Post Category → Formation

Friends and Family Rounds

Nutshell: A friends and family round should look, contractually, much like an angel round, and it will be subject to all the same rules/laws. However, there are a few crucial differences that will ensure (i) a smooth transition from F&F to angel money, and (ii) that your friends and family were given fair economics for all the risk they took on.

Before anything else, let’s get the definition of “friends and family round” out of the way: a financing round… involving only friends and family.

Notice how that definition doesn’t sound very “legal” or “official?” That’s because it isn’t. There is no legal definition of “friends and family round” because the term is meaningless with respect to all the regulatory restrictions/requirements that go into raising money as a startup.  Everything still applies. Most importantly, if you want to eventually raise VC money and aren’t totally desperate, those friends and family still need to be accredited investors, just like angels and VCs do.

Good Background Reading:

It’s well known and documented that the average cost of “starting” a startup and getting to a professional funding round is, today, a fraction of what it was 10 years ago.  And while that’s very true, a lot of founders have taken this fact to a conclusion that doesn’t quite fit with reality: that you can start a tech company with very little money, and bootstrap your product until angel investors find it attractive enough to close a seed round. This works for a limited number of businesses and groups of founders (with strong technical skills), but the truth is that for a whole lot (most) of tech companies it still takes at least $75-$200K of capital to get to a point where even angels will find it attractive.

Reality Check: Before Angels, You Still Need Money

Angel investors, especially angel investors outside of SV, very very rarely fund ideas or even MVPs.  They fund companies who can show credible traction with paying, or at least strongly interested, customers. All the cloud products and X-as-a-Service economics don’t change the fact that getting there usually takes some real money. The result is that, in the vast majority of instances I’ve observed, founders who close on seed money were supported first either by a decent amount of their own funds, or by affluent (accredited) friends and family.

Truth: many, if not most, founders who start successful startups are not coming from working class, or even middle class backgrounds.  They’re able and willing to take risks many others won’t because they have a personal support network to (i) fund them before professional angels are interested, and (ii) keep them from hitting rock bottom if everything blows up. That or they’ve already earned some money and have built their own bootstrap fund. They’re still ballsy risk-takers, no doubt, but they usually have parachutes unavailable to a good portion of the population. In any event, they are not attending pitch competitions or angel meet-ups before they even have a functional product, credible traction, and a rational business model. They use F&F money first to get there, and then go after angels.

As a side note: I’m not writing the above to discourage anyone without affluent friends and family or a decent savings account from pursuing their dreams.  I’ve of course also seen successful founders who risked actual homelessness to build their companies, but those are few and far between.  If you’re going to do it, at least know what you’re getting into, and what resources others had available to them before they themselves took the plunge.

The Structure of a Friends and Family Round

So friends and family rounds are important. Very important. A few key principles for structuring one:

  • Everyone should still be an accredited investor.
  • To keep legal costs down, it should look (on paper) exactly like a small seed round with angels (convertible note or SAFE with discount to future Series A price), save for a few crucial differences (described below).
  • Unless someone in your F&F group is a professional angel investor who is comfortable setting a valuation on your company, it should under no circumstances have a valuation cap.
  • It should contain what’s often referred to as an “MFN” (most favored nation) provision allowing the terms to be amended and restated to be on par with the next financing round (when angels get involved). This ensures that the lack of a valuation cap does not result in your later investors (who usually insist on a cap) getting a better deal than your biggest risk-takers (your friends and family).

The reason for not having a valuation cap is simple: if you don’t know what you’re doing, you’ll either (i) make it too high and signal to future investors that you’re a bit clueless, and it will look bad if your next money gets a lower cap than your earlier (highest risk) money, or (ii) you’ll set it too low, and future investors will use it as a starting point for arguing why their valuation cap should be low as well. The latter issue is referred to as “anchoring” your valuation, and it’s not a good idea.

A convertible note or SAFE with a discount on the Series A/AA price, no valuation cap, and an MFN provision is the most common structure for a F&F round. However, it often makes sense to provide one extra provision that, while totally logical, isn’t quite convention: the MFN should ensure that your F&F get a discount on the valuation cap that angel investors get.  

The classic MFN in a F&F note ensures that, at best, your F&F will get the same terms as your first angel investors.  But obviously your friends and family took on way more risk than even your earliest angels will. Though it means a bit more dilution, if you want to be as fair as possible you’ll ensure your F&F MFN includes language amending the F&F notes to include a valuation cap that’s, say, 20-30% lower than your first angel notes/SAFEs. Most friends and family won’t ask for something like this, because maximum return is not their primary motivation in writing you a check: but many founders would agree it’s the right thing to do for the people without whom you could never have built the company.

