The amount of the liquidation preference is usually expressed as a multiple, with the most common liquidation preference being “1X non-participating.”

This means that in the event the investor elects to use the 1x non-participating preference, the investor will receive up to 1 times the amount of the investment, but the investor will not get to participate with the common stockholders pro rata in the remainder of any sale proceeds. (Liquidation preferences that “participate” get to participate with the common after payment of the X multiple preference.)

Since an investor would only elect to use a 1x non-participating preference if the sale of the startup was for a “low” price, a liquidation preference typically is a defensive mechanism used to protect the investor’s downside.

However, 1x (or greater) participating or non-participating preferences with a multiple greater than 1 are just price negotiations, and anything better than a 1x non-participating liquidation preference is an investor offensive maneuver. The investor is maneuvering to increase returns and/or potentially blind you with a high valuation (only to be offset with a high multiple liquidation preference) so that you’ll take his or her deal.

Thus, if you see greater than a 1x preference and/or a ‘participating’ preference attached, know that your investor is just negotiating on price. If it were up to me, I’d rather have the startup and investor come to terms on the pre-money valuation rather than toying with anything other than a 1x non-participating liquidation preference.

For example, a startup requested I review a set of financing documents produced by investor counsel. The deal documents called the preferred stock “Series Seed” shares but after opening up the documents I quickly realized the deal terms were NOT the same as those in the well-known Series Seed document set. For example, the well-known Series Seed has a 1x non-participating liquidation preference, while the version I reviewed had a 1x participating preference. Ultimately, the deal document set was nothing like the well-known Series Seed set.

This confused my client, as he thought the deal was being done using the well-known Series Seed document set. However, provisions and deal terms can be different from standard sets even though a class of stock is called “Series Seed” or “Series AA” in your deal documents.

Therefore, if you think your deal is closing with a set of standard documents, you should at least run a compare document tool to see what, if any, deviations were made to the applicable standard document set. They might not be the standard set at all.

The standardized seed funding document movement is great and I fully support it.

So now you have more docs to choose from, and maybe more to be confused by. I have and will continue to use these document sets when a client requests. But there are a few myths about standardized seed funding docs, both in terms of their use and their effect on the legal landscape:

Myth #1: Startup Lawyers Hate Standardized Seed Funding Documents Because it Reduces their own Payday.

The premise here is simple: complicated/long docs = $$$ for lawyers.

But lawyers don’t make documents complicated to pad the bill. Legal documents can get “complicated” because of the potential issues that may arise pre- and post-transaction. If these issues didn’t actually happen, the documents wouldn’t be longer or more complicated.

For example, a founder stock purchase agreement is 12+ pages long because founders can, have, and will fail and/or bail on startups (hence the vesting schedule & startup repurchase option). When an issue like this occurs at your startup, you’ll be glad your documents are “complicated.”

Each time a new set of docs get released, I don’t cringe because it means I then have to remove the hockey stick from my revenue projections. I welcome these and future standardized seed funding docs because they provide entrepreneurs with the chance to take a look at financing terms. And since the model seed funding documents aren’t as cumbersome as those used in a typical Series A Round, I find that entrepreneurs tend to actually review them. Clients come better prepared now.

An educated entrepreneur is a better entrepreneur. And better entrepreneurs build more successful startups. Startup lawyers (myself definitely included) take the long-term view and want to see our clients succeed.

(Note: If you believe your lawyer is making documents complicated and long for the sake of his or her payday, ask your lawyer about the documents and the need for their complexity/length. If your lawyer’s answer isn’t good enough for you, then find a new lawyer. Of course, you can also ask for fixed-fee billing.)

Myth #2: Standardized Docs Reduce the Need for a Startup Lawyer

This myth is usually offered by someone who thinks lawyers are just gatekeepers of the legal document vault. There is no “walled garden” when it comes to legal documents. You can easily get legal documents via Lexis, Westlaw, Edgar, or any relevant legal treatise.

If you believe lawyers are simply document gatekeepers, you are missing the entire reason for hiring a lawyer — counsel. If you aren’t asking for counsel, you aren’t using your lawyer right. If your lawyer isn’t providing counsel, you have the wrong lawyer.

