WhatsApp Shows What’s Possible for Venture Capital Investors

WhatsApp is a cross-platform messaging service that is available on Internet-enabled devices. The app allows users to send messages via the Internet to other users of the app. The big selling point is that it costs 99 cents per year, with no added charges no matter where in the world a user sends a message. …

Google’s $3.2 Billion Acquisition of Nest is a Big Win for Silicon Valley Venture Capitalists, Signals Search Giant’s Increasing Presence

On January 13, 2014, Google announced it was purchasing Nest Labs, known for making “smart” home thermostats, for $3.2 billion.1 The acquisition was Google’s biggest since a 2012 purchase of another hardware maker, Motorola.2 The US Federal Trade Commission approved the deal in early February.3 Google’s purchase of Nest produced exceptional returns for several Silicon …

Detroit’s Burgeoning Entrepreneurial Ecosystem

When most Americans think of Detroit today, they think of the largest municipal bankruptcy in U.S. history, pictures of derelict buildings and houses, and ultimately, a city on the decline.  However, ask a true entrepreneur what they think of Detroit today, and you will most likely be given an answer that can be summed up …

With Single Class of Shares, Twitter’s IPO Breaks Industry Trend

For its Initial Public Offering, Twitter, Inc. hopes to differentiate itself from its competitors.1 It has tried to do this from day one. In its recent S-1 filing, the media and technology company broke a long running industry trend by offering a single class of shares to the public.2 In the past decade, beginning with …

Shareholder Adviser Responds To Silicon Valley Governance

Oracle Corporation, like many Silicon Valley tech companies, makes no secret about wanting to do things differently.1 But their different approach to corporate governance is now getting an angry response. On Tuesday, October 8th, CtW Investment Group, which advises union sponsored pension funds and is a substantial shareholder of Oracle Corporation, issued a letter to …

Convertible Equity

Innovative. In the world of private equity and venture capital this term is usually reserved to describe the entrepreneur. These days however, its not just the entrepreneurs developing new ideas. The Founder Institute and law firm Wilson Sonsini have created a new “startup-friendly seed-financing” tool – convertible equity. [1]

Traditionally, convertible debt has been the chosen vehicle to fund startup businesses.[2] The pervasive use of convertible debt has uncovered its shortcomings. First, some states’ laws create unique liabilities for the directors of startups if creditors, who hold convertible debt, are not paid upon its maturity.[3] Also, accounting principles dictate that convertible debt must be recorded on the books as a liability.[4] This may result in some startups being technically deemed insolvent.[5] Also, debt on the books is a road-block if the startup seeks a line of credit from a supplier or to close a deal with a large corporation.[6]

The risk that investors may demand repayment is also now a greater concern than it was in the past. When the conversion period occurs, which may be in as little as a year after issuance, an investor has the right to call the debt. This may result in the startup filing for bankruptcy or putting the startup in a weak position to renegotiate financing terms.[7] Adeo Ressi, creator of the Founder Institute, notes that while this “isn’t traditionally a problem in tight-knit Silicon Valley circles, first-time investors may be more prone to go against tradition and enforce their legal rights.”[8] Further aggravating the situation is the fact that “the percentage of companies with convertible debt that successfully raise Series A funding is shrinking, due to an explosion in new angel financings and just moderate growth in venture funding.”[9]

How does convertible equity solve these problems? It solves, because convertible equity is basically “convertible debt without the debt.”[10] Investors still get a discount for purchased shares that are realized upon conversion.[11] However, startups do not carry the corresponding debt on their books.[12] An example of the documents used to draft a convertible equity agreement can be found at TechCrunch.

The Startup Company Lawyer blog outlines the four following advantages of using convertible equity as opposed to using convertible debt:

1. Convertible debt may need to be repaid. The risk that an investor might demand repayment of a convertible note is eliminated with convertible equity.

