I get this question all the time (in one form or another): “Hey Scott, can I raise money for my startup via Twitter?  I have a lot of followers, and I know some of them would be interested in investing.”  As discussed below, the answer is no — unless the tweet is a direct message (a “DM”) to a follower with whom you have a substantive, pre-existing relationship. 

The Law

Under the Securities Act of 1933, as amended (the “Securities Act”), and Regulation D promulgated thereunder, a startup (or any person acting on its behalf) is generally prohibited from any form of “general solicitation” in connection with the offer or sale of securities.  Most States (including California) have similar laws, subject to limited exceptions.

The term “general solicitation” is not defined in the Securities Act, but has been broadly construed in SEC no-action letters to include any solicitations via mail, e-mail or other electronic transmission, unless there is a substantive, pre-existing relationship between the startup (or a person acting on its behalf) and the prospective investor.

Indeed, that’s the critical issue: whether there is a substantive and pre-existing relationship in place with the person receiving the offer.  Let’s break that down:

What Does “Substantive” Mean?.  Under SEC no-action letters, a relationship is substantive if the startup (or a person acting on its behalf) has reliable knowledge or information regarding the prospective investor such that it can evaluate the investor’s financial circumstances and sophistication.  In other words, the nature and quality of the relationship must be such that the startup (or a person acting on its behalf) can determine that the person receiving the offer would be a suitable investor.

What Does “Pre-Existing” Mean?.  Under SEC no-action letters, to be “pre-existing,” the relationship must be in place prior to the offer.

What Is an “Offer”?.  Under Section 2(a)(3) of the Securities Act, the term “offer” is broadly defined to include “every attempt or offer to dispose of . . . a security or interest in a security for value.”  The SEC has actually expanded the definition in regulatory proceedings to include press releases.

Analysis

Based on the foregoing, it is clear that if a startup (or a person acting on its behalf) tries to raise money via a tweet to all of its followers (as opposed to a DM), it will in all likelihood constitute a “general solicitation” in violation of applicable securities laws.  Not only is it extremely unlikely that there will be a substantive relationship with each of the followers, but also the retweeting of any offer will raise significant issues.  Moreover, since a tweet is available for public viewing via the Web, it could constitute an “advertisement,” which is also generally prohibited under applicable securities laws.

Conclusion

The securities laws are complex and are a potential minefield for the unwary.  While new technologies and social networks may make raising capital easier, the securities laws still prohibit certain activities in order to protect unsophisticated investors.  Indeed, in light of the Bernie Madoff affair and other external pressures, the Securities and Exchange Commission and State securities law commissions are significantly stepping-up enforcement of such laws.  Entrepreneurs thus must be careful and should seek advice from experienced counsel prior to any capital-raising activity, including via Twitter.

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.  Please shoot me any questions you have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

We’re a bootstrapped startup based in Palo Alto, and we’re getting some serious traction with our site and interest from angel investors.  We haven’t incorporated or done anything else from the legal side, but we started interviewing different law firms.  A few of them are offering to defer fees for equity, and we were wondering if that’s common practice – and if there are any issues with that.  Any input would be appreciated.  Thanks!

Answer

This question is close to my heart (and wallet).  Indeed, I have thought about the compensation issue quite a bit since launching my own firm a couple of years ago, and my position is not the norm — particularly in Silicon Valley.

The bottom line is that there are only four ways you can compensate your attorneys: cash, credit (i.e., deferred fees), equity or a combination of the foregoing.  Let’s look at each one in reverse order.

Equity.  I get calls all the time from entrepreneurs asking me to represent them for equity.  The obvious business problem is that I’m a lawyer, not a VC. The less obvious, but more significant problem is that it creates an inherent conflict of interest.  I would be wearing two hats: stockholder and lawyer.

To get around this conflict of interest, many Silicon Valley law firms do two things: first, they establish separate funds (controlled by the law firms) to hold the equity; and second, they require the startup to execute a waiver (usually as part of the engagement letter), waiving any conflict claims and expressly consenting to the law firm’s representation despite the conflict.

Needless to say, these law firms made a fortune in the late 1990’s taking equity stakes in their clients.  Indeed, that’s their business model – and it’s big business.  But I don’t think it’s in the best interest of the clients.

Credit/Deferred Fees.  The Silicon Valley firms justify their equity stake (usually about 1%) in return for deferring fees (usually capped at $15,000-$20,000).  The problem with this argument is that the fee deferral is just that – a deferral.  It just pushes-off the due date of the invoice to a later date – generally the closing date of the initial financing.

This, however, creates another inherent conflict of interest.  Why?  Because if the financing doesn’t close, the law firm doesn’t get paid.  This is akin to a success fee, and we all know the problems success fees create with middle-market investment bankers.  Let me share a simple example (which I discuss in my post “Dear Entrepreneurs: Choose Your Own Legal Counsel”):

Shortly after moving to California I got pulled onto an M&A deal at an LA law firm that I had just joined.  The managing partner of the firm was good friends with a middle-market investment banker, who recommended our firm to the client in connection with a complex leveraged buy-out.  I was tapped to quarterback the deal in light of my strong M&A experience in New York.

As noted above, the investment banker only gets paid if the deal closes.  Accordingly, we were supposed to play ball and make sure the deal closed so that the banker got paid.  Unfortunately, I’m not very good at playing this kind of ball – particularly when there were significant environmental issues that were not being adequately addressed.

The banker wasn’t too happy and, in fact, stuck his finger in my chest and warned:  “We’re going to get this deal done despite you fuck’n lawyers.”  He then vigorously complained to the managing partner that I was blowing-up the deal because I had retained special environmental counsel from my old New York City law firm and we were pushing too hard on the environmental indemnity.

Good work by the banker (and cheers to my former managing partner) for getting the deal closed by watering down the environmental indemnity: less than six months later our client’s company was indicted for significant environmental problems that it had assumed (by operation of law) as part of the acquisition.

Accordingly, the issue is how hard will your lawyers push with respect to key issues (particularly if it’s a small firm or a solo) if pushing could blow-up the financing and thus prevent them from getting paid?  For example, are the lawyers going to suggest that you test the market prior to executing the term sheet? Are they going to raise issues such as doing convertible debt in lieu of a preferred stock financing?  Are they going to push back hard if the liquidation preference includes some form of participation?  Are they going to push hard to cut back on any of the protective provisions?

Cash. Obviously, startups are trying to conserve the little cash they generally have.  That being said, cash is king and makes the foregoing issues go away.  I started my career at two major law firms in New York City, and none of the big New York firms takes equity stakes in their clients.  This is a Silicon Valley invention.

I think the most important role the startup lawyer plays is to watch his or her client’s back – i.e., to protect the client.  Most first-time entrepreneurs cannot appreciate all of the potential legal pitfalls (and potential liability) in connection with launching a venture and executing their business model.  To the extent the relationship between the lawyer and his client is muddied by inherent conflicts, it undermines that role.

Conclusion

I hope the foregoing is helpful.  Remember: any time a law firm or other service provider is willing to accept something other than cash for services, there has to be a trade-off.

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

My co-founder and I have been talking to some VC firms on Sand Hill Road, and I think we’re pretty close to getting at least one term sheet.  I read your post a few weeks ago about how one of the common mistakes startups make dealing with VC’s is focusing too much on valuation.  You also mentioned that there are other important terms that affect the economics of a financing, including the size of the option pool.  Can you please explain that.  Our company never issued any options, and my co-founder and I each own 50% of the shares.  Will the VC firms require an option pool and, if so, how will that affect us?  Thanks!

Answer

As I discuss in my post “Issuing stock options? Here’s what you need to know,” the issuance of stock options by startups is quite common because options give key employees an opportunity to benefit directly from any increase in the company’s value (creating substantial upside potential), without requiring any cash outlays by the company.  Options are thus an important tool to attract talented employees.

Accordingly, the VC firms will require your company to establish a large pool of unallocated options for future employees.  In fact, you will probably see language in the term sheet similar to this (with the blanks filled-in): “The price per share is based upon a fully-diluted pre-money valuation of $_________ and a fully-diluted post-money valuation of $________ (including an employee pool representing __% of the fully-diluted post-money capitalization).”

As I discussed in my post “How Do I Value My Startup?”, the pre-money valuation (or “pre”) is the value of the company prior to the VC investment, and the post-money valuation is equal to the pre plus the amount of the investment.

For example, if you and the VC negotiate a pre of $6 million, and the VC has agreed to invest $2 million, then the post-money valuation would be $8 million.  Accordingly, absent an employee option pool, the VC would own 25% of your company post-money  ($2 million divided by $8 million), and you and your co-founder would own 75%.

Now let’s turn our attention to the parenthetical language: “including an employee pool representing __% of the fully-diluted post-money capitalization.”  This is the language that most entrepreneurs do not understand and which has the effect of substantially diluting you and your co-founder, but not the VC.  (Note that it’s a little confusing in the term sheet because the dilution results from the way the price per share of the company is calculated.)

Indeed, venture capitalists impose an unusual methodology for calculating the price per share of the company following the determination of its pre-money valuation.  Here’s how it works: the post-money valuation of the company is divided by the “fully diluted” number of shares outstanding (which means the total number of shares, options and warrants that have been issued by the company), plus all of the shares or options that will be issued in the future as part of the employee pool.

Using our example above, if the employee pool were 20% of the fully-diluted post-money capitalization (which is fairly typical, though sometimes higher), you and your co-founder would only own 55% of the company post-money (75% minus 20%); the VC would still own 25%; and 20% would allocated to the employee pool.  All of the dilution is thus borne by the founders

Moreover, as a result of the employee pool, the founders’ ownership went from 75% to 55% – which is a 26.7% decrease.  How did that happen?  Because of the language “post-money capitalization.”  In other words, the 20% employee pool is calculated as if the VC’s shares of preferred stock have already been issued to the VC.

It actually gets worse because if your company were sold prior to a Series B financing, all of the unissued and unvested options would be cancelled, and the VC would thus share the additional sale proceeds proportionally with you and your co-founder (even though those options came out of your pocket).

Here are a couple of steps to mitigate this issue:  You will never be able to negotiate the option pool out of the deal; nor will you be able to require the VC’s to dilute equally with the founders.  What you can do, however, is negotiate a higher pre-money valuation to account for the option pool dilution.  Indeed, Jeffrey Bussgang, a VC at Flybridge Capital Partners, notes in his book “Mastering the VC Game,” that he has come-up with a new term called the “promote” to address the option pool issue and explains (on pps. 131-132) that:

This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs.  I learned it the hard way in the first term sheet that I put forward to an entrepreneur.  I was competing with another firm.  We put forward a “6 on 7” deal with a 20% option pool.  In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company.  The founders would own 34% and we would set aside a stock option pool of 20% for future hires.  One of my competitors put forward a “6 on 9” deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company.  But my competitor inserted a larger option pool than I did – 30% – so the founders would only receive 30% of the company as compared to my deal that gave them 34%.  The entrepreneur chose the competing deal.  When I asked why he looked me in the eye and said, “Jeff – their price was better.  My company is worth more than $7 million”.

At the time, I wasn’t facile enough with the nuances myself to argue against his faulty logic.  That’s why we instituted a policy at Flybridge to talk about the “promote” for the founding team more than the “pre”.  The “promote”, as we have called it, is the founding team’s ownership percentage multiplied by the post-money valuation.  It represents the $ value in the ownership that the founding team is carrying forward after the financing is done.

Moreover, as the guys at VentureHacks advise in their solid post “The Option Pool Shuffle,” you should present a hiring plan to the VC that sizes the pool as small as possible.  For example, “[i]f your company already has a CEO in place, you should be able to reduce the option pool to about 10% of the post-money.  If the company needs to hire a new CEO soon, you should be able to reduce the option pool to about 15% of the post-money.”

Conclusion

The foregoing is obviously frustrating to entrepreneurs – but is merely more evidence of the “golden rule”:  He who has the gold makes the rules.  The bottom line is that entrepreneurs must fully understand the economics of a VC financing, which include liquidation preferences and the option pool, prior to negotiating a term sheet.  Experienced legal counsel can certainly add value in this regard.

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

I’m the founder of a mobile apps startup, and we’re starting to get some incredible traction.  I’ve been bootstrapping the venture for the last year, but I’d really like to raise about $2 million to scale this thing.  If a VC invests $2 million, what percentage of the company will he own?

Answer

It depends upon the value of your company prior to the investment (commonly referred to as the “pre-money valuation” or “pre”).  For example, if the pre were $4 million, the VC would get one-third ($2,000,000 divided by $6,000,000); on the other hand, if the pre were $1 million, the VC would get two-thirds ($2,000,000 divided by $3,000,000).

