Startup Law Pricing: Fixed v. Hourly

TL;DR: There are very natural reasons – inherent in the dynamics of complex, high-end legal services, including for startups – that explain why flexible time-based billing is still the most common pricing structure among law firms specialized in emerging companies (startup) law. And there are very real downsides and limitations to “fixed fee” pricing that founders all need to be aware of.

First-time entrepreneurs, who’ve usually never hired serious lawyers before, understandably get heart burn when thinking about the cost of legal services. The goal of this post is to provide some clarity on how legal billing for startups works in general, and to also bust a few myths circulating around ecosystems on the topic.

First, I strongly suggest reading: Lies About Startup Legal Fees. A few highlights:

  • Long-term, client-facing legal technology does not dramatically cut legal spend for startups.
    • As a legal CTO who regularly tests and adopts new legal tech for our boutique firm, I have a very clear understanding of what technology, including cutting edge machine learning/AI, is capable of accomplishing in high-end, high-complexity legal services. In the very early days, where complexity and cross-client variability is minimal (like formations) tech can and does play a key role in keeping costs down, but in startup law its utility breaks down fast. I am a very early adopter, but one thing I don’t adopt is techno-BS.
    • In the long-term, given the high, often irreversible cost of errors and the significant variability between clients, legal technology plays only a small role in cutting overall spending. This is, at the end of the day, a highly trained human judgment/skill driven business, with targeted technology in the background. Anyone trying to make this area “LegalZoom-y” will eventually crash right into the fundamental realities of the business.
    • While some techies will certainly tell you otherwise, the most “disruptive” developments in law aren’t in adopting software or technology, but in eliminating unproductive overhead, simplifying firm structures, and implementing project and knowledge management more consistently and deeply; enabled by off-the-shelf tech that is hardly earth shattering. These strategies cut the cost of legal by hundreds of dollars an hour, while improving responsiveness and quality; which exactly zero pieces of tech can even get close to doing. See: The Boutique Ecosystem v. BigLaw. Subtractive, not additive, innovation.

Sidenote: there are big market opportunities for AI/ML and other legal tech in serving very large clients with hundreds/thousands of related contracts and transactions, all on top of a single corporate structure. I call this “vertical” legal tech. It’s in “horizontal” legal tech (automation across companies) that much of legal tech’s promise has been overblown. After automating secretary/paralegal work, it hits a hard wall of customization, complexity, and high error cost that renders the most cutting edge technology virtually useless.

  • DIY almost always costs more in the long-run – “Legal Technical Debt” is real. The cost of fixing legal errors compounds over time, and saving $1 today will very often cost you $5-10 in a few months or years, no matter how many blog posts you’ve read or templates you’ve downloaded.
  • Compensation and institutional infrastructure drive legal quality and scalability, which controls costs. – Great lawyers, just like great software developers, expect to be compensated for their talent. Oh, and btw, Law School costs about $200-250k and 3 years of your life. Very large firms and smaller firms can both have high-quality lawyers if they pay them properly, with the real difference being the additional overhead on top of compensation. Larger firms have much higher overhead to pay for infrastructure needed to represent unicorns in very large deals. Boutique firms are lower-overhead, and better designed for “normals.” Solos are best for small businesses.

Second, another Startup Law myth worth busting is the idea that fixing legal fees (as opposed to more flexible hourly billing) “aligns” incentives between entrepreneurs and their lawyers. I touch on this topic a bit in Standardization v. Flexibility in Startup Law.

It’s become lazily fashionable to criticize the billable hour as the main source of inefficiency in law. But the reluctance in traditional law firms to adopt technology and improve processes is driven, at least among startup-focused firms, far more by the decision-making structure of the firms, and the inertia that creates, than the billable hour. Partners in those firms often have so much control over how their clients are served, that the firm as an institution is incapable of mandating large-scale change. The egos of partners hold back the profession far more than billing structure.

The idea that time-based billing means lawyers are just going to maximize how much they charge clients, and never optimize, is economically ridiculous and ignorant. The lawyer-client relationship is very long-term, and smart entrepreneurs can easily get info in the market if they feel their lawyers are over-charging. Switching to more efficient firms is not that difficult.  Costs in Startup Law have been going down significantly over the past decade, with hourly billing still being the norm.

