Why BigLaw Over-Automates Startup Law

TL;DR: BigLaw’s very high operating costs require it to charge 3-4x of what its typical lawyers actually earn. This makes rates often stratospherically high. While billion-dollar companies that use BigLaw can afford those rates, early-stage startups often cannot. BigLaw is responding at times by hyper-standardizing and hyper-automating early-stage work. This has significant downsides, as companies lose out on flexibility, advocacy, and strategic guidance for very high impact projects, like financings. Much of this standardization ends up favoring VCs over startup teams. Elite lean boutique law firms offer an alternative approach, in which lower overhead allows for lower costs without requiring substantial inflexibility. In the end, this trend toward over-automation is leading many clients and lawyers to balk, and alternative approaches for achieving efficiency (while remaining flexible) are rightfully emerging.

Lawyers are not cheap. Elite lawyers – the kind with very extensive top-tier training, experience, and ability to handle high-stakes complexity – are in fact quite expensive.

Then again, elite human talent of all sorts is quite expensive. Top doctors make over half a million a year. Top software developers can make into the millions, and their “bugs” are much more easily corrected than bugs in contracts; which by design often can’t be “fixed” once they are signed.

I candidly find it amusing when “tech people” criticize elite lawyers for the amounts they earn, given what similarly elite talent in other industries (tech included) makes. If you’re expecting an apology, it’s going to be a while.

That being said, criticizing what people earn is not the same thing as criticizing what firms charge. There are in fact quite a few firms in “BigLaw,” including those who work with startups, where a lawyer charging over $1,000 an hour is in fact earning only a small fraction of that, maybe $200 or $250. “The beast” (the bloated institution) absorbs the rest. That, in my opinion as a leader of an elite lean boutique firm precisely designed to address this problem, is a very valid criticism.

Traditional elite law firms in “BigLaw” have virtually all designed themselves, with minor variances, around a similar high-overhead business model. They charge 3-4x+ what their typical lawyers are actually earning. That overhead pays for extremely posh offices designed to signal “prestige,” armies of non-lawyer staff, lavish events and other programming, as well as a small cadre of equity partners who absorb millions, sometimes tens of millions, in profits every year per partner without doing much of the actual billing.

The fact that BigLaw has entrenched itself in this way of doing legal business makes it very difficult, even impossible, to meaningfully address “efficiency” at an institutional level. It would require sacrificing too many sacred cows with political leverage in the firms’ bureaucracies. Thus when BigLaw does try to do something to become more efficient, or at least appear more efficient, it’s options are constrained. One option that is always on the table is adopting (often pricey) automation software, because it ostensibly allows charging less without actually having to do human legal work (contextual, flexible, strategic) any more efficiently.

Don’t deliver more efficient lawyers. Instead, make clients use dumbed-down, inflexible, and often quite clunky software. They can talk to professionals only once they can afford $900/hr for an associate and $1400/hr for a partner.

I’ve written about this issue before, such as in Vaporware Technology Won’t Hide Your Firm’s Business Model Problems (on Above the Law). Lean elite boutique law firms are about what I call substractive innovation. Finding efficiency by removing unnecessary (for clients) costs, and re-designing a firm’s operations around that leaner operating model. Yes, this does involve technology, but a particular kind of technology meant to replace unneeded overhead and traditional processes; not to simply layer on new software without otherwise changing much at all about the firm itself.

BigLaw, for the above reasons, is usually incapable of this kind of innovation. It virtually always leans more towards additive so-called “innovation” – buying more and more things that purportedly bring efficiency.

Tying this all together. BigLaw – which in 99.9% of cases works with billion-dollar multinational high-stakes projects for whom charging over $1,000 an hour is not a budget problem – has to charge a lot for its lawyers. 3-4x what those lawyers actually earn. The portion of BigLaw that actually touches early-stage startups – 0.1% of what BigLaw as a whole category really does – faces a problem. Early startups are not billion-dollar multi-national entities.

That’s a big constraint on what BigLaw as it relates to startups can really charge. Startups are constantly balking at what they are charged by BigLaw. The way some of BigLaw is addressing this is by removing their elite lawyers almost entirely from that segment of work. Automation – I would say over automation – combined with what is often called in industry circles “de-skilling” (delegating to lower-level staff).

BigLaw is thus heavily incentivized to over-automate Startup Law. As I’ve written before in many contexts, automation in law is not a free lunch. Not even close. It relies on heavy standardization and inflexibility for it to be workable at all. The problem is that a lot of what founders ask lawyers to do in early-stage Startup Law is extremely high-stakes from a financial perspective. Even minor tweaks to language in docs can have 8 to 10+ figure implications. We are not talking about parking tickets or coffee shops.

The extremely myopic way in which pockets of Silicon Valley have over-adopted YC’s Post-Money SAFE is a perfect example of this. Only now are many founders coming to realize how much of an “own goal” it was to let YC pretend their terms were founder friendly and “efficient.” In that article I show how literally adding a single sentence to the Post-Money SAFE can have tens of millions of dollars in improved economics for founders, and yet the vast majority of so-called “efficient” automated startup financing tools to do not allow for this tweak. People are pretending they are saving founders money. What they are really doing is “saving” a few hundred dollars (at most) in legal fees while letting VCs (including YC) take millions from startup teams.

There are countless ways in which over-standardization and over-automation in Startup Law are costing startups and founders enormous amounts of money. Every attempt to create a so-called “standard” term sheet for equity rounds ends up with VC-favorable economic and power terms that simply are in no way, shape, or form a universal “standard.” See also Standardization v. Flexibility in Startup Law.

Because VCs (and accelerators) are “repeat players,” whereas individual founding teams are not, they have the market leverage to heavily bias so-called “standards” in their favor. And the software companies intending to profit from all of this legal hyper-automation are happy to help them in the process. I wrote about the outsized leverage and influence that repeat players have in startup ecosystems, including over many law firms, in Relationships and Power in Startup Ecosystems.

