Post Category → Power

How Startup Employees Get Taken Advantage Of

TL;DR: When startup employees get taken advantage of in startup equity economics, it’s often not just about bad documentation or strategy. It’s about incentives, and games being played by influential “insiders” to gain control over the startup’s corporate governance. Ensuring common stock representation on the Board, independence of company counsel (from investors), and monitoring “sweeteners” given to common representatives on the Board are strong strategies for protecting against bad actors.

Related Reading:

A common message heard among experienced market players, and with which I completely agree, is this: if you are seeing significant dysfunction in any organization or market, watch incentives. In small, simple, close-knit groups (like families and tribes), shared principles and values can often be relied on to ensure everyone plays fairly and does what’s best for the group.  But expand the size of the group, diversify the people involved, and raise the stakes, and people will inevitably gravitate toward their self-interest and incentives. The way to achieve an optimal and fair outcome at scale is not through “mission statements” or virtue signaling, but focusing on achieving alignment (where possible) of incentives, and fair representation of the various constituencies at the bargaining table.

A topic that is deservedly getting a lot of attention lately is the outcomes of startup employees as it relates to their equity stakes in the startups that employ them. I see a lot being written about it in the various usual tech/startup publications, and we are also seeing companies reaching out to us asking about potential modifications to the “usual” approaches.  The problem being discussed is whether startup employees are getting the short end of the stick as companies grow and scale, with other players at the table (particularly the Board of Directors) playing games that allow certain players to get rewarded, while off-loading downside risk to those unable to protect themselves.

The short answer is that, yes, there are a number of games being played in the market that allow influential “insiders” of growing startups to make money, while shifting risk to the less powerful and experienced participants on the cap table. The end-result is situations where high-growth startups either go completely bust, or end up exiting at a price that didn’t “clear” investors’ liquidation preferences, and yet somehow a bunch of people still made a lot of money along the way, while startup employees got equity worth nothing.

The point of this post isn’t to discuss the various tactics being used by aggressive players to screw employees, but to discuss a higher-level issue that is closer to the root problem: corporate governance, and the subtle detachment of employee equity economics from other cap table players. When some people on the Board have economic incentives close to fully aligned with employees (common stockholders whose “investment” is labor, not capital, and often sunk), they are significantly more likely to deliver the necessary pushback to protect employees from absorbing more risk than is appropriate.  But if smart players find ways to detach those Board members’ interests from the employees who can’t see the full details of the company’s financing and growth strategy, things go off the rails.

Corporate governance and fiduciary duties.

Broadly speaking, corporate governance is the way in which a company is run at the highest levels of its organizational and power structure, particularly the Board of Directors. Under Delaware law (and most states/countries’ corporate law), the Board has fiduciary duties to impartially serve the interests of the stockholders on the cap table. Regardless of their personal interests, a Board is supposed to be focused on a financing and exit strategy that maximizes the returns for the whole cap table, particularly those at the bottom of the liquidation preference stack and who lack the visibility, influence, and experience to negotiate on their own behalf. That obviously includes, to a large extent, employee stockholders.

This is, of course, easier said than done. Remember the fundamental rule: watch incentives. Having a Board of directors that nominally professes a commitment to its fiduciary duties is one thing. But maximizing economic alignment between the Board and the remainder of the cap table is lightyears better.

“One Shot” common stockholders v. “Repeat Player” investors

As I’ve written many times before, anyone who behaves as if investors (capital) and founders/employees (labor) are fully aligned economically as startups grow, raise money, and exit is either lying, or so spectacularly ignorant of how the game actually works that they should put the pacifier back in their mouth and gain more experience before commenting.

Common stockholders (founders, employees) are usually inexperienced, not wealthy, at the bottom of the liquidation “waterfall” (how money flows in an exit), not independently represented by counsel, and not diversified. Preferred stockholders (investors) are usually the polar opposite: highly experienced, wealthy, have their own lawyers, heavily diversified, and with a liquidation preference or debt claim that prioritizes their investment in an exit. Common stockholders’ “investment” (their labor) is also often sunk, while major investors have pro-rata rights that allow them to true-up their ownership if they face dilution.

Investors are far more incentivized to push for risky growth strategies that might achieve extremely large exits, but also raise the risk of a bust in which the undiversified, unprotected common equity gets nothing. Common stockholders are far more likely to be concerned about risk, dilution and dependence on capital, and the timing / achievability of an exit. This tension never goes away, and plays out in Board discussions on an ongoing basis.

As I’ve also written before, this is a core reason why clever investors will often pursue any number of strategies to put in place company counsel (the lawyers who advise the company and the Board) whose loyalty is ultimately to the investors. A law firm whom the money can “squeeze” – like one that heavily relies on them for referrals, or who does a large volume of other work for the investors – is significantly more likely to stay quiet and follow along if a Board begins to pursue strategies that favor investor interests at the expense of common interests. See: When VCs “own” your startup’s lawyers. 

When Board composition is discussed in a financing, founder representation on the Board is often portrayed as being purely about the founders’ own personal interests; but that’s incorrect. Founders are often the largest and earliest common stockholders on the cap table, which heavily aligns them economically with employees, particularly early employees, in being concerned about risk and dilution.

Unless someone finds a way to change that alignment.

Founders and employees: alignment v. misalignment.

