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

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

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

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

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

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

Ask the VC “Are Advisory Boards Helpful?”

Ask the VC “Advisory Board Compensation”

Last week I had a conversation with an entrepreneur who was confused about option pricing, and no matter how many times I tried to explain it, he never seemed to get his head around it.  Now, there may be a psychological explanation for his inability to understand, because he clearly wanted to hear a particular answer, and it was not what I was telling him.  Nonetheless, option pricing is a topic that comes up all the time in the representation of early stage companies and, while I have written about it before, it is worth one more post.

What is 409A and why do you care?

409A is a section of the Internal Revenue Code that governs the tax treatment of certain options.  409A provides that an option either (1) be an option for common stock of the employer and have a per share exercise price on the date of the grant equal to or greater than the fair market value of a share of common or (2) if the option has an exercise price of less than the fair market value of a share of common stock the recipient and the issuing company suffer some pretty draconian tax consequences.  (There are other ways to comply, but relate to less usual situations, such as options that are only exercisable on a liquidity event, and I am not going into that level of detail here and now.)

What are the draconian tax consequences?

There are three particularly nasty tax consequences:  (1) The recipient of the option will have income equal to the difference between the fair market value of a share of common stock and the exercise price of the option multiplied by the number of options, at the time the option vests, even if the recipient does not exercise the option.  (2) The recipient will get to pay a surtax of 20% over and above his or her normal income tax on the option related income.  (3) For each year for which the option remains outstanding, the recipient will suffer the same nasty tax consequences with respect to any increase in the value of the common stock. 

Why on earth would the IRS create such a rule?

Consider what could happen if the issuing company were publicly traded and was issuing options with below marked exercise prices to its execs.  Need I say more?  Unfortunately, 409A applies to all companies – not solely public ones.

What can I do to avoid the bad tax consequence?

Issue your options with an exercise price equal to or greater than the fair market value of the underlying shares.

How do I know what the fair market value of a share of my privately held technology start-up is?

Here are some ways to price your options:

(1) You can take a guess at the fair market value.  If you guess wrong you are toast.  And, by the way, your guess will be judged with 20/20 hindsight by the IRS.  So, that does not seem like a good solution.

(2) If there is a recent actual arms-length transaction in which common stock was sold, then you have price.  Note that I said “actual,” “recent,” and “arms-length.”  The fact that your lawyer took a few shares a year ago in consideration of an old invoice won’t cut it. 

(3) If you have a financially sophisticated person on your board (or as your CFO), and your company has been in business fewer than 10 years, 409A provides that such person can perform a valuation. 

(4) You can pay an outside appraiser to perform a valuation.   Most (all?), of my clients who have professional money invested in them end up doing this.  It is a toll and it is unfortunate that you have this cost, but that is you tax dollars at work. 

Like my entrepreneur friend, you can want to price options at $.03 but if you sold common stock last week  in an arms-length transaction for $.30 per share, don’t do it.

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.

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.

I attended the MassTLC Mobile Summit at the Microsoft Nerd center this morning and was struck by how little discussion of the FTC’s recent proposals around privacy there was.  The issue is that FTC will regulate in this area.  As a matter of politics, there is no avoiding it.  The only issue is what will the regulations look like?

The tech community seems to think this is no big deal because industry will prevail.  By "prevail" tech folks seem to mean that the regs, whatever they are, will be so watered down that the regs will be meaningless.  Their position is that anything else is unthinkable because the really big boys, Facebook and Google –as well as many others, depend upon tracking and targeted advertising.  To put a damper on them would create massive disruption.  Also, traditional carriers have huge value in the data they have, so Verizon, ATT and etc. will not let it happen.

At some level you have to agree with these observations. 

But, the counterpoint to them is that the FTC has now come out with a proposal.  There is great political pressure on Congress to do something. There is wide bipartisan support in Congress for regulatory activity to protect personal privacy.  Finally, among the non-tech world (which is most of the population) is creeped out by the notion that they are tracked onthe web.

I am concerned that the tech world just does not recognize that the non-tech population really does not like tracking 9and other data gathering).  I think the tech world also underestimates the appeal of giving people a choice not to be tracked.  Strangely, Fred Wilson’s blog makes this clear.  He refers to the “silent majority” who are not troubled by the data collection practices of most web companies and the “vocal minority” that are.  My concern is that he may just be wrong. 

So, it is predictable that some compromise will be reached between the FTC and the large companies who are already alerted to the issues and are working on changes that will be OK for them.

One problem: large companies have different interest from early stage and smaller companies.  For example, large companies will have far greater resources to deal with and comply with all sorts of regulation.  If they are required to incorporate specific privacy based procedures into their product development and other activities, they have the financial and other resources to do this.  If they are required to make the gathered information available to consumers or place restrictions on “new” uses of such data they can carry the cost of doing these things.  In fact, big companies may support this type of regulation, in part, as a trade for leniency on tracking and, in part, because it will form a barrier to entry for little companies.

If this happens, regulation could go a long way to undermining the economics of some start-ups.  So, you can’t rely on Facebook, Google, Microsoft et. al. to carry the ball for early stage companies.

The FTC has a process by which interested parties can comment on and influence the outcome of proposed regulation.  The resulting regulation will reflect this input.  The problem that arises for small companies is that it (the process) is expensive and time consuming.  it takes time and money to write comments, track proceedings, contact congressmen etc.  Google, Facebook, Verizon, and ATT will be hiring armies of lobbyists to do this (they may already ahve the armies deployed) – but they will not be lobbying for changes that work for start-ups.  Smaller companies just will not be able to compete in the fight to influence regulation and may end up with a regulatory scheme that is not hostile to them.

