Did you get a “good” valuation?

TL;DR: What a “good” valuation is depends highly on context: geography, industry, timing, size, team experience, value-add of money, control terms, and a dozen other variables. Be careful using very fuzzy guidelines/statistics, or anecdotes, for assessing whether you got a good deal. The best valuation for your company is ultimately the one that closes.

VC lawyers get asked all the time by their clients to judge whether their financing terms are good, fair, etc; especially valuation. And that’s for good reason. There are very few players in ecosystems who see enough volume and breadth of deals to provide a truly informed assessment of a financing’s terms. Executives have usually only seen their own companies. Accelerators see only their cohort’s. Most advisors/mentors have even more limited visibility.

But VC lawyers/firms with well-established practices see deals that cross geographic, industry, stage, etc. boundaries.  In addition to a firm’s internal deal flow, there are third-party resources that can be subscribed to with data on VC valuations across the country and the world. Those resources tend to be expensive (5-figure annual subscriptions), and only firms with deep VC practices will pay for them. Given how much you’ll be relying on your lawyers for advice on your financing terms (for the above-mentioned reasons), ensuring that they are objective (and not biased in favor of your investors) is crucial. 

The above all being said, founders should understand that determining valuation at the early stages of a company (seed, Series A, B) is far far more an art than a science. It is for the investor making the investment, and it is for the people judging whether the terms are “good.” That’s why relying on broad metrics like “median Series A valuation is X” is problematic; there are simply too many variables for each company that could justify deviating from the median, in either direction (lower or higher).

What some people call a seed round, others might call a Series A. Some companies raise a Series A very early on in their company’s history because the nature of their product requires serious capital expense to even get to early milestones. Other companies bootstrap for a decade and only use a Series A as true growth capital (the way others would use a Series C or D). I saw a $150MM ‘Series A’ once. I’ve also seen $500K ‘Series A’s. And everything in between as well. So whenever someone asks me “what’s a good Seed or Series A valuation?” the answer has to start out with: “it depends.” 

Below is a break-down of the mental analysis that I might use in assessing a company’s valuation. Remember, it is an art, not a science. There are widely varying opinions here, and this is just one of them. Consider it a set of suggested guidelines, not rules.

1. What was the last valuation a professional investor was willing to pay, and what progress has been made since then?

The easiest answer to “what is X worth?” is “whatever price someone was willing to pay.” While not entirely helpful in the VC context, it certainly is relevant. If you’re doing a Series A and you have institutionals who invested in a convertible note at a $5MM cap a year ago, the obvious question then is “how much progress has been made since then?” This, btw, is why it’s dangerous for companies to set their own valuations without a true market check from professional investors. Your earlier valuations will influence your later ones.

2. What city are you in?

Location. Location. Location. One of the strongest determinants of valuations is the density of startup capital in the city your company operates in; because density means competition. Silicon Valley valuations are not 2-3x those of the rest of the country because the VCs there are just nice guys who are willing to pay more. It’s a function of market competition. SV has the highest valuations. NYC follows. And then there’s the rest of the country, with variations by city. Austin valuations are generally higher than Atlanta’s, which are generally higher than Houston’s or Miami’s. General deal terms are also more company-friendly where there is more investment density.

While the entire concept of “founder friendly” investors does have an important moral/human dynamic to it, people who play in the space enough know that at some foundational level it is a form of self-interested brand differentiation. The ‘friendliest’ investors are the ones in the most competitive, transparent (reputationally) markets. Why take our money over theirs? Because we’re ‘founder friendly’… which can mean a whole lot of things; some of which are relevant, and others which are nonsense.

Yes, online networks are breaking down geographic barriers and you are seeing more capital flow between cities/states, but the data is still crystal clear that if a Silicon Valley VC is investing in an Atlanta or Austin company, they are going to want to pay something closer to Atlanta or Austin (not SV) prices. Much like all the Ex-Californians buying up Austin homes, they likely will pay slightly above the local market (and in both cases, it pisses off local buyers), but not much. 

