Wednesday, February 28, 2007

Why VCs should not ask for Founder Indemnities

A Boston VC sent me an email agreeing with my last post, adding, " I always find it funny when co-investors insist on founder indemnities. What? Are they going to sue the founder for money he/she doesn't have? Just leaves a foul taste in everyone's mouth."

The founder indemnity is largely a creation of certain VCs here in the northeast. What is it? Let me explain by putting it in context:

In a typical financing, a VC (or its lawyers) will ask a company to represent and warrant various matters about the Company's business and its share capital structure. A long laundry list of representations ensues. This is necessary, the VC will argue, because VC investments are not the kind of deals in which extensive legal due diligence is done. Instead, your VC wants to use reps and warranties to act as confirmatory due diligence, by requiring the Company to disclose what it knows.

What is the legal significance of this? In certain circumstances, if any of the representations or warranties are wrong, it maybe considered a material breach of the investing agreement,entitling the VC to rescind the investment commitment and to ask for all of its money back. More likely, the VC would be able to sue for damages for breach of contract.

Happily for you, contract law is generally a fairly balanced body of law. The VC can't recover damages until he/she proves: (a) that a breach occurred, (b) that the damages claimed relate to the breach, (c) that the loss claimed is recognized as damages recoverable under contract law (not all are). The VC would also have to establish that he/she tried to mitigate any losses suffered, among other matters. Any damages are only paid out after the matter is disposed of.

Because of these variables, some VCs (or their lawyers) take the position that more of a stick is needed.Enter the indemnity.

You are probably more familiar with indemnities as part of your commercial contracts, where customers take the position that they should never be out of pocket as a result of selecting you as their supplier. Adding an indemnity to the contract allows them to bypass contractual remedies and be reimbursed for any losses the minute they are suffered (rather than at the end of a lawsuit). Customers can be reimbursed for any losses suffered as a result of its dealings with the other party. "Losses" can include expenses and costs that would not necessarily be recognized as damages in a breach of contract dispute. The events which trigger the right of indemnity also are defined so that they include events which fall short of a breach under contract law.

The potential impact of an indemnity on the cash flow of a company is huge, which is why it is typically given to customers for very limited circumstances (most often, when a product your customer bought is found to infringe someone else's patent).

In a financing, some VCs argue that it is not enough to rely on contractual remedies or to a receive an indemnity from the Company. Payout would simply come from the VC's invested funds. They want the founders to provide an indemnity and have skin in the game. What "skin" is at stake here? Sometimes it is simply the founder's stake in the company - the VCs would be able to take the founder's shares as compensation for any losses. Other times, VCs require that the indemnity be unlimited. In other words, they want the ability to seize any personal assets of the founder if there is a problem down the road.

Here's the fundamental flaw in the whole premise: much of the risk of an early stage company is unknown, and no amount of investigation will reduce the risk that, for example, there is unpublished prior art that creates an infringement problem. Why is a founder bearing the entire liability for what is the essence of high risk early stage investing?

Which takes me back to the VC's comment above. When is a founder indemnity ever a tenable or good idea? There are a number of ways to negotiate this provision so that it may be manageable - we can detail them in a later post if you want - but at the end of the day, companies should ask, is this the kind of deal that makes sense for me? Is too much risk, and too little accountability, being shifted to the founders of the company (who, incidentally, are not receiving any cash from the financing themselves)? More importantly, what kind of harbinger is this for your relationship with your VC going forward?

My two cents.

Monday, February 26, 2007

Startup Financing: What's Overdone and Other Matters

Over coffee this morning, a client and I discussed transaction strategy - that is, how to get his deal closed with maximum efficiency but minimum damage to the goodwill between him and his new investors. We've been through several rounds together, so we have similar views about what issues are critical to founders and and what issues are not.

Here are our lists:

Terms on which far too much time is spent:

1. Registration rights (Some VCs still require these in early stage companies, although mercifully this is a declining trend)
2. Board composition ("It's an emotional issue. Focus on your other rights." - client)
3. Protective Provisions (Unless they fall outside normal parameters and could potentially scuttle the current business plan)

Terms where not enough time is spent:

1. Representations and warranties - Many VCs (or their lawyers) take the position that all risk- including the risk of the unknown - is on the company, and as a result, require that the company make breathtakingly broad representations about the business. These kinds of terms are typical in later stage financings, where the issuer has made prospectus-level disclosure (and done the due diligence to back it up). I often wonder why it's reasonable to make early stage companies provide the same thing. A balance needs to be struck between what is an appropriate amount of disclosure (and risk) to be born by a new company and your VC's needs.

