Trae Nickelson: Hello and welcome back to Starting Up & Right conversations with a Startup CFO. I'm your co-host, Trae Nickelson. Joining me as always is Startup CFO, Ryan Keating. Ryan thanks for joining again. This should be a fun episode.
Ryan Keating: Thank you.
Trae: Our special guest today is Mr. Mark White, a startup attorney with Mark Summers Caffee & James based in Redwood City here in Silicon Valley. Mark thanks for joining us today. Why don't we get started by just you telling us a little bit about yourself and your firm? How you got roped into the Startup world?
Mark White: Sure. Hi, everybody. Nice to meet you. My name is Mark White. My firm is White Summers Caffee & James. We are a boutique transactional firm, corporate firm. We work with startups, the venture community with executives. Individually, our practice is global, so we have offices in the US and in Europe. We've worked with companies and investors for 24 years in this company.
All of us in this firm are ex-big firm attorneys coming from firms that are the leading firms here in the Bay Area and in technology generally. We work with all kinds of issues. We work with companies on financings, on acquisitions, on operational issues; a really deal-making in every form and operational issues for companies that are scaling and looking for an exit.
Trae: Terrific. Thanks again for joining us. In this episode, we're going to focus on two subjects where there's a nice healthy overlap and collaboration between finance and legal. First is strategic partnerships and the second is going to be some cap table management discussion. Mark, let's start off with strategic partnerships. I know that's a subject near and dear to your heart. Talk to us about strategic partnerships. Me as a startup founder, why should I be looking and considering strategic partnerships as part of my growth efforts?
Mark: The issue for any company is - companies have to show that they have traction, that they've mitigated risk, that they've proven their value proposition, that they've been in market, they've been able to show product-market-fit and they have to do this bootstrapping in virtually every case. Before outside investors come in, they want to know that the company has viability at some level. The question is, how do you bootstrap the company to a point of validation so that any investor of any profile will want to invest in the enterprise? Strategic partnerships are critical sources of verification and actually downloading some of the risk of getting the venture started.
Partners do virtually anything that is required to help your enterprise work. They're sources of innovation, they're channels to market, they are strategic in helping you define the business model and how you're going to move forward. In a sense, the idea of being a joint venture participant with other companies in building your platform and your solution is the ideal way to go. You're not cutting them in on equity. You're not making them participants in decision-making on how you're going to grow your enterprise but they are valuable to you in providing the resources you need to bootstrap the company to get to a point of verification to get outside capital.
Ryan: Yes, and if I can add in there.
Ryan: First of all, Mark, thanks for joining. We've been working together a long time, supported a lot of our clients. I really was looking forward to this. On that notion and where we talk to our clients about is we work with such early-stage companies that we often are involved when they're bringing in the first bootstrap or outside financing. You hit the nail on the head. It's about risk mitigation. Anytime you try to bring in an investor, they're looking for you to have taken risk off the table. They want to see where you have traction. They want to make that leap of faith as short as possible and we try to do that for the investor.
If you can get in with a partner, that not only shows it's not only non-dilutive like you were mentioning where you don't have to give up a portion of your equity for partnership participation, but it's also a great validator to the investors to see that somebody in the marketplace looks at your product or your solution in such a light that they want to partner with it. We really encourage obviously if there is a possibility for our clients to engage in these strategic partnerships.
Not to mention looking ahead, those strategic partners oftentimes turn into potential acquirers. They sometimes will even see them participate at what's called as corporate venture capitalists. Most companies have a corporate VC arm these days. You get those partners early, they like what you're doing, we'll often see them participate in these actual financing grounds and ultimately, as a potential exit for our clients.
Trae: Cool. Besides just credibility, it sounds like there are a lot of synergies that can be built up for my startup with strategic partnerships. Mark, what are some examples? What should I consider? As I'm brainstorming in what partnerships to form, what are some examples of good strategic partnerships that you've seen worked out well?
