Thanks for this piece as we are looking to secure a $1 - $1.5 M round of financing after realizing it isn't necessary for us to raise a more typical Series A size round. I will archive your article and follow up if we have any questions.
Thanks
Don Jones - VentureDeal
· 2 years ago
You'd probably get no complaints from the angel community, since they have less patience than the average venture capital guy (or gal) in dealing with the usual document stack.
mathew johnson
· 2 years ago
and here is some good advice from Kevin Merritt at blist on selecting an attorney for your startup - especially in Seattle:
There are B round investors to convince too. You want a clean deal -- including cap chart and all the previous investment documents. If those docs are nonstandard, that's a risk.
Why shouldn't A round investors just take a convertable note?
Jeff Loomans
· 2 years ago
Ted, very thoughtful position that head-on addresses a problem we've grappled with recently. We have an active seed program at Sierra for firms seeking capital roughly in the $500K-$1.5M range, and one of the first issues raised on the last term sheet I submitted was "can we find a way to drastically cut the legal process in time and cost since this really looks expensive on both dimensions compared to taking some more angel convertible debt?" Beyond that I am very sensitive to the entrepreneurs' and angel investors' sensibilities at this stage and it just comes off wrong saying "we set up this seed program to make it a lot easier to take this level of funding from a big firm", then turning around and dumping a term sheet the size of a small novel on them (much less what follows...!)
I ran this by our CFO as soon as I read it and am circulating your article to some other folks I know well. But since you put yourself forward as happy to debate these points, can I toss out a few initial questions we came up with for reaction - yours and others?
1. Seems silly I've never asked this before myself, I guess because I was always focused on the substance not the form, but why are the IR/VA/RFR docs separate today - I know there are good filing reasons for others but is there no more than "just the way it's been done" at work here from a legal standpoint?
2. Frankly diligence rather than obtaining an insurance policy has more often been the benefit of getting a legal opinion - we've had many occasions where the drafting process uncovered capitalization issues that otherwise might not have come to light but weren't really rep-and-warranty level. Maybe we're just not clever enough to think of everything we could possibly ask but having trained counsel give a thorough blanket scrub seems to have worked for us. Any thoughts on a more targeted mechanism to replace the opinion in early stage deals?
3. 15 Reps and Warranties seems a bit arbitrary, though I do agree I can't come up with a situation - especially early on - where more than half a dozen became serious discussion issues. Rather than trying to fix an arbitrary number and run the risk of gaming ("well we repped to the *most* important 15, you wouldn't let us list any more") you feel there are any broad categories in this area that are just much less applicable to companies in their infancy and/or with no institutional rounds in their past?
4. As the last poster noted the initial docs "set the tone" for later stage deals. One reason to set "our" reg rights or anti-dilution early (and very explicitly) would be that we should be much more aligned in interests with the entrepreneur than a later stage investor would be, and if real goodness occurs rapidly for the firm you could see valuation and round size inflation to a point where the next round investor has real incentive to seize on a lack of clarity in these areas to proactively set up nasty negotiating points, either to hammer on or trade off for more material terms. You see little to no risk in letting these particular terms basically float out there in the aether?
5. Finally, the money question: how do we gauge the practical savings from rolling docs together, cutting out a few generally boilerplate terms like reg rights, and restricting reps and warranties? With modern word processing and email circulation it doesn't exactly strike me as a linear "I save $x / line of text I save" - but then again I'm a venture capitalist, not an attorney, and I don't have a sense for how it really works in your back offices...?
Ted Wang
· 2 years ago
Great comments. On the notion of preparing for the Series B, I think this is the most compelling objection. It comes down to a cost benefit analysis. Does the benefit of getting "proper" terms set in a small Series A round, outweigh the cost of working through them in the Series A. I'd suggest that (a) the vast majority of the Series B folks will get this right and (b) for the few times that these terms are not exactly as good as you'd like them, its not really worth the cost of doing them across all seed Series A. Put another way, every investor that does a convertible note runs this exact risk.
On Jeff's question
1. The technical reason that the documents are seperate is that they have different parties. So whereas the founders are parties to the ROFR Co-Sale, they are not parties to the IRA (typically). If, for example, a founder goes off the reservation, you might not want to risk having the IRA become difficult to amend (and even if the amendment provisions say that you can amend without him/her not so clear that it works or too risky).
2. I agree that the legal opinion does force a deeper diligence from the company's counsel, but it's not cheap. Most firms require a second partner to review the opinion and the supporting materials. So I do agree that having an opinion is a valuable safeguard, but is it worth adding a couple of grand in legal fees to each $1m invesment?
