Act 255 Tax Credits and …. Convertible Equity

Active angel and venture investors in Wisconsin are generally familiar with Act 255, a state law that provides a tax credit for investors in the equity of qualifying emerging technology businesses.  In cases where an investment is made before a company receives Act 255 certification, the investment often takes the form of convertible debt: the Act 255 credits are triggered when the debt converts to equity – presumably after the company is appropriately certified.

While convertible debt is a wonderful vehicle for accessing the Act 255 tax credit in the above scenario, what about the situation where a company is Act 255 certified but the preferred investment vehicle is convertible debt for other reasons (most often, to avoid having to establish a valuation)?  In this case, if the conversion to equity takes place in a tax year subsequent to the year of the investment, the investor does not get to claim the tax credit in the year of the investment itself, but rather in the later year when the debt converts to equity.  Not good.

One way to avoid the delayed receipt of Act 255 tax credits in the above scenario is to make the initial investment in the form of convertible equity, rather than convertible debt.  All of the important features of the convertible debt structure – including postponing the valuation discussion and the provision of a “sweetener” to the convertible security investors – are retained, and the company will not have any debt on its balance sheet.  Voila – the investment being in equity, the investors get the Act 255 credit (assuming, again, that the company has received Act 255 certification) as of the date of the investment.

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Thoughts on Convertible Debt Valuation Caps

Convertible debt with an equity kicker – typically either in the form of warrant coverage or a discount on the conversion rice – is a common vehicle for seed stage financings.  As people on both sides of these deals have become more familiar with the convertible debt structure, a number of bells and whistles have begun popping up.  One twist is the notion of a cap on the conversion price of the debt.  As of today, valuation caps are included in most West Coast convertible debt deals, and are becoming more common in the Midwest.

While valuation caps may be here to stay, entrepreneurs and investors alike should understand when and how a valuation cap might negatively impact downstream financing.

First, it is probably worth asking why the “market” seems to be moving towards the regular use of valuation caps.  The answer, I think, is that the same market seems to have settled on an equity kicker in the 10%-30% range: that is, whether the kicker is in the form of warrant coverage or a discount on the conversion price the effective kicker in most convertible debt seed rounds is somewhere in the 10% – 30% range.

Assuming a very common 20% for the kicker, what is the problem?  That is, why with a 20% kicker, should a seed investor also want a capped conversion price?  Two situations come to mind, the first understandable but ultimately not very persuasive, and the second understandable but somewhere out there in “what would you do if you won the lottery” land.

In the first case seed investors use the valuation cap to try and end run the 10% to 30% market price for the convertible debt kicker.  And for good reason.  Be honest, here, Ms. Entrepreneur: capping a seed investor’s return at 10% to 30% from the seed round to the A round is pretty, well, parsimonious.  Considered in this context, the point of a valuation cap, from the investor’s perspective, is to juice the return.  That is, the idea is to get a cap below the likely A round valuation, so that the cap will have the effect of juicing the kicker on the seed debt.

Assuming juicing the convertible debt kicker is the point of the cap, what is the problem?    Well, the same problem that would exist if in the alternative you just bumped the basic kicker from the 10% to 30% range to say 50%-100% range.  The extra juice would likely be too much added dilution for the A round investors to accept.  A round investors can generally live with seed kickers to the extent they, at least in terms of optics, don’t seem to undermine the fundamentals of the A round price.  But when a kicker starts changing the fundamentals of the deal – that is when the seed round is either too large (say more than 1/3 the size of the A round) or the kicker too big (say more than 30%) – the dilution from the seed round at conversion begins to look more than marginal and the A round investors will likely start pushing back.

The second, and I think much more convincing, rationale for a cap on the convertible debt conversion price is the “what if we win the lottery” scenario.  Here, the point of the conversion price cap is to protect the investor if the A round price ends up being far beyond what either the seed investor or the entrepreneur might reasonably have expected when the seed round closed.  So, for example, consider the typical situation where a seed investor puts in $100k with a 20% kicker, on the assumption, shared by the investor and the entrepreneur, that if the deal goes well the A round will be priced at, say, $3-5 million pre-money.  What happens if, between the seed closing and the A round the entrepreneur catches a venture capital thermal and suddenly finds herself looking at an A round pre-money north of $15 million?  In this scenario, the point of the seed conversion price cap is to make sure that the benefits of the unexpected windfall are shared by the seed investor as well as the entrepreneur.  And I think, at least, that such sharing seems entirely appropriate.

