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Deal Strategies for

Venture Capital and

Private Equity Lawyers

Top Attorneys on Protecting IP Assets, Handling

Fund-Raising and Formation Issues, and Working with VC

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Copyright © 2007 by Aspatore, Inc.

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The

L

ife

C

ycle of a

V

enture-

B

acked

C

ompany

Frederic A. Rubinstein

Partner

Kelley Drye & Warren LLP

Audrey M. Roth

Partner

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Introduction

Throughout the life cycle of an emerging company, an experienced, well-connected venture capital lawyer can provide invaluable assistance and help the company avoid pitfalls and dead ends along the bumpy road to success. From a company’s start-up, through friends and family/angel financing, into building its sales and marketing strategy, to venture capital financing, to finding and structuring the right strategic alliances and relationships, and to maturity and exit, an experienced lawyer should be an integral part of the company. Helping with organization, structuring, strategy, networking (the non-technology kind), compensation, and capitalization, among many other areas, is a critical part of the lawyer’s job. Being proactive is an important way a lawyer can add value to a company. To be permitted to act proactively, counsel must be seen as a trusted advisor to the client who is available, responsive, and knowledgeable about the client’s industry, the venture capital world, technology/life science companies, and the problems usually faced by aggressive and rapidly growing companies.

A truly value-added lawyer is an active participant in all stages of the company’s growth without draining the company’s coffers or increasing its burn rate. This delicate balance is a difficult but not impossible feat, as we will show in this chapter.

Start-Up Phase

The initial year of a company’s existence often sets the stage for its ultimate success or failure. The company is at its most vulnerable stage. With little in the way of finances and no significant track record—other than past performance of the founders—the company must fend for itself. Bootstrapping becomes a way of life, and lawyers are perceived as a luxury, not a necessity. Nothing could be further from the truth. From the type of entity chosen to intellectual property protection, among other critical issues, founders need to make informed decisions based on reliable and time-tested knowledge. All too often, entrepreneurs retain counsel without investigating their relevant experience. This can have highly negative consequences, some of which may not become apparent until well into the company’s life cycle. The company’s valuation may be adversely affected, its intellectual property

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compromised irrevocably, and it may be faced with obligations that are oppressive and unnecessary at best and overwhelming at worst.

Organization

One of the first decisions an entrepreneur must make is the form of entity that will permit the venture to grow effectively. There are three meaningful choices,1 each of which has advantages and disadvantages:

Form of

Entity Advantages Disadvantages

S Corporation • Taxable income and losses of company flow through to shareholders

• No corporate income tax2

• Limited liability for owners and management

• With few exceptions, entities may not be shareholders

• Generally, company may not issue more than one class of stock3

1

We have included the three commonly used forms of entity. In extremely rare instances, we have seen founders use the general partnership model, which subjects each owner of the business to general liability and thus puts the owners’ personal assets at risk.

2

Although S corporations are not subject to income tax liability on a federal level, an S corporation may be obligated to pay state or local income taxes. Examples of this are (i) the 1.5 percent tax on income generally levied on S corporations in California and (ii) the unincorporated business tax that is payable by companies doing business in New York City.

3

S corporations may issue a separate series of common stock that is non-voting, but it must be the same as the voting common stock in all other ways.

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C Corporation • No restrictions on who may be a shareholder

• Different classes and series of stock permitted to be sold with different rights and at different prices

• Limited liability for owners and management

• Company is subject to taxation at the entity level, and shareholders then are taxed on dividends/

distributions, resulting in double tax and lower benefit to shareholders

• Each holder of a given series of stock must have exactly the same rights and pay the same amount per share for shares issued concurrently

Limited Liability Company (LLC)

• Same flow-through tax treatment as an S corporation

• No restriction on who may own securities in the company

• No restriction on classes or series of securities • Purchasers of securities may pay different amounts for their ownership interests in the company • Limited liability for owners and management

• Venture capitalists are reluctant to invest in LLCs • More complex to grant the equivalent of corporate stock options, which are an important component of an

emerging company’s compensation structure

Many start-ups choose the LLC as their form of entity without being aware of its disadvantages. Once an LLC is selected, it can subsequently be merged into a corporation, but it may be difficult to retain any options or similar future equity rights granted to employees or consultants that were granted prior to the date of the merger. Many experienced venture capital

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lawyers will advise entrepreneurs to organize initially as an S corporation in order for the shareholders/founders to avail themselves of the tax benefits of losses that will flow through to them individually, as they would in a limited liability company. The advantage of using an S corporation instead of a limited liability company is that at the time the company obtains institutional financing, it can revoke the S corporation election and become a C corporation at no extra cost and without modifying its essential form. An inappropriate choice of entity is not an insoluble problem for start-ups. However, it can be costly to fix and can have adverse tax consequences at precisely the time the company has few funds and is focusing on other, more critical parts of its business. It is always an advantage for entrepreneurs to limit distractions from their core mission: growing their companies.

Intellectual Property Protection

There is no more important issue to a technology or life science company than the protection of its intellectual property. Unfortunately, many entrepreneurs are not fully aware of the perils of failing to take adequate steps to secure their rights to their proprietary information. Protection can take many forms: patent, copyright, trademark, and trade secret, to name a few. Therefore, it is critical that the entrepreneurs establish a relationship with a knowledgeable, experienced intellectual property attorney early in the company’s life cycle.

An experienced attorney will encourage a prospective client to focus on intellectual property protection before almost anything else. While corporate, real estate, employment, and other problems can almost always be fixed, once unprotected intellectual property is disclosed to others, even the best lawyer may not be able to secure its protection. At the very least, entrepreneurs should obtain a preliminary online patent search on the U.S. Patent and Trademark Office Web site (www.uspto.gov/patft/index.html) to ascertain whether any issued patent or published application covers their ideas, products, or services. The search is not a substitute for intellectual property counsel, but it can

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provide some basic information about whether infringement issues may arise. Good patent counsel can steer the entrepreneur toward an alternative strategy if need be, may point out vulnerabilities in existing patents and applications, and may be able to suggest broader claims and protections for a prospective patent.

