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

I can’t say how often I have been called the first time an entrepreneur has to fire someone.  BTW, I get that call from seasoned execs as well.  Nobody likes to do it and everyone is nervous that they will mess up in light of all the applicable rules. 

One of my partners, Jonathan Keselenko, who practices in the Employment area, developed a nice simple termination checklist that I have found useful.  One thing about this list is that it applies to situations where the employee is an “employee at will.” If there is an employment contract, you will also need to review the contract to make sure you meet its requirements as well.  Here is the list, with some additions from me:

EMPLOYMENT TERMINATION CHECKLIST

• Have a good reason for the termination, and make sure that the reason is consistent with the documentation.
• Provide the employee with a truthful explanation for the decision.  For example, if the employee is being terminated for poor performance, do not characterize the termination as a layoff.
• Don’t be gratuitously cruel.  You should inform the employee of the reason for the termination, but you do not need to convince him that you are right or win a debate.
• Conduct the termination in a private and respectful way.
• If you any concerns about litigation, two people from the company should be present at the termination meeting, and both should take detailed notes.
• Pay: be prepared to pay all compensation due, including unused but accrued vacation pay.
• Explain that the employee will receive notice about continuing group health coverage under the Comprehensive Omnibus Budget Reconciliation Act of 1985 (“COBRA”).  Explain that all other benefits will cease as of the termination date.
• Provide state-issued information about filing for unemployment, even if you think the employee is not eligible.
• Collect all company property from the employee.  Consider having the employee sign an acknowledgement form that he has returned everything.
• Allow the employee to collect any personal belongings before leaving the work premises.
• Block the employee’s access to the Company’s premises and electronic access to the Company’s computer systems and email.
• If the employee is listed on your company website, remove him from the site.
• Remind the employee of any restrictive covenants (by this I mean noncompetes, nonsolicits, confidentiality and inventions agreements) and provide an additional copy.
• Think about how you intend to communicate the employee’s departure to customers and other employees, if at all.  Who needs to know and why?  Make sure you have a legitimate business reason for the communication.
• Think about whether you are willing to give the employee a reference. 
• Inform the employee about options that may be exercised (or restricted stock that may be repurchased by the Company).  Be prepared to repurchase restricted stock (if you intend to).  The repurchase agreement may not be “self-executing” with the result that you may have a time frame for acting.

The question that I most frequently get asked about advisory boards is:  “How much equity should I give to a member of my advisory board?”  The answer is very little, almost certainly less than the entrepreneur is thinking about.  Perhaps some numbers would be useful here.  How about .1% (that is a tenth of a percent) to perhaps .5% -- depending upon the value to be provided.  By the way there should be vesting involved.  The vesting period should be long enough to cover the period in which you expect to be getting value from the advisor.

Having now answered (to the extent I am comfortable doing so in the absence of any specific knowledge or facts of any particular case) the only question any client ever asks about advisory boards, I hasten to note that there are a lot of other – far far better – questions that could be asked about advisory boards.  Here are a couple:  What value can I reasonably expect from a member of my advisory board?  How do I get that value?  Why do I need an advisory board at all?  How do I find good advisors?

I don’t have any objective or quantifiable information around whether and how much value start-ups derive from their advisory boards.  My gut sense, based only on my law practice, is not much.  Mostly, what start-ups get is the opportunity to name a few luminaries on a slide towards the back of their deck.  The second thing they probably get is some introductions, probably to investors. 

I am sure there are some companies and entrepreneurs that have benefited greatly from advisory boards, but I have to believe this is a small number.  Below are a couple of links to blog posts on the subject of advisory boards.  The one from venture hacks seems to me to be particularly good in that it covers a lot more than just compensation, although it also covers comp.

Venture Hacks “Everything you ever wanted to know about advisors”

Ask the VC “Are Advisory Boards Helpful?”

