Thinking About Dilution

January 19, 2012

By: Paul A. Jones

For most entrepreneurs, dilution is an ugly word. Being diluted, after all, is about giving someone else a piece of your business. All other things being equal, that’s not a good thing. That said, for entrepreneurs that need third party risk capital to fund their business, dilution is inevitable. And (the silver lining in the dilution cloud) not always as bad as it might seem.

Entrepreneurs facing dilutive events typically have two concerns, both related to a reduction in relative ownership of the business: loss of management control and a diminished share of the “upside” if the business succeeds. Let’s look at control issues first.

Fear of losing management control to investors is something that keeps a lot of entrepreneurs up at night. Too often, though, the fear assumes that there is some magic number – usually 50% ownership – around which control pivots. Alas, it is not anything like that simple. The (possibly disturbing) fact is, an owner of the smallest fraction of a company’s equity (indeed, a creditor without any equity stake at all, though that is a matter for another blog) can have de facto control of a company’s management. And, indeed, venture capital investors with minority ownership positions almost always have substantial management control, as for example rights to prohibit strategic transactions (e.g. sale or merger of the business), limit future sales of equity, etc. well beyond those rights they would enjoy from a simple “who has the most shares” analysis. The devil, in terms of management control, is in the fine print of the deal terms, not the gross percentage of equity owned. The take home here is that control in venture backed startups is more a function of the (hopefully thoughtfully negotiated) finer points of the deal terms than simply a function of who has the bigger/majority equity interest.

As for dilution reducing an entrepreneur’s share of the upside, by definition, an equity investment involves some grant of interest in future profits and/or exit value to the investor. (For purposes of this blog, we’ll assume that the investor’s stake is commensurate with its ownership stake, though it need not be: while an investor’s ownership stake is less likely to diverge significantly from the investor’s ownership share than its control rights, such discrepancies are not uncommon, if not usually as significant.)

Now it is fair enough to say that giving a third party any stake in the ultimate equity value created by the business necessarily dilutes the interests of the prior stakeholders. But the story is more complex than that. Taking on a new investor is a priori (if not always a posteriori) a classic win-win proposition. More specifically, the investor is investing because he believes that the investment will grow in value, while the entrepreneur is accepting the investment ( and dilution) because she believes that the value of her diluted share of the post-investment equity in the business will exceed the value of her (undiluted) pre-investment equity. Unless both parties anticipate a wealth enhancing proposition, there won’t be a deal.

The win-win story is most easily understood in the context of an “up” round: that is, where the new investor pays a higher price than the prior investors. So, for example, an entrepreneur who owns say 50% of a business where the previous investor paid $1.00 per share is demonstrably wealthier if she takes on an additional investor at $2.00 per share even if doing so dilutes her ownership down to 25%. In fact, her wealth (even if not her liquidity) has been doubled (she now owns the same number of shares, each of which is worth twice what it was before the investment).

The $1.00/$2.00 example above does not mean that an entrepreneur should always accept dilution if doing so would increase her wealth. It may be that while the $2.00 offer doubles her wealth, the ownership stake she is selling is worth more than $2.00 to some other investor. What the example does illustrate, though, is that a dilutive event can also be a wealth enhancing event. Indeed, even in a down round scenario (say the price goes from $1.00 to $0.50 per share) the entrepreneur should only accept the dilutive event if she feels that her diluted ownership stake after the investment will be worth at least as much as her undiluted stake if she forgoes the investment.

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Posted by pajones1

Navigating Wisconsin State Income Tax Credit Incentives

September 14, 2011

By: Hamang B. Patel

A business executive can be excused for not knowing which of the various state income tax credit incentives is appropriate for his or her company.  At first blush, the various tax incentives all seem to be similar.  The following summarizes the various income tax incentives available to a company to expand operations in Wisconsin, and explains how a company would want to choose from among these programs.

Four Main Programs
There are four Wisconsin income tax incentives available to companies that seek to expand activities inWisconsin, which are the following: 

1.         Economic Development Tax Credits;

2.         Jobs Tax Credits;

3.         Relocation Tax Credits; and

4.         Enterprise Zone Tax Credits.

Many business owners are familiar with the Wisconsin Angel Investment Tax Credits (commonly known as “Act 255 Credits” after the statute creating the program several years ago) and the Early State Seed Investment Tax Credits.  A key thing to remember is that these two investment tax credit programs provide tax credits to investors seeking to invest in a company, which is a good way to assist a company to raise capital from investors.  However, these two programs don’t directly provide tax incentives to the company itself. 