As you can see, the VC’s percentage ownership is calculated by dividing the amount of its investment by the post-money valuation of the company (which is equal to the pre plus the amount of the investment).

The real issue then is — how do you determine the value of your company prior to the investment?  Let’s look at that.

I come from the M&A world in New York, where the valuation of target companies was more science than art.  Indeed, targets were valued based upon a number of different methodologies, the most significant of which is the discounted cash flow method (DCF).  As discussed in this excellent article from the Darden Graduate School of Business, DCF basically estimates the net present value of the target’s future cash flow, discounted to reflect the Weighted Average Cost of Capital or “WACC” (which, in simple terms, is the risk).

In the startup world, however, DCF doesn’t work because there is little or no historical financial data and projected cash flow is thus pure speculation.  Accordingly, the valuation of startups is highly subjective and is more art than science.  To put it bluntly: your startup is worth whatever the market says it’s worth, which was starkly demonstrated during the dot-com bubble and subsequent crash.

So what does this all mean in practical terms?  It means you need to get out there and effectively pitch a handful of VC’s in your space and get them excited about your venture.  By doing so, you can, in effect, drive the market by creating a competitive environment and playing the VC’s off of each other.  This is akin to what investment bankers do when they’re selling a company: they create a competitive environment (or the perception of one) to drive-up the purchase price and to provide negotiating leverage.

As legendary investor John Doerr, a partner at Kleiner Perkins, notes in the video I posted on Monday, “Helping Entrepreneurs Succeed: John Doerr”: “Valuations and how way to negotiate them?  I think the best thing to do is to talk to two or three venture capital groups at once – at the same time; not ten, but three.”

That being said, you should be aware of the following caveats:

• Creating a competitive environment and playing VC’s off of each other is very tricky and best done with the help of an experienced lawyer and/or consultant.

• At the end of the day, you will still need to convince the VC’s that you can deliver a 10X return (i.e., that they will make 10 times their investment).  VC’s will thus take into account certain significant factors such as the quality of your management team, the size of your market, etc.

• As I have previously discussed, startups often make the mistake of focusing too much on valuation.  Indeed, there are other important terms that affect the economics of a financing, including the liquidation preference and the size of the option pool.

Conclusion

I hope the foregoing was helpful.  And if you’re wondering how to get a meeting with a VC, I briefly discussed this issue in my post “Ask the Attorney: What Are the Most Common Mistakes Startups Make Dealing with VC’s?” (see #1).  In a nutshell, you need to hustle and build relationships so that you can get a “warm” introduction — i.e., an introductory phone call/email from a middleman or woman whom the VC trusts and respects; it takes tenacity and resourcefulness – qualities that every great entrepreneur possesses.

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

I’m the co-founder and CEO of an e-commerce startup, and I’ve been meeting with different VC firms regarding an initial round of funding.  I’ve started doing some reading on term sheets and the issues we will need to address, and I’m a little confused with some of the VC terminology.  Could you please explain to me what a liquidation preference is and how we should negotiate it.  Thanks!

Answer

Welcome to the world of venture capital.  A liquidation preference is one of the essential components of preferred stock and is generally considered to be the second most important deal term in a VC investment (the first being the company’s valuation prior to the investment, commonly referred to as the “pre-money valuation” or “pre”).

Let’s start with the basics:  A VC investor will be issued shares of preferred stock, not shares of common stock.  Preferred stock, as the name suggests, is preferable to common stock because it grants certain key rights to the preferred stockholders – making it far more valuable than common stock.  One such right is a liquidation preference.

The word “liquidation” is broadly defined in the VC documentation to include not only the actual liquidation of the company (i.e., the disposition of the company’s assets) upon dissolution or bankruptcy, but also the sale of the company (whether via stock, assets or merger) to a third party or a change of control.

The word “preference” flows from “preferred” and means that the shares of the preferred stock will have a priority over (i.e., will be treated better than) the common stock in the event of a liquidation.  For example, in bankruptcy, once the company’s creditors have been paid off, any remaining assets would be distributed to the holders of the preferred stock prior to the holders of the common stock.

Similarly, if the company were sold, the proceeds of the sale would be distributed first to the holders of the preferred stock and then to the holders of the common stock, based upon the terms of the liquidation preference.

There are three types of liquidation preferences:

• Straight (or Non-Participating) Preferred – this liquidation preference is most favorable to the company/founders.  Upon the sale of the company (or any other liquidation), the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders.  Alternatively, the preferred stockholders could choose to convert their preferred stock to common stock and simply be treated the same as the common stockholders (i.e., share ratably in the proceeds).

• Participating Preferred – this liquidation preference is most favorable to the investor (and is sometimes referred to as “double-dip preferred”).  Similar to straight preferred, the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders; however, the preferred stockholders would then also be treated like common stockholders and would share ratably in the remaining proceeds – thus, in effect, being paid twice (or “double”).  Indeed, issuing participating preferred has the same economic effect as issuing a promissory note and shares of common stock (or a warrant) to the investor.

• Capped (or Partially) Participating Preferred – this liquidation preference is often viewed as an intermediate approach.  The preferred stockholders have the same rights as participating preferred (i.e., return of investment, plus share ratably in the reminder), but their aggregate return is capped; once they have received the capped amount, they no longer have the right to share in the remaining proceeds with the other common stockholders.

Fully participating preferred is the exception (about 20% of the deals today) — particularly in the Series A round of funding.  You should thus push hard for a straight preferred liquidation preference and settle for capped participation as a fallback position.  Remember, whatever you agree to with your initial investors will carry forward to future rounds; that’s why fully participating preferred should be avoided.

As part of the negotiation of liquidation preferences, there is also a concept called a “multiple” (e.g., “2X multiple,” 3X multiple,” etc.).  Watch out for this one!  It means the preferred stockholders are entitled to a multiple of their original investment (e.g., double or triple the amount) before the common stockholders get anything.

Based on the foregoing, it is imperative that, before you agree to any participating preferred and/or multiples, you should require the VC to run spreadsheets/models demonstrating how much you and the other founder(s) will receive based on various sales price scenarios.  For example, if your company were sold for $40 million, and the VC had invested $5 million for one-third of the company, with a 2X participating preferred, the VC would receive $10 million off the top (not including any accrued dividends, if applicable), plus another $10 million (one-third of $30 million), for a total of $20 million.

The VC would thus receive 50% of the sale proceeds even though it only owned one-third of the company.

Conclusion

I hope the foregoing is helpful.  My colleague, Susan Morgan, has actually created proprietary software to help entrepreneurs create spreadsheets relative to liquidation preferences and the amount of proceeds they would receive under different sales scenarios.  Indeed, liquidated preferences (particularly when they are stacked onto different series of Preferred Stock) can be quite difficult to understand – until it’s too late.

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.

Question

My co-founder and I are getting some traction on our new site, and we would like to raise some money from angels to hire a marketing guy and for a couple of other projects.  One issue that has come-up is IP.  We don’t have any IP documents.  All we have are the corporate papers we got from LegalZoom.  Could you give us some guidance about IP issues.  What are some of the mistakes that you’ve seen startups make regarding IP?

Answer

For many start-ups, intellectual property (IP) is their most valuable asset.  Here are the five biggest mistakes I’ve seen startups make regarding their IP:

Mistake #1 – Moonlighting at a Prior Employer.  Startups must ensure that none of the founders’ prior employers have any rights to the venture’s IP because a founder was “moonlighting” while previously employed.  This is a particular concern if the startup is in the same space as a founder’s prior employer.  Even a founder’s use of a prior employer’s computer or telephone in connection with the new venture could be a problem.

Accordingly, each founder should carefully review any agreements with his or her prior employer (e.g., an offer letter/employment agreement, a confidential information and inventions assignment agreement, a stock options agreement, etc.) and the employee handbook to determine if there are any provisions that may give the prior employer rights to the startup’s IP.  Founders should also make sure that when they leave their prior employer they don’t take anything with them (e.g., electronic files, prototypes, customer lists, etc.).

Under California law (regardless of what the agreements or other documents say), an employee owns any “invention” that that he/she developed entirely on his/her own time without using the employer’s equipment, supplies, facilities or trade secret information, except for those inventions that either: (i) relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or (ii) result from any work performed by the employee for the employer.

Mistake #2 – Not Assigning to the Company Any IP Created Pre-Incorporation.  A common mistake startups make is not assigning to the company in writing all of the IP that was created or acquired prior to the company’s incorporation.  Any IP created or acquired by a founder (e.g., code or a domain name) prior to incorporation is typically assigned to the company as part of the founder’s restricted stock purchase agreement or subscription agreement.

Indeed, the IP is usually contributed or assigned by founders as full or partial consideration for the shares of common stock issued to them in a tax-free transaction under Section 351 of the Internal Revenue Code.  A problem arises, however, if one of the founders leaves prior to incorporation and takes his rights to certain IP along with him.

Another problem often arises with respect to IP created pre-incorporation by outside developers or consultants (i.e., non-founders), particularly if the developers or consultants are located outside of the United States.  The IP created often never gets assigned to the company at all either because there was no written agreement or because the company was not a party to the agreement (because it did not exist at the time).

Mistake #3 – Not Executing Confidential Information and Invention Assignment Agreements.  Once the company has been formed, the ownership of the IP should be protected by requiring all of the Company’s founders, employees and consultants to execute confidential information and invention assignment agreements.  Unfortunately, a lot of startups do not require founders, employees or consultants to execute this kind of agreement and run into significant problems with respect to IP ownership.

IP-ownership problems often arise in the context of an angel or VC financing, when the investors are unable to establish a clear chain of title to the startup’s IP as part of their legal due diligence investigation.  Chasing down third parties to execute invention assignment agreements in the context of a financing is not a prudent business approach.

Mistake #4 – Infringing on Another Company’s Trademark.  Another common mistake startups make in connection with their IP is infringing on another company’s trademark.  A trademark is a word, name or symbol etc. that is intended to distinguish a company or product (e.g., Google, Amazon, Zappos); in short, it’s a brand name.  A startup may not use a name or mark that is “confusingly similar” to a name or mark used by another company.

Just because a startup is able to register a certain domain name (or a corporate name in the State of its incorporation) doesn’t mean that it has the right to use a particular trademark.  This is a common misconception.  In order to have the legal right to use a trademark, a company must either (i) be the first to use the mark in interstate commerce or (ii) be the first to register the mark with the U.S. Patent and Trademark Office (USPTO), whichever comes first.

It is therefore very important that startups consult with IP legal counsel early on or, at a bare minimum, do a Web search and a search on the USPTO site to determine whether their use of a particular word or name will possibly infringe on another company’s trademark.  The last thing a startup wants is to start getting some traction and then get nailed with a trademark infringement lawsuit.

Mistake #5 – Not Developing and Implementing an IP Protection Strategy.  Finally, another big mistake that startups make (particularly technology companies) is not developing and implementing an IP protection strategy.  If a startup’s most valuable asset is its IP/technology, it is self-evident that reasonable steps must be taken to protect that asset.

Many entrepreneurs do not understand that IP protection comes in different forms, and one size does not fit all.  For example, “trade secret” protection may be a more effective method to protecting software than a copyright or a patent; or perhaps using all three is an even better option.  The bottom line is that founders of technology companies need to sit down with experienced IP counsel and identify all of their startup’s IP.  They then need to come-up with an effective, reasonably-priced strategy to protect their IP assets.

Conclusion

I hope the foregoing is helpful.  If you have any questions, please ask them in the comments section – or feel free to email our new IP specialist Terry Thomas at tthomas@walkercorporatelaw.com.  Many thanks, Scott

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat; below is a longer, more comprehensive version.  Please feel free to call me directly if you have any questions (415-979-9998).  Thanks, Scott

Question

My co-founder and I are crushing it, and we’re getting ready to approach VC’s for some cash.  We’re both first-time entrepreneurs, and we don’t want to make any rookie mistakes.  What are some of the common mistakes that you’ve seen guys like us make dealing with VC’s?

Answer

Obviously, that’s a pretty broad question.  Here are five quick ones:

1) Cold Calls.  One of the classic rookie mistakes is cold-calling or emailing a VC you don’t know personally; in short, you’re wasting your time.  The only way you will get a meeting with a VC is through a “warm” introduction – that is, an introductory phone call or email from a middleman (or woman) whom the VC trusts and respects.

The ideal middleman is a successful entrepreneur whom the VC has backed; investors can be good middlemen; and lawyers, accountants or recruiters may also be helpful.  As the guys at Venture Hacks so aptly put it in their book Pitching Hacks: “Getting an introduction is a test of your entrepreneurial skills.”

