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.

The Ad Hoc Law Firm?

The other day I wrote a post, In Startup Law, Big Can Be Beautiful, in which I reflected on the trend of boutique law practices popping up in the startup space, and whether large law firms really are as out-dated in this area as today’s zeitgeist would suggest.  One theme of the post was the notion of startup law being integrated, much like healthcare, in the sense that input from many specialists is often required to provide proper counsel to a client.  Boutique practices are obviously at a disadvantage in this respect because their whole model is built around not having teams of lawyers in dozens of specialties under the same roof: they call this “overhead.”

I recently came across an article with an extremely interesting concept: the ad hoc law firm. It talks about how solo practitioners and boutique practices, at least in some areas, are creating networks through which they can consult with one another and scale when required, but operate independently when not.  From a theoretical and economic perspective, this certainly sounds like the best of both worlds: you have capacity equivalent to a large firm built into your network with specialists and generalists on call when needed, but you only pay for what you use.

I posted a question on quora, which unfortunately no one has answered, asking what sorts of process boutiques and solos have in place to make this kind of system work.  The area that really interests me is how technology can be used to facilitate this concept.  Right now it seems that most boutiques simply call a specialist when they need one, and then begins a process of probably checking conflicts and transferring the necessary documents over.  Consulting outsiders seems to carry far more friction than it would inside of a firm.

But what if all the boutiques/specialists in this “network” operated on the same platform, and scaling was simply of matter of “inviting” others to a particular deal, much like you invite someone on LinkedIn or Basecamp. A few clicks and all the requisite checks and file access could happen automatically.  Going one step further, what if these networks had a shared document management system, through which they could share work-product with one another? That would address another advantage mentioned in my post: that volume and experience curves favor large firms.

That sounds like a powerful idea, and if someone’s not working on it already, there’s an enormous market opportunity to be grabbed.  Cloud-based law practice services like Clio and Lawloop are well-positioned to go after this, but right now it seems they’re focused more on connecting attorneys within a single firm.  Some form of Google+-esque granularity would need to be built in to accommodate a wider network.

The Founder’s Stock Issuance

There’s a lot of uninteresting formality that goes on in a startup’s corporate formation, most of which founders rightfully ignore because they have better things to worry about.  But there’s one document that pretty much every founder will make sure to ready carefully – or at least ask lots of questions about: the Founder’s Restricted Stock Purchase Agreement (or some variant of that name).  Here’s a quick outline that an entrepreneur might use to walk through the document:

General Themes: We (1) want to make sure the Company owns all IP; (2) want to incentivize the founder to stay with the Company and add value; and (3) if the founder leaves the Company or someone else gets ahold of the shares, we want to be able to get them back so no one who isn’t involved with the Company has voting power.

  • Number of shares and nominal price – Most of the time the stock is sold at par value, which will be a fraction of a cent.  Because the Company is at the very beginning stages and extremely risky, placing this miniscule value on the stock usually isn’t considered problematic.
  • IP Assignment – In exchange for the issuance of stock, the founder assigns all rights to the IP that he/she may have with respect to previous work.  Look for a very long definition of what constitutes Company IP.
  • Repurchase Right – This is where you’ll find the vesting schedule.  Nutshell: a mechanism to require the founder to earn the shares over time, and giving the Company the right to get the shares back if anyone leaves.  Explaining that in more detail would take too long for this post, so just click that link.  Unless a founder’s gone solo, there should be a vesting schedule in the document.  If not, fire your lawyer, or get one.  Also useful: Vesting Calculator.  You’ll also likely sign some form of Assignment that gives the Company the administrative ability to exercise this right.
  • Acceleration of Vesting – Upon certain events, usually termination of the founder, a Change in Control (think acquisition), or both, a certain percentage of the stock’s vesting is “accelerated.”
  • Miscellaneous Securities Law Reps – Lots of stuff thrown in by lawyers to ensure that the document doesn’t violate any securities laws.
  • Right of First Refusal – Basically, you can’t sell the shares to anyone without the Company first being able to buy them on the same terms.  Meant to keep shares from getting into the hands of strangers.
  • Divorce/Separation Repurchase Right – If you divorce or legally separate from your spouse, and such spouse happens to get ahold of some shares, the Company has the right to buy them back.
  • Death Repurchase Right – This is somewhat more optional and language varies, but still quite common.  If the founder happens to pass away, the Company has the ability to repurchase shares at fair market value to prevent them from being transferred to the founder’s heirs, devisees, etc.
  • Transfer Restrictions – General restriction that you can’t transfer the shares other than through a “Permitted Transfer” (or some variant of that term), which usually includes gratuitous transfers (not sales) to immediate family and affiliate entities, and requires consent of the Company.
  • Escrow of Shares – The Company (actually their attorneys) will hold on to the actual certificates of the shares and handle administrative matters related to them.  This helps the Company enforce the transfer restrictions and other covenants in the document, and for future diligence purposes it just makes it easier to have them in one central place.
  • 83(b) Election Language and Form – Here’s an explanation.  You have 30 days from the issuance of the shares. It keeps you from being taxed as your shares vest.  Do it, or you’ll be sorry.
  • Compensation Agreement/701 Language – In a nutshell, all share issuances need to qualify for a securities exemption in order to avoid having to “register” the shares, which is crazy expensive.  Rule 701 is one such exemption, and it requires that the shares be issued as compensation – in this case they’re being issued in exchange for IP and past service – not for an investment.
  • Spousal Acknowledgement – Your spouse acknowledges all of the restrictions in the agreements, agrees to be bound by them if he/she ever gains ownership of the shares, and gives you (founder) the right to act on his/her behalf with respect to shares.  This makes sure community property won’t muck up the ownership and that nobody has to ask your spouse for permission to vote the shares or do anything else with them.

Obviously, to make all of these provisions work together there will be lots of extra detail providing processes for exercise, waiver, notice, and explanations for how each provision interacts with the other.  The devil is definitely in the details, and, if you’re working with a reputable firm, this document will have been screened by specialists in tax law, employment law, IP, etc. to ensure that they pass legal muster.  A lone generalist with no outside input can be dangerous.