For some time convertible notes have been, and remain to this day, the preferred vehicle for an early stage company raising initial capital. A known commodity in the marketplace, the barriers and expenses of closing note bridge rounds continue to be less than opting for the sale of an equity security. What early stage investors might not be aware of, however, is a trend gaining steam of late – as company valuations increase in earlier investment rounds, a growing number of sophisticated lead investors in “Qualified Financings” (ie the company’s equity financing that triggers conversion of the notes) are applying increasing pressure to condition their investment in the round on the company amending the terms of their outstanding convertible notes to carve back a portion of the economic windfall received by noteholders in the Qualified Financing.
Setting the stage: The terms of a vast majority of convertible promissory notes in the marketplace provide that a note investor’s principal (plus interest) under a convertible note will, at a Qualified Financing, convert into the security sold in the Qualified Financing (ie Series Seed or Series A preferred stock) at the lower of (i) a discount to the price in the Qualified Financing or (ii) a pre-negotiated capped valuation.
The economic problem: Particularly in early friends and family note rounds, the pre-negotiated capped valuations are often times significantly lower than the valuation in the Qualified Financing. If the terms of the note are honored as-is, note investors would get the benefit of receiving not only the actual dollars (plus interest) invested under the note in the form of the same shares issued in the Qualified Financing, but also the (in most cases, material) discount premium as a result of the discount or capped price. This became known as the “phantom liquidation preference problem” – referencing the layered liquidation preference received on the lot of shares which had been converted into as a direct result of the cap piece of the conversion.
The Lead investor’s fix: Condition the closing of the Qualified Financing on the company obtaining the requisite approval from their noteholders to amend the notes to either (i) convert the discount portion of shares received in the round into common stock, as opposed to preferred stock or (ii) convert into a shadow series of preferred with the same rights as the preferred stock sold to new money investors in the Qualified Financing with the exception that the liquidation preference on the shadow security is carved back to the conversion price at which the notes converted in the round.
The note investor’s dilemma: Either (A) don’t approve the amendment and the company you are invested in doesn’t receive the capital to continue operations or (B) approve the amendment and lose out at the deal originally bargained for which credited the note holder for making a risky investment in the first place.
The Conclusion for early stage investors: The lead investors in a Qualified Financing wields significant power in setting the terms for the new money round, which includes potentially forcing early note investors to adopt alterations to their initial note conversion deal. As an early stage note investor, however, there are precision drafting protections your lawyer can help institute at the time of the original investment which have the effect of returning at least some of the power back in the hands of a company’s earliest investors at the time of conversion. In any event, don’t be naïve: the suppressed valuation cap you successfully negotiate for in your note investment documents, if left naked, may end up taking on a much different economic outcome than you originally bargained for.
One of the first conversations I have with founders following the incorporation process is around forming and filling an advisory board. As a founder, surrounding yourself with knowledgeable, connected and committed players can add significant value for your start-up out of the gate. On the flip side, there are uniform mistakes founders often make that end up hurting their company (and cap table). Here are 5 of them:
1. Too many advisors, too soon.
Coming out of inception can be a scary time for a founder, particularly if this the first time at the rodeo. There can be a resulting temptation to get as many advisors involved with your company as soon as possible. The thinking being that, given the relatively cheap costs of an advisor (often just a modest equity grant; see discussion below), your start-up doesn’t need to give up too much to get in return the cache of attaching a strong roster of big names toyour company. A founder’s concentration, however, should be on building meaningful relationships with a small handful of trusted advisors that are going to be available and committed to the success of your company (and, on the flip side, that you will have time to leverage). Additionally, what your company might need today (e.g. advisor with particular industry expertise and/or connections to VCs) is not what it will need in the future (e.g. advisor with experience building commercial relationships or connections to strategic investors/acquirers). Remember, nothing precludes you from adding additional advisors to your company’s roster at those future inflection points….which is when you will be able to get the most out of the relationship.
2. Defining your advisor’s responsibilities too broadly.
The most sought after advisors are often time the busiest advisors. It is important to set expectations at the outset by establishing discreet parameters for an advisor’s responsibilities. As opposed to the loosely defined roles: “general advising services,” “periodic check-ins,” etc. Think: quarterly calls, review of deck/investor pitch, make # of introductions, etc…the types of metrics that you can hold the advisor accountable for and which will help prevent the “disappearing” advisor problem. Advisors will appreciate a more defined role and set of expectations so they can pre-schedule their services into their busy calendar.
