TL;DR: The highly unequal relationship and power dynamics in most startup ecosystems mean that what is visible publicly is not an accurate representation of how the game actually works, because few people are willing to speak honestly and openly, for fear of retaliation from a “gatekeeper” with key relationships. This makes off-the-record diligence, and watching loyalties of your most high-stakes relationships, essential in order to prevent repeat “money” players (investors, accelerators) from dominating the voices of less influential “one shot” players (first-time entrepreneurs, employees).
There are a few underlying themes that have been covered in a number of SHL posts and are relevant to this one:
First, there is a fundamental divide and tension between inexperienced, “one shot” common stockholders and “repeat player” investor preferred stockholders (VCs, seed funds, accelerators) that feeds into all of the most high-stakes decisions around how to build and grow a company. It has nothing to do with good v. bad people. It has to do with core economic incentives.
Common stockholders (founders, early employees) typically have their wealth concentrated in this single company (not diversified), do not have substantial wealth as a backup in the event of failure, do not have the downside protection of a liquidation preference or debt claim on the company, and have almost no experience in the subtle nuances of startup economics and governance. This dramatically influences their perspective on what kind of business to build, how to finance it, whom to hire in doing so, and how much risk to take in order to achieve a successful outcome; including how to define “successful.”
Preferred stockholders / repeat players (investors, accelerators) are the polar opposite of this scenario. No matter how “founder friendly” they are, or at least pretend to be via PR efforts, their core economics interests are not aligned with one shot players. They are already wealthy, significantly diversified, have substantial experience with startup economics and governance, and have downside protection that ensures they get paid back first in a downside scenario. In the case of institutional investors, they also are incentivized to pursue growth and exit strategies that will achieve rare “unicorn” returns, even if those same strategies lead to a large amount of failures; failures which hit common stockholders 100x harder than diversified, down-side protected investors.
And the fact that some of the investors are themselves former founders (now wealthy and diversified) is irrelevant to the fundamental economic misalignment. A successful founder who is now an investor/repeat player is simply the latter, but perhaps more helpful on execution. They can probably empathize more with the common’s challenges, but they didn’t become successful by ignoring their economic interests. Successful founders who are not heavily aligned with your investors are a different story.
Second, apart from the economic misalignment between the common and preferred, there is a widely unequal amount of experience between the two groups. A first-time founder team or set of early employees do not have years of experience seeing the ins and outs of board governance, or how subtle deal terms play out in terms of economics and power. The preferred, however, are usually repeat players. They know the game, and how to play it. This means that the set of core advisors that common stockholders hire to leverage their own experience and skillset in “leveling the playing field” is monumentally important; including their ability to trust that those advisors will help ensure that the preferred do not leverage their greater experience and power to muzzle the common’s perspective.
This second point relates to why having company counsel who is not dependent on VCs / the money is so important; and it also highlights why repeat players go to such enormous efforts to either force or cleverly trick inexperienced teams into hiring lawyers who are captive to the interests of the preferred. We’ve observed this in pockets of every startup ecosystem we’ve worked in: that aggressive investors work hard to gain control over the lawyers who represent startups. The moment we became visible in the market as a growing presence in startup ecosystems, we lost count of how many of the strongest money players reached out to us to “explore” a relationship; even though they already had “relationships” with plenty of firms. It wasn’t that they needed lawyers; it’s their power playbook.
The point of this post is how these above facts – the economic misalignment, and particularly the greater experience – of influential investors plays out into how they exert power, often covertly, in startup ecosystems; not just with lawyers.
Think of any kind of business that needs to work with startups as clients: obviously lawyers, but also accountants, HR, outsourced CFO, benefits, real estate, even journalists who need access to entrepreneurs in order to write articles. All of those people need strategies for “filtering” startups (finding the more viable ones) and then gaining access to them; and they’re going to look for strategies that are the most efficient and less time consuming.
What many of these service providers come to realize is that an obviously efficient strategy is to work through VCs and other influential investors/accelerators. They’re doing the filtering, and because they’re repeat players, have relationships with lots of companies. So the service providers reach out to these well-connected investors, and immediately the investors recognize the power that this role as “gatekeepers” and brokers of relationships gives them over the ecosystem.
And when I say “power over the ecosystem,” what I mean is power over what people will say publicly, what they won’t say, and what “support” businesses become successful (or not). It heavily plays out into what gets written and not written on social media and in tech publications, and said at public events; because people are terrified of pissing off someone who will then cut them off from their lifeblood of clients.
“One shot” players are, by virtue of not being repeat players and lacking significant relationships, unable to counterbalance this dynamic. Put together a system of highly influential and wealthy repeat players and inexperienced, less influential “one shot” players, and you can bet your life that it will inevitably tilt itself toward those who can exert power.
So let’s tie this all together. Founders and other early startup employees are significantly misaligned from the repeat player investor community in a way that has nothing to do with ethics, but core incentives and risk tolerance. They’re also totally lacking in experience on how to navigate the complexities of startup growth and governance, and therefore rely heavily on trusted outside advisors to level the playing field. Finally, the most aggressive and clever repeat players will position themselves as gatekeepers to the ecosystem, exerting significant control over “support” players (not just lawyers) in a market by their ability to offer, or deny, access to startups.
