“Founder Friendly”

TL;DR: “Founder friendliness” should mean not being hostile, but also not being submissive, to founders. Good entrepreneurs and advisors know that.

Background reading:

Because we’re known as Startup/VC lawyers who don’t represent VCs (just companies), I often get asked about my thoughts on “founder friendliness.” Occasionally it’s someone inexperienced expecting me to say something totally one-sided, as if “founder friendly” means always giving founders what they want. The truth is, I’ve put my fair share of founders in their place, when appropriate. As I’ve written before, company counsel does not mean founder’s counsel.

Serious lawyers provide counsel, and represent something apart from the preferences of any particular person. They don’t just push paper in whatever direction someone tells them to. Real lawyers know when and how to say “no.”

To me, “friendly” means the opposite of “hostile.” It means respecting a person as an equal, being transparent with them, and strongly taking into consideration their own values, goals, ideas, etc.  But that is very different from spinelessly doing whatever they want you to do. The best founders seek out advisors, including investors, who will provide real, critical input; knowing that a bunch of sycophants will get them nowhere.

Founder Hostile

On the one hand, there is very much a culture among certain venture capitalists that treats entrepreneurs as necessary, but ultimately dispensable, steps toward returns. I have seen it firsthand, and while it exists everywhere, it is directly (negatively) correlated with (i) the number of investors willing to write checks into a particular ecosystem, and (ii) the degree to which entrepreneurs confidentially share information among each other on VC behavior, producing adverse selection issues for the real assholes. You very rarely hear about this on blog posts or twitter, but when the pep rallies and PR-oriented speaking panels come to an end, it is there.

VCs in this category vary in the level of sophistication with which they implement their “founder hostile” strategy.  Most know that playing hardball out of the gate won’t get them the deal, and they prefer more of a “bait and switch” approach where they sing the praises of the entrepreneurs upfront, and then slowly move the chess pieces over time. The moves are identifiable by people who know the game:

  • put “captive” lawyers and advisors in place;
  • avoid providing coaching / training resources to founders;
  • tightly control the recruitment of new executives to phase in loyalists;
  • keep a tight grip on unreasonable budgets so that achieving results is very hard, and failure justifies “necessary changes”;
  • maneuver to prevent competitive funds from putting offers on the table;

In the end, it doesn’t matter what the cap table says; it’s “their” company now.

Founder Submissive

On the other hand, in the most competitive deals and ecosystems, there is a counter-dynamic where VCs compete with each other, essentially, on how much unilateral control they’ll give entrepreneurs. This dynamic is strongest in California. It’s, in part, due to the failure of many VCs to effectively apply basic strategic concepts – like differentiation – into their market positioning. If you’re just another VC/fund with a few connections and ideas among dozens of others, what else can you do but try to be the “easiest money”? The end-result of having these “founder submissive” investors is often immature management teams that aren’t able to effectively scale. VCs with real brands are able to avoid this. 

As I’ve written before, a Board of Directors has fiduciary duties to all stockholders. As you’ll read in many different places, the moment an entrepreneur decides to take on investors, they have to step off the “king” train and focus on growing the pie, and eventually achieving an exit, for everyone.

That being said, under DE law Boards have primary fiduciary duties to common stockholders, insiders and outsiders.  As the largest common stockholders (usually), and those who’ve held the equity the longest, entrepreneurs are extremely important representatives on the Board for fulfilling those duties; whether or not they are in the CEO seat.  We know that preferred stockholders and common stockholders regularly have misaligned incentives.  A truly “balanced” Board will prevent one part of the cap table’s incentives and preferences from overriding those of the others.

“Founder hostile” VCs are problematic because they push for the perspective of institutional investors to override those of all the other constituents on the cap table. “Founder submissive” VCs are equally problematic because they expose the company excessively to founders whose priorities may conflict with the economic interests of the broader stockholder base.

The proper balance is, of course, in the middle; where the VCs with the best reputations operate.  Be transparent about your goals, incentives, and plans. Don’t beat around the bush about your investment horizon, exit expectations, and how you’ll approach executive succession when that time comes. Let the common stockholders, including founders, do the same. No BS or opaque maneuvering. And then work together, knowing that no one has the singular right to override the perspective of the others at the table.

 

SAFEs v. Convertible Notes, updated.

TL;DR: Still not seeing a ton of SAFE adoption, albeit a slight uptick. Convertible Notes still dominate outside of SV and pockets of LA/NYC.

