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Episode 23
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Substantive Law
In Search of the Unicorn: Advising early-stage start-ups
Law as stated: 7 August 2020
What is this?
This episode was published and is accurate as at this date.
In this episode, Richard Pragnell discusses the unique legal dynamics of advising early-stage, high-growth start-up companies.
Substantive Law| What area(s) of law does this episode consider? | Richard discusses the unique legal dynamics of advising early-stage, high-growth start-up companies. |
| Why is this topic relevant? | Silicon Valley might be the first place that comes to mind when we think of innovative start-ups, but here at home, New South Wales is the start-up capital of Australia, ranking third behind California and Singapore for its number of start-up founders. It comes as no surprise that it’s no surprise that many lawyers advise the sector hoping to be the lawyer of choice for the next unicorn – but start-ups have unique legal needs, from financing, to defending valuable intellectual property, to corporate governance. |
| What principles are considered in this episode? | Retention through incentives – share vesting:
Defensibility
‘Flipping up’
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| What are the main points? |
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| What are the practical takeaways? |
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| Show notes | 15 Key Questions Venture Capitalists Will Ask Before Investing in Your Startup |
| David Turner:
| Hello and welcome to Hearsay, a podcast about Australian laws and lawyers for the Australian legal profession, my name is David Turner. As always, this podcast is proudly supported by Assured Legal Solutions, a boutique commercial law firm making complex simple. Even in these uncertain economic times, NSW is the start-up capital of Australia, and it’s no surprise that many lawyers want to advise the sector hoping to be the lawyer of choice for the next unicorn. But start-ups and early stage companies have unique needs that set them apart from other clients and joining me today to talk about those unique needs is Richard Prangell, principal at Viridian Lawyers. Rich, thanks so much for joining me today on Hearsay. |
| Richard Prangell: 1:00 | Oh David look, thank you so much for having me, it’s great to be here. |
| DT: | Now Rich, let’s talk about the very, very early stages of advising a start-up. Now it’s common for an early stage start-up to begin its life with 2, maybe 3 founders, and theoretically those founders have equal rights. Now, this sounds like a fair, simple approach in theory, but you can sometimes end up with a deadlock in the former situation – in the two shareholder situation, and in the other situation you can sometimes end up with one founder being shut out of decisions by the other two. What sort of protections can you put in place at that very early stage where the company’s first being formed to try and avoid those difficult situations? |
| RP:
2:00
3:00
| Yeah so David, look, this is a difficult problem and I guess I’d preface my answer to this saying that the legal solution to this problem is really a secondary answer to this problem. One of the first things that I do with my clients when I’m working through the early stages of advising them on structuring their affairs, and often they’ll come to me having not done any structuring of their ownership of the company at all, is to is to start by impressing upon them how important it is over the longevity of the company for the two of them to really consider their relationship akin to a marriage is probably a phrase that your listeners have heard before. But it really is true and in fact I’d go so far as to say that founders of a technology start-up that go the distance, so to speak, almost certainly spend more hours a day together than they do with their significant others. But with that said, you know assuming that the parties go in on, you know, on good faith terms and do their best to resolve issues amicably, there are some things that can be done from the legal perspective to manage those deadlock issues. So ‘vesting’ is when the share ownership in a start-up is contingent upon continued participation in the day-to-day work of the start-up. TIP: Many start-ups use share vesting to incentivise founders and key employees in the start-up to stay committed to the business. Share vesting is a type of condition that a company attaches to the shares you own. A vested share is a share that you own completely, one that you can act on, vote on and sell. On the other hand, an unvested share is one that’s allocated to you but that you don’t quite own, not yet – you can only sell it or exercise the powers that come with it after a period has passed or an event has occurred. If you leave the company before the vesting condition has occurred, then you’ll forfeit your unvested shares and have to sell them back to the company for their nominal value, say, $1 per share. This entices key employees, especially the founders, to stay committed to the business. Now that can be structured in a number of ways and I’ve had clients who take different views on this, but the sort of standard industry view is that participation in a start-up on a day to day basis over time results in fractional vesting effectively. Usually on what we call the cliff, which is to say that after an amount of time, a large fraction of the shares vest all at once. We might have for example a one-year cliff and then thereafter, monthly vesting. |
| DT: 4:00 | I’m so glad you mentioned that the legal solution is really the secondary solution. I think that’s a really important point to hit because you can put all sorts of controls in the shareholders agreement in the constitution, you can limit certain decisions to special resolution, you can limit certain decisions to unanimous resolution, you can have shares vest on condition, you can have delegations to different shareholders and all of those things can from a legal perspective restrict the rights to make decisions without the consent of others. But ideally those founders are going to put your shareholders agreement in a draw and not look at it unless something really goes wrong. And I’m so glad you highlighted that. Tell me a bit about some of those secondary legal protections, particularly share vesting, that can be used to control decision making in that way? |
| RP:
5:00
