Post Category → Startup Lawyers

The Open Startup Pro-Forma Capitalization Model

TL;DR: In the earliest stages of a startup, paying for a proprietary cap table tool, or simply dealing with the hassle of a 3rd-party intermediary software layer for modeling your capitalization, is not really necessary. We’re publishing the Open Startup Model, an Excel-based “open source” cap table and pro-forma that startups and their lawyers or other experienced advisors (if they don’t already have their own tools) can use for free. It’s based on the pro-forma structure we’ve used for hundreds of deals, and is flexible, editable and auditable.

Background reading:

In the beginning, there was Microsoft Excel, and it was good (enough).

For decades, startup cap tables and pro-forma financing models were maintained on Excel. It wasn’t perfect (nothing is), but it worked well enough. Then as the ecosystem matured, we saw the emergence of specialized cap table software, like Carta (pricier incumbent) and Pulley (leaner alternative). These tools make a lot of sense at moderate (not low) levels of cap table complexity – based on our experience at Optimal, typically around Series A or post-Seed.

But somewhere along the way some founders got the impression that these tools might be needed as early as the incorporation of the company, when there are only a handful of people on the cap table. The argument, certainly made by the cap table software vendors themselves, is that Excel is too clunky, and too error-prone. There is also a bit of a land grab dynamic here, in the sense that it isn’t necessarily profitable for these tools to have tons of very small companies on them, but they have to build super early-stage offerings to prevent their competitors from owning the pipeline. There’s no simple way for the tools to agree to leave young companies alone, so we get these silly value-destroying attempts to onboard everyone.

All of this is, candidly, nonsense. I’ve seen seed-stage companies spending thousands of dollars a year and getting absolutely nothing extra of value that they couldn’t get from a basic excel spreadsheet maintained by someone moderately competent.

What makes old-school Microsoft Excel a still-used tool in startup finance is its flexibility, auditability, simplicity, and affordability (free, essentially). It’s really only once you’ve crossed about 20 cap table stakeholders that in our experience, as counsel to hundreds of VC-backed companies, a third-party tool starts to make sense. Before then, I often see more mistakes when founders try to use an inflexible outside tool than when they simply collaborate with a sharp outside advisor to keep things clean and simple on a spreadsheet.

That being said, one thing that has happened is the complexity of seed funding instruments has grown over time. See the Seed Round Template Library and Seed Round Educational Articles.

In the really early days, before the entire seed ecosystem even existed, most financing was in equity rounds. But as the SaaS revolution got started, financings both shrunk in size and exploded in volume, with equity rounds no longer making sense in many cases. So we got seed-stage convertible notes. Then we got notes with pre-money valuation caps, discounts, or both. Then you got pre-money SAFEs. Then you got post-money SAFEs, and various flavors of them. Then you got post-money convertible notes. Time-based discounts and caps. Milestone-based caps. Don’t forget friends & family SAFEs, which are slightly different. Oh, and let’s not forget seed equity v. NVCA equity. Even within these categories there are various nuances and flavors.

It is not surprising to us at all that the ecosystem has resisted all attempts to hyper-standardize fundraising instruments, notwithstanding the valiant (even if self-interested) attempts by high-profile VCs or software tools to centralize all fundraising terms. This reflects the decentralized reality of the startup ecosystem. Startups are not uniform commodities, nor are their investors. In the latter category, think of bootstrapping, friends and family, angels, super angels, angel syndicates, pre-seed funds, seed funds, family offices, crowdfunding, accelerators, VCs with seed fund arms, strategic investors.

Couple that organic diversity on the investor side with the extremely diverse industries, business models, geographies, team compositions and cultures, risk tolerances, and exit expectations of startup companies. Do we really expect all of these sophisticated business people playing with millions and tens of millions of dollars, gunning for hundreds of millions to billions, to fit into one or two template financing structures because some VC, accelerator, or cap table software says they should? Because of some childish aversion to actually reading a contract and tweaking a few terms?

The only people misguidedly trying to hyper-standardize this complex ecosystem are (i) specific VCs who profit from controlling terms, with their preferred templates, and (ii) specific software companies (often funded by the aforementioned VCs) who want to build some centralized proprietary tool on which all startup financing would at some point become dependent (surely with juicy margins to them as a result). Neither of these types of rent-seeking gatekeepers are looking out for the ecosystem itself, and its diversity of preferences and priorities; certainly not for entrepreneurs. They’re looking out for themselves (for which, as market actors, I don’t fault them).

