Startup Voice

Thursday, May 3, 2012

Startup Hiring - Typical Equity Compensation Ranges for Early-Hires

Very frequently I am asked by my early-stage clients what the "typical" equity compensation percentage is for... [insert the position they are currently trying to fill]. Since this is a topic of interest to many, I thought I would lay out some general rules of thumb.

Before I do so, however, let me preface this with a disclaimer that:

all generalizations, rules of thumbs, and industry practices are imperfect and flawed by definition;
no two companies are the same, so do what's right by your employees and consultants;
each individual contributor is different and may warrant a different percentage under a special set of circumstances; and
the ranges listed are only typical, if at all, for early-stage company (not a company with a $100,000,000 valuation).

So, provided below are merely benchmarks which may prove useful in creating your startup's own compensation scheme:

Chief Executive Officer	–	5-8%
C-Level Executive/VP	–	2-3%
Independent Director	–	1%
Advisory Board Member	–	0.15%/year
Lead Engineer	–	0.5 - 1%
Senior Engineer	–	0.33% - 0.66%
Junior Engineer	–	0.2% - 0.33%

Happy company-making to all!

Inna

Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

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Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

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Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.

Saturday, March 3, 2012

Cap Tables for Startups

Capitalization tables (referred to in the industry as “cap tables”) are not difficult to grasp. But first-time entrepreneurs are often caught off-guard when they are asked to produce a cap table by a prospective investor (or his lawyer) doing diligence on the company.

In this post, we’ll talk about cap tables, their purpose, and what should be included in a cap table both for internal and external viewing.

1. Purpose of a Cap Table.

A cap table is, first and foremost, an essential internal document of any corporation. It sets out ownership of the corporation, in terms of the numbers of shares (by class and series) and in terms of percentages that those shares translate into. Ownership percentages matter (1) any time a vote of the equity holders is required, (2) for calculation of dividends, and (3) in the event of a sale or liquidation of the company, where they are used to calculate distribution of proceeds.

In addition, a cap table is one of the first documents that a company will be asked to produce in diligence. Prospective investors will request a cap table because they need to understand what the shares they purchase represent in terms of percent ownership of the company. This goes back to voting control and to upside in a sale of the company. Investors (or their analysts) will run waterfall analyses using different potential valuations of the company on a sale to make sure the investment has a realistic chance of being a lucrative one. (Click here for more information about waterfall analysis.) The cap table with waterfall analysis (or with numbers based on future financing rounds) is usually referred to as a pro forma cap table.

2. Structure of a Cap Table.

A cap table is most frequently maintained in Excel, and is structured in several tabs. The first tab is a Cap Summary and looks something like this:

When speaking to prospective investors prior to a signed term sheet, a cap table request can be legitimately satisfied with a PDF of this tab alone. As you can see, the cap summary provides enough detail to enable investors to create pro formas and run waterfall analyses, without giving away potentially confidential or at the very least sensitive ownership information.

The full cap table kept by the company would have additional tabs for each of the issued classes and series of stock (e.g., Common Stock, Series A Preferred Stock, Series B Preferred Stock), a tab for the stock plan, and a tab for outstanding promissory notes with interest calculations, if any. Such tabs would break-down the ownership of the shares by stockholder, include vesting provisions for stock subject to vesting, and list stock certificate numbers and dates of issuance.

Most importantly, these tabs would have percent ownership calculations on a by-class, by-series and on a fully-diluted basis. This becomes especially important when a particular decision of the company requires the consent of the shares comprising at least 50% of the Common Stock, 55% of the Series A Preferred and Series B Preferred voting together as a class, 66 2/3% of the Series A Preferred, and 50% of the Series B Preferred. Having stock ownership laid out in a well-organized, easy-to-understand manner, allows an easy identification of the minimum necessary stockholders necessary to secure the required vote.

Happy company-making to all!

Inna

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

Tuesday, February 14, 2012

Speaking VC Speak: Waterfall Analysis

In evaluating an investment, investors will usually run what is known as a waterfall analysis. In layman's terms, they have to analyze their take if this company is sold for... $50,000,000, $100,000,000, $200,000,000, etc. When they compare this against what they think the company is likely to sell for, with room for error, they have an idea what multiple of their investment in the company they potentially stand to gain from such investment.

Let's use an example to illustrate this analysis. Suppose investors are purchasing $5,000,000 of participating preferred stock capped at 3x of their investment. For simplicity, let’s assume that the stock purchased by investors is the only preferred stock outstanding in this company. Let’s assume further that after the purchase, investors will own 5% of the company, on a fully diluted basis.

In our example, in a $50,000,000 sale, investors get $7,250,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $45,000,000], which isn't a bad return given that in our example the investors invested based on a $100,000,000 valuation.

If the same company sells for $100,000,000, on the other hand, the valuation at which the investors invested, investors get $9,750,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $95,000,000]. In case you are wondering why the investors get back more than they invested even if the valuation of the company doesn't change, the answer lies in the participating liquidation preference.

Let's now consider a $200,000,000 exit. At this price, the investors receive $14,750,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $9,750,000], an almost 3x return on their investment.

