Emerging Enterprise Center Blog

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.

Q1 venture activity levels and what will Q2 show?

Dave Broadwin — Sun, 07 Aug 2011 16:19:45 -0500

It has been a long time since I wrote a blog post. In part, I just ran out of steam. In part, I have been running non-stop since May. Why? Because business has picked up in a major way. Since May the pace of financings and exits has picked up in a very noticeable way. So, here is a prediction, when I write the comparison of Q2 deals published by by Foley Hoag, Fenwick, it will show a major jump from the Q1 numbers.

Here is what my partner, Dave Pierson, had to say about Q1 activity, “The total number of New England Series A transactions dropped 46% from Q4 …. The total number of New Englsnd Series B and Later round transactions during Q1 decreased 21% from Q4…”

Fenwick had similar observations. Fenwick had this to say, “Venture capitalists invested $6.4 billion in 661 deals in the U.S. in 1Q11, compared to $7.6 billion in 735 deals reported in January 2011 for 4Q10, according to Dow Jones VentureSource (“VentureSource”). Although this represents a 16% decline in dollars and a 10% decline in deal volume from 4Q10, the 1Q11 results were generally flat with the average of $6.6 billion raised per quarter in 2010.”

All I can say is that either Foley Hoag is lucky or the venture world took off in Q2.

Here is the open question, given the turmoil in the public markets, will I have written plenty of new posts and be lamenting the amount of time available for such pursuits?

Without further adieu, below is the same table I produce each quarter. This is, of course, a table reflecting Q1 activity.

Term	Foley Hoag New England Series A	Foley Hoag New England Series B and Later	Fenwick Silicon Valley All Series
Cumulative Dividends	42%	52%	8%
Preference with Participation	42%	35%	43%
Redemption	85%	82%	20%
Pay to Play	15%	40%	5%

There is no surprise in these numbers. They have followed a consistent pattern from quarter to quarter for as long as I have been tracking them. Note the greater frequency of dividends and redemption provisions in New England deals. Having wondered about why there is not convergence on terms, given that so many of the leading venture firms do deals on both coasts and having asked a number of people in the business about it, I have come to the conclusion that it the divergence in these terms reflects a basic cultural bias. New England just has more of a lender mentality than the Valley.

Content with Content? Some thoughts on blogs and a term sheet.

Dave Broadwin — Mon, 09 May 2011 09:55:00 -0500

My blogger friends (and the firm’s blogger consultants), indeed, it seems the entire blogosphere seems to agree that blogs are not really an optimal publication platform for dissemination of pure content. I take that to mean that putting law review articles (or any substantive articles on legal (or other) topics) is really not what blogs are “about.”

Instead, blogs are supposed to be pithy comments on other people’s posts (or perhaps some other thing going on in the real or virtual world). Hence the prevalence of blog posts that begin with some reference like, “Harry has a great post about his date with Sally….” Harry’s post, it turns out, is likely to be some observatlon about something Sally wrote on her blog. Sally’s blog, in turn, refers to Tom and Dick….

So, the consultants appear to say, blog posts should be pithy comments about pithy comments.

And, the occasional pithy comment is probably a good idea, but when I look at the statistical data concerning this blog and I consider which posts seem to have generated interest and which have not, the numbers (meager as they are) support a completely different notion.

Readers want content more than conversation – at least as much as conversation.

I am, for example, under the impression that Fred Wilson was very successful with MBA Mondays. (Now, his entire blog is a huge success.)

Switching gears, Prithvi has told me on many occasions that the content posts I have done in the past are more geared for consumption by lawyers than by entrepreneurs.

So, I am going to try and take a trick from Fred’s book and apply Prithvi’s advice and write a series of posts (I will try for weekly) that will be both substantive and usable by entrepreneurs. The posts will be checklists for things that are legal in nature. The idea is to put the entrepreneur in a position to think about whether he or she has covered everything he or she needs to cover in a document or deal.

Of course, the usual caveats about how this is not legal advice and does not create a lawyer client relationship etc. apply.