Given the diversity of businesses and investors in the startup ecosystem, which inevitably leads to a diversity of funding instruments, flexibility of any viable wide-reaching startup capitalization model is key. That’s why MS Excel still matters, because of how flexible it is. Flexible and transparently auditable in the way that open source code is flexible; and proprietary “no code” tools are not.

Led by a Partner colleague of mine, Jay Buchanan, we’ve published the Open Startup Model. Free, Excel-based, flexibly customizable and auditable, even “forkable” if others want to iterate on it. “Open Source” effectively. It’s based on the same model we’ve used hundreds of times at Optimal, with clients backed by elite VCs like a16z, Sequoia, Accel, Khosla etc. and dozens of “long tail” funds across the world as well. It works from the formation of the company through Series A (or a Series Seed equity round).

Jay will be writing periodically at OpenStartupModel.com, with info on how to take better advantage of it. Just like open source code isn’t intended to be handled by untrained end-users, this model is not intended to be entirely self-serve by founders. We are modeling very high-stakes and complex economics here. Rather, it’s meant to be a potential starting and focal point for various experienced market participants (including lawyers) to work with founders on.

Just as we are big believers in the thoughtful integration of elite legal industry values and lean tech values, we think an “open” startup ecosystem, with its enormous organic diversity of market players, is far healthier and more sustainable than misguided attempts to centralize everything behind a handful of rigid proprietary structures and tools. An open pro-forma model, together with our open-source contract templates that we’ve published here on SHL, is part of that vision.

In that vision, it’s not necessary that dozens of different actors come to agree on some “standard.” These templates and models will look extremely recognizable to all the serious law firms and other key players in the market. That alone saves time if startups or lawyers want to use them, and as institutions get more “reps,” efficiencies follow as institutional knowledge is gained.

We hope everyone – founders, lawyers, investors – will find this helpful, and welcome any feedback on improving it; particularly if “bugs” are found. As a final legal tech tip for lawyers, the ability to redline excel models, much like how you redline contracts, is super important and improves efficiency in reviewing model changes. Litera Compare is our favorite redlining tool for excel files.

As a separate tip for startup founders, if you need a 409A valuation, but don’t want to pay extra for a third-party cap table tool (because Excel is fine for now), Eqvista has a lean 409A-only (no extra software) offering.  Some seed-stage companies go this route, combining Excel and a 409A valuation without the extra bells and whistles of the pricier cap table tools, until their cap table has grown more complex (typically post-Series A).

Finally, once you get to the point of needing to onboard to Carta or Pulley (if you’re successful, you will get there eventually), the following may be helpful for saving on their costs.

Legal Tech for Startup Lawyers: Deal Closing Software

TL;DR: Deal closing software for collecting and tracking signatures, then compiling closing sets, is a great legal tech category for law firms to streamline administrative tasks on deals, saving clients money and time. Based on my research of the available options in adopting legal tech for our own elite boutique firm (Optimal Counsel), Closing Folders and Litera Transact are the closing tools that other firms should take a look at. Bigger picture, law firms need to think deeply about the proper balance of legal industry values (flexibility, advocacy) v. tech industry values (speed, standardization) as new legal tech hits the market. There are potentially serious negative consequences for companies (clients) if we thoughtlessly let one industry’s values dominate the other.

After publishing How Much Seed Rounds Cost – Lowering Fees and Expenses Safely, which ended up getting way more traction than expected, a number of lawyers from other firms reached out to me politely asking for recommendations as to what tools we use at Optimal for streamlining administrative tasks on deals. I sometimes forget that, even though this blog is targeted toward founders, quite a few lawyers and firms in the industry follow SHL as well. I also occasionally hear from law schools planning their course curricula.

Given that our firm is built around a thoughtful balance of blending lean legal tech with elite lawyers, I can understand other players in the industry looking to us for recommendations. My view has always been that the “optimal” blend of legal and tech ensures that the core values of neither industry get shoved down the throats of clients; who ultimately should be the ones getting better served. Rather, it’s about balancing the positives of both, while counteracting their negative tendencies.