What about if the company in our example sells for $350,000,000, a much better outcome for the investors? In that case, the investors’ return is $17,500,000 [5% of $350,000,000 because they would be above their cap for participating with the common stock and would opt for a return on a converted to common stock basis].

A basic understanding of waterfall analysis can be helpful for an entrepreneur in discussions with prospective investors.

Happy company-making to all!

Inna

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

Monday, January 16, 2012

Documenting Startup Expenses by Founders

Before a fledgling company is infused with funds from angels or VCs, it typically has to rely on its founders to fund startup expenses and subsequent operations. This is commonly known as bootstrapping. I am often asked about what the proper way is, from a legal perspective, to document these early capital infusions by founders.

First and foremost, founders must keep very good records of company expenses, and never comingle their own funds with the funds of the company. The right way to fund your company in the early days is, as soon as the company has a bank account, to place the funds committed to the venture into the company's bank account and make purchases and payments from that account whenever possible. If a founder does make a purchase on behalf of the corporation on his own credit card, which is what he must do before the company is incorporated and has a bank account, there should be evidence of reimbursement from the company, so that there is no possibility of the corporate veil being pierced.

There are several ways to document initial investment by a founder into his company, and we'll walk through each one:

Purchasing Equity. One way to document a capital infusion into a startup by its founder is by having the founder pay for his equity in cash.

However, if such purchase is not carefully structured, it can create some awkwardness around the capital structure of the company and the price of common stock. For example, if a founder wants to invest $100,000 and decides to buy 4,000,000 shares of common stock (a good starting number for a solo founder), he is effectively setting the price of common stock at $0.025, which is too high by a factor of... 25x for a very early-stage start-up. Setting the price this high this early may serve as an obstacle to attracting quality employees and consultants. On the other hand, issuing himself 40,000,000 shares at $0.0025 per share is too many shares and isn't appropriate for a company just starting out.

The other argument against this approach is: no matter how much you invest into your venture at the start, you cannot own more than 100% of it (although you can certainly own less). So if there is another way for you to purchase your shares (such as by using only a small part of the cash infusion for this purpose or by transferring IP to the company), why not provide additional consideration for the money that you, as the founder, invest?

A note for foreign entrepreneurs: If you hail from a country with which the United States maintains a treaty of commerce and navigation, and you would like to apply for E-2 classification to come to the U.S. on an investor visa, one of the requirements will be to demonstrate a "a substantial amount of capital in a bona fide enterprise in the United States." This investment "must be subject to partial or total loss if the investment fails." In other words, the investment should be made in the form of equity and not debt. In this case, the founder could use the bulk of the investment funds to purchase preferred stock to reflect such founder's investment.
Debt with Repayment. Another way to document startup investment by the founder is by a simple debt instrument, a loan obligation from the company to the founder. This does not provide a lot of upside for the founder on his investment, just the interest. On the other hand, the founder is going to get his upside through his equity stake, which is unrelated to his financial investment. Documenting startup investment by the founder on a promissory note is just a way for the founder to be repaid the money that he invested (with interest) sooner than waiting for the company to achieve a liquidity event. This mechanism can be used whether the founder invested $2,000 or $200,000 thousand into the venture.
Debt with Conversion. Sometimes founders prefer to have their initial investment convert at the time of the first VC round into preferred stock (of the series sold in that round). This especially makes sense for founders who don't need to have a quick return of their investment.

There are several advantages to holding preferred stock. First, when the company has an exit, there is a possibility, depending on the valuation of the company and the liquidiation preference of preferred stock, that the preferred holders as a group will receive a larger portion of the consideration in the sale than the holders of common stock. In fact, the holders of common stock sometimes receive nothing or next to nothing in a sale, while the preferred holders get their entire or almost entire liquidation preference.

Holders of preferred stock are entitled to various other rights, such as a right of first refusal on new issuances, antidilution protection, information rights, etc. And preferred shares are not subject to vesting and therefore won't be repurchased if and when the founder leaves the company.

Lastly, investors like to see founders have some skin in the game. A respectable initial investment by the founder, convertible into preferred stock tells investors that this founder is serious about the venture and is willing to put more than just his time (and personal happiness) on the table.

Happy company-making to all!

Inna

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

Saturday, December 31, 2011

Annotated Convertible Promissory Note

If you are working on a startup, you know how difficult it can be to secure investment from venture capitalists. By the time they are ready to invest, they want you to have a product and some decent traction, so that their investment can go towards growing your business. That means that you have to find a way to keep your business afloat while you are engaging in market research, designing and developing the product, and while you are immersed in early customer acquisition. Most entrepreneurs are not in a position to bootstrap their venture during this initial period, which can easily span over several years (depending on the product), so they will often raise a bridge financing from friends and family, angel investors, or sometimes even from venture capitalists.

