William Carleton, Counselor @ Law

Series Seed, everywhere

Yesterday I was critical of a template inventions assignment agreement, and suggested that state-by-state differences make standardizing employment documents difficult to pull off.

I want to circle back to Ted Wang's Series Seed Equity financing documents today, by way of being positive of the prospects for document standardization in other key areas.

The Series Seed templates are good and they're gaining traction. The AngelList Docs service offers them in a modified version, and it looks like a new, 3.0 "official" version of Series Seed takes advantage of and adopts those AngelList mods.

What's more, the Series Seed document repository has moved to GitHub. I'll bet this move will facilitate not only better dissemination, but communal iteration of the templates, too.

Docracy has posted the Series Seed 3.0 documents as well.

I use and recommend the Series Seed documents for seed financings where the parties agree to price the deal. And I'm noticing and hearing of other law firms that are using the vehicle.

What makes standardization viable in this area, compared to documents dealing with employer/employee rights and relationships?

For one thing, on core, corporate organizational issues, on relationships among companies, boards and shareholders, lawyers across the country can standardize against Delaware law.

Though you never bypass state anti-fraud authority, it also helps that virtually all seed financings are structured to meet the standard, federal 506 securities registration exemption.

In short, the law you are standardizing around is the same as to most (all?) of the key issues to address in an angel seed financing.

Do legal costs for a seed financing plummet - can a lawyer meet Fred Wilson's $5,000 seed financing legal challenge - using the Series Seed templates?

Yes and no.

AngelList says the Wilson Sonsini firm will that's isn't a company using the Series Seed documents in a seed financing, for free. But you have to be a client of that firm, and there is probably some fine print.

My fine print is that first time entrepreneurs can easily overlook the distinction between work to organize the company, and the financing transaction - they often blend the two efforts into the same project ("legal stuff").

In other words, if you are doing foundational things - like getting inventions assignments in place for founders! - at the same time, you won't get the seed financing done for under $5,000 in legal fees (unless you're working with one of those firms that provides start up services for free).

More Seattle self-reflection

From time to time, John Cook will post what amounts to a "state of the health of startup seed financing in Seattle" address.

I think he started doing this back at the Seattle P-I, then with TechFlash; certainly, the tradition is already now well established on GeekWire.

John's latest "address," Why this entrepreneur is moving to Vegas, and what it means for the Seattle scene, ran yesterday on GeekWire, and I thought it was the most heartfelt of John's calls for Seattle to step it up a notch:

"One of the rubs on Seattle is that the pool of angel investors is not that deep — a perplexing issue given the huge pockets of wealth created in the city in the past 25 years....

"But there’s no brand name angel investor with the drawing power of [Las Vegas-based Tony] Hsieh or the connections of Ron Conway or the rabble rousing of Dave McClure. Seattle needs some of that flowing into the startup community at heavier doses than is currently being administered, if it wants to establish itself as a go-to startup city."

What makes this post especially interesting is the response it drew from Bill Bryant, a mainstay of the Seattle startup investment scene (and someone whom others might put on a list of Seattle brand name angels that John suggests is blank).

"I do agree with John that we could use another 100 angel investors," Bryant commented, "but seriously, let's stop ripping on how bad Seattle is as a startup hub. Its wearisome." Bill draws no inference from the fact that an entrepreneur has left Seattle for Las Vegas, other than that entrepreneur's startup is probably not worth backing.

My own perspective is likely somewhere between John's and Bill's. I think there are many angels in Seattle who don't draw attention to themselves as such; and I think much of the wealth created by the larger tech ecosystem does get channeled into startup activity, of the self-funded variety.

But there's no question first time entrepreneurs without deep connections to (i.e., employment history in) some of the established tech giants find it much more difficult to find seed money in Seattle.

In the comment thread, John says he thinks "real impact could be made with $50M to $100M," presumably meaning a seed financing fund or just some kind of program or pool focused on pre-revenue seeding of startups.

Photo: four12 / Flickr.

