Post Category → Advisors

The Most Common Option Grant Mistakes

This is a post I should’ve written years ago because it involves issues our firm sees from startups on a weekly basis. These are the most common mistakes – often very, very expensive mistakes – that we see startups make in granting options to employees, contractors, advisors, etc.

1. Not understanding the (big) difference between promising options and granting options.

With respect to issuing any form of equity for services, there’s usually 2 broad steps: first you promise the equity in an offer letter, consulting agreement, advisor agreement, etc., and then after that agreement has been signed, further steps have to be taken to grant the equity, including with a Board consent.

We constantly see startups pile up offer letters and other documents promising options to people, and waiting months or even years before someone conducting diligence – often in prep for a financing – realizes that none of those options were ever granted. One might think that cleaning this up is simple enough, but it’s often not. For tax purposes, option grants need to be issued with an exercise/strike price equal to their fair market value on the day they are granted (not promised).

If you hire an employee on January 1st 2020 and promise them options, they are expecting to receive an exercise price close to the equity value on the day they signed their offer letter; especially if they’re an early employee and the idea of getting “cheap” equity was part of their reason for joining. Imagine if you sit on that offer letter until June 15, 2021, after which the company has hit multiple milestones and even raised some seed money putting a value on the company 10x of what it was a year and a half ago? When you finally get around to granting those options, the strike price now has to be equal to the higher value, and the employee has lost all of that upside. Think they’re going to be happy?

We’ve seen dozens of companies make this mistake. In the worst scenarios it often leads to a threatened lawsuit, or the need for the company to materially increase the amount of equity the recipient receives in order to make up for the lost value. Other times it just results in some very very disappointed employees, and loss of goodwill.

Promising equity is as simple as signing a napkin with a few sentences. Granting equity requires valuations, consents, and well-structured equity plan documentation managed by lawyers. This is not something to DIY.

2. Getting Board approval but never delivering the (important) grant documentation.

In this instance, the Company did take the main step of properly having grants approved by the Board, but they never finished the job by actually delivering the appropriate grant documentation to the recipients.

The reason this can be a big problem is that the option grant documentation (including the appropriate equity incentive plan) will have a number of important provisions around rights the recipient and/or company have with respect to the grant. For example, it will say what happens in an acquisition, have specifics around how vesting works, or set expectations around the expiration or termination of the option. By failing to actually deliver the grant documentation to the option recipient, the Company opens itself up to arguments that all those provisions are not enforceable; which can mean litigation when the stakes get high.

Offer letters often say nothing about how a vesting schedule, or exercise period, works in the event of an employee’s resignation. Those details are in the (much much longer) grant documentation. By failing to ever deliver that documentation, you open yourself up to claims by employees that their equity continues vesting, or continues being exercisable, regardless of what the documents (that they never received) say, or what you intended for their “deal” to be.

3. Not having a 409A valuation, or having a stale valuation. 

Option grants need to be issued with an exercise price equal to or greater than the fair market value of the equity on the grant date, to comply with IRS rules that ensure no one gets a tax hit on the grant date. The IRS does not accept any equity value the company decides on. It has special requirements, including “safe harbors,” for setting the value. The most common safe harbor used is to get a professional valuation report from a reputable valuation company, like Carta.

Some companies mess up by issuing options at a price that really doesn’t make sense given the state of the business, and they don’t have a valuation report to back it up.

Other companies fail to understand that valuation reports don’t last forever. If you do another financing, you almost always need a new valuation. And if any kind of business milestone is achieved that would realistically change the value of the business – like a substantial increase in revenue – the valuation also needs to be updated. If your valuation is 9 months old, the business has doubled in size since then, and you grant options with that 9-month-old price, you almost certainly have a tax problem, for which the penalties can be substantial. After 12 months, all valuations have to be refreshed.

4. NSOs (or NQSOs) v. ISOs.

There are so many articles already written on this topic that you can find with any online search, so I’m not going to go deep into it. Just understand that employees and independent contractors do not receive the same kind of option grant, for tax reasons. Employees receive ISOs, which are usually more tax favorable. Independent Contractors receive NSOs. The documentation is slightly different.

5. Not tracking vesting schedules and exercise period expiration properly. 

Vesting schedule calculations often aren’t super straightforward. When someone leaves the company and has a portion of vested and a portion of unvested equity, someone needs to verify that the unvested equity is actually being reflected as terminated and removed from the cap table. If the equity plan also has provisions around the expiration of vested equity if it goes unexercised for a period of time post-termination (most plans do), someone needs to track that as well and ensure the cap table stays updated. Something like Carta can help a lot here, but we still regularly see people make mistakes and/or use the wrong numbers.

Companies often forget to remove terminated unvested equity (when someone leaves the company) from a cap table, or to remove a grant that has fully expired. This can create problems long-term if they inadvertently allow the person to later exercise their option (which really should no longer exist), or if they are doing other calculations, or making representations, with an incorrect cap table.

6. Promising a percentage instead of a fixed number of shares.

When companies are discussing an equity grant with an employee or other service provider, they usually speak in terms of percentages, which is good and transparent. Promising someone 100,000 shares can be meaningless if they don’t know what the denominator is. But when they actually move to document the arrangement, they should use a fixed number of shares.

By documenting a % instead of the corresponding fixed number of shares, one of two problems can arise. First, if it’s not made abundantly clear in the same document that the % is calculated as of a specific date, the company opens itself up to claims that the % is indefinite (non-dilutable). Second, if the company makes the mistake of failing to actually grant the option quickly after they’ve promised the % (See #1 above), by the time they get around to granting the option, the cap table may have changed significantly. 2% Pre-Seed is a very different deal from 2% Post-Series A. I’ve seen this mistake get very ugly.

7. Generally sloppy drafting.

“The options will vest over 48 months.”

I can’t tell you how many companies will put a sentence like this into an offer letter or option grant. Can you tell what’s wrong with it?

