Post Category → Seed Rounds

Seed-Stage Startups Should Shrink Their Option Pools

Background reading:

You only get 100% of your cap table to give away (or keep), and the sad fact is founders make all sorts of tactical errors that needlessly give up points to investors and other parties. Sometimes those errors are driven by bad advice offered by misaligned participants in the ecosystem.

One example I’ve written extensively about is the aggressive anti-dilution mechanism built into YC’s default Post-Money SAFE Template. YC portrays its template as a wonderful legal fees-saving “standard” for founders, while staying quiet about its extremely harsh economics that amplify founder dilution. YC is, at the end of the day, a VC that benefits from making founders dilute more. So be skeptical about using their templates without any modification.

The reality is SAFEs are tweaked/modified all the time, and it costs essentially nothing in legal fees to do so. In that above-linked post I offer a very simple – just a few sentences – tweak to eliminate this issue, while preserving the post-money valuation mechanism that provides transparency on how much of the cap table a SAFE is purchasing.

Another issue I wrote about over ten years ago is how founders needlessly reserve too large of an option pool at formation. They’ll just pick a number, like 20% or 10%, and reserve that amount, regardless of what they actually intend to use. They think this costs them nothing, but it’s just not true.

First, most employee new hire equity grants are made based on a % of the fully-diluted capitalization. When you offer them 2% or 3%, the denominator of that percentage includes the reserved but unused pool. It’s simple math that if you reserved too large of a pool, you are needlessly giving them more of the cap table than you otherwise would have. If you had reserved a smaller pool up-front, the 2% or 3% would be of a smaller pie, and then in expanding the pool later (which you can always do), the employee dilutes alongside everyone else.

Second, reserving too large of a pool makes it easier for VCs to argue for a needlessly large pool in your first equity round. As I wrote before:

“The pool you reserve before your first VC financing will set the baseline for negotiating how much of an option pool “top up” VCs make founders absorb.”

If your pool is at 5% going into a funding round and your VCs are negotiating for a 10% or 15% pool post-closing, it’s going to show up as a very large increase. The optics of that increase will help you in negotiation. But if you start with a 10% or 15% pool that you didn’t even need, the increase will look much smaller, which means you basically made the VC’s job easier for zero benefit to yourself.

The above two issues are not new in my writings. Stop reserving too large of a pool at formation, because it ends up giving too much equity to employee/consultant/advisor hires via equity grant calculations, and to VCs via equity round negotiations.

A somewhat newer issue that I want to emphasize here: Post-Money SAFEs make it even more costly to have an artificially large pool, given how their conversion math works. Shrink your pool to as small as possible before your SAFEs convert.

The definition of “Company Capitalization” in the Post-Money SAFE (which is the denominator for purposes of SAFE conversion) includes the pool existing before the equity round, but excludes the pool increase negotiating with your new lead VC(s).

Thus by having a pointlessly large pool at the time of SAFE conversion, you are just handing money to the SAFE holders. Shrink the pool before SAFE conversion to only exactly what you need, and the full pool increase of the equity round will NOT drop the SAFEs conversion price.

I’m not going to show specific examples of the math here. You can use the Open Startup Model (free) if you don’t have your own excel model. Suffice to say based on a few examples I’ve modeled out, you can reduce the amount of dilution your SAFE holders take, in most scenarios, by about 10% or more. Free money.

So the costs of having a pointlessly large equity pool before an equity round continue to mount:

  1. It means you’re giving too much equity to new hires.
  2. It means you’re making the job of your VCs in your equity round easier by front-loading an option pool increase they would otherwise need to argue for themselves.
  3. It means your SAFE holders are getting more shares from their SAFE conversion than is actually necessary.

Stop. Reserving. Stupidly. Large. Option. Pools. The emergence of AI probably means hiring needs, and associated equity pool needs, are going to shrink anyway.

At formation, reserve only what you think you will need for the next 6 months or so. And before you start negotiating an equity round, shrink your pool to cover only what has actually been used. This will save you multiple percentage points on your cap table that could be worth millions in the long-run. Again, free money. Take it.

Pre-Seed Funding with Post-Money SAFEs: Revisited in 2024

There are few markets that evolve faster than the world of startups, for unsurprising reasons. I figured it was time to revisit some of my writings on seed and pre-seed funding given how much the market has evolved since 2019-2021, when I last wrote about this topic in depth.

