The Rise of Food Tech Start-Ups and the Legal Issues They Face

By: Catherine O'Neill

November 2016

A new trend in the food industry has the potential to transform the trillion dollar U.S. food economy with its novel approach to dinner preparation. This fad is the meal-kit start up industry, a space with over 150 brands competing in a $1.5 billion market of consumers eager to make healthy meals with pre-prepared, farm-fresh ingredients. Many brands in the industry, such as Blue Apron and HelloFresh, operate by allowing consumers to choose several meals per week from pre-set menus. Those meals are then shipped to the consumer in kits which have all the ingredients necessary to make the recipes.

Companies in this industry are attractive to investors because they have little overhead, aside from the costs of operating food distribution centers, and only bear shipping costs to the consumer. In fact, meal-kit start-ups have raised a reported $650 million in venture-backed capital in recent years while earning revenues of $500 million in 2015 alone. The industry’s revenues are expected to increase tenfold in the next five years. The tremendous amount of growth in this sector is impressive, but it has not come without growing pains. Few meal-kit start-ups are cash-flow positive, which reflects the reality that only those in the industry who are able to produce meals on a massive scale are able to survive the competition. The start-ups also offer deep discounts to entice consumers to try the products, while spending nearly $100 in marketing expenditures per consumer in hopes of educating consumers about the meal-kits.

One company in particular, Blue Apron, has emerged from the competition and is so successful that it is considering an initial public offering for next year. The company is purportedly projecting $1 billion in revenue over the coming twelve months, and would be valued at $3 billion if it were to go public. These estimates follow Blue Apron’s most recent valuation of $2 billion after receiving $135 million in investments in 2015. The industry leader has over 4,000 employees at three fulfillment centers and is growing rapidly. But Blue Apron, like others in the industry with venture-backed financing, has run into legal trouble keeping up with the pace of demand and the pressure to scale rapidly. The company in particular has had health and safety violations, violent incidents at its fulfillment centers, and poor working conditions reported by employees. On top of that, Blue Apron’s co-founder is a chef and has had no experience running warehouses before, adding to the chaos.

The governmental agency that oversees working conditions for meal-kit start-up employees is the Occupational Safety and Health Administration (OSHA). The Administration aims to ensure healthful workplaces by setting and enforcing standards for employers, while also providing training and education for employers. To that end, OSHA has created guidelines that food manufacturing facilities should implement for their workers which center around the prevention of work-related musculoskeletal disorders. The disorders often come from employees working in repeated and sustained postures while performing highly repetitive tasks, which is common in the meal-kit industry because of the chopping of food that occurs in fulfillment centers. Buzzfeed recently investigated the fulfillment centers of Blue Apron and found that the company in the past year alone had nine violations with California’s Division of Occupational Safety and Health for unsafe conditions that put workers at risk for both fractured bones and chemical burns. On top of that, earlier last year, Blue Apron was given another $13,050 penalty for an employee forklift accident.

In addition to OSHA regulations, the meal-kit industry also has to abide by USDA guidelines and Department of Labor employee working hour regulations. The USDA imposes a rule that proper storage temperatures for food commodities must be set at forty degrees Fahrenheit, so meal-kit fulfillment centers and workspaces must all be kept at that temperature. At Blue Apron, employees wear jackets, hats, thermals, and neck warmers at all times because of the cold temperatures. With regards to working hours, Blue Apron relies on employees to work over twelve hour days, hiring temporary workers when business is in high demand. Meal-kit companies like Blue Apron are clearly trying to piece together all of the regulations surrounding food items and employee safety conditions, but since the industry is so new and product is in such high demand, it seems as though they are cutting corners to deliver for consumers.

Now is the time for meal-kit companies to succeed in the marketplace, if they are able to abide by all federal regulations governing worker safety and food products. The idea is exciting to consumers,  especially millennials, who want healthy, farm-sourced recipes right at their doorstep. However, the companies must act fast to meet demand because other industry giants, including the grocery industry, will soon be moving into the meal-kit space. Whole Foods Market and Amazon are both planning on launching meal-kit lines later this year, while Giant Food Stores already rolled out its own service last December.

