Employee vs Consultant Classification – Does it really matter for stealth mode start-ups?

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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**.

Getting ready for your seed round? Don’t let your lawyers use these forms…

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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.

The Pitfalls of Vesting

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Ah yes, the “V” word. This is when the conversation starts getting juicy. One of the most sensitive discussions I have with co-founders as I help them navigate through the incorporation process and through their initial hiring is around vesting. It is also the place (other than IP) that entrepreneurs seem to get wrong the most. Let's look at two components of vesting which give founders (and investors) the most headache: 

Time based vs Milestone based

99.9% of the time, milestone vesting fails to accomplish the incentivizing that founders had initially anticipated. Instead, the metrics, amounts, and other key components that make up the milestone vesting become stale before the ink on the restricted stock agreement has a chance to dry. This problem is particularly emphasized at the inception of the business -- how can you successfully tie vesting to predetermined milestone achievements if you haven't figured out your business model? By the time you unearth the restricted stock agreement tucked away in your email folder to check the milestone vesting provisions, the business will have pivoted 5 times. Not to mention, that is the best way to bust your deferred legal fee threshold before you even get started. For those reasons, I strongly advise against it. Instead, stop being cute and stick to what every investor would have expected in the first place -- time based vesting with a cliff, of course, to incentivize folks to stick around and hedge against the founder/employee who isn’t carrying his/her weight!

Acceleration

The other truly customizable feature in vesting is around acceleration. Here are the two most typical flavors to consider:

o  Acceleration upon a sale of the company (ie “single trigger” acceleration):

Most likely ok at the start but typically when your first institutional investor comes in at a seed or A round, they will condition their investment on the founders and other key employees amending their stock agreements in favor of a flavor of double trigger acceleration (discussed below) as they know better than anyone else that your future acquirer isn’t going to love the idea that you walk on the closing of your company sale fully vested.

o  Acceleration if you are terminated without cause within 12 months of a sale of the company (ie “double trigger” acceleration)

This is the more common permutation and the most industry accepted. Some times, executives will request that in addition to the "without cause" trigger, they get the benefit of a "good reason" trigger so if the executive were to resign for good reason within 12 months of an acquisition, they would get the benefit of acceleration. The issue with including that second trigger is that the definition of "good reason" is almost always implicated at the point of sale of the company (re: you no longer get the title of CEO of your acquirer), so the double trigger concept loses its functional bite out of the gate.  

And now for the most important point of this post. Ready. Take a seat and break out the popcorn. If you are looking for a sure fire way to handcuff your start-up, flush all your hard work down the toilet, and force a dissolution, go ahead and include a third form of acceleration -- Accelerated vesting upon a termination without cause. The biggest no-no in the industry. Because of the market’s tight definition of what constitutes “cause” (basically you killing someone), you are 99.9% of the time going to be fired without cause. So what is the big deal you might ask. As a founder, doesn’t this protect me? Sure it does, but if you include this term in your agreement, then all your co-founders will get it as well. And if they get it, and it turns out one of them isn’t who you thought he/she was, you will want to fire them. And having them walk away with a material amount of their shares vested through acceleration, well, kiss your chances of raising money goodbye.

Interested in current market trends with respect to vesting for founders, advisors, consultants, employees? I'd love to chat. Oh, and, don’t forget to file those 83bs!

SAFES...the Death of the Convertible Note?

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If you are a founder of an emerging company looking to raise money in a bridge round, you should hope the answer to that question is “yes”  for a few key reasons I will get into shortly. First a quick anecdote. I was meeting with a founder of a high profile tech start-up last week (not a current client) in Boston and he informed me that he was in the middle of raising a friends and family bridge round. My first question – what was the vehicle for the investment? When he told me a traditional convertible promissory note I asked him whether he had considered utilizing (or been advised by his counsel to utilize) the SAFE alternative.  I was shocked that his answer was a flat no. In fact he had never even heard of a SAFE. For those in the same position, start by reading this. Although over 3 years have passed since their creation out of YCombinator, SAFEs remain under used in east coast bridge financings. Here is why founders should want that trend to change:

No Maturity

Arguably the biggest headache for start-ups in a bridge financing is getting the maturity date wrong. If you do it can become a founder’s worst enemy, a logistical nightmare that turns a fairly inexpensive financing, into a more expensive one, as counsel is needed to draft documentation to extend maturity and founders end up needing to chase signatures from the requisite majority, all simply to extend a maturity date on an instrument that no investor ever expected to be paid back cash under. Not to mention all the question a founder starts receiving when they circulate that paper work to their investors. Oy. Safes do away with maturity all together and in doing so place an emphasis on the economic terms investors truly cared about when they decided to invest – namely mechanics for conversion and payment upon an earlier sale of the company.

No Interest

URGENT PUBLIC SERVICE ANNOUNCEMENT. To all those founders of start-ups raising a bridge round to its first equity financing, if your investors are making a stink in negotiations about the interest rate % or form of interest calculation (simple vs compounding) in the round, walk away. This is something that drives me crazy when I represent my early stage clients and something I always tell investors to drop first in a negotiation if they truly want to win the deal. You are investing in a start-up. The bet is that the investment will convert, not that you will make a bank like return on a loan. SAFEs do away with this conversation all together. Thank the lord.

No Phantom Liquidation Preference

Historically, when an investor’s principal plus interest under a convertible note converted at a discount or capped rate in connection with the triggering equity financing, that investor would get the benefit of receiving not only the actual dollars invested under the note in the form of the same shares issued in the next round, but also the (in most cases, material) discount premium. As a result, the bridge round investors were receiving what became known as “phantom liquidation preference” specifically tied to the lot of shares which had been received as a direct result of the discount/cap piece of the conversion. So why should founders care? Liquidation preference, in the most simple terms, is the amount of cash you would need to sell the company for before the common stock holders (founders and employees) saw a dollar in their pocket. Increasing the size of the liquidation preference, only distances the common from cashing in at a sale. Good news SAFES correct this problem by providing for conversion of the amount under the safe plus the discount premium into a shadow security with the same rights as the preferred security sold in the equity round but with a per share liquidation price equal to the lowered rate at which the safe investment converted.