Post Category → Founders

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.

Why Founders Don’t Trust Startup Lawyers

“We received a term sheet from a competing VC syndicate, and if I go to our current lawyers, our existing investors will find out about it before I want them to.  Our law firm does a lot of work for our VCs.”

“Our VCs told us that if we used their preferred law firm, they’d close more quickly and even save us money by not hiring their own lawyers. But if we went with another firm, there ‘could be delays.'” 

“I went to my Board to disclose this highly confidential issue that only our lawyers and I knew about, and I realized that our VCs were already aware of it. No one but our lawyers could’ve disclosed it.”

“The lawyers that our investors connected us to said that the valuation in our term sheet was about market. It was only after closing that I found out we got totally hosed.”

The above are quotes or paraphrases of statements that we, as a firm, have heard directly from founders/executives as they explain their reasons for changing law firms. The unifying theme should be obvious, and it relates to the broader issue of why so many founders have such dim views of startup lawyers in general. In short, by playing fast and loose with conflicts of interest in the pursuit of maximizing short-term revenue, many startup lawyers and law firms have squandered their most valuable currency: trust.

Related Reading: How Founders Lose Control of Their Startups

What is Counsel?

No one who reads SHL or interacts with E/N’s tech practice would argue that our approach to the practice of law is “old school” in any sense of the term. The significant drivers of our growth include rethinking major facets of law practice, including organizational structure, compensation models, project management and technology adoption. However, while I am very much a tinkerer with respect to the delivery of legal services, I am quite old-school in my view of what lawyers fundamentally are, or at least should be: trusted counsel.

In a heated, high-stakes lawsuit or investigation, virtually everything you’ve ever said in writing to investors, to other executives, to friends and family, can be forced out into the open for everyone to review except for confidential communications with the Company’s lawyers (attorney-client privilege).  Take a moment to let that sink in. Nothing that you ever do or say as a company is more secure from forced disclosure than what you say to your lawyers.  That is, of course, unless the lawyers themselves disclose it.

Ask many founders whether they really trust the lawyers representing their company, and some will flat out say that, to them, their lawyers are just subject-matter experts there to paper deals and ensure the company doesn’t blow up from legal issues; highly-educated paper pushers and fire extinguishers.  Others will say that they do trust (in a sense) their lawyers, but when pushed into a serious, high-stakes situation in which total objectivity and confidence is paramount, the reality of their superficial relationship will surface.

  • Is the valuation they’re offering appropriate for our company, geography, and market?
  • Is this provision dangerous? Is it standard?
  • Some local people are pushing us to X accelerator, but we’re not sure it’s right for us. What should we do?
  • We need to make a major strategic shift that some of our stakeholders will want to block – what are our options?
  • My company is going under if I don’t get this deal done, but X investor says he will block it. Can he? What are my options?
  • We just got an acquisition offer, and I’m not sure whether it’s fair to me and my management team. What should we do?
  • One of our senior executives just got arrested. No one can find out about this until we know more. What do we do?

These are just a few of the kinds of questions that trusted counsel gets asked.  But trust, particularly the kind of trust we’re talking about here, carries a high price tag: independence and objectivity.  How can you trust my opinion about whether an acquisition offer is fair to the Company if the investors pushing you to sell have me on speed dial, and just sent me an invitation to their pool party? How can you trust me to give an honest assessment of a term sheet, or even a comparison of one term sheet v. another, if I’ve closed 20 deals for the VCs who submitted one of those term sheets, and have 3 more in the works? You are one deal. They are 25. Lawyers aren’t that bad at math.

Let’s be real: you can’t. Not possible. Founders know it, and in a world in which so many lawyers have given into the incestuous biz dev practice of playing both sides of the VC table, the result is a deep cynicism toward startup lawyers. Do I choose X firm or Y firm? Whatever. They’re all the same. I’ll just go with the cheaper one, or whatever one makes closing my financing easier. Some lawyers who regularly represent startups have even strategically made VC fund formation a core component of their firm. Smooth.

What “Alignment” Really Means

To the majority of lawyers (outside of the startup space) and investors (outside of the startup space), the above views are totally uncontroversial.  Make sure your own lawyers are independent and objective? Umm, yeah, thanks Captain Obvious. And even within the smaller sphere of startup/VC work, I know several investors and lawyers who draw a hard, ethical line to ensure that their reputation is not muddied in the pursuit of short-term revenue. If their investor-client is investing in a startup, they don’t shimmy over to the other side of the table with a smile on their face and a conflict waiver in-hand. They insist that the startup get their own lawyers. Trusted counsel.

But then there are the other people. “Deals get done faster” – “Startups save money on legal fees” – and (my favorite) “We’re all really aligned here, so why do we need two sets of lawyers?” Seriously?

I like to take complex issues and distill them into very simple statements totally free of B.S., so here’s one for you: when someone buys your startup for $200MM, there’s ultimately two places that money can go: in your pocket (and of your co-founders, team, etc.), or the pocket of your investors.

What was that about “alignment” again? And to be clear, the price tag gets negotiated in the acquisition, but guess where the % distribution between Pocket A and Pocket B gets largely negotiated? Financings. 1% of $200MM is $2 million.  So you’re negotiating whether millions of dollars in an exit will go into founders’ pockets or VCs pockets, and you’re telling founders they should just use the VC’s lawyers to close the round – because it saves maybe $10-20K in legal fees? Right. Thanks for ‘looking out’ on the legal budget.

Founders and their investors have shared interests in building a highly successful, profitable company. That much is doubtlessly true. But anyone who uses “alignment” as a justification for founders not worrying about the independence of their company’s lawyers is either (a) totally lying or (b) laughably lacking in even a basic understanding of human nature. 

This is not to say at all that founder-investor relations should be viewed as adversarial. Clearly not. I’m all for honesty, respect, transparency, and the like in company-investor relations.  It’s an important long-term relationship.  However, healthy relationships are built on reality. And the reality is that VCs have limited partners for whom they are legally obligated to maximize returns. It doesn’t at all make them bad people. It just means that they, like the rest of us, have a job to do. They are not your best friends, they are not your mom, and they are most certainly not fully “aligned” with the company’s economic interests. Hire your lawyers accordingly.

Drawing a Firm Line

In Austin, you frequently hear the mantra “be authentic.” No, not authentic in some anti-corporate, hipster sense, but “be who you say you are. do what you say you’re going to do.” Don’t hide behind excuses like “this is how it’s always been done before,” or “this is how the game has to be played.” Change the game. Rewrite the rules.

A while back the tech/vc attorneys at E/N sat down together over lunch to discuss the above issue. We’ve all dealt with it at prior firms we worked at, and there was no possible way of doing anything about it there. But there’s a funny thing about leaving big, corporate environments for smaller, focused firms (like startups) – it’s much easier to establish a set of firm principles, infuse them into the group’s culture, and protect them as the group grows.  And here we are: E/N, as a firm, does not and will not play both sides of the Tech VC table.

Everyone here understands it, is committed to it, and anyone who wants to join the firm will have to as well. And many of our clients are well aware of high-profile early-stage investors whom we’ve, politely, chosen not to represent as a result of this policy. Loss in short-term revenue? Sure.  But this is a long-term play. Rather than following other lawyers and firms in chasing anyone who will write us a check, we believe deeply in preserving our clients’ trust, and have chosen to bet on it.  If you want a paper pusher, I’m happy to make some recommendations. We provide legal counsel.

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.