Month: November 2009

Continuing my discussion on start-up legal issues, I met with Rubsun Ho, partner and co-founder of Cognition LLP to discuss term sheets. Again, standard disclaimers apply in that topics covered today are meant as general information only and not meant to imply specific legal advice.

Craig: Rubsun, thanks for taking the time to talk with the readership today. I thought we would talk about term sheets today and walk through some of the common term sheet clauses (see here and here). I’ll provide the (angel) investor’s perspective and you can comment on how this would impact things from the start-up and entrepreneur’s perspective. To start off, let’s begin with the type of deal structure: Equity vs. Convertible debt. What are your thoughts on these two approaches?

Rubsun: From a company’s perspective, I would recommend they try for an equity deal. Although as you and I would both agree, the attractive part of a convertible debt deal is that it postpones the valuation discussion, entrepreneurs need to make sure they have a clear understanding of what they would be giving up with a convertible debt based deal. They should work through the calculations on the accrued interest and the percentage discount and see what the share capital structure would look like if the convertible debenture ran its full course. We have seen cases where this can add a significant amount of shares to the company and thus dilution to the founders. Entrepreneurs should also ensure they understand any covenants placed on the company through the debenture. We have seen term sheets that put in place conditions where the debt can be called (i.e. if the company is not cash flow positive by a certain date).

Craig: So if an equity deal is done, what about common vs. preferred shares?

Rubsun: Again, we’d recommend trying to stick to one share class as it makes it easier to govern. To give a judgement on a preferred share deal, a lot would depend on the additional requirements investors are putting on the preferred share class.

Craig: In today’s climate, investors are putting more emphasis on liquidation preference to give them the greatest chance of getting their money back. This can take the form of terms such as upon sale of the company the preferred shares are paid out first (1x or 2x) and then all remaining proceeds are split pro-rata across all shares. What are your thoughts on this?

Rubsun: Obviously this is what an investor would want. The entrepreneur would need to ensure they work out the implications of this. i.e. run though some scenarios of various acquisition prices and show how the proceeds would be distributed to each shareholder. Depending on the amount of preferred shares issued, having a 2x liquidation preference can dramatically raise the price target that a company would need to be acquired at in order to provide other share classes an adequate payout as well. Investors should also do these calculations as they will want to ensure management still has enough equity incentive to want to stick with the venture. A good way to align management and investors is to have a separate carve out where a percentage of proceeds of an acquisition is reserved for management or to have a clause that eliminates the liquidation preference if the acquisition price is above a certain amount.

Craig: After ensuring they can get a good ROI, maintaining governance and control over the company is next on an investor’s priority list. At the seed stage, often companies do not have a board constituted. Do you have any recommendations as to how to structure the board at the seed level to provide governance but still allow for expansion with future investment rounds?

Rubsun: I would advise companies to start with a board of 3 with at least one of the seats being an independent director and another to represent the investors. As the company secures new investors with new financing rounds, this structure makes it easier to expand the board to include representation from the new investors or to bring on other board members that can help the company at their stage of growth. If you start with a large board at the seed stage, it can be hard to ask people to leave the board down the road when new investors come in.

Craig: In addition to the board and the term sheet outlining actions that require board level approval (i.e. setting the compensation of the management team, approving the annual operating budget), investors sometimes put actions in that require shareholder approval (i.e. entering into debt arrangements or contractual commitments over a certain dollar amount). What are your thoughts on this?

Rubsun: Corporate law requires that some fundamental changes such as creating a new class of shares, changing the company name or selling substantially all of the company’s assets need to be approved by holders of two thirds of the shares and potentially by each class or series of shareholders independently. Apart from these items, it’s usually better to try to push other actions to the board as it may increase the administrative burden on the company to call shareholders’ meetings or track shareholders down to approve resolutions.

Craig: A common reasoning I see when talking with entrepreneurs on valuation & how much money they are looking to raise is for them to start off and say they want to retain 51% of the shares so they retain control and then work back from this to figure out a valuation and how many shares they are prepared to give up in relation to how much money they are looking for. Can you comment on why this is a bad approach?

