Today, my partner Seth wrote a great piece on the merits of early-stage startups raising convertible debt rounds versus traditional preferred stock equity structures.  The piece was inspired by Paul Graham’s recent tweet that said:  “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”

Seth’s piece is a must read in this debate that is only gaining more participants, including a nice follow up from Mark Suster about his thoughts.  I can’t do justice to either Mark’s or Seth’s pieces trying to summarize them, so I strongly encourage you to read them.

I’m going to go out on a limb and break out my old law bar card and bring up one issue that I don’t think is getting enough focus in the debate:  the use of debt fundamentally changes the fiduciary duties of managers and board member of the company.

If a company raises cash via equity, it has a positive balance sheet.  It is solvent (assets are greater than obligations) and the board and executives have fiduciary duties to the shareholders in the efforts to maximize company value.  The shareholders are all the usual suspects – the employees and venture capitalists.  Life is good and normal. 

However, if a company is insolvent, the board and company now owe fiduciary duties to the creditors of the company.  By definition, if you raise a convertible debt round, your company is insolvent.  You have cash, but your debt obligations are greater than your assets.  Your creditors include your landlord, anyone you owe money to and folks that you might owe money to you, like former disgruntled employees and founders who have lawyers. 

How does this change the paradigm?  To be fair, I have had no personal war stories here, but it’s not hard to construct some weird and scary situations.

Let’s look at the hypothetical:

Assume the company is not a success and fails.  In the case of raising equity, the officers and directors only own a duty to the creditors (landlord, etc.) at such time that cash isn’t large enough to pay their liabilities.  If the company manages it correctly, even on the downside scenario creditors are paid off cleanly.  But sometimes it doesn’t happen this way and there are lawsuits.  When the lawyers get involved, they’ll look to try to establish the time in which the company went insolvent and then try to show that the actions of the board were “bad” during that time.  If the time range is short, it’s hard to make a case against the company.

However, if you raise debt, the insolvency time is forever!  Not just when cash got below the ability to pay liabilities like the equity situation, because the company has never been solvent. 

What does this mean?  It means that if your company ends up failing and you can’t pay your creditors, landlords, etc. that their ability for a plaintiff lawyer to judge your actions has increased dramatically.  And don’t forget, if you have any outstanding employment litigation, etc., all of these folks count as creditors as well.   

The best part of all of this is that many states impose personal liability on directors for screwing up things while a company was insolvent.  Read this to be:  “some states will allow creditors to sue directors personally for not getting all of their money they are owed.” 

Now I don’t want to get too crazy here.  We are talking about early-stage / seed companies and hopefully the situation is clean enough that my doomsday predictions won’t happen, but my bet is that few folks participating in convertible debt rounds are actually thinking about these issues.  And no, I don’t know of any actual cases out there, now.  But I’ve been around this business long enough to know that there is constant “innovation” in the plaintiff’s bar as well. 

Today, I received notice that the NVCA has formally rejected two parts of this lengthy-titled bill.  (You just have to love the names they put on these bills). 

Don’t let your eyes glaze over – this bill, if enacted with currently wording could really hurt innovation in this country.

As I previously wrote, Senator Dodd brought wants to repeal the existing federal preemption of state regulation over “accredited investor” securities offerings. This would end the uniform, national set of rules for financing start-ups. By eliminating regulation that is working well, the draft bill would expose technology startups to a potentially complicated system of patchwork, state-by-state regulation, resulting in higher costs, more legal risks, and the potential of not being able to raise capital because of different rules in different states.

Nothing would be gained from this change: no additional protections would be provided to the accredited angel investors and there would be no benefits to the national financial system or to the economy.  It would just make raising money much harder for entrepreneurs and line the pockets of corporate lawyers who would comply with these new rules.

