Are the deal terms that Australian VCs ask for actually ‘unfair’ to founders?
Note: This article highlights both the benefits and problems associated with using ‘open sourced’ legal documents (available to download via AVCAL) during seed funding rounds. It aims to educate Australian startup founders on the legal process behind early stage financing. Although the article aims to provide a detailed overview, it should NOT replace the advice of a lawyer.
Last month, Startup Daily reported on the news that a number of Australian venture capital firms, angel groups, incubators, accelerators and other industry stakeholders had agreed to “open source” legal documents used during seed fundraising processes. Inspired by US-based initiative Series Seed, Dan Atkin, Partner at Sparke Helmore Lawyers, Paul Bennetts, Investment Manager at AirTree Ventures, and Niki Scevak, Managing Director at Blackbird Ventures worked together to create “industry-wide standardised fundraising documents” that can be downloaded via AVCAL’s website and be used during early-stage equity investment rounds. The message that was put forth to the media was not only that the legal templates would “increase transparency” in the fundraising process, but also help startups reduce legal expenses from around $20,000-$25,000 to $5,000-$10,000, by cutting down the time it takes for lawyers to draft and finalise the documents. On AVCAL, it states:
Our goal in making this pledge is to create a set of documents that are both startup and investor friendly, in addition to increasing transparency and efficiency in the fundraising process. The documents should allow startups to approach investors with greater confidence and knowledge in the legal process behind early stage financing and generate a universal starting point for later financing rounds. Using these documents as a starting point, our companies have been able to complete equity financings for legal costs in the $5k-10k range on a regular basis. [Bolding added].
The news was met with some criticism from founders in the startup community who told Startup Daily that the documents represent the interests of investors and are ‘not founder-friendly’ though they’ve been claimed to be “both startup and investor friendly”.
Startup Daily contacted six lawyers, none of whom were associated with the initiative and four of whom responded to questions in great length, acknowledging both the benefits and problems with the templates. Although there were varying opinions on the initiative, most lawyers agreed that the terms presented in the templates are more appealing to investors than startup founders, and that startup founders should seek legal advice and negotiate important amendments. This is in-line with the statement that the documents need to be used as a ‘starting point’.
More emphasis needs to be put on this particular point. These model documents, which include the Term Sheet, Subscription Deed, Shareholders Agreement, Employment Agreement, and IP Assignment Deed, should not be used without legal counsel, nor should the terms be regarded as a fixed standard that must be blindly accepted. It’s worth mentioning that the templates are very helpful, in that they allow founders to know exactly what VCs want from a legal and financial perspective.
On the AVCAL website, it states:
Please feel free to use these documents, but please do so responsibly only after retaining your own legal counsel. Don’t use these documents blindly. Think of them as a good starting point that can save you some time and money. [Bolding added].
Malcolm Burrows, a former technology entrepreneur and currently the Principal and Founder of Dundas Lawyers, said that startups need to realise that the documents “are an attempt to reconcile a polarisation of competing interests: certainty and risk.”
“Investors want more certainty and less risk, it’s that simple,” said Burrows.
The following are clauses that need to be closely reviewed, negotiated and potentially amended to better suit the interests of the founder/s of a startup.
CLAUSE 7: CLASS OF SHARES
The Investor will be issued with Seed Preference Shares
Clause 7 indicates that investors will receive preference shares, so will need to be paid out ahead of founders if the company is wound up or sold. Depending on the circumstances, this could mean that founders may leave with nothing, whereas investors will receive recompense for their investment/s in the company.
Heidi Roizen, a long-time Venture Capitalist and Partner at Draper Fisher Jurvetson (DFJ), pointed out in an article that the ‘preferred’ part of ‘preferred shares’ is there for a reason. This is one of many terms VCs have created to protect themselves, so they can “recover capital in downside outcomes and improve their share of the returns in moderate outcomes”, according to Roizen.
“There is nothing inherently evil about terms, they are a negotiation and part of standard procedure for high risk investing. But, for you the entrepreneur to be surprised after the fact about what the terms entitle the venture firm to is just bad business – on your part,” Roizen wrote.
Clause 7 needs to be taken into careful consideration when negotiating the term sheet, because the investment founders put into their own companies – not just financially, but also time and effort – may equate to little or nothing. This is, of course, the worst case scenario.
Scevak explained that the worst case – founders leaving with nothing – happens when a company is sold for less than the amount of capital that was raised.
“If you raise money at a certain valuation and if you sell your company for less than the last round of funding, then the investors get their money first, and whatever’s left is distributed to the founders and employees,” said Scevak.
