Tuesday, December 19, 2006

What's on our Christmas Tree: Part II

We like to call this grouping on the right "Ode to IDG", a tribute to the international ways of IDG Ventures and its globetrotting group of affiliates. IDG in Boston includes a fellow Williams College alum, Mike Greeley, which de facto makes it a quality shop. I've also added a cow ornament in tribute to other Williams alum in the VC world like Russ Howard at High Peaks Venture Partners :

The cow is available at cowdepot.com. Russ is married and therefore not available, but his capital might be, if your venture is located in New England and fits his criteria.

What's on our Office Christmas Tree

I used to work at a large firm in New York. Then I worked at a large firm in Toronto. At both of them, junior lawyers were referred to as deal monkeys. "Send in the chimps!" was the rallying cry for every big fee deal we did.

Now you, too can have big firm leverage by buying your own chimps at Archie Macphee, too. They don't do research, but they still bill at a premium rate.

Holiday Greetings

My in-box is full of animated cards from many of you, for which I am grateful. My office manager cannot take these and arrange them into artful displays of snowmen and trees in our reception area. This is good.

I only wish I could return the favour. I am sending my sincere greetings by snail mail. Trees have died and pulp and paper workers have stayed employed so that I could maintain old school correspondence. Maybe next year, I will also cross the e-card chasm.

Until then, you'll have to make do with our YouTube video of our office staff licking envelopes. No lawyers were harmed in the making of it. Happy holidays!

Please watch this space over the Xmas break. we'll be addressing the following issues: constructive dismissal, hiring Canadians, software as a service.

BDC: SME hero

Not nearly enough noise is made about the Business Development Bank of Canada. The investment professionals are dedicated and sincere, and among the more pro-entrepreneur I've encountered. Plus, they often spring for donuts.

BDC is dedicated not only to venture capital investing, but also to fostering the growth of Canadian SMEs in all segments. Which means they are dedicated by proxy to, well, me.

Today's release announcing another $330 million fund to invest in Canadian SMEs sends a much-needed message of support to a business community that produces more than 50% of the country's GDP. The fund is a joint creation of BDC and Caisse de depot et placement of Quebec.
Go check it out and remember to send them the plaudits they deserve.

Wednesday, December 13, 2006

Replacing the Founder CEO: Part II

In the arts world, writers dream of finding a "script doctor", that person who can take good material and make it great. At certain stages of growth, companies also start seeking a "second act messiah" to take business to the next level. I've already discussed why I think there are perils to attempting this too early on in a company's development. But I also want to discuss how compensation for a second act CEO can create issues with execution and the strategic direction of a company.

If you and your investors succeed in finding the ideal CEO candidate, you will need to find a way to provide your CEO with enough equity upside to compensate for the lower than market salary of a startup CEO. Any equity you provide will be at a higher issue price than most of those held by founders and investors, who received the lion's share of their interests earlier and at a lower valuation. Because dilution is always a sticking point with investors, the usual outcome is to provide new CEOs (and the team they bring in) with equity plus a bonus scheme that will trigger golden parachute-like payments if there is a successful sale or change of control of the company. The size of the bonus makes up some ground for the CEO, but rarely all, particularly in the US, where the IRS has implemented a set or rules that make "excessive" bonus payments costly to both the company and the CEO.

Here's where this kind of compensation can be an issue: A CEO who received equity at $10 a share is not incented to pursue an opportunity to sell a company at $7.00 per share. By contrast, the investors and the founders, who hold a large portion of their shares at, say, $1.00, may well wish to forgo the possibility of a home run in the future by taking the lesser return on investment now. The second-act CEO is incented to pursue "bet the farm" strategies only.

This kind of misalignment can always be righted when and if a $7 exit opportunity presents itself, many investors will say. But that kind of "just in time" thinking is based on the flawed assumption that the opportunity will present itself without active care and feeding by management. In my view, time is better spent upfront on designing a comp scheme that aligns all parties to pursue the same strategic direction.