Ask the VC “Advisory Board Compensation”

At least where I am sitting, for the last month it has rained nondisclosure agreements.  On the one hand, these agreements have a certain cookie cutter repetitive quality.  On the other hand, there seems to be no end to ingenuity in these things.  The result is that something you hope would be straight forward and would not require much (any?) legal intervention, often does.  So, here are some thoughts on things to think about when you read an NDA.  Needless to say, this list is not comprehensive and – furthermore – I predict that the next one you look at will have something unique about it.  (Parenthetically, please feel free to send me samples (redacted to eliminate anything that should not be disclosed – like the identity of the parties) of unusual provisions.)  My last comments at the end of the list under the caption “Unusual Provisions” seem like the relevant comments to me.  Anyway, here goes:

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.

Check out an article from yours truly on things I wish founders would give a little more thought and time to.  I wrote this article a couple of months ago after Jarrod Phipps from MIT 100K approached me about writing something (Thanks JP!).  I enjoyed writing it and discussing it with Jarrod and my colleagues and then....completely forgot about it.  It was a nice surprise to get an email from Jarrod last night telling me that the article was posted at: http://www.mit100k.org/blog/things-all-start-up-founders-should-give-more-thought-to/

Like everything else i write and look at several weeks later, there are a few nuances that I wish I could rework and a few additional points I wish I could make, but all in all I'm pretty happy with the article and about those additional points you ask? .......Stay tuned!

I finally saw Social Network. Don't know why I avoided it for so long, but I did. Holding aside the bashing of Mark Zuckerberg (and the tech community in general -  including its attitude towards women), which I don't want to comment on (I am sure others have done a better job than I could), it seems to me that the plot was really driven by poor or, more exactly, nonexistent legal work. It turns out that this movie is a great case study of some of the things we are always counseling entrepreneurs on. I want to be clear that I don't have a view as to how realistic (or unrealistic) the movie was.

 First, agreements among founders. The notion that the agreement between Mark and Eduardo amounted to a conversation to the effect that I get 60% and you get 30% is flabbergasting. I have written too much about founders and vesting to repeat it all here. But, I routinely counsel founders to have some agreement in writing around who owns what and what happens when the founders come to a parting of the ways. In this context, I discuss vesting and its importance. For example, I often say something like,  "What happens when one of you is not pulling his weight? Or takes a job with some big company? Will he or she still own the same amount as you are now contemplating."

 Not everyone ends up deciding to use vesting among founders, but my clients have at least considered it. If even modest legal work had been done at the front end, the whole law suit with Eduardo would have been avoided. Note that Eduardo ended up with about 5% of the company. I don't know whether anyone thinks that was fair or not, but if there had been some sort of arrangement around vesting the deal would have been negotiated and agreed to. There might not have been a need for the sleazy dilution move.

 Well, with respect to the sleazy dilution move, the notion that a reputable attorney would put a bunch of documents in front of someone who is not his client (and to all appearances is unrepresented and unsophisticated) and does not give a stern warning that this person needs to seek his own counsel, seems over the top to me. On the one hand, there is no doubt but that it moves the plot along nicely. On the other hand, if the warning had been given and the advice taken, who knows where the story would have gone. It probably would have avoided the suit and ended in a fair place Ð or at least a place agreed upon by the parties not decided by a battle.

 Speaking of not seeking legal help, the beefcake twins top the charts. If they had intellectual property, they did nothing to protect it. When you hire someone to write code for you, you want to own the code --  thus an agreement that expressly makes the intellectual property a "work for hire."  BTW, Mark could have entered into an agreement to write the code and still use it for his own purposes. While it seems clear that the twins has some idea that was like Facebook, it is not at all clear that their idea was not a very limited directory for Harvard College students.

Anyway, all these problems worked out in the end because the massive juggernaut of Facebook overwhelmed them. As the lawyer said in the end, this is a traffic ticket. Having said that, not a lot of ventures have so much to divvy up that they can survive this sort of thing. A lesser business would have been sunk for want of competent legal work.

I figure if you're a founder or start-up on the hunt for an angel money, you'd want to at the very least want to know how things look from a potential investor's perspective and the rules that they are going to use to gauge potential invetments.  Enter Luke Johnson from across the pond.  Luke writes a column on entrepreneurship in the Financial Times and has worn both the successful entrepreneur and angel investor hats.  His latest piece: "My rules for being an angel investor" offer a glimpse into at least one angel's criteria for making investments.

