Post Category → Funding

The Economic Deflation of Startup Law

News.  Two big issues have been floating around the startup law space lately. First, Yokum Taku introduced “convertible equity” in an attempt to address the potential downsides (for entrepreneurs) of convertible debt, which set off a debate that Antone Johnson spectacularly Storified. More interesting to me, however, was AngelList’s announcement that seed rounds can now be closed, soup-to-nuts, on their platform.  The real news there, for lawyers at least, is that Wilson Sonsini will close those rounds for free.  Yes, as in nothing.

Startup Law – Deflation Accelerating

Much has been written about the “deflationary economics” concerning startups and the web, with Mark Suster’s post probably being one of the best articulations that come to mind.  Not as much has been written about the indirect effects that industries experiencing economic deflation can have on other sectors they interact with.  Wilson Sonsini’s AngelList pronouncement is, in my opinion, the clearest sign that the portion of the legal sector working with technology startups is itself experiencing rapid deflation — and not because lawyers have suddenly shed their luddite tendencies and read ‘The Innovator’s Dilemma’ (though they should).

What’s happened, essentially, is that with literally every other service used by their clients becoming radically cheaper, and the resulting downsizing of investment rounds, startup lawyers simply couldn’t maintain their usual fees and keep a straight face.  This deflation started out with what you might call Stage 1 deflation, with standardized docs emerging, fixed fee packages, etc.  Startup Law was just efficient at this stage, especially compared to other areas of the law.  But with free, dynamically generated documents from high-end firms available online, and now with one of the best firms in the country saying they will close seed rounds for free, I’d say its reached Stage 2, where commoditized is the more appropriate adjective.  And I’d argue that this has some serious implications going forward.

How We Got Here

First, it’s worth reflecting on the different steps that startup law firms have been (or should be) taking in order to compete in this deflationary environment.  I’d break those steps into 3 categories: contractual, technological, and operational.  These steps could also serve as a model for other parts of the legal field that, while not as aggressively deflationary as startup law, will likely eventually follow a similar path.

Contractual. 

  • Standard Firm Docs – In order to make contract drafting more efficient, firms started modularizing the language of their own documents.  If an investor gets a 1x participating liquidation preference with a 3x cap as opposed to the 1x non-participating currently in the document, ‘drafting’ involves mostly cutting and pasting bracketed language, with minimal tinkering.  While this cut down on internal drafting, it still left room for bickering about language with the other side of the deal.
  • Universal Standard Docs – Going one step further, standardized investor docs like the Series AA and the NVCA Model docs emerged, allowing for parties on both sides to have a common language framework to work from.

Technological.

The contractual efficiencies developed in startup law still required the usual process of opening a word document, filling in blanks, moving around language in a very straight-line fashion, and then proofing to make sure everything is coherent.  Closing required creating signature packets, then tracking signatures and assembling them back into fully executed copies.  But then technology emerged to streamline a lot of this process.

  • Proofing Software – A significant amount of time on a transaction used to be spent by junior attorneys flipping through pages to make sure names are properly spelled, commas are in the right place, and defined terms are properly in place.  Software like Deal Proof emerged that can scan a document and generate a proofing list for an attorney, cutting down on that proofing time by anywhere from (my estimate) 50-75%.
  • Document Automation – Companies like Brightleaf have emerged to turn the cut-paste-and-proof process of working with form docs into one of simply clicking certain options in a form.  Want that 1x participating LP w/ 3X Cap? Just click the right box in your template, and the language will get filled-in automatically, and every other area of the document that is impacted will also be modified. No need to proof.
  • Electronic Closing.  –  With multiple parties often signing dozens of documents, the usual closing process involved creating “signature packets” where you PDF’ed the signature pages of each contract, and created single files containing all the pages that each individual party had to sign.  Without doing this, mistakes would be inevitable.  With electronic signature software like Docusign, this process is largely removed.  Put the ‘Sign Here’ tabs for each person in the appropriate places, and Docusign will (1) guide them to where they need to sign, and (2) generate fully executed documents.

