Emerging Enterprise Center Blog - Commentary and Analysis For Entrepreneurs and Startups

My blogger friends (and the firm’s blogger consultants), indeed, it seems the entire blogosphere seems to agree that blogs are not really an optimal publication platform for dissemination of pure content.  I take that to mean that putting law review articles (or any substantive articles on legal (or other) topics) is really not what blogs are “about.”  

Instead, blogs are supposed to be pithy comments on other people’s posts (or perhaps some other thing going on in the real or virtual world).  Hence the prevalence of blog posts that begin with some reference like, “Harry has a great post about his date with Sally….”  Harry’s post, it turns out, is likely to be some observatlon about something Sally wrote on her blog.  Sally’s blog, in turn, refers to Tom and Dick….

So, the consultants appear to say, blog posts should be pithy comments about pithy comments.

And, the occasional pithy comment is probably a good idea, but when I look at the statistical data concerning this blog and I consider which posts seem to have generated interest and which have not, the numbers (meager as they are) support a completely different notion. 

Readers want content more than conversation – at least as much as conversation.

I am, for example, under the impression that Fred Wilson was very successful with MBA Mondays.  (Now, his entire blog is a huge success.)

Switching gears, Prithvi has told me on many occasions that the content posts I have done in the past are more geared for consumption by lawyers than by entrepreneurs. 

So, I am going to try and take a trick from Fred’s book and apply Prithvi’s advice and write a series of posts (I will try for weekly) that will be both substantive and usable by entrepreneurs.  The posts will be checklists for things that are legal in nature.  The idea is to put the entrepreneur in a position to think about whether he or she has covered everything he or she needs to cover in a document or deal. 

Of course, the usual caveats about how this is not legal advice and does not create a lawyer client relationship etc. apply. 

I thought I would tackle seed preferred term sheets first.  Although these can vary from one pagers to 5 pagers (or more), for the purpose of creating a checklist, I am going with the longish form.  After all, it is the purpose of a checklist to be over inclusive.  Also, I have linked each of the terms (and some other items) to the glossary defining these terms on the EEC microsite and, where it seemed relevant, to my blog. 

Please send me thoughts on the checklist.  If the checklists seem useful (or popular) I will post them on their own site on an easy to use open source basis.

Here goes:

First, a disclaimer: The client referred to below has read and signed off on this post.

Now to the matter at hand: We were retained by an investor leading a $1mm seed preferred type financing for a start-up digital media company. The investor will end up with around 20% of the company after close. The company is pretty hot and the entrepreneur is already a one time winner in the space. The entrepreneur is a huge Fred Wilson fan and can’t imagine how costs could exceed $5K for this deal.

In an effort to control costs, once the investment got passed the “term sheet” (and I use that phrase loosely) stage, the entrepreneur insisted that he would only make and take comments in the form of tweets. Our client agreed to this.

The deal went into hyperdrive as soon as the tweets started to fly, with tweets like:

            “Always get 6% cumulative dividends but only paid on liquidation”

            “why?”

            “standard”

            “won’t agree to have a common vote on the drag”

             “Why?”

             “have in all our deals”

As you might imagine, with this limitation on discussion we are way under Fred Wilson’s magical $5K.

Unfortunately for my client, a well-known angel got wind of all this and tossed her hat in the ring with a convertible note. She wised the entrepreneur up to a number of things including that idea that converts are better for entrepreneurs than priced deals.

So here is my challenge:

Explain in 140 characters or less why the entrepreneur should accept any of the following:

(1) a priced deal and not a convertible deal

(2) a 6% dividend

(3) a drag without a common vote

The winner for best explanation within the 140 character limit gets free legal services from me to the extent of the positive difference, if any, between $5K and my fees at standard rates on this deal.

From time to time I have written about so-called standard provisions.  Standard provisions are often “standard” for a reason – that is they address concerns that people commonly have in a way that makes common sense in a particular context. 

One problem is that sometimes parties assert that a particular provision is standard in a context that just isn’t the kind of place where it belongs.

My current bug bear is the “drag – along” -- a standard feature of venture investments.