Small companies and the people who invest in them need to find a way to participate in the process.  If they do not, they could be looking at a pretty bleak future.

Here are some semi-random thoughts on preferences after my recent post on this topic.  Also, an entrepreneur in town recently asked me whether, and how, he could protect himself from the inevitable dilution of future rounds.   Consider this: over the past ten years venture funds, as a group, have not provided any return to their limited partners.  Now, there are some funds that have done well, but the zero rate of return is true of the industry as a whole.  This situation exists despite the preferences and participations that are standard features of so many venture investments.  OK, what do you think the return to entrepreneurs was on their efforts during this period?

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.

If your start-up's website will collect user information.... and chances are it will, you need to start thinking about your website privacy policy.  I have often spoken with founders who think that the website privacy policy is a "one size fits all, grab an example from a well know e-retailer or established company web-site that appears to have a similar business model, snip here, paste there and you're all set" deal.  My wide eyed stare of horror in reaction to this is mostly dismissed as symptomatic of the overly cautious view of life that seemingly plagues my profession.  I have discussed this with a colleague Patrick Connolly and he had the great idea to write a primer on the issue of Privacy Policies for websites.  Now let me warn you, Patrick's primer is not short and it isn't meant to be because it highlights the issues that we step through and the risks and possible reprisals that we consider when we draft a privacy policy for a particular start-up.  So without further ado, here's Patrick's well thought out "Primer on the Website Privacy Policies", hopefully once your done reading you'll agree that your privacy policy is not something to be taken lightly...

Picture this: you’re an entrepreneur about to make your first foray into e-commerce.  This is exciting, but you can’t help but feel a little concerned.  Every day, you read a new story about advocacy groups and even Congress scolding businesses for being careless in their treatment of the personal data they collect, or criticizing the shadowy ways in which they collect it.  Publishers of major websites are rethinking procedures as they discover tracking technologies residing on their sites that they weren’t even aware of.  The dollar amount of settlements in the wake of high profile data breaches would be enough to cripple your budding enterprise.  I’d be worried if you weren’t concerned about the increasingly high profile area of consumer privacy protection.  Thinking carefully now and coming up with a website privacy policy in accordance with some simple guidelines can give you peace of mind and will allow you to focus on running and growing your business and making the most of your new website.

As you’re starting out, you probably have only a handful of site visitors.  You may even know many of them personally and you know they are rooting for you to succeed.  Because you would never want to do anything to breach the trust of your precious new customers, your task may seem simple: promise them absolute protection of their privacy.  Promise to keep everything they share with you in a Seinfeldian vault, and promise that the combination to the vault is theirs alone.  To achieve this, you may immediately set about cutting and pasting the most stringent provisions you can find from privacy policies of your favorite well-known websites.  Danger! Resist the urge to do this.  This approach is problematic (first off, consider the copyright implications).  Instead, engage in some thoughtful planning and keep a few concepts in mind as you conceive your privacy policy....

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

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

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

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

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

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

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

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

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

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

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.

In case you did not realize that the Broadband Plan had anything to do with energy management in homes and buildings, here are a couple of quotes from the Plan:

One of the most important and cost-effective ways to meet national energy goals is to encourage energy efficiency in homes and businesses—but end-users need better information in order to maximize energy and cost savings.

And

A national Smart Grid policy should encourage tens of thousands of entrepreneurs to innovate—using new technologies and business models—to create a wide variety of in-building energy management and information services. Making energy data available to customers and their authorized third parties, while employing open and non-proprietary standards, is the best way to unleash this vast potential for innovation.⁵⁷ The history of the Internet illustrates how entrepreneurs can develop disruptive applications, attract investment capital and compete to deliver value to customers—thereby driving innovation, economic growth and job creation.

Here are the kinds of things the regulatory push under the Plan intends to foster.

Here is the text that goes with the images:

It is a blistering hot summer day. You have just arrived at work and realize that you forgot to turn off your home air conditioning, which is blowing full blast. In the past there was nothing you could do until you returned home. But today there are new mobile applications (“apps”) that allow you to take action anytime, anywhere.

There are already dozens of apps on smartphones, computers and other devices dedicated to home energy measurement and management. Companies such as Visible Energy, Control4 and many others offer apps that let you monitor your energy consumption and control your lights, security system, entertainment system and thermostat from the comfort of your living room couch or a remote location.

These applications are not just for early adopters with high-end home automation systems. Socially minded or cost-conscious consumers who want to better track their energy use can use online sites like Microsoft’s Hohm and Google’s PowerMeter.

The Plan makes a number of recommendations for regulatory action related to consumer applications. My favorite is 12.7 which reads as follows:

States should require electric utilities to provide consumers access to, and control of, their own digital energy information, including real-time information from smart meters and historical consumption, price and bill data over the Internet. If states fail to develop reasonable policies over the next 18 months, Congress should consider national legislation to cover consumer privacy and the accessibility of energy data.

My point with this and some of my other Broadband posts is that the Feds are just getting cranked up to promulgate all sorts of rules and regulations across all sorts of industries – in point of fact, anything that uses or could use a broadband connection will be impacted. 

In the smart-grid space the Feds are leaning towards open standards, using the internet as a model and hoping to spark innovation and creativity. I agree that open standards are the way to go, but the battle remains to be fought. I suspect that there will be other interests. If you are making a bet with your start-up, you should be watching this unford. Whichever direction the Feds go in will affect you as well as a vast and increasingly important industry. 