First, a brief history:

1990s – Long before the term “pre-seed” was even a thing, before the SaaS revolution made it even conceivable to start building a tech company with only a few hundred thousand dollars (or less), almost all early startup funding occurred as a complex preferred stock round; what now is reserved for Series A and larger seed rounds. It was a very different world from today.

Early 2000s  – Then convertible notes, once reserved mostly for “bridge” rounds in between preferred stock financings, started being used for seed funding; a natural evolution for rounds that were getting smaller and couldn’t justify full equity round negotiation time or costs. It worked relatively well. We also saw in this era the emergence of “series seed” preferred stock templates, a slimmed-down version of the more complex NVCA, that allowed you to raise a seed equity round for about 40-50% less in legal fees. These also got a decent amount of traction.

2013 – Then the Pre-Money SAFE, which is a convertible note without interest or maturity (effectively) was released around 2013. Founders started (candidly) abusing that instrument by raising Pre-Money SAFEs for years and years while obscuring the real economics behind what angel investors were funding. This was do-able because if your second, third, or fourth SAFE round has a pre-money valuation cap, but nothing capping the post–money, your newest investors can’t really know what % of the company their investment is buying without making you model out all the conversion math.

They could, for example, be putting in $1 million at a $49 million pre-money cap, which would suggest a $50 million post-money valuation, but they were in fact getting way less than 2% of the business because numerous unmodeled earlier SAFE rounds were pushing up the post-money. The post-money valuation is what really hardens a startup investor’s ownership percentage.

2018 – In late 2018 Y Combinator released the Post-Money SAFE. It flipped the economics of SAFEs to have a post-money cap, making the % purchased by investors far more transparent and immune to this issue of companies obscuring a deal’s economics. This was a good development, and the Post-Money model of valuation caps has since gained substantial market share.

But there’s one very big problem. The solution YC devised went much further – to the benefit of investors (including themselves) –  than was necessary to let investors know what % of the cap table they are buying on the day they invest. It further promised those investors complete non-dilutability of that percentage until the SAFE converts, including through subsequent SAFE rounds with higher valuation caps. This makes the Post-Money SAFE far harsher economically (to founders) than any other instrument in the history of startup finance.

YC itself has made an enormous amount of money by implementing this new math into the deal it gets with its own accelerator’s startups. I’ve seen YC companies start with giving 7% (the usual deal) to YC, but by the time the SAFE actually converts, after two or three more convertible rounds, the YC % is functionally equivalent to having received 10% or more years earlier. The smartest YC companies get ahead of this issue and raise a seed equity round as soon as they can after exiting the accelerator, cutting off this problem by converting all their SAFEs, but most don’t. It ends up costing them dearly.*

That’s the history.

2024 – Today, pre-seed and seed rounds have evolved such that you very rarely see an equity round that is smaller than $3-5 million. Many companies raise more than $5-10 million as convertibles (SAFEs or Notes) before doing an equity round.

Given the current landscape and investor expectations, we typically advise founders to not swim too hard against the tide, but also not mindlessly drink the overly “standard” Kool-Aid. Yes, templates like the Post-Money SAFE have gained significant market share, but what you don’t hear as much in the (simplified) data is that they are still being negotiated, particularly on the anti-dilution economics issue discussed above.

Many founders are very uncomfortable with promising their SAFE holders anti-dilution for years, given how equity rounds have been pushed further into companies’ growth. Six years after the Post-Money SAFE’s release I still have not heard a logical argument for why if a startup successfully closes $X million as preferred stock, all prior investors get diluted (what normally happens), but if it happens to be a SAFE round (same valuation, same amount raised), no investors get diluted. Why is the paperwork structure of the round relevant to whether investors get diluted?

Many smart founders modify the Post-Money SAFE (lightly) to address the investor-biased anti-dilution issue. I posted a public redline for this years ago, available here, along with other info on the economic implications of making this modification. Changing just a few words in the Post-Money SAFE can, for a company that achieves at least a $100 million exit, amount to millions of dollars in the pockets of common stockholders (founders, employees) instead of VCs or accelerators. Anyone who thinks at least trying to make this change isn’t worth it, out of some fear of “friction” – isn’t (IMO) defending their cap table enough.

