Selling the Wisconsin Corporation — Good News for Directors

February 9, 2012

By: Michael H. Altman

On January 26, 2012, a three judge panel of the Seventh Circuit Court of Appeals determined that the directors of Ladish would not have liability for approving the $778 million sale of the company to Allegheny Technologies Inc., despite a plaintiff’s claim that Ladish directors failed to disclose material information in the proxy materials.  The plaintiff shareholder argued that Wisconsin’s business judgment rule does not apply to public statements and material omissions, because of a separate “duty of candor” outside the business judgment rule.  The appeals court panel rejected this argument.   

Under Wisconsin law, as in most states, a board’s decisions are governed by the business judgment rule, which recognizes that boards, rather than individual shareholders or the courts, are best positioned to make complex business decisions.  Therefore, as long as a board acts in a manner consistent with the exercise of honest discretion, its decisions will be given deference.  Wisconsin has codified this rule in a statute (specifically Wisconsin Statute §180.0828), which specifically shields directors from liability for failure to perform “any duty” that a director owes to the corporation or its investors, except only in limited listed situations involving a breach of a director’s duty of loyalty or willful or intentional misconduct.

Despite the Ladish plaintiff’s claim, the appeals court found that “any duty” as used in the statute is as applicable to a board’s “duty of candor” as it is to the general duty of care.  In other words, Wisconsin’s business judgment rule does not allow an award of damages to shareholders unless they allege willful or intentional misconduct or breach of the duty of loyalty, which the Ladish plaintiff failed to do (and which is, of course, much more difficult to claim or prove).

 Some states, including the common business state of incorporation Delaware, provide further exceptions to the business judgment rule in the context of a sale of the business (we lawyers sometimes call these “Revlon” duties, after a 1986 Delaware Supreme Court case, or in analyzing defensive measures, “Unocal” standards, after a 1985 decision).  The Court of Appeals panel in the Ladish case specifically rejected the plaintiff’s contention that Wisconsin would follow these Delaware decisions which would have provided a higher obligation than the simple business judgment rule in the sale context.  The panel’s decision reinforces that, when evaluating corporate merger transactions (other than those that implicate duty of loyalty concerns or willful or intentional misconduct), a board’s decision to enter into a merger transaction is governed by the business judgment rule and Wisconsin Statute §180.0828, plain and simple.   This is good news for directors of Wisconsin-incorporated businesses.

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Posted by rygray

Venture Capital and Private Equity: The Same, Only (Very) Different

February 3, 2012

By: Paul Jones

If you’ve followed Presidential politics of late – and as much as I want to look away I find myself gawking at a freeway pileup – you have no doubt heard a lot about private equity and venture/vulture capital. The good news is that much of what you have heard is not true; which, I suppose, is also the bad news. Herewith a brief attempt to provide a little clarity.

First, in a very technical sense, venture capital (VC) is a kind of private equity (PE). Both terms refer to pools of capital assembled by professional management/investment teams from wealthy individual and institutional investors in private offerings. However, in a practical sense, the VC business is fundamentally different from the PE business. As for “vulture capital,” the term is more of a slogan than a description of a business, but to the extent it somehow describes a business strategy it more often than not makes its appearance in the PE world.

Now, VC and PE investors are both out to make money; in fact, they are both out to generate returns that exceed the returns typically available in public securities markets. They both look to generate those returns by investing in businesses with higher risk/reward profiles than those that make up the vast bulk of securities on the major public stock exchanges. But as to how they expect to generate those returns, VC and PE are typically worlds apart.

Fundamentally, VCs make money by building new businesses. PE investors, on the other hand, generally make money by restructuring existing business. VCs are “clean slate” investors in the sense that they typically invest in young businesses with little or no track record with the expectation that those business will become “the next big thing.” Think Google, as an example of a VC deal that worked, and, say PetCo as a VC deal that failed. PE investors, on the other hand, generally invest in established businesses that have fallen on hard times, or are otherwise perceived as not performing to their potential. Think Hertz as a PE deal that worked and, say, Sears as a PE deal that (so far) has not worked very well.