We have seen start-ups lose intellectual property protection by publishing proprietary information on their Web sites or otherwise disseminating it publicly, or having their intellectual property misappropriated by larger companies that refused to signed non-disclosure agreements while taking advantage of unsophisticated entrepreneurs. Even relatively sophisticated founders will often be so eager to engage in discussions with large companies that they will deliver proprietary information before obtaining patent protection and without an adequate non-disclosure agreement or with one that is so diluted that it becomes meaningless.4 An experienced

attorney can intercede on the client’s behalf and seek meaningful protection.

Even something as seemingly uncomplicated as choosing a corporate name can present the start-up with a challenge. It is relatively simple to set up a corporate entity in most states, although the selection of the state of incorporation is an important choice. The founder can check the availability of a given name on most states’ Web sites and then incorporate the company immediately. What the founder may not consider is that a name that is clear in one state does not mean it is available in others. Moreover, corporate names are only the beginning. There are trademarks, trade names, URLs, and foreign translations of names, among other issues, to consider. The company’s counsel can help a start-up choose a name it should be able to grow with through its life cycle. Furthermore, a decision should be made as to whether the name of the company will be the same as the name of its

4

A recent example of how more sophisticated companies are attempting to lessen non-disclosure agreement protections is the use of an “unaided residual information” clause. This clause provides that even if information is confidential, to the extent a recipient can retain the information in his or her memory unaided, the information can be used by the recipient party. Clearly, this has potentially damaging ramifications for the disclosing party. We try to strike the clause or significantly narrow its application.

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initial product or service. Having to change a company’s name after it has achieved brand recognition can be costly and damaging.

Finally, experienced counsel can assist in the crucial step of hiring new employees, many of whom will have worked for other and possibly competitive technology or life science companies. Many prospective employees have signed proprietary information agreements with their previous employers, which prohibit their using any of the company’s proprietary information other than on behalf of the company. Those agreements usually provide that the employer owns any inventions created by the employee while employed by the employer.5 Some agreements also

contain enforceable prohibitions against competition with the employer. Counsel to the start-up can usually determine whether hiring a particular employee is likely to cause problems. Many large companies are extremely aggressive in protecting their intellectual property and may allege that the departed employee is using the former employer’s intellectual property for the benefit of its new employer. They may even sue the start-up, timing the suit and its announcement when the start-up introduces a competitive product. The start-up, in order to protect its intellectual property, should require each of its employees and consultants to sign its own form of proprietary information agreement. Experienced counsel will draft a form of agreement to address issues that may arise with prospective employees, and will review with management any disclosures by the employee of intellectual property he or she may claim to own, to ascertain whether any problems are likely to ensue.

Intra-Founder Arrangements

Entrepreneurs are well known for “hitting the ground running.” Upon the formation of their business entity—and frequently before—they work long days, nights, and weekends, moving at a rapid and aggressive pace to

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The scope of the agreement varies. Most often, it states that the employer owns any invention created by the employee that is related to the employer’s business and that the employee has worked on during business hours or while on the employer’s premises. Some provisions are much more broad, stating that anything created by the employee during the course of employment is owned by the employer, to the extent it relates to the business.

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develop their products or services, hone their business models, and try to raise funds. One important matter that tends to be deferred is determining how the founders will interact with each other. This is another area in which an experienced venture capital lawyer can be valuable. Founders need to have an agreed-upon set of expectations about their ownership of the business, their respective roles, how the board of directors and management will be structured, and how their ownership interests will be treated if they leave the company, if they die or are permanently disabled, and even if they get divorced. Counsel can aid in this process, sharing their experience with the founders and helping defuse any emotional discussions that may occur. Once the founders have made key decisions on these and other issues, counsel can draft an agreement between or among them that will manage expectations and reassure potential investors that the founders have already addressed issues that might otherwise have caused delays and distractions in the course of and after a financing.

Initial Stock Plan

One of the principal methods for young companies to attract quality employees—from engineers or scientists to salespeople, marketing experts, and operations staff—is to incentivize them with an ownership interest in the company. The rationale for this approach is several-fold. First, these companies are unable to compete with the salaries more mature companies can afford to pay. By giving employees a “piece of the company,” they are using the “capital” they have available—their stock—to offer the employees a chance to share in the company’s future successes, either through a stock option plan or the purchase of restricted stock.

Stock option plans are somewhat complex and need to be structured carefully and thoughtfully so as not to trigger adverse tax consequences to the employee or the company, or hinder later venture capital financings, among other reasons. Counsel should be familiar with the issues that are important to institutional investors, and can engage the founders in discussions about these issues. Two of the more important concerns of venture capitalists with respect to employee stock ownership are:

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Vesting. Typically, options should vest over four years, with no equity being earned until twelve months after the employee’s start date. Vesting thereafter may be monthly, quarterly, or annually, although monthly vesting is used predominantly.

Acceleration upon change of control of the company. Prior to arranging a

venture capital round of financing, management often includes an acceleration provision in the event of a sale or merger of the company so all options at that time become immediately exercisable. Venture capital lawyers know unrestricted acceleration of vesting can cause serious concern to institutional investors and can adversely affect the company’s valuation.6 We advise

companies to be flexible in their acceleration clauses or to provide a “double trigger” for acceleration upon a change of control.7

An alternative mechanism for stock issuance to consider, particularly early in a company’s life cycle, is a sale of “restricted stock” to management and key employees at a low price that can be justified because of the questionable value of the company at that early stage.8 Restricted stock

grants are popular among founders because they can be very tax-advantageous. Within thirty days after purchasing such shares, the grantee needs to file an election under Section 83(b) of the Internal Revenue Code of 1986, as amended, electing to pay tax on the difference, if any, between the purchase price and the fair market value of the stock at the

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Venture capitalists are concerned that if all the options vest, key employees will have no incentive to stay with the company after it is sold. This may cause the acquiror either to lower the purchase price in the sale or, in cases where continuity of management is important, to cause the acquiror to walk away from the deal.

7

A double trigger is commonly structured so vesting of options is accelerated if (i) the company is sold (whether by stock sale, asset sale, or merger) and (ii) the employee is terminated by the acquiror within some period of time thereafter—usually ranging from six to eighteen months.

