Venture Capital Deal Terms with Mital Makadia and David Siegel from Grellas Shah Law Firm in Silicon Valley | Ep. 184 | Business Podcast
Summary
Mital Makadia and David Siegel are Partners at Grellas Shah Law Firm in Silicon Valley and we talk about deal terms entreprenuers can expect when raising venture capital.
If you are, or are considering, raising money for your startup this epsiode will give you an overview on what terms to expect and lessons learned.
About Mital
Mital’s practice is focused on representing technology startups and startup founders . She provides counsel on a variety of corporate and transactional matters and negotiates and structures equity financings, M&A transactions, and commercial and intellectual property transactions for her clients.
About David
David is an unusual startup lawyer in having done sophisticated legal work in both transactional and litigation matters: he is an accomplished startup lawyer and litigator who has extensive experience with our firm in handling a broad range of corporate, transactional, and intellectual property matters, including work on multi-million dollar financings and acquisitions, all in addition to having a deep expertise in handling complex intellectual property, corporate, and commercial litigation matters.
Hello friends.
Brandon:
Welcome to the Edge.
Brandon:
Today we’re joined by metal Mckee idea and David Siegel from Grella’s shaw law firm here in Silicon Valley And we are talking all about venture deal terms.
Brandon:
If you were even remotely thinking about raising money for your company from venture capitalists, you’re going to want to tune into this episode.
Brandon:
Metal and David share a ton of experience that they’ve had and lessons learned so that you can avoid making any mistakes when you raise money.
Brandon:
Here we go.
Brandon:
Battle and David with Grella’s shaw law firm here in Silicon Valley.
Brandon:
Welcome to the Edge podcast, Your weekly playbook about the inner game of building a successful business, making you a happier, healthier and richer business owner.
Brandon:
And here’s your host, Brandon White, David Natale.
Brandon:
How are you?
Brandon:
That would be a good thing.
Brandon:
We thought you would be in a zoom expert by now.
Brandon:
You know, it can’t be an expert in everything. You can’t be an expert in anything. But that’s the truth.
Brandon:
How are you doing?
Brandon:
Oh, I’m good.
Brandon:
How are you?
Brandon:
Good. Is that it crib No, it’s a, it’s what it’s not really.
Brandon:
You know, it’s my daughter said it’s my daughter’s, I’m trying to let me see if I can multitask.
Brandon:
No, not that much fault.
Brandon:
She’s not in the room with her.
Brandon:
Whatever, whatever it takes to do a podcast in today’s day and age.
Brandon:
That’s true, That’s true.
Brandon:
Well, thanks a lot for joining again.
Brandon:
I really appreciate it.
Brandon:
Happy to.
Brandon:
And today I wanted to talk with you both about deal terms and what’s happening in the market and for our listeners out there who are looking to raise money, what they can expect in today’s deals and any tips and tricks that you have to protect them.
Brandon:
We only have one hour.
Brandon:
Yes we only have one hour today so hopefully we can, we’ll just get right to it.
Brandon:
Where do you want to start?
Brandon:
Do you want to start with seed documents and convertible notes and how they work or what do you do?
Brandon:
Yeah, that sounds good.
Brandon:
One thing I would say though is people in the market, you seed financing and lawyers, you seed financing differently at least you know the series C dogs.
Brandon:
I don’t know if you’re familiar with the open source documents, we’ve got the the full in D and D.
Brandon:
C.
Brandon:
A model docks for a series A right, there’s also a separate set for equity seed funding.
Brandon:
If you’re familiar with serie C dot com.
Brandon:
Those are popular and I think Coolly also has their own version on their website.
Brandon:
Also equity seed financing preferred stock.
Brandon:
And I’ve seen more and more especially repeat entrepreneurs out the gate start with those sorts of documents.
Brandon:
And so I I think of it more as equity or convertibles.
Brandon:
Right?
Brandon:
So it could be, it could be seen in the form of convertibles or it could be seen in the form of equity.
Brandon:
There are two different things whichever one you want to start with.
Brandon:
You start wherever you think we can start with convertible note and then work our way up the chain.
Brandon:
How about that are way up the chain sounds good, convertibles are self explanatory there.
Brandon:
They’re essentially a right to future equity.
Brandon:
So the investor puts in the money now and that could be in the form of a safe or a convertible note instrument.
Brandon:
And then sometime in the future when the company actually does it’s, you know, VC backed series a funding round then the convertible instrument will convert.
Brandon:
The original seed investor gets series a preferred stock or some shadow series thereof.
Brandon:
But at you know at at the pre negotiated valuation cap so there can be evaluation cap and there can also be a discount.
Brandon:
Is that right?
Brandon:
Right.
Brandon:
Yeah.
Brandon:
So yeah.
Brandon:
So taking a little bit of a step back, there’s two main types of vertebral securities as mental references convertible notes and safe.
Brandon:
It’s not exclusive.
Brandon:
There are others but those are the main types.
Brandon:
Either way the most significant negotiating point is is there going to be evaluation cap?
Brandon:
Is there going to be a discount or is there going to be both And evaluation cap just means that when you do a priced VC equity round they won’t have to pay more per share when there no door safe converts then the price that would have been determined based on whatever the pre agreed upon valuation.
Brandon:
Uh huh.
Brandon:
One of the things to be aware of when you’re when you’re looking at how a note, birds or how new money comes into a company and A.
Brandon:
B.
Brandon:
C.
Brandon:
Round the price per share is all about.
Brandon:
It’s just a simple formula of pre agreed upon or agreed upon pre money valuation and divided by what’s called the fully diluted capitalization of company.
Brandon:
Basically how many shares have been issued plus shares reserved space.
Brandon:
So if say Your series A is at a $40 billion $20 million dollar cap.
Brandon:
The safest and notes are going to convert at something like that.
