{"id":491,"date":"2016-08-03T19:32:00","date_gmt":"2016-08-03T22:32:00","guid":{"rendered":"https:\/\/www.hublegal.cl\/?p=491"},"modified":"2021-10-26T19:34:31","modified_gmt":"2021-10-26T22:34:31","slug":"abstracts-on-the-legals-of-funding-from-paul-graham-part-1","status":"publish","type":"post","link":"https:\/\/www.hublegal.cl\/en\/2016\/08\/03\/abstracts-on-the-legals-of-funding-from-paul-graham-part-1\/","title":{"rendered":"Abstracts on the \u201cLegals\u201d of Funding from Paul Graham (Part 1)"},"content":{"rendered":"

Paul Graham<\/a>, Founder of Y Combinator<\/a> wrote a very good post on 2005 on How to Fund a Startup?<\/p>\n\n\n\n

In this opportunity we present here all the paragraphs of the post that refer to legal issues related with the funding process, so readers can have a quick idea on the matter. But for any founder who is planning to launch his startup or has recently start working on it, I strongly recommend to read the\u00a0whole post<\/a>, because is very practical and comprehensive on the subject. Every time yo see (\u2026) it indicates the rest of the post.<\/p>\n\n\n\n

Friends and Family<\/strong><\/p>\n\n\n\n

The advantage of raising money from friends and family is that they\u2019re easy to find. You already know them. There are three main disadvantages: you mix together your business and personal life; they will probably not be as well connected as angels or venture firms; and they may not be accredited investors, which could complicate your life later.<\/p>\n\n\n\n

The SEC defines an \u201caccredited investor\u201d as someone with over a million dollars in liquid assets or an income of over $200,000 a year. The regulatory burden is much lower if a company\u2019s shareholders are all accredited investors. Once you take money from the general public you\u2019re more restricted in what you can do.<\/p>\n\n\n\n

(\u2026)<\/p>\n\n\n\n

A startup\u2019s life will be more complicated, legally, if any of the investors aren\u2019t accredited. In an IPO, it might not merely add expense, but change the outcome. A lawyer I asked about it said:<\/p>\n\n\n\n

When the company goes public, the SEC will carefully study all prior issuances of stock by the company and demand that it take immediate action to cure any past violations of securities laws. Those remedial actions can delay, stall or even kill the IPO.<\/p>\n\n\n\n

Angel Investors<\/strong><\/p>\n\n\n\n

Deal terms with angels vary a lot. There are no generally accepted standards. Sometimes angels\u2019 deal terms are as fearsome as VCs\u2019. Other angels, particularly in the earliest stages, will invest based on a two-page agreement.<\/p>\n\n\n\n

Angels who only invest occasionally may not themselves know what terms they want. They just want to invest in this startup. What kind of anti-dilution protection do they want? Hell if they know. In these situations, the deal terms tend to be random: the angel asks his lawyer to create a vanilla agreement, and the terms end up being whatever the lawyer considers vanilla. Which in practice usually means, whatever existing agreement he finds lying around his firm. (Few legal documents are created from scratch.)<\/p>\n\n\n\n

These heaps o\u2019 boilerplate are a problem for small startups, because they tend to grow into the union of all preceding documents. I know of one startup that got from an angel investor what amounted to a five hundred pound handshake: after deciding to invest, the angel presented them with a 70-page agreement. The startup didn\u2019t have enough money to pay a lawyer even to read it, let alone negotiate the terms, so the deal fell through.<\/p>\n\n\n\n

One solution to this problem would be to have the startup\u2019s lawyer produce the agreement, instead of the angel\u2019s. Some angels might balk at this, but others would probably welcome it.<\/p>\n\n\n\n

Inexperienced angels often get cold feet when the time comes to write that big check. In our startup, one of the two angels in the initial round took months to pay us, and only did after repeated nagging from our lawyer, who was also, fortunately, his lawyer.<\/p>\n\n\n\n

Seed Funding Firms<\/strong><\/p>\n\n\n\n

The fact that seed firms are companies also means the investment process is more standardized. (This is generally true with angel groups too.) Seed firms will probably have set deal terms they use for every startup they fund. The fact that the deal terms are standard doesn\u2019t mean they\u2019re favorable to you, but if other startups have signed the same agreements and things went well for them, it\u2019s a sign the terms are reasonable.<\/p>\n\n\n\n

Venture Capital Funds<\/strong><\/p>\n\n\n\n

VC firms are like seed firms in that they\u2019re actual companies, but they invest other people\u2019s money, and much larger amounts of it. VC investments average several million dollars. So they tend to come later in the life of a startup, are harder to get, and come with tougher terms.<\/p>\n\n\n\n

(\u2026)<\/p>\n\n\n\n

In a sense, the lower-tier VC firms are a bargain for founders. They may not be quite as smart or as well connected as the big-name firms, but they are much hungrier for deals. This means you should be able to get better terms from them.<\/p>\n\n\n\n

