Emerging Enterprise Center Blog

Founder Agreements -- COD

blogs@foleyhoag.com (Dave Broadwin) — Mon, 08 Mar 2010 07:00:00 -0500

Sim Simeonov has a great post on founder agreements, which I have noted before. One of the classic issues (terminating an agreement with a "co-founder") came up for one of my clients last week. I was surprised that it was the first time for this particular client because it seems to me to be almost an obligation on the part of start up clients that they make clear promises to pay (money and equity) to people they heartily believe will perform some much needed function, write some much needed code, obtain much needed financing – whatever, and those people don’t perform but nonetheless seem to think they should be paid in full.

Outrage is the first reaction-- "I am not going to pay that SOB…" I sympathize, but legal action is not a solution. (It is like taking an overdose of chemotherapy.) You are a start up. The distraction and the cost are rarely worth it. Ignoring it is not the solution either. (Best case, you are going to have to explain the potential dispute to some investor. Worst case, it could cloud your IP rights (do you really own your software?). I promise it wont go away.)

In the end we negotiate these things away (almost always). While I don’t think this problem (the nonperforming co-founder or consultant or early hire) ever totally goes away, I think you can help yourself by being very clear about performance expectations up front. (You get paid against delivery; you vest upon delivery etc.) You can also help yourself by careful hiring. In the end, though, I am hard pressed to think of a start up client that has not hit that speed bump.

Forms for angel and seed investments

blogs@foleyhoag.com (Dave Broadwin) — Thu, 04 Mar 2010 18:06:19 -0500

Despite all the talk in the legal world about forms, and there is a lot of it, and despite the great success of the NVCA Series A documents project originally inspired by Sarah Reed, it took Fred Wilson’s recent blog post to create some interesting back and forth commentary on seed forms.

Good forms are a wonderful thing. They can save tons of time and cost – each of which is in short supply for early stage entrepreneurs. Now, not every shoe fits every foot, and sometimes work is needed and is appropriate.

At the risk of stating the obvious, if you are raising $400,000 (let alone a smaller amount) and you spend $20K on your counsel and $20K on investor’s counsel, you’ve blown 10% of your money right there. (Remember, you are also giving away a pile of equity to get that money in the door.) This is really expensive capital. Creativity and clever negotiating have a price.

Having said all that, I think it was T.S. Eliot who said with respect to literary criticism that "The only method is to be very intelligent." At some level, the same applies to your legal dealings. Forms are great, but they must be used thoughtfully.

Broken Venture Model

blogs@foleyhoag.com (Dave Broadwin) — Wed, 03 Mar 2010 07:00:00 -0500

From time to time, I make reference to vast numbers of blog posts and the like that refer to the broken venture model (or its equivalent). Here is a recent post from Dharmesh Shah on this topic. I don't agree with all his conclusions, but it is one take on the general malaise in the venture industry and it is a good read.

Litigation: The Sport of Kings not Startups

blogs@foleyhoag.com (Dave Broadwin) — Tue, 02 Mar 2010 01:53:19 -0500

Yesterday’s WSJ carried a story about a legal skirmish between Google and, as the story implied, Microsoft. IT Business Edge also has a post on this topic. The background is that Google was pursing a collection action against a small company in Ohio, I think, for about $350K. Apparently, Google filed a "normal" collection action, but the defendant hired a well known antitrust litigator from the Washington office of the venerable New York based law firm of Cadwalader, Wickersham & Taft. This fellow, and his firm, have Mircrosoft as an important client. The thing that rightly caught WSJ’s eye is that no one would ever hire Cadwalader to defend a collection case (certainly not one in which $350K is at issue). Cadwalader, on behalf of their client, counter attacked with a bunch of antitrust claims. Of course I think it is interesting that these two titans of the tech world are engaging in legal skirmishes. But the point I want to make here is more akin to the WSJ’s initial insight. Cadwalader will burn way more than $350K if this "collection" case goes to trial. This type of litigation is the sport of kings.

