VC WATCH

Half-Time 2016: A Glass Half-Empty, or Half-Full?

After two record years for venture fundraising and investment, the “bears” among us are already planning for the next down-cycle. Recent headlines have included “Global Funding Chill Continues in Q1 ’16 as Investors Dial Back Deals,” “Venture capital pullback deepens in Q1 2016,” “This Tech Bubble Is Bursting” and “What the Decline in Venture Capital Funding Means for Entrepreneurs.” Dow Jones & Company, http://www.wsj.com/articles/this-tech-bubble-is-bursting ; Wharton School, http://knowledge.wharton.upenn.edu/article/how-entrepreneurs-can-weather-the-drop-in-vc. But the “bulls” among us recognize that “VC investment in North America” is holding “steady” and observe the increase in corporate venture funding and the financing success of companies in Internet and mobile, technology, digital health and cybersecurity. Venture Pulse, Q1 ’16, Global Analysis of Venture Funding, KPMG International and CB Insights, April 13, 2016; https://home.kpmg.com/xx/en/hom/media/press-releases/2016/04/venture-capital-pullback .

A global, all-company-stage, all-industry, “one-size-fits-all” analysis of venture fundraising and investment over one or even several quarters can be very misleading. “Unicorn” mania (i.e., inflated valuations fueled by large, later-stage investment), late-stage megadeals and IPOs have been silenced for now. That can be a good thing for some and bad for others — perhaps good for disciplined entrepreneurs and investors who can see through statistics, cycles and certain headwinds and double-down on bottom lines and building their companies. Alternative investors such as hedge funds are pulling back, as perhaps they should, leaving the way clear for more venture-savvy, knowledgeable and value-add angel, corporate venture and venture capital fund investors to find and help the best companies succeed. In contrast to corporate merger and acquisition and even private equity buyout deal flow, which are more directly and quickly affected by economic and capital markets challenges, venture capital lags behind those macro-economic trends and persists through them.

Of course, we do not have a crystal ball. Our current experience is that venture investors are raising money and they are investing. Short-term shifts from seed activity to Series A, or from late-stage megadeals to earlier-stage investing, do not portend a bursting of any bubble. Perhaps they will avoid one. It is July 2016, not March 2000, and even though the “world is flat,” the U.S. is not Europe or Asia. U.S. venture capital funds raised $12 billion for 57 funds in Q1 ’16, a 59 percent increase in dollar commitments from Q1 ’15, although a 17 percent decrease in the number of funds raised. Thomson Reuters and the National Venture Capital Association, http://nvca.org/pressreleases/venture-capitalists-raise-12-billion-in-first-quarter-invest-startup (“Strongest Quarter in Ten Years and More Than the Last Two Quarters Combined”). The attraction of limited partners to venture capital funds has never been stronger (think low interest rates and attractive limited-partner distributions and returns in recent years). Capital is in great supply and entrepreneurial innovation and technology advances will not end. Global markets and stock markets will always present short-term obstacles, but venture capital investment will continue to be a major long-term driver of our economy. Cycles, shifts and adjusting course (and even business models) is what venture capital is all about.Venture-Capital Firms Draw a Rush of New Money, The Wall Street Journal, http://www.swj.com/articles/funds-flow-to-venture-firms (“Venture-capital firms are raising money at the highest rate in more than 15 years, even as the values of some once-hot startups have begun to cool.”); 10 Growing Trends in Venture Capital for 2016, http://www.inc.com/lisa-calhoun/10-big-venture-capital-trends-to-watch-in-2016 (citing “more corporate deals,” “more incubators and accelerators,” “early-stage competition” rising for VCs, and the fact that the “number of funds continues a steady rise.”); Venture capital: It’s not all gloom and doom in 2016, htty://www.cnbc.com/2016/01/29 (encouraging readers “to take a thoughtful look at the long-term fundamentals of technology innovation”).

