How Startup Employees Get Taken Advantage Of

TL;DR: When startup employees get taken advantage of in startup equity economics, it’s often not just about bad documentation or strategy. It’s about incentives, and games being played by influential “insiders” to gain control over the startup’s corporate governance. Ensuring common stock representation on the Board, independence of company counsel (from investors), and monitoring “sweeteners” given to common representatives on the Board are strong strategies for protecting against bad actors.

Related Reading:

A common message heard among experienced market players, and with which I completely agree, is this: if you are seeing significant dysfunction in any organization or market, watch incentives. In small, simple, close-knit groups (like families and tribes), shared principles and values can often be relied on to ensure everyone plays fairly and does what’s best for the group.  But expand the size of the group, diversify the people involved, and raise the stakes, and people will inevitably gravitate toward their self-interest and incentives. The way to achieve an optimal and fair outcome at scale is not through “mission statements” or virtue signaling, but focusing on achieving alignment (where possible) of incentives, and fair representation of the various constituencies at the bargaining table.

A topic that is deservedly getting a lot of attention lately is the outcomes of startup employees as it relates to their equity stakes in the startups that employ them. I see a lot being written about it in the various usual tech/startup publications, and we are also seeing companies reaching out to us asking about potential modifications to the “usual” approaches.  The problem being discussed is whether startup employees are getting the short end of the stick as companies grow and scale, with other players at the table (particularly the Board of Directors) playing games that allow certain players to get rewarded, while off-loading downside risk to those unable to protect themselves.

The short answer is that, yes, there are a number of games being played in the market that allow influential “insiders” of growing startups to make money, while shifting risk to the less powerful and experienced participants on the cap table. The end-result is situations where high-growth startups either go completely bust, or end up exiting at a price that didn’t “clear” investors’ liquidation preferences, and yet somehow a bunch of people still made a lot of money along the way, while startup employees got equity worth nothing.

The point of this post isn’t to discuss the various tactics being used by aggressive players to screw employees, but to discuss a higher-level issue that is closer to the root problem: corporate governance, and the subtle detachment of employee equity economics from other cap table players. When some people on the Board have economic incentives close to fully aligned with employees (common stockholders whose “investment” is labor, not capital, and often sunk), they are significantly more likely to deliver the necessary pushback to protect employees from absorbing more risk than is appropriate.  But if smart players find ways to detach those Board members’ interests from the employees who can’t see the full details of the company’s financing and growth strategy, things go off the rails.

Corporate governance and fiduciary duties.

Broadly speaking, corporate governance is the way in which a company is run at the highest levels of its organizational and power structure, particularly the Board of Directors. Under Delaware law (and most states/countries’ corporate law), the Board has fiduciary duties to impartially serve the interests of the stockholders on the cap table. Regardless of their personal interests, a Board is supposed to be focused on a financing and exit strategy that maximizes the returns for the whole cap table, particularly those at the bottom of the liquidation preference stack and who lack the visibility, influence, and experience to negotiate on their own behalf. That obviously includes, to a large extent, employee stockholders.

This is, of course, easier said than done. Remember the fundamental rule: watch incentives. Having a Board of directors that nominally professes a commitment to its fiduciary duties is one thing. But maximizing economic alignment between the Board and the remainder of the cap table is lightyears better.

“One Shot” common stockholders v. “Repeat Player” investors

As I’ve written many times before, anyone who behaves as if investors (capital) and founders/employees (labor) are fully aligned economically as startups grow, raise money, and exit is either lying, or so spectacularly ignorant of how the game actually works that they should put the pacifier back in their mouth and gain more experience before commenting.

Common stockholders (founders, employees) are usually inexperienced, not wealthy, at the bottom of the liquidation “waterfall” (how money flows in an exit), not independently represented by counsel, and not diversified. Preferred stockholders (investors) are usually the polar opposite: highly experienced, wealthy, have their own lawyers, heavily diversified, and with a liquidation preference or debt claim that prioritizes their investment in an exit. Common stockholders’ “investment” (their labor) is also often sunk, while major investors have pro-rata rights that allow them to true-up their ownership if they face dilution.

Investors are far more incentivized to push for risky growth strategies that might achieve extremely large exits, but also raise the risk of a bust in which the undiversified, unprotected common equity gets nothing. Common stockholders are far more likely to be concerned about risk, dilution and dependence on capital, and the timing / achievability of an exit. This tension never goes away, and plays out in Board discussions on an ongoing basis.

