1. Why are the shares divided into preferred and common?
2. Why does the preferred stock have a limited “1x” return?
3. What will happen with liquidation preferences in future rounds?
4. What will happen with dividends?
5. Does the preferred stock have to convert to common to get more than its money back? Why? How?
6. Don’t these restrictions make preferred shares seem less “good?”

The short answer is that this is a standard seed round term sheet that balances all the issues in a reasonable industry-standard way that won’t hamstring follow-on rounds. What that means is that venture investors, and also their lawyers, expect to see companies with a structure that is within the normal variation of such things. The standard, as I’ve written before, is to see a Delaware C-corp with a reasonable division of equity among the founders, some sort of vesting, a clean balance sheet, and a reasonably clean cap table overall. Complications on any of these points can arise, and some variation is certainly common, and some variation is actually meaningful, purposeful, and beneficial to the company.

Of course there are two positions on each of these kinds of issues, but if you think about contracts as mechanisms for transferring risk from one party to another, then some structures make less sense because they’re economically inefficient by  not assigning a risk of loss to the person best able to prevent that loss.

Here are some longer and more precise answers:

1. Preferred and common shares — this is the traditional structure for venture-financed companies. The two classes of stock help fine-tune the relationship between the investors and the founders in light of the risk/rewards appropriate for each. Preferred stock allows certain holders, i.e., the investors, to receive their investment back before any return accrues to the other holders, i.e., the founders. This is the general practice. The use of preferred stock also provides other high-level protections to investors even if they own less than a majority of the company, which would not be the case if they only held common stock; there are similar protections for founders holding common stock even if the preferred stock holders own a majority of the company on a fully diluted basis.
2. The upside on the preferred shares is not limited. It is a 1x non-participating preferred. This means that the preferred stock holders have an option in the event of a liquidation event of some kind: (a) take their money back or (b) convert to common stock. The choice means that holders of preferred stock will, in the event the company is sold very early, not face a situation where they lose money and the founders make money.
3. It is the company’s goal, and standard in the tech industry for venture-financed companies, to maintain the 1x non-participating preferred structure. Whether those terms would vary in the future for a round of venture financing with particular investors cannot be determined. But the protections of current preferred stock holders to approve certain additional issuances of preferred stock generally acts to prevent unfair future sales of stock.
4. It is the company’s goal, and standard in the tech industry for venture-financed companies, to not actually declare and issue dividends. The basic assumption is that at the discount rates implicit in angel and venture valuations, it makes more sense for the relatively small amount of cash that dividends would represent to remain invested in the company for a far greater return. Also, since few early stage companies are producing cash, dividends are generally not distributions of free cash flow but just a deduction from cash on the balance sheet. That’s a very different corporate finance strategy, one that most startup CFOs would not suggest. The same points as it #3 regarding future rounds apply here except that dividend provisions rarely change; liquidation preferences are more likely to be different from round to round.
5. Yes, conversion to common is generally deemed to occur immediately prior to the closing of the liquidity event, e.g, a merger or IPO. The specifics are spelled out in the transaction documents; the general format can be seen in the Series Seed documents linked below.
6. Preferred shares are always thought of as better because they are protected on the downside. See Fred Wilson’s example in his post linked below for the basic scenario in which preferred stock investors are protected. As a general rule of thumb, in the absence of particularized 409A valuations, common shares are thought to be “worth” approximately 10% of the value of preferred shares; this ratio reflects the partial protection against downside risk that is the preferred return.

Some links:
Series Seed documents

Fred Wilson of Union Square Ventures discussing the liquidation preference: he discusses the point often on his blog; it could be helpful to read his comments.

Startup board packages should be 80% straightforward, easy to update materials: financials, sales pipelines, technical milestone progress, option grants, etc. — it’s data/information. The remaining 20% is what the management team should be working on — knowledge & questions. That 20% will vary from company to company, from VC to VC even, but it will almost certainly revolve around these three major themes:

1. the allocation of capital (of all kinds) across the strategic and tactical opportunities in front of the company
2. the status of execution against the opportunities being pursued
3. the identification of any roadblocks to execution and success that the board can affect

Sharing the weekly version of your 3x5x15 staff planning tool is one simple, low-overhead way to keep the board apprised of ongoing developments without overloading them with details or inviting discussion on minor points.