Which Series Seed terms are disadvantageous to investors? Should an investor try to modify these terms?

The following is the answer I gave on Quora this past weekend, to two questions put to me by Samuel Chenard. His questions are: "Which Series Seed terms are disadvantageous to investors? Should an investor try to modify these terms?"

There are no Series Seed terms that are disadvantageous to investors (plural). For a round of seed financing, the Series Seed terms are investor friendly, and they spare the company and the investors the cost and effort of negotiating customized terms.

Now, your second question, "should an investor," singular, "try to modify these terms," brings a different perspective to the subject.

If you're an individual investor, participating in the Series Seed round with other investors, then you do have an personal stake in where the definition of "Major Investor" is set. Let's say you mean to invest $25,000 in the round, but the term sheet says you need to invest $50,000 to be a "Major Investor." You would do well try to modify that term, to lower the threshold to the amount you mean to invest. The reason is that "Major Investors," under the Series Seed documents, are entitled to participation rights in subsequent financings, as well as information rights.

Another term that is arguably disadvantageous to an individual investor, singular, who does not control the Series Seed as a class, is a drag along covenant that is in the Series Seed documents. This covenant requires the individual investor to vote in favor of a sale, if a majority of the common, the Series Seed, and the company's board approve the sale. This covenant makes it harder for a minority shareholder to block a sale she does not want. On the other hand, I would argue that the drag along covenant is probably, in most cases, protective of all investors, insofar as it helps ensure that a transaction can occur, if in fact a majority of the Series Seed round is in favor of it.

Photo: "Sweet Bay Seed" by Phlora / Flickr.

To generally solicit, or not to generally solicit?

It's been a week now since the SEC proposed rules to lift the ban on general solicitation and general advertising in Rule 506 offerings, as mandated by the JOBS Act.

A lot was at stake. I had said the rules could prove disastrous to angel investing, should the SEC specify methods of "verification" of accredited status that were too onerous for companies, or too invasive of investors' privacy.

But disaster didn't happen.

The Commission proposed that existing 506 be preserved, meaning that those companies comfortable with the process as it works today could continue under that process (without, of course, generally soliciting or generally advertising). That's a good thing. It will give the ecosystem as a whole more time to transition.

And, rather than mandate particular methods of verification (as the language of the JOBS Act arguably contemplates), the Commission instead said issuers should "take reasonable steps to verify" accredited status. What's reasonable will depend on the circumstances of the offering, the investors involved, the means of solicitation, the amounts invested, and other factors.

Some lawyers are thinking that companies and investors would be better served to have safe harbors, clearly spelled-out methods to follow to ensure that the issuer will be deemed to have "taken reasonable steps." I'll bet we see that point repeated in the comments on the proposed rules.

Other fresh, current reading on what the SEC did last week:

• Be sure to read this memo from the Montgomery & Hansen law firm. It is the single best summary and analysis I've read.
• My buddy and StartupTriviaDaily.com partner Joe Wallin covers the topic on his blog as well. His most recent post takes that view that general solicitation in 506 offerings will be good for startups.
• Securities and hedge fund attorney John Myer blogs that the SEC let us down by refusing to define verification steps that will be deemed reasonable.

Convertible Notes Without the Notes

Yokum Taku has designed a new security for tech startup financing, something with the positive features of a convertible note, but without the problems presented when a new and unprofitable venture issues debt.

The thinking is: convertible notes do a good, entrepreneur-friendly job of deferring the pricing of an equity round - but they also carry a promise to repay principal by a deadline; and, as debt instruments, convertible notes must accrue interest.

Yokum's solution is a security that, in the ideal case, converts into preferred stock (if and when a "Qualified Financing" is obtained) or, in other cases (such as change of control), into common stock. All just as a convertible note might. And, like a note, the "no hassle" convertible security can convert at a discount or at discounts weighted differently for different investors.

The model "Convertible Security" Yokum has published also incorporates that clever feature of more sophisticated note templates, whereby the holder of the convertible instrument gets no more preferred equity for her investment than does the new money in the Qualified Financing, and takes her discount in the form of common shares.