Most (all?) startups do not fit that category. I recall a litigation between two founders related to stock ownership, handled, on behalf of one founder, by my firm. The two hated each other to the point where there was no settling the matter, and it went all the way through trial. The cost, on our side, was in excess of $250K. Even modest litigations with small amounts at issue will run up costs that can far outweigh the benefits to any party.

Also, by the way, no investor wants to see his or her money frittered away in pursuit of a litigation. If the prospect for litigation is high, then prospect for obtaining new financing is correspondingly low. I am actually aware of one industry segment, in which a reasonably well funded company is pursuing a policy of suing all other players – including new entrants – for patent infringement. The merits of their position is unclear to me, but the fact of their strategy has made it impossible, as a practical matter, for companies with related technologies to get financing in New England.

Another thing to note about litigation, that is, apparently, true of the Google case I began with, is that once you start the process you can’t unilaterally undo it. Why? Because the adverse party will inevitably bring counterclaims. In Google’s case they initiated a simple collection case and are now stuck in an antitrust case. If you sue your co-founder he or she may counterclaim. If you then drop your claim, you will still be stuck defending the counterclaim.

My larger point here is that litigation can be a self-inflicted wound that kills your company. Litigation does have its place, but don’t think that even a seemingly great claim is as strong as it sounds.

Grand Visions and the VC Model

blogs@foleyhoag.com (Dave Broadwin) — Fri, 26 Feb 2010 07:00:00 -0500

Having recently had a pretty bad skiing accident that required surgery and will require a long recovery (while chasing my son down the lift line at Ninety Nine 90 in the Canyons), I have not been able to write many posts, but now that I am past the initial stages of recovery, I have had some time to think about the tech world again.

Here is one of the somewhat intractable issues that have troubled me. I know, from internal research at our firm, that the average life of a venture financed client (from the time the company becomes a client until exit) is about 10 years. I also know from discussion with a VC friend that the average time to exit for companies in his portfolio is 8 years (at least that is what he is telling people). Remember, these are average numbers, so many investments take longer to get to exit. Also remember that our firm’s numbers reflect investments from a broad variety of VCs from the top tier to the little know funds. My friend is with a top tier firm, so their results may be somewhat better than those for the industry as a whole.

OK, so why waste time thinking about this number? Well, most funds have a ten year life. Ideally during that term, the fund is fully invested and fully liquidated. Most (all?) funds provide for extensions to liquidate laggard investments. Even still, limited partners in VC funds would like to get their return in ten years – that’s the plan.

If you know that your average time to exit is 10 years, then you know that investments made in years 3, 4, and 5 (let alone anything after that) are, on average, going to run way over. This accounts, in part, for the phenomena that many VC fundss will linger long after they are unable to raise new rounds.

But, it also may have an impact on investment style. Except in the earliest years of a fund, VCs will almost always be in the position of being under pressure to look for an exit. I am sure there are many ways in which VCs try to mitigate this pressure (doing follow on investments in new funds might be one, but that is a hassle for other reasons).

I suppose it is impossible to know how much pressure this situation exerts upon VCs to favor tightly defined business plans with a clear path to an exit over grander visions? I have commented elsewhere that VCs seem to me to favor narrowly focused tightly defined business plans that address clear pain points and have obvious exits. VCs also seem to me to have become very focused on domain expertise within their investment portfolios. This makes sense, why invest in something you don’t know about? But it also leads to a certain orthodoxy in the nature of investments.

In some sense the life of a normal fund is not suited to the life of a normal company. As a result, VCs are structurally driven to favor narrowly focused investments over grand visions.

