As some of you know I just returned from New Zealand where I shared some of our local startup knowledge and experiences. Overall the trip was energizing with an opportunity to see what we experienced in the early days of the tech communities in Southern California and Silicon Valley. Although I had a chance to see some impressive green tech and web 2.0 companies, the most interesting encounter was with Dr. Tom McKaskill, an Australian entrepreneur, writer and professor who has a lot to say about creating lasting value in companies and exits. In the current climate, where angels and VCs are even more driven by exits and liquidity events, Tom’s wisdom is quite timely. If you have a look at Tom’s website, be sure to check out the articles and two of his more popular books, The Ultimate Deal 2 and Get a Life!. Although his books aren’t sold in the US, you can order them through his website.

Every company has to face it sooner or later—selling against that entrenched player in your space.  You know the one.  They are the guys with the industry standard solution; they have every bell and whistle known to humanity.  No one every got fired for picking their solution, even if it is weak in some areas.  What do you do?

There are a few key steps you can take that will maximize your chances of winning, or minimize the expenditure of resources in an unwinnable situation.  I ran into this situation 3 weeks ago, and was reminded again of all the painful lessons (and a few glorious wins) that I’ve gotten at the hands of the 800lb gorillas in several industries.

Step 1: Tell the customer why they should buy your solution

There is no reason for someone to take the risk of buying a new solution, rather than the industry standard, unless there is a big payoff.  Why should the customer take the risk of buying your service or product instead of the safe choice?  You not only need a crisp answer, but one that translates into dollars and cents.  Be prepared to explain your advantage.  Provide examples and references.  Hammer the point home.

In our case, we presented to a large prospect that wanted internet distribution for their product.  We have an excellent network, with far broader distribution than the gorilla.  We drove the point home, and at least 3 or 4 people in the presentation nodded their agreement.  So far, so good.

Step 2: Understand the politics in your customer’s organization

Picking a new, risky vendor is an inherently politically charged situation.  Is there someone allied with the gorilla at your prospective customer?  You better identify them, quickly.  They will try to shoot you down at every opportunity.  Is there a new person on the scene who has reasons to pick an radical new solution?  Some of my best supporters have been young managers who are anxious to do something new and bold.

In our case, the gorilla-lover constantly argued, and continually raised new challenges.  Can you do this?  Can you do that?  What about a call center solution?  The gorilla has one, so where’s yours?  What about the security certification that the gorilla announced last week?  Do you have one yet?  I wanted to throw something at him.

What he didn’t know was that we had an ally on the senior management team.  I had out-flanked the gorilla-lover by having some discussions beforehand.  Without that political support, we would have been on the defensive throughout the presentation.

Step 3: Know when to cut your losses

There will be times when you simply can’t win, and you need to identify those situations before they consume your scarce resources in a losing cause.  Without the support of the Senior Management player I mentioned, my sales effort would have been wasted.  Worse, I could have been drawn into trying to match the capabilities of the gorilla.  There is always a temptation to say “I could build that, too” or something equally foolish.  Why would anyone buy your promise to duplicate the gorilla’s solution over time, when they could by the complete solution from your competitor now?

To win, you need a decisive advantage, but that is not enough.  You need to cultivate allies in the target company that value that advantage, and are willing to take some risk to get it.  If either of those key components is missing, think hard about whether you should proceed.

These are hard calls.  Prospects are few and far between, especially large ones.  Giving up on prospect runs counter to our belief in our business, and can be hard to explain to the rest of your team and your investors.  Know yourself, and pick battles you can win.  Remember, if you engage to early and lose decisively, you may never get another chance at the prospect.  If you choose to fight again another day, you are still in the game.

By the way, we ended up getting part of the business at the prospect I mentioned.  Politics carried the day.  Our Senior Management ally gave us 40% of the business.  Wisely, he chose to test our services, and use our presence to beat down the gorilla’s prices.  Everybody won, except the gorilla.  We got a healthy fraction of the business, and our executive ally looked statesmanlike for testing us in a prudent way.

