Post Category → Founders

The Fiduciary Duties of Founders

TL;DR Nutshell: The moment someone is added to a startup’s cap table, founders (as majority stockholders, directors, and officers) becomes fiduciaries of that stockholder. This means that, regardless of how much control founders may have over a company, corporate governance law draws a hard line on how that control can be used. Crossing that line can result in a lawsuit.

This is one of those “core concepts” posts that, to lawyers and professional investors, will seem laughably basic; and yet the topic is something that I regularly see first-time founders get very wrong. And like most SHL posts, I’m going to explain things without referencing statutes or complicated terms. Founders need to understand the concept of Fiduciary Duties. The details they can learn from their lawyers or on-the-job.

State Corporate Law

Most Angel/VC-backed startups are Delaware corps. If they are not Delaware corps, they are usually incorporated in their home state and will be required by institutional investors to become Delaware corps if/when they ever are offered a check.  Whether you are a Delaware corp or not, your state certainly has corporate governance rules giving founders (as directors and majority stockholders) varying degrees of fiduciary responsibility to minority holders in their company. The concept is the same.

At the most fundamental level, to say that founders have fiduciary duties to their stockholders means that they cannot, without seriously risking a lawsuit, unfairly enrich themselves at the expense of other people on their cap table. They can certainly get rich by making everyone on the cap table rich; by growing the pie. But they can’t, without some kind of very credible case that it is necessary for the well-being of the entire business, improve their part of the pie at the expense of the rest of it. 

Hypothetical: Founders X and Y hired Employee A and gave her 5% of the Company that, because of some big contributions she made, was 40% fully vested on the date of issuance (meaning 2% of the Company’s equity, of her holdings, is fully vested). After a few months after the issuance, they have a big dispute and the founders fire Employee A, which they are certainly entitled to do. Under the Stock Issuance Agreement terms, 3% worth of the Company gets returned (because it wasn’t vested yet), and Employee A walks away with the 2% she had vested.

But Founders X and Y are pissed off that Employee A has that 2%. “She doesn’t deserve it. She totally ruined the product” they say. Then the light bulb switches on. “We control the Board and the stockholder vote! We’ll just dilute the hell out of her by issuing ourselves more shares!” they say.

Sorry, dudes. If it was that easy to screw minority stockholders, no one would ever invest in a company.

Delaware and other states have rules around “Interested Party Transactions.”  Without getting in the weeds, Interested Party rules boil down to:

  • A Board of Directors has a duty (a fiduciary duty) to do what’s best for the company and all of its stockholders taken as a whole, without unfairly enriching its own members.
  • Any transaction in which the Board members themselves are specific beneficiaries – meaning they are getting something that others are not – is inherently suspect. It is an “Interested Party Transaction” and is open to claims by minority stockholders (the people who didn’t benefit from the transaction) that it was a fiduciary duty violation.
  • In order to “cleanse” (so-to-speak) the transaction and, in some cases, give it a safe harbor protection from lawsuits, extra steps must be followed to ensure the transaction really was fair. Those steps usually are (i) obtaining approval by the disinterested members of the Board (if any) and/or (ii) obtaining approval by the disinterested stockholders of the company. The disinterested people are the ones who aren’t getting the special benefits.

Put the above 3 bullets together, and it’s clear that Founders X and Y (i) are planning an Interested Party Transaction and (ii) without getting a “cleansing” vote of that transaction, are assuming a very serious risk of a lawsuit. If there were 5 people on the Board, and the planned dilutive issuance to X/Y was approved by the rest of the Board, then the risk profile of the transaction would be very different. Similarly, if there are other people on the cap table besides Founders X/Y and Employee A, then if their votes make up a majority of the stock not held by X/Y (the disinterested stockholders) and they approve the dilutive new stock, we’re again in much safer territory.

The key is that, in an interested party transaction, you need to get a majority of the people who aren’t getting the ‘special benefits’ to approve the deal. If you can’t, then you’re asking for pain. 