A bridge financing is generally implemented by means of a convertible promissory note (for simplicity, we'll refer to it as a "Note"). Notes come in a variety of shapes and sizes, and range from being very company-favorable to downright egregious. In this post, I will walk through a fairly typical and reasonably company-favorable Note. To follow along, download my Convertible Promissory Note form (use of the form is subject to the terms of the legal disclaimer at the bottom of the post). Also note that throughout this post I will refer to the company issuing the Note as the Company and to the purchaser of the Note as the Investor.

Let's start at the top:

THIS PROMISSORY NOTE HAS NOT BEEN QUALIFIED WITH THE COMMISSIONER OF CORPORATIONS OF THE STATE OF CALIFORNIA AND THE ISSUANCE OF THIS PROMISSORY NOTE OR THE PAYMENT OR RECEIPT OF ANY PART OF THE CONSIDERATION FOR SUCH SECURITIES PRIOR TO SUCH QUALIFICATION IS UNLAWFUL, UNLESS THE SALE OF SECURITIES IS EXEMPT FROM QUALIFICATION BY SECTION 25100, 25102 OR 25105 OF THE CALIFORNIA CORPORATIONS CODE. THE RIGHTS OF ALL PARTIES TO THIS PROMISSORY NOTE ARE EXPRESSLY CONDITIONED UPON SUCH QUALIFICATRION BEING OBTAINED, UNLESS THE SALE IS SO EXEMPT.

This is called a securities legend. The reason that most convertible Notes will include this (or similar) language is because a convertible Note is a security, and securities laws apply to the offer and sale of securities. Securities laws are complex, so I will not try to explain them in this post. Suffice it to say that this language will depend on the state in which the investor resides, and that you should leave the tweaking or tinkering with this language to your attorney.

Section 1:

Principal and Interest.

[Company Name]

[state]

Company

[Lender Name]

Lender

[*]

[The term “Notes” shall refer to this Note along with all other convertible promissory notes issued by the Company in exchange for cash advances to the Company at any time from [Date Bridge Loan Begins] until [Date Bridge Loan Ends]. The terms “Lenders” may be used herein to refer to the Lender along with all other lenders, if any, who advance or have advanced funds to the Company in exchange for Notes.]

This section is pretty self-explanatory. Principal is the amount borrowed. Because convertible Notes are debt instruments, or loans, in addition to being securities, an interest rate accrues on the amount borrowed. States have laws about rates which are considered usurious, or illegal, and therefore you will see language in the Note specifying that, to the extent that the interest rate is deemed usurious, instead of invalidating the entire Note, the rate is reduced to the highest permissible rate.

You will notice that defined terms are underlined and displayed in quotes when initially defined and are thereafter capitalized to signify that the specific meaning attributed to the term in this Note should be used, and not a general one. For convenience, parts that need to be customized are shown in bold and are set off by square brackets in this form.

One more general point, before we move on: if you have seen other forms of Notes, you may have seen the bracketed second paragraph of Section 1 refer to a note purchase agreement pursuant to which all of the Notes are purchased. And you may be wondering whether a note purchase agreement is necessary. The answer is, there is no legal requirement to sell notes pursuant to a note purchase agreement, but depending on your Investors (and their legal counsel), they may request one. A note purchase agreement provides for representations and warranties of the Company, for one. It can also include other deal terms, such as multiple closings and/or payment by the Company of Investor counsel's fees, to name a few. If you are raising money from friends and family, you can safely save yourself the time and expense of preparing and signing an additional agreement. On the other hand, if the Investors ask for it, you shouldn't fight it, unless the amount of their investment is so small that it seems silly. :)

Section 2:

Maturity.

[twenty-four (24) months]

Maturity Date

There are a couple of things going on in this section. First, it appears to provide a deadline for when the funds must be repaid. Second, it provides the Investors with some protection, a way to accelerate the obligations under the Note in the event that the Company hits rock bottom before the Note is due.

First why does it only "appear" to provide for a deadline? Generally speaking, an Investor has no expectation that a Note (remember that we are only talking about convertible notes now) will be repaid. The reason that Investors loan money on a Note and not by purchasing stock has less to do with the advantages that an Investor has when it comes to getting his money out, and more with the ease and efficiency of using this method. Jumping ahead to Section 3(c) for a second, we realize that if the Note is still outstanding on the maturity date, it converts into common stock based on a pre-agreed formula. This means that the Company (almost) never has to repay its Investor.

Another way that maturity dates are sometimes handled in convertible promissory Notes is by making it a "demand" note, or a Note that must be repaid after a certain date upon the Investor's demand. This variation, depending on the formula used for converting principal on a Note to common stock, can be either less or more favorable to the Company than an automatic conversion into common stock. Of course, a demand Note works best with sophisticated Investors who are not going to demand to be repaid arbitrarily, when they'd like to get their money back, regardless of the financial health of the Company. I have seen this work really well when the Investors are working with the Company, allowing it some breathing room to get to a Qualified Financing (defined in the Note) after the initial loan term or to find another source of funds to repay the Investors. But this can also backfire with an impatient, inexperienced Investor.