Intellectual property litigation can be the death knell of a startup.  Not only is the litigation costly, it distracts the company founders from operating and growing the business, and  it makes it a lot it harder (if not impossible) to raise capital.  If the litigation turns out really badly, an injunction can be issued that shuts down the business and there can be a substantial damages.

It’s impossible to completely protect a new business against an intellectual property lawsuit.  However certain steps can be taken, including:

1. Have trademark clearance searches conducted on all trademarks adopted, the name of the business, and the domain name used.

2. Have a right to use study conducted for any new products and methods.

3. Confirm ownership of all intellectual property of the business.

Even if these steps are taken, litigation can still result.  The diagram below can be helpful and gives you a rough overview of what happens if litigation occurs in a Federal Court. Hopefully this graphic also provides good incentive for avoiding it. I also have a good summary that compares patents, trademarks, copyrights and trade secrets, Send me an email at info@pasadenaangels.com if you’d like a copy.

The current economic crisis which we are facing is having a major impact on business everywhere. As one might expect, it is also having a significant impact on funding of early stage companies.

Earlier this month, Sequoia Capital communicated the seriousness of the situation with their portfolio companies (http://tinyurl.com/3sqrgy). The presentation started with a slide entitled “R.I.P Good Times” and ended with one which said simply “GET REAL OR GO HOME” before the Q & A. In between, there was substantial data presented on the economic reality along with strong advice on the need to preserve capital and to achieve profitability in short order.

Benchmark Capital communicated a similar message to their portfolio companies (http://tinyurl.com/3ku6es). They related the advice of a CEO who took a company during the dot-com crash through a 78% reduction in staff size, but was able to achieve profitability and eventually an IPO. The message was clear- survival mandates rapid course correction by all participants.

It appears that companies are starting to take heed of this advice. Just today the Financial Times reported a rapid reversal of the previously good mood, and a wave of job losses in Silicon Valley (http://tinyurl.com/5vrz3y). They cited the Sequoia meeting as a catalyst. Furthermore, CNET has started a live “scorecard” of tech layoffs to track the trend (http://tinyurl.com/5hcgkf).

So what does this all mean for the early-stage company which is trying to raise its first round of angel capital? First, it is important to understand that the cost of risk capital at all levels will go up substantially. This will directly translate into lower valuations and more stringent deal terms. Second, some companies which might have been fundable one year ago will no longer be able to raise funding- the bar has gone up. Third, it will take longer to close a funding event and may require the participation of more than one angel group to achieve the needed momentum. Fourth, turning to the operating plan, future funding needs, the cost of that money (higher), and the timeline needed to obtain it (longer) should be factored in. Revenue projections need to account for the current and anticipated future economic climate.

On the other hand, the door is not closed for focused entrepreneurs who have created disruptive new technologies in large and growing markets. There are major areas of unmet need in the green space, in healthcare (such as heart disease, obesity, and neurology), and in other areas. The key for the start-up today is to obtain market traction and profitability as quickly and as financially efficiently as possible.

Question: What kinds of things have entrepreneurs done (and should do) to increase the odds of getting funded?

From Matt Reno, Human Global Media

Answer: For this year’s LA County Tech Week, John Isaacson our Chairman did a presentation on “How to impress and Angel and get your company funded.” This presentation, which can be found on our website, provided a comprehensive overview of the common denominators (both good and bad) we’ve seen from companies pitching the Pasadena Angels over the past eight years. For John’s talk, he divided the presentation into the following topics:

• - What Every Entrepreneur Should Know
• - What We Look For
• - Investment Criteria and Cheat Sheet
• - Getting Inside the Mind of the Angel
• - Top Deal Killers

For this post I’ll address what every entrepreneur should know and provide some additional granularity to John’s main points on this topic:

1. Having a good idea is not enough

Every so often we come across an entrepreneur who believes they’re investment worthy based on how bright they are or because they came up with a good idea that was well articulated in a 2-page summary. Along with the funding criteria on our website, there are two other things we look for in companies: (1) a prototype or proof-of-concept that validates the company really can deliver on its idea; (2) the “plan” behind the plan, which I’ll address in a later post and covers how you’ll execute once you’re funded

2. Raising capital requires both time and money

Periodically we’re impressed by an entrepreneur that has left a well paying job so they could devote all of their time to their startup. To financially support their new venture, they will often take a second mortgage on their house and max out all their credit cards. The net impression when we see this is that he/she really believes in themselves and their business and have some serious ‘skin’ in the game. At the other extreme we’ve seen people who keep their day jobs, devote a few hours per week to their fledgling business and have invested only a few hundred dollars of their own money. Although you don’t have to follow the first scenario to secure funding, you should make sure that at a minimum you’re at least half-way between the two.

