Non-Compete Agreements

For many startups, founders are the most important assets of a company. After all, these are the individuals who are going to innovate and grow the company into a profitable business. What happens when the relationship between founders sours and someone wants to leave the company? How can entrepreneurs protect their startups from the fallout of such a rift? One answer is through a non-compete agreement. This post will give an overview of the non-compete agreement, its legality, and important items to discuss within a non-compete agreement.

New York is an at-will employment state. This means that in almost all employment matters, there is a presumption that either party can terminate the employer-employee relationship “at will.”[i] Unless an agreement between founders exists that restricts how a founder can be removed from his or her position, any party can terminate this relationship at any time. Even if an agreement is in place to protect founders from “firing” one another without cause, a founder still has the right to leave the company when he or she chooses to do so. Once a founder decides to leave a startup, he or she has the right to find employment in the field of his or her choosing, even if the new position could compete with the startup. Therefore, it is prudent for founders to obligate one another to a non-compete arrangement.[ii]

Non-compete agreements are self-explanatory. They are promises between contracting parties not to compete against each other. While the concept is simple, enforcing a non-compete agreement is not as straightforward. Non-compete agreements will only be enforced if they are reasonable and necessary under the circumstances.[iii] Drafting a non-compete that is enforceable is about finding the balance between protecting the interests of the business and the exiting party’s right to make a living.[iv] Because the nature of a non-compete agreement is to prohibit someone from working in a particular field, the contract’s scope, duration and distance is limited. Restrictions upon the agreement’s scope and duration are fluid; they depend on the nature of the founder’s contributions in the field.

Scope of Work
A non-compete can limit the scope of work in which a founder could work after leaving a startup. The language in the agreement cannot be so broad as to render the founder effectively unable to make a living in his or her field or specialty. It can, however, be worded so that the founder is less likely to be poached by competing companies or from starting his or her own business in the same field. For example, a non-compete agreement restricting an exiting founder from developing software with similar capabilities as the startup’s proprietary code may be enforceable. A non-compete agreement restricting a founder from developing any code at all, however, would not.

Geographic Scope
The geographic scope of the agreement pertains to the geographic reach of the non-compete clause: that is, the extent to which a founder is restricted to practice in a particular geographic area after leaving the company. This component of the non-compete agreement must also be limited if the agreement is to remain enforceable. Remember the concept behind enforceability is that the agreement itself must not place too much of a burden on the employee’s right to work.[v] An agreement completely restricting an exiting founder from working within the same state as the company from which he or she is leaving is likely too prohibitive to be enforceable. Restricting a founder from practicing within the same county as the startup may be appropriate. As with scope and duration, this notion is also fluid—it depends on the type of business. It is more likely that an agreement restricting founders of a small sales company from competing within a two-county radius is enforceable rather than an internet sales group that restricts its founders from joining another internet sales firm.

Duration
The duration of a non-compete pertains to the amount of time one is obligated to the terms of the agreement. No non-compete agreement can be indefinite. Instead, the duration must reflect the nature of the business in which the non-compete applies. Software companies, for example, are constantly creating new work. Software products are never stagnate, they are updated frequently. It is unlikely then that a non-compete limiting a founder of a software company from working on a type of software product for five years is enforceable because the company’s software product may be obsolete after only a year. A non-compete agreement obligating founders of a sales company not to compete for a period of three years may be enforceable because client relationships are the crux of the business and those relationships often take years of development in order to secure.

Generally, a two-year term is an acceptable duration for a non-compete for most types of companies, but remember, what is considered an enforceable duration in a non-compete is a fluid notion. It depends on the type of business.

Tailoring the Agreement to Match the Situation

There is no hard-and-fast rule that applies to every non-compete agreement in every situation. A clause in one non-compete agreement may be enforceable given the circumstances of that agreement, while the exact same clause in another agreement might be found fully enforceable. The difference really lies in the nature of the business. Despite this fluidity, here are some general pointers to guide founders in creating non-compete agreements:

• Keep in mind that non-compete agreements restrict a person’s ability to work; it is not a favored practice to restrict a person from earning a livelihood. Therefore, non-compete agreements are scrutinized to ensure they are reasonable in scope and duration. Make sure your non-compete agreement is reasonable under the circumstances of the industry.
• There is no one-size-fits-all non-compete agreement. The agreement founders reach should reflect the needs of the business, while respecting the rights of the founder.
• All non-compete agreements should discuss the scope of work restricted, the duration of the restriction and the geographic area in which a founder cannot practice his or her work.
• Non-compete agreements can be incorporated into other agreements such as a founder’s agreement, an employment contract or an operating agreement.

