Setting Board Size and Composition in Anticipation of a VC Financing

When forming a tech company, one of the key inputs in connection with the incorporation process is board size and composition. It is typical for multi-founder companies to throw each of the founders on the board out of the gate but it is also not unusual to have the lead founder serve on the board in their sole capacity. For sole founders, there may not be a choice.

In the case of a single member board, a common question from founders is how should one be thinking about board size and composition heading into the company’s first institutional raise. In most cases, once past the “friends and family round”, the first meaningful capital into the company will take the form of a Series Seed Preferred financing. So what can you expect from your lead seed round investor in terms of how they will think about the board make-up and what should you single board member founders do to set the stage appropriately for negotiating a board composition that shifts the balance of power into the hands of the founders?

As you would suspect there is no golden rule but here are a few bullets to get you thinking about the topic:

• A professional seed investor will require a board seat. In the cases they don’t, I think that might actually serve as a red flag around sophistication of investor/dedication to the investment (outside of unique circumstances).

• Depending on how close the company is to actually receiving a TS, it might not worth the exercise of extending the board pre-round. Many early stage companies are “preparing” for an equity round but in some cases it takes them another 6-12 months to see a TS (particularly in a tightening east coast seed market). If the founder thinks they have sufficient runway until they see that TS, I might say that exploring a board increase now by adding other common holders or founders might be a worthy chess move. In the alternative, if the company is moments from receipt of a TS, papering the increase pre-round might look hasty only to have the board completely renegotiated anyway in connection with the round. In the latter case, it probably makes sense to leave as a point of negotiation.

• Regardless, adding members to the board should not be taken lightly. It comes with fiduciary duties/decision making responsibility that doesn’t always make sense to give to your co-founders. Plus what happens if the round doesn’t come together in the near future? Then you’ve added two people that you didn’t think were initially worthy of such position out of the gate.

• Not always the case, but the advice I find myself usually giving is sit tight. Get your TS and mark it up to make the board size 3: 1 investor designee, 2 common seats. This is where things should really shake out at the series seed equity round. In fewer cases, I might see an investor push for 1 investor designee, 1 common seat, 1 independent but finding the right independent at this stage can be extremely difficult.

• But the fight will not be over there. Even in the 2 common vs 1 investor board construct, expect negotiation around who holds the power to vote in the common seats. Are those seats controlled by:

o “majority of common” (ie holders of common across the entire cap table)?

o “majority of common held by the Founders” (ie two named individuals)?

o “majority of common held by Key Holders” (ie common holders holding over a threshold of stock)?

o “majority of common held by Key Holders who are then providing services to the company” (so if you leave the company or are terminated no longer influence the vote)?

o A “CEO seat” (ie whoever serves in that role at any time)?

Lots to think through around board composition heading into your first institutional raise with consequences not only for operations following the round but also in the context of setting the stage for you’re A round….and just think…. that is only the board composition discussion!

Q1 2019 in VC: Bigger (But Fewer) Rounds

What a year 2018 was in the VC/start-up world. Coming into 2019 we all wondered whether the record pace could be sustained. Well, let the wondering end. An awesome report was just put out by Pitchbook and the NVCA on Q1 investment round data which unearthed some really interesting trends, particularly in the early stage space, namely:

·         Overall: fewer, larger venture transactions with deal numbers continuing to shrink even as investment levels maintained their 2018 pace.

·         Angel, seed & first financings: while overall deal count is down broadly, the earliest stage has seen the greatest decline with annual count falling 44% between 2015 and 2018, the take away being that as start-ups face steeper expectations for maturity from investors so capital is being concentrated in fewer but more developed start-ups.

·         Early stage VC: remains strong but has receded from decade peak in Q2 of 2018. The median size of early stage VC financings grew 36% YoY to $8.2m.

·         Sectors:  As huge flows of capital pour into the core software and SaaS companies, many VCs are looking to emerging sectors that are less congested with investments. Some areas to watch include cybersecurity, robotics, the applications of AI & ML, next-generation infrastructure, fintech, healthtech and traditional industries ripe for disruption.  

Some other great data in here around later stage deals, geographic regions, incubators, female founders, corporate VCs, etc.

Buckle-up should be a wild rest of the year!

Advisor Equity – How much is too much?

