Alignment in Startup Governance: Conflict, Collusion, Corruption

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Anyone looking to build a meaningful business needs to understand the importance of “alignment.” Alignment refers to the fact that building your company is going to involve the participation of numerous categories of people – founders, employees, executives, investors, etc. – all of whom come to the table with different incentives and motivations; and they are hardly going to be naturally in sync with one another. To make them all “play nice” you need to find ways of getting them aligned on a single vision, so you can get their approval and support on key transactions. It’s never as simple as it sounds.

Part of the “tension” in incentives stems from the fact that different people have different characteristics and legitimate needs. For example, most major preferred stockholders (VCs) are going to be affluent individuals with diversified portfolios, and (importantly) downside risk protection in the form of a liquidation preference. This means that, other than the absolute worst scenarios, they get their money back before the common stockholders (founders, employees) get anything. They also tend to be more interested in pursuing larger exits to satisfy their LPs return expectations, even if the paths to those exits take longer and involve more risk. Their already existing wealth means the potential return from this one individual company isn’t “life changing” for them in the way it could be for a founder or early employee. A life changing exit for a founder may be a waste of time for a large VC fund.

Patience is a lot harder when 80-90% of your net worth is sitting in unrealized value on a single company’s cap table. It’s much easier when you’re already in the 0.1%, and you’re just stacking more gold on top of an already healthy balance.

Even within broad categories like “common stockholder” there is very often misalignment of incentives and interests. Earlier common stockholders, like founders, sit in very different positions from later common stockholders, like professional executives. Someone who has been working at a company for 6 yrs and has tens of millions of dollars in fully vested equity value is going to assess the terms of a later-stage financing or acquisition offer very differently from someone who just showed up at Series B, got their stock at a relatively high exercise price, and thus needs the business to appreciate much more in value before they can really get much out of their equity.

Corporate Governance is the professional field of managing the relationships among the various constituents of a corporation and their varied interests. Good governance means achieving good alignment. Bad governance often results from ignoring misalignment, and letting it metastasize into destructive conflict, or other times into collusion or corruption. In Corporate Law, there are legal mechanisms in place to attempt to protect against misalignment getting out of hand in a corporation (including a startup). Members of a Board of Directors, for example, have enforceable fiduciary duties to look out for the interests of all the stockholders on a cap table, not just their own personal interests. If evidence arises that they approved a self-interested transaction at the expense of smaller holders not represented on the Board, those smaller holders can sue.

Conflict

The source of governance conflict that gets the most attention in startups is the tension between founders and venture capitalists, particularly as it relates to power (who ultimately calls the shots) within a company. This power tension is real, but it’s not what I intend to write about here. There are plenty of other posts on this blog about that topic.

Aside from hard power, conflict can arise between founders/common stockholders and investors because of economic misalignment. As mentioned above, given their different positions in terms of affluence, risk-tolerance, and concentration of personal wealth, it’s not uncommon to encounter situations where founders or common stockholders want to pursue path A for a company, while investors are insistent on pursuing path B. In the worst circumstances, this can get into battles over voting power and Board structure. I’ve even seen situations in which investors attempt a “coup” by swiftly removing founders from a Board in order to force through their preferred agenda.

From a preventive standpoint, one of the best ways to avoid this sort of conflict is fairly obvious: ask the hard questions up front and get alignment on vision before anyone writes a check. Founders and investors should be candid with each other about their needs and expectations, and both sides should conduct diligence (reference checks, including blind ones if available) to verify that the answers they’re getting are in sync with past behavior.

Another tool for achieving better economic alignment between founders/common and investors/preferred is allowing the common stock to get liquidity in financings. Years ago the predominant view was that letting founders take money off the table was a bad idea, because everyone wanted them “hungry” to achieve a strong exit. The fear was that by letting them liquidate some wealth, they’d lose motivation and no longer push as hard. While this was a legitimate “alignment” concern, the general wisdom today is (for good reason) that it was actually getting the issue backwards.

