In the world of start-ups, every dollar counts. It comes as no surprise then, that before I have a chance to wipe the mustard off my face from the Memorial Day BBQ, a tidal wave of client emails hit my inbox requesting “unpaid summer intern offer letters,” as if to throw an underhand pitch to the Massachusetts employment regulators. Enter Matt Mitchell, chair of the Morse employment group. As he highlights in his latest post in the Massachusetts Employment Law Blog, despite the fact that some start-ups tend to see their summer interns as “casual” or “unregulated” employees, the employment of summer interns, particularly with respect to interns who are under age 18, is a highly regulated area of Massachusetts law.
Both the Massachusetts Attorney General and the Federal Department of Labor have taken a clear line on intern pay: For-profit employers must compensate interns/fellows for work performed, unless the intern/fellow qualifies as a “bona fide student intern.” A bona fide student intern is not an “employee” for purposes of wage and hour laws, and need not be compensated for work performed.
Whether a worker qualifies as a bona fide student intern depends on the following factors:
The extent to which the intern and the employer clearly understand that there is no expectation of compensation. Any promise of compensation, express or implied, suggests that the intern is an employee—and vice versa.
The extent to which the internship provides training that would be similar to that which would be given in an educational environment, including the clinical and other hands-on training provided by educational institutions.
The extent to which the internship is tied to the intern’s formal education program by integrated coursework or the receipt of academic credit.
The extent to which the internship accommodates the intern’s academic commitments by corresponding to the academic calendar.
The extent to which the internship’s duration is limited to the period in which the internship provides the intern with beneficial learning.
The extent to which the intern’s work complements, rather than displaces, the work of paid employees while providing significant educational benefits to the intern.
The extent to which the intern and the employer understand that the internship is conducted without entitlement to a paid job at the conclusion of the internship.
Therefore, if a start-up is intent on providing an unpaid internship/fellowship experience for an individual, it must create an academic-like program that is consistent with the above factors. If the individual is presently a student, this might be accomplished through coordination with the school’s career services department. If the individual is not a student, it will be more difficult, but not impossible, to accomplish. Enter Matt and the employment group at Morse who are helping our clients conceive compliant programs.
As with all matters related to Wage and Hour laws, a non-compliant summer internship program may result in significant penalties and litigation liability. So founders, please proceed with caution!
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!
Rob Go, co-founder and partner at NextView Ventures , wrote an interesting article towards the end of 2018, which, among other things, highlighted the fact that of the universe of active investors in the seed space, only a small percentage of those investors take a lead position in their portfolio company investment rounds. I wasn’t surprised by the data, particularly based on my experience representing seed stage investors in early rounds of financings. Often times, those fund clients approach me to “look over their shoulder” as they invest a “modest” check into a round of financing being led by an alternative investor or syndicate of investors. In that capacity, there are 3 key items which become part of a shortlist of paramount points to highlight to ensure a passive investor is receiving the benefits and protections of the bargain they might be expecting:
Major Investor Threshold. Often times, in order to qualify as a “Major Investor” and therefore receive the benefit of participation rights in future rounds, information rights, and, in some cases, RoFR rights set forth in the financing documents, a threshold ownership level is set to correspond to a particular check size in the round. The threshold to qualify obviously varies deal-to-deal but given the importance of these rights, particularly the right to participate in future rounds of financings (a right at the core of a seed investor’s business), this becomes an important hurdle to identify and comprehend. In some cases, even as a minority investor, you may be able to persuade the company (and the lead investor) in setting the hurdle to ensure your check qualifies.
Voting Percentages. Beyond confirming the amount of $s being allotted to a passive investor in the round, it is important to understand the preferred voting % thresholds on key decisions throughout the documents and what constituency is required to carry those votes, whether particular investor or group of investor holds on a block on such votes, etc. Even in a non-lead position, voting your shares a certain way might have the effect of influencing those decisions. Understanding whether that power would come with your check size is an important point to understand.
Side Letters. The business of entering into “side letters” is a common practice in the investment arena. Often times, lead investors request rights which a company prefer not to incorporate into the primary suite of financing documents distributed to the broader investor group and instead offer to incorporate into a short side letter which would not otherwise be broadcast widely, perhaps in some cases to avoid having all the “other” investors asking for similar rights. It may cover topics around press release control, observer seats, MFNs, special blocking rights, perpetual pro rata rights, etc. The universe of things I see in these letters is endless. As a non-lead investor in the round, however, you have an interest in understanding the landscape into which you are investing. Without knowledge of whether a side letter exists would fall short of delivering a full picture. Therefore, it is always important to confirm whether side letters are being delivered in connection with the round. And in some cases, you might ask for the same rights :)
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.