Monday, January 22, 2007

Venture Capital: Negotiating the Ratchet

Anti-dilution, or price protection mechanisms, have become standard provisions in most VC term sheets in Canada and the US. How should you negotiate these terms?

Start by understanding how the proposed provision will work. Price protection terms allow an investor to protect the economic value of its investment in the event that shares are issued in future at a lower price. For example, VC #1 invests at a per share price of $0.50. 18 months later, VC #2 offers to invest at only $0.25 per share. A price protection term would adjust the original investment price paid by VC#1 - so that either the original price is $0.25 (a "full ratchet") or some average of the two prices (a "broad based" or "narrow-based" weighted average) - and VC #1 would receive additional shares to reflect the difference in the number of shares originally purchased and the number of shares that would have been purchased at the adjusted price. A full ratchet is almost unheard of these days. A broad based weighted average formula generally is more favourable to you, since it is takes all reserved and issued securities into account.

Understand the rationale behind the request. In an early stage investment, a VC typically will argue, there is a risk that the VC may overpay for its stake in a company. Traditional methods of valuation (such as discounted cash flow and market comparables) simply don't work when applied to an early stage company, a VC will say; however, in the interest of ensuring that founders keep a meaningful stake in the company, the VC is willing to accept now a valuation that may prove artificially high later, when future investors value the company. A related point some VCs make is that they also need the provision in place to protect them from the risk of a general market decline. Market fluctuations are not a theoretical risk, they will tell you. Look at 2002, when the dot-com bubble burst and valuations plummeted.

Apply the rationale to your company's circumstances. Is your VC trying to hedge against valuation/market risk, or is he really trying to mitigate against the risk that you will fail to execute on your business plan? Or both? If your company is at the "back-of the envelope" stage, then the answer is probably both.

But many of my clients are farther along in development; they have product, some customer validation, and a sales channel strategy. For companies at that stage, you might argue, there's little - if any - valuation risk. Surely the other terms the VC has required (a board seat, a veto over many key operational and strategic decisions) are better protections against poor execution by the company. In fact, you may suggest, you believe the VC should be incented to drive execution by actively using the oversight and control he's bargained for. You don't want the anti-dilution mechanism to act as a safety net.

Suggest a halfway point. You're not going to succeed in removing the term, but you can suggest a few tweaks that may blunt its impact on your share of the Company. For example:

1. Propose a floor price - i.e., if the price falls below a certain point, the anti-dilution mechanism is reduced so that management's stake is not completely wiped out.

2. If the VC is concerned about execution risk, use that to negotiate a term that eliminates the anti-dilution provisions once certain performance milestones are met by the Company.

3. Focus on management compensation, and negotiate for performance-based adjustments to offset any dilution caused by anti-dilution mechanisms.

In all cases, you should argue for a "pay to play" provision. If the VC does not participate in a future round at a lower price, it loses its rights to the protection in all future rounds.

The "C" Factor. It is important for Canadian companies to bear in mind the "C" factor in any of these negotiations. Canada had produced many outstanding tech companies, but only a handful of them qualify as home runs - RIM, Cognos, Nortel. This means that, to a degree, your ability to negotiate is coloured by the track record of our industry. You will be less likely to move management compensation or negotiate a floor price here than in the US, for the most part. Be sure to understnad that sensitivity, and don't overreach. For now.

My two cents.

Sunday, January 14, 2007

Venture Capital: Is a Liquidation Preference Acceptable?

These days, every term sheet you receive from a venture capital investor will include a liquidation preference. 99% of them will insist this is a non-negotiable part of the deal, for fairly valid reasons. When, if ever, should you resist?

The answer lies in the overall financing strategy for your company. I always tell my clients to work backwards from IPO/sale of the company (remember, if you are trying to finance yourself within the venture capital model, your business strategy has to steer to a liquidity event within 5-7 years). How much capital will you need to build product, customer channels and revenue?

Software companies typically need much less capital than fabless emiconductor plays (where the rule of thumb is $10 million to tape out one chip). You may need as many as 5-10 rounds before the company is sold, or $50 million ++ to reach that point. That's $50 million that will receive its return on capital in preference to anything you might receive as a common shareholder. And, if that invested money also had a participation right, it will also share in any proceeds distributed to common shareholders.

Very few Canadian startups have engineered acquisitions for more than $100 million, ever. Which means you need to consider now what a liquidation preference means for your stake in the company as a founder in the long term.

Are you likely to negotiate away a liquidation preference? No, unless you have a very solid track record for successful startups. VCs must have a floor that will guarantee some minmum return on investment. The better approach is to start considering now how to structure compensation (and your future contributions ot the business) to mitigate against the impact of multiple liquidation preferences. Here, US startups - many of whom received punishing liquidation preferences as part of financing rounds done during the internet meltdown - provide great examples of how to adjust management compensation where there are multiple liquidation preferences.

