Protect Your Angel Investors

Background Reading:

A lot of writing, including my own, breaks the world of startup  funding “players” into 2 broad categories: founders and investors. While that is helpful, it’s also important for founders to understand that within the investor category, there’s an important distinction between angel investors and institutional investors; in terms of incentives, behavior, and their overall relationship with the company.

Institutional investors are sophisticated (… usually), repeat players who are working with large amounts of other people’s money; and those other people expect (demand) great returns. They have their own lawyers (and therefore usually negotiate harder), have much deeper pockets, and usually invest much later in the game than true angels; when the company is a much more attractive investment from a risk-adjusted perspective.

Angel Investment: faster, easier, but more exposed. 

Angel investors are investing their own money.  Seed funds / angel groups do work with a broader pool of money, but they are more accurately described as an organized group of angels than a true institutional fund.  Angels often do not utilize their own lawyers in executing deals (because the check sizes don’t justify it), which means they rely more on trust in the team, and on standardized, more lenient terms. Their money goes in much earlier in the stage of the company, so at a point where the company is much riskier. Angels are accurately described as betting as much on a founder team as they are on the business.  Prominent angels also regularly serve as “social proof” for gaining the interest of VC funds.

Because angels invest much earlier in a company (than VCs), usually without lawyers, and usually on standard documents with minimal investor protections, their relationship with founders/management is often much more informal and trusting, and less about “the numbers,” than the founder-VC fund relationship. Accelerators usually also fall in the same category. This is all very much a good thing. It’s what allows seed investments to move quickly, at a time where the company doesn’t need or want to spend a lot of hours going back and forth on deal nuances when they could be building the foundation of the business.  But it also means that angel investors are exposed to gaming by later investors (or, sometimes, bad actor founders) who take advantage of key inflection points to push the angels’ investment away from the “deal” they thought they were going to get. 

The broad context in which this happens is fairly simple: an angel round has been closed for a while – usually convertible notes or SAFEs, but sometimes seed equity – and the company is raising a Series A. After negotiation and modeling, the parties have not aligned on numbers. The VC doesn’t like the terms that the angels are ‘getting’ in the round (from their notes/SAFEs), because after accounting for his own share, too much of the cap table is taken.  So he makes his check contingent on the founders going back to their angels and convincing them to accept modified terms.

The angels, not happy about it, are exposed because their money is already sunk, and much worse things could happen if the deal dies. So they cave; accepting worse terms so that, effectively, the new money can get better ones.  Requiring earlier seed money to raise their valuation caps is a common way to make lower Series A valuations more swallowable.

But to be totally honest here, sometimes the gaming is not led by the VCs, but by the founders. They see what the angels are getting in the deal, and might collude with the new money to force a change. I’ve never had one of my personal clients play that sort of game, but I have seen it happen.

There are situations, of course, in which terms simply need to be re-negotiated; usually because the company’s path took a number of unexpected negative turns, and things just won’t work if a reset doesn’t happen. Those situations should be distinguished from the ones in which a deal really can close, but someone is just using the exposure of angels to get more of the pie.

Reputation is capital. Don’t waste it.

The job of company counsel is not to do whatever founders / management want; it’s to advise on what is best for the company and all of its stockholders long-term. On a whole host of issues, people who’ve seen the life cycles of companies play out over time (like VC lawyers) can bring a long-term perspective that a fresh team may not understand intuitively.

My advice to founders, which I put down in Burned Relationships Burn Down Companies, is that relationships matter. A lot. Especially with your early money, which often acts both as your cheerleaders in the market, and as a safety net if things get rough. Putting aside the purely ethical aspects of gaming angel investors (which are important, mind you), burning your early investors is bad for the company.  It’s also just bad for founders personally, whose relationships can mean a soft landing if their company fails, or support for their next venture. 

As a startup and new team, you don’t have buckets of money, or a rock-solid reputation, to insulate you from everything that can go wrong with a company. Your reputation and social capital are some of your most valuable assets; don’t waste them. If anyone is asking you to hurt your social capital, stand your ground. They’re asking you to incur a cost, but for their benefit.

In fact, real chess players sometimes want to burn your other relationships, because it reduces your optionality, which increases their leverage. Always think multiple steps ahead.

Pro-rata rights are core economics.

