Early v. Late-Stage Common Stockholders in Startup Governance

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

Background reading: The Problem with “Standard” Term Sheets

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Moving (Too) Fast and Breaking Startup Cap Tables

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As I’ve written many times before, the “move fast and break things” ethos, which makes absolute sense in a software environment where fixing “bugs” is quite easy and low-stakes, becomes monstrously expensive and reckless when applied to areas where the cost of a mistake is orders of magnitude higher to fix (if it’s fixable at all). Silicon Valley got a very visible and expensive (to investors in terms of capital, and founders in terms of legal errors and terrible legal advice) lesson in this reality a while back with a very well-funded (but ultimately failed) legal startup heavily promoted as enabling (via over-hyped vaporware) startups to “move faster” and save significant costs. That legal startup was, perhaps unsurprisingly, controlled by money players with all kinds of reasons to profit from startups (that they invest in) getting weak legal and negotiation guidance. No one wants an in-experienced founder to move fast and mindlessly do what investors want more than… those investors.

That fundamental point is one that inexperienced founders need to keep their eye on throughout their entire fundraising and growth strategy. Notice how, for example, certain Silicon Valley groups adamantly argue that SV’s exorbitant rents and salaries are nevertheless worth spending capital on, and yet simultaneously they will howl about how essential it is that startups minimize their legal spend (a small fraction of what is spent on rent and salaries) in fundraising, and move as quickly as possible; usually by mindlessly signing some template the investors created? Why? Because they know that the one set of advisors most capable of “equalizing” the playing field between inexperienced startup teams and their far more seasoned investors is experienced, independent counsel. Aggressive (and clever) investors say they want you to adopt their preferred automation tools and templates because they care so much about saving you money, but the real chess strategy is to remove your best advisors from the table so that the money can then, without “friction,” leverage its experience and knowledge advantage.

At some obvious level, technology is an excellent tool for preventing errors, especially at scale when the amount of data and complexity simply overwhelms any kind of skilled labor-driven quality control mechanism. But there is a point at which people who sell the technology can, for obvious financial incentives, over-sell things so much that they encourage buyers to become over-dependent on it, or adopt it too early, under the delusion that it is far more powerful than it really is. This drive to over-sell and over-adopt tech for “moving really fast” is driven by the imbalance in who bears the cost of fixing “broken things.”

Ultimately the technology seller still gets paid, and puts all kinds of impenetrable CYA language in their terms of service to ensure that no one can sue them when users zealously over-rely on their products in ways clearly implied as safe by the tech’s marketing. Founders and companies are the ones who pay the (sometimes permanent) costs of a poorly negotiated deal or contract, or in the case of cap tables incorrect calculations and promises to employees or investors.

In the world of cap tables, automation and tracking tools like Carta (the dominant player, justifiably, by far) are enormously valuable, and doubtlessly worth their cost, in helping the skilled people who manage the cap tables keep numbers “clean.” In the early days of Carta’s growth (once called eShares), there was a general understanding that cap tables rarely “break” before the number of people on the table exceeds maybe 20-30 stakeholders as long as someone skilled at managing cap tables (in excel) is overseeing things. That last part about someone skilled is key.

There are in fact two broad sources of cap table errors:

  • Using Excel for too long, which creates version control problems as the number of stakeholders grows; and
  • Management of cap tables by people who are simply too inexperienced, or moving too quickly, to appreciate nuances and avoid errors.

Technology is the solution to the first one. But today it’s increasingly becoming the cause of the second one. The competitive advantage of technology is speed and efficiency at processing large amounts of formulaic data. But the advantage of highly-trained people is flexibility and ability to safely navigate nuanced contexts that simply don’t fit within the narrow parameters of an algorithm. In the extremely human, and therefore subjective and nuanced, world of forming, recruiting, and funding startups in complex labor and investor markets, pretending that software will do what it simply can’t do –  delusionally over-confident engineers notwithstanding – is a recipe for disaster. The combination of new software and skilled expertise, however, is where the magic happens.

