Good overview and advice from our friend Yokum at WSGR - pay attention here - there's alot covered!
http://www.startupcompanylawyer.com/2008/08/23/how-do-the-sample-y-combinator-series-aa-financing-documents-differ-from-typical-series-a-financing-documents-or-whats-the-difference-between-seed-and-venture-financing-terms/
How do the sample Y Combinator Series AA financing documents differ from typical Series A financing documents (or what’s the difference between seed and venture financing terms)?
August 23, 2008
Y Combinator recently published forms of Series AA equity financing documents that YC portfolio companies have used when raising angel financing. YC provides a three month startup program for entrepreneurs twice a year in Cambridge, MA and Mountain View, CA. YC typically provides $5K plus $5K per founder of seed funding for usually 6% of the equity in common stock (which, as an aside, Sarah Lacy seems to question, but in my mind seems like something that I would jump at if I were a fledgling entrepreneur).
[Disclaimer/disclosures: Please read the disclaimer on the documents and on my website. I write this blog in my personal capacity and my opinions may differ from my colleagues. WSGR represents Y Combinator and many of its portfolio companies. I represent a YC portfolio company that provides the Chatterous application and have worked with Y Combinator founder Trevor Blackwell's company Anybots. I have also represented investors that have invested in a couple of YC portfolio companies. I may update this post in the future.]
I was planning to write a post on the differences between angel financing terms and venture capital financing terms, and thought that the YC documents provided a good opportunity to explain the differences. I’ve already noticed some commentary about the documents and decided to provide some more detailed explanations and the situations that they might be used.
If you want to review annotated Series A venture capital financing documents, please review the NVCA model venture capital financing documents. (Please note that I think that the default provisions in the NVCA documents are generally fairly investor-favorable and reflect east coast practice rather than Silicon Valley practice. I will probably write a post about these documents are some point in the future.) This post assumes that you have a basic understanding of Series A financing terms. If you don’t, please educate yourself on this site, Venture Hacks and the term sheet series by Brad Feld/Jason Mendelson, among other places.
What situations should these documents be used in?
The YC documents are probably fine in situations where the investor (i) wishes to purchase equity rather than convertible debt, (ii) is otherwise somewhat indifferent on terms other than percentage ownership of the company, liquidation preference and right of first offer in future financings, (iii) is investing at a fairly low valuation (i.e. a couple of million dollars), and (iv) is only investing a small amount (i.e. a couple hundred thousand dollars or less).
In my experience, sophisticated angel investors expect to receive a full set of Series A documents with rights essentially the same as venture capital investors, so the Series AA documents may not be acceptable in these situations. I think these documents are most appropriate in a friends and family equity seed financing. However, I believe that companies are generally better off with convertible debt rather than an equity financing at a low valuation.
Why is it called Series AA?
To differentiate it from typical “Series A” preferred stock, which comes with certain expectations with regard to rights. I’ve had clients rename their Series A, B and C to Series A-1, Series A-2 and Series A-3, so that their first institutional venture capital financing was called the Series B. There is no real rule to what a particular series of preferred stock is called (i.e. Series FF for the Founders Fund invention). I suppose that YC could have named it Series YC, instead of Series AA, for better branding.
What rights does the Series AA have in the sample YC documents?
Obviously, please read the term sheet. The primary rights in these documents, ranked in order of importance in my opinion are:
Non-participating preferred liquidation preference. The investor receives their money back and the remainder goes to the common. According to WSGR’s survey of venture financings, a non-participating preferred is in around 40% of financings, with the liquidation preference in the remainder of deals being more investor-favorable.
Limited protective provisions. Among other things, the company can’t be sold without consent of a majority of the Series AA.
Right of first offer on future financings. Please note that these documents provide that the right of first offer expires five years after the financing, which I believe is not standard (but happens to be the company-friendly default in the WSGR form of documents that the Series AA documents were based on).
Information rights. The investor receives unaudited annual and quarterly financial statements.
There are situations where an investor might receive stock with even less rights. For example, if a founder contributes a significant amount of cash (i.e. enough to buy a car) to fund the company, then I might suggest that the company issue preferred stock with a liquidation preference and no other rights to the founder, as opposed to issuing common stock. The reason for issuing preferred stock instead of common stock is to preserve a low common stock value for option grants as explained in this post, and providing the stock with a liquidation preference.