Balancing Legal and Tech Industry Values

Key values of the elite tier of the legal industry are flexibility and trusted advocacy for a client, and (in the case of startups) a client led by executives (founders) often at a substantial informational disadvantage relative to players they are negotiating with. See Negotiation is Relationship Building for a deep-dive on just how much founders and startup teams lose when trusted and experienced legal counsel is pushed out of the picture by misaligned market players who profit from displacing lawyers at the negotiation table.

Legal: Trusted, Flexible Strategic Advocacy with Professional Liability

Having a relationship with a highly experienced and trusted senior lawyer, without ties to your investors, is one of the best “equalizers” for founding teams navigating the fog of an opaque market full of much more experienced players. Unlike regular vendors of services and tools, lawyers have professional ethical obligations to their clients, as skilled fiduciaries advocating for their interests. Paying for counsel is not just paying for a neutral product or service, it’s paying for an experienced advocate reviewing terms and negotiating specifically for your team’s context and priorities.

The downside tendencies of the legal industry are, for some lawyers at least, to “overwork” projects; making unnecessary comments and mountains out of molehills. Reputational competition can put limits on this behavior, but it still occurs in some circles. Clients and Boards should be educated as to what terms are very high impact and high-risk – such as core economic terms, or governance terms influencing the power hierarchy of the business – while, especially on smaller projects, accepting “good enough” for the more marginal terms unlikely to be impactful other than in rare edge-cases.

This is why I’m a big fan of taking an “open source” approach to legal templates for early-stage work, reflected in the Seed Round Template Library. Creating a common language framework as starting points can significantly reduce unnecessary negotiation over unimpactful issues, while preserving the flexible and trusted dynamics of each side having advocates looking out for their client’s interests. Independent counsel serve as the flexible “software developers” of this market (contract language is code), with open source templates serving as the transparent and modifiable “github” repository.

This is better for clients and the market than a centralized and proprietary “no code” framework by which self-interested participants, like prominent investors or VC-backed software vendors, impose their inflexible and uneditable “code” (contract terms) onto the entire ecosystem, in part by pretending that something is a universal “standard.” A flexible “open source” approach to early-stage deal terms provides efficiency, without requiring an enormous diversity of market players to fit their businesses and investor theses within a handful of narrow structures.

Tech: Standardization, Scale, and Speed

Unlike the legal industry’s values, which heavily prioritize strategic advocacy and flexibility, the values of the software industry are efficiency, scale, and speed. These are absolutely important values that law firms need to integrate into their cultures to serve clients well, while also being very candid when these values are being exaggerated to dupe inexperienced teams. The negative side of hyper-automation is reduced optionality (inflexibility), and a tendency to gloss over nuances in order to make it easier to sell a software-based service. This downside can sometimes be astroturfed with an over-emphasis on mass-market “data,” when even data compilation and visualization requires significantly narrowing the scope of variables, quietly labeling impactful terms as “standard” or “boilerplate” when they absolutely are not.

A great example of how this plays out is the selection bias of automated tools. They’ll promote “data” suggesting that X or Y is some kind of “standard,” while glossing over the fact that X or Y are the primary options promoted by their tool, creating a self-motivated circularity. You can only choose X or Y if you use the tool, and the tool then uses its self-selected “data” to tell you that X or Y are the “standards.” Given it’s evidently all “standard boilerplate,” you’re told to just pay for their tool and avoid all that negotiation and review mumbo jumbo; even if some of said mumbo jumbo would significantly help a team.

This clever sleight-of-hand – using biased “data” to pretend that important terms are far more standardized than they really are – is looking out for the needs of a company profiting from selling simplistic software that can’t function without hyper-standardization; not the needs of the end-user (the client).

As I’ve said many times before, “don’t ask your lawyers about this” sounds very suspicious. “Let’s save you some legal fees” sounds much more benign, but the end-effect can be the exact same. A huge number of inexperienced teams get duped into signing bad terms, or taking counterproductive actions, but the smoke-and-mirrors strategy of minimizing legal fees (and thus not talking to a trusted independent advisor) provides misaligned actors plausible deniability for their (air quotes) “advice.”

Early-stage private companies building unique products and services, and gunning for 8-10 figure (or more) exits, are not standardized commodities, nor are the contracts they are signing at the foundation of their businesses. This is a total contrast to standardized shares of large public companies, which by their nature are highly liquid, have minimal governance authority, and are a part of diversified portfolios; in other words “low stakes.”

