Adeo Ressi’s Founder Institute, a seed stage incubator and mentoring program that we first covered last month, is set to release a set of legal documents this afternoon that promise to protect startup founders from, as he eloquently puts it, the “atrocities of investors.”
The new documents, created by Wilson Sonsini attorney Yoichiro Taku, are posted publicly on the website. They have a variety of novel rights and privileges:
- Creation of a Class F Founders stock that has 2:1 board votes per founder and 10:1 voting power over normal common stock. These shares vest monthly without a cliff and have single trigger acceleration. Class F holders get acceleration on change in control and approval rights on new investments, liquidity events, Board size, and dividends.
- A clause that requires the payment of $100,000 to the Founders Institute in the event a founder leaves the board of directors to give a disincentive to firing founders down the road.
- Grant of a warrant to the Founders Institute to buy 3.5% of the fully diluted stock of the company in the form of the equity sold in the first round of financing, which is pooled for participating founders and mentors.
The stock grants and any penalty fees paid are put into an exchange fund that all participating founders have ownership in. Therefore, all companies participating in each class have some stock in all the other companies – a great way to reduce overall risk. One big winner in each class means everyone gets a little bit rich. 60% of the warrant stock goes to the founders, the institute keeps the other 40%.
There’s a risk that these extremely favorable founder terms could create problems when the companies try to raise outside funding. Ressi says they won’t let a financing die from these terms and will likely waive rights if forced to. His reputation will require that – if these agreements protect founders he’ll be a hero, but if they kill financing deals the program will collapse.
Applications for the first startup class are open until May 10.
thefunded.com could be worth $2 billion dollars. web 2.0 alive and well no bubble.
Lol. Good luck with that when you need a real Series A.
I hope this will protect startups. It’s about time.
We always need a startup Czar. Now we have one.
Maybe we should just put all the funding money into one big pot and then as a community vote on which compaines get what dollars. No! Wait, how about investors who invest in the calendar year automatically receive payouts from successful startups, we can just tax the startups for being successful the year the investor decided to invest. Ok, that sucks. Maybe we can design one giant plinko game where the winner ends up on celebrity apprentice.
What we need is a union for founders or pooled resources.
The investors have all the clout and hold all the cards.
Over the last 15 years founders have lost both to the level that we see today — getting crushed down, vesting their own shares, and most importantly having to do more (goal-wise) for less money.
Founders UNITE!!
“and most importantly having to do more (goal-wise) for less money”
Is that bad? I got a little confused and so I might be wrong here, but doing more with less is always a goal of any efficient society.
Will these kind of agreements really help though? If these can be waived, is there any reason they won’t be required to do so?
Great to see innovation in the VC space. It will be interesting to see more variants of this new, fresh approach.
Good idea on the founders stock but some of the other ideas sound a little whacked!
Which ideas do you have concern with, lilywhite?
I think the Founder Institute is a great idea, but as a former company founder and current investor I do take issue a bit with the “atrocities of investors” theme. Don’t forget – founders have all the power! They create a company, own all the stock, and can do whatever they want in the early days! They are free to hire and fire anyone they want, create any class of stock or preferred terms they want, and negotiate any deals they want– this has always been the case and will always be the case. If a founding team chooses to raise money, then they decide whether to let an investor join and at what terms. This process is a negotiation (like everything else) and different investors will prioritize quantitative and qualitative deal elements at different “exchange rates”. This has always been the case, and always will be the case.
There are certainly horror stories of founders being taken advantage of when they didn’t fully understand the impact of some of these terms, but that is the job of their lawyer, advisors, and (hopefully) an ethical investor on the other side of the table. If the team is strong and the idea is attractive enough, then they will naturally have more flexibility to trade off terms to get a high valuation and favorable deal terms (as was the case with Google). However, for the typical “hot” early stage deal (as was the case with my company) it will be more of a balanced discussion.
I am glad to see that you won’t push entrepreneurs to focus on governance terms at the expense of the other elements, because I suspect many of your founding teams will be more comfortable with “typical” structures in favor or higher valuations. I, for one, remain very glad that I made these trade offs with my company in these negotiations because they helped us maximize the value to our founders and common shareholders. If things had blown up and the investors took over and fired all of us I’m sure I’d feel differently, but there probably wouldn’t be much of a company to fight over in the end then anyway!
