Last week I had the privilege of speaking to angel investors at the Y Combinator Angel Conference. One of the trends I discussed is the movement toward convertible debt as the financing mechanism for angel investors versus equity. In fact, 80 percent of the startups I have worked with this so far this year in 2010 used convertible debt (with a capped pre-money valuation on conversion). The other 20 percent that reaised capital via equity raised it from "super" angels, i.e. angels that have limited partners. For more information, you can follow my remarks at http://www.justin.tv/ycombinator/b/267536844. At about 4 min. into the video.
July 31, 2010
July 22, 2010
Definition of Accredited Investor Changed
Please note that under the new Dodd Frank financial reform act signed by President Obama this week, the definition of Accredited Investor no longer permits the inclusion of the value of one's house for purposes of meetung the $1M net assets test. More to come later. "EMF " made the following annotations.
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To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication, unless expressly stated otherwise, was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein. =========================================================== NOTICE TO RECIPIENT: THIS E-MAIL IS MEANT FOR ONLY THE INTENDED RECIPIENT OF THE TRANSMISSION, AND MAY BE A COMMUNICATION PRIVILEGED BY LAW. IF YOU RECEIVED THIS E-
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July 14, 2010
What "legal" factors should you consider when choosing an angel investor?
I was recently asked what "legal considerations" go into choosing an angel investor. These considerations are in addition to determining who is a good strategic fit for you and who will help open doors for your business. On the legal side, you should consider the following:
1. Lead Investor Credibility . Choose an angel who has the credibility to set terms and have others follow with the impetus to renegotiate. For example, if an angel like Ron Conway sets terms with you, it is very unlikely anyone else will try to negotiate different terms.
2. Convertible Debt. Choose an angel who will do convertible debt instead of equity. I have more of regarding the benefits of on my blog at www.johnbautista.com, but convertible debt is faster, cheaper and provides you with more flexibility for your first venture round. And, convertible debt round can be cone for about $5k in legal fees..
3. Valuation Insensitive. Choose an angel who is fair on valuation. Some angels are looking for big ownership stakes without much investment. At most, you would sell 15 percent of the company in an angel round and you will want angels who are willing to pay these effectively higher valuations.
4. Founder Friendly. Choose an angel who is founder friendly. By this I mean an investor who will not insist on a board seat, who will not request voting rights or blocking rights on your next financing and who will not micro manage you.
5. Flexible Terms. Choose an angel who will sign up for standard legal documents, like Orrick's forms, and that won't require extensive reps and warranties from you. This will minimize the likelihood that they will use a lawyer to review documents, thus keeping your transaction fees to a minimum.
July 11, 2010
What is standard cash and equity compensation for software engineers of a startup?
Please see the public spreadsheet that shows ranges in compensation for companies that are funded and pre-funded companies (less data points here). Overall, the data is useful and it comes from a reliable compensation consultant. https://spreadsheets.google.com/ccc?key=0AuNgr7gv5HaBdDBmX3FiTDd1VGdpanpYS1pU...
What is the best way to structure independent contractor equity compensation for a bootstrapping startup (where compensation is 100% equity and no cash)?
The most important rule before you get started is to remember not to link number of shares to hourly, monthly or other compensation dollar amounts. If you do, you will establish the price per share of your common stock or options, and it will likely be higher than the price you will eventually determine as the fair market value of your common stock for employees you plan to hire. You don't want evidence of higher prices. You want the flexibility to keep your future employee price as low as possible The best way to structure consultant compensation is only to specify in the consulting contract a number of shares to be earned (or options to be vested) for either (1) unit of time worked, such as services per week or month (and specifying in the contract the minimum time required to work) or (2) a specific project to be delivered. The next question I usually get is whether consultants should receive stock or options. In my experience, this usually depends on the duration of the contract. If the duration is short term (less than 1 year), then I recommend stock. If it is expected to be longer term (greater than 1 year), then options can be used. The reason is that most option plans specify that options terminate (unless exercised) within 90 days after termination of services. So, if you grant a short term consultant an option, they will need to exercise it anyway within that period of time, which means they need to come out of pocket cash to receive the shares. They won't like this. You might as well grant them the shares as they earn them so that the shares instead cost them their tax rate multiplied by the fair market value of the shares (a lesser amount). This means that when earned at grant, the shares will be fully vested and will be deemed compensation to the consultant which you will need to report at fair market value on Form 1099. Another point is how many shares should the consultant earn? My rule of thumb is that full-time consultants usually earn 2x as many shares as similarly situated employees. And, anyone who is working 100% for stock and without compensation, would also earn 2x as many shares. Therefore, a full-time consultant working only for shares would earn 4x their full-time and fully-compensated counterpart.
