Post Category → Seed Rounds

“No Code” v. “Open Source” Approaches to Early-Stage Startup Law

TL;DR: Fully automated startup financing tools often utilize templates designed by and for investors. They claim to save founders money by reducing legal fees, but founders often end up giving 10-20x+ (relative to fees) away in cap table value as a result of the inflexibility and lack of trusted oversight over the “code.” Using vetted and trusted templates, while still incorporating non-conflicted counsel into the negotiation and review process, provides the best of both worlds: common starting points, with flexibility and trust.

Background reading:

“No Code” is a term I’ve been hearing more often lately. It refers to new tools that allow users to “program” various processes without actually having to code them; effectively modules of tools that are interoperable and allow building semi-customized programs without needing to actually get into coding. Very useful.

While “no code” seems to certainly have a good value proposition for many user contexts, it occurred to me recently that “no code” is good short-hand for the startup financing approach that parts of the investor community, and to some extent the tech automation community, has tried to peddle onto startup ecosystems and founders. By pushing the minimization of “friction” in funding (just sign fully automated templates), with the key “carrot” being the reduction in legal fees, these players want founders to think that it’s in their interests to simply close their financings with a few clicks, instead of leveraging lawyers to actually negotiate and flexibly customize the “code” (language).

The reasons behind why tech automation companies would push this perspective are obvious: they want to make money by selling you automation tools. But the reasons why the investor community is incentivized to also back this approach require a bit more explanation. For one example, see: Why Startups Should Avoid YC’s Post-Money SAFE.  First-time founders are what you would call “one shot” players in the startup ecosystem. They are new, inexperienced, and laser-focused on the single company they are building. Investors, including prominent accelerators, are instead repeat players. They are highly experienced, resource-rich, and stand to benefit significantly if they can sway the norms/”standards” of the market in their favor.

The most prominent, high-brand investors have all kinds of microphones and mechanisms for nudging the market in ways to make themselves more money, especially because the founders usually absorbing the content have little experience and knowledge for assessing substance. One of those ways is to push templates that they (the investors) themselves have drafted, and create an impression that those templates are some kind of standard that everyone should adhere to without any customization.  Of course, they’re far too clever to come out and say overtly that these templates are designed to make investors more money, so instead they’ll latch on to more palatable messaging: these templates will save you legal fees and help you close faster.

To summarize, investors and tech automation companies push the “no code” approach to early-stage funding out of self-interest, but they use the “save you legal fees” marketing message to get founders to buy in. The problem that not enough people talk about is that by taking the “no code” approach, founders become permanently stuck with the pre-packaged and inflexible code (contract language) that these players provide. And as I’ve written extensively on this blog, the code is dirty.

I want to emphasize the word permanently here. Look up what most “no code” tools do. They help you sort contacts, build a spreadsheet, maybe build some low-stakes automation processes. Good stuff, but very different from, say, permanently signing contractual terms for millions of dollars that in the long-run can have billion-dollar economic and power implications. In startup funding, we are talking about executing on issues that are literally 1000x more consequential, and un-modifiable once signed, than all the other areas where “no code” approaches are applied.

Having a trusted advisor (lawyer) make even just a few tweaks to a template document, or flexibly choosing a better-fit template to begin with, can have million/billion-dollar implications for a company. Given the enormous stakes involved – what bank account exit money goes into, and who gets ultimate decision-making power over an enterprise – founders need to think very hard about whether getting boxed into an inflexible automation tool, in order to save at most $5-25k in fees in a seed financing, is actually the smart approach. I see inexperienced founders regularly handing over millions in cap table value to investors, and in some instances unwittingly giving those investors strong “choke point” power over their governance, all because the founders were convinced that lawyers are a boogeyman extracting money to just push paper and hand-waive with no value-add.

Notice here that I’m not advocating for a wholesale reversion to the old-school days of simply letting lawyers take full control of the negotiation process, using whatever forms and standards they want. There is enormous value in having market-respected starting points for negotiation; sets of templates known and understood by investors, and trusted by lawyers who represent companies (and not investors), that can then be flexibly modified to arrive at a final deal that makes sense for a specific context. By having your lawyers (who hopefully aren’t conflicted with the investors they’re negotiating with) draft initial deal docs from a reputable template, the lawyers on the investor side can redline against that familiar starting point, instantly reducing the amount of up-front negotiation by 80% because they aren’t working with language (code) they’ve never seen.

What I’m effectively advocating for here is an “open source” approach to high-stakes early-stage startup law. It allows for some standardization (efficiency), but also flexible customization, to ensure every deal is fair for the parties involved. And importantly, it ensures that the templatization and customization is transparent and “open,” with lawyers from both the investor and startup (company-side) community participating; instead of the one-sided “here are the standards” model that certain VCs have tried to adopt. We can deliver founders and investors substantial efficiencies in fundraising, without using “saving fees” as an excuse for burdening founders with inflexibility and “dirty” code (contracts) that simply aren’t justified.

