How founder-friendly are they?
I led a study in 2019 where attorneys reviewed the six most popular startup financing documents—all of which were produced by investor-funded organizations. After pouring through 298 pages of legalese, the attorneys found the top six financing documents were, on average, only 38% compatible with Founder Friendly Standard. The NVCA Model Legal Documents were the least compatible with the Founder Friendly Standard. See for yourself by viewing our infographic where you can drill down and compare the term sheets.
Many default sections in the NVCA Model Legal Documents are not founder-friendly
Review written by Keith Strahan, Managing Partner at Fulton Strahan Law Group, on Oct 14, 2019.
NVCA Model Legal Documents can be very time-consuming and expensive to negotiate and document. They include 18 agreements. To write this answer, my associate, Josh Mathews, and I reviewed the following six documents:
- NVCA Voting Agreement
- NVCA Term Sheet
- NVCA Stock Purchase Agreement
- NVCA Right of First Refusal and Co-Sale Agreement
- NVCA Investor Rights Agreement
- NVCA Certificate of Incorporation
To write this review, we started with each issue in the Founder Friendly Standard and compared it to the NVCA Model Legal Docs.
Section 1.1 of the Founder Friendly Standard says:
Individuals who work for the company and are instrumental in its inception (“Founders”) receive a class of equity such as Common Stock which provides no less than twenty-four (24) votes to one (1) vote of stock held by investors or employees.
NVCA Model Legal Documents do not meet Section 1.1 of the Founder Friendly Standard. Article FOURTH (A)(2) of NVCA Certificate of Incorporation says that Common Stock holders are entitled to one vote for each share of common stock at meetings of stockholders. Common Stock holders can’t vote on issues solely affecting/reserved to Preferred Shareholders. These can potentially include issues such as voting on a director, allowing for conversion of shares, and receiving preferred dividend payments, among others.
Section 1.2 of the Founder Friendly Standard says:
Investors receive a class of equity such as Class A Preferred Stock which will have one vote per share with a higher par value justified by a liquidation preference.
NVCA Model Legal Documents do not meet Section 1.2 of the Founder Friendly Standard. The NVCA Certificate of Incorporation Article FOURTH (B)(2) provides that Preferred Shareholders have a liquidation preference, Article FOURTH (B)(3) of the same document provides that voting is done as a single class. Why this does not meet Section 1.2 of the Founder Friendly Standard is NVCA Model Legal Docs provide the option for investors to elect two members of a five-person board. This would give investors a type of super-voting equity, not one vote per share.
Section 1.3 of the Founder Friendly Standard says:
Employees and contractors receive a class of equity such as Class B Common Stock which carries one vote per share and does not have a liquidation preference.
NVCA Model Legal Docs do meet Section 1.3 of the Founder Friendly Standard. In the NVCA Stock Purchase Agreement, Section 2.2 (b) provides for a stock option plan, under which “officers, directors, employees and consultants” may be issued shares of Common Stock. There is no separate ‘Class B’ for employees/contractors, but according to Section FOURTH, (A)(1) of the NVCA Certificate of Incorporation, common stock does carry one vote per share, and liquidation rights are subject to qualified rights of Preferred Shareholders.
Section 1.4 of the Founder Friendly Standard says:
The first board consists only of Founders. The term of the board is one year. After the first year, a new board is elected by the equity holders at the annual meeting. Board decisions are made by a majority vote of the board. Board members cast no more than one vote each on any decision. Board committees are disallowed for at least the first two (2) years.
NVCA Model Legal Documents do not meet Section 1.4 of the Founder Friendly Standard. Section 1.2 of the NVCA Voting Agreement provides the option to select the number of directors that the Board will consist of. Though optional, the NVCA Model Legal Docs suggest that the Board initially consists of five directors, two of which are designated by investors.
Section 1.5 of the Founder Friendly Standard says:
New equity of any kind, including stock option pools, dilutes all equity holders equally. Therefore, no investor in the company has anti-dilution rights of any kind.