As I’ve also written before, this is a core reason why clever investors will often pursue any number of strategies to put in place company counsel (the lawyers who advise the company and the Board) whose loyalty is ultimately to the investors. A law firm whom the money can “squeeze” – like one that heavily relies on them for referrals, or who does a large volume of other work for the investors – is significantly more likely to stay quiet and follow along if a Board begins to pursue strategies that favor investor interests at the expense of common interests. See: When VCs “own” your startup’s lawyers. 

When Board composition is discussed in a financing, founder representation on the Board is often portrayed as being purely about the founders’ own personal interests; but that’s incorrect. Founders are often the largest and earliest common stockholders on the cap table, which heavily aligns them economically with employees, particularly early employees, in being concerned about risk and dilution.

Unless someone finds a way to change that alignment.

Founders and employees: alignment v. misalignment. 

Very high-growth companies raising large late-stage rounds represent many opportunities for Boards to “buy” the vote of founders or other common directors (like professional CEOs) at the expense of the employee portion of the cap table. In a scenario where a Board is pursuing an extremely high risk growth and financing strategy, and accepting financing terms making it highly likely the early common will get washed out or heavily diluted, a typical entrepreneur with a large early common stock stake will play their role in vocally pushing for alternatives.

But any number of levers can be pulled to silence that push-back: a cash bonus, an opportunity for liquidity that isn’t shared pro-rata with the rest of the employee pool, a generous refresher grant given post-financing to reduce the impact on the founder/executive (while pushing more dilution onto “sunk” stockholders). These represent just a few of the strategies that clever later-stage investors will implement to incentivize entrepreneurs (or other executives) to ignore the risk and dilution they are piling onto employees.

Of course, it’s impossible to generalize across all startups that end up with bad, imbalanced outcomes. The fact that any particular company ended up in a spot where the employees got disproportionately washed out isn’t indicative in and of itself that unfair (and unethical) games were being played. Sometimes there’s a strong justification for giving a limited number of people liquidity, while denying it to others. Sometimes the Board really was doing its best to achieve the best outcome for the “labor” equity. Sometimes.

Principles for protecting employee stockholders. 

That, however, doesn’t mean there aren’t general principles that companies can implement to better protect employee stockholders, and better align the Board with their interests.

First, common stockholder representation on a Board of Directors is not just about founders. It’s about recognizing the misalignment of incentives between the “one shot” common stock and the “repeat player” preferred stockholders, and ensuring the former have a real, unmuzzled voice in governance. Founders are the largest and earliest common stockholders, and therefore the most incentivized to represent the interests of the common in Board discussions.

Second, take seriously who company counsel is, and make sure they are independent from the influence of the main investors on the cap table. Company counsel’s job is, in part, to advise a Board on how to best fulfill its fiduciary duties. You better believe the advisory changes when the money has ways to make counsel shut up. Packing a company with people whom the money “owns” (including executives, lawyers, directors, and other advisors) is an extremely common, but often subtle and hidden, strategy for aggressive investors to gain power over a startup’s governance.

Third, any “extra” incentives being handed to Board representatives of the common stock (including founders) in later-stage rounds deserve heightened scrutiny and transparency. That “something extra” can very well be a way to purchase the vote of someone who would otherwise have called out behavior that is off-loading risk to stockholders lacking visibility and influence.

Startup corporate governance is a highly intricate, multi-step game of 3D chess, often with extremely smart players who know where their incentives really lie. Don’t get played.

p.s. the NYT article linked near the beginning of this post is provided strictly as an example of the kinds of problems that might arise in high-growth startups. I have no inside knowledge of what happened with that specific company, and this post is not about them. 

Relationships and Power in Startup Ecosystems

TL;DR: The highly unequal relationship and power dynamics in most startup ecosystems mean that what is visible publicly is not an accurate representation of how the game is actually played, because few people are willing to speak honestly and openly. This makes off-the-record diligence, and watching loyalties of your most high-stakes relationships (including counsel), essential in order to prevent repeat “money” players (investors, accelerators) from dominating the voices of less influential “one shot” players (first-time entrepreneurs, employees) both on boards of directors and in the market generally.

Background Reading:

There are a few underlying themes that have been covered in a number of SHL posts and are relevant to this one:

First, in startup dynamics there is a fundamental divide and tension between inexperienced, “one shot” common stockholders and “repeat player” investor preferred stockholders (VCs, seed funds, accelerators) that feeds into all of the most high-stakes decisions around how to build and grow a company. It has nothing to do with good v. bad people. It has to do with core economic incentives.

