94labs incubator (formerly Spreenkler incubator) recently showcased the fourteen companies graduating from its summer session. The event was hosted at the Wisconsin Institutes for Discovery and featured the founders of the fourteen companies as well as the five companies emerging from the second-stage accelerator class. Joe Kirgues, Greg Meier, Steve Glynn, Emmanuel Mamalakis and others from 94labs led the event.

In introducing the 94labs incubator to the more than 300 attendees, co-founder Joe Kirgues explained the four main goals for companies going through the incubator: (1) develop a scalable business model, (2) build a software prototype, (3) identify and talk with potential customers, and (4) create an investor presentation. The idea is that the companies then leverage the capital, partnerships, and customers that they gained while in the program.

Each of the founding teams gave a four-minute pitch with slides. Steve Glynn emcee’d the program. Despite the stereotypes about young engineers, computer science, and math major graduates, the speakers were dynamic and articulate. Each team wore matching t-shirts with their company logo.

Here are short synopses of each of the companies:

Jungol

Jungol offers an online platform to enable organizations to work together, with tools like to-do lists, file sharing and discussion boards, increasing efficiency and collaboration, leading to greater donations.

Door 6

Door 6 is developing a mobile game platform for making hard core games for mobile devices. The company was a finalist in Google’s Android Developer Challenge 2.

Quasi Electronics

Quasi Electronics offers a web-based tool and social community for non-professional market to design, build and order circuit boards. The tools on their site will facilitate the design and execution of electronics projects, targeting the rapidly growing non-professional market of students, DIYers, artists, and inventors.

Servique

Servique is an online platform for finding commercial and residential contractors. Their first city will be Milwaukee.

Open Education

Open Education offers a math learning software for teachers to create assignments online, where students can show their work, allowing teachers to track their progress.

Socle6

Socle6 provides a private social network that allows users to better manage the dissemination of pictures and messages that, through traditional social media, often fall into the hands of recruiters, ex-friends, and others who should not have access.

Shindig

Shindig offers a crowd-powered event booking platform that connects attendees, artists, and venues by allowing people to choose who they want to see perform where and when, by leveraging existing social media networks.

SASR

SASR has an iPad application called LivePaper for sharing class notes and communicating with professors and other students online, making studying more efficient and social.

ScioMD

ScioMD offers software to produce understandable lab test reports for patients. The software will compare a patient’s results with others in their demographic as well as give suggestions.

StyleShuffler

StyleShuffler offers a tool that gives personalized clothing suggestions, building on the customer’s preferences.

72 Web Design

72 Web Design offers professional campaign sites for small or local races, an alternative to more expensive web design firms. Their tools enable customization, online volunteer sign-up, and online political fundraising.

Searium Studios

Searium Studios is developing challenging multiplayer role-playing video game with unique, customized character and an immersive story targeting avid gamers, to be released on PC and xBox platforms.

PinPoint Software

PinPoint Software offers an expiration data management software called Date Check Pro, which tracks inventory expiration dates based on product purchases, saving grocers time and keeping expired items off of the shelves.

Jawnt

Jawnt is a social media related service that offers local hosts to provide authentic tours to travelers. The idea is to create unofficial and unique tours by giving people a “local’s view” of things to do.

The 94labs launch event was one of eight events that took place between August 18th and 27th as part of the Forward Technology Festival. The festival brought together up-and-coming and serial entrepreneurs, inventors, investors, and others plugged into the technology community.

A key financial backer of 94labs, Emmanuel Mamalakis, wrapped up the program with remarks that drew applause – that there’s no reason why Wisconsin can’t compete with the coasts in being a breeding ground for ideas, and that changing the culture of Wisconsin requires community, legislative, and family support.

The Capital Saving and Raising at the Brink event held Monday, August 22, 2011 as part of the Forward Technology Festival was a success!  Entrepreneurs, investors, government representatives, and others interacted and shared ideas in a collaborative forum.  We put together a resource page for the event: http://alphatechcounsel.com/capital-saving-raising-2011.html

Capital Saving

In the Capital Saving segment led by Troy Vosseller, attendees were divided into six teams, and each team collaborated to identify the ways in which they have saved capital in their businesses.  Teams simultaneously entered their ideas in different tabs of a GoogleDocs workbook.  Team captains pitched their team’s top two ideas, and attendees voted electronically on the top two ideas.  The winning ideas were:

(1)  Run contests for everything (from logo designs to product ideas)

(2)  Get your customers, strategic partners, and others to pick up company expenses

Members of winning teams selected prizes from local startups, murfie.com, FlattCola, and Sconnie Nation.  Many of the teams’ ideas are listed in the Team tabs in this GoogleDocs file: http://tinyurl.com/3h853a7.