There are also other tax credit programs that are specific to certain industries (e.g., credits for dairy, meat processing, food processing, woody biomass, film production manufacturing, etc.).  For the moment, let’s focus on the four major programs described above that can directly incentivize a company’s expansion plans without regard to industry type.

Economic Development Tax Credits
In 2009, Wisconsin(recognizing that simplicity is welcome in the business community) condensed five overlapping tax credit programs into the Economic Development Tax Credit program. This program provides a nonrefundable state income tax credit for certain types of economic development projects.  This program provides tax credits for companies that: (i) create jobs, (ii) invest in equipment or real estate, and/or (iii) train employees.  For job creation, the credit ranges from $3,000 to $7,000 per job depending on the salary paid to the full-time employee.  For capital investment, the credit can be up to 3% of the investment in equipment and 5% of the investment in real property.  A credit for employee training is up to 50% of the training costs.  These credits are typically less $3M per company, unless special approval is provided by the state.  In 2011, the state increased the aggregate amount of tax credits that may be allocated to all applicants by $25M.  Further information is available here. 

Jobs Tax Credits
Available for the first time last year, Wisconsinprovides a refundable state income tax credit specifically for creating jobs in Wisconsin pursuant to the Jobs Tax Credit program.  The credits are up to 10% of new full-time employee wages.  New jobs must pay annual wages of at least $20,000 ($30,000 depending on the classification of the county or city) but not more than $100,000.  The total amount of these credits available to all applicants per year is $5M.   Further information is available here . 

Relocation Tax Credits
In 2011, Wisconsincreated a new nonrefundable state income tax credit known as the Relocation Tax Credits program.  These credits are available for a company that moves at least 51% of its workforce payroll or at least $200,000 of wages toWisconsin from another state or country.  The credit equals the company’s totalWisconsin income tax liability (after taking into account all other credits, deductions and exclusions).  The credit can be claimed for two consecutive years, beginning in the year the business relocates toWisconsin. 

Enterprise Zone Tax Credits
In 2011, Wisconsinexpanded the Enterprise Zone Tax Credit program to allow up to 20 “zones” (up from the existing 12 zones).  The zones are created at the discretion of the Wisconsin Economic Development Corporation (the “EDC”), taking into account the area’s economic need.  Although not self-evident from the statutes, in practice a “zone” has been the area around a particular company’s facilities rather than a broad area.  So in practice, this program should be thought of as an incentive for a particular company’s expansion plans.  A company receiving these credits should make a significant investment in jobs and/or capital.  Our discussions with EDC staff suggests that projects that would receive these credits are for those that create or retain 800-1,000 jobs in Wisconsin and/or invest $80M – $100M of capital investment.  Several refundable state income tax credits are available under this program.  For job creation or retention, the credit is up to 7% of wages in excess of $20,000 ($30,000 depending on the classification of the county or city).  For job training, the credit is up to 100% of the training costs.  For capital investment, the credit is up to 10% of expenditures.  A final credit is equal to 1% of purchases of goods or services fromWisconsin suppliers.

Certification
To obtain any of the credits described above, a company needs to get certification from the EDC prior to starting the job creation or capital investment upon which the credits will be computed.  Certification is a competitive process and depends on the allocation constraints of the EDC (i.e., how much of the limited credits remain available).  Our experience with the EDC is that certification for a credit also depends on the quality of jobs created (i.e., whether the jobs are low-wage or transitory) and, for nonrefundable credits, whether the company has taxable income to use such credits.  The EDC has also told us that while there is no statutory prohibition against double dipping to obtain multiple credits, the EDC would never in practice certify a company to receive multiple credits for doing the same thing.  For example, the EDC wouldn’t certify a company to receive the Jobs Credit and the Economic Development Credit for creating the same jobs.  On the other hand, the EDC has told us that it might be possible for a company on a case by case basis to be certified, to get the Jobs Tax Credits for creating jobs and also to be certified to receive the Economic Development Tax Credits for other activities (e.g., capital investment or employee training). 

Choosing Among Programs
The EDC will ultimately choose among the above described incentives that are available/offered to a company.  Nonetheless, a company would need to know which incentive to push for.  The following lists some of the factors that should be taken into consideration from the perspective of the company.

