Startups, Politics, and “Cancel Culture”

I wrote The Weaponization of Diversity a little over a year ago. It was a combination of both my personal story growing up as a low-income latino raised by a single mom and eventually making it into the elite strata of the legal profession, combined with a more philosophical expression of how I see a lot of the rhetoric around diversity initiatives in high-stakes fields (law, startups, tech) leading to counter-productive consequences. It is an extremely complex, sensitive, and nuanced issue that doesn’t lend itself to easy summarizing, but nevertheless a quick break-down of my viewpoint is:

A. Growing up in a low-income Texas neighborhood filled with American latinos, but excelling in advanced coursework from an early age, I was criticized regularly by latino peers for my discipline in academics; referred to often as a “coconut” (brown on the outside, white on the inside).

B. History and geography have led to various selection mechanisms that have made cultural values, including about early academic effort in childhood, significantly varied across ethnic groups in America. That variance correlates dramatically with relative performance and representation in high-performance careers, most of which are reliant on compounding education and skills; and in the case of the highest risk careers (like entrepreneurship), generational building of wealth and resilience.

C. With respect to American latinos specifically, the strata of latin american populations that place a high emphasis on advanced education are far more likely to stay in their home countries, with lower-income and working class latin americans far more likely to emigrate to the United States. The exact opposite dynamic has been the case for the most successful ethnic groups in America, such as Indian or Taiwanese Americans, who on average place extreme emphasis on childhood education. Nevertheless, pockets of very successful sub-cultures within under-represented broader groups in America  – like Nigerian and Cuban-Americans – reveal how ascribing low representation to racism in high-performance industries is too simplistic, and how family culture is a significantly under-discussed variable.

D. Our unwillingness to allow honest people to bring issues like this up in diversity discourse, and instead weaponize accusations of racism against anyone who won’t toe the dominant line, has caused the entire discussion to stagnate around more politically correct, but far less impactful policies; like “trying harder” to find qualified candidates.

E. Large organizations with dominant market positions are privileged in this whole dynamic relative to smaller orgs facing extreme competition (like startups), because a substantial buffer of resources allows them to absorb the negative consequences of non-meritocratic recruiting (while enjoying the PR benefits) without substantially threatening their companies.

F. Very elite orgs with attractive compensation packages (including equity) are also privileged in that they can attract the more limited number of high-performing URMs in the market, even when “inclusiveness” has nothing to do with why URMs join those companies. Thus the logic that “greater diversity (in the sense of more under-represented minorities) leads to higher performance” often gets the causality backwards, in that the (already) best companies can use their weight to recruit away high-performing URMs from lower-performing companies.

G. There is also often a sleight-of-hand with the term “diversity” because much of the data on high-performing diverse teams is not speaking specifically about URMs, but about a broader definition of “diverse.”

H. While the high-performance startup world is extremely diverse in the broad sense of the term “diversity” – including all nationalities, ethnic groups, gender and international diversity – it also reflects the under-representation of specific groups (including American latinos) that we see in other fields like law and medicine.

I. But unfortunately the fierce competitiveness of early-stage business competition, and the lack of buffer resources that large organizations have, make startups unable to play the politically correct politics of larger and more elite orgs. They simply cannot afford to hire – especially among their executive teams – for anything other than merit, and yet they can’t compete on compensation for the high-merit URMs who are taken up by A-level companies. This makes the more nuanced aspects of the diversity discussion unavoidable when discussing startups.

J. Just as in other areas of the economy, overly aggressive “diversity” initiatives – like diversity startup accelerators – have unfortunately in many cases backfired, with highly visible under-performance of the teams/people actually reinforcing negative stereotypes. Failing to address the real (even if uncomfortable) issues thus hurts, instead of helps, many under-represented groups.

K. Politicized warmongering over diversity, instead of balanced and fair discussion, is thus not only damaging to under-represented minorities like American latinos, but it’s particularly damaging to highly competitive early-stage startups in ways that it’s not for larger businesses.

The point of this post is to tie the above perspective into another issue that has been coming up lately; “cancel culture” and political disagreement within an employee roster. Some very large tech companies, like Apple and Google, are known for having pockets of employees who are extremely politically vocal during their employment hours, and in some cases have even gotten other employees fired not because of any behavior by the terminated employees on the job, but because of what amounts to disapproval of political values or other issues. Thus one segment of the employee roster “cancels” the hiring of someone that they don’t want to work with.