“If the founders get nothing, then that means the company was not sold for more than a dollar of what it raised. Say, for instance, a company raises $10 million from investors and then sells for $9 million, the investors will get their $9 million back and lose 10% of their capital. Founders will get nothing. This has been standard for 30 years … Where it’s not standard and where it’s not founder-friendly is if there’s more than one liquidation preference.”
7(c) Anti-dilution – If, prior to the conversion of any Seed Preference Shares, the Company issues Shares at a price less than that paid by the holder of Seed Preference Shares, the conversion rate will be subject to a broad based weighted average anti-dilution adjustment.
Clause 7(c) ensures that the investor is not adversely affected if a company raises further capital at a lower price per share than what the investor has paid.
The broad based weighted average anti-dilution adjustment is the most common approach to anti-dilution protection. It accounts for the price and amount of equity previously issued and currently undergoing issue and the new weighted average price is adjusted for the preferred shareholder (i.e. the investor with Seed Preference Shares).
“The investors’ conversion price is reduced to a lower number that takes into account how many shares (or rights) are issued in the dilutive financing. If only a share or two is issued then the conversion price does not move much. If many shares are issued – i.e. there is real dilution – then the price moves accordingly,” said Ursula Hogben, Co-founder and the General Counsel of LegalVision.
“The goal is to diminish the old conversion price to a number between itself and the price per share in the dilutive financing, taking into account how many new shares are issued.”
Mira Stammers, Founder and CEO of Legally Yours, said that the weighted average anti-dilution protection is “more friendly to the founder than full ratchet anti-dilution.”
Full ratchet anti-dilution protection allows the investor to maintain his or her percentage of ownership of a company even after larger fundraising rounds.
“It seems unreasonable for seed investors to have invested say $250,000 for 25% and still retain 25% after $10 million has gone into the company after further rounds,” said Stammers.
According to Startup Company Lawyer, under the full ratchet anti-dilution formula, “If the outstanding preferred stock was previously sold at a price of $1.00 per share, and the new preferred stock in the dilutive financing is sold at a price of $0.50 per share, the effective price of the previously outstanding preferred stock would be reduced to $0.50 per share with the result that each share of such preferred stock previously convertible into one share of common stock would now be convertible into two shares of common stock.”
The result is that the investor’s percentage of ownership remains the same as the initial investment. Let’s say, for instance, that an angel investor puts $1 million into an early-stage company for 20% equity. Months down the track, the company may then receive a valuation of $50 million from a VC firm that agrees to invest $10 million for 20% equity. This means that the original angel investor’s $1 million investment converts to $10 million. This can get more and more complicated as more capital is raised.
Whereas the amount of money raised in dilutive financing rounds factors into determining the new conversion price in the weighted average anti-dilution formula.
However, Stammers said that “more carve-outs should apply than currently exist” if the term sheet is going to include any kind of anti-dilution clause.
“An alternative option is to delete anti-dilution provisions entirely given that any seed round is issued at a fairly low valuation in any event and anti-dilution from a ‘down round’ is unlikely,” Stammers said.
CLAUSE 11: KEY PROVISIONS IN SUBSCRIPTION AGREEMENT
11(c): The subscription agreement will “require the founder to enter into a deed of assignment under which it assigns all intellectual property related to the business to the Company.”
Hogben said that founders need to be wary that, under clause 11(c), they have to assign all intellectual property in relation to the business (e.g. code) to the company. If a technical co-founder, for instance, created an algorithm from scratch, they can no longer own it or use it if their employment is terminated by the company.
“This is a standard clause and would be expected by investors to protect the value of the company,” said Hogben.
CLAUSE 12: KEY PROVISIONS IN SHAREHOLDERS AGREEMENT
12(a): The shareholders agreement will “provide that the founder may appoint a director while it holds % or more of the shares.”
12(b): The shareholders agree will “provide that the holders of the Seed Preference Shares may appoint a director while they hold shares.”
The founder has the right to appoint a director as long as he/she holds % or more shares in the company. Sparke Helmore noted in the term sheet that the purpose of this clause is to “enshrine the founder’s right to appoint a director, but only while the founder is actively engaged in the business as a major shareholder”.
Clause 12(a) doesn’t acknowledge the possibility of there being multiple founders who may divide the shares and own less than 50% each.
Hogben said 50% is a high threshold, and that a lower threshold like 20% is “more appropriate so that the founders have sufficient influence on the direction of the company.”
Scevak clarified that 50% or more is the total amount of shares the founder or co-founders must own together. If there are three co-founders, each of whom own 20% of shares, that would exceed 50% and so they would be able to appoint at least one director. If each co-founder own 15%, adding to 45% in total, they would not be able to appoint a director.