1.         Tax Appetite.  The obvious difference among these programs is that the Jobs Tax Credit program and the Enterprise Zone Tax Credit program provide for refundable credits.  Thus, if a company doesn’t have taxableWisconsin income that can be offset by these credits, the state will literally send a check in the mail to the company for the unused portion.  In contrast, the Economic Development Tax Credit program and the Relocation Tax Credit program offer nonrefundable credits.  If the company doesn’t have taxableWisconsin income that can absorb the credit, it would have a preference for the Jobs Tax Credit or Enterprise Zone Tax Credit.

2.         Size of Project.  Based on our discussions with EDC staff, the Enterprise Zone Tax Credits is not for small projects.  Thus, unless a company is planning a major job creation or capital investment program, the company is unlikely to be certified to receive Enterprise Zone Tax Credits. 

3.         Quality of Wages.  For some programs, the level of wages for new jobs created must be above a certain threshold (e.g., Jobs Tax Credit and Enterprise Zone Tax Credit programs) due to statutory requirements.  Unless the expected jobs exceed this threshold, such programs can be disregarded.  For the Economic Development Tax Credit program, which allows tax credit solely due to capital investment activities, our experience is that if the jobs resulting from or saved by the capital investment are not well paying jobs (e.g., migrant workers earning minimum wage), then the EDC is unlikely to certify the program for credits.

The economic value of these tax credit incentives can be powerful.  A company considering a business expansion would be advised to spend some time evaluating the various state incentives and contacting the EDC to see if any of these incentives are available.

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Posted by hamangpatel

The Vision Rule

August 11, 2011

By: Paul Jones

One of the more insidious clichés of the venture capital business is the so-called “golden rule,” to wit that “he who has the gold, rules.” Alas, it’s a rule that too many less experienced entrepreneurs think is, well, golden. It’s not.

The problem with the golden rule is that it is premised on the notion that start-up success is mostly a function of access to capital. Now, when you are sitting in the proverbial garage and running out of money to keep even the lights burning, it is, I suppose, understandable to think that capital is the one indispensable mediator of success. But that is the thinking of ordinary folk. Entrepreneurs are made of sterner stuff – or at least the ones who earn the sobriquet are. Because while capital may be a necessary part of entrepreneurial success, it is not sufficient. Far from it. Ultimately, capital is like fuel in a NASCAR race: something you have to have, and you have to manage carefully – but ultimately it’s the driver (the entrepreneur) and the team/car (assembled and empowered with the entrepreneur’s vision) that wins the race (that makes the business a success). It’s as much about vision – more really – than it is about gold.

Entrepreneurs – even in places where gold is scarce, like here in Wisconsin – must remember that as necessary as investors may be to accomplishing their business objectives, they, the entrepreneurs, are equally as necessary to the investors if they, the investors, expect to accomplish their investment objectives. Because there is another rule of startup success besides the golden rule; let’s call it the “vision” rule. He who has the compelling vision, rules – because without a compelling vision no amount of gold will deliver the goods for either the entrepreneur or her investors.

Now, the vision rule can be just as insidious as the golden rule if taken out of context. Then again, if a prospective investor wants to play that kind of game, well, what’s good for the goose is good for the gander. Smart entrepreneurs, though, and smart investors, don’t live in cliché land. When a prospective investor implies that without capital an entrepreneur’s vision is worth almost nothing, a smart entrepreneur doesn’t get defensive but rather parry’s with the equally valid (and equally limited) notion that without the entrepreneur’s vision the investor’s capital isn’t going to produce the kind of returns that the investor is looking for, either. Or, to put it another way, either party – the one with the vision as well as the one with the gold – can stop the game before or during the match by taking his ball and going home.

The entrepreneur who understands the vision rule should not abuse it – any more than the investor who understands the golden rule should abuse it. But when an investor does abuse the golden rule – i.e. when an investor argues that the entrepreneur’s vision is worth next to nothing without the investors gold – the entrepreneur should remind the investor (gently if possible, but more forcefully if necessary) that without the entrepreneur’s vision their would be nothing to invest in. In practical terms, when the investor tries to shift the ground of the valuation discussion to what the vision would be worth without the investor’s gold, the entrepreneur should counter that no, the debate is really about what the valuation is when the vision and the gold come together. If the investor won’t go there, well, that is a pretty good sign that the investor thinks too highly of himself, or too little of the entrepreneur – or, perhaps more likely, both.