My takeaways from his article-

• Back teams (not just individuals) - I don't know if agree with this one all the way, though I do get his point.  I think an exception would be a highly technical founder (say an MIT professor) or a founder with some success behind him
• Intellectual property (who owns it?)
• Pick investors who have experience in your sector
• Management must have some skin in the game
   

 After all the chatter and political rhetoric about how innovation and entrepreneurship is going to lead the way for us out of this recession, it's great to see some solid economic evidence that when it comes to job-growth in a recession, start-up companies aren’t just the best, they are the only player in the game!

 Dr. Tim Kane’s study on the “The Importance of Start-ups in Job Creation and Job Destructions” is a revelation even to die-hard fans of the start-up community like myself.  Start-ups for purposes of the report are firms and companies in year zero, so they inherently have an advantage, as the report concedes,  since they can’t really lose jobs in year zero. Some cheering points that I took away:

• Without start-ups, there would be no net job growth in the U.S. economy (true on average and only not so for all but seven years between now and 1977).
• In recessionary periods, (we know what that feels like) job creation at start-ups remains stable, while net job losses at existing firms are highly sensitive to the business cycle.

   The study hopes that its finding will shift the standard focus of employment policymakers away from the common media stereotypes of thinking of the issue of job creation in large aggregates and in the context of very large layoffs by established companies.  Also, the report hopes to be an alarm call to states and cities that have policies and incentives in place mainly to lure in larger more established companies because, if the analysis is correct, these are not real drivers of job creation.  Hopefully cities and states take notice and we have more policies in place to help the real champions of job creation – start-up firms that develop organically.  

This recent article titled: "Entrepreneurs need to know when to let go" by Michael Skapinker  of the Financial Times raises a good point and got me thinking of an analogous example in the very early stages of a start-up. Letting go does not start with selling the company. It needs to start much earlier than that for technology teams looking for venture funding for their idea.

I have often heard senior advisors refer to the decision to raise venture funding as going down a path  where the final destination invariably means losing control of your company. Determining if you want to walk down this path is a question often not given enough serious thought by founders.  Think of it as an identity crisis of sorts - one way to determine if the founders are ready to take the VC route is for them to ask themselves: Am I ready to make distinction between myself and the start-up? If the answer is "NO - there is no distinction", then the path from start- up through venture funding to hopefully an exit will be at best more painful and angst ridden than normal and at worse will be a disaster of sorts. 

However, if you think of your company as its own entity (albeit one where you have significant input and credit for it's existence) then it helps to think of going down the venture capital route as sending your kid off to college. He/she is going to grow up to be their own person and though you will always have some influence in their lives, increasingly your sphere of influence will diminish and be replaced by that of their peers, partners, teachers etc..

Letting go also helps entrepreneurs do what they do best -find new problems to solve and start new companies!

Copyright: Micahel Valdez, iStock Photo

- Posted using BlogPress from my IPad. 

Hope all of you had a good Memorial Day weekend. Last Thursday was a little crazy. There was work of course , but I was also leaving for a four day trip early Friday morning which necessitated me driving for 7 straight hours so I knew that a good night’s sleep was essential. However, I also I wanted to attend the TIECON event the night before. TIE just does a fantastic job putting together entrepreneur events through the year, many hosted at the EEC, and it all culminates in the excellent TIECON East event. The catch was I knew that attending TIECON would mean a late night and a rough next day (that is how good the event usually is!). As I was mulling over the problem, I got an email notifying me of the Yaddapalooza event hosted by Boston Innovation and Pinyadda conveniently happening right across from our Boston offices in the Seaport District. Hmmm….

