VENTURE CAPITAL REVIEW
ISSUE 29 • 2013
PRODUCED BY THE NATIONAL VENTURE CAPITAL ASSOCIATION AND ERNST & YOUNG LLP
National Venture Capital Association (NVCA)
As the voice of the U.S. venture capital community, the National Venture Capital Association
(NVCA) empowers its members and the entrepreneurs they fund by advocating for policies
that encourage innovation and reward long-term investment. As the venture community’s
preeminent trade association, NVCA serves as the definitive resource for venture capital data
and unites its 400 plus members through a full range of professional services. Learn more at
www.nvca.org.
National Venture Capital Association
1655 Fort Myer Drive
Suite 850
Arlington, VA 22209
Phone: 703.524.2549
Fax: 703.524.3940
Web site: www.nvca.org
3
Fair Exchange: The Evolving Nature of Entrepreneurs and Venture Capital
By Bryan Pearce, Partner of Ernst & Young LLP
11
What’s Your 50+ Strategy? A New Investment Theme
By Jody Holtzman, Senior Vice President, Thought Leadership, AARP
23
Reengineering the Mechanics of the Exit Waterfall
By Michael J. McGrail, Patrick J. Mitchell, Alfred L. Browne III, Partners of Cooley LLP
29
10 years after PEIGG, is the world a better place?
By Steven Nebb, CFA and David L. Larsen, CPA, Managing Directors of Duff & Phelps LLC
36
Connell & Partners 2013 Executive Compensation in Recent IPO Study
By Jack Connell, Kim Glass and David Schmidt
50
Executive Severance Agreements and Policies in Venture-Backed Companies
By Pearl Meyer & Partners
55
Antonio Who? Investing in New Media and Social Media – When Legal Issues
Become Business Issues
Kristen Mathews and Paresh Trivedi, Proskauer Rose, LLP
64
Leadership Principles for Growing Companies
Elizabeth Brashears, SPHR, Director, Human Capital Consulting
The articles contained herein were contributed by our sponsoring organizations.
The views expressed should only be attributed to the authors and should not be
viewed as opinions of the NVCA.
2
Fair Exchange:
The Evolving Nature of Entrepreneurs
and Venture Capital
By Bryan Pearce, Partner of Ernst & Young LLP
Even through the last few years of challenging
economic conditions, entrepreneurs have been
undaunted in their optimism and their quest for growth
and job creation. And their outlook Is improving, as
overall economic conditions continue to advance
through 2013. A better climate will bolster market
demand for innovation and encourage investor interest.
Both private and corporate venture capital play a
significant role in the expansion of these innovative
businesses, not only guiding a company through
multiple rounds of financing but also actively
participating in company operations and the recruiting
and development of management talent. This
article explores the distinctive traits of successful
entrepreneurs and what characteristics venture
capitalists are seeking these days as they identify
companies with the best growth prospects.
Creating a bright future
Entrepreneurs are comfortable with reasonable levels
of risk even when there is a dull overhang of fiscal
uncertainty. The EY Entrepreneur Of the Year program
provides a ready source of insights as to what inspires
these individuals to continually perform at the top of
their game, and the important contributions they make
to the economy. For example, our annual survey of the
600 finalists in the 2012 US EY Entrepreneur Of The
Year program validates our belief that entrepreneurs
continue to be one of the world’s greatest sources
of wealth creation, expanding their businesses and
building momentum.
3
To succeed even in high-demand industries,
companies must still capitalize on opportunities,
solve problems, overcome competition, manage
their businesses effectively — and bring unrelenting
enthusiasm. It seems that passion makes an impact
in good times and bad. Often it is precisely “bumps”
in the economy that serve as the impetus to generate
the next great wave of innovation and growth. Between
2009 and 2011 – times of lackluster economic
momentum --- more than 72% of survey respondents
reported an employment growth rate of more than
20%. Nearly half reported raising capital through
venture capital, angel investment or private equity.
Among this group, we learned that, above all, passion
for their work is the primary driver.
Not surprisingly, finalist companies in certain industry
sectors experienced higher overall growth rates than
others. Companies in energy, cleantech and natural
resources led in employment growth, at 49% over the
period 2009 to 2011, closely followed by technology
(42%) and services (33%). From a revenue growth
perspective, energy, cleantech and natural resources
also led with two-year growth of 87%, followed by
technology (73%), retail and consumer products (49%),
and distribution and manufacturing (49%).
What’s special about these industries? For one, they are
“hot” fields, with demand for energy (including “clean”
energy), raw materials and innovative technologies
continuing to surge. Also, companies in certain
sectors, notably services, are not easily automated
and tend to involve hands-on operations that require
large workforces. The sectors generating the highest
revenue per employee, reflecting the highest productivity
and skill requirements are oil and gas, real estate and
construction, power and utilities, and mining and metals,
based on our 2012 finalist data.
These findings are consistent with those of the
National Venture Capital Association’s study Venture
Impact: The Economic Importance of Venture-Backed
Companies to the U.S. Economy. The study quantifies
the outsized contribution that venture capital-funded
companies make to the economy. In 2010, even as
venture investment constituted less than 0.2 percent of
U.S. GDP, venture-backed employment accounted for
11% of jobs in the US.
Passion is paramount
Operating in a hot sector does not translate
automatically to significant growth, however. Many
of these high-growth entrepreneurs can be found in
sectors that are not considered hot. For example,
among 2012 finalists in the Entrepreneur Of The
year program, those in the automotive sector had
the largest median revenue and second-largest
median number of employees, reflecting a “revenue
per employee” — a measure of productivity and skill
requirements — of $368,000, above the median of
$264,000.
Still more recently, as questions and concerns about
the global economy abound, many of the world’s most
successful entrepreneurs are not distracted from the
work at hand. In terms of standout growth, we find
dramatic evidence of venture capital’s contribution
when we look at the nominees and finalists of the US
Entrepreneur Of The Year 2013 program. Of the 649
company finalists, the revenue of those backed by
venture capital grew the fastest at 110% over the past
two years. In terms of employment, these businesses
bypassed all others in their growth rate of 86% over
the last two years
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The venture capital factor
Whether the current rhythms of venture capital are
speeding up or slowing down, the community —and
the approach — are here to stay. The principles honed
by seasoned venture capitalists are deployed by both
corporate and private investors. While the overall
emphasis in venture investing is moving from funding
early-stage companies to later, pre-IPO levels, what
they bring to the table remains the same;
Despite the absence of strong exit markets and the
related drop in fund formation, venture capital firms
raised $4.1 billion for 35 funds during the first quarter
of 2013, an increase of 22 percent compared to the
level of dollar commitments raised during the fourth
quarter of 2012, according to Thomson Reuters and
the National Venture Capital Association (NVCA).
• Patient and timely capital - With an equity stake in
the company, VCs share the risks that are an integral
part of day-to-day business. Good VCs understand
that timing is everything. For example, raising too
much capital at an inappropriate time can result in
greater dilution of value (Figure 1).
While the number of venture capital funds has been
contracting in recent years, it is important not to
lose sight of the increased activity in the world of
corporate venture investment. In fact, corporate
venture investment surpassed pre-dotcom levels in
2012 (see sidebar). Where corporates chose to invest,
typically in the later-stage, valuation was greater than
at companies at a similar stage without a corporate
investor. Corporate investors are keen to invest in
companies that have the technology and knowledge
base to fill their own gaps in strategy and innovation
capabilities.
• Vision – They share the passion and enthusiasm of
the company’s founders for the product or service,
and foresee a future of profitability and growth. They
also bring insights and experience as to what areas
of the company may warrant additional resources.
• Counsel – Members of the venture capital firm
are active participants in operations and decisions
around expansion, production and marketing, key
executive personnel and other strategic areas. They
often join the boards of directors.
In the US, during the period 2003 through year end
Q1 2013, on average, 25% of VC-backed companies
had a corporate investor — ranging from a high of
31% in the information technology sector to a low of
14% in the consumer goods sector. Also, corporates
participated in 13% of all VC rounds in 2012— versus a
recent high of 15% in 2006. Angel investors have also
been active, particularly with early-stage companies,
filling the void left by a consolidating venture
capital sector, which are moving toward later-stage
companies.
• Connections - The venture-backed company benefits
from an extensive network of advisory resources.
Figure 1: Trajectory of a VC-backed technology
company
117%
increase in valuation
160%
increase in valuation
The US data shows that the information technology
(IT) sector continues to attract the greatest number
of corporate investors — representing 39% of all
corporate deals through Q1 2013 and the highest
number of acquisitions. Activity in the IT sector is being
driven by a combination of healthy corporate cash
balances and the rapid pace of technological changes
as the rise of mobile, big data and cloud computing
creates a disruptive business environment.
189%
increase in valuation
$1 million
$4.5 million
$4.3 million
size of initial start-up
median size
median size
$3.3 million
median size
Start-up
Product development
Seed
round
Revenue generation
First
round
14 mos.
Second
round
18.3 mos.
First later-stage
round
18.8 mos.
Source: Dow Jones VentureSource May 2013
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Breakthrough ideas are not enough
For example, vision and fundraising skills are more
important than they were a decade ago. At that
time, fundraising was not as challenging, and the
marketplace of ideas was less competitive.
A venture capital general partner uses a highly
sophisticated selection process to determine which
companies the fund should invest in. As compelling
as a young company’s product or service might be,
the people and the strength of the management team
are the most important considerations for venture
capitalists when selecting potential investments.
This is one finding of a Spencer Stuart-NVCA study
that looked at the qualities and skills required for
today’s venture-backed CEOs.1 The study report
acknowledges that only the highest-performing
management teams can scale a young enterprise while
simultaneously dealing with a volatile marketplace.
Venture capitalists are also looking for a betterrounded CEO in terms of skills. It’s not enough to
be able to explain the product or service; the right
person is, on some level, good at many things and
can express a compelling business narrative. He or
she may be a technology wizard, but the individual
also needs a strong grasp of all the activities required
to commercialize an idea. When it comes to emerging
industries, the strong preference is for a CEO
candidate who has already worked in that field. And
finally, it is very important to find an executive who has
already worked in a small, growing company — ideally,
venture-backed.2
The Spencer Stuart-NCVA research also found that,
while the desirable qualities of a venture-backed CEO
have not changed, their relative importance has.
1
2
Spencer Stuart and NCVA, Emerging Best Practices for Building the Next
Generation of Venture-backed Leadership, p.3.
6
Ibid, p.5.
The Increasing Role of Corporate Venture Investment
In VC-Backed Companies
Many corporations realize they have an innovation gap – they cannot develop sufficient
innovation “in-house” to maintain their market leadership position and growth targets and
accordingly are eager to identify, invest in and, in certain cases, acquire venture-backed
companies to fill in the gaps in their strategy and innovation capability. They are looking to
acquire companies that fill out their strategies and enable them to “disrupt” rather than risk
“being disrupted” and lose their leadership position. From 2012 through Q1 2013 in the US,
a majority — 54% of corporate investments were made in the “shipping product/pre-profit”
stage – in other words, in companies whose technologies were ready to be integrated.
It is interesting to analyze the impact that a corporate investor may have on a VC-backed
company. The IT sector of companies based in the US is a good example. In the US, since
2003, 55% of venture-backed IT companies have had one or more corporate investors
participate in one or more investment rounds.
When corporate investors make an investment, historically in the “later stage” in the US, the
valuation of the business in that round is typically greater than in companies at a similar stage
with no corporate investor involvement, and the premium has ranged from 21% to 275% and
a median valuation premium over the past ten year period of 54%.
Through Q1 2013, of the US IT companies that completed an M&A transaction, 34% had a
corporate investor — suggesting that those US IT companies with a corporate investor (24%)
are more likely to have an M&A exit (40%). What is also interesting is that in only 4% of those
US IT M&A transactions was that corporate investor the ultimate acquirer. In all sectors in the
US, only 5% of companies were acquired by an existing corporate investor. This is interesting
to note because it helps to dispel fears that, if a company accepts corporate investment, its
options will be limited from an M&A exit perspective.
In terms of the M&A valuation impact,, the data going back to 2003 shows an inconsistent
pattern of valuation premiums at the time of exit as a result of having one or more corporate
investors in a company. In seven of the past 10 years, companies with a corporate investor
commanded a premium (which was 29%), while in the other 3 years; there was a discount in
the average of 21%.
Here are the takeaways for US VC firms, portfolio companies and corporate investors:
• Corporate investor activity in VC portfolio companies is likely to exceed 400 rounds again
in 2013 — with considerable cash reserves on corporate balance sheets, investment in
external innovation would seem to be here to stay.
• Corporate investors need to consider ways to be more effective in converting these
financing investments into strategic advantages. Why should corporate investments rarely
result in the corporate investor being the ultimate acquirer? Furthermore, why do investment
rounds involving corporate investors often result in a valuation premium that does not apply
as consistently in the ultimate exit?
7
From the inside out: the
entrepreneurial character
3. Demonstrate resilience and rapid recovery. While
all businesses make bad decisions from time to
time, the best entrepreneurs and their teams seem
to be more resilient. Encountering obstacles, they
are able to set a new course and rapidly recover
— perhaps being able to react more nimbly than
their corporate counterparts and to learn from
mistakes to avoid making them again.
Looking back at our Entrepreneur Of The Year
finalists, it is clear that they’ve mastered the means
of achieving extraordinary growth in very challenging
times for the global economy. So how do they do it?
EY sought to learn the answer through interviews with
the 636 finalists of our 2012 Entrepreneur Of The Year
awards. We found that these individuals embodied
eight key traits.
1.
A unique perspective on risk. A majority
of those interviewed said they believed that
entrepreneurs are born, not made. This suggests
the presence of a distinctive “entrepreneurial
DNA” that sets these individuals apart from their
more risk-averse counterparts.
2.
Communicate vision and instill passion in great
teams. More than 25% of those surveyed indicated
that their ability to identify and develop talent was
their biggest strength. More than 40% cited their
ability to communicate and still their passion – to
‘see around corners” — as their biggest strength
(Figure 2). In addition, we found a strong concern
for the individual employee among entrepreneurial
companies. More than half of these entrepreneurs
indicated that people are their number one priority
and many surveyed planned to upgrade talent in
the coming year (Figure 3).
4.
Embrace innovation. Entrepreneurial companies
such as these Entrepreneur Of The Year finalists,
have been found to be the predominant sources of
radical innovations. While older and larger companies
can also be sources of innovation — whether
incremental or in response to the need for reinvention
— all too often, more-established companies resist
the radical innovation that, while beneficial from a
long-term perspective, might displace their existing
revenue streams in the short term.
5. Pursue what you do best. High-growth
entrepreneurs also excel at focusing on the things
that they do best — instilling vision and passion,
building great teams and innovating — while
appropriately partnering with other, often larger
corporations, to carry out certain infrastructure and
technology needs, administrative functions, sales
channels, manufacturing and distribution, and
regulatory compliance, to name the most common
areas. This not only enables the high-growth
company to focus on doing what it does best but
also enables more rapid, flexible and cost-effective
scalability as its business grows.
Figure 2: What is your biggest strength?
Figure 3: What are your future priorities?
By percentage of respondents
By percentage of respondents
(multiple responses possible)
(multiple responses possible)
Ability to communicate vision and instill passion
People
41
51
Ability to identify and develop talent
New markets
26
32
Ability to “see around the corner”
Technology
18
31
Ability to listen to advice
Research and development
16
23
Other
Mergers and acquisitions
12
15
Decisiveness
Capacity
11
13
Not provided
Not provided
6
4
8
6. Pursue geographic expansion. The majority of
entrepreneurs surveyed also cited geographic
expansion as part of their growth strategies. Overall,
the majority indicated they are continuing to expand
their businesses in domestic (US) markets, while
more than 20% of all but the smallest companies
indicated they were expanding in developed global
markets. These ambitions highlight the fact that highgrowth companies, in general, are vital for economic
growth, often accounting for disproportionate shares
of job creation in any economy.
The innovation inheritance: the role
of entrepreneurs in the US economy
7.
As the venture capital sector approaches a halfcentury In the making, the sector continues to make
an important contribution to the US economy. The
US still maintains an approximately 70% share of the
global market, with Silicon Valley retaining the lead
by far (US$12.6 billion, 977 rounds), followed by New
England/ Boston (US$3.8 billion, 369 rounds), the
New York City metropolitan area (US $3 billion, 367
rounds) and then Southern California (US$3.3 billion,
286 rounds). Meanwhile, angel investors and crowdfunding platforms are expanding. Innovation continues
to be the greatest driver of growth and job creation.
And the visions of entrepreneurs do not waver. Among
our 2013 finalists for the Entrepreneur Of The Year, we
count a total of– 621,000 employees, and 157,000 jobs
added over the last two years. •
Economic growth — the process by which living
standards improve — is frequently uneven and often
contrary to expectations. Even during economic
expansions, there will be companies and industries
that struggle. Yet, there are companies, industries and
areas of the US that manage to thrive. Entrepreneurs
are perhaps the most dramatic exceptions, creating a
disproportionately high number of jobs.
Secure the right capital at the right time. There
is much debate as to what source of funding
matters most to high-growth entrepreneurs. The
preferred sources of finance differ by a company’s
level of revenue. Angels, friends and family, venture
capital and personal funds are more prevalent for
lower revenue companies (less than $100 million).
Bank loans, somewhat uniquely, were a consistent
source of financing.
8. Secure what you’ve built. Regardless of whether
they stay to lead their company or leave to start
their next venture, successful entrepreneurs look
to preserve those company qualities that allowed
them to attract their high performance teams,
develop loyal customers, establish their brand and
reputation, and buoy shareholder value (Figure 4.)
Figure 4: What do you focus on to preserve what
you’ve built?
By percentage of respondents
(multiple responses possible)
Preserve company culture
52
Attract and retain top talent
44
Protect and enhance brand/reputation
38
Retain our best customers
30
Align capital structure to future plans
12
Identify and monitor risk
12
Implement appropriate controls
6
Not provided
3
Other
3
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Venture Capital Turns 50: A Model in Motion
Few sectors are as dynamic as venture capital. In its early days – 1960s and 1970s, venturebacked companies were synonymous with start-ups. But this is no longer the case. Today,
it’s just as likely that family, friends and angel investors will provide funding to the youngest
companies. Web-based crowdfunding platforms also play a role Meanwhile, venture
capital funds are diversifying their investments, seeking out companies at various stages of
development.
Describing the current state of the market, Jeff Grabow, EY’s West Coast Venture Capital
Leader sums up the trend:. “Angels start companies and VCs help them scale.” And
there’s another active group as well: corporates. As they grow, large corporations find it
more challenging to generate innovation on the inside. This has driven greater numbers of
corporate investors into the venture market . Between 9% and 13% of venture financings
in the health care, consumer services and business and financial services sectors involve
corporate venture investment.
Still the intensified level of corporate investing does not translate to a large uptick in
acquisitions. Rather, corporate investors have highly specific goals, seeking certain
synergies that will help them gain a competitive edge in the marketplace. Through 2011
and the first quarter of 2013, only 2% of companies that were acquired were purchased by
a corporate investor.
About the Author
Bryan Pearce (bryan.pearce@ey.com), Partner, is the Americas Director, Entrepreneur Of The Year® and Venture Capital
Advisory Group, Ernst & Young LLP. Ernst & Young refers to the global organization of member firms of Ernst & Young
Global Limited, each of which is a separate legal entity.
Ernst & Young Global Limited does not provide services to clients. Ernst & Young LLP is a client-serving member firm
operating in the US. The views expressed herein are those of the authors and do not necessarily reflect the views of
Ernst & Young LLP.
10
What’s Your 50+ Strategy?
A New Investment Theme
By Jody Holtzman, Senior Vice President, Thought Leadership, AARP
Introduction
In the past few years since AARP started our
Innovation@50+ initiative to stimulate innovation in the
market that will benefit people over 50 and others, we
have:
• Created scholarships at DEMO,
• Sponsored demo/pitch days and established
partnerships with health innovation accelerators such
as Startup Health, Blueprint Health, Healthbox, and
Rock Health, and
• Twice sponsored the annual event of the NVCA.
The initial response to our participation in all of these
activities was the same – “What the heck are you
doing here?!”
The question, for the most part, did not get asked a
second time. And it definitely wasn’t asked when we
put on our first and second Health Innovation@50+
LivePitch events in New Orleans and Las Vegas, which
brought together startups, investors, and consumers –
30% of which have received funding.
But this common initial reaction, to AARP participating
in events comprised of investors and entrepreneurs,
illustrated that the scale and scope of the opportunity
to address the needs and wants of over 100 million
people with new products and services, and disruptive
innovation of existing markets, was not intuitive and
obvious with most investors and entrepreneurs alike.
11
The articles in this journal, in the NVCA newsletter and
elsewhere show an investment industry dealing with
significant challenges. Returns have not been close
to the glory days of the 90s. Big plays in several new
verticals, such as Clean Tech, with a few exceptions,
have not panned out. In Social, there are just so many
Facebooks, Twitters, and LinkedIns. Funds are taking
fewer risks and moving from a focus on early stage to
growth stage. Everyone is racing to be second. And
the industry itself has shrunk and consolidated.