What’s the conclusion here? There are two:
A. What you often see written or said publicly in startup ecosystems is not an accurate representation of how the game actually works, because very few people are willing to talk openly about it, for fear of being cut off by gatekeepers. This significantly increases the importance of off-the-record “blind” diligence to get the real story about a particular repeat player. If you are diligencing an investor or an accelerator, it is important that said entity not know whom you are contacting in conducting that diligence. That is the only way that they cannot retaliate against any particular person who says something negative; and you’re therefore more likely to get an honest answer.
You will absolutely encounter people who will say that the very notion of “retaliation” is some kind of paranoid fabrication, but remember how the chess game is played: “founder friendliness” is often (not always) a marketing tool. Of course the smartest users of that tool are going to wave away all this talk of bad actors, doing heavy diligence, and protecting yourself as unnecessary. Come on, they’re good guys. Just trust them, or their tweets. We’re all “aligned” here.
When you have an inherent and substantial power advantage, it is an extremely effective strategy to create a non-adversarial, “friendly” PR image of yourself, downplaying that power. Inexperienced, naive first-time players then buy into this idea that you’re not really about making money, and come to the table with minimal defenses; at which point you can get to work.
The money players with truly nothing to hide won’t be dismissive or defensive at all about the common’s need to conduct blind diligence and ensure the independence of their key relationships. Reactions are often a key “tell.” If you truly have a great reputation, and you have no intent to use the common’s inexperience and unequal power against them, then what exactly is the problem with respecting their right to be cautious and protect themselves?
There are definitely good people in the market, but only idiots navigate a highly unequal and opaque world under the premise that everyone is an angel, and you should “just trust them.”
B. In order to ensure that the power of repeat players does not silence the perspective of “one shot” common stockholders both on startup boards and in ecosystems generally, the “one shot” players must pay extremely close attention to the relationships of their high-stakes key advisors and executive hires. No rational human being who cares about being successful bites the hand that most feeds them; no matter how “nice” they are. That is the case with lawyers, with “independent” directors on boards, with any other outside service provider, and also with high-level executives that you might recruit into your company. Pay attention to loyalties, and diversify the people whose rolodexes you are dependent on.
In the case of lawyers, repeat players and their shills will always talk about how startup dynamics are “different” and it’s “not a big deal” for company counsel to have dependencies with the preferred stockholders. An honest assessment of the situation is that startups are different, but different in a way that conflicts of interest matter more than usual. You rarely see high-stakes business situations where there is such a wide gulf of experience and power between groups (common v. preferred), and such a high level of dependence on counsel for strategic guidance, as you see with first-time entrepreneurs and employees negotiating with VCs. Repeat players aren’t reaching across the table and controlling startup lawyers because it’s “not a big deal.” They’re doing it because the payoff is so uniquely high.
There is a clever narrative pushed around startup ecosystems painting a picture of startup finance and governance as always full of balanced transparency and generosity, with common stockholders and investors holding hands and being fully aligned as they build shareholder value together without bias or disagreement. But notice how quickly the tone changes from parts of the investor side the moment you suggest that the common be afforded even minimal defensive protections, like company counsel that investors can’t manipulate. Suddenly you’re being “overly adversarial.” Oh, so are the transparency and generosity, and “kumbaya” sing-alongs, only contingent on the common’s keeping their necks squarely under the boots of the powerful, but oh so benevolent and soft-heeled, money? Funny how that works. Smart common stockholders won’t accept “benevolent dictatorship” as the model for their company’s governance.
You should absolutely want transparency, fairness, and generosity to be the guiding principles of your relationship with your investors, and nothing supports that better than a foundation of knowing that you can fully trust the independent advice you are getting, and that the key people you are depending on aren’t ultimately controlled by the money.
A lot of the most egregious stories of startup flame-outs that you see written about – who grew too fast chasing a unicorn exit, raised more money than a business could sustain, took a high-risk strategy that blew up, or perhaps achieved a large exit while returning peanuts to the early common – are the end-result of a complex game by which repeat players come to exert so much power over how a particular startup scales that the voice of the “one shot” players – the early common stockholders without deep pockets or contacts – gets completely silenced until it’s too late. Gaining control over key relationships is a significant part of how that game is played. And what’s written about publicly is just the tip of the iceberg.
To put a bow on this post, healthy skepticism over what you see and hear publicly, and good instincts for understanding the importance of incentives and loyalties, are essential for any inexperienced team entering a startup ecosystem. The image of wealthy, powerful people “winning” via highly aggressive overt behavior at the negotiation table is a simplistic caricature of how complex business actually works; but it’s a caricature that often dupes founders lacking years of experience in the business community. Assholes are easy to spot, and the smartest winners are almost never visible assholes. Good people still follow their incentives; and aggressive but smart money players know how to assert their power while preserving a public image of selflessness and generosity. Navigate the market accordingly.