Startup Advice

Dallas’ Top Startup Lawyer: Kevin Vela

Kevin Vela, Startup LawyerEntrepreneurs ask me for referrals for lawyers all of the time and over the past couple of years my go-to-guy for startups has been Kevin Vela. I’ve worked with a number of lawyers over the years, but Kevin’s commitment to the startup community, reasonable billing and speed have convinced me that he’s the top startup lawyer in Dallas today. Kevin and his firm have helped me with a multitude of transactions including:

  • a management buyout of a seismic equipment company
  • organization of The Haul Company/ViewMarket Inc.
  • leveraged buyout of a media company

I’m pleased to announce that after two years of working together Kevin and his firm have decided to underwrite some of my efforts at StartupMuse and have become sponsors.

Kevin is the founding partner at Vela | Keller. He focuses on working with entrepreneurs and startups. He has performed hundreds of corporate formations and regularly handles governance matters, venture capital financing transactions, and M&A activities. In recent years, he has represented both startups and investors in over $30M in seed, angel and venture rounds. He is active in the legal and startup community, and regularly writes about startup issues on his blog.

Find out more: LinkedIn, Twitter, Facebook, Blog, Email.

Don’t fall for the exploding termsheet!

e273df5d8c9a2ceba9239cbcc018182b_mLast year my co-founders and I got a termsheet from an investor here in Dallas that had a 48 hour deadline. I’ve never taken ‘exploding termsheets’ very seriously and didn’t really pay attention to the clause. We sent the offer to our lawyer and the first time he could meet was 50 hours from the start of the deadline – again I didn’t imagine the investor (after having spent weeks looking at our deal) would seriously pull the offer if we were two hours late with our response.

In the meeting with the lawyer we decided we needed to negotiate a few points and I texted the investor and asked him to email a document we could edit. He responded by saying the offer expired. He said he would consider extending the deadline if we would agree to take it ‘as-is’, without any changes. I was flabbergasted.

After that exchange I knew we were done. My partner insisted on negotiating the deal with the investor and ultimately he did agree to let us make various changes to the offer. But at the end of the day the investor showed his true colors in a single text message – I knew I could never be in business with him.

If you’ve received an exploding termsheet you have two choices. You can ignore it or you can talk to the investor and explain you’re going to need more time. Some very obvious reasons are that you need:

  • Time to review with your co-founders
  • Time to have your lawyer review the termsheet
  • Time to check some references on the investor

At the end of the day the investor, by including a short deadline, is signaling a lack of confidence. If he was confident with his offer he’d happily let you ‘shop’ it around town. Fred Wilson describes how he does it – find guys like Fred to invest in your company and avoid the exploding termsheet.

Convertible Debt Sucks

This morning one of our investors, Dave McClure, created a twitterstorm when he went on an 18 tweet rant about convertible debt. You can read it here or see it below. It got me thinking about convertible debt and how much it can suck. First, for those of you who are unfamiliar with convertible debt I’ll briefly explain how it works.

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Lets say you and your co-founder have starting building a mobile app and need a little money to get it across the finish line. You are likely too early for venture capital so you start looking for an angel investor. You find an investor who is willing to invest $250K, but you’re not sure how to value a company that in reality is hardly a company, lacking revenue or traction. You could argue it is worth NOTHING. You could also argue that is could be worth BILLIONS in a few short years. If the investor is interested in giving you $250K he believes the latter. Many entrepreneurs, instead of getting into a difficult valuation discussion at this early stage, decide to defer it by offering the investor something known as Convertible Debt.

Convertible debt is basically a loan that converts into equity, usually, upon a future equity financing at a discount of around 20%. Convertible debt, usually, includes a Cap – a maximum valuation for the conversion – early stage deals seem to have a $5M Cap. Dave was complaining about the fact that he’s seeing startups demanding higher and higher Caps – $8-12M. He’s responding by asking for 2X liquidation preference in the event the company is sold BEFORE conversion. I’ll argue that he’s right, but that we’re getting to a point where it almost never makes sense for the investor or the entrepreneur to do a convertible debt deal.

