Post Category → Equity

Taking Non-Accredited Money – Survival.

Imagine you’re walking through a desert. You haven’t had water for days, it’s 100 degrees, and you know if you don’t get a drink soon your time here is done.  Then you come across a mucky pool of stagnant water that is almost certainly infested with some kind of bacteria. What do you do? Pass on it, for fear of getting sick? Sh** no. You get yourself a drink.  Rule #1: survive.  

This is the decision many startups face when questioning whether they should accept money from “non-accredited investors.”  It also highlights how ridiculous it is for startup lawyers to tell founders that non-accredited money is never worth taking.  They clearly haven’t stepped down from their mahogany pedestal and planted their feet on the same ground as their clients.  Being the product of low-income immigrants myself, and seeing how many successful startups rely on pre-angel funding (a lot), the “if you don’t have rich friends and family, don’t bother” mindset really rubs me the wrong way.

I’m not going to get into the background of what accredited v. non-accredited investors are, or why you shouldn’t take their money.  Most likely you’ve already heard it repeated in 5 different ways.  Professional investors don’t like them, there are onerous disclosure obligations, they can prevent you from raising larger amounts of money, etc. etc. Let’s just take it as a given. Taking non-accredited money is a bad idea. We all know it is. But you know what’s a worse idea? Shutting down when there’s life-giving capital on the table.

Texas is not California.

Unlike startups raised in the land of milk and honey (Silicon Valley), where many angels really will fund an idea, a true MVP, or something with no revenue, in Texas (including Austin) it generally takes a lot of work and some traction (with zeros) to get to a point where angels will even consider writing you a check.  And while it’s true that bootstrapping should definitely be considered, it simply isn’t feasible for a lot of business models; unless you’ve got some deep pockets.  For that reason, the “friends and family” round – $25K, $50K, $100K, whatever, just enough to build something angels actually find attractive – is often the difference between startups that scale, and those that never get off the ground. And statistically speaking, most people’s friends and family are non-accredited.

How do I safely take non-accredited money?

As a startup that knows professional venture capital will be essential to scaling, taking non-accredited money is not “safe” in an absolute sense.  No matter how you structure it, having non-accreds on your cap table/balance sheet will raise questions and diligence from future investors.  The real question should then be, given that whatever consequence is better than shutting down, how do I raise non-accredited money as safely as possible.  Here are some principles for taking non-accredited money, while minimizing the chances that it’ll prevent professional funding:

  • Get help.  Work with an experienced startup lawyer to ensure that you comply with relevant regulations as closely as possible, and within budget, for the financing.  A misstep from a legal standpoint could create an unfixable problem down the road.
  • Limit the group.  Take money only from people you consider true friends and family who can afford to lose all of the money they give you, and who understand that losing the money is a real possibility. This means people who care about you, want you to succeed, and absolutely do not view this money as a lottery ticket to becoming rich. This is not crowdfunding.
  • Lenders; Not Investors.  View the non-accredited friends and family as lenders, not investors.  Make it crystal clear to everyone that their money is a loan, not an investment.  It will not convert into stock, and hence if you hit it big, they will not get a piece of all the upside.  Post-IPO, you can offer free rides in your Bentley and shower them with benjamins. Just don’t offer them stock today. If the company succeeds, the money will be paid back. Offer them a very high interest rate, and work with your lawyer to structure a non-convertible promissory note.  Anyone who will write you a check for $5,000, knowing that it is extremely high risk, and that there’s no chance of a 100x upside, must truly be in it just to help you succeed.

Important sidenote: If you have people who are willing to back you in the above way, you are rich – in a way that many people aren’t. Other people leverage their affluence. Leverage yours.

  • Long Maturity; Subordinated.  Set the repayment terms of the non-convertible note so that the debt does not become “due” until the Company has raised a significant amount of money, maybe $2 million+, and that the debt will be subordinated to all future debt issued to professional angel (accredited) investors.
    • The goal here is to allay any fear from angel investors that their money will be used to repay your non-accreds, instead of funding growth.  The money is not payable until a true VC round, and their debt is always senior to the non-accred debt.