I thought I would tackle seed preferred term sheets first. Although these can vary from one pagers to 5 pagers (or more), for the purpose of creating a checklist, I am going with the longish form. After all, it is the purpose of a checklist to be over inclusive. Also, I have linked each of the terms (and some other items) to the glossary defining these terms on the EEC microsite and, where it seemed relevant, to my blog.

Please send me thoughts on the checklist. If the checklists seem useful (or popular) I will post them on their own site on an easy to use open source basis.

Here goes:

Term	Included		Comment
	Yes	No

Amount of Investment			Term sheets typically state the amount to be raised, either as a specific amount or a range.
Single closing			If the entire amount of the investment is to be raised at a single closing, then term sheets are often silent on the matter of single vs multiple closings
Multiple closings			Often the parties anticipate an initial close on some portion of the raise, with one or more follow-on closings at which additional investors come in. When multiple closings are envisioned, term sheets often state that.
Security			Term sheets clearly state the name of the security being sold (for example “Series Seed Preferred” or “Series A Preferred Stock”).
Dividends			Dividends typically come in one of two flavors: (1) no dividends (which really means that the investor gets dividends if any are declared on the common stock – which typically is never) or (2) the investor gets dividends that accrue (but are not actually paid until a liquidity event) at a stated rate. While experience indicates that accruing dividends are not the “norm” for seed stage deals, they are not unheard of (at least not in New England). Accruing dividends can have a material impact on the economics of a transaction and can set precedent for future investments (which can materially magnify the impact). If accruing dividends are contemplated, they should be discussed and included in the term sheet. If accruing dividends are not contemplated, the term sheet can merely refer to dividends as declared.
Liquidation Preference			By far the most common term is for a liquidation preference equal to the amount invested (referred to in the trade as a “1x liq pref”). However, rarely, but sometimes, you see no liq pref or, multiple x liq prefs. In each of these circumstances, there is some externality (such as a very hot deal or some unusual risk) that accounts for the variance.
Participation			Participation means that the Seed Preferred (or any preferred) gets to participate with the common stock in the proceeds of any liquidity event on an as converted basis. While this might seem self-evident, this provision must be considered in connection with the liq pref. There are investments in which any of the following might be the deal: (1) the investor gets the greater of the liq pref or whatever she would get upon conversion, (2) the investor gets the greater of the liq pref plus whatever she would get upon conversion up to a cap (for example 2 times money invested) or whatever she would get upon conversion or (3) the investor gets her liq pref plus (after receipt of the liq pref) gets to participate with the common on whatever is left over. Needless to say, number (1) is the best deal for the founder and number (3) is the best deal for the investor.
Conversion			Term sheets typically state the rate of conversion from seed preferred to common stock (typically the cap table is arranged so this rate starts out at one for one – and is subject to adjustment in accordance with antidilution provisions).
Antidilution -- Weighted Average			Broad based weighted average antidilution makes adjustments to the conversion rate to protect investors on a weighted average basis against future issuances of stock at prices below what they paid. It is by far the most commonly seen form of antidilution protection for investors. Unlike full ratchet provisions, its impact on entrepreneurs is not often draconian. This provision may be contrasted with narrow based and fully broad based provisions, as well as with full ratchet provisions. The formula for weighted average antidilution is complex and clumsy and a description is beyond what can be done in a checklist. Nonetheless, if you are not familiar with these terms check out the links provided above.
Antidilution -- Full Ratchet			Unlike weighted average provisions, full ratchet antidiluton provisions are likely to have draconian consequences for founders. Full ratchet provisions protect investors by reducing the conversion rate to the lowest price at which a share of common stock (or common equivalents) is sold by the company – without regard for the quantity of shares sold. Full ratchet provisions are only seen in a small minority of cases where there is some factor (such as an otherwise not bridgeable disagreement over valuation) that accounts for the full ratchet. If full ratchet provisions are contemplated, the founders should consider negotiating limitations such as a bottom on the conversion rate, or a time limit, or exclusions for strategic issuances or issuances to lenders (or all of the above or other additional limits).
Redemption			Many investments (particularly in Silicon Valley but also almost half in New England) do not provide for redemption at all. By far the most common redemption term is a right of the investor to require the company to repurchase his stock in three equal tranches in years five, six and seven.
Voting			Typically, voting is on an as converted basis so that the investor votes with the common stock on matters that are generally submitted to the stockholders. Delaware law requires class by class votes in some circumstances, and the investor will likely negotiate some specific protections that require a separate vote of the investor class.
