31 posts categorized "January 2011"

Fund Everything

Fund everything - if not just anybody.

The news that 90% of Y Combinator startups have already accepted a $150,000 convertible note investment offer from Yuri Milner and SV Angel has me wondering where Right Side Capital Management is in raising money for its startup seed fund.

I blogged about Right Side last April, and learned a bit more from Right Side co-founder Dave Lambert when we both appeared on one of Dan Rosen's panels at the ACA Summit last May. At the time, the plan was that the new fund would to make 100-200 seed investments annually. Startups would be accepted, or rejected, quickly, according to a standard application process designed to evaluate the quality of the team rather than attempt to assess the merit of any given startup's idea.

Here's part of what the Right Side website says about their intended application process:

"We will email founding teams either a term sheet or rejection letter. Teams that receive term sheets will have two weeks to accept the offer. We will be happy to explain any unclear information to founders but we will not negotiate on terms. With our high volume process, we simply cannot afford to engage in an extended back-and-forth. However, we will carefully monitor the overall seed stage market to make sure that our valuations and terms remain fair."

The Milner/SV Angel/Y Combinator arrangement seems similar, at least in the sense that Y Combinator has served some basic screening function for the investors, removing the need for the investors to consider the merits of particular startup ideas.

Michael Wolfe has an interesting answer on Quora about the investment savvy of, in his words, "peanut butter[ing] the money evenly over the whole class" of Y Combinator startups, rather than picking or choosing. Well worth reading. (Yes, I know, as of yesterday, Quora is no longer fashionable with the digerati - something I might blog later about this week!)

Did Tuesday's SEC "Net Worth" Release Reverse the Prior Guidance?

Answer: At first I thought it did, but now I think it just muddied it.

In July, promptly after passage of Dodd-Frank and its immediately-effective change to the net worth test of the accredited investor definition, the SEC issued guidance, pending rule-making, on how to interpret the new law:

"Under Section 413(a) of the Dodd-Frank Act, the net worth standard for an accredited investor, as set forth in Securities Act Rules 215 and 501(a)(5), is adjusted to delete from the calculation of net worth the 'value of the primary residence' of the investor. . . .

"Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth."

(Emphasis added.)

Last Tuesday, the SEC proposed an actual rule to conform the net worth standard under regulations to the Dodd-Frank change:

“Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of purchase, exceeds $1,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.”

(Emphasis added.)

On first reading, I thought the proposed rule meant that the "downside" of the exclusion of the primary residence was to be capped by "the estimated fair market value of the property.” That was exciting for two reasons: (1) fewer angels would be knocked out of startup investing simply by the happenstance of an underwater mortgage, and (2) the new rule would, unlike the preliminary guidance, be easy to administer - one would simply take the primary residence off the table, and assign it no weight, positive or negative.

But on second reading, after working through additional examples in the release, it's clearer that the SEC intends to "ding" you for an underwater mortgage, which is consistent with the prior guidance.

Joe Wallin and I are preparing a slide deck to give a presentation to an angel group on the new net worth standard. In connection with that, Joe came up with the following, plain language version of the new proposed rule:

"You calculate net worth in the ordinary way. So an upside down house dings you. If your house is not upside down then you only reduce your net worth by the value in excess of debt."

Joe also points out on his blog that the preliminary guidance is still posted on the SEC's website, implying that it is still in effect.

Now, there may be "wiggle room" between the prior guidance and the proposed rule, if you ignore the examples in the release: in a nonrecourse state, one could reasonably conclude that an underwater mortgage was not, to the extent of the deficiency, an actual liability, since it could not be collected. That is, in certain jurisdictions, under the "ordinary way" of calculating net worth, you would not go negative even if the value of your property plummeted below the balance on your mortgage. The language of the prior guidance didn't permit this nuance, but simply deemed that "indebtedness secured by the residence in excess of the value of the home should be considered a liability." The proposed rule, I think, may leave it up to you to determine whether a deficiency in an underwater mortgage is in fact legitimately "debt secured by the property." You might determine that your deficiency is not secured or that it is not a liability at all?

Let's go back to what Dodd-Frank itself says, emphasis added:

"The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person."

In retrospect, the phrase "the value of" should have been excluded, to avoid the mischief we are dealing with now in implementing it. IMHO, if we simply took the principal residence off the table, the net worth standard would be easier for all to understand and for the startup community to self-police.

