Negotiation and Inexperience

TL;DR: Having access to trusted advisors, and the time to consult with them, is essential for anyone negotiating terms with which they have very little experience. Don’t accept someone’s argument that you must negotiate important issues live. It’s simply untrue, and a tactic for gaining unfair leverage.

Background Reading:

A recurring theme of SHL posts is that entrepreneurs, particularly first-time entrepreneurs, need to be extremely mindful of the imbalance of experience between themselves and the many sophisticated, repeat players they’re going to be negotiating with as they build their companies. It’s obviously common for entrepreneurial personalities to be more comfortable (than most) with risk, and to go head-first into negotiations and activities without proper backup. But for really big, irreversible decisions, it will backfire, and others will happily use it against you.

One of the most overused phrases for getting naive negotiators to give in on issues they should push back on is “this is standard.” When you have no historical or market perspective – what’s normal, what’s fair, what are the risks, how will this play out in 5 years? – you can be easily manipulated into all kinds of bad outcomes. I’ve been at more than my fair share of board meetings or negotiations where someone at the table makes a completely biased, nonsensical claim that something is “standard,” at which point I’ve had to step in to set things straight, and gladly offer up data or a quick market survey.

There are two main things that I tell all companies to focus on in this regard:

  1. Have a group of experienced, trusted advisors that you can quickly communicate with on serious issues.
  2. Do not let yourself be bullied into a setting where your inexperience puts you at a substantial disadvantage.

Trusted Advisors

When I speak of trusted advisors, I’m not referring necessarily just to your Company’s “advisory board,” which serves a broader purpose of helping you on long-term strategic, business, and technological issues. I’m referring to people you can call or e-mail for specific, tactical guidance on more pressing matters; your “inner circle.” Seasoned entrepreneurs, mentors from accelerators, lawyers (who are independent from your lead VCs), and trustworthy angel investors often make up this group for most CEOs I work with. The most important thing is that they (i) have visibility into the broader market, to help you actually understand what is acceptable, and (ii) will be direct and honest with you when you most need them to.

Imbalanced Negotiation Settings

While it is far less common in the tech world than in other areas, you occasionally still encounter people (particularly VCs) who insist that the only appropriate way to “really” negotiate is live, and in person. And let me tell you: this is bullshit.

Of course, live discussion is important for communication and relationship-building; it has its place. But more often than not, attempts to force entrepreneurs and company executives to negotiate key issues live, or under a very tight deadline, is a tactic to gain unfair leverage from their inexperience. Of course the guy who’s done this type of deal 30 times wants you to agree to terms live, face to face, away from your set of advisors. It has zero to do with business norms. Plenty of high-stakes deals are negotiated asynchronously. 

How you push back and (respectfully) assert yourself in negotiations with other business parties will set the tone for your long-term relationship. If you allow them to force you into circumstances that favor them, they will do it indefinitely. There is nothing wrong with responding, diplomatically, that while you of course would love to grab beers and meet up in person for more casual matters, for real business, you expect time to consult with advisors.

If you’re working with people whom you should want to build long-term relationships with, they will respect your request.  In fact, I’ve known some great VCs and other business people who are very upfront about the experience imbalance with new entrepreneurs, and insist that companies work closely with key advisors.  Those are people playing a long game, and who know that their reputation in the market matters more than short-term opportunism.

If the person you’re negotiating with rejects your request, and dictates to you the medium of negotiation, then at a minimum you’ve gained some key information on what the relationship is going to really look like if you choose to move forward.

Commercial / Tech Transactions Lawyers

TL;DR: Apart from early-stage specialized corporate lawyers (startup lawyers), there’s a second kind of lawyer that almost every early startup needs: a commercial/tech transactions lawyer.

Background Reading:

Imagine you run into a doctor who says he can (i) perform heart surgeries, (ii) treat cancer, (iii) treat your asthma, and (iv) provide pregnancy care, on his own, and all at a lower than market cost. Is your first reaction “wow, this guy is an incredibly affordable genius!” ? A cardiologist, oncologist, pulmonologist, and OB/GYN all in one!

Probably not.

One of the first points I make to young tech entrepreneurs about how to source legal counsel is that the statement “I need a lawyer” is almost completely useless without specifying what kind (specialty) of lawyer. The complexity of the legal issues that even young emerging companies deal with is simply too high to entrust all of them to a single “generalist” claiming to be a jack of all trades. This is not a coffee shop, or a bakery. The stakes, and potential liabilities, are much higher.