Let me recap why you THINK you want a convertible note:

  • it takes less time to close
  • the legal documents are easier and cheaper
  • you defer the valuation discussion (reducing the amount of time needed)

First, I’ll argue that early stage deals are so straight forward that you can get an equity deal done as easily and quickly as debt deal. Second, most securities firms, assuming they think you’re going to be successful, will do your first equity raise for $5,000 (the same price for the convertible debt). Finally, you’re going to haggle about price ANYWAY. The investor is going to set a maximum valuation for the conversion – usually $5M and you will want to set a minimum valuation in the event a conversion event does not occur – usually $3M. Um, your company is worth about $4M – why not just agree now and issue the investor stock? You avoid the discount. You avoid the interest. You avoid all of the possible downsides of convertible debt. Oh and in the event you sell your company before your next round you don’t have to pay your investors that 2X liquidation preference Dave was ranting about.

Of course, if you can raise convertible debt WITHOUT a cap (or a very high cap – say $12M) you should. Most convertible debt deals don’t have control provisions or board seats – you’ll be in total control of your startup. The reality is that high cap or no cap convertible debt deals are almost unheard of today. In my view the ONLY other reasons you might consider raising convertible debt is if you will be raising money from several investors – getting four or five angel investors to agree on a price might prove itself too hard and the bounded box of a max/min Cap might help get them across the finish line. Additionally, with a convertible note you don’t have to set the amount to be raised – if your first investor agrees to put in $100K you can take it and close and then as the second investor agrees a few weeks later to put in $250K you can it and close and so on.

I used to be a big proponent of convertible debt – we financed ViewMarket and ShopSavvy with convertible debt – but I’m fairly convinced that you might as well just raise equity instead.

Lots of people have opinions on this topic:

Ted Wang, Yokum Taku, Mark Suster, Fred Wilson, and Paul Graham.

 

Who owns your startup’s software code?

software-developerYou might be surprised by the answer to this simple question. When I began mentoring entrepreneurs almost a year ago I was shocked that almost ALL of them using third-party contractors didn’t have written agreements. If you hire a third-party contractor to write software code for you, but fail to enter into a written contract specifying that the code is a “work-made-for-hire” you don’t own it, I’m not kidding. The courts use a three part test to determine who owns the copyright to the code written by third parties for your company:

  1. was the code commissioned by your company?
  2. is the code consumer facing? (almost all software meets this requirement)
  3. is there a written agreement between the developer and the company specifying the code was developed as a “work-made-for-hire”?

If you fail any one of these tests the actual developer who wrote the code, regardless of how much you have paid him, actually owns the copyright to the software you thought you owned. Even if there is a mutual agreement between you and the developer that the software is a work for hire, failure to obtain a written agreement PRIOR to commencement of the work means he owns the code, PERIOD. Oh and you can’t go back and fix your error. In Schiller & Schmidt Inc. v. Nordisco Corp., 969 F2d 410 (1992) the courts held that retroactive work-made-for-hire is not permitted. This means you can’t go back later and negotiate a contract in an attempt to ensure your startup owns the code.

Of course there is a way to ‘fix’ your screw up. You can enter into a Copyright Transfer Agreement. Work-made-for-hire agreements are far more desirable because the moment you execute the agreement the software is yours EVEN if the actual contract is breached. In the case of the a Copyright Transfer Agreement the developer (or his heirs) has up-to 35 years to terminate the agreement if he determines the contract has been breached. Copyright law is complicated so talk to your lawyer before you freakout, but whenever you hire someone to write software code for your startup make sure the written agreement specifies that the development work is “work-made-for-hire.”

Here is a simple bit of language you should get your lawyer to add to your contract:

The copyright in all works of authorship created pursuant to this agreement are owned by Client. All such works or portions of works created by Developer are “works made for hire” as defined in 17 U.S.C. § 201. Developer assigns to Clients all right, title, and interest in:

(a) The copyright to all works of authorship (“Work”) and contribution to any such Work (“Contribution”) created pursuant to this agreement;

(b) Any registrations and copyright applications, along with any renewals and extensions thereof, relating to the Contribution or the Work;
(c) All works based upon, derived from, or incorporating the Contribution or the Work;

(d) All income, royalties, damages, claims and payments now or hereafter due or payable with respect to the Contribution or the Work;

(e) All causes of action, either in law or in equity, for past, present, or future infringement of copyright related to the Contribution or the Work, and all rights corresponding to any of the foregoing, throughout the world.

