Options, options, options

Getting to grips with granting startup options

Photo by Nik MacMillan on Unsplash

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:

Employee Equity: How Much?The most common comment in this long and complicated MBA Mondays series on Employee Equity is the question of how much…avc.com

Analyzing AngelList Job Postings, Part 2: Salary and Equity BenchmarksA few weeks ago, I did a basic analysis of AngelList job postings. That analysis looked at attributes like job…codingvc.com

The Founder InstituteFor aspiring and idea-stage entrepreneurs up to the challenge, the Founder Institute provides a comprehensive step-by…fi.co

And these posts looking at the evolution of option pools over numerous rounds are worth checking out:

Startup Best Practices 16 – Option Pool PlanningNo matter the stage of the business, startups need to manage the size of their Employee Stock Option Pool or ESOP. The…tomtunguz.com

Option Pool sizing — by the Numbers.How large an option pool should you allocate? Here is some data to support your decision.tools.ltse.com

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!

— — —

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).

Originally posted on Medium.

Startup Boards — Why the “helicopter view” is crucial

When it comes time to formalise a board (often around the time of a Seed financing round), it can be hard for founders to get the most out of this potentially high value group of people.

A well functioning board can provide founders with an excellent opportunity to remove themselves from day-to-day operational matters and focus on high level strategic issues. Obtaining this “helicopter view” can help ensure the business is on the right track.

To help with this I’ve distilled down some actionable tips for founders to leverage their board and make such meetings as high impact as possible.

10 Tips for Startup Boards:

1. A board meeting isn’t an update session

Aim to send your board materials 3 to 4 days in advance and insist that everyone reads the materials and comes prepared. Consider catching up one-to-one with certain people ahead of the meeting if there’s some big topics you’d like their opinion on. The goal of all this should be to free up time to focus on the bigger strategic issues in the meeting itself (see tip 7).

2. Set an agenda and stick to it

Set out in minutes how long you propose to spend on each section. This can be included as one of the first pages of the board pack materials you prepare. Try to stick to the agenda and the allotted time for each section. Avoid spending too long on business updates and get to the key areas to discuss promptly.

3. Keep the board materials simple

Work with your board to get a version of the board materials that is easy for you to use as a template each time. The first few board meetings you should ensure you get a steer on material that’s useful for the board and you. It’s important to provide sufficiently comprehensive materials to help with the board discussion. However, I don’t think it’s the best use of time to spend too long producing beautiful presentation decks. The goal is a set of materials that gets everyone up to speed with the business as efficiently as possible and frames the topics for discussion.

4. Report your key performance indicators (KPIs)

I like to see KPIs clearly signposted in the materials circulated prior to the board. It’s always tricky to get the right balance of too much vs. too little when it comes to KPIs. It will likely take a few iterations to arrive at a set that achieve the goal of calibrating everyone on the status of the business whilst not overwhelming with detail. When you’ve arrived at the agreed set of KPIs stick to them and report the same each time.

5. Always provide a cash update

At a high level and as a minimum, you should include cash in bank, cash spent last month and months of runway remaining. Often management accounts with detailed financials will be circulated separate to the board deck.

6. Try to keep the business update short

Report the highlights and lowlights. Try not to fall into reporting everything that happened since the board met last. As per above, if you’ve circulated your board materials in advance then each board member should already be up to date so no need to overly dwell on this section.

7. Pick a small number of big topics to focus on

Choose one or two major topics that you want to spend the majority of the meeting discussing. Again, the topics should be included in the board materials sent in advance. You could also consider linking to additional background materials if this could help with the discussion. Be clear on what you want to get to out of the discussion. Try to include all of your board members to gather each opinion.

8. Take thorough notes

Basic, I know. However, it’s very difficult to lead the meeting and take notes at the same time. I’d recommend assigning one founder who isn’t doing the majority of presenting to take notes. You should use the notes to form the minutes of the meeting (that can be written up afterwards). Minutes are important because they help with keeping track of the history of the meeting. The minutes can also be used to document certain matters that may require board consent (for major decisions consider speaking with your lawyer in advance to determine what is required).

9. Track action items and follow-up

As you go through the meeting, your designated note taker (see above) should record where people volunteer to help with certain points that are discussed. Doing this makes it easy to follow-up after themeeting with the relevant people. Your board are there to help you so use them.

10. Don’t wait for board meetings to communicate

If there’s a major issue that you need to disclose to your investors do it right away. Don’t wait. Major issues discussed at a board meeting shouldn’t be surprises that the attendees are hearing for the first time. Having a clear and upfront dialogue with your board members and key stakeholders will make your job as a founder easier in the long run.

— — —

Additional resources on board meetings:

  1. “The Secret to Making Board Meetings Suck Less”
  2. “Preparing a Board Deck”
  3. “Should Your Startup Have an Advisory Board”

Originally posted on Medium.

EIS-y Money?

A primer for founders raising EIS and SEIS rounds

Source: https://unsplash.com

What are EIS and SEIS?

