How the new Mass. Non-Compete Rules Affect Boston Startups

Related reading: Non-Competes

Only a handful of states have full bans on non-competes, with California being the most prominent. While certain commentators with very specific motives (more on that below) want the market to believe that the total elimination of non-competes is essential for a thriving startup ecosystem, that is simply not the case. The vast majority of startups outside of California leverage non-competes in their employee documents, and for good reason.

When an employer and a key employee sign a contract with a non-compete, the “deal” is simple: I (as an employer) am going to invest in you (the employee), and that investment will take a long time to recoup returns. I need some reassurance that you are not going to take that investment, as well as all the specialized knowledge I hand you (particularly in the early days), and then jump ship to a competitor the moment they offer you a better compensation package. The economic logic is not that different from the logic for patents on strategic IP. Non-competes can provide a foundation of trust that allows employers to invest in their employees for the long-term.

You can see how important this arrangement can be to startups, because at their early-stages they are very vulnerable to having large companies or highly funded competitors hiring away their strategic talent. The total elimination of contractual non-competes can generate extremely expensive talent wars between startups and large companies. Talent wars make startups more dependent on venture capitalists for their success, and that is why VCs are often the most vocal proponents of non-compete bans.

Of course, non-competes are being abused. That is undoubtedly true. There are very strong arguments that very large companies should be limited in their ability to use them; and also that non-key employees, like low-level staff, should not be subject to them. But there are equally strong arguments that allowing early-stage companies to negotiate non-competes with their most important talent can strengthen entrepreneurship and startup creation.

In Massachusetts’s case, this debate resulted in a compromise. Rather than banning non-competes completely, various extra requirements were put in place that will have the effect of startups limiting them mostly to key strategic hires/executives, which to many people makes total sense. While you will need to work with counsel knowledgeable of the specific context in which your company is hiring, an extremely high-level summary of the changes is:

  • Non-competes of greater than 1-year are presumed to be unreasonable.
  • The non-compete must include a “garden leave” clause requiring extra payment to the employee during the non-compete enforcement period, or (and this is important) “mutually agreed” additional consideration.
  • The non-compete is not enforceable if the employee is terminated without cause (but is enforceable if they leave voluntarily).

The garden leave or mutually agreed additional consideration requirement is going to be key for Boston startups to follow. No one is fully sure what sufficient additional consideration will be, but the full consensus is that it must be meaningful; like a signing bonus, or an equity grant.

The key takeaway here is that non-competes are not banned entirely in Massachusetts. The legislature heard the arguments on both sides, and made a reasonable compromise. The result of that compromise will be that Boston startups will start limiting their non-competes to their most key employees for whom the threat of departure to a competitor is a material strategic threat; which is the main point of non-competes to begin with.

Boston Startups Should Avoid the YC Post-Money SAFE

Y Combinator’s “Simple Agreement for Future Equity” (SAFE), in its original form, was presented by YC as an alternative to convertible notes. It was effectively a convertible note without interest or a maturity date. While very popular within Silicon Valley, it remained a minority instrument almost everywhere else, including the East Coast, because most investors (not without justification) felt it was an imbalanced agreement that gave investors too few protections.

Entrepreneurs can get into trouble when attempting to replicate Silicon Valley norms and fundraising structures in tech ecosystems where the community approaches things differently. 

Recently, Y Combinator completely re-vamped the core economics of the SAFE, having it convert on a post-money instead of pre-money basis. This totally changed how the conversion of SAFEs into shares works, and made them far riskier of an instrument for startups; particularly because the new Post-Money SAFE has a very unique anti-dilution mechanism built in that can seriously penalize founders/the common stock if the startup does more seed rounds after the initial SAFE. Using a Post-Money SAFE can, in many contexts, mean far more dilution than if you’d used other acceptable alternatives. 

While SAFEs never became the dominant seed instrument outside of Silicon Valley (including in New England), we suspect that their more aggressive economics will make them even less utilized going forward. Seed equity and simple convertible notes with reasonable maturity dates and low interest are viable, and better, alternatives. In the latter case of simple convertible notes, they can be closed just as easily as a SAFE, with similar legal cost. 

For a deeper dive on this topic, see: Why Startups Shouldn’t use YC’s Post-Money Safe.

Options v. Stock for early Startup employees

Additional reading:

Equity compensation is a core component of how startups recruit and retain talent. The two most common types of equity compensation at early stage are Options and Stock.