In the coming months we'll have better visibility into best practices for exec compensation when the new SEC disclsoure rules take effect (and, as one of my public clients said, "The whole world will know everything including my underwear size"). Our firm will be holding a seminar on executive compensation schemes for later stage startups in q1; watch for further details soon.

Monday, December 11, 2006

VC Hanukkah: What Would Vinod Do?

Vinod Khosla wears a lot of black and grey, even though he is an autumn (perhaps he has never had his colors done). But there is nothing off season about his investing philosophy. Khosla goes about his business, pursuing new opportunities where he find them, like Group IV Semiconductor in Ottawa. We could think of nothing more fitting than to start the festival of lights with a gift that invokes the spirit of the man who, through his own cleantech investments, is searching for new ways to make a little drop of oil last for more than 8 days: a wristband that asks the eternal investing question: What Would Vinod Do?

Live Khosla.

Saturday, December 09, 2006

VC Funding: The Non-Compete Clause

In preparation for the Landmines seminar in January I have been checking my list (and checking it twice) of "VC terms that every investee should question". Near the top is the provision in shareholders agreements that restricts shareholders from working or investing in businesses that are competitive.

Every shareholder but your VCs, that is. Here's how the fine print on these provisions typically reads:

"The parties hereto acknowledges that the [VCs] may from time to time hold investments in corporations (a “Competitive Corporation”) which may be competitive with the Corporation and its business. None of the [VCs] shall have any liability to any of the parties to this Agreement for any claim arising out of or in any way relating to any such investment or any actions taken by any partner, director, officer, employee or other representative (each a “Representative”) of any [VC] to assist a Competitive Corporation (whether as a director of such Competitive Corporation or otherwise) regardless of whether any such action may have a detrimental effect on the Corporation."

In other words, your VC investor: (a) is not bound by any non-compete or non-solicitation restrictions, and (b) may invest in one or more of your competitors, and solicit employees or customers away from you, all without incurring any liability to your shareholders or your company for any breach of fiduciary obligation.

Most VCs will tell you that the intent behind such a provision is an honourable one. Venture capital looks for disruptive technologies and business models to invest in. If a technology or business model is truly disruptive, its market likely does not yet exist. It is therefore possible, a VC may explain, that an investment he/she makes may have started out in an adjacent market, but ended up in your segment. The VC does not wish to be penalized for this development.

I think this position is understandable, and even rational, but ultimately it's not defensible. Here's why: Regardless of what the agreement says, I doubt that most courts would agree that one can contract out of one's fiduciary obligations. Even if this provision were enforceable among shareholders, there are other stakeholders (option holders, employees, creditors, directors) who will not have not signed the shareholders agreement and have not therefore assented to this term. There is still exposure to a VC investor who works with competitors.

A possible solution here would be to require a firewall between fund members who work with one company and those who work with a competitor. Given the small size of most funds, however, this doesn't seem practical, or even possible.

So why agree to the term at all? If your investors are generalists, this may be an acceptable risk to take on. But if your backers include industry focused funds who invest in every place on the value chain for your market segment, this could be a significant problem.

Friday, December 08, 2006

Lawyer Fashion Workshop: Going Euro

My friends at Faskens have gone Euro trendy and merged with a London law firm. How best to integrate? Here's a fashion workshop idea that will allow you, with just a few extra hours in business class and some office supplies, to go from the plane right to London's City with minimal wardrobe adjustments. Follow these steps:

1. Pre-board as soon as you can and ask the flight attendant to bring you the cold lobster tray dinner. (You are flying business class, aren't you?) You need to be well fed and ready to work once the plane reaches cruising altitude.

2. Take: (a) one camel-haired jacket, (b) a ruler, and (c) whatever hi-liters you have on hand, and get to work! Remember the British design imperative: draw attention away from the pasty face and the teeth!

3. Try and tune your PVR to some Merchant Ivory production. If there isn't one available, try to visualize Rupert Everett. Ask the flight attendant for some bad coffee. And perhaps some crisps to wash it down with.

