I’m reluctant to give legalistic disclaimers, but in this instance, I do need to emphasize that the material in this article is legal information, not legal advice.  Unless you’ve engaged my firm to represent you or your startup, we do not have an attorney-client relationship.  I urge all entrepreneurs to consult and develop a good working relationship with a qualified startup lawyer.

Continuing my medical analogy, the documents are like powerful prescription medications and your lawyer plays the role of the physician.  This holds true on many levels; for example, patients like to understand the basics of prescription drugs they take, including risks and benefits, likely side effects, alternatives, and so forth.  Likewise, founders can benefit from understanding basic characteristics of the overall legal structure, formation and governance documents, rights and responsibilities of team members, etc.  Readers can anticipate my next point in continuing the analogy:  It makes no more sense for a non-lawyer to prepare fundamental legal, governance, equity and intellectual property documents than it would for a patient to self-diagnose and begin taking prescription-strength antibiotics or other medications.

Stepping off the soapbox, let’s examine the highest level “To Do” list for a new startup:

Formation, Governance and Equity

1. Pick a name for the new legal entity (e.g., “Bottom Line, Inc.”) and search for its availability as a corporate name, domain name and trademark (all separate inquiries)
2. Determine the allocation of equity among co-founders, early employees or other service providers, and future contributors as applicable, as well as the vesting schedule, if any, that will apply
3. Determine who will serve on the Board of Directors and in executive officer positions (usually founders)
4. Form a legal entity to operate the business (we’ll use a Delaware corporation as an example for Bottom Line)
5. Appoint Bottom Line’s initial Board of Directors
6. Adopt Bylaws and any other necessary documents to formalize the governance of Bottom Line
7. Take Board action to authorize everything done by the founders to date, appoint executive officers, authorize issuance of stock, approve forms of common agreements, authorize the opening of bank and brokerage accounts in the name of Bottom Line, delegate authority to the appropriate people to manage those accounts, set the company’s fiscal year and place of business, and so forth.
8. Take any steps needed to qualify Bottom Line to conduct the business it plans to conduct wherever it’s located (for example, a filing made in California qualifying a Delaware corporation to do business there if the management team is located in San Francisco)
9. Enter into agreements between Bottom Line and founders, early contributors, outside advisors or service providers under which they contribute or assign all intellectual property related to the company’s business to Newco in exchange for the issuance of founders’ stock (Common Stock)
10. Make escrow arrangements for restricted stock (i.e., founders’ shares subject to vesting) and IRS filings for most favorable tax treatment of those shares
11. Consummate the stock issuances, make any necessary securities filings and issue the corresponding stock certificates.

 When people ask me what it takes to “incorporate,” often citing very low prices quoted by filing services, the first thing I like to point out is that they’re referring to #4 alone.  A more complete description of the whole list might be “formation, governance, asset contribution and initial stock issuance.”  Yes, it’s a mouthful.  None of it is optional for a classic tech startup – that is, a small enterprise that aspires to create value through innovation and rapid growth, with a goal of being worth tens or hundreds of millions of dollars someday. The risk is simply too great.  Many corporate lawyers make a good living cleaning up messes created at inception by do-it-yourselfers or other lawyers working outside their areas of expertise.

Almost nothing on this corporate list is work I would recommend to do-it-yourselfers.  From choosing a legal entity or jurisdiction to properly documenting IP assignments and stock issuances to complying with securities laws and avoiding potentially enormous tax penalties in the future, there is plenty here to warrant consulting a professional.  For those of us who do it every day or every week, there is also a “well-worn path” involving reams of very familiar-looking documents that will take relatively little time (and therefore cost relatively little in legal fees) to prepare for a new startup.  Perhaps more importantly, investors and their counsel take comfort in seeing very standard-looking, “vanilla” startup corporate documents similar to those they’ve seen for many years in other deals with other companies.

For those who feel compelled to at least give it the old college try, the first five steps or so are most conducive to DIY.  A crude rule of thumb is that anything involving the issuance of stock or options, or promises, agreement, commitments or arrangements to issue stock or options in the future, has complications that merit involving legal counsel and/or tax advisors.