Developer may use the Work only until Developer delivers a final product to Client, and may use the Work only insomuch as such use is necessary to the creation of the final product. Client grants no license to developer for any use of the Work other than as expressly described herein. Developer must request a separate license from Clients for any use of the Work other than as expressly described herein. Such license must be explicitly granted in writing, signed by Client, or it is void. Should a court of law with jurisdiction over the parties and the subject matter of this contract deem the Work not a “work for hire,” and should a court of law with jurisdiction over the parties and the subject matter judge the above assignment of copyright void, Developer grants Client an exclusive, royalty-free, irrevocable worldwide license to use the Work without limitation in any manner Client deems appropriate. [via the ASP]

Startup Advice: Indemnity Boilerplate in Contracts

Entrepreneurs sign contracts ALL of the time and more often than not if you’re paying attention you’ll notice something called an indemnity clause. Here is a clause from an LOI related to an asset sale:

IMG_7039The Seller represents and warrants that the Purchaser will not incur any liability in connection with the consummation of the acquisition of the Business to any third party with whom the Seller or its agents have had discussions regarding the disposition of the Business, and the Seller agrees to indemnify, defend and hold harmless the Purchaser, its officers, directors, stockholders, lenders and affiliates from any claims by or liabilities to such third parties, including any legal or other expenses incurred in connection with the defense of such claims. The covenants of the Seller in this paragraph 13 will survive the termination of this letter of intent.

We see these sorts of clauses ALL of the time, so often in fact that you may assume they are ‘standard’ and ‘boilerplate’. I am here to tell you that you may be risking your ENTIRE business if you don’t take a moment to actually understand what you are agreeing to. Indemnity means YOU will pay for the other party’s lawyer, associated expenses AND any judgement. In many cases indemnity is warranted, but it must be taken in context with the scope and size of the contract.

For example, several years ago I licensed a piece of software to a billion dollar media company who used it in a mobile application. Subsequently a patent troll filed patent infringement lawsuits against more than 50 similarly sized corporations with mobile applications. I had agreed to a ‘standard’ / ‘boilerplate’ indemnity clause and my lawyer (who is no longer my lawyer) didn’t bother to negotiate it at all. According to the clause we would have to cover all of their legal bills (billion dollar media companies hire REALLY expensive lawyers) and pay any settlement/judgement against them. It was clear we would win the patent case, but the cost of defending against it would run into the hundreds of thousands of dollars – we only made $60K or so on the deal at the time. It was a stupid mistake that could have bankrupt the company.

There are two simple AND reasonable edits you should ALWAYS propose when you see an indemnity clause depending on the nature of your contract (BTW this is not legal advice, talk to your lawyer before signing anything):

Option One (I like this one best):

In no event shall the maximum liability hereunder exceed the sum of $10,000 (or whatever seems reasonable).

Option Two (good for larger contracts):

In no event shall the maximum liability hereunder exceed the amount actually paid to [your company] under this contract.

If the other party balks or has a problem with either one of these options you should really ask yourself “why”. Is there a high likelihood of litigation? damages? If there is maybe you shouldn’t do the deal in the first place. But never ever agree to blanket indemnification without a cap ever again. Okay?

Startup Funding: The problem is you, not your address.

asdfI had the opportunity to drop in on the opening ceremony for Dallas Startup Week 2015 on Monday. During the first panel Michael Johnstone of the Mark Cuban Companies was asked why it was so hard to raise money in Dallas and instead of agreeing with the premise of the question he argued that it wasn’t really harder to raise startup capital in Dallas versus San Francisco. I’ve been thinking about it and I’m starting to think he might be onto something.

Case in point, the other day I met a couple of founders at my StartupMuse office hours and listened to them talk about their mobile application. They’ve been working on it for two years and they’re struggling to raise outside capital. After asking the pair about their personal lives and determining they could easily pick up and move to the Bay Area I immediately told them they should move – that was the ticket to startup funding. The next week one of the founders dropped in on my office hours for a second time and we started playing with the actually mobile application – it was horrible. It was then that I realized moving to San Francisco would be a HUGE mistake for this company. Ironically, I imagine it would be EASIER to raise money in Dallas for this particular team – their deficiencies would be glaring in the Bay Area.

Optically, when you read TechCrunch, the startup publication of record, you’re reading about 90 Bay Area startups for every Dallas based startup so you might naturally assume it is easier for startups to raise money there. The truth might be very different.