6:00 | Founder share vesting operates a little bit uniquely, and perhaps counterintuitively to what most lawyers would expect when talking about vesting. We often talk about vesting as lawyers in the context perhaps of an employee share plan or employee share option plan something along those lines. Generally speaking, when you’re working with start-ups, founders will come with the intention of having an equal split of the business and they’ll often have an equal number of shares issued to them by an accountant or something along those lines. And that’s a good intellectual social starting point I think. And what happens is we have what’s called reverse vesting in a start-up arrangement among founders where the founders shares are issued up front, as they often are before they ever come to me in the first place, and then subject to progressively reducing buyback rights. And thus we have what we call the reverse vesting. That reverse vesting can take a number of structures and mostly the industry standard position will be that we have what’s called a four-year vesting term with a one-year cliff. And what that means in practise is that at the end of the first year of the start-up’s life, one quarter of the total shares issued to each of the founders are no longer subject to the buyback right that we mentioned a moment ago. Vesting proceeds on a monthly or quarterly basis over the next three calendar years of the start-up’s life. |
| DT: | And in what circumstances can the company exercise those buyout rights? |
| RP:
7:00 | There are a few circumstances. Primarily their exercise is in the event of a founder leaving the company, so the founder no longer contributes on a day to day basis. The different start-ups that I work with have different views on this, and some will intend everything from you know daily contributions to the business, perhaps a certain number of hours per week in way of contributions to the business. I’ve had clients come to me that keep extensive time sheets of contributions to the business in terms of hours sometimes minutes. And they have self-determined very complex formulas that they use to determine the speed of vesting for each of the respective company founders. There are a lot of options but far and away the standard that most of my clients will settle on is a basic involvement in the business threshold. So if there’s a founder who is no longer involved in the business and the meaning of that is intentionally broad, then the buyback rights can be triggered at that point. |
| DT: | And of course the more serious issues like fraud on the company, or on another shareholder, or serious indictable offences, you can of course have separate buyout rights exercisable in those situations. |
| RP:
8:00 | That’s exactly right. We call those ‘bad leaver’ rights and that’s exactly correct. So if there is a fraud on the company or an indictable offence or something of that nature, those bad leaver rights are often exercisable after the fact, potentially, you know, for a period of time following the founder leaving the company, and may also trigger buy-out rights against shares that have already been fully vested effectively. So there’s a second layer effectively of buyback rights they’re there to protect the interests of the company over the long term. TIP: Serious breaches of the shareholder’s own employment agreement (if the shareholder is also employed in the business), disqualification as a director by ASIC, breaches of restraints of trade, events of insolvency, and prohibited dealings in shares, which are usually also breaches of the terms of the shareholder’s agreement, basically, these are the sorts of events that bring a relationship of trust between founders to an end, the sorts of things that mean you’re going to have to dust off that shareholders agreement and look at legal remedies after all. Buyback of shares in ‘bad leaver’ circumstances usually occur at a different valuation to other share transactions, but care has to be taken to ensure that these aren’t construed as penalties. |
| DT: | Kind of got the carrot and the stick there, you know. You’ve got the carrot of reverse vesting to ensure that people remain actively involved in the prosperity of the start-up and then you’ve got the stick of ‘well if you do something really bad, we’re going to take all the shares off you anyway.’ |
| RP: | That’s exactly right. |
| DT: 9:00 | Now, let’s talk about defensibility. So the value proposition of a start-up, not always but is often, an innovative idea. But an early stage start-up doesn’t have the kind of natural defensibility of large market share, or high barriers to entry like a really technical or licensed industry. How can a start-up use legal protections to defend that value proposition? TIP: Let’s explore the term, ‘defensibility’ for a moment. Think of it this way – if a competitive advantage is what helps your company become successful, then defensibility is what helps the company stay that way. It’s something that prevents another person from copying what you’re doing. Defensibility can be achieved legally, which is what Rich and I will be talking about, but it can also be achieved economically, through having such a large share of the market and operating at such a scale that it would be impossible for a competitor to profitably operate at the prices you do. It can also be achieved through marketing, by having such a strong brand and such loyalty from your customers that they wouldn’t go elsewhere even if someone else could do what you do. |
| RP: 10:00
11:00 | That’s a difficult problem for a lot of start-ups, there’s no easy answer to that one unfortunately. Defending an idea at the best of times is difficult no matter how well funded you are, and start-ups are, at least in their early days by definition, not that well funded. So there are some possibilities though and I find that probably most clients that I work with, their first port of call I suppose is trademark protection. So intellectual property protection in the form of a trademark. Start-ups, generally speaking, closely guard their branding, they take marketing very seriously and so trademark protection combined with any sort of other common law remedies that might, or statutory remedies that might go along with trademark protection, perhaps passing off or misleading and deceptive conduct, are common options exercised by start-ups. |
| DT: | I find in that context, the kind of statutory IP protections, one thing that’s often misunderstood is the role of copyright. That copyright is vested in the expression of an idea but not in the idea of your business itself, you know that there are some business concepts that you can’t really protect. |
| RP:
12:00 | Yeah that’s exactly right, and so you said it better than I could David. The copyright absolutely does not help you unfortunately as a business, protect your idea. If a start-up has a genuinely patentable innovation might be something interesting to start-ups under some circumstances. I generally find that the kinds of clients that I work with find it difficult to justify the cost and perhaps more importantly the distraction of the patent process. And I guess I would suggest that there’s probably also a general bias against software patents in the software industry. And a lot of the clients that I work with, a lot of the start-up clients that I work with, whether they’re software companies that also make hardware, or they’re software companies that also perform other services, there is just generally speaking I think a bias against in the industry particularly at the ground level, patents as a rule. I think there is a sense in the industry that everybody is standing on the shoulder of giants and that in some sense it’s inappropriate to patent technology innovations that may be necessary for the functioning of… |
