#8: This is not ‘Suit’able

(This is the eighth post in a series of posts that address and demystify startup related issues using references from HBO’s popular TV Show, Silicon Valley. If you haven’t already, I urge you to read the first post for the context and background for these posts available at https://bit.ly/3mWEDSu)?

After a significant gap, we return this week (with a cheesy pun for a title) to find our startup gang facing legal troubles in the form of a legal notice issued to Pied Piper. Hooli files a legal suit against Pied Piper claiming, among other things, that Pied Piper’s algorithm belongs to Hooli because it was created using Hooli assets (ie, the Hooli laptop). Adding to the woes is Pied Piper’s financial condition which is dire and could spell the end of the company if funding is not arranged soon. The next two episodes set the base for us to understand certain issues that a lot of startups may have faced or are (unfortunately, but hopefully not), likely to face. This post tries to identify some mitigating or curative measures for situations as grave as those faced by Pied Piper.

Season 2, Episode 2 and 3

Once Pied Piper gets served with the legal notice, not only does Raviga pull their term sheet, but so does every other VC firm. The likely reason is that if an early-stage entity’s core product (in this case, the compression algorithm) is susceptible to ownership risks, those too from a company as large as Hooli, the risk-to-reward ratio for VC firms (which, in any event, is significantly high) increases significantly and the firms would find it difficult to justify the risks of the investment to their stakeholders. The absence of certainty of funding coupled with potentially significant legal costs likely to be spent in defending the matter leads Pied Piper to search for alternate funding.

Towards the end of episode 2, we also witness Gavin Belson attempting to settle the matter by offering to buy out Pied Piper and hire its employees. Coming to terms with the changed circumstance and the offer by Gavin, Richard is again dealt with a surprise in the form of an offer from Russ Hanneman, a colourful, bold, and unapologetic character that also appears to be a cunning businessman, as he agrees to offer Pied Piper a USD 5 million loan with several conditions (including board seats). Episode 3 further acquaints the viewer with Hanneman’s personality as a distracting and controlling investor who may create issues for the company in the future (future posts will cover this in detail). An example of such control is witnessed when Hanneman, without taking the team into confidence, buys a large billboard merely to annoy Gavin Belson. It also comes as little surprise that he gives the billboard contract to another one of his companies. While all of this concerns Richard, he remains focused on first identifying a solution for his legal problems.

Takeaways:

1.??????Legal suits; a costly game of chicken: Using the legal system to kill or crush the competition, sometimes purely on the basis of having more resources, is an unfortunate reality of business. It should not be shocking to know that numerous companies similar to Hooli exist, and these companies seek to destroy the competition by one way or another, sometimes by sheer brute force. The case of Pied Piper is no different, and Hooli tries to choke Pied Piper’s funding through the litigation, since Hooli knows that litigation is a costly affair, one that Pied Piper would unlikely be able to afford. Although no entity can shield itself completely from any legal risks, it can implement some best practices to reduce or mitigate those risks. The risks become significant if the entity is operating in a small niche with high growth potential, or has developed or possesses assets that allow its business to be distinguished from other businesses, thereby attracting greater scrutiny (positive and negative). Even though there is no playbook for risk mitigation against such attacks, potential issues can be ring-fenced by one or a combination of the following tactics:

a.??????Executing clear and comprehensive contracts with parties (ex-employers, current employees, service providers)

b.??????Ensuring IP and assets are suitably protected from infringement (again, possible through contractual protections)

c.??????Incorporating in the form of limited liability entities (LLPs, Private Limited Companies) to reduce personal risks

d.??????Establishing robust corporate and operational policies within the entity to prevent issues arising from internal resources.

As stated, while none of the above can ever guarantee ZERO risk, defending positions in a dispute resolution scenario becomes less challenging if the foundation of the business rests on a bedrock of clarity, transparency, and legal compliance.

2.??????Not every investor is a white knight: Desperate times cause people to make decisions that would not be taken in less-challenging times. It appears that Pied Piper’s decision to accept Hanneman’s offer for a loan may come back to bite Pied Piper (again, stay connected for updates, or just watch the next episode). The exchange between Hanneman and Richard underlines the importance of diligence by the startup on the investor. The allure of money creates a fog, clouding rationality and clarity, and the fog must be cleared before taking crucial decisions, especially around control and funding. Entrepreneurs should understand that an investor should be viewed not only as a source of funds but also as an asset who can leverage his / her skills and catalyse the growth of a startup. Conversely, an investor can also inhibit or stall a startup’s growth or operations, and even though money is important, the investor’s background, history, vision, and objectives for the startup MUST align with those of the founders. Absent such discussions, the endeavour is bound to encounter friction, which can spell the death knell for an entity.

3.??????Loans v equity: In a very generic sense, and on a superficial level, investments structured as loans are usually (and I cannot stress the generalization of this point enough) more favourable for young startups looking at a long-term growth trajectory (thereby implying exponential increments in valuation down the road). This is because early funding in the form of debt avoids any future dilutive impact of those funds, given those funds are provided by the investors in exchange for non-convertible instruments. These instruments (unlike convertible instruments) are structured as repayable loans with regular interest payment components and default triggers, not too dissimilar from standard commercial loans. For some entities, however, even these might be viewed as a challenge as repayment terms usually require cash payouts, a condition that might concern cash-starved startups. In some cases, loans may also be structured as 'asset-based loans' ie, loans whose terms are determined by the strength of a startup's balance sheet (as against cash flows) and may also be accompanied by the issuance of equity warrants (which the investor can exercise and acquire shares). Usually, these assets are receivables, inventory, real estate, intangibles (IP), etc. All the terms, obligations of the startup, and the implications of those obligations must be properly and clearly understood. It is unfortunately common to witness startups defaulting on minor terms of such investments, and ending up with dire consequences that may include losing control of their company.

Conclusion:

Startups face difficult decisions at every step in their journey. At times, it may even feel like war. This post is my humble attempt to assist entrepreneurs and startups in understanding the risks of doing business, and realise that risks are inherent in any fruitful venture. The key difference between a successful venture and a not-so-successful one is not the absence of failure or challenges, but the ability to persevere, withstand and learn from them.

Disclaimer: Nothing in this post constitutes legal advice. All posts are my personal views and commentaries on my understanding of the world and a take on the show.

Please feel free to reach out to your attorney or legal advisor for specific issues, since the posts are contextual to the show and even though the issues may appear similar, there are likely to be certain distinctions that one may have to consider.