Post Category → Power

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.

The Weaponization of Diversity

This is an unusually extra lengthy essay, because the issue is so complex, sensitive, and nuanced that it deserves an appropriate level of patience and attention. It includes my deeply honest, personal, and some would say risky perspective on the topic of diversity in high-performance elite careers, including tech entrepreneurship; and my concern, as a latino who grew up low-income, that the decision by some to “weaponize” diversity is backfiring and causing harm to under-represented minority (URM) groups.

I would like to emphasize the distinction between “American Latino” and “Latin American” in this essay. By American Latino, I refer to Latin Americans (and their children) who migrate to the United States, and as a result are a sub-group (with various selection biases) of Latin America. The importance of that distinction will become clearer as you read on. 

I grew up in a very “colorful” part of Northside Houston, with neighbors and schoolmates who were usually a mix of latino (immigrants and 2nd generation), black, asian and white; and a general socioeconomic range hovering between welfare, blue collar, and sort-of-middle class. My parents (Mexican immigrants) started a produce business selling avocados and tomatoes, which eventually grew but then unfortunately imploded. By the time I was sending off college applications, my two sisters and I were supported by our single mother who sold perfumes at an indoor flea market. After public K-12, I ended up attending the University of Texas and Harvard Law School, graduating in both cases with various honors. Today, with three healthy kids, happily married over a decade and a successful legal practice/leadership position at an elite boutique law firm, my cozy “1%” life definitely does not suck.

But this isn’t your classic self-congratulatory American Dream story. There’s a key twist, and that twist has given me a unique perspective on issues of socioeconomic inequality and diversity. My mother, despite ending up in a struggling, unstable situation, was actually a computer science graduate of the top technology university in Mexico; the Tecnologico de Monterrey. Basically the MIT of Mexico. And her family background includes a nationally celebrated Mexican artist and a biological (but estranged) father considered one of the top medical doctors and medical school professors in his field.

How did my mom go from a top-tier student with a strong family background to selling perfumes at a flea market as a single mother hovering preciously close to Medicaid-level poverty? This isn’t my autobiography, so I’ll cut that part of the story short and summarize: very difficult mental illness. Many people fail to appreciate how success is just as much about emotional stability and health as it is about intellectual and analytical capacity; and the formula for producing the former is often far more complex and nuanced than what’s necessary for the latter.

I mentioned these details about my mother because they are historical elements that keep me, if I’m honest, from painting for you a perfect “everything is totally fine because I made it” story; the kind of story that is too-often used to ignore real problems in society. My mother’s emphasis on academics and her love of computers – which she made every effort to expose me to, within her limited means – were key strategic assets in my childhood that differentiated me from my peer group, and undoubtedly propelled me forward. The truth is the vast majority of people who give you these “rags to riches” stories can, if they’re sincere enough, come up with their own kinds of privilege (including familial privilege) that they depended on growing up. If anything, simply being born “gifted” (to use a very broad but frequently used term) is itself an unearned privilege reserved for a lucky few who often like to conveniently overlook their luck.

Yes, we were poor latinos living in a low-income area and a broken home, speaking a blend of spanish and english and having our fair share of tamales, frijoles, barbacoa, etc. A (candidly) stereotypical and recognizable American Latino household portrait. But as it related to school, my home culture (driven by my mother) was different, and my latino peers noticed. I studied hard, taking advanced coursework beginning in elementary and through high school. I entered college on a full academic scholarship with enough advanced credit to almost qualify as a junior; some of that credit having been earned from reading textbooks on my own because my high school didn’t offer a particular course. My level of academic discipline got me labeled as “acting white” (by other latinos) more than enough times. There was even a special term for it: “coconut.” Brown on the outside, white on the inside. I had friends growing up who studied as hard as I did, but none of them were latino.

I didn’t know it at the time as a boy or young man, but the gulf in home culture between myself (via my mother) and my latino peers in Houston was encapsulated in a phrase I often heard from mom: “we don’t behave like those latinos.” It was all class cultural conflict reflected via playground insults (coconut) and maternal chastising (to succeed, don’t replicate “poor” culture). I struggled with this tension of identity growing up – I was definitely not “white” but somehow a different, less familiar and far less common (in the U.S.) kind of “Mexican,” and my latino friends could tell.

Very very few of my childhood American latino friends have ended up as successful doctors, lawyers, engineers, executives, or entrepreneurs, including some who had more money and far more stable families than we did. Many didn’t even go to college. Whenever I hear someone bring up statistics about the under-representation of latinos among the top economic strata in the U.S., I think about my childhood experiences and how differently I saw the world from my friends, because of the expectations I had at home; my “coconut” expectations. Rare among Mexican-Americans, yet not so for other American immigrant groups (more on that below), I grew up with a low socioeconomic status but cultural education expectations more typically aligned with upper classes.

I often think about how much I heard, and sometimes still hear, underachieving peers lash out at the world for its supposed racism and prejudice against latinos; and yet, with a name like Jose, there was no hiding my own ethnicity. If the world I was living in had deep, systemic discrimination against latinos, surely I was an easy target. Certainly I’ve encountered some bona fide racists, but rarely were they in positions of influence to alter my trajectory. And of course there are stereotypes that I’ve had to overcome. But, again, given the progressiveness and merit-driven nature of the people and institutions of influence I’ve encountered (and thank God for that), the stereotypes eventually gave way to what I could actually deliver.

I’ve learned to not be so offended by weak stereotypes, because given my experiences growing up, I understand full well why they exist. Stereotyping is at some level a normal, even if often unfortunate, function of human behavior. We had plenty of stereotype jokes in our household growing up, particularly about white people. Stereotypes alone do not really make you a racist. They make you human. It’s how strongly you hold onto a stereotype, and your willingness to give individuals the benefit of the doubt, that determines whether or not you deserve the label.

Yes, bias exists, and we should work to overcome it. But it doesn’t and hasn’t existed solely for modern-day under-represented minorities. Jews, Asians, Indians, and all kinds of immigrant and religious groups have historically faced discriminatory bias in America (and all over the world). For American Latinos to dwell on “unconscious bias” as the primary reason for their under-representation is to ignore the reality that dozens of other groups found ways to overcome the biases they faced in society. So why would the bias we face be so much more, and uniquely, insurmountable?

Constant discussion of bias in the market amounts to what I would call, frankly, “unfairness porn.” Addictive to some, and even a lucrative career for others, but ultimately of questionable impact relative to more actionable topics. It’s not entirely wrong, and there’s some value in it. I empathize with those who work in that area. But big picture it feels like a time-consuming distraction from deeper issues which, if addressed, would naturally resolve negative bias over time. Nothing is more impactful at overcoming bias than creating a record of unambiguous and credible results.

Let’s jump back to the unfortunate above-mentioned personal fact: very few of my latino friends ended up successful. Why? Racism? Systemic discrimination? I’m sorry, but you won’t convince me of that. I will acknowledge that stereotypes are out there, and they do impact latinos at the margins, but my own experiences, observations, and reflections make it impossible for me to accept that the dramatic under-representation of American latinos in high-performance industries today is the result of their being discriminated against for being latinos. The gap is simply too large, reflected across numerous top-tier industries, and many of these industries are simply too competitive and lucrative for key players to ignore truly untapped talent being kept on the sidelines.

If you want to argue for strong, systemic discrimination against latinos, you’ll have to explain the very big gaps in outcomes between, say, Cuban-Americans and Mexican-Americans. A reflective and honest latino can explain that gap very quickly. Cuba had a “brain drain” thanks to Castro. Mexico did not. Every major country has different strata with their own subcultures and attitudes, including about education, work, family building, and many other life factors. Mexicans certainly share a common culture, but a Mexican banker or professor has a very different attitude toward education than a Mexican laborer or restaurant owner; much like how the general culture of Cambridge, MA is very different from that of West Virginia.

History has caused Cuban immigration to the United States to select more for Cubans with values that help them succeed at higher levels of performance in an education and capitalism driven society, while Mexicans with similar values have disproportionately chosen to stay home, with their much more blue collar counterparts (with far less emphasis on academics) leaving to America. But because of relative population sizes and geography, the number of Mexicans who have migrated to America completely dwarfs Cubans, and so the generalized data (and outcomes) of American latinos reflects more the outcome of Mexican-American culture (laborer, blue-collar) instead of affluent Cuban-American culture (academics, entrepreneurship). Nevertheless, they are both American latinos, and would face similar “racism” and “bias” in American society. The dramatic difference in their economic outcomes is telling.

