A few years ago, Joe Torre (when still managing the Yankees) wrote an article for Business Week (Joe Torre on Winning) that’s well worth reading. One of the lines in the article pretty much sums up one of the hardest things for Angel investors to do and something that happens on a regular basis: “I have had to release guys I loved, and keep players I didn’t necessarily care for.”

In the world of startup investing, Angels invariably come across a lot of great entrepreneurs that they get to know on a personal level and think the world of. Unfortunately they sometimes have to say “no” to these individuals because they aren’t completely comfortable with the company’s market space and/or technology. Conversely there are company founders that drove us crazy, where we ended up investing in their companies because we knew the venture had a very high likelihood of success. What also makes saying no particularly tough is knowing that many of these entrepreneurs have leveraged themselves to the hilt through credit cards and second mortgages and have given up well-paying jobs to pursue their dreams.

In an earlier post I mentioned that 1-1.5% of all applications submitted to the Pasadena Angels get funded. Realistically—and with a finite amount of time and investment dollars—our group can do a maximum of 12 investments each year. In our world, that means saying no to many entrepreneurs.

As you work with Angel groups (and also VCs), there are three pieces of advice related to this topic worth considering. Since fundraising can be a real (but necessary) timesink with a substantial opportunity cost, focus on getting a quick yes/no from prospective investors. Even if the answer is no, you’re way better off getting a quick answer and not consuming time with those that are not likely to invest.

Secondly, look at how the group says no to evaluate them as investors. Although this won’t make a lot of sense at the time you’re rejected, it’s worth doing since you may have another venture in the future where they’d potentially invest.. For reputable investors, the experience should be constructive, positive and polite.

Lastly Bill Burnham, a former VC, has a series of great posts on The Art of Saying “No” and goes into considerable detail about the process and some of the unsavory tactics used by VCs.  In his third post, Bill summarizes the four reactions he typically gets from entrepreneurs when hearing “no.” The best advice I can share is always make sure your reaction is #4– Thanks, this has been helpful.  Let’s talk if we raise another round.

As Angel investors we all want the ‘A’ team managing our portfolio companies, but we rarely expect to find one. What we tend to do is supplement the existing team with people with experience so that we have a reasonable chance of growing the business and avoiding the basic mistakes. We want to see a team with good leadership, strong marketing and operations experience and good networking skills. But aren’t we simply assuming that there is one size fits all and that building revenue and profit is the only game in town.

I have been in number of investor meetings recently where the intention was to build up the team to create a business which had a reasonable chance of meeting higher revenue targets. However, when the discussion has come around to positioning the business for an exit, a completely new set of requirements have been identified with dramatically different timescales. The question of who should undertake the exit strategy activities is a very different one from who could grow the business.

Once you focus on the exit, the set of tasks to be undertaken to prepare the business for, say, a trade sale are often very obvious and some will be of a specialist nature such as IP, legal and deal negotiation. Also you may find that instead of building up a sales and marketing force and establishing a customer base, you only need a couple of good customer sties as proof of concept. Instead of growing the business to 10, 20 or 100 people, you might just need a small team to complete a limited set of development and proof of concept tasks.

While the founder/entrepreneur might not have the leadership skills to grow the business, he or she might be just right for building relationships to the prospective buyers. Alternatively, you might task the entrepreneur with getting the trial sites working and employ an experienced M&A corporate executive to set up relationships with prospective buyers and negotiate the final deal.

What is obvious from the many investor meeting I’ve attended is that they have failed to work back from the exit to establish what needs to be done and who should do it. If the only business model you have in your head is revenue growth, you will always end up with a growth oriented team. If, however, you have a strategic exit in mind, the nature of the tasks to be undertaken are likely to be very different and it will call for a different mix of people. What you will also find is that the existing team you have is more than capable of participating in the exit strategy.

Strategic exits are much less demanding on resources, tend to have shorter execution times, lower operational risks and higher investment returns. What is also obvious is that it needs a different set of skills from a conventional growth oriented business strategy. Before you commit to hiring anyone, take the time to set out your exit strategy and then see how you would use the existing staff and what additional skills you will need to execute the exit deal.

If you want to get into a heated argument, put a dozen CEOs in a room and ask them if they should tell their employees that they’re preparing to sell their company. What you’ll find is that they quickly polarize into those who would tell their staff and those who would not. Each group will advance very strong arguments for their case but few will have thought through the longer term implications of their position on the sale value of their business.

Those who argue for not telling employees will argue that the possibility of a sale will create stress and uncertainly among employees resulting in a drop in productivity, a loss of key employees who decide to leave rather than face an uncertain future and the possibility of the news reaching competitors who will use the information to undermine the business. Those who argue for informing employees believe that the information will leak anyway and that it’s better to inform employees rather than let them imagine worse case scenarios.