Brandon:
The price per share.
Brandon:
It’s not it’s not exact because it depends on some other details of the formula.
Brandon:
But that kind of gives you a sense of what evaluation test with me.
Brandon:
Can you explain for our listeners the difference between the note and the safe?
Brandon:
The three of us will talk about that as it’s normal but not a lot of people, not everybody understands the difference of that nuance.
Brandon:
Yeah.
Brandon:
The difference is significant at the most basic level.
Brandon:
A note is det.
Brandon:
It’s alone that somebody is making to the company like any other loan that you might see in your life with the special feature that rather than getting paid back in cash the terms will provide conditions under which it will instead convert into shares of the company at a future.
Brandon:
Rap A safe is not.
Brandon:
Yes.
Brandon:
It’s not alone.
Brandon:
The investor in a safe has no right to their money back as if they lent money to the company.
Brandon:
All they have is a right at a future date to convert into equity.
Brandon:
Yeah.
Brandon:
The afternoon for the safe is a simple agreement for future equity.
Brandon:
That’s what safe stands for.
Brandon:
So it’s really just an agreement to get preferred stock in the future.
Brandon:
Right?
Brandon:
So the difference is meaningful in a couple of ways.
Brandon:
One is, if things go south with the company, a convertible note holder has a right to get their money back in the same way as any other lender does.
Brandon:
A safe holder does not a safe holder doesn’t have the same kind of protections if the company were to go into bankruptcy or something like that.
Brandon:
As a note holder does know holder is a creditor of the company like any other lenders.
Brandon:
In addition, loans have interest.
Brandon:
So a convertible note will have an interest rate and it will bear interest.
Brandon:
A safe does not, it’s not alone.
Brandon:
It doesn’t have any interest rate that can add up.
Brandon:
It depends on what the percentage is.
Brandon:
The plants just tend to be pretty low.
Brandon:
But you know, it depends on the Yeah, depends it can add up.
Brandon:
But the other, I mean, the other difference is not so much interesting.
Brandon:
It’s not about anything to do with what a note versus a safe is.
Brandon:
But just kind of what’s become the traditional terms of notes versus saves in that safe star as Michael said, simple agreement for future equity.
Brandon:
It is very simple.
Brandon:
There’s a formula for how it converts and it will convert at whatever and whatever is the next equity financing where the company sells preferred stock to investors.
Brandon:
That’s not the case with a convertible note, convertible notes traditionally will not convert unless the round, unless it’s at a VC round that’s large enough in some sense.
Brandon:
So it might say, and this will be referred to as a qualified science.
Brandon:
So they will say this note will convert In the next financing where the company sells $5 million $1 million dollars 500,000.
Brandon:
It could be anything but that becomes a negotiation point of itself.
Brandon:
The safe’s will all convert.
Brandon:
It doesn’t matter how big or small the next round is.
Brandon:
The safe will convert the note on the other hand, might not.
Brandon:
Yeah, sometimes note note holder investors don’t necessarily want to convert if the round is too small.
Brandon:
Right?
Brandon:
Because then they dilute in future rounds so they want to wait until it’s a significantly large funding round and only then their note will convert ren are your, are your listeners, do you think they’d be familiar with?
Brandon:
And we’re throwing around terms like valuation cap And you know, I think you should, I think you should define that for our listeners and just assume that most of our listeners have businesses and ultimately you’re going to raise money they want to raise money.
Brandon:
But there’s no book or anything really on.
Brandon:
There was one book, one little book a while ago that came out.
Brandon:
I don’t even know if they’ve updated.
Brandon:
I forget it was VC investment turned or something, but the one on my shelf is way out dated.
Brandon:
Yeah.
Brandon:
Old and don’t even talk about safe.
Brandon:
So the answer would be, I think it’s good if you could explain all these different types of terms.
Brandon:
Yeah.
Brandon:
I don’t know if I have a definition that handy.
Brandon:
But essentially if for example, David had a company and I wanted to invest in that company And I gave him $10,000.
Brandon:
The question is, what percentage of the company do I own for that?
Brandon:
$10,000.
Brandon:
And so David and I would have to negotiate.
Brandon:
And David would say, well, I think my company is worth $100,000.
Brandon:
And so I’ll give you a valuation cap of $100,000.
Brandon:
Then I know that my $10,000 that I’m giving him will get me 10% of the company.
Brandon:
Now, whether I get 10% now or whether I get it in the future when my instrument converts doesn’t matter.
Brandon:
I’ve got my valuation cap negotiated.
Brandon:
And so when David strikes gold and he two years from now, you know, it goes to Sequoia and gets a, you know, evaluation of 40 million, I still get 10% of the company before what’s usually before he gets his funding round from, from Sequoia?
Brandon:
So whatever the price that Sequoia pays for their shares of David’s company, my price is going to be determined as if the company is only worth $100,000 and I put in $10,000.
Brandon:
And so that’s what the benefit of the valuation camp is.
Brandon:
I don’t believe it if you want to add anything more technical to it, but no basic Well, I think the question will be and I know there’s no definitive answer.
Brandon:
The question is, well, how do you come up with the evaluation Because David Thinks it’s worth 100,000.
Brandon:
I actually think it’s worth 50 and then it just comes down to negotiation and comparables ultimately right.
Brandon:
It comes out, yeah, exactly.
Brandon:
Yeah.
Brandon:
It essentially comes down to what you can get from your investors, but I also like to advise clients on how to sort of back into it.
Brandon:
I ask a series of questions, you know, for most of our clients who are not traditional small businesses who are, you know, startups and are going to the sea route.
Brandon:
The question I always poses well, your VC round, you want to do in two years, you’re incorporating now?
Brandon:
You want to, you know, go out for funding six months from now, a year from now, Two years from now?