Operational.

One obvious end-result of the contractual and technological developments has been that drafting simply takes a lot less time, which naturally means less money billed.  But what they’ve also done is made the drafting and closing process a lot simpler.  To modify a vesting schedule or a liquidation preference, you don’t really need to understand the actual mechanics of the language. Just click the box.  And to get a deal signed up, you don’t need to create complicated signature packets and coordinate signatures.  Just drop the Docusign tags in the right place, and it’ll do the rest.

Firms have taken advantage of this simplicity by pushing work down to junior attorneys and even paralegals, who bill a lot less per hour.  Where it might have previously required an experienced attorney to draft and close a seed financing, an innovative firm might have a paralegal do 95% of the work, with zero drop in quality.  A partner or senior attorney might spend a few minutes discussing very high-level issues with the client, but that’s it.

The Next Step: Deal Platforms

I have zero doubt that Wilson Sonsini is taking advantage of all three of the above categories.  But the key to really get the kind of deflation reflected in the free AngelList closings is the next step of legal technology: Deal Platforms.  Rather than just the initial drafting of docs being automated, with negotiation over terms and language to follow, the automation becomes bilateral.  If the investor wants a better liquidation preference, he simply fills in a field or checks a different box, and if the Company disagrees, they uncheck that box.

Contract language becomes completely secondary – commoditized – on a deal platform.  One can easily envision a time in which the negotiation of a full venture deal, not just a convertible note financing, involves nothing more than checking boxes and filling in a few fields, with full documents automatically generated and then electronically signed.  The chances of closing such a deal for free are practically zero, but all that automation could make a ~$10K legal bill for a full institutional venture capital financing a reality, which would be about a 50-80% cut on current rates.

Takehome: Nobody should be myopic enough to expect AngelList-like automation to stop at the seed deal stage.  Again, The Innovator’s Dilemma, legal version.  See below from AngelList’s Q&A.

Does Docs support Series A rounds?

No. Docs only supports seed rounds right now. (emphasis added)

Implications: Freemium Startup Law

There are a number of ways that this rapid deflation has and likely will impact the structure of startup law practices.  One result of the already-occurring deflation has been the growth of boutique firms competing with BigLaw by offering similar, albeit more limited, services at lower billable rates.  I wrote about this previously: ‘In Startup Law, Big Can Be Beautiful.‘

The economic advantage of a boutique practice is that firms can avoid the high billable rates necessary to sustain the breadth and overhead of large law firms, while still offering their experienced attorneys comfortable salaries.  That works well in an environment where the demand is for cheaper seed financings and venture deals. But what happens when free or practically free becomes the dominant expectation?

Cross-subsidize.  As Wilson Sonsini’s move has made absolutely clear, large firms have their own economic advantage with respect to legal fees: cross-subsidizing low-end work with profits from larger deals.  Large firms don’t just handle formations, seed financings, and venture deals, they also handle cash cow M&A and IPO transactions that are not experiencing anywhere near the kind of deflation going on at the low end.  Those deep pockets make offering free startup work a lot easier, provided enough of the loss-leaders generate big deals down the pipeline.

This model of offering a lot of stuff for free and profiting off of the high-end users should look very familiar to techies: it’s the freemium model, applied to law.  And it distinctly favors large, brand-name firms.  Boutique firms lack the institutional capacity to handle the large transactions that a larger firm can use to cross-subsidize free work.  Without more radical change, their only hope is to make up for deflation with volume.  But [insert large number] * free doesn’t pay the bills.  Commoditized deal work favors the cross-subsidization of large firms over the lower labor costs of boutique practices.