Finally, it is prudent to have all founders and integral employees sign a non-compete agreement at the outset of the business relationship. The process of entering into the agreement allows for an open discussion while all parties are on equal ground. Waiting until someone leaves before requesting a non-compete agreement sets the company up for a difficult negotiation. There is hardly any leverage to negotiate a non-compete with one founder on his or her way out the door.

BLOG DISCLAIMER: This blog is provided for general informational purposes only. It should not be construed as legal advice and is not intended to be a substitute for legal counsel. Persons requiring legal advice should retain a properly licensed lawyer. No attorney-client relationship will be formed based on use of this site and any comments or posts to this blog will not be privileged or confidential.

[i] Nat’l Conf. of St. Legislatures, The At-Will Presumption and Exceptions to the Rule, http://www.ncsl.org/research/labor-and-employment/at-will-employment-overview.aspx (last visited Sept. 4, 2015). This is contrasted to a “for cause” employment relationship in which an employer may only terminate an employee “for cause”—for an enumerated reason established via an employment agreement or company policies. Id.

[ii] Please note, non-compete agreements are not accepted everywhere. California, for example, rarely enforces these agreements. Nolo, Non-Compete Agreements: How to Create an Agreement You Can Enforce, http://www.nolo.com/legal-encyclopedia/noncompete-agreements-how-create-agreement-29784.html (last visited Sept. 4, 2015).

[iii] See 52 N.Y. Jur. 2d Employment Relations § 240 (Westlaw 2015).

[iv] Id.

[v] Id.

Please Join Us

Tuesday April 28, 2015 at 6PM
Lucas Confectionery
Troy, NY

Please join us for a legal presentation about best practices to protect your company when working with third parties.

Presentation: Licensing University Technology

Clean Tech Talks: Licensing University Technology
April 14, 6-7:30
Lucas Confectionery
12 Second St. Troy, NY

Come network and listen to a legal presentation informing entrepreneurs about licensing university technology.  Heather Hage, Esq., Senior Director for Innovations and Partnerships at the Research Foundation for SUNY will deliver the presentation.

Registration is required. Space is limited.  The first 40 registrants will receive a free drink ticket.

We hope to see you there!

Startup Law Day

Albany Law School will be hosting the first ever Startup Law Day, providing entrepreneurs an opportunity to attend legal seminars and apply for a free legal consultation. Startup Law Day will be held at Albany Law School on Saturday, September 13, 2014 from 10-2PM. Registration is required.  If you’d like to be considered for a free legal consultation, you must apply. Click here to register and/or apply for a legal consultation.

Timeline for Hiring Employees

As a business grows, entrepreneurs may not be able to handle the workload alone.  At first many entrepreneurs work with independent contractors, but there will come a point in time a business owner will want more say in the work product or more management power over work tasks.  When that happens, an entrepreneur needs to hire employees.[i]  There are certain legal formalities that must be met before entrepreneurs become employers.

This is a step-by-step timeline for hiring employees.

1. Obtain a federal Employee Identification Number (EIN)
   A company’s or an individual’s EIN is a method through which the Internal Revenue Service identifies a business.  The federal EIN is also how New York State identifies businesses operated within the state.  Businesses can apply for an EIN online or by contacting the Internal Revenue Service at 1-800-829-4933.
   
