Contracts are for the Divorce; Not the Honeymoon.

Principles:

  1. Small holes have a way of widening when you push a few zeros through them; and
  2. When a contract is being negotiated, founders are focused on the marriage. Their lawyer is (or should be) focused on the divorce.

Founders, for personality reasons, often pride themselves on being “closers” and able to accept levels of risk that others aren’t willing to tolerate.  They’re “upside” people. That’s generally a great thing, but seasoned negotiators know how to play off that tendency to their advantage.  This happens all the time:

Background: A draft’s been delivered and negotiated back and forth a bit. Then, right before signing, the other side’s counsel drops in a provision that they say should be uncontroversial – and casually includes a signed signature page, ready to close.

Company Counsel: (speaking to Founder) This provision is problematic.  It could lead to X, Y, or Z. I’ve seen it happen before.

Founder: (speaking to lawyer) Ugh, seriously? I just want to close this deal.

:: after discussion, Founder calls Investor to discuss ::

Investor: Your lawyer is being paranoid. There’s no way we’d do that. We’re all aligned here.

Founder: Yeah, you’re right. Damn lawyers.

:: Docs get signed ::

When the Company becomes more valuable, X, Y, or Z ends up happening.

Founder: F***ing S****!@#

Paranoid? No, Experienced. 

Why do good startup lawyers see red flags where founders just see corner cases holding up deals? The answer is simple, and it’s not risk-tolerance. It’s volume.  This is often the founders’  first VC deal, or at least they’ve never dealt with a fall-out with investors or business partners.  This likely isn’t even the lawyer’s 50th rodeo. The lawyer knows that contracts are drafted during the honeymoon, but enforced during the divorce. And holes in contracts have a way of getting bigger when there’s 7+ figures ($) waiting to be pushed through them.

Granted, there are a lot of lawyers who, because of the billable hour (or their own personality issues), do in fact make mountains out of molehills.  See ‘When it’s time for your startup lawyer to shut up.‘   But that doesn’t mean that a good lawyer will simply gloss over all issues to keep the business parties happy. Founders need to be prepared when experienced negotiators push the “let’s just get this closed, we’re all aligned here” button to discredit a lawyer’s advice. It’s an old-school tactic.

Good Cop, Bad Cop.

So my advice to founders stuck in this scenario is to go with another oldie-but-goodie: good cop, bad cop. In other words, ask, but blame your lawyer.  It goes something like this:

Investor: Your lawyer is being paranoid. There’s no way we’d do that. We’re all aligned here. (replay)

Founder: Yeah, you’re right. He is paranoid.  I know you’d never do X, Y, or Z. Lawyers are such a pain in the ass. But can we just make the change so that we don’t have to discuss things with him again?  We’re ready to close if you are.

Sidenote: I’ve found joint lawyer bashing to be an essential part of the founder-investor bonding experienceDon’t miss out.

Deal lawyers don’t mind being the bad cop at all. They’re used to it. It works.  Well, only if they’re actually your lawyer. See ‘Don’t Use Your Lead Investor’s Lawyers.’ You preserve your image as a closer, but still avoid the landmine pointed out by your “damn lawyer.”

If you don’t trust your lawyer, you should get a new one. And if you say you trust him, you should pay attention when he says that there is a serious problem in a contract.  We’re not all risk-averse pedants. We’ve just seen enough divorces to know what “we’re all aligned here” really means.

 

Startup Accelerators: The Legal Terms

Nutshell:  Getting into an accelerator can be a fantastic milestone, but there are serious obligations in their contracts that, if not properly understood by founders (and, if necessary, pushed back on), can cause very real problems down the road.  Founders should familiarize themselves with those obligations.

Startup Accelerators have by all measures become “a thing,” and for good reason.  They’re a fantastic way for founders to surround themselves with top-tier advisors, investors, and other founders, which is exactly what founders should be trying to do from the moment they start a company.  Getting into YC or Techstars is to a founder what getting into Harvard or Stanford is to a college student.  Though, as in any industry, there’s also a lot of garbage, including accelerators that have never resulted in serious follow-on funding, and some that even charge you for participation – lesson: do your diligence.