In response to this issue of hyper-politicized employees, companies like Coinbase and Basecamp have come out with clear policies that attempt to shut down this dynamic, by emphasizing that work is for work, and that political discourse should be left out of it. This has understandably led to – and they knew it would – some loss of talent as employees who would prefer the ability to vocalize their political views more openly move to more accommodating companies. Nevertheless, the executives at those companies felt the upfront pain was worth avoiding more long-term misery of low productivity and chaos within the employee ranks.

I think an important point to make to all who follow this issue is that, at some fundamental level, “cancelling” certain people for behavior that many others, but certainly not everyone, find abhorrent is unavoidable at any meaningfully-sized company. If you fire someone for wearing a swastika on their shirt, or for catcalling women, or telling a gay employee that they’re a sinner, a million protestations about how this may be “cancel culture” doesn’t change the fact that it’s the decent, right – and in many cases legally required – thing to do.

In reality, “cancelling” is not the problem. Ambiguity is. Ambiguity that gets filled by certain people on the employee roster who really should not be authorized to perform that role. The reason countries have things like unambiguous constitutions and laws, and hardened hierarchies to enforce them, is that the alternative is unpredictable and chaotic mob rule (even if democratic mob rule) that destroys value and makes it impossible to build the kind of stability that promotes society. The tragedy of what many people call “cancel culture” isn’t so much that certain behavior can get you canceled (it most certainly can), but the vacuum of leadership within organizations that allows termination decisions to be so surprising, erratic, and seemingly driven by unaccountable mobs.

Why is it that the most democratic countries in the world never have militaries run as internal democracies? Because democracies have all kinds of benefits, but meritocratic promotion and speed of execution – which are essential when losing means you are “game over” dead – are not among them. In a hyper-competitive environment, you do what has to get done to win and survive, and that’s often not the “popular” or “fair” (in the judgment of the masses) choice. In competitive business, as in war, hierarchy beats democracy. Every single time.

That being said, remember that not every company has to compete in the same way. Very large dominant companies with fat balance sheets and margins can afford to be a little more political than hierarchical, for PR reasons. Just as companies like Apple, Google, etc. can afford to promote various initiatives that may put democratic popularity above hard meritocracy, they can also afford a little more politicized chaos and employee mob rule “cancel culture” in their companies. If 5% of their employees devote substantial time to politicized initiatives, or even getting certain unpopular new hires fired, it’s not going to change the overall performance of a trillion-dollar company.

But for an early-stage startup, completely different story. Ambiguity in the values and culture of the company, and resulting chaos from certain lower-level employees taking it upon themselves to decide who should be hired or promoted, can quickly sink a young startup with limited resources facing stiff competition in the marketplace. Freedom of association and at-will employment mean your employees can simply choose to leave if they disagree strongly with a decision you made about hiring or promoting someone. There’s no getting around that. The only sustainable defensive measure is ensuring everyone understands on Day 1 what your company’s values and policies are, so this kind of reckoning day hopefully never materializes.

This is not a left/liberal or right/conservative politics issue. It’s a general business issue. Young startups need well-understood and enforced (hierarchically) values, and (as they grow) in many cases written-out policies, as to what merits an offer letter, a promotion, or cancellation (termination) in their company. This leaves plenty of room for pluralism, as different companies can sort themselves out as to what they find acceptable in their business environment, including the level of political discussion that’s acceptable. There’s no single answer, but not having any answer definitely won’t work.

I don’t believe more liberal, conservative, libertarian, or highly apolitical startups will have a universal competitive advantage in the market. But I do believe that those who don’t put much thought into this aspect of their culture at all, and don’t enforce (or defend) their chosen culture with a clear hierarchy, will lose (as a result of internal disagreement and chaos) to companies with a more cohesive identity and power structure.

Whether you want to be more like Google, like Coinbase, or something in-between in building your company’s culture is up to you and the rest of your founders. Just be clear and unambiguous about it, so that the employees who choose to join you know what they signed up for. The greater long-term alignment will allow your team to focus more on executing the mission, instead of executing fellow colleagues.

Myths and Lies about Seed Equity for Seed Rounds

TL;DR: The release of the Post-Money SAFE structure, which is the worst possible way to raise seed money for most startups, has incentivized seed investors to perpetuate various myths and lies about alternatives (particularly about seed equity), in order to push founders to accept bad economics. Founders need to look past the spin and self-interested advice, to ensure they are assessing all the variables clearly.

