Protect your equity Advice for cash-strapped, first-time entrepreneurs

BY  JAY  DEVIVO    CoFunder  

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Students and recent graduates often find themselves in a quandary; they have poured their personal savings into their startup, but need to hit additional milestones before it makes sense to pitch investors. One way these startups try to conserve cash is to pay contract developers, consultants, and other service providers with equity. We’ll explain why this is a bad idea and review some best practices to help you more efficiently use your company’s equity. In this paper we will cover:

- Why startups should never issue equity to pay service providers - How to structure equity grants to advisors - Raising a friends and family round of financing (selling equity is better than paying

with it) - An example of how deal terms impact investors’ ownership

Introduction

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Why You Should Not Pay w ith Equity

It’s expensive When you are low on cash, handing out stock certificates to service providers may feel cheaper than parting with dollars, but in the long run it could prove far more expensive.

Example You need some design work done on your prototype and your designer quotes you $1,000 for his time. Instead of paying him in cash, he agrees to accept 1,000 shares of your company. You have 1 million shares outstanding, so you are giving up 1/10 of 1% of your company. You and your co-founders still have 99.9% of your company, plus, you have an implied valuation of $1 million – terrific! Fast-forward 2 years, and you do $100,000 in revenue. In year 3, it jumps to $2 million, and you accept an offer to sell the company for $50 million. You just paid a designer who did some front-end work on a prototype (that bears virtually no resemblance to your current product) $50,000 for his work – 50x the value!

You will have plenty of opportunity to part with equity when you raise money; don’t give it away unnecessarily. Remember, you only come out ahead paying in equity instead of cash if your company fails.

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It’s bad for fund raising When you go out to raise money, investors are going to want to see who is on your cap table; the cap table tells them who owns what. If you are paying vendors in equity, they show up on your cap table. This presents two problems:

1. Paying vendors in stock signals to investors that you do not value your equity. They will therefore try to grab as much as they can. It also shows some level of desperation, so they may be more inclined to include particularly onerous terms.

2. Competition for capital is stiff. You will have a ton factors working against you as you compete for money; don’t make it easier for investors to say “no” by having an ugly cap table.

Who else shouldn’t get equity? Answer: Almost everyone who isn’t a founder or employee. Two more examples:

Mentors People mentor to give back. Mentoring with the expectation of payment is not mentoring. It is consulting. If you have a mentor that becomes more than a sounding board, consider asking him or her to serve on your advisory board (see below).

“Connectors” There people who offer to introduce entrepreneurs to investors in exchange for “finders fees.” They seek cash, equity, or some combination of both to make “introductions to their network.” If someone offers to connect you to investors in exchange for compensation – even if payment is only contingent on a successful fundraising – run in the other direction. You never need to pay for introductions.

An Exception: Your Board of Advisors

A Board of Advisors can be enormously beneficial to your startup. Advisors can open doors and share their experience so that you make more smart decisions and fewer bad ones. Advisory Board members typically fall into 1 of 2 categories:

1. “Generalists” who you can turn to for advice on a wide range of aspects of running your business.

2. “Strategic advisors” who you brought on board because they can help your company in very specific ways.

Generalists Generalists often start out as mentors that you have asked to become advisory board members because they have been instrumental in any early success you have had and you want to keep them involved. Their motivation for getting involved is often driven by a belief in you personally, and they may or may not have any experience in your industry.

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Strategic advisors Strategic advisors are often people you have met building out your company. While they also believe in your mission, their motivation for getting involved is often driven by their knowledge of an industry, market, or distribution channel. Strategic advisors often agree to become involved in your company in the hope that doing so also helps them directly or indirectly in their other business pursuits.

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How much equity should advisory board members receive?

The “typical” range of equity grants to advisors – 0.1% to 1% – is pretty wide. The amount depends on a number of things including their relative importance, how much time and effort they give to you, and how helpful they may have been prior to accepting an advisory board position. Instead of vesting immediately, use a monthly or quarterly schedule that vests the grant over three years. This ensures they continue to stay engaged and also protects you in case your business model changes. This is particularly important for strategic advisors.

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Example Suppose you have created a SaaS offering for financial advisors. You meet Bill who has 25 years experience as a wholesaler for major mutual fund company and he is connected with every major financial advisor in your region. Bill provides some initial introductions that are fruitful and you ask him to come on as advisory board member. Six months later, your offering is struggling to get traction with financial advisors but is a hit with hedge funds’ proprietary trading operations. You make the pivot. Bill doesn’t work with hedge funds; it no longer makes sense for your company (or for Bill) for him to continue on as an advisory board member. If you granted Bill shares that amounted to 1% of your company as soon as he signed on, you are out 1% of your company. That is a big take for someone who can no longer help you propel your company forward. But if you had the shares vest monthly over 3 years, you are only out 0.16%. Bill gets something for giving it a go and no one feels badly about needing to move on.

Raising a Friends and Family Round

While paying vendors in cash is far preferable to paying them in equity, to do so, you of course need to actually have cash. If you are running out of cash and have exhausted grants and other sources of “free money,” it is far preferable to raise capital from your family than it is to pay your expenses with equity. In addition to being “cleaner” from cap table perspective, you will likely give up less equity in small capital raise than you would by paying venders in stock.

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As much as angels and “pre-seed” VCs say they invest early, when it comes time to writing a check, they always seem to prefer that you be a little further along than where you are, particularly if you are a first-time founder. A friends and family round should be a small amount of capital that will get you to the early milestones where angels and other very early stage investors in your ecosystem typically invest.

