(1)  Be wary of “standard.”  There are some items legal things that are truly “standard” but not as many as some lawyers may imply. 

(2)  You can under most circumstances get some up front vesting from VC type investors.  My experience is that for many startups in which the founders have invested some sweat, investors will give you some credit in the form of fully vested stock.  So, a typical arrangement (again depending on the facts) might be 10% to 25% fully vested at the Series Seed (or Series A, as the case may be) closing with the remaining amount vesting ratable on a monthly basis over three years.

(3)  The notion of a “cliff” seems out of place for founders who have been working on a startup for some months (or longer).

(4)  I see a lot of so-called double triggers (as opposed to full acceleration upon a sale).  So, sometimes you see everything that is unvested vest upon a sale (a liquidity event other than an IPO).  More often, however, I see something along the lines of half of the unvested vests with the remainder subject to the “old” vesting schedule provided that (and here is the second trigger) if the founder is terminated by the acquirer in the liquidity event (or the founder quits for good reason) within some agree upon time after the liquidity event (say six months, but sometimes more) then the remainder vests. 

(5)  Vesting stops when the founder ceases to work for the company.  The notion that unvested shares might vest immediately upon termination other than for cause has some appeal to founders, for obvious reasons, but you may need to come to a parting of the ways with one of your co-founders.  If you do, that fully vested block of shares (typically a big percentage of the common stock) may loom very large.

With respect to series A deals, New York and New England each had 22 deals in Q1.  According to us, there were 223 series A deals nationally.  So, NY and NE collectively represented approximately 20% of the national market.

With respect to later stage transactions, there were 25 NY deals and 43 NE deals.  Again, according to us there were 368 deals nationally.  So collectively NY and NE represent about 18% of the market.

I imagine that the relatively smaller number of later stage deals in New York reflects a number of things.  One might be that the boom in NY deals is relatively recent so there may not be as many companies in the pipeline that are ready for a second or later round investment.  Another might be that the mix of investment opportunities in New York is more “capital efficient” than in NE (and maybe other places).

With respect to that later point, here is a breakdown of some categories.  We categorize deals into one of four categories technology, life science, cleantech and other. 

With respect to series A deals in NE in Q1 40% of deals were in the technology category, 14% were in life science and the rest were other.  That is there were no cleantech deals.  In NY 30% were technology and 70% were other.  There were no life science or cleantech deals.

With respect to later stage deals, in NE 37% were life science and 35% were technology.  In NY 72% were other and 16% were technology.

I suspect that most of the other deals in NY were companies with revenue models based on advertising revenue. 

All this leads to the conclusion that NY is a pretty exciting place for investors.  I predict that the upswing in NY deals will continue.  Stats over the next few quarters will tell the story.

Sometimes it is good to be reminded of the past -- even if you lived through it.  Here is a link to a lengthy, but thoughtful, blog post on the "bubble" of the late '90s.  Peter Thiel's Startup Class Notes.  My favorite quote from this post is "Bubbles arise when there is (1) widespread, intense belief that’s (2) not true."  This is, of course, in different words what Mr. Mackay might have said about Dutch Tulips or witches in Salem.

It seems to me that bubbles (good, bad or indifferent) airse when there is a lot of money hanging around with the result that people do irrational things with it.  The recent $646 million lottery is a good example.  As the pot got bigger the odds got smaller, but the rate at which money poured in increase.  More money chasing smaller odds?  Go figure.

Congress has just passed, and the President has just signed, a new law that is supposed to support capital raising by smaller companies.  It contains the so-called crowd-sourcing provisions that have gotten so much press.  It will be seen if this does something or nothing for small companies, but one thing it might do is send a lot of small investor money chasing every smaller odds of success. 

I finally got around to my quarterly comparison of deal terms published by our firm, Fenwick (a Valley based firm that reports on transactions in the Valley) and Cooley (a firm with many offices that reports on transactions handled by it).

And here of New York:  No one that I am aware of reports on New York transactions.  But, starting with Q1 o f 2012, we will, because we are doing increasing amounts of emerging company work there.

So here is part 1 of my thesis:  I expect that terms will be most favorable to entrepreneurs in the Valley, least favorable in New England and somewhere in between for the rest.  Of course, I think that the “somewhere in between” number will include Cooley’s New England transactions (which will have the effect of making them generally seem less favorable to entrepreneurs).  We should all note that Cooley feels compelled (at least in some instances) to report numbers for Northern California separately from the others.

So, without further fanfare, below is the table that compares certain of the deal terms reported on by the three firms for Q4 of 2011.

Fourth Quarter 2011 Transaction Terms

Of course I knew what the chart would say before I made the prediction, so no surprise that it supports my thesis.

Here, however, is part 2 of my thesis:  When we start reporting on New York separately (which we will be doing starting with a Q1, 2012 report – to come out soon), it will show that terms in New York are far closer to those in the Valley than to those in New England.  Now I don’t’ know the answer to that question, but we are doing the research now and will have an answer soon.

Keep in mind that New York has gone from nowhere just a few years ago to equaling (or passing by some measures) New England.  Could it be that NYC is just a friendlier place for entrepreneurs than New England?