That leaves one question.  What, in general, is a “fair” conversion price cap?  Given that the “good” rationale for a conversion price cap is to share an A round valuation windfall, the question becomes what constitutes an A round windfall.  I don’t know that there is a “right” answer to that question, but my sense is that 2x what the seed investor and entrepreneur reasonably thought the upper end of the A round price range would be at the time of the seed round.  In the example in the prior paragraph, that would be $10 million.

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Entrepreneurs with (Bad) Attitudes

Many high impact entrepreneurs have outsized personalities.  They combine a big ego with incredible creativity, drive and energy.  Pretty much all of them that I have known have had at least one serious personality … quirk.  That said, there are quirks and there are flaws, the latter being defined, for my purposes here, as traits that rub most venture capital investors the wrong way.  Herewith, some of the entrepreneur archetypes most venture investors try to steer clear of.

The Defensive Entrepreneur.  Defensive entrepreneurs take everything personally.  When an investor asks them a probing question, they assume they are being asked to justify their existence.  And that tells the investor that the entrepreneur is more concerned with proving himself than his vision.  These are the folks who fear just one thing more than they fear that their startup might not work: that it might work with someone else calling the shots.

The “There is No Competition” Entrepreneur.  If, perchance, a bona fide entrepreneur comes along someday who really doesn’t have any competition, I’ve got a very important piece of advice for her: make something up.  Because entrepreneurs who insist they don’t have any competition almost never get funded.  There is always competition for the customer’s dollar.  A good entrepreneur understands that every potential customer ultimately must be won with a better value proposition.  Better than what?  Better than the competition.  Sometimes the competition is obvious; sometimes less so.   But it is always there.

The God Complex Entrepreneur.  The prototype here is the tenured well-published academic.  Having made a name for themselves in the very demanding, cutthroat world of academia, these folks assume they must perforce be capable of building the next Merck in their spare time.  Alas, as even Michael Jordon found out, different sports are, well, different.  Being good at running a research lab is no more a proxy for building a business than being a basketball superstar is for being a major league baseball player.

The “I Can Do It All” Entrepreneur.  A cousin of the God Complex entrepreneur, the I Can Do It All entrepreneur doesn’t understand that even if he could do everything himself actually doing everything himself is always a bad idea.  Great entrepreneurs know that they need to focus all of their energies on those mission critical things that they are best at, and find and empower other folks to do the other stuff.  Like the captain of a ship, an entrepreneur is responsible for everything that gets done (or not) on the ship.   But they don’t actually do everything.

The Big Business Entrepreneur.  A lot of personal regrets with this one.  If you think that someone who can run a billion dollar business can necessarily run a startup, think again.  And again.  There is not all that much overlap between building a successful business from scratch and managing an established successful business.  Being good at the one is thus not a very good predictor of being good at the other.  In fact, being good at running a big, established business is more likely to have a negative correlation with being able to build a high impact startup business.  Beware of any entrepreneur who needs a personal assistant.

The Uneducable Entrepreneur.  This can be a tough one to spot, but in an age when most startups need to pivot at least once on the road to success, it is an important one to spot.  What makes this a tough entrepreneurial species to identify is the fact that most successful entrepreneur are “often wrong, but never in doubt.”  And that trait can too easily be mistaken for a lack of learning ability/willingness.  Really good entrepreneurs may not always acknowledge their mistakes (though many of them do) but they clearly learn from their mistakes.

No doubt there are rule proving exceptions to each of the above paradigms.  But all other things equal, if an entrepreneur can be fairly fitted into one of the above categories, they will find raising capital from smart investors more difficult than it would otherwise be – even if they are one of those exceptions.  So why make it tougher than it has to be.  Just stay out of the “bad attitude” neighborhood.

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The Good Angel Investor (Part 2): After the Closing

In Part 1 of this post, I focused on issues entrepreneurs and angels should think about as a seed deal comes together.  Today, I want to focus on how angels can engage with entrepreneurs after the money changes hands.

Foremost among post-closing advice for angel investors is this: never forget that as an angel investor you are a coach, not an athlete.  Many angel investors have been successful entrepreneurs themselves, and one of the “value adds” that these angels can bring to a startup is the benefit of their own entrepreneurial and management experience.  But good angels understand that their role is to give counsel, not orders.  Few things make for a more unhappy and usually dysfunctional angel/entrepreneur relationship than an angel who thinks he is, or should be, making decisions rather than offering advice and counsel.

Good angels also remember that the business plan they invested in will likely change quite a bit, and often within months, or even weeks, of the closing date.  “Pivoting” is the nature of the high impact startup beast.  If you are skittish about major changes in direction based on less than complete information, high impact angel investing is probably not for you.  Once in a deal, your thoughts and perspectives on pivots should be shared with the entrepreneur, but always with the caveat that that the entrepreneur should make the call.

