Interview with Attorney Jeremy Glaser from Mintz Levin about Startup Funding
“It’s almost always harder to raise capital than you thought it would be, and it always takes longer. So plan for that.” – Richard Harroch
In this interview with Jeremy Glaser, a partner and attorney at Mintz Levin, we discuss some of the startup funding basics during the seed stage and Series A stage for startups. Jeremy is the co-chair of the firm’s venture capital and emerging company practice. Recently, Jeremy was named the San Diego Venture Capital Law Lawyer of the Year.
In this interview, we discuss the pros and cons of convertible debt and preferred stock offerings. We also discuss the more important deal terms and what to watch for as an entrepreneur. Weather you’re a company founder, startup CEO, or first time startup CFO, this interview will be very valuable for you in understanding startup funding. There’s a good article in Entrepreneur about convertible debt for startup financing, and one in Forbes about key terms to understand about preferred stock. I think both of these articles are a good complement to this discussion with Jeremy.
Historically, seed stage investment rounds were almost always done with a convertible debt offering. Although interest rate and duration are deal terms, the key deal term has always been the conversion discount. However, seed stage investments and debt offering are now getting more complicated as some Angel investors want to negotiate a cap in the valuation for conversion, which effectively defeats the purpose of a convertible debt offering since it is implicitly setting a valuation on the company. This has lead to the advent of “Series Seed” preferred stock offerings. The key deal terms in this type of startup funding include valuation and liquidation preference. Ideally, you will avoid other key deal terms that will be negotiated in the Series A financing.
In a Series A financing, which traditionally is the first institution round of financing, typically lead by a venture capital firm, there is a laundry list of deal terms that entrepreneurs need to understand including:
- anti-dilution, also called a “ratchet”
- liquidation preference
- blocking rights
- corporate governance and board seats
- IPO threshold
- voting rights
- rights of first refusal on future financing rounds
- co-sale rights
- participating versus non-participating preferred stock
- caps on participating preferred stock
It is very important the your company is represented by a good attorney that has experience in all stages of startup funding for private companies along with experience in IPOs and M&A transactions.
Patrick: Hi, this is Patrick Henry, the CEO of QuestFusion, with the Real Deal…What Matters. I’m here today with Jeremy Glaser who is a partner of the law firm of Mintz Levin. Jeremy serves as the co-chair of the firm’s venture capital and emerging companies practice.
We’ve had Jeremy as a guest before, and he was very well received by the entrepreneurs out there. Jeremy has so many awards and recognitions in the legal field around startups that it’s hard to mention all of them.
Most recently, he was the San Diego Venture Capital Lawyer of the Year. Congratulations on that.
Jeremy: Thank you. It only took me 30 years to earn that.
Patrick: Jeremy has also served as the past president and board member for the San Diego Venture Group. A lot of the stuff that he does is venture related. He’s represented both startups, as well as venture capital companies, so he brings a unique insight there.
He’s also a member of the American Bar Association. Welcome, Jeremy.
Jeremy: Thank you, Patrick.
Patrick: Today we’re going to discuss the types of financing available to startups and some of the term sheet basics, as I like to call them.
Jeremy, can you describe, in layman’s terms, the available financing for startups and little details about the pros and cons of convertible versus preferred stocks?
Jeremy: Sure. Most companies, when they’re raising their initial capital, want to keep the cost very low. Typically what we’ll do is we’ll go ahead and bring the initial money in from angels, in what’s called a convertible note structure.
One of the main reasons we do that is because it’s a pretty straightforward document, pretty inexpensive to put together and you can try to keep the terms somewhat under control, because that’s when things get expensive.
Unfortunately, it’s gotten a little more complicated. As the angel investors have gotten a lot more sophisticated, we’ve started to see a lot of negotiation now around the terms of convertible notes, which, unfortunately, make those deals more expensive.
We’ve been seeing more of a trend now where more sophisticated angels are actually coming in and negotiating equity.
It’s what we call a Series Seed preferred, like the seed round of preferred. It’s a very simple, very basic preferred stock that can be done inexpensively as well.
The reality is that we’ve seen a bit of a change in the market, where it used to be always convertible notes for that first round of funding.
Now we’re seeing more of this Series Seed, very basic preferred stock for the initial funding of a company.
