VENTURE POLICY – CEO SPACE

THE FOLLOWING IS A RAW EMAIL FLOW OF FACULTY PARTICIPATING IN CEO SPACE IN LAW FIRMS NATION WIDE RELATED TO VENTURE FUNDING….THE DIRECTIONS SET FORTH HERE ARE DEBATE ENGAGING TO LAW FIRMS NATION WIDE:

Michael,

As a former Chairman of a publically traded investment banking firm supervising almost 6000 licensed brokers in 14 countries, I’m familiar with the security industry, administrating in that Global prior role for over twenty years. We employed senior partners at such firms as Gibson Dunn, across the USA, and worked with firms that employed the Compliance Advisory Leaders from within the SEC on small cap stocks as our attorney’s, such as Jerry Siegan “then” and Michelle Hallstead of Pillsbury (now). In my role at CEO SPACE the no debt issue is an absolute feature within our core lesson plans to all our students, and is embedded into our culture and to our legal team on faculty as policy. Why?

Because in forward years when conversion is optional or triggered or mandatory, the clients in many cases situation has changed. They desire now their money. The company requires more capital to execute growth precisely at the trigger period for the conversion. The structure provided assumes, in great majority in error, the mantra here, that the client projections will be realized and on time. The cost of growth was improperly stated in reality, in the majority of cases by the client to the law firm or was not stated at all. The capital was not sufficient, period to execute the business plan. While the law firm is NEXT on all these realities, CEO SPACE has to pick up the pieces for that Entrepreneur. A factoid I observed endlessly while in the security industry. The conversion theoretically works, but in early stage ventures versus more mature revenue firms, it is not ideal. We protect our clients absolutely by avoiding unwanted “capital calls” at a period the firm is ill advised to structure for their possibility. The notion most clients will convert is flawed in our experience, in sufficient application percentage so as to “by design and construction” saddle the horse, the young venture, with the inappropriate structure, for their ideal requirements. What is the reason to use sophisticated debt hybrids versus simple equity for firms at early stage? The is easier to raise money? I hear that a lot from Attorney’s who believe their “help” is “raising” money. As attorney’s giving the advice are ill experienced in truly raising money, I submit they error in their thinking. We know this to be true but tire of teaching to the legal profession. That conclusion, “this structure will be easier to raise capital is an experience of attorney’s. It is not my market experience, in fact it is worse in real world activity. Debt or income investors are unsuitable investors for early stage venture investing. When they are “lulled” to invest by structure, they place their expectations on the venture performance, which are far more absolute and anticipatory than the venture development, feeling their way along within the markets, projected into their future deadlines. If the dollar values do not rise to trigger conversion, if the client needs capital 36 months later, if their situation changed, the venture is obligated to propel precious cash and what may be precious earnings, out of the venture to repay investors. In most cases the venture cannot do so at the time period structured into the conversion. As the default on interest or delays in payment are worked out the young venture now has added unwanted legal fees, which can also be moved to litigation. All this is precluded by keeping early stage ventures away from what I call the “SOPHISTICATION ZONE”. Sophistication zone structures are designed into a firms life, when they have prudent revenues to repay debt. They are ideal anti-dilution constructions which was the original intent of their creator in modern terms, because I was in Wall Street in the 1960’s when these formats became more common to earlier stage ventures. I rallied against it then. For the same reasons I rally now. I can no longer count the venture owners who have failed to listen to my advice, and who have created their deal flow structure, in the model being suggested here. Later they suggest “oh Mr. Dohrmann I wished I had listened I so wish I could go back”. They typically are engaged in yet another offering to raise capital to repay the debt partners out. Now this construction is the most challenging money in the world to raise – new money to pay for old sins. The sins are the attorneys who simply fail to understand “valuation” and have never attended valuation training and classes for young venture firms, and all such classes are taught by my tribe who are “investment bankers” and who are by profession expert in valuation issues attorney’s are untrained upon. However attorney’s will not only mal practice by stepping out of their profession, “ compliance law and administrating full legal compliance disclosure and government filings at state and federal levels” but they will become somehow investment bankers and management, and design the first round of funding, which all too often is a financial prison for valuation and the firm’s growth in any second or third round. They lack experience to make such projections and cost reviews as prudent experts, into the companies real cost of growth over time. The only issue that becomes relevant in early stage ventures is the error on the conservative side to design sufficient capital to sustain venture growth, over time, overcoming the real and unforeseen cost of growth the venture owner has not considered. This risk is the cornerstone risk to the investors in any venture investing. I have never had a venture fail because they had too much capital, at least not in the past 21 years. I have had countless venture failures in debt construction because they were choked on capital forward acquisition by the SOHISTICATION ZONE applications of structure, by law firms, before that venture was suitable for more sophisticated later round funding designs, all built on revenue models with revenue firms who can predict and project future income. As we have raised the greater sums ( billions ) with the greater experience from the law firms in this early stage venture area, , at least in our application, we will remain within CEO SPACE policy. We do not desire to see our clients, advised to relocate their security structures from our lesson plan guidelines on this topic, into SOHISTICATION ZONE attorney conventions we know so well, that obviated our training modules at their face. Who would. The reasons set forth are conservative and prudent.