If you (cynically) think that hourly billing gives your lawyers a strong incentive to over-work, then fixed billing gives your lawyers an even stronger incentive to under-work. By guaranteeing a law firm a price on a transaction, regardless of how long it takes, you’ve tied their ROI to how little time they spend on it; narrowing optionality, delegating to less trained people, and rushing through material issues all become drivers of profitability. In the world of serious legal services, where speed/cheapness are hardly the only concern of clients, and there are very material, difficult-to-detect qualitative variables in service output, the idea that this is “aligning” lawyers with their clients is nonsense. Fixed fees do not align incentives; they reverse them.

Fixing fees, when the circumstances for “fixability” aren’t really in place (more on that below), therefore raises serious quality concerns. In healthcare, a botched job is almost always quickly noticeable to the patient. In law, especially startup law (where the client often isn’t seasoned enough to detect errors/rushed work) big quality issues can, and often do, take years to surface, since they’re tucked away in docs that sit unused until a major event, or the inexperienced founders simply never realize that an option their lawyer could have brought up, wasn’t. This, by the way, is why the most experienced players in any market are always deeply skeptical of new legal service entrants promising low prices, even if they’re early adopters in many other areas. It takes real effort and quality signaling to get them off of reputable legal brands. That reluctance is logical, given the opaque and high stakes nature of the service; very different from most fields.

If your law firm has agreed to a fixed fee, and suddenly you find yourself spending a lot more time interacting with paralegals working off of checklists (instead of lawyers), now you know what “alignment” really means.  Fixed fees are not magical, and they come with very real tradeoffs.

The predominance of the hourly billing model among high-end law firms is, first and foremost, a reflection of the significant variability among client needs and expectations, and the fact that flexible hourly billing is the most effective way to tailor work for each client.

  • Need a reseller agreement? We’ve drafted them for $1.5K, $5K, and over $20K. Unpredictable variables: strategic importance of the deal, dollar value, size of the company, location, who the reseller is, who the reseller’s lawyers are, industry, and a dozen others.
  • I see “seed stage” startups who spend nothing on legal for a full year, some that spend $10K, others $25K, and a few that spend $100K, all due to widely varying needs.
  • I’ve seen “Series A” financings close for $15K, $30K, and over $100K, and everywhere in-between, and all for perfectly logical reasons understood by the client in the context.
  • M&A deals are totally all over the place in terms of time and costs.
  • In short, companies are not like medical patients. Biology and medical science produce very clear “bell curves” that enable things like health insurance pricing and fixed-fee medical procedure costs. There is no underlying DNA/biology constraining variability among companies, and therefore far less rhyme or reason across a legal client base.  The drivers of legal cost variability are far wider, subjective, unpredictable, and randomly distributed, which makes fixed-fee pricing not feasible for many broad-scope firms and clients.
    • Name another field in which, on top of there being significant variability of the working environment (the legal/contract ‘code base’ for each company), there are also subjective drivers of cost on both the client side (your client’s preferences heavily drive time commitment) and also the third-party side (the counterparty/lawyers on the other side can dramatically increase time commitment). The level of structural uncertainty and variability is much higher than healthcare, construction, manufacturing, consulting, and many other industries.
  • Given the above, the only way to make fixed-fee pricing work economically in corporate law is to “tame” this variability, and that “taming” results in downsides that are often unacceptable both to firms and to clients.

So what are the variables that help “tame” client work enough to make fixed fee pricing viable in Startup Law?

A. Very early work – There is a reason that formation documents are the most heavily automated and price-fixed in startup law: the number of unknowns and idiosyncracies are minimized. When a startup has decided on a “standard” VC-track C-Corp structure (which, btw, we see this becoming a less obvious decision for founders – see More Startups are LLCs), there are no outside parties to negotiate with, or other lawyers to deal with. The scope is clear, and the circumstances in which costs could go off the rails are minimized. Most of our clients are incorporated/formed on a fixed fee.

  • Anyone who observes the heavily tech automation / fixed-fee driven nature of startup formations and extrapolates that across the full spectrum of legal work is incredibly naive as to how complexity and client variability increase exponentially immediately after formation; as circumstantial differences start to creep into the legal “code base.” The low hanging fruit for legal automation has been eaten (see Clerky), and people who understand both technology and law are rightfully skeptical re: what even the most advanced, cutting edge AI can really do for high-complexity corporate law for the next decade, outside of very *very* narrow applications.