Patrick: When you talk about keeping the cost down, relatively inexpensive, a traditional convertible note, how much are you going to spend putting something like that in place?
Jeremy: The reality is it could be very inexpensive. We’ve actually automated all the documentation around convertible notes.
Without joking, literally, if it’s a simple, straightforward deal and no one tries to make anything unusual in it, it’s $1,000.
Jeremy: It’s very straightforward now. We can generate a term sheet. We can generate the note purchase agreement and the note, literally by filling out a little one-pager with the terms. There it is, ready to go.
Unfortunately, as I indicated, what’s happened is there’s now been some more negotiation around notes. As the founder, if you could get money and negotiate a note with just, what we call, a discount on the conversion, meaning that the note will convert into that next round of financing that you do with a venture capital, for example, at an agreed upon discount- usually 20% to 25% is what market is- if you could keep it just at those terms, that’s a very straightforward deal.
What’s happened is now, I’m sure you’ve seen this, people are negotiating caps on the conversion. The minute you start negotiating a cap, you’re taking away the real advantage of a convertible note financing, which is you don’t have to negotiate valuation.
Negotiating cap, you’ve already started negotiating valuation. Then, once you have a cap, it starts getting even more complicated because you start then being concerned about how will the venture capitalists who are going to come in later view this note converting at basically a bigger discount.
When you negotiated a cap, the reason for that is that they’re getting an even bigger discount versus what that financing is going to be.
This whole concept of overhang becomes a problem, which then leads to more negotiations around, do you get preferred stock for that discount or do you get common for that discount? It just starts to steamroll into a much more expensive process.
Patrick: In your experience, these convertible notes that get more complicated with caps, what guidance you would give an entrepreneur?
Would you automatically go to a preferred stock offering as opposed to putting something in place like that? What kind have you seen?
Jeremy: That’s such a great question. I always start by telling the entrepreneur, “If you think that your investors will invest on a convertible note with a straight discount, go do that.”
That’s absolutely best for the company. You’re going to do better off with that. It’s going to be cheaper. You’re going to probably end up giving away less of your equity.”
I always tell them start that, float that, but don’t spend money doing it. Have the conversation and then come back.
Then, if in fact, your investors are saying, “We’re game. We’re ready to do that,” great, then we’ll put the documents together to do that.
Again, if the angel investor is a pretty sophisticated investor, they’re going to realize, “Wait a minute. I’m going to give you, Patrick, a $1 million and you’re now going to build a company. It’s worth $10 million.
You built that principally using my $1 million. Now I’m going to convert my million into a round that’s valued at $10 million. I get a 20% discount, so it’s $8 million.
I could have come in when the business was worth much less. My money is what made it more expensive.” That’s their reasoning.
They start going down that road and, lo and behold, the caps and all these other things come in. At that point, I usually advise entrepreneurs not to go down the road.
If that’s where they’re heading, just go ahead and negotiate a valuation. Do a very basic Series Seed preferred.
For entrepreneurs out there, it’s really a very basic document that merely gives the investor a preference, what’s called a liquidation preference, which means that if the company is sold or if the company goes out of business, that investor gets their money back first.
If they put in $1 million dollars, in our example, they’re going to get their $1 million out if the company goes out of business, if there’s $1 million there. If you sell the company, they get that $1 million off the top, basically.
It can be a pretty simple document. Again, we have those documents fully automated and we can generate those relatively inexpensively, too.
However, it is much more expensive than the note. You have to file a certificate of amendment. It’s like a real financing. Those would usually be more in the $7,500 to $10,000 range by the time you’re done.
Patrick: Order of magnitude, more expensive.
Jeremy: Order of magnitude.
Patrick: What do you see as current trends in convert versus equity financing? What’s the mix of deals you’re doing, primarily around seed rounds but even Series As?
Jeremy: The convertible note is really for the pre-Series A, assuming that we’re talking Series A is when the first institutional money comes in, meaning the venture capitalist.
I’d say we’re still doing a good number of the convertible note deals. I’d say now, maybe, ¾ of the deals are convertible note deals and ¼ are actually negotiated equity deals. That’s here in San Diego.