Mark: Yes, whatever you do, you don't want to reinvent the wheel. You're not going to raise money based on what somebody else did. You're going to raise money based on what nobody else has done before or what you can do way, way, way better. You don't want to create incremental value. You want to create great distinction. If somebody else has developed a module of a solution or a piece of the solution that you require, and you can cobble it together innovation from different sources into a cohesive suite and seamless offering, that's the first thing you want to think about which is, "What am I building? How do I build it in an efficient way?"
The second is, "How do I get into market quickly without spending a lot of money and wasting a lot of my time and chasing the wrong customers?" One way to do that is you work with channel partners and you get feedback from them on what they're looking for in their offerings. What is missing from what their customers are asking them to do? You're getting market feedback, you're getting innovation feedback which are the two key challenges that you have as an enterprise when you first set up the company and the real operating business.
Trae: Nice. Obviously, strategic partnerships when formed and when there's a real synergy can work out very well for a startup. What are some of the got you's? I know some of these sometimes go wrong. Do you have any horror stories? What are some things as the attorney that you're always aware of or are counseling startups to be aware of as they're forming up these strategic partnerships?
Mark: Yes. This comes up all the time. The horror story is really on the market side. It's not so much innovation. Companies are very careful about what they retain rights to and it's not something that founders and board of directors and investors are oblivious to. What people tend to forget is giving exclusive market rights out to certain participants and then you try to sell the company and maybe a third of your market is in the hands of other companies that have exclusive rights. They don't agree to give their market rights to an acquirer or the acquirer is a competitor of theirs.
What happens is that key market, those key customers go away. You thought you were selling your company for $20 million and it turns out that the market rights that are tied up represent maybe $12 million, so you got eight left. Is anyone going to buy the company for that? What companies tend to not be cognizant of is the expiration of exclusive rights. You cannot have perpetual ongoing rights that cannot be clawed back in some way or redefined as being non-exclusive by you as the owner of those markets at the outset of the venture. That's probably the biggest mistake that companies make.
Ryan: I really like what you're saying. This is that the attractiveness of a deal is going to change as you as a company get traction and move through funding rounds and become more independent and you can't be held to these legacy deals because they can have problems with your future funding or exits if you're not working them or wording them properly. We've had clients that sell hardware, for example, they'll have a deal with a pretty major channel at first. They're all excited about it but that channel decides, "It's not our top-performing product. We're going to have it sit here for a while." They don't put energy behind it and you're stuck.
That's your potentially exclusive channel and they've decided they're moving on to the next thing. Your fate is tied to are they going to incentivize their sales team to push your product or not. If you don't create these performance obligations with these clients, sometimes you got to give up exclusivity at first because you've got to earn the better terms. I've seen people where they'll do this and then the provider, the channel just decides, "Look, there's a higher margin product here we're going to focus on," and your product is sitting on your shelf, literally. You can't go sell it elsewhere.
Mark: Ryan, what you said, it's spot on which is this idea of performance being the key to exclusive rights or not. You define performance in a variety of ways. Is it minimum sales? Is it minimum royalties based on sales with a margin going back to us? Is it not any of that but more market promotion because you're at the front end of developing a new customer set and the blue ocean opportunity. You really can't look at sales as being the indicator of performance or not. You've got to have commitment to not have your partner just sit on their heels and not do anything.
Trae: Mark, it sounds like these partnerships can be very advantageous for a startup but you've got to have the foresight to think through what could go wrong over time, how this relationship could evolve over time. What's your approach to that? How can a startup form one of these strategic partnerships without getting locked into a bad relationship that ties them down?
Mark: No one can predict the future. You don't know how the relationship is going to evolve going forward, so you can't define that speculative environment which none of us are aware of. What you can do is build in review periods. We have this relationship; now we know what the market looks like. Now we know what a performance in each side should be and we look at it every year or every 18 months.
Either there's some core things that we have to renegotiate such as the economics or performance or the redefinition of markets altogether. You build the flexibility for inflection points on reviewing the relationship between the parties as you go and you define it as you go. That then allows for a dynamic relationship which I think is to the benefit of both sides.
