A standard investor protection clause commonly found in most VC led term sheets is unfortunately likely to become more relevant than ever as we move into a challenging fundraising landscape. So now seemed a great time to dive in and unpack the ‘anti-dilution’ clause.
The anti-dilution provision is a right that usually applies to preferred shares. It’s something that is negotiated by investors to protect them from the “economic dilution” of the company raising money in the future at a lower price than they invested at (i.e. a “down round”). The impact that this provision will have on the company depends on how it is drafted. Generally, there are two main ways that an anti-dilution clause is drafted. We’ll look at them both here and work through an example scenario to show the impact.
A quick note before we start, economic dilution (which we are focused on here) in the event of a down round is very different from “percentage dilution” which happens whenever a company issues new shares at a new higher-priced round. Percentage dilution is not an issue and any investors will expect to take percentage dilution when they do not invest at a new round to protect their stake (often known as investing their “pro-rata amount”).
Example Scenario: Company X has raised the following Series A:
Series A investment (Round size): £10,000,000
Option pool: 100,000
Fully Diluted share capital (pre the round, inclusive of options): 1,000,000
Price per Series A share: £40.00
Series A shares issued: £10,000,000/£40= 250,000
Fully diluted share capital post the round: =1,250,000
Company X then gets a term sheet for their Series B at the following terms:
Series B investment (Round size): £15,000,000
Price per Series B share: £30,000,000/1,250,000=£24
Series B shares issued: £15,000,000/£24= 625,000
Fully diluted share capital post the round = 1,875,000
In this example scenario, Company X raised its Series A at a £40m pre-money valuation and went on to raise £10m at this valuation. For simplicity assuming one investor did the whole £10m, this investor in our scenario paid a price per share of £40. Taking into account the shares issued at the round, Company X has a post-money valuation of £50m.
Company X then goes on to raise its Series B. However, market conditions have worsened and whilst Company X needs a minimum of £15m funding it’s only able to command a £30m pre-money valuation from the market. As a result, the 625,000 shares issued to the Series B investor (again, for simplicity, assuming a single investor) are issued at a price per share of £24. The £24 share price is lower than the price paid at the last round and therefore Company X has had a “down-round”. To look at it another way, this means the £10m invested by the Series A investor has gone from being worth £10m priced at the last round to now worth £6m (250,000*£24).
Once there’s a down-round this is where the anti-dilution provision kicks in. The full impact of the provision depends on if a “full-ratchet” or a “weighted average price” mechanism has been specified in the drafting.
The full-ratchet mechanism aims to fully compensate the earlier investor (in our case the Series A investor) and effectively put them in the position they would have been in had they invested at the lower price per share of the Series B round. So, if the Series A investor had acquired shares at the £24 price per share they would have received 416,666 shares (£10,000,000/£24)(rounded down to the nearest whole share). Therefore, applying the full-ratchet mechanism on the closing of the new Series B round, the Series A investor would receive 166,666 (416,666–250,0000) free shares. These 166,666 shares, assuming a £24 price per share, would represent full economic compensation for the £4m difference in value between the value of the Series A investor’s position at the Series A (£10m)and what it is now worth at the Series B (£6m).
In the VC market, this mechanism is highly unusual and definitely not founder-friendly. We’ll show the difference between applying the full-ratchet compared to weighted average price at the end of the post to show this.
Weighted average price
The weighted average price mechanism attempts to apply weighting to provide for how impactful the new round is on previous investors. Hence, it’s considered a more balanced mechanism compared to the full ratchet and a more common approach in VC financings. Even within the weighted average price mechanism, there are two different ways that this can be calculated but will get to that shortly. To start with let’s unpack the overall formula:
WAP = [(PPS(Series A) x SPM) + (PPS(Series B) x SN)] / (SPM + SN)
This looks like a scary formula but stick with me and we’ll break it down. Firstly, what do all these letters mean:
WAP = weighted average price
PPS (Series A) = price per share at the Series A
SPM = Total number of shares pre-money (i.e. before this new Series B down-round)
PPS (Series B) = price per share at the Series B
SN = New Series B shares issued at the Series B
As mentioned above, there are two different applications of the weighted average price mechanism:
the narrow-based weighted average (‘NBWA’); and
the broad-based weighted average (‘BBWA’).
