Startups apply for and join accelerators or incubators for a variety of reasons – to get seed money, to learn essentials of growing a young business, to connect with mentors and get strategic advice, to gain a network of other similarly situated companies, to get access to sources of funding and learn how to market the company to potential investors. And, of course, to leave investor demo day with a round of funding secured.
If the program delivers, these can be valuable benefits. But for participating companies, these benefits are bundled with ongoing contractual promises they do not always understand.
Some of the contractual promises either make sense or are designed to correct certain issues accelerators have faced in the past. But they can go too far, addressing an issue in an aggressive way that is out of proportion to the potential problem. Unfortunately, there is a significant imbalance of power between the companies applying to join the program and the accelerator, and often the company has little or no ability to revise the agreements to something more reasonable. Some accelerators have a “take-it-or-leave-it” approach and do not allow companies to modify their forms. Others accept companies with a very short consent period, leaving founders little time to review and negotiate better terms. When founders are concerned about the documents, the only alternative may be to walk away from the program, which is a hard decision to make.
Founders, particularly first-time founders, are often eager to join these programs as they believe the touted benefits are worth giving away a small chunk of equity and future investment rights. Depending on both the company and the accelerator it may be worth it, but founders often sign investor and equity agreements with accelerators without understanding or considering the long-term implications and assuming that their relationship with the accelerator will always be pleasant and reasonable. Before founders join an accelerator, they should carefully review the equity and legal provision and make sure to understand the implications. Here are some of the issues that frequently come up.
Accelerators usually take a certain percentage ownership up front, or the right to receive a certain dollar amount of securities in a future investment round, or both, in exchange for the right to participate in the program and sometimes seed money (which is often used to pay the accelerator for the right to participate in and expenses of the program). This may be a straight issuance of shares based on a percent of the company, or a security or note convertible into shares of the company at the next financing round, often at a discount. Because it is so early, this is probably the most expensive equity a company will issue after giving equity to founders.
Many accelerator equity agreements are designed so that the accelerator will not be diluted until the company enters into its next bona fide equity fundraising round of a certain level. This means that if a company issues any additional equity before that financing round, it must issue additional equity to the accelerator so that it stays at the same percentage ownership, and new issuances will dilute the existing founders only. From the accelerator’s perspective, they do not want to put in money only to have the founders immediately issue themselves a lot more equity, diminishing the accelerator’s stake at no benefit to the company. However, most accelerators address this concern with a broad antidilution provision that protects against all issuances until the next significant financing. This is an overreaching solution to a narrow problem. There are legitimate reasons for a company to issue equity prior to a significant fundraising round, such as bringing on an important hire like a CTO who negotiates a significant equity stake, issuing equity to a service provider in lieu of cash at a time when money is tight, or a convertible security financing (like notes or SAFEs) that brings in investment money prior to a full-blown equity round. A broad antidilution provision will mean that these issuances dilute the founders alone and not the accelerator. A more tailored way to address this concern is to have a narrow provision that protects against any additional equity issued to the founder but is not triggered for other equity issuances. Regardless, antidilution rights should terminate at the company’s next financing round, as a small investment should not entitle any investor to maintain a certain percentage ownership in perpetuity.
Preemptive Rights and Future Equity Investment
Like most investors, accelerators want to be able to invest in future rounds so that they can at least maintain their ownership percentage over time. It is very common to offer investors this preemptive right. More and more, however, accelerators go further and give themselves future investment rights that are disproportionate to their pre-round ownership. Some accelerators want straight percentages, such as the right to purchase up to 20 percent of the next financing round, even if they hold a much smaller pre-round percentage or a convertible security that would convert into a much smaller ownership stake. Others want the right to invest up to a certain dollar amount, sometimes at a discount, which could result in taking a significant chunk of the round. Money is fungible, so why should a founder care if the money is coming from the accelerator as opposed to another outside investor? If the accelerator exercises its investment rights in full, it could mean that an important or strategic investor is pushed out of the round. In the early financing rounds, companies often want to bring on investors with connections in their industry to help them grow in a particular direction or break into a certain market. Having to push out a strategic investor to accommodate an accelerator – even one you have a great relationship with – is not a good outcome. And if the relationship with the accelerator is not good, the company may not want to allow such an outsized ownership stake which could create future investor relations and voting headaches for the company. At a minimum, preemptive rights and future investment rights should terminate at the company’s next financing round. Otherwise they could conflict with the preemptive rights the company grants in the next financing round or require significant revisions to the standard investment documents in order to account for the promises made to an accelerator.
Accelerators often request various other promises, which can terminate on the next equity financing or continue beyond it. These may include the right to know certain financial and ownership information about the company, approval rights that would require a company to get the accelerator’s agreement prior to issuing additional equity, or the right to get whatever the best package of rights are that you offer to your future investors (essentially a most-favored-investor provision). If possible, these rights should terminate on your next financing round. At a minimum, they should not conflict with rights granted in a future financing. After the next round, the accelerator, which made a relatively very small investment and owns a small percentage of the company, should be on the same footing as other investors and should not retain rights that are outsize to their initial investment.
If these rights do not terminate, the company must keep track of the accelerator’s special right and approvals. The accelerator may have approval rights that are disproportionate to its investment and allow it to blow up a later investment round, or the rights promised to the accelerator may conflict with the rights of your future lead investors, who are putting in much more money.
Remember that accelerators are businesses and their interests are not always aligned with interests of the founders or even the company. Although accelerators market themselves as partners with the companies in their program, founders must be cognizant of what they are agreeing to give the accelerator before signing up. Speak to companies that have been through the program and gone through a few rounds of funding to see how the accelerator’s terms have affected its portfolio companies and their future financing rounds.
Randy Adler is a partner and National Co-Chair of Fox Rothschild’s Emerging Companies & Venture Capital Practice Group, representing businesses and investors in all stages of development. You can contact him at firstname.lastname@example.org.
Tamar Gubins is an associate at Fox Rothschild where she advises companies on formation, financing and governance as part of the firm’s Emerging Companies & Venture Capital Practice Group. You can contact her at email@example.com.