Dodd Banking Bill Aims Shotgun at Investor Fraud, Hits Early Stage Companies

March 30th, 2010

There has been a lot of news recently about Senator Christopher Dodd’s banking reform bill, which was introduced in the Senate a couple of weeks ago.  I dug into the details relevant to startup and private company financing transactions (with help from the comments on and an insightful piece on TechFlash), and thought a bit about how it would likely affect my client base.

Principal Terms
The entire bill runs 1036 pages, of which about 6 are relevant to angel and VC financings.

First, the proposal requires that the accredited investor dollar threshold be increased regularly to adjust for inflation.  The current requirement (which dates from 1996) is that an investor earn at least $200,000 per year or have a net worth of at least $1,000,000.  The Dodd bill requires that a retroactive inflation adjustment be applied to those figures and that they continue to be adjusted at least every 5 year going forward.  I haven’t tried to do the math, but pundits say this would increase the threshold to $450,000/$2,300,000.

Second, the bill kicks oversight of Regulation D transactions (the principal exemption from public offering registration requirements used by private companies) largely to state authorities.  The bill would (i) set a dollar threshold below which the SEC would not even try to regulate, saying that small transactions are exclusively overseen by state agencies, and (ii) for larger transactions provide a 120 day SEC review period, following which state authorities could also choose to review if the SEC did not.

Where This Comes From
The president of NASAA is also a Texas state securities regulator and in testimony to Congress explained NASAA’s belief that (i) fraud is most effectively prevented when SEC and state authorities can review/investigate problem cases, (ii) NSMIA prevents state authorities from preemptively investigating cases and only allows them to investigate after fraud has occurred, and (iii) lack of Reg D oversight contributed to the financial meltdown.

It looks to me as though NASAA is concerned about the Bernie Madoffs of the world and sees increased regulation over private securities transactions as the best way to reign in this type of fraud.  Clearly NASAA also does not believe the SEC is up to the job of policing this environment.

Things I Don’t Understand
I don’t understand how the 120 day rule would work and I would love to ask Sen. Dodd the following questions:

-Will private companies be required to wait 120 days before closing financing transactions?
-If not formally required to wait, will investors have a rescission right if the SEC or state authorities find noncompliance with procedural or substantive requirements?
-How would this rescission right be enforced?  Brokers are subject to bonding requirements so there is the possibility of recovery in a fraudulent sale by a stock broker, but seemingly none with early stage companies in particular.  Six months after closing an angel financing a company may have already spent a decent chunk of the financing proceeds.
-Will state pre-closing notice requirements apply even prior to the SEC’s review period, so that e.g. a company would need to file a notice (and forms!) in NY, file an SEC notice 2 weeks later and then wait 6 months to see if NY would be able to pick up again?

What I Will Probably End Up Telling My Clients
In the most practical terms as a California lawyer, if this bill passes I will probably tell my clients that there is a sliding scale for transaction costs and timing that depends on where investors reside.  My gut tells me neither the SEC nor the CA Department of Corporations wants to begin scrutinizing early stage investments, so my advice to clients will be to keep all their investors in CA, and if they have investors in XYZ other states then the cost of completing the transaction will be dramatically higher and riskier.  This will be unfortunate.

What I Plan to Do
I am going to write a letter to both of my senators raising the questions above and asking them to look carefully at how this language will affect companies in California, and also how the concepts might be revised to avoid penalizing startup companies for the sins of hedge fund managers and unscrupulous securities brokers.  I have also added my name to the online petition here: Apart from that, I plan to watch this closely to see how it plays out.

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Promise and Pitfalls of Convertible Debt

December 21st, 2009

Attorney Scott Edward Walker has a post up today on VentureBeat about angel financings.  His tips on due diligence and personal liability are superb and well recommended.  He also advises entrepreneurs to push for convertible debt as a way to take on small investments in a simple way.  I left a comment on his post with a caveat about debt financings and this blog is an extension of that.