Clarity in this clause is required; and a lower threshold would certainly be welcomed by founders, especially because clause 12(b) indicates that the investor has the right to appoint a director while he or she holds any percentage of shares.
Hogben said this is “an usually low threshold”, and suggested a higher threshold like 20% is “more appropriate to reflect the influence that a minority shareholder should have over the direction of the company”.
12(d): The shareholders agreement will “provide that critical business decisions such as those set out in Schedule 2 may not be made without the approval of a Required Resolution (being a resolution of % or more of the directors, provided that the director appointed by the holders of the Seed Preference Shares must be in favour of the decision).”
This clause means that specified critical business decisions – such as the adoption of a business plan, employees, accounting practices, company restructuring, capital expenditure and selling of assets, among others – require 75% or more of the directors to agree, and must include the investor’s representative director. This gives the investor’s director veto rights (i.e. right to reject a decision or proposal) on the business issues listed in Schedule 2.
Principal Solicitor Raena Lea-Shannon, who specialises in Entertainment Media and Technology, told Startup Daily that effectively, this puts “entire control of the company in the hands of the one director representing the interest of the investor”.
Hogben suggested that the list be “tailored to each business, negotiated to cover critical matters only, and to have flexible monetary thresholds that grow as revenue increases.”
“Founders do not want to seek investor consent for day-to-day management of the business or operational matters,” said Hogben.
12(h): The shareholders agreement will “provide for % of the founder’s shares to vest over a [insert] year period.”
This clause indicates that 50% of the founder’s shares vest over a certain number of years, presumably at least one year. This is in order to incentivise the founder to remain at the company for an agreed numbers of years and to ensure that if the founder resigns shortly after the company receives funding, that they don’t get to leave with a large chunk of equity.
Say for instance, the founder owns 2 million shares and the agreement is that 50% of founder’s shares will vest over a four-year period, that would mean that the founder’s 1 million shares do not become exercisable for four years. They must stay at the company for four years before they can exercise their stock options, at which point their shares will be fully vested. However, if the founder ceases to be employed by the company in those four years, or leaves the company because of unforeseen circumstances, then the company can buy back the shares at a nominal rate.
The Shareholders Agreement template states that “% will vest on the date that is  months after the date of this agreement” and “at a rate of [1/36th] of the balance at the end of each month period thereafter, provided that the relevant Founder remains engaged by the Company to provide services, whether as a contractor or employee at the date of vesting”.
Twelve months after the deal has been closed, 500,000 of the hypothetical founder’s shares will be vested. Every month from 13 months forward, 1/36th of the remaining shares will be vested. So 13 months after the deal has been closed, 500,000 shares, as well as a further 13,888 shares has vested, assuming the founder is continuing to provide services to the company, whether as a contractor or employee.
Lea-Shannon told Startup Daily that “the vesting provision of 50% over a year is pretty tough”.
“Founders have already justified their ability by setting up the startup; they are then made to jump through further hoops for 50%,” she said.
“That does not allow for illness, incapacity, etc. That is very harsh.”
The founder is especially at risk if his/her employment is terminated by the company without cause.
Hogben told Startup Daily that it is in the founder’s interests to have “(i) a higher percentage of shares owned outright; (ii) a lower percentage of shares vesting; (iii) a faster vesting period; and/or (iv) a sliding pricing scale or a fair market price, not a nominal price.”
Stammers acknowledged that while she is an advocate for founder vesting, there should be more protections against losing shares if the founder leaves under certain limited unforeseen circumstances.
“Currently, if the founder resigns within a certain number of years (to be agreed) then the vested shares are sold at a default rate of 50% of the fair market value and he or she loses all rights to unvested shares,” said Stammer.
“Required Resolutions for removal of the founder don’t seem to help if the founder is paid under $100,000 p.a., which is somewhat inevitable at seed round stage.”
VentureHacks suggests in an article that vesting should accelerate upon a change in control of the company including after the sale or acquisition of a company. Founders should not be afraid to implement both single and double trigger acceleration at seed stage. VentureHacks succinctly explains both:
Your options for acceleration upon a change in control, from best to worst, include:
1. Single trigger acceleration which means 25% to 100% of your unvested stock vests immediately upon a change in control. Single trigger acceleration does not reduce the length of your vesting period. It only increases your vested shares (and decreases your unvested shares by the same amount).
2. Double trigger acceleration which means 25% to 100% of your unvested stock vests immediately if you are fired by the acquirer (termination without cause) or you quit because the acquirer wants you to move to Afghanistan (resignation for good reason). The hack for acceleration upon termination already provides double trigger acceleration and provides sample definitions of termination without cause and resignation for good reason.
