Post Category → Seed Rounds

Optionality: Always have a Plan B

TL;DR: Always build some optionality into your startup’s financing strategy. Failing to do so will overly expose you to being squeezed by sophisticated players who can see how dependent you are on them.

Background reading:

The below is a fact pattern that we have seen happen with several of our clients. It will provide some context for why the point of this post is so important.

Company X has raised a decent-sized seed round, which includes several angels as well as a “lead” VC; though that VC is not on the Board. The Company knows that it will run out of funds in 3 months if it does not raise more money, and it has been in regular communication with the VC about that. The VC reassures the founders that they will “support” them with a new bridge round. A month passes, and the founders ask about the bridge. “Don’t worry, we’ll cover you” is the response. Then another month passes, with more reassurances, but no money. Then 2 weeks before their fume date (the date they’ll miss payroll), the VC drops a term sheet with very onerous terms, including a low valuation, and mandated changes to the executive team. The VC makes it clear that they won’t fund unless those terms are accepted. The founders panic. 

Before we dive in, there are a few important points worth making about this situation. First, it was clear every time that it has come up that the bait-and-switch dynamic was planned by the lead investor. They paid very close attention to the exact date that the Company would run out of funds, and timed the “switch” to deliver maximal pressure. Second, the regular “reassurances” provided to the founder team were calculated to discourage them from using their time to find other funding sources. Third, the best way to avoid investors who engage in this kind of “below the belt” behavior is to do your diligence before accepting their check; see: Ask the Users. 

Always have a Plan B.

A startup’s ability to avoid being burned by the above behavior depends on its level of strategic optionality.  Optionality means strategically avoiding a situation in which you have no choice but to depend on one investor/investor group for funding. This is very different from not committing to certain lead investors as your main funding sources. “Party rounds” are what you call financings where literally every investor is a small check. The end-result of a party round is that no one has enough skin in the game to really support the company when it hits a snag. You really are just an option to them. 

I strongly support having true lead investors writing larger checks in your rounds, because they will usually provide far more support than just money. And if you’ve done your homework and have a little luck, they’ll never even think about engaging in the kind of behavior described above. But in all cases the best way to maximize the likelihood of good behavior is to ensure a right of exit if someone decides to cross a line. I always try to work with “good people.” But no good strategist builds their life or company around the full expectation that everyone will be good. 

Lead fundraising yourself.

CEOs sometimes believe that they are doing themselves a favor by letting a lead investor do their fundraising for them – coordinating intros, negotiating terms with outsiders, etc. – so they can “focus on the business.” It often backfires. Angels and seed funds whose money has been sunk into the company, and who aren’t planning on writing larger checks in the future, are usually quite aligned with the founders/common stock in helping raise a Series A or future round. They’re being diluted just like you are.

But a VC fund with plenty of dry powder and a desire for better future terms is significantly mis-aligned with everyone else. Watch incentives closely.  Founders/the lead common holders should maintain visibility and control in fundraising discussions, with trusted independent advisors close by. 

Start early, and don’t tolerate unnecessary obfuscation and delays. 

Do not wait until a few weeks from your fume date to start communicating with investors for new funds. If someone says they will support you, great: when, and what are the terms? You want to know them now, not later. “We will support you” means very little without knowing what the price will be.

Expecting things to happen in a few days is unrealistic, but a month or more of delays is usually a sign that someone is playing games, and it’s time to pull the plug. No serious fund worth working with is that busy.

Build “diversity” into your investor base.

The power dynamics in a company are very different when all the major investors have strong relationships/dependencies with each other, and communicate regularly, relative to when various players come from different “circles.” Geographic diversity – meaning taking money from various cities/states – is a good strategy to avoid unhealthy concentration of power among your investor base. Also, diversity of investor types – angels, seed funds, institutionals, strategics – will ensure that your investor base includes people with differing incentives/viewpoints, which reduces the likelihood of collusion. 

In the scenario where a bad actor has tried a “bait and switch” on a founder team, a group of angels willing to write quick checks for an emergency bridge, or a lender offering a credit line, can be enormously valuable to relieve pressure and build time to correct course.

Contracts matter. A lot. 