The fundraising advice that vocal investors, many with blogs and twitter accounts, give to first-time founders often closely tracks their own incentives and self-interest. For example, a few years ago before the creation of the Post-Money SAFE, many early-stage investors complained that Pre-Money SAFEs had all kinds of problems, and that founders should strongly consider equity for their seed rounds. That was, of course, because Pre-Money SAFEs were very company (founder) friendly from an economic and governance rights standpoint, and those investors got more of the cap table by hardening their positions via an equity round with extra rights.

But now that YC has taken it upon itself to promote the Post-Money SAFE, which has terrible economics for companies/founders and is great for early-stage investors, suddenly the narrative has flipped. Now many of those same investors sing the praises of SAFE rounds, and have spun all kinds of myths and lies about why seed equity is apparently now such a terrible structure. The point of this post is to dispel some of those myths and lies.

Myth / Lie #1In an equity round you have to give investors a board seat.

Simple, you don’t. There’s nothing inherent in doing an equity round that requires giving investors a Board (of Directors) seat, and we’ve seen plenty of equity rounds that don’t. On the flip side, some SAFE and convertible note rounds will involve giving a Board seat to investors. Whether or not giving investors a Board seat in your seed round is appropriate or a good idea is entirely contextual, but there’s no connection to that negotiation point and the general structure of the round.

See also: Pre-Series A Boards.

Myth / Lie #2Equity rounds require you to close all of your investors at once, instead of with “rolling closings.”

Nope. You can do “rolling closings” quite easily in a seed equity round, so there’s no inherent need to have all of the money rounded up at once. Sometimes investors will place a limit of 120-180 days to do those rolling closings, but other times there’s no deadline and it’s open-ended.

Myth / Lie #3: Equity rounds require you to have a lead investor.

It certainly helps to have a lead investor – someone writing a big enough check, and with their own counsel – to do some light review of the equity docs in a seed equity round, but again there’s nothing inherent in the equity structure that requires it. It’s more about the comfort level of the investors. I have seen “party” seed equity rounds where everyone writes a $50K-200K check. It works fine, particularly now that there are relatively well-known seed equity templates out there that can be referenced and recognized among sets of specialized ECVC lawyers.

Myth / Lie #4: Equity rounds take months to close.

I’ve seen seed equity rounds go from term sheet to money in the bank in 2 weeks. Now that’s definitely on the faster end of the norm, and 3-4 weeks is more common. It’s not lightning fast, but neither is it the dragged-out process that some investors suggest it is. The primary drivers of a lengthier timeline are diligence issues (cleanup) and investor negotiations/delays. Nothing inherent in a seed equity round structure requires it to take a long time, given that well-used templates require minimal customization.

Given how high-stakes the terms you’re committing to in any fundraising are, there is some value in slowing down enough to really know what you’re getting into. See: Negotiation is Relationship Building.

Myth / Lie #5Equity rounds require paying $50-100K in legal fees.

It is true that any equity structure is likely to require somewhat higher legal fees than a SAFE or convertible note round, but seed equity, which is a simplified equity structure relative to full NVCA-style docs (which are more commonly used for Series A and later rounds) isn’t nearly as expensive to close on as some investors suggest. On the leanest end I’ve seen seed equity close for about $10-15K in company-side legal fees, and $5K on the investor side, but more realistically you’re going to be closer to $20K company side and $10K investor side, so about $30K total; possibly higher if you use very expensive firms. See: Automated Law v. Solos v. Boutiques v. BigLaw for more on legal fees and firm structures.

A good ballpark of fees spent from beginning to end for a multi-million dollar SAFE or convertible note round is $2.5K-$5K, so let’s say the delta between convertibles and seed equity is ~$25K in legal fees. The question then becomes, are the positives to closing on a seed equity round worth more than $25K? Very often they are. Easily.

Especially if your investors are asking for a Post-Money SAFE, which has extremely expensive (long-term) anti-dilution mechanics built into it if you end up needing (and likely will) more seed money later, the difference in dilution between a seed equity raise and a Post-Money SAFE can often be multiple percentage points on your cap table. If the difference is 1%, $25K implies a $2.5 million company valuation. If it’s 2%, it’s $1.25 million.