It does not seem to matter what the articulated reason for the loss of valuation – market conditions, ineffective management, too early to market, too late to market, technology challenges, long adoption cycles, etc. – in each case one down round leads to another.  With each successive down round the common holders (and option holders) become more and more diluted and demoralized.  Key players start to leave.  Vendors are not paid and they put the company on COD terms.  These things all slow product development and sales and also harm morale.  Eventually the CEO is replaced (perhaps the entire team) and the new team is faced with the almost impossible task of bringing Lazarus back from the dead.

If this observation is really true, even in just a majority of cases, why would anyone ever invest in a down round?  The investor would simply be throwing good money after bad. 

There seem to me to be a lot of reasons potentially at play:  The original investment thesis still seems good.  Investors and management (let alone founders) remain enamoured of the business.  Investors are not eager to admit to their limited partners that a mere 12 months or so after they put a large wad of cash into the business there is a total write off.  Investors are afraid that the next guy will pull off a miracle and make the business a success as a result of which they will look like they bailed too soon.

Well, here are some facts.  We sorted our database of venture capital transactions in New England  first by searching for companies that had follow on rounds since 2008.  We then looked at the follow on rounds to determine how many were up and how many were down.  About 71% were up and the other 29% were down.  We then searched the down rounds to see which ones had a subsequent round of financing (13%, as opposed to 49% of the up rounds).  Out of the financings that followed a down round, 30% were up, 15% were down, and the rest (55%) were even. On average the “up” rounds were up by about 56% from the down round price. 

While the sample size is relatively small, the data shows that down rounds are much less likely to be followed by another round of financing, at least within the 2-year period we’re looking at. If they are followed by another round, there’s a good chance (85%, according to our data) that it will be an even or up round.

 Assuming you made equal bets across all down rounds and only 4% of the down rounds had follow on up rounds, that 4% would have to return a lot more than 56% you to break even on the portfolio portfolion of down round securities. 

Now, among other things, this analysis does not account for (1) the possibility that some of the up rounds will improve even further over time or that some of the down rounds will return something, (2) the time value of money, or (3) a host of other factors that are of lesser importance but not of no importance.  Nonetheless, it does suggest that investors would be far better off betting on the flip of a coin than on a down round.

My blogger friends (and the firm’s blogger consultants), indeed, it seems the entire blogosphere seems to agree that blogs are not really an optimal publication platform for dissemination of pure content.  I take that to mean that putting law review articles (or any substantive articles on legal (or other) topics) is really not what blogs are “about.”  

Instead, blogs are supposed to be pithy comments on other people’s posts (or perhaps some other thing going on in the real or virtual world).  Hence the prevalence of blog posts that begin with some reference like, “Harry has a great post about his date with Sally….”  Harry’s post, it turns out, is likely to be some observatlon about something Sally wrote on her blog.  Sally’s blog, in turn, refers to Tom and Dick….

So, the consultants appear to say, blog posts should be pithy comments about pithy comments.

And, the occasional pithy comment is probably a good idea, but when I look at the statistical data concerning this blog and I consider which posts seem to have generated interest and which have not, the numbers (meager as they are) support a completely different notion. 

Readers want content more than conversation – at least as much as conversation.

I am, for example, under the impression that Fred Wilson was very successful with MBA Mondays.  (Now, his entire blog is a huge success.)

Switching gears, Prithvi has told me on many occasions that the content posts I have done in the past are more geared for consumption by lawyers than by entrepreneurs. 

So, I am going to try and take a trick from Fred’s book and apply Prithvi’s advice and write a series of posts (I will try for weekly) that will be both substantive and usable by entrepreneurs.  The posts will be checklists for things that are legal in nature.  The idea is to put the entrepreneur in a position to think about whether he or she has covered everything he or she needs to cover in a document or deal. 

Of course, the usual caveats about how this is not legal advice and does not create a lawyer client relationship etc. apply. 

I thought I would tackle seed preferred term sheets first.  Although these can vary from one pagers to 5 pagers (or more), for the purpose of creating a checklist, I am going with the longish form.  After all, it is the purpose of a checklist to be over inclusive.  Also, I have linked each of the terms (and some other items) to the glossary defining these terms on the EEC microsite and, where it seemed relevant, to my blog. 

Please send me thoughts on the checklist.  If the checklists seem useful (or popular) I will post them on their own site on an easy to use open source basis.

Here goes:

At the risk of fighting the last war, I am going to come back to idea (and in some cases reality) of “standard” open source seed preferred documents. 

To be clear: 

(1) A note that converts at a discount into the next round of equity financing is probably the best deal an entrepreneur can hope to get.  Now he or she may not be able to actually get such a deal (and certainly won’t get it from many VC investors).  Why is this the best deal an entrepreneur can hope to get?  Because it limits the investor’s upside.  Why do VC (and other) investors hate these notes?  Because the notes limit their upside.

(2)  A convertible note with a cap may be the worst deal an entrepreneur can get.  Why?  Because, she is selling equity at the lower of two prices.  One price is a fixed valuation and the other is something less.  If you are going to set a valuation, you might as well just take that.

(3)  The seed preferred is probably the investor’s best friend because it sets a valuation on the closing date.  And, it starts the capital gains clock ticking so that in the case of an early exit, there is some hope for capital gains tax treatment.

