Biggest legal mistakes in your startup, with Hutchison’s Justyn Kasierski

Today we have something a little different for you.  Justyn Kasierski, partner at Hutchison PLLC, shares some of the biggest legal mistakes that we see startups making – and what you can do to prevent them from happening to you.

GIVEAWAY: A few episodes back, Robbie Hardy shared the unbelievable story about how she used a magic 8-ball to help her decide whether or not to sell her company. All signs pointed to yes for her, and she had a successful exit. Well, we all have major decisions to make every day, so Hutchison thought it would be fun to give away one magic 8-ball each month in a drawing. And to enter the drawing, all you need to do is write a review on Apple Podcasts or wherever you listen – and let us know by sending an email to podcast@hutchlaw.com.

Transcript

Trevor Schmidt: Hey everyone, I wanted to hop on real quick to tell you about a special giveaway that Hutchison PLLC is putting on for listeners of this podcast. A few episodes back, Robbie Hardy shared the unbelievable story about how she used a magic 8-ball to help her decide whether or not to sell her company. All signs pointed to yes for her, and she had a successful exit. Well, we all have major decisions to make every day, so Hutchison thought it would be fun to give away one magic 8-ball each month in a drawing. And to enter the drawing, all you need to do is write a review on Apple Podcasts or wherever you listen – and let us know by sending an email to podcast@hutchlaw.com

Trevor Schmidt:Hello, and welcome to the Founder Shares Podcast. We’re so happy that you’ve chosen to spend some time with us. I’m your host, Trevor Schmidt. I’m an attorney at Hutchison law firm in Raleigh, North Carolina. We work with founders and entrepreneurs as they fight, grind, stress and push to bring their visions to reality. We are inspired by their incredible stories of success, failure, reworking and trying again.

Today we have something a little different for you.  My guest is Justyn Kasierski, one of my partners here at Hutchison PLLC.  Justyn is one of our corporate attorneys providing startups with guidance on a wide range of issues from formations, to financings, to exits. Justyn is going to share some of the biggest legal mistakes that we see startups making – and what you can do to prevent them from happening to you.  

For Justyn, he graduated from Duke Law and started his career in the Boston area, where he had a choice between a traditional buttoned down law firm and the one Silicon Valley based law firm in the Boston area.

Justyn Kasierski:And of course at the time, coming out of law school and being younger, it was also an opportunity from a cultural perspective to have a choice between firms where, you know, Friday business casual men take off the tie versus a Silicon Valley law firm where the uniform, if you will, was jeans and a t-shirt, maybe a polo shirt. There was a sandbox in the office, a foosball table, those types of cool amenities, which are all very pertinent to the practice of law.

Trevor Schmidt:Needless to say, the draw of the Silicon Valley crowd pulled him in, and he developed relationships with startups and a deep understanding of what startups need.  When family connections brought him back to Raleigh in 2004, he found Hutchison which was – and still is – also focused on the startup community.

Justyn Kasierski:I’m entering on my 17th year here, which is kind of crazy to think about, , and really enjoyed working here with the partners and with our clients, as you said, I’m sort of on the corporate and transactional side of the house, which means for our operating companies, working with them from startup, through getting going, and usually some initial funding. Getting some revenue and then we’d be more rounds of funding, all the things that kind of go along with growing a company at that point. And then for the ones that are fortunate enough to do so, working with them on their exit transactions on the other side.

Trevor Schmidt: If you’re trying to explain to an extended family member, like at a family reunion, what you do for a living, you know, what’s what’s your answer to that one? Cause I find that there’s some varying understanding of what we do.

Justyn Kasierski: Varying is, is a kind way of putting it. Yeah, usually it’s in response to a question, at least in my family reunion about, you know, can you help me with this parking ticket or something like that?  It’s like, hey, actually, one of the nice things about what I do, what we do, is I don’t see the inside of a courtroom.

I don’t do that stuff, right. It’s so I generally describe what we work on as transactional work for sort of tech entrepreneurs, right. We’re helping the sort of next generation of tech entrepreneurs and we’re helping them at all stages. And I think that’s one of the other things that sometimes, family members and friends don’t really appreciate, you know, they think you only work with startups.

Well, yeah, at some point they’re startups, but actually we have a whole bunch of clients that were startups and are now very big companies, and that’s exciting as well. But what I try to focus on is that tech aspect, because you’re right, there’s a lot of different types of entrepreneurs out there, but if you’re a restaurant entrepreneur, I’m not the attorney and we’re probably not the firm for you. Like good luck with that. That’s really hard, but it’s not really what  we do.

Trevor Schmidt: Yeah. Oh, I mean, it’s an interesting point because I think there is, , a good focus on the types of clients that we work with. And there’s a lot of different ways that we can help them out. And, you know, and I think. One of the things we say kind of on the Founder Shares Podcast is we talk about how at Hutchison we help entrepreneurs, startup operate, get funded and exit, and, it covers the whole life cycle of many of these companies. But, you know, I have to imagine that kind of in your career and kind of what I’ve seen as well, that you start to see some pretty common errors, a big mistakes that people make at each different stage of the company.

And so part of what I want to talk about today is just at each of those stages, what should people be looking out for? What are these big mistakes that they can avoid  before they form, at formation, when they’re raising friends and family rounds, those types of things. So, , yeah, that’s kind of how I want to talk about it today is, is this let’s start with pre- formation.

Okay. So I like to think of this as you know, the dorm room late at night or back of the cocktail napkin, we’ve got an idea. What kind of mistakes are you seeing companies make it this, this early stage?