For investors, the benefit of
understanding the Longevity
Economy is that this paradigm
provides even greater insight
into the potential business and
investment opportunities.
We have a couple of questions for the venture
community. Given the above, if we were a Limited
Partner in your fund we would want to know the
following:
As with any national economy, e.g. the United States,
China, Germany, or Barbados for that matter, the
characteristics of a healthy economy include the
following:
• Why would you leave money on the table by ignoring
a market of over 100 million people who spend
over $3 trillion per year and is the only humongous
growth market that exists? And,
• New ideas
• What’s your 50+ strategy?
• New technologies
The opportunity for the venture community is twofold:
• Investment
1.
• New business formation
2.
• New business models
• Disruptive innovation
Ask those same two questions of your portfolio
companies and the startups that come to you
seeking investment, and
• Job creation
• Productivity growth
Adopt the “Longevity Economy” as an investment
theme, i.e. the opportunities generated by the
sum of economic activity related to the needs and
wants of people 50+.
• New markets
• New industries
• New economic value
The Emerging Market in Plain Sight
• Supply chains and multiplier effects
The Longevity Economy
• Demographic growth
Typically, markets are defined by the supply and
demand of goods and services exchanged, and
sized by the aggregate amount of money spent in the
purchase of these goods and services. As described
below, by this measure the 50+ market is huge with
consumer expenditures over $3 trillion.
• And when all of this is aggregated, a growing measure
of total economic activity such as gross domestic
product (GDP) – which in the case of the Longevity
Economy according to a forthcoming study by Oxford
Economics is $7.1 trillion, making it the third largest
economy in the world after the US and China.
However, economic activity serving the needs and
wants of people over 50 is much greater than that. It
has the characteristics of an economy unto itself – the
Longevity Economy. It is the economy comprised of
and serving people 50+.
The Longevity Economy embodies all of the above
characteristics of a healthy and growing economy.
And the beneficiaries are not limited to people over
50. Whether it is the entrepreneurs, the companies,
the investors, those with jobs – and the economic
activity of the supply chains that feed and support this
economy - the beneficiaries are people of all ages (and
the larger U.S. economy).
12
When looked at this way, it is difficult to draw any
other conclusion than that the aging population of the
United States is a significant net positive contributor
to economic growth and prosperity; a conclusion that
challenges the usual argument in Washington where
serving the needs of over 100 million people is viewed
as an unaffordable cost and financial burden. The
private sector, including the venture community, should
view this very differently – i.e. that serving the needs
and wants of over 100 million people is an opportunity.
In the year 2000, there were a total of 77 million people
over 50 years of age - 42 million people ages 50-64, 31
million ages 65-84, and 4 million over 85 years of age.
By 2012 the number of people over 50 grew to 104
million - 61 million people ages 50-64, 37 million ages
65-84, and 6 million over 85 years of age.
By 2020, the number of people over 50 will number
118 million, and by 2030 132 million. So, in just thirty
years between 2000 and 2030 the number of people
over 50 will grow over 70 percent. And people 65
and older in 2030 will represent 1 in 5 Americans,
according to the Census Bureau.
For investors, the benefit of understanding the
Longevity Economy is that this paradigm provides
even greater insight into the potential business and
investment opportunities. The scale of products and
services and the investment opportunities in the
companies that create and offer them is large. But
add to this the scale of the supply chains that support
these companies and the underlying technologies
that are enablers and inputs, in addition to the
products and services themselves, and the investment
opportunities are huge.
Among the 50+ are the Baby Boomers, the last
of which will turn 50 in 2014. This generation has
changed markets and the world at every life stage that
they went through. They are active. The orientation
they have about their current life stage is that it is
about living, not aging. They don’t want to be boxed
in and categorized and labeled. They see opportunity
everywhere, even when facing adversity. They seek
ways to enrich their lives themselves. They have a
continuing desire to grow, learn and discover, and
have a positive view of their future. They embrace
change and are open-minded to new experiences. For
Boomers, it is all about “what’s next.”
And just as with previous technological advances
that later had applications which could not have been
envisioned at the time of their discovery, such as the
Internet, the technologies being created now and in
the future to serve the needs, wants, and challenges
of people over 50 will undoubtedly have future
applications yet to be created.
The key takeaway for investors
and entrepreneurs is this —
this market is too big to ignore.
Who Are These People And How Many Are
There?
In the 20th century, the average lifespan in the United
States and most Western countries increased by 30
years. What is important to realize, not just factually but
also from a business and investment standpoint, is that
these additional 30 years weren’t tagged on to the end
of a person’s life, they were inserted into the middle of
one’s life – when people are active, vibrant. productive,
socially engaged, interested in new experiences and
learning new things, and with today’s generations of
people 50+ technologically connected.
In survey after survey, by AARP and others, people
50+ want to remain physically and intellectually
active, learn new things, feel productive, stay socially
engaged, and plan to work past traditional retirement
age for both the emotional and intellectual benefits,
as well as the financial benefits. And even those who
must continue working for financial reasons, also
in many cases see this through an opportunity and
aspirational lens.
As recently noted in a report by the Nielsen Company,
“If a big market is of interest, a big market that’s getting
bigger faster should really be intriguing.” And when it
comes to the US population of people over 50, getting
bigger faster it is.
13
One of the myths about people over 50 that often comes up
as a reason to ignore the opportunity in this space is the all
too-accepted “common wisdom” that older people don’t use
technology, they aren’t online, they aren’t mobile and social. The
data suggest otherwise... To paraphrase Vint Cerf (70 years old),
Google evangelist and recognized “father of the Internet” —
“We aren’t scared of technology. We invented it!”
What might be surprising to the VC community, almost
half of all new entrepreneurs are aged 45-64, starting
businesses at rates significantly higher than people in
their twenties. Entrepreneurs 20-34 years old account
for just under 30% of new entrepreneurs, and those
35-44 years old just 22% of new entrepreneurs
(Kauffman Foundation). And although most of this
business activity by those 50+ is “small business
America,” it reflects the continued high and productive
level of activity of this generation. And while most of
these companies may not represent an investment
opportunity for VCs, they are a business and market
opportunity for startups that are. But in all of the cases
– Boomers and the 50+ overall, grandparents, and 50+
entrepreneurs – its only a business and investment
opportunity if you know the dynamics and demand
character of the market.
Why Should VCs Care?
Why should the venture community and entrepreneurs
be interested in people 50+? Several reasons, starting
with the fact that as a group they have a lot of money
and they spend it. People over 50 in the United
States have the highest net worth of any segment
of the population and in 2013 will account for $3.01
trillion in consumer spending. This represents 51% of
expenditures in the United States by all consumers
over the age of 25. Over the next 20 years, spending
by people 50+ is expected to increase by 58% to
$4.74 trillion, while spending by Americans aged 2550 will grow by only 24%, to $3.53 trillion (Oxford
Economics).
Baby Boomers spend the most across all product
categories, and it is even greater when people
67+ are included. Boomers account for consumer
packaged goods sales of almost $230 billion, 49% of
total sales (Nielsen). They account for roughly 45% of
sales in Apparel, 43% in Personal Care, 43% in Food,
45% in Entertainment, 44% in Transportation, 42%
in Housing, and 43% in Healthcare (Bureau of Labor
Statistics, 2010). In fact, as Nielsen notes, “Boomers
dominate 119 out of 123 CPG categories – that’s a
staggering 94%.”
And for those of you who have followed the debate
between Vinod Khosla and Vivek Wadwa over the
“age of creativity” among founders in Silicon Valley,
you know that there are plenty of venture-backed
entrepreneurs 50+. This is especially true once you
look past social media to sectors like life sciences,
big data, enterprise software, etc; sectors where
being able to identify problems let alone solutions
requires experience. And last we looked, experience
and age are highly correlated. Again the point is
that this generation is active, productive and in this
case returning value. And whether as customer or
entrepreneur, should not be ignored.
For example, one category dominated by Boomers
is car sales. If the car is the next tech platform
opportunity, as claimed by CEOs in Detroit, there is
a significant opportunity for venture-backed startups
to drive this innovation (pun intended). And given that
Boomers are the largest car buyer segment, to fully
optimize this market opportunity requires that these
startups and their investors understand older drivers,
just as BMW does when it designs the ergonomics of
a 5-Series car for a man in his late 50s.
14
The dynamic of spending by people 50+ also is
inter-generational. According to a 2009 study by
Grandparents.com, in 2009 grandparents spent
about $52 billion on their grandchildren, roughly 5%
of grandparents total consumer spending. Direct
and indirect spending by grandparents on their
grandchildren included $16.9 billion on education,
$10.2 billion on apparel, $4.0 billion on travel, $5.8
billion on toys, and $2.7 billion on baby-related
products (Grandparents.com).
In addition, there is huge growth in mobile. 23 percent
of people over 50 years old owned a smartphone in
2012, up from 12% in 2011 (Forrester). They are using
them to look things up and buy things. 20 percent
have researched products on their phone and 5%
have made a purchase on their phone, including digital
products, electronic tickets, coupons and reservations,
and clothing and food. And they are most likely to
pay for apps in anti-virus/security, music, games, and
ebooks (Forrester).
The key takeaway for investors and entrepreneurs is
this – this market is too big to ignore.
33 percent of all tablets are owned by people 50+
including 23% of all iPads and 30% of all Kindle
Fires (Forrester). This reflects growth from just 4%
of people owning a tablet in 2011 to 11% in 2012,
and it continues to grow (Forrester). And like the 1849 year old segment, the adoption of tablets has
resulted in less use of printed books, magazines, and
newspapers, less use of computers (desktops and
laptops), and less use of traditional mobile phones.
People 50+ and the Technology Myth
One of the myths about people over 50 that often
comes up as a reason to ignore the opportunity in
this space is the all too-accepted “common wisdom”
that older people don’t use technology, they aren’t
online, they aren’t mobile and social. The data suggest
otherwise. In addition, this is the generation that
grew up when computers were first introduced into
the workplace. To paraphrase Vint Cerf (70 years
old), Google evangelist and recognized “father of
the Internet” – “We aren’t scared of technology. We
invented it!”
When it comes to participation and having an account
on social networks, 50 million people over 50 years
old are users: of those online, 89% of them have a
Facebook account, 28% have a LinkedIn account,
13% Twitter, 10% Google+, 7% MySpace, and 5%
Pinterest (Forrester).
First, let’s note a very important fact. Although most
market research focuses on percentages, remember
that when talking about percentages of the population
of people 50+, we are talking about a percentage of
over 100 million people. This is important, because
while percentages are and may be higher for GenX and
others, the base is significantly smaller, resulting in some
cases in absolute numbers that are pretty comparable.
People 50+ also are gamers. Thirty-four percent
of people online over 50 play video games on their
computers, with 6% playing on a game console –
which reflects a significant opportunity to transition
these gamers to consoles.
And lastly, Boomers and other 50+ shop online. To
quote Nielsen’s recent study “A third of them shop
online and the 50+ segments spends almost $7 billion
when there. The Internet is their primary source of
intelligence when comparison shopping for major
purchases.”
78 percent of people 50+ are online. This is over 80
million people! Over 65% use broadband at home
(Forrester). And this isn’t limited to just Boomers. Just
over half of seniors 65+ are online as well (Forrester).
Given the above, it is hard to make (let alone sustain)
the claim that a lack of technology use and online
engagement is a good reason to ignore people 50+ or
the startups that target them as a market opportunity.
15
The Opportunities
Healthcare
The opportunities in the 50+ space are numerous – in
technology, social, ecommerce, travel, entertainment,
education, transportation, financial services,
healthcare, wellness, and yes, anti-aging. In this look
below at startup and investment opportunities, we
examine opportunities in the consumer, out-of-pocket
health and wellness space.
Healthcare covers many categories including many
such as Life Sciences that require regulatory approval
from various agencies like the FDA. However, there
is a significant and growing market in non-regulated
healthcare categories that are paid out-of-pocket by
consumers, especially around healthy living.
A combination of trends are driving this opportunity,
including:
The opportunities in health and wellness, as well as
other sectors, fall into two broad categories:
1.
Products and services designed specifically for
people over 50, and
2.
Opportunities to consciously design products
and services for all across the age continuum,
with the goal of capturing the largest marketshare
regardless of the age of the consumer – i.e. Design
for All. This is the path to market optimization. Put
another way, by designing products and services
with the conscious goal of not creating an artificial
wall that prevents or diminishes sales to this large
market of over 100 million people.
• Consumer/patient-centric health,
• Consumer engagement,
• Connected living,
• Prevention and wellness,
• The quantified self, and
• The overriding shift in orientation from sick-care to
health-care.
And the trend that flows across all of these among
people 50+ is the consistent desire of people to remain
independent, active, engaged, and live as long as
possible in their own homes, i.e. to age in place.
It also should be noted, that products and services
designed for the 65+ are also equally relevant to
GenX, as well as Boomers, as these are their parents
as well. And issues around healthy living, caregiving,
aging in place, etc., are by definition multigenerational
life-stage issues in which the adult child is often the
paying customer.
The opportunities reflect both categories – products and
services targeting the 50+, and those designed for all.
16
• Medication Management – Over 90 million people
among the 50+ will be on multiple medications by
2018 and over half of them will require assistance
managing their medications. Companies with
a hardware-centric strategy are likely to gain a
revenue opportunity comparable to a servicecentric strategy, but with lower risk due to greater
consumer cost-sensitivity toward service pricing.
This market has target users growing to 53 million
by 2018 and a cumulative five-year revenue
potential up to $3.1 billion.
A recent study by Parks Associates that was
sponsored by AARP identified nine healthy living
categories that together today comprise a $77 billion
market, with a growth opportunity over the next five
years of $20 billion in additional revenue and adoption
by over 100 million people. Each of these nine market
areas are currently unreimbursed and paid out-ofpocket. The forecasts assume that they will continue
to be paid out-of-pocket and are drawn from the Parks
study. They include:
• Aging With Vitality – After age 50 a majority of
people experience common age-related conditions,
including hearing and vision impairment, arthritis,
and memory loss. By 2018 the target market
for aging with vitality products is likely to grow
to 49 million people. In addition to companies
creating specific new breakthrough products, the
opportunity also benefits from the introduction of
age-mitigation features and underlying technologies
that make existing and familiar products easy to
use. This market has a cumulative five-year revenue
potential up to $1.9 billion.
Solutions are needed and opportunities exist
to address the following: Preventing in-home
accidents, managing medications, improving and
aiding memory.
• Vital Sign Monitoring – Proper interpretation of vital
sign data followed by an actionable plan is critical to
older adults’ ability to self-manage their conditions.
While startups and others have created products
addressing individual types of monitoring, the market
has yet to see an interoperable eco-system of devices
that will allow users to monitor multiple vital signs and
receive feedback through one central application.
This category is a prime example of the current lack
of connectivity and interoperability across products.
Startups that position their product(s) as a self-help
tool rather than a chronic care management device,
may benefit from greater consumer uptake due to
a more positive framing. This also is an area where
payers are likely to be interested in providing their own
or white-labeled products, as well as a path to exit.
This market has target users growing to 49 million by
2018 and has a cumulative five-year revenue potential
up to $4 billion.
This forecast does not include the investment
opportunity in those companies producing new
innovations in technologies such as High-Definition
(HD) Voice, location-based services (LBS), voice
recognition, gesture recognition, and text-to-speech
functionality which are inputs for the above products.
Solutions are needed and opportunities exist to
address the following: Brain fitness/improving and
aiding memory and cognition, improving and aiding
hearing, improving and aiding vision, maintaining
muscle strength, managing arthritis, boosting
daytime energy.
Solutions are needed and opportunities exist to
address the following: Improving sleep quality,
reducing bad cholesterol, keeping glucose in range,
maintaining healthy weight, keeping blood pressure
in range, detecting skin problems, maintaining good
dental hygiene.
17
• Social Engagement – Staying engaged with family,
friends, and the community is vital to healthy aging
and has multiple physical, behavioral, and emotional
benefits. The adoption of social media such as
Facebook by people 50+ shows the potential in
this space. Applications built on top of Facebook
to provide older users with an even easier user
experience may lead to faster and broader adoption.
The key is for these new products to help people
50+ solve real-world challenges through better social
connectivity, and rather than require a change in
behavior, fit into current behaviors and lifestyles. This
market has target users growing to 70 million by 2018
and a cumulative five-year revenue potential up to
$500 million.
• Emergency Detection and Response – Solutions
that can detect and initiate a response to
emergencies, and in the future can prevent adverse
incidents, will see consistent demand. This market
segment has many opportunities to improve on
the current PERS solutions to create a better user
experience and higher adoption rate. This is likely
also to help broaden the market beyond the typical
user base of people 75+ who have till now been the
primary target with a “fear-premised” positioning
around falling and an inability to get up. Combining
traditional PERS features with other lifestyle features,
greater mobility, and more attractive design, may
make these products more attractive to people
aged 50-75. This market has target users growing
to 28 million by 2018 and has a cumulative five-year
revenue potential up to $2.4 billion.
Solutions are needed and opportunities exist to
address the following: Reduce stress, improve and
aid memory and cognition, stay connected socially,
remain mobile and active, address isolation.
Solutions are needed and opportunities exist to
address the following: Detecting falls, sending alerts
when a person is lost, preventing in-home accidents.
• Diet and Nutrition – Proper diet is fundamental
to keeping older adults healthy and independent,
as it is with all age groups. And although there
are many tools and programs in this market,
there is a need for less costly, self-manageable,
and personalized solutions. There also is a need
to link diet and nutrition solutions together with
chronic care management and wellness services.
The key challenge in this market is to deliver clear
differentiated user experiences with documented
results. This market has target users growing to 59
million by 2018 and a cumulative five-year revenue
potential up to $1.6 billion.
• Care Navigation – The healthcare system is extremely
complex and consumers have significant difficulty
understanding options with regard to access, quality,
and cost. Current solutions suffer from a siloed
approach to sharing health data with consumers, thus
preventing a clear value proposition. Solutions that
provide clear and short-term benefits, e.g. medical
savings and better health service choices, are likely to
experience greater customer uptake. Integration with
PHRs and personal insurance coverage will also likely
increase both real and perceived value. This market
has target users growing to 39 million by 2018 and
has a cumulative five-year revenue potential up to
$3.3 billion.
Solutions are needed and opportunities exist to
address the following: Eating healthily, boosting
daytime energy, maintaining a healthy weight,
preventing dehydration, keeping glucose in range,
keeping blood pressure in range, reducing bad
cholesterol, addressing calcium deficiencies,
maintaining good dental hygiene.
Solutions are needed and opportunities exist to
address the following: Navigating the healthcare
system, identifying relevant providers, evaluating
quality of care, managing healthcare costs, planning
for end of life care.
18
Another key factor driving the opportunity in consumer
healthcare that cuts across the larger contextual trend
drivers and the individual verticals, and in several
cases are equally true for technology-based products
generally, is that current solutions are sub-optimal and
share a common set of weaknesses, including:
• Physical Fitness – A healthy body is essential to
an older person’s ability to live an independent
and satisfying quality of life. Most solutions on the
market either fall short on interactive and motivational
features, or are designed for younger demographics
and ignore people 50+. Design-for-All product design,
convenience, and ease of use are essential in this
market to attract adoption. There also is large potential
demand for more affordable solutions with interactive
features that older consumers can easily use and add
value to their lives. End-user demand is likely to be
strongest among people 50-65, but current products
barely cater to users in this age segment. Longer
term pairing with vital sign monitoring, dietary tracking
with physician input and feedback also present
significant opportunities. This 50+ segment could
have a potential market of up to 42 million users by
2018. This market has a cumulative five-year revenue
potential up to $1.8 billion.
• Poor design and aesthetics that limit usability and
consumer demand.
• A tendency to focus marketing on the sickest and
most frail and elderly with an excessive focus on
chronic conditions which creates an unnecessary
market stigma and thus limits market reach and
acceptance.
• A lack of connectivity and interoperability, which
limits the utility of collected data.
• Prioritization of younger demographics by newer
technology solutions – ignoring 100+ million people
and signaling “this isn’t for you.”
Solutions are needed and opportunities exist to
address the following: Engaging in age-appropriate
exercise, maintaining muscle strength, improving
balance, staying mobile and active, maintaining
healthy weight, boosting daytime energy, relieving
back pain, staying flexible, reducing stress.
• A fragmented approach to addressing consumers’
health needs when a more holistic solution could
drive higher usage.
• Designs that fail to incorporate the role of
caregivers and care providers.
• A lack of marketing resulting in low awareness of
cutting-edge solutions by many 50+ consumers.
• Behavioral and Emotional Health – Aging in a
healthy and happy way is essential to physical health,
as well as emotional health. Current solutions are
inconvenient and expensive. Social connectivity,
online and off-line, is key to success and adoption.
People need to connect with others with whom
they can relate. Solutions that provide groups and
therapists that address key sources of adverse
emotional health, such as isolation and depression,
are clearly needed and represent a market
opportunity. This market has target users growing to
29 million by 2018 and a cumulative five-year revenue
potential up to $400 million.