Although more and more companies are moving into the meal-kit space, it is still unclear of whether the industry is actually profitable. Recent studies have shown that only ten percent of those who subscribe to meal-kit companies are still with the companies after six months. The risks of the business, although low compared to other industries, include packaging, shipping, delivery of fresh food, ingredient costs, and a weighing of high and low costs to attract consumers away from supermarkets. These risks are on top of the hardships of educating consumers about the product, marketing so that consumers will buy from one company and stay with that company, and market differentiation when there is so much competition in the industry.

The meal-kit niche of the American food economy is a rapidly expanding area filled with regulations and business risks. It remains to be seen what the future of the industry is, given that increasing competition is entering the marketplace and that no company is confirmed to be profitable at this point. But, the industry is revolutionizing how consumers buy food and will have an impact on consumers in the coming years if it continues growing at the pace it currently is growing at now.

Protecting your Brand

By: Entrepreneurship & Innovation Clinic Student

November 2016

One of the best ways to protect your brand is to get a trademark. A trademark is a form of intellectual property that can help protect a business's brand. A trademark itself is a mark of some kind, generally a word or design, that denotes the source of a good and is used in commerce. If these conditions are all met, the mark can be registered as a trademark. An example of a trademark would be the brand CocaCola. This is a word mark that denotes a specific product (a cola drink) that comes from a specific producer.

Most states have some sort of trademark protection. However, the best way to completely protect your mark is to register the trademark with the federal government at the US Patent and Trademark Office (USPTO). A registration here will give your mark trademark protection throughout the entirety of the United States, while most state protection is only within the state or local area. Therefore, although generally states give common law protection at a lower rate, possibly without any cost, the cost of registering a trademark with the USPTO could be outweighed by the national benefits received, particularly if a business plans on having a presence in multiple states.

Most start-ups and small businesses should consider getting trademark protection as it prevents other people from using your mark. Determining what you want your trademark to be may be one of the first things a start up wants to consider, even before deciding on and creating an entity. This is because a company (or other entity) can trademark its name, its products, services, and anything else that is used in commerce. A great first step is to look up the name you want to use and to see if it has been trademarked already. The USPTO allows individuals to search through already taken trademarks. If your mark is not there, then you are free to register and use it. Although a trademark needs to be used in commerce before it can actually be protected, the USPTO also lets individuals pre-register their mark with an intent to use registration. This gives you some time to create your entity, start developing and producing products, etc. while still having the mark protected.

Unfortunately, early trademark protection may not be financially feasible for some start ups. Therefore, it is advisable that start ups continuously check the USPTO to see if their trademark has been registered by someone else. Although there is no way to predict whether or not it will be taken soon, it is useful to know whether or not it has been taken for future planning. This will allow you to adjust how you brand other things, such as products or services down the road.

So what should you do if your trademark has already been taken? The first step is to determine whether or not what you plan on using the trademark for is what the trademark has already been registered for. When registering with the federal government, a trademark must be assigned a class of use, generally a type of product or service. For example, imagine a company named King sold headphones. If someone who sold fruit wanted to name their business King and trademark it, they would be able to. Trademarks can only protect the type of goods they are registered for. If, however, King that sold headphones decided to also start selling fruit before the other King sold fruit, and added an additional registration, they would be able to use the mark and the second company couldn't. Therefore, if your mark has been taken but it is in an unrelated class of goods or services, then you are free to register the mark and use it for yourself.

Sometimes though, you will run into a circumstance where you've already got your business formed, a product idea ready to go, and branding all set before you realize that the name and trademark you actually want has been taken. There are several ways to remedy this situation. The first thing to think about is your business name. If the name has already been trademarked by someone else, you may wish to change your name in order to protect yourself from infringement liability. This is not a particularly difficult process. Although it varies state by state, most, if not all states, have methods of changing an entity's name. This may not be ideal, but it does help to protect against infringement and allows you to develop a new way to protect your brand.

Ultimately, if you do end up losing out on the trademark race, the best solution is to change your own branding, unless you've already started to sell your product and have a growing user base. In that case you still might be able to get some protection. Most states have some sort of common law trademark protection, at least for the area that you've been selling in. These protections occasionally carve out limitations on federal protections if you can show that you've been in the area longer and have generated enough goodwill and brand recognition. Thus, even if someone trademarks your mark, as long as you've been using it before and stuck to a geographical area you should still be able to use the mark.

For those who are less averse to risk, if the trademark has already been registered and you have not yet used it in commerce, you may wish to simply go ahead and use the mark in your geographical area. You may still be able to get protection if the registered trademark owner has not yet breached the market in your area. Of course, this method has significantly more risk associated with it, and you may not win on an infringement case here. 