B. Narrow the scope – Remember the point that fixed fees don’t align incentives, but instead reverse them? Fixed fees make it costless for the client to demand more work. This logically means the law firm has to start drawing hard boundaries over what is acceptable for the client to ask for (inflexibility). We recently started our Alpha Program offering a limited scope of early-stage work on a fixed monthly fee. While there’s definitely been interest, a lot of our best clients opt out simply because they prefer maximal flexibility in terms of what work gets done, and how it gets done. In their mind, the whole point of hiring serious lawyers, just like hiring serious software developers, is to not get boxed into a narrow approach.

C. Narrow the client profile – I know a decent number of firms that have built successful practices on heavy fixed fee utilization. The almost universal way they’ve accomplished this is by dramatically narrowing the type of client they take on. Specific industries, specific geographic locations, specific sizes or growth trajectories, etc. Pick a narrow niche, and own it. If you can make your clients look and act far more alike by limiting the type of client you take on, you can more easily create that healthcare-like “bell curve,” and then start pegging prices. But for many law firms that have a diverse client base with diverse needs – including firms that represent startups with varying industries, growth and funding trajectories, subjective preferences, etc. – this is simply not feasible. I have never seen a firm or lawyer successfully utilize fixed-fees at scale without significantly narrowing their target client profile; the economics otherwise don’t work.

  • Note: I have made the argument many times that part of “BigLaw’s” problem is that it simply does too much, and that the “subtractive innovation” brought about by lean boutiques with more specialized practice areas that can collaborate ad-hoc is a meaningful transformation of the legal market. But virtually every specialized high-end boutique we work with still heavily utilizes time-based billing, for all the reasons described here. For fixed-fees to work, you need far narrower specialization than by practice area; like “small businesses under 40 employees” or on the opposite end “very high-growth SaaS companies raising top-tier traditional venture capital.”
  • The need for very narrow specialization driven by fixed fees will create problems for clients who engage a firm that isn’t a 100% good fit. They will inevitably find themselves pushed to mold their company to the rigid capabilities of the narrow firm, which will feel like putting the cart before the horse. What this means is that the decision to keep many law firms more generalist, with more flexible time-based billing, is for many clients a feature; not a bug. 

Our approach to pricing legal services for our startup clients is the result of sitting down and talking to founders about what their concerns really are. What we’ve found is that, more than fixing prices (with all of the downsides that entails), clients just want to prevent surprises, and to not feel like they overpaid. If something takes longer for very good reasons, it’s OK for it to cost more. If it can be done faster, while fulfilling all the client’s goals, then cost-savings should go to the client. Happy clients generate more work and referrals. When combined with transparency and open dialogue, there’s a symmetry and fairness in this approach that is often much more aligned with the “partnership” nature of the long-term lawyer-client relationship than the inflexible dynamics of buying a hardened product. 

So we’ve implemented a number of processes to accomplish that – including regular (more frequent than monthly) billing reports, transparent budget ranges based on our historical client data, and flexible payment options. We’ve found that these go very far toward helping startups get comfortable with their legal bills, without deluding anyone into thinking that you can somehow universally fix the costs of services that are inherently unpredictable to everyone. Our Net Promoter Score (NPS) as of today is 77.

Tying this all together, entrepreneurs should understand that there are very logical, client-centric reasons for why the billable hour remains the dominant billing model for serious law firms working with diverse clients; notwithstanding what lazy arm-chair commentators say about the billable hour. Law is hardly the only industry that utilizes “cost plus” billing, which is what the billable hour is. Occasionally I run into founders who struggle to grasp this, and then I’ll find that they’ve engaged a software developer as a contractor who, lo and behold, is paid by the hour. Many startup lawyers refer to their job as “coding in Word.”

That developer didn’t go to Stanford to practice cookie-cutter programming, and I didn’t go to Harvard to practice cookie-cutter law.  Fixed fees are not – at all – a magical panacea that suddenly smooths out all the challenges of engaging serious lawyers. To the contrary, they create their own major problems.  Open dialogue between client and law firm will keep costs reasonable, and minimize surprises, without getting stuck with all the downsides of productizing something that fundamentally isn’t a product.

Contracts v. Might Makes Right

TL;DR: When a first-time entrepreneur is navigating an environment full of entrenched players who all know and depend on each other, the difference between a balanced decision process and a shake down can come down to a contract. Take contracts, and the independence of the lawyers who help negotiate them, seriously.

