There is a dichotomy in the world of entrepreneurship which is almost beyond belief:

• Every start-up entrepreneur believes that he is going to exceed his projections, yet
• None of them even reach them.

I know, I know, one should be very careful in using absolutes like “every” and “none,” but in over 40 years of start-up stage venture capital investing, I have seen only one exception to these statements.  Take a hundred entrepreneurs selected at random, hook them up to lie detectors, have them place their left hands over pictures of their moms and their right hands over books of worship of their choice, and ask them “in your heart of hearts, do you really believe that your projections are, to use your word, ‘conservative?’”  You will not only get one hundred yeses, but not a single needle will quiver.  Yet if you came back to them five years later, you would likely find that not a single one of them hit their numbers.

How can this be?!  To be sure, in any group of 100 entrepreneurs selected at random, there will be dozens of fools – people who are literally kidding themselves about their prospects.  But there will also be dozens of solid citizens – bright, hard-working, relevantly experienced men and women who have devoted serious research and thought to their prospects.

The answer is two-fold in nature, the first part of which is known to just about everyone, and the second part of which I have never heard anyone else voice.  The first part of the answer is that entrepreneurs are, almost by definition, optimists.  Their glasses are almost always at least half full.  They believe in themselves, their team and their opportunity.  They expect and project good things to happen.

The second, and far more important part of the answer is that, while entrepreneurs sincerely believe that their projections are conservative, they are in fact Utopian.

As the easiest proof of this fact, grill a start-up entrepreneur on his projected expenses.  Ask him questions like the following.  What provision has been made in your projections for:

• Uncollectible receivables?
• Management team member turnover and/or failure including management team member vacancies of months on end, and ultimately paying headhunter fees?
• Aggressive price reductions from competitors?
• Competitors ultimately leapfrogging your leading edge technology?
• Employee theft?
• National and/or industry recession?
• Products recalls due to component failures in the field?
• Litigation costs?

You will likely get a blank stare in return, because all of the above falls into the category of “stuff that goes wrong,” and there has been no thought given in the preparation of the projections to anything going wrong.  It’s not in the nature of the entrepreneurial beast to even acknowledge such things.

Why is this so important?  Cash flow.  Cash is literal life.  A friend of mine once described a start-up as a race against insolvency, and he was right.  One which badly misses its numbers will either become insolvent or require a whole lot more money to stay afloat than originally anticipated.

So how can you, as an entrepreneur, address this strange and frightening dichotomy?  Again, because it is easier, let me first address the below-the-top-line part of the profit and loss projections.

Start by doing some research on your industry’s metrics.  Secure some annual and quarterly reports for companies in your industry.  Get a copy of Robert Morris Associates’ Annual Statement Studies, which not only includes model balance sheets, income statements and financial ratios by business type, but also does it by business size.  Place a call to your industry’s trade association and find out what information they have that can guide you.  Fashion your projected expenses accordingly.

Next, take a look at your industry’s gross margins.  If the industry leaders are around 55% and your projection is for a shade under 70%, you are in all likelihood headed for a fall.  Your competitors have economies of scale which you do not.  They have momentum, they have name and brand recognition, and rock-solid balance sheets.  They have all manner of advantages over you.  They are not only industry survivors, they may well be industry leaders.  Stated another way, counting on a gross margin superior to the industry standard is not only likely foolish, but asking for a future cash flow crisis.  For at least the first two or three years, and even if you intend to push the state-of-the-art, assume that you will experience gross margins at least a little below the industry standard.

Now let’s address the much more daunting task of creating sales projections for a start-up.  Surely there is no more difficult challenge in all of business.  Here you are, at the very beginning of a business odyssey, trying to divine out of thin air what your sales will be in your first few years of business.  You have no history to look at.  Your company has no customers, no momentum, no reputation, no market awareness.