Here is the deal: I love football (and when I say that I mean soccer). I grew up playing it and watching it incessantly (even had a short stint playing D1 soccer in college). Although other members of my family might lament that my passion for the beautiful game has waned and that I am not much of a fan any more, every four years I find myself anxiously following the games, watching highlights as soon as I get home and running out of meetings to track the latest scores when my favorite team is playing (thank you modern technology). 

So it was a delightful surprise to read this latest blog post by Bettina Hein, Founder and CEO of Pixability on VentureFizz drawing parallels between the German world cup team (a big fan!) and start-ups and the lessons the latter can learn from the former. Highly recommended reading.

To paraphrase Ms. Heins analysis, the German Soccer team has the following attributes that start-ups should emulate:

1) Playing the Game as a Team Sport.

2) Staying focused on winning (putting substance before style).

3) Recruiting from a diverese talented pool and having a team that reflects that.

4) Having depth in your team.

I realize that alas the Germans have exited by the time this post goes up, but the article still makes excellent reading and Frau Heins' analysis still holds true. 

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

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

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

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

Copyright: Micahel Valdez, iStock Photo

- Posted using BlogPress from my IPad. 

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

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

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

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

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

On the topic of friends and family financing and how best to structure those agreements, I know we have written about this before, but I think that a topic this nuanced warrants revisiting.

Ok, so you're entrepreneur Joe, and your dad, mom or that rich aunt, who has always spoiled you silly and thought you were God’s gift to this earth, wants to help you and your start-up, so they give you some money to help you get that start.

Pause…so you got some money from a relative/friend who wants to see you succeed. First question: did they give you the money or was it money for the company? If they wrote you a check (lucky you!) this blog will not apply to you. However, if there was an implicit or explicit understanding that they wanted to lend the company some money, then read on....

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I hate losing clients, or potential clients, because of conflicts, or perceived conflicts. Unfortunately, this happens more often than I would like (which is never), and more often than I think is really necessary. 

There are many different types of conflicts. Some are harder to get over than others. As a general proposition, lawyers cannot represent one client in a matter that is adverse to another client. Litigation is a good example of this. For example, as a general proposition, a lawyer can’t sue a client on behalf of another client. 

Another example is that a lawyer cannot represent client 1, if her knowledge of something confidential about client 2 would materially impair her ability to represent client 1. One example of this arises in the patent context. If a lawyer is asked to prosecute a patent for client 1, say a medical device for spine surgery, and she has knowledge of research being done by client 2 that impinges upon the patent application because she has been helping client 2 with its patents in the area, there may be no way that she can represent client 1 in this patent.

The things I have been describing are true ethical conflicts, the kinds of things bar association rules generally prohibit without some sort of knowing waiver.

But, there are other conflicts, business conflicts, which arise more often and cause more problems. 

Here are two that arise all the time in the course of my practice: First, representing investors and companies. By this I mean generally, not both in the same transaction. Second, representing companies that are actual or potential competitors. 

By the way, if our firm represents someone, for legal and ethical purposes, it is the same as if I represented that person, even if another attorney in the firm was doing the work and I knew nothing about it.

So, back to the first conflict. I can’t tell you how often I find myself talking to a prospective client and the question comes up, “Do you represent venture capitalists?” The answer, of course, is “yes.” Then sometimes, the conversation goes this way, “isn’t that a conflict, if I want you to represent me in a financing?” 

Well, no, unless I am proposing to represent both sides in the same transaction. What about if, from time to time, I (or my firm) represent a particular VC fund and that is the fund that is proposing to invest in my client? Now we are getting closer to a conflict and the bar association may require (or may not) a waiver from both clients.

But all that is in the realm of technical conflicts. The real conflict is that the potential client is thinking, how good is the advice going to be if he has a relationship with the investor is he really in my corner? This is the rub of it. If the client can’t get comfortable with the relationship, then it is a problem and I am not going to get the engagement.

BTW, some clients like the idea that their lawyers represent their financing sources from time to time. They view it as a relationship enhancement. Something along the lines of they have connections and can help me get financing. And, to some extent, this is true.

In the end, you have to go with your gut on this one.

With respect to the second conflict, it is just not unusual for a large firm (or even a medium sized firm) to have multiple clients in the same space. This can lead to conflicts, as in the patent example above. Again, if you want a lawyer with knowledge of your industry, you may have to accept that he or she my have clients that are, or could become, your competitors.

I suppose there are some cases where the business conflict, or potential business conflict, is of such a nature that the firm really should not be representing both parties. The patent example above is the obvious case, but I am sure there are others.

Having said that, most business conflicts are not that direct. Is representing a company that does BI and one that does data storage a conflict? It could be, but how direct is the conflict. Should the founders of either company care? Need to know the particulars. 

There can be significant benefits to having a lawyer who knows your industry. It is a little bit like asking if you would take an investment from a VC who has other investments in related spaces. You can easily imagine the benefits: they know the industry, have good contacts that can be reached on your behalf, they are most likely to be interested in your company, etc. 

Analogous issues arise with lawyers, but in cases where there is not a direct irreconcilable conflict, you have to go with your gut. 

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

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

Founder Agreements: Vesting, vesting and more vesting.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 I 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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I 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.

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

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This should be of particular concern to directors appointed by holders of preferred stock. 

At the recent NVCA document group meeting there was a lot of discussion around a recent Delaware case (Trados) that pushes the law of fiduciary duty owed by directors generally in the direction of common stockholders. Jeffrey Wolters of the well known Delaware firm Morris, Nichols, Arsht & Tunnell LLP, recently sent around an email to the group noting another recent Delaware decision (QuadraMed) that is consistent with the Trados case. 

