As anybody involved with a start-up can attest, they are stressful. With constraints on resources and capital and pressures on time, there are many opportunities for disputes & disagreements to arise between the various stakeholders. Professional mediation, which has long been used in other areas such as family counseling and labour relations is becoming an increasingly more popular mechanism to be used for technology business related issues. I recently spoke with Michael Erdle, managing partner at Deeth Williams Wall and director at the Alternative Dispute Resolution (ADR) Institute of Ontario to learn more on the subject. Michael is a Chartered Arbitrator and Qualified Mediator who specializes in business and technology disputes. Again, standard disclaimers apply that this is purely meant as an informational discussion and not meant to imply specific legal advice.

Craig: Thank you for taking the time to speak today. For technology start-ups, what types of disputes would a mediator get involved with?

Mike: Disputes can be internal or external to the company. For example, founders of the company may disagree on the product strategy the company should pursue. Investors may get into a dispute with the company on whether a company should accept a buy-out offer or continue to let the company grow. The company may get into a disagreement with a supplier over project deliverables due to missed milestones or poor quality.

Craig: So in these situations, what typically happens and how is professional mediation coming in to play?

Mike: In any relationship, a small disagreement can easily escalate over time if the two parties stop communicating and lose trust in each other. Often when this happens each party turns to their respective lawyers and things escalate from there. Since start-ups are typically short of money, getting into a protracted legal dispute can be a company killer.

Craig: We’ve seen many times in business where a larger entity uses its financial position to try crush a smaller entity through its ability to hire better and more numerous lawyers, incur the costs as the legal process works its way through courts, etc. Why would the larger entity be interested in entering mediation?

Mike: If any party in a dispute is interested in winning at all costs, then there is not much that will compel them to mediate. But in most cases, cooler heads will prevail. At some point in the relationship between parties, both parties entered into an agreement because they felt it could provide benefit. If things have fallen off the rails, both parties should hopefully still see value in the original premise of the engagement and want to work to get things back on track. If things have gotten to the point where one side feels they must win at all costs (i.e. slighted investors feeling wronged and they want to cause the company to fold), if they are willing to spend time and money they can probably achieve this. However, in addition to the original promise of the investment being wiped out, this will have potentially larger implications in terms of reputation, future business relationships, etc.

Craig: What should companies be doing to better protect themselves?

Mike: In most disputes I get involved with, a small issue snowballs into a large issue. For example, one party is under the expectation to get something from the other party, this is not delivered to the expectation level of the first party, people do not communicate, and time goes by to the point where both parties lose trust, start to take positions, etc. Something as simple as having a board committee or steering committee structure in place to monitor important projects and ensure regular communication goes a long way to catching issues early and preventing them from escalating.

Craig: When would a professional mediator be brought in?

Mike: If a dispute has gotten to the point where the parties cannot find agreement themselves, a neutral third party facilitator or mediator can help find common ground. Building provisions for use of a mediator into contracts is a good practice as it allows either party to step back and suggest mediation as per the contract terms without feeling as if they have ‘backed-down’ by looking for a solution.

Craig: What happens during mediation?

Mike: Most mediation sessions are between a half day to a full day. Everything in the mediation is agreed to be confidential so cannot be used in any future legal proceedings. Each party prepares a brief on what they feel the issue is, what their position is, reasons for their position, and what they would like as an outcome. Both sides and the mediator start in the same room and review their briefs. This gives them the chance to express their positions face-to face. It also allows the mediator to develop a better understanding of the underlying issues and interests of each party. There are often big hidden elements beneath the surface. Generally the principles involved in the dispute do the talking and their respective lawyers take a back seat role just to provide legal advice for specific issues like interpretation of a contract.

After this initial period parties often split into separate rooms and the mediator starts to go back and forth between the parties. This allows for confidential discussions between the mediator and each party over possible options to resolve the issues. The main job for the mediator is to identify the issues where there is deadlock, get parties to look at the problem differently, come up with alternative suggestions on how to approach a problem, and find common ground on which a solution can be achieved.

Most mediations are resolved within the day with only more complex mediations or mediations where there are many parties involved requiring additional time. Sometimes, the parties need to line up other elements to make the proposed solution work. For example, if the settlement of a shareholder dispute is to have one party buy out the other, the buyer may need some time to arrange financing.

The outcome of the mediation is a course of action that both sides can accept and more importantly a re-building of the trust between the parties to provide a firm foundation for future interactions.

Craig: A related discipline is arbitration. Can you talk about this?

Mike: A mediator or facilitator works interactively with both parties to find a common solution. An arbitration hearing is more like a court case where both parties present evidence, and call witnesses. Based on the evidence, the arbitrator will then pick one side as the winner. Arbitration is used where the situation is more defined in nature (i.e. in the interpretation of a clause in a contract). In this, both parties have a position and just want an impartial entity to provide a decision. By going through an arbitrator, the issue can be settled far quicker and cost effectively than if it went through the courts.

Arbitration has been quite commonly used in a business context and many contracts have clauses in them calling for arbitration to be used when there is a disagreement. Mediation or facilitation is a newer discipline for use in business situations that gives parties a mechanism to work through more complicated differences in opinion. This is especially useful when it is important to re-build a broken relationship since both parties see the value in continuing the relationship forward.

Craig: Its been great talking with you today Mike, thank you for taking the time. In my next post I’ll be talking about how to engineer better exits.

craig at mapleleafangels.com

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