| DT:
13:00
14:00 | It’s an interesting point you raised there in terms of the culture of software development and the culture of communities like GitHub. We as lawyers want to zealously guard the secrets of our clients’ businesses, but that’s anathema to the culture of creative commons, and as you say so eloquently standing on the shoulders of giants in that development space. I’m glad you raised the point about whether a patent is worth the distraction because it’s an expensive process, it’s a time-consuming process. There’s really a sweet spot where it works for you, isn’t there? Because either you have the sort of product where that technology is going to be out of date in 7 years anyway, in which case go for it and it provides some defensibility if you can afford to do so, but if you want to defend that competitive advantage long-term, if there’s a secret to your success that you need to rely on for longer than the protection the patent offers you, because of course that’s the great bargain of patent registration you’ve got to tell everyone how you do it. You’re better off protecting it the same way that KFC protects the eleven herbs and spices and the same way that Coca-Cola protects its recipe which is to keep it secret. TIP: While legal protection of your intellectual property seems like an easy method of defensibility, it’s much harder than it sounds. Obviously, protecting your brand by way of a trade mark registration is one step you can take, but patents, which protect a ‘manner of manufacture’ or the technology behind your unique product, are a different story. The application, and examination process for patents in particular, is lengthy and time consuming; and expensive. In Australia, there are two types of patents – one, the standard patent and the other, the innovation patent. An innovation patent is designed to protect an innovative advance on existing technology, rather than a groundbreaking new invention, with protection lasting up to 8 years. However, the Australian government announced that the innovation patent is actually being phased out, with the last day to file an innovation patent being 25 August 2021. The reason for the change? Funnily enough, to encourage growth and innovation. It was found that innovation patents were actually being used as a tool by large firms to stifle competition from smaller businesses. |
| RP:
15:00 | That’s right, absolutely, no you’re absolutely correct. And there’s also the enforcement problem as well when it comes to patents, particularly technology patents are a tricky problem with respect to enforcement in that there’s a great deal of overlap between patentable innovations in the technology space, but also because of the broad participation in the technology industry around the world, they’re eminently challengeable. In the sense that they have to be brought to court and relied upon as an action against a competitor. That can be a costly and difficult fight for a small business. And so patents are interesting in the technology industry and unfortunately they’re the kind of things that are very easy to acquire for organisations like Google, Microsoft, Amazon, Facebook etc., and very difficult to acquire for those businesses coming up through the ranks and so they often pursue those protections intentionally perhaps to their detriment in the long-term, but as a result have been a very considered decision in the short-term. |
| DT: | In those very early stages, a start-up might be better served by a well drafted NDA than by pursuing patent protection. |
| RP: 16:00
17:00 | Yeah, I think that’s correct and NDA is a tricky problem in and of itself as well though. I mean, NDA’s really need to be, in the technology industry, deployed carefully. There are certain groups or participants in the industry that just won’t have them, won’t sign them, won’t be willing to participate in your venture if presented with an NDA. The group that jumps first most to the mind for me obviously is that venture capitalists won’t sign NDAs as a blanket rule. Reason being, well at least by way of their justification, is that they expect to see dozens, if not hundreds, of technology innovators in the course of any given year and maybe in any given month and it would be impossible for them to keep track of and maintain their compliance with an NDA or a confidentiality agreement from each and every organisation that comes walking through their door. NDAs do however have quite a lot of utility with respect to management of contractors. So a lot of my clients I find will have external contracting arrangements with developers, designers, technologists, whoever it might be either inside or outside of Australia, and an NDA gives them some amount of confidence that they can work with those third parties and maintain the protection of their competitive edge. |
| DT: | I’m glad you mentioned venture capital because that brings us onto our next topic which is attracting external capital. No company can grow without capital, and a lot of the start-ups we’re talking about are not the sort of businesses that can pass the credit assessment necessary to raise debt capital, especially in today’s economy. Now other than having a great business idea, which certainly helps, what do companies need to do to make themselves attractive to equity investment particularly venture capital? |
| RP: 18:00 | The first thing that they need to do, and it’s certainly not a legal requirement, is that they need to be a high growth venture. There needs to be some justification, some reason why a venture capitalist can believe that this business is presenting out a valuation of $1,000,000 AUD – might one day be valued at 10 billion dollars AUD. |
| DT: | I should pause to say that $1,000,000 is an extremely conservative valuation for any start-up in Sydney. I think every business idea is worth $10,000,000, isn’t it? |
| RP:
19:00
20:00
21:00 | Yep that’s pretty much correct. The first and most important thing is that any start-up has a good case for high growth. And I think that’s probably one, I’d probably like to take that opportunity actually to sort of clarify the difference I suppose between what I think of as a “start-up” in inverted commas and a small business, or small growing business. I think what is traditionally meant when someone talks about a start-up, particularly a technology start-up, is a start-up that has high growth potential. And so a start-up with high growth potential is, by definition, interesting to venture capitalists, and as a result a life cycle of venture capital funding, perhaps acquisition or listing falls into place consequently. At least in Sydney, venture capitalists like to see a few different things from the start-ups that they invest in. TIP: Richard is about to talk about this concept a little bit more, but I just wanted to dive in here first with an extra reading recommendation. Forbes published a really great article on 15 key questions venture capitalists will ask before investing in your start-up. A link to the