The next category is more promising for those who aspire to the corporate legal equivalent of the Homebrew Computer Club:

Common Operating Documents

1. Offer letters for employees
2. Independent contractor or consulting agreements
3. Advisory board agreements
4. Small-dollar-amount, routine commercial agreements
5. Confidentiality or non-disclosure agreements (NDAs)
6. Employment handbooks and policies
7. Website terms of use and privacy policies
8. Office and equipment leases
9. Strategic partnership or distribution agreements
10. Sales contracts accounting for significant revenue

No doubt there are many others, but these are common, illustrative examples.  Taking them in groups, 1-5 are driven primarily by commercial terms determined by the business people; once in possession of a well-drafted template, I’ve found clients are often happy to prepare these on their own in most situations, involving lawyers only in unusual or more complex arrangements.  There are still traps for the unwary in some of these, which your lawyer can highlight. Employment law is trickier (#6), in part because it changes by state as well as over time, but it’s possible to rely on a relatively new “state of the art” employee handbook for the state in which Newco is located that is prepared by a competent law firm or supplied by an organization such as SHRM.

Number 7 is a significant part of my own practice.  For startups that are Internet or mobile businesses, as I’ve written before, terms of use and privacy policies are far from boilerplate and are perhaps the most important documents setting the ground rules for the company’s interactions with potentially millions of users.  For a bricks-and-mortar business that merely maintains a website but doesn’t do significant business through it, it seems reasonable to use good templates for these documents, at least as a starting point.

Number 8 onward is lawyer territory.  With a few exceptions such as certain standardized commercial real estate leasing documents, none of these items could be described as “boilerplate.”  They involve large dollar amounts and/or material business, financial and operational risk on the part of the company.  The amounts involved typically justify working with a good business law firm.  In the case of revenue contracts, they help pay for the related legal work.  For repetitive sales transactions such as insertion orders for online advertising, if an industry standard form isn’t sufficient, it’s often feasible to create a versatile template with the help of a lawyer that the company can use for hundreds or thousands of deals going forward with minimal changes.

Finally, corporate projects beyond the first list above involve significant legal work.  Most startups will involve legal counsel whenever doing anything involving the company’s securities, such as adopting a stock option plan, making grants under the plan, issuing convertible notes in a financing round, and so forth.  Much of this work poses the formidable risk that “you don’t know what you don’t know.”  To throw out a couple examples, if Newco proceeded to adopt a certain kind of employee deferred compensation plan or issue a large number of stock options without being aware of the existence or requirements of IRC Section 409A or Securities Act Rule 701, some very unpleasant consequences could result.  Caveat entrepreneur!

 

This article first appeared at Gust Blog. Reprinted with permission.

Having covered the basic deal structure, we can begin dissecting an example term sheet based on a real deal.  For those playing at home, you may find it helpful to download the sample term sheet from the Resources page on our Bottom Line Law Group website and follow along with the commentary.

As with so many subjects in law and finance, mastering the jargon is half the battle.  A term sheet keeps things relatively straightforward by summarizing the most significant deal terms in outline form, whereas the deal documents themselves (often referred to as definitive agreements) — even for a relatively simple convertible debt financing — inevitably contain some densely written legalese.  Let’s dive in, taking it from the top:

Type of Security:  Convertible Promissory Notes, bearing interest at a simple interest rate of 8%.

This may seem like a no-brainer now that you understand the basic structure of a convertible debt financing.  In fact, there is a recent variation on this theme.  At least one well-known Silicon Valley venture accelerator is using a document referred to as a “convertible security” rather than “convertible promissory note” for its seed investments.  Although a convertible note is technically a loan made to the startup, in practice these loans are rarely expected to be repaid.  That being the case, removing the whole concept of repayment in favor of a legal document that makes no claim of being a promissory note, yet retains the upside characteristics of a convertible note, makes logical sense from the entrepreneur’s perspective.  (Investors, of course, may disagree.)

Assuming a conventional deal that is structured as a convertible note, the other term in this paragraph is the interest rate.  In case it isn’t clear by now, angel investors aren’t in the business of making risky early stage investments in order to earn 6% interest on their money, or even 10% — the upside is all in conversion to equity — so the interest rate isn’t a major point of negotiation.  Cash-strapped early stage startups also aren’t positioned to make interest payments on debt (except maybe for founders’ credit cards, but that’s another story), so unlike a typical home or car loan, where interest is amortized and paid over the term of the loan, interest on these notes usually accrues over the term of the loan and becomes payable only at the maturity date (or is converted in an eligible priced equity round or acquisition of the company).  Moreover, assuming an eligible equity financing takes place before the maturity date, the interest isn’t paid in cash, but rather is added to the principal amount of the note before converting it to equity.  New investors in a Series A round understandably would rather not have their funds used to pay interest to previous investors.

