How do the sample Y Combinator Series AA financing documents differ from typical Series A financing documents (or what’s the difference between seed and venture financing terms)?

August 23, 2008

Y Combinator recently published forms of Series AA equity financing documents that YC portfolio companies have used when raising angel financing.  YC provides a three month startup program for entrepreneurs twice a year in Cambridge, MA and Mountain View, CA.  YC typically provides $5K plus $5K per founder of seed funding for usually 6% of the equity in common stock (which, as an aside, Sarah Lacy seems to question, but in my mind seems like something that I would jump at if I were a fledgling entrepreneur).

[Disclaimer/disclosures:  Please read the disclaimer on the documents and on my website.  I write this blog in my personal capacity and my opinions may differ from my colleagues.  WSGR represents Y Combinator and many of its portfolio companies.  I represent a YC portfolio company that provides the Chatterous application and have worked with Y Combinator founder Trevor Blackwell's company Anybots.  I have also represented investors that have invested in a couple of YC portfolio companies.  I may update this post in the future.]

I was planning to write a post on the differences between angel financing terms and venture capital financing terms, and thought that the YC documents provided a good opportunity to explain the differences.  I’ve already noticed some commentary about the documents and decided to provide some more detailed explanations and the situations that they might be used.

If you want to review annotated Series A venture capital financing documents, please review the NVCA model venture capital financing documents.  (Please note that I think that the default provisions in the NVCA documents are generally fairly investor-favorable and reflect east coast practice rather than Silicon Valley practice.  I will probably write a post about these documents at some point in the future.)  This post assumes that you have a basic understanding of Series A financing terms.  If you don’t, please educate yourself on this site, Venture Hacks and the term sheet series by Brad Feld/Jason Mendelson, among other places.

What situations should these documents be used in?

The YC documents are probably fine in situations where the investor (i) wishes to purchase equity rather than convertible debt, (ii) is otherwise somewhat indifferent on terms other than percentage ownership of the company, liquidation preference and right of first offer in future financings, (iii) is investing at a fairly low valuation (i.e. a couple of million dollars), and (iv) is only investing a small amount (i.e. a couple hundred thousand dollars or less).

In my experience, sophisticated angel investors expect to receive a full set of Series A documents with rights essentially the same as venture capital investors, so the Series AA documents may not be acceptable in these situations.  I think these documents are most appropriate in a friends and family equity seed financing.  However, I believe that companies are generally better off with convertible debt rather than an equity financing at a low valuation.

Why is it called Series AA?

To differentiate it from typical “Series A” preferred stock, which comes with certain expectations with regard to rights.  I’ve had clients rename their Series A, B and C to Series A-1, Series A-2 and Series A-3, so that their first institutional venture capital financing was called the Series B.  There is no real rule to what a particular series of preferred stock is called (i.e. Series FF for the Founders Fund invention).  I suppose that YC could have named it Series YC, instead of Series AA, for better branding.

What rights does the Series AA have in the sample YC documents?

Obviously, please read the term sheet. The primary rights in these documents, ranked in order of importance in my opinion are:

  • Right of first offer on future financings.  Please note that these documents provide that the right of first offer expires five years after the financing, which I believe is not standard (but happens to be the company-friendly default in the WSGR form of documents that the Series AA documents were based on).
  • Information rights.  The investor receives unaudited annual and quarterly financial statements.

There are situations where an investor might receive stock with even less rights.  For example, if a founder contributes a significant amount of cash (i.e. enough to buy a car) to fund the company, then I might suggest that the company issue preferred stock with a liquidation preference and no other rights to the founder, as opposed to issuing common stock.  The reason for issuing preferred stock instead of common stock is to preserve a low common stock value for option grants as explained in this post, and providing the stock with a liquidation preference.

What are the primary rights that are missing from the these documents that a VC or sophisticated angel would expect?

Some people have suggested that various terms are unnecessary in early stage Series A financings.  See the VentureBeat article titled “Reinventing the Series A.”  In the sample YC documents, there are various terms that are missing that one would typically expect in a company-friendly Series A term sheet (i.e. one from Sequoia Capital).

