Sunday, August 29, 2010

Planets, Aristarchos, Ptolemy, Copernicus and Entrepreneurship

The power of discovery
I just came across this interesting news of one more step forward in the discovery of earth-like planets elsewhere in our galaxy. The increasing frequency of news like this supports the idea that we are getting close to proving once more that our plane is not only "not the center" but is also not unique, in which case various "other life" considerations inevitably follow.

The Greek philosopher Aristarchus of Samos had already figured the "not center" idea in 43 BC; he was ignored for 1500 years and even today is hardly given any credit.
Aristotle and Ptolemy with the flawed but more intuitive idea of Geocentricism (earth at the center of the universe), and with a better "sale pitch" got and controlled mind-share for 1500 years.
Copernicus and Galileo eventually sold Heliocentrism (sun at the center of the planets), a v2.0 of Aristarchus ideas, with better "showmanship" (drop balls from the Tower of Pisa and incarceration for heresy) to win the  mind-share race.

Centrism and Entrepreneurship
Humans would seem to have an instinct to imagine ourselves unique as much as permitted by ignorance, dogma and lack of facts. Possibly there is a survival value in brains intuitively "provincial" since it would limit the amount of data to be dealt with at any given moment: worry about immediate local threats (tigers), less about future and distant ones. With that trait, individually, we can intuitively and locally develop the notion that what we do is unique.  In reality however, we just have not looked for and found our competition.

For innovators and entrepreneurs, the remedy of this blind spot is getting out (talk to customers, talk to others in the same industry) and looking (search the blogosphere, academic research and industry press). Investigation will make us discover "another planet" like us, our competition. Loss of the myth of our uniqueness will require a radical change, a new perspective just as human psychology was impacted by the Copernican revolution. Finding our competition will demand a far less self-congratulatory and more guarded state of mind (i.e.we found the tiger, now what?).

Some more lessons from Aristarchus
Just as it happened to old Aristarchus, as an entrepreneur and innovator you may well have the right answer to "the question", but the market may not be  ready for it (e.g. there is lots of that happening now in the new green energy business!).  Pursuit just the same.

Recognize the possibility that the market will eventually accept your answer, but it may be in a version 2.0 advanced by a more compelling salesman.  The antidote is to strive to become a better salesman.  Meanwhile speak ( and twitt) loudly and consistently  "around" the established thinkers (the Aristotle and Ptolemy of your day).  Don't give up, the mind-share race is won one brain at a time.

Strive to find a way to stay in the game that is not totally dependent on the disputed idea you are championing. Staying power (most often enabled by capital) is the answer to the challenge. If you go out of business pursuing only the unpopular idea you will not survive to the day when reality will prove you right beyond dispute.

Marco Messina

Wednesday, August 25, 2010

Patents and Due Diligence

I frequently run into investors that seem to find a great deal of confidence in the fact that the company the are doing due diligence on has an "issued" patent.  They seem to believe that once the PTO issues it we are in Safe Land.  I wish I could be that optimistic, instead I often find myself "raining on the parade" suggesting that there are still big questions to be addressed:

Markets covered
If the projected market is global, but the patent is only issued in the US, what will the cost be to cover other countries?  
Is there still time to file abroad in desired markets? 
The rest of the world works on the basis of "first to file", so if someone invented well after the US inventor, but filed first in the country in question, it would be quite hard (not impossible) and expensive to contest the foreign filing.

Cost and means cost of enforcement
The PTO issues a patent but does no enforcement. Protection and enforcement of the rights implicit in the patent are up to the inventor/holder: Does the holder have the means to enforce its rights?  No cash to pay for litigation is about good as no patent.
If a company is granted a permanent irrevocable exclusive license to the patent by the inventor, the holder is the one that has to protect it through litigation, unless the right to prosecute infringers is granted along with the license, which normally isn't since the licensor is expected to protect the patent rights as consideration for the royalties received.  Does the holder have the ability, financial means and will to protect the patent rights? If not and the company does not either, it may have no means to prosecute infringers and in practice have no patent at all.

How "real" is the patent?
This is the question that seldom seems to be considered. In "Patents: what do they mean to you" I referenced the debacle of Research In Motion (RIM the maker of Blackberry) whose issued patent had one claim  invalidated years after being issued.

Another interesting case is that of so called "bogus patents" as this "Must Read" case reported by 
The notorious U.S. patent 6,411,947, a broad "method" for automatically classifying and responding to email inquiries known as the Firepond/Polaris patent, has finally been invalidated after 12 years on the books. (continue)
The warning here is: if it looks to you to be too easy, too obvious to be patentable, have an expert check the details, not just validate that the patent is issued. If it does not quack like a duck, it may not be one regardless of the stamp put on by the PTO or it may be so only for a short while.

Are patents useful?
Of course they are.  They certify to a good degree the novelty of an idea if not to its economic value. By virtue of the prior art research done, they attest to the difficulty of finding competitors.  Competitors could well exist that have prior art but never bothered to file a patent and they could come out later as they did for RIM.

Should inventors file them? Of course, but with the awareness that they grant no explicit protection. They only give one the right to spend money in litigation  to protect the rights implicit in the patent. 

Should investor value them?  Certainly, but, in my view, subject to the above considerations and making sure that due diligence includes looking carefully under the hood.

