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

A couple of quick observations resulting from a quick read of a “standard” founder vesting agreement. 

(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.

Sometimes I tend to think that bubbles are all bad.  I keep a book on my shelf titled "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay, LLD.  This book was originally published in 1841.  I read portions from time to time to remind myself that bubbles (including those in the South Sea) come and go.

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 was doing some data mining in our database of New England venture transactions (see Foley Hoag Venture Perspectives) for reasons completely unrelated to the topic I am about to address and inadvertently stumbled on this topic.  Let me start by saying that we are all prisoners of our own experience.  Probably there are people out there with a different experience, but in my experience down rounds happen because companies have started a downward spiral and it is just a matter of time and a certain amount of swirling before they get flushed by their investors.

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.

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 was skiing on Cannon Mountain the other day.  Below is what I saw.

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.

There are days when you come home from a full day of fly fishing without having caught anything.  Hence the old chestnut to the effect that that is why they call it “fishing” not “catching.”  Looking for financing is sort of like that.  There are a lot of days when you come home empty handed,

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:

Mark Suster has struck again with yet another contribution to the seemingly endless debate about convertible notes versus priced seed rounds.  His conclusions will, of course, shock and amaze:  Price the “effing” round.  All the investors agree.  (I probably overstated that.)

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.

After Q1, I was wondering if the venture economy was back or if folks just thought so.  At the end of Q1 things seemed to be on a steady upward trend; now they seem to be sputtering.

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.

Brad Feld has another fine post on seed investing. His post, like so many others, focuses on the intent of the investor. In effect, he says there are good seed investors and crappy seed investors. He is undoubtedly right about that, but I am not sure it matters as far as optionality and signaling are concerned.

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.

Every time I hear a founder or entrepreneur say they want to give X percent  of their company to this team member or that investor - I cringe a little.  Why?

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.

I did a brief presentation to a small group of med device execs the other day. After getting through the remarks that I expected and answering the questions that I expected, mostly on the state of the venture economy, a question which I should have been prepared for, but wasn’t, came up: “What do you think will be hot this year?” Meaning, what spaces will get the investment dollars. 

The first half of my answer was easy: Capital efficient projects will get funded.

The next observation, however obvious, had not really occurred to me: Projects that are not capital efficient will not be funded. Three spaces that are not capital efficient are (1) biotech, (2) renewable energy and (3) clean tech (maybe that is part of renewables).

No one can be surprised that in an era of fewer and smaller funds, it is hard to get large capital intensive projects financed. 

The unfortunate thing is that Boston is biotech central and as a tech community we have placed a huge emphasis on green technologies. (Rightly so, in my opinion since ultimately the world is going to be constrained to go green or die.) But it (a robust funding environment for these technologies) ain’t going to happen any time soon.

Why? Because it makes more sense for VCs with limited funds and ten year fund lives to fund mobile apps and twitter derivatives than to build alternative energy sources.

I am not sure, but I would bet that if we were all somehow making a thoughtful decision around what makes sense for society to pursue, I can’t believe we would set up system that rewarded the 299,999th iPhone app before it rewarded the next renewable source of electricity.

Maybe I’m wrong: All in favor of more iPhone apps please send me a comment.

My recent post on family and friends financing generated a few comments and questions, mainly off-line.  One reader commented on how the blog really zeroed in on what he perceived was a really under-served area of financing for start-ups.  To think about it, he's absolutely correct - the most common form of financing is the family and friends kind, of which only a very few will make it to an Angel round and even fewer to a VC round (just the way it is), and it's the one round of financing that founders generally shy away from legal counsel.

One question that did come up - what's the treatment of these financing rounds by the SEC and the state securities authorities?  Well - I have to say that I will have to give you the maddening answer of "it depends" on this one, here's my response from a comment to the blog:

"Security law questions though seemingly banal are quite complex below the surface and answers can be incredibly fact specific. You not only have to worry about the federal securities law but also "blue-sky" securities law in each state. My fellow bloggers article on this issue (see http://www.emergingenterprisecenterblog.com/2010/05/articles/startup-issues/thinking-about-selling-securities-consider-this/) might be a good starting place. Feel free to contact me or any of the other lawyers at the emerging enterprise center if you want to have a more detailed discussion on your particular situation."

