Monday, March 29, 2010

What Liabilities Do Board Observers Have?

A few years ago, I was sitting in a board meeting for one of my fund’s portfolio companies, listening to an investor rant on about why the board should turn down an offer to purchase the business. Now, the offer terms were not great, but they meant that everyone would receive some gain on their shares. Given the state of this particular company, this was a gift from heaven and it was hard to see how the board could find that the offer was not in the best interests of all. And yet, here this person was, insisting on a different path. I happened to know that he was in the middle of raising his next fund, and suspected that his position was driven by his desire not to record a modest return on this investment until the fund closed.

The board probably should not have allowed him to co-opt the meeting to pursue his own agenda. He was, after all, an observer with no right to vote on the matter. But this is not an unusual event in private companies – observers often feel emboldened to try and influence board decisions, relying on the belief that their status somehow insulates them from personal liability for their actions.

They are wrong.

The active participation of observers in board affairs can change their status and their liability to a corporation. In Canada, for example, the law imposes liability on those who function as directors, not just those who are elected by shareholders. In the US, there is a similar concept referred to as the "de facto" director. And while there have not yet been reported court decisions in Canada where an observer has been found liable for breach of fiduciary duties, there are to my knowledge claims that have been made (and settled) against investor/observers on this basis.

Angel and private equity investors need to particularly careful about their interactions with investees. Even as observers, investors will often manage the business of a corporation, even leading negotiations for additional financing or sales. It’s not unusual for them also to take an active role in board meetings, or to participate in what are otherwise purely directorial decisions. When things go wrong, it is inevitable that they may well be named in any lawsuit.

It has been the usual practice for sophisticated investors to require a company to sign an indemnity agreement for observers, so that they are protected. I do not necessarily agree that this is appropriate, unless the agreement also contains provisions that bind observers to certain standards of conduct. What are those? Post coming up.

Wednesday, March 24, 2010

After Bootstrapping: Preparing for the Mid Haul

Ten years ago, most bootstrapped start-ups were built for the short haul, on an 18-month plan: spend your friends' money, build a prototype and either attract investors or close doors.

Fast forward to today, and it's a different world. There are more bootstrapped, high growth innovative businesses than ever and - more importantly - most of them are surviving well past the 18-month mark.

If you are one of the many who has moved from the short haul to the next stage of growth, consider this your wake up call. It may be time to do some spring cleaning.

A start-up that reaches the mid-haul has meaningful assets: it has built goodwill in the business, acquired customers and built a core team. The manner in which you protected these assets in the early phases of business need to be appropriately upgraded.

Here are the areas where I often find there is a critical mismatch between the advancing stage of the company and its operating structures:

Employee Compensation : Companies heading into the mid haul have a fairly good sense of their growth path for the next 3-5 years. Now may be the time to consider whether options are the appropriate way to incent employee performance, or whether profit sharing plans would better match the company path for the mid haul.

Protecting the Company Brand: Your business now has an identifiable brand and goodwill to protect. Establishing usage rules so that your trademarks are not diluted is important. I will defer you to Jessica the trademark goddess for further advice on this matter, but the important note is this: you must establish corporate standards for how your brand is used in collateral, etc., so that you do not dilute any claim you have to that brand.

Equally important is controlling the way in which your company is discussed in the broader public sphere. Consider establishing company guidelines for employee use of social media, so that expectations are clear. Laso make sure that your alpha and beta testers (if appropriate) have agreed not to disparage any produucts or the company.

Intellectual Property : So many of you have gone all Frodo-in-the-shire and allowed your employees to moonlight that this bears discussion. It is one thing to permit key employees to supplement income in the early years of the business through outside jobs. It is quite another when you permit employees to start their own business on the side. For example, what happens when they start taking customer support questions during your office hours?

Business issues aside, you have no way of knowing what contracts your employees have signed with outside engagements, and these can potentially impact your own intellectual property. The mid-haul is the time to re-think your moonlighting policy,as well as the invention assignment terms your early employees agreed to.

