Sunday, February 5, 2012

Make sure it is yours!

One of the most important issues for start-ups is ownership of intellectual property. People sometimes get confused and think that the term intellectual property only includes patents and 'things' that can be registered, but it actually also includes source code, ideas, know how, and a lot of other things that cannot be registered.

 Why is that important? Many people come up with the concept for their new company, while working for another company. They then leave their old company, assemble a team and start developing new technology and raise money.

 What's the problem with that? Investors and potential buyers of your company will want to make sure that your new company owns all the IP and no one, including a former employer, can claim ownership. Well, the problem is that most employment agreements and proprietary invention assignment agreements (PIAA) would likely say that anything that you develop during your employment is owned by your employer. There are usually some exceptions, which are mandatory under some jurisdictions, that IP developed by the employee during his spare time, without using the company's property or proprietary information, and which does not compete with the employer, will not be owned by the employer.

So, assuming that you really developed your idea during the weekend and did not use any of your employer’s IP, are you all set if you have the carve- out language? Well, not always. Most people that start new companies don't really start a company in a new field, and in many cases they continue in the same field as their old company. It makes sense.

Therefore, even if they have that language, if the idea covers the same field of expertise as that of the previous employer, the employer may claim that the exception does not apply and that the employer owns the new idea. What's the solution? There are a few ways to resolve this issue.

The easy legal solution, but not practical in some cases, is to obtain a waiver from the old employer. This is applicable if you leave on good terms and while you will work in the same field, your employer is not really concerned that you are competing with him. Another solution, that is some times more difficult to prove, is to establish that the idea that was conceived during employment, was not mature enough and does not qualify as an invention. Obviously, this becomes more difficult to prove if by the time the employee resigns, he already has a developed product or a registered patent. Sometimes employees are successfully able to negotiate in advance carve-outs to their employment agreements which clear that issue in advance; but it will be very difficult to have an employer agree to a carve-out for IP that is in the same field.

If you cannot solve the problems and it is borderline, some investors, but not all, will agree to share some of the risk if you agree to specific IP indemnification, in which you agree to reimburse them, in the event that the this issue comes up. The vast majority will not touch your company if they think that it is a real issue.

The best advice is just to be patient! Don't start working full steam on a new idea before you disengage. Don't register patents and don't take any formal actions!

Thursday, January 12, 2012

Beware the Angel of Death!

Angels investors are great.  Some are better than others, but the vast majority are good for companies and can help the company when no one else can.  They will offer reasonable terms and will be quick to close. The best are the ones who come from industry; they tend to have an understanding of the required patience and can also guide you and introduce you to other investors and experts.  I don't want to discuss them in this post.

I want to discuss the small group of angel investors that you need to beware of.  They come in different shapes and colors, but you can usually identify them in advance.   They usually don't come from the industry, although there are exceptions. The terms that they will offer will be aggressive and one-sided, and sometimes they will require personal liability of the founders.  The valuation will be extremely low and they will want to have control plus direct or back door veto rights in the next round.  The terms will often be more aggressive than VCs, but without the added value or the big bucks.

Angel investment, at least the way I see it, is a leap of faith.  You usually have only a vague idea and a lot of question marks.  This should be reflected in the valuation, but you should not take an investment that almost pushes you out at the seed stage.  Getting to the first VC round after being substantially diluted in the seed round is bad for you and also bad for the company.  Founders with small stakes are not as effective as founders with big or normal stakes and will start thinking about their next start-up.  Investors that don't understand that should not join your company.  The professional angels understand that completely, and will try to make you feel happy and comfortable.

The other things that sometimes happens with the second type of angel investors, is that they will ask for full blown representations.  Not only is this bad for the company, but it is also bad for the angels. People sometimes think that they can give up on reps in the seed round, because it is a small round, the risk is low, and the angels will never sue them.  This would be the correct approach if the impact was only on that seed round.  The issue is simple, the rule of thumb is that next round will piggy back on the representations of the previous round.  So if you agree to aggressive representations in the seed round, there is a good chance that you will meet them again when the big money comes.  And it is bad for the angels as well, because in the next round they will be on the same side as you.

Finally, be careful of any angels that tell you that their agenda is to get to an exit without a VC or major investments.  This cannot be an agenda, even if the angel tells you that it worked for him with his start-up. If you end up building a company bootstrapping all the way, that's great, but it cannot be a strategy.  Keeping 100% of the pie is not a path to success, and most companies need substantial resources and the expertise that VCs have.  I am not saying that you have to take investment from VCs, but make sure that at least after the seed round, you are still in control of the decision making and not the angel.

Friday, August 12, 2011

Am I my brother keeper? It is all about the team!

When a start-up has a good team of founders, the sky is the limit.  Even if the initial product does not fly or is not focused, a good team can turn it around and create the thing that will work.  If you look at most companies, that's their story.  It is all about the team and the founders.

In my experience there are more companies that fail because of interaction between founders than as a result of the technology failing to pick up.  Many times the company goes bust, before the first product is actually developed.  It is more common for first time founders, but they don't have exclusivity on the issue.   It usually happens because of different expectations.  For example, one of the founders has an irrational expectation that the start-up will be sold in a year and he will then move on. When it does not happen, he wants to move to the next project.  Another example is a start-up with too many alpha personalities.  It starts with an unsuccessful model called co-CEOs and ends up with the founders not talking to each other.  Childhood friends are sometimes the best founders, but they are not shielded from this issue.  There is a big difference between dating and living together, and working on a start-up brings out the best and worst of people.  

