Post Category → Ethics

How fake “Startup Lawyers” hurt entrepreneurs

TL;DR: Entrepreneurs need to be aware of the growing trend of lawyers from random backgrounds re-branding themselves as “startup lawyers,” despite having only the thinnest understanding of the subject.

Background reading:

There are two trends worth discussing in this post, both of which I’ve seen seriously hurt entrepreneurs and startups.

Thrown to the juniors.

First, one reason many entrepreneurs are dropping very large law firms for more “right sized” boutiques is that those law firms have become so unaffordable for almost any early-stage company that entrepreneurs end up working almost exclusively with very young, junior lawyers. I touched on this issue briefly in The Problem with Chasing Whales.  One partner in our firm worked on a seed financing in which his BigLaw counterparty literally said on their phone call “I only have 15 minutes to spend on this deal; otherwise I start having to write off time.”

The firm you engage may have a marquee brand, but if to that firm you are small potatoes, you will end up working with that firm’s B or C-team, which will put you much worse off than having hired a set of lawyers that take your company more seriously.

Junior professionals absolutely have a place in law, but that place is not working directly with CEOs on their most strategic decisions, no matter the size of the company. It’s working mostly in the background, with real senior level involvement and oversight. When an entrepreneur is thrown to junior lawyers, it reflects how the firm has prioritized (or not) that work, even if to the entrepreneur the project is extremely important.

Fake “startup lawyers.”

But the title of this post is really about a second, even more troubling, trend. I’ve been seeing an increasing number of litigators, real estate lawyers, patent lawyers, and lawyers with all kinds of backgrounds who have suddenly decided to brand themselves as “startup lawyers.” A little tweak to the website, read a few blog posts, perhaps host a free session at a co-working space or two, and voila, now they’re ready to help entrepreneurs.

Holy crap is this dangerous. Imagine if you were talking to a doctor about a potentially serious heart condition, inquired about their experience, and then got back the following response: “well, I’ve been a dermatologist for the past 5 years, but after reading a few blog posts I decided I’d try my hand at cardiology.” Walk out the door, fast.

In the “thrown to the juniors” case, at least those juniors have some accurate, up-to-date institutional infrastructure (templates, checklists, internal firm training, partner review, etc.) to rely on as they try to help startups. But these random re-branded lawyers are essentially training on early-stage companies, while relying on extremely generalized resources (like this blog) as guidance. We see mistakes everywhere, often because we get hired to clean up the mess.

In every serious law firm with a real reputation for representing emerging companies, lawyers who call themselves “startup lawyers” are corporate/securities specialists with a strong understanding of early-stage financing, tax, commercial, IP, M&A, and labor law as they typically relate to early-stage companies. They have the depth and breadth of expertise to properly serve as an early-stage company’s “outside general counsel,” of sorts, while relying on deeper subject matter specialists when needed. 

But a litigator or patent lawyer who read a few blog posts and stayed at a holiday inn express? Disaster. As I’ve written many times before, “startup law” is largely built on contracts, and the entire point of contracts is that they are permanent unless everyone involved agrees to “fix them.” There’s no “v1.1” update to fix bugs. That means the iterative, “move fast and break things” “we can fix it later” culture of software development is the last approach anyone in their right mind will apply to legal issues.

Stop treating entrepreneurs like suckers.

Ultimately, what these developments reflect is an underlying mindset among lawyers (and other market players) that “startup” is synonymous with “little shit companies.” First-time entrepreneurs may be very smart, but they don’t know what they don’t know, and they rely on their ecosystems and advisors for guidance in almost every area. It’s the same problem that leads them to get pushed to hire captive lawyers who really work for their investors, instead of hiring independent counsel that will actually do its job. 

Just throw a junior, or a random lawyer who managed to maneuver into a few referrals, to them; they’ll figure it out. They’re just a tiny company anyway. Whatever.

So my request to the broader ecosystem is: please, stop referring entrepreneurs to your random, local lawyer friend who decided to take a stab at this “startup law” thing. That’s not how this works, and you are hurting real people, building real companies with long futures built on the foundations put in place by these fake advisors.

And to entrepreneurs: be careful out there, and do your diligence. Many of us know that you wouldn’t quit your job for, or pour your life savings into, a “little shit company,” so align yourself with an inner circle of people who think accordingly.