Serving Soup on a Plate - When good ideas suffer from the wrong business model

By: Alexa Esposito

November 2016

Introduction 

ABC Network’s hit reality show “Shark Tank” gives budding entrepreneurs the opportunity to pitch their business ideas to a panel of business tycoons and investors dubbed “Sharks”. On the Season 8 premiere, the Sharks were fed with a product that they believed tasted good, but not good enough for a second taste.

Founded in 2008 by CEO Marti Wymer, Spoonful of Comfort is a gift basket service website providing customers with a way to send “sick or struggling” loved ones “homemade soup gift baskets.” Wymer was inspired to start the company in 2007 when her now deceased mother was diagnosed with lung cancer. At the time of her mother’s diagnosis, Wymer was living in Florida but her mother was living thousands of miles away in Canada. Wanting to comfort her mother in a way that transcended their geographical distance, Wymer scoured the Internet for an appropriate gift to send her mother. Faced with an array of chocolate and flower options, Wymer could not find anything that seemed appropriate for her particular situation. Wymer wished that she could send her mother what she, and, and so many others take to be the ultimate panacea and source of comfort for any illness: a warm bowl of chicken soup. It was at this moment, when she realized that the gift basket delivery service market was failing to provide appropriate options for occasions like this one, that Wymer says that Spoonful of Comfort was born.

Spoonful of Comfort, operating under a business model similar to that of an online flower ordering service, now provides other individuals in situations similar to Wymer’s with the option of sending 4-6 servings of chicken, or tomato soup along with rolls, cookies, a card and a ladle, wrapped and shipped in customized packaging to their sick loved ones. In a gift delivery service market full of flowers, candy, and assorted fruit whose exemplary customers are traditionally a husband sending his wife a surprise on their anniversary, or a customer wanting to send a token of gratitude to a business for their services, Spoonful of Comfort seems to fill a clear gap in the market. A gift basket full of soup and baked goods provides an option for mothers with a sick child away at college, or individuals like Wymer, with a sick relative miles away to send their loved ones the gift of solace that comes with a home-cooked meal. Although the Sharks acknowledged Wymer’s great idea, they didn’t bite when Wymer and the company’s investor and 60% owner Scott Gustafson served their soup to the tank, demonstrating that simply filling a gap in the market is not enough for a business’ success.   

The Flawed Business Model – The Business is Hungrier than the Customer

Each Shark provided different explanations for their decision not to invest in Spoonful of Comfort, but the driving force behind the majority of the Sharks’ decisions was the same: Spoonful of Comfort’s business model was flawed. The business model of an organization refers to the way a business creates, delivers, and captures value. Business models may be flawed or fail for a variety of reasons, the most common being an entrepreneur’s underestimation of how difficult and expensive it will be to acquire customers. Difficulties in acquiring customers may occur due to the cost of acquisition, the cost of the product itself, and limited need for the product.  Acquiring customers can become expensive for businesses when the “Cost of Acquiring Customers” (CAC) exceeds the “Lifetime Value” (LTV) of the customer, when the costs of operating under the company’s business model exceeds the revenue actually generated from customers buying the company’s product or service. In his article “5 Reasons Why Start-Ups Fail,” entrepreneur David Shok states business can calculate their CAC by taking the entire cost of sales and marketing functions, such as salaries, marketing programs, lead generation, and travel, and dividing this cost by the number of customers attained during the period of time those costs were accrued. Shok goes on to state that in order to calculate the LTV of a customer, entrepreneurs should consider the gross margin associated with the customer, which is the net of all installation, support, and operational expenses, over the customer’s lifetime. In order for a business model to succeed, their CAC must not exceed the LTV of the customer.

