Emerging Enterprise Center Blog

Advice about Advisory Boards

Dave Broadwin — Sun, 29 Apr 2012 20:40:36 -0500

The question that I most frequently get asked about advisory boards is: “How much equity should I give to a member of my advisory board?” The answer is very little, almost certainly less than the entrepreneur is thinking about. Perhaps some numbers would be useful here. How about .1% (that is a tenth of a percent) to perhaps .5% -- depending upon the value to be provided. By the way there should be vesting involved. The vesting period should be long enough to cover the period in which you expect to be getting value from the advisor.

Having now answered (to the extent I am comfortable doing so in the absence of any specific knowledge or facts of any particular case) the only question any client ever asks about advisory boards, I hasten to note that there are a lot of other – far far better – questions that could be asked about advisory boards. Here are a couple: What value can I reasonably expect from a member of my advisory board? How do I get that value? Why do I need an advisory board at all? How do I find good advisors?

I don’t have any objective or quantifiable information around whether and how much value start-ups derive from their advisory boards. My gut sense, based only on my law practice, is not much. Mostly, what start-ups get is the opportunity to name a few luminaries on a slide towards the back of their deck. The second thing they probably get is some introductions, probably to investors.

I am sure there are some companies and entrepreneurs that have benefited greatly from advisory boards, but I have to believe this is a small number. Below are a couple of links to blog posts on the subject of advisory boards. The one from venture hacks seems to me to be particularly good in that it covers a lot more than just compensation, although it also covers comp.

Venture Hacks “Everything you ever wanted to know about advisors”

Ask the VC “Are Advisory Boards Helpful?”

Ask the VC “Advisory Board Compensation”

Of Froth and Bubbles

Dave Broadwin — Sat, 07 Apr 2012 16:00:34 -0500

Sometimes I tend to think that bubbles are all bad. I keep a book on my shelf titled "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay, LLD. This book was originally published in 1841. I read portions from time to time to remind myself that bubbles (including those in the South Sea) come and go.

Sometimes it is good to be reminded of the past -- even if you lived through it. Here is a link to a lengthy, but thoughtful, blog post on the "bubble" of the late '90s. Peter Thiel's Startup Class Notes. My favorite quote from this post is "Bubbles arise when there is (1) widespread, intense belief that’s (2) not true." This is, of course, in different words what Mr. Mackay might have said about Dutch Tulips or witches in Salem.

It seems to me that bubbles (good, bad or indifferent) airse when there is a lot of money hanging around with the result that people do irrational things with it. The recent $646 million lottery is a good example. As the pot got bigger the odds got smaller, but the rate at which money poured in increase. More money chasing smaller odds? Go figure.

Congress has just passed, and the President has just signed, a new law that is supposed to support capital raising by smaller companies. It contains the so-called crowd-sourcing provisions that have gotten so much press. It will be seen if this does something or nothing for small companies, but one thing it might do is send a lot of small investor money chasing every smaller odds of success.

Just how entrepreneur friendly is New York?

Dave Broadwin — Tue, 03 Apr 2012 11:14:22 -0500

I know that we are all bored with the perennial comparisons between the Valley and New England in which New England inevitably appears as the landof the hide-bound and the home of the risk adverse. The fact that we are all bored with the discussion does not however address the merits of the claim. It just blinds us to the looming consequence: New England, already only half the size of the Valley by many measures, will lose further ground as exciting start-ups from the Valley (and New York, but we will get to that in a minute) continue to make their mark and investor money drifts (or perhaps races) towards perceived greener pastures.

I finally got around to my quarterly comparison of deal terms published by our firm, Fenwick (a Valley based firm that reports on transactions in the Valley) and Cooley (a firm with many offices that reports on transactions handled by it).

And here of New York: No one that I am aware of reports on New York transactions. But, starting with Q1 o f 2012, we will, because we are doing increasing amounts of emerging company work there.

So here is part 1 of my thesis: I expect that terms will be most favorable to entrepreneurs in the Valley, least favorable in New England and somewhere in between for the rest. Of course, I think that the “somewhere in between” number will include Cooley’s New England transactions (which will have the effect of making them generally seem less favorable to entrepreneurs). We should all note that Cooley feels compelled (at least in some instances) to report numbers for Northern California separately from the others.

