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

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

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

November 1, 2011

By: Paul 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

What’s in a Name? Protecting Your Start-Up Trademarks

September 28, 2011

By: Jeff Peterson

Most new business ventures are started around a new idea.  The business focuses on a new product, a new service, something that will set the business world alight with the new idea and creativity that the business will bring to the marketplace.  The initial focus of new companies, rightfully so, is on the development of these new products and services and how to best to commercialize them in a competitive marketplace.  Unfortunately, businesses often tend to neglect another key aspect of their company’s property, namely, the intellectual property they have in the name of their company or products themselves.  Oftentimes, the initial inquiry around a new company’s name in today’s markets is whether the domain name is available for the name.  Companies often fail to do more in-depth trademark clearance searches on both the company name and any new product names which will be used in the marketplace.  Just because a domain name is available for use does not mean the company is free to use that name as the name of their business and/or their products.  Other parties may have trademark rights in that name, even if they do not have the domain name registered.  Selecting a trade name for a new company that is both available and strongly protectable can lead to an invaluable asset for the company as it grows in the marketplace.  If a new company does not do the appropriate due diligence on the selection of their name it can lead to painful and expensive name changes of either the company and/or products down the road if problems arise. 

Choosing a name
Oftentimes, a new company will choose a name which is somewhat descriptive of the new goods and services that they will bring to market.  For instance, “Quality Lenses”, or “Optic Technologies” may provide the commercial impression to consumers that the company is related to optical lenses but the marks themselves are so descriptive that any proprietary enforceability around such trademarks would be relatively weak.  This is because, in general, descriptive marks are not available for trademark protection.  Only when a mark has  been used for a long period of time and acquired so-called “secondary meaning” will courts find that descriptive marks, i.e., marks which describe a characteristic of the product or services, are afforded trademark protection.  The term “secondary meaning” stands for the principle that even though the mark is descriptive, the mark has been so widely used for such a long period of time that consumers recognize that the mark has another meaning beside the descriptive one, namely, it is an indicator of a specific source for the good or service associated with the mark.  Therefore, some of the best marks for choice of the name are fanciful or arbitrary marks that do not relate to the product or good themselves.  “Apple” for instance has nothing to do with computers or electronics.  Another good choice for a mark would be a mark that is suggestive of the good or service associated with it.  “Greyhound” for bus transportation is suggestive because a consumer may envision that the bus travels as fast as a greyhound dog.  Selecting a mark that is either arbitrary, fanciful or suggestive, but is not directly descriptive, can provide a business name or product name in which a company can strongly enforce if any competitors enter the marketplace using the same or similar brand.

Clearing the proposed name
It is important for any new company to make sure that the proposed name they are choosing to do business as is free and clear to use.  This clearance must not only be considered for the goods and services the business is planning on offering immediately but for any future expansions either in goods or services and/or geographical areas that the business is planning on expanding to in the future.  Certainly, checking domain name and corporate name availability at the corporate name registration level is appropriate.  Additionally, a company should make sure no other state trademark registrations or federal trademark registrations have been filed or registered on the same or similar mark.  Additionally, a search should be done to determine if any local businesses in the geographic area the company is operating in have been conducting business or offering products using the same or similar mark.  If such pre-existing companies have been conducting business under the same or similar mark, they may have common-law protection for the mark, even if they don’t have a trademark registration.  Working with legal counsel to perform a legal clearance search of the names is something that should strongly be considered by any new company to make sure that their proposed business and product names are available for use. 

Protecting the trademarks
Once a company has selected their business and product names, and have cleared them in a search, the next step is for the company to decide how to protect their new brands.  Fortunately, unlike patent protection, some level of trademark protection is available without undertaking any additional legal filings or expenses.  Just the mere act of using a business or product name in public, in association with marketing goods or services, is enough to obtain common law trademark protection for the mark.  Common law trademark protection is a right under state law and gives a company proprietary rights to prevent others from using the same or similar mark in the same geographical areas that the company uses the mark.  Obviously, the weakness of common law protection is that the protection would only encompass the geographical areas that a company has actually done business in.  In order to obtain more robust protection, a company can register their trademark with either the state or the federal government.  The rights granted with state trademarks vary from state to state, but generally provide the registrant similar protection to common law protection.  Federal trademark registration, however, gives presumptive nationwide rights in the use of a company’s trademark once it is registered.  Once a trademark has been registered with the United States Patent and Trademark Office the owner of the registration is, with few exceptions, the only one who may use the mark in the United States in conjunction with the goods and services for which it is registered for.  Trademark registration may be applied for at any time – even before the mark is in use.  This allows the company to reserve rights to the mark before the associated company name or product is introduced.  Before a final registration can be secured, however, the mark must pass through the registration process and be used.  The registration process can take upwards of eighteen months.  If a new company has enough financial resources it is always a good idea to try to establish a federal trademark registration at least in the company’s name to provide ample opportunities for that company to expand on a nationwide basis while preserving their right to use the mark and enforce it against other parties.

Best practices
No matter how small a new business is, they should always take the time to perform a clearance search in some aspect of the business name to make sure that there are no overlapping domain names or trademarks which would place restrictions upon how the company gets to use its name in commerce.  By performing a clearance search and picking a strong distinctive name, a new company should not run into any major issues which prevent them from using their brand in the future and will provide adequate protection to prevent others from using any brands developed by the company.  No company ever wants to have to change its business name and being forced to change something as important as the company’s name or the name brands of that company can easily spell the end of a new business.

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Posted by jdpeterson2

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

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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Posted by pajones1

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

Entrepreneur’s Guide to Litigation – Blog Series: Introduction

July 7, 2011

By: John Scheller

The words “lawsuit” and “trial” usually conjure up images based upon either media coverage of recent, significant cases or trials depicted on television and in movies. A real lawsuit and trial are significantly different than what we see on television or in the movies. Media coverage of a trial does not delve into the frequent reality of a lawsuit – the months and possibly years of pre-trial “discovery” and motion practice that occur before a case can even go to trial.

This upcoming blog series is aimed at removing some of the mystery of a lawsuit and a trial, and also at informing entrepreneurs what really happens prior to and during all those trials you see on television. The next seven blogs cover the basics on a lawsuit, from filing of a “Complaint” through trial and, ultimately, the appeal process. It can provide a complete picture of the litigation process to alert the entrepreneur what to expect as a potential party to a lawsuit.

There are other, important considerations to litigation not addressed in this series, such as insurance coverage, if any, and confidentiality agreements (known as protective orders) between the parties to a lawsuit. Additionally, a corporation usually cannot appear by one of its owners, but must be represented by counsel. Certainly, anyone that is sued or is thinking about suing another, should consult with a lawyer as soon as possible. We hope this blog series helps entrepreneurs develop a better understanding of the litigation process.

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Posted by jcscheller

Pitfalls of Provisional Applications

June 1, 2011

By: Charlene Yager

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

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

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

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

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

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Posted by clyager

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