In part 1 of this series, I discussed the importance of setting a good legal groundwork for an early-stage company, focusing on the areas of intellectual property, capital raising and employee relations. This post elaborates on issues encountered by start-ups in the context of financing efforts. Note that both posts are written from the perspective of “exit preparedness”; that is, common issues are canvassed that can either pose difficulty or create unexpected costs in the context of an exit. But the ideas discussed shouldn’t necessarily be limited to this perspective; rather, they are business and governance points that are intended to create value by preserving it.
Similarly, “exits” need not be considered strictly in terms of a buyout. Often, the very same issues (and often far more numerous issues) arise in the context of a public offering, and even more often, in the context of further rounds of financing. In this way, financing rounds are very similar to dating – a very bad first date doesn’t bode too well for a second (except that, in a twist worthy of a good horror film, all your subsequent dating hopefuls will know pretty much everything about that one disastrous date you went on).
Keep it simple
The adage that “less is more” is surprisingly apt in the circumstances of an early stage company. The importance of “keeping your house clean” cannot be understated, especially in the earliest stages of a company’s life, when the first rounds of financing occur. Not surprisingly, the “keep it simple” principle is often cited to start-ups by experienced angels. Until recently, it seemed that silicon valley angels were much more willing to follow this principle than their Canadian counterparts, but the seed capital market in large innovation hubs seems to be improving as it expands.
It is important to clarify what the principle is getting at. Crucially, remember what seed investments are and what they are intended to accomplish. Every time legal counsel is called on by a start-up looking for help with a seed investment, it is capital that is really needed and it is needed really fast. Often, seed financing is a lifeline for an idea. In hindsight, many ideas turn out to be not so great. Angels often lose their money. And this is normal. However, this truism is often lost on less experienced financiers who are used to more traditional investments.
Thus, it is important to understand the inherent risk in a seed investment. Once the gravity of the risk is accepted, it is easier for an investor to understand what is and what is not appropriate as terms attaching to their money. When the risk is not appreciated, the terms become cumbersome and may strangle the freedom of the start-up. The seed investment shouldn’t be anyone’s retirement savings, and attempting to make the investment as secure as one would want their retirement savings to be through complex financing structures, multiple share classes and security interests just doesn’t make much sense. It is equivalent to locking a bicycle to a two foot tall pole.
This is not to say that security, multi-class and tax-driven investment structures do not have their place. They definitely do; but more often than not, they are not necessary. And you must remember that certain structures can create difficulties down the road. For example, Canadian corporate statutes require some corporate actions to be approved by class vote. What that means is, the last thing you want to face in the situation where the approval required is a gating item to an exit or a financing lifeline is someone you haven’t talked to in three years that holds less than one per cent of the value of the company but just so happens to hold half of the class “TF.1” shares and an effective veto.
Remember, unlike with your product or technology, the last thing you want venture capital to think when they see your start-up’s books is, “wow”.
Why “simple” doesn’t mean “short”
The flipside to the thinking that “less is more” is that founders and early stage companies often misunderstand it. Simplicity is not measured by the number of words or pages of paper. Is it a good idea to have five classes of shares in your start-up? Most likely not. Should you do your seed round on a napkin? Certainly not in the literal sense, and probably not in the figurative sense, either. Despite that legal counsel are often on the receiving end of complaints regarding the length of subscription agreements and shareholders’ agreements, it is not always beneficial to opt for simpler (or shorter) versions of these agreements.
With subscription documents, the level of complexity is driven in large part by the complexity of applicable securities laws. In Ontario, there are practical limitations on how brief a subscription can be, and taking shortcuts can result in unintended breaches of securities laws that can have costly and unexpected consequences. Because private companies raise financing in reliance on “exemptions” from the onerous requirements of securities laws to prepare a prospectus describing the company, a subscription agreement needs to be sophisticated enough to conform to the requirements for the use of said exemptions, and this is not something can be done on a single page.
Shareholders’ agreements are a subject that perhaps deserves its own post. They can vary in length and complexity, and a shorter agreement is not necessarily better, but not necessarily worse. Modern start-ups have access to various “precedent” shareholders’ agreements disseminated by combinators and industry networks, many of which are very brief. Contrastingly, venture capital investors will require longer, more comprehensive agreements with significant restrictions on the way a company’s business is operated. It is important to understand that these aren’t alternative forms of shareholder agreements (although a comprehensive agreement can be used in the place of a short agreement), but are rather different devices appropriate for specific types of circumstances. As a result, which approach is “simpler” can depend on the circumstances.
In the end, it is important not only to “keep it simple”, but also to keep it right.