3. 15 reps is totally arbitrary, but it will force folks to make choices. I worked on a recent deal where we had to rep to financial statements and the company had just been formed and had no customers (or products!). It's tough to say generally what categories don't make sense because for a semi-conductor company you would care about different things than say an Internet company. That said, things like environmental reps and financial statements are obvious candidates for removal.
4. See above. It is an oddity of financing documents that the last round documents do in fact become the benchmark for the next round. I agree that by giving up on some of these rights, investors would subject themselves to greater risk in the next round, but this is always the case with convertible notes.
5. Show me the money! It's hard to say. I would guess that if a set of "short form" documents became the de facto standard for small Series A financings, it could save ~$15-20k in legal fees per deal ($7-10 on each side). That's a lot of dough for $1m raise.
Paul Graffagnino
· 2 years ago
Hey Ted,
A thought-provoking article. A few reactions:
Since most (or almost all?) of the volume of paperwork is for the benefit of the investor (the Company would be happy to take the money and run without any strings), I think it's the investor constituency that needs the convincing. In a rational world, you're completely right - a smaller deal should mean relatively simpler paperwork, as there is less at stake. It's not a linear relationship per se, since there should be some economies of scale with larger investments. But in my opinion if the documents are not significantly simpler for a $1.5 million deal than for a $15 million deal, someone isn't doing their job - unless, of course, it reflects a deliberate and informed decision by the clients.
I can see some investors putting up resistance for at least a couple of reasons. The first is that the idea of giving up all of that pro-investor boilerplate requires an educated balancing of the legal risk that some investors just don't have the requisite time and/or experience to deal with. So they default to "Let's not reinvent the wheel on this deal." Another concern would run like this: If I build a foundation with registration rights, a co-sale agreement, and the like in the seed round, even though they don't mean much now, when the next (hopefully bigger) round comes along and I don't have the funds to put meaningful new money in with the big boys, I'm more likely to end up in a more equitable relative position than if I have to argue that the old money should be included in a bunch of new provisions (i.e. I'd rather be defending a set of rights I already have). It's a purely psychological and momentum-based argument that may or may not work.
The last point I'd make is that what you are advocating does in fact happen, although perhaps not as often as it should. I've seen lots of small deals without legal opinions, or without voting agreements or co-sale agreements, or with short form reps and warranties. There is also a logic to your point about dropping registration rights altogether - especially for the life sciences companies, where (absent a paradigm shift in the markets and SOX reform) a successful exit is almost certainly going to be a sale as opposed to an IPO.
Lots of food for thought - this is a process tha definitely could be streamlined.
William Jolitz
· 2 years ago
Ted, Quite a thoughtful article. Every time through the Series A process have always wondered at the efficacy of these costly agreements - what are we really paying for, and what real security do they convey for the parties involved?
As an entrepreneur focused on building the relationship to pull off the investment partnership to mutual benefit, I can't afford to question the point of the instrument for fear of generating spurious issues.
I've found it no easier on the other side of the fence. As an investor for companies with a strategic interest, you fear upsetting the other investors who are already signing off on the deal. Even the lead venture investor worries about missing the key detail that wrecks the deal later on. Like Banquo at the feast, we don't want to talk about these real concerns but all know it's there waiting for a misstep.
I'd like to say these fears are all unfounded, however each has happened once or more times, even with more elaborate agreements than you are proposing here.
Does part of this problem stem from an imperfect attempt to capture in documents intent from the perspective of each of the components of the agreements? And that it hence follows why so much more has to be present in Series A such that given various contingencies follow on rounds inherit such treatment (note - these aren't always consistent due to flawed review, omission, or communications failure)? All premised on the belief we can guess all such contingencies, which experience proves false.
I've found in practice this model of simplification for less-complex deals works well: 1) identify the operating premise and the agreed upon target to be reached first and 2) set all of the agreements based on this premise. Structure all remedies to be a revision of the documents per joint agreement. It's a lightweight process with low initial legal costs, allowing an investor and entrepreneur to move quickly on opportunities. The revised documents more accurately resemble the situation of the qualities of the investment at any time - the agreements are "live". Of course, no agreement is perfect, but it's not a bad way of proceeding until we get comfortable with shorter boilerplate forms.
The caveat of "live agreements" is that they bring entrepreneur and investor close together. You have to be confident and knowledgeable to use them effectively.
