9 Reasons Your Start-Up Needs Patents

Guest post by Jim Cleary and Rob Latta – Mintz, Levin, Cohn, Ferris, Glovsky, and Popeo PC

1.  Patents Get Venture Capital.

Venture capitalists want to see patents.  67% of venture-backed startups report that patents were vital for them in securing investment.[1]  In a 2010 study, only 40% of startups held patents, 80% of startups that received venture capital owned patents.[2]

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How Venture Capitalists Talk

Joseph W. Bartlett, Co-Founder, VCExperts.com

This post reviews basic terminology commonly used in the venture world. First, the entities into which capital sources are aggregated for purposes of making investments are usually referred to as “funds,” “venture companies,” or “venture partnerships.” They resemble mutual funds in a sense but are not, with rare exceptions (AR&D was one), registered under the Investment Company Act of 1940 because they are not publicly held and do not offer to redeem their shares frequently or at all. The paradigmatic venture fund is an outgrowth of the Greylock model, a partnership with a limited group of investors, or limited partners, and an even more limited group of managers who act as general partners, the managers enjoying a so-called carried interest, entitling them to a share in the profits of the partnership in ratios disproportionate to their capital contributions. Venture funds include federally assisted Small Business Investment Companies (which can be either corporations or partnerships) and, on occasion, a publicly held corporation along the AR&D model, styled since 1980 as “business development corporations.” This book, following common usage, will refer to any managed pool of capital as a “fund” or “partnership.”

Once a fund makes an investment in an operating entity, the fund or group of funds doing the investing are the “investors.” A company newly organized to exploit an idea is usually called a “start up,” founded by an individual sometimes referred to as the “entrepreneur” or the “founder.” Any newly organized company, particularly in the context of a leveraged buyout (LBO), is routinely labeled “Newco.” The stock issued by a founder to himself (and his key associates) is usually sold for nominal consideration and those shares are labeled “founders stock.” (The use of the male gender is used throughout for ease of reference only.) The founder, as he pushes his concept, attracts professional management, usually known as the “key employees.” If his concept holds particular promise he may seek from others (versus providing himself) the capital required to prove that the concept works—that is, the capital invested prior to the production of a working model or prototype. This is called “seed investment” and the tranche is called the “seed round.” Each financing in the venture process is referred to as a “round” and given a name or number: “seed” round, “first venture” round, “second” round, “mezzanine” round, and so forth.

Once the prototype has been proven in the lab, the next task ordinarily is to place it in the hands of a customer for testing—called the “beta test” (the test coming after the lab, or “alpha,” test). At a beta test site(s), the machine or process will be installed free and customers will use and debug it over a period of several weeks or months. While the product is being beta tested, capital is often raised to develop and implement a sales and marketing strategy, the financing required at this stage being, as indicated above, “the first venture round.”

The next (and occasionally the last) round is a financing calculated to bring the company to cash break-even. Whenever a robust market exists for initial public offerings this round is often financed by investors willing to pay a relatively high price for the security on the theory that their investment will soon be followed by a sale of the entire company or an initial public offering. Hence, this round is often called the “mezzanine round.” A caution at this juncture: The term “mezzanine” has at least two meanings in venture-capital phraseology. It also appears as a label for junior debt in leveraged buyouts. In either event, it means something right next to or immediately anterior to something else. As used in venture finance, the financing is next to the occasion on which the founder and investors become liquid—an initial public offering (IPO) or sale of the entire company. As indicated earlier, the measures taken to get liquid are categorized as the “exit strategies.”

One of the critical elements in venture investing is the rate at which a firm incurs expenses, since most financings occur at a time when the business has insufficient income to cover expenses. The monthly expense burden indicates how long the company can exist until the next financing, and that figure is colorfully known as the “burn rate.”