In contrast to liquid public equities, Founders’ and employees’ livelihoods, and often their entire life savings, rely on permanent deal terms tied to high-concentration illiquid assets with significant power over a company’s trajectory. Taking an inflexible, high-speed approach to the super high-stakes terms controlling a startups’ financing, ownership, and governance reflects far more the desires of market players who rely on scale and diversification – like spray-and-pray “dumb money” funds or mass-market software vendors – than on what is actually good and appropriate for each unique company with all or most of its eggs in one basket. This is exactly what happens when “tech values” are allowed to steamroll over legal’s.

Deal Closing Software

There are two broad types of work that law firms do for clients on financings: (i) actual “lawyer work” – assessing terms, educating and advising clients, negotiation, drafting and structuring – and (ii) administrative work like creating signature packets and tracking signatures or assembling closing sets. The former category is very difficult, indeed at times dangerous, to heavily outsource to third-party software because of how high-stakes and permanent it is – flexibility and trusted advocacy really matter here, but the latter category is always great to apply thoughtful technology to.

Closing Folders and Litera Transact are two deal closing tools that all corporate lawyers should review and consider adopting for their practices (one or the other). We’ve used tools like this for years, and I know a lot of ECVC “BigLaw” uses them as well. They use focused web-based interfaces for:

  • Organizing deal checklists and document sets
  • Auto-generating signature pages and packets
  • Auto-issuing e-signature requests through trusted e-signature tools like Docusign
  • Tracking real-time status of signatures, and
  • Compiling closing sets efficiently

What I love most about these tools is their focus and flexibility. If there’s one thing I’ve learned being a legal CTO for a decade, it’s to never trust sprawling “all in one” kinds of tools that show significant feature creep. The tendency for a software company to constantly expand into other features, and even industries, more often reflects a desire for monopolistic empire building than what is actually good for the end-user. They inevitably end up confusing, bloated, and over-priced.

Instead, use tools that do a focused set of tasks extremely well, with a simple interface, and customizability that integrates well into the varying needs of a law firm (the user here). Unlike signature collection features bolted onto other kinds of software, these tools are designed for lawyers and can work on an extremely diverse sets of transactions, including equity or debt financings, and M&A. The fact that no particular deal structure is imposed on them is super important so law firms can apply them to their clients’ varying needs.

Client Data Privacy and Security

While both tools started out as independent startups (Litera acquired Doxly and renamed it Transact, iManage acquired Closing Folders), they’re now owned by trusted legal software companies with robust and transparent policies around client data privacy and security. Lawyers should always be cautious about what software tools might be mining their clients’ data for other ends.

In the most egregious cases I’ve seen software companies market tools to lawyers, use those tools to mine those same lawyers’ client data, and then leverage that data by attempting to displace law firms with high-cost, high-margin legal “products” lacking the flexibility, contextual awareness, and ethical obligations of actual counsel. Sometimes that “data” is being sold directly to your clients’ market counterparties, to improve their negotiating posture.

If the tool is offered to you for “free,” then the payment is in data. What is that data going to be used for? I prefer paying directly for straightforward, well-designed and focused tools. My firm’s (and my clients’) data is not for sale.

Hopefully this is helpful. Good luck.

How Much Seed Rounds Cost – Lowering Fees and Expenses Safely

TL;DR: There are effective and efficient ways to lower your closing costs, in terms of legal fees and other expenses, for your seed round. But be mindful of the lean v. cheap distinction. A lot of founders myopically over-cut corners thinking that minimizing negotiation or deal structuring saves them money. This can easily cost 10-20x+ long-term in terms of economics (dilution) and governance power, because teams end up mindlessly signing terms against their interests. Thoughtful customization, combined with lean process and tools, gets you to a better outcome. Thinking lean – balancing flexibility, optimization, and efficiency – but not short-sightedly cheap, protects you from being penny wise but pound foolish.

Background reading: Seed Rounds

There are two broad categories of costs for closing a seed round:

  • Legal Fees – Including whether you are using an incumbent “BigLaw” firm or a leaner boutique, and how you structure the round.
  • Post-Closing Expenses – Including state and securities filing fees, as well as 409A/cap table software costs

Seed Round Legal Fees

BigLaw v. Elite Boutique?