Customers: The mid-haul phase is when your business moves beyond missionary, early-adopter customers who sucked the life blood from you to follow-on customers who may be agreeable to more balanced contract terms. Now is the time to adjust contract terms and to make sure that your contracts follow your current revenue model.

Companies who have adopted a SAAS model for some of their solutions tend to need to pay particular attention to their agreements, in my experience. Most SAAS-based contracts should have provisions that allocate risk between the customer and the business for: export controls, data security, disaster recovery, redundancy backup, sales tax treatment, among other matters. If you've cobbled together your SAAS terms from a business that does not use the same model, chances are you've missed important elements.

I'll blog about each of these items in detail in the next few weeks. Other issues for the mid haul? Let me know.

Sunday, March 21, 2010

What Legal Duties Do Angels Owe Each Other?

Just about four years have passed since the current angel investing surge began, and we now have in our midst perhaps the largest group of active angel investors ever.

With increased investment comes a proportionate increase in disputes, and opportunities for courts to consider the nature of the angel investing relationship.

Earlier this year, the Ontario courts provided guidance on what obligations co-investing angels owe each other. Angel investing has always been done on largely a club basis, with loosely affiliated investors sharing information. How much angels shared with each other has been an unregulated matter.

Now, the Ontario courts have laid out some basic rules in a recent ruling involving angel investor Paul Alofs and his fellow angel investors in Kremeko Inc., the Canadian franchisee for Krispy Kreme donuts. Last June, the Ontario Superior Court ordered Mr. Alofs to reimburse his co-investors a total of $655,000 for failing to tell them that Mr. Alof was exiting his investment in Kremeko. The full judgment was finally published just a few weeks ago and is an important cautionary tale.

You may recognize Mr. Alofs' name, who returned to Ontario in 1999 after a much lauded California success with He was an early investor in Kremeko which raised money for angels and other investors in three tranches over 2001-2003 in order to fund the establishment of Krispy Kreme in Canada.

It was Mr.Alofs who contacted certain other angels about the opportunity. According to the court’s decision, the group agreed to work collaboratively, conducting some due diligence individually and exchange their own views about the opportunity. After the investment, two of the angels continued to collaborate directly – Mr. Alofs would share information packages he received for board meetings with the another angel. Some of them reviewed and discussed other investments with Mr. Alofs as well.

And when the company raised the second tranche of $14.5 million, one of the other angels asked Mr. Alofs for his views, and if there were “any red flags” that they should be aware of. Mr. Alofs reported that he would be doubling up his position (which, unknown to the other angels, he did not do). The angel repeated Mr. Alofs' comments to other angels, and they all participated in the round.

Following the second tranche, Mr. Alofs sold his shares to the some of the other investors and resigned his seat on the board of directors. Before that closing, the court found that Mr. Alofs failed to disclose his sale of shares when asked by the other angels, and did not provide the real detaile for his resignation from the board. When the company went under several months later,the angels sued for deceit and negligent misrepresentation. Had they known that Mr. Alofs was no longer participating, the angels claimed, they would not have further invested.

The court agreed. Given the relationship that one angel had not only with respect to Kremeko but also their ongoing discussions about various other investments” the court reasoned, Mr. Alofs should have known that his statements would be relied upon by other angels in determining whether to invest in the third tranche. The skill and knowledge of the angel did not in the court’s eyes reduce Mr. Alof’s liability: “Because someone is a sophisticated investor does not mean that such person would not listen to others and take their views into account.”

As a lawyer, this ruling has made me re-think the kinds of terms I like to see go into investmet involving groups of angels. It could also be the beginning of increased rules around angel club investing. Stay tuned.

Monday, March 08, 2010

Advisory Board Agreement Basics

Requests for advisory board agreements seem to be on the rise. Five years ago, I would have dissuaded clients from bothering with an advisory board, largely because advisors dilute founders' equity stakes and typically ended up as short term additions, often squeezed out when venture capital comes in.

