Happy 200th Birthday Mr. Winchester!

November 30, 2010

By: Jonathan M. Fritz

Today is the bicentennial anniversary of Oliver Winchester’s birth. Winchester presents an example of a historic venture capitalist, entrepreneur and innovator who founded and transformed a business influential to the history of the United States.

Winchester, a New York clothing manufacturer, was a major investor and eventually acquired a technology business started by the founders of Smith & Wesson. The business started by Smith & Wesson was based on technology too immature for commercialization and ultimately failed. The business was later reorganized and became the Winchester Repeating Arms Company. Winchester’s company was founded upon patented technology in the fields of ammunition and newly invented repeating firearm mechanisms. Through business acumen and innovation the original technology was adapted, improved, and successfully commercialized. Winchester’s innovation from the 1860s-1870s resulted in the Henry Rifle (U.S. Patent 30,446), newly designed ammunition, and the Winchester Rifle. Collectively these repeating rifles are often referred to as the “Gun that Won the West”.

Even 200 years after Winchester’s birth entrepreneurs today can learn valuable lessons from his story. First, patented technology can provide a start-up with a significant market advantage. However, there may not be a direct connection between patented technology and commercial success, which leads to the second lesson. Without a business goal towards actually commercializing the technology, the advantages provided by intellectual property won’t be realized. Lastly, the need for a successful businessman as CEO or investor/advisor can’t be taken for granted. Whether or not the experience is in the same business sector is less important.

Winchester identified an opportunity divergent from his existing clothing company, acquired the intellectual property and built a business through continued innovation and commercialization. Although his company has since been acquired, his name, trademarks and technology live on.

Leave a Comment » | intellectual property, start-ups | Tagged: , , , , , | Permalink
Posted by jonathanfritz

SEC PROPOSES DEFINITION OF VENTURE CAPITAL FUND UNDER DODD-FRANK

November 22, 2010


The Proposed Rules

One of the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was to require many more financial advisors to register under the Investment Advisers Act of 1940 (the “Advisers Act”). The Dodd-Frank Act exempted advisers that only manage venture capital funds from registration under the Advisers Act, and the Securities and Exchange Commission (the “SEC”) was directed to define the term “venture capital fund.” On November 19, 2010 the SEC proposed a definition of “venture capital fund”. Under the proposed definition, a venture capital fund is a private fund that:

  • Public Representation. Represents itself to investors and potential investors that it is a venture capital fund.
  • Invests in Qualifying Portfolio Companies. Only invests in equity securities (including convertible notes, warrants and other securities that are convertible into equity securities) of “qualifying portfolio companies” (see below) (and at least eighty percent (80%) of the equity securities of each qualifying portfolio company owned by the fund was acquired directly or indirectly from the qualifying portfolio company) or cash, cash equivalents or U.S. Treasuries with a remaining maturity of sixty (60) days or less.
  • Significant Management Guidance. With respect to each qualifying portfolio company, either has an arrangement whereby the fund or the investment adviser offers to provide, and if so accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company. 
  • No leverage. Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of fifteen percent (15%) of the fund’s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 days.   
  • No redemption rights. Does not offer redemption rights to its investors.

Under the proposed rules, “qualifying portfolio company” means any company that:

  • Private company. At the time of any investment by the fund, is not publicly traded and does not control, is not controlled by or under common control with a publicly traded company.
  • No borrowing. Does not borrow or issue debt obligations in connection with the fund’s investment in such company.
  • No purchase from existing security holders. Does not redeem, exchange or repurchase any securities of the company, or distribute to pre-existing security holders cash or other assets in connection with the fund’s investment in such company.

 Under a proposed grandfathering provision, existing funds that make venture capital investments would generally be deemed to meet the proposed definition, as long as they have represented themselves as venture capital funds.

The Concerns

If adopted, the proposed rules raise create significant ambiguity or significant concerns regarding existing practices of venture capital firms. 

  1. What constitutes “significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company”? Is Board representation sufficient? What about board observers? Smaller funds that are more passive nature?
  2. Public companies sometimes want to spin out very early stage technology that is years from commercialization to affiliated companies and then rely on venture capital funds to fund their growth. The proposed rules would prohibit that practice. 
  3. Many public companies have captive venture capital investment vehicles that invest in emerging companies. The proposed rules would prohibit co-investment by funds if the captive venture capital investment vehicle controls the company. 
  4. Many companies rely on governmental or other low interest loans to fund their growth. The loans often require some matching funds as an independent third-party validation of the company’s prospects. The proposed rules appear to prohibit companies from raising matching debt capital as part of a venture capital investment. 
  5. Occasionally, founders in later stage venture backed companies opt to “take some money off the table” by selling a portion of their equity in connection with later stage rounds. The proposed rules prohibit this practice. Potentially more problematic, the proposed rules could also be interpreted to prohibit repurchases of equity securities from former founders or employees who are no longer active in the company.  

While the SEC appears to have made a good faith effort in defining what constitutes an exempt venture capital fund, some of the proposed rules would negatively affect certain common practices in a manner that is hard to explain if the goal is to further investor protection.

Leave a Comment » | legal, start-ups, Technology, Uncategorized, Venture Capital | Tagged: , , , , , , , , | Permalink
Posted by Gregory Lynch

Free Money Isn’t Free (Except When It Is)

November 18, 2010

By: Hamang B. Patel

For many high growth technology companies, a state or federal grant is a blessing. It can help fund R&D, clinical trials, or otherwise provide the capital needed to expand. The casual observer could hardly be faulted for thinking that if, for example, the National Institutes of Health wanted to give a company a grant, that the IRS wouldn’t tax the grant. That would be absurd, right? After all, why would one hand of the government want to take back cash that the other hand just offered? The truth is complicated, and exasperating. Government grants are in fact taxable depending on how the money is used, and how the recipient chooses to do business (i.e. LLC vs. Corp).

