A Fair Way to Start a Startup—Part 2
In-kind work convertible note agreement
The second part of this article outlines an example of an agreement that can be used to fairly engage talent early on in a startup’s life when there is little or no financial resources.
The rationale for this agreement innovation is outlined in Part 1 of the article.
DISCLAIMER: This is a proposal for a new type of agreement that has not been prepared by legal experts. Any of the suggestions you wish to use should be checked by legal advisors.
Agreement Format
The In-kind Work Convertible Note Agreement contract is designed to be used in early days of a startup’s development. At this point, there are usually few shareholders, so it can be formatted to facilitate a rapid Shareholder Decision, thereby avoiding the need for prior board decisions.
To enable a swift start and avoid spending time on full employment contracts, the agreement also includes some minimal employment conditions. Long delays caused by formulating detailed contractual agreements can also be a risk when trying to get a startup up and running.
Startup Ltd
Company registration number:
SHAREHOLDERS DECISION
DATE: xx.xx.xxx
PLACE: Helsinki
DECISION: In-kind work convertible note agreement
PARTIES: Startup Ltd company (hereafter know as Company) and ………… (hereafter known as Service Provider)
PRESENT:
The following shareholders were present (all shareholders representing 100% of voting shares): Insert usual info including: Shareholder names — Social Security numbers — Addresses — Voting shares — Voting percentages.
- Number of shares to be allocated
The hourly rate used to calculate the value of Service Provider’s work will be ……€.
The hourly rate can be whatever you agree. It should reflect the following: the hourly rate the Service Provider could get on the open market (i.e. the type and level of their expertise), the depth and length of their commitment, and equity potential in relation to risk.
For a maximum possible total of …… contracted hours.
The number of contracted hours is an estimate of what the Service Provider needs to complete specific tasks, or the number of months you wish to engage during this initial trial period.
For the purposes of this agreement the Company is valued at ……………… euros.
It is acknowledged that determining the valuation of a startup is more art than science but can be managed along the lines stated in this overview of Nordic funding. In essence a startup with a Great Team with a Great Idea has to be worth somewhere between 0.5 to 1 million euros. To value it less could impair the long-term health of the startup as it would either not provide a long enough runway to find product/market fit, or it would result in giving away too much equity, which would constrain future funding round options.
If this form of contract is used at later stages then naturally previous funding rounds will also play a role in coming to a valuation consensus.
If the investor intends to be an active participant, and they are suitably networked with high impact potential their contribution may be regarded as being “smart” money and, in which case, the Company valuation can be reduced to enable them to acquire a larger stake in the Company’s ownership.
A startup is always a learning journey, and while experience doesn’t guarantee success, it does reduce the amount of learning required. So if your team has limited experience, then investors are also partially investing in extra learning and therefore a lower valuation might be appropriate. But a certain amount of naivety is usually always required otherwise people would rarely enter into startups in the face of statistical realities.
At the time of signing this agreement the total number of fully-diluted company shares is …….
The number of fully-diluted shares is the highest number of shares connected to the Company regardless of vesting provisions and other options. This is needed to calculate the share value used in the agreement.
The value of a share related to this agreement is €…….
The share value (for this agreement) is calculated based on the startups valuation (mutually agreed at the time of signing the contract) divided by the number of fully-diluted shares. For example, if you agree a 1 million evaluation and there are 10,000 shares the price per share is €100.
The equivalent in-kind investment monetary value for the assigned shares would be €….……..
The above value is calculated by multiplying the number of assigned shares by the agreed share value. This gives an overview of the equivalent monetary valuation of Service Provider’s in-kind work if the full amount of contracted hours are completed. For example, using Finnish Tekes innovation funding guideline figures, 1896 hours (around one year of employment) at an hourly rate of 19 euros (3000 euro per month) would equate to 36K euros of value invested.
After all the contracted hours are completed the Service Provider would be entitled to …………….. assigned shares, or the agreed monetary equivalent, at the note’s conversion.