The two key points on this topic are you’ll need to invest sufficient time and money into your business to get to the point where a prospective investor will be interested. Secondly, the process of raising money will invariably be the hardest part in a startup—which also translates into time and $$$$$.

3. You can save time and money if you understand the investment process

Although this is stating the obvious, you’d be amazed at how many companies don’t take the time to do this.

4. Identify and contact prospective investors whose investment criteria match your situation

Once again, it’s pretty much stating the obvious. One added benefit of doing this is that this research may also help you discover things about the investor that you can use to get your company noticed.

5. It’s like college…you’ll be graded on a curve

Back when I was in college I was surrounded by a lot of very bright people. As if the situation wasn’t challenging enough, my class grades were often determined by how I did relative to them (and the class average), and not on an absolute scale.  Raising money is somewhat like that, because investors make only a limited number of investments. For the Pasadena Angels, it’s typically 12 per year. Although your company may be great on an absolute scale, the chances of getting funded will go down if an investor is simultaneously considering more investment worthy (i.e., stage, market, team, exit, etc.) companies. Historically, there’ve been many good, potentially fundable companies we’ve had to forego because of this.

6. Don’t stop till it’s done

At times we’ve watched entrepreneurs reduce the amount of time and energy they invest in the fundraising process after hitting a milestone along the way—but before actually having the money in the bank. The most common time that we’ve seen them ease up has been after receiving the term sheet and investment agreements. The amount of time and enthusiasm that you expend during the latter stages should be the same as when you’re first pitching. Remember, don’t stop until all of the money has closed and it’s in the bank.

For more advice on raising money (particularly the human intangibles that we look for), you can find a good presentation by David Rose of the New York Angels on TED.com.

An industry colleague resigned his position today, after a significant stint at his company. With his departure, his company will actually be losing more than a single employee – they’ll be losing a significant marketing asset, in terms of both institutional knowledge and external influence.

The shame of this loss is that it would have been easy to convert into a marketing win – regardless of whether my colleague stayed at his company or not in the longer term.

Internally, “John” was well respected and well versed in best practices. He saved the company from repeating marketing mistakes. But arguably more importantly, externally, John was socially well connected in the industry. If his company had made even a minimal effort to show John appreciation and respect, he would have been an excellent evangelist for the company during his “off hours”. John’s annual salary couldn’t have paid for the word of mouth marketing that he would have done.

Alas, the company viewed John as a resource, not a person. The result is that despite a civil relationship, and significant contributions by John, he never felt any particular love for the company – and finally resigned in search of more fulfilling work.

What a waste.

The moral of the story: your employees can be your best evangelists. Invest in them first.

So you’ve just started your company, and as with most entrepreneurs, you have very limited money for service providers of any sort.  That said, you have heard in the past that it is always best to get a lawyer involved in the company sooner rather than later, especially if you’re looking to raise capital in the near future.  You’ve decided to bite the bullet and hire a lawyer, but you want to spend wisely. Lawyers can provide a large portfolio of services, but for the entrepreneur on a limited budget here are some suggestions for targeting your legal dollars:

1. STOCK OPTION PLAN.  In order to attract and retain the best executives and key employees, particularly in the technology industry, you will need to be able to offer attractive equity packages.  Potential hires respond to offers of cash for sure, but if that’s in limited supply, giving an equity stake in the future success of the company will make an offer more attractive.  However, if not done properly under an option plan, grants of equity are fraught with pitfalls for the unwary—unintended ambiguities in the grant language, failure to implement vesting, a lack of compliance with securities laws, unintended tax consequences to the company and its employees, and the list goes on and on.  These issues often lead to costly disputes.  At an extreme, they can make a company unfinanceable, for investors will rarely put money into situations where the capitalization of a company is unclear or in dispute. A properly drafted stock option plan is money well spent.