So, without further fanfare, below is the table that compares certain of the deal terms reported on by the three firms for Q4 of 2011.

Fourth Quarter 2011 Transaction Terms

	Foley Hoag		Fenwick	Cooley
	Series A	Series B and Later		Northern Cal	Other
Cumulative Dividends	47%	69%	4%	6%	24%
Participating Preferred	47%	25%	31%	21%	24%
Redemption	41%	78%	9%	13%	46%
Pay to Play	18%	17%	5%	2%	1%

Of course I knew what the chart would say before I made the prediction, so no surprise that it supports my thesis.

Here, however, is part 2 of my thesis: When we start reporting on New York separately (which we will be doing starting with a Q1, 2012 report – to come out soon), it will show that terms in New York are far closer to those in the Valley than to those in New England. Now I don’t’ know the answer to that question, but we are doing the research now and will have an answer soon.

Keep in mind that New York has gone from nowhere just a few years ago to equaling (or passing by some measures) New England. Could it be that NYC is just a friendlier place for entrepreneurs than New England?

The case for an early exit: Average price increases between rounds

Dave Broadwin — Mon, 26 Mar 2012 11:27:58 -0500

I have long had a theory that (for companies with up rounds) the greatest valuation increases occurs between the A and B rounds. So, I recently had occasion to do some data mining in our database of New England transactions. Below is a table of the results:

Industry	Round	Price increase as a percent of the prior round
Technology	B	95.56%
	C	15.20%
	D	51.02%
	E	55.87%
	F	1.37%

Biopharma	B	29.13%
	C	5.82%
	D	4.38%
	E	50%

Cleantech	B	55.07%
	C	-79.7%
	D	8.6%

All [Including transactions unclassified by industry]	B	55.36%
	C	18.66%
	D	16.00%
	E	6.59%
	F	10.35%

My hypothesis that the greatest increase is between the A and B rounds bears out very clearly in the technology sector. You can also see it in the biopharma data. The cleantech data may be unreliable because the sample size is small.

The reason I have been looking at this data is that I have a couple of clients that are debating internally whether to raise a B round or try for an early exit. While I think there are many factors to weigh in this type of decision (obviously valuation is one issue, expected size of exit is another and time to the eventual exit is yet another), these statistics are, I think, the first step in an analysis that could well lead to the conclusion that, in most cases, the best return for the entrepreneur is going to be in an early exit.

Net Neutrality - The SEC Finally Comes Around

Dave Broadwin — Mon, 19 Mar 2012 18:24:41 -0500

Lawyers read exciting periodicals such as SEC No-Action Letter Weekly (published by Wolters Kluwer see www.wolterskluwerlb.com.). Normally, I would not bore you with this stuff, but this week the lead article had the titillating title of “Staff Reverses Position on Net Neutrality Shareholder Proposals.”

Apparently, the SEC has finally come around to the notition that net neutrality is a really important issue. I have included three of the salient paragraphs below.

The SEC’s Division of Corporation Finance has advised Sprint Nextel Corporation and AT&T Inc. that they may not omit from their proxy materials shareholder proposals that ask the companies to publicly commit to operate their wireless broadband networks in accordance with network neutrality principles. The staff explained that, due to the sustained public debate over the last several years about net neutrality and the Internet, and the increasing recognition that the issue raises significant policy consideration, the proposals may not be omitted in reliance on the ordinary business exclusion.

AT&T wrote that the proposal represents an attempt to repackage substantially similar proposals about its network management practices, which the staff, in the past, has concluded were excludable as ordinary business. In AT&T’s view, the proposal would directly interfere with its network management practices and would seriously impair its ability to provide wireless broadband service to its customers. AT&T also sought to omit the proposal under Rule 14a-8(i)(2) on the basis that it would impair the company’s ability to comply with federal wireless licensing requirements.

AT&T said the proposal cited the same reports as in a 2011 proposal and that the only substantive addition was a citation to a 2011 survey that presents statistical information similar to that presented in the January 2010 report and cited in the 2011 proposal. AT&T challenged the notion that net neutrality has emerged as a consistent topic of widespread public debate that would reflect a significant policy issue for purposes of Rule 14a-8(i)(7).