The narrow version only takes into account shares actually issued at the time and the broad version also adds on any options etc. and is therefore based on the fully diluted capital of the company at the time. Applying the numbers from the example scenario we can see the difference between the two:
NBWA = [(£40.00 x 900,000)+ (£24 x 625,000)] / (900,000 + 625,000) = £33.44*
BBWA = [(£40.00 x 1,000,000)+(£24 x 625,000) / (1,000,000+625,000) = £33.85
Using the NBWA each Series A share has been economically diluted by £6.56 (£40 – £33.44) and in the BBWA by £6.15 (£40 – £33.85). Thus the BBWA mechanism is less dilutive for Ordinary shareholders and hence considered more founder-friendly.
Having obtained the weighted average prices for each we can now calculate how many shares the Series A investor would have received if they’d paid each respective price and hence calculate how many shares they would be due applying the anti-dilution mechanism.
How many shares they would have received total (NBWA): £10,000,000 / £33.44 = 299,043 shares (rounded down to nearest whole number)
How many shares they would receive applying the anti-dilution mechanism (NBWA) = 299,043 – 250,000 = 49,043
How many shares they would have received total (BBWA): £10,000,000 / £33.85 = 295,420 shares (rounded down to nearest whole number)
How many shares they would receive applying the anti-dilution mechanism (BBWA) = 295,420 – 250,000 = 45,420
The difference between Full-ratchet, NBWA and BBWA is significant as shown by this table of the amount of anti-dilution shares an investor would receive applying each different mechanism:
The vast majority of VC led rounds that I see in the market contain the BBWA approach to anti-dilution and this is definitely the market standard. It is highly unusual to see full-ratchet and if it’s included and there is a down-round then the impact can be catastrophic in terms of founder dilution (just look at those numbers in the table above!). However, in more challenging market conditionsterms that were previously considered standard can have a way of changing. Therefore, understanding how the different versions of an anti-dilution clause work can be of massive importance.
*Note: here I have rounded to two decimal places for the purposes of this post. However, an alternative approach is not to round here at all and use the raw number for the purposes of the ongoing calculations. This would lead to a different number of anti-dilution shares at the end. As with any calculation like this, it’s important to be clear on the method of rounding used and agree that between the relevant parties.
As a pre-seed and seed stage investor, we very rarely have the luxury of investing where there are clear signs of product-market fit and hence getting a sense of if founder-market fit is present is of crucial importance and something we spend a lot of time focused on.
3 ways that founder-market fit can manifest:
To really nail it, there’s usually some form of a combination of the above present across a founding team and the importance of each can be quite specific to the startup being built. The question that this framework is getting at boils down to:
Why is this THE team to do it?
Startups are incredibly hard, I’m constantly in awe of the founders I have the privilege to engage with across our portfolio and beyond. To build a successful startup there needs to be as many factors working in its favour as possible and one that can provide that edge is domain expertise. Sometimes domain expertise can be confused with domain interest. For example, just because someone might enjoy travelling (domain interest) does not necessarily mean that they have the founder-market fit necessary to build a billion-dollar travel startup. On the other hand, if the founding team have worked at booking, Skyscanner, Mr and Mrs Smith, Secret Escapes etc. and know the intricacies of how this market operates and the stakeholders involved then this would likely tick the box. Domain expertise likely carries more weight when assessing founder- market fit for certain sectors over others. Very broadly, I think this element of founder-market fit is likely most relevant in the B2B space where it’s even harder to really understand the specifics of a market without having been on the front-line immersed in the sector. As a rule of thumb, the more specialised the market the more such experience is crucial.
Founders who have this, in my experience, will push harder and not take no for an answer and therefore put themselves in an even stronger position to succeed. How it manifests itself might be a personal connection from the founding team to the problem that the startup is solving. We’ve seen a number of examples of this in the health space where a founder may have experienced first hand or via a family member the problem they are solving for. This mission-driven mindset can be incredibly powerful in creating a connection to the problem and a compelling narrative around why they are the perfect person and/or team to be building a product in such a space. Having this across the founding team can be influential in inspiring others to join the journey the startup is on, whether that be investors or early employees, and can be formative in creating a winning culture.
When considering technical skills generally we are thinking about across a founding team rather than specific to any one individual. The impact this can have on the degree of founder-market fit is dependant on the nature of the startup being built. Naturally, for a deeply technical company (i.e. artificial intelligence or biotech etc.) having the requisite skill set in the founding team is of the utmost importance. Equally, for less deeply technical products less emphasis can be placed on this element. However, for less technical products or applications, as technical skills may be less of a factor in assessing founder-market fit there likely needs to be excellence present across the other areas considered above.