But that was then. In the last two years, the number of VC-free start-ups has skyrocketed, and many will likely never add venture capital investors to grow their businesses. In the new start-up reality, the right technical and business advisors can fill gaps in product and business strategy, and even open doors.

What kind of agreement should there be between companies and their advisors? Obviously, I'd prefer it if you bought me a donut, or even sent me flowers and candy before I answer. A gal likes to be wooed before she provides favours. Let's start with a checklist of provisions I recommend advisory agreements contain:

1. Description of the Relationship:

You need to think of this agreement in a similar way to any consulting agreement, and set expectations as to deliverables. After all, your advisors likely are receiving an equity stake in your business; it should be clear how they are to earn those shares. At a minimum, there should be a generic statment that the advisor will agree to meet with the company on an intermittent basis and provide general advice and guidance/ or work on the Company's behalf in the advisor's areas of expertise. The amount of time involved should be specified, e.g. "up to X days per month." Some advisors provide specific deliverables as part of their role and you should be specific as to what these are.

2. Disclaimer of Employment:

The agreement should state that the advisor has no right to employment or continued engagement.

3. Payment for Services:

State clearly what the advisor is receiving (shares or options),their vesting schedule and strike price. In addition, specify whether any out-of-pocket expenses of the advisor will be reimbursed.

The vesting of options need not follow the traditional 3-4 year schedule of most option plans. Many early stage companies allow the options to vest upfront and while I understand the need to attract the right advisors from the get-go, it needs to be tempered with a need to ensure the advisors actually contribute to the business in the way you intend. My own view is that everyone performs better with a carrot dangling in front of them,and any vesting schedule - per meeting attended, over just one year - is better than none.

Do not forget to state that the options are non transferable and that the advisor will be expected to agree that a voting trustee will vote those shares, not the advisor. An advisor is receiving a stake in the value he has created in the business, but he is not receiving a say in how that business is run.

4. Confidentiality:

The law will not necessarily agree that advisors owe you or your company a duty of confidentiality. It is therefore critical that you have nondisclosure terms in place with your advisors.

5. Competitors:

Because advisors have other jobs and investments, it is difficult to get them to agree not to compete with yours or not to solicit your customers. A reasonable middle ground is to ask advisors to notify you if their other work might compromise your business, so that you may terminate the relationship (or at least, limit your disclosure to them while they are so engaged).

6. Ability to Perform Services:

This provision is a statement made by your advisor that the advisor is free to undertake the services required by the advisory agreement, and that there is no agreement that would prevent the advisor from giving the benefit of his/her services. You have no way of knowing whether the advisor is under an exclusive services agreement elsewhere, or whether he/she has a non compete or other covenant in place that would be breached by taking on this role with you. You want to protect your business from any claim that an employer or other party might make that you have interfered with their agreement or induced your advisor to breach his contract with that party.

6. Ownership of Work Product:

As would be the case with any consultant, you need to ensure that you own any written work, suggested product improvements or other contributions your advisor makes to the business.

7. Termination:

Do not be afraid to reserve a right to terminate the advisory arrangement at any time. 50% of marriages end in divorce, and business relationships are no different. Simply state that either party may terminate this arrangement at any time without further payment or penalty, and state what you intend will happen with the shares or options that have been granted (vesting typically ceases).

If you are already using an agreement, please take a look at the terms and consider whether you need to add any of the above rpovisions. If you have other suggestions for must have terms for an agreement, send a comment.

Thursday, March 04, 2010

Can Gaming Save the Publishing Industry?

This week Random House announced the formation of a 15 person division to focus on the creation of "original transmedia intellectual property" or, what my mother would call books.

To be less fancy about it: the book publisher is crossing over into the risky world of creating original content. Random House is betting that its team can fill the gaming industry's need for: (a) more complex plots, better character development and dialogue, and (b) a story that seamlessly threads across games, books, movies and social platforms. It is currently shopping two storylines created by the division, and also announced a deal with software publisher Stardock to work on Elemental: War of Magic, to be released in September.