Brandon:
Whatever your roadmap is, once dilution do you, are you willing to take until you get to that point and how much do you need until you get to that point?
Brandon:
Right.
Brandon:
Every business is different.
Brandon:
Every startup is different.
Brandon:
So they’ll know what kind of budget they have in mind and how much they need to raise from their angel investors.
Brandon:
And then it’s just a question of backing into that valuation number you need if you know you need 250 K.
Brandon:
You know, you need two million whatever the number is.
Brandon:
How much are you willing to give up of the company?
Brandon:
And mind you, you know when you do this series around so take a significant dilution chunk there.
Brandon:
So I’m talking about before then, Before you you give that you know 15% to the series a investor.
Brandon:
what what decision are you willing to take and that that’s that’s your number right there, your evaluation and then of course it’s a negotiation and backing into it and we could probably do six hour seminar on how to get your evaluation right.
Brandon:
And everybody thinks as an entrepreneur that you want the high valuation but the high valuation can actually hurt you long term.
Brandon:
I think tied Savage from Revolution Ventures has talked a lot about this out there and actually talking with him because he’s overrun from AOL really taught me how to think about it a little differently.
Brandon:
But for anybody listening out there, you’re going to have to sit down with your lawyer and your business advisors and you’re gonna have to figure out what your industry is.
Brandon:
I use yahoo finance and look up comparables to exist existing companies.
Brandon:
Then you’re going to have to get some and and lawyers will know in general what the market is in terms of your market and they’re going to have to come to some negotiation.
Brandon:
But that’s and that’s only one part of this whole process.
Brandon:
Right?
Brandon:
Mind you people do notes and safe without any evaluation cap but with a discount either instead or or in addition or really as an alternative.
Brandon:
So if you have a discount let’s say it’s 20% which is pretty typical if you’re going to have a discount, what that means is forget forget the idea of evaluation cap.
Brandon:
If at the series A where this note are safe is converting if The new money is coming in at a dollar per share you just get a 20% discount per share on that.
Brandon:
So you get 80% 80 cents per share.
Brandon:
And so that would be the price at which your note or safe birds which think more often than not that winds up being better.
Brandon:
But it’s not necessarily.
Brandon:
Yeah.
Brandon:
And in my experience discounts have kind of they’ve gotten less.
Brandon:
Yeah.
Brandon:
Unless they’re silent.
Brandon:
No that’s the most investors now want valuation camp.
Brandon:
And if the the other other I guess a scar on my back is if you do give them a discount, all of them will want a discount moving forward because you just set the standard from the beginning that you’re going to do that, right?
Brandon:
That’s another thing to deal with because it’s a hard it’s a hard discussion to defend when you’re new investor six months later says, well, I’m going to invest in this either a note or safe.
Brandon:
Well, a note and you gave them A 20% discount.
Brandon:
I want the same thing.
Brandon:
Right?
Brandon:
Every this is this is something for startups and founders be aware of most most investor concessions you make on day X.
Brandon:
Are your standard for the future that carries through with notes safe investment rounds you’re always making, you’re always setting precedent for yourself.
Brandon:
It’s not, yeah, that’s the floor, it’s not in stone.
Brandon:
I mean look, if you have great negotiating leverage later than that, you can change things.
Brandon:
But I always think about things that always remember you’re setting precedent and you’re setting a floor for the future.
Brandon:
Yeah, I find it’s harder for clients to remove those investor terms in equity rounds.
Brandon:
So once you’ve given that whatever term it is or right or obligation in a series A.
Brandon:
It’s really hard to remove in your Series B or series C.
Brandon:
I think in the earlier stages it’s still possible.
Brandon:
I think it’s it’s possible to give on the, on the convertible side, you’re early stage convertible note holder or safe holder, some sort of concession that you don’t give to your later angel investors because they took the risk on and they give you your first, you know, 50 K or whatever it was that got you started.
Brandon:
It makes sense that they would have a very low valuation cap or a large discount.
Brandon:
I think that’s easier to defend.
Brandon:
Then in an equity round, once you’ve given something in the series day, you’re gonna be giving that to everybody unless you have some extraordinary growth that was unexpected.
Brandon:
And, and shifts the pendulum, which, which we all, which we all say is going to happen and we all want.
Brandon:
But it’s, it is possible.
Brandon:
It won’t, it is possible.
Brandon:
It won’t things like covid can happen for for better or worse yet?
Brandon:
A question I have on the, on the safe in the note is everything that’s been described.
Brandon:
If I’m playing my entrepreneur hat, sounds like I want a safe because I don’t know debt.
Brandon:
I probably am not going to have any interest rate on that.
Brandon:
And if something happens, I don’t quote unquote.
Brandon:
Oh, that money, but if I put my investor hat on, I say, well, why wouldn’t I want some ability to get my money back?
Brandon:
But it seems like the market today pumps out saves pretty regularly.
Brandon:
Is that what’s happening or has anything changed?
Brandon:
No, that’s, that’s still happening.
Brandon:
Although some investors will insist on a convertible note.
Brandon:
David’s going to get into the post money safe, aren’t you?
Brandon:
Well, no, I wasn’t going to get into that so much as they’re there.
Brandon:
Are there are reasons why someone might, a company might want to know what we’re safe in that.
Brandon:
So I said saves convert at the next round or or if there’s an acquisition first, you know, obviously they get money that way and there, but there’s nothing that happens.
Brandon:
There’s nothing that by the terms of the safe can happen in the interrupt while with a note, notes can have provisions that so a note like like any loan, a note, federal note will have a maturity date.
Brandon:
So let’s say the maturity date is two years out now, some investors will want their money back at two years if it hasn’t converted, some will want the right to get their money back after two years and some are willing to agree depending on your negotiating leverage that at the end of that two year period.
Brandon:
If it hasn’t converted it will automatically at that moment convert at some pre agreed upon price with some pre agreed upon terms.
