Local v. Out-of-State VCs

Some things in life are certainties. The sun will rise tomorrow, you will be taxed for something… and startup ecosystem players across the world, outside of Silicon Valley and NYC, will complain about the lack of local VC capital, and the need for more foreign capital. Are they correct in complaining? I’m not going to answer that question. Too debatable, and the debate gets you nowhere.

What I am going to say, and I’m saying this as someone who manages a legal practice with visibility into a decent number of 2nd/3rd ‘tier’ ecosystems in the U.S., is that there are a lot of reasons to be optimistic about the overall trends in this area.

The Historical ‘Scarcity Culture’ of Local Venture Capital

Not just in Austin, but in many tech ecosystems that have a similar profile, there’s historically been a culture among the institutional investor community that directly reflected the scarcity of local capital, and of information about that capital. I will call this ‘scarcity culture.’ Trying not to come off as too judgmental, because all institutional capital plays a vital role in the business community, regardless of its approach, I would say that scarcity culture is largely summarized with the following statement:

“You don’t like our terms or our behavior? What can you do about it? What alternatives do you actually have?”

Does this mean that all local VCs outside of the densest markets think that way? Of course not. But it is definitely there, in a variety of ways.

Anyone with a broad enough visibility into American venture capital knows it is an absolute fact that California VCs are generally ‘friendlier’ than the VCs of any other ecosystem. By ‘friendlier,’ I mean that they are OK with higher valuations, they are more transparent in their intentions, and they tend to show significantly more deference to a founder team in terms of providing coaching/opportunities for growth as opposed to an early pink slip.  Why is that?

Is it something in the water? The weather? Have they achieved a new level of enlightenment? Hell no. California VCs have the same job as VCs anywhere else: to make money.  The answer lies in one very simple word: competition. And increasingly over the past few years it is magnified by one more factor: increased transparency through technology and decreased friction in networks. 

Competition and Reputation. 

Let’s use an analogy here.  Do you think that restaurant service is better or worse in dense urban environments relative to small rural areas? Obviously it’s better. There’s more competition.

Do you think the existence of Yelp, and the ability of restaurant goers to (i) easily find information on the past experiences of patrons of a specific restaurant and (ii) easily express their own experience about those restaurants, has improved or reduced the quality of restaurant service? It obviously has improved it. There’s a million times more transparency, which dramatically raises the reputational stakes.

In an environment where a quality founder team can, if they don’t like one particular set of VCs, walk almost literally across the street and talk to 10 more, investors have learned (rightly) that to be an asshole is to step right into a massive adverse selection problem. Combine a truly competitive market with inter-connected networks where reputational information flows freely, and you have a system that naturally corrects for bad behavior.  The really good companies, the one’s that everyone would want to invest in, don’t have to put up with anyone’s nonsense; and they do their homework. 

Contrast that with ecosystems where only a handful of investors, many of whom collude with one another, are available for companies that need serious funds, and you have a very clear explanation for why California capital is ‘sunnier.’  California VCs are more “founder friendly,’ because their circumstances make founder friendliness an almost essential requirement for deal flow. Most assholes can’t even survive in that environment, so it selects for ‘nicer’ people.

I am not saying that west coast money is all cotton candy and rainbows; nor am I saying that non-SV local VCs are all difficult to work with. But broadly and relatively speaking California VCs tend to be much easier for a founder/management team to get along with. It is also no surprise that the rise of industry/vertical-focused VC and VC ‘value-add services’ has come out of California. They’ve got to find a way of differentiating themselves in the noise.

Transparency and Friction.

A decade ago, if you needed to connect with X person for whatever reason – to diligence an investor, to connect to an investor, to find out some piece of information – you faced enormous opacity in finding a path to doing so. This opacity added friction not only to connecting with people far outside of your personal network, but also to obtaining information, including reputational information, about market players. Information is essential for separating marketing/branding from reality.

Blogging is marketing. Twitter is marketing. Talking on panels is marketing. Free office hours is marketing. That free beer at the ‘get to meet investors’ meet-up is marketing. This should be obvious to smart CEOs. Yes, this blog is marketing. Calling something marketing doesn’t mean it’s false; it just means you’re acknowledging the incentives behind it. And that you need a mechanism for verifying what you’re being told.

My method in biz dev is simple: “here’s a list of my clients. reach out to any of them, and don’t tell me which one. Ask them about our rates, and our responsiveness, and the independence of our counsel. I welcome diligence.”