What are the primary rights that are missing from the these documents that a VC or sophisticated angel would expect?
Some people have suggested that various terms are unnecessary in early stage Series A financings. See the VentureBeat article titled “Reinventing the Series A.” In the sample YC documents, there are various terms that are missing that one would typically expect in a company-friendly Series A term sheet (i.e. one from Sequoia Capital).
Dividend preference. Deleting the dividend preference is not a big deal, as almost all startup companies don’t declare dividends. The only practical situation that I can think of where a dividend preference is beneficial to a stockholder is where a company does a partial sale of assets and wishes to distribute the proceeds to stockholders. The liquidation preference would not apply in this situation, and any distribution to stockholders would trigger the dividend preference.
Registration rights. As a practical matter, I don’t think that most investors should really care about registration rights, especially in light of the shortening of the Rule 144 holding period to 6 months. (I suppose I will write a boring post about Rule 144 at some point.)
Anti-dilution protection. Deleting anti-dilution rights saves several pages of text in the Certificate of Incorporation. Given that the Series AA is issued at a fairly low valuation, anti-dilution protection is probably not that important, as a “down round” from a low valuation in the Series AA is unlikely.
Comprehensive protective provisions. The YC documents are fairly light on protective provisions compared to a typical Series A financing.
Right of first refusal and co-sale. These rights are missing. This is probably okay assuming that the founders restricted stock purchase agreement has a right of first refusal on transfers until a liquidity event. The right of first refusal on founder stock transfers in a typical restricted stock purchase agreement is in favor of the company. (Please note that when I say typical, I mean an agreement drafted by attorneys experienced in venture financings, not the boilerplate you might get from an online incorporation service.) The typical RFR/co-sale agreement in a venture financing gives the investors a right to purchase the shares if the company does not exercise its right.
Voting agreement. An optional bracketed provision in the Certificate of Incorporation provides for a Series AA board seat. In a typical venture financing, there would also be a voting agreement that governs how specific board seats will be filled. In angel financings, I typically eliminate the voting agreement anyway and simply have a closing condition that the board consist of certain persons.
Comprehensive representations and warranties. The Series AA Preferred Stock Purchase Agreement has fairly limited reps and warranties. As a practical matter, investors don’t sue companies for a breach of reps and warranties, so reps and warrants basically serve to flush out diligence issues. In an early stage company, extensive reps and warranties are probably unnecessary.
Legal opinion. A company counsel legal opinion is missing in these documents. A legal opinion for a newly-incorporated early stage company probably doesn’t add much to the due diligence process and is probably unnecessary compared to the incremental cost to prepare.
Legal fees. Each side pays its own legal fees in these documents. Venture funds expect the company to pay investor counsel fees.
Do I need an attorney to help me complete a financing if I have these documents?
Yes. Absolutely. These documents are not intended to be “fill in the company name,” sign the docs and collect checks/wire transfers. The fact that certain rights were intentionally omitted from the documents compared to typical VC financing documents is a judgment call that requires the guidance of an experienced attorney. There are always various corporate housekeeping matters that need to be cleaned up in connection with a financing. Please don’t try to use the YC documents without working with a competent attorney.
Tuesday, August 26, 2008
Thursday, August 21, 2008
[ENTERPRISE] 11 Things Startups Should Know About Enterprise 2.0
this is a great article from Read/Write/Web - for us the particularly interesting part is what they say about VC's needing Enterprise 2.0 now!
11 Things Startups Should Know About Enterprise 2.0
Posted: 21 Aug 2008 02:40 AM PDT
Yesterday we wrote about Enterprise 2.0 from the point of view of the Enterprise, the buyer. The conclusion was that the impact of social media on the Enterprise was very big, addressing the very "nature of the firm". This post looks at Enterprise 2.0 from the point of view of the vendor, specifically startups. This is a 30,000 foot view, but we aim to get past the hype to insights you can use in your startup. Further posts in our recently launched Enterprise Chanel will drill into specific market segments, companies and technologies.