Very high-growth companies raising large late-stage rounds represent many opportunities for Boards to “buy” the vote of founders or other common directors (like professional CEOs) at the expense of the employee portion of the cap table. In a scenario where a Board is pursuing an extremely high risk growth and financing strategy, and accepting financing terms making it highly likely the early common will get washed out or heavily diluted, a typical entrepreneur with a large early common stock stake will play their role in vocally pushing for alternatives.

But any number of levers can be pulled to silence that push-back: a cash bonus, an opportunity for liquidity that isn’t shared pro-rata with the rest of the employee pool, a generous refresher grant given post-financing to reduce the impact on the founder/executive (while pushing more dilution onto “sunk” stockholders). These represent just a few of the strategies that clever later-stage investors will implement to incentivize entrepreneurs (or other executives) to ignore the risk and dilution they are piling onto employees.

Of course, it’s impossible to generalize across all startups that end up with bad, imbalanced outcomes. The fact that any particular company ended up in a spot where the employees got disproportionately washed out isn’t indicative in and of itself that unfair (and unethical) games were being played. Sometimes there’s a strong justification for giving a limited number of people liquidity, while denying it to others. Sometimes the Board really was doing its best to achieve the best outcome for the “labor” equity. Sometimes.

Principles for protecting employee stockholders.

That, however, doesn’t mean there aren’t general principles that companies can implement to better protect employee stockholders, and better align the Board with their interests.

First, common stockholder representation on a Board of Directors is not just about founders. It’s about recognizing the misalignment of incentives between the “one shot” common stock and the “repeat player” preferred stockholders, and ensuring the former have a real, unmuzzled voice in governance. Founders are the largest and earliest common stockholders, and therefore the most incentivized to represent the interests of the common in Board discussions.

Second, take seriously who company counsel is, and make sure they are independent from the influence of the main investors on the cap table. Company counsel’s job is, in part, to advise a Board on how to best fulfill its fiduciary duties. You better believe the advisory changes when the money has ways to make counsel shut up. Packing a company with people whom the money “owns” (including executives, lawyers, directors, and other advisors) is an extremely common, but often subtle and hidden, strategy for aggressive investors to gain power over a startup’s governance.

Third, any “extra” incentives being handed to Board representatives of the common stock (including founders) in later-stage rounds deserve heightened scrutiny and transparency. That “something extra” can very well be a way to purchase the vote of someone who would otherwise have called out behavior that is off-loading risk to stockholders lacking visibility and influence.

Startup corporate governance is a highly intricate, multi-step game of 3D chess, often with extremely smart players who know where their incentives really lie. Don’t get played.

p.s. the NYT article linked near the beginning of this post is provided strictly as an example of the kinds of problems that might arise in high-growth startups. I have no inside knowledge of what happened with that specific company, and this post is not about them. 

The Problem with “Standard” Term Sheets (including YC’s)

TL;DR: Whenever an influential organization publishes a so-called “standard” financing document, important questions need to be asked about not just its specific terms, but also the entire concept of “standard” terms in general, and potential biases in their creation. In YC’s case, their decision to keep their “standard” TS very short (for speed purposes), and not address key economic/control issues, favors investors by deferring negotiation on those issues to a context (after signing) where common stockholders have less flexibility and leverage. YC’s default terms also give VCs substantial power that is hardly a “standard.” In the broader context (apart from YC), there are serious problems emerging in the startup legal market with how certain narratives around “standards”, closing fast, and the hiring of lawyers with deep conflicts of interest, are leading (and tricking) entrepreneurs & early employees into adopting legal strategies that hurt their long-term interests.

In Startup Law and financing, standardization and templates are often celebrated as noble, generous attempts at saving entrepreneurs money that they would otherwise “waste” on advisory fees. While it is definitely true that, to a point, creating uniform language improves efficiency, there are very real, and often dangerous, high-stakes issues that founders need to hear about regarding “standards,” but unfortunately they often don’t. The narrative of ‘reducing friction’ in financings has devolved into a clever excuse for imposing imbalanced terms on inexperienced startups, and keeping them ignorant of both the long-term implications and potential alternatives. 

Take Y Combinator’s recent so-called “Standard and Clean” Series A Term Sheet as just one example. YC has placed itself at the forefront of attempting to standardize early-stage fundraising docs for startups.  The SAFE (Simple Agreement for Future Equity) has become in Silicon Valley a dominant instrument for seed fundraising, though survey data (and our experience) suggests it’s not nearly as dominant outside of California.

Given that the SAFE was, relative to other instruments used in the market (like convertible notes) a quite company-friendly agreement, YC established itself as offering very “founder friendly” standards in templates they create.  So one would’ve expected that their “Standard and Clean” term sheet would follow the same trajectory. However, when we reviewed YC’s term sheet, our initial response – as lawyers who represent companies, and only companies (not their investors) – was “Uh oh.”

Side note: Recent changes to the SAFE instrument made by YC have made SAFEs significantly less company-friendly from an economics standpoint, which when combined with YC’s release of its problematic Series A term sheet template, suggests a reversal of YC’s historical philosophy on having “founder friendly” documentation. This means entrepreneurs should be extra cautious before rushing to use YC’s favored forms. See: Why Startups shouldn’t use Post-Money SAFEs.

Short term sheets benefit investors

First, YC’s term sheet is remarkably short as far as equity term sheets go. The reason is somewhat reflected in their own blog post’s words:

“So don’t lose sight of the ultimate goal: closing fast and getting back to work.”