(Convertible debt means that instead of purchasing stock in the company at $ per share, an investor buys a promissory note with the intent that when a larger financing happens in the future, the promissory note and accrued interest will convert into the same kind of stock sold in the large financing).

I agree 100% with everything Scott says about convertible debt.  It is simpler to document and it avoids having to put a valuation on the company.   I also know a lot of angels who know how to evaluate great technology, but have no idea how to figure out how much it is worth.  Convertible debt helps get money to entrepreneurs more quickly and with a bit less discussion of valuation.

There are a few gotchas, though.  The biggest one is that if the later financing never happens, or doesn’t raise the minimum amount needed to convert the notes, the company is stuck with a bunch of debt it generally can’t repay.  This becomes awkward.  The investors came on board expecting to end up with equity and instead hold a bunch of near-worthless promissory notes.  The notes themselves come ahead of the founders’ stock in line for repayment, so until the company can find a new source of cash to pay them down, management’s stock is completely worthless and the founders are working 100% for the investors.

Investors would end up with $0 if they foreclosed on their notes in this situation so they tend to be very accommodating, but entrepreneurs still spend a lot of time managing the relationships.

I have seen convertible debt work best as a bridge, where everyone knows the large financing is coming and one of the investors in that deal puts up a little short-term cash to see a company through a tight spot.  In a pure startup situation, taking on convertible debt is a gamble that the big money will present itself.

I talk to clients about their early-stage financing options all the time.  Here’s how I break it down to them in a nutshell:

Pro: Convertible debt is useful to document small investments quickly and without having to place a valuation on the company in its earliest days. 
Con: If the later financing doesn’t come through, or if it takes longer than expected, entrepreneurs can spend a lot more time managing the company structure than if they had sold stock at the outset.  In the worst case, note holders could force a company to sell and shut down before the founders are ready.

Con:  Preferred stock requires more paperwork to document.  It also requires that the founders commit to sell __% of the company to the investors, and the valuation can cause trickle-down issues for stock options and other equity incentive compensation, including the dreaded 409A rules
Pro: Once done, it’s done.  If founders and investors can agree on the valuation (and the investors can agree to do a stripped-down set of financing terms), I generally recommend going the equity route since then the investors’ situation is locked down and less likely to require time spent managing the equity relationship.

Good post, Scott.

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Use a Low-Cost Filing Service Instead of Me? Sure, Why Not?

September 30th, 2009

I talk to a lot of people about forming new corporations.  Some of them ask me “why do you charge $2,500 – $3,000 to form a new corporation when I can have it done by ABC filing service for $375?  The answer is that you get different things when you use a filing service versus me and there may be good reasons to use both.  Here is my rundown of what you get from a filing service, what you get from me and how to think about using your time and money most wisely.

Filing Service.  The service should provide you with the following:

* Articles/Certificate of Incorporation, plain vanilla version, signed and filed with the Secretary of State of your choice
* Statement of Incorporator naming the initial Board of Directors.  Be sure to get this!  It is a one-pager that causes big problems if inadvertently missed
* Bylaws, probably not the best form ever, but probably good enough 99% of the time
* Initial consent of Board of Directors, plain vanilla form finalizing incorporation and issuing shares to founder(s)
* Form of stock certificate to issue founder shares

Me.  Here is what I provide:

* Discussion of which state is the best in which to incorporate.  Delaware? California? Other?
* Plan for capitalization of the company, including founder equity, possible stock option plan, roadmap to potential equity financing, vesting terms for founder & early contributor shares
* Complete documentation of founder contributions to the company via founder stock purchase agreements so that there is no question that the company acquired ___ assets or that $XYZ were paid for founder stock
* Detailed Board action that reflects all the same information so that future generations of lawyers can check off all the right boxes in due diligence review
* Securities filings to document that stock was sold legally

You can see that the filing service focuses on a bare set of very generic documents, while I spend time working with clients to make sure the documents fit the plan we develop together.