Apart from this, Scott Edward Walker's recent article in Venture Beat also sheds some light on this issue and the dangerous notion of advertising that you are raising capital via facebook/twitter (one word....DON'T!)

If there's one thing I hope you all do take away from these blog entries, and the links.....please talk to a corporate lawyer before you go down the path of raising capital, even if the source is friends or family.

Everyone thinks things in the venture world are looking up. Numbers of deals are up, valuations are up, terms are friendly. VCs and entrepreneurs are lining Winter Street and Sand Hill Road holding hands and signing kumbaya. Well, not quite. Foley Hoag LLP, Fenwick &West LLP, and Cooley LLP have now all published their reviews of venture financing transactions for Q1 of 2010, and, while there are some interesting differences, the tone is generally upbeat. Having said that, perspective is everything and sweeping statements about the health of the venture economy are l likely to be wrong if you don’t take all the available facts into consideration.

Reports from these firms cover a lot of the same types of material however they each look at some different things and they each source the data in different ways.

Foley Hoag, my firm, is headquartered in Boston. Our publication, Foley Hoag Venture Perspectives, is devoted to an analysis of financings for companies headquartered in New England. We try to cover all New England deals (that is we don’t limit our reporting to deals in which our firm is involved). We cover activity levels, valuations, and terms. In each case we break it up between Series A investments on the one hand and Series B and later stage investments on the other hand. We also report on activity and size of deals by industry.

Fenwick describes its report as “Trends in terms of venture financings in Silicon Valley.” This firm reports on venture financings for companies headquartered in Silicon Valley, and reports on financing rounds, price changes, and something they refer to as the Fenwick & West Venture Capital Barometer (you will have to look that one up for yourself). They also report on a variety of deal terms.

Cooley has this to say about its report, “This quarterly report provides data reflecting Cooley’s experience in venture capital financing terms and trends. Information is taken from transactions in which Cooley served as counsel to either the issuing company or investors.” This firm reports on numbers of deals, valuations and certain terms. Cooley has nine offices, so their data comes from many regions but, as noted, is limited to deals in which they were involved.

Because we cover similar data (but not the same data) in different ways and present it in different ways, it just isn’t possible to compare the data from all firms on an apple to apples basis. So, I have focused this post on (1) activity levels (that is numbers of deals) and (2) deal terms. 

Activity Levels

All three firms are reporting increased activity in Q1 of 2010 over Q1 of 2009 and over Q4 of 2009.

Foley Hoag found that activity levels for Series A investments in New England measured by the number of deals was up both compared to Q4 of 2009 and Q1 of 2009. The picture was mixed for Series B and later stage investments. The number of these deals was down from last quarter but up from a year ago. It seems to me that variability is too great from quarter to quarter, so the year on year comparison seems to me to be more telling of the general direction of the venture economy.

Fenwick had this to say about the results they found, “1Q10 results were similar to 4Q09, with up rounds exceeding down rounds in 1Q10 49% to 32%, with 19% of rounds flat.” They also noted that according to their findings, internet/digital media had the best results while cleantech had the worst results.

Cooley had this to say about the deals they were involved in, “Though we saw a slight decline in deal numbers, we saw a significant increase in invested dollars compared to the same quarter a year ago. Additionally, up rounds reached a level we have not seen since the middle of 2008.”

In a big picture way, all three of us observed a modest but steady upward trend in the tech economy. 

Terms

The upward trend also appeared in the terms that companies are getting from their venture investors. I have tried to consolidate the deal terms reported on by the three of us 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

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. 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

If the differences are striking when it comes to dividends, the similarities are striking when it comes to participation. Cooley’s numbers for Series A and Series C transactions seem to be higher than the norm, but this may well be due to peculiarities in the sample. This really begs the question why there is a seeming convergence around participation but not dividends. I don’t even have a good speculation around this one.

Redemption

With respect to redemption provisions, Foley Hoag is finding numbers that are twice as high as Fenwick (Cooley does not report on this term). This one, however, I think has an explanation. In New England the incidence of redemption provisions is trending downward rapidly. As I have said elsewhere, I suspect that this is in response to changes in accounting practices. The numbers probably reflect a more rapid response to these changes in Silicon Valley than New England, but I predict the will converge at a very low percentage over the next year or so.