• High cost of many direct-to-consumer solutions
pricing many 50+ consumers out of the market.
Entrepreneurs that can develop solutions that
overcome these weaknesses will find significant
opportunity and competitive differentiation. Investors
who identify startups that effectively address these
weaknesses are likely to be rewarded.
Solutions are needed and opportunities exist to
address the following: Addressing depression,
addressing isolation, providing grief support,
providing divorce support, managing life transitions,
planning for end-of-life care.
19
So, where should a venture firm start? Add a single question
to your list of diligence questions when a startup comes
to you looking for investment: "What's your 50+ strategy?"
And ask this of your existing portfolio companies as well...
As you see your portfolio companies struggle to grow revenue,
you'd rather not want to be in a position to ask your CEOs,
"Why did you leave money on the table by ignoring the only
humongous growth market that exists?!"
A New Investment Theme for VCs
Analysis conducted by AARP a few years ago
examined VentureSource data to determine the
scale of venture investment in companies targeting
people over 50. Looking at venture investment in the
2001-2010 time frame, investment in these startups
amounted to a total of $2 billion. This compares with
total venture capital investment of $250.5 billion in
the same time frame (Venture Impact: The Economic
Importance of Venture-Backed Companies to the U.S.
Economy, NVCA , 2011).
Every investment in a startup has to stand on its own
with regard to the idea, the business model, ability
to scale, the technology and intellectual property, the
founders and management team, and the market. But
VC firms select investment themes because of larger
trends that create an environment with the potential
for multiple, large opportunities. We have seen this
with the Internet, Social Media, Clean Tech, Enterprise
Software, Big Data, Healthcare, Life Sciences,
Education, etc.
Looking just at venture investment in digital health,
between 2010 and 2013 a projected $250 million
will be invested in startups focused on people 50+,
compared with a total of $5.16 billion overall (Startup
Health). Given that in less than a year, AARP alone has
had over 200 startups in the healthcare space apply
to pitch at our two Health Innovation@50+ LivePitch
events, investment opportunities are being missed.
One powerful trend is the aging of the population. As
Steve Jurvetson of Draper, Fisher, Jurvetson is fond
of saying, “Demographics is Destiny.” And when you
examine the growing population of people 50+ there
is no getting away from the fact that this is a huge
and growing market, with a breadth of interests and
activities, and the ability to spend significant amounts
of money in the pursuit of these interests and activities
– more than any other segment of the population. And
in addition to all the things they purchase that are the
same as younger cohorts, they also have evolving
needs, wants, and preferences that present the
opportunity to break new ground.
Adopting the “Longevity Economy” as an investment
theme is the key to fully realizing this potential. (As
noted above, the “Longevity Economy” represents the
business and investment opportunities generated by
the sum of economic activity related to addressing the
needs and wants of people 50+.)
As with the adoption of any investment theme, it will
proactively put VCs on the lookout for opportunities in
this space – rather than simply react opportunistically
to a startup knocking on the door. And it will provide an
opportunity to create expertise that differentiates your
firm from others in the eyes of entrepreneurs with highpotential products/services/business models. And it will
provide an opportunity to drive disruptive innovation in a
huge growth market that is currently under-served.
Despite Boomer market dominance across all of the
various CPG categories, just 5-10% of total advertising
dollars are spent on these consumers. The behavior of
the venture capital industry, unfortunately, is the mirror
image of the “Mad Men” on Madison Avenue. And in
both cases, missing a huge opportunity by focusing
almost exclusively on the 18-34 year old segment.
20
So, where should a venture firm start? Add a single
question to your list of diligence questions when a
startup comes to you looking for investment: “What’s
your 50+ strategy?” And ask this of your existing
portfolio companies as well.
The mission of AARP’s Innovation@50+ initiative is
to identify ways that AARP can directly and indirectly
stimulate innovation in the market around breakthrough
products, experiences, and business models that will
benefit people 50+. In doing this, we seek to partner
with the venture community, with entrepreneurs, and
others, to build an eco-system that will nurture such
innovation. To that end, we are collaborating with the
industry in the following areas:
Our assumption is that when smart people, VCs and
entrepreneurs alike, ask questions they will start to
explore answers. And this exploration will potentially
yield creative and innovative ways to optimize the
market opportunity and the VC’s investment. Because
there is no getting away from the fact that when
products and services are attractive across the age
continuum, like an iPad or Facebook, the market is
larger and so are the potential rewards - and from
AARP’s viewpoint there will be more products and
services to better meet the needs and wants of people
50+ and others.
• Market Outreach: Raising awareness of the market
opportunity, needs, and wants of the 50+. We have
done this with original content, such as the Parks
Associates report on Health Innovation Frontiers
referenced above, with the purpose of identifying
unmet needs and opportunity for entrepreneurs and
investors. And we have done this with the creation of
the Innovation@50+ Scholarship for a select group
of startups that apply to pitch at DEMO. And with
our initial focus on healthcare, we have partnered
with the healthcare accelerator Startup Health
to ensure that companies that go through their
program have an understanding of the needs and
wants of people over 50. We also have a partnership
with the Consumer Electronics Association (CEA)
to highlight in their market research the buying
behavior of consumers over 50, to encourage the
industry to include the 50+ in their target market
and employ “Design for All” principles in the design
of their products so that they are easier to use by
everyone, with the incentive of optimizing the market
opportunity.
At a minimum, this line of questioning also will provide
insight about the management teams of these
startups, including existing portfolio companies.
Most importantly, you will know if you are investing
in a startup that is or is not aware of the opportunity
presented by over 100 million people who spend
over $3 trillion annually. For those that are not, it
also raises the question – what does it say about a
CEO and management team that is unaware of the
demographics of their market and potential customers?
Another assumption we have is that after making an
investment and as you see your portfolio companies
struggle to grow revenue, you’d rather not want to be
in a position to ask your CEOs, “Why did you leave
money on the table by ignoring the only humongous
growth market that exists?!”
• Market Development: Influencing ecosystem
development. We have done this internally by
creating and piloting new business models for
startups to work with AARP in order to make their
innovative products and services available to our 37
million members. And we have done this externally
by increasing deal flow for the venture community
with the circulation of deal books profiling hundreds
of startups in the Longevity Economy. We also have
sponsored the demo days of Startup Health, Rock
Health, Healthbox, and Blueprint Health, as well
as DEMO where several of our Innovation@50+
scholarship winners went on to win “DEMOgod”
awards.
Building the Eco-System
As we noted at the beginning of this journal article,
understanding the rationale for AARP’s participation
at events such as DEMO and others was not intuitive
for both VCs and entrepreneurs. Fundamentally, it is
driven by AARP’s overarching Mission, to enhance the
quality of life for all as we age. A key to this is that the
needs and wants of people 50+ be better addressed
with a proliferation of relevant and/or easy to use and
consumer-friendly products and services. That is why
we launched the Innovation@50+ initiative.
21
• Innovation Showcase: Creating platforms for
showcasing innovative technologies, products and
services. We have done this with two of our own
Health Innovation@50+ LivePitch events that have
attracted some of the top VCs and corporate VCs in
the Health space, including Psilos Group Managers,
Maveron, Polaris Partners, Cardinal Partners,
Interwest Partners, Comcast Ventures, .406
Ventures, and others. These events attracted over
200 startups focused on the opportunity presented
by people over 50 years old. Our third annual event
will be held in Boston on Mother’s Day weekend
in 2014. And we have showcased startups for the
10,000 AARP members who attend our semi-annual
Life@50+ Event and Expo.
The Nielsen study title described Boomers as
“Marketing’s Most Valuable Generation.” Boomers
and the 50+ overall have the potential to be the same
for the venture community. At a minimum, it is an
opportunity too big to ignore.
Let us know what you think. •
Sources:
The Longevity Economy: Generating Economic Growth and New Opportunities for
Business, Oxford Economics, Forthcoming 2013
Introducing Boomers: Marketing’s Most Valuable Generation, Nielsen and
BoomAgers LLC, 2012
• Member Involvement: Engaging AARP members
in providing early feedback on emerging trends
and innovation. We have done this through our
LivePitch event in which entrepreneurs received
real-time market feedback from AARP members in
response to a consumer pitch, in addition to getting
VC feedback following an investor pitch. And we are
tapping the wisdom and input of AARP members to
conduct concept testing, market research, and inhome pilots together with select startups.
“Kauffman Index of Entrepreneurial Activity: 1996-2012. Ewing Marion Kauffman
Foundation. April 2013.
The State of Consumers and Technology: Benchmark 2012, US, Gina Sverdlov,
Forrester, December 2012
Health Innovation Frontiers: Untapped Market Opportunities for the 50+, Parks
Associates, May 2013
Longevity is Opportunity: Riding the Demographic Wave, Milken Global
Conference, May 2013
The Grandparent Economy: A Study of the Population, Spending Habits, and
Economic Impact of Grandparents in the United States, Grandparents.com, 2009
About the Author
Jody Holtzman has more than two decades of experience helping companies develop and implement competitive
strategies and achieve their strategic market goals. At AARP, he leads the Thought Leadership group, where his focus
is to stimulate innovation in the market that benefits people over 50. This involves areas such as the future of technology
and the 50+, technology design for all, and 50+ entrepreneurship. It also involves developing partnerships with nontraditional players for AARP, such as the venture capital community, and the consumer electronics and technology
industries. Previously, Jody led AARP’s Research and Strategic Analysis group.
Before joining AARP, Jody was in senior leadership roles in several strategy consulting firms. He was a Director of Global
Strategy and Planning, and led the Market Intelligence Network of PricewaterhouseCoopers. Before that, he was Vice
President of Consulting for FutureBrand, where he helped clients develop and implement competitive brand strategies.
Jody is a frequent speaker on the opportunities and challenges presented by the demographic wave. He has led numerous
workshops on competitive strategy and organizational performance, and his work has been published in the Journal of
Business Strategy, Competitive Intelligence Magazine, The Competitive Intelligence Anthology, and Making Cents Out of
Knowledge Management. He has a graduate degree in international political economy from the University of Chicago.
22
Reengineering the Mechanics
of the Exit Waterfall
By Michael J. McGrail, Patrick J. Mitchell, Alfred L. Browne III, Partners of Cooley LLP
The article will cover a few
of the more recent waterfall
misdirections and make a
recommendation going forward
In venture-backed M&A transactions, the “exit waterfall”
generally refers to the legal mechanism by which
various stakeholders get paid out in an acquisition.
That legal mechanism is almost always contained in
the corporate charter of the acquired company (and
sometimes in related documents). In many venturebacked M&A transactions, however, the exit waterfall
is increasingly flowing in unintended directions causing
unnecessary legal disputes and anxiety at the time of
sale. This article will cover a few of the more recent
waterfall misdirections and make a recommendation
going forward — with the understanding, of course,
that getting this perfect, particularly in the context of
complicated sales, is (much like the notion of a perfectly
efficient hydroelectric turbine) impossible.
23
Background & Context –
Manufacturing Runs with Preferred
Stock Terms
Reallocation Techniques
Unfortunately, preferential preferred stock terms do not
grow the pie; they only reallocate it. As companies exit
at multiples that are respectable, but not eye-popping,
the preferred stock terms designed to increase returns
to one or more investor groups (at the expense of
another) are increasingly coming into play (and coming
under pressure). Stakeholders in the company who
do not have the benefit of preferential economics
in their securities (such as founders (current and
former), management and early round investors) are
increasingly looking for ways to minimize the economic
impact of preferred stock terms. Moreover, strategic
buyers, seeking to shift proceeds to management
(whom they likely perceive as more valuable to the
integration of the target business), are also getting into
the proceeds reallocation game and are increasingly
using retention plans and other employee-targeted
incentives to allocate more of the ‘pie’ to management.
Litigation is more common. The ‘negotiations’ between
management and the investors (and, frequently, among
different classes of investors) on things like retention
plans, option pool expansion, escrow contributions,
acceleration and a number of related items has simply
become more tense.
The average returns for the venture industry over the
last ten years have barely outpaced the Dow Jones
Average and other major market indices. Based on
data recently published by the NVCA, the substantial
majority of venture-backed M&A exits return
somewhere between one times the dollars invested
and four times the dollars invested. A meaningful
percentage of venture-backed M&A exits return less
than money invested. Venture holding periods have
become much longer. With a few notable exceptions,
the initial public offering market for venture-backed
companies remains quiescent. In many ways, it is
the dead ball era of venture capital. And, with this as
a backdrop, venture capital investors are forced to
manufacture runs anyway they know how. To be sure,
they have tried it all. From “spray and pray,” to growth
equity and buyouts. In terms of industries, venture
firms have invested aggressively in expected areas,
like clean energy, software and biotech, but also the
unexpected – royalty deals, overseas deals, and nongrowth companies.
But, while firms’ investment theses may have changed,
deal terms have not changed much. By and large,
based on market data, most of the investing is still
done by means of conventional preferred stock – i.e.
preferred stock with a liquidation preference or, if
greater, an as-converted return. While compounding
dividends are slightly more common than they were a
decade ago, the industry has not seen a pronounced
shift to include dividends. And participating preferred
stock, while included in a meaningful percentage of
deals, is not significantly more common than it was a
decade ago. In brief, the venture capital playbook for
manufacturing runs in an environment where modest
exits remain the norm includes the following timetested preferred stock terms: conventional preferred
stock, participating preferred stock, and capped
participating preferred stock; liquidation preferences
(and, increasingly, multiple liquidation preferences,
designed to ensure at least some return to the
investors in modest exit scenarios); and dividends
(both cash dividends and dividends payable-in-kind
(PIK), usually in the form of more shares). The impact
of multiple liquidation preferences and dividends
(especially PIK dividends) can be significant.
One technique that has become increasingly effective
for disgruntled stakeholders is fiduciary litigation. For
example, in Carsanaro v. Bloodhound Technologies,
Inc., the plaintiffs in the case (founding stockholders
of Bloodhound) filed suit in Delaware in connection
with the sale of Bloodhound challenging the amount of
merger consideration awarded to existing management
through a management incentive plan and the
allocation of the bulk of the transaction consideration
to the preferred stockholders. The court denied
Bloodhound’s motion to dismiss and let the litigation
proceed. In its decision, the court allowed the plaintiffs
to pursue a direct challenge to the fairness of the
merger based on the allegedly excessive payments
to the preferred. The court further noted that the size
of the management incentive payments (almost 19
percent of the total proceeds) was material and could
potentially provide an additional reason to challenge
the allocation of proceeds being proposed by the
company and its board in the transaction.
24
Stakeholders are taking advantage of the terms of the
corporate charter itself to reallocate proceeds from one series
of preferred stock to another.
In addition to fiduciary challenges, stakeholders
are taking advantage of the terms of the corporate
charter itself to reallocate proceeds from one series
of preferred stock to another. In two recent cases
in Delaware related to the allocation of proceeds on
M&A exits, holders of a junior series of preferred
stock took advantage of ambiguous drafting in
each company’s corporate charter to reallocate the
liquidation preference otherwise payable to the senior
preferred stockholders to themselves and holders of
common stock. In both Greenmont Capital Partners
I v. Mary’s Gone Crackers and Alta Berkeley v.
Omneon, the companies sold for fairly modest returns
to the invested capital. Some of the earlier investors
were rewarded with gains. However, the sale price
was below the valuation at which the later round
preferred stock investors invested. Although they did
not expect to profit from the sale, the preferred stock
investors expected to receive at least their money
back. But, in both instances, existing stockholders
exercised their mandatory conversion rights to reduce
the payout to the later stage investors – in one case
to less than half the money invested. The later round
investors sued the companies arguing that the
conversion was invalid, but the courts sided with the
company, dramatically reducing the return to the later
round investors.
While the decisions in Greenmont and Alta Berkeley
were not particularly controversial as a matter of
legal doctrine, they certainly frustrated one class of
investors’ expectations – and changed the return
profile on an investment in a way that was not likely
intended when the investment was made. There can
be little doubt that, in both those cases, the senior
preferred investors in those companies did not receive
the return that they thought they had bargained for
when they made their investment. Specifically, as is
typical with a conventional preferred stock, the senior
preferred investors expected to receive their investment
back first under circumstances where the amount of
their as-converted return would yield less (on a per
share basis) than their investment. For example, and
to illustrate just how conventional preferred stock is
supposed to work, if a preferred stock investor invests
$1 per share in a company, then his expected return
profile for that investment (as a function of the asconverted return payable to the holders of common
stock) can be shown graphically as follows:
Conventional Preferred Return
$3.00
Preferred Return ($/share)
$2.50
$2.00
$1.50
$1.00
$0.50
$0.00
$0.00
$0.20
$0.40
$0.60
$0.80
$1.00
$1.20
$1.40
$1.60
Common Equivalent Return ($/share)
25
$1.80
$2.00
$2.20
$2.40
$2.60
The point of ‘indifference’ — i.e. the break point at which
the as-converted common return equals the preferred
return – is, for each series of preferred stock, different.
It is determined as the result of a mathematical function,
based on that series’ percentage ownership and dollars
invested. But, because the break point is a function of
both the per share investment amount and the common
equivalent return, the function is dependent on not
only the total number of common equivalent shares
outstanding, but also the economic characteristics of
any other series of preferred stock. As additional series
of preferred stock are added to the capital structure, the
break points for each series change.
In this respect — i.e. because the break point for any
series of conventional preferred stock could (and likely
should) itself be considered an economic right of that
series – it is not clear that the Delaware courts got
things right (at least inasmuch as the forced conversion
changes the economic return for the senior series in a
range of values where the junior series is unaffected).
Put simply, the forced conversion of all preferred in
a certain range of exit values can (and will) have a
uniquely adverse effect on only the senior series. The
courts got around this issue, by simply viewing the
conversion ‘right’ independently. In the Greenmont
case, as an example, the court reasoned that the
liquidation provision of the corporate charter — and,
in that case the series B preferred stock — were
‘conditional’ upon the conversion features. That is, the
court reasoned that the series B negotiated away the
right to receive a preference if all of the preferred stock
elected not to receive it. But, realistically, it is unlikely
that the series B intended that result – and the court
says as much. Instead, the series B likely made the
liquidation preference conditional on the conversion
— to the extent it was ‘conditional’ — in order to allow
the company to effect a bona fide recapitalization or
similar event under circumstances where the company
was not performing. Or, perhaps, they wanted to
ensure that the company had the flexibility to eliminate
the preferred stock in the context of an initial public
offering or similar event. But eliminating the preferential
return on the eve of an exit event solely for the purpose
of changing the allocation payable to the company’s
equity holders seems like an entirely different matter
— and, in that regard at least, the preferred holders’
argument that the conversion had an ‘adverse effect’
on that series alone would seem to have some merit.
The problems in Greenmont and Alta Berkeley arose
from the fact that junior series of preferred stock would
simply do better on an exit in a certain range of values
by forcing all series of preferred stock to take an asconverted return. This range of values — i.e. the range
of values for which the junior series is economically
incented to force convert all series — begins at the
break point for the junior series and ends at the break
point for the senior series. In the example above,
by effecting a mandatory conversion of all preferred
stock, the senior preferred was forced to take $.80 (for
example), when the liquidation preference would have
dictated $1.00 per share.
The current climate should
force parties to investment
transactions to rethink the
way in which they currently
document transactions.
26
Participants in investment financings might be
better-served to eschew convention and draft the language
relating to economic returns on exit more directly.
A Recommendation: Attach the
Model and Incorporate the Related
Algorithms
Whatever your view on decisions in the Greenmont
and Alta Berkeley cases, the current climate should
force parties to investment transactions to rethink
the way in which they currently document those
transactions. Ambiguities in the liquidation provisions
of corporate charters, or the interplay of those
provisions and other provisions in the corporate
charter (such as those encountered in Greenmont
and Alta Berkeley) are all too common in venturebacked exits. And they can have dramatic impact,
particularly in an environment where a 2x return
is a very respectable return for a venture investor.
But, for a variety of reasons, and mostly based on
convention, the drafting of preferred stock economic
returns is arcane. The specific drafting relies on the
counterintuitive concept of a “liquidation” and the
extension of that concept to M&A exits by means
of the “deemed liquidation event.” These ‘liquidation
provisions’ contain the substance of the rights of
preferred stockholders on exit, but they are not
the exclusive province of those rights. Related
provisions that come into play include the ‘mandatory
conversion’ provision — whereby some percentage of
the stockholders can force a conversion of preferred
stock into common stock. The mandatory conversion
provisions are in separate sections of the charter, and
speak to different things. The ‘blocking provisions’
can also be relevant in determining the economic
rights of preferred stock (or any particular series of
preferred stock). Indeed the preferred investors in
both Greenmont and Alta Berkeley argued that the
blocking provisions prevented the company from
effecting a forced conversion of their senior security.
Once again, the interplay of these provisions and the
so-called liquidation provisions and can be confusing
— and, too often, ambiguous.
Participants in investment financings might be betterserved to eschew convention and draft the language
relating to economic returns on exit more directly.