More often than not, failing to let founders get some early liquidity is a source of misalignment with investors. Investors want to let the business continue growing and go for a grand slam, but founders (and their families typically) are impatient to finally realize some of the value that they’ve built. It can be very frustrating for a spouse to see a headline that a founder’s company is worth 8-9 figures, and yet they still can’t buy that home they’ve been eyeing and talking about for half a decade. Letting founders liquidate a small portion of their holdings (5-15%) – enough to ease some of their financial pressure but not enough that a later exit is no longer meaningful for them – can go a long way in achieving better alignment between the early common and the investor base. It makes founders more patient and thus better aligned with other stockholders with longer time horizons.

Today, I far more often see VCs and other investors be far smarter about founder and other early common stockholder liquidity. At seed stage it is still considered inappropriate (for good reason typically), and in most cases Series A is too early as well; though we are seeing some founder liquidity as early as higher-value Series As that are oversubscribed. By Series B it is more often than not part of a term sheet discussion.

But be careful. Relevant players should avoid any impropriety indicating that VCs are offering founders liquidity in exchange for better overall deal terms. That’s a fiduciary duty violation, because it benefits individual Board members while harming the cap table overall. For more on these kinds of risks, see the “corruption” part of this post below.

Collusion

Aside from destructive conflict in company governance, another concern is when various constituents on a cap table are able to consolidate their voting power in order to force through initiatives that may be sub-optimal for the cap table as a whole, but benefit the players doing the forcing.

One way in which this happens involves larger cap table players, with an interest in having their preferred deals approved, using quid-pro-quo tactics to convince other cap table holders to accept Deal A over Deal B because Deal A aligns more with the interests of the existing money players. For example, if a Series A lead currently holds a board seat and wants to lead a Series B, that VC has an interest in not only minimizing competition for that deal, but (assuming they don’t already have a hard block from a voting % perspective) also convincing other cap table players to go along with them.

All else being equal, an early seed fund investor should be more aligned with a founder than a Series A lead as to evaluating a Series B deal led by the Series A VC. They want the highest valuation, and the lowest dilution, possible. While the Series A VC is on both sides of the deal, both the seed and founder are only on one (along with the rest of the cap table). This is good from an alignment perspective. But all else isn’t always equal. For example, the seed fund and the Series A VC may have pre-existing relationships. The Series A lead and seed fund may share investment opportunities with each other in the market, and thus have an interest in keeping each other happy in a long-term sense despite their narrow misalignment on a particular company.

All it takes is for the Series A lead to invite the seed investor out to lunch, remind them of their extraneous relationships and interests, and now we have a collusion arrangement in which the seed fund may be motivated to approve a sub-optimal (for the company) Series B arrangement because of secondary benefits promised by the Series A lead on deals outside of this one.

This exact kind of dynamic can happen between VCs and lawyers, by the way. See: How to Avoid “Captive” Company Counsel. Many VCs very deliberately build relationships with influential corporate lawyers in startup ecosystems, because they know very well that a lawyer who depends on a VC for referrals and other work isn’t going to push as hard for his or her client if that client happens to be across the table from said VC. Watch conflicts of interest.

The key preventive tactic here is: pay very close attention to relationships between people on your cap table, on your Board, and among your key advisors and executives. It is too simplistic to look at the %s on your cap table and assume that because no particular holder has a number-based veto majority that you are safe. The most aggressive and smart players are very talented at cap table politics. Diversify this pool of people by ensuring that they are truly independent of one another, preferably even geographically, so that they will be more motivated by the core incentive structure of your own cap table and deals, and not by extraneous factors that muck up incentives.

Corruption

Collusion involves simply coordinating with someone else to achieve a desired goal, but it doesn’t necessarily mean that collusion violates some duty you have to other people. A seed investor who doesn’t sit on your board has no fiduciary duty to you or anyone else on your cap table. So if they collude with your Series A lead to force through some deal that you don’t like, you may not like it, but you don’t really have any statutory legal right – aside from contractual rights you and your lawyers may have negotiated for – to make them do otherwise.