Short term sheets get signed faster than longer ones, because there’s less to discuss. Here’s the problem with short term sheets, though: once you sign a term sheet, two things happen:

A. You are now locked in with a “no shop” clause. That requires you to inform any other investors you were talking to that you are taking someone else’s deal. Good luck going back to them if this deal ends up not closing.

B. You start racking up legal fees with your own lawyers, which for a cash-limited startup puts pressure to close, and accept terms on the table, in order to pay those fees.

In other words, once you sign a term sheet, your leverage and flexibility dramatically go down. It becomes far easier for investors to pressure you with this or that language (which they will usually claim is also “standard”) than it would’ve been during the term sheet phase. So rushing to sign a short term sheet favors investors over startups.  Slowing down and clarifying all material points at the term sheet phase also saves legal fees, because it reduces back-and-forth with the lengthier definitive documents.

Fair enough, you might say. YC favors moving fast anyway, because there can be benefits to moving fast for everyone. OK.

YC gives VCs full veto rights on equity financings

Here’s a second issue: as drafted, YC’s “standard and clean” terms give your VCs and other investors a complete veto right over all future equity financings, regardless of what the Board composition is. In other words, even if the common stock controls the Board (which shouldn’t necessarily be the case), and has a deal on the table with great terms, your VCs can block it simply because they, for whatever self-interested reason, don’t like it.

This is usually a point at which at least a few founders might be thinking “WTF?”

When you move to close an equity financing, there are at least two approvals that need to happen: Board and Stockholder votes. The Board vote is subject to fiduciary duties, but the stockholder vote isn’t, save for a few narrow circumstances. In a stockholder vote, you can block something for whatever reason you want, effectively. Yes, we have seen VCs block deals that common stockholders wanted, and with great terms; but because the VCs had self-interested reasons for favoring another deal, they refused to approve. This can give them remarkable power over what deals get done and don’t.

To be fair, YC points out this hard veto right in their blog post’s footnotes. Putting aside the fact that those footnotes won’t make it into a redline, probably their expectation is that good startup lawyers will always mention the issue to their clients, and negotiate if possible. In other words, their “standard” perhaps isn’t as big of a problem because it will be negotiated. And that brings us to a more important point in this post, which isn’t about YC specifically, but the entire concept of “standard” terms.

What is “standard”?

What exactly do we mean when we say something is “standard”? Whose data are we using?

Given that investors are on one side of a deal, and entrepreneurs (and other employees) on another, might we be a little cautious in letting investors be the ones telling the market what the “standards” are?

When YC, with its prominent brand, places the label of “standard” on giving VCs unilateral veto rights on future financings, that influences the market, even if unintentionally, in favor of VCs. Now lawyers representing the interests of startups/common stockholders (like us) have to negotiate not just with investors across the table, but against a now so-called “standard.”

We’ve closed many, many deals where we don’t give VCs this kind of broad veto right, and soften it significantly to make it more balanced. But now when we push back on giving VC’s these veto rights, their response is going to be: “Look at YC’s term sheet. Giving us a hard veto is the market standard.”

Which leads to another question: what is the appropriate threshold for something becoming “standard”? 75%? More than 50%? If 49% of deals don’t have a provision, or even 10%, there are good arguments that there are in fact multiple “standards.” But when some “standards” favor repeat players with microphones and dominance over startup ecosystems, while other “standards” favor “one shot” players (like first-time entrepreneurs and employees), which ones do you think get publicized? Taking a 75% standard, as an example, and then prominently publicizing it as the “standard” can be a way to move the market to 100%, with “efficiency” as a weak excuse for eliminating flexibility on such a high-stakes provision.

Even if we had perfect objective data, at what point should startups place more weight on their own priorities, unique context, and leverage for the permanent, highest-stakes economic and power terms of their company’s governance, instead of aggregated, anonymized data covering a huge diversity of companies?

One could argue that the publication by investors of their own so-called “standards” is a kind of assertion of market power, and a way to influence long-term the data that is then used to justify those same standards. Do common stockholders have the ability to do the same and ensure balance? No, they don’t. They depend on individual lawyers to represent their interests and help make up for the power inequality. And that finally brings us to an even bigger problem.

The “own the advisors” game.

Let us paint a picture of a “game” of sorts for you. The game has two broad sets of players: “one shot” players and repeat players.

The “one shot” players are first-time entrepreneurs and early employees; common stockholders. They are usually not diversified, which means their wealth is concentrated in their one company. They also typically lack significant personal wealth, and don’t have downside protection on their equity, further magnifying their “skin” in this “one shot” that they have. Finally, not having played the game before, they rely on experienced, trusted (hopefully) outside advisors (like lawyers) to help them not get taken advantage of.

The “repeat players” (investors, accelerators) are in the polar opposite situation. They are wealthy, diversified, downside protected (liquidation preference or a debt claim), and they’ve played the game many, many times. In the case of the largest repeat players, they’re also incentivized to take significant risks in order to “swing for the fences” and go after risky big prizes, even if doing so increases the number of total failures; failures which hit the one shot players far harder because they aren’t diversified across a portfolio juiced for “power law” returns.

There is a fundamental misalignment here that never goes away, and feeds into many high-stakes decisions (and disagreements) in a company’s history around recruiting, risk, fundraising, exits, etc. Both sides want to make money, but they are often misaligned in their perspectives on how to do so, whom to raise funding from (and on what terms), and what level of risk is acceptable. The repeat players have 100x the experience of the one shot players, but the one shot players hope their advisors can help “balance” the inequality as they navigate this misalignment.

