Announcing E/N Alpha

I’m very excited to announce the launch of E/N Alpha, a flat-fee subscription program ($500/mo) that our firm has launched for high-potential very early-stage startups.

The details are available on the linked page, and should be fairly straightforward. In particular, I think it’s important to read the section describing what it’s not, because it reflects our firm’s thought-out response to what we see as a lot of failures / nonsense in the legal market where firms, for marketing purposes, pretend to deliver efficiency, when what they’ve really done is watered down their service so much to the point of no longer being useful.

Not software – Readers of SHL and E/N clients know I love legal tech and that we’re always integrating new tools into our practice, but as I wrote in Lies About Startup Legal Fees, there is simply too much BS floating around startup ecosystems that some magical automation tool or piece of AI will dramatically cut legal spend long-term for startups. Significant automation requires significant standardization and inflexibility, which in the world of high-stakes legal work for scaling tech companies negotiating with sophisticated parties, most smart Founders and executive teams are not willing to accept.

Yes, you can automate formations and a few very early things, but complexity increases exponentially beyond that (like a code base), and the value of software automation tapers off fast.

Not paralegals and junior attorneys – I have lost count of how many startups have switched to us from firms that talked a good efficiency game, when their main tactic was to force CEOs to get on the phone with paralegals and junior attorneys whose expertise ends the moment you go off script or deviate from a checklist. I love paralegals and juniors, and we have and train them. But if you think a founder wants to talk to your paralegal about structuring their seed financing, or making that key first or second hire, you don’t understand founders; at least not the smart ones.  See: The problem with chasing whales for what happens when founders end up having to deal with a firm’s B or C team.

Not “everything legal for one price” – Oh man, I came across a firm promising this the other day. “We’ll do everything legal you need for one flat monthly price.” Right. See: Standardization v. Flexibility in Startup Law, for an explanation of what really happens when a firm is forced to work under a ridiculous fixed fee. Fixed fees are great for low-stakes, routine work with a well-defined scope, or for high-volume projects that (again) are well-defined in scope, but the idea that you can map all of the legal needs of scaling emerging tech companies onto some bell curve and peg a number, like an insurance company, without dramatically impacting quality or flexibility, is some straight-up ghostbusters nonsense.

The only possible way it works is if you limit your client base to companies that basically all look and act the same, and have virtually all the same expectations and needs within a narrow range. That’s not how we work, nor how any serious law firm I know works. Analogies to healthcare’s move into fixed-fee pricing don’t hold water without accepting the “narrowly tailored client profile” point, because human biology is 1000x more “standardized” (bell curves) than the corporate structures, investor expectations, growth trajectories, legal obligations, and company values of tech companies.

Not the only way to work with us – This is simple. E/N Alpha is an option for startups looking to lock-in price certainty on a specific scope of work they are sure to need within their early years. But it is not the only way to work with us.

Fundamentally, what we want E/N Alpha to reflect is that E/N is a lean, flexible, high-end boutique law firm built from the ground up to address the many dysfunctions we’ve seen in the emerging tech / startup legal market. Entrepreneurs hire us because they know they need serious, specialized, trustworthy lawyers to address complex, high-stakes issues, and they need some way of affording that; particularly in the early days.

Everything else: tools, low-level professionals, and all the other ways a law firm can optimize itself should stay in the background. They aren’t, and shouldn’t be, the end-product.

 

Optionality: Always have a Plan B

TL;DR: Always build some optionality into your startup’s financing strategy. Failing to do so will overly expose you to being squeezed by sophisticated players who can see how dependent you are on them.

Background reading:

The below is a fact pattern that we have seen happen with several of our clients. It will provide some context for why the point of this post is so important.

Company X has raised a decent-sized seed round, which includes several angels as well as a “lead” VC; though that VC is not on the Board. The Company knows that it will run out of funds in 3 months if it does not raise more money, and it has been in regular communication with the VC about that. The VC reassures the founders that they will “support” them with a new bridge round. A month passes, and the founders ask about the bridge. “Don’t worry, we’ll cover you” is the response. Then another month passes, with more reassurances, but no money. Then 2 weeks before their fume date (the date they’ll miss payroll), the VC drops a term sheet with very onerous terms, including a low valuation, and mandated changes to the executive team. The VC makes it clear that they won’t fund unless those terms are accepted. The founders panic. 