When we have revenue firms, such as a Chris Salter and Piano Wizard, a convertible debenture model which might tie to revenue sharing for an item of time like a preference to sweeten effective bond interest rate yields, becomes interesting in several ways. First Chris enjoys an anti-dilution potential and conversion may be to a nonvoting class of stock with preferences. Second, the pay back initiates at a low bond rate in today’s market but carriers a premium in the revenue sharing design model to “sweeten the bond” and advent conversion later. Even so, we would seek to have a share value threshold in time that automated the conversion without owner election at the bond level should the share value be breached. Now this SOPHISTICATION ZONE modeling is provided to a firm that has secured 13 million in funding, has stood a test of time, and who has revenues. The capital provided from the hybrid security, say 50 million dollars, overcomes further cost of hyper growth, and provides the inventory, and turn over in that inventory to justify the reasonable debt. Money management on the float can be applied to further advance equity shareholder value and reduce the debt burden. Again the tools of the SOPHISTICATION ZONE have no value to an earlier stage Piano Wizard who first appeared inside our world, and immediately suffered from a debt hybrid offering, in retrospect Chris would not have repeated to employ…had this third grade music teacher only knew. He followed advice from his attorney. The consequences set Chris back three years. We watch this pain all the time.

Thus the question really becomes can sophistication zone applications ( so family to law firms working with second tier more mature venture firms ) now translate to start ups and early stage venture capitalization modeling. The answer at CEO SPACE for the policy lesson plan and reasons set forth here remains a resounding NO. There is no reason to position a debt saddle of any nature on a non revenue horse developing its pony walk onto the venture track. It is premature to teach the debt conversion behaviors required to a venture that has many stages of development to pass through until the venture becomes a revenue firm sustainable to facilitate debt. We believe it is unsuitable and imprudent to place a debt saddle on early stage ventures and we believe full disclosure is impossible.