The only intelligent way I know of to bridge this chasm is to identify your company’s top dozen or so prospects – those companies where you probably have personal relationships, and which you believe would have a keen interest in buying your product after it’s developed.  Then call up the buyers at those companies and request an audience to share your plans and get their reaction.  Sit down with them and tell them what you’re up to.  Share your product specifications and prospective pricing.  Tell them what you think your product will do for them.  And then ask them:  What do you think?  How interested or excited are you about what we’re up to?  Would you have an interest in being a beta site?  How much of this product category do you buy each year?  Who do you buy from now?  How does our prospective product compare to their’s?  Do you have a policy of second sourcing?  If so, how does that work here?  How would you go about evaluating our product?  Over how long a period of time?  If we introduced our product to spec at the price I mentioned, how much of it do you think you would buy in the next few years?  While there will likely be buyers who will not divulge all of this information, you will be amazed by how many will, and particularly if you have a personal relationship with them beforehand.

Then, take what you learned and pessimize the numbers.  If the twelve buyers, in aggregate, estimated that they would buy one, three and four million dollars of your product in years one, two and three, assume that they will do half that.  Or maybe two-thirds.  When in doubt, go with the more conservative choice.  After the first two years, assume that you will sell to some other customers beyond these first ones.  Additionally, if your product category features resellers or sales reps, getting their feedback can be a useful sanity check on the above.

If you’re in a service business, check in with the executive director of your industry’s trade association for some guidance or references.  Then speak to as many leaders of similar companies as you can, to learn of their start-up experience.  You may have to focus on those in distant geographies so as to avoid concerns of competitiveness.

A word of caution – one popular method of start-up sales projecting which is not likely to be on the mark is to assume an arbitrary, seemingly low percentage market share multiplied by the size of the market (the market we are addressing is $800 million.  How could we fail to penetrate one percent of it after three years? There can be a very good answer to that question if there are 300 established companies already serving it.)

There is one final cash flow driver in a start-up, and that is the timing of initial sales; in other words, how long a period of time your product will be in development.  If, after protracted consideration by your engineers, they tell you that it should be ready for sale in nine months, assume twelve or thirteen.  If they’re right, the surprise will be a pleasant one.  If you’re right, you’ll have anticipated the need for the additional three or four months of funding.

You may be saying to yourself as you read my advice, “Boy, there are cushions for the cushions in this approach.”  And there are.  But I’ll bet you that even if you take my approach, you’ll still end up needing more capital to get to positive cash flow than your projections indicate.  The difference, though, will be one heckuva lot less than if you had done it your way.

Fred Beste has been active in the venture capital community for over 40 years.  He remains the CEO of the General Partners of Mid-Atlantic Venture Funds.  In addition, he currently holds the title of Partner Emeritus with Originate Ventures.

Background

Investment managers of private funds (“Private Fund Managers”) such as venture capital, private equity, real estate and hedge funds (i.e., funds not registered under the Investment Company Act of 1940, as amended (the “Act”)) have been greatly concerned about the regulations in the Dodd-Frank Act requiring such managers to register with the SEC as investment advisers.  In the past, Private Fund Managers were mostly exempt from investment adviser registration at both the federal and state levels.  The Dodd-Frank Act eliminated the exemptions Private Fund Managers relied on previously and requires Private Fund Managers with assets under management of $150 million or more to register with the SEC as investment advisers, subject to certain exceptions which were left to the SEC to clarify.

Private Fund and VC Exemptions

On June 22, 2011, the SEC adopted final rules under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) to implement the provisions of the Dodd-Frank Act relating to investment advisers.  These rules require most Private Fund Managers to register under the Advisers Act as investment advisers prior to March 30, 2012.  The SEC also adopted two exemptions from the registration requirements:

1. the “private fund adviser exemption,” which exempts managers who advise only private funds (managers who manage private funds plus managed accounts may not use the private fund or the VC fund exemption and therefore must determine whether they are required to register at the state or federal level) and whose assets under management are less than $150 million (measure annually) (the “Private Fund Exemption”); and
2. the “venture capital exemption” which exempts managers who manage only venture capital funds as the SEC has defined such term (the “Venture Capital Exemption”).  The second exemption is of particular interest to the venture capital community (as well as the private equity and real estate communities) because it allows managers of venture capital funds to manage in excess of $150 million but remain exempt from registration and (most of) the requirements of the Advisers Act.

What is a “venture capital fund” (according to the SEC)?