The second point of Section 2 is self-explanatory. If the Company is doing so poorly that it's starting bankruptcy proceedings or another type of winding down activity, in other words, if they've given up, the obligation to repay the Note is accelerated and, assuming that there is no other senior debt, the Investor is first in line to be repaid out of whatever proceeds there are from the liquidation of the Company.

Section 3, my favorite and juiciest section of the Note:

Conversion: Automatic Conversion in a Qualified Financing.

[*]

Qualified Financing

provided

however

[*]

Subsection (a) of Section 3 deals with the best case scenario--within the time frame contemplated by the Company and the Investor, the Company raises more money and the Note converts. There are a number of variables in this section. First, the parties need to decide how much money the Company needs to raise at a minimum to warrant automatic conversion of the Note. If the Note is for $150,000, and the company raises another $150,000 through sale of its stock, it's probably not enough because the Investors do not negotiate for any preferred stock rights at the time when they buy the Note. They are counting on the venture capitalists or the super-angels who are going to buy equity in a Qualified Financing on doing this for them. That means, that the amount that the Company raises which forces a conversion into the same security purchased in such round should be substantial. One million of new money is an amount I see frequently. However, it also depends on the initial investment amount. Notice that the amount is "inclusive of the amount represented by the Note". If an aggregate amount of $750,000 is raised via the Notes, then the Qualified Financing threshold should be at least $1,500,000 or even greater to be meaningful.

The other important variable is the extra bonus that the Investor gets upon a Qualified Financing for taking the early risk. There are several ways this can be handled, and our language exemplifies a best-of-both-worlds approach. It was once the case that Investors received only a discount of 15-20% off the preferred stock price in a Qualified Financing. This approach tends to be less common now, as Investors are asking for more upside for taking risk early.

Traditionally, Investors were not setting a valuation, with the idea that it was too early to tell. Now, Investors lending the Company money on a Note often request a valuation cap for conversion purposes (which is kind of like setting a valuation). If, upon a Qualified Financing, the Company valuation is lower than the cap specified in the Note, the Investors convert at the actual valuation in the Qualified Financing. However, if the Company valuation in a Qualified Financing is valued higher, even a lot higher, than the valuation cap in the Note, the Investors convert at the valuation they fixed when they invested.

One other small point on this section: as you will notice, it provides for the conversion of principal and interest. Financings generally never happen on the date they are supposed to and get moved by a day and then another day and another day. This means that the interest on the Note changes and, therefore, the number of shares into which the Note converts changes. Most likely, this also affects the price per share for preferred stock in the Qualified Financing. For simplicity, the Note can provide that the principal only converts and the interest can either convert or be repaid at the option of the issuer. Sometimes, this little tweak can save a lot of attorney hours.

Conversion: Optional Conversion on a Change of Control.

[*]

provided

however

Change of Control

Section 3(b) describes what happens to the Note in the event that the Company is sold prior to the maturity of the Note. In the event of a successful exit, the Note will convert at some pre-determined valuation into common stock. In the event of a bad exit, the Investors have the option to accelerate the Note and be repaid out of the proceeds.

This provision tends to be left out of Notes with friends and family and generally is found in more heavily negotiated Notes with sophisticated Investors. Another way that a premature sale of the Company is sometimes handled is by providing the Investor with a multiple return on his investment (like 3X the principal amount). If you are not working off a term sheet provided to you by the Investors, and are providing a draft Note to your Investors, I would leave this out for simplicity's sake. If they ask for it, you can add it.

Conversion: Mandatory Conversion into Common Stock on Maturity.

[formula for calculating the number of shares]

If Section 3(a) was the best possible scenario, then Section 3(c) is the second worst scenario (after the winding down of the company provided for in Section 2). The Notes have matured and there is no money to repay them, there has not been a decent-sized equity financing, and the Company has not been sold.

Sometimes mandatory conversion of Notes on maturity is into preferred stock of the last issued series, if applicable, or into the next series, created just for this purpose. If the Note converts into preferred stock, then the parties need to think through the rights of the preferred stock now, since there will not be a bonafide third party investor to negotiate these rights as there would be in a Qualified Financing. Having to agree on preferred rights at the time of the bridge financing complicates matters, which is why I prefer conversion into common stock. The main question is, at what valuation will the Note convert in that case? I have seen cases where the Note provides that it will convert into as many shares as are necessary for the Investors to own 55% of the Company. That's pretty egregious, but it's also the Investors' way of saying "you have failed and we are taking over."

Keep in mind, by the way, that Notes, like any other agreement of the Company, can be amended (subsequently changed) with the mutual consent of the parties. So even if your Notes provide for mandatory conversion on maturity and even if that conversion is not on terms that you love, when your Notes are getting close to maturity, if your Investors still believe in your and think you just need more time, they may agree to amend the Notes to extend the term. Legal documents are frequently amended to fit the reality of the business. But while it is technically possible, the trick is being on good terms with your Investors, so that they are motivated to amend the Note and keep your Company in business.

Section 4:

Mechanics of Conversion.

