Who Do Directors Represent?

June 15, 2011

By: Paul A. Jones

In companies with venture capital financing, the venture investors usually have a right to designate one or more directors. Indeed it is not uncommon, when companies have gone through multiple rounds of venture financing, to see boards where a majority of the directors are elected by the venture capital investors.

Many entrepreneurs, and even a few VCs, assume that “VC Directors” represent the interests of the venture capitalists who elected them. An understandable assumption, perhaps, but in fact that is not the case. All directors, no matter who elected them, are legally obligated to represent the interests of all of the equity owners of the company. (In fact, when companies are in severe financial distress, directors can find that their fiduciary obligations extend to creditors as well, but I’ll leave that for another time.) By way of analogy, just as the President of the United States represents all American citizens – those who voted for him as well as those who voted against him; indeed, those who did not or could not vote at all – a director of a company represents all of the owners of the company.

Most of the time, this legal principle has little practical import. Directors elected by the venture capital shareholders will tend to see issues brought to the board the way the people who elected them view those issues: presumably, that was why they were elected. Ditto, of course, for directors elected by common shareholders. But while there is nothing inherently wrong with that there is more to the story. Directors can take many actions the effect of which is to favor one group of shareholders over another. But a director who takes an action the purpose of which is to favor one group of shareholders over another, she is treading on dangerous ground.

Let’s look at an example and see how this plays out. Newco has gone through a round of venture financing, and Jane Doe, a general partner of the lead investor, Acme Ventures, represents the venture investors on the Newco board of directors. Newco is running low on cash, and Beta Ventures has offered to lead a new round of financing at $2.00 per share, a healthy premium over the previous financing. Director Doe votes against taking Beta’s offer, and, the following week, Newco’s board of directors, at director Doe’s suggestion, accepts an offer at $1.00 per share from Acme Ventures. Has director Doe done anything unlawful?

Well, in this case, the facts provide a lot of smoke, but do not go far enough to say, with certainty, that director Doe has done anything wrong. What we don’t know, on these facts, is why director Doe opposed the Beta Ventures offer. If, in fact, Doe thought the Beta offer was the “best offer” for the collective owners of Newco but voted against it with the purpose of forcing Newco to take a less attractive offer that favored the existing investors, Doe’s action would have been, well, actionable. On the other hand, if Doe, even knowing that turning down Beta’s $2.00/share proposal would result in Acme being able to do the deal at $1.00, had a good faith reason to believe that Beta’s offer was not, considering all terms of the offer, not just price, not the best deal for the company’s collective owners, Doe’s action would not be actionable.

None of this means that “who controls the board” is not an important variable for founders and investors alike. In most situations, the policy differences between directors elected by one group of shareholders and those represented by another group of shareholders are not going to rise to the level of compromising the fiduciary position of a director. Board control does matter. But at crunch time, when decisions are being made that will impact different ownership groups differently, every director should remember that her actions should reflect her view of what is best for the collective owners of the company, and not for any subgroup that elected her.

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Posted by pajones1

Entrepreneurs, Investors and Board Meetings: What’s the Right Balance for Start-Up Companies?

June 7, 2011

By: Paul A. Jones

Meetings are seldom fun, and board meetings are no exception. Moreover, meetings have a mostly deserved reputation for being unproductive wastes of time and talent. Still, some meetings – including board meetings – can’t be avoided, even by the most social-network enabled start-up entrepreneurs and their investors. So, given that board meetings are going to be with us whether we like them or not, let’s look today at the question of how often should you have them. I’ll talk about board meeting preparation and content in a later post.

While generalizations in this area can be problematic, my own view – based on having been both an entrepreneur and an investor in start-up technology businesses, as well as a counselor to such entrepreneurs and investors – is that most early-stage, tech-driven business should, at least for the first year post-funding, hold regular board meetings on a monthly basis, and that board members within a couple of hours drive time to the company should make every effort to attend in person.

