Post Category → Convertible Notes

Startup Legal Fee Cost Containment (Safely)

Given the COVID-19 crisis, every startup (every company really) is laser-focused on cost-containment. The below are some guidelines for getting legal work done efficiently, without relying on low-quality providers who will ultimately cost you far more in the long-run because of mistakes and missteps.

Related reading: Lies About Startup Legal Fees

1. Consider working with experienced, specialized lawyers in lower-cost geographies.

Bay Area and NYC lawyers have the highest rates, for obvious reasons like that the cost of living in those cities is much higher, and the firms in those markets tend to cater to unicorns with very large, multi-national transactions requiring extremely high-cost infrastructure. While it’s already been happening for years, I suspect more startups are going to realize that ECVC (Startup) lawyers in places like Seattle, Austin, and Denver have just as much visibility and specialization, but have rates that are more accessible.

In case it hasn’t already been made clear, there is nothing about corporate/securities legal work that requires you to meet in person with your legal team. You can usually shave a few hundred dollars per hour off your bills by simply using lawyers in smaller tech markets who still have the right experience.

2. Ensure your lawyers have the right specialization, and precedent/template resources for minimizing time burn.

While parts of the ecosystem have exaggerated the extent to which a “standard” startup financing really exists – stay away from un-modified Post-Money SAFEs – every serious Startup/VC lawyer has precedent and template forms they can use as starting points to avoid reinventing the wheel. A “Corporate Lawyer” is not good enough here. There are corporate lawyers who specialize in healthcare, energy, and other industries that will have no clue about ECVC norms. Read their bio, talk to clients, and/or ask about their deal experience. “Emerging Companies” and “Venture Capital” are key words to look for, unless you’re talking about an M&A deal, in which case obviously you want an M&A lawyer.

3. Unless you really are on a hyper-growth unicorn track, use boutiques instead of BigLaw.

“BigLaw” refers to the largest, multi-national law firms in the country; often with armies of staff and resources designed for the most complex and largest deals in the market. For the vast majority of the startup ecosystem, these firms are overkill. I’ve closed countless VC and M&A deals where the Partner on our side was $300-600 per hour leaner than the Partner on the other side of the table, and their bios were virtually indistinguishable.

Using a high-end boutique can dramatically lower your overall legal costs. The key issue is assessing the background/expertise of the boutique firm’s lawyers to ensure the drop in rates isn’t resulting in a drop in quality. Top-tier boutiques achieve their efficiency by eliminating infrastructure (overhead) that non-unicorn clients don’t need; not by recruiting B-player lawyers.

4. Leverage non-Partner staff (paralegals, junior and mid-level attorneys).

Some startups think they’re going to save fees by hiring a highly-seasoned solo lawyer, but this can backfire, because that solo doesn’t have any lower-cost staff. Maybe 10-30% of the legal work a typical VC-backed startup needs will require true Partner-level attention. The rest can be safely and far more efficiently handled by well-trained and monitored lower-level staff (paralegals, and non-Partner attorneys). You want a firm that has these resources available, while still having an accessible Partner that you can go to for the most high-level strategic issues.

Having a single lawyer with 10-20 years of experience do all of your legal work is like expecting a cardiologist to take your temperature, collect your insurance info, and treat your toddler for their sniffles. It’s inefficient and unnecessary.

5. For financings, opt for “simplified” deal structures if feasible.

I suspect that during the worst of the COVID-19 crisis, you’re going to see a lot more investors opting for convertible notes, because they’ll value the downside (debt) protection in case the outlook doesn’t improve in the mid-term. Convertible notes are also far simpler (lower cost) to negotiate and close than an equity round.

This is fine, and convertible notes are used hundreds/thousands of times across the country every year without problems. Just ensure you are working with specialized counsel who knows what to accept, and what to reject, in the terms. Maturity, conversion cap economics, and what happens in a down-round scenario are all key things they’ll need to pay close attention to.

If you’re able to convince investors to do an equity round, and it’s less than $2 million in total investment, you might consider a “seed equity” structure. Seed equity docs are much simpler than the classic NVCA-style VC docs, and are about 75% cheaper to close on, in terms of legal fees. They can include a provision that will allow your investors to get more robust “full” VC rights in a future round.

“Cost cutting” tips that don’t work

A. Solo lawyers won’t save you money. As mentioned above, using solo lawyers for corporate/securities (deal) work rarely results in that much efficiency. While the solo’s rates might be lower than a firm’s, the savings will be burned up by the absence of paralegals/lower-level attorneys. You also risk running into serious bottlenecks that will slow-down urgently needed work, because solos don’t have a team to help triage projects. See: Startups Scale. Solo Lawyer’s Don’t.