Amount of Financing:  Up to $600,000 may be issued.

Closing:  A first closing will be held on or before September 30, 2011, or such other date that the Company and the bridge investor(s) participating in such closing mutually decide upon (the “Initial Closing”). Additional closings may be held up to 90 days after the Initial Closing at the option of the Company.

These deal terms are simple but significant.  In most cases, an early stage startup will raise seed capital from more than one investor.  Theoretically everyone could cooperate to hold one grand closing at one time in one place, but in practice, life tends to be more complicated.  More often than not, multiple closings are held with different investors in the same round on the same terms using substantially identical documents.  These provisions establish the limits of what is considered to be the “same round,” setting investors’ expectations accordingly.

Mandatory Conversion:  The Notes and any accrued interest will be converted into the Company’s next issued series of preferred stock resulting in new money of not less than $1,000,000 (an “Eligible Financing”) at a discount to the per-share price of such preferred shares of 25% (the “Conversion Price”).

This paragraph is the heart of the whole deal.  The appeal of a convertible note financing to a new startup is that at its earliest, most uncertain stage, entrepreneurs and investors need not agree on all of the characteristics, terms, conditions, rights and preferences of a new series of preferred stock that would ordinarily produce an eight-page term sheet and a 100+ page stack of definitive legal documents.  As written, this mandatory conversion term

1. defines what kind of event will trigger conversion (a new priced equity round bringing in $1 million or more);
2. specifies generally what type of security the note will convert into (the “next issued series ofpreferred stock”); and
3. establishes a conversion discount (in this case, 25%) to compensate the convertible note holders for the increased risk associated with being the first to invest in a new venture.

This “uncapped note” example ignores the concept of a valuation cap, which we’ll take up in a future installment.  To use some concrete numbers, assume an angel invests $100,000 in a convertible note at 8% interest, and the Company raises a $2 million Series A round exactly one year later.  To keep the math simple without getting bogged down in share numbers and valuations, let’s assume the new investor pays $1.00 per share for 2,000,000 shares of newly issued Series A Preferred Stock.  Our angel fares as follows:

$100,000 + 8% interest = $108,000

that will convert to equity.  With the 25% discount applied to the $1/share price paid by new investors, the Note will convert to

$108,000 / $0.75 = 144,000 shares of Series A Preferred Stock.

With this deal structure, the angel is relying on the Series A investors to negotiate fair terms of the Preferred Stock that he or she will ultimately receive in the conversion, but has no opportunity to directly negotiate those terms.  In practice, given that (1) investors’ interests are mostly aligned most of the time, and (2) Series A investors generally put a much larger amount of capital at risk, this approach seems to work relatively well.  Nevertheless, reasonable minds can differ among entrepreneurs, angels and VCs, particularly with respect to specific companies and investments, and we’ll examine some of those differences in a future post.

 

Now that we’ve covered the mandatory conversion language at the heart of any convertible debt financing, there are other conversion scenarios to be addressed in any thoughtfully drafted term sheet:

Voluntary Conversion: The Notes and any accrued interest shall be convertible, at the option of holders of a majority-in-interest of the outstanding principal amount of the Notes (“Majority Holders”), on the 18-month anniversary of the Initial Closing (the “Maturity Date”), into shares of Common Stock at a conversion price equivalent to a pre-money valuation of $3 million.

First, a word about the maturity date.  In my experience, a term of 12 to 24 months is common, with 12 months being on the short end.  Particularly when there are multiple closings taking place over a period of months, the fuse burns awfully quickly on a 12-month note given the many competing priorities of early stage entrepreneurs. 

If you’re wondering why multiple closings would make a difference, the answer is that it usually makes sense to have all of the Notes in a given round mature on the same date (e.g., 18 months from the first closing), rather than on a rolling basis, to avoid administrative hassles and potential inter-creditor conflicts — or, in plain English, the prospect of newer lenders’ money being used to pay off earlier investors’ notes.  Some investors may say they face a 12-month limit based on lending regulations, as Yokum Taku has observed.