Well the “drag” is standard in venture investments because VCs typically own a controlling interest in the companies they invest in and they want to have more or less unfettered freedom to exit without regard to the structure of the exit.  Here is the pure case:

VC owns 60% (or more) of the voting stock of EasyTech, Inc..  VC wants to be able to force an exit and is concerned that for some unforeseen and unforeseeable reason, the exit may have to be structured as a direct to stockholder transaction.  That is to say the buyer may need to acquire the stock of Easy directly from the stockholders rather than through a merger (as is mostly done).  This means that each stockholder will have to make his or her own decision and, if there is a holdout, it might queer the deal.  So, the VC wants to be able to deliver all the shares (or almost all – not going to get into why not 100% at this time).  The drag is a contract that permits him or her to do just that, if certain conditions are met.  Those conditions are typically (1) board approval of the transaction and (2) approval of the holder of a majority of the preferred stock.  In effect, the holders of common stock are required to sell – it does not matter what they think.

Well, this makes sense in the context described above.  When the majority wants to sell why should the minority be able to hold them up, and why should it matter what form the transaction takes?  That is why the drag is standard in these deals.

But, what about other contexts?  Should an angel investor acquiring just 20% of the stock of a company have the same right to drag the holders of 80% of the stock as a VC who owns 60% of the stock?  There are a lot of angel investors meeting this general description who present this type of drag as a standard provision, and there are a lot of entrepreneurs who simply accept it without further consideration. 

So here are some things to consider.

First, the pure case (where the VC owns a majority):  Why is the board part of this at all:  From the director point of view it puts pressure on the directors to be extra careful from a fiduciary duty perspective because the only protection for the common stock is board approval.  So, in theory, at least, the board may become subject to attack from a common holder who thinks the deal was not “good enough.”  Remember, the board, in this context, is likely to be dominated by representatives of the VCs and the deal may be a direct to stockholder deal that might not otherwise require a board vote.  Why would a VC want this situation?  In the pure case, it might make sense to have the drag be a contract between the preferred holders and the common holders and not involve the board.

Second, the minority investor case:  Is it really the expectation of the majority that the minority can drag them into a sale they don’t want?  I don’t think most entrepreneurs think that when they take on an angel (even a professional angel group) for a minority investment that the angel will have the legal authority to sell the business out from under the majority.  So, in this case, it seems to me that the drag should require some vote of the common as well as the preferred – assuming it should exist at all.  The argument for a drag that requires a common and a preferred vote in this context is that the collective majority should not be able to be held up by a pain in the ass minority stockholder.  This type of drag is sometimes referred to as a “housekeeping drag” , and it makes a lot of sense to me, in the angel investment context.  Again, putting the board in the middle seems to me to invite a potential problem for the directors.  I wonder if it is not more consistent with the expectations of the parties that the drag be a purely contractual arrangement among stockholders and not subject to someone’s interpretation of their fiduciary duties.

Another question is whether the majority should not be able to drag the investor.  It seems highly unlikely than any investor would agree to such a thing on the grounds that they do not want to create a perverse incentive to sell early.

So, when would you put the board in the middle?  How about when the drag becomes a bone of contention in a negotiation and you need some compromise to get over the issue?

For a variety of reasons, drag-along provisions don’t tend to get a lot of thought.  They are often treated as standard or boilerplate with results that sometimes don’t really fit the situation.

Mark Suster has struck again with yet another contribution to the seemingly endless debate about convertible notes versus priced seed rounds.  His conclusions will, of course, shock and amaze:  Price the “effing” round.  All the investors agree.  (I probably overstated that.)

I don’t want to rehash the now tedious discussion, but the following thought has occurred to me more than once:  Investors who hold notes that are convertible at a discount are indifferent to the next round valuation (sort of – (a) a low valuation theoretically helps the return on the seed investment and (b) everyone likes to invest in a company that made it big).  These investors have a built in return that they will book at the next round no matter what the pricing of that round is. 

At the risk of being boring, a note that converts at a 20% discount to the next round provides a 25% return upon conversion whether the round is priced at $10 million or $500 million. 

So, consider this:  A VC investor who puts $500K into a priced seed round with the expectation of investing $5mm in the A round will want a low valuation on the A round.  It is in the VC’s economic best interest to get a “good deal” on his $5mm investment, to the detriment of the return on his seed investment because the seed investment is nominal by comparison to the A rond investment.  On top of this motive, the VC is probably on your board and probably has blocking rights, rights of first refusal etc.  As a practical matter, bringing in a true competitive bid will be difficult on a good day.  In fact, if there are blocking rights it may be impossible.

Also, consider this:  An angel who puts $500K into a priced seed round without the expectation of participating in the A round (or perhaps hoping to have a minimal participation) will want a really high valuation to avoid dilution.  Note this investor will also be worrying about later rounds.  Again, because of contractual rights (such as the right to block the issuance of senior preferred) this investor may be in a position to affect your ability to raise the next round.  Now, you can usually get around this issue because it always comes down to "raise the new money or die", and the investor will go with the obviously correct choice.  But, make no mistake about it, these investors can and do create major problems from time to time.