Common stockholders (founders, early employees) typically have their wealth concentrated in their one company (not diversified), do not have substantial wealth as a backup in the event of failure, do not have the downside protection of a liquidation preference or debt claim on the company, and have almost no experience in the subtle nuances of startup economics and governance. This dramatically influences their perspective on what kind of business to build, how to finance it, whom to hire in doing so, and how much risk to take in order to achieve a successful outcome; including how to define “successful.”

Preferred stockholders / repeat players (investors, accelerators) are the polar opposite of this scenario. No matter how “founder friendly” they are, or at least pretend to be via PR efforts (more on that below), their core economic interests are not aligned with one shot players. They are already wealthy, significantly diversified, have substantial experience with startup economics and governance, and have downside protection that ensures they get paid back first in a downside scenario.  In the case of institutional investors, they also are incentivized to pursue growth and exit strategies that will achieve rare “unicorn” returns, even if those same strategies lead to a large amount of failures; failures which hit common stockholders 100x harder than diversified, down-side protected investors.

And the fact that some of the repeat players are themselves former founders (now wealthy and diversified) is irrelevant to the fundamental economic misalignment; though investors will often use their entrepreneurial histories as smoke and mirrors to distract now first-time founders from that fact. They can probably empathize more with the common’s challenges, and help with execution, but they didn’t become wealthy by ignoring their economic interests. In fact, I would argue from experience that the moves/behavior of entrepreneurs-turned-investors should be scrutinized more, not less, because they’re almost always far smarter “chess players” at the game than the MBA-types are.

Second, apart from the economic misalignment between the common and preferred, there is a widely unequal amount of experience between the two groups. A first-time founder team or set of early employees do not have years of experience seeing the ins and outs of board governance, or how subtle deal terms and decisions play out in terms of economics and power.  The preferred, however, are usually repeat players. They know the game, and how to play it. This means that the set of core advisors that common stockholders hire to leverage their own experience and skillset in “leveling the playing field” is monumentally important; including their ability to trust that those advisors will help ensure that the preferred do not leverage their greater experience and power to muzzle the common’s perspective.

This second point relates to why having company counsel who is not dependent on your VCs / the money is so important; and it also highlights why repeat players go to such enormous efforts to either force or cleverly trick inexperienced teams into hiring lawyers who are captive to the interests of the preferred.  We’ve observed this in pockets of every startup ecosystem we’ve worked in: that aggressive investors work hard to gain influence over the lawyers who represent startups.  The moment we became visible in the market as a growing presence in startup ecosystems, we lost count of how many of the strongest money players reached out to us to “explore” a relationship; even though they already had “relationships” with plenty of firms. It wasn’t that they needed lawyers; it’s their power playbook.

The point of this post is how these above facts – the economic misalignment, and particularly the greater experience – of influential investors (including accelerators) plays out into how they exert power, often covertly, in startup ecosystems; not just with lawyers.

Think of any kind of business that needs to work with startups as clients: obviously lawyers, but also accountants, HR, outsourced CFO, benefits, real estate, even journalists who need access to entrepreneurs in order to write articles. All of those people need strategies for “filtering” startups (finding the more viable ones) and then gaining access to them; and they’re going to look for strategies that are the most efficient and less time consuming.

What many of these service providers come to realize is that an obviously efficient strategy is to work through VCs and other influential investors/accelerators. They’re doing the filtering, and because they’re repeat players, have relationships with lots of companies.  So the service providers reach out to the prominent repeat players (investors, accelerators), who immediately recognize the power that this role as “gatekeepers” and brokers of relationships gives them over the ecosystem.

And when I say “power over the ecosystem,” what I mean is power over what people will say publicly, what they won’t say, and what “support” businesses become successful (or not) via the direction (or restriction) of referral pipelines. It heavily plays out into what gets written and not written on social media and in tech publications, and said at public events; because people are terrified of pissing off someone who will then cut them off from their lifeblood of clients.

“One shot” players are, by virtue of not being repeat players and lacking significant relationships, unable to counterbalance this dynamic.  Put together a system of highly influential and wealthy repeat players and inexperienced, less influential “one shot” players, and you can bet your life that it will inevitably tilt itself toward those who can exert power; with strategies to obscure the tilting from the inexperienced. The ability to offer (and restrict) access to valuable relationships is the leverage that repeat players use to exert power in startup ecosystems and ensure their interests are favored; even when they aren’t formally the “client.”

