Burnout, Depression, and Suicide

Background Reading: Founder Burnout and Long-Distance Thinking 

This is going to be another personal post; less about how to close a financing or avoid legal issues, and more about the bigger fundamental issue of life outside of work. Because if you think what happens outside of work doesn’t heavily influence what you achieve at work, you’re clueless. Please move onto another SHL post if you want Startup/VC law advice.  This post is prompted by the very unfortunate passing of Anthony Bourdain, whom I admired as a voice of authenticity in a world that sterilizes and bullshits far too much.

Depression and suicide are two things with which my bloodline is far too familiar. Since I was a young kid – watching family members lock themselves in rooms for days and weeks in the dark, and openly discuss swerving their car into oncoming traffic, sometimes while I was in it – it’s been at the top of my mind.

Despite my many faults – my wife of 10 years is always happy to provide a list – one thing I know I’m good at is being observant. I watch people very closely, and pick up on patterns and subtleties that others miss.  As the old saying goes: the wise learn from the mistakes of others, the smart learn from their own mistakes, and fools never learn.

Another thing I’m particularly fond of is what I call asking the “meta question,” meaning trying to separate symptoms from the disease, and talk about the root cause of something. Because far too often people get caught up with trying to band-aid the symptoms of something, without digging deeper and probing into fundamentals. I didn’t switch majors in college from business honors to philosophy for nothing.

What’s absolutely crystal clear is that suicide and depression are way up in America. It is clearly a paradox, given that on many objective metrics, life has never been better: life expectancy, technological advancement, overall wealth, homicide/major crime rates, gender equality, etc.

The standard reaction to this rise in depression/suicide is to focus on mental health. If we just had more infrastructure for affordable therapists and anti-depressants, all would be better. But that obviously misses the bigger historical point. Life was, on many levelsway harder even just 50 years ago, and we didn’t have an army of public therapists then; yet depression and suicide were less prevalent. Clearly there is a meta issue here worth discussing.

To share my thoughts and observations on the topic, I’m going to first list out a few concepts that I’ve picked up over the years from reading, education, having good conversations over coffee, etc.:

Maslow’s Hierarchy of Needs – This is the idea that as peoples’ more physiological needs are met (shelter, food, etc.) and become less of a top-of-mind concern, their psychology shifts to prioritize “higher” needs, like love, belonging, art/beauty, etc.  People who grow up in more stable, loving environments (or societies) tend to be more open, creative, and communal, but that can also result in being more sensitive and emotionally vulnerable.

Specialization v. Generalism – Economic development inevitably leads to human specialization. People in rural communities are often decent at a lot of things, and more self-reliant, because they have to be. They’re also poorer. People in advanced markets tend to have much narrower, specialized skillsets, which they then sell in the market to earn surplus income to buy everything else.

Grit – The idea that exposure to hardship/struggle can build mental resilience, in the same way that exposing muscle to pressure makes it stronger, as long as it doesn’t go so far that things start to break. Moderate stress is good. Too little or too much is bad.

Dopamine v. Serotonin  – D and S are neurotransmitters. Without getting too bogged down in details that I certainly will botch, D is largely the “desire/drive” brain chemical. Heavily involved in addiction. Serotonin is heavily involved in calmness, satisfaction, a feeling of fulfillment. D and S have a tension with each other. If D overruns things, S decreases, which leads to depression.

Higher Pleasures v. Lower Pleasures – In the way that complex carbs are longer-lasting while simple carbs are often tastier but shorter-lasting, lower pleasures tend to be activities in life that are thrilling, fun, and even memorable, but don’t have much of an on-going positive effect. Lower pleasures drive dopamine. Higher pleasures, on the other hand, tend to be less thrilling, and in specific moments may actually be difficult/painful, but they have significantly longer-lasting positive impacts. Lower pleasures tend to cost you mostly money. Higher pleasures tend to cost you mostly time, but increase serotonin.

Traditional Culture v. Market Culture – Culture is largely the set of narratives and values that swirl in our brain to tell us how we should live, our role in the world, and the underlying purpose/meaning behind it. Many moderns dramatically under-appreciate the complexity and nuance in how culture plays into life satisfaction and progress.