Now consider this:  A VC with a $500K principle amount convertible note (at a 20% discount and no cap) will get a 25% return on the $500K at the closing of the A round without regard to valuation.  He will be planning to make his return on his A round investment and will negotiate like a VC to get a “good deal.”  But, these notes are typically done without all the ancillary documentation that accompanies priced seed rounds.  As a result, the holders do not have blocking rights.  Because of signaling and other issues (the investor is already involved with the company, he may have rights of first refusal etc.) the VC investor will be tough to deal with, but, from the entrepreneur’s point of view, it probably beats having to deal with all the contractual rights inherent in a priced seed round.

Finally, consider the angel investor holding the proverbial convertible note:  Economic indifference to the pricing (sort of – see my parenthetical in the second paragraph), fewer contractual rights, and no substantial new investment in the next round – how much better does it get?

As Suster points out, it is hard to argue that investors should like convertible notes (without caps), but it is also hard to argue that entrepreneurs should not like them.  In the end, it seems to me that this is all about supply, demand, familiarly with investments, savvy and negotiation.  Familiarity and savvy are usually on the side of the VC.  Because of the dynamics of the seed market, as it exists today (see Andy Payne’s recent blog regarding the glut of angel money), supply and demand may be on the side of the entrepreneur (for once).  Don’t feel bad about getting a “good deal”; investors sure won’t.

As VCs and large institutional investors take the plunge into seed financing-and begin to incorporate the concept of incubators into their existing offices - one has to ask what’s the impact?  From the entrepreneurs perspective the upsides include: more funding choices in early stages, hence a greater chance to get the capital to build up your idea and show its viability;  access to the expertise of VCs and their advisors, and perhaps;  the security, albeit fleeting, of having a big player supporting your venture from the get-go.

Not to be a complete downer on this recent trend, but if you are talking to a VC or a large institution investor about the possibility of incubating your start-up, ther are some possible downsides to keep in mind.

When the time comes the VC may choose to pass up participating in the first round of venture financing for your company.  Are you prepared for this?  Getting passed up during the venture round by the VC that seed-funded you might create a high barrier to overcome when you’re meeting with other potential investors. Do you have a good answer for when an investors asks you:  “You had company X put down $250,000 to seed you through the incubation phase, why haven’t they chosen to lead or even partake in the first round of VC financing?”

Why your company is passed up, unfortunately, could have nothing to do with the viability of your idea or the potential success of your business, but it will get people thinking.  Remember, putting down $250,000 in seed on an interesting idea and a great entrepreneurial team is very different from putting down $4 - 5 Million even if you met your milestones.  Just the loss of a cheerleader at the VC or the fact that your company is operating in a space or using a business model that the VC is not fully comfortable with, might stop them from participating in a larger equity capital round.  

If they are prepared to invest in a venture round, the VC will probably be in the drivers seat.  They probably already have a right of first offer as a provision of their seed investment.  More detrimentally, there will exist a sort of mental curtain around the start-up team in terms of their other financing options.  Think about it, if you are incubated by a VC, chances are that you are probably not making the rounds, talking to potential investors, talking to Angels, being introduced to other VCs as you approach the VC funding stage.  VCs might make a strong play to participate in VC funding only if they can lead a syndicate of other institututional investors.  This comes with its own set of challenges and its own set of downsides for the company, but that is a story for another blog.

Brad Feld has another fine post on seed investing. His post, like so many others, focuses on the intent of the investor. In effect, he says there are good seed investors and crappy seed investors. He is undoubtedly right about that, but I am not sure it matters as far as optionality and signaling are concerned.

Any VC seed investor is likely to have a choice whether or not to fund an “A” round. It does not matter whether they made the investment with the intent of securing that choice or not. With respect to the value of the option, it does not matter that they were great investors and helped the entrepreneur massively along the way or that they were crappy investors and never returned a call.

The choice is the choice and, if the VC doesn’t make the next investment, the signal is the signal. 

(Now a great investor is a fine thing and worth every percentage of equity you give her. I am not taking anything away from the value add of a great investor.)

The difference between a seed investor and a VC is that the seed investor typically will not have the funds to participate in a meaningful way in the A round, let alone lead it. If, from the beginning there was no real possibility of participation in the A round, there was never an option and no signal can be implied.

