Why Startups Need Signals

Here are a few uncontroversial facts about the general early-stage startup ecosystem:

  • The cost of starting a tech company has dramatically gone down over the past 10 years.
  • In the early days, the caliber of the founder team is at least as important for success as the caliber of the idea/technology.
  • New networks – like AngelList and LinkedIn – have dramatically increased the transparency of relationships in the market, and the ease with which currently unconnected people can become connected.

Putting the above points together, you could easily conclude that it’s never been easier for talented founder teams to obtain needed resources in the market, particularly early-stage capital. But, in some ways, you would be wrong.  Many would argue that while the difficulty of starting may have gone down, the difficulty of actually succeeding has gone up, due to increased competition (and noise) in the market. 

The reduction in cost/friction in the startup world has been met with an increase in volume, and that volume has made the market far more noisy and competitive. Far more entrepreneurs producing far more ideas, and flooding top tier resources with far more pitches. If you want a clear illustration of this, look up newly created companies on AngelList.

Where there’s an increase in noise (weak teams, weak products, me-too companies, etc.), the value of signals – credible ways to cut through the noise and indicate to the right people that you are, in fact, worth talking to – goes up. This post is about why all early stage entrepreneurs need to be very mindful of the importance of signals in the marketplace, and what those signals often look like.

First, a quick clarification: signals are ways of effectively indicating information, but they are not the information itself. In other words, they are ways of credibly sending a message to someone like “hey, we’ve got something truly interesting over here” when simply saying those words won’t work – perhaps because everyone says that, or because you simply can’t get the face-to-face time, and when hard metrics like revenue growth/customer traction may not be available (because it’s too early).  Imagine the startup world as a very dense fog – and the fog is getting denser, btw – good signals are your very visible beacons to flash into the fog so that investors and other resources can find you.

A Series B company needs to worry far less about signaling its value proposition to investors, because its history, financials and reputation in the market can already speak volumes. Successful serial entrepreneurs don’t have much trouble either. A seed stage, or pre-seed company run by new entrepreneurs, however, is in a completely different situation, and needs a different toolkit.

Common early-stage startup signals:

  • A really good logo
  • A really good website
  • A really well-done AngelList profile
  • A strong social media presence
  • Well done blog content
  • Very well-crafted messaging
  • A great pitch at a pitch competition
  • Connections to respected people on LinkedIn
  • Acceptance into a well-respected accelerator
  • Strong academic or professional history

Notice how none of these really have anything to do with the fundamentals of your business/technology? You’re a very early-stage startup. No one really knows whether your business will be successful, and at this stage you can’t even get the face time with the right people to sell them on it. That’s what signals are for.

Remember the point about how startup investors care at least as much about the strength of the team, especially the CEO, as they do about the business? Why is that? Because talent (properly defined) is highly correlated with success, and talent is easier to analyze in the early days than the future prospects of a business. Great entrepreneurs tend to be highly talented generalists (multiple skills); it’s what allows them to hit milestones without a staff of more specialized people.

Doing any or all of the things on the above list credibly signals some kind of skill/talent. Just take a good logo (which may seem silly to an engineering type, but that’s a big mistake): it takes good judgment/taste (marketing skills), and the ability to find a talented logo designer (recruiting skills). Strong LinkedIn connections signal strong networking skills. A great pitch signals strong sales skills. A degree from a respected school, or employment with a well-respected company, certainly isn’t essential, but it clearly signals strong technical skills/training.

Getting into a top accelerator is one of the strongest signals available (because of how thoroughly they vet companies), and that’s why demo days are so well attended by early-stage capital. But getting into a top accelerator often requires its own earlier set of signals.

Yes, in many ways the world has become flatter, more transparent, more meritocratic, etc., and it’s a very good thing.  Yes, the “good ol’ boys” network is weakening in the sense that there are far fewer true gatekeepers. But don’t delude yourself for a second into thinking that this means success in the market has gotten easier. And absolutely don’t think that networking and referrals from well-respected people don’t matter.

A warm referral from someone known and respected in the market is still – simple, cold fact – an incredibly powerful signal. Think about what it takes to get a strong referral. You first had to get connected to that (usually very busy) person (networking skills). Then you had to interest them enough to think your business is worth supporting (credible business idea, sales skills). People care so much about good referrals because in a market full of noise, they are a very efficient filter. And no one has time to work without filters.  

