The following is a response to an article Startup Daily’s editor Tas Bindi wrote titled Are the deal terms that Australian VCs ask for actually ‘unfair’ to founders?
To Startup Daily,
I read with interest the super detailed commentary on the open sourced seed financing documents that we (with Niki Scevak from Blackbird Ventures and Dan Atkin from Sparke Helmore) have worked on and agreed with a large number of industry participants to both publicise and support. Standardised seed financing documents that have been open sourced for investors and founders are common in more mature markets particularly the US.
Australia has been slow to get to the same level of maturity and openness. This has resulted in legal fees of up to $20,000-25,000 per fund raising. Those legal fees represent a massive leakage of investment dollars reaching startup teams. Think about the typical scenario of two co-founders coming together to test an idea by raising as little as $100,000 from family and friends as well as angel investors. In this scenario, the team would only receive $75,000-80,000 in investment dollars after accounting for legal fees.
In creating these template documents we borrowed heavily from the precedents used in the US for seed financing rounds. As we recommend on AVCAL’s site, we suggest all co-founders and angel investors read “Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist” by Brad Feld of Techstars fame in the US. In his book, he goes into more depth about how these clauses work (in plain English) and how they are currently being used and drafted in the US.
Breaking through the noise, the underlying purpose of these open sourced documents is to allow a set of angel investors, family and friends to come together and be able to complete a seed financing round as efficiently, quickly and cheaply as possible. These documents are not meant for later rounds such as Series A and beyond which are predominately done by venture capital funds. These are solely for the benefit of co-founders and the first outside investors usually angels, family and friends.
Open sourcing any profit driven exercise will always disrupt (and likely upset) the existing establishment. By open sourcing these documents, we are seeing lawyers’ fees being reduced to $5,000-10,000. I worry about contacting six lawyers for their view on this open source initiative. As Warren Buffett says, “Don’t ask the barber if you need a haircut”.
But just to be clear though, these documents have been drafted as version one. This first version understandably borrows heavily from the precedent of standardised docs in the US. If co-founders, angel investors, family or friends feel strongly about how a particular clause should work then they can easily change the clause to reflect what it is that they, as a group, want to achieve.
Our hope is that these documents will continue to evolve as we learn what works well for everyone over the next 5 to 10 years of startup successes and failures. And let’s agree to keep the discussion to actual clauses rather than just throwing rocks at the whole process.
As one person involved in trying to herd everyone together to make this open source initiative possible, let me respond to your commentary on specific clauses below.
A liquidation preference is used for every deal I’ve seen in the US. In plain English terms, it is used to protect investors in the worst and most common outcome of a startup – it fails. If a startup needs to be liquidated in a bad scenario (through administration or sale) those leftover dollars should probably go to investors before founders. In most cases, there’s not much left in the way of assets to liquidate, but I think it’s fair that the ping pong table should go to investors first. In a bad scenario, once investors have recouped their investment then the balance of the proceeds goes to founders. In a good scenario, the liquidation preference falls away and investors participate alongside founders in sharing the proceeds of the exit. Seems pretty fair to me.
Founder vesting is another term stated as controversial by the lawyers you contacted. Vesting of 50% of a co-founder’s stake is there to protect co-founders against each other first and investors second. The most debilitating scenario and unfortunately a common occurrence is co-founders fighting amongst themselves. If that fight results in one co-founder leaving, say the technical co-founder, the other co-founder is stuck with a large co-founder stake that can’t be used to recruit a replacement. We’ve seen too many startups fail due to this issue. It’s not fair to co-founders if one leaves but benefits from the ongoing work of the other co-founder while they can go off and start another startup. Founder vesting is there to protect co-founders first, investors second.
In your article, you state that full ratchet anti-dilution is less friendly and less common than broad based anti-dilution. We agree. As such, the open sourced documents contain broad based anti-dilution.
The open source documents organise decision making such that the Board is made up of the co-founders and one representative of the investor group. There are some critical business matters that should require the approval of the investor group, such as a major change in business plan. These matters are outlined clearly in Schedule 2 of the Shareholders Agreement. These are not related to day-to-day matters. Some people get confused and believe this puts “entire control of the company in the hands of the one director representing the interest of the investor”.
To illustrate, investors are investing significant sums of money based on a proposed business plan. They don’t want to wake up and find out that their software startup is now selling ice cream to Eskimos. Don’t laugh it’s happened many times before. This clause means that if a team proposes such as change of business at a Board meeting they should involve the investor Director in that decision.
The last point made in your article is that legal expenses are paid out of investment funds. We agree this creates the wrong incentives for both parties. If legal fees were coming out of a founder’s and an investor’s pocket; founders, angels, family and friends would probably have come together long ago to agree on a set of open source documents.
It’s never easy to balance the interests of co-founders who contribute their best ideas and their every waking hour to their startup, with the interests of investors who are contributing their life savings to an enterprise that in 9 times out of 10 fails resulting in those savings vanishing. Both parties have so much to lose, so let’s work together on this open source movement and not let those being disrupted muddle the water between all of us.