In a nutshell they (the Enterprise Investment Scheme and Seed Enterprise Investment Scheme) provide tax incentives for investors to invest in early stage companies. There is a lot of money flowing into startups structured this way. EIS investments in 2014–15 (the last time HMRC published data, see here for the full report) accounted for a total of £1,816 million with SEIS accounting for £175m. By sector, tech companies accounted for the largest proportion.

Generally speaking, EIS and SEIS relief is only available for investors who receive ordinary shares. The theory behind this is such a tax incentive should apply to the earliest and riskiest form of financings. As such, preference shares that carry favourable terms such as liquidation preferences etc. (see this post for more on this) don’t qualify. Due to the requirement for ordinary shares, convertible structures (see this post for more on convertible notes) will also usually not qualify under EIS or SEIS. I say usually because certain forms of advanced subscription agreements (a form of of convertible – see here for more on these) can qualify for EIS and/or SEIS but the discussion of that is beyond the scope of this post.

What are the benefits for Investors?

As mentioned above, the key benefit for investors is the potential tax relief. If they qualify, the tax benefits broadly cover:

1. Income tax:

  1. For EIS investments — 30% of the amount invested (on an annual limit of £1,000,000 investment) can be used as an income tax reduction.
  2. For SEIS investments— 50% of the amount invested (on an annual limit of £100,0000 investment) can be used as an income tax reduction.

So, for example, if an individual invested £10,000 in an SEIS eligible investment (see below for eligibility) they would get income tax relief of £5,000 (50%). Thus, the net cost of the investment to them can be thought of as £5,000. Although the limit is £100k per year it’s also possible to carry back. Therefore, if an investor made zero SEIS investments the year before they can make up to £200k in a year. Income tax relief is offset in the appropriate year of claim, up to a maximum of the income tax liability. In other words, initial income tax relief could reduce an investors tax bill to nil.

2. Capital gains tax:When the investors sell their shares they won’t pay capital gains tax on the gain. SEIS Investors can also get CGT reinvestment relief meaning that if an asset is sold (and a potential CGT is payable) and all or part of the amount of the gain is reinvested in SEIS qualifying shares, half of the amount reinvested may be exempted from CGT (see here for a worked example). EIS Investors can potentially defer payment of CGT meaning gains realised on different assets can be deferred if they invest such gain into EIS qualifying shares (see here for a worked example).

3. Loss relief: If the company fails and the investor loses all of their investment, they can reduce their taxable income by the loss.

4. Inheritance tax: Generally, there’s no inheritance tax to pay on shares under EIS.

The upshot of all this for investors is that they effectively get a discount on the investment (income tax reduction), they don’t pay any tax on gains if the company sells (zero cap gains tax) and they also have a nice downside protection (reduce taxable income by the loss). All in, It’s a pretty good deal for investors.

In addition to the Company requirements discussed below, there are a couple of investor requirements that are also worth noting. The investor can’t be employed by the start-up they are investing in or own more than 30% equity in total. Plus, they need to hold the shares for at least 3 years.

For more examples of how the various tax reliefs work check out the handy Enterprise Investment Scheme Association site.

Is my Company eligible?

Not all companies are eligible for EIS and/or SEIS. Firstly founders should consider the type of share they are issuing (as discussed above) to make sure the structure of the financing qualifies. After that there are some simple company requirements (note the below is a summary: for the full list please check out the gov.uk site).

To qualify for either EIS or SEIS:

  1. The company must have a UK permanent establishment (this does not mean that the Company has to be incorporated in the UK, see here for HMRC guidance on what constitutes permanent establishment);
  2. Companies carrying on certain excluded activities, including (amongst others) dealing in land, property development and banking are not eligible for the scheme; and
  3. The company can’t be a public listed company.

To qualify for SEIS:

  1. The company must not have had any investment under EIS before any shares are issued under SEIS;
  2. The company’s gross assets must not exceed £200,000 immediately before the investment;
  3. The company must have fewer than 25 full time employees; and
  4. Any trade being carried on by the company at the date of issue of the relevant shares, must be less than 2 years old at that date. That condition applies whether the trade was first begun by the company, or whether it was first begun by another person who then transferred it to the company (Note: the company need not have started trading when it issues the shares).

To qualify for EIS:

  1. The company must have gross assets of no more than £15 million before the investment and £16 million immediately after the investment;
  2. The company must have fewer than 250 full time employees; and
  3. The same trade rule as for SEIS but must be less than 7 years.

How much can you raise?

  1. Up to a maximum of £150,000 under SEIS and the money must be usedwithin three years. So companies can raise their first £150k under SEIS before moving on to EIS.
  2. Up to a maximum of £5 million under EIS and the money must be used within 2 years.

Sounds good…What are the next steps?

