GUEST POST: Startup questions, Foster Garvey answers

[Editor: It’s always a pleasure to get the chance to collaborate with folks in the Portland startup community to make things easier on founders around here. That’s why I was super happy to Jason Powell from Foster Garvey volunteer his time to discuss a variety of startup topics from his perspective. His responses to a frequently asked set of startup questions is posted in its entirety, below.]

Describe the Portland startup community as we, haltingly, emerge from the pandemic? What changed? What does the near future look like?

Startup activity often picks up after an economic slump. Portland’s startups are a strong reflection of the city’s diversity and commitment to improving the quality of people’s lives, be it through social interaction or the conservation of the natural world.

I am extremely bullish on the Portland startup market, and I believe that as it emerges from the pandemic Portland will continue the trend of becoming a player for meaningful, valuable companies that are building products that are globally attractive. I expect to see growth in tech, consumer product (including apparel) and food startups that will continue to result in an influx of talent and capital into the metro area. The rise of startup incubators and coworking spaces has been a boon to bootstrapping startups, allowing entrepreneurs to connect and collaborate with other entrepreneurs which helps foster ideas and growth.  

In the first quarter of 2021, venture investors pumped a whopping $398 million into companies in the Portland metro area, according to the latest Venture Monitor report from the National Venture Capital Association and research firm PitchBook. The amount was across 44 deals, and like the national trend, it was skewed to mostly late-stage deals. In the second quarter of 2021, there was $187.4 million invested across 32 deals, according to the report compiled by Pitchbook and the National Venture Capital Association. In the second quarter of 2021, across the entire state of Oregon there was $228.5 million invested across 45 deals. That’s up from the second quarter last year when $173.7 million was invested across 34 deals. Deal count and dollar amount is up from the second quarter last year, which was disrupted by the onset of the Covid-19 pandemic. The second quarter of 2020 saw $162 million invested across 28 deals.

Is SPAC-mania over? Is this a good or bad thing for startups looking for funding?

Special Purpose Acquisition Companies (or SPACs) raise money in an initial public offering (IPO), which is placed in a trust account to be used for the sole purpose of identifying, acquiring, and merging with a private target company. In the process, the private company receives a public listing and a fresh infusion of cash from the SPAC’s trust and/or a concurrent private investment in public equity offering.

According to Bloomberg, 300 SPACs were launched in the first quarter of 2021 alone, which was more than the approximately 250 launched in all of 2020 (and 2020 saw three times as many SPAC IPOs as 2019). The pace of SPAC IPOs slowed in the second quarter of 2021, primarily due to two factors. One, new guidance issued by the U.S. Securities and Exchange Commission (SEC) regarding accounting rules applied to SPAC warrants and two, concerns regarding the SEC’s increasing focus on SPACs.

Despite the slower pace in the second quarter, SPAC IPOs remain above historical levels. More than 400 SPAC vehicles are still looking for acquisition targets.   

I believe that increased exit opportunities for startup founders, including SPACs is a good thing for startups and their investors. However, the lackluster aftermarket performance for SPACs, both pre- and post-acquisition, could intensify the downward pressure on the attractiveness of a SPAC for a startup.  

Is venture capital money flowing all over the country, or still predominantly in coastal areas (heavily on the West Coast), such as Portland?

In 2020, $156.2 billion of venture capital was raised in the U.S., according to a report by PitchBook. Of the total, 22.7% of the dealmaking occurred in the Bay Area, and 39.4% of deal value was invested in Bay area-headquartered companies. According to PitchBook’s 2021 US Venture Capital Outlook report, the Bay area’s share of total VC count in the U.S. will fall below 20% for the first time in history, while other cities around the country grab larger amounts of equity capital for their home-grown innovators.

Big investors are moving to other cities where great disruptive ideas are bubbling up. Remote work makes it easier for talent to live outside of Silicon Valley and capital is following the trend. A startup no longer need to be down the street from your investor if you are an entrepreneur. A PitchBook analysis revealed the hotspots attracting VC activity beyond the Valley, including Austin; Atlanta; Los Angeles-Long Beach; Boston corridor; New York metro area; Seattle-Tacoma; Washington D.C./Baltimore/Arlington area; San Antonio, Texas; Denver-Aurora area, Chicago and Philadelphia.

I believe that startups with strong teams and appealing business models will be able to attract venture capital, regardless of the startup’s location.  