Focusing on giving the board decisions to make, rather than topics to discuss, will make everyone more productive, improve the quality of the interaction, and improve overall results. There’s no issue that can’t be handled in a single meeting that should be brought up for discussion in the meeting; what this means is that as things percolate, the management team member responsible needs to *write* up an information brief to highlight the concerns and issues. (Yes, it has to be written, e.g., in a document, not a presentation, to clarify the message with the appropriate level of detail and background and allow it to be digested over time.) Then, once the informal discussions, generally outside of the board meeting schedule, have taken place, someone should write up and present a decision briefing, the purpose of which is to give the board the issues, a recommendation, and seek a decision. This structure works wonders in clarifying issues and bringing ideas together.

Decide, don’t discuss. That’s the way to rock a board meeting.

In reference to a post on the use of the term aggressively, I wrote:

These comments seem like nitpicking and pedantry until you start to listen carefully and accept the empirical, outcome-based approach that Ken Adams has followed. What do courts do with our contract language? Isn’t that a significant goal of drafting? To tell parties to what standards they can expect to be held?

Every time I read one of these posts it energizes me to re-read my form contracts for even simple things like entity formation (startup and nonprofit), founder’s documents, and venture financing.

I have been in discussions with some of my colleagues around the country on creating both a new new set of startup and venture documents and some additional materials (still in stealth mode!) for entrepreneurs. If you’re interested in hearing about these directly when they’re available, sign up for free RSS updates, or send me an email at rick@rickcolosimo.com.

You may or may not get a formal list from the other side, depending on their level of formality and the nature of their advisors. Some investors know exactly what they are looking for and will figure out what they want to do from your financial model and a series of conversations. Others assume that the only way to be sure is to review a mountain of paperwork. The real answer lies somewhere in-between for most companies.

So, to get you started or at least calm you, here is a super Short Form Due Diligence Request List for a seed round investment or low-key quasi-acquisition, such as an asset purchase or stealth acquisition.

First, keep in mind that the other party may, and probably will, ask for additional information. Our goal here is first to identify anything that might concern them so it can be defused or resolved before it’s ever disclosed. (Hint to bad lawyers: you cannot hide things; there’s always a second copy floating around; the goal is to solve the problem so you can disclose how it has already been fixed.) Our second goal is to streamline as much of your work as possible so that you are not under time pressure later. The third goal is to identify the factual support for the business plan/budget that will be a critical piece of the transaction.

Here is the list of other materials you should be gathering in the background as negotiations continue, documents are drafted, and the deal moves forward.

1. Financials — Copies of all historical financials for existing operations: Income Statement, Balance Sheet, and Cashflow statements. (A backup version of a QB file is something that I regularly work with to extract these directly if necessary.)
2. Material contracts — all contracts that are either above a specified dollar value ($10-25k) or are otherwise important to the continued operations of the business on a similar basis. This should usually include customer contracts, all leases, all promissory notes, and IP licenses, and anything to do with stock or securities (like a warrant agreement or agreement to trade stock for services of a consultant).
3. Corporate documents — Copies of current articles/certificate of incorporation & bylaws; minute book with board/shareholder consents & minutes.
4. Other risks — A description of any pending litigation, whether company is plaintiff or defendant; any audit letters from auditors if financials have been audited in last 3 years; a description of any off-balance sheet obligations or other liabilities; and a summary of any related-party transactions, individually or in the aggregate greater than $25,000.

This ThoughtStorm Due Diligence Request list is a version written from the perspective of an investor and is a little more detailed than what I have above. It’s more like a reasonably thorough list that will get you most of the way to complete for an early-stage company.

The new page, Observations, is available from the header throughout rickcolosimo.com. Depending on the amount of feedback from those items, I may try to integrate them into the regular posts for anyone viewing the RSS feed.

Let me know what you think.

How do you know if your IP licensees are paying you properly?
I sat on a presentation about royalty audits today and think it’s a fantastic to collect due royalties – wrote about it here[.]
But I’d be interested to know what other methods are used to ensure proper payment, especially for smaller companies that license out to larger companies and either can’t afford an audit or don’t feel right about it.

