VENTURE CAPITAL REVIEWISSUE 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 Association1655 Fort Myer Drive Phone: 703.524.2549Suite 850 Fax: 703.524.3940Arlington, VA 22209 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 ThemeBy Jody Holtzman, Senior Vice President, Thought Leadership, AARP

23 Reengineering the Mechanics of the Exit WaterfallBy 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 StudyBy Jack Connell, Kim Glass and David Schmidt

50 Executive Severance Agreements and Policies in Venture-Backed CompaniesBy Pearl Meyer & Partners

55 Antonio Who? Investing in New Media and Social Media – When Legal Issues Become Business IssuesKristen Mathews and Paresh Trivedi, Proskauer Rose, LLP

64 Leadership Principles for Growing CompaniesElizabeth 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.

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By Bryan Pearce, Partner of Ernst & Young LLP

Fair Exchange:The Evolving Nature of Entrepreneurs and Venture Capital

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 futureEntrepreneurs 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.

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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.

Passion is paramountOperating 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.

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.

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.

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 factorDespite 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).

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.

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.

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.

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;

• 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).

• 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.

• Connections - The venture-backed company benefits from an extensive network of advisory resources.

$1 million

Seed round

First round

Second round

First later-stage round

size of initial start-up

189%increase in valuation

160%increase in valuation

117%increase in valuation

$3.3 million median size

$4.3 million median size

$4.5 million median size

14 mos. 18.3 mos. 18.8 mos.

Product developmentStart-up Revenue generation

Source: Dow Jones VentureSource May 2013

Figure 1: Trajectory of a VC-backed technology company

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Breakthrough ideas are not enoughA 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.

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 Spencer Stuart and NCVA, Emerging Best Practices for Building the Next

Generation of Venture-backed Leadership, p.3.

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.

Venture capitalists are also looking for a better-rounded 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

2 Ibid, p.5.

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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?

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From the inside out: the entrepreneurial characterLooking 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).

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.

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?By percentage of respondents(multiple responses possible)

Ability to communicate vision and instill passion

Ability to identify and develop talent

Ability to “see around the corner”

Ability to listen to advice

Other

Decisiveness

Not provided

41

26

18

16

12

11

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Figure 3: What are your future priorities?By percentage of respondents(multiple responses possible)

People

New markets

Technology

Research and development

Mergers and acquisitions

Capacity

Not provided

51

32

31

23

15

13

4

9

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 high-

growth companies, in general, are vital for economic

growth, often accounting for disproportionate shares

of job creation in any economy.

7. 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.)

52

44

38

Figure 4: What do you focus on to preserve what you’ve built?By percentage of respondents(multiple responses possible)

Preserve company culture

Attract and retain top talent

Protect and enhance brand/reputation

Retain our best customers

Align capital structure to future plans

Identify and monitor risk

Implement appropriate controls

Not provided

Other

30

12

12

6

3

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The innovation inheritance: the role of entrepreneurs in the US economy 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.

As the venture capital sector approaches a half- century 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 crowd-funding 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.

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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, venture-

backed 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 AuthorBryan 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 & YoungGlobal 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.

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What’s Your 50+ Strategy? A New Investment ThemeBy Jody Holtzman, Senior Vice President, Thought Leadership, AARP

IntroductionIn 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.

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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.

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:

• 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,

• What’s your 50+ strategy?

The opportunity for the venture community is twofold:

1. Ask those same two questions of your portfolio

companies and the startups that come to you

seeking investment, and

2. 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+.

The Emerging Market in Plain SightThe Longevity Economy

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.

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+.

For investors, the benefit of understanding the Longevity

Economy is that this paradigm provides even greater insight

into the potential business and investment opportunities.

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:

• New ideas

• New business models

• Disruptive innovation

• New technologies

• Investment

• New business formation

• Job creation

• Productivity growth

• New markets

• New industries

• New economic value

• Supply chains and multiplier effects

• Demographic growth

• 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.

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).

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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.

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.

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.

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.

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.

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.

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.”

The key takeaway for investors and entrepreneurs is this —

this market is too big to ignore.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.

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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.

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.

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 25-50 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%.”

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.

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!”

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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).

The key takeaway for investors and entrepreneurs is this – this market is too big to ignore.

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!”

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.

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).

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).

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 18-49 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.

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).

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.”

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.

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The OpportunitiesThe 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.

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.