One point in a final discussion. My last brokerage firm was sold in 1988. I made 90 minute speech to an investor group ( nothing was sold no offers were made ) which featured a convertible bond. The Bond, was in the final stages of being closed and interest payments were current. My stock in the brokerage firm was held by two outside law firms. The board was independent. I had resigned months earlier as an officer and director. The Chairman was a security attorney. Weeks later licensed security agents, primarily the brokerage firms CEO and President sold 87,000 dollars of bonds to some people who attended the speech. It was later concluded I had criminal liability for failing to disclose items – not that I knew- but ‘items I should have known” about the bond risk. There was no security law violation and the contention was the offering as perfectly legal and fully disclosed. Not one of the five compliance firms we paid five million to that year were involved in the case nor did they testify at the trail. The full weight of the criminalization of the liability fell upon my attachment even in the remote construction of legal theory, to having made oral disclosures that failed in hindsight to define the risk sufficiently to meet the later jury trial standard. I disclosed in the speech that the bond was a high risk investment, was not a mutual fund or bank investment and that the bond was a flier that one took speculative and one could lose all their money in the bond acquisition. More than once. This was no sufficient. I was no charged with fraud. I was not charged with a violation of security laws. I was not charged with taking any funds or miss using any funds. I was charged with CRIMINAL CONTEMPT OF COURT over the debt convertible bond offering. Perhaps I’m overly sensitive to protecting my forward clients, absolutely, by we will have to adjust inside CEO SPACE with our Clients by our rule set, to NEVER apply these constructions to early stage ventures. In the end, if I error far too conservatively, I will know in 21 years no client of “mine” has stood in the place I was forced to stand for the reasons I set forth here. My experience has been used to teach and instruct attorneys for two years of ongoing educational credits. In my opinion any attorney who see’s the regulatory trend line, and who appreciates my case and my over compliance passion leading up to it, still to stand in that defendant position, MUST conclude they can find some diamonds inside the fruit I’m taking time to define here.

WHEN do we add sophistication zone options to the relatively new Entrepreneur Age river flowing at law firms from the really early stage versus the more mature venture space clientele? The answer is defined here in, when we see two back to back quarters of revenue sufficient to support such revenues. Not before. Never before. And then with some expert input on future cost of growth and what “if” the payments can’t be made without grave risk to all capital infusers such that law firms use experts before ventures move from pure capital into the sophistication zone. All non revenue firms need to be anchor funded upon PURE CAPITAL. Venture pure capital investors, are long term venture friendly growth investors. This sentence defines who is suitable for anchor PURE CAPITAL early round funding into ventures ramping up. At CEO SPACE we seek to extend compliance with the law, into a culture of OVER COMPLIANCE. Over compliance seeks to take such steps so as to include:

• Lower cost faster delivery of compliance docs for pure capital
• Designing PURE CAPTIAL first second and often third rounds of capital before moving into the SOPHISTICATION ZONE
• Filing Reg D forms in all states in which an investor resides avoiding post filing and filing at the first offer and again at close.
• Designing docs more along public rounds of funding including audits. What does it take to put 1000.00 dollars in the bank and have an audit for a start up? Over compliance is not costly under compliance carry’s cost too horrific to consider. You can pay them ( I as I did ) when you believe from your attorney’s you are actually “in” over compliance. I have learned to step in front of my attorney on such liabilities and I have requested my clients do the same as such over caution and SUPER PRUDENCE cannot harm them, when the reverse can be hell on earth ( good fee business for attorney’s however ). Not that I’m jaded you understand.

Therefore, within CEO SPACE, which is a private protected world, I have asked all our legal practioners to preclude placing debt offerings upon early stage ventures who are CEO SPACE customers. When I see they disregard this agreement between us I rotate them out – permanently. Our goal is to keep our ventures from harm’s way in the future. The most significant problem in the venture space, is undercapitalized designs for firms who miss=appreciate their own growth cost. The rule remains ( although expressed here as an absolute we realize there are some minor percentage exceptions ) to wit: profits from sales will never overcome the cost of growth which include delivery expansion cost in hyper growth, branding, marketing and related administrative costs, during a first three year of ramp up. If often takes five to seven years and it by percentage is common to take three to five years. If profits do not overcome the cost of growth how would they overcome the edition of a debt saddle during these critical phase periods of ramp up ? If capital is insufficient to overcome such cost how are any investors safe?