Today, if I run into a set of founders who are talking to VCs, whether they are clients or not, I say “Here is a list of their past investments. Get connected to the founders of those companies, and start asking questions. And don’t tell anyone which ones you are talking to. Don’t treat any single ‘review’ as gospel, because it is a one-sided story. But look for patterns.” For a team that is even mildly good at networking, that is a fairly straightforward task. LinkedIn does 80% of the work for them by letting them know exactly who in their existing network, whether they’re local or not, can connect them to their target.

Tools like LinkedIn, AngelList, Facebook, and Twitter, and the way in which they eliminate huge amounts of friction and opacity in networking, have done two game-changing things for founders: (1) they’ve made expanding their networks beyond their local ecosystem 10x easier (I didn’t say easy, I said easier), and (2) in doing so, they have made finding accurate reputational information about market players 100x easier. That ease of accessing accurate information influences the behavior of investors in exactly the same way that Yelp influences the behavior of restaurants.

In an opaque market in which influencers can control access to people and information, you can reap the benefits of being an asshole without facing many of the costs. Today, the transparency brought about by modern tools and networks has made the costs of bad behavior 10x higher. Technology makes technology investors ‘nicer’ by opening up access to accurate information on market players. Knowledge is power. 

Improving Local VC. Accessing out-of-state VC. 

Thinking of this issue broadly with the above concepts: improving transparent access to accurate information, removing friction in expanding networks, increasing competition, I think we can arrive at some useful ideas for both improving the local investor environment in non-SV markets, and in increasing the flow of capital between markets; beyond the “great companies attract great capital” truism that rightfully causes eye-rolls among founders.

1. Founders/management need to talk to each other more, in places that aren’t controlled by the investor community. 

Information flows most freely when the consequences of sharing it are minimized. You better believe that in some markets where key players serve as gatekeepers (see: Gatekeepers and Ecosystems) the threat of being black-listed somehow for speaking honestly is real. You will never get accurate market information on blogs, on twitter, on panels, or in highly public events where anyone and everyone is watching.

To use Brad Feld’s categories: there are entrepreneurs, and then there are “feeders,” which sort of means everyone else. Events and communities where the whole ecosystem is invited are great. But that entrepreneur v. feeder divide is crucial, and there need to be ways for entrepreneurs to share information with each other, confidentially and alone.

That is the best way to create the following causal chain: (1) bad market behavior -> (2) information shared to broader entrepreneurial community -> (3) adverse selection for bad market player -> (4) correction to behavior.  You get along much better with the VC community when, instead of moralizing about their tactics and behavior, you try to understand their goals and their incentives; and find ways to align them with yours.

2. Outreach to foreign capital needs to come from people who don’t benefit from a scarcity/opacity environment.

Do not expect for a second that market players who benefit from scarcity of local capital and opacity of information will improve the environment for you. In a variety of ecosystems, I have seen circumstances in which local capital deliberately tries to keep out-of-state capital off of a cap table if it is not willing to enter on their terms. If a founder team builds local support and then themselves builds independent relationships with out-of-state capital (directly or via local relationships), that will create very different dynamics relative to a situation in which their local capital syndicates with its own existing out-of-state syndicate partners.

Is building those out-of-state relationship easy? Of course not. But it needs to start early. The companies that successfully receive out-of-state participation in their Series A round often were building those relationships at seed.  And the best intro to a particular investor is through a founder that they already invested in, so local founders who’ve accepted out-of-state capital are vital to encouraging that capital to engage more local companies. Once a foreign VC has made an investment in a city, it is a lot easier for them to look at others.

The angel v. institutional capital divide, highlighted somewhat in “Protect Your Angel Investors” is important here too. True angel investors – not the ones that behave essentially like micro-VCs, but the ones who are playing with their own money and who are really in it for more than just a return – typically behave very differently from institutional capital. They are usually more patient, more attached to the founder team, and usually aren’t laser-set on a “10x or bust” mindset that institutional investment often brings. Angel investors with broad networks can play a huge role in encouraging out-of-state capital to enter new ecosystems.

Just please for all things holy ignore any set of lawyers pretending to provide ‘special access’ to out-of-state investors. There is a hierarchy of paths to investors. If lawyers are even on it, they are near the bottom.