Background reading:

A background theme of many SHL posts is the following: entrepreneurs enter their startup ecosystems, from the beginning, at a massive structural disadvantage relative to the various market players they are going to be negotiating with. Everyone else knows each other, has worked with each other over the years, and has already made their money. And then you show up.

Now assume that environment as the background, and then imagine you start striking deals with these people: for a financing, a partnership, participation in a program, etc., but assume there are no contracts or lawyers involved. What do you think will eventually happen? Here’s how it will play out: as long as you continue to deliver exactly what everyone wants from you, very little will happen. When everyone’s expectations and preferences are 100% aligned in the short term, the absence of contracts means very little. They’ll “let” you stay in the spot you’re in. 

Until things (inevitably) go sideways. A market shift suddenly means a change in strategy might be necessary, but there’s disagreement on how and when. A quarter comes in under projections, and there’s disagreement as to what that means. A potential outside investor expresses interest in making an investment, and there’s internal disagreement as to whether it should be pursued.

I focus here on the word disagreement, because in many situations on high-level strategic issues, the right answer isn’t always clear cut. The goal (grow the company, improve economics) may be clear, but the right execution strategy is far harder to see.  People will disagree, and where they stand on an issue often rests on where they sit. For example, “portfolio” players (institutional investors) will often be far more comfortable, and even insistent, on taking higher risk (but much higher reward) growth strategies than entrepreneurs and employees, who have only “one shot.”  See Common Stock v. Preferred Stock for a more in-depth discussion on the substantial misalignment between “one shot” players (entrepreneurs, employees), who usually hold common stock, v. portfolio/repeat players (investors), who usually hold preferred stock.

The core point of this post is this: in an environment of substantial disagreement, and where everyone other than the entrepreneur is a repeat player that knows and has economic ties to each other, the first-time entrepreneur (who speaks for the early common stockholders generally) will lose every timeunless contracts in place say otherwise. 

In the absence of laws and contracts, the law of the market is “might makes right,” and established, repeat players have all the might.  

Here is a scenario that I’ve encountered far too often (although increasingly less so as awareness has increased) that is almost comical when viewed objectively:

  • A financing has closed, putting in place a “balanced” Board of 2 VC directors, 2 common directors (one of which is a new CEO, the other a founder), and an “independent” director.
  • In attendance at the meeting are 6 people: the Board and company counsel.
  • The 2 VCs regularly syndicate deals with each other and have known each other for a decade.
  • The new CEO is a well-known professional CEO who has worked in several portfolio co’s of one of the VCs, and was “recommended” by that VC for the position.
  • The “independent” director is an executive well-known in the local market who also has worked with the VCs at the table for over a decade, both of whom recommended her for the position.
  • “Company counsel” represents 6 portfolio companies of the VCs at the table, and has represented them as investor counsel on as many deals, and is actually currently doing so for other deals. In fact, company counsel became company counsel because he came “highly recommended” by the VCs when they were first negotiating the deal with the entrepreneur.

So let’s summarize: there are 6 people at the meeting, and 5 of them have all worked with each other for over a decade, regularly send deals to each other, and in some cases (at least with respect to the lawyer and a VC) are currently working with each other on other deals not related to this company. And then there’s the entrepreneur.

Wow, now there’s one “balanced” Board, don’t you think? I’ve encountered entrepreneurs (whose companies are not clients) in this situation before. I let them know that, whatever they think their position at the company is or will be, they are simply leasing that position until their investors, who hold virtually all the cards and relationships, decide otherwise; and regardless of what the common stockholders think. It’s possible things turn out fine, as long as all goes as planned. It’s also very possible they won’t.  But what’s absolutely clear is who decides, in the end.

The difference between a well-advised entrepreneur and the one in the above scenario is this: the former will have real protections in place to ensure the common stock are treated fairly, and have their voice on key company matters. The latter may feel protected, but ultimately their position is at the discretion of their investors; and protection that is contingent on the whims of people on the other side isn’t protection at all.

Well-drafted contracts are, when negotiated in a transparent manner, a key mechanism for controlling the power of sophisticated repeat players who, absent those contracts, can simply force through whatever they want because of their political / economic leverage. What else might this reality tell us about negotiation dynamics in startup ecosystems?

Rushing through negotiations / contract drafting favors established players.

If the default market position gives power to established players, and contracts are a mechanism for controlling that power, the inevitable result is that those established players (at least the most aggressive ones) will try to get entrepreneurs to rush through contract negotiations.

“Let’s just go with what’s standard.”

