Over the last couple of months, both entrepreneurs and some of my colleagues in the venture capital industry have filled the blogosphere by commenting that investments by VCs in seed stage companies require streamlined documentation and processes. They argue that spending weeks negotiating documents and tens of thousands of dollars in legal bills is inappropriate for an investment of only a couple of hundred thousand dollars in a company that is close to its inception. Even the use of standard form documents, such as those promulgated by the National Venture Capital Association are said to be too burdensome for use in this context. I think this is great news as it suggests 1) that my colleagues are doing more seed deals and 2) that we are interested in creating a process with less friction for entrepreneurs.
However from my perspective, this call for streamlined documentation has created a somewhat Newtonian effect (for every action there is an equal and opposite reaction). While I agree that the objectives of speed and thrift are unassailable, proponents of a substantially truncated approach to venture investing overlook the needs of institutional venture capital funds. As fiduciaries of our investors’ capital, we are required to be sound stewards of the monies entrusted to us. This requires a degree of documentation that may seem excessive, but is necessary to assure the proper protections are in place. Individual investors not subject to fiduciary obligations can literally write a check with as much, or as little, investigation and paperwork as they feel appropriate; the institutional venture capitalist must always behave as if its own investors are peering over its shoulder (which, if it comes to pass, would always occur on a 20/20 hindsight basis, and after an investment has gone bad).
At Highway 12 Ventures, we believe that there is a happy medium between the two and we’ve worked hard with our counsel (Bob Kraus and Steve Hardesty) to create a simplified set of documents that we believe accomplishes these goals. Lately though, we’ve come across a few entrepreneurs (and their counsel) who have internalized these discussions into believing that seed deals funded by institutional investors should have considerably less documentation and very little if any protective provisions.
Some of the protections afforded by the NVCA documents that should not be given up by institutional venture capitalists include: a right to designate one or more members of the portfolio company’s board of directors, antidilution protection, various protective provisions (requiring an affirmative shareholder vote for certain corporate actions), preemptive rights (the right of current shareholders to maintain their ownership percentage by investing a proportional amount in future financings), a right of first refusal and cosale in the event management shareholders wish to divest themselves of their stock in the company, and drag along rights (requiring all applicable shareholders to agree to a sale of the company when the requisite level of shareholder approval is obtained). Essentially what all of this says is that if you do something that affects our stock, we want a say in the matter.
In addition, certain other provisions may be appropriate depending on the experience of the entrepreneur who founded the company, or the business in which the company engages. Examples of these include: mandated scheduling of board meetings, obtaining certain types and levels of insurance, requiring investor-designee concurrence in certain board actions, and certain levels of financial and business results reporting.
Finally, entrepreneurs should consider that subsequent fundraising will likely be easier if the company already has in place a set of documents meeting the expectations of institutional investors. It is far more common for such investors to provide growth capital to companies than it is for such funding to come from individual investors. A properly structured set of governing documents will reflect well on the professionalism of the startup.
It is very much in the mutual interests of investors, including institutional VCs, and entrepreneurs to keep costs down and to close a financing round quickly. Many of my peers pride themselves in being nimble, able to identify and fund exciting prospects efficiently and effectively. Indeed, it is possible to use standard documents to achieve exactly these ends, and many counsel who are familiar with VC documentation are expert in bringing transactions to a close in a short period of time. The most valuable technique in achieving this end is the negotiation of a fairly detailed term sheet, making the documentation process more streamlined and less contentious. In appropriate circumstances certain terms (such as registration rights) can be truncated or modified, and institutional investors would be well advised to remain flexible in their discussions with entrepreneurs. However, the fundamental protections that fulfill a VC’s fiduciary obligations to its own investors should not be sacrificed.