These automated financing software companies – who need law to become hyper-standardized so that they can ever-so-generously step in to charge for the automation – are heavily incentivized to publish biased “data” about so-called “standards.” For example, they’ll build a software tool offering only 2 or 3 ways to do a seed funding, all heavily standardized and therefore inflexible. They’ll market this tool, and then publish data saying things like, “80% of seed deals are Post-Money SAFEs, and so it is a standard.” Actually (if you read the footnotes), 80% of seed deals on your half-baked automated platform are Post-Money SAFEs. Selection bias. That is not the same thing as saying 80% of all seed deals in the country or world are.

These tools are lying with so-called “data” to promote their own wares. For that, who can really blame them? Everyone’s got to make a buck. But let’s please stop pretending that they actually care about what’s best for startups, or their founders and employees. I don’t criticize people for talking their book. I criticize people for pretending to be far more benevolent and selfless than they really are.

Lawyers should be telling startups and their founders whenever they are facing these sorts of issues. They should be telling founders that the Post-Money SAFE is not a universal standard, and that many many deals end up customized, or even with entirely different structures, to make the economics better. They should be negotiating term sheets to better position the governance of their client, instead of letting some VC dictate what “standard” means. Instead, many of them are over-standardizing and over-automating. Why? Because they’re in BigLaw, and that’s what BigLaw does for startups.

Because of its institutional inability to actually do human legal work more efficiently (see above paragraphs), which involves assessing context, negotiating, tweaking, advising, etc., and the fact that Startups cannot pay over $1,000 per hour for extensive advisory, much of BigLaw is choosing to delegate the entirety of early-stage startup law to software. In my opinion, this is an abdication of the responsibility of lawyers to actually advise their clients as to what is best for them. If I were a paranoid BigLaw lawyer, I’d at least worry a little about the malpractice implications of practicing law this way.

On top of the fact that this is not actually in the best interests of startups or their stockholders, many lawyers are themselves starting to balk at the machine-like evolution of BigLaw’s way of operating. Boutique law firms, where the ratio of billed rates to lawyer earnings is more like 2x instead of BigLaw’s 3-4x (dramatic efficiency) are not just about lower rates. In many segments they are emerging as refuges for lawyers who want to step off the assembly line and actually think for their job.

When lawyers are able to charge, say, $500 per hour instead of $1100, they have time to actually negotiate for their clients. On top of this being good for the client (See: Negotiation is Relationship Building), from an intellectual standpoint it’s legitimately more enjoyable. Many ECVC lawyers prefer this way of practice over acting as if every deal before Series B should just be a cookie-cutter template.

The elite boutique law ecosystem (of which Optimal is a part) is thus emerging as a win-win countertrend to BigLaw’s tendency to over-automate and over-standardize. Many elite lawyers are tired of half-baked over-technologized (air quotes) “efficiency” that isn’t really efficient at all because of what the client loses. In moving to boutiques, lawyers get to drop their rates substantially without actually earning less. Clients get to pay substantially lower rates, while getting an actual elite human professional to help them navigate complexities and protect themselves; which many prefer over clicking a few buttons on software without ever being told what their options really were.

To summarize: the traditional cost structures of BigLaw require charging 3-4x+ of what their typical lawyers actually earn. This makes their rates, including for startups, extraordinarily high. Above $1,000 per hour in many cases. Sometimes $2,000+ per hour. Startup clients, who do not fit the billion-dollar mold of BigLaw’s average client, obviously cannot afford stratospheric legal bills. BigLaw is responding by accepting hyper-standardization and hyper-automation for its earliest stage work. Clients spend more and more time interacting with junior professionals and software that operate only in very narrow, inflexible lanes; depriving clients of real advocacy or negotiation on high-stakes issues. As a result of all this, inexperienced startup teams are increasingly pushed into these myopic inflexible fundraising approaches that are costing them enormous amounts of money and governance leverage.

There are ways to avoid this problem. The one I’m obviously an advocate for is to move a lot of this legal work to leaner elite boutiques. Some of the top boutiques in ECVC can deliver real legal horse power, especially in earlier-stage deals (pre-unicorn), at half the rates of BigLaw.

There’s another option: if you absolutely are going to use BigLaw, let them charge you for what the work really takes. Why pay BigLaw at all if you’re not using the real legal talent it is designed to house? If you’re raising a $75 million equity round, yeah, you’re going to pay a few hundred thousand dollars in legal fees with BigLaw if you let them actually do their job. As a percentage of the actual raise, it’s really not that much (under 1%). The alternative – over-automation and over-standardization – will be far worse.

If that doesn’t work for a $5 million or $15 million round, then again I suggest looking into elite boutiques. Their lower rates, but still elite rosters, will produce lower legal bills without compromising on the quality of the actual advisory you’re getting. See How Much Seed Rounds Cost – Lowering Fees and Expenses Safely to understand why boutique law is an increasingly popular option among top startup teams for earlier financing rounds. Boutiques are not doing pre-seed deals all day. We have clients closing Series A, B, C, even later, and exiting at 8-9-figure valuations. As I often say, the B in BigLaw is for billions. There’s a lot that happens before billions.

Straw-man prevention disclaimer – Let me be very clear here. I am not just a Partner at Optimal. I am also its Chief Technology Officer. I work with a lot of legal tech startups. I love legal tech, and I even like targeted, thoughtful automation. I’m particularly interested in upcoming ways to integrate AI to enhance lawyers’ productivity.

Some people with very loud microphones like to pretend that the legal profession is full of nothing but luddites who want to milk the entire world for fully bespoke, terribly inefficient work product. In startup ecosystems, this attitude is most often peddled by VCs who want your lawyers to shut up, because when lawyers shut up VCs get what they want, and software automation tools; because they want you to use their inflexible software instead of an actual human.

What I am advocating for here is a more balanced perspective on when automation really is in the best interests of legal clients, and really is streamlining things, relative to when it is hiding all sorts of biases and costs because the real driver isn’t what’s best for the client but some extraneous factor like institutional constraints. I’m a big fan of automating basic option grants, which no serious professional wants to waste their time on anyway. But raising millions or tens of millions of dollars, and setting permanent power & governance terms that will influence huge segments of the modern economy? Hold the F up.