A few minutes later – my blackberry dings – it’s an email from a “sharp as nails” entrepreneur, he just flew into town and is attending the "Lean into Spring" event hosted by Mass Challenge and wanted to discuss his company and future plans. Could I meet up? – You bet!  I get there and the place is packed – you would think there was a party happening. The excitement level is high and people are talking about their start-ups and ideas for future ventures and all I have to say is….Now here is a sign of a healthy start-up ecosystem. (click here for an article about the event posted at MHT )

Just think about it – for a fledgling start-up the most important asset really is its people (some would argue its technology, but making a business work and attracting investors goes well beyond that). Its people that make up your core team, people who help develop your product and business, people who serve as advisors and mentors and people who finance your plans.  Bringing these people together, you need not only venues, but also events and supportive sponsors, along with interested participants. 

Consider this, last Thursday in the Boston area, there were at least three different events, at three different locations (and my guess is all of them were as jam-packed as the “Lean into Spring” event) all trying to bring together entrepreneurs, advisors, investors (aka: people!). I would venture further and say that the audience at the three events were probably very different in terms of demographics and perhaps the business lifecycle of their ventures, but the key common component is that they were all either involved in or supporting an entrepreneurial enterprise. If nothing else, this points to not only a thriving start-eco system, but a diverse one to boot. We are lucky enough to live and work in one of the few diverse and thriving start-up ecosystem that has the resources to be able to sponsor and foster groups and events aimed at entrepreneurs.

It’s at events like these that you meet the person who has been struggling to find the application for the technology that your start-up needs, it's where you meet the CEO that can take your company to the next step, it’s where you meet the advisors and partners who have the same vision for your company as you do.  It’s where you meet other players who have had the same idea you had and are trying to make it into a reality and sometimes two heads work better than one. So as the moniker says…get out there and meet some people. After all, VCs and angels invest in people not companies.

Venture Hacks has another contribution to the wide ranging discussion of taking seed money from VCs. As I worked my way back through the links to posts by Suster and Dixon and read through various comments from Fred Wilson, the concerns for the entrepreneur that come to the fore are (1) is the entrepreneur giving the VC a cheap option to the detriment of a good valuation later on and (2) is there negative signaling?

There are, of course, two sides (maybe more) to this argument. The VCs acknowledge the issues but argue that mostly they are “entrepreneur mythology.” Nivi (from Venture Hacks) takes the other point of view. 

We are all prisoners of our own experience. So here is what I have seen. First, I have never had a situation in which a name brand VC (Suster and Wilson certainly fit that description) seeded a client (usually with $250K and usually with a co-investor VC for another $250K for a total of $500K) and did not follow through with a Series A round. I have seen one situation in which the concept did not prove out and the entrepreneur (with the support of the VC) walked away from the business idea. But, I hasten to add, that in each instance in which I have represented entrepreneur getting VC seed money of this type, it has been an “A” list entrepreneur. (By “A” list, I mean someone who has previously started a funded company.) It may be that the bets are good bets, and for this reason the VCs exercise their options.

Since I have not seen the situation in which the VC does not take up the investment, signaling has not been an issue. But here is what I have seen. In several cases, I have noted that entrepreneurs are unhappy with their VCs. In these instances (and there are many more than most VCs would like to admit), the entrepreneurs have not gone back to their original funding sources to fund their second and third ventures. 

Suster suggests that this situation would be a negative signal about the entrepreneur or the new business, i.e. how does the entrepreneur explain that so and so did not invest in the new venture? I suggest that it may be just as bad (worse?) for the VC, who has to explain why an A list player did not go back to him to fund a business that other name brand VCs lined up to fund and in fact funded.

One final thought. I think the whole area is way over analyzed. Good teams with good business concepts tend to get funded (in a normal environment – whatever that may be). Good business concepts coupled with good execution, tend to succeed. Options and signaling are secondary issues. Getting funded once is not like getting married -- you do it once for life (actually getting married is not like getting married since about half of all marriages end in divorce). 

VCs make investments in different teams at different times for all sorts of reasons, and entrepreneurs seek investments from different VCs (and other sources) at different times for all sorts of reasons. Neither VCs nor entrepreneurs should attach too much value to monogamy.

I wrote a second guest blog this one is about repurchase agreements and how to prepare for a parting of the ways for Sim Simeonov on the subject of founder agreements. This one is more . The prior one was on the subject of vesting. I have decided to repost it below.