Board of Directors			Term sheets tend to be very explicit about the size of the board and who will be on it. Three and five member boards are both common in early stage companies.
Founder			The term sheet should state if the founder is to be on the board.
Investor			The term sheet should state if the investor is to be on the board and, if there is more than one investor, how many investors will be on the board.
Other			The term sheet should state who else will be on the board (perhaps the CEO, if he is not the founder, or an independent person).
Information Rights			Term sheets sometimes go into some detail about what annual, quarterly, and monthly financial and other information must be made available to investors. Except in a case where something specific and particular to the investment is contemplated, a reference to usual and customary information rights is probably sufficient.
Registration Rights			Now that IPOs are back (sort of), registration rights may be of greater concern than they have been in the recent past. Typical provisions might be two demand rights, unlimited piggy back registrations, unlimited S-3 registrations and an 180 day lock up in the case of a company offering. Even in a hot market, the likelihood of an IPO is low, so I would not spend a lot of time (or political capital) fighting over this provision.
Right of First Refusal on Company issuances			Investors generally like to have a right to maintain their percentage ownership in a company through subsequent rounds of financing. The only downside is that many angels (and even some early stage funds) either can’t won’t or don’t really intend to participate in the future. In those cases and in cases where the seed players want tiny slices of the A round, this right can add some complexity to your negotiation with the next round investor.
Right of First Refusal on Founder sales and co-sale			Investors generally like to have a right to acquire any founder shares that might be for sale – if they want them. Also, investors don’t want founders selling out and leaving the investors holding the bag. So, they bargain for a right to sell along side the founder. These provisions are absolutely standard in VC transactions. They are less likely to be seen in seed/angel transactions.
Drag along			This is the right of someone to force the founders (or other common stockholders) to sell. Drags are typically structured to force everyone who is a party to the contract to sell in any transaction approved by all three of (1) the preferred holders, (2) the common holders, and (3) the board of the company. Such a provision is really a housekeeping arrangement whereby the majority can deliver the entire company in a nice clean package. Sometimes you see drag provsions by which the preferred can force the common to sell. This type of drag needs to be considered carefully – especially in a situation where the common constitutes a majority of the equity of the company. In such a situation, the minority could sell the company against the desire of the majority. And, make no mistake about it, these provisions are likely to be enforced by a court. Here are some thoughts on drag provisions.
Protective Provisions			This is a list of the things that will require a separate approval of the seed investor (that is in addition to any other requirement). The list below is pretty standard, and a term sheet could refer to standard provisions and leave it up to later negotiation, but listing them in the term sheet is probably good practice.
Merger
Sale of Assets
Dissolution
Issuance of senior securities
Issuance of pari passu securities
Dividends
Increase in authorized stock
Change in size of Board
Incurring debt
Vesting for Founders			It is not unusual for sophisticated angel groups and super angels to insist that the founders subject their stock to vesting. Very small investors typically don’t ask for this. Typical provisions might be for some portion (10% to 50%) to be fully vested and the rest to vest over some number of years (one to four – perhaps).
Costs of counsel			Angel groups and super angels often ask that their counsel fees be paid out of the transaction proceeds. (Sometimes they don’t use counsel – which has the benefit of reducing that cost.) Also, your counsel (who should be doing the drafting of the documents) will have to be paid. Especially in small raises you should strive to keep transaction costs down. The best way to do this is to discuss and agree upon costs up front with the investors and with both sets of counsel. Here is a link to some observations on this topic.
Founder Representations			This is a provision whereby founders represent various things about the company and are potentially liable for misstatements. It is never seen in the Valley and is sometimes (often?) seen in New England. I would not be overly paranoid about these, but if you agree to them, you should negotiate some limitations. See the next item on this list.
Limitations on Founder Representations			When founder reps are agreed to they are often limited as to matters (such as intellectual property and ownership of the company) as well as to exposure (such as the liability of founders will be limited to their stock).
Most Favored Nation			This is a provision not much seen, in New England anyway, that provides for the investor to be given whatever favorable terms the next investor negotiates. This provision may be more relevant where the seed investor has relatively few terms than in a fully negotiated deal (such as one that covers most of the terms listed in this checklist). Here are some thoughts on this topic.
Exclusivity period			Investors often ask for some period of exclusivity (30 to 60 days) during which the founders will only deal with the investor.