My understanding is, up in the Bay Area where, to be honest, you have much more sophisticated angel investors and you have actual angel funds, the deals are more traditionally now equity deals.
Patrick: What do you see as the key terms in a convertible data offering and why they’re important? Is it just the conversion discount or are there other things that come in?
Jeremy: Yes, as we talked about, it’s a note. You’re going to have an interest rate. No one’s really investing on the interest rate. The interest rate is generally not very high. That’s not a very significant term.
Again, it’s a promissory note, so there is going to be a due date. You have to negotiate that due date. Is the due date really that important? Not really, because most of these companies are so early.
Are they ever really going to pay that money back? No. The money’s going to end up being converted into exchange for some equity.
The reality is, the really important thing is what happens on the equity side. That’s where you’re negotiating the conversion we talked about, the conversion discount, what it converts into.
Again, I know that sounds so basic, but believe me, it could get very complicated. Are you converting into preferred? Yes. Well, what happens if you don’t do a preferred financing ever? Does it convert into common? If it does, at what valuation does it convert into on the common?
What happens if you sell the business before you do a preferred stock financing? What does it convert into? You have to deal with all these sorts of issues to make sure the note protects the investor so they ultimately do get an equity position, which is really what it’s all about.
There are a lot of little pieces along the way. We talked briefly about, once you’ve negotiated the discount, then you get into the whole conversation about, do I get those discounted shares in the same preferred stock as the VC is getting?
Do I get it in some different security? Do I get it in common? Do I get it in a different type of preferred? It could be all kinds of iterations.
Patrick: Traditionally, back when I was doing this, it would be that you do a convertible note for your seed financing. It converts into Series A preferred. This is just a normal example.
Jeremy: The good old days when it was kept simple, yes.
Patrick: How about in a preferred stock offering, especially early stage, whether it’s a Series Seed, as you call it, or a Series A? What do you see as the current deals terms that are most important there?
Jeremy: Again, with the Series Seed, the goal is to try to keep it very simple, because when we’re talking about this initial fundraising of $1 million, you don’t want to spend a lot of money on legal fees.
We really try to keep the focus on the liquidation preference. Obviously valuation is crucial. How much of the company is the investor going to get for their million-dollar investment, and then the liquidation preference for those shares?
Unfortunately, these things can also get really complicated. We have form documents that are based on the Series Seed documents that are actually out there publically on the internet, which try to keep it simple.
We’re trying not to get into negotiations around things like, are there registration rights for the investors, meaning can they get their shares registered if the company were to go public? Are their dilution protections?
You’re trying to push all of those issues to the Series A round and saying, “Whatever rights the Series A investors get later, you’ll get those same rights, too.”
You’re trying not to negotiate some of these things that can be very time consuming and maybe not all that relevant this early on in the investment.
Patrick: That could actually be a deal term then. All the bells and whistles, goodies, that the Series A offering gets, you automatically get that on your stock.
Patrick: Okay. That’s kind of a catchall.
As you get to the Series A, in my experience, the deal terms can actually be more important than the valuation, especially when you’re talking about a 2X or 3X preferred versus a 1X.
I’ve always tried to keep it as a 1X preferred. Usually if you go public, there has to be a vote around the preferred that says we’re not going to convert to common unless it’s at some specific valuation.
There could be blocking rights. There could be all these crazy things.
If you’re an entrepreneur and you have a company, what are the key things that you would try to make sure you have in a preferred stock offering and the things you would try to avoid?
Jeremy: I think you’re so right about the importance of terms versus valuation. The example I like to give people is what’s happening with the unicorns, these companies that had billion-dollar valuations.
There was so much focus on having a billion-dollar valuation, that, unfortunately, a lot of companies didn’t focus on the terms of those financings.
In particular, the term that was most painful and that people are starting to realize now is painful given what’s happened in public markets is the anti-dilution protection, what we call a ratchet.
A lot of those unicorn financings, even though they had high valuations, had that pre-IPO round, they provided that if the IPO or even a private financing, but in this case the IPO is the concern, is not at some predetermined valuation or multiple valuation, their conversion price would reduce down.
Meaning, they get more shares. They’re protected. It’s an anti-dilution protection based on this very high valuation and expectations of returns that, by not being realized, are resulting in a bunch more shares being issued to those initial investors.