But here is another way to look at the option/signaling debate (I admit not necessarily theoretically pure I the sense that the behavior would not exist in a world of pure economic actors). Entrepreneurs are afraid that if they bring in a VC for the seed round, they are placing downward pressure on their A round valuation. How can that be? If the A round price is too low, won’t someone bid higher? In a perfect world without friction and with perfect information, that might be true.

We don’t live in a perfect world with complete information. Once the VC has his nose in your tent, it will be hard (impossible?) not to deal with him when it comes time for the A round. The playing field will not be level for outside investors proposing to compete with the VC. The VC’s motive, of course, will be to keep the round price low since that implies a bigger percentage ownership and ultimately a bigger return.

Remember that those investment docs probably say that you can’t increase your authorized stock or create a senior preferred without your VC’s approval (true in most seed deals and absolutely true in all A and later rounds). This means your investor can block your next deal. You will not get far with an alternative investor unless you can get your seed investor on board. 

Whereas a VC seed player planning to lead (or at least participate in) the next round has a strong motive to get a lowish valuation for the reasons noted above, the angel seed player who can’t (or does not want to) participate in the next round has the exact opposite motive. She wants a high A round valuation since that preserve her investment and ultimate return.

On the topic of friends and family financing and how best to structure those agreements, I know we have written about this before, but I think that a topic this nuanced warrants revisiting.

Ok, so you're entrepreneur Joe, and your dad, mom or that rich aunt, who has always spoiled you silly and thought you were God’s gift to this earth, wants to help you and your start-up, so they give you some money to help you get that start.

Pause…so you got some money from a relative/friend who wants to see you succeed. First question: did they give you the money or was it money for the company? If they wrote you a check (lucky you!) this blog will not apply to you. However, if there was an implicit or explicit understanding that they wanted to lend the company some money, then read on....

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This issue (how much of a discount should there be on an angel note that converts into the next round of financing?) seems to come up every day. And, there does not seem to be a good answer. So, consider this: a 20% discount is, in effect, a “guaranteed” 25% return on the investment. (Of course it is not really guaranteed since you don’t get liquid until some dim point in the future, if ever.)  Perhaps one way to look at what is an appropriate discount is to ask what the return should be over what period of time. 25% in six months justifies a high degree of risk, but 25% over two years does not. So throw this in the hopper along with other typical thoughts such as how will the “next” investor react? How big is the angel investment? What precedent are you setting? And the like.

I had occasion to participate in a panel presentation on the general topic of angel financing terms and conditions. Many of the participants were concerned about how to negotiate terms and the consequences of certain kinds of provisions. The panelists, myself included, tended to cater to this by talking about trying to avoid certain terms, etc. In the world of angel financing, the range of size of investment and length and complexity of documentation varies dramatically from the family friend who writes a check for some common stock to the sophisticated angel group that behaves much like a VC. 

Upon reflection, however, all investors in this the category have at least this much in common: they invest relatively small amounts. By relatively small, I mean anything from thousands to a million or two, under some conditions. Because the investments are small, they cannot bear the weight of the kinds of transaction costs that one normally sees in a $10 million financing. By way of example, a “normal” VC financing might cost the issuer $40,000 in legal fees. $40,000 is 0.4% of 10,000,000. If you raise $250,000 in angel money you can’t spend $40,000 in fees to do it. While it might not cost you in dollars for the time you spend negotiating, it will pile up as you consult with your attorney. In addition, the further away you get from the simple, straight forward and standard, the more it will cost to document a deal. 

At the end of the day, you need to know what is important to you, and I suggest that prime among the things that should be important to you is maximizing the dollars you can put to work in your business and your economics. So, look at valuation; look at dividends, the discount in a convertible note, multiple X preferences, and full ratchet antidilution. Beyond these issues, you need also to be comfortable with your investor. Sometimes you need to take your money where you can find it, but if you just don’t get along with the investor, maybe you should keep looking. 

Keeping all this in mind, there is a lot of merit to closing and putting money in the bank. If the investor wants registration rights, don’t argue. Will accepting some seemingly unreasonable terms create issues later – it well could, and you may find yourself dealing with these “issues” later when they arise, but consider that in the light of (1) spending $25,000 to raise $250,000 (or less) and (2) going an additional some amount of (weeks or months) without funding.

To paraphrase the famous prayer – may God grant you the strength to negotiate the important terms, the fortitude to endure the effects of the ones you can’t (or shouldn’t) negotiate; and the wisdom to know the difference.