Post Category → Founders

The Open Startup Pro-Forma Capitalization Model

TL;DR: In the earliest stages of a startup, paying for a proprietary cap table tool, or simply dealing with the hassle of a 3rd-party intermediary software layer for modeling your capitalization, is not really necessary. We’re publishing the Open Startup Model, an Excel-based “open source” cap table and pro-forma that startups and their lawyers or other experienced advisors (if they don’t already have their own tools) can use for free. It’s based on the pro-forma structure we’ve used for hundreds of deals, and is flexible, editable and auditable.

Background reading:

In the beginning, there was Microsoft Excel, and it was good (enough).

For decades, startup cap tables and pro-forma financing models were maintained on Excel. It wasn’t perfect (nothing is), but it worked well enough. Then as the ecosystem matured, we saw the emergence of specialized cap table software, like Carta (pricier incumbent) and Pulley (leaner alternative). These tools make a lot of sense at moderate (not low) levels of cap table complexity – based on our experience at Optimal, typically around Series A or post-Seed.

But somewhere along the way some founders got the impression that these tools might be needed as early as the incorporation of the company, when there are only a handful of people on the cap table. The argument, certainly made by the cap table software vendors themselves, is that Excel is too clunky, and too error-prone. There is also a bit of a land grab dynamic here, in the sense that it isn’t necessarily profitable for these tools to have tons of very small companies on them, but they have to build super early-stage offerings to prevent their competitors from owning the pipeline. There’s no simple way for the tools to agree to leave young companies alone, so we get these silly value-destroying attempts to onboard everyone.

All of this is, candidly, nonsense. I’ve seen seed-stage companies spending thousands of dollars a year and getting absolutely nothing extra of value that they couldn’t get from a basic excel spreadsheet maintained by someone moderately competent.

What makes old-school Microsoft Excel a still-used tool in startup finance is its flexibility, auditability, simplicity, and affordability (free, essentially). It’s really only once you’ve crossed about 20 cap table stakeholders that in our experience, as counsel to hundreds of VC-backed companies, a third-party tool starts to make sense. Before then, I often see more mistakes when founders try to use an inflexible outside tool than when they simply collaborate with a sharp outside advisor to keep things clean and simple on a spreadsheet.

That being said, one thing that has happened is the complexity of seed funding instruments has grown over time. See the Seed Round Template Library and Seed Round Educational Articles.

In the really early days, before the entire seed ecosystem even existed, most financing was in equity rounds. But as the SaaS revolution got started, financings both shrunk in size and exploded in volume, with equity rounds no longer making sense in many cases. So we got seed-stage convertible notes. Then we got notes with pre-money valuation caps, discounts, or both. Then you got pre-money SAFEs. Then you got post-money SAFEs, and various flavors of them. Then you got post-money convertible notes. Time-based discounts and caps. Milestone-based caps. Don’t forget friends & family SAFEs, which are slightly different. Oh, and let’s not forget seed equity v. NVCA equity. Even within these categories there are various nuances and flavors.

It is not surprising to us at all that the ecosystem has resisted all attempts to hyper-standardize fundraising instruments, notwithstanding the valiant (even if self-interested) attempts by high-profile VCs or software tools to centralize all fundraising terms. This reflects the decentralized reality of the startup ecosystem. Startups are not uniform commodities, nor are their investors. In the latter category, think of bootstrapping, friends and family, angels, super angels, angel syndicates, pre-seed funds, seed funds, family offices, crowdfunding, accelerators, VCs with seed fund arms, strategic investors.

Couple that organic diversity on the investor side with the extremely diverse industries, business models, geographies, team compositions and cultures, risk tolerances, and exit expectations of startup companies. Do we really expect all of these sophisticated business people playing with millions and tens of millions of dollars, gunning for hundreds of millions to billions, to fit into one or two template financing structures because some VC, accelerator, or cap table software says they should? Because of some childish aversion to actually reading a contract and tweaking a few terms?

The only people misguidedly trying to hyper-standardize this complex ecosystem are (i) specific VCs who profit from controlling terms, with their preferred templates, and (ii) specific software companies (often funded by the aforementioned VCs) who want to build some centralized proprietary tool on which all startup financing would at some point become dependent (surely with juicy margins to them as a result). Neither of these types of rent-seeking gatekeepers are looking out for the ecosystem itself, and its diversity of preferences and priorities; certainly not for entrepreneurs. They’re looking out for themselves (for which, as market actors, I don’t fault them).

Given the diversity of businesses and investors in the startup ecosystem, which inevitably leads to a diversity of funding instruments, flexibility of any viable wide-reaching startup capitalization model is key. That’s why MS Excel still matters, because of how flexible it is. Flexible and transparently auditable in the way that open source code is flexible; and proprietary “no code” tools are not.