Justyn Kasierski: One is, is it ventricle, you know, are you looking to do something that a VC would be interested in funding? Is it a big idea with a big market opportunity? You know, do you have at least initially the talent to do it? Do you have some sort of beat on the solution and what the value proposition is? Because again, like, there are a lot of really great ideas out there, but not all of them are ventureable, you know, not all of them are the type of thing that is going to get a VC to go to her partners and say, listen, we can make half a billion dollars off of this if we invest in it. So have you spent the time to figure that part out?

You know, I always get nervous when folks come in and they may have just met in the last few weeks and they’re coming in as the founder team.  It’s like, okay, not that that’s a problem, but. This is going to be difficult.  how much cohesion is there among the team. And then related to that, you know, have they had discussions about allocations of responsibility and, allocations of even founder ownership and things like that. Where are they on that? And if they haven’t had those discussions, again this isn’t fatal, but they need to make sure that they do have them. And of course, that’s one of the things we can help them with , if they haven’t.

Trevor Schmidt: You were talking about kind of venture, something that’s capable of being funded by a VC. What’s that benchmark for you? I mean, what do people need to be thinking about? I mean, how much money or are you talking about when you’re talking about VC investments versus, you know, doing something on your own?

Justyn Kasierski: Yeah, so, you know, you and I like to work with generally the same type of company, right? And so this might be a little bit different for a life science company or medical device company, something like that. But for our typical type of software startup company, you’re looking at a company that maybe raise a series A round in the 2 to 5 million dollar range, and then go on and raise subsequent rounds of financing, maybe a series B and a series C and then generate for those investors, you know, ideally a 10X return, or if you’re doing it on a time-based kind of calculation, an IRR, and internal rate of return, of somewhere between 35 and 45% on their money.

And that’s in line with the venture capital model, right? So a venture capital fund, the ten-year fund, where they’re going to take commitments from limited partners and put it to work. And within the course of that 10 years, they want to invest during the first part of the fund and then manage and help grow during the middle part and then reap during the last part. But all of that, ideally within a 10 year period.

And so from your perspective, as the entrepreneur, you need to be thinking about those timelines in addition to the amount of money. And that’s the intersection there, right, is the money is fuel in the tank that makes you go faster, right. You know, so if, you know, you need to raise. I don’t know, $10 million, you know, how you raise it and how fast it helps you to grow as a really important part of the analysis.

Trevor Schmidt: Yeah. And it sounded like you hit on a few of the points that VCs might look at too, is kind of what is the market for this product? You know, what is the idea? You know, from my side of the shop, when we talk about IP protection, you know, is this an idea that is even available to get some sort of exclusive protections around that we can keep other people out of the marketplace and have some advantage, at least for a period of time to really demonstrate our value.

Justyn Kasierski: Yeah, we talk to entrepreneurs about trying to de-risk three things, right? You’re trying to, de-risk the team, the technology, and the market. And you’re not going to perfectly de-risk any of them, but for an investor looking at this, like, I would hope you could at least show them you’ve de-risked the team from a founding standpoint.

And, you know, maybe you’ve de-risked the technology. If this is a university technology or something, speaking, spinning out of a bigger company, maybe the technology is more fully developed. alternatively it could be slideware and it’s, you know, all stuff you’re promising you’re going to build, but that’s a very simplistic way of how I look at it in terms of yeah. How to de-risk these things for, for venture.

Trevor Schmidt: Well, and the team ideas is a good one as well. Cause you raised some great points about who am I working with? How well are we going to work together? But also to that question of just because I’ve had this idea, do I have the skill sets I need to build a company around it.

And if I don’t, that’s not necessarily a death knell for the company. That just means you need to surround yourself with people who can help.

Justyn Kasierski: Yeah. Listen, the entrepreneurs that we work with, right? Hardworking, wicked smart, like, you know, there’s just some common, hard- skill attributes.

What can separate a little bit, and I think what you, and I would say are the, also sometimes the ones that are a little more fun to work with on the soft- skill side, you know, folks that are confident, but not like, not arrogant, right. Folks that, they know what they know. Like, Hey, I’m an awesome engineer, but that doesn’t mean I’m an accountant, you know, I’m going to go.

Yeah. I just mean, I’m a lawyer, I’m going to go and talk to Trevor and figure out what the heck to do about this patent or this license or something.  So folks that are kind of in their lane, if you will, and then the other one, and this one’s always kind of interesting too, but I don’t mind doing it early on with clients. Right. Folks that don’t mind being told that their baby is ugly. Right. And, you know, like, because sometimes, and look, there’s this concept of founder-itis, and it can mean a whole bunch of different things, but you know, one aspect of  founder-itis is like, no, this is it, right.

You can’t see this, it’s so obvious how awesome this is. And it very well may be awesome. Yeah, look, I’m an English and political science double major. Like I’m not going to be in position to get on you about your tech, but you’ve gotta be able to kind of present and take feedback from folks and you have to be willing to kind of go out there and show people kind of what you’ve got in the pram and have them look at it and say, that’s an ugly baby, but here’s some things you could do to make it pretty.

Trevor Schmidt: Yeah. I mean, it’s a fine balance, I think, cause it seems like the most successful entrepreneurs that we’ve worked with have a balance of confidence in themselves, confidence in their idea of confidence in their team to pull it off, but also a willingness to take that feedback. And at least assess it. You know, they may not have to take everybody’s feedback and internalize it completely, but you have to at least entertain the possibility that you might be wrong.

Justyn Kasierski: I couldn’t agree more and I’ll tell you, and I think you probably feel the same way. Nothing makes you feel better as an advisor, at least when they’ve given me the impression that they hear you and they’re taking it under, they may go and do something completely different with, fine their call, you know, it’s their thing.