So let’s tie this all together. Founders and other early startup employees are significantly misaligned from the repeat player investor community in a way that has nothing to do with ethics, but core incentives and risk tolerance; and this is independent of the more obvious misalignment re: each side’s desire for more ownership of the cap table. They’re also totally lacking in experience on how to navigate the complexities of startup growth and governance, and therefore rely heavily on trusted outside advisors to level the playing field. Finally, the most aggressive repeat players will position themselves as gatekeepers to the ecosystem (or at least a valuable portion of it), exerting significant control over the market of advisors available to founders by their ability to offer, or deny, access to startups.

What’s the conclusion here? There are two:

A. What you often see written or said publicly in startup ecosystems is not an accurate representation of how the game is actually played, because very few people are willing to talk openly about it, for fear of being cut off by gatekeepers.  Others will say positive things publicly because of a quid-pro-quo understanding in the background. This significantly increases the importance of off-the-record “blind” diligence to get the real story about a particular repeat player. If you are diligencing an influential investor or an accelerator, it is important that said entity not know whom you are contacting (or at least not everyone) in conducting that diligence.  That is the only way that they cannot retaliate against any particular person who says something negative; and you’re therefore more likely to get an honest answer.

You will absolutely encounter people who will say that the whole idea of “retaliation” is some kind of paranoid fabrication, but remember how the chess game is played: the appearance of “founder friendliness” is often a marketing tool. Of course the smartest users of that tool are going to wave away all this talk of bad actors, doing heavy diligence, and protecting yourself as unnecessary. Come on, they’re good guys. Just trust them, or their tweets. We’re all “aligned” here, right?

When you have an inherent and substantial power advantage, it is an extremely effective strategy to create a non-adversarial, “friendly” PR image of yourself, downplaying that power.  Inexperienced, naive first-time players then buy into this idea that you’re not really about making money, and come to the table with minimal defenses; at which point you can get to work and surround them with relationships you “own.”

The money players with truly nothing to hide won’t be dismissive or defensive at all about the common’s need to conduct blind diligence and ensure the independence of their key relationships. Reactions are often a key “tell.”  If you truly have a great reputation, and you have no intent to use the common’s inexperience and unequal power against them, then what exactly is the problem with respecting their right to be cautious and protect themselves?

There are definitely good people in the market, including those who put integrity and reputation above money, but only idiots navigate a highly unequal and opaque world under the premise that everyone is an angel, and you should “just trust them.” Being a “win-win” person is not in tension with ensuring your backside is covered. Anyone who says otherwise is trying to cleverly disarm you, and is defending an approach that has clearly served them well.

B. To prevent repeat players from dominating the perspective of “one shot” common stockholders both on startup boards of directors, and in ecosystems generally, the “one shot” players must pay extremely close attention to the relationships of their high-stakes key advisors and executive hires, to ensure they can’t be manipulated (with bribes or threats) by the money’s relationship leverage.  No rational human being who cares about being successful bites the hand that most feeds them; no matter how “nice” they are. That is the case with lawyers, with “independent” directors on boards, with other key advisors, and also with high-level executives that you might recruit into your company. Pay attention to loyalties, and diversify the people whose rolodexes you are dependent on.

In the case of lawyers, aggressive repeat players and their shills will often talk about how startup dynamics are “different” and it’s “not a big deal” for company counsel to have dependencies (via engagements and referral relationships) with the preferred stockholders. They even argue that the lawyers’ “familiarity” with the investors will help the common negotiate better and save legal fees. How generous. An honest assessment of the situation is that startups are different, but different in a way that conflicts of interest matter more than usual. Outside of the world of promising startups run by first-time executives negotiating financing/governance with highly experienced investors, you rarely see high-stakes business contexts where there is such a dramatic inequality of experience and power between groups, and such a high level of dependence on counsel (on the part of the one shot common) for high-impact strategic guidance.

Repeat players aren’t reaching across the table and manipulating startup lawyers because it’s “not a big deal.” They’re doing it because the payoff is so uniquely high, and the power inequality (reinforced by the preferred’s inherent dominance over key ecosystem relationships) makes it so easy to do. Couple a basic understanding of human nature/incentives with the fact that the Board’s primary fiduciary duties under Delaware law are to the common stock, and any honest, impartial advisor will acknowledge that experienced company counsel who doesn’t work for the repeat players across the table on other engagements, and who doesn’t rely on them for referrals (in other words, is not conflicted), is one of the clearest ways to (a) ensure the common’s perspective gets a fair voice, and accurate advisory, in key Board decisions, and (b) help the Board do its actual job.