This is not going to be a lawyer's discussion of the case and the fact and the holding. We may prepare a client alert separately (and I am happy to discuss it with anyone who wants to).

The larger point is that the way Delaware law is trending is that the directors owe their fiduciary duties to the holders of common stock and the holders of preferred stock will have whatever rights they bargained for and that is that.

While those of you who “represent” the holders of preferred stock may not like this result, it does lend conceptual clarity to fiduciary the obligations of directors. Companies enter into contracts (and preferred stock is a contract albeit one among three parties the company that issues the stock, the purchaser/holder of the preferred stock and the State of Delaware whose corporation laws define certain rights limits etc of the preferred stock), and companies have a legal obligation to meet their contractual obligations. 

If companies fail to meet their obligations, bad things happen: They get sued for breach. But companies are not obligated to do more than is required under a contract. You fulfill the contract and that is the end of the obligation.

Once the company has fulfilled its contractual obligations, the board owes a duty to the common stock to run the company with the interest of the common stock in mind.

While this seeming conceptual clarification leaves a lot of questions to be decided and worked out, at least it starts to get us away from a world in which directors could, potentially, have conflicting duties to holders of preferred and common.

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.

I can’t recall being asked about whether and how to maintain confidentiality of business plans and other information when interviewing possible attorneys whom one might want to retain until very recently, but I have been able to tell from my interactions with potential clients that may of them worry about what is OK to tell the attorney they are interviewing (and might or might not hire). 

Attorneys, as a general matter, have a professional responsibility to keep such information confidential, and reputable attorneys will abide by these rules. Having said that, not all attorneys always meet this standard, so don't take a risk that you don't need to. 

I don't think you need to get very deep into details of your business plan at an initial meeting with an attorney, and, in general, I would advise you not to. Also, don't leave a copy of the plan or your slide deck or other materials that contain sensitive information with any attorney, until you have selected one to work with and he or she has agreed to represent you. 

A general high level description of your business should suffice for the initial meeting. Once you have entered into a formal attorney/client relationship, the matter is different. Once you are in a formal relationship, you should be able to rely on your attorney's duty to keep client information confidential. Attorney's typically do not sign NDAs, and I would not ask for one.

My last post concerning structuring to meet the needs of your financing sources, has led me to think about how to handle contracts. Businesspeople are often willing to go “skinny”. That is to say they are willing to live with contracts that are not comprehensive or rigorous. They often rely on relationships and accepted business practices (or simply trust). In many ways, this is what makes the world go around. The mere creation of a thorough carefully drawn contract that covers every (almost every) contingency and the negotiation that implies may itself be an impediment to doing business. 

A lot of the time the sales guy writes up the contract, the CFO signs off on it and the world rumbles on. If the relationship works and no third party ever has to look at it – you are fine. But, what happens when a third party gets involved. I am thinking particularly about what happens when you go to sell the business and the buyer is a Fortune 50 company (or even a Fortune 2000 company) that does not have a strong “personal” relationship with your counterparty? Or, what happens if you go to a financing source such as a name brand VC?

Family businesses (and my family used to have one, so I know) can operate at a level of informality that venture financed businesses just can’t ever get to. When IBM (or any other large buyer of companies) acquires your business, they want (need) to know that they will be inheriting the vendor and customer relationships. Assuring IBM that you and your customer have an understanding and are very simpatico just wont cut it. 

VCs get this, and they expect their portfolio companies to be set up for an exit. That means that informal arrangements (perhaps except for immaterial matters) are just not acceptable because they diminish the marketability of the portfolio company. If you are planning to get VC funding, you should assume that the VC will review your contracts (at the very least all the important ones) and a company with a squishy key contract may not be financeable (at least without an amendment to the contract).

Consider having to go from the easy squishy contract to the level of definition and tightness that IBM (or any other similar buyer) or a VC proposing a financing will want, under the pressure of a pending exit or pending financing. Your bargaining power just went out the window and your good will with the customer or vendor just went down the tubes. The moral to the story is that an ounce (or a several ounces actually) of prevention is better than an pound of cure.

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

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There is an endless amount of advice on the subject of board composition out there, but the reality for venture financed companies and pre-venture companies is very different. The archetypal situation for venture financed companies is for each VC to have a seat on the board, the CEO to have a seat and perhaps one outside industry person. As successive rounds pile up, more VCs are added to the board. You can like it or not like it. You can think it is good or bad to have one or four VCs on your board. You can argue that you get the same input from all of them – so why hear it four times? But, in the end, they typically have big buck on the line; they own big portions of the business; and they have a right to be represented.

Having said that, with respect to companies that have not yet gotten venture financing, who you have on the board becomes more interesting, in part because you may have more flexibility. Sometimes if there is a large angel investor, this person goes on the board. Sometimes if there has been a financing raised from several accredited investors, the lead, or largest, investor goes on the board. But these are situations in which a majority of the Company is still owned by the founders. The founders can, and should, expect to be a majority of the board.

Also, in this circumstance, you may have more room to bring in outsiders than in the archetypal VC situation. In this case you can do more than just pay lip service to the idea that a board member should bring some expertise, contacts or other value to the board. It is great when you can find such a person. However, experience shows that big time industry luminaries are busy people. Even if you can get one on your board, you are not likely to get much bandwidth from him or her. Their big value add will be their name on the team slide in your deck. Frankly, I think this is a very overvalued contribution.