The “atrocities of investors” is taken out of context. At least two dozen founders of high quality startups that I know have been terminated by investors in the last few weeks. Most of the terminated founders have had to fight to retain any value from their hard work launching a new company. Many investors fire the founders to cut the burn and take control.
This is an unfortunate circumstance that should be avoided going forward, and the Class F shares will ensure that these “atrocities” of terminating founders without good reasons happen a lot less.
This is a wonderful idea and coming as it does on top of the innovative things that Founders Fund are doing I think it might represent the start of a positive trend for founders. Well done Adeo.
Please name names. What companies? What investors?
I like the site, but found it not so direct in getting a response so one could know if your start up had any traction/hot or not. Kind of like sit and wait.
Of course being as brash as I am I got kicked the fuck off this fucking site. That was the best thing that could have ever happened to me as I started my company on my own. Fuck lame investors. Now I am a VC too. So go figure.
Byron, how funny to see your name here. I worked with your wife years ago at PW in LA.
I have experience both as a founder and as an angel and while I understand Adeo’s point, I think the terms Arrington highlighted would make me walk away from any such investment opportunity.
Ressi appears a godsend for entrepreneurs. I will definitely seek his professional services.
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MyLocator.me – find you
While I agree that a founder would be well served by getting this kind of deal, sadly, no reputable investor will agree to these terms. They know the power they wield with their $, and they aren’t going to give it up that easily.
Their simple argument – would you give me a 2:1 board right and a 10:1 voting right if I asked? No. Then why would I?
Right now, most founders are common shareholders, and common shareholders have no substantive rights. This gives investors with Preferred Equity and Convertible Debt nearly all of the power. Class F simply gives power back to the Founders.
Yes, it is likely that investors will negotiate some of the beneficial provisions out of the Class F shares. When this negotiation happens, the founders will get to negotiate some of the beneficial provisions out of the Preferred Shares.
Before today, the only negotiating leverage that a founder had was to walk from the deal…
There is a short summary of Class F common stock at http://www.star...f-common-stock/
Interesting. On the one hand, not sure there’s actually a problem here — VCs as institutions don’t make THAT much money. As an asset class, they don’t do so much better than the stock market. So at a high-level, the standard venture terms in aggregate are probably fair and fine.
Having said that, there’s a reason this is at least onto a great idea. VCs get to keep investing and provided they do, generally have rights to never be diluted (plus, they aren’t really even investing their own money). Founders work much harder and can easily — and often — do get squeezed out a company, and can be diluted to essentially nothing over time.
Dilution is fair and right but it is not always done in the most ethical and holistic fashion.
There is something unfair here the VCs and standard terms miss. Not sure if this is the answer, but seems to be trying to address it.
Invest Money (dumb lps)
Insert New Team (”stars”)
Burn Money
Find New Investors (dumb lps)
Insert New Team (”stars”)
Burn Money
Find New Investors (dumb lps)
Insert New Team (”stars”)
Burn Money
what really matters is whether better founder control will actually deliver a better return for investors. If it does, this is a good thing.
But if it insulates bad founders, it could cause trouble.
Funny. A poison pill to prevent investment!
A VC is going to do is ask you to fix the mess before they hand over their money. Founders should be focusing on execution, and not this sort of nonsense.
Ryan, you are right: founders should focus on execution. Unfortunately, dozens of founders who have executed well are getting laid off by professional investors looking to take control of companies.
Flawless execution does not make you invulnerable to being terminated. Look at Steve Jobs.
Steve Jobs was performing terribly when he got laid off though Adeo. He was all over the place and wasn’t helping the company. I think getting fired actually made him work better to prove himself.
Fair enough. I nearly threw an Apple product out the window at that time, and I switched to Microsoft. Steve may not be the best example, but he is well known.
My point is that flawless execution does not protect you from termination as a founder.
Love it.
This is a cheesy gimmick, period — and the timing is totally off. Class FF shares were developed by Parker/Venuto at a time when the balance of power rested with Founders/Issuers.
Now, it’s shifted toward investors. I’m telling you — this is going to get laughed at.
It’s also a sign that the BigLaw firms are in real trouble. These guys are losing business in droves. If Yokum had an active book, he would NOT have time for this nonsense.