1. Subscriptions are the best revenue you can get. Subscription revenue is more recession proof than advertising and more predictable than traditional enterprise software licensing. As long as you don't mess up, you will have a low churn rate. Then your new subscriptions drive your revenue growth
2. It is much easier to get subscriptions from a business than from consumers. Sure we all love the idea of consumer subscriptions, the potential is enormous. But do this reality check. How many subscriptions do you pay for? How many current subscription costs would you love to eliminate or drastically reduce? What would your really (no, really) agree to pay for every month? We are in a serious consumer recession in the developed markets that may last a while. What was always hard, just got an awful lot harder. Selling to business is much easier, if you focus hard on the next rule.
3. The other 80/20 rule. 80% of enterprise IT budgets just "keep the lights on". Only 20% goes to new stuff. I learned this in the technology nuclear winter in 2002, when a 20% cut in IT budgets meant that no (zero, nada) new projects were approved. If you can show how to reduce that 80%, you get a better shot at the 20%. That 80% market is a replacement market. You need to know what cost you are replacing. The incumbents are looking at the 20% budget as well and they have the inside track. You have to attack the 80% to make it big.
4. "Parallel replacement" is new. The old enterprise replacement market was based on capital expenditure write offs. If the client bought a $1m license fee over 5 years ago, you had a shot at selling another license fee for something "better, faster, cheaper". In the new enterprise world of SAAS and open source, upfront license fees are the exception rather than the rule. Buyers prefer to hold onto the old stuff a bit longer until they can see either an open source or SAAS alternative. Replacement is always very risky, leaving incumbents in control and startups banging outside the door in frustration. So you need to show that you can run in parallel with the existing solution for a period until you are established enough to be a viable, safe replacement. Step 1 is run in parallel, step 2 is replace. This is what Google Apps and Zoho are doing to Microsoft office (I use both Google Apps and MS Office. Even though I use Office less frequently I own a license, so why delete it? When I get a new laptop I will decide whether I need to buy Office). To play this new parallel replacement game you need to a) offer a free entry point (the Freemium strategy) so you get traction with a low cost of sale and b) you need to show one very clear new value proposition that will tap into that 20% budget for new stuff.
5. Have one simple new "blue ocean" value proposition that any business user can understand. You need this to access the 20% of budget going to new stuff. Being "cloudy" is not a value proposition, it is simple]y a way to deliver your value proposition. The incumbent can always launch their SAAS equivalent. Your free entry level just gets you through the door so that you get a chance to upsell to your subscription; free is not a value proposition. You have to show how you will do something really basic such as either a) increase revenue with a low cost of sale or, b) reduce cost on an existing process or c) create strategic sustainable advantage in measurable ways. Most likely you will do this by enabling better collaboration/communication, both within the enterprise but also, more critically, outside the firewall to the "extended enterprise". For a startup, this has to be "blue ocean", a market that has not yet been defined by the incumbents. By its very nature, this means the market size will be very hard to define and there will almost certainly not be recognized external authority that has defined the market size. Smart VC understand that Blue Ocean strategy and precise market size estimates seldom go together.
6. SaaS ++ means that Open Source is no longer a problem. Open Source has been great for buyers but it has also taken the entry level market away in most segments and that trend shows no sign of letting up. That is bad news for a startup looking to sell traditional software with a "better, faster, cheaper plus we try harder" replacement pitch. You cannot undersell Open Source. That has forced many ventures with great software and strong teams into the dead-pool. With a "SAAS ++" offering, you can use Open Source as the base, add a bit of new code and bundle it all up with hardware and service in a monthly fee. Unless buyers really want to do all that in-house, using their dwindling internal IT staff, you have a shot at it. SAAS alone however is not a barrier to entry. Anybody can replicate it. Which means (smart) VC will/should pass. You need the "++" bit as well. That is likely to be something to do with viral, communications and network effects that create a growing user base and proprietary data coming from that base. That is the "magic sauce".
7. You need to become a very good financial and data modeler. You will need some old-fashioned face to face relationship selling to get large enterprises to understand your solution, so that the "powers that be" encourage adoption and do not seek to block it. But the business will grow one subscriber at a time and users convert to subscribers one click at a time. Modeling becomes a core competency. Modeling the costs of all the SaaS components (R&D, hardware, infrastructure software, software maintenance, system and data maintenance). Modeling the cost of subscriber acquisition using SEO, SEM, social networking, conversion from free to paid and inside telephone sales in a highly efficient funnel process that delivers the right $ per subscriber. Modeling the revenue growth with multiple what if variable assumptions. Modeling the ROI for your clients at various levels of adoption.