2) Not Doing Your Homework.  Startups often make the mistake of not doing their homework regarding the different VC firms.  Prior to approaching middlemen to make introductions, you first need to do some research and figure-out which VC firms are a good fit for your startup based on a number of different factors, including (i) their space/industry focus, (ii) their investment criteria, (iii) their fund size, (iv) their geographic focus, (v) their “sweet spot” and (vi) their track record.

You also need to do your homework (including speaking to other founders) with respect to the particular partners with whom you are interested in working, including determining their reputation, domain expertise and capacity to take-on a new deal.  (See paragraph #3 of my post “Angel Financings: Legal Tips for Entrepreneurs – Part 1.”)

3) Requesting an NDA.  Another classic rookie mistake is asking a VC to sign a Non-Disclosure Agreement (“NDA”); it ain’t going to happen.  VC’s are inundated with business plans and executive summaries and are constantly talking to entrepreneurs whose ideas may be similar to yours.  Indeed, there is no way a VC is going to risk getting sued as a result of funding a startup with a similar idea or business plan to yours.   Moreover, they would need to hire a lawyer to review and negotiate NDA’s – which from their perspective is a waste of time and money.

To the extent you have any “secret sauce” or proprietary technology that you’re concerned about disclosing, you should just not share it with the VC.  (I discuss NDA’s in detail in my post “Ask the Business Attorney: Non-Disclosure Agreements.”)

4) Obsessing Over Valuation.  Another common mistake startups make is focusing too much on valuation.  Obviously, the pre-money valuation (or “pre” as it is commonly referred to) of the company is an important deal term; however, inexperienced startups make the mistake of obsessing over pre – and will often a sign a term sheet with the VC firm that gives them the highest pre.

This is the wrong approach for two significant reasons: first, there are other important terms that affect the economics of a financing, including the size of the option pool and the liquidation preference; and second, a top-notch VC firm (like a Sequoia) can add extraordinary value to a venture.  Thus, even if they come in with a lower pre than another VC firm, a smaller piece of a huge pie is better than a bigger piece of a little pie.

As Alan Salzman and John Doerr note in Chapter 7 of the book, Startup and Emerging Companies: “Unfortunately, those actively involved with start-up companies encounter numerous instances in which the focus on [valuation] is somewhat out of balance and tends to prejudice the discussions with venture capitalists.”

5) Not Retaining Strong Counsel.  Finally, rookies often make the mistake of trying to negotiate VC term sheets (or some of the key investment terms) without having spent the time to fully understand them and/or retaining strong, experienced counsel.  Needless to say, term sheets are complex and a potential minefield for first-time entrepreneurs.  Moreover, the VC guys (and gals) spend their careers negotiating term sheets and know every term (including every nuance) inside out.

Accordingly, startups need to be smart (and demonstrate a certain level of credibility with the VC’s) by getting a good corporate lawyer involved early on, among other things, to coach and prepare them for their preliminary negotiations with the VC’s.  As I note in the comments to Mark Suster’s post, “Want to Know How VC’s Calculate Valuation Differently from Founders?”: a good corporate lawyer will also run spreadsheets/models to show the founders how the purchase price will be disbursed (i.e., the waterfall) in different M&A exit scenarios.

Conclusion

I hope the foregoing is helpful; and if you’re interested, Sachin Agarwal, co-founder of Posterous, wrote an excellent post regarding the “personal side” of dealing with VC’s: “If you can’t buy your investor a beer, don’t take their money.”  You should check it out.

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat.  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

I read a few articles and blog posts a few months ago about how Senator Dodd’s financial reform bill was going to destroy angel investing.  Then I heard about certain amendments made in the U.S. Senate that watered down some of the provisions.  Now that the bill has passed, what’s the story with this issue?  Will the bill hurt angel investing?

Answer  

The bill was signed into law this morning.  There is good news and bad news.  First, some background:

The U.S. Securities Laws.  As I have previously discussed in my securities laws post, a company may not offer or sell its securities unless (i) the securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (ii) there is an applicable exemption from registration.  The most common exemption for startups is the so-called “private placement” exemption under SEC Regulation D, which comprises three different types of private offerings under Rules 504, 505 and 506.  

If a startup sells stock only to “accredited investors” (discussed below), compliance is much simpler, faster and cheaper because it can rely on Rule 506, which has two important advantages over the other SEC rules.  First, Rule 506 preempts or overrides State securities laws, which means that the startup doesn’t have to deal with State securities regulators for compliance purposes, other than filing a brief notice known as a Form D (which is also filed with the SEC).  Second, there is no written disclosure requirement under Rule 506 if the investors are accredited.

On the other hand, if one or more of the investors is not accredited, SEC Rule 506 generally may not be relied upon – which opens-up a Pandora’s box of compliance and disclosure issues under both (i) SEC Rules 504 or 505 and (ii) state law.  Indeed, the cost, risks and onerous disclosure requirements generally outweigh the benefit.  That’s why startups have been overwhelmingly (and effectively) relying on Rule 506 for nearly 15 years in connection with their seed and angel financings.  

The Good News.  The good news is that the financial reform bill just signed into law omitted the most troubling provision in Dodd’s original proposal, which essentially required a filing with the SEC in connection with any private placement (even if all the investors were “accredited investors” and the issuer were relying on Rule 506), and then gave the SEC 120 days to review the filing; and if the SEC did not review the filing within such 120-day period, then the applicable States securities commission(s) would have the right to review the merits of the financing.

As I discussed in my letter to Senator Dodd, this obviously would have created significant delay and cost in connection with seed and angel financings and also would have put the State securities commissions back in the private placement game – which is exactly what SEC Rule 506 is designed to prevent, as noted above. 

The fact that this provision has not become law is very good news indeed.

The other piece of good news is that under Dodd’s original proposal the definition of “accredited investor” would have been revised to require individuals to have (i) a net worth of at least $2.3 million (up from $1 million) or (ii) annual income in each of the two most recent years (and a reasonable expectation of such income level in the current year) of $449,000 individually or $674,000 jointly with his/her spouse (up from $200,000 and $300,000, respectively).  According to Business Week, this revision would have lowered the number of individual accredited investors by 77%.

The new law leaves the net-worth test at $1 million (subject to the change discussed below) and leaves the annual-income test at $200,000 individually and $300,000 jointly.  Again, good news.

The Bad News.  The bad news is that the net-worth test no longer includes the value of the investor’s principal residence.  Clearly, this is a big change and could significantly lower the pool of accredited investors.

The other piece of bad news is that the new law expressly permits the SEC to conduct an immediate review and modification of the annual-income test if “deem[ed] appropriate for the protection of investors. . . .”  Thus, the annual-income test may go up; we’ll have to wait and see.

Finally, the new law also requires the SEC in four years (and once every four years thereafter) to review the “accredited investor” definition “in its entirety” and make appropriate changes — though the applicable provisions are poorly drafted and this four-year review may not apply to the “accredited investor” definition for purposes of private placements under Regulation D.

CONCLUSION

I hope the foregoing was helpful.  Indeed, as I am constantly advising my clients, the securities laws are a potential minefield of problems; and non-compliance could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat; below is a longer, more comprehensive version.  Please feel free to call me directly if you have any questions (415-979-9998).  Thanks, Scott

Question

We’re a bootstrapped startup in the Valley, and we’re getting some serious traction.  Now there’s interest from potential investors and we’re also trying to negotiate a couple of partnering agreements.  Unfortunately, nobody on our team has any experience negotiating deals.  If you could just give us a few tips that would be great.  Thanks!

Answer

Here are seven quick tips for negotiating deals (some of which are skills that need to be developed over time):

Tip #1 – Check Your Emotions and Remain Disciplined. You have to be very careful about becoming emotionally wedded to a particular deal; it’s the same issue a first-time home buyer faces.  You’re going to get very excited as soon as an investor waves some money at you – and you will run the risk of getting drawn into the investor’s web (particularly the further along you get in the process).

It is critical that you understand this dynamic.  Entrepreneurs are often negotiating with guys/gals on the other side of the table who are far more deal savvy than they (e.g., venture capitalists, corporate development guys/gals, etc.) and who are masters at playing on entrepreneurs’ emotions.

As I saw first-hand in New York City representing big, successful private equity firms, the best dealmakers have an extraordinary ability to take their emotions out of transactions and remain extremely disciplined.  Indeed, they will generally walk from a deal if they get out of their comfort zone (e.g., with respect to the risk profile, price, etc.) — regardless of how much time and money they have expended.

Tip #2 – Try to Create a Competitive Environment.  There is nothing that will give you more leverage in connection with any deal negotiation than a competitive environment (or the perception of one).  Every investment banker worth his salt understands this simple proposition.  Not only does competition validate a firm’s interest, but also it appeals to the human nature of the individuals involved.  Competitors can be played-off of each other and, as a result, you will be able to strike the best possible deal.

That being said, keep in mind that this game must be played carefully; otherwise, you could end-up with no deal at all.

Tip #3 – Watch-out for the “Good-Cop, Bad-Cop” Routine.  Experienced dealmakers will often employ all kinds of negotiating tactics.  One of their favorites is the “good-cop, bad-cop” routine.  Here’s how it works:  The dealmaker plays the good cop and is smooth, friendly and agreeable; he will make you feel like all of your important issues are being taken care of.  But then the legal documents arrive — chock full of bells and whistles and boilerplate provisions designed to protect the dealmaker’s firm/company and often with significant gaps on the deal points.

When the dealmaker is questioned as to what’s going on here, the answer, of course, is “it’s my lawyer’s fault” (i.e., the “bad cop”).  This game will continue throughout the negotiating process as the dealmaker charms you while his lawyers pound away on every significant issue.

Tip #4 – Don’t Blink First.  There comes a point in time in just about every deal where both sides have dug into certain positions and the question becomes which side will blink first; for example, in a venture capital financing, perhaps the issue is the pre-money valuation or the liquidation preference; or, in an acquisition, perhaps the issue is the carve-outs to the cap on liability.  Whatever the issue, the rule of thumb in order to maintain negotiating leverage and credibility is not to blink first.

Indeed, if you have flatly stated that “this issue is a dealbreaker,” but then blink and nevertheless agree to go forward with the transaction (despite not getting what you demanded), you will have completely undermined your credibility and will have your clock cleaned with respect to other significant issues.  Like poker, if your bluff gets called, it will be difficult to bluff again.

Tip #5 – Leave Some Chips on the Table.  Speaking of poker, the best dealmakers always leave a few chips on the table.  What do I mean by that?  I mean they don’t fight tooth and nail to win every last penny (every issue) – knowing that such a “scorched-earth” approach will create ill-will and may blow-up the negotiations.  You generally have to compromise and give a little so that the other party feels like he or she is getting a good deal.

This is particularly important where there will be an ongoing relationship post-closing (such as in a venture capital financing or private equity acquisition).  You will need to work with the guys on the other side of the table post-closing, perhaps for a number of years.  Accordingly, you want to have a hugfest at the closing, not a boxing match.

Tip #6 – Control the Drafting.  This is an important (but often over-looked) key to effective negotiation.  Not only should you be retaining a strong lawyer to watch your back (as discussed below), but also you should try to have your lawyer control the drafting.  All good corporate lawyers understand this point.

For example, as a corporate associate at a large, New York law firm, I was representing Sony in connection with its acquisition of CBS Records.  Cravath, the lawyers for CBS Records, actually negotiated in the letter of intent that they would control the drafting.  Usually the acquiror’s counsel controls the drafting because the acquiror is paying the purchase price; however, Cravath was smart and got Sony to capitulate because they knew Sony was anxious to do the deal.

Tip #7 – Retain a Strong, Experienced Lawyer to Watch Your Back.  Finally (and this is obviously a bit self-serving), but every entrepreneur needs a strong, experienced lawyer to watch his or her back.  There is sometimes just too much at stake for entrepreneurs to be handling negotiations if they don’t have any deal experience.

The bottom line is that a strong, experienced corporate lawyer will sober you and lay-out all of the significant legal risks in a particular transaction; he will then push hard to negotiate reasonable protections.  If the deal sours and lawsuits are filed, well-drafted documents with appropriate protections become like a kind of insurance policy.

Conclusion

I hope the foregoing is helpful.  Like most things in life, strong negotiating skills can only be developed with practice and experience.  As you do more and more deals, you’ll start seeing patterns and start understanding human behavior that much better.

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat; below is a longer, more comprehensive version.  I know this stuff tends to be very technical (and perhaps boring), but it is nevertheless critical that entrepreneurs have a basic understanding of the securities laws.