As I wrote here, the “values” of the legal industry and the software industry are very different, and both serve a very important purpose in the economy. In legal, it’s expertise, context, flexibility, negotiation, leverage, compromise, trusted advocacy. It’s about having a perspective, and pushing for it, while the other side does the same.

There can be no single answer or “standard” in this value structure, because the decision-makers and process for setting it are suspect, as conflicts of interest and subjectivity abound. Companies are different. Investors are different. Goals, industries, values all vary organically across institutions and contexts. It’s contextual “truth” arrived at via a decentralized adversarial process, as opposed to a centralized proprietary one. This concept is not entirely alien to many engineers.

In software, it’s broadly about standardizing, automating, universalizing, cutting costs and centralizing data. It’s about scale and speed, reducing “friction.” In this worldview, customization and “verification” via independent review is seen as inefficient and pointless. But is it always? When the stakes are really high?

Analogies about making private startup equity operate like “frictionless” liquid public markets are spectacularly flawed. In the latter, the transactions are impacting small percentages of the company’s capitalization, and rarely altering their fundamental governance. What happens in a startup’s earliest days sets the stage for the company’s entire growth. The present dollar value may be small, but the derivative long-term impact is massive. Post-IPO, very little of what’s being negotiated fundamentally changes anything.

Nowhere am I saying here that the legal industry’s values should take full precedence over those of the software industry. Again, I’m a big fan of productivity tools in legal. We just need to avoid myopia in letting the software industry’s values (automation, standardization) steamroll over legal’s as it relates to high-stakes legal work simply because clients think (wrongly) that they have to use BigLaw, and BigLaw can’t make its actual lawyers cheaper. Automation and standardization can be good. Automating and standardizing everything, because we won’t consider alternative possibilities for achieving efficiency, most certainly is not.

Legal Tech for Startup Lawyers: Deal Closing Software

TL;DR: Deal closing software for collecting and tracking signatures, then compiling closing sets, is a great legal tech category for law firms to streamline administrative tasks on deals, saving clients money and time. Based on my research of the available options in adopting legal tech for our own elite boutique firm (Optimal Counsel), Closing Folders and Litera Transact are the closing tools that other firms should take a look at. Bigger picture, law firms need to think deeply about the proper balance of legal industry values (flexibility, advocacy) v. tech industry values (speed, standardization) as new legal tech hits the market. There are potentially serious negative consequences for companies (clients) if we thoughtlessly let one industry’s values dominate the other.

After publishing How Much Seed Rounds Cost – Lowering Fees and Expenses Safely, which ended up getting way more traction than expected, a number of lawyers from other firms reached out to me politely asking for recommendations as to what tools we use at Optimal for streamlining administrative tasks on deals. I sometimes forget that, even though this blog is targeted toward founders, quite a few lawyers and firms in the industry follow SHL as well. I also occasionally hear from law schools planning their course curricula.

Given that our firm is built around a thoughtful balance of blending lean legal tech with elite lawyers, I can understand other players in the industry looking to us for recommendations. My view has always been that the “optimal” blend of legal and tech ensures that the core values of neither industry get shoved down the throats of clients; who ultimately should be the ones getting better served. Rather, it’s about balancing the positives of both, while counteracting their negative tendencies.

Balancing Legal and Tech Industry Values

Key values of the elite tier of the legal industry are flexibility and trusted advocacy for a client, and (in the case of startups) a client led by executives (founders) often at a substantial informational disadvantage relative to players they are negotiating with. See Negotiation is Relationship Building for a deep-dive on just how much founders and startup teams lose when trusted and experienced legal counsel is pushed out of the picture by misaligned market players who profit from displacing lawyers at the negotiation table.

Legal: Trusted, Flexible Strategic Advocacy with Professional Liability

Having a relationship with a highly experienced and trusted senior lawyer, without ties to your investors, is one of the best “equalizers” for founding teams navigating the fog of an opaque market full of much more experienced players. Unlike regular vendors of services and tools, lawyers have professional ethical obligations to their clients, as skilled fiduciaries advocating for their interests. Paying for counsel is not just paying for a neutral product or service, it’s paying for an experienced advocate reviewing terms and negotiating specifically for your team’s context and priorities.

The downside tendencies of the legal industry are, for some lawyers at least, to “overwork” projects; making unnecessary comments and mountains out of molehills. Reputational competition can put limits on this behavior, but it still occurs in some circles. Clients and Boards should be educated as to what terms are very high impact and high-risk – such as core economic terms, or governance terms influencing the power hierarchy of the business – while, especially on smaller projects, accepting “good enough” for the more marginal terms unlikely to be impactful other than in rare edge-cases.

This is why I’m a big fan of taking an open source” approach to legal templates for early-stage work, reflected in the Seed Round Template Library. Creating a common language framework as starting points can significantly reduce unnecessary negotiation over unimpactful issues, while preserving the flexible and trusted dynamics of each side having advocates looking out for their client’s interests. Independent counsel serve as the flexible “software developers” of this market (contract language is code), with open source templates serving as the transparent and modifiable “github” repository.

This is better for clients and the market than a centralized and proprietary “no code” framework by which self-interested participants, like prominent investors or VC-backed software vendors, impose their inflexible and uneditable “code” (contract terms) onto the entire ecosystem, in part by pretending that something is a universal “standard.” A flexible “open source” approach to early-stage deal terms provides efficiency, without requiring an enormous diversity of market players to fit their businesses and investor theses within a handful of narrow structures.

Tech: Standardization, Scale, and Speed

Unlike the legal industry’s values, which heavily prioritize strategic advocacy and flexibility, the values of the software industry are efficiency, scale, and speed. These are absolutely important values that law firms need to integrate into their cultures to serve clients well, while also being very candid when these values are being exaggerated to dupe inexperienced teams. The negative side of hyper-automation is reduced optionality (inflexibility), and a tendency to gloss over nuances in order to make it easier to sell a software-based service. This downside can sometimes be astroturfed with an over-emphasis on mass-market “data,” when even data compilation and visualization requires significantly narrowing the scope of variables, quietly labeling impactful terms as “standard” or “boilerplate” when they absolutely are not.

