This post is the third part of a three-part primer on convertible note seed financings.  Part 1, entitled “Everything You Ever Wanted To Know About Convertible Note Seed Financings (But Were Afraid To Ask),” addressed the basics.  Part 2, entitled “Convertible Note Seed Financings: Econ 101 for Founders,” addressed the economics.  This part will address certain tricky issues.

[This post was originally published on TechCrunch.]

What Happens If a Startup is Acquired Prior to the Note’s Conversion to Shares of Preferred Stock?

As discussed in part 1, in the context of a seed financing, a convertible note is a loan that typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing.  One of the tricky issues that founders must address in the note is what happens if their startup is acquired prior to the note’s conversion (and prior to the note’s maturity date, as discussed below).  There are generally three different approaches:

1)  Money Back, Plus Interest (Founder-Friendly).  The first approach is the most founder-friendly, and it is a provision that merely requires the startup to pay-off the loan, plus interest.  In other words, in the event of the startup’s “acquisition” (which is often broadly defined to include a merger, change of control or sale of substantially all its assets), the maturity date of the note would be accelerated, and the amount of the loan, plus interest, would become due at the closing of the acquisition.  Obviously, this is not very appealing to sophisticated investors because their return on a high-risk investment would only be the interest on the loan, which (as discussed in part 2) is typically 5%-7% annually.  In Fenwick & West’s 2011 Seed Financing Survey (the “Fenwick Survey”), the percentage of convertible note seed financings that utilized this approach was 17% in 2010 and 9% in 2011.

2)  Conversion Right (Investor-Friendly).  The second approach is the most investor-friendly, and it is a provision that permits the noteholders to convert the notes into equity (or otherwise grants them a certain percentage of the sale proceeds), based on an agreed-upon valuation of the startup.  There are variations and complicated language that are typically negotiated to address the conversion right; however, the bottom line is that the noteholders would be able to share in any upside if the startup were acquired.

For example, let’s assume that the noteholders invested $500,000 and were granted the right to convert into shares of common stock at a $4.5 million valuation in the event the startup were acquired prior to the Series A round (or other “qualified financing”).  If the startup were then acquired for $20 million, the noteholders would receive $2 million or 10% of the proceeds (not including accrued interest), by converting the $500,000 loan into shares of common stock representing 10% of the issued and outstanding shares, post-conversion ($500,000 divided by the sum of $4,500,000 and $500,000).

In the Fenwick Survey, the percentage of convertible note seed financings that utilized this approach and thus granted the noteholders a right to convert at an agreed-upon valuation was 33% in 2010 and 65% in 2011.

3)  Premium (Intermediate Approach).  The third approach is generally deemed an intermediate approach, and it is a provision granting the investors the right to get their money back with interest, plus a premium, which is typically drafted as a multiple of the principal amount of the loan (generally in the 0.25x to 1.50x range).  Using our example above, and assuming a 1.0x premium, the noteholders would receive $1 million, plus interest, computed as follows: $500,000 (principal amount) plus $500,000 (premium) plus interest, which is obviously $1 million less than investors with a conversion right would receive.

Notice, however, that this so-called intermediate approach can actually be the most beneficial to noteholders (and the least beneficial to the founders) if the startup were sold for a relatively low price.  Using our example above, but dropping the purchase price to $7 million, we can see that the noteholders would receive (i) $700,000 (10% of $7 million), plus interest, if they converted the note into shares of common stock; and (ii) $1 million, plus interest, if they were granted a 1x premium (an additional $300,000).  This is why many sophisticated investors will push for both a conversion right and a premium, with the right to choose the higher amount.  (Sophisticated investors will also push for a provision prohibiting the pre-payment of the loan to prevent an end-run around the second and/or third approach.)

In the Fenwick Survey, (i) the percentage of convertible note seed financings that granted the noteholders a right to receive a premium was 50% in 2010 and 61% in 2011; (ii) the median premium was 0.75x in 2010 and 1.0x in 2011; and (iii) the percentage of convertible note seed financings that granted the noteholders both a conversion right and a premium was 0% in 2010 and 35% in 2011. 

What Happens If the Maturity Date Is Reached Prior to the Note’s Conversion to Shares of Preferred Stock?

This is another tricky issue.  Founders must not forget that a convertible note is a loan and, like most loans, has a fixed due date (or “maturity date”) for repayment of the total amount borrowed, plus interest.  Convertible notes are thus ticking time bombs: if the maturity date is reached, and there hasn’t been a Series A round (triggering the automatic conversion of the notes into shares of preferred stock), there is the potential for disaster.

The maturity date for convertible notes typically ranges from 12 to 24 months from the closing date, with 18 months being the most common.  In the Fenwick Survey, the median term was 18 months in both 2010 and 2011.  Accordingly, a startup that has issued convertible notes as seed financing will generally have an 18-month window in which to close a Series A round.  If the company is unable to do so during such period, it will generally be required to repay the loan, plus interest, or otherwise be in default under the note; in which case, the noteholders may force the company into bankruptcy.

As discussed below, there are two ways a startup can avoid this nightmare scenario: (i) include a provision in the note that requires an automatic conversion of the loan, plus interest, into equity on the maturity date; or (ii) negotiate an extension of the loan (i.e., a new maturity date) with the noteholders.

1)  Automatic Conversion.  Founders can often convince “friends and family” and less-sophisticated investors to agree on an automatic conversion into shares of common stock in the event that there hasn’t been a Series A round prior to the maturity date.  Sophisticated investors, however, will push back hard against such a provision.  From their perspective, requiring the loan (plus interest) to convert automatically into shares of common stock (or a new series of preferred stock) upon a default arguably rewards the founders and removes the significant leverage and rights the noteholders would have as creditors of the startup.  Indeed, in the event of the startup’s bankruptcy or an assignment for the benefit of creditors, the noteholders would have priority (i.e., be ahead of the stockholders) with respect to any payments or distribution of assets.  Moreover, the noteholders would likely have the leverage to negotiate a conversion into equity on terms satisfactory to them regardless of the terms of the note.

The Fenwick Survey does not address the percentage of convertible note seed financings that required the notes to convert automatically into equity at the maturity date.  It is interesting to point out, however, that the convertible notes issued by Y Combinator companies to the Start Fund include an optional conversion upon maturity into Series AA Preferred Stock based on a $5 million valuation (see post here).

2)  Loan Extension.  The second approach — negotiating an extension — is more common and obviously depends on a number of different factors, including the startup’s financial condition and prospects, the market conditions, the relationship between the founders and the investors, etc.  Moreover, for an extension to work from a practical standpoint, it is often necessary that the note include a provision permitting its amendment or a waiver of its terms upon the written consent of a majority of the holders (based on the principal amount outstanding).  Founders and company counsel sometimes miss this issue, and it later comes back to haunt them – when one minor noteholder ends-up holding the negotiations hostage.

Does a Startup Have to Comply with Any Securities Laws in Connection with the Issuance of Convertible Notes?

Yes, a convertible note is a “security” under federal and state securities laws.  Accordingly, founders must understand that, even though a convertible note is debt upon issuance, it is no different than issuing shares of common or preferred stock for purposes of securities-law compliance.  Needless to say, a comprehensive discussion of applicable securities laws is beyond the scope of this post; however, here are two key takeaways for founders: (i) make sure all the noteholders are “accredited investors”; and (ii) don’t compensate anyone for helping you raise funds unless they’re a registered “broker-dealer.”

1)  Accredited Investors.  The rule of thumb in connection with private placements (like a convertible note seed financing) is to issue securities only to accredited investors in reliance on Rule 506 of Regulation D of the Securities Act of 1933.  There are two significant reasons for this:  First, Rule 506 preempts (or overrides) state securities laws – which means that a startup doesn’t have to spend a lot of time and money dealing with applicable state securities commissions (other than preparing and filing a Form D).  Second, there is no written disclosure requirement, like a private placement memorandum, if the investors are accredited.

There are eight categories of investors under the current definition of “accredited investor,” the most significant of which for seed financings is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase, not including the value of their primary place of residence; or (ii) 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 such income level in the current year.

2)  Broker-Dealers.  There are lots of companies, individuals, websites and other so-called “finders” offering to help startups raise funds.  Founders must understand, however, that if a finder is receiving some form of commission or other transaction-based compensation (which is often the case), the finder will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions. If the finder is not registered as so required and sells securities on behalf of a startup, the private placement will be invalid and the startup will be in violation of applicable securities laws.

For example, in August 2011, the California Department of Corporations issued a formal consent order against Profounder (a crowdfunding site that recently shut down) to “desist and refrain” from engaging in securities transactions without registering as a broker-dealer.  Accordingly, any startup that raised funds via Profounder runs the risk of having violated applicable federal and state securities laws by utilizing an unregistered broker-dealer.  (Note: Pursuant to the recently-enacted Jumpstart Our Business Startups Act, certain sites will be permitted to register with the SEC as a “funding portal” in lieu of a broker-dealer, provided that certain other requirements are met.)

The bottom line is that founders must be very careful any time they are taking other people’s money.  Non-compliance with applicable securities laws could result in severe consequences, including a right of rescission for the investors (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

I’ve been a corporate lawyer for 18+ years, and there are certain fundamental mistakes that I’ve seen entrepreneurs repeatedly make in connection with fundraising.  Accordingly, I thought it would be helpful to provide a simple checklist tailored to first-time entrepreneurs.  I’ve also included links to prior posts for a detailed discussion.

1.  Do your homework and determine which investors are the right fit for your startup (see post here).

2.  Hustle and build relationships in order to get warm introductions to those investors (see post here).

3.  Optimize for people, not valuation (see post here).

4.  Only raise money from friends and family as a last resort (see #1 in post here).

5.  Get references and speak with other entrepreneurs and founders who have done deals with your prospective investors (see post here).

6.  Limit your pitch deck to 10 slides or less, tell a story and demo your product (see post here).

7.  If it’s a seed round, issue convertible notes (see post here).

8.  Don’t solicit investors via Facebook, LinkedIn or Twitter (see posts here and here).

9.  Only raise funds from “accredited investors” (see post here) and make sure your lawyers file a Form D with the SEC and applicable state commissions (see post here).

10.  Don’t pay anyone a commission for raising funds for you unless they are a registered broker-dealer (see post here).

This post is the second part of a three-part primer on convertible note seed financings.  Part 1, entitled “Everything You Ever Wanted To Know About Convertible Note Seed Financings (But Were Afraid To Ask),” addressed certain basic questions, such as (i) what is a convertible note? (ii) why are convertible notes issued instead of shares of common or preferred stock? and (iii) what are the advantages of issuing convertible notes?

This part 2 will address the economics of a convertible note seed financing and the three key economic terms: (i) the conversion discount, (ii) the conversion valuation cap and (iii) the interest rate.

