Author Archives →

Founder Convertible Notes – Put Your Money on the Cap Table

It’s quite the norm for a startup to run on its own founders’ sweat equity and personal funds (bootstrapping) until the Company is able to raise outside capital.  A very important question that isn’t asked often enough is, “how do I paper the money I’m putting in?” Does it just go in and disappear? Does it pay for my stock?  While there are + and -s to different approaches, the answer that I almost always arrive at is: treat yourself like an investor.  In other words, paper your bootstrapping in a way so that it goes (eventually) on the cap table.  You benefit economically, and investors actually like to see evidence that you put more skin in the game than just your time.

  • Don’t use it to buy Common Stock – Your Common Stock should almost always be issued at par value ($0.0001 per share or some similar number in your Certificate of Incorporation) at the very beginning of the Company. This is proper because the Company is worth very little from a “fair market value” perspective, and issuing it at a higher price sets a FMV precedent that ends up hurting later employees because they then have to pay that higher price too.
  • Don’t buy Preferred Stock – Unless you’re a seasoned entrepreneur, the documentation and terms are too complicated for you to handle at the very early stages, and you’re not experienced enough to set a valuation. You’ll likely end up setting a bad precedent that will come back to bite you if you bring on real investors.
  • Don’t treat it as a loan – How do you think it looks to an investor if you’re asking them to actually invest (not loan) their money and risk losing it all, but you’re only willing to loan your personal funds? Bad.
  • Answer: Founder Convertible Notes – Issue yourselves convertible notes. Pre-financing, they are effectively a debt claim on your own company.  But upon raising the threshold amount that you set in the notes, they’ll convert into Series A Preferred Stock. This means (1) you now have a liquidation preference that will ensure you at least get that money back on an exit alongside future investors (unlike your Common Stock, which will likely sit beneath them), and (2) you get to vote those shares alongside future Series A investors.  Papering this is also a lot easier than buying preferred stock, and you don’t have to set a valuation.

Background Reading

Issues to Consider

  • Interest rate on the notes: 4-8% is fair
  • Discount on conversion: 20% is fair
  • Qualified financing threshold – $500K-$1M is fair
  • Cap on Conversion Valuation – Probably not a good idea for a founder note.
  • Maturity – Give yourself enough time to raise funding. 18-24 months is fair.
  • What happens at maturity? – Realize that at maturity, the notes will become “due.” This means the person holding the note can, if they want to, demand repayment (they could just extend otherwise) and cause all kinds of problems if they don’t get repaid.  If it’s just one founder or a couple of people you trust, this likely won’t be a problem. Make sure the maturity period is long enough, and be aware of the risk.  A lawyer could draft in extra protections to kick in at maturity, but that customization will cost money.

Good Forms to Use

  • Clerky has the ability to issue convertible notes cheaply. For founder notes, you don’t need the term sheet. While these aren’t rocket science, it’s still best to hire a lawyer if you want to completely avoid mistakes. But if it’s just one founder, or a small group of founders with no legal budget, they could probably handle this on a DIY basis if they read carefully.
  • Note that the Company’s Board of Directors should formally consent to the note financing. If you have a lawyer, ask for a simple board consent.  The reality is, however, because only the founders are involved, you can just ratify later when you’ve hired decent counsel.

The Cost of “Staging” Your Startup Lawyers

An unfortunately common problem that successful startup entrepreneurs have to deal with is outgrowing their first law firm or lawyer.  The reason for this is two-fold:

  1. High-Growth – Unlike traditional “small businesses,” startups that seek angel/venture capital are by their nature meant to be very high-growth oriented: they start out simple and small with tiny legal budgets, but within a matter of a few years (sometimes months) they can be raising capital from sophisticated parties, striking complex commercial deals, developing valuable intellectual property, and otherwise requiring serious legal advice.
  2. Short-sightedness – Because startups start out so small and often with non-existent legal budgets, founders will often plan to go with an attorney or firm that markets itself as serving “small businesses” at very low rates. The problem, of course, is that a “startup” and a usual “small business” are not the same thing, because of the first point above.