Now, let’s say I’m a very smart repeat player – a “chess player” of sorts – and I’d prefer that this “balancing” not really happen. I make more money, and keep more control, if I can somehow get in the way of the lawyers helping the one shot players. But at the same time, if I look too visibly aggressive in doing so, the one shot players won’t want to play with me at all. So as an investor I want to win, but in a way that preserves a public image of selflessness so that inexperienced players keep coming to me, and preferably with minimal defenses. What’s a good multi-step strategy?

Here’s a suggestion.

1. Create “standards” for the game, based on limited data, and with microphones, that the one shot players can’t see or influence. Publish these so-called “standards” while emphasizing how much money they’ll “save” everyone by using them. Talk a bit about how you were once yourself a one shot player (former entrepreneur), so you’re really doing this out of selfless empathy for the new folks; even if now you’re highly misaligned.

2. Build relationships with lawyers that the one shot players hire for advice, by hiring those same firms on the much larger volume of deals you control, and also referring other people to them from your broad network as a repeat player. This ability to refer lots of work to said lawyers is a “currency” that the inexperienced one shot players always lack.

3. Recommend to the one shot players that they hire these same awesome lawyers that you (the repeat player) prefer, because of how “efficient” and “high quality” they are, and how well they know the “standards.” You know that those lawyers view you as a source of 50x as much “deal flow” as any one shot player, and would never do anything to jeopardize that deal flow. Emphasize how much money will be “saved” by using “familiar” lawyers.

4. Tell the one shot players that, given everything is “standard” anyway, they should focus on “closing fast” and saving fees. In fact, they should hire the lawyers on a flat fee, which ensures that the faster the lawyers move (the less time they spend advising the inexperienced startup and negotiating on its behalf), the more money those lawyers make. You can have two sets of lawyers who charge the exact same end-price, but those charging a “flat fee” (as opposed to billing by time worked) are actually rewarded for doing less work, with an improved margin.

5. With the “standard” (that repeat players created) in hand, the lawyers (that repeat players control) “close fast” (earning a better margin on their flat fee), with minimal discussion or negotiation, so everyone can move on and not “waste money” on unnecessary advisory.

6. The repeat players, very happy with how “high quality” and “efficient” the captive lawyers were at closing on their standard, refer them more work; regardless of how well it served the one shot players who, on paper, were the client.

7. Rinse and repeat over many iterations. Now we have market data that validates the “standards” that the repeat players created, further entrenching it.    

Does this game sound familiar to anyone? We bet it does to startup lawyers.

We go more in-depth into how the game is played, and strategies for avoiding it, in Relationships and Power in Startup Ecosystems and How to Avoid “Captive” Company Counsel.

The core point is this: there is a structural problem with how certain startup ecosystems have evolved to approach “legal” and the hiring of lawyers. It’s the result of a significant imbalance of power between “one shot” startups and the repeat player investors/accelerators they work with, the latter of which have found many (not all) startup lawyers quite eager to flout conflicts of interest in order to generate business for themselves.

“One shot” common stockholders (entrepreneurs, employees) and “repeat player” investors (including accelerators) are not fully aligned in terms of economics and incentives, given the above-described differences as it relates to diversification, wealth, experience, and downside protection. Repeat players, through their ability to operate as brokers/gatekeepers of referrals, have increasingly pushed founders to hire law firms that are ultimately “captive” to investors, and even then sometimes insist that those law firms adopt billing practices (like flat fees) that actually reward lawyers for rushing work and under-advising inexperienced startups. 

And all of this is done under the pretense of wanting to help founders “save” money. In this game, the appearance of “founder friendliness” is often a marketing tool to help lull first-timers into forgetting how misaligned they are from the money players, and then taking advice from those same money players that ends up, unsurprisingly, being an “own goal.” Former entrepreneurs-turned-investors are often the most skilled at using their pasts (as entrepreneurs) as smoke and mirrors to get now first-time entrepreneurs and early employees to forget their misalignment, and take their advice as gospel.

In fact, if you look around the market and find startup law practices that have grown at an abnormally fast, seemingly non-organic, pace, what you’ll often find is lawyers willing to juice this conflict of interest-driven game as far as possible, to a point getting preciously close to meriting litigation. We’ve seen at least one threatened law suit already.

We see the negative consequences of this game all the time around the country, as inexperienced “one shot” common stockholders (including entrepreneurs) are duped into signing (air quotes) “standard” deals, and taking certain “standard” actions, while having no real clue as to what the long-term consequences are because everyone was celebrating how great of an idea it is to “close fast” and keep it “standard.” When the long-term consequences of the “standard” docs and actions play out, it becomes clear no one ever actually explained to the inexperienced common stockholders and the company what the real implications were, or how they could’ve been negotiated for more balance; because everyone capable of doing so was ultimately incentivized to favor the interests of the money. 

So not only are we increasingly pushing so-called “standards” that are themselves biased and questionable, we’re depriving the most inexperienced and exposed people in the ecosystem, the new entrepreneurs and early employees, of the right to even be truly independently advised in assessing those “standards.” And we’re selling it all as noble and well-intentioned because it purportedly “saves” them fees, even if the long-term negative consequences for them far exceed whatever fees they “save.”