2. Founder employment agreements - Too many founders allow themselves to receive less severance and other benefits than they would otherwise have received had they been newly hired to the same company. As I've indicated in a prior post, this agreement is where a significant set of your rights resides, thanks to the pro-employee laws in Ontario. They should not be negotiated away lightly.

3. Indemnities - Although it is not the norm, there are still some VCs in the northeast who believe that founders should back their company with a personal guarantee of sorts, in the form of an indemnity. I'll post more about that tomorrow.

An Inconvenient Goof

I had no idea I was such a goddamned food snob until it snowed last night, leaving an icy patch outside my front door. Ordinarily, I have a large stock of ice melters at this time of year. But this year, global warming lulled me into a false sense of security.

Table salt is always a good standby when you're caught short, if you have any. Apparently, at some point in the last few years I decided that ordinary salt was not good enough for the likes of me. It seems I now only stock a selection of artisanal sea salts. Some of the bottles are actually signed by the salt raker who harvested them. ??? When did I become this person?

If you walk up my front steps today, please pause any breathe in the aroma of sea salt naturally dried and hand raked in France's Camargue region, then smoked over chardonnay chips from a prominent winery. Later, I will be caulking windows with wasabi paste. Or a chipotle coulis from Taos.

Sunday, February 25, 2007

Friends and Family: A Fatal blow

Rick Segal is one of the few VCs I know who actively, wholeheartedly engages with the startup community here in town. His efforts go beyond what's needed to attract near term deal flow, to the bigger picture: creating a world class business generation centre in Toronto. It's why, speaking strictly in a business sense, I get a fluttery feeling in my stomach whenever I visit his blog. I know that there will be something there that will e- touch me. His latest post could have been about many businesses we've encountered. The issue Rick raises is also why we've scheduled a Venture Law Lines seminar for March on how to paper friends, family and even angel investments by yourself, with minimal legal intervention from actual breathing lawyers like us. We'll be sending out the details in the next week or so. Please send me an email if you'd like to receive details.

Wednesday, February 21, 2007

Sock it to me

This is World Bank president Paul Wolfowitz. He can do this because he is working for a world free of poverty. You can't. A guy with holes in his socks probably has holes in his business plan.

Tuesday, February 20, 2007

Service Level Agreements, Jamba Juice and Vince

Those who know me understand that I have very special feelings for the town of San Mateo, CA, where I once spent many a day representing a certain startup. There is no emoticon I can paste here to adequately convey them. I thrill when I see the Fashion Island Blvd exit from the 101. I long for the rough, ever-so-slightly pilled sheets of the Hilton Garden Inn. My heart swells when the sun sets over Sam Mateo, turning the beige stucco, low-rise office buildings and temporary housing units to a burnished Tuscan beige, distinguishing them from all the other beige stucco low-rise buildings in Silicon Valley.

San Mateo is most special to me because it has my favourite Jamba Juice franchise, located close to the San Mateo Bridge entrance. If you look away from the road too long to check whether your protein boost has been thoroughly stirred into your Mango A-Go-Go, you will find yourself spending the next 7 miles driving across the bridge to Foster City.

My colleague Vince was a lousy navigator and as a result, he and I spent many hours taking the 14 mile round trip to Foster City after our morning Jamba Juice runs. Which is where we would debate Service Level Agreements, among other things.

It's important to know a little about Vince: he and I were the "wet ops" team for this particular startup's sales force. Once the sales people had finished overpromising, we'd come in and eliminate what we could so that the services we committed to deliver were more in line with, well, what the company could actually deliver. We became masters of padding the service specification and the service level agreement (the "SLA") so that they were, by the end, very forgiving documents.

In my view, new companies often prepare SLAs for their customers that are far more demanding (and potentially costly) than they need to be. This is partly because many startups hire from the customer side, and those new employees bring that "5 nines" mindset with them. Here are the basic principles I think new companies should bear in mind:

1. There is an increasing emphasis by acquirers on the support environment companies provide. The scope of service availability and other support commitments (and any penalties or credits provided to customers), is now being considered in due diligence and calculation of the purchase price.