Specifically noting that the exit provisions apply to all
sales and change in control transactions and that these
‘economic’ provisions should not be subject to (or
conditional upon) blocking rights or conversion provisions
more applicable to other circumstances. Furthermore,
and in light of the proliferation and broad adoption of
spreadsheets in corporate financings (and the parties’
reliance on them), parties should consider attaching
illustrative models to the corporate financing documents
with more frequency. And, in addition, specifically
incorporating the functions and algorithms on which they
rely in the text of the investment documents.
One why reason why this may not be happening more
frequently already (at least as to incorporating models and
referencing mathematical algorithms) is that the modeling
itself can be tricky. When a company issues multiple
series of conventional preferred stock, the ‘break point’
for each series is a function of the common equivalent
return (which itself influences the ‘break point’). This
‘circularity’ creates difficulty in modeling. As a company
issues additional series of preferred stock, the circularity
becomes more difficult to reconcile. Most practitioners
get around this by relying on numerical solutions to the
problem. For example, Microsoft Excel allows users of
the program to obtain numerical solutions by turning on
‘iterative’ calculations. The problem with this solution,
however, is that most people fail to understand exactly
how the numerical modeling works. And, for complicated
exit waterfalls, the built in iterative functions in Microsoft
Excel will fail (or become unworkably slow).
27
Investors and companies would
be well-served to reconsider
the way in which they are
documenting exit waterfalls in
their transaction documents.
While building these models represents a little
more work upfront, one could certainly argue that
it is better to spend the extra time at the time of
investment to ensure that everyone is looking at
things the same way — as opposed to fighting out
at the time of exit. But, of course, none of this is
perfect. And even with the model attached, there are
always means by which motivated parties can act
aggressively for their own benefit.
One alternative to Excel is to rely on more efficient
numerical problem-solving algorithms. Because the return
curve (i.e. economic characteristics) for almost all forms
of preferred stock (from conventional, to participating to
capped participating) is almost always a first order linear
equation, more conventional numerical algorithms are
available to solve these problems. By simply subtracting
from the specific exit value the sum of the linear equations
(of the kind described above) for each series of preferred
stock, the ‘exit function’ can be recast into one that
always crosses the x-axis and that will, therefore, have a
root (and only one root) equal to the common equivalent
return that will satisfy the equation for that exit value and
all series of preferred stock. While more non-numeric rootsolving methods (such as Newton’s Method) will not work
because the equations are non-differentiable (i.e. nonsmooth) at certain points, standard numerical solutions
do, in fact work. And one method that works particularly
well is the bisection method.
Nevertheless, at the end of the day, investors and
companies alike would be well-served to reconsider
the way in which they are documenting exit
waterfalls in their transaction documents. As always,
rote application of forms can cause significant
problems when things matter. By taking advantage
of spreadsheets, by attaching a model to one or
more of the governing investment documents, and/
or by simply referencing the algorithms used to
solve the circularities and dependencies that arise
from layering in multiple series of preferred stock,
the extra time upfront should be helpful getting the
waterfall flowing in the right direction and solving
some of the more common ‘disconnects’ that arise
in venture-backed M&A exits. •
About the Authors
Michael J. McGrail is a partner in the Cooley Business department and a member of the Firm’s Mergers & Acquisitions,
Medical Devices, Venture Capital Financings and International practice groups. Mr. McGrail’s practice includes the
representation of company and investor clients in a full range of corporate legal projects, including mergers and acquisitions,
private financings, corporate partnerships and technology licensing. He counsels companies and investors in many
industries, with a particular focus on medical devices and life sciences.
Patrick J. Mitchell is a partner in the Cooley Business department and serves as the co-founder of the Firm’s Growth
Equity Practice. Mr. Mitchell practices in the areas of private equity, growth equity, venture capital, mergers and acquisitions
and general corporate law. He represents several leading private equity, growth equity and venture capital firms in
connection with leveraged acquisitions, portfolio investments and matters relating to their portfolio companies.
Alfred L. Browne, III is a partner in the Cooley Business department, and is partner in charge of the Firm’s Boston office.
Mr. Browne specializes in mergers and acquisitions; late-stage venture capital and growth equity transactions; cross border
transactions; and complex intellectual property transactions, particularly in the software industry. Mr. Browne’s clients
include strategic and financial buyers and sellers in public and private acquisitions, including private equity sponsored
leveraged buyouts and take-private transactions.
28
10 years after PEIGG, is the
world a better place?
By Steven Nebb, CFA and David L. Larsen, CPA, Managing Directors of Duff & Phelps LLC
At a recent NVCA meeting of more than 100 Venture
Capital Fund CFOs, a question was posed: “Do you
think the current system of measuring and reporting
fair value is seriously flawed?” Every member of the
audience raised their hands in the affirmative. While
the question was purposefully provocative, it focuses
attention on the growing level of frustration in the
venture capital industry regarding how fair value
concepts are being applied. To help mitigate such
frustration and to suggest a way forward, this article
addresses three additional questions about fair value:
• Where did it come from?
• Why is it here?
• Where should it be going?
Fair Value: Where did it come from?
Investment companies were in early development in
1940. To create investor confidence and to protect
the public interest, Congress passed the Investment
Company Act. The new law defined and outlined how
to regulate investment companies. One outcome of
the law was that investments were required to be
reported at “fair value.” Yes, we had fair value in 1940
– but market events, political agendas and industry
developments have significantly impacted the meaning
and interpretation of fair value over time.
Do you think the current system
of measuring and reporting fair
value is seriously flawed?
29
One of the most troubling features of the GP-LP
interactions is the perceived inability of both sides to fully
understand the needs of the other.
Some of the early private equity firms trace their origin
back to the late 1930s. Many point to the passage of
the 1958 Small Business Investment Act as the catalyst
that allowed the venture capital industry to flourish.
In the 1960s, the limited partnership (LP) structure
emerged along with fee and carried interest structures,
which generally remain in place today. As limited
partner constituents migrated over time from high net
worth individuals primarily to institutional investors, the
content or framework for reporting to investors shifted
its focus from tax to Generally Accepted Accounting
Principles (GAAP).
Industry Guidelines Groups (PEIGG). The overall
constitution of this group was not all that different from
the 1989-1990 group. PEIGG was formed because
many LPs were concerned that General Partners (GP)
were not writing down investments quickly enough
given market conditions in 2001-2003.
After an extensive review by various industry groups
and service providers, the PEIGG guidelines were
issued in December 2003, with slight modifications
made in September 2004. The PEIGG Valuation
Guidelines were prepared to be consistent with GAAP
and underscored once again the GAAP requirement
that all investments should be reported at fair value. To
some extent the PEIGG guidelines provided a wake-up
call to the industry by directly stating that “cost” may
not represent the best estimate of fair value, especially
after the passage of time.
The Evolution of Valuation Guidelines
By the late 1980s, venture capital valuation questions
began to surface with more frequency. As a result, in
1989-1990, several private equity fund managers and
fund-of-fund managers formed a taskforce to develop a
set of portfolio company valuation guidelines. Contrary
to a very persistent rumor, the NVCA did not endorse,
adopt, bless, publish or otherwise opine on the draft
guidelines that resulted from the 1989-1990 taskforce.
The PEIGG Valuation Guidelines also served as
a wake-up call to international venture capital
associations who realized that their local guidelines
were not compliant with applicable GAAP. As a result,
three Europe-based venture capital associations
(AFIC, BVCA, EVCA) created the International Private
Equity and Venture Capital (IPEV) Valuations Board.
IPEV was tasked with creating valuation guidelines
compliant with international accounting rules and which
ended up being conceptually consistent with PEIGG.
Subsequently, 40 non-U.S. private equity and venture
capital associations endorsed the IPEV Valuation
Guidelines (http://www.privateequityvaluation.com).
Two noteworthy developments occurred in the
1990s. Despite no endorsement by the NVCA, these
guidelines became accepted practice by much of
the U.S. investment industry, especially in the venture
capital side of private equity. The second development
was that international venture associations created
localized guidelines based heavily on U.S. practices.
In their simplest form these “de facto” guidelines
required investments to be reported at the lower of
cost/last round of financing or market value. It should
be noted, however, that dating back to the 1940s,
GAAP always required investments to be reported at
“fair value.” Because of the accounting principle of
“conservatism” applied at the time, effectively “cost”
was deemed the best estimate of fair value.
In 2008 the IPEV Board added five practitioners from
the United States, including several PEIGG members.
The IPEV Board’s mandate includes continually
updating the IPEV Valuation Guidelines (and Investor
Reporting Guidelines) to ensure consistency with
relevant U.S. and International Accounting Principles
(GAAP). IPEV also aims to provide best practice
valuation and reporting guidance for the industry. The
latest update to the IPEV Valuation Guidelines was
released in December 2012.
During 2002–2003, a self-appointed group of private
equity practitioners, fund managers, fund-of-fund
managers and others formed the Private Equity
30
Fair Value: Why is it here?
LPs don’t always articulate
the reasons they need
fair value reporting.
Today most limited partnership agreements that define
the GP-LP relationship require GPs to provide financial
reports quarterly (unaudited) and annually (audited)
prepared in compliance with U.S. GAAP, International
Financial Reporting Standards (IFRS) or in some
cases local country accounting rules. No matter how
much judgment is required or how difficult it is to
value a company or security, U.S. GAAP requires that
financial statements be prepared in compliance with
Investment Company accounting rules which, similar
to SEC-registered Investment Companies, mandate
that all investments be reported at fair value. IFRS now
requires that investments held by Investment Entities
are reported at fair value as well.
Not all LPs articulate their needs as described above.
Some may even tell GPs that they prefer “cost” as
their reporting basis. In many cases, this failure to
communicate occurs because “deal” team members
of LPs speak with “deal” team members at the GP and
may not fully articulate all of the needs of the investor,
which include specific information required by back
offices to report properly to their beneficiaries.
As previously noted, Investment Companies have
always been required by GAAP to report investments
at fair value. Historically, “fair value” was defined and
applied inconsistently. The general definition was
the exchange price between a willing buyer and a
willing seller. In September of 2006, The US Financial
Accounting Standards Board issued SFAS 157 Fair
Value Measurements, (subsequently renamed as ASC
Topic 820) to harmonize the definition of fair value
and to expand disclosures about fair value. The new
fair value definition became “the amount that would
be received in an orderly transaction using market
participant assumptions at the measurement date.”
Arguably the new definition is conceptually congruent
with the “willing buyer/willing seller” definition of old,
but additional supporting language has continued to
identify appropriate valuation inputs and methodology.
One of the most troubling features of the GP-LP
interactions is the perceived inability of both
sides to fully understand the needs of the other.
Miscommunication has given rise to more specific
LPAs, requests for side letters, ad hoc data requests,
and LP initiatives such as the ILPA Private Equity
Principles. Any Institutional LP (LPs that produce
GAAP-based financial statements and invest on
behalf of others—Fund of Funds, Pension Funds,
Endowments, etc.) has need for timely, periodic,
robustly estimated Net Asset Values supported
by a rigorous measurement of the fair value of
underlying investments.
LPs don’t always articulate the reasons they need
fair value reporting. However, they need to have their
investments reported at fair value for a number of
purposes, including but not limited to:
In 2011, the International Accounting Standards Board
issued IFRS 13, creating an equivalent fair value
measurement standard to FASB ASC Topic 820.
Neither IFRS 13 nor ASC Topic 820 requires any asset
to be reported at fair value; they only drive how fair
value is estimated and disclosed when fair value is
required by other accounting standards. However, the
new fair value standards increased the visibility of and
concern about how fair value is estimated, especially
among auditors.
• compliance with their own financial reporting
requirements, which require all investments be
reported at fair value,
• manager selection,
• asset allocation decisions (all asset classes are
reported consistently on a like-like basis, fair value),
• fiduciary duties to diligently monitor their investments,
• incentive compensation decisions,
• satisfaction of third party or regulatory requirements,
e.g., ERISA regulation,
• eliminating the need to consolidate underlying
investments as they are reported at fair value.
31
It is understandable, given recent economic dislocation
related to financial instruments, that the PCAOB would
note audit failures relating to financial instruments
and loan portfolios. However, superimposing such
findings on venture capital indirectly through pressure
on auditors, seems vastly unjustified. Some of the
deficiencies identified by the PCAOB with respect
to financial instruments, which have now indirectly
impacted the interpretation of fair value GAAP and the
application of audit procedures to VC, include:
Why Valuation Guidelines Matter
In 2003, when the PEIGG Valuation Guidelines were
issued, the US Congress also enacted Sarbanes-Oxley
legislation, which among other provisions created
the Public Company Accounting Oversight Board
(PCAOB). The PCOAB regulates auditors of public
companies. The Dodd-Frank Act, enacted in 2011,
required certain Investment Managers to register with
the SEC and brought them under SEC oversight. Their
auditors also faced PCAOB scrutiny as a result.
• Failure to perform appropriate diligence on pricing
services, to the extent of not understanding the
pricing services methodology and/or not knowing
the key underlying assumptions,
The PCAOB in their inspection reports have noted a
number of deficiencies relating to auditing fair value.
While Venture Capital managers are generally not
covered by SEC regulation and PCAOB oversight, it is
difficult – if not impossible – for auditors to audit nonregulated investment companies differently than they
audit regulated investment companies. The SEC and
PCAOB directly impact the audits of venture capital
funds and auditors’ interpretation and application
of GAAP because of PCAOB and SEC pressure on
other similar entities. Interestingly, while the PCAOB
has identified a number of audit “deficiencies” that
theoretically could cause an audit failure, there have
been few, if any, publicized venture capital fund audit
missteps in recent history.
• Confirming prices with the same pricing agent the
audit client utilized,
• Failure to consider (challenge and understand)
material pricing differences among various sources
or from the same provider over time,
• Lack of documentation in support of differences
between recorded/reported price and the price
provided by the external pricing agent,
• Haphazardly extrapolating fair value between
calculation and reporting dates or extending
interim fair value conclusions without performing
procedures to determine the appropriateness of prior
conclusions to the current reporting period,
• Failure to assess the comparability of valuation inputs
derived from market data to the subject security
• Failure to test inputs and assumptions utilized by an
external valuation specialist,
• Lack of sensitivity testing of key variables including
projected results and discount rate assumptions to
determine potential misstatements,
• Not assessing the appropriateness of the valuation
model,
• No demonstrated working knowledge of the
valuation model; inquiries about the model are
insufficient to reveal any modeling weaknesses,
• Lack of appropriate testing of key assumptions and
inputs; unconfirmed appropriateness of sources for
to determine the reasonability of inputs,
32
Auditors’ desire to get the PCAOB and SEC off their back
has forced them to increasingly expand their requests for
documentation and has limited their tolerance for judgment.
Auditors’ desire to get the PCAOB and SEC off their
back has forced them to increasingly expand their
requests for documentation and has limited their
tolerance for judgment. Yet ASC Topic 820 and
IFRS 13 are principle-based and require the use of
market participant assumptions, which are inherently
judgmental. Therefore, the use of industry created
guidelines, incorporating the views of LPs, GPS, and
valuation specialists, provide a GAAP consistent basis
for exercising judgment in estimating fair value.
GAAP which specifies that fair value be determined
using market participant assumptions. The
collaborative process that took place reflects a strong
understanding of the nascent companies in which our
industry invests.”
Fair Value: Where should it be going?
Potential Wrong Turn
The IPEV Valuation Guidelines were developed by U.S.
and international industry participants to be compliant
with relevant GAAP. Because of the apparent pressure
on auditors to deviate from market participant
assumptions when estimating fair value in an effort
to satisfy PCAOB pressure, there is a risk that the
application of fair value deviates from FASB’s intent. As
with the ad-hoc poll of CFOs noted in the introduction
of this article, many in the industry are increasingly
frustrated by the direction where auditors’ fair value
estimates appear to be heading.
As a result of PCAOB and SEC direct or indirect
pressure, auditors are tending to consider the use of
mathematical models to estimate fair value. On the
surface, this may sound reasonable; after all, options,
warrants, and Black-Scholes models somehow seem
synonymous with venture capital. However, unlike
derivatives and debt markets, mathematical models
have not seen wide usage in the private equity
marketplace as market participant assumptions for
determining the value of a round of financing or the
value of a portfolio company. Some auditors have
indicated that for certain early stage investments,
option pricing models (OPM) or probability-expected
weighted return models (PWERM) accompanied by
a backsolve1 allocation of value provide a reliable
indication of Fair Value. From a market participant
perspective, the use of OPM for valuing early-stage
venture Investments may be fundamentally flawed.
By endorsing these guidelines, NVCA joins the
U.S. Private Equity and Growth Capital (PEGCC)
Association and 40 other venture capital, private equity,
and limited partner associations in North America,
Europe, Asia, Africa, and Australia.
Recently, the National Venture Capital Association
(NVCA) took the unprecedented step of endorsing the
IPEV Valuation Guidelines, in part to help stem this tide
of misapplication of fair value principles:
NVCA endorses the updated IPEV Valuation
Guidelines released by the IPEV Board in December
2012 and applauds the work of international and
US GPs and LPs in creating this guidance. We will
promote IPEV Valuation Guidelines to our members
and encourage our members to use this document in
establishing their own processes and procedures in
consultation with their LPs.
1
“The IPEV Valuation Guidelines are the result of
industry stakeholders across a number of countries
coming together to develop appropriate valuation
guidance for venture capital, growth capital, and
private equity firms,” said Mark Heesen, president
of NVCA. “These guidelines are consistent with U.S.
33
The backsolve method derives an entity’s enterprise value (and the value of
other securities) from the transaction value of a specific security class or round
of financing. The method uses option pricing theory (such as Black-Scholes)
requiring subjective assumptions concerning relative volatility, expected
returns, return horizon, etc. Each class of security within an entity’s capital
structure is modeled as a call, or series of call options, considering the unique
claim each class of security has on the assets (or value) of the entity. The
backsolve method requires considering the rights and preferences of each
class of equity and solving for a total enterprise value that is consistent with
recent transactions in the entity’s own securities. Because of these inherent
limitations, the backsolve method should be used with caution as it may under
or over allocate value to preferred and common equity depending on the
impacts of structuring (see section III 1.8. above) and is rarely used by Market
Participants to determine the value of an Investment.
not tools explicitly used by Market Participants to
price transactions. The use of OPM or PWERM is not
required by accounting standards.
OPM has a tendency to overstate the value of
securities reliant on upside conditions (i.e. common
equity) and understate securities with downside
protection (i.e. preferred/senior equity) because the
OPM mathematical framework requires investment
returns to follow a statistical normal distribution curve.
By definition, early-stage venture Investment returns
are relatively binary—the investment is either successful
and returns cash to the investor or, more likely, the
investment fails and no cash is returned. Therefore
if the underlying expected return data is not, from
a statistical perspective, normally distributed, OPM
would not provide a mathematically supportable result.
Additionally, a more compelling argument against the
use of OPM for VC investments is the fact that market
participants generally don’t use OPM.
Another area that increasingly is a focus of auditors
is the use the consideration of minority discounts, or
control premiums. Venture capital investors do consider
the effect of enhanced cash flows and the cost of
capital when pricing an investment. However, they
generally do not do so only because they obtain control;
in fact, it is common for a consortium of investors to
enter into a transaction together where no single investor
obtains control. In such cases, the investors work in
concert to maximize the value of the investment. It is
also common for two or more investors to enter into a
transaction where one has control and other investors
do not have control, even though rights and price paid
may be identical. When a single investment company
acquires a controlling interest, it does not does not
pay a premium to the price paid by the other (minority)
investors. That is because private equity investors do not
price investments in terms of premiums and discounts;
they determine the price they are willing to pay, and
very often the terms of the investment do not allow for
disproportionate returns amongst the investors.
PWERM, while arguably more theoretically
supportable than OPM, tends to be very subjective
and highly dependent on selecting appropriate
probability judgments. Implicitly, some venture
capital managers may use a simplified probability
assessment as they consider the amount they are
willing to invest in a startup company or an additional
round of financing. Therefore, PWERM may be
applicable to estimating fair value but, given the
significant judgment involved, it likely would not be
used in isolation to estimate Fair Value.
Venture capital investors often have unique rights and
privileges, and the fair value of their investments should
reflect those rights and privileges. Yet the existence
of rights alone is not sufficient to dictate valuation
adjustments; rather, what is needed is a demonstrated
history of obtaining value from those rights. Second,
the fact rights are generally modified in subsequent
financing rounds should be considered. For example,
liquidation rights and seniority are almost sure to
change in the future, as additional rounds of financing
are layered on top of the existing or latest round (which
is yet another argument against the validity of OPM for
VC investments).
PWERM techniques are more appropriately used as a
guide to provide a data point in allocating Enterprise
Value to individual securities or to estimate Enterprise
Value from transaction data provided by a recent
round of financing (known as the backsolve method);
with the understanding that the backsolve method will
likely depress the estimate of value for an Enterprise
when the benchmark transaction (most recent round
of financing) includes significant downside protection
rights. Generally speaking, OPM and PWERM are
If the industry does not continue to provide input to regulators,
valuation advisors and auditors, regulatory interpretation could
increase costs and reduce correlation to market based results,
adversely impacting both LPs and GPs.