Every commitment you make to investors requiring their approval, or guaranteeing their participation, in future rounds can have material strategic implications for how much optionality you have. Protective provisions matter. Super pro rata rights and side letters matter.  When you see dozens of financings a year, you regularly see how commitments made at seed/pre-seed stage play out over years and seriously affect the course of fundraising.

Good lawyers well-versed in the ins and outs of startup financing will go much further than just plugging some numbers into a template, which software can do.  They’ll dig deep on how the specific terms you’re looking at will impact the company, in its specific context, and how much room there is to stay within “market” norms while still keeping flexible paths open for the future. That’s, of course, assuming they aren’t actually working for your investors.

Make money, and own your payroll.

The ultimate optionality is being able to run on revenue if you need to; being “default alive” in Paul Graham’s words. Yes, you may grow slower than you’d like, but growing more slowly is always lightyears better than being forced into a bad deal.

Every salaried employee on your payroll raises the revenue threshold needed for your company to be default alive. Ensure that every member of your roster is essential, and that there aren’t redundancies that could be addressed by asking someone to be more of a generalist. And don’t let an institutional investor pressure you into hiring a high-salaried professional executive unless you have a clear strategy for how you are going to afford them, because, yes, that is another way that they can add fundraising pressure.

Stay in control of your fundraising. Start discussions early, and don’t tolerate delays. Build diversity of geography and incentives into your investor base. Let your lawyers do their actual job. And finally, watch your payroll closely. Following those guidelines will minimize anyone’s ability to squeeze you, and your investors will then act accordingly.

ICOs and Crowdfunding

TL;DR: Crowdfunding failed at fulfilling its goal of unlocking a massive new source of unprofessional capital for startups. Regulated, fully legally compliant token offerings (not the mostly unlawful ones done historically) may succeed where crowdfunding failed.

I am not going to spend any time in this post explaining or defining ICOs or Crypto. I know most SHL readers are familiar with them and, if not, a quick google search will do the job.

There was a time, I would say between 2016 and some of 2017, during which ICOs/Token Offerings were certainly on our firm’s radar as potential fundraising mechanisms for startups, but we were highly skeptical of their legal compliance; for reasons that the SEC and other regulatory agencies have now made clear. It is safe to assume that the vast majority of crypto tokens today are securities under U.S. law and that, just like a convertible note or SAFE, U.S. companies issuing them need to find some way of staying within the applicable legal boundaries. Forming some offshore entity to try to get around the securities law issues (tax issues are a separate matter) is playing with fire, and don’t expect us to play with you.

On top of the obvious legal issues, our skepticism of ICOs was supported by the fact that most of the teams we saw pursuing ICOs were, shall we say, not the “caliber” we like to work with. It was clear that in the early days the ICO space had an adverse selection problem: putting aside the small number of stellar teams building unicorns with legitimate reasons for being in crypto, the significant majority of the projects pursuing ICOs were simply the rejects of the conventional angel/seed fundraising world.

In other words, my skepticism of ICOs paralleled to a large extent my skepticism of “crowdfunding.” While the pre-sale kind of crowdfunding (Kickstarter, Indiegogo) has clearly been impactful, securities crowdfunding was pitched to the world as opening the floodgates of this vast world of middle class capital just dying to get into hot startups. It didn’t work out that way.

First, the middle class in America is trying hard to afford college, housing, and healthcare, and have some kind of retirement in place. It never was dying to invest in startups; beyond the occasional “man I wish I’d gotten into Facebook” hindsight remark. Second, average investors aren’t stupid, and are well aware that most crowdfunding sites are not full of A-level teams, but are often packed with the teams rejected by professional angel and seed investors. Startup investing in general is extremely high-risk even for professionals. Given the adverse selection issues, it’s orders of magnitude riskier for every-day investors seeing only the bottom 20%. Given all of this, the supply of capital simply isn’t there.

As of today, the impact of non-accredited investor crowdfunding on the general startup ecosystem has been marginal, at best, and I don’t see that changing much in the near future.

But… over the past year or so I’ve come to believe in the possibility that legally compliant (regulated) ICOs/token offerings may have a legitimate shot at realizing crowdfunding’s unfulfilled dreams. Here’s why: 

A. Unlike the average middle class American, the newly created “crypto rich” have (i) significant disposable income and, (ii) from the simple fact that they got into crypto early, tend to be much more tech literate and interested in early-stage projects than the average investor. They trust their ability to judge early-stage technology, and are therefore willing to invest in risky projects.