Unpacking the Significance of LinkedIn's Open Source Disclosure

Note from Bill: The following is a "re-posting" of a comment Jeremy left on this blog, and posted to his own blog, yesterday. Jeremy is writing about the following risk factor in a registration statement filed Thursday with the SEC in anticipation of LinkedIn's planned IPO:

"[W]e use open source software in our solutions and will use open source software in the future. From time to time, we may face claims against companies that incorporate open source software into their products, claiming ownership of, or demanding release of, the source code, the open source software and/or derivative works that were developed using such software, or otherwise seeking to enforce the terms of the applicable open source license. These claims could also result in litigation, require us to purchase a costly license or require us to devote additional research and development resources to change our solutions, any of which would have a negative effect on our business and operating results."

Let me see if I can do this succinctly (in-joke):

1. What’s the issue with open source?

Chances are that, even if you’re building a proprietary software application, it will include some open source. This will either be a deliberate decision to take advantage of pre-existing, tested, and free (or affordable) code, or a reality that comes from developers choosing to incorporate open source into a product despite corporate policy to the contrary, most likely for reasons of perceived efficiency.

Even then, whether the open source code may cause a problem for your proprietary model will depend on the license terms that apply to the code. While you should always be aware of the license terms that apply, most people confine their concerns to “copyleft” or “hereditary” license terms such as the GPL or L-GPL license terms.

At a very high level, the terms of copyleft or hereditary open source licenses may require you to disclose or distribute source code for other code you “combine” with the open source (including your proprietary code), or license code “combined” with the open source to the general public to enable them to modify it. In other words, you may be required to make public code you would prefer to keep secret.

If you don’t comply with the disclosure and modification licensing requirements of copyleft or hereditary open source license, then your use of the open source code will very possibly be treated as an infringement of the copyrights of the open source owner (or an organization to which they’ve transferred their enforcement rights) – which exposes you to damages claims (i.e., financial liability) and the possibility that you may be forced either to comply with the requirements (i.e., disclose and share your proprietary code), or to remove the open source from your product (i.e., re-engineer, and force your users to upgrade).

2. Why the reference to the miserable associate?**

The GPL licenses have been well-described as software developers’ revenge on intellectual property lawyers for making software the subject of copyright law. While the copyright law works “OK” for software, it isn’t a straightforward or intuitive fit. With the GPL licenses, software developers attempted to re-define copyright law concepts in a way that they believed both met their “free software” goals, and applied copyright law concepts more appropriately to software. The result, and I genuinely will not pick sides on this, is that it is incredibly complex to try to determine how the courts would apply the GPL license terms in determining the point at which a “combination” of GPL software and proprietary code would require disclosure and sharing of the proprietary code. Every time I get a call from a client saying, “Hey! It looks like we’ve included some GPL code in our proprietary product (and we want to release it tomorrow). Is this a problem?” I open up the GPL license terms and am reminded of Robert Falcon Scott’s words on reaching the South Pole – “Great God this is an awful place …”

3. But everyone’s using L-GPL, and plenty of people are using GPL – why can’t we?

This is true, and there are ways in which you can engineer your products so as to “insulate” your proprietary code from copyleft or hereditary software. But you have to do it right, and there will be some element of uncertainty owing to the challenging nature of the license terms for the open source code.

To be fair, this isn’t always the fault of the people who wrote the open source licenses or the lawyers who interpret them. For example, L-GPL is a less restrictive version of GPL designed to apply to libraries. But some developers don’t realize this and, thinking that L-GPL is simply a less restrictive version of GPL, apply it to code that isn’t a library at all. At that stage, you get an already complex license whose application to the technology it’s intended to cover is now incredibly difficult to interpret.

4. Why did LinkedIn disclose this as a risk factor?

My guess is that LinkedIn’s developers have built a significant portion of LinkedIn’s code using copyleft or hereditary code, but may not have sufficiently insulated LinkedIn’s proprietary code, so they may face exposure for infringement claims. “Ideally,” LinkedIn would have had better controls on their inbound licensing processes – but as those experienced with start-ups and early stage tech companies know, controls and processes are not always a priority.

**Refers to this bit of yesterday's comment thread.

My Favorite Risk Factors in the LinkedIn Registration Statement

LinkedIn filed a registration statement with the SEC yesterday. The draft prospectus it contains will undergo revisions before the IPO happens, but here now are excerpts of my 14 favorite risk factors from this initial filing.

