The purpose of this post is expand upon my answer to the question on Quora:

“What should you do as a startup when a Bay Area VC insists that you use their expensive legal counsel?”

Mark Suster, a VC at GRP Partners, has also written and spoken about how he likes to “share” his legal counsel with the startup in which he is investing.  My advice to entrepreneurs is clear: push back hard on this issue and choose your own strong, independent legal counsel – i.e., a law firm that’s going to work hard to protect you and watch your back.

Types of Conflicts of Interest

There are two types of conflicts of interests that need to be addressed when startups are pressured to use an investor’s law firm: ethical and business.

Ethics Rules.  Potential conflicts of interest that arise in the course of a law firm’s delivery of legal services are governed by applicable State Bar ethics rules, with which lawyers are required to comply.  As the Preamble to the ABA Model Rules of Professional Conduct provides in relevant part:

In the nature of law practice . . . conflicting responsibilities are encountered. Virtually all difficult ethical problems arise from conflict between a lawyer’s responsibilities to clients, to the legal system and to the lawyer’s own interest in remaining an ethical person while earning a satisfactory living.  The Rules of Professional Conduct often prescribe terms for resolving such conflicts. Within the framework of these Rules, however, many difficult issues of professional discretion can arise. Such issues must be resolved through the exercise of sensitive professional and moral judgment guided by the basic principles underlying the Rules.  These principles include the lawyer’s obligation zealously to protect and pursue a client’s legitimate interests, within the bounds of the law. . . .

In the event there is a potential conflict of interest between or among clients, most State Bar ethics rules require each client to consent in writing to the attorney’s representation — after full disclosure and consultation.  Indeed, each client must be able to appreciate the situation and have enough information to make a reasonable and informed decision as to whether or not the legal counsel can provide fair representation.  The consent of the client must also be entirely voluntary and not given under any pressure whatsoever, by the attorney or anyone else.

Business Conflicts.  Assuming that law firms are complying with the foregoing ethics rules, there is another issue that needs to be addressed: inherent business conflicts of interest.  This, to me, is the crux of the problem with entrepreneurs using law firms that also represent the investors.

As I noted on Quora, for many of the big Silicon Valley law firms, the venture capital firms are their gravy train and the big law firms need to play ball with them.  This is not to say that any lawyers at these firms are unethical (or that the law firms are not complying with applicable State ethical rules).  Instead, this is about the realities of the economics.

Let’s take a simple example:

Vinny VC meets with Eric Entrepreneur and gets very excited about Eric’s new venture; so excited, in fact, that a few weeks later Vinny presents Eric with a term sheet for a $750K seed financing.  Vinny advises Eric that this is his standard term sheet for seed financing and recommends that he retain Larry Lawyer at the ABC Law Firm to process the documents.  “Larry is great,” Vinny explains, “and we have some lightweight seed documents that we have put together with Larry’s law firm and used with other startups, which will make the process relatively quick and inexpensive.”

“Sounds good,” Eric says, and he meets with Larry Lawyer and signs an engagement letter (with the appropriate waiver of any potential conflicts of interest).  Now here’s the problem:

If Larry Lawyer and his firm are being sent a lot of work from Vinny VC and his firm, Larry is obviously not going to rock the boat and start pushing back on any key issues.  Why?  Because if he does, Vinny will just send his future work to the five other lawyers on his list.  This is not to say anyone is unethical here – this is just common sense.  Vinny wants his deals done quickly and cheaply (and on the forms that Vinny and Larry have created); and Larry wants Vinny to send him lots of legal work.

Accordingly, (i) Larry Lawyer is not going to suggest to Eric Entrepreneur that he talk to other investors and test the market prior to executing the term sheet; (ii) Larry is not going to raise issues such as doing convertible debt in lieu of a preferred stock financing; (iii) Larry is not going to push back hard if the liquidation preference includes some form of participation; (iv) Larry is not going to push hard to cut back on any of the protective provisions; and (v) Larry is not going to suggest that the company doesn’t need investor representation on the Board at this early stage.  In short, Larry is going to play ball because if he doesn’t, Vinny VC will stop calling.

As Antone Johnson, a smart startup lawyer, aptly points out in the comments to the Quora question:

My former firm ([Wilson Sonsini]) gets accused more often than any other of being in the pocket of the VCs, thanks to the “gravy train” alluded to in Scott’s answer.  It does have a vested interest in maintaining strong positive relationships with the VCs that feed it deal after deal.  I never met a lawyer there who wasn’t cognizant of his or her duties to represent the client zealously (meaning the company, not the investor), but I did feel there was a tacit understanding that pissing off the VCs would be a bad career move.