B. Fixed fees are more likely to result in mistakes/weak counsel than cost-saving. Fixed fees aren’t magical. Ultimately a firm has to charge a fee that aligns with what it costs to do the deal, and using a fixed fee won’t change that. But the real danger with fixed fees is that they incentivize lawyers to cut corners, because by rushing work (not negotiating/reviewing), the lawyers make more money. Ask for budget ranges, and you can talk with other founders to ensure the cost is aligned with what’s been delivered. See: The Race to the Bottom in Startup Law.

C. DIY work with fully-automated tools or templates found online will blow up in your face. Are you building a plumbing business or coffee shop? Great. Go use one of those $39.99 automated templates you can find online. Investor-backed startups are not cookie-cutter companies, and thinking you’re actually going to save money by using a fully automated template is delusional. You’re simply turning on a time bomb in your legal history that will eventually go off.

D. Do not let junior lawyers run your legal work. A huge mistake startups often make is hiring BigLaw (very high-cost firm) but thinking that by using a junior lawyer for virtually everything, they’re saving money. You do not want a junior negotiating your financing, or giving you high-stakes advice. They are great for doing checklist-oriented tasks while a Partner oversees things and interacts with the client, but not as the main legal contact. Their inexperience will cost you 10x in the long-run of whatever you think you’re saving today. If you’re struggling to cover BigLaw’s rates, the answer is to use a high-end boutique where you can still access senior lawyers but at leaner rates; not to use the most inexperienced person on BigLaw’s payroll.

There are a lot of good strategies for getting lean, but still high-quality legal counsel. The key thing is to ensure you are trimming fat from your legal budget, but not muscle.

A Convertible Note Template for Startup Seed Rounds

TL;DR: We’ve created a publicly downloadable template for a seed convertible note (with useful footnotes), based on the template we’ve used hundreds of times in seed convertible note deals across the U.S. (outside of California). It can be downloaded here.

Note: If you’d like to discuss this template or Notes generally, try Office Hours.

Additional Note: this post references a pre-money valuation capped convertible note. For a post-money valuation capped note, see here.

Background reading:

I’ve written several posts on structuring seed rounds, and how for seed rounds on the smaller side ($250K-$1MM) convertible notes are by far the dominant instrument that we see across the country. When SAFEs had pre-money valuation caps, they gained quite a bit of traction in Silicon Valley and pockets of other markets, but outside of SV convertible notes were still the dominant convertible instrument. Now that YC has revised the SAFE to have harsher post-money valuation economics (see above linked post), we’re seeing SAFE utilization drop significantly, though it was never close to the “standard” to begin with; at least not outside of California. For most seed companies, convertible notes and equity are the main options. 

For rounds above $1-1.5MM+, equity (particularly seed equity) should be given strong consideration. We are also seeing more founders and investors who really prefer equity opting for seed equity docs for rounds as low as $500K. The point of this post isn’t to get into the nuances of convertibles v. equity. There’s a lot of literature out there on the topic, including here on SHL.

What this post is really about is that many people have written to me regarding the absence of a useable public convertible note template that lawyers and startups can leverage for seed deals; particularly startups outside of SV, which has very different norms and investor expectations from other markets.

Cooley actually has a solid convertible note available on their Cooley GO document generator. I’m a fan of Cooley GO. It has strong content. But as many readers know, there are inherent limitations to these automated doc generator tools; many of which law firms utilize more for marketing reasons (a kind of techie signaling) than actual day-to-day practical value for real clients closing real deals. Your seed docs often set the terms for issuing as much as 10-30% of your company’s capitalization, and the terms of your long-term relationship with your earliest supporters. Take the details seriously, and take advantage of the ability to flexibly modify things when it’s warranted.

The “move fast and mindlessly sign a template” approach has for some time been peddled by pockets of very clever and vocal investors, who know that pushing for speed is the easiest way to take advantage of inexperienced founders who don’t know what questions to ask. But the smartest teams always slow down enough to work with trusted advisors who can ensure the deal that gets signed makes sense for the context, and that the team really knows what they’re getting into. Taking that time can easily pay off 10-20x+ in terms of the improved cap table or governance position you get from a little tweaking. The investor trying to rush your deal isn’t really trying to save you legal fees. They’re trying to save themselves from having to negotiate, or justify the “asks” in their docs.

As a firm focused on smaller ecosystems that typically don’t get nearly as much air time in startup financing discussions as SV, I realized we’re well-positioned to offer non-SV founders a useful template for convertible notes. The fact that, to avoid conflicts of interest, we also don’t represent Tech VCs (trust me, many have asked, but it’s a hard policy) also allows us to speak with a somewhat unique level of impartiality on what companies should be accepting for their seed note deals. There are a lot of players in the startup ecosystem that love to use their microphones to push X or Y (air quotes) “standard” for startup financings, but more often than not their deep ties to certain investors should raise doubts among founders as to biases in their perspective. We’ve drafted this template from the perspective of independent company counsel. 