I think that’s an important, I know you’ve been fortunate. You’ve got some great folks on the podcast here already. And a couple of them I work with and, you know, like Gail Peace from Ludi, Gail’s the first one of the first ones to call and say, I have no idea. Tell me like this isn’t what I do, right.

This is what you do. You tell me what, what goes on here. So, you know, and if you surround yourself with good people, like to me, that’s, that’s not a sort of non-obvious way to be successful.

Trevor Schmidt: And I think that’s important part because whether it’s at the pre formation stage or as you get into the formation stage of the company, right. You really do need to surround yourself with that key team.  And whether that’s, you know, your, your attorneys, whether it’s your, your CPA, whether that’s,  technical advisors, whatever it is, you’ve got to have that team surround you to realize you don’t have to be able to do everything yourself.

Justyn Kasierski:  Part of this is if you haven’t raised money before, in the marketplace, you’re kind of trying to create proxies for credibility. No one knows who you are. You know, you haven’t already returned 10X on your prior to ventures and things like that.

So, you know, one of the easy ways to kind of show people that you know what’s up is to affiliate yourself with a firm that does this, right. And again, with all due respect to all the great lawyers that do a whole bunch of other stuff, I don’t think it plays well with a VC when they ask who your counsel is.

And it’s like, Oh, you know, so my sister-in-law’s cousin who also does family law on the side, probably an awesome family law attorney, but like, do they really understand what it means to be a venture back company? And are they giving you the right guidance.

Trevor Schmidt:  Yup. That’s a great point. So let’s move down a little bit to the kind of the next stage of the company, when they’ve actually decided you got your team, you’ve got your idea, we’re ready to form some sort of a business entity and really get operating. So what do you see here? What are some of the biggest mistakes that people make?

Justyn Kasierski: Yeah, and I, I don’t think that there’s any real magic here in terms of what I’m going to say, right? It’s the choice of entity and then founder matters. You know, those are kind of two key areas you of course want to make sure you’re protecting IP. I know that’s an area of emphasis for you. I don’t mean to deemphasize that, but to me, that seems kind of an obvious thing. But you know, what are you going to be from a corporate standpoint? And also, what are you doing with your allocation of ownership investing on the founders side?

You know, generally speaking, you’re going to choose between being a C Corp or maybe an S Corp or an LLC. And any of those are probably fine, but ultimately you need to be aware that if you’re going to raise venture money, you’re going to need to be a C corporation if you are not already. And so therefore, should you start as a C Corp now? And if you’re not starting as a C Corp, why not?

What are your reasons for choosing something else? We had a deal, we were on the investor side of this one. The investor gets us all, you know, wound up on a term sheet, sending in a proposal. Awesome company, greatest thing since sliced bread. Comes back and says, so, um, turns out they’re an LLC that’s chosen to be treated as an S corporation. It’s like, I don’t even know what the heck that means. I have to ask our tax partner for guidance on what we were dealing with, but you know, those folks early on, I’m not sure what they were thinking, but I don’t think they were thinking they were going to be raising venture money or at least no one told them kind of how this works.

And that actually became kind of a big problem in that deal because of them being an S an LLC taxed as an S Corp. So that’s just a recent example, but to the point about not knowing what you’re getting into and making that decision, some of these bells are harder to un-ring than others. and frankly can be a little more expensive and this can be one of them.

And then on the founder side, you got to allocate your ownership. Who’s going to own how much, you know, who who’s going to control the company or what group of folks are going to control the company. But the other key one, and, you know, folks who are doing any research on this, will see this everywhere.

You have to make sure you’ve got founder vesting in place. Yes, investors are going to want you to have founder vesting, but you really need it vis-a-vis each other. You know, I think the world of you and we’re partners in a law firm, but if we were going to start an entrepreneurial effort together, it would make sense for us to have vesting on each other shares because unexpected shit happens.

And even though we’ve both have the best of intentions going in, one way to think about vesting, as between founders is, it’s a starting point for that hard conversation that you really hope you don’t need to have, but you may need to have, if we were to do it, it would probably be me starting the conversation like, hey Trevor, I know you meant to really be working hard on this, but you know, I know you’ve been busy with the family and your soccer.

And so we need to look at, you know, what it is you’re doing. That’s what vesting provides you, the opportunity to do, as opposed to me giving you a fully vested piece of our project together, and then you just flake out and you’re gone and you own that forever.

Trevor Schmidt: Yeah. So for our listeners who may not know is the vesting is really kind of making your ownership stick with you over a period of time or after a certain things have happened.

Justyn Kasierski: Yeah. You earn it over time, you know, so you get your, you and I do something and we’d probably be more like 70, 30. I don’t know.

Trevor Schmidt: I mean, if I could get 30 in our relationship, that’d be great.

Justyn Kasierski: So well, you know, I would earn my 70 and you would earn your 30 over, you know, four years. And if we left after two years, we would walk away with half of that. And the rest of it would be forfeit.   And again, as you can imagine, right? Yeah. Investors certainly want that. They’re going to be investing you and the team. They don’t want you to flake out right after they write their big check.

But again, even between founders and unfortunately we do see unexpected stuff happen. When I give a presentation along these lines to groups of entrepreneurs, I tell folks it’s never a great day when I pick up the phone and someone says, so I was looking at my founder’s agreement. It’s like, well, ideally, you’re going to sign your founders agreement, file it and never look at it again. But when you’re looking at it, it’s usually something to do with vesting and something’s not going as planned.

Trevor Schmidt: Yeah. That red flag, when a client calls and says, can you send me off my founder’s agreement?  Now I know you tried to sweep it under the rug here, but I do want to put the plug in for IP protection here for some these formation and getting started issues.