8

Restricted stock is stock that is sold by the company at its then-fair market value. It generally contains similar vesting provisions to those provided in stock options. The unvested shares are generally subject to buy-back by the company at their original purchase price.

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time of the purchase (the difference frequently being zero). The election, if properly made, can protect employees from being required to pay taxes on the gain between the purchase price and the fair market value at the time the restriction is eliminated even if the underlying stock is not sold (or cannot be sold because of securities law restrictions). This is especially important for holders of more than 10 percent of a company’s stock, who are not eligible under present law to receive “incentive” stock options (options that are not subject to taxation on their exercise). The recipients of non-incentive stock options, on the other hand, have the disadvantage of having taxable income upon the exercise of their options, in an amount equal to the difference between the exercise price of the options and the fair market value of the underlying shares at the time of exercise. Furthermore, it is possible that the employees may have to exercise their options at a time when the underlying shares have securities law restrictions against their sale. Such a situation would render the employees subject to taxation without the ability to sell shares to cover their tax liabilities. If the employees had instead been permitted to purchase restricted stock at its fair market value, typically very low in an early-stage company, they would have been taxed on the difference, if any, in the amount they paid and the fair market value at the time the restricted shares were purchased by them. Thereafter, they would not have any taxable income until they sold the shares.

Other Value-Added Early Input by Venture Capital Lawyers

Experienced counsel can add value in numerous other ways at the early stages of a company’s life cycle. In addition to the advice outlined elsewhere in this chapter, we are including some of the other major areas below where their input can have significant positive effect.

Employment Matters

The earlier a company standardizes its employment policies and practices, the more likely it is to avoid problems with its employees. Many start-ups hire people without checking references, doing adequate background checks (in the case of key employees), verifying immigration status, or using a

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standard and carefully drafted form of offer letter. We have seen companies enter into employment agreements with long terms of employment and even with severance provisions for all levels of employees. This type of agreement can be damaging for the company if it needs to terminate employment for any reason. Investors generally dislike companies using employment agreements with a guaranteed duration of employment and prefer instead that almost all employees be “at will,” thus giving management the right to terminate them without the requirement that severance be paid. Venture capitalists advocate the use of stock options or restricted stock as a more effective and appropriate tool to give employees an incentive to stay with the company.

Experienced counsel can draft employee manuals and put standardized practices into place, such as conducting regular performance reviews and creating a written record for each employee, which are highly useful when seeking to terminate employment. In addition, it is invaluable to have counsel conduct periodic trainings with managers and staff about employment practices, intellectual property protection, and other issues. Management and counsel should be a team, working together to protect the company in all matters relating to employees.

Business Modeling

Over the course of its life, a company’s basic business model is likely to evolve significantly. At its earliest stages, a defensible and well thought out model is a crucial part of a company’s ability to grow and move toward a financing event. Venture capital counsel can again be an invaluable part of the management team, giving input into the business modeling process. While this area does not usually involve legal issues, good venture capital counsel are more than mere lawyers. They should be advisors, giving start-ups the benefit of their experience representing young companies. These counsel are likely to have seen numerous mistakes made by other entrepreneurs, can point to specific examples of what tends to work and what doesn’t, and focus the company on the following practical issues. What is the market for the product or service? Is it a large enough target market to be of interest to future investors? What is the strategy for

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capturing a significant share of the market? Is the company going to be first to market, or is the space already crowded, making it difficult to differentiate the product or service? How is the product or service distinguishable, and what and how difficult are the barriers to entry for others? How will the company evolve? Is the business scalable? What hurdles are there, and how does the company plan to conquer them? What is the ultimate exit strategy for the investors—sale to a company or the public market? These are among the issues venture capitalists will be looking at in making an investment decision. Experienced counsel knows how companies have struggled with these issues in the past and should be familiar with the industry in which the company operates. The earlier a company has a solid business model from which to operate, the more readily it will be able to achieve its goals.

Securities Laws

One of the early mistakes young companies make is offering or selling securities without complying with federal and state securities laws. This can cause significant problems later in the company’s life, because offers and sales of securities that are not in compliance with securities laws can subject the company to rescission rights in the purchasers and/or penalties. When experienced counsel gets involved with a company at a later stage, much time and energy may be required to correct these problems. If experienced counsel enters the picture at a sufficiently early stage, it is likely that offers and sales of securities will be undertaken in compliance with laws, and the company will save money and avoid later distractions. Experienced counsel can also guide the company regarding terms of sale of securities and make sure it does not consent to provisions that may cause problems with later financings.

Readying the Company for Financing

After the start-up is organized and operating, one of its continuing tasks is raising sufficient funds to finance its business in each of its stages of development. The venture capital lawyer’s familiarity with this process, and all that must be done in preparation, can help the company in numerous ways.

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Business Plan and Executive Summary

The first contact a potential investor usually has with an emerging company is with an executive summary describing its contemplated business and addressing issues expected to be of concern to the investor. Assuming the investor desires to learn more about the company, the summary will be followed by its detailed business plan. These, then, are critical documents that can make or break a financing. Investors receive scores of executive summaries every month and at best give them a quick read-through. If the executive summary does not thoroughly and compellingly lay out a brief summary of the business and persuasive reasons justifying the sought-after investment, the company will lose the attention of the investor. The general rule of thumb is that an executive summary should be no longer than three pages and should capture certain critical information. It is the written equivalent of an “elevator pitch.”

Experienced lawyers will participate in the creation or thorough review and critique of the company’s business plan, particularly the executive summary. Lawyers who have worked with young companies understand the way executive summaries and business plans should be structured. Entrepreneurs are often too close to their product or service to give an objective view of the market, the competition, the business model, or the amount of financing it will take for their company to succeed. Experienced counsel focus their clients on presenting a persuasive and thorough plan that addresses the concerns and interests of venture capitalists, making sure the business model is credible, addresses and captures a significant portion of a large enough market, and fulfills a meaningful need that has not previously been adequately met. Lawyers should also make sure their clients update the business plan frequently. In a rapid-paced industry, important elements can change extremely quickly, and nothing can damage a company’s prospects more than outdated information.

