Category Archives: equity

The Deflation of Startup Law Continues: Clerky

Almost exactly a year go, I wrote a post (The Economic Deflation of Startup Law) in which I (i) documented how the rapid adoption of technology and standardized contract language in early-stage startup law was dramatically deflating the cost of quality (crappy law has always been affordable) legal services available for founders, and (ii) made a few predictions about how this might affect the segment of the legal market that serves early-stage tech entrepreneurs.

Background

  • Contractual Changes – Standardization of contract language within law firms  & the emergence of universally standardized documents like the NVCA model docs, Series AA, and Techstars Docs, to name a few.
  • Technological Changes – Proofing software, Document Automation, Electronic Closing, etc. – reducing the amount of lawyer time required to complete a formation, bridge financing, etc.
  • Operational Changes – Technology and standardization simplify the labor input required to complete a transaction, allowing less trained, less expensive professionals to perform more of the back-end work.
  • Deal Platforms – Technology is moving from being merely a tool within the traditional law firm process to a bilateral platform that allows parties on both sides of a transaction to close, from beginning to end, with significantly less lawyer time required.
  • Freemium Startup Law – Very early-stage legal work (formations, bridge/seed financings, routine forms), once the bread-and-butter of solo lawyers and boutiques serving entrepreneurs, will no longer support those practices, no matter how efficient they try to be.  The margins will be too thin.  Those attorneys able to serve higher-quality, later-stage clients (those that make it to Series B, C, exit) where legal work will remain much more high-touch, high-margin will dominate the market and cross-subsidize their work for premium early-stage clients.  In short, Startup Law will move closer to a freemium model, where standard work is free (or almost-free) and being able to attract “premium” clients is essential for profitability.

The point of this post is not to comment on the accuracy of my predictions. One year is too short a time-frame to judge (we’ll see in 3-4 more years), though I will say that in Austin’s legal market I’ve seen a definite trend of solo and almost-solo lawyers attempting to expand their practices into multi-specialty firms, suggesting their desire (or need) to move up-market. Nationwide, I’ve also encountered a few small firms with much higher-caliber partners/associates, broad networks of specialists, and low-overhead platforms to compete head-on with BigLaw: this is where things will get very interesting.

Deflation 2.0 – Clerky

Instead, I’d like to talk about how the above developments have manifested themselves in the form of a Y-Combinator startup called Clerky. Details:

  • Founders are UPenn and Harvard (represent!) JDs of Orrick pedigree, and the head partner of Orrick’s Emerging Companies Group is an advisor; lest you question the quality of the drafting.
  • Appears to have handled formations for several Y-Combinator classes (note: classes – hundreds of companies) over the past several years; lest you think they haven’t been vetted and won’t get traction.
  • For formations, founders fill out online questionnaires very similar to those used by startup-focused law firms, and documents are automatically populated with the appropriate names, numbers, vesting schedules, etc.
  • There is a “reviewer” option where the founders can designate a person (an attorney) to review the final documents pre-execution to give a thumbs-up.
  • Execution is handled electronically on the platform.
  • Delaware filings and registered agent registrations are handled by Clerky.
  • Final executed documents are stored online.
  • Currently Available: Simple Incorporation (no equity, IP docs, etc.) – $99. Full formation (equity docs with vesting, IP assignment, bylaws, etc. – option plans and indemnification agreements coming soon) – $398.
  • Coming Soon (In Private Beta): Employee Offer Letters, Consulting Agreements, Advisor Agreements, NDAs, Convertible Notes., LLC to C-Corp Conversion

So what exactly has Clerky done? Once they get option plans and indemnification agreements up and running, they will have taken what would cost $5K-10K in legal fees at an inefficient law firm (or $2.5K-$5K at a more efficient one) and reduced it to $398 by going one step past building tools for lawyers to developing a platform that effectively replaces them – or at least ~95% of the work they do for early-stage clients. LegalZoom prices, but for premium, startup-focused documents.

What about free options?

Major law firms have attempted to address the large portion of the founder population for which even $2.5K-$5K is too high a formation price tag by offering documents online for free. I even wrote this post offering my own checklist for forming your own startup and issuing equity, lawyer-free, via publicly available documents.  But $398 is close enough to free that founders in this same category will be willing to pay for peace-of-mind, knowing that their docs are filled-out and filed properly, and that a reputable service is helping them maintain them. Plus it’ll save them hours of having to read the forms themselves.