3. How much is being raised?

Valuations can (and often do) vary widely between markets, while the actual dilution that founders absorb doesn’t vary as much. How is that? Because founders in markets with higher valuations raise larger amounts of money, and founders in markets with lower valuations raise smaller amounts of money; in each case getting the VCs/investors to their desired %. A $1MM raise at a $4MM valuation produces the same dilution as a $5MM raise at a $20MM valuation.

You should never close any round without modeling (lawyers often help here) the actual dilution you are going to absorb from the round, including any changes required to your option pool. Many investors focus first on their desired % and then back into the right valuation and round size. Smart founders should focus on %s as well. It’s not intuitive; especially if you have multiple rounds involved.

4. Who are the investors?

Value-add, known-brand institutional VCs and professional angels that will be deeply engaged in building your company after the check hits are (obviously) worth a lot more than investors who just bring money. And they will often price themselves accordingly (lower valuations). Some money is greener.

Diligencing the valuations your specific investors were willing to pay for their past investments is a smart move. Again, it still requires discussions about the differences between companies, but it can help address any statements like “we never pay more than $X MM for Series A.”

5. What are the other terms?

A $4MM valuation with a 1x non-participating liquidation preference looks very very different in an exit from a $6MM valuation with a 2x participating liquidation preference. So does a $3.5MM valuation with investors getting 1 out of 3 Board seats v. a $5MM valuation with them getting 2/3. The non-valuation terms matter. A lot. Juicing up valuations by accepting terrible ‘other’ terms gets a lot of companies in trouble. 

6. Other Business-Focused Variables

  • What are valuations within this specific industry looking like over the past 12 months?
  • What are the obvious acquirers paying for companies they buy?
  • Where is the company in terms of revenue? Revenue-multiples generally don’t have a place in early-stage, but a $25K MRR v. $300K MRR absolutely influences valuation.
  • Any serial entrepreneurs on the team? Good schools? Other de-risking signals?
  • What’s growth look like?
  • Size of market?
  • etc. etc. etc.

Obviously, multiple term sheets are a great way to have a very clear idea of where your valuation should be, but in most non-SV markets that is a privilege bestowed on a small fraction of companies.

Take-homes:

A. If your friend’s startup got X valuation for their Series A round, that can be totally irrelevant to what valuation you should get,

B. Other terms of the financing matter a lot too, as well as who is delivering them, and

C. If you have in your hand a deal that isn’t exactly at the valuation you wanted, remember that there are thousands of founders out there who got a valuation of $0.

Over-optimizing for valuation can mean under-optimizing on a host of things that matter far more for building your business. Get the best deal that you can actually get, given your business, location, and investors, and then move forward. And ignore the broad market data, particularly the Silicon Valley data, that isn’t relevant to your own company.

The Best Seed Round Structure Is the One that Closes

NutshellPeople with strong opinions can argue endlessly about whether founders should be structuring their seed rounds as convertible notes/SAFEs or equity. The problem is that the optimal structure for any type of financing is highly contextual, so anyone offering absolutes on the subject should just “Put that Coffee Down” in the Glengarry sense, before they hurt someone.  The X round that closes is better than the Y round that doesn’t.

Complete standardization of startup financing structures has been a pipe dream for over a decade. Every once in a while someone will produce a new type of security, or flavor of an existing security, and proclaim its superiority. The problem, of course, is very much like the problem faced by any product whose founders hopelessly believe that it will achieve market dominance on technical superiority alone: distribution channels, inertia, and human idiosyncrasies.  In the end, a financing is the act of convincing someone, somewhere, to give you money in exchange for certain rights that they value enough to close the deal.  Values are pesky, subjective things that don’t do well with uniformity.

Outside of Silicon Valley and a very small number of other markets, the people writing the early checks are usually not all rich techies in jeans and t-shirts debating the latest startup/angel investing trends on twitter. Even in Austin they aren’t. They’re successful individuals with their own backgrounds, culture, and values, and very often won’t give a rat’s ass about a blog post saying they should suddenly stop using X security and use Y instead.