The M&A World

This inherent conflict of interest is not relegated to the VC world.  Indeed, I experienced it first-hand shortly after moving to California — when I got pulled onto an M&A deal at an LA law firm that I had just joined.

The managing partner of the firm was good friends with a middle-market investment banker, who recommended our firm to the client in connection with a complex leveraged buy-out.  I was tapped to quarterback the deal in light of my strong M&A experience in New York.

You have to understand that a middle-market i-banker’s entire year can be made or broken based on whether or not he can close one or two deals.  Indeed, he only gets paid if the deal closes.  Accordingly, like with the VC’s “recommended” or “preferred” legal counsel, we were supposed to play ball and make sure the deal closed so that the i-banker got paid.

Unfortunately, I’m not very good at playing this kind of ball – particularly when there were significant environmental issues that were not being adequately addressed.  The i-banker wasn’t too happy and, in fact, stuck his finger in my chest and warned:  “We’re going to get this deal done despite you fuck’n lawyers.”  He then vigorously complained to the managing partner that I was blowing-up the deal because I had retained special environmental counsel from my old New York City law firm and we were pushing too hard on the environmental indemnity.

Good work by the i-banker (and cheers to my former managing partner) for getting the deal closed by watering down the environmental indemnity: less than six months later our client’s company was indicted for significant environmental problems that it had assumed (by operation of law) as part of the acquisition.

Conclusion

Look – my goal here is not to point fingers and claim that anyone is being unethical or doing something wrong; this is the way business works.  There are inherent conflicts of interest in certain business relationships, and entrepreneurs need to have someone in their corner to point that out to them and to watch their back.  I am proud to play that role.

This week, we present legendary angel investor Ron Conway (commonly referred to as the “Godfather of Silicon Valley”) and super angel Mike Maples (managing partner of Floodgate).  In this interesting, three-minute clip (courtesy of Stanford University’s Entrepreneurship Corner), Ron and Mike provide strong, practical advice to startups, including the importance of (i) a low burn rate, (ii) a “lean, mean” team and (iii) a customer development strategy.  I hope you enjoy it.  Many thanks, Scott

Welcome to our weekly series entitled “Motivational Clips for Entrepreneurs.”  Each week, we post a short video clip to inspire and motivate our fellow entrepreneurs.  Why?  Because it’s fuckn tough being an entrepreneur; and whether you’re launching your venture, trying to execute your business model or trying to raise funds, you need a little juice to help you push the ball forward.  I hope these videos are a little juice.  Cheers, Scott

www.youtube.com/watch?v=pem0ZSsMQVA

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

I’m the founder of a mobile apps startup, and we’re starting to get some incredible traction.  I’ve been bootstrapping the venture for the last year, but I’d really like to raise about $2 million to scale this thing.  If a VC invests $2 million, what percentage of the company will he own?

Answer

It depends upon the value of your company prior to the investment (commonly referred to as the “pre-money valuation” or “pre”).  For example, if the pre were $4 million, the VC would get one-third ($2,000,000 divided by $6,000,000); on the other hand, if the pre were $1 million, the VC would get two-thirds ($2,000,000 divided by $3,000,000).

As you can see, the VC’s percentage ownership is calculated by dividing the amount of its investment by the post-money valuation of the company (which is equal to the pre plus the amount of the investment).

The real issue then is — how do you determine the value of your company prior to the investment?  Let’s look at that.

I come from the M&A world in New York, where the valuation of target companies was more science than art.  Indeed, targets were valued based upon a number of different methodologies, the most significant of which is the discounted cash flow method (DCF).  As discussed in this excellent article from the Darden Graduate School of Business, DCF basically estimates the net present value of the target’s future cash flow, discounted to reflect the Weighted Average Cost of Capital or “WACC” (which, in simple terms, is the risk).

In the startup world, however, DCF doesn’t work because there is little or no historical financial data and projected cash flow is thus pure speculation.  Accordingly, the valuation of startups is highly subjective and is more art than science.  To put it bluntly: your startup is worth whatever the market says it’s worth, which was starkly demonstrated during the dot-com bubble and subsequent crash.

So what does this all mean in practical terms?  It means you need to get out there and effectively pitch a handful of VC’s in your space and get them excited about your venture.  By doing so, you can, in effect, drive the market by creating a competitive environment and playing the VC’s off of each other.  This is akin to what investment bankers do when they’re selling a company: they create a competitive environment (or the perception of one) to drive-up the purchase price and to provide negotiating leverage.