No set of seed funding documents will replace counsel, either pre-financing or post-financing. But in the event one of you genius hackers does this, please consider me for a job at your startup.

Myth #3: Standardized Docs = Open Source Law.

“Open Source Law” is a buzz phrase thrown around frequently, but what the legal profession is experiencing is more of an automation of various parts of the law practice….not the entire practice of law. There will always be demand for good counsel.

While the practice of startup law isn’t rocket science, it is nevertheless complex. In addition to understanding the provisions of your particular agreement, you have to know (i) what is missing from the agreement, and (ii) how the various provisions, situations, people, and investment amounts interact and may affect other off-document rules and issues. It’s difficult to do this unless you do this frequently.

Law firms are no more immune to open sourcing than any developer, engineer, or pixel pusher. But it doesn’t mean we’ll all go away, we’ll just adapt by providing more value. Those that manage this feat will survive.

Myth #4: Standardized Seed Docs are Appropriate for My Startup’s Raise.

First, most if not all the model seed docs assume your startup is a Delaware corporation. Thus, you are going to have to either edit the docs or reincorporate your startup in Delaware to use them properly. (Next up: the model reincorporation merger kit)

Second, the model seed docs tend to impress upon the entrepreneur that preferred equity is the best angel investment structure. That may be so, but convertible debt can also be appropriate for your startup’s angel round.

However, most (all?) sophisticated investors will not invest via a convertible note. And since the people & groups behind these model seed funding docs are some of the most sophisticated angel investors in the world, preferred equity investment model docs are being released.

Since entrepreneurs trust groups like TechStars and YCombinator, there is the tendency for startups to blindly use these docs, without considering alternatives like convertible debt. To their credit, these groups have earned entrepreneurs’ trust and have altruistic reasons for their release. Nor do they push these docs as “must use” docs.

Nevertheless, entrepreneurs should still consider whether a model seed funding document set (preferred equity) is prudent relative to their startup’s situation.

Conclusion

I support any effort to bring transparency to the law firm establishment and otherwise educate entrepreneurs (including model seed funding documents). That’s one of the reasons why I started this blog in 2006. You can’t be a startup lawyer and not want startups to have a better chance at succeeding. Model seed funding docs help entrepreneurs, but not to the detriment of startup lawyers.

The drafters, Fenwick & West and Andreessen Horowitz, imply these docs should be used for $500,000 to $1,500,000 investments. The drafters are “open sourcing” the documents so that they may be continually improved by the startup community.

The Series Seed Documents include:

(1) Amended and Restated Certificate of Incorporation

The Amended and Restated Certificate of Incorporation includes the typical provisions you might find in a VC deal, less (i) preferential dividends, (ii) redemption rights, and (iii) price based anti-dilution.

The board is set up to consist of 3 directors: 1 director elected by the common (founders); 1 directors elected by the preferred (investors); 1 “independent” director (i.e., the CEO) elected by the common via fiat in the Investors Rights Agreement.

(2) Series Seed Stock Preferred Stock Purchase Agreement

The requirements of various closing conditions, an officer’s certificate, a secretary’s certificate, and a legal opinion (from company counsel) have been dropped. The drafters also anticipate a management rights letter will be included in order to ensure “Venture Capital Operating Company” compliance for the VC investor(s).

(3) Investors’ Rights Agreement

The IRA does not provide for any registration rights. It also scales back the right of first refusal and jettisons the co-sale right. Lastly, the IRA contains a provision that the Series Seed investors should get whatever rights the investors in the next round of financing get.

(4) Term Sheet

The term sheet summarizes the provision found in the documents 1-3 above, but also includes a $10,000 legal fee reimbursement (cap) for investor counsel and a 4 year vesting schedule with double trigger acceleration for the founders.

Check out the docs here.

It is usually expressed as a percentage of the original purchase price of the preferred, such as “2x.” Thus, if the purchase price of the preferred is $5 per share, a liquidation preference of 2x will be $10 per share.