So let’s start with the core principle of this post: The Best Seed Round Structure Is the One that Closes. That means priority #1, 2, and 3 for a group of founders is to get the money in the bank. Only from there can you work backward into what seed structure is optimal.

SAFEs are better than Notes? Many non-SV investors don’t care. 

This was the same reasoning in a prior post of mine: Should Texas Founders Use SAFEs? To summarize my answer: unless a TX founder is absolutely certain that every investor they want in the round will be comfortable with a SAFE, it’s usually not worth the hassle, and they can get 99% of the same deal by just tweaking a convertible note. Yes, a SAFE is technically better for the Company than a convertible note, and YC has done a great thing by pushing their use. But the differences are (frankly) immaterial if they pose any risk of slowing down or disrupting your seed raise. Here’s what a conversation will often sound like between a founder (not in SV or NYC) and their angel investor:

Angel: Why do we need to use this SAFE thing instead of a familiar convertible note? I read the main parts and seems pretty similar.

Founder: Well, it doesn’t have a maturity date, in case we don’t hit our QF threshold.

Angel: So you’re that worried about failing to hit your milestones and hitting maturity?

:: long pause::

Put. That Coffee. Down.

Debt v. Equity? Do you really have a choice?

There are so many blog posts outlining the pluses and minuses of convertible notes/SAFEs v. equity that I’m going to stay extremely high-level here. The core fact to drive home on the subject is that the two structures are optimized for very different things, and that’s why people debate them so much. Your opinion depends on which thing you value, and that will depend on context.

Convertible Notes/SAFEs are built for maximal speed and flexibility/control up-front. Cost: Dilution, Uncertainty. You defer virtually all real negotiations to the future, save for 2-3 numbers, and note holders often have minimal rights. You can also change your valuation quickly over time, at minimal upfront cost, as milestones are hit. The price for that speed is you’ll usually end up with more dilution (because notes have a kind of anti-dilution built into them) and possibly more liquidation preference. See: The Problem in Everyone’s Capped Convertible Notes You’ll also pay a harsher penalty if your valuation goes south before a set of Notes/SAFEs convert than if you’d done equity from the start.

Equity rounds are built for providing certainty on rights and dilution. Cost: Legal Fees, Control, Complexity. An equity round is more inflexible, and slower than debt/SAFEs, but the key benefit is that at closing, you know exactly what rights/ownership everyone got for the money.  Those rights are generally much more extensive than what note/SAFEholders get. If the business goes south, or the fundraising environment worsens significantly, you’ll pay a lower penalty than if you’d done a note/SAFE. But for that certainty, you’ll pay 10x+ the legal fees of a note round (if you do a full VC-style equity round), and have 10x the documentation. That’s why you rarely see a full equity round smaller than $1MM.

Raising only $250K at X valuation and planning to raise another $500-750K at a higher valuation soon, before your A round, because you’re super optimistic about the next 6-12 months? Note/SAFE probably. Raising a full $1.5MM round all at once that will last you 12-18 months, with a true lead? Probably equity.

Seed Equity is a nice middle ground, but if your investors won’t do it, it’s just theoretical. Series Seed, Series AA, Plain Preferred, etc. Seed Equity docs are highly simplified versions of the full VC-style equity docs used in a Series A. They are still about 2-3x the cost of a convertible note round to close in terms of legal fees, but dramatically faster and cheaper than a full equity set. They are a valuable middle ground for greater certainty, but minimal complexity and cost.

But after pondering the nice theoretical benefits of seed equity, we’re back to reality: will your seed investors actually close a seed equity deal? I can’t tell you the answer without asking them, but I can tell you that I know a lot of seed investors in TX and other parts of the country, including professional institutionals, who would never sign seed equity docs.