Part 3 will cover certain special issues, such as (i) what happens if the startup is acquired prior to the note’s conversion to equity? and (ii) what happens if the maturity date is reached prior to the note’s conversion to equity?

[Note: This post was originally published on TechCrunch.]

What Is a Conversion Discount?

As discussed in part 1, in the context of a seed financing, a convertible note is a loan that typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing.  A conversion discount (or “discount”) is a mechanism to reward the noteholders for their investment risk by granting to them the right to convert the amount of the loan, plus interest, at a reduced price (in percentage terms) to the purchase price paid by the Series A investors.

In other words, the founders are saying to the investors, in effect, if you take this risk and give us money today, we’ll reward you by giving you “20% off” at our Series A round down the road (20% being the usual discount, as discussed below).  For example, if the investors in a $500,000 convertible note seed financing were granted a discount of 20%, and the price per share of the Series A Preferred Stock were $1.00, the noteholders would convert the loan at an effective price (referred to as the “conversion price”) of $0.80 per share and thus receive 625,000 shares ($500,000 divided by $0.80), which is 125,000 shares more than a Series A investor would receive for its $500,000 investment and a 1.25x return on paper ($625,000 divided by $500,000).  (The foregoing example does not include accrued interest on the loan, which is typically about 5%-7% annually, as discussed below.)

Discounts generally range from 10% (on the low side) to 35% (on the high side), with the most common being 20%.  In Fenwick & West’s 2011 Seed Financing Survey (the “Fenwick Survey”), the percentage of convertible note seed financings that granted a discount to investors was 67% in 2010 and 83% in 2011; and the median discount was 20% in both 2010 and 2011.

As discussed in part 1 of this series, one of the significant advantages of issuing convertible notes, as opposed to shares of preferred stock, is the extraordinary flexibility they offer in connection with “herding” prospective investors and raising the round.  Clearly, a greater discount can be offered to early investors who are assuming more risk, particularly where the startup is closing its financing on a rolling basis over an extended period of time (as is the trend).

Moreover, a note can include a discount that increases over time – e.g., (i) 1.5% per month up to 25%; or (ii) 10% if the Series A round closes within 6 months, 15% if it closes between 6 and 12 months, and 20% if it closes after 12 months.  In the Fenwick Survey, the percentage of convertible note seed financings that included a discount which increased over time was 25% in 2010 and 5% in 2011.

Finally, founders should be aware that investors will sometimes push for the issuance of warrants in lieu of a discount.  In a seed round, this makes no sense and only creates more paperwork and, accordingly, higher legal fees.  In the Fenwick Survey, the percentage of convertible note seed financings that included the issuance of warrants was 0% in both 2010 and 2011.

What is a Conversion Valuation Cap?

A conversion valuation cap (or “cap”) is another mechanism to reward the noteholders for their investment risk (and for their efforts in increasing the value of the startup as a result of introductions, advice, etc.).  Specifically, a cap is a ceiling on the value of the startup (i.e., a maximum dollar amount) for purposes of determining the conversion price of the note — which (like a discount) thereby permits investors to convert their loan, plus interest, at a lower price than the purchase price paid by the Series A investors.

Using the example above, let’s assume the cap were $5 million and the pre-money valuation in the Series A round were $10 million.  If the noteholders invested $500,000 and the price per share of the Series A Preferred Stock were $1.00, the noteholders would convert the loan at an effective price of $0.50 per share ($5,000,000 divided by $10,000,000) and thus receive 1,000,000 shares ($500,000 divided by $0.50), which is 500,000 shares more than a Series A investor would receive for its $500,000 investment and a 2x return on paper ($1,000,000 divided by $500,000), not including any accrued interest on the loan.  Notice that if there were a 20% discount and no cap, the noteholders would only receive 625,000 shares or a 1.25x return, as noted above.

If we bump-up the pre-money valuation to $20 million and the cap remains at $5 million, you can see how the noteholders are rewarded (and protected): their $500,000 loan now converts at an effective price of $0.25 per share ($5,000,000 divided by $20,000,000) and they would thus receive 2,000,000 shares ($500,000 divided by $0.25), which is 1,500,000 shares more than a Series A investor would receive for its $500,000 investment and a 4x return on paper ($2,000,000 divided by $500,000), not including any accrued interest on the loan.  Again, if there were a 20% discount and no cap, the noteholders would only receive 625,000 shares or a 1.25x return.

As you can see, noteholders with a 20% discount and no cap would receive 625,000 shares whether the pre-money valuation in the Series A round were $10 million, $20 million or $50 million.  This is why sophisticated investors vehemently argue that a note without a cap (i) misaligns the interests of the founders and the investors; and (ii) penalizes investors for their efforts in helping the startup increase its value.  The math can be tricky, but the bottom line is that noteholders without a cap do not share in any increase in the value of the startup prior to the Series A round.

Accordingly, as discussed in detail in part 1, a cap is akin to a valuation in a priced round (i.e., if the startup were issuing shares of common or preferred stock); however, the beauty of a cap is that it is not a valuation for tax purposes — which facilitates the financing by allowing the founders to grant different caps to different investors.

In the Fenwick Survey, the percentage of convertible note seed financings that included a cap was 83% in 2010 and 82% in 2011; and the median valuation cap was $4 million in 2010 and $7.5 million in 2011.

How Do the Discount and the Cap Interrelate?

If the convertible note includes both a discount and a cap, the applicable language will typically provide that the conversion price will be the lower of (i) the price per share determined by applying the discount to the Series A price per share; and (ii) the price per share determined by dividing the cap by the Series A pre-money valuation.  As reflected in the examples above, the reason the conversion price is the “lower of” (not the “higher of”) is because the lower the conversion price, the more shares the noteholders are issued upon conversion.

In the first example above where the discount was 20%, the cap was $5 million and the pre-money valuation was $10 million, we saw that the conversion price was (i) $.80 when we applied the discount to the Series A price and (ii) $.50 when we divided the cap by the pre-money valuation.  Accordingly, the conversion price would be $.50 (the lower of) for purposes of computing the number of shares issued to the noteholders upon conversion.

Now watch what happens if we drop the pre-money valuation to $6 million:  Applying the discount, the conversion price, of course, stays the same at $.80; but when we divide $5 million (the cap) by $6 million (the pre-money valuation), we get $.83, which is obviously higher than $.80 — and thus the discount applies, not the cap.  This is a bit counter-intuitive because the pre-money valuation exceeds the cap by $1 million.  Notice, however, that unless the pre-money valuation were greater than $6,250,000, the cap would not be triggered ($5,000,000 divided by $6,250,000 equals $.80).

If this weren’t confusing enough, there is one other complex issue that founders need to be aware of with respect to discounts and caps: the additional liquidation preference that is created.  Indeed, this is a particular problem, and could result in a substantial windfall to investors, in a large convertible note financing with a low conversion price.

For example, in a $2 million convertible note financing with a 50% discount (or a 50% conversion cap ratio), the noteholders would receive $4 million worth of shares of Series A Preferred Stock upon conversion (not including accrued interest), which would include whatever liquidation preference is attached to the shares (typically 1x).  Accordingly, the noteholders would receive an extra $2 million of liquidation preference.

There are several different approaches to solving this issue, the most elegant of which is to convert the notes into a different series of preferred stock (e.g., Series A-1), with a liquidation preference per share equal to the conversion price; however, for purposes of this post, it’s enough for founders simply to be aware of this issue and how it relates to discounts and caps.

What is the Typical Interest Rate and How Do the Investors Get Paid?

The third and final piece of the economics puzzle is the interest rate component.  Again, a convertible note is a loan and typically requires the startup to pay simple (not compounded) interest on the amount of the loan.  Interest rates on convertible notes have historically been in the range of 7%-10% annually, but recently have dropped to the 5%-7% range.  In the Fenwick Survey, the median annual interest rate in convertible note seed financings was 6% in 2010 and 5.5% in 2011.

As alluded to in the examples above, the interest is not paid in cash on a periodic basis like a typical loan, but instead accrues (or accumulates), and then the total amount of interest due is added to the loan amount and converted into shares of preferred stock upon the closing of the Series A round.  For example, if the interest rate were 5% in a $500,000 convertible note seed financing and the Series A closing occurred on the one-year anniversary of the convertible note closing, the investors would convert an additional $25,000 ($500,000 x .05).

Each state has its own laws (called “usury” laws) that limit the maximum interest rate that may be charged on a loan.  In California, for example, unless an exemption applies, the maximum annual interest rate for a non-consumer loan is the higher of (i) 10% or (ii) 5%, plus the rate charged by the Federal Reserve Bank of San Francisco on advances to member banks on the 25th day of the month prior to the date of the loan (or, if earlier, the date of the written loan commitment).

Introduction

We are in the golden age of seed financing.  Venture capital funds, seed funds, super angels, angel groups, incubators, and “friends and family” are all playing the seed financing game and investing early in startups in an attempt to land the next Facebook.

As a result, the pendulum has swung dramatically in the founders’ favor, and the issuance of convertible notes for seed financing has never been more prolific.  Indeed, as a corporate lawyer for 18+ years, I have seen this development first-hand.

This post is the first part of a three-part primer on convertible note seed financings.  Part 1 will address basic questions, such as (i) what is a convertible note? (ii) why are convertible notes issued instead of shares of common or preferred stock? and (iii) what are the advantages of issuing convertible notes?

Part 2 will discuss the two most significant issues for founders in connection with the issuance of convertible notes: (i) the valuation cap and (ii) the discount (and how they interrelate).

Part 3 will cover certain special issues, such as (i) what happens if the startup is acquired prior to the note’s conversion to equity? (ii) what happens if the maturity date is reached prior to the note’s conversion to equity? and (iii) what securities laws do founders need to worry about in connection with the issuance of convertible notes?

[This post was originally published on TechCrunch.]

What is a Convertible Note? 

A convertible note is short-term debt that converts into equity.  In the context of a seed financing, the debt typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing.  In other words, investors loan money to a startup as its first round of funding; and then rather than get their money back with interest, the investors receive shares of preferred stock as part of the startup’s initial preferred stock financing, based on the terms of the note.

Why Can’t a Startup Issue Shares of Common Stock to Investors?

It can.  In fact, many incubators like Y Combinator and TechStars are issued shares of common stock for their initial investment (usually about $20,000).  Friends and family are also often issued shares of common stock.  Most sophisticated investors, however, will not accept shares of common stock for their investment and will push hard for shares of preferred stock, with special rights (as discussed below).

In addition, the issuance of shares of common stock creates three potential problems.  First, the founders risk substantial dilution because it is often difficult for the founders and the investors to agree on a valuation for the startup and, accordingly, to agree on the percentage ownership the investor will receive.  For example, if a startup is merely two guys and an idea, how much equity should an investor receive for a $100,000 investment? 10%?  25%?  50%?

