Post Category → Accelerators

Trust, “Friendliness,” and Zero-Sum Startup Games

Background reading: Relationships and Power in Startup Ecosystems

TL;DR: In many areas of business (and in broader society) rhetoric around “positive sum” thinking and “friendliness” is used to disarm the inexperienced, so that seasoned players can then take advantage. Startups shouldn’t drink too much of the kool-aid. Smile and be “friendly,” but CYA.

An underlying theme of much of my writing on SHL is that first-time founders and employees of startups, being completely new to the highly complex “game” of building high-growth companies and raising funding, are heavily exposed to manipulation by sophisticated repeat players who’ve been playing the same game for years or even decades. There are many important tactical topics in that game – around funding, recruiting, sales, exits – all of which merit different conversations, but the point of this post is really a more “meta” issue. I’m going to talk about the perspective that should be brought to the table in navigating this environment.

A concept you often hear in startup ecosystems is the distinction between zero-sum and positive-sum games. The former are where there’s a fixed/scarce resource (like $), and so people behave more competitively/aggressively to get a larger share, and there’s less cooperation between players. In positive-sum games, the thinking goes, acting competitively is destructive and everyone wins by being more cooperative and sharing the larger pie. Sports are the quintessential zero-sum game. Someone wins, and someone loses. Capitalism is, broadly, a positive-sum game because in a business deal, both sides generally make more money than if the deal had never happened.

The reality – and its a reality that clever players try to obscure from the naive – is that business relationships (including startup ecosystems) are full of both positive and zero-sum games, many of which are unavoidably linked. It is, therefore, a false dichotomy. In many cases, there are zero-sum games within positive sum games. In fact, rhetoric about “positive-sum” thinking, friendliness, trust, and “win-win” is a common tactic used by powerful players to keep their status from being threatened.

For a better understanding of how this plays out in broader society (not startup ecosystems), I’d recommend reading “Winners Take All: The Elite Charade of Changing the World” by Anand Giridharadas, who deep-dives into how, in many cases, very wealthy and powerful people (i) on the one hand, fund politicians/legislation that cut taxes and funding for democratically solving social problems while (ii) simultaneously, spending a smaller portion of the saved money on “philanthropic” or “social enterprise” initiatives aimed at addressing those same social problems, but in a privatized way where they are in more control. The latter of course comes with a hefty share of feel-good messaging about “giving back” and helping people.

The net outcome is that those powerful players direct discussion away from the full spectrum of solutions that may require addressing some unavoidable zero-sum realities, and instead get society to myopically focus on a narrower segment of purportedly “win-win” options that don’t actually threaten the power and status of the elite priesthood. There is much room to debate the degree to which Giridharadas’ perspective is an accurate representation of American philanthropy/social enterprise, but anyone with an ounce of honesty will acknowledge that it is definitely there, and large.

Sidenote: Anand is a clear hardcore socialist, and I’m not exactly a fan, but life is complicated and I’ll acknowledge when someone makes an accurate point. An enormous amount of “save the world” rhetoric is just kabuki theatre to maintain power and keep your money.

While the details are clearly different, this dynamic plays out all over startup ecosystems. They are full of influential market actors (accelerators, investors, executives) acting as agents for profit/returns driven principals, and in many cases legally obligated to maximize returns, and yet listen to much of the language they use on blogs, social media, events, etc. and an outsider might think they were all employees of UNICEF. This is especially the case in Silicon Valley, which seems to have gone all “namaste” over the past few years; with SV’s investor microphones full of messages about mindfulness, empathy, “positive sum” thinking, and whatever other type of virtue signaling is in vogue.  Come take our money, or join our accelerator, or both. We’re such nice people, you can just let your guard down as we hold hands and build wealth together.

Scratch the surface of the “kumbaya” narratives, and what becomes clear is that visible “friendliness” has become part of these startup players’ profit-driven marketing strategies. With enough competition, market actors look for ways of differentiating themselves, and “friendliness” (or at least the appearance of it) becomes one variable among many to offer some differentiation; but it doesn’t change any of the fundamentals of the relationship. Just like how “win-win” private social enterprise initiatives can be a clever strategy of the wealthy to distract society away from public initiatives that actually threaten oligarchic power, excessive “friendliness” is often used by startup money players to disarm and manipulate inexperienced companies into taking actions that are sub-optimal, because they lack the perspective and experience to understand the game in full context.

With enough inequality of experience and influence between players (which is absolutely the case between “one shot” entrepreneurs and sophisticated repeat player investors) you can play all kinds of hidden and obscure zero-sum games in the background and – as long you do a good enough job of ensuring no one calls them out in the open – still maintain a public facade of friendliness and selflessness. 

As startup lawyers, the way that we see this game played out is often in the selection of legal counsel and negotiation of financings/corporate governance. In most business contexts, there’s a clear, unambiguous understanding that the relationship between companies and their investors – and between “one shot” common stockholders v. repeat player investors – has numerous areas of unavoidable misalignment and zero-sum dynamics. Every cap table adds up to 100%. A Board of Directors, which has almost maximal power over the Company, has a finite number of directors. Every dollar in an exit goes either to common stock (founders/employees) or investors. Kind of hard to avoid “zero sum” dynamics here. As acknowledgement of all this misalignment, working with counsel (and other advisors) who are experienced but independent from the money is seen, by seasoned players, as a no-brainer.

But then the cotton candy “kumbaya” crowd of the startup world shows up. We’re all “aligned” here. Let’s just use this (air quotes) “standard” document (nevermind that I or another investor created it) and close quickly without negotiation, to “save money.” Go ahead and hire this executive that I (the VC) have known for 10 years, instead of following an objective recruiting process, because we all “trust” each other here. Go ahead and hire this law firm (that also works for us on 10x more deals) because they “know us” well and will help you (again) “save money.” Conflicts of interest? Come on. We’re all “friendly” here. Mindfulness, empathy, something something “positive sum” and save the whales, remember?

Call out the problems in this perspective, even as diplomatically as remotely possible, and some will accuse you of being overly “adversarial.” That’s the same zero-sum v. positive-sum false dichotomy rearing its head in the startup game. Are “adversarial” and “namaste” the only two options here? Of course not. You can be friendly without being a naive “sucker.” Countless successful business people know how to combine a cooperative positive-sum perspective generally with a smart skepticism that ensures they won’t be taken advantage of. That’s the mindset entrepreneurs should adopt in navigating startup ecosystems.

I’ve found myself in numerous discussions with startup ecosystem players where I’m forced to address this false dichotomy head on and, at times, bluntly. I’m known as a pretty friendly, relationship driven guy. But I will be the last person at the table, and on the planet, to accept some “mickey mouse club” bullshit suggesting that startups, accelerators, investors, etc. are all just going to hold hands and sing kumbaya as they build shareholder value together in a positive-sum nirvana. Please. Let’s talk about our business relationships like straight-shooting adults; and not mislead new entrepreneurs and employees with nonsensical platitudes that obscure how the game is really played.

Some of the most aggressive (money driven) startup players are the most aggressive in marketing themselves as “friendly” people. But experienced and honest observers can watch their moves and see what’s really happening. Relationships in startup ecosystems have numerous high-stakes zero-sum games intertwined with positive-sum ones; and the former make caution and trustworthy advisors a necessity. Yes, the broader relationship is win-win. You hand me money or advice/connections, and I hopefully use it to make more money, and we all “win” in the long run. But that doesn’t, in the slightest, mean that within the course of that relationship there aren’t countless areas of financial and power-driven misalignment; and therefore opportunities for seasoned players to take advantage of inexperienced ones, if they’re not well advised.

Be friendly, when it’s reciprocated. Build transparent relationships. There’s no need to be an asshole. Startups are definitely a long-term game where politeness and optimism are assets; and it’s not at all a bad thing that the money has started using “niceness” in order to make more money. But don’t drink anyone’s kool-aid suggesting that everything is smiles and rainbows, so just “trust” them to make high-stakes decisions for you, without independent oversight. Those players are the most dangerous of all.

Negotiation is Relationship Building

TL;DR: Aggressive investors, especially early-stage ones, hate it when you negotiate with them; but they’ll often mask their frustration by accusing you (and your lawyers) of nit-picking and not staying (air quotes) “standard.” It shouldn’t take a ton of explaining as to why that’s the case, but the truth is that there are very few ways to get to know your investors better than through negotiation of a financing or a difficult Board-level issue. People can say any number of nice-sounding things over beers, or in casual conversation, but the truth comes out when you ask someone to commit to it on paper.