You see this issue pop up between black Americans of recent African descent – like Nigerians and Ghanaians – relative to African-Americans with lengthy American histories, including with slavery and Jim Crow. Nigerian and Ghanaian Americans, and their children, are far more economically successful on average than other black Americans, including by some measures more successful than average white Americans. But just as between Cubans and Mexicans, any “racists” would have a hard time distinguishing them from appearances. Clearly this systemic discrimination narrative is more complex than some make it out to be. Immigration patterns have generated a “brain drain” from various African countries that selects for members of those populations with values that generate more positive outcomes.

Of course, this isn’t to pretend that the selection process of differential migration alone explains the full outcomes of different groups. Confucianism goes a long way in explaining why certain “Asian” cultures are obsessive about academic achievement for their children. China broadly cares a whole lot more about school performance than Mexico does (or anyone else for that matter). Talmudic history similarly explains the strong outcomes of Jews. Explaining Mormons is a little more complicated. But the general message is centuries of distinct history produce distinct cultures with distinct values that generate distinct kinds of performance in distinct environments. How many elite Chinese-American baseball players are you aware of? Culture matters. A lot.

So why is there such a disproportionately small number of American latinos in high-achievement careers? To give a full answer, it would take a day’s worth of conversations, and hours of writing. On a socioeconomic level, latinos in America obviously face barriers like higher amounts of poverty, poor schools, cramped housing, and all the challenges of being in the lower economic brackets typically reserved for recent immigrants. Regardless of what minority group you are talking about, these factors push down long-term performance.

Yet the data unavoidably shows that, even when controlling for socioeconomic barriers, certain groups still dramatically outperform others in school and long-term economic outcomes. It also shows that even in affluent environments, wide achievement gaps between groups persist, and are linked to parental educational engagement, expectations, and perceptions about how educational achievement impacts market success. There are even studies demonstrating that among under-represented minority students, there is a negative correlation between high academic achievement and popularity among their same-ethnicity peers.

Do not interpret this as suggesting that economic inequality is not a serious problem in America. Without a doubt, it is. But the point here is that given the number of under-represented minorities “of color” who aren’t poor, and even attend decent schools, if poverty and weak schools were the main issues we would see much better representation of URMs in high-performance industries than we currently do. The fact that, on average, even middle and upper middle class URMs continue to reflect an educational performance gap, but that the gap narrows and even disappears for specific sub-cultures of URMs, necessitates acknowledging that something deeper is at play.

To ignore the reality of cultural values is to cowardly stick your head in the sand, and therefore never fully address the main source of the problem. American Latino culture (generally) heavily promotes short-term economic gain over the kind of long-term success requiring what’s often called “delayed gratification.” If you find a decent job right outside of high school (and even during high school) that can afford you a relatively nice car and possibly a modest home, your “network” as an American latino is far more likely to celebrate your achievement. If you grind out your high school years acing AP classes (having taken advanced classes in middle school), forgoing short-term economic opportunities in hopes of getting a BA and even a masters degree, you’re more likely to be called a coconut.

American Latino culture (specifically the culture of the strata of latinos who come to America, which is very different from Latin American culture generally), for all of the above-covered reasons having to do with history and immigration selection, disproportionately prioritizes blue collar and middle-class success over the long-term delayed training required to reach the upper tiers of high-performance professions. Where are the millions of Mexican parents who demand academic excellence from their kids? Largely in Mexico, where, because of a dynamic economy (tied closely to the U.S.) that functions quite well for the upper classes, they are successful and have no reason to leave.

High-performance professions, like law, engineering, and medicine, are heavily oriented toward the kinds of skills that depend on long-term, compounding training and achievement. Unlike, say, marketing or sales, where someone with a natural gift could possibly not do that well in K-12 and still quickly absorb necessary skills for high-performance post-school, it is very hard to make up, in a matter of a few months or even years, for extremely weak math and science training if you want to be an engineer or doctor.

Heaven knows many universities try (and bless them for it), but they simply cannot waive a magic wand and erase a poor public education and home environment (culture) that failed to instill academic rigor over the course of over a decade, including during a child’s most formative years. They have made great strides in helping students with weak backgrounds “catch up” for middle class oriented careers, but the gap for top-tier achievement is simply too high. Think of what it takes to be a world class violinist. How many of them started training only when they got to university, or even high school? Virtually none. How a child spends their time heavily influences the performance level they are able to attain as an adult, especially in careers dependent on compounding skillsets with high-performance requirements.

Thus, these career tracks by their nature – a nature that has absolutely nothing to do with racial discrimination, mind you – heavily disfavor anyone who doesn’t show up to college with a relatively solid academic background. That means, disproportionately, American latinos (and also other subcultures, like rural whites in Appalachia). To really address this problem requires a lengthy, candid discussion about childhood, parenting, family structure, and cultural identity. Calling “the system” and its performance standards racist gets you nowhere.

Yes, certain groups do better than others in the system, but that’s generally because they better prepare children to meet its logical and unavoidable requirements, with a home environment that emphasizes high educational expectations from an early age. Rather than pretending that reasonable and necessary meritocratic standards, which an enormously diverse set of ethnic groups and nationalities are able to succeed within, are “racist” and oppressive – a logic that has more to do with defeatist Marxist ideology than racial supremacy – we should be addressing the background sociocultural and educational reasons (originating in early childhood and education policy) behind why certain groups struggle disproportionately with the standards.

To be clear, one can reasonably acknowledge that the historical origin of the educational values of certain URMs is directly tied to oppression and lack of opportunity. This is certainly the case with laborers and low-income migrants from Latin America, where social mobility is generally worse than it is in the United States. Latin American laborers have, because of colonialism and its legacy, historically been denied access to viable education and thus, over generations, a distrust and skepticism of the real payout of long-term academic effort (and starting very early in that effort) became engrained in their values. Contrast that with China, where for centuries the entire basis for virtually all social mobility rested literally on a standardized exam (the keju, or imperial examination). China invented standardized testing, so guess who is really good at studying for tests? History matters.

But with all of that being said, even if oppression is the historical cause of cultural values that now generate underperformance, that doesn’t at all mean that today URMs are (on average) underperforming because they are academically or professionally oppressed. History can’t be changed, but culture can evolve, if we’re willing to be honest about it. These groups have the opportunity to begin learning and integrating more successful strategies into their identities and cultures today, just like others have done so in the past. Unfortunately, some of the strongest interference in this process comes from confused third-parties who want to pretend that there really is nothing new to learn, other than a few statistics about “unconscious bias.”

Acknowledging the cultural underpinnings behind educational performance gaps, and how they directly align with under-representation in top-tier industries, is not about blaming under-represented minority groups for their challenges. No one chooses the culture of their childhood, or the history of that culture, any more than they choose their parents or skin color. But acknowledging the issue, no matter how much certain misguided commentators demand silence, is essential for ultimately resolving it. In fact, the combative tendency to immediately shout down anyone as “racist” or offensive for sincerely raising these issues is precisely why discussion remains stuck in a phase of stale and exhausted, but easier-to-discuss ideas; like “trying harder” to find qualified candidates.

Now speaking even more narrowly for the audience that frequents this blog: why are there so few successful latino tech entrepreneurs? I’ve already explained part of the answer. As much as we celebrate people like Mark Zuckerberg and Bill Gates dropping out of Harvard to start tech companies, it’s worth emphasizing that first they still got into Harvard, and second they surely must’ve learned the skills necessary to start tech companies somewhere before getting to Harvard. Tech entrepreneurship is dependent on a compounding skillset that, again, filters out people whose childhoods failed to help them develop that skillset. Zuck and Bill didn’t learn to code during their freshman years.

But let’s put aside the compounding/technical skill issue for a moment, because there’s a more nuanced issue at play here, and it relates to the point I made when discussing my mother’s poor outcome despite her clear academic intelligence: success depends on technical skill but also, particularly in certain environments, on emotional/psychological resilience.

There’s a frequently cited John Adams line that I am going to paraphrase and somewhat modernize: people become farmers, so that their children can become merchants, so that their children can become professionals, so that their children can become artists and entrepreneurs.

What is this line telling us? That there is often a generational progression to career trajectories, and that progression is tied to economic stability, which itself is tied to psychological resilience and willingness to take risk. I can tell you, having worked with and observed hundreds of entrepreneurial ventures, your average tech entrepreneur is not coming from a low-income or even blue collar/middle class background. Zuck and Bill certainly did not.

It often takes a childhood environment that infuses a person with confidence about their family/network’s overall economic stability to enable that person to confidently take the enormous personal risk of becoming an entrepreneur; instead of going into a nicely salaried career. Wealthy kids are far more likely to grow up to become entrepreneurs, because they know that going “bust” doesn’t mean actually going homeless, but instead there’s an enormous set of resources there to serve as a parachute.  Kids with similar technical or “intellectual” ability, but with families living on the precipice of poverty, or at least with very few excess resources to manage a blowup, do not have that luxury.