8. Most external market size projections do not help your business plan. Forrester Research reports that Enterprise 2.0 will be a $4.6 billion market by 2013. That is not nearly granular enough for a real business plan. You are not really in the Enterprise 2.0 market. Saying "we will get 1% of the $4.6 billion Enterprise 2.0" market is totally meaningless and will simply get you shown the door in the VC office. You are in the market of solving a specific business problem, for a specific type of customer, competing against specific incumbents and startups. That is how you need to build a market size, from the bottom up. This is particularly true for "blue ocean" strategies where the market has not been defined by an incumbent. Building the real world, bottom up market size takes real hard work and detailed market knowledge. Look for a small enough market where you can get 20% and take that to 50% share and then leverage that market to get 10% in another market. Rinse and repeat. It is an old formula, but it works.
9. You need VC, they need you but there is a disconnect. Since 2000, most VC have sent any business plan with the word "enterprise" straight to the trash. With good reason. During the nuclear winter, the enterprise IT market was dead as a dodo. Then the big incumbents got into the consolidation game and it looked like you would count enterprise IT vendors on the fingers of one hand. The cost of entry was high, needing expensive sales teams upfront and the revenue was lumpy and unpredictable. Yech. Better to back a few inexpensive developers building a free service that some big vendor would buy and figure out how to monetize. That was a great game for a while. Most VC now view it as in its final innings at best. There is a shortage of buyers, no IPO market, we are in a cyclical downturn for advertising and in a major funk figuring out how social media can be funded by advertising. So VC need Enterprise 2.0. But they have missed the early winners. Very few of the current Enterprise 2.0 startups are venture backed. This is a disconnect. The early players always find it easier to bootstrap than later vendors. Today you need capital to fund the ramp-up and to build distance from competitors as the Enterprise 2.0 market moves from "below the radar" to "early hype" phase, thus dragging more entrants into every category.
10. Vertical is not the same as Horizontal. Classic Web 2.0 services such as Delicious, YouTube and Skype are geared at mass markets. Anything that is more niche has tended to be called "vertical". That is confusing. Vertical means a specific industry such as banking, healthcare or manufacturing and sub-sets of those industries. Horizontal (applying to any industry) should mean a set of common and linked features used by a specific type of person in the company (e.g. accounts payable by Finance, CRM by Sales and so on). The general rule of thumb has been for vertical ventures to be bootstrapped and eventually rolled up into larger entities. VC tend to view vertical as too limited. Horizontal on the other hand is big enough.
11. Know how to deal with secrecy, structure and control needs. Social Media is about being open, loose, unstructured, informal and fun; no ties allowed. Enterprises are about secrecy, structure and control. Ties show that you are serious and fun is for after work. The ties and fun bit is just style. But secrecy, structure and control is real. If you threaten those, many forces within the enterprise will shut you out. It will be like the red blood cells attacking the foreign virus. On the other hand, if you go along with all the secrecy, structure and control rules of the enterprise you will lose the social media benefits of extended enterprise collaboration and innovation. Many people within enterprises understand this and some of them are in a policy-making position of authority. In general, the trend is towards loose, unstructured, "emergent business networks". So "make the trend your friend", but beware of the very strong forces of opposition and deal positively with their legitimate needs.
ConclusionWhat is your position in the Enterprise 2.0 market. Do you work in IT in a large Enterprise? Do you work for a large incumbent Enterprise IT vendor? Do you work for a startup that is going to change the Enterprise world? Are you writing about this rapidly emerging market? Do you have unique insights or research to share? We would love to hear from you in the comments and maybe as a Guest Author. Email us if you're interested in writing for ReadWriteWeb's Enterprise Channel.
11 Things Startups Should Know About Enterprise 2.0
Posted: 21 Aug 2008 02:40 AM PDT
Yesterday we wrote about Enterprise 2.0 from the point of view of the Enterprise, the buyer. The conclusion was that the impact of social media on the Enterprise was very big, addressing the very "nature of the firm". This post looks at Enterprise 2.0 from the point of view of the vendor, specifically startups. This is a 30,000 foot view, but we aim to get past the hype to insights you can use in your startup. Further posts in our recently launched Enterprise Chanel will drill into specific market segments, companies and technologies.