It’s possible to apply to HMRC for advanced assurance that a company will qualify for SEIS and/or EIS. This is a good tactic for founders to check they meet the necessary requirements (see here for a link to the form to apply). Last I heard it takes around 4–6 weeks to receive advanced assurance. Also, whilst advanced assurance isn’t a 100% guarantee that the company will qualify it will can provide an additional level of comfort to EIS or SEIS investors considering investing at the round.

Is this just relevant for Angel investors and small rounds?

Yes and no, EIS and in particular SEIS are usually relevant for individual investors. However, there are also a number of EIS funds that are actively investing utilising the schemes. Also, for most early stage financing rounds I’ve been involved with there is often some SEIS and/or EIS money as part of a larger round. It’s possible with careful drafting (experienced VC lawyers will be familiar with this) to structure equity rounds that bring in SEIS, EIS and institutional money (i.e. VC funds) all into the same round. Therefore it’s good for founders to research and consider these schemes so that they can potentially unlock further investment for their round.

The above points are by no means exhaustive (and, to flag, do not constitute any form of professional advice) but hopefully they provide some useful background for founders considering SEIS or EIS. As with anything technical like this, I’d also recommend founders seek advice from their lawyer and accountant.

Useful links:

  1. Enterprise Investment Scheme association: http://www.eisa.org.uk/
  2. Overview of the Seed enterprise investment scheme: http://www.seis.co.uk/
  3. UK government information site : https://www.gov.uk/topic/business-tax/investment-schemes

Thanks to Will Neale and Harry Glasstone for reading drafts of this post.

Originally posted on Medium.

Hitting the right note

A primer for founders raising using convertible notes

photo credit: https://unsplash.com/

Convertible notes are one of the most common ways of raising financing for a startup. Particularly the first round of financing. We currently use a form of convertible for all of our pre-seed deals at Seedcamp. Having reviewed and issued many convertible notes over the past few years, I wanted to distill this knowledge down into some key questions for founders to consider and why I think they’re important.

Before we get to the questions, some background..

What is a convertible note?

Broadly speaking, a convertible note is a financing instrument that can be used to provide funds to companies in advance of issuing shares. It is often used on early stage financings because it avoids the need to establish an explicit valuation. Convertible notes can provide a faster and simpler way to document a funding round than a priced equity round.

I’m using the term “convertible note” in this post but many of the below points will also apply to other convertible financing agreements such as: Simple Agreement for Future Equity (SAFE), Advanced Subscription Agreement (ASA) etc. The reason for choosing one variant over the other is often driven by potential tax preferences for investors (i.e. ASA for EIS / SEIS investors) or familiarity (i.e. SAFE for US investors).

For an example of a convertible note and advanced subscription agreement and some of the main differences between the two check out the Seedsummit site here.

8 questions to consider when reviewing a convertible note

(1) What constitutes a Qualifying Financing?

As mentioned above, the primary intention of convertible notes is for them to convert into shares (the clue’s in the name) and the majority of such conversions happens at the next financing round of the company that constitutes a “Qualifying Financing”.

The Qualifying Financing is usually the trigger for an automatic conversion of the note which is then calculated using either the valuation cap (see below), discount (also, see below) or price per share paid at the round -whichever results in the greatest number of shares to the note holder.

The amount (i.e. size of the next financing round) that constitutes a Qualifying Financing can vary depending on the stage of the company and how much the company is raising in total under the convertible note. A reason behind having a qualifying amount is that it protects the investor from having their investment converted to equity in a company that is under funded. Before it is converted the convertible note will technically class as debt and therefore rank higher in the event the company becomes insolvent. This can also ensure that the Qualifying Financing is a true financing for a meaningful amount. However, this lower bound amount should not be set too high so that the Company risks having the money not convert at a true financing round.

(2) Is there a Valuation Cap?

This is often one of the most negotiated elements of a convertible note. The level the Valuation Cap is set at can have a major impact on the number of conversion shares issued. Understanding how it works is of crucial importance. Simply put, it is the maximum value at which the convertible note would convert in a Qualifying Financing (see above), regardless of the price set at such Qualifying Financing. This mechanic prevents the shareholding on conversion from being reduced to a very small % in the event that the company raises at a high valuation for its next round. To illustrate how this would play out in practice let’s look at an example..

Valuation Cap — Example scenario:

Company X is raising a £1m priced equity round (i.e. they are issuing £1m worth of shares to the new investors investing at this round) at a £3m pre-money valuation (for the purposes of the two examples in this post, we’ll call this the “Seed Round”).

Previous to the Seed Round, Company X had raised £50,000 on a convertible note with a valuation cap of £1m (this is the only note they have raised to date).

Assuming that the £1m round is a Qualifying Financing (see above), the convertible note would automatically convert at the valuation cap of £1m because this will result in a greater number of shares than if the convertible note converted at the terms of the round (i.e. £3m pre > £1m cap). Broadly speaking, the convertible note investor would get an effective~3x lower price per share than that paid by the new investors investing at the round by taking the Valuation Cap as the basis for calculation rather than the pre-money of the round.