By the time you've crossed the Atlantic, voila! You should be ready to go! Your new British partners will appreciate your attempt to be bespoke.

Wednesday, December 06, 2006

Where did all the Venture Capital Lawyers Go?

Earlier this week a US client called me about a follow-on investment. Our firm had a conflict and could not handle the matter, so I rattled off the name of a few other firms about town that also worked in venture capital. Or, so I thought.

A few hours later, my client called me back to say that he had gone to the web sites of the firms I had recommended and that, in fact, they did not appear to have any venture capital specialists. In fact, they did not list venture capital as a practice area at all. He did not need a generalist, he said; he wanted someone who did VC deals on a regular basis, so could I please send him another lawyer's name?

Turns out, he was right. The same law firms who, until recently, were spending thousands of dollars on sponsoring venture capital fairs and other marketing initiatives appear to have dropped the startup community altogether. This trend to repositioning started a few years ago with Boston's now-defunct firm, Testa Hurwitz. I remember receiving one edition of the firm's Venture Capital newsletter, which announced it had been re-branded as a "Private Equity" newsletter. I understood the shift; venture capital is one part of what is a very broad private equity asset class, and appealing to all of investors in that class seemed to me to be a reasonable hedge against swings in the venture capital cycle.

I understand the repositioning by Canadian firms away from startups. Marketing to the cycle is standard law firm practice: this quarter's M&A specialist will be next quarter's workout guy. I even understand why most large firms make the business decision to reject clients that generate less than $30-50k in recurring annual revenues. Why risk getting locked out of a larger deal because of a conflict by a smaller client?

But I worry that this isn't simply market positioning; rather, it's a sign of a long term retreat from servicing startup clients altogether. Which would be a shame. 97% of Canadian businesses have 250 or fewer employees. As a group, they account for more than 60% of GDP. Even at reduced levels, the amount of venture capital that fuels our economy is staggering.

But it won't last if we can't generate and support businesses that yield venture capital returns. That much has been made increasingly clear by the venture capital community. To maintain a robust business generation centre, I think it imperative that as a profession we actively solicit and support those driving new businesses, regardless of the market cycle. Supporting those businesses means more than servicing them; it includes bringing the mythical "value add" we all talk about, building and fueling legal and business networks that will sustain your clients as they grow south of the border and beyond, among other things. The legal communities in Silicon Valley and the Northeast still actively solicit and support emerging companies. If we wish to maintain similar momentum, it seems to me we need to do the same.

Startup Holiday Gifts: for the Seed Stage Company

Many of our Venture Law Line clients are looking for angel investors. To inspire them, we have sent them engraved silver bells. We are hoping that Jimmy Stewart was right, and that every time a bell rings, an angel does get his wings.

Happy Holidays.

Startup Holiday Gifts: for your Investors?

We've branded some ratchet sets with our firm logo and sent them to some of our favourite funds and their attorneys with the followng message:

"Dear X, I hope that this is the last ratchet you get out of me for a while. I enjoyed doing business with you this year, and I look forward to doing business again in 2007. P.S., According to the instructions, this ratchet is reversible. Something to think about."

We love the holidays.

Tuesday, December 05, 2006

Startup Holiday Gifts: The Sequel

(Bacon Dream is the brilliant work of one of Toronto's many web comic gods, Ramon at Butternut Squash)

We have just sent the last of our gift baskets to our nutraceuticals clinets, so we can share with you the ideal combination for the protein loving entrepreneur: the Bacon wallet and first aid kit. (Available through Archie McPhee).

Startup Christmas: Holiday Gift Suggestions

Thanks to corporate policies that limit gift giving, we have had to find a way to provide meaningful holiday gifts to our clients and colleagues while at the same time staying within spending guidelines. Here are some of the special ways we will be thanking our friends and colleagues for their support and patronage this year:

For our bizdev clients, we have selected this fine cardboard decision enabler. With one spin of its all-plastic arm, you can direct corporate/sales strategy by asking "What Would a Ninja Do?"