Although the Cost of Acquiring Customers seems like an obvious factor for entrepreneurs to consider when launching a business, many entrepreneurs overlook this cost, an oversight that often leads to the business’ failure. The Sharks determined that Spoonful of Comfort had fallen victim to this common oversight and flawed business model. Wymer and Gustafson noted in their pitch to the Sharks that it costs the business $18 to acquire customers, and $31 to make the packages, which then sell for $69.99 with a shipping cost of $14.99. Shark Kevin O’Leary noted that under their current business model, the company is losing approximately 40% of their company’s profit margin because of their Customer Acquisition Cost, and if this continues, will make the business’ road to acquiring customers a slow and difficult process. Furthermore, O’Leary, Shark Barbra Corcoran, and Shark Daymon John pointed to two factors that aggravate Spoonful of Comfort’s difficulties in customer acquisition: the business does not lend itself well to repeat customers because the service is only needed at time when someone is sick, and the hefty price tag for these packages may act as a sales deterrent. The Sharks also noted that the gift service will only be valuable insofar as it reaches the sick individual when they are sick, and overnighting a package adds an additional $14.99 to the already high price of $69.99 for the basket itself. Simply put, Spoonful of Comfort is spending more on securing customers than it is actually generating revenue through sales, and for these reasons, the Sharks smelled blood in the future of the company.

Food For Thought

Spoonful of Comfort is an example of how wary entrepreneurs should be about starting a business solely on the basis of a good idea, or an apparent gap in the market for a particular type of service or good. Entrepreneurs also must consider the CAC and the likelihood of attaining a returning customer base. The combination of an expensive price tag and the limited need for a good or service may act as deterrents to attaining a returning customer base or in the worst-case scenario, customers at all. This in turn may cause a business to fail if the cost of customer acquisition is higher than the revenue being generated by the company.

The prudent entrepreneur should consider the CAC, and consider a change in business model if it becomes apparent that the CAC exceeds the LTV. To assess the viability of their business model, entrepreneurs should take the time to calculate their CAC and LTV in order to make sure the CAC is lower than the LTV. Furthermore, entrepreneurs should also consider whether their product is likely to fill an ongoing need, or a short-term need, and given the need, whether the price tag attached to the product or service will deter customers. Keeping these factors in mind when deciding to launch a business can help entrepreneurs satisfy customers’ hunger for longer. 

Naming Your Beers: Legal Risks

Starting a Brewery?

Remember You Aren’t “Crafting” in a Bubble.

By: Entrepreneurship & Innovation Clinic Student

November 2016         

I will start by saying-- lawyers are not evil beings trying to stifle your creativity! I think intellectual property lawyers get a bad rap sometimes for shutting down your “brilliant” ideas. Lawyers do not dispute the brilliance of your idea; they are merely telling you that your idea is so brilliant that others may have already thought of them. Lawyers simply want to protect you from the potential legal consequences of infringing on someone else’s mark. They are not looking to shut down every idea you have.

Now that we have gotten that out of the way, let me tell you why you can’t use that brilliant name for your beer.

The craft beer industry has recently come upon a dilemma—they are running out of beer names! According to the Brewers’ Association’s mid-year report, the craft beer industry continues to grow—in the past year, the total number of breweries (4,656) has grown by 917 breweries and there are approximately 2,200 breweries that are in the planning stages. With each of these breweries creating multiple varietals, there are a crazy number of catch pun names that have flooded the market. According to The Wall Street Journal, there are at least 25,000 active trademarks registered or in the application stages with the U.S. Patent and Trademark Office in connection with the beer industry. As such, new brewers looking to enter the market should be wary when it comes to “crafting” beer names. 

How You Can Protect Yourself Against Litigation

1. Search the web.  Seems simple, yet many business owners forget this step.  Make sure someone within the beverage industry isn’t already using your name.  Trademark protection is based on use.  The first person to use a mark in commerce, owns the mark for the particular class they are using the mark within.

You should not limit your search to your exact name- look for variations.  Trademark infringement is based on likelihood of confusion. The important question to ask is—would a consumer believe this company who is using a name similar to mine produces my product? Trademarks do not have to be identical in order to be found confusingly similar.

If your search results in multiple uses of the name, then it is likely that this name is within the public domain and free for you to use.  Just remember, if the name is in the public domain then you will not be able to trademark it, which means other breweries will also be able to use that name. This is probably not smart if you are trying to build branding around the name. Proceed with caution.  

2. Run a trademark search within the federal and state registries.  If a mark is registered with the USPTO or Secretary of the State, you are on notice regarding its existence. This is important. Should a company decide to bring a suit against you for trademark infringement, the court will presume you knew of the prior trademark when you crafted your own name.

It is also important to check the registries because companies may have registered an intent to use application. This means the mark is reserved and the company intends to use it in the immediate future. The only way of discovering these marks, in some cases, is through a trademark search with the USPTO and Secretary of the State (should the state allow Intent to Use filings).        