Capital Raising

The second segment of the event focused on Capital Raising.  The session leader Matt Storms gave the attendees a choice of these topics to discuss, in addition to angel financings: founders financings, friends and family rounds, government and nonprofit funding and resources, and other topics such as incubators and venture debt.  Matt raised questions on these topics and attendees shared information and their experiences and perspectives as well as their questions.   Here is some of the advice raised by attendees:

• Develop Relationships.  Raising capital and entering into strategic deals starts with developing relationships.  Investors value the quality of the management usually more than the technology or business model itself.  You may not know who is an accredited investor, but the well-established angel networks are a good place to start.  It’s never too early to approach VCs, angels, or strategic partners, not to pitch them, but just to ask for advice and build relationships to lay the groundwork for potential deals, referrals, or leads later.  A personal introduction to them through someone you know helps provide credibility.  It can be surprising, the types of companies that large consumer companies are looking to acquire (e.g., software, social media, security).  Generally, these types of companies prefer to be in contact with startups early, so they can help shape the direction of the business.
• Expand Search Regionally.  In addition to looking for investors locally, expand your search to Chicago, the Twin Cities, and other areas in the region.  Network at area events and meetings.  Be prepared to answer what position local investors have taken with regard to your company, because the question will likely come up when searching for angel or venture capital money outside of your local area.
• Educate Yourself.  Educate yourself on how to read your financial statements and understand the investors’ economics.  Also, understand legal terms related to investments.  Model out different scenarios with spreadsheets (e.g., liquidation preferences).  You’ll be better equipped to discuss deal terms.  As a couple people said, entrepreneurs should know as much about legal deal terms as their lawyers.  How you fare at the end of the day has as much or more to do with the legal terms than your pre-money valuation.  As one person mentioned in connection with the sale of the company, you don’t want to end up wearing a barrel.
• Investment Range and Terms.  The amount of an angel investment can vary by type of business.  It can be as low as $20,000 or as high as $2 million, if syndicated.  Sometimes angel deals end up above $5 million, but that’s rare in our area.  Attendees suggested that $200k – $250k for an early stage IT deal is typical, whereas the range is higher for other types of companies due to greater development costs.  Go into a potential deal with angels knowing the terms you want — terms that are standard in the region and for your type of company and growth stage.  There is typically less negotiating with angels  if the proposed deals terms are within the range of what is normal.  Contrast that with VCs, who will give you a term sheet.  Drum up interest between multiple investors to increase your negotiating leverage.
• Act 255 Tax Credits.  Apply early for Qualified New Business Venture status so future Wisconsin investors in your business can get the Act 255 25% income tax credits (assuming you meet the criteria).  Currently, it can take 6 – 8 weeks to get certificated and must be in place before an investor is eligible to receive the credit.  After your business plan is prepared, contact the Wisconsin Economic Development Corporation to see if your business meets the criteria and to discuss the application requirements.  Attendees stressed that not getting approved for the Act 255 program is not an invalidation of your business model; it just means your business didn’t meet the program criteria.  But, not meeting the criteria can affect your ability to raise capital locally.
• Government Programs.  The Small Business Development Center and Wisconsin Entrepreneurs Network can help entrepreneurs tap into the federal well of money, and your regional development manager at the Wisconsin Economic Development Corporation can help you get in touch with state money.  The application process, particularly for SBIR/STTR grants and loans, can be long and drawn out; it helps to stay in touch with the grant program manager.  Madison Development Corporation offers venture debt to qualified Dane County businesses that have reached revenue stage, even if they have a negative cash flow.  One attendee suggested that government funding should be supplemental to other sources of funding, and you have to be careful to maintain the focus of your business.
• Customer Funding.  Customers can be a source of funding, as they may want to invest in order to secure a right to be first-to-market with your product (that may be an add-on to theirs).  There were several in the audience that had done this, either receiving funding for their business or providing funding to others to enable them to expand.  They also may enter into a long-term contract which provides a solid stream of revenue.  Getting customer buy-in can provide validation to outside investors, as it demonstrates commercial interest.