And on a final note, it’s important for founders to understand that when angel/seed funds request “pro rata rights” for future rounds, those rights are not a nice-to-have that is independent from the economics of their existing investment. Successful angel investment depends on the ability to double down on winners (put in additional investment), because the vast majority of an angel’s investments are losers. That’s the core economics of angel investment. If you deny angels their pro-rata in a Series A, you are taking away a part of their deal that allowed them to invest in you in the first place. The long-term consequences for a company and a founder team are usually not worth the near-term benefit.

Promising Equity v. Issuing Equity

Background Reading:

An underlying theme of a number of SHL posts has been the common misunderstanding among young, first-time founders around what startup/vc lawyers in fact do. As I wrote in Legal Technical Debt, a mindset has emerged from certain startup circles suggesting that virtually anything legal that startups do at early-stage, from forming their company to raising seed financing, can be automated with software.

That confused mindset leads founders to (i) assume that all lawyers are just luddites over-charging startups for effectively filling in forms, and (ii) results in founders accruing an enormous amount of compounding ‘legal technical debt’ from badly drafted documents, mis-matched contracts, missed legal steps, etc. For companies that fail fast, the debt never comes due. And yes, there is a clear correlation, from my experience, between founders who arrogantly think lawyers are worthless and those that never build anything of significance.  Dumb people believe and do dumb things.

For those founders that do end up building a real business, however, the 10x cleanup cost of legal technical debt (relative to what it would’ve cost to do it correctly from the start) is often brutally painful. There are a lot of very interesting new tools out there being built to streamline and optimize how tech/vc lawyers work, and you should certainly look for lawyers who are using them. But if you think for a second that you’re going to build a real tech company without needing serious lawyers who can safely manage significant legal complexity, you are, without question, deluding yourself.  

A significant source of “automation confusion” arises from founders not understanding the difference between promising equity and actually issuing equity. I’ve noticed this from how many of our own (very early stage) clients will randomly e-mail us a set of contracts executed over a period of several months with a short message like: “we went ahead and *issued* some equity on our own.  just FYI.”  This blog post will save me from having to write the same e-mail 30 times in the future.

Promising Equity 

I can promise someone equity in 5 seconds, and 1 sentence.

“I promise to issue you 10,000 shares.”

See, it’s not hard. Promising equity is exactly as easy, and as automatable, as it sounds.  Anyone who automates a contract for promising equity, which usually means filling in numbers into a static template, doesn’t deserve the slightest bit of praise for innovation. It’s been do-able for decades.

Sure, people still make mistakes in promising equity all the time. They calculate the number of shares incorrectly, or they get the vesting schedule wrong (or don’t offer one at all), or they simply grabbed the wrong form to begin with.  But the point is that, perhaps with a little guidance from educational materials and a boilerplate form, promising someone equity is do-able as a DIY project.

Reality Check

The problem, of course, is that promising equity is 2% of the much more complicated process needed to actually issue equity. To correctly accomplish the issuance of equity from your company and into the hands of the intended recipient, a web of highly contextual legal analysis needs to occur. Just a short (non-exhaustive) example:

  • What kind of entity are you? That influences the type of equity you can issue.
  • Stock? Option?
    • If Stock, at what price?
    • If Option, at what price? To an employee, or a contractor?
  • Vesting schedule? 83(b)? Acceleration?
  • Was the price set correctly to avoid tax consequences?
  • Enough authorized shares?
  • Correct class of equity?
  • Is it being issued under an equity plan?
  • Was the plan adopted correctly?
  • Are there enough shares in the plan?
  • Is the recipient eligible to receive the equity under securities laws and tax rules?
  • Any state-specific rules/filings to comply with?
  • Any contractual approvals needed?
  • Any cap table adjustments needed, like anti-dilution?
  • Approved by Board?
  • Anyone else that needs to be notified about the Board action?
  • Any spouses we need to worry about for community property purposes?

I could go on, but you get the idea.

Want to try automating that? Good luck to you. Medical care will be fully automated before complex legal work is. Why? Because there’s far less variability in biology than there is between the legal structures of companies. You simply cannot automate (not in a commercially viable way, at least) in an environment where every use case has a totally different starting point, context, and history, in an infinite number of combinations. Even less so where high-stakes errors are cemented in ways (via contract execution and enforceability) that do not allow for quick and easy bug fixes. That is precisely the world in which serious VC lawyers operate.

Believe me, I empathize deeply with the disdain for lawyers held by many entrepreneurs, and share some of it myself. As someone who manages recruiting for our firm, I constantly find myself fighting a sense that the legal field is a magnet for people who think that perfecting their punctuation matters more than learning to actually advise clients on the what, why, and how of startup law.