Cause you know,  it does seem to me to be a big problem that I’ve seen with some companies not, not getting their IP fully kind of transmitted from different individuals up to the company. And so that can happen in a couple of different ways. You know, one, maybe the founder relationship where you started the company before you really organized and created an entity, and then you maybe invented something or wrote software code before that.

And you’ve got to make sure that that goes from these individuals up to the company. But then even after you’ve gotten past that kind of founder stage, you know, as you’re doing your early development work and hiring contractors, cause you might not have employees at this point in time, or you’ve got a buddy on the side who does some coding work for you, you know, really understanding who owns what’s being developed and making sure all of that gets back to the company and that you have your documents in place.

I can think of at least one scenario where, you know, a company thought they had everything lined up, thought they had everything ready to go and they were getting into a financing situation when out of the blue. You know, a former employee or a former contractor comes back and says, well, actually you don’t own that piece of code.

You just have a license from me for it. But you know, if you, I hear you’ve got some money coming in so if you’d like to own it, we work out a deal here. And that’s not the conversation that you want to be having at that time. So just making sure everything gets transferred into the company. Both so the company can operate, but then also, so you can demonstrate that value to investors down the road.

Justyn Kasierski: No, really good point. And you’re right. Yeah. The founder contribution of IP, but I liked the comment that you made because you’re right. We do bump into this, right. And we bump into it, I mean, sometimes you’re dealing opposite sort of dev shops and sort of third-party contractors.

And you may need to have a bit more arm wrestling than you think over who’s going to own this. And I know you spend some time with some of our clients kind of getting into, well, is this a tool that the dev shop uses or is it not a tool? Is it something unique, you know, sort of preexisting and, and things like that.

So there certainly are complications that can come into play there. I would say from the corporate side, you know, one of the things that we want to make sure of is they at least, and I think this sort of goes over to your side a little bit as well, want to make sure they have good form agreements that they’re using.

So, you know, Hey, if you use this contractor agreement, or if you use this employee IP protection agreement, we know if you stay on these documents, you’re going to be in good shape.  But of course, startups don’t always have the leverage to kind of insist on using their documents.

Trevor Schmidt: Well, I was going to touch on that, cause that seems to be the real challenge at, at this stage of the company that you have the, in some respects, you have an ability to create some very big holes for yourself as a company at this formation and early operation stage.

But you may not have the resources that you need to kind of protect yourself against that.  But, you know, to your point, I think this is critical point where you have to have somebody who can advise you on formation, what the different choices are going to be. And I think it’s just critical to find people you can work with that understands your stage of the company right now, but still can help you get, the advice that you need.

Justyn Kasierski: Yeah. I mean, ultimately they’re going to have to make a call in some cases, right. But at least as you said, if they get guidance from folks like us, they can make an informed decision. Sometimes they’ll forget that we had the conversation. They’ll still come back later and say, how the heck did this happen?

Why did you let me sign this? Well, no, I told you that. Yeah, which is fine, but no seriously though, like that’s, that’s sometimes it was a little frustrating and I know you bumped into it. You mentioned an example, and I know I have some as well is, you know, they come in and they’re, everything’s awesome.

And they’ve got this round of financing going. You haven’t heard from him in a little while. They’d just been kind of banging around out there. Crushing it, I guess. And then you kind of dig up these things. And that’s where it’s just a little bit of sort of ounce of prevention, pound of cure type of situation, because I know, I think we’re going to talk a little bit about what happens in the context of financing, but as you mentioned, not only does the cost go up in terms of negotiating with these third parties when they know there’s money on the table, but now you get the pleasure of doing it with an investor and their lawyer looking over your shoulder, which you know, is it just increases the degree of difficulty. So yeah, try to avoid the unforced errors. There’s going to be enough other hard stuff that happens.

Trevor Schmidt: Yeah. And I guess the only other comment I had on this formation and organizing side is kind of the situations where you have a company that may have started off as one thing, or with one group of founders, and then over time kind of molds and shapes into something that’s completely different and really not readdressing these issues at the point of time where the company has become something completely different.

Cause you know, there’s at least a few scenarios that we’ve worked on where, you know, something started off with an a dorm room, let’s say with nine founders. And it was an idea to be one type of software platform, but then really, you know, people graduate, others move on. And, and the reality is now that the business is operating, you’ve got three folks who were really working on it.

Justyn Kasierski: Yeah, no, I would agree. So yeah, vesting can help with that. But also that’s a, I think one of the things you’re getting out there is this concept of sort of dead equity on your cap table.

People that are holding shares and are no longer actively contributing to the business, you know, even if they did have vesting, but if you have a lot of dead equity on the cap table, particularly early stage, you know, before your first round of institutional funding that can become tricky to deal with as you move forward.

Because again, part of what your investors are going to be looking at is, you know, does Trevor have enough interest in this business going forward to make this worthwhile? Because I know how hard this is going to be. And if Trevor was one of nine founders and is one of only two or three left, you know, he may not have as much as he may need. And there’s things you can do to fix that and address it. But they’re a little tricky.

Trevor Schmidt:  So I guess bottom line, you know, get these things done up front and it’s going to save you a lot of heartache in the long run.

So the next question is you can kind of, you’ve been rolling along for a while and you realize you do need some cash infusion. And so I’m thinking about this as, as probably something before VC or institutional money. So something like some early money, what’s some big mistakes that you see people make at this point.

Justyn Kasierski: Yeah. So if it’s sort of pre institutional money, you know, it may be what you think about as friends and family round, potentially angel investors. And there’s even an important distinction there. And again, part of this, in my opinion, falls under the broader category of sort of knowing your audience and who it is that you’re speaking with and what are they looking for?

When it comes to raising friends and family rounds of financing, they’re easier in some sense, or they could be easier in terms of these are people that love you and care about you and may not be putting you through sort of a strict analysis of your business plan and whether they can make 10X, or they probably believe they can because they love you, but they don’t know for sure.