You can search the trademark registry at USPTO.gov.  Remember to search both for your mark and any variations on your mark.  You are able to limit your search to a particular class of goods.  If a mark is being used in a similar industry, it is more likely that a consumer would be confused as to the origin of your product.  You should play particular attention to other beverage or food companies using your name or a variation of it.      

3. Parodies of Famous Marks.  You may be tempted to create puns off famous trademarks in the world, such as Captain Crunch or Twinkie. A brewery should think twice before using a famous trademark in the name of their beer. There are certain fair use exceptions. One exception is the parodying of famous trademarks. But, this is a tricky exception to navigate. Famous trademarks are entitled to protection against dilution by blurring and dilution by tarnishment. When a company uses a famous trademark as a part of their trademark, they are not protected by the paradoxical fair use defense because of the dilution that occurs.

4. Use of Famous Names.  Avoid using the names of celebrities in your beer names. Celebrities have a right to publicity that would prevent the use of their name in a way that suggests their endorsement of the product.

5. If you have any questions, consult a lawyer.  Intellectual property lawyers are experienced in running trademark clearance searches and are in the best position to inform you of the risks associated with using a particular name.  Here at the Entrepreneurship and Innovation Clinic, we are happy to guide you through the process and work with you to weigh the risks of using a particular name.   

How You Can Protect The Name You Choose

1. File with the USPTO or Secretary of State.  Please remember that once you decide on a name, it is in your interest to file for a trademark with the USPTO (if you are engaged in interstate commerce) or with the Secretary of State (if your activity is limited to in-state commerce). This will put the rest of the industry on notice that your name exists. 

2. Enforce Your Mark.  Check every so often (i.e. run web searches, read industry magazines) and make sure your name is not being infringed upon. Should you find someone who is using your trademark or another mark in a confusingly similar manner, you should send a cease and desist letter and take any additional steps to enforce your mark. If you do not take these steps, a court may find that you have abandoned your mark through your failure to police.  

NOTE: This blog post is a general overview of the law and is not intended to represent or replace legal advice. Readers should consult a lawyer within their jurisdiction before taking any action or refraining from act based on a reading of this post.

“Let’s Just Call Them Independent Contractors”

By: Jack Thaler, J.D. Candidate, Boston College Law School Class of 2017

November 2016

Life is hard out there for a startup company. You have finally come up with a brilliant idea, you are excited to make it a reality, and you know it is going to be a massive success. There is only one problem. You have no money! A serious challenge facing most startups, or any new business for that matter. Lets’ face it, your service or product is new, no one knows anything about you or your brand, and you probably aren’t best friends with Mark Cuban and his Shark Tank friends who can get you started with a large investment. So, how do you run this new business? As any business owner would know, there is only so much that one person can do. Eventually, you will need help with a variety of tasks in order to grow the business. This can be a problem for an entrepreneur who is short on cash. Most business owners want and need help operating their business, but cannot or do not wish to spend their cash on hourly or salaried employees. There are three commonly used tactics that entrepreneurs will try to use in order to avoid having to treat those working for them as employees. Each of these tactics should be approached with caution.

1.)    Independent Contractors

One question that we frequently get from clients is whether or not they can classify the individuals that they hire as independent contractors. The answer depends in large part on the state in which the client is operating. In Massachusetts, however, the answer to this question will likely be, no. In 2004, Massachusetts amended its laws to make it more difficult for an employer to grant a hired worker independent contractor status. As a result, Massachusetts’s test for determining employment status is stricter than the federal requirements. The amendments create a rebuttable presumption that any person who performs services for another will be considered an employee. In order for an employer to overcome the presumption, the employer must show that the hired worker meets a three-prong test:

1.)       The individual must be free from control and direction in connection with the performance of the service, both under contract and in fact; and

2.)       The service is performed outside the usual course of the business of the employer; and

3.)       The hired individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service provided. 

For most businesses, this is a difficult test to meet and most of the individuals hired must be treated as employees. For a new business owner, this means complying with costly minimum wage and hour requirements, obligations to withhold income and payroll taxes, purchasing unemployment insurance, and providing other employee benefits. Obviously, this is a difficult realization for most entrepreneurs. Nonetheless, it is important to understand that non-compliance can have some serious consequences, including heavy fines and possible jail-time. It is also very important to understand that simply calling the hired individual an independent contractor in the employment contract will not be enough to meet the first prong of the test. This may be the most common mistake made by business owners who believe that by simply calling an individual an independent contractor it makes them one. The first prong of Massachusetts’s test states that not only must the independent contractor status be spelled out in a contract, but the relationship between the hired worker and the employer must be one of an independent contractor in fact. Meaning, that the employer must have very little control over the means in which the contracted services are performed.

