Sources of Venture Capital (VC) equity financing documents and information

April 5, 2012

As a follow-up to my previous blog, there are many sources of Venture Capital (VC) equity financing documents and information available on-line. Here are my favorites.  

1. TechStars Model Seed Funding Documents (Techstars.org)

TechStars and Cooley Godward Kronish, LLP put together a set of “Model Seed Funding Documents” that anyone can use.

There are five primary documents in the set:

2. Wilson Sonsini Term Sheet Generator

The Wilson Sonsini law firm has a term sheet generator. The website describes itself as: 

“This tool will generate a venture financing term sheet based on your responses to an online questionnaire. It also has an informational component, with basic tutorials and annotations on financing terms. This term sheet generator is a modified version of a tool that we use internally, which comprises one part of a suite of document automation tools that we use to generate start-up and venture-financing-related documents.” 

You need to go through the exercise to generate the forms.  

3. Wilson Sonsini Series AA equity financing documents 

Wilson Sonsini Series also offers a series of AA equity financing documents on ycombinator 

4. Veri course on Understanding Term Sheets 

Veri offers an on-line course called Understanding Term Sheets.   

 

I welcome comments and additions to this list.  

If you are going to obtain VC financing, I strongly recommend that you use an attorney experienced in this area. I do not recommend that people use legal forms in lieu of legal counsel. Legal forms are good for giving you a sense of how the documents might look and what language is typical. And they can be a good starting point for drafting purposes. But they should not be used as is. Every situation is different and only a good attorney can assess how well a particular legal form will work for you, what language might need to be changed, and what additional language should be added.  

And consider using two attorneys, one for the company and another for the founders. In some cases it would be best if each founder had their own attorney. The interests of the founders are closely aligned with the interests of the company, but they are not always the same. Often the VC will direct the company to use a law firm that has worked with the VC on funding many other startups. This law firm may not keep the best interests of the founders in mind.


Some Very Useful Advice for Startups from Guy Kawasaki

April 4, 2012

In case you missed it, Guy Kawasaki, a former Apple success story and now a successful venture capitalist, has posted a three-part series of excellent articles for entrepreneurs on his blog http://blog.guykawasaki.com. They are very informative, and come with downloadable templates for Microsoft Office. They are

 1. How to Create an Enchanting Pitch (includes a sample PowerPoint presentation)

 2. How to Create an Enchanting Business Plan (includes an outline of a business plan in Word)

 3. How to Create an Enchanting Financial Forecast (includes sample Excel files)

 I also really like two of his earlier blog articles:  

 The Top Ten Lies of Venture Capitalists

 The Top Ten Lies of Entrepreneurs

 There are many other excellent articles on his blog that are worth checking out.


Well Written Website Privacy Policy May Backfire

January 24, 2012

I know that I should be writing more short blog entries rather than just a few long blog entries. But as you can see, I have trouble keeping my entries short. There is so much to say about any topic. In this entry I will try to keep it short. Here goes.

I recently came across a website privacy policy that was well written and easy to understand. In this case, that may not have been a good idea.

I read an email post where someone said that he had read about the Nextdoor website in the news. He was excited to give it a try in his neighborhood. Here is how the website describes itself:

“When neighbors start talking, good things happen. Nextdoor is the private social network for your neighborhood. It’s the easiest way for you and your neighbors—and only you and your neighbors—to talk online and make all of your lives better in the real world. And it’s free.”

He added that he glanced at the Privacy Policy, but didn’t see anything “out of the ordinary” to his untrained eye. When he invited some of his neighbors to join, a storm of email erupted around the Privacy Policy. Neighbors feared the sale of all of their personal information and the storage of their data forever and responded that they “would never sign up on a site such as this!”