Now, monthly meetings may seem like overkill, particularly if, like me, you dread attending formal meetings, and think of the start-ups anti-meeting culture as one of the things that give entrepreneurial firms a leg up on their more established and bureaucratic companies (most of which hold board meetings no more often than quarterly, or maybe bi-monthly). So, what gives? Why should entrepreneurs who are rightly skeptical of meetings generally want to have more board meetings than their more established competitors?

Several things come to mind. One is the fast-pace of start-up living. Start-ups can – and do – move faster than more established firms. Internal developments, product development, for example, is less predictable in terms of both substance and timing. And even if the external market doesn’t change faster for the start-up than for the more established company, the impact of those changes is often greater on the start-up, and beyond that start-ups are usually on a steeper market knowledge learning curve than the more established players. In short, time is even more of the essence for start-up than for more established companies, and that is one reason start-up boards should as a rule meet more often than boards of later stage companies.

Another reason start-ups should meet more often has to do with the expectations of inside and outside directors in terms of the role of the board and, most importantly, the value add expectations for outside directors and the need for time establishing good working relationships among directors, particularly between the insiders and the outsiders on the board. As noted above, things tend to move faster in the start-up world. Further, important strategic and significant operational issues tend to come up more often. And, finally, even if the financing dance went well, it is likely that it left the entrepreneur and investor(s) a little unsure about each other and, in any case, a bit up in the air in terms of what to expect from each other, in terms of information sharing and value add abilities and expectations. More regular meetings, particularly in the first year or so post-funding, can help address both of those challenges, and in the process foster better intra-board relationships and trust, as well maximize the value add of outside directors.

Finally, more regular board meetings can help a company establish and institutionalize more efficient and productive communications channels among inside and outside directors. The process of preparing for board meetings on a more regular basis – a sometimes frustrating process for senior managers with what seem like obviously more important ways to invest their time – can itself help both inside and outside directors “find their way” in terms of the appropriate timing and sharing of information about the company and it’s business and technology environment. Over time, as intra-board communications become both more routine and less formal, the regular board meeting schedule can be cut back.

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Posted by pajones1

Valuation of the Company vs. Valuation of the Stock: A Venture Capital Paradox

June 3, 2011

By: Paul A. Jones

One of the first things entrepreneurs learn about venture capital speak is the significance and difference between pre-money valuation and post-money valuation. These are the terms that VCs use when talking about how much a company is worth before and after a round of financing. While investors in public companies tend to think of valuation in terms of how much one share of stock costs, VCs tend to think of valuation in terms of what percentage of the total ownership of the company they can buy for how much capital. So, for example, if a VC buys 1/3 of the ownership of Newco for $1.0 million, the “post-money” valuation is 3 * $1 million = $3 million and the “pre-money” valuation is $3 million – $1 million = $2 million. If say $2 million bought ¼ of the company the post would be $8 million and the pre would be $6 million.

Another thing entrepreneurs learn pretty early in the VC courtship ritual is that VCs typically get some form of “convertible preferred stock” in exchange for their capital. In the most general of terms, “Convertible Preferred” is a kind of stock that (i) has some extra rights that make it “better” than common (for example, liquidation and dividend preferences, the ability to prevent Newco from doing certain fundamental things like selling the company, etc.) and (ii) is optionally convertible into common stock by the holder at pretty much any time, and can be automatically converted in some instances (typically in connection with an exit transaction where the company is sold or completes an initial public offering at a sufficiently high price). Most often, the conversion rate is 1 to 1: that is, one share of Convertible Preferred converts in to 1 share of common. The rate can be more or less than that, and can change over time, but neither of those facts changes the fundamentals of the analysis in this blog.

Alas, these two concepts – pre/post-money valuation and Convertible Preferred – combine to create what looks like a valuation paradox. Let’s consider our $1 million for 1/3 ownership investment. And just to make the math simple, let’s say that the investor bought 1 million shares of Convertible Preferred for $1 each with a 1 to 1 conversion ratio, and the founders own all 2 million shares of common stock. In this situation, the post money is $3 million, right? And the 1 million preferred shares are worth $1 million, right? (Right in both cases.) So the 2 million shares of common stock must be worth $2 million, right? And each of the 2 million common shares must be worth $1, right?

