The Two Solitudes of Lawyering

I love being a lawyer. Always have. I attribute a lot of this to the fact that I spent so much of my early years at a leading law firm here in town with a very challenging, but collegial practice. Who couldn't love it? I ask you.

As it turns out, the partner I worked for. He has just penned a book about the profession. Its title? Lawyers Gone Bad.

Apparently, I have been skipping through fields of daisies all these years, overlooking the dark side of lawyering. The side which makes him ask:

"Are stealing and sexual misconduct a distraction from the grinding boredom that is a characteristic of even the best legal practice? Is there something about practising law that makes lawyers unusually prone to depression, anxiety, social isolation and obsessive-compulsiveness? Does legal training strip lawyers of a value system, and encourage them to be aggressive, judgemental, pessimistic and emotionally detached? "

Jesus Murphy. This is the same lawyer who once made me don a bald wig and pretend to be opposing counsel for a closing dinner skit. Where did the happy partner go? To Florida to retire with Santa and the Tooth Fairy? How many more of my misty, happy recollections of yore will die? Tell me now, before I finish making a snack for the Easter bunny.

Why VCs take meetings

I'm preparing for Rick Segal's workshop at MESH later this week, which is an overview of "How to Pitch to a VC." For me, you can't get the pitch right until you understand why you are pitching to a VC.

You should never take a meeting with a VC until you've determined whether there is a likely fit between the two of you. Where is the VC in its fund cycle - is it at the beginning of a new fund? Is it about to start raising its next fund? Is this VC raising a fund now, and having difficulty? The answers impact your ability to build an investment syndicate (who wants to co-invest with a lame duck fund?), and suggest how you need to adjust your pitch to fit the circumstances.

If the VC is a generalist (most in Canada are), you may want to adjust your pitch so it focuses more on how the current opportunity is an extension of other industries in which they have had success - for example, pitching enterprise 2.0 as an inevitable extension of current enterprise applications, rather than as a business model discontinuity.

If your VC is focused on your sector, you need to understand where it has already invested in the value chain, and whether your business overlaps with those plays. This VC is not looking for a missionary investment, but for a company that creates real barriers to entry. No "first mover advantage" slide here (in fact, keep that phrase out of all your pitches, please).

The people who do their homework and approach VCs as potential partners are the ones who have consistently better success. Still, many of you take shortcuts, and assume that if a VC agrees to meet with you, it means something. They must know you're a good fit for them, or they wouldn't take the time. Right?

Not so much. Here is a partial list of the other reasons I took meetings when I was a VC:

1. As a reason for getting to know the company's current investors.

2. As a favor for the advisor the startup had hired.

3. To listen to a new view on the addressable market for a business in which we had already invested.

4. To maintain the market perception that my fund was actively seeking new investments.

5. Because the CFO was rumored to look like Bruno Gerussi.

6. It was right after lunch.

7. There were still 45 minutes until lunch.

8. Lunch was being provided.


Many of these meetings resulted in longer term relationships, even if our interest was not in making an investment. Good business development? Yes. But a useful part of your search for near term money? Probably not.

My two cents.

Mesh Conference, May 30-31 Toronto

If you're coming to MESH next week in Toronto, be sure to check out Thursday's mid-day workshop with Rick Segal of JLA Ventures. And me. Rick has asked me to join him to discuss pitching and setting the stage for a term sheet. In addition to being a longtime supporter of MESH, Rick is an active investor in Web 2.0. In the last two years, he's probably seen more business plans for this space than any one else in North America. His views on what works in a 2.0 pitch are fascinating and worth your time. I'll be there to add my two cents on how the pitch can be used to shape any deal, too.

Kill the Lights, Save the Birds...perhaps

Each night when I leave the office I get a chirpy reminder from the cleaning crew to turn off the lights. Apparently, Toronto is the aviary murder capital of North America and thousands of migratory birds are killed each night by flying into lit office windows.

So? I ask you. Am I the only one who thinks the world could benefit from a few less pigeons and sparrows? (The phrase "migratory birds" is a nicer way of referring to ugly, disease-carrying birds. Morning doves, blue jays and cardinals seem able to avoid tall buildings.)