Background Reading:

A recurring theme of this blog is that the advice and strategy you take for fundraising needs to be right-sized and contextualized for where you are located. Because by an order of magnitude Silicon Valley has the most startups, VCs, large exits, etc., the majority of the content available online for founders to educate themselves comes from Silicon Valley. A lot of it is very good, but a lot is also totally inappropriate for a founder in, say, Austin, Boulder, or Atlanta (or markets like them); where the dynamics between entrepreneurs and investors are fundamentally different.

Context matters. 

Y Combinator created the SAFE (Simple Agreement for Future Equity) a few years ago as an “upgrade” on convertible notes. It is a well-drafted document, but when you get down to brass tacks, a SAFE is basically a convertible note without interest or a maturity date. Purely from the perspective of founders, it is a fantastic deal. Most convertible notes are already slimmed down in terms of investor rights, and SAFEs effectively strip those rights down even further by removing the “reckoning day” of maturity.

The problem with SAFE usage for “normals” outside of Silicon Valley (and perhaps Los Angeles and NYC, which mirror SV much more so than other markets) is that it reflects the unique market leverage of the people who produced it: Y Combinator. Apart from YC itself, Silicon Valley already is an aberration among startup ecosystems. The concentration of seed funds and venture capitalists in such a small geographic area creates a level of hyper competition that is not even close to what is seen anywhere else in the world. And Y Combinator is, to some extent, the Silicon Valley of Silicon Valley. It takes competition among investors to an even higher level, where many founders can effectively dictate terms.

It’s therefore unsurprising that YC produced a security that effectively tells investors “Here are the terms. Thank you for your money. Talk soon, when we get around to it.” That’s a slight exaggeration, but it’s not entirely off base from how many investors I run into view SAFEs. And it should therefore also be unsurprising when investors outside of that environment respond with “Excuse me?”

So when founders I work with ask me if they should consider using SAFEs, my viewpoint can be summarized as follows:

  1. Only if you believe that all of your seed investors will accept them. Because if only your earliest investors (most trusting/risk-tolerant) will take them, they are not going to be happy about later investors getting real debt, and you will have to re-do everything.
  2. In 99% of cases, you’re better off just asking for a convertible note with (i) a low interest rate, and (ii) a long maturity date (24-36 months). For all intents and purposes, it is effectively the same thing, but will keep “normal” angels investing in “normal” companies more comfortable.

A conventional convertible note with a low interest rate and reasonable maturity period represents a balanced tradeoff: give us some trust and freedom to iterate quickly and get to a serious milestone (minimal restrictions), and in exchange we’ll give you a mechanism for holding us accountable if we don’t perform (maturity). A SAFE, however, reflects the expectation that investors should hand over their money and hope for the best. I rarely see angels or seed funds that use a maturity date to actually harm the company, but that doesn’t mean it’s unreasonable for them to expect somprotection if they aren’t getting the kinds of rights (board representation, voting rights, etc.) that equity investors would get.

Know thyself, and thy leverage. 

There is a subculture among certain entrepreneurs that acts a tad self-entitled to investor money; and I’m sure you can guess where that culture originated. I can say that as a lawyer who (deliberately) represents exactly zero startup investors. I always tell my clients, if I detect it, to snap out of it. You won’t win with it. If you aren’t the CalTech/MIT superstar in the room, then don’t take her advice, or follow her lead, on how to get a job. Persistence and hustle work best when combined with self-awareness and humility.

I have seen a slight uptick in SAFE usage, but it’s almost just a blip. Convertible notes still dominate, and for understandable reasons.  They’re investors, not philanthropists to your entrepreneurial dreams. See “Angel Investors v. ‘Angel’ Investors” for understanding how many Angels you encounter actually think about startup investing.

The truth is that SAFE culture, which reflects YC culture, is a broad reflection of the binary dynamics of how Silicon Valley approaches fundraising; touched upon in Not Building a Unicorn. Billion or bust. If you haven’t made things happen and my seed investment hasn’t 5x-ed into your Series A, I’m already moving on and focusing on the unicorn in my 30-company portfolio.

But if you’re not building a unicorn, that’s not how your investors think, and you need to act accordingly.

Maturity about Maturity. 

So if the idea of your convertible notes maturing scares you, well, entrepreneurship is scary. First, ensure it’s long enough to give you a legitimate, but reasonable amount of runway to make things happen. If your angels have given you 3 years to convert their notes, that’s a very fair amount of runway. I personally think less than 24 months is usually unreasonable, given the timeline most companies need to get real traction and attract more capital.

Second, there are mechanisms you can build into a convertible note to further help with hitting maturity. The most common and important is ensuring a majority of the principal can extend maturity for everyone; so if enough of your early investors still support you, you get more time. Extensions are very common.