VC PLAYERS

Corporate VC Increases Its Share of the Pie

We have said it before, but the only players that deserve as much credit as seed-stage angel investors for backing early-stage companies are corporates and corporate venture arms. Their venture investment rose to 27 percent of all deals in Q1 ’16, a five-quarter high. Corporate strategic investors continue to outsource their research and development functions and are flush with cash, and they view entrepreneurs and startups as some of their best hedges against competitive and rapidly evolving technologies. Venture Pulse, Q1 ’16, Global Analysis of Venture Funding, KPMG International and CB Insights. Below, we pay our respects to the impact of corporate investment on this edition’s “VC Vertical” spotlight — the “Internet of things” or “IoT.”

Microsoft recently formed Microsoft Ventures, a new arm that will focus on “Series A and beyond” investments in North America and Israel. The fund will be led by former Qualcomm Ventures head Nagraj Kashyap. Kashyap explained: “In Microsoft’s history of engaging with and supporting start-ups, we’ve done a lot of investing, but not a lot of early stage ... . With a formalized venture fund, Microsoft now has a seat at the table.” http://techcrunch.com/2016/05/31/microsoft-confirms-microsoft-ventures-vc-arm . Hard to believe Microsoft is only now following Google’s Google Ventures model!

And Salesforce.com is committing $50 million to a fund called “Lightning Fund” as part of an incubator for early-stage cloud startups. Salesforce has been one of the most active corporate venture investors in software since 2009 and has substantially increased its early-stage investments in the past couple of years. Salesforce Ventures, the first fund, is the only corporate venture fund invested entirely in enterprise cloud computing. Through January 31, 2016, it had invested over $500 million, compared with $150 million in the prior year.

Corporate venture groups invested more than $7.5 billion in 905 deals in 2015, accounting for 13 percent of venture dollars and 21 percent of venture deals in that year. Corporate venture investments fell sharply after 2000 (its peak year), with $15 billion in funding over 1,948 deals (down 81 percent in the first quarter of 2001), and by the end of 2001 almost half of corporate venture funds had shut down. It will be interesting to see whether any downturn in overall venture capital activity will impact corporates, but so far they appear committed to the venture capital ecosystem. “Salesforce in Push to Aid Startups,” The Wall Street Journal, June 8, 2016, B5.

VC HUBS

Dallas, Texas

While Austin, Texas, continues to be the venture “capital” of the Lone Star State, first-quarter venture capital investments in Dallas-Fort Worth companies reached a two-year high, focused primarily on software companies. “While national trends show a decrease in early-stage investments, half of the top six deals in DFW were done with early-stage companies.” http://frontburner.dmagazine.com/2016/04/15/software-companies-boost-dfws-venture-capital . While still third behind Austin and Houston in Texas venture investment, Dallas demonstrated in the first quarter that the city is not just about industrial and engineering deals.

Jefferson’s Charlottesville, Virginia, Makes VC News

Thomas Jefferson would be proud of the bustling college town below his home place in the foothills of central Virginia. The National Venture Capital Association recently named Charlottesville, Virginia, as the fastest-growing venture capital ecosystem in the United States. Most of the companies contributing to that growth trace their roots to the University of Virginia, which Jefferson founded.www.vcpost.com/articles/115652/20160204/charlottesville-un. In five years, tech startups backed by venture capital increased 55 percent (with funding increasing from $250,000 to $27.7 million). NVCA President and CEO Bobby Franklin commented that “people should not have to live in either San Francisco, New York or Boston to receive venture capital funding for their business.” Six of the nine leading Charlottesville-based companies receiving venture funding worked directly with the University of Virginia Licensing and Venture Group, revealing that the university’s commitment to research and innovation is the driving force behind Charlottesville’s success as a venture capital ecosystem. Due to its cosmopolitan culture, quality of life, natural beauty and proximity to Washington, D.C., the town is also a popular destination for angel and fund investors.

VC VERTICALS

The Internet of Things: A VC Sleeping Giant

Just as we finally understand and appreciate the “software as a service” or “SAAS” phenomenon, along comes the “Internet of things” or “IoT.” Salesforce.com gets much of the credit for SAAS, moving software applications to the cloud so that customers of all sizes could have access to the best-of-class tools.http://fortune.com/2016/06/06/why-sass-consolidation-is-not-happening. SAAS companies have become the darling of venture capital investors due to their low-capital expenditure requirements and limitless scalability. However, their market has matured and become crowded. It appears that the next big thing is IoT.