When I’ve spoken with entrepreneurs who have sold businesses, I’ve been very interested to find out what they did pre-sale and what they would do differently if they had to do it again. In almost every situation where the information was kept from employees, the entrepreneurs regretted the decision. Employees who had worked diligently for the business felt betrayed for being left out of a critical decision which would materially effect their future. In some cases this had the result of undermining the sale process or in key employees leaving the business prior to the sale. Few entrepreneurs who told their employees had adverse outcomes.

My personal view is that the preparation process itself requires active support of key managers and employees. They are required to create the right foundation within the business so that the sale price can be optimized and they are most often needed to remain with the business so that the buyer is able to best operate the business after the sale. Basically you need your best people to support the process before and after the sale. So involving them in the sale process and providing incentives for them to assist you to prepare the business for sale and for being prepared to leave the business if required, or transition with the business if needed, is an essential part of selling a business. Key employees can be rewarded by being given shares, options or bonuses to assist in the preparation process. Those being made redundant can be compensated for their efforts up to the date of sale while those who are needed by the buyer can be given a bonus after some set period after the sale for staying with the buyer to assist the transition.

While competition is always an issue, businesses which are always open to the right offer can simply portray that position. That is, they are willing to sell out to a buyer who can best develop the business. This allows the current owner to position a future sale positively to customers and staff.

In my last post I talked about the responsibilities that board members have to a company both before and after insolvency occurs. The list below provides some practical precautions for prudent directors in financially distressed companies to keep in mind.

Below are some practical precautions that a prudent director of a financially distressed company should keep in mind.

Financial Monitoring

1. Maintain vigilance over the company’s financial situation.
2. Convene board meetings as often as necessary to discuss important issues affecting the financial health of the company and consider alternatives to a particular course of action.
3. Avoid actions that benefit one creditor over another.
4. Place limitations on the company’s ability to incur further debt if the corporation is slipping into the zone of insolvency or it is unable to pay its debts when due.

Corporate Formalities

1. Maintain company formalities including holding scheduled meetings and keeping good corporate minutes of all actions taken by the board including the discussion of alternative courses of action that were considered and the advice of outside experts.
2. Ensure that all minutes reflect the attendance and active participation of directors.

Governance

1. If the board is considering entering into a significant transaction, such as a sale of assets, incurring substantial debt, a financial restructuring or any other transaction that could pose a substantial risk to company assets, seek legal and financial advice from outside experts which will also demonstrate that the board is considering independent, objective advice.
2. Before entering into a significant transaction of the type described above, consider seeking the advice and/or consent of major creditors.
3. Continue to act in the best interests of the company as a whole without favoring one corporate constituency over another, particularly any action that favors equity holders over creditors such as dividends or redemptions of stock.
4. Be aware that any action that benefits insiders including officers and directors will be subject to closer scrutiny and could be viewed as a breach of fiduciary duty or avoided as preferential or fraudulent payments.
5. Avoid increasing executive compensation out of the ordinary course of business unless it can be supported by the circumstances; consider obtaining outside advice to validate any decision.

Corporate directors of a financially healthy and solvent company have a fiduciary responsibility solely to the corporation and its stockholders and do not have a duty to creditors beyond the contractual duty owed by the company.

In today’s economy, many companies face unprecedented financial strains and, as the financial situation deteriorates and nears insolvency (aka zone of insolvency) directors must consider the impact of their decisions on the company’s creditors as well.  Once a company has passed the threshold of insolvency, the beneficiaries of a director’s fiduciary duties in many jurisdictions include the creditors of the company because, as courts have reasoned, the equity owned by its stockholders is worthless and the burdens of poor decision-making by management fall on the corporation’s creditors.

Generally, the fiduciary duties of a director are the duty of care and the duty of loyalty.  The duty of care requires a director to be fully informed of all material information reasonably available, acting with due care and consulting with officers, employees and outside experts as reasonably necessary to make informed decisions.  The duty of loyalty requires that a director act solely in the best interests of the company without personal or private motive, avoiding self-dealing and any conflict of interest that may compromise the director’s independent decision-making process.

Until fairly recently, the prevailing wisdom was to advise boards of directors that the shift in their fiduciary duties occurred once the company entered the zone of insolvency.  Recent case law in Delaware has rejected this premise, and, moreover, prohibited the rights of creditors to bring direct claims against directors for breaches of fiduciary duty even when the company is insolvent.  See North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.D.2d 92 (Del. 2007).  However, “creditors may nonetheless protect their interest by bringing derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim . . . that may be available for individual creditors.”  Id. at 94.  In Trenwick America Litigation Trust v. Billet, 906 A.D.2d 168, 175 (Del Ch. 2006), the court held that “so long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equity holders.  Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become residual claimants and the advancement of their best interests has become the firm’s principal objective.”