  1. "We may not timely and effectively scale and adapt our existing technology and network infrastructure to ensure that our website is accessible within an acceptable load time."
  2. "Our U.S. corporate offices and certain of the facilities we lease to house our computer and telecommunications equipment are located in the San Francisco Bay Area and Southern California, both regions known for seismic activity."
  3. "Our core value of putting our members first may conflict with the short-term interests of our business."
  4. "If our members do not update their information or provide accurate and complete information when they join LinkedIn or do not establish sufficient connections, the value of our network may be negatively impacted because our value proposition as a professional network and as a source of accurate and comprehensive data will be weakened."
  5. "From 2007 to 2009, our net revenue grew from $32.5 million to $120.1 million, which represents a compounded annual growth rate of approximately 92%. We expect that, in the future, our revenue growth rate will decline . . . ."
  6. "Other companies such as Facebook, Google, Microsoft and Twitter could develop competing solutions or partner with third parties to offer such products."
  7. "As of December 31, 2010, approximately 57% of our employees had been with us for less than one year and approximately 74% for less than two years."
  8. "[W]e use open source software in our solutions and will use open source software in the future. From time to time, we may face claims against companies that incorporate open source software into their products, claiming ownership of, or demanding release of, the source code, the open source software and/or derivative works that were developed using such software, or otherwise seeking to enforce the terms of the applicable open source license. These claims could also result in litigation, require us to purchase a costly license or require us to devote additional research and development resources to change our solutions, any of which would have a negative effect on our business and operating results."
  9. "In addition to hiring new employees, we must continue to focus on retaining our best talent. Competition for these resources is intense, particularly in the San Francisco Bay Area, where our headquarters is located."
  10. "We believe that our culture has the potential to be a key contributor to our success. . . . [O]ur initial public offering could create disparities of wealth among our employees, which could adversely impact relations among employees and our culture in general."
  11. "If we are unable to develop mobile solutions to meet the needs of our users, our business could suffer."
  12. "Our ability to maintain the number of visitors directed to our website is not entirely within our control. Our competitors’ search engine optimization, or SEO, efforts may result in their websites receiving a higher search result page ranking than ours, or Internet search engines could revise their methodologies in an attempt to improve their search results, which could adversely affect the placement of our search result page ranking."
  13. "The dual class structure of our common stock as contained in our charter documents has the effect of concentrating voting control with those stockholders who held our stock prior to this offering, including our founders and our executive officers, employees and directors and their affiliates, and limiting your ability to influence corporate matters."
  14. "Prior to this offering, there has been limited trading of our common stock in alternative online markets [such as SecondMarket and SharesPost] at prices that may be higher than what our Class A common stock will trade at once it is listed."

Just How Many Angels Will the SEC's Proposed Rule Spare?

As noted yesterday, the SEC on Tuesday proposed changes to the accredited investor definition in a manner sensitive to startups and the means -- angel capital -- by which they are financed.

The greatest sensitivity was shown by what the Commission didn't do: it declined to exercise its discretion to revisit the annual income standard, indicating instead it would wait four years to do so. This move is very much in keeping with the spirit of the Angel Investor Amendment, passed by the US Senate at the last minute, just before the Senate bill was sent to conference to become part of Dodd-Frank.

The SEC Release discussing the proposed rule for the net worth test - a change that can't be avoided because Dodd-Frank already changed the standard and required the SEC to amend its rules accordingly - specifically calls out a lower impact on startups as one of the benefits to its proposed approach, over an alternative:

"The interpretation reflected in the proposed amendments would result in a smaller reduction in the pool of accredited investors than the first alternative interpretation. To the extent that exempt offerings to accredited investors are less costly for issuers to complete than registered offerings, a larger pool of accredited investors that may participate in these offerings could result in cost savings for issuers conducting these offerings."

Just how many angels were spared?

In a footnote to the Release, the SEC reveals the following:

"Using data from the 2007 Federal Reserve Board Survey of Consumer Finances, the latest data available, our Division of Risk, Strategy and Financial Innovation estimates that 10,496,312 of the 116,122,128 U.S. households (9.04%) qualified for accredited investor status on the basis of the net worth standard before it was modified by Section 413(a) of the Dodd-Frank Act; 7,604,374 (6.55%) would have qualified on the basis of the net worth standard after modification based on Section 413(a), as interpreted by our proposed approach to exclude from the net worth calculation both the estimated fair market value of the primary residence and all indebtedness secured by the residence up to the fair market value of the property; and 6,858,335 (5.91%) would have qualified if we adopted a standard based on the alternative interpretation of Section 413(a) to exclude from the net worth calculation the fair market value of the primary residence but not any indebtedness secured by the residence. More information regarding the survey may be obtained at http://www.federalreserve.gov/pubs/oss/oss2/scfindex.html."