How do investors view rounds where founders take money off the table?
This depends on the round of financing. In my experience, the most founders can take off the table in the Series A funding is $100 to $150k. This is usually calculated as deferred compensation and reimbursement of expenses. Structually, however, you will want money that you loaned the company to first be paid back to you. The reason is that return of indebtedness in not taxable, whereas deferred compensation is taxable.In a later round of financing, I have seen founders dispose of 5-15% of their holdings. Existing investors will tolerate this if the percentage to be liquidated is low, and the sale helps accommodate an investment by a new investor. I have never seen founders get liquidity in a later round of financing where the round is an inside round. However, in an outside lead round, existing investors want to minimize dilution. The option of founders selling some of their position actually helps existing investors because it minimizes dilution (fewer new shares are issued by the company) and it benefits new investors by giving them the ability to buy a bigger piece of the company. This is usually done in conjunction with also buying shares directly from the company.The biggest issue in founder liquidity is finding the sale structure that will not revalue the employee common stock price. Founders want to sell their shares at the preferred stock price. However, the company wants to keep the common stock price as low as possible. There are a number of approaches to solve this problem which I can address in a future response. Of course, putting in place founders preferred stock prior to the first round of financing is the best solution. But, if founders hold common stock without the founders preferred option, then alternatives structures will need to be explored.
What factors should you consider when determining how much equity to give an angel investor or other seed stage investor?
In my experience, most startups raise $250k-$500k in their first seed round (which is usually by means of convertible notes), and the company sells 15-25% of the company for this money. Recently I've worked with many startups (particularly Y Combinator companies) who successfully raised between $500k and $1M via convertible notes in their seed round. Hats off to you guys!!!To determine how much you should raise, you should only raise as much as capital as you need (and a bit more) to get to your next major milestone in the life of you business. For example, if you've just started an internet business, you will want to raise as much capital as you need to launch your product or service and to be able to demonstrate success in the market (e.g., customer acquisition or revenue). Once you've determined your funding requirements, you then need to determine whether you can raise the money in tranches. Many times it's easier to raise capital from angels in multiple closings (unless your angels as a group impose a minimum capital raise). In addition, you need to determine whether you can raise capital in the form of convertible notes or equity. See my blog atwww.johnbautista.com for a comparison of the two. In summary, I advice most startups to raise capital with convertible notes. It's faster, cheaper and more flexible for the company. And, if the notes have a valuation cap on conversion, it gives your investors a minimum guaranteed ownership, which is what they want for taking the early risk of investing in your company. With convertible notes, your angel investors will convert their investment into the same Series A that you see to experienced VC's,
When distributing executive summaries and financial projections to potential investors, are NDAs necessary?
Silicon Valley investors will not sign NDA's and it is best not to ask otherwise you will show you don't understand how the Valley works. To protect highly sensitive confidential information, I recommend the following:1. Only meet with the highest quality investors and stick to a limited number - don't blanket Silicon Valley with your business plan2. If you send documents electronically, password protect them. This will demonstrate that you've taken steps to protect your information. If investors see that you care about the confidentiality of your information, they will too.3. Make sure to write "{Company Name} Confidential Information" on every page of your powerpoint or other information.4. And, at the end of the day, disclose in writing what you are prepared for others to see. If information is super sensitive, then plan to discuss this information in person with the investor.
What are some standard ways to convert a startup capitalized in a foreign country to one capitalized in the U.S. with U.S. venture funding?