Without a doubt the two most significant drivers of legal fees are: (1) the type of law firm you are using, and (2) the round structure (contracts) you and your lead investors choose.  For a deep-dive on the “type of law firm” issue, see: Startup Legal Fee Cost Containment (Safely). In short, what has happened over the last decade or so is the incumbent Silicon Valley-based firms (BigLaw) have raised their pricing and grown so bloated (IMO) that they have simply overshot the needs of a huge segment of the startup ecosystem, especially at the earlier stages.

Granted, the market has historically not done a very good job of offering viable, credible alternatives to BigLaw in this space. What we’ve more often seen is (what I lovingly call) “shit firms” full of cheap but poorly-qualified lawyers, or peddlers of half-baked legal automation software that simply can’t handle the contextual nuances of high-growth companies. Lean but still elite boutique law firms, like Optimal (our firm), offer a more balanced package of highly-trained and credible professionals, including top-tier Partners, but lower costs derived from a more efficient firm operating structure.

To put this into more concrete numbers: a Partner in an incumbent “BigLaw” SV-based law firm will typically cost at least $900-1400 per hour (I did not add an extra zero there), often more. At an elite lean boutique firm, the Partner will have an extremely similar background in terms of credentials, training, and experience, but be more like $450-650 per hour. Certainly not cheap – remember Partners don’t do most of the work in early-stage, they oversee things (quality control) and strategize with the C-suite and Board – but dramatically leaner than BigLaw. What allows leaner law firms to do this, while retaining top talent, is that they “burn” so much less money than firms built on traditional operating models. They can pay lawyers extremely well, but at lower rates.

Convertibles (Note or SAFE) v. Equity (Seed Equity or NVCA)?

The second big driver of legal fees in a seed round is the contract structure you and your investors use. Certain market players like to pretend as if this decision is very easy and simple, often because they make money nudging you in one direction, but it really is not that universal or clean cut.

Convertible instruments (convertible notes or SAFEs) are most certainly cheaper to close on and negotiate. Even within that category, however, there are key nuances. For example, whether there’s a valuation cap or not, whether that valuation cap is post-money v. pre-money, and of course whether you’re using convertible debt (notes) or SAFEs. Good reading on this: SAFEs v. Convertible Notes and A “Fix” for Post-Money SAFEs. These nuances can have enormously consequential (economically) impacts on a company.

While the big positive of convertible notes and SAFEs is speed and simplicity, their primary downside is uncertainty. They do not harden economics or governance rights the way that an equity round does, but instead deliberately punt on various hard questions to the future –  this is precisely how they simplify things. In many cases, this is a feature and not a bug, but not always. A huge number of startups are feeling these downsides in this heavy post-pandemic post-ZIRP economic downturn that the ecosystem is experiencing.

So many founders drank the “click click close” kool-aid suggesting that seed rounds are all “standard” and they should just sign YC’s default post-money SAFE. The main peddlers of this perspective were specific investors, who profited from pushing a contract structure designed for their economic interests, and automated financing companies who need you to not negotiate your deals, and believe it’s all “boilerplate,” so that you can let their software tool close everything for you. Obviously, automation software breaks down when confronted with any meaningful level of flexibility or structure nuance.

Now that these startup teams need to raise more money in hard times, they’re feeling the pain of having failed to do a bit more negotiation up-front, including by hardening investor economics when valuations were higher instead of simply relying on a moving valuation cap with no floor. The harsh anti-dilution mechanics of YC’s default SAFE are also imposing significant dilution on founders, whereas if they had just done a tad more thinking and structuring up-front they could’ve saved themselves potentially tens of millions of dollars worth of dilution. Losing millions in dilution in order to save a few thousand in fees is a perfect example of penny-wise, pound-foolish judgment.

See Myths about Seed Equity Rounds for a deep-dive into when equity, instead of a convertible, can make sense for your seed round. Choosing a simplified “seed equity” structure, instead of the longer, more complex NVCA-based equity deal contracts, can save tens of thousands in legal fees, and safely (without material hidden risks). You and your counsel will just need to get your investors comfortable with it, if possible.