Fair and Not Fair in Deal Terms

blogs@foleyhoag.com (Dave Broadwin) — Mon, 15 Feb 2010 20:10:14 -0500

I have been thinking of the NVCA meeting of the forms group that I attended in LA last week. One of the themes of this group has been to make the NVCA forms even handed. The forms are not intended to be either investor friendly or entrepreneur friendly. They are intended to represent a fair compromise of the issues that are inherent in any VC investment. They are also intended to be consistent with current market practices. So, if the market has evolved in a direction that seems unbalanced, well, the form reflects market practices. In the areas where practice is variable, the forms either provide alternative provisions or make reference to differences in footnotes.

One good example of how the NVCA forms try to balance fairness and current practice is in the area of founder representations. Founder representations are rare (extremely rare) in west coast deals but appear with some frequency in east coast deals. In general, the trend is away from founder reps. So, the forms (in their next iteration) will provide a footnote explaining this (and going through the limitations commonly seen in connection with founder reps, when they appear).

Having said this, to the extent that there are obvious areas of unfairness that have found their way into regular market practices, then the forms just reflect the prejudices of the market. One example of this is the ubiquitous presence of weighted average antidilution provisions. I believe that (with the exception of deals that have full ratchet provisions – far worse for entrepreneurs) all VC investments have weighted average antidilution provisions. Despite what I am about to say, don’t try to get these provisions out of VC docs; you will fail and will waste time, resources, and will leave an impression that you are difficult to deal with.

How can anyone justify antidilution? As far as I can tell the reasoning is that it is up to management to increase shareholder value. If management fails to do this, the argument goes; they should take a hit for that failure. As far as it goes, that argument has some merit.

If we agree with this argument, how do we deal with the effect of antidulition provisions on common stockholders other than management (angel investors for example). By the way, management is often holding options, and they are often "topped up" with more options. In effect, the people who suffer the ill effects of antidilution are not the people who are responsible for the performance of the company.

If you get past the issue I just described, how do you deal with declines in shareholder value that are not due to poor management? For example, what if there is a world-wide recession that affects all businesses, without regard to the quality of management? What justification is there to put greater risk of macro-economic events on management (or the common holders) than on investors?

Let me be clear, if you try to get antidilution provisions out of VC investment docs, you will (a) fail and (b) cause people to think that you are weird. So don’t try.

NVCA Forms Project

blogs@foleyhoag.com (Dave Broadwin) — Fri, 12 Feb 2010 13:31:32 -0500

For the first time in several years, I was able to actually attend (as opposed to sign up for and then not be able to go) the annual meeting of lawyers and VC in-house counsel that was organized by Sarah Reed (of Charles River) long ago to develop what are now the NVCA document forms. In my view, this is one of (perhaps the) most successful forms projects ever undertaken. We are about to publish EEC Perspectives for Q4 (the link is to Q3, but Q4 will be available in the next day or so) and year end. It will show very high continued adoption rates. For those of you who are not familiar with these forms, they are an annotated set of series A deal documents. They are a great resource for any entreprenuer trying to understand what is in the docs and what is "market".

Based on comments at the meeting, there will be some modest revisions to the documents. Perhaps the most noteworthy is that we will be going back to the future: The next round of forms will (when done) include an additional form of charter with a pay-to-play provision. If my memory serves me well, we included pay-to-play when we did the original version of the charter seven or eight years ago (can it really be that long ago?).

Another noteworthy discussion revolved around whether or not registration rights should be deleted from the forms. They won’t be – at least not this time. Let’s hope that by the time this group meets again next year, there will have been a few (more than a few) IPOs and everyone will start feeling like reg rights are important after all, even if rarely used.

One final note, Ted Wang from Fenwick, discussed model seed series financing documents (based on the NVCA docs) that he prepared and will be making publicly available. This is another great project and great service to the entrepreneurial community.

Hiring an Attorney

blogs@foleyhoag.com (Dave Broadwin) — Wed, 10 Feb 2010 09:59:20 -0500

I can’t recall being asked about whether and how to maintain confidentiality of business plans and other information when interviewing possible attorneys whom one might want to retain until very recently, but I have been able to tell from my interactions with potential clients that may of them worry about what is OK to tell the attorney they are interviewing (and might or might not hire).