So here it is: A Convertible Note Template for Seed Rounds, with some useful footnotes for ways to flexibly tweak the note within deal norms. Publicly available for download.

A few additional, important points to keep in mind in using this note:

First, make sure that the lawyer(s) you are working with have deep (senior) experience in this area of law (emerging companies and vc, not just general corporate lawyers), and don’t have conflicts of interest with the people sitting across the table offering you money. When investors “recommend” a specific law firm they are “familiar” with they’re often trying to strip startup teams of crucial strategic advice. See: Checklist for Choosing a Startup Lawyer. Be very careful with firms that push this kind of work to paralegals or juniors, who inevitably work off of an inflexible script and won’t be able to tailor things for the context. You want experienced, trustworthy specialists; not shills or novices.

Second, be mature about maturity. You’re asking people to hand you money in a period of enormous uncertainty and risk, while getting very little protection upfront. As long as maturity is long enough to give you sufficient time to make things happen (2-3 yrs is what we are seeing), you shouldn’t run away from the most basic of accountability measures in your deal. Think about how bad of a signal it sends to investors if a 3 year deadline terrifies you.

Third, do not for a second think that, because you have a template in your hand, it somehow means you no longer need experienced advisors, like lawyers, to close on it. Template contracts don’t remove the need for lawyers any more than GitHub removes the need for developers. The template is a starting point, and the real expertise is in knowing which template to start from, and how to work with it for the unique context and parties involved. Experienced Startup Lawyers are incredibly useful “equalizers” when first-time entrepreneurs are negotiating with experienced money players. Don’t get played.

Fourth, pay very close attention to how the valuation cap works, particularly the denominator used for ultimately calculating the share price. We are seeing more openness among investors to “hardening” the denominator at closing, either with an actual capitalization number, or by clarifying that any changes to the option pool in a Series A won’t be included. These modifications make notes behave more like equity from a dilution standpoint, allowing more clarity around how much of the company is being given to the seed money.

Finally, don’t try to force this template on unwilling investors. It can irritate seasoned investors to no end to hear that they must use X template for a deal because some blog post, lawyer, or accelerator said so. There is no single “standard” for a seed round. There never has been, and never will be, because different companies are raising in different contexts with investors who have different priorities and expectations. We’ve used this form hundreds of times across the country, but that doesn’t mean there aren’t other perfectly reasonable ways to do seed deals.

Have a dialogue with your lead money, and use that dialogue to set expectations. See: Negotiation is Relationship Building. If they’re comfortable using this template, great. If they need a little extra language here or there, don’t make a huge fuss about it if your own advisors say it’s OK. And if they prefer another structure, like seed equity or even more robust equity docs, plenty of companies do that for their seed round and it goes perfectly fine, as long as you have experienced people monitoring the details.

If any experienced lawyers out there see areas of improvement for the template, feel free to ping me via e-mail.

Obligatory disclaimer: This template is being provided as an educational resource, and is intended to be utilized by experienced legal counsel with a full understanding of the context in which the template is being used. I am not responsible at all for the consequences of your utilization of this template. Good luck.

Why Startups shouldn’t use YC’s Post-Money SAFE

TL;DR: If you’re going to use it, you should make some slight (but material) tweaks. It otherwise gives your seed investors a level of extreme anti-dilution protection that is virtually unheard of (circa 2019) in startup finance, making it worse than seed equity and conventional convertible notes (or pre-money SAFEs) in terms of economics for most seed stage companies; which is of course why investors love it. There are far better, more balanced ways to “clarify” ownership for seed investors without forcing founders and employees to absorb additional dilution risk. YC has done a “180” in moving from the pre-money SAFE (very company friendly) to the post-money SAFE (extremely seed investor friendly).

Post-Publishing Updates:

  • After requests from a number of readers, I’ve posted a template convertible note based on the template we’ve used hundreds of times across the country. See: A Convertible Note Template for Seed Rounds.
  • We posted a google sheets model comparing the economics of a pre-money SAFE, YC post-money SAFE, and a redlined post-money SAFE that corrects the above-discussed anti-dilution problem in YC’s template. A corrected post-money SAFE is actually a great instrument for companies/founders, even if YC’s post-money safe is heavily investor-biased. See: A Fix for Post-Money SAFEs: The Math and a Redline

A regular underlying theme you’ll read on SHL is that key players in the startup community are incredibly talented at taking a viewpoint that is clearly (to experienced players) investor-biased, but spinning / marketing it as somehow “startup friendly.”  And lawyers captive to the interests of investors are always happy to play along, knowing that inexperienced teams can be easily duped.