Naturally, a lot of really good material has been written on the web about (i) how to get into an accelerator (or an incubator, the lines between those two continue to blur), and (ii) what to expect once you’re in. Remote Garage just recently wrote an excellent post on their experience in applying to Capital Factory – a local accelerator/incubator (A/I) we frequently run into with our Austin clients.

But not much has been written on the legal side of these programs – meaning the provisions in the contracts they make you sign before you’re allowed to peak behind the curtain. Depending on the accelerator, those provisions can sometimes be excessively aggressive and give the accelerator (or its creators) undue influence over your company’s trajectory. Pay attention.

The Core Economics

  • Equity - In exchange for participation, the accelerator (or incubator) wants an ownership interest in the company.  Standard % for accelerators is 6-7% in the form of Common Stock.  Incubators tend to be in the 2-3% range.  The equity is issued via a Stock Purchase Agreement with a similar structure to a founder’s stock purchase agreement.
  • Additional $ Investment – A typical accelerator acceptance will come with an additional investment separate from the equity; usually in the form of convertible note or SAFE (in the case of YC).  Higher-tier accelerators will put in about $100-$120k, though some give as little as $20-25k.  This money is often intended, in part, to help founders relocate to the location of the accelerator, pay for housing, etc.

The Important Details

The above is fairly straight-forward and well-known, but there are a whole lot more details (and potential landmines) in the actual agreements that Startup Accelerators expect you to sign.

RepresentationsTypical accelerators and incubators will require founders to make certain representations in their agreements; meaning that the founders are committing themselves, by contract, to the truthfulness of those representations.  And the Accelerators can bring suit if it turns out those representations are wrong.

  • Organization – The Company is an actually incorporated entity (typically in Delaware), and has qualified as a foreign entity (if applicable) in whatever states it needs to in order to legally operate its business.
  • Capitalization - Accelerators will often require you to state in the contract what your capitalization is, including how much total equity is outstanding, how much the founders own, the size of your option plan, etc.  Given that accelerators expect to own X% of your Company upon entering the program, there’s no way they can be sure of that without knowing what your cap table looks like.
  • Authorization – The Company’s Board of Directors has actually approved (meaning at a meeting or by written, signed consent) the documents being executed in connection with the accelerator acceptance.
  • IP Ownership – All the founders, and any other service providers, have signed documents making it very clear that all intellectual property relating to the business of the Company actually belongs to the Company.

While I haven’t seen it explicitly called out in a contract (yet), a lot of accelerators will also informally require/expect to see a vesting schedule among a group of founders.

If it’s not clear to you already, the above reps mean that, if you’re signing a contract with an accelerator and haven’t had a lawyer make sure you can actually make these reps, you’re insane – not in a cool, “founders love risk” sort of way – just insane.

Covenants - While the above representations are statements of fact about the company, in signing A/I docs, founders are also signing up to various covenants – on-going obligations that they owe to the accelerators after signing the contracts.

  • Information Rights – Accelerators are investors, and they expect to stay informed of material events in the Company’s trajectory.  This often includes (i) financings, (ii) acquisition offers, and (iii) periodic financial reports of the Company’s performance.
  • Anti-Dilution Rights - When the accelerators say they want to own 6% of your Company, they don’t want you to issue them that many shares and then immediately proceed to dilute them down to 1%. For that reason, they’ll require you to “top up” their ownership to maintain their ownership %.  This anti-dilution right will usually terminate upon a “qualified financing” – meaning a priced financing in which the company issues preferred stock.
  • Approval Rights – Some accelerators will require you to obtain their written consent in order to enter into certain key transactions, including (i) selling the Company, or (ii) issuing securities to employees or founders through an option plan not already approved at the time that the accelerator docs are signed.  Normally you wouldn’t need their permission because of the small (6-7%) stake of the Company they own, but this provision requires you to ask them anyway.
  • Preemptive Rights - In addition to anti-dilution rights, which protect the accelerator from dilutive issuances (like you issuing more stock to founders or employees), accelerators will also often request preemptive rights (also sometimes called pro-rata rights) to purchase their pro-rata share in any future financings.  Meaning that if they own 6% now, they can take 6% of your future financings, as long as they’re willing to pay whatever price is set in that round.
  • Investment Rights – While less common in national accelerators, accelerators run by more aggressive investors will typically include some form of additional investment right on top of their anti-dilution protection and preemptive rights: meaning that, after ensuring they maintain their ownership %, they can purchase an additional fixed $ amount of securities at a later date.

