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. 

Bad Advisors: The Problem with Localism

TL;DR Nutshell: One hour with an advisor who has exactly the domain expertise your company needs could be infinitely more valuable than 100 hours with someone who doesn’t. Yet, unless you live in a large ecosystem, that all-star may not be in your city. So go find her. Time is precious and mistakes are costly. Never put localism before competence and results.

Related Reading:

My wife loves farmers markets.  I love healthy, delicious fresh food, as well as supporting decentralized agriculture over conventional mega farms.  But I also personally have a ‘thing’ against rewarding inefficiency and mediocrity. I dislike the way in which a lot of the pro-local ethos appears to almost celebrate how badly businesses can be run – hand-made, hand-picked, artisanal, small batch, etc. etc. If it doesn’t actually produce a tangible benefit to the consumer (better taste, as an example), why should I wake up early on a Saturday morning just to reward your bad business skills?

Funny thing is that there’s one local farm here in Austin that has begun to just dominate farmers markets. More variety, more staff, consistent quality, better pricing, even better branding. They’re everywhere. I love it, and whenever I have to go to a farmers market, I usually just end up shopping at that one booth. And when I’m not at a farmers market, I’m probably shopping at Whole Foods, which is the farmers market fully self-actualized. Say what you want about its prices, but John Mackey and WF took the pro-local, pro-environment, humane food value structure and scaled it (out of Austin) like no one else has since. And it is spectacular.

Touchdowns; Not Pep Rallies. 

Now back to tech. Celebrating your local business / startup ecosystem is a great thing. There’s deep value in the close, repeat relationships and networks that develop through working with people within your city. But with that being said, there is still a completely unavoidable fact: nothing comes even close to supporting a local startup ecosystem as much as the building of scaled, successful tech companies. All the meet-ups, startup crawls, networking events, hackathons, pitch contests, publications, parties, etc. are great and important in their own way, but, to repeat, nothing matters more than the building of great companies. Touchdowns. Wins.  Pep rallies do not attract the kind of deep talent that ignites a local economy; awesome companies do.

Once you accept that building successful companies trumps all else, there’s another unavoidable fact: working with highly competent, experienced advisors with truly valuable insight for your specific company, whether they’re in Silicon Valley, Seattle, Los Angeles, New York, Austin, Houston, Boston, London, Dallas, or wherever, comes first, second, and third before working with someone who may be more accessible to you locally, but can’t deliver nearly as much value. 

If it’s my company, my capital, and my employees on the line, I ain’t got time for the guy selling his tiny backyard tomatoes across the street, even if he knows everyone in town. I need that big, juicy peak game stuff, and if I have to go to the coasts to get it, so be it. Hit your goals with quality, imported help (if necessary), and you’ll sow a dozen A+ farmers in your city for the next entrepreneur to reap. THAT’s how to support your ecosystem.

Bad Advisors <> Influencers. 

Bad advisors are usually influential, well-known people in a local economy. They aren’t bad people. They just don’t have very useful advice, and often give bad advice, to early-stage founders. 

If you want to start a startup-oriented business – let’s use an incubator as an example – and generate a lot of buzz around town, you are going to want to work with the influencers in your community. They know whom to call, what strings to pull, and can even usually put in some cash, to help establish your incubator’s brand around town. What do all of those influencers expect in return? Profit? Perhaps. But more often than not, they want access. They want to be involved. How can they get involved? As mentors /advisors.

So it should not surprise you that when a new incubator, accelerator, co-working space, or other startup-oriented org launches in your town, a significant portion of the people involved will be there not because of the value they can bring to startups, but because of the value they brought to the person starting the incubator, accelerator, or what not. They may be C-suite executives at a prominent local company who have never worked anywhere with fewer than 200 employees. They may be wealthy businessmen in industries totally unrelated to your own. Sometimes it’s just a guy who is really F’ing good at networking.

It’s an unfortunate fact of reality that many business referrals, even in tech ecosystems, are made more with an eye toward perpetuating the influence of the person making the referral (reward people who refer back, are part of your ‘circle’) than the value that the recipient of the referral will receive. Finding people who care more about merit than about rewarding their BFFs is extremely important for a founder CEO. Those people will be honest with you when there simply isn’t anyone in town worth working with. I find myself saying that often about lawyers in specific niche specialties needed by tech companies, although increasingly less so each year.

