I previously wrote that accelerator documents should be easy. At the time, I thought accelerator documents should be easy primarily because of the potential adverse selection problem for the accelerator. In other words, the more difficult the terms or onboarding process (including the investment documents), the more likely the best startups would choose a different accelerator or just decide not to join the accelerator. But as the accelerator ecosystem has evolved and after countless clients have participated in accelerators, it’s pretty clear that the investment documents used by accelerators should be not only easy, but that accelerator investments should be convertible equity.
A Bit of History
Accelerators have tried everything when it comes to structuring accelerator investments, including common stock, convertible notes, combinations thereof, preferred stock, etc. This experimentation, as it usually does, has had varying levels of success. And, as per my earlier post, originally the structure of accelerator investments wasn’t that bad in terms of simplicity.
The two main issues that created any type of difficulty in accelerator investments were either (1) tax-related (trying to minimize tax impact to the startup, their future employees and/or the accelerator and their LPs) or (2) issues because the accelerators investment was common stock.
Basically, there is usually some base-level protection afforded the accelerator against founders “going crazy” and this made sense since most accelerators were getting common stock. Thus, in the investment documents, you’d typically find a covenant or two against granting more equity to the founders or some other type of limited non-dilution right. Maybe even limited consent right for a change of control that returns a relatively low dollar amount. So, even with these covenants it really wasn’t a big deal for the accelerator or startup and the onboarding process was easy and the deals worked, but then things started got more complicated.
It’s Getting Complicated Up In Here
So what got complicated? Well, the incoming startups started coming in at a much “later stage” and therefore with a bigger (i.e., more complicated) cap table. Thus, the startups got more complicated.
Originally, it felt like the incorporations for the accelerator portfolio companies were being done upon acceptance to the accelerator. This allowed for a clean and simple cap table. No issues with making a quick and easy cap table rep in the accelerator’s investment document…and certainly no issues with prior investors. But now, it’s somewhat common to see startups hop from accelerator to accelerator or even have a small seed round prior to joining an accelerator. And who can really blame the accelerators for taking startups that are theoretically further along?
But because of this earlier accelerator/investment cap table complication, rather than a quick accelerator onboarding process, the accelerator is having to play VC, including conducting cap table diligence which may even include having to negotiate with current investors/founders on their terms and how their accelerator investment fits in with the current capitalization and investment structure. Problems normally arise because current investors (including sometimes an accelerator) were not even aware of the startup potentially joining an accelerator.
Current investors may have anti-dilution provisions or are otherwise just puzzled why you want to accept an accelerator investment at a fraction of the pre-money valuation or price cap you just negotiated with them. Ideally, a startup should get way out ahead of their investors if they are thinking of joining an accelerator as it’s not really the accelerators job to handle your current investors.
Alternatively, is it right that an accelerator that takes immediate common stock get diluted by a prior round of convertible notes? Probably not. Thus, enter the negotiation and ensuing “friction”.
Ultimately, the complications lead to so much unnecessary friction for onboarding into an accelerator. And of course, this leads to way too much time spent on the onboarding process.
It is not fun attempting to make everyone happy through various cap table reps, or having your seed investors freak out over the accelerator’s limited non-dilution rights (which may be something the current investors do not have). So, this naturally makes the startup feel like they have a “special circumstance” and that the accelerator should give in/carve out/ etc. because of their special circumstance. But even so, this part increases the transaction costs (including legal fees) for both the startup and the accelerator.
Why Convertible Equity Can Help Accelerator Investments
The fact that convertible equity doesn’t technically make the accelerator a stockholder may be easier for a current investor to tolerate. You can tell your investors, in all honesty, that the accelerator will not get shares until and as part of the next financing.
So yes, the accelerator gets a “deal” relative to the valuation or price cap you just gave them (and I hope you fully-explain to your investors why the accelerator valuation is low), but from a blended point of view when factoring in the rest of the investment capital at the next round’s pre-money valuation, it’s likely that the “blended” pre-money valuation of the next round will be higher than their valuation or price cap.
Additionally, because the convertible equity is not “debt”, the accelerator will likely have a higher priority than your current investors upon liquidation/dissolution. But another reason why accelerator documents should not be a convertible note is because I would want to bang my head on my desk if there is another “negotiation” over a couple points of interest on a $25k instrument. I’d rather have everyone focus on the price cap or valuation of the investment rather than bicker over interest that equates to something under $1,000 after a couple of years.
Is Anyone Special If We Are All Special?
We are often asked by startups (and not just those who are our clients) entering accelerators how to negotiate with them because they are “special”. Either because they are “further along” than a typical accelerator participant and/or because they have raised some money. It was fine when it was maybe 1 team per accelerator class having a complicated cap table…but now everyone is claiming they are special, and thus it becomes an issue. Who really wants to negotiate carve outs to limited non-dilution rights? For a $25k+ investment, it’s pretty much annoying for all parties involved.
And this is coming from a lawyer. Law firms really don’t want to charge you a lot for accelerator onboarding, if anything, but as it has gotten really complicated lately, maybe this is where convertible equity can help. So now it’s not just 1 startup an accelerator deals with these complicated issues, it’s multiple!
Is Convertible Equity the White Knight for Accelerator Investments?
So, why convertible equity? It just makes sense that convertible equity should be able to be used early. Frankly, if you can’t use convertible equity this early, it shouldn’t be used later (or it follows that it should be easier to incorporate earlier than the seed rounds that convertible equity is currently being used). Is convertible equity the solution that cures all ills? Nah, there will never be a structure that solves all potential problems. But convertible equity can likely solve most of the problems better than other structures.
Thus, it’s my belief that accelerator investments should be some form of convertible equity. If you are an accelerator that has some other structure, you aren’t ‘wrong’ for what you have, but I think you may end up being happier once you start using the convertible equity structure. At a minimum, it might be able to cut some of the diligence time and cap table rep issues. I think we’ll see accelerator investments structured more and more as convertible equity as accelerators continue forward.
And lastly, if you are a startup entering an accelerator, don’t take this post and show your prospective accelerator why they are “wrong” for not using a convertible equity instrument for their accelerator investments…that’s certainly not the reason (or even indirect reason) why I wrote this.