Don’t be an Asshole.

TL;DR: You probably can’t afford to be one.

Background Reading:

A regular theme of SHL involves different ways for founders and executives to protect themselves from bad actors – often via advice that I’m able to give by being in a position of not representing any institutional investors, deliberately. If you want more on that, see: How to avoid “captive” company counsel. 

The purpose of this post is to flip the topic, and discuss why there are very real, non-warm-and-fuzzy, reasons why entrepreneurs/execs should be very careful not to behave like bad actors themselves.

If you apply Maslow’s Hierarchy of Needs to the business world, you arrive at one very real truth: the most talented, value-additive people in any industry virtually never are in it just for the money. They have enough, and trust their ability to earn more. Their talent allows them to care about other things: like challenging work, trust, friendship, impact, fun, respect, etc. By no means does this suggest they don’t care about money at all – in some cases money is a way for them to ensure they are being valued and respected for what they deliver. But it does mean that anyone who approaches these people with a kind of opportunistic cost-benefit analysis is likely to get ice cold water poured on them, very fast.

Startup ecosystems are full of these kinds of people. If all they cared about was money, they’d never touch early-stage.  If they’re working with startups (and your very early-stage risky startup), there are non-financial motivations higher on the hierarchy of needs at play, and you need to be mindful of that as you interact with them.

When you’re building your brand new or very early-stage company, unless you have a LinkedIn profile that screams “winner,” people all around you are going to be risking their time and money in working with you. There are 1,000 reasons why they might say no, and move on to someone else with a different risk profile. The absolute last thing you want to do is give them a reason to walk away, because they smell an asshole. And trust me, they will walk away. 

“Startup people” react much more viscerally to assholes than “corporate people” do, because the startup world often selects for people who won’t do or tolerate anything for a big payout.

As startup lawyers, we’re often in a position to see firsthand who the assholes in the entrepreneurial community are. They treat lawyers and many other service providers as line items to be deferred, discounted, and written-off to the very last dime, as much as possible; and will play games to manipulate people into giving them more for less. Thinking extremely myopically, these assholes think they’re doing what’s best for their company by grabbing as much as possible on the table – but played out over time, they’re actually whittling down the number of people who will work with them to those who simply don’t have other options. And when someone doesn’t have options, it’s often for a reason. Interestingly, assholes have a way of ending up stuck with other assholes. 

All of this applies just as well to top investors, particularly angel investors (with more freedom than VCs) who know they deliver a lot more than money. God help you if you give them even the slightest reason to think you’re an asshole. Information travels fast.

The definition of a mercenary is someone whose every decision is cost-benefit calculated for money. The fact is that if you build a reputation in a startup ecosystem for being a mercenary – always maximize the valuation, minimize the equity grant, discount the bill – you’re dramatically reducing your chances of making money, simply because of the personalities and values you tend to find in the startup world.

Be careful out there. Don’t be an asshole. On top of it being simply wrong, you probably can’t afford it.

How Angels & Seed Funds compete with VCs

TL;DR: The emerging “seed ecosystem” of angel groups, seed funds, and accelerators now provides local startups a viable path to seed funding, and eventually “going national,” w/o having to prematurely commit to a Series A lead.  That has dramatically reduced the leverage that local institutional funds once had over their local ecosystems.

Background Reading:

Once upon a time, startup ecosystems (if they could even really be called that) outside of Silicon Valley had only a handful of local VC funds writing checks. Without AngelList, LinkedIn, Twitter, Accelerators, good videoconferencing, and the many other recent developments that have reduced geographic friction in startup capital flows, those funds effectively “owned” their cities, including most of the startup lawyers in those cities; which often resulted in harsh terms and aggressive behavior. For more on this, see: Local v. Out-of-State VCs.

Raising “angel” money in that era often meant needing close connections (family, friends, professional) to very high net worth individuals willing to make big bets on you until you were ready for one of the few local funds to take you under their wing. If you were one of those lucky few chosen, those local VC funds would then, once they were out of their own capital, show you off to one of their trusted out-of-state growth capital funds.

The pipeline was narrowly defined, and choice was minimal: local angels (or friends and family), then local VC, then out-of-state growth capital.

Times have changed.

Today, angel groups are much bigger, organized, and collaborative across city and state lines. Seed funds – which weren’t really even much of a concept a few years ago – will write checks of a few hundred thousand to a few million dollars for rounds that may have been called Series A 3-5 years ago, but are now “seed” rounds. Prominent accelerators have themselves joined the mix, writing their own 6-figure checks and serving as valuable filters / signaling mechanisms to reduce the search costs of investors.

This “seed ecosystem” of organized angels, flexible seed funds, and accelerators has not only increased the amount of “pre-VC” capital available to startups, but very importantly, it has significantly reduced the leverage that local VC funds have over their local startup ecosystems. 

As I wrote in Optionality: Always have a Plan B, sunk money has very different incentives from future money. A seed fund/angel that has mostly maxed out the amount of capital it can fund you with has every incentive to help you find a great Series A lead at a great valuation; they are quite aligned with the common stock. However, a VC fund that wrote you a small seed check but wants to lead your Series A has very different incentives. The “seed ecosystem” wants to maximize your Series A options, while a VC fund wants to minimize them, until it gets the deal it wants.

Foreign capital will usually require some heightened level of de-risking or credible signaling before it will cross state lines. It’s much less risky to rely on my local referral sources, and “monitor” my portfolio where I can drop in by the office whenever I need to. If I’m going to write a check a thousand miles away, I need a little more reason to do so. In that regard, it’s well-known that there is a “flipping” point beyond which the pool of capital available to a startup moves from being mostly local to much more national: that point is somewhere between $1M-$2MM ARR (it used to be higher). 

Historically, reaching that flipping point was almost impossible without local VC, and this effectively kept startup ecosystems captive to their local funds. The new seed ecosystem, with its ability to often fund 7-figure rounds all on its own, has changed that. Now, if a desirable startup wants to, it can often raise $1-2MM in seed capital without taking a single traditional VC check, then use that to hit the “flipping” point, after which the number of VCs it can talk to goes up considerably. 

Of course, this dynamic is not always so clean cut.  More progressive VCs have wisely developed symbiotic relationships with this seed ecosystem for the obvious reason that it can serve as a pipeline when startups are ready for bigger checks. That is a smart move. What we’ve also seen is that large VCs are playing much “nicer” in seed rounds than they used to, as an acknowledgement of their reduced control over the market. Years ago you much more often saw VCs condition a $250K or $500K check on a side letter giving them the right to lead your Series A. That is increasingly becoming an anachronism, and for good reason.

At the same time that AngelList, accelerators, LinkedIn networks, and other signaling / communication mechanisms for startups are giving foreign capital more “visibility” into other ecosystems, allowing it to invest earlier and more geographically dispersed, the emergent seed ecosystem is also increasingly allowing local startups to “go national” without having to commit themselves to a particular VC fund. The obvious winners in this new world are entrepreneurs and investors willing to be open and flexible with how they fund companies. The losers are the traditional investors who haven’t understood that the old game is gone, and it’s not coming back.

Optionality: Always have a Plan B

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

Background reading:

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

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

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

Always have a Plan B.

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

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

Lead fundraising yourself.

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

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

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

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

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

Build “diversity” into your investor base.

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

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

Contracts matter. A lot. 

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

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

Make money, and own your payroll.

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

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

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

ICOs and Crowdfunding

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.