Some more differences. VCs typically do not assume operating control of the businesses they invest in. They are active investors, to be sure, but fundamentally investors, not managers. PE investors, on the other hand, typically see themselves not as supporting but rather as taking over management of the businesses they invest in. VCs typically invest in businesses with no debt, or in later stage investments with limited debt. PE investors, on the other hand, usually leverage their equity investments by having the business take on debt that substantially exceeds the amount of equity the PE firm invested. Thus, most PE investments are in the form of “leveraged buyouts” or “management buyouts.” Finally, if and when a VC-backed company achieves an exit for its VC investors, the company will almost certainly employ more people, usually a lot more people, than when the first VC money was invested. In contrast, if and when a PE-backed company achieves an exit for its PE investors, the business will more often employ fewer people than it did when the PE investors first entered the picture.

While I have spent most of my career in and around the venture capital world, I am not going to argue that VC investing and investors are somehow better or worse than PE investing and investors. They both have their place, which, I think, can be summarized as follows: VC is about creating new value in new vessels, while PE is about salvaging value otherwise locked up in old, deteriorating vessels. The strongest economies excel at both.

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Posted by pajones1

Corporate Venture Capital: An Entrepreneur’s Perspective

January 16, 2012

By: Paul A. Jones

While never a dominant part of the venture capital industry, corporate-sponsored venture capital investors (think for example AOL Ventures) have long been an important part of the industry.  Entrepreneurs thinking about seeking venture capital should, preferably at the beginning of the quest, consider whether they want to seek, or will even consider, corporate venture capital.  For some deals, corporate venture capital is a priority; for most it is an option; and for some, it might be a last resort.  Herewith, some of the issues to consider.

Corporate Venture Capital as Deal Validation.  Generally, the more technology risk a deal has, the more attractive corporate venture money is, all the more so when the expected amount of pre-revenue capital needed and time to market are greater. Corporate venture capital is often a plus, for example, in biopharma deals, where technology risk, capital needs and time to market are huge.  Getting a corporate fund in a deal sends a powerful due diligence signal to all but the highest tier traditional funds (they are as a rule less impressed by third party due diligence) that the science passes the blush test.  On the other hand, deals where time to market, technology risk and risk capital requirements are not so great – say, a niche social networking concept – are not likely to get as great a validation enhancer across as broad a range of traditional funds.

Corporate Venture Capital as Lead Investor – Usually Not.  As a rule, corporate funds don’t make very good lead investors.  First, while a corporate fund can be a nice validator, getting too close to a corporate fund can make doing business deals with companies that compete with the corporate fund’s parent harder to do.  If “Competitor A” is your lead investor, “Competitor B” will be understandably more cautious about doing a deal – or even sharing information – with you than if Competitor A is only a follower in the deal.  Further, remember that most corporate funds (there are exceptions: ask) are not “pure return” investor, and thus is not in a good position to set the price – which is one of the important things the lead typically, well, takes the lead on.  (Traditional funds will – quite correctly – discount an entrepreneur’s assertion that a price agreed to by a corporate fund is a fair price, particularly if the corporate fund is not a pure return investor.)

 Corporate Venture Capital: The People Difference.  Not to say that there are not exceptions, and not to say that corporate venture capital professionals are not exceptional in their own corporate worlds, corporate venture capitalists are as a general rule not the brightest bulbs in the venture capitalist universe.  First, compensation at most corporate venture capital firms is generally not as generous/aggressive as at traditional funds that don’t have to “fit in” to a broader corporate compensation system.  If traditional venture capital firms pay more, you would expect they would attract the best people.  Second, corporate venture capitalists, while needing, of course, to earn the confidence of senior corporate managers, don’t have to go through the hurdle of successfully selling themselves to a typically fairly large group of sophisticated investors who specialize in evaluating venture capital professionals as traditional venture capitalists do.  Finally, most traditional venture capitalists – certainly the stereotypical venture capital professional – are folks with big egos who like to make others fit to their rules rather than vice versa.  That’s a personality profile that doesn’t generally fit very well in  below C-level jobs in big business management cultures.  