While these legal clarifications permit directors to focus on maximizing corporate value, the impact on creditors must be carefully considered as it remains difficult to assess when a company actually crosses the threshold of insolvency.  Under Delaware law, a company is considered insolvent if it fails one of several tests, including whether its total liabilities exceed its total assets, the so-called “balance sheet insolvency test” or whether the company is unable to pay its debts when due, the so-called “equitable insolvency test.”  Other states employ other tests.

Because of the subjective nature of these insolvency tests, the board of a distressed company exercising its fiduciary duties must remain cognizant of the impact of its decisions on the corporation’s creditors.  In next week’s post, I’ll outline some of the concrete steps and precautions that a director of a financially distressed company can take.

Patents, trade secrets, know-how, copyrights, and trademarks can be crucial to your business. Managing this intellectual property can make the difference between fortune and failure. This brochure presents ten recommendations for protecting what belongs to you. In the spirit of David Letterman, here’s my Top 10 List.

#1

Obtain written assignments of all inventions and copyrights from employees and third-party vendors including consultants, advertising agencies, and photographers, and have these assignments reviewed by your attorney.

#2

When adopting anything new, such as technology, a trademark, or software, contact your attorney about conducting a right-to-use study to avoid infringement.

#3

Assume that any disclosure to a third party, including a customer, a vendor, a consultant, or a competitor, will not remain confidential. Confidentiality agreements offer some degree of protection, but they are not guarantees against improper disclosure.

#4

Discussing an idea in the presence of others, such as actual/prospective customers, vendors, or consultants, can result in a claim of co-ownership of your idea. Avoid this situation by listening to the challenge presented, and then by conducting your problem-solving in private.

#5

When negotiating an agreement, avoid terms that may limit your ability to compete. Terms that require careful scrutiny include:

- An agreement stating that ownership of an invention does not belong to you
- A software or website development agreement that does not explicitly provide for your ownership of the software
- Prohibitions against reverse engineering by you
- Confidentiality clauses
- Unreasonable restrictions on the use of deliverables
- Continuing obligations to use the vendor, e.g., for software modifications or hosting
- Limitations on the other party’s indemnification obligations, e.g., no indemnification for infringement of patents, copyrights, or trade secrets

#6

Protect your inventions by documenting all improvements and promptly disclosing potentially patentable inventions to your patent attorney. Do not offer to sell the improvements and do not publicly disclose them until your attorney has considered the feasibility of patent and trade secret protection.

#7

Protect your copyrights by using a proper notice on all copyrightable works, including software, advertisements, brochures, and artwork. Check with your attorney to determine if the copyrights should be registered.

#8

Before adopting a trademark or service mark, have a search conducted to make certain that the mark, and the corresponding domain name, are available. If the mark is available, register the mark and use it properly. Do not allow third parties to use your mark without a written license agreement.

#9

If you have a claim against another party, proceed promptly. If you delay, you could lose your rights.

#10

Contact your attorney promptly if you receive a cease and desist letter. Your attorney may lessen the possibility of a lawsuit being filed against you, and failure to consult with your attorney may expose you to increased damages for willful infringement. If actually sued, contact your attorney promptly. Failure to timely respond to a lawsuit can have serious, and costly, ramifications.

Over the course of this week I’ve come across some great articles and blog posts that should be required reading for any entrepreneur looking for funding—including those that have done it before. Starting with The Entrepreneurs Report from the law firm Wilson Sonsini Goodrich & Rosati (WSGR) there are two articles from outside contributors on Perfecting Your Pitch and How Do I Get Meetings with Investors. For the first piece you can pretty much substitute ‘Angel’ for ‘VC’ and it’s right on the money with respect to the Pasadena Angels. One word of caution, however, when reading the WSGR report, try not to dwell on the VC financing trends. The good news in all this is that although Angel and VC financings are down, there are still good companies getting funded as we speak.

A couple of other good posts/videos that I’d highly recommend are Tony Tjan’s the Great Entrepreneur’s Secret and 10 Things to Know Before You Pitch a VC for Money by David Rose which do a good job of covering the intangibles we look for in entrepreneurs and pitches.

Most company founders accept the fact that they will sell their business sometime, usually in the distant future when outside investors expect an exit. For many family businesses, the founders anticipate passing the business down to children while others plan to sell it to their managers and employees. However, there are some very good reasons why selling out now might be a better option.