There is no ecologically defensible reason for so many pigeons to live in this town. Or gulls, for that matter. Gulls need to know their place, which is down by the lakeshore, NOT in the park by my house, at sunrise, several miles north. We humans appear to have killed the natural predator for these beasts, and we aren't eating enough squab to correct the imbalance. I say, let's multitask and use our office buildings to rebalance the ecosystem.

And while we're at it, let's find a lightbulb that attracts Canada Geese. Most of them don't even bother making it all the way north anymore; like many VCs, they can be found in a pond just south of the border, enjoying American grasses and algae.

I'm not suggesting we eradicate the entire bird population of Toronto. Show me a pigeon who eats lyme disease-bearing ticks or some other bug that might harm me, and I'll buy him some sunglasses. But for the rest of them, my light stays on.

Stock Option Plans: Sizing Grants by Country

Should foreign employees receive stock options? According to conventional startup compensation strategy, yes, so long as: (a) local securities laws permit,(b) there are no adverse tax implications for foreign employees (such as taxing employees at the date of grant), and (c) as a matter of local corporate culture, options are viewed as having value by foreign employees.

If these criteria are met, it used to be simple enough to simply issue options under the existing plan with the proviso that the foreign employees only exercised options in compliance with local securities law, and after any applicable taxes were withheld and remitted. But as startups extend operations to China, and elsewhere, the uncertain local regulatory environment made this approach more challenging.

In the result, may startups are now reconsidering their across-the-board approach to incentive compensation and reducing the size of option grants made to employees outside of North America. This is becoming a regular practice with respect to employees in Europe, where some countries require companies to make substantial payments into government pension plans. Should those employees receive the same sized option grant as their North American counterparts? Some boards view this as double dipping, and reduce grants accordingly. Others eliminate grants outside of North America altogether, instead offering foreign employees with a bonus plan.

The implications? A regular ESOP audit to assess the fit of your company's plan as operations expand is a good idea. Looking at overall compensation on a country by country basis never hurts, either. An option saved is...well, an option that's available for management refresher grants.

Selling/Acquiring a Startup: the Price Issue

"How can we be so far apart on price?" is the common lament of venture-backed companies who find themselves with an acquisition offer. Here's the view of one of my clients, a US company who has been an active acquiror of early stage industry players:

In the public markets, software companies are valued at predictable multiples, this acquiror says. Companies that aren't profitable trade at 1x revenue; companies that are growing, but not profitable - 2x revenues; companies that are growing and profitable - 3x revenues. By contrast, startups and their VCs are looking for purchase prices that yield 4-5X return on invested capital, minimum, regardless of revenue. Is this acceptable?

It can be, says this acquiror, if buying the target startup can jumpstart the multiples at which the acquiror is valued. Buying into the ground floor of a market with huge growth potential may increase the acquiror's share price, making the deal worth the price tag.

But a number of factors usually work against this theory, lowering the price tag. If the target startup has technology, but not a product, the price goes down. For most acquirors, (IBM, Tekelec or Alcatel excluded), buying technology is an inherently riskier proposition. It means the acquiror must create the product, the go-to-market strategy and locate the customers who will create a viral effect for the new product before the acquisition can have any impact on the bottom line. Very few software organizations have the large, well-honed sales force and go-to-market groups to accomplish all this in a speedy timeframe.

The purchase price goes up significantly if the startup has a product with a first-rate go-to-market structure and good sales support. But even here, the offer will still be discounted if there isn't yet sufficient traction with lead customers. It is not enough to have sales; are you selling to lead customers who will create a chain reaction demand for your product in the marketplace?

If not, this acquiror argues, the purchase price again should be reduced. A premium price is payable once the viral effect has started. A lower price applies if a target startup is still one step away from a viral market.

As you plan ahead, think of where your business currently sits in the value chain for potential acquirors. Having best practices go-to-market structures(and documentation), even in their early stages, can go along way in price negotiations.

Beef of the Week: Marketing in Stealth Mode

Despite numerous attempts to end overuse of the phrase "in stealth mode", the epidemic continues. On a recent tour of the web, I counted at least 25 Canadian startups who are out there marketing themselves as being "in stealth mode." None of them are in the defense industry, so I have to assume they aren't being literal.