Under the Venture Capital Exemption, a “venture capital fund” is a private fund that:

• Represents to investors and potential investors that it pursues a venture capital strategy;
• Invests at least 80% of its committed capital in “qualifying investments” (but may invest up to 20% in any other type of investment);
• Does not use leverage (including guarantees) in excess of 15% of the fund’s committed capital; and
• Does not provide any redemption rights to investors (except in extraordinary circumstances).

“Qualifying investments” are equity investments (which include convertible securities) in qualifying portfolio companies or equity securities issued in exchange for such equity investments made in qualifying portfolio companies by such portfolio company or any successor.  A “qualifying portfolio company” means any company (not funds or pools) that (i) is not an SEC reporting company or traded in the U.S. or abroad (nor controlled by any SEC reporting company or company traded in the U.S. or abroad), and (ii) does not issue debt in connection with the investment by the private fund and distribute the proceeds of such debt issuance to the private fund in exchange for the private fund investment (the SEC is excluding leveraged buyout funds from the venture capital fund definition).

The definition of venture capital fund did not change significantly from the proposed definition in November 2010, despite the SEC receiving over 70 comment letters on this definition alone.  The biggest change in the final rules was allowing venture capital fund managers to invest up to 20% of their capital in non-qualifying investments.  This will allow venture capital funds some flexibility to invest in what the SEC considers to be non-venture capital investments (such as bridge notes, leveraged transactions, IPO allocations, PIPEs, etc.), so long as the 20% limit is not exceeded.  The 20% limit is measured at the time of each non-qualifying investment based on value (at either cost or fair market value, whichever has been used by the fund since inception) of all non-qualifying investments as compared to committed capital (including uncalled capital) of the fund.

Are Exempt Managers Really Exempt?

Managers who meet either the Venture Capital Exemption or the Private Fund Exemption (“Exempt Managers”) will not have to register with the SEC and be subject to all of the rules, regulations and other requirements of the Advisers Act.  However, the SEC did not let Exempt Managers entirely off the hook.  Exempt Managers will still have to file a Form-ADV with the SEC, which is the same form that non-exempt managers have to file, though Exempt Managers only have to fill out certain specified parts of the ADV.  Exempt Managers will also have to pay a filing fee, be subject to certain record keeping requirements and be subject to SEC examination.  Additionally, as was the case prior to Dodd-Frank, all investment managers, whether registered or not, are subject to the anti-fraud rules of the Advisers Act.

The Form-ADV filed by Exempt Managers will be available publicly (like all Form-ADVs) and disclose basic identification details (such as name, address, contact information, form of organization, and who controls the adviser), provide details regarding other business activities in which the adviser and its affiliates are engaged, require advisers to disclose the disciplinary history of the adviser and its employees, and require disclosure information regarding each private fund.

An additional concern to Exempt Managers is how state securities regulators will look at private fund managers that fall below the federal threshold or are otherwise exempt.  Congress and the SEC delegated oversight of “mid-size advisers” (those with AUM between $25 and $100 million) to the states.  Many state securities laws and regulations previously exempted managers of private funds by relying on the federal exemptions that the Dodd-Frank Act repealed.  So it remains to be seen if private fund managers not required to register with the SEC, who in the past were also exempt at the state level, will now have to be registered with one or more states.

Conclusion

All Private Fund Managers will now have to assess where they fall in the spectrum of investment adviser registration rules (including at the state level) and whether they can avail themselves of either the Private Fund or Venture Capital Exemption.  Those that are not exempt will have to fully register, make necessary disclosures and deliveries to clients, put into place a full compliance program, name a chief compliance officer (CCO), and make themselves subject to routine SEC examinations.  Even those federally exempt advisers will have to file a shorter version of Form ADV (and update annually), pay a fee, and be subject to possible SEC exams.  Exempt Managers will also need to determine whether state registration will be required.

If you would like to review the SEC releases relating to these new investment adviser rules, you can access them under the Resources heading here.

Keith Marlowe, Esq., is the founder and managing partner of Marlowe Legal Advisors, LLC, a corporate and securities boutique law firm based in suburban Philadelphia, PA, which covers a wide range of corporate and securities matters.  A portion of Marlowe Legal Advisors’ practice is devoted to advising private funds (venture capital, private equity, real estate and hedge funds) on all aspects of their business.

