What’s in it for me? Beat the odds with CVC for digital ecosystems.

The book, Innovation Casino, uses its self-titled metaphor to describe the odds of generating financial returns from innovation so you can beat them. For decades, vertically integrated firms have made high-stakes bets on innovation. However, in the innovation casino, it is the players who bet big. Players think they will beat the odds, but few do. By taking a fresh look at your odds, you can retool your approach to win more frequently just as the house does in a casino.

Large firms have a unique opportunity to improve their odds in the innovation casino with an emerging business model called “digital ecosystems.” Digital ecosystems give large firms the opportunity to make thousands of bets on innovation, which is playing like the house. Each chapter in this book provides a “house strategy” to fund non-core innovation in digital ecosystems:

1. Fund startups instead of acquiring companies
2. Master the odds to invest in startups
3. Recoup principal with 100X more bets than VC
4. Standardize to deliver gains from overall performance

Like the “app store” on your phone, a digital ecosystem is a supply chain for data and digital services that are delivered over a platform. A digital ecosystem has three components: (1) a platform, (2) network effects, and (3) market expectations of continued growth. An example that checks all three boxes is the Apple App Store. At the end of 2019, the Apple App Store had 1.84 million apps. Apple is playing the innovation game like the house because it only makes a handful of the apps that reside on its platform. The rest of the 1.84 million apps were built by developers, and Apple reaps the financial rewards by housing them.

By contrast, BlackBerry developed a rival app store called “BlackBerry World.” BlackBerry World could not rival the network effects Apple was generating between developers and customers. The market increasingly expected BlackBerry World to fall behind. Its death spiral ended in 2019 when BlackBerry World was shut down. Using the above definition of a digital ecosystem, Blackberry checked the box for having a platform but fell short when it came to generating network effects and market expectations.

BlackBerry World typifies the challenge in building digital ecosystems: growing network effects between outside developers and customers. The solution is to give customers and developers more reasons to use your platform. This can be done by combining open innovation with seed funding, so outside startups—not internal teams—build thousands of new products and services that drive demand for your core products.

Innovation Casino proposes a new corporate venture capital strategy that transfers the approach of the US government’s Small Business Innovation Research (SBIR) program. As a grant program, SBIR is missing a way to generate returns. Venture capital fills this gap by making equity investments and raising capital from outside investors. To describe such a hybrid fund, this book introduces the term ecosystem innovation fund, or EIF. A large company with an EIF can become the house in the innovation casino by funding startups in its digital ecosystem with outside capital, returning principal from these investments, and delivering gains from its stock price.

The key message here is: The term “innovation casino” is a metaphor for the odds of generating financial returns from innovation. Digital ecosystems give your large firm the opportunity to make thousands of bets on non-core innovation, which is playing like the house. To play like the house, use a new type of corporate venture capital fund called an EIF.

House Strategy 1: Fund Startups Instead of Acquiring Companies

Even before COVID-19, US government debt was nearing all-time highs. The pandemic response compounded public debt to levels not seen since World War II. To restore public finances, the US government will need to raise taxes. Higher taxes will erode cash flow at a time when corporate debt is high. Having less cash flow will reduce credit quality and make borrowing more expensive. Companies seeking to deliver outsized returns will need to grow organically rather than via mergers and acquisitions.

Growing organically means that businesses will need to find new reasons for customers to pay a premium, remain loyal, and refer friends. To do so will require companies to tap their innovative powers and improve their core assets by 10X. Standing in the way is the fact that many large companies spent the last decade acquiring non-core assets. A non-core asset is not central to the service a company provides. For example, when Microsoft bought the devices and services business of Nokia in 2013, it acquired a non-core asset. Non-core assets can be good when they drive demand for your core business. But having them under one roof can distract from innovation and create sprawling bureaucracy. In a world of digital ecosystems, a non-core asset can be divested while remaining connected to customers through its former parent’s platform. That way, there is no interruption to the end customer.

Ideas for new, non-core assets can be funded with an EIF. The rest of this book is about becoming the house in the innovation casino with an EIF that uses cash from outside investors and returns principal and gains from ecosystem performance.

The key message here is: The business environment in the decade following COVID-19 will be saddled with debt and higher taxes. Companies will need to change course—focusing on core assets and moving non-core innovation to their digital ecosystems. In a digital ecosystem, non-core ideas can be funded with an EIF, which is new type of corporate venture capital fund.

House Strategy 2: Master the Odds to Invest in Startups

Venture capital (VC) fund returns are the closest proxy we have to calculate the odds of generating financial returns from innovation. There are three reasons why:

1. VC bets on young companies whose fortunes correlate to innovation, since they are often too young to have mature product portfolios.
2. VC funds typically bet on less than 20 companies; when one investment succeeds, the fund can post positive returns.
3. There are no other large datasets that directly measure financial returns on investments from innovation.

This book uses a dataset, compiled by PitchBook, of 827 VC funds established between 1976 and 2008, with performance data through January 2019.

Pitchbook data of Distribution of Paid in Capital (DPI) reveal the break-even point where investors in VC funds get their cash back is the 48^th percentile. At the same percentile, fund IRR equals 4.4%. This discrepancy between the break-even points of DPI and IRR suggests IRR is not accounting for costs, and the costs of running a VC fund are 4.4% per year. So, this book adjusts the power curve of VC returns down by 4.4% and calls the adjusted values “Historical VC Returns.”

Historical VC Returns form a base case for a company’s odds in the innovation casino:

• Just over 2 in 10 investments in innovation will beat the US stock market.
• Just over 1 in 2 investments in innovation will recoup principal.
• Just under 4 in 10 investments in innovation will lose more than a quarter of principal.

The key message here is: VC odds show a base case for how an EIF could perform. The VC risk/reward ratio is ideal for players in the innovation casino, but the odds are this way because VC concentrates its bets on just a handful of companies. To play like the house, an EIF must diversify.

House Strategy 3: Recoup Principal with 100X More Bets than VC

One way for an EIF to make 100X more bets than a typical VC fund is to pool with other EIFs. This book simulates 100 EIFs each making 20 investments—the number of investments typical VC funds make—and pooling 50% of each investment to gain exposure to 2,000 startups.

Pooled EIFs do not need to be as skilled at selecting investments as VC, and indeed, they are not. When separated from the pool, EIFs are 35% more likely to lose principal than Historical VC Returns. Yet, none of the same EIFs lose principal when they are pooled. This difference speaks to the power of diversification to preserve principal.

A VC fund or EIF that loses principal is likely to exit the game early. Simulated 500 times, Historical VC Returns fluctuate from -13.1% to 23.8% IRR while pooled EIFs consistently return principal between 2.3% and 13.8% IRR.

EIFs need to standardize their investment processes and criteria. This serves two purposes:

1. Recoup principal by enabling EIFs to pool investments with each other using a common framework
2. Build a thriving digital ecosystem with investments that accomplish corporate innovation objectives

The key message is: Investment processes and criteria can be used to diversify an EIF to the point where it nearly always returns principal. The same processes and criteria can help build a strong digital ecosystem.

House Strategy 4: Standardize to Deliver Gains from Overall Performance

Outside investors can capitalize your EIF, freeing up your parent company’s cash flow. Your EIF must return principal and gains. The previous chapter shows how to return principal by diversifying. This chapter is about driving gains. Outside EIF investors would receive warrants on your parent company’s stock, so they can gain when the share price goes up due to digital ecosystem success. Depending on what the stock market does, EIF investors can receive liquid gains sooner than typical VC investors.

To build a strong ecosystem, EIF processes and investment criteria must be standardized and honed. Here, companies can learn from the US government’s Small Business Innovation Research (SBIR) grant program. SBIR is perhaps the first funding program designed to achieve both innovation and ecosystem objectives. SBIR has helped generate 70,000 patents, start nearly 700 publicly traded companies, and raise around $41 billion in VC investments since its inception in 1982.

EIFs should adopt three practices from SBIR to align funding with corporate innovation and ecosystem outcomes:

1. Work with startups: SBIR discovered that startups outperform established small businesses in delivering new products and services that customers want.
2. Take an outside view: Keep your funding requirements flexible so startups can take approaches that were not considered by your internal teams.
3. Commercialize early: Require startups to maintain marketing and follow-on financing plans from the beginning when they apply for funding.

As a grant program, SBIR is missing a way to generate returns. VC fills this gap by making equity investments and raising capital from outside investors.

EIFs are a type of CVC fund best suited for “zebra” startups. The term zebra was introduced in 2017 by Zebras Unite, an organization calling for a more ethical and inclusive alternative to VC culture. Zebra startups focus on serving a niche. Many of the companies on the Inc 5000 list are zebras. Zebra startups differ from so-called “unicorn” companies, which VC culture tends to focus on: companies such as Facebook, Instagram, Twitter, Uber, and Airbnb. Unicorn companies often grow quickly and unprofitably with the hopes of raising prices down the road. Unlike their unicorn cousins, zebras are startups that aspire to grow profitably.

Your EIF can be a desirable source of funding for zebra startups with terms that let founders stay in control of their companies. VC deal terms contain investor protections that limit founders’ autonomy, which is documented in my 2019 study of popular VC term sheets. An EIF can stand out by adopting Founder Friendly Standard, a term sheet that gives entrepreneurs control of their companies. In exchange for offering founders unprecedented control, your EIF could undercut other VC firms and consistently buy low. Buying low is the number one driver of returns in venture capital. This practice could work for zebra startups because zebras only need small amounts of capital to reach profitable growth.

The key message is: An EIF can lift the stock price of your parent company by growing its digital ecosystem. Consistency is key. Transfer the approach of the SBIR grant program to consistently fund “zebra” startups that meet your innovation objectives. Use a Founder Friendly Standard term sheet to consistently buy low.

