Post Category → Seed Rounds

The Problem with Short Startup Term Sheets

TL;DR: Shorter term sheets, which fail to spell out material issues and punt them to later in a financing, reflect the “move fast and get back to work” narrative pushed by repeat players in startup ecosystems, who benefit from hyper-standardization and rapid closings. First-time entrepreneurs and early employees are better served by more detailed term sheets that ensure alignment before the parties are locked into the deal.

Related reading:

In my experience, there are two “meta-narratives” floating around startup ecosystems regarding how to approach “legal” for startups.

The first, most often pushed by repeat “portfolio” player investors, and advisors aligned with their interests, is that hyper-standardization and speed should be top priorities. Don’t waste time on minutiae, which just “wastes” money on legal fees. Use fast-moving templates to sign a so-called “standard” deal.  Silicon Valley has, by far, adopted this mindset the furthest; facilitated in part by the “unicorn or bust” approach to company building that its historically selected for.

An alternative narrative, which you hear less often (publicly) because it favors “one shot” players with less influence, is that there is a fundamental misalignment of interests between those one shot players (founders/employees, common stockholders) and the repeat players (investors, preferred stockholders), as well as a significant imbalance of experience between the two camps. Templates publicized by repeat players as “standard” are therefore suspect, and arguments that it’s *so important* to close on them fast should cause even more caution.

Readers of SHL know where I stand on the issue (in the latter camp).  Having templates as starting points, and utilizing technology to cut out fat (and not muscle), are all good things; to a point. Beyond that point, it becomes increasingly clear that certain investors, who are diversified, wealthier, and have downside protection, use the “save some legal fees” argument to cleverly convince common stockholders to not ask hard questions, and not think about whether modifications are warranted for their *specific* company. Hyper-standardization is great for a diversified portfolio designed for “power law” returns. It can be terrible for someone whose entire net worth is locked into a single company.

Among lawyers, where they stand on this divide often depends (unsurprisingly) on where their loyalties lie. See: When VCs “Own” Your Startup’s Lawyers.  Knowing that first-time founders and their early employees often have zero deal experience, and that signing a term sheet gets them “pregnant” with a “no shop” and growing legal fees, it’s heavily in the interest of VCs to get founders to sign a term sheet as fast as possible. That’s why lawyers who are “owned” by those repeat players are the quickest to accept this or that “standard” language, avoid rocking the boat with modifications, and insist that it’s best for the startup to sign fast; heaven forbid a day or two of comments would cause the deal to “fall through.”

I was reminded of this fact recently when Y Combinator published their “Standard and Clean” Series A Term Sheet.  It’s not a terrible term sheet sheet by any means, though it contains some control-oriented language that is problematic for a number of reasons and hardly “standard and clean.” But what’s the most striking about it is how short it is, and therefore how many material issues it fails to address. And of course YC even states in their article the classic repeat player narrative: “close fast and get back to work.”  The suggestion is that by “simplifying” things, they’ve done you a favor.

Speaking from the perspective of common stockholders, and particularly first-time entrepreneurs who don’t consider their company merely “standard,” short term sheets are a terrible idea. I know from working on dozens of VC deals (including with YC companies) and having visibility into hundreds that founders pay the most attention to term sheets, and then once signed more often “get back to work” and expect lawyers to do their thing. It’s at the term sheet level therefore that you have the most opportunity to ensure alignment of expectations between common stock and preferred, and to “equalize” the experience inequality between the two groups. It’s also before signing, before a “no shop” is in place, and before the startup has started racking up a material legal bill, that there is the most balance and flexibility to get aligned on all material terms, or to walk away if it’s really necessary.

A short term sheet simply punts discussions about everything excluded from that term sheet to the definitive docs, which increases the leverage of the investors, and reduces the leverage of the executive team. Their lawyers will say this or that is “standard.” Your lawyers, if they care enough to actually counsel the company, will have a different perspective on what’s “standard.”  This is why longer term sheets that cover all of the most material issues in VC deal docs, not just a portion of them, serve the interests of the common stock. It’s the best way to avoid a bait and switch.