NVCA Model Legal Docs do not meet Section 1.5 of the Founder Friendly Standard. Subsection 4.4.4 of the NVCA Certificate of Incorporation provides for anti-dilution rights. There are two options provided, including a broad and narrow option, i.e. a “broad-based weighted average” anti-dilution provision and a “full ratchet” anti-dilution option.
Section 2.1 of the Founder Friendly Standard says:
Founders agree in writing they will give and receive performance reviews at the end of each fiscal quarter for the first four (4) years.
NVCA Model Legal Docs do not address section 2.1 of the Founder Friendly Standard.
Section 2.2 of the Founder Friendly Standard says:
Sweat equity vests each month over a period of four (4) years with a one (1) year vesting cliff. Vesting begins on the date shares are issued.
NVCA Model Legal Documents do meet Section 2.2 of the Founder Friendly Standard. Section 5.3 of the NVCA Investor Rights Agreement suggests a 4-year vesting term with 1-year vesting cliff. This is required not only for sweat equity but for “all future employees and consultants.”
Section 2.3 of the Founder Friendly Standard says:
Founders keep all information confidential and assign the company all intellectual property created within the scope of their work for the company.
NVCA Model Legal Documents do meet Section 2.3 of the Founder Friendly Standard. Section 2.19 of the NVCA Stock Purchase Agreement says current and former employees, consultants, and officers of the Company represent they’ve executed confidentiality agreements. Furthermore, Section 2.8 of the NVCA Stock Purchase Agreement provides that the Company represents that all “employees and consultants have assigned all intellectual property rights.” Key Employees also must not have excluded works or inventions from their assignment of inventions. However, the term “Founder” is not used in the NVCA Model Legal Docs, so it may be important to note that there is the possibility for a founder to fall through the cracks of this Standard if they do not fit into one of the above-stated categories, such as an “employee, consultant, or officer.”
Section 2.4 of the Founder Friendly Standard says:
Due to potentially devastating tax consequences, the company tells individuals receiving sweat equity in the United States to consult with a tax professional about making an election under Section 83(b) of the Internal Revenue Code. Founders who live or pay taxes outside the United States are similarly advised to consult tax professionals about applicable local and national taxes.
NVCA Model Legal Docs do meet Section 2.4 of the Founder Friendly Standard. Section 2.22 of the NVCA Stock Purchase Agreement provides a representation by the company that all elections and notices for 83(b) have been or will be filed. However, there is no recommendation for individuals to consult any tax professional regarding 83(b) elections.
Section 2.5 of the Founder Friendly Standard says:
Non-compete restrictions only apply to employee or independent contractor agreements and do not survive termination. The company’s bylaws and other investor agreements are either silent on the issue of non-competition or expressly allow competition.
NVCA Model Legal Documents do meet Section 2.5 of the Founder Friendly Standard. Under Section 2.19 of the NVCA Stock Purchase Agreement, all key employees must sign a non-solicitation (and non-compete is bracketed as optional); this meets Founder Friendly Standard. It is worth noting that Section 2.11(b) of the NVCA Stock Purchase Agreement requires that the Company must represent that “no officers, directors, or employees, or respective spouses, children, or affiliates” are engaged in relationships with the Company’s competitors up to the time of closing the investment transaction; it is not express language that prevents competition moving forward.
Section 3.1 of the Founder Friendly Standard says:
For at least the first two (2) years of operations, the company will not agree to pay the legal expenses of any investor as a condition of investment.
NVCA Model Legal Documents do not meet Section 3.1 of the Founder Friendly Standard. Section 6.8 of the NVCA Stock Purchase Agreement provides that the Company pays the reasonable fees and expenses of counsel for the lead purchaser, up to a capped amount. Under Section 5.8 of the NVCA Investor Rights Agreement, in the event of a sale of the Company, the expenses for investor counsel is to be borne by the Company.
Section 3.2 of the Founder Friendly Standard says:
For at least the first two (2) years of operations, the company does not agree to binding arbitration with any investor.
NVCA Model Legal Docs do not meet Section 3.2 of the Founder Friendly Standard. Section 6.16 of the NVCA Stock Purchase Agreement provides for:
- The option of courts in a particular jurisdiction,
- Or two options for arbitration, using AAA or DRAA rules, both of which include binding provisions with no two-year prohibition.