Open Mic

The final segment of the program was an open mic session emcee’d by Jonathan Fritz.  Eleven attendees each gave a 2-minute pitch on an idea, and the attendees asked questions and provided feedback.  Ideas ran the gamut from tongue-in-cheek silly to potentially groundbreaking.

The Capital Saving and Raising at the Brink event was a success overall as attendees met new contacts, learned from each other, and had fun!  Several people urged doing it again next year.

Last night I attended the Spreenkler Launch Night in Milwaukee. What a great event! It marked the culmination of months of hard work by the inaugural class of the Spreenkler seed incubator by showcasing the graduating class of founders. More importantly, it marked the initial concerted effort in the area to use a systematic approach to create, refine, and commercialize multiple software/Internet-based products and services. And probably even more importantly, as evidenced by the event last night, the incubator brought together a community of like-minded people from all parts of the region and ends of the political spectrum who are motivated to work together to create exciting new technology companies in our area.

Here’s some information about the new companies:

Eventcopia

The first company that presented was Eventcopia. The company ties local businesses with customers by linking existing event calendar systems. It enables companies to provide more detailed information to their customers about the customers’ particular upcoming events, including things to anticipate in connection with the events and special pricing and offerings that the customers can take advantage of in connection with the event. Eventcopia has at least four beta customers in the Milwaukee area.

KnockDown Ninja

KnockDown Ninja is a company that “puts butts into seats.” It uses social media tools in a unique way for event promotion. Specifically, it uses peer-to-peer promotion and rewards those who promote an event through lower prices for the event for the promoters and their friends. The company takes a commission on sales and is current in beta testing.

CrowdSling

The third company that presented was CrowdSling. The company organizes and validates opinions. How so? They provide a platform to users to identify issues and for others to take supporting or contrary positions. CrowdSling also enables others to evaluate the quality of the opinions and the ability to sort the opinions by how strong the opinions are rated.

ZoomShift

ZoomShift offers a web-based staff scheduling tool. It enables companies like restaurants to create and communicate schedules to employees within in a couple of minutes, rather than a few hours. It also allows employees to change and swap schedules through the application. It recently landed its first beta customer.

Offermation

The final company that presented was Offermation. Offermation focuses on online advertising for small business. It uses a wizard web-based system to create and monitor online advertising campaigns. It covers online advertising, coupons, text messages, and other advertising mechanisms.

Kudos to Greg Meier, Steve Glynn, Joe Kirgues, Emmanuel Mamalakis, and the rest of the Spreenkler team for their efforts. Exciting stuff. Well done.

Small businesses often have challenges with raising capital from investors.  Gaining access to equity capital can be difficult and complying with a myriad of rules and regulations when seeking help in raising funds can be very confusing.  When raising equity capital, many entrepreneurs seek assistance from unlicensed “finders” for introductions to potential investors. Recent government enforcement actions and commentary from regulatory agencies, however, emphasize some of the risks associated with working with unlicensed finders.

So . . . What do Finders Find?

Generally, finders make introductions between investors and companies, but do not actually sell securities or close transactions on behalf of the companies selling the securities.  If a finder is providing anything more than a simple introduction or access to contact information, or is receiving a fee based on the completion of a transaction, then the finder needs to be licensed as a broker-dealer.

Finders are generally not allowed to pitch for the company, develop deal terms, or negotiate for or represent the company, unless they are licensed as broker-dealers.  Both state and federal law require anyone who is involved in the business of selling securities to be licensed.  If a company uses the services of an unlicensed finder when a broker-dealer license is required, then (1) the company may be at risk for civil and criminal penalties; (2) the investors may be able to rescind their investment transaction and demand their money back; and (3) the company’s ability to raise capital in the future may be limited. If the management of a company desires to have someone help develop deal terms for them, have someone pitch for or with them, and receive compensation for those or similar services based on a successful capital raise, then the company will likely have to engage a licensed broker-dealer.

