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(Editor’s note: “Ask the Attorney” is a weekly VentureBeat feature allowing start-up owners to get answers to their legal questions. Submit yours in the comments below and look for answers in the coming weeks. Author Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs.)
Question: We launched our company about six months ago, and we have a couple of angel investors lined-up for about $300,000. We don’t know if we should sell them common stock or preferred (they want preferred). I’ve read some stuff on the web that recommends issuing convertible notes. What do you recommend? Thanks!
Answer: This issue comes-up all the time. Short answer: I recommend that you issue convertible notes.
Long answer: There are advantages and disadvantages to each of the options from the founders’ perspective.
Common Stock: The advantage of issuing common stock is that it is relatively quick, simple and inexpensive. All you need is short subscription agreement and perhaps a stockholders agreement (if you don’t already have one). In addition, from the founders’ perspective, it puts the angels in the same boat as them.
There are four disadvantages to this method, though. First, you’ll need to value the company, which (as discussed below) can be difficult and may lead to a substantial dilution for you. You’re also likely to get substantial push-back from sophisticated angels — who generally will not agree to common stock because they don’t think their money should be in the same boat as the founders.
Additionally, there may be tricky tax issues depending upon the timing of the investment. For example, if you and your co-founders paid a nominal price for your shares of common stock and the angels pay substantially more for theirs shortly thereafter, the IRS may question how the value of the stock could have increased so much and may deem the shares issued to the founders a form of compensation. Finally, it may cause potential problems with respect to stock option grants because the value of the shares of common stock will be established.
Preferred Stock: Preferred stock is extremely favorable to the angels. The only advantage from your perspective is that the interests of the founders and the angels are aligned. Specifically, there is no incentive on the angels’ part to keep the valuation of the company low in the Series A round. (Whereas, if they hold convertible notes, they might want to do so. More on that in a second.)
The disadvantages to issuing preferred stock are significant. It’s relatively time-consuming, complicated and expensive. Legal fees can be in the neighborhood of $20,000 or more if the preferred stock has all the “bells” and “whistles”.
And, as noted above, valuing the company at such an early stage is difficult and often leads to protracted negotiations and substantial dilution to the founders.
Convertible Notes: The issuance of convertible notes is often viewed as a reasonable compromise between issuing common stock and issuing preferred stock. In essence, it’s a form of “bridge” financing that’s designed to provide the company with sufficient funds to get to the Series A round, at which point, the notes would automatically convert into preferred stock at a discount (e.g., 15 percent –35 percent).
The advantage of issuing convertible notes is that it is a relatively quick, simple and inexpensive process. All you arguably need is a short note. Also, it will defer the company’s valuation until the Series A round. By issuing convertible notes, you “kick the can” to the Series A round, at which point the valuation picture would be clearer.
The disadvantage of issuing convertible notes is that once again the founders’ interests and the angels’ interests may not be aligned because, it’s in the angels’ interest for the Series A valuation to be low.
Some angels who think they can make a significant contribution to your company (as a result of their introductions or domain expertise, for example) want to share in the increase in value they are creating. Accordingly, if the angels do agree to the issuance of convertible notes, they will often push for a “cap” on the Series A valuation – which is obviously not in your interest.
Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.
Photo by vaXzine via Flickr
02.08.10
This morning’s roundup of the latest venture capital news and analysis across the Web:
Art by Mike Lucas
Super Ad? - Drew Brees and the New Orleans Saints overcame Peyton Manning’s Indianapolis Colts in yesterday’s Super Bowl, but our eyes were tuned into the commercials, specifically seeking out venture-backed HomeAway.com’s 30-second spot. As we wrote a couple of weeks ago, the heavily-financed online vacation-rental company paid at least $2.5 million to show its first national ad and launch a yearlong campaign centered on Chevy Chase and the rest of the fictional Griswold family of “National Lampoon’s Vacation” movie fame. Was it worth it? Data from Akamai shows that HomeAway.com received an aggregate traffic spike of 460,000 views during the third quarter, compared to an average of 275,000 visitors per minute during most of the game. However, the few reviews of the ad - watch it here - appear to be mixed. The Hollywood Reporter called it hilarious while TVSquad.com said the resurrection of the Griswold family was brilliant, but the San Diego Union-Tribune blasted HomeAway’s spot for essentially being a teaser for a longer commercial on its Web site: “Commercials for ads? That’s just super lame.” And The Wall Street Journal says HomeAway’s ad “didn’t score well.” We didn’t see any other companies spending their venture cash on commercials, but we were expecting something from local-ad start-up Yext after its co-founder tweeted last night, “Yext commercial to air in 4th quarter.” Maybe Howard Lerman was talking about a college basketball game?
Offering Promise - The IPO market could use a swift kick in the butt - while offerings are still trickling out, eight the 10 IPOs since the beginning of December priced below estimates. Will venture-backed Internet marketing firm QuinStreet Inc. jump start the market this week? While investment bankers worry that one “dog” could scare everyone away, QuinStreet is anything but an ugly mutt, at least judging by its financials. In the six months ended Dec. 31, revenue increased 27% to $155 million and income rose 58% to $8.9 million. One concern for QuinStreet, though, is the low barriers to entry in the company’s business, according to WSJ. Meanwhile, Reuters points out that banker Frank Quattrone’s involvement in the IPO may help QuinStreet’s prospects - that is, if he and QuinStreet underwriter Credit Suisse are friends again.