We've never met a developer who didn't like Star Wars. And so, for the car of the code jockey, we have selected these signs (on the right):

We find that many of the VPs of Engineering are more traditional. For them, we have gone to the top of our budget and purchased these lovely, limited edition Star Trek watches. The second hand is the starship Enterprise, which boldly goes where no man has gone before every sixty seconds. An added bonus: press a button and the Star Trek theme will play:

For board presentations, what CEO (or CFO) would not enjoy a Dolphin laser pointer? You can adjust it so that the laser points a straight beam of light at your powerpoint or a heart , star or octopus shape! Perfect for accentuating your positive cash flow!

Some of our clients focus on enabling corporate compliance. For them, we can think of no more inspirational a gift than a piece of the biggest corporate scandal of them all, Enron:

Happy Holidays.

Series A: Civility and Negotiation

These are photos of Tom Jolls, also known as Commander Tom of Rocketship 7. Tom also did the weather on the nightly newscast for a Buffalo tv station, but for me, he was my after-school eye candy. William Shatner had nothing on this guy; growing up, Tom Jolls was THE rocket man for me.

Why am I bringing up Commander Tom here? Consider him a reference point. If you, too, enjoyed Commander Tom during your childhood and/or used your pillow to practice kissing him, then you and I are peers. We grew up in an era when Toronto was decidedly not cool, and Buffalo was a major cultural reference point. We've been through stuff, including the new flavour of Coke. We may know things. Like, for example, the importance of civility when completing investments.

When I speak of civility, I am referring to good manners - respect and courteousness. Timely and prompt attention to requests. Behaviour that, in effect, accords the other party respect. Not returning calls, ignoring requests or questions from the other side of a matter, or lecturing an investee on his business - these are bad manners, not good tactics.

The world of startups is a collegial one where civility is especially important. A vigorous defence of your client's position is always appropriate, but it is never okay to treat an entrepreneur with anything less than courtesy and good manners. These are people who have taken significant risk for a business they believe in. They know things. Condescension is just not appropriate.

So here's my rule: if you're not old enough to remember Commander Tom, you don't get to be discourteous to my clients. If you remember Tom (and Irv "We Begin with a Fire Tonight in Tonawanda" Weinstein), then I'll regret your approach, but I know we'll work it out. We got past pinwhale corduroy, and we can get through this.

Monday, December 04, 2006

Hiring and Firing Canadians

Americans like to shop North of the border at this time of year - for software engineers, CTOs, even entire companies. I thought it would be helpful to provide an overview of some of the key differences to hiring and firing in Canada:

1. Canada is a pro-employee jurisdiction. It's not France, but it's not an"at will" employment country, either. Every person you hire, or fire, will have his own employment lawyer review and comment on his offer. No sinister conclusions should be drawn from this.

2. Because Canada is a pro-employee jurisdiction, you cannot "just fire them" as some of my American clients would like. There are minimum amounts of severance that must be paid, based on length of service. The courts may increase severance beyond the minimum amounts to reflect age, seniority and type of position, among other factors. The case law is fairly well-developed on what are acceptable levels of severance (beyond the statutory minimums), so these amounts are regularly negotiated. In my experience, the amount of severance employers pay is commensurate with that which would have been agreed to in a negotiated contract in the US.

3. Forget about firing anyone in Canada for cause, unless you find them in the company safe stealing company money while perhaps sexually harassing a young employee (that last part is provided that you have a zero tolerance policy that was posted).Your legal dollars are better spent paying severance and moving on.

4. Even if you do not wish to fire anyone, the manner in which you integrate a newly-acquired Canadian business with the rest of your operations may have the same effect.The laws of constructive dismissal in Canada are broad and, much like my aging derriere, growing broader with every passing day. A toxic work environment, a diminution in profile (for example, no longer inviting someone to strategy meetings), personality clash - these have all been found by Canadian courts to be constructive dismissal, in which the employee was entitled to severance.