The point is that stockholders of public companies can propose that the stockholders, at the company’s annual meeting, adopt a resolution directing the company to observe principles of net neutrality. It will be interesting to see how many, if any, companies include this type of resolution and if any of them pass.

Heads or tails: Does it make sense to bet on down rounds?

Dave Broadwin — Wed, 07 Mar 2012 15:48:34 -0500

I was doing some data mining in our database of New England venture transactions (see Foley Hoag Venture Perspectives) for reasons completely unrelated to the topic I am about to address and inadvertently stumbled on this topic. Let me start by saying that we are all prisoners of our own experience. Probably there are people out there with a different experience, but in my experience down rounds happen because companies have started a downward spiral and it is just a matter of time and a certain amount of swirling before they get flushed by their investors.

It does not seem to matter what the articulated reason for the loss of valuation – market conditions, ineffective management, too early to market, too late to market, technology challenges, long adoption cycles, etc. – in each case one down round leads to another. With each successive down round the common holders (and option holders) become more and more diluted and demoralized. Key players start to leave. Vendors are not paid and they put the company on COD terms. These things all slow product development and sales and also harm morale. Eventually the CEO is replaced (perhaps the entire team) and the new team is faced with the almost impossible task of bringing Lazarus back from the dead.

If this observation is really true, even in just a majority of cases, why would anyone ever invest in a down round? The investor would simply be throwing good money after bad.

There seem to me to be a lot of reasons potentially at play: The original investment thesis still seems good. Investors and management (let alone founders) remain enamoured of the business. Investors are not eager to admit to their limited partners that a mere 12 months or so after they put a large wad of cash into the business there is a total write off. Investors are afraid that the next guy will pull off a miracle and make the business a success as a result of which they will look like they bailed too soon.

Well, here are some facts. We sorted our database of venture capital transactions in New England first by searching for companies that had follow on rounds since 2008. We then looked at the follow on rounds to determine how many were up and how many were down. About 71% were up and the other 29% were down. We then searched the down rounds to see which ones had a subsequent round of financing (13%, as opposed to 49% of the up rounds). Out of the financings that followed a down round, 30% were up, 15% were down, and the rest (55%) were even. On average the “up” rounds were up by about 56% from the down round price.

While the sample size is relatively small, the data shows that down rounds are much less likely to be followed by another round of financing, at least within the 2-year period we’re looking at. If they are followed by another round, there’s a good chance (85%, according to our data) that it will be an even or up round.

Assuming you made equal bets across all down rounds and only 4% of the down rounds had follow on up rounds, that 4% would have to return a lot more than 56% you to break even on the portfolio portfolion of down round securities.

Now, among other things, this analysis does not account for (1) the possibility that some of the up rounds will improve even further over time or that some of the down rounds will return something, (2) the time value of money, or (3) a host of other factors that are of lesser importance but not of no importance. Nonetheless, it does suggest that investors would be far better off betting on the flip of a coin than on a down round.

Confidentiality and Nondisclosure Agreements -- Odd and Different are Peculiar

Dave Broadwin — Wed, 08 Feb 2012 15:21:18 -0500

At least where I am sitting, for the last month it has rained nondisclosure agreements. On the one hand, these agreements have a certain cookie cutter repetitive quality. On the other hand, there seems to be no end to ingenuity in these things. The result is that something you hope would be straight forward and would not require much (any?) legal intervention, often does. So, here are some thoughts on things to think about when you read an NDA. Needless to say, this list is not comprehensive and – furthermore – I predict that the next one you look at will have something unique about it. (Parenthetically, please feel free to send me samples (redacted to eliminate anything that should not be disclosed – like the identity of the parties) of unusual provisions.) My last comments at the end of the list under the caption “Unusual Provisions” seem like the relevant comments to me. Anyway, here goes:

Parties to the Agreement

Consider who should be a party to the agreement. Should the agreement cover “affiliates”? The answer is probably yes.

Mutual or One-way

Consider whether the agreement should be mutual (i.e. each party is obligated to keep the other’s information confidential) or one-way (only one party discloses information and the other party is obligated to keep it confidential).