Brandon:
Let’s say you’re a company that thinks it wants VC funding but isn’t sure and might have a way to scale without it.
Brandon:
You if let’s say you had a note in a safe both with a $10 million dollar cap.
Brandon:
So you go through a couple of years.
Brandon:
The no VC funding, you’re growing.
Brandon:
You’re doing really well.
Brandon:
You sell for $100 million five years later, the note will have converted at your too, At the $10 million dollar cap.
Brandon:
The safe won’t the safe will ride through and will Get treated as it will get the benefit of a $10 million dollar cap at the acquisition.
Brandon:
Your stakeholders probably getting a lot more then the note holder will win getting because the note holder will suffer all the dilution in the next several years until the acquisition.
Brandon:
So I think states are generally a better choice for the company, but it’s not exclusively.
Brandon:
I think that makes that makes sense.
Brandon:
One other thing that’s going through my head on the safe is they’re not forced to convert.
Brandon:
What happens if you never raise money and then it just Yeah.
Brandon:
Yeah, that’s what I mean.
Brandon:
Either either it gets either they get some proceeds from an acquisition or if there’s an IPO, they get the proceeds of the IPO, but obviously if the company goes bankrupt then they get nothing.
Brandon:
Well, the other scenario is I just, my company does well, yeah, I don’t need to raise any money.
Brandon:
I don’t sell, I just want to, there’s a y Combinator company out there who I heard.
Brandon:
Yeah, they just said we’re not raising any money and now the safe holders, where does that leave the safe holders?
Brandon:
They sit there, they do under under the newer form of safe, they have a right to sum equivalent to dividends.
Brandon:
If the company issues dividends, they get those too.
Brandon:
So there’s that, but otherwise they’re just sitting there.
Brandon:
Yeah, this happens a lot actually with my clients who don’t end up going public, don’t end up actually selling and it turns into a lifestyle business startup And it’s been 10 years and the safe holders are still there and sometimes it’s usually a very small number, right?
Brandon:
It’s just a handful of safe holders is not a lot of company that went out and did huge rounds.
Brandon:
Usually at that point, each company approaches it differently.
Brandon:
What we’ve done is just repurchased the state’s half the times will negotiate and amend and, and you know, the investors have to be willing, you can’t force them obviously can you give them some sort of liquidity and buy them out or convert them again.
Brandon:
We would need their permission to do so outside of a funding round but just a voluntary conversion, that’s what, and I appreciate you asking answering that because, because I think that does happen, I mean, you could find yourself in a lifestyle business and that lifestyle isn’t negative, it’s just, it’s just not going to go this VC route and lightest rockets to the moon.
Brandon:
It can print some money and I think, I think one of the companies in SAN Francisco is popular that runs social media site did that, but I think that one thing that I did in some of these safe documents was I actually put the right to buy them out and that at an agreed upon interest rate should the company want to do that mainly because after a few of these things I realized that they don’t all go to the moon or mars.
Brandon:
It’s not bad.
Brandon:
But then you have these, these investors, I don’t mean sitting around, but they can call you, they take time and legitimately so they gave you money and you’re gonna have to figure out how to take care of them effectively.
Brandon:
So what are you seeing more of safe or notes This?
Brandon:
It’s and there they are generally pretty quick because of the of the forms that’s all that you were talking about that.
Brandon:
I mean entrepreneurs can effectively print off.
Brandon:
They should have their lawyers look at them, but it’s an open source document at this year.
Brandon:
Yeah, they’re very user friendly.
Brandon:
They’re designed to be so and there’s tons of information out there and online calculators and I’m sure lots of blog posts about about what it is, that what you’re doing when you sign on to a safe.
Brandon:
I would say most of the investors here in California.
Brandon:
Majority would use safe.
Brandon:
I still have some pushback from Asian clients.
Brandon:
You know, I used to get pushed back in new york, although I think they’re popular almost all over the world now, not as much what most people are aware of it and but I do get some pushback from europe and Asia.
Brandon:
It could be aware of it, but they still prefer the convertible notes.
Brandon:
Does it get tricky too?
Brandon:
Or is there any complex relationship?
Brandon:
Let’s say we’re going to raise 100 grand to make it simple.
Brandon:
Can you or is it smart to go out and say I’m doing a safe or does it get complex when someone wants a note and a safe as an investor group to manage if you see because because there’s a lot of different dynamics in these two different groups, so to speak, it’s only complicated for us, but we like to excel like tables.
Brandon:
So when you do your, when you do your series around, it will be a little bit more complicated in terms of doing the formulas to get everybody.
Brandon:
It’s the right numbers.
Brandon:
But but no, you can there, you don’t have to just stick with one.
Brandon:
And in fact it often happens where investors are starting, companies will do a friends and family around or you know, we’ll have some high net worth individuals in their network who aren’t as savvy and so they’ll use one type of instrument and then somebody’s a larger player comes along and has counsel and negotiates a different type of instrument.
Brandon:
And so then the the founders left wondering, well, what do I do with my friends and family?
Brandon:
They kind of got screwed.
Brandon:
They had to do this at this valuation and then I ended up having to do this kind of say for a convertible note.
Brandon:
Do I get to go back and amend everybody or do I leave it?
Brandon:
As is So those sometimes founders will go back and amend everyone so they’re sort of on the same instrument.
Brandon:
Other times folks just sit on the cap table with whatever they have and when it comes time to do this series a proforma will be a lot of shatter series.
Brandon:
I think one of my one of my startups has a pre money safe convertible note and opposed many safe and the pre money safe is at three different valuations.
Brandon:
So that’ll that’ll be fun with option their series around.
Brandon:
So talk about you mentioned this a few times shadow some kind of series.
Brandon:
So what is this shadow thing that’s in the shadows.