There is an obvious tradeoff in the convertible note/SAFE structure that has become culturally acceptable for both sides of the deal. Founders get more control and speed up-front, and investors get more downside protection and reassurance that in the future they will get strong investor rights negotiated by a strong lead.

With seed equity, investors are (like with Notes) being asked to put in their money quickly with minimal fuss, but without the downside protection of a note/SAFE, and with significantly simpler investor rights. Many seed investors see that as an imbalanced tradeoff. Whether or not they are right isn’t a question that lends itself to a single answer. It’s subjective, which means the Golden Rule: whoever has the gold makes the rules.  Can they beef up those protections in the next large round? Sure, but many don’t see it that way, and good luck ‘enlightening’ them when every delay brings more reasons for why the round may never close.

I think seed equity is great, and am happy to see founders use it as an alternative to Notes or SAFEs for their seed raise. But that doesn’t change the fact that for every 10-15 seed deals I see, maybe 1 is true, simplified seed equity. And those usually look far more like Friends and Family rounds – where the investors are so friendly that they don’t care about the structure – instead of a true seed with professional seed money.

When it comes down to getting non-SV seed money in the bank, most founders only really have 2 choices for their seed structure: convertible notes or a full equity round. If you’re lucky enough to get a SAFE or seed equity, fantastic. Go for it. But don’t let the advice of people outside of your market, with minimal knowledge of your own investor base, cloud your judgment with theories. When a team debates what type of product to build, the starting point isn’t which one is technically superior, but which one their specific users will actually pay for. Seed round structuring (like coffee) is for closers.

Burned Relationships Burn Down Companies

TL;DR Nutshell:  Success in building a company most often requires a founder team who can not only find great investors, advisors, employees, and other stakeholders, but build deep relationships with those people in a way that leads them to be emotionally, not just financially, invested in the success of the company.  Short-sighted founders focus on the costs of those relationships, ‘transactionalizing’ them in a way that weakens loyalty. The smarter ones realize that those costs are an investment in an invaluable safety net that will support the company when it hits rough waters.

A brilliant phrase that I learned a while back, and which I’ve often used in suggesting to founder CEOs how they should approach building their “roster” (not just employees, but investors, advisors, lawyers, and other stakeholders) is to never be the person who “knows the cost of everything and the value of nothing.”

If you approach every relationship from the perspective of maximizing your gains and minimizing your costs – get the highest valuation possible, keep as much control as you can, minimize the equity package, minimize the salary, discount the bill –  you may think you are doing what’s best for yourself and your company, but in reality you’re just isolating yourself from the people whom you should most want on your team. 

Talent cares about relationships. 

The most successful and talented people in any market/industry – venture capital, angel investing, design, programming, law, sales, PR, etc. – very very rarely get to where they are because they were chasing money. They often do what they do because they, in some sense, enjoy it. It may not be fun in the same way that going fishing or on a great vacation is fun, but work is something much deeper to them than just work. This is not at all, however, to say that money is irrelevant to them, but getting paid well is often more about respect for their talent – a moral acknowledgement of the value they provide – than about their actually needing the dollars themselves.

Put slightly differently, the highly talented people whom you want supporting your company’s success will very often have “F.U. Money” or “F.U. Skills” or both. They’ve already mastered the bottom rungs of Maslow’s hierarchy of needs and are looking for respect, involvement, trust, engagement, etc in their work and investments. They are looking for real relationships. Build and nurture those relationships, and the long-term returns will be massive, either for your company or you individually. Burn those relationships, and you’re fu**ed. 

Don’t Transactionalize People

Obsessed with maximizing your valuation/control and minimizing dilution? You’re going to end up with shitty VCs; the kind who add no value, are always whining about performance, and will replace you in a heartbeat for not producing the results that they can’t help you achieve. Insisting on keeping equity packages as small as possible? You’ll end up with shitty employees who will drive you insane with the amount of oversight, correction, and overall time sucking they require. Focused on keeping those legal bills to an absolute minimum? You’ll end up with shitty lawyers who are unresponsive, incompetent, and accruing legal technical debt that you’ll pay for later. The examples go on and on.