Second, there may be tricky tax issues depending upon the timing of the investment.  For example, if two co-founders are issued shares of common stock for a nominal purchase price upon incorporation, and investors pay substantially more for their shares of common stock at the same time or shortly thereafter, the IRS may impute a much higher value on the shares issued to the founders and deem the excess amount over the purchase price a form of compensation — and therefore taxable to the founders as ordinary income.

Third, the issuance of shares of common stock may cause potential problems with respect to stock option grants because the underlying value of the shares of common stock (i.e., the “strike” or “exercise” price) will have been established.  The goal, of course, regarding option grants is to price the options as low as possible so that the option recipients are incentivized and are able to adequately share in the increased value of the company that they help create.  A high strike price undermines that goal.

How Does the Issuance of Convertible Notes Address These Problems?

One of the key advantages of issuing convertible notes is that the valuation issue is kicked down the road until the Series A round of financing – when there are a lot more data points and thus it’s much easier to value the startup (i.e., price the round).  Accordingly, the issuance of convertible notes disposes of the foregoing three problems.  Again, a convertible note is a loan (debt, not equity).  A valuation of the startup is thus unnecessary; and, if there is no valuation, there are no problems of dilution, taxes and option pricing.

What are Some of the Other Advantages of Issuing Convertible Notes?  

Speed, simplicity and cost.  Indeed, a startup could close a convertible note round in a day or two by merely issuing a 2-3 page promissory note, which could cost as little as $1,500-$2,000 in legal fees (or a little more if a note purchase agreement is also executed, which is customary).  On the other hand, the issuance of shares of preferred stock is complex, and it can take weeks to negotiate all the terms and documents — with legal fees in the neighborhood of $10,000 – $30,000 or more (depending upon whether the investors insist on full-blown Series A-type documentation, as opposed to stripped-down documentation like the “Series Seed,” discussed below).

Another significant advantage of issuing convertible notes is to avoid giving the investors any control.  When investors receive shares of preferred stock, they are typically granted certain significant control rights, including a Board seat and veto rights with respect to certain corporate actions (such as the sale of the company) pursuant to so-called “protective provisions.”  They also have certain key rights as minority stockholders under applicable State law (usually Delaware).

Convertible noteholders are rarely granted control rights (and have no minority stockholder rights).  For example, in Fenwick & West’s 2011 Seed Financing Survey (the “Fenwick Survey”), convertible noteholders were granted a Board seat in only 4% of the seed financings; while preferred stockholders were granted a Board seat in 70% of such financings.

Finally, another advantage of issuing convertible notes (and probably the least understood and most important) is the extraordinary flexibility they offer in connection with “herding” prospective investors and raising the round.  As Naval Ravikant, a co-founder of AngelList, aptly noted in a recent interview on This Week in Startups with Jason Calacanis (at the 17:55 mark): “Convertible notes have made variable pricing possible.”

Paul Graham reached the same conclusion in his post, “High Resolution Fundraising”:

The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors all wait to see who else is going to invest.

Naval and Paul are referring to the conversion valuation cap (or the “cap”), which I will discuss in detail in part 2 of this series; however, suffice it to say that the cap is designed to protect the investors by putting a ceiling on the conversion price of the note and thereby permitting investors to share in any significant increase in the value of the startup subsequent to their investment.  If, for example, the cap were $5 million and the pre-money valuation in the Series A round were $10 million, the amount of the note (plus accrued interest) would convert into shares of preferred stock at an effective price of $5 million or one-half of the price paid by the Series A investors.

Accordingly, the cap is akin to a valuation in a priced round (i.e., if the startup were issuing shares of common or preferred stock).  But the beauty of the cap is that it is not a valuation for tax purposes, which is why different investors may get different caps, unlike in a priced round (unless there were subsequent closings sufficiently far enough apart to justify different valuations).  As Paul provides in his post above:

The reason convertible notes allow more flexibility in price is that valuation caps aren’t actual valuations, and notes are cheap and easy to do. So you can do high-resolution fundraising: if you wanted you could have a separate note with a different cap for each investor.

Why Do Sophisticated Investors Push for Shares of Preferred Stock Instead of Convertible Notes?

We’ve already covered one of the principal reasons: preferred stockholders are typically granted control rights, including a Board seat and certain veto rights.  They are also typically granted certain additional economic rights (like Series A investors), such as pro-rata rights and a liquidation preference.  In fact, in the Fenwick Survey, 9% of the preferred stock seed financings included a participating preferred liquidation preference (which is not founder friendly).

Other reasons have been articulated by a number of high-profile investors (including Fred Wilson, Mark Suster, Manu Kumar and Seth Levine), the most significant of which can be summarized as follows:

1)  There are now stripped-down, preferred stock financing documents (like “Series Seed” and other standardized forms) that make a priced round just as fast and cheap as issuing convertible notes.

2)  The interests of the founders and the investors are “misaligned” if the investors are issued convertible notes that are not capped.  This is because it’s in the founders’ interest to maximize the company’s valuation in the Series A round, and it’s in the noteholders’ interest to minimize it.  Investors are thus “penalized” for helping a startup get a higher valuation as a result of their introductions, domain expertise, etc.

3)  Obtaining a fair valuation may be tricky for unsophisticated investors, but not for sophisticated ones.  As Fred Wilson argues: “I can negotiate a fair price with an entrepreneur in five minutes…”

4)  Noteholders must wait for the date of conversion to start the clock running for long term capital gains treatment; with shares of preferred stock, the clock starts running immediately.

Are the Series Seed and Other Standardized Forms Really as Fast and Cheap as Convertible Notes?

The Series Seed and other standardized forms have solved a huge problem: how to get shares of preferred stock into the hands of investors in a seed investment without having to draft and negotiate a full-blown set of Series A documents, with all the bells and whistles (and associated legal fees of $50,000+).

However, to say that using these forms makes a preferred stock financing as fast and cheap as a convertible note financing is a bit misleading because we are talking about non-negotiable, fill-in-the-blank forms.  Obviously, any transaction will be fast and cheap if the parties utilize fill-in-the-blank forms, without any back-and-forth negotiation.

Indeed, as I have previously discussed, the fundamental problem with these standardized forms is this one-size-fits-all approach.  Every financing is different, and the structure and terms are based on a number of different factors, including (i) the size of the investment; (ii) whether the startup is “hot” (and there’s a competitive environment); (iii) who the investors are; (iv) current market conditions, etc.

Simply put, it may not be in the founders’ interest to utilize these forms and issue shares of preferred stock for a relatively small investment or if the founders have strong negotiating leverage (as recently demonstrated by the $2.35 million convertible note seed financing by HealthTap) — particularly because these forms require the founders to grant certain control rights (and additional economic rights) to the investors, as discussed above.  Nor does the issuance of preferred stock allow for the extraordinary flexibility that the issuance of convertible notes permits (also discussed above).

As Naval Ravikant profoundly pointed out in his recent interview with Jason Calacanis (at the 19:19 mark):

Venture capital used to be the bundling of advice, control and money. And now people have come along, like Y Combinator and TechStars and AngelPad and so on, to say ‘we’re the advice’; and then people have come in, like Yuri Milner at Start Fund, and say “we’re money – we just want to give you money” and the control provision has gone away.  So you’re starting to see the whole ecosystem become unbundled. 

This post was originally part of the “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998 (San Francisco) or 310-288-6667 (Los Angeles).  Thanks, Scott

Question

We’re a startup based in Palo Alto, and we just received a Series A term sheet for a $725,000 investment.  The investor is kind of insisting that we use his lawyer at a big Valley firm to represent us.  He said that he doesn’t need a lawyer, and this will save us a lot of money.  We’re first time entrepreneurs, and we don’t know if this is standard practice and what we should do.  Any advice would be appreciated.

Answer

Welcome to the world of the Silicon Valley!  This is not uncommon, but I still cringe when I hear it (probably because I was trained at two big law firms in New York City and this kind of stuff typically doesn’t happen there).

I think a good startup lawyer has two important roles: (1) to watch his client’s back – that is, to make sure his client is protected from a legal standpoint and doesn’t get blind-sided; and (2) to act as a consigliere – that is, to provide strong, disinterested business advice (to the extent necessary).

As the late, great attorney Craig Johnson wrote in the book The Silicon Valley Edge: A Habitat for Innovation and Entrepreneurship:

Although start-up lawyers in Silicon Valley draft documents and follow form books . . . , they usually play a much larger role in the businesses being started. They are often dealing with people with very limited or no business experience. These people need help in defining and pursuing their business goals. . . . How should the founders divide the initial stock ownership? Who should be on their board of directors? Which financing sources should they consider? At what valuation and on what terms?

Accordingly, in the context of negotiating your term sheet, a good startup lawyer will sit down with you and walk you through all of the key legal provisions in the term sheet to make sure you fully understand their ramifications.  For example, he will explain to you how the liquidation preference works and run spreadsheets, if necessary, to show you how much money you will receive based on different sale scenarios; he will explain to you how the option pool works, including the founders’ significant dilution; and he will discuss what protective provisions are and other tricky legal terms, such as drag-along rights and anti-dilution provisions.

But more importantly, a good startup lawyer will also discuss with you the business terms, including the structure of the deal.  Because this is only a $725K investment, a good lawyer will recommend structuring the investment as a convertible note or a “Series Seed” financing, rather than a full-blown Series A.  Indeed, this is what will save you money on legal fees.  Moreover, he will impress upon you the importance of talking to other investors (if you haven’t already done so) in order to create a competitive environment.

He will also help diligence the investors to make sure you choose the right partner for your startup.  Not to mention pushing back hard on unreasonable terms, such as “exploding” term sheets or certain redemption rights.

Simply put, how is the investor’s lawyer going to play this role?  From a business perspective, he is beholden to the investor.  If he doesn’t play ball and get the deal done on the investor’s terms, the investor will obviously stop sending him work. This is not to suggest that there’s anything nefarious or unethical going on; it’s just common sense.

Conclusion

There is too much at stake for entrepreneurs not to be represented by a smart, unbiased lawyer, who has no vested interest in the closing of a proposed financing.  As I learned in New York, no matter what an investor tells you, at the end of the day it’s all business.  And if an investor can convince you to use his lawyer, it’s good for his business — not yours.

This post is part 3 of my three-part series: “How do I raise seed capital if I don’t know any investors?”  In part 1, I discussed the importance of hustling and building relationships in order to get warm introductions to investors.  In part 2, I discussed some of the different mentorship and seed capital programs, including Y Combinator and TechStars.  In this post, I will discuss applying directly to a relatively new site called “AngelList.”

What is AngelList?

AngelList is a free service founded by Naval Ravikant and Babak Nivi of VentureHacks, which provides pre-screened startups with introductions to angel investors.  Naval is a smart entrepreneur and angel investor whom I just met in person this past Thursday at the Women’s 2.0 Pitch Conference in San Francisco.  Nivi is equally impressive, and I had the pleasure of working with him earlier this year in connection with my two sponsored posts on VentureHacks: “5 New Year’s Resolutions for Closing Deals in 2010” and “Top Ten Reasons That Entrepreneurs Hate Lawyers.”