Jeff Loomans
· 2 years ago
Thanks Ted. We're chewing on these and other responses we've received and fundamentally you and I (I can't speak for all my partners at Sierra) could probably agree at a minimum that:
1. complexity is overdone for seed-stage deals using all the conventional forms
2. combining docs, eliminating closing conditions and most reps are in most cases no brainers
3. In many but maybe not all cases dropping a legal opinion is OK. Think I'd want to reserve a lot of judgement (which, to be fair, I'd do with all the above anyway - I never give a pure boilerplate sheet) for situations where there was a lot of non-institutional round "investment history", especially of the FOF type, stretching back a ways. Easier to give up when the firm is newly formed.
4. Reg rights could similarly be dropped most if not all the time, and A-D.
A very interesting argument flushed out on A-D btw, one I wish I'd thought of (the credit goes to Michael Glaser of Perkins-Coie). Just as there are a lot of cases in very early stage deals where you really don't want to end up with fully participating preferred terms but want to set some sort of straight or capped preference precedent - since there's extremely little upside to full participation at that level of investment and of course a later investor putting a much larger round in will ask to keep the term if it's already there - you may as an investor not want *any* anti-dilution on a 1M investment. The post almost has to be quite small, in the single digit millions, so who is going to raise a down B round that gives you any very meaningful impact from the term, if it's not in fact you yourself? But if the B is up and one of the *subsequent* rounds is down... then you're in as bad a shape as the earliest common holders.
Obviously this argument doesn't work if you intend to step up in the B very significantly yourself - so it's a bit of a tricky one just as with the participating terms argument and probably requires a lot more thought about the given particulars of the firm, it's likely cash-usage scenarios, where/when it could get into a lot of trouble - but with the right expectations set of a "standard" doc to come, by striking it completely from A you probably leave a lot more latitude to include it or not in the B. That's even probably an appropriate outcome if as if the step-up for the B is large, you should feel "right" asking for protection, and if not, then not.
Hey, you mentioned being willing to step up to the bat and try this, and I think we are about convinced of the value of doing so. As Paul said this effort likely has to come from the investor consituency first so maybe Sierra could be an early trial of how well a real set of these docs might work in practice. Feel free to contact me at Sierra's main contact line and drop me a vmail.
Thanks,
Larry
· 2 years ago
Good for you for taking a public stance on this!
It has gotten pretty outrageous for legal fees on a Series A to constitute several percentage points of the raise. Like it or not, first money is going to adapt their terms to later money 100% of the time. It is an outdated adage that companies should fight hard to set the terms they want on an A round so that later investors fall in line. World doesn't work that way.
I also agree with your point that, at least initially, shorter new boilerplate docs will cost more initially than the current mess.
Thanks for bravely taking this topic into the open.
jeremy liew
· 2 years ago
Ted,
As one of the other commentors points out, the extra documentation goes to protect investors. Perhaps the investors could stick the extra $15-20k into the company to cover the "traditional" documents for no additional dilution (ie increase the Pre money a bit). On $1.5m cash in, its effectively a 1% increase in the pre money, which seems to be not that material for the investor, given the benefits that accrue.
Startupia.com
· 2 years ago
Very interesting post. I have bookmarked it on my website.
Tony
· 2 years ago
Agreed, setting the tone for B makes this prohibitive.
Perhaps use a catchy trade name for a very stock, widely circulated set of docs like you suggest. "Yes, that was/wasn't in the A round, but it was a Short Form A so you can't read into it that way."
All Comments
Thanks for this piece as we are looking to secure a $1 - $1.5 M round of financing after realizing it isn't necessary for us to raise a more typical Series A size round. I will archive your article and follow up if we have any questions.
Thanks
http://www.blist.com/blog/index.php/2007/09/10/...
Why shouldn't A round investors just take a convertable note?
I ran this by our CFO as soon as I read it and am circulating your article to some other folks I know well. But since you put yourself forward as happy to debate these points, can I toss out a few initial questions we came up with for reaction - yours and others?
1. Seems silly I've never asked this before myself, I guess because I was always focused on the substance not the form, but why are the IR/VA/RFR docs separate today - I know there are good filing reasons for others but is there no more than "just the way it's been done" at work here from a legal standpoint?
2. Frankly diligence rather than obtaining an insurance policy has more often been the benefit of getting a legal opinion - we've had many occasions where the drafting process uncovered capitalization issues that otherwise might not have come to light but weren't really rep-and-warranty level. Maybe we're just not clever enough to think of everything we could possibly ask but having trained counsel give a thorough blanket scrub seems to have worked for us. Any thoughts on a more targeted mechanism to replace the opinion in early stage deals?