IoT is almost incomprehensible, given its potential impact on all other industry sectors. In its simplest context, it is the intersection of sensors and software or the connectivity among various communications devices or machines. IoT makes everyday objects “smart” and connected. Increasingly, it is becoming the “Industrial Internet of Things,” characterized by “intelligent machines,” large, addressable industrial markets, and “Big Data” networks and analytics. The digital world is now about making machines, devices and large, physical infrastructures such as highways and the electric grid work better and more efficiently. Like SAAS, IoT serves companies in virtually all other industry verticals — cybersecurity, manufacturing and supply chain, mining and heavy industry, wearables (gaming and military), network infrastructure and sensors, transportation and fleet management, utilities and smart grid, and, yes, “Big Data” analytics and “machine learning SAAS.” Like with its predecessor SAAS, companies are emerging to provide IoT capabilities on cloud platforms for not just the largest industrial enterprises, but smaller companies with the same needs. McRock Capital is a Montreal, Canada-based, dedicated IoT venture capital fund whose website provided this succinct description and “map” of the Internet’s next big thing. http://www.mcrockcapital.com/.

For some time, manufacturers have been deploying software to collect data from equipment in order to detect early signs of mechanical problems. General Electric Co. installed sensors to machine pumps at a power and water plant in Schenectady, N.Y., to track voltage and monitor power usage. “ When Smart Technology Meets Old Machinery,” The Wall Street Journal, June 8, 2016, R2. IoT is not only changing manufacturing. Shopping mall owners are fighting online retail competition by investing in interactive mall maps and mobile advertising to help shoppers find parking spaces, navigate mall corridors and check out flash sales at stores. IoT solutions startups are also offering mall owners with data analytics capabilities that track cellphone signals to provide critical information on the numbers of shoppers and their shopping behavior. Mall owners are also buying smart lighting and sensor-data services to reduce energy costs with added security features. “Mall Owners Pour Cash Into Technology,” The Wall Street Journal, June 8, 2016, C6.

There are already several big corporate venture funds making investments in IoT, with Cisco Investments, Intel Capital, Google Ventures, GE Ventures and Qualcomm Ventures being the most active to date. We invite you to read the following article from Postscapes to develop an appreciation for the diversity of portfolio companies in which these corporate giants have already placed bets. http://postscapes.com/5-heavy-hitting-corporate-venture-funds-honing-in-on-the-internet-of-things CB Insightshas reported that venture capital funds Andreessen Horowitz, Khosla Ventures, True Ventures, and NEA are also among the most active investors in IoT, and also reports that IoT investments approached $2 billion in 2015. And Pitchbook adds Sequoia Capital, Accel, and Battery Ventures to a top-11 investor list in “big data” solutions, a sector with an obvious overlap with IoT. http://pitchbook.com/nesletter/the-11-most-active-vcs-in-big-data. A new venture capital sector has been born, and we have a lot to learn.

VC TIPS

Dividing Up the Startup Company Equity Pie

(We are grateful to the Virginia State Bar and the Virginia Lawyer magazine for their permission to excerpt here a portion of an article we authored in an upcoming edition of the magazine.)

Founders, Helpers and Angels

During the startup and early-growth phases of a company’s existence and prior to the company’s first “Series A” round, there will usually be three different categories of equity owners: the founders, key employees and consultants, and early “angel” investors. (This typically refers to the first equity financing of a company with a venture capital “fund” or other “institutional” investor and usually involves more complicated terms than the earlier “seed” preferred rounds. A Series A round typically occurs after a company has previously raised $5 million or more from “friends and family,” “angel” or “family office” investors.)