Attorneys, as a general matter, have a professional responsibility to keep such information confidential, and reputable attorneys will abide by these rules. Having said that, not all attorneys always meet this standard, so don't take a risk that you don't need to.

I don't think you need to get very deep into details of your business plan at an initial meeting with an attorney, and, in general, I would advise you not to. Also, don't leave a copy of the plan or your slide deck or other materials that contain sensitive information with any attorney, until you have selected one to work with and he or she has agreed to represent you.

A general high level description of your business should suffice for the initial meeting. Once you have entered into a formal attorney/client relationship, the matter is different. Once you are in a formal relationship, you should be able to rely on your attorney's duty to keep client information confidential. Attorney's typically do not sign NDAs, and I would not ask for one.

Measuring the effect of social media

blogs@foleyhoag.com (Dave Broadwin) — Mon, 08 Feb 2010 07:00:00 -0500

I attended a presentation at the Mass Technology Leadership Council a while back on the subject of measuring the effects of social media. I have been thinking about it ever since. Mostly because I sometimes wonder why I am writing a legal related blog. After all, who wants to read legal stuff? (Lawyers? Foley’s marketing department? My daughter, Megan, who reads it religiously but admits she understands little of the legal stuff? The good folks at Lexblog who host this blog?)

The speaker was K. D. Paine, whose business is consulting in this area. Without question she made many many interesting points. But, and I suspect I will make a complete hash of this, her main point was that the effectiveness of social media (such as blogs) is in fact measureable and not by counting eyeballs. Here is a link to the slides from the speech.

Her point is that the effectiveness of social media revolves around engagement. So, it does not really matter how many people read your blog or follow you on Twitter. What matters is how many of them are "engaged" and how many act on this engagement. You can have a million people hitting your site, but if none comment and none forward a link to someone who they think might have an interest, then so what? A recommendation from trusted source is far better than a random hit from a Google search. If you have engagement, you are more likely to get referrals and valuable positive buzz with people who care about your product, service or message.

There are lots of ways to measure engagement. One might be how many times you are re-Tweeted or how many comments you get or how many times your blog is cited by others. If you are staying on message and readers are commenting, citing and retweeting, they you are likely to be impacting your market in a much more direct and powerful way than with mass spamming or just mountains of passive traffic.

So measuring effectiveness begins with measuring engagement and ends with calculating an ROI from the people who took action based on the engagement.

None of this, of course, tells you how to create engagement, and that is where the magic ultimately lies. Now I am on the trail looking for insights into how engagement is created (not just how it is measured). One site that seems to be focused on this aspect of web marketing is pistachioconsulting.com. A f riend at Valley View Ventures turned me on to this site. There is currently a guest post on "Presenting with Twitter" that has some strategies for creating engagement. I am sure there are others. I will try to note them as I find them.

The Options for Options

blogs@foleyhoag.com (Dave Broadwin) — Thu, 04 Feb 2010 07:00:00 -0500

Sim Simeonov has a nice post on the subject of what is the best option vesting schedule. Options are a topic that has received a lot of attention in the blogosphere. A while back there was a lengthy discussion of options on Fred Wilson’s blog that, as I recall revolved around the need to think of option grants as percentages of the equity of the issuer (rather than in numbers of shares. The EEC blog has many posts on options (and the related topic of restricted stock). All these posts tend to focus on some discrete aspect of options that came up in the author’s business. For a more general discussion, you can go to the Emerging Enterprise Center web site under "Ask the Start-up Lawyer." There you will find a general overview of the basics.