Conclusion: Move Fast, Move Up, or Move Out

At this point (when deal platforms become ubiquitous), I see smaller startup law practices having to either (A) get used to operating at much lower margins, or (B) find a way to move up-market and take a piece of the larger deals.  I wrote previously about the possibility of boutiques using technology to scale for large transactions here: The Ad-hoc Law Firm? Granted, I don’t have much visibility into how boutique practices are doing, though I’d love to hear from other attorneys or knowledgeable people on how they see the future panning out.

As for large firms operating in this space, the choice is much more straight-forward: either become radically efficient with your commoditized startup work in order to keep the pipeline flowing, or get out.  I’ve seen firms here in Austin completely exit startup work for exactly this reason.  Thankfully, we’re going with the other option.

Post-script (years later): AngelList’s experiment failed, and no “deal platforms” have emerged. Why? Flexibility and coordination. The diversity of options for even early-stage rounds, and their different appropriateness depending on context, makes full standardization and automation an impossibility. And the subjective preferences of various investors (and companies) also serves as significant resistance. Automation and flexibility are fundamental tradeoffs, and the market has chosen flexibility for high-stakes deals.

The Need for a Seed Lead

Over the past several months the issue of signaling risk in seed investments has gotten a fair bit of attention. Here’s a break-down of the concern:

  • Because of the “deflationary” economics around running a startup, (i) seed rounds have gotten smaller such that investment amounts are below what would normally move the needle for an early-stage VC, and (ii) the number of startups has increased as a result.
  • VCs can manage only a fixed number of investments if they’re to avoid letting their attention be stretched too thin, lest they become a mere commoditized source of cash with no value-add.
  • Normally when a VC invests in a company, they’ve done their diligence, reserved a fixed amount of their dry powder for follow-on investments, and someone’s reputation is on the line for the success of that investment.
  • Some early-stage VC funds, in order to stay in on the action, have purportedly turned to a “spray and pray” investment strategy, through which they make lots of tiny investments with minimal diligence at the seed stage; so many in fact that there’s no way they could do follow-on investments for all of them.
  • But with tons of small investments, the claim is that these companies are viewed merely as options, not as portfolio companies that a VC would be more committed to, and the VC is therefore much less likely to participate in the next round.
  • Problem: Because later-stage investors will see this early-stage VC on the Company’s cap table and know that they have the cash to make a follow-on investment (not necessarily the case for an angel), they will understandably become suspicious of why that VC isn’t continuing to invest. This is the negative signal.
  • Theoretical Nutshell: Taking on real VC money at the early-stage is therefore risky because that VC may (i) just view you as an option, (ii) therefore really isn’t all that into you, and (iii) if he/she decides to end the relationship early, could make it a lot harder to find a dance partner for the Series A.

To be honest, I don’t have a dog in this fight. I can’t really because I’m too young and haven’t seen enough deal flow to say whether this happens or not.  I do know that some very well respected people are of the mindset that it does happen, and other well-respected people (and here) think it’s just hot air.  The takeaway that I’ve gotten from a lot of the discussion is that, most likely, some early-stage VCs really do screw entrepreneurs in this way.  But others are sensitive to the signaling issue and are committed to their seed investments. So do your homework.

I recently came across a very interesting post by Roger Ehrenberg over at IA Ventures that talks about the trend of what he calls “party rounds” in which founders, out of a fear of losing control early on, deliberately structure their seed round so that nobody is really a lead investor – lots of small checks.  The crux of his concern is as follows:

What if things don’t happen according to plan?… Isn’t this the time that the deal lead steps up to lead a bridge round assuming management is executing well but simply needs more time? Yes. But wait, we have no deal lead. We don’t have an investor with enough skin in the game to care…. By not having a lead, a partner who takes the long view and has the resources to back it up, the founders have placed themselves in a very risky situation.

What’s fascinating about his point is how, rather than early-stage VCs treating seed investments as options out of some reckless plan to keep their hands in lots of cookie jars, founders are, out of a bit of paranoia, turning themselves into options by not letting anyone write a large enough check.  This is an extremely important perspective to add to the whole signaling debate: there are huge advantages to bringing in a committed high roller at the seed stage.