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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

Are Video Game Companies Recession-Proof?

January 27, 2011

By: Chris Davis

Prior to becoming an attorney, I spent five years employed as a video game programmer at Electronic Arts, publisher of such game franchises as Madden and The Sims.  At that time it was an article of faith within the video game industry that video games, much like movies, were relatively immune from broad recessions.  To be sure, video game companies have their own cycles with which to contend; each new generation of consoles wrecks havoc with game sales, for example.  In theory, during a recession, consumers would use their limited discretionary funds on the relatively inexpensive sources of escapist entertainment available to them.  Historically, both movies and video games have tended to do well during recessions, at least in part, for that very reason.

The recent recession has seen commentators declaring the industry both booming and busting.  After a disappointing start, 2009 was filled with reports of layoffs and closures within the industry.  Conditions were perceived to be changing after the video game industry saw its best month ever in December 2009.  Sales this past December, however, dropped 8% from that lofty height and video game stocks have declined on the news.  What gives?

Essentially, it is just another year in the life of a game developer.  The game industry, again like movies, is fueled by consumers.  It is foolish, therefore, to believe that the industry is completely insulated from the broader economy – I imagine that people losing their house are less likely to buy a new Playstation 3.  However, as seen in the rapid game-sales cycles within the recent recessionary period, game sales are affected by a lot more than just the broader market.

As noted by video game-focused blog Kotaku, the game industry has seen a lot of closures and layoffs in the past couple of years.  This was likely due, at least in part, to developers facing reduced access to credit.  Small businesses are more likely to be damaged by a cut or reduction to their line of credit.  This is magnified in the video game industry where small studios often have only one or two games in development at any given time and may only publish a video game once every couple of years.  Recent sales numbers appear to support this theory, a larger-than-usual percentage of which came from large publishers.

Such bad news can present an opportunity for ambitious entrepreneurs.  Budding game developers, like any other new business, need a great business plan focused on keeping their overhead as low as possible.  Thanks to the recession, start-ups have access to inexpensive talent, facilities, and hardware – all waiting to be used to realize the next great idea.  There is no better time than the present to start making video games, but remember that video games, like every other business, will be shaped by the forces of the economy.

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Posted by Chris Davis

Milestone or Millstone? Financing, that is.

January 26, 2011

By: Paul Jones

As a lawyer, I’ve counseled many an entrepreneur, and even an occasional angel or venture investor, who thought so-called milestone-based financing rounds might bridge an especially irksome entrepreneur-investor gulf on valuation.  And, indeed, if you’ve been around the high-impact startup game awhile, you are bound to have seen some of these deals done.  You might even have seen some of them work out.  But as attractive as the idea of punting on valuation and/or funding timing pending the future achievement (or not) of some pre-defined milestone can be, more than a few words of caution are in order.

The kind of milestone financing I am talking about typically looks something like the following.  An investor agrees to put in some money up front, with the valuation thereof, and/or the provision of an additional sum of money, determined at some later time, when the company has (or has not) accomplished some defined milestone(s).  In theory, this structure can be a good mechanism for bridging otherwise intractable differences about valuation and funding requirements between entrepreneurs and investors.  In practice, though, this approach can be quite problematic.

The problems with milestone funding are basically as follows.  First, the parties too often leave the definition of what constitutes achieving the milestone subject to interpretation.  Some milestones are in fact hard to define with precision.  Beyond that, precision itself in terms of defining a milestone can be problematic if, as is often the case, success or failure in achieving a milestone can take forms not contemplated at the beginning of the enterprise.  Second, and particularly where the milestone is more distant in time, market conditions can change so that one party or the other inevitably ends up feeling like they are being held to a deal that no longer makes sense.  Finally – and this, for me, is the biggest issue with milestone funding – is that what seem like the best/most pressing milestones today might be overtaken by events before they are achieved.  Most technology-based startups evolve rapidly: what looks like the best use of limited resources at, say, the first closing of a milestone financing, might look like a less than optimal use of resources a day, week, month or quarter later.  But with a milestone financing clock ticking, the various parties – founders, managers and investors – can find themselves with confused and conflicting priorities.  At best, in this situation, you will have a serious management distraction on your hands.