The Carta folks have been at this game long enough to have seen how often over-dependance on automation software, and under-utilization of highly trained and experienced people in managing that software, can magnify cap table problems, because it creates a false sense of security in founders that leads them to continue flying solo for far too long. Sell your cap table software as some kind of auto-pilot, when the actual engineering behind it doesn’t at all replace all the things skilled experts do and know to prevent errors, and you can easily expect ugly crashes.

That’s why Carta very quickly stopped promoting itself as a DIY “manage your cap table by yourself and stop wasting money on experts” tool and evolved to highly integrate outside cap table management expertise, like emerging companies/vc law firms and CFOs; who spend all day dealing with cap table math. They realized that the value proposition of their tool was sufficiently high that they didn’t need to over-sell it as some reckless “you can manage cap tables all by yourself!” nonsense to inexperienced teams who’ve never touched a cap table before. The teams that use Carta effectively and efficiently see it as a tool to be leveraged by and with law firms, because startup teams are rarely connected to anyone who is as experienced and trustworthy (conflicts of interest matter) in managing complex cap table math better than their startup/vc law firm.

But as is often the case, the cap table management software market has its own “race to the bottom” dynamics – but a better name may be the “race to free and DIY.” If I’m a company like Carta, and I know that truthfully very few companies need my tool before maybe a seed or Series A round (excel is perfectly fine, flexible, and simple until then), I’m still extremely worried that someone will use the time period before seed/Series A to get a foothold in the market and then squeeze me out as their users grow. That someone is almost always a “move fast and break things” bottom-feeder that will, once again, over-sell founders on the idea that their magical lower-cost DIY software is so powerful that founders should adopt it from day 1 to save so much money by no longer paying for expertise they don’t need.

Thus Carta has to create a free slimmed down version, and they did. But they’ve stuck to their guns that cap tables are extremely high-stakes, and even the best software is still extremely prone to high-cost errors if utilized solely by inexperienced founders. That’s why Carta Launch has heavy ties to a network of startup-specialized law firms. It’s free as in beer, but honest people know that it still needs to be used responsibly by people who fully understand the specific context in which it’s being used, and how to apply it to that context.

But the bottom-feeders of cap table management are of course showing up, with funding from the same people who were previously happy to impose costs (errors, cleanup) on inexperienced teams as long as their software gets adopted and their influence over the ecosystem therefore grows. The playbook is tired and predictable.

Why are you using that other (widely adopted and respected) technology that still relies (horror of horrors) on skilled humans? It’s 2020, you need :: something something automation, machine learning, AI, etc. etc. :: to stop wasting money and move even faster. Our new lower-cost, whiz-bang-pow software lets you save even more time and manage your cap table on your own, like the bad ass genius that you are.

We know where this is going. Many of us already have our popcorn ready. While before I might run into startups who handled only a formation on their own, and show up with a fairly basic and hard-to-screw-up cap table, I’m increasingly seeing startups who arrive with seed rounds closed on a fully DIY basis, and totally screwed up cap tables involving investors and real money. They also often have given up more dilution than they should’ve, because no independent, skilled expertise was used to help them choose and negotiate what funding structure to use. Clean-up is always 10x of what it costs to have simply done it right, with a thoughtfully chosen (responsible) mix of technology and skilled people, on Day 1.

Technology is wonderful. It makes our lives as startup/vc lawyers so much better, by allowing us to focus on more interesting things than tracking numbers or inputting data. The stale narrative that all VC lawyers are anti-technology really gets old. We were one of the first firms to adopt and promote Carta, along with numerous other legal tech tools. Not a single serious law firm views helping their clients manage cap tables as a significant money driver. But that’s like saying no serious medical practice views X or Y low-$ medical service as a significant money driver. Something can be a small part of a professional’s expertise, and yet still way too contextual, nuanced, and high-stakes to leave to a piece of software pretending to be an auto-pilot.

