Post Category → Board of Directors

Negotiation and Inexperience

TL;DR: Having access to trusted advisors, and the time to consult with them, is essential for anyone negotiating terms with which they have very little experience. Don’t accept someone’s argument that you must negotiate important issues live. It’s simply untrue, and a tactic for gaining unfair leverage.

Background Reading:

A recurring theme of SHL posts is that entrepreneurs, particularly first-time entrepreneurs, need to be extremely mindful of the imbalance of experience between themselves and the many sophisticated, repeat players they’re going to be negotiating with as they build their companies. It’s obviously common for entrepreneurial personalities to be more comfortable (than most) with risk, and to go head-first into negotiations and activities without proper backup. But for really big, irreversible decisions, it will backfire, and others will happily use it against you.

One of the most overused phrases for getting naive negotiators to give in on issues they should push back on is “this is standard.” When you have no historical or market perspective – what’s normal, what’s fair, what are the risks, how will this play out in 5 years? – you can be easily manipulated into all kinds of bad outcomes. I’ve been at more than my fair share of board meetings or negotiations where someone at the table makes a completely biased, nonsensical claim that something is “standard,” at which point I’ve had to step in to set things straight, and gladly offer up data or a quick market survey.

There are two main things that I tell all companies to focus on in this regard:

  1. Have a group of experienced, trusted advisors that you can quickly communicate with on serious issues.
  2. Do not let yourself be bullied into a setting where your inexperience puts you at a substantial disadvantage.

Trusted Advisors

When I speak of trusted advisors, I’m not referring necessarily just to your Company’s “advisory board,” which serves a broader purpose of helping you on long-term strategic, business, and technological issues. I’m referring to people you can call or e-mail for specific, tactical guidance on more pressing matters; your “inner circle.” Seasoned entrepreneurs, mentors from accelerators, lawyers (who are independent from your lead VCs), and trustworthy angel investors often make up this group for most CEOs I work with. The most important thing is that they (i) have visibility into the broader market, to help you actually understand what is acceptable, and (ii) will be direct and honest with you when you most need them to.

Imbalanced Negotiation Settings

While it is far less common in the tech world than in other areas, you occasionally still encounter people (particularly VCs) who insist that the only appropriate way to “really” negotiate is live, and in person. And let me tell you: this is bullshit.

Of course, live discussion is important for communication and relationship-building; it has its place. But more often than not, attempts to force entrepreneurs and company executives to negotiate key issues live, or under a very tight deadline, is a tactic to gain unfair leverage from their inexperience. Of course the guy who’s done this type of deal 30 times wants you to agree to terms live, face to face, away from your set of advisors. It has zero to do with business norms. Plenty of high-stakes deals are negotiated asynchronously. 

How you push back and (respectfully) assert yourself in negotiations with other business parties will set the tone for your long-term relationship. If you allow them to force you into circumstances that favor them, they will do it indefinitely. There is nothing wrong with responding, diplomatically, that while you of course would love to grab beers and meet up in person for more casual matters, for real business, you expect time to consult with advisors.

If you’re working with people whom you should want to build long-term relationships with, they will respect your request.  In fact, I’ve known some great VCs and other business people who are very upfront about the experience imbalance with new entrepreneurs, and insist that companies work closely with key advisors.  Those are people playing a long game, and who know that their reputation in the market matters more than short-term opportunism.

If the person you’re negotiating with rejects your request, and dictates to you the medium of negotiation, then at a minimum you’ve gained some key information on what the relationship is going to really look like if you choose to move forward.

Common Stock v. Preferred Stock

TL;DR: Beyond the technical differences between Preferred Stock and Common Stock, there are deeper differences in their composition, incentives, and risk exposure that play out in the course of a company’s history. Understanding the tension between those differences is important.

Very quick vocabulary lesson:

Common Stock is the default equity security of a corporation. It’s what founders, employees, advisors, and other service providers get.

Preferred Stock (Series A, Series B, etc.) is “preferred” because it has extra privileges / rights layered on top of it relative to the Common Stock, including a liquidation preference, rights to block certain things, etc. Preferred Stockholders are almost always investors.

Why don’t investors (usually) buy Common Stock? Short answer: why be common when you can be “preferred”?