Led by a Partner colleague of mine, Jay Buchanan, we’ve published the Open Startup Model. Free, Excel-based, flexibly customizable and auditable, even “forkable” if others want to iterate on it. “Open Source” effectively. It’s based on the same model we’ve used hundreds of times at Optimal, with clients backed by elite VCs like a16z, Sequoia, Accel, Khosla etc. and dozens of “long tail” funds across the world as well. It works from the formation of the company through Series A (or a Series Seed equity round).

Jay will be writing periodically at OpenStartupModel.com, with info on how to take better advantage of it. Just like open source code isn’t intended to be handled by untrained end-users, this model is not intended to be entirely self-serve by founders. We are modeling very high-stakes and complex economics here. Rather, it’s meant to be a potential starting and focal point for various experienced market participants (including lawyers) to work with founders on.

Just as we are big believers in the thoughtful integration of elite legal industry values and lean tech values, we think an “open” startup ecosystem, with its enormous organic diversity of market players, is far healthier and more sustainable than misguided attempts to centralize everything behind a handful of rigid proprietary structures and tools. An open pro-forma model, together with our open-source contract templates that we’ve published here on SHL, is part of that vision.

In that vision, it’s not necessary that dozens of different actors come to agree on some “standard.” These templates and models will look extremely recognizable to all the serious law firms and other key players in the market. That alone saves time if startups or lawyers want to use them, and as institutions get more “reps,” efficiencies follow as institutional knowledge is gained.

We hope everyone – founders, lawyers, investors – will find this helpful, and welcome any feedback on improving it; particularly if “bugs” are found. As a final legal tech tip for lawyers, the ability to redline excel models, much like how you redline contracts, is super important and improves efficiency in reviewing model changes. Litera Compare is our favorite redlining tool for excel files.

As a separate tip for startup founders, if you need a 409A valuation, but don’t want to pay extra for a third-party cap table tool (because Excel is fine for now), Eqvista has a lean 409A-only (no extra software) offering.  Some seed-stage companies go this route, combining Excel and a 409A valuation without the extra bells and whistles of the pricier cap table tools, until their cap table has grown more complex (typically post-Series A).

Finally, once you get to the point of needing to onboard to Carta or Pulley (if you’re successful, you will get there eventually), the following may be helpful for saving on their costs.

Post-Money Valuation Cap Convertible Note Template

Link: Post-Money Valuation Capped Convertible Note Template

See also: Seed Round Template Library

Post-money (as opposed to conventional pre-money) valuation caps have become more of a thing in early-stage startup convertible rounds. The primary benefit of a post-money cap is that it makes it clearer to investors what percentage of the cap table they are purchasing as of the day of their investment, because the “all-inclusive” valuation cap incorporates all SAFEs and/or Notes the company has raised, even if they haven’t been formally converted or modeled on the cap table. In pre-money caps, what you are buying is more ambiguous.

The extra transparency of post-money caps can be a very good thing. But as I’ve written before, and many others have pointed out, the default post-money SAFE that YC published a few years ago had a very anti-founder “gotcha” built into it. Not only did it commit to a specific % of the cap table today, but it also gave investors aggressive anti-dilution protection for any future dilution from more SAFES or Notes, all the way until an equity round in which everything converts. Tons of companies have gotten burned by this, not understanding that YC’s Post-Money SAFE structure forces the common stock alone to absorb all dilution until SAFEs convert. This is way worse economically than other financing structures for early-stage.

Frankly, YC’s decision to make its SAFE instrument so investor friendly was surprising, even acknowledging that they, as investors, surely have benefited financially from it. Giving post-closing anti-dilution protection to SAFE investors isn’t necessary at all to give them the real primary benefit of a post-money cap, which is clarity as to what they are buying today. If I’m investing into a company that already has raised some SAFEs or Notes, I surely would like a hardened commitment as to what post-money valuation I’m paying for today, but I don’t see why I should expect protection from future dilution. For that reason, we published a “fixed” post-money SAFE template. With a few added words (clearly reflected in track changes for transparency), it “fixes” this anti-dilution problem in the YC template.

Acknowledging the benefits of even a “fixed” post-money SAFE, the truth is a lot of investors around the world, and in the U.S., still aren’t comfortable with SAFEs. They think SAFEs generally skimp too much on investor protection. For example, particularly in a down market like today, some investors would prefer the debt treatment of a convertible note. Even in 2023, we still see quite a few deals closed on convertible notes instead of SAFEs. I represent exactly zero VCs or tech investors, and what I’ll say on this topic is that in reality the differences between SAFEs and Notes are not super material; and never worth losing funding over them. Go with whatever works, and just make sure you have good advisors to protect you on more material points.

Most convertible notes I see today still use the older-style of pre-money valuation cap. There’s no reason why founders, in choosing to raise on a convertible note, should be stuck only with pre-money valuation caps, given that, as I described above, there can be very good reasons for using a post-money structure.