“It’s all boilerplate.”

“Let’s save legal fees and put them toward building the business.”

“Time kills deals. Let’s get this closed.”

If someone is telling you that what the documents say doesn’t really matter, or that you should just stick to a template, it’s because, outside of the contract, they’re in control.  That doesn’t mean you should burn endless amounts of time negotiating every point, but take the material provisions seriously.

A market ethos of “relax, we’re all friends here” is designed to favor power players.

Old-school business folks know very well how large amounts of alcohol have often been used to seal business deals. In the startup world, alcohol may still be used, but just as effective is fabricating an environment suggesting to first-time entrepreneurs that everyone is just holding hands and singing kumbaya, and being independently well-advised isn’t necessary.

I’m all for having very friendly relations with your business partners. Life is too short to work with people you don’t get along with well.  But any time someone extends that thinking to the point of telling entrepreneurs that “everyone is aligned” and they should let go of the skepticism to focus on “more important things,” I call bullshit. Alcohol and kool-aid; stay sober in business.

“Billion or bust” growth trajectories mean contracts matter less. Outside of those scenarios, they matter more. 

Among emerging company (startup) lawyers, it’s always been well-known that the Silicon Valley ecosystem as a whole takes standardization, automated templates, and rapid angel/VC closings to an extreme relative to the rest of the country/world. I’ve pondered why that’s the case, and in discussing with various market players, concluded that it has a lot to do with the kinds of companies that Silicon Valley tends to target: billion or bust is a good way to summarize it. I wrote about this in Not Building a Unicorn. 

If the mindset of an ecosystem is significantly “power law” oriented in the sense that “winners” are billion-dollar companies, and everyone else will just crash and burn trying to be one of those billion-dollar companies, I can see why the finer details of deal negotiation may be seen as an afterthought. That environment, which is very unusual when compared to most of the business world, leaves a lot less room for the “middle” scenarios – things aren’t going terribly, and we’re clearly building a solid business. but neither is this a rocket ship, and there are hard questions to be decided – where the deep details of who has what contractual rights really matter.

In a heavily binary “unicorn” world, you’re either knocking it out of the park, in which case no one even reads the contracts and just lets you do your thing, or you’re crashing and burning, in which case the docs are just useless paper. As a law firm headquartered in Austin and structured for non-unicorns, we don’t work in that world, and actually avoid it.

For true “balance,” pay close attention to relationships.

In my opinion and experience, the best outcomes result when the power structure of a company (both contractual and political) doesn’t give any single group on the cap table the ability to force through their preferences, but instead requires some hard conversations and real “across the aisle” coalition building to make a major change.

Balanced boards are, on top of other contractual mechanics, a fantastic way of achieving this, when they are in fact balanced. The above-described scenario where everyone except for the entrepreneur knows and has strong economies ties to each other, including a company counsel “captive” to the VCs, is a joke; and sadly, a joke played on too many startups.

As I wrote in Optionality: Always have a Plan B, build diversity of relationships into your Board and cap table. Feel free to let “the money” recommend people, because their rolodexes are valuable, and are often part of the reason why you’ve engaged with them. But you should be deeply skeptical of any suggestion that the preferred stockholders should, alone, decide who the CEO is, who company counsel is, who the independent director is, etc. etc. Letting them do that certainly may get your deals and decisions closed faster, but unless you are successful in delivering a true rocket ship, you will ultimately regret it.

The common stock, including the founding team and early employees, need a strong voice at the table, especially given the power imbalance with repeat players. Well-negotiated contracts and independent, trustworthy company counsel are the way to ensure they have that voice.

How LLC Startups Raise Money

TL;DR: Very similarly to how “classic” C-Corp startups do, with a few important caveats.

Background Reading:

As I’ve written a few times before, the trend of entrepreneurs (somewhat) mindlessly accepting the advice – that forming their companies and raising investment should always be as standardized as clicking a few buttons – appears to be reversing, at least outside of Silicon Valley. This trend is very much related to all the public stories from experienced founders emphasizing the downsides of following a “standard” path, taking on “standard” VC investment with very high-growth expectations, and how it can cut off a lot of more nuanced/appropriate growth and fundraising strategies. For more on that, see: Not Building a Unicorn. 