I always recommend founders model the impact that the notes they enter into will likely have on their cap table when they convert. As the above example shows, the Valuation Cap can have a significant impact on the dilution incurred by the company. However, it’s worth bearing in mind that the convertible note investor has likely invested at an earlier point in time and therefore should probably be entitled to better economics to reflect the increased risk they took.

(3) Has a Discount been specified?

Like the Valuation Cap, the Discount placed on a note is another variable that can have a significant impact when calculating the number of shares that the note converts into. Hence, it is also usually front and centre in any negotiation. Generally, where included, the discount it is drafted as a % of the price paid by investors investing at the round often ranging from 0–30%. Again, taking an example scenario to help illustrate..

Discount — Example scenario:

Using the Seed Round metrics from above (£1m at a £3m pre).

In this example, assume that Company X had raised £50,000 on a convertible note with no valuation cap but a discount of 20% (this is the only note they have raised to date).

Assuming that the £1m round is a Qualifying Financing (see above), the convertible note would automatically convert by taking the price paid per share and discounting by 20% because this will result in a greater number of shares than if the convertible note converted at the terms of the round (i.e. Seed Round price per share> 0.80*Seed Round price per share). Broadly speaking, the convertible note investor would get an effective 20% lower price per share than that paid by the new investors investing at the round.

Note: Convertible notes can also be drafted to include a Valuation Cap and a Discount (and, in rare cases, they could include neither). If they include both, the convertible note holder would choose to either convert into shares using the Valuation Cap or the Discount (whichever would result in them receiving the most shares).

Overall, both the Valuation Cap and Discount are very important terms and care should be taken in particular when determining the effect they can have on the ownership position following conversion.

(4) Is there an Interest Rate?

To flag, not every convertible note will carry an Interest Rate (i.e. the note we use as the basis for our pre-seed investments at Seedcamp does not carry an interest rate). If it is included, the Interest Rate will usually start accruing from the day the convertible note is signed and issued until the day the note becomes due and payable or converts. The interest rate is important to consider because, on a conversion, the accrued interest can be thought of as acting like an additional discount. Overall, the Interest Rate is an additional factor that impacts the investor’s return and therefore can form part of a negotiation.

(5) What happens if the next round is not a Qualifying Round?

Usually the convertible note holder would have the option of whether to convert or not if the next round does not constitute a Qualifying Round. The Valuation Cap or Discount may be set at different levels compared with how the note would convert on a Qualifying Financing (if different it would be common for the valuation cap and/or discount to be more favourable for the investor). This provision may also give the convertible note holder the option to convert the note to shares in the event there is no financing round prior to the maturity date (see below) based on an agreed pre-money valuation. This clause can have an impact in the event things don’t go to plan and the company has to raise a smaller than planned round (i.e. a bridge financing or similar).

(6) What happens if the company is acquired before conversion?

There will usually be a specific clause that addresses the situation in which the company is acquired before the convertible note has had a chance to convert into equity in the company. This situation is common in “acquihires,” or the acquisition of a company at a very early stage, and in which the amount being paid for the company is based on the recruitment of its employees rather than the company’s intrinsic value (i.e., the company’s intellectual property, revenue, etc.). The three most common possible scenarios for the treatment of the note are: (1) the convertible note converts into ordinary shares of the company, and then proceeds from the acquisition are distributed to the common stockholders on a pro rata basis; (2) the convertible note converts into preferred shares, which provides protection of liquidation preference, among others; (3) the convertible note holder is entitled to a return of a certain amount, based on then balance of the note (i.e. the amount they invested under the convertible note). In (3), the return entitlement can be 1x, 2x or higher. This clause is important for founders to consider particularly if aquihires are common in their industry or they believe the company may be acquired prior to a conversion.

(7) What’s the Maturity Date and what does it mean?

The Maturity Date is the date that the convertible note technically would need to be repaid if it is still outstanding (i.e. it has not converted or been repaid in some way). In practice, if the Maturity Date comes to pass it is often agreed by the convertible note holder that it can be extended (particularly common for VC investors, experienced Angels etc.). Look out for wording explicitly stating that the Maturity Date can be extended. However, investors may enforce the repayment which could have dire consequences for the company (i.e. if they have insufficient funds or if such a call on funds would lead to insolvency). Most sophisticated investors would appreciate that extending is likely the best route because, in practice, it is very unlikely that the company would have sufficient disposable funds to repay the note. However, the same may not be true of all investors. Be careful in picking your investors – particularly if they have not invested using a convertible note before and don’t fully understand the risks and what the situation would likely be in the event the company does not succeed.

(8) What type of shares will the note convert into?

Generally, this will be either ordinary shares or the same class of shares that are issued to other investors at the round. It’s favourable for the investor to receive the same class of shares as those issued at the round because they will generally be preferred shares and carry such rights (i.e. protection of liquidation preference etc.). It’s important for founders to understand this clause because they are potentially increasing the size of any liquidation preference (see this post) they create on a future round.

