As the next election cycle in Colorado gears up, I’ve been jumping up and down reminding everyone who cares about politics that the solution to the “growth of the technology industry in Colorado” is to improve our education system.  Our current governor has done everything he can to ignore education and at least one of our potential gubernatorial candidates can’t spell the word education.  Colorado has an excellent entrepreneurial and technical base – we just need much more supply at both the K-12 and college levels.  This isn’t a quick fix – at 20+ year view is required.

I think CU Boulder is the best college in Colorado and the one most likely to have a huge impact on the region in the next 20 years.  It’s always great to see additions to the faculty that have a clue about entrepreneurship and technology.  Phil Weiser – an Associate Profession in the School of Law with a joint appointment in the Interdisciplinary Telecommunications Program has been doing a great job as head of the Silicon Flatirons Telecommunications Program.  He sent me a note over the weekend that Vic Fleisher, a law professor at UCLA and a blogger at Conglomerate with a deep interest in entrepreneurship, has just joined the faculty at CU Boulder.

I don’t know Vic, but given Phil’s note, I hope to meet him soon and welcome him to Boulder.

I received the following question earlier this week.  It’s conveniently timed, as I recently participated in two angel investments – each with one of the structures defined below.

What’s the best/preferred structure of investment money pre-VC investment. We’re in the beginnings of raising angel capital (~500k) and were wondering what, if any, considerations we should make regarding the investments to allow for VC later. Should we take convertible loans or issue straight preferred stock? What are the other options that are out there for investment structure? Is it too much of a hassle to handle future investments when there is an “angel group (say 5 doctors banded together)” versus a singular angel?

Assuming that you are planning on raising VC money some time in the future, there are two different typical structures for the first angel financing: (1) convertible debt and (2) preferred equity.

Convertible Debt: This is the easier approach of the two.  In this case, the investment is in the form of a promissory note that converts into equity on the terms of a “qualified financing” (where qualified financing typically is defined by having a minimum amount – say $1m of total investment.)  The note will either convert at a discount to the price of the qualified financing (usually in the 20% – 40% range), will have warrant coverage (usually in the 20% to 40% range), or both.  This discount and/or warrant coverage gives the angel investors some additional ownership in exchange for taking the early risk.  This note should be a real promissory note with the conversion and redemption characteristics clearly defined to protect both the investors and the entrepreneurs from any misunderstandings.

Preferred Equity: This is also known as a “light Series A” – it’s preferred stock that is similar to that a VC will get, but usually with lighter terms due to the relatively low valuation associated with it.  For a very young company, a $500k investment can receive between 25% and 50% of the equity in the company and, as a result, many of the terms associated with a typical VC investment are overkill.

While either of these work, you’ll find some angels that strongly prefer one over the other.  In addition, if you don’t believe you are going to raise additional VC money and will only be relying on additional small angel-type investments, the preferred equity approach is fairer to the investors as they’ll more clearly be participating in the upside on terms that are agreed to early in the life of the company.

Finally, I don’t think there is a difference between having “an angel group” vs. a single angel investor.  However, you should try to insure that all of your investors are accredited and – if some aren’t – make sure you understand the implications of this.

Jeff Bussgang – a GP at IDG Ventures in Boston – has a good post up on the dynamics – from both an entrepreneurs perspective and a VC perspective – on syndicating deals.

I can’t get Chris Wand – who works with me at Mobius – to write a blog.  Nonetheless, he is a good writer.  He’s just published an article on the Kauffman eVenturing site titled Considering Debt Capital.  Well worth reading if you are an entrepreneur thinking about using debt financing, even if Chris won’t start a blog.

I’m chuckling as I write this.  After writing a few posts on S-Corps, C-Corps, and LLC’s, I had an email exchange today with someone that is putting together a small angel round.  He read my posts and concluded that he should do a C-Corp.  He’s only planning to raise a small angel round now and a follow-on angel round in a year – no VC, no significant financing, and no complex capitalization.  In addition, if the business is successful, it’ll start generating profits and positive cash flow in year 3. 

In this case, a C-Corp makes no sense, especially because of the risk of double-taxation if the business becomes profitable.  An S-Corp is fine, but the company potentially has a foreign investor as one of its angel investors.  In addition, the company is already an LLC, so converting to an S-Corp would be a pain.  Since the entrepreneur has no plans to raise money from VCs, the answer – in this case – was to stay as an LLC.

See – it depends.  Snicker.

Last week, I blogged an answer to the question “What’s The Best Corporate Structure For An Early Stage Company?“  A few people responded asking why I didn’t like LLC’s more.