The worst-case scenario would be to let institutional money into your seed round, but not let them put in real money.  Then you’ve loaded up on signaling risk, while making it virtually costless for them to write you off.

Assuming you’ve found a reputable early-stage VC who is sensitive to signaling issues and willing to take the reins (of the funding, not your company) and grab a large chunk of your seed round, realize that their deep pockets could be a potential lifeline when you hit some road bumps along the way.  And a lot of us know that the Series A is where you’re likely to find road bumps.  There are of course other benefits, like having the VC’s network opened up to you early on.  Regardless of how often founders get screwed by signaling, Roger’s advice is tangible enough to bypass theoretical debate.  Keep it in mind if you’re in the (fortunate) situation of having to choose whom to take seed money from.

Bridges or Seeds? A Primer on Your First Financing

by Nick Ares by Flickr

A lot of discussion has revolved around the appropriate structure for raising a “seed round,” which for most tech startups means a financing under $1M.  The two general options are (1) convertible debt and (2) a “lite” seed equity round.  Conventional wisdom seems to be that you should always issue convertible notes because it means fewer legal fees.  But the truth is that the economics of convertible notes are such that you’ll end up giving back any savings, and maybe a bit extra, through equity and liquidation preference.  While there are a lot of opinionated articles on this subject, my goal here is to be more balanced and simply outline the pros and cons to consider as an entrepreneur, because the right choice has a lot to do with context.

Summary

  1. How much do you intend to raise? – $1M+ likely means a full equity round. Below $500K probably means convertible notes. Somewhere in-between means the below analysis between seed equity and convertible notes.
  2. Who are your investors?  If they’ll happily sign your docs without negotiating them to death, then you should consider equity, provided you know what you’re doing with valuation. Otherwise, convertible notes are better.
  3. How long until your big funding? If you expect to raise money soon, and your Angels feel the same way, then convertible notes won’t cost you much more in terms of dilution.  But if you expect to rely on this money for a long time, and anticipate a rocky future funding environment, you should prefer seed equity.

Reality Check: The reality of many, but not all, startups today is that investors are conditioned to expect convertible notes in seed rounds, regardless of whether equity would be better.  If you find that your investors won’t even entertain the idea of a seed equity round, then you should simply use what you learn to minimize the cons of convertible notes.  Not much else you can do.

General Vocab

Debt/Notes – When you issue a “note” to someone, you are saying that they are lending you money.  Like with most loans, they are guaranteed only a fixed amount of payment, and they have the right to force you to pay it back, which can include liquidating your company.  I’m sorry, did I scare you? Good.

Equity/Stock – Generally, when you issue “stock” to someone, they aren’t “lending” you money; they’re investing it.  This means that if the company booms, they make more money (unlike a lender).  But if it collapses and loses everything, they can’t demand that you give them their money back, absent some showing of fraud

Convertible Notes – Rather than issuing stock, you issue “bridge” notes that carry a specified interest rate, maturity date, and mechanics for converting the principal and accrued interest into stock when the company raises a “qualifying” full-blown equity round.  So it starts out as debt, but converts into equity.  Very simple documents, and therefore fewer points of negotiation, which means fast and cheap.

Series A Round – The Company’s first fully negotiated financing, usually in an amount north of $1M, in which preferred stock is issued to investors, most of whom are likely professional institutional funds. Usually involves a fair amount of drafting and negotiation, with 5-figure legal bills.  Most experienced firms have their custom form documents, although they largely follow the NVCA Model Legal Documents.

Seed Equity Round – An equity financing, usually at or below $1M, that involves the issuance of simplified preferred stock.  There are probably a half a dozen or more versions of these standardized doc sets, the most popular being the Y-Combinator Series AA, the TechStars Model Seed, and the Series Seed.  You can find a great chart comparing these at this link.  The idea is that, because these docs are openly available on the internet and everyone can read them, you can agree in advance to “just use them,” and not spend time or money negotiating.