Trae: Yes, good stuff. Let's move on to topic number two for today. That is the cap table, management of the cap table. I know there's often a lot of healthy overlap between finance and legal on management and strategy behind the cap table. Ryan, I know you've got some insight into this. You've seen some technology change the landscape of cap table management such as Carta. How does it change the role of the CFO? How's it changed the role of legal when you've got technology now available to really help and facilitate management of the cap table?
Ryan: Yes, it's a good question. It has been a very noticeable technology that has come into play here. It's changed how cap tables are oftentimes managed and interacted with. What I have noticed is that Carta in particular, and there are other services like Carta, it has brought the day-to-day cap table management more or less out of the legal hands and more into the company's hands, the CFO. Oftentimes, our role now as interim CFOs and controllers, et cetera, is we will be the owners of Carta. Carta is basically the system of record for the cap table.
None of this happens without legal. Legal knows about everything but the day to day, capturing the new option grants and making sure the employees have received their paperwork, being able to share logins now with employees so they could see what their vesting is and what their strike price is. It's really changed how the employee interaction with the company around cap tables takes place. It used to be, I remember 10 years ago, we would print out in duplicate every option grant. We would sit down in person across from the recipient and say, "You sign this copy twice. We'll sign this copy twice," and everybody gets their own--
Trae: You are old, Ryan.
Ryan: I know. It's a good foundation. Part of that would lead to a conversation which is "What does it mean to now be a recipient of an option grant?" What's the strike price? What's the vesting period? What does it mean if you leave employment? How long do you have to exercise your options? A lot of that conversation has gone away with Carta. We're actually finding from our side that at the end of the day, legal, they still own the cap table. They have to be involved in the financings. They have to be involved when it comes to the options pool sizing and even the governance in the board meetings where options are approved. They have a pretty strong role there.
The day-to-day administration of the cap table, if you will, more specifically how it impacts employees and their option grants, has been moved to more of this platform. What we have found our role has changed a bit where we come in now, and we'll do a lot more employee company-wide presentations. Since we don't have that one-on-one opportunity to sit down and collect the signature for that particular grant, and have a conversation about that grant, we'll do a general presentation to the company, and say, "This is what an option grant is. This is what it means to have a four-year vesting period with a one year cliff. This is what a strike price is.
This is what happens after you leave the company, and how long you have to make a decision about purchasing those shares." To answer your question, I believe Carter has really brought in a new era of simplicity, I guess, in terms of administering the option grants, and giving visibility to the cap table, to the appropriate stakeholders. It's taken away a little bit of that personal touch, and that's what we had to step in as interim CFOs, and actually more interact with the recipients of the option grants and explain to them what it means, and how to benefit from it.
We still work very closely with legal. The cap table is something that you have to have right. It's something that can be very complicated, especially as you add on rounds, and as you have side letters, or you have warrants, or you have convertible notes, and all these things play into the cap table. We work very closely with legal, and it's always been that way, but I am curious from Mark's perspective, how Carter has changed because, again, it's changed our role as the interim CFOs on how we interact with the cap table and our role in it, but it seems to have brought it more into the company's hands.
Mark: Yes, I guess my comment dovetails with yours Ryan. In a very good way, Carter has freed us up to focus on the true input and advice that companies really need. The legal profession has two parts to it. One is standard maintenance operations, things you've got to do that don't require a lot of thinking, quite honestly. There's just statutes, and pricing, and documentation that you've got to comply, and keeping track of all of this with companies that are scaling and have greater numbers of stockholders and optionees and other participants, and layering all of that into a common template.
That's something Carter is very good at, something that quite honestly is a relief that there's an automated service like that that is taking responsibility for that. An issue we had in the old days, was that the company wouldn't tell us what's going on, and so we as a law firm and other law firms, our brethren, would have the issue of we can only keep a cap table based on the input that we have on what's going on, what the company tells us about. We may or may not be part of a board meeting. We may or may not be in the workflow of documents created by the company itself trying to save money.