Working out the number of assigned shares is a balancing act between the work that needs to be done, and the percentage of non-working equity that the startup could accommodate if The Expert leaves after the contracted work has been completed. Once a mutually agreed percentage is arrived at then simply calculate how many shares are required to match that percentage. For example, based on the previous figures used (1M valuation, 10K shares, and 36K of in-kind work) this would be 360 shares worth 3.6% of the company.
2. Payback period
The Company has a ………… month payback period from the signing of the agreement within which to pay for the hours accrued.
The payback period is designed to allow enough time for The Company to secure the funds necessary to pay for the accrued hours. This depends on the timeframe of the commitment but is most likely to be from 12 to 24 months, as you should only be using this form of contract for people with whom you see the potential for long-term commitment, i.e. not short-term work.
3. Terms of work
The Service Provider is primarily contracted to be responsible for …………………….. All work and related intellectual property undertaken as part of this contract is owned by the Company.
The Service Provider agrees to help with any reasonable task outside of their primary responsibility that might be needed to help the Company progress.
This agreement is designed to start swiftly, and therefore it avoids prescriptive (and thereby potentially limiting) work descriptions. You are hiring the Service Provider for a particular skill set and hopefully a strong personal motivation, so it should not be necessary to micro-manage them. However, it should be made clear that in an early stage startup it is also important that everyone helps out in multiple areas as necessary to enable things to progress rapidly.
The Service Provider will use a Company provided email for logging into all related online services and keep updated an online document with all the necessary information to access code and related service accounts created for the purposes of completing the work.
In the enthusiasm of starting a startup it is natural for people to open up multiple services with their personal details. This can cause complications if they leave. Making access information available to the core team members at all times should be a hygiene factor.
The contracted ………….. hours will be completed in …..……… months.
It is important to set expectations as to the overall workload. The deadline for this should come before the end of the payback period, e.g. six to twelve months to allow time for the Company to secure funds to reward with cash if that is its preferred option.
The Service Provider is committed to work for a minimum of ………. hours per week but there is provision for mutually agreed changes which must be stated in writing. Such changes may be agreed at any point depending on the development needs and available time.
For pragmatic working arrangements, the contract will state that if the hours recorded in any given week are less than X% of the agreed average commitment they will not count and the earnings will be forfeited.
The percentage required to avoid such forfeiture will vary depending on the nature of the work. It is really important that the required minimum level of activity is sustained over the long term. However, there is provision for waiving the forfeiture of earnings if the Service Provider has genuine mitigating temporary challenges.
The average weekly hours will be measured monthly.
It is important that sufficient pace is maintained. If the Service Provider is consistently not putting in the required number of hours this is not a good sign and grounds for seriously considering the termination of accruing additional hours (see the final section). While measuring hours is a crude way to measure someones level of engagement (insights in the shower, etc) it is the only mechanism available at this stage — all going to plan the agreement will convert into a permanent working partnership (see section 4) and hour tracking will no longer be necessary.
The Service Provider will log their hours worked online by adding daily hours to predefined work activity areas and they will be reviewed weekly.
It is advisable to set up an online spreadsheet (e.g. Google Sheets) or use an online service (e.g. Harvest) with a predefined list of work task areas + an “other” column. In this way the Service Provider just has to add a few numbers each day and occasionally comment to record their hours. In Nordic countries, where it is common to get government support, it is advisable to establish this practice from the outset.
4. Note Conversion
Eligible hours will be accrued based on tiered levels equivalent to monthly hours of work completed. The tiers are based on ……….. hour intervals.
By have vesting intervals (e.g. 0–158, 159–317, etc) it means that a minimum amount of work is required to justify a conversion to cash or equity. And it gives regular opportunities to review the status of the working relationship.
When the vested shares are converted into cash, or into common stock equity, the valuation will be based on the level of the last completed vesting tier divided by the maximum hours agreed.
This ensures that work that has already been performed will be duly rewarded, even if the full initial estimated number of hours are not reached.
If an investment round is undertaken during the payback period using a post-money valuation of ……… million euros or more, the convertible note can be converted prior to the financing round on the same conditions that would be applied at the note’s maturity date.