As I’ve written in several prior posts, including Relationships and Power in Startup Ecosystems, the world of startups is quite unique given the high inequality of experience and power between the business parties involved. In most business contexts, you’ve got relatively seasoned executives on both sides negotiating with each other. But in the startup context, you often have highly-networked, experienced, wealthy, and influential investors negotiating with a first-time entrepreneur who is ‘unequal’ in experience to the investor in every category. Obviously, investors enjoy this environment. It gives them a significant amount of control, and offers numerous opportunities to push things in the direction that they prefer… unless of course when annoying negotiations, or experienced outside advisors, get in the way.

But then again, many startup investors are constrained in the ways that they can express frustration when they don’t get what they want. Because many of them have come to rely on public marketing personas – via blogs, social media, etc. – of “friendliness,” if they pound the table and simply tell a founder to shut up and sign the docs, word will get around; hurting their brand and pipeline. It’s too visible, and too easy for the entrepreneur to quickly react to. So they need to be smarter and more subtle about how they can constrain negotiations, and keep the playing field slanted in their favor, but in a way that’s more difficult to detect.

In the early stages of a startup, there are very few advisors that a set of entrepreneurs will encounter with deeper negotiation experience, and ability to level the playing field between startups and their investors, than a seasoned startup lawyer who is independent from the money. They often see dozens of financings a year, across numerous geographies and industries, and have also observed the full playbook of power games that aggressive investors can play on Boards, deals, and cap tables. This makes them important “equalizers” in the founder-VC dynamic, and it’s precisely why you constantly see the investor community engaging in strategies to gain influence over, or otherwise silence, the legal community.

Behind the well-spun rhetoric about “saving” founders legal fees, and helping “streamline” things for startups, is in many cases a strategy by influential investors to remove independent counsel from the negotiation table, because in doing so investors can fully enjoy the advantages of how much more experienced and influential they are than first-time founders & employees. Lawyers heavily dependent on the investor community for referrals have been more than happy to collude with the money in this scheme, at the expense of common stockholders who, as a result, are deprived of real strategic counsel.

Imagine for a second that Apple and Google – two equally powerful companies with equally seasoned executives – are negotiating a high-stakes deal with each other. Now imagine if someone at Google suddenly tried to tell Apple what lawyers they should be using to negotiate the deal. You would immediately expect a response along the lines of, “You must be joking, right?” What if Apple tried to tell Google how much they should spend on their advisors in negotiating/structuring the deal? Again, same reaction, which you would expect in the vast majority of business contexts and industries. Seasoned business executives have a very keen understanding of incentives, and don’t react lightly to someone reaching across the table out of some pretense of being “helpful.”

And yet this sort of behavior is extremely common in startup ecosystems. Why? The stated reason from the investor community – the “spin” if you will – is that they’re looking out for the entrepreneur. Can’t let those loudmouth, over-billing lawyers take advantage of founders, right? It’s much better if investors, surely out of good will and generosity, reach across the table and ensure things are being done “properly.” While in almost any other business context this would be seen as obviously self-interested and patronizing infantilization, the experience and power inequality that is unique to startup ecosystems enables investors to take on a paternalistic “this is how things should work” stance in high-stakes discussions with common stockholders. Few things irritate those investors more than hearing an experienced lawyer respond unapologetically, “here is how things actually work.”

When there’s no one on the other side of the table to push back on behalf of the inexperienced players (the common stock), with credible experience and expertise, the experienced money has an easy time pushing important discussions, negotiations, and many other important company matters in the direction that they want. The following are the most common strategies that aggressive (and smart) startup investors will use to minimize negotiation, and therefore get what they want, while still maintaining an appearance of non-aggression:

A. Get startups to use “captive” lawyers.

I’ve written extensively about this already. See How to avoid “captive” company counsel and When VCs “Own” Your Startup’s Lawyers.  By emphasizing how much money will be “saved” by using “familiar” lawyers, entrepreneurs are often pushed to use lawyers who ultimately are controlled by the money. Those lawyers have every reason to keep their mouth shut in negotiations, because the money has heavy influence over the lawyers’ client pipeline.

B. Shrink the legal budget, to get lawyers to stay quiet. 

Negotiation takes time. Because of their experience, VCs often know how to negotiate deals themselves, without much need for lawyer involvement; certainly term sheets and Board issues. But first-time entrepreneurs and startup employees (common stockholders) are in the opposite situation. They rely heavily on outside advisors to walk them through terms and negotiate, and that requires a budget.

As we’ve said above, aggressive VCs hate negotiation. They know what they want, and they’re accustomed to being able to pressure founders into getting it. Any extra time negotiating (supported by counsel) means shrinking the power inequality between the VC and the entrepreneurs, so a great way to shrink that time is to shrink the budget. To the common stockholders, the extra time may be totally worth it, given how high-stakes and permanent the terms being negotiated are. But by saying something like “this deal shouldn’t cost more than $X” in legal fees, the investor has found an indirect way to get the lawyer to shut up in negotiating against… whom? The investor himself.

Flat fees are also a great tool for VCs to get your lawyers to rush their work. Under a flat fee model, the less your lawyer negotiates/advises you, the more of the fee they pocket while being able to do work for someone else. Less work means more ROI. Watch incentives.

If investors have opinions about how much to spend on legal in negotiating with a third-party, that’s great. Founders can often get good info from other experienced entrepreneurs as well. But the fact that certain investors are dictating to startups how much they should spend in negotiating against them is a sad joke. When a VC with a prominent blog throws into a post that a financing shouldn’t cost more than $X, process the incentives behind the statement. I bet he also has a list of preferred firms who’d be more than happy to “fit” within the budget for you. By convincing founders to view the selection of legal counsel as simply about who can do it faster/cheaper, investors create a race to the bottom where the winner just stays quiet and does what the investor wants. When VCs try to “save” you fees on a financing or serious Board issue, what they’re really doing is saving themselves from having to negotiate.

Investors should acknowledge their conflict of interest, stop treating startup teams like children, and keep their opinions on the legal budget to themselves.

C. Scare founders into rushing negotiations, for fear of losing the deal. 

“Time kills deals.” “Don’t lose momentum.” “Close fast and get back to the business.” Who hasn’t heard this over and over again from the investor community?

Sure, taking too long could kill a deal. But signing a terrible deal, or wedding yourself to bad actors, kills companies, or common stockholders. The number of times I’ve seen a deal actually die because founders chose to slow down enough to understand the structure, and move it to a better place for the common stock, is near zero. Remember the title of this post. Negotiation is relationship building. The point of negotiation isn’t just to get better terms. It’s also to observe the reactions of your potential investors when you ask them for something; because those reactions will tell you far more about whom you’re really working with than blog posts and tweets will. 

When you push back (respectfully), you are signaling not only what you care about, but the level of backbone they can expect from you in the on-going relationship. You’re setting the “terms” not just of a deal, but the dynamics of the relationship itself. Are you easily intimidated? Can you handle a high-pressure discussion? CEOs need to be able to. Your behavior in interacting with your lead investors heavily influences their judgment of how effective you’ll be in other difficult discussions with employees, commercial partners, etc.

I can’t tell you how many times we’ve seen founders rush through deals, only to find that once the ink has dried, the person they are now in a long-term and permanent relationship with is very different from what was portrayed pre-signing.

D. Fabricate “standards” and exert political/social pressure on startups to use them. 

See: The Problem with “Standard” Term Sheets (including YCs). Standards can be great, when drafted and implemented in a way that allows all sides to voice their perspective. They can offer a common starting point for negotiations. The problem with so-called “standards” in startup ecosystems is that, given the above-discussed power inequality, investors are the ones unilaterally setting the standards; and they then use their political influence to spread them across a market, creating social pressure to use them.

One influential investor creates a so-called “standard” document, without input from lawyers who are independent from the investor community, and publishes it on their well-followed blog. Other investors with strong social media followings, liking the “standard” because of how it’s written for them, then start sharing, liking, re-tweeting, blogging, and adopting the “standard” on their deals; emphasizing how much money everyone will “save” from keeping it “standard.” Couple that with the leverage investors have worked to build over startup lawyers, who can be pressured into adopting those “standards,” and then have the investors squeeze the legal budget tight to minimize negotiation, and you can see how groups of coordinated, high-profile investors can indirectly force an ecosystem to use their biased “standards” without negotiation.

Think about all the most well-followed blogs, podcasts, etc. that founders go to for advice on funding. How many of them are not published by investors? What about the most followed twitter profiles? VCs are repeat players. They have the time and resources to build strong networks and distribution platforms for disseminating their preferences in ecosystems, maintaining heavy influence over the microphones and amplifying narratives that suit their interests. You really think they’re all doing it to save founders money? First-time entrepreneurs and early employees, who are heads-down building their companies (not blogging and tweeting about startup fundraising and governance) aren’t coordinated or influential enough to counterbalance the dynamic. And if they even tried to speak out, the investor community has more than enough ways to retaliate and silence them.