Corporate Venture Capital:  Here Today, ….  Whether considering a relationship with a traditional or corporate venture firm, one criteria, of course, is how long a fund team  has been around: generally, fund teams that have managed several funds across several investing cycles are more desirable investors than less experienced funds. While there are notable exceptions, corporate venture capital funds don’t as a rule have the staying power of more traditional funds, as in addition to the performance hurdles all funds must overcome to stay in the business over the long haul, corporate funds have some of their own longevity issues.  For example, being pieces (usually small ones at that) of much larger enterprises, corporate funds are subject to the whims of senior management teams that at most companies blow hot and cold on venture capital investing, depending on short-term earnings pressures and more broadly shifting management priorities over the corporate cycle and as senior managers come and go.  Entrepreneurs considering venture capital should, to the extent possible, try to focus on corporate funds that have demonstrated both some staying power and some real success (which, of course, are also good criteria for evaluating competing proposals from traditional venture funds, too).

As noted, corporate venture capital is an important if relatively small part of the broader venture capital industry.  There are, as with traditional venture capital funds, good corporate venture investors and not-so-good corporate investors.  The ideas noted above are offered not as hard and fast rules – for all of them there are exceptions – but rather as a framework for analysis.  An analysis that entrepreneurs are wise to undertake before launching a campaign for venture capital funding.

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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

Venture Capital: Preliminary Questions for Entrepreneurs

August 8, 2011

 By: Paul Jones

The Venture Capital industry has been a critical component of the high impact business scene in the United States for fifty years.  It is hard to imagine a Silicon Valley anything like today’s without recognizing the critical role venture capital and venture capitalists have played in creating and sustaining it – “it” being an innovation engine of unmatched impact anywhere else in the world, and one that, gradually, is infiltrating other parts of the nation and globe.  And yet, many entrepreneurs are deeply suspicious of the industry and its practitioners.  Many entrepreneurs, including even a few who have, or at least seemed to have, benefited from working with venture capitalists, talk about the industry with terms like “vulture capital” and “vulture capitalist.”  What goes on here? 

As a serial venture-backed entrepreneur, venture capitalist and counsel to dozens of entrepreneurs and venture capitalists over a twenty-five year career in Silicon Valley, North Carolina and Wisconsin, my own take is that while there are surely bad actors in the venture capital community – as there are in any community, including the entrepreneurial community – most entrepreneurial animus for venture capitalists is based on misconceptions about the role and modus operandi of venture capital in the innovation process.  My own experience suggests that many (not all, but many) of the venture capital horror stories told by entrepreneurs involve deals that never should have been made at all: deals made by entrepreneurs who saw the capital but not the strings attached to it when they made their venture capital bargain.  In the interest of trying to stop some of those foredoomed venture capital deals that shouldn’t get done from getting done in the future, here are a few things entrepreneurs should think long and hard about before even considering looking for venture capital dollars for their deal. 

  1. Venture capital is expensive.  In fact, venture capital is the most expensive form of financing out there, at least on the right side of the law.  While an early stage venture capital investor may be seeking a “modest” 3x or 4x cash on cash return on their portfolio, the implications of that kind of portfolio return mean that they are looking for at least a 10x return on any given investment in that portfolio.  It takes a couple of such “home runs” to make up for the singles, doubles and strike outs that make up most of the typical venture capital portfolio, so every deal done has to have home run potential.  The implication of this, for entrepreneurs, is that the success bar is extremely high: that venture investors will hold them accountable for anything less than stellar results.  If you are not ready to be judged by those kinds of standards, don’t enter the arena.
  2. Venture capitalists are first and foremost accountable to their own investors, not themselves (and of course not their portfolio entrepreneurs).  They have legally binding fiduciary obligations to put the interests of their own investors ahead of their own interests and the interests of their portfolio companies and entrepreneurs.  Even the most entrepreneur-friendly venture capitalist, when push comes to shove, will look out for the interests of their own investors ahead of the interests of their portfolio entrepreneurs.  And they should: that is their job.
  3. Venture capitalists generally have egos on a par with entrepreneurs, which is to say that, pace entrepreneurs, they may be wrong a fair amount, but they are almost never in doubt.  If you are not comfortable working with folks who can be as stubborn and opinionated as you are, don’t expect a cozy relationship with your venture capital investors.
  4. Venture capitalists work for venture capital funds, and both venture capitalists and their funds are significantly influenced by the dynamics of their own career development path as well as their fund’s evolution – good or bad – over time.  Venture capitalists come and go – your great relationship with a venture fund can be recast overnight if your venture capitalist leaves the fund.  No matter how supportive and enthused your venture capitalist may be about your deal, if her venture capital fund has limited cash resources (and they all do) your ability to access those resources in a pinch is up to the fund’s management as a whole, not your particular venture professional (and, of course, at some point, there just isn’t any dry powder left for anyone). 
  5. Just about every venture capitalist believes – really – that they and their fund bring more than money to the table.  And many of them do.  Unless you agree, stay away.  Nothing can sour a venture capital relationship quite so fast as an entrepreneur who won’t listen respectively to, if not always take, advice from their venture capital investors.  If you want passive investors, don’t look for venture capital funding.
  6. Pretty much all venture capitalists have big egos (see above).  They all have strong and usually in some way unusual personalities (as do most serious entrepreneurs).  There are quiet, supportive types (well, a few) and there are folk like Don Valentine, a widely-respected dean of the industry who has been quoted over the years (without ever denying it, to my knowledge) as follows:  “I have never fired a CEO too early in my entire career.”  The point?  However good the fit might otherwise be with a venture capital fund, make sure you can get along and be productive working with the particular venture capitalist who will be working your deal.  (And, per 4 above, hope that particular venture capitalist stays with her fund and your deal for the long haul.) 