Alternatively, the liquidation preference can expressed as a per share amount, as seen in this generic liquidation preference clause:

The holders of the Series A Preferred Stock shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Corporation to the holders of the Common Stock by reason of their ownership thereof, the amount of $10 per share (as adjusted for any stock dividends, combinations or splits with respect to such shares) plus all declared or accumulated but unpaid dividends on such share for each share of Series A Preferred Stock then held by them.

Let’s take a simple scenario to see how the math works:

(1) Series A Price = $5 per share
(2) Series A Shares = 500,000
(3) Series A Equity Stake = 33% (i.e., they are investing at a $5MM pre-money valution)
(3) Series A Liquidation Preference = 2x (i.e., $10 per Series A share) = $5,000,000
(4) Startup Company is sold for $6,000,000

While the Series A investors paid $2,500,000 total for their shares for 33% of the startup company, the 2x liquidation preference will ensure that the Series A investors receive $5,000,000 of the $6,000,00 purchase price of the startup. Thus in this scenario, the 2x liquidation preference gives the Series A investors 83.3% of the total sales price of the startup (even though the Series A equity stake is 33%) and the common stock holders will receive the remaining 16.7% pro-rata in accordance with their common stock ownership.

(This example assumes that the Series A preferred shares do not participate with the common in the remaining 16.7%. I’m also leaving out the possibility of conversion-to-common to simplify this example.)

The model seed funding documents include:

Term Sheet. This sets out the terms of the proposed seed investment into your startup and alsos include the proposed cap table (reflecting the seed investment).

Amended and Restated Articles of Incorporation. Your startup will need to restate, i.e. re-do, the charter it originally filed with Delaware now that your startup will have more than one class of stock.

Bylaws. Think of this document as your startup’s Constitution. You may already have a set of bylaws, but consider upgrading to something like this now that your startup has an outside investor.

Subscription Agreement. While the term sheet is an outline, the subscription is the definitive agreement where your seed investor purchases the securities (preferred shares in the model docs) from your startup. It will contain various reps & warranties from both seed investor and startup company, along with transfer restrictions.

Board Member Election Consent. The model documents anticipate that the preferred shareholders will have the right to select 1 board member. The preferred shareholders elect this board member with this election consent.

If you are considering using these documents on your own, David Cohen, co-founder and Executive Director of TechStars, gives the following proviso:

Please feel free to use these documents, but please do so responsibly only after retaining your own legal cousel. Don’t use these documents blindly. All of the figures in them are made up, and are not necessarily accurate or consistent. We’ve made best efforts to call out the places that need to be edited based on the situation using brackets. But still, using these documents for a real financing and without good legal advice is just plain foolish. Think of them as a good starting point that can save you some time and money.

Also note that the model documents assume your startup is a Delaware entity and is issuing equity securities.

TechStars is a mentorship-driven seed stage investment fund located in Boulder, Colorado. Learn more about TechStars here.

Rounds of financing are tied to classes of preferred stock. You can name the preferred stock rounds whatever you like, but the norm is to follow the alphabet. For example:

1st round = Series A
2nd round = Series B
3rd round = Series C
26th round = Series Z

If a startup raises its rounds of financing at increasingly higher company valuations, each new class of preferred stock will represent an increase in price. This means that value is being created and progress is being realized at the startup. Thus, a startup may be going through a sixth-round financing (or Series F) simply because the startup needs more time or money than it anticipated.

Term Sheet – August 29th
Stock Purchase Agreement – August 30th
Board Consent – August 31st
Stockholder Consent – September 1st
Amended and Restated Certificate of Incorporation – September 2nd
Investors’ Rights Agreement – September 3rd

But until then, the following are my general comments about the documents and are geared towards those readers thinking of using the Y Combinator documents on their own:

“Neutral” is all about perspective. Entrepreneurs are often worried about being taken to the cleaners by their investors. Thus neutral legal documents appeal to the startup entrepreneur. But in order for an entrepreneur to be taken to the cleaners by an investor, the investor or investor’s counsel must be sophisticated regarding these deals. That isn’t always the case. (I have experienced situations where both investor and investor’s counsel were unsophisticated about these types of financings…and no I don’t have their contact information for you.) So keep in mind that you could be giving away terms instead of getting better terms by using these documents.