This is why the info you hear offline (and privately) in ecosystems is often starkly different from what you hear online.

Then when a first-time entrepreneur – a “one shot” player without much ecosystem leverage – is advised to question the standard, a VC can use the whole investor-dominated ecosystem backdrop to exert pressure. “What? This is “standard.” X, Y, and Z funds all use it. Why are you nit-picking? Time kills deals.”

There’s a very manipulative game in how aggressive investors apply this pressure, often playing on the entrepreneur’s self-image. Founders want to see themselves as bold risk-takers, and there’s often a level of insecurity in interacting with seasoned investors, who might be former (and successful) entrepreneurs themselves. By saying something like “This is nit-picking. Why are you wasting time?” the investor is subtly saying “I thought you were a real entrepreneur. A real entrepreneur would close this deal.” It’s an extremely clever way to use the imbalance in the relationship to get the startup to stay quiet, and hand the investor control; not that distant from the kind of social pressure-driven power games you might encounter in a middle school.

There is a “range” of acceptable negotiation. 

Imagine two lines on a negotiation table, with space in-between them. Move past the farther line, and you are over-negotiating, and really nit-picking over things that are unlikely to matter. If you really feel like the lawyer you are working with is pushing you in this direction, then your failure started in hiring the wrong lawyer. Very young, inexperienced lawyers may try to over-state their skillset, and impress you with endless comments. But experienced Partners with successful practices have neither the time nor the desire to play games with nonsense. You don’t build a strong client base by killing deals. Competition among reputable firms, and reputation among entrepreneurs, are constraints on startup lawyers who might want to run up a bill unnecessarily.

So beyond that farther line, you’re over-negotiating. But before the closer line, you are rushing the deal. You’re naively allowing a highly misaligned (economically) investor to muzzle negotiations and pressure you to just do what they want. And in doing so, you are solidifying relationship dynamics that will inform how that investor treats you going forward; knowing that with a little pressure, or clever rhetoric, they can make you dance. Your company’s lawyers are there to honestly advise the company on important issues of clear misalignment; not to overly ingratiate themselves to the money.

Within those two lines is a range of acceptable negotiation. Understand the incentives of both overly-aggressive lawyers and overly-aggressive investors to move you out of that range; and that highly experienced startup investors are very skilled at masking aggression with false “friendliness” and marketing. In the lawyer context, you should have plenty of time long before the negotiation to have done your diligence and ensured you’re working with a Partner whose judgment you truly respect. In the investor context, you should also have done some diligence on their reputation to better understand how they work.

High-integrity investors who view their investment as the building of a balanced, long-term relationship will respond respectfully to negotiation; and not try to infantilize you by questioning your judgment or that of your counsel. It doesn’t mean they’ll give you everything you want. But they’ll be honest and open about their perspective, and what they’ll be flexible on v. what is a sticking point, and give you an opportunity to do the same. No pressure tactics needed. If they instead respond with frustration over your desire to deviate from what they want, or nonsense about why you’re not sticking to their idea of “standard,” you now have some important data on how they approach things, and how they view the relationship.

When aggressive investors over-emphasize the importance of “minimizing friction” in funding, and not “losing momentum,” they sell it as being about saving you time and money. But behind the spin is the fact that they may view your company (and the employees and customers who depend on it) as a number in their portfolio, and would much prefer that you just shut up and make them rich, or die trying. Given you have 100x more skin in this one game than any “unicorn hunter” with a diversified portfolio, you have every reason to push back (again, respectfully) for a deal that works for this company.

No one’s perspective (not an investor, nor a lawyer helping you negotiate with an investor) deserves to be treated like gospel. As a leader, your job is to triangulate advice from many people, all with their own incentives and biases, and make the call based on what you see as the right move for your company’s unique context. Work with experienced advisors whose judgment you trust and can’t be discredited by outsiders trying to use your inexperience against you, and use their insights to work within the range of acceptable negotiation. But also understand that the purpose of negotiation isn’t just about the deal itself. By moving past conversation, into actions and real commitment, it’s a valuable opportunity to have your investors show (not tell) you who they really are.

Why Startups shouldn’t use YC’s Post-Money SAFE

TL;DR: If you’re going to use it, you should make some slight (but material) tweaks. It otherwise gives your seed investors a level of extreme anti-dilution protection that is virtually unheard of (circa 2019) in startup finance, making it worse than seed equity and conventional convertible notes (or pre-money SAFEs) in terms of economics for most seed stage companies; which is of course why investors love it. There are far better, more balanced ways to “clarify” ownership for seed investors without forcing founders and employees to absorb additional dilution risk. YC has done a “180” in moving from the pre-money SAFE (very company friendly) to the post-money SAFE (extremely seed investor friendly).

Post-Publishing Updates:

  • After requests from a number of readers, I’ve posted a template convertible note based on the template we’ve used hundreds of times across the country. See: A Convertible Note Template for Seed Rounds.
  • We posted a google sheets model comparing the economics of a pre-money SAFE, YC post-money SAFE, and a redlined post-money SAFE that corrects the above-discussed anti-dilution problem in YC’s template. A corrected post-money SAFE is actually a great instrument for companies/founders, even if YC’s post-money safe is heavily investor-biased. See: A Fix for Post-Money SAFEs: The Math and a Redline

A regular underlying theme you’ll read on SHL is that key players in the startup community are incredibly talented at taking a viewpoint that is clearly (to experienced players) investor-biased, but spinning / marketing it as somehow “startup friendly.”  And lawyers captive to the interests of investors are always happy to play along, knowing that inexperienced teams can be easily duped.

One example is how “moving fast” in startup financing negotiations is always a good thing for entrepreneurs. Investors are diversified, wealthy, and 100x as experienced as founders in deal terms and economics, but it’s somehow in the founders’ interest to sign whatever template the investor puts on the table, instead of actually reviewing, negotiating, and processing the long-term implications? Right.

Y Combinator’s move to have its SAFEs convert on a post-money, instead of pre-money, basis is another great example. Their argument is that it helps “clarify” how the SAFEs will convert on the cap table. Clarity is great, right? Who can argue with clarity?

What’s not emphasized prominently enough is that the way they delivered that “clarity” is by implementing anti-dilution protection for SAFE investors (like themselves) that is more aggressive than anything remotely “standard” in the industry; and that wasn’t necessary at all to provide “clarity.” Under YC’s new SAFE, the common stock absorbs all dilution from any subsequent SAFE or convertible note rounds until an equity round, while SAFE holders are fully protected from that dilution. That is crazy. It’s the equivalent of “full ratchet” anti-dilution, which has become almost non-existent in startup finance because of how company unfriendly it is. In fact, it’s worse than full ratchet because in a typical anti-dilution context it only triggers if the valuation is lower. In this case, SAFE holders get fully protected for convertible dilution even if the valuation cap is higher. It’s a cap table grab that in a significant number of contexts won’t be made up for by other more minor changes to the SAFE (around pro-rata rights and option pool treatment) if a company ends up doing multiple convertible rounds.

When you’re raising your initial seed money, you have absolutely no idea what the future might hold. The notion that you can predict at your initial SAFE closing whether you’ll be able to raise an equity round as your next funding (in order to convert your SAFEs), or instead need another convertible round (in which case your SAFE holders are fully protected from dilution), is absurd. Honest advisors and investors will admit it. Given the dynamics of most seed stage startups, YC’s post-money SAFE therefore offers the worst economics (for companies) of all seed funding structures. Founders should instead opt for a structure that doesn’t penalize them, with dilution, for being unable to predict the future.

Yes, YC’s original (pre-money) SAFE has contributed to a problem for many SAFE investors, but that problem is the result of an imbalanced lack of accountability in the original SAFE structure; not a need to re-do conversion economics. As mentioned in the above TechCrunch article, the reason convertible notes are still the dominant convertible seed instrument across the country is that the maturity date in a convertible note serves as a valuable “accountability” mechanism in a seed financing. A 2-3 year maturity gives founders a sense of urgency to get to a conversion event, or at least stay in communication with investors about their financing plans. By eliminating maturity, SAFEs enabled a culture of runaway serial seed financings constantly delaying conversion, creating significant uncertainty for seed investors.