When collusion becomes corruption, however, someone is in fact going against their legal obligations, and trying to hide it. A common kind of governance corruption I’ve encountered is when VCs try to ensure that senior executive hires are people with whom they have long-standing historical relationships, even when other highly qualified candidates are available. Those executives will typically sit as common stockholder Board members, and have duties to pursue the best interests of the Company as executive officers. But because of background dependencies those executives have on specific VCs – those VCs may have gotten them good jobs in the past, and will get them good jobs in the future – they’re going to ensure the VCs always stay happy.

If as a founder you suddenly find out that your VCs know about certain private matters going on in the company that weren’t formally disclosed to them, there’s a very high chance there are background relationships and dependencies you were ignoring. While it’s always great for investors to bring their rolodexes and LinkedIn networks to the table when a portfolio company needs to make key hires, my advice is to generally ensure that there is still an objective process for sourcing high-quality, independent candidates as well. Also, build the pipeline process in a way such that no one gets the feeling that it was really a VC hiring them instead of the C-suite team or broader Board. Executives should not be reporting to VCs individually without the involvement and knowledge of the Board.

A more serious form of potential corruption – and an extremely clever one – that I’ve observed in the market in recent years involves VCs and founders. Imagine VC X is a high-profile VC fund that sees lots of high-growth angel investment opportunities. The ability to “trade” access to those opportunities is extremely lucrative currency, and VCs are experts at using that currency to build relationships and influence in the market.

VC X is an investor in Company A. Founder Y is a founder of Company A. Normally, as we’ve seen, the economic misalignment between Founder Y and VC X as it relates to Company A ensures that Founder Y will negotiate for as high of a valuation as possible because she wants to minimize her dilution. This puts Founder Y very much in alignment with other common stockholders on the cap table (employees) because they too want to minimize dilution. But obviously VC X would prefer to get better terms.

What if VC X offers Founder Y “access” to the angel investment opportunities it sees in the market? Suddenly we have an extraneous quid-pro-quo arrangement that mucks up the incentive alignment between Founder Y and other common stockholders. While on this company Founder Y may want to make VC X provide as good of terms as possible for the common stock, Founder Y now wants to keep her relationship warm with VC X outside of the company, because VC X is now a lucrative source of angel deal flow for Founder Y.

See the problem? Founder Y can make money by accepting worse terms for the company and cap table as a whole, because it benefits VC X, who rewards the founder with outside angel investment opportunities. The founder’s alignment, and fiduciary responsibility, to the rest of the common stock has been corrupted by outside quid-pro-quo.

I have seen founders co-investing in the market alongside the VCs who are currently the leads in those founders’ own companies. The VCs are not doing this to just be nice and generous. They’re using their deal visibility as a currency to gain favor with founders, potentially at the expense of the smaller common stockholders whom the founders should be representing from a fiduciary perspective.

This is an extremely hard governance issue to detect because it involves the private behavior of executives and VCs completely outside of the context of an individual company. It is unclear whether default statutory rules would ever require Founder Y and VC X to disclose the outside arrangements they have, given they aren’t true affiliated parties in the classic sense of the word. Frankly, it’s kind of a “cutting edge” problem, because while investors have forever traded deal flow with other investors to build collusive relationships, only recently has this strategy (very cleverly) been extended to founders.

But it’s something everyone, including counsel, should keep their eye on. It may even be worth considering creating new disclosure requirements regarding anyone purporting to represent the common stock on a Board (founders included) and co-investment or investment referral relationships with key preferred stockholders.  We certainly want founders and VCs to be aligned on maximizing the value of a particular company. But this (trading deal flow outside of the company as quid-pro-quo favors) is not that. The losers are the employees and smaller investors whose interests aren’t properly being looked after, because founders as common board members may be favoring particular VCs on the cap table over other outside offers that have better (for the company’s stockholders) terms but don’t come with juicy personal investment opportunities on the side.