When the cost of fixing something is low, move as fast as you want and break whatever necessary. But that’s not contracts, and it’s not cap tables. In those areas, technology is a tool to be utilized by still-experienced people who regularly integrate new technology into their workflows, while maintaining skilled oversight over it. Be mindful of software companies, and the clever investors behind them, who are more than happy to encourage you to break your entire company and cap table as long as you utilize their half-baked faux-DIY tool. Their profit is your – often much larger than whatever money you thought you were saving – loss.

Bundled v. Unbundled Startup Capital

TL;DR: The market for early-stage startup financing has reached a level of fragmentation and hyper-competition (among capitalists) never seen before. This competition has led to an increasingly atomized market, with a multitude of players offering different takes on the traditional “bundled” offering of smart venture capital. Startups and founders should understand the reasons behind the marketing narratives pushed by each of these players, so they don’t get too swept up in an overly simplistic strategy for how to raise capital. The best strategy is to diversify your capital sources, while still allowing room for smart leads writing large enough checks to provide real value add.

The world of early-stage startup financing looks extremely different today than it did even 5 years ago, and completely unrecognizable to the market of a decade ago. The reasons are fairly straightforward. Near-zero interest rates and slowing of international economic growth, together with government policies of quantitative easing (which inflate traditional asset prices and make further returns harder to achieve) have produced a surge in the amount of capital seeking any kind of “alpha” in the seemingly “final frontier” of early-stage startups. There is far more money chasing startups than perhaps any time in history.

This surge in early capital naturally produces a surge in competition among early capitalists. In order to navigate that competition, capitalists, just like any other service provider, seek ways to differentiate themselves in the market to avoid appearing too much like a commodity. It’s this need for early capitalists to differentiate themselves that has produced the “atomization” or unbundling of startup finance that is increasingly visible in the market. The point of this post is to help founders and early teams understand that unbundling in assessing their own financing strategies.

To speak of unbundling of course requires first understanding the original bundle. Historically, conventional venture capitalists “sold” the following bundle to startups:

  • Green cash money (obvious)
  • Signal – a brand that credibly signaled “eliteness” to the market (de-risking to an early startup), making it easier to further attract capital, employees, commercial partners, etc.
  • Network – a deep rolodex/LinkedIn network of contacts to leverage in recruiting and expansion
  • Advisory – active involvement on Boards and “coaching” to inexperienced executive teams.

In the very early days of conventional venture capital, VC was very scarce. In many markets there was quite literally one, maybe two funds, who served as gatekeepers to the market; and unhesitatingly used their market dominance to squeeze teams on valuation and corporate governance power. This “asshole” behavior inevitably produced demand for alternatives.

Enter the new “friendly” venture capitalists. Very large VC funds started to break up because the personal brands of high-profile VCs incentivized them to form their own funds with fewer mouths to feed. Growing interest in early-stage also brought in new market entrants. As the VC market evolved from a more oligopolistic structure to an increasingly fragmented and competitive market, the need for differentiation increased. “Friendliness” (or at least the well-calculated appearance of it) became a successful way to achieve that differentiation. You now had VCs actually competing with each other based on their reputation. But the general bundle offered by those VCs largely remained the same.

Another successful form of differentiation in this era involved going deep on “value add” services. Particularly in SV but now also in other markets, VC funds began to hire non-partner staff whose purpose was to, completely apart from providing money and Board service, help CEOs with recruiting, marketing, sales, etc. as a kind of external extension of their internal team. All that extra staff naturally costs money, and increases the overhead structure of the fund, which then increases their pressure to achieve highly outsized returns and avoid overly generous valuations.

So in the initial era of startup funding growth, VCs became “friendlier” (though caveats are worth emphasizing, see Trust, “Friendliness,” and Zero-Sum Startup Games) – and bulkier. But the flood of new capital kept on coming. VCs continued splintering off and forming micro-funds. More entrants arrived. Successful exits produced new, younger teams interested in trying their luck at the VC game. What to do with the VC market becoming even more competitive? Differentiate even further.