Watch the bottom line and the cap table intelligently, but let good people make good money. When you push too hard against talent, they will either (i) pass  entirely on you for someone who values them more, or (ii) register in their mind that their relationship with you is purely transactional. The qualitative difference between a transactional relationship and a deeper one sounds small, but in a high-risk, low resource business it can be everything.

If you hit a funding snag and need a bridge to get to your next round, investors with whom you’ve built real relationships may put in some money to keep you going. Investors who view you as just another number in their portfolio will not. Need to cut compensation temporarily, or stretch payments on a bill, to get through that bridge period? You better hope your employees and service providers actually give a damn about your business for reasons beyond their paycheck.

Healthy long-term business relationships are built on a mutual sense of fairness; that it’s OK to take into account leverage and context in negotiations, but that everyone should in the end leave a little on the table as a statement that the relationship is there for something bigger than just money.

Mistrust Burns Money

Trust – meaning a feeling that you have a solid understanding of a person’s authentic character and that they’ll treat you fairly and respectfully – is not just some teddy bear “kumbayah” lets-all-love-each-other buzz word. It is currency that makes doing business long-term significantly, dramatically, more stable and less costly. If you frame it purely in terms of a risk-reward analysis, if I feel like I can trust someone, I automatically feel like working with them is less risky. And if it’s less risky, the threshold of reward that I need (my compensation) to make the relationship worthwhile goes down significantly. Mistrust is spectacularly expensive.  As a startup, you can’t afford for people to not trust you.

The end-conclusion here is a straightforward one: all of the data on business executives confirms that emotional intelligence – the kind of ‘people skills’ that enable you to connect and build trusting relationships with others – is a foundational trait for successful founders, particularly founder CEOs. People are born with varying degrees of those skills, but everyone should work on improving them.

Very very very few teams succeed purely on the momentum of their business. Study the histories of successful teams, and you’ll see a network of valued relationships being built and nurtured over time, propelling founders forward and often protecting them from hitting rock-bottom.  Don’t be the guy who knows the cost of everything and the value of nothing. He’s lonely, unsuccessful, and poor.

Why I (Still) Don’t Make Investor Intros

TL;DR Nutshell: If in today’s connected startup ecosystems, with today’s tools and resources, a founder CEO still needs his (paid) lawyer to introduce him to investors, there’s a very good chance he can’t build a company. And most investors know that.

Background Reading:

Certain law firms I come across love to use the following biz dev pitch: “our firm has close relationships with many investors, and we love helping make intros to them for our clients.” Some have even attempted to institutionalize this into an entire department within their firms.

Sounds great, doesn’t it? Lawyers are constantly interacting with investors, so they must be a great shortcut to getting intros, right? Not so fast.

A paid intro is generally worse than no intro, particularly in today’s ecosystems. 

I wrote Don’t Ask Your Startup Lawyer for Investor Intros about a year and a half ago, in which I made the following argument:

  • Early-stage investing is at least as much about betting on founders, particularly CEOs, as it is about betting on a particular business.
  • Because investors see 100-1000x more companies than they can fund, or even assess, they heavily rely on filters/signals to judge the quality of founding teams.
  • The way in which a CEO obtains an investor intro (and from whom) speaks volumes about that CEOs ability to network, persuade, and generally hustle; all of which are extremely important skills for a successful founder CEO.
  • There are far more ways, today, to get connected with investors and find true, authentic warm referrals – AngelList, LinkedIn, Twitter, Accelerators, etc. – than there were even 5-10 years ago.
  • Therefore, in a world in which there are 100s of possible paths to get introduced to an investor, the fact that your lawyer (someone you are paying) ends up making the intro can send an extremely negative message about the founding team – including that they can’t hustle, can’t convince anyone else in their ecosystem (that they aren’t paying) to introduce them, or both. Samir Kaji emphasizes this last point, about a weak intro making investors think negatively about the founders, in his post.