Widen your network. 

The take home here should be to (i) understand why those influential (but sometimes clueless) local people are being pitched to you as advisors, even when they don’t really have very good advice (but they may have money, and it’s green), and (ii) go find the advisors you really need, wherever they are. But please save your equity for the people actually delivering the goods. Vesting schedules with cliffs. Use them.

Videoconferencing is pretty damn good and cheap these days.  I use it with clients all the time. LinkedIn and Twitter make it 100x easier today to expand your network than even 10 years ago. Hustle. Every founder team does not need to fit the super extroverted, Type A entrepreneur stereotype, but I’ll be damned if any company can succeed without someone who can get out there and shake the right hands.

Interestingly, some people are working on building curated (important, get rid of LinkedIn’s noise) marketplaces to help founders find well-matched advisors, hopefully at some point across geographic boundaries. Bad Ass Advisors appears to be the best example I’ve seen thus far. If BAA doesn’t become a hit, something like it will. The value prop is obvious.

 Most startup ecosystems have some awesome people to work with. Find them. Local can be valuable.  But as your company grows and evolves, don’t let the geographic boundaries of your city force you to settle for influential, but not very useful advisors. Customers > Community. All day. Every day. Never forget: you’ll help your local economy and ecosystem far more by going big and going far than by going local.

How Startups Burn Money on Lawyers

TL;DR Nutshell: There’s a lot of bad advice floating around startup ecosystems about how lawyers work, and how founders should go about minimizing their legal burn. Much of that advice, which is given without ever actually consulting lawyers, ends up costing founders more in legal fees in the long run.  Below are some thoughts (from someone who actually knows how startup law works) on how to not burn money on legal, while also not blowing up your company.

First off, let’s go ahead and get this out of the way: I am a startup lawyer.  Some would claim that this discredits me in writing about startup legal fees, because clearly I’m just going to write whatever maximizes my compensation. Right? Never mind that I spend 90% of my time on SHL writing about how startups can or should, for example:

If your attitude is that all lawyers are money-grubbers with no ethics beyond maximizing legal bills, then (i) this blog is not for you and please don’t ever e-mail me, (ii) I’m 99.9% confident that you’ve never actually built anything successful in business, and are not likely to, which is why you’ve never known good lawyers, so again please (iii) never contact me.

Now that we have that out of the way, here is a starting fundamental principle: when you put aside the issue of institutional overhead (which is a massive issue), the economics of lawyers closely aligns with the economics of developers: great developers, and great lawyers, expect great pay. If you’ve come to accept the reality that building a company on quality, scalable, durable software code requires paying the money to bring in great developers, it should not stretch your imagination to grasp why building a company on quality, scalable, durable contract drafting (which, when you think about it, is a lot like software code) requires paying the money to bring in great lawyers. And lest you forget, it does not cost $250,000 in education to become a software developer, but sadly (very, very, deeply sadly) that’s the going rate of top-tier law schools. :: deep sigh ::

Software code may determine whether your company ever makes money, but legal code determines whether you ever make money. That’s why founders who actually know what they’re doing hire great developers and great lawyers. 

With all of that in mind, the startups who burn money on lawyers fail to follow these basic rules:

1. Hire an actual Startup Lawyer, early.

Not an M&A lawyer. Not an oil & gas corporate lawyer. Not an IP lawyer. And certainly not the schmuck hanging around your coworking space or incubator who, because he’s friends with someone, decided to re-brand himself as startup lawyer without ever having seen a real VC deal. If you have a heart issue, you call a cardiologist. If you’re building a startup that will raise venture capital, you hire a lawyer who specializes in (guess what?) startups and venture capital.

There is a very simple 2-part test for determining whether the lawyer you’re talking to is actually a startup lawyer, notwithstanding what his LinkedIn profile says:

  • A. Where is your AngelList profile?
  • B. What was the last VC deal (>$2MM) you closed?

If the lawyer doesn’t pass the above test, you will never forgive yourself after going through the world of pain he will bring to your company.

And separately, cleaning up the mess of a bad lawyer ALWAYS costs 10x what it would’ve cost to have it done correctly on Day 1. You are not being capital efficient by letting your “lawyer friend” handle your formation, with plans to get a real lawyer when you’ve raised a little seed funding. You’re just accepting a smaller legal bill early on for a much much larger one a bit later.