2. Register the business at www.nynewhire.com
   Businesses operating in New York now have the option of maintaining employee benefits and reporting employer taxes online.   Registering for online reporting is simple.  Business owners only need to supply their EIN, business address, and contact information.
3. Have employees file the necessary paperwork with the company
   • W-4
     Employees must fill out this form so employers can withhold the correct amount of federal tax from each paycheck.  Every new employee must fill this out, and existing employees must fill out a new form when their personal or financial situation changes (e.g. an employee gets married or becomes a parent).  Employers submit this information to the IRS.  The W-4 is available on the IRS website.
   • I-9 (employee eligibility)
     The Employment Eligibility Verification form (form I-9) is required for all employees hired in a business.  Employers are responsible for getting this information from the employee within 3 days of hire.  This form must be filed in company records for three years after hire or one year after termination, whichever is latest; it does not get filed with the government, although U.S. Citizenship and Immigration Services can request to see the form.  It is the responsibility of every employer to maintain employee eligibility information for the required period of time.
   • New York New Hire Reporting
     New York requires each employer to register each new hire or employees rehired after 60 days of separation from the company.  Employees must be reported within 20 days of hire or rehire.  This information is registered with the New York Department of Taxation and Finance.  Employers can register new employees online at www.nynewhire.com or by filing Form IT-2104, Employees Withholding Allowance Certificate.
4. Obtain employee benefits
   • Required benefits
     1. Workers Compensation Insurance.  All employers in New York must have workers compensation insurance for their employees.  This can be done through a private insurance broker or through the State Insurance Fund, a not-for-profit agency that provides insurance for New York employers.  Proof of insurance must be filed with the Board in Form C-105.
     2. Unemployment Insurance.[ii]  Each employer must pay a tax on his or her employee’s salary for the Unemployment Insurance Fund.
     3. Disability Insurance.  Employers in New York must provide disability benefits to employees for off-the-job injuries or illness.  Insurance can be obtained through private brokers approved by the Workers Compensation Board or through the State Insurance Fund.  There are more than 200 hundred authorized private insurance brokers in New York.  The Workers Compensation Board encourages employers to look for a broker that specializes in the business’s specific trade when looking for insurance.  Employers can find brokers through trade associations or listings such as the yellow pages.
     4. Family Medical Leave.  Under the US Family Medical Leave Act certain employees may take unpaid, job-protected leave for up twelve weeks to take care of their selves or a family member.  This only applies for larger companies (50 or more employees).
     5. Health care.  Under the Affordable Care Act certain employers are required to provide health insurance for employees.  The Act separates employers into four categories—self-employed, less than 25 employees, less than 50 employees, more than 50 employees—and regulates them according to those categories.  To see where a specific business falls read about the Act on the Small Business Administration website.
   • Benefits that are permissible but not required
     1. Leave plan—paid time off, vacation, sick days, jury duty, bereavement, holidays, etc.
     2. Health plan—if not mandated under the law
     3. Retirement/Pension plan
     4. Employee Incentives
5. Post the necessary notices
   Employers must post certain information in the office where employees can view the material.  The NY Department of Labor regulates these requirements.  Below are a few commonly required notices.  New York and federal notices are available online.
   • Workers Compensation/Disability certificate.  This is a notice of compliance with the Workers Compensation Board.
   • New York Human Rights Law/Equal Opportunity Employer.  Notice to employees that employers cannot discriminate against them on any of the enumerate grounds: race, creed, age, color, disability, national origin, sex or marital status.
   • Unemployment Insurance certificate.  This gives the employer’s information to show employees they are covered by the New York Unemployment Insurance Law.
   • Smoking.  All areas where smoking is prohibited must have a notice.
   • Fair Labor Standards Act.
   • Uniformed Services Employment and Reemployment Rights Act.  This outlines the policy regarding employment of servicemen and women.
   • Whistleblower Statutes.
6. File taxes
   State and federal wage withholding must be reported quarterly and annually.  Employers are also required to file regular installments for unemployment insurance.  This is tracked in New York and employers are given incentives based on timely filing.
7. Keep records
   Entrepreneurs need to keep good records for every aspect of their business.  Employee information, payroll, taxes, insurance, incident reports, etc., all of these need to be organized within the company.

BLOG DISCLAIMER:  This blog is provided for general informational purposes only. It should not be construed as legal advice and is not intended to be a substitute for legal counsel. Persons requiring legal advice should retain a properly licensed lawyer. No attorney-client relationship will be formed based on use of this site and any comments or posts to this blog will not be privileged or confidential.

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[i] See previous post “Employees versus Independent Contractors” for a review on the difference between these two kinds of workers,

[ii] See previous post “Unemployment Insurance.”

Stock Restriction Agreements

Usually startup companies have no capital to pay each founder for his or her work.  Instead, founders take what is known as “equity” in the company—a legal and financial stake in it—with the hope that one day that equity will be worth money.  This is a deceivingly simple concept.  Yes, all founders have to do is allocate equity amounts to one another, but if each founder receives 100% of his or her stock interests outright, what is the incentive to maintain a business relationship with the company?  Investors will point that out to a business owner right away.  In fact, most investors refuse to work with businesses that distribute equity outright to its founders.  So how does a founder compensate his or herself when there is no capital for a salary?  The answer is a Stock Restriction Agreement (“SRA”).  This post will discuss the SRA.

Most founders enter into a Stock Restriction Agreement to protect the business and appease investors.  Under an SRA, total stock allotted to a specific founder is set aside at the outset of the agreement, but the stock is only made available to that founder in installments according to a vesting schedule.  The vesting schedule sets the date of installment and the number of stocks granted upon such a date.  Here is sample vesting language:

The Unvested Shares shall vest in equal quarterly installments over a four (4) year period commencing on the Vesting Start Date, at a rate of ————- Shares each quarter, until the fourth anniversary of the Vesting Start Date, on which date, subject to the vesting conditions herein, all remaining Unvested Shares shall vest.