Regulation of Broker-Dealers and Finders

The regulation of broker-dealers was instituted under state and federal law to protect potential investors from abusive and misleading sales practices.  Broker-dealers are required to conduct a reasonable investigation into both the securities that they offer and the issuers of the securities.  They also are required to evaluate whether the securities are suitable for the investors purchasing them. By categorizing finders as broker-dealers, regulators are attempting to prevent them from engaging in the abusive and misleading sales practices that securities regulations are intended to curtail.

There is no specific “finder’s license” issued by the U.S. Securities and Exchange Commission (SEC), and obtaining a state and federal securities license to become a broker-dealer is a significant burden; moreover, most of the requirements to obtain the license has little to do with what finders actually do.  Most finders are well-connected people who only occasionally make introductions of companies to potential investors, so taking securities exams, meeting ongoing securities-related educational requirements, and being subject to the oversight and monitoring of a broker-dealer’s compliance department is generally not worth the hassle to them.

Recent Developments: Finders under Fire

Over the past few years, the SEC and state securities regulators have been more aggressively enforcing restrictions on the activities of unlicensed finders. On May 17, 2010, the SEC denied a request from a law firm seeking a “no-action letter” related to the law firm’s proposed introductions of a client to individuals who “may have an interest” in investing in the client, where the law firm would receive a small percentage of the investments made as a result of the introductions.  In its response, the SEC stated that “transaction-based compensation” is a “hallmark of broker-dealer activity” and that “any person receiving transaction-based compensation in connection with another person’s purchase or sale of securities typically must register as a broker-dealer or be an associated person of a registered broker-dealer.”  Additionally, the SEC stated that a finder who is introducing people who may be interested in buying securities would likely be both “pre-screening potential investors to determine their eligibility” to purchase the securities, and “pre-selling securities” to gauge the investors’ interest. The SEC concluded that compensation tied to successful investments would give the law firm a “salesman’s stake,” triggering the need for broker-dealer registration.

Cash-strapped states have also taken the approach of aggressively seeking civil and criminal penalties against unlicensed finders.  For example, a prominent national law firm acting as a finder was recently required to pay a $550,000 penalty for making introductions and arranging for meetings between a state pension fund’s representatives and one of the firm’s clients seeking investment from the pension funds.  Despite the fact that no investment was ever made, the state’s attorney general prosecuted the firm on the grounds that some of the firm’s attorneys were engaging in the marketing of securities without proper licenses.  State pension funds and other disgruntled investors are also using rescission rights under securities laws to force the return of money invested in unprofitable funds when unlicensed finders were used to assist with the transactions.

The increased legal prosecution of unlicensed finders means that fewer individuals are willing to provide critical introductions to potential investors. The actions by securities regulators reduce the ability of small businesses to raise capital at a time when capital is in short supply. The development of a “finder’s license,” with requirements that are narrowly tailored to the services that finders provide, might help resolve the issues facing finders and smaller companies, but a narrow license for finders is not the direction that state and federal agencies are currently heading towards.

The Difficulty of Using Broker-Dealers for Small Capital Raises

Instead of using a finder, a company seeking investment may want to try to find a licensed securities broker-dealer.   However, there are very few licensed broker-dealers that provide services related to offerings below $5,000,000 in value.  The potential risks and relatively modest compensation related to small offerings leaves little incentive for licensed broker-dealers to act as finders for those offerings.  Sometimes, however, broker-dealers are willing to assist companies with these smaller raises if they believe that a much larger raise is in the company’s future or that it will increase the likelihood of the broker-dealer being engaged in connection with the sale of the company.

To view a listing of registered broker-dealers, along with each broker-dealer’s history of disputes with customers and regulatory and legal problems, the Financial Industry Regulatory Authority (FINRA) offers on its website the free FINRA BrokerCheck®.

One of the sets of documents that we automated at AlphaTech is the bridge financing documents for an emerging company.  Attached is a sample of the documents: Convertible Note and Subscription Agreement 

Instead of just using form documents as most law firms do, robust automation allows us to deliver common document sets for emerging companies in a more efficient manner.  So what else does “robust automation” yield?  It improves document accuracy, provides a valuable knowledgebase from which to draw, and enables us to deliver common document sets to our clients quickly.  It also frees up time of our lawyers to enable them to spend less time on basic contract drafting and more time on activities that afford our clients higher value.