OK, you might say. I’m a startup, so I need a startup lawyer. Well, that’s an improvement, but what exactly is a “startup lawyer”?

In my experience, the correct definition of a “startup lawyer” is a corporate lawyer with a strong specialization in early-stage emerging companies and venture capital/angel financings. Very different from an M&A Lawyer, or a corporate lawyer who handles middle market or public company work. Startup lawyers typically serve as GC (General Counsel) for early-stage startups, which requires them to have a workable understanding of tax law, securities law, commercial issues, IP, and labor/employment legal issues.  They’re not experts in those areas (corporate law is their specialty), but they’ve seen those issues enough to cover the basics, while also knowing when to rope in deeper expertise. Your corporate/startup lawyer should serve as the quarterback of your general legal team.

For most startups we see, probably 50-75% of Pre-Series A legal needs are covered by these startup-specialized corporate lawyers: formation, financing, hiring and firing, equity compensation, etc. Small amounts of patent or trademark work may be needed by appropriate specialists, but that’s a minority of cases pre-Series A.  But there’s a second kind of lawyer – who isn’t a “startup lawyer” – that virtually all of our early clients end up needing, and that all founders need to be aware of in sourcing their own counsel: commercial, or sometimes called “tech transactions” lawyers.

Startup/corporate lawyers typically handle the more ‘internal’ issues of a company and its stakeholders: relating to the company’s founders, its employees/service providers, and stockholders.  Commercial or Tech Transactions (let’s use C/T) lawyers, in contrast, typically manage legal issues and contracts relating to a company’s customers/users and potential commercial partners. A good 25-50% of pre-Series A legal needs will often get handled by a C/T lawyer. Examples of C/T Lawyer work:

  • License Agreements (Inbound and Outbound)
  • OEM, Reseller / Distribution Agreements
  • Terms of Service and Privacy Policies (which may also require Data/Privacy Lawyers, but usually not)
  • EULAs, API / SDK terms
  • Technology Transfer Agreements
  • Manufacturing / Supply Agreements

The nature of these kinds of agreements is very different from the kind of work a classic “startup lawyer” does, and while most solid corporate lawyers probably could wing a simple version of a tech transactions document, I am deeply skeptical of a lawyer who claims to be able to handle both all of a company’s corporate needs and their commercial/tech transactions needs for a serious amount of time. In the very early days it *may* work, but even with a small level of scale it’ll start to look a lot like the “genius” doctor mentioned above. The most dangerous (and, in the long run, expensive) type of lawyer is the one who doesn’t admit what he/she doesn’t know, but incentives to maximize personal revenue often lead lawyers to exaggerate their abilities.

So, in short: if you’re building a tech startup, you don’t just need “a lawyer.” You need specialists. And a true startup lawyer, even a very good one, is very rarely enough. Ensure you have access to a solid commercial/tech transactions lawyer (reputable startup lawyers work with them). If you don’t, you’ll eventually regret it.

More Tech Startups are LLCs

Background Reading:

If you have spent almost any time reading about the basics of startup legal issues, you know that Delaware C-corps are the default organizational structure for a “classic” tech startup (software, hardware) planning to raise angel/VC money and scale. I’m not going to repeat what you can read elsewhere, so I’ll summarize the core reasons in 2 sentences:

Delaware because DE is the “english language” of corporate law and all serious US-based corporate lawyers (and many foreign lawyers) know DE corporate law.  C-Corp largely because (i) VCs have historically favored C-Corps for nuanced tax and other reasons, and (ii) virtually all of the standardized legal infrastructure around startup finance and equity compensation assumes a C-Corp.

However, times are changing. Over the past few years, we’ve seen a noticeable increase in the number of emerging tech companies that, despite knowing all of the reasons why startups favor C-Corps, deliberately choose to organize their company, at least initially, as an LLC. To be clear, C-Corps are still the norm, by far. But the C-Corp / LLC mix has, for us at least, moved maybe from 95/5 percentage-wise to about 85/15. That’s an increase worth paying attention to.

The growth in interest around LLCs has very little, or really nothing, to do with legal issues, in the sense that nothing much has changed about LLCs or C-Corps to drive people in one direction or the other.  The main drivers, from our viewpoint, are:

  • Many tech entrepreneurs no longer view venture capital as an inevitability in their growth path, and have grown skeptical of the traditional “growth at all costs” mindset found in many startup circles; and
  • An increasing number of VCs are growing comfortable with LLCs.