B. Regulatory agencies, instead of pounding the industry into non-existence by banning everything, have instead taken a more measured approach by going after the most egregious bad actors, but also extending an olive branch to those interested in finding fundraising mechanisms compatible with a valid legal framework.

C. Crowdfunding platforms, eyeing an opportunity to tap a market that actually exists, are pivoting toward supporting ICOs/token offerings that work within the legal framework created by the crowdfunding movement. That framework certainly adds some friction around how the classic wild-west “easy money” ICOs have historically been conducted, but it is significantly more greased (and could be greased further) than conventional startup investing; including “mini IPO” regulations that were previously passed that could allow tokens to be traded openly in a way that doesn’t bust securities laws.

D. The average caliber of teams we see approaching us with an interest in a token offering has gone up significantly. We have a few clients actively working on token offerings fully compliant with securities laws right now.

E. While most token offerings until now have involved utility tokens that actually serve a function in the operation of the company’s technology (which limits the types of companies that can offer them), the infrastructure is being built for “security tokens” that allow almost any asset – including shares in a corporation – to be sold and traded much like utility tokens.

I was quite skeptical of non-accredited “crowdfunding” generally. I was also deeply skeptical of the easy-money ICO boom that made headlines over the past few years. But I’m becoming cautiously optimistic that the infrastructure and demand is coming for a legally compliant ICO/Token Offering wave that could win where crowdfunding lost. The next 2 years will be interesting to watch.

Standardization v. Flexibility in Startup Law

TL;DR: Standardization reduces time and fees, but at the cost of increased inflexibility. And sometimes, flexibility matters more.

Related reading:

Imagine you’re about to have a baby. You start asking your OBGYN about the facilities, preparations, etc., and the response you get is: “don’t worry about it, it’s all standard.”

Ok…, but your family has a history of certain unique hereditary conditions. Things can go wrong. You try to prod further. “Don’t worry, everything is going to be standard procedure.”

Are all people “standard”? Well, are all companies?

Standardization has its place, and certainly has its benefits. Those benefits include:

  • Lower Costs (at least upfront);
  • Faster execution, often enabled by technology;
  • Easier review.

In short, standardization makes things cheaper and faster. As great as that is, for any high stakes situation, a half-intelligent person will step back and ask: are speed and low cost really my top priorities here?

The purpose of this post is to discuss why the general push toward standardizing all financing (and other) documentation for startups, while clearly lowering up-front legal fees, is not always as “founder friendly” as the automation companies, investors, and other parties who also benefit from standardization, would have you believe. Nothing is free.

As I’ve written before a few times: “don’t ask your lawyers about this” sounds sketchy, and potentially raises red flags. If you want a novice team to simply move on and not ask questions, a real chess player will say “let’s save some legal fees.”

We’re negotiating over millions of dollars with potentially tens or hundreds of millions in long-term implications, but great, let’s save a few thousand in legal fees now by “streamlining” things. Right.

Who chooses the “standard”?

By far one of the most over-used phrases I hear in financing negotiations is “this is standard.” Says who? Do you have data? When you personally close dozens of financings a year across state lines, and have visibility into hundreds, like our lawyers do, it is very amusing when someone who makes maybe a handful of investments a year starts trying to lecture you on what’s “standard.”

The other day I heard a VC say that not having an independent director on the Board post-Series A is “standard,” and virtually everyone else in the room could smell the manure.

If you are looking to adopt market “standards,” make sure they are actually standards. Work with advisors with broad market experience to verify claims, and triangulate advice from multiple, independent advisors. Don’t let anyone simply dictate to you what the “standard” is. 

Serial players benefit from standardization. It’s not about saving companies legal fees.

Investors have portfolio incentives; meaning that they have their bets spread around a dozen or two dozen companies, sometimes much more if they’re a “spray and pray” kind of fund. For investors who look for unicorns, they expect most of their investments to fail, and just need 1 or 2 grand slams to make their returns. Unicorn investors demand very high growth, because even if such an approach can increase the number of failures, it will also maximize overall returns across the portfolio by turning up the juice on the 1 or 2 unicorns.