How will it vest over the 48 months? In equal portions each month, or some other way? When exactly does it start (offer date or employment date)? What is the vesting conditioned on? It doesn’t say anywhere that actually providing services is a requirement. Does it continue vesting even if the person is terminated? What if they leave? What if an acquisition happens?

ECVC lawyers have language banks that they rely on for situations like this to quickly and efficiently capture a concept, but with language that they know works because it’s been used 1,000 times. Nine times out of ten when a company thinks they’re saving money or time by freestyle drafting a vesting schedule themselves, it backfires.

Being well-organized can get you far in terms of avoiding the most expensive legal mistakes commonly made by startups, but given all the corporate, securities, and tax-related nuances around issuing high-valued equity in private companies, there’s always a lot that entrepreneurs don’t know that they don’t know.

The key message here is: don’t think it’s simpler than it really is (it’s not), and work with people who truly know what they’re doing. The easiest and most efficient way to stay safe is to work closely with an experienced paralegal at an ECVC law firm.

Paralegals are a fraction of the rate of the senior lawyer/partner who is likely your main point of contact on legal, but they are (at least at good firms) extremely well trained to monitor and catch these sorts of issues around equity grants, because they help process hundreds/thousands of grants a year. I’ve also too often seen companies work with over-worked solo lawyers (detached from a firm) who have no access to specialized paralegals, and in rushing review/processing they make the same mistakes founders might make. Because paralegals are cheaper, they can take the necessary time and ensure all the boxes get checked.

Why Startup Accelerators Compete with Smart Money

TL;DR: As the smartest VC money has continued moving earlier-stage, its value proposition for early checks starts to resemble what’s offered by high-priced startup accelerators: signals, coaching, and a network. That means elite early-stage VCs and accelerators can be substitutes, and the accelerators know this. This may lead the latter to recommend financing strategies to entrepreneurs that, from the perspective of the startup can be counterproductive, but enhance the market power of the accelerator relative to investors who can offer similar resources at better “prices” (valuations). Entrepreneurs should understand the power games everyone is playing, and become beholden to no one.

Background reading: Startup Accelerators and Ecosystem Gatekeeping

First, a few clarifications on definitions. When I speak of “smart money” in the VC context I’m referring to investors who bring much more to the table, in terms of useful resources and connections, than simply raw cash. They often bring an elite brand that serves as a valuable signal in the market (which itself raises valuations and helps with follow-on funding), credible insight and coaching that they can use to help founders and Boards of Directors, and a network that they can tap into for helping companies find talent and connect with commercial partners.

Classifying some money as “smart money” doesn’t necessarily mean that any money that isn’t “smart” must be stupid in a classic sense. It just means that the other money isn’t useful other than to pay for things. So in short, “smart money” refers to value-add investors who can do a lot more for a company than simply write a check; while “dumb money” means investors willing to pay very high valuations because they are simply happy to get access to this deal at all, and have very little else to offer beyond money itself.

Another clarification: for purposes of this topic, I am referring to high-cost, high-touch startup accelerators; meaning the traditional kind who “charge” 7-10% of equity and put in significant resources into programming, education, nurturing their network, etc. As I’ve written before, various organic market dynamics that are eroding the value proposition of traditional accelerators (see above-linked post) have produced a new “lean” form of accelerator that has dialed back its proposition, and reduced its “price” to 1-2% of equity. That latter kind of accelerator is not part of this discussion, because they behave very differently, and interact with smart money very differently.

Ok, so now to the main point. “Smart” very early-stage money (seed and pre-seed) can be viewed as a bundle of a few things:

  • Green cash money
  • Signaling and Branding – simply by being publicly associated with them, raising follow-on money, and getting meetings with other key players, will become dramatically easier.
  • Coaching – they’ve seen lots of successful (and failed) companies, and can provide valuable coaching to entrepreneurs.
  • A network – they’ve built a rolodex/LinkedIn network of lots of talented people that they are heavily incentivized to make available to you.

Now, let’s compare that bundle to the value proposition of traditional accelerators:

  • Signaling and branding
  • Coaching
  • A network

See the overlap? Startup accelerators are basically a service provider whose core service is the above bundle. In exchange for equity and the right to a portion of your funding rounds, their “service” is that they’ll (i) apply a brand on your company that makes it (at least for the good accelerators) easier to access money, (ii) provide you some coaching and education, and (iii) share their network with you.

The core value proposition of early smart money can be effectively the same as an accelerator: a brand to leverage in networking and fundraising, coaching, and a network to navigate. Accelerators and smart early money are, therefore, substitutes; and substitutes inevitably compete with each other. Some might argue that the “programming” (the educational content) of accelerators is a key differentiator, but realistically the smartest entrepreneurs aren’t joining accelerators to get an education. They’re joining for the brand, the network, and to make it easier to find more money and talent; all of which entering the portfolio of a resource-rich and well-respected early stage investor can provide.

The earlier in a company’s life cycle that smart money is willing to go for their pipelines (and many smart funds are going very early), the more startup accelerators will find themselves competing with lots of market players offering a very similar bundle of services. Given that smart early money can challenge the value proposition of accelerators, aggressive accelerators are incentivized to, in subtle ways, push startups away from smart very early-stage money and toward dumber money, because it increases a startup’s dependency on the accelerator’s resources, and therefore helps justify the accelerator’s cost.

How does this fact – that aggressive, elite startup accelerators want to cut off smart early-stage money from competing with them – play out in the real market? Some of the ways I’ve already described in Startup Accelerators and Ecosystem Gatekeeping, but I’ll elaborate here.

Demo Day – Aggressive accelerators can push entrepreneurs to not do any fundraising other than through channels that the accelerator can control, like Demo Day, and then they can restrict access to Demo Day to investors who serve the interests of the accelerator (don’t compete with it). As I’ve written before, it is not in startups’ interests to restrict their fundraising activities solely to channels that accelerators can influence (because it allows accelerators to serve as rent-seeking gatekeepers). Many accelerators aggressively restrict how their cohorts are able to fundraise, enhancing the accelerators’ market power relative to VCs.