In your experience, what are some of the critical areas/items to be concerned about when forming a startup?

Launching a startup requires not only making important business decisions, but also the right legal ones in matters such as entity formation, financing agreements with outside investors, equity distribution among founders and employees, IP ownership, and corporate governance.

In my experience, some of the most critical elements any startup should meet to avoid a list of potential legal issues are the following:

  • Postponing engaging proper legal counsel: Many entrepreneurs are focused on their technology, product and/or service, and the business of selling it, and they delay engaging competent legal counsel, assuming that they cannot afford to do that. They may instead take advantage of do-it-yourself legal products, including templates, or copy forms or documents found on the internet. This bootstrapping approach may save money in the short term but can create significant problems in the future.
  • Not incorporating as an entity early: Companies are legal entities that can own property, enter into agreements, and have debts and obligations. Creating an entity allows a founder to separate business dealings from personal dealings. In particular, creating a startup, whether an LLC or corporation, insulates the founders’ assets from the debts and liabilities of the business. Additionally, incorporating and issuing founders equity early, a founder can put a low value on founder’s shares and, thus, avoid potential personal tax bills associated with receiving equity worth more than nominal value.
  • Failure to have proper IP assignments to the startup: Failure to have intellectual property (IP) rights assigned to the startup can result in expensive disputes over the rights to the IP. For example, a disgruntled inventor that retains his or her patent rights could give the startup’s direct competitor a license to the patent, thereby destroying the value of those patent rights. Properly counseled entrepreneurs will ensure that all IP created for or on behalf of the startup is assigned to the startup. This assignment of IP is often done in connection with the issuance of equity to the inventor.  
  • Improper or unwise equity issuances: Entrepreneurs that incorporate will have equity ownership in the startup that can be assigned to founders, employees, investors and others. Equity that is provided to employees should vest according to some specified period – so that employees are incentivized to continue working for the startup and help earn their ownership. Equity can also be used to barter for services and funding at later stages in the development of the startup. Properly counseled entrepreneurs will ensure that they do not immediately assign all equity but, rather, use vesting periods and reservations of equity to allow for the growth and development of the startup. Properly counseled entrepreneurs will also ensure that all assignments of shares comply with the federal and state securities laws. The basic rule is that all securities that are sold must be registered unless exempted from registration. Transactions involving directors and officers of the startup are exempt. Transactions involving persons and companies of substantial means are generally exempt from the registration requirement. But transactions involving persons of limited means – e.g., family or friends – may not be exempt if not issued in the right manner. Failure to comply with the registration requirements may hinder a startup’s ability to raise funding, since it allows purchasers to recover purchase price plus interest.
  • Lack of written agreements: Putting an agreement in writing is important for numerous reasons. Written agreements are good for business as they commemorate and set forth terms explicitly. Written agreements are not subject to the vagaries and inconsistencies of memory, and thereby help ensure that there is a mutual understanding of the terms of the agreement. Written agreements may also require more critical assessment than a conversation, and so may represent a more precise and stronger commitment. 
  • Noncompliance with employment laws: Properly counseled entrepreneurs comply with employment laws and knows that these laws may differ from city to city and state to state. Employees must be paid at least the minimum wage plus overtime, in cash, at least once a month. Certain roles are exempt from overtime requirements, including administrative and white-collar positions. In an ideal world, employees will sign an employment agreement or offer letter that identifies their wages, position and basic duties so that there is no dispute about what is due or what their role is

Should I be concerned about ESG?

Startup founders might hear “ESG” (environmental, social, governance) or “sustainability” and think those terms are simply buzzwords that are not relevant to their startups. ESG factors describe how a company impacts the world around it. Specific ESG issues relevant to a startup will differ depending on the industry and business model of the startup. ESG issues may include:

  • Environmental: Environmental factors will vary widely based on a startup’s business. Relevant environmental factors for an e-commerce startup may include composition of packaging and carbon emissions across the supply chain. For manufacturing businesses, relevant environmental factors could include ingredient/material sourcing, energy efficiency and waste disposal.
  • Social:  One social factor relevant to nearly all startups include data protection and cybersecurity. Other important social factors for startups are community relations and social inclusion, including businesses that sell ethically or sustainably sourced products, employ persons with disabilities, or engage in philanthropic activities.
  • Governance: Governance refers to aspects of a startup’s culture, structure, policies and procedures. Investors often examine a startup’s culture as an indicator of the startup’s resilience and reputational risk. Signs of a toxic startup culture such as high employee turnover and complaints about workplace bullying or harassment are red flags to investors.