Publishing and game development are two industries that are heavily supported by government funding. I am wondering how this kind of convergence will impact both streams of funding. Would Ontario's online gaming development funds could be used by gaming developers to pay for this kind of service? Stay tuned.

Wednesday, March 03, 2010

Budget 2010: Innovation or Incubation Economy?

Stephen Harper has scheduled the roll out of his federal budget for tomorrow, so that it coincides with the start of "Roll Up The Rim" time at Tim Horton's. I am trying to figure out what this means.

For the last two years, I've started each day with an extra large coffee in a cup bearing the discouraging words, "Please Play Again". Frankly, the messages I've been getting from the federal government haven't been all that different, either.

Now, things seem to be changing: two days in, and already I have won a donut from Tim's. Will the budget be giving out innovation sugar, too?

Early signs are that "innovation" and the "digital economy" will be important parts of the plan. That's the good news. The bad news: there remains the lurking fear that the government will continue to starve less popular parts of these sectors - venture capital in particular. Which could mean that, on the heels of the decline of the past few years, this budget will deal the final blow to the existence of venture capital in Canada in any meaningful amounts.

In the last two years, the preponderance of "innovation" spending has been allocated to pure research, in universities and by larger corporations. In other words, our tax dollars have supported ideas. Commercializing those ideas is traditionally performed using venture capital dollars. And here, we continue to let ourselves down.

Rather than providing funds to VCs for investment,the government has channeled money to Crown corporations EDC and BDC to do the job. The result is that today, Canada may well have the largest government-managed start-up portfolio in the world.

It's understandable how we got to this point. Lord love them, the venture capital community are just not successful advocates for themselves. Their pleas for tax reform have been unanswered for years (although stay tuned on that matter). And their positions on issues have shifted with the markets; you will hear many today bemoan the loss of labour-sponsored funds. However, 4 or 5 years ago (when there were too many funds competing for deals), the CVCA was promoting the LSIFs' demise.

But you need to support all parts of the ecosystem to be competitive. There will always be a need of some kind for local venture capital. And in times such as these, when the markets will not support it naturally, government support is required.

The alternative? We can continue to incubate ideas at the expense of developing businesses that can commercialize those ideas. If we do so, we may well become, as one of my larger foreign clients has said, "just a good place to buy an alogrithm."

Tuesday, March 02, 2010

Is CALPERS turning off the VC tap?

A consistent theme in Canadian innovation policy is the need to attract more foreign venture capital to underwrite our local start-ups. This is based on the theory that there is lots of venture capital willing and able to deploy cash north of the border. It's a relativistic theory that is deeply flawed, and as yesterday's Wall Street Journal hinted, one that becoming more foolhardy for the Canadian government to rely upon.

One of the largest sources of funds for VCs and Private equity players in the US has been CALPERS, the largest public pension fund in the United States. CALPERS manages more than $200 billion or so in assets and is reponsible for generating returns that will fund the pension payments to be made to retired California public employees.

In order to generate enough cash to meet these pension obligations, CALPERS typically targets investment that will generate an annual average of 7.75% return on its investments ("ROI"). Generating that level of ROI consistently has led CALPERS over the last 15 years or so to make high-risk, high-yield investments in private equity and venture capital funds. As a result, CALPERS has become one of the largest sources of fuel for the North American venture capital industry, providing more than $25 billion to those fund managers our governmetns hope to attract up here.

However, it now appears that this fuel source may be tapping out. Last year, CALPERS announced that it was reducing the number of funds that it invested in. And yesterday, CALPERS revealed its proposal to reduce the targeted ROI on new investments to 6%.

If adopted, this ROI reduction would allow CALPERS to focus on more traditional, conservative investments - in other words, away from the venture capital funds that Ontario and the federal government are seeking to attract.

This week's federal budget will be an opportunity to assess how self aware Canada's Government is about what will (or can) feed investment in our innovation economy. Will the budget provide the means for local growth? Or will it dangle bait over a drying up river bed?