full list can be found in the show notes, but to give you an idea, a few of them are: Is there a great management team? Is the market opportunity big? What are the potential risks of the business? And are the founders passionate and determined? But first let’s hear more from Richard. In addition to obviously having good business potential, from a legal perspective, venture capitalists usually like to see, founder vesting, one of the key terms venture capitalists in the local market will look for is founder vesting. Because the founder is one of the core characteristics of the business. A good founding team is highly valued by investors and often in a lot of cases, and in fact some cases venture capitalists are what we call ‘founder first’ venture capital funds where they’ll look to founders’ characteristics, profiles, histories, work histories, in order to determine whether or not they’ll invest in a business. Ignoring in large part, at least in the very early stages, the actual financials or ‘bread and butter’ business of the business itself. Now that’s not all venture capitalists, but the founding team is necessarily an important part of the viability and investability of a start-up. And so founder vesting, which we talked about a little bit earlier in this chat, is obviously very significant because they want to see an incentive for those founders to continue their participation in their business over, at least, the medium term, 3-4 year time frames. Venture capitalists also like to have what we call, and I quibble with this a little bit sometimes, participation rights in future investment opportunities. So a start-up technology company very likely will go through a series of stages, starting with what we might call friends and family funding or perhaps… |
| DT: | There’s another F in that group. |
| RP:
22:00
| There is another F, sometimes called ‘friends, family and fools’ funding and in that stage of the investment lifecycle, a start-up might take something to the tune of $50,000, $100,000, $150,000 in investment. Really what we’re looking at here is an investment amount that gives the founders a little bit of freedom financially to quit their jobs or take a hiatus from their work and focus their attention on the business itself. Then we move to what we call a seed round which is the next kind of structured, perhaps the first structured, investment round and that seed round can come in a number of structures but will generally happen around the time that the company is approaching something like $5,000,000 – $10,000,000 in valuation. They can make a genuine case to investors that the company is starting to get some traction, their business is going well there, they’re either sourcing quality clients or they have monthly recurring revenues that are at a certain threshold. And they’ll have what’s called a seed investment round, and thereafter, depending on the lifecycle of the company, there’ll be a series of subsequent rounds which we call series A, B, C and onwards, where preference shares are issued. Venture capitalists who come in at the seed round level, very often are going to want participation rights in those future rounds of investment. So as the company’s valuation improves, well really they think of it two different ways. First of all, that’s their ability to double down and improve upon their return. If they pick a winner early in the company’s life, they’d like to be able to make sure that they can ride that ticket all the way through the company’s life and improve returns to their own investors. |
| DT: | Without of course committing to that level of commitment at an early stage before that benefit has been borne out. |
| RP: | That’s exactly right. Exactly correct. |
| DT: 23:00 | Now those stages of investment, whether we’re talking seed or series A or B, can be structured in a number of ways, a number of instruments can be used to raise capital either at those key stages or between them. Tell me a bit about some of the instruments that you can use from a legal perspective to raise capital? |
| RP:
24:00
25:00
26:00 | The traditional, historic way to raise capital is the issue of shares. So that is, shares would be priced and issued to investors on a recurring basis. There are a few other more modern options available to start-ups, but far and away I guess I would say that an issue of shares in a company at a given valuation on a semi-recurring basis is the basic structure for venture investment in start-ups, at least in this country. There are a couple of other more modern innovations around this space and the first I suppose that I would suggest is a, what’s called, a convertible note. Now historically and generally it’s still the case that convertible notes were often issued between investment rounds and so perhaps you had a start-up that had completed its seed round, not yet ready for a Series A, perhaps the valuation of the business hadn’t grown to a point of a confidence raising valuation that would support that moniker perhaps they might raise on what’s called a convertible note, which is a hybrid instrument, which is both debt and equity. So it’s effectively a debt instrument that is convertible to equity and convertible to shares in the company at a given future date or in the coming of some future event. Often those will be time based, so perhaps it will convert to a number of shares that are given valuation after a given amount of time, perhaps they will trigger at the discretion of the issuer, so the investor in that instance. But more often than not, they are likely to trigger at the coming of the next equity round effectively, so waiting out the time and effectively handing over the money now and waiting out the time to the next round in which case, perhaps at the discretion of the investor the debt converts to equity. Which actually leads me nicely to a relatively more modern innovation which is an instrument called the SAFE. Being the ‘Simple Agreement for Future Equity’ which is not unlike in most ways a convertible note but doesn’t have the debt portion attached to it. It is a strict contractual, future equity transaction between the company and a potential investor. And they’ve really taken off in the last say 3-4 years I would suggest. TIP: Let’s talk about the SAFE, or Simple Agreement for Future Equity. Y-Combinator, a tech start-up accelerator in the US, created the SAFE as a simple instrument for early-stage tech companies to use to raise capital. Now as Richard has mentioned, it is basically like a convertible note but without the debt part. Under a SAFE, an investor agrees to make a cash payment (which isn’t a loan) to a company in exchange for a contractual right to receive shares when a pre-agreed trigger event occurs. The trigger event is usually the closing of a future priced equity round. Usually, the SAFE gives the investor more shares than they would have received had they invested the same amount in the priced round of capital raising. SAFEs are often quicker and easier to negotiate – but they aren’t without their risks, as Richard will now explain. |