Private Parts - David Hornik of August Capital has got Foursquare “fatigue.” Foursquare is an emerging mobile social-networking service that encourages people to broadcast their location with others. Hornik says it takes a real effort to “proactively check in where you go,” so he wonders it if would be better if Foursquare just broadcasted a person’s location automatically. “Or does that cross the privacy line for most of us?” Hornik asks. Read on here to find out which side of the “privacy vs. utility debate” that Hornik finds himself on.
New York State of Mind - An alert to all New York-area entrepreneurs and start-up executives: The spring program of Startup@Work’s Founder Speakers Series in New York kicks off Wednesday. Moderated by Warren Lee of Canaan Partners, this invite-only program is a series of intimate interviews with successful technology founders and angel investors who share the lessons they’ve learned with the New York start-up community (Check out our profile of the program here.) Lee tells us that Wednesday’s session spotlights 24/7 Real Media, which soared during during the dot-com boom and nearly collapsed in the ensuing bust, before turning things around and delivering a strong exit in 2007. David Moore, 24/7 Real Media’s founder and former CEO, and Mark Moran, former general counsel, will be interviewed. Further sessions include serial entrepreneur Mark Walsh (March 17), Skyhook Wireless co-founder and CEO Ted Morgan (April 21) and Heidi Messer, former chief operating officer and co-founder of Linkshare (May 11). A final spring session will occur sometime in June. Readers of this blog can request an invite by e-mailing startupatwork.org@gmail.com.
01.15.10
Futurist Ray Kurzweil predicts that over the next 20 years, we’ll see as much change in technology as we’ve seen in the past 100. If that’s true, it means the future changes faster than we can keep up with it, notes Draper Fisher Jurvetson managing director Steve Jurvetson in this entrepreneur thought leader lecture at Stanford University. And the only ideas worth following for entrepreneurs are the ones that seem crazy. Ignore consensus, he says, and look for ways to change the world.
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01.14.10
(Editor’s Note: The Start-up Chronicles is a weekly feature giving an inside view of the trials of a bootstrapped start-up – The Cost Savings Guy. CEO and founder Bruce Judson is also the author of “Go It Alone!: The Secret to Building A Successful Business on Your Own” and a senior faculty fellow at the Yale School of Management.)
Over the past few years, I have been approached from time-to-time by prospective entrepreneurs who have an idea that they believe will support a compelling Web-based business. In today’s create-a-job employment market, this occasional question has become a regular one.
There is obviously a long checklist that anyone should review before embarking on a new enterprise. So, this list is a set of prequalifications—based on my experiences—rather than a way of determining an ultimate go/no-go decision.
Can you code? I believe it’s critical that any solo entrepreneur who will use the Web as a marketing vehicle be able to create and maintain their own Web site. A fundamental rule of direct marketing is that you cannot predict what will work. You need to continuously modify your site based on experience with live prospects.
If you do not have the ability to creatively generate this ongoing evolution yourself, a couple of things can happen: First, you will inevitably spend a fortune asking a freelance designer to continuously make changes for you.
Second, the time between new insights and tests will take days or weeks, instead of hours, as you inevitably end up in a time consuming cycle of scheduling based on availability, back-and forth based on your vision and the inevitable conflict between beautiful designs and simple, effective direct marketing designs.
Moreover, since the optimization of a landing page can make a huge difference in your ultimate profits this cycle never ends.
Even if you can’t hand code a site, it’s possible to use Wordpress to build extraordinarily sophisticated services.
Why is your idea worth developing (in two sentences or less)? Sure, great ideas can be complex – but if you cannot express them simply, you will never be able to sell them to prospective customers or sources of funding. Business ideas that can’t be explained easily usually require more clear thinking.
Here’s a related point. An idea that is effectively a single, better feature for an existing type of service rarely wins. The incumbents see a good idea and incorporate it into what they are doing.
Do you have the right amount of expertise in your chosen industry? Outsiders are often the source of transforming ideas. So, it’s entirely possible that you can develop a business in an area where you are not presently an expert.
However, you need to understand why a seemingly brilliant, innovative idea hasn’t been previously implemented. Has it been tried and failed for reasons you don’t understand? Is it impractical because of some other reason, which is specific to this industry? In addition, long-term success will require that you become an expert in the industry associated with your business idea. Today, you may have a valuable insight, but a sustainable business will require that you become ever more sophisticated in how you serve an industry.
Do you believe a great idea will propel you to success? If so, you’re delusional.
Even if you’ve got the best idea anyone has ever heard, it’s still smart to keep your day job until you’re certain of how it could be flawlessly executed. (You want to plan for flawless execution, so that in reality you can achieve good execution. Nothing ever works the way its planned.)
Great execution is what matters. I have seen many good or even less good ideas lead to great businesses because of terrific execution. Rarely, if ever, have I seen the reverse. A great idea that is poorly executed it an almost-certain formula for failure.
Are you a good marketer or salesperson? These are crucial skills. Unfortunately, people who have spent their entire careers in the back office often attempt to become entrepreneurs without recognizing how hard it is to move the needle with prospective customers. A previous career in sales or marketing is not a prerequisite. But, an ability to convince other people of the value of your ideas and services is essential.
There is a myth that great ideas are what propel successful entrepreneurs. Finding a good idea is the easy part. It’s the execution that’s difficult.
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