What happens when a bunch of shares get issued to the initial investors? The founders end up owning a lot less of the company. They’re getting dramatically diluted because they were so focused on that billion-dollar valuation mark, as opposed to focusing on the terms of the actual financing.
Patrick: You could be in a situation where you think you own 50% of the company and, depending upon what happens with these anti-dilution shares, you might own 10% or 20% of the company.
Jeremy: That’s right. Then you also mentioned liquidation preferences and the potential for multiple liquidation preferences.
One of my favorite stories is a client of mine with a very sophisticated CFO, who had done a lot of deals. When the company was looking to get sold, the CEO asked the CFO to go ahead and run an analysis as to what everyone would get on the sale transaction.
The CFO provided the analysis. We instantly looked at it and realized, “Wait a minute. You just took the $100 million sale price and divided it by the total outstanding shares.”
That’s not way it works. This company had $100 million of venture capital in it. The preferred stock financing gets the money first.
When he redid the analysis, he realized that the common stock was basically getting nothing.
You need to be very aware of the fact that, on a sale transaction in particular, the amount of the liquidation preference, whether it’s 1X or 2X, is extremely important.
Then there’s another term about whether or not your preferred stock is a participating preferred, as you know about, or a non-participating preferred.
Patrick: Talk to us about the differences between those two things. I think this is one of the things I learned as an entrepreneur that’s actually very important.
Jeremy: Absolutely. Here is the simplest way to understand the participating preferred. Let’s say, in our example, the investor put in $1 million. They are always going to get that $1 million back first, even if your deal is phenomenally successful.
As opposed to them just converting their preferred stock into common and then sharing the whole pool on a per rata basis, if it’s, what’s called, a full participating preferred, it doesn’t matter how much the company sells for. They’re always going to get back that initial liquidation preference, which as we talked about, could be 1X or 2X. It depends on how it’s negotiated.
In addition, they then share in all the remaining proceeds, as if they had converted their preferred stock to common stock.
The key for entrepreneurs out there is there a lot of deals done with participating preferred and, obviously, everything’s market driven, whether you can negotiate something different.
If you have the market power to do it, you want to at the minimum, negotiate a cap on that participation, so that at some point, when there’s a successful M&A exit, they’re going to convert and they’ll give up that initial preference and just be sharing equally with the common on the sale proceeds.
Patrick: In the event of a public offering, there’s this requirement that everyone converts into common.
Patrick: You give up your preferred rights. What are the things you have to look out for in terms of those things?
With the advent of the JOBS Act, you can actually stay private for a lot longer and maybe even have, what I could call, liquid stock that you can trade, even though it’s not in the public markets.
What are the red flags and yellow flags that an entrepreneur needs to look out for in those situations?
Jeremy: I could tell the story of a company that had negotiated some terms around when the stock would convert at the IPO, and because the valuation that was negotiated as to when that automatic conversion could happen hadn’t been met, they had to go get a vote of the preferred stockholders on whether to convert and do the IPO.
Unfortunately, when you find yourself in that position, sometimes you have some people who like to take advantage of that vote.
If you have a preferred stock holder who maybe isn’t too happy about the IPO or too happy about the valuation that you’re proposing, they can use that vote as a block right to negotiate better terms for themselves in front of the IPO.
It’s really important that it’s not just a boilerplate provision. You want to really be focused on what is a reasonable valuation when we may go public.
You want to make sure that you have a provision in your certificate that says, “If we’re going to go public at a $50 million valuation, all the preferred automatically converts, as long as we hit that threshold for that IPO.”
If you miss that, you again put yourself in the situation where the deal could get re-cut in order for you to get the liquidity that you need and want for your business.
Patrick: Yes, those are definitely tough negotiations and tough situations to be in. In a convertible data offering, you have a variety of different terms, but the real salient term, the most important term, is the discount.
Patrick: Then in a preferred stock offering, in a Series Seed, a lot of these deal terms really don’t matter. It’s really, is it a 1X preference?
Jeremy: It’s valuation and liquidation preferences.
Patrick: As you get into later rounds, Series A and beyond, things like anti-dilution shares, things about when the things convert, participating versus non-participating preferred, all those things.