A typical SRA mandates that a founder maintain a business relationship with the company as a condition of the vesting schedule.  If the founder leaves the business or is fired for cause, that founder forfeits the remaining unvested shares.  This protects the company because founders have an incentive to continue working on the product or service the company provides; the founder’s investment is tied directly to the success of the company.

Founders looking into an SRA must retain a lawyer because an agreement like this touches a few important areas of law, specifically tax and securities regulation.

Tax professionals will most likely discuss what is known as the “83(b) election,” which is a reference to a specific provision of the tax code where this election is found.  An 83(b) election allows a founder to include in his/her personal income tax filing the purchase of equity at the time of transfer instead of the time it vests.  This has the effect of insulating a founder from recognizing phantom income in case the stock value increases during the vesting period.  If the election is taken, the founder can claim all stock allotted under the agreement in that year’s personal income tax return and the increase in value would be recognized at a capital gain when the stock is eventually sold.

This election is complicated.  It is conditioned on a substantial risk of forfeiture and can only be made within 30 days of the transfer of such equity so founders need to decide whether or not this election is right for them very quickly.  For more information on this election look up Edward Ohanian’s forthcoming publication in Government Law Center Entrepreneurial White Paper Series on the 83(b) election (coming soon).

Because an SRA involves stock, the U.S. Securities & Exchange Commission may regulate this transfer or purchase.  Again, it is imperative to retain an attorney to make sure any issuance of stock satisfies state and federal regulation.  The JOBS Act, signed into law in 2012, relaxes a number of regulatory obstacles for new businesses otherwise found in securities regulation, but the government still exerts significant control and oversight in this area.  Even among lawyers, this is a highly specialized area, and often a general practitioner will refer his or her client to a securities attorney because it is so important to follow the many rules created by the SEC that cover such transactions.

BLOG DISCLAIMER:  This blog is provided for general informational purposes only. It should not be construed as legal advice and is not intended to be a substitute for legal counsel. Persons requiring legal advice should retain a properly licensed lawyer. No attorney-client relationship will be formed based on use of this site and any comments or posts to this blog will not be privileged or confidential

Terms and Conditions

Everyone who uses the Internet or has downloaded a mobile application knows about “terms and conditions” (“T&C”).  What entrepreneurs may not know, however, is that these terms and conditions are an essential part of having a mobile or Internet presence.   This post will discuss why T&C are important, and discuss important elements of every T&C agreement.

Why Terms and Conditions Matter

In general, terms and conditions are important because they notify users about what the user can and cannot do with a product.  Legally, T&C are important because they bind users to a company’s legal policies.  Think about how many terms and conditions the typical consumer has assented to throughout the course of the last year.  By clicking “accept” or “yes, I agree” or even doing something as simple as downloading a program, one has formed a contract with the company offering the product or service.  The consumer who accepts such terms and conditions is then bound by them.[i]  Even if all one does is scroll through the terms and conditions of a website and click the “accept” button without looking at each clause, he or she is bound to follow the rules outlined on that webpage.  How is this possible?

New York imposes a “duty to read” on all parties to a contract.  Stated simply, the duty to read prohibits a person from canceling a legally binding contract because he or she failed to look at the terms of an agreement.  Each person entering a contract must read the entire document because he or she will be bound by those terms.[ii]  This means that, as long as a company’s terms and conditions are readily available and understandable, all users assenting to the use of that product have assented to the terms and conditions, and will be bound by the promises made within that agreement.

Therefore, to protect a company, entrepreneurs should draft company T&C, post them online, and make sure that any download or purchase of a company’s product references the T&C either by displaying the entire agreement or supplying a hyperlink to the T&C.  Users can assent to these items by clicking “I accept” or downloading the product as long as the business articulates that downloading the product constitutes an acceptance of the T&C.  New York courts will uphold these “Click-wrap” contracts as long as users have the opportunity to read the T&C and can unambiguously assent or decline.[iii]

Common Clauses of Terms and Conditions

These 10 items are not a complete list of clauses companies can put in their terms and conditions.  Lawyers and other business professionals specialize in drafting conditions of a product as well as privacy policies.  These services may be appropriate for new companies depending on the capital demands of running a business.  Always seek professional advice when drafting the terms of terms and conditions because these items will protect the company as a binding contract.  What follows is some of the basic elements of a simple set of terms and agreements.

1.  Promise of Agreement

“By downloading this product you agree to the following terms and conditions.”

