How To Tell If Your Startup Ecosystem Is Sick

I had an interesting lunch with some fellow lawyers the other day. I know, “interesting” and “lawyers” shouldn’t be used together in a sentence, but bear with me. We were discussing venture capital deal terms we had encountered with various startup financings we had worked on. One of the other lawyers mentioned that in two deals he had worked on recently involving local Midwestern startups and investors, the investors had insisted on a 3X participating liquidation preference. I was really taken aback by this. In a Series A financing I had worked on a couple of months ago, involving a startup and VC firm that are both in the San Francisco bay area, there was a 1X non-participating liquidation preference. The VC didn’t even try to get something more.

To understand why this is important to startups and to the health of a startup ecosystem, let me explain what a liquidation preference is, and how it works. A liquidation preference is money that the investors take off the top, when a startup they have invested in goes through an exit. For example, suppose a startup is being acquired by Facebook. If a VC that has invested $3 million in the startup has a 1X participating liquidation preference, that means that the VC takes the first $3 million off the top, leaving less money for everyone else. Since the liquidation preference is participating, the VC then gets to share in the remaining proceeds with the common stockholders, pro rata. Essentially, the VC gets to double-dip. In a small transaction, this could be devastating to the founders. For example, look at what happens if Facebook is paying only $5 million for the startup. The VC gets $3 million off the top, leaving only $2 million for everyone else. Because the liquidation preference is participating, the VC may also get a share of that remaining $2 million. And that’s just with a 1X liquidation preference.

Typically, the VC may only use the 1X liquidation preference in a smaller exit transaction, as it protects his downside. In a larger exit transaction, the economics may favor converting the preferred stock to common stock and sharing in the proceeds that way. A liquidation preference greater than 1X, however, may skew those decisions.

Now let’s look at how a 3X participating liquidation preference would impact the deal. Suppose the sale price of the startup is $10 million, and the VC invested $3 million. Now the VC gets $9 million off the top, leaving $1 million for everyone else. Because the liquidation preference is participating, the VC will get a share of that $1 million, too. The founders and any employees holding stock and/or stock options get screwed, to put it politely.

What are the implications of this for startups and a startup ecosystem? When you have a vibrant ecosystem with lots of strong startups and many angel and VC investors, you have competition for deals. As a result, the deals tend to be fairer to the startups. A strong startup has some bargaining leverage when seeking financing, and investors are eager to invest in such companies. When the investors have to compete for deals, they offer more favorable terms to the startups, lest they miss out. FOMO is a powerful force.

You see this at work in Silicon Valley, which has a well-established startup ecosystem with many VC investors and some of the most promising startups. In the Fenwick & West Silicon Valley Venture Capital Survey for the first quarter of 2017, only 16% of the deals involved multiple liquidation preferences. This is actually a steady rise over the past year; in the first quarter of 2017, the number was about 7%. Of those multiple liquidation preferences during 2017Q1, two-thirds were in the 1X to 2X range, and one-third were in the 2X to 3X range. Also, for 2017Q1, only 22% of the financings provided for participation; the remaining 78% were non-participating.

In smaller and new startup ecosystems, you don’t have a lot of strong startups, and you may only have a handful of investors operating. This is frequently the case in some of the emerging Midwestern startup ecosystems, like Louisville, Indianapolis, Columbus, Pittsburgh, and Cincinnati, where I’m located. As a result, the investors feel more emboldened, or more risk-averse, so they demand terms that are way out of the norm for places like San Francisco and New York. I emphasize the word “demand,” because that’s what these investors do – they demand these terms, with a “take it or leave it” attitude. If you don’t like what Investor A is offering, good luck with Investor B – they probably are offering the same terms. There is no Investor C.

As long as this persists, these smaller ecosystems will be weak. In order to improve and strengthen the ecosystem, you need stronger startups to attract more investors who will offer fair terms. These weak ecosystems, however, risk losing the best startups to more favorable ecosystems. Also, startups have to be prepared to look outside their community for funding. If you are a startup in a place like Cincinnati, and you aren’t trying to raise funds from investors in Chicago, New York, Austin, San Francisco, and LA, you are putting yourself at the mercy of your local investors. You may say that you can’t afford to fly all over the country seeking out investors, but the truth is that you can’t afford not to. Your obligations are to the shareholders, to produce the highest returns. If you give away a 3X participating liquidation preference to a local investor because you didn’t seek out investors in stronger ecosystems, you are basically taking the money out of your pocket and putting it in your investors’ pockets.

Can A Letter of Intent Be Binding?

Guy in Suit Scratching HeadThe answer is, sometimes.

When companies are exploring a potential deal – whether it is an investment, a merger, or the sale of real estate or some other asset – they often put together a “letter of intent” prior to finalizing and signing a definitive contract. The purpose of the letter of intent is to outline the key terms of the agreement, and to serve as a basis for negotiating all the details that will go into a definitive agreement.

Sometimes, however, the parties are unable to reach this definitive agreement. Some detail becomes a sticking point, or circumstances change, and one of the parties tries to walk away, thinking that the letter of intent won’t be binding. So what might make the letter of intent binding, and force the parties to conclude a deal?