Peak Oil

blogs@foleyhoag.com (Dave Broadwin) — Wed, 03 Feb 2010 07:00:00 -0500

I am no Peak Oil maven, but I read some commentary about it in the comments to one or another blog that I read regularly (perhaps Fred Wilson’s blog or Brad Feld’s or Don Dodge’s, I am not sure). Anyway it the issue was what the effect of peak oil would be on technology companies. Aside from placing a huge premium on all sorts of energy related technologies (that is why some massive percentage of investment is going into this space), I am not sure why technology should be affected differently from other industries. Anyway, it caused me to read a little about peak oil and the various debunkers of the peak oil theory. No surprises there. But it reminded me of something I have thought from time to time. I bet that all the peak oil theorists and their debunkers have their facts wrong. I can’t believe this is an original observation, but here is why:

In my capacity as corporate/securities lawyer, I have been watching clients, investment bankers, and others (by they way back in the days of oil and gas limited partnerships – the people who put those together) put together projections and financial statements. I don’t think any (perhaps a few) ever put together projections or financial statements in bad faith. But, whenever you put together these kinds of numbers you have to make choices. They can be totally legitimate and appropriate choices. Here is an example, in determining the net present value of a future payment, you have to pick a discount rate. This is a judgment call. Within the range of fair and proper, almost everyone errs on the side that benefits them.

I am guessing that the calculation of oil reserves is not an exact science. It involves judgment calls like the one I just described. Within the range of what is fair and proper, what kind of estimates do you think big oil is making?

My guess is that nobody knows what the world’s oil reserves really are (or even has a reasonably accurate guestimate). The same, by the way, applies to the calculation of demand. My guess is that nobody knows what the demand will be (or even has a reasonably accurate guestimate). The inaccuracies, of course, compound each other (that is my guess anyway). I would guess that the world reserves are less than anyone thinks (including OPEC). We may, or may not, find additional new and vast reserves – who knows?

My theory is that people who are making big bets on new enery technologies are going to get a pleasant surprise. (Although the rest of us may not find it so pleasant.)

Google Goals

blogs@foleyhoag.com (Dave Broadwin) — Mon, 01 Feb 2010 07:00:00 -0500

I just read Don Dodge's post on Google's goal setting. It strikes me that what works in one environment will not work in another. For every formula that drives human behavior there is an equal and opposite formula that works for someone else. In this case the perfect is the enemy of the good might be the equal and opposite formula. But, I think T.S. Eliot had the last word when he described literary criticism. He said, "the only method is to be very intelligent." To expand this concept, the only method is to be talented and driven. I certainly agree that some organizations bring out the best in people, but in the end it is the people not the formulas. In all fairness to Don Dodge, he kinda comes to this point in his post. Another blog that often (always?) has something enlightening to say on people managment is Rands.

Wealth of Nations

blogs@foleyhoag.com (Dave Broadwin) — Fri, 29 Jan 2010 07:00:00 -0500

My 17 year old son brought home the following list of the top 10 wealthiest countries based on GDP per capita:

10. Ireland

9. United States ($47,500)

8. Brunei

7. Singapore

6. Kuwait

5. Norway

4. Bermuda

3. Luxembourg

2. Qatar

1. Liechtenstein ($118,000)

Basically, you got tiny countries (Ireland has 6.2 million people, Singapore has 5 million, Norway has 4.8 million plus tons of oil), tax havens, oil producers, and the United States. I don’t know, but I am guessing that the next 20 would include Japan, Germany, France etc. I am also guessing that if you put together the list of the "next" 20 countries in 1970 (or perhaps 1870) it would not be much different.

He also brought home a list of the bottom 40 countries based on GDP per capita. It is basically sub Saharan Africa (with some exceptions, South Africa, and some add ins Afghanistan, Haiti, Burma etc.). At the bottom was Zimbabwe with a per capita GDP of $200. I am making three final guesses (1) if you put this list together in 1970, it would not be much different, (2) if you put this list together (assuming one could) in 1870 or 1670 it would not be much different, and (3) that the spread between the lowest and the highest per capita GDP has done nothing but increase.