Founders are really like a married couple, and while you may choose not to have a prenuptial agreement with your wife to be, you need to have that with the other founders.  There are two main reasons for that.  First of all, founders need it to protect themselves from each other, and second the investors will likely want to see that they have something in place and if there isn't - the investors will set the rules.

An agreement between founders touches very core issues, like who does what, initial board structure, whether each person is going to contribute 100% from day one or maybe after the initial investment, and assignment of relevant IP.  Most importantly, it states what happens if someone leaves.  The common practice is to have the shares of the founders subject to reverse vesting for a few years (ranges from two to four).  This means that if the parties agree that the founders’ shares are subject to 3 years vesting, and one of the founder decides that he would like to move on after 2 years, he will only be entitled to 66% of his original shares and he will need to return the balance to the company.  There are always discussions around what happens if a founder is terminated by the company without cause and what happens if he leaves for a good reason.  It is difficult for founders to decide what is good for them, because it not easy to predict who will leave before the term is up.  It is important to keep these terms normal and standard as much as possible.  If the terms are normal, the next round of investors may accept it as is.  If they are not, they may reopen everything, and this may end up not being beneficial of the founder.

It is always great to see founders working on their third and fourth start-up together, but it all starts with the right expectations.


Tuesday, July 26, 2011

Seed Money - Keep It Simple

Money is money.  People use the terms pre-seed, seed, and first round to describe different type of financings. There is supposed to be some correlation between the stage of the company and the type of financing.  It doesn't always work like that.

Many times, I have seen people use these terms to describe the size of the round.  So pre-seed round would generally be up to $300,000-$500,000, seed round would be between $300,000-$1,000,000, and round A would be above $1,000,000.

The size usually also determines the type of equity/securities being issued.  So if it is a pre-seed round or seed round, you should expect to issue a convertible promissory note, which is a debt convertable to shares in the next round of financing.  If it is not a convertible note, it would likely be common stock.  As the amount of the investment increases you may see a right to appoint a director and limited veto rights, but not necessarily.

If it is a round A, you should expect to see all the usual suspects such as preferred stock, anti-dilution protection, veto rights, etc.

The problem is that there are a lot of variations out there.  You could see small investors who would ask to get preferred stock on a $150,000 investment.  You may see professional VCs, who would invest $500,000 without asking for any veto right, except for an oversize preemptive right, just to be there if the startup becomes successful.  You may see a serial entrepreneur who is able to raise $5,000,000 with just a powerpoint presentation.   Try to stick to the usual structures.  If you raise $200,000, you need to keep it simple.  Keep your creativity for the technology, not the legal structures that are more expensive than the round, and will take an hour to explain in the next round.

There are also no rules for valuations.  The only rule I see is that if this is not your first company and you had a great exit before, you will get better valuation on your idea.  A great idea is wonderful, but sophisticated investors know that startups evolve all the time and the initial idea is rarely the end product.  The ability to adjust and adapt is more important than the idea itself and is based, among other things, on experience  You always get more value if this is not your first time.  It is a waste of time to fight it.

Finally, who should you raise it from?  Most people (if not all) who tell me that they don't want to raise from a VC cannot raise from a VC.  If you can raise from a first tier VC go for it.  I know all the stories.  If you cannot raise from a VC go to raise money from angels.  Your family should always be the last resort.  Obviously, if you can get a super angel involved from day one, that's great, but a real-estate mogul who is now interested in social networking because his daughter told him that google+ is great, should not be your first choice, even if the valuation he is offering is higher than that of a VC.

Sunday, July 10, 2011

Starting from basic

So what is it all about? Well nothing really.  I am a corporate lawyer, a partner in one of the largest law firms in Israel.  I am focused on technology clients.  From startups to late stage to public companies.  I see new companies and entrepreneurs all the time.  I love technology and love to see new stuff.   I think I have some knowledge about how to do it right, at least from the law side of things.  Let's start with basic stuff.  The first blog is about incorporation.

First rule - keep it simple.  Stick with ordinary normal corporation.  Forget about LLC, LLP or other structures.  If you want to raise money from VCs or angels, stick with what they know.  If you need to spend 5 minutes explaining why your structure is the best tax structure ever invented, you already lost the war.  There are only certain circumstances where the more complex structures make sense - trust me when I say it - you are not one of them, irrespective of what your father's tax advisor told you.  After you sell 3 companies and you feel you can sell an ice machine to a VC let's talk about it again, okay?

Second rule - don't start developing your company when you are working for someone else. I know this one is a tough one. People usually come up with the idea for their new startup while working for someone else. I get it, but do they really need to incorporate while they work for someone else? They don't. Do they need to file a PCT or a patent application when they work for someone? Not really. Don't register a trademark or a website, before you leave your position. Don't use your current employer laptop or facilities. This will get you in trouble later on.

Third rule - be nice to your old employer before you leave.  Don't piss them off.  You may think that once you left your old company, you don't have to be nice to anybody.  The problem is that there are many cases where you will have to go back to your employer and ask to get a waiver, clarification or something else that your investor will sometime ask as a condition for the investment.  They may not help, but at least you should be in a position to ask.

Fourth rule - if you are starting to work with the other founder before you have a founders agreement in place, at least make sure you guys have signed some document that assigned your IP to the startup. Many founders separate even before they start.  If you had someone write code, make sure he signed a paper that simply said that it is yours.  It will cost you a lot if you don't do it on time.

Fifth rule - don't wait for the first investor to set you straight.  If you don't have an employment agreement, founders agreement, IP assignment form, restricted stock agreement, when the VCs invest, I can promise you that the terms set by the VC will be much tougher than what you could have set by yourself.

That's it for now.  This was not legal advice.