There are numerous Web sites with advice on the elements of a good business plan and what an investor will look for. Here are examples of a few:

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• newyorkangels.com/entrepreneurs/criteria.html

• sbir.gsfc.nasa.gov/SBIR/BusPlan.html

• techventures.org/resources/docs/Outline_for_a_Business_Plan.pdf Many venture capital Web sites will also give valuable information about their criteria for investment as well as their primary areas of interest. Once the company’s business plan and executive summary are complete, the founders face the prospect of selecting appropriate candidates to approach for investment. Venture capitalists and angel investors are inundated with unsolicited business plans and rarely have the time or inclination to give those a careful review. Although many venture capitalist and angel Web sites provide for a mechanism for entrepreneurs to send their business plans, without the right personal introduction to the prospective investor, the company faces an uphill battle to garner any meaningful attention. One of the ways counsel can be most value-added is by providing these introductions. Entrepreneurs can learn much in an initial meeting with prospective counsel by asking about their approach to providing introductions. Good lawyers will suggest a targeted approach to venture capitalists with particular attention paid to their prior history, the industry of the company, and the stage of financing. It doesn’t help the early-stage company to solicit venture capitalists who normally invest in mid- or late-stage companies. The converse is also true. Investors often look to the lawyers with whom they have worked and whom they trust for deal flow. Experienced lawyers value their reputations and do not inundate investors with unwanted and inappropriate deals.

Managing Expectations

Valuation

Entrepreneurs are understandably enthusiastic about their product or service. Their passion is critical in moving the company forward and attracting financing and customers. However, a byproduct of their passion for their enterprise is that they often have unrealistic expectations about it and, in particular, its potential valuation. An important part of a venture

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capital lawyer’s role is to help create realistic expectations for the management team. Experienced counsel generally has an understanding of a reasonable range of valuation venture capitalists are likely to suggest and how much room there may be for negotiation.

Lawyers must walk a fine line in working with clients on this issue. Entrepreneurs like to feel their advisors believe in the company, and any suggestion of a lower valuation for the company can meet resistance. Our experience is that it is best to have this discussion with young companies before they actively seek financing. We have had clients who have lost financing because they were so insistent on a particular minimum valuation that all investors walked away. Ultimately, those companies did not succeed, because they were unable to obtain funds. One way for lawyers to approach this sensitive topic is to share illustrative anecdotes about other clients who have struggled and ultimately succeeded in growing their companies to a point where, based on performance, they received a much higher valuation in subsequent rounds. Pushing for a high initial valuation may haunt start-ups later, because on subsequent investment rounds, with added investors, which are invariably necessary, investors generally expect a ramp-up in valuation as confirmation that the company is improving. It is often better to start with measured expectations and increase them as the company has positive developments.

It is also important to try to assess the amount of money a client requires in any particular stage of financing. It may be preferable to seek less money at an early stage when the investor is likely to place a low valuation on the company, with the realization that the company will seek another round of financing after it has made sufficient progress to warrant a greater valuation. There are also proposals an experienced attorney can suggest to negotiate a higher valuation, although these are becoming less acceptable. Lawyers may propose milestones and staged investments, even volunteer possible downside protection in case the company fails to meet agreed-upon milestones. Some of these concessions to propose to the investor to use in the event the company fails to perform include granting warrants on the stock or an automatic downward change to the conversion ratio (increasing the number of shares the investor is entitled to so the valuation is implicitly

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reduced), increased protective provisions (using some of the typical debt-like negative covenants), and even permitting a takeover of the board of directors by the investors of the company. Venture capitalists, however, generally prefer less complex deals with lower valuations for the company while providing potential upsides to management via stock options or restricted stock.

Board Composition

Before a financing occurs, many founders underestimate the importance of their company’s board of directors. They view the board as a mere formality with no practical importance. Nothing could be further from the truth. From the earliest stages of a company’s development, it is important that the board be structured so it helps the company more easily accomplish its goals. Usually at the initial stage, the founders are the only board members. Once the company starts to grow and the founders seek financing, they should consider how to assemble a value-added board. Many entrepreneurs place friends or family on the board either in an effort to ensure that they will retain control of the company after a financing or as placeholders for likely venture capitalist representatives to the board. This tactic creates an unnecessary and unavoidable extra step to the financing process: a board restructuring. Leaving people off an early-stage board eliminates the embarrassment of subsequently asking them to resign.

Counsel can help the founders structure a board that will reassure venture capitalists that the company is already operating professionally and in a manner likely to promote its growth. We generally advocate a three-person board at early stages of a company’s life cycle, consisting of the chief executive officer, one other founder (usually the chief technical officer in a technology company and the chief scientific officer in a life science company), and one outside and independent director who supplies missing expertise in an area that will benefit the company—in the industry, in finance, or with connections to strategic partners. The second management director should understand that he or she will most likely need to resign after a financing to make room for a venture capitalist designee. We have found that with this board structure the company is more likely to prevail in a

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negotiation with venture capitalists regarding the number of board seats to which the venture capitalists will be entitled. The venture capitalists should then realize the entrepreneurs understand a board’s function and have tendered a positive working model with neither party having a majority. Founders are understandably reluctant to cede control to a group of financially focused investors who are not as thoroughly involved in the company’s day-to-day business as management is. Some clients are reluctant to “waste time” justifying everything they do to individuals who “just don’t get it.” This tension exists because investors believe they need substantial control to protect their investments, while entrepreneurs want to be given the money and be trusted to “do the right thing.” The job of counsel is to structure a compromise so both sides are reasonably satisfied—to manage expectations and needs, and to permit the parties to become true business partners.

