13th Great-Idea China Sourcing & New Industrial Delegation to China – Day 4

April 19, 2012

By: Lisa Mueller

During yesterday’s summit, local government officials described their vision and expectation that Suzhou would lead the way in transforming China’s economy from low-end services to high-end service outsourcing. This morning, the Delegation had the opportunity to see just how Suzhou plans to achieve this lofty goal.

After checking out of the beautiful Dushu Lake Hotel, the Delegation boarded buses to travel to several of Suzhou’s industrial parks. The one we visited was the Suzhou Industrial Park Institute of Services Outsourcing (SISO), which is a full-time public higher education institute. SISO’s first classes began in 2008 with only 180 students. Now, about 4 years later, the school has over 3,000 students. 

SISO has 5 departments (1) Information Technology; (2) Business & Management; (3) Finance; (4) Digital Media; and (5) General Education. A Nanotechnology Department is being added and classes are scheduled to begin this fall. The educational programs within each department are designed for the Outsourcing industry. Additionally, the facility of SISO is composed of a mix of national and non-national engineers with industry background. Approximately 90% of the faculty has their Masters or Doctorate degrees. SISO’s education ideology is “Borderless Mindset” and the teaching values are “Commitment, Creativeness, Cooperativeness and Conduct”. The school motto is “Diligence, Applicability, Practice and Innovation”. The first group of SISO students just recently graduated and amazingly, achieved 100% employment.

The Delegation was given a tour through an animation class that was in session. Upon entering the classroom, the first thing I immediately noticed was how each student was wearing an identical blue blazer. SISO requires each student to wear the blue blazer when attending class. They are free to wear whatever else they desire, but must wear the jacket. 

The next thing I noticed was that the students were sitting at long glass tables, in front of their own computer screen. They did not have any books, paper or pens. They simply had their computer, a mouse and a stylus pen. The students sat in their chairs, deeply focused on their computer screens, engrossed in their animation projects. Some of the animation that the students were working on was simply amazing and extremely sophisticated (i.e. designing and rotating 3D graphics). Even more impressive was the fact that this animation class was a freshman level course.

The second stop was the Suzhou International Science-Park, specifically, to the Suzhou International Science-Park Data Center (SISDC). Interestingly, not only is SISDC founded by the Suzhou government but has also received substantial funding from IBM.  SISDC aims to provide: (1) integrated data service platforms for medium and small high-tech enterprises in Suzhou; (2) support platforms for e-governments and digital cities; and (3) data outsourcing platforms for Information Technology Outsourcing (ITO)/Business Process Outsourcing (BPO) and financial back offices.

SISDC is very proud of the fact that it has a computer room constructed in accordance with Tier IV International standards and that its design was certified by Uptime USA. Data center tier standards exist to evaluate the quality and reliability of a data center’s server hosting ability. There are four tiers with four being the highest rating. The goal of SISDC is to be the first green data center in China

During the visit, I learned that SISDC has a very unique way of describing their corporate culture. Specifically, it is described as being like: (1) the “wind” – meaning as speedy as the wind; (2) the “forest” – meaning to be as compact as the forest; (3) “fire” – meaning as aggressive as fire; and (4) the “mountain” – meaning as firm as a mountain.

The next stops on the tour were the Suzhou Science & Technology Town (SSTT), the biomedical engineering park (also known as MedPark) and Suzhou New & Hi-Tech Industrial Development Zone (SND). 

A very nice buffet lunch was served to the Delegation at a local hotel after the tour of the SND.  The buffet contained some very unique items from across several different cultures (Chinese, Japanese and Muslim). I experienced some firsts, namely, Kettle Cooked Bullfrog, chicken feet and pig ears. 

After lunch, the Delegation made their way via bus to Pudong Airport to catch a flight to Wuhan. On the way, several in the Delegation noticed that the sky was getting darker. I turned to my colleague Justin Alden, from Wanno Capital LLC., and said, “Justin, I think it’s gonna rain”. Justin looked out the window and turned to me and smiled and said, “Nope, that’s just the pollution.” And yes, Justin was right. It was the pollution.  Several of us in the Delegation have been commenting on how each and every day the morning seems to start out bright and sunny but by mid-day the pollution rolls in and the sky gets very gray. I have never experienced pollution like I have thus far in China.