To be sure, not every team gets hurt by the emergent “close fast and keep it standard” dogma; in much the same way that not everyone who smokes gets cancer. Some teams manage to protect themselves in other ways, regardless of what the docs say, or are lucky to work with lawyers who fully do their job. But the issue is so pervasive, and there is enough damage occurring to inexperienced players, that it needs to be, at a minimum, discussed out in the open by people not incentivized to dismiss or downplay it.

We believe that startups are more than capable of making their own decisions as to how they want to hire advisors, including counsel, once they’ve heard the full story and potential implications. Part of the problem is how little open and honest discussion occurs on the topic, and how much market pressure to use captive lawyers is applied quietly in the background, precisely because the market is dominated by repeat player perspectives; many of which are cleverly spun and publicized as “friendly.”

Negotiating the YC “Standard and Clean” Term Sheet

To be crystal clear, this broader diagnosis of the market is not about YC at all. YC is a great organization, and many of our firm’s clients (including YC companies) have fantastic things to say about their program. We have no idea what YC’s arrangements are in terms of referring companies to certain conflicted or non-conflicted law firms, or the kinds of economic arrangements they promote with those firms. For all we know, YC legitimately believed that they could post this “standard,” and then expect truly independent, non-captive lawyers to then do their job and produce fair outcomes.

But while we have your attention, given that this “standard and clean” term sheet is already out there, a few suggestions that we would give to companies and common stockholders before signing it:

A. Soften the veto. Build some “boundaries” around the veto right on future financings. For example, if the valuation is a certain amount above the current price (not a down round), perhaps a Board vote should be sufficient. The Board is subject to fiduciary duties, which can constrain bad actors. Maintain some kind of “path” to a value accretive financing, even if the current money gets hostile and tries to reduce competition, or force a deal with their “friends.” There should also typically be some kind of ownership threshold below which all VC vetoes go away.

B. Clarify the shadow preferred’s economics. Be clearer about the economics of the “shadow preferred” referenced for Notes/SAFEs. What are their liquidation preferences? Term sheets are a good opportunity to address any liquidation overhangs if the Notes/SAFEs themselves don’t address them.

C. Clarify the common stock’s board voting rights. Do the common stockholders have to be employees in order to vote for the common stock’s board seats? This has significant power implications long-term, because there can be any number of reasons why early common stockholders might leave the company (or be forced out), and still want a voice (even if not control) in governance; and for good reasons. When there’s a power shift, common stockholders remaining on payroll are usually far more beholden to the money, and because their equity was often issued later (at a higher price), their economics and incentives are more aligned with later investors. Make VCs explain in full just why exactly it’s so important that all common directors be service providers, or be elected by service providers, to the company. Listen closely enough, and you’ll understand how the arguments are often thinly veiled power plays.

Also, does one common director have to be the CEO? This is usually (but not always) the case. Discuss it and spell it out in the term sheet. Just like the previously mentioned point, given that the CEO position often eventually gets filled by a later common stockholder recruited by the Board, with different priorities and incentives from early common stockholders, this has control implications long-term. Again, tying common director positions (and the voting in their elections) to being on payroll is often a subtle power move to eventually exclude (as a company scales) early common stockholders from having visibility and a say in company governance; because they’re the people most likely to disagree with later-stage investors on how to scale, when to exit, and how much risk is acceptable.

Provide a “yes” or a “no” to these questions. Silence means shifting negotiation post-term sheet, where the common have less flexibility. Be mindful of how some players will spin this discussion into a caricature of founders not wanting to give up control. Control and a voice/visibility are two completely separate issues. There are many constituencies on a cap table with various incentives and interests. There are good arguments for why, as a company scales and the stakes get higher, early common stockholders – who are the most exposed to dilution and risk – should still have some say and visibility (even if not control) in company governance, to voice concerns around risk, financing strategy, recruiting, exits, etc. Conflating the narrow context of a founder unwilling to share control with the far broader, and far more legitimate reality that early common stockholders and investors have very different incentives and perspectives on company growth, is a common straw-man tactic for obfuscating the issue.  Both sides deserve to have un-muzzled voices in governance.

D. Clarify the anti-dilution exceptions. Be clearer about the exceptions to anti-dilution adjustments, instead of engaging in a post-signing “battle of the standards.” While not always an issue, these can sometimes be ways for the preferred to squeeze the common by refusing to waive anti-dilution unless they “give” on something. Spell them out in the term sheet.

E. Clarify how all Board voting will happen. Are there specific Board actions that, aside from a Board majority, the investors expect for their own directors to have veto over? If not, say so. If so, list them. VC docs often have a section, apart from stockholder veto rights, that give the preferred directors veto (at the Board level) over certain key actions. If you’re silent about this issue, instead of making it clear that a majority governs all the time, investors will often claim that it’s an open point for negotiation in the docs. Silence is not your friend.

If YC truly wants their term sheet to serve as a balanced (and not biased) reference point for Series A deals (and I believe they do), they should prominently address at least these core economic and control issues; not in a passing blog post reference, but squarely in the document with appropriate brackets so as not to signal a “default” and therefore not slant negotiations. Having public templates as starting points, like the NVCA has done for some time, can be helpful, and we utilize them regularly to streamline negotiation and save fees. But it’s a big responsibility and needs to be done carefully; with input from people on the other side of the table whom the money can’t “squeeze” if they speak honestly and openly.