An additional area, that is something to bear in mind when considering the degree of founder-market fit present for a VC backable company, is the ability of the founding team to raise capital. Of course, there are many examples of perfect founder-market fit teams which will not need to go down the VC funding route. However, for those that do, having someone across the founding team who poses a skill for fundraising will put the startup in a strong position at the founder-market fit stage before the company has achieved product-market fit and can rely more heavily on traction and metrics for fundraising.
Overall, to give the above factors the chance to take effect and propel a startup to what it’s capable of a herculean amount of hard work, resilience and (of course) luck is also needed. Throw all that together and there’s a great shot of getting to that holy grail of product-market fit!
This is a follow-up post to the one I wrote on vesting, if you haven’t read that then I’d recommend starting here.
Now it’s pretty much universally accepted in early-stage financings that vesting is a crucial term to include and get right. However, following numerous discussions with founders we have backed recently, it seems that there remains confusion around how the mechanics of vesting play out in the event that a founder leaves. We hope this mechanism never needs to get used but shit happens and I always encourage founders to clearly understand each and every term on their term sheet so there are no unnecessary surprises down the road.
As ever, exactly how it works is dependent on the specific terms but broadly speaking there are a few ways that I’ve seen this structured in practice and they often hinge on the question of whether the founder is a good leaver or a bad leaver.
The most typical elements (note: this is not an exhaustive list) that these key concepts cover are:
Good Leaver – A founder who leaves in circumstances where they are generally not at fault e.g. death, permanent incapacity or where they are wrongfully terminated
Bad Leaver – A founder who leaves in circumstances where they have done something wrong e.g. gross misconduct, criminal offences like fraud or other termination with cause
Once you’ve determined if they are a Good or Bad Leaver, then the question becomes how much have they vested?
A Good Leaver will usually be required to transfer the shares they have vested and are entitled to to the company when they leave and will receive “market value” for the shares they transfer. Alternatively, they may be allowed to retain their vested shares. This is seen as fair because they have built value in the company and should be entitled to such value and the way they have left is through no fault of their own.
A Bad Leaver is generally, as a default position, required to transfer the shares they have vested back to the company at nominal value (often a very small amount, e.g. £1). This is sometimes limited to the most serious type of bad leaver scenarios and there is usually some discretion of the board/company built in.
How is this actually achieved by the company in practice?
The mechanism of how the company deals with the transfer of such shares is set out in the company’s articles. Shares could be bought back by the company, transferred to an option pool, made available to a new hire / joining founder (maybe via the option pool), or offered to the other shareholders. I often see Bad Leaver shares automatically converted into worthless deferred shares. I understand from counsel (although tax advice should be sought) this can be helpful, as it is tricky to transfer shares to employees below market value without creating tax issues.
What about the unvested shares?
The default position is that all unvested shares are treated as worthless regardless of how the founder leaves the company. Again, there could be some discretion available to the board that they may look into in the event of a Good Leaver.
The caveat to this is in the case of an acquisition, where there may be an acceleration of the vesting schedule so that a proportion or in some cases all of the shares become vested. Often not only the acquisition but also the firing/departure of the founder is required to “trigger” the acceleration. This is referred to as “double trigger acceleration” (acquisition + leaving). The theory here is that this is fair because if there is an acquisition and the founder is fired/asked to leave etc. then they have done nothing wrong and should be entitled to all their shares. Also, the double trigger ensures that there is a mechanism to protect the acquirer from having a disincentivised management team in the event they don’t fire them and want them to continue to work in line with their vesting schedule.
Anything else to consider?
Lots! The above is a framework and sets out the basics of how the good leaver and bad leaver provisions interact. Its a basis to start from and often negotiations, either at the term sheet stage or when a founder is departing will lead to variations of the above.
Firstly, I truly believe that any vesting schedule should be seen as not only an investor protection provision but also a founder protection provision (i.e. something that protects founders from each other). My view is that investors can provide frameworks but it is crucially important that founders buy into the benefit and structure of any vesting schedule. A well-designed vesting structure and leaving mechanic puts the company in the best possible position to weather any future storms. I generally recommend a clean and concisely drafted version of the “Good Leaver, Bad Leaver” mechanism as the best approach. This appropriately recognises work done by founders by allowing the retention of some or all vested equity whilst also providing an approach should founders leave before a startup’s journey is complete.
