Getting Funded

Lauren Celano – Founder and CEO Propel Careers.

I attended the Sept 22, 2010 TCN lunch program at Wolf and Company on “Equity Compensation & the Perils of 409A”. Scott Goodwin, the head of the technology practice for Wolf and Company and Michelle Basil, with Nutter McClennen and Fish LLP led a very in-depth discussion of this important topic which is relevant to all early stage entrepreneurs. In the room were individuals from many different types of companies in different sectors leading to diverse perspectives and questions. After the meeting, I reflected on how important this issue is with respect to bringing on employees to help grow a team. For companies, a firm understanding of equity compensation and its implications is critical to attract, retain, and align employees and protect your company from legal ramifications associated with non-compliance.

One sage word of advice from both Michelle and Scott before we dove into the presentation and discussion was to always contact your lawyer before enacting a stock option plan. This seems like a very reasonable thing to do, but some companies will enact option plans without considering legal input leading to inopportune outcomes….

Goals of Stock Options Plans

The entire goal for all stock option plans is to attract and retain employees and align them with the goals of the company. There are different intricacies within each plan, but companies and employees should remember this overarching goal: if things go well and the company exits for a large payout, then everyone holding options should benefit. For many early stage companies, options provide the ability to create incentives that are not tied directly to salaries, which can help them manage their resources and still attract top talent. We all know companies whose employees have benefited greatly from options – remember Microsoft and Google – and early stage ventures count on attracting people who are want to be part of the “next Google” and are comfortable with a higher risk/higher reward equation.

In thinking about a stock option plan, many emerging companies provide options to all employees but at different levels. The company typically sets out 15-20% of the equity for an options plan. In a series A, the VC likes to see this range since it typically provides the company an appropriate number of shares to incentive, attract and retain employees.

Samples for equity distribution:

§ New CEO – 5-8% on average

§ VP’s, CXO – 1-2% on average

§ Director/BOD – 0.5%

The option pool should last for a while – sometimes founders are too eager in giving out equity to early employees in a company and this can cause problems as the company grows if too much is handed out too early. This is especially true if the time it takes to develop a technology or reach an inflection point takes longer than expected. Without enough of an options pool, the ability to provide appropriate compensation and upside potential diminishes for future employees. This could hurt the ability to hire top talent, which is crucial to reach critical milestones. Lesson Learned – be careful in giving equity out and provide incentives for individuals to earn all of it. To align incentives, vesting is preferred, typically cliff vesting for the 1^st year and quarterly after this. This ensures that individuals who stay with the company are rewarded for their time and effort. The worst thing you can do is give, for example, 10% of the company to someone with no vesting, then two months later, the person leaves to get a “real paying job”. This person is no longer contributing, and they own a large stake in the company, which limits your ability to provide compensation to people who are really helping the company grow.

As a founder, it is completely justifiable to put vesting and milestones payment structures into the plan. Ultimately, you want to do what’s best for your company and this means making sure everyone who is a part of your organization (now and in the future) is aligned and incented to perform and drive your business to the end goal. Since the options pool comes out of the original founders equity, they really need to create incentives that are tied to success, otherwise you are doing yourself and the company a disservice.

Remember, the goal of an options plan is to align goals and incent ALL employees, including founders. Also remember, many times, post outside investment, option vesting provisions are set up to retain the founding team since success is not just about the technology. Doing this helps to align the investors and the team - ultimately everyone wants the company to be successful and to be rewarded for success.

Logistics of stock option plans

The Board of directors administers the plans and the parameters needed to determine fair market value. Typically options are non-transferrable and companies will have different versions of agreements for individuals (employers, consultants, and independent contractors) associated with their companies. Many companies typically use cliff vesting for 1 year, then quarterly after that. Plans usually outlines repurchase rights for employees who leave the co, do not exercise rights, etc. Documentation is CRITICAL. If a company gets to a stage for outside investment, the investors will review and audit the forms, so the company should, ensure everything is straightforwardly outlined. There is no need to make the investors’ jobs harder and give them a reason to second-guess a possible investment just because the company did not have good documentation.

Founders shares are usually non-compensatory salary since at the time of company formation, the shares typically have no value. There is a certain time period to issue founders shares and the value of the shares is created over time. To reissue these, you need to determine if “value” has been created, and if so, they can be swapped out - options are the most common form.