I have seen many companies raising at $10 million, $15 million, even higher valuations in their seed rounds, with multiple million in funding, and yet their investors act as if the extra cost of a seed equity round is so burdensome that the founders should just do a Post-Money SAFE; which in the long-run hands multiple percentage points on the cap table to the seed investors. Basically they are telling founders that they should avoid paying the equivalent of 0.25-0.5% of their enterprise value now in cash for a more hardened, company-favorable deal structure, and instead give 1-2% more of the company as equity (with upside) to the seed investors, which in the long run could be worth millions for the highest-growth companies. That is a horrible tradeoff for the founders.

Translation: “Don’t spend $25K in legal fees now. That’s a “waste of money.” Instead stick to our preferred template and give us 6-7 figures worth of extra equity!”

This isn’t to say that equity is always the right answer for a seed raise. Hardly. Sometimes pre-money SAFEs make sense. Sometimes convertible notes do. I’m a fan of modifying a convertible note to have the economics behave more like equity, but with the streamlined structure of a note; the best of both worlds. And sometimes your investors will demand that you give them a full NVCA suite of docs. Context matters, and so do the numbers.

There’s no universal answer to how you should structure your seed round, because every company is different, and different investors and founders have different expectations, priorities, and preferences. However, not falling for the most common myths and lies that investors give to push you in favor of their preferred structure – which usually is whatever makes them more money – will ensure your eyes are wide open, and you can assess the positives and negatives clearly.

Early v. Late-Stage Common Stockholders in Startup Governance

TL;DR: While the preferred v. common stock divide gets the most discussion in startup corporate governance, and for good reason, the early v. later-stage common stock divide is also highly material. Given their different stock price entry points, early common stockholders (like founders and early employees) are not economically aligned with common stockholders added to the cap table in Series B and later rounds. This has important power implications as to who among the common stock gets to fill the Board’s common stock seats, or vote on other key matters. Clever investors will often put in subtle deal terms that allow them to silence the early common stock in favor of later-stage common stockholders who are far more likely to agree with the interests of the money.

Background reading: The Problem with “Standard” Term Sheets

The Common Stock v. Preferred Stock divide is the most important, and most discussed, concept in corporate governance as it relates to startups. The largest common stockholders are typically founders, followed by employees. Preferred stockholders are investors. Sometimes in growth rounds investors will dip into the common stock via secondary sales, which muddies the divide, but for the most part the divide is real and always worth watching.

Investors (preferred) are diversified, need to generate high-returns for their LPs, prefer to minimize competition in rounds where they have the ability to lead, and have downside-protection in the form of a liquidation preference. Common stockholders, particularly founders and early employees, are far more “invested” in this one company, want to maximize competition among potential investors to increase valuations, and don’t have downside protection. That creates fundamental incentive misalignments.

This divide becomes extremely important when discussing the two key “power centers” in a company’s corporate structure: (i) the Board of Directors, and (ii) veto rights at the stockholder level. The latter usually takes the form of overt veto rights (often called protective provisions) spelled out in a charter, but there are also often more subtle veto rights that can have serious power implications; like when a particular party’s consent is needed to amend a contract that is essential for closing a new financing.

When founders (and their legal advisors) actually know what they’re doing, they’ll pay extremely close attention in financing terms to how the Board composition is allocated between the common v. preferred constituencies, and whether either group is given “choke point” veto rights that could be utilized to exert inappropriate power over the company. Unfortunately, because founders are often encouraged (usually by clever investors) to mindlessly rush through deals, and even sign template documents produced by investors, extremely material nuances get glossed over, with the far more experienced VCs benefiting from the rushing. It gets even worse when the lawyers startups use are actually working for the VCs.

As just one example, founders will often focus exclusively on high-level Board composition, because it’s the easiest to understand. They’ll say something like, “well, the common still controls the Board, so everything else doesn’t matter.” But that’s simply not true. You may have control over your Board, but if your preferred stockholders have a hard veto over your ability to close any future financing – if the preferred have to approve any amendments to your charter, you can’t close new equity – then your investors are really in control of your financing strategy. The Board is important, but it’s not everything.

The purpose of this post is to highlight another important “divide” among constituencies on the cap table: early-stage common stockholders (founders and employees) v. later-stage common stockholders (later hires, C-level execs who replace founders). While less relevant Pre-Series A, this divide becomes much more important in growth-stage financings, and plays into the power dynamics of company governance in ways that early-stockholders are often poorly advised on.

Any party’s “entry point” on the cap table has an extremely material impact on their outlook for financing and exit strategy. If I got my common stock in Year 1, which is the case with founders and early employees, the price I “paid” for that stock is extremely low. But if I showed up at Year 4, I paid much more for my stock, or I have an option exercise price that is substantially higher.

