Founder Employment Agreements: the Non-Compete

One of my favourite clients is a founder who is a startup winner several times over. He is also one of the most aggressive executives I've encountered when it comes to negotiating the terms of his employment agreement. A big no for him is any clause that would prevent him from participating in any other business (as an advisor or otherwise) while employed by the startup. I once asked him why.

His rationale made sense. "Once I bring in a VC, I'm far more likely to be given a reduced role than to be outright fired," he reasoned. "That's fair. But I also need to plan ahead. If I'm not needed 150% of the time, I'm going to use my free time to jump start the next opportunity."

In his experience, this founder says, VCs are reluctant to let a founder go even after they've scaled the company and recruited professional management. "It's mostly an emotional thing for them. But even if I wait them out," this founder continues, "I'm not going to get enough runway to move the next project forward by taking the 4-6 months of severance I'm limited to." It takes 12 months or longer to incubate an idea into a good startup opportunity, he says. "So I need the flexibility to start exploring while I'm still with my current company."

To my surprise, I've seen him get this concession from VCs more than once. As long as he agrees not to compete or solicit employees. It's a good reminder that serial entrepreneurs and founders sometimes need - and are entitled to - accommodations that reflect their nature.

iUpload....and iLeave

My dentist lets me watch The Young and the Restless while she removes tartar. Victor Newman, who is about 5,000 years old, alienates plucky wife Nikki, while his children sleep with each other's spouses, then they all reconcile, then it starts again...the plot plays on a continuous loop. I can't bear to look, but I can't bear to look away, either. Will it ever change?

Sometimes the startup story in Canada appears the same, too. Plucky company becomes a category leader in a giant emerging market, attracts Tier 1 US VC money, and then....the company moves south. Or east to Boston. The executive team, and sales and marketing are run out of its new US office, leaving its Canadian home reduced to a r&d office.

I thought we'd move past the attractions of this growth model, but now comes the story of iUpload. Having raised $7M from Boston VCs Greylock and Northbridge this spring, iUpload has announced that it is moving its 19 person office to Waltham MA. Good luck, troops. But remember: Dunkin Donuts isn't Tim Hortons. The coffee's not as good and the donuts come with scary icing that might be carcinogenic.

Re-Charging Battery Ventures

Another VC who came, saw and then left Canada is Battery Ventures. Its charge to Canada was led largely by Jim Orlando, a former member of Nortel's business development group. Jim spent time with my old fund BCE Capital before being lured to California to be a principal with Battery. As an Ottawa native, Jim was able to help source some great local deal flow for Battery, notably Akara (storage transport over fibre)and OpenCola in Toronto. But somewhere along the line Battery decided to move towards content related investments. Once California and Boston stop trying to posture as the new media centers of North America, I think they'll be back; Toronto is no slouch in the digital content and media area, either. We're one of the best centres for new animation and digital content there is. Jim has moved on to OMERS - if you're looking for someone with a passion for telecom infrastructure, try him there.

Canada's Startups: Unlocking US private equity

Like most lawyers, I find it hard to love any lawyer more than I love myself. But lately, I've been having unnaturally warm feelings about Stephen Hurwitz, late of Choate Hall in Boston. Many of you will remember his predecessor firm Testa Hurwitz, which rose to prominence on the back of its prowess in trade secrets litigation. When my clients wanted to make someone cry, I would send them to TH. Since the demise of TH, Stephen has made his home at Choate Hall.

Stephen's practice is built in part on US and Canadian VC activity, and I applaud his recent efforts to revive US interest in high tech Canada. In particular, he has done a good job identifying and advocating changes in tax treaty rules to make it easier for US VCs to invest in Canada.