The above points are by no means exhaustive but hopefully they provide a useful primer. I’d recommend founders run any detailed points past a lawyer and get legal advice before entering into any agreements.

Originally posted on Medium.

Why terms can matter more than valuations

If Participating Preferred was a sweet…

It goes without saying that the valuation placed on a company is a key variable forming part of any negotiation at a financing round. However, I’d argue that terms can matter more. This is never more true than when considering a VC favourite, the “liquidation preference”.

What is a liquidation preference?

A liquidation preference is a right that can be required by investors in respect of their capital contribution (i.e. their investment amount). It is a common right given to preference shareholders. It effectively provides a mechanism by which they can receive a certain amount before other shareholders on some form of liquidation event (this often also covers winding up, merger and acquisition). The amount they will receive could be equal to the amount they invested (typically referred to as 1x), or some multiple thereof, depending on the terms negotiated.

What’s the impact?

This largely depends on the drafting of the liquidation preference. In particular, whether the liquidation preference is “participating” or “non-participating”.

To explain let’s consider two simplified scenarios:

Scenario 1 — Non-participating liquidation preference

Company X has received an offer for an investment of £5m from “VC Fund” for its Series A at a £15m pre-money valuation. This will be its first outside investment (good going Company X!). The £5m will be invested in return for preferred shares that, amongst other things, benefit from the right to a 1x non-participating liquidation preference.

In Scenario 1, post investment the equity split amongst investors and founders is as follows:

  1. VC Fund = 25%
  2. Founders = 75%

In Scenario 1, assume the company struggles to achieve traction and fails to raise again and with limited options decides to pursue an exit for £10m.

From a £10m acquisition offer the proceeds would be split as follows:

  1. VC Fund = £5m = 50%
  2. Founders = £5m = 50%

Even though the equity split is 25:75 in favour of the founders, in this scenario, the 1 x non-participating liquidation preference results in a 50:50 split of the acquisition proceeds. This is because VC Fund would choose to get its preferred amount in order to recover their investment rather than participating pro rata with other investors.

Scenario 2— Participating liquidation preference

Assume the same economics as scenario 1 (£5m at a £15m pre) but this time the VC Fund has negotiated a 1 x participating liquidation preference.

The same post investment equity split amongst founders would apply:

  1. VC Fund = 25%
  2. Founders = 75%

Again, assuming a situation transpires whereby a £10m acquisition offer is to be pursued.

In scenario 2, for a £10m acquisition offer the proceeds would be split as follows:

  1. VC Fund = £6.25m = 62.5%
  2. Founders = £3.75m = 37.5%

Again, the VC Fund would elect to maintain its preferred share rights rather than convert into ordinary shares. This results in a significant swing in favour of the VC Fund in terms of returns received.

Participating vs. Non-participating

The two scenarios highlight the difference between participating and non-participating liquidation preferences. The non-participating variant can be thought of as an “either or” clause whereby the investor can receive the amount they invested or their pro rata share of the proceeds. In the above scenario 1 they would choose to receive their preference amount because this is the greater (£5m vs. £2.5m). However, if the acquisition price exceeded £20m the VC Fund would elect to convert its preferred shares to ordinary shares in order to participate pro rata because this would result in a greater return than £5m. This is why non-participating liquidation preferences are often classified as “down-side protection” provisions because they help investors potentially limit their loss on a liquidity event.

The participating variant gives the investor the right to receive their preference amount and their pro rata share of the remaining proceeds. In scenario 2 this results in £5m (1 x their investment amount) plus £1.25m (25% of the remaining £5m). A participating liquidation preference provides down-side protection whilst also giving the investor the right to participate in the upside, hence the “double-dip”.

In addition to non-participating and participating, other terms to look out for in relation to liquidation preferences are:

  1. senior liquidation preferences that stack on top of liquidation preferences that were provided to investors on previous rounds.
  2. multiple liquidation preferences in the above two scenarios we have assumed a 1 x liquidation preference but this could be higher (i.e. 1.5x, 2x etc.)

For a useful maths cheat sheet on the implications of participating, non-participating, senior and multiple liquidation preferences on exit proceeds check out this post.

How is this fair?

Whilst providing any form of preference may seem disproportionately favourable to an investor, let’s consider this for a moment from the investor perspective. Again using my £5m round and £15m pre example from above, a £10m exit is a very poor outcome for an investor and especially so for an institutional VC investor. When you take VC money you’re setting on a course to pursue outsized returns, a £10m exit likely does nothing for a VC with regards to them returning their fund. So although the inclusion of a liquidation preference does provide downside risk protection for an investor it also serves a secondary important purpose – aligning incentives. Without a liquidation preference a £10m exit would be an OK outcome for founders in the event there’s two of them and they each walk with £3.75m (£7.5m / 2) — that’s a pretty nice payday. But with the preference their potential proceeds are reduced significantly. Therefore the inclusion of a liquidation preference also further incentivises the founders to shoot for higher growth and a larger exit outcome and provides an additional mechanism for aligning their interests with that of their investors.