Final summary

The key messages in this summary are:

The term “innovation casino” is a metaphor for the odds of generating financial returns from innovation. Digital ecosystems give large firms the opportunity to make thousands of bets on innovation, which is playing like the house. The business environment in the decade following COVID-19 will be saddled with debt and higher taxes. Companies will need to change course—focusing on core assets and moving non-core innovation to their digital ecosystems. In a digital ecosystem, non-core ideas can be funded with an EIF, which is a type of corporate VC fund. VC odds show a base case for how an EIF could perform. The VC risk/reward ratio is ideal for players in the innovation casino, but the odds are this way because VC concentrates its bets on just a handful of companies. To play like the house, an EIF must diversify. Investment processes and criteria can diversify an EIF to the point where it nearly always returns principal. The same processes and criteria can help you build a strong digital ecosystem and thereby increase the value of your parent company’s stock. Consistency is key. Learn from the SBIR grant program to consistently fund startups that meet your innovation objectives. Learn from Founder Friendly Standard to consistently buy low, which is essential to driving returns.

Take this next step:

Categorize core and non-core assets to optimize digital ecosystem innovation

Begin the process at your company of categorizing assets as core and non-core. Non-core assets are likely preventing your organization from improving your core products by 10X. Explore with your team how non-core assets can be divested while remaining connected to customers through your core platform. Set up idea management software to capture new proposals and begin labeling them as core and non-core. Core ideas can be built by your internal teams while non-core ideas can eventually be funded by your EIF.

If you would like a copy of Innovation Casino, you can get it from Amazon here. Thank you for supporting my research about how corporate venture capital can spur digital ecosystem innovation.

Limit of Liability/Disclaimer of Warranty: The Author and the Publisher are not providing any financial, economic, legal, accounting, or tax advice or recommendations in this book. The information contained in this book was prepared for general information purposes only, does not constitute research, advice, or a recommendation from the Author and the Publisher to the reader, and is not a substitute for personalized financial advice. Neither the Author, the Publisher, nor any of their affiliates make any representation or warranty as to the accuracy or completeness of the statements contained in this book. The Author, the Publisher, and their affiliates expressly disclaim any liability (including any direct, indirect, or consequential loss or damages) for this book and its content.

The post Innovation Casino book summary appeared first on EISAIAH ENGEL.

In August, I was fortunate to be interviewed by Omar Valdez-de-Leon of Latitude 55° Consulting in Copenhagen about a better way to do corporate venture capital by aligning with corporate innovation strategy and digital ecosystem goals. Omar is a known practitioner of digital transformation, having advised companies such as Ericsson, CGI, Honeywell, Cemex, Bosch, Vodaffone, Bell Canada, and more. He is an authority on digital ecosystems, authoring papers about how to develop digital ecosystems, organizing for digital, and the Digital Maturity Model.

Earlier this year, I introduced myself to Omar and informed him that his definition of digital ecosystems serves a foundational role in my 2020 book, Innovation Casino. Omar’s paper, “How to Develop a Digital Ecosystem: a Practical Framework,” defines digital ecosystems as having three key elements: (1) a platform, (2) network effects, and (3) market expectations. To summarize Omar’s arguments, building a platform is table stakes. The hard part is jumpstarting network effects and market expectations. This is what my book solves for. Omar had great questions about the book which you can read in our interview.

Innovation Casino introduces the idea of an ecosystem innovation fund, abbreviated “EIF,” to help you meet the challenges of growing network effects and market expectations in a digital ecosystem. With an EIF, your large company invests in startups. In exchange for investment, startups build new products and services on your platform. The concept of an EIF combines best practices from corporate venture capital and the US government’s Small Business Innovation Research grant program.

An EIF is for corporate initiatives that are not part of your core business. There are valid reasons for supporting non-core ideas, especially if they drive demand for your core business. However, using internal teams is not the way to go. If a non-core idea would cost $1 million to build internally, Innovation Casino proposes funding 20 startups with $50,000 each to build the same idea. The funding would come with strings attached, namely that funded startups build on your platform. This accomplishes two goals. The first is innovation, which gives your customers new reasons to buy and refer others. The second is fueling network effects and growth expectations of your digital ecosystem.

An EIF differs from independent and corporate venture capital in that it only aspires to return principal. Gains come from the overall growth of your digital ecosystem, which eventually boosts your firm’s competitiveness and stock price. Innovation Casino is the eponymous metaphor of my book. The metaphor says large firms with digital ecosystems are better off playing like the “house,” making 2,000 small bets with an EIF. Continuing with the metaphor, independent and corporate venture capital are like “players,” often concentrating their capital into less than 20 investments in hopes of generating huge returns.

Omar asked me the following questions in our interview:

1. Tell me more about the idea of an ecosystem innovation fund.
2. Why should companies adopt this corporate innovation strategy?
3. How does an ecosystem innovation fund differ from corporate venturing?
4. How can corporates adopt the idea of an ecosystem innovation fund, and how can this improve results from corporate innovation?

Head over to the Latitude 55° Consulting blog to read the full interview: https://latitude55.consulting/how-your-digital-ecosystem-can-increase-corporate-innovation-success-by-10x 

The post Interview highlights from ‘How your digital ecosystem can increase corporate innovation success by 10X’ appeared first on EISAIAH ENGEL.

I managed a study in 2019 with attorneys who reviewed the six most popular startup financing documents—all of which were produced by investor-funded organizations. After pouring through 298 pages of legalese, the attorneys found the top six financing documents were, on average, only 38% compatible with Founder Friendly Standard. Of the six documents, Sam Altman’s personal term sheet is the most compatible with Founder Friendly Standard. See for yourself by viewing our infographic where you can drill down and compare the term sheets.

Comparison of Sam Altman’s personal term sheet with Founder Friendly Standard

Review written by Jennifer Rohleder, Principal of J. Rohleder Law, on July 25, 2019.

Below, you’ll see how Sam Altman’s Personal Term Sheet compares to Founder Friendly Standard. I wrote this review to help startup founders critically evaluate the issues in term sheet templates.

Section 1.1 of the Founder Friendly Standard says:

Individuals who work for the company and are instrumental in its inception (“Founders”) receive a class of equity such as Common Stock which provides no less than twenty-four (24) votes to one (1) vote of stock held by investors or employees.

Sam Altman’s Personal Term Sheet doesn’t meet Section 1.1 of the Founder Friendly Standard. There is no super-voting equity for Founders.

Section 1.2 of the Founder Friendly Standard says:

Investors receive a class of equity such as Class A Preferred Stock which will have one vote per share with a higher par value justified by a liquidation preference.

Sam Altman’s Personal Term Sheet does meet Section 1.2 of the Founder Friendly Standard. The term sheet provides that the Preferred Shares will receive the same number of votes as the number of Common Shares it could be converted into. The liquidation preference is limited to the original purchase prices of the shares, plus any declared and unpaid dividends.

Preferred Shares have an 8% dividend when declared, prior and in preference to any other dividends on other stock classes. Dividends are not addressed in version 1.1 of the Founder Friendly Standard.

Section 1.3 of the Founder Friendly Standard says:

Employees and contractors receive a class of equity such as Class B Common Stock which carries one vote per share and does not have a liquidation preference.

Sam Altman’s Personal Term Sheet does meet Section 1.3 of the Founder Friendly Standard. The term sheet contains no references to employees other than the 4-year vesting, 1-year cliff for employee options. One would expect employee options to purchase Common Stock which carries 1 vote per share and has no liquidation preference.

Section 1.4 of the Founder Friendly Standard says:

The first board consists only of Founders. The term of the board is one year. After the first year, a new board is elected by the equity holders at the annual meeting. Board decisions are made by a majority vote of the board. Board members cast no more than one vote each on any decision. Board committees are disallowed for at least the first two (2) years.

Sam Altman’s Personal Term Sheet doesn’t meet Section 1.4 of the Founder Friendly Standard. The term sheet is silent as to the composition of the Board of Directors. The investor is receiving a class of Preferred Shares under the term sheet. The term sheet also includes protection for the Preferred Class whereby certain company actions require the consent of a majority of the Preferred Class so long as any Preferred Shares are outstanding.

While the composition of the Board is not dictated, the Preferred Class has an overriding veto on any company action that would affect the powers of the Preferred, changes the authorized number of shares of Preferred, or authorizes any security that ranks senior to or on par with the Preferred.

Section 1.5 of the Founder Friendly Standard says:

New equity of any kind, including stock option pools, dilutes all equity holders equally. Therefore, no investor in the company has anti-dilution rights of any kind.

Sam Altman’s Personal Term Sheet does meet Section 1.5 of the Founder Friendly Standard. In his blog post describing the term sheet, Sam Altman specifically addresses what is NOT in his term sheet. The option pool for future hires is not included in the pre-money valuation. When an option pool is included in the pre-money valuation, only the Founders and not the investors are diluted. It’s an artificial manipulation of the valuation of the company. New hires benefit everyone – Founders and investors alike, and therefore should dilute everyone.

Section 2.1 of the Founder Friendly Standard says:

Founders agree in writing they will give and receive performance reviews at the end of each fiscal quarter for the first four (4) years.

Sam Altman’s Personal Term Sheet doesn’t address section 2.1 of the Founder Friendly Standard. The term sheet is silent regarding individual Founder or employee performance reviews.

Section 2.2 of the Founder Friendly Standard says:

Sweat equity vests each month over a period of four (4) years with a one (1) year vesting cliff. Vesting begins on the date shares are issued.

Sam Altman’s Personal Term Sheet does meet Section 2.2 of the Founder Friendly Standard. Both Founders and employees agree to 4-year vesting with a 1-year cliff.

Section 2.3 of the Founder Friendly Standard says:

Founders keep all information confidential and assign the company all intellectual property created within the scope of their work for the company.

Sam Altman’s Personal Term Sheet does meet Section 2.3 of the Founder Friendly Standard. All employees (current and former) and consultants, will enter into a non-disclosure and proprietary rights assignment agreement.

Section 2.4 of the Founder Friendly Standard says:

Due to potentially devastating tax consequences, the company tells individuals receiving sweat equity in the United States to consult with a tax professional about making an election under Section 83(b) of the Internal Revenue Code. Founders who live or pay taxes outside the United States are similarly advised to consult tax professionals about applicable local and national taxes.