Remember that this modification still promises investors the cap table percentage that the post-money valuation cap implies. If they put in $1 million at a $10 million post-money cap they are getting 10% today, effectively. What the “fix” does, however, is ensure that 10% shrinks pro-rata if you do a new SAFE round in 6-12 months with a higher valuation cap. Because that’s what would happen if you’d raised that $1 million as an equity round instead, or as a convertible note or pre-money capped SAFE. This idea of promising non-dilution to SAFE investors was completely novel, unnecessary, and introduced by YC, costing founders a lot of money. 

Of the founders I observe actually trying to fix the Post-Money SAFEs problems, a material number (but not all) have it accepted by their investors. They send a simple markup early in the process, a little discussion happens, and investors either OK it or they don’t. It ultimately comes down to leverage, which no lawyer can change for you.

For founders unable or unwilling to push for this change, other possibilities are:

A. At a minimum understand the anti-dilution issue, and factor it into your modeling of subsequent rounds. View future SAFE dilution as stacked on top of what was previously given to SAFE investors. The earlier SAFE holders are not themselves being diluted, which means you (the founders) are being diluted more. Your valuation caps in future SAFE rounds thus need to be higher to account for the more aggressive founder dilution.

B. We’ve also seen some founders, instead of tweaking the Post-Money SAFE, simply switch back to an old school pre-money formula. I personally find this a bit awkward in the context of investor expectations of 2024, but it certainly happens sometimes.

C. Convert your SAFEs as soon as possible. This is the advice I give to YC founders, and the advice I give to anyone who has raised a substantial amount of money on unnegotiated Post-Money SAFEs. Cut the anti-dilution off as soon as you can by raising a seed equity round, even a small one. See my article Myths and Lies About Seed Equity Rounds to dispel any boogeyman stories you’ve heard about how equity shouldn’t be used until Series A.

Those stories are often driven by investors holding post-money SAFEs, who make way more money staying unconverted and therefore undiluted even as you raise more money and increase in valuation. Investors can be great sources of advice, but they are not your best friends. Cap tables are unavoidably a zero-sum game, and investors’ advice is very often designed to maximize the amount they get. Watch incentives.

Startup finance continues to evolve. Templates are useful as starting points of a negotiation. They’ve dramatically streamlined the earliest stages of funding, as the number of pre-seed and seed funds (and deals) has exploded. But be skeptical of anyone suggesting that those templates are never negotiable. They most certainly (often) are. The tiniest amount of negotiation can save you and your team millions of dollars. Don’t foolishly leave money on the table.

If you’re raising a pre-seed or seed round, feel free to reach out to us. We often do virtual office hours to help founders better understand these granularities as applied to their market context.

Post-script: After you’ve closed on Post-Money SAFEs, shrink your option pool to save on dilution. Having an unnecessarily large option pool before your SAFEs convert is just handing extra equity to your SAFE holders for no good reason.

*YC will not modify their own Post-Money SAFE for their cohort of accelerator companies. The only way to minimize the economic harshness of its terms is to raise a small equity round as soon as possible after YC to convert their SAFE. 

Why BigLaw Over-Automates Startup Law

TL;DR: BigLaw’s very high operating costs require it to charge 3-4x of what its typical lawyers actually earn. This makes rates often stratospherically high. While billion-dollar companies that use BigLaw can afford those rates, early-stage startups often cannot. BigLaw is responding at times by hyper-standardizing and hyper-automating early-stage work. This has significant downsides, as companies lose out on flexibility, advocacy, and strategic guidance for very high impact projects, like financings. Much of this standardization ends up favoring VCs over startup teams. Elite lean boutique law firms offer an alternative approach, in which lower overhead allows for lower costs without requiring substantial inflexibility. In the end, this trend toward over-automation is leading many clients and lawyers to balk, and alternative approaches for achieving efficiency (while remaining flexible) are rightfully emerging.

Lawyers are not cheap. Elite lawyers – the kind with very extensive top-tier training, experience, and ability to handle high-stakes complexity – are in fact quite expensive.

Then again, elite human talent of all sorts is quite expensive. Top doctors make over half a million a year. Top software developers can make into the millions, and their “bugs” are much more easily corrected than bugs in contracts; which by design often can’t be “fixed” once they are signed.