What’s market here?

I don’t like solely looking at “what’s market” and would always rather encourage founders to discuss with their investors why they are looking for certain terms and get a sense for how important they are for them. However, for early stage financings where the company is issuing preference shares, 1 x non-participating is standard. If you’re a founder negotiating an early stage financing round and your investor is looking for participating or a multiple you should ask them to explain why they require this. If what they are asking feels inequitable this may be an area to push back because it could set a nasty precedent for future rounds.

Fenwick and West’s “The Terms behind Unicorn Valuations” analysed the terms of financings undertaken by US based unicorns during the 9 month period ended December 31 2015. The following is interesting to note with regards how liquidation preferences were structured in the surveyed companies documents:

  1. Non-participating liquidation preference over common (ordinary) shares was included in 98% of the equity documents
  2. Participating liquidation preference was in 6%
  3. Senior liquidation (preference over common and other series of preferred stock) was in 21%
  4. Multiple liquidation preference was in 6%

Hopefully the above illustrates why I think terms matter more than (or at least as much as) valuations and why it’s so important for founders to appreciate this and go into financing discussions armed with this knowledge.

Originally posted on Medium.

Bulletproof Vest – How vesting can save your startups life

Startups rarely (if ever) go perfectly to plan; things often go wrong and life throws up all sorts of scenarios that can have an impact. Sometimes things get so bad that founding teams split up. The chances of this are often increased where you have large founding teams formed in a short period of time (i.e. when the team haven’t really worked together before). Regardless of the size of your team and the likelihood of a founder fallout, how big an impact such a split has on your startup can make or break it. This is where vesting comes in.

One of the primary drivers behind the idea of vesting is to help reduce the impact of a co-founder leaving by ensuring they don’t leave with a disproportionate amount of equity. How this often works is that founder shares vest over time. So, as a founder you are 100% vested when you “own” 100% of the shares that have been allocated to you. For example (very simplified):

if you have a straight-line (meaning you vest daily a proportion of shares) vesting schedule in place over 4 years and you started vesting 2 years ago you will have vested 50% of the shares allocated to you.

Vesting is important to ensure that, should a co-founder leave during the vesting period, there is enough equity left in the company to adequately incentivise the remaining founders and team. This is even more important when you think that the company will likely have to hire someone to replace the departing co-founder and they will likely want a chunk of equity. Often vesting is thought of as solely an investor protection provision requested at the time of a fundraising round. I always advise founders not to think of it purely this way because, as described above, it helps protect against a potentially catastrophic impact of a founder fallout situation for all stakeholders (founders and investors).

Personally, I’m always impressed with founders who think about vesting early on and appreciate the theory behind it. It’s not necessary to worry about the detailed mechanics, your lawyer will incorporate this into the long-form legals when it is required (usually at a fundraising round). Often vesting schedules are set over 3–4 years with some form of a cliff after one year. This means that an amount (often 25%) is deemed to be vested only after one year of continued work (the “cliff”), with the remainder vesting incrementally on a straight line basis over the following 2–3 years. For example (assuming 4 years):

  1. 0–12 months = 0% vested
  2. 12 months = 25% vested
  3. 12–48 months = straight line vesting (i.e. you vest a small amount each day)
  4. 48 months = 100% vested

All sophisticated investors will request some form of vesting schedule should you raise a round of financing from them so it’s worth giving some thought to this when you are staring out.

I haven’t really dived into the nitty gritty of specific terms in this post (in particular I haven’t looked at the circumstances around founders leaving (i.e. Good Leaver, Bad Leaver, Acceleration on Exit etc.)). It goes without saying how important it is to fully understand any legal documents and the implication of the terms contained therein.

Originally posted on Medium.

Yet to incorporate your startup? Read this!

Often startups begin life as a project, hobby, hackathon submission etc. way before anyone thought about incorporating a company to formalise it. This is perfectly normal and it’s very likely that there will be some period of collaboration and figuring stuff out prior to incorporation. However, I’ve been involved in a couple of situations where individuals crop up further down the line (i.e. once a startup has received some press attention after having raised a round etc.) and stake a claim for a share in a company.

Often the claim goes something like:

“I was there that time in the coffee shop when we (current founders and them) were discussing the idea and I made X suggestion therefore I’m a co-founder and I’m entitled to Y% of the company”

Whilst it may be very difficult for someone to provide enough evidence to actually bring a successful claim like this, even having it potentially hanging over the company can be problematic (particularly around fundraising when investors are doing due diligence).

So, what can you do to protect against this?

At the point you start collaborating you should set out who you are collaborating with on your idea and who is going to own what in terms of % should you go on to set up a company. This doesn’t require a long-winded shareholders agreement or an expensive lawyer to draft it. You can probably get away with something on the back of a napkin at a push. However, I’d recommend something a bit more robust – for a free example of a simple template checkout the Seedsummit website here.