Automatic extension, or conversion into common stock, upon achieving certain milestones – for example, upon raising an additional convertible note round, or hitting certain metrics – are another good option. Lawyers specialized in early-stage financing can help here.

The people who are the best at sales are also the best at getting into the heads of their buyers, and understanding their concerns. The same is true for founders “selling” to investors. It is not unreasonable for investors in high risk startups to expect some downside protection in the highest risk segment of a startup’s history, and that’s why so many angels and seed funds reject SAFEs. Give them what they want, while getting what you need. And don’t spend too much time listening to people who are experts in a world that you don’t live in.

Transparency, Risk, and Failure

TL;DR: In the very uncertain, high risk environment of an early-stage startup, the most successful founders are extremely good at practical risk mitigation. One of the most important forms of risk mitigation is to build a culture of transparency and honesty at all levels of the company; meaning people say what they’re thinking/feeling, and do what they say they’re going to do. No politics. No surprises.

Background Reading:

One of the biggest myths, in my experience, about successful entrepreneurs is that they are generally risk-seeking, risk-loving, uber-optimists who fearlessly run right into unknown unknowns, expecting things to turn out for the best. It’s just false. My word for the person I just described is “idiot.”

Yes, they are optimists, but what they’re often optimistic about is their risk mitigation skills. To an outsider, they may look fearless and indifferent toward risk. But in their mind they’re constantly analyzing risks, including seeing risks that others don’t see (the paranoid survive), and actively taking steps to address them.

In the early days of a company, without a doubt one of the largest sources of risk is, to put it simply, people. Co-founders, employees, consultants, commercial partners, investors, advisors, etc. Before your company has become a fully greased and well-running machine with an established brand, market presence, and gravitational pull, it is, in large part, a highly fragile vision of the future; dependent, to the extreme, on a handful of people and their ability to execute toward a common goal. It takes just one “bad” person, or decision, or accident, in that group to bring it all crashing down. 

Each person carries around risks; either risks that originate from them, or risks they know more about than others. Examples:

Co-founders: Are they truly satisfied with their equity stake/position at the company, and committed to the cause? Do they feel like the CEO is the right person for that position, and making the right decisions, with the right input?

Employees: Are they happy with their compensation/position, given the resources and stage of the company, or are they already planning an exit? Do they feel like the company is moving in the right direction? Are there behaviors/activities going on at the company that the C-suite should know about, but maybe aren’t aware of?

Commercial partners: Are their intentions the ones they’ve actually stated at the negotiation table? If circumstances or incentives change, will they try to preserve the relationship or at least reasonably negotiate a fair break, or will they try to maximize one-sided gains?

Investors: Do they truly believe the current executive team can execute effectively at the current stage of the company, and if not, have they communicated their thoughts to the team? If they are planning for changes, are they letting the team know, so the process can be open and balanced?

By working with people with a heavy bias toward transparency and honesty, you maximize your visibility into risks, which maximizes your ability to proactively address them. Risks that take you by surprise are 100x more deadly than those you can see coming. But what does transparency mean, and how do you find it?

Transparency means:

  • Saying what you’re truly thinking, feeling, and planning to do, instead of what may be optimal for you to convey in a short-term self-interested sense;
  • Even if you’re not the best at verbalizing your thoughts/feelings, conveying them in other non-verbal ways – transparent people tend to show more emotion. The perpetually sterile, calculated, always careful not to speak off-script demeanor that all of us encounter in business is the opposite of what you should look for.

It does not mean blurting out your thoughts at random without proper self-awareness or sense of propriety, or conveying more information than specific people really need to know. The “radical transparency” I’ve read about in some circles – for example, the idea that everyone needs to know everyone’s compensation – in my mind is asking for trouble. There is always information that the CEO has that should be heavily filtered before it gets to employee #200, and visa versa. But a thoughtful, respectful, durable culture of transparency ensures that the right information flows to the right people who truly need it and can benefit from it. 

It also does not mean always being the nicest, most agreeable person in the room.  Sycophants and glad handers may keep the peace, but at a cost of smothering you with so much bullshit that you can’t hear the things you really should be hearing. There is an art to conveying uncomfortable information, and people can be trained/coached for it, but it will always still be somewhat uncomfortable.

I’ve been very happily married for almost 10 years (this December!), but I’ll be damned if I ever tell you that hasn’t come with conflict. If anyone ever tells me that they’re in a serious, complex relationship that is completely conflict free, I hear one word in my mind, and one word only: divorce. Small conflicts prevent massive ones. If there is honesty and transparency, there will be some conflict, and it will make you stronger. 