3. De-risk long-distance investment by improving communication.

If I’m an investor deciding whether to invest locally or make a bet on a team 1,000 miles away, I see substantial additional risk in the latter simply because of the added friction in communication. This is particularly important at seed/Series A, where feedback loops between investors and founders are more important. Think of ways to signal to long-distance investors that you will actively remove that friction.

Videoconferencing, well-done regular investor updates like through AngelSpan, committing to flying to meet-up in person regularly, are a few ways to do this. If entire companies can run with remote teams, leverage similar mechanics/tools to make long-distance startup investment seem natural and logical.

4. Reduce search costs. Successful curation is king. 

Finally, while communication issues often make long-distance investment at least seem difficult, you should never ignore the fact that to any investor, simply vetting out-of-state companies is much harder than vetting local ones. Most institutional investors build in various filters and qualification mechanisms into their pipeline/deal flow, and they often break down when looking at companies that are mostly outside of their usual network.

So creating credible, successful curation mechanisms to reduce the ‘search costs’ of institutional investors exploring non-local markets is essential. The obvious answer here is, and has been, accelerators; at least to the extent that accelerators aren’t beholden to particular local funds (in some markets, they are). The most prominent accelerators are playing extremely important roles in connecting companies in one market to investors in other markets, because those investors trust that the accelerator has done a significant amount of pre-qualifying for them. In fact, this curation dynamic is part of the core value proposition of accelerators in the first place.

Another obvious answer is angel investors with prominent personal brands. As angel investors develop broader reputations for selecting winners, out-of-state institutional capital can leverage them to reduce the search costs of exploring other markets.

So, is raising a Series A outside of Silicon Valley and NYC really hard? Absolutely. Then why the reason for optimism? Because every single variable/dynamic mentioned above is improving, and at an accelerated pace. Founders are finding each other and communicating directly, sharing accurate information about the investor community and other market players; aided by modern networking and communication tools. Local angels and entrepreneurs are actively using those same tools to expand their networks far beyond their local ecosystem. Tools for long-distance communication and investor relations are maturing. And accelerators and prominent angels are increasingly becoming curation mechanisms leveraged by institutional investors to reduce search costs and explore new markets.

We are certainly seeing all of this happening at an increasing rate in our work in the market. As additional funds that are more comfortable operating in the new environment pop up, and as geographic barriers are reduced for capital flows, the more established players are increasingly more concerned with their brands and reputation. Instead of a “scarcity culture,” an open, transparent market culture favors investors that deliver real value and build durable, authentic brands.

Raising local and out-of-state institutional capital, and ensuring you’re working with good people, is still extremely hard if you’re not in a top-tier ecosystem. And speaking as ‘just’ a lawyer, I don’t want to minimize that fact in any way.  But the truth is that it’s also never been easier, and the core trends suggest it will keep getting better. 

Founder Education

TL;DR: Accelerators have emerged as elite universities of sorts for tech entrepreneurs. But they offer a bundled value proposition at a price (in terms of time and equity) that doesn’t work for everyone. For those teams in need of just the educational aspects of an accelerator, other (quality, but lower cost) offerings are starting to be developed that should be considered.

I’m a huge proponent of curation and leveraging the knowledge of trustworthy domain experts to avoid burning time; time that could otherwise be spent running a company.

The value of curation in the lives of founders is perhaps reflected best, above all else, in the rise of accelerators. Accelerators’ core value proposition to founders is that, in exchange for (i) several weeks of their time, (ii) an equity stake, and (iii) rights to invest in future investment rounds, founders in accelerators gain virtually immediate access to significantly curated resources: investors, mentors, other founder teams, prime office space, educational content, etc.

And on the flip side, great accelerators are able to attract quality resources by promising the people who provide those resources access to a curated set of startups; saving them time from having to sort them out in the general marketplace.

Of course, the value of those resources and their curation varies wildly depending on the quality of the accelerator. Top accelerators have proven invaluable to many young, inexperienced founder teams who’ve saved countless time searching, networking, vetting, etc. by tapping into an accelerator’s network and resources. Lower quality accelerators, however, are often a time suck, and much like the “Top Startups to Watch” lists we all see get thrown around, can serve as a damaging and distracting vanity metric.

But as much of a fan as I am of great accelerators, the reality remains that accelerators offer a bundled value proposition. And not every founder team needs, or is willing to ‘pay’ for, the entire bundle. Some founders have already arrived at a successful business model showing strong traction, and are good in the advisor department, but just need connections to Series A investors.  Other teams are well-funded, and already have their own office space, but could really use some guidance on the ‘fundamentals’ of recruiting, managing a scaling company, etc. It shouldn’t surprise anyone if resources are developed in startup ecosystems to address these types of companies for which a typical accelerator isn’t the right fit.