10000 SFO Based Startups (unfunded)
1000 SFO Based Startups (funded)
10% funding rate

1000 DFW Based Startups (unfunded)
100 DFW Based Startups (funded)
10% funding rate

These numbers are simply for example, but I hope you get the idea. There are simply far fewer startups in the Dallas area seeking funding. I would imagine that for every 100 startups running around in the Valley there is just one here in Dallas. This is just conjecture, but I wonder if it is actually EASIER to get funded in Dallas? In the Bay Area EVERYONE is starting a company and very few of them are getting funded. In Dallas most everyone is NOT starting a company so those who do are the exception not the rule. Perhaps it is easier for Dallas startups to get attention because they look more like black swans than white ones.

In fact, I am the poster child for Dallas based companies raising venture capital. I have attempted to raise startup capital exactly three times. First with LayerOne (total investment $30M+), then with ShopSavvy (total investment $7M+) and finally with ViewMarket (total investment $10M+). In each case I was able to secure the initial funding as well as follow on funding – I really wonder if I would have been as successful if I was in San Francisco.

I am 100% certain that I am not certain whether or not it is harder for Dallas companies to raise venture capital, BUT I am certain raising money is hard. I do, in fact, believe that most of the companies that aren’t successful at raising capital aren’t successful BECAUSE of their product and team – NOT their location. Good products and teams WILL find investment capital regardless of location.

 

 

You Only Have 90 Days to Exercise Stock Options

stock_options_cartoonWhen you first took that early stage startup job you were likely enticed by startup lottery tickets called ‘stock options’. These options to purchase shares in the company were granted to you at some exercise price and they vested over a number of years. Lets assume its been a couple of years and you’ve decided to leave to start your own company. Did you realize that in most cases you need to exercise those options within 90 days of the termination of your employment? If you don’t exercise those options you’ll lose them. Ouch!

Here’s how it works. Lets say you were granted 30,000 options at a dollar a share that vested over three years. You’ve been at the company for two years and you’re ready to leave. Within 90 days you need to write a check to the company for $20,000 to exercise your option to buy 20,000 shares (the amount that has vested). Again, ouch! You’re leaving the company and the absolute last thing you want to do is write them a check EVEN if you think the shares will be worth far more in the future.

So what do you do? My advice to employees taking early stage jobs at startups is to negotiate their employment contracts better. The easiest language to add to your agreement is a simple provision that requires the company to ‘loan’ you the money to exercise your vested options upon termination of your employment. In the case of this loan no money would change hands AND you only pay when you can sell your shares (the shares are the only collateral for the loan). Remember, your holding period does NOT begin in this case from an income tax perspective. If you want to begin your holding period upon exercise you need to ensure that the loan is full-recourse (i.e. you own the money even if the shares turn out to be worthless). My advice? Make sure the loan is non-recourse AND don’t worry about paying the higher tax rate. Good luck and keep exercising. :)

How to raise angel investment in 6 steps.

indexThis morning during my office hours at Cafe Express I had the opportunity to meet with an entrepreneur who is just beginning the process of looking for seed/angel capital for his startup. He had a deck, an idea, a team and was hoping to get some help finding potential investors. I could have made a few referrals, but figured it would MORE helpful to share my own personal experiences raising seed and/or angel capital.

Thesis One: Money Ain’t Equal

When we began looking for seed investors for ViewMarket (an ecommerce marketplace for video content creators) we intentionally sought out investors who’ve had success in the space. For example, we thought Dave McClure would understand the ecommerce aspect of the business from his early experience at PayPal. Next we thought Christine Tsai would would understand the video part of the business from her early experience at YouTube. Finally, we thought Will Bunker would understand the analytics side of the business from his experience as one of the Match.com founders. Once we secured funding from these three we knew we were onto something – they helped us validate our own thinking. Had we raised money from local real estate or oil and gas investors we we’d still be wondering if we were on the right track. Smart money CAN be very smart.

Thesis Two: Smart Money Begets Smart Money

Eventually, if you have any level of success, you’re going to raise a Series A investment from institutional investors (VCs). The fact that you’re earliest investors are familiar with the space and had their own successes will give you a big leg up. First, it is very likely that these engaged angels will help introduce you to the same investors who funded their prior companies (presumably the VC made a lot of money on this deal so they’ll take the meeting). Second, other investors, when they learn that seasoned/successful/known entrepreneurs have risked their own money to help you launch they’ll be curious and want to meet.