I candidly find it amusing when “tech people” criticize elite lawyers for the amounts they earn, given what similarly elite talent in other industries (tech included) makes. If you’re expecting an apology, it’s going to be a while.

That being said, criticizing what people earn is not the same thing as criticizing what firms charge. There are in fact quite a few firms in “BigLaw,” including those who work with startups, where a lawyer charging over $1,000 an hour is in fact earning only a small fraction of that, maybe $200 or $250. “The beast” (the bloated institution) absorbs the rest. That, in my opinion as a leader of an elite lean boutique firm precisely designed to address this problem, is a very valid criticism.

Traditional elite law firms in “BigLaw” have virtually all designed themselves, with minor variances, around a similar high-overhead business model. They charge 3-4x+ what their typical lawyers are actually earning. That overhead pays for extremely posh offices designed to signal “prestige,” armies of non-lawyer staff, lavish events and other programming, as well as a small cadre of equity partners who absorb millions, sometimes tens of millions, in profits every year per partner without doing much of the actual billing.

The fact that BigLaw has entrenched itself in this way of doing legal business makes it very difficult, even impossible, to meaningfully address “efficiency” at an institutional level. It would require sacrificing too many sacred cows with political leverage in the firms’ bureaucracies. Thus when BigLaw does try to do something to become more efficient, or at least appear more efficient, its options are constrained. One option that is always on the table is adopting (often pricey) automation software, because it ostensibly allows charging less without actually having to do human legal work (contextual, flexible, strategic) any more efficiently.

Don’t deliver more efficient lawyers. Instead, make clients use dumbed-down, inflexible, and often quite clunky software. They can talk to professionals only once they can afford $900/hr for an associate and $1400/hr for a partner.

I’ve written about this issue before, such as in Vaporware Technology Won’t Hide Your Firm’s Business Model Problems (on Above the Law). Lean elite boutique law firms are about what I call substractive innovation. Finding efficiency by removing unnecessary (for clients) costs, and re-designing a firm’s operations around that leaner operating model. Yes, this does involve technology, but a particular kind of technology meant to replace unneeded overhead and traditional processes; not to simply layer on new software without otherwise changing much at all about the firm itself.

BigLaw, for the above reasons, is usually incapable of this kind of innovation. It virtually always leans more towards additive so-called “innovation” – buying more and more things that purportedly bring efficiency.

Tying this all together. BigLaw – which in 99.9% of cases works with billion-dollar multinational high-stakes projects for whom charging over $1,000 an hour is not a budget problem – has to charge a lot for its lawyers. 3-4x what those lawyers actually earn. The portion of BigLaw that actually touches early-stage startups – 0.1% of what BigLaw as a whole category really does – faces a problem. Early startups are not billion-dollar multi-national entities.

That’s a big constraint on what BigLaw as it relates to startups can really charge. Startups are constantly balking at what they are charged by BigLaw. The way some of BigLaw is addressing this is by removing their elite lawyers almost entirely from that segment of work. Automation – I would say over automation – combined with what is often called in industry circles “de-skilling” (delegating to lower-level staff).

BigLaw is thus heavily incentivized to over-automate Startup Law. As I’ve written before in many contexts, automation in law is not a free lunch. Not even close. It relies on heavy standardization and inflexibility for it to be workable at all. The problem is that a lot of what founders ask lawyers to do in early-stage Startup Law is extremely high-stakes from a financial perspective. Even minor tweaks to language in docs can have 8 to 10+ figure implications. We are not talking about parking tickets or coffee shops.

The extremely myopic way in which pockets of Silicon Valley have over-adopted YC’s Post-Money SAFE is a perfect example of this. Only now are many founders coming to realize how much of an “own goal” it was to let YC pretend their terms were founder friendly and “efficient.” In that article I show how literally adding a single sentence to the Post-Money SAFE can have tens of millions of dollars in improved economics for founders, and yet the vast majority of so-called “efficient” automated startup financing tools to do not allow for this tweak. People are pretending they are saving founders money. What they are really doing is “saving” a few hundred dollars (at most) in legal fees while letting VCs (including YC) take millions from startup teams.

There are countless ways in which over-standardization and over-automation in Startup Law are costing startups and founders enormous amounts of money. Every attempt to create a so-called “standard” term sheet for equity rounds ends up with VC-favorable economic and power terms that simply are in no way, shape, or form a universal “standard.” See also Standardization v. Flexibility in Startup Law.