Finally, the above principle can logically be applied to Founder Convertible Notes as well. If you’re papering investment in your own startup well before angels will even talk to you, you shouldn’t be setting a valuation, but there’s a good argument for why it should still receive terms that are at least slightly better than what your first angels receive.

Early Hires: Options or Stock?

Nutshell:  While the conventional equity path of a startup is to issue (i) common stock to founders and (ii) options to employees, early hires concerned about taxes will often insist on receiving stock as well. Voting power, along with other political factors, present a few tradeoffs for founders to consider in that scenario.

Vocabulary:

  • “Option Pool” – a portion of the company’s capitalization set aside (after founder stock is issued) for equity issuances to employees, consultants, advisors, etc., and subject to a special “plan” designed to comply with complex tax rules.  Even though it’s referred to as an “option” pool, properly designed equity plans will allow for direct stock issuances under the pool as well; not just options.
  • “ISO“ – Incentive Stock Option – a tax-favored type of option issuable only to employees, if certain requirements are met. The main benefit is that upon exercise, the difference between the exercise price and the fair market value on the stock at the time of exercise is not taxed as ordinary income. However, it is subject to the Alternative Minimum Tax (AMT), which can hit certain people depending on their tax situation.
  • “Restricted Stock” – For purposes of a private startup, just another way of saying Common Stock. The same security that founders get, except for non-founder employees it’s usually issued from the “pool” (under the Plan) using different form documents.
  • “Early Exercise Options” – Conventional options issued to employees are not exercisable until they vest; meaning until the recipient has worked long enough to “earn” the right to exercise them.  Early exercise options have modified vesting/exercise provisions so that they can be exercised from Day 1 – with the underlying shares becoming subject to the vesting schedule.  From the Company’s perspective, early exercise options are very similar to restricted stock issuances. The only real difference is that the recipient has the option to exercise and receive the Stock on Day 1, or sit on it and exercise later.

Convention.

The conventional path of a Company’s equity issuances goes something like this:

  • Founders receive direct issuances of Common Stock (not options)
  • Non-Founder employees receive ISOs (options)
  • Consultants, advisors, etc. receive NSOs (options)
  • Investors receive Preferred Stock, or SAFEs/Convertible Notes that convert into Preferred Stock

Backround:  

  •  The value of restricted stock is taxable as ordinary income on the date of issuance, unless its fair market value (FMV) is paid in cash.
  • Options, both ISOs and NSOs, however, are generally not taxable on the date of grant, as long as their exercise price is equal to the FMV.
  • So, you would normally expect employees to prefer receiving options over stock. No tax > Tax. And this is the case when the stock’s FMV is relatively high. That’s why later hires (usually after a Series A) almost always receive options, without question.
  • Stock gets to vote on stockholder approvals. Options do not (until they’re exercised for stock).

The Issues: Early employees want to minimize tax. Companies want to avoid giving away voting rights/complicating stockholder votes too early.

  • However, in the very early days of a startup’s life, avoiding tax on restricted stock is easy because of how low the FMV of the stock is (fractions of a penny): write a check for a few dollars (the full FMV), or just pay the tax on the few dollars of ordinary income.  You therefore get the “no tax on grant” benefit of options, without worrying about paying tax later on an exercise date.  Receiving stock also gets the clock running on long-term capital gains treatment.
  • Therefore, very early hires, when they do their homework, tend to insist on receiving restricted stock (or early exercise options) over conventional options. Better to deal with tax when the stock is worth (at least to the IRS) virtually nothing, instead of years later upon exercising the option when the tax bill could be much greater (ordinary income for NSOs, or AMT (for some people) for ISOs).
    • Sidenote: Conventional equity plans also have a 90-day post-termination exercise period, meaning, when an employees leaves a company (voluntarily or involuntarily) they have to exercise their options within 90 days, or they then get terminated – even if vested. Paying the exercise price isn’t an issue for an early hire in that scenario, because it’s very low (the fractions of a penny FMV), but if the AMT comes into play it can hit them with a tax bill.  This doesn’t come up in a Restricted Stock scenario.
  • The tradeoff from the Company’s perspective is that, just like founders, those hires that receive restricted stock will have full voting rights (including seeing whatever is submitted for stockholder votes) for all of their stock on Day 1, before they’ve vested in anything.  When only one or two people are in question, this may not be a big deal. It can be a way of making early employees feel like a part of the core team, because their equity is being treated just like founders.  When there are more than a handful of hires, however, it can get unwieldy fast. The number of people to consult for stockholder votes can go from 2-3 to 10, 15, 20. If there are consultants and advisors in the picture, they may start to ask why they aren’t getting the same tax benefits as early hires. And then at some point you have to draw a line and start granting options. Is the first optionee not as special as the restricted stock people? Politics. 