A simple change that can reduce complexity for early-stage financings
A challenge that I see founders struggle with when raising money using a convertible (note: I’ll use convertible as a term to capture advanced subscription agreements (ASAs) and/or simple agreements for future equity (SAFEs) throughout this post) is correctly understanding the dilution they are taking. This has traditionally been one of the advantages of doing an equity round (where shares are issued at the time of investment) because it allows everyone to have a clear picture when the round closes of where they stand from an ownership perspective. However, for multiple reasons (time, cost etc.) often an equity round isn’t a founder or investors preference at the earliest stage.
I think there is a simple fix to this problem, set the cap in the convertible as a post-money valuation.In this scenario, the post-money is in relation to any money raised under such convertibles (see below for an example) but, to flag, is not inclusive of the money raised at the converting round (i.e. Seed or Series A). This is something that we have incorporated in the standard advanced subscription agreement we’ve been using for our pre-seed investments at Seedcamp. It’s also something that YC have recently incorporated in their standard deal documents.
So, how does this work in practice?
Firstly, I’ve written previously about considerations to bear in mind when setting caps. If you haven’t checked that out, I’d recommend starting here.
The difference between using a post-money and a pre-money cap is best illustrated using numbers:
If you were to raise £100k and set a cap at £2m post money then on conversion at the cap the investor would own:
£100k / £2m * 100 = 5%
If you raised an additional £150k on the same cap that would add an additional:
£150k / £2m *10 = 7.5%
Total dilution => 5% +7.5% = 12.5%
Suppose you went out to raise £100k and agreed to give up 5% of your company for this. Using an ASA you, therefore, set a cap at £1.9m pre-money. On conversion at the cap the investor would own:
£100k / (£1.9m +£100k)*100 =5%
So far the same as the post-money scenario. If you then went on to raise an additional £150k on the same cap that would add the following dilution:
£150k / (£1.9m+£250k)*100= 6.97%.
This is lower than the post-money scenario because the additional amount raised has been added to the pre-money cap resulting in a new cap for the purposes of calculation.
Furthermore, as the cap has effectively increased by this additional £150k, the original £100k would now equate to the following dilution:
£100k / (£1.9m + £250k ) * 100 = 4.65%
Total dilution => 6.97% + 4.65% = 11.62%
The above is a very simplified example but you can imagine how complex this can get when using a pre-money cap to raise investment from multiple investors.
Why the concept of time is crucial
As the above illustrates, the pre-money example actually results in less founder dilution and therefore could be seen as founder favourable. This is because each incremental amount raised using a post-money cap just dilutes the current shareholders which at the pre-seed stage are usually the founders. However, I think the key concept to layer onto this analysis is time. A startup can be seen as having a value attributable to a certain period in time. The post-money method allows founders to clearly define what the valuation of their startup is for a period of time that they will raise convertibles for. Often this time period is pre a large institutional Seed or Series A. By clearly defining this time and setting the post-money cap for this period it allows founders to have a very clear picture of the dilution they are taking at each funding event documented using a convertible and therefore where they stand going into the Series A. Obviously if this time period is particularly long, a founder could determine that there are two or more distinct periods prior to the large institutional Seed or Series A and therefore there is a higher cap for the second or additional period. There are numerous ways that founders and investors can get creative to structure such financings but I think a key driver should be simplicity and speed and the post-money approach helps with this.
The exact timing of when the mechanic of conversion takes place is another area that can cause confusion. For example, often convertibles are drafted as being inclusive of an option pool that may be requested at the round in which it converts. This can add additional dilution for founders because it means that the dilution of the future option pool comes before the convertible is converted and is therefore borne by the founders and not the note holders. This is not a particularly unusual provision but it is something for founders to be aware of. For example, a pre-money cap that is inclusive of any option pool could end up resulting in a similar level of dilution as a post-money cap not inclusive of an option pool.
Overall, I think the focus should be on simplicity and speed. I do think navigating to a post-money world helps with this and provides a clearer basis for founders and investors alike.
We recently hosted a get together of some of our founders and one of the topics that came up was investor updates. From my experience startups that set up a process to update investors effectively put themselves in a much better position to succeed.
