The Technology Entrepreneur Will Save Us!

It's difficult to read the news today without feeling depressed. Each day brings new reports that the business world is going from bad to worse and that an economic turn around is not likely to happen for some time to come. Who can pull us out of this downward spiral? Peggy Noonan, current Wall Street Journal columnist and former presidential speechwriter, suggests in today's Wall Street Journal that it will be the technology entrepreneur:

"Dynamism has been leached from our system for now, but not from the human brain or heart. Just as our political regeneration will happen locally, in counties and states that learn how to control themselves and demonstrate how to govern effectively in a time of limits, so will our economic regeneration. That will begin in someone's garage, somebody's kitchen, as it did in the case of Messrs. Jobs and Wozniak. The comeback will be from the ground up and will start with innovation. No one trusts big anymore. In the future everything will be local. That's where the magic will be. And no amount of pessimism will stop it once it starts."

Innovation now!

The End for Non-Compete Agreements in Massachusetts?

There's a movement is afoot in Massachusetts to legally ban non-competition agreements just as California has done a long time ago. This has created quite a buzz within the entrepreneur community (see also altgate.com and innoeco.com). Having started my career in Silicon Valley, I had always found non-competition agreements to be rather odious, but had to accept them when I began practicing in New England where they are usually an absolute requirement for working in a tech start up. Most tech companies in New England require everyone from the CEO down to the receptionist to sign a non-competion agreement. I must confess I even managed to successfully enforce a non-competition agreement against a former employee while serving as general counsel for a local startup (Entrepreneurs please forgive me!).

The argument for non-competition agreements is that they are really designed to prevent particularly unethical employees from leaving one company and taking that company's secrets to a competitor (and since you have no idea who these bad apples will be, you make everyone sign one). While it's true that confidentiality agreements are designed to protect against this risk, the reality is that confidentiality agreements are difficult to enforce, while it's certain that if you can prevent a former employee from working for a competitor, you're likely to prevent the transfer of company secrets. And given the cost and difficulty of enforcing non-competition agreement, companies would generally only seek to enforce a non-competition agreement in the most egregious cases.

Arguments against non-competition agreements:
- Non-competition agreements make New England companies less competitive with companies in California, where non-competition agreements are unenforceable as a matter of law. I've actually participated in negotiations with prospective employees where the non-competition agreement becomes an issue between choosing a job in Silicon Valley versus a job in New England (though lifestyle and weather are probably bigger factors). Why make it any harder to keep talent in Massachusetts?
- It's just wrong! It's bad public policy to prevent people from working where their talents are most valuable. In fact, courts in Massachusetts and other states where non-competition agreements are enforceable are generally reluctant to enforce non-competion agreements as a matter of public policy.

Bridge to Somewhere

In addition to cram down financings, I've been seeing a lot of bridge financings in recent months. This is not surprising as companies and investors alike struggle to establish company valuations during these turbulent economic times.

In venture finance, a "bridge financing" is a type of financing where a company raises capital (usually from existing investors) through the issuance of convertible notes or other debt instrument to provide a company with just enough cash to get to the company's next equity financing (hence the term "bridge"), at which time the bridge debt typically converts into the same type of stock being issued in the equity financing. Bridge financings are also used to provide a company with enough operating capital until the company is able to close a liquidity event or other strategic transaction.

While some commentators urge entrepreneurs to avoid bridge financings whenever possible, if the bridge financing is truly in anticipation of a near term event (within the next 3 to 6 months) that is reasonably certain to occur and to increase the valuation of the company, then a bridge financing may be the ideal financing approach.

One advantage of bridge financing is that they are generally simple from a legal documentation perspective since they generally do not require any change to the company's capital structure or amendment of the company's charter. Documentation often involves only a simple form of convertible note (and sometimes a note purchase agreement).

One of the primary drawbacks of bridge financings is that if the equity financing or other bridge event does not occur before the maturity date of the bridge debt, the bridge debt holders will have significant leverage over the company to negotiate more favorable conversion or repayment terms than those originally negotiated at the time of making of the bridge loan. Bridge financing investors also often demand that the company issue them warrants or agree that the bridge debt converts at a discount to the price per share paid by other investors in the company's equity financing. Such warrants and conversion discounts are dilutive to holders of common stock.

2009: The Year of the Cramdown

Launching a blog with an inaugural post on 2009 being the “Year of the Cramdown” certainly seems like an inauspicious way to begin a blog on entrepreneurship and launching start ups. But based on the last half dozen deals I’ve been working on to close out 2008, there’s no denying that 2009 will be a rough year for raising capital for start ups. This should come as no surprise as we are now in the midst of the most severe market correction since The Great Depression. Based on what I’m hearing from VCs and others in the financial community, many predict it will be at least another year before the lending and debt markets stabilize, which is a necessary condition for a rebound in the equity markets. The equity markets in turn drive the valuation of start up companies. So if your company needs to raise money in 2009, don’t be surprised if the term sheet calls for a cramdown.

In venture finance, a "cramdown" is defined as a transaction where new capital is invested into a company on the condition that existing investors in the company accept undesirable terms, such as conversion of their preferred stock into common stock or into a new class of preferred stock stripped of protections and preferences enjoyed by the preferred stock being issued to the investors participating in the cramdown. A cramdown is also often accompanied with a reverse stock split to reduce to the total number of outstanding shares before the new money is invested in the company, which further dilutes the interest of existing stockholders.

As painful as a cramdown may be, it is often necessary to reset a company’s valuation – as well as everyone’s expectations about a company. A cramdown also has the effect of clearing out the “dead wood” from a company’s capitalization by reducing the interest of investors and former employees who are no longer actively involved with the company and not contributing to the company’s future success.

Unfortunately, none of this is much comfort to those stockholders whose equity positions are reduced to nothing – or next to nothing - in the cramdown, especially when those stockholders may have invested millions of dollars or countless hours of sweat equity in the company prior to the cramdown. During a cramdown, there is often a temptation among investors and management to lay blame upon each other. Often, there is a temptation on the part of the investors leading the cramdown round to “punish” those investors who are unwilling or unable to put up additional capital in the cramdown round. Laying blame and seeking retribution, however, only makes the process more difficult and legally risky for everyone involved. Stop and think before you fire off that vitriolic email that might make you feel better today but you will likely regret tomorrow. Imagine how those emails will be used later in a disgruntled stockholders' lawsuit, which is likely to pop up months or years after the cramdown when the company has turned the corner.

What you should be focusing on is getting through the cramdown process as fairly and efficiently as possible and making the best use of the new capital raised in the cramdown.

What It's All About

I realize this is a very crowded space. There is no shortage of bloggers, opinions and viewpoints on venture capital, startups and entrepreneurship. It’s a very vocal and chatty community. But having been a start up lawyer for more than a decade – both inside and outside of startup companies – I’m hoping some of you might be interested in my experience and perspective. If I’m successful, you will find something interesting. If I'm really successful, you might even find some practical advice on legal and other issues related to the formation, operation and growth of start up companies. Yes, I work at a law firm at my day job. And yes, it isn’t in the nature of lawyers to offer free advice. But this blog is truly a hobby of mine and no one is paying me to do this. Perhaps it's the former journalist in me (emphasis on former). Perhaps I'm inspired by the advice of Atul Gawande, the author of "Better: A Surgeon's Notes on Performance", who encourages everyone to Write something to become a positive deviant. I welcome your suggestions on topics to cover and how I can make this blog better.