Generally speaking, the decision to give restricted stock v. options to very early hires is a practical/political one.  While the tax-favored nature of ISOs means that most early employees won’t see much of a tax difference between receiving ISOs v. restricted stock, the prospect of an AMT hit in the ISO scenario does make restricted stock, on net, better for recipients.  That needs to be balanced, on the company’s side, against the early voting power/information rights given away when an employee receives stock instead of options, and how it will play out with all of the company’s other hires.  

My general advice to founders is to be aware of the tradeoffs, and to consciously treat the early voting power and tax benefits associated with restricted stock as currency not to be wasted.  If there’s a very early superstar that you deliberately want to single out as a key player, use the currency.  If not, then make the decision based on all the other factors. Company culture will likely factor greatly into the calculus.  Many, many founders prefer to avoid the politics/complications and simply draw a line at the founder (stock)/non-founder (option) division.  Others are more selective. There’s no magic formula.

A few separate issues worth addressing:

  • The 90-day post-termination exercise period (after which unexercised options, vested or not, are terminated) often gets criticized as being unfair to employees, and there’s some justification for that criticism. The view is that the employee shouldn’t be forced to “use it or lose it” if they did their time (their option vested) and are now moving on to a new company.
    • The actual 90-day number comes from tax rules requiring that ISOs be exercisable only within 90 days of termination.  If an option is exercisable after that, it automatically becomes an NSO for tax purposes. But there’s nothing in the tax rules requiring that the option be terminated at 90 days. That’s largely meant (i) as a deterrent (frankly) to people quitting, and (ii) a way to clean up the cap table for people who didn’t want to pay their exercise price, allowing that portion of the pool to then be re-used for new hires.
    • While the 90-day period is still convention, key executives/hires will often either negotiate for an extended exercise period for their own grants, or the Company will as a gesture of good will, decide on its own to selectively extend the period when someone leaves on good terms.

Obligatory Disclaimer: This post contains a lot of fundamentals and generalizations on tax rules, but it’s obviously not intended to be an exhaustive statement of those rules. Circumstances vary, and you should absolutely not rely on this post without consulting your own attorney and/or tax advisors.  If you do, don’t blame me when it blows up in your face.  You’ve been warned.

How Founders (Should) Break Up

Nutshell: There are two ways for founders to break up. One preserves everything those founders built together, including a chance of a successful outcome. The other can bring everything crashing down, ruining months, even years, of hard work, and damaging lives in the process. Simple decisions made at the beginning of the relationship dramatically influence which outcome you end up with.

Worthwhile reading:

First off, like any good lawyer, let’s get our definitions straight. I’m talking about Founders (capital F) in this post – meaning the people who were there at the beginning of a startup, or at least well before it became something investors wanted to buy a part of. For better or for worse (probably worse), the term “founder” has become just another title that gets negotiated by early hires to help artificially build their street cred. If you showed up to a startup with your own lawyer, or with data on compensation packages, you’ve gone through very different dynamics from actual founders.

The Honeymoon Period – Setting the Foundation.

Know and trust each other. 

It sounds sappy, but it’s unquestionably true: starting a startup with a cofounder is about as close (emotionally) to starting a family with a spouse as you’ll ever get, without actually starting a family with a spouse. CEOs refer to their startups as “their baby,” and they’re not kidding.

You have to go in totally trusting the other person, and committed to the good of the startup as something separate and higher than your own self-interest. If you don’t, you’re demented and asking for a world of pain.  I look at our portfolio of startup clients, and the vast majority (but not all) of the top ones were started by either (i) two or more cofounders who are real friends, or (ii) a single founder with total control. In each case, minimal time is spent arguing over equity %s or vesting schedules. It doesn’t mean everything is lollipops and sunshine, but everyone knows their role. Founders who are mere ‘business partners’ generally underperform compared to founders with a strong, personal relationship.

Paper it.