This is not to say that tech entrepreneurs with wealthy backgrounds are not big risk takers. Most of their equally wealthy friends probably still went into consulting and other salaried jobs. But it is to at least acknowledge that having an affluent background dramatically subsidizes personal risk tolerance.

I do not regret for a second becoming a VC lawyer instead of becoming an entrepreneur. Neither of my parents had any substantial savings. In fact, I support my mother in her retirement, and most of the rest of my family struggles on a daily basis to even stay in the middle class (loosely defined). Unlike Zuck or Bill, failure in my case would’ve, quite literally, risked homelessness. I have met entrepreneurs who really did risk homelessness/poverty in starting their entrepreneurial ventures, but they are a far smaller minority than is suggested from the heroic “risk absolutely everything” stories one often hears in the media.

So I went into a career that made sense for my low-income family background/history. No regrets. I can guarantee you countless high-achieving latinos (and other minorities) make this exact decision on a daily basis. Startup? Sorry, I’ve got parents and other extended family to help out. I’ll take that high-salaried job I busted my tail and sacrificed for. Maybe my kids will have a better parachute.

Many high-achieving under-represented minorities simply do not have the luxury of parents, aunts, uncles, and cousins all with stable incomes and savings to provide them a parachute for an entrepreneurial adventure. Now, their kids might (see the John Adams line), but that’s why changing the long-term economic success of any broad group simply cannot be wished into existence. The most challenging forms of success take an entire childhood of compounding learning, and going even further, the very highest risk paths often take generational building of wealth and resilience.

We like to think of entrepreneurship, including tech entrepreneurship, as a very democratizing, equalizing playing field where anyone with the right motivation and persistence can succeed; but my honest experience is that today, in fact, it’s the opposite. High-achieving entrepreneurship takes a spectacularly rare and complex combination of analytical and technical skills, communication skills, social skills, and creative judgment about current and changing market conditions, on top of incredible psychological resilience. Rather than an easily accessible field for anyone who wants to play, modern hyper-competitive tech entrepreneurship represents the apex of human abilities, creativity, and endurance. We should not be surprised that, for most people, the necessary (but not sufficient) conditions for reaching that apex start well before adulthood; and include a childhood environment that supports high achievement.

Tying this all together: first, the compounding technical skill “filter” disproportionately impacts American Latinos (and similar groups) because cultural, not just socioeconomic, factors lead fewer of them to develop the compounding skills in childhood that make tech entrepreneurship (or many other high-performance careers) feasible. Second, for the disproportionately small number of them who still end up getting there, they are far less likely than other groups to come from the kinds of stable economic backgrounds that make high-risk paths like entrepreneurship attractive. Among under-represented minorities like American latinos, the “best and brightest” are, much more so than other groups (but certainly not always), drawn toward stable high-income professions and away from high-risk paths like startup employment and entrepreneurship.

Now, let’s ask ourselves a hard question. How much of this unfortunate reality can actually be materially impacted by recruiters and investors in any short-term sense? It takes time for the descendants of low-income immigrants to build the kind of economic stability and resilience that encourages very high-risk, very high-reward paths. Anyone expecting to actually impact long-term collective outcomes needs to face, head on and without unproductive outrage or finger-pointing, the fact that helping people meet the requirements of high-performance takes time. It also takes honesty about the cultural/behavioral values that build up children to face those requirements as adults. The requirements themselves, no matter how much we might wish otherwise, are not going to budge.

I want to see more “people of color” in tech entrepreneurship and other high-performance careers just like all other good, honest, progressive people. But I’m afraid that a segment of the community – either well-intentioned or not – has chosen to weaponize the issue of diversity in a way that is not only hostile and disingenuous, but counterproductive to its own cause.

There are historical, cultural, and socioeconomic reasons – all of which have been exhaustively studied – that explain why a disproportionately small number of people in certain ethnic/minority groups are able to achieve the high levels of performance and economic success attained by other groups. The number of high-performing candidates “of color,” in the sense we are discussing, is in fact smaller. Throwing the label “racist” around indiscriminately, and trying to guilt decision makers – like recruiters and investors – into hiring or investing in more of these candidates than realistically exist (today) can backfire. Dramatically. I’ve seen it happen.

I’ve seen very well-intentioned “diversity” accelerators created with much fan-fare and PR. But because they didn’t actually dig into the deep, complex reasons for the low representation of certain groups in their industry, and instead wanted quick and easy results, what actually ended up happening is that they promoted companies that underperformed and underachieved. The end-result? They very loudly and publicly reinforced the very stereotypes they were trying to break. Even more sadly, already successful/wealthy people, usually white, still get their PR and photo ops from these initiatives, while minorities are, once again, left holding an empty bag. On the most important issues, good intentions are not enough. Instead of stereotypes truly holding us back, we are foolishly incentivizing their amplification.

In the case of many mission-driven “diversity” venture funds, they’ll often amplify the idea that venture capital is racist or systemically discriminatory, but a quick glance at their portfolio makes it clear that they are sourcing and funding various kinds of businesses that do not generate true venture capital returns (but fulfill their mission). That they are choosing to fund other lower-margin, lower-scale kinds of businesses is great, and yet their claims that venture capitalists seeking high-scale, high-margin venture level returns are “racist” are still disingenuous.

The more exposed any position is to the harsh, unforgiving reality of the market, the harder it is to compensate for underperformance. This is why large organizations, like the government (including the military) have historically been the best environments for “affirmative action” type initiatives that acknowledged some preferential treatment of under-represented minorities, but are able to contain and address any performance issues with the “slack” of the large organization. Very high-performance, high-stakes positions, like startup entrepreneurship (and also complex law, by the way) unfortunately don’t have this luxury. If there are nuanced, complex reasons for why a disproportionately small number of American latinos meet the requirements of medical schools, I doubt anyone wants to suggest we guilt and shame the schools into graduating more of them anyway.

Tech startups operate in the most performance-driven, cut-throat, “figure it out or die” segment of the economy. Unlike large organizations with many layers of staff and substantial buffer resources for training, bringing on anyone who underperforms risks catastrophic failure for a startup team. The reasons they underperform may be totally unfair: disadvantaged background, low-income, poor education, etc., but, again, customers don’t care. Can an NFL team afford to take into account “fairness” in whom they put on the field? No, and neither can startups. Once we clear out true discrimination, any attempts at increasing representation must involve actually improving the performance of the underrepresented groups.

The world of startups is one of the most culturally progressive environments I have ever encountered in my life. But it is also, by necessity, fiercely (even if imperfectly) meritocratic. This fact makes it quite “colorful” in terms of the full diversity of ethnicities and nationalities one encounters – hardly all white American-born men, but it also means wide performance differentials between groups are going to be unavoidably visible in outcomes.

The great “myth” of the tech sector, or really of the entire high end of the modern economy, isn’t a myth of meritocracy. Competitive markets make it very expensive to hire under-performers, or to discriminate against available talent. We have, perhaps more than any time in history, meritocracy. The myth is that meritocracy (alone) means equal opportunity. To the contrary, hyper-meritocracy puts an enormous premium on having a strong (socioeconomic and cultural) background that prepared you with compounding training, because you need to show up on Day 1 ready to perform. Meritocracy massively privileges having a good childhood, including a home culture that enables, from very early on, high achievement. Appealing to racism and prejudice among the decision-makers in elite institutions (including employers) isn’t necessary at all for explaining the wide disparities we see in our increasingly meritocratic market economy. The problems aren’t post-college, but pre-high school; going as deep as early-childhood development and parenting.

The fact is that, in the United States, equal opportunity largely stops at who your parents are. Relative to other developed countries, America is particularly egregious in how little it does, especially in early childhood, to prevent young kids’ educational trajectories from becoming extremely dependent on the private initiative (and resources) of their parents. Meritocracy ensures people are measured by the skillset they bring to the market, but without additional public policies it does nothing for the kids who aren’t born into families that, from a very young age, help them develop their skills so that they benefit from the kind of long-term compounding that produces very high-performing adults. Some of those kids start to take control of their educations around high school when they begin thinking about financial independence as adolescents, but by then high achievers have had a 5-10 year head start. The nature of compounding is that gaps widen over time; they rarely close.

It’s these “late bloomer” strivers who often struggle the most with observed performance differentials in the market. They are just as intelligent and hard-working (as adults) as higher-achieving peers, and so they understandably conclude that employers and universities must somehow be stacked against them unfairly. The variable they’re missing is the 5-10 year head-start (late elementary, middle and high school), with compounding learning and training, that high-achievers typically leveraged before even arriving in college; virtually always driven by parents with high educational expectations of their young children.