My thoughts on the “go cheap at first” attitude are already articulated in another post. In a nutshell, I’m of the mindset that because of the high-quality DIY resources available online for startups, founders might often be better off going it alone, until they can afford real lawyers, instead of relying on a mis-matched provider whose mistakes can cost serious money to fix as the company scales.

But the goal of this post is really to emphasize a different, but related point: switching law firms can be a lot more expensive than you think.  Put differently, you might think you’re saving money by going with a “starter” attorney, knowing you’ll just “upgrade” if you’re successful, but make sure you understand the full cost of staging your legal providers in this way. It’s likely substantially higher than you expected. Here’s why.

Diligence Cost – What’s in that “other lawyer’s” contracts?

Startup-focused legal practices, particularly at large firms built to serve startups at all growth stages, will have their own set of contract/agreement templates that they regularly work with.  All of the attorneys at a particular firm will have deep experience working with those templates and know, without having to review them every time, what they do and don’t contain.  So if a new transaction ever comes up and an attorney ever has to make a decision or answer a question that depends on what a historical contract does or doesn’t contain, they won’t have to fully review (and hence you won’t be billed for) having to re-diligence all of the Company’s history.

Naturally, when you switch firms, you bring with you all of the legal foundation that you’ve built on someone else’s contract forms, but are now using attorneys who have no idea what those forms contain.  This means your new attorneys will need to fully review the work you’ve done in the past to be confident that the documents are kosher. On top of the cost of fixing any problems, this review process alone will carry a sizable bill.

Drafting Cost – Making everything fit.

On top of having standardized forms, properly run startup law practices draft their forms to integrate with one another. Defined terms, section references, and contract provisions are in sync between sets.  Formation docs -> Seed Docs -> VC docs -> Acquisition Docs, etc. This integration saves a startup money by allowing an attorney to pick up a set of, for example, venture capital deal forms knowing that it it’s designed from the get-go to sync with the Company’s previously signed contracts.  She can focus on the core deal terms instead of having to tinker with what should be standard language.

Introducing a foreign firm’s contracts into this “legal chain” produces a serious disturbance in “the force.” Everything on a going-forward basis will need to be tailored to fit the foreign legal docs that the Company executed with another firm.  And, unfortunately, that tinkering won’t be pro-bono.

Conflict Risk – Something lost in translation.

It’s also worth mentioning that by requiring your attorneys to engage in all this diligence and custom drafting that they otherwise wouldn’t have needed to do if you’d used them from the beginning, you are automatically taking on the risk that something will be messed up.  A provision in your old contracts might be missed (because your attorneys were working quickly to try to keep the bill low), or the “tailoring” to your old docs might not have been done perfectly (for similar reasons), and a straight conflict within your contracts will arise.  Hopefully it’s a small one. But it might not be. Just know the risk is there.

Think Ahead in Hiring Your Startup Lawyers

So how much can all of these “transition” costs add up to? It depends.  The longer you spend with your “starter” lawyer, the higher it will likely be, but it can easily reach 5-figures.  Keep that in mind when making decisions about how to provide for your startup’s legal needs.  For a successful startup that inevitably has to switch firms, the transition costs of staging, along with those of fixing the mistakes of “starter” lawyers, will likely eclipse what the startup would’ve paid if efficient and scalable legal counsel had been engaged from the beginning.

Form Your Austin Startup Yourself Before Hiring a Cheap Lawyer

Note to reader: Please share this with as many low budget startup founders (particularly in Texas) as you know. Friends don’t let friends waste money on crappy lawyers.

Update: If you’re looking for DIY-ish startup formation options, this is another viable alternative: Clerky

So you’re starting a company with virtually no budget for legal fees, and you just found a guy in Austin who’s willing to help you out on the cheap. He even bills $175/hr and seems to come well-recommended by other entrepreneurs. Awesome, right? For me it is.