Sam Altman’s Personal Term Sheet doesn’t address Section 2.4 of the Founder Friendly Standard. No such warning is included in the term sheet.

Section 2.5 of the Founder Friendly Standard says:

Non-compete restrictions only apply to employee or independent contractor agreements and do not survive termination. The company’s bylaws and other investor agreements are either silent on the issue of non-competition or expressly allow competition.

Sam Altman’s Personal Term Sheet does meet Section 2.5 of the Founder Friendly Standard. The term sheet is silent on the issue of non-competition, which makes it possible for founders to find work after they leave the company.

Section 3.1 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company will not agree to pay the legal expenses of any investor as a condition of investment.

Sam Altman’s Personal Term Sheet does meet Section 3.1 of the Founder Friendly Standard. In the blog post presenting his Term Sheet, Sam Altman specifically states that the company does not have to pay his legal fees. “Requiring the company to pay investors’ legal fees always struck me as particularly egregious.” In a funding round with a simple deal structure, legal fees are typically very low anyway.

Section 3.2 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any investor.

Sam Altman’s Personal Term Sheet does meet Section 3.2 of the Founder Friendly Standard. The term sheet is silent on dispute resolution, which leaves the door open for the company and its investors to go to court rather than arbitration.

Section 3.3 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any Founder.

Sam Altman’s Personal Term Sheet does meet Section 3.3 of the Founder Friendly Standard. The term sheet is silent on dispute resolution, which leaves the door open for the company and its Founders to go to court rather than arbitration.

Section 4.1 of the Founder Friendly Standard says:

Upon any transfer or sale of Founders’ super-voting equity, the portion of equity transferred converts to the class of equity described in Section 1.3. This also includes any transfer to a Founder’s estate, spouse, or heirs.

Sam Altman’s Personal Term Sheet doesn’t meet Section 4.1 of the Founder Friendly Standard. Founders do not have super-voting equity and no conversion of shares upon transfer is discussed in the term sheet.

Section 4.2 of the Founder Friendly Standard says:

The company has the right of first refusal on any transfer or sale of equity for up to forty-five (45) days, but it cannot veto a transfer or sale. This provision is void after a company’s stock is listed on a public exchange such as the NASDAQ, OTCBB, New York Stock Exchange, etc.

Sam Altman’s Personal Term Sheet does meet Section 4.2 of the Founder Friendly Standard, although perhaps not as strongly as a Founder might like. The term sheet provides for “customary first refusal and co-sale rights” for the company and the investors, as applicable. Additional limitations include the transfer of shares to competitors and transfers on secondary markets or that may trigger public reporting obligations.

Should startup founders accept ‘standard’ seed investment terms that are not founder-friendly?

Sam Altman’s Personal Term Sheet meets 10 of the issues (sections 1.2, 1.3, 1.5, 2.2, 2.3, 2.5, 3.1, 3.2, 3.3, and 4.2) addressed in the Founder Friendly Standard. The term sheet doesn’t meet three of the issues (sections 1.1, 1.4, and 4.1) and is silent on two issues (sections 2.1 and 2.4). All issues can carry long-term ramifications.

In my experience, and especially in the greater Washington D.C. metro area, companies do not start with outside investment. Rather, they start with what professor John W Mullins calls “customer-funding,” which means getting customers to pre-pay. The DC metro area has the highest concentration (1 in 326) of high-growth companies in the United States. Compare that to an investment-obsessed culture like San Francisco, where less companies, 1 in 797, become high-growth.

Another benefit of owning a customer-funded company is that you will be able to run it the way that you want without investors telling you what to do. If you still want or need investment, you should consider waiting until you can get terms in line with Founder Friendly Standard, which are meant to help keep you in charge of your company.

If your startup has received a term sheet from an investor and you would like to talk through the issues, visit my website to book a consultation.

INFOGRAPHIC: How does Founder Friendly Standard compare to term sheet templates from 500 Startups, Y Combinator, NVCA, Gust, and Sam Altman?

Limit of Liability/Disclaimer of Warranty: Jennifer Rohleder (“Author”) is not providing any financial, economic, legal, accounting, or tax advice or recommendations on this site. Although Author is an attorney licensed in the District of Columbia and Virginia, the information contained on this site was prepared for general information purposes only, does not constitute research, advice, or a recommendation from Author to the reader and is not a substitute for personalized financial or legal advice. Neither Author nor any of her affiliates make any representation or warranty as to the accuracy or completeness of the statements contained on this site. Author and her affiliates expressly disclaim any liability (including any direct, indirect, or consequential loss or damages) for all posts and their content.

The post Review of Sam Altman’s Personal Term Sheet appeared first on EISAIAH ENGEL.

I orchestrated a study in 2019 with attorneys who reviewed the six most popular startup financing documents—all of which were produced by investor-funded organizations. After pouring through 298 pages of legalese, the attorneys found the top six financing documents were, on average, only 38% compatible with Founder Friendly Standard. Y Combinator Safes are silent on a number of important issues. See for yourself by viewing our infographic where you can drill down and compare the term sheets.

Many founders don’t realize how much of a company they’re giving away with YC Safes

Review written by Ryan Juliano, Vice President, Head of Platform, and Attorney at Howell Legal on June 6, 2019.

The below review of the Y Combinator (YC) Safes compares them to the Founder Friendly Standard. Y Combinator publishes four variants of post-money Safes:

1. Valuation Cap, no Discount
2. Discount, no Valuation Cap
3. Valuation Cap and Discount
4. MFN, no Valuation Cap, no Discount

When I refer to YC Safes, I’m talking about all four variants. The only difference between the Safes in this comparison occurs in Section 1.5 below on the topic of anti-dilution.

Section 1.1 of the Founder Friendly Standard says:

Individuals who work for the company and are instrumental in its inception (“Founders”) receive a class of equity such as Common Stock which provides no less than twenty-four (24) votes to one (1) vote of stock held by investors or employees.

Y Combinator Safes do not address the voting rights of the founders, investors, or employees. Typically, experienced investors will expect that Safes will convert into a class of preferred stock with terms consistent with the National Venture Capital Association’s (“NVCA”) standard documents. For the remainder of my answer, I’ll be referring to the NVCA documents. Those documents do not provide for the super-voting founder equity described in Section 1.1.

Section 1.2 of the Founder Friendly Standard says:

Investors receive a class of equity such as Class A Preferred Stock which will have one vote per share with a higher par value justified by a liquidation preference.

Each YC Safe is a convertible security that will convert into preferred stock at the company’s next equity financing. Preferred stock that is consistent with the NVCA documents has one vote for each share of common stock into which the preferred stock is convertible. Initially, the preferred stock is typically convertible into common stock on a 1:1 basis, subject to adjustment for dilutive issuances. Although preferred stock in the NVCA model has a liquidation preference, it does not have a higher par value.

Section 1.3 of the Founder Friendly Standard says:

Employees and contractors receive a class of equity such as Class B Common Stock which carries one vote per share and does not have a liquidation preference.

Y Combinator Safes do not address employee or contractor equity.

Section 1.4 of the Founder Friendly Standard says:

The first board consists only of Founders. The term of the board is one year. After the first year, a new board is elected by the equity holders at the annual meeting. Board decisions are made by a majority vote of the board. Board members cast no more than one vote each on any decision. Board committees are disallowed for at least the first two (2) years.

Y Combinator Safes do not address board composition. Under the NVCA documents, holders of preferred stock typically have the right to appoint a board observer or director.

Section 1.5 of the Founder Friendly Standard says:

New equity of any kind, including stock option pools, dilutes all equity holders equally. Therefore, no investor in the company has anti-dilution rights of any kind.

With discount-only or MFN Safes, the amount of equity into which Safes are convertible is entirely dependent on the pricing of the next equity financing, so there is no dilution to measure until after the conversion.

YC Safes with valuation caps effectively give the holders full-ratchet anti-dilution rights. They are guaranteed a minimum percentage of the company (on a post-money basis). If the valuation of the next equity financing is below the cap, the Safe holders receive a higher percentage of the company, diluting all other stockholders.

Most commonly, the NVCA documents give preferred stockholders weight-average anti-dilution protection, which means that stockholders other than the preferred stockholders take most of the dilution.

Section 2.1 of the Founder Friendly Standard says:

Founders agree in writing they will give and receive performance reviews at the end of each fiscal quarter for the first four (4) years.

YC Safes do not address performance reviews.

Section 2.2 of the Founder Friendly Standard says:

Sweat equity vests each month over a period of four (4) years with a one (1) year vesting cliff. Vesting begins on the date shares are issued.

Y Combinator Safes do not address vesting terms for “sweat equity.” However, the NVCA documents often require uniform vesting terms, and 4-year vesting with a 1-year cliff is the most commonly prescribed schedule.

Section 2.3 of the Founder Friendly Standard says:

Founders keep all information confidential and assign the company all intellectual property created within the scope of their work for the company.

YC Safes do not address founder confidentiality and IP assignment.

Section 2.4 of the Founder Friendly Standard says:

Due to potentially devastating tax consequences, the company tells individuals receiving sweat equity in the United States to consult with a tax professional about making an election under Section 83(b) of the Internal Revenue Code. Founders who live or pay taxes outside the United States are similarly advised to consult tax professionals about applicable local and national taxes.

YC Safes do not address 83b elections or other founder tax consequences.

Section 2.5 of the Founder Friendly Standard says:

Non-compete restrictions only apply to employee or independent contractor agreements and do not survive termination. The company’s bylaws and other investor agreements are either silent on the issue of non-competition or expressly allow competition.

Y Combinator Safes meet section 2.5 of Founder Friendly Standard because they are silent on the issue of non-competition.

Section 3.1 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company will not agree to pay the legal expenses of any investor as a condition of investment.

Y Combinator Safes are silent on the payment of legal expenses.

Section 3.2 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any investor.

Y Combinator Safes do not include an arbitration clause.

Section 3.3 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any Founder.

YC Safes do not include an arbitration clause.