| DT: | Yeah, and they’ve taken off because at first blush that sounds like quite an attractive prospect to the start-up, doesn’t it? To the founders? Because you’re getting your money now, you don’t have to have the shareholders on your cap table yet, and you don’t have to carry any debt either, right? It sounds good but there are some unforeseen issues with SAFE sometimes, aren’t there? |
| RP: 27:00 | It can cause problems for future equity rounds and start-up founders perhaps are very rarely super clear on the cap table implications… |
| DT: | Yes that’s the one I was thinking of. |
| RP: | That’s the one you were thinking of? And there may be contractual issues. I do wonder about sufficiency, not sufficiency, but certainty of consideration when it comes to SAFEs; is the consideration being given by the start-up illusory? |
| DT: | So they do sound quite attractive to the start-up for those reasons, but there can be some unforeseen drawbacks or some surprising results as a result of SAFEs can’t there? |
| RP:
28:00
29:00 | Yeah they absolutely can, and I think the first and foremost reason for that is that they can be complex instruments in the sense that they often are paired with a discount, so that in the event of the future equity raise, those SAFE investments convert but they convert at a discount rate. That discount rate is against the price of the future rate. So we have investors coming into the business at a given valuation of the company, let’s say we’re valuing the company at $20,000,000, investors come in on a valuation of $20,000,000 the SAFE participants will take shares at the $20,000,000 valuation less a discount. And a discount is usually expressed as a percentage so 20%, 30%, 40%, 50% something along those lines, and that number will go up the further away effectively the anticipated fund raising is likely to be. So if a client is anticipating a fund raising in 12 months, we would be talking about a 15% or 20% discount. If it’s a fundraiser that might be happening in 2-3 years, the discount might be higher. The consequence of that, is that I find that many start-up founders lose track of, or have difficulty projecting the future implications of those SAFE investments. The cap table implications in particular, the capitalization table, the number of shares likely to be issued in the company, and how the percentages of those shares, with respect to control of the company, breakdown starts to get a little bit blurry when we’re talking about future issues at percentage discounts where the final price hasn’t been determined yet. So it becomes a problem I find for long-term capitalization planning. |
| DT:
| And it can be a problem when you are seeking to attract venture capital firms, as we were discussing earlier, what is attractive to venture capital firms, something that’s not attractive when they’re considering who they’re going to be in business with for the next few years is to see dozens of shareholders on your cap table already at a very early stage perhaps because you’ve been a little too trigger happy issuing these SAFEs to your nearest and dearest. But in the end it comes back to simple economics doesn’t it? With the convertible note of course that’s giving you the protection of ranking as debt until it converts, and if you’re not giving your investors that protection, of course that’s going to be reflected in the price that they’re paying. |
| RP: 30:00
| That’s exactly right, and I actually want to take that opportunity now that you mentioned the debt again, to point out that there is an inherent risk there as well. In the sense that convertible notes, although they are often expected to be converted to equity, that conversion often happens, particularly if start-up founders are not careful, may be triggered at the discretion of the investor. And very few start-ups are really able to carry the debt if the debt is ever called back in again. I mean the money is taken for the purposes of being spent. It’s investment that’s there to be spent in the development of the business whether that’s in business growth, or research and development, that money goes relatively quickly. And so convertible notes are not without their risks in and of themselves and if you find yourself with an aggressive or difficult investor, the business might be putting itself at a pretty substantial risk there. |
| DT:
31:00 | Yeah, I mean the businesses we’re talking about aren’t cash flow positive businesses often they’re running at a burn and then perhaps they are raising money on these convertible notes to cover that for the next few years, and as you say that they’re not going to be in a position to pay off debt from revenue. |
| RP: | That’s exactly right. |
| DT:
| Now we’ve talked a bit about venture capital investment, we’ve talked a bit about investment by angel investors, ‘friends, family, fools’, any of these investors, they’re likely to be some of the first new shareholders to those founders that we were talking about earlier, those first two or three people who are actively involved in the growth of the business. What can those individuals expect from this process of having new shareholders to be accountable to, to hear the wishes and preferences of? Particularly where that might be a venture capital firm? What do they have to change about the way they run their company? |
| RP:
32:00 | Oh, quite a lot. And shareholder management is probably one of the primary skills I think that sorts the wheat from the chaff amongst successful early stage start-ups. It’s quite a bit that changes once external investors get involved. And I think the primary core early skills start-up founders need to get on top of is investor reporting. I find that the most important thing that keeps an investor happy is regular updates on the status of their investment. Surprise surprise! |
| DT: | Yeah it’s a little nerve-wracking to have to go asking, isn’t it? |
| RP:
33:00
34:00 | It absolutely is. And I would say that the future legal success or the future financial success of the business really is predicated in a large way on the management of and happiness of I suppose, of the other shareholders in a company. One of the implications of the pre-emptive rights, the participation rights that we talked about earlier in this discussion, is that future fund raising is in some ways tied to existing shareholders. And depending on what the terms of those rights are in particular, the ability of the business to raise future capital may still be stymied by the actions of the existing shareholders. They have a right to participate again depending on the terms of that right, how long do they have to consider their opportunity to participate, what powers do they have to participate, or to slow the participation process, when do they have to be notified and what changes to the deal require re-notification, are all grounds on which a future fundraise might fall over. Equity investments are very often fragile things, and a deal that’s ready to go today may not still be ready to go in a month if there has been 30 days worth of um-ing and ah-ing, and back and forth with the shareholders. Sometimes when the investor’s ready to sign, you need to get that John Hancock on the paper as fast as possible. And so shareholder management, the ability to keep your shareholders in agreement with your decisions to have them not get in the way, to get them to sign consents and waivers of their rights when a deal needs to get done as fast as possible, is very very important to the success of the business. In addition as start-ups grow, it needs change. What is an appropriate legal structure for a small technology start-up, may not be an appropriate legal structure for a large technology start-up. And many of the kinds of changes that need to be made to the corporate structure of a business need the consent of the existing shareholders. Notably changes to a shareholders’ agreement or the constitution of the company, you will very likely need a large majority, if not unanimous, agreement on the changes. |