As legendary investor John Doerr, a partner at Kleiner Perkins, notes in the video I posted on Monday, “Helping Entrepreneurs Succeed: John Doerr”: “Valuations and how way to negotiate them?  I think the best thing to do is to talk to two or three venture capital groups at once – at the same time; not ten, but three.”

That being said, you should be aware of the following caveats:

• Creating a competitive environment and playing VC’s off of each other is very tricky and best done with the help of an experienced lawyer and/or consultant.

• At the end of the day, you will still need to convince the VC’s that you can deliver a 10X return (i.e., that they will make 10 times their investment).  VC’s will thus take into account certain significant factors such as the quality of your management team, the size of your market, etc.

• As I have previously discussed, startups often make the mistake of focusing too much on valuation.  Indeed, there are other important terms that affect the economics of a financing, including the liquidation preference and the size of the option pool.

Conclusion

I hope the foregoing was helpful.  And if you’re wondering how to get a meeting with a VC, I briefly discussed this issue in my post “Ask the Attorney: What Are the Most Common Mistakes Startups Make Dealing with VC’s?” (see #1).  In a nutshell, you need to hustle and build relationships so that you can get a “warm” introduction — i.e., an introductory phone call/email from a middleman or woman whom the VC trusts and respects; it takes tenacity and resourcefulness – qualities that every great entrepreneur possesses.

This week, we present legendary investor John Doerr, a partner at Kleiner Perkins.  Eric Schmidt calls John “one of Google’s best board members”; and Jeff Bezos noted that “Doerr (and Kleiner) is the center of gravity in the Internet.”  In this interesting, one-minute clip from 2005 (courtesy of Stanford University’s Entrepreneurship Corner), John discusses how to negotiate valuations with VC’s and related issues.  

I included this clip as a supplement to my blog post today on VentureBeat in which I advised entrepreneurs that: “[Y]ou need to get out there and effectively pitch a bunch of VC’s in your space and get them excited about your venture.  By doing so, you can, in effect, drive the market by creating a competitive environment and playing the VC’s off of each other.”  Many thanks, Scott

Welcome to our weekly series entitled “Motivational Clips for Entrepreneurs.”  Each week, we post a short video or movie clip to inspire and motivate our fellow entrepreneurs.  Why?  Because it’s fuckn tough being an entrepreneur – and whether you’re launching a venture, trying to execute on your business plan or pitching investors, you need a little juice to help you push the ball forward.  I hope these videos are a little juice.  Cheers, Scott

www.youtube.com/watch?v=T6MhAwQ64c0

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

I’m the co-founder and CEO of an e-commerce startup, and I’ve been meeting with different VC firms regarding an initial round of funding.  I’ve started doing some reading on term sheets and the issues we will need to address, and I’m a little confused with some of the VC terminology.  Could you please explain to me what a liquidation preference is and how we should negotiate it.  Thanks!

Answer

Welcome to the world of venture capital.  A liquidation preference is one of the essential components of preferred stock and is generally considered to be the second most important deal term in a VC investment (the first being the company’s valuation prior to the investment, commonly referred to as the “pre-money valuation” or “pre”).

Let’s start with the basics:  A VC investor will be issued shares of preferred stock, not shares of common stock.  Preferred stock, as the name suggests, is preferable to common stock because it grants certain key rights to the preferred stockholders – making it far more valuable than common stock.  One such right is a liquidation preference.

The word “liquidation” is broadly defined in the VC documentation to include not only the actual liquidation of the company (i.e., the disposition of the company’s assets) upon dissolution or bankruptcy, but also the sale of the company (whether via stock, assets or merger) to a third party or a change of control.

The word “preference” flows from “preferred” and means that the shares of the preferred stock will have a priority over (i.e., will be treated better than) the common stock in the event of a liquidation.  For example, in bankruptcy, once the company’s creditors have been paid off, any remaining assets would be distributed to the holders of the preferred stock prior to the holders of the common stock.

Similarly, if the company were sold, the proceeds of the sale would be distributed first to the holders of the preferred stock and then to the holders of the common stock, based upon the terms of the liquidation preference.

There are three types of liquidation preferences:

• Straight (or Non-Participating) Preferred – this liquidation preference is most favorable to the company/founders.  Upon the sale of the company (or any other liquidation), the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders.  Alternatively, the preferred stockholders could choose to convert their preferred stock to common stock and simply be treated the same as the common stockholders (i.e., share ratably in the proceeds).