A great example of how this plays out is the selection bias of automated tools. They’ll promote “data” suggesting that X or Y is some kind of “standard,” while glossing over the fact that X or Y are the primary options promoted by their tool, creating a self-motivated circularity. You can only choose X or Y if you use the tool, and the tool then uses its self-selected “data” to tell you that X or Y are the “standards.” Given it’s evidently all “standard boilerplate,” you’re told to just pay for their tool and avoid all that negotiation and review mumbo jumbo; even if some of said mumbo jumbo would significantly help a team.

This clever sleight-of-hand – using biased “data” to pretend that important terms are far more standardized than they really are – is looking out for the needs of a company profiting from selling simplistic software that can’t function without hyper-standardization; not the needs of the end-user (the client).

As I’ve said many times before, “don’t ask your lawyers about this” sounds very suspicious. “Let’s save you some legal fees” sounds much more benign, but the end-effect can be the exact same. A huge number of inexperienced teams get duped into signing bad terms, or taking counterproductive actions, but the smoke-and-mirrors strategy of minimizing legal fees (and thus not talking to a trusted independent advisor) provides misaligned actors plausible deniability for their (air quotes) “advice.”

Early-stage private companies building unique products and services, and gunning for 8-10 figure (or more) exits, are not standardized commodities, nor are the contracts they are signing at the foundation of their businesses. This is a total contrast to standardized shares of large public companies, which by their nature are highly liquid, have minimal governance authority, and are a part of diversified portfolios; in other words “low stakes.”

In contrast to liquid public equities, Founders’ and employees’ livelihoods, and often their entire life savings, rely on permanent deal terms tied to high-concentration illiquid assets with significant power over a company’s trajectory. Taking an inflexible, high-speed approach to the super high-stakes terms controlling a startups’ financing, ownership, and governance reflects far more the desires of market players who rely on scale and diversification – like spray-and-pray “dumb money” funds or mass-market software vendors – than on what is actually good and appropriate for each unique company with all or most of its eggs in one basket. This is exactly what happens when “tech values” are allowed to steamroll over legal’s.

Deal Closing Software

There are two broad types of work that law firms do for clients on financings: (i) actual “lawyer work” – assessing terms, educating and advising clients, negotiation, drafting and structuring – and (ii) administrative work like creating signature packets and tracking signatures or assembling closing sets. The former category is very difficult, indeed at times dangerous, to heavily outsource to third-party software because of how high-stakes and permanent it is – flexibility and trusted advocacy really matter here, but the latter category is always great to apply thoughtful technology to.

Closing Folders and Litera Transact are two deal closing tools that all corporate lawyers should review and consider adopting for their practices (one or the other). We’ve used tools like this for years, and I know a lot of ECVC “BigLaw” uses them as well. They use focused web-based interfaces for:

  • Organizing deal checklists and document sets
  • Auto-generating signature pages and packets
  • Auto-issuing e-signature requests through trusted e-signature tools like Docusign
  • Tracking real-time status of signatures, and
  • Compiling closing sets efficiently

What I love most about these tools is their focus and flexibility. If there’s one thing I’ve learned being a legal CTO for a decade, it’s to never trust sprawling “all in one” kinds of tools that show significant feature creep. The tendency for a software company to constantly expand into other features, and even industries, more often reflects a desire for monopolistic empire building than what is actually good for the end-user. They inevitably end up confusing, bloated, and over-priced.

Instead, use tools that do a focused set of tasks extremely well, with a simple interface, and customizability that integrates well into the varying needs of a law firm (the user here). Unlike signature collection features bolted onto other kinds of software, these tools are designed for lawyers and can work on an extremely diverse sets of transactions, including equity or debt financings, and M&A. The fact that no particular deal structure is imposed on them is super important so law firms can apply them to their clients’ varying needs.

Client Data Privacy and Security

While both tools started out as independent startups (Litera acquired Doxly and renamed it Transact, iManage acquired Closing Folders), they’re now owned by trusted legal software companies with robust and transparent policies around client data privacy and security. Lawyers should always be cautious about what software tools might be mining their clients’ data for other ends.

In the most egregious cases I’ve seen software companies market tools to lawyers, use those tools to mine those same lawyers’ client data, and then leverage that data by attempting to displace law firms with high-cost, high-margin legal “products” lacking the flexibility, contextual awareness, and ethical obligations of actual counsel. Sometimes that “data” is being sold directly to your clients’ market counterparties, to improve their negotiating posture.

If the tool is offered to you for “free,” then the payment is in data. What is that data going to be used for? I prefer paying directly for straightforward, well-designed and focused tools. My firm’s (and my clients’) data is not for sale.

Hopefully this is helpful. Good luck.

Startup Governance Choke Points: Protective Provisions

Related Reading:

As I’ve written many times before, one variable that makes the world of startup governance very different from other areas of corporate law is the substantial imbalance of experience and knowledge between the business parties involved. On one side you often have seasoned VCs who’ve been in the game for decades. On the other you often have an inexperienced entrepreneur for whom all of the complex terms in the docs are completely new. This imbalance leaves open numerous opportunities for leveraging founders’ inexperience to gain an advantage in negotiations either in deals or on complex board matters.

This can make the role that corporate lawyers play in VC<>founder dynamics quite pivotal. Whereas seasoned executives at mature companies usually rely on legal counsel for executing specific directives, but not for material strategic guidance, in the startup world good VC lawyers serve as strategic  “equalizers” at the negotiation table. This is why guarding against any conflicts of interest between your lead lawyers and your VCs is so important (see above-linked post). If your lawyers’ job is to help you guard against unreasonable demands or expectations from your counterparties, you don’t want those counterparties to have leverage over those lawyers. No one bites a hand that feeds them. VCs know this, and deliberately feed (engage and send referrals to) *lots* of lawyers in the ecosystem.

Because of this imbalance of experience, and even the tendency for some VC lawyers to not fully educate founders on the material nuances of deal terms and governance issues, I regularly encounter founding teams with overlooked “choke points” in their companies’ deal and governance docs. By choke points I mean areas where, if there were a material disagreement between the common stock and investors, the latter could push a button that really puts the common in a bind. It’s not unusual to find founders who simplistically think something like, “well the VCs don’t have a Board majority, so they can’t really block anything.” Trust me, it’s never so simple.