I am sure there are some entrepreneurs reading this who are wondering just why, in light of the above, anyone would want to work with venture capitalists.  If you are one of those, well, don’t; seek venture capital, that is.  Devise a bootstrapping financing plan, or, if that isn’t practical, think of an idea where that is practical, or find another direction to go with your career.  On the other hand, if you can, with your eyes really open to the above rules of the road, think of working with a venture capitalist as just another part of your challenge, something to be relished rather than feared, go for it.  But if you end up road kill, well, that happens.  Just about every ultimately successful entrepreneur makes big mistakes and has big failures.  Just ask Steve Jobs, he of the Newton PDA and NeXT Computer.

 

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Posted by pajones1

Commercial Biopharma in Wisconsin: What Next?

August 3, 2011

By: Paul Jones

The University of Wisconsin – Madison, is one of the country’s leading centers of public biopharmaceutical research, and the campus has spawned dozens of spinout companies based on University research. For this, the citizens of Wisconsin should be grateful; and, even more so, hopeful. Grateful because a foundation capable of supporting future growth is in place; hopeful because given the right conditions that growth could, over the next five years, support the emergence of the Madison area as one of the nation’s top five centers of commercial life sciences investment, and indirectly the emergence of Wisconsin as an important mid-continent oasis for venture capital investors that today think of the state as flyover country.

The major progress to date is reflected in the dozens of Madison area life sciences companies, including biopharma companies, with important ties to UW-Madison research. While not large by national standards (UC-San Diego – good school, but hardly a match for Madison – has spawned a couple of hundred life sciences companies) it is a big enough number to establish that the University is technically capable of, and, as important, culturally willing to enable, the kind of private/public collaborations that are critical to realizing the “real world” potential of the University’s basic research.

So, the question is no longer can Wisconsin play in the biopharma major leagues, but can it compete for championships. Can Wisconsin, instead of being known for a handful of companies worthy of acquisition by larger, better funded national firms with roots outside the state, become a major center of large, well-funded companies acquiring promising competitors and moving their operations to Wisconsin. The answer is, in my opinion, yes – if we can take two big steps. The ultimate step is becoming tightly integrated into the major venture capital markets, particularly on the two coasts. The penultimate step is moving our biopharma university spinouts from founder/scientist-managed to professionally managed earlier in their development.

We need stronger ties to the major venture centers, particularly on the coasts, because that is where the majority of biopharma venture and other risk capital money is, in terms of quality as well as quantity. That is critical because compared to just about every other tech-driven sector, what sets biopharma company-building apart is the vastly more time and money it takes to build a profitable business. You simply can’t get a major biopharma company off the ground with a succession of six and low seven figure investments and SBIR grants. At best you will get to the table too late with too little – and create something for larger, better funded firms to snap up. Unfortunately, multiple high seven and eight figure risk capital investments are simply beyond the capacity of Wisconsin’s limited venture capital base; even more so if you limit the field to firms with nationally recognized life sciences bona fides.

So, how do we get the major biopharma venture capitalists on the two coasts to Madison on a regular basis? Not now and then, but as a regular stop where they make regular investments?