Question

We’ve been bootstrapping our startup and have pretty much run out of money.  We have a few friends and family members who said they would buy some stock to help us out.  We also thought we could put something up on our website and tweet about our need for funds.  Could you please give us a little guidance about these issues.  What are the biggest legal mistakes you’ve seen startups like us make trying to raise capital?

Answer

Any time you are raising capital you need to be very careful – and make sure you’re complying with applicable securities laws.  Below are the seven biggest mistakes I’ve seen startups make.

Mistake #1: Advertising or Soliciting Investors

Subject to certain limited exceptions, startups are prohibited from “general advertising” or “general solicitation” in connection with the private offering or sale of securities.  These terms have been broadly construed in SEC no-action letters.  “General advertising” includes any ad, article, notice or other communication published in a newspaper, magazine or on a website or broadcast over television, radio or the internet.  “General solicitation” includes any solicitations via mail, e-mail or other electronic transmission, unless there is a “substantial and pre-existing relationship” between the issuer and the prospective investor sufficient for the issuer/startup to determine that the offeree would be a suitable investor.

Thus, the bottom line is that you may not advertise on your website that you seek funding nor may you solicit investors via Twitter (unless it’s a DM to a person with whom you have a “substantial and pre-existing relationship”).

Mistake #2: Playing Securities Lawyer

A company may not offer or sell its securities unless (1) the securities have been registered with the Securities and Exchange Commission (SEC)and registered/qualified with applicable state commissions; or (2) there is an applicable exemption from registration.  The most common exemption for startups is the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933 and/or Regulation D, the safe harbor promulgated thereunder.  This is very complex stuff – and now is not the time for entrepreneurs to play securities lawyer.

Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.  That being said, no matter how many times I advise otherwise, there are always a handful of clients who decide they don’t want to pay legal fees to comply with securities laws and they handle the issuance themselves.  In a word: reckless.

Mistake #3: Selling Securities to Non-“Accredited Investors”

The rule of thumb for startups in connection with a private placement is only to offer and sell securities to “accredited investors” under SEC Rule 506.  There are two significant reasons for this: (i) Rule 506 preempts state-law registration requirements – which means, in general, that the startup merely must file a Form D notice with the applicable state commissioners; and (ii) there is no prescribed written disclosure requirement.

There are eight categories of investors under the current definition of “accredited investor”– the most significant of which for startups is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year. 

If a startup offers or sells securities to non-accredited investors, it opens a Pandora’s box of compliance and disclosure issues, under both federal and state law.  Yes, there are ways for entrepreneurs to sell stock to non-accredited investors under SEC Rules 504 and 505 (and perhaps other exemptions), but it requires that specific disclosure requirements be met and registration/qualification under applicable state law, both of which are very time-consuming and costly.

Mistake #4 – Using an Unregistered Finder to Sell Securities

Startups often make the mistake of retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) to raise capital for them.  The problem is that finders must be registered with the SEC if they operating as a “broker,” which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others.”   If the finder is receiving some form of commission or transaction-based compensation (which is usually the case), he will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions.

If he is not registered and sells securities on behalf of an issuer, the private placement will not be valid (i.e., will not be exempt from registration), and the issuer will have violated applicable securities laws – and thus could be subject to serious adverse consequences, as noted above (in Mistake #2).  I discuss this issue in detail in my “Beware of Finders” post.

Mistake #5: Not Diligencing the Investors

In the course of my 15+ years of practicing corporate law (including nearly eight years at two major law firms in New York City), the most common mistake I have seen entrepreneurs and inexperienced deal people make in any dealmaking context is the failure to investigate the guys (or gals) on the other side of the table.  Indeed, in the angel financing context, the entrepreneur will, in effect, be married to the angel for a number of years.

Accordingly, at a minimum, the entrepreneur should get references and speak with other entrepreneurs and founders who have done deals with the angel in order to make an informed judgment as to whether the angel is an appropriate individual with whom the entrepreneur should be partnering.  Issues to consider include:  What is the angel’s motivation to invest?  Is the angel a good guy or a jerk?  Can the angel be counted-on and trusted?  Will the angel add significant value (e.g., through his contacts, technical expertise, etc.)?

Mistake #6: Issuing Preferred Stock

Angel investors will sometimes request shares of preferred stock for their investment; however, unless the start-up is raising at least approximately $750K, it generally is not in the entrepreneur’s interest to issue such shares.  Indeed, preferred stock financings are complicated, time-consuming and expensive.  Moreover, the company would need to be valued, which is obviously difficult at such an early stage and could be extremely dilutive to the founders.

Accordingly, startups are better served by issuing convertible notes to angel investors, not equity — i.e., the angels would loan money to the company, which would automatically convert into equity in the first professional (the “Series A”) round of financing; this approach will keep the financing relatively simple and inexpensive and will defer the company’s valuation (i.e., the pricing) until the Series A round.  If an angel insists on equity, the company should issue shares of common stock — which will place the angel in the same boat as the founders (though still requiring a valuation and causing potential problems with respect to stock option grants).

Bill Reichert, Managing Director of Garage Technology Ventures,  briefly discussed the “note vs. equity” issue on The Frank Peters Show (starting at the 22:51 mark) and expressly advised that: “If you’re putting a few hundred thousand [dollars] in, it’s just not worth all the brain damage to price the round. . . [and] it’s not worth spending too much on the lawyers.”

Mistake #7: Selling the Same Shares at Different Prices

Finally, another big mistake that startups make is selling shares of common stock at the same time to its founders and investors, but charging them different prices; in other words, valuing the shares differently depending upon the purchasers.

This issue often comes-up when a startup has waited to incorporate until it has found investors and then issues a majority of the shares of common stock to the founders for a de minimisprice and a minority stake to investors for a few hundred thousand dollars (if not more).  Simply put, startups cannot do that without triggering potential tax problems.

Indeed, the IRS will take the position that the shares were properly valued at the price sold to the investors, and that the difference between what the founders paid and their actual value will be deemed compensation to the founders – triggering not only income tax liability to the founders, but also withholding tax liability to the startup.

Conclusion

I hope the foregoing is helpful.  Again, I know this stuff is very technical and hard to digest.  I think the takeaway, however, is to make sure you talk to an experienced securities lawyer before you start offering or selling securities to anyone.  In fact, you can feel free to call me directly if you have any questions (415-979-9996).  Many thanks, Scott

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs); it is part 3 of 3 of my posts on choice of entity.  Two weeks ago (in part 1), I discussed what’s wrong with an LLC.  Last week (in part 2), I discussed what’s wrong with a sole proprietorship; and this week I’ll address what’s wrong with a partnership.  Please shoot me any questions you may have in the comments section.  Many thanks, Scott

Question

I’m a student at Stanford, and my classmate and I are launching a new web venture.  We agreed to split the ownership 50-50, and I found a good partnership agreement template on the web to reflect that.  I was wondering if there are problems with us just being partners for now, and then perhaps incorporating down the road.

Answer

Yes, unfortunately there are a number of big potential problems with respect to you and your co-founder forming a partnership (referred to in legal parlance as a “general partnership” as opposed to a “limited partnership”).

First, there is a significant issue from a personal liability perspective.  Indeed, a partnership is like a sole proprietorship on steroids – meaning that not only will you have unlimited personal liability for all of the business’s activities (like a sole proprietorship), including its debts and liabilities, but also you will have unlimited personal liability for the acts of your co-partner within the ordinary course of partnership business.

For example, if your co-partner executes a consulting agreement on behalf of the partnership with a developer, and the partnership breaches that agreement for whatever reason, the developer could sue the partnership and you personally.  (This would not be the case if you formed a corporation or a limited liability company.)

In addition, you also would generally be personally liable for any tortious acts of your co-partner committed within the ordinary course of partnership business.  And the same problem arises if you hire an employee: any related liability could flow through to you personally.

Second, as I have previously discussed, it is imperative that the equity of your co-founder vest over time (usually for four years and sometimes with a one-year “cliff”) to avoid a situation where he or she exits the venture early (e.g., after a few months), but still maintains ownership of half the company.  It is highly unlikely that your template addresses this issue.

Third, each partner has a fiduciary obligation to the other partner with respect to all matters affecting the business – which is an extremely high legal standard requiring undivided loyalty, good faith and fair dealing.  This standard has led to quite a bit of litigation between/among partners, including allegations of conflicts of interest and self-dealing.

Fourth, if there has been and/or will be any intellectual property (IP) created by your partner, there are some tricky issues with respect ensuring that the IP is assigned to the company.  Again, it is highly unlikely that your template addresses this issue, and this could cause significant problems and complications in the event of your partner’s departure (similar to the vesting issue).

Finally, angels and other sophisticated investors will never invest in a partnership (due to the potential personal liability and other issues) and will generally require you to convert the partnership to a corporation.  Such a conversion, however, can be complicated and costly and can create significant tax problems (this issue is discussed in my post on LLC’s – which are also governed by complex tax partnership rules).

Conclusion

The bottom line is that a general partnership has limited utility for entrepreneurs and should be avoided due to the unlimited personal liability of the owners and the other issues discussed above.  For those of you who are interested, a couple of months ago I wrote a lengthy post on the choice of entity for entrepreneurs, which summarizes most of the information in this three-part series.

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs); it is part 2 of 3 of my posts on choice of entity.  Last week (in part 1), I discussed what’s wrong with an LLC.  This week I address what’s wrong with a sole proprietorship; and next week I’ll address what’s wrong with a partnership.  Please shoot me any questions you may have in the comments section.  Many thanks, Scott

Question

I founded a web company by myself a while ago and for the last six months I’ve been making some serious coin.  I never formed a corporation or an LLC and was wondering  if you think I should.  I’m not looking for VC funding, and all the guys who work for me are independent contractors.  Why can’t I just remain a sole proprietorship – seems like a waste of money to incorporate at this point.

Answer

The short answer is that a sole proprietorship is great until you get sued.  Indeed, I’m not a big fan of sole proprietorships — and not many good corporate lawyers are.

The advantages of a sole proprietorship are pretty obvious.  First, it’s simple.  There are no legal documents that need to be drafted and no filings with governmental entities (other than perhaps a simple fictitious name or “DBA” certificate if you are doing business under a name other than your own).

Second, it’s inexpensive for the reasons noted above – that is, no legal documents and no filings means no legal fees and no filing costs; and third, there is no “double taxation” – meaning, unlike with a C corporation, the business does not pay income taxes separately.  All income taxes are handled on the owner’s personal tax returns.

As noted above, the biggest disadvantage with a sole proprietorship is that you have unlimited personal liability.  In other words, you as the owner will be held personally liable for all of the business’s activities, including its debts and liabilities.  Why?  Because for legal purposes, there is no distinction between the business and the sole proprietor.

With a web business, there may not be a lot of potential liability exposure compared to, for example, a medical device company or a real estate owner; however, there could be lawsuits relative to IP infringement, privacy regulations, your contractors (in certain circumstances) and other issues.  And if you do get sued, that would mean all of your personal assets (money, home, car, etc.) would be at risk.

Another major disadvantage of a sole proprietorship is that you cannot issue equity (whether it be to a key employee or an investor) because, again, a sole proprietorship is not a separate legal entity.

Finally, there is arguably greater tax audit risk running a business as a sole proprietorship and, accordingly, reflecting the business’s profit or loss on the Schedule C of your federal income tax returns.

Conclusion

The bottom line is that sole proprietorships have limited utility for entrepreneurs and should generally be avoided due to the unlimited personal liability and lack of structure for equity issuances.  Nevertheless, if you still insist on remaining a sole proprietor, you should definitely buy some comprehensive liability insurance from a reputable insurer to protect against lawsuits and other claims.

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  Below is a longer version.  Please shoot me any questions you may have in the comments section.  Many thanks, Scott

Question

I set up an LLC on LegalZoom about a year ago and now my new lawyer is telling me I have to change it to a corporation if I want to get VC funding.  I think he’s just trying to create work for himself.  My accountant told me an LLC is the best structure.  I don’t know what to do, and I don’t have a lot of money.  What do you think? 

Answer

As I have previously discussed, each venture is unique and the correct choice of entity depends upon a number of different factors, including the type of venture, whether the venture will be seeking outside investors, the amount of initial capital contributions of the founder(s), etc.

There are three major advantages to utilizing an LLC (or limited liability company).  First, an LLC is a “pass-through” entity for income tax purposes – which means that profits and losses flow directly through the entity to the members (unless the LLC elects otherwise, which is quite rare).  This can be very appealing to avoid the double taxation of profits of a C corporation and to permit the members to write-off certain losses of the company.