YC now wants to “fix” the problem they themselves enabled, but the “solution” goes too far in the opposite direction by requiring the common stock (founders and early employees) to absorb an inordinate amount of dilution risk. If “clarity” around conversion economics is really the concern of seed investors, there are already several far more balanced options for delivering that clarity:

Seed Equity – Series Seed templates already exist that are dramatically more streamlined than full Series A docs, but solidify ownership for seed investors on Day 1, with normal weighted average (not full ratchet) anti-dilution. 100% clarity on ownership. Closing a seed equity deal is usually a quarter to a third of the cost of a Series A, because the docs are simpler. Seed equity is an under-appreciated way to align the common stock and seed investors in terms of post-funding dilution. Yes, it takes a bit more time than just signing a template SAFE, but it’s an increasingly popular option both among entrepreneurs (because it reduces dilution) and investors (because it provides certainty); and for good reason.

See also: Myths and Lies about Seed Equity to better understand the false arguments often made by investors to push founders away from seed equity as a financing structure.

Harden the denominator – Another option I’ve mentioned before in Why Notes and SAFEs are Extra Dilutive is to simply “harden” the denominator (the capitalization) that will be used for conversion on Day 1, while letting the valuation float (typically capped). This ensures everyone (common and investors) are diluted by subsequent investors, just like an equity round, while allowing you to easily model conversion at a valuation cap from Day 1. If the real motivation for the SAFE changes was in fact the ability to more easily model SAFE ownership on the cap table – instead of shifting economics in favor of investors – this (hardening the conversion denominator) would’ve been a far more logical approach than building significant anti-dilution mechanisms into the valuation cap.

See “Fixing” Convertible Note and SAFE Economics for a better understanding of how hardening the denominator in a note or SAFE valuation cap gives the “best of both worlds” between convertibles and equity rounds.

Add a Maturity Date – Again, the reason why, outside of Silicon Valley, so many seed investors balk at the SAFE structure altogether is because of the complete lack of accountability mechanisms it contains. No voting rights or board seat. No maturity date. Just hand over your money, and hope for the best. I don’t represent a single tech investor – all companies – and yet I agree that SAFEs created more problems than they solved. Convertible notes with reasonable maturity dates (2-3 years) are a simple way for investors and entrepreneurs to get aligned on seed fundraising plans, and if after an initial seed round the company needs to raise a second seed and extend maturity, it forces a valuable conversation with investors so everyone can get aligned.

Conventional convertible notes – which are far more of an (air quotes) “standard” across the country than any SAFE structure – don’t protect the noteholders from all dilution that happens before an equity round. That leaves flexibility for additional note fundraising (which very often happens, at improved valuations) before maturity, with the noteholders sharing in that dilution. If a client asks me whether they should take a low-interest capped convertible note with a 3-yr maturity v. a capped Post-Money SAFE for their first seed raise, my answer will be the convertible note. Every time, unless they are somehow 100% positive that their next raise is an equity round. The legal fees will be virtually identical.

Before anyone even tries to argue that signing YC’s template is nevertheless worth it because otherwise money is “wasted” on legal fees, let’s be crystal clear: the economics of the post-money SAFE can end up so bad for a startup that a material % of the cap table worth as much as 7-figures can shift over to the seed investors (relative to a different structure) if the company ends up doing additional convertible rounds after its original SAFE; which very often happens. Do the math.

The whole “you should mindlessly sign this template or OMG the legal fees!” argument is just one more example of the sleight-of-hand rhetoric peddled by very clever investors to dupe founders into penny wise, pound foolish decisions that end up lining an investor’s pocket. It can take only a few sentences, or even the deletion of a handful of words, to make the economics of a seed instrument more balanced. Smart entrepreneurs understand that experienced advisors can be extremely valuable (and efficient) “equalizers” in these sorts of negotiations.

When I first reviewed the new post-money SAFE, my reaction was: what on earth is YC doing? I had a similar reaction to YC’s so-called “Standard” Series A Term Sheet, which itself is far more investor friendly than the marketing conveys and should be rejected by entrepreneurs. Ironically, YC’s changes to the SAFE were purportedly driven by the need for “clarity,” and yet their recently released Series A term sheet leaves enormous control points vague and prone to gaming post-term sheet; providing far less clarity than a typical term sheet. The extra “clarity” in the Post-Money SAFE favors investors. The vagueness in the YC Series A term sheet also favors investors. I guess YC’s preference for clarity or vagueness rests on whether it benefits the money. Surprised? Entrepreneurs and employees (common stockholders) are going to get hurt by continuing to let investors unilaterally set their own so-called “standards.”

One might argue that YC’s shift (as an accelerator and investor) from overly founder-biased to overly investor-biased docs parallels the natural pricing progression of a company that initially needed to subsidize adoption, but has now achieved market leverage. Low-ball pricing early to get traction (be very founder friendly), but once you’ve got the brand and market dominance, ratchet it up (bring in the hard terms). Tread carefully.  Getting startups hooked on a very friendly instrument, and then switching it out mid-stream with a similarly named version that now favors their investors (without fully explaining the implications), looks potentially like a clever long-term bait-and-switch plan for ultimately making the money more money.

YC is more than entitled to significantly change the economics of their own investments. But their clear attempts at universalizing their preferences by suggesting that entrepreneurs everywhere, including in extremely different contexts, adopt their template documents will lead to a lot of damaged startups if honest and independent advisors don’t push back. The old pre-money SAFE was so startup friendly from a control standpoint that many investors (particularly those outside of California) refused to sign one. The new post-money SAFE is at the opposite extreme in terms of economics, and deserves to be treated as a niche security utilized only when more balanced structures won’t work. Thankfully, outside of pockets of Silicon Valley with overly loud microphones, the vast majority of startup ecosystems and investors don’t view SAFEs as the only viable structure for closing a seed round; not even close.

The most important thing any startup team needs to understand for seed fundraising is that a fully “standard” approach does not exist, and will not exist so long as entrepreneurs and investors continue to carry different priorities, and companies continue to operate in different contexts. Certainly a number of prominent investor voices want to suggest that a standard exists, and conveniently, it’s a standard they drafted; but it’s really just one option among many, all of which should be treated as flexibly negotiable for the context.

Another important lesson is that “founder friendliness” (or at least the appearance of it) in startup ecosystems is a business development strategy for investors to get deal flow, and it by no means eliminates the misaligned incentives of investors (including accelerators). At your exit, there are one of two pockets the money can go into: the common stock or the investors. No amount of “friendliness” changes the fact that every cap table adds up to 100%. Treat the fundraising advice of investors – even the really super nice, helpful, “founder friendly,” “give first,” “mission driven,” “we’re not really here for the money” ones – accordingly. The most clever way to win a zero-sum game is to convince the most naive players that it’s not a zero-sum game.

Don’t get me wrong, “friendly” investors are great. I like them way more than the hard-driving vultures of yesteryear. But let’s not drink so much kool-aid that we forget they are, still, investors who are here to make money that could otherwise go to the common stock; not your BFFs, and certainly not philanthropists to your entrepreneurial dreams.

Given the significant imbalance of experience between repeat money players and first-time entrepreneurs, the startup world presents endless opportunities for investors (including accelerators) to pretend that their advice is startup-friendly and selfless – and use smoke-and-mirrors marketing to convey as much – while experienced, independent experts can see what is really happening. See Relationships and Power in Startup Ecosystems for a deeper discussion about how aggressive investors in various markets gain leverage over key advisors to startups, including law firms, to inappropriately sway negotiations and “standards” in their favor.

A quick “spin” translation guide for startups navigating seed funding:

“You should close this deal fast, or you might lose momentum.” = “Don’t negotiate or question this template I created. I know what’s good for you.”

“Let’s not ‘waste’ money on lawyers for this ‘standard’ deal.”  = “Don’t spend time and money with independent, highly experienced advisors who can explain all these high-stakes terms and potentially save a large portion of your cap table worth an order of magnitude more than the fees you spend. I’d prefer that money go to me.”

“We’re ‘founder friendly’ investors, and were even entrepreneurs ourselves once.” = “We’ve realized that in a competitive funding market, being ‘nice’ is the best way to get more deal flow. It helps us make more money. Just like Post-Money SAFEs.”

“Let’s use a Post-Money SAFE. It helps ‘clarify’ the cap table for everyone.” = “Let’s use a seed structure that is worse for the common stock economically in the most important way, but at least it’ll make modeling in a spreadsheet easier. Don’t bother exploring alternatives that can also ‘clarify’ the cap table without the terrible economics.”

There are pluses and minuses to each seed financing structure, and the right one depends significantly on context. Work with experienced advisors who understand the ins and outs of all the structures, and how they can be flexibly modified if needed. In the case of startup lawyers specifically, avoid firms that are really shills for your investors, or who take a cookie-cutter approach to startup law and financing, so you can trust that their advice really represents your company’s best interests. That’s the only way you can ensure no one is using your inexperience – or fabricating an exaggerated sense of urgency or standardization – to take advantage of you and your cap table.