You can check out my own personal advice on Page 5.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups, early stage and emerging growth and middle market companies.

There are a number of sites out there that appear to focus on this crowdfunding model, although most appear to be centric to the creative arts (music, painters, sculptors, fashion, etc.).  On the whole, people do not appear to be selling securities, with a few exceptions.  That is, they are not selling an ownership stake in their business.  They speak in terms of “pledging” or “contributing” or “donating” to a “campaign” or a “project” in return for a “reward” or a “perk”.  When they speak of rewards and perks, think along the lines of free samples, coupons, autographed CDs, a personal phone call or visit from a band member, copies of songs prior to release to the public, free t-shirts or a limited edition copy of original art work and the like.  Here’s a list of some of the current sites in this space:

• 33 Needs – geared towards social ventures.  Claims that the “backer” receives a percent return based on revenue.  They claim that if a backer’s core motivation is not financial return but, rather, impact or consumption, then the securities laws do not apply.
• Rockethub – geared to the creative arts.  No ownership exchanges hands.  Investors get a reward.
• Pozible – Australian based.  Geared towards the creative arts.  No ownership exchanges hands.  Investors get a reward.
• Catwalk Genius – U.K. based.  Geared towards fashion.  Claim to provide both perks as well as a share in the revenue.
• Fans Next Door – focused on the creative arts.  You can contribute and receive a reward.
• Cofundos – primarily focused on the creation of open source software.
• Profounder – claims to be focused on raising money for your business.  This appears to be the only site involved in businesses outside of just creative arts projects.  That being said, they claim not to be selling ownership shares but rather selling a portion of revenues over a fixed period (we can argue about whether or not that is still a “security” under the Securities Act of 1933).
• Peerbackers – you can contribute money in return for rewards or perks.  No offers of equity or shares of ownership.
• Kickstarter – you can pledge money in return for a reward.  Rewards are typically produced by the project itself – think, if they were raising money to make soup, you’d get a bowl of soup.
• IndieGoGo – focused on the creative arts.  No equity investments.
• Spot.us – geared towards journalists.  Open source project pioneering “community powered reporting”.
• Pledge Music – geared towards funding music artists.  Investors get no rights in the end product.  In return, you get music or signed merchandise.
• Artist Share – geared towards music arts and funding recording projects in exchange for access to the creative process.  This site appears to be the oldest, dating back to 2003.

I’ve had a few entrepreneurs recently ask me whether or not crowdfunding is an alternative financing route for start-ups.  Crowdfunding certainly appears to offer an alternative to raising a few thousand dollars from friends and family.  And if not an alternative, maybe simply a way to augment a friends and family round.  Although the average dollar amounts raised aren’t very high, they still might be sufficient enough to put towards some market research, early concept exploration, product samples and the like.  Beyond the friends and family round, I am not sure that the current crowdfunding models could support the significant dollars that an emerging growth stage company might need.  In addition to not supporting the dollar level, you’d lose out on the advantage of raising money from committed partners with experience in building companies and that can provide additional resources (e.g., contacts, connections, advice) above and beyond simply writing a check.  If you plan on bootstrapping your company into positive cash flow and never taking on investors, crowdfunding might be an interesting place to start.

That being said, if you want to try crowdfunding a friends and family round, or just match some other friends and family money, then my first suggestion would be to stick with the sites that offer rewards or perks in return for a contribution (out of all the sites above, only 33 Needs, Catwalk Genius and Profounder appear to go beyond rewards and perks and get into ownership or revenue streams).  Of course, this assumes that your business model lends itself to doing rewards or perks.  But be creative!  You could turn anything into a reward or a perk.  Why do I suggest that you stick with sites just offering rewards or perks?  Here are a few reasons:

You Want to Avoid Selling a Security

Why?  Because there’s a lot that goes into selling securities (even privately) and none of these sites appear to be structured for doing that.  The rewards and perks, like free copies of CDs or t-shirts, will not put you in the realm of securities.  However, selling equity and potential future interests in revenue streams might.

