Outsourcing Software Development and the IP Conundrum

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! 
 

NDAs. One glove does not fit all.

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.

Wire Fraud on the Rise… Could the VC Community Be Hit Next?

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.

Nascent App Dev Shops: The ins and outs of taking equity in your clients

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:

Convertible Notes

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.

SAFES

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.

Warrants

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.

Seed Investors: read this if you care about your pro rata!

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!

Getting ready for an equity raise? Read this if you want to save time and money on legal fees.

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.

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

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…

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

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?

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.