In the US, there are two types of options that are typically granted:

Incentive stock options (ISOs). These have a tax benefit for employees. The options are not considered as property by the IRS and therefore not taxed. On exercise, the individual does not have to pay ordinary income tax on the difference between the exercise price and the fair market value of the shares issued. These are only available for employees. These can only be offered by corporations (C and S)

Although ISO are seen to be the “Holy Grail”, the % of ISO holders who realize ISO benefit is small. For rank and file employees, the non-qualified options seem to be better. With options, these do not lead to true dilution of equity since if people leave or don’t exercise their options, etc then the options go back into the options pool.

Non-qualified options (NQSOs or NSOs). These do not qualify for the special tax treatment. NSOs result in additional taxable income to the recipient when they are exercised, with the amount being the difference between the exercise value and the FMV on the date of issue. Employers typically prefer these since they can take the tax deduction equal to the amount the recipient is required to include in their income.

83(b). Issuing shares of stock with restrictions such as vesting can be beneficial if value is low, as with most early stage companies. Employees can do the 83(b) election that allows the employee to avoid the possibility of substantial income in the future upon the lapse of the restrictions contained in the buy-back agreement. 83b allows employees to file and pay tax now since value can increase over time. This is good if the value is low, however, if the company fails the employee would be out of luck since the tax was already paid.

409a. Section 409a, of the Internal Revenue Code, deals with the treatment of non-qualified deferred compensation given to individuals. These individuals could include employees, BOD, or in some cases, independent contractors. Companies should get a valuation of fair market value for their options. If this is not done, then an employee receiving the options could have a tax problem (instead of this being a benefit) and the tax problem could include the following: Ordinary income tax, 20% penalty withholdings, interest and penalty for late payment tax bill could be issued even before exercising. The company could also have a problem such as: being liable for misholdings, employee issues, and Potential liability for employee taxes also

Valuation Methodology. Valuations are usable for up to 12 months. Many companies do either annual or 6-month valuations. This depends upon the company and the relevant financial milestones and significant events. Typically, companies utilize the services of a valuation firm, however, an internal company representative could also do this if they meet specific requirements.

Considerations for a LLC. LLC’s would need to offer membership shares. To incent employees, a profit interest could also be given. If a LLC gives stock to an employee and the employee exercises it, then the employee becomes a member. This means that the employee would need to utilize a K1 creating tax implications for them.

Venture Fast Track Program

TCN has a Venture Fast Track Program, which is a One Day Boot Camp for VC and Angel Success on November 9, 2010. This program will go over all of these details in much more depth. See link for more details

http://www.thecapitalnetwork.org/programs.bootcamp.home.php

Dan Allred - Senior Relationship Manager, Silicon Valley Bank

There has been lots of talk lately about how innovation will be the means by which the economy starts growing again. We hear this from politicians, from academics, from economists, and most importantly, we hear it from the entrepreneurs and investors who are taking the inherent risks associated with the business of innovation.

However, those risks have been evolving. Traditionally, entrepreneurs have taken on a lot of technology risk in their attempts to bring new products to market, and angel and venture capital investors provided the capital needed to develop such technology. The premise was such that if entrepreneurs could solve a very hard technical problem that met a market need, then there would be lots of customers, often large enterprises, ready to buy the product made possible by the entrepreneur’s technical breakthrough. In short, the technology risk was very high, but the market risk was relatively low. In such a scenario, there were large amounts of capital needed early on in a company’s life to hire advanced engineers and to develop very complicated and often unproven technology. This dynamic set-up well for venture capitalists who had large funds to deploy and were willing to bet on high-profile, experienced technologists, scientists and entrepreneurs. The VCs knew they were taking on lots of technology risk, but they could rest assured that there was market demand for the products if these teams of entrepreneurs could pull it off.

Of late, I have seen the model shifting to a dynamic where the technology risk is relatively low but the market risks are high, just the opposite of what I describe above. Open source software, cloud infrastructure and distribution platforms such as the App Store and Facebook have changed the way that entrepreneurs are thinking about innovation, and as a result, the way they are thinking about risk. They are able to leverage established technologies and established infrastructure to build out products much quicker and much cheaper than the entrepreneurs described in the paragraph above. Also, they are leveraging the Internet as a distribution platform for reaching the masses, the proverbial long tail. They are less concerned with Fortune 500 clients and their many demands leading to long product development and long sales cycles, and more concerned with consumers and SMBs who are not likely to pay as much for any particular product but offer a hugely scalable business should the product be adopted. And product adoption is the key question. SMBs and consumers are notoriously difficult to predict, especially where innovation is concerned. Thus, technology risk is low, but market risk is high.