With this in mind, I’ve published a Seed Round Template Library, with links to templates for convertible notes, pre-money SAFEs, seed equity, and full NVCA docs, along with a few educational articles. By using these starting points, founders can have the efficiencies of working from vetted and trusted language, but without the enormous costs of using fully automated templates designed to favor investors.

A Friends & Family (F&F) SAFE Financing Template

TL;DR: An uncapped, discounted SAFE with a special (not conventional) “Super MFN” provision that allows your F&F investors to get a discounted (from your seed round) valuation cap is the best and fairest structure for most friends and family rounds, but none of the public SAFE templates provide for this concept. Uncapped SAFEs are typically designed to provide a discount only on a future equity round (not future convertible round), which means the discount won’t apply if the round after your F&F is another convertible round. Use an F&F SAFE instead to ensure your F&F investors get a fair deal, but you avoid the downsides of setting a valuation too early. This is also the exact structure that most of our clients use for “bootstrapping” investments (from founders into their own companies).

Note: If you’d like to discuss this template or F&F Financings generally, try Office Hours.

Background reading:

For true seed rounds, convertible notes and SAFEs (preferably pre-money, and not post-money, SAFEs) are both viable options, along with equity.

However, for friends and family (F&F) rounds – the first and usually “friendliest” money in the door – there are very good reasons to utilize a SAFE. First, your friends and family are unlikely to be insistent on significant investor protections (like debt treatment), and so they are likely to accept whatever reasonable instrument you ask them to sign. Second, because your F&F round occurs very early in the company’s history, it may be outstanding and unconverted for a long time; which makes having a maturity date of a convertible note more risky.

The problem is that all the SAFE templates currently out there aren’t really well-structured for an F&F round.

Valuation Cap SAFEs – In the case of SAFEs with valuation caps (the most common), an F&F round often occurs so early in the company’s life that setting a valuation is fraught with excessive risk. If you set it too high, you can create unrealistic expectations, and your first true professional round (seed) may end up being a “down round.” If you set it too low (often the case), it can “anchor” the valuation that your seed investors are willing to pay; they’ll question why they should pay X multiples of what your F&F got. We generally recommend that companies avoid valuation caps in their F&F rounds. Whatever you end up picking will just be a random guess anyway. Wait to set any valuations until serious investors are at the table, so they can provide a realistic market check.

Uncapped, Discount SAFEs – Conventional uncapped “discount only” SAFEs are often also a poor fit for an F&F round, because the discount applies only to a future equity round. In the vast majority of cases, your first serious financing after an F&F round will itself be a convertible round (note or SAFE), and so the conventional discount in this SAFE won’t apply. Your F&F may end up getting only a 20% discount on your Series A price, which is quite disproportionate if they invested years before the closing of your Series A round.

MFN SAFEs – The only other public template alternative is a conventional “MFN” (most favored nation) SAFE. This effectively gives your F&F the right to get the same deal that your seed investors get. But is that really fair? If your friends and family invested a year before your seed round investors, before you hit significant milestones, shouldn’t they get a better economic deal than your seed?

Better: an F&F SAFE – For this reason, we’ve found a modified SAFE to be the most logical structure. We’ve taken a conventional SAFE, and added an extra concept to ensure that an MFN provision gives your F&F a discount on the valuation cap that your seed investors get. So, for example, if your seed investors invest in a convertible note with a $10 million valuation cap, this “super MFN” provision will amend the F&F SAFEs to provide an $8 million cap (assuming a 20% discount is provided for). Thus with this structure your F&F get the best deal on the cap table, but you avoid all the downsides of setting a valuation cap too early in the company’s history.

Important note: the F&F SAFE Template can also be an excellent way for founders to paper their own cash investments in their companies. In all cases, consult with counsel before relying on any public template, including this one.

The F&F SAFE Template can be downloaded here.

Myths and Lies about Seed Equity for Seed Rounds

TL;DR: The release of the Post-Money SAFE structure, which has very harsh economics for founders, has incentivized seed investors to perpetuate various myths and lies about alternatives (particularly about seed equity), in order to push founders to accept more dilution than is really necessary. Founders need to look past the spin and self-interested advice, to ensure they are assessing all the variables clearly.

The fundraising advice that vocal investors, many with blogs and twitter accounts, give to first-time founders often closely tracks their own incentives and self-interest. For example, a few years ago before the creation of the Post-Money SAFE, many early-stage investors complained that Pre-Money SAFEs had all kinds of problems, and that founders should strongly consider equity for their seed rounds. That was, of course, because Pre-Money SAFEs were very company (founder) friendly from an economic and governance rights standpoint, and those investors got more of the cap table by hardening their positions via an equity round with extra rights.