Well, it’s not intended to be a gimmick. The theory is as follows:
(1) the Institute required legal documents to incorporate with and have participating companies use,
(2) the caliber of mentors, the application process, and the program are all carefully designed to produce world-class companies, so…
(3) the Institute produced a founder-friendly set of incorporating documents that represents the best terms available.
Why not give these documents away to all founders to use? You need a great company for the terms in the Class F agreements to survive negotiation with a professional investor. The assumption is that the institute will be producing great companies on a regular basis.
You are right. Don`t listen to the naysayers.
I hope WSGR got paid up front for preparing these documents. No investors will invest in companies using them, but they will look pretty on a forms site. This is a waste of time. Successful founders with a strong track record can negotiate reasonable protections, but these are stupid. When you take outside money, you give up control That is how it works. He or she who has the gold, rules.
There is no such thing as investment without ideas, Bill. The visionaries who can execute should ultimately reap the rewards. More often than not, visionaries who can execute are exploited, discouraged, and, many times, terminated without any good reason.
A smart individual who were to review the current state of affairs would not blindly accept Preferred Equity agreements because of a cliche: “He or she who has the gold, rules.”
It’s time for a change.
Founders who can execute are in fact rarely terminated. However, few founders execute in all phases as well as they think they can. I find it hard to believe that your provisions will yield better return for investors, which is the driving goal of VCs who put in the money. If investor return is not the goal of the founder, the founder should find funding from an alternative source (angels, bootstrap, home equity, whatever).
The VC’s I’ve worked with do not fire founders because they want to. They fire founders because they have to. And if the founder is truly invaluable to the business, the founder cannot get fired.
Bill, unfortunately, capable founders are frequently terminated. It’s a reality that is rarely discussed openly. There are many different justifications by the investors: control, burn reduction, redemption, forced liquidity, etc.
In today’s market, a capable founder can get terminated without any recourse. Incorporating with Class F is not a foolproof solution, but Class F gives founders both a bulletproof vest and life insurance.
Adeo, good luck to you. We obviously have different views on how often capable founders are terminated. My data points would say few capable founders get terminated but that few founders are able to grow their business to large scale–few people have the unique mix of traits necessary to have the great idea, grow a business, hire people effectively, develop a revenue model, etc. Ultimately, founders negotiate their protections when they take outside money. I’d doubt these protections will hold up as designed (i.e., the 10:1 voting could hold up but the VC’s will have it as well, leaving only employee optionholders with one vote per share) and they could kill deals, but it sounds like you will find out. My angel investments include companies that have gone public and that have been sold for 15x+ returns, and I don’t think I’d look seriously at a company that was wedded to your terms.
Bill, my guess is that you would take the company seriously with the Class F terms if it were a great company, which is the point.
These are the terms for the next suite of great companies, and these great companies will be started shortly.
Hello Adeo,
Too many times the founders of companies are visionaries but cant execute beyond a certain point. They also get blinded by their passion and personal friendships within the company.
I am all for the golden parachute. My fund would not invest in a company where the founder had an unreasonable amount of power.
Jeff Easton
Browning
Last time I checked, documents do not change the balance of power. Power changes the balance of power. These are worthless.
These documents are free to use, Dave. I am not sure if that makes them “worthless.” TheFunded Founder Institute used them to incorporate in Delaware.
Additionally, they will be used by a few hundred companies coming out of the Institute every year, so they will have some traction in the marketplace, too.
Excellent stuff! If anything, the site has an awesome logo and feel.
It’s about friggin’ time. The VCs have their clubby little NVCA that sets “market” terms but those terms include a bunch of stale, crappy protective provisions and other items designed to limit management’s ability to operate the company. The industry has needed a counterweight for a long, long time and this looks like a good start. If these founders perform and can get multiple financing sources interested (including non-vc money), they might be able to actually get some of this. At a minimum, the vcs will have to think about and explain why they want the stuff rather than sleep-talking through the same lame, brain-dead mumblings about market terms. Go Adeo!
While I think this Founders stock idea will not work, I agree re the NVCA terms. The NVCA is not “market” in any West Coast market I’ve invested in and are a bunch of over-lawyered, overly investor friendly bunk.
I know but they thump it so hard you’d think it was the bible.
