The Role of a Lawyer + Fundraising Flashcards
How should I think about engaging with lawyers to help me?
Lawyers have important and complex roles in the startup world. Many founders don’t make effective use of legal counsel, but at their best lawyers are trusted advisors who accelerate the startup journey and create significant value.
They have excellent pattern-matching skills, understand market terms and mechanics, and will (by law) keep your communications confidential. They can answer “dumb” questions, private questions, and hard questions. They are often the best weapon against aggressive VCs, vendors, or customers, who oftentimes are far more sophisticated than the founders.
Legal work for early-stage companies (let’s use the following milestones as a rule of thumb: $0 - $2,000,000 raised, $0 - $25,000 MRR, 0 - 10,000 users, team of 1 – 10) is generally an exercise in avoiding obvious mistakes. Has the company issued the appropriate types of equity in appropriate amounts on appropriate terms? Were 83(b) elections filed? Has everyone signed an intellectual property assignment agreement? Has all investment been appropriately documented, and completed on reasonable terms?
For companies that operate in highly-regulated spaces (this might include anything from biotech to aerospace to fintech), having excellent legal advice early on creates significant value.
A founder must learn how much to invest in legal advice, and when. This is part of a broader skill set of engaging with expert third-party advisors to get needed help at critical moments (other examples might include hiring a design firm for branding exploration or a dev shop for product development). We endeavor to outline the contours of some of these legal decisions, options, and costs in this resource.
What is a law firm’s business model?
Law firms are run by the partnership, typically delegating strategy and operations to a managing partner and various committees. Some partners also hold various managerial roles such as overseeing timekeeping, client development, or industry-focused groups within the firm. Associates are hired by the firm to do most of the day-to-day legal work, such as drafting documents for clients. Junior associates work under senior associates, and all associates work under the direction of a partner or partners. Paralegals help all attorneys with tasks like research and drafting documents; they can do some legal work under the paralegal license.
SAFEs: Most Favored Nations
A SAFE with a “Most Favored Nations” clause stipulates that if a subsequent investor invests on a SAFE with more favorable terms (e.g., a higher discount or lower valuation cap), the earlier SAFEholder has the option to receive the benefit of those terms. It is a reasonable protection sometimes requested by sophisticated investors, particularly if they are one of the first checks in and it’s unclear whether the company will have to increase the discount or lower the valuation cap with future investors in order to meet its fundraising needs.
Pro Rata Rights
Some investors, in conjunction with SAFE or equity financing, will ask for Pro Rata rights, often memorialized in a separate contract or side letter. Pro Rata rights give the investor the rights to invest additional capital at future fundraises in order to maintain their percentage ownership in a company. For example, if an investor with Pro Rata rights owns 5% of the company, and the company is raising $10,000,000 in new funding, the investor would have the right to purchase up to 5% of the new round ($500,000).
Sometimes Pro Rata rights can cause turbulence with new investors because the new investors will receive less allocation than they hoped for. However, this is rarely a serious sticking point unless Pro Rata rights amount to a very significant proportion (e.g., 25%) of the new round.
SAFEs: Discount
A discount is the discount at which the SAFE investment will convert in the next equity round as compared to the price paid by the equity investors. SAFEs either have a discount, valuation cap, both, or neither. SAFEs with a valuation cap or discount plus valuation cap are the most common forms of SAFE.
Example: NewCo raises $1,000,000 via SAFE with a 20% discount.
If NewCo raises future equity capital at a $9,000,000 post-money valuation, the SAFEs will convert at a $7,200,000 valuation ($9,000,000 * [100% - 20%] ), meaning the SAFE investors receive 13.89% of NewCo in the same type of equity sold at the equity round.
If NewCo raises future equity capital at an $20,000,000 post-money valuation, the SAFEs will convert at a $16,000,000 valuation ($20,000,000 * [100% - 20%] ), meaning the SAFE investors receive 6.25% of NewCo in the same type of equity sold at the equity round. Basically, the SAFE investors get twice as much equity as they would have if they’d invested at the equity round.
Discounts are especially fair & useful if a company wants to collect one-off investments before an upcoming funding round. For example, let’s say NewCo raises $1,000,000 on SAFEs at a $10,000,000 valuation cap then 12 months later begins moving toward its Series A. Let’s say it would like to take on a little bit more capital in the meantime, but that the Series A might close in the near future, perhaps 3 - 4 months. Rather than using SAFEs with a valuation cap, the parties might defer the valuation of the company to the incoming Series A investors, and simply use a 20% discount. This will give the investors a good deal as compared to the Series A investors, but will avoid the thorny questions and optics challenges around choosing a valuation cap with the next round of financing looming.
SAFEs: Valuation Cap
A valuation cap is the highest price at which the SAFE investment will convert in the next equity round. SAFEs either have a discount, valuation cap, both, or neither. SAFEs with a valuation cap or discount + valuation cap are the most common forms of SAFE.
Example: NewCo raises $1,000,000 via SAFE with a $10,000,000 valuation cap.
If NewCo raises future equity capital at a $9,000,000 post-money valuation, the SAFEs will convert at the $9,000,000 valuation, meaning the SAFE investors receive 11.11% of NewCo in the same type of equity sold at the equity round.
If NewCo raises future equity capital at an $20,000,000 post-money valuation, the SAFEs will convert at the $10,000,000 valuation cap, meaning the SAFE investors receive 10% of NewCo in the same type of equity sold at the equity round. Basically, the SAFE investors get twice as much equity as they would have if they’d invested at the equity round.
SAFEs: In general
A Simple Agreement for Future Equity (SAFE) is an investment instrument that converts into the same class of stock that’s sold in the next equity fundraise. It was developed by YCombinator as a quick, legal-light way to raise money from angel investors and small VC funds without having to go through the process of an equity fundraise, which requires hundreds of pages of contracts and costs tens of thousands of dollars in legal fees. SAFEs made life much easier for investors writing checks in the $10,000 - $250,000 range, but, as the SAFE has become more widely accepted, investors have become comfortable investing larger and larger sums via the SAFE (in some cases several $million). Most early-stage founders will raise at least one round via SAFE before pursuing an equity fundraise.
Because they are convertible equity, SAFE notes are not immediately dilutive, that is, the SAFE investor does not receive stock (which dilutes the other stockholders) until the first equity round. So, founders who own 100% of the stock in their company still own 100% of the stock after closing, for example, $1,000,000 in SAFE on a $10,000,000 valuation cap.
But beware: Total dilution upon SAFE conversion can sometimes catch founders by surprise. To continue the example above, let’s say that the founders go on to raise $3,000,000 in Series Seed Preferred Stock at a $15,000,000 post-money valuation and create a 10% option pool.
The capitalization of the company would be as follows:
$4,000,000 raised (SAFE + Series Seed)
60% owned by founders
10% Series Seed Preferred Stock held by SAFE investors after SAFE conversion
$1,000,000 / $10,000,000 SAFE valuation cap = 10%
20% Series Seed Preferred Stock held by Seed investors
$3,000,000 invested / $15,000,000 post-money valuation = 20%
10% option pool
Sometimes founders raise money via multiple rounds of SAFEs with increasing valuation caps as the company achieves certain milestones (product launch, letters of intent with future customers, user growth, revenue growth, licensure or regulatory approval, etc.).
Note that, while a SAFE investment does not formally price the company, founders should consult an experienced corporate startup attorney when granting common stock or options to employees after SAFE investment because the company may need to seek a new 409A valuation to update the purchase or exercise price of stock or stock options, as applicable.