2. Hire a law firm (not a solo lawyer), but not one too big.

Now I’m ruffling some feathers, but SHL is not about making friends. Background reading:

Hire a solo lawyer, and you will (i) end up paying for a massive amount of inefficiency that an intelligently structured law firm would’ve avoided by adopting the appropriate technology, processes, and staffing, and (ii) max them out quickly. A $200/hr rate is not efficient if it’s multiplied by 3x the number of hours. If you are building a small company for which maybe a 6 or 7-figure exit is the end-game, a solo lawyer can be a great, even optimal fit. But companies going after big exits outgrow solo lawyers very quickly, and switching lawyers is very expensive.

Hire a very large firm, however, and you will pay for an enormous amount of bureaucracy and overhead that will not add a single bit of value to your company.  You’ll pay $600/hr, and $150 will make it to the lawyer, if she’s lucky. The fundamental principle requires paying for lawyers, not a bunch of unnecessary fluff. Modern software/SaaS has rendered the institutional structure of large firms completely unnecessary.

And be careful with referrals w/o your own verification. Out of hundreds of people I interact with, there are only a handful whose opinions on referrals for various services I actually trust as objective and based on merit. There are so many side-deals, “I scratch your back, you scratch mine” arrangements, and general cronyism in startup ecosystems that should lead you to be skeptical of any particular person’s lawyer recommendations. See also: Why Founders Don’t Trust Startup Lawyers. 

3. Use Specialists.

Background reading:  Startups Need Specialist Lawyers, But Not “Big Firm” Lock In

If a single lawyer says he can form your startup, close your seed financing, draft your real estate lease, draft your provisional patent, and apply for your trademark, run like the wind. This should be self-explanatory.

4. Do your homework, but don’t pretend that you can DIY.

If your startup law firm offers some work on a fixed fee (and they should), they are not doing it out of the kindness of their charitable heart. They are doing it because it (hopefully) makes economic sense for both sides. If you expect your lawyers to spend hours explaining to you the ins-and-outs of vesting schedules, IP, how convertible notes work, etc. etc., and yet somehow magically fit it all into an affordable fixed fee, you’re only going to select for crappy lawyers who have no choice but to accept such an unprofitable arrangement. Remember the fundamental principle.

The best founders I work with do their homework, and when they come to me with a request, they have already developed a working grasp of 75% of the concepts. Reading startup/vc law blogs, books, articles, etc. is to building a startup what reading WebMD is to being a medical patient. You will save money, make fewer mistakes, and get an overall much better end-result.

But the flip side of this is – accept that, no matter how much startup law might seem totally simple, even easily automatable, this is some complicated sh**. Very very smart people hire smart lawyers because they are smart enough to know what they don’t know.

You may think “I just want to issue some stock. That’s simple, right?” without having any clue as to all the steps that need to be taken, questions that need to be answered, and processes that need to be followed to actually accomplish that goal in a way that doesn’t create huge regulatory or contractual problems.  If you’ve hired the right lawyer(s), trust them to do their job. You will mess it up. 

5. Be Organized, and Make Clear Requests.

Related to “do your homework,” go to your lawyer(s) w/ clear action items or, at a minimum, clear questions that will help you arrive at clear action items.  You will burn a lot of legal funds asking your lawyer for one thing on Monday, changing the request on Wednesday, and then asking for tweaks on Thursday, than if you’d just waited until you knew exactly what needed to get done before making the request.

6. Be Realistic.

Good developers try everything they possibly can to avoid clients/CEOs whose views on how much time it actually takes to accomplish a task are totally detached from reality.  Good lawyers do the exact same thing with clients.  If (i) you have vetted your lawyer(s) and determined that they are trustworthy, efficient, and highly knowledgeable, then (ii) you should not be badgering them every month about why the bill is higher than you wanted it to be. It could backfire.  It would be ridiculous for me to walk into a company and tell the CEO how to run it, with zero domain expertise. Don’t be just as ridiculous with your lawyers and their practice.

Newsflash: you will ALWAYS pay more for lawyers than you want to pay. Remember the fundamental principle.