2. Convertible debt holders must be paid interest. Convertible debt must have interest at the applicable federal rate (AFR) published by the IRS or higher, or the IRS will deem that the lender should have received imputed interest at AFR. If convertible debt with a price cap is supposed to mimic the economics of equity, then removing interest seems logical. (Of course, one may argue that some preferred stock financings contain a feature called cumulative dividends that is similar to interest on debt, but I find the provision to be fairly unusual in typical West Coast venture financings.) In addition, when a financing occurs and the convertible debt converts, creating the spreadsheet to track interest on the notes to the penny, especially when notes have been issued on different days, ends up being a painful task — especially as the closing date of a financing may be delayed and the amount of interest increases, resulting in more shares being issued to note holders.

3. Convertible equity is “equity” and probably can be characterized as qualified small business stock, which may have a tax benefit for investors.

4. Convertible debt with a maturity date longer than one year creates problems for California-based investors due to licensing requirements under the California Finance Lenders Law. Making it equity removes this issue. [13]

However, convertible equity is not without its critics. Some concerns raised by skeptics are that investors may be reluctant to give up their position as a creditor of the company.[14] Investors would also lose a return on their investment in the form of paid principle and interest.[15] Will the loss of these benefits undermine convertible equity’s chance of being the financing vehicle of the future? Or will it go away as quickly as it came? Creators are optimistic believing “all it takes is one major player to adopt it.”[16] Deals made in the upcoming year should determine whether or not they are right.


[1] Convertible Equity, a New Early-Stage Funding Concept, First Venture Legal (Oct. 2, 2012), http://www.firstventurelegal.com/convertible-equity-a-new-early-stage-funding-concept/.

[2] Id.

[3] What is Convertible Equity (or a Convertible Security)?, Startup Company Lawyer (Aug. 31, 2012) http://www.startupcompanylawyer.com/2012/08/31/what-is-convertible-equity-or-a-convertible-security/.

[4] Adeo Ressi Introduces ‘Convertible Equity’, Convertible Debt Without Debt, Forbes (Aug. 31, 2012) http://www.forbes.com/sites/jjcolao/2012/08/31/adeo-ressi-introduces-convertible-equity-convertible-debt-without-debt/ .

[5] Startup Company Lawyer, supra note 3.

[6] Forbes, supra note 4.

[7] Id.

[8] Id.

[9] Leena Rao, Convertible Equity, A Better Alternative To Convertible Debt?, Tech Crunch (Aug. 31, 2012) http://techcrunch.com/2012/08/31/thefunded-founder-institute-and-wilson-sonsini-debut-startup-friendly-seed-financing-vehicle-convertible-equity/ .

[10] Forbes, supra note 4.

[11] Id.

[12] Id.

[13] Startup Company Lawyer, supra note 3.

[14] First Venture Legal, supra note 1.

[15] Id.

[16] Startup Company Lawyer, supra note 3.

The Acqui-Hire: Success, Failure, or Just Plain Acquisition?

It’s got to be great news when Facebook, Google, or any of the other Silicon Valley giants is buying up one of the smaller companies or startups, right? What many are surprised to learn, however, is that these giants aren’t always looking to capitalize on an opportunity to control the product produced by these startups. But if they don’t want the product, what is it that these Silicon Valley giants are after?

The real end game of many startup purchases is to bring the engineering talent from that startup to the purchasing company; the so called “aqui-hire.” While it may cost millions of dollars to purchase the small startup whose product may be simply mothballed by the purchaser, the return on investment can still be astronomical. Even if Facebook gets only one high-quality engineer from each startup purchase, then it possibly sets itself up to continue on the path toward millions of dollars of reported profits each year. [1]

It’s simple economics and a little bit of sociology. Silicon Valley is arguably a seller’s market: there is high demand for highly-skilled engineers and there are very few of them to go around. That being the case, a well-established engineer, being courted by the wooing ways of Silicon Valley giants, can demand a pretty penny in exchange for leaving his current startup and working with the others at, say, Google(as if the free haircuts, ping pong tournaments, and snack times were not enough to convince you to head over to the Googleplex). [2] By purchasing a startup and thus acquiring its engineers, the giants don’t have to be on the weak side of the negotiation table. Instead, they use their money and reputation to buy the company, thereby bypassing the individual negotiations with the engineers—the real item of value.