Founders should understand all of these obligations as they move through and graduate from their accelerator programs, as a misstep could either burn valuable relationships, or require expensive cleanup down the road.

Where to Pay Close Attention

There’s a whole spectrum of philosophies among the people who run accelerator/incubators across the country, ranging from a “we’re really just here to help change the world, have fun, and maybe make a little $ at the same time” attitude to “this is a business, and we’re really here to make money.”  Somewhat unsurprisingly, the best national accelerators tend to lean toward the former, with founder-friendly docs not needing any push-back. Local and lower-ranked A/Is more often (but not always) fall in the latter category.  While the previously mentioned terms are fairly standard across all accelerators, here are areas where founders should pay very close attention, and if they have the leverage, push back on the terms.

Overly-Lengthy Anti-Dilution Rights - Anti-dilution rights should stop at a priced VC financing of between $500K – $1 million. Anything beyond that is (i) way more aggressive than “market” terms, and (ii) almost certainly going to create problems in raising funding.  While watered down “weighted average” anti-dilution is very common in startup financing, the kind of full anti-dilution given to accelerators/incubators is only tolerated pre-Series A.  Some accelerators have narrower anti-dilution rights that apply strictly to future issuances to founders (not all issuances), and those are more acceptable to carry on after a VC financing.

Overly-Lengthy Preemptive/Investment/Approval Rights Preemptive, Approval, and Investment Rights should also terminate upon a VC financing; where similar rights tend to be granted to all investors as a class.  Post-Series A, your accelerator/incubator should play ball along other, larger investors.

If you’ve raised $20M in venture capital and are on your Series C, it makes zero sense (beyond a power grab) for you to still have to go to your A/I for preemptive rights waivers, approvals, etc., separate from everyone else. National accelerators get this, and their docs reflect it.  But I’ve seen smaller A/Is let these rights drag on, giving them too much influence and power to disrupt major post-Series A deals.

Right of First Refusal on Accelerator Shares - The accelerator should not be allowed to sell its equity in your company to third-party investors without first giving the Company an opportunity to buy them back. Virtually every other investor in your company will be subject to a similar ROFR (as are the founders themselves); it should be no different for the accelerator.

Real Money should pay for Notes/SAFEs, not equity - This is less of a control/power issue than a legal nuance that a good lawyer will catch and prevent at the time of an accelerator’s investment.  As a founder, you have an interest in keeping the Fair Market Value (FMV) of your common stock as low as possible in order to ensure employees who receive equity can receive that equity at a low price, and hence enjoy more of the upside.  If your accelerator is paying $20K+ for a single-digit % of your Company via common stock, that’s often putting a FMV on your common stock that’s higher than you’d want at an early-stage.  This will make future equity more expensive for your employees.

For this reason, pay attention to the price the accelerator is paying for your equity.  If it’s higher than you want, you can ask them to move some of the money to a convertible note or SAFE, explaining the FMV issue.  Every major accelerator that I’ve brought the issue up with has been cooperative, so it should be uncontroversial.