The hidden VC “block” on future fundraising. 

One of the most common hidden “choke points” I see in startup governance is overly broad protective provisions. These are located in the company’s Certificate of Incorporation (charter), and basically are a list of things that the company cannot do without the approval of a majority or supermajority of either the preferred stock broadly, or a specific subset of preferred stock. Given that the preferred stock almost always means the investors, these are effectively hard blocks (veto rights) over very material actions of the company. No matter what your cap table or Board composition looks like, these protective provisions mandate that you get the consent of your VCs for whatever is on that list.

Fair enough, you might say. The investors should have a list of certain things that require their approval, right? Of course. Balanced governance is good governance. But good, balanced governance terms should protect against the possibility of misalignment of incentives, and even conflicts of interest, in governance decisions for the company. In other words, they should prevent situations where someone can take an action, or block an action, purely out of self-interested motivations, while harming the cap table overall.

Very often so-called “standard” (there are all kinds of biases in what ends up being called standard) VC deal terms will give VCs protective provision veto rights over these sorts of actions:

  • creating any new series of preferred stock
  • making any change to the size of the Board of Directors
  • issuing any kind of debt or debt-like instrument.

The end-result of these protective provision is that, at the end of the day, you need your VC’s permission to raise any new money, because you can’t raise money without taking at least some of the above actions.

Let me repeat that so it sinks in: regardless of what your Board or cap table composition looks like – even if a VC is a minority holder, and the preferred don’t have a majority on the Board – the kinds of protective provisions that many VC lawyers call (air quotes) “standard” allow your VC(s) to completely block your ability to raise any new financing, no matter what the terms for that financing are. A “choke point” indeed.

Why is this a problem? Well, to begin with it’s a serious problem that I encounter so many founding teams that aren’t even aware that their governance docs have this kind of choke point, because nobody told them. A fair deal negotiation should require clear understanding on both sides. But more broadly, the problem is that VCs can have all kinds of self-interested reasons for influencing what kind of funding strategy a startup will take. They may want to block a lead from competing with them, for example. Or they may want to ensure that the follow-on funding is led by a syndicate that is “friendly” (to them) as opposed to one whose vision may align more with the goals of the common stock.

I have encountered startup teams several times who think they are in control of their company’s fundraising strategy, again because they simplistically looked at just their cap table and board composition, only to have a VC inform them that, in fact, the VC is in control because of an obscure protective provision that the founders never even read.

Preventing / Negotiating this Choke Point

The simplest way to prevent your VCs from having this chokehold on your fundraising strategy is to delete the protective provision(s) entirely. That may work, but often it doesn’t. Again, balanced governance is good governance. It’s reasonable for VCs to expect some protections in ensuring the company isn’t willy-nilly fundraising with terms that are problematic. I agree with that. But as I said above, it’s also unreasonable for the VCs to expect a hard block on any fundraising whatsoever, regardless of terms.

A more balanced way of “massaging” these protective provisions is putting conditions or boundaries around when the veto right is actually effective. For example, you might say that the veto right is not enforceable (the VCs can’t block a deal) if:

  • the new financing is an up-round, or X% higher in share price than the previous raise;
  • is a minimum of $X in funding;
  • maintains a Board with specific VC representation;
  • doesn’t involve payment to a founder, to ensure they are objective.

There are all kinds of conditions you could add to provide that only “good” (higher valuation, legitimate amount of money, balanced Board representation, etc.) financings can get past a VC block. Putting this kind of list in a term sheet can be an excellent conversation starter with a VC as to what they see as the long-term fundraising strategy, and where their own red lines are. It allows you to candidly ask your VC, “OK, if the deal checks all of these boxes, why exactly do you still need a veto right over it?”

But if your VC simply responds with a “this won’t work, we need a hard veto on fundraising” position on the negotiation – at a minimum you now have valuable data as to this VC’s worldview on governance and power dynamics in their portfolio. See Negotiation is Relationship Building. Regardless of where deal terms end up, forcing a discussion about them, and requiring the other side to articulate their position clearly, still serves a valuable purpose. Sometimes you don’t have the leverage to achieve better balance in your deal terms, but it’s always a positive to at least have your eyes wide open.

Putting substantive deal terms aside, I enjoy helping founding teams understand that many of the most (air quotes) “founder friendly” investors in the market are still far from charitable actors, and can be quite clever and subtle in their methods for maintaining power, despite the “friendly” public persona. See: Trust, “Friendliness” and Zero-Sum Startup Games. Note: this is not a moral judgment, but just an acknowledgement of reality. You and I aren’t Mother Teresa either. Navigate the market with the clear-eyed understanding that everyone is following their incentives, and protect your company accordingly.

A less balanced, but still improved, configuration of these protective provisions is to create an exception if a VC Board member approves the deal. You might (understandably) think: how is this better, if the VC Board member can just refuse to approve? Without getting too in the weeds, Board members have fiduciary duties to the cap table overall, whereas non-controlling stockholders generally do not. So at least theoretically, you could call out, and even sue, a Board member if it’s blatantly obvious that they are blocking a particular deal for reasons that are more about their own interests than the company’s.

I say theoretically, because the smartest and most aggressive investors, if they really want to play games with pushing your fundraising strategy in their preferred direction (and away from the preferences of the common), will be quite creative in developing plausible deniability for their behavior: they blocked the deal because that other lead wasn’t “value add” enough, they don’t believe now is the right time to raise because of market conditions, they’re concerned about X or Y thing that at least gives them an argument that they are still looking out for the company. So don’t get too excited about these fiduciary-related exceptions to protective provisions. They’re not nearly as helpful as the better strategy of putting concrete bypasses to a protective provision veto.

To be very clear, I still see quite a few founding teams who are fully informed about these issues, have a candid conversation with their VCs about it, and still ultimately put in some kind of hard VC-driven block on fundraising. I of course also see plenty of teams who, as soon as we bring this topic up to them, dig their heels squarely in the sand and completely refuse to do a deal unless the VC vetoes are removed/modified. It depends on context, leverage, values, trust, etc. But in all cases it is a net positive for the inexperienced founding team to know what they are signing.

