Post Category → Venture Capital

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.

Representations: Typical 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.

Reserve an Option Pool; Not an Ocean.

TL;DR  The larger the pool reserved at formation, the more dilution founders are shouldering that would otherwise be shared with employees and investors. Take it seriously.

Here’s how much discussion usually goes into determining a startup’s option pool size at formation:

Attorney: What size of an option pool do you want to reserve?

Founder: I don’t know, what’s the usual size?

Attorney: 20%

Founder: Ok, let’s go with that.

The reason so little thought goes into it is partially due to the fact that startup formations have (for good reason) become very standardized.  Neither founders nor attorneys are interested in delving into any nuances beyond the core questions about equity distribution and founder dynamics.  The founders want to focus on their product.  The lawyers don’t want to burn time on a fixed-fee transaction.

But here’s why failing to take the time to think through your initial option pool size is a problem: reserving too large of a pool, even if it’s never used, means you’re giving away a larger amount of the company to future hires/investors than you want to.

“That can’t be!”, the founder says. How can an unused pool impact my dilution? Whatever doesn’t get used just gets canceled at an exit, right?  While technically correct, this misses a very important issue: future employees and investors will rely on the term “fully diluted capitalization” in determining how much of the Company they want to ask for in the hiring or investment process. And “fully diluted capitalization” includes the unused part of the option pool.

The Hiring Example

You’re negotiating a compensation package for a rockstar developer, and they say they want 5% “of the Company.” What does that mean? The vast majority of the time it means 5% of the “fully diluted capitalization,” which means all outstanding equity AND all reserved but unused equity in the option pool.

Think this through a bit.  5% means having to give them more shares if your option pool size is 20% instead of 10% (because the pie is larger), even if none of the pool is in use.  If you end up getting a good exit in a year without having used much of the pool, the unused pool will get canceled, but the “5%” shares the developer received won’t be reduced proportionately.  The pie shrinks, but his slice stays the same size – which means yours shrinks.  The 5% hire ends up with a much higher percentage of the cap table.

Nutshell: The larger pool you reserve, even if none of it is in use, the more shares you’ll have to give to early hires to get them to a % they feel comfortable with.  Those extra shares mean, if the pool is unused at an exit, those hires own more of the Company than the % they bargained for.

Incubators-Accelerators also base their equity requests on a “fully-diluted” basis (%-based), so by having an excessively large pool, you’re giving them too many shares.

The Investment Example

This is a bit more nuanced, and I suggest you read the excellent Venture Hacks post: The Option Pool Shuffle.

Background:

  • Convertible Notes with caps generally use “fully diluted capitalization” (remember, that includes an unused pool) in determining the conversion price. So a larger pool means the investor gets more shares to get them to the right %, producing the same issue as with employees: if the pool is unused at an exit, they end up with a larger chunk.
  • In a Term Sheet, VCs generally make you “top up” the option pool to have a certain % of availability post-closing, but they make the pre-money cap table absorb all the dilution from it.  The ask will look something like this:

“the total post-Closing available option pool (excluding granted options) represents 15% of the fully diluted shares of the Company.“

The Venture Hacks article gives a mathematical example, but the most important point is this: the higher % the VCs require as available (unused) post-closing option pool, the lower the price they are paying for their shares, and the more dilution the founders are absorbing.

How does this relate to the point of not going overboard in reserving your original option pool? The pool you reserve before your first VC financing will set the baseline for negotiating how much of an option pool “top up” VCs make founders absorb.  If you have a 16% available pool pre-funding, it makes it look a lot more benign for a VC to demand a 15% post-money pool than, for example, if your pre-funding pool was only 5%.  Getting from 5% pre-funding to 15% post-funding will require a very large increase in the pool size.

By having a smaller pool before your funding, it reveals a much bigger “hit” on the founders when the financing is modeled and the VCs post-funding pool “ask” is reflected.  When both the VCs and the founders see the substantial dilution resulting from the pool increase, it forces a deeper discussion about what the post-funding pool should really look like. And that’s where the Venture Hacks wisdom comes in: have a hiring plan and a solid argument for how much of a pool you really need, and make the VCs argue for theirs.

Nutshell:  By keeping your pool size small before funding, it requires a much larger pool increase to get to a VC’s desired post-funding unused pool, all of which is borne by the pre-financing cap table.  This forces a necessary discussion with the VCs about what the appropriate pool size really is, instead of just accepting whatever number they pull out of thin air.

So what is the right formation pool size?

It depends. How many founders are there? Whom are you likely to need to hire in the next 12 months? These are details to discuss with your attorney.  Whatever you do, don’t just accept 20% without thinking about it.

Conclusion

As a founder, your ownership is set at formation.  Everything afterward is dilution.  By reserving an unnecessarily large pool, you’re basically protecting future hires and investors from dilution, while absorbing it all yourself.  It’s not that hard to increase your pool size if you run out of room, and when you do so, at least everyone on the cap table will absorb the dilution with you.  By keeping your pool smaller, you’ll also make VCs think twice about casually dumping an unnecessarily large pool size on their term sheets in order to drive their share price down.

409A as a Service: Cash Cows Get Slaughtered

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

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

The Necessary Evil

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

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

409A-as-a-Service: The Slaughtering

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

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

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

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

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

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