3. Giving away too much equity.
I’ve talked with a number of high profile advisors who are constantly being asked to formally advise tech start-ups. One of the pieces of feedback from them is that they are often times amazed at how much a start-up is willing to give-up in equity for only a small amount in return. As a founder, it is easy to get excited about adding that star name advisor to your advisory board but don’t deviate from market expectation. Depending on what services your company will receive, expect to give up anywhere from 0.10% - 0.50% of the fully diluted capitalization of your company. Anything more begins to look expensive (and may be questioned as such by your investors).
4. Getting vesting wrong.
A founder’s instinct may be to set a service provider's vesting period as long as possible to maximize value over a longer period of time. When it comes to advisors, however, that is most often the wrong approach. Advisors typically have a shelf life as to their value accretion. VCs absolutely appreciate the fact that these advisor relationships take their course over a much shorter period than the standard 4-year employee vest period. And that period is typically no longer than 2 years. So instead of diluting value over a longer vest period, the question a founder should be asking is how to maximize value within that shorter window.
5. Don’t judge an advisor by its cover.
Picking the right advisor is not a “one-glove-fits-all" exercise. It can be tricky to anticipate which advisor relationship will ultimately prove to be fruitful. That said, there are initial signs that a founder should certainly not ignore. If the engagement process takes weeks to close out (perhaps because the prospect keeps disappearing on you or they over negotiate the arrangement, etc) or you find yourself being too shy to flesh out the details of what you might expect from the relationship (perhaps because you are concerned you would be bothering the prospect or overburdening them), chances are its not the right fit. A star advisor looks great on the final slide of your pitch deck but an advisory board alone will not be the determining factor for a VC to give you money. Results are. Choose wisely.
Cash burn. Two words that keep founders up at night and inevitably force them to at least consider outsourcing all or a portion of their start-up’s software development to an independent contractor (“IC”), as opposed to incurring the costs of adding another technical co-founder or employee on payroll (not to mention the time and energy those searches take). With more and more development shops/moonlighting developers to tap into in the marketplace (domestically and abroad), its no surprise that more and more start-ups are turning to outsourcing opportunities.
If you are beginning to head down this path, there are some key considerations to discuss with your attorney at the outset, none more critical, however, than ensuring that there are no roadblocks to your company owning outright the IP in the work delivered by the IC. Anything short of that fact will result in a surefire way to jeopardize your company’s ability to close future financings/exit without exposure to future claims of IP infringement. So you might be thinking: “I am all set, the form consulting agreement my lawyer provided me has clear language that the IC’s deliverables are work for hire and therefore assigned (along with all associated IP) to my company.” Think again.
The classic example - The IC you engage is moonlighting as a part-time developer, but has a full-time day job as an employee at Company X. The IC’s overreaching employment agreement with Company X states that any software created while employed at Company X, belongs to Company X, regardless of whether the software is developed “on the side” or related to the current business of Company X. You never establish this fact upfront with the IC, the IC develops the software, and on the eve of closing your Series A financing, you receive a letter from Company X claiming they own the IP delivered by your IC. Yikes.
TAKE AWAY: When you are considering engaging an IC, it is absolutely critical to ask up front whether the IC is under any other arrangement (employment or otherwise) with a third party that would in any way restrict the IC’s ability to freely assign to your company the deliverables and associated IP created on your behalf. If so, your alarm should go off...
...time to call your lawyer!
The Non-Disclosure Agreement has been commoditized to the point that start-up companies looking to save on legal costs have found ways to get comfortable executing these types of agreements without bothering to run them by their attorney, particularly in light of the fact that, from a founder’s perspective, the NDA serves as a major barrier to engage in potentially life changing conversations with a possible commercial partner, investor, advisor, or acquirer. Maybe your lawyer provided you with a form in the past or perhaps given the "mutual" nature of the form NDA presented by the counter party, you’ve concluded that the risks of signing are minimal.
Depending on the context of when/why you are protecting your information as confidential, however, the form in play may be missing critical terms that might not be so obvious at first. For example, discussions leading up to a potential:
- sale of the company – does your NDA contain a non-solicit of employees?
- partnership or other commercial relationship – does your NDA include protection on reverse engineering?
- engagement of a high profile advisor or consultant– does your NDA carve out the company’s ability to disclose the existence of the engagement through a press release or pitch deck?
- investment in a company – from the VC’s perspective, does the NDA make clear that your fund will not be restricted in any way from investing in companies in a competing space?