Curmudgeon Criticism 1: Founders will want more customization than Clerky Offers

Yes, there will always be a segment of the founder population that wants high-touch, custom lawyering from the very beginning and will pay for it; just as there are people for whom Nordstrom or Macy’s isn’t good enough for their clothing and require tailors and boutiques.  But the reality is that for the large swath of the pre-funding founder population (95%+) that just wants to “get the job done” and focus on their product, Clerky, with its 80-90% discount on even the most efficient startup lawyers, will be a viable option. Those lawyers who’ve offered quality startup formations for $2.5K have themselves done so by limiting the amount of customizability and focusing on standard terms, so the difference in terms of documents between what you would get from a lawyer v. from Clerky will be very small.

Curmudgeon Criticism 2 Good lawyers will never accept a third-party service’s drafting language for their own clients.

After an inevitable phase of whining, kicking, and screaming, smart lawyers will accept whatever good clients and the market dictate, or they’ll just leave the space.  As stated above, there will always be clients who are willing to pay a premium for ensuring that all of their lawyering is 100% airtight, but those clients will be fewer and farther between.  And you can certainly expect a chorus of lawyers poking through the Clerky docs with a laundry list of ways their own documents are better. But like many disruptive innovations, it’s about the ratio of quality to cost, not absolute quality. At $398 for documents based on those used by one of the country’s leading tech firms and delivered by a YC company run by Ivy-League JDs, the value for founders is unquestionable. Quality, both in terms of legal drafting and user experience, will also improve over time.

Clerky will allow founders to engage quality, scalable lawyers earlier on.

Clerky’s “reviewer” option and its clear intent to incorporate lawyers in their processes shows that the goal here is not to completely replace lawyers, which would clearly be silly and reckless. The nuances of individual circumstances, the need for sound professional judgment that can’t be reduced to an algorithm, and the general realities of running a company will always require good, human legal counsel.

What a service like Clerky does is allow founders with very low legal budgets to stop having to settle for low-quality, mismatched lawyers who end up costing a whole lot more money (in mistakes) than founders expect. As I wrote in a previous post, a lot of founders know they need a lawyer, but can’t afford a good one, so they take the “staging” approach of going cheap up-front with plans to “upgrade” later. The consequences of this approach can be very expensive, and often disastrous.  Founders need lawyers that can serve them at all stages of development, not just when they’re tiny and the stakes seem low.

With Clerky, the “cost” of hiring a good lawyer at the very early stages of a startup can be the time it takes to quickly review some Clerky docs and answer any questions a founder might have about non-standard matters. For quality startup lawyers who stop pretending that all document drafting, no matter how routine, needs to occur in private silos, this is liberating. They can focus their practices on more complex matters that are far more profitable and interesting from a professional standpoint, while still maintaining relationships with early-stage clients who might one day require their skills. It also means the need for deferring fees will be dramatically reduced.

A missing piece: what do the documents say?

One issue that has gone under-addressed in the startup legal landscape is how to make all these automated legal documents understandable to founders.  While no founder should care to understand all the nuances of their option plan, stock purchase agreements, etc., they should at last be able to grasp at a high-level the concepts that they contain.  And sitting down with a lawyer for every explanation is and always will be too expensive for most founders.

Offering lists of books and links to founders is very helpful.  A “customer support” model of cheaper professionals without JDs who can easily answer common founder questions will also likely emerge.

One startup here in Austin is taking an interesting approach: crowdsourced annotations of contracts (Lawful.ly). They call themselves the “Rapgenius for Law.” Imagine having all of the legal forms that your startup uses available online with annotations, so you can click around the document and get plain-english explanations of what a particular provision means. That’s what they are working on, and hopefully it (or something similar) will fill a gaping hole in the early-stage startup law landscape.

For lawyers who’ve built their practices on charging clients thousands of dollars for basically filling in forms and doing some cutting-and-pasting, the future looks increasingly grim. For those of us who love working with entrepreneurs and tech companies, but find cookie-cutter legal work utterly boring and a waste of our intellect, life is getting a whole lot better.