This language offers an example of  some language that can be used in an agreement statement.  Entrepreneurs may use different language, but the purpose of the sentence is the same.  It must be clear that the action outlined in the T&C constitutes an acceptance of the agreement.

2.  Description of Service and the Agreement

Most T&C agreements start out by explaining to the user he or she is reading a company T&C.  The section following that description explains the product.  By explaining the company policy and product, entrepreneurs can be sure that consumers will understand that the T&C apply to the product they are downloading or purchasing.

3.  Prohibited Activities/Termination

Usually businesses include a description of product uses that would prompt a company to terminate a consumer’s contract with its product.  If users are not on notice that certain actions can result in their disqualification to use a product, it could be a breach of contract to take it away.  The company’s procedure to terminate a product subscription should be articulated in this section.

4.  Privacy Statement

Do not confuse this with a privacy policy.  Privacy policies should be drafted separately and referenced in the T&C.  This is a general statement that says a company will, to the best of the company’s ability, protect its clients’ private information collected by the company from employee misuse and/or hackers.  Usually this section also describes what information is collected and why.

5.  Disputes

• Limited Liability

This section lists all the ways in which a company will not be subject to damages that result from claims against the company because of its product or services, others using the product/service, or the inability to use a product/service.  Some companies articulate a monetary ceiling for liability if a user is successful against the company in court; most ceilings are around $1.00.  These provisions are generally upheld in New York as long as they are not the result of willful acts or gross negligence, and as long as the result does not disrupt public policy protecting consumers.

• Indemnification

Indemnification means to hold someone harmless, and to reimburse him/her/the entity the cost of defending a claim arising out of a user’s use of the service or product.   This is an important part of a company’s T&C.

• Litigation or Arbitration

A company can designate whether claims against it can be brought in court or resolved through arbitration.  Arbitration is like court except it is a private forum for dispute resolution.  Like a court proceeding, arbitration has a “judge” often called an arbitrator and both sides can be represented by attorneys or appear pro se (i.e. representing one’s self).  (Sometimes a panel of arbitrators will resolve a particular dispute.) Each arbitrator enforces a set of procedural rules regarding evidence, depositions, witness calling, and pleadings.  At the end of arbitration, the arbitrator gives a ruling and it is binding on all parties.  Business owners can obligate users to arbitrate claims instead of going to court in their T&C.  Whether arbitration or litigation is right for your company depends on your needs as a business.

• Choice of Law

This clause binds both parties to using a particular state’s laws when litigating.  This clause supersedes a legal concept called “conflict of laws.”  The conflict of laws doctrine permits one state to apply another state’s substantive rules about a legal issue in a claim in court.  For example, if a claim is brought in Massachusetts against a New York company and the company has a choice of law provision in its T&C mandating that all claims will be governed by New York Law, Massachusetts should apply New York law in that claim.  A company may choose to select a body of laws that is beneficial to it, or that it makes sense to apply to a given dispute.  Sometimes, a contract’s choice of law clause will not be upheld if it is against public policy to honor it.

•  Forum/Venue

Similar to the Choice of Law provision, terms and conditions can often control where a claim may be brought.

6.  Disclaimer

Most T&C will claim the product or service is provided “as is.”  This is just a representation that there are no warranties or guarantees tied to the use or download of the product/service.  Disclaimers are included so users cannot claim a breach of contract to use a product because there are bugs that need to be fixed or kinks in the product/service abilities.

7.  Intellectual Property

Almost always, products or services offered by a company will touch intellectual property law.  Whether this section claims that that use of the product is a license to use the software or that items connected to the product are trademarked or copyrighted, intellectual property rights are explained in this clause.  This section also states the procedure users must follow if they believe their intellectual property rights have been violated by the company or other users.

8.  Agreement Updates

From time to time, companies will update their T&C, usually because a new product/service has been developed or the product itself has evolved.  If that is the case, the terms and conditions should express how contract updates will be relayed to users.  This is important because it will put users on notice that the terms and conditions they originally accept may be amended, and how to find out about such a change.

9.  Severability

This is a standard contract clause.  It explains that if any part of the contract is found to be illegal and void, that clause will be treated as separate from all other clauses.  The contract continues to exists, but the voided term is dropped as if it was not part of the contract to begin with.

10.  Complete Agreement

This is another standard contract clause.  It states that the agreement supersedes all prior understandings regarding the T&C between both parties.  This has the effect of binding users to all updates whether the new T&C were read or not.