34
Conclusion
The relative value of the ownership interests within
the capital structure is the subject of much debate
recently. In many ways, this relates to the unit of
account. The total enterprise value for an investee is
reflected in the price paid for an expected ownership
percentage (typically, fully diluted). The way that
enterprise value is “carved up” amongst the various
investments in the capital structure does not change
the market participant’s assessment of total enterprise
value in and of itself. When determining how to
“carve up” the total enterprise value, it is important
to ask why the fair value of one component of the
capital structure would affect the fair value of the
other components. It is also important to determine
whether a market participant buyer of one of those
components would pay more or less for that particular
component if it were to buy others at the same time.
Therefore, for the Investment Company industry in
particular, the use of terms such as discounts or
premiums may be both confusing and misleading.
Fair Value, as defined by FASB and as promulgated
in the venture capital industry initially through the
PEIGG Valuation Guidelines and now through the IPEV
Valuation Guidelines, is the reasonable and consistent
basis of reporting investments to LPs. Regulatory
pressure on auditors has the potential to derail
FASB’s intent and LP’s fair value needs. The industry,
including both GP and LPs, can rally around the IPEV
Valuation Guidelines to ensure that market participant
assumptions are used in valuation. If the industry does
not continue to provide input to regulators, valuation
advisors and auditors, regulatory interpretation could
increase costs and reduce correlation to market based
results, adversely impacting both LPs and GPs.
Fair Value continues to require the exercise of
judgment based on objective evidence, such as
calibrating the original investment decision with the
current performance of the company and the current
economic environment using market participant
assumptions. Deviating from such principles is not
helpful to any industry participant. •
About the Authors
David L. Larsen is a managing director and a leader of the Alternative Asset Advisory practice in the San Francisco office
of financial advisory and investment banking firm Duff & Phelps. He serves a wide variety of investors and managers in
resolving valuation and governance-related issues. Mr. Larsen is a Member of FASB’s Valuation Resource Group, a Board
Member of the International Private Equity and Venture Capital Valuations Board (IPEV), lead the team that drafted the US
PEIGG Valuation Guidelines, and is a Member of the AICPA Private Asset Valuation Task Force.
Steven Nebb is a managing director in the San Francisco office of financial advisory and investment banking firm
Duff & Phelps and member of the Portfolio Valuation practice. He serves as the project lead for numerous Alternative
Asset managers and investors including large global private equity, venture capital, and Business Development
Companies. He provides advisory support to many limited partnerships and corporate pension plans regarding fund
management, financial reporting requirements and general valuation of investments, and has over 15 years of experience
in performing valuations of intellectual property, private equity, illiquid debt, and complex derivatives for a variety of
purposes including fairness opinions and transaction advisory, financial reporting, tax, litigation, and strategic planning.
35
Connell & Partners 2013
Executive Compensation in
Recent IPO Study
By Jack Connell, Kim Glass and David Schmidt
Executive Summary
The transition from pre-IPO to a publicly traded
company is significant in many areas, including
executive compensation levels and practices. Some of
the major areas that change include:
Cash Compensation – Cash compensation
levels increase for all executives, particularly
for the CEO and CFO.
Cash compensation levels increase for all executives,
particularly for the CEO and CFO. This is usually
because companies try to rebalance their total
compensation offering and shift from a heavier reliance
on equity to a balanced approach of short- and longterm incentives. With their newly procured cash,
there is less of the need for employees to defer their
compensation into equity holdings. Furthermore, the
additional risk, exposure, shareholder commitments,
and management of Wall Street expectations, is a
significant increase in executive responsibility, and the
pay levels reflect that.
Cash compensation levels
increase upon IPO for all
executives, particularly for
the CEO and CFO. Increased
amounts are generally in the
double digits for key executives
such as the CEO, CFO
and Head of Sales.
36
Head of Sales – Head of Sales compensation (actually
the #2 most highly paid executive at the median vs. the
typical CFO or COO role in larger public companies)
target total cash compensation increased 9% at the
median with a mean of 16%. Base salaries had median
and mean increases of 3% and 6%, respectively, and
target bonuses had increases of 8% and 16% at the
median and mean, respectively.
Focus of Study
Our study is comprised of 46 companies in the
high technology, biotechnology and alternative
energy arena that went public in the year 2011
and have since released proxy data for that
year. We looked at the compensation levels and
practices in the year prior to their IPO, and in
the year of their IPO to examine the changes.
We examined the CEO, CFO and Head of Sales
Positions as these were the three most prevalent
positions listed. Other roles did not have enough
data points to be statistically significant. We only
used incumbents who were in their roles for the
two-year timeframe.
Bonus Targets – Bonus targets increase and
bonus plans shift from primarily discretionary
to more formulaic and goal based.
This is because sustained growth in traditional metrics
such as revenue and income (and often earnings
per share or EPS) becomes more expected. Public
companies also tend to have greater ability and
resources to forecast future performance, thus a more
formulaic approach to compensation becomes a viable
option once public.
Increase Amounts – Increased amounts are
generally in the double digits for key executives
such as the CEO, CFO and Head of Sales.
Share Usage and Dilution – Equity dilution and
the annual stock “burn rate” increases as the
IPO approaches.
CEO – The median increase for a CEO’s base salary
was 14%, and the mean 21%. The target bonus
opportunity as a percentage of base salary had a
median increase of 12%, and a mean increase of 16%.
(Note: This is an increase in the percentage of base
salary. For example, an increase from 25% of base to
75% would be an increase of 200%, not 50%. The
math of each is as follows—the correct calculation
is (75-25=50 then (50/25)*100=200% and not just
75-25=50 which is just the delta in the percentages.)
The increase in CEO target total cash compensation
was 21% at the median and our group had a mean
increase of 36%. This number reflects the distribution
of the change in target total cash among companies
that reported target bonus figures for both the year of
IPO and the year prior.
Equity dilution and the annual stock “burn rate”
for executive and employee stock plans, which
were significant early on in pre-IPO firms, temper
as the company approaches later stages prior to
the IPO. Burn rate then increases again as the firm
approaches and completes the IPO due to refresh
grants to enhance retention for executives and key
employees, and ESPP’s are implemented. Once in a
public company environment, dilution and overhang
need to be managed relative to institutional investor
expectations. “Evergreen” stock plan replenishment
is often highly recommended, as it will provide the
share pool with flexibility to make on-going grants to
new critical employees, and pre-public is the only time
a company can implement such a plan feature. It is
critical to ask for a large enough evergreen (typically
4-5%/year in the industries we studied,) to fund the
stock needed per year. This does not mean you have
to use this amount every year as it can be “banked” for
future years.
CFO – CFO target total cash compensation increased
16% at the median with a mean of 20%. Base salaries
had median and mean increases of 5% and 9%,
respectively, and target bonuses had increases of 6%
and 11% at the median and mean, respectively.
Bonus Targets – Bonus targets increase and bonus plans shift
from primarily discretionary to more formulaic and goal based.
37
Share Usage and Dilution – Equity dilution and the annual stock
“burn rate” increases as the IPO approaches.
Equity Vehicles – Options continue to
remain the primary vehicle of choice for
pre-IPO/IPO firms.
Stock Ownership Guidelines – Formal Stock
Ownership Guidelines are a minority practice.
Only two of the companies in the sample
implemented executive stock ownership guidelines.
This differs greatly from most mature public
companies who have implemented them, as stock
ownership guidelines have evolved into a corporate
governance best practice. Companies at such a
young stage likely do not feel the need to implement
them as most key executives are holding large
quantities of stock and are subject to post-IPO lock
ups, typically delaying insider sales for up to six
months post-IPO, and are therefore appropriately
aligned with shareholder interests. Thus, companies
typically will wait several years before implementing
formal guidelines. Given some of the poor stock price
performance of recent IPOs, however, we may begin
to see more of a focus on ownership guidelines in the
future, as Boards and shareholders look for additional
tools to ensure executives remain focused like owners
and are aligned with shareholder interests.
In the first years after IPO (often 2-3 years out),
companies begin to shift away from relying solely
on stock options to incorporating other stock based
vehicles, such as full-value shares. Restricted stock
awards or restricted stock units help to manage stock
dilution, provide downside protection in the event
of moderate to flat growth post-IPO, and provide
increased retention potential. Performance-based
awards are still a significant minority of shares used,
or not used at all, as companies often have limited
performance history to predict multi-year performance
necessary for implementing these plans.
Security Provisions – Severance and Changein-Control protection helps to provide added
security for the employee and ensure business
continuity for the company due to the
heightened risk of an IPO.
Because of the increased risk of IPO failure and
heightened potential for takeover in the first years of
being a public company, companies will often provide
enhanced security through severance and changein-control (CIC) arrangements (although still below
those in the level of more mature public companies).
Given the current governance environment, they
usually lack the so-called “egregious” or “problematic”
provisions such as single triggers and golden
parachute gross ups (IRC SS. 280(g) AND 4999) that
were prevalent many years ago. There is generally
some (most common practice is 100% though a few
companies have less) acceleration of equity vesting
upon a double-trigger (CIC and loss of employment)
severance. Severance and CIC levels for freshly public
firms are still low when compared to the broader public
company environment of 2-3X for the CEO and 1-2X
for his/her direct reports.
Equity Vehicles – Options
continue to remain the
primary vehicle of choice for
pre-IPO/IPO firms.
38
Compensation Levels – CEO and
CFO Pay Increases with Additional
Responsibilities.
Why do we Illustrate Multiple
Compensation Changes?
You will notice that when we talk about the
various changes in compensation, we first
present the median and mean increase in
various compensation elements. It is important
to differentiate these increases from the
differences in the median or the mean summary
statistics for each year of data. For the increase
amounts, we took the difference between the
two years of data examined for each individual
executive, then presented the median (50th
percentile) and mean (arithmetic average) of the
data set of those changes.
CEO and CFO compensation changed the most
dramatically in the year of IPO, likely in response to the
significant changes to their roles.
Out of all the public company officers, these two roles
often have the biggest increase in risk since they now
have to sign off on the financial statements under
Sarbanes-Oxley, and they also have the additional
responsibilities of working with Wall Street and the
investment community to generate continuing interest
in the company.
Compensation also increases as the companies no
longer, in general, have the cash burn constraints
that they had as private, venture-backed
organizations, and therefore can take a more
reasonable and balanced approach to total
compensation by shifting compensation into cash
instead of relying on mostly equity.
Now, why do we do this? We feel this is the best
way to illustrate how compensation philosophies
can adjust with an IPO, because this group was
crafted without respect to size of the company.
On base salary for example, this methodology
helps a firm anticipate what a typical base salary
increase might look like in the year of IPO.
39
Chief Executive Officer (CEO) Compensation Changes (Pre- and Post-IPO)
The median change in base salary for a CEO from pre-IPO
to the year of IPO the year of IPO was 14% and the mean
was 21%. The median change of our sample went from
$307K to $383K, or an increase of 25%. For companies
that reported annual bonus targets in both years, the median
increase in target Total Cash Compensation was 21% and
the mean was 36%. Total Cash Compensation reflects base
salary+annual target bonus.
Element of Compensation
Some of the bigger names in IPOs also had some
of the most drastic changes to their CEOs’ pay.
LinkedIn doubled their CEO’s cash compensation,
with base salary going from $250K to $480K per
year, and target total cash from $400K to $818K.
On the other hand, Groupon CEO Andrew Mason
had his base salary shifted, at his request, from
$180,000 to $756.62.
Changes in Cash Compensation with IPO
25th Percentile
50th Percentile
75 Percentile
Mean
Base Salary Change (%)
3%
14%
28%
21%
Target Bonus Change (% points of base)
0%
12%
34%
16%
Target Total Compensation Change ($K)
7%
21%
67%
36%
Notes:
Executives for which target bonus was not available were not figured into target total cash compensation.
Element of Compensation
Base Salary ($K)
Target Bonus (as % of Base)
Target Total Compensation ($K)
Fiscal Year Before IPO
25th Percentile
50th Percentile
75 Percentile
$282.2
$307.4
$382.0
35%
50%
80%
$404.3
$482.5
$664.2
Notes:
Executives for which target bonus was not available were not figured into target total cash compensation.
Element of Compensation
Base Salary ($K)
Target Bonus (as % of Base)
Target Total Compensation ($K)
Year of IPO
25th Percentile
50th Percentile
75 Percentile
$318.1
$382.5
$450.0
46%
67%
100%
$482.5
$727.5
$834.0
Notes:
Executives for which target bonus was not available were not figured into target total cash compensation. When possible, executive’s post-IPO cash
compensation is used.
40
Chief Financial Officer (CFO) Compensation Changes (Pre- and Post-IPO)
The median of the changes in base salary for the CFO
was 5% and the mean was 9%, with increasing base
salaries from $250K to $285K, or a change at the median
of 12%. Annual target bonuses had a mean increase of
11% and target total cash compensation had a mean
increase of 20%. Also, there was a slight increase in
the premium the CEO receives relative to the CFO over
the time period examined. The average premium for
target total cash went from 54% in the year prior to IPO
Element of Compensation
to 65% in the year of IPO. This is likely due to market
pressures for the CEO role, versus a prior focus of more
internal equity between executives while still private/
VC-backed. Also, the CEO might delay an increase in
cash compensation while guiding what is often his or her
company towards IPO, while CFOs are often brought in
and expect to be compensated closer to the market rate
from the outset.
Changes in Cash Compensation with IPO
25th Percentile
50th Percentile
75 Percentile
Mean
Base Salary Change (%)
2%
5%
13%
9%
Target Bonus Change (% points of base)
1%
6%
16%
11%
Target Total Compensation Change ($K)
7%
16%
33%
20%
Notes:
Executives for which target bonus was not available were not figured into target total cash compensation.
Element of Compensation
Base Salary ($K)
Target Bonus (as % of Base)
Target Total Compensation ($K)
Fiscal Year Before IPO
25th Percentile
50th Percentile
75 Percentile
$221.3
$250.0
$290.0
25%
38%
50%
$302.8
$355.0
$386.5
Notes:
Executives for which target bonus was not available were not figured into target total cash compensation.
Element of Compensation
Base Salary ($K)
Target Bonus (as % of Base)
Target Total Compensation ($K)
Year of IPO
25th Percentile
50th Percentile
75 Percentile
$250.0
$286.0
$309.0
30%
50%
60%
$336.5
$435.0
$500.8
Notes:
Executives for which target bonus was not available were not figured into target total cash compensation. When possible, executive’s post-IPO cash
compensation is used.
41
Head of Sales (HOS)
The median of the increases in base salary for the
HOS was 3% and the mean at 6%. Annual target
bonuses had a mean increase of 16% and target total
cash compensation also had a mean increase of 16%.
This is actually the #2 position in terms of total target
compensation; however, it is a small sample size of
12 and is due primarily to the high targeted bonuses
Element of Compensation
of nearly 100%, showing the importance of meeting
revenue targets once a company goes public. This
“targeted compensation” is generally earned in the form of
commission, which is paid only if sales or margin targets
are met unlike the “corporate” plans that the CEO and
CFO are likely on.
Changes in Cash Compensation with IPO
25th Percentile
50th Percentile
75 Percentile
Mean
Base Salary Change (%)
1%
3%
7%
6%
Target Bonus Change (% points of base)
3%
8%
26%
16%
Target Total Compensation Change ($K)
5%
9%
27%
16%
Notes:
Executives for which target bonus was not available were not figured into target total cash compensation.
Element of Compensation
Base Salary ($K)
Target Bonus (as % of Base)
Target Total Compensation ($K)
Fiscal Year Before IPO
25th Percentile
50th Percentile
75 Percentile
$202.8
$225.5
$235.0
28%
70%
119%
$283.6
$331.3
$445.0
Notes:
Executives for which target bonus was not available were not figured into target total cash compensation.
Element of Compensation
Year of IPO
25th Percentile
50th Percentile
75 Percentile
Base Salary ($K)
$208.6
$228.0
$249.0
Target Bonus (as % of Base)
350%
98%
117%
Target Total Compensation ($K)
$350.3
$450.0
$498.5
Notes:
Executives for which target bonus was not available were not figured into target total cash compensation. When possible, executive’s post-IPO cash
compensation is used.
42
Share Usage and Dilution
Companies Refresh or Revamp Equity Incentive Plans Pre-IPO
An important step before completing an IPO is to
approve a new stock plan and share reserve, as
previous methods of distributing shares to employees
will likely have been exhausted or close to it.
Furthermore, it is much more efficient to get plans
with the needed flexible provisions, such as annual
replenishment features (or Evergreens), approved
in a private company environment than with public
shareholder scrutiny. The graph below illustrates the
equity outstanding, shares available for grant, and the
total equity overhang percentiles for the study group
pre-and post-IPO.
plans where possible. Many companies will approve
the stock plan before the IPO and wait to implement it
concurrently with the offering. Others will start using it
before the offering.
Equity Outstanding — The sum of stock
options outstanding and unvested restricted
shares outstanding as a percentage of shares
outstanding.
Total Overhang — The sum of equity
outstanding and shares reserved for issuance.
We examined these figures from each company’s
prospectus filing and separated out the new equity
Equity Overhang
35%
35%
32.7%
Pre-IPO
29.6%
30%
Post-IPO
25%
25%
23.3%
22.5%
21.6%
20%
20%
17.6%
15%
10%
30%
26.1%
13.5%
16.9% 16.6%
15%
13.0%
13.8%
9.0%
10%
8.3%
6.2%
5%
0%
5%
3.8%
0.7%
PG...
PG...
Equity Outstanding
PG...
1.7%
PG...
PG...
PG...
Shares Available for Grant
Approval of the new share plan outweighs the
incremental dilution caused by the share offering
leading to increases in total overhang. “Evergreen”
provisions provide for the automatic annual
replenishment of a stock plan’s share reserve by a set
amount of shares, a percentage of shares outstanding,
PG...
PG...
PG...
0%
Total Overhang
or more often, the lesser of the two. These have
become increasingly popular, with a vast majority of
companies in the study enacting them pre-IPO. Many
companies have implemented Evergreens as a part of
their Employee Stock Purchase Plans (ESPPs) as well.
43
The following charts display the breakdown of
Evergreens for stock plans and ESPPs according to
the percentage of shares outstanding providing for in
the plans.
We have long recommended between 4% and 5%
of shares outstanding for stock plan Evergreens, and
the data shows this continuing to be the trend. 1% of
shares outstanding is the most popular amount for an
ESPP evergreen.
Equity Plan Evergreen Percentages
Pre-IPO and IPO Equity Grants Remain a
Prevalent Practice, with Options Continuing to
be the Vehicle of Choice
5.0%
No Evergreen
28%
25%
Grants of any type of equity vehicle (stock option,
restricted stock award/unit, performance share) were
awarded by approximately 75% of companies in the
year prior to IPO and nearly 90% of companies in
the year of IPO, indicating that companies are likely
“reloading” executives and key employees prior to
the IPO. Many of them are presumably nearly or fully
vested with very low strike prices given the length of
time that it is taking companies to go public these
days. Gone are the days of the “initial/new hire” grant
prior to IPO and then no further grants until post-IPO,
which was very prevalent in the dot.com boom of the
late 90’s.
3.0%
5%
4.5%
3.5%
7%
5%
4.0%
3.9%
28%
2%
ESPP Evergreen Percentages
Approximately 70% of the companies granted stock
options in the year prior to IPO and slightly over 75%
in the year of IPO. Stock grants (either restricted stock
awards or restricted stock units (RSUs)) were granted
by approximately 15% of companies in the year prior
to IPO and nearly 30% in the year of IPO. Finally,
performance awards (either grant or vesting contingent
on performance hurdles being met) comprised less
than 10% of companies each year, likely due to the fact
that for companies in this stage of growth, it is very
difficult to predict and forecast multi-year performance.
2%+
7%
1%
23%
No ESPP
56%
0.50%
2%
ESPP w/o
Evergreen
12%
44
LTI Design
CEO LTI Instrument Usage
Vehicles – Stock Options Remain the Most
Prevalent Choice of Equity Vehicles
This LTI usage chart is for the CEO who was in place in
their respective company for both year of IPO and the
year prior to IPO. 46% of the CEOs were granted stock
options in the year prior to IPO and approximately 65%
in the year of IPO. Stock grants (either restricted stock
awards or restricted stock units (RSUs)) were granted by
approximately 15% of companies in the year prior to IPO
and fell slightly too approximately 13% of companies
in the year of IPO. Finally, performance awards (either
grant or vesting contingent on performance hurdles
being met) were granted by 7% and 2% of companies
each year, respectively, likely due to the fact that for
companies in this stage of growth, it is very difficult to
predict or forecast multi-year performance. Grants of
any type were made by 59% of companies in the year
prior to IPO and 72% in the year of IPO. These figures
are all lower than the Top 5 reported officers, likely
because the CEO has the highest total shares held as a
percentage of shares outstanding and thus is least likely
to need any “refresher” shares.