• Is it a Security – First, know whether or not you are even selling a security.  You should understand that the definition of a security is a broad one – see Section 2(a)(1) here.  Broader than most people think.  Every early stage growth company that is raising money by either selling equity or taking on a loan (including convertible debt) is generally selling a security.  Under the Securities Act of 1933, if you sell a security you need to either register that security or fit within an applicable exemption.  Selling ownership in a company or a revenue sharing or royalty financing structure (see this article explaining royalty financing) could be interpreted to be a security, thus requiring compliance with the securities rules – not something you want to screw up in the beginning stages of starting a company.  Consult your lawyer on this type of structure.  Profounder is selling a future interest in a revenue stream but takes the position that since there is no promise of a profit that it is not a “security” (similar to the argument posed by 33 Needs above).  Here’s a message board response by one of the founders of Profounder in which they lay out the legal basis for what they are doing.  Even though Profounder appears to take the position that it is not a security, they nevertheless claim to rely on Rule 504 under Reg D as a transactional exemption to the requirement that securities be registered for sale.  Not sure why they would indicate the securities exemption they rely on if they don’t believe they are selling a security.

• Have you Found an Exemption – Second, if you are selling a security, you need to find an exemption for that transaction both under federal and state securities rules.  Some exemptions require certain disclosures and have other restrictions built around them.  The crowdfunding sites do not appear to be structured to handle this issue.  For instance, most companies raising angel or venture money rely on Rule 506 under Reg D for their exemption.  Under Rule 506, if you sell to accredited investors only then you can avoid much of the disclosure requirements.  If you sell to non-accredited investors (which is most likely what you would find by crowdfunding), you are limited to 35 and you need to provide certain disclosures which would require a fair amount of coordination and help from a lawyer.  You might decide to rely on Rule 504 as an exemption (which Profounder appears to do), but Rule 504 has its problems.  At first blush it appears useful because it has no limitation on the number of non-accredited investors (although your total dollar raised over the past 12 months is capped at $1,000,000) and it has no disclosure requirements for non-accredited investors.  One issue with Rule 504 is that it can be very difficult to find state securities exemptions (unlike Rule 506 where most states accept the Rule 506 filing along with some filing fees).

• No General Solicitation or Advertising Permitted – Third, the prohibition on general solicitation or advertising could impact your ability to crowdfund securities.  Rule 502(c) under Reg D prohibits general solicitation or general advertising when relying on Reg D (with some very narrow exceptions).  Best practices require that you treat this restriction with broad interpretation.  Crowdfunding runs a serious risk of violating this restriction.

• 500 Shareholder Rule – Fourth, Section 12(g) of the Securities Exchange Act of 1934 requires companies with 500 or more equity security holders (along with a few other factors) to register under the Exchange Act.  What’s this mean?  Well, you are now a public company for purposes of reporting under the Exchange Act.  Not exactly where you want to be as a start-up.  Is this likely to happen in most angel and venture rounds?  No, because you never have that many investors.  But with crowdfunding, you could easily end up with 500 or more people – and if you are selling securities, intentionally or by mistake – then you have 500 or more “equity securities holders”.  See here for the letter where a few years back Facebook tried for an exemption from that rule because it had so many employee security holders, only to run into it again with the recent Goldman deal.

You Want to Avoid Giving Non-Accredited Investors Preemptive Rights

Another quick practice tip on selling securities to non-accredited investors.  Avoid giving those investors preemptive rights or, if you must, make sure the provision states that at the time of exercising any preemptive rights those investors are no longer non-accredited but now meet the accredited investor rules.  Preemptive rights generally give equity security holders the right to participate in future financing rounds of the company, with some customary and limited exceptions.  If you successfully structure a financing round with non-accredited investors, regardless of whether or not you use Rule 504 or 506, and you provide the non-accredited investors with preemptive rights then you may have a difficult time structuring a future round of financing.  Why?  Because if the non-accredited investors have a “right” to put money into the round and you cannot structure another Rule 504 round (maybe because you’ve exceeded the dollar cap) and you now need to structure it as a Rule 506 – you’ve just created a situation where you’ll need to make all of the disclosures that Rule 506 requires for non-accredited investors.  Had you not made this mis-step, you could have relied on Rule 506 and sold only to accredited investors and provided only the minimum disclosures required.