Unfortunately, nothing can stop someone bringing an entirely fictional and unfounded claim against your startup. I hate seeing such claims stress out founders and take up their valuable time. Having a clear paper trail in the early days, however basic, is a great way of hopefully mitigating against any effect and allows you to get on with building your business!

Legal Tech – Mapping Disruption

We (Seedcamp) recently hosted a Legal Tech focused event in partnership with Next Law Labs to bring together influencers in the Legal Tech community and those interested in finding out more. The turnout for the event was great and speaking to the founders who came along it really feels like the space is at a tipping point. Being an ex-lawyer this has always been a space that has really interested me, I wanted to share the below map and some market insights on why I think now is a great time for Legal Tech.

Market Map

The aim of the map is to provide an overview of many of the different startups within the Legal Tech space. It’s not designed to be all encompassing or fully comprehensive. I’ve included a full list of all the companies on the map and how much they’ve raised to date at the end of this post. If I am missing something, tweet me @tom_wils

What is Legal Tech?

Firstly, what is Legal Tech? Broadly speaking, the Legal Tech market covers companies (mostly startups) utilising technology to build products solving problems faced both by industry (i.e. law firms, corporates etc.) and consumers related to legal services.

Why now?

Whilst the space has been slow to take off (i.e. in comparison to Fin Tech), a combination of factors are coming together to make now a great time to build a startup focused on the Legal Tech space:

  1. Maturing ecosystem – as the map shows we are seeing increasing numbers of well funded startups. This in turn raises the profile of the industry and provides further validation for startups looking to get those first customers in a notoriously risk-averse market.
  2. Increased transparency – the legal services market has historically been viewed as one that is opaque when it comes to knowledge and therefore costs. The introduction of marketplace models and startups focused on document services (see the Map above) are improving this information asymmetry. This increased transparency is presenting opportunities for startups to compete with the more well-established players.
  3. Automation – advances in natural language processing have enabled people to build solutions addressing various verticals within the overall legal tech market (see eDiscovery, IP Management, Contract Review). In particular, such solutions are taking advantage of large data sets to assist with the automation of certain low level repeatable tasks. The opportunities here to reduce the time taken and therefore costs are significant (law firms still tend to bill by the hour). As this technology improves and the data sets they work on are scaled up it could be possible for solutions to be built to automate more advanced work.
  4. Innovation – we are seeing the emergence of startups that are aiming to go beyond the automation and provide additional insights (see Legal Research). Whilst this space is still in its infancy, this arguably could lead to the removal of the need to instruct lawyers for certain tasks.
  5. Generational shift – there is an increasing interest in the space both from those within the law (particularly towards the junior level) and those building solutions from outside the law aimed at the sector. Furthermore, law students and future practitioners will start and grow their careers utilising advances in technology.

— –

Map: Breakdown by sub-sector

I’ve taken the following as sub-sections of the overall market:

  1. eDiscovery – solutions to manage emails, documents and other files specific to the litigation process.
  2. IP Management – tools to help track and analyse trademarks, copyrights, patents and other IP assets.
  3. Marketplace – tools to help people find lawyers for specific matters.
  4. Research – tools to help lawyers with legal research and / or make more data-driven decisions.
  5. Practice Management – tools to help law firms with issues around on-boarding clients, tracking matters, billing, invoicing, time-tracking etc.
  6. Document Services – providing legal documents or forms and (in some cases) legal advice. i.e. covers contract creation, management and / or legal services.
  7. Contract Management – helping companies keep track and manage contracts throughout the contract lifecycle.
  8. Contract Review – technology solutions (e.g. natural language processing and machine learning) for automatically abstracting contract terms to help with contract review.

Map: Breakdown by company


Kcura — raised $125m, developers of e-discovery software.

CS Disco — raised $12.4m, e-discovery platform.

Everlaw — raised $9.6m, litigation platform beginning with e-discovery.

AccessData — raised $45m, digital forensic, e-discovery and incident response solutions.

RenewData — raised $41m, e-discovery, e-storage risk management solutions, and forensic.

Lighthouse eDiscovery — raised $34.5m, e-discovery litigation services.

Guidance Software — raised $7.54m, e-discovery, data discovery and computer forensics.

Catalysy Repository Systems — raised $31m, provides litigation support software and hosted document repositories.

PSS Systems — raised $18m, provides solutions for legal holds and retention problem.

StoredIQ — raised $41.84m, analysis and governance of unstructured data (acquired 2012).

Recommind — raised $22.5m, enterprise search and categorisation platform automatically organises, manages and distributes large volumes of information from multiple sources.

X1 Technologies — raised $12.2m, enterprise wide collection and processing as well as review and analysis platform for litigators.

Modus eDiscovery — raised $10m, data management firm that helps organisations leverage eDiscovery intelligence.

Cicayda — raised $6.8m, Saas based e-discovery software.

Zapproved — raised $17.24m, e-discovery for corporate legal teams.

Mimecast — raised $90m, amongst other features, e-discovery (went public in 2015).