It is easy for a founder to gloss over the NDA but doing so may prove costly in the long run.
It has been widely reported that cyber criminals are hijacking real estate transactions by finding increasingly sophisticated ways to intercept and make alterations to wiring instructions being distributed between parties leading up to a real estate closing, resulting in the wiring party being duped into releasing funds to an alternative (and often times, off shore) bank account. Over the last year, hackers are starting to apply the same techniques to prey on the venture capital community and financings transactions. Read here.
This got me thinking about the standard practice for how venture financings are closed, specifically the process around how wiring instructions are shared between a company and its soon-to-be investors as well as the particular ripeness of the industry to be targeted by similar scams.
It is customary that leading up to the final moments before a VC transaction closing, lawyers find themselves caught in the middle of coordinating distribution of final deal documents along with the company’s wiring instructions. Here’s how it typically unfolds: (1) a company will email its lawyers the company's wiring instructions to distribute along with executed documents and the filed charter, (2) the company's lawyers turn around and send a closing email, which contains those instructions, to the Investor’s lawyers, (3) Investor’s lawyers then forward along to their client with confirmation that the closing conditions have been met and the wire should be released. By my count that is 3 emails sent containing wiring instructions…. which is 3 emails too many!
It is time for lawyers to insist that the parties to a transaction take much more calculated steps to limit the risks associated with this particular style of cyber crime. Founders and VCs should communicate directly on wiring instructions, separate from the lawyers' deal document distribution, through secured means other than email and, prior to wiring any funds, the VC (or a member of their finance team) should contact the company by phone and confirm that the wiring information sent over email is accurate. In my experience, this isn’t common practice. But it should be.
Last month I was sitting down for coffee with the CTO of one of the most successful app development shops in Boston. He confirmed what I had suspected –his firm, like many of his largest competitors in the space, resisted the temptation of taking equity in their clients in lieu of service fees. Unlike venture backed product based companies, for app dev shops and other service based companies, leveraging investor capital to grow your company is much more rare, and rather, your fee compensation is the lifeline of your business. But for you founders of newly formed app dev shops, agreeing to take all or a portion of your fees in the form of equity, if you can stomach the risk, might end up being the difference maker in winning your next job from an early stage start-up that is preserving burn at all costs. Here are a few alternative forms of consideration you might contemplate taking from your potential clients, and the upside and downside of each:
If the start-up you are contracting with has an open bridge round whereby the company is taking investment in exchange for the issuance of convertible notes, you might consider exchanging services for principal in a note issued in the round.
Upside: Convertible notes have the benefit of running interest (typically at a rate of 3-8%) and, at conversion, noteholders enjoy a steep discount to the price paid by new investors for the security into which the noteholders debt converts in the next equity round.
Downside: There are plenty of start-ups that are successful raising an initial friends and family bridge note round but aren’t able to build a business which attracts enough interest from institutional investors to successfully close an equity round.
Regardless of whether your potential client has an open bridge round, the YCombinator SAFE security is flexible to allow for a single SAFE to be issued to an investor, or in this case, a service provider, without the need for your potential client to open a broader round of financing.
Upside: Although there is no interest running on the note, SAFE holders, similar to noteholders, enjoy the same steep discount to the price paid by new investors for the security into which the SAFE holder’s purchase amount converts in the next equity round.
Downside: Similar to the risks of a noteholder, there is a chance the SAFE never converts and you are left holding an illiquid, equity security (junior in payment to debt) in a failing company.
If the potential client prefers not to issue their service providers an investment instrument in exchange for services, an alternative form of compensation can come by way of a warrant. A warrant is a security which gives a holder the right to purchase a certain number of shares (common or preferred), within a defined period, at a set price equal to the fair market value of the underlying security on the date of grant of the warrant. The idea, similar to a stock option held by an employee, is that as the value of the underlying security increases, the warrant holder will enjoy the delta over that set price stated in the warrant and the ultimate value (most likely at a sale of the company).
Upside: The issuance of a warrant is not contingent on the company having an open bridge round and the warrant security will provide for a cashless mechanism whereby the warrant holder will never have to actually come out of pocket to enjoy the increase in value of the warrant.
Downside: The term of a warrant is typically 10 years and, even if the potential client is able to sell their company within that time frame, there is always the risk that the valuation of the company in such sale may not be high enough for the warrant to be in the money.