For those of you wondering about Wuhan, it is the capital of Hubei province, and is one of the largest and most important cities in China. Specifically, it is recognized as the political, economic, financial, cultural, educational, and transportation center of Central China.  In China, Wuhan ranks fourth in population and third in science and technology.

Tomorrow begins the 6th Wuhan Service Outsourcing Industry Development and Cooperation International Forum. 

Delegate Spotlight: Sandy Forbes from Vancouver, British Columbia.

Sandy is the Director of Information Technology & Sustainability for Vancity. Sandy’s responsibilities involve ensuring that the IT infrastructure for Vancity is stable, secure and sustainable. Sandy has placed particular emphasis on sustainability in his role as Director for Vancity. He has introduced a number of new innovative programs to facilitate and improve Vancity’s sustainability. First, Sandy replaced the traditional trash cans in the office with significantly smaller sized trash cans. Although unpopular at first, this measure has contributed significantly to the reduction of waste in the company. Second, he instituted an active composting program. As a result, Vancity now composts all of their organic matter – everything from banana peels, to tea bags, to coffee cups, etc. The composting program includes the use of compost bins on each floor that the cleaning staff removes while cleaning at night. Third, Sandy is establishing a sky or roof top garden on the company premises. The sky garden is being implemented in two phases. The first phase involves providing enough green space for the staff. The second phase involves developing a sustainable garden that Vancity will use to attract local farmers to come and grow crops to then sell to the local community. Fourth, in connection with their servers, Vancity partnered with BC Hydroelectric to identify opportunities to reduce their energy consumption and carbon footprint. As a result of this program, the company went from 250 servers to just 5 servers. Sandy’s efforts have helped Vancity to be able to realize a cost savings of 35% per year and have reduced its carbon footprint by 7%.

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Posted by lvmueller

Transformation. Repositioning. Adjustment.

April 18, 2012

By: Lisa Mueller

Transformation. Repositioning. Adjustment. Service + Innovation = Jobs. These were the keys from today’s 2012 China (Suzhou) Service Outsourcing Innovation Development and Investment Promotion Summit in Suzhou, China. 

The summit was attended by the Delegation, a number of local government officials, business leaders from Suzhou and other business leaders from around the world. The stage used for the formal presentations contained a large multimedia screen and was surrounded with red flowers, and the podium top had a dozen red roses on it. I was told by an attendee that decorating the stage with flowers is very common in China. Also, the introduction of each speaker was very unique. When introduced and while approaching the podium, a “theme” song was played, the morning session featured the “Star Wars” theme song. Although most of the speakers presented in Chinese, simultaneous translation into English was provided. 

As emphasized several times by the various speakers during today’s presentations, service outsourcing has contributed greatly to China’s economic growth. As part of China’s 12th Five Year Plan, and in view of the recent global economic downturn, it is a top priority of the Chinese government to restructure and transform China’s economy. The fundamental purpose of this restructuring and transformation is to ensure the quality of economic growth and enhance the overall competitive strength of China. Therefore, the recurring theme throughout the day was the refocusing of China’s service industry from manufacturing outsourcing, considered to be low-end or low-tech outsourcing, to high-end/high-tech service and international service outsourcing. Innovation is considered to be the key in making the change away from low-end industrial and increasing the overall competitiveness of China’s service outsourcing enterprises. Clearly, China wants to be the worldwide leader in service outsourcing enterprises and is willing to invest the time and resources to achieve this goal.

In 2009, China’s state council approved setting up 21 cities as models of service outsourcing. These cities receive preferential treatment in terms of tax benefits and receipt of certain subsidies. The selected cities themselves have invested heavily in public infrastructure, industrial parks and education and training. One such selected city is Suzhou, the location of today’s summit. 