Given these two thoughts I recommended that the entrepreneur do the following:

  1. create a list of all former/current startup competitors.
  2. create a list of all startups that have ‘pain’ that his product solves.
  3. create a list of the investors in the above companies.
  4. create a list of the founders of the above companies.
  5. reach out to the investors to ask advice about his product and ask for referrals to potential seed investors.
  6. reach out to the founders to ask advice about his product and ultimately ask for investments.

Only AFTER the entrepreneur had secured an investment from two of these angels should he move forward with a broader conversation with more financial investors. This process will save you a LOT of time. If you can’t convince someone who’s had experience and success in your space to invest – you might want to keep working on your idea before raising money. Remember, most startups fail. If you can find a few entrepreneurs who’ve been there and done it in your space you’re much more likely to find success – leverage their experience. Good luck!

Want to join a startup but don’t code? My 3 Secrets.

creative_sellingI was reading Kyle’s Wong post on LinkedIn titled, “Making An Impact At An Early-Stage Startup If You’re Inexperienced And Don’t Code“. His points are good, but I think he is missing the real point. If you want to join a startup these days you need to do one of two things:

  1. learn how to code
  2. learn how to sell

I’ll tell you my first secret, learning how to sell is MUCH harder than learning how to code. Many developers will likely argue with me, but I can let you in on my second little secret – my 13 year old learned how to code in two languages by the time he was 10. Coding isn’t rocket science – it is something you can learn over the summer. There are scores of online learning resources and with new languages like Apple’s Swift there are more and more opportunities to become an expert within months. My advice? Learn how to code iPhone apps using Swift and start your own company or join a startup. It will be a lot easier than starting a company as a non-technical founder or joining a startup as – well whatever inexperienced non-coders call themselves.

My third little secret is that people who know how to sell make a LOT more money than people who only code. The people who had sales skills at each of the startups I founded got paid more than me – a lot more than me. Selling is a LOT of work, but its a lot of fun. And you CAN learn how to sell. Selling skills translate throughout a startup. For example, when you are recruiting new employees or raising money from investors you’re really just selling them on the vision of the company.

The best place to learn how to sell? The BIGGEST company you can find. They will invest tens of thousands of dollars in you in an attempt to teach you how to sell. Some of the biggest telecom and internet companies in the world spent hundreds of thousands of dollars teaching me to sell. They made HUGE investments in me and I sold millions of dollars of stuff before I left to start my own companies. Take three years and REALLY learn how to sell. It is a BIG investment of your time, but along the way you’ll make a lot of money AND obtain a skill that is very hard to learn.

Most VCs look to hire a CEO who can sell when looking for your replacement. Be that guy/girl from the start. Selling makes everything else possible. Good luck!

 

 

Startup Investor Relations 101

sand-hill-roadOnce a startup founder has raised outside capital, regardless of stage or amount, it is time to think about building a lasting relationship with his investors. Here are my top four tips:

  1. COMMUNICATE regularly with each investor/director by sending a monthly progress/update email. Spend 30 minutes detailing all your accomplishments, challenges and go-forward plans. You don’t want to wait until your next board meeting or until they email you asking what the hell is going on.
  2. ASK each investor/director for help each month. Think about how each investor/director can help you – perhaps with a product launch, a candidate for employment or a business development deal. If you keep them busy they will be a LOT less likely to get in your ‘business’. One of two things will happen – you will get much needed help or he will hide from you.
  3. MEET (in person or via phone) with each director PRIOR to each board meeting. Show him your agenda and ask him if there is anything he’d like discussed at the meeting. If there are controversial issues to be discussed determine where he stands. If he’s on your side enlist him to meet one-on-one with directors who might not be on board yet PRIOR to the board meeting.
  4. DOCUMENT each interaction with your investor/director. The day after your board meetings email an overview of what happened and what decisions were made to each director. You will approve the minutes at the next board meeting, but you’d be surprised how time can change your perception of history. Do the same thing EVERYTIME you engage with your investor/director – a quick followup email detailing what was accomplished and what everyone has committed to do is VERY important.

Let me know if you have any ideas to improve your investor/director relationships.