Longer answer: they want the downside protection that a liquidation preference provides (they get their money back before anyone else), and they want various contractual privileges that separate them from the “common” holders; like the right to elect certain directors. Also, another argument often made is that by having investors buy Preferred Stock, the “strike price” of options (which buy common stock) used as service compensation can be lower (when a valuation occurs). The logic is that common stock at the time is less valuable due to its lower rights and status on the liquidation waterfall.

So if your investors pay $1 for Preferred Stock with a liquidation preference and other rights, you can still issue your employees options at 20 cents per share (or whatever your valuation reflects) without busting tax/equity compensation rules. The options are for Common Stock, which lacks the bells and whistles of Preferred Stock, and therefore the “fair market value” exercise price is lower. If the investors had paid $1 for Common Stock, your employee options would’ve been much more expensive.

Interesting corporate law factoid: between the Common Stock (founders, employees, etc.) and the Preferred Stock (investors), which group does the Board of Directors owe greater fiduciary duties to in the event of a conflict?

Answer: the Common Stock. And yes, that means even the directors elected by preferred stockholders, even if the director is a VC. Ask your corporate lawyer if you don’t believe me. The Delaware case law is pretty clear.  All the more reason to avoid “captive” company counsel, to help the Board actually do its job.

Kind of ironic. The investors get “Preferred” stock, but the Board is actually legally required to “prefer” (in a way) the Common Stock.

Apart from the technical differences between Common Stock and Preferred Stock, it’s important to keep in mind the different characteristics of the people who make up the two groups.

A. Common Stockholders are much less “diversified” than Preferred Stockholders. This is their “one shot.” 

As I wrote in Not Building a Unicorn, venture capitalists and founders/management often have very different incentives when it comes to setting out a growth and exit strategy for a company; especially when the VCs are the type that look for “unicorns” (larger funds).

Most startup investors (preferred stockholders) have a portfolio of investments. If a few go bust, their hope is to more than make up for it with a grand slam from another. For a less diversified common stockholder, like a first time founder: going bust is really going bust.

Imagine, for simplicity, you have 2 potential growth/exit strategies: Option A and Option B. Option A has a 50% chance of success, and would result in the Company exiting at a $80MM valuation. Option B has a 10% chance of success, but would result in a $1B exit.

Now imagine a portfolio of 10 companies, each with an Option A and an Option B. The Preferred Stock are invested in all 10 of those companies, but the Common Stock are exclusive to each company.

Do you think the Common Stock and Preferred Stock are always going to see eye to eye on which option to take? Hell no. With downside protection (liquidation preference) and diversification, preferred stockholders are far more incentivized to take much bigger risks than common stockholders are.

The Common Stock v. Preferred Stock divide is very real, and that matters from a corporate governance perspective.

B. Common Stockholders are typically less “sophisticated,” and don’t have their own lawyers. 

Part of the idea of fiduciary duties is that someone more sophisticated, informed, or influential is given responsibility to look out for the best interests of someone who is less sophisticated, informed, and influential. That’s why the Board of Directors, which has the most power in the corporation, has fiduciary duties to all the smaller stockholders who can’t see everything that’s going on.

Naturally, because many institutional investors are diversified, they are by definition “repeat players,” which makes them more sophisticated at the complexities of financing, corporate governance, etc. In negotiating transactions with the Company (like financings), they also often have their own lawyers to negotiate directly on their behalf.

Common Stockholders rarely involve their own lawyers when they are getting their equity from the Company. They rely much more on the norms of how the Company treats all of its equity recipients. And, frankly, they just have to trust that they will be treated fairly.

It’s worth noting that, at least in this regard, individual angels are a lot more like common stockholders than institutional venture capitalists. They too often sign standardized docs, with little negotiation or personal lawyer involvement, and they also often don’t have visibility into Board decisions. They are usually more trust driven in their dealings with their investments. This is why founders will often feel more “aligned” with angels than with VCs. That’s because they are usually more aligned.

Even founders, with much bigger stakes than a typical employee, often do not involve personal lawyers in dealings with the Company; not until the later stages when the cap table and board composition are very different. They rely much more on company counsel to advise on what’s best for the Company as a whole, which indirectly means what’s best for the common stock.