It is hard to object to a fair valuation.  Of course, if it is fair, then so be it.  Unfortunately, experience suggests that valuations at the seed stage are chronically too low, with the result that after the first VC round, founder equity is diluted to the point where it is hard to see how (in the absence of a spectacular exit) the founder pay day will be all that good.

Of course, the black magic of valuation is the special provenance of VCs.  So that last paragraph was just an observation from the peanut gallery.  Unfortunately, I have seen this show more than a few times, and it doesn’t change much over time.

But here is one that is more in the provenance of lawyers:  Sometimes seed preferred docs carry in them the germ of a most favored nation clause.  That is the clause that says something like:  The Series Seed will be given the same rights as the next series of Preferred Stock (with appropriate adjustments for economic terms). 

In effect, your seed investor has gotten today’s valuation (the low one) and tomorrow’s terms (the good ones that the VCs negotiate).  If you are an entrepreneur and you believe, as I am told some people do, that investment negotiations sometimes involve a trade off between price and terms, then you just lost on two counts.

Ah, but what did you get?  A nice, simple, clean deal (that give the investor what he wants low price and good terms) at a low transaction cost (whatever fixed fee you agree to with the lawyers).

Unfortunately, many seed investors won’t stop at a simple deal.  They have loads of their own requirements.  But that will be the subject of another post.

I have been giving some thought to Fred Wilson’s recent post, “A Challenge to Start Up Lawyers”.  His basic point is that he should be able to close an angel financing of under $1mm for legal cost of $5K.  Needless to say, this post brought out the sycophants (the Fred you are absolutely right crowd) and the deeply offended (the lawyers are worth every penny they charge crowd). 

I don’t think it is reasonable to be in either crowd.  Our firm enters into a wide variety of arrangements with start-up (and other) clients.  These arrangements are intended to reflect the needs of the client and the particulars of each situation.  We may agree with a client on fixed fees, deferrals, reduced hourly rates, premiums, blended rates – to describe just a few of the arrangements we have with various start-up clients and other clients.

But, I want to talk about the $5K for a $1mm seed preferred investment.  Let me start by separating the invoice amount from the time that needs to be put into the transaction.  In the world of hourly rates, these two things are inextricably intertwined, but they need not be.

Our firm knows, because we do many angel financings, that the result of hourly rates multiplied by the time spent is highly likely to exceed $5K.  (That does not mean that we charge more than $5K or less than the hourly rate times the hours – what we charge depends upon many factors, the most important one, of course, is any agreement we have with a client.  For example, it is not unusual for us to write off time that we feel is excessive for any reason.)

So, why are the time charges (remember not necessarily the invoiced amount) likely to exceed $5K when so many angel deals are done and the terms are so “standard?”

VCs and lawyers do tons of deals, entrepreneurs only a handful.  Investments, even (or perhaps especially) angel investments involve a lot of discussion.  By way of illustration, they may involve discussion of valuation, option pools, vesting for founders, structure (seed preferred versus convertible notes) and other items.  Note that I have not yet mentioned the actual terms of the seed preferred. 

I can just hear Fred and his army of outraged investors saying:  “But we posited that the deal would be a seed preferred on standard terms and we agreed (hypothetically) on readily available open source docs.” 

OK, but I know from experience that the entrepreneur is highly likely (near 100% of the time) to come to me and say, “Fred wants to do a priced deal, but my buddy Winston got funded with convertible notes, which is better?”  So, now we have a discussion on the merits vel non of priced deals and convertible deals.  (I know that Fred won’t do a convertible deal, but that does not mean the entrepreneur won’t ask the question.) 

So, Fred, does the time spent on the discussion of priced deals versus convertible deals count towards your $5K or not?  Well let’s tick off $500 for that discussion (in the hours times rate world) and move on.

OK, now there is some sort of email or other with the “terms”.  At this juncture, the entrepreneur wants to discuss whether the valuation is fair.  (Remember that the fact that I am a lawyer and (according to most investors) as likely to know about valuations as about paleo-anthropology will not stop the entrepreneur from asking what other clients are getting.)  The meter ticks on….

Eventually we get to the seed docs themselves.  I produce the docs at the speed of greased lightening.  Unfortunately, the entrepreneur reads them and, guess what, has intelligent questions. 

Here is a good question:  Ted Wang’s open source docs provide an MFN provision for new terms arrived at in the next equity round.  I have a client that asked at least these questions about that provision alone:  What does it mean?  Is it fair?  How might it impact my negotiations in the next round?  Does it give my angel investor a practical veto over the next round?  And the meter ticks on….

Anyway, you get my point.  It is not mere document production; it is time spent with the client.  No lawyer wants his client to sign something that the client is not comfortable with and does not understand.  It is just not good corporate hygiene.  (In fact, it might be malpractice.)

So here is one for you Fred:  Would you want your portfolio company to be using a lawyer who just says these are the standard open source docs, just sign them please?  Would you invest if you knew the entrepreneur signed on that basis?  Would you invest if the entrepreneur read the docs and did not have any questions?

Now back to the price.  Many high quality reputable firms would agree to a fixed price (perhaps $5K) – not because they believe they will be able to bring in the time at a profitable rate, but because they think of it as business development.  They may have other reasons as well.  The thing to do is to have a discussion and agree at the front end as to how the billing will be handled.  But don’t be under any illusion.  It is unlikely that rate times hours will yield $5K.

