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

 I had lunch today with an A list entrepreneur and we got around to the topic of whether or not the facts matter.   By the facts, I mean what is “market” in the venture investment world. This is a topic upon which I recently wrote a blog post pointing out that, at least in some cases, the facts don’t matter. I admit that I must have been in a funk, because I took the position that it probably does not really matter what is going on in the market. Basically, I said that if you are a repeat entrepreneur with a strong record you will get good deal terms from the VC community and if not not. 

Babak Nivi commented on this post pointing out that people generally, and investors are no exception, are subject to all kinds of social pressures. Here is what Nivi said,

This post seems to imply that BATNAs are the only leverage in negotiations. They're not. Having access to a database of deals and their terms is great normative leverage. Humans are susceptible to a host of psychological principles (consistency, reciprocity, etc.) and normative leverage exploits them. So the non-rock star in this post can and should use norms to get a better deal.

The entrepreneur I was lunching with made another compelling point. Even if the facts don’t matter you have to do your best to fight the battle because small incremental things that happen early in the deal and seem like things you can give or that seem like they could be minor, can have huge effects over time. 

His specific point was that shifting a small amount of ownership (several percent) from the investors to the entrepreneur at the first round can make a huge difference to the entrepreneur after several rounds of investment. In effect a small amount today gets magnified over time. 

Other terms have a similar effect. Two examples are a dividend and a full participation. If you do the numbers and run a spread sheet out over the eight years (or more) that are likely to pass before the venture gets to an exit, you will see exactly how dramatically a few percent or a participation can affect you. This is even more true if you assume a modestly successful exit (as opposed to a big score).

So, fight the battle with everything you’ve got, because in the end it matters.

We recently hosted a networking night organized by The Capital Network to help angels and VCs connect with entrepreneurs. Brian Halligan, Founder and CEO of HubSpot (www.hubspot.com), which recently completely a $33 Million round of financing gave a brief yet entertaining recap of his adventures down the founding path. Keeping in mind, Brian and his co-founder Dharmesh Shah, who has a great blog on startups (www.onstartups.com), were seasoned entrepreneurs, and already had fantastic connections within the VC and angel community in Boston, here is what I took away from his talk:

Funding for Start-ups - Bootstrap all you can, raise money from friends and family first. Go to angels before you think about VC’s. Angel financing is a good way to build a solid business and company. VC financing is the equivalent of swinging for the fences and it really does not make sense to try to hit a homerun before you have something that is off the ground.

Angels financing - Try to structure your angel round as convertible debt (this can be structured in many different ways – check the EEC glossary or stay tuned for a future blog post on the issue). Convertible debt helps you to stay away from the issue of putting a stake in the ground in terms of valuation. 

Connecting with Angels - In this respect, Hubspot had it easy. Dharmesh’s reputation preceded Hubspot and when the time was right Joe Caruso of Common Angels and the Bantam Group was ready to step in with angel financing for the new venture. However, if they had not been so lucky, their path would have involved reaching out to contacts and attending events like the ones the EEC. Brian made a point to repeat this….GO TO ANGELS FIRST. Angels are really your best bet in building a solid small company. I wish Senator Dodd, with his angel killer bill could have heard this.

VC funding: “It was FRIKKIN HARD” and took so much time! That’s after they had a solid team in place, had a rapidly growing customer base, and had solid angel backers! His rationale was - once you have a solid company and you want to be a superstar – that’s when you start thinking VC money.

Disclaimer - Brian did later acknowledge that the HubSpot choice of going to angels first, might not necessarily make sense for all start-ups. You might have a capital-intensive business, you might have a very small window of time where you need to expand rapidly and whole myriad of other factors. Talk to your start-up lawyer to see what options make the most sense for your company as you decide to go down the financing path.

 Business plans were meant to be broken or tweaked a countless times until they run right – not look great on paper. As a start-up takes, what is essential a good idea on paper and tries to make it operate in the real world they will run up against several roadblocks. These could come from faulty assumptions, not targeting the right market, not having the right product, or a countless other gremlins that are conspicuously absent in the pristine land of business plans created for academic review. 