Delaware corporation and not [Insert state and type of legal entity here]. There’s a reason why the documents have a Delaware corporation as the default entity. A Delaware corporation is really the only option if you want to do these types of financings and move on to venture capital. I have written a few posts about “Why Incorporate in Delaware?” and “Why a Corporation for Venture Capital?” explaining the subject. Of course, the Series AA documents aren’t for venture capital financings, but the underlying reasons for using a corporation exist in an angel round.

Read between the disclaimer’s (many) lines The lawyers at WSGR didn’t add the legal disclaimer at the top of each document just to run up Paul Graham’s legal bill. Sure, WSGR doesn’t want to get sued. But implied by WSGR not wanting to get sued is that people will take these documents and royally screw up.

And don’t think only those that do large amounts of editing to the sample documents will screw up. Legal documents must reflect the deal. You could be in a bad situation if you sell (or believe you have sold) your investor one thing and the documents reflect something different.

No legal document is dispute-proof. Don’t assume that you are immune from disputes because you used “neutral” document or “boilerplate” provisions. If I created a dispute-proof legal document, I’d be (a) the first lawyer in the history of the world to accomplish that, and therefore (b) be on my way to Boracay for a 12-month sabbatical.

And finally, I think you should take a look at this article at the Startup Company Lawyer. It is written by Yokum Taku, a partner at WSGR (the law firm that wrote the Y Combinator documents), and therefore he will have fantastic insight regarding these documents.

Next – The Y Combinator Term Sheet

Y Combinator and Wilson Sonsini Goodrich & Rosati are happy to announce the Series AA Equity Financing Documents.

The Y Combinator documents are back up again–grab them while you can.

At first glance, it looks like they added a term sheet. And now each document comes with a fancy new header:

This [document] and all of the Series AA financing documents on this website have been prepared by Wilson Sonsini Goodrich & Rosati for informational purposes only and do not constitute advertising, a solicitation, or legal advice. Transmission of such materials and information contained herein is not intended to create, and receipt thereof does not constitute formation of, an attorney-client relationship. Internet subscribers and online readers should not rely upon this information for any purpose without seeking legal advice from a licensed attorney in the reader’s state. The information contained in this website is provided only as general information and may or may not reflect the most current legal developments; accordingly, information on this website is not promised or guaranteed to be correct or complete. Wilson Sonsini Goodrich & Rosati expressly disclaims all liability in respect to actions taken or not taken based on any or all the contents of this website. Further, Wilson Sonsini Goodrich & Rosati does not necessarily endorse, and is not responsible for, any third-party content that may be accessed through this website.

So don’t forget to delete the headers when you customize your legal documents…

Sorry, there’s a glitch with the documents and we had to take them down. We hope to have something back soon.

Well 6 days later the same error message appears if you visit the link. This leads me to believe that WSGR really did have an issue with the release of the documents. I do understand why WSGR would have an issue with the release, but I hope WSGR and Y Combinator can work it out.

Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. The most commonly used method to obtain an exemption when conducting a private placement is Regulation D, which contains two exemptions in Rule 504 and Rule 505 and one safe harbor in Rule 506.

In order to conduct a private placement properly, the issuer must follow a multitude of requirements. Some of these requirements encompass:

-How much capital can be raised
-Who can be offered the securities
-When can the securities be offered
-Who can offer the securities
-Advertising and soliciation
-Information requirements
-Where the securities are offered

Definition of Preferred Stock

Preferred stock is a class of stock that provides certain economic and control rights and protections not given to the holders of a startup’s common stock (the founders usually hold the common stock). Hence this class of stock is “preferred.”

Typical economic rights of preferred stock include a liquidation preference, anti-dilution protection, and conversion rights. Control rights deal with a host of voting issues and electing the board of directors.

Which Investors Receive Preferred Stock?

Preferred stock is most commonly issued when a startup undergoes a large financing, such as one with a venture capital fund. Angel investors and the friends & family round may sometimes receive preferred stock. Keep in mind there is no bright-line rule when it comes to angels and the f&f round.

Other than the Capital Raised, Does the Startup Benefit from the Issuance of Preferred Stock?