One example is how “moving fast” in startup financing negotiations is always a good thing for entrepreneurs. Investors are diversified, wealthy, and 100x as experienced as founders in deal terms and economics, but it’s somehow in the founders’ interest to sign whatever template the investor puts on the table, instead of actually reviewing, negotiating, and processing the long-term implications? Right.

Y Combinator’s move to have its SAFEs convert on a post-money, instead of pre-money, basis is another great example. Their argument is that it helps “clarify” how the SAFEs will convert on the cap table. Clarity is great, right? Who can argue with clarity?

What’s not emphasized prominently enough is that the way they delivered that “clarity” is by implementing anti-dilution protection for SAFE investors (like themselves) that is more aggressive than anything remotely “standard” in the industry; and that wasn’t necessary at all to provide “clarity.” Under YC’s new SAFE, the common stock absorbs all dilution from any subsequent SAFE or convertible note rounds until an equity round, while SAFE holders are fully protected from that dilution. That is crazy. It’s the equivalent of “full ratchet” anti-dilution, which has become almost non-existent in startup finance because of how company unfriendly it is. In fact, it’s worse than full ratchet because in a typical anti-dilution context it only triggers if the valuation is lower. In this case, SAFE holders get fully protected for convertible dilution even if the valuation cap is higher. It’s a cap table grab that in a significant number of contexts won’t be made up for by other more minor changes to the SAFE (around pro-rata rights and option pool treatment) if a company ends up doing multiple convertible rounds.

When you’re raising your initial seed money, you have absolutely no idea what the future might hold. The notion that you can predict at your initial SAFE closing whether you’ll be able to raise an equity round as your next funding (in order to convert your SAFEs), or instead need another convertible round (in which case your SAFE holders are fully protected from dilution), is absurd. Honest advisors and investors will admit it. Given the dynamics of most seed stage startups, YC’s post-money SAFE therefore offers the worst economics (for companies) of all seed funding structures. Founders should instead opt for a structure that doesn’t penalize them, with dilution, for being unable to predict the future.

Yes, YC’s original (pre-money) SAFE has contributed to a problem for many SAFE investors, but that problem is the result of an imbalanced lack of accountability in the original SAFE structure; not a need to re-do conversion economics. As mentioned in the above TechCrunch article, the reason convertible notes are still the dominant convertible seed instrument across the country is that the maturity date in a convertible note serves as a valuable “accountability” mechanism in a seed financing. A 2-3 year maturity gives founders a sense of urgency to get to a conversion event, or at least stay in communication with investors about their financing plans. By eliminating maturity, SAFEs enabled a culture of runaway serial seed financings constantly delaying conversion, creating significant uncertainty for seed investors.

YC now wants to “fix” the problem they themselves enabled, but the “solution” goes too far in the opposite direction by requiring the common stock (founders and early employees) to absorb an inordinate amount of dilution risk. If “clarity” around conversion economics is really the concern of seed investors, there are already several far more balanced options for delivering that clarity:

Seed Equity – Series Seed templates already exist that are dramatically more streamlined than full Series A docs, but solidify ownership for seed investors on Day 1, with normal weighted average (not full ratchet) anti-dilution. 100% clarity on ownership. Closing a seed equity deal is usually a quarter to a third of the cost of a Series A, because the docs are simpler. Seed equity is an under-appreciated way to align the common stock and seed investors in terms of post-funding dilution. Yes, it takes a bit more time than just signing a template SAFE, but it’s an increasingly popular option both among entrepreneurs (because it reduces dilution) and investors (because it provides certainty); and for good reason.

See also: Myths and Lies about Seed Equity to better understand the false arguments often made by investors to push founders away from seed equity as a financing structure.

Harden the denominator – Another option I’ve mentioned before in Why Notes and SAFEs are Extra Dilutive is to simply “harden” the denominator (the capitalization) that will be used for conversion on Day 1, while letting the valuation float (typically capped). This ensures everyone (common and investors) are diluted by subsequent investors, just like an equity round, while allowing you to easily model conversion at a valuation cap from Day 1. If the real motivation for the SAFE changes was in fact the ability to more easily model SAFE ownership on the cap table – instead of shifting economics in favor of investors – this (hardening the conversion denominator) would’ve been a far more logical approach than building significant anti-dilution mechanisms into the valuation cap.

See “Fixing” Convertible Note and SAFE Economics for a better understanding of how hardening the denominator in a note or SAFE valuation cap gives the “best of both worlds” between convertibles and equity rounds.