One or more founders may have formed the company, agreeing to contribute services or intangible assets such as a business plan, know-how and other intellectual property, and agreed on some sharing of “common” shares or loans to the company. There are seldom material tax issues associated with the founders’ initial equity, as property contributions for equity are generally tax-deferred under IRC Section 315 (corporations) and IRC Section 721 (LLCs). If equity is being acquired for services, compensation income can usually be minimized or avoided if the founders’ equity is issued well before the company’s first capital raise, or the common equity value can be minimized due to any convertible debt or preferred stock sold to investors.

The company may have promised or granted common shares or “stock” options to one or more key employees or independent contractors as additional incentive compensation and “golden handcuffs” for staying with the company through the critical phases from startup, to development and commercialization. (This is an area where many emerging companies’ records are inadequate, thereby creating legal and morale issues as to what was promised to which service providers and often causing otherwise avoidable tax issues.) And one or more “angel” investors may be considering an investment in the company or may have already advanced funds, either in the form of a loan or purchase of shares. In this edition, we discuss founder stock and employee equity planning best practices and pitfalls, and in a future edition, we will tackle the latest trends in structuring angel and “seed” investments in startup companies.

Founder Equity — Fair Slices and Future Flexibility

Here are some of the most common mistakes relating to the issuance of founder stock (some of which were taken from “Working Knowledge, Harvard Business School, Top Ten Mistakes Made by Entrepreneurs,” by Constance Bagley):

  1. Protect the Founders From Each Other. While it may seem odd for founders to “self-impose” vesting restrictions, it can provide important incentives and protections as among them and also make angel investors more comfortable to invest (as they are investing in people, not just the business concept). For actual stock held by a founder, vesting is accomplished by subjecting the stock to a company repurchase option at “cost” over the term of a vesting period such as three or five years or which is based upon the company’s achievement of agreed performance milestones.
  2. Always Ask About the 83(b) Election. Failing to issue founder shares as early as possible (e.g., to avoid proximity to a priced equity round) or consider and file a timely “83(b)” election with the Internal Revenue Service (i.e., if the shares are subject to vesting restrictions) can become a costly distraction later. Even if a founder contributes cash or assets for their stock (rare), if the stock is subject to employment-related vesting conditions, an 83(b) election is necessary to avoid compensation income on any future appreciation in the value occurring between the date of purchase and the date the stock vests.
  3. Honest Equity-Sharing Decisions. Equal equity sharing percentages among the founders, or percentages that do not account for current and future contributions, seldom turn out to be fair. Time and again, we see founders regret the percentage of equity they gave to a fellow founder who simply has not earned it over time. Ultimately, they may be forced to agree on a price at which to buy the less-active founder down. Even if it is not practicable to precisely determine a fair equity allocation among the founders at the startup stage, appropriate vesting and “buy-sell” conditions will allow for future reallocations where and when they are appropriate.
  4. The Founders’ “Prenuptial” Agreement. Founders and their management teams are often frustrated by a departed founder’s continued ownership of stock, either due to the company’s failure to include a buyback right in the documents or its failure to timely exercise the right following the termination of the founder or employee. Failing to have the founders bound by an appropriate “buy-sell” or “stockholder” agreement that provides appropriate rights and restrictions regarding transfers of their stock is a recipe for future legal disputes among the founders or their estates. Such an agreement, when coupled with vesting restrictions on founder equity, essentially serves as a “prenuptial” agreement among the founders and future stockholders. And as noted above, it provides some ability to adjust ownership percentages to account for future events.

Key Employee Equity — Get It Right From the Start

Almost all emerging companies eventually decide to award key employees (and consultants, directors and independent contractors) equity incentives. These can take a variety of forms, but most often are structured as “restricted stock grants” or “stock options.” Following is a list of planning opportunities and pitfalls (many of which are similar to founder stock considerations):