Second, an LLC offers extraordinary flexibility, including with respect to the distribution of cash and other assets, the allocation of profits and losses, and management structure (all of which is generally reflected in a written operating agreement).  Indeed, an LLC may be operated like (i) a corporation, with a Board of Managers and officers, (ii) a general partnership, with all members appointed “managers” or (iii) a sole proprietorship, with one member (or outside individual/entity) appointed the manager; and, in certain states (like Delaware), an LLC may even limit the fiduciary obligations of its manager(s). 

Third, an LLC is an effective shield against personal liability, subject to one caveat: a few courts have held that the sole owner of an LLC is not protected against personal liability (see my post regarding single-member LLC’s).

There are also three major disadvantages to utilizing an LLC, the most significant of which for entrepreneurs is that VC funds and other institutional investors usually do not invest in pass-through entities such as LLC’s.  Accordingly, if a venture will be seeking VC funding, an LLC is generally not a good choice of entity; and converting an LLC to a C corporation (which is the typical entity in which VC’s invest) can be tricky and expensive.  In fact, a new client of mine ended-up paying tax attorneys close to $15,000 in legal fees to effect such a conversion.

The second disadvantage of an LLC is its complexity, particularly from a tax and accounting perspective (as noted above).  Indeed, LLC’s are subject to complex partnership tax rules, and anyone who has seen a well-drafted operating agreement will notice the pages and pages of tax provisions.

The third disadvantage is the limitation on capital structure; for example, it is difficult and expensive to grant options to employees/consultants in an LLC.  The issuance of other types of securities can be tricky as well, such as “preferred” membership interests.

Conclusion

Based on the foregoing, I would agree with your lawyer that if you’re seeking VC funding it would make sense to convert to a C corporation and otherwise get your house in order before you approach investors.  That being said, you will need input from strong tax counsel to effect the conversion, and if it turns out that you cannot afford to convert, you should go directly to the investors and propose either (i) effecting the conversion as part of the financing (e.g., as a condition to closing) or (ii) setting-up what’s called a blocker corporation, which would permit you to maintain the LLC structure.  Neither alternative, however, is generally appealing to investors.  Good luck!

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  Below is a longer, more comprehensive version — with ten mistakes, instead of six. 

Question 

My buddy and I are coding up a new site and we will be ready to launch the beta in about a month.  We have a couple of angel investors who are interested, and we don’t want to screw anything up.  What are the biggest mistakes that you’ve seen guys like us make?    

Answer 

Here are ten quick ones (in no particular order):      

1.  IP Ownership.  Some entrepreneurs make the mistake of creating IP for their new venture while they are still working for someone else.  They then quit and launch their startup, not realizing that the IP is actually owned by their prior employer.  This is a tricky issue, and you should carefully review all employment-related agreements to determine if there are any provisions that may inhibit your new venture, including IP ownership.  I discuss this issue in detail in paragraphs 2 and 4 of my blog post regarding formation issues (part 2). 

2.  Choice of Entity.  Some entrepreneurs make the mistake of forming the wrong entity.  Investors generally invest only in corporations – not LLC’s or partnerships.  You should thus form a corporation – and consult with an accountant as to whether you should make an S corporation election (and then convert to a C corporation down the road).  I discuss the issue of choice of entity in detail in my blog post “Choice of Entity for Entrepreneurs.” 

3.  Place of Incorporation.  Some entrepreneurs make the mistake of incorporating the company in the wrong state.  You should incorporate in Delaware – that’s what investors generally require.  You should then qualify the company to do business in California and/or any other State in which it is “doing business.”  I discuss this issue in paragraph 1 of my blog post regarding formation issues (part 1). 

4.  Vesting Restrictions.  Some startups make the mistake of issuing stock to co-founders without imposing vesting restrictions.  Then, one of the founders ends-up leaving in a few months and keeps all of his or her equity.  You should make sure you and your co-founder execute a restricted stock purchase agreement with reasonable vesting schedules (typically four years) upon the issuance of the company’s stock.  I discuss this issue in detail in my blog post “Founder Vesting: Five Tips for Entrepreneurs.” 

5.  Securities Law Issues.  Some startups make the mistake of not complying with applicable securities laws; for example, they issues shares to “friends and family” who are not “accredited investors” without proper disclosure documents; or they retain a consultant who is not a registered “broker-dealer” to sell company stock for a commission.  You should be very careful when issuing any kind of securities; non-compliance could cause severe consequences, including a right of rescission for the securityholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.  I discuss these issues in detail in paragraphs 2 and 4, respectively, of my blog post “Five Common Mistakes Entrepreneurs Make in Raising Capital.”

6.  Splitting Equity.  Some startups make the mistake of splitting equity equally between or among the co-founders.  The splitting of equity is a significant business decision which must be negotiated between or among the co-founders based upon their respective contributions to date and their expectations going forward.  Simply dividing the shares equally may sound fair on its face, but it’s usually not the correct decision.  I discuss this issue in detail (and the various factors to consider) in my blog post “Ask the Attorney – Splitting Equity.” 

7.  Employment Issues.  Some startups make the mistake of not addressing employment-related issues with respect to new hires.  For example, if an employee is hired by a startup, he or she generally should be required to execute two documents: (i) an offer letter and (ii) a confidentiality and IP/invention assignment agreement.  The offer letter will set forth all of the employee’s respective rights and obligations, including position, compensation (including stock options and/or other incentive compensation), benefits and, most importantly, whether the relationship is “at will.”  The confidentiality and IP/invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any IP developed by the employee is legally owned by the company.  I discuss this issue in paragraph 8 of my blog post “Launching a Venture: Ten Tips for Entrepreneurs.”

8.  83(b) Elections.  Some founders make the mistake of not making an “83(b) election” in connection with the restricted stock (i.e., stock subject to forfeiture) issued to them.  Section 83(b) of the Internal Revenue Code permits the founders to elect to accelerate the taxation of restricted stock to the grant date, rather than the vesting date.  As a result, the founder would pay ordinary income tax rates on the fair market value of the stock at the time of the grant (which presumably would be quite low or would be equal to the purchase price if such stock was purchased), with any subsequent appreciation of the stock being taxed at capital gains tax rates upon its sale.   Such an election is made by filing the appropriate IRS form within 30 days after the grant/purchase date (no exceptions applicable).   I discuss this issue in detail in paragraph 3 of my blog post “Founder Vesting: Five Tips for Entrepreneurs.”

9.  Due Diligence.  Some startups make the mistake of not diligencing the guys or gals on the other side of the table.  Indeed, whether a startup is doing a financing, a partnering agreement or some other transaction, it must investigate the other party or parties involved.  This means determining the reputation of both the company/firm (if it’s not a marquee name) and the particular individuals with whom it is dealing.  Who are these guys?  Are they good guys or are they jerks?  Can they be trusted?  When they say they are going to do something, do they do it?  Do they add value?  Remember, in certain deals (such as an angel or venture capital financing), the startup will, in effect, be married to the firm and the individuals for a number of years.  I discuss this issue in paragraph 1 of my blog post “Five Mistakes Entrepreneurs Make in Dealmaking – Part I.”  

10.  LegalZoom.  Finally, some startups make the mistake of using LegalZoom or other sites to prepare their legal documentation.  Websites like LegalZoom are not law firms and do not render legal advice; nor are they able to create the kind of sophisticated documents that you need to protect yourself and to demonstrate credibility with your prospective investors.  You should retain an experienced corporate lawyer to help you from the legal side.  I discuss this issue in detail in the FAQ’s section of my website. 

Conclusion

I hope the foregoing is helpful.  I realize it’s a lot of information to digest; however, I see these mistakes made by startups all the time.  Please shoot me any questions you may have in the comments section.  Many thanks, Scott

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section.  Many thanks, Scott

Question 

My co-founder and I are ready to hire a couple of key employees, and one of our advisors told us we need to set-up a stock option plan and offer the employees some stock options.  What is a stock option and what are some of the issues we need to worry about?  Thanks!

Answer

An employee stock option is a security which grants the employee-recipient the right to buy a certain number of shares of common stock of the company at a future point in time and at a price (i.e., the “exercise” or “strike” price) generally equal to the fair market value of such shares at the time of the grant. 

The issuance of stock options is quite common in startups because it provides employees with an opportunity to benefit directly from the increase in the company’s value – creating extraordinary upside potential; it is appealing from the founders’ perspective as well due to the alignment of interests and the avoidance of any cash outlays. 

Below are five significant issues that you will need to address in connection with the issuance of employee stock options.

1.  Vesting Schedules.  You should establish reasonable vesting schedules in order to incentive the employees to remain with your company and to help grow its business.  The most common schedule vests an equal percentage of options (25%) every year for four years, with a one-year “cliff” (i.e., 25% of the options vesting after 12 months) and then monthly, quarterly or annually vesting thereafter.  (Jeff Bussgang, a General Partner at Flybridge Capital Partners and a smart VC, recently discussed the issue of four-year vesting in his post “Stock vesting: Why is four the magic number?”.)

For senior executives, there is also generally a partial acceleration of vesting upon (i) a triggering event (i.e., “single trigger” acceleration) such as a change of control of the company or a termination without cause; or (ii) more commonly, two triggering events (i.e., “double trigger” acceleration) such as a change of control followed by a termination without cause within 12 months thereafter.

2.  Securities Laws.  As I have previously discussed, a company may not offer or sell its securities unless (i) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable State commissions; or (ii) there is an applicable exemption from registration.  Fortunately for startups, SEC Rule 701 provides an exemption from registration for any offers and sales of securities (including stock options) made pursuant to the terms of compensatory benefit plans or written contracts relating to compensation, provided that they meets certain prescribed conditions.  Most states have similar exemptions, including California, which amended certain securities regulations in July 2007 in order to conform with Rule 701. 

It is indeed imperative that you seek the advice of experienced counsel prior to the issuance of any stock options: non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the holders, injunctive relief, fines and penalties, and possible criminal prosecution.

3.  IRC Section 409A.  Under Section 409A of the Internal Revenue Code, a company must ensure that any stock options granted as compensation has an exercise price equal to (or greater than) the fair market value (the “FMV”) of the underlying stock as of the grant date; otherwise, the grant will be deemed deferred compensation, the recipient will face significant adverse tax consequences and the company will have tax-withholding responsibilities. 

A company can establish a defensible FMV by (i) obtaining an independent appraisal; or (ii) if the company is an “illiquid start-up corporation,” relying on the valuation of a person with “significant knowledge and experience or training in performing similar valuations” (including a company director or employee), provided certain other conditions are met.  

4.  Size of the Option Pool.  As many entrepreneurs have learned (much to their surprise), venture capitalists impose an unusual methodology for calculating the price per share of the company following the determination of its pre-money valuation — i.e., the total value of the company is divided by the “fully diluted” number of shares outstanding, which is deemed to include not only the number of shares currently reserved for in an employee option pool (assuming there is one), but also any increase in the size (or the establishment) of the pool required by the investors for future issuances. 

The investors typically require a pool of approximately 15-20% of the post-money, fully-diluted capitalization of the company.  Founders are thus substantially diluted by this methodology, and the only way around it is to try to keep the option pool as small as possible (while still attracting and retaining the best possible talent).  When negotiating with investors, entrepreneurs should therefore prepare and present a hiring plan that sizes the pool as small as possible; for example, if the company already has a CEO in place, the option pool could be reasonably reduced to closer to 10% of the post-money capitalization.  (There is an outstanding post “The Option Pool Shuffle” by Nivi of Venture Hacks, which discusses this issue in detail.)

5.  Restricted Stock.  Finally, depending upon the stage/value of your company, you should consider issuing restricted stock to the employees in lieu of stock options for three principal reasons: (i) restricted stock is not subject to Section 409A; (ii) restricted stock is arguably better at motivating employees to think and act like owners (since the employees are actually receiving shares of common stock of the company, albeit subject to vesting); and (iii) the employees will be able to obtain capital gains treatment and the holding period begins upon the date of grant, provided the employee files an election under Section 83(b) of the Internal Revenue Code.

The downside of issuing shares of restricted stock is that upon the filing of an 83(b) election (or upon vesting, if no such election has been filed), the employee is deemed to have income equal to the then fair market value of the shares.  Accordingly, if the shares have a high value, the employee may have significant income and perhaps no cash to pay the applicable taxes.  The other downside is compliance with applicable securities laws (as discussed in paragraph #2 above).