3. Zero acceleration which is a little better than getting shot in the head by the Terminator.
12(i): The shareholders agreement will “include a right to buy back the shares of any founder who is a bad leaver at % of fair market value.”
A company can buy back the founder’s shares at [50%] of fair market value if a founder is considered a ‘bad leaver’.
Bad Leaver has been defined in the Shareholders Agreement as “a person who ceases to be employed or engaged by a Group Company, as a result of his or her:
(a) resignation within [insert] years of the date of this agreement;
(b) termination by the Company with cause, including because he or she has
(ii) an indictable criminal offence;
(iii) a breach of a restrictive covenant; or
(iv) a material breach of his or her employment or consulting agreement.
Under these terms, the founder is required to stay within the company for an agreed period of time, presumably at least until their shares are fully vested, otherwise he/she will be considered a ‘Bad Leaver’.
If the founder resigns within a certain number of years (to be agreed), regardless of the circumstances surrounding his/her resignation, or if his/her employment is terminated with cause the company may buy back the founder’s shares at a discount of [50%] of fair market value.
“Bad Leavers also would appear to be at the whim of a Board who will decide by Required Resolution what the Fair Market Value of the Bad Leaver’s shares are. It is our view that arrangements such as this may be problematic as depending on the exact circumstances they could be seen as a penalty which may not be enforceable at law. Further, it is uncertain whether they may be seen as oppressive under the Corporations Act 2001 (Cth),” said Burrows.
Burrows also noted that there is no ‘Good Leaver’ clause which outlines circumstances where a founder could be released early provided that he/she complied with all reasonable obligations and left the business in good sharp.
Hogben said founders can strengthen their position with: (i) a narrow definition of bad leaver; (ii) an end period for this clause; and/or (iii) a scale to increase the % paid over time, to fairly reward the time and effort of the founder before the employment ceases.”
CLAUSE 16: COSTS
“The Company will bear all of the Investor’s third party expenses following execution of this Term Sheet including but not limited to expenses relating to the negotiation and preparation of the definitive documentation required for the Proposed Transaction, up to a maximum of $[insert], plus GST.”
The company is required to pay the investor’s third party expenses relating to negotiation and preparation of the transaction documentation, to a maximum threshold (to be negotiated).
Hogben said “This is standard if you’re raising funds from one or more VC funds. It could unfortunately act as a disincentive for the founder to negotiate the term sheet to be more balanced to the founder. If you’re raising a seed round with unconnected angel investors you should ensure each party pays for his or her third party expenses.”
Clause 10 also indicates that investors have the option to pull out of the deal on ‘further’ due diligence, presumably because prior due diligence was not enough. Lea-Shannon pointed out that founders may end up spending thousands of dollars on complex legal documents with the possibility they may fall through.
Hogben said it’s in the founder’s interest to add further clauses to protect his/her interests such as minimum salary, a founder anti-dilution clause and that the company will obtain insurance including director’s and officer’s insurance.
Currently, the model documents limit the founder’s ability to leave and compete with the company they helped create in the event of a relationship breakdown between the investor(s) and founder(s).
“In this respect, [the documents] appear to do what they are designed to do – protect the investor,” said Burrows.
“Each startup will have different strengths and weaknesses that an investor can supplement. But entrepreneurs need considered legal advice on their rights and obligations before committing to any sort of third party investment!”
Hogben added that it’s also in the founder’s interests to have a reciprocal non-compete clause that applies to the investor during and after the agreement. “This is designed to limit the investor’s ability to compete with the company, poach staff, poach clients and interfere with other business relationships.”
Although it’s been stated that the model documents can potentially reduce legal costs, this is not necessarily the case because making the documents more ‘founder-friendly’ requires significant amendments, a task that can be more difficult and time-consuming than drafting documents that are founder-friendly from the start.
“Having these documents available does not substantially change the costs in my opinion, as the costs are in reading and negotiating and revising; and these documents will require a lot of reading and negotiating and advising on behalf of founders,” said Lea-Shannon.
“Acting for the founders and using documents that contain mostly provisions favourable to the Investor/VC makes it quite a task for the founder’s lawyer to bring it back to a document more favourable to their Founder clients.”
Burrows communicated the same point, but acknowledged that “the architecture of the documents appear to have created some variables which may be simply changed to shift the balance.”
It’s worth mentioning that legal costs can vary enormously; and so it’s not true that founders will have to spend $20,000 to $25,000 during seed rounds if their lawyers draft their own documents.