For that reason, I’ve taken the convertible note template that’s historically been publicly available here on SHL, and made a post-money valuation cap version. The benefits of a post-money valuation cap’s clarity, but under a convertible note structure. Just one more potential template to leverage in closing an early-stage round. Importantly, it does not have YC’s harsh anti-dilution mechanisms built in. The purpose of this post-money cap is to reassure investors as to what they are investing in today. There is no promise of anti-dilution for future fundraises because, in my opinion, there shouldn’t be.

The usual disclaimers apply here. This is just a template, and it is intended for use with experienced counsel. I am not recommending that founders use this template on their own without experienced advisors. If you choose to do so, do not blame me for any negative consequences.

Related recommended reading: Myths and Lies about Seed Equity. As useful as SAFEs and Convertible Notes are for simple early-stage fundraising, my impression is that they tend to get over-used, sometimes in contexts when an equity round really makes a lot more sense. Make sure you understand the full pros and cons of an equity round, including potential “seed equity” structures that are simpler and cheaper to close than full “NVCA” equity docs. A lot of the over-use of Notes and SAFEs stems from myths and falsehoods often shared in the market about equity deals.

Milestone-Based Valuation Caps for SAFEs and Convertible Notes

TL;DR: When it’s difficult to get aligned with investors on the appropriate valuation cap in your Convertible Note or SAFE, having a tiered milestone-based valuation cap can be a reasonable compromise. If you hit the milestone, you get the better (for the company) deal. If you don’t, investors get the better deal. But avoiding ambiguity in the language is key.

Related Reading:

Equity rounds, including simplified/leaner seed equity, have always been preferred by founders for whom “certainty” over their cap table is a key priority. Equity allows you to lock in a valuation and certain level of dilution, which is often an optimal strategy in boom times when valuations are very juicy; though of course over-optimizing for valuation alone, to the exclusion of other factors (like liquidation preferences, governance power, investor value-add, etc.) is never a good idea.

But as of right now (December 2022), we are definitely not in boom times. The startup ecosystem has seen a dramatic contraction in financing activity, and uncertainty over valuations has taken over; with investors demanding that they move lower, and entrepreneurs struggling to accept the new reality.

Convertible securities (Notes and SAFEs) have always had the benefit of being more “flexible” and simple than equity. They have their downsides for sure, but in many contexts when speed-to-closing is important, and fully “hardening” a valuation is not possible, they make a lot of sense. But in times of maximal uncertainty, like now, even agreeing on an appropriate valuation cap can be tough. You believe you deserve more, but the investors, often citing all the apocalyptic data, say you’re being unrealistic.

A milestone-based valuation cap can be a good way of getting alignment on a valuation cap, especially if you’re highly confident in your ability to hit that milestone, but you have no credible way of getting an investor today to share your confidence. Investors tend to like valuation caps because they are asymmetrically investor-friendly – if the company performs well, the cap limits the valuation, but in a bad scenario, investors get downside protection (lower valuation at conversion). A milestone-based cap is a way of making the cap’s “flexibility” a bit more symmetrical, with upside for the company if it outperforms.

A milestone valuation cap would say something like (paraphrasing): “If the Company achieves X milestone by Y date, the Valuation Cap will be A. If it does not, the Valuation Cap will be B.”

Simple enough, but as always the devil is in the details. When using a milestone valuation cap, you want to minimize ambiguity and the possibility of disagreement in the future as to whether the milestone was in fact achieved.

Bad milestone language: “The Company successfully launches an alpha product to market.”

What do you mean by “successful”? In whose opinion? By what date? What constitutes a “launch”?

Better milestone language: “The Company’s product/service achieves at least 10,000 daily active users by [Month + Year], with such metric to be calculated and reported in good faith using a consistent methodology determined by the Board of Directors in its reasonable discretion.”

Not 100% air-tight – it can often be unproductive to over-engineer the language, and too much distrust between investors and management as to calculating the milestone is a bad sign – but still far clearer and less subject to disagreement than the first one.

If you find yourself cycling in discussions with investors over what the “right” valuation is for your seed round, consider committing to a milestone-based structure as a way of (i) getting alignment as to what “success” looks like post-close, and (ii) bridging the “confidence gap” between the founding team and the money.

Startup Governance Choke Points: Protective Provisions

Related Reading:

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

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

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

The hidden VC “block” on future fundraising. 

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

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

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

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

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

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

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

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

Preventing / Negotiating this Choke Point

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

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

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

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

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

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

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

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

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

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

Alignment in Startup Governance: Conflict, Collusion, Corruption

Related Reading:

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

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

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

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

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

Conflict

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

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

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

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

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

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

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

Collusion

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

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

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

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

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

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

Corruption

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

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

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

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

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

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

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

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

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

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

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

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