How Broad is the Definition of Confidential Information

Usually it is very broad. In particular note whether or not the information has to be specifically identified as confidential or whether it merely needs to be such that a reasonable person would understand that it is confidential. Depending on the circumstances you might want to go one way or the other on this. You may also want to identify certain specific categories of information as either confidential or non-confidential.

Is the Obligation to keep Information Confidential Clearly Stated

The agreement should expressly state that the parties (or party in the case of a one-way) must keep confidential information confidential. An ancillary point is the standard of care which could be best efforts or reasonable efforts or the same level of effort used in the case of a party’s own information.

Exceptions

There are a number of usual and customary exceptions to the definition of “confidential information”. These include: (1) information that is or becomes public without a breach of the NDA, (2) information that becomes available to the recipient on a nonconfidential basis from a source not bound by an NDA that covers the relevant information, (3) information that a party knows (and can demonstrate that it knows) before entering into the NDA, (4) information independently developed by a party without the use of confidential information subject to the NDA, and (5) information required to be disclosed by law (SEC disclosure obligations for example) or judicial process (discovery in a litigation for example). In this later case (legally compelled disclosure), there is usually a requirement of notice so that the party whose information is about to be disclosed can contest the required disclosure or seek some other protection.

Return or Destroy

There is (or should be) an obligation to return confidential information and destroy all copies at the end of the NDA. This requirement is often coupled with a requirement that the recipient certify compliance in writing. Also, some large companies like to retain one archival copy of whatever they get. This is usually rationalized by arguing that they need it for the record in case of a law suit.

Limitation on Use

Very important. These agreements should expressly limit the right of parties to use the confidential information they receive to the purpose for which it is delivered: for example, to decide whether or not to proceed with a particular transaction. So, the agreement should say that the confidential information may only be used for the specified purpose. If it does not say this, it may turn out that parties use the information for other purposes, such as advancing their own R&D.

Ownership etc.

The NDA should make it expressly and clear that no license or other rights to the confidential information is conveyed. In a sense, this is part of the limitation on use, but is often stated separately as well. Similarly, these agreements often state that no joint venture or other entity is formed and that neither party can act for the other in any respect.

Term and Termination

NDAs can be for a stated term (months or years) or they can be perpetual. The argument for a stated term of years is that at some point the information is old and cold and the parties should be able to stop worrying about their obligations under the agreement. In any event, the disclosing party should be concerned to make the term long enough so that the information is no longer likely to have value as a result of being confidential when the agreement expires.

With respect to termination, the termination of the agreement should not terminate the obligations of confidentiality and non-use. The termination provision should expressly state that these obligations survive an otherwise general termination of the agreement.

Equitable Relief

These agreements often state that injunctive relief (a court order prohibiting a disclosure) is an available remedy. Some companies want an agreement that such relief is automatically available, while others will only agree that the discloser has the right to seek an injunction.

Governing Law and Venue

There is a distinction between the jurisdiction whose law will govern the contract and where suits may be brought. I won’t comment on governing law, except to say that your lawyer may have an opinion about it and that in general all U.S. jurisdictions will enforce your garden variety NDA (that is plain vanilla ones). What about NDAs with odd, different or peculiar provisions – who knows, it will depend on the provision.

Venue is more interesting. At issue is where cases may be brought. If you are in Boston, having to enforce your rights in Alaska is likely to be inconvenient and expensive. Consider that when you agree to a specific venue.

Unusual Provisions

The foregoing list of provisions and comments is by no means exhaustive. But, if you are presented with an NDA that raises any questions for you, consult your lawyer. Just because someone from a big company (even a household name company) says “this is our standard NDA” does not mean that it is either standard or, even if it is their standard, that it does not have odd, different and perhaps pernicious provisions.

Just to give you a flavor, here are a couple of provisions that I consider odd, that I have recently run across:

In a supposedly mutual NDA, I found the following “XXX agrees to use YYY’s Confidential Information for the sole purpose of evaluation or as otherwise agreed upon in writing by YYY.” This provision looks fine except that YYY never agrees to limit its use of XXX’s confidential information.