There is a clever narrative pushed around startup ecosystems painting a picture of startup finance and governance as always full of warm, balanced transparency and generosity, with common stockholders and investors holding hands and being “fully aligned” as they build shareholder value together without bias, disagreement, or power plays. But notice how quickly the tone changes from some parts of the investor community the moment you suggest that the common be afforded even minimal defensive protections, like company counsel that investors can’t manipulate. Suddenly you’re being “overly adversarial.” Oh, so are the transparency and generosity, and “kumbaya” sing-alongs, only available if the common keep their necks directly under the boots of the powerful, but oh so benevolent and soft-heeled, money? Funny how that works. Smart common stockholders won’t accept “benevolent dictatorship” as the model for their company’s governance. The way you address power inequality is by actually addressing it; not by taking someone’s BS reassurances that they’ll be “really nice” with how they use it.

You should absolutely want transparency, fairness, and generosity to be the guiding principles of your relationship with your investors – that’s always my advice to founders on Day 1. Also understand that while the common’s perspective deserves to be heard and respected (and not muzzled or infantilized), it is obviously not always right. Balanced governance is good governance; and true “balance” requires real, independent ‘weight’ on both sides. Too many repeat players have manipulated the market into a charade – propped up by pretensions of “friendliness” and “cost saving” – where inexperienced common stockholders become unwittingly dependent on advisors to help them negotiate with investors 100x as experienced as they are, when in fact those advisors are far more motivated to keep the investors happy than their own (on paper) clients.

High-integrity startup ecosystem players should forcefully assert that the “friendly” ethos promoted by VCs and accelerators only has real substance if they’re willing to stay on their side of the table, and not use their structural power advantage to maintain influence over the key people whom founders and employees depend on for high-stakes guidance and decision-making. Call out the hypocrisy of those who put on a marketing-driven veneer of supporting startups and entrepreneurs, while quietly interfering with their right to independent relationships and advisory; including independent company counsel that repeat players can’t “squeeze” with their relationship leverage.

A lot of the most egregious stories of startup flame-outs that you see written about – who grew too fast chasing a unicorn exit, raised more money than a business could sustain, took a high-risk strategy that blew up, or perhaps achieved a large exit while returning peanuts to the early common – are the end-result of a complex game by which repeat players come to exert so much power over how a particular startup scales that the voice of the “one shot” players – the early common stockholders without deep pockets or contacts – gets completely silenced until it’s too late. Gaining control over key company relationships is a significant part of how that game is played. And what’s written about publicly is just the tip of the iceberg.

To put a bow on this post, healthy skepticism over what you see and hear publicly, and good instincts for understanding the importance of incentives and loyalties, are essential for any inexperienced team entering a startup ecosystem. The image of wealthy, powerful people “winning” only by loudly and aggressively pounding the negotiation table is a caricature of how complex business actually works; but it’s a caricature that often dupes inexperienced founders into thinking that everyone else who smiles and seems helpful must be aligned with their interests. Assholes are easy to spot, and the smartest winners are almost never visible assholes. Good people still follow their incentives; and aggressive but smart money players know how to assert their power while preserving a public image of selflessness and generosity. Navigate the market, and recruit your advisors, accordingly.

Why our lawyers work fewer hours

Background Reading:

When you hire a typical large high-end law firm, the lawyers you work with are generally required to work 60-80 hour weeks non-stop if they want to keep their jobs; and at the higher end of that range if they want to make partner (in 8-10 years).  This is considered totally normal among that tier of law, as a “price” for the privilege of working there. If you want to see the inevitable end-result of that kind of culture, read the NYT article I’ve linked to above. It may seem extreme, but that profile of life is far less rare in law than most outsiders would think.

On top of the work expectations, most non-partners take home about 25% of the revenue they generate from clients. The other 75% goes to firm overhead (infrastructure) and partners. So when elite BigLaw charges you $695/hr for a senior associate, maybe $175/hr goes to the associate, the rest goes elsewhere. Obviously, the big question becomes how much of that “other stuff” is really necessary; and the answer varies depending on the type of client.

The causal chain here is pretty straightforward: bloated overhead and bureaucracy -> lower take-home for lawyers (and higher rates for clients)-> elite lawyers work insane hours to make good money -> divorce, depression, therapy, drug addiction, etc. etc. This is why, as we’ve built and scaled out our leaner but still high-end boutique firm, people have often heard me speak of “bloat” as if it’s the next incarnation of satan. Because I know that, from having studied that causal chain very closely, the extra piece of bullshit technology, or administrative person who just over-complicates processes, is directly tied to why many lawyers’ marriages fall apart, or their kids end up in therapy; or why they can’t get married or build families/relationships in the first place.