Fundraising Processes that Select Against Smart Money – One thing that’s been interesting to observe in the market is how entrepreneurs who go through certain accelerators are much more likely to emerge with a view that early-stage venture capital has largely been commoditized. If you think that all early money is the same, and all that matters is getting the best economic terms possible, you are going to approach fundraising in a very different way from someone who better appreciates the very subtle, human-oriented dynamics of connecting with value-add (smart) lead investors. “Party rounds” where entrepreneurs don’t allow anyone to serve as the lead are a very visible manifestation of this.

Entrepreneurs who treat fundraising as a kind of auction process, where you amplify FOMO and aggressively get the money to compete for the best price, are often creating a fundraising system that much of the smartest money will simply opt out of. Quality smart money players are looking to build long-term relationships, and that takes time. Their resource-intensive approach to investing also requires building meaningful positions on a cap table; a slot in a party round won’t work.

Elite value-add VCs know that they bring much more to the table than a random investor willing to pay a high valuation, and so the end-product of a hyper-competitive fundraising process that forces them to compete with a swarm of dumb money simply isn’t worth their time. The valuation will be too high, and their allocation on the cap table too low.

Aggressive accelerators know this, and it’s why they often nudge founders toward engaging in these kinds of hyper-competitive fundraising processes that push out smart money, because by removing other “smart” early market players with their own networks and brands, the accelerators enhance the relative value of their own network. The strategy is to marginalize any potential substitutes, so startups see the accelerator and its own network as the only “smart” player they need.

If you, as a founder, have come to believe that value-add VCs – who can deliver A LOT more value than simply cash – don’t exist, you may have fallen for a lot of the propaganda on social media pushed by traditional accelerators and the “dumb money” funds affiliated with them. Value-add VCs most definitely exist, and founders who’ve raised from them will say they’re worth their weight in gold. Accelerators may spin a story as to why it’s in founders’ best interests to be hyper-aggressive with their fundraising, and alienate many value-add VCs in the process, but startups need to understand this is driven far more by what’s in the accelerator’s interests than the startup’s.

It’s also worth pointing out the irony in certain accelerators telling founders that they should maximize valuations and minimize dilution in fundraising, while the same accelerators keep their own admission prices (valuations) fixed; and in the case of accelerators who’ve moved to post-money SAFEs, the price has actually gone up. If the market has become flooded with early-stage capital and signaling alternatives, should accelerators themselves not be subject to market forces?

I’m not an investor, nor do I even represent investors. I’m a lawyer who represents companies, including in lots of financing rounds. Read my lips: relationships matter, and smart relationship-oriented money can really make a difference. Want to know what a possible end-result is of startups pursuing a naive, hyper-competitive, relationship ignorant fundraising strategy that treats getting a high valuation as the only goal; long-term relationships and “value add” VCs be damned? Failed unicorns (getting SoftBanked) and thousands of employees burned because people guiding the company in the earliest days were just lottery-ticket chasers instead of smart players who know how to build viable businesses. Treat investors like it’s all just about numbers, and you’ll inevitably surround yourself with people for whom you are just a number.

As I’ve written many times before, it’s extremely important that new entrepreneurs entering startup ecosystems understand the power dynamics operating in the background. See Relationships and Power in Startup Ecosystems. Different market actors compete for access and control over pipelines of entrepreneurs; and they “trade” access to deals with people who serve their interests. Startups are much better served when they are in the driver’s seat for what relationships they build in the market, as opposed to allowing repeat players (like accelerators or VC funds) to trade access to them as currency. Don’t let your company become a pawn in another power player’s game.

The smartest investors in the market have realized that outsourcing their business development to a handful of “sorters” (accelerators) is a losing strategy, because those sorters have their own agendas. One of those agendas is to make the earliest money in the market “dumber,” so that the accelerators can continue giving startups $125K for 7-10% of their cap table (which translates to as low as a $1.25 million valuation) when many smart early funds would offer multiples of that. It is an own-goal for founders to help accelerators do this.

Scout programs, pre-seed funding, exclusive “meet and greet” events, open “application” processes for intro meetings, and many other activities are ways in which smart money is moving earlier in the startup life cycle, to find early startups that they can “accelerate” themselves. That can be useful to founders, saving them both time and equity. Competition with accelerators is why most elite VCs no longer require warm intros. 

All of these ecosystem players are here, in one way or another, to make money; endless PR about friendliness, “positive sum” thinking, and saving the whales notwithstanding. Frankly, so are you, and so am I. The more they can cut off competition, the more money they can extract from the market that would otherwise go to entrepreneurs and their employees. That means the most logical strategy is: become beholden to no one. Nothing better ensures good behavior by your business relationships than a little optionality.

That does not mean treating everyone as a means to an end, nor does it mean preventing serious VCs from taking lead positions on your cap table. To the contrary, it means slowing down and building a diverse set of long-term and durable relationships, with a mix of value-add and “dumb,” that you can leverage toward your company’s goals. The emphasis, however, is on the diversity of your relationships, so no particular group has more leverage than is justified. Diversify your network.

Let everyone offer their service, but don’t naively become over-dependent on any single channel. If you have access to smart early money, take it, nurture that relationship, and respect the fact that smart money deserves a better price than party round “dumb” checks. Just don’t agree to any terms that cut you off from raising from alternative money later if it makes sense. Independent counsel will help ensure that.

If you’re in an elite accelerator, fantastic. Use them. But don’t let them push you into myopic fundraising approaches that just increase their control over the market, which keeps their “prices” high relative to where the market should move. Keep connecting with smart money, and diversify your network. Understand that it’s in founders’ interests to not let a handful of very expensive accelerators cut off smart money from competing on the same playing field (the earliest checks); often at much better valuations.

Startups thrive best in actual ecosystems, where market players aren’t able to gain so much control that they start to “charge” more than their real value proposition justifies. Let the smart money and accelerators compete, and build your long-term relationships accordingly.