It’s somewhat ironic that ten years ago company-side startup lawyers (I don’t represent investors) had to think a lot about overly aggressive “asshole” VCs who mistreated founders, in many cases to the detriment of a company. But today it’s much harder for VCs to play that game because the ecosystem has become so much more competitive and transparent reputationally. Now we instead need to have a conversation about the exact reverse: “founder friendliness” getting so out of hand that it’s now potentially generating fiduciary duty issues and harming smaller cap table holders. Unsurprisingly, Silicon Valley is, from my observation, where things have flipped the most.

When the stakes and dollar values are very high – and in top-tier startup land they very often are – incentives drive behavior. Understand how the incentives align and misalign among the key constituencies on a cap table, and use that knowledge to achieve outcomes that maximize value not just for particular “insiders,” but for all stockholders who’ve contributed to the company.

“No Code” v. “Open Source” Approaches to Early-Stage Startup Law

TL;DR: Fully automated startup financing tools often utilize templates designed by and for investors. They claim to save founders money by reducing legal fees, but founders often end up giving 10-20x+ (relative to fees) away in cap table value as a result of the inflexibility and lack of trusted oversight over the “code.” Using vetted and trusted templates, while still incorporating non-conflicted counsel into the negotiation and review process, provides the best of both worlds: common starting points, with flexibility and trust.

Background reading:

“No Code” is a term I’ve been hearing more often lately. It refers to new tools that allow users to “program” various processes without actually having to code them; effectively modules of tools that are interoperable and allow building semi-customized programs without needing to actually get into coding. Very useful.

While “no code” seems to certainly have a good value proposition for many user contexts, it occurred to me recently that “no code” is good short-hand for the startup financing approach that parts of the investor community, and to some extent the tech automation community, has tried to peddle onto startup ecosystems and founders. By pushing the minimization of “friction” in funding (just sign fully automated templates), with the key “carrot” being the reduction in legal fees, these players want founders to think that it’s in their interests to simply close their financings with a few clicks, instead of leveraging lawyers to actually negotiate and flexibly customize the “code” (language).

The reasons behind why tech automation companies would push this perspective are obvious: they want to make money by selling you automation tools. But the reasons why the investor community is incentivized to also back this approach require a bit more explanation. For one example, see: Why Startups Should Avoid YC’s Post-Money SAFE.  First-time founders are what you would call “one shot” players in the startup ecosystem. They are new, inexperienced, and laser-focused on the single company they are building. Investors, including prominent accelerators, are instead repeat players. They are highly experienced, resource-rich, and stand to benefit significantly if they can sway the norms/”standards” of the market in their favor.

The most prominent, high-brand investors have all kinds of microphones and mechanisms for nudging the market in ways to make themselves more money, especially because the founders usually absorbing the content have little experience and knowledge for assessing substance. One of those ways is to push templates that they (the investors) themselves have drafted, and create an impression that those templates are some kind of standard that everyone should adhere to without any customization.  Of course, they’re far too clever to come out and say overtly that these templates are designed to make investors more money, so instead they’ll latch on to more palatable messaging: these templates will save you legal fees and help you close faster.

To summarize, investors and tech automation companies push the “no code” approach to early-stage funding out of self-interest, but they use the “save you legal fees” marketing message to get founders to buy in. The problem that not enough people talk about is that by taking the “no code” approach, founders become permanently stuck with the pre-packaged and inflexible code (contract language) that these players provide. And as I’ve written extensively on this blog, the code is dirty.

I want to emphasize the word permanently here. Look up what most “no code” tools do. They help you sort contacts, build a spreadsheet, maybe build some low-stakes automation processes. Good stuff, but very different from, say, permanently signing contractual terms for millions of dollars that in the long-run can have billion-dollar economic and power implications. In startup funding, we are talking about executing on issues that are literally 1000x more consequential, and un-modifiable once signed, than all the other areas where “no code” approaches are applied.