If the entire cap table is X, Y, and A, then X & Y are just asking for trouble and (frankly) deluding themselves by thinking that they can dilute A (without her consent) in a legally air-tight manner. I’ve seen founders throw out a phrase like “let’s just do a recap” (short for recapitalization) as if recaps are a magical get-out-of-fiduciary-duties card. I think that idea was spread by ‘The Social Network,’ but I’m not entirely sure. Recaps are complicated, and you still have to worry about fiduciary duties to get them done properly.

Corporate Governance is Real

The overarching umbrella of the rules, processes, etc. that govern how corporate directors and officers interact with stockholders is called ‘corporate governance.’ Founders sometimes think it’s all silliness reserved for when they go IPO, but it’s not. From Day 1, corporate governance matters. Yes, it becomes more formalized as you grow as a company and the stakes get higher, but it’s the same rules at Seed v. at Series D, just being applied differently. You better believe it matters the moment a VC is on your cap table.

Fiduciary duties do not mean that you always have to do what your minority stockholders want. That would be impossible. It just means that, as a director/officer, you have to do what’s best for the Company (the whole pie), and not just for yourself. If there’s a financing coming up that some of your stockholders don’t like, you should be safe if disinterested parties approve it as something that is the best move for the entire company. I say should, because the rules, the process, and even the language in your board resolutions matter. They can be (and often are) the difference between moving forward knowing that your decisions can’t be challenged v. handing disgruntled stockholders a loaded gun to use against you when you least want them to.

Bad Advisors: The Problem with Localism

TL;DR Nutshell: One hour with an advisor who has exactly the domain expertise your company needs could be infinitely more valuable than 100 hours with someone who doesn’t. Yet, unless you live in a large ecosystem, that all-star may not be in your city. So go find her. Time is precious and mistakes are costly. Never put localism before competence and results.

Related Reading:

My wife loves farmers markets.  I love healthy, delicious fresh food, as well as supporting decentralized agriculture over conventional mega farms.  But I also personally have a ‘thing’ against rewarding inefficiency and mediocrity. I dislike the way in which a lot of the pro-local ethos appears to almost celebrate how badly businesses can be run – hand-made, hand-picked, artisanal, small batch, etc. etc. If it doesn’t actually produce a tangible benefit to the consumer (better taste, as an example), why should I wake up early on a Saturday morning just to reward your bad business skills?

Funny thing is that there’s one local farm here in Austin that has begun to just dominate farmers markets. More variety, more staff, consistent quality, better pricing, even better branding. They’re everywhere. I love it, and whenever I have to go to a farmers market, I usually just end up shopping at that one booth. And when I’m not at a farmers market, I’m probably shopping at Whole Foods, which is the farmers market fully self-actualized. Say what you want about its prices, but John Mackey and WF took the pro-local, pro-environment, humane food value structure and scaled it (out of Austin) like no one else has since. And it is spectacular.

Touchdowns; Not Pep Rallies. 

Now back to tech. Celebrating your local business / startup ecosystem is a great thing. There’s deep value in the close, repeat relationships and networks that develop through working with people within your city. But with that being said, there is still a completely unavoidable fact: nothing comes even close to supporting a local startup ecosystem as much as the building of scaled, successful tech companies. All the meet-ups, startup crawls, networking events, hackathons, pitch contests, publications, parties, etc. are great and important in their own way, but, to repeat, nothing matters more than the building of great companies. Touchdowns. Wins.  Pep rallies do not attract the kind of deep talent that ignites a local economy; awesome companies do.

Once you accept that building successful companies trumps all else, there’s another unavoidable fact: working with highly competent, experienced advisors with truly valuable insight for your specific company, whether they’re in Silicon Valley, Seattle, Los Angeles, New York, Austin, Houston, Boston, London, Dallas, or wherever, comes first, second, and third before working with someone who may be more accessible to you locally, but can’t deliver nearly as much value. 

If it’s my company, my capital, and my employees on the line, I ain’t got time for the guy selling his tiny backyard tomatoes across the street, even if he knows everyone in town. I need that big, juicy peak game stuff, and if I have to go to the coasts to get it, so be it. Hit your goals with quality, imported help (if necessary), and you’ll sow a dozen A+ farmers in your city for the next entrepreneur to reap. THAT’s how to support your ecosystem.