Service outsourcing originated in Suzhou in the 1990′s and has developed rapidly. As of 2011, Suzhou had more than 1,600 service outsourcing enterprises employing approximately 160,000 people. In fact, in 2011, 488 new service outsourcing enterprises were established in Suzhou. Additionally, the signed contract value of Suzhou’s offshore outsourcing services in 2011 was 3.57 billion US dollars, an increase of 57.4% over 2010 with an executed contract value of 2.01 billion US dollars, an increase of 58.6%. 

Suzhou hopes to lead the way in the transformation from low-end services to high-end service outsourcing and it appears to be well positioned to do so. Specifically, the city is the source of a lot of talent: (1) it’s home to 20 colleges and universities; (2) it has over 30 Chinese-foreign cooperatively run institutions; and (3) it has a variety of projects with universities such as University of Liverpool, National University of Singapore and the University of Dayton. In addition, Suzhou established the first service outsourcing institute having a capacity to train over 20,000 professionals per year.

Today, government officials described in detail Suzhou’s aggressive economic plan to create a unique service outsourcing industry in the following ten areas:

1.  Software development outsourcing – focus will be on software development in the areas of user operations, production, supply chain, customer relations, human resources and financial control, computer aided design, embedded software, system software, and software testing.

2.  Research and development design outsourcing – focus will be on providing design services in the automotive, electronic products, chip design, and other industries.

3.  Biomedicine research and development outsourcing – focus will be on the development of medical test technology services, animal experiment services, medical non-clinical research and evaluation services, biotechnology services, clinical trials for new pharmaceuticals, preclinical services, drug safety and evaluation, and medical apparatus design, research and development. 

4.  Financial background service outsourcing – focus will be on the development of financial outsourcing businesses, including data mining and analysis, financial payment services, credit analysis and rating, insurance services, and financial consulting services.

5.  Animation and creativity outsourcing – focus will be on the development of international animation processing, original animation development, comic digitized applications, and special effects production.

6.  Logistics and supply chain management outsourcing – focus will be on the development of total logistics and supply chain management services in the areas of e-communication, chemicals and pharmaceuticals.

7.  Testing and inspection outsourcing – focus will be to establish “world-renowned” testing and inspection outsourcing enterprises and to actively develop professional analysis and testing services, including software evaluation services, quality inspection and testing services, and consulting services. 

8.  Outsourcing in the field of cloud computing – focus will be on the development of software operation services including on-line software delivery services, on-line system maintenance services, IT infrastructure management, data centers, trust and call centers.

9.  Outsourcing in the field of Internet of Things – focus will be on the construction of a smart city and expansion in the business fields including the Internet of Things, development of information processing platforms, development of intelligent building equipment, sensor networks, small grids, and intelligent equipment.

10. Shared service centers for transnational companies – focus will be on those transnational companies that have settled in Suzhou and encouraging them to establish shared service centers by separating their service businesses.

The government officials of Suzhou are very proud of all that they have achieved with respect to their service outsourcing enterprises and are confident that they can achieve a service outsourcing industry in the above areas. Time will tell.

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Posted by lvmueller

13th Great-Idea China Sourcing & New Industrial Delegation to China – Day 2

April 17, 2012

By: Lisa Mueller 

We woke up to a bright, beautiful and warm morning in Shanghai. The nice weather was greatly appreciated as the Delegation was up and out early, traveling to the Shanghai Pudong Software Park (Park). The Park is only 12 years old and is currently home to 1,086 companies. Two of these companies are in Forbes’ Top 20. Additionally, companies such as Citi, Texas Instruments, Olympus, Sony, Kyocera, Tell Labs and Qualcomm, each have offices within the Park.

During our visit we were taken to the first location and given a short presentation describing the size of the Park, the various campuses that comprise the Park and the development cost of each campus. After the presentation, we traveled to a second location which was quite stunning, as it contained a central lake surrounded by several buildings and beautiful landscaping. The lake contained docks that were staffed with paddle and small motor boats. Interestingly, the campus was very quiet; there was very little activity, at least on the outside, and strangely, we saw very few people during our visit.   