 

FinTech Companies Face Big Privacy Challenges in 2016

Guest post by Natalie Prescott and Cynthia Larose – Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

According to the FBI, “there are only two types of companies: those that have been hacked and those that will be.”  It does not take an actual data breach, however, for a company to be liable for its data security practices.  In March 2016, the Consumer Financial Protection Bureau (CFPB) made this clear when it settled its first-ever data security enforcement action against an online payment processing company, Dwolla.  The CFPB pursued Dwolla because it found the company’s representations to customers about its cybersecurity misleading – disregarding the fact that Dwolla had never, since its inception, experienced even a single reported cybersecurity incident.  As a part of the settlement, Dwolla agreed to sign a Consent Order, pay a $100,000 fine, take certain steps to improve its data security for the next five years, and make accurate representations to consumers.  The Dwolla case offers important guidance to FinTech companies and provides a framework for data protection and preparedness plans.

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What Makes a Good Business Plan?

Guest post by Daniel I. DeWolf  – Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

The way most businesses are initially funded is by the three Fs. That is, by “friends, family, and fools.” After all, who else would provide the initial seed capital to start a new enterprise? But self-funding (or relying on friends and families) will only take you so far in building out your new business.

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Seniority Matters

Guest post by Daniel I. DeWolf  – Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

There is little doubt that activity in the trading of secondary shares of private companies remains robust. Private companies are staying private longer and there seems to be an unlimited demand to buy into the newest “Unicorn” anointed each week.  As the market for secondary shares stays strong, valuations seem not to matter much to most buyers. Additionally, many buyers seem to pay little attention to whether they are buying senior preferred stock at the top of the stack, as compared to junior securities or common stock sold by many former employees.  But as we all know, things that can’t go on forever, don’t.  And, as Warren Buffet once famously said:  only when the tide goes out do you discover who has been swimming naked.

At some point a number of these Unicorns will become Unicorpses.  We recently saw this with the sale of Good Technology to Blackberry at a huge discount to valuations achieved only weeks prior to the sale. And when these companies are forced to sell (often in order to survive), where a stockholder stands in the stack is of critical importance.

In a sale of a company, after the payment of deal expenses and any carve out for management, the senior preferred stockholders receive their money back first. After holders of the senior preferred get paid, then holders of the junior preferred are paid.  Lastly, the residual proceeds if any, is paid to the common shareholders.   In many sale situations, particularly if a sale is the only alternative to survival, the common shareholder walk away with zero.   The closer you are to the top of the stack, the more likely you will at least receive your money back.  The closer you are to common, the greater the chance you will receive back less than your basis.

In an era where investors are making wild bets on companies that often lack meaningful profit margins or even meaningful revenues, and doing so relatively blindly without receiving  the normal financial information generally available to investors in the public markets, it really does matter that you are as close to the top of the equity stack as possible. For when the market turns just a little bit South, as it inevitably will, you really don’t want to be the one swimming naked.


Daniel I. DeWolf, Member Chair, Technology Practice Group, Co-Chair, Venture Capital and Emerging Companies

Daniel is Co-chair of the firm’s Venture Capital & Emerging Companies Practice Group and Chair of our Technology Practice Group. In addition to his active legal practice, he is an adjunct professor of law at the NYU Law School and he has a wealth of experience in private equity and venture capital, having co-founded Dawntreader Ventures, an early stage venture capital firm based in New York.

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Who Controls – Me Or Them?

Joseph W. Bartlett, Co-Founder of VC Experts

To understand that cohort of issues which has to do with the control of a startup, some background is in order. Thus, in a mature business corporation, it has been understood, at least since Berle and Means’s seminal work, that non-management purchasers of stock in public companies are passive investors. If they don’t like the way the company is being run, their remedy (absent some actionable legal wrong) is to sell their shares. Venture capital operates on an entirely different set of principles. When raising money from his own investors—the limited partners in his venture pool—the professional manager of a venture-capital partnership holds himself out as someone with the expertise to “add value” to the investments under his control. The notion is that the typical founder is an incomplete businessman, with gaps in experience in matters such as financial management and marketing. An active board of directors, staffed by representatives of the investors, is expected to help fill these gaps. Significantly, even in successful venture-backed companies, a large percentage of the founders are fired, moved sideways or otherwise relieved of their duties as chief executive officer prior to the company’s achieving its maturity. It is rare to find the likes of a Ken Olson at Digital Equipment or a Bill Gates at Microsoft, executives with the necessary breadth and scope to take the company through every phase of its path toward maturity. Consequently, a term sheet will deal with a series of related control issues immediately after the question of valuation is tentatively settled.

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