Raw intelligence and effort are inputs. The market rewards outputs, and years of extra studying and training, especially during childhood and adolescent years that are dramatically influential on a person’s cognitive and social development, adds an enormous boost to any person’s output. That’s uncomfortable to acknowledge, and extremely challenging (if not impossible in many cases) to rectify decades later in life. But it is nevertheless the reality clearly visible in the market to anyone with their eyes wide open. If in college you suddenly decide you want to learn and play golf or basketball professionally, you may make it to the top if you are exceptionally talented and train like crazy. But more often than not you will find that other exceptionally talented players, who’ve also been playing the game competitively since they were 10 yrs old, will run laps around you.

Industries like tech and law may be different in the sense that there are far more “slots” to make a comfortable middle class living, but the requirements and challenges of making it to the top – a wealthy entrepreneur, an elite managing partner – are far closer to those of professional athletes. Simplistically demanding “representation” at this tier of the economy is as vacuous and fruitless as expecting the NBA or the PGA, or perhaps more appropriately the Olympic Committee (business is international), to adopt affirmative action quotas for “proportionate” ethnic representation. Given the constraints and demands of international competition, there is no HR department or recruiting committee with power over who can fill these positions. Once you step onto the field, into the arena, or into the C-suite, there is only performance today. The scoreboard or financial results make everything else secondary.

Promoting diversity in tech entrepreneurship and startups is an extremely noble and good goal. I support it. Wholeheartedly. But for the love of God, let’s please be honest, decent, and smart about it. If we’re honest, we’ll first acknowledge all of the nuances and complexities – some of them clearly uncomfortable – about the background sources of the problem. We’ll also acknowledge that extremely competitive industries – like venture capital – are heavily incentivized to look for and exploit “undervalued” talent. Literally hundreds of funds, many of them led by people hardly from the kinds of backwater places simmering with racism, are all competing to the death to find successes. If they still are not substantially moving the needle on finding numerous tech ventures led by teams of underrepresented color capable of generating venture returns, maybe racism isn’t the real problem.

Second, if we’re decent about it, we will not play this unfair game of simply looking at a team or portfolio, finding that there’s no one “of color” on it, and throwing a racist label at someone. We will stop weaponizing diversity. Many recruiters in certain high-performance industries know how much extra effort it can take to find truly high-performing “diverse” candidates. It is not because they do not exist. It is because they, for all of the discussed reasons, are in shorter supply; and because they are in shorter supply, they get taken up by employers with the best brands and compensation packages. When a particular A-level firm – whether it’s a law firm or a venture capital firm – loudly promotes their “diverse” roster, it does not mean every company with less “diverse” rosters is full of racists. It means that in a market increasingly looking for these scarcer candidates, those with the most “pull” (better brand, better pay, lower risk) are able to win, and those with less pull lose. In many cases “inclusiveness” has absolutely nothing to do with it.

This last fact is a real problem with arguing simplistically that “more diverse teams outperform.” Of course if you hire meritocratically from the broadest pool of talent (including all ethnicities and international talent), you are going to get more high performers. If we count the full spectrum of ethnicities and nationalities, together with gender diversity, in “diversity” (broad diversity), the argument that diversity improves performance is almost certainly accurate. It’s the story of American immigration and outperformance. Even Silicon Valley is extremely “diverse” in this sense. Bigger talent pool, more meritocracy. But people who use that data to then justify weaponized diversity initiatives for specific under-represented groups (narrow diversity, just URMs) are engaging in a sleight-of-hand with the term “diverse.” There is no data suggesting that early-stage founding teams comprised of those specific groups outperform.

If we expand the discussion to later-stage teams hiring employees (not entrepreneurs or senior executives), the causation between “diversity” (in the narrow sense of URMs only) and performance can easily run in the opposite direction. The highest performing companies raise from the most prestigious funds, pay the best, and are able to absorb the high-achieving under-represented minorities in the talent pool. Because high-performing URMs are, for the discussed reasons, in more limited supply, lower performing companies have fewer to recruit; thus top companies are more “diverse”, and lower-tier companies are less so.

All of these attempts at using misapplied data to force overly-aggressive hiring of under-represented minorities are at best unhelpful, and at worst disingenuous; and they distract us from addressing the real problems behind under-representation. I cannot stress this enough: our unwillingness to openly talk about the uncomfortable reality, and instead continue with the same “we just need to try harder at ending racism” stories, is exactly why we are making so little progress.

Relatedly, the weaponization (and in some cases monetization) of diversity heavily incentivizes tokenism. As long as I can secure enough people who, from outer appearances, check the “diverse” box, I can move on and totally avoid actually addressing the systemic issues that demonstrably disadvantage certain people over others, i.e. actual poor people. For example, many latinos at elite universities are the children of doctors, lawyers, and executives, from stable homes and private prep schools. Are these really the “diverse” candidates we want to pour substantial resources into helping? Does a Jose who summers in the Hamptons and got a BMW for his 16th birthday bring “color” to your workplace in the way diversity initiatives intend? Maybe. But if that’s what we really want, let’s be honest and open about it. Filling your workplace or portfolio with people from objectively affluent and privileged backgrounds, who nevertheless have the right names or skin tones, feels different to some of us than really putting in effort to level the playing field for people facing real structural barriers.

Finally, if we’re smart about diversity in high-performance areas, we’ll acknowledge how important patience is. Instead of pretending that a few well-intentioned initiatives are going to suddenly erase decades and even generations of differences with compounding effects, we’ll start going after long-term policies that will really change the landscape. Policies like:

-equalized public school funding and school choice
-funding for schools to engage with low-income homes and communities on educational culture
-public daycare and pre-K
-criminal justice reform
-public funding for healthcare, including mental healthcare
-social and economic support initiatives

Evidence is mounting that the charter schools most successful at breaking cycles of poverty, and closing the early achievement gap of URMs (which widens over time when left unaddressed), are those that go well beyond educational instruction; directly engaging with parents and households to instill a culture of high educational expectations. Achieving results requires intervention into household environments, and that requires letting go of our misguided and self-defeating fears of discussing family cultural differences.

Recklessly and indiscriminately warmongering over diversity is the business world’s equivalent of breaking windows and looting. The anger and frustration over the slow pace of results are understandable and worthy of empathy. And yet angrily pointing fingers at people who are sincerely trying to improve an issue that they really did not cause, and in truth are very limited in their ability to quickly fix, is counterproductive. If we push them to promote candidates who truly are not ready, the resulting underperformance will not only ruin the confidence of people who otherwise might’ve had very positive outcomes in a more appropriate environment, but it will also harden stereotypes that we should instead be, strategically, weakening.

For too long we’ve allowed discussions of diversity in tech and other high-performing professions to be hijacked and unjustifiably dominated by those who want us endlessly distracted by searching for racism and systemic discrimination as the supreme, seemingly supernatural explanation for all our challenges; and who at times see a profitable opportunity in that distraction. Their often vitriolic refusals to even engage in respectful substantive discussion about other explanations, and other solutions – including long-term policy solutions – are, unfortunately, a significant reason why our community is stalling in its progress.

I’m thankful every day that the decision-makers I encountered throughout my life didn’t just see “a latino.” They didn’t see a stereotype to be quickly discarded, nor a token to be pushed in directions driven by a political agenda. They saw Jose Ancer – a specific kid with some challenges but also some abilities – and gave me a shot at showing what I could really deliver within the background and life I was actually living. We should want nothing less for every single child that enters the school system, and adult that enters the market. How many individual people are we failing to objectively help, because we are paralyzed by grand theories chasing rushed collective goals that have never been feasible on any short timeline?

Results over misdirected rage. Adult discussion over childish tantrums. Equal opportunity over unrealistic expectations of quickly equal outcomes. But getting there requires all of us to talk honestly, empathetically, and carefully about the real issues, without demonizing those who sincerely feel like we are spinning our wheels. That’s the only way we will finally get past the anger and frustration that understandably result from misguided quick fixes that ignore the complexity and depth of the challenges.

I want to see, on top of the public policies that directly address the social and economic challenges of poverty in America, an environment in which every young latino can throw him or herself into whatever subject they want, and make long-term sacrifices to succeed, without facing labels like “coconut” or other counterproductive messaging from other latinos that children from other ethnic backgrounds simply never have to face. We absolutely know how to work hard, but as it relates to high academic and business achievement, we too often celebrate working on the wrong things, and wait too long to correct course.