- Under the DRAA alternative, there is the option to remove the waiver of the right to appeal.
- There is no distinction made between investors or founders.
Section 3.3 of the Founder Friendly Standard says:
For at least the first two (2) years of operations, the company does not agree to binding arbitration with any Founder.
NVCA Model Legal Documents do not meet Section 3.3 of the Founder Friendly Standard. Section 6.16 of the NVCA Stock Purchase Agreement, Section 6.4 of the NVCA Right of First Refusal and Co-Sale Agreement, Section 6.11 of the NVCA Investor Rights Agreement, and Section 7.16 of the NVCA Voting Agreement, all provide for:
- The option of courts in a particular jurisdiction,
- Or two options for arbitration, using AAA or DRAA rules, both of which include binding provisions with no two-year prohibition.
- Under the DRAA alternative, there is the option to remove the waiver of the right to appeal.
- There is no distinction made between investors or founders.
Section 4.1 of the Founder Friendly Standard says:
Upon any transfer or sale of Founders’ super-voting equity, the portion of equity transferred converts to the class of equity described in Section 1.3. This also includes any transfer to a Founder’s estate, spouse, or heirs.
NVCA Model Legal Documents do not meet Section 4.1 of the Founder Friendly Standard. There is no super-voting equity provided for in the NVCA Model Legal Docs; and as such, there is no conversion mechanism, as provided for and in accordance with the Founder Friendly Standard.
Section 4.2 of the Founder Friendly Standard says:
The company has the right of first refusal on any transfer or sale of equity for up to forty-five (45) days, but it cannot veto a transfer or sale. This provision is void after a company’s stock is listed on a public exchange such as the NASDAQ, OTCBB, New York Stock Exchange, etc.
NVCA Model Legal Documents do not meet Section 4.2 of the Founder Friendly Standard. While Section 2.1(b) of the NVCA Right of First Refusal and Co-Sale Agreement does provide the Company with the first right of refusal for up to 45 days, Section 3.3 of the same agreement says equity cannot be transferred to (a) an entity which directly or indirectly competes with the Company, in the Board’s discretion; or (b) any customer, distributor, or supplier of the company if the Board determines it would put the Company at a competitive disadvantage. Section 3.2 of the same agreement provides that this right of first refusal shall not apply to the sale of stock to the public in an IPO.
Should you sign a term sheet that isn’t founder-friendly?
NVCA Model Legal Documents meet five of the issues addressed by Founder Friendly Standard (sections 1.3, 2.2, 2.3, 2.4, and 2.5). NVCA Model Legal Docs conflict with nine of the issues (sections 1.1, 1.2, 1.4, 1.5, 3.1, 3.2, 3.3, 4.1, and 4.2) and are silent on one issue (section 2.1). Nearly all the issues carry long-term ramifications.
Agreeing to an investor-friendly deal can ultimately result in you getting fired from your own company. Investors fire startup founders more often than you think. It happened to Steve Jobs at Apple, Sean Parker at Plaxo, and the authors of Founder Friendly Standard.
Whatever agreement you sign today will be following you into the future. If you’ve built a customer-funded business, you can delay investment until you can get terms that you’re comfortable living with.
If your Texas-based startup has received legal documents from an investor and you’d like to talk through the issues, visit our law firm’s website at https://www.fultonstrahan.com
INFOGRAPHIC: How does Founder Friendly Standard compare to term sheet templates from 500 Startups, Y Combinator, NVCA, Gust, and Sam Altman?
* Limit of Liability/Disclaimer of Warranty: Keith Strahan and Josh Mathews (“Authors”) are not providing any financial, economic, legal, accounting, or tax advice or recommendations on this site. Although Authors are attorneys licensed in Texas, the information contained on this site was prepared for general information purposes only, does not constitute research, advice, or a recommendation from Authors to the reader and is not a substitute for personalized financial or legal advice. Neither Authors nor any of their affiliates make any representation or warranty as to the accuracy or completeness of the statements contained on this site. Authors and their affiliates expressly disclaim any liability (including any direct, indirect, or consequential loss or damages) for all posts and their content.