Where investors have the right to only one board seat, they will expect contractual provisions giving them veto rights over certain significant actions that may be taken by the company. These actions usually include the right to merge, sell the company, sell a material portion of the company’s assets, amend the charter, borrow amounts in excess of an agreed-upon amount, enter into certain types of transactions, and so on. The object of the company is to attempt to minimize or circumscribe these rights so the investors have a veto right only if their board designee does not approve the action. This works to the company’s advantage, because the board designee has a fiduciary duty to act in the interest of the company, including all of its stockholders. Investor stockholders, however, do not have the same level of fiduciary duty and can vote as stockholders, not directors, to protect their own interests.9

When a financing round is syndicated by venture capitalists, which happens more often in later-stage rounds (so the venture capitalists mitigate their risk and secure the benefit of the added venture capital access, funds, and experience), investors may have conflicts about board membership. In

9

In many states, the majority stockholders may have a fiduciary duty to the minority stockholders, which provides a measure of protection for the common stockholders of the company—the founders, employees, and often friends and family.

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stage deals, as the amount of money raised generally increases (with some deals now raising more than $100 million in one round), these issues may become even more contentious. Because of the inherent conflict in the fiduciary obligation the venture capitalist director designee has both to the company’s stockholders and to his or her venture capital fund’s limited partners, some venture capitalists may prefer not to designate a director but to have the right to have an observer attend board meetings and receive the same information furnished to directors. They rely on contractual provisions for their protection.

Capitalization and Founder Ownership

One of the major concerns of founders, especially at their company’s early stages, is how large a piece of their company they will have to yield in order to obtain financing. We have discussed this earlier in the “Valuation” subsection. Most founders are unwilling to give up a majority of their ownership to investors at an early stage because they realize they will have an ever-shrinking piece of the pie as the company seeks additional financings in its later stages. There are many ways an experienced venture capital lawyer can help management address this thorny issue:

• Counsel can help management estimate the amount of funding the company needs to progress to its next stage, when the company’s valuation will hopefully be higher and the percentage of the company it gives up will thus be smaller.

• Founders should be made to consider that voting control of the company may not be as important to them as the ultimate value of the company in which they are likely to be significant stockholders.

• Counsel can help entrepreneurs obtain critical common stock voting requirements for key issues such as board control and change of management to protect entrepreneurs against arbitrary or inappropriate action by the venture capitalists or their director designees.

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• Management may be able to make up some lost ground by negotiating for additional stock options or shares of restricted stock, some of which may have performance vesting provisions, so if the company does well management will be able to regain some portion of its lost ownership.

Founders often do not adequately take into account the reserved pool of equity that must be available for future grants to employees, directors, and others. Before undertaking a financing, counsel should focus management on how to calculate what a justifiable and appropriate option pool will be. The dilution that results from any increase to the option pool will almost always be absorbed by the existing stockholders, and not jointly with the investors. Therefore, founders are reluctant to reserve too large a pool. On the other hand, they should not underestimate the company’s need to attract top-quality employees and compensate them adequately with equity. Investors will generally have a good idea of the quantity necessary, so founders are better off if they make an informed decision about this. Broadly speaking, the company should assess what key roles it will need to fill in its management in the following twelve to eighteen months, and how much equity it will need to offer to those prospective employees. Counsel should know what the current typical grants are for various positions— whether sales, marketing, business development, chief technology officer, chief financial officer, or top engineers—and how much of a cushion venture capitalists will expect. At present, a rule of thumb is that the equity pool should be about 20 percent of the fully diluted equity of the company. This can vary significantly, however. If most of the key roles are already filled, the pool may be 15 percent, and if a large number of roles will need to be filled (as will often be the case in young companies), the pool may be as large as 30 percent. It is better for the founders to work this out with their counsel than to have it urged on them by venture capitalists or angels, who are often seen as having a different agenda than the founders. In this regard, the company and the investors should share an interest in keeping top management motivated to meet or exceed expectations. Professional investors are aware of the need to keep management and employees content so they are not distracted from their labor and focus their time and energies on the rapid growth and progress of the company.

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Corporate Clean-Up and Due Diligence

Before seeking financing, it is important for the company to undergo an internal due diligence process. Prospective investors will do a thorough job of due diligence in deciding whether to invest in a potential portfolio company. A venture capital or professional angel fund will undertake at least a financial and legal due diligence review. Often, especially with respect to life science companies, investors will undertake an intellectual property review as well. The better prepared a company is, the faster and more smoothly the process will go. In addition, the investor (and its counsel) will be reassured by the professional manner in which the company has conducted itself. Many entrepreneurs are initially shocked when they receive due diligence checklists from investors and their counsel. The checklists are overwhelming to many first-time entrepreneurs, who may deem them intrusive and overreaching. Counsel can warn founders of the impending inevitable due diligence investigation and assure them that it is conventional. If a venture capitalist or its counsel overreaches, however, the company’s counsel should attempt to limit the scope of the investigation. Experienced counsel will undertake a review of the company’s corporate documents in order to ascertain that they are in good order and, if not, take appropriate action before potential investors start looking into the company’s operations. The most frequent problems found in a review are:

• A lack of appropriate written directors’ and stockholders’ actions (either in the form of corporate minutes or actions in lieu of meetings)

• Failure to document material oral agreements and arrangements adequately, particularly with consultants

• Failure to take adequate steps to protect the company’s intellectual property (including having all employees and consultants sign a thorough form of proprietary information and confidentiality agreement acceptable in the industry and training its employees about the importance of keeping information confidential)

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• Having entered into agreements without prior counsel review (which can result in the company losing valuable protections or giving too much away, especially in licensing arrangements)

• Not properly documenting stock option or restricted stock issuances to employees

• Obligating the company to give away far more of the company’s stock or options for stock than it intends or realizes

The earlier a company brings in experienced counsel, the less often these issues will present problems.

Finders and Other Purported Sources of Financing

It is not unusual for even sophisticated clients to make mistakes that create unnecessary challenges as they seek outside funding. One of the most frequent of these that we have encountered has been the willingness of young companies to engage aggressive lower-tier investment banks or “finders”10 who represent that they will be able to raise funds on the

companies’ behalf. In their haste to obtain investment, entrepreneurs often agree to extravagant terms, including paying large non-refundable retainers, agreeing to high success fees, and giving away far too much equity. In our experience, very few such banks or finders have succeeded in accomplishing much other than enriching themselves. These banks and finders are generally far too expensive for the services they purport to provide, and venture capitalists are reluctant to have them involved because they perceive them being compensated either out of cash or stock of the company without adding value. Similarly, entrepreneurs often sign such deals without consulting qualified lawyers and generally promise to the

10

We use the term finders loosely. Strictly speaking, finders are individuals or entities that do little more than introduce one party to another. Under federal securities laws, finders are not permitted to receive a fee based on the success of the financing unless they are registered broker-dealers, except if they do no more than provide the introduction. If they are engaged at all in the structuring or negotiation of the transaction, they must be registered to get the success fees upon which they usually insist.

