Kathi Rawnsley on Startup Hurdles & Advice

Kathi Rawnsley is a Member of the Firm for Lowenstein Sandler as well as Managing Partner and Co-Founder of their Silicon Valley office in Palo Alto. Previously, Kathi worked at Intel Capital as Regional Counsel and during 2007, she was Acting General Counsel in a year where they invested $639 million in 166 deals. She’s been involved with venture capital and startups since she began her career in 1995. We got to talk about a variety of subjects, including where founders go wrong and what types of hurdles they have to deal with. Enjoy…

So a few months back, Twitter unveiled its Innovators Patent Agreement. Basically, Twitter told its employees that any patents related to their work will only be used for defensive purposes, even if the patents are later sold. It’s a neat concept, but could it have a larger effect on the tech community?

It’s hard to say what kind of impact it will have because I don’t know what their patent portfolio looks like. There are a lot of big players engaged in patent wars right now. It seems like Twitter doesn’t want to get involved with them and they believe in innovation and the general goodness of the tech community. While it likely does have a lot to do with image, I don’t want to say it’s all about that. Regardless, I’m just not sure how valuable it is in the larger scheme of things. There are a few patent trolls that use them offensively on a regular basis, and that’s their business model. This won’t change them. I guess they can’t acquire Twitter patents, but there are still a whole bunch of other ones available. There are certain companies that have huge patent portfolios because they want to have protection when a patent troll or competitor is in the same space.  You don’t see patent battles every day in certain industries because companies/competitors have built their patent portfolios so none of their competitors will sue them. They all know that; they’re all protected. So really, I don’t know. I’d take a wait and see attitude, but it’s an interesting branding and reputational move for Twitter.

We’re a little bit into the post JOBS Act World. Net-net, do you think it’s long-term positive or negative for startups? What types of risks or benefits will folks be exposed to?

I honestly think it’s going to be neutral. I don’t know that it’s going to change much. I question whether or not the regulation will make it that much easier for startups to raise money. We already have a bunch of different ways for companies to do that. Yes, it addresses crowdfunding. Maybe it’ll help, but maybe not. Once the regulations are set and we have all the details and see what offerings will look like, I think it won’t look all that different from things we already have in place that people just aren’t using. We already have regulations that are supposed to permit small offerings for small companies. Regrettably, it’s a lot of work which ends up being so prohibitive that most companies won’t do it. They’d rather raise cash from accredited investors. If you can’t do that, then you’re just strapped and in trouble. It might help in some places outside of technology, where people have more of an emotional connection with the product or service. It also won’t be as simple as putting up a website and saying give me money, there will be more to it. As for the lessening of public market regulations, while I’m not sure the thresholds are set correctly, I don’t think it’s a bad thing. It’ll help companies, make it a little less expensive to go public and stay public. But really, it will only help the 2^nd and 3^rd tier companies already on the fringe.

So we just talked about Twitter and Congress trying to address some regulatory issues. What are the biggest regulatory or legal hurdles hurting startups right now?

I think some of the things that make startup life difficult are not as grand as crowdfunding or how to take your company public. On a day to day basis, companies are spending a lot of money on employment and tax issues and that gets costly. 409A is a tax regulation that relates to deferred compensation, and it applies to both huge corporations and small companies. The amount of money and time companies spend on preparation of 409As, special corporate approvals, option plans, and making sure they’re compliant can be quite high. And if the small business gets bought or goes public they need to have another scrub. That costs startups a lot of money and makes CEOs and other founders go crazy. It also makes it difficult for them to incent their employees in the way that they want to, and at the end of the day people are the key.

When a startup is raising a new round, what form of investment do you advise they use, i.e. convertible debt, preferred stock, common stock, etc.?

For startups, you do what you need to do to get funded in the most efficient manner possible for your company. If you’ve got friends or family that are willing to lend you money in a convertible note with terms that aren’t egregious, absolutely raise in a convertible note. If you’ve got investors willing to do it, terrific. It’s easier and faster. The notes have become a little more complex over the past twelve to eighteen months, but they’re still fairly simple and can get done more quickly than an equity round. That being said, lots of investors won’t do it. I tell companies not to anchor on that issue. You’ve got to figure out what’s the most important thing for your company. If some potential investor is the best one for your company and will only do an equity deal, so long as you come to a reasonable valuation, you do the deal. What’s most important is getting the right people behind your company as soon as possible.

A lot of first time entrepreneurs will use a friend or family member as their lawyer to start. Since these lawyers aren’t experts in the startup space, I imagine there are issues you’re forced to unwind. What’s the most typical one?