A good investor update keeps all stakeholders plugged into key developments and therefore allows people who aren’t involved day-to-day to provide the best representation of your startup to others. An example of this is with regards to follow-on investors. Investors in your company are likely meeting with other investors who could be a perfect fit for your next round on a regular basis. At Seedcamp, we’re constantly catching up with other funds who are keen to be kept up to date with developments in our portfolio. One of the reasons I strongly encourage the startups in our portfolio to provide consistent updates is so that we can be the best advocates on their behalf to such funds. These updates don’t have to be detailed and will vary from startup to startup but the more relevant context the better. The same is true for when your investors are meeting with potential customers, BD contacts, key hires etc. Good investors will want to help and make relevant connections where they can. However, investors (particularly VCs or active Angels) will likely be working with a number of companies at any one time so the more in sync you are with them the more likely it is that you will be top of mind for any opportunities that come about.
Some founders I’ve worked with have had concerns or been reluctant to update investors when things aren’t going well. However, often this is the most important time to keep your investors well informed. Being transparent with your investors can provide them with context to help before things escalate. I’ve seen examples where startups may not be hitting key milestones (i.e. MRR targets ahead of a new fundraise) but because they kept everyone informed and explained the context their investors remained fully supportive of the company. Startups rarely if ever go fully to plan and experienced investors will know this. During the bad times is where you should lean on your investors to help. Keeping them updated enables your investors to plan for how best to assist the company and brainstorm with you. Maybe that requires a bridge round or pivoting to a different approach, either way clear and consistent updates will help your investors to best help you.
Pre-emption rights are often talked about as one of the most important terms for early stage investors. But it’s not just important for investors, it’s also a key term for founders to understand when negotiating a financing round.
First things first, what is a pre-emption right?
A pre-emption right gives an existing shareholder the right to participate in a future financing round to the extent necessary to maintain its percentage stake in the company. It provides shareholders the right to acquire shares before they can be offered to a third party (i.e. a new investor) on either an issue of new shares or a share transfer by an existing shareholder. In this post I’m going to focus on the issue of new shares and not transfers.
Pre-emption rights are usually pro rata to a shareholder’s existing holding (so if a shareholder holds 10% of the issued share capital, broadly speaking they will be entitled to 10% of the shares being issued). However, occasionally certain investors will look for a multiple of pre-emption (also known as a “super pre-emption”) which would give them the right to invest more than their pro rata. Or, less common, an investor may look to include a right where they can take the entire round at such new financing (also known as a “right of first refusal”). Rights of first refusal on a new issue of shares can be potentially toxic for founders because they effectively reduce the options available when raising a new round (discussed more here)- definitely something to watch out for.
What does this look like in a typical termsheet?
Below is an extract of how a simple pre-emption right might look in a typical VC termsheet:
This is a fairly standard and founder friendly pre-emption clause. The right is pro rata and therefore no one investor is getting any preferential treatment such as super pro-rata or a right of first refusal (see above) on the issue of new shares.
Why do investors care?
Returns in VC are driven by the outlier big outcomes. The right of pre-emption is therefore very important for investors to be able to continue to invest in their strongest performing companies and back the winners. Hence why it’s one of the key terms that any experienced investor will fight for.
Should founders care?
Yes, there are two main reasons why they should:
On a new financing round, new investors will be keen to understand if existing investors are following on at this round with respect to their pre-emptive amount (also interchangeably referred to as “pro rata”). If they’re not then this can send a negative signal to the new investor because the existing investors are expected to generally be more knowledge of the company. This is most applicable for VC funds where the expectation will be that they follow-on (less so for smaller funds).
For example, if a Seed VC has led a £1.5m seed round and post that round holds 15% then the Series A VC (considering leading the next round) will want to know whether the Seed VC is following on for their pro-rata. If they are not this could be a negative signal for the Series A VC.
(2) % available for new investors
The right to pre-emption means that on a new financing round the company will be obliged to offer the opportunity to existing investors to invest at the same terms on a pro rata basis.
For example, if following a Seed round investors hold 20% and at the Series A they are raising £5m then ~£1m (20% of this £5m) must be made available for existing investors.
Now, in practice some of the existing investors may not take up their pre-emption (e.g. Angel investors may not have liquid reserves to follow-on). However, it’s an important consideration because the amount of pre-emption taken up will effect the amount available for new investors. This could be important if the new investors have a target ownership in mind (which VCs often do). Whilst technically this is true, in oversubscribed competitive rounds there may be pressure placed on existing investors to reduce the amount they invest to provide space for new investors.