2.)    Unpaid Internships

Another tactic frequently used by entrepreneurs is hiring unpaid interns. Unpaid internships are by no means a new method used by employers to take advantage of free labor. In fact, they are still frequently used here in Massachusetts. However, these kinds of internships are frequently illegal. In Massachusetts, the legislature created a much more restrictive set of guidelines for hiring unpaid interns. Under the Massachusetts minimum wage law, an unpaid internship is almost impossible to implement legally. The law specifically states that only legitimate training programs run by charitable, educational, or religious institutions can operate legally without running afoul of the state minimum wage requirements. This rule makes it impossible for profit driven companies to hire unpaid interns. Non-profit companies that still wish to hire unpaid interns should understand that they must still follow the six factors adopted by the Massachusetts Division of Occupational Safety.

3.)    Exchanging Equity for Work

Lastly, new entrepreneurs are consistently tempted to trade equity in their company for another’s services. For a new company, with relatively no value to speak of, this may not seem like such a bad idea. I mean what is the big deal, right? You need help and it is not like you are actually giving up anything other than some possible future value. Wrong. There are several concerns with such a transaction.

First, depending on the work being performed by the hired individual and the amount of equity exchanged, it is possible that the exchange is actually a violation of federal and Massachusetts minimum wage laws. The Fair Labor Standards Act provides that no employee may be paid in equity in lieu of the required minimum wage, unless they meet the executive-business owners exception. This means that the employee being paid in equity must:

1.)    Be employed in an executive capacity; and

2.)    Own at least 20% interest in the company; and

3.)    Be actively engaged in the management of the business.

Obviously, most business owners have no intention of giving up such a large interest in their company. Consequently, business owners engaging in this kind of transaction will often find themselves in violation of the minimum wage laws and open themselves up to liability.

Second, for entrepreneurs who do decide to trade 20% equity for simple services, it is highly unlikely that they intended to give up such a large stake in the company. Giving up equity in the company equates to giving up some control. Although 20% does not appear to be of any real consequence when the business has little value, if the business owner expects the business to be a success, exchanging 20% of the company could end up being millions of dollars in the future. Additionally, if the company seeks out a large capital investments in the future, that 20% can no longer be used as a bargaining chip for a much more valuable investment.

Understanding the implications of engaging in such a transaction is imperative to succeeding in growing a company without compromising its legal integrity or potential future value.

A “Winter of Investment Discontent”

By: Entrepreneurship & Innovation Clinic Student

November 2016

A cold air mass has been moving slowly across the United States, from the Silicon Valley all the way to Boston, Massachusetts. As it passes from state to state, the skies darken, a strong northwest wind picks up speed, and temperatures quickly drop, indicating an impending polar destruction. In its wake are thousands of little crops, barely matured from their seed stage, dead and covered in frost. Only the most cold-tolerant, the mostly matured plants, survive. Farmers who once had high aspirations for budding, plentiful crops that would feed their families for years to come, are left in despair with little direction for what to do next. This cold air mass is called “winter” and it is predicted to cause a national freeze that will last the next twelve to eighteen months.

“Winter,” more commonly known as the dreaded “down round” in the investment finance world, has left its killer frost on even the most innovative startup companies. A “down round” is a “financing in which a company sells shares of its capital stock at a price per share that is less than the price per share it sold shares for in an earlier financing.” Private startup companies (companies that have yet to go public on the market—most early-staged startup companies—also called “venture-backed companies”) in particular dread “down rounds” for several reasons:

(i)                 A round at $0.10 per share lower than a prior round carries much more baggage than a $0.10 up round carries goodwill;

(ii)               “Down rounds” are detrimental to employee morale because in order to continue to attract investment to retain capital and talent, evidence of rapid growth in a company is often required—a “down round” is evidence of the opposite;

(iii)             Following a “down round,” investors who hold preferred stock with anti-dilution protection (protection from dilution when shares of stock are sold at a price per share less than the price per share paid by prior investors) will sometimes look to renegotiate the price of the prior round to more closely reflect the valuation of the company, which has a negative impact on, and actually magnifies, the dilution to common stockholders from the financing, resulting in a smaller percentage of ownership for the common stockholders; and

(iv)             Investors in a startup company that has experienced a serious “down round” are often forced to “write down” the value of their other existing holdings in their financial statements, which can have a negative effect on the fund’s ability to continue fundraising for the startup company.