If I generated a dollar, and you want to take a cut of it, you better believe I’m going to make you earn it. And I say “no” far more often than I say “yes.”

At E/N, our lawyers, including partners, work on average 25% fewer hours than their BigLaw counterparts, at rates about $200-300+/hr lower; and our credentials speak for themselves. Top-performers (on a number of metrics, not necessarily hours) actually out-earn what they’d expect to make in BigLaw, while everyone generally makes more than what they’d expect as a GC or in some other “lifestyle” lawyer-type job.

It hasn’t been easy to piece together – getting extremely intelligent (the 1%), highly-trained professionals to coordinate and integrate together into a new brand is way more complicated than most would think, and it’s why precious few boutique firms reach any meaningful level of scale before falling apart. It still takes quite a lot of scalable “infrastructure,” just designed very differently from how old firms build it. But ultimately it’s a great set up for clients and for lawyers; not just those at the top of the hierarchy. It works, and we’re growing, sustainably, by knowing what we’re building, and who we’re building it for.

I am 100% convinced that our emphasis on quality of life for lawyers translates to better service for clients, in terms of responsiveness, creative solutions, and ultimate value add for our time. When your lawyers aren’t forced to over-stuff their “plate” all day, every day, the clients they work with get better service. That’s demonstrated in our client testimonials.

Part of our focus on client satisfaction is in selecting for clients who, themselves, have a strong sense of balance. They want to build great things and make great money – and work hard, but they reject the toxic values, pervasive in so much of the market, that myopically celebrate the neglect of so many other important things in life in order to “win.” Trust me, we’re winning and our clients are winning, but at a much broader, more important game.

In my value structure and those of our lawyers, there’s no bigger “loser” than the guy with tons of money, but a failed personal life, horrible health, and nothing meaningful to come home to other than more work; and there’s no amount of spin that can get us to reframe that life as “crushing it” or “strong work ethic.”

I have no doubt that the hard-grinding culture of traditional elite law will continue, in the same way that it continues in big pockets of tech ecosystems. It has its place in the world. We see our role as simply building out an alternative, and letting people – both clients and lawyers – self-select for what they want and support.

 

 

 

Don’t be an Asshole.

TL;DR: You probably can’t afford to be one.

Background Reading:

A regular theme of SHL involves different ways for founders and executives to protect themselves from bad actors – often via advice that I’m able to give by being in a position of not representing any institutional investors, deliberately. If you want more on that, see: How to avoid “captive” company counsel. 

The purpose of this post is to flip the topic, and discuss why there are very real, non-warm-and-fuzzy, reasons why entrepreneurs/execs should be very careful not to behave like bad actors themselves.

If you apply Maslow’s Hierarchy of Needs to the business world, you arrive at one very real truth: the most talented, value-additive people in any industry are virtually never in it just for the money. They have enough, and trust their ability to earn more. Their talent allows them to care about other things: like challenging work, trust, friendship, impact, fun, respect, etc. By no means does this suggest they don’t care about money at all – in some cases money is a way for them to ensure they are being valued and respected for what they deliver. But it does mean that anyone who approaches these people with a kind of opportunistic cost-benefit analysis is likely to get ice cold water poured on them, very fast.

Startup ecosystems are full of these kinds of people. If all they cared about was money, they’d never touch early-stage.  If they’re working with startups (and your very early-stage risky startup), there are non-financial motivations higher on the hierarchy of needs at play, and you need to be mindful of that as you interact with them.

When you’re building your brand new or very early-stage company, unless you have a LinkedIn profile that screams “winner,” people all around you are going to be risking their time and money in working with you. There are 1,000 reasons why they might say no, and move on to someone else with a different risk profile. The absolute last thing you want to do is give them a reason to walk away, because they smell an asshole. And trust me, they will walk away. 

“Startup people” react much more viscerally to assholes than “corporate people” do, because the startup world often selects for people who won’t do or tolerate anything for a big payout. The large hierarchies of corporate environments enable, naturally, more hierarchical behavior among peers. In contrast, the “flatter” nature of startup ecosystems generates, and enforces, more “democratic” (respect everyone) norms.

As startup lawyers, we’re often in a position to see firsthand who the assholes in the entrepreneurial community are. They treat lawyers and many other service providers as line items to be deferred, discounted, and written-off to the very last dime, as much as possible; and will play games to manipulate people into giving them more for less. Thinking extremely myopically, these assholes think they’re doing what’s best for their company by grabbing as much as possible on the table – but played out over time, they’re actually whittling down the number of people who will work with them to those who simply don’t have other options. And when someone doesn’t have options, it’s often for a reason. Interestingly, assholes have a way of ending up stuck with other assholes. 