Burnout, Depression, and Suicide

Background Reading: Founder Burnout and Long-Distance Thinking 

This is going to be another personal post; less about how to close a financing or avoid legal issues, and more about the bigger fundamental issue of life outside of work. Because if you think what happens outside of work doesn’t heavily influence what you achieve at work, you’re clueless. Please move onto another SHL post if you want Startup/VC law advice.  This post is prompted by the very unfortunate passing of Anthony Bourdain, whom I admired as a voice of authenticity in a world that sterilizes and bullshits far too much.

Depression and suicide are two things with which my bloodline is far too familiar. Since I was a young kid – watching family members lock themselves in rooms for days and weeks in the dark, and openly discuss swerving their car into oncoming traffic, sometimes while I was in it – it’s been at the top of my mind.

Despite my many faults – my wife of 10 years is always happy to provide a list – one thing I know I’m good at is being observant. I watch people very closely, and pick up on patterns and subtleties that others miss.  As the old saying goes: the wise learn from the mistakes of others, the smart learn from their own mistakes, and fools never learn.

Another thing I’m particularly fond of is what I call asking the “meta question,” meaning trying to separate symptoms from the disease, and talk about the root cause of something. Because far too often people get caught up with trying to band-aid the symptoms of something, without digging deeper and probing into fundamentals.

What’s absolutely crystal clear is that suicide and depression are way up in America. It is clearly a paradox, given that on many objective metrics, life has never been better: life expectancy, technological advancement, overall wealth, homicide/major crime rates, gender equality, etc.

The standard reaction to this rise in depression/suicide is to focus on mental health. If we just had more infrastructure for affordable therapists and anti-depressants, all would be better. But that obviously misses the bigger historical point. Life was, on many levels, way harder even just 50 years ago, and we didn’t have an army of public therapists then; yet depression and suicide were less prevalent. Clearly there is a meta issue here worth discussing.

To share my thoughts and observations on the topic, I’m going to first list out a few concepts that I’ve picked up over the years from reading, education, having good conversations over coffee, etc.:

Maslow’s Hierarchy of Needs – This is the idea that as peoples’ more physiological needs are met (shelter, food, etc.) and become less of a top-of-mind concern, their psychology shifts to prioritize “higher” needs, like love, belonging, art/beauty, etc.  People who grow up in more stable, loving environments (or societies) tend to be more open, creative, and communal, but that can also result in being more sensitive and emotionally vulnerable.

Specialization v. Generalism – Economic development inevitably leads to human specialization. People in rural communities are often decent at a lot of things, and more self-reliant, because they have to be. They’re also poorer. People in advanced markets tend to have much narrower, specialized skillsets, which they then sell in the market to earn surplus income to buy everything else.

Grit – The idea that exposure to hardship/struggle can build mental resilience, in the same way that exposing muscle to pressure makes it stronger, as long as it doesn’t go so far that things start to break. Moderate stress is good. Too little or too much is bad.

Dopamine v. Serotonin  – D and S are neurotransmitters. Without getting too bogged down in details that I certainly will botch, D is largely the “desire/drive” brain chemical. Heavily involved in addiction. Serotonin is heavily involved in calmness, satisfaction, a feeling of fulfillment. D and S have a tension with each other. If D overruns things, S decreases, which leads to depression.

Higher Pleasures v. Lower Pleasures – In the way that complex carbs are longer-lasting while simple carbs are often tastier but shorter-lasting, lower pleasures tend to be activities in life that are thrilling, fun, and even memorable, but don’t have much of an on-going positive effect. Lower pleasures drive dopamine. Higher pleasures, on the other hand, tend to be less thrilling, and in specific moments may actually be difficult/painful, but they have significantly longer-lasting positive impacts. Lower pleasures tend to cost you mostly money. Higher pleasures tend to cost you mostly time, but increase serotonin.

Traditional Culture v. Market Culture – Culture is largely the set of narratives and values that swirl in our brain to tell us how we should live, our role in the world, and the underlying purpose/meaning behind it. Many moderns dramatically under-appreciate the complexity and nuance in how culture plays into life satisfaction and progress.

