Legal Stuff, Explained

Take Aways From Wednesday’s Founders’ Legal Gym: Co-Founders’ Agreements and Convertible Note Financing

Thank you to all who were able to join us Wednesday for an in depth look at pre-nupping your relationship with co-founders and an analysis of convertible notes from both an investors and a founders’ perspective. Check out the below take aways from the class and stay tuned for a special guest blog by Nigel Austin, founder of Austin Law PLLC, covering co-founders agreements in further depth.

Co-Founders Agreements:

What happens to the company and its control when your co-founder decides to go to the beach and is no longer performing in his capacity? What about if your co-founder wants to sell a controlling portion of his shares to a third party? Or what if your co-founder dies? In all of these situations your company’s equity and thus its control is at stake. Without a co-founders’ pre-nup these issues and how to handle them become a huge “elephant in the room.” Nigel Austin broke down these very critical components of the co-founder relationship. 

• Founders should begin thinking about “pre-nupping” their relationship at a very early stage. They should seek the advice of an experienced advisor who has dealt with co-founder situations (not necessarily an attorney). It is critical to sit down and explore the tough questions about how equity in the company will be handled in the event that a situation arises.

• In the case of multiple co-founders, it may be a good idea to make one founder the lead and grant the other founders equity in the form of stock options that vest at a later point according to a pre-determined schedule. There are a variety of tax implications of this, most notably that an 83(b) election must be filed to avoid harsh tax penalties.

• We have a great co-founders agreement up on Docracy (available here: https://www.docracy.com/5854/founder-agreement) that can provide a starting point, and might give you an idea of what one of these look like. But it is important to recognize and remember that these agreements are not the same for all deals. The many specifics of your situation will almost certainly require modifications to any “standard” you find. Such specifics include the relationship of the co-founders, the type of company, the expected investment, and the long-term outlook of the company.

Convertible Notes and Angel Financing:

Ryan Ambrose of FF Venture Capital, and Vivek Boray of De Franceschi & Shefayee LLP, opened up the second half of the class with an in depth analysis of the current funding environment. Ryan see’s a bubble effect overall, but maintains that the smart money is still going into investments that will continue to be successful. He anticipates that with the recent influx of early stage investment we may see more company’s raising a first round and then tailing off. But this trend should not affect the smart money investors as much.

Convertible notes are a type of hybrid debt instrument. At a very basic level, an investor gives the company money in exchange for a debt note which has the option to convert after a predetermined time or event such as a Series A equity financing. In the case of a Series A, the note provides the company with some much needed early capital and gives the investor the rights to shares of series A according to the future terms of the negotiation.

From an entrepreneurs perspective, these are good agreements to use because they are typically short documents that are not too complex to negotiate. This keeps the legal costs of issuing a convertible note relatively low compared to a Series A or other equity fundraising. For a cash strapped startup, these are often the most cost effective and beneficial ways to raise some much needed capital to get an idea off the ground and running.

There are some great sample convertible notes out there. The following are just a few of those available on Docracy:

• Vivek Boray’s memorandum of Terms for Sale of Convertible Promissory Notes: https://www.docracy.com/5976/memorandum-of-terms-for-sale-of-convertible-promissory-notes
• Zeke Vermillion’s Convertible Note Term Sheet Template: https://www.docracy.com/2740/convertible-note-term-sheet-template-
• Y Combinator Series AA Termsheet: https://www.docracy.com/5/y-combinator-series-aa-termsheet