One more point is that law firms are likely to view fixed fee arrangements as loss leaders.  They are planning to get more work on which they can make a profit.  Fred’s example of the exit (where the law firm charged six figures) is an excellent case in point.  The risk, of course, is that the firm that did the early work at what is in effect a discount, does not get the more profitable back end work.  This can happen when VCs (and other advisors – most of whom know as much about legal work as they do about paleo-anthropology) come to the conclusion that the company needs a thousand lawyer national megafirm for the “important” work, and they push the client away from the start-up lawyer.  It can happen for other reasons as well, the ingrained preferences of a new CEO or CFO, the insistence of a new investor that the company use one of its “favorite” firms, or the insistence of a heavy hitting board member to the same effect.

This leads to a lose lose situation for the start-up lawyer, who will now think twice before doing the angel financing at a loss.

This is the time of year when pundits look forward and make predictions.  So, I decided to do the same.  Here are ten predictions for next year:

 1)     The Pats will beat the Eagles in the Superbowl

 2)     Angels will continue to invest at a torrid rate.

 3)     There will be continued modest improvement in numbers of VC financings (but not enough to get back to 2007 levels).

 4)     Cleantech and renewable energy start-ups will continue to have difficulty raising venture money.

 5)     There will be continued modest improvement in M&A exits (but not enough to get back to 2007 levels).

 6)     There will be approximately 50 IPOs of venture financed companies (more than half of t he 86 that happened in 2007).

 7)     VC fund formation will also be slower than 2007 (both in amount raised and new funds raised).

 8)     The west coast will continue to provide better terms and valuations to entrepreneurs than the east coast.

 9)     Consumer web privacy rules will be promulgated and they will not have a material impact on tracking.

 10)   Net neutrality rules will be promulgated, and they will allow differential pricing of some sort.

So we will not be seeing 2007 levels of activity, but the entrepreneurial ecosystem will be livelier than last year.  So, I am predicting cold, but with a chance of fun.

Now consider the following investment scenario:  you get a $5mm on $5mm valuation, but what does that mean?  If there is a preference, then the investor's $5mm is worth more than yours (this is even more true if there is also a participation).  (Just consider what happens in a low value exit.)

But -- how much more is the investor’s position worth?  I am not a finance maven, but think about the exercise price of your company’s options.  This price is supposed to be the fair market value of a share of common stock.  Now no one (except maybe the IRS) really believes that the strike price of an option is actually the fair market value of share common stock on the date of issue since setting the exercise price of options is mostly an effort to pick the lowest price you think you can get away with.  Nevertheless, everyone agrees that a share of preferred stock is worth a lot more than a share of common stock.  For argument's sake, let's assume a share of common stock is worth half of a share of preferred stock.  In this case your $5mm on $5mm is really $5mm on $2.5mm.

Thinking of your common stock position this way will also give you a sense of how much bigger a score has to be for you to make a return than it has to be for the investor.  I am really thinking of smaller exits, which a lot of people think is likely to be one of the hallmarks of capital efficient businesses.

If you raise $5mm (at $5 mm pre (i.e. $5 on $5) with a preference and a participation) and you sell for $20mm in two years, your investor gets $12.5mm (a return of 150%) and you get $7.5 (a return of 50%).  If the exit is at $200mm, there is still a disparity, but it fades into insignificance.  A capped participation preserves the disparity in the low value exit scenario while making it go away in the high value scenario. 

It sometimes seems to me that the quid pro quo for downside protection should be a diminution of upside return, but that is not the way VC investments are structured.

When you realize that returns to VCs in the last decade have been at or near zero (industry wide, and despite the downside protection), you have to realize that returns to entrepreneurs have been far far worse.

Not many mechanisms have been devised to mitigate this situation from an entrepreneur’s point of view.  One that has been used on occasion is to structure the initial capitalization of the Company (i.e. before venture investment) with common stock and a preferred stock.  Usually this is a preferred "lite."  It does not have all of the bells and whistles of the usual VC preferred, but it carries some important rights such as a preference and anti-dilution provisions.  These preferred shares are issued for “real” consideration (cash for example) and then the argument is made (at the time of venture investment) that they are really an early seed round.

 Whether you can succeed with this strategy is, of course, a matter of negotiating strength.

Then every now and again, you catch something.  The other day I went steelhead fishing on the Salmon River and caught a couple of monsters.  Here is one:

Anyway it is time for the quarterly catching report – that is the report on venture deals for Q3. 

Foley Hoag (my firm), Fenwick & West (a Silicon Valley based firm), and Cooley (with offices sprinkled about the country) have each published their activity reports for Q3 of 2010.  The consensus view is one of cautious optimism that recognizes continued signs of trouble.

My partner, Dave Pierson, put it this way, “The reported information suggests that the environment for venture investing continues to be sluggish.  Nevertheless, there are positive signs…..Unfortunately, there are negative indicators as well….”

Fenwick has this to say, “Third party analysis of the venture industry in the third quarter of 2010 reported a decrease in venture investment compared to the second quarter of 2010, but a continued improvement in venture funded company liquidity.”

