Summary
Much of the “venture capital is dead / broken” cacophony focuses on how most angel and venture capital investors have been unable to adapt their investment and operational models to fit the new economics available to many entrepreneurs. Perhaps we just need an alternate investment structure to align incentives and economic models.

Not a replacement, but an alternative for some situations. Instead of accepting what is, let’s think about what could be.

Feedback Requested: A Flexible Structure for Partnering with Entrepreneurs

Conversations around the best structures for pre-venture capital Series A investments often focus on convertible debt and preferred equity. It’s not a simple question: the “best” structure really depends on the specific situation and often comes down to a value judgment over which structure is more “fair” or “easy”.

Structures create incentives; perhaps what the venture industry needs is an alternate model to align incentives and economic models.

In response to a couple business opportunities I’ve been evaluating, I’ve been playing around with some ideas for an investment and compensation structure that could work for the type of fluid investor, consultant and entrepreneurs partnering relationships that new organizational and economic models are making more possible and more common.

Goals

• The fundamental problem: how can investors and consultants help entrepreneurs start businesses and get fairly compensated for the value they create?
• Establish the rules and create more interactions: what’s the hardest problem in starting a new venture? What decisions need to be made in the beginning?
• Create structures that enable flexibility, create more intermediate decisions and tie payments to actions, not to negotiations.
• Allow consultants and investors to contribute as needed to help entrepreneurs.

Structure
The structure has two key parts to create compensation and investment agreements for investors / consultants and entrepreneurs:

1) Compensation: Convertible Preferred Shares granted under a Kudos Model.

• Convertible Non-Participating Preferred Shares.
• Granted by the entrepreneur to the consultant / investor under a version of a Kudos Model: the entrepreneur selects the number of shares to grant every three months based on their estimate of the value created over the past three months. The entrepreneur cannot retract granted shares.
• Shares are priced at $X per share (price TBD: set at same for all shares).
• Share holder holds the decision to convert (portion or all) of shares to 1) Equity at next qualified investment round or 2) Convertible Debt at any time under the terms in the instrument detailed below.
• Shares are convertible at 1:1 ratio for shares bought by the next investor at the next round (common, preferred or whatever form of equity negotiated).
• “Next round” traditional VC sets the pricing and terms of the shares.
• The shares vest immediately.
• Cash compensation: the holder of the shares holds the option to be paid cash compensation whenever the company reports a cash flow positive month (or whenever the entrepreneur draws cash from the business), commensurate with the share holder’s % equity ownership of the company. Repayment will reduce the amount of Preferred Stock held by the Consultant / Investor. E.g. if the preferred stock holder owns 10% of the granted shares in the overall company, whenever the entrepreneur draws cash compensation from the business the preferred stock holder will be paid 10% of the cash compensation.

2) Investment: Convertible Debt

• Consultant / investor invests capital into the business through a convertible note.
• Note carries an interest rate of 10%. Interest is not paid as cash but is added to the contributed capital in the note.
• Multiple closings: the note is “open” for continued investment for one year from date of issue. This is so that the investor can continue to gauge progress and invest money into the business depending on capital needs and continued interest and commitment to the business.
• The note converts at a discount to the conversion price on the next round. The discount will be a maximum of 25% (five percent per month, depending on how long it takes to close the financing, up to the maximum) off of the per share price.
• Debt repayment: the holder of the convertible debt holds the option to be repaid portions of the debt whenever the company reports a cash flow positive month (or whenever the entrepreneur draws cash from the business). Repayment will be X% of the positive cash flow or X% of the cash flow drawn by the entrepreneur (% TBD, to be negotiated).
• No personal guarantee of the note by the entrepreneur.
• Weighted average anti-dilution protection.
• Investor holds the right to participate equally (pro-rata) in further investment rounds under the same terms as the next investors.
• Basic protective provisions: no pre-payment of the note by the Entrepreneur, pre-specified payment if there is a change of control prior to a venture round, and a cap on the amount of additional debt a company can take.

Other Terms:

• Financial statements: entrepreneur is required to send a monthly CEO update; unaudited financial statements available upon request.

Starting the conversation…

• A little confusing? Perhaps.

  As you think through the terms and the necessary improvements, consider one of my basic thoughts: How can we let continuous interactions and decisions, rather than scheduled commitments, determine the flow of attention, talent, time and capital? How can we introduce elements of game theory into our investment and operating structures?

• Valuation: Why aren’t the convertible shares or the convertible debt properly priced to a % ownership of the company at the time of grant or issuance?

  Establishing valuation at this stage really isn’t worth it. The intention is to push the valuation decision to when all parties have more information.

• Can’t the entrepreneur choose to “underpay” the consultant / investor by not granting enough shares?

  Yes, but that will make the working relationship pretty short, and that’s probably not in anyone’s interest.

• What if the entrepreneur will never be able to sell the business or achieve a qualified investment?