Profitability is now a serious consideration among tech entrepreneurs. 

C-Corps have 2 “layers” of tax: corporate-level tax, and then tax at the shareholder level. LLCs don’t have a corporate-level tax, and therefore have only 1 layer. Speaking in broad terms, this “disadvantage” of the C-Corp structure has not deterred tech startups for one simple reason: the corporate level tax is on profits, and many tech startups don’t intend to be truly profitably any time soon. Achieving very fast growth through reinvestment of any ‘profits’ has been the dominant growth path among tech entrepreneurs, which means no “profits,” which means being a C-Corp doesn’t really result in more tax.

However, the zeitgeist among startup ecosystems is shifting from “focus on growth, and raise VC” to “unless you’re absolutely positive you’ll raise VC, keep your options open.” Keeping your options open favors starting out as an LLC, because converting an LLC to a C-Corp is way easier than converting a C-Corp to an LLC. The reason for that is simple: the IRS welcomes you with open arms if you choose to move from 1 tax layer to 2. But going in the opposite direction costs you significantly.

As more tech entrepreneurs take seriously the possibility of building a profitable, self-sustaining business, their interest in starting their companies as LLCs is growing, because building a truly profitable business as a C-Corp is much more expensive (tax wise) than it is as an LLC. Many angel investors, and also strategic investors, are comfortable investing in LLCs, particularly under a convertible security structure that doesn’t immediately result in equity holdings.

So starting as an LLC allows you to build your company, and even raise some early capital, while letting things develop to see if you’re really building a business that needs conventional venture capital (and then convert to a C-Corp), or if you’re building one that may instead become profitable and distribute profits to investors (stay an LLC).

VCs are also growing more comfortable with LLCs.

The conventional line given for why VCs “must” invest in C-Corps is that the “pass through” treatment of LLCs can result in various negative consequences to their own investors (LPs), many of whom are tax exempt – so the C-Corp structure prevents the tax problems. However, more sophisticated VCs have realized that in most cases this problem is quite fixable. They can set up what’s often called a “blocker corp” that eliminates the possibility of pass-through income negatively impacting their tax-exempt LPs. Problem solved. It’s not that hard to do.

Truth be told, a lot of VCs still don’t want to mess with LLCs. But at this point it has more to do with inertia and a desire to minimize their own legal bills than any real legal issue. Also, most VCs are only looking for companies in a high-growth track where any net revenue will be reinvested for growth (no corporate profits, no corporate tax), so they are selecting for companies for whom an LLC structure isn’t really that appealing.

But not all VCs think that way. VCs are growing increasingly comfortable with LLCs, and when it makes sense, they will invest in them.

If you are an LLC tech startup, you need tax counsel.

If you are a tech startup that wants to be an LLC, realize that while LLCs may save you taxes, they will not save you legal fees. Equity compensation, particularly to employees, is much more complex under LLCs, and requires the oversight of true tax lawyers. It is not something to be handled solely by a “startup lawyer.” Any law firm working with LLCs should have access to tax specialists, and if they don’t, that is a red flag.

Also, as startups move from a uniform growth path to one that considers a wider variety of sources of capital (angel, non-traditional seed, strategic, private equity, debt, royalty-based, etc.), they need to accept that the standardization found in conventional Silicon Valley-style fundraising is simply not a possibility. The huge push to standardize investment documentation into templates that can be almost automated stems from the “billion or bust” mindset of classic VC-backed startups. In that world, everyone is a Delaware C-Corp. Everyone is trying to be a billion-dollar company that will eventually get acquired or go IPO. All the angels talk about the same things on twitter and are comfortable investing on the same docs. So just automate a template, plug in some numbers, and focus on growth.

But in a world where everyone isn’t a Delaware C-Corp; everyone isn’t on the same “billion or bust” growth path, and there is far more diversity among companies and investors, the conditions for heavy automation and standardization simply aren’t there, and likely never will be. It requires real financial, tax, legal, etc. advisors to handle real complexity, while right-sizing it for the stage and size of each particular business.

The truth is that outside of a few large startup ecosystems, there has always been much less uniformity among financing structures. Software engineers – frustrated with their inability to force everyone into uniform documentation that can be automated – have criticized this reality as backward and just needing to “catch up,” but to people on the ground it’s been pretty obvious they’re just hammers screaming at everyone to become a nail. More entrepreneurs are no longer comfortable being pigeon-holed into a one-size-fits-all growth path or legal structure, and long-term that’s a good thing for everyone.