It’s difficult to overstate just how often clients end up paying our firm more to close a transaction, sometimes substantially more (think 5-6 figures), because we have to clean up a mess created by some cheap local lawyer with “startup friendly” (read: questionably low) rates.  Garbage sold at a low price is just expensive garbage.  There’s one solo practitioner in particular who’s done work for two people I know, separate companies, and screwed up big time on both of them (2/2).   One ended up closing a VC round at 2-3x the usual fees in order to clean up the disaster he created. Cheap is awesome until real investors hire real lawyers to actually read the documents your cheap lawyer drafted… or failed to draft.

I’ve previously articulated my views about going alone on startup legal issues, including a discussion on the growing number of DIY tools available online.  There are so many multi-specialty legal issues that come into play in forming, growing, and financing a company, that I highly advise against trying to do things yourself, at least if you expect to raise professional venture capital and scale your business. The stakes are simply too high.

But, the reality is that no matter what every lawyer with a blog says, founders will keep trying to form their companies on their own.  Given this reality, here’s my suggestion to all of Austin’s startup founders with zero funds budgeted for legal fees (and who can’t find a decent attorney who will be flexible):  meet Docracy, read this post, and follow everything very carefully.

Lawyerless > Crappy Lawyer

The beauty of quality DIY online resources is that, while they will never provide the level of service that an experienced, quality attorney will provide, they sure as hell are better than relying on a crappy one.  With the right contracts available for free online (via Docracy), the right guidance (via blogs, articles, etc.), and the patience to seriously read the instructions, you can stand a much better chance of not screwing your company up by doing things yourself versus hiring an incompetent attorney, trusting him to do things correctly, and then finding out two years later that he didn’t.

So here’s my free guide for using the power of the internet to form your own Delaware C-Corp based in Texas. If you are forming an LLC instead of a C-Corp, then for the love of all things good and holy, please get a competent lawyer.  And again, let me reiterate: I do not think you should try to form your startup on your own. My desire here is to simply provide a helmet and a flashlight for those who are going to do it anyway, so that if they are ever able to afford a real attorney and raise serious funding, their legal history won’t be a complete nightmare.  You will screw some things up, but hopefully the clean-up costs will be much smaller than those caused by Austin’s crappiest lawyers.

DIY Startup Formation – Powered by Docracy, Orrick, and “the Internets”

Background Reading:

Requisite Formation Docs:

Steps (Order is important)

  1. Read all of the Background Reading – very very carefully.
  2. Figure out your Founder Common Stock distribution and Vesting details
  3. Execute and File the Charter in Delaware
  4. Execute the Action by Incorporator
  5. Execute the Board Consent (Make sure you designate at least a CEO and Secretary)
  6. Execute the Common Stock Purchase Agreements for each Founder, including all exhibits. – Set
  7. File your 83(b) Election immediately
  8. Fill out Common Stock Certificates
  9. Execute the Stockholder Consent
  10. Have the Secretary execute the Bylaws
  11. Did you file your 83(b) election yet? (30 days within Stock Issuance, or your toast)
  12. Apply for an EIN at the IRS Website
  13. Have officers and directors execute Indemnification Agreements
  14. Have all founders execute a Confidential Information and Inventions Assignment Agreement
  15. Register as a Foreign Entity in Texas.
  16. Keep digital copies of everything in a safe place.

Useful Forms to Possibly Use Later:

The above does not cover granting options to employees via a formal option plan, because, frankly, by the time you are granting equity to non-founders you’re insane for not having hired a lawyer – and the legal issues around options are complicated – real complicated.

Disclaimer: As I said before, you will screw some things up. And yes, trying this yourself is silly and irrational – much like a lot of things entrepreneurs tend to do.  The above steps and documents might not even be the right ones for your startup’s context.  I did not draft the above-referenced documents, nor do I vouch for their legal enforceability. You absolutely should hire a lawyer before trying to form your startup. But, putting all that side, if you read carefully and follow the above instructions, you will be probably be on better legal footing than 99% of the startups formed by terrible lawyers.