It sure does. Since preferred stock comes with economic and control rights and protections, common stock typically gets a lower valuation for the purposes of stock option grants or share issuances to the corporation’s employees. Employees can generally exercise their common stock options at a lower price than the price of the preferred stock. Thus, employees may feel as though they are receiving some sweat equity for their contribution to the corporation.

But little did you know that Uncle Steve subscribes via RSS to VentureBlog and follows Brad Feld’s tweets. Thus, Uncle Steve doesn’t want mere common stock but rather desires to be issued preferred stock. You were prepared to issue preferred stock to venture capitalists, but what do you do with Uncle Steve?

Issue Uncle Steve a diluted ‘Series A’ preferred shares. While you can oblige Uncle Steve’s risk tolerance through various economic, control, liquidity, and management terms with the preferred stock, the most important thing to do is maintain the ability to raise future venture funds. Limit shareholder rights (tag-along), keep a basic liquidation preference, think about a drag-along provision, etc. It’s OK to let Uncle Steve get some preferred provisions, but it can’t become an obstacle to future financings.

Series FF was created for those founders desiring to cash out a small part of their overall stake in their startup company at a funding (rather than waiting to go public or get acquired). Thus, the FF class provides founders with the opportunity for a more immediate return on their investment of cash, blood, sweat, and tears.

The mechanics of Series FF Stock work like this: At a very early stage in the startup company’s life, the founders are issued a very weak class of preferred stock. The issued FF shares typically come attached with the right to convert into a future round of preferred (such as a Series B) and then sell the converted shares to investors. This conversion and sale can only take place at a financing.

The issue of early founder liquidity can lead to tension between investors and founders. The investors want to keep the founders properly incentivized. In theory, letting founders cash out any of their stake may make the founders disinterested in growing the newly-funded company.

My belief is that a little bit of liquidity for founders at funding may actually benefit the venture backed company. The founders may have maxed out credit cards or have other bills they incurred in order to get to their startup to the point of funding. Even if the founders are debt-free, I don’t think founders will lose focus over a (relatively) small payday compared to an acquisition or IPO exit.

Keep in mind that if a founder converts and sells Series FF shares, the founder’s equity in the company is reduced. Therefore, if an IPO or M&A exit is in the startup’s future, selling shares early will likely be a costly move for the founder.

For more background about the origin of Series FF stock, click here.

The definition of an accredited investor is found in Regulation D’s Rule 501 of the federal securities laws. An accredited investor is:

• a bank, insurance company, registered investment company, business development company, or small business investment company;
• an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
• a charitable organization, corporation, or partnership with assets exceeding $5 million;
• a director, executive officer, or general partner of the company selling the securities;
• a business in which all the equity owners are accredited investors;
• a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
• a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
• a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

In addition to accredited investors, Rule 505 and 506 permit raising capital from up to 35 non-accredited investors (i.e., anyone that does not fit the accredited investor definition above). But that doesn’t mean your company should raise capital from non-accredited investors, and for a good few reasons:

(1) Non-Accredited Investors Trigger a Larger Disclosure of Information – If you raise capital from non-accredited investors in a Rule 505 or Rule 506 registration-exempted financing, you must provide a huge amount of information about your startup company. Think IPO-registration huge, thereby leading to larger legal and accounting costs. Such additional costs may not be prudent if your startup company is tight on capital.

(2) Non-Accredited Investors Tend to be More Hostile Than Accredited Investors – Implied by the definition of a non-accredited investor, the investment a non-accredited investor makes to your startup company will mean much more to him or her than an investment an accredited investor makes. A non-accredited investor will be much more emotional. Thus, non-accredited investors are much more likely to sue your company if things don’t go according to plan.

(3) Non-Accredited Investors can Hinder an Acquisition – It may be difficult for your startup company to be acquired after it has completed a registration-exempted financing with non-accredited investors. Non-accredited investors trigger additional rules in the context of an acquisition (e.g., a purchaser’s representative). Sometimes the acquiring entity will require a startup company to perform a buyout the non-accredited investors pre-acquisition.

Therefore, if at all possible, your startup company should refrain from raising money from non-accredited investors. They simply create too many problems during and after your financing.