One of the challenges of seed investments is that the time and expense involved in negotiating and documenting the investment can balloon to the point where the investment doesn’t make economic sense. For example, if the seed investment is for $250,000 but takes large portions of the founders’ time for several months and results in legal and accounting fees of $100,000 or more, the founders probably would have been better off preserving their equity position, focusing on growing their business, and passing on the investment opportunity.
There is a way to prevent these challenges, but first it is important to clarify what is meant by “seed investment.” There is no precise or uniform definition, but a seed investment typically has the following characteristics:
- It is the first investment in the company beyond friends and family investment;
- The company uses the funds for market research, customer identification, early-stage product development, and similar early-stage expenses;
- The amount of the investment ranges from $250,000 to $2,000,000; and
- Investors are typically angel investors rather than venture capital funds, and hence invest their own funds rather than a raised fund of money from other third parties.
The next phase beyond seed investment is typically a Series A investment; i.e., an investment amount ranging from $2,000,000 to $15,000,000 made by a venture capital firm or other professional investors. The typical Series A investment uses the National Venture Capital Association (NVCA) forms, which means that the parties need to negotiate the following documents: 1) term sheet; 2) stock purchase agreement; 3) company disclosure schedules; 4) right of first refusal and co-sale agreement; 5) investor rights agreement; 6) management rights letter; 7) indemnification agreement; 8) amended and restated certificate of incorporation; 9) amended and restated bylaws; and 10) unanimous written consents of the company’s directors and shareholders. Depending on the specifics of the transaction and the industry, other documents will also likely be required.
In many cases, investors use Series A type documents in connection with a seed investment. This is overkill, and in my opinion a key reason that the time and cost of a seed investment can balloon to the point that the overall value of the transaction is questionable. About ten years ago, in order to address this problem, Ted Wang, who at the time was practicing law in Silicon Valley, drafted a set of form documents specifically designed for seed investment, and Marc Andreesen of Andreesen Horowitz publicly promoted these forms.
These forms are not short and simple; the document package for a typical investment using these forms will run to forty pages or more. But the forms consist of a term sheet, stock investment agreement, and an amended and restated certificate of incorporation – that’s it! That is considerably shorter and simpler than the VC set of documents that is often used for seed investments.
One advantage of these Series Seed forms is their relative simplicity compared to NVCA forms. Another advantage is that if the investor and the company agree to rely on the Series Seed documents, the parties will have agreed at the outset on key terms that have the potential to become contentious and time-consuming subjects of negotiation. For example, a potentially contentious issue is agreement on the types of transactions that require investor approval once the investment has been made. Some items are standard, such as the right to approve the issuance of a new series of preferred stock and changing the number of directors. The Series Seed documents include these rights and a limited number of other rights. However, investors in seed rounds often demand a longer and more intrusive list of rights, such as the right to approve hiring, firing, and adjustment of compensation for employees. A front-end agreement to use the Series Seed forms forecloses the need to negotiate on what those approval rights will be.
Another area where using the Series Seed forms simplifies matters is the area of company representations and warranties. All investors will want the company to make written representations as part of the purchase agreement; typical company representations include assurance that the company has full ownership of its intellectual property and is not involved in litigation. The standard Series Seed documents have twelve reps and warranties that total four pages in length. In contract, the NVCA forms for a Series A investment have twenty-nine reps and warranties covering sixteen pages. The advantages of the Series Seed documents are obvious.
Based on the above advantages and other features of the Series Seed forms, a company pursuing seed investment would be wise to insist on the use of Series Seed documents. However, while the Series Seed documents are more straight-forward than Series A documents, there are some areas where the company may want to push for deviation from the Seed forms. Also, in the years since the original Series Seed forms were released, various parties have released alternative versions, so the question will arise, “which version of Series Seed forms should we use?” Stay tuned for my next blog, where I’ll discuss the various versions of these forms and point out some of the downsides of the Series Seed forms.