Without a doubt, let’s ensure we’re rooting out whatever racism and non-meritocratic discrimination that exists in our high-performance industries. I’m sure some does, though we too often exaggerate (dramatically) its explanatory power for disparities in outcomes. Importantly, we also shouldn’t deny the personal responsibility necessary in our own communities to evolve our identities so that no child is ever forced to choose between high achievement and culture. In doing so, we must not forget to support socioeconomic and educational public policies that can legitimately level the playing field for everyone.

The evidence is nevertheless quite clear that no amount of public policy or reconciliation over historical injustices will ever replace the profound, long-lasting impact of private household cultural values, including about education and long-term training, on the performance level children are able to reach as adults. Sometimes the very hardest problems are the ones that no one else can fully solve for us. Yet at the same time, there can be hope in realizing that many of the long-term solutions are much more in our control, and we don’t have to wait for outsider heroes to be our saviors.

It’s time for the most honest among us to demand that the level of diversity discourse be elevated and civilized; above the yells and sand-pounding of those who continue pretending that the key to increasing true high achievement in our community lies in another inclusiveness seminar, another infantilizing apology from a colleague, or another lecture from self-appointed “experts” on our universal, never-ending victimization. The truth is that it lies far closer to our communities, our families, and our homes.

On a closing note, I was careful to keep this discussion personal, and about my own experiences as a latino. I don’t pretend to speak in any way for other minority groups; and certainly not for the black community, which has faced a very different and legitimately harsher historical reality in America. I cannot pretend to know what it is like to be a black American, or to fully understand the incredibly justifiable outrage sparked by George Floyd’s murder. This essay was not at all about police brutality, for which there is seemingly limitless evidence, or well-documented racism and discrimination in segments of society outside of tech entrepreneurship and other high-performance career paths. It by no means is an argument that we live in a perfect, fully meritocratic world; but rather a personal observation and reflection on whether we are completely missing the mark on the real reasons – or at a minimum, the most impactful reasons – why certain groups, like American latinos, remain so under-represented in the very high-performance, high-risk world of tech entrepreneurship.

I do hope, however, that some of my thoughts might be helpful for other people of color to assess and chart their own paths on the issue of diversity, and what changes they hope to effect in the market. I hope we will no longer allow legitimate voices and perspectives to be silenced in favor of the same mono-narrative that wastes precious time and fails at delivering durable results. Anger and frustration can be fuel for enormously productive action, but only if we channel them in ways that truly hit the source of a problem; even if that source is more complex and uncomfortable, and less responsive to simplistic outrage and politicization, than we want to admit.

Post-Script: The following is a shorter, more practical post targeted toward CEOs and Boards of startups, on how they can respond constructively to “weaponized” diversity attacks in the market: Diversity in Startups: Whining, Warring, Winning.

Why Startup Accelerators Compete with Smart Money

TL;DR: As the smartest VC money has continued moving earlier-stage, its value proposition for early checks starts to resemble what’s offered by high-priced startup accelerators: signals, coaching, and a network. That means elite early-stage VCs and accelerators can be substitutes, and the accelerators know this. This may lead the latter to recommend financing strategies to entrepreneurs that, from the perspective of the startup can be counterproductive, but enhance the market power of the accelerator relative to investors who can offer similar resources at better “prices” (valuations). Entrepreneurs should understand the power games everyone is playing, and become beholden to no one.

Related reading:

First, a few clarifications on definitions. When I speak of “smart money” in the VC context I’m referring to investors who bring much more to the table, in terms of useful resources and connections, than simply raw cash. They often bring an elite brand that serves as a valuable signal in the market (which itself raises valuations and helps with follow-on funding), credible insight and coaching that they can use to help founders and Boards of Directors, and a network that they can tap into for helping companies find talent and connect with commercial partners.

Classifying some money as “smart money” doesn’t necessarily mean that any money that isn’t “smart” must be stupid in a classic sense. It just means that the other money isn’t useful other than to pay for things. So in short, “smart money” refers to value-add investors who can do a lot more for a company than simply write a check; while “dumb money” means investors willing to pay very high valuations because they are simply happy to get access to this deal at all, and have very little else to offer beyond money itself.

Another clarification: for purposes of this topic, I am referring to high-cost, high-touch startup accelerators; meaning the traditional kind who “charge” 7-10% of equity and put in significant resources into programming, education, nurturing their network, etc. As I’ve written before, various organic market dynamics that are eroding the value proposition of traditional accelerators (see above-linked post) have produced a new “lean” form of accelerator that has dialed back its proposition, and reduced its “price” to 1-2% of equity. That latter kind of accelerator is not part of this discussion, because they behave very differently, and interact with smart money very differently.

Ok, so now to the main point. “Smart” very early-stage money (seed and pre-seed) can be viewed as a bundle of a few things:

  • Green cash money
  • Signaling and Branding – simply by being publicly associated with them, raising follow-on money, and getting meetings with other key players, will become dramatically easier.
  • Coaching – they’ve seen lots of successful (and failed) companies, and can provide valuable coaching to entrepreneurs.
  • A network – they’ve built a rolodex/LinkedIn network of lots of talented people that they are heavily incentivized to make available to you.

Now, let’s compare that bundle to the value proposition of traditional accelerators:

  • Signaling and branding
  • Coaching
  • A network

See the overlap? Startup accelerators are basically a service provider whose core service is the above bundle. In exchange for equity and the right to a portion of your funding rounds, their “service” is that they’ll (i) apply a brand on your company that makes it (at least for the good accelerators) easier to access money, (ii) provide you some coaching and education, and (iii) share their network with you.

The core value proposition of early smart money can be effectively the same as an accelerator: a brand to leverage in networking and fundraising, coaching, and a network to navigate. Accelerators and smart early money are, therefore, substitutes; and substitutes inevitably compete with each other. Some might argue that the “programming” (the educational content) of accelerators is a key differentiator, but realistically the smartest entrepreneurs aren’t joining accelerators to get an education. They’re joining for the brand, the network, and to make it easier to find more money and talent; all of which entering the portfolio of a resource-rich and well-respected early stage investor can provide.

The earlier in a company’s life cycle that smart money is willing to go for their pipelines (and many smart funds are going very early), the more startup accelerators will find themselves competing with lots of market players offering a very similar bundle of services. Given that smart early money can challenge the value proposition of accelerators, aggressive accelerators are incentivized to, in subtle ways, push startups away from smart very early-stage money and toward dumber money, because it increases a startup’s dependency on the accelerator’s resources, and therefore helps justify the accelerator’s cost.

How does this fact – that aggressive, elite startup accelerators want to cut off smart early-stage money from competing with them – play out in the real market? Some of the ways I’ve already described in Startup Accelerators and Ecosystem Gatekeeping, but I’ll elaborate here.

Demo Day – Aggressive accelerators can push entrepreneurs to not do any fundraising other than through channels that the accelerator can control, like Demo Day, and then they can restrict access to Demo Day to investors who serve the interests of the accelerator (don’t compete with it). As I’ve written before, it is not in startups’ interests to restrict their fundraising activities solely to channels that accelerators can influence (because it allows accelerators to serve as rent-seeking gatekeepers). Many accelerators aggressively restrict how their cohorts are able to fundraise, enhancing the accelerators’ market power relative to VCs.

Fundraising Processes that Select Against Smart Money – One thing that’s been interesting to observe in the market is how entrepreneurs who go through certain accelerators are much more likely to emerge with a view that early-stage venture capital has largely been commoditized. If you think that all early money is the same, and all that matters is getting the best economic terms possible, you are going to approach fundraising in a very different way from someone who better appreciates the very subtle, human-oriented dynamics of connecting with value-add (smart) lead investors. “Party rounds” where entrepreneurs don’t allow anyone to serve as the lead are a very visible manifestation of this.

Entrepreneurs who treat fundraising as a kind of auction process, where you amplify FOMO and aggressively get the money to compete for the best price, are often creating a fundraising system that much of the smartest money will simply opt out of. Quality smart money players are looking to build long-term relationships, and that takes time. Their resource-intensive approach to investing also requires building meaningful positions on a cap table; a slot in a party round won’t work.

Elite value-add VCs know that they bring much more to the table than a random investor willing to pay a high valuation, and so the end-product of a hyper-competitive fundraising process that forces them to compete with a swarm of dumb money simply isn’t worth their time. The valuation will be too high, and their allocation on the cap table too low.

Aggressive accelerators know this, and it’s why they often nudge founders toward engaging in these kinds of hyper-competitive fundraising processes that push out smart money, because by removing other “smart” early market players with their own networks and brands, the accelerators enhance the relative value of their own network. The strategy is to marginalize any potential substitutes, so startups see the accelerator and its own network as the only “smart” player they need.