The best board members I have observed on early stage company boards have been successful industry players who do not fit the description of industry luminary. These folks typically do the job because they are older and more experienced than the entrepreneur and they like to mentor or because they get the vision and are believers in the business thesis or they have some other reason why they are willing to focus and give the entrepreneur time and energy. The ones who will really contribute are the ones you want. Choose wisely because you don’t have a lot of slots and you need to make progress.

Let’s start with an assumption: You are forming a company with the intention of obtaining venture financing within a year. (I will hold aside the probability of such a thing actually occurring.) If you followed my posts on Delaware franchise tax and par value you know that the number of shares you pick can affect your franchise tax – but it is not likely to have much of an effect if you use the so-called alternative calculation. Let’s also be clear with one definition. "Authorized shares" are all the shares a company may issue – not just the ones that are issued and not just the ones that are not issued. "Authorized shares" are all the shares.

One approach to the issue of how many shares could be to pick a number that kinda – sorta – looks like what you might have in the case of a venture financing. That might be something like ten million. When you have a large number of authorized shares, you can have a large number of issued shares and a large number of options.

Another approach might be to pick a small number to minimize franchise tax (under the basic calculation) and deal with changing later when you get financing. BTW, making a change in the authorized shares early in the life of a company is very straight forward. A stock split authorized by the holders of a majority of the shares is all that is needed.

Different strokes for different folks, but despite the fact that what is important is the percentage and not the number of shares, it sounds chintzy to give a new employee an option to buy one share – compared to, say, an option to buy 100,000 shares. Perception has a value. For this reason, despite the fact that it has no substantive effect on anything, most of my clients pick big numbers for authorized shares.

That annual statement from Delaware is always a heart stopping experience. Clients often get statements indicating a franchise tax bill in the many tens of thousands. This is because when Delaware sends out their invoice, they calculate the amount owed based upon the number of shares authorized. But, there is an alternative calculation based upon gross asset value, that is very likely to lead to a much lower number. Below is what the Delaware Secretary of State has to say about calculating franchise tax.

HOW TO CALCULATE FRANCHISE TAXES

A domestic stock for profit corporation incorporated in the State of Delaware is required to pay annual franchise tax.  The minimum tax is $75.00 with a maximum tax of $180,000.00.  Corporations owing $5,000.00 or more make estimated payments with 40% due June 1st, 20% due by September 1st, 20% due by December 1st, and the remainder due March 1st.

The Annual Franchise Tax assessment is based on the authorized shares. Use the method that results in the lesser tax. The total tax will never be less than $75.00 or more than $180,000.00.

Authorized Shares Method

For corporations having no par value stock the authorized shares method will always result in the lesser tax.

·         5,000 shares or less (minimum tax) $75.00

·         5,001 - 10,000 shares - $150.00

·         each additional 10,000 shares or portion thereof add $75.00

·         maximum annual tax is $180,000.00

For Example

A corporation with 10,005 shares  authorized pays $225.00 ($150.00 plus $75.00)
A corporation with 100,000 shares authorized pays $825.00 ($150.00 plus $675.00[$75.00 x 9])

Assumed Par Value Capital Method

To use this method, you must give figures for all issued shares (including treasury shares) and total gross assets in the spaces provided in your Annual Franchise Tax Report.  Total Gross Assets shall be those "total assets" reported on the U.S. Form 1120, Schedule L (Federal Return) relative to the company's fiscal year ending the calendar year of the report.  The tax rate under this method is $350.00 per million or portion of a million.  If the assumed par value capital is less than $1,000,000, the tax is calculated by dividing the assumed par value capital by $1,000,000 then multiplying that result by $350.00.  

The example cited below is for a corporation having 1,000,000 shares of stock with a par value of $1.00 and 250,000 shares of stock with a par value of $5.00 , gross assets of $1,000,000.00 and issued shares totaling 485,000.

1.      Divide your total gross assets by your total issued shares carrying to 6 decimal places.  The result is your "assumed par".

Example: $1,000,000 assets, 485,000 issued shares = $2.061856 assumed par.

2.      Multiply the assumed par by the number of authorized shares having a par value of less than the assumed par.

Example: $2.061856 assumed par s 1,000,000 shares = $2,061,856.

3.      Multiply the number of authorized shares with a par value greater than the assumed par by their respective par value.

Example: 250,000 shares s $5.00 par value = $1,250,000

 

4.      Add the results of #2 and #3 above.  The result is your assumed par value capital.

Example:  $2,061,856 plus $1,250,000 = $3,311 956 assumed par value capital.

5.      Figure your tax by dividing the assumed par value capital, rounded up to the next million if it is over $1,000,000, by 1,000,000 and then multiply by $350.00.

Example: 4 x $350.00 = $1,400.00

NOTE: If an amendment changing your stock or par value was filed with the Division of Corporations during the year, issued shares and total gross assets within 30 days of the amendment must be given for each portion of the year during which each distinct authorized amount of capital stock or par value was in effect.  The tax is then prorated for each portion of the year dividing the number of days the stock/par value was in effect by 365 days (366 leap year), then multiplying this result by the tax calculated for that portion of the year.  The total tax for the year is the sum of all the prorated taxes for each portion of the year.