Founder Convertible Notes – Put Your Money on the Cap Table

It’s quite the norm for a startup to run on its own founders’ sweat equity and personal funds (bootstrapping) until the Company is able to raise outside capital.  A very important question that isn’t asked often enough is, “how do I paper the money I’m putting in?” Does it just go in and disappear? Does it pay for my stock?  While there are + and -s to different approaches, the answer that I almost always arrive at is: treat yourself like an investor.  In other words, paper your bootstrapping in a way so that it goes (eventually) on the cap table.  You benefit economically, and investors actually like to see evidence that you put more skin in the game than just your time.

  • Don’t use it to buy Common Stock – Your Common Stock should almost always be issued at par value ($0.0001 per share or some similar number in your Certificate of Incorporation) at the very beginning of the Company. This is proper because the Company is worth very little from a “fair market value” perspective, and issuing it at a higher price sets a FMV precedent that ends up hurting later employees because they then have to pay that higher price too.
  • Don’t buy Preferred Stock – Unless you’re a seasoned entrepreneur, the documentation and terms are too complicated for you to handle at the very early stages, and you’re not experienced enough to set a valuation. You’ll likely end up setting a bad precedent that will come back to bite you if you bring on real investors.
  • Don’t treat it as a loan – How do you think it looks to an investor if you’re asking them to actually invest (not loan) their money and risk losing it all, but you’re only willing to loan your personal funds? Bad.
  • Answer: Founder Convertible Notes – Issue yourselves convertible notes. Pre-financing, they are effectively a debt claim on your own company.  But upon raising the threshold amount that you set in the notes, they’ll convert into Series A Preferred Stock. This means (1) you now have a liquidation preference that will ensure you at least get that money back on an exit alongside future investors (unlike your Common Stock, which will likely sit beneath them), and (2) you get to vote those shares alongside future Series A investors.  Papering this is also a lot easier than buying preferred stock, and you don’t have to set a valuation.

Background Reading

Issues to Consider

  • Interest rate on the notes: 5-8% is fair
  • Discount on conversion: 20% is fair
  • Qualified financing threshold – $500K-$1M is fair
  • Cap on Conversion Valuation – Probably not a good idea for a founder note.
  • Maturity – Give yourself enough time to raise funding. 18-24 months is fair.
  • What happens at maturity? – Realize that at maturity, the notes will become “due.” This means the person holding the note can, if they want to, demand repayment (they could just extend otherwise) and cause all kinds of problems if they don’t get repaid.  If it’s just one founder or a couple of people you trust, this likely won’t be a problem. Make sure the maturity period is long enough, and be aware of the risk.  A lawyer could draft in extra protections to kick in at maturity, but that customization will cost money.

Good Forms to Use

  • Techstars has a great free set of Convertible Note docs to use here under “Debt Financing Structure. For founder notes, you don’t need the term sheet. While these aren’t rocket science, it’s still best to hire a lawyer if you want to completely avoid mistakes. But if it’s just one founder, or a small group of founders with no legal budget, they could probably handle this on a DIY basis if they read carefully.
  • Note that the Company’s Board of Directors should formally consent to the note financing. If you have a lawyer, ask for a simple board consent.  The reality is, however, because only the founders are involved, you can just ratify later when you’ve hired decent counsel.

Form Your Austin Startup Yourself Before Hiring a Cheap Lawyer

Note to reader: Please share this with as many low budget startup founders (particularly in Texas) as you know. Friends don’t let friends waste money on crappy lawyers.

Update: If you’re looking for DIY-ish startup formation options, this is another viable alternative: Clerky

So you’re starting a company with virtually no budget for legal fees, and you just found a guy in Austin who’s willing to help you out on the cheap. He even bills $175/hr and seems to come well-recommended by other entrepreneurs. Awesome, right? For me it is.

It’s difficult to overstate just how often clients end up paying our firm more to close a transaction, sometimes substantially more (think 5-6 figures), because we have to clean up a mess created by some cheap local lawyer with “startup friendly” (read: questionably low) rates.  Garbage sold at a low price is just expensive garbage.  There’s one solo practitioner in particular who’s done work for two people I know, separate companies, and screwed up big time on both of them (2/2).   One ended up closing a VC round at 2-3x the usual fees in order to clean up the disaster he created. Cheap is awesome until real investors hire real lawyers to actually read the documents your cheap lawyer drafted… or failed to draft.