Sim's introduction: Following my [Sim's] posts on improving the performance of founding teams, founder agreements and strategies for dealing with poorly performing co-founders, I continue to receive many emails at FastIgnite from entrepreneurs having difficulties with managing and formalizing the relationships with their co-founders. I reached out to my blogger friend Dave Broadwin, head of the Emerging Enterpise Center at Foley Hoag LLP, and invited him to provide his perspective in a series of guest posts of which this is the first. (No, it’s not legal advice.) I hope you enjoy them and follow Dave’s writing.

Founder Agreements: Vesting, vesting and more vesting.

Some time ago Sim Simeonov asked me to write a guest post on the subject of founder agreements.  For one reason or another it has taken a long time to get it done.  In part this is because I broke my leg skiing and in part it is because the number of founders walking through our doors these days seems to be on the rise.  So the very issues that Sim wanted me to write about have been taking up my time.

As Sim has pointed out in his two prior posts (Ten Rules for Better Founding Teams and Startup Founder Agreements), there are a lot of different types of contracts that founders have to enter into in the course of starting up a business.  Most of them, though, don’t give lawyers a lot of heartburn.  That is not to suggest that they are not important or that you should not pay attention to them, but from a lawyer’s point of view, there is not usually, a lot of controversy around NDAs and the like.  Having said that, Sim has mentioned that he routinely asks for changes in standard forms of NDA in the areas of information management, protection, destruction and return of information.  While it is true that most companies are very reluctant to make changes in employment related NDA (and other) forms which they ask all their employees to sign, it is also true that with the rise of the cloud and other factors, these forms may be at odds with the way information is actually handled.  If you have a legitimate point, most tech companies will hear it – so don’t be shy.

The shoals upon which founders founder, seems to me to be first and foremost, the allocation of equity among co-founders, and secondarily the use of equity to pay consultants and other people providing services in the early stages of the business.

I have said this elsewhere, but it almost seems like a rite of passage that founders give away too much equity to someone who later does not perform (and, often, who leaves the business to pursue some other job and wants to keep the equity).  Somehow you then have to get the toothpaste back in the tube.  This can be an ugly process.

Here is a very typical (perhaps I should say archetypal) fact pattern:  Sally wants to start a web based company.  She needs some coding done for her web page.  She meets Harry.  Harry is out of work (having been laid off from MondoHuge Software, Inc.).  Harry, who seems like a charming fellow, has the time and, apparently, the skills that Sally needs.  Moreover, Harry professes to have had his fill of big companies and is ready to launch an exciting new start-up.  So, for a mere 25% of the equity, Harry agrees to do all the coding and have the beta ready in six months.

Sally and Harry enter into an agreement (in the form of a letter that Sally sends to Harry without running it past her attorney, Clarence Darrow).  The letter says something to the effect of Harry will be in charge of software development and will be issued 25% of the common stock right away.  The letter says nothing about performance expectations or what happens if they are not met.  The performance expectations are all in Sally’s mind.  Sally never considers what might happen if Harry does not perform, let alone what might happen if he leaves the company.

Harry is issued a nice shiny new stock certificate.  Everything is cool for about two months.  Then Harry, who unbeknownst to Sally has been looking for a job all along, gets a job offer from Ginormous Software Corp.  He takes the job and tells Sally that he is moving to the west coast to run Ginormous’ new Flash division.

It turns out that Harry only wrote a few lines of code and is not planning to give back the stock, which he feels is his (since he is a co-founder).  Sally then calls Clarence ”How do I get the stock back?”  Although he uses other words, Clarence is thinking “I hope you are taking the little purple pill because heartburn is about to become a part of your life.”

Since an ounce of prevention is worth a pound of cure, I am not going to write about how to negotiate with Harry under these conditions, rather I am going to write about the things you can do to avoid walking a mile (more like 40 miles) in Sally’s shoes.

To paraphrase the famous line from The Graduate “I have one word for you “vesting.’”