Bad Advisors <> Influencers. 

Bad advisors are usually influential, well-known people in a local economy. They aren’t bad people. They just don’t have very useful advice, and often give bad advice, to early-stage founders. 

If you want to start a startup-oriented business – let’s use an incubator as an example – and generate a lot of buzz around town, you are going to want to work with the influencers in your community. They know whom to call, what strings to pull, and can even usually put in some cash, to help establish your incubator’s brand around town. What do all of those influencers expect in return? Profit? Perhaps. But more often than not, they want access. They want to be involved. How can they get involved? As mentors /advisors.

So it should not surprise you that when a new incubator, accelerator, co-working space, or other startup-oriented org launches in your town, a significant portion of the people involved will be there not because of the value they can bring to startups, but because of the value they brought to the person starting the incubator, accelerator, or what not. They may be C-suite executives at a prominent local company who have never worked anywhere with fewer than 200 employees. They may be wealthy businessmen in industries totally unrelated to your own. Sometimes it’s just a guy who is really F’ing good at networking.

It’s an unfortunate fact of reality that many business referrals, even in tech ecosystems, are made more with an eye toward perpetuating the influence of the person making the referral (reward people who refer back, are part of your ‘circle’) than the value that the recipient of the referral will receive. Finding people who care more about merit than about rewarding their BFFs is extremely important for a founder CEO. Those people will be honest with you when there simply isn’t anyone in town worth working with. I find myself saying that often about lawyers in specific niche specialties needed by tech companies, although increasingly less so each year.

Widen your network. 

The take home here should be to (i) understand why those influential (but sometimes clueless) local people are being pitched to you as advisors, even when they don’t really have very good advice (but they may have money, and it’s green), and (ii) go find the advisors you really need, wherever they are. But please save your equity for the people actually delivering the goods. Vesting schedules with cliffs. Use them.

Videoconferencing is pretty damn good and cheap these days.  I use it with clients all the time. LinkedIn and Twitter make it 100x easier today to expand your network than even 10 years ago. Hustle. Every founder team does not need to fit the super extroverted, Type A entrepreneur stereotype, but I’ll be damned if any company can succeed without someone who can get out there and shake the right hands.

Interestingly, some people are working on building curated (important, get rid of LinkedIn’s noise) marketplaces to help founders find well-matched advisors, hopefully at some point across geographic boundaries. Bad Ass Advisors appears to be the best example I’ve seen thus far. If BAA doesn’t become a hit, something like it will. The value prop is obvious.

 Most startup ecosystems have some awesome people to work with. Find them. Local can be valuable.  But as your company grows and evolves, don’t let the geographic boundaries of your city force you to settle for influential, but not very useful advisors. Customers > Community. All day. Every day. Never forget: you’ll help your local economy and ecosystem far more by going big and going far than by going local.

Legal Technical Debt

TL;DR: The entire point of contracts is that they are permanent, and can’t be fixed unilaterally. That makes legal mistakes far more costly to fix than coding mistakes. But similar to code, your early stage legal work sets the foundation upon which everything else gets built, and therefore the cost of fixing errors compounds over time; like technical debt. In short, legal work is the last area where any knowledgeable entrepreneur should cut corners, thinking they can just fix issues later.

“Siri, please amend my charter to authorize a Series AA round, prep me an offer letter for a CTO, issue options to 3 recent hires… oh and review/execute that stock purchase agreement with my accelerator. Keep the fees under $500.”  — Not too far off from how a (confused delusional) segment of the startup community thinks startup/vc law should work.

Imagine if advisors told startup founders that, in order to conserve cash, they should aim to spend as little as possible on developers. Find cheap ones. If the non-technical CEO can code something himself to get by, do so.  Just get it done. Don’t overpay.  In fact, if we can automate our development process, do it. Keep cash spend on ‘the business.’