2. FOUNDER ARRANGEMENTS.  Preparing the appropriate arrangements between the company and the founder is an important step and should be done before capital investment is made.  These arrangements typically include the purchase of founder’s equity, assigning intellectual property from the founder to the company, documenting founder loans to the company, and putting in place a founder employment agreement with the company.  Often, founder’s stock is subjected to vesting similar to stock options.  Investors like to see vesting for founder’s stock because this gives the investors comfort that the founders will be around for awhile or at least until their stock is fully vested.  It is also important to put in place legal arrangements amongst multiple founders.  Fact is, it is the rare management team that is 100% the same from inception to exit event.  How will you feel if your 50% partner leaves the company but keeps his stock while you continue to build the company’s success?  Co-founders need to put in place legal arrangements, most typically either through a simple vesting schedule or else through a more detailed buy-sell agreement, setting forth what will happen to the equity of the company in the event the co-founders’ participation in the business changes over time.

3. EMPLOYEE AND INDEPENDENT CONTRACTOR AGREEMENTS. Clarifying in writing the terms of employment and contractor relationships is one of the best ways to ensure your company is protected and avoids disputes and litigation down the road.  Ask your lawyer for a form employee offer letter and a form independent contractor agreement.  Particularly if you are a technology company, you also want a form employee proprietary information and inventions agreement (see intellectual property below).  The forms you use should be geared toward entrepreneurial companies and therefore include appropriate language for making stock option grants and covering other issues unique to emerging growth companies.

4. INTELLECTUAL PROPERTY ARRANGEMENTS.  Any intellectual property created by one or more of the founders should be properly transferred and assigned to the company such that the company now owns that intellectual property.  With respect to employees and contractors, it is important to document terms such as confidentiality and the assignment of intellectual property developed by the employee or contractor while working for the company, including those of any founders that are also employees.  Any future investors or potential buyers will want to have assurance that the intellectual property of the company is in fact owned by the company and not by one of the employees or contractors.  Accordingly, preparing the documents to evidence such terms is one of the most important steps in “getting your ducks in a row.”   Likewise, if you hire software developers or others to help you code, you need appropriate legal arrangements to ensure that the end product will be 100% owned by the company.

5. FINANCING TERM SHEET.  Experienced emerging growth attorneys have seen hundreds if not thousands of financing term sheets.  What likely looks like a foreign language to you is actually standard fare for your lawyer.  Your lawyer can walk you through an Angel or VC term sheet to help you understand where the risks and areas of opportunity for negotiation are.  This is time well invested.  It does take some time for new founders to come up to speed on this stuff, and you are best to begin your education regarding financing terms in advance of negotiations with potential investors.  With a solid foundation of the impact of various terms, and the knowledge of the range of what comprises market, you will be able to negotiate a financing deal that emphasizes the terms that are most important to you and also is reasonable and attractive to investors.

In my next post I’ll talk about the top five worst uses!

As promised in my last post, here’s a brief checklist and some rules of thumb to determine if a patent is right for your business. Before you go through the time and expense of filing a patent application, go through the following checklist and honestly answer the questions.

Question 1:  Is the invention (product or process) different in any way from information that has been available to the public for more than a year (e.g., described in a printed publication, offered for sale, used to produce a product)?

Significance:  “The public” means anyone who does not have a confidential relationship with you.  The information can be in any form, for example a product, a written publication (including for example, a U.S. or foreign patent, a scientific or trade journal, or a trade brochure), a publication on the Internet, or a display at a trade show.  A sale, or offer for sale, of the new product, or of a product of the new process is also “information”.

Question 2:  Does the invention provide us a competitive advantage?

Can it do something not done before?

Can it do it cheaper?

Can it do it better?

Significance:  If the answer is no, it’s not worth filing since a competitor can practice an equally good option.

Question 3:  How large is the potential market?

Significance:  If the market is less than $50,000 per year, then it is possible no one will compete.