Brandon:
Sure.
Brandon:
So the state from noteholders are guaranteed the same rights and preferences as the new money coming in that whatever the conversion round is.
Brandon:
Series A let’s say so a series A the D.
Brandon:
C.
Brandon:
Coming in with their you know 15,000,020 million whatever it is is going to get a type of stock called series a preferred stock and we’ll have a whole bunch of rights and preferences and the noteholders and safe holders will get those same ones.
Brandon:
But here is one difference some of the rights and preferences of preferred stock are tied to the price per share their pain.
Brandon:
The big e that most of us talk about his liquidation preference.
Brandon:
So liquidation preference is basically the right of a preferred stock holder to essentially get their money back in an acquisition or a liquidation of the company before any of the common stuff does.
Brandon:
And that oversimplifies it.
Brandon:
But that’s the basic idea and that’s something that goes into your certificate, inc let’s assume you’re a Delaware company.
Brandon:
So when you’re stupid inc it will say holders of series A preferred stock will get, Let’s say the series a price with $1 per share.
Brandon:
So holders of series a preferred stock, We’ll have the right to receive $1 per share back in liquidation event, such as a symbol of the company before common stock gets in.
Brandon:
The thing is we’ve been talking about notes and saves having discounts or evaluation camps.
Brandon:
Right?
Brandon:
And so $100,000 safe in this series A Where there’s evaluation capital or a discount instead of converting at the BCS $1 per share their paying.
Brandon:
It’ll convert it 80 cents a share.
Brandon:
Let’s just say that’s what So for that $100,000 saved The certificate inc is going to say not that they have a right to receive $1 per share In preference to the common stockholders, they just get to receive their money back, which is 80 cents per share.
Brandon:
Right?
Brandon:
In David’s example, if someone put in $100,000 at the seed level And they had a 20% discount That we’re using 80 cents a share.
Brandon:
Right?
Brandon:
So my $100,000 that I put in way back when At 80 cents a share will give me 120.
Brandon:
I don’t know if you can’t do the math on top of about 120 series a preferred stock.
Brandon:
Right.
Brandon:
And so in a liquidation preference, I shouldn’t be getting $120,000 back.
Brandon:
I should only be getting what I put in $100,000 back.
Brandon:
So we want to make sure that if there’s, if it’s not a hockey stick, right?
Brandon:
And and if there’s liquidation preference that’s going to be exercised, then we want to make sure that those early investors get back only the amount that they actually put in.
Brandon:
Right.
Brandon:
And so the way that gets done is Because they said the Superb inc says series a preferred thought gets of liquidation preference of $1 a share, say For the safe holders who can bring in 80 cents per share.
Brandon:
They get something called series a one preferred stock And series a one preferred stock gets 80 cents back per share as elimination purpose.
Brandon:
And that series a one preferred, we referred to in the shadow schools.
Brandon:
It’s exactly the same as series a except for this.
Brandon:
Yeah.
Brandon:
It’s just like a one a two a three.
Brandon:
What’s your record, David?
Brandon:
I feel like I think I’ve gone up to six or 7.
Brandon:
Yeah, six or 7.
Brandon:
Well if you’re listening to this and it sounds complicated.
Brandon:
It is very complicated and that’s why you need an attorney for one and two, two.
Brandon:
If you’re doing some of the math in your head, even if it’s not perfect, what you’re realizing or you should be realizing Is that when you think you own 30% of the company, that may be true while you’re running it.
Brandon:
But when you sell it, You actually might only get 10 and right because of the how this, how these liquidation preferences and how all of these people who converted at all these crazy different prices actually get their money back.
Brandon:
So so far just to bring us back, we’ve talked about early stage funding where we can use a safe or a note and they both have different terms in different and results.
Brandon:
Now let’s move into a series a round, which is probably more of a institutional round versus it would be a firm, a mini firm.
Brandon:
I don’t know what they call them these days, but some sort of institution versus a group of high net worth individuals or an high net worth individual or an angel network or some accelerator or one of these.
Brandon:
I don’t know, there’s like so many things out here these days.
Brandon:
So many things out there out funding follow on investors following the investors.
Brandon:
They’re not lead investors.
Brandon:
So now we’re at this series A, this is like now we’re in the N.
Brandon:
B.
Brandon:
A.
Brandon:
We’re in the major leagues, what mechanisms and types of terms happen here versus what’s happened in the in the safe And the note.
Brandon:
Typically your investors are going to be putting in tons of money and they’ll get a negotiated percentage, there will be a negotiated valuation and they’ll get a percentage of preferred stock.
Brandon:
They won’t get common stock.
Brandon:
Many Vcs that are willing to take common stock will get preferred stock with the liquidation preference and possibly dividend rights in addition to doing all sorts of diligence on the company.
Brandon:
Right?
Brandon:
So they’ll ask to see all of your paperwork, They’ll they want to see everything and question everything and their lawyers will go through everything with a fine tooth comb in addition to getting all kinds of representations and warranties from you and and looking through your corporate documents and your financials.
Brandon:
They will also ask for certain voting rights and certain rights going forward.
Brandon:
The voting rights will typically be veto rights on your ability to do enumerated list of things Without their approval.
Brandon:
Even if they have, you know, even if your series a investor has 10 or 15% of the company after the round, they’ll still have veto rights on on the startup’s ability to Do the next financing round two sell themselves, you know, to do an M.
Brandon:
And a transaction.
Brandon:
There’s a lot laundry list of things, they’ll have veto rights on.
Brandon:
So they’ll have they’ll have veto rights and they’ll likely get a board seat and in addition to that they will want rights to invest in the future.
Brandon:
So they’ll have they’ll want preemptive rights, parental rights, they’ll want a right of first refusal on the sale of your stock and they’ll want information rights going forward and registration rights.
Brandon:
Those are the big category.
