Why Almost Every Startup Needs a Business Plan (Lean Startups, Too)

February 13, 2013

By: Paul A. Jones

Venture Best Co-chair, Paul Jones, was approached by Technori to regularly contribute to their weekly blogs.  Technori is a publication that gives real and accurate accounts of what it’s like to start a company, detailing both the good and the bad, they are committed to profiling and celebrating the people behind the leading companies.

Jones’ first blog, Why Almost Every Startup Needs a Business Plan (Lean Startups, Too), was posted to the Technori site on January 31, 2013.  Please see the link below to view the full article.

Why Almost Every Startup Needs a Business Plan (Lean Startups, Too)

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Posted by pajones1

Social Media: Reap the Rewards While Avoiding the Pitfalls

March 8, 2012

By: Jeffrey D. Peterson

Facebook, Twitter, Linkedin and other social media sites are becoming standard tools for businesses to market their services and communicate with their customers. Social media sites can be powerful tools for companies to promote their brands, provide word-of-mouth marketing, and allowing direct communication between the company and its customers. While social media sites provide many potential benefits, they also come with associated risks that companies should be prepared to identify and manage.

The first thing a company should be aware of is to make sure its specific social media pages are compliant with the terms of use and privacy policies of the social media providers that govern the use of the site. Most social media sites have prohibitions against posting material which infringes the intellectual property of others, defamatory material or material posted by minors. Companies should make sure that its own postings and materials posted on such sites are compliant with these terms. Companies should monitor usage on social media platforms, especially when customers are allowed to post to the company’s social media pages, to insure that the customer is also complying with the terms of usage. Additionally, monitoring of the company’s social media pages should be done to examine if any posts contain defamatory or negative statements about the company on the page.

Another pitfall to be aware of are testimonials and endorsements a company may use or post on their social media site. The Federal Trade Commission has indicated that companies are subject to liability for failing to make material disclosures relating to any endorsement relationship between an endorser or testimonial and the company. Therefore, if the endorsements or testimonials on a social website are in some way controlled or sponsored by the company this relationship needs to be disclosed.

Another area in social media that companies must be vigilant of is the social media activities of the employees of the company. Apart from simple efficiency losses, due to personal use of social media by employees during work hours, companies should be vigilant about possible leaks of confidential or proprietary information by their employees about company practices, policies and plans on these websites.

A helpful tool for companies to manage their usage of social media, is to develop a social media policy for the business. The social media policy should serve a number of functions. First, it should provide guidelines on how and what type of material the company should distribute on the different social media sites. Secondly, it should provide a monitoring protocol for the social media sites of a company to make sure that the sites are in compliance with the terms and conditions of the site providers, and that the third-party material posted to the sites are also in compliance. Thirdly, the policy should have an action protocol in place for dealing with non-compliant posts of third parties on the social media sites, including a simple request from that can be sent to the social media hosts to take down any non-compliant posts, and canned statements to the users of such sites addressing such non-compliant activity (such as defamatory statements or use of infringing intellectual property). Fourthly, a company should have a protocol in place for dealing with harmful statements made about the company or its products on the website. Fifthly, a company should have policies on its employee’s use of social media sites in relation to company information to protect against the inadvertent release of confidential information

By developing a social media policy and how a company handles its own social media, monitors the social media of others with respect to its company and how its employees deal with social media, a company can manage and avoid all the pitfalls associated with social media activities.

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Posted by jdpeterson2

Don’t throw the baby out with the bathwater

December 2, 2011

By: Gregory J. Lynch

Ronald Bailey has criticized the federal government’s loan guarantee provided to Solyndra (“With a Government-Funded ‘Success’ Like This What Does a Government-Funded Failure Look Like” Reason Magazine, Sept. 1, 2011). While it may be easy to attack a decision that ultimately turns out to be wrong, it is important also to highlight the successful government investments, especially in basic research, that have played a critical role in the American innovation engine that has been for some time now the envy of much of the rest of the world.

View the complete blog at IBMadison.com’s Open Mic page.

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Posted by Gregory Lynch

IRC 409A: Good Faith is Good, but not Good Enough

November 1, 2011

By: Paul A. Jones

From very early on, one of the distinguishing features of the Silicon Valley school of innovation was the notion that virtually every one on the team – from the receptionist at the front door to the founders in the corner office – should have a stake in the success of the venture. While founders and in some cases other very early employees often acquired their “sweat equity” in the form of common stock, most later employees got their “upside participation” in the form of options to purchase common stock – typically at a price substantially less than the price paid for shares of preferred stock by more or less contemporaneous venture capital or other sophisticated investors. How much less? Well, therein lies a tale; alas, an increasingly frightening tale in recent years.