The Problem with “Standard” Term Sheets (including YC’s)

TL;DR: Whenever an influential organization publishes a so-called “standard” financing document, important questions need to be asked about not just its specific terms, but also the entire concept of “standard” terms in general, and potential biases in their creation. In YC’s case, their decision to keep their “standard” TS very short (for speed purposes), and not address key economic/control issues, favors investors by deferring negotiation on those issues to a context (after signing) where common stockholders have less flexibility and leverage. YC’s default terms also give VCs substantial power that is hardly a “standard.” In the broader context (apart from YC), there are serious problems emerging in the startup legal market with how certain narratives around “standards”, closing fast, and the hiring of lawyers with deep conflicts of interest, are leading (and tricking) entrepreneurs & early employees into adopting legal strategies that hurt their long-term interests.

In Startup Law and financing, standardization and templates are often celebrated as noble, generous attempts at saving entrepreneurs money that they would otherwise “waste” on advisory fees. While it is definitely true that, to a point, creating uniform language improves efficiency, there are very real, and often dangerous, high-stakes issues that founders need to hear about regarding “standards,” but unfortunately they often don’t. The narrative of ‘reducing friction’ in financings has devolved into a clever excuse for imposing imbalanced terms on inexperienced startups, and keeping them ignorant of both the long-term implications and potential alternatives. 

Take Y Combinator’s recent so-called “Standard and Clean” Series A Term Sheet as just one example. YC has placed itself at the forefront of attempting to standardize early-stage fundraising docs for startups.  The SAFE (Simple Agreement for Future Equity) has become in Silicon Valley a dominant instrument for seed fundraising, though survey data (and our experience) suggests it’s not nearly as dominant outside of California.

Given that the SAFE was, relative to other instruments used in the market (like convertible notes) a quite company-friendly agreement, YC established itself as offering very “founder friendly” standards in templates they create.  So one would’ve expected that their “Standard and Clean” term sheet would follow the same trajectory. However, when we reviewed YC’s term sheet, our initial response – as lawyers who represent companies, and only companies (not their investors) – was “Uh oh.”

Side note: Recent changes to the SAFE instrument made by YC have made SAFEs significantly less company-friendly from an economics standpoint, which when combined with YC’s release of its problematic Series A term sheet template, suggests a reversal of YC’s historical philosophy on having “founder friendly” documentation. This means entrepreneurs should be extra cautious before rushing to use YC’s favored forms. See: Why Startups shouldn’t use Post-Money SAFEs.

Short term sheets benefit investors

First, YC’s term sheet is remarkably short as far as equity term sheets go. The reason is somewhat reflected in their own blog post’s words:

“So don’t lose sight of the ultimate goal: closing fast and getting back to work.”

Short term sheets get signed faster than longer ones, because there’s less to discuss. Here’s the problem with short term sheets, though: once you sign a term sheet, two things happen:

A. You are now locked in with a “no shop” clause. That requires you to inform any other investors you were talking to that you are taking someone else’s deal. Good luck going back to them if this deal ends up not closing.

B. You start racking up legal fees with your own lawyers, which for a cash-limited startup puts pressure to close, and accept terms on the table, in order to pay those fees.

In other words, once you sign a term sheet, your leverage and flexibility dramatically go down. It becomes far easier for investors to pressure you with this or that language (which they will usually claim is also “standard”) than it would’ve been during the term sheet phase. So rushing to sign a short term sheet favors investors over startups.  Slowing down and clarifying all material points at the term sheet phase also saves legal fees, because it reduces back-and-forth with the lengthier definitive documents.

Fair enough, you might say. YC favors moving fast anyway, because there can be benefits to moving fast for everyone. OK.

YC gives VCs full veto rights on equity financings

Here’s a second issue: as drafted, YC’s “standard and clean” terms give your VCs and other investors a complete veto right over all future equity financings, regardless of what the Board composition is. In other words, even if the common stock controls the Board (which shouldn’t necessarily be the case), and has a deal on the table with great terms, your VCs can block it simply because they, for whatever self-interested reason, don’t like it.

This is usually a point at which at least a few founders might be thinking “WTF?”

When you move to close an equity financing, there are at least two approvals that need to happen: Board and Stockholder votes. The Board vote is subject to fiduciary duties, but the stockholder vote isn’t, save for a few narrow circumstances. In a stockholder vote, you can block something for whatever reason you want, effectively. Yes, we have seen VCs block deals that common stockholders wanted, and with great terms; but because the VCs had self-interested reasons for favoring another deal, they refused to approve. This can give them remarkable power over what deals get done and don’t.

To be fair, YC points out this hard veto right in their blog post’s footnotes. Putting aside the fact that those footnotes won’t make it into a redline, probably their expectation is that good startup lawyers will always mention the issue to their clients, and negotiate if possible. In other words, their “standard” perhaps isn’t as big of a problem because it will be negotiated. And that brings us to a more important point in this post, which isn’t about YC specifically, but the entire concept of “standard” terms.

What is “standard”?

What exactly do we mean when we say something is “standard”? Whose data are we using?

Given that investors are on one side of a deal, and entrepreneurs (and other employees) on another, might we be a little cautious in letting investors be the ones telling the market what the “standards” are?

When YC, with its prominent brand, places the label of “standard” on giving VCs unilateral veto rights on future financings, that influences the market, even if unintentionally, in favor of VCs. Now lawyers representing the interests of startups/common stockholders (like us) have to negotiate not just with investors across the table, but against a now so-called “standard.”

We’ve closed many, many deals where we don’t give VCs this kind of broad veto right, and soften it significantly to make it more balanced. But now when we push back on giving VC’s these veto rights, their response is going to be: “Look at YC’s term sheet. Giving us a hard veto is the market standard.”

Which leads to another question: what is the appropriate threshold for something becoming “standard”? 75%? More than 50%? If 49% of deals don’t have a provision, or even 10%, there are good arguments that there are in fact multiple “standards.” But when some “standards” favor repeat players with microphones and dominance over startup ecosystems, while other “standards” favor “one shot” players (like first-time entrepreneurs and employees), which ones do you think get publicized? Taking a 75% standard, as an example, and then prominently publicizing it as the “standard” can be a way to move the market to 100%, with “efficiency” as a weak excuse for eliminating flexibility on such a high-stakes provision.

Even if we had perfect objective data, at what point should startups place more weight on their own priorities, unique context, and leverage for the permanent, highest-stakes economic and power terms of their company’s governance, instead of aggregated, anonymized data covering a huge diversity of companies?

One could argue that the publication by investors of their own so-called “standards” is a kind of assertion of market power, and a way to influence long-term the data that is then used to justify those same standards. Do common stockholders have the ability to do the same and ensure balance? No, they don’t. They depend on individual lawyers to represent their interests and help make up for the power inequality. And that finally brings us to an even bigger problem.

The “own the advisors” game.

Let us paint a picture of a “game” of sorts for you. The game has two broad sets of players: “one shot” players and repeat players.

The “one shot” players are first-time entrepreneurs and early employees; common stockholders. They are usually not diversified, which means their wealth is concentrated in their one company. They also typically lack significant personal wealth, and don’t have downside protection on their equity, further magnifying their “skin” in this “one shot” that they have. Finally, not having played the game before, they rely on experienced, trusted (hopefully) outside advisors (like lawyers) to help them not get taken advantage of.

The “repeat players” (investors, accelerators) are in the polar opposite situation. They are wealthy, diversified, downside protected (liquidation preference or a debt claim), and they’ve played the game many, many times. In the case of the largest repeat players, they’re also incentivized to take significant risks in order to “swing for the fences” and go after risky big prizes, even if doing so increases the number of total failures; failures which hit the one shot players far harder because they aren’t diversified across a portfolio juiced for “power law” returns.

There is a fundamental misalignment here that never goes away, and feeds into many high-stakes decisions (and disagreements) in a company’s history around recruiting, risk, fundraising, exits, etc. Both sides want to make money, but they are often misaligned in their perspectives on how to do so, whom to raise funding from (and on what terms), and what level of risk is acceptable. The repeat players have 100x the experience of the one shot players, but the one shot players hope their advisors can help “balance” the inequality as they navigate this misalignment.

Now, let’s say I’m a very smart repeat player – a “chess player” of sorts – and I’d prefer that this “balancing” not really happen. I make more money, and keep more control, if I can somehow get in the way of the lawyers helping the one shot players. But at the same time, if I look too visibly aggressive in doing so, the one shot players won’t want to play with me at all. So as an investor I want to win, but in a way that preserves a public image of selflessness so that inexperienced players keep coming to me, and preferably with minimal defenses. What’s a good multi-step strategy?