A standard pre-emption right (like the extract above) can provide a win for both founder and investor. Investors get the crucial opportunity to follow-on in successful companies and founders get additional support, funding and a positive signal for their next financing round.
I’ve previously written about the basics and some of the key considerations when raising using a convertible note (if you haven’t read that I’d suggest starting there). In this post I wanted to dive into probably the most negotiated term, the valuation cap. It’s a topic that’s come up a lot in discussions I’ve had with founders raising using convertibles and I thought it was worth sharing some thoughts more broadly.
Some very hot companies raise money using convertibles without a valuation cap, but in todays market (and any market) that is very rare. When thinking through how best to arrive at a fair and reasonable cap, I find it useful to consider both the startup and investor perspectives. Whilst I operate on the investor side of the table, I believe that both sides fully understanding the variables at play leads to more efficient negotiations and therefore less time spent. My goal is to help founders get back to building and spend less time negotiating with investors or worse yet…lawyers (I’m allowed to say that as I used to be one 😜).
The Startup 🚀
A key consideration from the startup perspective is what any amount raised under the note will convert into at the next round. In particular founders should be mindful of the potential dilution that they will take on conversion. A very low cap could result in a toxic cap table situation and deter the next round investors — this is a situation to be avoided at all costs. I always recommend founders consider a new convertible note in the context of the next round and model this out in their cap table to understand the potential impact.
The Investor 💰
It’s logical to think that an investor would want to set the valuation cap as low as possible. The lower the cap the potentially larger % of the company their investment will convert into at the next round. However, this approach misses the point. The valuation cap is not exactly the same as a valuation. It’s primary purpose is to protect an investor against converting to a disproportionately small % if the next round valuation is very high. As such, the cap should likely be set at a premium to achieve the desired effect. As it usually works in conjunction with a discount (see my earlier post), there’s usually a range by which an investor will get comfortable by looking at proxies for valuations of similar stage startups (at the time of investment) and what is likely an achievable valuation at the next round. Add to this an investors target ownership % (on conversion) and you can see how most investors arrive at valuation caps they believe reasonable.
An additional consideration from both startup and investor perspective, is the likely amount of time between the money raised under the convertible and the next financing round. The longer the convertible round represents in terms of runway the more the cap should likely be a proxy for valuation at the time of such convertible note investment. This is logical from a pure risk allocation perspective. If an investor can wait until the next round and get similar economics then they’re likely to do that (caveat if it’s a super hot deal and they’re worried about future access). Whereas if the convertible round in question is a short term bridge it may be more appropriate to use the potential imminent next round valuation as the number to more closely base the cap from.
Overall, setting a valuation cap is more art than science. Personally, I think the most crucial factor is ensuring that founders do not take a disproportionate amount of future dilution. After all, it’s the founders (and their team) who drive the most value creation in any startup so it’s in all stakeholders interest for them to be properly incentivised.
p.s. I’m yet to come across any good data on valuation cap ranges by stage of investment – if anyone has any I’d love to hear from you.
We recently hosted a legal tech roundtable together with our friends at Draper Esprit to discuss some of the big topics related to the sector. It was a lively discussion between founders, investors and industry experts and it got me thinking to the size of the market opportunity in legal tech and why more VC money hasn’t been invested in the space. This was also a topic that came up a lot at the recent excellent Legal Geek conference in London so I thought I’d dive in to take a bit more of a look.
Big numbers are often thrown around regarding the size of the legal tech market. I’ve seen pitch decks with numbers ranging from over £26bn for the UK market to $400bn for the US. However, as indicated by the chart above, investment in the legal tech sector isn’t anything to write home about. Total VC funding globally for 2016 was less than $250m, which given the size of the global VC market is not a huge number. 2017 seems to be tracking at a similar rate and the spike for 2015 was largely driven by two large financings (Relativity and Avvo).
To add to this, the recent legal tech report produced by Legal Geek and Thomson Reuters (Movers and Shakers: UK Lawtech Start-ups, 2017) had the amount invested into UK Seed stage startups (those who had raised <$5m) for 2017 (to June) at a mere £6.7m.
This poses the question, why isn’t more VC funding flowing into Legal Tech? I wanted to unpack 3 of the headline reasons I often hear and explain why I remain very bullish on the potential for the sector.