All of this applies just as well to top investors, particularly angel investors (with more freedom than VCs) who know they deliver a lot more than money. God help you if you give them even the slightest reason to think you’re an asshole. Information travels fast.

The definition of a mercenary is someone whose every decision is cost-benefit calculated for money. The fact is that if you build a reputation in a startup ecosystem for being a mercenary – always maximize the valuation, minimize the equity grant, discount the bill – you’re dramatically reducing your chances of making money, simply because of the personalities and values you tend to find in the startup world.

Be careful out there. Don’t be an asshole. On top of it being simply wrong, you probably can’t afford it.

Contracts v. Might Makes Right

TL;DR: When a first-time entrepreneur is navigating an environment full of entrenched players who all know and depend on each other, the difference between a balanced decision process and a shake down can come down to a contract. Take contracts, and the independence of the lawyers who help negotiate them, seriously.

Background reading:

A background theme of many SHL posts is the following: entrepreneurs enter their startup ecosystems, from the beginning, at a massive structural disadvantage relative to the various market players they are going to be negotiating with. Everyone else knows each other, has worked with each other over the years, and has already made their money. And then you show up.

Now assume that environment as the background, and then imagine you start striking deals with these people: for a financing, a partnership, participation in a program, etc., but assume there are no contracts or lawyers involved. What do you think will eventually happen? Here’s how it will play out: as long as you continue to deliver exactly what everyone wants from you, very little will happen. When everyone’s expectations and preferences are 100% aligned in the short term, the absence of contracts means very little. They’ll “let” you stay in the spot you’re in. 

Until things (inevitably) go sideways. A market shift suddenly means a change in strategy might be necessary, but there’s disagreement on how and when. A quarter comes in under projections, and there’s disagreement as to what that means. A potential outside investor expresses interest in making an investment, and there’s internal disagreement as to whether it should be pursued.

I focus here on the word disagreement, because in many situations on high-level strategic issues, the right answer isn’t always clear cut. The goal (grow the company, improve economics) may be clear, but the right execution strategy is far harder to see.  People will disagree, and where they stand on an issue often rests on where they sit. For example, “portfolio” players (institutional investors) will often be far more comfortable, and even insistent, on taking higher risk (but much higher reward) growth strategies than entrepreneurs and employees, who have only “one shot.”  See Common Stock v. Preferred Stock for a more in-depth discussion on the substantial misalignment between “one shot” players (entrepreneurs, employees), who usually hold common stock, v. portfolio/repeat players (investors), who usually hold preferred stock.

The core point of this post is this: in an environment of substantial disagreement, and where everyone other than the entrepreneur is a repeat player that knows and has economic ties to each other, the first-time entrepreneur (who speaks for the early common stockholders generally) will lose every timeunless contracts in place say otherwise. 

In the absence of laws and contracts, the law of the market is “might makes right,” and established, repeat players have all the might.  

Here is a scenario that I’ve encountered far too often (although increasingly less so as awareness has increased) that is almost comical when viewed objectively:

  • A financing has closed, putting in place a “balanced” Board of 2 VC directors, 2 common directors (one of which is a new CEO, the other a founder), and an “independent” director.
  • In attendance at the meeting are 6 people: the Board and company counsel.
  • The 2 VCs regularly syndicate deals with each other and have known each other for a decade.
  • The new CEO is a well-known professional CEO who has worked in several portfolio co’s of one of the VCs, and was “recommended” by that VC for the position.
  • The “independent” director is an executive well-known in the local market who also has worked with the VCs at the table for over a decade, both of whom recommended her for the position.
  • “Company counsel” represents 6 portfolio companies of the VCs at the table, and has represented them as investor counsel on as many deals, and is actually currently doing so for other deals. In fact, company counsel became company counsel because he came “highly recommended” by the VCs when they were first negotiating the deal with the entrepreneur.

So let’s summarize: there are 6 people at the meeting, and 5 of them have all worked with each other for over a decade, regularly send deals to each other, and in some cases (at least with respect to the lawyer and a VC) are currently working with each other on other deals not related to this company. And then there’s the entrepreneur.

Wow, now there’s one “balanced” Board, don’t you think? I’ve encountered entrepreneurs (whose companies are not clients) in this situation before. I let them know that, whatever they think their position at the company is or will be, they are simply leasing that position until their investors, who hold virtually all the cards and relationships, decide otherwise; and regardless of what the common stockholders think. It’s possible things turn out fine, as long as all goes as planned. It’s also very possible they won’t.  But what’s absolutely clear is who decides, in the end.