Two Birds, One Stone

If you go the crowdfunding route, try and kill two birds with one stone by leveraging the crowdfunding model to create a community of supporters, early adopters or product evangelists.  Even though the average amount raised through crowdfunding may be small, you might still be able to drive some significant PR if your story gets picked up, or if the social networks become well stocked with your new supporters that have contributed money to your business and received some cool rewards.  If you can make crowdfunding double as viral marketing, then there are extra benefits to be reaped.

As always, I welcome your comments and questions.  Thanks.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups, early stage and emerging growth and middle market companies.

As you know, my blog is about venture capital, angels, start-ups, emerging growth companies and the like as these are the areas I’ve spent my career working in.  Despite being a lawyer, I really don’t write much about the law per se as most people would think of it, but more about the legal aspects of doing deals with angels, venture capitalists and start-ups.  There are certainly laws you need to know as a start-up or emerging growth lawyer.  You need to know securities laws and corporate laws, among others.  But being a corporate transactional lawyer isn’t driven by rules of law and procedure like in other areas.  Trust and estates lawyers, litigators, tax lawyers, environmental lawyers – their careers are spent knowing, understanding and interpreting hundreds of pages of law, code, regulations and statutes.  Securities and corporate laws aside, the career of a corporate transactional lawyer is mainly spent negotiating deal documents or providing very strategic advice based on years of being around deals.  These things aren’t guided by legal process necessarily but more by practice, course of dealing and market terms.  It’s experiential.   

Despite the fact that my practice doesn’t center around heavy rules of law, I still have an appreciation for how complicated it has become.  Slip and falls, tort claims, the exorbitant costs of litigation and the fears of getting sued.  It’s risen to an all time high of craziness.  My wife and I were laughing the other day at the fake goalie masks that our kids got as a hand-out at a recent Flyers game.  They were fold up goalie masks that were made completely of paper and clearly, even to a child, only a play toy.  Nevertheless, it had a warning on it – “Not intended for actual use.  Will not provide protection.”  How many of these ridiculous warnings have you seen on products that I am sure the lawyers have required.  Here are some funny ones, and here are some more.

So I thought it was very apropos when my wife recently sent me the following video.  I couldn’t have guessed how appropriate it would be given the topics I had been thinking about.

Watching this video made me think of a book I had read many, many years ago called “The Death of Common Sense”.  It was a great book with great examples of how the law and the legal system had unintended consequences.  I pulled it off the book shelf and low and behold, it was written by the same guy giving the lecture.  Watch the video above and, if you get the chance, buy the book – it’s a fun and interesting read and will get you thinking.  Let’s all bring common sense back (as they say, it’s something you cannot legislate). 

I welcome your comments, thoughts and questions.  Thanks.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

Industry CEO Keynote:  Neil Cole of Iconix Brand Group
Designer Keynote:  Norma Kamali
Entrepreneur Keynote:  Ben Fischman of RueLaLa (acquired by GSI Commerce for $350mm)

Liza Boyd of Constellation Growth Capital
Jon Brilliantof Atelier Fund and WellDoc

Michael Dart co-author of the “New Rules of Retail”

Ed Foy of eFashionSolutions
Gilbert Harrisonof Financo
Paul Hurleyof Ideeli
Matt Kaness of Urban Outfitters

Robin Lewis of Robin Reports and co-author of the “New Rules of Retail”

Yona Shtern of Beyond the Rack
Michael Wallaceof ADAM/Kellwood

Opening Reception December 14th at 6pm Hosted by LIM College

I hope to see you there!

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

People in the start-up community have long called for a set of standard financing documents – a set of financing documents whose structure and substance were widely viewed as acceptable to both the entrepreneur as well as the financier (e.g., angel, super-angel, early stage venture fund) and that fulfilled each side’s legal/business needs.  Why standardize financing documents versus any other corporate set of documents?  Well, one of the greatest needs for a start-up or early stage technology company is the capital needed to fund growth.  The lack of capital lies at the very heart of building an emerging growth company.  Entrepreneurs also don’t have the patience for long drawn out procedures so early in a company’s existence.  Speed is viewed as a competitive advantage to some.  Given that lack of capital, as well as the quick need for it, both entrepreneurs and angel and venture financing groups have long wanted a standard set of financing documents that could quickly result in a closed financing round.  A round of financing quickly closed on mutually acceptable terms and costing the least amount of money (i.e., legal fees) would be the goal.  If both goals couldn’t be achieved, I think reduced fees would be favored over speed when it comes to standardized financing documents. 