Question 1: How much money are you raising?

If you are raising around $1M+, then 99% of the time you will just do a full Series A.

  • The people you are likely taking money from will not be OK with the simplified Seed Equity docs, because of what they leave out, and the convertible notes will similarly be too simple for what investors want.
  • Also, a $1M+ raise is usually enough to justify the legal costs of drafting and negotiating a full Series A set of docs.

If you are raising less than $500K, then the vast majority of the time you will just go with Convertible Notes.

  • Exception: if you are (i) raising money from people who really don’t care much about the legal nuances of the docs, and therefore will just sign what you give them, and (ii) you, because of personal experience or experienced outside input, are comfortable with setting an early-stage valuation on your company, then you might still go with Seed Equity.  Otherwise, the amount of money being raised will not justify the legal cost in negotiating even lite Seed Equity docs.

If you are raising between $500K and $1M, then you’re in a territory where analyzing the pros and cons of convertible notes v. seed equity becomes important.  Many lawyers will just tell you to do convertible notes because it’s cheaper, but that isn’t always the case, and in some cases slightly higher legal costs may still be worth it.

Convertible Notes v. Seed Equity: Theory

Convertible Notes

Pros:

  • Shorter documents with fewer deal terms, so less to negotiate over. Cheaper.
  • Delay giving certain rights: Board seats, information rights, protective provisions, etc. rarely are given to convertible noteholders, so at least you maintain maximum control over your Company for a longer period of time.
  • Avoids setting a hard valuation on the Company, which is good if you and your investors are inexperienced and are likely to get it way wrong.  If you set too high of a valuation, you risk (i) looking like an idiot to future investors, which may put them off from investing altogether, and (ii) having a down-round in the future, which is dilutive and makes everyone feel as if they lost money.  If you set too low a valuation, you (a) also look like an idiot, and (b) likely have limited the valuation you get in your next round because those investors won’t want to pay a significant multiple over the seed valuation, even if it’s justified.
  • Exception: Capped Notes – It’s becoming fairly common to issue “capped” convertible notes, a full description of which is beyond the scope of this post.  Basically this means that the notes will convert at the lesser of the valuation at the next round or the valuation cap that you placed in the note.  While not exactly a valuation, it will more or less be seen that way by the future investors, which removes a lot of the above-mentioned benefits of deferring valuation.
Cons:
  • Forced Liquidation: Remember that part about a lender being able to force your company to liquidate? While this rarely actually happens because of reputation and the fact that early-stage startups rarely have hard assets to grab, you’re still handing someone a loaded gun, and you will worry about it if maturity time comes around.  This is why you should choose your angels wisely.
  • Discounted Conversion, Interest: Convertible notes almost always (i) accrue interest that will also convert into equity, and (ii) convert at a discounted price to what investors in the future round are paying.  The purpose of this discount is to “compensate” the early investors for taking on extra risk relative to the later investors, which makes sense. But it also means that you are effectively giving away more shares for the same amount of money than if you would have just issued equity.  So you may save on legal fees, but you’re paying for it with more dilution.
  • Liquidation Overhang – Liquidation overhang has to do with the fact that, while the convertible notes are converting at a discount to the price in the Series A round, the liquidation preference on their shares is set at the full Series A price, so they’re getting more preference than they actually paid for. Again, you’re giving away more for less money.  This also means that the Series A investors have to share more of their liquidation preference with the convertible note holders than if the noteholders had simply bought equity, which is unfair to those Series A investors, and might result in their forcing you to change the notes in the later round. A theoretical solution is to create the discount by issuing more common stock on top of the preferred stock, but this unfortunately is quite rare.
  • Misaligned Incentives: Just to explain this quickly, when someone approaches you to make an equity investment, they want the lowest company valuation possible, because it means they get a larger chunk of your company.  When someone gets convertible notes, they already handed you their money, but the valuation keeps moving until the notes convert. So while you’re trying to make the Company more valuable, they are incentivized to want the opposite, because a higher valuation means they get a smaller portion of the Company.  This may be a purely theoretical issue depending on your investors, but incentives shouldn’t be ignored, especially when you’re relying on your Angel investors for advice and introductions to VCs.  This is also why valuation caps, explained above, have become more common-place in convertible note rounds, because they guarantee a certain percentage of your Company to the noteholder.