Entrepreneurs and their employees, on the other hand, have “one shot” incentives. Their net worth is concentrated in one company, and therefore the specific details, and risks, applied to their specific company matter a lot more to them.

The emphasis on very fast, very cheap financings benefits, above all else, large investors with broad portfolios who are looking to minimize their costs on any particular bet. It is not something developed out of beneficence toward companies; who often stand to gain more from adopting structures better suited to their specific circumstances. 

Standardization necessitates inflexibility, and when you’re fully invested for the long-haul in one specific company, flexibility may matter much more to you than simply moving as fast and cheaply as possible.

So who is standardization really for? The people who work in volume.

Lies about fixed legal fees.

One of the worst lies spread throughout some startup law circles is that fixed fees somehow “align” incentives between clients (companies) and lawyers. The argument is that, if lawyers bill by the hour, they will simply bill endlessly without reason. Thus, fixing their fees “solves the problem.”

Except it doesn’t.

Assuming all lawyers are principle-less economic actors who will do whatever maximizes their profits (cynical, but the general argument here is cynical), fixing legal fees does not align incentives between a client and the lawyer; it reverses them.

If Mr. Jerk Lawyer will run up the bill unjustifiably when the economics are hourly, he will, once you fix his fees, reverse course and do the absolute bare minimum necessary to complete the work; pocketing the difference. Why put in that extra hour or two to discuss a few nuances with potentially very material implications to the team, if it just hurts my fixed fee ROI? “This is fine and standard” is a much easier answer. Trust me, the minimum professional standards to avoid malpractice are very low. Close the deal, and move on to the next one.

Oh, but wait, the fixed fee proponent would retort: the fixed fee lawyer will still do a great job because he’s concerned about reputation. Response: (i) isn’t the hourly billing lawyer also concerned about reputation? (ii) you often don’t find out whether the lawyering you got was “good” or “bad” until years later. The difference between great counsel and bad counsel is in nuanced, long-term details not visible at closing. A-players and C-players can both close deals. I’ll let you guess which ones more often agree to fixed fees. 

There is a place for fixing legal fees when the work being done really is commoditized, and not of high strategic significance to a company in the long-term.  But anyone who thinks that fixed fees are some kind of magical solution to long-term lawyer-client relationships is, to put it bluntly, full of sh**. In attempting to solve one problem, they create other ones. So let’s all please stop pretending that when investors insist that you cap your legal fees when negotiating against them that they’re doing it to save you money. It’s a way to get your lawyers to stop talking to you. 

Our view is that clients definitely deserve some level of predictability in their fees, and we provide that by crunching data across our broad client base, and providing clients budget ranges based on that hard data. We also keep clients regularly updated on accrued billings, to avoid surprises. I promise to deliver transparency and data-driven predictability within reason, but I need, and smart clients want me to have, the flexibility to address unforeseen issues that, in my judgment, are material enough to fix, even if I could get away with ignoring them without anyone noticing for years.

Reputation plays a huge role in keeping legal fees reasonable. You’ll go much further diligencing a set of lawyers, asking their clients whether they feel they keep their bills honest, instead of adopting some nonsense idea that fixing/capping fees will magically produce the outcome you really want.

Standardization and Flexibility need to be balanced.

All good startup lawyers adopt some level of standardization, as they should. There is a lot of room for creating uniform practices that save time and money, without damaging quality and flexibility. But any attempts to pretend that complex, high-stakes law can be “productized” should raise serious skepticism, at least from entrepreneurs who view their company as something more than just another cookie-cutter number in someone else’s portfolio.

If I refuse to fix all of my legal fees, it’s because the reality of serious startup law does not fall along some neat bell curve; not when you represent a diverse client base, with diverse goals beyond simply getting as big as possible as fast as possible. There is far more qualitative nuance to strategic lawyering than there is even in healthcare, where the goals are much cleaner, quality is more easily evaluated, and the base structure of each “client” (biology) is more uniform. Business goals are subjective, and the right outcome for one client may look totally different for another, requiring totally divergent, and unpredictable, levels of work. That requires flexibility, both in process and pricing.

Where the final outcome really matters, speed and low cost are not the top priorities. Leave room for flexibility and real strategic guidance, or you’ll move very fast and very cheaply right into a brick wall.