I know a lot of people (of whom one was a partial inspiration for this post) who believe that services like corporate formation are going to become totally free in the future and that the model forms provided by Orrick, Cooley and probably every other firm as soon as they can get the documents published are the vanguard of this movement.  I am not totally convinced on that- lawyers have a duty of care to clients that seems hard to meet if we don’t put some effort into working through the planning items I mentioned above- but I see the point.  The forms are out there and the services are straightforward.  Costs will probably trend downward, so it is really just a question of how close to $0 they get.

While we wait for that discussion to evolve, here is how I recommend you think about how to best spend their time and money.

1)  Talk to me.  I will give anyone a (free) hour of my time to discuss plans, figure out what will work and what is going to take you down the wrong path.  I don’t try to hold back the “key steps” so that people are forced to hire me.  You should walk away thinking you could incorporate on your own if you so choose.

2) Research the costs.  Once we develop the roadmap, figure out how much it will cost to have the filing service handle your documents.  Some clients do this and decide to have a service file for them (I have sent people to; for others it is easier to have me handle everything.  I am fine with it either way.

3) If you decide to use the service, tell me.  I won’t be upset or offended.  I will give you the summary of information you need to do it properly the first time: how many shares to authorize, what state to file in, etc.

My job to help clients incorporate their businesses efficiently and properly.  It honestly is not a big money-making part of my law practice, but I enjoy it and get a lot of satisfaction seeing clients launch their businesses.  The important thing for me is getting it all right the first time, not whether clients use my forms or someone else’s.

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Startup Valuation, Preferred Stock and Common Stock Prices

July 17th, 2008

This post may get a bit wonky.  I’ll do my best to keep it straightforward.

I have talked to a lot of people in my career who get confused by the value of shares of stock in a startup company.  A venture-oriented company has two or more different kinds of shares with different values attached.  Here’s how to keep them separate.

Pre-Money, Post-Money and Per-Share Value
When a company does a financing, it sets a value for the entire company- the “pre money” valuation before the new money comes in.  Let’s say the value is $10M.  If the company has 5M shares outstanding, this means that each share is worth $10M/5M = $2.00.  This is the price investors will pay to buy stock in the company.

If the investors are putting in $5M, they are buying $5M/$2 = 2,500,000 shares.  The company now has 7.5M shares outstanding, and the total “post-money” valuation is $15M.  We can see by the numbers that on a per-share basis (2.5M/7.5M) and a dollar-value basis ($5M/$15M) that the investors now own 1/3 of the company.

Common Stock vs. Preferred Stock Pricing
The part that gets tricky is that investors buy preferred stock, but the company also has common stock that it will issue to employees.  Preferred stock has superior rights, especially including a right to get paid first when the company is sold.  By convention and IRS rules, we are allowed to say that the preferred stock is worth more today than the common stock.  Thus, when we sell preferred stock to investors at $2.00/share, we can give options to employees to buy common stock at a much lower price- $0.30 or so.

This works well for the most part.  Investors want certain rights that employees don’t care about and pay extra for them.  Employees would rather get low-priced options than the preferred rights.  Everybody is happy.

But I Thought Each Share Was Worth $2.00?
The place people get tied up is comparing the enterprise valuation with the common/preferred stock differential. We valued the entire company at $10M, which meant that each share was worth $2.  At the same time, we say that common stock is not worth $2 and is only worth $0.30.  Which is true?  Both.  Here is how and when to use each number.

Enterprise Valuation is for the Big Picture and Financings Only
When we value the company for a financing, we put a value on the whole company as though it is about to be sold.  We take into account all of the economic preferences and assume that all stock is converted to common.  Every share is the same at that point.  In other words, if the pre-money valuation is $10M and the company has only common stock outstanding, each share is worth $2.  The valuation is really forward-looking to an eventual exit.