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finder too much of the proceeds of the prospective financing or stock of the company.

One of the most egregious examples involved a venture capitalist client that wanted to finance an engineer who had an expiring right to receive an assignment of valuable intellectual property from a company he was leaving. This intellectual property would have enabled him to start a potentially valuable technology company. In his haste to obtain financing, he had signed agreements presented to him by a number of investment bankers and finders. Most of the agreements were either unlimited in scope or the promised compensation was not clearly based on successful performance by the investment bank/finder. The engineer had unwittingly promised, after issuance of all the warrants and options provided for in these agreements, an aggregate of a majority interest in the company he had formed. Countless hours (and dollars) were spent negotiating the reduction of the fees and equity of the finders down to an acceptable level for our venture capitalist client, and the deal literally closed the day before the expiration of the assignment right. Without these arduously negotiated reductions, our client would have walked away. If this entrepreneur had engaged experienced counsel prior to retaining the banks and finders, all of the time, energy, and money expended would have been saved and the near-disaster would have been averted.

Going for the Gold: Obtaining Financing

Determining the Appropriate Type of Investor and Model

The appropriate investor and form of financing depends largely on the stage of a company’s life cycle. All too often, entrepreneurs approach venture capitalists at an early stage of development, either because they are not aware of alternative sources of funding or because they believe they are further along in their business than they are. Venture capital counsel generally have their fingers on the pulse of venture capitalists—they work with them as often as they work with companies—and they should have a good idea of the stage at which a company is most likely to be funded at a valuation that will not dilute the entrepreneurs so heavily as to make the financing unpalatable.

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Attorneys should educate their clients about the various forms of financing that are appropriate for the different stages of their life cycles. These range from “friends and family” to angels and venture capitalists and even beyond, as some private equity firms are beginning to invest in or purchase late-stage technology and life science companies that are unable, because of an unready market, to go public.

Friends and Family

This type of financing typically occurs at a relatively early stage in a company’s life, usually after the founders have infused all the capital they can afford, and sometimes more. This is technically angel financing, in that the people who put money into the company at this stage are truly angelic sorts, when the risk is greatest and the reward most attenuated. This phase of financing is often accomplished through the sale of the company’s common stock, without many additional rights. One trap for the unwary in this round of financing is a valuation by the founders far above market value. Friends and family may well be willing to “help” their loved ones by infusing cash at high valuations at a much-needed time without overly diluting the founders. But while this seems positive at the time, it creates unrealistic expectations both for the founders and the investors. The next round of financing is highly unlikely to be at the same or a higher valuation, once more sophisticated investors are involved. This leads inexorably toward undue dilution for the early investors and potentially hard feelings. Founders should be counseled about this risk and be given recommendations for alternative structures that may ameliorate this situation.11

Angels

In the earlier days of venture capital, angels were in fact friends and family, or groups of wealthy but not necessarily sophisticated investors nicknamed the “doctors and dentists.” Over the years, this category of investors has

11

One such alternative is the use of convertible debt, which we discuss below. Another is the use of a pure debt instrument with warrants attached, giving the lenders an upside as a thank-you for their invaluable support.

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morphed into a more formal network of high net worth individuals who are more sophisticated and more hands-on in oversight of their investments. Effectively, there are two subcategories of angel investors. The first is the individual high net worth individual, who may or may not have experience and expertise in the industry or type of company in which he or she is investing. We have seen many former entrepreneurs, who have had successful exits from their companies, become early-stage investors. Many of these angels can be extremely valuable to an early-stage company because of their relevant experience—they have taken companies through the early stages and understand what it takes for them to grow and thrive. Others, however, believe they know what is best for all companies based on their personal experience, and if their experience has not been all positive, there can be negative ramifications for the companies in which they invest. One extreme example of this was with a former founder of a company who felt ill-used when he was demoted from chief executive officer to chief technical officer in an early financing round. The company went on to be hugely successful, netting the founder hundreds of millions of dollars. Despite this, he harbored resentment and profound distrust of investors, and he became an early-stage investor himself. The terms of his investments were generally extremely onerous for the companies in which he invested, because they included a veto right over any venture capital investors. Experienced counsel would have recognized this term as one of the more chilling terms possible for a future financing and warned the founders not to accept it. We were asked for help in undoing this unusual blocking right, which took a great deal of effort and money that could have been saved by retaining skilled attorneys at an earlier stage.

Venture Capitalists

Most venture capitalists do not invest in extremely early-stage companies, although there are some who undertake seed financings. In the earlier days of venture capital investing, seed financings used to be the first round of financing an emerging company received (other than amounts infused by founders and their families, virtually all of which took the form of common stock or debt instruments). Now, seed financings by venture capitalists may or may not be the first round of preferred stock (as we will discuss in more depth below), but they almost never are as early-stage as they used to be.

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Most venture capitalists now do not invest small amounts of funds ($500,000 to $2 million) into companies, which is often exactly what young companies may need. For one thing, the size of venture capital funds has skyrocketed since the late 1990s, in the midst of the dot.com boom. Funds that used to manage $50 to $100 million started raising $500 million to $1 billion funds. Making small investments became unwieldy and ultimately impossible, because it would take too many investments to invest the fund fully and require too much venture capitalist attention on each investment for an inadequate return. Providing real oversight to the portfolio companies and fulfilling their fiduciary duties to their fund investors became possible only if the funds invested larger amounts. Large amounts, in turn, could only be invested appropriately into later-stage companies. Thus, the angel investor boom was born. In a swing back to early-stage investments, however, some venture capitalists have begun investing small amounts in relatively raw start-ups. Charles River Ventures, for example, has begun a program to invest $250,000 in promising new companies to help them grow their businesses to the stage where a larger investment would be appropriate.