Actually, in both the later cases, no. The common is not worth $1 share – how could it be worth as much per share as the Convertible Preferred, which can be converted to common at any time and has a bunch of special rights that add more value to it? If not a problem, we seem to have at least a paradox.

What is going on here? How can both the pre/post money valuation formula work AND at the same time the Convertible Preferred and Common stock have different values? Let’s try and hash that out, starting with the difference in value between the Convertible Preferred and the Common stock. As to the Convertible Preferred, the price, when it is purchased by a third party investor in an arms length transaction (in this case $1) is, by definition, the fair market value of the Convertible Preferred. Which means that the value of a Common share, at the same time, must, given that it lacks various valuable features of the Convertible Preferred, be worth something less than $1. How much less? Well, that depends. Since no one – or at least no third party in an arms length transaction is buying any at the time – it depends on what the Board of Directors, in good faith, determines it is as, for example, when it issues an option to buy such shares to an employee at what the Board says is the then fair market value of a Common share of stock.

Ok, at this point we know that a Common share is worth less than a Convertible Preferred share, and that the fair market value of the Common share is what the Board says it is. How should the Board determine the fair market value of a Common share?

In theory, the answer is simple; in practice, not so much. In theory, the board should (and any good board resolution purporting to establish the fair market value of a Common share will) “consider all relevant factors” to conclude that such value is less than the $1 value of the Convertible Preferred and more than $0. In fact, most boards will want to set a low value on the Common (to make equity incentive shares cheaper for employees and others getting shares of options on shares as an incentive to make the company succeed), but not so low as to attract the attention of the IRS, which is anxious to tax people who acquire assets, including stock, for less than it is worth.

In practice, there are some informal rules of thumb that tend to apply to very young and immature companies, and some explicit IRS/SEC rules that come into play for more mature companies. So, for example, a brand new startup like Newco might reasonably conclude that the value of a Common share was 1/5 the value of a Convertible Preferred share – which is to say the Common share has a fair market value of $0.20. No legal opinion is expressed here, but trust me: lots of companies have said as much without incurring the wrath of the IRS.

Ok, let’s go with $0.20. What, then, is the value of all of the stock – which is to say the value of the company? Well, there are 1 million shares of Convertible Preferred worth $1 per share, which is $1 million of value. And there are 2 million shares of Common worth $0.20 per share, which is $400,000 of value. So the total value of all the shares is … $1.4 million. Which is to say less than ½ of the post-money valuation of the company! Houston, we have a problem.

Or do we? Ok, there is a seeming paradox, but is there really a problem? I don’t think so. Because while the fair market value of the common might, at some level, seem like a more or less arbitrary determination of the Board of Directors, in fact it has to be something less than $1 in the example. And if it is anything less than $1 we will arrive at a total value of all equity that is less than the post-money valuation calculated by the VCs (and typically accepted, in normal conversation, at least, by the management/founders of Newco). The problem – perhaps a better word is artifact – is with the pre/post money concept.

And this is it. Buried in the pre/post money calculation is a very important assumption; namely that the VC post-money calculation assumes that the company will have a favorable – e.g. north of $1 per share (and probably at least 3x or more of $1 per share) – exit price when the company is sold or goes public. In which case all of the Convertible Preferred will convert into Common – and suddenly the assumption that they are worth the same amount … works.

It’s not elegant. It’s more than a little arbitrary and capricious. But it (more or less) works.

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Posted by pajones1

Compensation for Directors of Startups

June 2, 2011

By: Paul A. Jones

One issue that comes up fairly early for most start-ups, certainly by the time of the first outside funding if not before, is how members of the Board of Directors should be compensated. Every situation is unique, but what follows is my take on the generic question.

As a preliminary matter, Directors can fall into several categories, and compensation is most often tied to those categories. Inside directors include the founders and management team. Investor Directors are those who are associated with, or themselves are, material third party investors. The classic example is a director who is appointed by and affiliated with a venture capital investor or angel investor group. A significant “lone wolf” angel investor would also fit here (more on that later). Finally, everyone else – typically people who bring industry expertise or contacts, or are mentors for the management team – is pooled together as Independent Directors. Independent Directors may have made small investments in the business, but are not significant in terms of their capital contribution.