One thing that drives me crazy is people who set up as a Limited Liability Company (LLC). For a company that’s going to be losing money for a long period of time, why set up as an LLC? You’ve got entrepreneurs, people who don’t really need the losses because they’ve got nothing to write off, and someone convinces them an LLC is easier and more flexible. All it means you have to convert it later on and in the meantime you’ve probably created some issues for yourself you didn’t even know might exist. It’s harder to incent employees through equity with an LLC, there are higher tax compliance costs, and the benefits just don’t outweigh the detractors. Set it up as an S Corp and it’s easy to become a C Corp later. That’s the most common thing with lawyer friends or family. They learned in law school that LLCs are the be-all, end-all to company structure, but for certain kinds of businesses that’s not true. Especially technology startups.

When investors and entrepreneurs are agreeing on a term sheet, what should an entrepreneur be thinking about?

I think the economics of it are really important but it’s not the only thing. You can probably get investors to agree to good economics, but the most important thing to think about is how your company is going to run going forward. It’s governance. It’s how your investors see your role versus how you see your role. If your investors see you as their servant and that comes out in the term sheet, that’s a bad term sheet for a CEO. An entrepreneur’s goal should be to work together as partners with investors to make the business grow and that should be reflected in writing. It’s how detailed the protective provisions are for the investors, what kind of rights the founders are going to have. Yes, there are a standard set of restrictions on founders that you expect to see, and founders shouldn’t fight about it because it makes sense for the company. There are also things I’ve seen that are overreaching and frankly, investors don’t really need that protection if it’s a company into which they want to invest with clean fair documents. Now, if you’ve gone and had your brother-in-law or cousin set up your company, and an investor comes in and needs to untangle the mess, they’ll think the founder doesn’t know how to run the company and will have a more restrictive term sheet. They’ll want to feel 100% protected. It helps to be straightforward and simple out of the gate, and then you can negotiate things going forward from a stronger position.

Lawyered: Talking to Bo Yaghmaie

Bo Yaghmaie has been a lawyer in the New York venture capital and entrepreneurship spaces since 1996. He currently heads Cooley’s Emerging Companies and Venture Capital effort in New York. Besides working with his clients, Bo’s been very engaged with the local community by serving as a TechStars mentor, ER Accelerator mentor, and on Columbia’s Entrepreneurial Sounding Board. More recently, he was involved with the launch of the Digital Media Center in New York earlier this year, which you can read about below. As an integral participant in the startup space, I had to put some time on his calendar to catch up. You can find our conversation below.

                                                                                                                                                                                                       

When most people outside of the startup community think about its participants, they typically think about people like entrepreneurs, angels, and venture capitalists. Can you talk about the types of critical services you provide, and why working with someone who’s an expert in this space is so important?

First time entrepreneurs have less of an understanding of how important a professional network is to your enterprise’s successful launch and the ultimate execution of your business plan. Serial entrepreneurs, on the other hand, inevitably turn to their lawyers as the first phone call, about whatever they’re doing. Those of us who do this for a living do a lot more than the paperwork attendant to the formation of the company, protecting the company’s IP assets, and venture and other financings, even though that’s part and parcel of our day-to-day job. How we really add value is through our understanding of the ecosystem in which our clients operate, our relationships with all the players in the ecosystem, and our judgment that’s born of “been there, seen that.” In other words, you become their valued, trusted advisor because you’ve seen anything they’re going to see, time and time again. The difference between a serial entrepreneur and the first timer is the serial entrepreneur has been through the curves in the road and has inevitably learned that “Man, if I had someone on my side that knew what was coming, it would of been a lot easier for me and for the enterprise.” The first time entrepreneur doesn’t necessarily know that but more often than not learns the hard way.

In a very crowded environment, a lawyer isn’t just a lawyer when it comes to working with startups. Any lawyer can do some of the basic things that a startup needs but there are only a handful of lawyers in New York that bring the value-add we are talking about. From where I sit, the ideal partner brings together a few things. First, they need to bring a really strong platform and a robust set of capabilities across a broad range of specialties so that they can meet all of your needs, at every turn, as the enterprise grows and scales. Second, they have to have a truly deep understanding of your business and the ecosystem in which you live. And third, the person you’re working with must have a lot of experience and should serve as an advisor. They’re the person you turn to and say “Hey, I’m struggling with how to think about A, or how to present B to the board, or I was thinking about reaching out to my investors and asking them the following, what do you think?” It’s that kind of experience and judgment that makes a big difference in advising startups properly, rather than just meeting basic needs. We give entrepreneurs board-level advice about the issues they’re having and the commercial arrangements they’re pursuing day in and day out.

In early April, President Obama signed the JOBS Act into law. What type of impact do you think that will have on startups?