Anyone with an ounce of experience in building successful tech companies would recognize this advice as absurd and dangerous, as if quality and accuracy are irrelevant. Yet every so often I hear about advisors giving this exact advice to founders, about legal spend. And while fewer may acknowledge it, such advice is equally as absurd.

Of course you’d say that, Jose. You’re a startup lawyer.

Well, maybe. But let’s process it a bit.

Why would minimizing your spend on software development (like legal services) be stupid and dangerous?

It can be explained in part with the term ‘technical debt.’ via Wikipedia:

“Technical debt… is a recent metaphor referring to the eventual consequences of any system design, software architecture or software development within a codebase. The debt can be thought of as work that needs to be done before a particular job can be considered complete or proper. If the debt is not repaid, then it will keep on accumulating interest, making it hard to implement changes later on. Unaddressed technical debt increases software entropy.”

While I’m not a developer, my general understanding of the term is that bad coding becomes more expensive to fix over time, in an almost compounding way. And there are even circumstances in which it is so bad that nothing short of a complete re-write will make it scalable and useable. In other words, going cheap on developers just means you are compounding your cleanup cost and headaches for the future, and even threatening a complete shut-down of the product.

Minimizing legal spend works exactly in this way, but magnified 10x.  I frequently write on SHL about the many parallels between complex contract drafting/VC law and top software developers. Both groups involve highly skilled people capable of analyzing, managing, and manipulating large amounts of complexity. Both implement changes for which the stakes on a company are very high. Both expect to be compensated well for their skill set.

Software developers produce the code base on which your product runs. Lawyers produce the code base on which your company, including its relationships with investors, board members, executives, and employees, runs. 

A crucial difference between software code and legal code is that bugs are far easier to find and fix in the former than in the latter. Software code is constantly being revised, with thousands or millions of users revealing bugs on a regular basis. Legal code (contracts) are executed and then put away, often to be reviewed only at high-stakes moments, when fixing them is extremely expensive or even impossible.

Unlike software code, you can’t unilaterally issue ‘updates’ to executed contracts. Any experienced lawyer has seen a deal cost 6-figures more than it should have, or even completely die, because of legal mistakes made earlier in the company’s history. So think of contract drafting for a scaled startup as high-stakes software development for which virtually any material bug is completely unacceptable once the code is shipped. Still want to ‘minimize’ legal spend?

Law is Code; Not Product.

In my experience dealing with many many sets of founders, a part of the startup community carries the very deep misconception that startup/vc law has been, or even can be, completely productized. Want to ‘just’ issue some stock, grant some options, close a seed round, etc? It’s been done hundreds of times before, so it must be all ‘standard’ by now. Just click a few buttons, fill in some names and numbers, and you’re done.

This is the attitude of someone using a product for which clean, standard, predictable, pre-defined features are already in place. “Just” issuing a service provider some stock should be like ‘just’ moving some files around on Dropbox, right? There’s a serious flaw in this thinking. The clean, standard, predictable company and contract history simply does not exist, and hence full automation is pure fiction. 

  • What state are you located in? Laws vary, even if you’re a standard DE corp.
  • Are you a C-corp? S-corp?
  • Are there protective provisions that need to be complied with?
  • Any anti-dilution protection?
  • Enough authorized shares in the charter?
  • Enough reserved equity in the equity plan?
  • A well-documented value of the equity?
  • Is there a written agreement explaining the consideration and complying with securities laws?
  • Is the recipient an individual or an entity?
  • Board approval?
    • Are we confident the composition of the Board is well-documented?
  • Is stockholder approval necessary?
    • Any specific thresholds?
  • Vesting?
    • 83b?
  • Acceleration? What kind?
  • Any other special provisions/requirements implemented by past investors?
  • etc. etc. etc.

Virtually every VC, angel group, accelerator, large company, etc. has its unique variances in the contracts it executes/negotiates. States have different requirements. Laws change. Reality: people are not standardized.  They have their idiosyncrasies, and people determine what does and doesn’t get signed; what gets added to the code base.