Here’s an edited version of my answer:

First off, “not feeling right” about making sure you’re getting paid is a bad strategy. If you need excuses or a way to eliminate the decision-making, institute a program of auditing some random number of customers (volume/dollar weighted, to be sure) each period – month, quarter, year. You can certainly “blame” your accountants, and as a lawyer I’ve often told my clients to use me as an excuse. Most businesses will commiserate with you, rather than complain, if you tell them your lawyer’s making you do it.

Now, as for how to structure payments, the best course is to choose metrics that are easily measured and hard to game. For example, one person I know will only take a percentage of the gross sales, since there’s much less room for fudging costs of goods sold and SG&A for a particular item. Of course, the number has to change, but the amount should be close, if a little lower, to a % of the net model. (Why would the dollar amount be lower? You’re accepting less risk by taking part of the gross vs. the net, even apart from reduced fudging; it’s fair to share that with the licensee.)

Others suggest a similar approach by using other easily audited materials, such as checking the gross weight of a key component for a licensed process. That’s a great example because invoices from a third party are good proof and easy to cross-check with the actual third party.

At the end of the day, the best model will depend on what type of IP you’re licensing and your goals about risk/reward. Is it easy to measure the contribution to value from your IP, like a Tiger Woods sneaker where you can count pairs, or is it something more vague, like using music in an advertisement? Probably the best advice I can give is to price your license based on your business model and not on someone else’s. Most licensees want either a pure net basis percentage fee or a fixed fee regardless of how much money they make. You should be able to analyze these models under various scenarios and see how they work for you. Once you know what you want, then turn the plan over to your licensing lawyer to translate it into a legal structure that implements what you want.

One alternative to drafting that I’ve always liked: “check the box” forms.” During any moderately stable period in Silicon Valley, certain terms become “market,” meaning that there’s little real dispute about them in substance and only some modest dispute about seemingly meaningless particulars (such as how many demand registrations an investor gets — as Ted notes, how often is that number, 1 or 2 or 3, actually operative? How often is the number even relevant for discussions, negotiations, or planning?). A similar drafting approach is used in traditional corporate finance documents, where definitions are used to maintain standard document formats with the deal particulars implemented via the definitions, e.g., Interest Rate shall mean seven percent (7%) per annum.

Using reasonable standard language would allow any law firm to essentially take minor issues off the table, or at least put them in proper perspective, and push the negotiations and diligence process to the most economically important items: capitalization, IP, voting rights, and liquidation rights. This reductionist approach helps parties move past the distracting issues and focuses them on the critical facts to identify in the due diligence process: the dealbreakers, the price-changers, and the term-changers. (Everything else is effectively ignored at this stage if it doesn’t have one of those three effects.)

I’ll look for the forms and post whatever I come up with.

My colleague Pierre Khawand at People-OnTheGo has presented his Accomplishing More with Less workshops to teams in the past, and we’ve discussed how this sort of simple tool has a disproportionately positive impact on how a team gets along over time.  People regularly object that “but there are always exceptions!” C’mon, I say, you’re a bunch of smart people, right? (No one ever objects to that!) There’s no reason that a group of smart people can’t come up with a standard way of dealing with exceptions and emergencies. In the linked post, it’s simple:

EMERGENCY? = Use phone

The understanding here is that if you know that people will check email at roughly the stated times, and your need is legitimately more urgent than that, you can use the phone. The implication is that the team leader has instituted, as part of the team culture, the rule that phones are to be used only for emergencies and that they have to be available to receive emergency requests. That’s a rule that others might disagree with, but that’s not the standard.

When asked by people what rules they should have, expecting us to pull out a laminated “rules of the office” list, we always go back to the underlying situation, habits, and culture. The key to this sort of SOP is that it should be organically generated by the team to improve/ensure adoption and compliance.

(NB: no specific reason for two POTG posts today other than that I’m clearing through emails and getting things written that needed writing.)