• Participating Preferred – this liquidation preference is most favorable to the investor (and is sometimes referred to as “double-dip preferred”).  Similar to straight preferred, the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders; however, the preferred stockholders would then also be treated like common stockholders and would share ratably in the remaining proceeds – thus, in effect, being paid twice (or “double”).  Indeed, issuing participating preferred has the same economic effect as issuing a promissory note and shares of common stock (or a warrant) to the investor.

• Capped (or Partially) Participating Preferred – this liquidation preference is often viewed as an intermediate approach.  The preferred stockholders have the same rights as participating preferred (i.e., return of investment, plus share ratably in the reminder), but their aggregate return is capped; once they have received the capped amount, they no longer have the right to share in the remaining proceeds with the other common stockholders.

Fully participating preferred is the exception (about 20% of the deals today) — particularly in the Series A round of funding.  You should thus push hard for a straight preferred liquidation preference and settle for capped participation as a fallback position.  Remember, whatever you agree to with your initial investors will carry forward to future rounds; that’s why fully participating preferred should be avoided.

As part of the negotiation of liquidation preferences, there is also a concept called a “multiple” (e.g., “2X multiple,” 3X multiple,” etc.).  Watch out for this one!  It means the preferred stockholders are entitled to a multiple of their original investment (e.g., double or triple the amount) before the common stockholders get anything.

Based on the foregoing, it is imperative that, before you agree to any participating preferred and/or multiples, you should require the VC to run spreadsheets/models demonstrating how much you and the other founder(s) will receive based on various sales price scenarios.  For example, if your company were sold for $40 million, and the VC had invested $5 million for one-third of the company, with a 2X participating preferred, the VC would receive $10 million off the top (not including any accrued dividends, if applicable), plus another $10 million (one-third of $30 million), for a total of $20 million.

The VC would thus receive 50% of the sale proceeds even though it only owned one-third of the company.

Conclusion

I hope the foregoing is helpful.  My colleague, Susan Morgan, has actually created proprietary software to help entrepreneurs create spreadsheets relative to liquidation preferences and the amount of proceeds they would receive under different sales scenarios.  Indeed, liquidated preferences (particularly when they are stacked onto different series of Preferred Stock) can be quite difficult to understand – until it’s too late.

This week, we present Marc Andreessen, a brilliant entrepreneur and co-founder and general partner of the venture capital firm, Andreessen Horowitz; he is also co-founder and chairman of Ning.  In this interesting, three-minute clip (courtesy of Stanford University’s Entrepreneurship Corner), Marc discusses (i) how to attract top talent to your startup and (ii) the hiring process generally.  I hope you enjoy it.  Many thanks, Scott

Welcome to our weekly series entitled “Motivational Clips for Entrepreneurs.”  Each week, we post a short video clip to inspire and motivate our fellow entrepreneurs.  Why?  Because it’s fuckn tough being an entrepreneur – and whether you’re launching a venture, trying to execute on your business plan or pitching investors, you need a little juice to help you push the ball forward.  I hope these videos are a little juice.  Cheers, Scott

www.youtube.com/watch?v=LsKDGM5KTBY

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.

Question

My co-founder and I are getting some traction on our new site, and we would like to raise some money from angels to hire a marketing guy and for a couple of other projects.  One issue that has come-up is IP.  We don’t have any IP documents.  All we have are the corporate papers we got from LegalZoom.  Could you give us some guidance about IP issues.  What are some of the mistakes that you’ve seen startups make regarding IP?

Answer

For many start-ups, intellectual property (IP) is their most valuable asset.  Here are the five biggest mistakes I’ve seen startups make regarding their IP:

Mistake #1 – Moonlighting at a Prior Employer.  Startups must ensure that none of the founders’ prior employers have any rights to the venture’s IP because a founder was “moonlighting” while previously employed.  This is a particular concern if the startup is in the same space as a founder’s prior employer.  Even a founder’s use of a prior employer’s computer or telephone in connection with the new venture could be a problem.

Accordingly, each founder should carefully review any agreements with his or her prior employer (e.g., an offer letter/employment agreement, a confidential information and inventions assignment agreement, a stock options agreement, etc.) and the employee handbook to determine if there are any provisions that may give the prior employer rights to the startup’s IP.  Founders should also make sure that when they leave their prior employer they don’t take anything with them (e.g., electronic files, prototypes, customer lists, etc.).