Section 4.1 of the Founder Friendly Standard says:

Upon any transfer or sale of Founders’ super-voting equity, the portion of equity transferred converts to the class of equity described in Section 1.3. This also includes any transfer to a Founder’s estate, spouse, or heirs.

YC Safes do not deal with the transfer or sale of founder equity.

Section 4.2 of the Founder Friendly Standard says:

The company has the right of first refusal on any transfer or sale of equity for up to forty-five (45) days, but it cannot veto a transfer or sale. This provision is void after a company’s stock is listed on a public exchange such as the NASDAQ, OTCBB, New York Stock Exchange, etc.

YC Safes are not transferable, other than to affiliates of the holder. The NVCA documents do not subject investor stock to a right of first refusal.

Should startups insist on Founder Friendly Standard terms when negotiating with angels or venture capitalists?

While the Founder Friendly Standard sections are indeed “founder-friendly,” many of them are significantly different from market terms for venture capital deals. I think including them in a company’s organizational documents will add a fair amount of complexity beyond what’s in the standard set of tech startup forms.

While I could tell a client that the Founder Friendly Standard terms were—in and of themselves—more founder-friendly than what’s typical, I’d also have to advise them that many of the terms would be rejected by investors, and the documents would likely need to be revised before a financing, unless the company has significant leverage. Without significant negotiating leverage, insisting on terms consistent with the Founder Friendly Standard could likely cost a founder the deal.

INFOGRAPHIC: How does Founder Friendly Standard compare to term sheet templates from 500 Startups, Y Combinator, NVCA, Gust, and Sam Altman?

Limit of Liability/Disclaimer of Warranty: Ryan Juliano (“Author”) is not providing any financial, economic, legal, accounting, or tax advice or recommendations on this site. Although Author is an attorney licensed in Rhode Island, California, and New York, the information contained on this site was prepared for general information purposes only, does not constitute research, advice, or a recommendation from Author to the reader and is not a substitute for personalized financial or legal advice. Neither Author nor any of his affiliates make any representation or warranty as to the accuracy or completeness of the statements contained on this site. Author and his affiliates expressly disclaim any liability (including any direct, indirect, or consequential loss or damages) for all posts and their content.

The post Review of Y Combinator Safes appeared first on EISAIAH ENGEL.

I organized a study in 2019 with attorneys who reviewed the six most popular startup financing documents—all of which were produced by investor-funded organizations. After pouring through 298 pages of legalese, the attorneys found the top six financing documents were, on average, only 38% compatible with Founder Friendly Standard. 500 Startups KISS Notes are silent on a number of important issues. See for yourself by viewing our infographic where you can drill down and compare the term sheets.

500 Startups KISS Notes are silent on important legal issues for startups

Review written by Zev Safran of Safran Law on June 25, 2019.

500 Startups KISS Notes are investment templates meant to enable early stage startups to raise money without a lengthy negotiation of legal terms. I reviewed both variants of 500 Startups KISS Notes to write this comparison to Founder Friendly Standard.

• KISS: Debt Version (which includes an interest rate and a maturity feature)
• KISS: Equity Version (without interest or maturity)

When I refer to 500 Startups KISS Notes, I’m talking about both variants.

Section 1.1 of the Founder Friendly Standard says:

Individuals who work for the company and are instrumental in its inception (“Founders”) receive a class of equity such as Common Stock which provides no less than twenty-four (24) votes to one (1) vote of stock held by investors or employees.

500 Startups KISS Notes do not address founder equity.

Section 1.2 of the Founder Friendly Standard says:

Investors receive a class of equity such as Class A Preferred Stock which will have one vote per share with a higher par value justified by a liquidation preference.

500 Startups KISS Notes do not address voting rights.

Section 1.3 of the Founder Friendly Standard says:

Employees and contractors receive a class of equity such as Class B Common Stock which carries one vote per share and does not have a liquidation preference.

500 Startups KISS Notes do not address “sweat” equity issued to employees and contractors.

Section 1.4 of the Founder Friendly Standard says:

The first board consists only of Founders. The term of the board is one year. After the first year, a new board is elected by the equity holders at the annual meeting. Board decisions are made by a majority vote of the board. Board members cast no more than one vote each on any decision. Board committees are disallowed for at least the first two (2) years.

500 Startups KISS Notes do not address board composition or representation.

Section 1.5 of the Founder Friendly Standard says:

New equity of any kind, including stock option pools, dilutes all equity holders equally. Therefore, no investor in the company has anti-dilution rights of any kind.

500 Startups KISS Notes do not meet section 1.5 of the Founder Friendly Standard. Some KISS terms, including the Valuation Cap, grant investors certain anti-dilution rights.

Section 2.1 of the Founder Friendly Standard says:

Founders agree in writing they will give and receive performance reviews at the end of each fiscal quarter for the first four (4) years.

500 Startups KISS Notes do not address performance reviews.

Section 2.2 of the Founder Friendly Standard says:

Sweat equity vests each month over a period of four (4) years with a one (1) year vesting cliff. Vesting begins on the date shares are issued.

500 Startups KISS Notes do not address vesting of sweat equity.

Section 2.3 of the Founder Friendly Standard says:

Founders keep all information confidential and assign the company all intellectual property created within the scope of their work for the company.

500 Startups KISS Notes do not address founder confidentiality.

Section 2.4 of the Founder Friendly Standard says:

Due to potentially devastating tax consequences, the company tells individuals receiving sweat equity in the United States to consult with a tax professional about making an election under Section 83(b) of the Internal Revenue Code. Founders who live or pay taxes outside the United States are similarly advised to consult tax professionals about applicable local and national taxes.

500 Startups KISS Notes do not address sweat equity or IRC Section 83(b) elections.

Section 2.5 of the Founder Friendly Standard says:

Non-compete restrictions only apply to employee or independent contractor agreements and do not survive termination. The company’s bylaws and other investor agreements are either silent on the issue of non-competition or expressly allow competition.

500 Startups KISS Notes do meet section 2.5 of the Founder Friendly Standard because KISS Notes do not include any non-compete provisions. Remember to compare section 2.5 to future agreements including bylaws and shareholder rights.

Section 3.1 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company will not agree to pay the legal expenses of any investor as a condition of investment.

500 Startups KISS Notes do meet section 3.1 of the Founder Friendly Standard. KISS Notes do not require the company to pay legal fees except where the company does not comply with the KISS agreement.

Section 3.2 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any investor.

500 Startups KISS Notes do meet section 3.2 of the Founder Friendly Standard. KISS Notes do not include an arbitration requirement or provision for investor disputes.

Section 3.3 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any Founder.

500 Startups KISS Notes do meet section 3.3 of the Founder Friendly Standard. Because KISS Notes do not address founder disputes, they do not require founders to submit to binding arbitration. Remember to compare section 3.3 to future agreements including labor, bylaws, and shareholder rights.

Section 4.1 of the Founder Friendly Standard says:

Upon any transfer or sale of Founders’ super-voting equity, the portion of equity transferred converts to the class of equity described in Section 1.3. This also includes any transfer to a Founder’s estate, spouse, or heirs.

500 Startups KISS Notes do not address founder equity.

Section 4.2 of the Founder Friendly Standard says:

The company has the right of first refusal on any transfer or sale of equity for up to forty-five (45) days, but it cannot veto a transfer or sale. This provision is void after a company’s stock is listed on a public exchange such as the NASDAQ, OTCBB, New York Stock Exchange, etc.

500 Startups KISS Notes do not meet section 4.2 of the Founder Friendly Standard. KISS Notes generally permit transfer of the securities upon notice to the company.

How do 500 Startups KISS Notes compare to Founder Friendly Standard?

500 Startups KISS Notes meet only 4 of the 17 sections of the Founder Friendly Standard (sections 2.5, 3.1, 3.2, 3.3). KISS Notes take the opposite position on 3 of the 17 sections of the Founder Friendly Standard (sections 1.5, 4.2, 5.1).

500 Startups KISS Notes enable investors to convert their investment to equity at a later time but are not direct equity investments. KISS Notes are silent on 10 of the 17 sections reflected in the Founder Friendly Standard (sections 1.1, 1.2, 1.3, 1.4, 2.1, 2.2, 2.3, 2.4, 4.1, 5.2). These sections are left to be determined at the time of conversion to equity or by other corporate documents.

The web is full of opinions about whether Y Combinator’s Safe is more founder-friendly than the 500 Startups KISS. But read Ryan Juliano’s comparison of the Founder Friendly Standard to the Safe, and you’ll see the Safe and the KISS Notes are similar. They kick many issues down the road. How does kicking issues down the road work out for startup founders in your experience?

INFOGRAPHIC: How does Founder Friendly Standard compare to term sheet templates from 500 Startups, Y Combinator, NVCA, Gust, and Sam Altman?

Whether the KISS Notes comply with certain Founder Friendly Standard terms or whether certain terms are applicable to KISS Notes may be a matter of judgment. This answer is not legal advice. Please consult with an attorney to evaluate the specifics of your situation.

The post Review of 500 Startups KISS Notes appeared first on EISAIAH ENGEL.

I conducted a study in 2019 with attorneys who reviewed the six most popular startup financing documents—all of which were produced by investor-funded organizations. After pouring through 298 pages of legalese, the attorneys found the top six financing documents were, on average, only 38% compatible with Founder Friendly Standard. The Y Combinator (“YC”) Series A Term Sheet Template was not the most founder-friendly nor was it the least. See for yourself by viewing our infographic where you can drill down and compare the term sheets.

Founders who want to be their own bosses shouldn’t use the YC Series A Term Sheet Template

Review written by K. Adam Bloom, Startup and Entertainment Attorney, on September 7, 2019.

To write this comparison, I used the Founder Friendly Standard to grade the Y Combinator Series A Term Sheet Template.

Section 1.1 of the Founder Friendly Standard says:

Individuals who work for the company and are instrumental in its inception (“Founders”) receive a class of equity such as Common Stock which provides no less than twenty-four (24) votes to one (1) vote of stock held by investors or employees.