BLOG DISCLAIMER:  This blog is provided for general informational purposes only. It should not be construed as legal advice and is not intended to be a substitute for legal counsel. Persons requiring legal advice should retain a properly licensed lawyer. No attorney-client relationship will be formed based on use of this site and any comments or posts to this blog will not be privileged or confidential

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[i] There are always contractual defenses that may be able to free an Internet user of an agreement, but this post does not go into those defenses.  Retain a lawyer if you are looking to rescind an agreement.

[ii] See above endnote.

[iii] Serrano v. Cablevision Sys. Corp., 863 F.Supp.2d 157, 164–65 (E.D.N.Y. 2012).

Convertible Notes and Convertible Equity

Convertible notes and convertible equity may be new terms to entrepreneurs depending on how active they are in raising capital.  Convertible notes are the more commonly used form of seed funding, but convertible equity is on the rise.  This blog post will discuss those two items.

Convertible note

Legally speaking, a note is a debt instrument that is expected to take a number of years to pay back in full.  A convertible note is a debt instrument, a loan more or less, but, instead of demanding payment until the life of the loan is complete, this note can convert the debt into an equity interest in the company.

The purpose behind convertible notes is to provide much needed capital to startup companies need.  Typically, startups can only get that capital by selling stock or taking out a loan.  The minute a company sells stock though, the company has been valued; investors cannot buy into the company unless it is for the minimum valuation dollar amount.  If investors do not want the company to have an explicit value, for later-stage investment reasons, they will not buy stock.  This leaves both parties in need: the startup still needs funds and the investors still want to work with the company.  Convertible notes are one solution to this problem.  By issuing a convertible note, investors give startups the funds they need while delaying the valuation process.  Startups would pay investors as if they were paying back a loan, but if a later investor came in and bought stock, the original investor could convert the outstanding balance on the note into company equity.  How much equity the original investor would receive from the balance depends on the company’s new value and the terms of the convertible note.

This is a quick, simple way to raise money without diluting equity control in the company.  It has been the standard fundraising method for some time now.

Things to Think about with Convertible Notes

• What happens if the startup is acquired before the note is converted into equity?  If a startup never holds a funding round there is no opportunity for the investor to receive equity.  This will leave a startup with a very unhappy investor.  The parties (the startup, the note holder, and maybe the acquiring company) will have to discuss what happens to the note.  This process can take time.
• Will later investors have a problem with this “potential” equity interest hanging over the company’s shares?  A convertible note is a promise that an investor will receive equity eventually.  Until the shares are given, new investors see this looming conversion as another player on the field.  Depending on the investor, this may not be an acceptable term under which they are willing to give money.
• What happens if the maturity date of the note comes before the startup is ready to solicit investors in a funding round?  Like every loan, a convertible note will have a maturity date in which the entire loan amount, plus interest, is due.  The principle of convertible notes holds that a startup would eventually sell stock and receive capital to pay back the money due on the note.  If the maturity date arrives before a startup has the opportunity to raise capital through investment the startup must still pay back the convertible note.  If this happens and the startup has no money to offer the note holder there is a big problem—how can a startup pay the note holder back when the startup has no cash flow from investors?  In short, the startup cannot, and it will be in default on the loan.  The note holder can exercise whatever legal remedies it might have under the note due to this default.
• Are investors looking to use convertible notes really interested in the success of the company or the balance of the note?  One of the nice things about angel and VC funding is those investors really want the business to succeed so they can receive a high rate of return.  Angels and VCs will often help the business with their expertise in addition to offering money.  What is the incentive of a convertible note holder?  Either way this party is either receiving all of the money back plus interest, or equity in a company that will have strong angel or VCs helping them out.

Convertible Equity

A newer concept developed in the Y Combinator, convertible equity offers many of the benefits of convertible debt without some of the disadvantages.  Called a “Safe,” Simple agreement for future equity, it is not a debt instrument.  This is an exchange of money for a future interest in preferred stock.  The stock is automatically acquired upon an event specified in the Safe agreement, and the Safe is terminated.  Because this is not a loan, there is no maturity date.

Under this kind of agreement, it looks like a startup will have to create a specific Safe Preferred Stock series with special liquidation preferences—sometimes known as “shadow preferred.”  In addition, Safe Preferred Stock gets pro rata rights with the rest of the preferred series like pre-emption rights, for example.  Y Combinator developed four versions of Safe agreements: Valuation Cap, No Discount; Cap and Discount; Discount, No Cap; and No Cap or Discount, MFN Provision.  The standard Safe agreement has a valuation cap and no discount.  The valuation cap is the amount being “invested” in the company for the agreement, and the discount applies to the shares when they are issued to the investor.