To make matters even worse for the common stock, it’s become fashionable in some parts of startup ecosystems to suggest that all VCs deals should be closed on a fixed legal fee; as opposed to by time.  Putting aside what the right legal cost of a deal should be, whether it’s billed by time or fixed, the fact is that fixed fees incentivize law firms to rush work and under-advise clients. Simply saying “this is standard” is a fantastic way to get a founder team – who usually have no idea what market norms, or long-term consequences, are – to accept whatever you tell them, and maximize your fixed fee margins. Lawyers working on a fixed fee make more money by simply going with your investors’ perspectives on what’s “standard” and “closing fast so you can get back to work.” For more on this topic, see: Startup Law Pricing: Fixed v. Hourly. 

When the “client” is a general counsel who can clearly detect when lawyers are shirking, the incentives to under-advise aren’t as dangerous. But when the client is a set of inexperienced entrepreneurs who are looking to their counsel for high-stakes strategic guidance, the danger is there and very real; especially if company counsel has dependencies on the money across the table (conflicts of interest). For high-stakes economics and power provisions that will be permanently in place for a long time, the fact that investors are often the ones most keen on getting your lawyers to work on a fixed fee, and also seem to have strong opinions on what specific lawyers you’re using, should raise a few alarm bells for smart founders who understand basic incentives and economics. If your VCs have convinced you to use their preferred lawyers, and to use them on a fixed fee, that fixed fee is – long term – likely to help them far more than it helped you.

Much of the repeat player community in startup ecosystems has weaponized accusations of “over-billing” and “deal killing,” together with obviously biased “standards,” as a clever way – under the guise of “saving fees” – to get common stockholders to muzzle their lawyers; because those lawyers are often the only other people at the table with the experience to see what the repeat players are really doing.  

The best “3D Chess” players in the startup game are masters at creating a public persona of startup / founder “friendliness” – reinforced by market participants dependent on their “pipeline” and therefore eager to amplify the image – while maneuvering subtly in the background to get what they want. You’ll never hear “sign this short template fast, because it makes managing my portfolio easier, and reduces your leverage.” The message will be: “I found a great way to save you some fees.”

I fully expect, and have experienced, the stale, predictable response from the “unicorn or bust” “move fast and get back to work” crowd to be that, as a Partner of a high-end boutique law firm, of course I’m going to argue for more legal work instead of mindlessly signing templates. Software wants to “eat my job” and I’m just afraid. Okay, soylent sippers. If you really have internalized a “billion or bust” approach to building a company, then I can see why the “whatever” approach to legal terms can be optimal. If you’re on a rocket ship, your investors will let you do whatever you want regardless of what the docs say; and if you crash, they don’t matter either. But a lot of entrepreneurs don’t have that binary of an approach to building their companies.

Truth is that, in the grand scheme of things, the portion of a serious law firm’s revenue attributed to drafting VC deal docs is small. Very small. You could drive those fees to zero – and I know a lot of commentators who simply (obviously) hate lawyers would love that – and no one’s job would be “eaten” other than perhaps a paralegal’s.  It’s before a deal and after, on non-routine work, and on serious board-level issues where the above-mentioned misalignment between “one shot” and repeat players becomes abundantly clear, that real lawyers separate themselves from template fillers and box checkers. The clients who engage us know that, and it’s why we have the levels of client satisfaction that we do.  We don’t “kill deals,” because it’s not in the company’s interest for us to do so. But we also don’t let veiled threats or criticisms from misaligned players get in the way of providing real, value-add counsel when it’s warranted.

So while all the people pushing more templates, more standardization, more “move fast and get back to work” think that all Tech/VC law firms are terrified of losing their jobs, many of us are actually grateful that someone out there is filtering our client bases and pipelines for us, for free.

Contracts v. Might Makes Right

TL;DR: When a first-time entrepreneur is navigating an environment full of entrenched players who all know and depend on each other, the difference between a balanced decision process and a shake down can come down to a contract. Take contracts, and the independence of the lawyers who help negotiate them, seriously.

Background reading:

A background theme of many SHL posts is the following: entrepreneurs enter their startup ecosystems, from the beginning, at a massive structural disadvantage relative to the various market players they are going to be negotiating with. Everyone else knows each other, has worked with each other over the years, and has already made their money. And then you show up.

