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Month: October 2018

The Importance of “Friends and Family” Rounds

When people in startup ecosystems speak of “friends and family” rounds, they are typically referring to a very early round of financing – often the first round – of a startup in which all the people putting in money have very close, personal ties to the founders; which makes them more willing to take on a level of risk that a true investor may not.

Because so much of the wealth circulating in Silicon Valley was created in tech, “angels” in SV tend to be more more risk-tolerant relative to angels elsewhere in the country. They trust their ability to judge vision and team, independent of traction, and are therefore willing to invest much earlier. In other parts of the country, however, there is far less of that truly angelic angel money.  Much of the wealth available outside of SV for angel investment originated in non-tech industries, and the investors are therefore more conservative in their risk tolerance; often expecting more traction and milestones before they’ll invest.

That means that in ecosystems like Colorado, friends and family rounds are a vital part of helping entrepreneurs jumpstart their companies.  The most common F&F structure that we see is a convertible note, with a discount on a future funding round. The note should have a very long maturity date, like 3 years.

We advise that you avoid placing a valuation/valuation cap in a F&F note (most angel/seed convertible notes have valuation caps), however, because friends and family investors usually aren’t experienced enough to properly value the company. If you place it too high, you can create unrealistic expectations for the future. If you place it too low, it will “anchor” the valuation expectations of future investors, weighing the valuation down.

While we advise against putting valuation caps in F&F notes, we will include a provision giving your friends and family investors a discount (often 20%) on the future valuation or valuation cap that your angels/seed investors get. Say, for example, a year after your F&F round you do an angel/seed round at a $5 million valuation cap in a convertible note. This provision will amend your F&F notes to then give them a $4 million valuation cap; with the discount being the reward for additional risk they took on. And if your seed round is an equity round, the F&F note will simply convert into the seed equity, at a $4 million valuation.

This dual discount structure ensures that, whatever investment structure your seed investors get, your friends and family end up with the best deal, which they deserve because they invested the earliest.

Important point: There’s a common misconception among first-time founders that friends and family investors do not need to be accredited investors. This is incorrect. There is no such thing as a “Friends and Family exemption” from securities laws. To avoid serious problems down the road, startups expecting to eventually take on more experienced, institutional investors should steer clear of all non-accredited investment and only take money from people, friends and family or otherwise, who have sufficient income or assets to qualify as accredited investors.

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What Startup Accelerators Do

Background Reading:

When most people think of the core value of top-tier universities, they think it’s obviously to educate top students. While that may be true, there is a strong argument that education is actually secondary to top universities’ “sorting” function; in other words, by credibly filtering out and selecting the most elite among millions of students, universities help employers and other people find those students more easily.

Sidenote: there’s empirical evidence suggesting that students who get into the ivy league but don’t attend do just as well as those who do attend, lending backing to the idea that top universities are far more about sorting and finding talent than developing it.

Top-tier accelerators are the elite universities of startup ecosystems. As “doing startups” has become more of a thing and the number of entrepreneurs has gone up (correlating inversely with the drop in cost of starting companies), business ecosystems have become far more “noisy.” More pitches, more teams, more ideas, make it much harder for interested investors to sort through and find the cream. It’s the exact same problem employers have with students.

Here in Colorado, Techstars is clearly the most notable accelerator, although there are others here and throughout the country. Ask entrepreneurs about the value of the educational content of these accelerators, and feedback will vary; but almost universally founders will say that the top ones pay for themselves simply from the network they open up for you by putting their stamp on your startup; just like a Harvard or MIT.

Are accelerators necessary for startup founders to succeed? Absolutely, positively not. The large majority of successful companies we work with never touched an accelerator. But for entrepreneurs lacking strong connections to investors and other key players early on, they can dramatically accelerate a startup’s ability to find capital, advisors, etc.; and should be strongly considered.

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Why the “independence” of a Startup Lawyer matters.

Background Reading:

There are two general types of work that a corporate lawyer (startup lawyers are corporate lawyers) provides: strategy and execution. Very experienced, senior executives who’ve been in the game for a very long time tend to use their lawyers much more for execution than strategy. They know how to navigate the environment themselves, and how to negotiate, and just want good lawyers to paper things properly.

First-time entrepreneurs, however, are not seasoned executives. They’re often entering an environment of total opacity, where lots of the people they’re dealing with (investors, partners, etc.) have 10-20x more experience and connections than they do, and very misaligned incentives. In this context, entrepreneurs lean on their startup’s lawyers – who have very broad visibility into the market, and broad experience on a variety of deals – not just for execution, but for deep strategic guidance: how and what to negotiate, how to navigate the ecosystem, what to push back on, how to protect themselves, etc.

Unfortunately, because startup lawyers play such a pivotal role in helping entrepreneurs negotiate with and protect themselves from bad actor investors, those investors often make it a point to gain significant leverage over the lawyers in their local ecosystems: by sending deals in their direction, working with them on deals, etc. This is a huge problem.

If you are an entrepreneur working with a lawyer to negotiate a term sheet, how on earth can you trust the objectivity / impartiality of that lawyer’s advice when the people who sent you the term sheet have employed him on 20 other deals, and will do so in the future? Fact: you can’t. The conflicts of interest are simply too high. For that reason, one of the core questions any startup founder needs to ask a prospective lawyer is: what investors do you work for? Do not hire lawyers with deep ties to people you expect to raise money from.

Well-negotiated and fair deals result when both sides are represented by experienced, independent counsel. No matter what anyone else in the ecosystem tells you about how a certain set of lawyers will help you close on money, if you don’t take their independence from the money seriously, you will regret it in the long run.

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