Expanding on the pivoting theme, angels investors in early stage high impact startups should remember that mistakes will be made, most likely quite a number of them, as a startup matures.  In more traditional businesses, the first thing that happens when a mistake is discovered is usually a search for someone to blame.  Later on, after the appropriate parties are duly punished and steps taken to reduce the risk of future mistakes, the focus shifts to correcting the mistake.

At high impact startups, mistakes are thought of more as learning opportunities than career killers.  Entrepreneurs that don’t make mistakes are likely not sufficiently pushing the envelope, and entrepreneurs who don’t promptly learn from mistakes and move on seldom find much success.  The angel investor’s role in all of this is to hold entrepreneurs accountable for mistakes – that is for timely recognizing and learning/recovering from those mistakes.  Angels who take the more traditional approach of assessing blame and punishing the malfeasors simply waste resources, undermine entrepreneurial confidence, and discourage prompt recognition of mistakes going forward.

Taking a “let’s learn from this and move on” approach to entrepreneurial mistakes is important, but so, paradoxically, is establishing a culture of accountability.  Being supportive, even entrepreneur-friendly, does not imply passivity.  Particularly for angels who are on the Board of Directors, being pro-active about regularly asking the hard questions about the business is a critical part of the job.   Think of it like this: as an active angel investor, it is your job to make sure that when the entrepreneur starts pitching new investors for the A round, she doesn’t get any questions you have not already asked.  If she does, she should hold you accountable.

Finally, good angels understand that as the company grows, their role will decline, in most cases precipitously.  Typically, the arrival of a solid lead investor for the A round marks the beginning of the end for the angel as a key member of the entrepreneur’s cabinet.  Angels that want to stay as close to an entrepreneur as possible are wise to recognize this rather than fight it.  Even angels that still have a lot to contribute are best served by moving off center stage, if only because that is ground the downstream investors understandably consider their own.

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The Good Angel Investor (Part 1): Doing the Deal

At a time when lean startups often require considerably less than $1 million dollars to develop the proverbial minimum viable product and even validate the same with some customers, angel investors are playing an increasingly important role in startup financings.  And that’s a good thing, particularly in places outside of the major venture capital centers, where institutional venture capital is scarce.

That said, most startups successfully launched with angel capital will want to tap deeper pools of capital later on, often from traditional venture capital investors.  That being the case, entrepreneurs and their angel investors should make sure that the structure and terms of angel investments are compatible with the likely needs of downstream institutional investors.  Herewith, some of the issues entrepreneurs and angels should keep in mind when they sit down and negotiate that first round of seed investment.

  1. Don’t get hung up on valuation.  Seed stage opportunities are difficult to put a value on, particularly where the entrepreneur and/or the investor have limited experience.  Seriously mispricing a deal – whether too high or too low – can strain future entrepreneur/investor relationships and even jeopardize downstream funding.  If you and your seed investor are having trouble settling in on the “right” price for your deal, consider structuring the seed round as convertible debt, with a modest (10%-30%) equity kicker.  Convertible debt generally works where the seed round is less than one-half the size of the subsequent “A” round and the A round is likely to occur within 12 months of the seed round based on the accomplishment of some well-defined milestone.
  1. Don’t look for a perfect fit in an off-the-shelf world.  In the high impact startup world, probably 95% of seed deals take the form either of convertible debt (or it’s more recent twin convertible equity) or “Series Seed/Series AA” convertible preferred stock (a much simplified version of the classic Series A convertible preferred stock venture capital financing).  Unless you can easily explain why your deal is so out of the ordinary that the conventional wisdom shouldn’t apply, pick one of the two common structures and live with the fact that a faster, cheaper, “good enough” financing is usually also the best financing at the seed stage.
  1. On the other hand, keeping it simple should not be confused with dumbing it down.  If the deal is not memorialized in a mutually executed writing containing all the material elements of the deal, it is not a “good enough” financing.  The best intentioned, highest integrity entrepreneurs and seed investors will more often than not recall key elements of their deal differently when it comes time to paper their deal – which it will at the A round, if not before.  And the better the deal is looking at that stage, the bigger those differences will likely be.
  1. Get good legal advice.  By “good” I mean “experienced in high impact startup financing.”  Outside Silicon Valley, the vast majority of reputable business lawyers have little or no experience representing high impact entrepreneurs and their investors in financing transactions.  When these “good but out of their element” lawyers get involved in a high impact startup financing the best likely outcome is a deal that takes twice as long, and costs twice as much, to close.  More likely outcomes include unconventional deals that complicate or even torpedo downstream financing.  This suggestion is even more important if your deal is perchance one of those few that for some reason does need some custom fitting.
  1. Finally, a pet peeve.  If you think your startup’s future includes investments by well regarded institutional venture capital funds, skip the LLC tax mirage and just set your company up as a Delaware “C” corporation.  If you want to know why, ask one of those “experienced high impact startup lawyers” mentioned in point 4 above.
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Maybe It Can Happen Here