3. 15 Reps and Warranties seems a bit arbitrary, though I do agree I can't come up with a situation - especially early on - where more than half a dozen became serious discussion issues. Rather than trying to fix an arbitrary number and run the risk of gaming ("well we repped to the *most* important 15, you wouldn't let us list any more") you feel there are any broad categories in this area that are just much less applicable to companies in their infancy and/or with no institutional rounds in their past?
4. As the last poster noted the initial docs "set the tone" for later stage deals. One reason to set "our" reg rights or anti-dilution early (and very explicitly) would be that we should be much more aligned in interests with the entrepreneur than a later stage investor would be, and if real goodness occurs rapidly for the firm you could see valuation and round size inflation to a point where the next round investor has real incentive to seize on a lack of clarity in these areas to proactively set up nasty negotiating points, either to hammer on or trade off for more material terms. You see little to no risk in letting these particular terms basically float out there in the aether?
5. Finally, the money question: how do we gauge the practical savings from rolling docs together, cutting out a few generally boilerplate terms like reg rights, and restricting reps and warranties? With modern word processing and email circulation it doesn't exactly strike me as a linear "I save $x / line of text I save" - but then again I'm a venture capitalist, not an attorney, and I don't have a sense for how it really works in your back offices...?
On Jeff's question
1. The technical reason that the documents are seperate is that they have different parties. So whereas the founders are parties to the ROFR Co-Sale, they are not parties to the IRA (typically). If, for example, a founder goes off the reservation, you might not want to risk having the IRA become difficult to amend (and even if the amendment provisions say that you can amend without him/her not so clear that it works or too risky).
2. I agree that the legal opinion does force a deeper diligence from the company's counsel, but it's not cheap. Most firms require a second partner to review the opinion and the supporting materials. So I do agree that having an opinion is a valuable safeguard, but is it worth adding a couple of grand in legal fees to each $1m invesment?
3. 15 reps is totally arbitrary, but it will force folks to make choices. I worked on a recent deal where we had to rep to financial statements and the company had just been formed and had no customers (or products!). It's tough to say generally what categories don't make sense because for a semi-conductor company you would care about different things than say an Internet company. That said, things like environmental reps and financial statements are obvious candidates for removal.
4. See above. It is an oddity of financing documents that the last round documents do in fact become the benchmark for the next round. I agree that by giving up on some of these rights, investors would subject themselves to greater risk in the next round, but this is always the case with convertible notes.
5. Show me the money! It's hard to say. I would guess that if a set of "short form" documents became the de facto standard for small Series A financings, it could save ~$15-20k in legal fees per deal ($7-10 on each side). That's a lot of dough for $1m raise.
A thought-provoking article. A few reactions:
Since most (or almost all?) of the volume of paperwork is for the benefit of the investor (the Company would be happy to take the money and run without any strings), I think it's the investor constituency that needs the convincing. In a rational world, you're completely right - a smaller deal should mean relatively simpler paperwork, as there is less at stake. It's not a linear relationship per se, since there should be some economies of scale with larger investments. But in my opinion if the documents are not significantly simpler for a $1.5 million deal than for a $15 million deal, someone isn't doing their job - unless, of course, it reflects a deliberate and informed decision by the clients.
I can see some investors putting up resistance for at least a couple of reasons. The first is that the idea of giving up all of that pro-investor boilerplate requires an educated balancing of the legal risk that some investors just don't have the requisite time and/or experience to deal with. So they default to "Let's not reinvent the wheel on this deal." Another concern would run like this: If I build a foundation with registration rights, a co-sale agreement, and the like in the seed round, even though they don't mean much now, when the next (hopefully bigger) round comes along and I don't have the funds to put meaningful new money in with the big boys, I'm more likely to end up in a more equitable relative position than if I have to argue that the old money should be included in a bunch of new provisions (i.e. I'd rather be defending a set of rights I already have). It's a purely psychological and momentum-based argument that may or may not work.
The last point I'd make is that what you are advocating does in fact happen, although perhaps not as often as it should. I've seen lots of small deals without legal opinions, or without voting agreements or co-sale agreements, or with short form reps and warranties. There is also a logic to your point about dropping registration rights altogether - especially for the life sciences companies, where (absent a paradigm shift in the markets and SOX reform) a successful exit is almost certainly going to be a sale as opposed to an IPO.
Lots of food for thought - this is a process tha definitely could be streamlined.
Quite a thoughtful article. Every time through the Series A process have always wondered at the efficacy of these costly agreements - what are we really paying for, and what real security do they convey for the parties involved?