Under California law (regardless of what the agreements or other documents say), an employee owns any “invention” that that he/she developed entirely on his/her own time without using the employer’s equipment, supplies, facilities or trade secret information, except for those inventions that either: (i) relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or (ii) result from any work performed by the employee for the employer.

Mistake #2 – Not Assigning to the Company Any IP Created Pre-Incorporation.  A common mistake startups make is not assigning to the company in writing all of the IP that was created or acquired prior to the company’s incorporation.  Any IP created or acquired by a founder (e.g., code or a domain name) prior to incorporation is typically assigned to the company as part of the founder’s restricted stock purchase agreement or subscription agreement.

Indeed, the IP is usually contributed or assigned by founders as full or partial consideration for the shares of common stock issued to them in a tax-free transaction under Section 351 of the Internal Revenue Code.  A problem arises, however, if one of the founders leaves prior to incorporation and takes his rights to certain IP along with him.

Another problem often arises with respect to IP created pre-incorporation by outside developers or consultants (i.e., non-founders), particularly if the developers or consultants are located outside of the United States.  The IP created often never gets assigned to the company at all either because there was no written agreement or because the company was not a party to the agreement (because it did not exist at the time).

Mistake #3 – Not Executing Confidential Information and Invention Assignment Agreements.  Once the company has been formed, the ownership of the IP should be protected by requiring all of the Company’s founders, employees and consultants to execute confidential information and invention assignment agreements.  Unfortunately, a lot of startups do not require founders, employees or consultants to execute this kind of agreement and run into significant problems with respect to IP ownership.

IP-ownership problems often arise in the context of an angel or VC financing, when the investors are unable to establish a clear chain of title to the startup’s IP as part of their legal due diligence investigation.  Chasing down third parties to execute invention assignment agreements in the context of a financing is not a prudent business approach.

Mistake #4 – Infringing on Another Company’s Trademark.  Another common mistake startups make in connection with their IP is infringing on another company’s trademark.  A trademark is a word, name or symbol etc. that is intended to distinguish a company or product (e.g., Google, Amazon, Zappos); in short, it’s a brand name.  A startup may not use a name or mark that is “confusingly similar” to a name or mark used by another company.

Just because a startup is able to register a certain domain name (or a corporate name in the State of its incorporation) doesn’t mean that it has the right to use a particular trademark.  This is a common misconception.  In order to have the legal right to use a trademark, a company must either (i) be the first to use the mark in interstate commerce or (ii) be the first to register the mark with the U.S. Patent and Trademark Office (USPTO), whichever comes first.

It is therefore very important that startups consult with IP legal counsel early on or, at a bare minimum, do a Web search and a search on the USPTO site to determine whether their use of a particular word or name will possibly infringe on another company’s trademark.  The last thing a startup wants is to start getting some traction and then get nailed with a trademark infringement lawsuit.

Mistake #5 – Not Developing and Implementing an IP Protection Strategy.  Finally, another big mistake that startups make (particularly technology companies) is not developing and implementing an IP protection strategy.  If a startup’s most valuable asset is its IP/technology, it is self-evident that reasonable steps must be taken to protect that asset.

Many entrepreneurs do not understand that IP protection comes in different forms, and one size does not fit all.  For example, “trade secret” protection may be a more effective method to protecting software than a copyright or a patent; or perhaps using all three is an even better option.  The bottom line is that founders of technology companies need to sit down with experienced IP counsel and identify all of their startup’s IP.  They then need to come-up with an effective, reasonably-priced strategy to protect their IP assets.

Conclusion

I hope the foregoing is helpful.  If you have any questions, please ask them in the comments section – or feel free to email our new IP specialist Terry Thomas at tthomas@walkercorporatelaw.com.  Many thanks, Scott

This week, we present David Heinemeier Hansson, who is the creator of the Ruby on Rails web development framework, a co-founder of 37signals and the co-author of the best-selling book Rework.  In this interesting, three-minute clip (courtesy of Stanford University’s Entrepreneurship Corner), David discusses the problem with accepting venture capital funding.  I hope you enjoy it.  Many thanks, Scott

www.youtube.com/watch?v=IqdtzJvliMk

Welcome to our weekly series entitled “Motivational Clips for Entrepreneurs.”  Each week, we post a short video or movie clip to inspire and motivate our fellow entrepreneurs.  Why?  Because it’s fuckn tough being an entrepreneur – and whether you’re launching a venture, trying to execute on your business plan or pitching investors, you need a little juice to help you push the ball forward.  I hope these videos are a little juice.  Cheers, Scott

www.youtube.com/watch?v=suAmkLn1VIQ

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat; below is a longer, more comprehensive version.  Please feel free to call me directly if you have any questions (415-979-9998).  Thanks, Scott

Question

My co-founder and I are crushing it, and we’re getting ready to approach VC’s for some cash.  We’re both first-time entrepreneurs, and we don’t want to make any rookie mistakes.  What are some of the common mistakes that you’ve seen guys like us make dealing with VC’s?