Section 4, as its name suggests, walks through the mechanics of the conversion. The main takeaway is--the Investor will have to turn over the Note to get shares. Even though the conversion is automatic, the Company does not have to issue a share certificate until it has received (and cancelled the note). Some Notes will provide more detail around the process for dealing with lost, stolen and destroyed Notes. I like to keep Notes simple and don't include this. Bottom line is, it can be worked out if it comes up.

Section 5:

Payment.

Whenever any payment hereunder shall be stated to be due, or any other date specified hereunder would otherwise occur, on a day other than a Business Day (as defined below), then, except as otherwise provided herein, such payment shall be made, and such payment date or other date shall occur, on the next succeeding Business Day. As used herein, “Business Day” means a day (i) other than Saturday or Sunday, and (ii) on which commercial banks are open for business in [City, State].

The main takeaway from this section is that the Note cannot be prepaid without the consent of the Investor. Why not? If it could be prepaid, and there was a lucrative sale of the Company in the works, the Company could repay the Note and leave the Investor without the upside. The same is true for a Qualified Financing. In a convertible Note, the investors bargain for more than just interest as their upside. But terms are negotiable, so if you'd like to try to make the Note prepayable by the Company without penalty and without Investor's consent, go for it. Depending on the specific terms of your Note, that might be the right approach.

Section 6:

Representations and Warranties of Lender

(a) Authorization. Lender has full power and authority to enter into this Note and such agreement constitutes its valid and legally binding obligation, enforceable in accordance with its terms.

(b) Purchase Entirely for Own Account. This Note (and any securities issued upon conversion of the Notes, herein, collectively, the “Securities”) has been purchased by the Lender for such Lender’s own account, not as a nominee or agent, and not with a view to the resale or distribution of any part thereof, and such Lender has no present intention of selling, granting any participation in, or otherwise distributing the same. Such Lender does not have any contract, undertaking, agreement or arrangement with any person to sell, transfer, or grant participation to any person with respect to the Securities.

(c) Disclosure of Information. Such Lender acknowledges that it has received all the information that it has requested in connection with the purchase of the Securities. Lender further represents that it has had an opportunity to ask questions and receive answers from the Company, as well as to consult their own legal, tax and other advisors, regarding the information provided and the terms and conditions of the offering of the Securities.

(d) Investment Experience. Lender is an investor in securities of companies in the start-up or early development stage and acknowledges that it is able to fend for itself, can bear the economic risk of its investment and has such knowledge and experience in financial or business matters that it is capable of evaluating the merits and risks of the investment in the Securities. If other than an individual, such Lender also represents it has not been organized for the purpose of acquiring the Securities.

(e) Restricted Securities. Such Lender understands that the Securities are characterized as “restricted securities” under the federal securities laws inasmuch as they are being acquired from the Company in a transaction no involving a public offering and that under such laws and applicable regulations such securities may be resold without registration under the Securities Act of 1933, as amended (the “Act”), only in certain limited circumstances. In this connection, such Lender represents that it is familiar with SEC Rule 144, as presently in effect, and understands the resale limitations imposed thereby and by the Act.

(f) Accredited Lender. Lender is an “accredited investor” as that term is defined under the Act.

(g) Further Limitations on Disposition. Without in any way limiting the representations set forth above, the Lender further agrees not to make any disposition of all or any portion of the Securities unless and until each of the following have been satisfied:

(i) There is then in effect a Registration Statement under the Act covering such proposed disposition and such disposition is made in accordance with such Registration Statement, or (i) the Lender shall have notified the Company of the Proposed disposition and shall have furnished the Company with a detailed statement of the circumstances surrounding the proposed disposition and (ii) the Company shall have obtained an opinion of counsel, reasonably satisfactory to the Company, that such disposition will not require registration under the Act.

(ii) If such transfer is not being made pursuant to Rule 144 or a registration statement under the Act, the transferee shall have agreed in writing, for the benefit of the Company, to be bound by this Section 6.

(iii) Notwithstanding the provisions of paragraphs (i) and (ii) above, no such registration statement or opinion of counsel shall be necessary for a transfer by the Lender which is a partnership to a partner of such partnership or a retired partner of such partnership who retires after the date hereof, or to the estate of any such partner or retired partner or the transfer by gift, will, or in testate succession of any partner to the partner’s spouse or to the siblings, lineal descendants, or ancestors of such partner or spouse, if the transferee agrees in writing to be subject to the terms hereof to the same extent as if he were an original Lender hereunder.

(h) Foreign Investors. If Lender is not a United States person (as defined by Section 7701(a)(30) of the Internal Revenue Code of 1986, as amended), Lender hereby represents that it has satisfied itself as to the full observance of the laws of its jurisdiction in connection with any invitation to purchase the Securities, including (i) the legal requirements within its jurisdiction for the purchase of the Securities, (ii) any foreign exchange restrictions applicable to such purchase, (iii) any governmental or other consents that may need to be obtained, and (iv) the income tax and other tax consequences, if any, that may be relevant to the purchase, holding, redemption, sale or transfer of the Securities. Lender’s payment for, and his or her continued beneficial ownership of the Securities, will not violate any applicable securities or other laws of Lender’s jurisdiction.