Good Seed; Bad Seed (Preferred that is)

Dave Broadwin — Mon, 25 Apr 2011 09:55:00 -0500

At the risk of fighting the last war, I am going to come back to idea (and in some cases reality) of “standard” open source seed preferred documents.

To be clear:

(1) A note that converts at a discount into the next round of equity financing is probably the best deal an entrepreneur can hope to get. Now he or she may not be able to actually get such a deal (and certainly won’t get it from many VC investors). Why is this the best deal an entrepreneur can hope to get? Because it limits the investor’s upside. Why do VC (and other) investors hate these notes? Because the notes limit their upside.

(2) A convertible note with a cap may be the worst deal an entrepreneur can get. Why? Because, she is selling equity at the lower of two prices. One price is a fixed valuation and the other is something less. If you are going to set a valuation, you might as well just take that.

(3) The seed preferred is probably the investor’s best friend because it sets a valuation on the closing date. And, it starts the capital gains clock ticking so that in the case of an early exit, there is some hope for capital gains tax treatment.

It is hard to object to a fair valuation. Of course, if it is fair, then so be it. Unfortunately, experience suggests that valuations at the seed stage are chronically too low, with the result that after the first VC round, founder equity is diluted to the point where it is hard to see how (in the absence of a spectacular exit) the founder pay day will be all that good.

Of course, the black magic of valuation is the special provenance of VCs. So that last paragraph was just an observation from the peanut gallery. Unfortunately, I have seen this show more than a few times, and it doesn’t change much over time.

But here is one that is more in the provenance of lawyers: Sometimes seed preferred docs carry in them the germ of a most favored nation clause. That is the clause that says something like: The Series Seed will be given the same rights as the next series of Preferred Stock (with appropriate adjustments for economic terms).

In effect, your seed investor has gotten today’s valuation (the low one) and tomorrow’s terms (the good ones that the VCs negotiate). If you are an entrepreneur and you believe, as I am told some people do, that investment negotiations sometimes involve a trade off between price and terms, then you just lost on two counts.

Ah, but what did you get? A nice, simple, clean deal (that give the investor what he wants low price and good terms) at a low transaction cost (whatever fixed fee you agree to with the lawyers).

Unfortunately, many seed investors won’t stop at a simple deal. They have loads of their own requirements. But that will be the subject of another post.

February 2011 Issue

Admin — Tue, 19 Apr 2011 16:42:09 -0500

Quarterly and Annual Review of Series A Financings and Series B/Later Round Financings: Q4 and Year 2010

Foley Hoag scores with LevelUp

Paul G. Sweeney — Tue, 19 Apr 2011 12:55:48 -0500

It’s not every day a top tier law firm offers a 91% discount on its legal services. Let’s face it, deals like that are usually reserved for commodity items, and excellent legal advice is no more a commodity than is brain surgery. When everything’s on the line, you want the best lawyer, not the cheapest.

But when our client SCVNGR asked if we’d be interested in participating in one of their groundbreaking new LevelUp promotions, we jumped at the opportunity. LevelUp is SCVNGR’s exciting new pilot for building customer loyalty by combining online daily deals and location-based gaming mechanics.

Here’s how it works. LevelUp works with merchants to create the best deals in your city – say, a special on burritos, rock climbing, or fitness centers. Each business has three levels of deals - Level 1, Level 2 and Level 3. Buying Level 1 not only gives you a great discount, but it automatically “unlocks” Level 2, allowing you to “level up” to a great deal for a second visit. If after the second visit you like what you’re experiencing, you can “level up” again and get a third great deal.