First, if the letter of intent includes all the material terms in it, a court could decide that there is enough agreement between the parties to find an enforceable contract. This can be the case even if the letter of intent says that it is subject to reaching a comprehensive agreement satisfactory to both parties.

Second, if the letter of intent contains a provision saying the parties will negotiate in good faith, a court might require the parties to continue to do just that. There have been cases where circumstances have changed for one party, so that it wants to walk away, but there was a “good faith” clause that prevented the party from getting out of the deal.

If you want to maintain maximum flexibility, therefore, leave out one or more material terms, deferring agreement on those terms to further negotiation. Also, ensure that there’s no obligation in the letter of intent to continue to negotiate in good faith.

On the flip side, however, companies often expend considerable resources putting deals together, and they want to ensure that a letter of intent will lead to a final deal. For companies in this situation, by all means get those material terms nailed down in the letter of intent, and put in a clause requiring the parties to negotiate in good faith. Another tactic to discourage walkaways is to include a break-up fee clause. That clause provides that if one party walks away from the deal, it will be obligated to pay a break-up fee to the other party, to compensate for the time and other resources invested to date. The problem with this approach, however, is that after making efforts to ensure the letter of intent is binding, you may discover that you no longer want to be bound.

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Anatomy of a Term Sheet – Piggyback and S-3 Registration

Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth.

Last time we began a discussion of registration rights, and focused on demand registration rights. Today we are going to focus on two other kinds of registration rights — piggyback rights and S-3 registration rights — as well as expenses and lockup terms.

Piggyback Registration Rights

Here is the piggyback registration rights term from our Model Term Sheet:

The holders of Registrable Securities will be entitled to “piggyback” registration rights on all registration statements of the Company, subject to the right, however, of the Company and its underwriters to reduce the number of shares proposed to be registered to a minimum of [2030]% on a pro rata basis and to complete reduction on an IPO at the underwriter’s discretion.  In all events, the shares to be registered by holders of Registrable Securities will be reduced only after all other stockholders’ shares are reduced. 

This is a fairly straightforward and noncontroversial term. Basically, if the company is going to be registering its securities with the SEC for a public offering, the investors want to be able to register the securities they hold at the same time. This will enable the investors to cash out without complying with Rule 144’s requirements.

There are a couple of interesting aspects to note. In the case of an IPO, the underwriter has the discretion to override the piggyback rights of the investor. In the case of subsequent public offerings, the underwriter can cut back the percentage of the investors’ shares that will be permitted to piggyback on the registration.

Founders and management should also negotiate to have piggyback registration rights, for the same reason the investors want them. The founders will want to participate in an IPO or other public offering, so they can cash out shares without complying with the requirements of Rule 144.

S-3 Registration Rights

The S-3 registration rights term is as follows:

The holders of [10-30]% of the Registrable Securities will have the right to require the Company to register on Form S-3, if available for use by the Company, Registrable Securities for an aggregate offering price of at least $[1-5 million].  There will be no limit on the aggregate number of such Form S-3 registrations, provided that there are no more than [two] per year.

A Form S-3 registration is shorter and less burdensome than the Form S-1 registration used in an IPO. It can be used by the company one year after an IPO, and allows the company to reference certain items contained in other SEC filings. Consequently, while the S-3 registration rights are demand rights, they aren’t as burdensome as the primary demand registration rights.

The company will want to limit the number of S-3 registrations to 1 or 2 a year, because of the costs and time involved. The company also will want to set a minimum dollar amount for S-3 registrations (somewhere between $1 million and $5 million), again because of the cost and time involved.

Expenses and IPO Lockup

There are two other items related to registration rights worth covering while we are on the subject. The first is expenses. Typically the company will pay the expenses of an SEC registration. Our model term sheet also contains a provision for the company to pay for one special counsel to represent all participating stockholders, subject to a negotiable cap on fees.

The second item is the IPO lockup. The lockup term prevents investors, directors, officers, and major shareholders (1-5%) of the company from selling their shares until 180 days after an IPO, if the underwriter requests. This allows the market to adjust and absorb the additional sales.

Thank you for reading. You can follow me on Twitter @PaulHSpitz

Anatomy of a Term Sheet – Registration Rights

Welcome back to Anatomy of a Term Sheet, a multi-part series in which we take the model Series A term sheet from the NVCA, and analyzing the various terms in depth. 

We have finished with the charter terms and the Stock Purchase Agreement section of the model Term Sheet. Today we start working on the Investor Rights Agreement section, and we will begin with registration rights.

The ultimate goal of any venture capital investment is to make money. Most VC investments either fail, or just barely return the investors’ money. Consequently, VC’s have to hit a grand slam now and then, to pay for all the mediocre and poor investments, and allow the VC’s to cash out with a good return on their investment.

