The Critical Role that Accelerators Play in Venture Financing

July 1, 2021  |  By Kevin Vela

Over the past several years, the startup world has seen a boom in new accelerator programs. They are springing out of angel groups, public/private business organizations led by city governments, corporate venture capital arms, and astute investors. For the most part, this has been a good thing. Accelerators provide much needed structure for startups – office space (well, when that was a thing), startup focused programming, guidance on founder relationships, overviews of business fundamentals, introductions to mentors and service providers, and, most importantly, seed capital. Most of these benefits are relatively straightforward and can be successfully installed and taught in various ways, all with similar results.

Seed capital, however, must be provided with great care, or else the long-lasting ramifications can be dangerous. And, unfortunately, this is often overlooked.

The primary goal of accelerators, at least for-profit ones, is to return value to the investors. Let’s be clear about that. There are a number of great secondary benefits – aiding the local ecosystem, facilitating mentor relationships, providing programming that can help the whole community – but for-profit enterprises are not created solely for those reasons. Accelerators want to make money. Return of value from startup investment comes from exits. Exits come from an IPO or sale of the business, both of which come after years of work, progress, and many stages of investments. Or, put another way, no startup ever exits after the accelerator round. Or the Seed or Series A round, for that matter. I believe we can all agree on that. The problem is that many accelerators treat their investment as if it’s the lynchpin in a 100x return, instead of the spoke in the wheel that it often is.

While accelerators have tried to harmonize their investment structure in order to reduce the burden on corporate record keeping, treating startups with a set of one-size-fits-all investment docs leads to different sized startups with ill-fitting, one-size-fits-all deal structures.

For instance, many accelerators like to take 6%-8% of common stock in exchange for the program’s services and a cash investment. This works for very early startups, but does not work for startups who may have some value already. For later stage startups, granting common equity to the accelerator will lead to income recognition for the accelerator (because of the value of the grant), reporting requirements for the startup, potential issues with over-issuance of shares, and disruption to the startups stock option pricing.

What I’ve also seen accelerators do is work with standard documents – like the YC post-money safe, but then add their own terms to it. This defeats the purpose of the Safe (they should all be EXACTLY THE SAME save for the cap, discount rate, amount, and investor name). This could lead to the startup using the same accelerator form with the accelerator friendly terms for other investors, or, a situation where the startup now has different forms of the Safe in the same round. We recently conducted a Series Seed round where the client had 30+ convertible instrument investors (Notes, Safes, KISSes), with 15 different forms. This led to conversion chaos and a number of hard conversations to seek amendments to reconcile the conversion mechanics. Of those different forms, three were from accelerators.

So what can accelerators do?

Use round building investment forms

Use round building investment forms like Common Stock purchases for day 1 startups, and the YC post-money Safe for later stage startups. That’s it. If you must have terms that are nuanced to your accelerator, be flexible with them in the future if needed (meaning waive them or sunset them at the next qualified round).

Seek feedback from the attorneys in your network

Here’s some text from an email I recently received from a fantastic accelerator we regularly work with:

I’m excited to announce a change that we’re making to our equity grant template for 2021. We are removing the perpetual nature of our regular pro rata right. Instead, it will terminate with the same round of funding that triggers, then terminates, our investment right (an institutional-led preferred equity round of $##M+). The regular pro rata persists through the triggering funding round, but regardless of our decision to invest per our $$$K right, both investment rights terminate thereafter.

We see this change as a founder-friendly one and appreciate the periodic reviews and feedback you’ve provided on our equity grant templates over the years.

This is a great example of an accelerator listening to the stakeholders and advisors in its network, and making valuable changes to the benefit of the startups, and the entire ecosystem.

Encourage startups to work with venture attorneys as soon as possible

Many early stage investors feel that Safes and Convertible Notes are a substitute for venture attorney guidance until a later round. They are not.

Early stage financing rounds should be like Lego® bricks – they can be different shapes, colors, and sizes, but they all need to stack neatly on top of each other. Once accelerators (or early stage investors in general) try to build with wooden blocks, or knock-off bricks, they may be able to be forced on top of each other, but they don’t truly fit; and that will end up hurting the startup in the long run.

About the Author(s)

Kevin Vela

Kevin is the managing partner at Vela Wood. He focuses his practice in the areas of venture financing, M&A, fund representation, and gaming law.

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