An option is the right to purchase stock at some point in the future, at an “exercise price.”

Stock, on the other hand, is a full voting security in the company, with all of the economic rights of ownership. 

The core driver of whether companies award stock or options to early hires is taxes. No one wants to have to pay the IRS tax for receiving equity, but under the broad framework of how IRS rules work for compensation, if you receive something (from your employer) worth more than you pay for it, the spread (the difference in value) is compensation, and therefore you owe taxes on it; even if you only got, in a sense, a “paper” gain.

At the very early stages of a startup, the “fair market value” (FMV) of stock is very little from an IRS perspective, because revenue is low or non-existent, and there hasn’t been much financing setting a third-party price. Issuing stock to employees is therefore fairly easy to do without a big tax hit, because the recipients can just pay the FMV of the stock; typically par value or close to it – fractions of a penny. No tax problem. 

As the company increases in value, however, having people pay the FMV is no longer feasible; it could mean having to pay thousands of dollars, or more, for the stock. This is what drives startups to switch to options.

Without getting too in the weeds, the IRS has certain “safe harbor” rules that allow employees to receive options on a tax-free basis as long as certain conditions are met, and one of those conditions is that the exercise price equals the fair market value on the date of grant. This safe harbor is the reason options are the primary form of equity compensation for post-seed stage startups; to avoid sticking recipients with a tax bill.

A company can be worth millions of dollars, but as long as its option grants have a FMV exercise price, employees receiving those options can (i) pay nothing to get the option (though they’ll need to pay to exercise it), and (ii) not owe the IRS anything for receiving the option. 

An equity incentive plan (the broad term for the legal paperwork behind “option pools”) is not a simple document. Specialized law firms and services have equity plans that have been vetted by appropriate tax counsel to ensure compliance with tax rules. Do not just pull something off of google and use it. You won’t like the long-term results.

The Value of Startup Accelerators

Background Reading:

Boston is known as an epicenter of top-tier universities. While most people think that the main purpose of top universities is to educate top students, from a societal perspective there is a very strong argument that, relative to lower-tier universities, the main role of selective universities is actually sorting, not educating. The empirical evidence for this is that students who are accepted into top universities but choose to attend lower-ranked schools on-average perform just as well economically as those who went on to top universities. Top universities serve as valuable signals to employers and other players of the caliber/innate talent of a particular student, even if lower-ranked schools could have done just as good of a job at educating that student.

On that same note, top-tier startup accelerators are the elite universities of tech ecosystems.  As tech entrepreneurship has become more widespread and the number of entrepreneurs has gone up (as the cost of starting up has gone down), tech ecosystems have become far more “noisy.” More pitches, more teams, more ideas, which overall is a great thing, but it makes it a lot harder for investors to find the investment-worthy companies. Not unlike employers sorting through millions of students.

Here in Boston, Techstars is arguably one of the most notable accelerators, although there are others here and throughout the country. MassChallenge is larger, and less selective. See Seed Accelerator Rankings for more national info.

Ask founders about the educational value of accelerators, and feedback will vary; but almost universally founders will say that the top ones pay for themselves simply from the network they open up for you by putting their stamp on your startup; just like a Harvard or MIT.

Must you attend a startup accelerator to succeed? Clearly not. The large majority of successful companies we work with never touched an accelerator. But for founders lacking strong connections to investors and other key players early on, they can dramatically accelerate a startup’s ability to find capital, advisors, etc.; and should be strongly considered.

Why Boston Startups need right-sized law firms.

Background Reading: Checklist for choosing a startup lawyer. 

The market for law firms that represent emerging companies (startups) can be split up into 3 categories, in order from smallest to largest: (i) solos / tiny firms, (ii) boutique firms, and (iii) large firms (BigLaw). Similarly, the overall cost of the services that law firms charge can be split up into 2 categories: (i) compensation, and (ii) everything else (overhead).

The first category of law firm costs, compensation, plays the largest role in determining the quality of service. Great lawyers, just like great developers, engineers, doctors, etc., expect to be paid well for their talent. There is no getting around that, and it sets a floor on what law firms employing talented lawyers can charge. The second category, overhead, is often related to law firm size, as discussed below.

Solos / tiny firms (1-5 lawyers) are typically the cheapest on an hourly basis, because they have so little overhead. For clients whose work does not require a lot of team coordination and scalability, they are a good fit. The problem is that higher-growth startups do require those kinds of resources, and we regularly see them run into issues like slow response times, and errors resulting from rushing, when using tiny firms. For that reason, solo and tiny firms are much better suited for “small businesses” than true startups.