Every now and then I use SHL to spread awareness about new resources in the market that I feel are really adding something differentiated and high value for founders relative to what’s currently available. Years ago I wrote about Clerky and how it filled a void in the market of startups that just need a super-fast, totally standard incorporation and corporate organization, and due to capital constraints are willing to go through it without a lawyer. I also wrote about how eShares was using a SaaS model to liberate early-stage startups form burning money on 409A valuations. I later wrote about how services like Bad Ass Advisors can help companies connect with specialized advisors/mentors beyond the limited roster of people available in their local market.

Today, I’m writing about another topic: Founder Education; meaning how founders can get access to the wisdom/pattern recognition of people who’ve observed dozens, or even hundreds, of startups. It includes best practices on topics like starting a company, finding advisors, finding product-market fit, using advisors, compensating people with equity, targeting investors, understanding metrics, building sales/distribution channels, etc. etc. Books and blogs are great, but they can only go so far, and sorting gold from garbage gets hard. Top accelerators have developed internal curriculums for these sorts of topics, but (remember) they come bundled with a lot of other resources, and at a price, that don’t necessarily work for all companies.

In Austin, I was recently introduced to Founders Academy; an educational curriculum designed for tech founders. It’s run by Gordon Daugherty, a very well-known and respected (including by me, and SHL readers know I’m jaded from experience) startup advisor in Austin who’s had a front seat for some time at one of Austin’s best known accelerators, Capital Factory. Gordon’s built Founders Academy into a packaged, structured curriculum for new tech founders; offered both as a set of online videos that you can buy, and also as an in-person course (taught by Gordon over a few days) that founders can sign up for.

I got some feedback from a few teams that participated in the in-person course, and they all said it was extremely valuable for the price of a few hundred dollars.  I’ve reviewed much of the material myself, and have also interacted with Gordon enough, to say that he knows what he’s talking about, and because his background is in Austin / Texas, his curriculum will resonate well with founders operating in markets that aren’t Silicon Valley.

As I’ve written about before on: Bad Advisors: The Problem with Localism, many tech entrepreneurs operating in second and third-tier ecosystems run into a serious problem when they limit their pool of advisors to their city’s geographic boundaries: they get bad (sometimes really bad) advice. Founders Academy, and other programs like it (if you know of them, leave comments please) thankfully help solve that problem by scaling the wisdom of domain experts (advisors who aren’t charlatans) in ways that are more structured and digestible than just blog posts or books.

Education means leveraging the wisdom of others, so you can avoid the mistakes that they made. For tech entrepreneurs who don’t have time or money to waste, the right kind of education is invaluable. And while top accelerators have emerged as the elite universities of the tech startup world, they clearly aren’t for everyone. It’s great to see quality educational resources popping up to fill the void.

p.s. Like Clerky, eShares, and Bad Ass Advisors, I don’t have any ownership interest in Founder Academy. The mention was entirely earned.

Angel Investors v. “Angel” Investors

TL;DR: The term “angel” investor has connotations that in reality don’t apply to a significant portion of early-stage seed investors outside of Silicon Valley. Historically, angel investors were very wealthy individuals who’d take big, almost irrational (from a risk-adjusted perspective) bets on entrepreneurs for reasons that go well-beyond a profit motive. Many “angels” that you’ll encounter as an entrepreneur, however, think and act in a much more self-interested, conservative manner; much like venture capitalists, but with smaller checkbooks. Both types are crucial to startup ecosystems, but knowing the difference is still important.

Related Reading:

One of the core reasons behind this blog’s existence is that the majority of legal/fundraising advice available to startup entrepreneurs comes from places (like Silicon Valley or NYC) that are dramatically different (in terms of access to capital and key resources) from the environments in which most tech entrepreneurs find themselves. That doesn’t mean at all that SV or NYC advice is bad or wrong. On the contrary, much of it is very very good and founders who look only to local advice will screw themselves – see: The Problem with Localism. But founders also need to understand the mismatches between the advice/culture they’re exposed to on the most popular podcasts, blogs, etc., and how things tend to work for normals.