Without culture, humans are just advanced monkeys. Traditional culture is the accumulation of centuries of slow-changing values and life-structures interacting with history, human psychology, social dynamics, etc. Market culture is the result of marketing/advertising messaging, often informed by PhDs in psychology and neuroscience, nudging people to engage in activities that ultimately maximize economic growth for someone.

Bottom-up Organic v. Top-Down Theoretical – There are two ways that cultural values, systems, and ideas in general emerge. A bottom-up “organic” approach starts from the ground, interacting with all the nuances and variables of reality, and iterates “upward” over time to arrive at an equilibrium.  A top-down structure starts with logic or theoretical principles, focusing on a kind of abstract consistency, and then imposes itself “downward” on reality. Organic emergence is messy, iterative, and often slow. Top-down is “cleaner” and more consistent, and usually faster. But also more prone to extreme errors. Traditionalists (at least those who aren’t dogmatic) tend to favor organic emergence of ideas. Intellectuals tend to favor the top-down.

Individualism v. Communalism – The free market pushes individualism as a primary value, because it maximizes economic growth. The more differences we can parse out among people, slowly nudging them to like different things, pursue different paths, the more things we can sell to them. It may feel like “discovering yourself,” but there’s a lot of outside nudging involved. Communalism, on the other hand, emphasizes similarities and long-standing histories between people. It’s driven by more traditional value structures, which focus less on peoples’ economic outputs, and more on their deep relationships to one another. It also is more constraining on individual freedom/choice.

Age-Mixing – Somewhere along the way, society got the idea that it’s better for everyone if people of the same age spend all of their time with each other. I suspect industrial-age schooling, and the efficiencies of standardizing education, are partially at play. Yet the evidence is clear that age-mixing produces significantly better outcomes on a psychological level. When you age-mix, older people (including older children) learn responsibility and empathy, and how to teach the younger. They also feel more “needed,” which gives life a sense of meaningful purpose apart from their market value.

And the younger benefit from the longer-term perspective of people who’ve “been there” and know how life progresses, instead of just being focused on immediate wants/needs. When people fail to age mix in their lives, they tend to be more hierarchical, competitive, myopic, and neurotic.

Ok, that’s a lot, and it took a while. But hopefully at least some of the concepts were enlightening. Now, using those concepts, here are my own personal observations/thoughts from my own life, my family’s history, and observation of others regarding the “meta” question of why society is so much more depressed and suicidal:

Affluence has taken away a lot of the hardship and struggle that once was a defining feature and motivator of people’s lives. Obviously, this is not necessarily a bad thing. I know so many people today whose life largely boils down to specialized work and leisure. They do one narrow thing that someone pays them for, and they buy everything else, so that they have “free time” to do things they enjoy; which usually involve seeking entertainment in the market. Specialization obviously makes people wealthier. But is there a point beyond which it makes people less happy?

Now you can order any meal you want on Uber Eats, and it’ll be delivered right to your door. That’s fantastic. It’s efficient. But what if the act of cooking, and even the act of picking out ingredients has some deeper psychological benefit that we missed? Now we can Lyft or drive to wherever we want, but what if the act of walking does something for us that we missed (and I don’t just mean burn calories)?

Market economics (and culture) says to specialize. Only do what has the highest market value, and you can just buy everything else. But traditional culture says hyper-specialization makes you fragile. You may become wealthier, but you also become less self-reliant and therefore more dependent on the market. And the idea that everyone should just do one narrowly defined thing, and then seek “entertainment” the rest of the time, is a speck in humanity’s evolutionary history.

Is the person who works their own garden and cooks on the weekends  just wasting their time on inefficient activities? Should the person who works on their car in their garage just stop wasting time and send it to a mechanic? Maybe. Or maybe there’s something more there than top-down market theory can grasp.

Social revolutions told people to throw away traditional, organic culture and “be themselves.” Modern “top-down” market culture then filled the void. The idea that you are born with some inner core “you” that you must discover over time, free from the influences of everything external, has a very romantic sound to it. It’s also totally false, or at best extremely incomplete. “You” are heavily a by-product of your environment. You don’t “free” yourself from culture; you simply adopt one over another.

So as age-mixing gave way to age-sorting, and people stopped taking advice from grandparents, family, traditions, etc., the market was there to fill the void. But the values of the market are top-down and profit-driven.  When a grandparent tries to teach their grandchild about life, one can assume that in most circumstances the child’s long-term well-being is an end-goal. When a market actor teaches a child something, there can be any number of other incentives; often tied in the end to economics.