Cashing out is not an easy or simple process for the VC. Until the company goes public, all the investments in the startup, whether it is the seed investment or the Series A (and B, and C, etc.), have been private transactions. The company’s securities – common stock, convertible notes, and preferred stock – have all been sold without registering them with the SEC, and therefore the securities are “restricted.” Rule 144 of the Securities Act of 1933 imposes certain restrictions on the sale of unregistered securities, including that you must hold them for at least one year before you can sell. Also, certain public information about the company must be available, and there are limits on the volume of shares that can be sold, unless the seller holds the securities for at least two years and is not an affiliate of the company. Registration of the stock allows the VC investor to sell the stock without complying with Rule 144, but it is an expensive, time-consuming process involving lawyers, accountants, and investment bankers.

There are two kinds of registration rights: demand rights and piggyback rights. Here’s an example of the demand rights term from our model term sheet:

Upon earliest of (i) [three-five] years after the Closing; or (ii) [six] months following an initial public offering (“IPO”), persons holding [__]% of the Registrable Securities may request [one][two] (consummated) registrations by the Company of their shares.  The aggregate offering price for such registration may not be less than $[5-15] million.  A registration will count for this purpose only if (i) all Registrable Securities requested to be registered are registered, and (ii) it is closed, or withdrawn at the request of the Investors (other than as a result of a material adverse change to the Company). 

“Registrable securities” are defined as all shares of common stock that will be issued upon conversion of the Series A preferred stock. The idea behind demand registration rights is that at some point in time, the VC investors want to be able to compel the company to register their shares with the SEC, so that they can cash out. The registration process takes up an enormous amount of management time and attention, and as a practical matter, it is extremely unlikely that investors are going to invoke demand registration, forcing a company to go through registration of their securities without management’s full buy-in. Nevertheless, there are points to negotiate. For example, the company will want to limit the number of demand registrations to one, while the investors will want the right to demand two or more. Another negotiable point is the minimum dollar size needed to trigger the demand rights. The company will want to set a reasonably high minimum dollar size for the offering, given the expense of a registration. The company also will want to ensure that a significant percentage of the investors support the registration demand, and that a single investor cannot cause a registration.

In the next installment, we will look at piggyback rights. Thanks for reading!

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Five Keys To Working With Investors

If you are a startup founder and you are looking for outside investment, here are five keys to working with angel investors and venture capital funds.

Investigate Your Investors

Potential investors are going to put a lot of money into your company, and they will investigate your company thoroughly. You should do the same with your investors. After all, you will be in a close relationship with these investors over a period of several years, and you will be giving up a great deal of equity and control to them. Consequently, you need to be comfortable with how they operate, and you need to know what they bring to the table. Talk to other startups that these investors have put money in. Are they easy to deal with? Do they respect the founders and employees? Are they accessible? Do they pepper the founders with 3 AM phone calls? What kind of business background do they have? Do they have good contacts?

Create a Competitive Environment

You will have greater leverage in negotiating favorable terms if investors have to compete with each other for a chance to invest in your company. If your startup is hot, if it has good buzz, there will usually be more than one angel or VC eager to invest. Creating a competitive environment, or even the appearance of a competitive environment, can be crucial to getting more favorable terms. You have to be careful with this, however, because if you go too far in playing one investor off against another, you could drive them all away and be left with nothing.

Be Cold-Blooded

Your startup is your baby, but to the investors, it is just another company they might invest in. They aren’t being emotional when dealing with you, and you need to avoid becoming emotional as well. Be prepared to walk away if the terms aren’t good. This is especially hard when you have already put a lot of time and effort into closing a deal. Establish reasonable deal-breakers in advance, and stick to them.

Understand the Deal

Even if this is your third startup and you have been through a couple of financings before, your investors do this for a living, and you don’t. As a result, they will always have a greater facility with the deal terms than you. I recall sitting in a meeting with a VC a few months back, and the guy was speaking at about 90 mph. He was rattling off numbers, terms, and formulas at far too rapid a clip for his audience to keep up with him. He may have been speaking total nonsense, but it was all going by so quickly who could tell? The point is, he was completely comfortable dealing with these complex terms and ideas, while many in the audience were hearing it for the first time. It is crucial, therefore, that founders put the time into understanding each and every part of the deal. Rely on advisors, rely on lawyers, but make sure you read every word and ask questions. That leads us to our fifth key…

Get Your Own Lawyer

An angel financing or Series A financing is no time to go it alone. You cannot rely on Legalzoom to help you here. And you absolutely should not use your investor’s lawyer, or even a lawyer recommended by your investor. Your investor’s lawyer cannot represent you and the investor at the same time; it is a honking big conflict of interest. If it comes down to you or the investor, guess which one of you will get screwed? The same applies to a lawyer recommended by the investor. He is going to rely on the investor to continue to recommend him to clients, so he isn’t going to push that hard on your behalf. The risk of cutting off those referrals is too great, compared to the small amount he will make from you on this one transaction. You need to get your own lawyer, and you need someone who understands these kinds of transactions. The guy who does your patent applications or your parents’ will generally is not going to have sufficient expertise and experience in this area. Remember, the investors do this every single day. You need an experienced, strong corporate lawyer who can explain the deal to you, and negotiate hard to make the terms more favorable to you.

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