I was curious about his comment so I read the entire Nextdoor privacy policy. (I would think that only a lawyer would actually do that, but apparently people actually do read these things.) It is well written and is in plain English, rather than in difficult to understand legal jargon. I like that. I try to draft my agreements that way as well. But that may be the problem. Most people do not realize just how little privacy they have. Because the agreement is very clear, someone who reads the agreement will better understand how their data will get stored and used. It is not that the Nextdoor site will use their data any differently than other sites, it is that Nextdoor is more honest and more open and clear about how the data will be used. Even when a website does not share information, it often stores that information for a long time and uses that information on its website in various ways. The Nextdoor privacy policy explains all of this quite well. I suspect that their data retention and use policies are not unusual. What is unusual is how open and honest they are about it. As a result, people who read the privacy policy may be more concerned about this particular site than they should be. That is a strange case where being open and honest about what you do may not be the best policy.

As a side note, one of my themes in this blog is how little privacy we now have. Here is a good example. Even without joining the Nextdoor site, much of your neighborhood information is already quite public. Where I live, in King County Washington, if you want to know who owns the house across the street from you and how much they paid for it, all you have to do is look up the address on the King County Assessors office website. You can find a history of sales including the parties and the price paid, tax value assessments by year, pictures of the house, floor plans, statistical details about the house, and lots of other data. All of that is already public information.

I am not sure telling your neighbors that their privacy is already gone will help convince them to join the Nextdoor website. But it is largely true.

Update May, 2013:

Instagram had a similar reaction from its customers when it tried to simplify its terms of use contract. The newer terms were easier to understand and protected the customer more, but because the customer could now understand the contract, many of them complained. Instagram ended up reinstating its older terms of use contract. See Why
the Instagram debacle just taught every tech company to be shadier than ever
.

 

 


Top Ten Intellectual Property (IP) Law Traps

November 2, 2011

Intellectual property (IP) law is a deceptively complex area of law. IP law is very rules based, and the rules vary depending on the type of IP protection. Non-IP attorneys and individuals who attempt to practice IP law without the assistance of an IP attorney often run into trouble. Here are ten common traps.

Copyright

1. Copyright law is one of the few areas of law where transfers of rights must usually be in writing (real estate is the other obvious example.)

2. The owner of the copyright is the person who created the work, not the person who paid for it. You hire someone to design a website for you. It is your website. You paid for it. But absent a written agreement to the contrary, the website developer owns the copyright in the website.

3. It is deceptively easy to end up accidentally jointly owning the copyright instead of owning it outright. Say you write a software game program, but you hire an outside firm to handle the sounds. It is quite possible for the outside firm to own part of the copyright in the entire software game program. (This is called joint authorship.) This is easy to fix with a written agreement that covers copyright ownership.

Trademark

4. The right to register a federal trademark belongs to the person who used the mark first in interstate commerce, not the person who filed a registration first. But if the first person to use does not object to the other person’s improper federal registration within five years of registration, they may permanently lose the right to object.

5. You do not lose copyright rights by not policing your rights, but you can lose trademark rights by not aggressively policing your rights.

6. One way you can fail to police your rights and lose your trademark is if you license someone to sell your widgets under your trademark and the license agreement does not allow you the right to police the other party’s use of your mark.

Copyright and Trademark Registration

7. Copyright rights and trademark rights are both created automatically. Copyright rights exist as soon as you create something. Trademark rights exist as soon as you use a trademark in commerce. But in each case, you gain considerable additional protection by registering your rights. People often neglect to register.

Copyright registration is only at the federal level. It is fairly straightforward and can usually be done by a non-lawyer. (Practice Tip: Have you registered the copyright in your website and other marketing materials?) Trademarks can be registered at both the state and federal level. State trademark registration is also fairly straightforward but does not help much. Federal trademark registration is deceptively complex. Sometimes a federal trademark registration will be approved as submitted, but quite often it will not. You may need to negotiate with the Trademark Office, and there is a specialized technical language that they use and expect you to use as well. When trying to register a trademark federally, it is best to use an attorney who is familiar with the federal trademark registration process.

Trade Secret

8. A customer list is considered a trade secret. An employee cannot take a physical copy of the list with them when they leave a company. If the employee memorizes the list, that is considered the same as taking a physical copy.