Stock Options are still far and away the vehicle of
choice for new IPO’s. In the year of IPO, 76% of the
participants in the survey granted stock options, while
28% granted RSU’s. This is not surprising given the
strong alignment between pay and performance and the
direct connection options create between employees
and shareholders. Moreover, they are an effective
way to reward employees in a start up environment
for their significant hard work and sacrifices prior to
the IPO. Additionally, as small, early-growth stage
companies they generally have a larger allowable burnrate by institutional investors, and/or they adopted an
Evergreen element to their plan while still private so
they do not have the burn-rate constraints that many
larger public companies have and thus are forced to
use restricted stock units to manage their share pools
more conservatively. Additionally, they often do not
have the executive/key employee retention concerns
that larger companies with flat share prices may have;
again alleviating the need to deliver RSU’s to increase
retention value. Only one recent public company offered
performance-based LTI as most likely cannot forecast
multi-year financials accurately enough to make them a
feasible alternative.
CEO LTI Instrument Usage
100%
80%
The previous LTI usage chart is for all Top 5 reported
officers (not the entire employee population, which
likely differs, as this is not disclosed) in the S-1 filings
who were in place in their respective companies for
both years (year of IPO and prior year). This is likely
more illustrative initially than showing a position-byposition look, which we will look at after this analysis
as there are some intriguing differences.
IPO Year
Options
Stock
Performance
Options
Stock
Performance
Any Instrument
54% of the CEO’s were granted stock options in the
year prior to IPO and in the year of IPO. Stock grants
(either restricted stock awards or restricted stock units
(RSUs)) were granted by 7% in the year prior to IPO
and rose significantly to 15% in the year of IPO (likely to
insure retention of the CFO and to reflect the significant
increase in responsibilities for this position). Finally,
performance awards (either grant or vesting contingent
on performance hurdles being met) were granted by
4% of companies each year, likely due to the fact that
for companies in this stage of growth, it is very difficult
to predict multi-year performance. Grants of any equity
type were made by 61% and 60% of companies,
20%
0%
IPO Year
CFO LTI Instrument Usage
80%
40%
40%
0%
100%
Prior Year
Prior Year
20%
NEO LTI Instrument Usage
60%
60%
Any Instrument
45
respectively, in the year prior to IPO and in the year
of IPO. This is likely low due to the fact that most VC/
PE-backed companies do not hire a CFO to take the
company public until a couple of years before the IPO,
thus there is no need to refresh the shares.
Employee Stock Purchase Plan (ESPP) –
ESPPs Remain a Critical Mechanism for
Encouraging Employee Ownership
40% of the recent IPO’s implemented an ESPP upon
IPO. Of those that did, roughly 50% implemented
an evergreen feature in the plan with a median
replenishment of 1% of shares outstanding added to
the plan every year. All (100%) also had a “look-back”
feature, with an average look-back of 6 months, allowing
participants to purchase their company’s stock at a 15%
discount, making these plans a very attractive benefit
for the broad-based population. The majority of larger
public technology and life science firms have an ESPP,
so this is an area of significant difference between the
two types of firms. We suspect that this is due to the
notion that IPO companies typically grant equity more
broadly than their more mature counterparts, and
therefore, already have broader ownership levels.
CFO LTI Instrument Usage
80%
60%
Prior Year
40%
IPO Year
20%
0%
Options
Stock
Performance
Any Instrument
Stock Ownership Guidelines – While Equity
Grants are Prevalent, Formal Ownership
Guidelines are Not.
Severance/CIC
Only 2 of the companies in the sample implemented
executive stock ownership guidelines. This differs
greatly from most mature public companies who have
implemented them, as it has evolved as a corporate
governance best practice. They likely do not feel the need
at such a young stage as most key executives are holding
large quantities of stock and are subject to post IPO lock
ups preventing insider sales for up to six months postIPO. Thus, companies typically will wait several years
before implementing them. Given some of the poor stock
price performance of recent IPOs, however, we may
begin to see more of a focus on ownership guidelines
in the future, as Boards and shareholders look for tools
to ensure executives remain focused like owners and
aligned with shareholder interests.
65% of companies in the study offered severance
benefits for executives without a change-in-control
(CEO and CFO), whereas 82% (CEO and CFO) of
companies offered severance benefits to executives
with a change-in-control.
The median cash payment to a CEO upon a separation
without a CIC was 6 months of salary, including
non-receiving. The median was 12 months for those
receiving. For a separation with a CIC (all doubletrigger), the median was 12 months, including nonreceiving and the mean for those receiving was 12
months. For the CFO, the median without a CIC was 6
months, including 0’s and 12 months for those receiving.
Compensation Committee Checklist for Pre-IPO
Companies
Other Plan Design Features
The compensation changes outlined in this white paper
are only a fraction of what the Compensation Committee
must address as it prepares for an IPO. Here below are
additional topical areas the Compensation Committee
should be thinking about as a firm is contemplating going
public in the near future. If companies can address these
issues as early in the run up prior to the IPO as they
can, they will be rewarded with more flexibility on share
usage, compensation expense forecasting, disclosure,
and potential for increased performance to help drive the
business strategy. They will also have a more strongly
written CD&A, with fewer comments, that need to be
responded to, by the SEC.
Annual Bonus Plan Design – Most Bonus
Plans Remain Discretionary
Of the 46 annual bonus plans, 17 (37%) were formula
based, 27 (59%) were discretionary and 2 (4%) had
no formal plans. Revenue (in 20% of companies) and
profitability (net income, EBITDA, etc.), used in 16% of
companies, were the most prevalent metrics listed in
the Companies’ Compensation Discussion &Analysis
(CD&A) sections of the Proxy. This is not surprising
given that these are typically the two biggest drivers
of value creation and expectations by Wall Street of a
new public company.
46
Overall
Long-Term Incentive
ˆ Determine roles and decision rights of employees
(HR, Finance) and consultants in developing
executive compensation programs.
ˆ Review / develop a long-term incentive strategy
including appropriate instrument use / mix.
ˆ Develop an LTI award matrix with values and
participation rates for all employee levels.
ˆ Assess current compensation consultant, including
independence and potential conflicts of interest. If
you do no not currently have a consultant, hire one
before the IPO. If you do, assess current consultant
and select for next year ensuring the firm is as
strong in a public company environment as it is in a
VC-Backed environment.
ˆ Determine if an “Evergreen” provision will be used. If
so, determine appropriate evergreen size.
ˆ Set equity utilization (share run rate) budget for
coming fiscal year.
ˆ Determine if any IPO awards will be made to top
executives and key employees. This will be key to
do if most or all of current awards are fully vested
as the company thus has little or no retention
capability.
ˆ Develop an executive compensation philosophy
(including program objectives, pay positioning, mix,
types of vehicles, etc).
ˆ Develop a defensible Peer Group of comparable
public companies.
ˆ Discuss and potentially implement executive and
Board share holding/ownership requirements.
ˆ Review competitiveness of executive compensation.
Employment, Severance, and Change-in-Control
(CIC) Arrangements
ˆ Set competitive compensation levels (base,
target bonus, equity/long-term incentive awards,
perquisites/benefits and total direct compensation).
ˆ Review existing employment, severance, and CIC
agreement terms and conditions and potential
payouts.
Short-Term Incentive/Bonus Plans
ˆ Determine overall strategy and framework (e.g.,
financial goals, milestones, discretionary, frequency).
ˆ Complete a competitive analysis of key terms for
employment, severance, and CIC agreements and
set terms going forward based on the market and
overall pay philosophy.
ˆ Select financial performance measures and
individual / MBO goals.
ˆ Calibrate financial performance targets versus
market/street expectations, internal budget, and
Peer Group performance.
ˆ Ensure all “egregious” pay provisions are removed
from any existing agreements or a commitment
is made in the CD&A to grandfather in existing
executives but not have any egregious provisions in
any new agreements going forward.
ˆ Develop formalized Short-Term Incentive Plan
document.
Governance
ˆ Develop or amend (as needed) Compensation
Committee charter.
ˆ Draft Compensation Discussion & Analysis (CD&A)
and accompanying tables for S-1 and Proxy.
ˆ Compensation risk assessment.
ˆ Review and set Board of Directors compensation
for the following year.
ˆ Set equity award approval process, including what
authority, if any, will be delegated to management.
Formalize policy regarding award grant timing.
47
Best Practices for Companies Preparing to IPO
In working with many Compensation Committees for
firms that are going to IPO, we consider these to be “best
practices” in the marketplace:
• Compensation Committee selects and has an
independent executive compensation consulting firm
work for it — a firm that does no other work for the
management of the company and whose consultants
have no personal (e.g., non-business ) relationships with
the Board.
• A named Peer Group of public company comparables
(for executive compensation purposes) exists that
is similar in terms of industry, revenues and market
capitalization so the executive compensation decisions
are reasonable, appropriate and defensible (if
challenged by institutional investor advocacy groups).
ż Ideally 15-20 firms
ż Company at or near the median of proposed group
of companies in terms of both revenues and market
capitalization.
• Executive compensation levels are within market norms
(defined as 25th to 75th percentile of the Peer Group
and any surveys that are used).
ż Longer-term, CEO pay levels need to be supported
by company performance, most notably TSR.
• The company should adopt an “Evergreen” provision in
its Equity plan pre-IPO which will be the only time that
this is feasible.
ż Ensure evergreen is large enough to support annual
ongoing equity grants and any M&A activity that may
occur– typically in the 4-5% range for human capital
intensive firms such as high-technology, biotechnology
and alternative energy firms.
ż Having a 4-5% pool become available every year does
not mean the firm has to use all of those shares – they
simply become available for grant and may be “banked”
for future use. Implementing too small of an evergreen
will cause it to have to be discarded, as it is seen as an
egregious compensation practice for mature companies
by Institutional Shareholder Services (ISS) who would
vote “no” on any stock request with such a provision.
ż Market (Peer Group) median annual burn rates and
dilution levels will have to be achieved over time (the
numbers fall as the Company gets larger/more mature).
48
• Remove any “egregious” executive compensation
practices so that they are not “red flags” to ISS
and similar advisory firms providing counsel to
Institutional shareholders:
• Ensure key management and other employees
are “locked in” for the foreseeable future through
equity refresh grants prior to/concurrent with the
IPO, as the time to IPO/exit has extended and that
may mean that many people are or are near fully
vested upon IPO and therefore there is no retention
capability. The best way to look at this is through
a “carried interest” analysis that looks at “in the
money” value of awards not vested under various
stock price scenarios.
ż No gross-up provisions in severance/change-incontrol arrangements.
ż Double (i.e., CIC and termination/material change
in employment relationship) versus single trigger
change-in-control arrangements.
ż Excessive executive benefits and perquisites (not
typically found in firms that are going to IPO). Were
typical in larger public companies.
• Have a succession plan in place for the CEO so
management continuity is ensured should something
unfortunate happen to him/her. This is becoming
a market governance best practice, plus it is far
cheaper and less dilutive to shareholders to promote
from within that to recruit a new CEO. •
• Firm is prepared for a Say-on-Pay vote after being a
public company.
• Conduct a compensation risk assessment and
include the results in the CD&A.
About the Authors
Jack Connell was the founder and Chief Executive Officer of DolmatConnell & Partners and is now the Managing Director
of Connell & Partners, a division of Gallagher Benefits Services, itself a division of Arthur J. Gallagher (NYSE:AJG). Jack is
a nationally recognized expert in executive compensation, short-term and long-term incentive plan design linking pay and
company performance, and executive reward strategy development. He works with organizations ranging from start-ups
to Fortune 50 companies. He focuses on industries with intensive human-capital needs, including high technology, life
sciences, and alternative energy/clean technology. He earned a Bachelor’s Degree in Economics from the University of
Michigan and an MBA in Organizational Behavior and Corporate Strategy from the University of Michigan Ross Graduate
School of Business.
Kim Glass is Principal at James F. Reda & Associates a division of Gallagher Benefits Services, in Atlanta, Georgia, and has
over 15 years of experience in the executive compensation field. Kim works closely with compensation committees and/or
management of public and private companies. She consults in all areas of executive compensation, including competitive
benchmarking, incentive program design (cash and equity), compensation disclosure (including issues related to the CD&A
and required tables), outside director compensation strategy and design, change-in-control and general severance design,
and Board and Compensation Committee governance. Kim graduated from the University of Virginia and started her career
as a C.P.A. at Arthur Andersen & Co.
Dave Schmidt is a Senior Consultant at James F. Reda & Associates, a division of Gallagher Benefits Services, and has
over twenty years of experience and functional expertise in economics, sales management, and customer research. Dave
is an expert in the valuation of stock-based compensation arrangements, the review of senior executive compensation
packages, modeling for FAS 123R purposes, and the design of special situation incentives and change-in-control programs.
Dave earned a B.S. in Mathematics and an M.A. in Economics from Western Illinois University.
49
Executive Severance
Agreements and Policies in
Venture-Backed Companies
By Pearl Meyer & Partners
Members of senior management need to feel secure
in their positions and in the prospects for the new
company so they can remain singularly focused on
executing its long-term strategy.
Though widely applicable for private companies,
severance/change-in-control (CIC) arrangements are
a good means of gaining the trust of the executive
team in advance of a transition to public ownership.
Such programs provide management, as well as
shareholders, with a measure of security that the
company will remain stable after entering the public
arena, or in the event the IPO doesn’t transpire.
Such arrangements are similarly helpful in promoting
retention and recruitment at venture-backed
companies that are not yet ready to embark on the
road to public ownership.
This article explores the key
considerations for companies
planning a public offering in
deciding whether and how
to structure a severance or
CIC arrangement, including
data on current practices
from a Pearl Meyer & Partners
study of 66 software and life
science firms that had IPOs
between 2010 and 2012.
50
Whether transitioning to public ownership or being sold privately,
venture-backed companies are essentially selling their
executive talent and vision – making the ability to secure that
talent of critical importance to their success.
Key Benefits and Forms of
Severance Arrangements
Unlike employment agreements, severance and CIC
policies cover severance benefits only and do not
include any current employment terms. Such policies
have two advantages for the company: it can make
changes unilaterally at any time and the policy can be
structured to provide uniform benefits (and therefore
equal treatment) to employees and executives who
serve in similar positions within the company.
Security arrangements typically guarantee a stated
level of compensation under specific circumstances,
such as if the company undergoes a change of
ownership and the executive is terminated or demoted.
This provides an element of job and financial security,
and an incentive to remain with the company, to
incumbents who might otherwise view an IPO or
private sale of the company as destabilizing.
While there can be separate agreements for payout
of severance with or without a CIC, we find that both
situations are generally addressed in one agreement
or policy in order to reduce the potential for conflicting
terms in separate policies and documents.
Having a safety net in place encourages the
management team to provide unbiased feedback and
analysis of possible business opportunities (such as
whether to sell the company or to undergo an IPO).
It also offers an element of security to newly recruited
executives who would be giving up a more stable
situation at their current employer. Finally, putting in
place a consistent approach to agreements helps
avert potential conflict among executives, when the
exact terms of executive arrangements for named
executive officers (NEOs) are disclosed as part of a
public offering.
In our experience, pre-IPO companies have a
mishmash of different agreements in place that
typically were entered into under varying circumstances
over a period of time. These differences were usually
born out of necessity as a company was making key
hires and each candidate had different demands and
different leverage in the negotiation. For example, one
of our clients discovered in a pre-IPO review that it
had five different post-IPO severance agreements for
its top five officers, ranging from payment of one year
of salary and annual incentive to zero payout. The
client replaced those with consistent policies for similar
levels of executives, heading off possible resentment
when the newly public company had to disclose the
severance terms for its named executives.
Security arrangements can take several forms
including:
• Employment agreements
• Severance agreements or policies
• CIC agreements or policies
Important Terms in Severance and
CIC Arrangements
Typically, employment agreements define the terms of
the executive’s current employment (starting salary,
bonus opportunity and any initial equity grants) and
set forth the benefits if employment is terminated. In
many cases, such agreements also include a noncompete and/or non-solicitation agreement and an
intellectual property agreement. In most cases, the
executive would be required to sign a release of claims
to actually receive a payout.
A severance arrangement typically includes
provisions for:
• Cash severance
• Continuation of benefits
• Treatment of unvested equity
• Non-compete/non-solicitation agreements
• Golden Parachute excise taxes
51
The scenarios typically addressed in regard to equity
include:
Cash Severance – If the executive is terminated
without a CIC taking place, cash severance is usually
based on a multiple of base salary. If the executive
is terminated following a CIC, it may include a larger
benefit calculated as a multiple of base salary that
is usually higher than if there is no CIC, plus target
annual incentive. However, in recent years severance
multiples both with and without a CIC have declined
as a result of increased stakeholder scrutiny of such
arrangements.
• Termination Absent a CIC – Treatment may depend
on the specific circumstances:
ż The Company may find it appropriate to offer
accelerated vesting upon termination without
cause or if the executive resigns for good
reason, as defined in the agreement or policy.
Alternatively, continued vesting for a period of time
may be offered post-termination. In either case,
accommodation is generally provided for some, but
not all, of the unvested equity.
The severance can be paid out either as a lump
sum or over time. Some companies find it easier
to pay a lump sum rather than keep the executive
on the payroll. Others prefer to stagger the cash
cost which has the benefit of allowing the company
to stop payments if the executive violates any
agreement in effect, such as a non-compete or a
confidentiality agreement. In either case, internal and/
or external counsel needs to carefully draft these
agreements because the method of payment has tax
consequences under the deferred compensation rules
under Section 409A.
ż No additional vesting is granted upon a simple
resignation of the executive, absent good reason for
the resignation.
• Vesting Following a CIC – Single-Trigger –
Companies may provide accelerated equity vesting
upon a CIC in the form of partial (e.g. 50%) or
full vesting. There is growing sentiment against
single-trigger acceleration among public company
stakeholders, on the grounds that it eliminates any
retention value at the date of the CIC and leaves the
acquiring company with no retention leverage. We
have seen a marked decrease in new single-trigger
vesting provisions, particularly in the last 24 months.
This trend has been led by public companies, but
private companies have followed suit, particularly if
an IPO is the exit strategy. Legacy provisions exist at
many companies and tend to be retained even when
newer grants have double-trigger provisions.
Benefits – Continuation of medical, dental and
life insurance benefits is commonly provided to
the executive in conjunction with cash severance.
Benefits are typically paid for the duration of the cash
severance period, with the executive continuing his or
her requisite payroll deduction toward the premiums.
In a non-CIC termination, mitigation may be
required. That is to say, benefits are stopped once
the executive is re-employed and eligible for similar
benefits and another employer. Mitigation is much
less prevalent in a CIC.
Vesting Following a CIC – Double-Trigger - Vesting
is accelerated only upon termination following a CIC
by the acquiring company or, for good reason, by the
executive. This is the most prevalent form of equity
vesting and recognizes that the executive led the
company to an exit and should reap some benefits of
the sale upon termination.
Treatment of Unvested Equity – Equity incentives are
the primary component of executive compensation at
emerging companies. They offer significant retention
value when designed with vesting restrictions, since
executives typically want to preserve the equity
value they have worked hard to build, often in lieu of
accepting better cash opportunities at established
companies. Many view equity as their “investment”
in the company prior to the IPO, and are particularly
concerned how it would be treated upon termination
of employment.
52
The terms of the agreements and policies serve both the
company and the executive, providing certainty regarding
corporate liabilities in severance situations and supporting
their objectivity in evaluating strategic alternatives,
as well as providing an element of security to executives
Key Factors in Determining the Need
for a Severance Arrangement
280G Considerations – CIC arrangements may also
cover all or part of the 20% “Golden Parachute” excise
tax imposed under IRC sections 280G and 4999.
There are several approaches that can be taken in CIC
arrangements to mitigate the impact on the value of
payouts:
As a general rule, Boards should consider
severance and CIC protections based on factors
that are particular to their own company, industry
and circumstances. The extent to which they are
competitive should be weighed with how effective they
will be in aligning the objectives and financial interests
of shareholders and executives. An optimal agreement
will address both goals, within the framework of market
practice, although market practice should not trump
the needs of the corporation.
• Gross-up: Providing additional severance to cover
the excise tax can be costly to the acquiring
company and favors the executive. This approach
is mainly offered by larger companies, but with
decreasing frequency.
• Reduction: Scaling back the severance to avoid
triggering the excise tax favors the acquiring
company. It is particularly punitive to the executive
in the frequent situations when the executive’s total
taxable compensation was not high prior to the IPO.
Among the key questions to ask about a proposed
severance agreement:
• Is it consistent with industry practices?
• Best Net Benefit: The executive has a choice of
paying the tax liability or accept a reduced payment
that won’t be subject to the excise tax. This option
is neutral to both parties, although the company
loses its deduction on any payment subject to
the excise tax if the executive chooses to pay the
tax. Keep in mind, however, that most pre-IPO
companies are not taxpayers.
• Does the company have any existing severance
arrangements?
• No Action: The excise tax is not addressed in the
agreement, which works out as a best net benefit
since the executive decides whether to pay the tax
or ask for a reduction.