The general theme here is that you should be clear in the term sheet on all material issues. Nothing is more material than economics and control. Keeping it short, and glossing over things by referencing a nebulous “standard,” or simply not addressing a point at all, favors investors because it transfers negotiation to a context where the company has less optionality and flexibility. We’ve closed deals that land, after transparent discussion and negotiation, in any number of places on these above-mentioned points. The real point we’re trying to emphasize in this post isn’t about pushing deals to go in one direction or another – that depends on the context – but highlighting just how often these issues aren’t even discussed with startup teams because of games that investors and lawyers are playing, and their incentives to “close fast.”

Some people argue that you should “sign fast” on a term sheet because if you negotiate, you might “lose the deal.” We don’t see that actually happen in practice, and can’t think of a clearer signal that you might not want to take someone’s money than being told that the deal will die if you try to clarify even a few material points. This, again, is the kind of sleight of hand rhetoric that sounds like it’s advice to help entrepreneurs, when in fact it helps investors. In reality, spending more time to achieve alignment on a more detailed term sheet expedites drafting and closing once the term sheet is signed.

Start asking the right questions.

In a game of the inexperienced v. the highly experienced, moving very fast, and not taking the time to ask important high-stakes questions, favors the experienced. Great startup lawyers prioritize deals because they know they deserve urgency, but show us lawyers who act as if speed should be a founder team’s top priority in a financing, and we’ll show you lawyers who are captured by money players. In too many cases, startup entrepreneurs’ cultural inclination toward speed and automation – which in the right contexts is a good thing – has been hijacked by misaligned but very clever repeat players in order to dupe the inexperienced into adopting legal strategies that actually hurt their interests.

Wrapping this topic up, as counsel our job isn’t to always provide startup clients direct answers, but sometimes to simply ensure they, in their inexperience and unequal power in the market, are asking the right questions. Questions like:

  • What do we really mean by “standard”? Can the data be manipulated?
  • Whose “standard” is it, and are they biased? Can their “founder friendliness” be a marketing tactic instead of full reality?
  • How much should I even care whatever “standard” means, at least as it relates to my most high-stakes terms, if I’m building a unique company with its own priorities, context, leverage, etc.?
  • Might it be a bigger problem (than my investors will acknowledge) if my company counsel is far more motivated, via referrals and other economic ties, to keep my investors happy instead of the inexperienced common stockholders whose skin is entirely in this one company?
  • Is “moving fast” and rewarding my company’s lawyers for minimizing their involvement (with flat fees) really in my best interests, or is “saving money” a clever excuse to keep me ignorant and not properly advised of what I’m getting into, so that more experienced players can then take advantage of the imbalance?

We don’t pretend to have universal answers for these questions, because there aren’t any. Where you land depends on the context, the people involved, their unique priorities, and the kind of relationship they expect to have going forward. You know, a lot like term sheets.

This post (which is not legal advice, btw) was co-authored with my NYC colleague, Jeremy Raphael.

Relationships and Power in Startup Ecosystems

TL;DR: The highly unequal relationship and power dynamics in most startup ecosystems mean that what is visible publicly (on blogs, social media, etc.) is not an accurate representation of how the game is actually played, because few people are willing to speak honestly and openly for fear of being penalized by a well-connected gatekeeper. This makes off-the-record diligence, and watching loyalties of your most high-stakes relationships (including counsel), essential in order to prevent repeat “money” players (investors, accelerators) from dominating the voices of less influential “one shot” players (first-time entrepreneurs, employees) both on boards of directors and in the market generally. Hire and engage people without hidden dependencies on the money.

Background Reading:

There are a few underlying themes that have been covered in a number of SHL posts and are relevant to this one:

First, in startup dynamics there is a fundamental divide and tension between inexperienced, “one shot” common stockholders and “repeat player” investor preferred stockholders (VCs, seed funds, accelerators) that feeds into all of the most high-stakes decisions around how to build and grow a company. It has nothing to do with good v. bad people. It has to do with core economic incentives.

Common stockholders (founders, early employees) typically have their wealth concentrated in their one company (not diversified), do not have substantial wealth as a backup in the event of failure, do not have the downside protection of a liquidation preference or debt claim on the company, and have almost no experience in the subtle nuances of startup economics and governance. This dramatically influences their perspective on what kind of business to build, how to finance it, whom to hire in doing so, and how much risk to take in order to achieve a successful outcome; including how to define “successful.”

Preferred stockholders / repeat players (investors, accelerators) are the polar opposite of this scenario. No matter how “founder friendly” they are, or at least pretend to be via PR efforts (more on that below), their core economic interests are not fully aligned with one shot players. They are already wealthy, significantly diversified, have substantial experience with startup economics and governance, and have downside protection that ensures they get paid back first in a downside scenario.  In the case of institutional investors, they also are incentivized to pursue growth and exit strategies that will achieve rare “unicorn” returns, even if those same strategies lead to a large amount of failures; failures which hit common stockholders 100x harder than diversified, down-side protected investors.

And the fact that some of the repeat players are themselves former founders (now wealthy and diversified) is irrelevant to the fundamental economic misalignment; though investors will often use their entrepreneurial histories as smoke and mirrors to distract now first-time founders from that fact. They can probably empathize more with the common’s challenges, and help with execution, but they didn’t become wealthy by ignoring their economic interests. In fact, I would argue from experience that the moves/behavior of entrepreneurs-turned-investors should be scrutinized more, not less, because they’re almost always far smarter “chess players” at the game than the MBA-types are.