There are certain questions that I get over and over again. One of them is “Why shouldn’t I just use one of the many internet services to incorporate? It’s cheap; it’s easy…” Well, it turns out that there is a reason. First, let me note that you can get a perfectly effective incorporation over the internet. If you use one of the many services, you will actually have a company and you can get the benefits of incorporation. For many purposes it will serve just fine. Having said that, in each case where I have had occasion to review one of these incorporations, there has been an issue of one form or another. One example of an issue that seems to arise with some frequency is that the certificate of incorporation does not contain certain optional provisions (indemnification and exculpation of officers and directors) that under some circumstances can have real value. (For the sake of clarity (a phrase after which you know something completely opaque is about to be written), under Delaware law you can include in your certificate of incorporation provisions permitting the indemnification of officers and directors and limiting their liability to the company – under some circumstances. Sophisticated investor will insist on the inclusion of these provisions.) Another issue that sometimes arises is around the creation of preferred stock. Sometimes I see a class of preferred stock but no terms and no provision allowing the board of directors to set the terms. Never having used one of these services, I can’t tell if these problems arise because of the limitations of the service or because the users don’t really know what to do. Are these issues fatal? Probably not. Also when you finally do go to sophisticated counsel or get a sophisticated investor, they will note these issues and they will be changed/fixed. But, on the one hand, I think (and I am curious what anyone out there thinks) the real problem is that having these kinds of glaring issues in so basic a document makes you look amateurish. On the other hand, sophisticated investors are going to be able to evaluate your level of sophistication whether or not you incorporate on line. The result is that you pay the online people and then later you pay someone to fix the issues. (All in it will be more expensive, but you can put off some of the cost to a later date.)

We had a great kickoff to the new "season" of programs at the EEC on Tuesday night, when we hosted the IEEE Boston Entrepreneurs' Network (ENET) September meeting "Launching Your Successful Company."  There are many more upcoming events of interest to entrepreneurs at the EEC in September, so check out our events calendar.

The slides from the presenters will be posted to the ENET website shortly, so I won't try to summarize them in full, but some interesting take aways from the three presenters:

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

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

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This is a theme to which I keep returning – email (and other electronic records) is forever. At this point everyone has a horror story about the email that got sent to the wrong person or that had some embarrassing statement. The observation that email seems to inspire people with a freedom to say – whatever, has been made so many times that it can’t possibly bear repeating, can it? Well, despite the well know phenomena of misdirected email, embarrassing statements and etc., all these email faux pas seem to continue unabated.

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I have already tried to attack the delicate subject of the use of legal forms once. Certainly one of the more abused "forms" is the nondisclosure agreement or NDA. Clients often like to get a "standard" NDA which they then apply in all sorts of circumstances. Some clients are very savvy about NDAs and really know the issues and how to edit and negotiate them. Some clients have themselves developed a set of very sophisticated NDA forms covering the universe of business circumstances with which they deal. For may reasons, it is really nice to have clients who can and do deal with their own NDAs. For one, the need for an NDAs tends to come up fast and clients sometimes do not want to slow down a deal to negotiate one. This is especially true if getting their lawyer involved will mean the other party gets their lawyer and soon cycle times start going up. But, if you are not one of those clients that knows, you can make missteps. Here is an example:

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One of o the issues that has plagued directors of all sorts of companies is the potential for personal liability. Over the last several decades, Delaware has enacted provisions in its corporate law that can limit the liability of directors and permit a corporation to provide indemnification to directors. One thing that has always been a “hole” in these protections has been that they depend upon having and keeping in place certain bylaw and charter provisions. To put a fine point in it, Delaware corporations have been able to change existing bylaw and charter protections to deny them to directors, who thought they were protected. Delaware has made an important change (effective August of this year) to improve the protection of directors. See our firm’s client alert on this topic which says in relevant part: “The statute now explicitly prohibits the elimination or impairment of any indemnification and advancement rights provided in the corporation’s charter and by-laws once the act or omission in question has occurred. Indemnification and advancement rights could only be eliminated or impaired retroactively where the by-law or charter provision, existing at the time of the act or omission in question, expressly authorized such elimination or impairment.”

I spend this past Saturday judging the 13^th annual HBS business plan competition. I am not sure that I have judged every one of them, but it is pretty close. I always enjoy it. In part it is that I run into people I know but don’t often see. In part it is the plans. The competition seems to be an inexhaustible source of energy, creativity, ambition and insight into human behavior. Perhaps not surprisingly, this year the competition attracted a lot more entrants than in prior years. In addition, the plans I saw seemed both surprisingly doable and, in many cases, they were in fact well into the execution stage. More than that, however, this year’s plans reminded me of some of the things that make a good business, not necessarily a venture fundable technology business, but a good business: simplicity and an understanding of human behavior.

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When confronted with an optimistic point of view on the economy, one entrepreneur had this to say:

One of the other silver linings is the insane amount of work that an entrepreneur can get done with very little money today. I have 6 unpaid interns …One is a PhD student …. and four are computer science majors that could have gotten great paying summer jobs 2 years ago. I also have a CFO that put together professional financial documents for us on deferred cash, and over $XXX,XXX in programming being done on deferred cash. None of that would have happened two years ago.

Entrepreneurs are finding a way to get their businesses off the ground without angels or VCs.

To a large extent, but not exclusively, whether to be a “C” corporation or an “S” corporation or a limited liability company (and “LLC”) is a tax issue. LLCs and “S” corporations are so-called pass-through entities. That is to say that the entity itself is not taxable; its tax attributes (profits and losses) are passed through to the owners of the entity, and they pay tax in accordance with their particular tax situation (often at the highest marginal rate for individuals – assuming they are well-to-do). (Most LLCs and “S” corporations distribute cash to enable their owners to pay these owner-level taxes.)   Distributions or dividends that an LLC or “S” corporation pays to its owners are then free of a second level of tax.  Profits of a “C” corporation, on the other hand, are subject to double tax: first, the entity itself is taxed, and the shareholders are taxed on any dividends paid to them.