Y Combinator Series A Term Sheet is incompatible with Section 1.1 of the Founder Friendly Standard. There is no super-voting equity for founders.

Section 1.2 of the Founder Friendly Standard says:

Investors receive a class of equity such as Class A Preferred Stock which will have one vote per share with a higher par value justified by a liquidation preference.

YC Series A Term Sheet is incompatible with Section 1.2 of the Founder Friendly Standard. While the term sheet provides a liquidation preference of 1x the original issue, it lets the Lead Investor appoint one member (“Preferred Director”) of a three-person board. Investor shares also have special veto powers when adjusting Preferred Stock to let new investors in, selling the company, or changing the number of directors on the board. This is akin to giving investors super-voting equity, not one vote per share.

Section 1.3 of the Founder Friendly Standard says:

Employees and contractors receive a class of equity such as Class B Common Stock which carries one vote per share and does not have a liquidation preference.

Y Combinator Series A Term Sheet is compatible with Section 1.3 of the Founder Friendly Standard. Although the term sheet doesn’t provide for a third class of stock for employees, one would expect employee equity to receive 1 vote per share with no liquidation preference as this is not special treatment.

Section 1.4 of the Founder Friendly Standard says:

The first board consists only of Founders. The term of the board is one year. After the first year, a new board is elected by the equity holders at the annual meeting. Board decisions are made by a majority vote of the board. Board members cast no more than one vote each on any decision. Board committees are disallowed for at least the first two (2) years.

Y Combinator Series A Term Sheet is incompatible with Section 1.4 of the Founder Friendly Standard. The term sheet provides that two directors are elected by the holders of a majority of Common Stock, and one Preferred Director is appointed by the lead investor. While it looks like the founders would control two-thirds of the board, further provisions require the Preferred Director and the majority of the holders of Preferred Stock to approve actions like adjusting Preferred Stock to let new investors in, selling the company, or changing the number of directors on the board. These veto powers can put the investors, rather than founders, in control of the company. Founders, isn’t the point of starting your own company to be your own boss?

Section 1.5 of the Founder Friendly Standard says:

New equity of any kind, including stock option pools, dilutes all equity holders equally. Therefore, no investor in the company has anti-dilution rights of any kind.

YC Series A Term Sheet is incompatible with Section 1.5 of the Founder Friendly Standard. The conversion of Preferred into Common shares is subject to the “Broad-based Weighted Average anti-dilution protection.” This means that if the company raises money in the future at a lower valuation than the valuation used in the current round, the current investors will be partially protected. Down-side protection seems unnecessary in such an early round of funding. Early-stage companies are risky by definition. Do you think investors and founders should share that risk equally?

On a positive note, the Y Combinator Series A Term sheet calculates the option pool on a post-money basis. That helps reduce the trickery that my colleague, Jennifer Persico Rohleder, points out in Section 1.5 of her analysis of the Gust Series Seed term sheet.

Section 2.1 of the Founder Friendly Standard says:

Founders agree in writing they will give and receive performance reviews at the end of each fiscal quarter for the first four (4) years.

YC Series A Term Sheet does not address section 2.1 of the Founder Friendly Standard. The term sheet is silent on this issue.

Section 2.2 of the Founder Friendly Standard says:

Sweat equity vests each month over a period of four (4) years with a one (1) year vesting cliff. Vesting begins on the date shares are issued.

Y Combinator Series A Term Sheet does not address Section 2.2 of the Founder Friendly Standard. This is a big issue to be silent on. What if a co-founder holding 25% of the equity leaves after a few months? Watch out for how vesting gets addressed in any follow-on documents that may be needed to finalize the investment.

Section 2.3 of the Founder Friendly Standard says:

Founders keep all information confidential and assign the company all intellectual property created within the scope of their work for the company.

YC Series A Term Sheet does not address Section 2.3 of the Founder Friendly Standard. Watch out for how confidentiality and intellectual property get addressed in any follow-on documents that may be needed to finalize the investment.

Section 2.4 of the Founder Friendly Standard says:

Due to potentially devastating tax consequences, the company tells individuals receiving sweat equity in the United States to consult with a tax professional about making an election under Section 83(b) of the Internal Revenue Code. Founders who live or pay taxes outside the United States are similarly advised to consult tax professionals about applicable local and national taxes.

Y Combinator Series A Term Sheet does not address Section 2.4 of the Founder Friendly Standard. The term sheet is silent on this issue. Make sure you talk to a licensed tax professional in your state/province/country as soon as possible.

Section 2.5 of the Founder Friendly Standard says:

Non-compete restrictions only apply to employee or independent contractor agreements and do not survive termination. The company’s bylaws and other investor agreements are either silent on the issue of non-competition or expressly allow competition.

Y Combinator Series A Term Sheet is compatible with Section 2.4 of the Founder Friendly Standard. The term sheet is silent on the issue of non-competition, which makes it possible for founders to find work after they leave the company. Watch out for non-compete restrictions in any follow-on documents that may be needed to finalize the investment. Agreeing to a non-compete can have devastating consequences if you are underpaid and ultimately leave the company without selling your equity at a high price.

Section 3.1 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company will not agree to pay the legal expenses of any investor as a condition of investment.

YC Series A Term Sheet is incompatible with Section 3.1 of the Founder Friendly Standard. The term sheet says the Company is responsible for paying the Lead Investor’s legal fees up to $30,000. How could this be used to extract concessions from founders in any follow-on documents to finalize the investment?

Section 3.2 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any investor.

Y Combinator Series A Term Sheet is compatible with Section 3.2 of the Founder Friendly Standard. The term sheet is silent on dispute resolution, which opens the door for founders and investors to go to court rather than arbitration. Watch out for arbitration clauses in any follow-on documents that may be needed to finalize the investment.

Section 3.3 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any Founder.

YC Series A Term Sheet is compatible with Section 3.3 of the Founder Friendly Standard. The term sheet is silent on dispute resolution, which opens the door for founders and investors to go to court rather than arbitration. Watch out for arbitration clauses in any follow-on documents that may be needed to finalize the investment.

Section 4.1 of the Founder Friendly Standard says:

Upon any transfer or sale of Founders’ super-voting equity, the portion of equity transferred converts to the class of equity described in Section 1.3. This also includes any transfer to a Founder’s estate, spouse, or heirs.

Y Combinator Series A Term Sheet is incompatible with Section 4.1 of the Founder Friendly Standard. Founders do not have super-voting equity in the term sheet.

Section 4.2 of the Founder Friendly Standard says:

The company has the right of first refusal on any transfer or sale of equity for up to forty-five (45) days, but it cannot veto a transfer or sale. This provision is void after a company’s stock is listed on a public exchange such as the NASDAQ, OTCBB, New York Stock Exchange, etc.

YC Series A Term Sheet is compatible with Section 4.2 of the Founder Friendly Standard—although not as much as founders might like. The term sheet doesn’t provide an outright veto right, but it does have stipulations. Investors get the right of first refusal to buy a founder’s stock. And if a founder finds a buyer for her stock, investors would have the right to sell to her buyer first.

Should you accept investment terms that are not founder-friendly?

YC Series A Term Sheet is compatible with five issues (sections 1.3, 2.5, 3.2, 3.3, and 4.2) in Founder Friendly Standard. The term sheet is incompatible with six issues (sections 1.1, 1.2, 1.4, 1.5, 3.1, and 4.1). It is silent on four issues (sections 2.1, 2.2, 2.3, and 2.4).

Y Combinator Series A Term Sheet states that all terms are non-binding except the 30 day “No Shop” provision. The implication is more legal documents are needed to complete the transaction. Combined with my finding in Section 3.1 above that the startup pays up to $30K of legal fees, the “No Shop” provision could set entrepreneurs up to make big concessions before the deal is done.

The problem, once you sign a term sheet, is your leverage and flexibility dramatically go down. It becomes far easier for investors to pressure you with this or that language (which they will usually claim is also “standard”) than it would’ve been during the term sheet phase. So, rushing to sign a short term sheet favors investors over startups.

José Ancer in “The Problem with ‘Standard’ Term Sheets”

Experienced investors will expect the final legal documents to be consistent with the National Venture Capital Association (“NVCA”) Model Legal Documents. To see how the 100+ pages of NVCA Model Legal Docs compare to the Founder Friendly Standard, read Keith Strahan and Josh Mathews’ analysis. (Spoiler: The docs are not founder-friendly.) You don’t want to forfeit your negotiating leverage until your deal is signed.

If you need to build more leverage to get the investment terms you want, consider walking away from prospective investors and bootstrapping. Read The Customer-Funded Business by John W Mullins for ideas on how you can adjust your business model to be cash-flow positive with customer funds—even as you’re investing in growth. Bootstrapping is short-term pain for long-term career fulfillment. You’re more likely to end up your own boss if you bootstrap.

INFOGRAPHIC: How does Founder Friendly Standard compare to term sheet templates from 500 Startups, Y Combinator, NVCA, Gust, and Sam Altman?

Limit of Liability/Disclaimer of Warranty: K. Adam Bloom (“Author”) is not providing any financial, economic, legal, accounting, or tax advice or recommendations on this site. Although Author is an attorney licensed in California and New York, the information contained on this site was prepared for general information purposes only, does not constitute research, advice, or a recommendation from Author to the reader and is not a substitute for personalized financial or legal advice. Neither Author nor any of his affiliates make any representation or warranty as to the accuracy or completeness of the statements contained on this site. Author and his affiliates expressly disclaim any liability (including any direct, indirect, or consequential loss or damages) for all posts and their content.

The post Review of Y Combinator Series A Term Sheet Template appeared first on EISAIAH ENGEL.

I led a study in 2019 where attorneys reviewed the six most popular startup financing documents—all of which were produced by investor-funded organizations. After pouring through 298 pages of legalese, the attorneys found the top six financing documents were, on average, only 38% compatible with Founder Friendly Standard. The NVCA Model Legal Documents were the least compatible with the Founder Friendly Standard. See for yourself by viewing our infographic where you can drill down and compare the term sheets.