(i) Standoff Agreement. Lender agrees, in connection with the Company’s initial public offering of its equity securities, and upon request of the Company or the underwriters managing such offering, not to sell, make any short sale of, loan, grant any option for the purchase of or otherwise dispose of any shares of the Securities (other than those included in the registration, if any) without the prior written consent of the Company or such underwriters, as the case may be, for such period of time (not to exceed one hundred eighty (180) days) from the effective date of such registration as may be requested by the Company or such underwriters; provided, that the officers and directors of the Company who own stock of the Company also agree to such restrictions.

(j) Legends. It is understood that in addition to or in place of the legends currently on the Securities, the Securities may bear any legend required by the laws of the State of California, including any legend required by the California Department of Corporations and Sections 417 and 418 of the California Corporations Code or other applicable state blue sky laws, and a legend referring to the restrictions on transfer described in this Section 6.

Section 6 is a long section that I am actually not going to spend a lot of time on. These are representations of the Investor and most of them are mandated by securities laws. Note that my sample Note does not contain any representations by the Company, but if your investors are represented by legal counsel they will likely either add Company representations to the Note or add a note purchase agreement to the transaction documents(as discussed earlier in this post).

Generally, Investors are asked to complete an accredited investor questionnaire at the same time when they are sent a draft of the Note (unless you know that they are not accredited, in which case you should consult with your attorney to make sure there is another securities law exemption that can be used).

Section 7:

Miscellaneous.

(a) Assignment. This Note, and the conversion rights described herein, shall not be assignable by the holder without the prior written consent of the Company, which consent shall not be unreasonably withheld. Subject to the restrictions set forth in the foregoing sentence, the rights and obligations of the Company and the holder of this Note shall be binding upon and benefit the successors, assigns, heirs, administrators and transferees of the parties.

(b) Waiver and Amendment. Any provision of this Note may be amended, waived or modified upon the written consent of the Company and the [Lender][Lenders holding Notes with cumulative outstanding principal amounts representing at least a majority of the total principal amount of all Notes, so long as such amendment, waiver or modification applies equally to all Notes].

(c) Interpretation. Whenever possible, each provision of this Note shall be interpreted in such manner as to be effective and valid under all applicable laws and regulations. If, however, any provision of this Note shall be prohibited by or invalid under any such law or regulation in any jurisdiction, it shall, as to such jurisdiction, be deemed modified to conform to the minimum requirements of such law or regulation, or, if for any reason it is not deemed so modified, it shall be ineffective and invalid only to the extent of such prohibition or invalidity without affecting the remaining provision of this Note, or the validity or effectiveness of such provision in any other jurisdiction.

(d) Jurisdiction. The Company and each Lender hereby (i) submit to the exclusive jurisdiction of the courts of the State of California and the United States Federal courts of the United States sitting in the State of California for the purpose of any action or proceeding arising out of or relating to this Note and any other documents and instruments relating hereto, (ii) agree that all claims in respect of any such action or proceeding may be heard and determined in such courts, (iii) irrevocable waive (to the extent permitted by applicable law) any objection which it now or hereafter may have to the laying of venue of any such action or proceeding brought in any of the foregoing courts, and any objection on the ground that any such action or proceeding in any such court has been brought in an inconvenient forum and (iv) agree that a final judgment in any such action or proceeding shall be conclusive and may be enforced in other jurisdictions by suit on the judgment or in any other manner permitted by law. This Note shall be governed by the law of the State of California, without regard to choice of law principals.

(e) Notices. Any notice required or permitted by this Note shall be in writing and shall be deemed sufficient upon receipt, when delivered personally or by courier, overnight delivery service or confirmed facsimile or confirmed electronic mail, or three business days after being deposited in the U.S. mail as certified or registered mail with postage prepaid, if the notice is addressed to the party to be notified at the party’s mailing or email address or facsimile number as set forth below or as subsequently modified by written notice.

To the Company:

To the Lender:

(f) Arbitration. Any claims arising under this Note, except for any such claims for which injunctive relief is sought, shall be resolved in binding arbitration with a duly authorized representative of the American Arbitration Association (“AAA”) in accordance with the provisions hereof and thereof. Either the Company or the Lender may submit the matter to binding arbitration before the AAA in [San Francisco County, California], which arbitration shall be final and binding on the parties and the exclusive method, absent agreement between the Company and the Lender, for purposes of determining the ability of the Company or the Lender to satisfy such claim. All claims shall be settled by a single arbitrator appointed in accordance with the Commercial Arbitration Rules then in effect of the AAA (the “AAA Rules”). The arbitrator shall render a final decision pursuant to the AAA Rules within thirty (30) days after filing of the claim. The final decision of the arbitrator shall be furnished to the Company and the Lender in writing and shall constitute the conclusive determination of the issue in question binding upon the Company and the Lender, and shall not be contested by any of them. Such decision may be used in a court of law only for the purpose of seeking enforcement of the arbitrator’s decision. The prevailing party shall be entitled to reasonable attorneys’ fees, costs and necessary disbursements in addition to any other relief that such party may be entitled. For purposes of this Agreement, the prevailing party shall be that party in whose favor final judgment is rendered or who substantially prevails, if both parties are awarded judgment.