“[Legal costs] adjust to the scale of the deal and the size of the legal practice. So if you have a $250,000 investment and use a boutique firm the costs will be closer to $5,000-$10,000. If it is a $250,000 deal and a big end of town law firm it will be closer to $20,000. If it is a $5 million+ Investment and a big end of town Firm then it will be upwards of $20,000 I expect,” said Lea-Shannon.
“Big Firms have big overheads. If you do not need the M&A guru who closed the latest multibillion dollar deal then don’t go there.”
Legal firms that specialise in startups or have startup clients usually have their own ‘founder-friendly templates’ as a way of systemising their own operations.
“Lawyers working in the startup sector will have their own versions of these documents they have developed to suit their founder clients. Preferably, a founder in a strong bargaining position will use their own lawyer’s agreements and make the other side do the work to negotiate in their terms,” said Lea-Shannon.
Lea-Shannon said what would save costs is shorter form documents written in plain English and vetted and endorsed by a broad spectrum of the startup sector representing founders, investors and senior employees such as developers. This would reduce the legal hours needed to read, negotiate and revise the documents.
She also suggested that the best way to save legal costs is for the founder(s) and investor(s) to negotiate the term sheet, come to a deal they are both happy with and be in a position where either party’s lawyer can simply draft a document that reflects what has been agreed on.
“That way both sides can keep the lawyers out of it until absolutely necessary. It is also a good idea to do all the negotiations themselves and just refer the drafting and some advice back to their lawyer rather than let their lawyer run things,” said Lea-Shannon.
Hogben said many new and boutique firms, particularly ones focusing on startups, offer fixed fees for certainty and peace of mind.
“A founder-friendly law firm will offer assistance in stages. For example, the founder can seek advice and a consultation to discuss their business, the seed financing document suite, and important changes. The founder can then decide whether to negotiate directly with the investors, or to involve the founder’s law firm,” said Hogben.
“Good legal advice for founders can pay for itself many times. This includes obtaining the founders a higher salary, a bonus, ensuring that the founders receive a better exit price if the founder leaves, and/or assisting the founder to receive or retain considerably more shares.”
Whatever the total legal costs end up being, Scevak did tell Startup Daily that VCs usually take the expenses into account when agreeing to invest money into a company.
Fair or unfair?
Adeo Ressi, founder of global startup incubator Founder Institute and managing director of Expansive Ventures, a US$100 million fund, told the Australian Financial Review that many of the Australian deals he’s familiar with have terms that are “unfair to the entrepreneurs” and “hurts the trust between them (entrepreneurs) and their investors, creating a more hostile and less productive environment”.
Lea-Shannon believes the model term sheet is “a wish list for investors in a strong bargaining position”, however, can be used as a learning tool and arguably an incentive for founders to build solid returns on sales before seeking investment or better still, build a business that is profitable and never seek VC investment.
Although there are varying opinions on the terms presented in the term sheet, Lea-Shannon said their fairness really depends on the founder’s bargaining position and how much money is being invested versus how profitable the startup is.
“These documents could be very unfair to a startup unless there is a lot of money being invested and the startup is happy to live with what are one-sided terms as a payoff and be prepared to potentially lose their business,” said Lea-Shannon.
“Some Founders like what they do and want to stay in the business not just have an exit to the yacht and the private plane … as a founder, you would not want this to become an industry standard deal memo, in my view.”
One founder stated confidentially that “The open source agreements basically represent a collection of the worst case terms a founder could ever face, all bundled up into one neat package that is portrayed as industry standard.”
“This has the effect of creating an artificial anchor for founders who believe that this is the norm, and therefore do not know any better. It also creates an anchor for non-VC investors as to what terms they should ask for. In both instances, it leads to founders getting a raw deal and being taken advantage of. If anything, publishing the ‘open source’ terms is a master stroke, as it strengthens VCs negotiating position and takes advantage of already vulnerable startup founders.”
“At best, AVCAL’s open source initiative sets unrealistic founder expectations on what a term sheet should look like. At worst it is a concerted effort by Australia’s small but powerful VC industry to collude and distort Australian startup’s view on what fair terms are.”
Lea-Shannon pointed out, however, that the documents “would only skew things at an industry level if the terms proposed by the term sheet were broadly adopted and insisted upon by a swathe of major investors/VCs in Australia”.
“Taken just as a template for people to use or not use, it does not, in my view, set any ‘norm that startups will feel pressured into accepting’. Rather it is a heads up up on what to look out for and negotiate a better outcome,” she added.