One important area where I see the disconnect arise is in founders’ expectations in interacting with “angel” investors. The typical “angel” investor that you encounter in Austin, Houston, Atlanta, Dallas, or Miami does not look, think, or act like what Silicon Valley people have historically referred to as “Angels.” 

Classic Angels

While the full origin of the term “angel” investor goes beyond this post, in general very early stage investors were very wealthy individuals who, in addition to other activities, wanted to “give back” to the business community by making bets on promising entrepreneurs that no one else (rational) would be willing to make. Hence, their investments were “angelic.” While this doesn’t mean at all that Angels didn’t scrutinize their investments, or that that they acted completely out of charity (hardly), the term absolutely has (correct) connotations of motives that are much broader than just making a great return.

These classic “Angels” were wealthy enough that writing a $100K or $200K+ check barely moves their needle, and so they could take the risk of investing in a company with little more than a very promising team and an idea, and perhaps the very early beginnings of a product. If it fails, NBD. They’re doing it for the relationships, the excitement, and the chance at supporting something new.  I often see founders take very early money from investors that fit the classic “Angel” profile, but those relationships take a long time to build. They don’t spark over a pitch contest or business plan competition.

Anyone who says there isn’t enough money in Texas/the South is painting with way too broad of a brush. There’s tons of money floating around here and elsewhere. The core difference is that in Silicon Valley, the true capital-A “Angel’ money was created in tech, and therefore much more easily flows back into early-stage tech (because the Angels trust their judgment on tech teams/companies). Outside of that environment, much of the ‘Angel’ money comes from other industries (like Energy, Healthcare, etc.), and so much more relationship-building, selling, and (cultural) translation is needed to convince it to go into a tech startup.  Great t-shirts and a pitch deck won’t get you there.

Most “Angels”

In most other tech ecosystems (outside of SV), when people speak of “angel” investors they are often talking about successful individuals who, while willing to take on the risk of early-stage seed investment (which is great), are not so wealthy and altruistic that they’ll barely feel losing $100K-$200K.  That means that most “angels” seen in non-SV ecosystems are much more conservative in how they pick their investments (and will therefore have higher expectations), because to many of them angel investing really is about making a great financial return.

Classic Angel investors were/are generally very wealthy senior executives and business people with net worths well into 8 figures and above, who will bet on team, vision, and minimal traction (if any); so very early stage. The majority of “angels” that entrepreneurs encounter in their own ecosystems, however, come from broader backgrounds (lawyers, doctors, real estate, business owners, etc.) and are affluent/comfortable, but not quite the 0.1% (their angel investments are material to them), and they”ll often want to see clear customer traction, revenue, and a more mature product; and a lower valuation. 

Of course, there are far more “angels” than Angels, so I’m not suggesting at all that the more conservative, self-interested nature of typical “angel’ investors is bad or a problem. They are crucial to startup ecosystems. I’m not running around writing $100K checks on team+vision either. But the distinction between the two categories often gets lost on first-time entrepreneurs, with negative consequences.

You likely need a Pre-Angel Plan

So the net result of the above is that tech entrepreneurs outside of the most dense ecosystems like SV and NYC encounter much higher expectations from “angels,” and therefore (and I’ve written this in prior posts) pre-angel money, what is typically called “friends and family” money, is often essential to building something attractive to “angels.” If I encounter a founder team planning to start a company without a viable path to $50K-$200K in initial funds, either from their own savings, friends and family, or a classic Angel, that is very often a red flag. Not game over, but it is a concern. 

It’s certainly been done before, especially when the founder team is very self-contained and willing to work for nothing until there is real traction, but most companies will never make it to the “angel” investment stage (product, traction, revenue) without either bootstrap/F&F funds, or a classic Angel investor willing to make a big bet. Accelerators have helped with this issue by (often) being the first non-F&F money in and serving as a valuable signal to “angels”, and they deserve credit for that, but even getting to a point where you’re attractive to a top accelerator often takes some real cash.

In short: most angel investors are much more conservative, and have higher expectations, than the term “angel” suggests, because they’re in a different category from the classic wealthy “Angel” investors that give the term its meaning. Be mindful of that fact, and prepare for it in your early-stage fundraising strategy.

Founder Compensation: Cash, Equity, Liquidity

TL;DR: Before investor money shows up, founders should pay themselves very little, if anything. As the company reaches milestones, including fundraising milestones, founder compensation increases as a % of market comp, although it rarely reaches full ‘market’ until a Series B/C or later. As a general matter, investors want founders (i) focused on the long-term success of the company’s stock and not on a lofty cash compensation arrangement, but (ii) also comfortable enough financially to pay their bills and not be distracted by financial worries.