As an entrepreneur focused on building the relationship to pull off the investment partnership to mutual benefit, I can't afford to question the point of the instrument for fear of generating spurious issues.
I've found it no easier on the other side of the fence. As an investor for companies with a strategic interest, you fear upsetting the other investors who are already signing off on the deal. Even the lead venture investor worries about missing the key detail that wrecks the deal later on. Like Banquo at the feast, we don't want to talk about these real concerns but all know it's there waiting for a misstep.
I'd like to say these fears are all unfounded, however each has happened once or more times, even with more elaborate agreements than you are proposing here.
Does part of this problem stem from an imperfect attempt to capture in documents intent from the perspective of each of the components of the agreements? And that it hence follows why so much more has to be present in Series A such that given various contingencies follow on rounds inherit such treatment (note - these aren't always consistent due to flawed review, omission, or communications failure)? All premised on the belief we can guess all such contingencies, which experience proves false.
I've found in practice this model of simplification for less-complex deals works well: 1) identify the operating premise and the agreed upon target to be reached first and 2) set all of the agreements based on this premise. Structure all remedies to be a revision of the documents per joint agreement. It's a lightweight process with low initial legal costs, allowing an investor and entrepreneur to move quickly on opportunities. The revised documents more accurately resemble the situation of the qualities of the investment at any time - the agreements are "live". Of course, no agreement is perfect, but it's not a bad way of proceeding until we get comfortable with shorter boilerplate forms.
The caveat of "live agreements" is that they bring entrepreneur and investor close together. You have to be confident and knowledgeable to use them effectively.
1. complexity is overdone for seed-stage deals using all the conventional forms
2. combining docs, eliminating closing conditions and most reps are in most cases no brainers
3. In many but maybe not all cases dropping a legal opinion is OK. Think I'd want to reserve a lot of judgement (which, to be fair, I'd do with all the above anyway - I never give a pure boilerplate sheet) for situations where there was a lot of non-institutional round "investment history", especially of the FOF type, stretching back a ways. Easier to give up when the firm is newly formed.
4. Reg rights could similarly be dropped most if not all the time, and A-D.
A very interesting argument flushed out on A-D btw, one I wish I'd thought of (the credit goes to Michael Glaser of Perkins-Coie). Just as there are a lot of cases in very early stage deals where you really don't want to end up with fully participating preferred terms but want to set some sort of straight or capped preference precedent - since there's extremely little upside to full participation at that level of investment and of course a later investor putting a much larger round in will ask to keep the term if it's already there - you may as an investor not want *any* anti-dilution on a 1M investment. The post almost has to be quite small, in the single digit millions, so who is going to raise a down B round that gives you any very meaningful impact from the term, if it's not in fact you yourself? But if the B is up and one of the *subsequent* rounds is down... then you're in as bad a shape as the earliest common holders.
Obviously this argument doesn't work if you intend to step up in the B very significantly yourself - so it's a bit of a tricky one just as with the participating terms argument and probably requires a lot more thought about the given particulars of the firm, it's likely cash-usage scenarios, where/when it could get into a lot of trouble - but with the right expectations set of a "standard" doc to come, by striking it completely from A you probably leave a lot more latitude to include it or not in the B. That's even probably an appropriate outcome if as if the step-up for the B is large, you should feel "right" asking for protection, and if not, then not.
Hey, you mentioned being willing to step up to the bat and try this, and I think we are about convinced of the value of doing so. As Paul said this effort likely has to come from the investor consituency first so maybe Sierra could be an early trial of how well a real set of these docs might work in practice. Feel free to contact me at Sierra's main contact line and drop me a vmail.
Thanks,
It has gotten pretty outrageous for legal fees on a Series A to constitute several percentage points of the raise. Like it or not, first money is going to adapt their terms to later money 100% of the time. It is an outdated adage that companies should fight hard to set the terms they want on an A round so that later investors fall in line. World doesn't work that way.
I also agree with your point that, at least initially, shorter new boilerplate docs will cost more initially than the current mess.
Thanks for bravely taking this topic into the open.
As one of the other commentors points out, the extra documentation goes to protect investors. Perhaps the investors could stick the extra $15-20k into the company to cover the "traditional" documents for no additional dilution (ie increase the Pre money a bit). On $1.5m cash in, its effectively a 1% increase in the pre money, which seems to be not that material for the investor, given the benefits that accrue.
Perhaps use a catchy trade name for a very stock, widely circulated set of docs like you suggest. "Yes, that was/wasn't in the A round, but it was a Short Form A so you can't read into it that way."