I'll want to get Steve Bell's take on these numbers, and particularly any thoughts he has on the interplay between the net worth pool and the annual income pools. But just doing the straight arithmetic here, it sounds like the SEC is saying the following:

  • Prior to Dodd-Frank, 10,496,312 US households would have qualified as "accredited" by virtue of the net worth test alone;
  • After Dodd-Frank, under a regressive interpretation that would deduct all mortgage debt without an offset of equity value, an approach rejected here by the SEC, 6,858,335 US households would have so qualified; and
  • After Dodd-Frank, under the rule actually proposed Wednesday by the SEC, 7,604,374 US households will so qualify.

Thus, with the most regressive interpretation, the SEC could have knocked fully one-third of households out of meeting the net worth test. With the proposed interpretation, Dodd-Frank ends up knocking out 28% of households.

SEC Does Right Thing, Shows Sensitivity to Angel Financing

UPDATE Jan. 28: I'm reading the release a second time and think now my "underwater mortgage" conclusion below is mistaken. By some of the examples given in the release, it appears the intention of the SEC is to say that, yes, to the extent a mortgage liability exceeds the equity value of the principal residence secured, that excess "dings" your net worth; so the principal residence isn't simply taken off the table altogether. Because the proposed rule is not as clear as the prior SEC guidance, I do think that, in a nonrecourse jurisdiction, one could reasonably determine that a mortgage liability in excess of value may be no actual liability at all, and in that way have zero impact on net worth. The best thing, IMHO, would be to simply take the principal residence off the table, as that would be an easier rule for all to understand and to self-police.

* * * * * *

My gut told me that the SEC was not going to jack up the annual income thresholds for the accredited investor definition, in spite of wiser heads assuming that it would, and NASAA advocating it take Dodd-Frank implementation as an excuse to do so.

Well, the Commission left well enough alone.

What's more, they listened to the better argument on the ambiguity Dodd-Frank left us as to how to deal with underwater mortgages. So when you exclude the value of the principal residence from your net worth, for purposes of measuring the $1 million threshold, you exclude all positive value, but you don't "ding" yourself for negative value. In other words, if your principal residence is a net liability, and not an asset at all, you simply ignore it for purposes of the $1 million net worth threshold.

At least that is what the rule proposed yesterday states. I suppose its conceivable that some will argue over the course of the rulemaking process to make it less angel financing friendly.

But I doubt the SEC will go for that.

I see "signaling" in language in an SEC press release, a suggestion that the Commission means to leave the definition alone for four years:

"The new net worth standard must remain in effect until July 21, 2014, four years after enactment of the Dodd-Frank Act.  Beginning in 2014, the Commission is required to review the definition of the term 'accredited investor' in its entirety every four years and engage in further rulemaking to the extent it deems appropriate."

Now, as a technical matter, the four year moratorium on messing with the accredited investor definition technically only applies to the net worth definition. Arguably, the SEC remains free to reconsider the income thresholds at any time. So I think the language quoted above is significant, a soft indication that the SEC will not exploit its arguable discretion to act earlier on the annual income tests.

Lest it start to sound like I am engaging in rank partisan rent seeking for angel investors, let's all be reminded that most startups are angel backed, that even the few that secure VC funding likely first receive seed money from angels, and that experience suggests that the current thresholds for accreditation -- which in real terms move lower over time, at least in years where there is inflation -- remain appropriate and safe.

I think the ACA and other angel groups really did the startup ecosystem a great turn last year in advocating and educating legislators and the SEC about what angel capital is, and how startup and entrepreneurial activity is dependent on angel financing.

Tomorrow morning on this blog: Just How Many Angels Will the SEC's Proposed Rule Spare?

Today's SEC Open Meeting

Today's SEC open meeting agendaThe agenda for today's SEC open meeting (pictured left) suggests to me that the Commission will, in fact, limit new rulemaking around the accredited investor definition to the specific issue of how to deal with underwater mortgages for purposes of the net worth test.

If so, that will be a relief. There had been some worry that the SEC might take the occasion to revisit the net income thresholds - something I think would violate the spirit of what Dodd-Frank wrought after the last minute amendment to save angel financing.

I have a breakfast meeting this morning, so will miss the SEC webcast of the meeting scheduled to begin at 7 AM Pacific. But I'll plan to update this post and/or post tomorrow on what actually ends up being proposed today.

Update 9:40 am Pacific: I missed the webcast and the archive version is not up yet. Will likely update on this topic tomorrow morning.

Update 10:48 am Pacific: The new proposed rule is up on the SEC site. Looks to be good news for angel investing. I'll have a post tomorrow for sure, putting this all into context.

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