| DT: | Some of those structuring considerations that you might think about as that client start-up is growing might include new subsidiaries or siloed companies perhaps to hold intellectual property or a treasury company. What other sorts of structuring changes do you think come up as the business grows? |
| RP:
35:00
36:00 | One that comes up for my clients most often is what we call in the industry ‘the flip up.’ Which is the flip up to the United States in most circumstances, which is to say the movement of the company from an Australian-based company to a US-based company because it’s getting a lot better, particularly in 2020, the venture capital industry is a lot stronger than it was in this country then it was five years ago. But the truth is that most of the money out there, venture capital for large businesses, is still in the United States. And even when it’s not in the United States, European and other foreign investors are often comfortable with US-based legal corporate structures, in a way that they’re not comfortable with Australian-corporate structures. And so it is very common that start-ups reach a tipping point in their growth where if they wish to continue to take funding, particularly investment funding, they need to make a corporate move to the US. That’s an issue that largely requires the consent of all of the shareholders of the company. In that their shareholdings are effectively, the US based business effectively, acquires the Australian business and there is a share swap event that occurs where the shareholders in the Australian company relinquish their Australian shares and in return receive an equivalent number of shares in the US based company. That’s a tricky problem if you have difficult shareholders that are hard to manage. TIP: Richard has briefly touched on the pros and cons of so-called ‘flip ups’, but I just want to explore this a little more. An obvious pro of flipping up is access to a broader pool of overseas investors – the Australian venture capital market is pretty small by comparison to the States. On the other hand, a flip up can be hard to undo and wind back, and an international structure brings with it more stringent compliance obligations and increased annual compliance costs. |
| DT:
37:00 | Moving away now from equity corporate structuring, corporate governance kinds of considerations to data, privacy and security, not all start-ups are technology companies, not all start-ups are digital start-ups, but many are. And we’ve been talking about that context particularly today, a lot of start-ups really rely on handling a great volume of customer data to offer their competitive advantage, whether it’s you know big data insights or whether it’s just that they’re an e-commerce business and they’re, as a matter of their operations, collecting a lot of data. What role do privacy policies and website or app terms of service play in managing those data risks? |
| RP:
38:00 | Yeah so look, it very much depends on the kinds of services that the company itself provides. And I guess I would say that the very starting point is the website terms of service and company privacy policies, or public facing privacy policies, are really the starting point for the solution of that problem. They’re not the ‘be all and end all.’ One of the great and difficult problems in 2020 of managing data privacy is that most technology start-ups in particular are global facing. They take clients from all over the world and therefore the privacy policy that they have in place, even if it is not strictly required to comply with privacy standards everywhere, there is a strong incentive to be aware of and comply as much as possible with all of the different privacy regimes all around the world. Whether that’s the Australian privacy principles, the European Union’s GDPR, the new California privacy rules, whatever it might be, those international privacy standards really have a, are at the front of mind for a lot of my clients. |
| DT: | We’ve talked before on this show about the GDPR and how Australian businesses might unwittingly become bound by the GDPR if they’re seen to be doing something that’s targeting European consumers as well and one of the common ways that occurs is by tracking the preferences of European consumers online. It’s interesting you mention all of those jurisdiction’s privacy laws, it seems every day there’s more and more jurisdictions to keep track of. I recently saw that Brazil’s privacy laws have become one that we need to get comfortable with. |
| RP: | Wow yes, of course. |
| DT: 39:00 | Do you think the GDPR is probably the gold standard at the moment? In terms of following one to keep track of? |
| RP:
40:00 | There’s been a lot of ink spilled over the need to comply with the GDPR. In particular from an end-user GDPR perspective. So Australian businesses for whom end-users might be based in the European Union. But I found that in practice, by far and away, that the biggest driver for GDPR compliance for my clients, is actually business-to-business transactions. For my clients often, they’ll be providing services to customers who are themselves based in the EU and therefore they are obliged to comply with the GDPR and so by way of flow-on GDPR compliance requirements, my client is therefore obliged to comply with the GDPR whenever handling data for that third-party. And so the GDPR has absolutely slid its tentacles into the Australian data privacy compliance industry. |
| DT: | And that’s, you know, because, I suppose, those GDPR compliant third parties, the customers in those business to business transactions, they have to ensure that their suppliers are complying with the GDPR or equivalent local legislation and Australian legislation is, at least for now, still not regarded by Brussels as the equivalent of the GDPR. |
| RP:
41:00 | That’s it exactly. Exactly. There was an interesting, and I haven’t unfortunately had a chance to look through the details of it yet, an interesting determination the other day if I’m not mistaken, stating that the standard contractual clauses that have been adopted in the industry standard around the EU and have been largely adopted around the rest of the world in sort of fearful compliance and hope that they will get local business over the line, are sufficient grounds for GDPR compliance. And so hopefully that takes some of the pressure off Australian businesses, given that our local laws are not de-facto compliant, but it’s yet to be seen I suppose. |