Rubsun: For the reasons we discussed above, using separate share classes, certain rights and vetos in shareholders’ agreements and through having a controlling number of board seats, an investor can easily structure a term sheet to have ‘control’ of the company while owning less than 51% of the total shares. Entrepreneurs are better to first decide what important areas of the company they want to retain control over and then ensure the term sheet is aligned to this.

Craig: In terms of legal fees, usually the term sheet will state the company pays their legal cost and investor’s legal costs. Any advice on this?

Rubsun: I would ensure there is a cap negotiated on the amount of the investor’s fees that are paid. This will limit the exposure to the company and help ensure investors are motivated to work though the closing process without too much back and forth between lawyers while finalizing the documents. There should also be a clause in on what happens regarding the payment of legal fees if the investment does not close – the entrepreneur would normally want each party to be responsible for its own costs.

Craig: Often companies that are engaging angels for their first outside financing round already have some level of friends, family, founder investment that probably has not gone through a formal investment closing process. Any thoughts on how a company should be handing FFF rounds to make angel rounds go smoother?

Rubsun: The main thing would be to ensure the main legal documents that angels will be looking for (e.g. shareholders agreement, employment contracts, terms of any debt arrangements, option grants) are properly documented and can be shown to the investors as they start their due diligence process. This will give investors more comfort and not have to react to ‘surprises’ late in the due diligence process such as finding out some prior FFF investment was actually a debt arrangement compared to common share equity, or that it is unclear what equity or options have been promised to whom.

Craig: With the dearth of funding sources available, what advice would you have to companies when they are presented with a term sheet that has clauses in they do not like. Are they stuck in a ‘take it or leave it’ situation?

Rubsun: The best thing a company can do is ensure they are in the strongest position possible by being a solid investment opportunity and to be in a position where they have multiple options for funding (i.e. other investors, bootstrapping, etc). Regardless, the company should approach an investment negotiation just as with any negotiation. If there are terms they are not comfortable with, they should go back to negotiate and understand the root concerns of the investor that are behind the terms. Often the investor’s concerns can be addressed using another mechanism that is more palatable to the company.

Craig: Any other closing thoughts?

Rubsun: Having a ‘drop dead’ date for the investment to close would be a good idea. This gives both sides the incentive to wrap up the investment so it does not become a distraction to management in growing and operating their business, and it doesn’t allow the investors to delay in committing to the company while they wait to see how the operating results are progressing.

Craig: Well, great talking with you today Rubsun, thanks for you and Joe taking the time to speak to the readership on these topics.

craig at mapleleafangels.com

I thought I would write a couple of posts on legal issues start-ups should be aware of early in their lifecycle. In particular I wanted to cover some issues, that if not handled correctly, can have a detrimental impact at a later stage in the company’s life such as when they are looking for outside financing.

I recently met with Joe Milstone, partner and co-founder of Cognition LLP. Cognition is quite active in the start-up space in Toronto. They work with start-ups by offering a dedicated lawyer to act in the role of in-house counsel on a fractional, as-needed basis, and at a cost that is about a half to a third of a more traditional business law firm.

Craig: Joe, thanks for taking the time to talk with the StartupNorth readership today. Before we start, I guess we should get the formalities out of the way by stating everything we will cover today is meant as general information only and not meant to imply specific legal advice. For this post, I thought we would talk about intellectual property. From an investor standpoint, intellectual property can be a very strong factor in how an investor values a company and forms a big part of their decision in the company’s investment worthiness. When people think about intellectual property, the first thing that probably comes to mind are patents. However, there are many other aspects relating to the ownership of intellectual property that a start-up needs to ensure are in properly place, correct?

Joe: That’s right. Most start-ups will use their own employees, outside consultants, and external vendors to help create a product. Intellectual property ownership rights need to be clearly spelled out in all of these relationships to ensure when a company goes to file a patent, seek investment or often even to complete and comply with their own sales and marketing documentation, that there is no possibility that an outside entity can stake claim to their intellectual property. We work with companies when they are at the stage when they are looking for angel or VC financing and also when they are targets of acquisition. We know that investors or acquirers will look for this in their due diligence so we advise our clients to ensure they have a strong foundation from the start.