Having spoken with some; having worked on the west coast for life sciences companies and their investors; and having seen money center biopharma investors warm to the Research Triangle life sciences market over the period from roughly 1995 to 2005, I think the answer is professional management. Biopharma and other life science spinouts from places like UC San Diego – at least those that in fact receive substantial capital from the most highly-regarded life sciences venture investors – tend to share one key characteristic besides compelling science: experienced professional management. I believe that if our most compelling young biopharma and other capital and time intensive life sciences companies could match management resumes with their comparable counterparts on the coasts, our companies would, in short order, find themselves with comparable balance sheets as well.

Why is professional management so important in the biopharma space? Several reasons. Foremost among them is that building a major biopharma business not only takes more capital and time then building, for example, a software company, it is just plain more complex. The science is more complex, the regulatory environment is more complex, the market is more complex, and the business/financial models are more complex. The bottom line is that venture investors, who in almost every case put the quality of the management team ahead of other factors on their investment checklists, do so even more regularly when they evaluate biopharma and other complex capital and time intense life sciences investment proposals.

Why don’t our management teams match up well with west coast management teams? Two factors jump out. First, our founders (mostly university professors) have less experience (indirect as well as direct) than their counterparts on the coasts with the company building process. These are incredibly bright folks with incredible amounts of energy and, no offense intended, they all too often underestimate the time, energy and skill it takes to build a world class biopharma company. As a result, they are often reluctant to transfer management of their companies to “the suits” nearly as early in the process as they should. We have to change that mentality if we want to generate sustained serious investments from serious life sciences venture capital investors.

Another reason we don’t have a deep pool of experienced company builders managing our biopharma spinouts is that it is hard to attract them here. No, I am not talking about the climate, though I am sure weather is not a net plus for us. Rather, I am talking about the career risks an experienced biopharma professional takes when they move to what is, for now, a minor league city in terms of “big time” (read “big money”) emerging biopharma companies. The kind of manager we are talking about wants to know that if the deal they are working on now doesn’t work out – or even if/when it does – they won’t have to relocate (again) to find their next opportunity.

To some extent there is not a lot we can do, locally, to change the metrics of the “what will I do next problem.” But there are a few things that would help. One is changing the dominant “I can do this myself” culture common among the area’s founders. Another is making sure that the great science we have here in Madison is more visible in the business community on the coasts. I very much doubt, for example, that the typical life sciences manager on the west coast realizes that UW-Madison is a top-3 recipient of NIH funding.

UW-Madison, and the region, has made enormous progress over the last dozen years in demonstrating both the ability and willingness to work with the private sector to commercialize the University’s extraordinary research. If we can take the next big step – recognizing the need for and successfully competing for experienced professional biopharma managers – we will, I think, rapidly find ourselves among the nation’s leading centers of biopharma venture capital investment. And, once the venture people are here, they will – probably to their surprise – find that we have lots of other great technologies ripe for venture investment as well, all around the state.

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Posted by pajones1

Startup Valuation: Sometimes Less is More. Part I.

August 2, 2011

By: Paul Jones

A good rule of thumb when you are selling something is to sell it to the highest bidder.  Alas, if you are an entrepreneur selling a stake in your startup company, this seemingly self-evident rule is subject to a number of exceptions, large and small.  In this first installment of a couple of blogs exploring startup world exceptions to the higher is better rule, we’ll be looking at one of the biggest and for some entrepreneurs most frustrating exception: what we’ll call the “Over Zealous Investor” exception.

Of the more frustrating experiences of my 25 years in and around venture capital, among the most frustrating is the otherwise interesting deal that prices itself out of the capital markets.  It goes something like this.  A usually less sophisticated entrepreneur with an at least fundable idea but little else finds some usually even less experienced investor willing to buy in at some outrageous price.  Like, say (you can’t make this stuff up) $100 million pre-money for a somewhat generic IT idea.  The entrepreneur takes the money, uses it more or less wisely, and through hard work and determination gets the company to the “next stage” where it needs more funds – but is now worth, in the minds of more sophisticated investors, say, $2-5 million on a pre-money basis. 

Or would be worth $2-5 million but for the fact that the over zealous investors already in the deal paid $100 million.  With that baggage, it isn’t worth the paper the entrepreneur’s new PowerPoint presentation is printed on. 