In short: Common Stockholders, broadly, (i) are less diversified, and therefore more exposed to risk in this specific company, (ii) have less downside protection, (iii) are less wealthy and sophisticated, and (iv) usually don’t have their own lawyers to review and negotiate things on their behalf. This is, to a large degree, why the case law puts such an emphasis on fiduciary duties to common stockholders.  Because the bigger Preferred Stock players can negotiate contractually for their rights and protections, Corporate Law says officers and directors should focus on what’s best for the Company as a whole, with special care toward the interests of the common stock.

ps: should Company Counsel own equity in the Company? Usually they don’t, but sometimes they do. After reading the above, it should be crystal clear what type of security they should own, and why letting your lawyers buy preferred stock can, in many circumstances, be a very bad idea.

Do my startup’s lawyers need to be local?

TL;DR: No. Most top startup lawyers have clients in many different cities, and lawyers specializing in emerging tech/startup work usually exist only in denser tech ecosystems. Familiarity with your ecosystem, and the expectations of its participants, matters more than being physically local.

Background Reading:

If you live in a small town/city and need specialized (not general practice) medical care, you most likely need to look to a larger city to find that specialist. Any kind of service provider needs some minimal user base to build a viable practice. Larger cities have a higher concentration of patients, and therefore a higher number of patients needing a particular specialty, which is what enables the development of specialist doctors.

This is why cardiologists generally don’t live in farm towns, at least not during their working-week. They live in larger cities. And neonatal cardiologists (even more narrowly specialized) generally only live in the very largest cities.

For localized work, specialization requires density.

It’s also why true startup lawyers – corporate lawyers with a focused practice in emerging tech and venture-backed companies – generally exist only in cities with dense startup ecosystems. Even with modern technology that enables casting a wider net for your market reach, most professionals rely significantly on a local client base. If that local base doesn’t exist, they move to where one does, or they change their practice to mirror the local market. Houston has among the world’s top energy lawyers, but slim pickings for technology/vc lawyers. Boston has among the world’s top healthcare lawyers, but slim pickings for entertainment lawyers (many of which are in Los Angeles). No surprises there.

So to the extent work has a heavily local component (like healthcare, and to a lesser extent law), if you need a particular kind of specialized service, you are smart to look for it in places that have a real density of users for that service. Otherwise you will end up with sub-par local providers, which can be fine if the stakes are low, but disastrous when they aren’t.

Startup Law really isn’t that localized.

It may come as a surprise to people that, for a significant portion of my client base, I have never met the principals in person; and likely never will. Videoconferencing and teleconferencing serve just fine (in addition to other tech tools). That is actually the case for a lot of lawyers with specialized practices. Most serious startup/VC lawyers that I know have clients in multiple cities. In my case, about half of my clients are in Austin (reflecting the need for a dense local base to usually build a specialized practice), and the other half are not (confirming that being local isn’t required at all).

Unlike a cardiologist, I don’t need to physically examine anyone to do my job, which makes geography largely irrelevant. Because most startups generally incorporate in Delaware for reasons discussed throughout the startup blogosphere, local state law only plays a small role in most of the legal issues that startups deal with (usually local employment law); and for those issues, most startup lawyers collaborate with local employment lawyers. The corporate issues generally require very little understanding of local state law. I have quite a few clients with lawyers in half a dozen different cities, none of which are the city where the company is headquartered. And it works just fine.

More important than truly local lawyers is lawyers who are familiar with working in ecosystems that look like your own. The norms of Silicon Valley financing and governance are very different from those of Denver and Atlanta, as an example; both what some would call “2nd tier” ecosystems.  But a Denver lawyer would be quite comfortable with Austin norms, and visa versa.

Local v. foreign specialized lawyers is about tradeoffs.

Silicon valley startups generally use silicon valley startup lawyers. Austin startups generally use Austin startup lawyers. And in both cases, that works very well, because there isn’t a cost to ‘going local.’ Being able to meet up once in a while in person with your service providers is obviously nice from a relationship standpoint. There is some benefit also to your investors being familiar with company counsel, although that issue is usually exaggerated for reasons that I’ll discuss more below.

So if you can get the nice benefits of having someone local, without many costs, going local is usually a good idea as long as you can find someone local who isn’t captive to local investor interests. And sometimes you can’t. See: “How to avoid ‘captive’ company counsel.” There is no set of advisors for whom a founder/management team should care more about their independence than company counsel.

For startups with less dense ecosystems than Silicon Valley or Austin, however, the cost to going local can be much higher. The reason VC or Angel-backed startups in Houston, San Antonio, Dallas, Atlanta, Miami, New Orleans, Phoenix, Salt Lake City, and similar cities often hire startup lawyers who aren’t local is that they (correctly) recognize that their local ecosystems (generally) lack the density to support truly specialized, scalable startup/vc law practices. Each of those cities has fantastic, very smart corporate lawyers who likely have some tech clients, but startup/vc law as a specialization is more difficult to find; although there are exceptions.