As the Wall Street Journal noted:

AngelList, started in February by angels Naval Ravikant and Babak Nivi, vets dozens of deals before highlighting the best ones in emails each week sent free to a group of 200 investors.

Messrs. Ravikant and Nivi—who also run Venture Hacks, a for-profit site that provides advice to start-ups—say they have received pitches from more than 1,000 start-ups, mostly consumer Internet companies. Of the 48 companies featured so far on AngelList, about half have received funding, they say.

Accordingly, if you’re a startup seeking seed capital, you can apply to AngelList via their online application; and, if you are chosen as an appropriate investment opportunity, you will be introduced via email to an extraordinary list of angels.  As Naval and Nivi advise on the site, “[w]e look for the same things that early-stage investors look for: traction, social proof, and team.  You don’t need all 3, but you need to kick ass in at least one of them.”

The founders of BlockChalk wrote an excellent post, “Lessons From Raising a Seed Round” about how they secured funding via AngelList.  Here are a few highlights:

The team is key

We found that the makeup of our founding team contributed directly and measurably to our ability to raise funds. . . .

It’s hard to go it alone. It’s probably also not smart in most cases. A powerful team is greater than the sum of its parts, and investors know that.

Always be tweaking

We never stopped tweaking our pitch. Every meeting we had was an opportunity to both audition our latest pitch and to gather feedback for the next iteration. . . .

Prototypes will love you and leave you

There is no substitute for real feedback from real users. . . .

If we could do it again we might have launched our prototype under a different brand. Or perhaps emblazoned it with the word “beta”, or even “alpha”. But at some level this is the price you pay for having a “product” before you have funding. Prototyping is a double-edged sword. Be prepared for both blades!

Gagan Biyani, the Co-Founder and President of Udemy (whom I discussed in part 1 of this series with respect to his extraordinary hustle) also gives very high marks to AngelList in his post, “Udemy’s $1M Fundraising: Lessons Learned about Pitching Investors from a First-Time Entrepreneur”:

We can’t speak higher of AngelList and the value it provided to Udemy’s fundraising process. We received over 25 intro’s to top-tier investors. What other way can you get 25 investors to ask for intros to YOU! AngelList led to investments from Jeremy Stoppelman (CEO of Yelp), Dave McClure (500 Startups), Josh Stylman (Angel Investor, co-founder at Rotomedia and Reprise Media), and Ben Ling (executive roles at Google, Facebook, YouTube).  But what was even more important was that AngelList got our round over-subscribed, so we had momentum which helped convince our other investors to make their decisions faster and in our favor.

Rafael Corrales, the co-founder of LearnBoost and a very scrappy and highly-intelligent entrepreneur, discusses AngelList at the 33:10 mark in this mixergy.com video.  Indeed, in terms of the role that Nivi and Naval play, Rafael specifically notes that:

Nivi, even Naval, would hop on the phone and say, hey, here’s how you can think about this. Here’s an interview that we did that we haven’t even released publicly. This will help you. That will help you. Go talk to this guy.

And so, these guys were basically, while we were fundraising, really hands on coaches, and it’s really great coming from them because they’re basically these really incredible guys who know exactly what they’re talking about. And they’re biased in your favor. So, they’re going to try to help you find ways to solve your problems in ways that are beneficial to the entrepreneur as opposed to, maybe, meeting with, a hypothetical example, meeting with someone at a VC firm who is going to have more biased advice.

And so, these guys are sort of more independent or, at least, biased in your favor. And so that’s really how they can help is prep you for meetings, help you with your pitch. And then, ultimately it’s also on the entrepreneur to go to VentureHacks.com and read all the blog posts that they’ve done because those resources are incredible.

Finally, if you would like to learn more about AngelList, you can check out some of the answers on Quora to the following questions:

• What do people think of AngelList?

• Which startups have been funded via AngelList?

• How do venture capitalists feel about AngelList taking all the prime deals and leaving them with the leftovers?

Conclusion

In conclusion, it is clear that AngelList is a great place to go if you’re an entrepreneur seeking to raise seed capital.  I would also recommend applying to Open Angel Forum, which was founded by Jason Calacanis, a highly-successful serial entrepreneur and super angel, in response to his disgust with angel groups charging entrepreneurs to pitch.  Indeed, I am a big fan of Open Angel Forum and have not only been a sponsor, but also wrote a poem about my experience at one of the events: “Ode to OAF: A Personal Tribute to Jason Calacanis, Tyler Crowley and the Angels.”  Cheers, Scott

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat.  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

I read a few articles and blog posts a few months ago about how Senator Dodd’s financial reform bill was going to destroy angel investing.  Then I heard about certain amendments made in the U.S. Senate that watered down some of the provisions.  Now that the bill has passed, what’s the story with this issue?  Will the bill hurt angel investing?

Answer  

The bill was signed into law this morning.  There is good news and bad news.  First, some background:

The U.S. Securities Laws.  As I have previously discussed in my securities laws post, a company may not offer or sell its securities unless (i) the securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (ii) there is an applicable exemption from registration.  The most common exemption for startups is the so-called “private placement” exemption under SEC Regulation D, which comprises three different types of private offerings under Rules 504, 505 and 506.  

If a startup sells stock only to “accredited investors” (discussed below), compliance is much simpler, faster and cheaper because it can rely on Rule 506, which has two important advantages over the other SEC rules.  First, Rule 506 preempts or overrides State securities laws, which means that the startup doesn’t have to deal with State securities regulators for compliance purposes, other than filing a brief notice known as a Form D (which is also filed with the SEC).  Second, there is no written disclosure requirement under Rule 506 if the investors are accredited.

On the other hand, if one or more of the investors is not accredited, SEC Rule 506 generally may not be relied upon – which opens-up a Pandora’s box of compliance and disclosure issues under both (i) SEC Rules 504 or 505 and (ii) state law.  Indeed, the cost, risks and onerous disclosure requirements generally outweigh the benefit.  That’s why startups have been overwhelmingly (and effectively) relying on Rule 506 for nearly 15 years in connection with their seed and angel financings.  

The Good News.  The good news is that the financial reform bill just signed into law omitted the most troubling provision in Dodd’s original proposal, which essentially required a filing with the SEC in connection with any private placement (even if all the investors were “accredited investors” and the issuer were relying on Rule 506), and then gave the SEC 120 days to review the filing; and if the SEC did not review the filing within such 120-day period, then the applicable States securities commission(s) would have the right to review the merits of the financing.

As I discussed in my letter to Senator Dodd, this obviously would have created significant delay and cost in connection with seed and angel financings and also would have put the State securities commissions back in the private placement game – which is exactly what SEC Rule 506 is designed to prevent, as noted above. 

The fact that this provision has not become law is very good news indeed.

The other piece of good news is that under Dodd’s original proposal the definition of “accredited investor” would have been revised to require individuals to have (i) a net worth of at least $2.3 million (up from $1 million) or (ii) annual income in each of the two most recent years (and a reasonable expectation of such income level in the current year) of $449,000 individually or $674,000 jointly with his/her spouse (up from $200,000 and $300,000, respectively).  According to Business Week, this revision would have lowered the number of individual accredited investors by 77%.

The new law leaves the net-worth test at $1 million (subject to the change discussed below) and leaves the annual-income test at $200,000 individually and $300,000 jointly.  Again, good news.

The Bad News.  The bad news is that the net-worth test no longer includes the value of the investor’s principal residence.  Clearly, this is a big change and could significantly lower the pool of accredited investors.

The other piece of bad news is that the new law expressly permits the SEC to conduct an immediate review and modification of the annual-income test if “deem[ed] appropriate for the protection of investors. . . .”  Thus, the annual-income test may go up; we’ll have to wait and see.

Finally, the new law also requires the SEC in four years (and once every four years thereafter) to review the “accredited investor” definition “in its entirety” and make appropriate changes — though the applicable provisions are poorly drafted and this four-year review may not apply to the “accredited investor” definition for purposes of private placements under Regulation D.

CONCLUSION

I hope the foregoing was helpful.  Indeed, as I am constantly advising my clients, the securities laws are a potential minefield of problems; and non-compliance could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.

T’was the second Open Angel Forum here in LA, 

  Six startups pitching angels and not one had to pay. 

Hot on the heels of the inaugural OAF events in NYC and SV, 

  This event was destined for greatness, and I was excited it included me. 

The inaugural OAF LA in January was hosted at the beautiful home of Matt, 

  Down by the pool in the heated gazebo we all comfortably sat. 

This time it was being hosted at the headquarters of Mahalo, 

  So I hopped in my car in Beverly Hills and drove west to 902 Colorado. 

When I arrived I shook some hands and then quickly smelled the barbecuing beef, 

  So I had myself a juicy burger – with onions, tomatoes and a fresh lettuce leaf. 

There was lots of positive energy in the room and lots of ice-cold beer, 

  I was again one of the sponsors – and I was indeed proud to be here. 

The history of Open Angel Forum is pretty fuckin’ sweet, 

  Congrats to Jason and his team for pulling-off quite a feat. 

It all started when Jason was interviewing a guest on his weekly show TWiST,” 

 And when he learned that Keiretsu was charging startups for pitching, boy was he pissed! 

So he wrote a scathing blog in which he called this practice “predatory” and “low-class,” 

  And he pulled-out his AK-47 on TWiST #23 and, in effect, told Steve Bell to kiss his ass. 

It’s an “MLM scheme” Jason “suspected” and gave Keiretsu 30 days to drop their fees, 

  If not, he guaranteed he’d build a better competitor and would even bet the Tesla keys.   

Needless to say, Keiretsu never complied and Open Angel Forum was born, 

  So now entrepreneurs can pitch super angels for the same price as watching porn. 

Add it to Jason’s list: Silicon Alley Reporter, Weblogs, TechCrunch 50 and Mahalo,  

  And I think we can all agree: his career is undoubtedly inspirational to follow. 

Jason’s right-hand man is Tyler or should I say @SteepDecline, 

  Whose work ethic is unparalleled, and whose TWiST insights are so fine. 

In fact, “like wheelchairs at Disneyland” was voted his best insight of the year, 

  He’s the man who makes OAF happen – so let’s all give Tyler a cheer. 

The angels included Matt Mullenweg, the co-founder and CEO of WordPress, 

  Which has 221,000,000 monthly uniques and is the ninth largest network in the U.S. 

I chatted with Matt about the new 3.0 release, and he seemed like a super, humble guy, 

  And to say he is one of “the most successful college drop-outs in history” is truly no lie. 

Another angel was David Cohen, the CEO of TechStars in Boulder, 

  He founded several companies as an entrepreneur, but became an investor as he got older. 

I really enjoyed his interview on Mixergy with my friend Andrew Warner, 

  And if David wants to hit some tennis balls, I’m happy to just stand in the corner. 