Sim has a lot of great things to say about vesting, but here is my take on it:

Every member of the team should be subject to vesting. Unless you are planning to go it alone, in which case who cares, every member of the team should be subject to some form of appropriate vesting.  Consider the divorce rate among practicing Catholics, and they are expecting to suffer eternal damnation if they break up.  Breaking up may be hard to do, but people do it a lot.  Like the Boy Scouts, Be Prepared, in case it happens to you.  If Sally had followed this policy, no matter how sure she thought she was about Harry, she would have been OK when he bolted.

Consider this, if Harry leaves with a big chunk of equity and won’t give all (or some) back, you are going to have to figure out how to dilute his position.  This means getting more stock into the hands of the remaining productive team members.  This topic is beyond the scope of this post, but you probably can’t just give everyone (other than Harry) a pile of new shares.  If you did, then everyone is likely to have phantom income equal to the value of the new pile of shares.  So, you have to consider options (which have other drawbacks).  You also have to consider the impact on your investors, if any, and what rights they have in connection with your issuance of shares and options.  Fixing the capitalization once the shares are issued and vested is hard to do.

Vesting should be part of an express agreement between the stockholder and the Company. No handshakes, vague understandings, or oblique references in emails, unless you plan to become part of AstraZeneca’s cash flow (they make the little purple pill).  Vesting can be made a part of a stockholder agreement signed by all stockholders.  One drawback of the collective approach is that it may be cumbersome or a diplomatic challenge to have different vesting schedules and arrangements for different stockholders.  Vesting can also be set forth (to use a lawyerly turn of phrase) in individual agreements.  This approach makes it easier to strike different deals with different people for whom different considerations might apply.  If Sally had a written agreement with Harry, she would not be looking for a scrip for the purple pill.

Immediate vesting is a bad idea.  By this I mean that all stock vests upon issuance.  The day after formation Harry gets to (a) keep all 25% and (b) leave for greener pastures.  Having said that, some level of immediate vesting is often appropriate.  For example, if the founders have been working part time for six months pulling the business together in their garage and they have real sweat in the business, a recognition of that contribution may be entirely appropriate.  This does not mean that everything should be fully vested right away.  Another common situation is when someone puts in actual money (in addition to sweat equity).  Stock that is bought and paid for probably should not be subject to vesting.

Time based vesting is often a good idea.  Time based vesting means that stock vests with the passage of time.  A very common scheme used in venture financed companies is four year vesting.  This typically has a one year cliff (after one year 25% is vested) and then three additional years during which stock (or options as is often the case in venture financed companies) vests ratable on a monthly or quarterly basis.  Companies that are not (or not yet) venture financed, often choose time based vesting in which stock vests ratable over three or four years beginning right away.  With this scheme, when Harry left to work for Ginormous, he would only have two months of vesting (way less than 25%).  One issue with time based vesting is that it does not take performance into account.  Often founders are reluctant to let people go, with the result that they time vest way longer than they should and they don’t deliver.

Milestone vesting is often a good idea.  With milestone vesting, stock vests upon achievement of stated milestones.  By way of example, 25% might vest upon shipment of beta with more vesting on final shipment and more on V2.0.  If Harry had agreed to milestone vesting, he would be leaving all his stock behind, which is probably the right outcome in the little morality play that this post is based upon.  One of the issues with milestone vesting is, of course, how clearly defined are the milestones.  If there is ambiguity around whether or not milestones have been reached then there can be disputes around that.  For example, if Harry is going to vest 25% on shipment of beta, maybe Harry will ship beta before it is really ready.  The only way to handle this issue that I have ever felt good about is to have very clear and unambiguous milestones.  The CEO of one of my clients has milestone vesting tied to specific revenue levels.  Now, you might think you either have the revenue or you don’t, but you can grow revenue by dropping price (and margin).  That is not what the board had in mind.  Now, in my client’s case it is working out because the CEO is not playing games, but not everyone could resist the temptation. Keep in mind, the company can play games too.  Unless you can find some measure that is truly clear and unambiguous, you reach a point where trust has to enter into the equation.  BTW, milestone vesting is also good for consultants and certain service providers.