It’s obviously too soon to have a real sense of how the JOBS Act will play out but there’s no question it removes some barriers to fundraising for smaller companies and fundamentally alters the pathway to an IPO. Clearly, taking some of the regulatory hurdles out of the way of capital formation will inevitably enhance those capital markets. We’re in a uniquely dynamic market for venture capital and early stage investing in New York where some of these additional incentives, like crowd sourced funding exemptions, aren’t necessarily required to create an impetus for additional investments. So exceptions for crowd sourced funding, raising the limits on number of investors before you’re required to register for the ‘34 Act, some of the flexibility you have around solicitation, those are all great but they would be a lot more valuable if we were in a tight investment environment. It’s hard to know how these changes will play out because there’s already so much capital in play in the system. It’s the really challenged companies that will need to go to crowd sourcing, because honestly, it’s not that hard to raise half a million dollars of seed or angel money if you’ve got a good idea. There’s no question the JOBS Act is great for emerging growth companies, particularly for later stage companies that have an IPO in their 12 to 18 month plan. I think the flexibility around confidential filings and the more limited requirements around financial disclosure and controls create a lot of flexibility that will ultimately be highly valuable.  We are already seeing a tremendous amount of activity across the firm for issuers that are gearing up to move forward with an IPO, despite little visibility into the whether or not the markets will be there.  That’s largely because there’s no reason to not pursue a confidential filing and be ready if you are essentially there on business metrics that the market is expecting to see.

Every other day there’s an article about whether or not the startup markets are overheated or if we’re in a bubble. A lot things point to yes and here’s a few: Instragram’s billion dollar buyout without a dollar of revenue, constantly rising valuations, and Bravo’s new reality TV show “Silicon Valley.” From what you see on a daily basis, do you think the pundits are correct?

The markets have been extremely active so it’s definitely a concern. There are too many dollars in the system funding too many companies in each of the verticals that we play in. Now is that good or bad? Companies are getting funded even though they haven’t gone through the typical analytical process that’s long been an integral part of venture investing. That’s the bad. The good is that clearly this additional capital, particularly in New York, has enhanced the viability of the ecosystem. It’s created a fertile ground for entrepreneurship. Fundamentally the markets will determine who the winners will be; I think that’s a good thing. Sure, you have four or five companies getting funded simultaneously that are tackling a similar challenge, and not all of them will survive to raise a B, C or D round. But that additional funding creates an additional layer of competition in the markets so entrepreneurs and companies are forced to produce the best products to win. It’s not all bad. Is it bad that valuations are on the rise and people are going to get burnt? Yes. The venture community understands that. They invest on a thesis that out of every ten investments, they only need one or two big winners and two or three okay returns, and the rest aren’t going to play. On the entrepreneur’s side, in my experience, the best entrepreneurs are the ones who have started a business and failed. This market will provide enough learning experiences like that. In the end though, this excess capital is fueling a really vibrant ecosystem for entrepreneurship. Net-net that’s a very good thing, especially in New York.

You advise a lot of venture backed companies and many of them are seeking exits. What types of exits are most common right now and are people finding it easy to reach them?

Couple of things. One challenge over the last few years has been that the public capital markets weren’t a viable exit for late stage companies. That’s changed. We’ve got a lot of companies in the IPO pipeline looking at valuable exits. By definition, that puts pressure on buyers in the market to act and take some of these companies out before they’re public. I think that dynamic has fundamentally enhanced the likelihood of liquidity events for companies with enough traction to pursue an IPO. Therefore, the folks that have the balance sheet are going to be more motivated to act. The truth is at the end of the day, most venture guys prefer M&A exits. They’re a lot cleaner and easier than IPOs. The notion of being a reporting company that lives quarter to quarter and having insider limitations does not have the same appeal to venture investors as a meaningful sale with meaningful liquidity. Overall, we are seeing a lot of vibrancy in the IPO markets, with clients like LinkedIn, Zynga, and Yelp that have gone out and done very well, and that flows downstream. As VCs see liquidity in some assets they’ve been sitting on for five, six, or seven years when there wasn’t a vibrant M&A or IPO market, they then have a greater ability to put more money to work. There’s a network effect that hopefully leads to relatively stronger market opportunity for emerging companies.

You’ve been doing this for a long time and across multiple business cycles. Can you talk about how the venture and startup scene has changed in New York over time?

I’ve been doing this in New York going back to ‘96. I was here when there was nothing going on and then I saw the dot com boom and bust in 2000-01. Now we’re seeing the emergence of really good companies and a completely different level of activity in New York. Some people parallel it to the dot com bubble but it’s very, very different. What we have in New York is a true baseline ecosystem. Back in the last iteration, there were a handful of companies that raised a lot of money in the public markets without a viable business model that could survive without additional funding. More importantly, there ultimately wasn’t a real deep ecosystem of entrepreneurship. Since then, there’s been a confluence of factors that have really changed the market dynamics in New York.  First, some very exciting companies in New York emerged in the mid-2000’s and got the attention of venture luminaries in the west coast and Boston. In addition, you had venture funds anchor in New York and invest in some really high growth companies. As a result, the markets started looking at New York for good, new exciting opportunities – almost a green field –  and you saw an influx of capital. At the same time, there was the Lehman collapse and the financial meltdown. A lot of the talent that by default used to go to Wall Street all of a sudden didn’t have that opportunity. Some really smart young kids said hey, let me try my hand at a startup instead.  And, that was the moment when things changed – the spark that set New York on fire.