Secondly, the draft of the bill recommends adjusting the accredited investor standard for inflation. As we understand it, this section would change the current requirement for an individual of $1 million in net worth or $200,000 in annual income to about $2.3 million in net worth or $450,000 plus in annual income. At a time when many accredited investors have lost more than 20 percent of their net worth in 2008 and innovative start-ups are having an increasingly difficult raising equity capital, decreasing the potential pool of angel investors is counter-productive to supporting the very companies that will create new high-paying jobs.

the Angel Capital Association has joined forces with the NVCA.  Hopefully Washington will listen to reason here.  Otherwise, this could have a tremendously bad effect on our ecosystem. 

Brad and I are thinking about updating our Venture Capital Term Sheet Series. We’ve heard over the years from folks that they’ve used our series to teach classes.  We are delighted by this and whenever we’ve been asked, we’ve always said (and will continue to always say) “with our blessing.”  However, we haven’t kept track of any of this over the year and have a few ideas for things we can do to update the material now that five years have passed.

So – I’m writing with a simple request.  If you’ve used, or encountered, our Term Sheet series in a college (undergraduate or graduate) course or any other teaching / seminar environment, can you leave a comment below with the information (school / program / year / professor) or email me the information?

For those of you concerned about nefarious plots on our part, I assure you that we are delighted this material is out there in the public and are happy to have it freely used and passed around for all eternity.  I promise we won’t send Jack Bauer your way.

Yesterday I posted about Young Startup Ventures trying to rip off Boston-based entrepreneurs.

Today, I’m pleased to report that after hearing of the pay-to-pitch requirements of Young Startup Ventures, Microsoft has done the right thing and no longer is allowing the group to use their facilities.  We should all congratulate them on doing the right thing. 

It appears that the event is no longer on their website, either.  Nice.

I’d also like to thank Dan Primack for the real estate on PEHub and all of you who supported my position via retweets. 

If any of you hear of other similar scams, let me know.  I’d like to weed out as many of these as possible.

Apparently, our work to weed out unscrupulous venture events is not done.  Today, I learned that Boston entrepreneurs will be the next victims to be fleeced out of their cash in order to have the opportunity to pitch to VCs. 

To quote my partner Seth:

THERE IS NO CIRCUMSTANCE IN WHICH ENTREPRENEURS SHOULD PAY TO PITCH THEIR BUSINESS TO PROSPECTIVE INVESTORS.

PERIOD. END OF STORY.

It’s not just Seth.  Much of the credit goes to Jason Calacanis for leading the charge against such practices.  But while Jason was instrumental in dissolving a few pay-for-pitch groups, it seems like this one has managed to survive.  (Hopefully not for long).

Name:  Young Startup Ventures

Date and Location: April 21st, at the Microsoft New England Research & Development Center in Boston, MA. 

Cost to Pitch: $4,500.  (Attendance only is a hefty $1295 unless you early register for $895)

Now unlike some other events like this, there are a list of credible VCs attending and it is being held at Microsoft.  This makes it all the more worse.  I bet that some are unaware of the payment mechanism. 

Just for toppers, this group offered one company that I know a featured “Top 20 innovators spot” if they paid their bounty.  So these con artists are also trying to con the VCs on what the best companies are by who pays.  Nice work.  This just makes the whole thing dirtier than it already was.

Overheard from one VC planning to attend is that he wouldn’t fund a company that pays for access like this, as it shows they aren’t that smart.  Question why the VC is attending, I don’t know.  But I bet it’s not a unique viewpoint.

I’d encourage both entrepreneurs and VCs to boycott this event.  There is plenty of money around the table here to have an event that doesn’t steal from founders.  Most all credible VCs I know are happy to take an email from you and discuss your venture.  You showing up at an event like this isn’t necessary. 

Today has been a busy day meeting companies.  2-3 a day is about average for me, but today I’ll hit double digits.

Several of the teams today exhibited red flag issues that most likely shot their chance for Foundry Group funding them.  And they were simple things that they should have gotten correct. 