Hire an actual startup lawyer, at a firm that isn’t too big. Use specialists. Do your research, but trust your lawyers. Stay organized, and stay realistic.  Follow these principles and you will not get that Series A financing for $5,000 like you always wanted, but you will easily save 6-7 figures in legal fees over the life of your startup, and have a much healthier relationship with some of your closest advisors.

Should Texas Founders Use SAFEs in Seed Rounds?

Nutshell: Because of the golden rule (whoever has the gold…), probably not – at least not for now.

Background Reading:

For some time now, there have been people in the general startup ecosystem who have dreamt that, some day, investment (or at least early-stage investment) in startups will become so standardized and high velocity that there will be no negotiation on anything but the core economic terms. Fill in a few numbers, click a few buttons, and boom – you’ve closed the round.  No questions about the rest of the language in the document. For the .1% of startups with so much pull that they really can dictate terms to investors (YC startups included), this is in fact the case.  But then there’s the other 99.9%, much of which lies outside of Silicon Valley.

Much has been written about how SAFEs were an ‘upgrade’ on the convertible note structure, and in many ways they are.  But anyone who works in technology knows that there’s a lot more to achieving mass adoption than being technically superior, including the “stickiness” of the current market leader (switching costs) and whether the marginal improvements on features make those costs a non-issue. And any good lawyer knows that when a client asks you whether she should use X or Y, she’s not paying you for theory. You dropped that sh** on your way out of law school.

This isn’t California

From the perspective of Texas founders and startups, which are the focus of SHL, the reality is that going with a SAFE investment structure is very rarely worth the cost of educating/convincing Texas angel investors on why they shouldn’t worry and just sign the dotted line. The entire point of the convertible note structure, which by far dominates Texas seed rounds, is to keep friction/negotiation to a minimum.  Yes, there are many reasons why equity is technically superior, but that’s not the point.  You agree on the core terms (preferably via a term sheet), draft a note, they quickly review it to make sure it looks kosher, and you close.  You worry about the rest later, when you’ve built more momentum.  Professional angels know what convertible notes are, and how they should look. They also know how to tweak them.  In Texas, many of them still do not know what a SAFE is. 

And, in truth, many Texas angels and seed VCs who do in fact know what a SAFE is simply aren’t willing to sign one. The core benefit of SAFEs to startups is that they don’t mature, and hence founders without cash can’t be forced to pay them back or liquidate.  To many California investors, this isn’t a big deal, because they’ve always viewed maturity as a gun with no bullets.  But Texas investors don’t see it that way.  Many find comfort in knowing that, before their equity position is solidified, they have a sharp object to point at founders in case things go haywire. I’ve seen a few TX founders who rounded up one or two seasoned angels willing to sign SAFEs, only to have to re-do their seed docs when #3 or #4 showed up and required a convertible note to close. It’s not worth the hassle, unless you have your entire seed round fully subscribed and OK with SAFEs

Just Tweak Your Notes

The smarter route to dealing with the TX funding environment is to simply build mechanics into your notes that give a lot of the same benefits as SAFEs. A summary:

  • Use a very low interest rate, like 1-2%. – TX angels tend to favor higher interest rates (seeing 4-8%) than west and east coast seed investors. But if you can get a very low rate, it’s more like a SAFE.
  • Use a very long maturity period, like 36 months. – 18-24 months seems to have become more acceptable in TX, which is usually more than enough time to close an equity round, or at least get enough traction that your debt-holders will keep the weapons in their pockets.  But if you can get 36 months, go for it.
  • Have the Notes automatically convert at maturity –  This gets you as close to a SAFE as possible, and we’ve seen many angels accept it. If you run out of time and hit maturity, either the angels extend, or the Notes convert, often into common stock at either a pre-determined valuation (like the valuation cap, or a discount on the cap), or at a valuation determined at the conversion time.

How successful you’ll be at getting the above is just a matter of bargaining power and the composition of your investor base. Austin investors, who think more (but not completely) like California investors, tend to be more OK with these kinds of terms.  In Houston, Dallas, or San Antonio, you’ll likely get a bit more pushback.  But that pushback will almost certainly be less than what you’d get from handing someone a SAFE.

Closing Summary: There isn’t, and likely will never be, a national standard for seed investment documentation.  Every ecosystem has its nuances, and working with people who know those nuances will save you a lot of headaches. In Texas, the convertible note, however suboptimal, reigns supreme. Respect that reality, and work within it to get what you want.