So when venture money, availability of capital, and a rich pool of human capital combined in one place, you saw a lot of great companies get formed in some important verticals: media, adtech, fintech, e-commerce, mobile and social. As these companies have grown, there’s now a real network that’s been built. You have companies founded 5 or 6 years ago that are really far along and now some of those founders have peeled off and started something new. We’ve never had that before. The first bubble was like a big party where someone came in and turned the lights on. All of a sudden everyone had a hangover and no one wanted to go out for a long, long time. This time it’s very different. Sure, a lot of companies aren’t going to make it in this environment either. They won’t be able to meet their milestones to raise additional capital. But that’s okay, not every venture investment is going to be a 7x. Most of them end up being write-downs and write-offs, which is why it’s called venture capital. Some of these companies will build great things and have great value, and that’s where the returns are. They’re here in New York and coming up through the ranks.  But more importantly, the pool of human capital that is being built, regardless of whether the companies are winners or losers, that is here to stay and is now built to last.  That’s a very different environment than any other time in New York because the overall ecosystem is more mature, and there’s a lot more talent and capital deployed in it. This results in an ecosystem that can host great startups that go onto do even greater things.

It’s a pretty frequently discussed topic, but how does the New York scene compare to Palo Alto and Silicon Valley?

The Official Seal of Palo Alto, CA. (Photo credit: Wikipedia)

Truth is, New York is not on equal standing with Palo Alto or the Valley and won’t for a long time. If you look at the numbers of companies started, funded, or with great outcomes, the valley outhits New York by about a 3-to-1 margin. Palo Alto and Silicon Valley will be the hub for tech innovation for the foreseeable future. Over the past three to four years though, New York has emerged from being a second tier tech and emerging company hub to a real first tier player. We’re now on equal footing with cities like Boston and San Francisco, and we can actually hold our own in certain verticals against the Valley, at large.  If you look at internet based business, you see that New York and San Fran are the leaders. But for the overall emerging company ecosystem, Palo Alto is still significantly larger because there’s a lot of tech innovation coming out of places like Stanford, as well the great tech companies anchored out there – Apple, Cisco, Google, Facebook, Intel and the list goes on. You just need to drive by their campuses to be amazed. They have the machine built but it wasn’t built over night.  They’ve been at it in earnest since the 60s.

There will be a day when we’re a lot closer.  I have no doubt about that.  It won’t be four or five years, because that’s not realistic. But if you look at our growth trajectory, the hockey stick is at a much steeper angle here than the Valley. What’s really exciting is that New York is at the heels of Boston when Boston and Route 128 have long been the east coast hub for venture activity and emerging growth. To have New York in the same league as Boston and even in the same conversation as the Valley is really exciting and flattering for the community. My view is that’s going to remain a consistent theme. If things do continue in this trajectory, New York will outpace Boston in the next decade. Silicon Valley is safe for quite some time though.

I know that you’ve been very involved in the launch of the Digital Media Center (DMC) earlier this year. What exactly is it and why have you and Cooley gotten involved?

One of the things we do at Cooley is spend a lot of time and energy supporting key groups and areas that will bolster and support entrepreneurship and create a community that can help entrepreneurs thrive. It’s part of our real investment in the community and its core to who we are at Cooley. The DMC is an example of that. Together with Silicon Valley Bank, Deloitte, and NASDAQ, we wanted to create a forum for companies in the digital media space to get together and share ideas and have an unfiltered, substantive, valuable, peer-to-peer exchange of information and ideas. There’s so much noise in the market that we thought it’d be great to create a forum for the thought leaders to share ideas and challenges and create that dialog. We support a whole host of forums, including TechStars, ER Accelerator, DreamIT and other smaller accelerators, and a variety of groups. We have startup leadership programs with Harvard Business School Angels and Insite. There’s a long litany of community organizations that we support. DMC is a relatively high profile example of that, and we’ve got high aspirations for what it can do for the community.

What’s one free piece of advice you have for people involved with startups?

First and foremost, be true to yourself and your idea. Pick your partners carefully. Whether it’s your founding team, venture investors or the professionals you work with. That matters in a big way.  And, make sure you avoid some of the hubris that goes around in this ecosystem when capital is plentiful.  We are ultimately playing in a very small sandbox and you’ll be surprised how much smaller the sandbox gets when the markets get tough.  So ultimately, build a business based on trusted relationships. I think it’s that simple.