Cooley described it this way, “Consistent with a theme we reported on during the prior quarter, Q3 2010 financing results remained mixed.”

By way of background, Foley Hoag’s Venture Perspectives reports on New England transactions, Fenwick reports on Silicon Valley transactions and Cooley reports on transactions in which it is involved.

Activity Levels

According to our research, overall New England Series A deals increased in Q3 over Q2 but the number of New England Series B and later stage deals declined.  Perhaps the most striking thing is that, in terms of numbers of Series A deals, the technology sector looks to be on track to top 2007!  (Cleantech too, but that is a very small number of New England deals.)

According to Fenwick, in the Valley, “up rounds exceeded down rounds in 3Q10 52% to 30%, with 18% flat.  That was generally consistent with 2Q10…”

Cooley has much the same point of view, “The percentage of up versus flat/down rounds remained relatively consistent with the prior two quarters of the year, with the majority of deals being up rounds for the third consecutive quarter.”

Looked at from 30,000 feet, we are circling.  It looks like there is a slight trend towards improvement that has been sustained through the year.  But it looks fragile and who knows if it will continue.

Terms – Usually boring but this time there are some striking east coast/west coast differences.

As I have done in the past, I have prepared a table comparing some of the deal terms reported on by the three firms. 

Comparison of Terms for Q3 2010 Venture Deals from Foley Hoag, Fenwick & West, and Cooley

(some percentages are approximate)

(1) In 58% of these cases the participation was not capped

(2) Represents all transactions collectively

Cumulative Dividends

Just look at the difference between what Foley Hoag is reporting and what Fenwick is reporting – an order of magnitude!  Since I have been writing this quarterly post, I have noted a divergence in practice between the two coasts with respect to cumulative dividends, but the divergence is increasing not decreasing.  It is hard for me to explain this divergence.  One explanation could be that while New England VC firms that operate on both coasts are not extracting cumulative dividends from their portfolio companies, the smaller regional firms in New England retain a very conservative investment style and continue to get these dividends.

Preference with Participation

There is good news and bad news.  The good news is that only about half the deals reported on have this deadly combo.  The bad news is that about half the deals reported on have this deadly combo.  Looked at in this very high level broad brush way, east and west seem to have a consistent practice with respect to preference and participation.

Redemption

Another shock to the system.   Again compare the numbers between New England and the Valley.  The prevalence of redemption provisions in New England is hard to explain.  In past quarters I have attributed this to a slower rate of change in New England than on the west coast, but the numbers are not converging. 

Venture Capital or Banking?

When you look at the numbers over several quarters and you add up the dividends, preferences and redemption, you could come to the conclusion that New England VCs have a banking mentality.  They will lend you money at interest (dividends), you need to pay back the principal (preference) in a five year term (redemption), and they get an equity kicker (participation).

So How is the Fishing?

Well there are some good indications that the fish are biting (or soon will be).  Here is one:  There have been some 40 IPOs of venture financed companies to date this year.  A number which is more than 3x the total 2009 number but is still half of 2007’s full year total.  I don’t know exactly where the Dow is right now, but it is getting ever closer to the 12,000 number and has risen significantly this year.  The improved atmosphere for exits should generate confidence in investors and therefore investment.  Hopefully, the fish will be out there feeding.

A contra indicator is that VC fund raising appears to be behind 2009.  Just for scale, 2009 was the lowest fund raising year since 2003 (I think).  This trend (low rates of fund raising) suggests that there will be fewer fish in the river.

Anyway, if you are lucky, you will catch one of these:

Diligence is a topic that tends to be overlooked, probably because it is boring.  Mostly people think of it from the perspective of whether your documents are in order etc. and mostly that is right.

But, there is one thing that deserves special mention:  background checks. 

Not every investor hires an investigator, but they all know how to use Google and in this day and age, almost everything about you is easy to find online.  If you have something in your past, let’s call them “Uglies” that an investor might be sensitive to (say an SEC consent decree, a law suit for sexual harassment, or something else ugly) and you try to hide it and your investor finds out from the net or elsewhere (and they will find out), you will be doubly damned. It is bad to have the ugly but its much worse to have the ugly and hide it. 

So, how can you protect yourself?   Here are some best practices:

Rule number 1:  Google yourself so you know what others will find. 

Rule number 2:  If there is anything in your past that you would like to hide, assume that your investor will find out about it

Rule number 3:  Be up front and honest.  How your deal with uglies can magnify or mitigate their effect.

Here is a video (produced by me using xtranormal.com – so please forgive the clumsy production values) showing how the conversation is likely to go in the hallowed halls of your potential VC investor.

If you have something in your past that an investor might be sensitive to and you disclose it properly and candidly you get damned once (for having the ugly) but you are likely to get mitigation points for being up front, honest and candid.  . 

Here is my second video showing how an upfront and candid conversation might go down with your investor

I don’t want to rehash the now tedious discussion, but the following thought has occurred to me more than once:  Investors who hold notes that are convertible at a discount are indifferent to the next round valuation (sort of – (a) a low valuation theoretically helps the return on the seed investment and (b) everyone likes to invest in a company that made it big).  These investors have a built in return that they will book at the next round no matter what the pricing of that round is. 