Craig: Ok, let’s start with employees. If you have an employee on payroll, doesn’t general law cover this off and give the employer rights to any intellectual property they may develop while employed?

Joe: That is correct as a broad and general proposition, however it is best practice to get an employment agreement in writing that will cover off this and other aspects that can have a determinant on the success of a company. For example, there are certain slippery residual rights that all inventors of intellectual property retain, whether they are employees or not, and that if not handled correctly, can impede what a company can do with the intellectual property. Also, without a specific employment agreement there will be more grey areas that everyone wants to avoid. Like what if one of their employees works on their own computer/equipment on their spare time – the employee may stake claim that some of the intellectual property is his or hers. Additionally, we have also run into situations where everybody in the company has an employment agreement except the founder. This covers the founder’s interests when he or she owns all of the shares, but when outside entities are looking to make an investment, they are obviously investing in the company as an entity, not the founder.

Craig: What about non-competes?

Joe: From a company’s standpoint, the knee-jerk reaction is to seek a broad non-compete clause if it ends a relationship with an employee. However, this is usually counterproductive, because courts believe fundamentally in the rights of people to work wherever they want. As a result, courts have a strong aversion to enforce almost any non-compete against an employee unless it is framed reasonably narrowly so as to address a specific business concern that can’t be protected in other ways. A company would be better off to have a very tailored and proportional non-compete clause that outlines specific timeframes, geographies, narrowly defined businesses, etc. Even better and more likely to be upheld is the use of other mechanisms to achieve generally the same results such as non-disclosure agreements and non-solicitation covenants with respect to employees, customers and even key suppliers of the company.

Craig: Start-ups often use flexible compensation structures in the early days when money is scarce (i.e. giving people below market salaries in exchange for equities). Any comments on legal aspects around this?

Joe: Ideally in those situations, there should be a cash component and the company should ensure that the market value of the overall compensation is sufficient to ensure that the employee has received adequate consideration in exchange for him or her agreeing to be bound by any non-competes, non-disclosure and IP assignments. The main thing is to get the relationship properly documented so both sides have a record of what kind of ownership is actually being provided and on what terms, and so the company can document and comply with corporate and securities legal requirements. Also, companies should ensure that the value of any services they receive is roughly equal to the fair market value of the shares that they grant in return. This is important from a corporate governance perspective as well as a tax perspective, and companies should avoid the temptation to entice an employee by back dating share grants to a period when the market value was lower.

Craig: Any other issues around the topic of employees / employment agreements?

Joe: The other thing would be around termination (either by the company or employee). Notice and severance period should be spelled out so both sides are clear on what their responsibilities are and so, from the company’s perspective, it can set and minimize its exposure. If the wrong language is used, the company can be exposed to a multiple of four or five times. If the employee has stock options, it should be carefully spelled out what happens to unvested options as well as the exercise of vested options. This can often vary depending on whether the notice period is or is not treated as part of the term of employment, and again there is careful language that has to be used to get it right.

Craig: Moving on to consultants and outside vendors, in today’s outsourced business model it is pretty common that start-ups will use outside entities in the development of their offerings. What should start-ups be aware of?

Joe: Dealing with intellectual property ownership is critical with outside entities such as consultants and vendors, because by definition they are separate business entities from the company offering their own distinct services and sometimes products. Each consultant or vendor contract needs to clearly spell out proper IP transfers , waivers and other cooperation and assistance. Unlike employees where the employer has default ownership of the intellectual property, this is not the case for vendors and consultants, so the scope and phrasing of the contractual inclusions is even more paramount.

Craig: Start-ups often hire people on as consultants vs. employees to reduce exposure to EI/CPP payments, wrongful dismissal, etc. Have you seen any issues with this?