So what happens upon maturity?  Without any other language to the contrary, the Notes become due and payable in full, including principal and accrued interest.  That is obviously a challenge for the typical cash-strapped early stage startup that is seeking to raise more capital and is not in any kind of position to be repaying loans.  It’s worth mentioning two key attributes of convertible note venture deals here:  The debt is almost always unsecured, meaning there are no underlying assets to be seized as collateral in the event of default (unlike, say, a mortgage or car loan), and is not personally guaranteed by founders or shareholders.  Those deal terms reflect the relatively high-risk nature of this kind of early stage investment; a bank lending money to a small business would likely require collateral, a personal guarantee by the owners, or both.

In practice, if the notes mature and a startup has no cash and minimal hard assets, investors are left with little more than theoretical claims against an insolvent business entity (usually a corporation).  Thus, it’s in everyone’s best interest to see the startup raise more capital rather than declaring default and demanding repayment.  There are as many variations on this scenario as there are startups, but here are some common scenarios upon maturity:

1.  The startup negotiates with the bridge lenders to extend the maturity date;
2.  The agreement contains language providing that, at the Company’s option, the notes may be converted to shares of Common Stock at a predetermined valuation;
3. Same as above, except at the option of the noteholders (per the term sheet example above);
4. The company is unable to raise more financing and becomes insolvent (whether or not it formally files for bankruptcy); or
5. In rare cases where a startup is cash flow positive very early in its lifecycle, it may actually be able to pay off the notes without raising any equity investment.

Practically speaking, if the company is out of money, it’s out of money, so the difference between numbers 1 through 4 may not mean much.  Nevertheless, in some scenarios, a new influx of funding can resuscitate a startup, in which case there are meaningful distinctions between different classes of debt and equity holders.  For that reason, investors commonly insist on #3 (or nothing) rather than #2, giving them more flexibility.  Entrepreneurs generally prefer #2, provided it’s at a valuation that wouldn’t be absurdly dilutive given the amount of notes outstanding.

It’s worth pausing on the definition of the phrase “at the noteholders’ option.”  The sample language above includes the term “Majority Holders” defined as holders of a majority-in-interest of the outstanding principal amount of the Notes.  This is a helpful construct because if the Company has to negotiate with lenders or investors, particularly under financial duress, it’s much better to only have to deal with one or two of them on behalf of all noteholders rather than having many simultaneous discussions and running the risk that one minority investor could derail the whole thing. 

The “Majority Holders” concept also appears elsewhere in the financing documents, most commonly in the section regarding amendments and waivers, for similar reasons.  From the investor perspective, you are being asked to give up individual rights as a creditor of the Company for the greater good; assuming others are behaving rationally, you can reasonably expect that the Majority Holders, with the most skin in the game, holding notes identical to yours, will have interests aligned with yours in maximizing the return on their investment (or minimizing loss).

Prepayment.  The Notes may be prepaid only upon prior written approval of the Majority Holders. Any prepayment must be made in connection with the prepayment of all Notes issued under the Note Purchase Agreement, as amended.

To angels, prepayment defeats the entire purpose of making a convertible note investment in an early stage startup:  A 6% or 10% return within a year or two isn’t worth the risk associated with making an unsecured, non-recourse loan to an unproven, development-stage company with little or no revenue.  Investors want to see the company hit a home run, achieve an exit at a hefty valuation, and ultimately generate a 10x or greater return on their capital.  Therefore, it’s unusual for the company to be permitted to prepay the Notes without the holders’ consent (again, typically a decision the Majority Holders can make on behalf of all noteholders).  The one exception, which we’ll get to next, is if the startup is acquired before it closes a priced equity round; the company needs a way to retire the Notes in connection with a merger or acquisition, and investors will expect a decent return in that scenario.

 

For convertible notes, the only liquidity event we need realistically be concerned with is an acquisition of the startup in the near future, before the maturity date; otherwise, the notes will convert to equity of one kind or another, and the eventual sale of that equity (in a public offering, acquisition, or private sale) is a different subject for another day.  To account for scenarios in which the startup is acquired before it has a chance to complete a priced equity financing round, most term sheets and deal documents contain a “change in control” provision.  Entrepreneurs generally don’t ask for this kind of language, but most sophisticated investors will insist on it in one form or another.  To understand why, consider what would happen without such a provision if the startup turned out to be an overnight sensation acquired by Google for $30 million six months later.  What happens to the outstanding convertible notes?  In descending order of preference, from the founders’ point of view:

1. The company pays off the notes immediately according to their terms, with prorated interest.  Assuming a hypothetical $100,000 investment at a 10% interest rate, this kind of payoff would yield a return of $5,000 (5%) six months later – not exactly the kind of return angel investors are looking for when they make risky early stage investments.
2. If the notes contain a “no prepayment” clause, which is usually the case, another option might be to wait out the clock and repay the principal and interest upon maturity.  Using our hypothetical numbers, assuming the notes have an 18-month term, the return would be $15,000 (15%) – again nothing to write home about.
3. Suppose the notes converted as if the acquisition were an eligible financing round.  Investors would be repaid their principal, plus accrued interest, divided by the conversion price (let’s say 30% discount, so 1 – 0.3 = 0.7).  Again using the numbers above, the return is $50,000 (50%) in six months – a good investment to be sure, but still a relative pittance for a startup making such a successful early exit.

What these approaches have in common is that they cap the investors’ upside such that even in the most spectacular of liquidity events, unless the notes convert to equity first at a lower valuation, angels don’t get anywhere near the payoff awarded to equity holders.  Most would agree this is not a fair outcome.

Returning to our sample term sheet, here is one flavor of change-in-control provision that I like to use:

Change of Control:  If an acquisition or similar change of control transaction occurs prior to the Preferred Financing, then upon the closing of such transaction, the Notes will, at the election of the Majority Holders, become

(a)   payable upon demand as of the closing of such transaction; or

(b)   redeemable for a payment equal to the amount each Note Holder would have received had the Note converted immediately prior to the transaction to

(i)   Preferred Stock (if a Preferred Financing is pending at the time of the transaction) or,

(ii)   if no Preferred Financing is pending, to Common Stock at a price per share equivalent to a fully diluted pre-money valuation of $3 million,

to be paid in the same form of consideration (e.g., a mix of cash and stock) received by other equity holders in the transaction.

Thanks to Gil Silberman for reminding me of this formulation in his Quora post.  The language is a mouthful, so bear with me as we review the salient points:

• “…at the election of the Majority Holders…” is helpful to the company because if there are any decisions to be made regarding the payout, it’s more expedient for the company to deal with one majority investor (or a small control group) rather than with each of many small investors.  This is particularly true under the severe time pressure that tends to accompany M&A.
•  “Payable upon demand as of the closing of such transaction” is the fallback position described above as #1.  In a “fire sale” of a distressed company at a very low valuation, this can be the best option for investors.
•  “Redeemable for a payment equal to the amount each Note Holder would have received had the Note converted immediately prior to the transaction to…” is the language that enables investors to share in the upside of a successful exit.  The simplest possible formulation is to state a multiple (i.e., if the startup is acquired before the notes mature or convert, investors will be paid 2X or 3X their investment).  The downside to that approach is that it bears no relationship to the purchase price paid by the acquirer.  Hence:
•  “Preferred Stock (if a Preferred Financing is pending at the time of the transaction)…” reflects the notion that a financing offer on the table at the time of acquisition is one of the most reliable indications of valuation for an early stage, privately held company.  This is not uncommon in practice; rapidly growing, successful startups tend to attract both buyout and investment offers around the same time.  Including this language in a change-of-control provision essentially turns the clock forward a little, assumes for the sake of calculation that the imminent financing round actually closed, and applies the conversion discount (30% in our example).

Using some sample numbers, let’s assume the startup has a term sheet on the table from a VC to invest $3 million at a $10 million pre-money valuation when our hypothetical $30 million acquisition offer materializes.  The noteholders essentially triple their money (ignoring interest), but if the conversion discount also applies to this scenario (a drafting subtlety in the documents), they actually do better.  Nevertheless, this is the variant most favorable to founders, and is often omitted in favor of the next clause:

• “…to Common Stock at a price per share equivalent to a fully diluted pre-money valuation of $3 million” gives investors the best shot at participating in the upside of a highly successful early M&A exit.  In our hypothetical example, the angels would get a 10x return on their convertible note investment six months after making it.  Not too shabby.  As above, this can get even better if the conversion discount also applies.

It’s worth noting that the $3 million figure here is not the same thing as the valuation cap investors and founders regularly negotiate in convertible note deals, but it is a related species of cap that serves a similar purpose of protecting investors in a scenario in which the company achieves a stratospheric valuation.  To make things extra confusing, there can be three distinct places where these figures appear in a convertible debt financing term sheet or deal documents, which may or may not be the same valuation:

1. The valuation cap that applies to conversion of the notes in a priced equity round;
2. the agreed-upon price at which the notes may convert to equity if the maturity date is reached without an equity round that triggers conversion; and
3. the figure that applies if the company is acquired before conversion.