Second, apart from the economic misalignment between the common and preferred, there is a widely unequal amount of experience between the two groups. A first-time founder team or set of early employees do not have years of experience seeing the ins and outs of board governance, or how subtle deal terms and decisions play out in terms of economics and power.  The preferred, however, are usually repeat players. They know the game, and how to play it. This means that the set of core advisors that common stockholders hire to leverage their own experience and skillset in “leveling the playing field” is monumentally important; including their ability to trust that those advisors will help ensure that the preferred do not leverage their greater experience and power to muzzle the common’s perspective.

This second point relates to why having company counsel who is not dependent on your VCs / the money is so important; and it also highlights why repeat players go to such enormous efforts to either force or cleverly trick inexperienced teams into hiring lawyers who are captive to the interests of the preferred.  We’ve observed this in pockets of every startup ecosystem we’ve worked in: that aggressive investors work hard to gain influence over the lawyers who represent startups.  The moment we became visible in the market as a growing presence in startup ecosystems, we lost count of how many of the strongest money players reached out to us to “explore” a relationship; even though they already had “relationships” with plenty of firms. It wasn’t that they needed lawyers; it’s their power playbook.

The point of this post is how these above facts – the economic misalignment, and particularly the greater experience – of influential investors (including accelerators) plays out into how they exert power, often covertly, in startup ecosystems; not just with lawyers.

Think of any kind of business that needs to work with startups as clients: obviously lawyers, but also accountants, HR, outsourced CFO, benefits, real estate, even journalists who need access to entrepreneurs in order to write articles. All of those people need strategies for “filtering” startups (finding the more viable ones) and then gaining access to them; and they’re going to look for strategies that are the most efficient and less time consuming.

What many of these service providers come to realize is that an obviously efficient strategy is to work through VCs and other influential investors/accelerators. They’re doing the filtering, and because they’re repeat players, have relationships with lots of companies.  So the service providers reach out to the prominent repeat players (investors, accelerators), who immediately recognize the power that this role as “gatekeepers” and brokers of relationships gives them over the ecosystem.

And when I say “power over the ecosystem,” what I mean is power over what people will say publicly, what they won’t say, and what “support” businesses become successful (or not) via the direction (or restriction) of referral pipelines. It heavily plays out into what gets written and not written on social media and in tech publications, and said at public events; because people are terrified of pissing off someone who will then cut them off from their lifeblood of clients.

“One shot” players are, by virtue of not being repeat players and lacking significant relationships, unable to counterbalance this dynamic.  Put together a system of highly influential and wealthy repeat players and inexperienced, less influential “one shot” players, and you can bet your life that it will inevitably tilt itself toward those who can exert power; with strategies to obscure the tilting from the inexperienced. The ability to offer (and restrict) access to valuable relationships is the leverage that repeat players use to exert power in startup ecosystems and ensure their interests are favored; even when they aren’t formally the “client.”

So let’s tie this all together. Founders and other early startup employees are significantly misaligned from the repeat player investor community in a way that has nothing to do with ethics, but core incentives and risk tolerance; and this is independent of the more obvious misalignment re: each side’s desire for more ownership of the cap table. They’re also totally lacking in experience on how to navigate the complexities of startup growth and governance, and therefore rely heavily on trusted outside advisors to level the playing field. Finally, the most aggressive repeat players will position themselves as gatekeepers to the ecosystem (or at least a valuable portion of it), exerting significant control over the market of advisors available to founders by their ability to offer, or deny, access to startups.

What’s the conclusion here? There are two:

A. What you often see written or said publicly in startup ecosystems is not an accurate representation of how the game is actually played, because very few people are willing to talk openly about it, for fear of being cut off by gatekeepers.  Others will say positive things publicly because of a quid-pro-quo understanding in the background. This significantly increases the importance of off-the-record “blind” diligence to get the real story about a particular repeat player. If you are diligencing an influential investor or an accelerator, it is important that said entity not know whom you are contacting (or at least not everyone) in conducting that diligence.  That is the only way that they cannot retaliate against any particular person who says something negative; and you’re therefore more likely to get an honest answer.

You will absolutely encounter people who will say that the whole idea of “retaliation” is some kind of paranoid fabrication, but remember how the chess game is played: the appearance of “founder friendliness” is often a marketing tool. Of course the smartest users of that tool are going to wave away all this talk of bad actors, doing heavy diligence, and protecting yourself as unnecessary. Come on, they’re good guys. Just trust them, or their tweets. We’re all “aligned” here, right?

When you have an inherent and substantial power advantage, it is an extremely effective strategy to create a non-adversarial, “friendly” PR image of yourself, downplaying that power.  Inexperienced, naive first-time players then buy into this idea that you’re not really about making money, and come to the table with minimal defenses; at which point you can get to work and surround them with relationships you “own.”

The money players with truly nothing to hide won’t be dismissive or defensive at all about the common’s need to conduct blind diligence and ensure the independence of their key relationships. Reactions are often a key “tell.”  If you truly have a great reputation, and you have no intent to use the common’s inexperience and unequal power against them, then what exactly is the problem with respecting their right to be cautious and protect themselves?

