Where Deals Die Between Seed and Series A
A two part conversation on what an investor and a lawyer each see before a Series A closes.
Nitin Rai is the Founder and Managing Partner of Elevate Capital, an institutionally backed venture firm. Before that he was the founder and CEO of several companies. Daniel Novela is the founder of Novela Law, a Miami transactional firm that structures financings and acquisitions from pre seed through Series A. In the first half of the conversation, Daniel asked Nitin what an investor sees in a company before writing the check. In the second, Nitin turned the questions around and asked Daniel what the documents reveal.
Part One: What the Investor Sees
Daniel Novela asks Nitin Rai
You find a founder you like. You are leaning in. What makes you take a step back?
You want to invest in every founder you like. You fall in love with the founder. I tell people we invest in jockeys. But there are things you find during diligence that turn you off and make you walk away from the deal, and usually those are things that take time to surface. When I was an angel, with no resources for diligence, if I fell in love with a founder and the idea I wanted to write the check immediately. Over time I have learned that you have to spend the time with them. When you spend time, you learn things about the market, but more importantly you learn things about the founder. As you move through diligence, something pops up that hits your gut, and you start pattern matching to previous deals. I have invested in over 100 companies, so something is going to pattern match to a deal where there was a breakdown. It is not only pattern matching to the successes. It is pattern matching to the failures. Largely, it is the founder himself or herself. Something about them pops up and you say, not for me.
Is that a data room problem? Where in diligence does it show up?
The data rooms that work well are the ones that are well organized, starting with a table of contents, so everything is structured and the story flows. I do not personally do the diligence. I have a team for that. But sometimes I get into a data room and things are missing or disorganized. The data might all be there, but it is not presented in a way that shows you everything you want to know about the deal and the company, and you have to keep going back and saying, I need these four pieces.
What about that process tells you to slow down and think again?
Largely, it is the numbers. Revenue projections that are out of control and not in sync with the rest of the deal. Missing market data. Market metrics that were inflated. No solid pro forma showing where the growth is going to come from and how they are going to achieve it. And a lack of transparency about certain things: employee issues they were working through, or customers they said they had but did not. Those are things we need to know, and we find them. If a founder cannot clearly articulate how they are going to get to the 100 million dollar vision, and it is not a data backed plan, all bets are off.
Where does the lawyer become a problem? Where are they not adding value?
They nitpick the wrong things, things that are inconsequential. At the end of the day, you want to get the deal done. Do not drag it out. It is the lawyers who drag it out to create billable hours. That creates friction when you do not need friction. What we have found is that those lawyers survive the investment, but after the investment they are done, because all they were doing was generating billable hours. The other problem is lawyers who try to give founders business and valuation advice. Those are the worst. It is outside their scope. They do not know this business and they have never built a company, so they should not act like they have.
We do a lot of mentoring, and we give founders specific advice on what kind of lawyer to hire for that first deal, often before they have hired anyone. Some lawyers are great for larger or later stage deals. At the early stage where we come in, you do not need a lot of lawyer. You need good, solid legal advice to construct the document, get it done, get the money, and start building your business.
Daniel Novela: I teach at the University of Miami School of Law, and one of the things I tell students is that a good lawyer is not just someone who finds problems. You have to find solutions to problems. And do not bring up non issues and make problems that do not exist.
Nitin Rai: Inconsequential things that have no legal bearing on getting the deal done and moving forward.
Part Two: What the Documents Reveal
Nitin Rai asks Daniel Novela
What are the typical legal mistakes founders make at the seed stage that become expensive and derail a Series A?
Most mistakes, even small ones, become more problematic and more expensive later, because the fix is much easier in the beginning. Start with promises of equity. Founders have a bad habit of wanting to give equity to all kinds of people for all kinds of things, and they never paper it correctly. It is an email. It is forgotten. Sometimes the service was never even rendered. Everyone forgets about it until the company becomes valuable, and now it is a problem. Those things are easily taken care of early, when the valuation is much lower.
Then there are missed deadlines. An 83(b) election that was not filed cannot be fixed. Once the deadline passes, it is gone. Options promised to employees before there was a plan in place. And anything the company treated as authorized that was never properly authorized, such as board resolutions that never actually went before the board.
What about agreements between cofounders? Do you review those, and is there anything in place if the founders separate?
This just came up with a client. They decided to give a large amount of equity and cofounder status to someone who is now not performing. What do you do? That is where vesting comes in. I tell founders they should all vest. That can be a difficult conversation. What do you mean I have to vest into my own company, the one I founded? But here is the rub. When somebody is not performing, or is not interested, or does not get along and leaves, you are stuck with that person as a founder. It is an easy fix early and a very difficult one later.
What about agreements with venture funds and institutional investors? What should a founder be conscious of before taking that money, including what is in the term sheet?
Any agreement at that level should be reviewed by an attorney. I get involved at the venture stage and again at the M&A stage when there is a later sale, so I see what these documents look like years on. One thing that really bothers me early on is finder fee agreements. Most of them are unenforceable, and most of them are securities law violations unless the finder is a registered broker dealer. Yet you see them all the time, because early stage companies are desperate for capital. Somebody says, I will bring you an investor and I get a percentage of whatever I bring in. We have to clean those up.
The same goes for promises outside the investor relationship. Exclusivity for a certain market or a certain customer, where the other side is not performing and the deal may never be enforced, but it becomes a problem later. I find handshake deals troubling. If they are great deals, they should be papered, because that adds value. If they are not great deals, you do not want to be stuck with them.
A founder took money from an investor who is now on the board and being destructive rather than constructive. How do you handle that?
This is a real issue, and you hear about it most from founders who have been successful, because they have been through that pain. It is hard for a startup to see it as a real issue. When you are desperate for capital, you think any investor is a good investor. It is only once you are in it that you realize this is a problem.
How you handle it depends on what rights they have. Hopefully not tremendous ones. If you can bring in another investor, they may be bought out or diluted down. They are not going to be your lead, and they become less of a problem. But small investors can be a very big thorn. Dissenters rights, appraisal rights, preemptive rights. It all depends on what they negotiated when they came in, and difficult people tend to negotiate difficult terms from the beginning, because they have probably done this before.
The only advice I can really give is to be very careful with your cap table and very sparing with who you give equity to. That is hard in the beginning, because you are desperate for capital, but it pays big dividends later. And it goes beyond investors. When a client tells me this person is going to be great, I am going to give them five percent, and this one ten, I ask: you do understand there is only 100 percent?
Do you see many participating preferred terms anymore?
It depends on the market and the stage. My firm works from pre seed and friends and family through Series A, and by then the company generally moves on to larger counsel. We do not see much of it at that level.
Nitin Rai: Those can be quite damaging.
For a founder who does not have a lawyer yet, how should they go about finding one for the seed to Series A stage?
Do not go to the family lawyer who did your father’s will and handled the divorce. Do not get a generalist. Get a specialist. That does not necessarily mean a big firm. Some big firms have good programs for startups now, and I would not rule them out. But get somebody who does this every day.