I said hello to super angel Matt Coffin, who again was the first OAF LA host, 

  The founder of LowerMyBills, Matt certainly has reason to boast. 

He sold his company to Experian in 2005 for “almost 400” mill, 

  Having launched six years earlier, after receiving a “crazy” cell phone bill. 

Missing this time, unfortunately, was “The Godfather of Silicon Valley” Ron, 

  Who, as Ben Horowitz explained, “is always on the job and the network is always on.” 

In 2009, he was named #6 in Forbes Magazine’s top deal-makers “Midas List,” 

  And with his incredible deal-sheet and experience, I’d love to hear him on TWiST. 

Also missing was my friend Mark Suster, whom I was looking forward to see, 

  He’s the founder of Launchpad LA, blogger extraordinaire and a partner at GRP. 

He’s also crushing it with Jason on his new ThisWeekIn Venture Capital show, 

  And if you’re an entrepreneur looking for funding, you gotta love GRP’s dough. 

Each of the startups was quite impressive giving its five-minute pitch, 

  But if I had to choose the best one, I really would not know which. 

Turbo140, MeeGenius and Kidzmet I definitely liked a lot,  

  Belgrave Trust and FaceChipz were also good – and the other company’s name I forgot.  

Turbo 140 is a new beta site where “posting a gig is fast, simple, and easy,” 

  The issue, of course, as Matt mentioned to Jonathan, is whether requests will get sleazy. 

You let people know what you’re looking for in 140 characters or less, 

  And if the company can work out its pricing issues, it could be a grand success. 

MeeGenius was co-founded by David Chung Park, who flew out to LA from New York, 

  I actually met David on Twitter, and I’m glad we finally had a chance to meet and talk. 

Kidzmet was founded by Jen Lilienstein, who gave everyone a nice Kidzmet Tote, 

  And in terms of enthusiasm and energy, Jen definitely gets my vote. 

Adieu! adieu! thy plaintive anthem fades – t’was time to bid farewell, 

  To Jason, Tyler and the angels – the very word is like a bell. 

And as I drove home and reflected in the clear, starry night,

   For a brief moment in time, everything was right.

My colleague, Susan Morgan, conducted a webinar yesterday with respect to venture capital term sheets for the “CFO University,” which is group of Chief Financial Officers convening monthly webinars via CFOwise.  As I have previously discussed, Susan recently joined our team and has strong financing experience, including 7+ years at Fenwick & West in Silicon Valley where she closed more than 30 financings.  (You can learn more about Susan’s background on her bio page.)  In conjunction with the webinar, Susan also wrote a brief post on convertible notes.  You can see the webinar and read the post below.  Many thanks, Scott

Webinar: Venture Capital Term Sheets

CFO University:  VC Term Sheet and Deal Point Discussion

Guest Speaker:  Susan Morgan of Walker Corporate Law Group, PLLC

Date:  April 14, 2010, 9:09 am (Denver Time)     

Summary:  This webinar runs for about 55 minutes and covers all of the key venture capital terms, including liquidation preferences, dividends, redemption rights, conversion rights and anti-dilution provisions.  

Link:  Please click the following link to play the webinar (you can start at the 3:30 mark): 
https://cfowise.webex.com/cfowise/ldr.php?AT=pb&SP=MC&rID=11196707&rKey=ebb4537ffb730d0b

Why I Recommend Convertible Notes for Entrepreneurs by Susan Morgan

The vast majority of startup entrepreneurs obtain their first few morsels of financing from friends and family, founder infusions and/or (with some luck) small, but sophisticated angels.   These infusions may aggregate up to $500,000 or less, and every penny is desperately needed by the entrepreneur to reach the “next stage” of development – which would then allow the entrepreneur to obtain more serious capital from more institutional investors.  At the point in time in which these initial small infusions are made, the company is often unknown, their products undeveloped and their markets unrealized.  What then is the best financing structure for these initial investments?  I would argue that it is convertible promissory notes (or “Bridge Financing”).

The alternative to a Bridge Financing – issuing the first round of preferred stock – requires (i) the valuation of the company for pricing the stock and (ii) the determination and documentation of all of the rights, preferences and privileges of the stock.  How do you price the company at this stage?  Any metric you use can easily produce a number that turns out to be “way off the mark” when the company later completes its development (or whatever progress it has made using the initial funds), and then seeks to obtain subsequent funding.  Accordingly, the founders could be substantially diluted at this early stage.

At the “second funding” stage (the so-called “Series A” round), a larger institutional angel or VC will evaluate the company’s progress and determine a valuation (and price per share) for the more substantial infusion that they are proposing to make.  The rights, preferences and privileges of the preferred stock will also be negotiated at this stage, and the Bridge Financing notes will simply convert to the preferred stock on those terms.  The advantage for the entrepreneur, of course, is that the documentation for the Bridge Financing is far simpler and therefore much cheaper than that of the preferred round.  With a Bridge Financing, the shares will thus be priced much later on when the company has more to show, yielding a potentially higher, more realistic price for the funds infused.

So, what is to induce the early stage investors to invest in the convertible notes?  Typically, they are offered “equity sweeteners” in the form of either (i) conversion at a discount (generally from 10% to 40% discount) or (ii) warrants to purchase shares in the future (preferred or common shares).  These are somewhat equivalent economically, and usually either one or the other is used. 

As my colleague Scott Edward Walker discusses in his post on types of angel financing, the disadvantage of issuing convertible notes is that the founders’ interests and the angels’ interests may not be aligned because it’s in the angels’ interest for the Series A valuation to be low.  Indeed, angels who think they can make a significant contribution to a venture (e.g., as a result of their introductions or domain expertise) want to share in the increase in value they are creating.  Accordingly, if angel investors do agree to the issuance of convertible notes, they will often push for a “cap” on the Series A valuation — which is obviously not in the founders’ interest and is heavily negotiated.

Conclusion

This post obviously covers a lot of territory, but hopefully introduces entrepreneurs to some of the key issues with respect to angel and venture capital financings.  If you have any questions, please shoot them to us via the comments section.

March 31, 2010 

Via Email 

Senator Christopher J. Dodd, Chairman 

Committee on Banking, Housing and Urban Affairs 

534 Dirksen Senate Office Building 

Washington, DC 20510-4605 

Re:  The Restoring American Financial Stability Act of 2010 (the “Reform Bill”)  

Dear Senator Dodd: 

As a corporate lawyer for entrepreneurs, I would like to get a few things off my chest with respect to the Reform Bill.  Indeed, I do not understand why a 1,336-page bill designed to address our recent financial crisis includes two major changes to the federal securities laws that could destroy angel investing.   

As you may recall (and as I discuss in detail in my recent blog post on VentureBeat), the first change relates to the definition of “accredited investor” and increases the qualification thresholds for an individual from $1 million of net worth to $2.3 million and from $200,000 of annual income to $449,000 (or from $300,000 of joint annual income with a spouse to $674,000).   

According to Business Week, this change would lower the number of individual accredited investors by 77%.  Should I repeat that?  77%!  Over two-thirds, amigo! 

If that weren’t bad enough, here comes the second change – which provides that even if all the investors are “accredited” under your new definition (and despite SEC Rule 506, discussed below), a filing must be made with the SEC, and the SEC will have 120 days to review it; and if the SEC does not review the filing within such 120-day period, then the applicable State securities commissions would have the right to review the merits of the angel investment. 

In case you or your staff haven’t done the math: 120 days equal four months.  Thus, under your bill, we will have 77% less angel investors and then startups will have to wait up to four months (or longer) while the SEC and/or State securities commissions review the merits of their angel investment.  With all due respect, Senator, this is fucking nuts!   

And, sadly, it gets even worse:  Alternatively, the SEC can designate that certain financings under Rule 506 are too small in size or scope to warrant SEC review and push such review to the State securities commissions altogether.  This is exactly what the National Securities Markets Improvement Act of 1996 (“NSMIA”) was designed to prevent.  Why are we moving fucking backwards? 

As you know, the beauty of NSMIA has been that startups could rely on Rule 506 if all of their investors were “accredited” – and thereby preempt state law and no longer have to deal with the excessive cost, delay and onerous disclosure requirements of State securities commissions (which was a significant problem pre-1996).  Indeed, NSMIA has facilitated the extraordinary growth of angel investing for the past nearly 15 years, which has contributed to the success of companies such as Google, Facebook, Twitter and many others (not to mention the concomitant job creation). 

Let’s take a simple example and see how this plays out in the real world: 

On April 26th, I will be co-sponsoring an Open Angel Forum event in Los Angeles, which will provide each of five startups with the opportunity to pitch 15-20 angel investors for an investment of approximately $500,000 to $1 million.  All of the angel investors are “accredited investors” under the SEC’s current definition and your new definition; in fact, some have a net worth in excess of $100 million. 

Under current law pursuant to SEC Rule 506, if an angel investor decided to invest in one of the startups, a deal could be closed and the investment funds could be wired to the startup within 24 to 48 hours – particularly if the deal were structured as a convertible note (as opposed to preferred stock) due to the simplified paperwork.     

Why?  Because under Rule 506, there is no written disclosure requirement (such as a private placement memorandum) if the investors are accredited; and, as a result of the enactment of NSMIA, Rule 506 preempts State law and thus the startup would not have to comply with any disclosure or other requirements under applicable State securities laws, other than filing a Form D notice (which is also filed with the SEC) within 15 days after the sale.     

Now let’s see what happens if your bill were enacted. 

First, instead of money being wired to the startup within 48 hours, it would presumably be put into escrow for up to four months pending the SEC’s review of the startup’s filing.  If the SEC did not review the filing within four months, the startup would then need to comply with all applicable State securities laws — which presumably would mean any State in which part of the offer and/or sale takes place (i.e., California and any other State implicated as a result of subsequent emails, telephone calls, delivery of the notes/stock certificates, etc.).  Again, fucking nuts!   

Alternatively, as noted above, the SEC could require the startup, due to the small size or scope of the investment, immediately to comply with applicable State securities laws even though all of its investors were “accredited” and may have net worth in excess of $100 million.  In other words, NSMIA would be thrown out the window, and we would be back to the pre-1996 days where counsel must work his way through the maze of State securities laws, including dealing with State regulators for weeks and weeks (and perhaps months and months), and legal fees mount, and investors walk away in frustration. 

The bottom line, Senator, is that not a lot of thought has gone into this aspect of the Reform Bill.  Clearly, you and your staff have been heavily lobbied by the North American Securities Administrators Association, who are anxious to repeal NSMIA and restore their power; it’s a classic regulatory turf battle.  The problem, however, is that you are about to destroy angel investing and job creation in the process. 