There are definitely good people in the market, including those who put integrity and reputation above money, but only idiots navigate a highly unequal and opaque world under the premise that everyone is an angel, and you should “just trust them.” Being a “win-win” person is not in tension with ensuring your backside is covered. Anyone who says otherwise is trying to cleverly disarm you, and is defending an approach that has clearly served them well.

B. To prevent repeat players from dominating the perspective of “one shot” common stockholders both on startup boards of directors, and in ecosystems generally, the “one shot” players must pay extremely close attention to the relationships of their high-stakes key advisors and executive hires, to ensure they can’t be manipulated (with bribes or threats) by the money’s relationship leverage.  No rational human being who cares about being successful bites the hand that most feeds them; no matter how “nice” they are. That is the case with lawyers, with “independent” directors on boards, with other key advisors, and also with high-level executives that you might recruit into your company. Pay attention to loyalties, and diversify the people whose rolodexes you are dependent on.

In the case of lawyers, aggressive repeat players and their shills will often talk about how startup dynamics are “different” and it’s “not a big deal” for company counsel to have dependencies (via engagements and referral relationships) with the preferred stockholders. They even argue that the lawyers’ “familiarity” with the investors will help the common negotiate better and save legal fees. How generous. An honest assessment of the situation is that startups are different, but different in a way that conflicts of interest matter more than usual. Outside of the world of promising startups run by first-time executives negotiating financing/governance with highly experienced investors, you rarely see high-stakes business contexts where there is such a dramatic inequality of experience and power between groups, and such a high level of dependence on counsel (on the part of the one shot common) for high-impact strategic guidance.

Repeat players aren’t reaching across the table and manipulating startup lawyers because it’s “not a big deal.” They’re doing it because the payoff is so uniquely high, and the power inequality (reinforced by the preferred’s inherent dominance over key ecosystem relationships) makes it so easy to do. Couple a basic understanding of human nature/incentives with the fact that the Board’s primary fiduciary duties under Delaware law are to the common stock, and any honest, impartial advisor will acknowledge that experienced company counsel who doesn’t work for the repeat players across the table on other engagements, and who doesn’t rely on them for referrals (in other words, is not conflicted), is one of the clearest ways to (a) ensure the common’s perspective gets a fair voice, and accurate advisory, in key Board decisions, and (b) help the Board do its actual job.

There is a clever narrative pushed around startup ecosystems painting a picture of startup finance and governance as always full of warm, balanced transparency and generosity, with common stockholders and investors holding hands and being “fully aligned” as they build shareholder value together without bias, disagreement, or power plays. But notice how quickly the tone changes from some parts of the investor community the moment you suggest that the common be afforded even minimal defensive protections, like company counsel that investors can’t manipulate. Suddenly you’re being “overly adversarial.”

Oh, so are the transparency and generosity, and “kumbaya” sing-alongs, only available if the common stock behaves in the exact way the money demands? Funny how that works. Smart common stockholders won’t accept “benevolent dictatorship” as the model for their company’s governance. The way you address power inequality is by honestly fixing it; not by taking someone’s BS reassurances that they’ll be “really nice” with how they use it.

You should absolutely want transparency, fairness, and generosity to be the guiding principles of your relationship with your investors – that’s always my advice to founders on Day 1. Also understand that while the common’s perspective deserves to be heard and respected (and not muzzled or infantilized), it is obviously not always right. Balanced governance is good governance; and true “balance” requires real, independent ‘weight’ on both sides. Too many repeat players have manipulated the market into a charade – propped up by pretensions of “friendliness” and “cost saving” – where inexperienced common stockholders become unwittingly dependent on advisors to help them negotiate with investors 100x as experienced as they are, when in fact those advisors are far more motivated to keep the investors happy than their own (on paper) clients.

High-integrity startup ecosystem players should forcefully assert that the “friendly” ethos promoted by VCs and accelerators only has real substance if they’re willing to stay on their side of the table, and not use their structural power advantage to maintain influence over the key people whom founders and employees depend on for high-stakes guidance and decision-making. Call out the hypocrisy of those who put on a marketing-driven veneer of supporting startups and entrepreneurs, while quietly interfering with their right to independent relationships and advisory; including independent company counsel that repeat players can’t “squeeze” with their relationship leverage.

A lot of the most egregious stories of startup flame-outs that you see written about – who grew too fast chasing a unicorn exit, raised more money than a business could sustain, took a high-risk strategy that blew up, or perhaps achieved a large exit while returning peanuts to the early common – are the end-result of a complex game by which repeat players come to exert so much power over how a particular startup scales that the voice of the “one shot” players – the early common stockholders without deep pockets or contacts – gets completely silenced until it’s too late. Gaining control over key company relationships is a significant part of how that game is played. And what’s written about publicly is just the tip of the iceberg.

To put a bow on this post, healthy skepticism over what you see and hear publicly, and good instincts for understanding the importance of incentives and loyalties, are essential for any inexperienced team entering a startup ecosystem. The image of wealthy, powerful people “winning” only by loudly and aggressively pounding the negotiation table is a caricature of how complex business actually works; but it’s a caricature that often dupes inexperienced founders into thinking that everyone else who smiles and seems helpful must be aligned with their interests. Assholes are easy to spot, so the smartest winners are almost never easily visible assholes. Good people still follow their incentives; and aggressive but smart money players know how to assert their power while preserving a public image of selflessness and generosity. Navigate the market, and recruit your advisors, accordingly.