Final point, as you begin to examine recent trends in Silicon valley, you must be guarded. Venture firms funded around 6700 ventures last year. 1.4 Million start ups were funded without them. Their average buy in was 50 million to balance sheet round firms that already had their seed capital. Venture firms don’t do seed rounds. In the penchant for debt offerings venture firms are now funding ventures with structures that rip control of the venture to the professional firms, using “value added discussions”, either initially or in stages which the unsophisticated venture owner may never see coming. One way this commonly occurs is to position the debt saddle for all the reasons set forth here, such that full control materializes in the default such that only savior is the venture firm adding more capital into the mix at the point of DISTRESS they engineered exactly into the matrix for this purpose of engineering. Again CEO SPACE seeks to protect the owners control throughout the enterprise cycle as an “ideal goal” and to add in management that is professionals on TERMS that venture firms would find, sufficiently empowering to the entrepreneur so as to preclude. So while predator capital formulations ( SHARK TANK ) has won in Silicon Valley it has not won in the law firms of the nation or the service family of firms protective to the entrepreneur space, of which CEO SPACE remains the world leader in 2011.

If the structure does not appreciate the industry, by expertise, ( and what law firm has industry start up expertise in such costing specialized to the industry at a moment in time to fabricate with precise accuracy forward costing against real cost of growth expenses that if not overcome will end the business for all investors ) the venture WILL likely fail. The reasons venture commonly fail in this order of importance is:

• Weak plans
• Failure to accurately project cost of growth
• Weak Teams
• Lack of resources to execute improvements in the forgoing

Law firms are ill equipped to advise and develop venture firms toward structure within the criteria they see walking in their doors. They are not financial diagnosticians. Although they are not trained to be so, that is precisely the expertise the industry of the Entrepreneur requires today to propel the future we all seek to see unfold. My hope is that you will embrace these principles, as ethical, moral, legal, protective, and of the highest good and service to the individual entrepreneur, not only in your own practice but in your advocacy of advancing the discussion with other attorney’s of your level of experience. To the extent I have been any way presumptions versus educational I apologize at the start.

Sincerely,

Berny Dohrmann
Chairman

PS: We want to convey this information as pure information, for discussion. CEO Faculty Policy teaches to the membership to preclude debt, in early stage offerings for the reasons we have set forth in our continuing education series in these communications. We appreciate the defense of such policies by our team in our market as ENTREPRENEUR PROTECTIVE and in our opinion highly protective to the early stage investor as an intellectual property.

BJ Dohrmann
Chairman CEO SPACE Inc.
3030 Starkey Blvd Suite 270
New Port Richie Florida 34655
Deborah Gilbert asst/attorney/256 850 4710
www.ceospace.net
bj@ceospace.net
bj4ceos (skype yahoo )
ceospace twitter

From: Michael Horten [mailto:mhorten@hortencc.com]
Sent: Saturday, September 04, 2010 4:02 PM
To: ‘Berny Dohrmann’; jwarner@hhk.com
Subject: RE: clarification re: raising capital

