Time to Reboot Venture Capital Deal Structures

Edwin Miller of Sullivan and  Worcester recently published an article called Time to Reboot the Basic VC Deal Structure, in which he argues that we should radically change the way VC deals get done.  In his words:

"New York Times columnist Tom Friedman recently suggested that “It’s Time to Reboot America,” meaning that the financial crisis gives us a chance to fundamentally re-examine the way government and the private sector operate. Perhaps it is also time to re-examine the basic venture capital deal structure that has changed little since the 1970s.

A related issue is bloated legal documents. Simple forms that address only realistic scenarios are desirable. Sensible legal documents do not have to paper to death every one-in-a-thousand scenario. Simple, common-sense documents are easier for all parties to understand and be comfortable with, and they are cheaper and quicker to negotiate and sign. This approach may be a competitive advantage, or if broadly accepted, would promote a better outcome for all parties."

He had me at "bloated."  For those readers of my Law Firm 2.0 series, it should not come as a surprise that I think today’s legal documents are indeed, bloated.  Edwin’s thesis that many of the terms included and negotiated in today’s financing documents are unnecessary, irrelevant and / or just plane crazy is both thoughtful and correct. 

If you are interested, you should read the article.  He addresses many of the major deal points found in VC financings.  I agree with most of his assertions, but feel compelled to push back (quickly) on a few of them.

Registrations Rights:  I couldn’t agree more that any time spent negotiating reg rights is wasted time for entrepreneurs and venture capitalists and billable hours for lawyers.  However, I have been in situations that I’ve needed demand rights on a company that blew a filing and was no longer eligible for S-3 registrations.  I’m very far away from being a public company lawyer, so perhaps this doesn’t matter any more, but did then.

Anti-Dilution Rights: I am a VC, so I’m clearly biased, but I wouldn’t agree to the termination of Anti-dilution rights.  I think they are appropriate for two reasons.  One, there are large information asymmetries between a VC and a company and no amount of due diligence will ever put a VC into the same knowledge shoes as an investor.  Second, I’ve seen situations where a new potential VC to the company (who wants to invest in a lower priced round) teams up with management to try to squeeze out an early round VC.  They promise management an option refresh making them whole and the new VC would get an outsized share of the company.  For this reason, I want the protection to protect against such opportunist behavior.

Liquidation Preferences:  Alright Edwin!  I’ll take your new paradigm.  Problem is that I don’t think that I can find high quality entrepreneurs who will agree to this.

Founder Guarantee:  I think that I’d rather keep how we operate now in that there is no guarantee of ownership, as I think that properly incentivizes management.

That being said, I love the concept of dumbing down the NVCA model documents and making things easier.  Ediwn, nice job and keep the ideas coming. 

  • As a practical matter, I'm not sure that eliminating/modifying some of the suggested rights will significantly decrease the length/complexity of the documents that much to make a difference. Perhaps there needs to be some sort of common understanding so that standard term sheet language refers to a commonly understood standard — like "Creative Commons Attribution 3.0" refers to a longer license agreement with a human readable summary.

    Getting rid of some of the registration rights might get rid of a couple of pages. Deleting price-based anti-dilultion might save a couple of pages, but the rest of the structural anti-dilution needs to remain. Getting rid of some reps and warranties would save a few pages — but I don't think that reps are particularly difficult to read, as compared to, say, IRA indemnification provisions. Eliminating the RFR/Co-sale would eliminate an agreement, but most people never have substantive comments on a typical form anyway. Redemption rights aren't in most deals anyway, so I think there really isn't a savings there.

    In any event, making venture financings easier to complete is a worthy goal.

  • Making venture financings easier to complete is a worthy goal. But Jason's post and Yokum's comment indicate that it won't be easy.

    Yokum's suggestion of a commonly understood standard is probably much more realistic. I'd like to suggest taking it in a slightly different direction.

    When I was a leasing lawyer in NY (ummm, 15 years ago), there was a Blumberg standard form for office leases. Perhaps at first it was actually signed as is. In my time, the Blumberg form was used for smaller deals together with a rider developed by each law firm which overrode certain provisions or added to them. While the rider mechanism limited the benefits of the standard form, it certainly cut down on the time necessary for the other side to read and comment on the document.

    The NVCA (or Techstar) documents could be used as an "initial form" right now. Issues of bias or overinclusion would be irrelevant.

  • I'm not sure I would call this "dumbing down" the current NVCA model documents. Instead, I'd call "making them smarter." As every hacker knows, less is usually bettter (as in less, more elegant code is usually better code). Software developers love to eliminate big chunks of code in the quest for making better software; maybe lawyers should take a clue from their clients.

  • I'm not sure I would call this "dumbing down" the current NVCA model documents. Instead, I'd call this "making them smarter." As every hacker knows, less is usually bettter (as in less, more elegant code is usually better code). Software developers love to eliminate big chunks of code in the quest for making better software; maybe lawyers should take a clue from their clients.

  • Dave

    The deal docs could be simplified but early round deal docs between VC's and founders are still pretty simple. More pieces of paper and more words than they should be (and I agree that someone could simplify them), but still pretty simple and the extra words don't really cause much pain. No one ever reads the ROFR/Co-Sale agreement, registration rights agreements are fairly harmless–a lot of words and paper but very little time is ever wasted on them by lawyers who know what they are doing, voting agreements are easy to read. A Series A round with reasonable VC's and experienced lawyers is an easy, cheap proposition.

    Even though there is no real remedy, reps/warranties in purchase agreements are the way investors backstop their diligence and make sure people take the process seriously. Can you imagine VC's trying to tell their LP's they don't get reps/warranties and just invest off a subscription agreement because they decided reps were not necessary?

    Ultimately, I believe the core issue is that the VC's are compelled to get overly creative and complicated among themselves as you move into later rounds. Complex liquidation waterfalls in Series B and later financings–with various combinations of participation rights, participation caps, cumulative dividends, etc.; who gets what price based anti-dilution (particularly in a difficult market where terms like a "full ratchet" make a comeback as no one is certain pricing is correct); drag-along rights issues, as well as control provisions and various types of blocking rights are what make financings hard. It is not the documents, it is the business deal that ends up making financings complicated. The problem is compounded by complex terms often leaving management feeling left out in the cold because they don't put money in so VC's seem to forget about them when putting in many of these terms–and management rarely has its own counsel in a typical later round VC financing.

  • John

    It is probably not a coincidence that the best regarded VC firms I've dealt with used the simplest deal terms and structures. Either they believed an investment was a good one and the real issue was valuation, or they did not and no amount of financial alchemy or complex terms could save it.

  • Law should not be excluded from the design aesthetic: "remove the obvious and add the meaningful."

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