If a startup does this kind of financing there are more valuation considerations and calculations, but it is all explained on the Y Combinator website: http://ycombinator.com/safe/.  Entrepreneurs interested in this type of financing should read this information.

Entrepreneurs should be aware that this type of financing is not mainstream yet; it is extremely new.  So it is unclear what will happen with this funding option.  Entrepreneurs looking to use convertible equity should retain counsel to ensure the agreement protects their interests and  complies with all applicable laws.

 

BLOG DISCLAIMER: This blog is provided for general informational purposes only. It should not be construed as legal advice and is not intended to be a substitute for legal counsel. Persons requiring legal advice should retain a properly licensed lawyer. No attorney-client relationship will be formed based on use of this site and any comments or posts to this blog will not be privileged or confidential.

Let’s Talk Business: Richard Frederick

It is important for entrepreneurs to network with people and organizations that can mentors startups.  These relationships often distinguish thriving businesses from stagnant companies.  In the spirit of networking and mentorship, the GLC will post short interviews with different business organization executives, innovators, and other essential people who affect economic development throughout the state.  The first interview is with Richard Frederick of Eastern NY Angels.  He offered great insight on early-stage funding.

Richard Frederick is an experienced C level executive and serial entrepreneur with over 35 years of experience.  He spent the last fifteen years of his career building and growing early stage companies.  He has served as a mentor and coach to over 100 companies in the past 5 years.  In 2010 Mr. Frederick co-founded the Eastern NY Angels (ENYA).  ENYA funds early stage companies located in Tech Valley. In addition Mr. Frederick taught Entrepreneurship at a number of local colleges, was the Entrepreneur in Residence at the Lally School, and ran the RPI business incubator, EVE. His primary area of concentration is entrepreneurship and all aspects of developing business plans, specifically  financial management, operations and marketing.

Mr. Frederick continues to focus his time on funding and growing early stage companies and is the Entrepreneur in Residence for the New York State Small Business Development Center in Albany.

What is the difference between Angel investors and Venture Capital?

Angel investing is a process by which high net-worth individuals look for opportunities to invest.  These are people looking to invest in their community.  Angel investments are typically smaller compared to venture funding. Venture capital firms, on the other hand, are usually more concerned with a return on investment.  Venture funds are larger and the individual investments are larger.   Typically Angels invest from $50,000 to $250,000 where VC’s start at the $1,000,000 level and go from there. Venture firms also seek to exert some form of control in their investments to increase the likelihood of a strong return on investment.  In short, Angels look more toward stimulating their individual communities and Venture Capital firms look to drastically increase revenue of the businesses.

How do entrepreneurs secure Angel funding?

There are a few different ways.  In the broadest sense, a lot of Angel investors, Eastern New York Angels (ENYA) for example, are part of a group called the Angel Capital Association (ACA).  The ACA is a collective membership of 2500 angel investing organizations around the world.  As a member, angel investors have access to GUST, a database for entrepreneurs seeking investments.  GUST lets entrepreneurs set up a profile explaining the business and sharing information that investors looking to invest should know.  In addition to showcasing their business, GUST lets entrepreneurs seek out investors.  So entrepreneurs can seek angel funding through GUST or by approaching angel firms on their own.

Once an entrepreneur submits a funding request, angel investors start a screening process.  Preliminarily, ENYA looks at the current status of the company—company prototypes or products, the business plan, the money the company needs to go to market, the founders specifically, anything that gives us a good sense about the company.  One of the key things we look for is a coachable management team that is looking for support.  It’s common that angel investors will want to mentor early stage companies.  If the screening goes well, we invite the entrepreneurs to give a presentation to all the investors.  The company is given 15 minutes to present, followed by a 15 minute question-and-answer segment.  If, from that presentation, the members of ENYA decide to move forward with this business, we form a due diligence committee, which takes a detailed review of the company: what’s the product, what’s the management team, what is the business structure, what’s the technology, does the business have enough substance to warrant an investment, what is an appropriate investment, etc.  Based on the due diligence research, the committee files a report and makes an investment recommendation to the investors for a final decision.  This process typically takes between 60 and 90 days, but this varies depending on the company.

What makes a business stick out to you as a good investment?

This answer has two parts.  First, I look at the tech community.  Different parts of New York produce different kinds tech.  If I were to invest in Buffalo, I’d be looking at medical technology, or if in Rochester, optical technology.  Here in Albany there is a lot of engineering technology.  The ecosystem of the community sets the tone of our screening, we look at the tech and ask, is it scalable.  Next, I look to see whether the entrepreneur is passionate about his or her business.  A lot of the decision depends on how passionate the entrepreneur is in that first presentation.  Enthusiasm and fire, this says that a person is going to do whatever he or she needs to do to make this business successful.