“The market isn’t actually that big”
Whilst the headline numbers are impressive (£26bn, $400bn etc.), when you actually look at the market size for some of the legal tech solutions the addressable market could be seen as much smaller. For example, ML contract review is an exciting space that many legal tech startups are focussed on (Beagle, Luminance, Kira to name some of the more established players). However, on the face of it, the universe of potential purchasers of such solutions is a lot smaller than the large market numbers would suggest. Such startups that sell into law firms (to note, not all are focused on this segment) are only likely to find appetite amongst the larger more technologically savvy firms who, whilst significant, represent a smaller sub-set of the overall market.
Whilst the market size concern is valid and I’m not a fan of startups solely pitching the massive headline numbers. I believe it’s short sighted to see this as a substantial issue. There’s no doubt that the legal services market is becoming more sophisticated and technology adopted at the more tech forward law firms will filter down to the smaller firms (or arguably such smaller firms will cease to exist). We just have to look at the adoption of tech solutions across the larger firms and even the steps by certain large firms to set up accelerators (MDR Labs), investment arms (Next Law Labs), work spaces (Fuse) etc. as evidence of an increased appetite.
Also, law firms themselves are only one aspect of the market. Selling into the in-house legal, business or compliance teams is another lucrative market segment (Juro, Legit and Libryo are some examples from our portfolio of startups addressing such respective segments). Such in-house teams are often more astute purchasers of software and as such a potentially better route to market.
Additionally, one could argue, there is an untapped latent legal market that could present an even larger market opportunity. For example, we’ve only began to scratch the surface of democratising access on a B2C level to legal services (e.g. Willing, Farewill, DoNotPay, CrowdJustice, Absolute Barrister). p.s. I’d love to meet founders building Legal Tech companies focusing on the B2C space – I think there’s some big opportunities here!
2. “The incentives aren’t aligned”
Law is an odd industry where many law firms (not all) still bill clients by the hour. Therefore tech solutions that make them more efficient may not be positively received and hard for legal tech startups to sell in.
Whilst this has traditionally been an issue, I think the market is finally turning on this point. For one, a large proportion of the consumers of legal services are themselves sophisticated users and purchasers of software across different business areas (Accounting, CRM etc.). Therefore, there is an expectation that their legal service providers utilise tech solutions to provide the best service. Clients / consumers expect more transparency around how much they are paying and startups are helping provide more transparency here (Apperio, SeedLegals and Lexoo are some taking advantage of this trend). Furthermore, the emergence of startups such as Atrium is further evidence that startups are seeing the move away from the billable hour as an opportunity to provide tech to leverage efficiency gains across the market.
We’re also seeing law firms look to tech solutions as a way to differentiate versus competitive firms. Adopting the latest advancements in technology ahead of their competitors such as smart contract technology (Clause are a startup in our portfolio doing some exciting stuff in this space) or ML contract review (see companies listed above) is an additional way for firms to stand out in a crowded market.
To add to this, as per above, law firms is only one potential customer segment and for other segments (e.g. in-house etc.) the incentives to keep legal cost and time spent down are very much aligned.
3. “The sales cycle is too long”
Lawyers and law firms are notoriously tough to sell to. Law firms are usually structured as partnerships requiring multiple sign offs to get to a sale. Add this to the inherent risk averse nature of the industry and you have a bit of a perfect storm.
I think this one is potentially here to stay for a while but there are signs things are improving. Larger law firms are putting tech on the exec team (partnership board) agenda and we’re even seeing CTOs start to be appointed. All promising signs. Furthermore, looking outside of law firms and more towards in house teams or non-legal businesses and the sales cycle point begins to fall away.
Whether selling in-house, private practice (law firms) or otherwise, the key thing for startups to do is to try to identify the key decision makers to expedite the process. As the spotlight on legal tech increases this should help raise awareness of its potential and reduce the sales cycle.
The future of the funding landscape
I firmly believe there are huge opportunities for startups in the legal tech space. It feels like the sector is at a real tipping point and I see the emergence of major startup success stories as an inevitability. I think we’re going to see more VC funding looking to back the standout startups scaling up. I’m excited about seeing what talented founders build to tackle some of the biggest problems and take advantage of such massive opportunities.
An option pool is a key tool at a high growth startups disposal to attract and retain top talent. This post sets out some of the key concepts that founders should consider when thinking about granting options to employees.
What is an option?
Options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. In our case we’re focused on the right to buy a set number of shares at a specified price on or before a defined date. The price is often referred to as the “strike price” and refers to the price set on the date the options are granted. In successful startups, options can become very valuable as the fair value of the shares in the company increases significantly beyond the strike price.