Better how? The most obvious is valuation: they\u2019ll take less of your company. But as well as money, there\u2019s power. I think founders will increasingly be able to stay on as CEO, and on terms that will make it fairly hard to fire them later.<\/p>\n\n\n\n

(\u2026)<\/p>\n\n\n\n

For example, lower-tier firms are much more likely to pretend to want to do a deal with you just to lock you up while they decide if they really want to. One experienced CFO said:<\/p>\n\n\n\n

The better ones usually will not give a term sheet unless they really want to do a deal. The second or third tier firms have a much higher break rate\u2014it could be as high as 50%.<\/p>\n\n\n\n

It\u2019s obvious why: the lower-tier firms\u2019 biggest fear, when chance throws them a bone, is that one of the big dogs will notice and take it away. The big dogs don\u2019t have to worry about that.<\/p>\n\n\n\n

Falling victim to this trick could really hurt you. As one VC told me:<\/p>\n\n\n\n

If you were talking to four VCs, told three of them that you accepted a term sheet, and then have to call them back to tell them you were just kidding, you are absolutely damaged goods.<\/p>\n\n\n\n

Here\u2019s a partial solution: when a VC offers you a term sheet, ask how many of their last 10 term sheets turned into deals. This will at least force them to lie outright if they want to mislead you.<\/p>\n\n\n\n

(\u2026)<\/p>\n\n\n\n

Because VCs invest large amounts, the money comes with more restrictions. Most only come into effect if the company gets into trouble. For example, VCs generally write it into the deal that in any sale, they get their investment back first. So if the company gets sold at a low price, the founders could get nothing. Some VCs now require that in any sale they get 4x their investment back before the common stock holders (that is, you) get anything, but this is an abuse that should be resisted.<\/p>\n\n\n\n

Another difference with large investments is that the founders are usually required to accept \u201cvesting\u201d\u2014to surrender their stock and earn it back over the next 4-5 years. VCs don\u2019t want to invest millions in a company the founders could just walk away from. Financially, vesting has little effect, but in some situations it could mean founders will have less power. If VCs got de facto control of the company and fired one of the founders, he\u2019d lose any unvested stock unless there was specific protection against this. So vesting would in that situation force founders to toe the line.<\/p>\n\n\n\n

The most noticeable change when a startup takes serious funding is that the founders will no longer have complete control. Ten years ago VCs used to insist that founders step down as CEO and hand the job over to a business guy they supplied. This is less the rule now, partly because the disasters of the Bubble showed that generic business guys don\u2019t make such great CEOs.<\/p>\n\n\n\n

But while founders will increasingly be able to stay on as CEO, they\u2019ll have to cede some power, because the board of directors will become more powerful. In the seed stage, the board is generally a formality; if you want to talk to the other board members, you just yell into the next room. This stops with VC-scale money. In a typical VC funding deal, the board of directors might be composed of two VCs, two founders, and one outside person acceptable to both. The board will have ultimate power, which means the founders now have to convince instead of commanding.<\/p>\n\n\n\n

(\u2026)<\/p>\n\n\n\n

It is, unfortunately, common for VCs to put terms in an agreement whose consequences surprise founders later, and also common for VCs to defend things they do by saying that they\u2019re standard in the industry. Standard, schmandard; the whole industry is only a few decades old, and rapidly evolving. The concept of \u201cstandard\u201d is a useful one when you\u2019re operating on a small scale (Y Combinator uses identical terms for every deal because for tiny seed-stage investments it\u2019s not worth the overhead of negotiating individual deals), but it doesn\u2019t apply at the VC level. On that scale, every negotiation is unique.<\/p>\n\n\n\n

Keep reading the Part 2<\/a>.<\/p>\n\n\n\n

Abstracts from Paul Graham.<\/p>\n\n\n\n

Picture: Luis Poletti (CC0)<\/p>","protected":false},"excerpt":{"rendered":"

Paul Graham, Founder of\u00a0Y Combinator\u00a0wrote a very good\u00a0post on 2005 on How to Fund a Startup?<\/p>","protected":false},"author":2,"featured_media":492,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_et_pb_use_builder":"off","_et_pb_old_content":"","_et_gb_content_width":"","inline_featured_image":false,"footnotes":""},"categories":[1],"tags":[],"class_list":["post-491","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-sin-categoria"],"_links":{"self":[{"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/posts\/491","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/comments?post=491"}],"version-history":[{"count":1,"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/posts\/491\/revisions"}],"predecessor-version":[{"id":493,"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/posts\/491\/revisions\/493"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/media\/492"}],"wp:attachment":[{"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/media?parent=491"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/categories?post=491"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.hublegal.cl\/en\/wp-json\/wp\/v2\/tags?post=491"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}