As entrepreneurs are spending more time exploring all their options, LLCs are increasingly popping up. I’ve written before about when an LLC may make sense for a startup (C-Corps are still by far the dominant structure). It generally boils down to whether the founder team thinks there’s a possibility that, instead of constantly reinvesting earnings for growth and looking for an exit, they’ll decide to let the business become profitable and distribute dividends to investors. C-Corps are very tax inefficient for those kinds of companies.

So naturally as LLCs become part of the discussion, the next question is how LLC startups can raise investment. Some founders have been incorrectly advised that LLC startups simply don’t raise investment at all. They think that C-Corp = investment, and LLC = run on revenue. That’s far from the case. While true that institutional tech VCs very often won’t invest in LLCs (although that too is changing), the pool of investors interested in early-stage tech companies is much more diverse now than it was even five years ago. Lots of strategic investors, angels, and investors from other industries looking at tech are quite comfortable investing in LLCs, and do so all the time.

LLC startup fundraising looks, at a high level, a lot like C-Corp fundraising.

Capital Interests – Units, Membership Interests, Capital Interests. These are all synonyms for the LLC equivalent of stock. The documentation for these types of investments looks very different from a C-Corp preferred stock financing only because the underlying organizational docs of LLCs are different: you don’t have a “Certificate of Incorporation,” as an example, you have an LLC Operating Agreement.  But the core rights/provisions often end up very similar. A liquidation preference giving the investors a right to get their money back before the common – often see “Common Units” for founders/inside people and “Preferred Units” for investors. Voting provisions re: who gets to elect the Board of Managers (LLC equivalent of a Board of Directors), and other similar rights.

Convertible Notes – These look 95% like C-Corp convertible notes, including with discounts/valuation caps to reward early-stage risk, just drafted a bit more flexibly to account for whether the notes convert into LLC equity or C-Corp equity (if the company decides to become a C-Corp).

SAFEs – Yes, there are LLCs now doing SAFEs, although the SAFE instrument requires tweaking (like convertible notes) to make sense for an LLC. Even for C-Corps, we still see SAFEs being used only in a limited number of cases (again, because we serve companies outside of California, where SAFEs dominate). That’s because they are about as company favorable (and investor unfavorable) as you can get, and many investors balk at what they see as an imbalance. LLC SAFEs are even rarer than C-Corp SAFEs, but they do come up.

LLCs are known for their flexibility, and given that LLC companies tend to be more “cash cow” oriented than C-Corps, even more alternative financing structures are popping up: royalty-based investment is one example, where investors take a % of revenue as a way to earn their return, instead of expecting it in the form of a large exit or dividend. But those are still so uncommon (for now at least) that they’re not worth digging further into.

As I’ve repeated several times before, the big issue with LLCs and fundraising is you absolutely need a tax partner involved. By that, I mean a senior lawyer with deep experience in the tax implications of LLC structures and investment. This is not a “startup lawyer,” but a very different specialty. The flexibility of LLCs brings with it significant tax complexity at the entity and individual holder level, and even the brightest corporate lawyers are not qualified to handle that on their own. 

The majority of emerging tech companies still end up as C-Corps, simply because it still makes sense for the type of business they plan to build. But even with C-Corp land, founders are digging much deeper into how to structure and fundraise for their companies, and pushing back on the suggestion that they should just sign some templates and move on; as if what the templates say (and don’t say) doesn’t really matter.  That may still work for the “billion or bust” high growth mentality of unicorns, but entrepreneurs who feel they’re building something different want flexibility, and to understand the full scope of options.

How Angels & Seed Funds compete with VCs

TL;DR: The emerging “seed ecosystem” of angel groups, seed funds, and accelerators now provides local startups a viable path to seed funding, and eventually “going national,” w/o having to prematurely commit to a Series A lead.  That has dramatically reduced the leverage that local institutional funds once had over their local ecosystems.

Background Reading:

Once upon a time, startup ecosystems (if they could even really be called that) outside of Silicon Valley had only a handful of local VC funds writing checks. Without AngelList, LinkedIn, Twitter, Accelerators, good videoconferencing, and the many other recent developments that have reduced geographic friction in startup capital flows, those funds effectively “owned” their cities, including most of the startup lawyers in those cities; which often resulted in harsh terms and aggressive behavior. For more on this, see: Local v. Out-of-State VCs.

Raising “angel” money in that era often meant needing close connections (family, friends, professional) to very high net worth individuals willing to make big bets on you until you were ready for one of the few local funds to take you under their wing. If you were one of those lucky few chosen, those local VC funds would then, once they were out of their own capital, show you off to one of their trusted out-of-state growth capital funds.