| DT:
| We’ve talked about a few different areas where lawyers can assist on advice legal protection, whether that’s around IP protection, whether that’s around corporate governance, whether that’s around corporate governance, whether that’s around privacy and data, but we’ve also talked about some considerations that are really more commercial than legal. That are around attracting equity investment, that are around keeping the cap table of a new company manageable, in your role advising early stage start-ups where do you see your role as an adviser begin and end? Do you restrict yourself to advising on the legal issues or do you think it’s the role of a lawyer in a position like ours to advise on those commercial issues as well? |
| RP:
42:00 | Oh I absolutely think it’s appropriate for lawyers to advise on commercial issues where they’ve got the requisite experience in a situation like this. I would argue that’s where the bulk of the value I provide my clients is if I’m being completely honest with myself. The ideas that we’re talking about here, everything we’ve discussed, none of it is hugely technical from a legal perspective. It requires some experience to get your head around, but most of the expertise that I feel like I offer as a practitioner is around understanding the commercial reality of these deals and being able to advise on what is, you know, what might be perhaps a standard deviation from the standard, or you know what are the parameters within which my client can negotiate on a commercial basis. So I definitely see my role as being part commercial, part legal. I obviously charge for my legal work. I think that the reason a client might choose me over another lawyer, is the additional commercial value I can provide them. |
| DT:
43:00 | One of the things that makes a start-up founder a great start-up founder is the ability to get things done, to be a doer and to do something even if you don’t have experience in that area before, you know bootstrapping, and I think that’s something that investors look for but does it make it difficult to advise founders who have a bias towards doing perhaps before asking you whether it’s a good idea? |
| RP:
44:00
| I suppose the answer that question does come down to how closely I work with a given client. There are clients that I work with who I find myself well ingrained into their decision-making process, where I have clients who gun to their head would probably say that they think of me as if I were an internal employee rather than an external consultant. I have clients for whom I regularly participate in their business Slack channels and communicate with them by chat on a regular basis. So look, the answer to this question obviously hinges on how well a practitioner understands and knows their client. However, I would suggest that being able to manage a client to head off potential client risks, to be able to guess at or anticipate possible actions your client might take, perhaps without asking permission first, and advising them on the possible outcomes of those actions, is probably an important skill to have when you have a client that charges head first into danger, so to speak. |
| DT: | I mean I’ve found in my experience of advising early stage companies that you really have to frame your advice around action and solutions. That your advice, if it’s as the uber risk-averse lawyer who’s always saying ‘no,’ you’re unlikely to be heard and it’s unlikely that advice is going to be adopted regularly. But if you’re giving your advice in a way that’s action focused and that’s in a way that enables a step to be taken even if it’s not the step that was the first choice, it tends to be received much better. |
| RP: 45:00
| Absolutely, and I think it’s important for lawyers in this context as well to focus on risk. I think when it comes to advising all clients, but particularly clients that aren’t risk-averse, that are perhaps risk positive, that if you focus your advice on risk, you lay out a number of scenarios, the branching tree of the things that could possibly happen from a risk profile perspective, you enable your client to make an informed decision and that’s all you can ultimately do; is present the possible risks and let the client make the decision as to what he or she wants to do with his or her business. |
| DT:
46:00 | Yeah you have to understand where your role ends and be prepared to accept that it’s ultimately not your call. Now we’ve talked about legal controls and a whole different range of areas from corporate governance to corporate finance in the early stages of a company’s life, but one practical issue that a lawyer advising start-ups has to grapple with is whether that start-up actually has the cash flow to pay you for the work that you’re doing. What are some options for start-up founders who are accessing legal services in terms of paying for it and for those of our listeners who want to be advising start-ups, who want to find the next unicorn and be their lawyer of choice, what sort of fee structures should they be looking at offering? |
| RP:
47:00 | Look, this is a really difficult problem and it’s a problem that I grapple with effectively with every new client and I take a few different approaches to this problem depending on the client. I think the most important thing that I would say at the top of my answer to this question is to be flexible. To be open to alternative fee structures and to think about your fee structure as a lawyer in the same way you might think about presenting commercial or legal options to a client and weighing up for yourself and for the client you know risk and reward. Some of my clients I find prefer a traditional fee structure. So it’s not out the window that start-up clients are willing to pay by the hour for legal work. In fact I find that there is a subset of very hands-on engineer types that like to have a higher degree of control over the their bill, to be regularly updated on the billable hours that I’ve accrued, and to take as much of the busy work out of the process from me into their own hands so that they can directly manage my fees. And so I guess it’s important to point out upfront I suppose that a traditional fee structure is not out the window. However, by far and away I find that technology company start-ups are most amenable to a fixed fee billing structure. That a fixed fee with a certain amount of funds that, you know with strict guidelines around how much is to be paid under what circumstances, is the preferred approach in most cases. |
| DT: | I guess even when you’re describing that traditional fee model there of charging by the hour that approach of ‘well tell me what I can do myself to lower the legal bill,’ is still kind of an unbundled service there where you’re not providing 100% of the task as you might traditionally do for a more established business. |