Pay to Play

The incidence of pay to play provision is low across the board, but higher in New England than in Silicon Valley and higher than Cooley reports. My sense, entirely subjective, is that the difference is not particularly dramatic and probably reflects a slightly more conservative investment culture in New England than in Silicon Valley. I also predict that, as the venture industry works through the current very rough fund raising environment and more funds know where the stand with investment dollars, that the incidence of pay to play provisions will both decline to a lower number and converge across the country.

Antidilution

No surprises here. Weighted average antidilution is the universal standard. Full ratchet deals are rare everywhere, and, I believe, that they reflect unique circumstances.

Conclusion

While it is nice to be able to report an upward trend in our sector of the economy, it is not time for kumbaya yet. Let’s remember that it isn’t 2007 (which was a good, but not a great, year). We are staring at some chronic problems (trends like the retirement of the baby boomers and how is that going to be paid for and the staggering debt the U.S. and other countries have run up) and some acute problems (the debt crisis in Europe and the volatility of the stock markets). We are not going to dig our way out of this hole with a strong manufacturing comeback. We need a thriving entrepreneurial tech economy to lead the way. Fortunately, this sector looks like it may come back to life.

Yesterday we (Foley Hoag) released our review of Q1 venture activity and deals in New England. Here is the link to Foley Hoag Venture Perspectives. As usual, the numbers are fascinating. A big downward trend in redemption provisions. Why? Perhaps accounting reasons. A topic for another post. Also, a noticeable trend favoring entrepreneurs. Why? Perhaps just the result of an overall improvement in the economy? Series A investments seem stronger than Series B and later. Why? Perhaps because all Series A investments are optimistic whereas at least some later stage deals are not? I will write more on this subject in the next few days.

Hats off to the organizers and the volunteers that helped put together the MIT 100K contest this year. It was evident at the finale that all of you had a great time pulling it together. 

For anyone that thinks otherwise: check these out:

http://www.youtube.com/watch?v=gHgV6F6zvsE

and the remix…… http://www.youtube.com/user/jarrodphipps#p/a/u/0/_S8cZHrSMHA.

Paul Fireman, the man who took Reebok  from a small family run business that made a couple of thousand shoes a year to the worldwide megabrand that eventually sold to Adidas for close to $3.8 Billion dollars in 2005 was the keynote speaker. He had some great advice for start-ups and entrepreneurs that had me scrambling for a memo pad. This might not be exactly what he said, but you get the idea…

“A business plan is a ticket, it gets you in the game, but by no means does it guarantee success in the game”

“Communication is the key; putting all that fancy and cool technology to the side, you have to be able to explain the need that your product fulfills and the market that it is directed at”

“Communication inside is just as important outside, you and your team have to make sure that you are all headed in the same direction”

“You have to believe you are doing something special…in our case it was making the greatest running shoe…ever”

Kudos to all the participants and special congratulations to all the finalists. I was hoping that a certain team would win (you know who you are) but I think the quality of all the final presentations and business plans was superb.

For me though, the show stealer was the team from Couchange.org, these guys get up on stage to receive the Twitch award, and in their 5 minute acceptance speech: tell everyone about how great their product is; put up $500 of their own money to match the first $500 donated and; challenge Paul Fireman..or as they called him “Mr Billionaire” to give to their good cause…..the sheer audacity, you got to love it!! 

Apparently Paul loved them just as much and the company raised $20,000 last night….is that a great 5 minute pitch or what! 

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

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

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

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

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

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

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

Bijan Sabet has a post on the subject of east coast versus west coast term sheets. The post raises the issue of whether there are differences and why. The more interesting part is the comments. There is a lot of back and forth on east coast having tougher terms etc. There is a comment to the effect that east coasters are more likely to have redemption rights and founder reps and, perhaps, other terms. There is even comment to the effect that a lot of the differences stem from the lawyering style.

But I want to make a few points. First, while we all have some experience with both coasts, and some have more than others, no one has a comprehensive view of what is going on on both coasts. As a result, all the assertions are impressionistic. 