Having been around the high impact startup and venture capital business for almost 30 years, on both coasts and now here in Wisconsin, I’ve developed a pretty good set of rules of thumb.  One of them is that while all kinds of folks like to think they can duplicate the success of venture-center accelerators like YCombinator, most of them – particularly in flyover country – can’t.  The fact is, very few folks in the accelerator business have the skills, experience, networks and capital to even approach the value add proposition of a YCombinator.

Thus, a year or so back, when I first heard of the folks at gener8tor, then setting up shop in Milwaukee, I was more than a little skeptical.  And when I met gener8tors first class, early in the process, my skepticism only grew.

Alas – well, actually, happily, as someone who continues to believe that Wisconsin can develop a self-sustaining high tech startup/venture capital community – when I saw that class at Launch Day 2012 I was, if not stunned, at least very surprised at what I saw and heard.  Entrepreneurs that a couple of months earlier seemed more or less like clueless wannabes were now looking like credible go-getters with fundable business plans.  Not surprisingly, most of them got funded, and several are making waves well beyond flyover country.

Now, on any given day, anything can happen.  Just ask the Florida Gulf Coast University Men’s Basketball Team.  Well, here we are in 2013 and … the folks at gener8tor have done it again, this time here in Madison.  They sifted through 200 plus entrepreneur applicants, picked out six keepers, and in 12 weeks of intense counseling, mentoring, prodding, testing and pivoting, they are ready to launch 6 more promising high impact businesses into the economy.  I know because as advisor to an angel fund, I had an opportunity to see the pre-Launch day pitches this week and, well, while I very much doubt all of these companies will hit home runs, I’d be surprised if they all don’t at least raise some serious capital and take a serious shot at success.  Which is a lot more than I can say for most of the startup entrepreneurs/deals that come across my desk.  If you don’t believe me, come to gener8tor’s Launch Day April 4 in Madison and see for yourself.  For a free invite, email joe@gener8tor.com.

 

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Some Thoughts on Telecommuting

Marissa Mayer, over at Yahoo!, is making a fair amount of news these days, most recently for reversing the company’s longstanding embrace of telecommuting and insisting that employees work at the company’s offices.  A lot of people were surprised by the move, mostly, as near as I can tell, either because it seems to go against the idea that the workplace of the future, enabled by modern technology, is best defined by where people are (say, at home) than where they are supposed to be (say, at the office), or perhaps because being a new mom, it is assumed that Mayer will want to make it easier for working moms to, well, work, by letting them work from home.  The tide of opinion, so far, seems to be that Mayer’s new policy is at least strange, and likely a mistake.

As a telecommuter myself at various points in my career, including to some extent now, my take is rather more nuanced.  Telecommuting is, I think, a great option for some employees at most businesses – even, I suspect, at Yahoo!  But for most businesses and most employees, working in a communal environment offers important advantages that can make or break a business.  As I see it, done right the office environment offers two key competitive advantages over the dispersed (i.e. home) working environment: it fosters collaborative thinking; and it promotes esprit de corps.

As for facilitating collaboration, as society becomes more complex and interconnected, innovation – the lifeblood of a thriving business – becomes more and more a collaborative process.  And it is just plain easier to collaborate with people face to face than smartphone to smartphone.  As for esprit de corps, the importance is too often overlooked, I think, in a culture that more often promotes the individual than the team.  But whether we are talking about sports or business, whether it involves teammates or workmates, other things being equal, more esprit de corps is going to result in more success.  Just ask the folks at Google.  Or Apple.  Or, in my own experience in and around the high impact entrepreneurial and investing space, the folks at just about any young, high-risk/high-reward startup out to change the world.

To be clear, I am not suggesting that telecommuting is always a bad idea.  There are jobs – as there are sports – that are basically individual activities; say, for example the proverbial bond trader who plies his trade from his home office in Vermont.  There are people that work better without the distractions of a busy workplace: say, for example, some journalists I’ve met.  And there are situations where the fit/synergies between the business and the employee are greater than the real costs of working remotely; say, for example, some entrepreneurial lawyers I know.  But at the end of the day, I still think the best question for Marissa Mayer is “what took you so long.”

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