With the possible exception (depending upon when you measure) of the United States and the Asian countries (Japan, Korea others?), the countries that have really cracked the top group are, generally speaking, oil rich countries with tiny populations. (Where are Nigeria and Venezuela?)

Oil is going to become less valuable over time. Yes, the price per barrel will increase (and increase dramatically as world supplies dry up and become harder and harder to exploit), but other sources of energy will have to be developed. Certainly our children, and probably anyone who reads this post, will live to see the day when today’s oil powerhouse countries will resemble Lichtenstein – rich but so what? Sustained wealth and influence does not come so much from cashing in the winning lottery ticket in the natural resources game but rather from constant innovation.

So, here is one final guess, if you take this measurement again in 2070, the U.S. will still be near the top of the list.

Prediction for 2010

blogs@foleyhoag.com (Dave Broadwin) — Wed, 27 Jan 2010 07:00:00 -0500

I like Don Dodge’s predictions for 2010, it seems as if we are about to enter the brave new world of mobile everything (commerce, computing, internet whatever), but I have been trying to figure out what bugs me about the predictions. I finally got it. Here is the answer. I was recently reminded of the scene in Star Wars when R2D2 plugs into the Death Star and turns off the trash compactor. In the brave new world of the future interoperability will be seamless. Think about all the devices we have (and shortly will have: the Android, the new Apple "pad" is that is what it will be, mp3 players etc.). Think about all the services (Pandora, Twitter, GPS directions etc.). My prediction is that 2010 will be another year of technology chaos demonstrating that we are still in the infancy of the technological age.

Quattro and Apple

blogs@foleyhoag.com (Dave Broadwin) — Tue, 26 Jan 2010 17:47:50 -0500

Marc Theermann has this to say about the acquisition of Quattro by Apple,

If I hear another quote that contains any part of the “year of mobile” sentence I will jump out of a high window. Just like the “local Starbuck coupon” example it is heavily overused, and profoundly misunderstood. The reality is that mobile advertising died today. Not because consumers will not use it, or because advertisers will not spend money. Quite the opposite. Mobile advertising will be huge. However, with the acquisition of Quattro, the pure mobile advertising industry died. As a result, there might never be “a year of mobile”. From now on, mobile advertising will become another check box in the interactive/online advertising budget. Tom Burgess, Omar and Andy have done everything right: they brought our industry to the point that it should be — But the harsh reality is: “the year of mobile” coincides with the year that mobile died (as a stand alone industry).

While Marc clearly thinks this is a regrettable event, with the continuing convergence of mobile, desktop, pads and whatever else comes along, I wonder if it was probably inevitable.

Venture investment activity

blogs@foleyhoag.com (Dave Broadwin) — Mon, 25 Jan 2010 07:00:00 -0500

Once again the year end numbers are out and the ritual wringing of hands has started. As is often the case, Fred Wilson has a clear point in his post The Venture Diet is Working. His basic point, which many others have also made, is that there is too much money floating around the venture industry and that this excessive amount of money drives down industry returns. If there is less money invested in any given period, presumably it will go to the better deals (generally speaking) and will ultimately provide better returns. You can’t argue with that proposition. It is economics 101.

However, Fred is looking at the supply side of the equation (i.e. the supply of money). I am not an economist (in fact I am an attorney with a graduate degree in English literature), but if you look at the demand side of the equation (entrepreneurs seeking money) you might conclude that underlying Fred’s and others’ analysis is an assumption that the rate of change along the demand curve is more or less constant. For every dollar that you take out of the venture market a somewhat consistent corresponding amount of demand increases (or to put it another way – the value of the investment dollar gets bid up in a somewhat consistent way).