Conclusion

Startup accelerators and incubators are (at least the good ones) fantastic opportunities for founders.  Unless it’s a really questionable one, I rarely find myself counseling clients that they shouldn’t attend one.  That being said, just like other big players in startup ecosystems, A/Is are not charities.  They have financial interests they need to protect, and that means requiring founders to sign contracts containing very real and serious obligations.  Go in with eyes wide open.

Reserve an Option Pool; Not an Ocean.

Principle:  The larger the pool reserved at formation, the more dilution founders are shouldering that would otherwise be shared with employees and investors. Take it seriously.

Here’s how much discussion usually goes into determining a startup’s option pool size at formation:

Attorney: What size of an option pool do you want to reserve?

Founder: I don’t know, what’s the usual size?

Attorney: 20%

Founder: Ok, let’s go with that.

The reason so little thought goes into it is partially due to the fact that startup formations have (for good reason) become very standardized.  Neither founders nor attorneys are interested in delving into any nuances beyond the core questions about equity distribution and founder dynamics.  The founders want to focus on their product.  The lawyers don’t want to burn time on a fixed-fee transaction.

But here’s why failing to take the time to think through your initial option pool size is a problem: reserving too large of a pool, even if it’s never used, means you’re giving away a larger amount of the company to future hires/investors than you want to.

“That can’t be!”, the founder says. How can an unused pool impact my dilution? Whatever doesn’t get used just gets canceled at an exit, right?  While technically correct, this misses a very important issue: future employees and investors will rely on the term “fully diluted capitalization” in determining how much of the Company they want to ask for in the hiring or investment process. And “fully diluted capitalization” includes the unused part of the option pool.

The Hiring Example

You’re negotiating a compensation package for a rockstar developer, and they say they want 5% “of the Company.” What does that mean? The vast majority of the time it means 5% of the “fully diluted capitalization,” which means all outstanding equity AND all reserved but unused equity in the option pool.

Think this through a bit.  5% means having to give them more shares if your option pool size is 20% instead of 10% (because the pie is larger), even if none of the pool is in use.  If you end up getting a good exit in a year without having used much of the pool, the unused pool will get canceled, but the “5%” shares the developer received won’t be reduced proportionately.  The pie shrinks, but his slice stays the same size – which means yours shrinks.  The 5% hire ends up with a much higher percentage of the cap table.

Nutshell: The larger pool you reserve, even if none of it is in use, the more shares you’ll have to give to early hires to get them to a % they feel comfortable with.  Those extra shares mean, if the pool is unused at an exit, those hires own more of the Company than the % they bargained for.

Incubators-Accelerators also base their equity requests on a “fully-diluted” basis (%-based), so by having an excessively large pool, you’re giving them too many shares.

The Investment Example

This is a bit more nuanced, and I suggest you read the excellent Venture Hacks post: The Option Pool Shuffle.

Background:

  • Convertible Notes with caps generally use “fully diluted capitalization” (remember, that includes an unused pool) in determining the conversion price. So a larger pool means the investor gets more shares to get them to the right %, producing the same issue as with employees: if the pool is unused at an exit, they end up with a larger chunk.
  • In a Term Sheet, VCs generally make you “top up” the option pool to have a certain % of availability post-closing, but they make the pre-money cap table absorb all the dilution from it.  The ask will look something like this:

the total post-Closing available option pool (excluding granted options) represents 15% of the fully diluted shares of the Company.

The Venture Hacks article gives a mathematical example, but the most important point is this: the higher % the VCs require as available (unused) post-closing option pool, the lower the price they are paying for their shares, and the more dilution the founders are absorbing.

How does this relate to the point of not going overboard in reserving your original option pool? The pool you reserve before your first VC financing will set the baseline for negotiating how much of an option pool “top up” VCs make founders absorb.  If you have a 16% available pool pre-funding, it makes it look a lot more benign for a VC to demand a 15% post-money pool than, for example, if your pre-funding pool was only 5%.  Getting from 5% pre-funding to 15% post-funding will require a very large increase in the pool size.