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I have been out of the country and not watching the blog scene as carefully as I should, but as I sit here in Beijing waiting for my delayed flight, a friend has brought two postings to my attention, and they are both good posts.

Data on the startup/venture industry:

Techcrunch has posted its exec summary (or a portion thereof) for its first year in review.  In an industry where good data (let alone information) is hard to come by, this promises to be a welcome new source.  Congratulations. 

With respect to antidilution:

Fred Wilson has a post on "Founder Dilution -- How Much is Normal."  It is followed by something like 62+ comments almost all of which are worth the read if dilution concerns you.  There are also a number of links that may also be of interest. 

In the context of venture financed technology companies, a one year post employment noncompete is standard stuff, at least here in Massachusetts. California, famously, passed a statute making employment related noncompete agreements illegal in that state. That statute has led to a few sticky issues for companies that start out in other states, such as Massachusetts, and then open operations in California. For example, what do you do when you have a long standing Massachusetts employee and you relo him or her to California? Or, what about requiring some employees to sign noncompetes and not others? By the way, California permits nonsolicitation agreements, nonhire agreements, confidentiality agreements and the like. So, how significant is it really that you can’t have a traditional noncompete? Acutally, I am heading down the wrong path California noncompetes, blue sky laws and etc. are going to be the topic for another day.

I recently met with the first employee of a start up client (located here in Massachusetts) who told me, quite sincerely, that he was unwilling to sign a noncompete because he objected to them on philosophical grounds. While I can imagine a lively debate on this subject, it would be completely impractical. Professional investors will require all employees (especially key technical people) to sign them or they wont invest. Savvy founders know this and, whatever their private thoughts may be, will insist that their employees sign standard forms of noncompete (ditto invention agreements and confidentiality agreements). If you are of the philosophical persuasion that noncompetes are a bad idea, that is fine; don’t let it get in the way of your signing one.

Even though it is not much money, incorporation costs money. So, when should you incorporate? It does not need to be the first thing you do. But, you should certainly incorporate before you enter into any contractual agreements with third parties or, if there is more than one of you, when you start building up some value in terms of intellectual property or other assets.

When you enter into a contract with another person or company, you are likely to want that contract to be between your company and the other person. If this is not the case, it is likely that you will have personal liability under the contract. Personal liability is almost always a bad idea. Before you sign a lease, a license, or incur obligations to consultants, accountants, attorneys or enter into any other agreement, incorporate and have the company sign the contract or incur the obligation. When you start to build up assets, such as IP, you may want to make sure the assets are owned by the company. This is particularly true if there is more than one founder. For example, if Harry writes a lot of code, the company can’t own the code until (a) it exists and (b) Harry transfers the IP to the company. It may not matter much if Harry is the sole entrepreneur, but if he has a co-founder, that person is likely to be toiling away with the assumption that both she and Harry are contributing value to the enterprise. In that case, it is time to create a company, move the IP into the company and have everyone work on behalf of the company. 

Look at it this way:  when you have something of value and you are ready to deal with third parites such as co-founders, investors, customers, suppliers etc. then you need to have your corporation.  By the way,  you may not want a corporation -- you may want a limited liability company, a limited partnership or some more obscure form of entity.  How to incorporate will be the subject of another post.

What on earth is “traction”? One entrepreneur and client, told me the other day, that she has done a lot of pitches (and she has). Her company is addressing a large niche in a hot space (mobile advertising). It seems like everyone has some level of interest, but they all tell her to come back when she has “traction.” When asked what would be evidence of traction, one wag is reported to have said, “I’ll know it when I see it.”

The elusive traction is particularly important to web based businesses, but is not limited to some measure of unique visits or eyeballs. Non-web businesses are being confronted with requests for evidence of “market traction.” If you have 1000 hits per day, traction is more than that; if you have a $10 million annual run rate, traction is more than that. Webster’s defines traction as:

(1) the act of drawing : the state of being drawn ; also : the force exerted in drawing (2): the drawing of a vehicle by motive power ; also : the motive power employed (3) (a): the adhesive friction of a body on a surface on which it moves “the traction of a wheel on a rail” (b): a pulling force exerted on a skeletal structure (as in a fracture) by means of a special device “a traction splint” ; also : a state of tension created by such a pulling force “a leg in traction”

Judging from this definition, traction is being used as an analogy suggesting the need for sufficient friction to prevent wheels from skidding while pulling a heavy load. However, the practical reality is that I have never heard an entrepreneur report being told that they had “traction” – whatever its meaning. 

You may be familiar with Xeno’s paradox. The gist of it is that if you always get half way to your goal, you never actually reach your goal. You may also be familiar with the myth of Sisyphus. The gist of it is that Sisyphus is condemned to pushing a rock up a hill and, just as he gets near the top, the rock rolls down and he has to begin again. 

So, I think “traction” means credible evidence that you can get to the end -- to an exit with a reasonable return within a reasonable time frame (for the relevant investor) (or that you can get the rock to stay at the top of the hill). In other words, when an investor says the “T” word, it sounds like they are trying to eliminate execution risk. 

Since execution is often the last hurdle before an exit, if you hear the “T” word, you are probably talking to an investor who wants a sure bet not someone who is going to take a risk on your business.