Firstly, consider the risk of the business getting into difficulty and being forced to sell out and receiving much less than what the business is worth right now. Can it happen to your company – certainly! The rate of failure of early stage ventures is quite high, estimated to be around 50% in the first 6 years. Even older businesses still have a 2% failure rate. If large businesses like Enron, Worldcom, Arthur Anderson, Bear Stearns and other large well established corporations can go under, what makes you think you cannot?

If you were like me, then you may have the greater part of your wealth tied up in your business. When my business started making losses during a recession, I recognized that it could easily be sold out from under me and I would end with very little for the risks I had taken, the low salary I had received for many years during the early stages and the long hours I had put in. Sometimes you need to capture the wealth in your business so that you get the rewards for those efforts. If you are any good at what you do, you can always start another one or buy a small business and develop it and make the money all over again.

Then consider whether your business is the best place for your hard earned wealth. Even if you are taking $200,000 a year out of it in income, what could you sell it for and continue working? Say you could get $2 million after tax for your business and you could continue working as an employee for $80,000. While you are worse off by, say, $70,000 net, you would need to keep your business for another 20 years to be as well off. But of course you now have $2 million to put away in the bank and a way to provide a more  secure future for yourself and your family.

Family businesses have their own dynamics but few founders fail to educate their children to be better educated than themselves. Thus their children end up being dentists, doctors, lawyers and so on. Many don’t wish to go into the business of their parents or want to go into a new technology business, a very different proposition to the old technology business of the parents. The founder should seriously think of selling out all or part of the original business in order to create an investment fund for new business ventures which tap into the passions of the next generation.

Successful entrepreneurs are capable of developing several ventures throughout their working lives. No doubt some will be more successful than others. Seriously consider whether it is time to take some money off the table from your current venture and then have a go at the next one. In this way you will have put some wealth aside for your future and taken considerable risk out of your life. You might even find that the next one is much more successful than your current one.

By now everyone has seen the infamous Sequoia presentation, R.I.P. Good Times. From what I can tell traveling around the US and overseas, it looks like these slides have circulated faster than the Paris Hilton video (sorry, no link on this last one–you’ll have to find it yourself). If you’ve already seen the presentation, there’s a good post worth checking out from Silicon Alley Insider that provides a few more details on what was discussed at the all-hands Sequoia meeting.

There’s also a good post from last week by Jason Calcanis of Mahalo, What to do if your Startup is About to Fail. Although it’s vintage tell-it-like-it-is Calcanis and a little disparaging of investors (VCs), it provides some further thoughts and granularity for dealing with the current tough times.  Although Jason’s been in the news this week for not fully vetting a prospective employee and accidentally hiring a felon, don’t discount the worthiness of his advice. Even though we may not agree with his explanation and apology for this recent mis-step, I can vouch for the quality of his advice having been on the other side of the table in a number of startups.

Part III of a Continuing Series on How to Select an Angel Group

Imagine going to a VC or bank and receiving a bill for a few thousand dollars for your first meeting. Imagine also that the requests for payment only get worse the further into their funding process you go. By now you’ve probably figured out that I’m making this up. However, there are Angel groups that operate in a somewhat similar manner.

Here on the west coast there are angel groups that charge $3000+ for the ‘opportunity’ to present your company to them. These organizations are sometimes based on a franchise model and try to extract money from entrepreneurs any way they can. I’ve heard all the excuses from these groups, including that they have to charge entrepreneurs to cover their management expenses. Reputable Angel organizations typically cover their management expenses out of their own pockets and don’t ask struggling company founders to shoulder that burden. In reality the best Angels make money the old fashioned way—working with entrepreneurs to generate investment returns upon exit.

There are a couple of exceptions to this that are worth mentioning. Some reputable Angel organizations charge a nominal fee (~$50-100) to submit a funding application. The intent here is not to use this as a money making opportunity, but to provide a filter or sincerity test for the entrepreneur and to reduce the number of poor and incomplete business plans (aka junk) that get submitted. Secondly—and this applies to the vast majority of Angel groups and VCs—companies receiving funding (and only when that happens) will be asked to cover the investor’s legal expenses (~$15-20k) with the proceeds at the time of closing.

The Angel Capital Association (ACA) has some good guidelines about this on their website. They also “recommend that angel groups charge entrepreneurs no more than nominal fees for applying for and/or making presentations for angel capital and that all fees are fully disclosed, ideally appearing on the group’s Web site.” Out of 82 groups they also mention that two thirds of all Angel groups don’t charge any fees. Since starting in 2000, the Pasadena Angels has never charged companies fees for anything short of closing (applying, presenting, mentoring, etc.) and we’re proud to state this on our homepage.