Marco Messina

Thursday, August 5, 2010

Business organization for your startup

Thoughts from business experience.  For legal opinions, consult your attorney and tax accountant.

Do not start as a sole proprietorship
This is the only recommendation sure to have no dissenters. All else following is meant as a general guideline to use in questioning your attorney on the best course for your particular circumstance.

The LLC - quick, easy, inexpensive
Many would agree that on a minimal budget this is the best alternative to get limited liability protection cheaply and quickly.  Most states now have web sites where name availability may be checked and reserved, sample minimum articles of organization are provided, applications may downloaded and filed by mail.  If you are in business alone in most states you can be in business in a few weeks, for $100 or less, and have little else to worry besides doing business.  Your local SBDC or SCORE chapter will help you free of charge to get it done.

A more complicated picture
The picture of course gets complicated as soon as you propose to add partners and investors. These are my rules of thumb:

Operating Agreement (OA)
Also called Partners Agreement and other similar names, this not required to organize an LLC in many states, but it is required by common sense: If you have even a a single partner, spouse included, you owe it to yourself to have an OA that spells the rules of engagement: how key decisions are made: e.g. sale of the business, personal guarantee of loans, call for incremental investments from founders, approval of financial control processes, access to records, management compensation approvals, etc.
Most importantly you should agree in writing to how you will part ways if needed (spouses included) - who can buy out whom when and how, how to value the business, etc. To promote fairness, strive to implement the old "parting the cookie" technique " (one cuts the cookie, the other picks which half).  It is much easier to agree when you are friends than when you will want to separate, probably because of irreconcilable differences   If in this negotiation process you learn something about your partner and your partnership dies and untimely death, you won't be the first - better early and with less pain now, before committing time and treasure, than later.

Tax Liability
In most cases, with proper elections filed with the IRS, your LLC will not require separate income tax filings and members report their share on Schedule C of their personal return. Advice from an accountant will cost little and ensure no bad surprises - make it mandatory.

However, regardless of how taxes are filed, members will take the tax liability impact of the LLC's income or loss, so the Operating Agreement should include a requirement that cash be disbursed to cover the members' tax liability.  Otherwise you risk having a tax bill due with no cash to pay it.  Partners with very different financial postures may have very different perspectives, so agree in writing ahead of time.

Complexity increases further as the number of members and investors increases. In particular, outside investors, angels and VCs, are likely to have a very different tax exposure, cash position, needs and objectives from the founders.  Of late many attorneys advertise that an LLC can be set to be govern and to function internally as a C corp with the "proper" Operating Agreement.  Perhaps so, but in my experience managing the different needs with amendments of the Operating Agreement will  become cumbersome, costly and beneficial only to the attorneys.

Furthermore the flexibility of defining the Operating Agreement however one wants is a two-edged sword that impacts investors' due diligence workload and cost.  Corporations' governance is much determined by state statutes which local corporate lawyers know well.  LLCs with complex Operating Agreements require careful review because only what is written governs and what is written could be unusual or unexpected and whatever is missing may be litigated later. Many angel investors simply avoid this risk but investing only in a C corp.

Switching to a C Corp.
At some point, switching to a C corp organization may be a desirable option.  Professional advice from tax and corporate lawyers is mandatory.  Mistakes can have dire consequences.

If you come to this point, be prepared to encounter a painful reconciliation of diverging interests of the owners.  This will be particularly so if along the way some "family and friends" investors extorted or were offered a "non-dilutable" clause or "unanimous approval" of funding decisions or changes in organization.  You may have % majority interest, but veto power trumps and is costly to remedy and there may not be statutes to help you out.  In any event this step will require time, and the less time you have the more leverage the competing interests will have against you - allow plenty of time.

Starting as a C corp
This option is of course preferable if you can afford it and particularly if you start with a business vision that includes angel investors, VCs, many shareholders, IPO, publicly trading stock, etc.  In this case you'll face significant differences relative to an LLC including:

  • Higher organization costs
  • State corporate filing requirements
  • Income tax filing requirements
  • Corporate governance statutes 
Details on these points are beyond the scope of this post. However, with respect to tax liability management, in the early stages of your startup you may personally benefit from any tax losses by electing to have the corporation taxed as a partnership (S election). The election can be reversed (only once) later when you no longer benefit from that method of taxation or your corporate needs change (e.g. IPO).
With regards to corporate governance, I have mentored many a budding entrepreneurs (mostly MBAs) much concerned with "preferred states of incorporation" (e.g. Delaware, Nevada, etc.). I am certain a case may be made and supported for their relative advantages. However I subscribe to KISS: In all states there are thousands of corporations that manage to do business successfully subject to their local statutes.  Relative differences among states become relevant primarily in cases of proxy fights and similar circumstances which are unlikely to occur with a startup (you better figure how to avoid them).  Instead, incorporating out of your state of primary operation is sure to require additional costs such as for multiple state filings, "domestication" into the state where your head office is located, retaining a registered agent, and more.  In my view, when your business makes it to be part of the S&P Index and you develop high concerns for proxy fights, you'll have the cash to relocate it then whatever state is desired.

In the end all agree: avoid sole proprietorships.  Beyond that, be ready to adjust your corporate organization to match your budget requirements of your shareholders and investors.  

Marco Messina