Fast-forward to Year 5. The company’s valuation is tens or hundreds of millions of dollars. The Y1 common stockholder is sitting on substantial value in their equity. Multiples upon multiples of what they paid for their stock. They’ve also been grinding it out for years. The Y4 common stockholder, however, is in a very different position. They only recently joined the company, and their equity is only worth whatever appreciation has occurred in the past year.

Now an acquisition offer for $300 million comes in. Put aside what investors (preferred stockholders) think about the offer. Do you think the “common stock” are all going to see things in the same way? Is the Y1 common stockholder going to see the costs/benefits of this offer in the same way that the Y4 common holder will? Absolutely not. Later-stage common stockholders have far less sunk wealth and value in their equity than early-stage common stockholders do, and this fundamentally changes their incentives.

Now apply this early-stage v. late-stage common stock divide to Board composition. Simplistically, founders often just think about “common stock” seats. But who among the common stock gets to fill those seats? Investors who want to neutralize the voice of the early common stock on a Board of Directors will put in subtle deal terms that allow them long-term to replace early common stockholders with later-stage common stockholders on the Board, because the later-stage holders (often newly hired executives) will be more aligned with later-stage investors who want to pursue “billion or bust” growth and exit strategies. A Y1 common stockholder has far more to lose in turning down an exit offer, and instead trying for an even bigger exit, than a Y4 common stockholder does.

The most popular way that this shows up in terms sheets / equity deals is language stating that only common stockholders providing services to the Company get to vote in the common’s Board elections, or in approving other key transactions. Once you’re no longer on payroll, you lose your right to vote your stock, even if you still hold a substantial portion of the cap table.

Through the natural progression of a company’s growth, founders and early employees will usually step down from their positions, or be removed involuntarily. Whether or not that should happen is entirely contextual. However, it is one thing to say that an early common stockholder is no longer the right person to fill X position as an employee, but it is an entirely different thing to say that such early common stockholder should have no say at the Board level as to how the company should be run. Whether or not I am employed by a company has no bearing on the fact that I still own part of that company. The entire point of appropriate corporate governance is to ensure that the Board is properly representing the various constituencies on the cap table. Early common stockholders are a valid constituency with a valid perspective distinct from executives hired in later stages by the Board.

Deal terms that make a common stockholder’s voting rights contingent on being employed by the company are usually little more than a power play by investors to silence the constituency most likely to disagree with them on material governance matters, and instead fill common Board seats with later-stage executives who will toe the line. Importantly, aggressive investors will often rhetorically spin this issue as being simply about “founder control,” to make it easier to dismiss as self-interested, but that is flatly inaccurate. Many Y1 or Y2 common stockholders are not founders, but their economic incentives are far more aligned with a founder, who also got their stock very early, than with an executive hired in Y5+.

Yes, the largest early common stockholders will often be founders, but the reason for giving them a long-term right to fill Common Board seats is not about giving them power as founders, but as representatives of a key constituency on the cap table that is misaligned with the interests of investors and later-stage common holders. This isn’t “founder friendliness.” It’s balanced corporate governance.

The message for early common stockholders in startups is straightforward: don’t be misled by simplistic assessments of term sheets and deal terms. It’s not just about the common stock v. preferred, but whether all of the common stock gets a voice; not just the common holders cherry-picked by investors.

The Carta SAFE for Seed Rounds

Background reading:

As I’ve written in various places (see above), a significant problem that has emerged in startup ecosystems involves certain investor organizations pushing startups to adopt their preferred financing templates. Predictably those templates are often riddled with issues that favor the interests of the money. Of course these organizations are far too clever to come out and state transparently, “we want you to use this document because it makes us and other investors more money,” so they spin other narratives about saving founders time, or reducing legal fees; even though the “cost” to founders is often orders of magnitude higher than whatever they might be “saving” by mindlessly signing the templates.

This dynamic was most visible with YC’s announcement of the Post-Money SAFE, which implemented economic concepts exorbitantly favorable to seed investors (including YC of course), but was marketed as a way to (air quotes) “help” founders have more “clarity” about their cap table. YC, their long list of positive impacts on the ecosystem notwithstanding, is still an investor with lots of mouths to feed. No one should’ve been surprised that it would use its brand leverage to push a more investor-favorable document onto startups, particularly now that, with its brand having significantly matured, it no longer needs to rely as much on “founder friendliness” to attract startups.