Background Reading:

As with many things, how different parties assess and calculate appropriate founder compensation is far more of an art than a science.  One thing to keep in mind is that all comp numbers at each stage are heavily influenced by (i) location and cost of living, (ii) industry, and (iii) life circumstances of the founders.  Older founders with families tend to have slightly higher salaries than younger single founders. The same goes for founders in more expensive cities, and for founders in industries (like biotech, energy) where the founder team is made up of seasoned executives that have taken very large pay cuts to join the venture.

There are also tax nuances involved that are not the scope of this article. That being said, the below is an outline of the overarching common principles that I’ve observed among companies along the various stages of their life cycle.

Pre-Seed: Cash In, Not Out

Money in should be documented as a Founder Note or SAFE. Paying yourself a salary  at this stage makes little sense, unless there’s substantial revenue. If you need to get some money back, a small bonus upon raising a larger ($2MM+) round is sometimes kosher. 

If a startup is currently bootstrapped and not running on a sizable amount of customer revenue, paying founder salaries amounts to taking cash from one pocket and placing it in the other, while allowing the IRS to take a percentage of it. It is very rarely rational. Keep what you need to survive in your own bank account, and only fund the company with the rest.

Contributions of capital from founders beyond minimal amounts should usually be documented as a founder convertible note or SAFE (see articles above), with the expectation that it will convert later into preferred stock, providing that founder a “little extra” on the cap table and eventually in a liquidity event. It should not, however, be expected to be paid back.

However, occasionally founders will put in such a large amount of money that they really need to get some of it back much earlier than in an exit. In those instances, discussing a small ‘performance bonus’ with your seed or Series A investors can often work, as long as the amount isn’t too large of a percentage of the overall round. I’ve seen founders get a $50K ‘performance bonus’ upon raising a $2MM+ Series A, with the logic being that they were taking barely subsistence salaries for the past year and need something to help cover deferred expenses. Sometimes it works. Sometimes it doesn’t. Usually founders with personal obligations, like student loans or families to support, are able to make a more credible case for an early cash bonus. 

I would also put “Friends and Family” round territory in this category, although it depends. If you’ve raised $250K or less, which is usually what I see for F&F, paying yourself any kind of salary often doesn’t make sense. For larger F&F rounds that are meant to last for over a year, very small founder salaries can work. As a general matter, however, anyone looking to build a company without at a minimum 6-12 months of cash reserves to live off of should re-consider whether they are in the right position to start a company.

Seed/Series A: Enough to pay the bills

Founders get paid ‘subsistence’ salaries; enough to cover expenses, but low enough to where they’re still hungry for growth. 

Once investors are on the cap table and/or the company is generating real revenue, discussions about founder salaries start to make more sense. The core principle to understand in this stage is that investors will want to avoid paying founders such high salaries that they’re no longer hungry and are just enjoying the ride. The vast majority of a founder’s long-term payout should come from their equity stake in the company, and investors want founders laser focused on turning that stake (and the investors’ stakes) into cash with a successful liquidity event.   That being said, most investors also do not want founders to be so desperate for cash that they are worried about paying their mortgage, or their kids’ schooling, which will be distracting from company matters. 

While this is an extremely rough benchmark and there are all kinds of variations, if you assume 100% as being the aggregate cash compensation of a C-level executive in a respectable, matured middle-market company in a startup’s industry and geography, seed-stage founders will often get paid 20-25% of market, and Series A founders bump up to something like 35-50%. So, as an example, if $250K is ‘market’, a seed-stage founder CEO might earn $50-60K a year, and $85K-$125K at Series A; with the universal understanding that industry, cost of living, and the personal circumstances of founders will push it in either direction.

At this stage, any discussions of founder liquidity (taking some money off the table via a secondary sale) will be non-starters, and even send a negative signal to investors that the founder isn’t as bullish as he/she should be on the company’s long-term prospects. If a founder needs more money (often family circumstances), cash comp, like a special bonus, should be the focus.

Series B/C and BeyondEdging Toward Market, Liquidity

Now we’re running a real enterprise, with the market compensation to prove it. 