I keep saying "somewhat" because I think the demand curve may be more (and sometimes less) steep at various points along the supply curve. Here is the part that I cannot "prove" or demonstrate, but I believe that the ecosystem needs a certain amount of investment activity to remain viable. In order to motivate people to pursue their entrepreneurial dreams, they have to have some hope of getting funded and, ultimately, of a cool exit. If the investment supply becomes too small, that hope may disappear and the ecosystem may not support entrepreneurial life at all. If you take enough oxygen out of the pond, the fish will die.

So, the system needs to be smaller to permit good returns to investors (or they will go away), and the system needs to be large enough to provide incentive (hope of funding), even to those who might fail. Those two points define the space of viability for the venture capital/tech entrepreneur ecosystem. The question that needs to be answered is whether that space exists at all. A second question is, if it does exist, where is it?

To me this issue also raises larger questions about the so-called venture model. From my vantage point, I see VCs investing in well conceived tight investment thesis tech companies with the plan of an M&A exit (mostly). One way to think of this (and not a particularly original way) is to observe that the buyers (Microsoft, Google, et al) are outsourcing new product development risk. That is why VC investments seem to be focused on tight investment thesis companies with a seeming clear path to an acquisition. (I can just feel the VC community pounding me with the "we want to create great companies speech," but look at what they actually do not what they say they want to do.) In part this model is driven by the ten year fund cycle. Recently, I have run across VC investments (I have two in my client portfolio), that are not driving to an exit so much as towards developing larger sustainable businesses.

While it may be that the VC diet works, it also may be that it doesn’t and something new must emerge. Either way, it is a critical issue. We need tech entrepreneurs to grow wealth and we need a way to value them and provide a handsome return to people who invest in them. If we don’t we will end up having to compete with Brazil to make Nike sneakers.

Three words

blogs@foleyhoag.com (Dave Broadwin) — Sun, 24 Jan 2010 14:37:35 -0500

Here is a link to a fun post (and series of comments) from Dharmesh Shah called Start-up Advice in Exactly Three Words. I am a little late to note it because it was posted on Jan 10, but it is fun, so take a look.

More on cumulative dividends

blogs@foleyhoag.com (Dave Broadwin) — Fri, 15 Jan 2010 11:18:29 -0500

Eric Belsley from our office had this to add on the subject of accruing but non-cumulative dividends. More concise and to the point than my post of Wednesday.

This is a relatively unusual provision. However, it would mean that although dividends accrue daily (and thus are computed when payable on a number of days in the year to date basis), the amount of such dividends is reset to $0 at the beginning of each year.

An interesting issue is the effect of this provision on payments made in liquidation and redemption. If the liquidation and redemption sections expressly refer only to "accrued and unpaid dividends" in addition to the principal amount, the company would have an argument that the non-cumulative nature of the dividend reduces the payout attributable to the accruing dividend in these events. This argument is much weaker if the liquidation and redemption sections expressly refer to the amount defined in the accruing dividend section, without referring to it as a "dividend."

Dividends pay dividends - or do they?

blogs@foleyhoag.com (Dave Broadwin) — Wed, 13 Jan 2010 07:00:00 -0500

As a general proposition, with respect to dividends in venture capital style preferred stock, there are two main choices and a third that is rarely; but not never, seen, that is easy to comprehend and then there is a fourth choice that is rarely, seen and is hard to understand, but occurs with some frequency.

You might ask, "What is it?" But, before we go and make our visit, let’s do a quick review of the dividend provisions that are more commonly seen.

First, there are venture capital preferred stocks that do not bear dividends. That is easy, they just don’t have dividends. This is true of approximately [50%] of all deals done in New England. Even the VCs don’t seem to know this fact. I once negotiated a deal with a VC from a name brand fund who asserted that all [he said "all" not "most" or "a majority" or anything else: "all".] his firm’s deals had dividends. Of course, I could not resist, so I checked. It was about half. Make no mistake about it. Dividends are just a way of grossing up the return to the investor. They are about economics: it is as simple and as complex as that.