Corporate Venture Capitalists and Strategic Alliances

Many entrepreneurs are unaware that corporations often have venture arms and stand ready to invest in young companies in which there are synergies. The investments are often, but not always, accompanied by some sort of strategic relationship—for joint development of a product or service, marketing, or distribution, among others. This can be a blessing or a curse for a young company. There are many advantages to an investment by a corporate investor, among which are the credibility it gives the company, a greater valuation than a financially minded venture capitalist might offer, less pressure regarding financial milestones and a financial return on investment, and less desire for board and management oversight. However, companies must be mindful that alliances with corporate venture capitalists carry risks as well. Well-versed attorneys will counsel their clients that an investment by a corporate partner, especially at an early stage, has risks attached as well, including the possibility that competitors to the investing corporation may not adopt the company’s product or service, seeing it as an extension of the competitor. Furthermore, the acquired company may not

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be perceived as having sufficient importance to the bottom line of the acquiror, with consequent lack of adequate support and attention. While these have been issues for some years in the life sciences arena, they have become equally true in the technology world as well. Technology companies are well advised to look to corporate investors where there are synergies, but not the appearance of anti-competitive behavior on the part of the corporate partner. More than a few early-stage companies have been swallowed up by large companies that invest in order to lock up their portfolio companies and thus avoid a potential competitor. Another risk is that the relationship with the large company is at a lower management level that may not see significant advantage to itself by investing time and effort in supporting the early-stage company and may even see it as a potential rival.

Among very active corporate investors are Intel, Motorola, AMD, Nokia, 3M, and Siemens. These investors often invest in technology companies in which their products will be used. After recovering from the burst of the dot.com bubble, corporations are beginning to invest again with gusto, which is good news for technology companies.

Initial Financing

A company’s first financing event is among its most important events. It can set the stage for future financings and give the company some critically needed funds to build its business model to the point where it can seek further financing from angels and venture capitalists. Management, which consists largely at this phase of the founders, must decide who the most likely investors will be, and target that group. Unfortunately, founders are often not well versed in whom to seek out, how to go about finding investors, what these investors will require, and the onerous process that may await them. What the founders need most at this stage is a trusted advisor, someone they can turn to for the answers they need and who may be able to make introductions to funding sources. Perhaps most importantly, they need someone who can keep them from making mistakes from which it may take time, energy, and money to recover. An experienced venture capital counsel can provide all these services and steer management

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away from inappropriate or unrealistic targets, as well as from finders and lower-tier investment banks that prey on young companies.

Helping clients delay talking to venture capitalists until the appropriate time is one of the more value-added things a good lawyer can do. It is best not to shop the company around. Venture capitalists do not like to waste their time and energy on companies that are too early-stage or outside the venture capitalist’s areas of interest. If they are approached too early, venture capitalists can develop a negative attitude about the company that will survive the company’s early stage.

We advise our clients that, as a rule, there are two appropriate sources for the first stage of financing—friends and family members, and angel investors. We have already described these types of investors generally.

Friends and Family

Founders may wish to tap into their networks of family and friends before reaching out for more institutionalized forms of financing. One of the most common mistakes entrepreneurs make is to offer securities (in whatever form) to these friendly investors before ascertaining that there is an available exemption under the federal and state securities laws. We have represented venture capitalists in portfolio company investments in which offers of rescission had to be made to early-stage investors who did not qualify as “accredited investors.”12 This is a costly procedure for a

relatively young company. An ounce of securities law prevention is worth a pound of rescission cure.

12

Accredited investors are defined in Regulation D promulgated under the Securities Act of 1933, as amended. Regulation D provides a safe harbor for offers and sales made to individuals or entities that meet certain financial thresholds. The idea behind the Regulation D exemption is that by having a certain level of financial wherewithal, these investors have a certain level of sophistication and can afford to lose their investments in a worst-case scenario. The threshold for individual investors is that they either (a) have had income of at least $200,000 for the past two years and the expectation of at least that amount in the coming year or (b) a net worth of at least $1 million.

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There are three forms such a financing can take. It is simplest to have a first round of friends and family money invested in common stock, with no special rights. It is important for these investors to understand that they are coming into the company at a nascent stage and will most likely be diluted heavily by institutional financing as the company grows. These investors are the next step for the company after the founders are no longer able to bootstrap the company with their personal resources. If the founders or investors feel it would be unfair to put this group into the same “sweat equity” class of stock as the founders, we suggest considering a pared-down Series A preferred stock that has a liquidation preference over the common stock, but few if any other rights, so that in the event of liquidation the investors get their money back before the founders do. Another alternative structure is convertible debt, in which the principal and interest automatically convert into equity in the next round of equity financing. Convertible debt has advantages and disadvantages, as we will describe more fully in the “Angels” section below.

Experience has taught us that later-stage investors like to see a relatively clean capitalization structure in their portfolio companies. It is important, then, to structure even the earliest financings with a goal of keeping a simple capital structure. If a company has several series of preferred stock outstanding before even approaching venture capitalists, the venture capitalists may either pass on investing in the company or require a restructuring of the company, which is costly and most likely will have the effect of wiping out the early-stage investors. In order to manage the expectation of the parties, it is best to create a structure that will survive later stages of financings.

Angels

As the angel investor market has matured, the types and sophistication of the investment vehicles used by them has evolved. Angels are now starting to demand a seat at the table in later rounds of financing, as they have found themselves diluted dramatically over time, rather than rewarded for taking a higher degree of risk than venture capitalists and other later-stage

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investors. The easiest way of dealing with this issue is by using convertible debt as the funding structure.

A convertible debt financing consists typically of a note purchase agreement and a convertible promissory note. Examples of these documents can be found in the forms of convertible note purchase agreement and convertible promissory note, respectively. The simplest structure for this type of financing provides that the note will convert automatically into the same type of shares that are sold in the next round of financing that meets certain minimum thresholds (e.g., as to aggregate amount raised or type of investor). Usually, the principal and accrued but unpaid interest convert at the same price per share as in that subsequent financing, minus some discount. The discount rewards the angel investor for taking a higher degree of risk by investing in the company at an earlier stage than a venture capitalist would be willing to do.