By way of background, in the good old days of sweat equity pricing – say, before 2004 (more on that later) – the task was in principal more or less what it is today. The option exercise price was supposed to be set at the fair market value of the common stock on the date the option was granted. The “technical” problem of figuring out fair market value was as much ritual as science: the process typically culminated in a boilerplate board resolution that implied a timely, exhaustive, good faith effort by the board – that in reality was mostly driven by rules of thumb. Among those rules, the “common is worth 1/10th the preferred at the time of a first round venture financing” was one of the most popular. Life was more or less good for founders, employees and investors alike. As for the IRS, well, if you stuck to the rules of thumb and backed it up with the appropriate boilerplate, the IRS generally looked the other way.

And then came 2004, and Internal Revenue Code Section 409A, and the game was up. Valuation rules of thumb were out (bad enough) and the cost of getting it wrong went way up (much worse). Whereas in the good old days a board could be pretty confident that using a rule of thumb to set the valuation (albeit dressing it up in the board resolutions) would keep the IRS agents away, these days a board often does considerably more than that if it wants to sleep well at night, IRS-wise. First, because 409A essentially eliminated using rules of thumb to determine fair market value in favor of some very particular – in terms of factors to be considered in setting a valuation and who should do the considering and how often – guidelines. Second, because the cost of getting it wrong (in the old days mostly theoretical if occasionally somewhat problematic from an accounting perspective in an exit transaction) went up. Way up. For the employee, the company, and potentially even the individual members of the company’s board of directors.

Okay, first to the valuation question. 409A provides (in broad substance: this blog is a business heads up, not a comprehensive or even summary legal analysis) a specific list of factors that must be considered in making a valuation determination. It also provides specific criteria as to who can do the valuation analysis if you want the IRS to take it seriously. Alas, for most venture-backed companies the folks that qualify under the criteria are generally independent,  appropriately experienced, and expensive (say $5k to $50k depending on stage of development of the business and complexity of the capital structure) professional appraisers. Follow the rules (i.e. absorb the expense) and you can be reasonably (if not totally) certain that the IRS will find better ponds to fish in than yours. Don’t follow the rules, and ….

What can happen if you mess up a 409A valuation? It’s not pretty. Let’s take a hypothetical, and to make it both simple and less scary, let’s start with what happens if an employee is granted a vested option to purchase a single share of common stock at an exercise price of $1.00, and that the IRS later (say 12 months later) decides the fair market value was $3.00. Well, first the employee is on the hook for not paying federal and state taxes on the $2.00 difference between the option exercise price of $1.00 and the IRS determined fair market value of $3.00. Oh, and on top of that a 20% penalty tax and likely interest. And in some states, like California, an additional 20% penalty. And the company – and if the company can’t come up with the money, the various directors of the company personally – are on the hook for the unwithheld withholding taxes on the $2.00 – over and above the cost of redoing the accounting books to reflect the added compensation expense. Ugly, indeed.

And, of course, it gets worse. Because in most cases stock options vest over time; that is, an award of say 1,000 option shares might vest over four years. At each vesting date, figure out the difference between the exercise price and the then fair market value and repeat the calculation for the shares that vested. Even uglier.

So it looks like directors of venture backed companies that want to sleep well at night need to comply with 409A, such compliance most likely to include spending scarce corporate cash resources on periodic (at least every 12 months, and in many cases more often than that) professional appraisals of their common stock. Among the prices we pay, I guess, for living in a post-Sarbanes-Oxley world.

An important footnote. Some entrepreneurs and investors take the view that the fair market value exercise price problem posed by 409A can be avoided by simply setting the option exercise price at least equal to the then preferred price. That’s true, if perhaps too clever. If you live someplace where likely employees don’t understand the value of having an option exercise price below the current investor preferred price, well, good for you (not really, but that is another story). Except that if you ever find yourself needing to bring on board a key player who does understand the difference you are going to have a problem figuring out how to explain to everyone else why their options are priced higher than the new guy’s.