  The consultant / investor has the continuing option to take cash or hold shares; if the business turns out to be a cash-flow based business, then the consultant / investor will want to convert their ownership into whichever instrument maximizes their return.

  Yes, that means the investment may turn out to just be a loan.

• Keeping an accurate share register is very, very important to track the conversion options and current shares / debt structure.

  No question. And while this is a bit more complex, is it anything more than a couple extra lines in our Excel models?

• Why are the grant timelines set for every three months? Why don’t the grants only occur at investment rounds?

  Because for some “lifestyle” startups there may never be qualified investment rounds; the economic models simply won’t fit. Why three months? No particular reason, open for ideas.

• This is way more complex than the typical convertible debt or preferred equity structure; investors, entrepreneurs and lawyers understand those agreements and this type of agreement will create large legal costs for investors and entrepreneurs. Legal agreements are already too large of a transaction cost (time, money and focus) in starting businesses.

  Really? Seriously? We are nowhere close to a set of industry standard documents. A huge variety of structural decisions, terms and clauses are negotiated on a case-by-case basis. Legal fees are a pretty hefty transaction cost in raising capital and and creating option / equity structures. Is this really that much harder to structure?

  The goal of this idea is to create a standard structure and a set of interactions and less-standard decisions after the agreements are signed and the business starts, instead of focusing on the decisions before the business starts. Legal agreements are important; let’s help figure out ways to get them done sooner and quicker to let people start creating businesses.

  In addition, this structure effectively “punts” on many decisions and pushes the negotiations over pricing and other terms to the next investors, the next round or the later stages of the company, at which point the entrepreneurs and investors will be in better position to pay the necessary transaction costs and additional investors will be involved to help set terms.

• We (investor and entrepreneur) know exactly how we’re going to work together, how we’re going to balance our time and capital contributions and how the business will make money for both of us.

  If you know all of that, awesome.

  But there’s a good chance you don’t, and a better chance you’ll be wrong.

  Why create a structure that won’t allow you to adapt and change your relationship, time commitments and capital contributions over time?

Disclaimers

• It’s not meant to work for all situations. It probably won’t work for traditional angels or venture capital investors: in my mind it is best suited for the $0 to $100K “friends and family” pre-seed stages. But more importantly, it might work for consultants / investors and entrepreneurs that need a flexible, multi-facted, non-priced investment and compensation model to fit their fluid organizational model and “the great unknowns” of the future for their businesses.
• I’m not an expert. I’m not a VC. I’m not even an entrepreneur, really. But by sitting in the middle I see a both sides to similar arguments. I’m trying to imagine something different. Maybe I’m wrong: I’m fine with that, but I’m interested in learning why I’m wrong.
• This is not fully baked; it’s lacking many necessary terms, covenants, warranties and representations; I haven’t introduced the “Qualified IPO” concept,or “drag-along” rights and protective provisions on sale, I’m not sure about the nature of the convertible shares and liquidation preferences (participating? preferred or common?), maximum conversion clause, there are decisions to make on share vesting schedule, anti-dilution, Board of Directors, tax implications, etc… I’m looking for the discussion to help flesh out the details, point out holes and hopefully add new ideas that may help investors, consultants and entrepreneurs.

Inspirations and Resources:

• Yokum Taku, Startup Company Lawyer. Fantastic resource, easy to spend a day or two or ten just digging through the posts on the legal details behind venture capital investing.
• Basil Peters, The One Page Term Sheet for Angel Investors. Great resource for angel investors.
• Michael Lewkowitz, Kudos for Equity. The inspiration for the Kudos for Compensation idea.
• Ted Wang in VentureBeat, Reinventing the Series A
• NVCA Model Venture Capital Documents
• The CRV QuickStart Seed Funding Program
• Fred Wilson, CRV Quickstart
• David Cohen of TechStars, TechStars Model Seed Funding Documents
• Y Combinator Series AA Documents
• Sachin Agarwal, Quick Compare-and-Contrast of the Y Combinator and TechStars Series AA Model Documents
• TechCrunch, Y Combinator To Offer Standardized Funding Legal Docs
• Discussion on Tech Stars Documents on Hacker News
• Yokum Taku, What is upgradeable Series A preferred stock?
• Brad Feld, What’s the Best Structure for a Pre-VC Investment?
• Venture Hacks, Should I raise debt or equity?
• Dick Costolo, Convertible Debt Jeopardy
• Josh Kopelman, Bridge Loans vs. Preferred Equity
• Basil Peters, Exchangeable Shares
• Jeff Clavier, Debt or Equity in your seed round
• Julien Wallen, Web funding norms are a context, not guidance
• Mark MacLeod, Is Web 2.0 the great VC return equalizer?

Updated: Mentioned in the Wall Street Journal online Venture Dispatch column The Daily Start-Up.