Now assume that environment as the background, and then imagine you start striking deals with these people: for a financing, a partnership, participation in a program, etc., but assume there are no contracts or lawyers involved. What do you think will eventually happen? Here’s how it will play out: as long as you continue to deliver exactly what everyone wants from you, very little will happen. When everyone’s expectations and preferences are 100% aligned in the short term, the absence of contracts means very little. They’ll “let” you stay in the spot you’re in. 

Until things (inevitably) go sideways. A market shift suddenly means a change in strategy might be necessary, but there’s disagreement on how and when. A quarter comes in under projections, and there’s disagreement as to what that means. A potential outside investor expresses interest in making an investment, and there’s internal disagreement as to whether it should be pursued.

I focus here on the word disagreement, because in many situations on high-level strategic issues, the right answer isn’t always clear cut. The goal (grow the company, improve economics) may be clear, but the right execution strategy is far harder to see.  People will disagree, and where they stand on an issue often rests on where they sit. For example, “portfolio” players (institutional investors) will often be far more comfortable, and even insistent, on taking higher risk (but much higher reward) growth strategies than entrepreneurs and employees, who have only “one shot.”  See Common Stock v. Preferred Stock for a more in-depth discussion on the substantial misalignment between “one shot” players (entrepreneurs, employees), who usually hold common stock, v. portfolio/repeat players (investors), who usually hold preferred stock.

The core point of this post is this: in an environment of substantial disagreement, and where everyone other than the entrepreneur is a repeat player that knows and has economic ties to each other, the first-time entrepreneur (who speaks for the early common stockholders generally) will lose every time: unless contracts in place say otherwise. 

In the absence of laws and contracts, the law of the market is “might makes right,” and established, repeat players have all the might.  

Here is a scenario that I’ve encountered far too often (although increasingly less so as awareness has increased) that is almost comical when viewed objectively:

  • A financing has closed, putting in place a “balanced” Board of 2 VC directors, 2 common directors (one of which is a new CEO, the other a founder), and an “independent” director.
  • In attendance at the meeting are 6 people: the Board and company counsel.
  • The 2 VCs regularly syndicate deals with each other and have known each other for a decade.
  • The new CEO is a well-known professional CEO who has worked in several portfolio co’s of one of the VCs, and was “recommended” by that VC for the position.
  • The “independent” director is an executive well-known in the local market who also has worked with the VCs at the table for over a decade, both of whom recommended her for the position.
  • “Company counsel” represents 6 portfolio companies of the VCs at the table, and has represented them as investor counsel on as many deals, and is actually currently doing so for other deals. In fact, company counsel became company counsel because he came “highly recommended” by the VCs when they were first negotiating the deal with the entrepreneur.

So let’s summarize: there are 6 people at the meeting, and 5 of them have all worked with each other for over a decade, regularly send deals to each other, and in some cases (at least with respect to the lawyer and a VC) are currently working with each other on other deals not related to this company. And then there’s the entrepreneur.

Wow, now there’s one “balanced” Board, don’t you think? I’ve encountered entrepreneurs (whose companies are not clients) in this situation before. I let them know that, whatever they think their position at the company is or will be, they are simply leasing that position until their investors, who hold virtually all the cards and relationships, decide otherwise; and regardless of what the common stockholders think. It’s possible things turn out fine, as long as all goes as planned. It’s also very possible they won’t.  But what’s absolutely clear is who decides, in the end.

The difference between a well-advised entrepreneur and the one in the above scenario is this: the former will have real protections in place to ensure the common stock are treated fairly, and have their voice on key company matters. The latter may feel protected, but ultimately their position is at the discretion of their investors; and protection that is contingent on the whims of people on the other side isn’t protection at all.

Well-drafted contracts are, when negotiated in a transparent manner, a key mechanism for controlling the power of sophisticated repeat players who, absent those contracts, can simply force through whatever they want because of their political / economic leverage. What else might this reality tell us about negotiation dynamics in startup ecosystems?