Second, a lot of the major VC firms have offices on both coasts and regularly do deals on both coasts. It is hard for me to imagine that they sit in their Monday meetings and say “well this is a west coast deal so no redemption but this one is an east coast deal we have to have redemption.” Just stating the proposition makes it sound ridiculous. There has to be convergence. Perhaps there are some identifiable differences (such as the founder reps thing or the redemption thing), but these are at the margins. If there were significant variations in valuations and terms, arbitrage would be closing the gap.

Finally, and this is what I really want to get to, the founder’s rep variation has really done the east coast a vast disservice. It is undeniably true that seven or eight years ago, when we first started working on the NVCA forms there was a significant difference in practice with regard to founder reps between east and west. For certain kinds of series A deals, east coast VCs insisted on getting founder reps. Whereas, this practice was anathema west coast VCs. 

I am not going to go into the merits of the two positions (BTW – I think the west coast VCs have largely beaten their east coast brethren into submission on the point). Rather I want to point out that the way the argument set up was that one coast (west) was entrepreneur friendly and one coast (east) was not. Despite the fact that, from my limited observation post, the differences between the coasts are very minor, this view of the east coast VC community as less friendly to entrepreneurs than the west coast VC community persists. It has become an unexamined bit of tech culture.

Again, while the practice of asking for founder reps has a sort of nasty edge to it (after all it tries to saddle the entrepreneur with personal liability for a variety of things), I think it rarely (perhaps never) has a practical consequence. I am unaware of even one instance in which a VC has sued to get made whole based upon a failure of a founder rep. Of course, I am not aware of everything. I have a hard time imagining a VC fund suing a founder other than in the context of serious fraud, in which case the VC would have claims outside the purchase agreement. If you agree with what I just said, it is hard to imagine why a VC would insist on founder reps.

This is the one issue that everyone consistently points to when noting the different attitudes towards entrepreneurs between the two coasts. So, I think that the negative view of east coast VCs is largely a self-inflicted wound.

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

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

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

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

Ignore and move on.

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

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

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

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

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

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

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

“Typical” weighted average:

CP₂ = CP₁ * (A+B) / (A+C)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I was talking to an entrepreneur client yesterday (this client is a rock-star and a visionary in his space), and I just talked to another client who is working hard to do his first start-up (in a different space from yesterday’s client).

The rock-star has name brand VC (that he does not actually know) making cold calls to him trying to get into his next venture. For the other guy, it’s an uphill battle. No surprises here. 

Here is the issue. In each case, I have met with the client and discussed what is “market” for terms in series A investments. Now, I actually know what market is in Boston/New England because our firm does the research on New England deals every quarter. We actually have a database with the terms, the valuations, the investors etc. And, to make the point again, we update every quarter. To my knowledge, no one else does that for New England. (Note that I stress New England because Fenwick does something similar on the West Coast.)  BTW, we also publish some of the data in EEC Perspectives.

I can assure you that I have been in plenty of conversations in which a VC, lawyer, banker or other person has baldly asserted that XXX is a current market term, and I know that that only a small minority of deals had XXX last quarter (last year, whenever). I had a VC assert in a negotiation that his fund only did deals with dividends. But I knew, based on our research that this particular fund did about half their deals with dividends and half without. We can tell you the actual range and distribution of dividend rates on deals that had dividends in the last quarter… and so on.

But who cares?

The rock-star can (and will) get any deal he wants. He just wants to know what are the best terms (i.e. no participation etc.). He doesn’t care, nor should he, whether they are prevalent market terms or not. He is going to ask for and get the best terms.

The other client is not going to have a lot of (any?) choices. He is going to take what he can get.

In either case the facts (i.e. what is going on in the market) don’t matter. 

Now, you could point out that there must be people in the middle, for whom such knowledge could be useful for negotiation. Unfortunately, one of the characteristics of the market we are in is that it is really tough to raise money if you are not a rock-star.

Despite all the talk in the legal world about forms, and there is a lot of it, and despite the great success of the NVCA Series A documents project originally inspired by Sarah Reed, it took Fred Wilson’s recent blog post to create some interesting back and forth commentary on seed forms.

Good forms are a wonderful thing. They can save tons of time and cost – each of which is in short supply for early stage entrepreneurs. Now, not every shoe fits every foot, and sometimes work is needed and is appropriate.

