Well, it finally happened. After a nearly decade-long battle, MA has enacted legislation which limits the use, scope and enforceability of non-competition agreements. The new law will go into effective on October 1, 2018, meaning employers have a short window to start preparing now to protect their business interests moving forward as it relates to restricting its (future) former service providers from entering into or starting competing businesses. So if you have founded a started or are planning on doing so and intend on including a non-compete provision for the co-founding team, new hires or engaged consultants, keep reading…..
Starting with the least “headliner” of the headliners: the new law imposes a strict 1 year post-termination time limit on non-competition agreements with any longer period being considered invalid and unenforceable. As pointed out by the tech/VC community, including the NVCA, this does little by way of changing the status quo as the strict nature of this temporal limit is already aligned with the Massachusetts courts’ current approach as well as most tech companies in this region.
But here is where the novelty starts to heat up: The new law requires that the non-compete must be supported by continued payment of at least 50% of base salary during the restricted period or “other mutually-agreed upon consideration.” This is a monumental deviation from the status quo and a requirement which is at the core of the state’s attempt to put a quantifiable $ price on restricting continued innovation and competition in the marketplace.
And then there is this: the new law provides that non-competes cannot be enforced against an employee who is terminated without cause if it is entered into other than in connection with employment termination. This blew my socks off as it is almost always the case (outside egregious circumstances) that employment lawyers advise their clients to terminate high ranking employees without cause or otherwise open your company up to litigation. So now a company may find themselves in the difficult position of deciding whether to fire without cause (and risk an existing non-compete from not being enforceable) or fire with cause (and risk finding yourself in a lawsuit).
And just in case you thought you could rely on your old form non-compete or procedures for on-boarding a new employee: You were wrong. The employer must now comply with new procedural rules in connection with signing a non-compete. Specifically, if signed before the commencement of employment, the agreement containing the non-compete must have been provided to the employee either before a formal offer of employment is made or 10 business days before the commencement of the employee's employment, whichever comes first.
So where does this leave you, employer? Undoubtedly in a less powerful position when instituting and enforcing non-competes, which is a big win for employees and innovation within this state. As we await for things to unfold in practice and through the courts, at a minimum, employers need to take the time to revisit their form on-boarding materials/procedures with their attorney to ensure compliance with the new law. Otherwise, risk looking like a dinosaur….perhaps with a new competitor!
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!
Convertible note and SAFE financings remain the most commonly used instruments to bridge a start-up to its first preferred stock equity raise. Given the changing landscape around Series Seed and Series A rounds, in particular, a well-documented rising of the bar from VCs on “equity round ready” companies, more than ever before, start-ups are relying on these type of investment vehicles as a lifeline to raise capital for an increasingly extended period of time. The challenge for a start-up is how to rely on these vehicles, often accompanied with discounts and valuation capped rates of conversion, without giving up a disproportionate amount of equity at the ultimate conversion but, at the same time, continue to entice new investment from angels and early stage funds through the bridge phase. Some of those non-economic levers utilized by a company might include, to name a few, pro rata preemptive rights, guaranteed “major investor” status in the equity round, pre-equity round information rights, etc.
Accordingly, from an early investor’s perspective, there has developed an increased risk that your note will look a whole lot less favorable than the notes issued by the same company in connection with subsequent note financing rounds. To protect against that risk, I also encourage my investor clients to require inclusion of a Most Favored Nation, or MFN, provision in their note at the time of investing. If written thoughtfully, the MFN has the effect of giving investors the right to amend the terms of their existing notes to incorporate those additional rights and/or benefits (not just economic), which the company may introduce in the context of subsequent raises.
But a word of caution for you investors relying on a MFN, particularly the off-the-shelf MFN found in the form YC SAFE, if written poorly or without customization, there is a strong chance the insurance that accompanies the MFN right may be worthless. So watch out!
For the first time since 2014, the National Venture Capital Association, or NVCA, has updated its model financing documents to reflect a handful of key updates in order to account for the changing world over the past 4 years. In particular, two updates really stuck out which emphasize the times we live in:
Blocks on Crypto-Currency offerings
A new protective blocking right has been added to the model charter to provide investors a veto over token, crypto-currency and block chain related offerings given that the pre-existing veto rights did not clearly apply to or cover these new types of offerings. Without the change, existing investors may have been exposed to a portfolio company circumventing the standard block on future financings by pursuing alternative crypto offerings.
Anti-Harassment/Code of Conduct
A covenant has been added to the model IRA that requires the company to adopt a code of conduct governing appropriate workplace behavior and a policy prohibiting discrimination and harassment at the company. Previously, the covenants contained in the form financing documents had never gone so far as obligating the company to adopt employee handbooks, particular policies, etc. To ease the pain and cost for companies, the NVCA published a sample HR policy to address this point. This is a welcome change for the tech/VC industry and emphasizes the issues that have plagued the community the past couple years.
Kudos to the association and its general counsel advisory board!
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.
For founders, raising that first equity round is a true milestone. It is not only an opportunity to bring in meaningful dollars from professional investors to fuel a start-up’s growth but, if you have had outstanding notes running interest since the early days coming out of inception, it also serves as a chance to clean up your company’s cap table by converting outstanding convertible instruments in connection with the round. With angel investors’ broad adoption and comfort of investing into early stage companies through convertible instruments, companies are delaying the need to sell preferred stock in an equity round, in some cases, for the first couple years of a company’s development. The fallout from this reality, however, is that when you do head toward closing that first equity financing, a founder will have the task of coordinating with the (sometimes, many) noteholders in connection with the conversion of those noteholders’ outstanding notes.
With a syndicated noteholder base, the risks of holdout (or unreachable) noteholders is elevated and without collection of all signatures from that constituency in connection with the equity round, the new money investors in the financing will inevitably be spooked. To combat the potential negative effects and risks of a “standoff” down the road at the time of the equity financing, initially when preparing and issuing your convertible notes, your counsel should be advising you on the appropriate language to include in the instrument to ensure there is zero room for interpretation in the event the noteholder does not provide its signature at the time of a triggering financing and resulting automatic conversion. Without an air tight documented mechanism, you will otherwise risk taking the “automatic” out of automatic conversion and open up potential delay in the closing of you ever-so-important equity financing.
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.