Brandon:
Am I missing anything?
Brandon:
They didn’t think my first born, your first born, I want my firstborn and maybe my second or part of the interest in them.
Brandon:
I want the right still want rights to it first said it.
Brandon:
So let’s talk about a few of these things because they actually have huge impacts on operating the company when you and first let’s go back.
Brandon:
You said tons of money, Tons of money is probably north of $5 million a these days.
Brandon:
Is that fair?
Brandon:
Yeah.
Brandon:
Okay.
Brandon:
And when we start talking about veto rights basically that means that it sounds like if I want to sell my company for 100 million and they don’t think it’s enough.
Brandon:
They can stop that.
Brandon:
They can stop anything.
Brandon:
They can stop you borrowing $100,000.
Brandon:
They can stop you from yes selling the company but they can also stop you from doing your series B round without their approval.
Brandon:
So it sounds like I’ve lost control of my company.
Brandon:
Yes.
Brandon:
I mean depending on what you’ve negotiated, these are the terms that I was talking about our are fairly common terms and so you have to be careful about knowing what you’re getting yourself into and and some of that, some of it is reasonable.
Brandon:
I mean, if they’re putting in millions of dollars, they don’t really know you and they don’t have control over the company.
Brandon:
Otherwise it’s understandable, they want to protect their investment.
Brandon:
But just because something is, market doesn’t necessarily mean you should agree with it or if you’re going to agree with it, you should go into it with your eyes very wide.
Brandon:
I’d say one of the things that I’d throw in here and I want to get us off track, but I want to mention it because I learned this lesson also is you as a founder or in your co founders and maybe key management, however far down the line you can get away with should have a employment contract, mainly because they can not only block things, but they can arguably fire you.
Brandon:
And if they fire you, you are out of a job, out of your income and potentially even out of your stock, if they forced you to go vest your stock back, which we haven’t talked about yet, but I’d like to bring up because if you have not, if you have no vesting schedule, if one of you want to tackle this, they can actually tell you that you’re going to give your stock back and you’re gonna earn it over four years, right?
Brandon:
I mean, not necessarily give your stock back but imposed vesting terms on it.
Brandon:
Yeah.
Brandon:
And even if you have a vesting schedule, they can renegotiate that so that you’re only invested, you know, let’s say one year or two years, that’s pretty common.
Brandon:
And you’re right.
Brandon:
You know, I find oftentimes founders aren’t so concerned about the veto rights because it’s the honeymoon phase.
Brandon:
You know, they really like their Dc partner and things are going well, they’re not concerned about the D.
Brandon:
C.
Brandon:
Having veto rights.
Brandon:
They’re usually more concerned about the horror stories right of being out of their own, their own baby, their own company and and being out all of their equity.
Brandon:
And so usually that’s what they’re trying to protect.
Brandon:
Yeah.
Brandon:
I think first time founders don’t know what to protect and then they realized after the first time, what they needed to protect and they try to do it the second time from a guy talking from experience who did have an acquisition blocked and veto rights would definitely be on my list of high priorities along with a employment contract.
Brandon:
Yeah.
Brandon:
We usually try to negotiate those those protective provisions.
Brandon:
You know, we try to encourage clients to say, you know, okay, it’s market for VCS to have veto rights on an M.
Brandon:
And a transaction, but only if the return is, you know, less than three X.
Brandon:
Or something like that.
Brandon:
So yeah, there is, there are ways you can protect yourself and cut back on some of those veto rights.
Brandon:
And let’s unpack because we talked about it with the safe and the note when we talk about preferred stock and David you went down that list or this scenario pretty easily.
Brandon:
But in simple terms if they have preferred stock and they have a liquidation preference it basically means they get their money back before before everyone participates in the percentage.
Brandon:
Can you walk us through that well that have participating?
Brandon:
Yeah so there is Broadly two types of liquidation preferences.
Brandon:
There is participating preferred in nonsense incurred.
Brandon:
We’ll start with nonpartisan participating preferred which is much more common.
Brandon:
What it does is essentially gives the investors a choice.
Brandon:
They can either get their money back before anyone else gets anything they get their money back.
Brandon:
But if they do just get if they do elect that then they don’t get anything else.
Brandon:
And they’re only really going to elect that.
Brandon:
If the if their percentage of the proceeds are if they did if they Just got their percentage of the proceeds that would have been less.
Brandon:
So option one is get your money back.
Brandon:
Option two is to essentially be treated like you were converted into common stock and get your percentage of the proceeds like anybody else.
Brandon:
But it’s one or the other.
Brandon:
Not both participating preferred is the both scenario first you get your money back then whatever money is left you get a percentage of that money as well.
Brandon:
And that’s pretty dangerous.
Brandon:
I mean it’s it’s pretty rare.
Brandon:
No I would say less rare, 95.
Brandon:
More than 95% of the deals are regular non purchasing Back in the day.
Brandon:
It was 14 years ago.
Brandon:
That was like the you could negotiate that it was really hard one to swallow because you really that’s where your percentage actually gets significantly affected.
Brandon:
Could you talk about other common in general?
Brandon:
Nobody’s going to hold you to it.
Brandon:
But in general what we’re seeing out there in the market for a series A that a business owner could expect two reasonably negotiate in a fair deal.
Brandon:
Sure.
Brandon:
So I think it’ll give the broad outlines of what the rights are that you should expect.
Brandon:
You should expect.
Brandon:
You should expect what when we refer to as a one x non participating liquidation preference which is the just get your money back.
Brandon:
The investors get their money back first and nothing else.
Brandon:
Or they have the choice to participate in the proceeds of the acquisition.
Brandon:
They will likely get a board seat which is okay.
Brandon:
But the details there matter a lot and in minutes they will want these veto right protective provisions that mental talked about.