We think this is genius, and we wanted to be a part of the fun. Although LevelUp is usually retail-focused, we worked with SCVNGR to create “LevelUp Your Startup,” a special LevelUp deal for entrepreneurs with great ideas who could use discounted legal and accounting advice as well as coveted access to premier investors. As part of Level 1, Foley Hoag attorneys will meet with entrepreneurs to help get their companies incorporated with a startup legal package. Entrepreneurs who buy Level 1 will unlock Level 2, which includes a startup accounting package. Buying Level 2 unlocks Level 3, where top-notch investors like Rich Miner from Google Ventures, Alex Taussig from Highland Capital Partners and folks from Common Angels, Robin Hood Ventures and Dreamit Ventures will take the entrepreneurs out to lunch and hear their pitch.

LevelUp Your Startup launched on April 5th. We offered 10 startups $2,800 worth of legal services for $250 (no, there’s no comma missing there). What’s more, a share of the proceeds of this promotion goes to support a very deserving organization: MassChallenge. Within about an hour, the deals had sold out.

Given the numbers involved, it’s probably obvious that in the case of this LevelUp our goal was not necessarily to make money. Instead, we wanted to be part of a great team and show how an awesome new program could be used to foster our local entrepreneurial ecosystem and help new businesses get off on the right path. By every measure, LevelUp Your Startup has been a huge success for Foley Hoag, SCVNGR, our new entrepreneurial clients, and MassChallenge. I think this is where I yell “Woot!”

A challenge for Fred Wilson and other Investors

Dave Broadwin — Fri, 01 Apr 2011 10:51:39 -0500

First, a disclaimer: The client referred to below has read and signed off on this post.

Now to the matter at hand: We were retained by an investor leading a $1mm seed preferred type financing for a start-up digital media company. The investor will end up with around 20% of the company after close. The company is pretty hot and the entrepreneur is already a one time winner in the space. The entrepreneur is a huge Fred Wilson fan and can’t imagine how costs could exceed $5K for this deal.

In an effort to control costs, once the investment got passed the “term sheet” (and I use that phrase loosely) stage, the entrepreneur insisted that he would only make and take comments in the form of tweets. Our client agreed to this.

The deal went into hyperdrive as soon as the tweets started to fly, with tweets like:

“Always get 6% cumulative dividends but only paid on liquidation”

“why?”

“standard”

“won’t agree to have a common vote on the drag”

“Why?”

“have in all our deals”

As you might imagine, with this limitation on discussion we are way under Fred Wilson’s magical $5K.

Unfortunately for my client, a well-known angel got wind of all this and tossed her hat in the ring with a convertible note. She wised the entrepreneur up to a number of things including that idea that converts are better for entrepreneurs than priced deals.

So here is my challenge:

Explain in 140 characters or less why the entrepreneur should accept any of the following:

(1) a priced deal and not a convertible deal

(2) a 6% dividend

(3) a drag without a common vote

The winner for best explanation within the 140 character limit gets free legal services from me to the extent of the positive difference, if any, between $5K and my fees at standard rates on this deal.

Fred Wilson's challenge: $5K to raise $1mm

Dave Broadwin — Mon, 28 Mar 2011 20:44:29 -0500

I have been giving some thought to Fred Wilson’s recent post, “A Challenge to Start Up Lawyers”. His basic point is that he should be able to close an angel financing of under $1mm for legal cost of $5K. Needless to say, this post brought out the sycophants (the Fred you are absolutely right crowd) and the deeply offended (the lawyers are worth every penny they charge crowd).

I don’t think it is reasonable to be in either crowd. Our firm enters into a wide variety of arrangements with start-up (and other) clients. These arrangements are intended to reflect the needs of the client and the particulars of each situation. We may agree with a client on fixed fees, deferrals, reduced hourly rates, premiums, blended rates – to describe just a few of the arrangements we have with various start-up clients and other clients.