Here’s a suggestion.

1. Create “standards” for the game, based on limited data, and with microphones, that the one shot players can’t see or influence. Publish these so-called “standards” while emphasizing how much money they’ll “save” everyone by using them. Talk a bit about how you were once yourself a one shot player (former entrepreneur), so you’re really doing this out of selfless empathy for the new folks; even if now you’re highly misaligned.

2. Build relationships with lawyers that the one shot players hire for advice, by hiring those same firms on the much larger volume of deals you control, and also referring other people to them from your broad network as a repeat player. This ability to refer lots of work to said lawyers is a “currency” that the inexperienced one shot players always lack.

3. Recommend to the one shot players that they hire these same awesome lawyers that you (the repeat player) prefer, because of how “efficient” and “high quality” they are, and how well they know the “standards.” You know that those lawyers view you as a source of 50x as much “deal flow” as any one shot player, and would never do anything to jeopardize that deal flow. Emphasize how much money will be “saved” by using “familiar” lawyers.

4. Tell the one shot players that, given everything is “standard” anyway, they should focus on “closing fast” and saving fees. In fact, they should hire the lawyers on a flat fee, which ensures that the faster the lawyers move (the less time they spend advising the inexperienced startup and negotiating on its behalf), the more money those lawyers make. You can have two sets of lawyers who charge the exact same end-price, but those charging a “flat fee” (as opposed to billing by time worked) are actually rewarded for doing less work, with an improved margin.

5. With the “standard” (that repeat players created) in hand, the lawyers (that repeat players control) “close fast” (earning a better margin on their flat fee), with minimal discussion or negotiation, so everyone can move on and not “waste money” on unnecessary advisory.

6. The repeat players, very happy with how “high quality” and “efficient” the captive lawyers were at closing on their standard, refer them more work; regardless of how well it served the one shot players who, on paper, were the client.

7. Rinse and repeat over many iterations. Now we have market data that validates the “standards” that the repeat players created, further entrenching it.    

Does this game sound familiar to anyone? We bet it does to startup lawyers.

We go more in-depth into how the game is played, and strategies for avoiding it, in Relationships and Power in Startup Ecosystems and How to Avoid “Captive” Company Counsel.

The core point is this: there is a structural problem with how certain startup ecosystems have evolved to approach “legal” and the hiring of lawyers. It’s the result of a significant imbalance of power between “one shot” startups and the repeat player investors/accelerators they work with, the latter of which have found many (not all) startup lawyers quite eager to flout conflicts of interest in order to generate business for themselves.

“One shot” common stockholders (entrepreneurs, employees) and “repeat player” investors (including accelerators) are not fully aligned in terms of economics and incentives, given the above-described differences as it relates to diversification, wealth, experience, and downside protection. Repeat players, through their ability to operate as brokers/gatekeepers of referrals, have increasingly pushed founders to hire law firms that are ultimately “captive” to investors, and even then sometimes insist that those law firms adopt billing practices (like flat fees) that actually reward lawyers for rushing work and under-advising inexperienced startups. 

And all of this is done under the pretense of wanting to help founders “save” money. In this game, the appearance of “founder friendliness” is often a marketing tool to help lull first-timers into forgetting how misaligned they are from the money players, and then taking advice from those same money players that ends up, unsurprisingly, being an “own goal.” Former entrepreneurs-turned-investors are often the most skilled at using their pasts (as entrepreneurs) as smoke and mirrors to get now first-time entrepreneurs and early employees to forget their misalignment, and take their advice as gospel.

In fact, if you look around the market and find startup law practices that have grown at an abnormally fast, seemingly non-organic, pace, what you’ll often find is lawyers willing to juice this conflict of interest-driven game as far as possible, to a point getting preciously close to meriting litigation. We’ve seen at least one threatened law suit already.

We see the negative consequences of this game all the time around the country, as inexperienced “one shot” common stockholders (including entrepreneurs) are duped into signing (air quotes) “standard” deals, and taking certain “standard” actions, while having no real clue as to what the long-term consequences are because everyone was celebrating how great of an idea it is to “close fast” and keep it “standard.” When the long-term consequences of the “standard” docs and actions play out, it becomes clear no one ever actually explained to the inexperienced common stockholders and the company what the real implications were, or how they could’ve been negotiated for more balance; because everyone capable of doing so was ultimately incentivized to favor the interests of the money. 

So not only are we increasingly pushing so-called “standards” that are themselves biased and questionable, we’re depriving the most inexperienced and exposed people in the ecosystem, the new entrepreneurs and early employees, of the right to even be truly independently advised in assessing those “standards.” And we’re selling it all as noble and well-intentioned because it purportedly “saves” them fees, even if the long-term negative consequences for them far exceed whatever fees they “save.”

To be sure, not every team gets hurt by the emergent “close fast and keep it standard” dogma; in much the same way that not everyone who smokes gets cancer. Some teams manage to protect themselves in other ways, regardless of what the docs say, or are lucky to work with lawyers who fully do their job. But the issue is so pervasive, and there is enough damage occurring to inexperienced players, that it needs to be, at a minimum, discussed out in the open by people not incentivized to dismiss or downplay it.

We believe that startups are more than capable of making their own decisions as to how they want to hire advisors, including counsel, once they’ve heard the full story and potential implications. Part of the problem is how little open and honest discussion occurs on the topic, and how much market pressure to use captive lawyers is applied quietly in the background, precisely because the market is dominated by repeat player perspectives; many of which are cleverly spun and publicized as “friendly.”

Negotiating the YC “Standard and Clean” Term Sheet

To be crystal clear, this broader diagnosis of the market is not about YC at all. YC is a great organization, and many of our firm’s clients (including YC companies) have fantastic things to say about their program. We have no idea what YC’s arrangements are in terms of referring companies to certain conflicted or non-conflicted law firms, or the kinds of economic arrangements they promote with those firms. For all we know, YC legitimately believed that they could post this “standard,” and then expect truly independent, non-captive lawyers to then do their job and produce fair outcomes.

But while we have your attention, given that this “standard and clean” term sheet is already out there, a few suggestions that we would give to companies and common stockholders before signing it:

A. Soften the veto. Build some “boundaries” around the veto right on future financings. For example, if the valuation is a certain amount above the current price (not a down round), perhaps a Board vote should be sufficient. The Board is subject to fiduciary duties, which can constrain bad actors. Maintain some kind of “path” to a value accretive financing, even if the current money gets hostile and tries to reduce competition, or force a deal with their “friends.” There should also typically be some kind of ownership threshold below which all VC vetoes go away.

B. Clarify the shadow preferred’s economics. Be clearer about the economics of the “shadow preferred” referenced for Notes/SAFEs. What are their liquidation preferences? Term sheets are a good opportunity to address any liquidation overhangs if the Notes/SAFEs themselves don’t address them.

C. Clarify the common stock’s board voting rights. Do the common stockholders have to be employees in order to vote for the common stock’s board seats? This has significant power implications long-term, because there can be any number of reasons why early common stockholders might leave the company (or be forced out), and still want a voice (even if not control) in governance; and for good reasons. When there’s a power shift, common stockholders remaining on payroll are usually far more beholden to the money, and because their equity was often issued later (at a higher price), their economics and incentives are more aligned with later investors. Make VCs explain in full just why exactly it’s so important that all common directors be service providers, or be elected by service providers, to the company. Listen closely enough, and you’ll understand how the arguments are often thinly veiled power plays.

Also, does one common director have to be the CEO? This is usually (but not always) the case. Discuss it and spell it out in the term sheet. Just like the previously mentioned point, given that the CEO position often eventually gets filled by a later common stockholder recruited by the Board, with different priorities and incentives from early common stockholders, this has control implications long-term. Again, tying common director positions (and the voting in their elections) to being on payroll is often a subtle power move to eventually exclude (as a company scales) early common stockholders from having visibility and a say in company governance; because they’re the people most likely to disagree with later-stage investors on how to scale, when to exit, and how much risk is acceptable.

Provide a “yes” or a “no” to these questions. Silence means shifting negotiation post-term sheet, where the common have less flexibility. Be mindful of how some players will spin this discussion into a caricature of founders not wanting to give up control. Control and a voice/visibility are two completely separate issues. There are many constituencies on a cap table with various incentives and interests. There are good arguments for why, as a company scales and the stakes get higher, early common stockholders – who are the most exposed to dilution and risk – should still have some say and visibility (even if not control) in company governance, to voice concerns around risk, financing strategy, recruiting, exits, etc. Conflating the narrow context of a founder unwilling to share control with the far broader, and far more legitimate reality that early common stockholders and investors have very different incentives and perspectives on company growth, is a common straw-man tactic for obfuscating the issue.  Both sides deserve to have un-muzzled voices in governance.