Note: a few examples of elite value-add VCs competing head-on with traditional accelerators include Sequoia Arc, a16z Start, Accel Atoms, as well as the Neo Accelerator, which “costs” less dilution than traditional accelerators. Examples of elite VCs who haven’t formed formal accelerators but invest very early (pre-Seed) include Nfx and First Round Capital. Many founders are finding that, after weighing all the factors, entering these kinds of pipelines or programs leads to substantially less dilution relative to going into a traditional accelerator (paying 7-10% in dilution for that) and then doing a seed round.

Startup Accelerators and Ecosystem Gatekeeping

TL;DR: Startup accelerators face a fundamental challenge to their value proposition: they don’t “own” their networks, and therefore struggle to continue extracting fees for accessing them. Classic disintermediation. Their responses to that challenge take a number of forms, and generally involve either dropping their price or attempts at controlling ecosystem players; the latter of which is misaligned with the interests of entrepreneurs and startups.

Related reading:

As I’ve written before in the above posts, Startup Accelerators became “a thing” in ecosystems because they were a reasonably optimal method for solving the “noise” problem faced both by startups and investors; a problem which became more visible as the cost of starting a company went down. With far more people “starting up,” early-stage investors needed someone to help them filter out duds. The solution, referred generally as “sorting,” is similar to the value prop offered by elite universities to employers needing talented labor, and students needing credible ways to signal their talent.

By creating credible brands (signals) for quality entrepreneurs, accelerators reduced the search costs for early-stage investors who, instead of needing to filter through lots of duds themselves, had a concentrated place to build their pipeline. That value proposition attracted investors, advisors, great employee hires, etc., and over time successful “alumni,” which magnifies the value proposition to entrepreneurs who, in exchange for equity, got a fast-track to building their network and raising capital.

For some time, you had a virtuous cycle with clear “network effects.” Attract great entrepreneurs, which then attracts investors and other key people, which then attracts more great entrepreneurs, and so on and so forth; just like a classic network effect for a software platform. During this period, accelerators can build significant leverage over their ecosystems as gatekeepers to talented entrepreneurs, and use that leverage to push the market in directions the accelerator wants.

The “Network” Can’t Be Controlled

But accelerators face a distinct problem that doesn’t get talked about a lot publicly, but local market players absolutely know is there: they can’t lock in (air quotes) “their” network. It’s not proprietary. The “networks” of startup accelerators are really just compilations of individual peoples’ networks; not at all like a “network” of a tech platform for which the tech “owner” can sustainably charge access fees. Those people in the accelerator’s “network” aren’t employees of the accelerator, nor are they paid out of its returns, and so they aren’t aligned in propping up the network’s “access fee.” Inevitably, people find it worth their while to simply bypass the accelerator and makes themselves accessible to founders directly, after having built their own personal brands with a few iterations with the accelerators’ initial cohorts. If a team needs X, Y, and Z, and I know X, Y, and Z and can help them get access with my own branding/signal, why should they have to pay this 3rd-party a fee to access those people?

So after a few years of an accelerator having filtered and aggregated a network, helping great people find great founders, and great founders find great people, the network takes on a life of its own. Suddenly with a little hustle and networking, it’s not nearly as hard as it was 5 years ago to simply navigate the “network” without ever needing to pay the gatekeeper. I’ve seen this play out in a number of startup ecosystems across the country, where accelerators faced an initial golden age when they were seen as prime “sorters” of an opaque ecosystem willing to pay for the sorting, and then suddenly the quality of entrepreneurs they can get to pay their “fee” starts to take a clear downward turn. Top entrepreneurs are, by definition, fantastic hustlers. They aren’t going to pay you for something once they’ve realized they can do it themselves with a little effort, or that someone else is offering similar “access” at a lower “fee.”

Once top entrepreneurs realize that they can bypass the accelerator and access its “network” directly, and word gets around, the value proposition of the accelerator can begin to unwind. Suddenly the accelerator cohorts start to fill not with the most highly skilled entrepreneurs (those hustle it out on their own now), but with lower quality entrepreneurs less capable of making things happen “in the wild” and therefore more needy of the accelerator’s high-touch, high-priced assistance. As the quality of the accelerator’s average entrepreneur goes down, the leverage over key people on the other side of the “market” – investors, advisors, etc. – goes down, and fewer of them show up to the accelerator; which then reduces the value prop for entrepreneurs, and you get the exact reverse of the original virtuous cycle.

Seeing this dynamic play out, accelerators have three ways of responding, and I’ve seen them in different markets.

Drop the Price

The first is to simply acknowledge that the accelerator cannot maintain the original value proposition they had before the ecosystem/network had matured, and drop their price accordingly. With less significant of a signal, and less leverage over the market, the high 6-8% fee can’t be sustained, so build something leaner that can be offered at a 1-2% level perhaps. I’ve seen these “leaner” accelerators enjoy some success. Some accelerators started out with the expectation that they were going to dominate a startup ecosystem with high “access” fees, and then over time got humbled when the market delivered a reality check.

Employ the Network

Another option is to convert the accelerator into a kind of “startup studio,” where the main pieces of the network are actually employees paid by the accelerator, or at least with deeper economic ties to the accelerators’ performance; reducing their incentive to leak out of the network. The key challenge here is whether the accelerator really has the cachet/leverage, and resources, to employ those people; or whether A-players find it far better to simply stay outside and keep their pipelines more open.

Another way to “employ” certain network players doesn’t require actually employing them, but simply maintaining some economic control over them. For example, a prominent accelerator might use referral relationships with certain law firms as a way to keep those firms from questioning the accelerators’ behavior, even if it’s clearly at times not in the best interest of the startups the firms represent. That strategy is straight out of the playbook of VCs. See: When VCs “own” your startup’s lawyers and Relationships and Power in Startup Ecosystems. Offering or restricting “access” to potential investments, clients, employers, etc. has always been a currency used by startup power players to keep other market participants loyal and “well-behaved.”