Remember that organic, bottom-up progression involves slow evolution; strongly path-dependent on the past, which is assumed to carry a kind of underlying wisdom/understanding that is perhaps difficult to articulate, but is nevertheless there. On the other hand, top-down progression is about intellectual consistency with some defining value structure, like freedom, or fairness.

Older generations had their views on family, life roles, responsibility, money, work, and they were the product of slow evolution over time, integrating feedback from history’s experiments and mistakes. They had their problems, for sure, but evidently large-scale depression and suicide was not one of them. Then social revolutions came in and demanded corrections, many of which made sense at a theoretical level, and were amplified by market incentives. But top-down theory breaks down when it hits messy, multi-variate reality.

Without getting too bogged down in specifics, there is a meta issue here: a theoretical framework that hyper-emphasizes individuality and freedom may be more productive economically, and intellectually “purer” but it breaks-down, or at least reveals fundamental flaws, when it hits the reality of human psychology; which evolved on older, more organically evolved values.

Modern market culture pushes us to pursue things that lead to greater economic activity (dopamine), while neglecting those that may actually make us happier (serotonin), but can’t be monetized.

There’s a better job for you in another state. Go, pursue “your” dreams. You can visit your parents, childhood friends, and cousins on holidays.

If you have kids now, you’ll get “tied down.” You can always have them later (maybe…). Build your career. Travel the world.

Why are you wasting time cooking for yourself? Bill a few extra hours, and have the food delivered.

Your parents’ and grandparents’ views on life are out-dated. “Be yourself” and “follow your own path” with your peers, who largely feel the same.

Apologies to my millennial friends with romantic notions about how the “experience” of travel “expands your mind” and is “life changing.” I love traveling too. But that doesn’t mean I don’t recognize really good marketing when I see it.

There’s a big difference between what makes you wealthier, free-er, or more “empowered” (abstract concepts that, conveniently, have a way of increasing GDP) and what actually makes you – advanced monkey with a brain evolved over millennia – happier and more resilient.

The market’s individualism (liberating, but cold and detached) and traditional communalism (constraining, but warm and connected) are competing goods that need to be balanced. We are sucking at that balancing. 

It is much harder to balance competing goods than to simply let one take over our lives, even if the former is far better for us in the long run. When virtually all of the messaging/reinforcement in our environments supports only one side (because that’s the side that literally pays for messaging/reinforcement, including advertising and our educational infrastructure), that’s where so many of us end up.

Individuality, freedom, and financial wealth (all quintessential American, market values) – “following your own path” “pursuing your dreams” “not getting bogged down” “crushing it” – are real, valuable things. They’ve all played a key role in my life, for sure.

But the happiest, most resilient people I’ve known (men and women) have never “bought” fully into the market ideology (and it is ideology) that they are the be-all end-all of life. They understand that what’s old may be flawed and constraining, but if it’s old, that means it’s lasted. And things last for a reason; even if that reason isn’t easy to explain or fit within a theoretical framework. Freedom, empowerment, etc. are surely valuable. But so are durability and longevity; in other words, life paths and values that have been proven to “work” in the long-run.

As another old saying goes, winning is not the same as winning an argument; not even close.  The human brain is not designed in logic.  There’s no reason to expect an optimal human life to be either.

So if someone asks me for my thoughts on depression and suicide: sure, more therapists, discussion, and anti-depressants; certainly for the specific people who need emergency help now. But the meta-answer is to ask deeper questions about humanity, and to start questioning the life values that have been sold (and I do mean sold) to us; no matter how much we think they are supreme. Because we’ve clearly broken something, and it’s worthwhile to look back and examine a time when it wasn’t broken. 

Optionality: Always have a Plan B

TL;DR: Always build some optionality into your startup’s financing strategy. Failing to do so will overly expose you to being squeezed by sophisticated players who can see how dependent you are on them.

Background reading:

The below is a fact pattern that we have seen happen with several of our clients. It will provide some context for why the point of this post is so important.