The real genius of the acqui-hire is the feelings of success that all involved parties tend to get out of the sale and purchase of the startup. The giants get their engineer, the engineer gets to work for an exceptional company alongside other equally-talented engineers, and the CEOs get to tell all their friends at the bar that their company was bought out by Google. Everyone’s a winner!

Not everyone’s a winner, says Fred Wilson, the oft-quoted voice of the venture capital finance community. In fact, Wilson is cited in an article of The Observer saying that the CEOs of the companies that Google and Facebook-types buy for the sake of their engineers are “essentially failed entrepreneurs.“ [3] To be sure, not everyone sees these sales as failures. Matt Langer, a former lead web engineer for a company recently purchased by Facebook in an acqui-hire, responded to Wilson’s claim: “[W]hen the single most important company on the Web considers it worth their while to acquire the product you’re building and the people you’re working alongside, the absolute last word that comes to mind is ‘failure’.” [4]

[1] Facebook Inc, Google:Finance, http://www.google.com/finance?q=NASDAQ:FB&fstype=ii.

[2] Jonathan Strickland, How the Googleplex Works, How Stuff Works, http://computer.howstuffworks.com/googleplex3.htm.

[3] Leyon Neyfakh, Don’t Blow It! New York Tech’s Top Investors Have Bubble Trouble on the Brain, The New York Observer, http://observer.com/2010/11/dont-blow-it-new-york-techs-top-investors-have-bubble-trouble-on-the-brain/.

[4] Id.

Cyber Security Start-Ups

Enterprises and consumers alike have experienced two recent and rapid technological innovations that will continue to alter the tech landscape: the rise of cloud computing and a mass move to mobile devices and applications. “‘We are on a shift that is as momentous and as fundamental as the shift to the electrical grid,’ said Andrew R. Jassy, the head of [Amazon Web Services]. ‘It’s happening a lot faster than any of us thought.’” [1] Indeed, recent research concludes that paid cloud services are expected to double among small and midsize businesses in five years. [2] Computing giants Microsoft, Google, and Amazon, each with its own set of cloud offerings, will compete to meet this growing demand.

Cloud computing, which promises substantial cost-savings for businesses via “pay-as-you-go access to sophisticated software and powerful hardware,” [3] also poses certain security risks that derive primarily from the security, or lack thereof, of the channel by which information travels to the cloud and that of the data itself while on the server and in use by the cloud service. [4] When it comes to mobile devices, the risks are no less. In fact, the frequency of mobile threats doubled between 2010 and 2011 and the volume of malware targeting smartphones increased 155 percent in 2011 alone. [5] The rash of hacks on mobile devices and public and private networks by “pranksters, criminal syndicates or foreign governments” [6] illuminates the disconcerting reality that “[n]o one is immune to the threat posed by cyber criminals.” [7]

From an economic standpoint, the risks posed by potential security breaches are great: a typical breach might cost a business more than a half million dollars to rectify.[8] Likewise, such an occurrence might have a detrimental psychological effect, reducing the confidence of customers in a particular company or, worse, chilling the transition to cloud and mobile services overall, since no sector is impervious to the security threats.

It is perhaps of little surprise that, against this backdrop, “big companies are expected to spend $32.8 billion on computer security this year, up 9 percent from last year. Small and medium-size businesses will spend more on security than on other information technology purchases in the next three years.”[9] The “white hat” cyber security professionals, whose challenge is to “foster a faster and more open exchange of valuable information [while striving to] stay a step ahead of technically advanced, well-financed cyber criminals,” [10] are not only security powerhouses like McAfee, but also obscure security start-up companies, such as Imperva, Splunk, and Palo Alto Networks. [11] The remarkably strong stock performances that these companies have enjoyed since going public, with shares ranging from 26 to 65 percent above their offering price, has piqued the interest of the venture capital world. Not to be understated, venture capital contributions to these tech security start-ups reached $935 million in 2011, nearly doubling 2010 venture capital investments in the same genre. [12]

Most security start-ups seeking venture financing are focused on one of the following areas of weakness: mobile devices, authentication, intrusion detection, or “big data.” [13] For example, Bit9 is a start-up that blocks malware, Zenprise brings enterprise-level security to consumer mobile devices, and Solera Network tracks breaches in real time. Each of these companies has recently raised tens of millions of dollars in investment rounds led by top-tier venture capital firms, including Sequoia Capital and Intel Capital.[14]

Though this infusion of capital into the cyber security realm is likely spurred on by the potential for big monetary gains for venture capital firms and not altruistic motives, the ultimate security outcome, if the start-ups are successful, will be highly beneficial for many, if not all. Given the positive externality that seems to ensue from this particular type of investment in this age of increasing cyber crime, I can only hope that the unusual risks borne by investors of security companies, such as death threats and aggressive cyber counterattacks by criminals, [15] will not dampen its popularity going forward.