Carta, the dominant (by far) capitalization SaaS used by startups, recently announced that it is enabling automated SAFE financing on its platform. Interesting news, and I’m sure it’ll save teams planning on closing SAFE financings a bit of hassle. But automated SAFE closings have been available on other platforms, like Clerky, for some time, and realistically the technology behind it is hardly earth-shattering. Given that SAFEs are utilized far more in California than in the rest of the market, that’s probably where the automation will have the most impact.

What I find much more interesting, and relevant to topics I write about, is that Carta chose to tweak the YC SAFE docs and create a “Carta SAFE.” Companies can still close on YC’s Pre-Money or Post-Money SAFE templates, but they also have the option of a Pre-Money or Post-Money “Carta SAFE.” The changes themselves are fairly innocuous, but helpful and balanced. More importantly, I think it’s worth recognizing the valuable role that an organization like Carta could play in promoting various template financing structures to startups.

YC is a venture capitalist, and thus highly biased in the terms it purports to offer as “standard.” They lost tremendous credibility among the legal and startup community – although surely gained favor among VCs – with their 180 on the Post-Money SAFE. They absolutely deserve respect for their track record of picking successful startups, but lines have been crossed with respect to any facade of “founder friendliness” in their template standards.

Carta, however, is a technology company that (as far as I know) is not investing in dozens of startups every year. Carta has far less reason to favor an investor-biased document, and thus potentially has far more credibility in swaying market “standards” in a more balanced direction. This is visible in how they’ve implemented their automated seed financings and templates, relative to how YC pushed out the Post-money SAFE.

Go to YC’s website, and you can’t even find the old pre-money SAFEs with more company-favorable economics and terms. All you have is the new (profoundly investor-biased) Post-Money docs for download. This simple fact has actually caused huge confusion among inexperienced founders, who often aren’t even aware that YC dramatically changed their forms and economics, and thus (thinking they are doing themselves favors) simply download and execute the forms on YC’s site. YC could’ve very easily offered up the new Post-Money SAFEs, while leaving the old forms also available for download, with clear prompting to founders to work with advisors to decide which form they prefer. Instead, YC consciously chose to promote only the new forms, signaling a clear desire to change the market “standard” in favor of investors.

Contrast that with Carta. The Pre-Money v. Post-Money distinction is front and center in their UI, with both types of forms easily accessible to startups, and with helpful tools for comparing dilution from the different structures. This is a far more honest and transparent way for helpful templates to be offered to startup teams, without shady gimmicks or marketing spin to nudge them in favor of the money. It should be applauded.

Of course, I’m not going to wrap up this post without acknowledging that Carta still has bias. Who doesn’t? As an automation tech company, they are obviously biased toward automation and templates that enable automation. There are countless ways in which financing documents can (and often should) be negotiated and tweaked to make them a better fit for the unique context of a particular company raising money from particular investors. Sometimes convertible notes of various flavors make more sense. Other times seed equity. Other times the full suite of NVCA equity docs.

Despite growing traction among public templates, an enormous amount of investors and startups still take advantage of flexibility and customization in their deal docs, because the stakes are so high, the context and people involved so nuanced, and the terms so permanent, that it’s worth doing a bit of negotiation. If a few thousand dollars of legal fees can save you a few million in the long-run on your cap table, it doesn’t take advanced calculus to arrive at a decision.

In saying that, I’m obviously reflecting my own bias as company counsel to startups (and not investors). My job is to ensure startup teams are aware of all the options on the table for their financings and corporate governance. That of course includes bringing up when an automated template might make sense. Sometimes it does, often times it doesn’t. We can all stop pretending that serious lawyers are in any way threatened by tools like Carta or Clerky. I love these tools, because the last thing I enjoy spending my time on is shuffling cookie-cutter forms. Use the cookie-cutter when it makes sense, but make sure you really understand the tradeoffs and limitations, because a lot of very smart teams decide to put the cookie-cutter down and take a more “custom fit.”

Venture capitalists, together with Startups, are biased in favor of their own bank statements. Automation tech companies, like Carta, are biased in favor of hyper-standardization and automation. And high-end ECVC (Startup) lawyers, like me, are biased in favor of flexibility and customization. There’s no need to hide any of this. Every party has an important role to play in the ecosystem, and the interaction of all the moving parts ensures we all arrive at a reasonable equilibrium. All of that being said, I’m glad an organization like Carta has entered the template financing arena, because a well-branded but less biased player was sorely needed.