And of course, if you’ve struggled to find, attract, and retain people who are honest and trustworthy, a very good place to analyze the problem is a mirror. Company culture is very much a reflection of the people who started it. Be the person you expect others to be.  And if you want transparency, don’t penalize people when they act accordingly.

At the end of the day, transparency is the foundation of trust in relationships, and the data is universally clear that virtually nothing helps teams, businesses, and broader networks thrive (and minimize serious conflict) better than trust. In the world of startups, there are hundreds of sources of potential failure that you are constantly battling against, and that you can’t do a lot about. Very very few risk mitigation tools are in as much of the founders’ control as the culture they implement in their team from Day 1.

Do the intentional, hard work up-front to recruit/engage people who say what they’re thinking, and do what they say they’re going to do, and you’ll maximize your chances of survival. You’ll also keep your legal fees way lower in the process.

The problem with chasing whales.

TL;DR: Always trying to work with “the best” people in any category – investors, advisors, accelerators, service providers – can result in your company getting far less attention and value than if you’d worked with people and firms who were more “right sized.”

Background reading:

Founders instinctively think that pursuing the “best” people in any category is always what’s best for their Company. Need VC? Try to get Sequoia or A16Z. Need an advisor? Who advised the founders of Uber and Facebook? Need an accounting or law firm? Who do the top tech companies use?

The problem with this approach is that it confuses “product” value delivery – where what you get is mass produced and therefore uniform – with “service” value delivery – which is heavily influenced by the individual attention you are given by specific people of varying quality within an organization.

If you buy the “best” car, it doesn’t matter whether you’re a billionaire or just comfortable, you paid for it, and you get effectively the same thing. Buying the “best” product gets you the best value.

Don’t chase whales if you’re not a whale.

However, if you hire the “best” accounting firm, that firm will have an “A” team, a “B” team, and possibly even a “C” team within it. That is a fact. Every large service-oriented organization has an understanding of who their best clients are, and allocates their best people and time to those clients, with the “lesser” clients often getting terrible service. To get the “best” service from one of the best service organizations, you need them to view you as one of their best clients; otherwise you’re going to get scraps.

To get real value from a “whale,” you need to be a whale yourself. Chase whales (the absolute best people in their category) without having the necessary weight to get their full attention, and they’ll just drown you. In many areas of business, getting the full attention and motivation of someone who is great, but not olympic medal level, can be far better for your company than trying to chase those who may take your money or your time, but will always treat you as second-class, or a number. I call this hiring “right sized” people. 

Firms matter, but specific people matter more.

I use this reasoning a lot in helping founders work through what VC funds they are talking to. The brand of the firm matters, but you want to know exactly what partners you are going to work with, and you want to talk to companies they specifically have worked on, to understand how much bandwidth you’re going to get. There is a wide range of quality levels between partners of VC firms, and going with someone local who will view you as their A-company and give you the time you need can be much more important than being second or third fiddle at a national marquee firm.

We also use this reasoning in explaining to clients how we see ourselves in the legal services market. We do not work for Uber or Facebook, and we are not even trying to work with the future Ubers or Facebooks, or other IPO-seeking companies of the world. The very high-growth, raise very large rounds in pursuit of an eventual billion-dollar exit via acquisition or IPO approach is suited for certain kinds of law firms and practices designed for those kinds of companies. Most of those firms are in Silicon Valley, because most of those companies are in Silicon Valley.

There was a time when every tech ecosystem looked to Silicon Valley for guidance, and did everything it could to get its attention. Now a lot of people outside of the largest tech ecosystems have come to realize that, in fact, Silicon Valley isn’t really that interested in them; and thats ok. Those SV funds, firms, and people are whales looking for other whales. That is totally fine – the world needs whales, but the rest of the world needs help too.

If you are a unicorn, or legitimately are viewed as on the track to be a unicorn, then working with VCs, advisors, law firms, and other service providers that cater to unicorns will get you great service by ensuring you are working with the top quality individual people within them.

Hire within your class.

However, a recurring trend we’ve seen in many areas, including legal, is companies initially hiring one of the national marquee firms because they wanted the “best,” only to realize that not only were they working with that firm’s B-player or C-player, but even getting responses to e-mails from a specific person was a matter of days and even weeks. By “right sizing” their service providers, they fixed the problem.

In short: be honest with yourself about what you’re building, and then be honest about whom you should build it with. If a $75MM or $100MM exit would be a true win for you, that is nothing to apologize for. The world needs those kinds of companies; lots of them. But to avoid a nightmare, align yourself with people truly “right sized” for a company on that kind of track.

