Can Directors' Indemnities Be Undone?

Angel Investors and VCs who read August 6's Globe and Mail must have had the bejesus scared out of them as they poured over the summary of Schoon v. Troy Corp., a Delaware Chancery Court case that has had boards buzzing south of the border since last spring.

Why? Schoon has established that companies may amend their by-laws and retroactively eliminate indemnity protection for former directors. In other words, investors can find themselves without protection long after their term on a board of directors has ended.

Here's the analysis: Like most North American companies, Troy Corp. had broad indemnification bylaws which entitled directors to seek advances from the company to pay their litigation costs in cases where a lawsuit was brought directors. The indemnification right applied even if the company sued its current or former directors for theft, fraud, or fiduciary-duty breaches (the money would be returned if it is ultimately found that the director was, in fact guilty).

The board suspected that a former director has been disclosing confidential information to third parties and, before proceeding further, took steps to eliminate its obligation to pay the former director's legal costs. So, even though there was an indemnity in place while the director was in office,the director found that the retroactive by-law amendment removed the protection he thought he enjoyed while in office. The court upheld the amendment.

Angel investors and VCs need to think carefully about how this impacts their own protection. Because investors typically wear many hats - advisor, director, controlling shareholder - there is perhaps a greater risk of conflict and dispute in the private company realm, particularly when start-ups go sideways. Sales of a company and highly dilutive "down round" financings are particularly contentious. I've always viewed the typical investor-required broad indemnity as a good check and balance against hard feelings: don't sue unless the harm is so great it justifies the nuisance of disputing the indemnity as well. Now, with Delaware's ruling, the incentive to act in a balanced manner is gone. Will repealing indemnities become a tool for litigation?

The American practice has been to create bilateral indemnification agreements between the company and each director, and this is probably the right apporach to take here (agreements, unlike by-laws, cannot be amended or terminated without the agreement of both parties). I'm not a fan of over-papering early stage investment deals (more on that later) but it seems like a proper response if we are to create a safe haven for angel investors.

Toronto's Emerging Nanotech Stars

Toronto's reputation as a centre of excellence for new materials and nanotech has been quietly building in the last few years. Our favourite data point: our client Northern Nanotechnologies , currently featured in July's edition of the University of Toronto's Engineering magazine. As the article notes, since its spin out of University of Toronto in 2006, the company has quietly raised millions of dollars in funding to build its nanomaterials business. The business is led by Keith Thomas, who built a successful startup in the Healthcare IT space before joining Northern Nanotech.

VC Brain Drain

Interesting dicussion over here about the new $800 million fund being raised by DAG Ventures in California. For the last few years, DAG has been the home of my former colleague Greg Williams, a tremendously talented guy and truly, the worst driver I have known. God only knows how the man gets to his Silicon Valley office in the morning - do managing directors cycle in?

Greg earned his VC stripes here in Canada at a number of prominent funds (many located near subway stations, allowing Greg to avoid the entire parallel parking issue) before being lured south. The fund's strategy is hardly unique (it's the dream strategy for many regional VCs); that they've succeeded, is.

Liquidity for Fantasy Sports Network Pool Expert

Congratulations to our client PoolExpert on the sale of its business. You can read more about it over here, as well as more about Ron and Steve's next great start-up, Filemobile.

Micro VCs: Tiny Rainbows, or Snake Oil?

The emergence of micro VCs is an interesting phenomemon here in Canada. Generally speaking, a "micro VC" is one who has received formal or informal commitments of modest sums from a handful of limited partners. The total amount of capital these funds have to spend generally ranges between $10 - 30 million, often only if and as the fund's limited partners approve.

No VC is going to make a living managing that little amount of money, so what's the rationale behind these enterprises? It can be a clever way to create a track record for investing where one might not exist, which in turn could convince LPs to invest in larger funds later on. To that end, micro VCs will sometimes essentially buy future deal flow by demanding a "right of first refusal" to fund 100% future rounds of their current portfolio. In the current environment, start-ups who cannot access angel money may be happy to agree to the term. (As a lawyer for start-ups, I'm not a big fan of these terms, unless they're appropriately adjusted.)

In many ways, you have to admire this incremental approach to being a VC. It takes a certain amount of faith in the venture capital cycle to place small bets without drawing a paycheck. I'm growing less cynical about the whole scheme; yesterday's announcement from Vancouver's Pangea Ventures (an investor in early-stage clean tech and advanced materials)that it has managed to increase its stake to $32 million is a sign that the model can progress, albeit slowly. And a micro fund can be a reasonable way to deal with the challenges a first-time fund faces in trying to attract limited partners. For a read on what that takes, visit yesterday's Private Equity Hub post by Andrew Scurria here. It'll make you despair of seeing another large venture capital fund in Canada anytime soon.

Developer Compensation: The New Reality?

The compensation plans we have been designing for our later stage software clients have become increasingly light on employee retention and incentive features, such as stock option grants. The trend is an inexorable one, best explained by one client as follows: "Software engineering has evolved from being highly prized to being just another skill set, and compensation has been adjusted accordingly."

In contrast to emerging industries like clean tech and biotech, the skills needed to scale a software business are widely available in many parts of the world. Recruiting employees is no longer driven by the need to attract specialists from a scarce candidate pool; now, it is largely driven by cost. (This is not great news for Canada, once the near-shoring alternative for the US, unless our dollar take a tumble).

Where does that leave employees? One HR professional summed it up: "Software developers are in the same position as automotive industry workers 20 years ago. They are frustrated that their skills no longer garner a premium, yet hamstrung by few options currently available."

In this new software reality, how SHOULD compensation schemes incent software employees? We're working on it.

Toronto's Digital Media Footprint Expands

Congratulations to our favourite animation studio, House of Cool, for completing its recent acquisition of Red Rover Studios, the animation house made famous by the late Andy Knight. We've been working with House of Cool since their early start-up days, when founder Ricardo Curtis left behind Disney and Pixar to return to Toronto to build his own studio. With this latest move, and a number of successful contracts and original projects in hand, Ricardo, Wes and the team continue to build a local digital animation success story.