This agreement is mainly designed for early-stage startups; however, if the startup has been running for a few years already the above component could be included. This would enable the Service Provider to benefit from their in-kind investment in the event of an A-round happening within the conversion note’s timeframe. The post-money valuation could be set between eight to twelve million.
Having this clause would be particularly relevant if there is a longer pay-back period, e.g. two to three years, as it provides extra encouragement for the Service Provider to stay committed and go the extra mile to help make an A-round possible.
At a mutually agreed point during the payback period or at the note’s maturity date one or the other of the following scenarios will be activated at the discretion of the Company:
a) The convertible note will be bought back at the value of in-kind debt accumulated, together with a ……….. multiplier applied.
In this case, the contract reverts to a cash relationship and therefore the Service Provider no longer has the option to gain from potential increases in share value so a premium is added. The premium is a multiple of the principal amount of value accumulated (generally in the 0.1x to 1.50x range). The premium is decided on how much of a learning experience the Service Provider will have, e.g. a young person learning and gaining valuable experience should have a lower premium than a highly experienced professional.
b) The convertible note will convert to equity on the agreed terms.
This includes accrued hours multiplied by agreed hourly rate, interest and the premium.
NOTE: Income gained though working is taxable. So you will need to be aware of how your own country tax authorities will view the income — either as a cash payout or as an equity gain. Cash will most likely be counted as taxable income in the year that the invoice is submitted. And shares are subject to be taxed at a value related to the Company’s assets. There could be complications if Service Provider is not in a position to pay the taxes for shares they gain. If upcoming investors would prefer the debt to be converted to equity then it would make sense to do the conversion prior to the funding round.
It is recommended that the agreement is done with a company and not as an private individual to make sure the service provider is not seen as an employee. In Finland this can be easily done via registering as a toiminimi (literally translated as trade name) but I am not sure how many other countries offer this lightweight legal business status.
5. Option to convert to vested shares as part or a working partner agreement
At a mutually agreed point during or at the end of the payback period, the shares already secured via this contract could be converted to vested shares in line with other working shareholders. This conversion would happen, for example, if both parties would like to enter in a more formal partnership arrangement in which shares would be vested over a number years.
The incentive for the Service Provider would be to enter into a long-term commitment in exchange for an increased amount of shares.
A vesting schedule of 4 to 5 years is a common way to encourage shareholders not to leave while holding non-working shares.
The start date of the vesting schedule is calculated by subtracting the number of full-time months already worked from the date of entering into the working partner agreement. The number of months already worked is calculated by dividing the total hours worked by …… hours.
This takes into account the work already done and means that the Service Provider is not starting the vesting schedule from scratch.
The number of hours in an average month will vary. Finnish authorities such as Tekes commonly assume a month to be 158 hours.
In exchange to the increased commitment to full-time position the number of vesting shares would be multiplied by a factor of ……
This is because the initial amount of equity allocated in contractor-type relationships tend to be substantially lower due to the lack of long term commitment. The multiplier is dependent on the long-term benefits to the startup and continued professional growth opportunities.
5. Agreement termination
Both parties to this arrangement must weigh the risks carefully. The Company is accepting the risk of engaging an unknown worker and potential shareholder and the Service Provider has no assurance that the Company will be a success. Therefore this agreement must always be based on mutual trust and commitment to the Company’s vision and value proposition. Hence there is provision in the contract for either party at any time to terminate the contract and stop the accumulation of further hours.
The above terms and conditions were agreed unanimously by all shareholders and parties.
present:
All the shareholders
Service Provider
Conclusion
There are quite a few interactive variables so some juggling will be required to optimise the contract for all parties. Among these, the most challenging issue that must be dealt with is the Company’s valuation because the higher the valuation the lower the proportion of shares gained by any given amount of contributed work.
I hope that this will be a useful tool, and I would welcome your thoughts on its practicality and how it may be improved to be as fair as possible for contractors/partners, while not compromising the financial viability of the startup.
DISCLAIMER: This is a proposal for a new type of agreement that has not been prepared by legal experts. Any suggestions you wish to use should be checked by legal advisors.