Try to Lock Down the Network

This is where things start to get interesting. So I’m an accelerator enjoying success, but I can clearly see that over time my ability to keep extracting gatekeeping fees over my “network” is weakened by my inability to maintain control over the investors, founders, advisors, etc. within it. Possible solutions:

  • Lock Down Demo Day – Maintain tighter control over who gets access to demo day and, importantly, “discourage” founders from raising financing outside of demo day.
  • Lock Down Financing Structures – Maintain tighter control over how financings within the network occur, by “soft mandating” that they follow templates created and controlled by the accelerator.
  • Lock Down Network Communication with Technology – Create proprietary message boards, mail lists, and other media platforms for communicating within and navigating the network, to “incentivize” networking in ways that give the accelerator visibility and control.

Of course, none of this will ever be communicated openly as mechanisms for the accelerator to maintain power over an ecosystem/network, including founders. They’ll be spun as ways to provide efficiency and value for founders and other people. But as with much spin, there is a point at which it fails to pass the laugh test.

Listen in the market (what gets said privately rarely mirrors what is said publicly), and it becomes clear that the more aggressive accelerators have for some time been building local resistance; irritating investors who resent having a “big brother” dictating how to do biz dev and deals, irritating founders who don’t want to pay a gatekeeping fee for accessing specific ecosystem resources, and irritating other market players who don’t want a rent-seeker standing in-between them and potential business.

When an accelerator “discourages” a startup team from fundraising outside of demo day, it’s going to offer some paternalistic platitude about how having a controlled process helps “protect” the entrepreneurs, but what it’s really about is ensuring the accelerator has (i) leverage over the investor community via ability to deny and control access to its founders, and (ii) leverage over founders by controlling the venue in which they fundraise; which sustains the power of the accelerator to charge high gatekeeping fees.

Once I’ve publicly announced my cohort, the sorting is done and the signal is out. Investors don’t need me (the accelerator) anymore, and in many cases nor do the founders whose main purpose of joining the accelerator was to get “branded” to make getting meetings with investors easier. That threatens the power of the accelerator, which wants to charge not just for sorting/signaling, but for access to a network. “Locking down” outside fundraising, with some clever spin as to why it’s good for startups, is the response.

If an accelerator builds proprietary communication channels for alumni to utilize, maybe that’s to be helpful. Or maybe it’s a way of preventing the network from doing exactly what networks do organically, which is resist gatekeeping and build multiple nodes/channels to prevent a single point of entry through which a rent-seeker can extract access fees. Accelerator’s don’t hold monopolies on brands/signals that startups can leverage to get funding, and therefore other people (like angels, seed funds, and respected founders) within a “network” who can connect founders to money/other resources (offer cheaper “signaling”) are, in a sense, competitors whom the accelerator has a strong incentive to control. Maintaining control / visibility over communication channels is a way for accelerators to prevent leaner competition.

Accelerators are Service Providers, Like Everyone Else

The general conclusion from all of the above should not be that startup accelerators are bad or good; on an individual level many are of course full of great people. Instead, it should be that accelerators are profit-driven service providers and political actors, just like everyone else. They want to charge a higher price, and will do what they can to maintain their power to charge that higher price. Other market players will attempt to build alternatives, and drop that price, and the accelerators will respond by trying to compete with, block, or control those other market players. It’s just like VC, Law, and any other industry that caters to startups.

When transparent meritocracy and markets start to challenge a player’s ability to charge high fees, they often turn to politics; using backdoor relationships to build loyalties and amplify supportive messaging. Accelerators who maintain tight referral and economic relationships with specific funds, firms, and other market players do so in order to ensure there’s a loyal base of people out there toeing the party line, even as opposing voices in the ecosystem start to emerge.

For entrepreneurs, the message is simply to understand where their interests are aligned, and where they’re misaligned, with the interests of accelerators. Branding and signaling are useful. To the extent they are useful to you, use them, at the appropriate price. But by no means allow them to dictate how or when to fundraise, or how to navigate the network. It’s in startups’ interest (and that of ecosystems generally) to stay flexible and keep their options open, even if accelerators would prefer having a tight grip. The golden era of accelerators is almost certainly over, as startup ecosystems and networks have begun to mature, offering multiple accessible paths to networking and investment. But they will still have a place and function for a pocket of the ecosystem that needs them.

To the extent accelerators use politics and leverage to lock down ecosystem resources that founders could otherwise access on their own just fine, or demand that startups and investors do things in a specific way favored by the accelerator, they are no longer transparent market players; they’re rent-seeking gatekeepers. If there’s anyone that startup entrepreneurs love painting a bullseye on, it’s gatekeepers.

After-note: see Why Startup Accelerators Compete with Smart Money for some observations on how early-stage VCs are eroding the value proposition of accelerators further by bundling new roles/services alongside their investments, and moving up-stream.

Trust, “Friendliness,” and Zero-Sum Startup Games

Background reading: Relationships and Power in Startup Ecosystems

TL;DR: In many areas of business (and in broader society) rhetoric around “positive sum” thinking and “friendliness” is used to disarm the inexperienced, so that seasoned players can then take advantage. Startups shouldn’t drink too much of the kool-aid. Smile and be “friendly,” but CYA.

An underlying theme of much of my writing on SHL is that first-time founders and employees of startups, being completely new to the highly complex “game” of building high-growth companies and raising funding, are heavily exposed to manipulation by sophisticated repeat players who’ve been playing the same game for years or even decades. There are many important tactical topics in that game – around funding, recruiting, sales, exits – all of which merit different conversations, but the point of this post is really a more “meta” issue. I’m going to talk about the perspective that should be brought to the table in navigating this environment.

A concept you often hear in startup ecosystems is the distinction between zero-sum and positive-sum games. The former are where there’s a fixed/scarce resource (like $), and so people behave more competitively/aggressively to get a larger share, and there’s less cooperation between players. In positive-sum games, the thinking goes, acting competitively is destructive and everyone wins by being more cooperative and sharing the larger pie. Sports are the quintessential zero-sum game. Someone wins, and someone loses. Capitalism is, broadly, a positive-sum game because in a business deal, both sides generally make more money than if the deal had never happened.

