Wednesday, January 01, 2014

Serious Entrepreneurial Knowledge for Patents, Financing, and Risk

I'd like to discuss some concepts I learned from attending a seminar last November in SVC Wireless' Advanced Entrepreneur Development Program.  I learned a lot about how legal experts solve problems in patent portfolios, startup financing, and sources of risk (both internal and external) to an enterprise.  I'm interspersing my own knowledge and observations with the concepts I picked up from the speakers, so none of this constitutes legal advice.  Aspiring entrepreneurs reading my stuff are welcome to seek out Fenwick and West's Silicon Valley office in Mountain View for a more professional discussion of risk management.

TechCrunch and CB Insights track the growing influence of angels and seed round investors.  I think the VC community is still getting over its reluctance to endorse crowdfunding but that is changing as more VCs establish a presence on crowdfunding portals.  Seed-DB shows the growth of accelerators and their ability to attract seed capital to participating startups.  Their list will never be complete because new accelerators pop up all the time.  If this database survives the accelerator bubble it can help us avoid survivorship bias among surviving accelerators once we analyze those that fail.

Term sheets decide valuation, dilution, liquidation preferences, voting rights, and board structures.  The largest corporate law firms have automated term sheet generators.  I like the ones from Orrick and WSGR.  Those are free because startups have to make their own term sheets in the early rounds.  VCs will have their own term sheets in later rounds.  Startups that don't hire attorneys to track their cap tables will have to do it themselves, and it is extremely important that they get it right the first time to avoid securities fraud.  The SEC doesn't like business owners who misrepresent the ownership of their companies.  Mapping cap tables to key employees tells those team members how much time they need to spend at the enterprise before their sweat equity options will vest.  Series Seed has a very interesting take on a term sheet that has what appear to be crowdsourced edits.

I once saw a very lengthy due diligence checklist on the website of a major VC firm.  That was back in 2007 but it stuck in my mind.  Larger VCs that have the resources to commit eight-figure sums to a round will have a multi-page checklist.  Smaller investors with less at stake can get away with simpler tools.  I use Google searches and superior court website name queries to see if any entrepreneurs I meet have questionable backgrounds.  That's how I uncovered the history of a Stolen Valor fraud who ripped off the San Francisco veterans' community.  That stupid jerk continues to prospect rich suckers around town.  Some people never learn anything.

Big law firms perform a public service by tracking VC funding trends.  These are usually located in the "entrepreneurial services" section of the firms' websites.  Every quarter entrepreneurs can see how much money is chasing the hot sectors.  I'm pretty sure funding for mobile software will dry up after what I saw at many tech conferences in 2013.  The world doesn't need another calendar app.  Pitchbook also has data on PE valuations so entrepreneurs can see whether VC-funded companies have matured.

Enterprise IP ownership matters.  Employment agreements matter.  Prior employees can bring lawsuits for IP infringement if the IP they created isn't clearly assigned to the company with an employment agreement.  Contractors who are specifically tasked to do something can end up owning what they create even if an assignment agreement governs their final product.  Clean IP assignment in the eyes of the law happens under an employment agreement.  Employment lawyers exist to review those agreements.  I am so glad to be a sole proprietor because I don't ever have to understand employees' needs or try to solve their problems.

Startups with little cash will have to figure out creative ways to employ people with non-cash compensation, which to me means sweat equity.  Entrepreneurs can do their part in building credibility with key employees by showing them where they stand on the cap table and by forgoing any deferred salary themselves.  More mature startups (i.e., those with enough revenue to pay salaries) should use publicly available compensation figures to lure the expertise they need.  That's part of the reason why and Glassdoor exist.

I disagree with a lot of the conventional wisdom on patent protection.  A lot of what lawyers say about the importance of filing patents just seems like a sales pitch for hiring them.  Prior art can invalidate a patent and the wide availability of so much information through online searches makes it very difficult to write a patent that truly secures something original.  USPTO's patent manual section 2128 paints a very broad definition of accessible prior art.  Non-disclosure agreements (NDAs) covering trade secrets are probably more effective in keeping the lid on something proprietary, because a filed patent is immediately searchable and thus visible to competitors.

Fenwick and West helpfully provide a free guide to developing a patent strategy, with a separate patent checklist.  Once again, a lot of this strikes me as a full-employment program for attorneys.  The market ultimately decides whether a proprietary technology succeeds once its creators start executing their business plan.  I must admit I like the use of military-type terms like sword, shield, guard, numbers, and counterstrike that I hear mentioned in discussions of patent strategy.  It seems that some enterprises will protect a core tech by filing a decoy patent for some vaporware product just to throw a competitor off their trail.  I think the best patent strategy is a proactive search for existing patents.  That avoids duplicating something that already exists and thus inviting a lawsuit.

Legal risks come in three flavored layers:  occurrence (when some adverse event actually happens), detection (an attorney or regulator discovers the action), and challenge (the likelihood of an injured party launching litigation).  I think minimizing occurrence through good management is the easiest mitigation strategy, but my job is easy because I only have to manage myself and not a bunch of troublesome people.  Copyright infringement damages are quite hefty and DMCA makes discovery inevitable in our digital society.  Enterprises with in-house IP counsel like to keep them busy taking on infringers.

Startups that pivot from software to IoT devices are going to get hit with regulatory risk.  Our society has spent the last two decades incentivizing coding over making, and the smartest job creators need to learn the craft of manufacturing all over again.  A lot of coders have no clue how to get federal and state regulatory approval for new physical devices.  Adding network connectivity means adding the FCC to an approval list.  I question the legal strategy of playing for regulators to give up with repeated requests for delayed action.  Regulators may not be as smart as those of us in the private sector but technology means they won't even need to be alive.  Governments will eventually automate regulatory functions into BRMS engines that will automatically troll their responsible sectors for violations and send repeat notices demanding compliance.  Soft law can become hard law but I think that happens when sufficient industry lobbying demands it.  That's why startups can stay ahead of industry moves by joining relevant trade associations to watch pending regulatory changes.

FEMA's emergency preparedness guide for business includes a business impact analysis that is adaptable to non-emergency situations.  I think it behooves entrepreneurs to graph all of their legal and regulatory risks on a chart that compares severity of impact to probability of occurrence.  They can then design mitigation strategies for each source of risk, estimate the cost of mitigation, and then prioritize the solutions by either strategic importance or cost.  That's not taught in MBA programs but I learned how to do that in the military.  Startups don't think about insurance but policies for errors and omissions, or for directors and officers, may come in handy.

I'll make one final announcement about Alfidi Capital.  I don't have to register a trademark to own it.  I am the first and only user of the terms and logos for "Alfidi Capital" and I don't have to register anything.  I can and will sue anyone who tries to use or register my marks.  You can all see that I learn a ton of stuff from the free seminars I attend.  I love using free information from the public domain.

Nota bene:  Nothing in this article constitutes legal advice.  I'm not telling anyone what to do here.  I'm kicking these ideas around purely for my own enjoyment.  None of the organizations mentioned above paid me any money at all to publish anything in this article.