Just because an entrepreneur gets turned down by a group of Angel investors the first time doesn’t mean she or he should give up.  Listen to why you weren’t brought into a second interview and go back to the drawing board.  A lot of “no’s” are not bad.  It’s normal.  Just to give you an idea, every two weeks we screen the ENYA website.  In 2012 we looked at 238 proposals, 49.8% came from New York, which is where we invest.  Of the proposals, we researched due diligence on 12 and invested in 2.

A lot of new business owners worry that they will have to give up significant control in order to raise money through investors.  As an investor, do you have any advice or warnings for entrepreneurs that are concerned about this?

This is a very common issue and has stopped new businesses from growing.  Entrepreneurs need to understand the difference between ownership and control.  You can own 99% of your company, but if you’ve given control rights to that 1% coming from an investor, you effectively do not have control over the business decisions.  When negotiating with investors you should distinguish ownership and control.  Venture capital firms like to have control in their investment.  Angels are far less predatory in this regard.  An angel investor’s goal is to get the company started and running.  If an entrepreneur is worried about losing control, he or she should deal with Angels as long as possible.

What is the most important thing an entrepreneur should do if he or she is seeking Angel funding?

Understand that Angels are there to help and if you’re just looking for money and not help, you’re probably not going to get funding.  A good idea isn’t worth a lot unless there’s a good plan behind it and a team to push it forward.  When I see a product, I assume anyone can build it if given the right amount of money so I look at everything else.  The three questions you must have answered before talking to investors: who is the target customer, how are you getting your product into the market, and why do consumers need it.

BLOG DISCLAIMER: This blog is provided for general informational purposes only. It should not be construed as legal advice and is not intended to be a substitute for legal counsel. Persons requiring legal advice should retain a properly licensed lawyer. No attorney-client relationship will be formed based on use of this site and any comments or posts to this blog will not be privileged or confidential.

Alternative Capital: Royalty Financing

Most entrepreneurs seek seed or startup capital from two sources: loans or venture capital investors.  Interest rates accompanying loans makes them unattractive for some entrepreneurs.  Investors usually require some stake in the company in exchange for their money; this is also unattractive if an entrepreneur’s priority in his or her business is autonomy.  Outside of spending one’s own money on a business idea, loans and investors were the only two options for a long time.  Now, it appears a third option is becoming popular to fund startup companies—royalty financing.

Traditionally used in the pharmaceutical and entertainment businesses, royalty financing obligates entrepreneurs to pay back a loan with a percentage of business revenue.   Under this funding scheme, entrepreneurs negotiate the royalty percentage and the repayment period.  Some entrepreneurs may agree to pay royalties for a certain number of years, and others can negotiate until a multiple of the original loan is paid back.  These items depend on the product, the loan figure, and the needs of each party.  Royalty investment firms usually expect between two and six percent of business revenue.  As with other traditional forms of funding, royalty financing has its pros and cons.

The Good

• Usually, entrepreneurs do not have to give much, if any, equity with these loans.  Firms can try to negotiate stock warrants into the agreement, but this is still fairly non-traditional.
• Because royalties are a percentage of revenue, this repayment offers flexibility.  Loans demand a fixed payment at a fixed rate of interest.  Your repayment will always be a percentage of whatever the revenue was that month.
• You do not necessarily need tangible assets in your business to attract one of these firms.  If you can show a steady profit or strong business model you can attract this kind of money.
• The payments do not show up on your business records as debt.

The Bad

• This may be more expensive than taking on a bank loan.  If your revenue is high, the percentage negotiated to be paid back to the royalty firm may be higher than a traditional loan minimum payment.
• At the end of the day, this is a loan.  If you have no revenue, you are not paying anything back, which results in a “default.”
• Entrepreneurs still need to present their business as if they were trying to get a traditional bank loan or venture capital.  Royalty financing is not a quick fix for money problems.  These firms are just as serious as traditional lenders.
• Usually a business needs to show a history of revenue flow to take advantage of this funding.  Relatively new businesses that do not have a couple years of profits are not viable options to most royalty financers.

BLOG DISCLAIMER:

This blog is provided for general informational purposes only. It should not be construed as legal advice and is not intended to be a substitute for legal counsel. Persons requiring legal advice should retain a properly licensed lawyer. No attorney-client relationship will be formed based on use of this site and any comments or posts to this blog will not be privileged or confidential