Having a trusted advisor (lawyer) make even just a few tweaks to a template document, or flexibly choosing a better-fit template to begin with, can have million/billion-dollar implications for a company. Given the enormous stakes involved – what bank account exit money goes into, and who gets ultimate decision-making power over an enterprise – founders need to think very hard about whether getting boxed into an inflexible automation tool, in order to save at most $5-25k in fees in a seed financing, is actually the smart approach. I see inexperienced founders regularly handing over millions in cap table value to investors, and in some instances unwittingly giving those investors strong “choke point” power over their governance, all because the founders were convinced that lawyers are a boogeyman extracting money to just push paper and hand-waive with no value-add.

Notice here that I’m not advocating for a wholesale reversion to the old-school days of simply letting lawyers take full control of the negotiation process, using whatever forms and standards they want. There is enormous value in having market-respected starting points for negotiation; sets of templates known and understood by investors, and trusted by lawyers who represent companies (and not investors), that can then be flexibly modified to arrive at a final deal that makes sense for a specific context. By having your lawyers (who hopefully aren’t conflicted with the investors they’re negotiating with) draft initial deal docs from a reputable template, the lawyers on the investor side can redline against that familiar starting point, instantly reducing the amount of up-front negotiation by 80% because they aren’t working with language (code) they’ve never seen.

What I’m effectively advocating for here is an “open source” approach to high-stakes early-stage startup law. It allows for some standardization (efficiency), but also flexible customization, to ensure every deal is fair for the parties involved. And importantly, it ensures that the templatization and customization is transparent and “open,” with lawyers from both the investor and startup (company-side) community participating; instead of the one-sided “here are the standards” model that certain VCs have tried to adopt. We can deliver founders and investors substantial efficiencies in fundraising, without using “saving fees” as an excuse for burdening founders with inflexibility and “dirty” code (contracts) that simply aren’t justified.

With this in mind, I’ve published a Seed Round Template Library, with links to templates for convertible notes, pre-money SAFEs, seed equity, and full NVCA docs, along with a few educational articles. By using these starting points, founders can have the efficiencies of working from vetted and trusted language, but without the enormous costs of using fully automated templates designed to favor investors.

“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.

Bundled v. Unbundled Startup Capital

TL;DR: The market for early-stage startup financing has reached a level of fragmentation and hyper-competition (among capitalists) never seen before. This competition has led to an increasingly atomized market, with a multitude of players offering different takes on the traditional “bundled” offering of smart venture capital. Startups and founders should understand the reasons behind the marketing narratives pushed by each of these players, so they don’t get too swept up in an overly simplistic strategy for how to raise capital. The best strategy is to diversify your capital sources, while still allowing room for smart leads writing large enough checks to provide real value add.

The world of early-stage startup financing looks extremely different today than it did even 5 years ago, and completely unrecognizable to the market of a decade ago. The reasons are fairly straightforward. Near-zero interest rates and slowing of international economic growth, together with government policies of quantitative easing (which inflate traditional asset prices and make further returns harder to achieve) have produced a surge in the amount of capital seeking any kind of “alpha” in the seemingly “final frontier” of early-stage startups. There is far more money chasing startups than perhaps any time in history.

This surge in early capital naturally produces a surge in competition among early capitalists. In order to navigate that competition, capitalists, just like any other service provider, seek ways to differentiate themselves in the market to avoid appearing too much like a commodity. It’s this need for early capitalists to differentiate themselves that has produced the “atomization” or unbundling of startup finance that is increasingly visible in the market. The point of this post is to help founders and early teams understand that unbundling in assessing their own financing strategies.

To speak of unbundling of course requires first understanding the original bundle. Historically, conventional venture capitalists “sold” the following bundle to startups:

  • Green cash money (obvious)
  • Signal – a brand that credibly signaled “eliteness” to the market (de-risking to an early startup), making it easier to further attract capital, employees, commercial partners, etc.
  • Network – a deep rolodex/LinkedIn network of contacts to leverage in recruiting and expansion
  • Advisory – active involvement on Boards and “coaching” to inexperienced executive teams.