(g) Counterparts. This Note may be executed in two or more counterparts, each of which shall be deemed an original and all of which together shall constitute one instrument.

(h) Entire Agreement. This Note is the entire agreement between the parties hereto relating to the subject matter hereof and supersedes any prior arrangement or agreement, written or oral.

Section 7, the last section in our Note, is what is sometimes referred to as "General Provisions," or boilerplate. This is not to diminish the significance of this section--it certainly contains a number of very important provisions--they are just not as interesting for the Company founders to read about.

I will just make a note here about Section 7(b), the amendment provision. If you are selling multiple Notes (and using that bracketed paragraph in Section 1), it is in your best interest to think carefully about this section. Most agreements, as I've mentioned, can be amended by mutual consent of the parties. However, if a Company has issued 10 Notes, having to chase down 10 signatures to amend the same term in all those Notes (whether it be the threshold amount for a Qualified Financing or the Maturity Date) can be a nightmare. It can be especially silly if one of the Investors loaned $500,000 to the Company and the others, in total, merely $100,000. For the situation where a substantially identical agreement is entered into by the Company with multiple parties, I always advise my clients to allow for amendment, on the Investor-side, by a majority-in-interest.

I find Notes to be a fascinating subject, and I could keep talking about them on and on. If you have further questions, you must have more than a mere philosophical interest in the subject. Call (650-298-6014) or email me, and we'll talk through the details of your specific bridge loan financing.

Inna Efimchik

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Friday, May 27, 2011

10 Things Not To Do In Your Social Sharing | Polyvore Shares Lessons Learned

Earlier this week I went to an event at Hacker Dojo, a coworking space in the heart of Mountain View. It was my first event there, and while I had certainly heard the name before, on more than one occasions, embarrassingly enough I did not know it was a coworking space. So anyway, that was exciting!

The presentation, by Jonathan Trevor of Polyvore, a social commerce company with some 10 million unique visitors per month, goes to the heart of the big, burning question at the heart of every (internet) startup: how do I use social media to get consumer eye balls on your product and, ultimately, traction?

There are many things you can do wrong in this area, which is a science (or perhaps an art) evolving right before our very eyes. In his presentation, Jonathan walked us through some of the common misconceptions about social media as a tool, using examples from Polyvore's own experience. You can find the slide deck for his presentation posted here, but for a more narrated version, keep reading.

Misconception 1: I know what's going on

Never assume that you understand the way social sharing is working or that it is working the way that you think it is. You might think Facebook is the way to attract the most users via social sharing. Or Twitter? Jonathan was surprised to find StumbleUpon to be one of the better organic disseminators. StumbleUpon? I know, I haven't used it either, but apparently it's big, in the right circles.

Measure, instrument and iterate to try and get a better picture of what's going on. You can use Google Analytics, or collect your own data and run SQL queries, whatever suits your fancy. The better that you are at measuring, instrumenting and iterating, the better, more effective, product design you will have.

Don't limit yourself to measuring on your own site. To the extent possible, try to do this on third party sites as well. There are even applications for that, like awe.sm (love the name!).

Misconception 2: I'll focus on the CTR on my site

While CTR (click-through rate) is obviously important on its own, it's even more important as part of a larger social sharing loop. Getting people to "like" your page is not enough, if it is not bringing return traffic to your site.

Once one of your users clicks the Facebook "like" button, or posts content generated on your site to Tumblr, or tweets one of your pages, who sees that content? How many of those who see it are interested enough to follow the link to your website? How many of those who follow the link to your website become a user? This may seem like an obvious point, but it's easy to get caught up in improving CTR on your site, losing sight of the big picture.

Misconception 3: Users want to share

Sure, users want to share, but not all the time. They are inundated in their web browsing experience with all kinds of social sharing buttons, so much so that they've become little more than noise.

What's important in getting people to shares is to align intent with, well, sharing... To use Polyvore as an example, when their users browse sets by other users, maybe they'll "like" those, but there is not an impetus to share. On the other hand, when users create their own sets, sets that they've spent time on and take pride in (hopefully) they want to scream about it from the rooftops. The breakdown of sharing between their set viewers and set creators is 25% to 75%, which is staggering considering how many viewers there are and how many fewer users are creating sets. And it's a good example of how powerful it is to align users' intent with your own.

Misconception 4: One size fits all

There are different kinds of users that you need to think about as you are designing your website.

Bloggers don't share as often (and certainly when it comes to the same service), and they will have a bias against sharing something that already exists (old news). If they can create something original with your product, they are more likely to share it. There is a way to optimize your website for bloggers.

Social sharers, on the other hand, share often and freely. If it's easy to do (e.g., no login required, one-click), they'll do it. There is a way to optimize your website for social sharers, and that's going to look different than a website optimized for bloggers.

One size does not fit all.