• “…to be paid in the same form of consideration (e.g., a mix of cash and stock) received by other equity holders in the transaction.”  Mergers and acquisitions come in many varieties.  This language allows for the possibility that the startup may be acquired for stock, or a mix of cash and stock, of the acquiring company.

 

Having covered just about every path a convertible note can take, there are assorted terms commonly seen in term sheets and deal documents that are worth touching on briefly. What seem like “boilerplate” provisions can be meaningful in some situations:

Documentation.  The transaction will be documented by counsel to the Company with the documents containing the provisions described above and consisting of the following:

• Note Purchase Agreement
• Convertible Promissory Note(s)
• Investor Questionnaire

Why is this of interest to anyone other than the lawyers? First, it’s worth noting that we’re proposing to have Company counsel draft the documents. This is the norm for West Coast deals, but it’s often the case in dealing with East Coast investors (more commonly for VC financing rounds rather than angel seed rounds) that the lead investor wants its lawyers to draft the documents.

I have to admit my West Coast bias here, having learned the ropes at a large Silicon Valley firm; it makes little sense to me to have investor’s counsel drafting documents that are woven into the fabric of a company’s governance and capital structure, with which the company will likely be living for years after the investment is made. Regardless, assuming both parties are well represented by competent legal counsel, the documents will end up in good shape, so to me it’s primarily an issue of efficiency. A firm that cranks out these deals in large numbers is likely to be using fairly standardized documents that require relatively few changes to reflect the terms of any particular transaction.

The Note Purchase Agreement and Convertible Promissory Note are essential documents for any convertible note financing. Returning to our sample term sheet:

Note Purchase Agreement. The Notes will be issued pursuant to a definitive Note Purchase Agreement containing customary covenants, representations and warranties of the Company.

The purchase agreement may be a single-use document covering a single investor’s note, but more commonly it contemplates a series of identical notes to be issued to multiple investors within some period of time and/or up to a specified dollar limit comprising what the Company views to be the same “round.” Often this proves to be a moving target, and there’s no reason the agreement can’t be amended to increase the size or lengthen the time period, provided the necessary consents are gathered. (See discussion of amendments below.) The purchase agreement sets forth the terms of the investment, often including the mandatory and voluntary conversion provisions we’ve covered in this series, as well as customary representations and warranties of the Company and the investors.

On the Company side, this document often becomes the impetus behind a startup’s need to catch up on deferred “corporate housekeeping.” When a company is asked to make legal representations about its standing, prior equity and debt issuances, corporate governance formalities and so forth, if taken seriously, matters of “deferred maintenance” often surface and must be handled before closing.  Common examples include papering founders’ stock issuances, catching up on Board minutes, and ensuring that all members of the team have entered into IP agreements with the company assigning rights in their work to the startup.

On the investor side, representations and warranties in the purchase agreement primarily relate to securities law compliance. Without going down the deep rat hole of securities regulation, suffice it to say that the Company risks being held liable for violating securities laws unless it qualifies for applicable exemptions that are tied to the nature, knowledge and intentions of the investors. In most VC and angel financing transactions, there are three pieces to this puzzle:

1. The Company requires investors to make certain representations in the purchase agreement (e.g., that the securities are being purchased only for investment rather than resale);
2. investors are asked to complete an investor questionnaire substantiating that they meet the net worth, income or other requirements necessary to qualify as “accredited investors” under the Securities Act; and
3. the Company will make one or more securities filings at the state and federal levels reporting the transaction as exempt, based on this information. It’s common to skip the questionnaire when dealing with “known quantity” institutional investors provided they are willing to make the representations in the purchase agreement.

Next section:

Amendment. The Majority Holders may amend or waive any provision of the Notes and such amendment or waiver shall be binding on all Note Holders.