When hiring any firm in any service industry, ask who exactly your main contact will be, and talk to the clients/portfolio companies of that specific person. Does their client base look a lot like the company you’re building? How responsive are they to you in your initial communications? That can tell you a lot about what level of bandwidth/priority you’re going to get from them.

For the kinds of strategic relationships that really matter, where the quality of advice depends on specific people and the attention they’ll give you, focus on “right sized” people; not just engaging the “best” firms. Don’t get pulled under water by chasing a whale that isn’t really that interested in you.

Tiered Valuation Caps

TL;DR: Using a “tiered” valuation cap structure in a convertible note or SAFE can provide flexibility that bridges the gap between (i) what founders expect their company to be worth in the near future, and (ii) what investors are comfortable accepting now.

Background Reading:

This post assumes that, for a company’s early seed round, they’ve decided to use convertible notes or SAFEs; because the majority of startups do. SAFEs and Notes are optimized for speed and simplicity, with a cost of future uncertainty and dilution. They have their downsides, which are discussed in some of the above links.

Convertible notes/SAFEs are usually executed around times of maximal uncertainty for a company; the very early stages. For that reason, pegging an appropriate valuation can be very difficult for investors. The valuation cap has evolved into a proxy for valuation, even though by definition it is in fact a cap on valuation, and if things go south, the actual valuation at which the security converts goes downward with it.

Traditional valuation caps: downside protection for investors. No upside for founders.

When you think about it, though, the valuation cap structure is a bit one-sided. If things go badly, investors get a lower price. But what if things go very well very quickly? Under the standard approach, even if the outlook for the company dramatically changes (positively) within 1 month post-closing (which at seed stage can happen), the valuation cap is what it is.  Normally this is accepted as given, much like how when you close an equity round, the price you got is the price you got.

However, there are circumstances in which founders know there are potential serious milestones on the short-term horizon that would dramatically influence valuation, but they need to close their seed money now. Obviously, smart investors reward results, not promises; so they’re not going to budge on valuation just because the founders are confident they’ll hit a milestone in a month. Tiered valuation caps are a useful mechanism for bridging this uncertainty gap in seed rounds.

Tiered valuations can bridge the uncertainty gap, and give companies some valuation upside. 

A tiered valuation cap would look something like this (language simplified because this isn’t an actual contract):

  • If the Company achieves [X milestone], the valuation cap will be [A];
  • If the Company does not achieve [X milestone], the valuation cap will instead be [B].

Convertible notes and SAFEs are optimally designed for providing this kind of valuation flexibility. It is much more complicated to implement something like this in an equity round, which is why you almost never see it. Also, there are a number of other nuances around valuation caps that are too “in the weeds” to get into in this post, but that, depending on the circumstances, may make sense for a company. One example would be, if a certain important milestone is hit, turning the valuation cap into a hard valuation.

Standardization v. Flexibility

Something related to the above that is worth briefly discussing is why, despite there being many logical circumstances in which deviation from “standardized” startup investment structures makes total sense and would be acceptable to both sides of the table, founders are often encouraged to “move fast” and stick to the usual docs.

There is a mindset in parts of the startup world – and very much coming out of Silicon Valley – that promotes the idea that startup legal documentation should all be standardized and closed as fast as possible, with minimal fuss. The PR story behind that trend – the way it gets sold – is that it’s about saving companies money. Don’t bother actually talking to counsel on these “standard” things; you’ve got to stay lean and focus on “more important” stuff.  Sounds legit.

Of course, every heavily promoted story has incentives behind it. Who benefits from saying “nevermind with the lawyers; just close quickly?” Software companies selling you the automated tool that relies on inflexible standardization, for one part. Savvy investors (repeat players) who have a 10x better understanding (than you do) of what the documents actually say, for another. As I wrote in “How to avoid ‘Captive’ Company Counsel“, it is very amusing when, during high-stakes negotiations where small variances in terms can have multi-million dollar long-term implications, certain investors take such a keen interest in “watching the legal bill.”

Everyone’s favorite sucker is the guy who shoots himself in the foot, and then sings a song about it.

Always always remember: if you’re doing this for the first time, and someone else has done it dozens, the “let’s get this done quickly” mindset is definitely saving someone money; but it’s usually not you. If a few discussions with counsel could result in a 25% higher seed valuation, you tell me if that is “wasted” legal fees. 

There are times when the standard terms make sense, but there are a lot of times when they don’t. Companies not fully on the “move fast and break things” train should slow down and take advantage of some customization when it could have a serious impact on dilution. Good investors who don’t view you as just another number in their “spray and pray” portfolio won’t criticize you for doing so.

ps. for the best companies, the “standard” valuation in an accelerator’s convertible note/SAFE is almost always negotiable.