In the very early days of conventional venture capital, VC was very scarce. In many markets there was quite literally one, maybe two funds, who served as gatekeepers to the market; and unhesitatingly used their market dominance to squeeze teams on valuation and corporate governance power. This “asshole” behavior inevitably produced demand for alternatives.

Enter the new “friendly” venture capitalists. Very large VC funds started to break up because the personal brands of high-profile VCs incentivized them to form their own funds with fewer mouths to feed. Growing interest in early-stage also brought in new market entrants. As the VC market evolved from a more oligopolistic structure to an increasingly fragmented and competitive market, the need for differentiation increased. “Friendliness” (or at least the well-calculated appearance of it) became a successful way to achieve that differentiation. You now had VCs actually competing with each other based on their reputation. But the general bundle offered by those VCs largely remained the same.

Another successful form of differentiation in this era involved going deep on “value add” services. Particularly in SV but now also in other markets, VC funds began to hire non-partner staff whose purpose was to, completely apart from providing money and Board service, help CEOs with recruiting, marketing, sales, etc. as a kind of external extension of their internal team. All that extra staff naturally costs money, and increases the overhead structure of the fund, which then increases their pressure to achieve highly outsized returns and avoid overly generous valuations.

So in the initial era of startup funding growth, VCs became “friendlier” (though caveats are worth emphasizing, see Trust, “Friendliness,” and Zero-Sum Startup Games) – and bulkier. But the flood of new capital kept on coming. VCs continued splintering off and forming micro-funds. More entrants arrived. Successful exits produced new, younger teams interested in trying their luck at the VC game. What to do with the VC market becoming even more competitive? Differentiate even further.

Enter accelerators and seed funds, and eventually pre-seed funds. As the true Series A market became increasingly crowded, continued competition among capitalists led many to conclude that the new way to avoid commoditization was to go earlier in the life cycle, closer to the territory once filled exclusively by angels (named as such because of their willingness to take risks once deemed off the table for professional investors). Rather than continuing the game of bulking up and emphasizing the “full package” bundle of traditional VCs, these new institutions sought differentiation by slimming down, and emphasizing their ability and willingness to move fast and early. Those old-school VCs are slow and over-bearing, the marketing content says. They don’t really provide any value-add. Take our cheaper, faster, “friendlier” money instead.

We are now entering a new era where “solo capitalists” are the hot topic. New in some ways, but the same dynamics of market competition and necessary differentiation are quite old. Why take money from a fund at all, when you can just raise from a set of successful solo founders? They’re super friendly, don’t care about a board seat, and will move lightning fast without pestering you with “negotiation” or other trivialities. Their ultra-low overhead also means they can pay higher valuations. And of course they’re enabled by new tech platforms for raising and distributing capital that are very much invested in the increasing atomization of startup capital, which increases demand for technology to coordinate and facilitate that atomization.

In 2020, the market of very early-stage funding for startups now looks like this:

  • Solo angel investors
  • Angel networks
  • Angel “syndicates”
  • Accelerators of various flavors
  • Scout money from “bulky” traditional VCs
  • Pre-seed funds
  • Seed funds
  • Series A funds that invest in seed rounds
  • Solo VCs
  • “Lean” startup lenders

Throw in the reality that geography is hardly a barrier to capital flows now – especially in the COVID era – and the early-stage funding market has reached a level of hyper-fragmentation and competition that was unimaginable a decade ago. Within a particular market, the number of players has shot up dramatically, and now those players are increasingly happy to cross state lines.

This is undeniably a fantastic environment for top-tier teams looking to raise early funding. It’s also undeniably a far more stressful environment to be a startup investor. Ten years ago being a VC meant everyone came to you, very warm intro required, and you called the shots. Now VCs hustle so hard for visibility some are even engaging production studios to help them create polished youtube channels. Others don’t even require intros anymore and have opened their DMs on twitter. There are even jokes about VCs trying to create viral memes to get eyeballs. Life comes at you fast.