The process of analyzing what part of your business plan fits the real world and constantly changing what doesn’t fit to work without breaking everything else is a daunting process, but also one that gives any entrepreneur the most bang-for-your buck in terms of learning and understanding your market, product, and business. Many successful start-ups (hotmail.com to name just one) grew not out of their primary business plan, but a realization by the founders during this iterative process of a more sustainable opportunity. 

From a legal perspective, it’s important for a start-up to make sure than any new technical developments by founders in the area or related areas of the original business plan are assigned to the company during their time with the start-up (in some cases including related developments by key-founders shortly after they leave the company might also reasonable). The presence of a sensible and balanced non-competition clause in existing founder agreements will also help the founders have more confidence in their start-up team and could help keep the team together during this rather trying process by discouraging defection by a team member who thinks he/she can do it alone without his/her co-founders. 

I had the good fortune of being invited to participate on a panel discussion on “Starting your New Company” at Boston University’s Technology Entrepreneurship Night last week. The program was well organized and the attendees comprised of graduate students from the MBA, engineering and hard science’s programs along with a smattering of alumni. The panel had a good mix of seasoned entrepreneurs, professional advisors, and relative newcomers to the same. As with many start-up events, unfortunately the topic of discussion and the questions of interest from those attending quickly veered from the issue of starting your own company to that of valuation and exit. It took some expert maneuvering from our moderator to get us back on the discussion of founding companies. Do not get me wrong, I think an exit strategy and valuation of a start-up are important and have their place in the list of things founders should consider when making choices about founding their start-ups. However, more often then not I see a rather skewed amount of time and effort at a very early stage devoted to the discussion of how much is my company worth and what’s market for my company (though still in the business plan or early implementation phase). I think it’s fair to point out at this time that if you were to approach me with either of the two above questions, my honest answer would have to be... "I don’t know". What I do know is that most founders start worrying about these questions well before they have taken the time and effort to build any value in their start-up. Instead of worrying about valuation, the day after you have finished drafting the first version of the your business plan, a better use of time would be to: a) build a team that will help you put the plan into practice; b) take care of the legal aspects of forming the company and executing the agreements and arrangements between the founding team-members and the company; and then c) start the process of implementing the business plan. No doubt - easier said then done.

On March 20 of this year,  Mike Rosen, one of our Partners, wrote a post in his blog on the subject of the pending noncompetition legislation in Massachusetts. A lot of folks in the Mass entrepreneurial community have been pushing for a legislative ban on noncompetes similar to that enacted many years ago in California.

As Mike notes, legislation on noncompetes in Massachusetts took a step forward. When it, or if, it will pass remains to be seen. 

I am generally in favor of the legislation. I don’t see how it can hurt the tech community to get rid of this restraint on freedom of enterprise. 

But, I hasten to add that I am not particularly excited about the issue. Let’s look at what the law is in California. Certain noncompetes (employment related ones) were made illegal by statute. OK, that sounds great but… consider the basic elements of protection that a company might want from a noncompete. 

First and foremost: Don’t solicit my customers. Well, nonsolicits are not illegal in California (and no one is proposing to make them illegal in Massachusetts).

Second and secondmost: Don’t solicit my employees. Well, employee nonsolicits are not illegal in California (and no one is proposing to make the illegal in Mass).

Third and thirdmost (I guess I should give up with this rhetorical device before I get to sixth and sixthmost):   Don’t disclose (or use) my proprietary IP. Well, NDAs are perfectly fine in California. Does anyone think they should not be?

Fourth: If an employee invents something on company time or using company resources – should it belong to the company? Well, that is what the typical inventions agreement provides. 

You get the idea. It is like a venn diagram. There is a circle in the middle called noncompetition and there are many overlapping circles called NDA, nonsolicit, inventions and whatnot. If there is any part of the noncompetition circle that is not covered by one or another circle , it ain’t very big.