[1] Quentin Hardy, Active in Cloud, Amazon Reshapes Computing, The New York Times (Aug. 27, 2012), http://www.nytimes.com/2012/08/28/technology/active-in-cloud-amazon-reshapes-computing.html?ref=technology .

[2] 2012 Microsoft/Edge Strategies Cloud Adoption Study, http://www.edgestrategies.com/component/k2/item/117-just-released-2012-microsoft-edge-technologies-smb-cloud-adoption-study.html (last visited Oct. 13, 2012).

[3] Jeff Beckham, The Top 5 Security Risks of Cloud Computing, Cisco Blog (May 3, 2011, 8:36 AM), http://blogs.cisco.com/smallbusiness/the-top-5-security-risks-of-cloud-computing/ .

[4] Id.

[5] Ian Paul, Mobile Security Threats Rise, PCWorld (Sep. 7, 2012, 9:36 AM), http://www.pcworld.com/article/262017/mobile_security_threats_rise.html .

[6] Nicole Perlroth & Evelyn M. Rusli, Security Start-Ups Catch Fancy of Investors, The New York Times (Aug. 5, 2012), http://www.nytimes.com/2012/08/06/technology/computer-security-start-ups-catch-venture-capitalists-eyes.html .

[7] Kevin Johnson, CIOs Must Address the Growing Mobile Device Security Threat, Forbes (Aug. 16, 2012; 7:55 PM), http://www.forbes.com/sites/ciocentral/2012/08/16/cios-must-address-the-growing-mobile-device-security-threat/ .

[8] Id. (citing cash outlays, business disruptions, and revenue losses as elements of the cost of a security breach).

[9] Perlroth & Rusli, supra note 6.

[10] Johnson, supra note 7.

[11] Nicole Perlroth & Evelyn M. Rusli, Security Start-Ups Catch Fancy of Investors, The New York Times (Aug. 5, 2012), http://www.nytimes.com/2012/08/06/technology/computer-security-start-ups-catch-venture-capitalists-eyes.html .

[12] Id.

[13] Id.

[14] Id.

[15] Id.

Health Care and Venture Capital: An Uncertain Outlook

When most people hear “health care” today, their minds automatically pivot to the national health care debate dominating the election season. Many venture capitalists, however, are thinking about their next target in the broad health care and biotechnology industry. Investment in the sector, which includes companies developing “medical devices, diagnostic [platforms], technology based healthcare services, life science tools,”1 and pharmaceuticals, has been on the rise. In 2011, venture capital investment in biotechnology reached $4.82 billion, with medical devices and healthcare services financings realizing gains of 17% and 41%, respectively, year-over-year. 2

What’s behind the uptick in a sector “long shunned by venture-capital investors?”3 Two key explanations are optimism over “new U.S. laws that could speed up drug approval in key areas”4 and the increasing role of software in health care. The current regulatory climate makes it a difficult and lengthy process to receive FDA approval for pharmaceuticals and medical devices.5 As the founder of a short-lived medical device startup, I can attest to the difficulties that FDA approval can bring a similarly-based business – our startup’s projections, for example, indicated that simply becoming eligible for 510(k) clearance (which is necessary to market certain categories of medical devices in the United States) would cost $20 million and take at least 5 years. The FDA has since established the Center Science Council to improve the predictability of its decision-making on new innovations,6 and the response from venture capitalists has been cautiously positive.7