I’ve previously articulated my views about going alone on startup legal issues, including a discussion on the growing number of DIY tools available online.  There are so many multi-specialty legal issues that come into play in forming, growing, and financing a company, that I highly advise against trying to do things yourself, at least if you expect to raise professional venture capital and scale your business. The stakes are simply too high.

But, the reality is that no matter what every lawyer with a blog says, founders will keep trying to form their companies on their own.  Given this reality, here’s my suggestion to all of Austin’s startup founders with zero funds budgeted for legal fees (and who can’t find a decent attorney who will be flexible):  meet Docracy, read this post, and follow everything very carefully.

Lawyerless > Crappy Lawyer

The beauty of quality DIY online resources is that, while they will never provide the level of service that an experienced, quality attorney will provide, they sure as hell are better than relying on a crappy one.  With the right contracts available for free online (via Docracy), the right guidance (via blogs, articles, etc.), and the patience to seriously read the instructions, you can stand a much better chance of not screwing your company up by doing things yourself versus hiring an incompetent attorney, trusting him to do things correctly, and then finding out two years later that he didn’t.

So here’s my free guide for using the power of the internet to form your own Delaware C-Corp based in Texas. If you are forming an LLC instead of a C-Corp, then for the love of all things good and holy, please get a competent lawyer.  And again, let me reiterate: I do not think you should try to form your startup on your own. My desire here is to simply provide a helmet and a flashlight for those who are going to do it anyway, so that if they are ever able to afford a real attorney and raise serious funding, their legal history won’t be a complete nightmare.  You will screw some things up, but hopefully the clean-up costs will be much smaller than those caused by Austin’s crappiest lawyers.

DIY Startup Formation – Powered by Docracy, Orrick, and “the Internets”

Background Reading:

Requisite Formation Docs:

Steps (Order is important)

  1. Read all of the Background Reading – very very carefully.
  2. Figure out your Founder Common Stock distribution and Vesting details
  3. Execute and File the Charter in Delaware
  4. Execute the Action by Incorporator
  5. Execute the Board Consent (Make sure you designate at least a CEO and Secretary)
  6. Execute the Common Stock Purchase Agreements for each Founder, including all exhibits. – Set
  7. File your 83(b) Election immediately
  8. Fill out Common Stock Certificates
  9. Execute the Stockholder Consent
  10. Have the Secretary execute the Bylaws
  11. Did you file your 83(b) election yet? (30 days within Stock Issuance, or your toast)
  12. Apply for an EIN at the IRS Website
  13. Have officers and directors execute Indemnification Agreements
  14. Have all founders execute a Confidential Information and Inventions Assignment Agreement
  15. Register as a Foreign Entity in Texas.
  16. Keep digital copies of everything in a safe place.

Useful Forms to Possibly Use Later:

The above does not cover granting options to employees via a formal option plan, because, frankly, by the time you are granting equity to non-founders you’re insane for not having hired a lawyer – and the legal issues around options are complicated – real complicated.

Disclaimer: As I said before, you will screw some things up. And yes, trying this yourself is silly and irrational – much like a lot of things entrepreneurs tend to do.  The above steps and documents might not even be the right ones for your startup’s context.  I did not draft the above-referenced documents, nor do I vouch for their legal enforceability. You absolutely should hire a lawyer before trying to form your startup. But, putting all that side, if you read carefully and follow the above instructions, you will be probably be on better legal footing than 99% of the startups formed by terrible lawyers.

What’s my startup’s stock worth?

Stepping back a bit from current events and meta issues, let’s talk about something more mundane, but nevertheless frequently asked by startup founders. What’s my stock worth, and why should I care?

Categories: I’d say there are three different types of “worth” that could be discussed here:

(1) worth to you,

(2) worth to others (what they would pay), and

(3) fair market value (FMV).

From an economic perspective, (1) and (2) are the most important.  But from a legal perspective, (3) is the one you should care the most about. Think of FMV as something related to, but conceptually distinct from, what others think the stock is worth. And to be as absolutely straight-forward and jargon-free as possible as to why you should care about it, one word: taxes.

Why should I care?