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.

Healthcare

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:

• 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.

The opportunities reflect both categories – products and services targeting the 50+, and those designed for all.

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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-of-pocket. 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.

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.

• 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 service-centric 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.

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.

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.

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• 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: Detecting falls, sending alerts when a person is lost, preventing in-home accidents.

• 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: Navigating the healthcare system, identifying relevant providers, evaluating quality of care, managing healthcare costs, planning for end of life care.

• 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.

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.

• 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.

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.

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• 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.

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.

• 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.

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.

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:

• 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.”

• 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.

• 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.

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A New Investment Theme for VCsEvery 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.

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.

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.

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).

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.

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 high-potential products/services/business models. And it will provide an opportunity to drive disruptive innovation in a huge growth market that is currently under-served.

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?!"

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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.

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.

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?!”

Building the Eco-SystemAs 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.

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:

• 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.

• 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.

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• 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.

• 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 in-home pilots together with select startups.

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.

About the AuthorJody 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 non-traditional 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.

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

“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

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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 forwardIn 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 venture-backed 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.

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Background & Context – Manufacturing Runs with Preferred Stock TermsThe 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 non-growth 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 time-tested 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.

Reallocation TechniquesUnfortunately, 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.

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.

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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 as-converted return payable to the holders of common stock) can be shown graphically as follows:

Stakeholders are taking advantage of the terms of the corporate charter itself to reallocate proceeds from one series

of preferred stock to another.

Common Equivalent Return ($/share)

Pre

ferr

ed R

etur

n ($

/sha

re)

Conventional Preferred Return

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$0.00 $0.20 $0.40 $0.60 $0.80 $1.00 $1.20 $1.40 $1.60 $1.80 $2.00 $2.20 $2.40 $2.60

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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.

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 as-converted 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.

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 current climate should force parties to investment transactions to rethink the way in which they currently

document transactions.

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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 venture-backed 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.

A Recommendation: Attach the Model and Incorporate the Related AlgorithmsParticipants in investment financings might be better-served 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).

Participants in investment financings might be better-served to eschew convention and draft the language

relating to economic returns on exit more directly.

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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 root-solving methods (such as Newton’s Method) will not work because the equations are non-differentiable (i.e. non-smooth) at certain points, standard numerical solutions do, in fact work. And one method that works particularly well is the bisection method.

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.

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.

Investors and companies would be well-served to reconsider

the way in which they are documenting exit waterfalls in their transaction documents.

About the AuthorsMichael 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.

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By Steven Nebb, CFA and David L. Larsen, CPA, Managing Directors of Duff & Phelps LLC

10 years after PEIGG, is the world a better place?

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?

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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).

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.

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.

During 2002–2003, a self-appointed group of private equity practitioners, fund managers, fund-of-fund managers and others formed the Private Equity

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 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).

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.

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.

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Fair Value: Why is it here?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.

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:

• 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.

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.

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.

LPs don’t always articulate the reasons they need

fair value reporting.

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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.

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 non-regulated 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.

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:

• 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,

• 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,

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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.

Fair Value: Where should it be going?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.

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.

“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.

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.”

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.

Potential Wrong Turn

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.

1 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.

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.

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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.

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.

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

not tools explicitly used by Market Participants to price transactions. The use of OPM or PWERM is not required by accounting standards.

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.

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).

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.

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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.

ConclusionFair 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 AuthorsDavid 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.

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By Jack Connell, Kim Glass and David Schmidt

Connell & Partners 2013 Executive Compensation in Recent IPO Study

Executive SummaryThe 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 long-term 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.

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Focus of StudyOur 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.

Increase Amounts – Increased amounts are generally in the double digits for key executives such as the CEO, CFO and Head of Sales.

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.

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.

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.

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.

Share Usage and Dilution – Equity dilution and the annual stock “burn rate” increases as the IPO approaches.

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.

Bonus Targets – Bonus targets increase and bonus plans shift from primarily discretionary to more formulaic and goal based.

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Equity Vehicles – Options continue to remain the primary vehicle of choice for pre-IPO/IPO firms.

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 Change-in-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 change-in-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.

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.

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.

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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.

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.

Compensation Levels – CEO and CFO Pay Increases with Additional Responsibilities.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.

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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.

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.

