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In this roundtable episode with the Nessa Group, we discuss the importance of accredited investors in venture capital, what it means to be an accredited investor, what the possible pitfalls are if the investors are not accredited, and solutions from various disciplines in the case that a business looking for venture capital happens to fall into this trap.
Enjoy the episode.
And welcome to episode six of our special mini-series with the NESSA Group. And let’s just start this off. Jim Huerta, how are you doing?
Hi, I’m wonderful. Enjoying the company and enjoying the conversation.
Thank you, sir. Barry Kolevzon, how’s it going?
Going very, very nice. And we’re very excited at the movements that we’re making to go forward again.
All right. I only like going forward never backwards, but I practice law. So, Wil Jacques is with us. How are you doing, Wil.
Very good to be here. Hello to our listening audience.
Justin, how’s it going?
Doing great. Compliments on that joke.
Thank you, sir. Justin’s buddy over there, Scott Mautner. How you doing Scott?
I’m doing well, thank you.
And since you and I are attorneys, what firm are you with?
I’m with Harrington, Ocko and Monk.
And I’m managing partner of Verna Law, as well. So let’s start here. Scott, this situation came from you. An entrepreneur had a great idea. Some friends worked on source code with this entrepreneur to launch an app. There were some issues there and I believe they came to you with already $2 million raised.
Scott Mautner: (01:13)
And with unaccredited investors.
Anthony Verna: (01:16)
Yeah. So that $2 million came from unaccredited investors.
Not all of it, but some of it, yes.
So, all right, let’s start here. What’s the difference between an accredited third party and an unaccredited third party?
Scott Mautner: (01:30)
So under the securities laws to be accredited, you need to have income individually for $200,000 per year or with your spouse of $300,000 per year or have net assets excluding your home value of over $1 million. And so when you’re raising money, it’s a lot easier because you don’t have to provide the amount of information for accredited investors that you would for unaccredited. So, when we raise money, we always want to do it with accredited investors. And if you don’t meet the security laws, exceptions and rules relating to that, what happens is your investors can rescind their investment at any time. So, you could be running a company for four years and someone finds out that you didn’t meet the exemptions you need under the securities laws. And they could say, I want my money back and you have to give them their money back. So it becomes a much bigger problem than just, “Oh, I forgot to give them financials.” or “I forgot to give them this or you know, other information.” So that’s the first thing. And, and you know, every sort of company when you’re dealing with venture capitalists and angel investors, they’re always going to want to deal with accredited investors. It makes it simpler.
Anthony Verna: (02:45)
So is that what the definition of bad securities exemptions are, is the ability to take that money back?
Scott Mautner: (02:51)
Effectively if you have a bad offering? Yes, it would be rescinded. Rescission of the offering.
So basically if somebody is not accredited, could take the money back and if you said a company is working for four years and maybe they’re burning through capital, they don’t have that.
It’s a problem. Yes, yes. Yeah. I mean there’s ways to fix it, but the best way to fix it is just to make an offering from the get go that includes only accredited investors and it also avoids a lot of other issues.
So this group of people came to you, did they have any signed agreements within themselves?
Scott Mautner: (03:28)
No, but we’re going back in time and putting all the agreements in place. So, what you have to look at is obviously you’re re constituting the company, it becomes a bigger issue. Cause obviously you start to look at what evaluations, how much money as people put in, what is the equity split of the business? What have people contributed to the company in terms of in your world IP, cash, other things, whether there’s notes that have been put in place and whether this is considered data or equity, whole lot of issues to go through.
Anthony Verna: (04:13)
Right. So let’s talk about some of the IP issues. Wil, if there’s a patent here in the software and, let’s get over the hump of the difficulty of getting an algorithmic patent involving the software. But if there’s something patentable here, where the ownership lie, especially without an agreement?
It lies with the inventors in the US right.
And I am now in the copyright issues as well. If there’s no work for hire agreement, it vests with the author and everybody else who’s involved would totally have no rights whatsoever.
I get calls from people like Scott all the time where that hasn’t been determined up front and now there’s an argument during the formation of the company as to who owns what.
Right. If there are any in a situation like this, if there are any trade secrets whatsoever, they’re probably not going to be deemed secrets at some point because there is no confidentiality agreement in there as well. So, without an agreement, no confidentiality. Chances are as well, I’m assuming that the information probably wasn’t kept behind multiple passwords or systems like that as well. So the whole trade secret idea kind of would fail completely with a company like that.
Yep. All the IP as effectively been retained by the original people. That company doesn’t own it. And what we call that is the tail wagging the dog. It becomes a big problem because the inventors, if you go to them now and say, “Hey, can you assign over the IP? We’re raising money.”