“Fixing” Convertible Note and SAFE Economics in Seed Rounds

TL;DR: In an equity round, including seed equity, any post-closing dilution is shared proportionately between investors and common stockholders (founders and employees). This is fair. Assuming no shenanigans and the business is increasing in value, why shouldn’t dilution be shared? Convertible notes and pre-money SAFEs have a math formula that makes them more dilutive to founders than an equity round with an equivalent valuation, by “protecting” seed investors from some post-closing dilution. Post-Money SAFEs are even worse. The solution is fairly simple: “fix” or harden the denominator in the conversion price formula, instead of having it dependent on complex language and variables. This gives everyone the benefit of a “floating” valuation that is so valuable in convertible instruments, while making post-closing dilution mechanics equivalent to an equity round.

Broadly speaking, there are 3 main instruments being used by startups in seed rounds: equity, convertible notes, and SAFEs. From a historical standpoint, equity (issuing actual stock at a fixed price) is the default instrument, but for reasons of speed and flexibility (on pricing), convertible notes and SAFEs have gained traction in early rounds smaller than about $2 million in total funding (the number in Silicon Valley is a bit higher).

Equity Math

While glossing over a few nuances, the formula for setting the price of stock sold in an equity round is fairly simple: pre-money valuation divided by capitalization. The higher the valuation, obviously the higher price. But importantly, the higher the capitalization (the denominator), the lower the price. In equity term sheet negotiations there is often some (necessary) back-and-forth around what actually gets included in the capitalization denominator. For example, being forced to put any increases in the option pool is fairly common. Somewhat less common but still extremely impactful is being forced to put all of your existing convertible instruments (notes or SAFEs) in the denominator. In this sense, two startups can have the same “pre-money valuation” but dramatically different actual stock prices (price paid by investors) if they negotiated different denominators.

Assumptions:

Pre-money Valuation: $10 million

Capitalization on your date of closing, including option pool increase in the round: 10 million shares

Math: valuation ($10 million) / capitalization (10 million shares) = investors pay $1 per share of preferred stock.

Simple enough. Fixed valuation, fixed capitalization, and you get a fixed price for easy modeling. Any financings (excluding down rounds) that happen after your equity round dilute the entire cap table proportionately. But the “math” for convertible notes and SAFEs is not so simple, and not as favorable as an equity round.

Convertible Note and Pre-Money SAFE Math (more dilutive)

In Why Convertible Notes and SAFES are extra dilutive I explained how the typical math of convertible notes and SAFEs makes them extra dilutive to founders/startups compared to an equity round. To summarize: because convertibles fail to “harden” the conversion math for the investors, convertibles allow seed investors to pack more shares into the denominator. Remember: higher denominator = lower price, which means the seed investors pay less and get more of the cap table even without changing the “valuation.” In an equity round, increases to the option pool after you close get absorbed by your seed investors pro-rata, but not so in typical convertible note math. Your seed note holders get “protected” from that dilution by including the pool increases in their denominator up until closing.

The fact that the denominator in convertible notes (and SAFEs, which are derived from convertible notes) isn’t fixed is actually a remnant from when convertible notes were traditionally used mostly for “bridge” rounds closed only a few weeks or months before a Series A. When your convertible round is truly a “bridge” for an equity raise in a few weeks, having your note investors get the same denominator as your Series A investors makes sense. But today seed rounds are being closed 2-3 years before a Series A. Keeping the denominator “open” for that long does not make sense.

So, keeping valuation constant, convertible notes and traditional pre-money SAFEs are more dilutive than an equity round because the denominator is larger. Why do startups use them then? Speed and flexibility.

First, given how early-stage fundraising and company-building has evolved, many (but certainly not all) seed rounds lack a true lead willing to hire their own counsel and negotiate hardened seed equity terms. Also, at the very early stages of a startup, pegging the exact valuation that investors are willing to pay can be difficult given the lack of data and track record. The valuation cap concept in Notes and SAFEs allows startups to set a proxy for the valuation, while flexibly allowing seed investors to get a lower price if the Series A valuation ends up in fact being lower than what was originally expected. Valuation flexibility (via a cap, as opposed to a fixed valuation) is a big reason why, despite the advantages of seed equity, many young startups still opt for convertibles. The ability to incrementally increase the cap over time, as milestones are reached, is also seen as valuable flexibility offered by convertible instruments.