For the angels, there are upsides and downsides to this structure. Allowing venture capitalists to negotiate the terms of the preferred stock in a larger financing is likely to result in more and better rights in the ultimate preferred stock the angels receive, because venture capitalists are more likely to obtain more valuable liquidation preferences, board and board observer seats, protective provisions, and anti-dilution protection, than a small angel round can. The downside for the angels is that the valuation negotiation will occur at a later stage of the company’s life cycle, after it has been able to use the funds raised from the angels to achieve sufficient traction and milestones to negotiate a higher valuation. This is where the conversion discount, more fully explained below, plays an important role. For the company, putting off the valuation can be a huge advantage.

Negotiating the terms of a convertible debt financing is fraught with challenges. Many entrepreneurs do not understand this type of structure or are not aware of nuances that could have an effect on later financings. Among the issues are (i) what is the appropriate discount off the purchase price of the shares sold in the next round of financing13—we generally

13

In lieu of a discount, some investors choose to receive warrants exercisable for the type

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propose a sliding percentage, reflecting the level of risk faced by the angels (e.g., 10 percent if the equity financing occurs within the first six to nine months, 15 percent if it occurs within the first twelve months, and 20 percent if it occurs within eighteen months)—depending, of course, on the ultimate due date of the notes; (ii) whether the note holders receive a right of first refusal or first offer on any new financings by the company, which can have a chilling effect on the company’s ability to obtain later financing; (iii) what level of majority of note holders can determine whether the notes can be pre-paid; (iv) what is the appropriate due date for the promissory notes (i.e., how far out should the deadline be for the contemplated equity financing that will trigger the automatic conversion of the debt); and (iv) should the notes be secured by the company’s assets, which are usually at this point its intellectual property (we strongly recommend against this).

Counsel can act as a partner to the company to help weigh the plusses and minuses of a convertible debt financing, and then negotiate the best possible deal on the company’s behalf.

More and more, however, angels are demanding the right to receive their own series of preferred stock, opting to obtain immediate equity and clout, as well as a valuation that is more favorable to them than is likely in a convertible debt financing. Angels are realizing they may be acting against their interests by providing the funds that will increase the company’s valuation and result in the angels receiving less ownership in the company than had they negotiated the valuation at the time they actually provided the funds. Here again, it is critical for the company to negotiate carefully the rights the angels receive, including the liquidation preference, blocking rights for future financings, rights to participate in future financings, board seats, and anti-dilution protection. Experienced counsel is likely to know how much it is possible to push back on the rights requested by angels. They can point out other deals the angels themselves may have done, or that other angels have agreed to, and

of warrants without a purchase price can result in an original issuance discount for the investor, which creates a phantom taxable income. Thus, most deals are now done using a discount from the purchase price.

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should know the basic standards for these early-stage investments. They should also be able to alert the company—and the angels—as to whether and to what extent any prospective terms may make later financings more difficult or hamper the valuation discussions. Sophisticated angels are likely to listen to opposing counsel they respect.

We have included as Appendix M a form of term sheet for a Series A preferred stock angel financing that has been drafted from the company’s perspective. In the term sheet, we have provided for the grant of a limited number of rights to the Series A preferred stock, which gives the company the freedom to grant more rights to later investors when more money is put in without being put in a position of having to ask the angels to give up rights that have already been granted.

After the Initial Financing

The consummation of the initial financing is a major achievement in the life of a young company. It provides validation, credibility, and much-needed cash to take the company to its next stage—and next financing. The company must now use the funds carefully and in a focused way in order to meet its goals, while at the same time being accountable to outside investors (and potentially a board member or observer) for the first time. Getting used to this accountability—having regular board meetings, sticking to its business plan, and not resenting outside questioning—is a transition that is difficult for some young companies. Here, experienced counsel can be quite useful as a sounding board and in guiding management through the initial phases of this period in its life cycle. Counsel will be able to advise management about ordinary course growing pains and help put into place new policies and procedures that will protect both management and the board. For example, the company will likely be hiring new employees at this stage, and if it has not already done so, it should adopt an employee manual, possibly retain a payroll service, and engage in more formal review processes.

The company may at this stage be moving toward attaining revenue or commercializing its product or service (this will likely not be true in medical device or biotech companies, but they may seek strategic partners for development purposes). The licensing, joint development, and other agreements entered into at this stage are particularly critical, because their

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breadth will have a profound impact on the company’s ability in the future to enter into related agreements. At this phase of the company’s life cycle, management is often tempted to rely on short and simple agreements in the interest of moving forward quickly and showing progress. They may feel lawyers are a hindrance rather than a help when they insist on spelling out the scope, term, and exclusivity of these arrangements. It can be helpful to give clients a checklist of the major issues they should consider when negotiating the business terms of a license agreement. This list should illustrate the potential complexity and dangers involved in a poorly negotiated license agreement. We have provided a template of a checklist for license agreements as Appendix L.

We had a client that only wanted three-page license agreements. Instead of agreeing or preparing a fifteen- or twenty-page agreement, we explained why we needed to add protective provisions. We reviewed the need for specificity in the field in which the licensee could use our client’s product so the client would be able to license the product in other fields. We pointed out the need for performance milestones if he were going to grant exclusive rights to the licensee so he wouldn’t be tied up with a non-performing license and be unable to terminate the agreement and enter into alternative arrangements. In addition, we insisted that our client think seriously about the company’s international strategy if the license grant was to be worldwide. In this increasingly global economy, entering into opportunistic international licenses can profoundly and adversely affect future growth. International strategy must be carefully thought out, discussed at the board level, and applied consistently. After our client heard our concerns about the company’s long-term success, he agreed we should prepare a more detailed agreement. As a result, we provided for our client the important protections it needed.

Later-Stage Financings

After growing enough so it has sufficient traction and is ready for the next important stage of its life cycle, the company will probably seek financing to help it attain its next set of milestones, which are necessarily larger in scope. More substantial goals translate into the need for a larger funding event. A technology company may be ready to market its product aggressively and/or develop other complementary or next-generation products. It might be considering acquiring other companies or technologies as part of its strategy.

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