Without culture, humans are just advanced monkeys. Traditional culture is the accumulation of centuries of slow-changing values and life-structures interacting with history, human psychology, social dynamics, etc. Market culture is the result of marketing/advertising messaging, often informed by PhDs in psychology and neuroscience, nudging people to engage in activities that ultimately maximize economic growth for someone.

Bottom-up Organic v. Top-Down Theoretical – There are two ways that cultural values, systems, and ideas in general emerge. A bottom-up “organic” approach starts from the ground, interacting with all the nuances and variables of reality, and iterates “upward” over time to arrive at an equilibrium.  A top-down structure starts with logic or theoretical principles, focusing on a kind of abstract consistency, and then imposes itself “downward” on reality. Organic emergence is messy, iterative, and often slow. Top-down is “cleaner” and more consistent, and usually faster. But also more prone to extreme errors. Traditionalists (at least those who aren’t dogmatic) tend to favor organic emergence of ideas. Intellectuals tend to favor the top-down.

Individualism v. Communalism – The free market pushes individualism as a primary value, because it maximizes economic growth. The more differences we can parse out among people, slowly nudging them to like different things, pursue different paths, the more things we can sell to them. It may feel like “discovering yourself,” but there’s a lot of outside nudging involved. Communalism, on the other hand, emphasizes similarities and long-standing histories between people. It’s driven by more traditional value structures, which focus less on peoples’ economic outputs, and more on their deep relationships to one another. It also is more constraining on individual freedom/choice.

Age-Mixing – Somewhere along the way, society got the idea that it’s better for everyone if people of the same age spend all of their time with each other. I suspect industrial-age schooling, and the efficiencies of standardizing education, are partially at play. Yet the evidence is clear that age-mixing produces significantly better outcomes on a psychological level. When you age-mix, older people (including older children) learn responsibility and empathy, and how to teach the younger. They also feel more “needed,” which gives life a sense of meaningful purpose apart from their market value.

And the younger benefit from the longer-term perspective of people who’ve “been there” and know how life progresses, instead of just being focused on immediate wants/needs. When people fail to age mix in their lives, they tend to be more hierarchical, competitive, myopic, and neurotic.

Ok, that’s a lot, and it took a while. But hopefully at least some of the concepts were enlightening. Now, using those concepts, here are my own personal observations/thoughts from my own life, my family’s history, and observation of others regarding the “meta” question of why society is so much more depressed and suicidal:

Affluence has taken away a lot of the hardship and struggle that once was a defining feature and motivator of people’s lives. Obviously, this is not necessarily a bad thing. I know so many people today whose life largely boils down to specialized work and leisure. They do one narrow thing that someone pays them for, and they buy everything else, so that they have “free time” to do things they enjoy; which usually involve seeking entertainment in the market. Specialization obviously makes people wealthier. But is there a point beyond which it makes people less happy?

Now you can order any meal you want on Uber Eats, and it’ll be delivered right to your door. That’s fantastic. It’s efficient. But what if the act of cooking, and even the act of picking out ingredients has some deeper psychological benefit that we missed? Now we can Lyft or drive to wherever we want, but what if the act of walking does something for us that we missed (and I don’t just mean burn calories)?

Market economics (and culture) says to specialize. Only do what has the highest market value, and you can just buy everything else. But traditional culture says hyper-specialization makes you fragile. You may become wealthier, but you also become less self-reliant and therefore more dependent on the market. And the idea that everyone should just do one narrowly defined thing, and then seek “entertainment” the rest of the time, is a speck in humanity’s evolutionary history.

Is the person who works their own garden and cooks on the weekends  just wasting their time on inefficient activities? Should the person who works on their car in their garage just stop wasting time and send it to a mechanic? Maybe. Or maybe there’s something more there than top-down market theory can grasp.