Conclusion

I hope the foregoing is helpful.  The takeaway (which may sound a bit self-serving) is that you need to get experienced counsel involved early on to address the foregoing issues.  Indeed, there are generally three documents that must be drafted in connection with the issuance of stock options: (i) a Stock Option Plan, which is the governing document containing the general terms and conditions of the options to be granted; (ii) a Stock Option Agreement to be executed by the company and each optionee, which specifies the individual options granted, the vesting schedule and other employee-specific information (and generally includes the form of Exercise Agreement annexed as an exhibit); and (iii) a Notice of Stock Option Grant to be executed by the company and each optionee, which is a short summary of the material terms of the grant (though this is not a requirement).

This post is part of the “Ask the Attorney” series I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  Below is a longer, more-comprehensive version of the VentureBeat post.

Question 

We’re trying to negotiate a partnering agreement with a marketing firm, and we’re worried about sharing our click rates and other sensitive information with them.  I assume we should have them sign a non-disclosure agreement, but we don’t have the money for a lawyer and was hoping you could give us a heads-up regarding some of the key issues.  Thanks!

Answer 

As I discuss on my firm’s website (and this may sound self-serving but), you really need to get a lawyer involved to protect you.  Indeed, you should never sign any agreement without having it first reviewed by experienced corporate counsel.  That being said, below are five key issues to think about with regard to your non-disclosure agreement (commonly referred to as an “NDA,” a “confidentiality agreement,” a “confi agreement” or a “CA”). 

1.  Scope of “Confidential Information”.  Most NDA’s will include a definition of “Confidential Information” or a similar term to address the issue of what information specifically is being protected.  You, as the discloser, should push hard to protect all of the confidential or proprietary information that you provide to the recipient, regardless of its form (whether written, oral or otherwise).  You should also attempt to include in the definition of Confidential Information any notes, analyses or other documents prepared by the recipient or its representatives which have been “based upon or derived from” the Confidential Information.  The recipient will try to define Confidential Information narrowly to include just written materials marked “Confidential” or “Proprietary.”

2.  Exceptions to “Confidential Information”.  Most NDA’s also include exceptions or exclusions to the definition of Confidential Information.  For example, the recipient will argue that it should not be required to maintain the confidentiality of information that (i) is or becomes publicly available, other than as a result of recipient’s breach; or (ii) it possessed prior to its disclosure under the NDA.  The recipient may also argue that Confidential Information should not include information it receives from a third party known by the recipient not to have been bound by a confidentiality agreement.  You, as the discloser, should push back on this and at least require the recipient to have a duty of inquiry with respect to such information. 

3.  Maintaining Confidentiality and Permitted Uses.  You, as the discloser, want to make sure that the NDA clearly provides that the recipient will keep the Confidential Information confidential and will not, without your prior written consent, disclose it to anyone other than the recipient’s representatives (such as employees, attorneys, etc.) on a need-to-know basis.  You also should require the recipient to limit the use of the Confidential Information solely in connection with the partnering agreement. 

There are often lengthy negotiations regarding the identity of recipient’s “representatives” and whether the recipient will be responsible for any disclosure by such representatives.  Particularly in the M&A context, disclosers of confidential information generally push hard to require the recipient to have all of its representatives sign a separate NDA or an acknowledgement agreeing to be bound by the confidentiality provisions in the current NDA.  Recipients will often push back and argue that this is an extraordinary administrative burden. 

4.  Non-Solicitation of Employees.  One provision that is often overlooked by disclosers is a provision preventing the recipient from hiring and/or soliciting its employees.  In your situation, I assume that some of your employees will be working closely with the marketing firm and, accordingly, you would want to make sure they don’t poach any of them.  Disclosers are especially vulnerable in the M&A context because of employee concerns about corporate stability. Recipients often try to narrow these kinds of provisions to exclude (i) general employment solicitations made via web postings or newspaper ads, etc. and (ii) any employees with whom it has not come into contact; and to limit their duration to one year.

5.  Termination.  Typically, the recipient’s obligation to keep the information confidential will survive the termination of the NDA (even if the recipient has returned or destroyed the information).  The issue then becomes how long should recipient’s confidentiality obligations last.  You, as the discloser, will want the obligations to run indefinitely, particularly with respect to any trade secrets.  The recipient will push back and argue for a date certain (e.g., two or three years). 

Conclusion/M&A

In conclusion, please note that most of my experience with NDA’s is in the M&A context.  Accordingly, I would add the following quick points if you are a target and are executing an NDA with a prospective acquirer: (i) the NDA should include an obligation on the part of the acquirer and its representatives not to disclose the fact that negotiations are taking place and that the acquirer is considering an acquisition of the target; (ii) if the acquirer is a competitor, certain key issues must be addressed to avoid any potential antitrust issues, including limiting the acquirer’s access to certain sensitive information (e.g., pricing, planning, marketing, etc.) and prohibiting the acquirer from contacting customers or suppliers; and (iii) if the target is a public company, a standstill agreement is imperative.

This post is part of my “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”  Below is a longer, more-comprehensive version of the VentureBeat post, which provides seven tips to entrepreneurs contemplating selling their venture.

Question 

I liked your posts on VentureBeat a few weeks ago about what to watch-out for as a buyer of a business.  What about if I’m a seller?  I’m the founder of a web-based music business, and I’m ready to sell and move onto my next venture.  Any advice would be appreciated.          

Answer 

Thanks, below are seven quick tips in connection with selling your company.

1)  Be Careful with Private Equity Buyers.  Private equity firms are in the business of buying and selling companies.  Accordingly, they are extremely sophisticated and savvy and are often represented by large, aggressive law firms.  Indeed, I used to represent private equity firms when I worked at two major law firms in New York City, and I understand very well how they operate. 

Deals with private equity buyers are generally more complex than those done with strategic buyers due to, among other things, the level(s) of debt added to the target and/or financial engineering.  Moreover, unlike most strategic buyers, private equity buyers usually require the selling entrepreneur to rollover part of his/her equity into the acquirer (i.e., to maintain skin in the game) and may include a financing condition in the acquisition agreement – which obviously adds a level of uncertainty to closure.  

2)  Negotiate the Material Terms in the Letter of Intent.  As I have previously discussed, your strongest leverage as a seller is prior to the execution of the letter of intent (the “LOI”).  This is the time when a solid investment banker will create a competitive environment (or the perception of same), and prospective buyers will be required to compete on price and terms.  One buyer, for example, may offer a higher purchase price, but require a “cap” (as discussed below) equal to such price; another buyer may offer less, but only require a 10% cap.  Accordingly, prior to choosing a buyer, you should negotiate and weigh all of the material terms of the offer, and the LOI should reflect such terms. 

3)  Sell Stock (Equity) Not Assets.  As a general rule, you should sell stock, not assets, for three significant reasons: (i) potential tax savings if your company is a “C” corporation (i.e., there will not be “double-taxation”); (ii) to pass the company’s undisclosed liabilities onto the buyer (subject, of course, to the indemnification provisions); and (iii) because it generally requires less documentation and less time to close (which means less legal fees).  Obviously, every deal must be structured with the assistance of competent counsel, including tax counsel; however, as a seller, you should be thinking about selling stock, not assets.

4)  Cap Your Potential Liability.  Obviously, you want to sleep well after you sell your venture (and enjoy the fruits of your labor).  Accordingly, it is critical that certain key provisions be inserted into the acquisition agreement to protect you post-closing.  One such provision is a cap on liability, which, as noted above, should ideally be negotiated in the LOI.  You should strive for a cap of 10% of the purchase price and should also try to minimize any buyer carve-outs.  Your message to the buyer is simple: inherent in any business are certain ongoing risks; thus, once the business is sold, the buyer should only be able to recover a limited amount of the sale proceeds (absent fraud).   

5)  Insert a Non-Reliance Provision in the Acquisition Agreement.  Another important seller protection that should be inserted into the acquisition agreement is a so-called “non-reliance” provision, which requires the buyer, in effect, to acknowledge that it is buying the business based solely on the seller’s representations and warranties in the acquisition agreement.  Indeed, such a provision is intended to prevent the buyer from suing the seller based on any oral statements, writings, projections, etc. outside the four corners of the agreement.

6)  Retain a Strong, Experienced Corporate Attorney to Watch Your Back.  This is obviously a bit self-serving, but you, as the seller, need a strong, experienced attorney to watch your back.  There is just too much at stake for you to be (i) utilizing an inexperienced lawyer (such as the guy or gal who formed the company or negotiated the office lease) or (ii) retaining the cheapest lawyer to save money.  Moreover, as the Madoff affair and other recent high-profile cases demonstrate, there are a lot of unscrupulous characters out there trying to take advantage of unsophisticated entrepreneurs.  

The bottom line is that a strong, experienced corporate lawyer will sober you and lay-out all of the significant legal risks; he will then push hard to negotiate reasonable protections.  If the sale sours post-closing and lawsuits are filed, well-drafted documents with appropriate protections become a kind of insurance policy.

7)  Get the Buyer to Pay a Termination Fee.  Finally, you should try to require the buyer to pay a termination fee if the acquisition agreement is terminated through no fault of your own.  This is sometimes referred to as a “reverse break-up fee,” which can be as high as 10% of the purchase price or as low as the total amount of the seller’s transaction expenses.  This is an issue that is often not addressed by middle-market sellers, but should be.

Conclusion

I hope the foregoing is helpful.  I currently have two sales of businesses on my plate and, I can assure you, that I am working hard with my colleagues to protect the sellers and make sure that nothing comes back to bite them.  If you have any questions, please shoot them to me through the comments section or via email at swalker@walkercorporatelaw.com.  Many thanks, Scott

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”  Below is a longer, more-comprehensive version than I posted on the VentureBeat site.

Question: 

My co-founder and I are friggin crushing it.  We launched our company about two years ago, and we now have an opportunity to buy a couple of struggling companies in our space.  We have lawyers we work with, but I was wondering if you could just give me a heads-up on some of the legal issues we should be thinking about.  Thanks!      

Answer:  

Last week I discussed the following significant issues: (i) executing an exclusivity agreement; (ii) avoiding negotiating the material terms in an LOI; (iii) doing adequate due diligence; (iv) buying assets, not equity; and (v) protecting against a fraudulent conveyance claim.  Below are five more issues to think about.

1.  Escrow a Portion of the Purchase Price.  An important step you can take is to escrow a portion of the purchase price (e.g., 15%) for a period of time post-closing (e.g., 18 months).  Indeed, escrows are relatively common (particularly where there are multiple sellers) because of the inherent unfairness of requiring the buyer to sue the seller(s) to try to get some of its money back for a problem or liability it never agreed to take on. 

Alternatively, you, as the buyer, can push for a hold-back (i.e., a right to hold part of the purchase price) and/or a right of set-off in deals where part of the purchase price has been deferred (e.g., where the buyer has issued a promissory note to the seller as part of the purchase price); however, escrows are obviously more amenable to sellers because the money is held by an independent third party and the buyer does not have the unilateral right to withhold payment. 

2.  Use Earn-Outs Only As a Last Resort.  Earn-outs (i.e., post-closing contingency payments) are often touted by unsophisticated investment bankers and counsel as an effective way to bridge the gap between what the buyer is willing to pay for a business and the seller’s asking price.  The reality, however, is that earn-outs often lead to major disputes and business problems post-closing and should, accordingly, be avoided if at all possible. 

On the legal side, a number of critical issues must be negotiated, including (i) the metric (e.g., revenue, EBITDA, profit, etc.) and milestones, (ii) measurement/accounting issues, (iii) exclusions/carve-outs (e.g., allocation of administrative or general overhead expenses, intercompany transactions and charges, etc.), (iv) the duration of the earn-out period, (v) the effect of acquisitions or dispositions relating to the acquired business and (vi) most significantly, post-closing operational control issues.  The amount of time and energy that is required to address adequately the foregoing issues can be extraordinary (often leading to pages and pages of provisions), and there will still be gaps because it is virtually impossible to anticipate every post-closing contingency. 

On the business side, earnouts usually create significant impediments to the integration process and conflicting interests between the buyer and the target post-closing — e.g., if the metric is revenue growth, the target may sign-up a number of new customer contracts that may not be profitable or in the best long-term interest of the business; if the metric is profit or EBITDA, the target may cut back on capital expenditures or other expenses (such as marketing or advertising) — particularly as the end of the earn-out period approaches.  Moreover, target management may lose its motivation if it is unable to achieve its goals and thus is never entitled to an earn-out payment.  The bottom line is that earn-outs are very tricky from both a legal and business perspective and should only be used as a last resort.

