Print
Email
Print Edition Stories
Wednesday, November 10, 2010
Entrepreneurs face term sheets, taxes and options in VC and angel fundings
By Galen Moore
MHT's Julie Donnelly: Boston lines up tech events for fall calendar
MHT's Emerging Technologies Forum: Health IT and the Cloud
A young entrepreneur could be forgiven for shaking his head at the lions of startup investment these days, as they debate and posture over small funds, large funds, signaling, debt and equity. When one needs cash to keep the lights on over a high-risk dream, these look like first-world problems of the highest order.
Here are three factors, which haven’t come up in the VCs vs. Angels royal rumble but are worth considering. Two are contractual issues that come up when choosing between convertible notes and equity investment. The other is something founders should consider well before they go out looking for investment.
Taxes
Shawn Broderick
Managing director, TechStars Boston
Last month, TechStars directors and partners met and talked seriously about tearing up the standard term sheet the nationwide incubator program uses for the 10 or so startups in each of its four locations. In exchange for mentorship, education, office space and a little cash, TechStars currently takes 6 percent equity in participating companies. The problem with that isn’t board control, or the valuation the deal sets up for later investors, TechStars Boston director Shawn Broderick explained. It’s taxes.
“Nobody does TechStars for the money. They do it for the mentorship, the network and the community,” Broderick said. “Unfortunately, the IRS doesn’t see it that way. A lot of times it can create tax liability issues.”
Each TechStars company gets a check that amounts to $6,000 per founder. Since the incubator takes a 6-percent equity stake, tax collectors now assess the startup at $200,000, pre-money — even if it doesn’t yet have a product. That means if the company wants to add another founder and give her a third of the equity, she gets a tax bill in the tens of thousands. “Most people involved in startups in this state aren’t looking to get involved to work like a dog at low pay and have a five-figure tax bill,” Broderick said. “That’s not how you sweeten the deal.”
What about investors? Those who prefer convertible debt typically cite problems with setting valuation too early in a startup’s career. Has that problem ever come up as a result of the TechStars term sheet?
“That’s never been an issue in four years,” Broderick said. “There have been some bonehead investors who’ve gone and said, ‘Well, I’m not giving you a 20x value bump.’ But those people are boneheads. Investors understand that that isn’t what the value was. The value was the education, the network, the mentorship.”
Founder equity and legalese
Jean Hammond
Managing Director, Goldenseeds
Usually, before founders take outside investment from angels or VCs, there are decisions to be made about how to divide ownership among the founders and the very early friends-and-family investors. Jean Hammond, a managing director at the angel group Golden Seeds, has seen this done any number of ways — from simple 50/50 splits, to Uncle Bill’s family lawyer drawing up some term sheets. If not done right, a cap table can put off potential investors.
“I think that the investors expect to see that the CEO owns more of the company than the other people in the company, as an individual against any one other individual — so that we don’t get into the 50/50 share problem,” she said. “Somebody has to decide. Somebody has to be where the buck stops. We want that.”
But a CEO who holds too much of the equity? That’s not smiled upon, either. “We want to see people treating their team really fairly, and keeping around enough extra options that they can reward the people who are doing marvelous things.”
Angels and super-angels are working on ways to simplify term sheets for early-stage companies, she said. For example, right now the typical Series A term sheet contains weighty language describing what happens in an IPO. “Guess what? How many IPOs did we have last year?” Hammond asked, rhetorically.
Now, investors are asking startup lawyers for a simpler way that won’t cost their companies precious dollars. “If you have an inch of paper produced by one lawyer, you have to have another lawyer read it,” she said. “And that’s why we have these $15,000 or $20,000 legal fees on these deals.”
Control
Roy Rodenstein
Going Inc. co-founder and HackerAngels member
Whether they take equity or debt, investors in venture- and angel-backed companies may want a seat on the board of directors. Institutional investors sometimes want more than one seat. Founders may fear giving up control, or being out-voted on their own board. That rarely happens, says Roy Rodenstein, a member of the HackerAngels angel group, which, like many angel investors, often invests without a board seat. That hasn’t presented a problem, Rodenstein said.
“The funny thing about the board is, most people that are not in the business think that what matters is around voting — you might be outvoted three to two or four to one,” he said. But board meetings almost never come down to a vote, he said. “That’s almost beyond a last resort. That means there’s a massive disagreement and they’re just not communicating properly .... Just people speaking their mind is what controls the board meeting. You can have one or two people taking up 70 to 80 percent of the airtime.”
In fact — and this may be obvious — a company’s direction is not usually determined in board meetings. It’s determined in less formal sessions, like instant-message exchanges that take place in the witching hour. “I tend to have a close enough relationship with the entrepreneur,” Rodenstein said. “I often literally talk to these guys at 3 a.m., because I’m up at all hours. I feel like I have certainly enough of a channel to them.”
Comments
If you are commenting using a Facebook account, your profile information may be displayed with your comment depending on your privacy settings. By leaving the 'Post to Facebook' box selected, your comment will be published to your Facebook profile in addition to the space below.
RSS Feeds