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Posted by pajones1

Convertible Debt Financing: Thoughts on the Default Conversion Price

October 25, 2011

By: Paul A. Jones

Convertible debt financing structures, with or without equity kickers, are a popular choice for many seed stage entrepreneurs and investors.  (Disclaimer: this blog is about first money in seed investments, and not about the many other situations where convertible debt structures can be profitably employed.) The ability to punt on the contentious and often problematic valuation issue until some combination of greater opportunity visibility and/or attracting larger post-seed investors to the table can be very attractive to the entrepreneur and seed investor alike. However, while the concept is based on the notion that a valuation will ultimately be established in the context of a future, larger round of equity financing, what happens if no such round ever takes place? Presumably, the seed investor will want to have the option to convert at some valuation (to participate in the upside) – without being obligated to convert to equity at any valuation (to protect on the downside). It thus seems that while convertible debt financing makes the valuation issue at the seed stage less contentious than it might otherwise be, it doesn’t completely remove valuation from the negotiating table. The entrepreneur and seed investor will still have to agree on a default conversion valuation if the anticipated post-seed “conversion trigger” financing doesn’t, for whatever reason, happen.

Before talking about the default conversion valuation, let’s consider when it comes into play. A typical seed convertible debt financing anticipates that there will be a larger downstream “conversion trigger” financing, with the valuation in that financing serving as well as the valuation for conversion of the seed debt. Usually, entrepreneur and seed investor alike put a lot of thought into how big the future finding has to be to trigger conversion of the debt. While each party may have its own ideas on what the trigger valuation needs to be, those ideas are more often than not relatively easy to bridge. Both sides will want a trigger financing to be big enough (particularly if there is an equity kicker associated with the convertible debt) to assure that the “convertible tale does not wag the trigger investment dog” so to speak. And both parties will presumably have some more or less similar ideas on at least the minimum amount of next round capital the business will need to get to the round after that (or exit, if you are an incurable optimist).

But there is a more subtle piece of the trigger financing question. How long does the company have to pull it off? Put differently, besides defining the amount of capital that must be raised to trigger conversion of the seed convertible debt, you also have to set an outside time limit on that financing: a time after which, if no trigger financings has occurred, the seed convertible debt will have the option to convert at the default conversion valuation. On that score, sooner is better for the seed investor and later is better for the entrepreneur – but at the end of the day, the entrepreneur should not rush into a short fuse no matter how certain she is that the trigger financing will happen sooner rather than later. In my experience, most seed investors will accept a 12-18 month time frame for the trigger financing, and, well, the longer the better.

Finally, we get to the heart of this blog. Given that higher is always better for the entrepreneur, and lower is always better for the seed investor, how should the parties approach setting the default conversion valuation?

Let me cut to the chase and then circle back on the rationale. In my experience, a good default conversion valuation is one that will, if the seed investor decides to convert at that time/price, result in a fully-diluted ownership stake in the 10-20% range. If that sounds arbitrary, well, it is. But capricious it is not. Here’s why.

Lets start by predicting the future of the entrepreneur’s business, focusing on just those futures that are most likely if you assume that no conversion trigger financing ever takes place. It seems to me that the vast majority of such futures will fall into one of two buckets. Either the business the business tanked without ever getting additional financing, or the business took off without needing additional financing, or. In the later case, the seed investor will not want to convert, it being all but certain that remaining in their creditor position will maximize the amount, if any, of their investment that is recoverable. And this should be fine with the entrepreneur (who, of course, was wise enough not to sign any personal guarantees (which, if you think about it, makes sense – but that is a digression).

So what about the case where the business became wildly successful, without ever needing to raise additional equity capital? Shouldn’t, in that case, the entrepreneur fairly expect a very high valuation for the conversion of the seed debt?

In theory, yes, but lets look at the practicalities of the assumed outcome. The entrepreneur will, in my 10-20% dilution scenario, find themselves with 80-90% ownership of a business that, short of an exit transaction (or perhaps bank or other non-dilutive financing), by definition does not need additional equity capital. Sure, at a higher default conversion valuation, they would own an even bigger piece of the pie. But at some point, shouldn’t the entrepreneur ask herself something like the following question: “Just how rich does the seed investor have to make me before I will be satisfied – given that the seed investor’s money is what got me all the way home, and that my expectation going into the seed round was that there would ultimately be a lot more than 10-20% dilution before we got home?”

Now, every situation is different, and there are situations where my 10-20% default conversion rule of thumb may not be the “right” answer (whatever that is). But it does seem to me that an entrepreneur who hits a home run so much faster, and with so much less risk capital than even she thought possible, well, she ought to be able to share a little of her good fortune with the seed investor who made it possible.