Company X has raised a decent-sized seed round, which includes several angels as well as a “lead” VC; though that VC is not on the Board. The Company knows that it will run out of funds in 3 months if it does not raise more money, and it has been in regular communication with the VC about that. The VC reassures the founders that they will “support” them with a new bridge round. A month passes, and the founders ask about the bridge. “Don’t worry, we’ll cover you” is the response. Then another month passes, with more reassurances, but no money. Then 2 weeks before their fume date (the date they’ll miss payroll), the VC drops a term sheet with very onerous terms, including a low valuation, and mandated changes to the executive team. The VC makes it clear that they won’t fund unless those terms are accepted. The founders panic. 

Before we dive in, there are a few important points worth making about this situation. First, it was clear every time that it has come up that the bait-and-switch dynamic was planned by the lead investor. They paid very close attention to the exact date that the Company would run out of funds, and timed the “switch” to deliver maximal pressure. Second, the regular “reassurances” provided to the founder team were calculated to discourage them from using their time to find other funding sources. Third, the best way to avoid investors who engage in this kind of “below the belt” behavior is to do your diligence before accepting their check; see: Ask the Users. 

Always have a Plan B.

A startup’s ability to avoid being burned by the above behavior depends on its level of strategic optionality.  Optionality means strategically avoiding a situation in which you have no choice but to depend on one investor/investor group for funding. This is very different from not committing to certain lead investors as your main funding sources. “Party rounds” are what you call financings where literally every investor is a small check. The end-result of a party round is that no one has enough skin in the game to really support the company when it hits a snag. You really are just an option to them. 

I strongly support having true lead investors writing larger checks in your rounds, because they will usually provide far more support than just money. And if you’ve done your homework and have a little luck, they’ll never even think about engaging in the kind of behavior described above. But in all cases the best way to maximize the likelihood of good behavior is to ensure a right of exit if someone decides to cross a line. I always try to work with “good people.” But no good strategist builds their life or company around the full expectation that everyone will be good. 

Lead fundraising yourself.

CEOs sometimes believe that they are doing themselves a favor by letting a lead investor do their fundraising for them – coordinating intros, negotiating terms with outsiders, etc. – so they can “focus on the business.” It often backfires. Angels and seed funds whose money has been sunk into the company, and who aren’t planning on writing larger checks in the future, are usually quite aligned with the founders/common stock in helping raise a Series A or future round. They’re being diluted just like you are.

But a VC fund with plenty of dry powder and a desire for better future terms is significantly mis-aligned with everyone else. Watch incentives closely.  Founders/the lead common holders should maintain visibility and control in fundraising discussions, with trusted independent advisors close by. 

Start early, and don’t tolerate unnecessary obfuscation and delays. 

Do not wait until a few weeks from your fume date to start communicating with investors for new funds. If someone says they will support you, great: when, and what are the terms? You want to know them now, not later. “We will support you” means very little without knowing what the price will be.

Expecting things to happen in a few days is unrealistic, but a month or more of delays is usually a sign that someone is playing games, and it’s time to pull the plug. No serious fund worth working with is that busy.

Build “diversity” into your investor base.

The power dynamics in a company are very different when all the major investors have strong relationships/dependencies with each other, and communicate regularly, relative to when various players come from different “circles.” Geographic diversity – meaning taking money from various cities/states – is a good strategy to avoid unhealthy concentration of power among your investor base. Also, diversity of investor types – angels, seed funds, institutionals, strategics – will ensure that your investor base includes people with differing incentives/viewpoints, which reduces the likelihood of collusion. 

In the scenario where a bad actor has tried a “bait and switch” on a founder team, a group of angels willing to write quick checks for an emergency bridge, or a lender offering a credit line, can be enormously valuable to relieve pressure and build time to correct course.

Contracts matter. A lot. 

Every commitment you make to investors requiring their approval, or guaranteeing their participation, in future rounds can have material strategic implications for how much optionality you have. Protective provisions matter. Super pro rata rights and side letters matter.  When you see dozens of financings a year, you regularly see how commitments made at seed/pre-seed stage play out over years and seriously affect the course of fundraising.

Good lawyers well-versed in the ins and outs of startup financing will go much further than just plugging some numbers into a template, which software can do.  They’ll dig deep on how the specific terms you’re looking at will impact the company, in its specific context, and how much room there is to stay within “market” norms while still keeping flexible paths open for the future. That’s, of course, assuming they aren’t actually working for your investors.

Make money, and own your payroll.