The cap table that we have is different from the cap table the company has. Then there may be changes of personnel within the company itself, and so you've got different professionals that are responsible for maintaining the cap table, that Ryan your organization isn't following, and that we're not following. At the end of the day, the company is going to be sold, or it's going through a financing, and you've got to do a corporate clean-up and figure out, what did the company promise? Who under what terms? You've got to reinvent the cap table every time you do one of these events, one of these transactions.
Carter does away with that. They're responsible. Now, they've got the same problem on their cap tables can only rely on what the company tells them, but at least they are more structured in being able to get that information from the company itself. The role that we're following right now are more complex issues that relate to equity ownership in the company. The pricing of issuances both options and stock as the company matures, and there's inflection points and material developments, and the question is, does that change pricing, yes or no?
Then you have issues of secondary sales of the executive team members in companies that are more mid-staged, later-staged, and the executive team wants to get some level of liquidity. How is that done? How is it priced? How does that affect the pricing of options coming forward? It's not automatic that a 409A valuation would address this because that in itself is a negotiation between the company and the valuation firm. It really is. What's important to be put into the metrics that are used to measure the company's value at any one point in time. That's where we get involved as well.
In particular, we get involved when you have executives joining the company mid-stage, the price of the stock is actually pretty high. How do you get incentive compensation to an executive coming into a new company where the price of equity to him or her is priced high? Do you provide a loan? What kind of recourse do you have? This is not black and white, quite honestly.
Boards have different risk profiles and how they perceive this based on the leverage of risk versus accommodation to executives coming in. What are the terms of the equity rights you're giving? RSUs versus stock, versus options, vesting tied to that performance. These are things that Carta does not address. These are judgment calls and the board is looking at counsel’s perspective on this, what they've seen in 20 other companies that went through the same change in the past 24 months.
I'm sure you're seeing the same thing, which is we're being asked for our experience on what we see other companies doing. It's not just the paperwork, it's the thinking behind it on what is the relationship the company ought to have with an executive and the deal that that person is getting versus everybody else, and how will an acquirer look at it. Those are issues that are challenging and refreshing to deal with, quite honestly, because there's no right answer. It's a fact and circumstance determination. I see Carta's freeing us up to focus on those issues.
Trae: Yes, so it sounds like technology such as Carta has freed both you guys up to focus a little less on the math of the cap table and the admin, and collecting signatures, and focus more on the higher-level strategy and dealing with the people that the cap table affects. Ryan, what's an example of some of these higher-level issues now that you deal with? How's your role changed now that you've got these tools in place?
Ryan: Even as Mark said, Carta's a great tool, but you still have to interact with it. It's like Microsoft Excel and financial modeling, garbage in is garbage out. There's still a requirement to know what's going into Carta. There's still a requirement to understand when it needs to be updated and when it's current. We see some pretty common mistakes when we start working with early companies. It really revolves around the initial iteration or two of the cap table.
How do you think about founders and the split day one? How do you think about creating the option pool for now wanting to go out and retain talent or retain advisors? How do you think about that first, upcoming dilutive round? Those are things that Carta won't solve for you. Carta will take your input when you know what to put in but we still see these issues that require, honestly, advice and a lot of times legal advice.
Mark actually came into our firm about a year ago and presented it to our employees. One of the things I really found was valuable was he listed some red flags that he sees with cap tables. I think that really captured a lot of the mistakes that we see early on in these very first couple of iterations. Maybe we could talk about those, Mark, if you don't mind.
Mark: No, I'm happy to do that. Ryan, you're referencing a presentation I made to your team in November of last year. Here we are a year later, we're in the pandemic. Quite honestly, with respect to the common mistakes that companies make, nothing has changed. I would love to just spot a couple of common mistakes. The first is, we work with companies that come to us one way or the other, they've got a track record, and they've got a capitalization table.
The first thing we look at is, is there a sequencing of the pricing of equity from the company's inception to where we are at that point in time. If we see variable pricing of stock and options where it's up and down, or you've got stock that's priced high and it goes low for some type of favoritism given to a group of participants that joined the company for whatever reason, then it goes back up again, that's a red flag. There's got to be consistency of value.