Non-Compete Agreements

9. In Washington, where I practice law, a non-compete agreement entered into after the employee has started working for a company is not enforceable unless the employee is given new consideration for signing the agreement. The right to continue working for the company and to not get fired is not considered new consideration. Labriola v. Pollard Group, Inc., 152 Wn.2d 828, 834,100 P.3d 791 (2004).

Family Law and Estate Planning

10. Intellectual property is property. Yet I often see a divorce property settlement agreement or a will where there is no mention of intellectual property. Have you written a book, or painted a picture, or created other intellectual property? If so, it should be accounted for in the legal documents.

 

(These examples are oversimplified. Although they apply most of the time, I omitted all of the caveats for when they do not apply. Do not rely on these rules without seeking specialized IP law advice first. )

 


Copyright Enforcement on the Internet – Where should we draw the line?

October 26, 2011

In this week’s news a woman is suing Apple for copyright infringement because two of the iPhone apps it sells are using pictures that belong to her. She complained to Apple but they did not remove the pictures. Details here.

.When should we hold a company liable for contributing to copyright infringement by others on its web site? I am not talking about direct infringement, when the company itself uses someone’s copyright protected work without their permission. That one is easy. They should be liable. But what if somewhere on the company’s web site someone else has posted material that violates someone’s copyright? In the early days of the Internet we still held the company liable, although we usually gave them a chance to fix the problem. They were not liable unless they were notified of the infringement and we gave them an opportunity to correct it, and they still failed to fix the problem. (See in particular the Digital Millennium Copyright Act (DMCA)).

These days web sites are so large, and the databases that drive the web sites are even larger. We have a company like Google that is trying to put every book ever written on its web site. Now we are starting to see cloud storage of music, and important files, and perhaps eventually cloud storage of everything. Has the Internet become too big to expect individual companies to be able to police their own web sites?

I was talking to an attorney from Facebook recently. I am paraphrasing what he said. If Facebook had to search its own web site for all the instances of a particular item, it would take months, or perhaps even years, even at computer speeds. Their database is that large.

In the case in the news, the woman used an iPhone app to take pictures which she then uploaded and posted on a picture sharing web site with the appropriate copyright notice. The iPhone app she had used copied her pictures, after removing the copyright notice, and posted them on the Apple App store web site to help market its app. She claims to have notified Apple at least six times prior to filing the law suit. I am not privy to the actual details of the case, but I find it hard to believe that Apple would intentionally ignore her complaints. I suspect they just have too much ‘stuff’ out there, and can no longer effectively police it all. According to Wikipedia, as of May 2011 the Apple App store had over 500,000 third-party apps officially available. That number is growing all the time.

So what is the answer? Do we let Apple get away with contributing to copyright infringement? Do we require that companies with large web sites/databases develop new techniques to police their sites? Or do we require companies to keep their web sites/databases small enough that they can effectively police them with today’s technology? I suspect that the answer will come from new technology, not from new laws. These companies will get better at policing their sites, and we as a society will get more tolerant when they do not do so as effectively as some people would like.

I would have advised this woman that once she posts something on the Internet, her ownership and control is effectively gone, no matter how aggressively she tries to police its use. That may not be fair. That may not be legal. But that is the way it is.


The Lesson from Skype: Don’t Count Your Stock Options Before They Hatch

August 30, 2011

Founders of startups and senior executives who join startups often place too much value on their stock options. Stock options are extremely risky. You may count on your stock options as a possible way to make you rich some day, but you should be very careful if you are counting on them to be part of a reasonable compensation package.

There is the obvious problem that the stock in the company may never be worth anything. But there are many other potential problems with stock options as well. A recent case is illustrative.

It was rumored that one or several senior executives of Skype lost their stock options when Skype agreed to be acquired by Microsoft earlier this summer. As best I can tell many employees of Skype had the right to purchase shares of Skype in accordance with a stock option agreement. That agreement was subject to the terms of the standard company-wide Stock Option Agreement. This is very common. The company-wide stock option plan in turn was subject to the terms of an investor stock plan. There was a provision in the investor stock option plan that allowed the investors to buy back the vested stock options of former employees of Skype at the stock election price. So if you had a vested option to buy 100 shares at $1 each, and the shares were now worth $100 each, the investors could buy back your stock options at $1 per share, wiping out any value you had gained in the stock options. At least one former employee appears to have lost his stock options this way. It is also rumored that a number of senior executive were recently fired and that they too will lose their stock options.