My point is that making employment related noncompete’s illegal won’t change much. Even Bijan Sabet (who says he tries to avoid noncompetes - see the end of his post on east coast term sheets) probably asks for all these other things (maybe he will comment here and set me straight by saying that he doesn’t go for non-solicits etc.). I could be wrong.

Many people in the tech community (myself included) think getting rid of noncompetes is a good idea, but it is not worth a ton of effort, and we got way bigger fish to fry – like net neutrality.

I got home well after midnight on Friday, after a long and brutal day of meetings in NYC. And, I am still dragging my left leg around after a spiral tib/fib fracture in February.  Then, I judged the super-Saturday HBS business plan competition starting at 8:00 am on Saturday. This is the round that goes from about 80 plans to 10 plans. I am not sure, but I think I have been doing the super-Saturday judging since the inception of the competition 14 years ago.

Each year it is the same format with the same winnowing. Each year it is also different. Fashions have changed over the last 14 years. I only see five teams out of the 80 or so that entered the competition, but talking to the other judges over lunch, there does seem to be a consistency to the plans this year (and last year as well). 

For confidentiality reasons I can’t discuss the actual business plans. But, unlike plans from the dot com era, plans this year (and last year) were doable in scope, modest in capital needs and ambitious in their goals. Not a single one of the five plans I judged was looking to raise more than $1 million. Furthermore, of the five plans three were actually in process, in the sense that students were actually executing on them. Of the five plans none seemed to me patently unrealistic, although I suspect that two would not work (one for technology reasons and the other because the business model simply wont work). This year, and last year, have been great – actual entrepreneurs who will create businesses that will improve our lives and employ people.

In 1999 the competition was the same, but the plans were from a different conceptual universe. If my memory serves me well, students were looking for big bucks and were going to change the world. It is not at all clear to me that they did.  I had to leave lunch before hearing Mike Robert’s annual speech about how many plans have been funded and how much exit value has been realized etc.   

I wonder if Prof. Roberts should not start analyzing the competition in terms of eras and start looking at the values produced in the bubble compared to the values produced in eras of more modest expectations.

Having said all this, HBS has, over the years, consistently produced crop after crop of impressive students with impressive ideas and impressive skills. If I came in from out of town at 6:00 a.m. with two broken legs, I would still show up for Super Saturday.

Like may of you, I have regular automated Google searches for certain topics.  One of them has to do with clean energy.  I have had this search active for a while, so I only expect new stuff.  On Sunday, though, it turned up an interesting blog post by Brad Bradshaw on the subject of predicting peak oil from 2008.  Why would a 2008 post come up now? 

As if that was not enough, Monday's WSJ had an article on a subject near to my thesis that I have posted on from time to time that global oil reserves are systematically overstated.  The WSJ headline is "Natural-Gas Data Overstated."

I continue to report from time to time on what I read out there on the subject of peak oil.  It is not entirely clear to me how peak oil affects the tech world.  But I continue to believe that the methodologies used for calculating oil reserves systematically overestimate the size of reserves.  Another seemingly undeniable force is the growing appetite for oil in India and China (soon to be followed by other developing countries, I imagine).  One conclusion that I draw from this is that we, as a society, are grossly underinvesting in alternative energy and renewable energy technologies.  See my post on investment in New England versus California.  BTW, I think that taken together (meaning California, Mass, Texas and anything else you want to add to it) investment levels are still way too low. 

So, here is part 2 (see last Wednesday's post for part 1).

Here is my list of half a dozen things not to negotiate (much) over:

(1)            Voting Rights. Here is a mistake the VCs made a few times way back in the dawn of time, and now they don’t make the mistake any more. Under Delaware law, unless your certificate of incorporation provides otherwise, you need the vote of the holders of common stock, voting separately as a class, to increase the authorized stock of the company. Without this provision, the common have veto rights over all sorts of things, including additional financing. Here is the provision:

The Company’s Certificate of Incorporation will provide that the number of authorized shares of Common Stock may be increased or decreased with the approval of a majority of the Preferred and Common Stock, voting together as a single class, and without a separate class vote by the Common Stock, irrespective of the provisions of Section 242(b)(2) of the Delaware General Corporation Law.