Here is another provision: “This NDA may not be assigned by either party by any means, including without limitation, by operation of law or merger, without the prior written consent of the other party.” We all get that one can’t just transfer an NDA, but but what happens when you go to sell your business? Did you just unwittingly make the other party’s consent a precondition to a sale of your business.

Beware of limitations of liability provisions in NDAs. Some pro-recipient NDAs include a disclaimer of indirect and consequential damages. The problem is that almost all of the damages that would arise from misuse of confidential information are indirect or consequential. If the recipient breaches the NDA, it would probably argue that it can be liable only for injunctive relief, but not for damages. While I have my doubts about the enforceability of a disclaimer of this nature, there is certainly a risk that it results in a fairly toothless NDA from the discloser’s perspective.

Occasionally, an NDA will include provisions which may allow the discloser of information to claim ownership of the IP rights in any modifications that the recipient makes to that information. These provisions may be hidden in the definition of “Confidential Information”, which is one reason not to gloss over that provision, even if the beginning of the paragraph reads like a laundry list of every type of information and technology that the drafter could think of.

SOPA and Quora

Dave Broadwin — Sun, 15 Jan 2012 12:22:23 -0500

SOPA is obviously a huge issue these days. Whether there is more panic than is merited is not clear to me. But this is not a post about SOPA; it is a post about Quora.

I was curious about what people were saying about SOPA, so I decided to check out the questions and answers in Quora. Now, I know there are a million things out there on SOPA and probably anyone interested would read about it elsewhere.

Having said that, the Quora activity seemed meager, to say the least. For example, 13 people are following the question What is the Stop Online Piracy Act (SOPA)? Looking at related questions, the numbers seem to go down from there.

My initial (and continuing) reaction to Quora is that it is a great way to cluster commentary and opinion around topics. I wonder though if it is not losing steam/market share. If this is the case, and I suspect that it is, there are probably several reasons for it.

One reason might be that Quora is not really all that easy to use. Like many techie things, it sometimes seems as though the technology stands between the user and the use. Here is a post from Semil Shah (on Quora)that touches on this issue. His first point: Make it easier for Quora users to ask questions, especially on the mobile app, goes to the heart of the matter. If Semil Shah has this reaction, imagine the experience of a less tech savvy user.

Like many things technological, ultimate success does not depend so much on capturing the fancy of Semil Shah, Michael Lopp and other members of the tech vanguard, but on massive adoption by people for whom the site is a means not an end.

One more thought about SOPA, old distribution and revenue models will not come roaring back into fashion because SOPA is passed. Hollywood’s content creators will still have to change their business models as technology and social networking continues to grow up.

409A Option Pricing Redux

Dave Broadwin — Mon, 09 Jan 2012 19:08:28 -0500

Last week I had a conversation with an entrepreneur who was confused about option pricing, and no matter how many times I tried to explain it, he never seemed to get his head around it. Now, there may be a psychological explanation for his inability to understand, because he clearly wanted to hear a particular answer, and it was not what I was telling him. Nonetheless, option pricing is a topic that comes up all the time in the representation of early stage companies and, while I have written about it before, it is worth one more post.

What is 409A and why do you care?

409A is a section of the Internal Revenue Code that governs the tax treatment of certain options. 409A provides that an option either (1) be an option for common stock of the employer and have a per share exercise price on the date of the grant equal to or greater than the fair market value of a share of common or (2) if the option has an exercise price of less than the fair market value of a share of common stock the recipient and the issuing company suffer some pretty draconian tax consequences. (There are other ways to comply, but relate to less usual situations, such as options that are only exercisable on a liquidity event, and I am not going into that level of detail here and now.)

What are the draconian tax consequences?

There are three particularly nasty tax consequences: (1) The recipient of the option will have income equal to the difference between the fair market value of a share of common stock and the exercise price of the option multiplied by the number of options, at the time the option vests, even if the recipient does not exercise the option. (2) The recipient will get to pay a surtax of 20% over and above his or her normal income tax on the option related income. (3) For each year for which the option remains outstanding, the recipient will suffer the same nasty tax consequences with respect to any increase in the value of the common stock.

Why on earth would the IRS create such a rule?

Consider what could happen if the issuing company were publicly traded and was issuing options with below marked exercise prices to its execs. Need I say more? Unfortunately, 409A applies to all companies – not solely public ones.