Looking through the template documents Yokum put together to illustrate the debt-free convertible concept, I wondered where the corresponding charter provisions were. Shouldn't there be something authorizing and defining the rights and preferences of this convertible security? I asked Yokum about this in a Disqus thread, and he explained: "The concept is that the convertible security is a contract -- like a warrant."

That makes sense.

For entrepreneurs with the leverage, or in seed deals where the angels are truly indifferent to downside protection, a convertible instrument that raises cash but leaves no residue of debt is clever.

Some angels will want the debt feature. It isn't that such angels would ever expect (or desire) a note issued in a seed financing to be repaid in cash. But having a note means the investor has a kind of liquidation preference - they will receive value, if any, from the liquidating company's assets, before the founders do.

Debt with a maturity date also gives investors the ability to say, time's up, time to re-capitalize, give way, or let go. But here we come full circle. It is the very purpose of Yokum's new security to foreclose the possibility of foreclosure.

Trends in Angel Seed Financings

Great, current, on-the-ground intelligence re: current trends in seed financing, shared day before yesterday by angel investor Geoff Entress and deal attorney Charles Carter at an LSI seminar in Seattle.

The headline news: convertible notes have returned to Seattle.

After the turn of the century, angels in Seattle implemented their increasingly clear preference for priced rounds. The problem with notes was that the invested company's success ended up punishing the earliest investors. When the note later converted at a high valuation, the note holders were in effect not rewarded for exposing themselves to the earlier, higher risk. The risk could be compensated for, to some extent, by warrants, a conversion discount, or a combination of the two. But pricing seed rounds wholly mitigated the possibility that the company would ride the notes into a future equity round at a huge valuation.

What makes notes more palatable and viable today, Entress explained, are the new norm that notes come with valuation caps. That's a method by which the startup agrees that the note won't be converted at too high a later valuation. In essence, the investor gets the benefit of the conversion at the cap, or the actual price of the later equity round, whichever is lower. If you set the cap where you would have priced an equity seed round anyway, the investor is arguably no worse off accepting a note.

What's happening in Seattle is reflective of a broader trend on the West Coast. Carter cited a Fenwick seed financing survey that reports convertible notes accounted for 41% of seed transactions in 2011, up 10 percentage points from 2010.

But the new norm is in flux.

The caps on seed round notes are rising, driven by the competition for deals in Silicon Valley. Whereas the median cap was $4 million in 2010, it rose to $7.5 million in 2011. In the Valley, Carter said, some deals have no cap at all. To the extent that Seattle startups include California in their fundraising efforts, these trends necessarily impact Seattle angels.

Photo: "caps (some decorated) of graduates at the Unversity of Nebraska - Lincoln" by John Walker / Flickr.

Financing, Fundraising, Pre-Selling Are Starting to Blur...

"Change is coming," tweeted @EricKoester on Valentine's Day this week, "and it is called @Kickstarter."

Eric was referring to the phenomenal story of game developer Double Fine Adventure, which appears to have raised funds equating to or surpassing a very fine seed round in a ridiculously short amount of time (less than 24 hours?). As of this writing, Kickstarter logs 53,606 backers pledging an aggregate $1.8 million.

What do you get for your pledge?

Not stock. But stuff, access, keys, soundtracks, your portrait by the artists, lunch with the founders, all depending on your pledge level. Oh yes, and the finished game, too.

There's a lot to sort out here. (See this discussion on Fred Wilson's blog, where said sorting is underway.) Eric's tweet grabbed me because he seemed to be saying - or, I interpreted him to be saying - hey, this has implications for startup seed financing.

It's a reminder, as we watch some kind of crowdfunding securities law exemption develop in Congress, that there are other things to sell besides a share in the profits of a business. Does it mean that selling shares in the profits of a business are not interesting? Certainly not. But add another means to bypassing equity financing at the outset. This is not your grandfather's bootstrapping.