Joe: The biggest issue is with the Canada Revenue Agency. They have published a guide as to how they will examine a situation to determine if a consultant is actually an employee, but the criteria often don’t point all in the same direction. Start-ups should ensure their consulting agreements and arrangements fit into the guidelines outlined by the CRA. Otherwise, simply calling someone a “consultant” won’t cut it. If a start-up has been using a consultant on a consulting basis that the CRA determines is actually an employee relationship, the start-up will be exposed to fines. The other issue is to realize that a true consultant is by law an “outside” entity, meaning that more tailored and elaborate IP provisions are necessary, and also that the company has to be mindful of such relationships when entering into non-disclosure agreements, joint ventures, privacy policies and the like, particularly where that consultant will be involved and will receive sensitive information. For example, a consultant will not be bound to a NDA that a company signs with another commercial party, meaning that those terms need to be properly “flowed through” to the consultant’s company and often the consultant individually too.

Craig: A lot of good information here, thanks again for taking the time today Joe. In my next post, I’ll be talking with Rubsun Ho, also from Cognition, to discuss term sheets from an entrepreneur’s point of view.

craig at mapleleafangels.com

In today’s challenging times it is a strong possibility that companies/investors may be faced with a cram-down financing round. Depending on how well or not well this is handled can have a big bearing on the future success of the company and the investor’s potential for return. So what does this mean?

Here is how a typical scenario would go:

• An early stage company is seeking funding to get their company to the next stage (i.e. get their initial prototype to market, achieve cash flow break even, expand to the US, etc).
• They do pitches to investors and close out an investment round.
• Everybody is happy and optimistic of future success.
• According to management’s ‘conservative’ projections the funding will allow them to execute their plan to reach a milestone (say cash flow break even) in 8 months.
• 7 months later, the investment group is told things have gone slower than expected and the company needs to raise more money to meet their original milestone.
• The investors, having not been engaged, decline to put more money in.
• The company finds another set of investors that is willing to put money in, but only under their terms.

Such terms can include:

Lower valuation – the new investors’ shares are priced cheaper than the previous round shares. This means the new investors will get a larger stake in the company based on the amount they put in compared to the previous investors. Previous shareholders have a smaller percentage of ownership and their holdings are worth less than when they closed their financing round.

Board seats – the new investors may require the current board to be dissolved and re-constituted with a composition that allows them to control the board.

Management – the new investors may require the current CEO to step down and be replaced with a CEO of their choice.

Liquidation preference – the new investor’s shares will receive liquidation preference. In other words, on sale or wind-up of the company, the new investor’s shares are paid out first (could be 1x, 2x, etc) then the remaining proceeds are pro-rata split (i.e. if things go south, the new investors will ensure they get their money out).

So you ask, what about the previous round’s term sheet that you collectively spent hours negotiating and thousands on legal bills? There could have been very well thought out anti-dilution and control mechanisms. However, the new investors will simply state their investment is depending on prior shareholders forfeiting their rights in the old term sheet. The existing shareholders can either refuse to sign and most likely the company will run out of money and go bankrupt or accept the conditions of the new investors.

At best case, the company closes the deal and lives on. However, the investors are not happy since their investment is not on favourable terms and the management, if they have not been replaced, are under control of the new investors.

The way to be more proactive is to:

a) Ensure there is a good investor management program in place where investors are kept apprised of the successes and failures of the company.

b) With an engaged investor base, start the ground work early to plan for potential future financing rounds. Ensure investors are kept up to date with the realistic future funding requirements the company is facing and get a feeling for current investors’ appetite for participating.

c) Leverage investor’s networks to tap into co-investment initiatives between angel groups.

Bryan Watson, executive director of the National Angel Capital Organization sums it up nicely:

“At the recent National Angel Summit the panel called Co-Investment – Taking It To The Next Level discussed this topic. This is a real concern for many Angel investors they often represent some of the first outside money invested into a company.

The panelists noted that operational failure is understandable in an investment. That is, even though best efforts were put in, the company failed because of the market, team, technology, etc. What is unacceptable, the panel noted, is financial failure where Angels are crammed down because they didn’t reserve enough capital to participate in future rounds.

Through co-investment, Angels are able to syndicate with more investors and, while still raising significantly sized rounds, ensure they retain enough capital in reserve to ensure that when the next round of funding comes along they have the capital to participate and avoid being crammed down.”

craig at mapleleafangels.com