Misconception 5: All shares are equal

Not all social shares are equally valuable. Shares on Facebook and Twitter, in theory at least, reach a lot of people, those the viewership may actually be quite small. The environment is noisy. And the content there is short-lived. Perhaps most-importantly, though, it is a low match to reader interest.

When bloggers write about your site, it adds SEO value. There are fewer bloggers than social sharers, but the content is richer and last longer. Finally, there is a much better correllation to reader interest.

Misconception 6: Users can read

Well, maybe users can read, but they don't and they won't.

Polyvore ran tests where they manipulated the amount of text on the same dialog, leaving the pictures and graphics intact. They found that changing or even removing the text altogether had no impact on the users' choices in the dialog.

Misconception 7: Wizards are better than complex forms

We might think wizards are better than complex forms because we know that complex forms are bad. But really, they are both bad. If you can, simplify a complex form into a simple one, instead of breaking it up into a wizard.

Keep in mind that every time there is a new dialog box with a cancel option, you are going to lose users. It's just too easy!

Misconception 8: More networks is better

There is a lot of overlap between networks. And placing 50 buttons on your site just creates noise and clutter. A user doesn't want to sift through all those buttons to find the networks she wants to share on. So how many networks do you really need to get 90% coverage? Maybe up to three? More than that is probably too many.

Misconception 9: Make complex simple ... by hiding

For whatever reason, I think this is my favorite point of the presentation. Simplifying by hiding really works, said Jonathan. If you hide options behind tabs or "advanced" links, users won't find them. So rather than be clever and hide additional features, consider whether you need them in the first place. If you do, find a way to integrate in a simple and graceful way.

Misconception 10: That there are 10 misconceptions

And so we come full circle to where we started: this is an evolving field, where new discoveries are made every day and negated the next and where no truism stays true for long. It is up to today's entrepreneurs to redefine all the conventions of web design and user experience. And I can't wait to see what you come up with!

Inna Efimchik

Emergence Law Group, specializing in assisting emerging technology companies in Silicon Valley and beyond, provides incorporation, financing, and licensing services as well as general corporate counseling.

Tuesday, May 10, 2011

Runway Program by Innovation Endeavors | Giving Entrepreneurs Runway to Launch Their Next Big Company

Undeniably, being in the Silicon Valley gives technology startups a huge boost. This is the place that has amassed the most talent, the most VC dollars, and the best ecosystem for launching. Whatever else may be said for its ridiculously high cost of living (and cost of labor), employer-unfriendly laws, and, take your pick, nasty traffic or seismic uncertainty, I doubt there is another place that can boast so many startup incubators, accelerators, and coworking spaces as the San Francisco Bay Area. The links page on my website features 14 different organizations in this category, and I am sure it is not exhaustive. (In fact, if you are aware of anything I've omitted, please let me know.)

Yesterday, I met for coffee with Corey Ford, Director of Runway Program, a paid six-month entrepreneurship program based out of Innovation Endeavors, to learn more about their project. Here's what I learned.

Who?

Runway is pre-team, pre-idea. You should consider applying if you are (1) entrepreneurially-inclined and think you have the skills, whether on the technical, business or design side, to be an entrepreneur, (2) are willing to commit at least 6 months, full time, to building a company in Palo Alto, (3) are interested in a collaborative process to identify a problem and develop a solution that is a viable business opportunity. (You should also be authorized to work in the United States for any employer.)

Runway is not for entrepreneurs who already have a business solution they are committed to and are just looking for cofounders. It is also not an ideal fit for established teams, as the application process is for individuals and considers each applicant individually (though established teams may apply individually and indicate a preference to work together).

How?

If you are itching to start a company and fit the criterial above, you can submit an application to the program. Applications for the August program will only be accepted for another couple of weeks (deadline is May 23, 2011). There is no cost to apply.

Each application will be individually reviewed filtered on values and on disciplines. Some of the applicants will then be selected to do a mini-project, to test their entrepreneurial skills, followed by interviews. The finalists (less than 20 in all) will meet at a Final Team Weekend and will work on small group projects, observed by Runway program coordinators. Final selection of program participants will be made following another interview round.

What?

Runway gives entrepreneurs "the cushion, connections, and coaching [they] need to take the entrepreneurial leap and succeed." The inspiration and culture for the program has its roots in the Stanford d.school.

The winners, working in self-selected groups of ~3-4, will incorporate a company, receive initial funding of up to $150,000 from Innovation Endeavors (in the form of a capped convertible note) and will proceed to work over the next 6 months, with the mentorship and support from Runway program coordinators, on identifying their business idea and building a business around it.

"Nothing comes from the top down," said Corey during our meeting. "We catalyze the entrepreneurs. The direction comes from them."

At the end of 6 months, which is the financial runway of the Runway companies, they will need to look for venture funding. Innovation Endeavors will not lead the round, but they will help with introductions and may participate along-side the lead investors.

Take Away

This program is obviously not for everyone, and not even for every talented entrepreneur. But I think this can be a great opportunity for some of you out there, so I wanted to help spread the word. More information can be found on the Runway Program website, and you can schedule your own meeting with Corey Ford here.

Inna Efimchik