Investment Poutine: Buyback of Founder Shares

If you're in Quebec in winter (and it pretty much always IS winter in Quebec), nothing goes down better than a bowl of poutine. Poutine is a combination of french fries, cheese curds and gravy. It's a regional dish, and only Quebecois can make it well. This hasn't stopped many avant-garde restaurants and fast food chains from trying; it's on the menu in New York and Chicago, and the fast-food chain Harvey's tries to sell it,too. I don't blame them, but here's the thing: poutine just doesn't work out of context. In fact, removed from the charm of a candlelit apre-ski chalet, it's a tub of fairly nasty, congealed stuff.

The return of VC investors to angel and seed investing has led to a number of investing terms that, while they can make sense at the Series A stage, don't fit well in an earlier stage investment. For me, these are just so much financial poutine, and need closer consideration before you place your order.

Poutine #1: Buyback of founder shares. In a Series A deal, investors typically require founders to agree that a portion of their shares may be bought back if the founder leaves the company (or is fired) within the first few years following the investment. One underlying rationale of the Series A buyback is that the founders may not be the right team to scale the business, once the product and market have been de-risked by seed money. When negotiating this term, I always advise founders to insist that the number of shares subject to the buyback must be reduced in certain circumstances - most importantly, if the board fires the founder without cause. (You can read lots more on the topic by Nivi and the lads at Venture Hacks. There also are a number of other subtleties to this term, but let's leave that for another post).

In an angel/seed investment, the need for acceleration to protect a founder is even more compelling. In my experience, the period between seed and Series A is when most differences between investors and founders (and founders and founders) emerge. A broad right to buyback founders' shares at this stage can incent investors to replace founders who don't get along rather than trying to resolve issues. It can also incent investors to remove founders earlier, in an attempt to recapture equity that can be reallocated on a less-dilutive basis to post-Series A hires. (This raises the interesting legal question as to whether investors who exercise this right after firing a founder without cause are engaging in oppressive shareholder conduct. Lawyers for ex-CEOs ousted by VCs have advanced a number of interesting argumentss over the last few years along these lines. Since most of these cases have settled in Canada, there presently is little case law on the matter.)

To balance the incentives created by a buyback, I often advise clients to insist that NO shares will be bought back if the founder is terminated within the first year following the investment for reasons other than cause. If a founder steals from the Company, that's one thing. But unless the investment is a back-of-the-envelope kind of deal, any issues with founders should have been sussed out in due diligence.

As a founder, you might well agree that, if you leave the business and your angel investors high and dry, then they should be able to buy out most of your stake. But tread carefully when you extend that right. Ask yourself whether you are comfortable with forfeiting up to 75% of your stake in your company the day after you close an investment. Make sure your lawyer is fighting this point for you.

Blowing Smoke Up Your ASP

I often remind my clients that, just like the rest of us, high-tech businesses are subject to the rules and laws of misleading advertising. As new service delivery models and technologies proliferate in the market, the phrases we coin and the terms we use to describe them often evolve into de facto standards. And where there is a perceived standard, liability for inaccurate marketing follows.

In the consumer sphere, "high definition" tv is the current target. In my view, "software as a service" is not far behind. There is a perception that having a SAAS-delivered solution tells customers and investors that you're on the bleeding edge; "SAAS" is this year's "ASP". But are all SAAS providers actually providing SAAS? The answer depends on whether SAAS has the market perceives the term as a generic description of service delivery or something more.

Maintenance fees should not exist in a SAAS model, for example. The essence of SAAS is access to the best and the latest version of the application, all the time. Similarly, is it fair to call other remote desktop technologies SAAS? Is the customer receiving the same perceived benefits (including scalability and security)in those cases as it would if it were paying for a mutli-tenant, scalable application that is hosted and managed in a robust environment? Time will tell.

Non-Compete Agreements....Again

What is it about the weather that has everyone ranting all over the blogosphere? Let’s start with Bijan Sabet’s call for the end of non-compete clauses. Bijan has been touting this since at least late last year, and I thought VCs on both sides had nicely dissected the issue back then. But it seems Bijan is a man with a mission, bringing the matter up again in a recent guest post for GigaOm. It’s not mission I’d sign up for.

The crux of Bijan’s argument is that non-compete agreements are a significant barrier to innovation; enforcement of these agreements prevents new ideas from making it to market, which is one reason why New England lags in innovation behind California (where statutes prohibit the use of non-compete agreements). Here are my thoughts:

As a lawyer, my main job is to protect the assets of each client’s business.
The non-compete covenants given by key employees are, in fact, assets that are reflected on the balance sheet as goodwill. (This is even recognized under California law, which permits non-compete agreements in connection with a sale of a business so that shareholders may capture all of the business’ goodwill.) Abandoning a company asset for no consideration in the name of the broader public good strikes me as corporate waste and a breach of the obligation to preserve shareholder value.

The power of the non–compete is essential in the start-up phase of most businesses. It provides the incentive for founders to work out their differences and to continue to develop and launch their product vision, even before the value of the aggregate know-how and intellectual property that the start-up is based on is fully understood.

In later stages, non-compete agreements encourage businesses to develop employee retention initiatives. Why spend corporate resources on developing human capital if employees can walk across the shop and open competing businesses? I often hear this from larger corporations, who see their California employees as “free riders” on the benefits and incentive plans created for the rest if their staff.

I should note that Bijan differentiates between non-compete agreements, confidentiality agreements and agreements not to solicit customers, all of which employees typically sign. The latter two, he says, are fair game and should remain. In my view, however, breaking up this three-pronged asset protection scheme creates more problems than it solves. The non-compete agreement is the easiest for a company to enforce, since a breach can be established from public knowledge. By contrast, proving that confidential information has been disclosed, or that customers have been compromised, requires access to third party records and information. Removing the non-compete from the equation imperils a company’s entire intellectual property scheme.

No question, Massachusetts lawyers make a terrific living tracking down and trying to stop former employees from breaching these agreements, and Massachusetts courts have been fairly obliging. (Some of our own clients have been the recipients of lawsuits from their Boston-based employers.) And it’s also no question that many start-ups are heavy- handed in their approach to non-compete agreements. For example, having all employees sign non-competes is unnecessary, and even harmful. Litigators will tell you that it is more difficult to enforce an agreement against a CTO if you failed to do the same when a secretary also crossed the street to work for a competitor. Where possible, we advocate having only key employees agree to restrictions. Adjusting how you protect your assets is a more sensible approach than doing away with it altogether.

One last point: In most jurisdictions, the enforceability of a non-compete is a function of its reasonableness. Many later stage companies – RIM is a good example – provide for the possibility that employees may moonlight and develop new ideas after hours. This approach is not typically followed in agreements signed by founders, but it should be considered as any engineering and tech teams are scaled. The scope and range of non-compete provisions need to be considered and reviewed as a company scales, so that the whole structure doesn't fail because of a one-size fits all approach.

Happy Easter, all.