The difference between a well-advised entrepreneur and the one in the above scenario is this: the former will have real protections in place to ensure the common stock are treated fairly, and have their voice on key company matters. The latter may feel protected, but ultimately their position is at the discretion of their investors; and protection that is contingent on the whims of people on the other side isn’t protection at all.

Well-drafted contracts are, when negotiated in a transparent manner, a key mechanism for controlling the power of sophisticated repeat players who, absent those contracts, can simply force through whatever they want because of their political / economic leverage. What else might this reality tell us about negotiation dynamics in startup ecosystems?

Rushing through negotiations / contract drafting favors established players.

If the default market position gives power to established players, and contracts are a mechanism for controlling that power, the inevitable result is that those established players (at least the most aggressive ones) will try to get entrepreneurs to rush through contract negotiations.

“Let’s just go with what’s standard.”

“It’s all boilerplate.”

“Let’s save legal fees and put them toward building the business.”

“Time kills deals. Let’s get this closed.”

If someone is telling you that what the documents say doesn’t really matter, or that you should just stick to a template, it’s because, outside of the contract, they’re in control.  That doesn’t mean you should burn endless amounts of time negotiating every point, but take the material provisions seriously.

A market ethos of “relax, we’re all friends here” is designed to favor power players.

Old-school business folks know very well how large amounts of alcohol have often been used to seal business deals. In the startup world, alcohol may still be used, but just as effective is fabricating an environment suggesting to first-time entrepreneurs that everyone is just holding hands and singing kumbaya, and being independently well-advised isn’t necessary.

I’m all for having very friendly relations with your business partners. Life is too short to work with people you don’t get along with well.  But any time someone extends that thinking to the point of telling entrepreneurs that “everyone is aligned” and they should let go of the skepticism to focus on “more important things,” I call bullshit. Alcohol and kool-aid; stay sober in business.

“Billion or bust” growth trajectories mean contracts matter less. Outside of those scenarios, they matter more. 

Among emerging company (startup) lawyers, it’s always been well-known that the Silicon Valley ecosystem as a whole takes standardization, automated templates, and rapid angel/VC closings to an extreme relative to the rest of the country/world. I’ve pondered why that’s the case, and in discussing with various market players, concluded that it has a lot to do with the kinds of companies that Silicon Valley tends to target: billion or bust is a good way to summarize it. I wrote about this in Not Building a Unicorn. 

If the mindset of an ecosystem is significantly “power law” oriented in the sense that “winners” are billion-dollar companies, and everyone else will just crash and burn trying to be one of those billion-dollar companies, I can see why the finer details of deal negotiation may be seen as an afterthought. That environment, which is very unusual when compared to most of the business world, leaves a lot less room for the “middle” scenarios – things aren’t going terribly, and we’re clearly building a solid business. but neither is this a rocket ship, and there are hard questions to be decided – where the deep details of who has what contractual rights really matter.

In a heavily binary “unicorn” world, you’re either knocking it out of the park, in which case no one even reads the contracts and just lets you do your thing, or you’re crashing and burning, in which case the docs are just useless paper. As a law firm headquartered in Austin and structured for non-unicorns, we don’t work in that world, and actually avoid it.

For true “balance,” pay close attention to relationships.

In my opinion and experience, the best outcomes result when the power structure of a company (both contractual and political) doesn’t give any single group on the cap table the ability to force through their preferences, but instead requires some hard conversations and real “across the aisle” coalition building to make a major change.

Balanced boards are, on top of other contractual mechanics, a fantastic way of achieving this, when they are in fact balanced. The above-described scenario where everyone except for the entrepreneur knows and has strong economies ties to each other, including a company counsel “captive” to the VCs, is a joke; and sadly, a joke played on too many startups.

As I wrote in Optionality: Always have a Plan B, build diversity of relationships into your Board and cap table. Feel free to let “the money” recommend people, because their rolodexes are valuable, and are often part of the reason why you’ve engaged with them. But you should be deeply skeptical of any suggestion that the preferred stockholders should, alone, decide who the CEO is, who company counsel is, who the independent director is, etc. etc. Letting them do that certainly may get your deals and decisions closed faster, but unless you are successful in delivering a true rocket ship, you will ultimately regret it.

The common stock, including the founding team and early employees, need a strong voice at the table, especially given the power imbalance with repeat players. Well-negotiated contracts and independent, trustworthy company counsel are the way to ensure they have that voice.