  1. Taxes and 83(b), Again. The receipt of stock in connection with the performance of services results in compensation income equal to the excess of the fair market value of the stock over any purchase price paid for the stock (whether in cash or pursuant to a recourse note). However, if the stock is subject to vesting, unless an 83(b) election is made within 30 days of receipt of the stock, income is recognized as the vesting restrictions lapse and is based on the value of the stock on the future lapse dates. As a result, an 83(b) election permits the employee to recognize less ordinary income upon receipt and make the future appreciation in value of the stock eligible for capital gain treatment.
  2. Options Should (Usually) Be at Fair Value Exercise Price (or Not Exercisable When Vested). The grant of a stock option with an exercise price equal to the fair market value of the optioned stock is generally not taxable, while the exercise of the option will result in compensation income equal to the difference between the fair market value of the optioned shares at the time of exercise and the exercise or “strike” price. (This assumes the stock options are the currently more common “nonqualified” stock options and not “incentive stock options.”) Perhaps the biggest pitfall and planning tip with respect to stock options is setting the exercise price below the fair market value of the stock. Unless the stock option is designed to defer exercise until the earlier of termination of employment or a company sale, granted “bargain” stock options will trigger immediate income tax and penalties under Section 409A of the Internal Revenue Code. The potential application of IRC Section 409A to a wide variety of employee compensation arrangements (including salary deferrals) and other agreements cannot be overstated. 409A applies to any employee, director or independent contractor — not just executives — of a private or public company. Inadvertent violation results in severe tax penalty to the individual (immediate income inclusion and an additional 20 percent income tax upon vesting) and reporting and withholding obligations for the company.
  3. LLC Profits Interests — Our Favorite. Although beyond the scope of this article, LLCs (but not corporations) permit the use of a tax-favorable employee equity incentive known as a “profits interest.” Although, for state law purposes, a “profits interest” is typically documented as and constitutes actual equity (like corporate stock), the tax laws governing the issuance of vested and unvested LLC (or “partnership”) interests for services allow for non-recognition treatment, provided that the LLC’s operating agreement and tax records satisfy certain requirements (Rev. Proc. 93-27, 1993-2 CB 342; Rev. Proc. 2001-43, 2001-2 CB 191; Notice 2005-43, 2005-24 I.R.B. 1221).
  4. Securities Law Compliance. In addition to tax laws, emerging companies must comply with the securities laws when granting equity incentives to employees. Fortunately, Rule 701 of SEC Regulation D exempts equity incentive grants under a compensatory plan even though the recipients are not “accredited investors” for purposes of the Rule 506 safe harbor exemption, which is most commonly relied upon by emerging companies. However, the amount of securities issued sold under Rule 701 (including those issued in the prior 12 months) may not exceed the greater of $1 million or 15 percent of the company’s total assets or outstanding securities of the class being issued. It is advisable to either adopt an equity incentive “plan” or clearly reflect in the underlying restricted stock award agreements or stock option agreements that the stock or options are being granted as part of a compensatory plan.
  5. Vesting and Transfer Terms. Many emerging company restricted stock award or stock option agreements are poorly drafted or fail to anticipate certain scenarios. For example, does vesting accelerate upon a sale of the company in full or only partially, or should there be a “double-trigger” vesting term that incentivizes the employee to remain with the company for at least a short transition period after the sale? “Single-trigger” vesting results in full or partial vesting of unvested shares upon certain events such as a company sale or termination without cause. “Double-trigger” vesting requires two vesting events — a sale of the company followed by a termination by the buyer without cause within typically nine to 18 months. Because most emerging companies actively plan for a sale, their investors prefer double-trigger vesting because prospective buyers will want adequate incentives in place to retain company management through a post-sale transition or integration period. Accelerated vesting may trigger the “golden parachute” tax rules under IRC Sections 280G and 4999.

Also, is the agreement clear as to when the right to exercise an option following termination of employment expires? Does the agreement permit the company to repurchase the stock upon termination of employment either at fair market value for vested shares or “cost” or zero for unvested shares or in the case of termination for cause? Does the agreement clearly obligate the employee with respect to withholding and income taxes relating to the grant or exercise of the option? A good form of restricted stock or stock option agreement will clearly address vesting (whether time vesting or performance vesting or both) and events causing the holder to forfeit the shares, and apply different purchase prices depending on whether termination of employment is for cause, good reason, death, disability or a company sale.