Does following the above principles mean that having non-accredited money in your company won’t blow up a possible financing? No, it doesn’t.  But, in my opinion, it will significantly de-risk things for you.  When VCs or angels ask about your non-accreds, you can make it clear to them that (i) everyone knows that they are being paid back, will never be equity holders, and are subordinated to all other investors, and (ii) they are a highly vetted group of true friends/family who will be cooperative with whatever helps the founders succeed. Once they are paid back, they are a non-issue.

To be clear, I am not promoting the funding of startups with non-accredited money in a broad sense.  I tell founders the exact same things other experienced startup lawyers do: it’s a bad idea, it creates more disclosure obligations, and some investors might not touch you.  If you can avoid it, do so. But being alive yet uncomfortable is always preferable to being dead.  And my observation is that, at least in Texas, a F&F round is often a prerequisite for progressing far enough to where angels find you investable. Drink the mucky water, and live to fight another day.

 

Reserve an Option Pool; Not an Ocean.

TL;DR  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.

409A as a Service: Cash Cows Get Slaughtered

Background: 409A is a set of tax rules passed, in part, to stop companies from avoiding taxes through issuing underpriced (cheap) equity as compensation.  While well-intentioned, it spawned a cottage industry of third-party valuation firms/i-bankers who charge companies, including startups, thousands (sometimes tens-of-thousands) of dollars to get ‘409A valuations’ for their stock to avoid tax penalties in setting their stock’s Fair Market Value.

Anyone who deals with 409A valuations on a regular basis knows that they are the quintessential ‘cash cow’ for valuation firms and small i-bankers; evidenced by the number of those firms that are constantly inviting lawyers and influential tech players out to lunch in order to get referrals (btw, sorry guys, I’m blogging right now). And if they’ve dug a little deeper, they’ve found that, particularly at the early stage, these valuations are generated in an almost entirely automated fashion. Hence, cash cows: premium price, lots of hand-waiving to make them seem difficult to produce, but ultimately with a low marginal cost.

The Necessary Evil

In practice, startups have been advised by lawyers and their advisors to avoid a 409A valuation until a Series A. Pre-Series A there’s usually not much on the balance sheet and no arms-length price on the Company’s equity to generate a meaningful valuation, so startups just wing it.  Post Series A, however, the vast majority of startups pony up $3-10k to get their valuation, and it has to be refreshed (i) every 12 months, (ii) if there’s a material change in the startup’s financials, or (iii) if a new equity round is done; otherwise it goes ‘stale’ and no longer provides a safe harbor on FMV.

That can get expensive quickly, though any serious company looking to get acquired by a large company or eventually go public knows that the consequences of not doing this can be substantially more expensive.

409A-as-a-Service: The Slaughtering

Finally, eShares (the paperless stock certificate and capitalization tracking company) has pulled off something brilliant: 409A as a Service. Priced as a continuous service (which makes total sense given the on-going need for re-doing a valuation) and supported by well-known and established valuation firms, startups get continuous 409A valuation services at a monthly fee: $159/mo for a post-Series A startup – higher for later stage.

Doing the math, that’s $1,908/yr: easily a 40-50% discount on even the most ‘sweetheart’ deals offered by local valuation firms for post-Series A startups. If you need a refresh within a year, you’re in 90%+ discount territory. Add in the fact that (i) it’s done paperlessly via the web, and (ii) the valuation will be updated for major changes in capitalization or financials (no huge cost to avoid going stale), and we have ourselves a game-changer.

The pricing for Series B, Series C+ valuations is even more competitive relative to market rates for 409A services.  It’s also a brilliant feature for eShares because of how it ties in directly with their existing capitalization tracking platform.

Something tells me that this slaughtered cash cow is going to net eShares and Preferred Return a lot of steak dinners in the future.  The cottage i-bankers who’ve built practices off of milking 409A as much as possible? Not so much. The better i-bankers of course do higher-value things that justify their costs, so they have nothing to worry about. Yes, there are serious parallels to startup law here.

Nutshell:  Startups historically had to pay $3-10k for a valuation after closing a Series A in order to protect themselves from 409A issues, and they had to keep re-paying it on an on-going basis to keep it from going stale.  eShares has changed all of that by offering 409A valuations as a continuous service (as they should be) and pricing them in a manner that aligns more closely with what it costs to produce them.  Cash cows, particularly when visible to techies who like to disrupt things, eventually get slaughtered.

p.s. Like all of the other tools I recommend to startups for saving their capital, I have no financial interest in eShares.