The reason for that is that the enterprise either it's going up in value. If it comes down, it comes down for everybody. You have to have an explanation for that. The board must have looked at that and there's got to be resolutions that back that up. That's a red flag. You can't go up and down without any reason, there's got to be a basis in fact on how the company is actually doing.
Another problem that we see early on are with very early-stage companies, working with individuals that they have a contract relationship with the company because the company doesn't have the ability to pay persons as employees yet. Very common. You've got a concept company, building its solution, hasn't gotten revenue, hasn't gotten any money yet, trying to economize working with folks as contractors but then gives out options as incentive stock options to the persons that aren't employees.
The problem is, that you can't give incentive options to non-employees. Incentive options have a tax advantage in that the pricing and the exercise of an incentive stock option when invest, and the difference between the exercise price and fair value on the date of vesting of those options, that spread is taxed to individuals if it's not an ISO. If it's an unqualified option and it's not taxed on exercise to employees that have been properly granted ISOs. This is a big issue, tax issue for the optionee if the individual gets an ISO purportedly when that person doesn't have employee status for the company. That's a red flag.
Another problem. It is mandatory that companies reflect fair value of common stock as the company matures over time. There are inflection points of value enhancements. One is when the company begins to generate revenue of any materiality, and we can talk about what that means. Certainly, when a company does a financing, where outside investors come in and price the company, price preferred stock that has a reflection on pricing of the common stock typically set by an outside valuation firm in a 409A valuation. If a company's early stage, doesn't really have an outside verification of pricing and keeps the same common price after a preferred financing is made into the company, that's a mistake because outsiders have come in, they value the company's not reflected in the pricing of the common stock.
A lot of companies do modeling and there may be multiple cap tables where the company keeps track of, for example, convertible notes or convertible equity rights on a cap table but it's not reflected in other cap tables. The problem is when you're raising money, and you're presenting these capitalization tables to your prospective outside investors or to a bank, for example, the bank is trying to verify ownership and you've got different versions of a capitalization table taking into account different owners of rights one way or the other on the cap table, and so you've got two or three versions of the cap table, that's a mistake.
We've seen companies that actually do this, they're not sure what is their real cap table, is it fully deluded, is it not fully deluded. What do you show outside participants in the company's future like banks and new investors? It's important in any capitalization table if there's special rights or commitments for equity in the future, given to individuals to reflect that not in the cap table itself because securities haven't been issued but in footnotes to the capitalization table. Those footnotes explain what is happening in the company's commitments before there's been an issuance of stock or a conversion of an equity right tied to some other contracts.
That's important to track and to disclose on your capitalization table. This isn't on the cap table itself but every time there's an issuance of securities, it's got to be made in conformance with applicable securities law. If it's an outside financing coming in, you've got to have the right exemptions that have been affected. There's either been a filing under Regulation D, or there's a private placement exemption that's been relied on that's not a Reg D. In California there's requirements for filing a 25102(f) notice for the issuance of securities within the state, actually anywhere but actually, we took persons in the state.
You need a permit to grant options under an option plan. The plan itself is exempted under a broad permit which is called the 25102(o) permit. The cap table doesn't really identify the security filings that have been provided, but when we see a company and we're looking at the capitalization table, anytime there is a reflection of new securities being issued, you've got to track what was the exemption that applied to that issuance. All of these things have to be considered - they're red flags. Companies make mistakes in these areas. These are not insurmountable problems to overcome if one of these points have been ignored but you've got to know what the status is as you go through the life cycle of the company.
Trae: All right, it's a great conversation. Ryan thanks again as always. Mark thanks for joining. It was interesting hearing you guys talk about the overlap between finance and legal. We'll do this again. I know there's a lot more to cover.
Ryan: Great. Yes. Mark thanks so much for joining. We could definitely have another episode out of this.
Mark: That'd be great, Ryan.
Ryan: I would enjoy it.
Mark: Thank you.
Ryan: Thank you.
Mark: Thank you.