At the risk of stating the obvious, if you are raising $400,000 (let alone a smaller amount) and you spend $20K on your counsel and $20K on investor’s counsel, you’ve blown 10% of your money right there. (Remember, you are also giving away a pile of equity to get that money in the door.) This is really expensive capital. Creativity and clever negotiating have a price.

Having said all that, I think it was T.S. Eliot who said with respect to literary criticism that "The only method is to be very intelligent." At some level, the same applies to your legal dealings. Forms are great, but they must be used thoughtfully.

My last post reminded me to come back to a theme that I address from time to time – transaction costs for small transactions. While it is true that smaller deals are not necessarily less complex than larger deals (sometimes it seems like just the opposite), you just can’t paper a $1,000,000 deal (let alone a smaller one) the way you can a $10,000,000. $40,000 is 4% of $1,000,000 – it might be a material item that eats into the money you have to put to work in your business in significant way. (By the way, I picked $40,000 randomly because it is not far off the cost of a typical Series A investment from a VC (that is the cost of one side’s lawyer).) But, there are risks in doing a less than thorough and careful job of documenting a transaction. I am sure there are many horror stories out there. Having said that, all businesses have to manage risk one way or another to preserve the value of the transaction. At the risk of stating the obvious, the best thing you can do is use an attorney experienced in representing early stage companies and hope the other side does too. The other thing you can do is be sensible about your own deal strategy – pick your battles. If you feel the need to negotiate every sentence of a document, guess what – your transaction costs will reflect that.

When start-ups raise money, the question inevitably comes up whether the proposed investor is “accredited” or not. One question is simply who is and who is not accredited. Another question is why should you care. 

To begin with the second question: The way the SEC regulates sales of securities is to begin with the principle that all transactions in securities must be registered with the SEC, unless there is a specified exemption from registration. (For those of you not familiar with registration, one example of it is the process that companies go through in their initial public offering. It can be expensive, time consuming and a real hassle, although there are streamlined versions of the process.) In any event, the SEC has exemptions for all sorts of transactions in securities, including trades on exchanges and the like. One exemption that the SEC has is for private transactions: so-called private placements. There are many forms of private placement, but almost all investments in venture financed companies fit this exemption. Having said that, if you make offers to too many people, its public – not private. If you advertise (maybe mail to the Harvard Business School class of 1999) it is public – not private. Anyway, you get the idea. It is not always clear what is qualifies a public and what qualifies as private. As a result of the ambiguities that have arisen in this area, the SEC adopted Regulation D.   Regulation D is a so-called safe harbor. It has a set of objective requirements. If your transaction meets these requirements, then it qualifies as an exempt private placement. 

Among the requirements of Regulation D is that if you make offers to sell securities to persons who are not accredited, you must make disclosures essentially equivalent to those made by public companies in their SEC filings. These requirements are onerous. They include delivery of all sorts of information that may not be readily available to a start up. In any event it will be expensive and time consuming to pull together. Not a desirable, or easy to meet, requirement for an early stage company. If you restrict your offers to “accredited investors”, as defined in the rule, the disclosure requirements are much much lower. As practical matter, the only applicable disclosure requirement is that you not commit fraud. The reason for this is that the SEC deems accredited investors to be able to fend for themselves. So, offerings that are restricted to accredited investors are faster, easier and cheaper. 

So, what is an accredited investor? It is someone (or some entity) that meets one of the criteria described below. Actually, there are other categories of accredited investor, but I have just listed the ones that apply to natural persons (lawyer speak for people). Needless to say, complexity can creep into the definition, so you must get professional advice to make sure you are compliant. But, below is the gist of it.

Accredited investor means any person who comes within any of the following categories:

Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000;

Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii) and

Any entity in which all of the equity owners are accredited investors.

Sometimes you have to take your financing where you can find it and deal with the consequences later. If there were but world enough and time, you could negotiate the correct fair valuation for you business and the correct fair terms for you and the investors. But there never is (world enough and time) nor is this the best of all possible worlds. So, in the end you will have to settle, and, with luck, if you don’t get what you want at least you will get what you need. Along the lines of dealing with the real imperfect world, here are a few thoughts based on some client experiences.

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Below you'll find my article from the March '09 issue of EEC Perspectives, entitled The End of Gloom and Doom.

I like my gloom and doom as much as the next guy, but a whole year of unrelenting gloom and doom is overdoing it. Looking back on a year’s worth of numbers, it occurs to me that there is a lot to say that is not in the numbers.