Startup governance and power dynamics are much more nuanced than just what your Board and cap table look like, or the usual 2-3 high-level terms that founders read in a term sheet, thinking everything else is just “boilerplate.” Ensure you’re surrounded by objective, experienced advisors who can help you understand those nuances, so the deal you think you’re signing is in fact the one on the table.

Alignment in Startup Governance: Conflict, Collusion, Corruption

Related Reading:

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

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

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

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

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

Conflict

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

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

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

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

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

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

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

Collusion

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

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

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

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

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

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

Corruption

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

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

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

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

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

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

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

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

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

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

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

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

Diversity in Startups: Whining, Warring, Winning

Recommended Reading: The Weaponization of Diversity

Almost two years ago I wrote a lengthy personal essay regarding my own story growing up as a low-income child of Mexican immigrants, weaving through the American educational system (UT Austin, Harvard Law), and eventually finding success in startups and venture capital as a managing partner of an elite boutique law firm specialized in that field. In that essay I described the significant cultural divide I observed growing up in the latino community in Houston, between the educational expectations I had at home driven by my elite college educated Mexican mother, and the cultural values of my latino peers; all of whom came from blue collar and laborer backgrounds.

We lived in the same neighborhood and were all lower-income, but our home cultures were starkly different. Many of my latino friends found my study habits extremely peculiar and aberrant from how they felt a latino child “should” grow up. As a result I was often labeled a “coconut” (brown on the outside, ‘white’ on the inside).

In that essay I applied my own childhood observations to research I’ve reviewed regarding the under-representation of certain minorities in various high-performance professions (tech entrepreneurship, elite law, etc.), as well as to my observations as an adult responsible for recruiting lawyers into our firm. My general thesis is that “warmongering” over diversity in these industries has resulted in two very negative dynamics.

First, it leads to the silencing of many people – good, very much not racist, progressive people – who see a clear causal relationship between home culture, including childhood educational values, and under-representation in elite industries dependent on compounding education and training; like tech and law. For fear of being penalized personally and professionally, these people avoid contributing constructively to the discussion, and as a result the general topic of diversity becomes dominated by stale and exhausted narratives suggesting that “racism” and “unconscious bias” are supremely explanatory for disparities. Because these narratives are (flatly) wrong, the results of their non-solutions are disappointing.

Second, aggressive pressure to increase representation in elite industries leads employers, investors, and other decision-makers to make rushed hirings, promotions, and investments in URM (under-represented minority) candidates. Because the market isn’t nearly as irrational, discriminatory, and “racist” as many people make it out to be, a significant portion of those individuals who are elevated by these “affirmative action” initiatives end up very visibly underperforming. That underperformance ends up reinforcing stereotypes (bias) in the minds of observants. In other words, it backfires. Being overly aggressive and simplistic with increasing representation of URMs in highly competitive meritocratic industries, when their under-representation broadly is actually reflective of real performance issues (on average) in the marketplace, ends up harming those same groups in the long-run by strengthening stereotypes that we should instead be strategically and methodically weakening.

The essay is long for a reason. This is an extremely sensitive and nuanced topic, and to give it its due requires time and depth. For that reason, I respectfully ask that anyone bothered or offended by the above paragraphs please actually read the essay, to understand the real point I am making. It is not victim blaming. It is not pretending socioeconomic inequality isn’t a problem. And it most certainly is not pretending that racism and discrimination do not exist at all in our society. Rather, it is an honest attempt to explain why, all else being equal, focusing on racism and “unconscious bias” as the primary reasons why URMs, like American Latinos, are under-represented in elite industries has been incredibly unproductive, even counterproductive, and it will continue as such until we inject some sincerity and reality into the discussion.

The purpose of this post is to be less theoretical and analytical than the original essay, and more practical. How should founders, CEOs, and Boards of Directors in the startup ecosystem respond to concerns about diversity and the under-representation of certain minority groups? How can they empathetically listen to the variety of voices on this topic, while constructively and safely fulfilling their fiduciary duties to maximize the performance and success of their businesses? To cover this topic, I’m going to touch on three categories of approaches advocated by “diversity activists” in elite industries (including tech startups) – whining, warring, and winning – and why it’s in the interest of both key decision-makers and under-represented minority groups to steer discussion and action toward the third.

Whining

This post assumes the perspective of my original essay; those claiming that “racism” and “bias” are the main drivers of under-representation of URMs (or at least of American Latinos specifically) in elite industries are flatly, demonstrably, wrong. Of course isolated instances of racism and discrimination can be found in a country of 300 million people, just as they can be found all over the world. These isolated cases are unacceptable, illegal, and deserve to be addressed forcefully.

But pointing to a limited number of isolated anecdotes does not in any way demonstrate that the startup ecosystem as a whole is racist. We are talking about an industry full of thousands of individual companies, and hundreds of venture capital funds, all led by highly educated and progressive people from an enormously diverse set of ethnicities and nationalities. These people are not all racists, and they would be punished financially by market competition if they were neglecting high-performing undervalued talent that competitors could then recruit or invest in.

In fact, the startup ecosystem is one of the most diverse (in terms of skin colors, surnames, ethnicities, etc.) industries you will find in America. Its diversity is part of what drew me to that kind of work in the first place. Not only is the industry incredibly diverse, it is so starved of high-performing talent that it has had to bid average salaries far above other industry norms, and aggressively recruit internationally, in order to fulfill demand; stretching even further the credibility of the suggestion that tech companies would, simply out of irrational prejudice, ignore millions of high-performing candidates available for work.

The industry is, however, fiercely, almost olympically, competitive and meritocratic; by necessity. We are talking about very small entities, with very limited budgets running usually at a perpetual operating loss, in hyper-competitive markets often filled by incumbents 100x in size, and funded by high-risk investors with high-stakes expectations of returns from their own LPs. The room for error in this segment of the economy is smaller, and the cost of underperformance is higher, than anywhere else in the market.