2. No one needs 99% service availability. Think of your most co-dependent girlfriend; did she really need you to call her before she went to bed? Or to see if her cat's check up went well? A reasonable average availability in any 24 hour cycle should be adequate for your customers.

3. Termination of the agreement should be a last resort only in the most dire circumstances. I see many SLAs in which the company has agreed that the customer can end the agreement for any breach of the SLA. Termination should be available only for breaches of critical service levels for key services. If required, you can consider giving credits for other service level breaches. (Note: Vince advises that in Europe, contractual penalties for failures in network service availability are unenforceable. I am reviewing whether this extends to hosting and application service levels also).

4. If your company exceed customer support service levels, consider asking for a bonus payment.

5. Reporting forms change often in a company's early stage. Try to avoid agreeing to a specific format (agree to metrics but not form) so that you can remain nimble as you perfect your reporting operations.

My two cents.

Monday, February 19, 2007

Term Sheets: Venture Law in the News

Rick Spence wrote a great article for the National Post a few weeks ago that summarized many of the term sheet issues we debated here in town at a January Venture Group breakfast. Thanks, Rick!

D&O Insurance: the Startup Challenge

It continues to surprise me how little attention some investors pay to directors and officers insurance. Once D&O insurance makes its way into the investment documents (usually as a commitment by the company to obtain insurance post-closing), it is almost never mentioned again. It's understandable, mind you (insurance is right up there with optical add-drop muxers as compelling cocktail conversation); but it's not a terrific practice.

Recently, I was asked to join the board of a terrific startup. As part of my homework, I asked to see the company's D&O insurance policy and the application itself. Why? A potential director always wants to insure that a company has indemnified him/her against any costs that director may suffer should a lawsuit be brought against the board. But because most startups are cash constrained, D&O insurance is the usual way to ensure that funds are available to honor that indemnity.

The insurance application is maybe the most critical part of the insurance policy. It contains representations and warranties about the Company, its share structure and other matters such as the Company's employment practices, changes in management, financial statements and the like. If any of these representations or warranties are inaccurate or materially misrepresent facts, any claim a director may make could be denied, or the entire policy could be rescinded altogether.

Applications for policy renewals are equally important. The information on the application is the information most likely to change from year to year in any company,particularly in a startup. Larger companies actually hold day-long interviews with their insurers at renewal time to ensure that all changes are properly reported and coverage is not at risk.

The insurance application is often left entirely in the hands of the company controller or the CFO. Very little review or oversight of the process occurs. I urge my clients (and you) to ensure that there is a check and balance to this process - either a review by the CEO and the audit committee of the board, or a regular report on the annual renewal process. Why wait until your insurer rejects a claim to examine the issue more closely?

Thursday, February 15, 2007

The Venture Capital of Love

Ordinarily, I use this blog to discuss issues affecting start-ups and other high tech companies. But some matters are so compelling that I cannot remain silent. I speak, of course, of the Valentine's Day date.

The risk of investing in a relationship is much like the risks associated with venture capital: probably 2 out of 10 attempts win big. Going out on Valentine's Day is like a relationship IPO: expectations are high, even though you have fully disclosed the risks of the venture. So trust me when I tell you that what you order for Valentine's dinner is critically important.

For reasons I cannot entirely explain, there are some dishes which tell a gal that you're just not that into her. Anything with a roasted garlic aioli, for example. If I were to emphasize one thing, it would be that you avoid fish. DO NOT order fish for dinner on a Valentine's Day date. It suggests you're watching your weight instead of the woman across the table from you. Last night I watched in horror as an earnest young man debated the merits of Tilapia versus Orange Roughy with the waiter. My husband shook his head in disgust, observing, "That's not going to end well."

Later, the same guy asked for the cheese cart. (There really is nothing like a wonderful raw milk camembert to freshen a lad's breath.) We left before he could ask for irish coffee. I have a feeling that his date did, too.

Like an IPO, any relationship should last at least 6 months before its stock starts to drop. Don't let your Valentine's date make your girlfriend restate your earnings.

Venture Capital Word of the Month: Resonate

I've been feeling nostalgic lately about the late 1990s. Adding ".com" to everything except the name tags on my underwear, putting my back out from lugging around copies of Business 2.0 and Red Herring to read on flights to San Jose (remember when they had 200 pages of ads?) was a magical, overinflated time.