Anthony Verna: (05:55)
Hell no. Hell no. Pay me a lot of money to do so. And so it becomes an ongoing sort of problem from the get go.
Anthony Verna: (06:08)
So, we can end questions of IP ownership in any agreement to form the company, whether it’s the articles of organization or whatever it might be…
No, we would use people like you and Wil to prepare the work for hire and assignment proprietary assignment agreements with NDAs involved so that at least the initial software and or other IP is assigned over to the company. If you’re issuing equity in exchange for that, go put in the appropriate documents on the equity side, which would be things like restrictions on transfer, drag along rights, lock up rights, anything you’d sort of see, um, that would prevent people from selling their equity. You might discuss vesting over time because if you expect the inventor to continue to work for the business, you may not want to issue all of the equity upfront because what tends to happen is they stopped working over some period of time and then you end up fighting over the equity that you’ve now granted them.
Anthony Verna: (07:16)
Well, let’s talk about that from a human standpoint, Jim. And a lot of inventors create something. A business gets started, right? And, at some point it might not be vested, but they’re tired of working in the business and because they’re tinkerers, because they’re inventors because they’re creative type people, they want to go to the next thing. What are some of the human ways, Jim, that you would advise a company to handle that particular situation? And we’ll go back to Scott for some of the legal thoughts on that.
If I understand your question correctly, it’s this whole idea of the focus that they’re going to put on this particular product or this endeavor that they’re getting tired of. Is that right?
Anthony Verna: (08:00)
Well, yes, absolutely. Because a lot of inventors get tired. Yeah.
Speaker 3: (08:04)
There’s a point you encourage that kind of behavior if you see that their minds heading in the same direction and they’re becoming byproducts to what they original started with because that’s a way to keep, in my mind, keeps someone focused on where their mindset is and why they invented it in the first place. But usually what I do from a human perspective, if a fact the company or the people can afford it over, have someone in their group that can do it, I like a dedication of an individual that I know is going to stay grounded to that particular task as opposed to one heaving it and moving onto the next thing. And now you have 12 months, 15 months of no progress. So I kind of like the idea of creating some kind of way that there is some handoff where you don’t kind of discourage yourself and walk away from the project, if it’s value is worth it.
So basically, if I’m using a carrot stick analogy, what you’re trying to say is keep a carrot out there for the inventor to stick around or maybe go out gracefully, slowly so that we don’t have some kind of cut off.
I think the carrot is a good thing. I think the key is to, let’s say you’ve been with this inventor for a while and you know, the aptitude and the way their mind works. And how possessive they are of what they come up with. You have to, in the business, keep looking at what they have in front of you and keep thinking about things that you can create from that main product or what are the things that you can say, “you know, I bet if you did this and did this”, this might be what you’ve done there is that you’ve kept them within there where they’re happy to have walked away from the main product yet you’ve making them and pointing out to them that there’s other things that can come from that main product. You’re trying to keep them with some kind of interest, like having a four-year-old kid and trying to keep them occupied. Okay. You don’t, if you see the Valley, you can’t let this guy walk away because he truly is or, she is the person that knows what’s going on.
Justin, I know that you have experience with this particular situation with that founder who’s like getting a little tired with that company. How do you work with businesses that are beginning to to see that inventor fade away?
I think it’s a big problem and not only for inventors, but all cofounders of our business. One thing I’ve noticed today, because today it is much easier to start a business or to try to start a business than it has been 15, 10 years ago. I see a lot of founders, not a part of just one project anymore, but dabbling in a lot of different things and kind of not, and not everyone, but I see it enough now where they’re diluting their attention across multiple projects to see which hits. And I think it’s very important for any team, even if for a small business that’s been established to have a unified vision on what they’re looking to accomplish with specified roles and expectations aligned. As a business owner, if it was, let’s say a company I founded and I was inviting others in to participate, I would want to keep them inspired and incentivized. But I’d also want to protect myself divesting idea is one way of doing that. There could be revenue being produced, there could be profit sharing, success metrics. There’s a lot of different ways. But as a business owner, you want to protect yourself, but you also want to inspire and incentivize them to continue doing a great job. And I would also say as an inventor, there’s big differences between creating products and creating software. And the way you would look at that is completely different.
Anthony Verna: (11:44)
So, since you bring up that particular topic, how do you look at a company making a product that you can hold in your hand? Software, Which is generally intangible.