| RP: 48:00
49:00
50:00
| That’s a really good point. And I find that that’s a very common way that I will bill. That I will provide quotes to my clients whether on an hourly basis or a fixed fee basis in a series of often quite granular stages. Including everything from drafting, to negotiation, to amendments, to general advice and strategy discussions. The industry may call that unbundling, but to me that’s always just been smart business. I can’t imagine if I was a customer, if I was a client of a lawyer that I wouldn’t want some say in the way that the services being presented to me were managed. Yeah that’s right, look David you’re absolutely correct, so I do offer, generally speaking, I will offer unbundled services and different clients will have different preferences. I will occasionally, and one of the things that I find that many clients particularly doing venture capital work will react well to, is deferred fees. And so if you know as a lawyer with some degree of certainty that there is a venture capital raise underway and it seems likely that is going to come together, deferring your fees til settlement of that raise is often something that clients will fondly appreciate. That’s a difficult problem for you as a practitioner though because you really need to be able to pick them in order to make sure that you get your fees. There is a lot of work that goes into even a seed or a series A round that a small business, a small legal business, may be unable to absorb the loss of. So it does require you as a practitioner to have a strong commercial eye for the kinds of clients that you’re willing to take that risk on, and given enough experience in the industry I think it’s not too difficult to see when those deals are likely to come together. Which actually Interestingly leads me to another option, and something that I often will hesitate on, but some lawyers will, in this space, take equity in their clients for fees. I don’t see a lot of it in the local industry, I see some. More often than not I’ll often see lawyers participating in the round of an invest round as an investor but also charging fees. So they’ll take their fees as a lawyer, but also then take money out of their pockets to invest in their clients that they believe in. Even some of the largest Silicon Valley practises will have start-up focused practises that work exclusively on equity. Now they have a strong vetting process and only take those start-ups from certain feeder groups such as incubators, particularly well-respected ones. And those practises could be quite profitable in the long term, but there is a long delay on their profitability unfortunately. |
| DT:
51:00 | I think sweat equity it’s something that sounds really attractive at first blush but unless in very specific circumstances, it’s often a bad deal for both sides. Because on the one hand, that start-up will probably wish they hadn’t given part of the company away to their lawyer at a very early stage in the company’s life they have a lot of equity to give away and not much else, and I think when they get to a later stage when they’re more successful they think ‘oh well I wish I had paid the money instead of giving them part of the company which is now worth a lot more than, than the services that were rendered.’ But on the other hand, the firm is as you say getting equity in something that’s perhaps never going to be valuable and if it is, is going to be valuable in years, not months. And as you say if you get paid in cash there’s nothing stopping you from putting that cash into the next round of funding if you’re invited. |
| RP:
| That’s right, exactly correct. It’s a difficult balance and one that I probably shy away from myself if I’m being honest, although with that said I have some regrets. I have a few clients that are now pushing that came to me with single digit million valuations now looking down the barrel of acquisitions in the 10s of millions and I rather would have liked 50 times my fees, so it’s not without its downsides unfortunately. |
| DT: | Some of those disappointments we have to be prepared for if we’re advising start-ups. |
| RP: | That’s right. |
| DT: 52:00 | We’ve talked about a few different issues today, we’ve talked about corporate governance, we talked about raising capital, we’ve talked about privacy and data, and we’ve talked about some of the practical issues advising a start-up client. If there’s one tip you’d like to leave our listeners with today about advising early stage companies and start-ups, what would that be? |
| RP:
| Get to know the industry. I suppose that’s where I would start if there’s anybody that wants to get into this space or participate in this space, the first thing I would say is, well perhaps in non COVID-19 times, rub shoulders, press hands get out to events and get to know the people on the ground who are doing the hard work to build these companies. Start your practise with the view that you want to use your expertise to help people doing interesting work. And only when you get a knack for finding people to do interesting work, will you be able to build the broad base of skills and knowledge and network to be there on the ground when the next unicorn crops up. |
| DT: | In other words, don’t get into this area hoping to get rich quick! |
| RP: | Oh absolutely not. |
| DT: | Rich thanks so much for joining us today on Hearsay! |
| RP: 53:00 | It’s my pleasure, thanks so much for having me David. |
| DT:
54:00 | You’ve been listening to Hearsay The Legal Podcast! I’d like to thank my guest Richard Prangell from Viridian Lawyers for coming on the show. Now if you liked this episode about advising early stage start-ups, try my interview with Reece Corbett Wilkins from Clyde and Co about handling data breaches where we touch on some of the same privacy and data law issues. Or try my interview with Wenee Yap from thedocyard to learn about how you can take an entrepreneurial approach to your own practise. If you’re an Australian legal practitioner, you can claim one CPD unit for listening to this episode. Whether an activity entitles you to claim a CPD unit is self-assessed, but we suggest this episode constitutes an activity in the substantive law field. If you’ve claimed 5 CPD points for audio content already this year you might need to access our multimedia content to claim further points from listening to Hearsay. Visit htlp.com.au for more information on claiming and tracking your points on our platform. The Hearsay team is Tim Edmeades who edits our episodes, Kirti Kumar who writes our online educational content, Araceli Robledo who helps us out with business development and guest booking, and me David Turner. Nicola Cosgrove is our executive producer and director and herds all of the cats. Hearsay The Legal Podcast is proudly supported by Assured Legal Solutions, making complex simple. You can find all of our episodes as well as summary papers, transcripts, quizzes and more at htlp.com.au. That’s HTLP for Hearsay The Legal Podcast.com.au. Thanks for listening and we’ll see you next time! |
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