Saying that underperformance is the main reason URMs are under-represented in elite industries, like tech startups, is not a slam dunk argument for silencing debate; much like it isn’t in other policy discourse about race and social justice. In other parts of the economy, like universities and government, there are many activists who will argue that even if URMs underperform, organizations are responsible for elevating them anyway. This is, in essence, the argument for “affirmative action.”

The affirmative action debate in the university context gains its legitimacy from the fact that most universities are non-profit entities with missions that can be tied very closely to broader issues of social justice and fairness. Elite universities also in particular have large endowments, and spend at least 4-years with students – a fair amount of time to “catch up” – before those students enter the marketplace. Thus it takes some rhetorical gymnastics for an elite university with an endowment the size of a small country’s GDP to say that it can’t “afford” to accept and train some number of underperformers in order to pursue some higher-level societal goal.

As we move from large elite universities to large for-profit employers, the argument for “affirmative action” begins to reach stronger resistance, but not so much that there isn’t room for reasonable debate. Once a company has reached a market capitalization of, say, $25 billion, with thousands of employees and layers of staff, the idea that it too “can’t afford” to incur some costs to pursue a broader societal concept of “fairness” is far from obvious. This is why various “diversity initiatives” are not uncommon in large companies. You see them in law as well, with “diversity fellowships” in the AmLaw 100.

Gains have been made in improving the representation of URMs in large, for-profit companies, particularly at entry and mid-level positions. But activists are now starting to turn their attention to the C-suite, noticing that far smaller gains have been made there. And this is where the very real challenges and constraints of startups and much larger companies start to look similar, in terms of their legitimate inability to afford substantial underperformance. Underperformance from a CEO or CFO is catastrophic at a Pfizer or an Apple just as it is at a far smaller startup. Your views about social justice and fairness may have some legitimacy and weight in the non-profit university context, and in some market contexts, but that legitimacy ends when it starts threatening entire companies and industries, on whom millions of peoples’ livelihoods, and the economy at large, depend.

What’s a word used to describe situations when someone makes strong complaints for X or Y, often citing “unfairness,” and yet the justified response is that it simply can’t and won’t be done? Whining. I understand some people may object to my use of this term as being overly dismissive and offensive, but I nevertheless think it accurately captures the tone and language often encountered by key decision-makers in the startup ecosystem when “diversity” is used as a reason to question their judgment.

In this context, of high-stakes startups and venture capital, we aren’t talking about the right to any kind of employment, or the right to use a particular essential facility or public resource. We’re not talking about civil or human rights; the contexts in which morality and fairness really should override all other concerns. Far more often, we see someone already earning a relatively comfortable salary in a white collar job using “diversity” as a reason why they should be earning an even higher salary in a more senior position. Or someone already in the top quartile of education and income nevertheless arguing that they should receive millions of dollars in private funding for their business, because they are “diverse.” In other words, here “diversity” looks far less like a legitimate, authentic moral argument for societal fairness, and more like a rhetorical device for self-promotion and advancement.

I’m sorry, but Cesar Chavez fought for oppressed very low-wage farm workers. His spirit should not be invoked while discussing whether or not a software engineer or lawyer deserves a promotion. Speaking as someone who grew up surrounded by true low-wage laborers, let’s not hijack their challenges and the moral force of their causes for high-class soft-handed gains.

My advice to key decision-makers when they encounter this kind of argument is to focus on specifics and context. Is the argument being made that this particular individual has been judged by different performance standards than those applied to other similarly positioned individuals? That is illegal, and should be addressed immediately. But if that isn’t really the argument – and it often isn’t – but rather someone is trying to claim an entitlement to “affirmative action” treatment from a startup, return to the specific context in which it is being raised.

We are not an elite non-profit university with a billion-dollar endowment and years to help someone catch up on performance. We are not a Fortune 500 company with enormous insulation in the market to absorb the costs of helping someone meet performance standards. We’re a startup trying to survive and fulfill our obligations to our employees and investors to build a successful business in a hyper-competitive market. For that reason, we need performance today, and those who can’t perform today are not the responsibility of startups. In this context, expecting a private business to absorb the cost of fixing enormously complex and nuanced social and historical issues is unreasonable and unsustainable.

Many intelligent, thoughtful, progressive people who support upper-income diversity in far more appropriate and sustainable contexts will understandably draw a hard line when asked to risk the survival of their own businesses and careers for such a cause; the equivalent of levying a tax on people who simply do not have the means to pay it. We need to leave space for people agreeing on the goal of greater diversity to still be open and honest about the very real problems with specific tactics for achieving it.

Warring

When mere arguments and complaints about “fairness” have not resulted in the action that diversity activists want to see, the most aggressive have turned to weaponizing and politicizing diversity. In other words, they start using economic punishment as a way to force private market actors to improve their “diversity numbers.”

For very large consumer-focused companies, weaponizing diversity can take the form of public shaming and threats of economic boycotts. Activists may put together statistics about “disproportionate representation” at X or Y company, and fund a PR campaign to make those numbers highly visible. Public backlash then results, with consumers withholding their purchasing dollars, and the company responds by increasing their hiring of the appropriate groups. This is effectively politicizing hiring, by making it no longer simply about the productivity of the individual candidate, but about how that candidate’s characteristics feed into statistics that then impact the public image of the company, which then impacts the purchasing of the company’s products and services, and ultimately benefits the bottom line. It can be highly effective in some mass-market contexts.

In more private areas of the economy, this sort of weaponization can take the form of channeling investment dollars or referrals of work depending on a particular company’s “diversity statistics.” For example, very large Fortune 500 companies who have responded to their own weaponized diversity incentives by upping “diverse” hiring in their ranks, can make sending legal work to X or Y law firm dependent on that firm meeting certain diversity statistics for its own roster of lawyers. Activist limited partners of venture capital funds have started this tactic as well, pressing the venture partners that they fund to improve the “diversity” of their portfolio.

This is where benign pushing for diversity now becomes much more aggressive shoving. Do it, or it will cost you money that we control. Is it effective?