Because VCs (and accelerators) are “repeat players,” whereas individual founding teams are not, they have the market leverage to heavily bias so-called “standards” in their favor. And the software companies intending to profit from all of this legal hyper-automation are happy to help them in the process. I wrote about the outsized leverage and influence that repeat players have in startup ecosystems, including over many law firms, in Relationships and Power in Startup Ecosystems.

These automated financing software companies – who need law to become hyper-standardized so that they can ever-so-generously step in to charge for the automation – are heavily incentivized to publish biased “data” about so-called “standards.” For example, they’ll build a software tool offering only 2 or 3 ways to do a seed funding, all heavily standardized and therefore inflexible. They’ll market this tool, and then publish data saying things like, “80% of seed deals are Post-Money SAFEs, and so it is a standard.” Actually (if you read the footnotes), 80% of seed deals on your half-baked automated platform are Post-Money SAFEs. Selection bias. That is not the same thing as saying 80% of all seed deals in the country or world are.

These tools are lying with so-called “data” to promote their own wares. For that, who can really blame them? Everyone’s got to make a buck. But let’s please stop pretending that they actually care about what’s best for startups, or their founders and employees. I don’t criticize people for talking their book. I criticize people for pretending to be far more benevolent and selfless than they really are.

Lawyers should be telling startups and their founders whenever they are facing these sorts of issues. They should be telling founders that the Post-Money SAFE is not a universal standard, and that many many deals end up customized, or even with entirely different structures, to make the economics better. They should be negotiating term sheets to better position the governance of their client, instead of letting some VC dictate what “standard” means. Instead, many of them are over-standardizing and over-automating. Why? Because they’re in BigLaw, and that’s what BigLaw does for startups.

Because of its institutional inability to actually do human legal work more efficiently (see above paragraphs), which involves assessing context, negotiating, tweaking, advising, etc., and the fact that Startups cannot pay over $1,000 per hour for extensive advisory, much of BigLaw is choosing to delegate the entirety of early-stage startup law to software. In my opinion, this is an abdication of the responsibility of lawyers to actually advise their clients as to what is best for them. If I were a paranoid BigLaw lawyer, I’d at least worry a little about the malpractice implications of practicing law this way.

On top of the fact that this is not actually in the best interests of startups or their stockholders, many lawyers are themselves starting to balk at the machine-like evolution of BigLaw’s way of operating. Boutique law firms, where the ratio of billed rates to lawyer earnings is more like 2x instead of BigLaw’s 3-4x (dramatic efficiency) are not just about lower rates. In many segments they are emerging as refuges for lawyers who want to step off the assembly line and actually think for their job.

When lawyers are able to charge, say, $500 per hour instead of $1100, they have time to actually negotiate for their clients. On top of this being good for the client (See: Negotiation is Relationship Building), from an intellectual standpoint it’s legitimately more enjoyable. Many ECVC lawyers prefer this way of practice over acting as if every deal before Series B should just be a cookie-cutter template.

The elite boutique law ecosystem (of which Optimal is a part) is thus emerging as a win-win countertrend to BigLaw’s tendency to over-automate and over-standardize. Many elite lawyers are tired of half-baked over-technologized (air quotes) “efficiency” that isn’t really efficient at all because of what the client loses. In moving to boutiques, lawyers get to drop their rates substantially without actually earning less. Clients get to pay substantially lower rates, while getting an actual elite human professional to help them navigate complexities and protect themselves; which many prefer over clicking a few buttons on software without ever being told what their options really were.

To summarize: the traditional cost structures of BigLaw require charging 3-4x+ of what their typical lawyers actually earn. This makes their rates, including for startups, extraordinarily high. Above $1,000 per hour in many cases. Sometimes $2,000+ per hour. Startup clients, who do not fit the billion-dollar mold of BigLaw’s average client, obviously cannot afford stratospheric legal bills. BigLaw is responding by accepting hyper-standardization and hyper-automation for its earliest stage work. Clients spend more and more time interacting with junior professionals and software that operate only in very narrow, inflexible lanes; depriving clients of real advocacy or negotiation on high-stakes issues. As a result of all this, inexperienced startup teams are increasingly pushed into these myopic inflexible fundraising approaches that are costing them enormous amounts of money and governance leverage.