At the risk of being boring, a note that converts at a 20% discount to the next round provides a 25% return upon conversion whether the round is priced at $10 million or $500 million. 

So, consider this:  A VC investor who puts $500K into a priced seed round with the expectation of investing $5mm in the A round will want a low valuation on the A round.  It is in the VC’s economic best interest to get a “good deal” on his $5mm investment, to the detriment of the return on his seed investment because the seed investment is nominal by comparison to the A rond investment.  On top of this motive, the VC is probably on your board and probably has blocking rights, rights of first refusal etc.  As a practical matter, bringing in a true competitive bid will be difficult on a good day.  In fact, if there are blocking rights it may be impossible.

Also, consider this:  An angel who puts $500K into a priced seed round without the expectation of participating in the A round (or perhaps hoping to have a minimal participation) will want a really high valuation to avoid dilution.  Note this investor will also be worrying about later rounds.  Again, because of contractual rights (such as the right to block the issuance of senior preferred) this investor may be in a position to affect your ability to raise the next round.  Now, you can usually get around this issue because it always comes down to "raise the new money or die", and the investor will go with the obviously correct choice.  But, make no mistake about it, these investors can and do create major problems from time to time.

Now consider this:  A VC with a $500K principle amount convertible note (at a 20% discount and no cap) will get a 25% return on the $500K at the closing of the A round without regard to valuation.  He will be planning to make his return on his A round investment and will negotiate like a VC to get a “good deal.”  But, these notes are typically done without all the ancillary documentation that accompanies priced seed rounds.  As a result, the holders do not have blocking rights.  Because of signaling and other issues (the investor is already involved with the company, he may have rights of first refusal etc.) the VC investor will be tough to deal with, but, from the entrepreneur’s point of view, it probably beats having to deal with all the contractual rights inherent in a priced seed round.

Finally, consider the angel investor holding the proverbial convertible note:  Economic indifference to the pricing (sort of – see my parenthetical in the second paragraph), fewer contractual rights, and no substantial new investment in the next round – how much better does it get?

As Suster points out, it is hard to argue that investors should like convertible notes (without caps), but it is also hard to argue that entrepreneurs should not like them.  In the end, it seems to me that this is all about supply, demand, familiarly with investments, savvy and negotiation.  Familiarity and savvy are usually on the side of the VC.  Because of the dynamics of the seed market, as it exists today (see Andy Payne’s recent blog regarding the glut of angel money), supply and demand may be on the side of the entrepreneur (for once).  Don’t feel bad about getting a “good deal”; investors sure won’t.

In the end, when it comes to the new Accredited Investor definition - it’s not that bad.  The new standard for accredited investor does raise the bar (but not by much).  To qualify under the new standard an individual’s net worth (or joint net worth with their spouse) must be greater than $1,000,000.  However, the net worth must exclude the value of the person’s (or couple’s) primary residence.  Perhaps the government does not want people to make investments based on the purported value of their house.  Why should you be able to claim that you have the ability to make a liquid investment in a speculative investment when most of your assets are illiquid?  The alternative income test of annual income over the last two years of at least 200K annually (or 300K if factoring in a spouse’s income) stays the same.  As a tangential thought, should someone who meets the income test but not the new net worth test be making what is in reality a speculative investment?

I spoke about the new standard and its impact with one the firm’s senior securities lawyers, and his response: “Sure they raised it, they have been talking about doing that for ages, and frankly I am bit surprised that they only raised it the amount they did”.  On the other hand, there are good arguments as to why the old standard was sufficient given how the world has changed over the last three decades and the ability for more investors to protect themselves via access to information and services that was once only available to the very wealthy (see Dave’s blog on this very subject).  At the end of the day, any way you slice it a higher bar means less people who can invest in start-ups without going through the cumbersome registration process which mean less angel financers and unfortunately harder time for start-ups to raise capital to bridge the valley of death.

Check out Foley Hoag’s official advisory on the Revised Accredited Investor Standard and talk to your lawyer to see how the new standard applies to you.

Well, the Q2 results have now been reported on by many sources, including the three law firms that publish data, Foley Hoag (my firm), Fenwick & West (a Silicon Valley based firm), and Cooley.  Unfortunately, I think Dave Pierson from my firm put it well in his analysis of New England based activity, “the environment for venture investing … has generally improved compared to the dismal conditions prevailing last year, but also that pace of improvement has stalled.”

Fenwick described third party analysis of the venture industry as follows, “2010 reported a significant increase in venture investment, mild improvement in venture funded company liquidity, and continued difficulty in capital-raising by venture funds.”

Cooley had this to say, “the second quarter of 2010 produced mixed signals for the venture financing environment.”

In my last post on quarterly results, I described what each firm covers in its reports so I won’t go into that again except to say that my firm’s publication, Foley Hoag Venture Perspectives, is devoted to venture financings for companies headquartered in New England.  Fenwick’s publication is devoted to companies headquartered in Silicon Valley.  Cooley’s is devoted to information taken from transactions in which Cooley served as counsel and is not focused on any particular geography.