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Posted by pajones1

Steve Jobs: Concept Precedes Design

October 11, 2011

By: Paul A. Jones

Among the many tributes to Steve Jobs on his passing, perhaps the most common theme is the man’s prowess as a designer. And, indeed, from the Mac to the iPod to the iPhone to the iPad (if not so much Newton, or Lisa, or iTV, or …) Jobs’ talent for matching form to function was nothing short of astounding. Asking his successors at Apple to maintain the standards he set is asking a lot. But for arguments’ sake, let’s assume they can do it.

Unfortunately for Apple, meeting the design challenge will only get them part way home in terms of living up to their now departed leader’s legacy. Because as good as Jobs may have been as a designer, he was even better as a conceptualizer: which is to say, his conceptual prowess was at least the equal of his design flair, and while I can – well, sort of– imagine that Jobs’ successors at Apple can design a better iPod, iPhone and iPad, I really struggle with the idea that they will be able to conceive of the next, well, iNext. And, ultimately (which is to say probably within a year or two or maybe three at the outside) Apple will have to come up with a compelling iNext to keep the Apple juggernaut on top of the tech world for the next few years after that.

Design, ultimately, is a craft, and Jobs was a superb craftsman. The ability to conceive something utterly new in function as well as form, on the other hand, is the mark of true genius. Making a better iPad is a big task, but not as remotely challenging as conceiving the notion of the iPad in the first place. Even conceding that Apple has the talent to live up to Jobs’ standards in the design of the next iPhone, it strains credulity, I think, to believe that anyone at Apple can match Jobs standards and timing in conjuring the iNext.

Look at it this way. Suppose you had to rank three teams in terms of how likely each was to conceptualize a blockbuster iNext. Team one was the Apple team with Jobs. Team two was Jobs, and team 3 was the Apple team without Jobs. Go ahead, rank them. Doesn’t your ranking (we all came up with the same ranking, right?) tell you something about Apple’s likely longevity as the center of the consumer technology universe – or at least as the most valuable company on the planet?

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Posted by pajones1

2011 Patent Audio Conference Series: What You Need to Know About the America Invents Act

October 6, 2011

Recent patent law reform legislation brings sweeping changes to the patent system in the U.S. Some of the key provisions include the change to a first inventor to file system, the addition of new post grant review proceedings for challenging patent validity, a prior user defense to infringement, and modifications to the patent marking statute. Learn the details of these and other changes, when they take effect, and how they impact your operations.

Click here to listen to the audio conference.

For more information on this event click here.

Click here for a listing of our upcoming events.

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Posted by jadurant

Entrepreneur of the Century or Company of the Century: Pondering Steve Jobs and Apple

August 29, 2011

By: Paul A. Jones

With Steve Jobs passing the reins at Apple (well, sort of: my guess is that he will be more active than the average Chairman of the Board) two main streams of analysis of the move have emerged. On the one hand, there is the not unexpected almost worshipful take on his career and his genius. On the other hand, there has been a pretty consistent message that “hey, Apple’s future is golden even without Steve.” Does anyone else think these two messages – Jobs as Second Coming and Apple as continuing master of Wall Street – are a bit, well, incongruous?

If Steve Jobs really is as brilliant as everyone seems to think (yours truly included) how can anyone seriously think that his departure from Apple will not herald a new era of diminished success for Apple? I mean, Tim Cook seems like a good manager – even very good – but is he a genius on the level of Jobs? If not, either Jobs being a genius wasn’t a material factor in Apple’s rising to the top spot in the business world, or, well, maybe he isn’t a genius. But he clearly he is a genius.

Genius to genius hand-offs are in the real world are pretty rare, and it seems to me especially so when you talk about genius in terms of softer skills like design, vision and negotiating prowess – the kind of skills Jobs is justly heralded for; and the kind of things that are pretty much universally acknowledged as the foundation of Apple’s success. I can’t recall ever having read an article lauding Apple’s manufacturing prowess, or its financial engineering, though doubtless at least a few such articles have been written. Frankly, in the business world, none come quickly to mind, andMontanato Young and Favre to Rodgers in the sports world seem more like exceptions that prove the rule than repeatable models.