Question 4:  How long will the market exist?

Significance:  If the market will not exist two years from now, patent protection may not make sense since it generally takes at least two years to get a patent.

Question 5:  How likely is it that there will be competitors in the market?

Significance:  If there will be no competitors, there is no reason to file.

Question  6:  Can I contractually prevent all customers from doing it themselves or purchasing from a competitor?

Significance:  If the answer is yes, there may be no reason to file.

Question 7:  Is this an invention that can be licensed to third parties?

Significance:  If the answer is yes, then most likely file since royalty rates are generally higher for a patented invention.

Question 8:  Can I protect this as a trade secret?

Would it take considerable effort to reverse engineer the invention?
Will disclosure to the customers be unnecessary for them to use the invention?
Will disclosure to the government be necessary (which may destroy trade secret protection)?
Does anyone already know the invention such as consultants or university researchers (which may destroy trade secret protection)?
Can I protect the invention from ex-associates and partners and ex-spouses?

Significance:  If the answer is yes, trade secret protection may be the way to go.  An option is to file a patent application, and reserve the trade secret vs. patent decision for later.

Question  9:  Will filing a patent application and satisfying the “best mode” requirement require disclosure of valuable trade secrets

Significance:  A “yes” answer may mean no filing.

Question  10:  Can I protect this with a copyright or trademark or trade dress rights?

Significance:  If the answer is yes, there may be a cheaper and easier way to obtain protection than through a patent.  Consult an attorney regarding these options.

Question  11:   Is this invention unobvious compared to what came before it?

How different is the invention from the prior art?
How long have people been trying to solve the problem?
How much effort and time did it take to solve the problem?

Significance:  To actually receive a patent, it is necessary that the invention be unobvious.  However, I recommend that a patent application be filed for any commercial product that is “different”, even if “obviousness” is problematic.  The “patent pending” notation generally slows down competitors enough to more than justify the cost of a patent application.

Question  12:  Has anyone who does not have to assign his or her rights to me contributed to the invention?

Significance:  If third parties will have the right to practice the patented invention, it may not be worth filing.

Question 13:  Can I obtain an enforceable patent? Can I detect if someone is infringing?

Significance:  If the patent is not enforceable, there may be no reason to file.  For example, if the invention is a new process for making a product, but the product is indistinguishable from products made by the old process, it may not be possible to detect infringement.

There are multiple types of applications for patent protection that are available.  Two of the more common are Utility (Provisional and Regular) and Design.  The difference between design patents and utility patents is that design patents only protect the non-functional appearance of a product, while utility patents cover how your invention works.  For some products both patent types may be available.  The main advantage of design patents is they are relatively inexpensive to obtain.  The main disadvantage of design patents is the scope of protection is generally narrow – they only cover the appearance of the product shown in the drawings, and not the product’s function.

If a utility patent is appropriate for your invention, then you need to decide whether to file a regular application or a provisional application. Because of their lower initial cost, provisional patents can be more attractive to start ups. Some of the more significant pros and cons of filing a provisional patent include:

ADVANTAGES OF A PROVISIONAL APPLICATION

1. Slightly Lower Initial Cost. The initial cost of preparing and filing a provisional patent application generally is lower than that of preparing and filing an actual patent application. This is because of the lower PTO filing fees and the more limited requirements of a provisional application.

2.  Delay of Examination Costs. Since a provisional application is not examined by the PTO, examination costs are delayed during the pendency of the provisional application.

3.  Shift of Patent Term. The end of the patent term can be shifted one year into the future, an important advantage for inventions, such as drugs, whose commercial value may be at the end of the patent term.

DISADVANTAGES OF A PROVISIONAL APPLICATION

1.  Delay in Issuance of a Patent. A provisional application cannot result in a patent— an actual application will eventually have to be filed.  Accordingly, the initial filing of a provisional application, instead of the immediate filing of a regular application, necessarily delays the issuance of any resulting patent.

2.  Higher Total Cost. The overall cost of initially filing a provisional application and then following up with the filing of an actual application will necessarily be more than the immediate filing of a regular application.