This is a subject touched upon in earlier discussions of voluntary conversion upon maturity of the Notes or upon a change of control (i.e., merger or acquisition). Broadened to cover any kind of amendment or waiver that might apply to the Notes, some investors understandably object to having their own rights compromised by allowing them to be outvoted in an action that could impair the value of their investment. In practice, this sort of provision usually prevails because:

• Holders of the same class of securities (convertible notes in this case) usually have aligned interests;
• Relatively small investors are accustomed to “piggybacking” on the terms negotiated by large/lead investors in venture financings generally; and
• Having this kind of provision is important both to the Company (for reasons we’ve discussed) and to the largest or lead investor(s), who may be as reluctant as the Company to involve too many cooks in the kitchen if things get complicated and need to be renegotiated or restructured down the line.

Finally, we come to everyone’s least favorite provision:

Expenses. The Company and the Investors will each bear their own legal and other expenses with respect to the transactions contemplated herein.

In most friends-and-family or angel seed financing rounds, the parties agree to bear their own legal expenses. Many angels are comfortable enough to work without legal counsel in deals that follow the established patterns they’ve seen many times before, whether structured as convertible debt or preferred stock. By contrast, VCs usually involve legal counsel, given the larger amount of capital put at risk in any one investment, and typically ask the Company to pay or reimburse the fees of investors’ counsel out of the proceeds of the financing.

I’ll discuss some of the pros and cons of different deal structures, more recent innovations such as Series Seed documents, and other variations in future posts.  I hope you’ve found this overview to be informative and would love to hear from entrepreneurs or investors with any questions or comments.

 

 

Amid the remembrance of the September 11, 2001 terrorist attacks, much was made of the voluminous 9/11 Commission report, which described in excruciating detail countless ways in which the United States homeland security and emergency response infrastructure failed to respond adequately to a disaster of unprecedented proportions.  The “system” as it existed at the time broke down, with every point of failure costing innocent lives.  The lesson of the report was clear:  Preparation is everything when disaster strikes, and we as a nation were caught woefully unprepared to deal with a large-scale terrorist attack.  This principle is no less true of businesses than government agencies; particularly in the decade following 9/11, large corporations have made it a priority to invest considerable resources in disaster recovery plans, crisis manuals, business interruption insurance and so forth.

There are many kinds of business crises beyond the natural disasters and acts of terrorism that come to mind.  Consider the far less serious, but still newsworthy, disaster that befell startup Airbnb this summer.  A darling of the tech startup community, reportedly valued at more than $1 billion with investors including Greylock Partners, Sequoia Capital, Andreessen Horowitz and DST Global, Airbnb is an online “marketplace or spaces” that facilitates short-term rental of properties such as members’ homes or apartments.  The incident, involving a woman “EJ” whose apartment was ransacked by short-term tenants who booked a stay through Airbnb, was promptly christened “Ransackgate.”  The company was savaged by critics for its initial mishandling of the incident; reportedly, she got little response or assistance until she published a blog post on the subject, which spread virally and became a serious embarrassment to the company.  (I couldn’t resist calling the company “AirbnbB&E” after that—look it up.)  Even then, some of the responses appeared to focus on silencing the victim and denying responsibility.

How could such a well-regarded, highly successful startup be so inept in its response to an entirely foreseeable customer risk/abuse incident that was guaranteed to happen sooner or later?  The answer, I believe, lies in the “echo chamber” nature of Silicon Valley, early adopters, the startup community and the tech business press.  Much has been written about the cooperative nature of Valley culture, and Airbnb itself was an outgrowth of the idealistic “couch surfing” movement.

 As with almost any online community, the well-meaning early adopters arrive first, and if all goes well, a culture of respect evolves (together with some snark and skepticism) that keeps behavior within relatively civilized boundaries.  The trouble comes when a site becomes wildly successful, going from 1,000 closed beta members to 100,000 or 1,000,000 users.  As it grows, any service will come to resemble a diverse cross-section of the general population, with the full range of human conduct misconduct represented.  I wrote about this phenomenon in a previous blog post, “If You Build It They Will Abuse It,” which bears revisiting in the wake of Ransackgate.

Why wasn’t Airbnb better equipped to respond swiftly and effectively to the incident?  The primary answer, in my view, lies in the vastly divergent cultures of startups vs. established businesses.  A startup is in the business of creating value from nothing – or, as Steve Blank describes it, “searching for a repeatable and scalable business model.”  Large companies focus on protecting and expanding upon their existing successful business.  A startup that has found product-market fit needs to transition quickly into that category, with operational excellence taking precedence over bursts of creative brilliance, because it has much to lose.  The very best startups, such as Facebook, have been able to make this transition gracefully even without changing CEOs.  I give Mark Zuckerberg tremendous credit for that accomplishment, together with Sheryl Sandberg and the rest of Facebook’s senior team.