One repeated question I receive working with start-ups out of the gate is how much equity is appropriate to issue to advisors. The answer to that question requires an understanding and analysis of a number of circumstances, including, by example, the identity of the advisor, services to be provided, length of term of engagement, stage of start-up, to name a few. Recently, however, I came across an interesting form advisor agreement which provided a methodology and helpful set of metrics for founders to set the boundaries for an advisor grant based on somewhat objective criteria. Here is the matrix that was provided:

With the advisor performance level determined using the guidelines below:

And the company stage determined using the guidelines below:

A few key takeaways:

1) In my experience and based on what I am seeing in the market, the matrix's assignment of an equity grant to an expert advisor is quite high at 1%, 0.8% and 0.6% respectively. Typically, outside extreme cases, advisor grants very rarely head north of 0.5%. 

2) I find that start-ups have a tendency of applying unrealistic goals for advisors and in some cases vague critera for performance. Above all in the above methodology, I like the objective nature of the performance metrics.

3) No matter what, don't forget that advisor grants should still be subject to vesting!

5 founder mistakes that keep your lawyer up at night

1. Giving away board seats to convertible note holder investors

Finding the right partner to invest in your business out of the gate is paramount to the success of a start-up (particularly) through its infancy stage. If your initial investors are conditioning their participation in your “friends and family” bridge round on receipt of a board seat, that should serve as a red flag. Your venture’s earliest investors, if experienced, should understand the fact that the founding team requires a maximum amount of flexibility at the board level as the company is coming out of inception and through its bridge financing. Adding an outside investor influence is more appropriate at the time of the company’s initial equity financing. Disrupting that equilibrium beforehand can cause problems for founders (too many cooks in the kitchen) and most importantly, may slow the company’s ability to achieve desired growth (forcing founders to chase after partially committed investors). And don’t buy the “but we want to help more than just giving you capital” argument. If that’s the case, set up a quarterly scheduled call or coffee meeting.

2. Issuing founders convertible note

Common Stock should be held by founders/management/employees and preferred stock should be held by investors. Any disruption of that fact inevitably introduces complexity as it relates to establishing an appropriate and unbiased governance structure of a company. For founders who have dedicated significant $ resources before outside capital becomes available, there is a temptation to “honor” that debt and roll it into the first convertible note round. The terms of that convertible note round, however, will undoubtedly have a conversion mechanism whereby investment in the convertible note ultimately converts into the preferred stock sold to investors in the initial equity round. Suggestion: instead of piggybacking the founder’s loan through that convertible note instrument, founders should consider documenting their loan instead as a straight promissory note (without a conversion feature) that would get repaid at some future trigger date.   

3. Not getting assignment of IP agreements from contributors out of the gate

This is one I see too often. At the time of engaging lawyers to legally form an entity that will house a product that you and your 2 other co-founders have been dedicating time to over the last 3 months, you get asked by your attorney to have everyone who has contributed to the IP of the company in the prior 3 months to execute an assignment of IP agreement. The problem: there was a 4th individual who was a part of the early conception stage but disappeared on you last week because they disagreed with the direction of the product build. Now they won’t answer your emails. The takeaway: if you are leaning on the contributions of individuals other than yourself out of the gate, immediately forming the legal entity and putting all the IP created in the company is paramount to not finding yourself in this situation.    

4. Spending too much time coming up with special vesting arrangements for co-founders

You are not only an incredibly intelligent individual but you are brave enough to put everything on the line to pursue an idea you feel passionate about. That fact is what gets me up in the morning to work and why I love my job so much. BUT, nothing is more frustrating that seeing you divert your efforts and intelligence away from building your company to instead coming up with novel vesting schedule schemes for you and your co-founders. 9 out of 10 times it will end up being a waste of the company’s money and time. Stick to what you do really well. Building companies. Not unique vesting schedules.

5. Not filing 83(b)s

And… I saved the best for last. You go through the incorporation process with your lawyers. You form your entity, you finalize equity documents and then you are off to the races building your company. You are feeling really good until you find out that your lawyer (and most likely their paralegal or junior associate) becomes complacent and fails to file or remind you to file your 83(b) election for the un-vested equity you received at incorporation. This is the ultimate mistake you and your lawyer can make out of the gate. If a founder does not make an 83(b) election, in any taxable year in which equity vests, the founder will be required to include in his/her gross income as ordinary income the delta between the fair market value of the equity at the time such equity vests and the price he/she paid for the equity.  As a result, income that likely would have been taxable at capital gain rates upon sale if the founder had made an 83(b) election would be taxable at ordinary income rates upon vesting. Yikes.