Caveat: Ted and I worked on a deal several years ago where he represented the investors and I the company. So, my opinions of Ted’s proposal are definitely colored by personal experiences (in this case, for the better).
Ted proposes that small series A rounds, like seed rounds have in the past, take on a more standard “short-form” approach to the structure and volume of the financing documents. He notes that costs for using longer documents might add $7,000-$10,000 in legal fees each for the investor and company, which is not insignificant for a small $1-1.5m financing.
On its face, the uninitiated might not realize that it’s not the documents themselves, in terms of pieces of paper that lawyers draft from a wide range of forms, that create the “excess” costs: it’s the promises on those pages that are the culprits. Promises about facts mostly: what we call due diligence.
Fundamentally, the purpose of contracts, in general and definitely venture financing agreements, is to allocate risks among the parties. These risks come in three flavors: present, operating, and potential problems.
- In the “present” category, investors are concerned about knowing what is actually going on today with the company: they want to know what’s behind door #1 as much as possible. So, for example, we ask founders and companies to promise that there are only so many shares of stock, or that the intellectual property has a clean trail, and that employees are allowed to work for the company.
- In the “operating” category, we create rights to information and ongoing reports so that the “present” concerns above are regularly addressed, and we provide a bundle of rights, some affirmative (the investors get power to do something) and some negative (the investors get power to vote on something). In this category are information rights, board seats, protective charter provisions, and operating covenants.
- In the “potential problem” category, we include provisions that protect the value of the investment under different scenarios, such as future financings or sales, changes in the risk exposure of founders or other investors, and registration rights.
Before analyzing what changes should or could be made to the usual course of business, it is important to make explicit what every VC knows but often forgets: the company’s legal fees come out of investor money, the VC’s legal fees come out of investor money, and so the cost of these extra provisions is very much equivalent to insurance bought by investors with their own money! (Yes, these expenses don’t get offset against the money raised and owed, so like points on a mortgage, companies either raise more or have less cash to work with. Same result.) Ted even calls these agreements an “insurance policy,” recognizing their function and, implicitly, their underlying economics.
To me, the revealed preference for the status quo by VCs indicates that these provisions are worthwhile expenses. This could be because they actually chose to spend money this way or, perhaps more likely, the information cost of determining that they are inefficient uses of resources is too high given the uncertain value. Ted’s put a stake in the ground for value, right or wrong. What’s the risk of choosing to go with Ted? Any VC making that choice in a given investment where it turns out wrong would be subject to having to “prove” that he wasn’t simply being reckless about disregarding “industry standard” terms. (It’s a West Coast version of “nobody ever got fired for hiring IBM). I don’t know many VCs that want to deal with that, regardless of whether they have the clout to survive no matter the outcome (e.g., John Doerr). In other words, there’s enough failure built-in to the VC model that few would be willing to invite more!
So where does this leave Ted and his idea? Here are some options:
- The NVCA could/should adopt Ted’s trim set of documents to ease adoption in the wild. Having drafted sets of Brobeck-based forms for Stanford Law School classes, knowing that those forms dated from Gunderson-era drafting, we all know that forms can take on a life of their own.
- VCs could share, anonymously or within the attorney-client privilege, outcome and history data on investments. Empirical research on the actual usage of different provisions would be extremely helpful to those trying to allocate costs all around. This research project could be big, but there is a wealth of resources available to undertake it and track the performance of these contracts.
- It will be critical for VCs, the real constituency to be addressed, to recognize that they are not choosing Ted’s model in a vacuum, but against alternatives with different costs and risks.
- Finally, there is a role for lawyers like Ted to put on the counseling hat and help VC clients understand when they are spending too much money on too little protection. My two favorite examples from Ted’s piece: environmental representations for a dotcom and financial statement reps (or, sometimes, an audit!) for a new corporation.
We as lawyers should be analyzing these documents like the insurance agreements they actually are (transferring risk between parties); Ted even calls them insurance policies. The hallmark of well-crafted insurance policies is that they transfer each risk to the party best situated to bear it. One [thought-]exercise I would often run through, on either side of a financing transaction, would be to wonder what the other side would be willing to trade in terms of either pre-money valuation or amount invested in exchange for some term of vague or frankly unknowable value. Want two demand registrations? Up the valuation by $50,000? Want 90 day lockups instead of 180 days? Take $25,000 less money in. These sound like silly examples, don’t they? But they’re absolutely [un-]realistic in that my opinion is that no one at the table — company, investor, or either lawyer — has any estimate (as opposed to a guess within an order of magnitude) of what any of these terms is worth.
And that’s what makes Ted’s point sing. If all sides are spending time, money, and effort to trade worthless rights and privileges that no one really wants to keep or avoid, there just might be a better way.
I’m with you, Ted. Who’s with me? What techniques have you used to narrow down the range of operative reps and warranties or place a value on other terms?
(I’ll address the legal opinion question in a separate post as well as one alternative for implementing some of Ted’s ideas in a format I invented years ago that might also be useful for analyzing past deals to discover the economic benefit/cost of the suspect provisions.)