By having a smaller pool before your funding, it reveals a much bigger “hit” on the founders when the financing is modeled and the VCs post-funding pool “ask” is reflected.  When both the VCs and the founders see the substantial dilution resulting from the pool increase, it forces a deeper discussion about what the post-funding pool should really look like. And that’s where the Venture Hacks wisdom comes in: have a hiring plan and a solid argument for how much of a pool you really need, and make the VCs argue for theirs.

Nutshell:  By keeping your pool size small before funding, it requires a much larger pool increase to get to a VC’s desired post-funding unused pool, all of which is borne by the pre-financing cap table.  This forces a necessary discussion with the VCs about what the appropriate pool size really is, instead of just accepting whatever number they pull out of thin air.

So what is the right formation pool size?

It depends. How many founders are there? Whom are you likely to need to hire in the next 12 months? These are details to discuss with your attorney.  Whatever you do, don’t just accept 20% without thinking about it.

Conclusion

As a founder, your ownership is set at formation.  Everything afterward is dilution.  By reserving an unnecessarily large pool, you’re basically protecting future hires and investors from dilution, while absorbing it all yourself.  It’s not that hard to increase your pool size if you run out of room, and when you do so, at least everyone on the cap table will absorb the dilution with you.  By keeping your pool smaller, you’ll also make VCs think twice about casually dumping an unnecessarily large pool size on their term sheets in order to drive their share price down.

Startup Tax Filings: Get Them Done Efficiently

Background Reading: 7 Biggest Tax Mistakes New Startups Make

A recurring theme on this blog is that, at the very early stages of a startup, running “lean” should not mean finding garbage service providers whose shoddy work will end up costing 5-10x to fix later on. It does mean being smart about whom you hire and ensuring you get cost-effective, quality work that’s appropriate for the task.

Previous examples:

  • Clerky for the 1-2 founders who just need to incorporate, assign some IP, and issues stock with vesting schedules, but not necessarily engage lawyers yet.
  • SnapTerms for the SaaS startup that just needs a decent TOS/Privacy Policy to get up and running.
  • eShares for the startup that needs to track capitalization, issue certificates, or get a 409A valuation.

And at this time of year, it’s only appropriate to bring up another thing that early-stage startups need to get done, but often screw up by going cheap instead of going efficient: taxes.  Trust me, at some point your taxes will be diligenced by investors. You don’t want this holding up your Series A closing.

Thankfully, I’ve found a startup that helps other startups get this done easily and efficiently: LiveWire. $399+ to have a professional handle your startup’s taxes, paperlessly via the web, so you can get back to work. A whole lot easier and cheaper than engaging a CPA old-school or tinkering with an inflexible piece of software.  And lest you question the user experience, check out the reviews.  If you’re an early-stage founder who hasn’t the slightest clue how to file taxes for your startup, but realize you’re too early for fully engaging an accountant, this is the place to go.

As always, I don’t hold a financial interest in any of the companies referenced above. 

The Texas Startup Ecosystem: Curated & Connected

Nutshell: You can’t build a startup alone. Find your city’s startup “watering hole,” and start drinking.  But remember: that watering hole is not a charity.

In a world of abundance, including abundance of noise, curation becomes incredibly valuable.  Few people have the time to sort through hundreds of duds (products, information, people) before finding something or someone that they truly need. Curation is actually one of the main points of this blog; particularly the Learn the Essentials section. Undercapitalized Texas founders need information on basic startup law and finance.  That information has historically either been locked up in expensive silos (law firms), or spread out over the web alongside loads of crap.  I help them avoid the noise.

If you (just) build it, they won’t come.

When I run into very green founders, my first piece of advice is always simple and direct: get plugged in. By that I mean find people who “do” startups: either as  founders, developers, investors, advisors, etc. – and start making connections. It’s great to rely on your friends and business associates for general advice, but unless they work specifically in startups, it will not be good enough.  The challenges you encounter as a founder of a tech startup (business, legal, financial, etc.) will be very different from those that people outside of that space have experienced.  You need specialized advice, and that means specialized people.