The reality – and its a reality that clever players try to obscure from the naive – is that business relationships (including startup ecosystems) are full of both positive and zero-sum games, many of which are unavoidably linked. It is, therefore, a false dichotomy. In many cases, there are zero-sum games within positive sum games. In fact, rhetoric about “positive-sum” thinking, friendliness, trust, and “win-win” is a common tactic used by powerful players to keep their status from being threatened.

For a better understanding of how this plays out in broader society (not startup ecosystems), I’d recommend reading “Winners Take All: The Elite Charade of Changing the World” by Anand Giridharadas, who deep-dives into how, in many cases, very wealthy and powerful people (i) on the one hand, fund politicians/legislation that cut taxes and funding for democratically solving social problems while (ii) simultaneously, spending a smaller portion of the saved money on “philanthropic” or “social enterprise” initiatives aimed at addressing those same social problems, but in a privatized way where they are in more control. The latter of course comes with a hefty share of feel-good messaging about “giving back” and helping people.

The net outcome is that those powerful players direct discussion away from the full spectrum of solutions that may require addressing some unavoidable zero-sum realities, and instead get society to myopically focus on a narrower segment of purportedly “win-win” options that don’t actually threaten the power and status of the elite priesthood. There is much room to debate the degree to which Giridharadas’ perspective is an accurate representation of American philanthropy/social enterprise, but anyone with an ounce of honesty will acknowledge that it is definitely there, and large.

Sidenote: Anand is a clear hardcore socialist, and I’m not exactly a fan, but life is complicated and I’ll acknowledge when someone makes an accurate point. An enormous amount of “save the world” rhetoric is just kabuki theatre to maintain power and keep your money.

While the details are clearly different, this dynamic plays out all over startup ecosystems. They are full of influential market actors (accelerators, investors, executives) acting as agents for profit/returns driven principals, and in many cases legally obligated to maximize returns, and yet listen to much of the language they use on blogs, social media, events, etc. and an outsider might think they were all employees of UNICEF. This is especially the case in Silicon Valley, which seems to have gone all “namaste” over the past few years; with SV’s investor microphones full of messages about mindfulness, empathy, “positive sum” thinking, and whatever other type of virtue signaling is in vogue.  Come take our money, or join our accelerator, or both. We’re such nice people, you can just let your guard down as we hold hands and build wealth together.

Scratch the surface of the “kumbaya” narratives, and what becomes clear is that visible “friendliness” has become part of these startup players’ profit-driven marketing strategies. With enough competition, market actors look for ways of differentiating themselves, and “friendliness” (or at least the appearance of it) becomes one variable among many to offer some differentiation; but it doesn’t change any of the fundamentals of the relationship. Just like how “win-win” private social enterprise initiatives can be a clever strategy of the wealthy to distract society away from public initiatives that actually threaten oligarchic power, excessive “friendliness” is often used by startup money players to disarm and manipulate inexperienced companies into taking actions that are sub-optimal, because they lack the perspective and experience to understand the game in full context.

With enough inequality of experience and influence between players (which is absolutely the case between “one shot” entrepreneurs and sophisticated repeat player investors) you can play all kinds of hidden and obscure zero-sum games in the background and – as long you do a good enough job of ensuring no one calls them out in the open – still maintain a public facade of friendliness and selflessness. 

As startup lawyers, the way that we see this game played out is often in the selection of legal counsel and negotiation of financings/corporate governance. In most business contexts, there’s a clear, unambiguous understanding that the relationship between companies and their investors – and between “one shot” common stockholders v. repeat player investors – has numerous areas of unavoidable misalignment and zero-sum dynamics. Every cap table adds up to 100%. A Board of Directors, which has almost maximal power over the Company, has a finite number of directors. Every dollar in an exit goes either to common stock (founders/employees) or investors. Kind of hard to avoid “zero sum” dynamics here. As acknowledgement of all this misalignment, working with counsel (and other advisors) who are experienced but independent from the money is seen, by seasoned players, as a no-brainer.

But then the cotton candy “kumbaya” crowd of the startup world shows up. We’re all “aligned” here. Let’s just use this (air quotes) “standard” document (nevermind that I or another investor created it) and close quickly without negotiation, to “save money.” Go ahead and hire this executive that I (the VC) have known for 10 years, instead of following an objective recruiting process, because we all “trust” each other here. Go ahead and hire this law firm (that also works for us on 10x more deals) because they “know us” well and will help you (again) “save money.” Conflicts of interest? Come on. We’re all “friendly” here. Mindfulness, empathy, something something “positive sum” and save the whales, remember?

Call out the problems in this perspective, even as diplomatically as remotely possible, and some will accuse you of being overly “adversarial.” That’s the same zero-sum v. positive-sum false dichotomy rearing its head in the startup game. Are “adversarial” and “namaste” the only two options here? Of course not. You can be friendly without being a naive “sucker.” Countless successful business people know how to combine a cooperative positive-sum perspective generally with a smart skepticism that ensures they won’t be taken advantage of. That’s the mindset entrepreneurs should adopt in navigating startup ecosystems.

I’ve found myself in numerous discussions with startup ecosystem players where I’m forced to address this false dichotomy head on and, at times, bluntly. I’m known as a pretty friendly, relationship driven guy. But I will be the last person at the table, and on the planet, to accept some “mickey mouse club” bullshit suggesting that startups, accelerators, investors, etc. are all just going to hold hands and sing kumbaya as they build shareholder value together in a positive-sum nirvana. Please. Let’s talk about our business relationships like straight-shooting adults; and not mislead new entrepreneurs and employees with nonsensical platitudes that obscure how the game is really played.