The pipeline was narrowly defined, and choice was minimal: local angels (or friends and family), then local VC, then out-of-state growth capital.

Times have changed.

Today, angel groups are much bigger, organized, and collaborative across city and state lines. Seed funds – which weren’t really even much of a concept a few years ago – will write checks of a few hundred thousand to a few million dollars for rounds that may have been called Series A 3-5 years ago, but are now “seed” rounds. Prominent accelerators have themselves joined the mix, writing their own 6-figure checks and serving as valuable filters / signaling mechanisms to reduce the search costs of investors.

This “seed ecosystem” of organized angels, flexible seed funds, and accelerators has not only increased the amount of “pre-VC” capital available to startups, but very importantly, it has significantly reduced the leverage that local VC funds have over their local startup ecosystems. 

As I wrote in Optionality: Always have a Plan B, sunk money has very different incentives from future money. A seed fund/angel that has mostly maxed out the amount of capital it can fund you with has every incentive to help you find a great Series A lead at a great valuation; they are quite aligned with the common stock. However, a VC fund that wrote you a small seed check but wants to lead your Series A has very different incentives. The “seed ecosystem” wants to maximize your Series A options, while a VC fund wants to minimize them, until it gets the deal it wants.

Foreign capital will usually require some heightened level of de-risking or credible signaling before it will cross state lines. It’s much less risky to rely on my local referral sources, and “monitor” my portfolio where I can drop in by the office whenever I need to. If I’m going to write a check a thousand miles away, I need a little more reason to do so. In that regard, it’s well-known that there is a “flipping” point beyond which the pool of capital available to a startup moves from being mostly local to much more national: that point is somewhere between $1M-$2MM ARR (it used to be higher). 

Historically, reaching that flipping point was almost impossible without local VC, and this effectively kept startup ecosystems captive to their local funds. The new seed ecosystem, with its ability to often fund 7-figure rounds all on its own, has changed that. Now, if a desirable startup wants to, it can often raise $1-2MM in seed capital without taking a single traditional VC check, then use that to hit the “flipping” point, after which the number of VCs it can talk to goes up considerably. 

Of course, this dynamic is not always so clean cut.  More progressive VCs have wisely developed symbiotic relationships with this seed ecosystem for the obvious reason that it can serve as a pipeline when startups are ready for bigger checks. That is a smart move. What we’ve also seen is that large VCs are playing much “nicer” in seed rounds than they used to, as an acknowledgement of their reduced control over the market. Years ago you much more often saw VCs condition a $250K or $500K check on a side letter giving them the right to lead your Series A. That is increasingly becoming an anachronism, and for good reason.

At the same time that AngelList, accelerators, LinkedIn networks, and other signaling / communication mechanisms for startups are giving foreign capital more “visibility” into other ecosystems, allowing it to invest earlier and more geographically dispersed, the emergent seed ecosystem is also increasingly allowing local startups to “go national” without having to commit themselves to a particular VC fund. The obvious winners in this new world are entrepreneurs and investors willing to be open and flexible with how they fund companies. The losers are the traditional investors who haven’t understood that the old game is gone, and it’s not coming back.

Optionality: Always have a Plan B

TL;DR: Always build some optionality into your startup’s financing strategy. Failing to do so will overly expose you to being squeezed by sophisticated players who can see how dependent you are on them.

Background reading:

The below is a fact pattern that we have seen happen with several of our clients. It will provide some context for why the point of this post is so important.

Company X has raised a decent-sized seed round, which includes several angels as well as a “lead” VC; though that VC is not on the Board. The Company knows that it will run out of funds in 3 months if it does not raise more money, and it has been in regular communication with the VC about that. The VC reassures the founders that they will “support” them with a new bridge round. A month passes, and the founders ask about the bridge. “Don’t worry, we’ll cover you” is the response. Then another month passes, with more reassurances, but no money. Then 2 weeks before their fume date (the date they’ll miss payroll), the VC drops a term sheet with very onerous terms, including a low valuation, and mandated changes to the executive team. The VC makes it clear that they won’t fund unless those terms are accepted. The founders panic. 

Before we dive in, there are a few important points worth making about this situation. First, it was clear every time that it has come up that the bait-and-switch dynamic was planned by the lead investor. They paid very close attention to the exact date that the Company would run out of funds, and timed the “switch” to deliver maximal pressure. Second, the regular “reassurances” provided to the founder team were calculated to discourage them from using their time to find other funding sources. Third, the best way to avoid investors who engage in this kind of “below the belt” behavior is to do your diligence before accepting their check; see: Ask the Users. 