And they tend to be a little bit less sophisticated on this. So maybe you’ve got an advantage in terms of being able to extract really great terms for you in the company, but. You know, there’s some downsides to that. You know, one of them is from a business perspective, extracting great terms from your wealthy aunt now could come back to bite you and unfortunately your aunt in the butt going forward when things kind of get normalized, when real investors show up and kind of put real valuations in terms down. And then the other one, which unfortunately we bumped into and can be a difficult conversation with clients is you’re still selling equity in a sketchy startup company.

And you need to comply with securities laws and you know, I’m sorry, but you know, I tell folks, my degenerate brother is not going to be investing in startup companies. He should not be investing, you know, my wealthy brother, fine, you know, that he can afford the risk, but the one that isn’t able to afford the risk, we shouldn’t be selling him that, you know, and folks sometimes want to do that out of the goodness of their heart.

Well,  he’s had down on his luck. He’s having a rough time, but if I put a little bit of his money into this and when I hit, cause I know I will, he’s going to be a millionaire. I understand you still have restrictions on selling him equity in your sketchy startup. I’m sorry. So that’s the legal side.

Trevor Schmidt: Yeah. Can you talk a little bit about that first point where you talked about having good terms with your aunt could occur to you down the road? How does that look?

Justyn Kasierski: So, you know, you’re wealthy aunt maybe is let’s assume she’s wealthy. Not because she has a track record of success, of successfully investing in tech startups. Right? Let’s assume it’s something else yeah, she’s, she’s a little bit out of her depth with this and you go to her and you show her, you know, the last five valuations of the hottest startups on Sandhill road, and you say, so this is what my startup’s worth.

Right? And then she agrees to invest in your startup at a, you know, $10 million pre money valuation. And then you’re going along and you go back out to the market to raise more money and a “real VC” shows up and the real VC, she tells you that two years after your aunt’s investment, your company is now worth $5 million from a pre money valuation standpoint.

Well, that’s not great from a dilution standpoint, it’s not great for Thanksgiving dinner with your aunt, you know, and, and you need to kind of find a way to make that work. You know, frankly, it also betrays a little bit of naivete. On your part as the entrepreneur as well. If you’ve got two parties who are relatively unsophisticated on valuation, maybe you shouldn’t be having a valuation discussion there’s mechanisms out there like safes, a simple agreement for future equity, or convertible notes.

These are things that allow folks to make a quasi equity investment into your company without having to pin down a valuation right now. They can tie the valuation to what a more experienced professional investor will pay in the future. So, you know, those types of conversations are ones that we’re happy to have with clients. And generally speaking, clients are happy to do it. And the wealthy relatives are, are pleased with that too.

Trevor Schmidt: Yeah, is there anything at this stage that, I mean, you touched on it some here where it’s a financial impact for you and for the potential investors, but is there anything here that is really going to threaten the long-term longevity of the company?

Justyn Kasierski: Okay. Well, so there’s, a couple of things that you, you want to be aware of here. And I don’t know if this one is a threat to long-term, right. But if you are selling securities to non-accredited investors, folks that don’t meet this sort of bright line tests that the sec gives us, generally speaking, you know, million dollars of personal net worth exclusive of your primary residence, or you’re making $200,000 a year or $300,000 with your spouse.

If you’re not selling to someone who meets that test then, you know, you can do a lot of stuff to still try to squeeze them in and comply with securities laws, but because you’re not following a bright line test. You’re at some risk of giving those investors a right of rescission, which means they can come to you in the future and say, this isn’t working out. I want my money back. Okay, I don’t think you’ve complied with the securities laws when you sold me the shares. Yeah, having a bunch of folks with a right of, a theoretical, I don’t see this happen in practice, but if theoretical right of rescission on the cap table could be a problem for future investors. So again, this is why we tell folks as a general rule, you’re only selling your securities to accredited investors who by the SECs definition can afford the risk.

You know, the other thing would be the terms of the investment, because one of the things you’re trying to do as the company with an early round of financing, whether it’s friends or family or institutional is you’re trying to get terms that you know can be sort of repeatable in subsequent rounds of financing. Understanding as the company that as you move down the alphabet of venture funding from series A to B to C, the terms don’t generally move in your favor, right, they move in the company’s favor. And so you’re trying to start with as company favorable terms, as you can, knowing that you may have to seed more ground in the terms as you raise more money.

Seeding a lot of ground in the early round could be really, really hard for the, you know, giving up control of the board of directors in a friends and family round. You know, you’re never getting that control back as the founder group. You may need to do it, you know, that may be the cost of this capital and it’s the only capital you can find, but ideally, for example, you’d prefer to not do that.

Trevor Schmidt: So for this early money, is there’s anything beyond capital that an entrepreneur should be looking to get? I mean, is this an opportunity to get additional advisors or some good access to a network, or is that something you’d look for more than an institutional round?

Justyn Kasierski: Well, you know, so I mentioned these friends and family rounds might also be angel rounds. And at one of that’s one of the important distinctions. And again, assuming that your friends and family don’t necessarily come with a lot of industry expertise and what it is you’re working on, angel groups and angel networks do provide an opportunity for some of that.

Now angel groups and angel networks can also provide kind of their own version of a pain in the butt for you as an entrepreneur, you know, relatively smaller checks, but sometimes the same amount of overhead and hassle as you may get dealing with an institutional VC, which is fine, but you know, these are generally speaking. Well off successful folks who have made a career,  and sometimes a legacy doing something really, really well. And there may be one or more folks in that angel group who are from the industry that you’re hoping to get into. And when you go and present, you know, they may raise their hand in or come up and talk to you afterwards and say, I’d love to help you with this.

