All posts by Ryan Roberts

Why Seed Round Due Diligence Should Not Start Too Early

Seed Round Due Diligence Time

Occasionally, early investors will send extensive seed round due diligence requests to a startup way too early. By way too early, I mean when a potential investor sends your startup an 8+ page seed round due diligence request list– without having made any sort of “commitment” to invest. This transmission of a “too early” seed round due diligence list is problematic for a number of reasons.

Time is Money (and likely money you don’t have yet)

First, the early due diligence process could be a waste of your startup’s time and money. If the potential investor is just fishing rather than actually reeling you in, all the time and money spent preparing the answers and documents (including any associated attorney time) in response to a seed round due diligence production request ends up being a complete loss.  Why risk both time and money if the potential investor has not even made a soft commitment to invest in your startup?

You could be working on closing deals..or other investors

Second, responding to an extensive seed round due diligence list early (without any sort of commitment) can put your startup at a standstill. It will likely take a good chunk of your startup’s personnel to prepare the seed round due diligence, which puts a halt on development of your startup’s product and/or service.  You could risk taking people off your development projects for a small period of time and for what?

Also, the request for due diligence might give your startup a false positive, by interpreting the seed round due diligence request as a commitment. Then you could end up focusing on this one particular investor. And, unfortunately, when the seed investor ends up not investing, your startup will be left with no investor momentum, a lost couple of weeks, and maybe a small legal bill.

Too much information (TMI)

Third, some of the diligence requests may involve information that you may not want to divulge at such an early juncture. This information could be of a confidential nature, intellectual property or trade secrets, or customer lists and contacts. You don’t have to send a detailed cap table to someone just ‘fishing’ — worst case send them a cap table summary which lumps groups of people together (founders, optionholders, convertible debtholders, etc.). Be prudent about what you send across.  One mistake I see startups make is they send the kitchen sink to each potential investor (sometimes without a signal from the seed investor that they are interested in investing).

 

Conclusion

Due diligence is a process that benefits both seed investors and startups. A startup can learn about a potential investor by the diligence requests and associated questions. But your startup shouldn’t enter into an extensive seed round due diligence phase without some sort of commitment by the potential investor. Sure, a term sheet is a sign of commitment, but a seed investor should be able to demonstrate commitment prior to a term sheet, especially if they are asking for more than nominal diligence about your startup.

Technology Startup Law Firm Now Accepting Bitcoin

lawyer bitcoin

My firm has decided to start accepting payment via bitcoin. We had our first bitcoin transaction yesterday from a client that just so happens to be in the bitcoin space. The firm decided to go with Coinbase as our “international digital wallet”.

The firm made the decision to accept bitcoin since we represent tech savvy individuals and entities, many of which are international clients. International wires tend to have transactions costs and sometimes take too long. We do realize there is an exchange rate risk, but we like to think we’re at least half as risk-loving compared to our clients.  Of course, we reserve the right to change our minds on this.

Why Your Current Employer Invention Assignment is Key

employer invention assignment

Due primarily to monetary constraints, many founders maintain a separate job (i.e., “day job”) during the initial stages of their startup. This is usually the case whether or not the startup is incorporated, and is a common way for the co-founders to self-fund or otherwise hedge their bet prior to a startup’s seed round of financing.  However, many startup founders overlook the fact that  a certain document they may have signed at their day job can hold great importance with respect to their startup’s viability. Prior to launching a startup, each co-founder should review their current employer invention assignment to see if the IP they are developing for their startup could possibly be claimed by their current employer.

Employer Invention Assignments do not come with all jobs

If in the technology field, a co-founder’s day job likely requires their employees to sign an invention assignment in conjunction with or as part of their employment agreement. In a nutshell, the employer invention assignment defines parameters that an employee assigns intellectual property to its employer. (And for what it’s worth, a startup should have such an invention assignment with each of their co-founders.)  Thus, if your day job isn’t related to the development of technology or your employee is not a technology company, you may not have signed and invention assignment.

Check the Scope of Your Employer Invention Assignment

Some employer invention assignments are broad in scope while others are very narrow in scope. Regardless of what the contract says, you should note that certain jurisdictions like California place boundaries on how broad employers can make their employer invention assignment.  For what it’s worth, the general trend is that employer invention assignments are somewhat fair and do not try to assign every thought you have ever had over the the company (although we’ve seen a few companies try).

The broader the scope of the invention assignment, the greater the potential problem for the founder and his or her startup, as the founder may be unknowingly assigning intellectual property to the day job rather than the startup. If the startup or the technology involved is in any way related to the day job or if the founder is using the equipment of the day job while working on the startup, the risk of such an assignment increases.