Social revolutions told people to throw away traditional, organic culture and “be themselves.” Modern “top-down” market culture then filled the void. The idea that you are born with some inner core “you” that you must discover over time, free from the influences of everything external, has a very romantic sound to it. It’s also totally false, or at best extremely incomplete. “You” are heavily a by-product of your environment. You don’t “free” yourself from culture; you simply adopt one over another.

So as age-mixing gave way to age-sorting, and people stopped taking advice from grandparents, family, traditions, etc., the market was there to fill the void. But the values of the market are top-down and profit-driven.  When a grandparent tries to teach their grandchild about life, one can assume that in most circumstances the child’s long-term well-being is an end-goal. When a market actor teaches a child something, there can be any number of other incentives; often tied in the end to economics.

Remember that organic, bottom-up progression involves slow evolution; strongly path-dependent on the past, which is assumed to carry a kind of underlying wisdom/understanding that is perhaps difficult to articulate, but is nevertheless there. On the other hand, top-down progression is about intellectual consistency with some defining value structure, like freedom, or fairness.

Older generations had their views on family, life roles, responsibility, money, work, and they were the product of slow evolution over time, integrating feedback from history’s experiments and mistakes. They had their problems, for sure, but evidently large-scale depression and suicide was not one of them. Then social revolutions came in and demanded corrections, many of which made sense at a theoretical level, and were amplified by market incentives. But top-down theory breaks down when it hits messy, multi-variate reality.

Without getting too bogged down in specifics, there is a meta issue here: a theoretical framework that hyper-emphasizes individuality and freedom may be more productive economically, and intellectually “purer” but it breaks-down, or at least reveals fundamental flaws, when it hits the reality of human psychology; which evolved on older, more organically evolved values.

Modern market culture pushes us to pursue things that lead to greater economic activity (dopamine), while neglecting those that may actually make us happier (serotonin), but can’t be monetized.

There’s a better job for you in another state. Go, pursue “your” dreams. You can visit your parents, childhood friends, and cousins on holidays.

If you have kids now, you’ll get “tied down.” You can always have them later (maybe…). Build your career. Travel the world.

Why are you wasting time cooking for yourself? Bill a few extra hours, and have the food delivered.

Your parents’ and grandparents’ views on life are out-dated. “Be yourself” and “follow your own path” with your peers, who largely feel the same.

Apologies to my millennial friends with romantic notions about how the “experience” of travel “expands your mind” and is “life changing.” I love traveling too. But that doesn’t mean I don’t recognize really good marketing when I see it.

There’s a big difference between what makes you wealthier, free-er, or more “empowered” (abstract concepts that, conveniently, have a way of increasing GDP) and what actually makes you – advanced monkey with a brain evolved over millennia – happier and more resilient.

The market’s individualism (liberating, but cold and detached) and traditional communalism (constraining, but warm and connected) are competing goods that need to be balanced. We are sucking at that balancing. 

It is much harder to balance competing goods than to simply let one take over our lives, even if the former is far better for us in the long run. When virtually all of the messaging/reinforcement in our environments supports only one side (because that’s the side that literally pays for messaging/reinforcement, including advertising and our educational infrastructure), that’s where so many of us end up.

Individuality, freedom, and financial wealth (all quintessential American, market values) – “following your own path” “pursuing your dreams” “not getting bogged down” “crushing it” – are real, valuable things. They’ve all played a key role in my life, for sure.

But the happiest, most resilient people I’ve known (men and women) have never “bought” fully into the market ideology (and it is ideology) that they are the be-all end-all of life. They understand that what’s old may be flawed and constraining, but if it’s old, that means it’s lasted. And things last for a reason; even if that reason isn’t easy to explain or fit within a theoretical framework. Freedom, empowerment, etc. are surely valuable. But so are durability and longevity; in other words, life paths and values that have been proven to “work” in the long-run.

As another old saying goes, winning is not the same as winning an argument; not even close.  The human brain is not designed in logic.  There’s no reason to expect an optimal human life to be either.