Why do startups grant employees options?
There are a number of key reasons for startups to grant options to employees:
(1) Alignment of interests – options allow employees to share in the success of the startup (alongside its founders) and potentially provide an additional incentive for an employee.
(2) Economic/ pay – options also provide a mechanism by which startups can fill the gap between what an employee could earn in the market and what a startup is able to pay. For example, an employee may be able to earn £100k working for a large tech company with an additional very small option package (or none at all) whereas a startup may not be able to match such a salary but is able to offer a potentially more generous options package.
(3) Retention – most option packages are on a vesting schedule and/or be subject to leaver provisions (all Seedcamp and other VC backed companies will include vesting in their ESOPs). Therefore, employees who receive options will be additionally incentivised (in positive situations) to stick around to gain the maximum benefit.
(4) Tax and governance – when considered in comparison to issuing shares to employees rather than options, options have the benefit of potentially being more favourable from a tax perspective (see below). Also if shares are issued the employee would become a shareholder in the startup and inherit certain rights (i.e. dividend, information, voting) that may not be appropriate.
How many options should the first employees get?
This is a common question that comes up regularly with the companies that I work with. There’s no magic formula and often the answer is the incredibly frustrating “it depends”. The process is often described as more art than science and it’s very difficult to point to an exact way of answering the question.
There’s some great posts out there going into more detail on the topic so I’m not going to dwell on this here but I’d recommend reading these to get an overview of methods to arrive at amounts for individual grants broken down by roles:
A key point to note, that my colleague Carlos flags in his post, is the importance of being clear with what % the grant is in relation to. It’s important to highlight that the % is in relation to the current fully diluted cap table (at the date of the grant).
eShares have a great example of how they explain employee equity to new hires in their offer letter – in this, they clearly set out the scenarios and what such a grant could be worth to the employee. Buffer famously also include a full transparent breakdown of how they calculate option grants and the factors and variables they take into account — more on that here.
How do startups grant options?
Once the total pool size and breakdown has been determined the process needs to be properly documented. Getting the paperwork right is crucial to avoid complications down the line.
For UK companies, generally, the first thing required is to get an Employee Share Option Plan (ESOP) written up and approved by the startup and its board. Such a plan requires careful drafting and advice from a specialist tax adviser and/or lawyer. Most UK startups go down qualifying their ESOP under the Enterprise Management Incentive (EMI) route. The major benefit of this approach is that it potentially means there is no income tax payable by employees when exercising their options — only on the gains on an exit (where Capital Gains Tax (CGT) will be payable). This is a significant potential tax benefit for employees. Before any option grants are made it’s necessary to get a valuation of the startup done. Such a valuation for an EMI qualifying ESOP is different from that referred to at a funding round (where it’s set by third party investors (VCs, Angels etc.)) and in this case actually requires an application to be made to HMRC. Care needs to be taken with the application and advice should be sought from a specialist accountant to assist. Obtaining a low valuation for the purposes of pricing the options (strike price) is generally seen as preferable because it will maximise the potential gains and therefore the impact of the grant for the employee (as such it’s helpful for hiring purposes). The valuation will only be valid for a set period of time (~60 days or so) so it’s important to make the option grant shortly thereafter. It’s worth noting also that options granted under the EMI route only qualify if made to employees. Once all the paperwork has been approved, finalised and signed by startup and employees the option grants need to be filed with HMRC (within 3 months) to qualify for the tax advantage.
The market for options in Europe
Overall I don’t think there’s enough value given to startup options in Europe. Perhaps this is down to the risk tolerance of us Europeans and our tendency to favour a certain salary over equity. I’d like to see European startups be more aggressive with their option grants and spend more time educating employees as to the potential value that such option grants could present. It feels like there’s value being left on the table there. The US market appears to be ahead in this regard probably buoyed by the fact founders there can point to more success stories of startups scaling to exit. For any startup, one thing is for certain, talent is absolutely critical and therefore spending time devising a strategy around how options can be used to attract and retain world class talent is time well spent!
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It goes without saying that ESOPs are a complex area and advice should be sought from a qualified account and/or lawyer to ensure all the proper steps are taken. Also to note, the above is meant only as a quick summary and there are some other points to consider such as: eligibility criteria and a maximum amount that can be granted (the full criteria can be found here).