Post Category → Angels

Startup Accelerators: The Legal Terms

Startup Accelerators have by all measures become “a thing,” and for good reason.  They’re a fantastic way for founders to surround themselves with A-level 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 top-tier 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 peek behind the curtain.  Founders who sign these agreements without actually understanding what they say can run into very serious, and expensive, problems down the road. 

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.

Representations: Typical 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 with a heavy investor-component 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 accelerators tend to lean toward the former, with founder-friendly docs not needing any push-back. 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. Top 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.

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.  It also leaves open flexibility for re-shuffling founder equity if circumstances require it.

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 means recipients of your common stock after your accelerator pays for its shares may need to pay a much higher price, or incur taxes for receiving the stock.

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.

What a Valuation Cap Isn’t

Background Reading

In a nutshell, a “valuation cap” is a limit on the valuation that a convertible note will convert at upon a “qualified financing.” Seems simple enough, but there are a few serious misconceptions about valuation caps that I feel someone should clear the air on.  Here’s what a valuation cap isn’t. 

1.  A Valuation Cap is Not a Valuation

Sort of.  In the strictest technical sense, a valuation cap is not a valuation.  It relates to future valuations.  It also doesn’t (generally) require a re-valuation of the FMV of your company’s equity for stock grant purposes.  And if a Series A ends up happening at a valuation below the cap, it’s not exactly considered a “down round.”

But in practice, investors and founders often treat caps like valuations.  When you come across an AngelList profile saying a startup is raising $500K at a $4M ‘valuation’, the majority of the time they mean they are issuing convertible notes with a $4M cap.  This “sort of but not really a valuation” aspect of capped notes is seen by some as the best of both worlds: you get to price a round without all the costs of negotiating  a full set of equity docs.  Others see it as having removed the main benefit of issuing notes (instead of equity) in the first place: deferring a valuation discussion to a future date.  Both sides have good points.

2. A Valuation Cap does not guarantee investors a minimum % of the Company

This is the issue that really needs the most clearing up.  I’ve seen angels make the claim that a valuation cap guarantees an angel a specific % of the Company post-Series A. This is just not true.  In a theoretical sense, a valuation cap guarantees a minimum pre-Series A % of the Company, but the note-holder never actually owns that % because the Series A money comes in alongside the conversion.

Take the example in Joe’s post:

  • $5M cap, $200K in notes (assume no interest for simplicity), $2M in new money at Series A at a $10M pre-money valuation.

I’ve seen investors do the following math:

  • % Ownership Post-A = Investment / (Cap + Investment)
  • So: $200K / ($5M + $200K) = ~3.8%
  • Therefore, they say, the note-holder should own 3.8% of the Company after the Series A.

The problem, of course, is that the new $2M from the Series A is nowhere in this equation.  That 3.8% is a percentage of the Company without the new Series A money coming in.

When you do the math correctly for the full Series A (see Joe’s post), the noteholder’s % comes out to 3.22% of the Post-A company. That’s the number the investor(s) will see on the cap table after conversion. And it could be higher or lower depending on the economics of the Series A.

This kind of confusion shouldn’t happen if you’re working with seasoned angels who’ve done several investments that have gone on to raise a Series A.  But if you’re not (often the case in Texas), make sure they understand the math of their own investment so there aren’t squeals when conversion time comes around.

Don’t Ask Your Startup Lawyer for Investor Intros

Principle:  Nothing says “I can’t hustle” like a paid introduction.

A lot of young founders looking to raise seed funding for their startup go through the following thought process:

  • I need to get in touch with investors, but I don’t know any of them.
  • Well-known Startup Lawyers must know investors, and I need one anyway;
  • Therefore, I should ask the Startup Lawyer that I hire to make some investor intros for me.

The logic here isn’t bad. In fact, some startup lawyers emphasize their strong relationships with investors as a marketing pitch to companies.  Unfortunately, those relationships are sometimes too strong.

Yes, good startup lawyers do know many investors, and yes, they certainly can make investor intros.  The truth is, though, you shouldn’t want them to. Before I explain why, a bit of background facts:

  • Startup investors, particularly VCs, receive hundreds, maybe thousands of pitches every year.
  • There are very few areas of investing that carry as much uncertainty/risk as startup investing.
  • Therefore, investors rely on as many signals (shortcuts) as possible for filtering out founders that can’t build a successful business.
  • The ability to hustle (related to and including networking) is extremely important for a startup team, or at least the founder who will play the CEO/business role of the startup (investors will excuse a technical co-founder who sits in a closet all day coding); and
  • Finally, VCs often intentionally make themselves difficult to get ahold of as a way to test (find a signal for) the networking skills of founders.

As a sidenote: cold calling/e-mailing VCs almost never works, for the above reasons.

Hustle Deficiency

So here’s the big issue: if you type a well-known investor’s name into LinkedIn, there’s a 99% chance that you’ll find 100s of different “paths” to get an introduction to that investor. Twitter also often helps, as do AngelList, Accelerators, etc.  Now, of all those paths to a warm intro, what do you think it signals to the investor if the only person you could find to introduce you is someone you’re paying?  The first thing that will run through that VCs mind will be something like “huh, well, putting aside the actual business idea, the founder clearly sucks at networking.”  That’s not a first impression you want to make.

A second thought might be, “maybe they’re not bad at networking, but just couldn’t find someone to sincerely recommend them.” You get the idea. Having your lawyer introduce you to investors isn’t too far off from having your mom write you a reference for a job.

What good is my Startup Lawyer then for helping get investment?

Does this mean whom you hire as your Startup Lawyer is irrelevant as far as finding investors is concerned? No, it still matters, just in different ways.  A knowledgeable startup lawyer can help with (i) how to approach particular investors, (ii) making recommendations as to which investors would be better targets, and (iii) signaling to investors that there’s been some “adult supervision” in the Company’s development to avoid legal land mines.

Because reputable startup lawyers are (often) selective as to whom they represent, a good startup lawyer can also signal that, by representing you, he/she at least thinks your startup has good prospects.  Granted, a lawyer’s business judgment isn’t exactly on par with Warren Buffet’s or Paul Graham’s (obviously, he wouldn’t be lawyering if it was), but it’s something.

Nutshell:  Ask your Startup Lawyer for suggestions on whom you should seek intros to, and on how to do it, but don’t ask him for the intro itself.  It’ll just make an investor think that, because you resorted to a paid intro, the company lacks a competent hustler. Nobody wants to invest in a hustle-deficient startup.