Logikcull — raised $4m, e-discovery platform.

Cloud Nine — e-discovery platform.

IP Management

Trademarknow — raised $3.5m, trademark search and watch results.

Anaqua — raised $125m, provides a range of IP management software solutions.

Lecorpio — raised $25m, provides IP management software to automate intellectual property processes.

PatSnap — raised $13.6m, search platform for patents.

Zhiguoguo — raised $3.7m, IP management software including registration and legal services.

Naming Matters — IP visual search and related naming tools.

RPX Corporation — raised $undisclosed, provides patent risk litigation solutions (went public in 2011).

Innography — raised $13.02m, patent management software.

P Street — raised $6.96m, IP and patent search tool.

Turbopatent — raised $2m, patent application and prosecution solution.

Deltasight — raised $400k, IP analysis and visualisation.

IPlytics — raised $undisclosed, monitors and analyses company’s competitive position for patenting.


Ravel — raised $9.2m, legal search, analytics, and collaboration platform for lawyers. (Acquired 2012).

Judicata — raised $7.8m, turning unstructured court opinions into structured data.

ROSS Intelligence — raised $undisclosed, using IBM Watson to provide answers to legal research questions.

vLex — raised $5.2m, multilingual database of legal content.

LexMachina — raised $10m, IP, litigation data and predictive analytics to law firms. (Acquired 2015).

Casetext — raised $8.8m, community site for lawyers to share knowledge.

Juristat — raised $3m, big data analytics and research tool focused on patent prosecution.

Practice Management

Clio — raised $26m, practice management suite that is designed for sole practitioners and small law firms.

Apperio — raised $2.4m, enables firms to track legal spend at an overall or matter level, in real time. (Seedcamp is an investor).

Peppermint — raised $15m, platform that delivers application services across accounts, practice, case document, risk management.

Total Attorneys — raised $15m, practice management software and customer acquisition for attorneys.

Viewabill — raised $1.1m, real time access to time entries and billing practices.


Avvo — raised $132m, legal marketplace, directory, and question and answer forum that connects individuals with lawyers.

Lexoo — raised $1.7m, lawyer comparison marketplace for businesses.

UpCounsel — raised $14m, marketplace for legal services.

LawDingo — raised $790k, marketplace for virtual legal consultations.

Lexdir — raised $420k, legal marketplace and directory.

Zhuanjiabao — raised $692k, legal marketplace plus virtual legal consultations.

Priori Legal — raised $undisclosed, lawyer comparison marketplace for businesses.

Legal Reach — raised $900k, legal directory.

LawAdvisor — raised $590k, marketplace for virtual legal consultations.

Lvgou — raised $1.9m, legal marketplace.

Legal Hero — raised $750k, legal marketplace focused on fixed fees.

On Legal — legal case management platform with marketplace.

LinkiLaw — legal marketplace.

Access Solicitor — legal marketplace.

Lexstep — legal recruitment marketplace.

Document Services

LegalZoom — raised $266m ($200m of secondary), contract creation and legal services.

Rocket Lawyer — raised $53.3m, contract creation and legal services.

DocStoc — raised $4m, contract creation and sharing platform.

LawPath — raised $1.9m, contract creation and legal services.

Docracy — raised $850k, contract creation and signing.

Juro — raised $80k, contract creation and management. (Seedcamp is an investor).

Dragon Law — raised $410k, contract creation and legal services.

LawBite — raised $170k, contract creation and legal services.

Clerky — raised $120k, contract creation and management.

IronClad — raised $undisclosed, contract creation and management.

Shake — raised $4m, mobile-first contract creation. (acquired 2015)

Intelligize — raised $3.59m, legal form (i.e. SEC filings) creation and management.

Brightleaf — raised $3m, contract creation and management.

Iubenda — raised $100k, privacy policy generator.

Contract Management

Icertis — raised $21.4m, contract creation and management, focused on enterprise.

Contract Live — raised $1.4m, contract creation and management.

Avvoka — contract management.

SpringCM — raised $85m, work flow automation and contract management.

Selectica — raised $23.3m, work flow automation and contract management. (went public in 2010)

Exari Systems — raised $10m, contract creation and management.

Pekama – raised $undisclosed, contract management and collaboration tool.

Clausematch – raised $600k, contract management and collaboration tool.

Contract Room — raised $850k, contract management and collaboration tool.

Seal — raised $13m, contract management and analytics.

Contract Review

eBrevia — raised $500k, natural language processing and machine learning to understand legal language.

Legal Robot — natural language processing and machine learning to understand legal language. Focused on both B2B and B2C.

Beagle — natural language processing and machine learning to understand legal language. Focused on B2B.

LegalSifter — raised $1.6m, natural language processing for contracts.

Kira Inc — natural language processing and machine learning to understand legal language.

LawGeex — raised $2.5m, natural language processing for contracts.

Cognitiv plus — natural language processing for contracts.

Originally posted on Medium.