Enter accelerators and seed funds, and eventually pre-seed funds. As the true Series A market became increasingly crowded, continued competition among capitalists led many to conclude that the new way to avoid commoditization was to go earlier in the life cycle, closer to the territory once filled exclusively by angels (named as such because of their willingness to take risks once deemed off the table for professional investors). Rather than continuing the game of bulking up and emphasizing the “full package” bundle of traditional VCs, these new institutions sought differentiation by slimming down, and emphasizing their ability and willingness to move fast and early. Those old-school VCs are slow and over-bearing, the marketing content says. They don’t really provide any value-add. Take our cheaper, faster, “friendlier” money instead.

We are now entering a new era where “solo capitalists” are the hot topic. New in some ways, but the same dynamics of market competition and necessary differentiation are quite old. Why take money from a fund at all, when you can just raise from a set of successful solo founders? They’re super friendly, don’t care about a board seat, and will move lightning fast without pestering you with “negotiation” or other trivialities. Their ultra-low overhead also means they can pay higher valuations. And of course they’re enabled by new tech platforms for raising and distributing capital that are very much invested in the increasing atomization of startup capital, which increases demand for technology to coordinate and facilitate that atomization.

In 2020, the market of very early-stage funding for startups now looks like this:

  • Solo angel investors
  • Angel networks
  • Angel “syndicates”
  • Accelerators of various flavors
  • Scout money from “bulky” traditional VCs
  • Pre-seed funds
  • Seed funds
  • Series A funds that invest in seed rounds
  • Solo VCs
  • “Lean” startup lenders

Throw in the reality that geography is hardly a barrier to capital flows now – especially in the COVID era – and the early-stage funding market has reached a level of hyper-fragmentation and competition that was unimaginable a decade ago. Within a particular market, the number of players has shot up dramatically, and now those players are increasingly happy to cross state lines.

This is undeniably a fantastic environment for top-tier teams looking to raise early funding. It’s also undeniably a far more stressful environment to be a startup investor. Ten years ago being a VC meant everyone came to you, very warm intro required, and you called the shots. Now VCs hustle so hard for visibility some are even engaging production studios to help them create polished youtube channels. Others don’t even require intros anymore and have opened their DMs on twitter. There are even jokes about VCs trying to create viral memes to get eyeballs. Life comes at you fast.

The important message for startup teams is to understand why the landscape now looks the way it does, and the incentives behind why any particular type of investor markets itself the way it does. Accelerators, for example, now face far more competition than they did in their golden era, particularly from seed funds with legitimate “value add” offerings. See: Why Accelerators Compete with Smart Money. Because the “bundle” of an accelerator is heavily weighted toward its network and signaling value, accelerators have for some time been incentivized to promote a narrative of “dumbing down” early capital that doesn’t have its own competing network, thus keeping the accelerator’s value proposition somewhat relevant.

Similarly, ultra-lean funds and Solo VCs lack by design the resources of larger funds, and thus they are incentivized to push a narrative that traditional “hands on” VCs don’t really add value. The new lean players don’t have the time or the resources to add value themselves, so best to talk as if that particular part of the traditional bundle isn’t that meaningful anyway.  This all, of course, is easily disproven by the number of founders in the market who credibly testify to the value (in advisory, network, deep long-term pockets) in having a large fund with full skin-in-the-game on your Board and cap table. Some (not all) large funds really do provide significant added value.

And of course, traditional VC funds talk their own books with the exact opposite story. The fragmented lean investors are all spray-and-pray “dumb money” looking for party rounds. Teams need value add from seasoned, steady hands willing to roll up their sleeves on Boards. You need more than atomized money. You need a trusted “partner” to shepherd you toward success.

There is absolutely no need to take sides in all of these narratives. Why should you? Every player in the market offers a grain of truth, but also exaggeration and over-simplification, in what they’re saying. The most important thing is not to get too swept up in moralizing or marketing. Understand what each player is selling, and understand what your particular needs are.