Before we dive in, there are a few important points worth making about this situation. First, it was clear every time that it has come up that the bait-and-switch dynamic was planned by the lead investor. They paid very close attention to the exact date that the Company would run out of funds, and timed the “switch” to deliver maximal pressure. Second, the regular “reassurances” provided to the founder team were calculated to discourage them from using their time to find other funding sources. Third, the best way to avoid investors who engage in this kind of “below the belt” behavior is to do your diligence before accepting their check; see: Ask the Users. 

Always have a Plan B.

A startup’s ability to avoid being burned by the above behavior depends on its level of strategic optionality.  Optionality means strategically avoiding a situation in which you have no choice but to depend on one investor/investor group for funding. This is very different from not committing to certain lead investors as your main funding sources. “Party rounds” are what you call financings where literally every investor is a small check. The end-result of a party round is that no one has enough skin in the game to really support the company when it hits a snag. You really are just an option to them. 

I strongly support having true lead investors writing larger checks in your rounds, because they will usually provide far more support than just money. And if you’ve done your homework and have a little luck, they’ll never even think about engaging in the kind of behavior described above. But in all cases the best way to maximize the likelihood of good behavior is to ensure a right of exit if someone decides to cross a line. I always try to work with “good people.” But no good strategist builds their life or company around the full expectation that everyone will be good. 

Lead fundraising yourself.

CEOs sometimes believe that they are doing themselves a favor by letting a lead investor do their fundraising for them – coordinating intros, negotiating terms with outsiders, etc. – so they can “focus on the business.” It often backfires. Angels and seed funds whose money has been sunk into the company, and who aren’t planning on writing larger checks in the future, are usually quite aligned with the founders/common stock in helping raise a Series A or future round. They’re being diluted just like you are.

But a VC fund with plenty of dry powder and a desire for better future terms is significantly mis-aligned with everyone else. Watch incentives closely.  Founders/the lead common holders should maintain visibility and control in fundraising discussions, with trusted independent advisors close by. 

Start early, and don’t tolerate unnecessary obfuscation and delays. 

Do not wait until a few weeks from your fume date to start communicating with investors for new funds. If someone says they will support you, great: when, and what are the terms? You want to know them now, not later. “We will support you” means very little without knowing what the price will be.

Expecting things to happen in a few days is unrealistic, but a month or more of delays is usually a sign that someone is playing games, and it’s time to pull the plug. No serious fund worth working with is that busy.

Build “diversity” into your investor base.

The power dynamics in a company are very different when all the major investors have strong relationships/dependencies with each other, and communicate regularly, relative to when various players come from different “circles.” Geographic diversity – meaning taking money from various cities/states – is a good strategy to avoid unhealthy concentration of power among your investor base. Also, diversity of investor types – angels, seed funds, institutionals, strategics – will ensure that your investor base includes people with differing incentives/viewpoints, which reduces the likelihood of collusion. 

In the scenario where a bad actor has tried a “bait and switch” on a founder team, a group of angels willing to write quick checks for an emergency bridge, or a lender offering a credit line, can be enormously valuable to relieve pressure and build time to correct course.

Contracts matter. A lot. 

Every commitment you make to investors requiring their approval, or guaranteeing their participation, in future rounds can have material strategic implications for how much optionality you have. Protective provisions matter. Super pro rata rights and side letters matter.  When you see dozens of financings a year, you regularly see how commitments made at seed/pre-seed stage play out over years and seriously affect the course of fundraising.

Good lawyers well-versed in the ins and outs of startup financing will go much further than just plugging some numbers into a template, which software can do.  They’ll dig deep on how the specific terms you’re looking at will impact the company, in its specific context, and how much room there is to stay within “market” norms while still keeping flexible paths open for the future. That’s, of course, assuming they aren’t actually working for your investors.

Make money, and own your payroll.

The ultimate optionality is being able to run on revenue if you need to; being “default alive” in Paul Graham’s words. Yes, you may grow slower than you’d like, but growing more slowly is always lightyears better than being forced into a bad deal.

Every salaried employee on your payroll raises the revenue threshold needed for your company to be default alive. Ensure that every member of your roster is essential, and that there aren’t redundancies that could be addressed by asking someone to be more of a generalist. And don’t let an institutional investor pressure you into hiring a high-salaried professional executive unless you have a clear strategy for how you are going to afford them, because, yes, that is another way that they can add fundraising pressure.