Brandon:
They will want what registration rights mental referred to so the right in the future to have their shares registered as publicly.
Brandon:
Tradable securities they will want to impose if you don’t already have it And this is not a bad thing.
Brandon:
Something called a drag along provision.
Brandon:
So that if typically if the board, the common stockholders and the investors all vote in favor of a sale of the company, then everybody has to vote.
Brandon:
They were a bit so that it’s eliminating holdouts.
Brandon:
But investors who want to eliminate holdouts, they will want as Mitchell said and typically get a right of first refusal over the founders shares of their own stuff.
Brandon:
So if you as a founder want to sell your stock to some 3rd Party out there was that Bill Gates, Bill Gates, yes, investors that your series a investor will want the right to step in and buy your shares instead.
Brandon:
And the corollary right is called the coastal right.
Brandon:
If they decide not to exercise their right, they want the ability to eat into your sale and force the fire to buy some of their shares.
Brandon:
In addition to buying well, basically a percentage of what you have to give up a percentage of your sail and give that percentage to your investors.
Brandon:
So say Say you were selling 100 shares and your series ACC.
Brandon:
And trying to keep this number simple own 20% of the company.
Brandon:
They would want the ability to force you to only sell 80 shares and they get to sell 20 ships.
Brandon:
This is all, I mean, these are pretty standard and these are, these are the ones that we find objection.
Brandon:
Yeah.
Brandon:
You know, it makes sense why these rights coming.
Brandon:
Yeah.
Brandon:
A lot of, a lot of what we try to, I mean, look, I mean we’re trying to, we want our clients to go into a price ground with their eyes open.
Brandon:
That’s hugely important.
Brandon:
And we, we want to help them close around if they want to close around, we want to help them close around.
Brandon:
There’s no getting around the fact that somebody putting $10 million dollars into your company is going to want it And the market while Certainly better for founders than it was 15 years ago the ecosystem is who largely built around investor rights, not founder.
Brandon:
So you’re going to almost all the time.
Brandon:
You’re going to give up a lot of, you know, you’re gonna give up a lot of rights.
Brandon:
You’re going to give a lot of rights to your investors.
Brandon:
We tried this.
Brandon:
There are ways to mitigate some of the harshness around terms in all sorts of ways that actually do work.
Brandon:
A simple example is this coastal right?
Brandon:
It sounds, it sounds terrible, right?
Brandon:
But most investors at least a larger vision will agree to have what one refers to as a de minimus transfer exception.
Brandon:
So basically will negotiate a fish that says, okay, you get this coastal right?
Brandon:
But not Until the founder has had the right to sell 5% of their ships.
Brandon:
So you can, I was able to get 10%.
Brandon:
Okay, that’s the highest.
Brandon:
You’re hired.
Brandon:
You’re already hired, you’re hired.
Brandon:
I do want to before we run out of time talked about, you know, one thing that, that we found that stuff like is founder protective provisions did want to Put that out there into the ecosystem.
Brandon:
Hopefully somebody is listening and grabs it and runs with it.
Brandon:
Well, let’s talk about that right now because we have like 10 minutes left.
Brandon:
Yeah.
Brandon:
So if you’ve done this before you understand and the charter and the amended and restated certificate of incorporation, there will be the enumerated list of protective provisions for the series.
Brandon:
They preferred investor, right?
Brandon:
It will be Like 10 or 15 items, essentially veto rights that the series a investor has.
Brandon:
So you can’t sell the company.
Brandon:
You can’t amend the bylaws or the charter.
Brandon:
You can’t change the board.
Brandon:
You can’t, you know, increase the authorized shares basically.
Brandon:
You can’t do anything, can’t take on debt without approval of the majority of the preferred.
Brandon:
So those those we call investor protective provisions.
Brandon:
What we’ve done is have a corollary.
Brandon:
The common stockholders don’t have that.
Brandon:
The founders don’t have their own version of protective provisions.
Brandon:
So we’ve pitched And they’ve only been successful twice.
Brandon:
Like I always say, I’ve been pitching this for like 10 years and I’ve only been able to get advice.
Brandon:
Common stock protective provisions.
Brandon:
So essentially mirroring those rights, but for the key holders.
Brandon:
The common stockholder.
Brandon:
So the investors or the company, the company can’t be sold without approval of a majority of the common stockholders or the company can’t we can’t change the board.
Brandon:
The Ceo can’t be fired, their compensation can be adjusted downwards.
Brandon:
What are the other big ones?
Brandon:
Yeah, I mean that’s that’s pretty much what, you know, founder.
Brandon:
Those are the horror stories of founders have right, try to put that in Into the charter itself and say, look here, it’s it’s fair, you’re putting in $10 million, you know, you want protection for that.
Brandon:
But we’ve put in blood, sweat and tears for five years.
Brandon:
So we want protection too.
Brandon:
And so if if this partnership is going to work well, we’re all gonna have to trust each other and work together.
Brandon:
We understand you want to be protected.
Brandon:
But this has to go both ways and and we want that same level of protection and so we want the corollary which is founder protective provisions.
Brandon:
So I anyone who has the the leverage I would recommend being creative and and trying to I mean, the NBC model documents are great, right?
Brandon:
I’m glad that they’re exhaust but they’re not, they’re not beyond we might want to explain what those are.
Brandon:
My guesses.
Brandon:
People.
Brandon:
Mm.
Brandon:
Yeah.
Brandon:
So most investment rounds, there’s a lot of paper to do an investment round.
Brandon:
This stuff is not generally written from scratch.
Brandon:
There is too, I would there are two sense of standard documents that are most often used for a series A B.
Brandon:
C.
Brandon:
It’s almost certainly going to be model documents put out by the National Venture capital Association of People called NBC A for us in earlier rounds for a seed equity round.
Brandon:
There’s documents put out on a website called seriously dot com.