At the time I published that post, most people providing feedback on it agreed, but I had a few dissenters – generally lawyers arguing that they’ve made successful intros themselves. I don’t doubt that they’re telling the truth, but what was telling is that few could give examples of successful intros in recent years – and my point is very time-contextual. Even five years ago, relationships within startup communities were far more opaque than they are today, and an intro from a lawyer didn’t have nearly the level of negative signaling then that it does now.

But one pattern become obvious that relates to another point I’ve made before:

For a lawyer’s investor intro to not have a negative signal for a particular investor, the lawyer and investor must have a very close relationship, and that means you shouldn’t want that lawyer representing your company in a deal with that investor.

See: Why Founders Don’t Trust Startup Lawyers

There absolutely are particular lawyers who have very close relationships with particular investors, much more than other lawyers who simply run into those investors on deals and on boards (professional acquaintances). The issue is that those close relationships develop, nine times out of ten, from those lawyers working for those investors. And for reasons that should be obvious (but if they aren’t, read the above post), the last lawyer you want representing your company in a VC deal is the lawyer who is BFFs with the VCs you are negotiating with.

So maybe some lawyers can make a decent intro… but you shouldn’t work with them… which makes it significantly less likely that they’ll make the intro. Life is complicated.

Other founders, particularly well-respected ones and especially those who’ve been funded by an investor, are the best source of referrals. Other well-respected, non-service providers (advisors, accelerators, angels, etc.) are the second best. Anyone you are paying comes dead last.

Jeff Bussgang has a great post on how to ‘rank’ different potential paths to investors – Getting Introductions to Investors – The Ranking Algorithm. His hierarchy makes a lot of sense. And aside from other founders being the best source of referrals, they are absolutely the best source of intel on investors, when you’re diligencing them. If a group of VCs have provided you a term sheet and you aren’t actively (but discreetly) talking with their portfolio founders to understand what working with those VCs is actually like, you’re doing it wrong.

As ecosystems become more transparent, and prospecting tools become more sophisticated, investors may be relying less on referrals anyway.

I found the data reported by First Round Capital in their 10 year Project to be pretty interesting, including the data suggesting that First Round’s referred investments significantly underperformed relative to investments that First Round hunted on their own. Honestly, this isn’t that surprising.

A lot of studies on investor performance emphasize that, while many people get lucky with one or two home-runs, the people who consistently outperform the market are those who actively take a process, data-oriented approach, and try their best to counteract their biases. That doesn’t mean success in VC is about number crunching, but it does mean that if your personal relationships are the main way that you find companies, you’re going to have a lot more sources of bias in your decision-making than someone who takes a broader, but more calculated approach.

In short, we live in a very different world from the one in which VCs sat in their offices relying on proprietary, somewhat opaque deal flow sources. In that world, lawyers were a better source of investor intros. That world no longer exists. Investors fund hustlers, and (today) hustlers don’t need their lawyers to introduce them to investors.

The Problem in Everyone’s Capped Convertible Notes

TL;DR Nutshell: Standard capped convertible notes have a flawed structure in that noteholders often end up, when their notes convert, with substantially more liquidation preference than they actually paid for; which means money taken from founders’ pockets and placed in those of investors, without justification. As companies continue to push their “Series A” rounds further out with various series of capped convertible notes, the problem is growing, and a corrected note conversion structure should become the norm.

The existence of the “liquidation overhang” problem in capped convertible notes is not news. It can be explained with a simple mathematical example:

Assumptions for Hypothetical:

  • $500K seed round with notes carrying a $2.5MM valuation cap.
  • Series A has a $10MM pre-money valuation, resulting  in a per share price for new money of $4.00.
  • The Series A has a run-of-the-mill 1x participating liquidation preference. This means that the Series A have a per share liquidation preference of $4.00.
  • The $2.5MM valuation cap means the notes convert at $1.00.