With that being said, if I had to argue against standardized financing documents, I’d probably point out the following flaws:

• Not all Deals are the Same – the earlier the financing round, the more homogeneous the terms, however, the later the round of financing the less likely standardized documents are going to work.  If standardized financing documents were a reality, I think for this reason they would be limited to either angel or series seed deals.  Growth rounds have more complexity built into them (e.g., recapping, taking out early investors, letting founders take money off the table, wash-outs or cram downs, etc.), and therefore may not lend themselves to a “canned” document.
• As Much as People Love to Knock Lawyers, Getting Deals Done is an Intelligent Process -  as much as people like to knock lawyers, some of us love the start-up space and work very hard to provide real value to early stage companies.  Many of you have probably witnessed first hand the value add from these types of lawyers being involved in these types of rounds.  Create standardized documents and I can guarantee you lawyers of all walks (read:  lawyers without the proper start-up or early stage financing experience) will start offering these types of services to early stage companies because of the comfort that “canned” documents give them.  Just because you attend a CLE (continuing legal education) course on mergers and acquisitions, and walk with your book of forms, does not an M&A attorney make.  Look at every venture blogs’ posts (including my own) and you’ll see advice about hiring the right lawyers early for this type of work.  Start relying on “canned” documents and this problem will grow worse by a magnitude.  The fact that most lawyers that do this work have learned the trade in the old apprentice fashion (having been taught by those that have done it for generations prior) is a barrier to entry.  Remove that barrier and the goals of speed and saving money will produce leagues of early stage companies with inexperienced advisors. 
• Do You Really Want to Feel Like You Just Bought a House When You Close Your Series AA Round? – look at the areas that do use standardized documents and look at the lack of leverage in those deals – buying a house, taking out a mortgage, leasing a car, renting an apartment.  These form documents certainly save money for the person with the leverage (i.e., the person selling the house, offering the mortgage, leasing you the car or renting you the apartment), but they don’t create a level playing field.  The person taking the product or service generally carries the risk that the form documents are adhesive.  The old adage – he who has the gold makes the rules, applies here.  I think over time, the standardized document might shift to the party with leverage.
• Attempts to Date Have Failed- other than the form documents that are used specifically inside a model (think TechStars, YCombinator, etc.), most form documents have not taken off.  In particular I think of the NVCA form documents.  The only time I hear or see them referenced in a deal is when one party is trying to convince the other that a particular provision is or is not industry.  To the extent that provision is or is not in the NVCA form documents, I’ve seen parties reference that fact as proof that they are correct.

Leveraging off of the second bullet point above, I think my greatest argument against standardized documents requires one to think back to the industrial revolution.  Prior to the industrial revolution, goods were made by craftsman.  A trade taught to the young by those with more experience, and passed down over the years.  Following the industrial revolution, mechanization (read:  standardization) was the key to saving time and money.  The industrial revolution killed the craftsman, much the way big box retailers killed the mom & pop store (for those of you that remember the days when customer service actually meant something).  I think standardized financing documents will have the same effect.  It will destroy the legitimate skill set that some of us possess in the start-up and early stage space.  And it will rob the younger associates of the real skills required to represent great start-up and early stage companies in financing rounds. 

My Solution:  Okay, but come on – for those of us touting the fact that we are innovative start-up lawyers and providing value to these young companies, we cannot just end it there -right?  If I am right, that saving money is at the heart of the problem, then there must be some way to reap the same savings but maintain the valuable process of drafting and negotiating financing transactions.  I think the answer lies in how lawyers bill for this work.  I think you can get to the same result of standardization if lawyers would just agree to cap the fees they charge.  For those of us that possess the right experience for this work, most of the problems or hurdles we hit in closing financing rounds have been seen before and dealt with.  I have yet to come across an issue in getting a round of financing done that isn’t somehow derivative of some other issue I’ve run into before, and therefore I probably already have some way of dealing with the issue.  I see no reason lawyers cannot come up with flat fees for closing these rounds that solve the “expense” issue and still allow the deal to move quickly and close inside a time frame that any of us would consider reasonable.