3.  Don’t Give Away the “Basket”.  One of the provisions sellers generally insist on in the acquisition agreement is a “basket” to prevent the buyer from “nickel and diming” the seller for any claims post-closing.  The size of the basket varies from deal to deal, but based on a recent study of the Committee on Negotiated Acquisitions of the American Bar Association (of which I am a member), the norm is approximately .5% of the purchase price. 

If you agree to a basket, there are a number of significant issues that you must address, including the following: (i) push for a “first-dollar” basket (sometime referred to as a “threshold”) as opposed to a “deductible” so that if its damages exceed the basket, the seller would be responsible for all of the damages (i.e., beginning with the first dollar); (ii) the basket should only relate to breaches of representation and warranties and not to covenants or specific indemnity provisions (this is a common mistake); (iii) any materiality qualifiers in the representations and warranties should be disregarded for purposes of the basket — otherwise there would be a so-called “double-materiality” problem (another common mistake); and (iv) there should be appropriate carve-outs to the basket, the most common of which include capitalization, due organization, due authority and ownership of shares.

4.  Include a Carefully-Drafted “MAC”.  From the buy-side, one of the most important representations and warranties of the seller (and closing condition if there is a signing and a subsequent closing) is that the business has not suffered a material adverse change (“MAC”) over a certain period of time pre-signing/closing.  Lawyers have a field day wordsmithing the definition of MAC — arguing over such issues as (i) the applicable period, (ii) whether “prospects” should be included, (iii) whether the target and its subsidiaries should be “taken as a whole” and (iv) of course, the exceptions. 

The bottom line, however, is that most MAC definitions are extremely ambiguous, and there is little case law to provide any guidance as to what constitutes a MAC.  Moreover, the leading Delaware case, IBP, Inc. v. Tyson Foods, Inc., suggests that the standard as to what constitutes a MAC is quite high — “measured in years, rather than months.”  Accordingly, the buyer must be careful about relying on a MAC to terminate an acquisition agreement (or otherwise to sue the seller for breach of the MAC rep) unless the definition includes specific objective criteria — e.g., a specific dollar decrease in EBITDA or sales, etc.  (Note: as a downsize protective measure, an expense reimbursement provision should be coupled with the MAC and other closing conditions.)

5.  Watch Out for “Caps”.  One of the most important and hotly-negotiated issues in any private company acquisition is the cap (or ceiling) on the seller’s damages.  Like other material terms in the acquisition agreement, there is no right or wrong answer (or “customary” or “market” amount): it all depends on the context of the transaction — i.e., the bargaining power of the parties, the risk profile of the target, the purchase price, etc. 

For example, in an auction context with numerous bidders expressing interest in a target, the cap may end-up being 10% or less of the purchase price due to the competition; on the other hand, if the target has a host of significant problems (and/or is financially troubled) and there is only one prospective buyer on the horizon, the cap may end-up being equal to the purchase price (or there may be no cap). 

The lesson here — and the key takeaway of this post — is that you, as the buyer, must fully understand the businesses that you are buying and the significant deal risks in order to make an informed judgment with respect to price and terms, including the cap.  Indeed, if the cap is less than 100% of the purchase price, you should generally push hard to include certain carve-outs.

Conclusion

I hope the foregoing is helpful.  Indeed, as I noted last week, acquiring another company is tricky and raises a host of significant issues that need to be buttoned-down.  If you have any questions, please shoot them to me in the comments section of this post or via email at swalker@walkercorporatelaw.com.  Many thanks, Scott

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”  

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question

My co-founder and I are friggin crushing it.  We launched our company about two years ago, and we now have an opportunity to buy a couple of struggling companies in our space.  We have lawyers we work with, but I was wondering if you could just give me a heads-up on some of the legal issues we should be thinking about.  Thanks!      

Answer 

Wow – that’s a pretty broad question.  There are, in fact, many issues that you should be thinking about.  I will address five significant ones in this post and five more in part 2 next week.   

1.  Execute an Exclusivity Agreement.  Your first step in connection with a potential acquisition should be to execute a tightly-drafted exclusivity (or “no-shop”) letter agreement with the seller, granting your company the exclusive right for a period of time (e.g., 90-120 days) to negotiate with the seller and to complete your due diligence investigation.  Such an agreement is often part of a letter of intent (an “LOI”); however, from your perspective, as the buyer, it is generally advantageous to execute a separate letter agreement and skip the LOI (i.e., proceed directly to the negotiation and execution of a definitive acquisition agreement) for the reasons discussed in #2 below.

2.  Avoid Negotiating the Material Terms in an LOI.  The seller’s negotiating leverage is strongest prior to the execution of an LOI — particularly if an investment banker has effectively created a competitive selling environment or the perception of one.  (See my post on investment bankers.)  Accordingly, it is in the seller’s (not the buyer’s) interest to negotiate the material terms of the deal in an LOI.  You, as the buyer, can avoid this trap in one of two ways: (i) as noted above, by executing an exclusivity letter agreement and skipping the negotiation of an LOI; or (ii) by executing an LOI that includes a binding no-shop provision, but is otherwise non-binding (except perhaps with respect to expense reimbursement and/or other “special” provisions) and is as non-specific/general as possible. 

Either approach will give you not only strong negotiating leverage, but also the time and flexibility to complete your due diligence investigation prior to agreeing to any material terms – without getting into a bidding war with other prospective buyers. 

3.  Do Your Diligence.  A comprehensive due diligence investigation is critical to the success of any acquisition.  The fundamental purpose of due diligence is to validate assumptions with respect to valuation and to identify risks.  Accordingly, there are typically three separate investigations: operational/strategic, financial and legal.  Clearly, the scope of your investigations must be tailored to the particular transaction; however, it cannot be emphasized enough that most deals fail due to inadequate diligence — resulting in the buyer (i) overpaying for the target, (ii) assuming significant unknown liabilities and/or (iii) experiencing major integration problems.       

4.  Buy Assets, Not Stock (Equity).  It is generally in your interest to purchase assets, not equity, of the target for two principal reasons: (i) you will get a stepped-up tax basis in the acquired assets; and (ii) you will minimize the assumption of any unwanted liabilities.  Indeed, in a stock transaction or merger, the buyer assumes all of the target’s liabilities (known and unknown) by operation of law; in an asset transaction, however, the buyer only assumes those liabilities that are expressly agreed to in the acquisition agreement (subject to the doctrine of “successor liability” – which requires the assumption of certain liabilities as a matter of public policy).

5.  Protect Against a Fraudulent Conveyance Claim.  You need to be very careful if you’re going to be acquiring a “struggling” company.  One of the issues you need to worry about is a subsequent “fraudulent conveyance” claim by a dissatisfied creditor of the seller (which is a complex issue).  What happens is, after the deal has closed, a creditor would sue your company to avoid (or set aside) the sale on the ground that there was “actual” fraud (i.e., the sale was actually intended to hinder, delay or defraud creditors) or, more likely, “constructive” fraud (i.e., the sale was made for less than fair consideration or reasonably equivalent value and the target was insolvent at the time of, or rendered insolvent by, the sale). 

To minimize this risk, you must do two things: (i) build the best possible record that “fair consideration” or “reasonably equivalent value” was paid (e.g., by obtaining a fairness opinion from a reputable investment bank); and (ii) require that (A) the sale proceeds be used for the benefit of the seller and not be distributed to the seller’s stockholders and/or (B) adequate arrangements are made to pay-off the seller’s creditors.  (You can learn more about fraudulent conveyance and related issues in my post “Buying a Distressed Business: Ten Tips for Entrepreneurs.”) 

Conclusion

I hope the foregoing is helpful.  Indeed, acquiring another company is tricky and raises a host of issues that need to be buttoned-down.  If you would like to learn about some of the typical mistakes entrepreneurs make in connection with doing deals generally, you should check out my video “Five Mistakes Entrepreneurs Make in Dealmaking” on YouTube.

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”  Below is a longer, more comprehensive version.  Please give me your input in the comments section.  Many thanks, Scott

Question 

I’m launching a new venture and read your VentureBeat post a few weeks ago about Class F stock.  I’m a little confused because I asked around, and none of my friends who are founders heard of it.  One guy did mention Series FF stock, but I wasn’t sure if that’s the same as Class F?  Please let me know.

Answer 

Yes, it’s definitely confusing — but “Class F” stock and “Series FF” stock are different.

As I previously discussed, Class F stock is a separate class of common stock that was designed in 2009 by The Founder Institute to provide the founders with certain special rights (e.g., super-voting rights) upon incorporation.  The articulated goal is to level the playing field for founders in connection with their negotiations with investors and to protect them from the “atrocities of investors.”   

Series FF stock, on the other hand, is a separate class of preferred (not common) stock that was designed in 2006 by Sean Parker of the Founders Fund to permit founders to cash out a small percentage of their stock prior to a liquidation event. (The “FF” stands for Founders Fund, and it has been used in several Founders Fund deals.)

Indeed, as Barney Pell, the founder of Powerset, noted in the San Francisco Chronicle:

“There is often a tension between venture capitalists and founders. The venture capitalist wants the founders to starve and to have no cash liquidity until the very end. Of course, the founders, unlike the venture capitalists, are putting all of their eggs in one basket…. Sean came up with the idea of allowing founders to sell small amounts of their shares along the way so you can have some life-changing effects and reduce your risk and everyone can be aligned for a home run.”

Here’s how Series FF preferred stock works:

1)      Shares of the Series FF preferred stock are generally issued to the founders upon incorporation or immediately prior to the Series A round. 

2)      The shares are generally identical to shares of common stock, except they are  convertible at the shareholder’s option into shares of the same series of preferred stock issued in a later round (provided that the buyer of the Series FF shares purchases them as part of that round and pays the same price as the preferred stock being issued).

3)      The conversion of the shares of Series FF must be approved by the issuer’s Board of Directors.

As noted above, the significant advantage of issuing Series FF preferred stock is that it allows the founder(s) to take a few chips off the table.  Indeed, for many founders, the opportunity to cash-out is quite appealing, particularly where they have run-up significant credit card debt and/or are interesting in buying a home for their family.  The amount of the cash-out, however, is generally capped to between 10 and 15 percent (depending upon the round of financing). 

The other advantage is that it is a clever way of avoiding issues relating to the increased pricing of options if investors were to buy founders’ common stock, as opposed to preferred stock (converted from the Series FF).

Obviously, the significant disadvantage of issuing Series FF stock is that it may deter investors from investing because investors generally want founders to be “all in” and not pull any money out of the venture.  That being said, there are circumstances where investors permit founders to take some money out, but usually it’s done through a mechanism other than Series FF stock.

Other disadvantages include an added layer of complexity (thus increased legal fees, among other things) and potential litigation from other stockholders (including employees of the company) if the company doesn’t have a successful exit.  Indeed, in the event of litigation, it may be difficult for the founders and/or the Board of Directors to justify having investment funds arguably diverted from the company.

Conclusion

The bottom line is that Series FF stock (like Class F stock) is relatively new and its issuance is not widespread.  Accordingly, for first-time entrepreneurs, it probably makes sense to keep it simple and just issue ordinary shares of common stock.  Nevertheless, I wholeheartedly support any effort to help founders better align their interests with their investors.

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  Below is a longer, more comprehensive version.  Many thanks, Scott

Question 

My buddy and I are launching a new venture, and we’ve read some articles on the web about incorporating in Delaware and other things we need to do from the legal side.  One issue that came up that we don’t understand is Class F stock, which we read about on a few blogs.  What is Class F stock and do you think we should be utilizing it?  

Answer 

This issue has come-up quite a bit recently with several new clients.  “Class F” stock is a special class of common stock that was designed by The Founder Institute to protect founders.  The “F” is for “Founders” – but it really doesn’t matter what you call it: Class H, Class Q or Class X.  The key point is that a separate class of common stock is issued to the founders upon incorporation with the following special rights (as set forth in the sample certificate of incorporation on the Founder Institute’s website): 

• super-voting rights (10 votes per share);
• certain protective rights similar to those that preferred stockholders are generally granted (e.g., the consent of a majority of the Class F holders is required for the company to enter into a “Liquidation Event”); and
• the right to elect a director that has two votes on the Board (not one).

The advantage of issuing Class F Stock is that it will arguably level the playing field for you and your co-founder in connection with your negotiations with investors and protect you from the “atrocities of investors.”    

The disadvantage of issuing Class F Stock is that it may deter investors from investing in your startup.  Indeed, it is tough enough for entrepreneurs to raise capital these days; throwing Class F stock in the equation may make your company less attractive.  Moreover, the issuance of Class F stock will increase your legal fees due to the added complexity.