• Are severance arrangements for all the NEOs
consistent?
• What is the total potential cost to the company?
• Are retention incentives sufficient to keep the
executive focused on the job?
• How much trust has been built up between
management and the Board?
As a general rule, Boards
should consider severance
and CIC protections based on
factors that are particular to
their own company, industry
and circumstances.
While gross-up provisions were common many years
ago and still exist in older agreements, it is rare to
find the provision in new agreements. This is a result
of aggressive and successful stakeholder campaigns
against gross-ups as an inefficient use of corporate
assets and an excessive perquisite for executives.
The most prominent provision in new agreements is
the Best Net Benefit, as described above.
53
Conclusion
Data on Current Practices
Executive severance agreements or policies are an
important part of the employment equation. The
terms of the agreements and policies serve both
the company and the executive, providing certainty
regarding corporate liabilities in severance situations
and supporting their objectivity in evaluating strategic
alternatives, as well as providing an element of security
to executives.
The remainder of this article highlights findings of
Pearl Meyer & Partners research regarding 66 firms,
including 36 in high technology and 30 in life sciences,
and our assessment of typical arrangements.
• The majority of companies provide some form of
severance for termination with and without a CIC for
the CEO and NEOs.
• All firms with security arrangements provide
some form of cash severance for termination of
employment as a result of a CIC and/or termination
by the company without cause when no CIC has
taken place.
Companies need to carefully consider the terms of
these arrangements, which have been changing
in recent years. Generally, severance amounts are
more modest, single trigger benefits, including equity
acceleration are less prevalent, and excise tax grossups are becoming a thing of the past. Please examine
the data summarized below when evaluating these
market practices.
• About half the companies provide continuation
of health and welfare benefits during the
severance period.
• More than 60% of companies provide doubletrigger equity vesting following a CIC, defined as a
termination of employment within a certain period
(e.g., one year following a CIC).
Generally, severance amounts
are more modest, single trigger
benefits, including equity
acceleration are less prevalent,
and excise tax gross-ups are
becoming a thing of the past.
• Fewer than 25% of companies provide single-trigger
equity vesting, meaning that equity would vest
upon a CIC regardless of whether employment was
actually terminated.
• Fewer than 25% of CIC agreements provide a
gross-up to cover the Golden Parachute Excise Tax,
a punitive 20% excise assessment on payments
made in connection with a CIC that can significantly
reduce the value recognized by the executive. •
About the Author
With offices in the U.S. and London, Pearl Meyer & Partners is a recognized leader in executive and Director compensation
strategy and governance. The firm advises companies on the philosophy and implementation of executive reward programs
that link pay and performance to deliver maximum return on their compensation investment.
54
Antonio Who? Investing in New
Media and Social Media – When
Legal Issues Become Business Issues
Kristen Mathews and Paresh Trivedi, Proskauer Rose, LLP
New media and social media start-ups often provide
interesting and attractive investment opportunities. When
examining investment opportunities in this space — in
addition to conducting routine analyses of a company’s
products and services, potential to generate income
and profits, competiveness, prospects for growth and
potential exit strategy — investors should also understand
the unique legal and regulatory issues facing such
companies, as these issues can significantly impact a
company’s value.
Appropriate protection and management of intellectual
property rights and compliance with legal and regulatory
requirements are as important to a company’s present
and future value and growth as the ingenuity of its
products and services and the soundness of its business
plan. The story of Antonio Meucci is just one example
of how a good idea without appropriate attention to
legal issues can lead to a start-up’s failure. Meucci, an
inventor and entrepreneur, developed the world’s first
device capable of electromagnetic voice transmission
in 1856. Today, however, his name and the name of
his start-up, the Telettrofono Company, are largely
unknown because Meucci failed to adequately protect
his intellectual property rights. This misstep opened the
door for Alexander Graham Bell to obtain a patent for
electromagnetic transmission of vocal sound in 1876 and
attain recognition as the inventor of the telephone. As a
result, Bell and his start-up went on to enjoy success,
wealth, fame, and a place in history, while Meucci’s
start-up failed.
This article provides an overview of some of the
intellectual property, legal, and regulatory issues that
investors should consider when evaluating investment
opportunities in new media and social media companies.
55
I. Intellectual Property Rights for
Technology Assets
Without effective work-forhire and intellectual property
assignment agreements, a
company may fail to secure
ownership of valuable
intellectual property assets,
causing significant loss in
the company’s value and
competitive advantage.
Securing rights in intellectual property is vital for
new media and social media companies, given the
relative ease of emulating competitors online and the
fact that intellectual property often comprises the
most valuable and important assets in new media
and social media. In light of this, companies should
utilize all means available to develop and protect a
robust intellectual property portfolio. At a minimum,
each company should register material eligible for
trademark and copyright protection, and obtain strong
patent rights to its inventions, if appropriate. Once
intellectual property rights are acquired, the company
should take proper action to preserve those rights
against infringers. Failure to actively defend intellectual
property rights may constitute acquiescence to the
infringement and adversely affect a company’s value
and competitive advantage.
In addition, maintaining a strong online presence
requires the registration and protection of domain
names that identify and distinguish the enterprise
and its online brand. When use of the Internet for
commercial transactions began in the 1990s, few
restrictions governed the registration of domain
names. “Cybersquatters,” who registered domain
names containing trademark terms in order to sell
them to the trademark owner, were prevalent. In
1999, the Internet Corporation for Assigned Names
and Numbers (ICANN), the non-profit organization
charged with managing assigned domain names,
implemented a uniform policy for resolving domain
name disputes through mandatory arbitration.
Around the same time, the U.S. Congress adopted
the Anticybersquatting Consumer Protection Act
(ACPA), which gave trademark owners new tools for
combatting cybersquatting.1 Since then, numerous top
level domain names have been added to the system,
increasing the burden of companies to protect their
brands’ use in domain names. New media companies
should understand the limitations on using certain
domain names, as well as the tools for protecting their
own trade names.
Companies must also secure full ownership to all
intellectual property their employees and contractors
produce through enforceable work-for-hire and
intellectual property assignment agreements. Workfor-hire agreements formalize the concept that
ownership of copyrights in works produced in the
course of employment belong to the company, and
not to the employee or contractor who creates the
work. Intellectual property assignment agreements
assign all right, title, and ownership in patents, trade
secrets, copyrights, and other intellectual property
rights from an employee or contractor to
the company.
1
56
The ACPA amends the Lanham Act, the centerpiece of trademark legislation,
to provide that a person who registers, traffics in, or uses a domain name that
is identical or confusingly similar to a protected mark or that is dilutive of a
famous mark will be subject to civil liability if the person has a bad faith intent
to profit from the mark. Anticybersquatting Consumer Protection Act of 1999,
Pub. L. No. 106-113, 15 U.S.C. § 1125(d).
Another intellectual property issue facing new media
companies arises if a company incorporates open
source software when developing its own technology.
Open source software, sometimes referred to as
“free software,” is software that is made available in
source code form. This way, in contrast to proprietary
or “closed code” software, the code can be read,
modified, and redistributed by users. Using open
source software to develop proprietary products may
reduce the cost and time required to bring a product
to market. However, if not used properly, open source
software could result in a company being forced to
disclose the “secret sauce” behind its product or being
exposed to liability, thereby negatively impacting the
company’s competitiveness and value.
II. Safe Harbors for User-Generated
Content
A. Digital Millennium Copyright Act
The interactive nature of social media means that
online service providers no longer generate all of their
own content. Rather, consumers use online platforms
as a forum for sharing self-generated content with
other consumers interested in similar content. Although
providers typically hold the ultimate control over
content — that is, they retain the discretion to monitor
and remove undesirable content — the proliferation of
user-generated content makes it highly burdensome,
if not impracticable, to adequately review such content
on a real-time basis. At the advent of social media,
it was feasible that online service providers could
bear responsibility for all content, including usergenerated content, on their online platforms. That is,
if a user posted infringing content in an online forum,
the service provider could be held liable for copyright
infringement. Such a policy would have necessarily
limited the ability of new media companies to offer a
forum for instant and open communication, due to the
threat of crippling liability and the resources required to
review content prior to posting. Rather than leaving it to
the court system to address, policymakers addressed
this issue in favor of encouraging free and open
speech online.
In addition to securing its own intellectual property,
new media companies often engage in activities that
may result in the infringement of intellectual property
rights held by another party and subsequent exposure
to liability. On a basic level, the duplication and online
transfer of unauthorized copies has induced industrywide shifts in fields dominated by owners of copyrighted
works, such as books, music, and video content.
The increased availability of copyrighted information
online and the new mechanisms for electronically
sharing copyrighted information have made it easier to
infringe upon exclusive rights. For example, seemingly
innocuous electronic actions, such as providing a
hyperlink to third-party content, may expose the
operator of a website to liability if the link offers access
to unauthorized copies of a protected work.2 At the
same time, copyright owners find it more difficult to
enforce their rights, because, among other challenges, it
may be difficult to identify the offending party or parties.
Content owners have responded with litigation against
the operators of file-sharing sites, file-sharing technology
distributors, and individual file-sharers. Such litigation,
in parallel with legislation, continues to shape and
refine the body of law dealing with potential liability for
certain online actions that do not fit neatly into the legal
framework existing before the digital age.
2
See e.g. Jones Day v. Blockshopper LLC d/b/a Blockshopper.com, et al., 2008 U.S. Dist. LEXIS 94442 (N.D. Ill. Nov. 13, 2008), the court found a possible basis
for trademark infringement claims in hyperlinks on a real estate firm’s website to biographies of its attorneys; Perfect 10, Inc. v. Amazon.com, Inc., 508 F.3d 1146
(9th Cir. 2007), the Ninth Circuit held that a search engine was not liable for direct infringement for in-line linking to plaintiff’s photographs on third-party sites, but
remanded the case to determine whether a search engine could be liable for contributory infringement; the parties settled. But see Flava Works, Inc. v. Gunter, 689
F.3d 754 (7th Cir. 2012) where the court found that a video bookmarking site where users embedded and stored links to third-party videos was not likely liable for
contributory infringement.
57
The Digital Millennium Copyright Act (DMCA) contains
“safe harbor” provisions that immunize some online service
providers, under certain circumstances, from liability for
user-generated content that infringes a copyright and
appears on their platforms.3
As a threshold matter, to be afforded the safe harbor,
the content may not be generated, selected, or edited
by the service provider. Next, online service providers
must meet three key requirements in order to qualify
for the safe harbor. First, the provider must register a
designated agent to receive notifications of claimed
infringement with the U.S. Copyright Office. Second,
the provider must expeditiously block access to or take
down infringing material upon notice of infringement.
Third, the provider must adopt and reasonably
implement a policy of terminating the accounts of
repeat infringers. In addition to limiting liability of online
service providers, the DMCA also improves the means
for copyright owners to reach the user posting the
infringing content, without substantially increasing the
burden on service providers. In this way, the DMCA
attempts to balance competing interests by creating
a limited safe harbor that encourages online service
providers to permit free speech, while protecting the
rights of copyright owners.
sought to strike a balance between protecting
free speech online and guarding against false and
damaging speech.
At a basic level, the CDA contains a safe harbor
provision that immunizes an innocent “middleman”
who merely provided an online forum for speech.
Specifically, Section 230(c)(1) of the CDA states that
“no provider or user of an interactive computer service
shall be treated as the publisher or speaker of any
information provided by another information content
provider.” Section 230 has been liberally interpreted to
offer broad immunity to interactive service providers,
such as website or mobile app operators, from
defamation and other tort-type claims based on
content generated by third-party users.5 However,
the CDA safe harbor does not grant immunity for the
speaker itself, whether that is a user of a social media
platform or the service provider. In practice, this federal
law eliminates one barrier for online service providers
permitting consumer free speech on interactive internet
platforms by limiting potential liability of the service
provider for user-generated content.
B. Communications Decency Act
The capability to communicate online—immediately
and over vast distances—to large numbers of people
has countervailing positive and negative aspects,
particularly in the context of free speech and
defamation. This accessible method for instantaneous
and far-reaching communication carries clear benefits
in disseminating useful information. Yet, it compounds
the damage of false, misleading, or defamatory
information, and such damage is often irreparable. This
dichotomy is well-reflected in legislative enactments
regulating online activity, such as the Communications
Decency Act (CDA).4 Through the CDA, Congress
III. Digital Privacy
A. Privacy Policies
Privacy law continues to evolve rapidly in an increasingly
digital environment. The collection, storage, and use
of personally identifiable information in electronic
commerce and online advertising has roused
controversy, forming the basis of numerous legal
disputes under existing laws and spurring development
of new laws to deal with changing circumstances.
3
17 U.S.C. §§ 512(a)-(e).
4
47 U.S.C. § 230.
5
See, e.g., Zeran v. America Online, Inc., 129 F.3d 327 (4th Cir. 1997) (holding that Section 230(c)(1) confers immunity on service providers for both publisher and
distributor liability with respect to tort-like claims).
58
In most respects, the United States lacks uniform
privacy legislation. Rather, privacy laws in the
United States stem from various sources and form
a complex and varied legal “patchwork.” Indeed,
privacy law consists of common law principles
rooted in federal and state constitutional provisions,
federal and state statutes specific to subject
matter like health and financial information, and
communications privacy laws that limit access to
communications by law enforcement and third
parties. In addition, administrative agencies like
the Federal Trade Commission (FTC) and other
consumer protection agencies provide a regulatory
overlay for privacy issues. Online service providers
must take care to determine which laws govern and
what compliance requires.
Tailoring a privacy policy
to fit the unique needs of
each business is essential to
shielding the firm from liability
and preserving its value as a
prospective target for future
investment or acquisition.
Some start-ups fall into a trap with far-reaching
consequences by approaching its privacy policy
with a one-size-fits-all mentality that is far removed
from the legal reality. A privacy policy drafted for a
seemingly similar business cannot be copied and
pasted without tailoring to a company’s specific
needs. There is no such thing as a boilerplate privacy
policy, because every company collects, manages,
shares, and uses data differently. Moreover, it is very
difficult to remedy an inaccurate or inapplicable privacy
policy, due to restrictions on making material adverse
retroactive changes to privacy policies after they have
been adopted and communicated to users, absent
affirmative consent to such change by consumers.
Therefore, in order to limit exposure to privacy-related
liability, companies operating online businesses or
services should take care to adopt and implement the
correct privacy policy from the beginning.
One requirement is that all online service providers
must adopt, conspicuously post, and adhere to a
privacy policy that, among other things, identifies
what kinds of personally identifiable information will
be collected and with whom the data will be shared.
Although federal legislation does not currently require
a general commercial website to disclose a privacy
policy, California has enacted and enforced this
requirement in the California Online Privacy Protection
Act (OPPA). Importantly, this law reaches far beyond
California firms and purports to apply to every website
and online service that collects personally identifiable
information from California residents.6 The practical
consequence is that this important piece of California
legislation impacts commercial websites and online
services across the globe. After a company adopts its
privacy policy, the FTC requires that the firm adhere
to that policy, or else risk an action for unfair and
deceptive trade practices.7 The FTC has brought
a number of enforcement actions against online
providers that breached privacy promises or otherwise
failed to keep consumer data secure.8
B. Mobile Applications
Similar to more traditional online platforms, such as
Internet portals and websites, privacy is a crucial
consideration in developing and deploying mobile
applications, or apps. Moreover, the unique features
offered by mobile apps only enhance the importance
of digital privacy. For example, many mobile apps have
the powerful ability to identify the precise location of a
user, a function known as geolocation. This ability to
track geographic movement, and the accompanying
ability to target advertising and content based on that
data, requires permission from the user and caution by
the party collecting data to mitigate privacy concerns.
6
California Online Privacy Protection Act, Cal. Bus. & Prof. Code § 22575 et seq.
7
Section 5 of the Federal Trade Commission Act (FTC Act) prohibits unfair or deceptive trade practices. 15 U.S.C. § 45.
8
See, e.g., In re Google, Inc., FTC File No. 1023136 (Settlement announced Mar. 30, 2011) (settling deceptive practices charges against Google relating to the rollout
of the Google Buzz social network in 2010, including charges that Google violated the substantive requirements of the E.U. -U.S. Safe Harbor agreement); In the
Matter of Chitika, Inc., FTC File No. 1023087 (Mar. 14, 2011) (settling charges of deceptive practices with an online advertising company that gave consumers the
opportunity to opt out of its tracking cookies, but limited the opt-out period to ten days).
59
Data collection through mobile apps occurs in
various ways: requesting users to provide information,
accessing information stored on the mobile device,
or collecting information automatically during use of
the app. In addition to collecting typical personally
identifiable or sensitive information (such as name,
contact information, financial information, or health
information), mobile apps may also collect information
uniquely associated with mobile device technology,
such as hardware identifiers or location data. It is
important to note that tracking users with unique
persistent identifiers still implicates privacy issues, even
without access to more traditional personal identifiers
like name and contact information.
C. Age-Related Concerns
Federal and state authorities have placed particular
importance on enforcing laws protecting the
privacy of children online. The Children’s Online
Privacy Protection Act (COPPA) impacts operators
of websites or online services that are directed to
children under thirteen, as well as providers that have
actual knowledge that children under thirteen are
providing personal information through the website
or online service.9 At a basic level, COPPA requires
covered online services to provide notice of what
information they collect and how they will use that
information. With some exceptions, a provider must
obtain verifiable parental consent before collecting
any personal information from children. Online service
providers must also provide parents with access to
review and change both the collected information and
the manner in which providers use the information.
The FTC vigilantly enforces COPPA against operators
of websites and online services who fail to comply
with its requirements.10 As a result, awareness of and
compliance with age-related requirements should be
key concerns for new media companies.
In general, online service providers are subject to the
same privacy requirements when offering mobile apps
as with more traditional online services. Given the
unique issues presented by mobile app technology,
the FTC and state regulators have prioritized
enforcement related to mobile privacy. Moreover,
based on agreements among California authorities
and six owners of leading mobile app stores, app
stores must now provide a mechanism for mobile app
developers to disclose privacy policies and for users
to report non-compliance with California privacy law.
Like the far-reaching scope of OPPA for traditional
online platforms, these requirements apply globally to
any mobile app that may impact California residents.
California can seek to enforce this law against any
mobile app provider that fails to comply by posting
a privacy policy for the app. In order to minimize the
legal and financial liability and reputational harm that
could occur as a result of a privacy breach, companies
should consider privacy as a critical and ongoing issue
when developing and distributing a mobile app.
9
Children’s Online Privacy Protection Act of 1998, 15 U.S.C. §§ 6501–6506.
10 See, e.g., FTC v. Xanga.com, Inc., No. 06-CIV-6853 (S.D.N.Y. settlement
entered Sep. 12, 2006) (assessing a $1 million civil penalty against a social
networking site that allowed the creation of accounts by individuals whose
birth date information indicated an age under 13, without complying with
COPPA parental notice and access requirements); United States v. Industrious
Kid, Inc. FTC File No.: 072-308 (assessing a $130,000 fine for, among other
things, enabling children to create imbee accounts by submitting their first and
last names, dates of birth, and other personal information prior to the provision
of notice to parents or the receipt of their consent).
60
IV. Data Security
the effect of the costs of cybersecurity incidents on a
company’s financial condition, the description of the
company’s business, disclosure of material pending
legal proceedings, and discussion of the effectiveness
of disclosure controls and procedures.
The proliferation of online communications and
commerce has accelerated the creation of large
databases containing many types of personal
information, from contact and financial information to
shopping preferences and browsing histories. These
valuable databases of personal information are open
to misuse, whether at the hands of the online service
provider that compiles the information or a hacker that
wrongfully accesses a database. This intrinsic risk has
driven the adoption of laws aimed at protecting those
repositories from unauthorized access and data theft
and protecting the public from the harmful effects of
such misuse.
The explosive growth of e-commerce over the past
several years has been accompanied by growth in
the incidence of credit card and other payment card
purchases. Increased use of payment cards has
increased the risk of fraud. A consortium of payment
card companies has developed the Payment Card
Industry (PCI) Data Security Standards, which apply
to companies that process, store, or transmit credit
card or other payment card information. Although the
PCI Data Security Standards are not legislated laws
or governmental regulations, they do bind companies
pursuant to contractual agreements such as merchant
agreements. Accordingly, a failure to comply with these
requirements could expose a company to significant
financial liability and operational disruption.
Pursuant to the Federal Trade Commission Act, the FTC
has employed two key theories to take action against
companies that fail to maintain the security of consumer
data. The first position is that failure to comply with
published security promises is deceptive. The second
is that failure to use reasonable means to secure data is
an unfair trade practice. Recently, the FTC has brought
actions for failure to adequately secure data, even in
the absence of a specific promise in a privacy policy to
maintain consumer data securely.11 The FTC has also
taken the position that the act of distributing technology
that jeopardizes the security of personal consumer
information may constitute an unfair or deceptive trade
practice. Firms must take care to avoid the costs,
both monetary and reputational, incurred as a result of
problems with data security.
