belongs to the holder of restricted stock. By way of example, if the company makes $1mm of profit and distributes $400K to the stockholders to pay tax liability, there will be $600K of post tax dollars in the company. If the company were dissolved, these post tax dollars would go pro rata to the stockholders. (In the case of an option holder in an “S” corporation, there would be no ownership and no tax burden.) So, when it comes time for a distribution, even if the option holder exercises his options, he does not get the benefit of the after tax dollars – that is to say, he does not take the dollars out tax free. (Nonetheless, the tax regulations described above require that an option holder who exercises his options must share pro rata in any distributions. In this example, if the company distributes the $600K of accumulated post-tax profits, a pro rata portion of the $600K would go the option holder who had exercised his options, even though none of the $600K has been taxed to him. This, of course, reduces the amounts distributable to the other stockholders, so that they would not receive their full pro rata portion of the $600K based on their ownership prior to the option exercise.) Compare this to a holder of restricted stock with reverse vesting. The holder of restricted stock will have incurred taxable income, will have received cash from the company to pay the tax, and will then get a distribution of post tax dollars equal to (in our example) his pro rata share of the $600K.

Noncompetition Agreements

Posted by Dave Broadwin on July 15, 2009

California has long had a statute making employment related noncompetition agreements illegal. There has been for some time now in Massachusetts a movement to make these agreements illegal here as well. An article in xconomy has this to say on the subject:

The alliance, founded last year by partners at Boston’s Spark Capital, argues that the non-compete clauses imposed by many Massachusetts employers stifle innovation by preventing entrepreneurs with good ideas from setting up new businesses that might be seen as competing with those of their former employers. Such agreements are unenforceable in California—a fact that may aggravate brain drain from New England to the West Coast, in the view of many people active in the local entrepreneurial scene.

Noncompetition agreements are also a topic on which Mike Rosen, one of my partners, writes with some frequency. 

I don’t have an opinion whether these agreements actually stifle innovation nor do I know how such a thing would be measured. I can safely say that I have not heard anyone make the case with any conviction that noncompetes promote innovation by protecting investment in new companies. But, noncompetes are a “standard” part of the employee package at any venture funded company here in Massachusetts. They are typically (universally ?) one year agreements – in the venture funded world. Once you get outside the venture funded world they get longer and longer. I have seen employers ask for as much as five (count them – five) years.

Having said all this, there are other agreements that are part of the “standard” package including, for example, non-solicitation of employees, non-hire provisions and non-solicit of customers. My understanding is that these provisions are just as legal in California as they are in Massachusetts. Employers can get much (most? all?) of what they might in a noncomp from these provisions. If you agree with that last sentence, it is going to be really hard to determine what, if any, benefit there will be from making noncompete’s illegal.

Monetizing Social Networking Sites

Posted by Dave Broadwin on July 08, 2009

For those of us with businesses or clients in one social networking space or another, Don Dodge has a sobering post on how much traffic it takes to reach $1 million.

No Exit

Posted by Dave Broadwin on July 06, 2009

LogMeIn has now successfully opened trading – the fourth IPO of a venture backed company since RackSpace in August of 2008. Four is better than zero. But if you consider how many there were in 2007 (fifty something, if memory serves me well), we still have a long way to go before there is an IPO market that will sustain the so-called venture model. In the meanwhile, consider a recent article in VentureWire to the effect that there were 137 M&A exits for venture backed companies in the first half of 2009, and – here is the truly alarming news – only 2 of them reported prices in excess of $100 million. There is more detail in the article about average prices in M&A transactions, but the take away is that the smaller deals don’t represent good returns for venture investors. As a historical matter, most exits for venture financed companies are through the M&A process – not the IPO process. Not long ago, I posted the observation (from Mike Feinstein) that there are north of 9000 venture backed companies and only 30 exits north of $100 million last year. If the IPO market is down approximately 90% from 2007 levels; it is hard to even conceive of how far down the M&A market is.

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Some interesting numbers

Posted by Dave Broadwin on July 03, 2009

This will be my last post taken from material in Saturday’s Times, I promise. Charles M. Blow had a fun op ed piece titled "The Prurient Trap." His basic point had to do with the hypocrisy of conservative who deliver the family values sermon and find themselves chasing young women in Argentina. But in the course of the article, he sites some statistics on divorce rates, teenage birthrates and subscriptions to online porn. States won by McCain dominate the wrong end of each of these charts. Having said that, Massachusetts has really low divorce rates and really low teenage birthrates, but is somewhere in the middle of the pack on subscriptions to online porn sites. What gives? Maybe it is a highly educated tech savvy state. The highly educated helps keep divorce and teenage birthrates down (it also seems to make for liberal politics) and the tech savvy part perhaps leads people to find their porn on line (as opposed to in other forms).

Unemployment numbers

Posted by Dave Broadwin on July 01, 2009

Last Saturday’s Times had a number if interesting articles. In addition to the one I noted on Monday, there was an op ed piece by Bob Herbert entitled "No Recovery In Sight." The gist of his piece is that until there is a marked improvement in employment, any recovery is a hollow recovery. Of course he is right at least in so far as if people are not working then life continues to be hard even if the economy is expanding.

Paul Tsongas was a Partner in our law firm, and I distinctly remember him telling a story about his hard working parents in Lowell. The moral to the story was that no matter how hard they worked, and they worked hard, they were prisoners of larger economic trends. Unfortunately, I think the same will have to be said of the many many people who have lost their jobs in this recession. A lot of these jobs just aren’t coming back until it is equally cost efficient to build stuff here rather than elsewhere. The time necessary to level the playing field is not going to be measured in months. Also, if the process is just a leveling process, the end result may not be so great. Do we really want to look like a better China?

To state the obvious, this is why all the talk about entrepreneurial effort and new technologies is so critical to the equation. If we can’t bring the entrepreneurial world back in a big way, we are going to suffer for a really long long time. This is why I feel so committed to the Emerging Enterprise Center and why we should all care about the turmoil in the angel and venture world and, ultimately, in the world of exits and the capital markets.