Element of CompensationChanges 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 CompensationFiscal Year Before IPO

25th Percentile 50th Percentile 75 Percentile

Base Salary ($K) $282.2 $307.4 $382.0

Target Bonus (as % of Base) 35% 50% 80%

Target Total Compensation ($K) $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 CompensationYear of IPO

25th Percentile 50th Percentile 75 Percentile

Base Salary ($K) $318.1 $382.5 $450.0

Target Bonus (as % of Base) 46% 67% 100%

Target Total Compensation ($K) $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.

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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

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.

Element of CompensationChanges 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 CompensationFiscal Year Before IPO

25th Percentile 50th Percentile 75 Percentile

Base Salary ($K) $221.3 $250.0 $290.0

Target Bonus (as % of Base) 25% 38% 50%

Target Total Compensation ($K) $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 CompensationYear of IPO

25th Percentile 50th Percentile 75 Percentile

Base Salary ($K) $250.0 $286.0 $309.0

Target Bonus (as % of Base) 30% 50% 60%

Target Total Compensation ($K) $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.

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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

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.

Element of CompensationChanges 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 CompensationFiscal Year Before IPO

25th Percentile 50th Percentile 75 Percentile

Base Salary ($K) $202.8 $225.5 $235.0

Target Bonus (as % of Base) 28% 70% 119%

Target Total Compensation ($K) $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 CompensationYear 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.

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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.

We examined these figures from each company’s prospectus filing and separated out the new equity

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.

Share Usage and DilutionCompanies Refresh or Revamp Equity Incentive Plans Pre-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.

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,

Equity Outstanding

13.5%

9.0%

17.6%

13.8%

26.1%

22.5%

PG... PG... PG...

Total Overhang

16.9%16.6%

21.6%23.3%

29.6%

32.7%

PG... PG... PG...

Shares Available for Grant

0.7%

6.2%

1.7%

8.3%

3.8%

13.0%

PG... PG... PG...

Equity Overhang

0%

5%

10%

15%

20%

25%

30%

35%

0%

5%

10%

15%

20%

25%

30%

35%

Pre-IPO

Post-IPO

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.

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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.

No Evergreen25%

5.0%28%

3.0%5%

3.5%5%

4.0%28%

3.9%2%

4.5%7%

Equity Plan Evergreen Percentages

ESPP Evergreen Percentages

No ESPP56%

ESPP w/o Evergreen

12%

0.50%2%

1%23%

2%+7%

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.

Pre-IPO and IPO Equity Grants Remain a Prevalent Practice, with Options Continuing to be the Vehicle of Choice

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.

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.

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LTI Design Vehicles – Stock Options Remain the Most Prevalent Choice of Equity Vehicles

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 burn-rate 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.

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-by-position look, which we will look at after this analysis as there are some intriguing differences.

CEO LTI Instrument Usage

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.

CFO LTI Instrument Usage

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,

NEO LTI Instrument Usage

Options Stock Performance Any Instrument0%

20%

40%

60%

80%

100%

Prior Year

IPO Year

CEO LTI Instrument Usage

Options Stock Performance Any Instrument0%

20%

40%

60%

80%

100%

Prior Year

IPO Year

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Stock Ownership Guidelines – While Equity Grants are Prevalent, Formal Ownership Guidelines are Not.

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 post-IPO. 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.

Other Plan Design FeaturesAnnual 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.

CFO LTI Instrument Usage

Options Stock Performance Any Instrument0%

20%

40%

60%

80%

Prior Year

IPO Year

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.

Severance/CIC

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 double-trigger), the median was 12 months, including non-receiving 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

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.

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Overall

Determine roles and decision rights of employees (HR, Finance) and consultants in developing executive compensation programs.

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.

Develop an executive compensation philosophy (including program objectives, pay positioning, mix, types of vehicles, etc).

Develop a defensible Peer Group of comparable public companies.

Review competitiveness of executive compensation.

Set competitive compensation levels (base, target bonus, equity/long-term incentive awards, perquisites/benefits and total direct compensation).

Short-Term Incentive/Bonus Plans

Determine overall strategy and framework (e.g., financial goals, milestones, discretionary, frequency).

Select financial performance measures and individual / MBO goals.

Calibrate financial performance targets versus market/street expectations, internal budget, and Peer Group performance.

Develop formalized Short-Term Incentive Plan document.

Long-Term Incentive

Review / develop a long-term incentive strategy including appropriate instrument use / mix.