What can I do to avoid the bad tax consequence?

Issue your options with an exercise price equal to or greater than the fair market value of the underlying shares.

How do I know what the fair market value of a share of my privately held technology start-up is?

Here are some ways to price your options:

(1) You can take a guess at the fair market value. If you guess wrong you are toast. And, by the way, your guess will be judged with 20/20 hindsight by the IRS. So, that does not seem like a good solution.

(2) If there is a recent actual arms-length transaction in which common stock was sold, then you have price. Note that I said “actual,” “recent,” and “arms-length.” The fact that your lawyer took a few shares a year ago in consideration of an old invoice won’t cut it.

(3) If you have a financially sophisticated person on your board (or as your CFO), and your company has been in business fewer than 10 years, 409A provides that such person can perform a valuation.

(4) You can pay an outside appraiser to perform a valuation. Most (all?), of my clients who have professional money invested in them end up doing this. It is a toll and it is unfortunate that you have this cost, but that is you tax dollars at work.

Like my entrepreneur friend, you can want to price options at $.03 but if you sold common stock last week in an arms-length transaction for $.30 per share, don’t do it.

What's in a name: thoughts on domain names and corporate names

Dave Broadwin — Fri, 30 Sep 2011 13:44:47 -0500

Sometimes it seems like all clients have the same issue at once. One series of issues that seems to be among the popular issues du jour is what to do to secure domain names and corporate names. Needless to say, this should also dovetail with securing appropriate trademarks.

Here are some strategies you can consider when registering domain names:

1. Register with the most popular top-level domains. Obviously, .com domains are the most popular by far, followed by .net and .org. You might also register domain names in the .biz registry, and in the .info, and .us registries. The Columbian registry (.co) is also making a big push to be an alternate .com (though it’s not clear it has much traction yet), so you might consider that as well.

2. You might consider registering some of the popular country-code top-level domains such as .co.uk, .ca, .asia, .de, .cn, .eu, .jp, and so forth, and country domains for any country where you expect to have significant business activity.

3. You might consider applying to register a “non-resolving” (inactive) .xxx domain name once they become available on December 6, 2011, or if you already owned a trademark registration prior to September 1, 2011, you may be able to take advantage of the cost-effective .xxx “Sunrise B,” which allows trademark owners to block a domain name for at least ten years for a one-time fee. See http://www.icmregistry.com/launch/general-availability/. Josh Jarvis, one of my colleagues writes a blog on trademarks, copyrights and related matters, and you might check his blog out for more on these topics.

4. To protect against competitors and cybersquatters, you may wish to “defensively” register certain variations of "yourdomainname" in at least the most popular domains (.com, .net, and .org). Some tricks used by competitors and cybersquatters include:

a. Changing singular to plural, or vice-versa.

b. Common misspellings or spelling variations -- e.g., using “z” instead of “s”.

c. Hyphens in obvious phrase breaks -- e.g., “soft-boiled.com.”

c. Typos -- e.g., sofboiled.com (missing letter) or substituting “d” for “s” or vice versa because it’s adjacent on keyboards

5. To protect against disgruntled customers or unscrupulous competitors, you may wish to “defensively” register so-called “gripe” domain names, at least in the most popular domains (.com, .net, and .org). Ever popular creative favorites among the disgruntled are “Sucks” (e.g., softboiledsucks.com) which is by far the most popular of these, though other obvious four letter words are used.

Generally, it’s easy to get carried away -- it’s simply not possible to capture every possible misspelling, typo, or gripe variation in a single top-level domain, let alone multiple top-level domains. This is especially the case where the number of top-level domains is expected to increase exponentially over the next few years. The key is to get the most obvious and most likely suspects, at least in the .com registry if nowhere else. Keep in mind that you may have legal recourse available in the event of future bad-faith cybersquatting.

With respect to corporate names, as with domain names, you can't, as a practical matter, get every similar name in every relevant jurisdiction, but again you should think defensively and get whatever makes common sense in Delaware. You might consider, but I also think it may be going too far, other big jurisdictions such as New York, California, Texas, and Mass. Getting the corporate name, really means forming a corporation (even if it is an inactive shell) in the relevant jurisdiction.