Now you might think that the losers here are the over zealous investors who overpaid, and you would be right.  But so, too, is the entrepreneur, who can’t raise more money because she took too high a price early on.  And so, even, are the investors who would be very interested in the deal at a $2-5 million admission price.  It turns out, in practice, that the initial investment was such a good deal for the entrepreneur that … everyone ends up with nothing.  Thus the Over Zealous Investor exception: an entrepreneur who lets less sophisticated investors pay a scary high price for a deal runs a very high risk that when more money is needed no one (unless the initial folks want to poney up) with any brains is going to provide it.

In this situation the “sell to the highest bidder” rule led the entrepreneur astray because it brought a bunch of people in to the company as shareholders who (i) clearly (consider the price they offered) had no business making the kind of early stage high risk investment they made, and (ii) probably are the kind of people who would make good plaintiffs if the company and some group of new, smarter investors made a success of the business – albeit one that would almost certainly not, in retrospect, justify the early investors’ $100 million valuation.  To put a finer point on it, no sophisticated investor is going to come in and wash out the prior investors and – management has to remain incented – jack up the shareholdings of the founder and/or management team for the simple reason that if they do that they are inviting the wrath of the earlier investors.  Such wrath often taking the form of an expensive, time and energy-wasting lawsuit of uncertain outcome.  As I have heard at least one top tier investor say about a company with a Over Zealous Investor problem, “I wish we could do this deal, but life is too short, and, as you know, there are too many other fish in the ocean.”

So, if you are an entrepreneur with a good, fundable idea, the first exception to the “sell to the highest bidder” rule of thumb is “don’t sell if the price offered doesn’t pass the blush test” (which is to say, could you look a judge in the eye and say the price was reasonable without blushing).  When you break the Over Zealous Investor rule you all but eliminate bringing in smart money down the road.

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Posted by pajones1

Thinking About the Next Round

July 28, 2011

By: Paul Jones

For many less experienced entrepreneurs, the search for that first round of outside capital is so all-consuming and stressful that it is hard for them to imagine that a subsequent capital campaign could be any more difficult.  More experienced entrepreneurs know better.  Now, a hot company in a hot financing environment may indeed find existing and prospective new investors tripping over themselves to provide capital at outrageous valuations.  Just ask Facebook.  Far more typical, however, is the company that is more (or less) on plan, but running out of cash and confronted with a soft risk capital market.  For entrepreneurs in that scenario, getting the next round done can make getting the first round closed look like a relative cakewalk.  This post explores how, for the “it’s not going so good” to the “it’s going fine, but not great” entrepreneur, the second (and possibly third and ..,) round financing challenge shapes up from a negotiations perspective.

The first thing to know about follow on financings is that there are more people at the table than there were in the first round.  The relevant players in the first round are generally limited to the founders and the first round investors (usually represented by a lead investor).  When the second round comes along, however, there are three key players – the founders, the new investors and the original investors.  While it may seem as if the original investors “made their deal” when they did the first round and now just have to live with that deal, in fact they did not so much make a deal when they signed on to round one as put a stake in the ground.  A stake that includes a long list of rights, almost always including the ability to block a future round of financing that gives a new set of investors any priorities over the earlier investors – including at least some priorities which just about every credible new investor will insist on.  The bottom line: you probably can’t make a deal with new investors without the cooperation of the prior investors – and the new investors are often going to ask the prior investors to revise, to their detriment, some of the rights and privileges they fought so hard for at the first round negotiation.

And this is where it gets tricky for a lot of entrepreneurs – and even some less experienced first round investors.  Because while de jure (in law) the first round of investors likely have a veto over any financing that puts a new investor ahead of them in terms of rights and privileges, de facto (in fact) that veto is not quite as big a stick as it first appears.  Unless the original investors are able (and willing) to provide needed funding on their own, at terms that reflect fair value (i.e. that do not attract lots of third party interest), they will want at least some new deal to get done rather than see the company run out of cash.  It can be as if they have a big stick, in the form of protective rights built into the original financing terms, but lack the strength to wield it with maximum effect.