So what if it turns out the founders cant run a bigger company? The VC gets to run an ad-hoc b-school, on his dime, where the students can outvote him?!
Fuuuuun.
I gotta admit you do have quite an incentive for your startups to raise rounds with these kind of terms. Goodluck, I really would love to see what a success coming out of this looks like.
Sorry, Adeo, too late… I had already created Class G Stock (God Stock)… It only has One Share, it has complete voting rights and infinite controls and is resistant to any of the other claims to rights that any other class of stock can make, ever, and it applies to all companies, even before they are founded.
Sound absurd? It does share one commonality with Class F stock, and that is its completely divorced status from business reality in Silicon Valley.
Class F (or my Class G example) illustrate something that seems overlooked here in this exercise: a class of stock is only as good as its communal transference and acceptance. I believe your efforts will succeed in creating a lot of frustrated entrepreneurs who look for subsequent funding and meet the reality of historical precedent and communal non-acceptance in the form of unfavorable term sheets. They will set themselves up for a contentious discussion with future investors that will overshadow the merits of the business (which, last I checked, should be what this is all about.)
I write this as a founder, not an investor, by the way.
Regards,
Lao
Class F is simply an attempt to bring some value back to common stock and protect completely vulnerable founders.
Plain common stock has become largely worthless in funded companies. Preferred shareholders have increased their rights and protections, while liquidity events have become rare. Meanwhile, common stock has remained largely unchanged, having value diminished by the changing world.
Let’s look at a simplified example to identify some of the problems with common stock. A five year old company with $10 million in revenues decided to sell for $50 million in cash. The company has raised $10 million for 25% in preferred stock. The investors have a 1.5 liquidation preference that provides them with $15 MM on exit, and they also participate at 1/3 of the remaining proceed as a result of preferred dividends, providing investors with roughly $27 million of the $50 million in proceeds. If you pull 10% off the top for closing related expenses, common stockholders are left with just under $21 MM.
In this example, a CEO with 10% in common will stand to earn $2.1 MM on a 5x revenue sale for $50 MM. An investor with 10% will stand to earn $10 MM. It is likely that the CEO has taken below market compensation for years to get the company off the ground, which may average out to $500,000 of lost wages over five years, assuming that the CEO earned nothing for some period of time. It is also likely that the common shareholders, who are often management and employees, will be asked to bear the burden of an escrow, earnout, or other type of holdback. If 20%, or $10 million is held at the time of close, the CEO would walk away with $1 MM, $500,000 of which makes up for lost wages. This simplified example does not factor in the impact of having to purchase options, which diminish the value of common further.
There is an argument that creating value in common stock may help to improve returns from private equity and venture capital. Common stock is the foundation of entrepreneurship. It is the basis of management compensation, employee options, and voting control. Creating the opportunity for management to make real returns from their common holdings creates an alignment of interest with investors.
Any experienced entrepreneur, investor, or wise employee understands that an extraordinary success is required to get any value from common stock when there are investors involved today. Owning 10% in common of a company with a liquidation preference coupled with participation, dividends, redemption and other rights present is worthless, even if the company sells for tens of millions of dollars.
Adeo, you’re a very lucid thinker coming from a genuine place of concern. That is very obvious. However, the above example beautifully illustrates merely the following (for me):
1. Venture is more-or-less broken when you don’t have a home-run. If the above math is disheartening to the entrepreneur, look for alternatives. They exist.
2. If you raised the substantial sum of $10mm from venture capital, achieved revenues of $10mm and sold for just $50mm, you didn’t actually knock if out of the park. That potential non-optimal outcome would have been obvious to the founders before they signed the term sheet for $10mm in the first place! So, they knew this going in and must be accountable for their own upfront contract. It may be sad, but it was their choice.
3. Entrepreneurship is not really about “lost revenues” for founders. I’d be extremely hesitant to work with folks who use internal head metrics to calculate their lost income if they are building a business.
Silicon Valley has become very soft and entitled. This is risky business and risk means tolerance for exposure and loss. It cannot be engineered out of a situation. VCs knew this a long time ago, and so they pushed the risk to the common shareholders of their portfolio companies, as you accurately illustrate. Accordingly, if entrepreneurs find themselves uncomfortable with that risk dynamic, seek alternative funding structures.