Many default sections in the NVCA Model Legal Documents are not founder-friendly

Review written by Keith Strahan, Managing Partner at Fulton Strahan Law Group, on Oct 14, 2019.

NVCA Model Legal Documents can be very time-consuming and expensive to negotiate and document. They include 18 agreements. To write this answer, my associate, Josh Mathews, and I reviewed the following six documents:

1. NVCA Voting Agreement
2. NVCA Term Sheet
3. NVCA Stock Purchase Agreement
4. NVCA Right of First Refusal and Co-Sale Agreement
5. NVCA Investor Rights Agreement
6. NVCA Certificate of Incorporation

To write this review, we started with each issue in the Founder Friendly Standard and compared it to the NVCA Model Legal Docs.

Section 1.1 of the Founder Friendly Standard says:

Individuals who work for the company and are instrumental in its inception (“Founders”) receive a class of equity such as Common Stock which provides no less than twenty-four (24) votes to one (1) vote of stock held by investors or employees.

NVCA Model Legal Documents do not meet Section 1.1 of the Founder Friendly Standard. Article FOURTH (A)(2) of NVCA Certificate of Incorporation says that Common Stock holders are entitled to one vote for each share of common stock at meetings of stockholders. Common Stock holders can’t vote on issues solely affecting/reserved to Preferred Shareholders. These can potentially include issues such as voting on a director, allowing for conversion of shares, and receiving preferred dividend payments, among others.

Section 1.2 of the Founder Friendly Standard says:

Investors receive a class of equity such as Class A Preferred Stock which will have one vote per share with a higher par value justified by a liquidation preference.

NVCA Model Legal Documents do not meet Section 1.2 of the Founder Friendly Standard. The NVCA Certificate of Incorporation Article FOURTH (B)(2) provides that Preferred Shareholders have a liquidation preference, Article FOURTH (B)(3) of the same document provides that voting is done as a single class. Why this does not meet Section 1.2 of the Founder Friendly Standard is NVCA Model Legal Docs provide the option for investors to elect two members of a five-person board. This would give investors a type of super-voting equity, not one vote per share.

Section 1.3 of the Founder Friendly Standard says:

Employees and contractors receive a class of equity such as Class B Common Stock which carries one vote per share and does not have a liquidation preference.

NVCA Model Legal Docs do meet Section 1.3 of the Founder Friendly Standard. In the NVCA Stock Purchase Agreement, Section 2.2 (b) provides for a stock option plan, under which “officers, directors, employees and consultants” may be issued shares of Common Stock. There is no separate ‘Class B’ for employees/contractors, but according to Section FOURTH, (A)(1) of the NVCA Certificate of Incorporation, common stock does carry one vote per share, and liquidation rights are subject to qualified rights of Preferred Shareholders.

Section 1.4 of the Founder Friendly Standard says:

The first board consists only of Founders. The term of the board is one year. After the first year, a new board is elected by the equity holders at the annual meeting. Board decisions are made by a majority vote of the board. Board members cast no more than one vote each on any decision. Board committees are disallowed for at least the first two (2) years.

NVCA Model Legal Documents do not meet Section 1.4 of the Founder Friendly Standard. Section 1.2 of the NVCA Voting Agreement provides the option to select the number of directors that the Board will consist of. Though optional, the NVCA Model Legal Docs suggest that the Board initially consists of five directors, two of which are designated by investors.

Section 1.5 of the Founder Friendly Standard says:

New equity of any kind, including stock option pools, dilutes all equity holders equally. Therefore, no investor in the company has anti-dilution rights of any kind.

NVCA Model Legal Docs do not meet Section 1.5 of the Founder Friendly Standard. Subsection 4.4.4 of the NVCA Certificate of Incorporation provides for anti-dilution rights. There are two options provided, including a broad and narrow option, i.e. a “broad-based weighted average” anti-dilution provision and a “full ratchet” anti-dilution option.

Section 2.1 of the Founder Friendly Standard says:

Founders agree in writing they will give and receive performance reviews at the end of each fiscal quarter for the first four (4) years.

NVCA Model Legal Docs do not address section 2.1 of the Founder Friendly Standard.

Section 2.2 of the Founder Friendly Standard says:

Sweat equity vests each month over a period of four (4) years with a one (1) year vesting cliff. Vesting begins on the date shares are issued.

NVCA Model Legal Documents do meet Section 2.2 of the Founder Friendly Standard. Section 5.3 of the NVCA Investor Rights Agreement suggests a 4-year vesting term with 1-year vesting cliff. This is required not only for sweat equity but for “all future employees and consultants.”

Section 2.3 of the Founder Friendly Standard says:

Founders keep all information confidential and assign the company all intellectual property created within the scope of their work for the company.

NVCA Model Legal Documents do meet Section 2.3 of the Founder Friendly Standard. Section 2.19 of the NVCA Stock Purchase Agreement says current and former employees, consultants, and officers of the Company represent they’ve executed confidentiality agreements. Furthermore, Section 2.8 of the NVCA Stock Purchase Agreement provides that the Company represents that all “employees and consultants have assigned all intellectual property rights.” Key Employees also must not have excluded works or inventions from their assignment of inventions. However, the term “Founder” is not used in the NVCA Model Legal Docs, so it may be important to note that there is the possibility for a founder to fall through the cracks of this Standard if they do not fit into one of the above-stated categories, such as an “employee, consultant, or officer.”

Section 2.4 of the Founder Friendly Standard says:

Due to potentially devastating tax consequences, the company tells individuals receiving sweat equity in the United States to consult with a tax professional about making an election under Section 83(b) of the Internal Revenue Code. Founders who live or pay taxes outside the United States are similarly advised to consult tax professionals about applicable local and national taxes.

NVCA Model Legal Docs do meet Section 2.4 of the Founder Friendly Standard. Section 2.22 of the NVCA Stock Purchase Agreement provides a representation by the company that all elections and notices for 83(b) have been or will be filed. However, there is no recommendation for individuals to consult any tax professional regarding 83(b) elections.

Section 2.5 of the Founder Friendly Standard says:

Non-compete restrictions only apply to employee or independent contractor agreements and do not survive termination. The company’s bylaws and other investor agreements are either silent on the issue of non-competition or expressly allow competition.

NVCA Model Legal Documents do meet Section 2.5 of the Founder Friendly Standard. Under Section 2.19 of the NVCA Stock Purchase Agreement, all key employees must sign a non-solicitation (and non-compete is bracketed as optional); this meets Founder Friendly Standard. It is worth noting that Section 2.11(b) of the NVCA Stock Purchase Agreement requires that the Company must represent that “no officers, directors, or employees, or respective spouses, children, or affiliates” are engaged in relationships with the Company’s competitors up to the time of closing the investment transaction; it is not express language that prevents competition moving forward.

Section 3.1 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company will not agree to pay the legal expenses of any investor as a condition of investment.

NVCA Model Legal Documents do not meet Section 3.1 of the Founder Friendly Standard. Section 6.8 of the NVCA Stock Purchase Agreement provides that the Company pays the reasonable fees and expenses of counsel for the lead purchaser, up to a capped amount. Under Section 5.8 of the NVCA Investor Rights Agreement, in the event of a sale of the Company, the expenses for investor counsel is to be borne by the Company.

Section 3.2 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any investor.

NVCA Model Legal Docs do not meet Section 3.2 of the Founder Friendly Standard. Section 6.16 of the NVCA Stock Purchase Agreement provides for:

• The option of courts in a particular jurisdiction,
• Or two options for arbitration, using AAA or DRAA rules, both of which include binding provisions with no two-year prohibition.
• Under the DRAA alternative, there is the option to remove the waiver of the right to appeal.
• There is no distinction made between investors or founders.

Section 3.3 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any Founder.

NVCA Model Legal Documents do not meet Section 3.3 of the Founder Friendly Standard. Section 6.16 of the NVCA Stock Purchase Agreement, Section 6.4 of the NVCA Right of First Refusal and Co-Sale Agreement, Section 6.11 of the NVCA Investor Rights Agreement, and Section 7.16 of the NVCA Voting Agreement, all provide for:

• The option of courts in a particular jurisdiction,
• Or two options for arbitration, using AAA or DRAA rules, both of which include binding provisions with no two-year prohibition.
• Under the DRAA alternative, there is the option to remove the waiver of the right to appeal.
• There is no distinction made between investors or founders.

Section 4.1 of the Founder Friendly Standard says:

Upon any transfer or sale of Founders’ super-voting equity, the portion of equity transferred converts to the class of equity described in Section 1.3. This also includes any transfer to a Founder’s estate, spouse, or heirs.

NVCA Model Legal Documents do not meet Section 4.1 of the Founder Friendly Standard. There is no super-voting equity provided for in the NVCA Model Legal Docs; and as such, there is no conversion mechanism, as provided for and in accordance with the Founder Friendly Standard.

Section 4.2 of the Founder Friendly Standard says:

The company has the right of first refusal on any transfer or sale of equity for up to forty-five (45) days, but it cannot veto a transfer or sale. This provision is void after a company’s stock is listed on a public exchange such as the NASDAQ, OTCBB, New York Stock Exchange, etc.

NVCA Model Legal Documents do not meet Section 4.2 of the Founder Friendly Standard. While Section 2.1(b) of the NVCA Right of First Refusal and Co-Sale Agreement does provide the Company with the first right of refusal for up to 45 days, Section 3.3 of the same agreement says equity cannot be transferred to (a) an entity which directly or indirectly competes with the Company, in the Board’s discretion; or (b) any customer, distributor, or supplier of the company if the Board determines it would put the Company at a competitive disadvantage. Section 3.2 of the same agreement provides that this right of first refusal shall not apply to the sale of stock to the public in an IPO.

Should you sign a term sheet that isn’t founder-friendly?