Stay in control of your fundraising. Start discussions early, and don’t tolerate delays. Build diversity of geography and incentives into your investor base. Let your lawyers do their actual job. And finally, watch your payroll closely. Following those guidelines will minimize anyone’s ability to squeeze you, and your investors will then act accordingly.

Early Startup Employee Compensation

Background reading:

Given how deeply involved we are with early-stage startups hiring their first key employees, I figured it would be helpful to outline a few key principles to help entrepreneurs navigate the topic.

Make sure they are actually employees, and if they are, minimum wage.

States vary in how strict they enforce the line between contractors and employees. California is way harsher than elsewhere in the country.

In general, employees are under your control as to how they work and when they work. Contractors, on the other hand, are required to deliver a service/end-product, but have more control over how it gets done, and they usually are working less than full-time hours and have multiple ‘clients.’ Those are very rough guidelines, and you should work with lawyers to ensure you stay on the right side of your state’s (and federal) specific rules.

The employee v. contractor classification is very important, because contractors can be engaged for free from a cash perspective (equity only). Employees, however, need to be paid at least minimum wage, and may be entitled to benefits. The legal and tax requirements for engaging (and terminating) contractors v. employees are also very different.

Every startup lawyer knows stories of startups that treated someone as a contractor in order to keep costs low, then the relationship went south, and the person ended up filing complaints and getting the startup into hot water. On top of following the rules, your best protection is to be careful with whom you hire, and be respectful/thoughtful if you have to terminate them.

All else being equal, more equity means less cash, and visa versa.

Generally speaking, if someone is getting paid significantly less than what’s “market” for their position, they will expect to receive more equity in order to make up for the difference. Very early employees are generally working at below-market (often substantially below market) cash compensation, and therefore receive much larger portions of equity than someone hired post-Series A or Series B.

And the converse is true as well. If someone, for whatever reason, needs to make $X, even if it’s a serious stretch at the startup’s current budget, then their equity should be proportionately lower. And it should go without saying, all employee equity should have a vesting schedule. 

All of that being said, the early employees will of course expect their compensation to move closer to market as the startup raises funds and hits revenue milestones.

In the very early days, employees are often paid more than founders / senior executives.

The further you move away from the founder team, the greater the dilution of a person’s commitment to the “mission” of the startup; and that means more cash to keep them committed.  For that reason, at pre-seed and seed stage, it is not uncommon for *true* employee hires to actually be earning more, from a cash perspective, than the founder CEO; obviously with substantially lower equity ownership.

After a decent-sized seed round (and certainly Series A), it becomes a lot rarer for the CEO to not be the highest cash earner on the roster.

For more info on what founders are typically able to pay themselves at the various stages, see: Founder Compensation: Cash, Equity, Liquidity.

Don’t over-optimize for market data.

When you reach post-Series A or Series B, it can be helpful when hiring people to obtain hard data on what’s “market” for a certain position, and use that data in negotiations. There are some good services to help with that.

But at very early stages, everything is highly contextual. I’ve seen teams where everyone is making almost nothing. I’ve seen situations where the founder CEO is making nothing, and their lead developer is making six figures. I also see everything in-between. It all depends on the relationships and context. Maybe ask around if you need to, or do some AngelList Jobs perusing, but don’t put too much faith in the value of broad market data for your pre-seed or seed stage startup’s hiring needs.

Employment laws and taxes are not a place to move fast and break things.

Finally, as much as I appreciate keeping things lean, moving fast, and skirting the rules where the costs are low, realize that violating laws around employee compensation and hiring/firing can burn you, badly.

In some contexts, unpaid employee compensation is even recoverable against the Board or executives, outside of the Company. Did you catch that? Let me repeat it for you: failing to pay employees compensation you promise them, or taxes for that compensation, can in some contexts result in personal liability for you, even if the company itself files for bankruptcy.

Take. This. Sh**. Seriously. While I’ve seen more than my fair share of nuclear wars between founders – see: How Founders (Should) Break Up – the deep relationships among founders often allow for more leeway in terms of following/not following the letter of the law. Employees are usually different, and will hesitate significantly less to use every weapon against you if you cross them. Make sure you’re well-advised from the moment you bring on your first *true* hire. 