More later.

Thursday, January 04, 2007

Non-Compete Clauses: Canada vs the US

Dan McKeown and I worked together at Nortel, where he was master of the kinds of employment issues that come with a workforce of 65,000. Here's a terrific piece Dan put together that explains the subtle differences in approach to non-competes with American and Canadian hires:

Employment Non-Competes in Canada and the US

As many organizations that employ in both Canada and the United States can attest, there are significant differences in how Canadian and American courts interpret and apply post-employment restrictions on departing employees.

Known colloquially as non-competes, post-employment restrictions purport to prohibit or place parameters on a departing employee’s post-employment remunerative activities. Non-competes appear in various guises, including an obligation to protect a former employer’s business interests by maintaining the confidentiality of trade secrets and other confidential information obtained during employment, a prohibition on employment with a competitor (referred to as a non-competition covenant), and a prohibition on soliciting a former employer’s customers and employees (referred to as a non-solicitation covenant).

In the U.S., a non-compete arises almost exclusively from a written agreement between an employer and an employee. However, in Canada, a post-employment restriction may also be implied by the common law. In other words, in Canada, a court may enforce a restriction against a departing employee even in the absence of a written, non-compete agreement.

Regarding implied restrictions, an important legal distinction that operates north of the border is whether the employee in question is, or is not a fiduciary. If the departing employee is a fiduciary, it is more likely that a court will imply a restriction.

Fiduciaries tend to occupy top management roles and are characterized by an ability to exercise discretion and power unilaterally in affecting the employer’s legal and practical interests. If a departing employee is a fiduciary, the common law imposes a duty of utmost good faith. A fiduciary cannot usurp, or divert to others, a maturing business opportunity, or solicit his former employer’s customers/employees for a reasonable interval post-departure.

Employees in Canada who are not fiduciaries nevertheless owe their former employer a common law duty not to divulge or otherwise use trade secrets and other confidential information acquired during employment.

American courts are also willing to apply a doctrine known as inevitable disclosure. The doctrine is sometimes used as a ground to request an injunction against a former employee, prohibiting the employee from employment with a competitor on the basis that the employee will inevitably reveal to the new employer trade secrets and other confidential information of the former employer. To date, Canadian courts have been reluctant to recognize and apply this doctrine.

Written, non-competition covenants are also treated differently in the two countries. In the U.S., a written, non-competition covenant is generally enforceable (i.e., provided that the agreement satisfies the legal requirements of contract law, and enforcement of the covenant is necessary to protect the former employer’s legitimate business interest). However, in Canada, courts are not inclined to enforce non-competition covenants because they constitute a restraint of trade and ,therefore, are considered not in the public interest. Instead, Canadian courts are more likely to accept a tightly drafted, otherwise reasonable, non-solicitation clause.

The notion of “consideration” is also treated differently by Canadian and American courts. In the context of a non-compete, consideration is some form of “payment” by an employer in return for an employee’s agreement to be bound by a restrictive covenant. Consideration is usually a payment of money (e.g. a pay raise), but a promotion, or being made eligible for an incentive award may suffice.

In the U.S, an employer’s agreement to continue an employee’s employment (or, stated conversely, to forbear from terminating the employee’s employment if the employee should not agree to become bound to the non-compete) is, generally speaking, enforceable. However, this is not always the case. Where the employment is at-will, an employer is free to terminate or demote an employee at any time, with or without just cause or notice of termination. Accordingly, some U.S. courts have held that an at-will employee who has received a promise of continued employment, in return for a non-compete, has received nothing.

In Canada, courts have very rarely found an employer’s forbearance from termination to constitute adequate consideration for a non-compete. Consideration in the form of a promise of employment is more likely to be successful in a new hire situation (i.e. prior to commencement of employment).

Finally, it is significant that U.S. courts have demonstrated a willingness to modify a restriction imposed on an individual in a non-compete agreement to the extent necessary to render the restriction reasonable (sometimes referred to as blue penciling). This might include reducing the geographic or temporal ambit of a restriction.

Canadian courts, on the other hand, are more inclined to strike out covenants they find unenforceable, rather than amend or modify them.

In summary, it should come as no surprise that the courts in two sovereign nations - - Canada and the United States - - often take different approaches to employment non-competes. It is also clear that, given the continuing evolution of the information age and growth of the service economy, protecting confidential information and preserving customer relationships will remain high on the corporate agenda. Prudent employers that are serious about protecting these interests will, therefore, want to bear these considerations in mind when designing and recording employment relationships.

If you want to chat with Dan about a specific issu, let me know and I"ll introduce you.

The information contained in this article is provided for general information purposes only and does not constitute legal or other professional advice. Reading this article does not create a lawyer-client relationship.