Even if companies share 90% of the same legal DNA, the 10% variance is a massive wrench that makes automation, or even any kind of significant simplification, impossible without taking on enormous legal technical debt. That statement is not coming from a luddite lawyer who hates technology, but from the CTO of a startup/vc law practice that I am 100% certain is on the cutting edge of legal technology (the kind that actually works) adoption.

Telling a VC lawyer that you ‘just’ want to issue some stock is not equivalent to ‘just’ using a pre-coded feature in a product. It is far more like telling a software developer that you ‘just’ want to add a feature to your existing, non-standard, unique code base.  Imagine telling that developer to do it as quickly and cheaply as possible. Imagine hiring the cheapest developer you can find to implement that feature.

The contract that actually issues the stock may be 99.8% standard, but it has to be implemented into the historical set of contracts/context without blowing anything up. Contracts and laws do not sit in little, isolated modules without any impact on the other. They’re all inter-connected, with a change in one potentially resulting in a cascade of effects in others. Hence the code base analogy.  The larger, more complex the code base (set of contracts, number of jurisdictions, people involved), the greater the skill and experience required to work with it safely. And having a well thought-out, well-designed architecture implemented from Day 1 dramatically impacts the scalability and resilience of that code base.

So when a client says they ‘just’ want to issue some stock, all they might think about is opening a word document, filling some names, and signing. Of course that can be automated.  What often isn’t considered is the lengthy, complicated list of steps and analysis needed to fit that template document within the Company’s existing legal history. That, not the template stock purchase agreement, is what lawyers do, and software cannot do.

De-Valuing Law, like De-velopers, is De-lusional.

Anyone who sells a product or service into a market learns that not every buyer is willing to pay the cost necessary to deliver that product or service in an efficient manner, within the bounds of physics/reality.  Some buyers simply can’t afford it. But many others just don’t value the product or service enough to pay even the lowest possible price. As a lawyer, I learned very early on in my career that this is the case with founders looking to engage lawyers.

If I’ve been sold the lie that startup/vc law is a completely commoditized, standard product, I am going to shop for lawyers, and assess cost, the way I would for any other commoditized, standard product. I “just” want to issue some stock. Like I “just” want some toilet paper. There are founders (a minority, but many) who understand very quickly why they need to pay good compensation for software developers, and yet will question every single invoice from lawyers.

While I’m always more than happy to walk through an invoice when it makes sense, E/N’s client intake process has been deliberately designed to filter out clients who, for whatever reason, de-value lawyers in this way.  Our website’s home page says “World Class Counsel, Brought Down to Earth.” Translation: top lawyers who are more efficient, responsive, and accessible than the large firms where they’ve historically been found. We compete with other firms who provide top-tier legal counsel to scaling tech companies; not with the unrealistic price expectations of people who, through inexperience or delusion, want Teslas at Kia prices.

The seed-stage period is the toughest time for startup legal budgeting. Things are starting to get more complex, but with only a few hundred thousand raised (let’s put aside California ‘seed’ rounds), every dollar paid hurts. Fixed fees, flexible payment arrangements, deferrals (but be careful), and good old-fashioned budgeting are the key to getting through that period with your lawyers. Any experienced set of startup/vc lawyers will know how to be flexible for seed-stage companies. Just always remember that flexibility (and efficiency) does not mean defying the laws of physics to get things as cheap as you’d like them to be. 

At the level of law that scaling companies require, technology will forever (or at least into the very distant future) remain a complement and not a replacement for lawyers. Yes, the legal industry as a whole is and will continue to undergo disruption as software eats up the more routine, commoditized parts of the profession. But VC-backed companies are not dealing with commoditized lawyers, and talented, creative VC lawyers are hardly, not even remotely, underemployed.  If anything, those of us who adopt new tools as they are developed have found our practices enhanced, not diminished, by technology.  It allows us to deliver more concentrated value with our time, which means a healthier attorney-client relationship overall.

If you engage your lawyers as the developers of an important foundation for your company – expecting effectiveness and efficiency, but staying realistic about the amount of complexity and value actually underlying their work, you’ll be surprised by the rewards.  For those who continue fantasizing about replacing lawyers entirely with apps, nothing will provide a better education than the moment the debt comes due.