Some of the most aggressive (money driven) startup players are the most aggressive in marketing themselves as “friendly” people. But experienced and honest observers can watch their moves and see what’s really happening. Relationships in startup ecosystems have numerous high-stakes zero-sum games intertwined with positive-sum ones; and the former make caution and trustworthy advisors a necessity. Yes, the broader relationship is win-win. You hand me money or advice/connections, and I hopefully use it to make more money, and we all “win” in the long run. But that doesn’t, in the slightest, mean that within the course of that relationship there aren’t countless areas of financial and power-driven misalignment; and therefore opportunities for seasoned players to take advantage of inexperienced ones, if they’re not well advised.

Be friendly, when it’s reciprocated. Build transparent relationships. There’s no need to be an asshole. Startups are definitely a long-term game where politeness and optimism are assets; and it’s not at all a bad thing that the money has started using “niceness” in order to make more money. But don’t drink anyone’s kool-aid suggesting that everything is smiles and rainbows, so just “trust” them to make high-stakes decisions for you, without independent oversight. Those players are the most dangerous of all.

How Paralegals and Junior Lawyers Can Hurt Startups

TL;DR: In engaging startup law firms, founders need to pay close attention to the differences between inexperienced junior legal professionals, like paralegals and junior attorneys, relative to experienced senior attorneys and partners. In order to fit their high-cost structures into tight startup budgets, some law firms significantly water down their services by forcing startups to regularly engage mostly with inexperienced junior people; many of whom are advising founders on issues they simply lack appropriate experience and judgment for. For high-stakes, complex issues, many of which come up in the early days of a company, this can lead to costly missteps for which startups end up paying a very high price.

Because of their inexperience, first-time founders often get tripped up in engaging their first legal services providers. Very often, they think they just need “a lawyer,” without understanding that, just like doctors, law has dozens of specialties and sub-specialties; and they need lawyers who specialize in emerging technology companies. But even if they narrow down the options of firms they are talking to, founders often lack an understanding of the differences in how various startup law firms/practices are structured in terms of senior professionals v. junior, and how that has a very material impact on the kind of service the company is going to receive.

In What Partners in Startup Law Firms Do, I walked you through what the different titles and levels of expertise at law firms mean. Partners at serious, respected firms have gone through extremely strict vetting and training processes, ensuring that they’re capable of delivering very high-stakes (very high-cost of errors) and flexible legal expertise in complex, multi-variate contexts that fast-moving startups often find themselves in. The process of moving away from Partners toward more junior-level attorneys and paralegals is often referred to as “de-skilling.” It requires adding rigidity and uniformity to work (checklists, templates, standardization, automation), so that less-capable professionals are able to handle limited-scope projects without blowing things up.

De-skilling is an important and very useful part of building up any law firm, because it allows firms to make highly-specialized and trained Partners accessible to companies when they’re needed (which is often, but certainly not all the time), while also handling lower-stakes and simpler work more efficiently and at lower cost.  While every law firm that works with startups offers a level of de-skilled work, it’s clear that firms vary dramatically in how far they go with it.

Some firms keep partners and senior-level attorneys highly involved with a startup from Day 1, while delegating periodically to paralegals and juniors. Other firms go so far as to make paralegals and junior lawyers the main point of contact for early-stage founders. To a first-time founder, the difference between these two approaches can seem subtle, but in terms of what is actually being delivered by the firm (and long-term outcomes), the differences are the opposite of subtle. In fact, we constantly see fast-growing startups make extremely expensive legal mistakes (or poorly thought-out strategic decisions) because the founders were relying on paralegals and juniors – as a “cost saving” mechanism – when those junior professionals were totally out of their league in the advice they were giving.

When paralegals and junior lawyers are made the main legal contacts of a startup, it’s the law firm’s way of saying “You’re little right now, and therefore just a number to us. But if you become something more significant, we’ll allocate our real expertise (senior level) to you.” The problem with this mindset is that many of the decisions made in the very early days of a startup are setting up the foundation and relationships that the company is going to live with throughout its trajectory. The company may be small at the moment, but actions being taken can be extremely high-impact and permanent, and therefore often require experienced judgment. This is especially true if the company doesn’t fit into a cookie-cutter context that can be distilled into a linear, simplified template for a junior to follow.

High-cost firms with weak(er) brands often over-delegate to inexperienced paralegals and juniors.

While a number of variables can play into it, the single largest driver of how much startup law firms rely on paralegals and junior lawyers is the interplay between the firm’s overall cost structure and the budget that startups engaging that firm are willing to accept. I emphasize that it’s the interplay of those two factors, because while some very high-cost law firms could stretch the amount of junior delegation that they throw onto startups, their reputation is sufficiently strong that founders who engage them are willing to pay the high cost of staying closely in contact with partners and seniors.

The very top of the top-tier of high-cost startup “BigLaw” – the top 3-5 firms, what I often refer to as the “Ferrari” tier – often doesn’t have to play games with excess de-skilling. They’re expensive, founders know they’re expensive, and yet they stay very busy anyway because if you’re legitimately on a Unicorn track (>$15MM Series A, clearly gunning for a 10+ figure long-term valuation) you’re a fool for using any other firm outside of that category. Companies on this track usually don’t struggle to pay their legal bills, even if they’ve engaged a Ferrari firm, because the size of their financings can more than accommodate a large legal budget.

It’s often the second tier of the very high-cost firms that I’ve seen start playing games with over-delegation to juniors. These firms also have extremely high operation costs, including all of the pricey infrastructure of the Ferrari tier, but they don’t have the brand credibility to command appropriately sized budgets from their early-stage clients. How do you make the math work in that case? You offer founders lower-priced fixed-fee projects, while putting in the fine print that the founders are going to spend 99% of their time talking to paralegals and juniors incapable of offering effective advice outside of very narrow contexts. Some of these firms will also throw in some half-baked automation software (cue the “machine learning” and “AI” buzz words) to make over-dependance on juniors seem “cutting edge,” when it’s actually a playbook that firms have been using for some time; and smart entrepreneurs know to avoid it.