Answer

Obviously, that’s a pretty broad question.  Here are five quick ones:

1) Cold Calls.  One of the classic rookie mistakes is cold-calling or emailing a VC you don’t know personally; in short, you’re wasting your time.  The only way you will get a meeting with a VC is through a “warm” introduction – that is, an introductory phone call or email from a middleman (or woman) whom the VC trusts and respects.

The ideal middleman is a successful entrepreneur whom the VC has backed; investors can be good middlemen; and lawyers, accountants or recruiters may also be helpful.  As the guys at Venture Hacks so aptly put it in their book Pitching Hacks: “Getting an introduction is a test of your entrepreneurial skills.”

2) Not Doing Your Homework.  Startups often make the mistake of not doing their homework regarding the different VC firms.  Prior to approaching middlemen to make introductions, you first need to do some research and figure-out which VC firms are a good fit for your startup based on a number of different factors, including (i) their space/industry focus, (ii) their investment criteria, (iii) their fund size, (iv) their geographic focus, (v) their “sweet spot” and (vi) their track record.

You also need to do your homework (including speaking to other founders) with respect to the particular partners with whom you are interested in working, including determining their reputation, domain expertise and capacity to take-on a new deal.  (See paragraph #3 of my post “Angel Financings: Legal Tips for Entrepreneurs – Part 1.”)

3) Requesting an NDA.  Another classic rookie mistake is asking a VC to sign a Non-Disclosure Agreement (“NDA”); it ain’t going to happen.  VC’s are inundated with business plans and executive summaries and are constantly talking to entrepreneurs whose ideas may be similar to yours.  Indeed, there is no way a VC is going to risk getting sued as a result of funding a startup with a similar idea or business plan to yours.   Moreover, they would need to hire a lawyer to review and negotiate NDA’s – which from their perspective is a waste of time and money.

To the extent you have any “secret sauce” or proprietary technology that you’re concerned about disclosing, you should just not share it with the VC.  (I discuss NDA’s in detail in my post “Ask the Business Attorney: Non-Disclosure Agreements.”)

4) Obsessing Over Valuation.  Another common mistake startups make is focusing too much on valuation.  Obviously, the pre-money valuation (or “pre” as it is commonly referred to) of the company is an important deal term; however, inexperienced startups make the mistake of obsessing over pre – and will often a sign a term sheet with the VC firm that gives them the highest pre.

This is the wrong approach for two significant reasons: first, there are other important terms that affect the economics of a financing, including the size of the option pool and the liquidation preference; and second, a top-notch VC firm (like a Sequoia) can add extraordinary value to a venture.  Thus, even if they come in with a lower pre than another VC firm, a smaller piece of a huge pie is better than a bigger piece of a little pie.

As Alan Salzman and John Doerr note in Chapter 7 of the book, Startup and Emerging Companies: “Unfortunately, those actively involved with start-up companies encounter numerous instances in which the focus on [valuation] is somewhat out of balance and tends to prejudice the discussions with venture capitalists.”

5) Not Retaining Strong Counsel.  Finally, rookies often make the mistake of trying to negotiate VC term sheets (or some of the key investment terms) without having spent the time to fully understand them and/or retaining strong, experienced counsel.  Needless to say, term sheets are complex and a potential minefield for first-time entrepreneurs.  Moreover, the VC guys (and gals) spend their careers negotiating term sheets and know every term (including every nuance) inside out.

Accordingly, startups need to be smart (and demonstrate a certain level of credibility with the VC’s) by getting a good corporate lawyer involved early on, among other things, to coach and prepare them for their preliminary negotiations with the VC’s.  As I note in the comments to Mark Suster’s post, “Want to Know How VC’s Calculate Valuation Differently from Founders?”: a good corporate lawyer will also run spreadsheets/models to show the founders how the purchase price will be disbursed (i.e., the waterfall) in different M&A exit scenarios.