Sincerely yours,  

Scott Edward Walker

I am pleased to welcome officially Susan Morgan to our team.  Susan has 10+ years of sophisticated corporate law experience, including 7+ years at Fenwick & West in Silicon Valley where she closed more than 30 private financings; she is an Adjunct Professor at Golden Gate University, where she teaches a course on Business and Legal Issues in High Technology Startups; and she is a highly successful entrepreneur, having co-founded two software companies.  (You can learn more about Susan’s background on her bio page.)

For Susan’s first assignment, I asked her to review and comment on the new “Series Seed” financing documents posted by Ted Wang and the related posts by Brad Feld, Fred Wilson, Yokum Taku and Jason Mendelson.  Indeed, I concurred with Jason in the comments section of his post that “there will never be a standard set of seed documents” because of the lawyers and their own self-interest (as I discuss in my VentureHack’s post “Top Ten Reasons Why Entrepreneurs Hate Lawyers”).  Susan, however, surprised me and actually sided with Ted and Brad and their optimism.  Below are her thoughts.  Many thanks, Scott

Series Seed Documents

By Susan Morgan

Much has been written recently regarding the concept of standardizing a “lite” version of first round financing.  The compelling idea is that a small, early-stage “seed round” financing should not include all of the massive documentation, negotiation and legal expense that accompany a more substantial later financing round.  Ah, but the problem is that each law firm (and institutional investor) has its own well-used and well-loved proprietary set of form documents which they trot out as the starting point for any financing.  Because these forms are of a “one-size-fits-all” variety, they tend to include all of the complex, intricate and specialized terms that might be appropriate to negotiate in a later-stage financing, but needlessly drive up the costs and complexity of an early-stage seed round financing.

How to solve this problem?  Enter the “lite” versions.  Over the past couple of years, several attorneys and/or law firms have created a publicly-available, “stripped-down” set of form financing documents which eliminate some of the “less essential” terms for an early stage seed financing and thereby streamline the process and reduce costs.  The most recent iteration of such documents are the “Series Seed” documents post by Ted Wang, an attorney at Fenwick & West (my former law firm).  In fact, a recent post by Brad Feld lists four such sets (including Ted’s) and proposes that we “finish the job” by getting “everyone” in a room together to hammer out a single set of final terms and documents, which the entire industry can then standardize around.   A nice idea, but will it work?

Jason Mendelson (Brad Feld’s partner) thinks not.  In a recent post, Jason predicted a stunning failure of this effort to standardize.  Why?  Because Jason believes that the two constituent groups that will need to come to agreement on a standardized set of forms (i.e., lawyers and VCs) are, to some extent, inherently motivated not to do so.  Lawyers like to put their own proprietary stamp on things (including these seed financing documents), and VCs tend to trust and support the lawyers they have hired to protect their interests.  Jason fears that an all-day meeting with 50+ lawyers (who would all insist on being included) and any number of VCs and other parties will deteriorate into an “ego fight” – each participant insisting on including his or her own special tweaks into the documents.  Jason’s fears are not entirely unfounded – he has witnessed this before in drafting sessions of the National Venture Capital Association (the “NVCA”) for their model venture capital financing documents.

So, should we abandon this effort as a potential waste of time?  I don’t think so.  For one, we should consider re-defining what we mean by “success.”  If our only standard for success is perfect agreement on a single set of seed documents; well, then that is a very high standard indeed and we just may not reach that.  But why should that be our only gauge of success?  I would propose that we have already reached some measure of success!  Just look at the term sheet comparison produced by Yokum Taku.  There is far more agreement in terms among these term sheets than disagreement.  In fact, it’s not hard to take the next step and put together a composite term sheet (with some alternative terms, as the NVCA does) that encapsulates everything in this comparison.  The composite term sheet would look like this:

                                                                  Seed Financing Term Sheet

Of course, this hasn’t melded the underlying text in the documents together, but if we do no more that just get everyone (or a core subset of attorneys and VCs) to agree on this term sheet as a starting point, we have already achieved a significant milestone!  In one quick stroke, we have eliminated a considerable volume of drafting and negotiating:  anti-dilution provisions, registration rights provisions and legal opinions – gone.  This alone would save entrepreneurs a huge chunk of legal fees.  And I would propose we use that as our measure of success – i.e., how much money we save entrepreneurs. 

So, I don’t know whether an all-day drafting session can get us to full standardization (or even a little closer to that goal), but it certainly seems worthwhile to keep the conversation going.  As Ted so aptly put it in his comments to Jason’s post: “[L]et’s not give up just yet!  Let’s talk about ‘standard seed documents’ and see where that leads.  It may take years, but I’ve got a long horizon.”  Who knows, maybe an all-day drafting session will yield some random pieces of conformity that will, at least, save the entrepreneurs some amount of legal fees.  And that, by my definition, would be a success.

This post is part of a weekly series called “Ask the Attorney,” which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”   

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question 

We launched our company about six months ago, and we have a couple of angel investors lined-up for about $300,000.  We don’t know if we should sell them common stock or preferred (they want preferred).  I’ve been reading some stuff on the web that recommends issuing convertible notes.  What do you recommend?  Thanks!

Answer 

This issue comes-up all the time.  In short, I recommend that you issue convertible notes.  Below are the advantages and disadvantages of each choice from the founders’ perspective. 

1.  Common Stock.  The advantage of issuing common stock is that it is relatively quick, simple and inexpensive.  All you need is a short subscription agreement and perhaps a stockholders agreement (if you don’t already have one).  In addition, from the founders’ perspective, it puts the angels in the same boat as them. 

There are four disadvantages: (i) you will need to value the company, which (as discussed below) can be difficult and may lead to the founders’ substantial dilution; (ii) you’re likely to get substantial push-back from sophisticated angels — who generally will not agree to common stock because they don’t think their money should put them in the same boat as the founders; (iii) there may be tricky tax issues depending upon the timing of the investment — e.g., if you and your co-founders paid a nominal price for your shares of common stock and the angels pay substantially more for theirs shortly thereafter, the IRS may question how the value of the stock could have increased so much and may deem the shares issued to the founders a form of compensation; and (iv) it may cause potential problems with respect to stock option grants because the value of the shares of common stock will be established.  

2.  Preferred Stock.  Preferred stock is extremely favorable to the angels.  The only advantage from your perspective is that the interests of the founders and the angels are aligned.  Specifically, there is no incentive on the angels part (unlike if they were holding convertible notes, as discussed below) to keep the valuation of the company low in the Series A round.

The disadvantages to issuing preferred stock are significant.  First, it is relatively time-consuming, complicated and expensive.  Indeed, legal fees can be in the neighborhood of $20,000 or more if the preferred stock has all the “bells” and “whistles.” And second, as noted above, valuing the company at such an early stage is difficult and often leads to protracted negotiations and substantial dilution to the founders.    

3.  Convertible Notes.  The issuance of convertible notes is often viewed as a reasonable compromise between issuing common stock and issuing preferred stock.  In essence, it is a form of “bridge” financing – i.e., it is designed to provide the company with sufficient funds to get to the first professional (i.e., “Series A”) round, at which point, the notes would automatically convert into preferred stock at a discount (e.g., 15%-35%).  

The advantage of issuing convertible notes is that it is relatively quick, simple and inexpensive; all you arguably need is a short note.  As discussed above, the other significant advantage is that it will defer the company’s valuation (i.e., the pricing) until the Series A round.  By issuing convertible notes, you “kick the can” to the Series A round when the valuation picture would be clearer. 

The disadvantage of issuing convertible notes is that, as noted above, the founders’ interests and the angels’ interests may not be aligned because, again, it’s in the angels’ interest for the Series A valuation to be low.  Indeed, angels who think they can make a significant contribution to your company (e.g., as a result of their introductions or domain expertise) want to share in the increase in value they are creating.  Accordingly, if the angels do agree to the issuance of convertible notes, they will often push for a “cap” on the Series A valuation (which is obviously not in your interest).

Conclusion

I hope the foregoing is helpful.  If you would like a few tips with regard to angel financing generally, you can check-out these two posts: Angel Financings – Legal Tips for Entrepreneurs (Part I) and Angel Financings – Five Tips for Entrepreneurs (Part II). 

This is part two of my two-part series on angel financings.  In part one, I provided the following five tips for entrepreneurs: (i) push for the issuance of convertible notes; (ii) understand the key business terms; (iii) diligence the angel(s); (iv) never subject yourself to personal liability; and (v) comply with applicable securities laws.  Below are five additional tips for entrepreneurs to help them through the angel financing process.  Obviously, this is still a difficult environment in which to raise capital; however, I am confident that 2010 will bring greener pastures.

Tips for Entrepreneurs

1.  Get Your House in Order.  Most angel investors will perform due diligence on the startup prior to any investment, including a legal due diligence investigation.  Accordingly, it is imperative that all of the company’s organizational documents and agreements are in order and that there are no significant potential problems.  Indeed, I discuss this issue in the acquisition context in my post “Selling a Company: Ten Tips for Entrepreneurs” (see tip #3) and point out that: “An easy way to instill confidence in prospective buyers is for the selling entrepreneur to deliver (or make available) a complete, well-organized set of diligence documents.”  The same advice applies to angel financing.

Remember: angels may have hundreds of potential investment opportunities each year, but will only choose a select few.  Thus, if the legal documentation demonstrates a lack of  credibility, the angel(s) will more likely just move on.  To demonstrate its credibility (and sophistication), the startup needs to button-down certain fundamental legal issues prior to approaching the angel, including (i) organizational matters (e.g., incorporating in Delaware); (ii) founders’ stock issuances and vesting; (iii) IP issues; and (iv) compliance with applicable securities laws (all of which I discuss in detail in my post “Launching a Venture: Ten Tips for Entrepreneurs”).  Needless to say, any red flags that are raised as part of the legal due diligence investigation will adversely affect the entrepreneur’s chances of getting funding.  (This is one of the primary reasons I warn entrepreneurs against playing lawyer and/or utilizing web services like LegalZoom to try to save money.)

2.  Consider Angel Groups Carefully.  There are a number of angel groups throughout the United States that invest in startups.  As noted in a white paper from the Ewing Marion Kauffman Foundation (one of the world’s largest foundation devoted to entrepreneurship), “[t]hese groups have several characteristics: loosely to well-defined legal structures; part-time or full-time management; standardized investment processes; a public face usually with a Web site and public relations activities; and, occasionally a traditionally structured venture capital/angel investing fund.”  Here, in California, two of the largest groups are the Band of Angels in Silicon Valley and Tech Coast Angels in Southern California.  (Incidentally, I have attended a couple of Tech Coast Angels events, and they have some impressive members, including John Morris of GKM Ventures, the past Chairman.)

The good news with respect to these groups is that, generally speaking, they are a solid source of smart money for entrepreneurs, and they often have strong relationships with venture capitalists and other investors.  The bad news is that each group has its own distinct set of policies, procedures and form documents, which can make the process onerous, slow and at times frustrating.  Moreover, there are certain angel groups that are exploiting entrepreneurs by charging them excessive fees in connection with pitching and are otherwise taking advantage of them.  Jason Calacanis, the founder and CEO of Mahalo.com, has done an extraordinary job of calling-out these groups — and he has recently launched his own angel group called “Open Angel Forum,” which allows entrepreneurs to pitch for free.