But, I want to talk about the $5K for a $1mm seed preferred investment. Let me start by separating the invoice amount from the time that needs to be put into the transaction. In the world of hourly rates, these two things are inextricably intertwined, but they need not be.

Our firm knows, because we do many angel financings, that the result of hourly rates multiplied by the time spent is highly likely to exceed $5K. (That does not mean that we charge more than $5K or less than the hourly rate times the hours – what we charge depends upon many factors, the most important one, of course, is any agreement we have with a client. For example, it is not unusual for us to write off time that we feel is excessive for any reason.)

So, why are the time charges (remember not necessarily the invoiced amount) likely to exceed $5K when so many angel deals are done and the terms are so “standard?”

VCs and lawyers do tons of deals, entrepreneurs only a handful. Investments, even (or perhaps especially) angel investments involve a lot of discussion. By way of illustration, they may involve discussion of valuation, option pools, vesting for founders, structure (seed preferred versus convertible notes) and other items. Note that I have not yet mentioned the actual terms of the seed preferred.

I can just hear Fred and his army of outraged investors saying: “But we posited that the deal would be a seed preferred on standard terms and we agreed (hypothetically) on readily available open source docs.”

OK, but I know from experience that the entrepreneur is highly likely (near 100% of the time) to come to me and say, “Fred wants to do a priced deal, but my buddy Winston got funded with convertible notes, which is better?” So, now we have a discussion on the merits vel non of priced deals and convertible deals. (I know that Fred won’t do a convertible deal, but that does not mean the entrepreneur won’t ask the question.)

So, Fred, does the time spent on the discussion of priced deals versus convertible deals count towards your $5K or not? Well let’s tick off $500 for that discussion (in the hours times rate world) and move on.

OK, now there is some sort of email or other with the “terms”. At this juncture, the entrepreneur wants to discuss whether the valuation is fair. (Remember that the fact that I am a lawyer and (according to most investors) as likely to know about valuations as about paleo-anthropology will not stop the entrepreneur from asking what other clients are getting.) The meter ticks on….

Eventually we get to the seed docs themselves. I produce the docs at the speed of greased lightening. Unfortunately, the entrepreneur reads them and, guess what, has intelligent questions.

Here is a good question: Ted Wang’s open source docs provide an MFN provision for new terms arrived at in the next equity round. I have a client that asked at least these questions about that provision alone: What does it mean? Is it fair? How might it impact my negotiations in the next round? Does it give my angel investor a practical veto over the next round? And the meter ticks on….

Anyway, you get my point. It is not mere document production; it is time spent with the client. No lawyer wants his client to sign something that the client is not comfortable with and does not understand. It is just not good corporate hygiene. (In fact, it might be malpractice.)

So here is one for you Fred: Would you want your portfolio company to be using a lawyer who just says these are the standard open source docs, just sign them please? Would you invest if you knew the entrepreneur signed on that basis? Would you invest if the entrepreneur read the docs and did not have any questions?

Now back to the price. Many high quality reputable firms would agree to a fixed price (perhaps $5K) – not because they believe they will be able to bring in the time at a profitable rate, but because they think of it as business development. They may have other reasons as well. The thing to do is to have a discussion and agree at the front end as to how the billing will be handled. But don’t be under any illusion. It is unlikely that rate times hours will yield $5K.

One more point is that law firms are likely to view fixed fee arrangements as loss leaders. They are planning to get more work on which they can make a profit. Fred’s example of the exit (where the law firm charged six figures) is an excellent case in point. The risk, of course, is that the firm that did the early work at what is in effect a discount, does not get the more profitable back end work. This can happen when VCs (and other advisors – most of whom know as much about legal work as they do about paleo-anthropology) come to the conclusion that the company needs a thousand lawyer national megafirm for the “important” work, and they push the client away from the start-up lawyer. It can happen for other reasons as well, the ingrained preferences of a new CEO or CFO, the insistence of a new investor that the company use one of its “favorite” firms, or the insistence of a heavy hitting board member to the same effect.

This leads to a lose lose situation for the start-up lawyer, who will now think twice before doing the angel financing at a loss.