The true Ferrari tier of Startup BigLaw often doesn’t need to play games with over-delegation to juniors, because founders who engage them know exactly why those firms are so expensive, have accepted it, and are willing to pay for experienced, senior-level attention. It’s more… OK let’s stick with the car analogy, the “Jaguar” tier of BigLaw (high-cost, but not the top of the top tier) that most often follows the junior-driven playbook. Their operating costs are the same as (or very close to) the Ferrari firms, but they have to offer discounts and lower budgets to attract startup clients (weaker brand); necessitating a watering-down of the actual offering to make the math work. What you end up with is still far from cheap, but requires you to stay within a very rigid, narrowly defined path for everything to not fall completely off the rails.

The point here isn’t to come down hard in saying that one approach or the other is right for every startup, but to simply ensure founders are aware of it, and use their judgment rather than being duped by clever marketing. Companies on what could truly be called “cookie cutter” trajectories can be OK having paralegals and inexperienced junior lawyers be their main legal contacts via what amounts to a “LegalZoom with a little extra” type of legal service offering. But experience has shown me that many entrepreneurs over-estimate how much of their legal work is (air quotes) “standard,” which can result in a blow-up once the legal technical debt comes due.

For negotiation-oriented issues, like structuring the subtleties of financings or serious Board-level discussions, there may also be ulterior motives behind investors pushing their portfolio companies to lean on inexperienced advisors (law firms that push startups to use junior people), with fabricated “standards” as an excuse. If it’s all just templates and standards, then what’s the harm in having your investors pick your law firm, right? Watch incentives and conflicts of interest. See: Negotiation is Relationship Building and When VCs “own” your startup’s lawyers.

When you, as a first-time entrepreneur, don’t know what you don’t know about high-stakes legal and financing issues, and you’re interacting with extremely seasoned and smart (but misaligned) business players, the last thing you want is to be relying on advisors who are only marginally more experienced than you are; or worse, are also “owned” by the money across the table.

High-end Boutique Law Firms are leaner and can offer lower costs, without over-reliance on inexperienced juniors.

Excess amounts of de-skilling and delegation to paralegals/juniors is not the only way that the legal market has attempted to lower legal costs for startups. An alternative, which we are a part of, is the emergence of high-end boutique law firms. These firms can offer regular access to true Partners and Senior Lawyers, but at rates equivalent to what the Ferrari tier charges for junior lawyers (hundreds less per hour); because they’ve cut out a lot of the overhead infrastructure that tends to inflate the cost of BigLaw. If your clients are Apple, Uber, and companies on that track (Ferrari tier of BigLaw), the way you build and market your firm will by necessity look very different from firms who deliberately target clients that, while serious and building important products/services, rarely make it onto the headlines of the NYT or WSJ (boutique firms).

This “lower overhead” (lean) boutique approach to law is not without its trade-offs, and I make that clear in my writings on the emerging boutique ecosystem. Every firm structure ultimately still has to follow math, and there simply is no magical wand that you can waive to deliver (again with the car analogies) Ferrari performance and resources at Acura/BMW prices. The very highest-end law firms that cater to marquee billion-dollar companies (and aspiring Unicorns) are extraordinarily expensive to grow and run, and there are very smart people running them who are well aware of how to safely trim costs within the constraints of what it takes to serve their clients. Boutiques offer a fundamentally different cost structure, because they are designed for a fundamentally different kind of client that doesn’t need a lot of the resources of the Ferrari class.

And please spare me the vaporware marketing suggesting that some new whiz-bang-pow piece of automation technology fundamentally changes the math of law firm economics. At the tier of corporate legal work that we are discussing (scaled, high-complexity and variability, high cost of errors, contextualized subjectivity), the amount of work even within the realm of possibility of being automated away with AI and data is a microscopic portion of what serious firms do. With apologies to the soylent-sipping lawyer haters out there (I see you, Silicon Valley uber-engineers), Siri isn’t going to negotiate your financings, or navigate your corporate governance, any time soon. We love legal tech and have adopted a lot of useful new tools, some of which are still in private beta; but nothing in the next 5-10 year horizon is going to fundamentally re-make law firms. Not at this level of complexity.

Properly structured high-end boutique law firms can and do offer significantly lower costs than BigLaw, without denying startups regular access to Partner-level, flexible strategic expertise. But the savings come from removing costs and resources that are required only if you are trying to serve the very highest end of the tech market; and boutiques don’t.

I tell founders all the time, “If you legitimately think an IPO or billion dollar valuation is on your visible horizon, please hang up and call the Ferrari tier of BigLaw.” We don’t do IPOs, and we’re not going to do your 10-figure cross-border merger involving 5,000 employees, 500 stockholders, and four tax jurisdictions. Hard pass.

At E/N, our Partners are perfectly happy letting the Ferrari firms compete for and serve Ferrari clients, while we work with a segment of the tech ecosystem that has been badly underserved.  Our clients tend to exit between $50MM and $250-ish MM, and obviously at lower sizes if it’s an earlier-than-expected sale. Their legal needs and financings are sufficiently large and complex to pay rates high enough to support serious lawyers and right-sized infrastructure for scalability, but the founders also have an instinctive understanding that their trajectory isn’t going to be anything you’d call “cookie cutter,” nor are they aspiring to be a Unicorn.

High-end boutique startup law firms thus offer a balanced compromise and useful value proposition for founders building companies that clearly need credible, highly-trained and specialized senior-level expertise (without reckless over-reliance on paralegals and juniors, or half-baked automation software), but for whom the Ferrari tier of the tech legal market is clearly overkill. Boutiques cannot and do not scale like the very top-tier of BigLaw, but the fact is that an important segment of the tech ecosystem doesn’t need them to.

Founders exploring the legal market should, at a minimum, ensure that they understand not just the varying cost structures of law firms, but also the varying levels of expertise/service those firms are offering within their cost structures. Two firms might look like apples to apples on the surface, but what your budget actually gets you ends up being wildly different. Firms promising low fees in exchange for inexperienced junior professionals (who can’t navigate significant complexity/flexibility safely, and offer poorly-fitted rigid advice) are selling something that – to experienced players who aren’t easily fooled – looks far less like efficiency, and far more like a time bomb.