So if someone asks me for my thoughts on depression and suicide: sure, more therapists, discussion, and anti-depressants; certainly for the specific people who need emergency help now. But the meta-answer is to ask deeper questions about humanity, and to start questioning the life values that have been sold (and I do mean sold) to us; no matter how much we think they are supreme. Because we’ve clearly broken something, and it’s worthwhile to look back and examine a time when it wasn’t broken. 

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. They want a higher valuation and better terms for the existing cap table, just like you do, because they are being diluted too.

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 $500k-$2MM ARR (it used to be higher, and can be even lower if you have a strong network). 

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 – particularly those who used their old leverage to squeeze founders – who haven’t understood that the old game is gone, and it’s not coming back.

Startup Equity Compensation for LLCs

Background Reading:

As I’ve written before, with more entrepreneurs realizing that the “standard” (whatever that means) corporate trajectory for startups may not be what’s best for their specific company, we are seeing more tech companies explore the possibility of operating as LLCs (limited liability companies). By all accounts, C-Corps are still the market norm, especially for companies with no near-term plans to achieve profitability (everything is reinvested for growth) and with plans to raise conventional institutional venture capital.

But nevertheless, the “LLC Startup” market is real, and there’s far less info ‘out there’ for entrepreneurs to understand core concepts.  Here we’re going to cover the basics of how LLC startups typically issue equity, and how it differs from what C-Corp startups do.

The primary driver behind why LLC equity comp is very different from C-Corp equity comp is that W-2 employees of an LLC can’t hold equity in that LLC, under IRS rules. For C-Corps, both contractors and employees can hold equity, which simplifies equity compensation. But for LLCs, holding *true* equity requires the LLC to issue you a K-1 on an annual basis (you’re a “partner” for tax purposes), and the Company doesn’t cover employment taxes the way it does for W-2 employees.

Units/Membership Interests and Profits Interests (True Equity)

High-level executives (including founders) in an LLC startup are usually OK with this issue, and will hold direct equity in the LLC. They’ll receive K-1s annually.

That equity usually takes one of two forms: Units (sometimes called membership interests), which are the LLC equivalent of stock. Units can be voted (usually) on Day 1, and they are taxable on receipt if their “fair market value” is not paid for, which is why they’re typically issued only in the very early days of the company, like founder/early employee common stock in C-Corps. They can be expensive to receive if they are very valuable (in the IRS’ judgment) on the issue date.

As the value (for tax purposes) of units increases, companies will switch to Profits Interests, which are kind-of a LLC corollary to options, because (i) they only entitle you to the appreciation in value of your equity after the grant date, and (ii) when issued properly, they are tax-free to receive. When profits interests are granted, the Company has to obtain or decide on a valuation that pegs the “threshold value” of the company on the grant date, and the recipient of the PI is then entitled to the increase in value of the equity above that threshold value.

Returns on both units and profits interests receive capital gains treatment, like stock in a corporation. While units usually have voting rights, profits interests can have voting rights, but companies often times structure them to not vote.

Unit Appreciation Rights (Phantom Equity)

While founders and senior executives of LLCs will often be OK with K-1 status and holding true equity, it can become problematic for a number of reasons (tax oriented, benefits oriented, etc.) to have everyone be a K-1 recipient as the business scales. When LLCs want to issue equity-like compensation to lower-level employees, while continuing to treat them as true W-2s, they will usually switch to Unit Appreciation Rights, which are the LLC equivalent of phantom equity.

UARs don’t vote, and aren’t really equity at all. Instead, they entitle the recipient to a cash payment (like a bonus) upon some future milestone (typically an acquisition/exit) that is pegged to the value of equity. Much like profits interests, on the grant date a valuation is determined, and then as the LLC’s equity appreciates in value after the grant date, the UAR holder’s future bonus increases proportionately. When granted properly, UARs are also (like PIs) tax free on the grant date.

While the upside of UARs is that they significantly simplify tax filings/treatment for recipients (no annual K-1s, can stay W-2), the downside is that returns on the UARs are treated as ordinary income by the IRS; no capital gains treatment.

LLCs require Tax Specialists

The main reason startups choose to be LLCs is taxes: given the nature of their business, they want to avoid the corporate-level tax applied to C-Corps, even if that means deviating from the C-Corp norms of typical venture-backed startups.