BigLaw (>100 lawyers) is on the opposite end of the spectrum. The majority of what large, international law firms charge is not actually going to the lawyer you are directly working with, but to pay for the very high-cost, complex infrastructure needed to represent billion-dollar companies on IPOs, international mergers, etc. For companies on what we could call the “unicorn track” and who expect to raise very large, very fast rounds and eventually go public or have a billion-dollar valuation, this type of firm is the best fit, because any other kind of firm will not be able to scale at the level needed to manage the work.

Boutique firms (about 5-75 lawyers) represent a middle ground between tiny firms and BigLaw. Their smaller size allows them to eliminate a significant portion of the overhead that inflates the cost of BigLaw services, while serving clients that need more scalability than a tiny firm can provide.

Egan Nelson (our firm) is a high-end boutique firm. We take lawyers from top-tier BigLaw tech firms and place them on a lower overhead platform, using technology and process efficiency, to drop their rates by hundreds of dollars an hour, without changing their compensation. We also drop their annual billing requirements, to improve their quality of life; which we think makes them better lawyers. Our profile client is a startup for whom a $25MM to $250MM exit would be considered a win. For a better discussion on the philosophy behind the kinds of clients we typically represent, see Not Building a Unicorn. 

Historically, entrepreneurs in startup ecosystems have believed that if their company intended to achieve any level of scale, they needed BigLaw. Given the SaaS revolution and availability of new low-cost software/technology for running firms and collaborating among different firms, the emergence of the high-end boutique ecosystem has made that no longer the case. If you’re building a unicorn, yes, you probably still need BigLaw. But the “middle market” of startup ecosystems now has much better, more right-sized options.

Seed Financing Structures for Boston Startups

Background reading:

The three most common options that, from our experience as a top-tier emerging companies boutique firm, make up 95+% of seed rounds are: Equity (Preferred Stock), Convertible Notes, and SAFEs (Simple Agreement for Future Equity).

If you want a deeper dive into their pluses and minuses, read the above-linked posts. Generally speaking, stock (equity) is the most expensive and complex to do, but the main benefit is that post-closing everyone has greater certainty around ownership % and rights. The larger the round (particularly >$2MM), the more likely it is to close as a preferred stock round.

“Seed equity” is a subset of equity financing using slimmed down, highly standardized documentation that can be closed much more quickly (with lower legal fees) than a full VC-style equity round. When rounds below $1.5-2 million are to be closed as an equity round, we see Seed Equity being increasingly utilized as an option.

Aside from preferred stock described above, convertible notes and SAFEs (collectively often referred to as “convertible securities”) are the 2 dominant forms. Convertible securities are much simpler to draft (lower fees) because they defer a lot of the hard issues/negotiations to the future.  But the tradeoff is more uncertainty, and also somewhat more dilution. 

A convertible note is basically a debt (loan) instrument that, instead of actually being paid back, intends to convert into equity in the future, when a larger financing occurs; that converting financing is referred to as a “qualified financing.” It has a maturity date (typically 18 months to 3 years) that sets a deadline on the company reaching that milestone financing, or else a discussion/re-negotiation with the investors needs to happen.

SAFEs are effectively convertible notes without a maturity date; a structure invented by Y Combinator in Silicon Valley. They also convert into equity in the future, but there is no “deadline” of a maturity date, which is much more company favorable, and investor unfavorable.

recent survey of seed financing structures reveals that in California, where the volume / density of seed investment is magnitudes higher than the rest of the country, and competition among seed investors is dramatically higher, SAFEs are well on their way to becoming a dominant seed round instrument.

A key takeaway from that survey, and which I’ve emphasized several times before, is that entrepreneurs in Massachusetts, Colorado, Texas, and other ecosystems should be very careful to not assume that market conditions in their local ecosystems parallel Silicon Valley. Among convertible security seed rounds, convertible notes are far more preferred by seed investors here than SAFEs.

I don’t represent any tech investor funds, for reasons I’ve written about in How to Avoid “Captive” Company Counsel, which means I have no reason to be biased in favor of investors; and with that being said, I still think SAFEs are extraordinarily, some might say ridiculously, anti-investor and pro-company in their terms.