Checklist for choosing a Startup Lawyer

A friend mentioned to me the other day that, as much great content as there is on Startup Law, there isn’t a simple list of things a founder team should assess in choosing their own company counsel. So here it is, leveraging past SHL posts in a distilled form.

Background Reading: Startup Lawyers – Explained.

Are they actually a “startup lawyer”?

The number of lawyers over the years who have attempted to re-brand themselves as startup lawyers – meaning corporate lawyers with a heavy specialization in early-stage technology and venture capital – has gone up significantly. Law has numerous specialties and subspecialties, much like healthcare, and you want to ensure that, if you’re building an early-stage technology company looking to raise outside capital, your main lawyer(s) has deep experience in exactly that.

See: Startups Need Specialist Lawyers. The last thing you want to end up with is a litigator, patent lawyer, or small business lawyer who thinks that, because he stayed at a Holiday Inn Express, he suddenly knows startup law.

Ask for their AngelList profile, or a list of deals they’ve closed in the last 6 months.

Do they have access to other specialist lawyers that you’ll need?

In line with the above, the first lawyer you’ll need is a startup lawyer, but once the business gets going, you’ll quickly need others, including commercial/tech transactions lawyers, tax lawyers, data/privacy lawyers, patent lawyers, trademarks, litigation, etc. They do not need to be under the same firm (and you often benefit if they aren’t), but a serious startup lawyer who represents scaled companies must have direct access to these kinds of specialists to provide responsive counsel to their clients.

A simple “yes, we have access” is not enough. Ask for names, info on how they normally engage, and do your diligence.

Is their infrastructure / cost structure right-sized for what you’re building?

Be realistic about what your company will look like over the next 5 years if things go as planned, and hire a lawyer/firm that can serve that company, without scalability problems. Are you building a narrow app for which a successful exit would be a few million dollars? A solo lawyer would probably be a good fit for you.

Do you legitimately see yourself as on a potential IPO or >$500MM exit track, and targeting a $10-20+MM Series A in a year or two? Law firms that represent “unicorns” may be a good fit for you, even if they’re much more expensive.

Are you realistically on more of a $3-10MM Series A, and $50-300MM exit path; or maybe you’re more interested in scaling on revenue alone? You’re going to get too big for a solo, fast, but “unicorn” firms are probably overkill for you. Try a boutique law firm.

See: When a Startup Lawyer can’t scale and Lies about startup legal fees.

Are they familiar and aligned with the norms / expectations of your likely investors?

In line with the idea of hiring a right-sized law firm, if you’re not on the unicorn track, you will run into problems if you hire lawyers who generally represent (and target) companies who are.

We see this often when, for example, law firms from Silicon Valley represent a tech startup raising local money in, say, Texas or Colorado. Ecosystems of different sizes often have very different norms and expectations, and you can run into cultural or even process conflicts when your lawyers simply don’t speak the same language as your investors, or other stakeholders. The largest deals in the largest tech ecosystems – SV and NYC – have much closer market norms, and smaller/mid-size deals in smaller ecosystems like Austin, Boulder, Seattle, etc. often behave similarly among themselves.

See: The problem with chasing whales.

Are they not conflicted with investors you’re likely to raise money from?

Entrepreneurs, and especially first-time entrepreneurs, lean heavily on their startup lawyer(s) for core strategic guidance in navigating negotiations / issues with their main investors. Ensure that the lawyers you hire do not have deep ties to, or dependencies on, the people who are likely to write you checks, or the lack of true independence of the advice you get can burn you in the end.

See: How to avoid “captive” company counsel. 

Finally, do they “not suck”?

After all of the above, do these folks actually answer their damn e-mails quickly enough? Do they have good technology / processes in place to make your life easier and work efficiently? Do they give real strategic advice, and not make tons of costly mistakes that you end up having to pay for in the long run?

See: Lawyers and NPS.

There are lawyers who will check all of the above boxes, and yet after you talk to their clients, you’ll find that they just suck to work with. Do your homework / research on the more objective checklist items, but in the end never forget to choose lawyers who actually care about doing all the subtle human-oriented things that result in good service.

post-script: A few questions that don’t belong on the checklist:

  • Is the lawyer in my city? – Nothing about local city law applies to startup lawyering. Think regionally, or focus on their client base resembling what you’re building.
  • Can they introduce me to investors? – See: Why I (still) don’t make investor intros.  There are far more effective ways to get connected to investors than through intros from a law firm.