Common Stock Price is For Employees Today
Until that happens, though, we maintain different types of stock with different rights- common and preferred.  The preferred is sold based on the as-converted valuation, but the common has fewer rights and we can issue options at a lower price.  The company’s total valuation continues to be $10M and each share would be worth $2 on a sale of the company, but before that happens each share of common stock is actually worth $0.30.

The Simple Rule
The easiest way to think about this is that preferred stock is for investors and common stock is for employees.  Be aware that pricing is set differently for each.

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How Much Money Do I Need from Investors?

May 29th, 2008

This is one of the hardest questions to answer. There is no “right” answer to be sure, but here are the considerations.

1) Raising money costs both time and money. It takes time away from other things (it is not uncommon to see revenue dip during a financing since attention is focused on the investment instead of sales), so you don’t want to do it often. Legal costs are also considerable.

2) On the other hand, raising money involves dilution. You don’t want to raise too little because you don’t want to have to do it all over again soon. You don’t want too much, either, lest you dilute your ownership more than necessary.

One rule of thumb is to seek enough cash to last 18-24 months. This allows a decent amount of time in between financings, both so that no one needs to think about the next round immediately- and so that everyone can get a sense of where the business is headed before diving into another set of negotiations.

All of this is really preamble to a fascinating hint of a different model I saw this morning. Sapphire Energy announced a $50M “open checkbook” financing that allows the company to draw as much money as it needs to commercialize its technology rapidly.

What does this mean and how is it different from a standard financing? At first blush it sounds more like “venture debt” where a company takes a line of credit from a bank and agrees to repay it in cash and/or equity, but Sapphire’s investors aren’t known for making those kinds of investments.

I am going to poke around a bit and see if I can come up with some more information on the terms of the financing. What was the valuation? How is management/founder dilution calculated? Is it less if the company doesn’t need all $50M over a set period of time? What if Sapphire needs more than $50M?

Truly new investment models are rare. It will be interesting to see what this one actually looks like.

P.S.  Sapphire’s business sounds terrific as well.  A highly scalable crude oil-like substance from algae.   Neat.


Preferred Stock and Risk Apportionment

May 27th, 2008

I wrote a post on Gigaom over the weekend that covers the basics of a VC investment term sheet. A couple of the comments wondered whether preferred stock screws the founding team by definition. Another comment there answered the direct point pretty well (preferred stock is just part of the process). Fred Wilson’s post from this morning covers the philosophical angle as well and is worth reading as a complement to the mechanics I spelled out.

To paraphrase him- and dig under the surface of his comments a tiny bit- a VC’s job is to take risks, and so is a founder’s. The founder takes a chance with his idea and livelihood. The VCs risk someone else’s money- and in the process her own livelihood as well, because if none of her investments pan out she is going to be looking for a new line of work.

The VC may also be very active in a business, but not on a day-to-day basis. Ultimately, a VC’s job is to give an entrepreneur some tools to build a company, but the VC has only so much control over how (and how well) the tools get used.

Preferred stock helps line up the relative risks given all of these factors. As a friend of mine put it even more simply, preferred stock offers a mechanism to ensure that if things go poorly, morale runs low and everyone starts to wonder when to throw in the towel, the people actually running the company on a day-to-day basis will feel more pain than the investors.

Sometimes this is enough glue to keep the whole thing together and sometimes it isn’t. I have seen cases where a company has failed and investors have given up some of their liquidation preference so that founders can get *some* cash back. I have also seen preferred stock terms used to enrich investors at founders’ expense. There is no magic about any of it. Cheating and fairness are a function of the people involved; preferred stock is merely the framework on which the VC investment process is built.

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Near-Perfect Summary of Angel Financings

May 7th, 2008

Todd Vernon is the CEO of Lijit and wrote a post this morning that covers all the bases in angel financings.

I won’t rehash the whole thing, but will comment on a couple of points.

Todd’s analysis of the different types of angel investors is very insightful.  In my ten years of experience advising startups, the family investor class is the most common type, but the companies that are unable to broaden their investor base beyond that seldom succeed in raising further money.