Always have a Plan B.

A startup’s ability to avoid being burned by the above behavior depends on its level of strategic optionality.  Optionality means strategically avoiding a situation in which you have no choice but to depend on one investor/investor group for funding. This is very different from not committing to certain lead investors as your main funding sources. “Party rounds” are what you call financings where literally every investor is a small check. The end-result of a party round is that no one has enough skin in the game to really support the company when it hits a snag. You really are just an option to them. 

I strongly support having true lead investors writing larger checks in your rounds, because they will usually provide far more support than just money. And if you’ve done your homework and have a little luck, they’ll never even think about engaging in the kind of behavior described above. But in all cases the best way to maximize the likelihood of good behavior is to ensure a right of exit if someone decides to cross a line. I always try to work with “good people.” But no good strategist builds their life or company around the full expectation that everyone will be good. 

Lead fundraising yourself.

CEOs sometimes believe that they are doing themselves a favor by letting a lead investor do their fundraising for them – coordinating intros, negotiating terms with outsiders, etc. – so they can “focus on the business.” It often backfires. Angels and seed funds whose money has been sunk into the company, and who aren’t planning on writing larger checks in the future, are usually quite aligned with the founders/common stock in helping raise a Series A or future round. They’re being diluted just like you are.

But a VC fund with plenty of dry powder and a desire for better future terms is significantly mis-aligned with everyone else. Watch incentives closely.  Founders/the lead common holders should maintain visibility and control in fundraising discussions, with trusted independent advisors close by. 

Start early, and don’t tolerate unnecessary obfuscation and delays. 

Do not wait until a few weeks from your fume date to start communicating with investors for new funds. If someone says they will support you, great: when, and what are the terms? You want to know them now, not later. “We will support you” means very little without knowing what the price will be.

Expecting things to happen in a few days is unrealistic, but a month or more of delays is usually a sign that someone is playing games, and it’s time to pull the plug. No serious fund worth working with is that busy.

Build “diversity” into your investor base.

The power dynamics in a company are very different when all the major investors have strong relationships/dependencies with each other, and communicate regularly, relative to when various players come from different “circles.” Geographic diversity – meaning taking money from various cities/states – is a good strategy to avoid unhealthy concentration of power among your investor base. Also, diversity of investor types – angels, seed funds, institutionals, strategics – will ensure that your investor base includes people with differing incentives/viewpoints, which reduces the likelihood of collusion. 

In the scenario where a bad actor has tried a “bait and switch” on a founder team, a group of angels willing to write quick checks for an emergency bridge, or a lender offering a credit line, can be enormously valuable to relieve pressure and build time to correct course.

Contracts matter. A lot. 

Every commitment you make to investors requiring their approval, or guaranteeing their participation, in future rounds can have material strategic implications for how much optionality you have. Protective provisions matter. Super pro rata rights and side letters matter.  When you see dozens of financings a year, you regularly see how commitments made at seed/pre-seed stage play out over years and seriously affect the course of fundraising.

Good lawyers well-versed in the ins and outs of startup financing will go much further than just plugging some numbers into a template, which software can do.  They’ll dig deep on how the specific terms you’re looking at will impact the company, in its specific context, and how much room there is to stay within “market” norms while still keeping flexible paths open for the future. That’s, of course, assuming they aren’t actually working for your investors.

Make money, and own your payroll.

The ultimate optionality is being able to run on revenue if you need to; being “default alive” in Paul Graham’s words. Yes, you may grow slower than you’d like, but growing more slowly is always lightyears better than being forced into a bad deal.

Every salaried employee on your payroll raises the revenue threshold needed for your company to be default alive. Ensure that every member of your roster is essential, and that there aren’t redundancies that could be addressed by asking someone to be more of a generalist. And don’t let an institutional investor pressure you into hiring a high-salaried professional executive unless you have a clear strategy for how you are going to afford them, because, yes, that is another way that they can add fundraising pressure.

Stay in control of your fundraising. Start discussions early, and don’t tolerate delays. Build diversity of geography and incentives into your investor base. Let your lawyers do their actual job. And finally, watch your payroll closely. Following those guidelines will minimize anyone’s ability to squeeze you, and your investors will then act accordingly.