Pro Rata Right to Participate. Preemptive Right. Participation Right. Call it what you may but this is one of the most important economic rights that attach to the preferred security received by a seed investor when making an investment into a portfolio company. For early stage investors, particularly those funds with limitations on their ability to cut larger checks to put them in the running to lead future rounds, preserving the right to participate in a portfolio company’s follow-on financing is paramount to future returns. Here is a word of caution for you seed stage investors (and your lawyers): Don’t risk being shut out of your participation right by missing a simple, yet key, technical drafting feature in your deal documents. The following anecdote sheds light on how that could happen:
Recently I was representing a VC in a subsequent round of financing for one of their portfolio companies. The round was being led by a strategic investor that had not previously invested in the company. My client and certain other existing investors planned to exercise their right to participate in the deal pro rata through a subsequent closing but, as is standard in financings, at the initial closing, existing stockholders, including my client, agreed to waive their contractual right to participate pro rata in the round, with the understanding that they would participate nonetheless. Note to the reader: This waiver is almost always solicited by the company, regardless of whether the company and new investor intend to honor the right of existing stockholders to participate, as it removes the need for the company to comply with the hoops and notice periods set out under the existing preemptive rights provision and, by doing so, a company avoids further delay on closing the current financing. Existing investors end up getting comfortable consenting to the waiver so long as the handshake business deal allows them to participate for an amount at least as large as what they were contractually entitled to had they not waived.
So back to the deal I was working on….when the deal documents were distributed for final sign off, the lead investor had included language which would have subject participation in subsequent closings to that lead investor’s approval. Cue the lawyer’s alarm! With the participation waiver in hand at the initial closing and the lead investor’s ability to block who the company could accept as investors in subsequent closings, that set up a situation where existing investors could have technically been shut out of investing in the deal all together, in spite of the company’s desire to let them participate. Lesson for seed investors: ensure that your deal documents expressly carve out existing investors from lead investor’s block on who participates in subsequent closings, otherwise risk losing your ability to invest pro rata……and getting burned!
I am working with a handful of companies expecting to raise an equity round in the next couple months. In some cases, it will be a company’s first real fundraise, with prior investment coming through a bridge round (notes, SAFES, etc). In other cases, it will be a Seed-2 or A round. Regardless, It is a nerve racking time for a founder/management team and with everything else on your mind, ensuring your company’s books and records are in order from a legal perspective is most likely not high on the to-do list to prepare for the financing, but it should be. Here are 3 easy steps you and your team should be taking weeks before you execute a term sheet to ensure you will cut down on deal timeline and, most importantly, legal fees.
1) Start Populating your Dataroom
Often times your lawyers will have records relating to incorporation, stock grants, board consents, etc. but there are non-legal categories of information which your lead investor’s counsel will absolutely request in the course of their diligence which you or your team members will be better equipped to provide (as opposed to your lawyers), like, for example, commercial agreements with customers, financials, schedule of IP assets and descriptions of third-party source code that the company has incorporated in its products, etc. A member of the team should be taking the time to organize, gather and populate the dataroom before the term sheet is signed so when the diligence request comes in from investor’s counsel, all you have to do is send the invitation. Leaving this task in the hands of your lawyer becomes inefficient and time consuming. So do yourself a favor, open up a dropbox account (a now totally accepted venue for investors and their counsel) and take control of creating/populating your dataroom. Not doing so will be costly.
2) Start Collecting Information for Disclosure Schedules
One of the key tasks of a junior associate in connection with a financing is guiding the disclosure schedule process. Often they invite a kick-off call with the client early in the transaction process whereby the associate spends the time (and your company’s money) to hold your hand and give you instruction on how to populate the disclosures in response to the reps and warranties in the stock purchase agreement. Here is a secret - you can save yourself the pain of that call by going to NVCA’s (National Venture Capital Association) website, download the form Stock Purchase Agreement (for free) and read through the reps and warranties (Section 2 of the form Stock Purchase Agreement) in close detail before the term sheet is even signed. To the extent you have an exception to a rep or the rep calls for you to disclose certain information, jot that disclosure down (informally is fine) on a piece of paper. 9 times out of 10 the reps that make it into the Purchase Agreement in your deal will look very similar, if not identical, as the reps and warranties are rarely negotiated heavily in the context of an early stage equity financing. Hand that list of disclosures over to your lawyer and they will be impressed. More importantly, you’ve just saved yourself a 2 hour call (at least) with a junior associate after the deal is in full swing. Woohoo!