Clean energy technology entrepreneurs might seem to have reason to be more optimistic these days than their counterparts in other fields such as software and technology. After all, most VCs and industry observers maintain that quality clean energy startups remain good candidates for funding even in this challenging environment. However, promising clean energy startups can get caught in the dreaded funding gap between proof of concept in a lab setting and the establishment of commercial viability that might attract venture capital.

This is where state support can be crucial. In Massachusetts, the SEED funding program administered by the Massachusetts Technology Collaborative’s Renewable Energy Trust has brought almost $5,000,000 to early-stage clean companies, mostly in the form of convertible debt, in deals up to $500,000 matched by other debt or equity investment.

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Bad times may well cause this beast to come out of its cave. Full ratchet antidilution is a provision that protects investors to the max from low priced issuances. The gist of this provision is that the conversion price of a security (usually preferred stock, but not necessarily) will be reduced to the lowest price at which a company sells any shares of its common stock. So, if you have 1,000,000 shares of preferred outstanding with a conversion rate of $1.00, these shares will convert into 1,000,000 shares of common stock. However, if these shares have a full ratchet antidiluton provision and you issue one share of common stock for $.10, then the conversion rate will drop to $.10, and the preferred stock will convert into 10,000,000 shares. You can imagine the dilutive effect on other stockholders. 

For the reason outlined above, full ratchet is rarely used. However, it does have its place when there is a disagreement about valuation. If you can’t bridge the valuation gap, you might end up saying something like “OK, if I have to raise money next year at a lower valuation than you are getting, I will adjust you to that valuation.” In a world where money is very hard to come by and investors are very nervous about valuation, I predict we will start seeing more of these provisions.

Having said that, if you are constrained to agree to full ratchet, you need to consider negotiating some parameters around it. By way of example, try to exclude options issued under the option plan, try to exclude small issuances of warrants to equipment lessors, try to limit the time period in which the full ratchet operates to some period (perhaps one year). Consider other issuances that you might make and try to negotiate exceptions for them. Also, consider a range inside of which you don’t have to make the adjustment. For example, consider trying to negotiate a provision the gist of which is that the full ratchet will only operate if you raise more than $X at a valuation that is less than 90% of the preferred.

Full ratchets have another negative effect, they cause the next investor to want one too. Consider negotiating a termination upon closing of the next round.

I predict that the next year will see an increase in full ratchet provisions.

I spend a lot of time with entrepreneurs explaining how restricted stock and Section 83(b) or the tax code work. It was the subject of a prior blog entry. However, it comes up so often and different people absorb the concept in different ways, so I thought it might be worth attacking again in a different way. Restricted stock can have some very material tax benefits when compared with options, especially in the early stages of any venture. So, here is how restricted stock works. I will compare it to options later.

You may want to incent employees by giving them stock. Here is an example. Easy Company decides to incentivize one of its employees by giving her a stake in the company. It then grants to Jane 100,000 shares (assume for the purposes of this example that the shares have a fair market value of $.01 per share). Two things follow. First, Jane owns the stock and, in our example, has no particular incentive to stay of the sort associated with vesting. Second, Jane has income equal to the value of the shares of stock she has been given. In this example she has income of $1,000. Easy Company must report (and withhold taxes for) this income on Jane’s Form W-2  for the year in which she was given the stock, and Jane must pay tax on that income. Now, $1,000 of income does not seem like much, but if the stock had a fair market value of $1.00 per share, Jane would have $100,000 of income on which she would owe tax. If her marginal tax rate is 40%, then she has to pay $40,000 of tax to the feds.

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Since Sequoia's 56 slides of gloom and doom, a lot has been written on surviving the downturn.  Don Dodge has captured 11 items of advice from John Doerr of Kleiner Perkins.  This focus on what you need to do to survive the downturn seems healthy to me because it assumes that you can and, with some grit and determination, will survive the downturn.  And, I think most start-ups will survive.  Having said that, some will experience a lot of pain and find themselves in dire straights.  And, yes, some will get into real trouble.  By real trouble, I mean bankruptcies and personal financial disasters.  To prevent these situations from becoming worse than they need to be, you need to understand where your personal liability begins and ends.  There has not been a lot of blog advice that I have seen on these points.  You can look at one thing I have written  Liability of Officers and Directors.  Item 6 of Doerr's list is "Renegotiate all contracts including rent. You will be surprised what can be renogitated for a lower price of better terms."  I agree with this item, but you need to be forward thinking about it.  Don't avoid the landlord or the bank -- deal with them up front in a realistic way.  For example, if you promised a payment on a day -- make it.  If you can't then communicate early so the lender is not surprised.  When dealing with creditors in these circumstances you need all the credibility you can get.  Also, raising and dealing with issues early (before the landlord has so many defaults that he gets panicked) will maximize the amount of flexibility that you get from the creditor.  By way of contrast, dodging phone calls and avoiding will just annoy the lender and may lead to inflexibility.

A question that comes up with some frequency is how many options to grant to an advisory board member. One of my partners advises his start up clients not to issue more than 1% of a company’s equity to the entire advisory board. I think this is a pretty good goal. My experience, however, is that some advisory board members should be paid more than others because they ad more value, either because they undertake to do more than others or because they bring more visibility and credibility than others. One advisory board member that I know insists on half of a percent for her commitment, but she is a rock star in her industry and agrees to make phone calls and provide introductions. In effect, she adds more value than simply her good advice. So, those are some guideposts, but when considering a new advisory board member you should consider the contribution that is expected as well as the dilutive effect of the option grant.

11/04/08 update -- One of my start-up clients just faced this issue and settled on a pool of 1.5% for all advisory board options.