Brandon:
They’re much more streamlined.
Brandon:
They differ a lot of those rights to later, but that’s, that’s what your lawyers are going to be using.
Brandon:
That’s what everyone’s expecting.
Brandon:
Bu that’s helpful.
Brandon:
I think for anybody out there who’s thinking about the documents back in the day.
Brandon:
Those documents, It ages me a little bit, but my first deal I ever did, I think they were literally written from scratch that was 25 years ago and it was really expensive because there wasn’t a model and I think the advantage that business owners have now is is that at least you’re getting a template, but you’ve got to work with your attorneys like you to work through this and say, okay, what are we going to adjust here?
Brandon:
Because we’re just not going to take that out of the gate and we’re gonna try to put our best foot forward.
Brandon:
Yeah, I know we’re coming up on top of the hour.
Brandon:
Is there anything, there was a, maybe we talk about two last things in this series A, we’re not going to get to a B and beyond today for sure.
Brandon:
The board seats.
Brandon:
David, you had mentioned something about, well they get one board seat.
Brandon:
I actually, maybe that’s true now as an investor, I tend to want more as an entrepreneur, I tend to want one.
Brandon:
But what is common today and you had alluded to what the terms were around that board seat and series a suit.
Brandon:
So I’m gonna assume here a series A where there’s not been a price see ground the most common thing to see in a term sheet would be one director appointed by the series A lead investor.
Brandon:
Two directors appointed by common stockholders, one of whom will be the company’s CEO.
Brandon:
That’s the common formulation are the most common formation and then the big part about the fight there is to get rid of that Ceo board seat because if you removed to Ceo, then a new Ceo has brought in then common stocks essentially lost control of the board because now the boy is going to be 11 series A one common one.
Brandon:
Ceo That undoubtedly was founded by the very startled but it’s not exclusively that it could be, sometimes the investors will really want an independent board member chosen whether that is 1/4 or even fifth board member.
Brandon:
It depends or it could be that third board seats at series A.
Brandon:
You really really, really should be fighting to keyboard control.
Brandon:
Yeah, it depends on the, it depends on the industry, to some of the my life science companies, they really pushed on the independent director C.
Brandon:
Yeah, I would say typically in the market it’s common to have one additional investor boards he added at each round.
Brandon:
And so, like David said, it’s, you know, usually too common one series a preferred director.
Brandon:
And then when you do your B round, it’s the director, the director and then the common directors and then the C round, sometimes they will drop off.
Brandon:
But sometimes it’s a B and C.
Brandon:
And then by then you’re probably going for a growth fund and they don’t really care to have an investor seat on the board.
Brandon:
They just, they’re just putting in their money.
Brandon:
But if you don’t have enough founders to sit on the board to kind of keep control of the board, then you can also adjust the voting rights.
Brandon:
Right?
Brandon:
So you could, instead of putting your mother or your wife or your brother on the on the board to keep control of that that come and The board, you can say the founder gets two votes for every feet, the founder has on the board.
Brandon:
Things like that.
Brandon:
I mean, you can get creative, but usually in terms of actual physical bodies on the board, at least likely be one, three each round.
Brandon:
Well, that’s really helpful.
Brandon:
I want to end on one last question as it relates to what business owners, once they’ve gone through all this and they’ve agreed and both of you have protected us with every right that we could possibly get in this in this new relationship.
Brandon:
How often our board’s meeting these days.
Brandon:
Is it every month?
Brandon:
Is it every quarter?
Brandon:
It’s More often than every quarter.
Brandon:
But it’s not every month.
Brandon:
I would say it’s about every 8-10 weeks.
Brandon:
And in those meetings they expect an update on operations finances, your general KPI is like sales and things like that.
Brandon:
And then any discussion on key hires or anything like that, right?
Brandon:
They want to see the dilution on the cap table.
Brandon:
How much of the option pool is being used up?
Brandon:
Things like that.
Brandon:
Well, I want to thank you both for taking time out of your day and joining us to talk about all these deal terms.
Brandon:
Like I said, really complicated.
Brandon:
It is not if you haven’t been through it before, you need an attorney.
Brandon:
Find a good attorney that you get along with and is really good at excel because you don’t use your investors attorney.
Brandon:
Oh my God.
Brandon:
Yes.
Brandon:
Well that’s a, that’s a great piece of advice that I’m taking for granted.
Brandon:
But considering you never use your investors attorney, even when the investors like, oh well, we can just save costs and do that.
Brandon:
Uh, or investors sometimes bad mouths the company counsel because we negotiated hard at the, at the a round and they don’t want to deal with that.
Brandon:
So it’s time for you to get, you know, one of the big players, it’s time for you to be more professional.
Brandon:
That’s B.
Brandon:
S.
Brandon:
Uh I agree.
Brandon:
And actually we had another guest on the show and I couldn’t remember, I’ve had so many lately, but they listen to our last episode and they said we use them and we love them.
Brandon:
So.
Brandon:
So I think that’s awesome.
Brandon:
Well that’s nice to hear.
Brandon:
Yeah.
Brandon:
Where can people get ahold of you both so that they can sign you up to hide you like to stake it?
Brandon:
And uh don’t hide, don’t hide business owners need, you know, it’s gorillas dot com.
Brandon:
It’s G.
Brandon:
R.
Brandon:
E.
Brandon:
L.
Brandon:
L.
Brandon:
A.
Brandon:
S.
Brandon:
Gorillas dot com.
Brandon:
You can find us there with all and David, thanks a lot for going today.
Brandon:
Thank you.
Brandon:
Thank you.
Brandon:
Thank you.
Brandon:
Thanks for being generous with your time and joining us for this episode of the edge.
Brandon:
Before you go, a quick question, are you the type of person who wants to get 100% out of your time, talent and ideas?
Brandon:
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