Rushing through negotiations / contract drafting favors established players.

If the default market position gives power to established players, and contracts are a mechanism for controlling that power, the inevitable result is that those established players (at least the most aggressive ones) will try to get entrepreneurs to rush through contract negotiations.

“Let’s just go with what’s standard.”

“It’s all boilerplate.”

“Let’s save legal fees and put them toward building the business.”

“Time kills deals. Let’s get this closed.”

If someone is telling you that what the documents say doesn’t really matter, or that you should just stick to a template, it’s because, outside of the contract, they’re in control.  That doesn’t mean you should burn endless amounts of time negotiating every point, but take the material provisions seriously.

A market ethos of “relax, we’re all friends here” is designed to favor power players.

Old-school business folks know very well how large amounts of alcohol have often been used to seal business deals. In the startup world, alcohol may still be used, but just as effective is fabricating an environment suggesting to first-time entrepreneurs that everyone is just holding hands and singing kumbaya, and being independently well-advised isn’t necessary.

I’m all for having very friendly relations with your business partners. Life is too short to work with people you don’t get along with well.  But any time someone extends that thinking to the point of telling entrepreneurs that “everyone is aligned” and they should let go of the skepticism to focus on “more important things,” I call bullshit. Alcohol and kool-aid; stay sober in business.

“Billion or bust” growth trajectories mean contracts matter less. Outside of those scenarios, they matter more. 

Among emerging company (startup) lawyers, it’s always been well-known that the Silicon Valley ecosystem as a whole takes standardization, automated templates, and rapid angel/VC closings to an extreme relative to the rest of the country/world. I’ve pondered why that’s the case, and in discussing with various market players, concluded that it has a lot to do with the kinds of companies that Silicon Valley tends to target: billion or bust is a good way to summarize it. I wrote about this in Not Building a Unicorn. 

If the mindset of an ecosystem is significantly “power law” oriented in the sense that “winners” are billion-dollar companies, and everyone else will just crash and burn trying to be one of those billion-dollar companies, I can see why the finer details of deal negotiation may be seen as an afterthought. That environment, which is very unusual when compared to most of the business world, leaves a lot less room for the “middle” scenarios – things aren’t going terribly, and we’re clearly building a solid business. but neither is this a rocket ship, and there are hard questions to be decided – where the deep details of who has what contractual rights really matter.

In a heavily binary “unicorn” world, you’re either knocking it out of the park, in which case no one even reads the contracts and just lets you do your thing, or you’re crashing and burning, in which case the docs are just useless paper. As a law firm headquartered in Austin and structured for non-unicorns, we don’t work in that world, and actually avoid it.

For true “balance,” pay close attention to relationships.

In my opinion and experience, the best outcomes result when the power structure of a company (both contractual and political) doesn’t give any single group on the cap table the ability to force through their preferences, but instead requires some hard conversations and real “across the aisle” coalition building to make a major change.

Balanced boards are, on top of other contractual mechanics, a fantastic way of achieving this, when they are in fact balanced. The above-described scenario where everyone except for the entrepreneur knows and has strong economies ties to each other, including a company counsel “captive” to the VCs, is a joke; and sadly, a joke played on too many startups.

As I wrote in Optionality: Always have a Plan B, build diversity of relationships into your Board and cap table. Feel free to let “the money” recommend people, because their rolodexes are valuable, and are often part of the reason why you’ve engaged with them. But you should be deeply skeptical of any suggestion that the preferred stockholders should, alone, decide who the CEO is, who company counsel is, who the independent director is, etc. etc. Letting them do that certainly may get your deals and decisions closed faster, but unless you are successful in delivering a true rocket ship, you will ultimately regret it.

The common stock, including the founding team and early employees, need a strong voice at the table, especially given the power imbalance with repeat players. Well-negotiated contracts and independent, trustworthy company counsel are the way to ensure they have that voice.

How Angels & Seed Funds compete with VCs

TL;DR: The emerging “seed ecosystem” of angel groups, seed funds, and accelerators now provides local startups a viable path to seed funding, and eventually “going national,” w/o having to prematurely commit to a Series A lead.  That has dramatically reduced the leverage that local institutional funds once had over their local ecosystems.