After completing our visit to the Park, the Delegation traveled to a restaurant in downtown Shanghai specializing in Peking duck. The duck arrived after course number two, each course being anywhere from 2-3 different dishes, and was followed thereafter, by four additional courses. Favorites among the Delegation included the duck skin and meat, which were presented on separate plates, deep-fried fish in red sauce, and wheat rolls stuffed with duck. I particularly enjoyed the spicy jellyfish, which was a new experience for me. 

After lunch, we boarded a bus to travel to the town of Suzhou. Suzhou was founded in 514 B.C. and its history dates back more than 2,500 years. Suzhou is frequently referred to as the “Venice of the East” or the “Venice of China” for its beautiful canals and stone bridges. Suzhou also has a number of magnificent gardens. In fact, several of Suzhou’s classical gardens were named UNESCO World Heritage Sites in 1997 and 2000.

Upon our arrival in Suzhou we were taken to Dushu Lake Hotel. The hotel blends traditional Suzhou architecture with cutting-edge contemporary design. There is a beautiful story the locals tell regarding Dushu Lake:

“Ancient stores tell the tale
of a small branch that fell
from the moon into the lake
and grew into a large single-branch there. 

Locals believe that those who live
around the lake will be
Blessed with happiness.”

The hotel is located in the Suzhou Industrial Park (SIP). The SIP is the largest cooperative project between the Chinese and Singapore governments. SIP covers an area of 288 square kilometers, of which, the China-Singapore cooperation area covers 80 square kilometers. 

After a wonderful buffet dinner, the Delegation was treated to a nighttime cruise on Jinji Lake. 

Tomorrow the Delegation will participate in the 2012 China Service Outsourcing Innovation Development and Investment Promotion Summit and China-Europe CIO Summit.

In addition to reporting on the day’s activities, I thought it might be interesting to profile some of the people comprising the Delegation. Therefore, I will try in each blog to introduce you to one or two people in the Delegation.

Delegate Spotlight: Thomas Gephart from Irvine, California, US. 

Tom is the founder and managing partner of “Ventana,” which is Spanish for “window”. Ventana was founded in 1974 and is a leading multi-stage equity firm. Specifically, Ventana invests in the best of breed innovative companies with technology products and services that meet the challenging global demands of commercial industrial, technological, federal, and international customers. Most impressively, Ventana has provided more than 30 years of syndicated financing for 100 plus portfolio companies totaling 3.2 billion US dollars from Southern California to Latin America, and Europe to Asia. 

Tom has an engineering degree and worked for several years for Hughes Aircraft and then TRW, Inc.  After TRW, Tom was hired to find and develop new products for AMP, Inc. After AMP, Tom started his own electronic components business that ultimately had two divisions. Three years after Tom started his business he sold it and founded Ventana. 

Tom is currently working on forming a China-US strategic alliance and innovation region cross-border fund and hopes to launch the fund later this year. In working on forming this fund, Tom has observed that the Chinese government seems particularly interested in moving technology to China, and once here has no problem paying for its commercial development. Specifically, in Tom’s opinion, the Chinese government is interested in things that are “explosive” and beneficial to Chinese society and is willing to pay for them. Once this China-US fund has been completed, Tom hopes to form a similar fund between India and the US.

Delegate Spotlight: Martin Venzky-Stalling from Hamburg, Germany.

Martin works as a senior advisor for the Technology Development Center for Industry (TDCI) at Chiang Mai University in Chiang Mai, Northern Thailand. Martin’s role with TDCI is to assist with the development of a Science and Software Park and creating links between government, universities and private sectors. In addition to the Science and Software Park project, Martin also supports the local government with a creative economy initiative called, “Chiang Mai Creative City.” This initiative aims to establish Chiang Mai as the international center for creative industries, including software, crafts, and graphic design.  