Milestone financing structures can be good tools in the right situations.  Considering the real world risks, however, they should be considered as if not last at least late-in-the-day resorts.  And, when used, both sides should be careful to pick milestones that can be achieved sooner, rather than later, and defined, appropriately, with precision.  And then everyone should still cross their respective fingers that the business – technology, markets, competition, etc. – stays reasonably stable at least until the milestone is achieved.

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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)

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Posted by pajones1

Beyond Madison

October 15, 2010

By: Alexander Fraser

In the 15 years I’ve been working with Wisconsin early-stage companies, I’ve always done so in the shadow of Madison.  The conventional wisdom is that Madison is the end-all and be-all of technology, innovation and entrepreneurship in Wisconsin.  And as a two-time UW-Madison graduate, you will get no argument from me on the importance of UW-Madison as a driver of research and innovation and the role played by the University and its tech-transfer and licensing entity, the Wisconsin Alumni Research Fund (WARF).  In the 20 years since I left Madison, the City and region have been transformed by the efforts of the UW-Madison and WARF and the start-up activity that has grown out of those institutions. 

The flip side of that conventional wisdom is that Milwaukee and the rest of the state lags far behind Madison in technology, innovation and entrepreneurship. But if you take a closer look beyond Madison, this State has an extraordinarily active culture of entrepreneurship and a plethora of resources for entrepreneurs.

The Madison/Milwaukee comparison is based, in large part, on the dominance of UW-Madison relative to the size of the other research universities in Wisconsin.  However, university-based researchers in southeastern Wisconsin have four major research institutions (UW-Milwaukee, The Medical College of Wisconsin (MCW), Marquette University and the Milwaukee School of Engineering (MSOE)) which assist faculty with tech-transfer, licensing and start-ups.  Combined, these institutions do not approach UW-Madison’s overall research size, but they significantly exceed $200 Million in the aggregate and have actively been looking for ways to collaborate in research and commercialization.

UW-Milwaukee, in particular, has dramatically increased its focus on entrepreneurship through the creation of the UW-Milwaukee Research Foundation (UWMRF) and the significant investment by the University in new faculty hiring – particularly in the School of Engineering.   In the four short years since creating UWMRF, invention disclosures, patent, licensing and start-up activity are dramatically up at UW-Milwaukee, and I can tell you from my work with UWMRF that the research conducted at UW-Milwaukee is both groundbreaking and commercially valuable.  Long-term, these efforts will spin-off start-up companies which create jobs, wealth and new start-ups, through the sale of those start-ups to larger companies.  A recent example is the sale of an MCW start-up, Prodesse, to Gen-Probe.  Many of those investors are busy reinvesting sale proceeds in new Wisconsin-based start-ups.

Outside the university context is where it gets interesting (and from the entrepreneur’s standpoint, unconventional).  For many years, “conventional” organizations like the Greater Milwaukee Committee (GMC) and the Milwaukee Metropolitan Association of Commerce (MMAC) have been working on economic development for the region by creating organizations which directly impact entrepreneurs and early-stage companies.  Examples are the creation by the GMC and MMAC of the “Milwaukee 7” to foster economic development within the seven county southeastern Wisconsin region.  In turn, these three groups and their members spawned the Milwaukee Water Council and BizStarts Milwaukee, each of which (in very different ways) focus on research, economic development and the promotion of new business.

More recently, the Wisconsin Energy Research Consortium (WERC) was launched to foster research, collaboration and economic development in the energy, power and controls fields. WERC includes university partners (UW-Madison, UW-Milwaukee, Marquette and MSOE) along with some of Wisconsin’s leading energy, power and controls companies (including Rockwell Automation, Johnson Controls, WE Energies and American Transmission Company).  WERC and the Water Council are unique models nationally – what makes them most exciting for the region is the way they attempt to leverage traditional areas of the region’s strength in “old school” manufacturing as way to promote new business initiatives based on technology and advanced manufacturing.

On the funding side, the market for funding for early-stage companies in southeastern Wisconsin has never been more active – Silicon Pastures and the Golden Angels have been active in the area for many years, and remain so today.  More recently, Capital Midwest Fund and Successful Entrepreneur Investors have launched financing resources for very early stage companies.

Every region has its strengths and weaknesses.  While it is true that the academic research dollars in Southeastern Wisconsin are not as plentiful as in Madison, we do have strong research universities and the research dollar gap with Madison is shrinking.  Where Milwaukee really distinguishes itself in the state is through the use of its more traditional resources – partnerships with industry in particular – to leverage our growing university research.  So as an entrepreneur, you sometimes need to look beyond the obvious resources and get the broader picture of what exists in your region.  Here in Southeastern Wisconsin, those resources are plentiful and growing, and the excitement surrounding our region’s approach to entrepreneurship is palpable.