Ok, what do all these folks get for their Board service?

Let’s start with the easy ones. Insiders typically get nothing for their service on the Board. These folks, being founders or members of the management team, are already well compensated for their service. Being on the Board is a reward (of sorts) in itself, and simply goes with the territory.

Investor Directors are more or less in the same boat. They are by definition material investors (or represent material investors) in the business and serving on Boards of portfolio companies is part of their job, just as part of the CEO’s job typically includes serving on the Board. If the investment does well, they will be amply rewarded by the people or fund they represent.

That leaves the Independent Director. The easier cases, here, are the truly independent director who is not affiliated with or representing an investor group and has made no independent investment, or has made only a token independent investment. Depending on level of experience and perceived value add, these folks may get something in the twenty-five to two hundred basis points range – something between 0.25% and 2.0% of the equity, typically vesting over two years. Beyond expense reimbursement, you should not have to pay these folks any cash compensation (beyond expenses), at least not until the company is actually generating cash in the business.

While these are good general rules, there are some common situations that sometimes don’t fit within them so easily – or at least the Director in question might think they don’t. The first of these situations, and the easiest to deal with, is the “superstar” director. For example, if Steve Jobs tells you that he is really excited about your iPhone applications company and would be willing to serve on your board of directors for a hefty chunk of equity, don’t feel bound to tell him that the most you can offer is two hundred basis points.

In my experience the most contentious Board compensation issues arise when a Director affiliated with a fund of some sort, typically a group of angels, wants an independent equity stake for serving as a Director. My own view, and I think the majority view in the major venture capital centers, is that these folks are in the Investor Director camp and should not “double dip” in terms of their equity compensation. If the angel group they are affiliated with wants to provide them with some deal specific incentive compensation they should do it by carving out a piece of the equity they purchased. That said, in tight capital markets; in places (like Wisconsin) with limited risk capital access in even good times; or in situations where the capital-affiliated director is in fact going to be an active contributor above and beyond the level expected of the typical outside director, this is an area where entrepreneurs are often either (i) forced to cave on the principles of the matter to get a deal done in the first two cases, or simply recognize the realities of the situation in the later instance. If the “independent investor” insists on compensation, try to keep it under 100 basis points.

Board compensation for start-up companies is as much art as science, and the above guidelines are just the thoughts – albeit based on 25 years in and around these deals with multiple experiences as an Inside, Independent and Investor Director – of one man. But as a starting point, I think they will serve startup companies well.

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Posted by pajones1

Pitfalls of Provisional Applications

June 1, 2011

By: Charlene L. Yager

A poorly written provisional application can have dire consequences for the unsuspecting applicant. A patent application – provisional or not – must meet all the disclosure requirements of Section 112. That is, each application must contain a full and complete enabling description of the invention. Claims are entitled to the benefit of the filing date of the provisional application if they are fully supported in the provisional application. If not, the claims will only be entitled to the filing date of the utility application.

This is particularly important if there is a public disclosure – either before or after the provisional filing date. In the U.S., the public disclosure can be used as a basis for rejection of all claims not explicitly supported in the provisional application if the disclosure is before the filing date of the provisional application.

The problem is even worse in most foreign countries. Many foreign countries do not have a one-year grace period so a public disclosure after the filing date of the provisional application can be used as a basis for rejection of all claims not explicitly supported in the provisional.

Thus, the description of a provisional application should be written just like any other patent application. Use caution when basing a provisional application on a manuscript or scientific article. These tend to describe the invention in very narrow terms with little more than the specific experimental conditions and results. Without more, the provisional application will not be able to support broad claims to the invention and only the narrow embodiments taught in the article will be entitled to the benefit of the provisional filing date. The lesson – a hastily-filed cover page provisional may not protect your foreign rights.

That said, the provisional application can be a very useful tool to provide an additional year of priority at a relatively low cost, particularly when the ultimate end use and market are not fully developed at the time the application is filed. Take the time and effort to fully and completely describe the invention in the provisional application and it will serve you well.

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Posted by clyager

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