But the cost of those tax savings is significant ongoing tax complexity in issuing and managing equity, and making annual tax filings. That requires not just good accountants, but good tax lawyers; who are very different from classic “startup lawyers.” If you’re planning to be an LLC that will use equity as compensation, make sure you’re using lawyers with access to solid tax counsel.

Tax Disclaimer: I’m not your tax lawyer or advisor. I don’t want to be your tax lawyer or advisor. The above is just a summary of what we typically see in the market for LLC startup equity. LLCs are highly flexible, and circumstances vary. Do NOT try to rely on any of the above advice without engaging your own personal tax advisors, including tax lawyers. 

Announcing E/N Alpha

I’m very excited to announce the launch of E/N Alpha, a flat-fee subscription program ($500/mo) that our firm has launched for high-potential very early-stage startups.

The details are available on the linked page, and should be fairly straightforward. In particular, I think it’s important to read the section describing what it’s not, because it reflects our firm’s thought-out response to what we see as a lot of failures / nonsense in the legal market where firms, for marketing purposes, pretend to deliver efficiency, when what they’ve really done is watered down their service so much to the point of no longer being useful.

Not software – Readers of SHL and E/N clients know I love legal tech and that we’re always integrating new tools into our practice, but as I wrote in Lies About Startup Legal Fees, there is simply too much BS floating around startup ecosystems that some magical automation tool or piece of AI will dramatically cut legal spend long-term for startups. Significant automation requires significant standardization and inflexibility, which in the world of high-stakes legal work for scaling tech companies negotiating with sophisticated parties, most smart Founders and executive teams are not willing to accept.

Yes, you can automate formations and a few very early things, but complexity increases exponentially beyond that (like a code base), and the value of software automation tapers off fast.

Not paralegals and junior attorneys – I have lost count of how many startups have switched to us from firms that talked a good efficiency game, when their main tactic was to force CEOs to get on the phone with paralegals and junior attorneys whose expertise ends the moment you go off script or deviate from a checklist. I love paralegals and juniors, and we have and train them. But if you think a founder wants to talk to your paralegal about structuring their seed financing, or making that key first or second hire, you don’t understand founders; at least not the smart ones.  See: The problem with chasing whales for what happens when founders end up having to deal with a firm’s B or C team.

Not “everything legal for one price” – Oh man, I came across a firm promising this the other day. “We’ll do everything legal you need for one flat monthly price.” Right. See: Standardization v. Flexibility in Startup Law, for an explanation of what really happens when a firm is forced to work under a ridiculous fixed fee. Fixed fees are great for low-stakes, routine work with a well-defined scope, or for high-volume projects that (again) are well-defined in scope, but the idea that you can map all of the legal needs of scaling emerging tech companies onto some bell curve and peg a number, like an insurance company, without dramatically impacting quality or flexibility, is some straight-up ghostbusters nonsense.

The only possible way it works is if you limit your client base to companies that basically all look and act the same, and have virtually all the same expectations and needs within a narrow range. That’s not how we work, nor how any serious law firm I know works. Analogies to healthcare’s move into fixed-fee pricing don’t hold water without accepting the “narrowly tailored client profile” point, because human biology is 1000x more “standardized” (bell curves) than the corporate structures, investor expectations, growth trajectories, legal obligations, and company values of tech companies.

Not the only way to work with us – This is simple. E/N Alpha is an option for startups looking to lock-in price certainty on a specific scope of work they are sure to need within their early years. But it is not the only way to work with us.

Fundamentally, what we want E/N Alpha to reflect is that E/N is a lean, flexible, high-end boutique law firm built from the ground up to address the many dysfunctions we’ve seen in the emerging tech / startup legal market. Entrepreneurs hire us because they know they need serious, specialized, trustworthy lawyers to address complex, high-stakes issues, and they need some way of affording that; particularly in the early days.

Everything else: tools, low-level professionals, and all the other ways a law firm can optimize itself should stay in the background. They aren’t, and shouldn’t be, the end-product.

 

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.