The important message for startup teams is to understand why the landscape now looks the way it does, and the incentives behind why any particular type of investor markets itself the way it does. Accelerators, for example, now face far more competition than they did in their golden era, particularly from seed funds with legitimate “value add” offerings. See: Why Accelerators Compete with Smart Money. Because the “bundle” of an accelerator is heavily weighted toward its network and signaling value, accelerators have for some time been incentivized to promote a narrative of “dumbing down” early capital that doesn’t have its own competing network, thus keeping the accelerator’s value proposition somewhat relevant.

Similarly, ultra-lean funds and Solo VCs lack by design the resources of larger funds, and thus they are incentivized to push a narrative that traditional “hands on” VCs don’t really add value. The new lean players don’t have the time or the resources to add value themselves, so best to talk as if that particular part of the traditional bundle isn’t that meaningful anyway.  This all, of course, is easily disproven by the number of founders in the market who credibly testify to the value (in advisory, network, deep long-term pockets) in having a large fund with full skin-in-the-game on your Board and cap table. Some (not all) large funds really do provide significant added value.

And of course, traditional VC funds talk their own books with the exact opposite story. The fragmented lean investors are all spray-and-pray “dumb money” looking for party rounds. Teams need value add from seasoned, steady hands willing to roll up their sleeves on Boards. You need more than atomized money. You need a trusted “partner” to shepherd you toward success.

There is absolutely no need to take sides in all of these narratives. Why should you? Every player in the market offers a grain of truth, but also exaggeration and over-simplification, in what they’re saying. The most important thing is not to get too swept up in moralizing or marketing. Understand what each player is selling, and understand what your particular needs are.

Often times the smartest teams do a bit of “shopping” across various aisles in the new VC supermarket. Team up with a reputable seed fund, but use your optionality to ensure the terms are reasonable. Let them write a large enough check to be emotionally invested, but fill the rest of the round with smaller high-signal checks that will also be motivated to connect you with their networks. For good measure, if you have interest from a traditional Series A VC fund, let them write a small check in your seed round to keep the connection warm when Series A discussions start. The fact that they know how well networked you are (thanks to the other players on your cap table) will ensure good behavior at the Series A term sheet stage.

Contexts will vary and team needs will vary, so the particular mix of early capital any particular startup takes will naturally vary as well. Stay flexible and avoid rigid theories about the (air quotes) “right” way to raise funding. But in all cases, make an effort to diversify your network and capital sources. Nothing ensures good behavior from the money better than making it crystal clear that you are well-networked and happy to take someone else’s check if your current investors don’t play ball. You can do so while still building strong connections with your investors, demonstrating that you value their relationship. This is a great time to be an entrepreneur, whether in or outside of Silicon Valley. In navigating the new early-stage funding market, don’t drink too much of anyone’s kool-aid, and shop wisely.

Crisis, Relationships, and VCs

TL;DR: Startups who resisted building durable relationships with professional institutional investors, and instead pursued the “party round” competitive fundraising mindset promoted heavily by certain SV voices, are going to get a rude awakening in this current crisis. But the same may be true of startups who failed to reasonably diversify their funding options. The easiest money in good times is the first to leave the stadium in scarier times.

In talking with various market players in startup ecosystems, you’ll hear a wide spectrum of philosophies on how early-stage startups should engage with investors, particularly institutional investors (VCs). On one end of the spectrum are, of course, the VCs themselves. Predictably they tend to favor fundraising philosophies that minimize competition between investors, emphasize qualitative over quantitative (valuation, ownership %) variables, and keep the number of players on the cap table low; which improves their leverage and ability to get a bigger piece of the limited pie. Terms like “marriage” “value add” and “partnership” tend to dominate this perspective. We’ll call this “relationship maximalism.”

On the other end of the spectrum are players who might be called “competitive maximalists” as it relates to VC funding. From their perspective, there is so much capital chasing deals, and the true “value add” of institutional investors is minimal, so any smart set of founders will focus on maximizing valuation, and minimizing control given to investors. This often means “party rounds” in which lots of funds write smaller checks with no true lead. This perspective finds its greatest proponents in Silicon Valley, where the largest concentration of capital (and therefore competition among capital) can be found.