Entrepreneurs remain hopeful, as increased software penetration, beyond electronic medical records, exposes new opportunities in the field. Venture firms have begun “broadening the types of businesses they consider part of the life-sciences field”8 to include those creating software solutions to many of healthcare’s most pressing problems. These firms aren’t comparable to those such as Google or Facebook when they were still startups, but that’s a good thing – venture capitalists such as Kevin Kinsella of Avalon Ventures recognize that “every therapeutic idea or product is a big idea”9 and has a better chance of disrupting a field still relatively foreign to the Internet. Cyrus Massoumi, founder of ZocDoc, a startup which allows users to find and book appointments online, finds the current financing landscape superior to that of years prior. In 2007, the reaction to ZocDoc’s pitch was “less, ‘Good idea,’ and more, ‘Good god, you’re crazy.’”10 In the five years since, Massoumi and his team have raised $95 million, culminating in a $75 million Series C last year with DST Global and Goldman Sachs.11

While some parties are optimistic for biotech’s resurgence, “[p]ricing pressures, slower economic growth and greater regulatory scrutiny”12 continue to make investment difficult to come by. Ernst & Young’s global life sciences practice released a report two weeks ago finding capital harder to come by for younger companies in the sector.13 According to their numbers, venture capital investment in biotechnology remains substantially lower than the $5.40 billion peak reached in 2006-2007,14 and the situation may not be improving to the degree that 2011’s numbers suggest. The data available so far for 2012 support their pessimistic stance. In Q2 2012, biotech companies received $697 million, or 42% less money in deals than the same quarter a year prior, the lowest amount seen by the National Venture Capital Association “since the first quarter of 2003.”15 Most affected by these trends are the small, young startups hurting for cash, especially those on the software-side of things. While more established companies, such as Merck, who launched its own $250 million venture fund in 2011, “invest in [early-stage] innovation with a portion of the dollars they would have invested in their own R&D,”16 these dollars end up at companies immersed in the pharmaceutical sector – the bread and butter of companies like Merck. Nevertheless, the experience of ZocDoc and others in the field show that substantial venture money is still out there – only now it’s being packaged in smaller, but smarter, deals.17

1ARBORETUM VENTURES, http://www.arboretumvc.com/about.php.
2 Sarah McBride, Venture firms see signs of rebirth in life sciences, REUTERS (Sep. 24, 2012, 2:42 PM), http://www.reuters.com/article/2012/09/24/us-venture-capital-life-sciences-idUSBRE88N0UG20120924.
4 Id.
5 Kate Greenwood, Venture Capitalists Complain of ‘Regulatory Challenges,’ FDA Responds, HEALTH REFORM WATCH (Dec. 20, 2011), http://www.healthreformwatch.com/2011/12/20/venture-capitalists-complain-of-regulatory-challenges-fda-responds/ (“The venture capitalists blame ‘regulatory challenges,’ primarily ‘the hostile FDA.’”).
6 See CDRH Center Science Council FAQs, U.S. FOOD AND DRUG ADMINISTRATION (Mar. 31, 2011), http://www.fda.gov/AboutFDA/CentersOffices/OfficeofMedicalProductsandTobacco/CDRH/CDRHReports/ucm249249.htm.
7 See Greenwood, supra note 5.
8 McBride, supra note 2.
9 McBride, supra note 2.
10 Cyrus Massoumi, Healthcare Momentum: Our Shared Responsibility, THE HUFFINGTON POST (Oct. 4, 2012), http://www.huffingtonpost.com/cyrus-massoumi/appointment-booking-tech-startup_b_1939854.html.
11 ZocDoc, TECHCRUNCH, http://www.crunchbase.com/company/zocdoc.
12 Susan Kelly, Venture capital for medical technology harder to come by: report, REUTERS (Oct. 2, 2012, 1:23 AM), http://www.reuters.com/article/2012/10/02/us-medtech-investing-idUSBRE89104D20121002.
13 Id.
14 Id.
15 John Carroll, New biotech deals scrape record low as VC groups lose steam, FIERCEBIOTECH (July 19, 2012), http://www.fiercebiotech.com/story/new-biotech-deals-scrape-record-low-vc-groups-lose-steam/2012-07-19.
16 McBride, supra note 2.
17 See McBride, supra note 2.