I’ve got a Rolodex or I’ve worked on stuff like this. I understand the tech. So yeah, I don’t typically expect as much of that from the friends and family round, if you get it, great. I think it’s reasonable for an entrepreneur to at least be asking about it as part of an angel round, if they’re raising angel money. And of course, when you get to institutional funding from venture funds, you should really only be talking to VCs that can help you in your industry.

Trevor Schmidt: Well, I mean, that provides a good segue. So, I mean, I think now we’re to the point for the company where you’ve demonstrated, you’ve got some legs for the company. You’ve either got some initial revenue or you you’ve shown, you can at least attract clients or customers to whatever your business is building. So talk a little bit about some of these mistakes that a startup might make here at this point where you’re raising a series A or you’re looking for your first VC fund.

Justyn Kasierski: One of the things that we talk about and it, I guess, part of it Trevor, because it’s, it can be an accumulation of things. Maybe started back at the choice of entity or the founder stage and maybe after they, so if you take all the little things that we’ve spoken about, if you haven’t raised money, you haven’t gone.

Or even if you’ve raised a friends and family around that, and they didn’t do legal diligence, all of these things could be percolating in the background.  And sort of just waiting for legal diligence, right? If you sort of waiting for me to show up and our team, because as I mentioned, we do this on the company side, but we also do this on the investor side.

And when we do this on the investor side, we’re coming in on behalf of our VC client. And one of the things we’re doing from legal diligence is we’re looking for all of the F ups, right? We’re turning over every stone. We’re looking at every contractual provision and we’re going back to our client. We’re telling them all this stuff that’s wrong.

I think an important part of this for entrepreneurs is, if you have a misclassification issue, for example, of a contractor versus an employee, or you’ve made a decision on selling shares to non-accredited investors versus accredited investors, like yes, technically the SEC or your state regulator could show up there.

Probably not. The department of labor could show up, like, you know, those could be technical violations of law, but really where this is all going to end up coming out is going to be in your venture round. Like, that’s the audience. Yes, you should do it because it’s the proper thing to do legally, but you should also do it because it’s going to come out in legal diligence as part of your financing round.

And you’re going to need to explain, you know, why you didn’t do it the right way. And it’s kind of difficult, right? From a venture perspective  when you have an entrepreneur who seems to be a little bit loosey goosey, with legal matters. I think VCs kind of consider that to be the brushing and flossing of, you know, venture backs.

Like you should just be doing that stuff that, you know, you shouldn’t be rounding corners too much. That being said, and you alluded to this earlier. There just may be some situations where there are contractual terms that suck, but you have to live with them because you don’t have leverage that’s one thing.

But you know, it’s like sort of flat out misclassifications of folks as contractors, even though they’re clearly employees. You made that decision as the entrepreneur, even if you did it on willingly, you, you made a decision.

Trevor Schmidt: It’s part of the way I think of that too, is you talk about not having good contract terms. That may not be something you can do, but not having a fully executed document that you can put your hand on when you have to produce your documents to an investor who’s trying to do diligence. Not being able to show that you’ve got, you know, all of your employees signed up to your form employment agreements, not, you know, not having that organization kind of at the background.

I think again is a signal as much as anything else is, is can we trust this company? Can we invest our money in this company? Are they going to be able to take care of our money me better than they took care of their contracts?

Justyn Kasierski: You’re right. I think contract management is one of those, like, you know, are you organized, are you on top of this? Have they spent time with you and your team talking about terms and renewal and management and tracking and you know, how are they doing all of that?  Another example. Yes, I understand. You’re an entrepreneur.

There’s a reasonable point to which just kind of DIY on finance and maybe even on HR, but back to sort of staying in your lane. Are you bringing in outside help, fractional CFO help, fractional HR help? Because you know that you’re a little in above your head on this stuff. Now, you know, you’ve got real, you’ve got employees, you need payroll, you’ve got to do financial reporting, you’re about to go raise money, you know, are your financials accurate, or are you doing your best at it and you think they’re accurate. And so yeah, those kinds of things, when you come up to actually doing a financing and starting to meet with investors and they start to do their business diligence, which will precede the legal diligence, you wanna, you wanna put on a sort of a good show. Handle all the stuff you can handle by appearing organized and putting your best foot forward.

Trevor Schmidt: So talk a little bit about kind of this process of going out to find VCs. Is there other ways that I guess a company can put their best foot forward as they’re trying to get in the door or kind of demonstrate their value to a VC kind of even before getting into that diligence stage?

Justyn Kasierski:  You need to start networking with VCs really early and ideally before you’re raising money, you know, give them a chance to meet you, get to know you a little bit. And give yourself a chance back to those sort of a proxy for credibility, give yourself a chance to tell them what you’re going to do, and then go do it and report back and then tell them what you’re going to do next. you know, this very high say-do ratio I think is really important.  Entrepreneurs who have success in fundraising may not believe this, but like VCs meet with a lot of folks that just sketch out and they never hear from them again.

Right, so you can really separate yourself by, Hey, it’s really nice to meet you.   Not raising money, just getting going on this. I understand that your fund may be interested eventually in learning about companies like mine, tell you what we’re working on. You know, do you mind if I follow up with you? And then you just put them on this BCC list that you keep, that you send out not every week, maybe not even a month, but you know, every quarter just telling folks what it is that you’re doing and then keeping tabs. And then that puts you, it doesn’t guarantee you that anyone’s going to write a check, but it definitely puts you in a better position when it comes time for you to go look for the check.