Post-Money SAFE Math (even more dilutive)

A while back Y Combinator completely re-vamped the math behind their SAFEs, converting it to a post-money formula. See: Why Startups shouldn’t use YC’s Post-Money SAFE. Rather than setting a pre-money valuation cap, startups using the post-money SAFE are now required to set a post-money valuation, including all money they expect to raise as seed. YC’s stated reason for changing the math on the SAFE was to make it “easier” to model how much a company is giving to seed investors, but as discussed in the blog post, anyone who’s deep in this game and unbiased knows that claim is smoke and mirrors. The formula change made the SAFE structure far more favorable to investors (including YC) economically.

What was really happening was that because pre-money SAFEs had exactly zero accountability protections relative to seed equity and convertible notes – the maturity date in notes constrains the ability of startups to keep raising more and more rounds without converting the seed round into equity – seed investors in SAFEs were getting burned by startups raising SAFE rounds for years and years without ever converting. As an investor, YC itself was getting burned. So they changed the SAFE to be more investor friendly, benefiting YC and all seed investors.

But in the opinion of many ecosystem players, including lawyers focused on representing companies (and not the investor community), the change was egregiously one-sided. It effectively forces founders and employees (common stockholders) to absorb all dilution for any other convertible note or SAFE rounds that they raise after the post-money SAFE round, even if the valuation cap is higher. That’s an extremely high price to pay just for making modeling seed rounds a little easier. I have a better (fairer) idea.

“Fix” the Denominator in Notes and Pre-Money SAFEs (same dilution as equity round)

The benefit of convertible notes and SAFEs is flexibility and speed. They are simpler, and allow you to have a “floating” (flexible) valuation (cap) that helps companies and investors get aligned despite the uncertainty. This “floating numerator” is important and valuable.

But as discussed above, while the benefit of notes/SAFEs is a more flexible numerator (valuation), the benefit of seed equity math is you get a hardened denominator. That hardened denominator ensures that everyone (common stock and investors) shares pro-rata in post-closing capitalization changes, like future rounds and option pool changes. Everyone has appropriately-apportioned “skin in the game.” Another benefit of this hardened capitalization (denominator) is that it makes modeling the round easier. Wasn’t that what YC says they were trying to do with the Post-Money SAFE? Why not make modeling easier without hurting founders with harsher dilution?

So the “best of both worlds” solution is: do a convertible note or pre-money SAFE, but harden the denominator with the capitalization at the time of closing. You can even ensure it has an appropriately sized pool to account for expected equity grants until the next raise, much like you would in an equity round. Flexible numerator, but hardened denominator.

Making this change in a convertible note or SAFE is extremely easy. You simply delete all the language used for describing the denominator (the fully-diluted capitalization) and replace it with a number: your capitalization at the time of closing. Now both sides have the benefit of a valuation cap that adjusts if there is a “down round,” but a hardened denominator that allows everyone to model the expected dilution of the round; while ensuring that future dilution is shared proportionately between both founders and investors.

On top of being far more aligned with equity round economics (the default approach to fundraising), this approach can save common stockholders several percentage points on their cap table; a very high impact from just deleting a few words and replacing them with a number. When a seed equity raise won’t do, my recommendation is usually a low-interest, lengthy (2-3 yrs) maturity convertible note with a valuation cap and hardened denominator. As a lawyer who represents zero investors (all companies), I’ve felt that pre-money SAFEs are too company-biased, and post-money SAFEs are too investor-biased. SAFEs in general are also far less respected by investors outside of Silicon Valley than convertible notes are.

We’ve been explaining this issue to clients and investors and are happy to say that there has been a positive reception. We hope to see it utilized more broadly in the market over time. See: A Convertible Note Template for Startup Seed Rounds for a convertible note template that startups can utilize (with appropriate lawyers) for their seed rounds.

Do I expect all seed investors to adopt this approach? Of course not. They’re investors, and will naturally prefer something far more aggressive in their favor, like YC’s post-money SAFE. It all depends on context, character, and leverage. Nevertheless, founders should go into seed rounds with their eyes wide open about the significant economic implications of the various structures and formulas, and not give into any hot air about there being a single (air quotes) “standard” approach, when what investors are really promoting is their preferred “standard.”  Pushing misleading “standards” is a far-too-common negotiation tactic for getting inexperienced founders to mindlessly pursue financing strategies that are against their company’s interests.