Prior to moving to Chiang Mai, Martin was Senior Vice President for International Operations at PCCW (Hong Kong Telecoms), Director of Consulting at Ovum in London and Associate Director with the Global IT, Communications, and Entertainment (ICE) Strategy Group of PricewaterhouseCoopers. Martin specializes in strategy development, market entry, technology enabled business transformation, and launching new entities.

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Posted by lvmueller

JOBS Act Update

April 11, 2012

By: Greg Lynch and Jeff Barrett

On March 14, we summarized a package of bills called the Jumpstart Our Business Startups, or JOBS Act passed by the U.S. House of Representatives on March 8, aimed at making it easier for small businesses to go public, attract investors, and hire workers, by reducing U.S. Securities and Exchange Commission (SEC) registration requirements and other restrictions. On March 22, the Senate approved the JOBS Act after adding an amendment that provides additional safeguards on “crowdfunding” to prevent credit scams. On March 27, the House passed the JOBS Act as amended by the Senate. It is anticipated that President Obama will quickly sign the bill into law.

What follows is a brief summary of the key provisions of the JOBS Act, as amended by the Senate.

Increase of 500 Investor Threshold to be a Reporting Company
The JOBS Act increases the offering threshold for companies exempted from SEC registration from $5 million, the threshold set in the early 1990s, to $50 million.  The measure also raises the threshold for mandatory registration under the Securities Exchange Act of 1934, as amended, from 500 shareholders to either (i) 2,000 shareholders or (ii) 500 shareholders who are not accredited investors for all companies  (and 2,000 shareholders for all banks and bank holding companies) and excludes securities held by shareholders who received such securities under employee compensation plans from the calculation. Raising the offering and shareholder thresholds is intended to help small companies gain access to capital markets without the costs and delays associated with the full-scale securities registration process.

Crowdfunding
Also, included in the legislation is a new registration exemption from the Securities Act of 1933, as amended, for securities issued through internet platforms also known as “crowdfunding.”  The aggregate amount sold to all investors in any 12-month period in reliance on this exemption cannot exceed $1 million. Investors with annual income or net worth of more than $100,000 can invest up to 10% of their annual income or net worth, not to exceed an aggregate of $100,000. Thresholds are scaled lower for investors with annual income or net worth of less than $100,000. The transaction must be conducted through an intermediary that is registered with the SEC as a “funding portal” or broker and registered with a self-regulatory authority. In addition, intermediaries must provide disclosures to investors regarding the level of risk of the offering and comply with other SEC regulations. Issuers must file with the SEC and provide to investors and intermediaries basic information about the issuer, including financial statements, its officers, directors, 20% shareholders and the risks related to the offering.  Issuers requesting less than $100,000 are required to have the CEO of the issuer certify the accuracy of the issuer’s financials. Issuers seeking to rise between $100,000 and $500,000 are required to have a CPA certify the accuracy of the issuer’s financials. Issuers seeking to rise over $500,000 are required to make their audited financials public. The legislation implements a three-week listing-to-closure period, which allows some time for the collective “wisdom of the crowd” to identify possible fraudulent activity through feedback loops. By exempting such offerings from registration with the SEC and preempting state registration laws, the legislation seeks to enable entrepreneurs to more easily access capital from potential investors across the United States to grow their business and create jobs.

Removal of Ban on Small Company Advertisements to Solicit Capital
The legislation would remove the prohibition against general solicitation or advertising on sales of non-publicly traded securities, provided that all purchasers of the securities are accredited investors. The Securities Act of 1933, as amended, currently requires that any offer to sell securities either be registered with the SEC or meet an exemption. Rule 506 of Regulation D is an exemption that allows companies to raise capital as long as they do not market their securities through general solicitations or advertising. The legislation would allow small companies offering securities under Regulation D to utilize advertisements or solicitation to reach investors and obtain capital, provided that all purchasers of the securities are accredited investors. The goal is to allow companies greater access to accredited investors and to new sources of capital to grow and create jobs, without putting less sophisticated investors at risk.