We lawyers are often rightly criticized for being excessively conservative and risk averse in pointing out everything that could go wrong.  In the startup world, seeking to eliminate all risk is a hallmark of big company or big firm lawyers who “don’t get it.”  When speed of execution and efficiency are paramount, the eternal grind of that style of lawyering is excruciating.  Yet when it comes to risk management of user communities – content, community or commerce – failure to be looking around the curve ahead can result in pretty ugly crashes.

As it gains traction, every social or consumer Internet startup should pause at some point and take stock of risk and abuse issues, viewed as broadly as possible.  It doesn’t necessarily mean hiring an expensive consultant (or reasonably priced Web 2.0 startup lawyer) with deep expertise in the area, but applying a mindset of pessimism and paranoia is helpful for purposes of this thought exercise. 

 Essentially, get inside the bad guy’s head.  Here are some concrete recommendations:

1. Make a list of the most obvious ways in which someone could abuse the service – either with a specific objective in mind (e.g., Nigerian money transfer scam) or out of simple malice or mischief.
2. Compare notes with the rest of the team, and with external experts if possible, to see what you might be missing.  Sometimes the elephant is right there in the room with you.
3. Recognize that the nature of the user base will change over time, and you will become a victim of your own success.  Resign yourself to the notion that almost every bad thing you can think of will occur sooner or later if the service scales to the point of hundreds of thousands or millions of users.  This is one time the entrepreneur’s unflagging optimism is not helpful, and is actually downright counterproductive.
4. Create a feedback loop between users reporting misconduct, community managers or moderators, and senior management to stay abreast of abuse issues as they grow and morph over time.
5. Empower users to spot and report issues of all kinds.  The greatest strength of consumer Internet businesses is the sheer quantity of information that can be collected, either using analytics or through voluntary reporting by users who genuinely care about the community.  Consider “deputizing” some of them with limited administrator powers.  Perhaps most importantly, listen.
6. Crucially, prepare some kind of crisis management plan to keep in your back pocket ahead of time.  Speed of response can be critical when a PR disaster like “Ransackgate” strikes.  If nothing else, determine who is on the core team with clear authority to respond to any ugly abuse incidents.  Most companies caught flat-footed do one of two things:  Say too much or too little.  Too little usually results from well-intentioned legal advice “not to admit anything” in the event of litigation.  Often a company will lose more as a result of reputational damage than it would spend having to defend or settle a lawsuit.
7. In the age of social media, word of this kind of incident travels lightning fast.  With a prompt, helpful response, that can be turned to your advantage.  Take a look at Better Business Bureau complaints and notice how many incidents are ultimately resolved to the customer’s satisfaction.  That’s generally a business’s attempt to preserve its good BBB rating.  Any business with a large number of customers will have some who are dissatisfied; handling them in the right way can turn them from vocal critics who damage your brand to some of its most ardent cheerleaders.
8. Plan more specific responses to the single most likely (or better yet, top 3 or top 5) kind of abuse or fraud incidents based on the unique nature of your business.  Large companies sometimes sketch these out in hundred-page disaster manuals.  That’s overkill for a startup with limited resources, but recognizing the need to come out with an immediate statement and involve the right people is a big head start.
9. Tone is everything.  Showing empathy, admitting that nobody is perfect, expressing an earnest desire to make things right – and actually taking care of the squeaky wheel to his or her satisfaction – speaks volumes about a company and how much it cares about its customers.
10. Know where to draw boundaries.  No company will make 100% of its customers happy 100% of the time. Develop a think skin regarding (a) garden-variety commercial disputes, which are devoid of news value and therefore won’t have “legs” in the media, and (b) genuine nutcases, of which there will be plenty.

To its credit, Airbnb came out with a long list of improvements in the wake of “Ransackgate,” but only after sustaining serious damage to its reputation that undermined confidence in its entire business model.  More than fifteen years into the consumer Internet revolution, there is no excuse for not foreseeing and preparing for the kind of incident that major players in online dating, auctions and similar businesses have been dealing with since the mid-1990s.  Financial, legal and reputational consequences await those who are reactive rather than proactive—and competitors will take advantage of each misstep.  (As Michael Arrington wrote in TechCrunch, in Airbnb’s case, “The hotel lobbyists couldn’t ask for anything more.”)