The ultimate optionality is being able to run on revenue if you need to; being “default alive” in Paul Graham’s words. Yes, you may grow slower than you’d like, but growing more slowly is always lightyears better than being forced into a bad deal.

Every salaried employee on your payroll raises the revenue threshold needed for your company to be default alive. Ensure that every member of your roster is essential, and that there aren’t redundancies that could be addressed by asking someone to be more of a generalist. And don’t let an institutional investor pressure you into hiring a high-salaried professional executive unless you have a clear strategy for how you are going to afford them, because, yes, that is another way that they can add fundraising pressure.

Stay in control of your fundraising. Start discussions early, and don’t tolerate delays. Build diversity of geography and incentives into your investor base. Let your lawyers do their actual job. And finally, watch your payroll closely. Following those guidelines will minimize anyone’s ability to squeeze you, and your investors will then act accordingly.

Early Startup Employee Compensation

Background reading:

Given how deeply involved we are with early-stage startups hiring their first key employees, I figured it would be helpful to outline a few key principles to help entrepreneurs navigate the topic.

Make sure they are actually employees, and if they are, at least minimum wage.

States vary in how strict they enforce the line between contractors and employees. California is way harsher than elsewhere in the country.

In general, employees are under your control as to how they work and when they work. Contractors, on the other hand, are required to deliver a service/end-product, but have more control over how it gets done, and they usually are working less than full-time hours and have multiple ‘clients.’ Those are very rough guidelines, and you should work with lawyers to ensure you stay on the right side of your state’s (and federal) specific rules.

The employee v. contractor classification is very important, because contractors can be engaged for free from a cash perspective (equity only). Employees, however, need to be paid at least minimum wage, and may be entitled to benefits. The legal and tax requirements for engaging (and terminating) contractors v. employees are also very different.

Every startup lawyer knows stories of startups that treated someone as a contractor in order to keep costs low, then the relationship went south, and the person ended up filing complaints and getting the startup into hot water. On top of following the rules, your best protection is to be careful with whom you hire, and be respectful/thoughtful if you have to terminate them.

All else being equal, more equity means less cash, and visa versa.

Generally speaking, if someone is getting paid significantly less than what’s “market” for their position, they will expect to receive more equity in order to make up for the difference. Very early employees are generally working at below-market (often substantially below market) cash compensation, and therefore receive much larger portions of equity than someone hired post-Series A or Series B.

And the converse is true as well. If someone, for whatever reason, needs to make $X, even if it’s a serious stretch at the startup’s current budget, then their equity should be proportionately lower. And it should go without saying, all employee equity should have a vesting schedule. 

All of that being said, the early employees will of course expect their compensation to move closer to market as the startup raises funds and hits revenue milestones.

In the very early days, employees are often paid more than founders / senior executives.

The further you move away from the founder team, the greater the dilution of a person’s commitment to the “mission” of the startup; and that means more cash to keep them committed.  For that reason, at pre-seed and seed stage, it is not uncommon for *true* employee hires to actually be earning more, from a cash perspective, than the founder CEO; obviously with substantially lower equity ownership.

After a decent-sized seed round (and certainly Series A), it becomes a lot rarer for the CEO to not be the highest cash earner on the roster.

For more info on what founders are typically able to pay themselves at the various stages, see: Founder Compensation: Cash, Equity, Liquidity.

Don’t over-optimize for market data.

When you reach post-Series A or Series B, it can be helpful when hiring people to obtain hard data on what’s “market” for a certain position, and use that data in negotiations. There are some good services to help with that.

But at very early stages, everything is highly contextual. I’ve seen teams where everyone is making almost nothing. I’ve seen situations where the founder CEO is making nothing, and their lead developer is making six figures. I also see everything in-between. It all depends on the relationships and context. Maybe ask around if you need to, or do some AngelList Jobs perusing, but don’t put too much faith in the value of broad market data for your pre-seed or seed stage startup’s hiring needs.

Employment laws and taxes are not a place to move fast and break things.

Finally, as much as I appreciate keeping things lean, moving fast, and skirting the rules where the costs are low, realize that violating laws around employee compensation and hiring/firing can burn you, badly.

In some contexts, unpaid employee compensation is even recoverable against the Board or executives, outside of the Company. Did you catch that? Let me repeat it for you: failing to pay employees compensation you promise them, or taxes for that compensation, can in some contexts result in personal liability for you, even if the company itself files for bankruptcy.