Justin Tripodi: (11:57)
It’s not to be over-generalize, but a product is something that I think depending on what it is, whether it’s a mold, a unique design is something that’s done in a more collapsed period of time. They might be reinventions to it along the way. But with software, it’s constant development. The level walls software today is you, you typically have your MVP product that you put out, which is a very watered down version to prove your value proposition in the market. And then you continue to develop around there. When you are teaming up with an inventor or a software developer, they are very important to your business. If you are a technology company and you try to go forward and even raise money without a technologist on your team, you’re going to have a lot of people perking their ears at you. CTOs or people in those positions are very important for technology or software based companies. Those individuals should be incentivized to participate in the company in both the short term and the long term.
Anthony Verna: (12:54)
And, and when five, six people may have raised $2 million but they don’t have any signed agreements, they don’t necessarily know how they’re working together. It doesn’t sound like that particular scenario matches up with your best-case scenario.
Justin Tripodi: (13:07)
It’s unfortunately not something that I haven’t seen before. And I’m sure you, obviously you guys have not. There’s a personal side of the business so hopefully they can figure it out. It could easily get messy if people try to get over greedy. But then they’re all gonna have or trying to get a whole lot of nothing. They need to figure out a way to play together, um, figure out both time served, what the value was that was brought to the table so far and what their expectations are going forward. Because the work, any startup, especially within software is heavy lifting and there’s always a lot to do. And if you have one individual who’s trying to swallow up a lot of equity without being willing to put forth the effort to go forward, they’re going to suffocate the company because it’s going to prohibit that company from going in and finding the other talent that would be required to continue growing it.
Anthony Verna: (13:57)
All right. Scott, getting back to this idea of vesting, what are some of the structures that you have used in the past to keep a structure like this together and to keep those founders in a business?
So usually you see this in a few different ways, but usually there’s a protagonist for the business. So that person has an idea. They bring in other people to work with them and help them develop that idea. And so what you’re looking at from the quote real founders point of view, the protagonist that I just said is they have to figure out how much equity they’re willing to give up to keep people, as Justin said, incentivized and engaged in the business. What I’ve seen on more than one occasion where sort of the protagonist brings in a cofounder and where you’re bootstrapping the business and people aren’t getting paid and are kind of working through what they have to work through.
And this is all in the early stage sort of business world. Any of the people who come in to work with the protagonist tend to fall off over some period of time because they’re not getting paid and they want to get income and they want to look for other ways to develop their own personal sort of situation in the business world then. So what you’re looking to do as the protagonist is one, you can obviously do stock options and give them equity and have that vest over time. And you know, the standard vesting of a one-year cliff and 25% is still out there. But people definitely play with that. You can do stock grants or where you’re actually granting someone equity up front and that vests so over time as well, that that affords some holding periods and allows them to get better tax treatment on the back end.
But you’re really relying on the vesting and the time value of keeping someone involved in the business to keep them engaged because until you really raise additional money and can pay salaries, people are only gonna be incentivized as Justin was referring to through the equity version.
Quick question, Scott. Is there a difference and if so, what is the difference between a stock grant and a purchase warrant?
A purchase warrant?
A warrant to purchase assets of the company? Are they one in the same? Because I’ve seen…
A warrant is actually just a contract or an option to buy equity in the business on a going forward basis. Stock option is the same thing. Typically when you talk about employees and consultants and people who are involved in the business and providing services, you’re talking about stock options. Typically warrants are issued to third parties… in years past, companies would sometimes issue units consisting of stock and warrants together when investors bought a unit so they would have the warrants as well.
But a warrant is typically not used in connection with actually financing the business or issuing equity to employees and consultants and advisors.
Thank you. I also think it’s important for the audience to know what a cliff is. It was something I was going to bring up. Do you want to explain the cliff and the purpose behind it?
So a cliff is a period of time, again, it’s usually one year, but an employee or a consultant needs to provide services on an ongoing basis to the company for at least that one year to vest their initial traunch. And the reason why you have the cliff is because of what we were talking about here is employees, consultants get tired, bored, need to move on with their lives and leave before the end of the year. So, you’re not actually granting someone equity for not fulfilling their obligations and moral sort of imperatives that they’ve agreed to with the company.
Justin Tripodi: (18:06)
I like to think about that as a dating period before getting married.
Every business partner should date before they get married. And I actually think that that’s a very important point that Justin has brought up. Like Scott, if these five guys, I mean like are old college friends, I mean, chances are they might be able to work well together, but if they’re old friends, a friendship and a business relationship are radically different.
Hundred percent, 100%.
I guess it depends on whether or not you’re falling off the cliff or if you’re moving over a bridge.
Or being pushed off the cliff.
Barry, in our previous episode, we were talking about a company that had been around for a while, where as in this episode we’re talking about companies for the most part that are new. But when you see a company that is long term, 15 years, and the founders are they excited? How do you keep them excited if they’re coming to you for business advice?