I have no issue with startups actually operating in stealth mode. There are good reasons to build in silence, and I look forward to hearing about them when you deactivate your cloaking device.

But using "in stealth mode" as your first message to market? Jesus Murphy, no. For one, it's a dated phrase; "under the radar" would give you so much more street cred. Also, it's not clear what you mean. A recent Vancouver angels forum featured 30 companies "in stealth mode", complete with business descriptions. Shhhh.

Perhaps most importantly, it's a ticking marketing time bomb. How long can you be in stealth mode before people conclude you are never leaving it? I have been "losing baby weight" since my last child was born. He's 9 now. Pilates instructors don't take me seriously anymore. I don't think the outcome would be different if I had announced my abs and gluts were in stealth mode.

My view? The only good time to market yourself as in stealth mode is when you are emerging from it.

Toronto Venture Group: Hiatus?

Last week's "Speed Dating for Capital" marks the first time in months that the Toronto Venture Group has been publicly involved in an event for the venture community. Rumours have been abounding that TVG, with its substantial roster of sponsors and members, is now on hiatus since March's Financing Forum. "On hiatus" is never a good thing; when "Square Pegs" was put on hiatus, we didn't see Sarah Jessica Parker on tv again for 12 years.


Whatever the real story is, I am deeply concerned about what this means for our community. What does it say about us as a business generation centre when we can't rally support for a group branded with the name "Toronto"? The group's breakfast meetings - easily the largest gatherings for the startup community here in town - have also disappeared from the events calendar. Let's hope for good news soon.

Friends, Family and US VCs

Mark McQueen at Wellington Fund interviewed me for his blog, which resulted in a wide-ranging discussion about the state of early stage financing. You can take a look over here. I don't want to hear back about my musical choices, but I welcome any additional suggestions for my iPOD.

Calling Toronto CEOs - Canadian Innovators Forum Event

Loewen & Partners is sponsoring an Innovators Forum seminar on partnering with private equity firms to drive growth. Featured speakers include Ed Rieckleman, a partner at ONCAP and Markus Luft, CEO of Headwater Technology Solutions. June 1 is the date. This looks like a great networking event for those who want to assess the later stage equity players here in town. I know I'm going - the National Club has great mints. Need further details? Contact Jacoline Loewen at Lowen& Partners

Slipping Rick a Little Tungle

Last night I loafed around and watched American Idol. In other words, I was seed investing. There's no difference between what I did and what many self-styled seed investors are doing in Canada.

In my view, if you haven't made any seed stage investments in the last 12 months, you lose the right to market yourself as a seed investor. You're just seed. (Seed that your LPs are paying management fees to so you can ride out the market.) And you're wasting my clients' time taking meetings, when they they could be talking to the handful of active investors and angels in the industry. Ever watch a seed grow? Not a good use of time.

Thank goodness Rick Segal and his team at JLA Ventures have provided some reason for optimism, announcing this week a seed investment in Tungle, a Montreal based startup founded by some of the former team from Nimcat Networks. Kudos to JLA and Pierre Donaldson for stepping up in a seed round that includes Desjardins and a prominent US angel investor. Tungle has the perfect tool for managing special project teams...like the ones assembled to close an investment, for example. I'm just saying.

Selling a Startup: the Impact of your SLAs on Purchase Price

These days, the number one factor that impacts the purchase price offered for a high tech company is the target's support environment/go-to-market operations. Here's why:

Deficiencies in a technology or product can be fixed, many acquirors say, but problems with a target's going to market structure take time. If an acquiror is a public company, time is a problem, as public markets demand that acquisitions be immediately accretive to the bottom line.

The sales organization is usually a break- even operation, acquirors say; the profit margin for a tech business lies in support and renewals. If a technology needs to have upgrades in its maintenance process, or in any other part of the value chain to the customer, then from a potential acquiror's perspective, the product will be out of the market until these are put in place, and the likelihood of return from that acquisition is delayed. As a result, (a) the purchase price offered may be adjusted or re-structured, or(b) the deal may fall away completely.