Stammers communicated a similar sentiment saying “The current collaboration (between Sparke Helmore, Airtree Ventures and Blackbird VC) is enough provided that there is an opportunity for the public to scrutinise the documents before they become ‘standard.”
Both Lea-Shannon and Stammers also acknowledged that, ultimately, there is no such thing as standard terms.
“Every deal is different reflecting every different bargaining position and relevant deal variables. The analogy I use when someone says “do you have a Template?” is that it is like saying is there one way to play a game of chess. Complex deals like startup share investments have common parameters just like a chessboard has 64 squares and 16 white pieces and 16 black pieces with their prescribed moves and there are a very very many ways that can be played out,” said Lea-Shannon.
“A template that is ready to sign does not exist but a good precedent document can save both sides a whole lot of jostling about and get them as close as possible to a fair deal (which ironically in chess would be a stalemate).”
It’s therefore worth stressing again that the terms presented in the term sheet are all negotiable. Rather than going into negotiations with no clue of what VCs would want or demand and then feeling pressured, these documents reveal what will likely be put on the table from the VC side. These documents also allow founders to understand beforehand what protections investors want in exchange for their investment.
Nathan Kinch, Entrepreneur in Residence at edgelabs, said that while it’s clear the documents were prepared by VCs or those who represent the interests of investors, the terms are not necessarily ‘unfair’.
“As an example, the company paying for legal fees is standard, which may seem strange to anyone who is seeing a term sheet for the first time. Don’t bother arguing this point; focus your time on more meaningful terms but just be sure to cap the legal spent proportionally to the raise,” said Kinch.
“Also, a 1x non-participating liquidation preference is also pretty standard, this is merely downside protection for the VC. If you take the time to understand how the business of venture capital works, it will likely go a long way in your term sheet negotiations.”
Roizen wrote in the aforementioned article that terms matter way more than valuations, yet founders try to optimise for valuation.
Kinch said this can be a big mistake: “VCs protect against downside risk through favourable economic and/or control terms. Founders should be aware of this, and should also be looking to incorporate both single and double trigger acceleration at seed stage.”
“An option pool of 15-20% of the post-money valuation is pretty standard at seed. But in context, if you’re raising $1 million at a defined pre money valuation of $5 million, your effective pre-money valuation is only $3.8 million. In addition, make sure you, or together with the VC, run a spread sheet of multiple exit scenarios based on terms so that you truly understand the impacts prior to agreeing to anything.”
‘Venture capital is not free money. It’s debt. And then some.’ – Heidi Roizen
Perhaps one of the reasons why some startup founders have been taken aback by the reality of raising capital – i.e. the terms – is because capital raising has been glamorised to the point where every time an official announcement is made by a company about a recent capital raise, it’s as if the company has received a massive donation from a philanthropic investor. A more accurate tone would be: “Startup X is now an additional $Y million in debt.” Founders need to understand that although investors are seeking to profit from their investment after the company has been acquired or sold, if things don’t quite go as planned, they’d probably want their money back. At least they won’t come after you like a bank and repossess your assets.
“People mistakenly think of an equity investment as ‘only’ equity dilution. After all, if you lose everything, your venture investor can’t come after you for your house like a bank lender could. However, most all venture transactions are done for preferred shares with a liquidation preference, which means all that venture money is guaranteed to be paid back first out of any proceeds before you get to make a dime. The more money you raise, the higher that ‘overhang’ becomes. And interestingly, the higher the valuation, the higher the delta of value you need to create before the investor would rather hold on to the end instead of getting his or her money back (or a multiple thereof, as some terms dictate) in a premature sale if things are looking iffy,” Roizen wrote in an article.
Unless you’re an impulsive spender, you probably carefully consider major purchases like a house, car or insurance. You weigh your options and make sure you’re making the right decision and getting the best value for your buck.
Investors are no different. They’ve worked hard to earn their wealth, and they want to put it good use.
Whether or not Australian investors are more risk-averse than American or Israeli investors, it’s naive to think that an investor will pour money into a company without any kind of control or protection mechanism around their investment. That’s considered ‘dumb money’ from an investor’s point of view.
“The entire global venture capital industry protects against downside. This isn’t at all unique to us. However, understanding that VC is a cash returns business, and that the typical liquidity event occurs after an average of seven to eight years, meaning fund return cycles are more like 10 years, the entire point of VC is to go long on upside,” said Kinch.
He added that he doesn’t believe Australian startups, generally, are focusing on the highest-value, global problems worth solving, and that this has impacted deal flow quality.
“The result of this is that VC’s deal-flow quality, at least in the context of startups that can potentially deliver a 100x or entire fund size returns, is low,” said Kinch.