3) Start Cozyin’ up with your Cap Table
Arguably the most important step you can take to save yourself a big headache heading into your financing is knowing your current cap table inside and out. It is your chance to start your relationship off on the right foot with your lead investor and helps you and your lawyers with organizing for the diligence process and preparing for drafting deal documents, as well as your counsel’s opinion (which will mostly require your lawyers to opine on the number of securities you have issued up until the financing). So go down each cell in your cap table well before your financing, ensure everyone that has received equity is on there and that anyone who is on there is being shown as receiving the right amount. Sounds simple enough but I can’t tell you how many times lawyers are left with this job. And trust me, it can get costly.
You can find plenty of literature on worker misclassification and the topic couldn’t be hotter in light of Uber’s business model (and high profile litigation). But for you early stage founders starting companies which are expected to be in stealth mode for the foreseeable future, you might be asking yourselves two questions:
1. Is this something I need to really worry about given the company’s early stage and low profile?
2. How would a misclassification actually come to light?
The following example, comes by way of anecdote from an on-boarding client (fictitious names used), and serves to answer those questions:
Robin is starting a company and decides to bring on her first employee and dear friend, Brian. With the understanding that they don’t have money right out of the gate, they get comfortable with the idea that they will each start as a “consultant,” and save some money by not setting up payroll while they see if they can get this idea off the ground. 1 year in they are ready to close on their first investor money but over the past couple months Brian has gotten side tracked with another venture and isn’t pulling his weight so Robin decides to fire Brian. Brian, being a recent college graduate, decides to file for unemployment. 3 months later, Robin receives a notice in the mail from the Massachusetts department of labor informing Robin that Brian had been misclassified as a consultant and Robin owes payment to cover the unemployment taxes she should have been withholding while Brian was technically employed by the company. Panic ensues. And Robin starts looking for a new attorney.
The moral of the story? It is critical for founders of start-ups to classify their service providers appropriately, right out of the gate, regardless of size, reach, publicity or development. Otherwise, risk getting bit in the a**.
There is no question, over the past 10+ years, the trend in the industry has pushed companies and investors away from a more robust “Series A” round as a form of initial equity financing to a leaner “Series Seed” round. We almost take for granted now that a company can access much smaller (yet meaningful) amounts of capital, much earlier than they would have been able to, from established institutional investors willing to commit time and energy to a company and its vision. Over the course of that same period, the tech community became comfortable leaning a lighter set of customary legal rules, rights and obligations for companies and investors to live by as they navigate together toward the Series A round. This reality was spearheaded by Fenwick & West through their initiative to open source a set of financing documents called “Series Seed Documents”. The first version of the documents were made available in 2010. They had some kinks but overall they were industry changing. In 3 fairly simple documents (a charter, stock purchase agreement and investors rights agreement), they were able to establish a market standard for how to paper Series Seed rounds. For companies this was a huge deal as they had, up until that time, been forced to rely on variations of the full suite of NVCA Series A documents (a charter, stock purchase agreement, investors rights agreement, voting agreement and ROFR/CoSale Agreement) with lengthy rights and legal concepts which very rarely (if ever) came into play given the company's stage.
In 2013, however, the Series Seed forms took a bad turn. Fenwick decided to combine the stock purchase agreement with the investors rights agreement in one agreement called the Stock Investment Agreement. So you might ask, why would it be a bad thing to limit the paper work further from 3 to 2 documents? Well, I’ll tell you why. After closing your initial Series Seed round, not all companies experience the trajectory that allows them to follow-on with an immediate Series A round 1-2 years later. Instead, a large majority of my clients (and other seed stage companies) end up opting to put together a follow-on “Series Seed-2” round, typically to take advantage of raising additional capital, at a slight uptick in valuation to the Series Seed round, while leveraging the same defined rights/obligations set forth in the Series Seed round. And it is at this moment, after hanging up the phone with their client, that the lawyer runs into technical drafting issues. Whereas, with the version 1 Fenwick documents, amending those forms to layer in the Series Seed-2 security sold in the follow-on round was seamless and required only a small handful of changes to the already approved documents, with the version 2 Fenwick documents, specifically, because of the combination of the stock purchase agreement with the investors rights agreement, lawyers were left with only clunky (and I mean CLUNKY) ways to layer in a Series Seed-2 security appropriately.
So what is the solution? Hopefully Fenwick will address this issue and revert back to help standardize an industry around their original forms composed of 3 documents. Otherwise, you should pressure your lawyers to rely on alternative forms which have the flexibility to account for that follow-on Series Seed-2 round (even if you don't end up utilizing it). Anything otherwise would be short sighted.