Different people have different approaches to marriage. Some are big on prenups, and others aren’t. But for founders, sign some damn contracts. Standard ones that shouldn’t take startup lawyers very long to produce. They should have:

  • Clear language regarding the Company’s ownership of all IP;
  • A vesting schedule (~4 yrs), with a cliff (~1 year);
  • Non-solicits and (depending on the state, but def. if you’re in TX) non-competes;
  • Language about returning all company property on termination; and
  • No ambiguity as to what happens if/when a founder leaves voluntarily or involuntarily.

I’ve often heard founders say something like “we don’t have VCs yet, so we don’t need vesting schedules.” Totally wrong reasoning.  The vesting schedule is there to ensure that if someone walks away before a meaningful milestone (especially if they walk away angry), they can’t take with them any chance of the Company’s ever succeeding.  Try raising VC money with 40% of your cap table held by an inactive founder.   The cliff serves a similar purpose – it puts in black ink what everyone should already understand: this is a long-term project, and if you’re not in it for the long-term, you shouldn’t be signing up.

Papering this kind of arrangement among a good group of founders should not be controversial.  If I start seeing founders bickering over vesting schedules, or random contingencies in their founder docs, my views on their long-term prospects are automatically dropped several notches.  I’m also not a fan of founders negotiating “single trigger acceleration” among themselves – “if you fire me, I get X% of my vesting schedule accelerated”.  If you’ve chosen the right founders, no one should be getting fired unless it’s the right decision for the startup. And if it’s the right decision for the startup, you shouldn’t be walking away with more than what you actually earned.

When the Honeymoon’s Over – A Clean Break.

I’ve said it before, and it’s worth repeating: Contracts Aren’t for the Honeymoon; They’re for the Divorce.  While there are hundreds of reasons why a founder might break away from a startup, if the proper foundation was set, there should be minimal legal ambiguity as to what happens to the startup when that founder is gone.  IP stays, as do all unvested shares. The departing founder keeps what she vested. Deliver everything to the company relating to the startup – hardware, code, login credentials (which should be changed after the departure), etc. Don’t try to take any employees with you, or build a competing product. Move on.  

A simple letter stating the definitive termination date should be delivered by the Company to the departing founder, spelling out what the post-termination equity holdings will be, and delivering the small amount of money needed to repurchase the unvested shares.  It’s also often considered a best practice to give a departing founder a small “sweetener” – a few extra shares, or a little cash, in exchange for signing a full waiver and release of all claims, including a non-disparagement clause (you can’t start insulting everyone on twitter).  Hopefully there aren’t any real claims to waive, but when VCs diligence the company and see an exit of a major founder, it gives them a bit of comfort to see that release signed.  Founder lawsuits have a way of creeping up once a few zeros are added to the valuation.

Emergency Maneuvers.

Not everyone is so lucky to have a clean founder breakup.  Sometimes angry founders refuse to return company property, or refuse to sign documentation relating to their departure.  I’ve even seen situations in which founders are caught maliciously hacking into servers.  Prepare yourself.

If the proper legal foundation was set early on, a refusal to sign anything shouldn’t be a serious problem. Good founder docs are drafted so that simply e-mailing a termination notice, along with a check, gets everything material done. Signatures on termination docs is nice, but not essential. As to other things like refusing to return property, usually the first step is to have some personal conversations about how small startup ecosystems are, and that reputations take a long time to rebuild. A nastygram from your corporate lawyers can help too.  If all that fails, it may be time to get other lawyers (litigators), or other authorities, involved. Hopefully it never gets there.

But if you didn’t do what you were supposed to do when the founders first got together, and now you have an angry, defiant founder who perhaps still owns rights to company IP, or has walked away with half the cap table… well, you fu**ed up. Is this the end of your company? Not necessarily, but it definitely could be. Talk to your lawyers. Maybe there’s enough of an e-mail trail making it clear that IP was intended to be transferred. Maybe a recapitalization (a ‘recap’) is possible to wipe out everyone’s equity and start fresh. Maybe you can eventually convince them to sign the right docs now.  Maybe. Regardless of the outcome, you’re going to be paying your lawyers a lot more (like 20-100x) to clean it up than you would’ve paid to do it right on day one.

Only idiots start families with people they don’t trust, or truly understand. Founders who start companies with people they don’t trust, or who think it’s unnecessary to paper things properly, aren’t much smarter. Find the right cofounder, and then sign some damn contracts. Then hope you never have to read them again, and start building.