ICOs and Crowdfunding

TL;DR: Crowdfunding failed at fulfilling its goal of unlocking a massive new source of unprofessional capital for startups. Regulated, fully legally compliant token offerings (not the mostly unlawful ones done historically) may succeed where crowdfunding failed.

I am not going to spend any time in this post explaining or defining ICOs or Crypto. I know most SHL readers are familiar with them and, if not, a quick google search will do the job.

There was a time, I would say between 2016 and some of 2017, during which ICOs/Token Offerings were certainly on our firm’s radar as potential fundraising mechanisms for startups, but we were highly skeptical of their legal compliance; for reasons that the SEC and other regulatory agencies have now made clear. It is safe to assume that the vast majority of crypto tokens today are securities under U.S. law and that, just like a convertible note or SAFE, U.S. companies issuing them need to find some way of staying within the applicable legal boundaries. Forming some offshore entity to try to get around the securities law issues (tax issues are a separate matter) is playing with fire, and don’t expect us to play with you.

On top of the obvious legal issues, our skepticism of ICOs was supported by the fact that most of the teams we saw pursuing ICOs were, shall we say, not the “caliber” we like to work with. It was clear that in the early days the ICO space had an adverse selection problem: putting aside the small number of stellar teams building unicorns with legitimate reasons for being in crypto, the significant majority of the projects pursuing ICOs were simply the rejects of the conventional angel/seed fundraising world.

In other words, my skepticism of ICOs paralleled to a large extent my skepticism of “crowdfunding.” While the pre-sale kind of crowdfunding (Kickstarter, Indiegogo) has clearly been impactful, securities crowdfunding was pitched to the world as opening the floodgates of this vast world of middle class capital just dying to get into hot startups. It didn’t work out that way.

First, the middle class in America is trying hard to afford college, housing, and healthcare, and have some kind of retirement in place. It never was dying to invest in startups; beyond the occasional “man I wish I’d gotten into Facebook” hindsight remark. Second, average investors aren’t stupid, and are well aware that most crowdfunding sites are not full of A-level teams, but are often packed with the teams rejected by professional angel and seed investors. Startup investing in general is extremely high-risk even for professionals. Given the adverse selection issues, it’s orders of magnitude riskier for every-day investors seeing only the bottom 20%. Given all of this, the supply of capital simply isn’t there.

As of today, the impact of non-accredited investor crowdfunding on the general startup ecosystem has been marginal, at best, and I don’t see that changing much in the near future.

But… over the past year or so I’ve come to believe in the possibility that legally compliant (regulated) ICOs/token offerings may have a legitimate shot at realizing crowdfunding’s unfulfilled dreams. Here’s why: 

A. Unlike the average middle class American, the newly created “crypto rich” have (i) significant disposable income and, (ii) from the simple fact that they got into crypto early, tend to be much more tech literate and interested in early-stage projects than the average investor. They trust their ability to judge early-stage technology, and are therefore willing to invest in risky projects.

B. Regulatory agencies, instead of pounding the industry into non-existence by banning everything, have instead taken a more measured approach by going after the most egregious bad actors, but also extending an olive branch to those interested in finding fundraising mechanisms compatible with a valid legal framework.

C. Crowdfunding platforms, eyeing an opportunity to tap a market that actually exists, are pivoting toward supporting ICOs/token offerings that work within the legal framework created by the crowdfunding movement. That framework certainly adds some friction around how the classic wild-west “easy money” ICOs have historically been conducted, but it is significantly more greased (and could be greased further) than conventional startup investing; including “mini IPO” regulations that were previously passed that could allow tokens to be traded openly in a way that doesn’t bust securities laws.

D. The average caliber of teams we see approaching us with an interest in a token offering has gone up significantly. We have a few clients actively working on token offerings fully compliant with securities laws right now.

E. While most token offerings until now have involved utility tokens that actually serve a function in the operation of the company’s technology (which limits the types of companies that can offer them), the infrastructure is being built for “security tokens” that allow almost any asset – including shares in a corporation – to be sold and traded much like utility tokens.

I was quite skeptical of non-accredited “crowdfunding” generally. I was also deeply skeptical of the easy-money ICO boom that made headlines over the past few years. But I’m becoming cautiously optimistic that the infrastructure and demand is coming for a legally compliant ICO/Token Offering wave that could win where crowdfunding lost. The next 2 years will be interesting to watch.