If you are blogging about multiple issues, you should consider separating your blog writing into categories to improve or reinforce your personal branding. Leading by example, here’s our breakdown:

http://www.thoughtstorm.com/blog.html – this is the TSC “official” blog. I try to keep the topics closely aligned to our thinking, our service offerings, and our opinions about similar transactions or related issues. I will soon be making this content the primary focus of the website, using it to give a fuller impression of who we are and how we think – what separates us from larger firms providing seemingly similar services.

http://www.rickcolosimo.com/ - this is my “personal” blog. By personal, I mean only that it’s separate from my TSC business. But I fully expect that business contacts will also see this blog and so the real difference is that I address topics that are slightly different from the TSC core business , such as more law-related issues, or expansions of TSC ideas and themes into other areas that TSC would be unlikely to explore for business.

http://www.30seats.com/ – this is the autism-related blog that I primarily write. I am trying to focus it on creating tools to help people (parents) help themselves. It will slowly accrete links to Pam’s blog (below) and to our wiki-driven site for creating and collecting content, to be found at www.wolfhoundfund.org (no link since it’s not fully installed yet).

http://pamcolosimo.blogspot.com/ – this is my wife’s “science of autism” blog. She has a Ph.D. in Genetics and is beginning to look for a position following the completion of her NIH post-doctoral fellowship at Sloan-Kettering in NYC. Its purpose is as much to get her in the practice of writing about science as it is to provide a deeper portfolio that will resonate with the people she meets.

As you can see, there are some clear lines we’ve drawn between what goes where. While this could be accomplished on a single blog, there are, at least in our case, pretty clear distinctions between the types of things I write about. The autism-related issues, in particular, are interesting to a very different group of people than those who care about our use of data-driven analysis to guide pre-merger due diligence on target companies. Of course the groups overlap to some extent, but nearly everything about the communication is different – tone, style, frequency, subject matter, and call to action. It makes sense to us to give people what they want. Separating your blogs helps people understand what you’re offering. With the cost of a second blog being so low (free from a blogger.com/wordpress.com perspective), the benefits to your readers almost certainly outweigh the costs. Using a second or third blog improves the signal-to-noise ratio for your readers when your topics diverge.

Please feel free to describe your blog separation strategy in the comments, or why you have decided not to use different blogs.

I will complain, however, about the article’s use of the word “sheepskin” to refer to a diploma or college degree: “…dramatically undermining any value a sheepskin adds.”

A few weeks ago, there was an episode of the show “House” that had a character, a working-class fellow who owned a scrapyard. Talking to his son the night before graduation, he mentions wanting to watch his son “get that sheepskin.”

Please! Who has ever used that word, deliberately and honestly, in casual conversation? “Sheepskin” is one of those words that no one actually uses and should have died out years ago. My belief is that it’s kept alive by writers who know lots of words and simply get bored with using “diploma” or “degree” or anything similar. “Sheepskin” has a nice Shakespearean tone to it, and if challenged, the writer can always launch into the “well, in the olden days, they actually…” story and further impress people about her extensive knowledge of stuff that matters much less than we thought it did in college.

Full disclosure: I was an English major at a liberal arts college, and I really liked it. I read a lot, and I am trying to write more. I seriously considered becoming a professor. To add insult to injury, I have an Ivy-League law degree and started out as a litigator, one of those people who writes long persuasive argumentative documents and letters. I have already walked the path these people are, with one small difference. I’ve listened more to the people around me and realize when language is just not appropriate.

These phrases have effectively turned into jargon or argot [see, I did it there just to prove a point -- argot is a French word, borrowed by English, that means slang], even though they don’t meet the traditional definitions of those terms. “Sheepskin” isn’t a term of art among anyone, but using it creates the same effects as the use of jargon: exclusion, hubris, and confusion.

For lawyers, I’ve found the “Dictionary of Modern Legal Usage” to be very helpful at eliminating the stumbling-block phrases that seem to infect legal writing more than you think. I like this book so much that it’s my standard gift to new lawyers and law students that I know. It’s that good.

I’ve always liked Quentin Tarantino’s comment about his films; he said that even if you didn’t like the story, the film, or any number of other things, you had to admit that he wrote great dialogue that sounded realistic. People don’t always talk like they do in Jackie Brown or Pulp Fiction, but they could.

When you’re editing your own writing, think about your audience and catch those words that they wouldn’t ever write themselves. Eliminating the deadwood words will freshen up your writing and help it flow more smoothly.

Please add your suggestions for similar words that should be retired in the comments; I’ll do a round-up post once we have enough nominations.