Second, there are venture capital preferred stocks that bear dividends that accrue and cumulate. These dividends are not actually paid until the business is sold. They just keep adding up year after year. These dividends are not usually converted in the event of an IPO (so, the economic value of the dividend is lost in that exit scenario – why is something I will go into at another time). When a liquidation event occurs (and by liquidation event I mean a sale of the business) the dividends get paid. These dividends do not compound (compounding is different from cumulating). To put a really fine point on it: If you have $1,000,000 of Series A Preferred Stock with a 10% (way too high but easy to calculate for the purposes of a blog post) and a 1x liquidation preference and you sell the business three years after the issuance of the Series A Preferred Stock, the holders of your Series A Preferred Stock get $1,300,000 as their preference. Each year the dividend accrued (it was not paid) and for three years the dividend cumulated (it added up each year). Note, the dividend did not compound.

Third, I have (very rarely) seen a dividend that gets paid on a quarterly (or semiannual basis). This is not typical. In the situations I have seen it, the reason for it is that the investor is a leveraged fund that must pay interest to its debt source and needs cash flow from investments to make these payments. Don’t worry about this situation; it almost never arises.

Fourth (and here is the odd one), sometimes you see this language or its equivalent:

"Accruing dividends will accrue from day to day, whether or not declared, and shall be non-cumulative…."

What is an "accruing non-cumulative dividend" you might ask? Let’s go back to my example of the $1,000,000 preferred with the 10% dividend. In this case (case number four), the dividend accrues but it does not cumulate. So, when you sell the company on the third anniversary of the sale of the preferred stock, the holders of the preferred stock get $1,100,000 (not $1,300,000). This is because the dividends, which accrued over the course of each year, did not cumulate across the three years.

I suppose the parties could have negotiated this result, but I suspect that what they really meant to agree upon was that the dividends would not compound. (By they way, I don’t recall ever seeing compound dividends – not that it can’t happen; I just don’t recall ever seeing it.)

All in all, don’t be shy about negotiating for no dividends, but in any event, know what you did negotiate.

Getting Real

blogs@foleyhoag.com (Dave Broadwin) — Mon, 11 Jan 2010 07:00:00 -0500

First, don’t put too much store in sales advice from a lawyer. Second, here is something I have observed more than a few times, so it seems to me that it merits mention. Every now and then I run across what seems to me to be a very compelling story. The entrepreneur has identified a pain point in the market. They have a service or a product that seems to address it elegantly. The business thesis hangs together in a very coherent and compelling way. The company has talented, energetic and committed officers and employees. Investors buy into the thesis and invest. But, somehow, for some reason after several years of trying the business is just not developing.

I am just the lawyer. I don’t know what the problem is, but I have seen the situation before and I recognize the symptoms. Everyone involved is engaged in a collective delusion. They are all ignoring (perhaps they really don’t see it) an important fact. The emperor has no clothes.

If you find yourself doing the same thing over and over again and getting the same results and you continue to be convinced that your strategy and tactics are destined to succeed – you just can’t explain why they haven’t, consider whether or not you and your team have not fallen into a collective delusion. You need to find reality in order to address it effectively.

Your widget is perfect. It is the best thing on the market. The competition, while well established, is lumbering and slow and expensive. But no one is buying. You need to go back over each of the facts and examine each one. Somewhere you are missing something. Here is my bet. The most basic premise is where you have gone wrong. In this widget example, I began with “your widget is perfect.” I am willing to bet that it isn’t. If there is some premise that can’t be examined, that is truly an article of faith. If the CEO keeps saying our widget is faster, and no one ever challenges that assumption, it is almost certain that that is where the problem lies.

It may be that the problem can’t be fixed, but you might as well know it. If it can’t be fixed and the problem is fatal, at least you can move on. If it can be fixed, then you at least have a shot at it if you can identify the problem. The real world gives you feedback. What you think is nice, but it better not fly in the face of what is actually happening or you may find that you are parading down the street with no clothes.