It’s at true “growth” rounds when cash compensation starts to edge closer to ‘market,’ and when discussions about some small founder liquidity start to make more sense.  A ‘growth round’ would generally mean that the company has found strong product-market fit, growth is going strong, and they just need gasoline (cash) to propel the rocket ship. At this stage, founder cash comp would usually be closer to 75-100% of market for the founders’ position in the company, which may still be C-level, but might not be. See: Rich v. King: The (Core) Founder’s Dilemma.

A dynamic that starts to arise at the growth stage of a company is the feeling among a founder team (and, frankly, their spouses and families), that even though the company hasn’t exited yet, they’ve ‘made it.’ They’ve made it through the sleepless nights, the chaotic weekends, and the strained personal lives, and have built something with sustainable, sizable market value… but the ‘big pay day’ may still be years away.

It’s at this stage that a spouse might ask a question like, “So… you’ve been at this 5 years and your company just raised $20MM. Why can we still not afford to buy that house I told you about?” Those types of thoughts, which are often not unreasonable, prompt discussions about founder liquidity; meaning the sale of a portion of a founders’ common stock for cash beyond an amount that would be reasonable as a cash compensation package directly from the company.

Some VCs, when prompted by a founder looking to take a little money off the table, will respond bluntly, “absolutely not.” The logic being the conventional “I want you to be hungry” mindset. Over the past few years a counterpoint to that perspective has emerged that is reflected in It All Changes When the Founder Drives a Porsche and Some Thoughts on Founder Liquidity. The logic goes something like this:

  • Once a founder has built demonstrable enterprise value and their equity stake represents a life-changing amount of money, personal psychology and (often) family dynamics can lead them to become impatient toward converting that stake into cash;
  • This impatience can lead founders to become overly conservative in company decisions, edging toward smaller, but earlier exits (early acquisition), when a little more patience and longer horizon could achieve a significantly larger outcome (larger acquisition, IPO);
  • Therefore, allowing founders a small amount of liquidity in growth stage – enough to bring something significant home to their spouses/families/friends to reflect their achievement and calm the financial impatience, but not enough to take their eyes off the much larger pot at the end of the rainbow – can maximize the value of the company, and the eventual payout to investors, in the long run. 

You’ll still often run into both the “keep them hungry” and “let them take a little off the table” mindsets within a single cap table, but I would say the latter view, that some founder liquidity (think 5-10% of their stake) in true growth rounds can push founders to achieve bigger exits, is winning out. It depends a lot on the context, and on the particular investors.

So to summarize, while there are wide variations in the market, some reasonable, rough guidelines for founder comp are:

Pre-Seed / F&F: All equity, minimal or no cash comp, liquidity impossible.

Seed: 20-25% of market cash comp, liquidity impossible.

Series A: 35-50% of market cash comp, don’t ask about liquidity.

Series B-C+: 75-100% of market cash comp, small liquidity possible in right circumstances.

Why Your [Specialist] Lawyer Sucks

TL;DR Nutshell: A common complaint from startups about their law firms is that, while they like their corporate counsel, the ‘specialists’ (patent, employment, benefits, export, etc.) that they end up working with suck. The core reason for this usually has to do with the incentives of large, outdated law firms to cross-sell their poorly-fitted specialists, even when better suited alternatives can be found elsewhere.

Background Reading:

Here are some very common complaints I’ve heard from funded startup founders about their law firms:

  • The patent lawyer I got connected to knew nothing about the background technology of our product. I spent half a day explaining the basic tech/science, and frankly had to do all the legwork myself.
  • The benefits/ERISA lawyer I spoke with took me through all kinds of corner cases/issues that seem far more relevant to a large company than to my startup, when all I want is an off-the-shelf equity plan and to grant a basic employee option.
  • I e-mailed the employment law specialist they referred me to about a time-sensitive executive termination issue, and it took 5 days to get a response, and it ended up being a junior lawyer they ‘throw’ to companies at my stage.
  • My TOS needed to cover some touchy healthcare privacy issues because of the nature of our (med-tech) product, but the guy my lawyer sent me to could barely tell me the basics of HIPAA.

Specialists and Sub-Specialists

One of the most important concepts founders need to understand in interacting with lawyers is that lawyers, just like doctors, have specialties and even sub-specialties; at least the good ones do. Corporate law is a specialty. Startup/VC Law is a sub-specialty of corporate law. There are also energy-focused corporate lawyers, healthcare-focused corporate lawyers, etc. The sub-specialties available in a city mirror the types of industries that dominate the local economy. That’s why Houston startups often use Austin tech/vc lawyers, and Austin energy companies often use Houston energy lawyers.