Conclusion

Thus, it is very important that startup founders who choose to maintain a day job first locate their employment contract and then look closely at applicable invention assignment. Determine under what parameters intellectual property is being assigned to the day job. Founders should at least be aware of the scope of any applicable invention assignment located in their current employer invention assignment agreement – even if their startup is a completely different product or service relative to their day job.  And if you are not sure, it’s not out of bounds to call the company and speak to someone in human resources in order to determine what the scope of your employer invention assignment.

When Majority of the Board Doesn’t Mean Control

In conversation at various startup events, I hear a common but potential misconception relating to “control” and the board of directors. For example, I often overhear “it’s great that the founders only had to give up 1 board seat, so they still retain control of the board/company.” But board composition is not necessarily the sole determinant of control, as certain mechanisms can erode or supersede the traditional majority rules formula of control.

Beginning at a significant seed round, it is not uncommon for an investor to require certain elements of control, in addition to a board seat. For example, they may require that in order for a certain corporate action to be approved, a specified board member such as the board member appointed by the investor, must approve such action (in addition to a majority vote of the board). This can allow an investor, through their board seat, to maintain control over specified matters while possessing a minority of the board seats. Additionally, certain corporate actions may require approval of certain a class or series of a startup’s stock (in addition to a majority vote of the board).

Alternatively, and rarely, a startup may set up a board structure that gives certain directors more than 1 vote per seat. Thus, one person on a three-person board could ‘control’ the board if they were given enough votes for their board seat. This is another instance of control being retained by a minority of the board in terms of the numbers. (Note: I don’t recommend startups start working this mechanism into their docs.)

A startup needs to look closely and understand each and every control aspect of a deal, as it could be giving up only one board seat in absolute terms but effectively relinquishing control if there are certain strings attached to the investment. The founders should know exactly how much control they are losing — and that it is not always determined solely by the number of board seats.

If I Launched a Startup in 2014

launch startup

I thought I would expand upon and update my “If I Launched a Startup” post from 2010 to include recent issues such as incubators and crowdfunding.

So in 2014, here’s what I’d do in the beginning:

Incorporation

(1) When: As soon as I was serious about making my startup a business, but after I checked my current job’s employment contract
(2) Type of Legal Entity: C Corporation, and not an S Corporation or LLC
(3) State of Incorporation: Delaware (since I’m at least potentially looking to raise capital)
(4) Authorized Shares in Certificate of Incorporation: 10,000,000 shares of Common Stock
(5) Par Value of Common Stock: $0.00001 per share
(6) Aggregate Stock Issuance to the Initial Founders: 6,000,000 shares
(7) Founders Equity Split: Depends on the Team, But Quickly but only after the Difficult Conversation(s)
(8) Vesting For All Founders?: Heck yeah
(9) Vesting Schedule: 4 years with a 1-year Cliff with Double-trigger Acceleration
(10) Payment for Founders’ Shares: Cash and Intellectual Property
(11) Handling of “Lost Founders”: Get an Assignment and/or Release (then wish them well)
(12) Freak-Out on My Lawyer When I get My Delaware Franchise Tax Bill?: No

Incubators, Mentors, Advisors and Developers

(1) Choosing an Incubator: It’s all about the mentorship
(2) Incubator Funding Documents: Easy and Light
(3) Strike a Deal with a Mentor During the Incubator Program?: Probably not
(4) Raise a Round Before Demo Day?: No, wait until after…unless it’s a great Series A.
(5) Option Grant Size to an Advisor: 0.10% to 0.50%, but only after execution of an Advisor Agreement
(6) Outsource all Technical Development?: No

Raising Capital

(1) Length of Investor NDA: 0 pages
(2) Fees Paid to Pitch: $0
(3) Investors: Accredited only (no crowdfunding until the rules are easier on startups)
(4) Seed Round Structure: Convertible Notes
(5) Convertible Note Incentive: Discount and Price Cap, but with a liquidation preference regulator.
(6) Convertible Note Interest: 2-8%, but hopefully 2%
(7) When to Hold Closing: On a Rolling Basis
(8) First Purchase after Closing: A Legit Scanner

Best of luck to you in 2014!

How Many Shares Should be Issued to Founders at Incorporation?

I typically advise issuing 50% to 80% of the authorized shares of Common Stock to the initial founders upon incorporation.

Thus, if the certificate of incorporation authorizes 10,000,000 shares of Common Stock, an aggregate of 5,000,000 to 8,000,000 share should be issued at incorporation.

If the startup plans to bring on additional founders in the very near future, or for some reason wants a large option pool, then that initial number should be closer to 50% than 80%.