In practice, the position of the prior investors can be further complicated by differences of opinion within their own ranks.  While as a group the original investors were probably on pretty much the same page when they made the initial investment, the chances are pretty good that over time their attitudes towards the company have changed, either based on their analysis of the company’s prospects or for internal fund reasons (e.g. dwindling capital reserves).  While the lead investor from the earlier round is the obvious candidate to manage any such fracturing of opinions or capabilities, the lead could be one of the investors with a change of perspective.  Or the lead may see the diverging of interests/capabilities among the original investors as an opportunity to gain advantage over one or more of the other original investors.  The complexities can be maddening for the entrepreneur, as the task of raising needed new funds becomes, in large part, the task of making the old investors happy without turning off the new investors or – and this does happen – taking the hit himself to bridge any gaps between the two investor groups.

None of this is to say that a modestly down, flat or modestly up round has to be a trial by fire.  If the company has maintained a good working relationship with its early investors, and approaches them in a thoughtful (but not philanthropic) frame of mind, with a good appreciation for the practical realities of the bargaining powers of the various parties, a good deal for all parties can often be done with – well, realistically, let’s say about the same level of stress as a typical first round.

As noted, hot companies in hot markets often find the experience of closing a follow on round more exciting than stressful.  But for the rest, which is to say for most entrepreneurs, the best way to think of the first round, once it is in the books, is in terms of Finance 101 – a good introduction to the material, and a fine jumping off point for Finance 201.

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Pay to Play: Its About Breakfast

July 27, 2011

By: Paul Jones

Among the many variously simple and arcane provisions of venture capital term sheets, one of the more mysterious to many less experienced entrepreneurs and investors is the so-called “Pay to Play” provision.  The mechanics of Pay to Play are reasonably straight forward: if, in a subsequent down round financing after a round where a Pay to Play provision was installed, an investor in the earlier round refuses to participate in the new round (usually to the full extent of the investor’s pro rata participation in the earlier round), that investor will lose various of their special rights and privileges acquired in the earlier round of financing.  So, for example, an investor subject to a Pay to Play provision that refuses to take its pro rata share in a subsequent round would typically lose, going forward, its anti-dilution price protection and future round participation rights.

If the mechanics are reasonably clear, it is often less clear who the a priori winners and losers are.  Who, initially, wants to see a Pay to Play provision on the term sheet, and why?  And who is likely to resist a Pay to Play provision?

In terms of a first order analysis, Pay to Play is an intra-investor issue.  Typically, one or more investors favor the Pay to Play (lets call them the Pigs, in that, as pigs regard breakfast, these investors consider themselves fully committed to the investment) and the other investors the Chickens (in that they, like the chickens that provide the breakfast eggs, are interested in the proceeedings, but perhaps not really committed).  The Pigs are motivated by a concern (just how much of a concern will be revealed by how hard they fight for the Pay to Play provision) that if the company for some reason needs more money at a lower price in the future the Chickens will either not have any more eggs to contribute (one possibility) or will for some reason refuse to provide any more eggs.  Pay to Play, then, is a mechanism for the Pigs to say to the Chickens “when we say we are in this together, for better or worse, we really mean it.”

Now, this analysis is fine so far as it goes, and many entrepreneurs assume, based on this line of thinking, that they, as entrepreneurs, don’t really have anything at stake in the Pay to Play negotiation.  Which is a mistake.  Because while the implementation of a Pay to Play provision in a down round primarily pits Pigs against Chickens, the outcome of the dispute can have a big impact on what served at breakfast – which is to say whether and how the portfolio company is financed.  Look at it this way: a Pay to Play provision encourages current investors to participate in future down rounds, which is always (off hand, I can’t think of an exception) a good thing for the company.  And that is true even where, a priori (i.e. in the round where the Pay to Play is or is not imposed) the investors are all Pigs (or all Chickens, for that matter).

Conclusion?  While Pay to Play provisions may seem, at first blush, like something an investor syndicate can solve internally, in fact, Pay to Play is something entrepreneurs should be concerned with from the get go.  So, if as an entrepreneur your prospective investors offer a term sheet without a Pay to Play provision, my advice to you is to ask for one.  Depending on the broader context of the deal, you might decide to fight hard for it, or just use it as a bargaining chip.  But it has real value – both to give you a sense of what investor attitudes are to future rounds, and to have in your back pocket in the eventuality of a future down round – and thus should be on the table .

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Posted by pajones1

Who Do Directors Represent?

June 15, 2011

By: Paul 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

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