Thoughts on startups by investors that fund them & entrepreneurs that run them
Antone is a business lawyer and executive advising technology and media companies, entrepreneurs and investors in corporate, commercial and intellectual property matters. Johnson is Founding Principal of Bottom Line Law Group, a business and IP law firm and was the former VP and head of worldwide legal affairs at eHarmony.
Last month, the SEC announced it was taking action regarding Netflix’ (NFLX) securities compliance based on a Facebook status update posted by CEO Reed Hastings. The move came as a shock to many in the tech business community, in which we’ve become accustomed to real-time disclosure by company executives through social media. What could be wrong with more transparency?
To understand the SEC’s point of view, it’s necessary to review the principles underlying securities law in the United States. Compressing 80 years of history into a paragraph, securities regulation here is fundamentally a disclosure-based system. With a few exceptions (notably corporate governance requirements imposed by the Sarbanes-Oxley Act in 2002), beginning with the original Securities Act of 1933, Congress and the SEC adopted a philosophy that financial markets work best when investors are free to make their own decisions based on timely, complete and accurate disclosure by publicly traded companies. Modern theories of economics and finance teach us that in a world of perfect information, the market will decide what a fair price is for any company’s stock at any point in time based on its current financial condition, results of past operations, analysts’ forecasts of future performance, industry conditions and so on.
The key words worth repeating here are “perfect information.” Like all forms of perfection in an imperfect world, it exists as an aspirational goal, not in reality. Certain people inside a company will always know more than the general public. This is why insider trading can be a criminal act: Trading on the basis of material nonpublic information that would affect the stock price is a form of cheating, taking advantage of those who lack access to the same information. The person or business on the other end of an insider trade is at an automatic disadvantage.
As I write this, days after the 2012 presidential election, I’m probably not alone in feeling relieved that the political jeering and soapboxing that reached a feverish pitch during the seemingly endless campaign season has finally subsided. Yet amidst all the partisan cheerleading and name-calling, there has been some discussion of substance. One particular four-letter word has been used pervasively by candidates of all stripes: Jobs.
An impromptu Twitter debate arose among Fred Wilson, Dave McClure, Mark Suster, Chris Dixon and others about convertible debt, priced equity rounds, and the nuances of early stage financing. It was such a good discussion that Fred asked that someone Storify it. I’ve done that here and expanded it with some additional references, background info and light commentary.
How to finance a new seed-stage startup? Equity? Convertible debt? Convertible equity?
As of August 2010, Paul Graham famously proclaimed, “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.” Yet in my little corner of Wonksville, Founder Institute CEO Adeo Ressi and Yoichiro “Yokum” Taku, a partner at my “alma mater” law firm Wilson Sonsini Goodrich & Rosati, created quite a stir this past week by announcing a new set of template deal documents dubbed “Convertible Equity.” Ressi in particular seems to be passionate about removing the “debt” component from convertible debt seed financing transactions. For a good summary with links to the documents, see Leena Rao’s post at TechCrunch. The whole episode has reopened a broader discussion about the virtues and vices of each variety of seed financing, as exemplified by Mark Suster’s most recent post on the subject. Read more
At the threshold of one of the most recognizable landmarks in human history — the sole survivor among the Seven Wonders of the Ancient World, dating back nearly five thousand years — my entrepreneur host was engaged in heated debate with a rotating phalanx of functionaries. As our group sweltered in the July heat on the outskirts of Cairo, each of these purported minions of the Egyptian state — none of whom wore a uniform or badge — in turn blocked our entry, determined to exercise the modest amount of authority bestowed on him by demanding that my host surrender his digital SLR camera. (Never mind that tourists of all nationalities, sizes and colors streamed past us carrying similarly weighty “prosumer” equipment.)
Whether in English or Arabic, all appeals to logic and authority fell on deaf ears because our host had unfortunately shown his journalist visa at the window when buying our tickets. Tempers flared, fueled by the unrelenting midday sun. (It probably didn’t help to be here during Ramadan, when Muslims fast from 5 a.m. to 7 p.m. every day for a month. That includes abstaining from water, despite the 95-degree heat.) ”What’s the problem?” We needed to be escorted by a press officer, or something. ”I’m just here to show my friends the pyramids.” Yes, but we needed to check in with the press office, or something —yet the office was closed because this was a national holiday. ”Why? This is personal, not a professional assignment.” Then we needed a permit to go unescorted, or something. ”But my credentials are for a television network. Do you see a TV crew with me?” No, but a camera is a camera, or something. ”Show me the law that says I need a permit to bring in a still camera just like all these tourists!” There is no law, other than the word of the manager on duty — who decrees that we could get in with the camera if we paid some ludicrous amount of money to procure a permit on the spot. Or something. ”Yes, but….” Read more
Entrepreneurship is often born of founders’ sheer frustration with the status quo. One class of clear business opportunity, which wouldn’t exist in an ideal world, is created by the service that seemingly makes it as difficult as possible for potential paying customers to make it take their money. This sort of chronic customer dissatifaction flies in the face of both common sense and economic theory, yet it persists in countless contexts.
When it comes to inefficient outcomes and dissatisfied customers, it’s hard to beat the U.S. domestic airline industry. (In fact, it’s literally impossible; accordingly to a 2011 customer satisfaction survey, the airline business tied for last place out of 47 industries.) Don’t get me wrong, I’m grateful to get online at 35,000 feet as I write this. Yet in classic tone-deaf fashion, airlines have gone about implementing in-flight WiFi connectivity in such a customer-hostile fashion that it’s almost as if they’re competing vigorously to make things as difficult as possible for their most valuable customers: Frequent business travelers who are motivated to pay for WiFi to stay productive even on relatively short flights. Read more
Rhetoric has the power to engage or alienate, to enchant or disaffect. Perhaps no better example exists than the term “Corporate Governance.” Even the wonkiest law geeks like me find our eyes glazing over as soon as the term is mentioned. Yet I’ve rarely seen entrepreneurs more fired up than when recounting war stories of startups whose founders had control of the company wrested from them, were forced to take financing or compensation deals on outrageously onerous terms, or worst of all, fired from their own companies. Framed that way, “corporate governance” starts seeming a lot less dry and academic. It’s probably no coincidence that one of the questions I get most often from founder is “How do I keep control of my company?” Read more