Post Category → Employees

Startups, Politics, and “Cancel Culture”

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

A. Growing up in a low-income Texas neighborhood filled with American latinos, but excelling in advanced coursework from an early age, I was criticized regularly by latino peers for my discipline in academics; referred to often as a “coconut” (brown on the outside, white on the inside). This was a tacit acknowledgement that my family’s home culture was a very different “Mexican” from what American latinos themselves consider the norm.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Early v. Late-Stage Common Stockholders in Startup Governance

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

Background reading: The Problem with “Standard” Term Sheets

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Most Common Option Grant Mistakes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

4. NSOs (or NQSOs) v. ISOs.

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

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

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

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

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

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

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

7. Generally sloppy drafting.

“The options will vest over 48 months.”

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

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

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

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

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

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