Convertible notes, which are the dominant convertible seed financing structure, represent a balanced trade-off. Investors get up-front stronger “pay back” protection than an equity holder would, and in exchange they get fewer voting and other rights.  Upon conversion, that stronger protection goes away, and they become stockholders.  A SAFE basically tells an investor to accept all of the downsides of convertible notes, without any of the benefits. Hope for the best.

It’s no surprise that SAFEs came from YC. Already within California, the extreme density of startup activity means competition among investors to get into top startups is more fierce, slanting the market toward companies. By being the elite of Silicon Valley at early stage, Y Combinator takes company leverage up several notches. But it’s dangerous for more “normal” companies outside of SV to take their cues from such a different environment from the one they’re operating in.

Still, as the data shows, while SAFEs are a minority structure, we still see them. But the core point here is to not get too hung up on them. We regularly see founders think they can get a SAFE closed, and then mid-way they are forced to re-do everything because a serious investor balked. Our advice is that, if you are going with convertible securities, stick to convertible notes, unless you are 100% certain that all investors you intend to raise money from will accept a SAFE.

As long as the maturity date is far off enough (2-3 years), the difference from a SAFE is minimized, and yet you’ll see far less friction from investors.

Legally Forming Your Boston Startup

Background reading:

If you are in the formation stage of your startup, here are a few key points to keep in mind to avoid legal pitfalls.

Formation/Organization and Incorporation are not the same thing. 

When you file a “Certificate of Incorporation” in Delaware, you are “incorporating” your company. It takes a few minutes, and a small filing fee, to do it. It also leaves 99% more work to do before the company is properly “organized,” including from an equity, control, and IP perspective.

When comparing offerings from different firms for organizational legal costs, pay close attention to what is actually included in their “formation package,” because it’s easy for firms to leave things out in order to appear to offer a lower price; while making you pay more later on to get everything done properly.

Don’t assume you want a “standard” Delaware C-Corp.

If you read info from Silicon Valley, you’d think 100% of tech startups are C-Corps. That’s not true. Yes, a majority are, but your particular business model and growth trajectory may make it a less obvious choice. See: More Tech Startups are LLCs. 

Be aware of fully automated options.

There are automated and safe options like Clerky, if you are comfortable with a fully template-based structure with no customization whatsoever. If keeping legal costs to an absolute minimum is a top priority, Clerky is far safer than a DIY project with Word-based templates.

Tech entrepreneurs should not use LegalZoom or Rocket Lawyer, both of which are designed for non-tech small businesses (think coffee shops), and lack much of the documentation you’ll need.

Most startups hire law firms. Hire one right-sized for what you’re building in the next 5 years.

See: Checklist for Choosing a Startup Lawyer and Why Startups hire law firms, not a lawyer.   Most startup-specialized firms have formation packages that will allow for more flexibility/customization (and guidance) than an automated formation, without incurring excessively high costs.

Why so many Boston Startups incorporate in Delaware

Background reading: Should I incorporate in my home state or in Delaware?

Why has English become a uniform standard for business language around much of the world? Because without a common language, it can be incredibly inefficient for companies doing international business to communicate. 

In the United States, Delaware has evolved to become a kind of national standard for corporate law. Having a standard used by everyone around the country streamlines deal-making, and reduces legal fees. 

A large majority of angel and VC-backed tech startups in the U.S. are incorporated in Delaware, regardless of their physical geographic location. That’s why serious startup lawyers in any U.S. state are very familiar with Delaware corporate law. 

There are of course other reasons why Delaware is preferred by so many companies and investors, much of which are explained in the above-linked post. But the main point for founders to understand is that scaling Boston startups have good reasons for starting out in Delaware.

Delaware can save you money long-term.

Given how much of the startup ecosystem is built on Delaware corporation law, all serious startup lawyers have large sets of form documents and processes built around Delaware law. Taking advantage of those forms and processes will save you legal fees.

Both in the short term and long-term, Boston founders intending to build companies looking to scale faster than a typical small business should strongly consider Delaware.

Sidenote: See also: Not Building a Unicorn for a discussion on how, while being a “startup” means going after some amount of scale, it doesn’t have to mean a Silicon Valley-style hyper growth trajectory. 

Introducing New England Startup Lawyer

While a lot of the content available on the web is focused on west coast startup ecosystems, this blog will relay curated, high-quality content on startup law and VC issues relevant to the Boston startup ecosystem; including from top-tier tech/vc lawyers within our boutique firm, Egan Nelson (E/N). 

Much of the content will come from sister blogs of our firm’s lawyers, to avoid reinventing the wheel.