Barry Kolevzon: (19:15)
Well, one of the things when I had conversations with them, I was very, very reserved,
Anthony Verna: (19:20)
Meaning like, they’re kind of tired of this business, like, gee, this isn’t the way we thought it would go?
Barry Kolevzon: (19:27)
I think they were ready to throw up their hands and go out of business and retire. Maybe, they just found another business. They want to sell this one and they want to move into a more profitable business. Well, because when you do it the first time and you set it up, you’re in there as they have been here, I would like to sell it and then do another company. You know, there are people that do that to build their companies.
Anthony Verna: (20:01)
Sure. I think one of the thoughts that we have that we have all mentioned is that we are thinking positively about, a group of five people have already been able to raise $2 million and they have some source code but they don’t have an app that works yet. I’m putting my IP legal hat on. I sit here and I’m like, well, what if there’s litigation? I mean, what if somebody isn’t, what if they go and they file some documentation, but maybe the copyright is not filed properly. Maybe the patent, you know, only has the inventor, doesn’t have an assignee on it. And what happens if there’s litigation, then you’d wonder who the plaintiff is and then after that if there might be a recovery, it’s not going to the business properly. You know, I look at issues like that and it just kind of actually freaks me out more than trying to think positively. But one good thing I like is that we’ve thought positively about this particular situation to make sure that the business is successful in the long run. So, Scott, I want to say thank you for bringing this particular situation here and does anybody else have any closing thoughts on this particular matter?
Justin Tripodi: (21:19)
Only to what Barry was saying before. I think especially when you look at either a startup or a more established business and the founder themselves is personally what do they want out of this business? Sometimes people are very content with running a smaller business that might be doing a couple of hundred thousand to low millions a year. Some want to blow it out of the water and try to get $100 million valuation. It’s very important to understand personally what your client or your partner’s goals are. Long term goals, the long trade, short term and long term goals. Just very quickly, I have a client in California, in the essential oils business. He grew the business to $3 million has and he’ll sell full claim, limited understanding of business. He is a herbologist, acupuncturist, student of Eastern medicine. He’s been able to embed that in the mission of his company and reach clients, but from a business point of view, even reaching 3 million they lost money the last two years. And he was at a point where he was talking with me about raising money for his company, diagnosing the problems which are marketing and technology with no wholesale presence in the market. And he started at the same time as two industry giants, doc Terra and Young Living, both of which are billion-dollar clients, different business models. They’re multilevel marketing.
Anthony Verna: (22:32)
But essentially selling similar products with a much greater profit line.
Justin Tripodi: (22:36)
Exactly. And he has a high-quality product would even a higher profit margin. Okay. But in talking with him and learning what he wants to do, is he wants to be a teacher, he wants to be an educator. He does not want to run a business. So, the strategy we went forward with was to find an acquisition to look for an acquisition to so 90% of the company keep him in at a carried interest to continue being an educator, creating content and product development, but let a better company and more experienced company run the day to day and scale the business.
Anthony Verna: (23:08)
You know, when you said that that he wanted to be an educator, the first pop, first thought that popped in my mind was content and video. That just sounds like exactly what he wants to do.
Justin Tripodi: (23:17)
He is infectious, so is his wife. They can be phenomenal brand ambassadors for the business. And that’s how we positioned them. I mean they have a following over 261,000 emails of people who tune in for their content on how to use their products and learn about natural organic home remedies. It’s pretty inspiring. It’s as now the business instruments and processes and methodologies need to get put in place and they’ve been missing for awhile.
So, Justin, why did they sell it versus going out and hiring a CEO who could potentially run the business?
Great question. We explored that. We actually interviewed a CEO who lived 45 minutes from the facility who has direct industry experience growing similar businesses from low millions to 30 million. We talked about bringing them in. There’s a large cashflow issue within the business. Raising money that would be necessary would would necessitate giving up a large chunk of equity within the company and his interest is not owning or running the company anymore. We’ve had a lot of lengthy, lengthy discussions with him. He’s ready and willing at the point of his life to kind of turn this over to someone else. Now part of this acquisition process, and we’re going to through that right now to deal, I should actually talk to you about because there’s a lot of latent value in this business, this tremendous opportunity. His current factory can scale to 30 million with limited capital expenditures which is exciting. We just have to position him where his talents are best served and he’s fully aware of that, which is great for a client because you get a lot of clients who understand they have a problem but don’t want to change.
Scott Mautner: (24:51)
No, it’s, he’s very enlightened in that sense.
Yeah. I think that’s, that’s a fantastic story to end this episode on. Jim, as always how can everybody find you?
If you want to know more about us and what we’re all about, go to www.thenessagroup.net. Thank you.
Thank you very much for listening. We’ll see you soon with our next episode.