Accordingly, my advice to entrepreneurs with respect to angel groups is two-fold: (i) do your due diligence (e.g., at a minimum, you need to talk to other entrepreneurs and founders who have dealt with the particular group in which you are interested) in order to obtain a deep understanding of the group’s processes, including the timing and fees; and (ii) recognize that you will have little negotiating leverage in connection with their standard deal structure and forms — e.g., very few angel groups will agree to the issuance of convertible notes, in lieu of preferred stock (which I strongly recommended in tip #1 of part one of this post).

3.  Try to Create a Competitive Environment.  There is nothing that will give an entrepreneur more leverage in connection with any deal negotiation than a competitive environment (or the perception of same).  Indeed, every investment banker worth his salt understands this simple proposition in connection with selling companies.  Accordingly, if an entrepreneur is seeking angel financing, he will clearly have more negotiating leverage if the prospective angel investor thinks that other investors are interested in his startup.  Competitors can be played-off of each other and, as a result, the entrepreneur will be able to strike the best possible deal.  (I briefly discuss this issue in Lesson #3 of my video post “Lesson Learned in the Trenches of Two Big NYC Law Firms.”)

Needless to say, this game must be played carefully and is better-handled by an experienced entrepreneur (or attorney).  The last thing an entrepreneur wants in this difficult fundraising environment is to end-up with no investment at all.  One final related point (which is the flip-side of this tip): do not appear desperate.  Angel investors are often savvy deal guys who can spot desperation a mile away; and if they think you’re desperate, they generally will either walk (thinking something must be wrong) or they will roll you.

4.  Develop a Game Plan.  There are no “standard” deal terms or “standard” documents in an angel financing.  Indeed, every deal is different — different players, different negotiating leverage, different risks, different timing.  As I noted in the introduction to part one of this post, I have been involved in a number of angel financings, and they run the gamut: from an angel handing a check to an entrepreneur and instructing him to “send the paperwork when it’s ready” — to an angel retaining a large, aggressive law firm and insisting on shares of preferred stock, with all the “bells and whistles.”

It is thus imperative that the entrepreneur sit down with his transaction team (lawyer, accountant, co-founder, etc.) and strategize to develop a game plan in connection with the financing.  The entrepreneur must communicate to the team, among other things, his deal-breakers, wish-list and potential problems.  For example, maybe one of the deal-breakers is preferred stock, as opposed to convertible notes; or maybe the entrepreneur only wants angels who have industry contacts or operational experience; or maybe there are IP issues that need to be disclosed and a strategy must be devised regarding timing, etc.  The bottom line is that entrepreneurs should treat angel financings like it would treat any other project: build a strong team, develop a game plan and then execute.

5.  A Great Angel Trumps Every Tip.  The final tip of this series is pretty simple: if a superstar angel is interested in investing in your company, don’t worry about all of the other tips and take the money; a great partner trumps all rules.  Indeed, as Roger Ehrenberg (a smart angel investor and the founder of IA Capital Partners) advises in his recent post on taking venture money: “[H]aving the right deal partner is critical, regardless of whether you are talking about the seed round, the A round, B round or beyond.  A strong deal partner can help materially de-risk a business through sound mentoring, prudent board leadership and valuable connections.”  Mark Suster (another smart investor and a partner at GRP Partners), gives similar advice in his post “Raising Angel Money”:

“As an entrepreneur you should raise money from the most experienced people possible – period.  If you have the opportunity to raise a small amount of money from a group of experienced investors who have a track record of helping companies get from that tricky idea stage to being a well-formed company with a good product and solid market-entry strategy[,] I would take the money – even if it were priced.  Worrying about giving up an extra 10% of your company at this stage can be meaningless if the ultimate outcome is either success or failure.  Even VC’s think this way, which is why Fred Wilson when describing his decision to syndicate a portion of his invesment in GeoCities to another investor says, ‘I learned that good partners are worth every penny of returns you give up to get them’.”

VentureHacks, one of the best websites for entrepreneurs, recently put together a list of top angel investors, including such stars as Jeff Clavier, Dave McClure, Aaron Patzer, Matt Mullenweg, Peter Chane and others.  In short, if any of them want to invest in your company, just roll-out the red carpet and take the money.

I am currently working with several smart, young entrepreneurs who are trying to raise capital from “angels” (i.e., wealthy individuals who invest in start-up companies).  Indeed, since I moved to Los Angeles from New York City in 2005,  I have been involved in a number of angel financings; and what’s interesting from my perspective as a corporate attorney is that the deals run the gamut from an angel handing a check to an entrepreneur and instructing him to “send the paperwork when it’s ready” — to an angel retaining a large, aggressive law firm and insisting on shares of preferred stock, with all the “bells and whistles.”  Below are five tips for entrepreneurs to help them through the angel financing process.  (This is part one of a two-part series; I will provide five additional tips in my next post.)

Five Tips for Entrepreneurs

1.  Push for the Issuance of Convertible Notes.  As noted above, angels will sometimes request shares of preferred stock for their investment; however, unless the start-up is raising at least approximately $750K, it generally is not in the entrepreneur’s interest to issue such shares.  Indeed, preferred stock financings are complicated, time-consuming and expensive.  Moreover, the company would need to be valued, which is obviously difficult at such an early stage and could be extremely dilutive to the founders.  Accordingly, entrepreneurs are better served by issuing convertible notes to angel investors, not equity — i.e., the angels would loan money to the company, which would automatically convert into equity in the first professional (the “Series A”) round of financing; this approach will keep the financing relatively simple and inexpensive and will defer the company’s valuation (i.e., the pricing) until the Series A round.  If an angel insists on equity, the company should issue shares of common stock — which will place the angel in the same boat as the founders (though still requiring a valuation and causing potential problems with respect to stock option grants).  Bill Reichert, Managing Director of Garage Technology Ventures,  briefly discussed the “note vs. equity” issue on The Frank Peters Show (starting at the 22:51 mark) and expressly advised that: “If you’re putting a few hundred thousand [dollars] in, it’s just not worth all the brain damage to price the round. . . [and] it’s not worth spending too much on lawyers.”

2.  Understand the Key Business Terms.  Regardless of whether the company issues convertible notes or preferred stock, it is imperative that the entrepreneur understand all of the key business issues.  In a convertible note financing, the key business issues include: (i) the amount of the discount on the conversion price (generally 20-35%); (ii) the terms of the warrant, if applicable; (iii) the interest rate on the note (generally 6-10% per annum); (iv) the definition of “event of default” and the related remedies; (v) the conversion rights of the noteholders; and (vi) whether the note will be subordinated to “senior indebtedness.”  In a preferred stock financing, the key business issues include: (i) the pre-money valuation; (ii) the terms of the liquidation preference; (iii) the terms of the anti-dilution provisions; (iv) the Board composition; (v) dividend-related issues; (vi) whether and to what extent vesting will be imposed on the founders’ shares; and (vii) the protective provisions.  Needless to say, an experienced corporate lawyer will help negotiate the foregoing issues; however, as Chris Dixon (co-founder of Hunch) aptly pointed out in a recent blog post: “you can’t outsource the understanding of key financing and other legal documents to lawyers.”

3.  Diligence the Angel(s).  In the course of my 15+ years of practicing corporate law (including nearly eight years at two major law firms in New York City), the most common mistake I have seen entrepreneurs and inexperienced deal people make in any dealmaking context is the failure to investigate the guys (or gals) on the other side of the table.  Indeed, in the angel financing context, the entrepreneur will, in effect, be married to the angel for a number of years.  Accordingly, at a minimum, the entrepreneur should get references and speak with other entrepreneurs and founders who have done deals with the angel in order to make an informed judgment as to whether the angel is an appropriate individual with whom the entrepreneur should be partnering.  Issues to consider include:  What is the angel’s motivation to invest?  Is the angel a good guy or a jerk?  Can the angel be counted-on and trusted?  Will the angel add significant value (e.g., through his contacts, technical expertise, etc.)?

There is an outstanding video discussion on Mixergy.com of how the angel process works (and what could happen if you don’t adequately diligence your angels) between Brandon Watson, a smart entrepreneur (currently at Microsoft), and Andrew Warner, the founder of Mixergy.  Brandon is extremely candid and discusses how he got “bullied” by his Board.  Moreover, he expressly notes in the comments section of the post (in response to my comment) that: “The diligence factor was that I knew them, but had never taken money from them.”  He also adds that: [O]ur legal counsel wasn’t worth a damn, and they were the expensive Silicon Valley kind.  My issue was that the partner would bill for a lot of stuff that I felt shouldn’t have taken as long (my whole family are lawyers). I know that this could have been a partner specific issue, but my experience with the expensive SV lawyers has been a mixed bag at best.”  (I discuss the big firm problem in my recent post, “Behind the Big Law-Firm Curtain: The Good, The Bad, The Ugly.”)

4.  Never Subject Yourself to Personal Liability.  It is self-evident that founders should not be personally liable to angel investors if their company fails (other than in connection with fraud).  Indeed, that’s one of the principal reasons for forming a corporation or limited liability company: to protect the entrepreneur against personal liability (see tip #1 of my post “Launching a Venture: Ten Tips for Entrepreneurs).”  Unfortunately, there are angels and inexperienced business attorneys who will request that the founders personally make certain representations and warranties.  In fact, I was involved in two separate angel financings in the past 18 months in which the angel’s legal counsel insisted on just that; and in one deal, the angel requested a personal guarantee from the founder (but dropped the request when I pushed back very hard).  My tip here for entrepreneurs is simple:  Never agree to potential personal liability.  Every sophisticated player understands that angel investing is a “high-risk, high reward” proposition, and there is no reason whatsoever that an entrepreneur should be sticking his neck out and subjecting himself to any personal liability if the deal sours.  If an angel is pushing this issue, it’s time to find a new angel.

5.  Comply with Applicable Securities Laws.  Whether the company issues convertible notes or shares of common stock or preferred stock, it will be issuing a “security” within the meaning of Section 2(a)(1) of the Securities Act of 1933, as amended (the “Securities Act”).  Accordingly, such security must be registered with the Securities and Exchange Commission (the “SEC”) and registered/qualified with applicable state commissions, or there must be an applicable exemption from registration.  For startups, there are certain prescribed transaction exemptions which may be applicable in connection with an angel financing, the most common of which is the so-called “private placement” exemption under Section 4(2) of the Securities Act and Regulation D promulgated thereunder.  The rule of thumb in connection with private placements is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506 thereof.  There are two significant reasons for this: (1) Rule 506 preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996 – which means, in general, that the issuer merely must file with the applicable state commissioners (i) a Form D (see my recent post regarding Form D), (ii) a consent to service and (iii) a filing fee; and (2) there is no prescribed written disclosure requirement if the investors are “accredited” — though it still may be prudent in certain cases to furnish investors with a private placement memorandum (or at least a summary and/or a set of risk factors).