The absurdity of Class F points to the displeasure with the venture model of financing in its entirety, but it is not a solution. If entrepreneurs feel this frustration, then the answer is to step out of the cycle and pursue other means to company building.
Regards,
Lao
Lao, agreed. Some of the terms in Class F stock are far reaching, only able to be justified by the best new companies. Over the next months and maybe even over the next couple of years, only the best companies will raise money, anyway.
In the negotiation about whether a particular Class F right should survive through an investment, some preferred terms may be reduced or eliminated. Hopefully, there will be a meaningful discussion about the rights and value of common stock in this new world.
Keep in mind that many of the the most obnoxious preferred stock terms only became prevalent in the last downturn. If there is no counter-balance in this downturn, I dread the outcome.
My point about the $500,000 in lost wages is a point about opportunity cost. It’s hard to attract the best talent, when the talent can make more money elsewhere with less risk. If venture capital relies on great entrepreneurs and if the odds of making money as an entrepreneur in a venture-backed startup rival the odds of the lottery, then there is a problem…
All excellent points. I now better understand your objectives with this endeavor, Adeo. I had not considerd its sheer audacity as part of the entrepreneur’s toolset, and that does indeed make sense.
Thank you for your thoughtful presence in communicating on this topic!
Regards,
Lao
3.5%?! Even Orrick only kills you for 1% or so maybe up to 3% max. All the law firms do this and technically you can reproduce this at those firms as well (Orrick had something vaguely familiar). Point taken though the law firms are closer to the VCs than any startup.
In any case all this is meaningless until funding starts rolling again. 3.5% of $0 is $0.
The Institute asks for 3.5% in warrants, and 60% of the value from these warrants is distributed back to Founders and Mentors in the program. Founders can generate returns from participating in the program because their peers do well as a result of the warrant offering.
Also, since warrants are not equity, but the right to buy equity, they are not -necessarily- dilutive. In fact, the Institute plans to use a portion of the warrant to make fair market value investments in participating companies.
I’ve participated in many deals as both founder and VC, with a wide range of valley VC’s. I don’t think Adeo’s idea will fly with most VC’s, and any founder who demands a set of terms like this is unlikely to be funded.
A more practical way to protect the common shareholders is to balance the board with a mix of financial investors and independent directors who are compensated through common stock option grants. Of course, the independent directors must have domain expertise that is valuable to the company to justify the support of the financial investors.
When an issue/decision arrises that pits the interests of the common shareholders vs. the preferred shareholders, the common at least has meaningful board representation. The preferred shareholders may still have the upper hand through their associated rights, but the common will have an advocate.
I am puzzled how everyone is saying that this will not work.
You are entrepreneurs! One of the marks of an entrepreneur is to find ways how to make something work. Let the rest of the world find ways for things not to work.
I remember seeing similar comments when TheFunded was being launched and subsequently getting press coverage.
Adeo does have entrepreneurs’ interests at heart. I’d apply to be a portfolio company, but I think I found a business model that will make funding unnecessary.
Venture capitalists have one problem – they are all selling the same product – money. As that industry is not doing so well today, Adeo’s timing for a proposed reform is perfect.
Thank you, Leonid.
One clarification, any Founder can apply to the Institute, whether the Founder is planning to raise no money or a lot of money. Only one session out of 18 is focused on fundraising.
The goal is to help the broadest range of world-class companies get their start.
Founders need options in a very dense jungle. The Founder Institute is an amazing chance for people, and I mean people because lifes and efforts from people are at stake. Theres a massive amount of education on how to make money, how to be creative, how to run a company. But most of that education has limited focus.
Founded companies most of the time stay answering the wrong questions correctly. Improving products, corporate image, etc, until the day they meet a VC and discover that most of their decorational efforts are worthless through the eyes of an investor.
Adeo is offering the same educational roadmaps entrepreneurs have had for years from other sites, but this time education is given on time, right before you develop your idea. To educate entrepreneurs at early stages with a focus on going for VC, makes sense to say the least.
Yes, a lot of investors will panic in a world were founders are prepared with VC knowledge, most will prefer to hunt naive fish in the big sea, since funding the new twitter at 3x liquidation preference has its own benefits. But the sea is changing and the fish are being trained. In the comming years if you want the best fish you´ll have to settle with standard terms and open negotiations.