If you, as a founder, have come to believe that value-add VCs – who can deliver A LOT more value than simply cash – don’t exist, you may have fallen for a lot of the propaganda on social media pushed by traditional accelerators and the “dumb money” funds affiliated with them. Value-add VCs most definitely exist, and founders who’ve raised from them will say they’re worth their weight in gold. Accelerators may spin a story as to why it’s in founders’ best interests to be hyper-aggressive with their fundraising, and alienate many value-add VCs in the process, but startups need to understand this is driven far more by what’s in the accelerator’s interests than the startup’s.

It’s also worth pointing out the irony in certain accelerators telling founders that they should maximize valuations and minimize dilution in fundraising, while the same accelerators keep their own admission prices (valuations) fixed; and in the case of accelerators who’ve moved to post-money SAFEs, the price has actually gone up. If the market has become flooded with early-stage capital and signaling alternatives, should accelerators themselves not be subject to market forces?

I’m not an investor, nor do I even represent investors. I’m a lawyer who represents companies, including in lots of financing rounds. Read my lips: relationships matter, and smart relationship-oriented money can really make a difference. Want to know what a possible end-result is of startups pursuing a naive, hyper-competitive, relationship ignorant fundraising strategy that treats getting a high valuation as the only goal; long-term relationships and “value add” VCs be damned? Failed unicorns (getting SoftBanked) and thousands of employees burned because people guiding the company in the earliest days were just lottery-ticket chasers instead of smart players who know how to build viable businesses. Treat investors like it’s all just about numbers, and you’ll inevitably surround yourself with people for whom you are just a number.

As I’ve written many times before, it’s extremely important that new entrepreneurs entering startup ecosystems understand the power dynamics operating in the background. See Relationships and Power in Startup Ecosystems. Different market actors compete for access and control over pipelines of entrepreneurs; and they “trade” access to deals with people who serve their interests. Startups are much better served when they are in the driver’s seat for what relationships they build in the market, as opposed to allowing repeat players (like accelerators or VC funds) to trade access to them as currency. Don’t let your company become a pawn in another power player’s game.

The smartest investors in the market have realized that outsourcing their business development to a handful of “sorters” (accelerators) is a losing strategy, because those sorters have their own agendas. One of those agendas is to make the earliest money in the market “dumber,” so that the accelerators can continue giving startups $125K for 7-10% of their cap table (which translates to as low as a $1.25 million valuation) when many smart early funds would offer multiples of that. It is an own-goal for founders to help accelerators do this.

Scout programs, pre-seed funding, exclusive “meet and greet” events, open “application” processes for intro meetings, and many other activities are ways in which smart money is moving earlier in the startup life cycle, to find early startups that they can “accelerate” themselves. That can be useful to founders, saving them both time and equity. Competition with accelerators is why most elite VCs no longer require warm intros. 

All of these ecosystem players are here, in one way or another, to make money; endless PR about friendliness, “positive sum” thinking, and saving the whales notwithstanding. Frankly, so are you, and so am I. The more they can cut off competition, the more money they can extract from the market that would otherwise go to entrepreneurs and their employees. That means the most logical strategy is: become beholden to no one. Nothing better ensures good behavior by your business relationships than a little optionality.

That does not mean treating everyone as a means to an end, nor does it mean preventing serious VCs from taking lead positions on your cap table. To the contrary, it means slowing down and building a diverse set of long-term and durable relationships, with a mix of value-add and “dumb,” that you can leverage toward your company’s goals. The emphasis, however, is on the diversity of your relationships, so no particular group has more leverage than is justified. Diversify your network.

Let everyone offer their service, but don’t naively become over-dependent on any single channel. If you have access to smart early money, take it, nurture that relationship, and respect the fact that smart money deserves a better price than party round “dumb” checks. Just don’t agree to any terms that cut you off from raising from alternative money later if it makes sense. Independent counsel will help ensure that.

If you’re in an elite accelerator, fantastic. Use them. But don’t let them push you into myopic fundraising approaches that just increase their control over the market, which keeps their “prices” high relative to where the market should move. Keep connecting with smart money, and diversify your network. Understand that it’s in founders’ interests to not let a handful of very expensive accelerators cut off smart money from competing on the same playing field (the earliest checks); often at much better valuations.

Startups thrive best in actual ecosystems, where market players aren’t able to gain so much control that they start to “charge” more than their real value proposition justifies. Let the smart money and accelerators compete, and build your long-term relationships accordingly.

Note: a few examples of elite value-add VCs competing head-on with traditional accelerators include Sequoia Arc, a16z Start, Accel Atoms, as well as the Neo Accelerator, which “costs” less dilution than traditional accelerators. Examples of elite VCs who haven’t formed formal accelerators but invest very early (pre-Seed) include Nfx and First Round Capital. Many founders are finding that, after weighing all the factors, entering these kinds of pipelines or programs leads to substantially less dilution relative to going into a traditional accelerator (paying 7-10% in dilution for that) and then doing a seed round.

Trust, “Friendliness,” and Zero-Sum Startup Games

Background reading: Relationships and Power in Startup Ecosystems

TL;DR: In many areas of business (and in broader society) rhetoric around “positive sum” thinking and “friendliness” is used to disarm the inexperienced, so that seasoned players can then take advantage. Startups shouldn’t drink too much of the kool-aid. Smile and be “friendly,” but CYA.

An underlying theme of much of my writing on SHL is that first-time founders and employees of startups, being completely new to the highly complex “game” of building high-growth companies and raising funding, are heavily exposed to manipulation by sophisticated repeat players who’ve been playing the same game for years or even decades. There are many important tactical topics in that game – around funding, recruiting, sales, exits – all of which merit different conversations, but the point of this post is really a more “meta” issue. I’m going to talk about the perspective that should be brought to the table in navigating this environment.

A concept you often hear in startup ecosystems is the distinction between zero-sum and positive-sum games. The former are where there’s a fixed/scarce resource (like $), and so people behave more competitively/aggressively to get a larger share, and there’s less cooperation between players. In positive-sum games, the thinking goes, acting competitively is destructive and everyone wins by being more cooperative and sharing the larger pie. Sports are the quintessential zero-sum game. Someone wins, and someone loses. Capitalism is, broadly, a positive-sum game because in a business deal, both sides generally make more money than if the deal had never happened.

The reality – and its a reality that clever players try to obscure from the naive – is that business relationships (including startup ecosystems) are full of both positive and zero-sum games, many of which are unavoidably linked. It is, therefore, a false dichotomy. In many cases, there are zero-sum games within positive sum games. In fact, rhetoric about “positive-sum” thinking, friendliness, trust, and “win-win” is a common tactic used by powerful players to keep their status from being threatened.

For a better understanding of how this plays out in broader society (not startup ecosystems), I’d recommend reading “Winners Take All: The Elite Charade of Changing the World” by Anand Giridharadas, who deep-dives into how, in many cases, very wealthy and powerful people (i) on the one hand, fund politicians/legislation that cut taxes and funding for democratically solving social problems while (ii) simultaneously, spending a smaller portion of the saved money on “philanthropic” or “social enterprise” initiatives aimed at addressing those same social problems, but in a privatized way where they are in more control. The latter of course comes with a hefty share of feel-good messaging about “giving back” and helping people.

The net outcome is that those powerful players direct discussion away from the full spectrum of solutions that may require addressing some unavoidable zero-sum realities, and instead get society to myopically focus on a narrower segment of purportedly “win-win” options that don’t actually threaten the power and status of the elite priesthood. There is much room to debate the degree to which Giridharadas’ perspective is an accurate representation of American philanthropy/social enterprise, but anyone with an ounce of honesty will acknowledge that it is definitely there, and large.

Sidenote: Anand is a clear hardcore socialist, and I’m not exactly a fan, but life is complicated and I’ll acknowledge when someone makes an accurate point. An enormous amount of “save the world” rhetoric is just kabuki theatre to maintain power and keep your money.

While the details are clearly different, this dynamic plays out all over startup ecosystems. They are full of influential market actors (accelerators, investors, executives) acting as agents for profit/returns driven principals, and in many cases legally obligated to maximize returns, and yet listen to much of the language they use on blogs, social media, events, etc. and an outsider might think they were all employees of UNICEF. This is especially the case in Silicon Valley, which seems to have gone all “namaste” over the past few years; with SV’s investor microphones full of messages about mindfulness, empathy, “positive sum” thinking, and whatever other type of virtue signaling is in vogue.  Come take our money, or join our accelerator, or both. We’re such nice people, you can just let your guard down as we hold hands and build wealth together.