NVCA Model Legal Documents meet five of the issues addressed by Founder Friendly Standard (sections 1.3, 2.2, 2.3, 2.4, and 2.5). NVCA Model Legal Docs conflict with nine of the issues (sections 1.1, 1.2, 1.4, 1.5, 3.1, 3.2, 3.3, 4.1, and 4.2) and are silent on one issue (section 2.1). Nearly all the issues carry long-term ramifications.

Agreeing to an investor-friendly deal can ultimately result in you getting fired from your own company. Investors fire startup founders more often than you think. It happened to Steve Jobs at Apple, Sean Parker at Plaxo, and the authors of Founder Friendly Standard.

Whatever agreement you sign today will be following you into the future. If you’ve built a customer-funded business, you can delay investment until you can get terms that you’re comfortable living with.

If your Texas-based startup has received legal documents from an investor and you’d like to talk through the issues, visit our law firm’s website at https://www.fultonstrahan.com

INFOGRAPHIC: How does Founder Friendly Standard compare to term sheet templates from 500 Startups, Y Combinator, NVCA, Gust, and Sam Altman?

* Limit of Liability/Disclaimer of Warranty: Keith Strahan and Josh Mathews (“Authors”) are not providing any financial, economic, legal, accounting, or tax advice or recommendations on this site. Although Authors are attorneys licensed in Texas, the information contained on this site was prepared for general information purposes only, does not constitute research, advice, or a recommendation from Authors to the reader and is not a substitute for personalized financial or legal advice. Neither Authors nor any of their affiliates make any representation or warranty as to the accuracy or completeness of the statements contained on this site. Authors and their affiliates expressly disclaim any liability (including any direct, indirect, or consequential loss or damages) for all posts and their content.

The post Review of NVCA Model Legal Documents appeared first on EISAIAH ENGEL.

I led a study in 2019 with attorneys who reviewed the six most popular startup financing documents—all of which were produced by investor-funded organizations. After pouring through 298 pages of legalese, the attorneys found the top six financing documents were, on average, only 38% compatible with Founder Friendly Standard. The Gust Series Seed Term Sheet was one of the least compatible with the Founder Friendly Standard. See for yourself by viewing our infographic where you can drill down and compare the term sheets.

Gust Series Seed Term Sheet does not guarantee founders any control of their companies

Review written by Jennifer Rohleder, Principal of J. Rohleder Law, on July 25, 2019.

If you can muster the patience to build what John W Mullins calls a customer-funded business, you can reject the terms of the Gust Series Seed Term Sheet that you don’t like. (Always consult with an attorney when negotiating a term sheet.)

As Mullins writes in The Customer-Funded Business, “Making do with the probably modest amounts of cash your customers will give you enforces frugality, rather than waste… and will force you to run your business better.” Customer-funded companies have the option to walk away from angels and venture capitalists (VCs) and grow organically until they command investment terms in line with the Founder Friendly Standard.

This review is for Founders who want to build companies their way.

Comparing the Gust Series Seed Term Sheet to the Founder Friendly Standard

How do you define founder-friendly? For this comparison, I used the Founder Friendly Standard to grade Gust Series Seed Term Sheet (“the term sheet”) for founder-friendliness. Before I get started, Gust is a trademark of Gust, Inc., which is not affiliated with this content and does not endorse it. This content is not legal advice. See disclaimer below.

Section 1.1 of the Founder Friendly Standard says:

Individuals who work for the company and are instrumental in its inception (“Founders”) receive a class of equity such as Common Stock which provides no less than twenty-four (24) votes to one (1) vote of stock held by investors or employees.

The Gust Series Seed Term Sheet doesn’t meet Section 1.1 of the Founder Friendly Standard. There is no mention of a super-voting class of shares for Founders. This is not surprising, and can be remedied by already having super-voting shares included in the company’s bylaws.

Section 1.2 of the Founder Friendly Standard says:

Investors receive a class of equity such as Class A Preferred Stock which will have one vote per share with a higher par value justified by a liquidation preference.

The Gust Series Seed Term Sheet doesn’t meet Section 1.2 of the Founder Friendly Standard. While the terms sheet provides a liquidation preference of 1x the original issue price plus accrued and unpaid dividends, it lets investors elect one member (“Preferred Director”) of a three-person board. This is akin to giving investors super-voting equity, not one vote per share. (Section 1.4 below describes the powers given to the Preferred Director)

Section 1.3 of the Founder Friendly Standard says:

Employees and contractors receive a class of equity such as Class B Common Stock which carries one vote per share and does not have a liquidation preference.

The Gust Series Seed Term Sheet does meet Section 1.3 of the Founder Friendly Standard. While the term sheet does not provide for a third class of stock for employees, one would expect employee equity to receive one vote per share with no liquidation preference.

Section 1.4 of the Founder Friendly Standard says:

The first board consists of only Founders. The term of the board is one year. After the first year, a new board is elected by the equity holders at the annual meeting. Board decisions are made by a majority vote of the board. Board members cast no more than one vote each on any decision. Board committees are disallowed for at least the first two (2) years.

The Gust Series Seed Term Sheet doesn’t meet Section 1.4 of the Founder Friendly Standard. The term sheet provides that two directors are elected by the holders of a majority of the Common Stock, and one is elected by the holders of a majority of the Preferred. While it looks like the Founders would control two thirds of the board, further provisions require the Preferred Director’s approval before taking an action. These actions include taking on debt, selling assets, changing Founders or executive officers, and entering into a liquidation event that would result in the Preferred receiving less than 5x the original purchase price. This can put the investors, rather than the Founders, in control of the company. Founders, is this what you want?

Section 1.5 of the Founder Friendly Standard says:

New equity of any kind, including stock option pools, dilutes all equity holders equally. Therefore, no investor in the company has anti-dilution rights of any kind.

The Gust Series Seed Term Sheet doesn’t meet Section 1.5 of the Founder Friendly Standard. The price per share is calculated using a set-aside of 15% of the company’s shares as an option pool. The pool exists after the investment is made but is used in the calculations before the investment is made. This means that all of the shares of the option pool come from the Founders shares, not the investor shares. The investors are protected from dilution for future employees.

The conversion of Preferred into Common shares is subject to the “Broad-based Weighted Average anti-dilution protection.” This means that if the company raises money in the future at a lower valuation than the valuation used in the current round, the current investors will be partially protected. According to Gust, this provision is the “middle-of-road industry standard, halfway between the Founder-biased no anti-dilution approach and the investor-biased full ratchet anti-dilution version.”

The focus on the down-side protection seems misplaced in such an early round of funding. Early-stage companies are risky by definition; that risk should be shared equally. Does that sound right to you?

Section 2.1 of the Founder Friendly Standard says:

Founders agree in writing they will give and receive performance reviews at the end of each fiscal quarter for the first four (4) years.

The Gust Term Sheet doesn’t address the principle laid out in section 2.1 of the Founder Friendly Standard. The term sheet is silent on this issue.

Section 2.2 of the Founder Friendly Standard says:

Sweat equity vests each month over a period of four (4) years with a one (1) year vesting cliff. Vesting begins on the date shares are issued.

The Gust Series Seed Term Sheet does meet Section 2.2 of the Founder Friendly Standard. The term sheet provides for “reverse vesting” so the company can repurchase unvested stock if a Founder leaves before four years. The term sheet provides for full acceleration upon “double trigger,” meaning if the company is acquired prior to the 4-year period and the new company terminates a Founder, that Founder’s remaining stock immediately vests.

Section 2.3 of the Founder Friendly Standard says:

Founders keep all information confidential and assign the company all intellectual property created within the scope of their work for the company.

The Gust Series Seed Term Sheet does meet Section 2.3 of the Founder Friendly Standard. The term sheet requires all Founders to have assigned all relevant IP to the company and executed a non-disclosure agreement.

Section 2.4 of the Founder Friendly Standard says:

Due to potentially devastating tax consequences, the company tells individuals receiving sweat equity in the United States to consult with a tax professional about making an election under Section 83(b) of the Internal Revenue Code. Founders who live or pay taxes outside the United States are similarly advised to consult tax professionals about applicable local and national taxes.

The Gust Series Seed Term Sheet doesn’t address Section 2.4 of the Founder Friendly Standard. The term sheet is silent on this issue.

Section 2.5 of the Founder Friendly Standard says:

Non-compete restrictions only apply to employee or independent contractor agreements and do not survive termination. The company’s bylaws and other investor agreements are either silent on the issue of non-competition or expressly allow competition.

The Gust Series Seed Term Sheet doesn’t meet Section 2.5 of the Founder Friendly Standard. The term sheet requires Founders sign a non-compete and non-solicitation agreement that extend one year after termination. Non-competes can restrict Founders’ ability to find work in their industry.

This isn’t fair for Founders receiving below-market salaries; it’s unlikely they will have enough savings while they look for jobs in other industries. Fired and restricted from finding work, founders can be exploited when it comes time to sell their equity. Have you ever heard of this happening to a founder?

Section 3.1 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company will not agree to pay the legal expenses of any investor as a condition of investment.

The Gust Series Seed Term Sheet doesn’t meet Section 3.1 of the Founder Friendly Standard. The term sheet states that the company is responsible for reimbursing a flat fee to the preferred for background check expenses, due diligence, and review of transaction documents by investors’ counsel. This an egregious term; such costs are the costs of doing business for a professional investor.

Section 3.2 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any investor.

The Gust Series Seed Term Sheet does meet Section 3.2 of the Founder Friendly Standard. The term sheet is silent on dispute resolution, which leaves the door open for Founders and investors to go to court rather than arbitration.

Section 3.3 of the Founder Friendly Standard says:

For at least the first two (2) years of operations, the company does not agree to binding arbitration with any Founder.

The Gust Series Seed Term Sheet does meet Section 3.3 of the Founder Friendly Standard. The term sheet is silent on dispute resolution, which leaves the door open for Founders and investors to go to court rather than arbitration.

Section 4.1 of the Founder Friendly Standard says:

Upon any transfer or sale of Founders’ super-voting equity, the portion of equity transferred converts to the class of equity described in Section 1.3. This also includes any transfer to a Founder’s estate, spouse, or heirs.