Seed Equity

Pros:
  • Clearly defined rights and ownership – Because you are having the investors sign definitive equity agreements, their rights and their percentage ownership are clearly set, instead of being deferred to another negotiation.
  • Aligned incentives – You avoid the misaligned incentives mentioned above.  They have as much of an interest in increasing the value of the Company as you do. No conflicts between the converting notes and investors in later rounds either.
  • Good practice for the big leagues – By having issued equity, gone through some basic equity documents, and even taken on a board member or two, you’ll be well-prepared for when you have to raise a full VC round.
  • A False Pro: It’s often claimed that a benefit of seed equity over convertible notes is that, when issuing equity, the holding period for capital gains treatment begins at issuance, but for the stock issued upon conversion of notes it doesn’t start until conversion. This is generally not true.
 Cons:
  • Valuation Risk: Issuing seed equity requires you to value the Company at a very early stage, which is risky, as described above.
  • More Negotiation and Legal Cost: As simplified and stripped-down as all the lite seed equity docs are, it’s uncommon to find investors who will sign the docs and be done with it. The rare exception would be professional early-stage investors who’ve grown extremely comfortable with a certain set of docs.  Again, choose your angels wisely.
  • Follow-on rounds slightly more complicated: At some point, you will likely need to raise a full blown venture capital round with all the bells and whistles. Normally the docs in one equity round become the basis for the docs in the next round.  Given that the firm you’re working with is likely to have their own forms that don’t completely sync with the terms of the lite seed equity docs, there may be a slightly higher cost in having to modify things to make it all work.

Question 2: Who are your investors?

If your investors are mostly interested only in the economics of your company, and you’re comfortable that they (or their lawyers) won’t start negotiating the docs to death, then the difference in negotiating/legal costs between convertible notes and seed equity probably goes away, and you should go with seed equity.  You’ll have better aligned incentives, clearly defined rights, and you won’t end up paying more in equity later on because of discounts, etc.

However, if there’s any hint that your investors are going to want to go through the docs and negotiate various points, and there usually is, then the seed equity transaction will almost certainly end up more expensive than a convertible note round.  Angel investors and their lawyers, especially in Texas, are notorious for not knowing what they’re doing in negotiations, and it will cost you.  Just have them sign simple convertible notes, and let them return to their cattle ranching or dentistry practice.

Question 3: How quickly do you expect to raise a full VC round?

Convertible notes have historically been called “bridge” financing because they were meant to be just that: some money to hold you off until you close a larger funding round that’s already in the works.  If you and the seed investors know a larger round is coming soon, then a quick convertible note round can be worth it, provided you can use this expectation to keep the discount to a minimum, and possibly keep the note uncapped.

However, if you don’t anticipate raising a larger round anytime soon, which means that you are going to rely on this money for a longer period of time, then you’re better off issuing seed equity.  You’ll avoid a long period of accrued interest, your investors won’t be worried about getting hosed because of valuation changes, and therefore you won’t have to give a substantial discount in order to compensate the investors for that risk.  You also won’t have to go for a long period of time being paranoid about that coming maturity date.

As a closing note, I’ll remind you of the reality check I mentioned.  Some investors are highly opinionated about debt v. equity and won’t let you persuade them in the opposite direction.  In that situation, you just have to go with the flow and pay attention to all the variables.