Note that VCs usually insist on imposing vesting on founders in early stage investments (Series A).  Depending on a variety of factors a common approach is to let the founders have 25% to 50% fully vested and have the rest time vest over three years.  VCs see a lot more situations than you ever will.  There is a reason why they do this, even while they believe enough in the founder to invest millions.  Learn from them grasshopper.

Negotiation when you let someone go is the norm.  I have noted that often underperformers stay too long.  When you finally get around to terminating Harry, it could be before the cliff (assuming you have one) or after.  Particularly before the cliff (but it could be at any time) Harry is going to want to hang on to some options.  You should be aware that options are contracts, and like any contract, the option terms can be changed by agreement of the parties.  Option plans typically provide that an employee who is terminated, other than for cause, will have a period of time (usually 60 or 90 days) after termination to exercise vested options.  This means there must be some vested options and the employee has to be ready to stroke a check.  Sometimes neither is the case.  Rank and file employees typically have to live with the plan, whatever it says, but “senior” people often negotiate for some vesting and for a longer period of time to exercise.  I have not noticed that there is any standard length of time but perhaps a year is common for additional time to exercise.  Typically, the employee is looking for enough time for the company to reach some new valuation that will give the employee clarity as to the wisdom of exercising.  Also, with respect to the amount of vesting I have not noticed any “standards” – the senior employee gets what he or she negotiates.  My experience is that employees ask for the cliff (in a pre-cliff termination) and some portion of the remaining in a post-cliff termination.  Usually the company is willing to do something in a termination (other than for cause) and the negotiating space is not that great, so it is readily compromised.

Your board must approve option grants and changes to option terms.  This may be a technical point, but all option grants (including those promised to new employees when the come on board) and all changes to the terms of options (for example the negotiated changes that might happen on departure of a senior employee) must be approved by your board of directors.  The Delaware law reason for this is that you are, in effect, proposing to issue stock and that is the right of the board of directors.  For this reason, option grants in offer letters are often conditioned on board approval.  You must make sure you understand what your board will approve before you make offers.  Otherwise you could be embarrassed or worse.  From the employee’s perspective, you should get some assurance that the option grant will be considered by the board at its next meeting.  You might also want to get some assurance from whomever you are negotiating with that he or she has at least discussed the proposed grant with key board members and they are OK with it.

Once in a very dark blue moon, the bad thing happens: an employee or consultant is promised options subject to board approval and the board does not approve.  Consultants rarely protect themselves from this sort of thing.  I am not sure why – perhaps because they feel it is not diplomatic to suggest that they are not comfortable that the founder or CEO hiring them is not in sync with her board.  In any event, if you think you might find yourself in that position, you might suggest some alternative compensation that is not subject to board approval.  For example, in some cases CEOs have the authority to commit to signing bonuses.

As if that is not enough, investors (and this is absolutely true of VCs) negotiate for and obtain contractual restrictions on the issuance of options and the vesting and other terms upon which they can be issued.  Your grants must comply with your contractual agreements or you have to get a waiver from your investors.

The Internal Revenue Code will also have something to say about your grants.  I don’t want to go too far afield with tax stuff about qualified and nonqualified options, but I do want to note that Section 409(A) of the Internal Revenue Code has the practical effect of requiring that option grants be issued with an exercise price that is equal to or greater than fair market value on the date of grant.  If this stuff is of interest to you, check out Options and 409(A) – Sometimes the Law is an Ass.

Finally, and I hesitate to mention this because I am a lawyer and it will sound self-serving, but don’t be penny wise and pound foolish.  Consult with Clarence; have him review (preferably actually draft) the stockholder agreement.  It may be a sad life, but it is what he lives for.   In addition, he, like the VCs, sees a lot more deals than you ever will.

There are many other arrangements among founders having to do with stock and what happens if the founders come to a parting of the ways.  These include things like transfer restrictions, puts, calls, repurchase rights, mutual options and the various methods of valuation that go along with buying and selling stock.  These are beyond the scope of this post.  Also, they don’t typically apply to venture financed companies.  But, if there is sufficient indication of interest, I will write another post covering those items.