There are eight categories of investors under the current definition of “accredited investor” — the most significant of which for entrepreneurs is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or (ii) 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 such income level in the current year.  Indeed, if a company offers or sells securities to non-accredited investors, it opens a pandora’s box of compliance and disclosure issues, under both federal and state law.  Accordingly, the entrepreneur must ensure that the angel is an “accredited investor” and that he represents and warrants such in a subscription agreement or other applicable agreement/document.  (Obviously, this should not be difficult based on the foregoing definition.)  Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (see my recent post “Rescission Offers: Five Tips for Entrepreneurs”), injunctive relief, fines and penalties, and possible criminal prosecution.

Conclusion

In part two of this series, I will provide five additional tips for entrepreneurs in connection with angel financings, including (i) how to work with angel groups (such as the Band of Angels, Tech Coast Angels, etc.); and (ii) why having a superstar angel as an investor (such as Ron Conway, Jeff Clavier or Kevin Rose in the San Francisco Bay area; or Matt Coffin, Kamran Pourzanjani or Jason Calacanis in the Los Angeles area) trumps all other tips.

There has been quite a bit of excitement on the blogosphere and twitter with respect to Jason Calacanis’s crusade against angel groups charging entrepreneurs fees to pitch them (see, e.g., the discussion on Hacker News and this recent post).  As a corporate attorney representing entrepreneurs, I generally agree in principle with Jason’s position; however, I think it is important to distinguish among the different angel groups and their respective practices. 

Needless to say, to the extent an angel group (i) is not adequately disclosing their fees, (ii) is charging unreasonable fees and/or (iii) is deceiving entrepreneurs, it is a significant problem that needs to be addressed.  On the other hand, (i) if the fees are reasonable/de minimis and are adequately disclosed and (ii) the angel group is providing a legitimate service to entrepreneurs, there may be compelling reasons to support such a fee-based service.  Indeed, as discussed below, John Dilts (the founder and President of Maverick Angels, LLC) recently attempted to make that case to Frank Peters during his podcast interview on 9/24/09 here (referred to herein as the “Dilts Podcast”).

This post briefly (i) provides some background and context, (ii) sets forth the respective arguments made by Jason and John and (iii) concludes by recommending that they should meet face-to-face and have a live debate (in the great American tradition). 

The Players

Below is some background information with respect to Jason Calacanis and John Dilts (which is quoted verbatim from the Mahalo website and the Maverick Angels website, respectively). 

Jason Calacanis is an Internet entrepreneur and former blogger.  He has founded many companies including Silicon Alley Reporter and Weblogs, Inc.  He is the founder of Mahalo.com and has been its CEO since 2007.  Calacanis returned to podcasting on May 1, 2009 with his new program This Week In Startups. 

John Dilts is the Founder and President of Maverick Angels, LLC, a highly innovative angel investor network based in Southern California, which focuses on funding and mentoring early-stage companies.  Since founding the company in 2006, John has established Maverick Angels Chapters in Southern California and in Europe.  John is an expert in the areas of innovation, leadership and entrepreneurship and often serves as a featured speaker at innovation conferences and angel investor forums.

The Fees

Based upon (i) my review of the “Apply to Present” page of the Maverick Angels website and (ii) the comments made by John Dilts during the Dilts Podcast (beginning at the 31:02 mark), Maverick Angels has the following fee structure for entrepreneurs: (A) no fee to apply; (B) a mandatory fee of $495 for an 8-hour “bootcamp”; (C) no fee for the “deal line-up”; and (D) a $1,000 fee if the entrepreneur is chosen to “present” (all of which must be agreed to by the entrepreneur prior to applying). 

Note that certain recent blog posts have been inaccurately disclosing such fee structure, including today’s post on PEHUB’s site, which provides in relevant part that:

“Any entrepreneur can apply for a hearing to Maverick Angels or Keiretsu Forum, [their representatives] said, and those who are chosen to move forward get weeks of free coaching and mentorship on their pitches before they’re asked to pay.  Also, entrepreneurs don’t have to pay — they can drop out if they want.” 

The Argument for Charging Fees: John Dilts 

As expressly stated in the Dilts Podcast, John’s arguments for charging entrepreneurs fees to pitch the Maverick Angels are as follows: 

1)  “We feel it’s perfectly appropriate because we’re entrepreneurs; and we’re innovating in ways that a lot of angel groups just [cannot] because there are too many chefs in the kitchen.” 

2)  “Why do we [charge $495 for the bootcamp]?  Because we have a full-time staff.  It’s like saying why does an entrepreneur need to charge fees to sell their products or services?  Can’t they give that away to customers? . . . Because we’re delivering value to entrepreneurs; we’re delivering value to our members; and we charge a fee for that. . . . [Otherwise,] “entrepreneurs don’t take us seriously.” 

3)  “The reason [they pay the $1,000 fee] is because we put a lot of effort into coaching that entrepreneur between the time they’re chosen at the deal line-up and the time [of the presentation].  Because we want them to put their best foot forward — not because we’re consulting to the entrepreneur and now all of a sudden they’re our customer — it’s that we want our members to see the best possible deals.  And through the coaching and through the support and through the facilitation all the way through the process, we feel that’s in the best interest of our members. ” 

The Argument Against Charging Fees: Jason Calacanis

As expressly set forth on his post, Jason’s arguments against charging entrepreneurs fees to pitch angel investors are as follows: 

1)  “It’s low-class, inappropriate and predatory for a rich person to ask an entrepreneur to PAY THEM for 15 minutes of their time.  Seriously, what is the cost to the party hearing the pitch?  If you answered ‘nothing’ or ‘the cost of two cups of coffee’ you win the prize!

Even if you rent a hotel room and put out breakfast for your fellow angel investors that’s like $20 a person. You mean to tell me that a room full of rich investors can’t afford to pay for their own God-damned $20 in bad coffee, stale pastry and stained ballroom rugs?

Really?

To be clear, I am making this a class war because it is one: cash-poor startups are bringing RICH angel investors an opportunity to become EVEN MORE RICH.  As such, the rich folks should pick up the non-existent to minimal costs.”

2)  “These pay-for-play scams remind me of the ‘modeling agencies’ that charge people for representation, acting lessons and to have their headshots done.  Trust me kids, Brad Pitt and Kate Moss did not pay to get representation–they didn’t have to.  If you’re paying to get an agent, it’s because you’re being scammed.” 

3)  “It’s your job as an angel investors to do the filtering and that should come out of YOUR RETURNS on your investments. If you have to charge it’s because either a) you’re a predatory DB or b) you suck at investing so much that your returns can’t pay for the time that you spend evaluating companies. . . .” 

Conclusion 

Based on the foregoing, I think it would be extremely productive (and indeed entertaining) to watch Jason Calacanis and John Dilts debate this important issue.  I would suggest that such debate be shown live on the web to all interested parties via Ustream.  I am happy to help in any respect to make this happen.

http://www.youtube.com/watch?v=NtSeN0wA598

Mistake #1 – Playing Securities Lawyer 

A company may not offer or sell its securities unless (1) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable state commissions; or (2) there is an applicable exemption from registration.  The most common exemption for start-up companies is the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933 and/or Regulation D, the safe harbor promulgated thereunder.  This is very complex stuff – and now is not the time for entrepreneurs to play securities lawyer.  Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.

Mistake #2 – Selling Stock to Friends and Family Who Are Not “Accredited Investors”

The rule of thumb in connection with private placements is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506 of Regulation D.  There are two significant reasons for this: (1) Rule 506 preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996 – which means, in general, that the issuer merely must file with the applicable state commissioners (i) a Form D, (ii) a consent to service and (iii) a filing fee; and (2) there is no prescribed written disclosure requirement if the investors are “accredited” – though it still may be prudent to furnish to investors a private placement memorandum (or at least a summary and a set of risk factors).  There are eight categories of investors under the definition of “accredited investor” – the most significant of which for entrepreneurs is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or (ii) 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 such income level in the current year.  Indeed, if a company offers or sells securities to non-accredited investors, it opens a Pandora’s box of compliance and disclosure issues, under both federal and state law.    

Mistake #3 – Advertising or Soliciting Investors 

Subject to certain limited exceptions, Regulation D of the Securities Act of 1933 prohibits issuers from “general advertising” or “general solicitation” in connection with a private placement.  These terms are not defined under the Securities Act, but have been broadly construed in SEC no-action letters.  “General advertising” includes any ad, article, notice or other communication published in a newspaper, magazine or similar media or broadcast over television or radio or on a website; “general solicitation” includes any solicitations via mail, e-mail or other electronic transmission, unless there is a “substantial and pre-existing relationship” between the issuer and the prospective investor.  That’s the test: there must be a “substantial and pre-existing relationship” – and there are a number of SEC no-action letters which discuss what that means; simply put, it means there must a business relationship that is in place prior to the offer sufficient for the issuer to determine that the offeree would be a suitable investor. 

Mistake #4 – Using an Unregistered Finder to Sell Securities 

Entrepreneurs often make the mistake of retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) to raise capital for them.  The problem is that finders must be registered with the SEC if they operating as a “broker,” which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others.”   If the finder is receiving some form of commission or transaction-based compensation (which is usually the case), he will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions.  If he is not registered and sells securities on behalf of an issuer, the private placement will not be valid (i.e., will not be exempt from registration), and the issuer will have violated applicable securities laws – and thus will be subject to serious adverse consequences (as noted in paragraph #1 above), including giving the securityholders the right of rescission. 

Two caveats: (1) In 2004, California enacted a law specifically addressing this issue, which provides for (i) an express right of rescission to any investor who purchases a security from a person or entity that acted as a “broker-dealer” but was not registered; and (ii) the right of the purchaser to sue the unregistered seller for money damages.  (2) In 2008, the SEC adopted a new Form D (which, as noted above, is the official notice of a private placement under Regulation D), which must include the identities of all brokers and/or finders engaged in the offering of securities of the issuer.  This will obviously result in increased scrutiny of finders that are not registered as broker-dealers.

Mistake #5 – Selling Preferred Stock to Angel Investors  

Unless a start-up is raising at least $750K for an angel financing, it may not make sense from a practical standpoint for it to issue preferred stock.  Indeed, preferred stock financing are complicated, time-consuming and expensive – plus the company would need to be valued, which could be extremely dilutive to the founders.  Accordingly, entrepreneurs are better served by issuing convertible notes to angel investors, which keeps the financing simple and inexpensive, defers the valuation until the Series A round and gives the investors a discount on the conversion price (or a warrant) as a sweetener.  Needless to say, if superstar angels are interested in investing in your company, but insist on preferred stock, bite the bullet and take the money; great partners trump all rules.