Jeremy: Blocking rights. Voting rights. Board seats. Rights of first refusal on potential future financings. Co-sale rights, which would allow people to jump in and sell.
Patrick: There’s a lot of complexity.
Jeremy: There are a lot of things that get negotiated as you get to that Series A deal. At that point, theoretically, you’re raising enough money that all those issues can be addressed.
The thing that concerns me is, unfortunately, when you find angel investors wanting to negotiate all of those terms in small transactions, $2 million and below raises. That can just get really expensive and prohibitive.
Patrick: Yes, I understand. Many of us have watched Shark Tank. It seems like the only part of the discussion is on valuation and the amount of capital being raised.
Clearly, that’s a little bit misleading for the entrepreneurs out there. There a lot of things that you have to consider in addition to that.
Jeremy: It is entertaining to watch.
Patrick: It’s very entertaining, especially Mark Cuban.
Jeremy: No one wants to watch a negotiation around registration rights. I promise you. You’d all be asleep. I would never make it on television.
Patrick: With all these different deal terms, it’s obvious, at least to me, you need to have an attorney or a general counsel to help represent you on these kinds of financings.
You made it simple in terms of Mintz Levin. Some of this stuff, in terms of keeping the cost down, if it’s a very simple convertible note or even a simple Series Seed preferred stock offering, you can do it at a much more reasonable cost.
As an entrepreneur, what would you look for in terms of selecting an attorney? How do you access some of this basic information from you guys?
Jeremy: It’s important to have someone who does a lot of these transactions and can negotiate the terms of that convertible note or that preferred stock financing.
The reality is all these issues are really looking towards the ultimate exit, meaning an IPO or an M&A.
Whatever attorney you use to do these deals, you want to make sure that that attorney has also done initial public offerings and has also done M&A selling companies.
Without knowing how those transactions work out, they could potentially make some serious mistakes in negotiating the terms of, whether it’s that convertible note or more importantly, the terms of your preferred stock financing. That’s a really important thing to ask when you’re going to work with someone.
As far as getting access to these resources, we at Mintz Levin, have been focusing on how we get good information to entrepreneurs in a very cost-effective way. That was certainly behind us automating some of these basic documents, to try to keep the costs down for entrepreneurs.
In addition, we’ve recently launched a website called MintzEdge. MintzEdge has a lot of free resources for entrepreneurs to help them answer those basic questions that we’ve been talking about.
What is a convertible note? What is a term sheet? What is preferred stock? How do I negotiate a valuation? What should my business plan or executive summary have in it?
All those issues are on the website. That information is available for free at MintzEdge.com.
In addition, we have a resources page that links out to a lot of really good resources that we’ve found useful for entrepreneurs over the years. It has a lot of great information about all aspects of venture capital financing, cap tables, experience in negotiating deals and things like that.
I would urge your viewers to go to that site and peruse a little bit. I think they’ll get a lot of good information there, all for free.
Patrick: Awesome. That’s great.
At least in my experience, deal terms are as important, sometimes more important, than valuation in a preferred stock offering.
You need to have good advice. You need to have a good counsel representing you. You want to do that cost-effectively, obviously, but I think you don’t want to overly cut corners when you’re talking about putting together a real company.
I have even seen situations where venture capitalists will pass on a deal because the cap table isn’t clean, as they say, or there are major issues, even if they like the company. It’s not always the case, but those situations do occur. Being mindful of these things, I think, is really important.
Jeremy: I think you just said something so important that we should touch on. So many entrepreneurs get so focused on valuation when they’re raising their money that they forget that this first round is just the first round. They’re going to have to raise money from a venture capitalist.
If you raise money at a valuation from a bunch of unsophisticated investors, at a valuation that doesn’t make sense, meaning it’s too high, you’ve created a real problem for yourself when you go out to venture capitalists.
You’re right. I’ve seen lots of venture capitalists walk away from transactions because of that.
Patrick: This has been great. Again, I’m with Jeremy Glaser from Mintz Levin. He’s a partner there and co-heads their venture capital practice. This is Patrick Henry from QuestFusion with the Real Deal…What Matters.
I hope you find this interview informative and educational. Please let me know your thoughts!
This is Patrick Henry, the CEO of QuestFusion, with The Real Deal…What Matters.