Activity Levels

According to Foley Hoag’s research, as a general matter, activity levels for both Series A and Series B and later rounds in New England were up significantly when compared to Q2 of last year.  The data shows a more mixed performance when compared to Q1 of this year.  Perhaps the most striking piece of data is that there were no (as in none) cleantech deals in New England in Q2.  Variability is too great from quarter to quarter to draw much of a conclusion from this fact.  Having said that, it is consistent with anecdotal evidence indicating that VCs are being very cautious about cleantech deals.  Also the flattening between Q1 and Q2 is consistent with anecdotal evidence of a general slowing in the economy.

Fenwick had this to say about activity in the Valley, “Up rounds exceeded down rounds in 2Q10 55% to 27%, with 18% of rounds flat.  This was an improvement over 1Q10, when up rounds exceeded down rounds 49% to 32%, with 19% of rounds flat.  This was the fourth quarter in a row in which up rounds exceeded down rounds. … In general, the cleantech, software and internet/digital media industries had the best valuation-related results in 2Q10, while the life science and hardware industries trailed.”

But, Cooley seems to have slightly different experience.  Cooley had this to say about their findings, “Overall, our data points to mixed signals in the venture financing environment. In Q2, we saw a reversal in a recent trend of increasing up rounds. Though the majority of deals were still up rounds, the percentage decreased to 52% from 61% in the prior quarter. Median pre-money valuations were also mixed. The data showed valuation increases for Series A and C deals, while pre-money valuations declined for Series B and D+ rounds.”

Looked at from 30,000 feet, reports from all three firms seem to have picked up on some mixed results for Q2.  While it is not clear what this augers for Q3 and beyond, it does seem to reflect the general queasiness of the general U.S. economy.

Terms

The flattening trend, if that is a fair description, is also reflected in the terms for transactions.  I have tried to consolidate the deal terms reported on by the three firms in the table below.  This table shows the percentage of deals having a particular term and compares the findings of each firm (to the extent that the firm covers the particular term) with respect to particular terms that appeared in deals closed during the first quarter of 2010.

Cumulative Dividends

Consistent with a long standing trend and as was the case last quarter, the most striking comparison in this table is the fact that more than half of all New England deals carry cumulative dividends but less than 10% of Silicon Valley deals have them.  As I noted last time, “That is huge difference.  And, it is hard to explain. Many VC funds have offices in both markets.  Based on that fact alone, I would have guessed that there would be a tendency to have some homogeneity within a fund and that this alone would cause differences to be much narrower than an order of magnitude.  So, I checked out historical numbers going back a couple of years and this seems to be a persistent and consistent difference between New England and Silicon Valley.  It certainly suggests that Silicon Valley is more founder friendly than New England, I am sorry to say.”

Preferences with Participation

Also consistent with last quarter, the similarities are striking when it comes to participation.  Foley Hoag’s numbers for Series B and later stage deals and Cooley’s numbers for Series C transactions seem to be higher than the norm, but this may well be due to peculiarities in the sample.  As I noted last time, “This really begs the question why there is a seeming convergence around participation but not dividends.”  I would love to get some commentary from readers on this inconsistency in convergence.  BTW, I have again run across a New England based VC (and counsel) who insist that founder reps (covering all the company reps in a superseed deal but with recourse limited to the founder’s equity) are the norm.  I don’t think this is ever asked for on the West Coast, and I think it has been many years since some version of this was the “norm” on the East Coast, but I would also love to get some commentary on founder reps in the context of superseed deals, as well.

Redemption

With respect to redemption provisions, Foley Hoag continues to find that redemptions provisions exist in more than half of all deals or twice as much as Fenwick reports.  Last quarter I thought I had identified a trend away from redemption, but the numbers seem to be holding steady.  I will be curious to see how the numbers trend over the next few quarters.

Pay to Play

The incidence of pay to play provision is low across the board, and I don’t think the small differences are meaningful.

Antidilution

No surprises here:  Weighted average antidilution rules.  Full ratchet deals are rare everywhere, and, I believe, that they reflect unique circumstances.

Conclusion

While it would be nice to be able to report a steady upward trend across the country and across various factors, it ain’t happening.  But the news if not great is not all bad.  As one of my partners, Dave Pierson, put it in his article in Foley Hoag Venture Perspectives, “Thomson Reuters and the National Venture Capital Association have reported that exit activity for venture-backed companies was up during Q2 2010…..There were … 92 M&A exits, down from Q1 2010 but up significantly from Q2 2009.  The M&A exits with reported values generally yielded more favorable returns than in Q1 2010.  Venture-backed M&A exits with reported values greater than 4X the venture investment represented 65% of the Q2 2010 total versus only 45% of the Q1 2010 total. Venture-backed M&A exits with reported values less than 1X the venture investment represented 15% of the Q2 2010 total versus 31% of the Q1 2010 total.”  In addition, there were 17 venture-backed IPO’s in Q2.  This is the most in any quarter since 2007.

Mostly the debate revolves around who is and who is not a “good” angel investor. If the disputants are to be believed, a VC who just plopped $250K into your business to get an option on leading the next round is a “bad” seed investor but a VC who thinks like an angel investor and will give you some bandwidth is a “good” seed investor.

I am going to take the position that the later is just a “less bad” angel investor and that if you are looking for angel money, you should go to someone who does angel investing and has no pretenses to leading (or maybe even participating in) the next round. (I can hear the chorus now: But you want an investor who can support you as you grow etc….) My point of view is that if your business merits VC investment, you will get it on better terms if you started with an angel and then went to a VC than if you started with VC angel money. (Now, I may come to a different conclusion with respect to businesses that require really large amounts of capital, such as biotech and some cleantech companies.)