Concrete Legal Fee Numbers:

If you’re using a lean elite boutique law firm, closing a convertible note or SAFE round is at most a few thousand dollars in legal fees ($2.5K-$5K). A little more if it’s heavily negotiated, but rarely more than $10K. BigLaw, with often double the rates, will naturally be more. This is for company-side costs. Investors usually pay their own fees in convertible rounds.

For simplified seed equity (not NVCA), a more typical range from a boutique law firm is $15K-$25K if we’re thinking of a 10%-90%-ile range, with below that range being zero negotiation super-fast closing, and above that range being when more heavy negotiation or cleanup diligence issues are involved. Again, BigLaw with its higher rates is probably twice that.

Some VCs will insist on structuring “seed rounds” in the exact same format as a Series A, using NVCA-based forms. This adds significant complexity and drafting time, as it’s a rejection of the simplified seed equity structure. For this structure, with a lean boutique a reasonable 10/90 range is $25K-$40K. This is about what Series A’s cost at elite boutiques as well. Again, BigLaw’s rates will drive that higher if you go that route. But importantly, a small minority of seed rounds are structured this way, as using this structure is more a response to a particular fund’s idiosyncratic preferences, and not some inherent necessity of seed financing.

Only perhaps 10-15% of these cost ranges boil down to what might be called “administrative” work – paralegal-esque mechanics like coordinating signatures, inputting numbers, etc. The real drivers are high-impact legal work of negotiation (including educating executives and Boards), structuring, drafting, and integration of the “code” (contract language) for the deal and planned corporate governance arrangement.

Sidenote to law firms: See Legal Tech for Startup Lawyers for some experienced advice on helpful software for reducing administrative time on financings. 

The key takeaway is how much seed rounds cost to close is heavily driven by the type of law firm you’re using, and the contract structure. My point here is not to pretend there is some formulaic, straightforward answer as to what any particular company should choose. It depends on context. My suggestion, however, is that founders actually act like executives and exercise some judgment – weighing the pros and cons, balancing flexibility v. speed, negotiation v. automation – instead of biting into X or Y peddler’s nonsense as to whatever a “standard” seed round looks like. We’re talking here about selling 10-30% of your cap table. Don’t be a myopic fool.

Other Seed Round Expenses

While not as meaningful as legal fees, there are a few other expenses that still impact the bottom line in a seed round. State filing fees, along with securities filings, can run you anywhere from $750-2,000 as a 10/90 range.

Carta or Pulley?

Higher than state or filing fees will be the cost of adopting capitalization table software and getting a 409A valuation; the latter of which is usually recommended if you intend to grant options after closing your round. Before a seed round, adopting any kind of cap table tool apart from MS Excel has always struck me as pointless. At under 10-20 cap table stakeholders, it’s not hard for a competent team, in collaboration with competent counsel, to maintain a spreadsheet. In fact, when very early founders introduce third-party cap table software into the mix, I sometimes see more mistakes, not fewer ones.

Historically, Carta has been the big incumbent player in this space, and deservedly so. But as is the case with many incumbents, there are growing concerns in the market about feature creep and excessive (rising) pricing. Sentiments like:

A big concern among law firms and VCs has been that no other leaner alternatives seemed to be gaining sufficient market share to counteract the network effect advantages that Carta has. But from what we’ve been observing, Pulley (Founders Fund Series B-funded) appears to be reaching a threshold where, at a minimum, founders need to be aware of them as a significantly less costly and simpler cap table + 409A option to the tune of thousands of dollars per year. Most serious law firms in this space are growing comfortable and familiar with it. Its simpler, more focused interface is certainly helpful.

Summary

All smart founding teams are rightfully concerned about not over-spending to close their seed funding. But there’s a lot of opaque, and sometimes patently false, information available in the market as various commentators “talk their book” instead of laying out all the factors honestly.

On legal fees, law firm type and deal structure are big drivers. For the former, it’s BigLaw v. elite boutique. For the latter, the decision matrix is multi-variate. If convertibles: SAFE or Note, and within those categories, type of valuation cap. If equity: simplified seed equity or NVCA. Where you land on deal structure has millions of dollars in implications long-term. Take the time to exercise real judgment on this issue. Remember: lean, not cheap.

On post-closing cap tables and 409As, Carta is the quite expensive but solid incumbent, and Pulley is the increasingly attractive lean alternative. Assess both.

Good luck.