While there are several advantages of an LLC over an S-Corp (ability to issue different classes of securities, ease of set up, informality of operating agreements, lower state taxes, non-US investors), venture funds typically cannot (or don’t want to) invest in LLCs.  When a VC invests in an LLC, they risk getting an income tax called UBTI (unrelated business tax income). This type of income is frowned upon by investors in venture funds partnerships and most funds have a provision in their fund agreements that they will use best efforts not to bring UBTI into the partnership. As a result, VC funds shy away from investing in LLCs.

The able minded entrepreneur says “yeah Brad, but I’m not ready for venture capital yet – I’ll just do an LLC now and convert to a C-Corp when I raise VC in a year.”  Ok, but in order to “convert” an LLC into a C-Corp, one actually has to go through a complete merger, whereby a new entity is created, which usually drops down a wholly owned subsidiary, that sub is merged into the LLC, leaving the LLC as the sub of the parent. In short, it’s complicated and makes the lawyers and accountants some extra cash.  Yuck.

In contrast, converting an S-Corp to a C-Corp is simply a “check the box tax election” (or – actually – “unchecking the box”) – this can be done in a day with a single tax form.  No lawyers, no accountants, no money.  Therefore, while the LLC has some benefits, the costs of converting the LLC into a fundable entity is substantially higher and usually not worth the additional effort.

I got the following question from a reader a week ago.

A project I’m involved with is aiming to go from a team of “4 founders with a great idea and a prototype” to a full fledged online service. I believe that even at an early stage, structuring ourselves to allow for growth/investment is critical. Naturally passion for our core mission, competence, and an ability to connect with the existing team are critical. Yet compensation (with an equity component) is a big part of the equation. I want people to have a sense of ownership and our current back of the envelope structure just isn’t suited at the moment for bringing people onto the team. To avoid reinventing the wheel, is there a “best practices” template for early stage companies with respect to structure/incorporation? What’s the smartest structure for an early stage company?

There are two logical choices (S-Corp or C-Corp) and a third one (LLC) that pops up occasionally.  The best choice depends on the financing path you are ultimately planning on going down.  Rather than define each of them in-depth, I’ve linked to the Wikipedia definitions which are very good.

S-Corp: If you are not going to raise any VC or angel money, an S-Corp is the best structure as it has all the tax benefits / flexibility of a partnership – specifically a single tax structure vs. the potential for double tax structure of a C-Corp – while retaining the liability protection of a C-Corp.

C-Corp: If you are going to raise VC or angel money, a C-Corp is the best (and often required) structure.  In a VC / angel backed company, you’ll almost always end up with multiple classes of stock, which are not permitted in an S-Corp.  Since a VC / angel backed company is expected to lose money for a while (that’s why you are taking the investment in the first place!) the double taxation issues will be deferred for a while, plus it’s unlikely you’ll be distributing money out of a VC / angel backed company when you become profitable.

LLC: Often an LLC (Limited Liability Company) will substitute for an S-Corp (it has similar dynamics) although it’s much harder to effectively grant equity (membership units in the case of an LLC vs. options in an S-Corp or C-Corp – most employees understand and have had experience with options but many don’t understand membership units.)  LLC’s work really well for companies with a limited number of owners; not so well when the ownership starts to be spread among multiple people.

Based on your question, it seems like you’ll ultimately want to raise money in which case a C-Corp is probably best for you.  An established lawyer who does corporate work with early stage / VC backed companies can set this up quickly, easily, and inexpensively for you – they are often the best source for the equivalent of a “best practices template” since this is routine work and requires simple, boilerplate documents and filings.

Earlier this week I was enjoying myself at an Oxlo board meeting (the food was “ok” – at least there was food) and I realized that a number of people in the room were folks that I had met randomly. I’ve had a long standing “random meeting” policy – I try to set aside time to get together with people that are referred to me by someone I know. While I don’t do coffee, breakfast, lunch, or other time consuming things, I’m always happy to spend 15 minutes meeting someone for the first time, hearing their story, and seeing if I can connect them up with something I’m involved in.

A year or so ago I realized that the endless context switching between random meetings and all the other stuff I did was disruptive.  So – I started doing “random days.”  Twice a month, I schedule a day in the office where I fill it up with as many random meetings as I can.  I space them apart by 30 minutes and aim for each interaction to be 15 minutes long.  If we get into something profoundly interesting, it stretches to 30 minutes.  Since I started doing this, I’ve gotten rid of the endless daily interactions that are “random” and end up having a great, super stimulating day where I meet 15 to 20 new people in a very efficient (for me) context.

As I pondered the folks that I work with today that I met “randomly” I smiled and realized this has been working very well for me over the past 20 years.

Earlier this week I wrote that Tim Wolters – CTO of Collective Intellect had starting posting on terms associated with VC financings.  Yesterday – Niel Robertson – CTO of Newmerix (who just closed a follow on to their Series B financing) just wrote an extensive post about his experience with early stage venture financings.  Great insight from the entrepreneur’s point of view (in the case that you are sick and tired about hearing about things from a VC point of view.)