Ultimately, the goal of most startup companies is to go public in order to expand the growth of the company in their specific market; this goal cannot be attained if the company stops receiving, or receives significant less financing from venture capitalists. A “down round” makes going public incredibly difficult; the ability of a startup company to continue producing returns after a “down round” is significantly hindered.

In the second quarter of 2016, the market saw a spike in “down rounds” from the previous quarters. According to a report issued by Cooley LLP, seventeen percent of the financing rounds in that quarter were “down rounds.” This is compared to the mere three percent experienced in the second quarter of 2015. Of the 154 deals that Cooley analyzed from the second quarter, twenty-one percent were “down rounds,” which is triple the number when compared to previous quarters. Other law firms experienced similar trends in the second quarter, with most reporting that the number of “down rounds” from the first quarter of 2016 to the second, increased by at least four percent. Moreover, firms have reported that invested capital in the second quarter decreased by an overall fifty-seven percent from the prior quarter, indicating a major cooling in the venture capital market. Industries that experienced the worst “frost bite” included life sciences and software startup companies—companies that had experienced a boom in the market in previous years.

This harrowing trend in the venture capital market suggests that entrepreneurs are no longer commanding significant valuations like they had in prior quarters, and investors who backed these private startup companies are reevaluating their market expectations. Market analyzers have concluded a few reasons for the rise in the dreaded “down round.” One reason is that in previous quarters, investors were valuing startup companies at such high levels, that the companies could not match valuation upon their next round of financing. Over-valuation is a significant problem for many startup companies who must prove their worth to investors in order to continue receiving funding. Companies that fail to meet valuation are not as lucrative to investors, and as discussed above, can cause serious headache to the venture capitalists. Market analyzers have also pointed to the demise of the “unicorns” as a potential reason for the rise in “down rounds.” Unicorns are private companies with valuations of $1 billion or more. In the past, venture capitalists threw massive dollars at these companies, but as of late, the valuation of the unicorns has fallen significantly.

Venture capitalists are now predicting that “‘the true day of reckoning lies ahead’ for overvalued startup companies and ‘will hit home in the next several quarters’.” To be exact, this “winter of investment discontent” is predicted to last twelve to eighteen months, and to impact seed-staged startup companies the most. Whereas seed-staged startups are experiencing a freeze in investment, middle-staged “mature” startup companies are experiencing a steady stream of cash flow. In part, this is because these mature companies have already proven their worth, and are a safer bet for investors to receive anticipated returns.

Recommendations

So what can seed-staged startup companies do to receive venture capitalist funding? During an interview with Cooley LLP, Felicis Ventures’ founder and managing director Aydin Senkut, indicated that “the best way to counter [down rounds] is for companies to be a lot more hawkish on cash management.”   Felicis Ventures recommends to all of their companies not to set maturity dates below nine to twelve months, and to take sixth months as the absolute minimum time to be able to manage a funding round. Other investors, such as Seattle angel investor Jon Staenberg, recommend that seed-staged startups figure out ways to avoid raising money to get profitability. If companies don’t need venture financing, then they can avoid the dreaded “down round” that other startup companies have experienced. Investors also recommend that founders look at the industries that haven’t been as effected by the market freeze—namely, the food technology industry—and try to fit their products in that “hot” market.

Whereas larger startup markets, including the United States and China, have experienced, and are predicted to continue experiencing a “winter” of investment for months to come, other markets such as India have continued to flourish. “India is one of the highest growth businesses we have anywhere in the world. It has strong double-digit growth,” reported John Flannery of GE Healthcare. Because of India’s strong business growth, major investors in the United States are looking to India for future, more reliable investment options. Investors find Indian business’ focus on cost, quality and outcomes particularly attractive. In the past few years, investment in India has spiked, and analysts predict Indian markets to continue to grow despite other markets experiencing “global economic uncertainty.” So perhaps American seed-staged startup companies should pack their bags and take a twelve to eighteen-month vacation to warmer weather. I hear India is pretty nice this time of year.