1. Subscriptions are the best revenue you can get. Subscription revenue is more recession proof than advertising and more predictable than traditional enterprise software licensing. As long as you don't mess up, you will have a low churn rate. Then your new subscriptions drive your revenue growth
2. It is much easier to get subscriptions from a business than from consumers. Sure we all love the idea of consumer subscriptions, the potential is enormous. But do this reality check. How many subscriptions do you pay for? How many current subscription costs would you love to eliminate or drastically reduce? What would your really (no, really) agree to pay for every month? We are in a serious consumer recession in the developed markets that may last a while. What was always hard, just got an awful lot harder. Selling to business is much easier, if you focus hard on the next rule.
3. The other 80/20 rule. 80% of enterprise IT budgets just "keep the lights on". Only 20% goes to new stuff. I learned this in the technology nuclear winter in 2002, when a 20% cut in IT budgets meant that no (zero, nada) new projects were approved. If you can show how to reduce that 80%, you get a better shot at the 20%. That 80% market is a replacement market. You need to know what cost you are replacing. The incumbents are looking at the 20% budget as well and they have the inside track. You have to attack the 80% to make it big.
4. "Parallel replacement" is new. The old enterprise replacement market was based on capital expenditure write offs. If the client bought a $1m license fee over 5 years ago, you had a shot at selling another license fee for something "better, faster, cheaper". In the new enterprise world of SAAS and open source, upfront license fees are the exception rather than the rule. Buyers prefer to hold onto the old stuff a bit longer until they can see either an open source or SAAS alternative. Replacement is always very risky, leaving incumbents in control and startups banging outside the door in frustration. So you need to show that you can run in parallel with the existing solution for a period until you are established enough to be a viable, safe replacement. Step 1 is run in parallel, step 2 is replace. This is what Google Apps and Zoho are doing to Microsoft office (I use both Google Apps and MS Office. Even though I use Office less frequently I own a license, so why delete it? When I get a new laptop I will decide whether I need to buy Office). To play this new parallel replacement game you need to a) offer a free entry point (the Freemium strategy) so you get traction with a low cost of sale and b) you need to show one very clear new value proposition that will tap into that 20% budget for new stuff.
5. Have one simple new "blue ocean" value proposition that any business user can understand. You need this to access the 20% of budget going to new stuff. Being "cloudy" is not a value proposition, it is simple]y a way to deliver your value proposition. The incumbent can always launch their SAAS equivalent. Your free entry level just gets you through the door so that you get a chance to upsell to your subscription; free is not a value proposition. You have to show how you will do something really basic such as either a) increase revenue with a low cost of sale or, b) reduce cost on an existing process or c) create strategic sustainable advantage in measurable ways. Most likely you will do this by enabling better collaboration/communication, both within the enterprise but also, more critically, outside the firewall to the "extended enterprise". For a startup, this has to be "blue ocean", a market that has not yet been defined by the incumbents. By its very nature, this means the market size will be very hard to define and there will almost certainly not be recognized external authority that has defined the market size. Smart VC understand that Blue Ocean strategy and precise market size estimates seldom go together.
6. SaaS ++ means that Open Source is no longer a problem. Open Source has been great for buyers but it has also taken the entry level market away in most segments and that trend shows no sign of letting up. That is bad news for a startup looking to sell traditional software with a "better, faster, cheaper plus we try harder" replacement pitch. You cannot undersell Open Source. That has forced many ventures with great software and strong teams into the dead-pool. With a "SAAS ++" offering, you can use Open Source as the base, add a bit of new code and bundle it all up with hardware and service in a monthly fee. Unless buyers really want to do all that in-house, using their dwindling internal IT staff, you have a shot at it. SAAS alone however is not a barrier to entry. Anybody can replicate it. Which means (smart) VC will/should pass. You need the "++" bit as well. That is likely to be something to do with viral, communications and network effects that create a growing user base and proprietary data coming from that base. That is the "magic sauce".