Add a Maturity Date – Again, the reason why, outside of Silicon Valley, so many seed investors balk at the SAFE structure altogether is because of the complete lack of accountability mechanisms it contains. No voting rights or board seat. No maturity date. Just hand over your money, and hope for the best. I don’t represent a single tech investor – all companies – and yet I agree that SAFEs created more problems than they solved. Convertible notes with reasonable maturity dates (2-3 years) are a simple way for investors and entrepreneurs to get aligned on seed fundraising plans, and if after an initial seed round the company needs to raise a second seed and extend maturity, it forces a valuable conversation with investors so everyone can get aligned.

Conventional convertible notes – which are far more of an (air quotes) “standard” across the country than any SAFE structure – don’t protect the noteholders from all dilution that happens before an equity round. That leaves flexibility for additional note fundraising (which very often happens, at improved valuations) before maturity, with the noteholders sharing in that dilution. If a client asks me whether they should take a low-interest capped convertible note with a 3-yr maturity v. a capped Post-Money SAFE for their first seed raise, my answer will be the convertible note. Every time, unless they are somehow 100% positive that their next raise is an equity round. The legal fees will be virtually identical.

Before anyone even tries to argue that signing YC’s template is nevertheless worth it because otherwise money is “wasted” on legal fees, let’s be crystal clear: the economics of the post-money SAFE can end up so bad for a startup that a material % of the cap table worth as much as 7-figures can shift over to the seed investors (relative to a different structure) if the company ends up doing additional convertible rounds after its original SAFE; which very often happens. Do the math.

The whole “you should mindlessly sign this template or OMG the legal fees!” argument is just one more example of the sleight-of-hand rhetoric peddled by very clever investors to dupe founders into penny wise, pound foolish decisions that end up lining an investor’s pocket. It can take only a few sentences, or even the deletion of a handful of words, to make the economics of a seed instrument more balanced. Smart entrepreneurs understand that experienced advisors can be extremely valuable (and efficient) “equalizers” in these sorts of negotiations.

When I first reviewed the new post-money SAFE, my reaction was: what on earth is YC doing? I had a similar reaction to YC’s so-called “Standard” Series A Term Sheet, which itself is far more investor friendly than the marketing conveys and should be rejected by entrepreneurs. Ironically, YC’s changes to the SAFE were purportedly driven by the need for “clarity,” and yet their recently released Series A term sheet leaves enormous control points vague and prone to gaming post-term sheet; providing far less clarity than a typical term sheet. The extra “clarity” in the Post-Money SAFE favors investors. The vagueness in the YC Series A term sheet also favors investors. I guess YC’s preference for clarity or vagueness rests on whether it benefits the money. Surprised? Entrepreneurs and employees (common stockholders) are going to get hurt by continuing to let investors unilaterally set their own so-called “standards.”

One might argue that YC’s shift (as an accelerator and investor) from overly founder-biased to overly investor-biased docs parallels the natural pricing progression of a company that initially needed to subsidize adoption, but has now achieved market leverage. Low-ball pricing early to get traction (be very founder friendly), but once you’ve got the brand and market dominance, ratchet it up (bring in the hard terms). Tread carefully.  Getting startups hooked on a very friendly instrument, and then switching it out mid-stream with a similarly named version that now favors their investors (without fully explaining the implications), looks potentially like a clever long-term bait-and-switch plan for ultimately making the money more money.

YC is more than entitled to significantly change the economics of their own investments. But their clear attempts at universalizing their preferences by suggesting that entrepreneurs everywhere, including in extremely different contexts, adopt their template documents will lead to a lot of damaged startups if honest and independent advisors don’t push back. The old pre-money SAFE was so startup friendly from a control standpoint that many investors (particularly those outside of California) refused to sign one. The new post-money SAFE is at the opposite extreme in terms of economics, and deserves to be treated as a niche security utilized only when more balanced structures won’t work. Thankfully, outside of pockets of Silicon Valley with overly loud microphones, the vast majority of startup ecosystems and investors don’t view SAFEs as the only viable structure for closing a seed round; not even close.

The most important thing any startup team needs to understand for seed fundraising is that a fully “standard” approach does not exist, and will not exist so long as entrepreneurs and investors continue to carry different priorities, and companies continue to operate in different contexts. Certainly a number of prominent investor voices want to suggest that a standard exists, and conveniently, it’s a standard they drafted; but it’s really just one option among many, all of which should be treated as flexibly negotiable for the context.

Another important lesson is that “founder friendliness” (or at least the appearance of it) in startup ecosystems is a business development strategy for investors to get deal flow, and it by no means eliminates the misaligned incentives of investors (including accelerators). At your exit, there are one of two pockets the money can go into: the common stock or the investors. No amount of “friendliness” changes the fact that every cap table adds up to 100%. Treat the fundraising advice of investors – even the really super nice, helpful, “founder friendly,” “give first,” “mission driven,” “we’re not really here for the money” ones – accordingly. The most clever way to win a zero-sum game is to convince the most naive players that it’s not a zero-sum game.