Scratch the surface of the “kumbaya” narratives, and what becomes clear is that visible “friendliness” has become part of these startup players’ profit-driven marketing strategies. With enough competition, market actors look for ways of differentiating themselves, and “friendliness” (or at least the appearance of it) becomes one variable among many to offer some differentiation; but it doesn’t change any of the fundamentals of the relationship. Just like how “win-win” private social enterprise initiatives can be a clever strategy of the wealthy to distract society away from public initiatives that actually threaten oligarchic power, excessive “friendliness” is often used by startup money players to disarm and manipulate inexperienced companies into taking actions that are sub-optimal, because they lack the perspective and experience to understand the game in full context.

With enough inequality of experience and influence between players (which is absolutely the case between “one shot” entrepreneurs and sophisticated repeat player investors) you can play all kinds of hidden and obscure zero-sum games in the background and – as long you do a good enough job of ensuring no one calls them out in the open – still maintain a public facade of friendliness and selflessness. 

As startup lawyers, the way that we see this game played out is often in the selection of legal counsel and negotiation of financings/corporate governance. In most business contexts, there’s a clear, unambiguous understanding that the relationship between companies and their investors – and between “one shot” common stockholders v. repeat player investors – has numerous areas of unavoidable misalignment and zero-sum dynamics. Every cap table adds up to 100%. A Board of Directors, which has almost maximal power over the Company, has a finite number of directors. Every dollar in an exit goes either to common stock (founders/employees) or investors. Kind of hard to avoid “zero sum” dynamics here. As acknowledgement of all this misalignment, working with counsel (and other advisors) who are experienced but independent from the money is seen, by seasoned players, as a no-brainer.

But then the cotton candy “kumbaya” crowd of the startup world shows up. We’re all “aligned” here. Let’s just use this (air quotes) “standard” document (nevermind that I or another investor created it) and close quickly without negotiation, to “save money.” Go ahead and hire this executive that I (the VC) have known for 10 years, instead of following an objective recruiting process, because we all “trust” each other here. Go ahead and hire this law firm (that also works for us on 10x more deals) because they “know us” well and will help you (again) “save money.” Conflicts of interest? Come on. We’re all “friendly” here. Mindfulness, empathy, something something “positive sum” and save the whales, remember?

Call out the problems in this perspective, even as diplomatically as remotely possible, and some will accuse you of being overly “adversarial.” That’s the same zero-sum v. positive-sum false dichotomy rearing its head in the startup game. Are “adversarial” and “namaste” the only two options here? Of course not. You can be friendly without being a naive “sucker.” Countless successful business people know how to combine a cooperative positive-sum perspective generally with a smart skepticism that ensures they won’t be taken advantage of. That’s the mindset entrepreneurs should adopt in navigating startup ecosystems.

I’ve found myself in numerous discussions with startup ecosystem players where I’m forced to address this false dichotomy head on and, at times, bluntly. I’m known as a pretty friendly, relationship driven guy. But I will be the last person at the table, and on the planet, to accept some “mickey mouse club” bullshit suggesting that startups, accelerators, investors, etc. are all just going to hold hands and sing kumbaya as they build shareholder value together in a positive-sum nirvana. Please. Let’s talk about our business relationships like straight-shooting adults; and not mislead new entrepreneurs and employees with nonsensical platitudes that obscure how the game is really played.

Some of the most aggressive (money driven) startup players are the most aggressive in marketing themselves as “friendly” people. But experienced and honest observers can watch their moves and see what’s really happening. Relationships in startup ecosystems have numerous high-stakes zero-sum games intertwined with positive-sum ones; and the former make caution and trustworthy advisors a necessity. Yes, the broader relationship is win-win. You hand me money or advice/connections, and I hopefully use it to make more money, and we all “win” in the long run. But that doesn’t, in the slightest, mean that within the course of that relationship there aren’t countless areas of financial and power-driven misalignment; and therefore opportunities for seasoned players to take advantage of inexperienced ones, if they’re not well advised.

Be friendly, when it’s reciprocated. Build transparent relationships. There’s no need to be an asshole. Startups are definitely a long-term game where politeness and optimism are assets; and it’s not at all a bad thing that the money has started using “niceness” in order to make more money. But don’t drink anyone’s kool-aid suggesting that everything is smiles and rainbows, so just “trust” them to make high-stakes decisions for you, without independent oversight. Those players are the most dangerous of all.

Why Startups shouldn’t use YC’s Post-Money SAFE

TL;DR: If you’re going to use it, you should make some slight (but material) tweaks. It otherwise gives your seed investors a level of extreme anti-dilution protection that is virtually unheard of (circa 2019) in startup finance, making it worse than seed equity and conventional convertible notes (or pre-money SAFEs) in terms of economics for most seed stage companies; which is of course why investors love it. There are far better, more balanced ways to “clarify” ownership for seed investors without forcing founders and employees to absorb additional dilution risk. YC has done a “180” in moving from the pre-money SAFE (very company friendly) to the post-money SAFE (extremely seed investor friendly).

Post-Publishing Updates:

  • After requests from a number of readers, I’ve posted a template convertible note based on the template we’ve used hundreds of times across the country. See: A Convertible Note Template for Seed Rounds.
  • We posted a google sheets model comparing the economics of a pre-money SAFE, YC post-money SAFE, and a redlined post-money SAFE that corrects the above-discussed anti-dilution problem in YC’s template. A corrected post-money SAFE is actually a great instrument for companies/founders, even if YC’s post-money safe is heavily investor-biased. See: A Fix for Post-Money SAFEs: The Math and a Redline

A regular underlying theme you’ll read on SHL is that key players in the startup community are incredibly talented at taking a viewpoint that is clearly (to experienced players) investor-biased, but spinning / marketing it as somehow “startup friendly.”  And lawyers captive to the interests of investors are always happy to play along, knowing that inexperienced teams can be easily duped.

One example is how “moving fast” in startup financing negotiations is always a good thing for entrepreneurs. Investors are diversified, wealthy, and 100x as experienced as founders in deal terms and economics, but it’s somehow in the founders’ interest to sign whatever template the investor puts on the table, instead of actually reviewing, negotiating, and processing the long-term implications? Right.

Y Combinator’s move to have its SAFEs convert on a post-money, instead of pre-money, basis is another great example. Their argument is that it helps “clarify” how the SAFEs will convert on the cap table. Clarity is great, right? Who can argue with clarity?

What’s not emphasized prominently enough is that the way they delivered that “clarity” is by implementing anti-dilution protection for SAFE investors (like themselves) that is more aggressive than anything remotely “standard” in the industry; and that wasn’t necessary at all to provide “clarity.” Under YC’s new SAFE, the common stock absorbs all dilution from any subsequent SAFE or convertible note rounds until an equity round, while SAFE holders are fully protected from that dilution. That is crazy. It’s the equivalent of “full ratchet” anti-dilution, which has become almost non-existent in startup finance because of how company unfriendly it is. In fact, it’s worse than full ratchet because in a typical anti-dilution context it only triggers if the valuation is lower. In this case, SAFE holders get fully protected for convertible dilution even if the valuation cap is higher. It’s a cap table grab that in a significant number of contexts won’t be made up for by other more minor changes to the SAFE (around pro-rata rights and option pool treatment) if a company ends up doing multiple convertible rounds.

When you’re raising your initial seed money, you have absolutely no idea what the future might hold. The notion that you can predict at your initial SAFE closing whether you’ll be able to raise an equity round as your next funding (in order to convert your SAFEs), or instead need another convertible round (in which case your SAFE holders are fully protected from dilution), is absurd. Honest advisors and investors will admit it. Given the dynamics of most seed stage startups, YC’s post-money SAFE therefore offers the worst economics (for companies) of all seed funding structures. Founders should instead opt for a structure that doesn’t penalize them, with dilution, for being unable to predict the future.

Yes, YC’s original (pre-money) SAFE has contributed to a problem for many SAFE investors, but that problem is the result of an imbalanced lack of accountability in the original SAFE structure; not a need to re-do conversion economics. As mentioned in the above TechCrunch article, the reason convertible notes are still the dominant convertible seed instrument across the country is that the maturity date in a convertible note serves as a valuable “accountability” mechanism in a seed financing. A 2-3 year maturity gives founders a sense of urgency to get to a conversion event, or at least stay in communication with investors about their financing plans. By eliminating maturity, SAFEs enabled a culture of runaway serial seed financings constantly delaying conversion, creating significant uncertainty for seed investors.