The bottom line is that the issuance of Class F Stock is relatively new.  Accordingly, in the current economic environment (where investors generally have the leverage), Class F Stock probably only makes sense for successful, serial entrepreneurs who are going to have lots of investors interested in their venture.  For first-time entrepreneurs, I would suggest that you just keep it simple and issue ordinary shares of common stock to the founders.

That being said, I tip my hat off to Adeo Ressi, the founder of the Founder Institute, for his efforts.  Having spent the bulk of my career doing large M&A transactions in New York City, I was surprised to see how complex and pro-investor the standard VC financing documents are.  Clearly, any effort to level the playing field is a net plus for entrepreneurs and something that I wholeheartedly support.

Conclusion 

I hope the foregoing is helpful.  In conclusion, please note that Class F stock should not be confused with “Series FF” stock, which was created by Sean Parker of the Founders Fund and is designed to permit founders to cash out a small percentage of their stock prior to a liquidation event.  I will discuss Series FF stock next week.

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question

My two friends and I have been working on a new venture for almost a year.  Our site is in beta and we actually have a few customers (it’s a subscription-based model).  We’ve spoken to a lawyer about incorporating, but we don’t know how to split-up the stock.  Should everyone just get one-third?

Answer  

That’s a great question.  Before I answer it, however, let me just make a quick point:  When launching a venture, the first rule of thumb is to incorporate as soon as possible when the venture has as little value as possible.  Why?  Because, among other things, you want to be able to issue stock to the founders for a nominal purchase price so that they can share in the increased value of the company (and start the capital gains holding period).

To the extent the venture’s incorporation is delayed and its value increases due to the meeting of certain milestones, etc., there may be tricky tax issues with respect to the purchase price (or value) of the shares issued to the founders.  Indeed, if the company were ever audited, the IRS may take the position that the shares sold for a nominal purchase price actually had value and deem such value compensation to the founders (particularly if the shares were issued on a date close to a financing date).

As I have previously discussed, another important reason to incorporate as soon as possible is to protect against personal liability.

Now, with regard to your question whether the equity should be split equally, the short answer is “usually not.”  The splitting of equity is a significant business decision which must be negotiated among the founders based upon their respective contributions to date and their expectations going forward.  Simply dividing the shares equally among the three of you may sound fair on its face, but it’s usually not the correct decision.

Factors to consider include:

1. Whether any of the founders contributed cash and/or intellectual property to the venture – which would warrant a higher percentage for that founder.
2. Whether any of the founders actually came-up with the idea for the venture – which would warrant a higher percentage for that founder.
3. Whether any of the founders will be working part-time or less than the other founders going forward – which would warrant a lower percentage for that founder.
4. Whether any of the founders put in more time prior to the incorporation (e.g., drafted the business plan) or actually started the venture – which would warrant a higher percentage for that founder.
5. Whether any of the founders will have greater responsibility or will be adding more value going forward than the other founders (e.g., due to domain expertise) – which would warrant a higher percentage for that founder.

The bottom line is that every venture is different, with varied contributions (past and future) by the founders.  It might help to sit down with your co-founders and your lawyer and hash this issue out.  As I discuss in my VentureBeat post regarding founder vesting, you will also need to hash out the vesting schedules, including (i) whether any founders will vest a portion of their stock “up front” and/or (ii) whether a  one-year “cliff” will be imposed on any founders.

Conclusion

I hope the foregoing is helpful.  There is an interesting post by Frank Demmler entitled “The Founders’ Pie Calculator,” which provides a way to quantify the elements of the decision-making process.

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”   

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question 

We just got an offer to buy our company for a sweet pile of cash, but we don’t know what the next step is.  My father said we should hire an investment banker and let him handle the negotiations.  Do you agree?  Thanks.

Answer 

Congratulations!  Without knowing more about the deal and the proposed purchase price, it’s hard to say.  I practiced law for a number of years in New York City, and it was pretty rare not to have an investment banker involved in an M&A transaction.  Here in California, it’s a little different since most of the deals tend to be relatively small. 

A strong investment banker can add a lot of value — not only in connection with negotiating the material terms of the transaction, but also in valuing the company and making sure that you’re not selling too low.  A strong banker will also create a competitive environment (or the perception of one) and play bidders off of each other to make sure you get the best possible deal terms.  Indeed, Martin Lipton, a prominent M&A attorney in New York City, captured the value (and qualities) of a strong investment banker in his remarks at the Memorial Service of legendary banker Bruce Wasserstein here.

The problem in the lower middle-market space (e.g., $5-50 million sale price) is that it’s sometimes difficult for entrepreneurs to find a strong investment banker.  A lot of the bankers I have come across here in California are more like business brokers just trying to close two or three deals a year.  I have found that this creates a certain inherent conflict of interest – they don’t get paid if the deal doesn’t close; thus, some of them tend not to push very hard on the key issues. 

Moreover, middle-market investment banks often have relationships with certain buyers (e.g., private equity firms) and bring those same buyers lots of different deals.  Accordingly, they don’t necessarily want to rock the boat.

The bottom line is that you should talk to an experienced M&A attorney, and he or she can discuss the foregoing with you.  If you decide that you would like to retain an investment banker, you should ask the attorney for a few recommendations and then meet with them and choose the best fit.  Make sure you ask for references and talk to other clients they have helped sell their businesses.

If you decide that you do not need an investment banker, your attorney can help negotiate the letter of intent (or term sheet).  The letter of intent is very important from your perspective, and you want to make sure that all of the material terms of the deal (e.g., the “cap” on liability, the size of the “basket/deductible,” the survival period of the reps and warranties, etc.) are negotiated at this stage of the transaction.  I discuss this issue in detail in my post “Selling a Company: Ten Tips for Entrepreneurs” (see #5).    

Why?  Because this is when you have the strongest leverage – i.e., prior to the execution of the letter of intent. This is when, as noted above, bidders can be played off of each other.  Once the letter of intent is executed, you will not be allowed to shop your company around or talk to any other potential buyers pursuant to the no-shop provision (which is generally in all letters of intent).  Accordingly, if you don’t retain an investment banker, this is when you and your lawyer will need to button-down the key issues.

The buyer, on the other hand, is better served by simply keeping the letter of intent general (other than the no-shop provision) and then negotiating the key issues in the acquisition agreement when the other interested parties (if there are any) have gone away and your leverage is weakest.  I discuss this issue in detail in my post “Buying a Business: Ten Tips for Entrepreneurs” (see #2).

Conclusion

I hope the foregoing is helpful.  If you’re interested, there’s an excellent article in yesterday’s New York Times with respect to the role of investment bankers generally and Warren Buffett’s concern regarding their inherent conflicts of interest (see “Buffett Casts a Wary Eye on Bankers”).

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”   

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question 

We launched our company about a year ago, and we’re having trouble raising money.  I met a consultant at a conference who said he has a lot of connections and could help us raise about $500K if we paid him 6%.  This seems like a pretty good deal.  Are there any legal issues we need to worry about?   

 Answer  

Yes, there are number of legal issues you need to worry about — and the one that jumps out front and center is whether the consultant is licensed as a “broker-dealer”; if he isn’t, I strongly suggest that you run the other way, as discussed below.

The securities laws are complex and are a potential minefield for the unwary.  Under both federal and California securities laws, a so-called “finder” – i.e., someone who holds himself out as being able to introduce companies to interested investors – must be registered with the Securities and Exchange Commission (SEC) and the California Department of Corporations if he is acting as a “broker-dealer”.   

The term “broker-dealer” is very broadly defined under both federal and California law and includes any finder who receives some form of commission or success-based compensation (such as in your situation).  Other broker-dealer activities include making presentations to investors, participating in the negotiations between the company and the investors, structuring the transaction between the company and the investors, and/or regularly engaging in the business of finding investors for companies (as opposed to a one-off). 

The bottom line is that if a finder does anything beyond merely introducing the company to potential investors, he will likely be characterized as a broker-dealer requiring registration.

You may be thinking, so what – not my issue.  Wrong!  If he is not registered (which is probably the case since he’s calling himself a consultant, as opposed to an investment banker) and you pay him his 6% commission, the company faces the following consequences:

First, the company’s issuance of securities will be in violation of applicable securities laws, which could result in possible SEC and/or state regulatory action, including injunctive relief, fines and penalties, and possible criminal prosecution.  Indeed, as I have previously discussed, in light of the Madoff affair and other external pressures, the SEC and state securities are significantly stepping-up enforcement of the securities laws.

Second, investors will be able to sue the company to rescind the transaction – i.e., to unwind the sale and get their money back, plus interest.  Under California law, they also arguably would have a right to sue for damages up to $10,000.

Finally, the company’s use of an unregistered finder may adversely affect any future capital raising activities, including an initial public offering, and may subject to the company to liability for “aiding and abetting” the securities law violations of the finder. 

Conclusion

I hope the foregoing is helpful.  I, of course, understand that this is a tough environment for entrepreneurs to raise capital – and adding one more hurdle (i.e., avoiding unregistered finders) makes the fundraising process even more difficult.  That being said, it is foolhardy for entrepreneurs not to comply with applicable securities laws.  Indeed, my firm is representing several clients who did not and now regret it.   If you would like to learn more about the five common mistakes entrepreneurs make in raising capital, you can check out my post here.   

This post is part of a weekly series called “Ask the Attorney,” which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”   

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question 

We launched our company about six months ago, and we have a couple of angel investors lined-up for about $300,000.  We don’t know if we should sell them common stock or preferred (they want preferred).  I’ve been reading some stuff on the web that recommends issuing convertible notes.  What do you recommend?  Thanks!

Answer 

This issue comes-up all the time.  In short, I recommend that you issue convertible notes.  Below are the advantages and disadvantages of each choice from the founders’ perspective. 

1.  Common Stock.  The advantage of issuing common stock is that it is relatively quick, simple and inexpensive.  All you need is a short subscription agreement and perhaps a stockholders agreement (if you don’t already have one).  In addition, from the founders’ perspective, it puts the angels in the same boat as them. 

There are four disadvantages: (i) you will need to value the company, which (as discussed below) can be difficult and may lead to the founders’ substantial dilution; (ii) you’re likely to get substantial push-back from sophisticated angels — who generally will not agree to common stock because they don’t think their money should put them in the same boat as the founders; (iii) there may be tricky tax issues depending upon the timing of the investment — e.g., if you and your co-founders paid a nominal price for your shares of common stock and the angels pay substantially more for theirs shortly thereafter, the IRS may question how the value of the stock could have increased so much and may deem the shares issued to the founders a form of compensation; and (iv) it may cause potential problems with respect to stock option grants because the value of the shares of common stock will be established.  

2.  Preferred Stock.  Preferred stock is extremely favorable to the angels.  The only advantage from your perspective is that the interests of the founders and the angels are aligned.  Specifically, there is no incentive on the angels part (unlike if they were holding convertible notes, as discussed below) to keep the valuation of the company low in the Series A round.

The disadvantages to issuing preferred stock are significant.  First, it is relatively time-consuming, complicated and expensive.  Indeed, legal fees can be in the neighborhood of $20,000 or more if the preferred stock has all the “bells” and “whistles.” And second, as noted above, valuing the company at such an early stage is difficult and often leads to protracted negotiations and substantial dilution to the founders.    

3.  Convertible Notes.  The issuance of convertible notes is often viewed as a reasonable compromise between issuing common stock and issuing preferred stock.  In essence, it is a form of “bridge” financing – i.e., it is designed to provide the company with sufficient funds to get to the first professional (i.e., “Series A”) round, at which point, the notes would automatically convert into preferred stock at a discount (e.g., 15%-35%).  

The advantage of issuing convertible notes is that it is relatively quick, simple and inexpensive; all you arguably need is a short note.  As discussed above, the other significant advantage is that it will defer the company’s valuation (i.e., the pricing) until the Series A round.  By issuing convertible notes, you “kick the can” to the Series A round when the valuation picture would be clearer. 

The disadvantage of issuing convertible notes is that, as noted above, the founders’ interests and the angels’ interests may not be aligned because, again, it’s in the angels’ interest for the Series A valuation to be low.  Indeed, angels who think they can make a significant contribution to your company (e.g., as a result of their introductions or domain expertise) want to share in the increase in value they are creating.  Accordingly, if the angels do agree to the issuance of convertible notes, they will often push for a “cap” on the Series A valuation (which is obviously not in your interest).

Conclusion

I hope the foregoing is helpful.  If you would like a few tips with regard to angel financing generally, you can check-out these two posts: Angel Financings – Legal Tips for Entrepreneurs (Part I) and Angel Financings – Five Tips for Entrepreneurs (Part II).