Startup Governance Choke Points: Protective Provisions

Related Reading:

As I’ve written many times before, one variable that makes the world of startup governance very different from other areas of corporate law is the substantial imbalance of experience and knowledge between the business parties involved. On one side you often have seasoned VCs who’ve been in the game for decades. On the other you often have an inexperienced entrepreneur for whom all of the complex terms in the docs are completely new. This imbalance leaves open numerous opportunities for leveraging founders’ inexperience to gain an advantage in negotiations either in deals or on complex board matters.

This can make the role that corporate lawyers play in VC<>founder dynamics quite pivotal. Whereas seasoned executives at mature companies usually rely on legal counsel for executing specific directives, but not for material strategic guidance, in the startup world good VC lawyers serve as strategic  “equalizers” at the negotiation table. This is why guarding against any conflicts of interest between your lead lawyers and your VCs is so important (see above-linked post). If your lawyers’ job is to help you guard against unreasonable demands or expectations from your counterparties, you don’t want those counterparties to have leverage over those lawyers. No one bites a hand that feeds them. VCs know this, and deliberately feed (engage and send referrals to) *lots* of lawyers in the ecosystem.

Because of this imbalance of experience, and even the tendency for some VC lawyers to not fully educate founders on the material nuances of deal terms and governance issues, I regularly encounter founding teams with overlooked “choke points” in their companies’ deal and governance docs. By choke points I mean areas where, if there were a material disagreement between the common stock and investors, the latter could push a button that really puts the common in a bind. It’s not unusual to find founders who simplistically think something like, “well the VCs don’t have a Board majority, so they can’t really block anything.” Trust me, it’s never so simple.

The hidden VC “block” on future fundraising. 

One of the most common hidden “choke points” I see in startup governance is overly broad protective provisions. These are located in the company’s Certificate of Incorporation (charter), and basically are a list of things that the company cannot do without the approval of a majority or supermajority of either the preferred stock broadly, or a specific subset of preferred stock. Given that the preferred stock almost always means the investors, these are effectively hard blocks (veto rights) over very material actions of the company. No matter what your cap table or Board composition looks like, these protective provisions mandate that you get the consent of your VCs for whatever is on that list.

Fair enough, you might say. The investors should have a list of certain things that require their approval, right? Of course. Balanced governance is good governance. But good, balanced governance terms should protect against the possibility of misalignment of incentives, and even conflicts of interest, in governance decisions for the company. In other words, they should prevent situations where someone can take an action, or block an action, purely out of self-interested motivations, while harming the cap table overall.

Very often so-called “standard” (there are all kinds of biases in what ends up being called standard) VC deal terms will give VCs protective provision veto rights over these sorts of actions:

  • creating any new series of preferred stock
  • making any change to the size of the Board of Directors
  • issuing any kind of debt or debt-like instrument.

The end-result of these protective provision is that, at the end of the day, you need your VC’s permission to raise any new money, because you can’t raise money without taking at least some of the above actions.

Let me repeat that so it sinks in: regardless of what your Board or cap table composition looks like – even if a VC is a minority holder, and the preferred don’t have a majority on the Board – the kinds of protective provisions that many VC lawyers call (air quotes) “standard” allow your VC(s) to completely block your ability to raise any new financing, no matter what the terms for that financing are. A “choke point” indeed.

Why is this a problem? Well, to begin with it’s a serious problem that I encounter so many founding teams that aren’t even aware that their governance docs have this kind of choke point, because nobody told them. A fair deal negotiation should require clear understanding on both sides. But more broadly, the problem is that VCs can have all kinds of self-interested reasons for influencing what kind of funding strategy a startup will take. They may want to block a lead from competing with them, for example. Or they may want to ensure that the follow-on funding is led by a syndicate that is “friendly” (to them) as opposed to one whose vision may align more with the goals of the common stock.

I have encountered startup teams several times who think they are in control of their company’s fundraising strategy, again because they simplistically looked at just their cap table and board composition, only to have a VC inform them that, in fact, the VC is in control because of an obscure protective provision that the founders never even read.

Preventing / Negotiating this Choke Point

The simplest way to prevent your VCs from having this chokehold on your fundraising strategy is to delete the protective provision(s) entirely. That may work, but often it doesn’t. Again, balanced governance is good governance. It’s reasonable for VCs to expect some protections in ensuring the company isn’t willy-nilly fundraising with terms that are problematic. I agree with that. But as I said above, it’s also unreasonable for the VCs to expect a hard block on any fundraising whatsoever, regardless of terms.