At our firm, we've developed a model for evaluating the customer chain that we use when acquirors ask us to do due diligence, which helps the acquiror assess the impact that deficiencies here might have on their offer. Here are areas that create the most issues:

- Renewal schedule for maintenance agreements: How many will come due within the next 6 months? 12 months?
- Adequacy of professional services training and geographical allocation of resources: Will the acquiror have to create and train professionals and to support foreign markets?
- Adequacy of marketing collateral: will new materials need to be created?
- Adequacy of sales channel training

This last point is particularly important. As one client told me, "We can acquire really cutting edge technology, but if we can't acquire a properly trained sales force (or train our own force effectively), products won't sell. This means the technology will be out of the market for at least a year while we fix these gaps, and that needs to be priced into the offer we make."

High growth companies, take note: support environment due diligence is a good preventative practice. Don't take money off the table because you failed to identify and fix problems before an acquiror comes calling.

FashionWorkshop: You Can't Always Cross the Chasm

With the release of his latest book, Lee Iacocca also has revealed a new look. I want to read it, but I don't want to look at his neck. And all that black. Who does he think he is, Vinod Khosla?

If you've been a suit guy all your life, and you're looking for a change, start slowly. Wear a golf shirt. Then progress. I don't want Lee Iacocca flashing his neck at me like this without warning. It makes his book business lit porn.

I'm just saying.

The Secret VC: Export Development Corp.

Export Development Corporation of Canada has quietly gotten itself a significant mandate to make equity investments of up to $3 million in new businesses. An added bonus: funding is available at the commercialization stage, as well as later stage startups.

The Catch: EDC generally likes to invest alongside a partner VC. Angel groups might also qualify, although this is not clear. Need more information? Go to their site and check out the contact information under the heading "Equity Investments".

Shopping in Canada: What to do When a US Buyer Comes Calling

The buying spree that is being fueled by its technology buyout players continues. Most notable was the announcement last month fo the acquisition of Vancouver-based Fincentric by Open Solutions, a vehicle backed by US private equity giants Carlyle Group and Providence Equity.

Before taking venture capital money eight or so years ago, Fincentric had been growing a successful financial software business for 15 years. But despite a capital injection from Ventures West and notable US funds the company did not seem to scale to IPO. The price at which Fincentric was finally sold was not disclosed, but given the length of time between the first VC investment and the sale of the company, one wonders if management could have improved its own return had the company exercised any retraction rights that may have matured beforehand.

Retraction rights allow a company to buy back shares upon the expiry of a period of time or the occurrence of certain events. I try to negotiate for these rights to parallel any redemption rights requested by VC investors, who usually want to have a "last resort" right to liquidate their holdings in a company if, after 5-7 years, the Company fails to achieve an IPO.

If you think your industry niche is ripe for consolidation, please do some basic homework now. For older companies, check and see whether there is a retraction or other right that could be exercised to clean out disinterested shareholders before the company is in play. If your investors have been around for 5-7 years, they likely are coming to the end of the fund that holds its investment in you, and they may be willing to accept a reasonable cash payout now to assist in the returns they advertise to potential investors in their next fund.

Young and old companies alike: Check your share register and your capital structure. Do you have current addresses for your shareholders (including those contractors you gave shares to five years ago)? Any potential transaction is easier to effect (and more appealing to buyers) if you have voting trust in place to minimize the interactiosn you must have with your shareholders. Are your option grants properly documented with formal grant agreements?

This week's posts will cover other aspects of preparing for sale to a US investor. Stay tuned.

Beef of the Week: the Term Sheet Ratchet

As term sheet season winds down to summer, just a reminder to founders: not all terms commonly used in a VC term sheet are terms of art. If a term has a range of meanings, make sure it is defined precisely in a term sheet, particularly if it affects share price.

In particular, make sure you are clear about what is meant by a term sheet reference to anti-dilution mechanisms.These are the provisions which adjust the original subscription price paid by a VC if a future investment is made at a lower price. The investors' rationale for these provisions is twofold:(a) as a new investor, they do not wish to assume the risk that the valuation they agree to is too high; and (b) they need to preserve as much economic value as possible.

Many term sheets still refer to "customary anti dilution mechanisms." Some try to be clearer by referring to "weighted average" and "full" ratchets. These are not the real terms of art, and there is some difference in what most think they are. Make sure you get clarity.