Background Reading:

Once upon a time, startup ecosystems (if they could even really be called that) outside of Silicon Valley had only a handful of local VC funds writing checks. Without AngelList, LinkedIn, Twitter, Accelerators, good videoconferencing, and the many other recent developments that have reduced geographic friction in startup capital flows, those funds effectively “owned” their cities, including most of the startup lawyers in those cities; which often resulted in harsh terms and aggressive behavior. For more on this, see: Local v. Out-of-State VCs.

Raising “angel” money in that era often meant needing close connections (family, friends, professional) to very high net worth individuals willing to make big bets on you until you were ready for one of the few local funds to take you under their wing. If you were one of those lucky few chosen, those local VC funds would then, once they were out of their own capital, show you off to one of their trusted out-of-state growth capital funds.

The pipeline was narrowly defined, and choice was minimal: local angels (or friends and family), then local VC, then out-of-state growth capital.

Times have changed.

Today, angel groups are much bigger, organized, and collaborative across city and state lines. Seed funds – which weren’t really even much of a concept a few years ago – will write checks of a few hundred thousand to a few million dollars for rounds that may have been called Series A 3-5 years ago, but are now “seed” rounds. Prominent accelerators have themselves joined the mix, writing their own 6-figure checks and serving as valuable filters / signaling mechanisms to reduce the search costs of investors.

This “seed ecosystem” of organized angels, flexible seed funds, and accelerators has not only increased the amount of “pre-VC” capital available to startups, but very importantly, it has significantly reduced the leverage that local VC funds have over their local startup ecosystems. 

As I wrote in Optionality: Always have a Plan B, sunk money has very different incentives from future money. A seed fund/angel that has mostly maxed out the amount of capital it can fund you with has every incentive to help you find a great Series A lead at a great valuation; they are quite aligned with the common stock. They want a higher valuation and better terms for the existing cap table, just like you do, because they are being diluted too.

However, a VC fund that wrote you a small seed check but wants to lead your Series A has very different incentives. The “seed ecosystem” wants to maximize your Series A options, while a VC fund wants to minimize them, until it gets the deal it wants.

Foreign capital will usually require some heightened level of de-risking or credible signaling before it will cross state lines. It’s much less risky to rely on my local referral sources, and “monitor” my portfolio where I can drop in by the office whenever I need to. If I’m going to write a check a thousand miles away, I need a little more reason to do so. In that regard, it’s well-known that there is a “flipping” point beyond which the pool of capital available to a startup moves from being mostly local to much more national: that point is somewhere between $500k-$2MM ARR (it used to be higher, and can be even lower if you have a strong network). 

Historically, reaching that flipping point was almost impossible without local VC, and this effectively kept startup ecosystems captive to their local funds. The new seed ecosystem, with its ability to often fund 7-figure rounds all on its own, has changed that. Now, if a desirable startup wants to, it can often raise $1-2MM in seed capital without taking a single traditional VC check, then use that to hit the “flipping” point, after which the number of VCs it can talk to goes up considerably. 

Of course, this dynamic is not always so clean cut.  More progressive VCs have wisely developed symbiotic relationships with this seed ecosystem for the obvious reason that it can serve as a pipeline when startups are ready for bigger checks. That is a smart move. What we’ve also seen is that large VCs are playing much “nicer” in seed rounds than they used to, as an acknowledgement of their reduced control over the market. Years ago you much more often saw VCs condition a $250K or $500K check on a side letter giving them the right to lead your Series A. That is increasingly becoming an anachronism, and for good reason.

At the same time that AngelList, accelerators, LinkedIn networks, and other signaling / communication mechanisms for startups are giving foreign capital more “visibility” into other ecosystems, allowing it to invest earlier and more geographically dispersed, the emergent seed ecosystem is also increasingly allowing local startups to “go national” without having to commit themselves to a particular VC fund. The obvious winners in this new world are entrepreneurs and investors willing to be open and flexible with how they fund companies. The losers are the traditional investors – particularly those who used their old leverage to squeeze founders – who haven’t understood that the old game is gone, and it’s not coming back.