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.

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.

Common Stock v. Preferred Stock

TL;DR: Beyond the technical differences between Preferred Stock and Common Stock, there are deeper differences in their composition, incentives, and risk exposure that play out in the course of a company’s history. Understanding the tension between those differences is important.

Very quick vocabulary lesson:

Common Stock is the default equity security of a corporation. It’s what founders, employees, advisors, and other service providers get.

Preferred Stock (Series A, Series B, etc.) is “preferred” because it has extra privileges / rights layered on top of it relative to the Common Stock, including a liquidation preference, rights to block certain things, etc. Preferred Stockholders are almost always investors.

Why don’t investors (usually) buy Common Stock? Short answer: why be common when you can be “preferred”?

Longer answer: they want the downside protection that a liquidation preference provides (they get their money back before anyone else), and they want various contractual privileges that separate them from the “common” holders; like the right to elect certain directors. Also, another argument often made is that by having investors buy Preferred Stock, the “strike price” of options (which buy common stock) used as service compensation can be lower (when a valuation occurs). The logic is that common stock at the time is less valuable due to its lower rights and status on the liquidation waterfall.

So if your investors pay $1 for Preferred Stock with a liquidation preference and other rights, you can still issue your employees options at 20 cents per share (or whatever your valuation reflects) without busting tax/equity compensation rules. The options are for Common Stock, which lacks the bells and whistles of Preferred Stock, and therefore the “fair market value” exercise price is lower. If the investors had paid $1 for Common Stock, your employee options would’ve been much more expensive.

Interesting corporate law factoid: between the Common Stock (founders, employees, etc.) and the Preferred Stock (investors), which group does the Board of Directors owe greater fiduciary duties to in the event of a conflict?

Answer: the Common Stock. And yes, that means even the directors elected by preferred stockholders, even if the director is a VC. Ask your corporate lawyer if you don’t believe me. The Delaware case law is pretty clear.  All the more reason to avoid “captive” company counsel, to help the Board actually do its job.

Kind of ironic. The investors get “Preferred” stock, but the Board is actually legally required to “prefer” (in a way) the Common Stock.

Apart from the technical differences between Common Stock and Preferred Stock, it’s important to keep in mind the different characteristics of the people who make up the two groups.

A. Common Stockholders are much less “diversified” than Preferred Stockholders. This is their “one shot.” 

As I wrote in Not Building a Unicorn, venture capitalists and founders/management often have very different incentives when it comes to setting out a growth and exit strategy for a company; especially when the VCs are the type that look for “unicorns” (larger funds).

Most startup investors (preferred stockholders) have a portfolio of investments. If a few go bust, their hope is to more than make up for it with a grand slam from another. For a less diversified common stockholder, like a first time founder: going bust is really going bust.

Imagine, for simplicity, you have 2 potential growth/exit strategies: Option A and Option B. Option A has a 50% chance of success, and would result in the Company exiting at a $80MM valuation. Option B has a 10% chance of success, but would result in a $1B exit.

Now imagine a portfolio of 10 companies, each with an Option A and an Option B. The Preferred Stock are invested in all 10 of those companies, but the Common Stock are exclusive to each company.

Do you think the Common Stock and Preferred Stock are always going to see eye to eye on which option to take? Hell no. With downside protection (liquidation preference) and diversification, preferred stockholders are far more incentivized to take much bigger risks than common stockholders are.

The Common Stock v. Preferred Stock divide is very real, and that matters from a corporate governance perspective.

B. Common Stockholders are typically less “sophisticated,” and don’t have their own lawyers. 

Part of the idea of fiduciary duties is that someone more sophisticated, informed, or influential is given responsibility to look out for the best interests of someone who is less sophisticated, informed, and influential. That’s why the Board of Directors, which has the most power in the corporation, has fiduciary duties to all the smaller stockholders who can’t see everything that’s going on.

Naturally, because many institutional investors are diversified, they are by definition “repeat players,” which makes them more sophisticated at the complexities of financing, corporate governance, etc. In negotiating transactions with the Company (like financings), they also often have their own lawyers to negotiate directly on their behalf.

Common Stockholders rarely involve their own lawyers when they are getting their equity from the Company. They rely much more on the norms of how the Company treats all of its equity recipients. And, frankly, they just have to trust that they will be treated fairly.

It’s worth noting that, at least in this regard, individual angels are a lot more like common stockholders than institutional venture capitalists. They too often sign standardized docs, with little negotiation or personal lawyer involvement, and they also often don’t have visibility into Board decisions. They are usually more trust driven in their dealings with their investments. This is why founders will often feel more “aligned” with angels than with VCs. That’s because they are usually more aligned.

Even founders, with much bigger stakes than a typical employee, often do not involve personal lawyers in dealings with the Company; not until the later stages when the cap table and board composition are very different. They rely much more on company counsel to advise on what’s best for the Company as a whole, which indirectly means what’s best for the common stock.

In short: Common Stockholders, broadly, (i) are less diversified, and therefore more exposed to risk in this specific company, (ii) have less downside protection, (iii) are less wealthy and sophisticated, and (iv) usually don’t have their own lawyers to review and negotiate things on their behalf. This is, to a large degree, why the case law puts such an emphasis on fiduciary duties to common stockholders.  Because the bigger Preferred Stock players can negotiate contractually for their rights and protections, Corporate Law says officers and directors should focus on what’s best for the Company as a whole, with special care toward the interests of the common stock.

ps: should Company Counsel own equity in the Company? Usually they don’t, but sometimes they do. After reading the above, it should be crystal clear what type of security they should own, and why letting your lawyers buy preferred stock can, in many circumstances, be a very bad idea.

Transparency, Risk, and Failure

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

Background Reading:

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

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

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

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

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

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

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

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

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

Transparency means:

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

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

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

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

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

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

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

Tiered Valuation Caps

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

Background Reading:

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

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

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

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

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

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

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

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

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

Standardization v. Flexibility

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

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

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

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

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

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

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