7. You need to become a very good financial and data modeler. You will need some old-fashioned face to face relationship selling to get large enterprises to understand your solution, so that the "powers that be" encourage adoption and do not seek to block it. But the business will grow one subscriber at a time and users convert to subscribers one click at a time. Modeling becomes a core competency. Modeling the costs of all the SaaS components (R&D, hardware, infrastructure software, software maintenance, system and data maintenance). Modeling the cost of subscriber acquisition using SEO, SEM, social networking, conversion from free to paid and inside telephone sales in a highly efficient funnel process that delivers the right $ per subscriber. Modeling the revenue growth with multiple what if variable assumptions. Modeling the ROI for your clients at various levels of adoption.
8. Most external market size projections do not help your business plan. Forrester Research reports that Enterprise 2.0 will be a $4.6 billion market by 2013. That is not nearly granular enough for a real business plan. You are not really in the Enterprise 2.0 market. Saying "we will get 1% of the $4.6 billion Enterprise 2.0" market is totally meaningless and will simply get you shown the door in the VC office. You are in the market of solving a specific business problem, for a specific type of customer, competing against specific incumbents and startups. That is how you need to build a market size, from the bottom up. This is particularly true for "blue ocean" strategies where the market has not been defined by an incumbent. Building the real world, bottom up market size takes real hard work and detailed market knowledge. Look for a small enough market where you can get 20% and take that to 50% share and then leverage that market to get 10% in another market. Rinse and repeat. It is an old formula, but it works.
9. You need VC, they need you but there is a disconnect. Since 2000, most VC have sent any business plan with the word "enterprise" straight to the trash. With good reason. During the nuclear winter, the enterprise IT market was dead as a dodo. Then the big incumbents got into the consolidation game and it looked like you would count enterprise IT vendors on the fingers of one hand. The cost of entry was high, needing expensive sales teams upfront and the revenue was lumpy and unpredictable. Yech. Better to back a few inexpensive developers building a free service that some big vendor would buy and figure out how to monetize. That was a great game for a while. Most VC now view it as in its final innings at best. There is a shortage of buyers, no IPO market, we are in a cyclical downturn for advertising and in a major funk figuring out how social media can be funded by advertising. So VC need Enterprise 2.0. But they have missed the early winners. Very few of the current Enterprise 2.0 startups are venture backed. This is a disconnect. The early players always find it easier to bootstrap than later vendors. Today you need capital to fund the ramp-up and to build distance from competitors as the Enterprise 2.0 market moves from "below the radar" to "early hype" phase, thus dragging more entrants into every category.
10. Vertical is not the same as Horizontal. Classic Web 2.0 services such as Delicious, YouTube and Skype are geared at mass markets. Anything that is more niche has tended to be called "vertical". That is confusing. Vertical means a specific industry such as banking, healthcare or manufacturing and sub-sets of those industries. Horizontal (applying to any industry) should mean a set of common and linked features used by a specific type of person in the company (e.g. accounts payable by Finance, CRM by Sales and so on). The general rule of thumb has been for vertical ventures to be bootstrapped and eventually rolled up into larger entities. VC tend to view vertical as too limited. Horizontal on the other hand is big enough.
11. Know how to deal with secrecy, structure and control needs. Social Media is about being open, loose, unstructured, informal and fun; no ties allowed. Enterprises are about secrecy, structure and control. Ties show that you are serious and fun is for after work. The ties and fun bit is just style. But secrecy, structure and control is real. If you threaten those, many forces within the enterprise will shut you out. It will be like the red blood cells attacking the foreign virus. On the other hand, if you go along with all the secrecy, structure and control rules of the enterprise you will lose the social media benefits of extended enterprise collaboration and innovation. Many people within enterprises understand this and some of them are in a policy-making position of authority. In general, the trend is towards loose, unstructured, "emergent business networks". So "make the trend your friend", but beware of the very strong forces of opposition and deal positively with their legitimate needs.
ConclusionWhat is your position in the Enterprise 2.0 market. Do you work in IT in a large Enterprise? Do you work for a large incumbent Enterprise IT vendor? Do you work for a startup that is going to change the Enterprise world? Are you writing about this rapidly emerging market? Do you have unique insights or research to share? We would love to hear from you in the comments and maybe as a Guest Author. Email us if you're interested in writing for ReadWriteWeb's Enterprise Channel.
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