So, if you are an entrepreneur, and you are pursuing a start-up that you need to finance, you should ask yourself which of these is the predominant risk that you are taking on – technology risk or market risk. If you are developing proprietary technology that will be the core of your product, that will offer your business significant barriers to entry and will be protected by a strong IP defense, then you are most likely taking on a lot of technology risk, and you would be well served to find deep pocketed investors, likely VCs, that understand your business and are accustomed to longer product development cycles, complex engineering projects and partnerships with larger companies such as OEMs, joint development agreements, etc. which may help you in bringing your product to market. Chances are you will need to take on more capital (probably in the millions of dollars) early on to be able to hire the right team and to develop and protect your technology.

If however, you see a relatively short path to market that will only require a few months and a few developers and you already know how you will distribute your product (through an app store, through social media, SEO, SEM, inbound marketing, etc.), then you may be a better candidate for a seed financing (probably in the hundreds of thousands of dollars). Such investors are likely to be angels who know your market well or who like to work with early-stage companies and founders. Micro-VCs or super-angels (many of which are raising micro-VC funds) are also candidates for such a financing. These companies are likely to raise money on lower valuations as there is little value in the their IP; however, the amount raised will be much lower than in the “technology risk” scenario, so dilution to the entrepreneur will not be significantly different.

In the “market risk” scenario, it is important to understand that you are likely to need larger dollars eventually, once you prove out your concept (thereby overcoming, or at least mitigating, the market risk). At this point, you would probably want to raise a larger round (again, in the millions of dollars), perhaps from your existing investors if they have deep pockets, or from VCs or strategic partners. Keep in mind, that you would theoretically be raising this money on a higher valuation now that you have mitigated the market risk in your company and are taking on execution risk, a risk that is typically easier to handicap, account for and manage.

A final note: I know that I am speaking in generalities here, but there is a very clear trend that I am seeing in the market. Sure, there are still plenty of IP-centric companies that are undertaking huge technology risks and solving big problems, and we should be very excited about these companies as they are very important to our region and our economy as they tend to be high profile companies and larger employers. We should also embrace this newer class of companies that want to leverage technology, versus creating it, in order to reach new customers and to innovate on old business models. If they are successful in doing so, they have the potential for serious economic impact as well.

So if you are reading Blog it is likely that you are an entrepreneur. You may be a first time founder. Or you might be on your 5^th startup – this time as the Founder/CEO. In either case, you may now be asking yourself how you are going to fund your venture. Worse, you are likely fully aware that you are trying to raise money during the “Great Recession” and that capital is very hard to come by.

There are a number of resources available to help you understand and master the early stage fundraising process. Because I serve as the Chairman of The Capital Network (TCN), this post is about how TCN can help you. But TCN is not the only place that can help you. More important that coming to TCN is that you get the education and support you need. Speaking for TCN – our mission is to make sure that no fundable idea goes unfunded – that we help every entrepreneur, and particularly those with high growth ideas, find the capital that will sustain their company and grow our collective innovation economy.

TCN’s programming reflects the funding cycle and development phases of a start-up. That said, it is not a unitary program where you have to attend prior sessions to get a huge amount of content and connections at a current program. Instead, every program stands alone, but in the context of the curriculum.

So what might be your first question. What kind of capital is right for my business? Well, it all depends upon your business model, your product service mix, your industry, your development timeline, and well, frankly, lots of other factors. As you might imagine, building a company that designs MobileApps has very different capital needs and opportunities from a venture developing cancer therapeutics. On Sept. 7, TCN will run its Funding Options program, helping entrepreneurs understand whether the investment proposition in their company is a good match for:

• Friends and Family
• Angels
• Angel Groups
• Venture Capital
• Corporate Venture Capital
• Strategic Partners
• Bank Debt
• Venture Debt
• Federal and State Grants
• Bootstrapping

While many young ventures think they are a good fit for Venture Capital, this often turns out not to be true – sometimes because it is a bad deal for the entrepreneur – not because they can’t raise the capital! This program is designed to help you understand an investor’s needs, point of view and risks:

• Investment criteria
  • Development stage of product and team
  • Industry
  • Business Model
  • Margin Structure
  • Growth Potential
• Time to closing
• Investment range
• Return requirements (IRR/ROI)
• Success rates
• Control features
• Compliance requirements
• Costs of capital
• Uses of capital

Okay, so you attended the Funding Options program, or you have worked with industry folks to ask good questions, and you have determined that high growth finance is your path. Now you would like to know What are the terms of an Angel or Venture Capital Deal? What will this deal mean to you? In October, TCN will host first a panel discussion on Angel Group and Venture Capital Term Sheets and then a small group Deep Dive Expert Lunch a few days later. This will help you answer the question - What on earth are: anti-dilution rights, preemptive rights, co-sale rights, drags-along provisions, re-vesting, registration rights, redemption rights, dividend preferences, liquidation preferences, participation, pre-money valuation, fully diluted shares, performance milestones, tranches, board rights, negative covenants, closing conditions etc.? Wise entrepreneurs know that they will negotiate a better deal, or avoid a terrible deal, if they understand the specifics before talking to capital.

If, having learned all the legal-speak and the economics, you actually still want to have third party investors (which is by no means certain), then the question may arise: “How do I find, pitch and close on investors?” TCN’s Pitching the Plan will help you maximize your chances of identifying the right investors and securing the capital. The session includes how to create an “Elevator Pitch” and what to include in your PowerPoint style “Investment Deck”.

So now you decided you want capital, in specific, equity capital, and you understand the terms, and you have found investors – now the big question is: “How do you and the investors value your early stage company?” Welcome to TCN’s one of a kind Negotiation and Valuation program program. In an interactive and fun table format setting, you will learn what kinds of assets, opportunities and risks affect the valuation of the company and, in turn, the dilution you will incur from selling your equity. This session will also case study a recent successful financing to highlight how the theory translates to practice.

One of the big questions that plagues entrepreneurs is the chicken-egg dilemma of “no money, no team, no team no money.” That is, investors value the team even more than the idea, but it is hard to attract a “rock star” team in the absence of capital. TCN’s Building a Fundable Team program helps entrepreneurs understand how investors evaluate teams, the founder’s ongoing role, transition management, succession planning, compensation, how to attract talent and the use of interim or part-time personnel.

You should also look out for programs that focus on Strategic Capital, as customers, vendors and partners are often an ideal way to capitalize your company – that is, if you are extremely careful you understand the interplay between the commercial deal and the financial deal.

If all of the above wasn’t complicated enough, TCN also runs a program called Preparing for Growth and Exits – which ties to help you balance your short term capital objectives with your long term economic value and interests in growing or selling the company. The contradictions in these dual objectives mean that making informed trade-offs is the key to optimizing your success and satisfaction with being an entrepreneur.

Keep a look out for other key panel and lunch programs like

• Understanding Equity Compensation
• Understanding Dilution
• 409A and Equity Pricing
• D&O Insurance
• SBIR/STTR Funding
• SBA Loans
• Networking Strategies
• Founder Equity Issues
• Using Debt in Financing your Startup
• Accounting 101
• Funding through IP Licensing

Also, if you are now thinking, “Wow – all of that is a lot of content, but I don’t have a lot of time to learn” then the one day TCN Venture Fast Track Boot Camp may be the solution for you. But bring your A-Game, because this program is like drinking from a fire hose.

While not contained within the Roundtable Series, TCN also helps entrepreneurs solve other challenges. What are the special opportunities and challenges for companies in the Life Sciences? In Mobile? In Cleantech? TCN provides addition support to Women Entrepreneurs with programs that help entrepreneurs find and access the support systems and mentor that are invested in the success of women-led businesses. If you are an undergraduate or graduate student seeking on-campus programming and discussions of your challenges in fundraising, you should also take a look at the TCN University Series.

What do you do if you are trying to form longer term relationships related to capital raising and entrepreneurship. Some qualified entrepreneurs, after an application process, will be given access to the TCN’s Mentor Meal Program - one day mentors in a casual environment that will help build your knowledge base and your community, and/or the Venture Coaching Program - a longer term mentor team for those qualified ventures actively raising capital.

As the Fall season kicks off – I hope that all of you participate in The Capital Network. But most important, I hope that you continue to get the education and support you need to drive your venture towards success.

At the risk of repeating myself in the same post, my wish for the season remains that no fundable idea should go unfunded!