While your startup can always authorize additional common stock (upon appropriate board and stockholder consent), keeping a good-sized reserve of unissued, but authorized shares means that you will not have to incur the transaction costs associated with increasing the authorized shares. In order to increase the authorized shares, your startup will have to file a certificate of amendment with the secretary of state which has filing fees associated with it.

Startup Advisor Agreements: A Primer on the Basics

advisor agreement startups

By the time a startup compensates an advisor with incentive equity, it is best practice for startups to also have a written agreement typically called an “Advisor Agreement” or “Advisor Letter” in place to protect the startup. The Advisor Agreement also has the side benefit of managing expectations on both sides.

What is an Advisor Agreement?

A typical advisor agreement defines the startup-advisor relationship. For example, the Advisor Agreement will typically set forth the advisor’s incentive equity amount and type (i.e. options or restricted stock grant) and a vesting schedule. (Note that the Advisor Agreement is not a substitute for the Stock Option Agreement or Stock Grant Agreement.) More importantly, the Advisor Agreement should include, or have attached, various terms and conditions.

Confidential Information Clause

The protection of confidential information should be addressed. To be useful as an advisor, they will have to know all about your startup including some or all of the confidential information and/or technology you may have. Advisors aren’t in the business of divulging confidential information, but worst case scenario you will have an agreement in place and set the expectation that your startup’s confidential information is not to be disclosed or used for any other purpose. This type of clause is usually non-negotiable, except maybe for the duration of the obligation. Meaning, if a potential advisor will not agree to the confidential information clause, it’s time to let that ship sail and find a new advisor.

Inventions Assignment may be a good idea

Another essential issue relates to the assignment of intellectual property. While all startup employees should be party to an inventions assignment, the inventions assignment provision in an Advisor Agreement should likely be ‘narrower’ than a typical employee’s inventions assignment clause. And in some cases, it may be deleted.  It does depend on the actual circumstances, including how involved such advisor will be with confidential information and the development of the company’s products or services.  The more involved, the more likely at least a light inventions assignment would be ideal.

Term and Termination

Finally, usually advisor agreements may be terminated by either the startup or the advisor at will (i.e., immediately).  Sometimes an advisor requests a longer termination period, but before you write such into the advisor agreement, ask why he or she is asking for that clause.  Usually there’s a workaround in their incentive equity grant that is a better solution than being forced to stay together.

Advisor Stock Option Grants

One asset that startups should consider taking advantage of is advisors. Luckily for startups, advisors are prevalent and can be readily found through incubators, networking and/or personal contacts. The best advisors are in it to pay it forward or give back to the startup community.

If you want to take a very informal advisor relationship to the next level, your startup should consider granting incentive equity to the advisor. Most often, this incentive equity is given in the form of stock options (but can be an outright stock grant).

The usual range for an advisor grant is the 0.10% to 0.50% range of the startup’s fully-diluted capitalization. The most common size of the grant is 0.25% and vesting is usually over 1 or 2 years, monthly, and without a cliff.

Some entrepreneurs are stingy with their equity, and understandably so, but advisors are generally worth the price. Though, obviously, an incentive equity grant and this relationship should not be entered into lightly — do your diligence on the advisor. At the end of the day, these incentive equity grants are typically very small and the return can potentially be very large.

Insights Seminar: Convertible Notes

On January 22, 2014, my law firm is putting on a seminar on the topic of Convertible Notes. I will be the presenter and will discuss topics such as the pros and cons of a convertible debt round to specific terms and structural tactics.

The seminar is free for entrepreneurs (and investors) and will be held from 6:30pm to 7:45pm at The Grove, a coworking and collaborative space in Dallas.

Click here to register or find out more information about the seminar

As of right now, we do not plan to stream this seminar but are looking into doing so for future seminars.

Startups Should Invest in a Quality Scanner

When your startup goes through due diligence for an investment round or an exit, investor’s or buyer’s legal counsel will typically send a laundry list of document requests. These documents range from the startup’s bylaws to stock option agreements to third party contracts to prior financing documents.

Quite often, these diligence materials are not readily available and/or can be difficult to track down. Or, only pieces of documents can be found (e.g, a signature page rather than the full document).

This leads to “corporate cleanup” which is ultimately a time consuming and expensive process. Most of this time and expense can be prevented with the use of a quality scanner. (In our experience, online signature services are only good for a one-off contract.)

Good scanners today won’t wreck your burn rate. For example, the fujitsu line of scanners like the iX500 can usually be found in the $420 to $495 range. We have a fujitsu here as a backup scanner to our large Bizhub.

If your startup raises a round in the low six figures or more, it should purchase a scanner soon after the wire comes through. It will save time and money down the road.