  • Dividend preference.  Deleting the dividend preference is not a big deal, as almost all startup companies don’t declare dividends.  The only practical situation that I can think of where a dividend preference is beneficial to a stockholder is where a company does a partial sale of assets and wishes to distribute the proceeds to stockholders. The liquidation preference would not apply in this situation, and any distribution to stockholders would trigger the dividend preference.
  • Registration rights.  As a practical matter, I don’t think that most investors should really care about registration rights, especially in light of the shortening of the Rule 144 holding period to 6 months.  (I suppose I will write a boring post about Rule 144 at some point.)
  • Anti-dilution protection.  Deleting anti-dilution rights saves several pages of text in the Certificate of Incorporation. Given that the Series AA is issued at a fairly low valuation, anti-dilution protection is probably not that important, as a “down round” from a low valuation in the Series AA is unlikely.
  • Comprehensive protective provisions.  The YC documents are fairly light on protective provisions compared to a typical Series A financing.
  • Right of first refusal and co-sale.  These rights are missing.  This is probably okay assuming that the founders restricted stock purchase agreement has a right of first refusal on transfers until a liquidity event.  The right of first refusal on founder stock transfers in a typical restricted stock purchase agreement is in favor of the company.  (Please note that when I say typical, I mean an agreement drafted by attorneys experienced in venture financings, not the boilerplate you might get from an online incorporation service.)  The typical RFR/co-sale agreement in a venture financing gives the investors a right to purchase the shares if the company does not exercise its right.
  • Voting agreement.  An optional bracketed provision in the Certificate of Incorporation provides for a Series AA board seat.  In a typical venture financing, there would also be a voting agreement that governs how specific board seats will be filled.  In angel financings, I typically eliminate the voting agreement anyway and simply have a closing condition that the board consist of certain persons.
  • Comprehensive representations and warranties.  The Series AA Preferred Stock Purchase Agreement has fairly limited reps and warranties.  As a practical matter, investors don’t sue companies for a breach of reps and warranties, so reps and warrants basically serve to flush out diligence issues.  In an early stage company, extensive reps and warranties are probably unnecessary.
  • Legal opinion.  A company counsel legal opinion is missing in these documents.  A legal opinion for a newly-incorporated early stage company probably doesn’t add much to the due diligence process and is probably unnecessary compared to the incremental cost to prepare.
  • Legal fees.  Each side pays its own legal fees in these documents.  Venture funds expect the company to pay investor counsel fees.

Do I need an attorney to help me complete a financing if I have these documents?

Yes.  Absolutely.  These documents are not intended to be “fill in the company name,” sign the docs and collect checks/wire transfers.  The fact that certain rights were intentionally omitted from the documents compared to typical VC financing documents is a judgment call that requires the guidance of an experienced attorney. There are always various corporate housekeeping matters that need to be cleaned up in connection with a financing.  Please don’t try to use the YC documents without working with a competent attorney.

Comments

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  • http://www.dawdle.com Sachin Agarwal

    This is a fantastic commentary on the docs, especially for the intelligent founder who is already looking a step ahead to the Series A and should be prepared for that conversation. In particular, the note that founders should be issued preferred, rather than common, stock for significant cash investment is most welcome – many people I’ve spoken to are unaware of how that benefits the company in the long term by keeping the common stock option grant strike price low.

    A couple of quick questions: given the increased legal expense of an equity raise versus a convertible note, should this Series AA structure really be used for friends and family money? I understand that they are likely to be more friendly than a sophisticated angel, but the legal expenses (even with these as a base) are sure to be higher. Also, does the Series AA avoid having to have a 409A valuation done? That’s another additional expense for a “by the book” equity round that is not addressed.

    Your commentary is excellent for both the entrepreneur and investor as they move from the term sheet to the legal documents stage of a Series AA angel investment. I’ve written a simpler, introductory piece on the term sheet here: http://www.sachinagarwal.com/2008/08/an-analysis-of.html

  • http://www.startupcompanylawyer.com Yokum

    @Sachin,

    1. Generally speaking, I think that a company is better of with convertible debt rather than an equity round, because the valuation in the equity round is likely to be very low. Even a significant conversion discount is likely better than a low valuation in the equity round.

    1A. I think that legal fees for convertible debt will still be less than an equity round using these stripped down documents. An equity round still has more variables and will require stockholder approval and a secretary of state filing of the COI.

    2. In my experience, most early stage pre-VC financed companies do not get a 409A valuation. Whether the seed round is equity or debt wouldn’t necessarily materially change the risk analysis on whether or not to get a 409A valuation.

  • http://www.newscred.com Shafqat

    Hi there – I was looking at the Series AA Term Sheet and it seems catered towards a single investor model (i.e. Y-Combinator). Most angel rounds would have a syndicate (even if its a few friends and family). Could you just rinse and repeat with this one or is it important to have details of the syndicate and total amounts of the round in each term sheet for each investor? Thanks much!

  • http://www.startupcompanylawyer.com Yokum

    @Shafqat – The term sheet already shows (or will show once blanks are filled in) the aggregate amount to be raised in the round. As a practical matter, the company is typically providing this kind of term sheet as a “straw man” to potential investors as a solicitation, rather than vice versa in a typical financing with institutional venture capitalists. Thus, unless the identity/investment amounts of lead investors is already confirmed and is important, the term sheet will be silent on the identity of the investors.

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