“I think this conundrum, when combined with a young VC industry means that we’re all learning and trying to be better … both venture capital and startups in Australia have a long time to go and the bottom line is that we need genuine liquidity within the ecosystem. We need to remember that these are merely templates and they do not replace negotiation and genuine advice from a lawyer representing the entrepreneurs.”
Underlying much of the criticism around the seed financing document templates has been a sense that VCs are out to exploit founders. Sure, there a few ethically-questionable investors out there. There are also investors who believe they have a right to be involved in the management of a startup because their money is at stake. Disagreements around business decisions can take a bad turn and the relationship between the founder and investor can go sour and adversely affect the business.
But there are plenty of other investors that are well-intentioned. They want startups to succeed because ultimately that translates to greater returns for them.
That doesn’t mean founders should overlook the terms they’re agreeing to.
“[M]ost investors I deal with are great, ethical people. If I didn’t think of venture capital money as good for entrepreneurs on the whole, I wouldn’t be a venture capitalist. But we VCs do a lot more deals than you entrepreneurs do, and you need to go into them with your eyes open to the downside consequences of the terms you agree to,” Roizen wrote in an article.
On the flipside, there are also startup founders who take funding again and again and spend it irresponsibly or just don’t have a solid go-to-market strategy. Bill Gurley, general partner at Benchmark, a Silicon Valley venture capital firm, told The Wall Street Journal that he believes the burn rate for companies is at an all-time high since 1999.
In response to Gurley’s comments, Fred Wilson, a well-respected VC and co-founder of New York-based VC firm Union Square Ventures, admitted in a blog post to being unhappy about the way some companies in the firm’s portfolio are burning through their cash:
We have multiple portfolio companies burning multiple millions of dollars a month. Thankfully its not our entire portfolio. But it is more than I’d like and more than I’m personally comfortable with.
I’ve been grumpy for months, possibly for longer than that, about this. I’ve pushed back on long term leases that I thought were outrageous, I’ve pushed back on spending plans that I thought were too aggressive and too risky, I’ve made myself a pain in the ass to more than a few CEOs.
I’m really happy that I’m not alone in thinking this way. At some point you have to build a real business, generate real profits, sustain the company without the largess of investor’s capital, and start producing value the old fashioned way. We have a number of companies in our portfolio that do that. And I love them for it. I wish we had more.
Atkin told Startup Daily that investors are essentially investing in founders. Great founders can turn what may seem like a mediocre idea into highly profitable business. Not-so-great founders can have the best idea and fail to execute.
“The intention [of the legal documents] is to show that if you’re going to take professional money from people, there’s going to be an array of protections they’re going to want. If you’re taking money from family and friends, it’s going to be a very different scenario. You’re not going to get this level of complexity,” said Atkin.
Conversely, if investors are cognisant of the fact that much of the value of an early-stage company and the likelihood of its success sit with the founders, then it can just as easily be argued that investors need to place less limitations on founders.
“Investors need to ensure that a founder has scope to lead the business, and incentives to focus fully on growing the business,” said Hogben.
Scevak said that investors are risking their capital, whereas entrepreneurs, for the most part, are risking their time and effort. This is not to say that time and effort has no monetary value, but when money is involved, there will be a trade-off.
Funded companies can and have failed
Investors know that it takes time to build a big profitable company. It’s usually years before a company can provide a meaningful return once it has taken funding from investors. Even then, there’s is a chance that the company will fail.
Take anonymous messaging app Secret, for instance. It raised US$10 million at a post-money valuation of $50 million last year, followed by a US$25 million capital raise at a $100 million valuation. But in April this year, Secret announced that it is shutting down and will be giving investors back their money. Clearly, it wasn’t working out.
Another example is Clinkle, a FinTech startup that raised more than $30 million in 2013 based on the belief that it could be the next PayPal. Although it plays in the mobile payments space, it’s still unclear to the general public what Clinkle does or wants to do.
The startup pivoted numerous times in the past couple of years; and this year, it’s been reported that a bunch of Clinkle’s employees have left the company or were fired. At the start of the year, the company had about 30 employees; now, the headcount is down to less than a dozen.
Clinkle also experienced resignations from high-profile individuals like former Netflix CFO Barry McCarthy, former Twitter lead designer Josh Brewer and former Yahoo executive Chi-Chao Chang, who lasted less than 24 hours, according to Forbes.
Forbes journalist, Ryan Mac, wrote in an article that most firms never had more than an “arm’s length relationship” with Lucas Duplan, Clinkle’s CEO, and were not aware of the company’s performance or financial health because they did not sit on the board.