Conclusion

I hope the foregoing is helpful; and if you’re interested, Sachin Agarwal, co-founder of Posterous, wrote an excellent post regarding the “personal side” of dealing with VC’s: “If you can’t buy your investor a beer, don’t take their money.”  You should check it out.

This week, we present Mark Pincus, co-founder and CEO of Zynga and a very smart and successful entrepreneur.  First, there is an interesting, four-minute excerpt from Mark’s presentation at Stanford in October 2009 (via Stanford University’s Entrepreneurship Corner), in which Mark discusses (i) mapping a strategy as CEO, (ii) “writing your story” and (iii) negotiating with VC’s. 

As a bonus, we also present Mark’s interview in December 2009 on Charlie Rose.  There is also an interesting article in yesterday’s New York Times discussing Zynga and Mark’s success.  We indeed hope you find the videos and article helpful.  Many thanks, Scott

www.youtube.com/watch?v=Exi-n5hXZQY

I’m using Twitter as a form of micro-blogging to share interesting articles, blog posts and podcasts relating to entrepreneurship, business and corporate law issues, and mergers & acquisitions.

For those of you who missed this week’s Twitter updates, below are my five most popular tweets (via bit.ly) and two most popular blog-related tweets.  If you’d like to see all of my tweets (or an RSS feed of them), you can do so here.  Many thanks, Scott

Top 5 Tweets

1. Excellent article via NYTimes re what happens if you don’t button-down partnership issues (particularly re IP) http://nyti.ms/cIN7kG
2. “What is the ideal number of co-founders?” my answer at 17:25 (Mixergy Panel in Santa Monica) http://bit.ly/cWS6V2 (note: bad audio)
3. “Most founding CEO’s don’t know that they’re cannon fodder in the search for a business model.” -@sgblank http://bit.ly/cZnP8h
4. “Why is it that as we grow up we lose all the passion, the energy, the will and the strength to keep our dreams alive?” http://bit.ly/dpxrZd 
5. “The problem is that once you start raising money, raising money becomes the top idea in your mind.” -Paul Graham http://bit.ly/csdr1B

Walker Blog-Post Related

1. “[T]he financial reform bill just signed into law omitted the most troubling provision in Dodd’s original proposal.” http://bit.ly/bR5HvO 
2. New vid post: “Motivational Clips for Entrepreneurs: Selling by Day, Learning by Night (via Mark Cuban)” http://bit.ly/cYACfa

Welcome to our weekly series entitled “Motivational Clips for Entrepreneurs.”  Each week, we post a short video or movie clip to inspire and motivate our fellow entrepreneurs.  Why?  Because it’s fuckn tough being an entrepreneur – and whether you’re launching a venture, trying to execute on your business plan or pitching investors, you need a little juice to help you push the ball forward.  Here’s a video of superstar entrepreneur Mark Cuban (which I hope provides a little juice).  Cheers, Scott

www.youtube.com/watch?v=BnvRpGmpoNg

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat.  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

I read a few articles and blog posts a few months ago about how Senator Dodd’s financial reform bill was going to destroy angel investing.  Then I heard about certain amendments made in the U.S. Senate that watered down some of the provisions.  Now that the bill has passed, what’s the story with this issue?  Will the bill hurt angel investing?

Answer  

The bill was signed into law this morning.  There is good news and bad news.  First, some background:

The U.S. Securities Laws.  As I have previously discussed in my securities laws post, a company may not offer or sell its securities unless (i) the securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (ii) there is an applicable exemption from registration.  The most common exemption for startups is the so-called “private placement” exemption under SEC Regulation D, which comprises three different types of private offerings under Rules 504, 505 and 506.  

If a startup sells stock only to “accredited investors” (discussed below), compliance is much simpler, faster and cheaper because it can rely on Rule 506, which has two important advantages over the other SEC rules.  First, Rule 506 preempts or overrides State securities laws, which means that the startup doesn’t have to deal with State securities regulators for compliance purposes, other than filing a brief notice known as a Form D (which is also filed with the SEC).  Second, there is no written disclosure requirement under Rule 506 if the investors are accredited.

On the other hand, if one or more of the investors is not accredited, SEC Rule 506 generally may not be relied upon – which opens-up a Pandora’s box of compliance and disclosure issues under both (i) SEC Rules 504 or 505 and (ii) state law.  Indeed, the cost, risks and onerous disclosure requirements generally outweigh the benefit.  That’s why startups have been overwhelmingly (and effectively) relying on Rule 506 for nearly 15 years in connection with their seed and angel financings.  