Often times the smartest teams do a bit of “shopping” across various aisles in the new VC supermarket. Team up with a reputable seed fund, but use your optionality to ensure the terms are reasonable. Let them write a large enough check to be emotionally invested, but fill the rest of the round with smaller high-signal checks that will also be motivated to connect you with their networks. For good measure, if you have interest from a traditional Series A VC fund, let them write a small check in your seed round to keep the connection warm when Series A discussions start. The fact that they know how well networked you are (thanks to the other players on your cap table) will ensure good behavior at the Series A term sheet stage.

Contexts will vary and team needs will vary, so the particular mix of early capital any particular startup takes will naturally vary as well. Stay flexible and avoid rigid theories about the (air quotes) “right” way to raise funding. But in all cases, make an effort to diversify your network and capital sources. Nothing ensures good behavior from the money better than making it crystal clear that you are well-networked and happy to take someone else’s check if your current investors don’t play ball. You can do so while still building strong connections with your investors, demonstrating that you value their relationship. This is a great time to be an entrepreneur, whether in or outside of Silicon Valley. In navigating the new early-stage funding market, don’t drink too much of anyone’s kool-aid, and shop wisely.

Legal Office Hours for Remote Startups

TL;DR: I’ve become particularly interested in, and connected to, the distributed/remote startup ecosystem; and decided to throw in a few hours of my time each week to support new teams growing specifically under that model via free virtual office hours. Info on that is near the end of the post.

Over the past several years, I’ve become fascinating with the idea of a startup ecosystem largely detached from geographic constraints, with companies recruiting talent based on fit and merit, regardless of where they live. For years I lived in the Hill Country outside of Austin, barely ever working from the firm’s downtown office because I just didn’t see a need to; and my clients didn’t care. Highly regarded Startup Lawyers don’t really need to spend much time in coffee shops or conventional offices. All they really need is a solid internet connection. Sidenote: I think Elon Musk’s StarLink (high-speed broadband anywhere) could be a game changer.

As my family – particularly my wife, who grew up in SoCal – realized that my growing client base didn’t care at all about my physical location, their willingness to continue putting up with Austin’s mosquitoes and deadly snakes (big problem outside of urban core), humidity, horrible traffic, decidedly limited outdoor beauty (save for a lake) and seemingly endless scorching summers (Mid-May through mid-October really sucks) reached a breaking point. Austin is an amazing and thriving city for many reasons, but it is not for anyone who likes needs the outdoors. No city is for everyone.

Because my wife and I had already decided to homeschool our three young kids, we had almost total freedom to pick a destination; and ultimately we landed on living near the mountains about an hour outside of Denver. Amazing weather and mountain views, literally limitless outdoor recreation, and a short flight or road trip to almost anywhere we needed to go. And yes, still rock solid broadband so I can close deals and work with clients just as easily as I did before. Little did we know that with both “homeschooling” and “remote” work, we’d started riding waves that would suddenly turn into a massive tsunami because of a pandemic.

I bring up this background to highlight how escaping the “tyranny of geography,” and the growing comfort with distributed startup teams, is not just an intellectual curiosity to me; it’s a core part of my life. When we’d announced that we were leaving Austin, there was no shortage of people who thought I was absolutely nuts and lighting a match to my legal career. They didn’t know I’d already been living in “the Texas countryside,” with a thriving ECVC client base and firm, for years. If my clients – all scattered across the U.S. and world – didn’t care that I was living on acreage in the Texas hill country, I knew they wouldn’t care about my living in the mountains of Colorado.

As our own adventures with remote/distributed work have continued, I’ve watched the broader ecosystem of “remote” startups mature as well. The number of companies using a distributed team, with few if any people in the Bay Area, has grown exponentially over the past 5 years or so; and we’re also increasingly seeing institutional investors who are happy to “venture” outside of their local markets in search of high-potential businesses that aren’t on the classic Silicon-Valley style VC circuit. Suddenly the distributed startup ecosystem has moved from a fringe quirk to a desirable asset with distinct competitive advantages.