5. Firing must be done in a sensitive manner, to avoid claims for punitive damages.

6. Non-competition clauses are enforceable if drawn in a reasonable manner. Unlike California, these clauses are not per se prohibited, so long as they are drawn reasonably. The current practice with founders and other key employees is to embed this clause in the shareholder agreement.

I'll address trends in employment contracts (including relocation allowances, etc.) being offered to Canadians to move to the US in a separate post this week.

Replacing the Founder CEO

It's been a while since I've heard the talk, so I was taken aback when it happened during a recent term sheet negotiation. You know the one: "We won't make it a condition of the financing, but we'd like to hear your thoughts about bringing in a CEO to take the company to the next level. You've done a great job, as a founder, but we feel we need a CEO with a track record from here on in."

Much has been written about when and how to transition from a company run by founders to one headed by professional managers. The theory is that, as the company moves to profitability, it moves away from the typical founder culture of group consenus and multitasking. Tensions arise between marketing and engineering, among others. A new CEO, the thinking goes, is better suited to overseeing these functional power shifts.

That's the theory. In practice, actually finding the right CEO remains a huge challenge, at least here in Canada. First rate CEOs who are willing to engage at the Series A/B stage of a startup remain in critically short supply. There seem to be two main reasons for this: first, there is no obvious path to a liquidity event in the current market that would entice a potential CEO candidate to accept the risk of failure and the lower compensation a startup offers. Some even believe that the overhang of bad public company news will remain for several more quarters, leaving little room for new public issuers for the forseeable future.

Second, the recent wave of leveraged buyouts in North America has created far more opportunities for near term profit in later stage companies than in stratups. There is a noticeable "flight to quality" by eligible candidates to form part of the management team for newly-private tech companies.

Entrepreneurship is really just a socially acceptable form of gambling. So the question is, if there are few gamblers at the table, why try and ruin the game? Why bring up team transition during term sheet discussions? Unless there is a world class candidate waiting in the wings, raising the issue seems to be an exercise in "setting expectations." This seems to me to be a waste of perfectly good relationship capital that the investors and the founder team have managed to accumulate. Perhaps worse, it can have a viral effect on the founding team's passion for the business. And passion - not talent or experience - is often what determines success.

Speaking at my graduation from Williams College years ago, Neil Simon said "Passion is the Super Bowl of enthusiasm...You pay attention to the details. And it's the details that determine the quality of life. " Or, in this case, the quality of a business.

There are many other blogs who can advise on the right way to manage transition. But raising it as a discussion point isn't it.

Friday, December 01, 2006

Using Open Source in a Startup: Bad Idea

If you want to sell your own proprietary software, make sure you have a strictly enforced policy against using open source. Here's why: even if you agree that open source has crossed the chasm in the lifecycle that is technology adoption, your investors have not. Even the inclusion of an inconsequential open source tool can cause headaches, or stop a deal altogether.

Here are the concerns often raised about open source at the due diligence stage:
- there is no meaningful warranty or indemnity for this portion of the product
- how do we know the open source license is enforceable?
- do the terms for this piece of open source contaminate the rest of your product?
- if this was inadvertently incorporated into the product, what else was?

[Holly Towle at Preston Gates has done a good review of some of these issues here.]

These concerns can be managed, but they can't be eliminated altogether. And while venture capital investing is about risk, these aren't the kinds of risks VCs assume. Managing them sometimes isn't enough.

What does this kind of open source use mean for your financing (or acquisition) prospects? That depends on (a) the philosophy of your investors/acquirors, (b) whether the open source is incorporated in to your proprietary software or simply part of the internal operating systems of your business, and (c) whether the business' prospects hinge on the integration of your software/internal systems with those of others. But why get to the point where you are defending your approach?

As strongly articulated policy for use of third party software in your business needs to be developed, posted and enforced with your development team at the outset. Subcontractors (who in my experience are the usual culprits) need to be rigorously policed. Your product group may have an opposing (and equally valid) perspective on the issues I have raised, but it's not their perspective I'm worried about: it's your ability to persuade those with the cash to grow your business. Many of them are still sitting on the other side of the chasm.