I had the great pleasure of interviewing Rob Dellenbach and Don Reinke, from Reed Smith

 
Roe:   Why should a company incorporate?

An entrepreneur should consider incorporating or forming a limited liability entity for at least three reasons:

i.  It provides a barrier to liability.  If organized and operated correctly, a corporation or limited liability company can shield the entrepreneur from personal liability for the acts and obligations of the company.

ii.  It allows the entrepreneur to share equity.  Corporations allocated equity ownership (shares) among shareholders.  Limited liability companies grant economic rights to members.  Equity ownership can entitle the holder to voting rights, dividends and other ongoing payments and payments on liquidation of the business.  Significantly, equity ownership can provide tax advantages in the form of favorable capital gains tax treatment on sale.

iii.  It offers a vehicle for holding valuable intellectual property and other assets contributed from multiple sources.  Patentable inventions, copyrights, trade secrets and other assets developed by multiple individuals generally remain the property of those individuals unless the assets are assigned.  By aggregating assets in a single entity, entrepreneurs build value in a way that can be shared with and sold to others.

Roe:  When is it the right time to incorporate?

An entrepreneur should incorporate or form a limited liability entity when:

i.  There is a prospective commercial, business or employment relationship.  Entering into an agreement with another person or conducting business with others exposes the entrepreneur to liability.  The entrepreneur’s liability can be limited if the agreement is entered into in the name of the company and the business is operated under the umbrella of the corporation or limited liability entity.

ii.  There is more than one founder and value is being created.  When multiple founders begin to discuss a venture, they need to consider the impact of a founder withdrawing or other founders moving ahead alone.  An entity provides a vehicle in which to centralize the intellectual assets of the founders and offers the opportunity to allocate ownership.  Founders may defer the cost of forming the entity for a time to see if there is true value in the venture; but delaying too long risks losing key intellectual property or ownership rights.

iii.  The company seeks investment.  Investors generally want to invest in entities. Although they may lend to individuals, investors buy equity from entities.  They want tangible rights and the benefits of capital gains taxation.  

Roe:    Why should a business owner hire an attorney?

Key reasons to hire an attorney include:

i.  A good business attorney knows the ropes.  By working with many companies over long periods of time, a seasoned business attorney is exposed to many more of the best practices and pitfalls than any single business owner is likely experience alone.

ii.  The best outcomes require advanced planning.  Taxes and unnecessary business expenses can eat into a business owner’s profits and expected returns.  Setting up the company and conducting business according to a well conceived tax plan can help maximize the business owner’s take home pay and long term profitability.  An intellectual property protection plan can pay enormous dividends if wisely conceived and executed.  However, it is easily to unwittingly lose intellectual property rights – particularly patent and trade secret rights, which can be lost forever by disclosing or using information without taking adequate steps to protect them.

iii.  Liability lurks around every corner.  Even in business environments based primarily on trust and good will, disputes happen.  For some areas that are fraught with liability—such as basic employment matters and preparation of simple tax returns—resources are readily available to guide the entrepreneurial and cash-strapped business owner.  Other areas, such as tax planning, patents, finance, stock options and equity incentives, should not be attempted without the guidance of a skilled attorney.  

Roe:  Do you help connect your clients to investors?  If yes, share some tips on getting funded?

We introduce qualified clients to potential investors.  Within our firm, we have relationships with principals at all of the major venture capital firms and have contact with many angel, private equity and corporate investors.  We value our investor relationships and are very selective in making introductions, and we help our clients to make sure they are ready.

Success in obtaining funding involves several factors, including (i) the size of the potential addressable market; (ii) the strength of the founders and management team, (iii) competitive advantages, such as intellectual property, complexity of the problem the company solves, a head start in the market and other barriers to entry, and (iv) finding a qualified investor who is interested in the company.  This last factor should not be underestimated.  Whereas most business owners can walk into a commercial bank and have a sense of whether they will obtain a loan (if you qualify according to some relatively objective criteria, there is some reasonable likelihood you will be able to get a loan), finding startup equity is very uncertain.  The market is disaggregated – each individual or investment firm has its own criteria and needs to do its own review of your opportunity.  Even among the largest members of the venture community, no single venture firm invests in a sufficient number of companies for the outcome of an investment pitch to be in any way predictable.  So you need to talk to many potential investors, each of which may think your company is great, but won’t invest because they have three other prospects that better meet their very particular criteria and timing.  The most salient predictor of investment success is past success with an investor.  So one of the best things a new entrepreneur can do is ally with other entrepreneurs who have done well for their investors.