But now that YC has taken it upon itself to promote the Post-Money SAFE, which has terrible economics for companies/founders and is great for early-stage investors, suddenly the narrative has flipped. Now many of those same investors sing the praises of SAFE rounds, and have spun all kinds of myths and lies about why seed equity is apparently now such a terrible structure. The point of this post is to dispel some of those myths and lies.

Myth / Lie #1: In an equity round you have to give investors a board seat.

Simple, you don’t. There’s nothing inherent in doing an equity round that requires giving investors a Board (of Directors) seat, and we’ve seen plenty of equity rounds that don’t. On the flip side, some SAFE and convertible note rounds will involve giving a Board seat to investors. Whether or not giving investors a Board seat in your seed round is appropriate or a good idea is entirely contextual, but there’s no connection to that negotiation point and the general structure of the round.

See also: Pre-Series A Boards.

Myth / Lie #2: Equity rounds require you to close all of your investors at once, instead of with “rolling closings.”

Nope. You can do “rolling closings” quite easily in a seed equity round, so there’s no inherent need to have all of the money rounded up at once. Sometimes investors will place a limit of 120-180 days to do those rolling closings, but other times there’s no deadline and it’s open-ended.

Myth / Lie #3: Equity rounds require you to have a lead investor.

It certainly helps to have a lead investor – someone writing a big enough check, and with their own counsel – to do some light review of the equity docs in a seed equity round, but again there’s nothing inherent in the equity structure that requires it. It’s more about the comfort level of the investors. I have seen “party” seed equity rounds where everyone writes a $50K-200K check. It works fine, particularly now that there are relatively well-known seed equity templates out there that can be referenced and recognized among sets of specialized ECVC lawyers.

Myth / Lie #4: Equity rounds take months to close.

I’ve seen seed equity rounds go from term sheet to money in the bank in 2 weeks. Now that’s definitely on the faster end of the norm, and 3-4 weeks is more common. It’s not lightning fast, but neither is it the dragged-out process that some investors suggest it is. The primary drivers of a lengthier timeline are diligence issues (cleanup) and investor negotiations/delays. Nothing inherent in a seed equity round structure requires it to take a long time, given that well-used templates require minimal customization.

Given how high-stakes the terms you’re committing to in any fundraising are, there is some value in slowing down enough to really know what you’re getting into. See: Negotiation is Relationship Building.

Myth / Lie #5: Equity rounds require paying $50-100K in legal fees.

It is true that any equity structure is likely to require somewhat higher legal fees than a SAFE or convertible note round, but seed equity, which is a simplified equity structure relative to full NVCA-style docs (which are more commonly used for Series A and later rounds) isn’t nearly as expensive to close on as some investors suggest. On the leanest end I’ve seen seed equity close for about $10-15K in company-side legal fees, and $5K on the investor side, but more realistically you’re going to be closer to $20K company side and $10K investor side, so about $30K total; possibly higher if you use very expensive firms.

A good ballpark of fees spent from beginning to end for a multi-million dollar SAFE or convertible note round is $2.5K-$5K, so let’s say the delta between convertibles and seed equity is ~$25K in legal fees. The question then becomes, are the positives to closing on a seed equity round worth more than $25K? Very often they are. Easily.

Especially if your investors are asking for a Post-Money SAFE, which has extremely expensive (long-term) anti-dilution mechanics built into it if you end up needing (and likely will) more seed money later, the difference in dilution between a seed equity raise and a Post-Money SAFE can often be multiple percentage points on your cap table. If the difference is 1%, $25K implies a $2.5 million company valuation. If it’s 2%, it’s $1.25 million.

I have seen many companies raising at $10 million, $15 million, even higher valuations in their seed rounds, with multiple million in funding, and yet their investors act as if the extra cost of a seed equity round is so burdensome that the founders should just do a Post-Money SAFE; which in the long-run hands multiple percentage points on the cap table to the seed investors. Basically they are telling founders that they should avoid paying the equivalent of 0.25-0.5% of their enterprise value now in cash for a more hardened, company-favorable deal structure, and instead give 1-2% more of the company as equity (with upside) to the seed investors, which in the long run could be worth millions for the highest-growth companies. That is a horrible tradeoff for the founders.

Translation: “Don’t spend $25K in legal fees now. That’s a “waste of money.” Instead stick to our preferred template and give us 6-7 figures worth of extra equity!”

This isn’t to say that equity is always the right answer for a seed raise. Hardly. Sometimes pre-money SAFEs make sense. Sometimes convertible notes do. I’m a fan of modifying a convertible note to have the economics behave more like equity, but with the streamlined structure of a note; the best of both worlds. And sometimes your investors will demand that you give them a full NVCA suite of docs. Context matters, and so do the numbers.

There’s no universal answer to how you should structure your seed round, because every company is different, and different investors and founders have different expectations, priorities, and preferences. However, not falling for the most common myths and lies that investors give to push you in favor of their preferred structure – which usually is whatever makes them more money – will ensure your eyes are wide open, and you can assess the positives and negatives clearly.