D. Clarify the anti-dilution exceptions. Be clearer about the exceptions to anti-dilution adjustments, instead of engaging in a post-signing “battle of the standards.” While not always an issue, these can sometimes be ways for the preferred to squeeze the common by refusing to waive anti-dilution unless they “give” on something. Spell them out in the term sheet.

E. Clarify how all Board voting will happen. Are there specific Board actions that, aside from a Board majority, the investors expect for their own directors to have veto over? If not, say so. If so, list them. VC docs often have a section, apart from stockholder veto rights, that give the preferred directors veto (at the Board level) over certain key actions. If you’re silent about this issue, instead of making it clear that a majority governs all the time, investors will often claim that it’s an open point for negotiation in the docs. Silence is not your friend.

If YC truly wants their term sheet to serve as a balanced (and not biased) reference point for Series A deals (and I believe they do), they should prominently address at least these core economic and control issues; not in a passing blog post reference, but squarely in the document with appropriate brackets so as not to signal a “default” and therefore not slant negotiations. Having public templates as starting points, like the NVCA has done for some time, can be helpful, and we utilize them regularly to streamline negotiation and save fees. But it’s a big responsibility and needs to be done carefully; with input from people on the other side of the table whom the money can’t “squeeze” if they speak honestly and openly.

The general theme here is that you should be clear in the term sheet on all material issues. Nothing is more material than economics and control. Keeping it short, and glossing over things by referencing a nebulous “standard,” or simply not addressing a point at all, favors investors because it transfers negotiation to a context where the company has less optionality and flexibility. We’ve closed deals that land, after transparent discussion and negotiation, in any number of places on these above-mentioned points. The real point we’re trying to emphasize in this post isn’t about pushing deals to go in one direction or another – that depends on the context – but highlighting just how often these issues aren’t even discussed with startup teams because of games that investors and lawyers are playing, and their incentives to “close fast.”

Some people argue that you should “sign fast” on a term sheet because if you negotiate, you might “lose the deal.” We don’t see that actually happen in practice, and can’t think of a clearer signal that you might not want to take someone’s money than being told that the deal will die if you try to clarify even a few material points. This, again, is the kind of sleight of hand rhetoric that sounds like it’s advice to help entrepreneurs, when in fact it helps investors. In reality, spending more time to achieve alignment on a more detailed term sheet expedites drafting and closing once the term sheet is signed.

Start asking the right questions.

In a game of the inexperienced v. the highly experienced, moving very fast, and not taking the time to ask important high-stakes questions, favors the experienced. Great startup lawyers prioritize deals because they know they deserve urgency, but show us lawyers who act as if speed should be a founder team’s top priority in a financing, and we’ll show you lawyers who are captured by money players. In too many cases, startup entrepreneurs’ cultural inclination toward speed and automation – which in the right contexts is a good thing – has been hijacked by misaligned but very clever repeat players in order to dupe the inexperienced into adopting legal strategies that actually hurt their interests.

Wrapping this topic up, as counsel our job isn’t to always provide startup clients direct answers, but sometimes to simply ensure they, in their inexperience and unequal power in the market, are asking the right questions. Questions like:

  • What do we really mean by “standard”? Can the data be manipulated?
  • Whose “standard” is it, and are they biased? Can their “founder friendliness” be a marketing tactic instead of full reality?
  • How much should I even care whatever “standard” means, at least as it relates to my most high-stakes terms, if I’m building a unique company with its own priorities, context, leverage, etc.?
  • Might it be a bigger problem (than my investors will acknowledge) if my company counsel is far more motivated, via referrals and other economic ties, to keep my investors happy instead of the inexperienced common stockholders whose skin is entirely in this one company?
  • Is “moving fast” and rewarding my company’s lawyers for minimizing their involvement (with flat fees) really in my best interests, or is “saving money” a clever excuse to keep me ignorant and not properly advised of what I’m getting into, so that more experienced players can then take advantage of the imbalance?

We don’t pretend to have universal answers for these questions, because there aren’t any. Where you land depends on the context, the people involved, their unique priorities, and the kind of relationship they expect to have going forward. You know, a lot like term sheets.

This post (which is not legal advice, btw) was co-authored with my NYC colleague, Jeremy Raphael.

Relationships and Power in Startup Ecosystems

TL;DR: The highly unequal relationship and power dynamics in most startup ecosystems mean that what is visible publicly (on blogs, social media, etc.) is not an accurate representation of how the game is actually played, because few people are willing to speak honestly and openly for fear of being penalized by a well-connected gatekeeper. This makes off-the-record diligence, and watching loyalties of your most high-stakes relationships (including counsel), essential in order to prevent repeat “money” players (investors, accelerators) from dominating the voices of less influential “one shot” players (first-time entrepreneurs, employees) both on boards of directors and in the market generally. Hire and engage people without hidden dependencies on the money.

Background Reading:

There are a few underlying themes that have been covered in a number of SHL posts and are relevant to this one:

First, in startup dynamics there is a fundamental divide and tension between inexperienced, “one shot” common stockholders and “repeat player” investor preferred stockholders (VCs, seed funds, accelerators) that feeds into all of the most high-stakes decisions around how to build and grow a company. It has nothing to do with good v. bad people. It has to do with core economic incentives.

Common stockholders (founders, early employees) typically have their wealth concentrated in their one company (not diversified), do not have substantial wealth as a backup in the event of failure, do not have the downside protection of a liquidation preference or debt claim on the company, and have almost no experience in the subtle nuances of startup economics and governance. This dramatically influences their perspective on what kind of business to build, how to finance it, whom to hire in doing so, and how much risk to take in order to achieve a successful outcome; including how to define “successful.”

Preferred stockholders / repeat players (investors, accelerators) are the polar opposite of this scenario. No matter how “founder friendly” they are, or at least pretend to be via PR efforts (more on that below), their core economic interests are not fully aligned with one shot players. They are already wealthy, significantly diversified, have substantial experience with startup economics and governance, and have downside protection that ensures they get paid back first in a downside scenario.  In the case of institutional investors, they also are incentivized to pursue growth and exit strategies that will achieve rare “unicorn” returns, even if those same strategies lead to a large amount of failures; failures which hit common stockholders 100x harder than diversified, down-side protected investors.

And the fact that some of the repeat players are themselves former founders (now wealthy and diversified) is irrelevant to the fundamental economic misalignment; though investors will often use their entrepreneurial histories as smoke and mirrors to distract now first-time founders from that fact. They can probably empathize more with the common’s challenges, and help with execution, but they didn’t become wealthy by ignoring their economic interests. In fact, I would argue from experience that the moves/behavior of entrepreneurs-turned-investors should be scrutinized more, not less, because they’re almost always far smarter “chess players” at the game than the MBA-types are.

Second, apart from the economic misalignment between the common and preferred, there is a widely unequal amount of experience between the two groups. A first-time founder team or set of early employees do not have years of experience seeing the ins and outs of board governance, or how subtle deal terms and decisions play out in terms of economics and power.  The preferred, however, are usually repeat players. They know the game, and how to play it. This means that the set of core advisors that common stockholders hire to leverage their own experience and skillset in “leveling the playing field” is monumentally important; including their ability to trust that those advisors will help ensure that the preferred do not leverage their greater experience and power to muzzle the common’s perspective.

This second point relates to why having company counsel who is not dependent on your VCs / the money is so important; and it also highlights why repeat players go to such enormous efforts to either force or cleverly trick inexperienced teams into hiring lawyers who are captive to the interests of the preferred.  We’ve observed this in pockets of every startup ecosystem we’ve worked in: that aggressive investors work hard to gain influence over the lawyers who represent startups.  The moment we became visible in the market as a growing presence in startup ecosystems, we lost count of how many of the strongest money players reached out to us to “explore” a relationship; even though they already had “relationships” with plenty of firms. It wasn’t that they needed lawyers; it’s their power playbook.

The point of this post is how these above facts – the economic misalignment, and particularly the greater experience – of influential investors (including accelerators) plays out into how they exert power, often covertly, in startup ecosystems; not just with lawyers.

Think of any kind of business that needs to work with startups as clients: obviously lawyers, but also accountants, HR, outsourced CFO, benefits, real estate, even journalists who need access to entrepreneurs in order to write articles. All of those people need strategies for “filtering” startups (finding the more viable ones) and then gaining access to them; and they’re going to look for strategies that are the most efficient and less time consuming.