In light of the increased importance being placed on ESG across the globe, startup founders should be concerned about ESG. Being ESG conscious can:

  1. Attract investors.  Many investors are increasingly integrating ESG factors into investment decisions in light of their risk analyses and pressure from their investors.
  2. Enjoy a competitive advantage. Numerous studies have shown that companies prioritizing ESG issues perform better across several financial metrics.
  3. Better reputation. A focus on ESG could help a startup build trust with consumers and distinguish it from its competitors.
  4. Attract and retain employees. Millennials and Gen Z, now the largest generations in the workforce, are seeking more purposeful employment opportunities

Can I raise capital from anyone?

The simple answer is no, however, raising capital isn’t as simple as pitching an idea and receiving funds. When a startup takes in capital from investors, the startup in general is selling an equity piece of ownership interest in the startup. The equity in the startup being sold is a “security” under federal and start securities laws. Under federal and state securities laws, when a startup sells a security, that security either has to be registered or an exemption from registration must apply. 

The requirements for an entrepreneur to raise capital while remaining in compliance with securities laws and regulations can be quite onerous. The entrepreneur will be required to navigate the confusing set of laws and regulations involved with private placements. In addition, the entrepreneur will have to carefully consider what it will disclose to investors, to ensure that no misleading statements are made, and nothing is omitted that may cause the other statements that are made to be misleading. The result is a private placement memorandum. Usually, all of this can only be accomplished with the help of a securities attorney. 

At the extreme end, it is possible that the startup and its principals can face criminal charges (both state and federal). Even if no charges are brought, the U.S. Securities and Exchange Commission (SEC) or state securities commissioner can, and often does, bring claims for civil penalties, such as monetary fines and injunctions against any further capital raising activity. An even more likely situation to occur is where investors lose their capital investment in a startup, and then, decide to sue the startup and its directors and officers to have the securities offering rescinded. An adverse judgment against the startup could require the startup to return investor capital (potentially often out of the principals’ own personal assets if the startup no longer has the cash). Furthermore, many debts due to violations of securities laws are non-dischargeable in bankruptcy, so violators could be burdened with a large judgment for the rest of their lives or worse.

The consequences of an entrepreneur ignoring securities laws and regulations and not taking appropriate steps to ensure compliance goes beyond civil penalties, fines, and injunctions and extends to criminal liability. In fact, when a startup issues securities improperly and intends to issue exempt securities but, either intentionally or negligently, fails to follow the guidelines necessary to qualify for such an exemption, the result is termed a “busted exemption.” This essentially means that the issuer has failed to attain an exemption from registration, and has, in fact, illegally issued securities which were neither exempt nor registered. By doing so, if investors clamor for a return of their investment capital, and if the startup can return the investment as part of a rescission, most investors and regulators will be satisfied. However, the more common situation is that investor capital is spent and cannot be returned, and this is extremely dangerous for startup founders because they have essentially illegally accepted investor capital, and if this illegal action is pursued by an enforcement agency such as the US Attorney’s office, such action will be considered criminal and felony fraud.

In addition, violating securities laws in the early rounds of fund-raising for an entrepreneur could doom future efforts to raise capital. Once the entrepreneur goes beyond the seed or “friends and family” rounds, it will likely seek to raise money from angel investors, venture capital firms and high net worth individuals. The problem is that these later investors will likely perform due diligence on the startup and its principals. This will include reviewing any past sales of stock or debt. When sophisticated or institutional investors discover the securities violations, they will either lose interest in the startup or they will reduce the startup valuation to take into account the contingent liability that needs to be added to the startup’s balance sheet for any potential lawsuits or civil penalties. In the least, non-compliance with the securities laws will be expensive because the entrepreneur will have to pay lawyers to “clean up” the damage that has already been done.

If a startup company intends to raise money from investors, even a small amount on initial rounds, it is in their interest to expend the time, financial resources, and effort into ensure that the capital raise is conducted in a manner that is in compliance with securities laws.

Jason M. Powell is a principal at Foster Garvey, operating out of the full-service law firm’s Portland and Seattle offices. As a results-oriented dealmaker, Jason enjoys creating solutions that bring together great people, projects and capital. He can be reached at (503) 553-3185 or jason.powell@foster.com.