Under the current regime, US VCs typically invest through an alternate structure to ensure their capital gains on any Canadian investment aren't double-taxed. Whenever a US VC is added to any deal I work on, I mentally add $100k to the legal fees, and I'm usually not far off. A reform of Canada's tax rules could eliminate this hurdle, at a time when new sources of capital are sorely needed. A summary of the tax challenges of cross border VC investing is available on Choates' web site; I recommend a look for those who want greater detail.

How to Draft an IP Strategy

Consistently the weakest part of investor pitches I see deals with intellectual property strategy. An ip strategy is NOT a list of patents and patent applications. Even at the Series A stage, most investors expect to see (and SHOULD see) a proactive plan that accomplishes two things: 1. ensures that your company can use its technology in its business without fear of infringement, and 2. shows how your company may generate royalty revenue from licensing its ip. It is not essential that you have applications or patents in place prior to financing, as long as you have an overall pitch about how you will proceed.

As general counsel of a startup, I got tasked with developing this part of our story. Later, as a VC, I got to review a strategy from one of our portfolio companies in California that for me remains the gold standard of ip strategies. If it had been a man, I would have taken it home and made it breakfast the next day. (Well, taken it home and then driven it to Starbucks the next day for a scone and a vente bold with an espresso shot). Based on these, I've developed my own flashpoints for shaping an ip strategy:

1. Summarize your company's inventions, products in development and planned development. Identify which areas are likley to yield future inventions.

2. Provide your own assessment of the quality of these inventions/patents. A strong patent not only helps defend your company's market position, but also provides you with leverage to extract licenses for other strong ip from companies who infringe your patents. For inventions that have not yet been patented, assess and identify those which are likely to be strong future patents. As a rule of thumb, these generally are inventions from products with longer life cycles and those which (in whole or in part) are likely to continue to be modified into new products.

3. Identify defects in patents filed, and any prior art issues that may be lurking. Defects in patent applications are often the result of using the cheapest agent, instead of a lawyer/patent agent who is an expert in yoru space and can draft correctly.

4. Explain your competitors' patent situations- for example, the relative strength of their portfolio, what trends you see in their filings or expected filings (aka "whitepaper roulette"). A good patent agent will insist that you do some assessment here, so that he/she may draft claims with a view to capturing potential infringers. If there are prior art or overlapping claim issues, a good agent can also draft a work around so that your patent works.

5. Add some blue sky to your strategy story; give examples of how your strongest patents may be licensed for uses outside of your core business' market.

6. End with a basic plan for policing and enforcing your patents and other ip.

Having a strategy is a critical part of your business plan at any stage. It shows the breadth and quality of your long-term thinking about your company and its place in the market. Stop hiding that light under a bushel!

Lest We Forget: Pequot Ventures

In our continuing salute to the dearly departed (US VCs who've left the Canadian landscape), we recall Pequot Ventures. Formed in 1998, Pequot dabbled briefly in two notable plays here in Canada: Klocwork, the Nortel spin-out and Syndesis, the Toronto-based next generation telecom OSS business. Klocwork also was one of the Ottawa companies I think of as bearing the mark of Goodwin; you all remember Eric Goodwin, first CEO of Fulcrum and then Flonetwork, who has been the go-to Chair of many companies since - including most recently Fortiva. Syndesis has since been acquired and after three announced rounds of financing, Klocwork appears to still be going like, well...you know.

Canada's done well by Pequot. Let's hope they come back soon.

What Your Advisory Board Agreement Should Contain

My views on advisory boards generally go like this: Technology advisory board: good. Advisory board for social networking company: good. Other advisory boards: would have contributed more as independent directors.

If you must have an advisory board, make sure you aim high in building it. Go for marquee names if you must, but strive for members who will really contribute - to the esprit de corps as well as everything else. And make sure they sign an agreement.