The Good News.  The good news is that the financial reform bill just signed into law omitted the most troubling provision in Dodd’s original proposal, which essentially required a filing with the SEC in connection with any private placement (even if all the investors were “accredited investors” and the issuer were relying on Rule 506), and then gave the SEC 120 days to review the filing; and if the SEC did not review the filing within such 120-day period, then the applicable States securities commission(s) would have the right to review the merits of the financing.

As I discussed in my letter to Senator Dodd, this obviously would have created significant delay and cost in connection with seed and angel financings and also would have put the State securities commissions back in the private placement game – which is exactly what SEC Rule 506 is designed to prevent, as noted above. 

The fact that this provision has not become law is very good news indeed.

The other piece of good news is that under Dodd’s original proposal the definition of “accredited investor” would have been revised to require individuals to have (i) a net worth of at least $2.3 million (up from $1 million) or (ii) annual income in each of the two most recent years (and a reasonable expectation of such income level in the current year) of $449,000 individually or $674,000 jointly with his/her spouse (up from $200,000 and $300,000, respectively).  According to Business Week, this revision would have lowered the number of individual accredited investors by 77%.

The new law leaves the net-worth test at $1 million (subject to the change discussed below) and leaves the annual-income test at $200,000 individually and $300,000 jointly.  Again, good news.

The Bad News.  The bad news is that the net-worth test no longer includes the value of the investor’s principal residence.  Clearly, this is a big change and could significantly lower the pool of accredited investors.

The other piece of bad news is that the new law expressly permits the SEC to conduct an immediate review and modification of the annual-income test if “deem[ed] appropriate for the protection of investors. . . .”  Thus, the annual-income test may go up; we’ll have to wait and see.

Finally, the new law also requires the SEC in four years (and once every four years thereafter) to review the “accredited investor” definition “in its entirety” and make appropriate changes — though the applicable provisions are poorly drafted and this four-year review may not apply to the “accredited investor” definition for purposes of private placements under Regulation D.

CONCLUSION

I hope the foregoing was helpful.  Indeed, as I am constantly advising my clients, the securities laws are a potential minefield of problems; and non-compliance could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.

Today we present Sergey Brin and Larry Page, the co-founders of Google and brilliant entrepreneurs, from a 2001 interview with Charlie Rose.  In this interesting, 14-minute clip, Sergey and Larry discuss, among other things, (i) the history of Google, (ii) their search for money, (iii) their business model, (iv) their relationship (and why they disliked each other) and (v) the rationale for bringing on Eric Schmidt as CEO.  I hope you enjoy it.  Thanks, Scott

I’m using Twitter as a form of micro-blogging to share interesting articles, blog posts and podcasts relating to entrepreneurship, business and corporate law issues, and mergers & acquisitions.

For those of you who missed this week’s Twitter updates, below are my five most popular tweets (via bit.ly) and two most popular blog-related tweets.  If you’d like to see all of my tweets (or an RSS feed of them), you can do so here.  Many thanks, Scott

Top 5 Tweets

1. “Investing in companies that are fundamentally different from the companies VC’s look at could be a very good strategy.” http://bit.ly/ceiKT1
2. Automated Debt-Collection Lawsuits Engulf Courts (NYTimes) – “works out to more than 5,700 cases per lawyer” http://nyti.ms/cxYpnC
3. My Winding Road to Lean Startup – “choose and validate ‘one’ critical business” & other lessons via @giffconstable http://bit.ly/9ccfjC
4. An Overview of the Dodd-Frank Wall Street Reform and Consumer Protection Act – solid summary via Weil Gotshal http://bit.ly/cauB3u
5. “An elegant…online store can be had for a few $100K – that’s…less than the legal fees 2 revu a lease…on 5th Ave”   http://nyti.ms/dsHB9b

Walker Blog-Post Related

1. New blog post: 7 Negotiating Tips for Entrepreneurs http://bit.ly/9CWMTY
2. New vid post: “Motivational Clips for Entrepreneurs: If You Want It, Go Get It.” http://bit.ly/aCYJmC cc: @venturehacks

Welcome to our weekly series entitled “Motivational Clips for Entrepreneurs.”  Each week, we post a short video or movie clip to inspire and motivate our fellow entrepreneurs.  Why?  Because it’s fuckn tough being an entrepreneur – and whether you’re launching a venture, trying to execute on your business plan or pitching investors, you need a little juice to help you push the ball forward.  I hope these videos are a little juice.  Cheers, Scott

www.youtube.com/watch?v=X83H1JCV8ME