“Because Clinkle has not raised another round, those investors’ debt holdings have not yet converted into equity, and some may see a portion of their money returned if Clinkle folds,” Mac wrote in an article on Forbes.
Based on information provided to Forbes by anonymous sources, Clinkle has between $10 million to $15 million left of the $30 million plus raised in 2013. At least one investor had written off their investment due to ongoing problems with the startup last year.
There are plenty more examples of funded companies failing due to overspending, poor leadership or a weak go-to-market strategy, among many other reasons. Investors demand stringent terms not necessarily to exploit founders, but to protect themselves. However, founders can end up disenfranchised by the limitations placed on them.
The challenge is to find a middle ground that satisfies the interests of investors and founders.
“Investors and founders need to strike a balance between the company’s expenditure, development and growth objectives, capital requirements, the benefits brought to a company by a particular investor and the fit between the founder and investor,” said Hogben.
Scevak said the fit between the founder and investor needs to be right because “no legal agreement is going to protect you from an arsehole.”
“The deal is ultimately between two people. If the person isn’t someone you want to work with, then you shouldn’t do a deal with them,” he said.
Earlier this year, Drew Banks, Prezi’s Head of International, told Startup Daily that startups need to choose their investors carefully. Unless founders and investors are on the same page about what they’re trying to achieve, the relationship will crumble – which is especially problematic when there’s money involved. For instance, if an investor wants the company to focus on revenue growth, whereas the founder is more interested in user growth, there will be tension around goals not being met.
For the relationship to be long-lasting, Banks said that founders and investors have to genuinely like each other: “There are going to be some hard times and hard discussions. Same goes for your co-founder and executive team. You really need to know that you can argue with them, then come back the next day and be in a good place.”
Banks also stressed the importance of actually asking investors for advice, something that entrepreneurs often forget or are reluctant to do in fear of exposing weakness.
“Call them, ask for advice, ask for introductions. Don’t treat them [investors] as just board members, treat them as a partners, get the value out of them. They have experience, use them. That’s what they’re selling you on. They say ‘you’re not just getting our money, you’re getting our network’,” Banks said.
“[After I raised $20 million for my previous company], I was just too intimidated to ask for advice. I’d been trying to get this money for so long that I was too intimidated to call them and expose that I didn’t know something. Entrepreneurs have egos, they don’t want to admit they don’t know something, especially to their investor. If I had to do it all over again, I would have asked everything. I would have been much more transparent in every conversation and get value out of it.”
For Australian startup founders the realisation that a good idea alone does not guarantee investment can be a bitter pill to swallow. Interestingly, it’s when startups don’t need capital that investors come knocking with cheques in their hands.
Banks said the reason why Prezi has been able to raise over US$71 million is because it didn’t need any funding. He added that, in his own business, prior to joining the team at Prezi, he couldn’t get a single VC to return his call for five years. Eventually, he was able to raise $20 million, but the process was all-consuming. He couldn’t focus on building company. All he was doing was raising money and managing the investors. This is one of the reasons why he left the company.
Yet, in his first week at Prezi, a prestigious VC came knocking on the door delivering a gift. Banks laughed as he said, “I couldn’t even get my own VC to come to my office ever.” He realised that “if you can be in a position to not need money, everyone is going to want to give you money”. In many occasions, Prezi’s founders were simply rejecting investors when they called: “No thanks, we don’t need the money”
Banks said that startups have to be frivolous and always maintain an eye on money, and a closer eye on the company’s run rate – that is, the amount of money being spent on the business every month.
“You want to make sure you don’t spend yourself out of money before you start making money or before you can raise another round. A lot of startups do that; they raise a lot of money, then create an unsustainable run rate and they’re forced into raising that second round before they actually have a viable product,” said Banks.
“You need to focus on viability. I’m a strong believer in trying to get to the revenue. Growth is great in good times, but in more tight financial times, investors want answers.”
Bootstrapping proponents argue that it’s best not raising capital at all and that customers are the best investors. They’re more forgiving, and best of all, you don’t have to pay them back.
The great news is now that the model legal documents are out there in the public sphere, startups can really weigh their funding options.
It’s worth noting that the founders of the initiative are very open to feedback. If the community strongly objects to the document templates, they’re willing to create version 2.
“If someone has something concrete that they want to change, let’s have that conversation and make the legal documents better at the end of it,” said Scevak.
Atkin also told Startup Daily that in the upcoming weeks, they’ll be publishing a paper that explains in much greater detail what Australian VCs want, how they operate, the legal process behind raising capital, how to interpret the open-sourced legal documents, and how terms apply to and impact different businesses in different circumstances.