Roe:   Do you do pro bono work?  Why types of companies do you do pro bono work for?

We do pro bono work for a wide range of people and organizations.  Our firm helps indigent individuals with basic legal matters, such as landlord-tenant disputes as well as high profile political asylum cases.  On the corporate side, we work with organizations that provide inner city economic development opportunities, support women entrepreneurs and offer funding alternatives in Africa and other developing areas.

Roe:   Since you help with venture finance, can you share with us how companies get valued during funding?

Valuation in the venture world is certainly an art, not a science.  By definition, an interesting venture for a VC is one where there is an unbounded growth opportunity and great uncertainty as to how and whether the opportunity will be realized.  Because of the lack of certainty, traditional valuation methods, such as book value, discounted cash flows and comparable valuations, often do not offer meaningful guidance to an investor setting the pre-money valuation of a company.  Rarely do venture investors look at what the company has accomplished or what it owns today as an indication of value – for example, early revenues reflect product and market validation, but generally do not correlate with the magnitude of the company’s long-term potential value.  Venture investors look backwards from the future.  After doing homework on the market and competitive solutions, they use a combination of experience and market data to determine whether there is an obtainable future value that will allow them, within their particular risk parameters, to make a substantial return, and from there, estimate the expense, dilution and risk that stand between the investment today and the various levels of possible future returns.  The prospective investor determines or validates the entrepreneur’s estimates of the amount of money needed at each stage of the company’s development, then looks at how much of the company they will need to own in order to achieve their projected internal rates of return and control objectives.  The amount of money required for the investment divided by the required percentage of the company yields a current post-investment value used to set the price of the investment.  For example, if the company needs $2 million of investment, and the investors want 1/3 of the company’s equity for that investment, they are placing a value of $6 million on the company, including their investment, or $4 million on a “pre-money” basis.  This is of course a simplified explanation.  There are many other factors that go into the valuation process, and there are as many different approaches as there are investors.

 
Rob Dellenbach

Rob Dellenbach is a partner with Reed Smith LLP and co-chair of its clean tech practice. His practice focuses on high-growth companies, their financing and their strategic, complex and cross-border transactions. He has more than 20 years of experience working with technology, life science, energy and clean tech, online media and hosted services, and other high-growth companies. Over the course of his career, Rob has led teams that have advised clients on hundreds of venture capital and private equity financings, mergers, acquisitions, public offerings and strategic intellectual property transactions aggregating several billion dollars in value. Rob serves as general counsel and trusted advisor to many of his clients. He’s particularly skilled in business planning and has written and advised on many of his clients’ business plans, private placement memorandums and prospectuses. Rob devotes many hours to pro bono representation and promotion of diversity in entrepreneurship and in the legal community. Rob can be reached at rdellenbach@reedsmith.com.

 
Don Reinke

Don Reinke is a partner with Reed Smith LLP and Vice-Chair of the Firm’s Global Emerging Company/Venture Capital Practice.  He has extensive experience as a corporate lawyer in the areas of venture capital finance, public securities offerings, mergers and acquisitions, and other general corporate representation of technology start-up and emerging growth companies, as well as venture funds and investment banks. Before joining Crosby Heafey in late 2001 to chair its Corporate Department, which combined with Reed Smith in 2003, Don was a co-founder and the managing partner of Bay Venture Counsel, LLP.  Previously, Don was also selected as a Northern California "Super Lawyer" by Law & Politics magazine and the publishers of San Francisco Magazine.  Don can be reached at dreinke@reedsmith.com.