Yee Lee, the individual who appears to have lost his stock options in Skype had written about his experience in a blog. The letter Ricardo Velez, Skype’s associate general counsel, sent him is available here, and his stock option agreement is available here.

(Mr. Lee might still have legal recourse. It is possible that Mr. Lee could argue that the contract terms that forfeited his stock options were unconscionable, or that he had an implied contract right to the options that superseded. I am interested to see if he fights for his options.)

I have read blog comments that this situation is unusual. I do not agree. I have reviewed many stock option plans for clients. The company-wide Stock Option Plan is often subject to the terms of one or more other documents. I always ask the clients to get me a copy of those documents so that I can review them. Sometimes the client thinks I am just trying to run up my fee. But as the Skype case demonstrates, it is important to follow up on the details. In my experience it is rather common that the Stock Option Plan or the additional documents contain one or more legal conditions that could potentially make the client’s stock options worthless. It has also been my experience that the company is not gong to make any changes in these documents for just one person. It is a take it or leave it offer. My standard advice to clients is to insist on enough salary or outright stock grants to make the job worth taking, and consider the stock options as a potential bonus that may or may not come to be. Or accept the risk that you are taking a large risk and that the risk factors are mostly beyond your control.

Do not rely on the fact that you are friends with the people in charge of the company. They may be your friends now. But when there is a large amount of money at stake, friendships tend to fade fast.

If you think the company has value, you should try to stay with the company until you can cash out. As one Skype representative has been quoted as saying in response to the Skype situation,

“You’ve got to be in it to win it. The company chose to include that clause in the contract in order to retain the best and the brightest people to build great products. This individual chose to leave; therefore he doesn’t get that benefit.”

Of course every situation is different. There is less risk if you are receiving stock options in a public company with a large number of shareholders, positive financial track record, and is not likely to undergo a major change in order to raise capital. There is more risk in a start up that has yet to make a profit, and has no market for its shares, and is likely to restructure itself through a merger or sale, or other stock manipulation, in order to raise capital.

Stock options are still a great way to get rich. But they also remain a very risky way to do so. If you go the stock option way, be aware of the high degree of risk involved.


Lawyer Equity – A Bad Idea (Part 2 of 2)

July 18, 2011

Paying Attorneys with Equity: Other Problems

In part one of this article, I brought up the issue that many start-ups will pay their attorneys with equity in the company rather than or in additional to paying them cash. I maintain that this is a bad idea. I described the main problem with this arrangement in the first part of this article – that such an arrangement creates a potentially harmful conflict of interest for the attorney. But there are many other reasons why this arrangement should be avoided as well.

Tendency to Over-litigate

I also get the sense that companies tend to over-litigate cases when they are not paying for them up front. The cost of attorneys fees is an incentive to try to avoid litigation and settle disputes. But if you are not paying the attorneys, you may feel that it makes sense to fight to the bitter end. That is still not the case. First, of course, you are still paying the attorneys. You are giving up some of your precious ownership interest in the company. Second, litigation is very distracting. You will end up spending valuable time on your litigation cases that you should be spending making your company successful. Third, litigation is a terrible way to resolve disputes. The judge who will decide your case will have very little time to get to know your case and will bring their own personal biases to the case. The end result is often a somewhat random decision. Do you really want to bet your company on the mood of a particular judge on a particular day? Better to settle the case and get back to building your company. You will have more incentive to settle if you are paying your attorney with cash instead of equity.

Failure to Value Legal Advice

The company may treat the attorney’s advice differently if the company is not paying for that advice. People tend to value advice in proportion to what they pay for it. When the attorney who is taking equity is giving what is in essence free advice, the company may not value that advice highly. If the company is paying its lawyer for advice, the company is more likely to take that advice seriously.

 I have seen this first hand. When I have offered my advice for free (what we attorneys call pro bono service), the client tends not to respect the advice.