Advisory board members are not, de facto, fiduciaries of your company (although in Canada, the Supreme Court has held that a fiduciary duty can be created in pretty much any circumstance). This means that, in order to protect the assets of the company (your number one job before creating shareholder value),you need to have an agreement with your advisors that requires the advisor to do the following:

1. Agree to keep company information confidential.
2. Assign inventions, and other work product created for the Company in his/her capacity as advisor.
3. Assure the Company that acting as an advisor and entering into the agreement do not violate any other commitment of advisor – eg., no moonlighting policies or other obligations. Your Company does not want to be in aposition of having induced your advisor to breach his/her contract with her employer.
4. Require that your advisor tells you if he/she becomes involved with an overlapping or competing business. Since your advisor has other business endeavours, it would not be appropriate to ask for a non-compete from him/her; this soft provision will, however, provide some protection.

Blast From the Past: Kodiak Ventures

Recently I began to create an honour role of the dearly departed - those American VCs who once graced our shores during the height of the high tech boom. Some of them came north in 1998, seeking deals in a less competitive market. Almost all of them returned south once the market slowed down in 2001, and haven't been seen since.

Take Kodiak Venture Partners, the seed stage fund formed by Jim Furneaux and son Dave. At one point, half of Kodiak's seed investments were done in Ottawa, including Icefyre Semiconductor, Solidum Systems, Extreme Packet Devices, Sybridge and Potentia Semiconductor, all of whom raved about Kodiak's support. Kodiak even had an Ottawa man on the street for a while in the form of Bruce Gregory.

Kodiak has announced only one new investment in Canada in recent years - Simpler Networks in Montreal. It still supports BTI Photonics, an earlier Ottawa investment that's still going strong, but otherwise, all appears quiet on the Furneaux front. As its 2001 fund (a reported US$290 m) winds down, let's keep our fingers crossed that the next Kodiak fund heads north again.

Vancouver: Maxed out on Internet Startups?

For me, Civilization reached its low water mark the day I realized that Michael Jackson could convince two women to marry him, but my single women friends could not get dates. Then Markus Frind came along and, with a server and a song, put the universe in balance by setting up Plenty of Fish out of his home in Vancouver.

Styling himself as the anti-VC, Markus has spoken often about how to build a company outside of the venture capital model. Sometimes I want to tkae him aside and say, take it down a notch, already. This is a point of view you're expressing, not an exorcism. Still, his obeservations are interesting.

Take this recent post about the sorry state of Vancouver's internet community. Markus believes Vancouver can't support its nascent internet startups, let alone build the next MySpace. Here are his thoughts:

"The main problem is Myspace alone would need more datacenter space then there are data centers in Vancouver. The major hosting companies have no more power to power servers and space is maxed out, the telco’s don’t want to lay more lines and because of strict building codes leaving no more places to build datacenters that have a fibre connection. Last time I checked peer1 and netnation were no longer taking customers for Vancouver datacenters. From discussions with them it seems there won’t be a solution to this problem any time soon."

Startup Boards: Paying Your Chairman

Many of the boards I work with have Chairs who provide invaluable support and guidance to management. But how much should they be paid for their efforts?

Some Chairs will point to compensation paid to public boards as a reasonable proxy, and then propose that they receive the same, less a discount to reflect the lower liability associated with chairing the board of a private company.

I don't necessarily disagree with this approach. Some of the Chairs I work with are essential parts of the startup team. But do they provide equivalent value to the Company as that received from a public company chair?

Here's the description of the role of the Chariman of the board taken from National Association of Corporate Directors. The Chair:

1. Establishes procedures to govern the Board's work

2. Ensures the Board's full discharge of duties

3. Schedules meetings of the full board and (in consultation with committee chairs) committees

4. Organizes and presents the agenda for board meetings with input from the board members

5. Ensures proper flow of information to the board, reviewing adequacy and timing of materials in support of management's recommendation

6. Oversees the preparation and distribution of proxy materials to shareholders

7. Acts as a liason between the board and management

8. Together with the CEO, represents the company to external groups: shareholders, creditors

These functions, as a whole, are the manner in which the Chair ensure that the Board discharges its fiduciary duty to provide oversight. In most startups, these functions end up performed largely by management. I'm not a big fan of this practice - aside from the obvious legal issues associated with delegating what is really a good chunk of your fiduciary process, the Chair is really taking precious time way from management's ability to build the business. However, as long as a Company believes it receives equivalent value, it may be a reasonable approach.