1. Not having a clue who I am.  No, this isn’t an ego thing.  (Okay, maybe a little), but how do you show up and pitch me when you know NOTHING about me?  You should be tailoring your pitch to what you think you know about me.  For instance, you don’t need to tell me that the music industry is changing or that the future of BigLaw might be different than it is today.  We can certain debate what the specifics are (and I welcome the conversations), but not having a clue that you are deeply involved in some of my domains is off putting.  Besides, I’m really easy to find on the web and figure out mostly what I’m about;

2. Not doing a Google search for your competitors.  I met with a company today that claimed they had no competitors.  It was the classic 4 square chart where they were in the upper right quadrant and there were no other companies.  The problem is that there are two that I know of who have raised over $60m between them and this company had never heard of them.  When I asked them if they had done any research, the answer was “no”’; and

3. Not listening.  Entrepreneurs need conviction in order to be successful.  I get that.  But when you are pitching me, it might be a good idea to listen to my advice and not step all over me.  If you do, it makes me worry about what future board meetings might be like.  I always tell entrepreneurs that “I have no idea if I’m right, but here are my opinions.”  And if you don’t like my opinions, then I’m not a good funding partner for you.  No offense taken, either.  There were several folks today who “knew everything” and I found it quite difficult to imagine investing in them.

Ironically, my bet is that none of the companies who committed these infractions will see this blog, so this isn’t for them.  But if you are pitching a VC, don’t make it ever harder by screwing up the easy stuff. 

Today, I was asked through AskTheVC the following question:

‘”Why don’t VCs tell you the reason why they don’t invest? Any feedback would be useful. It’s just plain rude.”

I figured that this is really a personal question, so I thought that I’d post on my personal blog, as I certainly can’t speak (or even guess) the response for the entire VC industry.

I say “no” all the time.  (My partner Brad talks about “saying no” in a great post here).  In fact, I say no to over 90% of what I’m invited to invest in immediately.  On top of this, I get several to many emails a day regarding investment opportunities. 

Time is a resource that I don’t have nearly enough of.  Therefore, if your company is not doing something that we’d invest in, I feel the best use of my time is to send a quick email saying that it’s not right for our fund.  For me to give feedback on your idea, business model, team, etc. seems arrogant given that I haven’t spent any real time evaluating your company.  I’m not trying to be rude, rather, I don’t feel qualified to give you opinions on something that I’ve only taken a short gander at.  Unfortunately time constraints don’t allow me to deeply look at companies that aren’t right for our fund. 

For the other 10% of things that I spend time on, I do try to give some meaningful feedback, but sometimes it’s easier than other times.  Sometimes, there are one or two things that I have strong opinions about which I’m happy to share.  Sometimes, there are things that I’m seeing with our own portfolio companies that are relevant to your company that I may want or not want to share with you.

Lastly, one thing that has always been tough for me to deal with is when the main issue with the company is the entrepreneur(s) themselves.  It’s not easy for me to say “I wouldn’t invest in you” and I try to stay away from that, because people change and improve over time.  But there are times when the opportunity doesn’t involve an entrepreneur that excites me and thus my feedback, generally, is lighter.

I’m sure there are plenty of VCs out there that are rude out there.  I try not to be and hopefully succeed more often than not. 

All of us in the startup eco-system hear about the “evil” down round or “cramdown” financings that happen.  These days, the noise level around this financing dynamic is increasing, not decreasing.

While most entrepreneurs worry about down rounds, I’d argue that many times the entrepreneurs and employees are the ones that come out ahead.  In most cases, while the valuation is reset, the VCs funding the round don’t want to injure the current employee base by wiping out their equity holdings.  So what’s the answer?

VCs will look first to wipe out other VCs that are not participating in the round and give additional options to the employees.  Secondly, the VCs may consider wiping out their own previous equity to accomplish the same effect.

What I’ve seen over the past 10 years is that most (not all) times, the employees end up with roughly the same amount of equity while non-participating VCs are completely taken out and participating VCs being partially diluted.  Of course, ex-employees are wiped out as well.