As I mentioned in my original essay, no one engaging in a serious discussion about diversity issues argues that high-performing URMs simply do not exist. That would be racist, but no one is saying that. What they say is that for historical, socioeconomic, and (importantly) cultural reasons high-performing URMs are much harder to come by in the market. What happens when you have a scarce resource for which demand is subsidized with economic incentives? Those who can pay top dollar are able to obtain it, and those who can’t don’t.

Already elite companies, capable of paying the highest amounts of compensation, absorb the more limited number of high-performing URMs; high-performers who wouldn’t have had trouble getting work to begin with. These companies are then able to promote how “diverse” and progressive they are, as if their superior cultures are the reason they are so “inclusive.” Weaker and smaller companies (startups?) can’t afford to bid away those in-demand high-performers from the deep-pocketed elite, and so they end up being less “diverse.” Calling one “inclusive” and the other “racist” completely misses the mark of what is actually happening. It’s about money.

It’s unclear that, even at large companies, using sticks and stones for diversity has moved the needle much on the core issue (the supply of high-performing URMs) other than creating a bidding war for the already-existing high-performers in the market; a war which benefits those able to pay the highest comp packages. There is, however, an emerging strategy that both large companies and startups are increasingly adopting in response to aggressive warring over diversity, and it almost certainly wasn’t intended by activists.

Have you noticed how in recent years the startup and tech ecosystem has dramatically increased its involvement in both Africa and Latin America? There are surely a number of reasons for this, but one big reason is companies realized that international hiring is a highly effective way to disarm some of the strongest rhetoric from diversity activists. If you know there are complex social, historical, cultural, etc. reasons why it is not feasible to dramatically increase your domestic (US-side) URM recruiting and investment without running up against very costly performance issues, but you also know that you really aren’t racist and that skin color and ethnicity are not drivers of your decision-making, there is a growing industry more than happy to help you recruit highly qualified talent directly from Mexico, Chile, Argentina, Nigeria, Kenya, and Ghana, among other countries full of ambitious, driven prospects.

Because American companies can pay so much better than local industry in those countries, they can recruit among the cream from their very large populations. Also, those populations aren’t subject to the historical, cultural, and immigration selection dynamics that are the core backdrop (see my essay) of why American URMs struggle disproportionately with performance in education-driven technical industries. Google and tomorrow’s Googles want diverse high-performing talent, but they are not fools, and will recruit directly in Mexico City or Lagos before diversity warriors force them into hiring US-side underperformers that they can’t even acknowledge as underperformers (and thus in need of extra training or lower-level roles) because someone will accuse them of being racist.

Thus we are seeing tech companies and startups increasing their “diversity” with more international talent. Is this a “win” for diversity? It depends on whom you ask. If the goal was simply to increase the number of latino and black people in tech and startups, then yes it is definitely a win. But if the goal was to increase hiring and investment in American under-represented minorities, then no, much less progress is being made. Such little progress will continue until activists are willing to put down their weapons, and let industry be honest about the real causal relationships behind disparities. Until that happens, no one should blame founders, CEOs, and Boards for taking a logical path, via international hiring, that proves they aren’t racist, while still fulfilling their obligation to recruit high-performing talent that furthers the survival and success of their companies.

International hiring and investment is a very effective near-term tool for improving the diversity of the startup ecosystem, even if it’s not the result that warmongering activists actually wanted to force decision-makers into.

Winning

We are thus faced with the fundamental tension in the diversity debate as applied to startups, and other high-performance, high-stakes industries. Diversity and increasing representation of minorities is a categorically good thing in an abstract sense. You will be hard-pressed to find someone actually say, publicly or privately, that they’d prefer a less diverse startup ecosystem. That would be inane.

But startups operate in the most competitive, high-stakes, low-margin-of-error segment of the modern economy. Arguments and tactics used by diversity activists that have found some success in universities, and even in large companies, face a fundamentally different set of constraints and realities in the startup economy. As I said in my original essay, and I will repeat here, if you want to see more URMs in startups, you need to actually help them win.

Whining and warring will not materially move the needle on diversity in a startup ecosystem that simply cannot safely absorb underperformance in the way that universities and massive companies can. Winning will. Unambiguous, credible, level-playing-field winning. You know who really doesn’t care about representative disparities, and judges a startup’s products and services purely on their objective merits? Their customers. There is no more brutal judge of performance than the open market, and for that reason no one does URMs any favors by acting as if affirmative action special treatment should continue well past the educational system and into the for-profit marketplace. When results, and only results, silence all other factors, help people actually deliver.

The most honest and effective diversity activists in tech and startups do not adopt childish arguments suggesting that hundreds of founders and VCs are “racists.” Nor do they suggest that highly competent and progressive executives are ignoring high-performing talent out of some dramatically oversold armchair idea of “unconscious bias.” Rather, they understand performance gaps are real, and are doing the work of filling those gaps; via additional resources, training, and networks applied to under-represented candidates. This is a perfect corollary to how elite universities who’ve adopted affirmative action policies didn’t do so by simply throwing sub-qualified URM students into their schools and hoping for the best. They thoughtfully implemented extra training and resources to help those students “catch up” to the performance of the rest of their student bodies.

This costs time and money. As I’ve emphasized, elite universities are very large, very rich orgs with plenty of time and money to pursue higher-level societal goals. The vast majority of the players in the startup ecosystem simply do not have the time or resources to play a material role in this process. For completely understandable reasons, they can only afford to recruit and invest in today’s winners, with the ethnic or racial makeup of their teams and portfolios being neither here nor there. That is their mandate. It doesn’t make them racists or jerks. It makes them pragmatic, normal businesspeople with a job to do.

But tomorrow’s winners, including those who are under-represented minorities, are being trained, built, and elevated by honest people who aren’t shying away from uncomfortable realities. They aren’t throwing colleagues and friends under a bus with slanderous labels. They also aren’t pretending that feel-good messaging, “bias workshops,” or public guilting and shaming of decision-makers are the key to success for URMs in a highly competitive market economy. They’re addressing the game actually on the field, and putting in the time and resources to help URMs win it, under the same rules everyone else plays by.

We all want to see a more “diverse” startup ecosystem, in every sense of the word. To get there we need less whining, less warring, and good people willing to put in the work and honesty to ensure there’s far more winning.