Under the above example, the $500K in notes will convert, ignoring interest, into 500,000 shares.   $500,000 / $1.00

If the Notes convert directly into the same Series A preferred stock as “new money” investors get (which is what most notes require), their aggregate liquidation preference is $2 million.  500,000 shares * $4.00

So those investors paid $500,000, but they have $2 million in liquidation preference. In other words, they got a 4x participating liquidation preference. The $1.5 million difference is the “liquidation overhang.”  Ask me if I think founders/common stockholders care whether they will get an extra $1.5 million in an exit.

If you increase the size of the seed round (which is happening in the market), the overhang gets bigger on a dollar basis. (1MM shares * $4.00) – $1,000,000 = $3 million.

If you increase the gap between the Series A valuation and the seed “cap” valuation (which is also happening in the market), the overhang also gets bigger.  A $15 million Series A valuation, with a $6 share price, produces a liquidation overhang of $2.5 million.  (500,000 shares * $6.00) – $500,000

So as seed rounds get larger, and Series A rounds are extended further out (with higher valuations), the liquidation overhang grows, and more money is transferred from founders to investors.  Historically, convertible notes were called “bridge” notes because they were closed only a few months before a full equity round, offering a small discount to the Series A price. When the price differential is only 10-20%, the overhang is perhaps worth ignoring.  But when the Series A valuation is 2-3x+ of the seed valuation, it’s time to pay attention.

The Most Viable Solutions

The two most common solutions to the liquidation overhang are as follows, and both have tradeoffs.

Create the “Discount” with Common Stock – Instead of issuing (in the above example) 500,000 shares of Series A to the noteholders, issue them 125,000 Series A shares, and the remaining 375,000 as common shares.  In the end, they still have 500,000 shares, but their liquidation preference is equal to their purchase price. 125,000 * 4 = $500,000.

The downside to this approach is that it can significantly affect the voting of common stock.  There is almost always a stock class divide with “common stock” representing founders, executives, employees, and other people performing services, and “preferred stock” being investors. This keeps things simple when calculating approval thresholds for a major transaction – the “common vote” is a very distinct group from the “investor vote.”  However, depending on the numbers, it’s very easy with this “common stock solution” to reach a point where a very large chunk of the common stock is in fact investors, reducing the voting power of founders.  Not an insurmountable problem, but it is a problem.

Issue Sub-Series of Preferred Stock – This is actually my favored approach. In the above example, instead of issuing 500,000 shares of Series A to the noteholders, issue them 500,000 shares of Series A-2. Series A-2 would just be a series of stock that is exactly the same as the Series A in all respects, including voting, except for the liquidation preference (and basis of anti-dilution and dividend rights, which are related). The Series A would have a per share liquidation preference of $4.00 per share, and the Series A-2 would have $1.00 per share. Problem solved.

The most commonly brought-up downside to this approach is that it creates more complexity in the Company’s deal documents and cap table.  While it’s true that you will need to do a bit more work in the company’s deal docs, it does not take that much work to create a Series A and Series A-2, but have them all work together for everything other than liquidation preference.  Even if you have multiple valuation caps, doing a Series A, A-2, A-3, etc. is not that hard.

My somewhat cynical view is that this complaint comes mostly from (i) investors who are trying to convince founders that all of this liquidation overhang “stuff” isn’t that big of a deal and not worth addressing (meaning, an extra few million in their pockets isn’t a “big deal”), or (ii) lawyers at overpriced firms who are ALWAYS running over fixed legal budgets, so having to do ANY kind of extra customization to their template docs results in kicking and screaming.

In the exact same way that “why do we need two sets of lawyers? just use ours, and save on legal fees” is complete non-sense designed to screw founders, the “just give everyone Series A shares and keep it simple” position is ridiculous given the economic impact on founders.  If you’re being told to pay a few extra thousand in legal to potentially save several million in an exit, the issue is fundamentally an IQ test.