Develop an LTI award matrix with values and participation rates for all employee levels.

Determine if an “Evergreen” provision will be used. If so, determine appropriate evergreen size.

Set equity utilization (share run rate) budget for coming fiscal year.

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.

Discuss and potentially implement executive and Board share holding/ownership requirements.

Employment, Severance, and Change-in-Control (CIC) Arrangements

Review existing employment, severance, and CIC agreement terms and conditions and potential payouts.

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.

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.

Governance

Develop or amend (as needed) Compensation Committee charter.

Draft Compensation Discussion & Analysis (CD&A) and accompanying tables for S-1 and Proxy.

Compensation risk assessment.

Review and set Board of Directors compensation for the following year.

Set equity award approval process, including what authority, if any, will be delegated to management. Formalize policy regarding award grant timing.

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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).

Ideally 15-20 firms

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).

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.

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.

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.

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).

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• Remove any “egregious” executive compensation practices so that they are not “red flags” to ISS and similar advisory firms providing counsel to Institutional shareholders:

No gross-up provisions in severance/change-in-control arrangements.

Double (i.e., CIC and termination/material change in employment relationship) versus single trigger change-in-control arrangements.

Excessive executive benefits and perquisites (not typically found in firms that are going to IPO). Were typical in larger public companies.

• 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.

• 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.

• 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.

About the AuthorsJack 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.

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By Pearl Meyer & Partners

Executive Severance Agreements and Policies in Venture-Backed Companies

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.

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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.

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.

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.

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.

Important Terms in Severance and CIC ArrangementsA severance arrangement typically includes provisions for:

• Cash severance

• Continuation of benefits

• Treatment of unvested equity

• Non-compete/non-solicitation agreements

• Golden Parachute excise taxes

Key Benefits and Forms of Severance ArrangementsSecurity 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.

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.

Security arrangements can take several forms including:

• Employment agreements

• Severance agreements or policies

• CIC agreements or policies

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 non-compete 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.

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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.

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.

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.

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.

The scenarios typically addressed in regard to equity include:

• Termination Absent a CIC – Treatment may depend on the specific circumstances:

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.

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.

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.

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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:

• 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.

• 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.

• 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.

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.

Key Factors in Determining the Need for a Severance ArrangementAs 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.

Among the key questions to ask about a proposed severance agreement:

• Is it consistent with industry practices?

• Does the company have any existing severance arrangements?

• 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?

• Are severance arrangements for all the NEOs consistent?

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

As a general rule, Boards should consider severance

and CIC protections based on factors that are particular to their own company, industry

and circumstances.

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ConclusionExecutive 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.

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 gross-ups are becoming a thing of the past. Please examine the data summarized below when evaluating these market practices.

Data on Current Practices 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.

• About half the companies provide continuation of health and welfare benefits during the severance period.

• More than 60% of companies provide double-trigger equity vesting following a CIC, defined as a termination of employment within a certain period (e.g., one year following a CIC).

• 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.

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.

About the AuthorWith 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.

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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.

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I. Intellectual Property Rights for Technology AssetsSecuring 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.

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. Work-for-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.

Without effective work-for-hire 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.

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.

1 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).

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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 ContentIn 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 industry-wide 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.

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 user-generated 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.

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.

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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.

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

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.

III. Digital PrivacyA. 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).

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

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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.

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

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.

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.

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.

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).

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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.

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.

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.

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).

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IV. Data SecurityThe 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.

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.

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,

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 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.

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.

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.

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V. Online Agreements and Terms of UseA. 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).

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B. Developer Agreements for Mobile Applications

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.

VI. ConclusionThe 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.

About the AuthorsKristen 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.

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Elizabeth Brashears, SPHR, Director, Human Capital Consulting

Leadership Principles for Growing Companies

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.

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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.

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 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.

Here are ten leadership principles to grow by 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.

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.

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.

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.

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.

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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.

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.

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.

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.

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:

• Clarify the behaviors that are important for success within the organization

• 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

• 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.

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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.

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.

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.

Assessing talent and identifying employee strengths is critical for effective leadership. Here are a few tips to get started in the right direction:

• 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.

• 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.

• 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.

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.

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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:

• 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.

• 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.

• 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.

• 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.

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.

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.

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.

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.

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.

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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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.

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.

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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 long-term 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.

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 long-term 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.

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.

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.

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.

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.

About the AuthorLiz 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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