Venture Law Line Seminar Series: Event #2

Thanks to all of you who attended last week's breakfast seminar on Friends, Family and Angel Financings. We'll be repeating the event in Ottawa on May 7, as part of the Entrepreneurs Symposium hosted by CATA's Women In Technology group.

We're going to fit one more large session in before golf season gets underway. The topic: Expanding Your Sales and Operations to the US (working title: On a Clear Day, You Can See Buffalo). The session will cover the issues we most often confront as our clients begin to sell products and services into the US, hire sales consultants and open American offices. We'll look at everything from: using US-based data centers to run your business, to hiring sales reps and US employees, and pursuing US investors. We'll also talk about special issues affecting startups as they expand south: pending changes in export controls, intellectual property issues, selling toolkits to the US, providing post-sales support from Canada, and the like.

If this sounds like a good topic for you, email me and we'll add you to the list. Space will be limited, but as always carbohydrates, coffee and sardonic commentary will be plentiful.

Rho Canada: More Seed Money You Might Never Have Heard of

Here's another fund that has recently established a Canadian arm for seed investing. In 2006, New York-based Rho Capital announced it had set aside $100 million for seed stage investing. Rumblings about this initiative had been circulating since 2005 as Rho searched for partners to staff the Canadian office.

Jeff Grammer and Antoine Paquin came on board in 2006 and now run Rho Canada's office in Montreal. Many of you will remember Antoine as the CEO of Skystone and Philsar Semiconductor, some of the first Ottawa-area successful startup exits of the dot-com boom. Antoine then went on to the far less successful Bitflash, before heading to California for some surfing and RF power amp designig. I understand he has now settled back in Ottawa.

Although quiet, Rho appears to be taking its first steps in joining the seed investing community. He has re-teamed with Su Abu-Hakima to revive AmikaNow, for one. But its strategy is far from clear; the contact information is sparse,and plans are not actively solicited through their web site. Anyone who can enlighten us, write on in.

New Angel in Town?

Steven McArthur has landed in Toronto, at least part time. The former President of Expedia North America announced his resignation last September. Last month he quietly set up shop in town as Red Devil Capital. What he intends to do with red Devil remains to be seen, but a past that includes stints as President of AOL Canada, responsibility for the Netscape Portal and instant messaging, speculation abounds.

Guy Kawasaki's Canada: When Does this Garage Door Open?

Over a year ago, a Canadian affiliate of Guy Kawasaki's legendary fund, Garage Technology Ventures, was launched with much fanfare.

And then...nothing, as far as I can tell. Events have been held, speeches have been made, but we still have yet to see an investment announced. Guy Kawasaki has made several trips to our fair land on his own, even showing up in the interior of BC as to speak at a local venture fair.

If Guy Kawasaki can find Kelowna, then it seems to me he can find a seed deal to do here, too. Let's hope for an announcement soon.

To patent or not to patent

More and more, I am hearing the same question from entrepreneurs: is it really necessary to file patents, or to have a patent strategy at all? I thought the market and the investor community had dealt with this matter pretty definitively, but maybe I'm wrong. I also thought we'd never again hear from the boy band Menudo, but they're back, too.

Here's the bottom line on patents: if you require venture capital money to grow your business, you must have patents and a rigourous intellectual property program and strategy. While there are many VCs who decry the use of certain types of patents, few believe their investees should do without them. The same applies to those of you who are hoping to sell your Web 2.0 companies to Cisco in under 18 months. Hear me out:

The traditional theory is that patents give the holder a monopoly in the marketplace, and therefore contribute strongly to company value on acquisition or IPO. This theory has been largely debunked by the realities of the patent regime in the United States, the largest customer market for many startups.