The standard approach to converting a startup capitalized in a foreign country to one capitalized in the US is to flip the company into the US. The flip transaction involves setting up a US corporation (usually a Delaware corporation) with a standard Silicon Valley style capital structure (usually 10 million authorized shares). Stockholders of the foreign company will exchange their shares for shares of the US company. As a result, the foreign company will become the wholly-owned subsidiary of the US parent. There is one big "gotcha" with this approach. You need to be sure that by exchanging the shares you hold in the foreign company for shares of the US company that you don't trigger tax in the foreign country if you are a taxpayer in that country. This goes for the other stockholders as well. There are work-arounds, however, to this problem. We have developed a deferred exchange structure whereby the stockholders of the foreign company who would be subject to tax enter into put and call arrangements with the US company agreeing to effect the exchange of their shares at the time of a liquidity event of the US company. At that time, they should have funds to pay the tax and the US company is assured that it has a contractual basis to be the sole stockholders of the foreign subsidiary.
What are some standard ways to convert a startup capitalized in a foreign country to one capitalized in the U.S. with U.S. venture funding?
The standard approach to converting a startup capitalized in a foreign country to one capitalized in the US is to flip the company into the US. The flip transaction involves setting up a US corporation (usually a Delaware corporation) with a standard Silicon Valley style capital structure (usually 10 million authorized shares). Stockholders of the foreign company will exchange their shares for shares of the US company. As a result, the foreign company will become the wholly-owned subsidiary of the US parent. There is one big "gotcha" with this approach. You need to be sure that by exchanging the shares you hold in the foreign company for shares of the US company that you don't trigger tax in the foreign country if you are a taxpayer in that country. This goes for the other stockholders as well. There are work-arounds, however, to this problem. We have developed a deferred exchange structure whereby the stockholders of the foreign company who would be subject to tax enter into put and call arrangements with the US company agreeing to effect the exchange of their shares at the time of a liquidity event of the US company. At that time, they should have funds to pay the tax and the US company is assured that it has a contractual basis to be the sole stockholders of the foreign subsidiary.
What do you need to get a meeting with, and then present to, Ron Conway?
I work with several companies that Ron Conway has invested in. A great way to get in front of Ron Conway and David Lee is to build a relationship with Y Combinator. SV Angel has invested in many YC companies. Paul Graham can help by selecting the best startups and providing coaching for making an introduction to SV Angel and other angel investors
July 8, 2010
We made it!
For the fourth consecutive year, Orrick has made The American Lawyer's A-List, a highly competitive ranking that "looks beyond pure dollars to quantify the qualities that define the 20 most successful law firms."
July 6, 2010
Stay Tuned!
Orrick is soon to roll out a group blog with contributions from lawyers in our Emerging Companies Group for the benefit of clients and friends of the firm. "EMF " made the following annotations.
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=========================================================== IRS Circular 230 disclosure:
To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication, unless expressly stated otherwise, was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein. =========================================================== NOTICE TO RECIPIENT: THIS E-MAIL IS MEANT FOR ONLY THE INTENDED RECIPIENT OF THE TRANSMISSION, AND MAY BE A COMMUNICATION PRIVILEGED BY LAW. IF YOU RECEIVED THIS E-
MAIL IN ERROR, ANY REVIEW, USE, DISSEMINATION, DISTRIBUTION, OR COPYING OF THIS E-MAIL IS STRICTLY PROHIBITED. PLEASE NOTIFY US IMMEDIATELY OF THE ERROR BY RETURN E-MAIL AND PLEASE DELETE THIS MESSAGE FROM YOUR SYSTEM. THANK YOU IN ADVANCE FOR YOUR COOPERATION. For more information about Orrick, please visit http://www.orrick.com/
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=========================================================== IRS Circular 230 disclosure:
To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication, unless expressly stated otherwise, was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein. =========================================================== NOTICE TO RECIPIENT: THIS E-MAIL IS MEANT FOR ONLY THE INTENDED RECIPIENT OF THE TRANSMISSION, AND MAY BE A COMMUNICATION PRIVILEGED BY LAW. IF YOU RECEIVED THIS E-
MAIL IN ERROR, ANY REVIEW, USE, DISSEMINATION, DISTRIBUTION, OR COPYING OF THIS E-MAIL IS STRICTLY PROHIBITED. PLEASE NOTIFY US IMMEDIATELY OF THE ERROR BY RETURN E-MAIL AND PLEASE DELETE THIS MESSAGE FROM YOUR SYSTEM. THANK YOU IN ADVANCE FOR YOUR COOPERATION. For more information about Orrick, please visit http://www.orrick.com/
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