I recently returned from a 3 week trip to India visiting family and friends.  Looking through recent developments during my travels from the perspective of a corporate lawyer, and former business consultant, I made some several interesting observations, some of which I hope to recap in this and following blogs.  As always, take everything I say with a grain of salt...

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A start-up wants to formalize a relationship between the company and certain advisors who have been providing invaluable advice for the last couple of months. The start-up is also considering granting these advisors some equity in the start-up and want to know what market is. The answer, infuriating for some, is the classic lawyer answer of “it depends”.

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David Wessel’s recent article in the Journal, “A Prozac Economy has its Costs,” asks: If we were able to invent the economic equivalent of Prozac – something that would take away the high-highs and the low-lows of our current economy (think the tech bubble of the late 90’s and the current recession) – would we elect for a prescription? Would we, given the choice between a dynamic, volatile economy with painful depressive phases, and a more mellow economy with fewer crises but a slower growth rate over the long term than its manic doppelganger, settle for a calmer existence? Though my understanding of economics is limited to my college-level macro and micro courses, from an entrepreneur’s and VC’s point of view, I think my answer would be: give me manic any day.

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Prithvi Tanwar, an associate at Foley who does a lot work with us at the EEC, recently had occasion to consider the General Public License in the context of start-ups.  This resulted in the following comments which I thought would make a useful post.

A start-up wants to develop its online application using scripts licensed under the GNU General Public License (“GPL”). What are the potential ramifications? Any modifications and works derived from a script or product that is licensed under the GPL must themselves be licensed under the terms of the GPL when distributed to third parties (they must be made available in source code, at no additional cost, to anyone to whom you distribute the modifications or derivative works).

There are two questions a start-up building software derived from scripts under the GPL needs to ask: (i) Do we plan to distribute the software? and, (ii) How much of the software do we plan to develop using the GPL scripts? If your business plan requires the sale/distribution of software to customers - move to question two. If however, you plan on providing a service using your web application, where all your software sits and runs on your servers and users access these servers through their computers (be it desktops or smart phones) you might not trigger the distribution requirement under the GPL license. If you are distributing software, the next step of the analysis is to determine whether your product “as a whole” is a derivation of the script under the GPL. If this is the case you might very well have to disclose the source code for your entire product and not just the portion you developed by modifying the GPL script. Not the route you want to take if you view your product as proprietary. Unfortunately, the question of what constitutes “as a whole” is difficult and requires a case-by-case analysis. This might be a good time to call your IP Counsel to get an idea of how much risk you plan on taking using open source software in your development process.

Your choice of a software distribution vs. service provider model will also affect investment and exit events in the future. Using GPL scripts in the development of your website application will raise concerns for potential investors and buyers. If a potential acquirer or investor views your product as the main asset, to be distributed and marketed as a closed-source proprietary product, they might balk at your use of GPL scripts. If however, the buyer or investor view you as a services company where your main asset is your customer base and market presence, the use of GPL scripts might not be a problem. Executing a software development process in tandem with your business plan and still having room for flexibility is a difficult process, but is key to avoid boxing yourself into a corner over the long run.

For the most part, the startup companies we represent fit into the tech category in one flavor or other, whether its internet, mobile, cleantech, life sciences, etc.  But like the VCs, we follow the entrepreneurs.  So despite Foley Hoag not being a Hollywood power house, when a great entrepreneur, Marc Fienberg, had the crazy idea that despite having no Hollywood connections he was going to take a script he wrote and somehow manage to start his own production company, raise the money needed to produce the film himself as a first time writer/director/producer, attract top actors and actresses and actually make it happen, I happily signed on.  The culmination of all that happens this weekend when Play the Game, starring Andy Griffith, Paul Campbell, Liz Sheridan, Doris Roberts and Marla Sokolov opens in select cities nationwide today, August 28, including in the Boston area (Kendall Square, West Newton and South Dennis).  I had no idea how long it would take and how much fun it would be along the way...

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