And founders absolutely need to dispel any “if you build it, they will come” (just focus on the product) thinking. No, they won’t come. You probably don’t know how to build it in the first place. And even if you do, distribution matters.  You or someone working for your startup needs to be out there building relationships. Every startup needs at least one hustler. 

The Noise

Naturally, the number of these specialized “startup people” is a tiny fraction of the general business community in any particular city; especially in large cities with relatively small (but growing) startup communities.  But as startups have become much more of a “hot” topic (evidenced by political campaigns and a boom in angel investing among non-tech people), everyone and their mother has suddenly decided to bill themselves as a startup consultant, mentor, advisor, founder, whatever.  You see this in the legal field, where lots of general business lawyers have suddenly become ‘startup lawyers’ overnight. There are also a lot of business executives trying to mentor startups, with zero experience having actually worked with one.

So knowing that they need to find good startup advice, but there are a lot of duds out there, what are founders to do?

People, Curated

As the Texas startup ecosystem continues to mature, in each major city we’re seeing startup “hubs” emerge: places where the signal-to-noise ratio of real, valuable startup experience v. ‘everything else’ is orders of magnitude better than throughout the rest of the city. They’re like watering holes for the founderati. Startup people, curated for you. You’ll find far more jeans and sneakers than slacks and loafers in these places.  That’s a very good thing.

To help Texas founders get plugged in , I’ve created lists for Austin, Houston, and San Antonio (cities where the majority of our client base is) of the key startup locations, events, and even people in each city.  While every incubator, meetup, and person that I list on those pages is a great resource, there are stand-out “core” places that, in my opinion, any new founder should use as a starting point for plugging in – by following their posts, attending events, etc.

In Austin, Capital Factory has by far emerged as the largest “hub” of the startup community. Tech Ranch, while somewhat less well known, is also an important player. While not physical spaces, Austin Open Coffee and Austin Lean Startup Circle are also regular meetups whose attendees pack a significant amount of startup experience.

In San Antonio, Geekdom is hands-down the epicenter of the startup community. I’ve yet to encounter a serious startup out of San Antonio that has not connected with Geekdom in some way.  SA New Tech, a regular meetup, also has a solid attendance.

In Houston, the Houston Technology Center (HTC) appears to be evolving into a core of Houston’s startup community. Not exactly a cultural/social hub (yet) the way CF is for Austin or Geekdom is for SA, but an important player. The Houston Lean Startup Circle  is also very well attended by experienced startup folks.

Dallas is noticeably absent from this list. I frankly don’t work a lot with Dallas startups, and I only write about what I know. Also, there are a lot of very important players in these cities that I didn’t mention (accelerators, investors, etc.) simply because the point of this list is to emphasize how very early-stage founders should get ‘plugged in’ to their startup ecosystem. A brand new founder shouldn’t be “plugging in” to accelerators or investors.

Eyes Wide Open

Texas founders benefit enormously from the above institutions.  The connectedness and collaboration that result from their “dense” environments of startup activity are absolutely essential to a thriving Texas startup ecosystem.  All that being side, founders need to understand that these are not charities, and the people running these organizations (while great) are not Mother Teresa.

A number of the “startup hubs” in any city are either for-profit themselves, or connected to/run by very for-profit investors. The density that they provide is not strictly for the public good: it’s a way to pool resources and systematically reduce the search costs for (i) investors looking to invest in great startups, and (ii) executives looking to join startups on the rise.

There’s certainly nothing wrong with this. Doing well by doing good is awesome. I “do well” by this blog just the same. But founders should avoid becoming naively enamored and approach these institutions for what they are: very useful players in a profitable market for influence.  That market is competitive (incubators, accelerators, co-working spaces, etc. are in competition), and the players are incentivized to do and say things that maintain their influence, but aren’t always in the best interest of founders.  Founders should absolutely plug themselves in, but keep their eyes wide open in doing so.