3.  Accelerated Foreign Filing Costs. Filing a provisional patent application starts the one-year period within which foreign patent protection must be applied for.

In next week’s post I’ll provide an entrepreneur’s checklist for determining if a patent application is required (or appropriate for your product or invention.

Periodically we will have posts from local entrepreneurs that provide some sound advice from a slightly different perspective. Today’s post is from Jason McDowall, a local serial entrepreneur that I’ve had the opportunity to work with and get to know over the last couple of years.  Jason was previously the co-founder and CEO of Adhoc Mobile, a developer of a sophisticated mobile ad and content delivery platform, that raised $3M in Angel financing. Jason is now the VP of Product Development at Benchmark Metrics, an angel funded developer of web-based business analytics tools.  Just a brief editorial note…the angel investors he describes below were not from the Pasadena Angels. 

By Jason McDowall

You’ve  shaken the loose change from friends and family, and now you’re desperate for cash to get your startup to the next level.  Do you think any check that doesn’t bounce belongs in your checking account?  In my experience, I believe you should be picky about who supplies the cash.  If your investors aren’t helping your company, they’re hurting it.  Here’s what can go wrong:

Risk: the investor does nothing

Who cares?  At least you’ve got some extra time and resources to build your dream, right?  That hasn’t been my experience.  Sure that convertible debt or silent investor may have bought you extra time, but your milestones and plans are probably wrong to begin with.  You’ll need even more time and more resources to execute than your business plan indicates.  For seed-stage companies, there is so much work to be done, so many adjustments to make, so many relationships that need to be established that you need your investors working for you.  Why waste your time or equity on an investor who cannot contribute essential customers, contacts, or credibility?  Your competitor is already better funded and has that support.

Risk: the investor promises a lot and does nothing

This is even worse than the risk above because you have misplaced expectations and end up wasting a bunch of precious equity/cash/time on a non-delivering member of the team.  If you are lucky enough to have someone offer you money, you owe it to your company/team to do some reference checking on the source of funds.  Talk to other companies that have received investments from the same source, and find out if they have they delivered on similar promises in the past.  If the investor is taking a role in the company (e.g., temporary C-level exec, VP of anything) check the investor’s work references just as you would for any other hire.

Risk: the well runs dry…or loses interest

Chances are the specifics of what your company does and how it makes money will change between the start and the declaration of success.  And to make it more challenging, it will take longer and cost more than you think to get there.  An unsophisticated investor or one unfamiliar with your industry may not have the appetite for the inevitable trial and error process.  You definitely need to be smart about market validation and finding ways to try/learn/adjust quickly

But you also need an investor who appreciates the need for, and can supply or quickly facilitate, additional funding to get you to that next major milestone (assuming you deserve the chance).  Finding an angel who made a bunch of money in real estate to invest and take a board seat in your web widget software startup is probably not the best move.

Risk: adversity strikes and visions begin to differ

At the beginning, everyone is full of excitement and enthusiasm.  But as you struggle to make your milestones and find yourself tweaking the business model, things can quickly get contentious.  It can be hard enough to keep the founding team on the same page, motivated, and making progress.  Having to deal with investors who have different visions of how and where to make necessary adjustments can make life miserable.  I’m not suggesting investors should all be drinking the same amount of Kool-Aid and believe all of the hopeful assurances of the founder.  But you should make sure financial incentives are properly aligned and voting procedures clearly in place to help deal with the hard times.  Also ask other portfolio companies how the investor has dealt with hard times in the past.  If you’re looking for strategic money at the seed stage, understand how that will likely restrict your growth options in the future.  If you’re looking for angel money, he or she needs to understand the likely dilution of ownership and power that will come if you end up needing another round.  And when things begin to diverge from the plan, be clear, be honest, and be prepared to make some concessions.

Creating a successful company is hard.  It requires a market insight, hard work, tenacity, flexibility, and some luck.  And it requires a lot of help.  In addition to cash, seed investors (and board members) should bring or be at least one of the three essential C’s: contacts, customers, or credibility. Remember that due diligence goes both ways.

Now if you could just elicit enough interest to actually have a choice….