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 possibleand 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.

 

Contracts are for the Divorce; Not the Honeymoon.

Principles:

  1. Small holes have a way of widening when you push a few zeros through them; and
  2. When a contract is being negotiated, founders are focused on the marriage. Their lawyer is (or should be) focused on the divorce.

Founders, for personality reasons, often pride themselves on being “closers” and able to accept levels of risk that others aren’t willing to tolerate.  They’re “upside” people. That’s generally a great thing, but seasoned negotiators know how to play off that tendency to their advantage.  This happens all the time:

Background: A draft’s been delivered and negotiated back and forth a bit. Then, right before signing, the other side’s counsel drops in a provision that they say should be uncontroversial – and casually includes a signed signature page, ready to close.

Company Counsel: (speaking to Founder) This provision is problematic.  It could lead to X, Y, or Z. I’ve seen it happen before.

Founder: (speaking to lawyer) Ugh, seriously? I just want to close this deal.

:: after discussion, Founder calls Investor to discuss ::

Investor: Your lawyer is being paranoid. There’s no way we’d do that. We’re all aligned here.

Founder: Yeah, you’re right. Damn lawyers.

:: Docs get signed ::

When the Company becomes more valuable, X, Y, or Z ends up happening.

Founder: F***ing S****!@#

Paranoid? No, Experienced. 

Why do good startup lawyers see red flags where founders just see corner cases holding up deals? The answer is simple, and it’s not risk-tolerance. It’s volume.  This is often the founders’  first VC deal, or at least they’ve never dealt with a fall-out with investors or business partners.  This likely isn’t even the lawyer’s 50th rodeo. The lawyer knows that contracts are drafted during the honeymoon, but enforced during the divorce. And holes in contracts have a way of getting bigger when there’s 7+ figures ($) waiting to be pushed through them.

Granted, there are a lot of lawyers who do in fact make mountains out of molehills.  See ‘When it’s time for your startup lawyer to shut up.‘   But that doesn’t mean that a good lawyer will simply gloss over all issues to keep the business parties happy. Founders need to be prepared when experienced negotiators push the “let’s just get this closed, we’re all aligned here” button to discredit a lawyer’s advice. It’s an old-school tactic.

Good Cop, Bad Cop.

So my advice to founders stuck in this scenario is to go with another oldie-but-goodie: good cop, bad cop. In other words, ask, but blame your lawyer.  It goes something like this:

Investor: Your lawyer is being paranoid. There’s no way we’d do that. We’re all aligned here. (replay)

Founder: Yeah, you’re right. He is paranoid.  I know you’d never do X, Y, or Z. Lawyers are such a pain in the ass. But can we just make the change so that we don’t have to discuss things with him again?  We’re ready to close if you are.

Sidenote: I’ve found joint lawyer bashing to be an essential part of the founder-investor bonding experienceDon’t miss out.

Deal lawyers don’t mind being the bad cop at all. They’re used to it. It works.  Well, only if they’re actually your lawyer. See ‘Don’t Use Your Lead Investor’s Lawyers.’ You preserve your image as a closer, but still avoid the landmine pointed out by your “damn lawyer.”

If you don’t trust your lawyer, you should get a new one. And if you say you trust him, you should pay attention when he says that there is a serious problem in a contract.  We’re not all risk-averse pedants. We’ve just seen enough divorces to know what “we’re all aligned here” really means.

 

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.

RepresentationsTypical 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.