Smart Money versus Dumb Money

There is a saying that smart money comes from banks and professional investors, and that dumb money comes from attorneys, doctors and friends and relatives. Banks and professional investors know about the risks of start-up businesses. They may not like it when they lose money, but they know and accept the risk. They also know about the ups and downs of business and will not be quick to pull the plug if they think the business idea still has merit. Dumb money people expect to get rich. They may cause trouble if they lose their money. And they may want to run at the first sign of trouble.

You may think that a lawyer who deals with start-ups all the time will not follow the dumb money pattern. That is true sometimes, but not as often as you would think. There is a reason why that person became an attorney and not an entrepreneur.

If You Need to Pay Your Attorney with Equity, Are You In Trouble Already?

One of the tests of whether a potential business idea has merit is whether the founders can raise capital. If you are having so much trouble raising capital that you need to in essence borrow money from your attorney, what does that say about the viability of your business plan? You may be too underfunded to start a business or your business plan may need adjustment. If your best source of money is your attorney, your company may have serious problems.

Lack of Attorney Choice

A start-up should be free to hire and ultimately to fire any legal advisors. But what if the current legal advisors are also shareholders in the company? Then there are problems. If you fire them, you may have to deal with disgruntled shareholders for the rest of the life of the company. That will influence whether you keep or fire them. This can lead to a messy situation. If you owe a former law firm money they are a creditor just like the rest of your creditors. But if they are shareholders instead, you are still partners with them, whether you like it or not.

Attorney Ethics Rules

Attorneys are governed by a set of ethics rules. These rules are imposed on a state-by-state basis, but the rules are very similar throughout the country. I do not believe that the rules prohibit an attorney from taking an equity stake in a client company. But they do impose conditions to protect the client, and those conditions are rarely actually met.

In Washington, where I practice, there are two rules that are directly on point. They are:

Ethics Rule 1.7 Conflict of Interest; Current Clients

… a lawyer shall not represent a client if the representation involves a concurrent conflict of interest …

and

Ethics Rule 1.8 Conflict of Interest: Current Clients: Specific Rules

(a) A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest adverse to a client …

There are exceptions to these rules. Basically it is permissible to represent a client or enter into a business transaction with a client where there may be a conflict of interest, if the client is fully informed of the potential conflict and the risks involved, has an opportunity to seek independent legal counsel concerning the relationship, and agrees in writing. This rarely happens in practice. Yet the client rarely seeks independent legal counsel. It just does not feel right to pay one attorney to review an arrangement to hire another attorney for free.

If you will be giving your attorney equity instead of cash, who will put together the deal and prepare the paperwork? Usually it is the attorney you have hired. That could create major problems. If you are negotiating an equity arraignment with an attorney who negotiates equity arrangements all the time, how can you be sure you are getting a fair deal, and not being taken advantage of? Is the attorney giving you the best representation possible, or is the attorney looking out for himself? Will the attorney fully disclose the nature of the deal in a way that you can actually understand?

There is a reason why attorneys are required to take many steps if they want to enter into a potential conflict of interest situation with a client. The fact that there are many steps is a sign that the relationship has serious potential problems. The fact that the required steps are not often followed is just a further warning sign that it is best to avoid this situation all together.

There is also an ethics requirement that the attorney’s fees be reasonable (In Washington see Ethics rule 1.5). What is a reasonable amount of equity to receive from a start-up given the enormous risks involved and the large potential reward? It is usually very hard to say.

There are some lawyers who will push the rules of ethics as far as they can. There are others who try to make sure they stay within the rules. Wouldn’t you rather that your attorney was one who made sure they stayed within the rules, at least when it comes to rules that are meant to protect you, the client?

What Do You Think?

Attorneys are pretty evenly divided on whether it is appropriate to take an equity stake in a start-up client. Many start-ups like the idea, but they may not be well informed on the subject. You now know what I think. What do you think?

(My thanks to fellow Seattle attorney Mason Boswell whose comments in an on-line discussion on this issue helped me focus my thoughts on the subject.)