There are ways to avoid this problem. The one I’m obviously an advocate for is to move a lot of this legal work to leaner elite boutiques. Some of the top boutiques in ECVC can deliver real legal horse power, especially in earlier-stage deals (pre-unicorn), at half the rates of BigLaw.

There’s another option: if you absolutely are going to use BigLaw, let them charge you for what the work really takes. Why pay BigLaw at all if you’re not using the real legal talent it is designed to house? If you’re raising a $75 million equity round, yeah, you’re going to pay a few hundred thousand dollars in legal fees with BigLaw if you let them actually do their job. As a percentage of the actual raise, it’s really not that much (under 1%). The alternative – over-automation and over-standardization – will be far worse.

If that doesn’t work for a $5 million or $15 million round, then again I suggest looking into elite boutiques. Their lower rates, but still elite rosters, will produce lower legal bills without compromising on the quality of the actual advisory you’re getting. See How Much Seed Rounds Cost – Lowering Fees and Expenses Safely to understand why boutique law is an increasingly popular option among top startup teams for earlier financing rounds. Boutiques are not doing pre-seed deals all day. We have clients closing Series A, B, C, even later, and exiting at 8-9-figure valuations. As I often say, the B in BigLaw is for billions. There’s a lot that happens before billions.

Straw-man prevention disclaimer – Let me be very clear here. I am not just a Partner at Optimal. I am also its Chief Technology Officer. I work with a lot of legal tech startups. I love legal tech, and I even like targeted, thoughtful automation. I’m particularly interested in upcoming ways to integrate AI to enhance lawyers’ productivity.

Some people with very loud microphones like to pretend that the legal profession is full of nothing but luddites who want to milk the entire world for fully bespoke, terribly inefficient work product. In startup ecosystems, this attitude is most often peddled by (i) VCs who want your lawyers to shut up, because when lawyers shut up VCs get what they want, and (ii) software automation tools; because they want you to use their inflexible software instead of an actual human.

What I am advocating for here is a more balanced perspective on when automation really is in the best interests of legal clients, and really is streamlining things, relative to when it is hiding all sorts of biases and costs because the real driver isn’t what’s best for the client but some extraneous factor like institutional constraints. I’m a big fan of automating basic option grants, which no serious professional wants to waste their time on anyway. But raising millions or tens of millions of dollars, and setting permanent power & governance terms that will influence huge segments of the modern economy? Hold the F up.

As I wrote here, the “values” of the legal industry and the software industry are very different, and both serve a very important purpose in the economy. In legal, it’s expertise, context, flexibility, negotiation, leverage, compromise, trusted advocacy. It’s about having a perspective, and pushing for it, while the other side does the same.

There can be no single answer or “standard” in this value structure, because the decision-makers and process for setting it are suspect, as conflicts of interest and subjectivity abound. Companies are different. Investors are different. Goals, industries, values all vary organically across institutions and contexts. It’s contextual “truth” arrived at via a decentralized adversarial process, as opposed to a centralized proprietary one. This concept is not entirely alien to many engineers.

In software, it’s broadly about standardizing, automating, universalizing, cutting costs and centralizing data. It’s about scale and speed, reducing “friction.” In this worldview, customization and “verification” via independent review is seen as inefficient and pointless. But is it always? When the stakes are really high?

Analogies about making private startup equity operate like “frictionless” liquid public markets are spectacularly flawed. In the latter, the transactions are impacting small percentages of the company’s capitalization, and rarely altering their fundamental governance. What happens in a startup’s earliest days sets the stage for the company’s entire growth. The present dollar value may be small, but the derivative long-term impact is massive. Post-IPO, very little of what’s being negotiated fundamentally changes anything.

Nowhere am I saying here that the legal industry’s values should take full precedence over those of the software industry. Again, I’m a big fan of productivity tools in legal. We just need to avoid myopia in letting the software industry’s values (automation, standardization) steamroll over legal’s as it relates to high-stakes legal work simply because clients think (wrongly) that they have to use BigLaw, and BigLaw can’t make its actual lawyers cheaper. Automation and standardization can be good. Automating and standardizing everything, because we won’t consider alternative possibilities for achieving efficiency, most certainly is not.