There are plenty of examples of these types of transaction and there are plenty of examples of ultimate success stories with these companies.  My personal favorite is Stratify, but my friend Lorenzo Carver wrote a blog post about two recent examples: Open Table and SpringSource.  He points out that these are among the best exits of the year.  It’s an interesting read.

Bottom line, a down round / cramdown isn’t the end of the world for either the company or its employees.  While still stressful and painful, don’t get too out of shape.  All could turn out just fine. 

Edwin Miller of Sullivan and  Worcester recently published an article called Time to Reboot the Basic VC Deal Structure, in which he argues that we should radically change the way VC deals get done.  In his words:

"New York Times columnist Tom Friedman recently suggested that “It’s Time to Reboot America,” meaning that the financial crisis gives us a chance to fundamentally re-examine the way government and the private sector operate. Perhaps it is also time to re-examine the basic venture capital deal structure that has changed little since the 1970s.

A related issue is bloated legal documents. Simple forms that address only realistic scenarios are desirable. Sensible legal documents do not have to paper to death every one-in-a-thousand scenario. Simple, common-sense documents are easier for all parties to understand and be comfortable with, and they are cheaper and quicker to negotiate and sign. This approach may be a competitive advantage, or if broadly accepted, would promote a better outcome for all parties."

He had me at "bloated."  For those readers of my Law Firm 2.0 series, it should not come as a surprise that I think today’s legal documents are indeed, bloated.  Edwin’s thesis that many of the terms included and negotiated in today’s financing documents are unnecessary, irrelevant and / or just plane crazy is both thoughtful and correct. 

If you are interested, you should read the article.  He addresses many of the major deal points found in VC financings.  I agree with most of his assertions, but feel compelled to push back (quickly) on a few of them.

Registrations Rights:  I couldn’t agree more that any time spent negotiating reg rights is wasted time for entrepreneurs and venture capitalists and billable hours for lawyers.  However, I have been in situations that I’ve needed demand rights on a company that blew a filing and was no longer eligible for S-3 registrations.  I’m very far away from being a public company lawyer, so perhaps this doesn’t matter any more, but did then.

Anti-Dilution Rights: I am a VC, so I’m clearly biased, but I wouldn’t agree to the termination of Anti-dilution rights.  I think they are appropriate for two reasons.  One, there are large information asymmetries between a VC and a company and no amount of due diligence will ever put a VC into the same knowledge shoes as an investor.  Second, I’ve seen situations where a new potential VC to the company (who wants to invest in a lower priced round) teams up with management to try to squeeze out an early round VC.  They promise management an option refresh making them whole and the new VC would get an outsized share of the company.  For this reason, I want the protection to protect against such opportunist behavior.

Liquidation Preferences:  Alright Edwin!  I’ll take your new paradigm.  Problem is that I don’t think that I can find high quality entrepreneurs who will agree to this.

Founder Guarantee:  I think that I’d rather keep how we operate now in that there is no guarantee of ownership, as I think that properly incentivizes management.

That being said, I love the concept of dumbing down the NVCA model documents and making things easier.  Ediwn, nice job and keep the ideas coming. 

Ever since Brad and I created our term sheet series, we’ve been regularly asked "okay, so what do some model documents look like?"

Well, today, our friends at Techstars posted their model forms of seed financing documents.

Techstars worked with Brad, myself and very closely with Cooley Godward Kronish, LLP (and specifically Mike Platt) to put together a set of “Model Seed Funding Documents” that anyone can use.

There are five primary documents in the set:

• Term Sheet
• Articles of Incorporation
• Bylaws
• Subscription Agreement
• Election Consent

Of course, these are just example documents so all legal disclaimers about usage apply (e.g. “do with them what you want, but we take no responsibility for your actions.”)  That said, I think these are a great starting point for anyone doing an early stage financing.