Should we have a codified legal environment for investing in startup companies?

Because I am stupid and like to work hard while underperforming the S&P 500, I do a bit of angel investing, mostly for MIT spinoff companies. One of my portfolio companies just received seed funding from a partner (Fortune 500 company), which means that the earlier investors are having their debt converted to stock. There are more than 100 pages of documents for me to review and sign and mostly I don’t understand them. I’m wondering if we could boost the U.S. economy a little, and perhaps reverse some of the trend away from startups that Tyler Cowen has identified, if we codified this stuff. The situation with startup companies is nearly always the same. A few insiders want to sell convertible debt to a few outsiders. Then a bigger outsider comes in to buy stock and the early outsiders get converted. The people who put up cash have preferred shares and get paid first when the company invariably fizzles and is sold for less than the total invested. Why not create a way for people to say “I want to skip out on all of the legal fees and use a standard structure”? This would save taxpayers money as well. If things go south and there is litigation, the judge doesn’t need to read 100+ pages of custom contracts to figure out who had which rights and responsibilities.

Readers: What do you think? Would this make sense? Obviously it is already being done to some extent by law firms using templates, but each law firm has a slightly different template!

14 Comments »

  1. Dan Maas

    April 21, 2017 @ 2:05 pm

    1

    Y Combinator is trying to solve this with their public set of standard startup docs: https://www.ycombinator.com/documents/

  2. Tom

    April 21, 2017 @ 2:09 pm

    2

    Y Combinator apparently pushes a bit of standardization in this area. Seems like a good idea to this non-expert.

    http://www.ycombinator.com/documents/

  3. Tom

    April 21, 2017 @ 2:10 pm

    3

    Jinx!

  4. superMike

    April 21, 2017 @ 5:06 pm

    4

    I’ve been thinking about making an app to track shares in small ventures (and very small ventures). Standardized contracts would be great, too.

  5. superMike

    April 21, 2017 @ 5:07 pm

    5

    One problem: how will lawyers justify their fees if the contracts are clear and uniform?

  6. bobbybobbob

    April 21, 2017 @ 8:23 pm

    6

    Wouldn’t it make more sense to cut out the middle-men lawyers and VC funds and incentivize corporations to more seriously invest in R&D? This whole startup scene is mostly a three card monty where risk gets shoved on to ambitious and naive kids and “angels”.

  7. toucan sam

    April 21, 2017 @ 9:25 pm

    7

    I think the reason you have hundreds of pages of incompressible language is because it is designed to screw you out of your money. If it were simple and everyone understood everything you would most likely be able to keep more of your money, which is in nobodies interest except for of course you! It must be so nice to be an angel investor and travel on private aircraft. You have a great life phil!

  8. philg

    April 21, 2017 @ 9:51 pm

    8

    Thanks, Sam, but my happiness level is about the same as when I was as a near-starving graduate student.

    Travel on private aircraft? I remember some long flights in the Diamond Star DA40 where the canopy made it at least 30 degrees F hotter inside than out. Flying in Canada I’d need to wear jeans on the ramp. Once at cruise altitude I would set the autopilot and remove shoes, socks, and blue jeans. Then I would land at an FBO and have to put my clothes back on before getting out. I thought “this is probably not what most people imagine when they hear the words ‘private airplane'”.

  9. Ed M.

    April 22, 2017 @ 11:48 am

    9

    I believe Tyler Cowan has his head really far up his .

    Why would anyone bother starting a startup with the HUGE regulatory burden and regulatory UNCERTAINTY of the Obama admin. Sure he’s gone now, but the last eight years were quite anti-business, unless you made solar panels or electric cars you were the devil. God forbid you didn’t donate cash to the Democrats, you were persecuted, just look into the BS charges brought upn Gibson Guitars…

    –Ed

  10. Neal

    April 22, 2017 @ 9:50 pm

    10

    I’m not sure that government intervention is warranted in this case, but the example does nicely illustrate that as bothersome as laws and regulations can be, sometimes they are more efficient than leaving things to lawyers and courts.

  11. philg

    April 23, 2017 @ 12:37 am

    11

    Neal: I didn’t mean to imply that I wanted “government intervention,” e.g., the government forcing people to create entities using this standard structure. I merely wanted it to be an option, in the same way that creating a Wyoming or Nevada LLC is an option for founders and investors to consider.

    I’m not sure why you would lump “laws and regulations” together into the same bucket. Libertarians, for example, are big supporters of laws and, when things go bad, courts to enforce those laws (so a homeowner could sue a nearby polluter for violating his or her Common law right to clean air and water). People who favor a market economy are not anarchists.

  12. Neal

    April 23, 2017 @ 2:04 am

    12

    @philg: I did understand that you weren’t looking for a mandatory standard, but passing a law, even one creating a voluntary standard, counts as a government “intervention”. The posting posits, correctly I think, that such an intervention could introduce a (small) efficiency for the economy. My point was that laws and regulations (which are also government interventions although not necessarily in the same “bucket” as the one you proposed) can introduce efficiencies in the same way. In some cases we know this from before and after comparisons. A good example is the workers compensation system which may be a mess, but was nonetheless an improvement on the common law based litigation system which preceded it. Litigating compensation for employee injuries was time consuming, expensive and produced very large payments for a few lucky individuals but left most injured workers with no compensation because of the many common law defenses an employer could raise. You propose litigating pollution control, but adjudicating employee injuries is dead simple compared to managing pollution in our complex industrial economy. The U.S. spends billions on environmental compliance (separate from spending on environmental controls), but a system where individuals litigated with polluters would be much more expensive.

    The reasons I say that government intervention may not be warranted in the case described in the original posting is that (as other posters have pointed out), government intervention is not really needed to industry groups to create voluntary standards and the tiny potential benefits probably don’t justify a government effort to kick start the process.

  13. Jim W

    April 23, 2017 @ 6:30 pm

    13

    The “lawyers need to eat too” argument is certainly valid, but the answer may be even simpler than that. Most founders may believe that their idea and wonderful new company is such beautiful precious snowflake that no “standard” agreement could ever work for them. No one disrupts by following the crowd… The kind of irrational ego that drives innovation also has unpleasant consequences.

  14. Brian McDaniel

    April 25, 2017 @ 1:56 am

    14

    This problem is actually already largely solved. The National Venture Capital Association (NVCA) keeps a set of “standard” forms that are very widely used by law firms and startup companies. (The Y Combinator SAFE documents are really looking to solve a different problem.)

    Using the NVCA forms is incredibly cheap, and if the parties agree, can be very fast.

    The problem is that both companies and investors want their own special terms/departures from the NVCA forms (and, to be fair, the NVCA forms aren’t perfect). The NVCA forms can still be useful as a starting point for documents.

    Of course, pace Phil’s original complaint, the fact that the NVCA forms are standard doesn’t necessarily make it easy to understand them. The “100s of pages” are necessary to describe the parties rights and obligations. This would be the same whether the rights and obligations are spelled out in the legal documents or incorporated by reference to some other body of law. (i.e. a checkbox on a Delaware incorporation form for “use standard terms” doesn’t actually help you understand your rights and obligations). Of course, the fact that the NVCA form exist can help your understanding. If both sides agree to use NVCA forms (completely, or with some departures) that can help you understand your deal _if_you_understand_the_NVCA_forms.

    TLDR: A standard solution already exists. However, companies and investors depart from the standards. The fact that a standard solution exists doesn’t solve Phil’s complaint about difficulty of understanding; difficulty of understanding arises because the subject matter itself is complex.

    Yes, IAAL that works in the VC industry. No, this is not legal advice.

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