The analogy to burning cash is a good one, though I usually use winning the lottery to make the same point.  Startup entrepreneurs should be aware that at least on some level investment in a brand-new company offers about as much hope of return as lighting cash on fire, or spending $25,000 on lottery tickets.  No one makes that decision lightly.

I mostly agree with Todd about convertible note financings, with a couple of qualifiers.  First, no company should offer convertible notes if it doesn’t intend to convert them.  Todd seems to say that some people might undertake note financings intending to pay them off in cash rather than equity.  That is a terrible strategy and borders on abusive.

Second is that I have done successful note financings.  In almost every case the Note investor(s) are also participants in the equity round and are using the Notes as a genuine bridge so that the company can get some cash while completing the steps to a larger investment.  Notes usually come with warrants or other discounts from the equity round so there can be tension between the Note investors and the equity investors.  Having the same people on both sides of the deal helps immensely to smooth that out.

Good post Todd.  I am going to send a lot of clients to read your summary.

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On Raising an Angel Round for Your Startup

March 21st, 2008

Here is a thoughtful post on raising money from angel investors. Author Charlie O’Donnell points out that it is really the same process as any other kind of networking- get out and meet people in your space and over time you will develop the kinds of trust relationships that faciliate investment.

This is going to be BIG! – The Secret Life of Angels: Raising an Angel Round for Your Startup

The problem I have seen many people run into is finding a great idea for a business and then trying to find the capital. Occasionally it works. So does looking for relationships in bars, but the odds are better if you aren’t going at it randomly.

The companion to this is the advice from Jeff Clavier and Brad Feld about making sure your investors are accredited. Everyone says they are accredited and as long as the company does well everyone is happy. In the worst case burnout, though, unaccredited investors put the burden on the company to say that risks were properly disclosed.

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How Greg Lemond Might Respond to Dick Costolo and Marc Andreesen

November 8th, 2007

In Founders at Work, Joshua Schachter advises new entrepreneurs to keep the product simple- do one thing and do it well, in essence. This strategy worked well for, which is a simple (in a good way) web tool. He built it largely on his own in his spare time while working for Morgan Stanley and that setup worked very well for him.

Mike Ramsay from Tivo, on the other hand, developed an extremely complex product (I found great humor in the section of the book where he describes the enormous back-end efforts to manage programming information for every TV service in the US, and then explains why he feels compelled to throttle anyone who describes Tivo as “like a digital VCR”) that required enormous engineering, marketing and other resources. Tivo raised significant money from VCs and went public to raise even more. Again, this has worked well for Tivo.

This pattern also reminds me of the Dick Costolo/Marc Andreesen online debate about raising outside capital that I continue to see discussed from time to time. Dick built Feedburner with a relatively small amount of outside cash, developed an excellent product with it and sold the company to Google for a solid return. Consequently, his advice to entrepreneurs is to raise enough capital to allow for a good return for founders and investors even if the business is not a home run.

Marc, on the other hand, has built two large businesses and sold each of them for over $1B- two grand slams. Both companies were heavily VC funded and Marc believes that the cash gave both businesses the wherewithal to survive difficult times, revise their business plans and ultimately become very successful. Based on his experience, then, the advice is to raise as much money as possible whenever it is available on acceptable terms.

All of these companies and people were successful, which means all of them are correct. and Feedburner needed only modest capital to acheive their objectives. Tivo, Netscape and Opsware needed far more.

This brings me back to a piece of advice I picked up years ago in an entirely different context. Professional cyclist Greg Lemond wrote a book on cycling training in which he talked about one of the great fallacies of training- emulating someone else’s habits just because the person was famous or successful. As he put it “what works for ___ is good because it works for ____. That fact that it worked for ___ doesn’t mean it is right for anyone else.”

In other words, the paths to success of others are valuable for the ideas they can provide, but they are not the “right” path for everyone. Past experiences are data points to analyze, not prescriptions to swallow whole.

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