I believe we need to re-coin 1990s lingo. If Justin Timberlake can bring sexy back (highly debatable) then surely we, as a community can bring back irrational markets in part by invoking irrational vocabulary.

Let's start with a favourite verb choice of one CEO: resonate. Why agree with something when you can "resonate" to it? "I resonate to that" is another way of saying that you concur, but in a start-up savvy way. (The CEO who used this term also coined my favourite phrase for replacing founders: "repositioning for success").

People who resonate own houses built high on the hill of an old orchard in the Silicon Valley, and drive cars with doors that open upwards. They climb mountains in exotic places for reasons that are unclear. They probably have lots of extra capital to deploy in these web 2.0 times. Let's make them feel at home.

Tuesday, February 13, 2007

Venture Law Line Seminar Series: Friends, Family and Angel Financing

Here's your first notice: the first of our 2007 seminar series will be held in late March/early April here in Toronto. In an hour and a half, we're going to run through how to structure, paper and complete an investment from your friends, family and angels. We'll teach you the principles for valuing an investment, structuring it in a manageable way, and we'll also address special issues (US relatives, deal "sweeteners" and the like). You'll leave with a CD of handy reference materials and model documents. And donuts.

In the current market, the number of friends and family financings done each year far outnumber the actual amount of venture capital deals closed (according to one Ottawa angel, angel complete 30 times more deals than VCs). A common complaint we hear is that the legal fees in these cases are too large relative to the amount of money raised. This seminar will help address this issue by giving you a good grounding in the basics, so your legal fees can be spent more efficiently. And did we mention the donuts?

Dates, location will be posted here shortly. Any additional issues you would like to see addressed under this topic? Just let me know.

Monday, February 12, 2007

Founder CEOs - A Good Thing

It's been quiet here, and a quick peek through the blogosphere tells me why - my Ricky is on vacation. It's hard to provide counterpoint when your pointman is on a beach somewhere, with margaritas the only liquidity event on his mind.

Luckily, before departing Rick left a thoughtful post chastising founders who resist being replaced as owner-operators. Rick's view is that founders should "stop treating the title of CEO and President as a goal in itself".

I would like to offer a different view on the subject.

Before I do, however, I want to specify that offering a different perspective is NOT the same as actually disagreeing with Rick, who is American. Apparently, anyone who disagrees with Americans is currently considered to be emboldening the terrorists. Not me.

So, with that qualification out of the way, let's get to the matter at hand: is it short-sighted for founders to insist on the CEO title, or simply a very good defense tactic?

When you agree to receive venture capital, you agree to give up control over your business and its strategic direction in order gain funds for the execution of your business plan. You also agree to allow the company to buy back some (or all) of your shares, should you depart. Your continued role in the company therefore becomes a function of two variables: (a) your ongoing performance and (b) how much it costs to replace you. The higher the position, the more significant the termination pay.

A founder never know how well he will work with his VCs, or how long they will share the same strategic view of the market. It is therefore a valid strategy to make sure that the cost of terminating or demoting a founder CEO is significant enough to incent investors to replace only when there is a compelling business reason to do so. In my experience, there is almost never consensus on when (or how) to replace a founder CEO. So why make it easier for a vocal investor to sway the others?

My two cents.

Monday, February 05, 2007

Not My Kind of Long Tail

There have been disturbing rumours about this for a while now, but in recent discussions with a British client, I received confirmation: the British high tech community is single-handedly bringing back the mullet.

The mullet is that haircut most often described as "business in front, party in the back." It seems odd that it would re-emerge in the UK - kind of like hearing that NASCAR fans are bringing back spats. I also think it could be downright dangerous. Hear me out:

We all know that those who do not learn from fashion history are doomed to repeat it, and I am very concerned in this case. Mullets have never been kind to the Brits. Historically, they have been a harbinger of bad things to come. Just look at the Bay City Rollers (above, circa 1973). Some stylist took one look at their hair and said, here are fellows who can be conned into cropped gaucho pants and platform shoes. A few months pass and suddenly the whole Sceptred Isle is dressing the same way. Next thing you know, Edward Heath is Prime Minister, Britain is fighting cod wars with Iceland, and the whole country is on strike (I would insist on a 3-day work week, too, if my fashion choices were similar).

One never knows when actions will trigger a domino effect. Still, no good trend has been kicked off by a mullet. Careful, Britannia. But if you can't be good, then for pity's sake, make sure you use a good conditioner.