Emerging Growth Companies
The legislation establishes a new category of security issuers, identified as “Emerging Growth Companies” (EGCs), which will be exempt from certain regulatory requirements until the earliest of three conditions: (1) five years from the date of the initial public offering; (2) the date an EGC has $1 billion in annual gross revenue; or (3) the date an EGC becomes what is defined by the SEC as a “large accelerated filer,” which is a company with a  worldwide market value of outstanding voting and non-voting common equity held by non-affiliates, also known as “public float,” of $700 million or more. The regulatory relief provided by the legislation is designed to be temporary and transitional, encouraging small companies to go public but ensuring they transition to full conformity with regulations over time or as they grow large enough to have the resources to sustain the type of compliance infrastructure associated with more mature enterprises.

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Posted by Gregory Lynch

JOBS Act

March 12, 2012

By: Jeff Barrett and Greg Lynch

On Thursday, March 8, 2012, the U.S. House of Representatives easily passed a package of bills called the Jumpstart Our Business Startups, or JOBS Act aimed at making it easier for small businesses to go public, attract investors, and hire workers by reducing U.S. Securities and Exchange Commission (SEC) registration requirements and other restrictions.  If it becomes law, the JOBS Act has the potential to significantly reduce the securities compliance costs of raising capital for emerging companies. 

The Senate is expected to soon introduce its own version of the legislation and President Obama has indicated his support of the measure.

Increase of 500 Investor Threshold to be a Reporting Company
 The JOBS Act increases the offering threshold for companies exempted from SEC registration from $5 million – the threshold set in the early 1990s – to $50 million.  The measure also raises the threshold for mandatory registration under the Securities Exchange Act of 1934, as amended, from 500 shareholders to 2,000 shareholders, provided that fewer than 500 such holders are non-accredited investors, and excludes securities held by shareholders who received such securities under employee compensation plans from the calculation.  Raising the offering and shareholder thresholds is intended to help small companies gain access to capital markets without the costs and delays associated with the full-scale securities registration process. 

Crowdfunding
Also included in the legislation is a new registration exemption from the Securities Act of 1933, as amended, for securities issued through internet platforms also known as “crowdfunding.”  To use this new exemption, the issuer’s offering cannot exceed $1 million, unless the issuer provides investors with audited financial statements, in which case the offering amount may not exceed $2 million.  An individual’s investment must be equal to or less than the lesser of $10,000 or 10 percent of the investor’s annual income.  By exempting such offerings from registration with the SEC and preempting state registration laws, the legislation seeks to enable entrepreneurs to more easily access capital from potential investors across the United States to grow their business and create jobs.  

Removal of Ban on Small Company Advertisements to Solicit Capital
Lastly, the legislation would remove the prohibition against general solicitation or advertising on sales of non-publicly traded securities, provided that all purchasers of the securities are accredited investors.  The Securities Act of 1933, as amended, currently requires that any offer to sell securities either be registered with the SEC or meet an exemption.  Rule 506 of Regulation D is an exemption that allows companies to raise capital as long as they do not market their securities through general solicitations or advertising.  The legislation would allow small companies offering securities under Regulation D to utilize advertisements or solicitation to reach investors and obtain capital, provided that all purchasers of the securities are accredited investors.  The goal is to allow companies greater access to accredited investors and to new sources of capital to grow and create jobs, without putting less sophisticated investors at risk. 

Emerging Growth Companies
The legislation establishes a new category of security issuers, identified as “Emerging Growth Companies” (EGCs), which will be exempt from certain regulatory requirements until the earliest of three conditions: (1) five years from the date of the initial public offering; (2) the date an EGC has $1 billion in annual gross revenue; or (3) the date an EGC becomes what is defined by the SEC as a “large accelerated filer,” which is a company with a  worldwide market value of outstanding voting and non-voting common equity held by non-affiliates (also known as “public float”) of $700 million or more.  The regulatory relief provided by the legislation is designed to be temporary and transitional, encouraging small companies to go public but ensuring they transition to full conformity with regulations over time or as they grow large enough to have the resources to sustain the type of compliance infrastructure associated with more mature enterprises.

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Posted by Gregory Lynch

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

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