Perhaps, though, there is a third alternative. In “Outliers: The Story of Success” Malcolm Gladwell posits that truly exceptional achievers in any field are the products of a combination of great skill and great luck. Anyone who knows the key twists in the emergence of Microsoft knows the peculiar mix of ability and good fortune that transformed Bill Gates from a modestly gifted programmer to one of the richest men in the world. Maybe luck is the real story at Apple, not Jobs?

I don’t think so. For one thing, while I am sure Apple got some breaks over the course of time, I can’t think of any on a par with the break that came Microsoft’s way with IBM and DOS. But even if luck was a big factor in Apple’s return from the dead under Jobs, does past good fortune make it any more likely that Apple can keep up the pace, so to speak, in the post-Jobs era? Unlikely: getting lucky, by definition, is not (with due respect to the cliché that the harder you work the luckier you get) something you can plan for.

So, it seems to me that if you can’t assume genius will follow genius, and that luck will follow luck, you can’t, I think, really believe that Apple’s success over the past decade can be repeated in the coming decade. Just as it was, in 1997, absurd to predict that a struggling Apple would over the next dozen years go from needing a handout from Microsoft to overtaking Microsoft in the hearts, minds and pocketbooks of consumers and investors alike, so, I think, it is ultimately folly to predict that Apple’s success over the past dozen years will be replicated in the next dozen. Check back in, say, 2022 and see if I am right.

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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

Patent Rights and Attracting Investors

May 25, 2011

By: Ivan T. Kirchev

It is very important for startups, entrepreneurs, and small companies to protect their intellectual property rights. Creating a patent portfolio (or even several pending patent applications) will improve the company’s ability to attract venture capital financing. Typically, investors are faced with different uncertainties when they evaluate a startup and they often rely on patents (or pending patent applications) as indicators for calculating the company’s potential. For that reason, startups, entrepreneurs, and small companies have to understand not only the patent application process, but the patent assignment processes as well.

Correctly assigning the patent rights of an invention to the company should be as important for a startup as is filing patent applications or acquiring patents for its core technology or business model. A patent assignment is a transfer or sale of the entire interest in a patent. In other words, all rights that were originally granted to the patentee will transfer to the assignee. Generally, patent assignments can be made during the application process, or after a patent issues. It is recommended that patent applications be immediately assigned from the inventor(s) to the company so that the company can control the prosecution of the application and can add the patent (when issued) to its portfolio. Although recording an assignment with the USPTO is not required, recordation can protect against confusion as to the true owner of the patent.

A company’s patent portfolio is crucial to its ability to attract investors, and therefore a company should make sure that all patent rights are properly documented and assigned to the company. Before investing in a startup or a small company, investors typically conduct due diligence to investigate ownership, chain of title, product marking practices, maintenance fees, and litigation issues relating to the company’s patents. Startups, entrepreneurs, and small companies should be aware of some ownership issues related to their patent rights. There are several issues that can impact a company’s ownership of patent rights:

  • Incorrectly drafted employment contracts. Generally, employment contract bind an employee to assign all inventions and discoveries within the scope of employment to the company. However, some employment contracts fail to include such provision.
  • Absence of employment contracts, and rights of co-inventors. In the absence of an employment contract or an agreement with each inventor addressing the assignment of an invention, each co-inventor or prior assignee retains the right to practice, and perhaps assign, the invention without compensating or even notifying the other co-inventors or assignees.
  • Rights of former employers. Many startups are founded by former employees of other, typically larger companies. If this is the case, the prior employment contracts of the founders and inventors of patents and applications should be examined for provisions that allow a former employer to assert rights in the company’s IP or provisions that limit the former employee’s ability to compete in its technology and market areas.
  • Rights of universities. Because many startups are based on technology that is first developed by professors or graduate students, agreements between universities and inventors of that technology should be studied to ensure that a university cannot assert rights in the company’s IP.
  • Rights of the government. A company funded by the government should be aware that the government might retain rights in a patented invention resulting from the government support.
  • Rights of spouses. When a company is owned by both spouses, it is very important to decide and understand who owns the majority shares of the company and, therefore, rights to the company’s IP. For example, if the spouses get divorced the person who owns more shares of the company’s stock can ultimately receive ownership rights of the patents and the entire company.

In summary, potential investors not only evaluate the intellectual property assets of a startup (e.g. patents, etc.), but they also examine the assignments of the patent rights of these companies to ensure that the core technologies of these startups are protected with patents correctly assigned to the companies. An entrepreneur or a startup company should accordingly be aware of the importance of intellectual property rights protection and proper assignment of these rights.

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Posted by itkirchev

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