If you work with a generalist lawyer who dabbles in a little real estate, corporate law, litigation, and maybe does a few tax returns on the side, you’re asking for a world of pain if you’re building a scale-seeking tech company. But even if you work with a general corporate lawyer, failing to work with one who focuses on technology and venture capital (sub-specialty), you will waste time and money.

In the end, it’s all about incentives. 

OK, so now you understand that depending on the issue, you need corporate, tax, patent, trademark, employment, etc. etc. specialist lawyers. The question then is: which one should you use? Large, traditional law firms (BigLaw) always have the same answer: “use ours!” Nevermind that the benefits lawyer I’m sending you to spends 95% of her time talking to billion-dollar companies and will take 10 days to respond to your itty-bitty (to her) issue. Nevermind that “my patent guy” has a BS in chemical engineering and still uses a Blackberry, and you’re trying to patent a piece of consumer hardware. Nevermind that the lawyer I just sent you to keeps (as compensation) only 20% of the $650/hr he charges you, and there are far smarter lawyers in his specialty at a boutique charging half his rate.

Two law firm concepts: “origination credit” (I make money off of the lawyers in my firm that you use) and “cross-selling” (my firm expects you to use our firm’s specialists) are at the core of why so many startups end up wasting time, energy, and money dealing with specialist lawyers who (for startups) suck; because they are either over-kill, not responsive enough, or simply unnecessarily expensive.

Ecosystem v. BigLaw

You would think that, as a startup/VC lawyer at a boutique law firm, I would always tell companies that they should avoid BigLaw and choose focused boutiques instead (the “ecosystem” I write about). You’d be wrong. No matter how much disruption occurs in healthcare, pushing medicine out of hospitals and closer to the patient, you will always need the Mayo Clinics of the world. In that sense, BigLaw still “works” very well in a very specific context, and that context is very large, complex M&A transactions and IPOs.

We regularly tell clients that, while our senior partners have closed and managed $750MM, even billion-dollar deals as partners in BigLaw, boutique firms are institutionally not designed for fast, complex, very large transactions requiring armies of lawyers and other staff who can be rapidly deployed onto a large deal. That being said, the vast majority of startups, even successful ones, will never, not even in their exit transaction, need those kinds of resources. 

Right-Sized Lawyers. 

The “max out” size of boutique firms varies with their structure and the credentials of their attorneys (particularly partners, who manage the large deals). At MEMN, we say about $400MM is where our model usually stops making sense, and we’ll even assist a client in finding successor counsel to handle that size of deal. At that point, you’re probably not worried too much about your legal bill as a proportion of the overall transaction proceeds, and the players you’re working with (particularly I-Bankers in IPOs) will often require you to use a short list of brands simply for marketing and insurance purposes.

But a $100MM acquisition? $200MM? With the right boutique corporate partners running the deal (trust me, you want real partners running your exit; read bios), and the right specialists chosen for the project, wherever they are, that is not (and has not been) a problem. The newly emerging ecosystem of top-tier boutique law firms can easily thrive while still being totally honest about its limitations. It cannot represent Uber. Uber needs BigLaw. But there are plenty of successful tech companies who aren’t Uber but still need serious legal counsel.

If you have decided that you want and need BigLaw, my completely honest suggestion to you is that you go all-in and choose one of the very small number of Silicon Valley based brands that regularly represent the tech unicorns of the world. While you will still deal with several of the “poor fit” issues that plague young startups using over-sized law firms, those firms are the most likely to at least have specialists and sub-specialists who understand issues faced by technology companies, and they at least try to work well with startups.  You’re “locked in,” but at least you’re locked into a place with lawyers who can competently address your needs.

Choosing a BigLaw firm that is not one of the top tech brands will be like going on your once-in-a-lifetime luxury off-roading trip in the mountains, and buying a $200K Ferrari for the task. Your friends (who aren’t morons) will show up in souped-up Range Rovers. If you’re going big on bling, at least do it correctly.

For the rest of the world’s founders who need serious legal counsel, but honestly don’t see themselves needing the institutional resources of BigLaw any time soon, the emerging boutique ecosystem (which is thriving outside of Silicon Valley) offers a serious answer to the “my specialist lawyers suck” problem: well-compensated, top-tier, responsive lawyers at right-sized firms, chosen not because of background economic incentives, but because they are the right lawyers for the job.