Take for example the attached bridge financing documents.  With a click of a few buttons and filling in of a few blanks, we can change the attached bridge financing document set from a $1,000,000 bridge financing with a single lead investor but with multiple closings and a 20% discount on the next round’s security to a set of documents that includes a $750,000 bridge financing from five investors in a single closing with 30% warrant coverage and a $5 million pre-money cap on the next round’s valuation for conversion purposes.  To quote a client, “that’s neat.”

Last month, President Obama signed the Small Business Jobs Act of 2010 (Act) into law. One of the incentives under the Act effectively eliminates capital gains tax on certain investments in qualified small business stock that are made before the end of 2010. This incentive under Section 1202 of the tax code may help a number of emerging technology companies to close investment deals before year end. As may be expected though, there are both significant requirements to qualify for the tax incentives as well as limitations on the capital gains exclusions. But, a 0% capital gains tax rate is compelling for those who qualify for the Section 1202 tax incentives.

Scope of Investment Incentives

Under the Act, the capital gains from investments made between September 27, 2010 and January 1, 2011 in qualified small business stock are generally not subject to taxation. The total amount of the capital gains that are eligible for exclusion is capped at the greater of $10 million or 10 times the taxpayer’s basis in the stock. The Act also eliminates the alternative minimum tax (AMT) preference for qualified investments, further improving the potential tax benefits to investors who are subject to AMT.

What Investments Qualify for Incentives?

In order to qualify for the limited capital gains tax exclusion for an investment made during the remaining months of 2010, an investment must be made in an entity that has the following characteristics:

• a C corporation that meets certain active business requirements–no pass-through entities, such as LLCs, S corporations, or partnerships;
• a “qualified small business,” which means that it must have less than $50 million in assets (parents and their majority-owned subsidiaries are treated as one entity for purposes of the exclusion); and
• a “qualified trade or business,” which excludes (among others) banking, insurance, financing, leasing, investing, farming, and hotel businesses, and a variety of service businesses (such as those in health, law, consulting, financial services, etc., or any other trade or business where the principal asset of such trade or business is the reputation or skill of its employees).

Likely the most onerous requirement to qualify for the incentives is the holding period for the investment. Generally, stock must be held by the investor for at least five years to qualify. In addition, the investment must be (a) for the purchase of stock directly from the issuer of the stock or through an underwriter, rather than purchasing previously issued stock from an existing shareholder; and (b) acquired in exchange for cash, property (not including stock), or services.

Who Qualifies for the Section 1202 Tax Incentives?

Angel investors, venture capital firms, and individual investors should all be able to take advantage of the small business investment tax break. Corporations are excluded, however. Gains realized by pass-through entities, such as limited liability companies, partnerships, S corporations, and common trusts qualify to the extent that they meet the five-year holding requirement or transfer the stock to the partners in the entity.

What are Some Notable Exclusions to the Section 1202 Tax Incentives?

Certain stock repurchases made by a corporation before the issuance of the stock may disqualify the original investment from the capital gains tax exclusion. Investors may also disqualify themselves from the tax break if they (a) hold a short sale position for the same stock; (b) acquire an option to sell the stock at a fixed price; or (c) enter into a transaction that reduces the risk of holding the investment.

The combination of the potential tax incentives and an expected increase in capital gains tax rates in the near future means the timing of investments may be critical to maximizing potential tax benefits and limiting exposure to tax increases for investors, which should make investing before year more attractive.

As public companies are increasingly opting out of providing paper certificates to shareholders in favor of providing electronic registration (a movement known as “dematerialization”), most private companies and their shareholders have yet to follow suit.  Issuing uncertificated shares is allowed under most states’ laws, and, as many on the public company side can attest, numerous cost and time efficiencies can be gained by going paperless with shares.  As we accept electronic statements to represent our public company holdings and exhibits to Operating Agreements to note our LLC ownership interests, do we really still need as evidence of our private company ownership a hokey, bordered piece of paper with an eagle on it? 