Given the gravity of the issues at stake, new media
companies must seek to minimize the risk of suffering
a security breach, or being targeted for investigation
by a regulator or pursuant to a private claim. Even
a relatively “less serious” breach in data security
could attract widespread public attention and years
of expensive, and possibly debilitating, litigation.
Damages and reported settlements arising from data
security breaches involving seemingly innocuous data,
such as only email addresses, have frequently cost
affected companies tens of millions of dollars, as well
as significant reputational harm.13 Such settlements for
recent incidents involving limited contact information,
without traditionally sensitive data like financial or health
information, drives home the point: even if you do not
handle consumer financial information or social security
numbers, you can still suffer significant exposure from
losing a large volume of consumer contact information.
In addition, the Securities and Exchange Commission
(SEC) has issued guidelines suggesting that public
companies have an obligation to disclose cybersecurity
risks and cyber incidents publicly.12 The SEC guidelines
suggest that companies should routinely disclose such
information alongside preexisting disclosure obligations
involving cybersecurity, including, among other things,
Even a relatively “less serious”
breach in data security
could attract widespread
public attention and years
of expensive, and possibly
debilitating, litigation.
11 See, e.g., In the Matter of BJ’s Wholesale Club, Inc., FTC No. 042 3160
(June 16, 2005).
12 SEC, Div. Corp. Fin., Disclosure Guidance: Topic No. 2, Cybersecurity
(Oct. 13, 2011).
13 See In re TD Ameritrade Accountholder Litigation, No. C 07-2852, 2011
BL 234454 (N.D. Cal. Sept. 13, 2011) for an account of an email address
security breach at TD Ameritrade, resulting in a settlement for up to $6.5
million. Similarly, a security breach of email databases at Epsilon in 2011
highlighted concerns about outsourcing email marketing to third-parties.
Epsilon maintained email address databases for many well-known institutions,
who suffered adverse consequences as a result of Epsilon’s failure to ensure
security of consumer data.
61
V. Online Agreements and Terms
of Use
A. Enforceable Agreements and Terms of Use
Another important legal issue that every new media
company faces is ensuring that its terms of use are
enforceable. A variety of factors require consideration
when evaluating the enforceability of online
agreements, including proof of executing an electronic
document and authentication of the terms of use and
related materials.
New media companies must
carefully design the protocol
for disclosing and requiring
consumer assent to terms of
use for their online products
or services, in addition to
formulating the appropriate
provisions of those terms.
Most commonly, new media companies contract with
online users via standard form agreements, such as
the so-called clickwrap and webwrap agreements.
Clickwrap agreements present a user with a message
requiring the user to assent with a “click” to the
terms of use, while a webwrap agreement involves
posting a passive notice on a website, often in the
footer, that any user of that website is subject to its
terms of use. Such standard form agreements are
usually enforceable, provided that the agreement
meets certain requirements, such as clarity of terms
and adequacy of notice. In contrast, the terms of a
clickwrap agreement may not be enforceable if the
agreement is not immediately available and presented
in such a way that the average consumer would
recognize that the agreement exists and understand
how to obtain a copy of the agreement.14 The same
issues apply to mobile apps, as well. Ultimately, the
firm can protect its value by prescribing enforceable
terms of use.
14 Harris v. Comscore, Inc., 2011 U.S. Dist. LEXIS 115988
(N.D. Ill. Oct. 7, 2011).
62
VI. Conclusion
B. Developer Agreements for Mobile
Applications
The quick pace of change and innovation in new
media and social media makes investing in the industry
equal parts captivating and challenging. Investors
should take a holistic approach to their evaluation of
potential investments in this industry, paying close
attention to business, financial, economic, market,
and legal strengths and risks of potential investment
opportunities. Accordingly, in addition to procuring
sound business and technical advice, investors
should also obtain sound legal advice and conduct
appropriate legal due diligence of a company before
committing to make an investment. •
Development and distribution of mobile apps raise
unique issues and require agreement among multiple
parties, including the developer, publisher, and app
store owner. App stores, which are often operated
by mobile platform providers, are the primary conduit
for distributing or commercializing a mobile app to
consumers. Companies must agree to and comply
with developer agreements before submitting their
apps for distribution in app stores. Although there is
some variation among app store operators, developer
agreements are typically standard form contracts that
are not open to negotiation. The process of executing
developer agreements is usually quick and easy — it
may simply involving clicking “Agree” via a clickwrap
agreement. The implications of the agreements,
however, are far-reaching and complex. Developer
agreements often incorporate additional agreements,
such as third-party licenses or agreements with the
owner of related technology. Thus, despite the ease of
entering into the agreement, a mobile app developer
must fully understand the terms of the agreement.
Failure to comply with developer agreements could
result in a costly rejection of the app by the app store
operator or a significant increase in development costs,
which may ultimately affect the value and profitability of
a company.
About the Authors
Kristen J. Mathews is head of the Privacy & Data Security Group and a member of the Technology, Media &
Communications Group at Proskauer. Kristen focuses her practice on technology, e-commerce and media-related
transactions and advice, with concentrations in the areas of data privacy, data security, direct marketing and online
advertising. She regularly advises clients on a wide range of matters, including privacy and data security compliance,
customer authentication, responding to data security breach incidents, preparing privacy and data security policies, data
profiling, behavioral marketing, open source software issues, financial privacy, children’s privacy, international privacy, health
care privacy, identity theft prevention, geolocational privacy, mobile marketing, social networking, payment card data security
and telematics. She is the editor of the leading treatise in her area “Proskauer on Privacy,” published by the Practicing Law
Institute, the editor of Proskauer’s Privacy Law Blog at www.proskaueronprivacy.com, the editor and author of Proskauer’s
“A Moment of Privacy” e-newsletter and the chair of Proskauer’s annual “Proskauer on Privacy” conference.
Paresh Trivedi is a transactional lawyer at Proskauer with more than ten years of experience representing clients in
technology, media, communications, cable programming, digital advertising and content distribution transactions and
counseling clients on related legal compliance issues. Paresh works in a variety of industries including communications,
Internet/e-Commerce, entertainment, television, sports, banking and financial services, publishing, oil and gas,
manufacturing, retail, professional services and advertising. He practices in Proskauer’s Corporate Department and its
Privacy & Data Security, Technology, Media & Communications and Sports Law Groups.
The authors would like to thank Laura Goldsmith, a summer associate in Proskauer’s New York office, for her valuable
contributions to this article.
63
Leadership Principles for
Growing Companies
Elizabeth Brashears, SPHR, Director, Human Capital Consulting
Every startup company has big dreams of fast growth
and increased revenue. The early stages of a new
venture bring with it great excitement. There is an
energy in the atmosphere and a continuous buzz in
the air. Along with the Red Bull on the table, people
are getting things done and perceived genius is being
birthed right in front of everyone’s eyes.
Startups are exciting because they are filled with
potential. They can capture all the hopes and dreams
of the inspired entrepreneur and represent the
American dream. An entrepreneur has a great idea,
finds a little bit of funding, hires a few hard workers,
and then the company takes off and everyone takes
home a healthy paycheck. That’s how it works, isn’t it?
Not quite. The reality of the startup world often looks
much different. Two-thirds of all startups fail within two
years and even making it past the twenty-four month
mark is no guarantee of success. For those that do
succeed, most start out slow, and some may hit a
growth curve at a later point in time.
Then there is that rare breed of company that puts the
pedal to the metal and grows fast and furiously from
the get-go. How do those rapid-growth companies
go from a startup sensation to a company with the
potential to endure over time?
An infusion of capital could certainly be helpful, but
there is nothing more critical than the organization’s
leadership and the way the leaders drive the ultimate
culture of the business.
64
The leadership within a new venture can be a
competitive advantage and the reason behind its success,
or it can be a road block to any future growth.
Here are ten leadership principles to
grow by
The leadership within a new venture can be a
competitive advantage and the reason behind its
success, or it can be a road block to any future
growth. An organization’s growth is only held back by
its leader’s ability to both manage and lead the teams
around them.
1. It’s about people, not about strategy. In early-stage
companies, there is great focus on the strategy that
the company will take to bring its product or service
to market. There is definitely a place for strategy and,
without a doubt, it is critical to any company’s success.
However, strategy should not be the focus within any
organization if the company is trying to grow and
evolve into an enduring company over the course of
time. The focus should be around people and the
talent within the organization.
An entrepreneur is someone with a vision and a dream.
Often they just might be a creative individual who
takes a great idea to market and then suddenly finds
themselves having to manage others without being
equipped with the necessary knowledge, skills, or
ability of a leader. Make no mistake, being a manager
or a boss doesn’t necessarily make you a leader. In
fact, leadership doesn’t have to be about the role an
individual holds. It isn’t about authority at all. It’s about
influence and the ability to accomplish what one hopes
will be extraordinary results through ordinary people.
The strategy, the product, the service, the technology;
they all mean absolutely nothing without the right
people to make it happen. Employees are often
the greatest expense and the greatest asset of a
company. Focusing first on developing and engaging
employees will have a more significant impact on
the business than if all of the effort is focused on the
strategy. Engaged, productive employees will fulfill the
company’s strategy and continue the organization on
a trajectory of growth. People are important no matter
what stage in the business lifecycle a company finds
themselves in, but when companies are on a growth
curve, the impact of their people is substantial.
The good news for the new leader is that the old
adage that “Leaders are born, not made” is simply
not accurate. Leadership is a process of influence. It
can be taught and honed like other important skills.
Additionally, there are a few principles that leaders
should remember. Whether a company is experiencing
fast growth or they have begun to stabilize, these
leadership principles could potentially make or break
where the company is headed.
Part of focusing on people is taking the time to hire the
best and the brightest talent for the organization. While
this seems self-evident, often the process of hiring
talent is seen as getting in the way of doing the “real”
work of the organization. Great leaders will concentrate
the most time, money, and effort on identifying and
developing the talent around them. When leaders
focus first on people, they will find that in return, the
people will fulfill the strategy of the organization.
Leadership is a process
of influence. It can be
taught and honed like other
important skills.
When leaders focus first on
people, they will find that in
return, the people will fulfill the
strategy of the organization.
65
3. Strong leaders identify and live out the values that
are important to the organization. Every organization
is guided by a set of beliefs and values. These values
communicate what an organization believes and what
it considers to be important. Establishing a set of Core
Values for a company can help the organization as it
continues to experience growth. Additionally, values
that are embedded into the culture help to:
2. Effective leaders drive the company culture.
Culture is defined as the identity and personality of
an organization. It consists of the shared thoughts,
assumptions, behaviors, and values of the employees
and stakeholders. It is dynamic and evolves over time
and with new experiences. Multiple factors help drive
and define the culture, including leadership styles,
policies and procedures (or sometimes lack thereof),
titles, hierarchy, as well as the overall demographics
and workspace.
• Clarify the behaviors that are important for success
within the organization
Leaders spend time and energy to make decisions
every day regarding the available resources, whether
those are budget decisions, product decisions,
process decisions, or decisions around people. The
appropriate amount of time and energy should also be
given to the core fabric that serves as the foundation
of the organization. Culture drives or impedes the
success of an organization and leaders must actively
work to control it.
• Instill a sense of ownership and pride within the
company
• Build consensus around vital issues
• Provide a framework for how people are expected to
interact with each other
• Acclimate new employees to the culture of the
organization
• Guide decision-making
An organization’s culture can be one of its strongest
assets or it can be its biggest liability. Culture impacts
the talent, the product, the clients, the revenue, and
it is critical that leaders take an active approach in
ensuring that their culture develops through intentional
efforts and not by default.
• Determine if the company is on the right path to
achieving their business goals
Leaders are responsible for ensuring that the Core
Values do more than just live in a PowerPoint or hang
on the wall of the front office. A true Core Value should
have an active influence over the people and the
organization. Though identifying and establishing values
starts with leadership, this in no way is a one-person
job. Defining your Core Values should involve the entire
company. The Core Values should be brought to life in
the people, events, products, space, and the stories that
are told. They should be used in selecting the right talent
and in managing and developing that talent to continue
and further the growth of the organization.
In order for a venture to experience high growth
and productivity, it is imperative to have an aligned
workforce that can innovate, execute, and meet
designated targets. A thriving culture that engages the
workforce will generate a return on investment through
the success of the organization’s product, people,
customers, and brand.
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Every individual has a unique set of strengths
that when identified, nurtured, and channeled appropriately,
can have a dramatic impact on employee engagement
and the overall performance of the company.
Assessing talent and identifying employee strengths is
critical for effective leadership. Here are a few tips to
get started in the right direction:
4. Recognize and leverage the strengths of others.
Many leaders focus on overcoming weaknesses
and spend untold time and energy trying to address
shortfalls in themselves and their employees. While
these leaders are busy trying to fix themselves and
others, they are often missing the powerful asset of
truly leveraging employee strengths.
• Have leaders and employees complete objective
assessments of their strengths (perhaps with a
tool such as StrengthsFinder 2.0). The information
gathered from the assessment can be used in
career and development plans. Without an objective
assessment, strengths can easily be misidentified
when you are only reviewing subjective evidence.
Strengths can be described as an individual’s innate
talents and preferences. Studies show that rather than
trying to overcome weaknesses, people actually grow
the most in the areas in which they are naturally strong.
Every individual has a unique set of strengths that
when identified, nurtured, and channeled appropriately,
can have a dramatic impact on employee engagement
and the overall performance of the company.
• Recognize the possibility that an employee’s
strengths may be better suited for a role other than
their current one.
• Abandon the concept that a business is best
composed of well-rounded employees. Leaders can
get the best out of those around them by developing
the innate strengths that each individual brings to the
organization.
Learning to assess the talents of others isn’t as easy
as it may sound. When leaders master the art of
talent assessment, their organizations can develop
loyal, enthusiastic, and engaged employees who
want to grow along with the company. Discovering
strengths involves more than patting people on the
back. It’s a powerful tool that leaders can use to help
their employees recognize the best of what they bring
to the table. Additionally, identifying and focusing on
strengths provides a way to ensure the continuity of
leadership and to build the future of the company.
Armed with this information, leaders can structure
jobs and opportunities so that people can exceed
their potential.
• Leaders should ask employees if they feel they
have the opportunity to do what they do best every
day and then listen to their answers and probe for
additional understanding.
• Drive the culture to support employee growth and
advancement based on each person’s strengths.
An easy place to start is incorporating the
strengths concept into the company’s performance
management and review process.
• Leaders that leverage the strengths of their
people can produce empowered and engaged
employees. Ultimately this creates a more productive
organization that fully maximizes the investment in
their human capital.
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A vision should be shared with others and translated
into specific, measurable, and achievable goals. It
should create alignment and help others to connect
their personal goals to the long-term strategic goals.
Vision should create action. Without action, the vision
is simply an unfulfilled dream, but when aligned with
action, it will provide the momentum to continue the
organization on a trajectory of growth.
5. Great leaders inspire others and create a vision for
the future. They have purpose and an understanding
of the reasons behind their actions. They are intentional
and have conviction and clarity in their purpose. During
the early stages of a company, and particularly during
rapid growth times, inspiring others to see their vision
of tomorrow’s success is vital.
There are some basic fundamentals of a leader’s vision
that can excite and motivate others to follow. These
include:
6. Leaders should operate with honesty and
transparency and promote trust. Trust is an inherit
part of leadership. Leaders should say what they mean
and mean what they say. Integrity and candor are
imperative to building effective business relationships.
Employees have to trust that a leader is serving
everyone’s best interest and the leader needs to
trust that their team is executing on the vision. It
is, therefore, critical that leaders lead with integrity,
honesty, and clear values.
• Presents an organizational direction and purpose that
can resonate with others.
• Inspires enthusiasm, commitment, and loyalty from
stakeholders.
• Has emotional appeal. People get excited when they
talk about it and they want to help others see it and
join them in their journey.
Most individuals have had to work with a leader
they did not respect. No matter how intelligent or
charismatic, placing blind faith in them would be a
mistake. Without trust, people feel they have to watch
their backs and fear becomes a primary motivation.
Trust is something that has to be earned.
• Reflects the Core Values of the organization.
• Encourages employees to believe that they are part of
something bigger than themselves and their current
responsibilities.
• Is communicated in multiple ways.
Trust is a relationship established between a trustor
and a trustee. The trustor has to take some risk and
the trustee must prove to be trustworthy. Leaders must
be taught both how to trust and how to be trusted.
People are not willing to recognize someone as their
leader unless they trust them and are convinced that
the leader knows what they are doing and where
they are going. Leaders who exhibit integrity, honesty,
and trust will set the tone for establishing those same
values within the organization. When the relationships
within a company are built on trust, people come
together and will find a way to achieve the objectives
laid out before them.
• Has enough clarity so that people are empowered to
make day-to-day decisions, knowing that their actions
are helping to achieve the vision.
Vision without inspiration behind it can often fall flat, so
it is just as critical that the leader can inspire others.
So, what makes a leader inspirational?
• They have passion and purpose, and the ability to
communicate that passion and purpose to others in a
clear and exciting way.
• They include others and allow others to feel intimately
connected to the vision and the ultimate outcome of
that vision.
Trust is at the heart of leadership and when a leader
“walks the talk” and builds trust, care, and concern
into those they lead, it can create a bond that will span
positional gaps, survive mistakes, and overcome even
the toughest of challenges.
• They embody what they ask of others.
• They create fun and excitement around them and help
others to find joy within the vision they create.
• They emotionally engage with people around them.
People are motivated to change when they are
emotionally engaged and committed.
In the book The Speed of Trust: The One Thing That
Changes Everything, Stephen M.R. Covey concludes
that trust is the one thing that can build or destroy
every human relationship. Most find that is true in
business as well as in life in general.
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Leaders in rapidly growing companies have to learn to how to
remove themselves as the primary thought leader or service
provider, and instead position themselves as leader of the
leaders of the organization that their people will quickly become.
7. Leaders in fast-growing companies need to be
unnecessary in the day-to-day operations of the
business. Too many leaders want to be needed
and derive satisfaction from the critical nature
of their presence in the business. In established
organizations, it isn’t uncommon to hear new
managers talk with almost a sense of pride about
how things seems to fall apart when they take a
day off or go on vacation. That isn’t even successful
management, let alone successful leadership.
Leaders in rapidly growing companies have to learn
to how to remove themselves as the primary thought
leader or service provider, and instead position
themselves as leader of the leaders of the organization
that their people will quickly become.
8. Good leaders take the time to solicit feedback
from those around them, and then they do something
astounding…they listen. In a rapidly growing company,
taking the time to truly listen to those around you can
be difficult. It is often the person who speaks first
or loudest that is heard, but good leadership entails
listening and understanding all of those around you
so that obstacles can be anticipated and removed.
Feedback can be used to build consensus among
employees and give them ownership of the ideas and
concepts to be implemented within the organization.
When companies grow quickly, it is important to
capture the momentum and keep it moving forward.
The more involvement leaders seek from employees,
the easier it will be to implement new ideas, resolve
issues, and minimize conflict.
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The impact of leadership on any organization is
significant, but when a company is in growth mode
there is much more at stake. If not managed properly,
this pivotal time of growth can sabotage the future
of the business and things can quickly spiral out of
control. When leadership is properly executed, a small
venture can become a bigger organization that can
endure over time.
Identifying and developing
future leaders, whether for
future growth or to prepare for
departures of key individuals,
is critical to an organization’s
long-term success.
But leadership isn’t just about the top of the
organization. True leadership is seen at all levels of the
company and has nothing to do with the number of
people they manage or any sort of positional authority.
Leadership is not about control, it’s about influence.
Even the inexperienced entrepreneur with little
experience in managing others can practice the art of
leadership and nurture the appropriate skills to lead
others with success. The true reflection of a leader’s
ability is measured not just in a company’s bottom line,
but also in the success and empowerment of those
around them. •
9. Strong leaders build the next generation.
Identifying and developing future leaders, whether
for future growth or to prepare for departures of
key individuals, is critical to an organization’s longterm success. Unfortunately, new leaders don’t just
magically appear. That is why it is important to build a
pipeline for the next generation.
There is no greater investment a leader or a company
makes than the investment in their people. Developing
a leadership pipeline should certainly start with
internal employees. However, leaders must also spend
time networking and identifying others who may fill
leadership gaps at future points in time.
Even the inexperienced
entrepreneur with little
experience in managing
others can practice the art
of leadership and nurture
the appropriate skills to lead
others with success.
10. Egos should be checked at the door. Often when
a company is in growth mode, it is easy for ineffective
leaders to hide behind the growth. The growth may
have even disguised the lack of competence and skill
of the organization’s highest leader.
Great leadership isn’t just about competence and
skill though. Effective leaders recognize when they no
longer possess the necessary knowledge, skills, and
abilities to keep the company headed toward longterm success. It doesn’t mean that they don’t have a
place or role within the scope of the organization, but
it’s important for them to always place the company’s
growth needs above their personal need for success
or power.
About the Author
Liz Brashears is a Director of Human Capital Consulting for TriNet overseeing their client experience for the Southwest
Region. In addition to partnering with clients on their human capital strategies, Liz is the National Practice Leader for TriNet’s
Leadership Development practice and advises clients on assessment and leadership matters.
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