Here’s how the tax rules work. The general IRS rule is that all income (regardless of the source) is taxable. However, there is a major exception to this general rule. In 1954, the federal income tax laws were amended so that corporations (including S-corporations) could receive government grants tax-free – if certain conditions are met. Some of the key conditions for a grant to be tax-free include the following:

  1. the government money can’t be compensation for goods or services;
  2. the government money must be invested in depreciable property (e.g. equipment) rather than spent on payroll;
  3. the government money must be used to generate income (i.e. invested in the business rather than paid as a dividend).

Notably, the 1954 law didn’t cover grants received by LLCs or partnerships. This omission isn’t believed to be because of a federal bias against LLCs and partnerships. Rather, in 1954, the concept of LLCs and limited partnerships had not yet been created, and Congress probably thought that nobody in their right mind would do business (other than a mom and pop store) using a general partnership. Back then, corporations were essentially the only game in town. So Congress could be excused back then for not including LLCs and partnerships in the scope of this rule.

In the half century since, Congress never got around to clarifying the tax treatment of grants made to LLCs or partnerships. In the absence of any guidance from the IRS, most tax advisers assumed that LLCs and partnerships could rely on ancient Supreme Court law from the 1930s saying that grants are always tax-free.

The IRS recently broke its self-imposed veil of silence on this issue, and issued a memo to its auditors arguing that grants made to LLCs and partnerships are taxable. Many tax advisers responded to the IRS memo with a collective “They can’t really mean that, right?” In fact, in the last few years, the IRS has followed with a flurry of additional memos essentially saying “Oh yes, we really meant it.” Not wanting to pick a fight with the IRS, most tax advisers have now done a 180-degree turn and are advising that grants to LLCs and partnerships are taxable.

For the company that is expecting a government grant, the new IRS position may play a major factor in choosing between organizing as an LLC or corporation. As noted above, S-corporations (even though taxed as a passthrough) get the same ability to receive grants tax-free as C-corporations. But before an LLC expecting a grant rushes to convert to a corporation, it would be wise to examine how the upcoming grant would be used. Keep in mind that grants used to pay payroll or to pay independent contractors are always taxable, regardless of whether the grantee is a corporation. And also keep in mind that LLCs and partnerships have other tax benefits. So organizing as a corporation isn’t always the solution. Of course, there is always the hope that Congress will change the law and treat LLCs and partnerships the same as corporations in this regard – but don’t hold your breath.

Leave a Comment » | legal | Tagged: , , , , , , | Permalink
Posted by hamangpatel

Angel Investing Principles: Doing Good While Doing Well.

November 18, 2010

By: Paul A. Jones

Recently, I attended an exploratory meeting for a possible new Wisconsin Angel fund. Typical of these kinds of events, and gratifying as well, was the number of folks who seemed genuinely interested in participating in a fund that would promote regional economic development. Also typical, if less satisfying, was the confusion about what “giving something back” and promoting economical development meant in terms of running an Angel fund. Too many people seemed to think that public spirited Angel investing was about doing deals that didn’t have the growth and profitability metrics – and ultimately investment returns – offered by deals that might interest professional investors. And that’s just silly.

Now it is true that Angel investors may be willing to pay somewhat higher prices for deals than professional investors – but even there, paying too high a price can actually kill a company if it needs subsequent funding from professional investors. But beyond that, Angel’s are not only not helping entrepreneurs – or regional economies – when they in effect lower the performance bar for the entrepreneurs they invest in, they are hurting them. High impact businesses – as opposed to more traditional small and lifestyle businesses – by definition compete far beyond the region (think nationally and even internationally) for people, technologies, markets and ultimately capital and exits. Being Angel-backed doesn’t get an entrepreneur some sort of “extra credit” with customers, employees or, ultimately, with potential exit partners. The bottom line is that Angels who tell entrepreneurs that it’s somehow ok to pretend that what’s counts is being the best of breed in the region, rather than in the relevant market space, do themselves, the entrepreneurs they invest in and their regional economies serious damage.

Now, I am not saying that good Angel investing doesn’t involve giving back to the community and promoting regional economic development. But the giving back is not about lowering investment standards, it’s about providing more active assistance than most VCs can provide in terms of helping entrepreneurs meet those standards. It’s about working with entrepreneurs that combine world-class ideas with the rough edges typical of high impact entrepreneurs that are new to the game and/or otherwise do not have the polish and experience – yet – to pass muster with more seasoned professional investors. Put differently, good Angel investing is about doing good – helping raw entrepreneurs become seasoned and capable, ultimately, of being the best of breed in their market space  – and doing well – by doing the same thing.

In conclusion, public-spirited Angel investing is a wonderful thing, so long as being public spirited is about helping entrepreneurs be the best – something that takes as much elbow grease as money – and not about throwing dollars and good wishes at deals that shouldn’t get done because it makes you feel good.

Leave a Comment » | Uncategorized, Venture Capital | Tagged: , , , , , , | Permalink
Posted by pajones1

Startup Valuation Workshop Slides & Worksheets

November 8, 2010

Recently, Paul Jones, Chair of Venture Best Practice Group, conducted a workshop which discussed valuation for startup companies. The presentation, slides and worksheets have been posted below:

Click here to view the presentation.

PowerPoint Slides: Startup Valuation Workshop (PAJ) 

Worksheets: Venture Best.Startup Valuation Workshop_ Valuation Cheat Sheets (PAJ)

1 Comment | formation, start-ups | Tagged: , , , , , | Permalink
Posted by pajones1

Follow

Get every new post delivered to your Inbox.

Join 41 other followers