Take. This. Sh**. Seriously. While I’ve seen more than my fair share of nuclear wars between founders – see: How Founders (Should) Break Up – the deep relationships among founders often allow for more leeway in terms of following/not following the letter of the law. Employees are usually different, and will hesitate significantly less to use every weapon against you if you cross them. Make sure you’re well-advised from the moment you bring on your first *true* hire. 

Replacing the Founder CEO

TL;DR: When an investor pushes to replace a Founder CEO, there are usually one of two motives behind it: performance or power. By keeping the process open and balanced, investors with strong reputations will demonstrate that the former, and not the latter, is at play.

Background Reading:

Here’s a story about two startups, each with struggling founder CEOs in need of a change, but with very different governance approaches, and very different outcomes. I’ve seen both of these fact patterns multiple times among my own client base, and I’ve made sure to strip any details that could be construed as too specific.

Company A:

Company A raises a small Series A round led by a well-known VC. During that round, no discussion ever occurred about what Company A’s management structure might look like in the next 5 or even 10 years. The VC and Founder CEO “hit it off” and closed the round, with the assumption simply being that the founder CEO would stay in charge of management.

Fast forward 18 months, and the Company is struggling. There’s been revenue growth, but not nearly enough to justify a serious uptick in valuation. One day the VC calls a meeting and informs the founder that they are getting a new CEO, and he’s already been identified. It’s a CEO the VC has worked with before, but whom the founder CEO has never met. His compensation package has already been finalized.

There had been no prior discussion of looking for a new CEO. The founders/common directors were never asked for input on who might be a good fit, or to interview candidates to ensure alignment. So naturally, the founder CEO goes into panic mode. He lashes out at his Board, starts reviewing his company contracts and talking to litigators, and some very lawyerly-sounding e-mails start getting fired off.

In the end, the founder CEO digs his heels and asserts at the next Board meeting that the new CEO candidate is not the right person, that as a Board member the fact that he was not consulted on the process was a violation of appropriate corporate governance, and that he will refuse to step aside at this time.

In order to avoid a full-blown dispute, and knowing that the founder’s threats could credibly create damage, the Board decides to slow down. The founder CEO stays in his position, and they work on a performance improvement plan. With trust being burned, they struggle to get aligned on the recruitment of new management. A year later, the company is still struggling.

Company B:

Company B also closes its Series A round led by an institutional VC. During the Series A negotiation process, however, the founder directly asks the VC about their philosophy on founder management, executive succession, and when they would expect professional management may be needed.  A candid discussion ensues in which the VC acknowledges that there will likely be an appropriate time to bring in more seasoned executives, but that such a process would be open, and the common directors/stockholders would be heavily involved in choosing the candidates.

As part of that discussion, the Founder CEO acknowledges that he himself is not interested in being in control forever, but that he does have a specific vision for how the Company might scale, and what its culture might look like through that scale. He also makes it clear that he expects to receive support in the form of a COO or other C-level support to scale his skillset before any definitive conclusions are drawn as to whether he can lead the company.

The VC makes a few comments about his own philosophy on how to approach management changes, but overall they are aligned. The founder CEO quietly verifies the VC’s answers by speaking with other teams who’ve worked with him before, confirming that is in fact how he operates.

The founders and VC also put in place a board structure that ensures the replacement of the CEO would require support not just from investors, but from an independent director, and they agree on what a fair process for recruiting that independent director would look like. With everything in place, they close the round.

Fast forward 2 years, and the Company has achieved some traction, but it’s stalling. After some hard discussions, the Board determines that it’s time to bring in some outside help. All directors, including the common directors and CEO, are invited to suggest candidates, and to be part of the open interview process. In the end, a CEO is chosen with the assistance of a 3rd-party recruiter, with both the support of the VC and the original management team. The founder CEO moves into the Chief Product Officer position, and remains on the Board. The company is doing much better.

As I’ve mentioned before, I’ve seen both of these fact patterns play out within my own client base. What can we learn from them?

Hard, but respectful conversations up front prevent much harder, and potentially more destructive, conversations later.

Lead investors are heavily incentivized to “sweet talk” a founder team, promising the sun, moon, and stars, in order to close the deal. VCs who overplay their “founder friendliness” are setting themselves up for drama in the future when reality pours cold water on everyone.