But there are lawyers in the market who know how to get things done efficiently and correctly. I hire those lawyers. You can either (i) pay them now, (ii) pay them 10x later, or (iii) assume your company will fail before the debt comes due.

Startup Advisors: Best Practices

Background Reading:

Advisors. The best startups have great ones. They save you lots of headaches, time, and money. In fact, I’m not sure I’ve come across any successful client that didn’t have a strong set of advisors. Here’s some advice on how to not screw it up:

Advisory ‘Boards’ Rarely Exist.

A set of advisors is sometimes referred to as an advisory ‘board,’ but 99% of the time that’s just a term to make it sound cool. The advisory ‘board’ never meets as a group, and often doesn’t even know each other. They’re just a loose set of advisors that a company works with 1:1, or occasionally in smaller groups. Nothing like a Board of Directors, which actually does have to coordinate schedules.

Don’t Stay Local.

As the first linked post above explains in depth, 20 minutes on the phone with someone who has the right expertise is 1000x more valuable than days spent with someone who is more accessible, but can’t provide real insight that isn’t available already via blog posts or books. This means that if you’re relying solely on the very limited pool of people available via your local business ecosystem, you’re doing it wrong.

LinkedIn, Twitter, Angellist, E-mail, Phone. Work ’em. Connect with the key people in your local ecosystem who can make things happen, but don’t fish only in your little pond.

Don’t Confuse Mentors with Advisors.

Mentors can be really valuable to new founders. They can provide emotional support, friendship, coaching, and all kinds of other things. But are those the kinds of things that deserve an equity grant?

It’s ultimately the team’s call. But just realize that those are not the kinds of things that real advisors are meant for. Advisors provide real strategic insight, connections, recruiting, investor introductions, things that go beyond moral support for the founders and actually move the ball forward for the company in an obvious way. That’s the kind of value-add that typically merits equity.

Get Independent Viewpoints

For high-stakes, complex questions for which the answer isn’t clear, advice needs to be triangulated. You don’t treat any particular person’s perspective as gospel; instead you speak with multiple people and combine all of their viewpoints to make your judgment call.

That sort of triangulation is not possible when all of your advisors have the same background, are part of the same circles, etc. Especially when the questions involve big decisions for which various stakeholders have incentives to favor one option over another, you want advisors who are detached from those incentives, so their advice is objective. This, btw, is also the case with lawyers.

Favor Intellectual Honesty over Politeness

The whole point of getting outside advice is to help you see things you can’t see on your own. If your strategy for choosing advisors is to work only with the people who are agreeable to your own opinions, you’re wasting your time. People who are blunt with their advice, but deliver real insight when they give it, can be game changers for a company. 

Use an Advisor Agreement.

It’s not magical; templates abound. The Founder Institute’s FAST Agreement is perfectly acceptable, and even simplifies equity calculations. The most important thing is that an Advisor Agreement removes any ambiguity as to (i) compensation owed for advisory services, (ii) who owns the contributions, IP, etc. that result from the advisory (the company), and (iii) confidentiality of any info shared. Yes, any vc lawyer has seen founders get in trouble with these issues for not taking the time to document it properly.

Equity; %, Vesting Schedule, Cliff, Acceleration.

If an advisor expects cash from an early-stage startup, that’s usually a red flag, short of a really unusual circumstance.

The FAST Agreement has pretty solid guidelines for what’s appropriate in terms of equity %, depending on the Company stage. Pre-equity round, 0.25%-0.5% is a typical advisor. 1% is someone extremely strategic whose name you absolutely want behind your company. After an equity round, the %s naturally shift down a bit because the company is more valuable.

1 or 2-year vesting schedule and a 3-month cliff, and full single-trigger acceleration on a change of control.  Advisors get full acceleration because acquirers never expect them to stick around after a sale, unlike founders or executives.

Use that cliff.

We regularly see founders engage an advisor expecting tons of value to be provided, and then crickets once the equity is granted. But the founders don’t do anything about it. 3-months should be more than enough time to know whether a new advisor will really deliver the goods, and if not cut the cord and get that equity back for re-use.

 The hard part, of course, is finding the right advisors and selling them on your vision, so they’ll give you the time. If no one on your team knows how to hustle and sell, either start learning yesterday, find someone who can, or (honestly) just give up now. Selling, in a dozen different ways (including to advisors), is 75% of what a competent founder CEO does.