Purpose of a friends and family round

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About your family… In all likelihood, your friends and family are not professional investors. An investment in your startup may very well be the first – and perhaps only – startup investment they make. And while all investors say they invest in people before products, when you raise money from friends and family they really are investing in you. Because these investors are so different from professional investors and the amounts of capital much smaller, simplicity is key in structuring these agreements.

Before your raise a single dollar from anyone, read Venture Deals by Brad Feld and Jason Mendelson. There is no more valuable resource for entrepreneurs about raising capital than Venture Deals. Though the book is geared toward those raising money from a VC or angel fund (as opposed to Aunt Fran), it is never too early to start viewing your company through the same lens as the professional investors you will be calling on down the road. Venture Deals can help you avoid mistakes in a friends and family round that might arise from a “helpful” uncle who offers to put together the deal for you. It will also prove to be a frequent reference guide as you negotiate term sheets from VCs and angels in the future.

Structure and valuation

Convertible notes and valuation Startup valuation is more art than science, and at the earliest stages it is complete guesswork. For that reason, early stage investors and startups often agree to kick the valuation can down the road by waiting to value the company until future round of “priced” equity is raised. Historically, that has been done using convertible debt. With convertible debt, the debt converts to equity upon certain events, including raising equity that is “priced” – i.e. the equity places a pre/post money valuation on the company. Typically, the debt converts at a discount (20% is a common discount) to recognize the fact that earlier convertible debt investors took on more risk.

Before we offer suggestions for how you might raise your friends and family round, we are going to take a brief detour to introduce a common security used to address the issue of startup valuation. We do this because the options discussed below are simplified version the old workhorse, the convertible note.

 

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Example A company raises $100k in convertible debt and 9 months later raises $1 million of Series A Preferred Stock at a $3 million pre-money valuation. If the Series A investors get 1 million shares in the company at $1 a share, the convertible debt holders convert their $100k at 80 cents a share, giving them 125,000 shares of Series A Preferred Stock.

A SAFE approach to raising a friends and family round Convertible debt solves the valuation issue, but it is not a perfect fix. Terms can still get complicated, and though typically cheaper to issue than equity, it is still cost prohibitive for a small friends and family round. Two leading accelerator programs have developed agreement templates that offer three advantages to hiring a lawyer to draft convertible note documents:

1. Simplified terms make them easier for the parties to understand 2. They are recognizable to (and sometimes used by) angel groups and VCs1 3. They are free

Y Combinator has developed a series of documents called SAFEs (Simple Agreement for Future Equity). There are few different flavors of SAFEs but all work similar to convertible notes, though they are not technically debt instruments. Not to be outdone, 500 startups developed KISS docs, which come in 2 flavors; equity and debt, the latter of which is comparable to SAFEs. There are differences between the debt KISS and SAFEs. A significant one is that KISSes provide rights to investors to participate in future financings.2 Since participants in a friends and family round do not need that right, I would lean toward the SAFEs for a friends and family financing (the document is also shorter – only 5 pages). The version that provides for a discount, but no cap is good balance between investors and the entrepreneur (for more information on caps, discounts, and the myriad of other deal terms see the page 4 sidebar on the book Venture Deals). Any of these templates can of course be modified to accommodate your company’s unique needs. You should have an attorney review any documents you plan on using to make sure you have all of your bases covered.

1 While VCs and angels may be familiar with SAFEs and KISSes, they all do not necessarily like them. There is some advantage to using a form document in a friends and family in that VCs do not have to spend time familiarizing themselves with the deal terms. That said, VCs and angels are like snowflakes, and they each have their own view as to what they prefer to see in previous financings. 2 While SAFEs do not explicitly stipulate that investors can participate in subsequent rounds, they anticipate that a separate such agreement will be included as part of the financing. This is referred to in the document as the “Pro Rata Rights Agreement.” If one will not be used, it is best to remove this defined term, found on page 3 of the document, from your agreement, as well as paragraph 1(a)(ii), found on page 1 of the document that says such an agreement will be executed.

   

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The Uncle Bob Paradox Suppose you raise $25,000 from your Uncle Bob. The agreement provides that his investment will convert to equity once a priced round is raised at 20% discount. In 6 months, you raise $500,000 from an angel fund. That investment is also structured as a convertible note with a 20% discount. One difference from Uncle Bob’s security is that this convertible note carries a 12% interest rate. The interest isn’t paid out to investors, but is added to the amount that will ultimately convert to equity. 12 months after your seed round, you raise a $1 million Series A from a VC at a $3 million pre-money valuation. The VC receives 3 million shares at $1 a share. Here is where everyone stands after the Series A round:

Impact of deal terms

Typically, the earlier one invests in a company, the greater percentage of the company each dollar buys. Depending upon how rounds are structured, that isn’t always the case.

 F&F   Seed   Series  A   Founders  

Price  paid  per  share   $0.80   $0.80   $1.00    Initial  investment   $10,000   $500,000   $1,000,000    Total  Investment  (includes  interest)   $10,000   $560,000   $1,000,000    Number  of  shares   12,500   700,000   1,000,000   2,287,500  

%  Ownership   0.31%   17.50%   25.00%   57.19%  

         Initial  investment  per  basis  point  of  equity   $320   $286   $400      

The Series A investors were the last investors in, so as one would expect, they paid the most: $400 for every basis point of equity. However, because the seed investors had a coupon attached to their note, they paid almost 11% less –$286 per basis point of equity vs. $320 – than Uncle Bob, even though he invested 6 months earlier.

Final thoughts

Building a successful company is incredible difficult. No one will be more committed to your success than you and your co-founders. If you are building a company that will one day be venture-backed, you will likely be parting with the majority of your equity through venture rounds and option pools. Efficient use of equity early on can make a big difference in how much of your company’s success you realize. Your company’s equity is the company; part with as little of it as you possibly can.