Ignore and move on.

(2)            Protective Provisions. I admit there are some nuances in here that merit negotiation (which is why this might have been item 6 (or 7) of terms to negotiate), but the basic principle that there are some things for which the company will need the consent of the series A stockholders voting as a class by themselves is not assailable. Here is the NVCA list:

(i) liquidate, dissolve or wind up the business and affairs of the Company, or effect any Deemed Liquidation Event or consent to any of the foregoing; (ii) amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws [in a manner adverse to the Series A Preferred]; (iii) create or authorize the creation of [or issue or obligate itself to issue shares of,] any other security convertible into or exercisable for any equity security, having rights, preferences or privileges senior to or on parity with the Series A Preferred, or increase the authorized number of shares of Series A Preferred or of any additional class or series of capital stock [unless it ranks junior to the Series A Preferred]; (iv) reclassify, alter or amend any existing security that is junior to or on parity with the Series A Preferred, if such reclassification, alteration or amendment would render such other security senior to or on parity with the Series A Preferred; (v) purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, [other than stock repurchased from former employees or consultants in connection with the cessation of their employment/services, at the lower of fair market value or cost;] [other than as approved by the Board, including the approval of [_____] Series A Director(s)]; (vi) create or authorize the creation of any debt security [if the Company’s aggregate indebtedness would exceed $[____][other than equipment leases or bank lines of credit]unless such debt security has received the prior approval of the Board of Directors, including the approval of [________] Series A Director(s)]; (vii) create or hold capital stock in any subsidiary that is not a wholly-owned subsidiary or dispose of any subsidiary stock or all or substantially all of any subsidiary assets[; or (viii) increase or decrease the size of the Board of Directors].

One thing that people sometimes like to talk about is how many shares of Series A have to be outstanding for the class to have these rights. As a general proposition, the Series A is not going to convert a bunch and leave a bunch just to keep these rights. Pick a number that is sizable enough to discourage gamesmanship and move on.

The nuances that I refer to above are in the bracketed language. Some of these bracketed alternatives could end up having some relevance to you. For example, there are businesses that are looking to get equipment leasing or lines of credit. The notion of being able to do things with the approval of the Series A appointed directors is some modest help. Despite the fact that Delaware law is moving in the direction of making it clearer and clearer that directors owe a duty to the holders of common stock and not preferred stock, there is enough gray zone so that, except in some pretty odd cases, the directors are going to be able to rationalize doing what is in the interest of the Series A holders. Still, in all, it is worth going for that. 

One more word of caution. If the list has more stuff on it than the NVCA list, try to negotiate down to the NVCA list.

(3)            Antidilution. Broad based weighed average antidilution is the accepted standard. According to our research it appears in close to all series A deals. This provision for which it is somewhat hard to find a clear intellectual argument, protects investors (a little) against future issuances of securities at prices lower than those paid by the investors. There are some alternatives. I mentioned full ratchet in the intro. If you see full ratchet, consider running screaming from the room. If you see “fully” broad based, it is good for you. But, you are not likely to see it. Sometimes (rarely) you may get no price based antidilution protection (even better for you). If you want to get into this topic more, here is a link. If you clicked on that link, you probably have too much time on your hands.

            For the sake of stylistic consistency, here is the NVCA antidilution formula:

“Typical” weighted average:

CP₂ = CP₁ * (A+B) / (A+C)

CP₂  = Series A Conversion Price in effect immediately after new issue

CP₁ = Series A Conversion Price in effect immediately prior to new issue

A = Number of shares of Common Stock deemed to be outstanding immediately prior to new issue (includes all shares of outstanding common stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing)

B = Aggregate consideration received by the Corporation with respect to the new issue divided by CP₁

C  =  Number of shares of stock issued in the subject transaction

            As is the case with all else, there are nuances. In this case, here are some exceptions to the issuances that trigger the antidilution protection for the series A holders. Here is the NVCA list of exceptions:

(i) securities issuable upon conversion of any of the Series A Preferred, or as a dividend or distribution on the Series A Preferred; (ii) securities issued upon the conversion of any debenture, warrant, option, or other convertible security; (iii) Common Stock issuable upon a stock split, stock dividend, or any subdivision of shares of Common Stock; and (iv) shares of Common Stock (or options to purchase such shares of Common Stock) issued or issuable to employees or directors of, or consultants to, the Company pursuant to any plan approved by the Company’s Board of Directors [including at least [_______] Series A Director(s)] [(v) shares of Common Stock issued or issuable to banks, equipment lessors or other financial institutions, or to real property lessors, pursuant to a debt financing, equipment leasing or real property leasing transaction approved by the Board of Directors of the Corporation [, including at least [_______] Series A Director(s)]

            You need these exceptions, and it is worth spending a few minutes making sure you have them and trying for the max in flexibility. If you don’t have substantially all of these exceptions, there is something wrong, and you do need to raise the issue.

(4)            Registration Rights. These come into play after you have gone public. You should be so lucky. If you have had your IPO and there is a nice market for your stock and some benighted VC is bugging you about registering some sale of her stock while you are busy swilling martinis on your yacht, you can tell Jeeves to give her the run around. Don’t waste your breath arguing about reg rights now.

(5)            Management Information Rights Letter. VCs need this to meet the tax requirements for Venture Capital Operating Companies (the so-called VCOC rules). Your lawyer should make sure the agreement is in fact standard and does not overreach. Beyond that, go back to sleep. But, I hasten to add, if you are dealing with an investor who is not a VCOC, you can, and should, get rid of this nasty little agreement.

(6)            No-Shop. Your investor will want a period of exclusive dealing during which she can negotiate and close. I see a lot of 45 day periods, but 60 is OK too. My advice: go with the flow.

Well, I am at 4000 words (spread across two posts) and I have skipped over a bunch of stuff in the typical term sheet including such gems as the redemption rights provision. The one I feel badly about is things requiring investor director approval. So, here, by special mention, is the NVCA list of things requiring investor director approval. These are things that a company cannot do unless the board approves and that approval includes the affirmative vote of the series A appointed directors (or at least one of them). As noted with respect to other things above, you would like to keep this list to a minimum.   But, you are not going to be able to make it go away. My comment about the duties of directors under Delaware law applies here, but don’t expect these directors to act against the interest of the series A.

(i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company; (ii) make any loan or advance to any person, including, any employee or director, except advances and similar expenditures in the ordinary course of business or under the terms of a employee stock or option plan approved by the Board of Directors; (iii) guarantee any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; (iv) make any investment inconsistent with any investment policy approved by the Board; (v) incur any aggregate indebtedness in excess of $[_____] that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business; (vi) enter into or be a party to any transaction with any director, officer or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such person [except transactions resulting in payments to or by the Company in an amount less than $[60,000] per year], [or transactions made in the ordinary course of business and pursuant to reasonable requirements of the Company’s business and upon fair and reasonable terms that are approved by a majority of the Board of Directors]; (vii) hire, fire, or change the compensation of the executive officers, including approving any option grants; (viii) change the principal business of the Company, enter new lines of business, or exit the current line of business; (ix) sell, assign, license, pledge or encumber material technology or intellectual property, other than licenses granted in the ordinary course of business; or (x) enter into any corporate strategic relationship involving the payment contribution or assignment by the Company or to the Company of assets greater than [$100,000.00].

There is lots that can be said about term sheet provisions not discussed above. There are lots more resources on the web (and elsewhere) including our web site here at Foley Hoag's Emerging Enterprise Center to help you with term sheets. Keep in mind that in the end you want to (a) close the deal and (b) establish a good working relationship with your investor. Be sensitive to her needs and she will be sensitive to yours. Argue the points that count and settle when you have gotten what you can get. Strive to be tough but realistic and fair, and hope the other side strives for the same.