What many of these service providers come to realize is that an obviously efficient strategy is to work through VCs and other influential investors/accelerators. They’re doing the filtering, and because they’re repeat players, have relationships with lots of companies.  So the service providers reach out to the prominent repeat players (investors, accelerators), who immediately recognize the power that this role as “gatekeepers” and brokers of relationships gives them over the ecosystem.

And when I say “power over the ecosystem,” what I mean is power over what people will say publicly, what they won’t say, and what “support” businesses become successful (or not) via the direction (or restriction) of referral pipelines. It heavily plays out into what gets written and not written on social media and in tech publications, and said at public events; because people are terrified of pissing off someone who will then cut them off from their lifeblood of clients.

“One shot” players are, by virtue of not being repeat players and lacking significant relationships, unable to counterbalance this dynamic.  Put together a system of highly influential and wealthy repeat players and inexperienced, less influential “one shot” players, and you can bet your life that it will inevitably tilt itself toward those who can exert power; with strategies to obscure the tilting from the inexperienced. The ability to offer (and restrict) access to valuable relationships is the leverage that repeat players use to exert power in startup ecosystems and ensure their interests are favored; even when they aren’t formally the “client.”

So let’s tie this all together. Founders and other early startup employees are significantly misaligned from the repeat player investor community in a way that has nothing to do with ethics, but core incentives and risk tolerance; and this is independent of the more obvious misalignment re: each side’s desire for more ownership of the cap table. They’re also totally lacking in experience on how to navigate the complexities of startup growth and governance, and therefore rely heavily on trusted outside advisors to level the playing field. Finally, the most aggressive repeat players will position themselves as gatekeepers to the ecosystem (or at least a valuable portion of it), exerting significant control over the market of advisors available to founders by their ability to offer, or deny, access to startups.

What’s the conclusion here? There are two:

A. What you often see written or said publicly in startup ecosystems is not an accurate representation of how the game is actually played, because very few people are willing to talk openly about it, for fear of being cut off by gatekeepers.  Others will say positive things publicly because of a quid-pro-quo understanding in the background. This significantly increases the importance of off-the-record “blind” diligence to get the real story about a particular repeat player. If you are diligencing an influential investor or an accelerator, it is important that said entity not know whom you are contacting (or at least not everyone) in conducting that diligence.  That is the only way that they cannot retaliate against any particular person who says something negative; and you’re therefore more likely to get an honest answer.

You will absolutely encounter people who will say that the whole idea of “retaliation” is some kind of paranoid fabrication, but remember how the chess game is played: the appearance of “founder friendliness” is often a marketing tool. Of course the smartest users of that tool are going to wave away all this talk of bad actors, doing heavy diligence, and protecting yourself as unnecessary. Come on, they’re good guys. Just trust them, or their tweets. We’re all “aligned” here, right?

When you have an inherent and substantial power advantage, it is an extremely effective strategy to create a non-adversarial, “friendly” PR image of yourself, downplaying that power.  Inexperienced, naive first-time players then buy into this idea that you’re not really about making money, and come to the table with minimal defenses; at which point you can get to work and surround them with relationships you “own.”

The money players with truly nothing to hide won’t be dismissive or defensive at all about the common’s need to conduct blind diligence and ensure the independence of their key relationships. Reactions are often a key “tell.”  If you truly have a great reputation, and you have no intent to use the common’s inexperience and unequal power against them, then what exactly is the problem with respecting their right to be cautious and protect themselves?

There are definitely good people in the market, including those who put integrity and reputation above money, but only idiots navigate a highly unequal and opaque world under the premise that everyone is an angel, and you should “just trust them.” Being a “win-win” person is not in tension with ensuring your backside is covered. Anyone who says otherwise is trying to cleverly disarm you, and is defending an approach that has clearly served them well.

B. To prevent repeat players from dominating the perspective of “one shot” common stockholders both on startup boards of directors, and in ecosystems generally, the “one shot” players must pay extremely close attention to the relationships of their high-stakes key advisors and executive hires, to ensure they can’t be manipulated (with bribes or threats) by the money’s relationship leverage.  No rational human being who cares about being successful bites the hand that most feeds them; no matter how “nice” they are. That is the case with lawyers, with “independent” directors on boards, with other key advisors, and also with high-level executives that you might recruit into your company. Pay attention to loyalties, and diversify the people whose rolodexes you are dependent on.

In the case of lawyers, aggressive repeat players and their shills will often talk about how startup dynamics are “different” and it’s “not a big deal” for company counsel to have dependencies (via engagements and referral relationships) with the preferred stockholders. They even argue that the lawyers’ “familiarity” with the investors will help the common negotiate better and save legal fees. How generous. An honest assessment of the situation is that startups are different, but different in a way that conflicts of interest matter more than usual. Outside of the world of promising startups run by first-time executives negotiating financing/governance with highly experienced investors, you rarely see high-stakes business contexts where there is such a dramatic inequality of experience and power between groups, and such a high level of dependence on counsel (on the part of the one shot common) for high-impact strategic guidance.

Repeat players aren’t reaching across the table and manipulating startup lawyers because it’s “not a big deal.” They’re doing it because the payoff is so uniquely high, and the power inequality (reinforced by the preferred’s inherent dominance over key ecosystem relationships) makes it so easy to do. Couple a basic understanding of human nature/incentives with the fact that the Board’s primary fiduciary duties under Delaware law are to the common stock, and any honest, impartial advisor will acknowledge that experienced company counsel who doesn’t work for the repeat players across the table on other engagements, and who doesn’t rely on them for referrals (in other words, is not conflicted), is one of the clearest ways to (a) ensure the common’s perspective gets a fair voice, and accurate advisory, in key Board decisions, and (b) help the Board do its actual job.

There is a clever narrative pushed around startup ecosystems painting a picture of startup finance and governance as always full of warm, balanced transparency and generosity, with common stockholders and investors holding hands and being “fully aligned” as they build shareholder value together without bias, disagreement, or power plays. But notice how quickly the tone changes from some parts of the investor community the moment you suggest that the common be afforded even minimal defensive protections, like company counsel that investors can’t manipulate. Suddenly you’re being “overly adversarial.”

Oh, so are the transparency and generosity, and “kumbaya” sing-alongs, only available if the common stock behaves in the exact way the money demands? Funny how that works. Smart common stockholders won’t accept “benevolent dictatorship” as the model for their company’s governance. The way you address power inequality is by honestly fixing it; not by taking someone’s BS reassurances that they’ll be “really nice” with how they use it.

You should absolutely want transparency, fairness, and generosity to be the guiding principles of your relationship with your investors – that’s always my advice to founders on Day 1. Also understand that while the common’s perspective deserves to be heard and respected (and not muzzled or infantilized), it is obviously not always right. Balanced governance is good governance; and true “balance” requires real, independent ‘weight’ on both sides. Too many repeat players have manipulated the market into a charade – propped up by pretensions of “friendliness” and “cost saving” – where inexperienced common stockholders become unwittingly dependent on advisors to help them negotiate with investors 100x as experienced as they are, when in fact those advisors are far more motivated to keep the investors happy than their own (on paper) clients.

High-integrity startup ecosystem players should forcefully assert that the “friendly” ethos promoted by VCs and accelerators only has real substance if they’re willing to stay on their side of the table, and not use their structural power advantage to maintain influence over the key people whom founders and employees depend on for high-stakes guidance and decision-making. Call out the hypocrisy of those who put on a marketing-driven veneer of supporting startups and entrepreneurs, while quietly interfering with their right to independent relationships and advisory; including independent company counsel that repeat players can’t “squeeze” with their relationship leverage.

A lot of the most egregious stories of startup flame-outs that you see written about – who grew too fast chasing a unicorn exit, raised more money than a business could sustain, took a high-risk strategy that blew up, or perhaps achieved a large exit while returning peanuts to the early common – are the end-result of a complex game by which repeat players come to exert so much power over how a particular startup scales that the voice of the “one shot” players – the early common stockholders without deep pockets or contacts – gets completely silenced until it’s too late. Gaining control over key company relationships is a significant part of how that game is played. And what’s written about publicly is just the tip of the iceberg.

To put a bow on this post, healthy skepticism over what you see and hear publicly, and good instincts for understanding the importance of incentives and loyalties, are essential for any inexperienced team entering a startup ecosystem. The image of wealthy, powerful people “winning” only by loudly and aggressively pounding the negotiation table is a caricature of how complex business actually works; but it’s a caricature that often dupes inexperienced founders into thinking that everyone else who smiles and seems helpful must be aligned with their interests. Assholes are easy to spot, so the smartest winners are almost never easily visible assholes. Good people still follow their incentives; and aggressive but smart money players know how to assert their power while preserving a public image of selflessness and generosity. Navigate the market, and recruit your advisors, accordingly.