Since the early 1980s, when the US patent system was overhauled, patents have become progressively easier to obtain and enforce. (Adam Jaffe and Josh Lerner's book, Innovation and Its Discontents, is a terrific recount of the decline of the patent system, for those of you wanting to learn more) The result? Instead of providing a single patent holder with a protected monopoly, there are now multiple players with overlapping monopolies. Patent litigation has grown exponentially and the cost of infringement litigation or royalties have become an expanding cost of doing business for high tech companies.

This is the current reality in which you are scaling your companies. If you succeed, chances are someone will sue you for ip infringement. (We know our clients have made it when that first statement of claim comes in the door). When that happens, you need to have on hand some defensive patents that can either knock out parts of any infringement claim, or that can be sued as bargaining chips in any patent licensing discussions.

This applies to you Web 2.0 startups with equal force. Look at the amount of money that Tier 1 VCs in the US are putting into this space. It is getting harder and harder to attract top investors as the space continues to crowd. Patents are a key indicator of your competitive advantage in this kind of market.

There's no cost-efficient way to get a good patent application done. Everything you've heard is true - $5,000-17,000 tends to get you to the first step. That does not mean that you should not dig deep early on and find some funds to get the job done. A patent application drafted by someone who is steeped in the technology, and who understand the business, is worth every dime. It can also form the cornerstone of the ip strategy you articulate to investors and acquirors. (Finding that lawyer is priceless, too. I know of only two, and I'm not telling you who they are. They might get too busy to help my clients out).

My two cents.

"No" is a two letter word

I am fascinated by last week's blogfest about how vcs should reject potential investees. Speaking for the sisters, let me applaud this progress; never have so many men cared so much about how to breakup with someone.

For me, the matter is pretty simple: if they're not calling, they're not interested. If they are not sending you a term sheet, they're not interested. Does it really matter how they tell you? I often ask my clients. You have a business to run and money to raise. Don't waste the pretty on someone who doesn't appreciate you.

Still, many gnash their teeth. They need clarity. They want closure. (Is this an episode of Sex and The City?). Here's my working theory on why this is such a sore subject: VCs and entrepreneurs speak two different languages.

On the one hand, entrepreneurs are consummate salespeople. And in sales speak, silence is never an option. When a customer says "No," a salesman hears "Maybe." When a customer says "F@!k Off!", a salesman hears "Maybe Next Quarter." For them, the art of the no is fundamental to business.

By contrast, VCs speak the language of financial romance and behave accordingly. VCs may not want to take things to the next step, but they will want to preserve you as a future option (in case the bar closes down that night without anyone prettier walking in). Mixed signals are the natural language of investing.

Given the context, it's a reasonable way to communicate. Think of the last girl you decided not to call after the first date. Did you tell her you'd had enough while you were both still eating? Did you recommend her to other buddies, in case they might find her more appealing? Of course not.

Entrepreneurs: Don't expect more from the men you are trying to date (financially speaking) than you would do if the situation was reversed. If a VC tells you that they have no bandwidth for your investment, it's not a cop out. Let him who has not said "It's not you, it's me" cast the first stone (J'accuse, Paul Kedrosky!)

Beef of the Week: Share Certificates

I keep a running list of bad moves made in the early days of startups that have ended up costing my clients time and money. Here's one:

DO NOT send your individual shareholders their share certificates. They will lose them. Share certificates are the socks of negotiable instruments; you put two in the dryer, but only one comes out. This means that, just before you want to sell the Company, you will have to send a lawyer out to their house with a declaration of loss that must be sworn and signed, so that a new share certificate can be issued. Of course, chances are that the shareholder moved and forgot to advise you of their forwarding address. So your lawyer will be knocking on the door of the wrong house. Where an odd man who looks he may be involved in internet porn now resides.