But there’s one distinct disadvantage of “remote” startups that I keep seeing come up over and over again: they don’t connect as easily with serious lawyers. Most ECVC (emerging companies and venture capital) lawyers are still heavily tied down to local geographies, particularly the Bay Area. Strong teams in non-traditional markets often end up either using nearby lawyers who are totally lacking in the appropriate expertise/specialization, or they just wait until their investors happily “recommend” their favorite $1,000/hr Bay Area lawyer whose firm represents Uber and Apple. People who read SHL regularly know that I’ve discussed ad nauseam the deep problems (conflicts of interest) with using your investors’ pet lawyers; and also how the Bay Area market often promotes norms/practices (“unicorn or bust”) that are a poor fit for “normal” startups.

As I’ve been living through this pandemic and watching the growing zeitgeist around distributed startups, it occurred to me that I’m in a place where I could contribute some of my time to supporting the ecosystem. So I’ve decided to allocate a few hours of my time each week to free virtual “office hours” specifically for distributed teams outside of the Bay Area. We can spend, via a phone call or Zoom, up to an hour talking about any legal/strategic issue on the team’s mind: formation, founder relationships, fundraising and structuring, governance, hiring, etc. No expectation of billing or future engagement. I really just want to get more visibility into how this growing ecosystem is evolving, and how existing market players can help it thrive.

My personal thesis is that America’s size and unique geo/climate diversity is an enormously under-utilized asset in tech. Why should entrepreneurs and employees be forced to live in a handful of narrow, crowded, and increasingly over-priced concrete jungles when there are an endless number of beautiful, affordable, perfectly livable places that need high-potential residents but just don’t have the “tech” base to employ people locally? Because of some nonsense about the importance of “body language” and regular in-person meetings? Please. I think this pandemic is not just helping everyone realize the superficiality in some of their assumptions about remote work, but about a lot of virtual interactions: education, healthcare, and even connecting with the investor community.

A secondary thesis of mine is that the more geographically diversified a startup team’s network becomes, the less exposed they are to local startup power politics. Every geographically constrained ecosystem has organizations that have consolidated a level of influence/control such that it can feel like you need to kiss a brass ring in order to access resources you need. That dynamic is the opposite of what a real ecosystem should be; a decentralized resource where no single player can play gatekeeper and extract more value than their own value-add really merits. Promoting a more distributed startup ecosystem reduces the influence of overly self-interested power players, and enhances the kind of transparent meritocracy that helps teams access the right people with minimal wasted time.

Startup ecosystems are ultimately about relationships and people; not about artificial city or state borders. It’s time we talked more about the American ecosystem, and freed entrepreneurs and talented employees to work and live wherever is best for their companies and families. In the process, we’ll spread economic opportunity further across the country, and reduce many of the ills that have resulted from cramming people into too few of cities with not enough space and resources to make “living” affordable and accessible.

Info on participating in virtual legal office hours for remote/distributed teams:

My bio: here.

E-mail: [email protected]

Criteria (please explain in intro e-mail how you meet the below):

  • HQ is not in the Bay Area
  • You already have, or expect to have, a distributed team. Not a 1 or 2 people that you “let” work remotely, but a full orientation around enabling remote work such that no one outside of whatever you might call “HQ” is disadvantaged in opportunities, because the whole team is included in events/meetings.
  • The market you are going after has a credible shot at producing an at least $50 million (enterprise value) business.

This isn’t any kind of formal program with a hardened schedule, because my own availability varies day to day with deal/client work and firm admin, and I’ll scale my time allocation up or down as the number of teams fluctuates. Looking forward to getting to know new teams that reach out.