As I see it, the issue is that VCs who made angel investments are motivated to keep the first round valuation low whereas true angel investors are motivated to keep the first round valuation high.

The reasoning is simple. A VC who will be investing big dollars in the A round will get more for his or her money if the price is low than if the price is high. The dilution resulting from a low price will fall disproportionately on the founders, the holders of common stock and angel investors.

The exact opposite is true for an angel investor who is unlikely to participate in (or at least unlikely to participate in a big way) the first big round. A low price means more dilution to them than a high price.

Once you have a VC inside the tent, they will influence the next round price by their mere presence and because of the contractual rights you will have given them. Your VC investor will in all probability be involved (either as a BOD member or an advisor) in your efforts to find financing. In addition, their financing docs are likely to require that you get their consent to the issuance of new securities or any amendment to the certificate of incorporation (not to mention rights of first refusal and other things that might be in the docs). So, you are going to need their consent to any deal. All this of course assumes that your VC will participate in the new round. If they don’t you may have even bigger issues.

It is hard to imagine that in this context the VC’s presence won’t have a depressing effect on the price you can get from a “new” investor.

So, when you take on a VC angel investment, you are taking a significant risk that your next round valuation will not be as high as it would be if you went with a regular angel investor.

Any VC seed investor is likely to have a choice whether or not to fund an “A” round. It does not matter whether they made the investment with the intent of securing that choice or not. With respect to the value of the option, it does not matter that they were great investors and helped the entrepreneur massively along the way or that they were crappy investors and never returned a call.

The choice is the choice and, if the VC doesn’t make the next investment, the signal is the signal. 

(Now a great investor is a fine thing and worth every percentage of equity you give her. I am not taking anything away from the value add of a great investor.)

The difference between a seed investor and a VC is that the seed investor typically will not have the funds to participate in a meaningful way in the A round, let alone lead it. If, from the beginning there was no real possibility of participation in the A round, there was never an option and no signal can be implied.

But here is another way to look at the option/signaling debate (I admit not necessarily theoretically pure I the sense that the behavior would not exist in a world of pure economic actors). Entrepreneurs are afraid that if they bring in a VC for the seed round, they are placing downward pressure on their A round valuation. How can that be? If the A round price is too low, won’t someone bid higher? In a perfect world without friction and with perfect information, that might be true.

We don’t live in a perfect world with complete information. Once the VC has his nose in your tent, it will be hard (impossible?) not to deal with him when it comes time for the A round. The playing field will not be level for outside investors proposing to compete with the VC. The VC’s motive, of course, will be to keep the round price low since that implies a bigger percentage ownership and ultimately a bigger return.

Remember that those investment docs probably say that you can’t increase your authorized stock or create a senior preferred without your VC’s approval (true in most seed deals and absolutely true in all A and later rounds). This means your investor can block your next deal. You will not get far with an alternative investor unless you can get your seed investor on board. 

Whereas a VC seed player planning to lead (or at least participate in) the next round has a strong motive to get a lowish valuation for the reasons noted above, the angel seed player who can’t (or does not want to) participate in the next round has the exact opposite motive. She wants a high A round valuation since that preserve her investment and ultimate return.

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. 

Percentages are fixed, however #'s are always changing.  When a founder is promising a consultant, advisor, team member, investor (or whomever) a percentage of the company he/she is no doubt promising them a percent of the company at that point in time (so if there are 1,000 outstanding and issued shares, 20% would be 200 shares).  However, the pie is always growing so that 1,000 shares today might be a 1,000,000 shares in the future and that 20% is all of a sudden 200,000 shares. 

Now you're probably wondering, PT are you seriously saying that someone could have a credible argument that the 20% of 1,000 shares could be extrapolated to mean 20% of 1,000,000 shares?!! Get real.

I'm not saying it does, but depending on the facts and the circumstances, someone could very possibly make an argument that it might. Also, if it does or does not is besides the point.  Take this in the perspective of an exit or a large round of VC financing.  You really want this joker showing up a week before you close the deal with a document or a written agreement stating that you promised him/her X% of your company?  Granted, it might not be a very credible argument, but it's going to take either time or money (or most likely a lot of both) to make this go away and even worse it will create doubt in the mind of the investor/buyer, at the very worst could crater the deal.

Promising someone X% of your company? Don't do it - you'll sleep easier and so will your lawyer.

It's a great read in its own right and Seth Burgett has some excellent advice on a) how to get a start-up off the ground and raise some capital and b) no nonsense tips for would be founders. 

But one thing mystified me...the fact that he stays clear of freinds and family financing...well I thought about it a bit more and for Seth Burgett it makes sense...Why?

1) He's rich - he fronted what would usually be covered by friends and family fianancing himself.

2)  He's a rock-star as far as institutional investors are concerned - among other things, he led development for surgical robot company that eventually went public ! 

So here's my "rockstar-millionaire" exception to the path of family and friends financing:  If you already took a company public,  made your millions, and in the eyes of the VC and Angel community you/re a rock-star founder you might not go the family and friends financing route.