Disadvantages of Issuing Paper Stock Certificates

Consider the inefficiency and chances for errors in the typical cumbersome process to issue paper stock certificates: 

1. Law firm staff orders special certificate paper
2. Attorney gives legal staff information needed to complete the certificates
3. Law firm staff keys in information on a blank Word document in calculated places on the page to line up with the paper form (or pulls out the old typewriter)
4. Law firm staff puts special certificate paper in the shared printer
5. Law firm staff reprints each certificate until the text lines up in the blanks
6. Law firm staff flips over the certificate (hopefully correct side up) and puts it back in the printer and prints the restrictive legend on the back side
7. Attorney reviews certificates for accuracy
8. Law firm staff sends or delivers the certificate to the company
9. The company obtains two busy officers’ signatures
10. The company sends the signed certificates back to the law firm to send out
11. Law firm staff prepares cover letters and overnight envelopes (or arranges for messenger service) to the investors
12. If the delivery was set for “do not release without signature,” the investor can be frustrated with having to be available for the package
13. The investor is then instructed to sign the stock receipt and return it in the envelope
14. Law firm staff follows up with investors who have failed to return the signed stock receipt, and sends another one

In addition to the inefficiency and error prone nature of issuing paper stock certificates, replacing lost stock certificates can be administratively burdensome for private companies.   Private companies typically require an affidavit of lost stock certificate and could (but usually do not) also require an indemnity bond to replace a lost certificate.  If a shareholder fails to replace a lost stock certificate while the company is private and it goes public, replacement can be quite expensive for the shareholder.  The transfer agent will pass through to the shareholder a fee charged by its indemnity carrier to insure replacement of the certificate, typically 2 – 3% of the fair market value on the date of replacement.  This could easily be tens of thousands of dollars!  What’s more, when delivering the certificates to the company or transfer agent for the IPO, most courier services will not insure a legal document delivery worth more than about $50,000.  I have seen a situation where a paralegal from the firm representing the selling shareholders in a follow-on offering, flew to the transfer agent’s office with shares worth millions in hand.

As rapidly growing emerging companies can go through one or more stock splits before an exit event, the disadvantages of issuing paper certificates multiply – more certificates for shareholders to safeguard, more chances for errors, and more costs associated with printing, proofing, and delivery.

Written Statement Instead of Paper Stock Certificates

The laws of Delaware, Wisconsin, Illinois and 42 other states/territories (all but Louisiana, Missouri, New Hampshire, New Jersey, North Dakota, Oklahoma, West Virginia and certain territories), with limited exceptions, provide that the board of directors of a company may approve the issuance of shares without certificates as long as the shareholder is provided with a written statement containing applicable information within a reasonable time after the issuance or transfer.  The written statement, which in most situations can be transmitted by email, typically must include the following: 

• Name of the corporation and what state organized under
• Name of the shareholder
• Number and class of shares and the designation of the series
• If a corporation is authorized to issue different classes or series of shares, include (i) a summary of the designations, relative rights, preferences and limitations applicable to each class and for each series, and the board’s authority to determine variations for future series and (ii) a conspicuous statement that the corporation will furnish the shareholder the information described in item (i) on request, in writing and without charge
• Transfer restrictions, if any

Usually, the board of directors can authorize the creation of uncertificated shares either by the first issuance or as replacement for shares previously represented by certificates.  The board also typically has the discretion to issue stock certificates for some classes and series of shares and not others.  Generally, there are no differences between certificated and uncertificated shares, except for the process to transfer them and to perfect security interests in them. 

Resistance to Uncertificated Shares

Despite the legality of uncertificated shares in most states, most private companies still issue paper stock certificates and most shareholders still expect them.  Shareholders sometimes prefer to have tangible evidence of their company ownership even though they do not appear to have the same expectation for partnership or LLC interests.  Some people want stock certificates for historic preservation and pride.  That may make sense in the context of long-standing businesses, but makes less sense with emerging companies funded by angel and venture capital investors.  With most technology start-ups, the company sells, merges, dissolves, or goes public within several years, in which case the stock certificates typically must be tendered for replacement shares or cash; shareholders cannot keep them for historic sake, unless of course the certificates become worthless.  On the public company side, many brokers have been discouraging shareholders from requesting paper certificates in their name by passing through a $500 fee that the Depository Trust Company (DTC) started charging on July 1, 2009.

Changing the Tide from Paper Stock Certificates to Uncertificated Shares

DTC’s change in fees and procedures last year led to declining public company shareholder demand for physical stock certificates.  Just as stock certificates are becoming a thing of the past for public companies, it is time for privately held emerging companies to consider issuing uncertificated shares.