Don’t get me wrong, “friendly” investors are great. I like them way more than the hard-driving vultures of yesteryear. But let’s not drink so much kool-aid that we forget they are, still, investors who are here to make money that could otherwise go to the common stock; not your BFFs, and certainly not philanthropists to your entrepreneurial dreams.

Given the significant imbalance of experience between repeat money players and first-time entrepreneurs, the startup world presents endless opportunities for investors (including accelerators) to pretend that their advice is startup-friendly and selfless – and use smoke-and-mirrors marketing to convey as much – while experienced, independent experts can see what is really happening. See Relationships and Power in Startup Ecosystems for a deeper discussion about how aggressive investors in various markets gain leverage over key advisors to startups, including law firms, to inappropriately sway negotiations and “standards” in their favor.

A quick “spin” translation guide for startups navigating seed funding:

“You should close this deal fast, or you might lose momentum.” = “Don’t negotiate or question this template I created. I know what’s good for you.”

“Let’s not ‘waste’ money on lawyers for this ‘standard’ deal.”  = “Don’t spend time and money with independent, highly experienced advisors who can explain all these high-stakes terms and potentially save a large portion of your cap table worth an order of magnitude more than the fees you spend. I’d prefer that money go to me.”

“We’re ‘founder friendly’ investors, and were even entrepreneurs ourselves once.” = “We’ve realized that in a competitive funding market, being ‘nice’ is the best way to get more deal flow. It helps us make more money. Just like Post-Money SAFEs.”

“Let’s use a Post-Money SAFE. It helps ‘clarify’ the cap table for everyone.” = “Let’s use a seed structure that is worse for the common stock economically in the most important way, but at least it’ll make modeling in a spreadsheet easier. Don’t bother exploring alternatives that can also ‘clarify’ the cap table without the terrible economics.”

There are pluses and minuses to each seed financing structure, and the right one depends significantly on context. Work with experienced advisors who understand the ins and outs of all the structures, and how they can be flexibly modified if needed. In the case of startup lawyers specifically, avoid firms that are really shills for your investors, or who take a cookie-cutter approach to startup law and financing, so you can trust that their advice really represents your company’s best interests. That’s the only way you can ensure no one is using your inexperience – or fabricating an exaggerated sense of urgency or standardization – to take advantage of you and your cap table.

The Problem with Short Startup Term Sheets

TL;DR: Shorter term sheets, which fail to spell out material issues and punt them to later in a financing, reflect the “move fast and get back to work” narrative pushed by repeat players in startup ecosystems, who benefit from hyper-standardization and rapid closings. First-time entrepreneurs and early employees are better served by more detailed term sheets that ensure alignment before the parties are locked into the deal.

Related reading:

In my experience, there are two “meta-narratives” floating around startup ecosystems regarding how to approach “legal” for startups.

The first, most often pushed by repeat “portfolio” player investors, and advisors aligned with their interests, is that hyper-standardization and speed should be top priorities. Don’t waste time on minutiae, which just “wastes” money on legal fees. Use fast-moving templates to sign a so-called “standard” deal.  Silicon Valley has, by far, adopted this mindset the furthest; facilitated in part by the “unicorn or bust” approach to company building that its historically selected for.

An alternative narrative, which you hear less often (publicly) because it favors “one shot” players with less influence, is that there is a fundamental misalignment of interests between those one shot players (founders/employees, common stockholders) and the repeat players (investors, preferred stockholders), as well as a significant imbalance of experience between the two camps. Templates publicized by repeat players as “standard” are therefore suspect, and arguments that it’s *so important* to close on them fast should cause even more caution.

Readers of SHL know where I stand on the issue (in the latter camp).  Having templates as starting points, and utilizing technology to cut out fat (and not muscle), are all good things; to a point. Beyond that point, it becomes increasingly clear that certain investors, who are diversified, wealthier, and have downside protection, use the “save some legal fees” argument to cleverly convince common stockholders to not ask hard questions, and not think about whether modifications are warranted for their *specific* company. Hyper-standardization is great for a diversified portfolio designed for “power law” returns. It can be terrible for someone whose entire net worth is locked into a single company.

Among lawyers, where they stand on this divide often depends (unsurprisingly) on where their loyalties lie. See: When VCs “Own” Your Startup’s Lawyers.  Knowing that first-time founders and their early employees often have zero deal experience, and that signing a term sheet gets them “pregnant” with a “no shop” and growing legal fees, it’s heavily in the interest of VCs to get founders to sign a term sheet as fast as possible. That’s why lawyers who are “owned” by those repeat players are the quickest to accept this or that “standard” language, avoid rocking the boat with modifications, and insist that it’s best for the startup to sign fast; heaven forbid a day or two of comments would cause the deal to “fall through.”