Independent Counsel in an Economic Downturn

TL;DR: In all parts of an economic cycle, up or down, there is significant value in having independent (from investors) strategic counsel that you can trust to protect the common stock in navigating negotiations with investors who are 20x as experienced as the founding team. In a downturn, however, the number of “company unfriendly” possibilities in deal and governance terms goes up ten-fold. That means the value of independent, trustworthy counsel shoots up as well.

Background reading:

I’ve written multiple posts on the topic of how first-time entrepreneurs place themselves at an enormous disadvantage when they hire, as a company counsel, lawyers with deep ties to their lead investors. To people with good instincts, the reasons are obvious, but for those who need it spelled out:

A. First time entrepreneurs are regularly interacting, on financing and governance issues, with market players who are (i) misaligned economically with the common stock, and (ii) 20x as experienced as the management team and largest common stockholders. They rely heavily on experienced outside advisors to “level the playing field” in the negotiations.

B. One of the most impactful strategic advisors an early set of founders/management can look to for navigating this high-stakes environment is an experienced “emerging companies” specialized corporate lawyer (startup lawyer), who (if vetted properly) sees far more deals and board matters in any given month than many sophisticated investors see in an entire year.

C. Because investors have contacts with/access to lots of potential deal work, and corporate lawyers need deal work, aggressive investors have come to realize that their “deal flow” is a valuable currency that can be leveraged with an overly eager portion of the “startup lawyer” community; shall we say, “nudging” them to follow the investors’ preferred protocols in exchange for referrals. By pretending that only a handful of firms have credible/quality lawyers, they also try to block law firms with more independent, but still highly experienced, lawyers from getting a foothold in the market.

D. Founders, because they lack their own contacts and experience vetting lawyers, often find themselves influenced into hiring these “captive” lawyers. As a result, they are deprived of some of the most strategic and high-value guidance that smarter teams are able to tap into for protecting the common stock.

For a deeper dive into how this game is fully played out in the market, read the above-linked posts. The point here is not to promote an exaggeratedly adversarial take on startup-investor relations, but to emphasize a simple reality of how things really work.

The main point of this post is: in an economic downturn, when company “unfriendly’ terms are going to be far more on the table than they were in years past, the value of independent strategic counsel is magnified ten-fold. In go-go times when competition for deals and excess amounts of capital shoot valuations up and “bad terms” down, deal terms gravitate toward a closer-to cookie-cutter, minimalist kind of flavor: good valuation, 1x liquidation preference non-participating, minimal covenants, and sign the deal.

That doesn’t mean there’s really a “standard” – I’ve also written extensively about how saying “this is standard” has become the preferred method for clever investors to trick startup teams into mindlessly signing docs that are against their company’s long-term interests. But, in good times deals do tend to start looking a lot more like each other in a way that makes negotiation a little easier.

But when there’s an economic shock like what we’re experiencing right now from COVID-19, and the investor community starts to improve in their leverage, it’s inevitable that you start seeing a lot more “creativity” from VCs with terms: higher liquidation preferences, participating preferred, broader covenants and veto rights, more aggressive anti-dilution, tighter maturity dates on convertible notes, etc. etc.

In this environment, it is incalculably valuable to have people to turn to, including independent deal lawyers, who can tell you what really is within the range of reasonableness, what to accept v. push-back on, and generally what is “fair” given the environment you’re fundraising in. Independent counsel will help you protect the common stockholders, while granting your investors some terms that you may not have needed to accept a year or two ago. Captive counsel, however, will know that his/her “good behavior” (for the investors) in structuring the terms will ensure more deal flow from their real clients. And because most startup teams are understandably lacking in market visibility, they have no way to quality-check the advice they’re getting. Trust is everything here.

Research and diligence your legal counsel just like how you’d diligence any high-stakes advisor. Importantly, ask them what VCs they (and their firm) represent and/or rely on for referrals. They may be great, very smart people, but if the answers you get make it clear that they are closely tied to people likely to write you checks, find someone with more independence. A muzzled corporate lawyer is ultimately an over-priced paper pusher.