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Posted by apfraser

The Startup Business Plan

September 7, 2010

By: Paul Jones

Recently, Paul Jones, Of Counsel to the Business Practice Group and a member of the Venture Best team, gave a presentation on “The Startup Business Plan.”  Click here to view the presentation.  In this presentation, Jones focuses on the basic observations and the substance of early stage venture capital business plans.

To view the presentation, click the play button.

Part 1 (of 4)

Part 2 (of 4)

Part 3 (of 4)

Part 4 (of 4)

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Posted by Lauren Falk

Employee Non-Disclosure Agreements: the Unreasonable Requirements to make them Reasonable

September 1, 2010

 By: Craig Johnson

At a recent Venture Best meeting we were discussing the substance of the set of documents every startup company needs.  One such fundamental document to make the list was an Employee Non-Disclosure Agreement (“Employee NDA,” also commonly called a Confidentiality Agreement) wherein your employee agrees to maintain the confidentiality of sensitive information of your business (a non-disclosure agreement can apply to many situations but this article focuses on its use in restricting employees’ ability to disclose information).  You probably didn’t need a lawyer to tell you this was an important protection to have in place. 

Yet, it might surprise you that this fairly universal and conceptually simple agreement is subject to many formal requirements under Wisconsin law.  The formal constraints stem from a Wisconsin statute (Wis. Stat. § 103.465) limiting the enforceability of employee restrictive covenants, including non-disclosure agreements.  As interpreted by the Wisconsin courts a valid restrictive covenant must: (1) be necessary for the protection of the employer; (2) provide a reasonable time period; (3) cover only a reasonable territory; (4) not be unreasonable to the employee; and (5) not be unreasonable to the general public. 

These constraints make sense as applied to a Non-Compete Agreement.  For example, it is reasonable to prevent a grocery store manager from taking a similar job with a competitor located across the street, but less reasonable if that competitor is located 100 miles away.  The first situation involves unfair competition whereas the second is merely competition.  Wisconsin courts take the position that a mobile workforce is good for the state, as long as that mobility doesn’t cross into unfair competition.  The grocery store should come up with incentives to keep its manager, such as a good salary, other than contractually limiting her ability to advance her career. 

Wisconsin courts apply the same test to Employee NDAs.  These requirements make a whole lot less sense in this context.  Should there really be a time limit on not being able to disclose confidential information?  It might hurt your business less if an employee can’t tell your competitor everything right away and instead has to wait two years, but it will still hurt and be unfair.  Also, how do you create a limited geographic scope on the Employee NDA?  It doesn’t make any difference to you if your former employee discloses the information across state lines, over the internet, or in your backyard. 

As if these seemingly irrelevant requirements weren’t enough to worry about, the Wisconsin court will also look at your restrictive covenant and: (1) automatically deem it suspect; (2) closely scrutinize it; (3) construe it so that it does not extend beyond a proper scope or further than absolutely necessary; and (4) construe it in favor of the employee.  Then, it will make you prove the length of restriction is reasonable rather than make the former employee prove it is unreasonable. 

We should point out that your sensitive information is not as hopelessly vulnerable as it may sound.  For example, a restrictive covenant in the context of a sale of the business is viewed more leniently.  Also, there is some precedent recognizing a geographic scope on an Employee NDA doesn’t make any sense and allowing other terms to substitute for it.  Finally, any information that meets the statutory definition of a “trade secret” is automatically protected, regardless of whether you have an agreement or not, until that information is no longer a trade secret.  Unfortunately, meeting the standards for a trade secret has its own set of challenges, and you and the court might not agree on whether something qualifies as a trade secret or whether you made efforts to protect it.  Therefore, you should always separate and preserve trade secrets in an Employee NDA.

The bottom line: your Employee NDA has to be a carefully drafted document that addresses all of the requirements of Wisconsin law, however seemingly ill-fitting and unpredictable.  An ambiguous reference to a geographic scope will demonstrate an appropriate deference to the law, as will defining the categories of information covered and the prohibited recipients of the confidential information.  An exercise in form over substance?  Yes, but more importantly, also a legally enforceable Employee Non-Disclosure Agreement.

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Posted by craigjjohnson

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