Berny,
Inasmuch as I have been copied on this dialogue, I thought I would throw in my views on the use of debt financings in early-stage capital raises.
I take it that your position is that “Debt saddles in any form on early stage ventures are almost uniformly un-desirable for early stage non-revenue or early revenue ventures.” While I agree that traditional debt is not desirable, I do see a place for convertible notes. They are frequently used in these types of financings and I use them regularly. Indeed, the Angel Capital Association had a session on convertible notes at its past annual meeting.
Although I presume you are familiar with these types of notes, let me just briefly describe them to make sure you know to what I have in mind. Typically these notes are required to convert, usually at a discount, into the next equity round (to compensate the debt investors for their risk) and sometimes carry warrants (same rational) or a cap on the equity price that the debt converts into. In other words, it is not envisioned the investors will ever be paid back as note holders – I call it disguised equity. I use convertible debt when I know that the company will need a larger follow-up round of equity capital. Convertible debt has two advantages over a Series A preferred stock financing, which is the only real other alternative in today’s capital market: First, they get around the issue of company valuation, which is one of the toughest hurdles to overcome in an early stage financing when the company has no operating history and the projections are highly speculative because the product is new to the marketplace. Convertible debt postpones the valuation issue to a later date when the company has gained some traction and probably will be dealing with an institutional or sophisticated investor. Second, convertible notes are lot cheaper to do than is a Series A preferred round.
By the way, there is currently a big debate in the early-stage venture community about the use of convertible notes. The debate was triggered when Paul Graham, founder of Y Combinator (a highly influential early-stage Silicon Valley venture capital firm), sent out a tweet in early August saying: “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.” This has generated considerable discussion about their use and their terms. While most other angel and venture groups use them, they don’t use them to the same extent as does Y Combinator.
One reason I wanted to participate in your dialogue with Jackie is that a number of CEO Space instructors and participants came up to me after my July presentation to tell me that I should not have mentioned convertible notes because “Berny does not believe in them and does not want us to mention them.” If this is the CEO Space policy, I was not aware and I apologize. My PowerPoint presentation, which I submitted in advance of the Forum and I presumed had been cleared, had a whole section on convertible debt. I believe it is important that the Forum instructors not convey conflicting messages and I will abstain from discussing convertible notes in the future if this is indeed the Forum policy.
If we are not to discuss this form of financing, I think it is the wrong policy. Convertible debt is a widely used early-stage financing vehicle and I think we are doing the members a disservice if we do not bring it to their attention. If we don’t, they will be totally unprepared when they encounter investors, such as Y Combinatory, who insist on this kind of financing. It would be analogous to teaching home owners about mortgages and not discussing ARMs.
I know you value your instructors’ input and I hope you don’t mind me stating my opinion on this issue. I am doing it because I care about CEO Space and I want the Forums to convey the best and most current information to the members. Yet I realize that you are the ultimate arbiter on what is being taught at the Forums.
Michael

Michael R. Horten
75 Fifth Street, NW, Suite 311
Atlanta, GA 30308
?: 770-436-7834
?: 770-234-5770
?: mhorten@hortencc.com
?: www.hortencc.com

From: Berny Dohrmann [mailto:bj4ibi@spamarrest.com]
Sent: Wednesday, September 01, 2010 11:21 PM
To: jwarner@hhk.com
Subject: RE: clarification re: raising capital

Dear JW:

1. Well you and I have talked at length about non revenue early stage venture firms having “debt” in the construction of their early rounds of capitalization funding – which I will review below. We view such construction as less than ideal.
2. If the firm grows properly taking early profits needed to re-invest for growth cost ( which is enormous for sixty months of any ramp up ) removes shareholder value but having early shareholders have a preference in what is really a preferred stock offering.
3. If the payment is debt like a deferred debenture or a profit claim such as a revenue participation factor of the equity offering detail –we fall back to our CEO SPACE position to wit: “debt is ideal for firms with two back to back revenue quarters defining carrying capacity for any defined debt or revenue sharing repayment. No other “agreement” to create investor EXPECTATIONS on projected hypothetical future income, is ideal to early stage venture investing. Investors lock into this income factor and then get “upset” if the income is delayed or unpaid even when the firm is actually “winning” for them as a pure GROWTH play. The multiples in their growth are ripped out – for income that has tax and unwanted burdens to the now stabilizing and early profit making firm. Cash is too precious for such firms to capitalize upon “entitlements”. This aspect is a later stage of a venture security work in my opinion, limited to more mature ventures.
4. Investors investing in LONGER TERM VENTURE shareholder growth should find it suitable that “income in short term returns” is another form of investing and not ideal venture patronage. Suitability comes into play.
5. Most of the problems I have seen in forward development firms are derived from structures ( legal of course ) created by law firms that fail to understand ( from their training ) the real cost of growth – the timing needs of profits to re-invest in forward growth – versus repayment of early founder investors who should rely on share value GROWTH. Ventures at this stage are ideally pure growth plays. Which is enough. And far safer when early profits are not forward obligations to pay out – as such firms would not pay out dividends for 72 months – with few exceptions. Very few.