It’s important to point out that there are “money players” in the market who, at least historically, have themselves promoted the competitive maximalist view of early-stage fundraising. Prestigious startup accelerators are, effectively, a service provider whose “bundle” of value is in many ways competitive with “smart” relationship-oriented venture capital, which encourages them to promote a narrative that downplays relationship-based fundraising and promotes competitive processes. See: Why Startup Accelerators Compete with Smart Money.

In order to get more control over their pipelines, institutional VCs have moved much earlier-stage in their investing, often writing seed checks for a few hundred K as a way to get a meaningful foot in the door on a promising but very early startup. If you manage to build strong relationships very early on with VCs and “value add” angels whose brand/signal can give you access to a helpful network of talent, resources, and other investors, then your need for an “accelerator” is reduced significantly. The whole point of an accelerator is to make it easier to access talent, money, and other resources. That means your willingness to pay their “fee” of 6-8% of your cap table goes down if you can access that “bundle” via smart money, or other people, that you’ve hustled connections to on your own.

Naturally, those accelerators don’t like that, so they’re incentivized to promote a philosophy that makes founders believe all institutional investors are effectively the same, and that relationship-oriented early-stage VCs who resist competitive fundraising processes and very high valuations are largely blowing smoke. They want to, in the eyes of startups, marginalize a potential substitute (smart VCs with their own networks and value add) and promote a complement (dumb money).

Now how does this all relate to the current environment, in which the COVID-19 market shock has clearly slowed down early-stage funding? The length and intensity of the slow-down is still of course an open question with all the uncertainties around how long quarantines/lock-downs will last, and the fact that many funds are sitting on cash that they still need to deploy; but it is certainly real. How should founders approach VCs? As a venture lawyer who doesn’t represent a single institutional investor – see: Relationships and Power in Startup Ecosystems if you want to understand why – my opinion from experience is that the correct approach for most startups lies somewhere in the middle.

I have seen “party round” culture result in so many blowups that it clearly is reckless and should be avoided. Even some of its most vocal evangelists find themselves back-tracking on the approach as the results play out in the market. But I’ve also seen the extremely negative consequences from becoming too dependent on a single VC or syndicate of closely affiliated VCs, which increases their ability to play power games on Boards and extract value that they otherwise wouldn’t have if the cap table were slightly more competitive.

Relationships matter, and it is unquestionably the case that some institutional investors truly are worth accepting a lower valuation, a larger “lead” check, and giving more control away to, in order to “partner” with them long-term. This is obviously the case in a bear market, but it’s also true in a bull market because even in bull markets no founder team ever knows when a crisis – personal or systemic – will slap them in the face. A VC with a sizable percentage of your cap table has “skin in the game” to help you through a crisis. A party round investor for which you are one of 40 investments is far more likely to sit out a crisis and play it safe.

That being said, you can still build strong relationships with VCs, and give them meaningful skin in the game, without being foolishly over-dependent on them. It is wise, if you have options, to include on your cap table a sufficient diversity of un-affiliated investors such that if one group becomes unreasonably “uppity” you have other supporters to turn to. Too much optionality turns into a party round, but some optionality is wise and valuable.

Clearly the startups that will have the easiest time in this crisis, however long it lasts, are those with enough cash in the bank to weather the storm. But for those who will need to enter the fundraising market in the next 3-6 months, without a doubt the competitive maximalists who’ve filled their cap tables with lots of small checks, and refused to let anyone participate in governance and build a relationship with the executive team, are going to be in for a rude awakening. They’re going to learn the hard way how “easy come, easy go” applies to early-stage fundraising.

Build meaningful, durable relationships with professional investors with the character and resources that can provide valuable insurance when an unpredictable crisis hits. Just ensure you’re well-advised throughout the process, so the “relationship” develops in a way that is balanced, and your company isn’t over-exposed.