Smart founders and good VCs are open and honest about the issues that will inevitably come up in the future, and have candid conversations about them before docs get signed. They set realistic expectations, so that when a change is needed, there is much more alignment on how to effect that change.

And just as importantly, once those conversations occur, smart founders verify the answers they’ve gotten by speaking, off the record, to people who’ve worked before with those VCs. It is one thing to tell founders that you’ll be respectful, open and honest. It’s much more significant to have a portfolio full of teams that will confirm, without you looking over their shoulder, that it’s in fact how you work.

Commit to fair processes, but not specific outcomes. 

Good, litigation-preventing corporate governance always boils down to fair processes. No one ever knows at Series A who will be in the CEO seat at Series B, or Series C, but they can commit to what the process will look like for determining the final outcome.

Save for the very very small number of unicorns in which founders can keep strict control (think Facebook), reputable VCs will never tell a founder CEO that she/he will stay CEO as long as they want to. The job of a Board of Directors is to do what’s best for the all of the Company’s stockholders as a whole, even if that means making a founder CEO unhappy.

What really distinguished Company B from Company A wasn’t the outcome, but the process. By agreeing that executive succession would not be a surprise bomb dropped out of the blue, but a transparent process in which new executives are brought in with the honest support and vetting from all constituencies, Company B kept drama to a minimum.

In many situations where I’ve seen drama occur at the Board level, it’s started from one or two directors on the Board forgetting that there are other directors on that same Board – as well as outside stockholders to whom the Board has to answer – and thinking that they will successfully force through whatever they wish without having to answer to others.

It’s possible that in Company B the founder CEO may have not agreed that it was time to step aside. He may have even contemplated getting a little difficult, in the way that Company A’s founder CEO did. But by ensuring (i) open communication, (ii) a balanced recruiting process, and (iii) a voting procedure that included support not just from the investors, but from disinterested parties, the Board ensured that the founder would have had a much harder time creating drama; at least credible drama.

Excellent, thoughtful governance processes ensure that if anyone ever gets angry and wants to rock the boat, all they can really do is pound sand. Bad governance, however, effectively hands someone else a weapon to use against you.

Contracts enforce good process.

As I’ve written before in Don’t Rush a Term Sheet, anyone who doesn’t take the time to really understand what the material terms of their term sheet mean, not just in terms of economics, but in power structure and how hard decisions will be made, is in for an inevitable rude awakening at some point in the future.

If you have the tough conversations up front, and agree on what good, balanced process will look like, put that process on paper.

I’ve seen some investors sing wonderful songs about their principles and openness, but somehow try to insist that they *need* “simpler” decision-making processes on paper. Don’t worry about what the documents say, they’ll tell you. You can trust me. I’ll treat you right.

Cute.

There are two very different potential motives when investors insist that a startup needs to replace its founder CEO. The first is to improve the performance of the company, which benefits all stockholders and is consistent with the fiduciary duties of Board members. The second is to put in place someone that the investors can more easily control/influence, which is really about power and does not benefit all stockholders. By committing, contractually and reputationally, to balanced processes that include all Board members in executive recruitment, VCs can credibly demonstrate that shareholder value, and not power grabbing, are behind their actions. 

Great governance protects shareholder value.

There are plenty of institutional investors who follow solid corporate governance and still achieve fantastic returns. Yes, it takes more diplomacy and negotiation on the part of investors to build alignment and trust with other members of the Board and the cap table; instead of simply ramming through their agenda. But that is the investment culture and mindset that emerges when startup ecosystems mature from being captive to 1 or 2 funds toward more dynamic, competitive capital markets in which investors have to actually care about their reputation. See: Local v. Out-of-State VCs.   True ecosystems filter out bad actors by funneling deal flow toward those with the best reputations. 

For the most high-stakes decisions a company can make – like whom to raise money from, or whom to have in charge – speed should never be the top priority. Good processes and discussions take time up-front, but in the long-run they can prevent the kinds of disputes that destroy shareholder value, and can even destroy entire companies.

Ending note: Ensuring that company counsel is not “captive” to the investors is often important for maintaining balanced corporate governance, and protecting against hostile behavior. See: How to avoid “captive” company counsel.