I was reminded of this fact recently when Y Combinator published their “Standard and Clean” Series A Term Sheet.  It’s not a terrible term sheet sheet by any means, though it contains some control-oriented language that is problematic for a number of reasons and hardly “standard and clean.” But what’s the most striking about it is how short it is, and therefore how many material issues it fails to address. And of course YC even states in their article the classic repeat player narrative: “close fast and get back to work.”  The suggestion is that by “simplifying” things, they’ve done you a favor.

Speaking from the perspective of common stockholders, and particularly first-time entrepreneurs who don’t consider their company merely “standard,” short term sheets are a terrible idea. I know from working on dozens of VC deals (including with YC companies) and having visibility into hundreds that founders pay the most attention to term sheets, and then once signed more often “get back to work” and expect lawyers to do their thing. It’s at the term sheet level therefore that you have the most opportunity to ensure alignment of expectations between common stock and preferred, and to “equalize” the experience inequality between the two groups. It’s also before signing, before a “no shop” is in place, and before the startup has started racking up a material legal bill, that there is the most balance and flexibility to get aligned on all material terms, or to walk away if it’s really necessary.

A short term sheet simply punts discussions about everything excluded from that term sheet to the definitive docs, which increases the leverage of the investors, and reduces the leverage of the executive team. Their lawyers will say this or that is “standard.” Your lawyers, if they care enough to actually counsel the company, will have a different perspective on what’s “standard.”  This is why longer term sheets that cover all of the most material issues in VC deal docs, not just a portion of them, serve the interests of the common stock. It’s the best way to avoid a bait and switch.

To make matters even worse for the common stock, it’s become fashionable in some parts of startup ecosystems to suggest that all VCs deals should be closed on a fixed legal fee; as opposed to by time.  Putting aside what the right legal cost of a deal should be, whether it’s billed by time or fixed, the fact is that fixed fees incentivize law firms to rush work and under-advise clients. Simply saying “this is standard” is a fantastic way to get a founder team – who usually have no idea what market norms, or long-term consequences, are – to accept whatever you tell them, and maximize your fixed fee margins. Lawyers working on a fixed fee make more money by simply going with your investors’ perspectives on what’s “standard” and “closing fast so you can get back to work.” For more on this topic, see: Startup Law Pricing: Fixed v. Hourly. 

When the “client” is a general counsel who can clearly detect when lawyers are shirking, the incentives to under-advise aren’t as dangerous. But when the client is a set of inexperienced entrepreneurs who are looking to their counsel for high-stakes strategic guidance, the danger is there and very real; especially if company counsel has dependencies on the money across the table (conflicts of interest). For high-stakes economics and power provisions that will be permanently in place for a long time, the fact that investors are often the ones most keen on getting your lawyers to work on a fixed fee, and also seem to have strong opinions on what specific lawyers you’re using, should raise a few alarm bells for smart founders who understand basic incentives and economics. If your VCs have convinced you to use their preferred lawyers, and to use them on a fixed fee, that fixed fee is – long term – likely to help them far more than it helped you.

Much of the repeat player community in startup ecosystems has weaponized accusations of “over-billing” and “deal killing,” together with obviously biased “standards,” as a clever way – under the guise of “saving fees” – to get common stockholders to muzzle their lawyers; because those lawyers are often the only other people at the table with the experience to see what the repeat players are really doing.  

The best “3D Chess” players in the startup game are masters at creating a public persona of startup / founder “friendliness” – reinforced by market participants dependent on their “pipeline” and therefore eager to amplify the image – while maneuvering subtly in the background to get what they want. You’ll never hear “sign this short template fast, because it makes managing my portfolio easier, and reduces your leverage.” The message will be: “I found a great way to save you some fees.”

I fully expect, and have experienced, the stale, predictable response from the “unicorn or bust” “move fast and get back to work” crowd to be that, as a Partner of a high-end boutique law firm, of course I’m going to argue for more legal work instead of mindlessly signing templates. Software wants to “eat my job” and I’m just afraid. Okay, soylent sippers. If you really have internalized a “billion or bust” approach to building a company, then I can see why the “whatever” approach to legal terms can be optimal. If you’re on a rocket ship, your investors will let you do whatever you want regardless of what the docs say; and if you crash, they don’t matter either. But a lot of entrepreneurs don’t have that binary of an approach to building their companies.

Truth is that, in the grand scheme of things, the portion of a serious law firm’s revenue attributed to drafting VC deal docs is small. Very small. You could drive those fees to zero – and I know a lot of commentators who simply (obviously) hate lawyers would love that – and no one’s job would be “eaten” other than perhaps a paralegal’s.  It’s before a deal and after, on non-routine work, and on serious board-level issues where the above-mentioned misalignment between “one shot” and repeat players becomes abundantly clear, that real lawyers separate themselves from template fillers and box checkers. The clients who engage us know that, and it’s why we have the levels of client satisfaction that we do.  We don’t “kill deals,” because it’s not in the company’s interest for us to do so. But we also don’t let veiled threats or criticisms from misaligned players get in the way of providing real, value-add counsel when it’s warranted.