Just my two cents.  I welcome your comments and/or questions. 

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

The event starts at 6 p.m. and will take place in the Levitt Auditorium, Gershman Hall at University Arts (corner of Broad and Pine Streets).  Check out the site here for more information.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

Go to the Zecozi site and register for launch updates and check out the article!

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

Here are some of the articles that popped up since my last piece:

• What’s Really Going on in the VC Industry?  What Does it Mean for Startups? (Mark Suster) – I put this post first for a reason.  In Mark’s usual style, it kicks ass.  He covers so many valid, timely points that I’d rather just link to it than have written about them on my own.
• Angel Investor Ron Conway:  Every Entrepreneur Should Get Funded (Anthony Ha – VentureBeat) – Ron believes there still aren’t enough angels out there.  On the other hand, Mike Arrington was quoted as saying that angels are training “an entire generation of entrepreneurs who are building dipsh*$ companies” that sell to Google for $25M.  This division shows that not everyone agrees with the direction the market is taking.  I can see one of the points that Arrington was making and it is going to be the basis for my next post on the “fat/lean” start-up and how all the talk on that subject hasn’t necessarily filtered down to the entrepreneurs in the correct way.
• It’s Still Expensive to Build a Great Product (Redfin) – I like this article because it helps give some context to the capital efficiencies everyone keeps talking about.  I’ve heard the saying lately (which I think can be attributed either to Brad Feld or Fred Wilson) that it’s cheaper to start a company today (I’d re-phrase this piece to limit that to Web 2.0-type tech companies) but it costs the same amount to grow it.  This article helps flush out that issue.
• Moneyball for Startups:  Invest Before Product/Market Fit, Double-Down After (Dave McClure) – Dave hits many issues using his lively fonts, colors and language.  What I like about Dave’s posts is that you know where he stands, which you cannot say about most people.  Part of his post is devoted to his assertion that the traditional VC model is dead and that the super-seed/super-angel model will prevail.  I hate saying anything is dead, because there are no certainties in life, just cycles in my experience but Dave has some valid points.
• The Buzz on Angel and Seed Investing Continues (Brad Feld).
• Thoughts on the Seed Fund Phenomenon (Fred Wilson).
• The Rush to Early Stage Seed . . . (John Boyd).
• Understanding a VC’s Seed Funding Policy is Crucial (Mark Suster) – this is an important article to read for those of you debating between super-angel funds and raising full-on VC funding but at the seed stage.  If a VC fund puts a small seed investment into your company in order to preserve a “toe-hold” for down the line, understand that if that fund opts not to do a follow-on investment with you it could be the kiss-of-death.  Others will wonder what the VC fund (being a current investor) knows about the company that others don’t and why they opted not to invest.  They might have opted out for the most mundane of reasons, but the crowd will assume the worst and it could hurt your fundraising.  Of course, the same might be said of super-angel funds unless people begin to believe that some of those funds just don’t have the bandwidth to follow-on in all the deals they would like to.
• Why Micro-VCs are so Damn Friendly (Gregory Huang – Xconomy).
• Y Combinator’s Paul Graham:  Say Goodbye to Traditional Venture Rounds (Anthony Ha – VentureBeat) – again, I don’t believe in the “this is dead” assertion, but I do see many changes in the works.

Not only does it appear that super-angel (or micro- or super-seed) funds are filling some of the gaps and taking early stage investors off the endangered list, it may be that the pendulum is swinging back in the other direction.  Some are now forecasting a seed-stage bubble in the near future.  See the article by Liz Gannes on GigaOm, the article by Gary Whitehill, the article by Paul Kedrosky and the article by Chris Yeh at VentureBeat.  The theory goes that if too many companies receive seed stage funding, there will not be enough VC funding down the road to move those companies along to the next level and thus they will flame out due to lack of follow-on funding.  This is very similar to the bubble that occurred in the early 2000′s as a result of the ramp-up in VC funding that occurred mid-90′s to end of the 1990′s.

Comments and questions welcomed.  Thanks.

 Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.