Instead, keep the original share certificates in the corporate record books.

Also, DO NOT print your own share certificates. The forms you bought at the book store last week are not complete.The certificates need to contain proper legends that specify if: (a) there are restrictions on the transfer of the shares, (b) the rights are subject to a shareholders agrreement, and (c) if an "accredited investor" (in Canada) is purchasing the shares, the apporpriate language on securities law restrictions may also be added.

More later.

Managing the Startup Board: the Compensation Review Process

Most VCs insist on requiring their startup boards to appoint a Compensation Committee, usually staffed by VC representatives and the odd independent board member. Great concept, but in practice these committees often don't shoulder the full workload one would expect of them.

There are lots of valid reasons for this shortfall: the size of the company, the demands of the rest of a VC's portfolio justify a succinct approach, a VC will argue. Unfortunately, executives seldom agree; they see an unstructured, limited process as arbitrary and even unfair. Particularly when VCs reschedule meetings due to other commitments; too often I have seen executives receive their annual bonuses 6 months late.

I often advise CEOs I work with to become actively involved in the Compensation Committee process, taking the lead in setting the Committee's schedule with them, to ensure that all of the duties one would expect from the Committee are performed. Here's a typical schedule:

February/March:

- Determine annual bonus plan awards
- Determine ESOP grants
- Review CEO performance and establish personal objectives for the coming year
- Review executive team stock holdings

April/May:

- Annual review of CEO and executives' base salaries

October/November:

- Outside consultant's analysis of competitiveness of compensation (note: this is not "What do we pay our other portfolio company teams?" At a minimum, purchasing compensation reports is appropriate)
- Outside consultant's analysis of company performance versus comparable companies

December:

- Establish corporate financial goals for annual bonus plan
- Independent director's compensation review

If your board is not following these steps in some way, it's time to rethink compensation review.

Questions Every Start-Up Board Should Ask their Auditor

In the last five years, I have seen a marked improvement in the way VC-backed boards work with auditors. Many now use as a guide the kind of due diligence questionnaires that we typically prepare for the audit committees of our public company clients. It's a pretty good practice, as long as it's consistently applied and adjusted for the nature of a prviate company.

Here are the questions I wish ALL my board regularly asked of their auditors (or managment):

1. Can you give us a valuation of the level of expertise and overall competence of the Company's finance personnel? (This is particularly important as the trend to underhire continues. "We'll hire a seasoned CFO if and when we're IPO ready" is a strategy I still hear quite regularly.)

2. Are there any unusual revenue recognition issues?

3. Do you believe the Company's accounts receviebales reserves are adequate?

4. What export controls is the Company subject to? (This is an area undergoing considerable change. For example, the US has a number of changes under consideration that could impose new controls on everything from nanomaterials to medical devices.)

5. Level of internal controls - how does the Company compare to industry standards?

My two cents.

Home for the Holidays

I am not what one would call a fancy lass, but I did overpay for a house recently, and now live among the quality. Thanks to school holidays like today, when I have to work from home, I am beginning to understand just how out of my element I am.

Take right now. As I write this, in the park across the street is a father teaching his young boys cricket. As in, the fake British sport of. He brought his own wicket and is wearing cricket whites. Seriously. I'm betting the bumper sticker on his Range Rover says "I brake for Plutocrats."

We don't have a mortgage; we have a mort-GHAGE.

Last Call: Friends, Family and Angels Financing: How to Structure, Sell and Paper the Deal

Enrollment for next Wednesday's breakfast seminar has been brisk, but there are still a few spots available. The deadline for registering (and our catering order) is Friday. After that, you can still show up, but I'm not sharing my bagel with you. Also attending will be the folks from Entrepreneur TV and some other press, looking for entrepreneurs to interview. THEY will get bagels, because they've already registered. You, maybe not so much.

For information and a registration form, email info@venturelawassociates.com.