Entrepreneurs are like weeds

If you just look at the national numbers you could come to the conclusion that there are fewer deals than last year, that the VCs are taking longer to invest and are investing at lower and lower valuations, and that all of this just acts as disincentive for entrepreneurs to start new ventures. But, anecdotal evidence is to the contrary. I polled some of my partners, and we all agree there is steady stream of new start-ups in all industries. They are not necessarily getting financing from VCs. In fact, the pattern that I see evolving is that entrepreneurs spend a bunch of time (many months) hiking up and down Winter Street to no avail. After that, they figure out other ways to keep moving forward by self-funding and going to family and friends or others with special affinity, and they make do with less. In a number of cases, they seem to me to be happier and more productive once they accept that there will be no VC money and they figure out something else. Entrepreneurs are like weeds; it will take more than a long dry spell to kill them off.

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A recent report released by the National Venture Capital Association and Thompson Reuters shows that the rate of venture fundraising continues to slow.

This statistic measures the amount of money raised by VC firms from their limited partner investors. The report states that 43 VC funds raised $3.4 billion in the Q4 2008. This is a steep decline from both Q3 2008, in which $8.4 billion was raised, as well as the fourth quarter of 2007, during which funds raised $11.7 billion.

For the full year in 2008, 211 VC funds raised a total of $28.0 billion, a 21.4% decrease in volume from 2007.

At first glance, this might not look too bad given the percentage losses and declines in valuation, in the economy generally and the tech sector. However, the drop in Q4 is so drastic that if it proves a sign of things to come, it could signal a real tightening of VC funds available to venture-backed companies and those seeking their first venture investment.

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I am pleased to announce that the next issue of EEC Perspectives is now available.   Each issue of EEC Perspectives presents quarterly data and analysis on the number and size of transactions in the New England region and, with respect to numbers of transactions, nationally, and provides analysis on certain key terms of the New England transactions. We have been publishing EEC Perspectives since last May, alternately focusing on early rounds and later rounds. (Prior issues of EEC Perspectives can be found in the News and Publications section of  the EEC website.)  The current issue is the second to focus on Series B and later rounds.   It includes a market perspective from entrepreneur and investor Vinit Nijhawan.  Among other things, Vinit has some helpful suggestions about steps you can take to help yourself prepare for a later stage round in today's circumstances.  The issue also contains commentary from Foley Hoag lawyers Amanda Vendig, Jerry O'Connor and me, including perspectives on the current investment environment.  You can find other comments about the impact of the current economic situation in my recent blog about the current venture capital outlook and other blogs below, such as Dave Broadwin's recent entry regarding terms in down times. 

There has been a lot of interest recently in the level of venture capital investment activity that can be expected over the near term in light of the recent meltdown in the credit and capital markets. Through the third quarter of 2008, investment activity seems to have held up pretty well, but what will the future bring? I’m no fortune-teller, but based on what I’ve been seeing and hearing, I can hazard a few educated guesses:

• There will be a slowdown in activity as investors wait for the economic picture to stabilize.
• Seed rounds and Series A rounds will continue to get done for promising companies, but at reduced valuations and with more onerous terms.
• Follow on rounds will become harder to do, and will more often be internally led.
• Down rounds will become more prevalent.
• Bridge financings will serve as the finger in the dike until denial progresses to acceptance.

One potentially positive note for emerging companies that may arise out of the current economic situation:  engineering and other technical talent may become easier to find and less costly to recruit.

According to the NVCA approximately $36 billion has been raised by venture funds in 2007 (see my blog titled Money on the Sidelines).  This is a really big number, and I am not sure what is included. 

Research into DowJones VentureSource indicates that (according to their methodology) the following is the money raised by VC funds in the last ten years. 

Any way you look at it a lot of money was raised in since 2003, and some of it is getting old.  Without having an accurate fix on how much has been invested, it is impossible to know what is on the sidelines.

Congratulations to our client Advanced Electron Beams, Inc. which recently completed a financing led by GE Energy Financial Services, a unit of GE (NYSE: GE).

Congratulations to our client Vanu, Inc., which recently announced the closing of a $32 million venture round led by Norwest Venture Partners.