A. Taxable Gain

First, virtually any time that someone gets stock with a fair market value above what they paid, that’s taxable gain. Naturally, whenever possible, you want to ensure that when you issue someone stock or options, they aren’t also being handed a tax bill with it. Unfortunately, the IRS doesn’t let you pay your taxes with options. Equity in your hand + cash out of your wallet = bad.

B. Regulatory Compliance

Second, with the understanding that promoting equity incentives can be valuable to companies and the economy as a whole, the IRS has provided some safe harbors (of sorts) through which you can issue options to employees while being able to defer taxes down the road, preferably around the time of a liquidity event (cash in your hand to pay that tax). Your attorney can discuss details with you in more detail, but the most important one for purposes of this discussion is: the exercise price of the option needs to be at fair market value.

C. Key Relationship between (1) and (3)

Notice the key relationship between (1) the value that you place on your stock and (3) fair market value. To the extent FMV is below what you and your employees view (subjectively) as the value of your startup’s stock, you’re able to give something that, at least to you and them, is worth more than what needs to be paid to avoid taxable gains. If FMV for tax purposes is $0.50 per share, but to me the stock is worth $2.00, I can pay $0.50 per share, get $1.50 worth of (subjective) gain, and not pay tax.

Nutshell: a low FMV relative to subjective value is a good thing.

So what’s the fair market value of my startup’s stock?

It depends.

Never Sell Common Stock in an Outside Financing

The number one determinant of FMV is always (2) in the above list: what people are willing to pay for it. If/when the IRS chooses to look back at the FMVs you applied to your stock, that will be the first thing they look for. This is precisely why any competent startup lawyer will tell you that, while Common Stock is good for founders and equity incentives for services, you should almost never sell Common Stock in a financing. This will likely “taint” the FMV of your Common Stock, and effectively force you to set a significantly higher FMV for your stock options than you otherwise would have to. For that reason, it’s almost always recommended to do a financing either through preferred stock or convertible notes that will eventually convert into preferred stock. Because preferred stock has various preferences/privileges that Common Stock does not, you can sell preferred stock for, say, $2.00 per share, while still making a credible claim that the Common Stock is worth a fraction of that.

At Formation

So how is it that founders and early employees are able to get millions of shares in their startups for practically nothing, without being taxed? Simple. At formation, the FMV of your startup’s stock is considered virtually nothing. Now, it’s certainly not worth nothing to you. But because you haven’t built an actual Company yet, the IRS accepts the argument that the huge amount of uncertainty and risk of failure make the stock worth fractions of a penny. We generally issue founder stock at a price per share equivalent to par value (usually $0.0001 per share). So an issuance of 2,000,000 shares to a Founder would require a check for $200.00. Assuming that founder files her 83(b) election (bad news if she doesn’t), she won’t realize taxable gains until she decides to sell her stock.

Note that this is also an argument for getting your founder shares and early employee equity issued as soon as possible.  The further along in your Company’s trajectory that you are (customers, revenue, investors), the greater likelihood that your Common Stock will have a higher FMV, and that the recipient will need to hand over meaningful cash either to you or the IRS in order to receive it.

After Formation, Financing

After formation, and as you move into seed funding, setting the fair market value of your Company’s stock becomes much more complex. Section 409A of the Internal Revenue Code is largely what drives that complexity, which this post is not meant to cover. The nutshell is that before a full venture capital financing, your lawyer will recommend that your Board of Directors use various “illiquid startup” guidelines to set the FMV of your stock.  After a VC financing, you’ll likely get a formal 409A valuation from a bank or valuation firm, and use that to set the exercise prices of your options. There are a number of reputable valuation firms in Austin that we recommend to our startup clients, and, as with hiring a lawyer, you should be careful about going with the firm that offers the lowest price. That can come back to bite you.

Take-home message:

  • FMV is related to (but not the same as) your or a potential investor’s value of your stock.
  • Issue equity and equity incentives as early as possible to avoid taxable gains.
  • To avoid “tainting” the FMV of your Common Stock, never sell Common Stock in a cash financing.
  • Consult with your attorney about setting the FMV of your stock as your company progresses.

Obligatory Disclaimer: I know you’re smart enough to know this, but this is not tax or legal advice. Things might be different in your particular context. Contact a professional before making a decision you might regret.