The Gust Series Seed Term Sheet doesn’t meet Section 4.1 of the Founder Friendly Standard. Founders do not have super-voting equity per the term sheet.

Section 4.2 of the Founder Friendly Standard says:

The company has the right of first refusal on any transfer or sale of equity for up to forty-five (45) days, but it cannot veto a transfer or sale. This provision is void after a company’s stock is listed on a public exchange such as the NASDAQ, OTCBB, New York Stock Exchange, etc.

The Gust Series Seed Term Sheet does meet Section 4.2 of the Founder Friendly Standard. The company has the right of first refusal with respect to any proposed transfer of capital stock at the same price that was offered. The term sheet doesn’t provide a veto right. The term sheet doesn’t limit the amount of time such a right of first refusal is valid.

Should you accept seed investment terms that aren’t founder-friendly?

The Gust Series Seed Term Sheet meets six issues (sections 1.3, 2.2, 2.3, 3.2, 3.3, and 4.2) addressed by the Founder Friendly Standard. The terms sheet doesn’t meet seven issues (sections 1.1, 1.2, 1.4, 1.5, 2.5, 3.1, and 4.1), and is silent on two issues (sections 2.1 and 2.4). Nearly all the issues carry long-term ramifications.

José Ancer says in his article, Legal Technical Debt, “The entire point of contracts is that they are permanent and cannot be fixed unilaterally. That makes legal mistakes far more costly to fix than coding mistakes.” Have you seen or experienced this? If you’ve built a customer-funded business, you might hold off fundraising until you can get terms you can live with permanently.

INFOGRAPHIC: How does Founder Friendly Standard compare to term sheet templates from 500 Startups, Y Combinator, NVCA, Gust, and Sam Altman?

Limit of Liability/Disclaimer of Warranty: Jennifer Rohleder (“Author”) is not providing any financial, economic, legal, accounting, or tax advice or recommendations on this site. Although Author is an attorney licensed in the District of Columbia and Virginia, the information contained on this site was prepared for general information purposes only, does not constitute research, advice, or a recommendation from Author to the reader and is not a substitute for personalized financial or legal advice. Neither Author nor any of her affiliates make any representation or warranty as to the accuracy or completeness of the statements contained on this site. Author and her affiliates expressly disclaim any liability (including any direct, indirect, or consequential loss or damages) for all posts and their content.

The post Review of Gust Series Seed Term Sheet appeared first on EISAIAH ENGEL.

How does an EIF fit into corporate innovation initiatives? 

My book, Innovation Casino, explains that you can fit a company’s products and services under two labels: core and non-core.

Core: Core offerings are at the center of your company’s skill set and reason for existing. Like the Apple iPhone or the Amazon Web Services platform, core products can become platforms for other companies to extend. You should focus your resources for research, development, and acquisitions on refining and transforming your core offerings.

Non-Core: Non-core offerings are not at the center of your company’s skill set and reason for existing. Non-core products may drive demand for your core products, which can make it temping to devote teams and budgets to them. However, Innovation Casino proposes you fund promising non-core ideas with an EIF, which uses capital from outside investors to fund startups in your digital ecosystem. EIFs are like the 2010 iFund for iPhone apps: Kleiner Perkins put up the capital and managed the iFund while Apple provided market research and support. 

In summary, EIFs give promising non-core ideas a way to get built without diffusing your team’s focus or eating into your budgets for research, development, and acquisitions. 

Are the corporate innovation strategies in the EIF model practiced today?

The closest examples to an EIF today are corporate venture capital funds such as Salesforce Ventures, Google Ventures, Microsoft Ventures, and the Amazon Alexa Fund—all of which prefer to fund startups that build on their platforms. Here is where the EIF model differs: EIFs are for investing small amounts of money in more companies than venture capital. 

To invest in more companies, the EIF transfers the investment selection approach of SBIR. SBIR has been around since 1982 and has catalyzed nearly 70,000 patents. SBIR is a better model for investing in lots of companies than venture capital, which likes to make large bets on a few companies. Like SBIR, you would fund startups that meet your corporate innovation objectives.

What the SBIR model is missing are straight-forward ways to recoup principal and generate a return on capital. For this piece of the puzzle, we look to venture capital, which makes equity investments. So, like venture capital, your EIF would buy equity in the startups it funds.

Your EIF should look nothing like the SoftBank Vision Fund, which made enormous investments in a handful of unicorn companies. Instead, your EIF would be most compatible with a new generation of startups called “zebras.” (See section on zebras below.)

Why would a corporate venture capital fund need to invest in lots of startups? 

Since the financial crisis of 2008 and 2009, borrowing costs and taxes have remained low. When borrowing costs and taxes go up, companies with too much debt may not be able to refinance. This has not happened yet. However, if a critical mass of companies could not refinance their debts, asset prices would go down, and it would become difficult to sell non-core assets without incurring permanent losses. The remaining option would be to spin off non-core assets into their own companies. 

Digital ecosystems present an elegant solution for divesting non-core products and services while maintaining a consistent client experience. This can be done by turning non-core products into “apps” that customers can access and by organizing these apps under new companies. Employees who manage the apps would move to the new companies to do their same jobs—this time, with less bureaucracy and more control over their work. Divested apps could remain revenue sources for their former parent companies through ecosystem-related commissions and other equity arrangements.

Your corporate innovation strategy should account for the possibility that your company’s growth could become linked with your success in creating a digital ecosystem. 

In a world where large companies are creating digital ecosystems in every industry, customers and developers will wonder whose digital ecosystem they should choose for the long run. BlackBerry launched their app store called “BlackBerry World” within a year of Apple’s. However, developers and customers didn’t believe that BlackBerry World would catch up to the Apple App Store. BlackBerry World was eventually shut down. Your corporate innovation strategy should account for the possibility that your company’s growth could become linked with your success in creating a digital ecosystem. 

How do you become more like Apple than BlackBerry? For starters, your large firm will need to attract developers to build in your digital ecosystem versus that of the competition. This is where the EIF model, with its ability to invest in many companies, can help. The EIF model makes the following offer to the companies it funds:

• Startups get total control of their companies with Founder Friendly Standard investment terms (as opposed to less control with VC) and a little money in the door (as opposed to a lot of money from VC). 
• This is in exchange for building products and services on your platform.

The above trade would not work for “unicorn” startups that aspire to grow rapidly and unprofitably. Instead, your EIF would be most compatible with a new generation of startups called “zebras,” which are resourceful and aspire to grow profitably.

Why are “zebra” startups a match for EIFs to fund?

Your EIF will probably fund a new type of startup called a zebra. The term zebra was introduced in 2017 by Zebras Unite, an organization calling for a more ethical and inclusive alternative to venture capital culture. Zebra startups focus on serving a niche. Many of the companies on the Inc. 5000 list are zebras. 

Zebra startups differ from unicorn companies, which venture capital culture tends to focus on: companies such as Facebook, Instagram, Twitter, Uber, and Airbnb. Unicorn companies often grow quickly and unprofitably with the hopes of raising prices down the road. As a result, unicorn companies rely on an ample amount of investment and luck. Unlike their unicorn cousins, zebras are startups that aspire to grow sustainably from day one. Zebras often try to dominate a niche, not an entire market. This makes zebras a mismatch for venture capital and a match for your EIF, which needs niche solutions to execute your corporate innovation strategy. 

Where can I read more about EIFs?

My December 2020 book, Innovation Casino, introduces the idea of an EIF. The term “innovation casino” is a metaphor for the odds of generating financial returns from corporate innovation. The book takes an odds-based approach to show how companies using an EIF to fund non-core innovation can get higher returns from their investments than companies using internal teams to tackle the same initiatives. Innovation Casino is available on Amazon in kindle, audiobook, and paperback formats. You can also read a chapter-by-chapter summary of the book on this blog. And be sure to check out my August of 2021 interview about ecosystem innovation funds.

This article is for informational purposes only and is not investment advice. See this site’s terms of use and social media disclaimer for more details.

The post What is an Ecosystem Innovation Fund (EIF)? appeared first on EISAIAH ENGEL.

Non-competes can advance the interests of investors to the detriment of entrepreneurs. That is why Founder Friendly Standard section 2.5 limits non-competes to the period of a founder’s work for the company, making it possible for a founder to earn a living in his/her industry after he/she leaves.

In 2019, I led a study where attorneys compared popular term sheets to Founder Friendly Standard. The below videos were produced during the study and originally posted on Quora. Other noteworthy outputs from the study include this infographic comparison and this attorney roundtable discussion.

The below video is an analysis of non-compete issues from attorney Zev Safran’s review of the 500 Startups KISS document:

The below video is an analysis of non-compete issues from attorney Keith Strahan’s review of the NVCA Model Legal docs:

The below video is an analysis of non-compete issues from attorney Jennifer Persico Rohleder’s review of Sam Altman’s personal term sheet:

The below video is an analysis of non-compete issues from attorney Jennifer Persico Rohleder’s review of the Gust Series Seed term sheet:

The below video is an analysis of non-compete issues from attorney Ryan Juliano’s review of the Y Combinator Safe:

As you may have gathered from the above videos, you need to retain the right to earn a living in your industry if you leave your startup. Agreeing to a non-compete can take that right away from you. You can still agree to compete fairly and not breach confidentiality and intellectual property rights.

If investors insist on a non-compete that lasts longer than your employment at the company, then you should insist each investor personally guarantee a severance package equivalent to your fair market salary for as long as the non-compete is in place. Restricting your ability to lawfully practice a trade should be as personal for them as it is for you. And it is personal. I am speaking from experience. Yes, I made this mistake. Read about my startup struggles here.

INFOGRAPHIC: For side-by-side attorney comparisons of the 6 most popular startup term sheets to Founder Friendly Standard, visit our interactive infographic here.

For the investment case behind the Founder Friendly Standard, check out my December 2020 book, Innovation Casino: Grow Digital Revenue with an Ecosystem Innovation Fund.

The post Should a startup founder agree to a non-compete? appeared first on EISAIAH ENGEL.