Trevor Schmidt: Yeah, I think that’s a great point. Cause it’s, this idea that if I need this check now, if my runway is running out and I’m a couple months away from needing a serious cash infusion, that’s not the time that you want to be. All right. Open up the Rolodex to see who, who might have some money for me. You need to have those conversations over a period of many, many months, if not years, to kind of before that point.

Justyn Kasierski:  I think doing that, and of course, you know, you have to balance your time yet, go continue to build a company and do all of those things. You can’t be constantly fundraising, but part of it is, and you alluded to this, right. You should also be maybe getting some value, as opposed to just telling the VCs about what you’re up to.

You may have an ask. You know, Hey, look, I’m really looking to meet someone at Microsoft or Google or Amazon, you know, do you know anyone, can you help me make a connection? you may even get something out of it besides just kind of pushing the fundraising conversation along.

Trevor Schmidt: Yeah. So I think that kind of raises a question. So once you’ve kind of done your diligence in the end, you’ve had these conversations with VCs, what are some big mistakes that you make actually, in taking in the funds? I mean, aside from, you know, just taking a check with somebody who can’t help you otherwise grow the business, what are some things, mistakes that people make there?

Justyn Kasierski:  Obviously when you’re raising money from institutions, you’re talking about a defined set of transaction terms, generally speaking in the industry. And so there’s the headline terms of valuation and amount invested, which roughly calculates to how much dilution you and the rest of the team is going to take in order to bring this money in.

And then there’s terms that are below the headline, if you will, that can also affect the economics. And so two important things to keep in mind when doing the deal from the entrepreneur side is to understand the economic impact of the non headline terms, not only in terms of dilution, but also what happens in an exit transaction.

And then secondly, what about control? You know? Yeah. And it’s reasonable that anyone writing a large check into your sketchy startup company is going to want to have some level of protection, but there should be a healthy discussion, in particularly an understanding for the entrepreneur of what type of controls the investors are going to have over the business going forward. I think failure to understand that can be a real problem.  You get to your first board meeting or you get to your first board vote and you didn’t understand that the VC may have some special rights in board meetings and special rights to approve things.

Or you get to your next round of financing and you understand that your VC has rights in that financing, including the right to stop you from raising more money. Not that they would stop you, but the right to veto it if they don’t like the terms, right. You really need to make sure, and generally speaking, yes, as your counsel, we’d advise you to read all 200 and something pages of the financing documents, but you should certainly read the seven to eight page term sheet, which precedes that and make sure you understand it and ask questions.

I like it when entrepreneurs try to get savvy on, sort of venture financing vocabulary, when they’re getting close to maybe getting a term sheet in. Okay. Yes. I understand valuation and I understand amount raised. What’s the other vocabulary I need to know now? What’s a liquidation preference?

What’s anti dilution protection? It’s worth spending a session with your counsel to get a little smart. You don’t need to know it all the way that we know it, that’s part of what you count on us to do, but you should know some of the bigger ones.

Trevor Schmidt: Is there a resource that you can think of that would be a good place where people start?

Justyn Kasierski: You could speak with us, we have materials that we can provide on this, where we kind of do an announce. We we’ve done presentations on term sheets, right? Sort of tier one terms, tier two terms, things like that. That would be an easy PowerPoint to flip through. You know, you can also look at the NVCA form term sheet.

If you want to actually look at what the financing documents are most likely going to end up looking like, you know, go to the NVCA, the national venture capital association website, and they show you what documents VCs use. And these are their negotiated documents, you know, but they’re mostly documents that are put together by lawyers like us who represent venture funds as well as companies. But they’re more on the VC side, but this, this, these are what the documents are going to look like.

Trevor Schmidt: All right. So now we get to the last stage we’ve raised our money. Everything’s going great. We’re ready for kind of the heyday of being an entrepreneur. We’ve got this exit coming up. So what’s, what’s the big mistakes here.

Justyn Kasierski: I found that the adage of the best companies are bought not sold, tends to hold true.

Trevor Schmidt: What does that mean?

Justyn Kasierski: That means that,  folks that are out there and are networking in their market with players, that may be aquisitive, but not actually out there sort of selling themselves. They’re not, you know, they haven’t put a book together.

They’re on the street, they’re running a process to sell the business. That definitely can work. But at least, yeah, my experience, it’s the folks that take the initial inbound inquiry sort of unsolicited. Hey, we’ve been tracking this company for a while, we think we want to take them off the market before someone else does, and we’re willing to pay a premium to do that.

Like that’s the best companies are bought and not sold. And then being ready for that, right. So I’ve got a couple of examples of this recently that I’m thinking of, but one of them is a company in the enterprise software space and they engage with an investment banker relatively early. They didn’t engage with an investment banker to run a process by any means. They just wanted to have an investment banker who was really reputable and well-known in their space who was out there when that banker was talking to the bigger players, saying how awesome this company was. And just using it as an opportunity to tell you a little bit more about this company, that you should be keeping an eye on.

And they did that and they did it for a few years. And then one day they got an offer from a big company, sort of unsolicited. They knew it was coming, but it showed up and the investment banker helped them immediately turn that one unsolicited offer into a total of three offers and then ran an auction and ended up getting the ultimate exit valuation to be nearly 2X what the initial offer was. You know, and so that’s a company and to be fair, that was a team of serial entrepreneurs who had had some previous experience. So they knew a little bit more, you know, probably smarter than your average bear on thinking ahead to the exit and how to lay the groundwork for that.

But I’m always impressed when that kind of magic can happen for a company in an exit scenario. And it doesn’t happen all the time. Matter of fact, it doesn’t happen very often. Sometimes you’re single threaded around one offer to buy your company and you and your board need to figure out is this the best price or not?

You know, are we selling or are we not selling? In terms of the legal side of things and being ready for that. M&A diligence is like financing diligence on steroids.  Obviously bigger price tag, bigger risk for the acquirer. And they’re going to, again, turn over every stone and do all of that.