This point is worth repeating: the “democratization” of the startup landscape has certainly reduced the power of gatekeepers – specific people (usually men) whose approval you needed to raise capital and connect with important resources – but it has not (and will not) eliminate the importance of building relationships with credible, trustworthy people who can then refer you to other people who trust their judgment. The democratization arrived in the form of diversifying the number of possible referral sources; not from eliminating the need for referrals altogether.

Utopian visions of a world in which great entrepreneurs will frictionlessly connect with capital purely based on the merit of their technology/business, eliminating all the superficialities of networking and personal marketing, are a dead end.  Someone on your team needs to be good at building relationships, because relationships are incredibly powerful signals. 

Just don’t expect your lawyers to connect you with investors. See: Why I (Still) Don’t Make Investor Intros. Signals can be negative. And the fact that, of all the people in the market whom you could’ve convinced to refer you, you chose someone you’re paying (instead of someone who refers based on merit), is very often, in today’s environment, a negative signal.

A good logo, or a well done AngelList profile, can seem superficial, but signals are often about how seemingly superficial things can help people with low information sort through noise. If it takes talent to produce it, and it’s the kind of talent needed for market success, it’s a signal worth caring about.

Negotiation and Inexperience

TL;DR: Having access to trusted advisors, and the time to consult with them, is essential for anyone negotiating terms with which they have very little experience. Don’t accept someone’s argument that you must negotiate important issues live. It’s simply untrue, and a tactic for gaining unfair leverage.

Background Reading:

A recurring theme of SHL posts is that entrepreneurs, particularly first-time entrepreneurs, need to be extremely mindful of the imbalance of experience between themselves and the many sophisticated, repeat players they’re going to be negotiating with as they build their companies. It’s obviously common for entrepreneurial personalities to be more comfortable (than most) with risk, and to go head-first into negotiations and activities without proper backup. But for really big, irreversible decisions, it will backfire, and others will happily use it against you.

One of the most overused phrases for getting naive negotiators to give in on issues they should push back on is “this is standard.” When you have no historical or market perspective – what’s normal, what’s fair, what are the risks, how will this play out in 5 years? – you can be easily manipulated into all kinds of bad outcomes. I’ve been at more than my fair share of board meetings or negotiations where someone at the table makes a completely biased, nonsensical claim that something is “standard,” at which point I’ve had to step in to set things straight, and gladly offer up data or a quick market survey.

There are two main things that I tell all companies to focus on in this regard:

  1. Have a group of experienced, trusted advisors that you can quickly communicate with on serious issues.
  2. Do not let yourself be bullied into a setting where your inexperience puts you at a substantial disadvantage.

Trusted Advisors

When I speak of trusted advisors, I’m not referring necessarily just to your Company’s “advisory board,” which serves a broader purpose of helping you on long-term strategic, business, and technological issues. I’m referring to people you can call or e-mail for specific, tactical guidance on more pressing matters; your “inner circle.” Seasoned entrepreneurs, mentors from accelerators, lawyers (who are independent from your lead VCs), and trustworthy angel investors often make up this group for most CEOs I work with. The most important thing is that they (i) have visibility into the broader market, to help you actually understand what is acceptable, and (ii) will be direct and honest with you when you most need them to.

Imbalanced Negotiation Settings

While it is far less common in the tech world than in other areas, you occasionally still encounter people (particularly VCs) who insist that the only appropriate way to “really” negotiate is live, and in person. And let me tell you: this is bullshit.

Of course, live discussion is important for communication and relationship-building; it has its place. But more often than not, attempts to force entrepreneurs and company executives to negotiate key issues live, or under a very tight deadline, is a tactic to gain unfair leverage from their inexperience. Of course the guy who’s done this type of deal 30 times wants you to agree to terms live, face to face, away from your set of advisors. It has zero to do with business norms. Plenty of high-stakes deals are negotiated asynchronously. 

How you push back and (respectfully) assert yourself in negotiations with other business parties will set the tone for your long-term relationship. If you allow them to force you into circumstances that favor them, they will do it indefinitely. There is nothing wrong with responding, diplomatically, that while you of course would love to grab beers and meet up in person for more casual matters, for real business, you expect time to consult with advisors.