YC now wants to “fix” the problem they themselves enabled, but the “solution” goes too far in the opposite direction by requiring the common stock (founders and early employees) to absorb an inordinate amount of dilution risk. If “clarity” around conversion economics is really the concern of seed investors, there are already several far more balanced options for delivering that clarity:

Seed Equity – Series Seed templates already exist that are dramatically more streamlined than full Series A docs, but solidify ownership for seed investors on Day 1, with normal weighted average (not full ratchet) anti-dilution. 100% clarity on ownership. Closing a seed equity deal is usually a quarter to a third of the cost of a Series A, because the docs are simpler. Seed equity is an under-appreciated way to align the common stock and seed investors in terms of post-funding dilution. Yes, it takes a bit more time than just signing a template SAFE, but it’s an increasingly popular option both among entrepreneurs (because it reduces dilution) and investors (because it provides certainty); and for good reason.

See also: Myths and Lies about Seed Equity to better understand the false arguments often made by investors to push founders away from seed equity as a financing structure.

Harden the denominator – Another option I’ve mentioned before in Why Notes and SAFEs are Extra Dilutive is to simply “harden” the denominator (the capitalization) that will be used for conversion on Day 1, while letting the valuation float (typically capped). This ensures everyone (common and investors) are diluted by subsequent investors, just like an equity round, while allowing you to easily model conversion at a valuation cap from Day 1. If the real motivation for the SAFE changes was in fact the ability to more easily model SAFE ownership on the cap table – instead of shifting economics in favor of investors – this (hardening the conversion denominator) would’ve been a far more logical approach than building significant anti-dilution mechanisms into the valuation cap.

See “Fixing” Convertible Note and SAFE Economics for a better understanding of how hardening the denominator in a note or SAFE valuation cap gives the “best of both worlds” between convertibles and equity rounds.

Add a Maturity Date – Again, the reason why, outside of Silicon Valley, so many seed investors balk at the SAFE structure altogether is because of the complete lack of accountability mechanisms it contains. No voting rights or board seat. No maturity date. Just hand over your money, and hope for the best. I don’t represent a single tech investor – all companies – and yet I agree that SAFEs created more problems than they solved. Convertible notes with reasonable maturity dates (2-3 years) are a simple way for investors and entrepreneurs to get aligned on seed fundraising plans, and if after an initial seed round the company needs to raise a second seed and extend maturity, it forces a valuable conversation with investors so everyone can get aligned.

Conventional convertible notes – which are far more of an (air quotes) “standard” across the country than any SAFE structure – don’t protect the noteholders from all dilution that happens before an equity round. That leaves flexibility for additional note fundraising (which very often happens, at improved valuations) before maturity, with the noteholders sharing in that dilution. If a client asks me whether they should take a low-interest capped convertible note with a 3-yr maturity v. a capped Post-Money SAFE for their first seed raise, my answer will be the convertible note. Every time, unless they are somehow 100% positive that their next raise is an equity round. The legal fees will be virtually identical.

Before anyone even tries to argue that signing YC’s template is nevertheless worth it because otherwise money is “wasted” on legal fees, let’s be crystal clear: the economics of the post-money SAFE can end up so bad for a startup that a material % of the cap table worth as much as 7-figures can shift over to the seed investors (relative to a different structure) if the company ends up doing additional convertible rounds after its original SAFE; which very often happens. Do the math.

The whole “you should mindlessly sign this template or OMG the legal fees!” argument is just one more example of the sleight-of-hand rhetoric peddled by very clever investors to dupe founders into penny wise, pound foolish decisions that end up lining an investor’s pocket. It can take only a few sentences, or even the deletion of a handful of words, to make the economics of a seed instrument more balanced. Smart entrepreneurs understand that experienced advisors can be extremely valuable (and efficient) “equalizers” in these sorts of negotiations.

When I first reviewed the new post-money SAFE, my reaction was: what on earth is YC doing? I had a similar reaction to YC’s so-called “Standard” Series A Term Sheet, which itself is far more investor friendly than the marketing conveys and should be rejected by entrepreneurs. Ironically, YC’s changes to the SAFE were purportedly driven by the need for “clarity,” and yet their recently released Series A term sheet leaves enormous control points vague and prone to gaming post-term sheet; providing far less clarity than a typical term sheet. The extra “clarity” in the Post-Money SAFE favors investors. The vagueness in the YC Series A term sheet also favors investors. I guess YC’s preference for clarity or vagueness rests on whether it benefits the money. Surprised? Entrepreneurs and employees (common stockholders) are going to get hurt by continuing to let investors unilaterally set their own so-called “standards.”

One might argue that YC’s shift (as an accelerator and investor) from overly founder-biased to overly investor-biased docs parallels the natural pricing progression of a company that initially needed to subsidize adoption, but has now achieved market leverage. Low-ball pricing early to get traction (be very founder friendly), but once you’ve got the brand and market dominance, ratchet it up (bring in the hard terms). Tread carefully.  Getting startups hooked on a very friendly instrument, and then switching it out mid-stream with a similarly named version that now favors their investors (without fully explaining the implications), looks potentially like a clever long-term bait-and-switch plan for ultimately making the money more money.

YC is more than entitled to significantly change the economics of their own investments. But their clear attempts at universalizing their preferences by suggesting that entrepreneurs everywhere, including in extremely different contexts, adopt their template documents will lead to a lot of damaged startups if honest and independent advisors don’t push back. The old pre-money SAFE was so startup friendly from a control standpoint that many investors (particularly those outside of California) refused to sign one. The new post-money SAFE is at the opposite extreme in terms of economics, and deserves to be treated as a niche security utilized only when more balanced structures won’t work. Thankfully, outside of pockets of Silicon Valley with overly loud microphones, the vast majority of startup ecosystems and investors don’t view SAFEs as the only viable structure for closing a seed round; not even close.

The most important thing any startup team needs to understand for seed fundraising is that a fully “standard” approach does not exist, and will not exist so long as entrepreneurs and investors continue to carry different priorities, and companies continue to operate in different contexts. Certainly a number of prominent investor voices want to suggest that a standard exists, and conveniently, it’s a standard they drafted; but it’s really just one option among many, all of which should be treated as flexibly negotiable for the context.

Another important lesson is that “founder friendliness” (or at least the appearance of it) in startup ecosystems is a business development strategy for investors to get deal flow, and it by no means eliminates the misaligned incentives of investors (including accelerators). At your exit, there are one of two pockets the money can go into: the common stock or the investors. No amount of “friendliness” changes the fact that every cap table adds up to 100%. Treat the fundraising advice of investors – even the really super nice, helpful, “founder friendly,” “give first,” “mission driven,” “we’re not really here for the money” ones – accordingly. The most clever way to win a zero-sum game is to convince the most naive players that it’s not a zero-sum game.

Don’t get me wrong, “friendly” investors are great. I like them way more than the hard-driving vultures of yesteryear. But let’s not drink so much kool-aid that we forget they are, still, investors who are here to make money that could otherwise go to the common stock; not your BFFs, and certainly not philanthropists to your entrepreneurial dreams.

Given the significant imbalance of experience between repeat money players and first-time entrepreneurs, the startup world presents endless opportunities for investors (including accelerators) to pretend that their advice is startup-friendly and selfless – and use smoke-and-mirrors marketing to convey as much – while experienced, independent experts can see what is really happening. See Relationships and Power in Startup Ecosystems for a deeper discussion about how aggressive investors in various markets gain leverage over key advisors to startups, including law firms, to inappropriately sway negotiations and “standards” in their favor.

A quick “spin” translation guide for startups navigating seed funding:

“You should close this deal fast, or you might lose momentum.” = “Don’t negotiate or question this template I created. I know what’s good for you.”

“Let’s not ‘waste’ money on lawyers for this ‘standard’ deal.”  = “Don’t spend time and money with independent, highly experienced advisors who can explain all these high-stakes terms and potentially save a large portion of your cap table worth an order of magnitude more than the fees you spend. I’d prefer that money go to me.”

“We’re ‘founder friendly’ investors, and were even entrepreneurs ourselves once.” = “We’ve realized that in a competitive funding market, being ‘nice’ is the best way to get more deal flow. It helps us make more money. Just like Post-Money SAFEs.”

“Let’s use a Post-Money SAFE. It helps ‘clarify’ the cap table for everyone.” = “Let’s use a seed structure that is worse for the common stock economically in the most important way, but at least it’ll make modeling in a spreadsheet easier. Don’t bother exploring alternatives that can also ‘clarify’ the cap table without the terrible economics.”

There are pluses and minuses to each seed financing structure, and the right one depends significantly on context. Work with experienced advisors who understand the ins and outs of all the structures, and how they can be flexibly modified if needed. In the case of startup lawyers specifically, avoid firms that are really shills for your investors, or who take a cookie-cutter approach to startup law and financing, so you can trust that their advice really represents your company’s best interests. That’s the only way you can ensure no one is using your inexperience – or fabricating an exaggerated sense of urgency or standardization – to take advantage of you and your cap table.