A full ratchet is a compete repricing of the shares originally issued - a capital mulligan. A weighted average mechanism generally takes into account the number of shares actually sold in the down round. Two types of weighted average adjustments are often used: broad based (usually, refers to calculating the average of all convertible securities plus options) or narrow-based (adjustment calculated based on issued shares only). Broad based is more favourable to you as it shares the pain of a lower share price.

Now go forth and issue shares.

Mark McQueen: Why You Should be in His Debt

In the midst of the venture capital decline, Wellington Fund has been going about its business, deploying tens of millions in dollar of venture debt this year to later stage startups. Venture debt allows companies with cash flow to leverage their assets for additional capital without further dilution of equity or investor interference.

While debt is never easy on the financial statements, there are advantages. Although lenders will require numerous restrictive covenants (similar to the protective provisions shareholders already require) to follow, generally venture lenders do not require board seats or other controlling roles in the business. (Secured creditors typically do not wish to control debtor operations, lest it impair their secured status under certain equitable principles.)

Venture debt should be part of any startup financing strategy, if only to keep up with the competition in the US, who are compounding their available cash in droves through debt. Some startups and startup boards still resist the concept, which puzzles me. When JAVA releases a new plugin, do you ignore it?

Maybe it's the French cuffs venture lenders favour. For some, nothing says you have left the soothing world of shareholder-contributed capital like French cuffs held together by man jewelry. But even Brad Pitt and Jude Law wear them on occasion. Chances are they'll look good on you, too.

Venture Capital in Canada: Ending the Silent Death Spiral?

My clients are fed by angel and venture capital. I therefore care about how much financial food they have; it's a good economic indicator for whether or not I will be able to pay for both of my kids to get braces.

While there's been a VC famine here for several quarters, public discussion of the issue has been tepid at best. Thank goodness, some of our most prominent players are finally speaking out. In the last few weeks, Terry Matthews and Pat DiPietro have become the Bono and Angelina Jolie of the venture capital scene, using their celebrity to sound the alarm.

What's the nature of the crisis? Here's a sketch of what's being said:

Venture capital is fed by the limited partners ("LPs") who invest in VC funds. Historically, the pool of Canadian LPs who are attracted to high risk capital has been discrete. To bolster the industry(and the startup community), the Canadian government therefore has from time to time created vehicles such as labour sponsored funds to attract additional capital.

When there is an irrational market (1998-2000), the usual pool of LPs expands to include new players such as US LPs and institutional equity funds. The number of VCs and the amount of venture capital available to Canadian entrepreneurs skyrockets. When the market cools, those LPS retreat to later stage investing, leaving too many funds competing for fewer LPs. A consolidation of the number of venture capital investors results, until the next irrational market heats up the investing cycle all over again.

Which is where we find ourselves today. However, a growing number of people believe that this current retrenchment is not simply part of the venture capital cycle, but a death spiral for venture capital in Canada. They point to a few developments:

- LPs are now attracted by the more robust US market and are less interested in re-investing in Canadian VCs' next funds. Our best VCs are therefore finding themselves with little support for new funds for IT, software and telecom investments. This means there could be a 5-7 year gap in funding for those industries.

- US VCs continue to stay out of the Canadian market, in part because of Canadian tax rules that prevent US VCs from investing in a cost effective way. This is continuing at a time when the US VC industry is again overheating, thanks to the Web 2.0 bubble. There is a tremendous capital overhang south of the border, but Canada is not effectively accessing those extra dollars.

- There is no agreement on the right way for the government to support our own venture capital industry. At this point in the cycle, I would expect to see another legislative initiative to incent new LP activity. There are no signs of it. There is a concern that the government will instead legislate more seed investing programs of its own, which will compete with the few remaining VCs, instead of supporting them.

- There are not enough resources - tax incentives, support infrastructure,etc - to foster the development of startups into superstars.

These concerns aren't new, but the efforts to elevate discourse beyond the venture capital community are coming just in time. We may no longer be riding a market correction.

As a nation of entrepreneurs, we are failing to capitalize on the next cycle of investing currently being played out south of the border. The issue isn't going to get solved just by a small number of VCs rallying Industry Canada. It's a start, but it's also time for the investee side to the equation to join the discourse.