My non-Austin clients have concluded that it’s much better, and more efficient, to collaborate with lawyers in another city who’ve seen the exact issues they’re dealing with dozens of times, and have the resources to address them quickly, relative to someone who may be easier to grab beers with, but hasn’t. CEOs need to exercise their own judgment for their own circumstances.

Be careful with localism, and localist incentives.

“Localism” is a term I’ve started using to refer to the underlying, subtle incentives among ecosystem players that push them to promote local people onto a set of founders, sometimes at a very high cost to the company; discussed in the links at the beginning of this post. Ask any experienced founder, and they’ll tell you about so-called “advisors” or “mentors” in their local ecosystem who, while fun to hang around as cheerleaders, unfortunately don’t actually deliver much real advice or mentorship. There are some great advisors/mentors out there, but also a lot of duds.

There are, broadly speaking, 2 ways (not mutually exclusive) in which service providers (venture capitalists, lawyers, accelerators, accountants, advisors, etc.) build their portfolios: (A) being actually good (objectively) at their service, and (B) building relationships and generating referrals from those relationships. Most A-level people rely on both (because the first leads to the second).  But there are a whole lot of people in every business community who are quite mediocre at the actual service they provide, but are exceptional at marketing themselves and building referrals.

If my social capital is the primary way that I get business, then I’m heavily incentivized to refer to people within my personal, local social circle, even if I know that objectively, someone better may be in another city. That “someone better in the other city” has his own social circles she/he belongs to that aren’t as inter-connected (or dependent) on my own. Sending business to them makes it less likely that it’ll come back to me, unless there’s some objective reason for the referral.

I don’t mean to sound cynical about all of this. It is how a lot of good people build their practices and reputations in the business world, and it’s just fine. But it’s important for every team to to be aware of these dynamics in their raw form, and correct for them as needed. And believe me I get the “farmers market” “go local” “support the LOCAL ecosystem” aspects of promoting local people as well, even if I believe the more self-interested dynamics underly a lot of that; at least as it relates to service providers. 

There’s something noble in that, but not when it comes at the expense of founders – who are putting their entire livelihoods on the line – getting shit service. As I’ve written before, nothing builds an ecosystem more than great companies, and great companies aren’t built with mediocre people. 

Watch out for ‘captive’ local counsel.

Circling back quickly to the issue of captive company counsel is a good place to close this out. For many people in startup ecosystems, localism is driven either by self-interested referral circles, or ecosystem cheerleading.  But for the most influential players in a particular ecosystem, it can also be driven by control. Thankfully the transparency of the web is weakening this dynamic, but institutional investors with heavy local influence often like to see local VC lawyers in the company counsel seat because they’ve strategically built leverage over those lawyers by (i) being their clients, and/or (ii) pushing portfolio companies to use them as company counsel. In other words, they’re company counsel, but… not really. 

Obviously you’ll never hear anything like this stated flat out in a board meeting. What you’ll more often hear is discussion about credentials, or familiarity, or experience, etc. etc. “I’m not sure those lawyers have the right experience” or “We’re more comfortable with these guys.” As I’ve written before, sometimes those concerns have merit. Take them seriously, and if you need to upgrade, go through the process yourself to find independent counsel. But also understand how these comments are usually veiled attempts at pushing companies to engage lawyers who are captive to the investors’ interests, and unable to fully represent the company.  If your lead investors seem peculiarly interested in your using a particular set of lawyers, that’s often a good indication of whom you should avoid.

Yes, there’s some reduction of “friction” when company counsel is familiar with the norms/expectations of investors across the table. But its value shouldn’t be overstated. Sometimes what investors call “friction” is just your lawyers doing their damn job. In this regard, we have seen companies from smaller ecosystems choose to engage foreign company counsel not because local VC specialists weren’t available, but because the founder team viewed them all as captive. Sometimes (but not always) they are right. 

There’s no right answer for all companies on this issue. Specialization is important. Local can be helpful at times, but also costly in specific circumstances. But you’ll arrive at a much better decision by weighing all the variables, instead of just assuming that “going local” is a requirement. It most certainly is not.