“Founder Friendly”

TL;DR: “Founder friendliness” should mean not being hostile, but also not being submissive, to founders. Good entrepreneurs and advisors know that.

Background reading:

Because we’re known as Startup/VC lawyers who don’t represent VCs (just companies), I often get asked about my thoughts on “founder friendliness.” Occasionally it’s someone inexperienced expecting me to say something totally one-sided, as if “founder friendly” means always giving founders what they want. The truth is, I’ve put my fair share of founders in their place, when appropriate. As I’ve written before, company counsel does not mean founder’s counsel.

Serious lawyers provide counsel, and represent something apart from the preferences of any particular person. They don’t just push paper in whatever direction someone tells them to. Real lawyers know when and how to say “no.”

To me, “friendly” means the opposite of “hostile.” It means respecting a person as an equal, being transparent with them, and strongly taking into consideration their own values, goals, ideas, etc.  But that is very different from spinelessly doing whatever they want you to do. The best founders seek out advisors, including investors, who will provide real, critical input; knowing that a bunch of sycophants will get them nowhere.

Founder Hostile

On the one hand, there is very much a culture among certain venture capitalists that treats entrepreneurs as necessary, but ultimately dispensable, steps toward returns. I have seen it firsthand, and while it exists everywhere, it is directly (negatively) correlated with (i) the number of investors willing to write checks into a particular ecosystem, and (ii) the degree to which entrepreneurs confidentially share information among each other on VC behavior, producing adverse selection issues for the real assholes. You very rarely hear about this on blog posts or twitter, but when the pep rallies and PR-oriented speaking panels come to an end, it is there.

VCs in this category vary in the level of sophistication with which they implement their “founder hostile” strategy.  Most know that playing hardball out of the gate won’t get them the deal, and they prefer more of a “bait and switch” approach where they sing the praises of the entrepreneurs upfront, and then slowly move the chess pieces over time. The moves are identifiable by people who know the game:

  • put “captive” lawyers and advisors in place;
  • avoid providing coaching / training resources to founders;
  • tightly control the recruitment of new executives to phase in loyalists;
  • keep a tight grip on unreasonable budgets so that achieving results is very hard, and failure justifies “necessary changes”;
  • maneuver to prevent competitive funds from putting offers on the table;

In the end, it doesn’t matter what the cap table says; it’s “their” company now.

Founder Submissive

On the other hand, in the most competitive deals and ecosystems, there is a counter-dynamic where VCs compete with each other, essentially, on how much unilateral control they’ll give entrepreneurs. This dynamic is strongest in California. It’s, in part, due to the failure of many VCs to effectively apply basic strategic concepts – like differentiation – into their market positioning. If you’re just another VC/fund with a few connections and ideas among dozens of others, what else can you do but try to be the “easiest money”? The end-result of having these “founder submissive” investors is often immature management teams that aren’t able to effectively scale. VCs with real brands are able to avoid this. 

As I’ve written before, a Board of Directors has fiduciary duties to all stockholders. As you’ll read in many different places, the moment an entrepreneur decides to take on investors, they have to step off the “king” train and focus on growing the pie, and eventually achieving an exit, for everyone.

That being said, under DE law Boards have primary fiduciary duties to common stockholders, insiders and outsiders.  As the largest common stockholders (usually), and those who’ve held the equity the longest, entrepreneurs are extremely important representatives on the Board for fulfilling those duties; whether or not they are in the CEO seat.  We know that preferred stockholders and common stockholders regularly have misaligned incentives.  A truly “balanced” Board will prevent one part of the cap table’s incentives and preferences from overriding those of the others.

“Founder hostile” VCs are problematic because they push for the perspective of institutional investors to override those of all the other constituents on the cap table. “Founder submissive” VCs are equally problematic because they expose the company excessively to founders whose priorities may conflict with the economic interests of the broader stockholder base.

The proper balance is, of course, in the middle; where the VCs with the best reputations operate.  Be transparent about your goals, incentives, and plans. Don’t beat around the bush about your investment horizon, exit expectations, and how you’ll approach executive succession when that time comes. Let the common stockholders, including founders, do the same. No BS or opaque maneuvering. And then work together, knowing that no one has the singular right to override the perspective of the others at the table.

 

Common Stock v. Preferred Stock

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

Very quick vocabulary lesson:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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