So while all the people pushing more templates, more standardization, more “move fast and get back to work” think that all Tech/VC law firms are terrified of losing their jobs, many of us are actually grateful that someone out there is filtering our client bases and pipelines for us, for free.

How LLC Startups Raise Money

TL;DR: Very similarly to how “classic” C-Corp startups do, with a few important caveats.

Background Reading:

As I’ve written a few times before, the trend of entrepreneurs (somewhat) mindlessly accepting the advice – that forming their companies and raising investment should always be as standardized as clicking a few buttons – appears to be reversing, at least outside of Silicon Valley. This trend is very much related to all the public stories from experienced founders emphasizing the downsides of following a “standard” path, taking on “standard” VC investment with very high-growth expectations, and how it can cut off a lot of more nuanced/appropriate growth and fundraising strategies. For more on that, see: Not Building a Unicorn. 

As entrepreneurs are spending more time exploring all their options, LLCs are increasingly popping up. I’ve written before about when an LLC may make sense for a startup (C-Corps are still by far the dominant structure). It generally boils down to whether the founder team thinks there’s a possibility that, instead of constantly reinvesting earnings for growth and looking for an exit, they’ll decide to let the business become profitable and distribute dividends to investors. C-Corps are very tax inefficient for those kinds of companies.

So naturally as LLCs become part of the discussion, the next question is how LLC startups can raise investment. Some founders have been incorrectly advised that LLC startups simply don’t raise investment at all. They think that C-Corp = investment, and LLC = run on revenue. That’s far from the case. While true that institutional tech VCs very often won’t invest in LLCs (although that too is changing), the pool of investors interested in early-stage tech companies is much more diverse now than it was even five years ago. Lots of strategic investors, angels, and investors from other industries looking at tech are quite comfortable investing in LLCs, and do so all the time.

LLC startup fundraising looks, at a high level, a lot like C-Corp fundraising.

Capital Interests – Units, Membership Interests, Capital Interests. These are all synonyms for the LLC equivalent of stock. The documentation for these types of investments looks very different from a C-Corp preferred stock financing only because the underlying organizational docs of LLCs are different: you don’t have a “Certificate of Incorporation,” as an example, you have an LLC Operating Agreement.  But the core rights/provisions often end up very similar. A liquidation preference giving the investors a right to get their money back before the common – often see “Common Units” for founders/inside people and “Preferred Units” for investors. Voting provisions re: who gets to elect the Board of Managers (LLC equivalent of a Board of Directors), and other similar rights.

Convertible Notes – These look 95% like C-Corp convertible notes, including with discounts/valuation caps to reward early-stage risk, just drafted a bit more flexibly to account for whether the notes convert into LLC equity or C-Corp equity (if the company decides to become a C-Corp).

SAFEs – Yes, there are LLCs now doing SAFEs, although the SAFE instrument requires tweaking (like convertible notes) to make sense for an LLC. Even for C-Corps, we still see SAFEs being used only in a limited number of cases (again, because we serve companies outside of California, where SAFEs dominate). That’s because they are about as company favorable (and investor unfavorable) as you can get, and many investors balk at what they see as an imbalance. LLC SAFEs are even rarer than C-Corp SAFEs, but they do come up.

LLCs are known for their flexibility, and given that LLC companies tend to be more “cash cow” oriented than C-Corps, even more alternative financing structures are popping up: royalty-based investment is one example, where investors take a % of revenue as a way to earn their return, instead of expecting it in the form of a large exit or dividend. But those are still so uncommon (for now at least) that they’re not worth digging further into.

As I’ve repeated several times before, the big issue with LLCs and fundraising is you absolutely need a tax partner involved. By that, I mean a senior lawyer with deep experience in the tax implications of LLC structures and investment. This is not a “startup lawyer,” but a very different specialty. The flexibility of LLCs brings with it significant tax complexity at the entity and individual holder level, and even the brightest corporate lawyers are not qualified to handle that on their own. 

The majority of emerging tech companies still end up as C-Corps, simply because it still makes sense for the type of business they plan to build. But even with C-Corp land, founders are digging much deeper into how to structure and fundraise for their companies, and pushing back on the suggestion that they should just sign some templates and move on; as if what the templates say (and don’t say) doesn’t really matter.  That may still work for the “billion or bust” high growth mentality of unicorns, but entrepreneurs who feel they’re building something different want flexibility, and to understand the full scope of options.