We’ll talk but these have always been our lesson plan – our core mantra – our differentiation – our safe spot – directionally for keeping first and second FOUNDATIONAL rounds “protected” for venture safe haven against the deceptive and always hidden growth costs, which are frankly fantastic for early stage ventures. We also teach ( with so few exceptions ) that the overwhelming rule is the early profits from sales will never over come the cost of growth in the first three years. This rule is so often prophetic. Protecting that CORE DEVELOPMENT time phase for first and second round CAPITALIZATOINS to overcome operational, and hidden cost for branding and marketing, typically under budgeted by an order of magnitude against real time cost, requires prudent directorship and legal advice. Another rule, early stage ventures fail to appreciate their forward branding, carrying cost, operational ramp up real time cost, sap cost and marketing costs which climb with sales exponentially. Attorney’s typically lack training in these details and rely on the weak information from the client. Helping the client to remain SUPER CAUTIONS against these factors represents superior law in my opinion to entrepreneurs.

I have found many attorney’s in this field lack perspective investment bankers typically breathe as to the value area for venture IP in these early rounds, against these difficult industry specific criteria. Their compliance designs are often well constructed from the exemption perspective while relying on the founder budgeting and projections ( which why shouldn’t law firms rely on such details as client provided ) and it is in these details the law so fails as they move from serving more mature firms to the NEW SPECIALITY of Entrepreneur early venture space. The founder so frequently fails to appreciate real growth cost, real branding and marketing allocation requirements, and assumes the profit on sales will self amortize growth – I just don’t see it happen in my two decades of helping so many thousands to win. How would we hurt the owner by error on the more conservative side of this equation.

I submit law firms that embrace these principles, and any circulation to your partners is welcomed for debate on this item, would not soar to a market differentiation as the ENTREPRENEURS LAW FIRM driven upon a foundation of these principles. Debt saddles in any form on early stage ventures are almost uniformly un-desirable for early stage non revenue or early revenue ventures. More mature ventures with the debt capacity of course move to debentures and conversion and typically they are not dividend paying or “revenue sharing” constructions. Revenue sharing obligations to early stage ventures remove multiples of profit to share value at the critical time GROWTH investing most requires the leverage of shareholder growth. Removing growth multiples ( say x times earnings ) to remove those earnings to shareholder early repayment is a key aspect of constructions that place ceilings on momentum just when the firm is stabilizing.

As you know I teach ongoing education credits on this topic. I would welcome giving a free workshop on this topic if desired should your firm and others affiliated wish to have another perspective which I believe adds great value to any firm specializing in the AGE OF THE ENTREPRENEUR to higher level their service to this new and exciting Entrepreneur industry.

I’m hopeful we can talk soon to further this conversation.

With Great Respect,

Berny Dohrmann
Chairman

PS: A growing number of firms “wish” their clients had graduated from a crash program such as CEO SPACE in these criteria to better resolve the mutual issues so specialized in pure early venture capitalization at early successive funding rounds. I’m so proud of your firm and their work on the entrepreneurs behalf.

BJ Dohrmann
Chairman CEO SPACE Inc.
3030 Starkey Blvd Suite 270
New Port Richie Florida 34655
Deborah Gilbert asst/attorney/256 850 4710
www.ceospace.net
bj@ceospace.net
bj4ceos (skype yahoo )
ceospace twitter

From: Warner, Jackie [mailto:jwarner@hhk.com]
Sent: Wednesday, September 01, 2010 6:41 PM
To: bj@ceospace.biz; bj@ibi.org
Subject: clarification re: raising capital

Hi there Boss,

I need you to clarify something for me either via email or we can chat for a few via phone. Someone advised me that you have lectured at length and even reprimanded persons for structuring equity deals that provide for expected ‘interest’ payments to investors, for say 2 years prior to principal payback, For example, a start up company (or one with limited operating history) discloses that is expects, though no assurance can be given, to repay principal in 5 years and also expects to begin paying ‘interest’ of 5% or 10% 3 years following completion of the offering.

Your thoughts on this hypothetical please.

Thanks,

Jacqueline J. Warner, Esq.
Hinman, Howard & Kattell, LLP
106 Corporate Park Drive, Suite 317
White Plains, New York 10604
(914) 694-4102
(914) 694-4510 (fax)

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