So you need to be ready. And if you’ve been through rounds of financing, you’re probably more prepared for M&A legal diligence, but even companies that have been through financing rounds can have their hair blown back by the extent of M&A legal diligence. and then the other thing that I would say as part of being ready for it, which ties into diligence, right?

When we talk to companies about, letters of intent for an M&A transaction where you may be acquired, there’s a lot to go that goes into those, but at a high level, we tell them that we’re looking for two things that are really important. We’re looking for certainty of price and certainty of transaction.

And you could do a whole different podcast or presentation on this stuff. But under that certainty of transaction, one of the things that we want to know is what needs to happen in order to close this deal. And of course we want to know is does the acquire have the money to do this? Do they need to go raise money?

Do they need to get a stockholder vote to approve it? Do they need to register shares on NASDAQ? What needs to happen from the acquirer standpoint, but for you as the company, what third parties have the ability to stand in the way of you closing the deal?

Does your lease contain a provision that says you won’t sell the company without the landlord’s provision? I’m sure you deal with this in contracts all the time. You know, do key customers and vendors have a blocking right on a sale. A blocking right, but you know what I mean, a provision that says you can’t have a change of control without our permission.

Do you have founders, former founders kind of floating around in the ether with a whole bunch of shares, and you need to go chase them and get them to vote for the deal or agree to sell their shares? So there there’s some things regarding controlling the process of selling your company, that you should be keeping an eye on. Well, before you’re thinking about the company, but with an eye on that ultimate exit transaction.

Trevor Schmidt: Yeah, I think that’s a good point. And it just seems to summarize kind of a lot of what we’ve talked about today is that as hard as it is to do from the very beginning, it sounds like as a founder, as an entrepreneur, you need to have your eyes on, on where you’re going.

So as you’re forming your entity or picking your entity, you understand that it’s going to have an impact on your first round of financing. It’s going to have an impact on the money you take it in how you do it. That’s going to have an impact on how that exit looks or who might have the ability to step into it.

So as hard as it is to both build a ship while you’re sailing, you also need to know where you’re going, and have that in your mind and as part of that focus throughout the whole process.

Justyn Kasierski: You want to have a good Sherpa, right? And we can be your Sherpa. Good council can help be your Sherpa. We’ve been up this mountain before, we do it all the time. Not all the paths, there’s a lot of ways to get to the top. You know, we’re not saying we know the path, but we also know where you don’t want to go. We know there’s a crevasse over there. You know, we know there is something over there.

There’s a Yeti behind that Hill, you know, just so yeah, to your point, you want to know where you’re going as an entrepreneur, but you should avail yourself of folks that have walked. And counsel, of course, this is why we’re doing this podcast, but there’s mentors, advisors, there’s a lot of folks you can surround yourself with, who will have help for you on that. We’re certainly going to do our best from the legal stance.

Trevor Schmidt: Well, I mean, it’s a great point because you, as a founder may go through this process once, or if you’re, you know, you’re very lucky to go through it multiple times. But having advisors and councils who, by virtue of their job, see hundreds of these types of deals and hundreds of these types of transactions, they have the advantage of seeing things that you’ll never be able to see as running the business kind of over multiple lifetimes.

Justyn Kasierski: Yeah, exactly. And rely on us for that again. And I know you and I work on a lot of the same clients together, and I know we’ve heard this from see CEOs, right. When you’ve seen this before you see this dozens of times a week, what’s with the understanding that yes, we see it dozens of times per week, but it doesn’t mean that there is an answer, right. It just means, you know, we kind of understand what the scattergram looks like. What’s the range of outcomes might be.

Trevor Schmidt:  So anything that we haven’t really touched on, that you see as a big mistake, you know, that doesn’t necessarily fall into one of these buckets, something that trips people up.

Justyn Kasierski:  No, I mean there’s always sort of one-off things that are founder specific company specific, but I think this is we’ve covered on the big things, at least as far as I have in my notes here and what I can think of.

Trevor Schmidt: All right, well, this wouldn’t be an episode of the Founder Shares Podcast. If I don’t ask this question, you’re not a founder, but we still always ask, you know, since this is the Founder Shares Podcast, is there one piece of advice that you would share with entrepreneurs or with somebody who’s thinking about starting a business. Either that you’ve heard, that has been valuable to you. What is it that you’d want to share with people?

Justyn Kasierski:  Yeah, so one of I’m actually going to borrow a quote from Paul Graham, the founder of Y Combinator. And I love this quote, I try to keep this quote in mind for myself, but I think it’s also terrific.

And it goes back to kind of that, mindset of the entrepreneur and how they think about things. I’m not going to get it exactly right. But it was, it’s something along the lines of, you can tell genuinely smart people by their ability to say, I don’t know, I’m not sure, or you may be right.

I, I think that that’s really important, again, you’ve got to have the self confidence of like, I know I’m good. I know I’m a really good venture attorney. That’s cool. But you and I are going to have a conversation about hardcore, like enterprise licensing and things like that.

I don’t know, you may be right. You know, I’m not sure. So I think that that’s the piece of advice that I would give to folks. And again, it, a lot of successful folks that we’ve had the good fortune of working with, I think abide by that.

Trevor Schmidt: Yeah, absolutely. I think it’s great advice and it’s as always just a pleasure to sit down and have a chance to chat with you about these things. And I appreciate the time.

Justyn Kasierski: Alright Trevor, take care.

Trevor Schmidt: Thanks Justyn.

Full Episode Transcript

Hosted by Trevor Schmidt, Founder Shares is brought to you by Hutchison PLLC, and is edited and produced by Earfluence.

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