If you’re working with people whom you should want to build long-term relationships with, they will respect your request.  In fact, I’ve known some great VCs and other business people who are very upfront about the experience imbalance with new entrepreneurs, and insist that companies work closely with key advisors.  Those are people playing a long game, and who know that their reputation in the market matters more than short-term opportunism.

If the person you’re negotiating with rejects your request, and dictates to you the medium of negotiation, then at a minimum you’ve gained some key information on what the relationship is going to really look like if you choose to move forward.

Commercial / Tech Transactions Lawyers

TL;DR: Apart from early-stage specialized corporate lawyers (startup lawyers), there’s a second kind of lawyer that almost every early startup needs: a commercial/tech transactions lawyer.

Background Reading:

Imagine you run into a doctor who says he can (i) perform heart surgeries, (ii) treat cancer, (iii) treat your asthma, and (iv) provide pregnancy care, on his own, and all at a lower than market cost. Is your first reaction “wow, this guy is an incredibly affordable genius!” ? A cardiologist, oncologist, pulmonologist, and OB/GYN all in one!

Probably not.

One of the first points I make to young tech entrepreneurs about how to source legal counsel is that the statement “I need a lawyer” is almost completely useless without specifying what kind (specialty) of lawyer. The complexity of the legal issues that even young emerging companies deal with is simply too high to entrust all of them to a single “generalist” claiming to be a jack of all trades. This is not a coffee shop, or a bakery. The stakes, and potential liabilities, are much higher.

OK, you might say. I’m a startup, so I need a startup lawyer. Well, that’s an improvement, but what exactly is a “startup lawyer”?

In my experience, the correct definition of a “startup lawyer” is a corporate lawyer with a strong specialization in early-stage emerging companies and venture capital/angel financings. Very different from an M&A Lawyer, or a corporate lawyer who handles middle market or public company work. Startup lawyers typically serve as GC (General Counsel) for early-stage startups, which requires them to have a workable understanding of tax law, securities law, commercial issues, IP, and labor/employment legal issues.  They’re not experts in those areas (corporate law is their specialty), but they’ve seen those issues enough to cover the basics, while also knowing when to rope in deeper expertise. Your corporate/startup lawyer should serve as the quarterback of your general legal team.

For most startups we see, probably 50-75% of Pre-Series A legal needs are covered by these startup-specialized corporate lawyers: formation, financing, hiring and firing, equity compensation, etc. Small amounts of patent or trademark work may be needed by appropriate specialists, but that’s a minority of cases pre-Series A.  But there’s a second kind of lawyer – who isn’t a “startup lawyer” – that virtually all of our early clients end up needing, and that all founders need to be aware of in sourcing their own counsel: commercial, or sometimes called “tech transactions” lawyers.

Startup/corporate lawyers typically handle the more ‘internal’ issues of a company and its stakeholders: relating to the company’s founders, its employees/service providers, and stockholders.  Commercial or Tech Transactions (let’s use C/T) lawyers, in contrast, typically manage legal issues and contracts relating to a company’s customers/users and potential commercial partners. A good 25-50% of pre-Series A legal needs will often get handled by a C/T lawyer. Examples of C/T Lawyer work:

  • License Agreements (Inbound and Outbound)
  • OEM, Reseller / Distribution Agreements
  • Terms of Service and Privacy Policies (which may also require Data/Privacy Lawyers, but usually not)
  • EULAs, API / SDK terms
  • Technology Transfer Agreements
  • Manufacturing / Supply Agreements

The nature of these kinds of agreements is very different from the kind of work a classic “startup lawyer” does, and while most solid corporate lawyers probably could wing a simple version of a tech transactions document, I am deeply skeptical of a lawyer who claims to be able to handle both all of a company’s corporate needs and their commercial/tech transactions needs for a serious amount of time. In the very early days it *may* work, but even with a small level of scale it’ll start to look a lot like the “genius” doctor mentioned above. The most dangerous (and, in the long run, expensive) type of lawyer is the one who doesn’t admit what he/she doesn’t know, but incentives to maximize personal revenue often lead lawyers to exaggerate their abilities.

So, in short: if you’re building a tech startup, you don’t just need “a lawyer.” You need specialists. And a true startup lawyer, even a very good one, is very rarely enough. Ensure you have access to a solid commercial/tech transactions lawyer (reputable startup lawyers work with them). If you don’t, you’ll eventually regret it.

“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 Tech 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.