A more balanced way of “massaging” these protective provisions is putting conditions or boundaries around when the veto right is actually effective. For example, you might say that the veto right is not enforceable (the VCs can’t block a deal) if:

  • the new financing is an up-round, or X% higher in share price than the previous raise;
  • is a minimum of $X in funding;
  • maintains a Board with specific VC representation;
  • doesn’t involve payment to a founder, to ensure they are objective.

There are all kinds of conditions you could add to provide that only “good” (higher valuation, legitimate amount of money, balanced Board representation, etc.) financings can get past a VC block. Putting this kind of list in a term sheet can be an excellent conversation starter with a VC as to what they see as the long-term fundraising strategy, and where their own red lines are. It allows you to candidly ask your VC, “OK, if the deal checks all of these boxes, why exactly do you still need a veto right over it?”

But if your VC simply responds with a “this won’t work, we need a hard veto on fundraising” position on the negotiation – at a minimum you now have valuable data as to this VC’s worldview on governance and power dynamics in their portfolio. See Negotiation is Relationship Building. Regardless of where deal terms end up, forcing a discussion about them, and requiring the other side to articulate their position clearly, still serves a valuable purpose. Sometimes you don’t have the leverage to achieve better balance in your deal terms, but it’s always a positive to at least have your eyes wide open.

Putting substantive deal terms aside, I enjoy helping founding teams understand that many of the most (air quotes) “founder friendly” investors in the market are still far from charitable actors, and can be quite clever and subtle in their methods for maintaining power, despite the “friendly” public persona. See: Trust, “Friendliness” and Zero-Sum Startup Games. Note: this is not a moral judgment, but just an acknowledgement of reality. You and I aren’t Mother Teresa either. Navigate the market with the clear-eyed understanding that everyone is following their incentives, and protect your company accordingly.

A less balanced, but still improved, configuration of these protective provisions is to create an exception if a VC Board member approves the deal. You might (understandably) think: how is this better, if the VC Board member can just refuse to approve? Without getting too in the weeds, Board members have fiduciary duties to the cap table overall, whereas non-controlling stockholders generally do not. So at least theoretically, you could call out, and even sue, a Board member if it’s blatantly obvious that they are blocking a particular deal for reasons that are more about their own interests than the company’s.

I say theoretically, because the smartest and most aggressive investors, if they really want to play games with pushing your fundraising strategy in their preferred direction (and away from the preferences of the common), will be quite creative in developing plausible deniability for their behavior: they blocked the deal because that other lead wasn’t “value add” enough, they don’t believe now is the right time to raise because of market conditions, they’re concerned about X or Y thing that at least gives them an argument that they are still looking out for the company. So don’t get too excited about these fiduciary-related exceptions to protective provisions. They’re not nearly as helpful as the better strategy of putting concrete bypasses to a protective provision veto.

To be very clear, I still see quite a few founding teams who are fully informed about these issues, have a candid conversation with their VCs about it, and still ultimately put in some kind of hard VC-driven block on fundraising. I of course also see plenty of teams who, as soon as we bring this topic up to them, dig their heels squarely in the sand and completely refuse to do a deal unless the VC vetoes are removed/modified. It depends on context, leverage, values, trust, etc. But in all cases it is a net positive for the inexperienced founding team to know what they are signing.

Startup governance and power dynamics are much more nuanced than just what your Board and cap table look like, or the usual 2-3 high-level terms that founders read in a term sheet, thinking everything else is just “boilerplate.” Ensure you’re surrounded by objective, experienced advisors who can help you understand those nuances, so the deal you think you’re signing is in fact the one on the table.

Optimal Counsel

One career chapter closes, and another opens.

About 9 yrs ago I left BigLaw, very much against the advice of senior people around me (I was much too junior they said), and joined a very small boutique firm in Austin that was, at the time, relatively unknown in the broader ECVC market. As the youngest lawyer at a small shop, and breaking all kinds of conventional career advice, I saw it as an adventure to see what could be done – with some creativity and hustle – in a market dominated by traditional firms.

I’d also started a popular legal blog in which I wrote about problems I saw in the industry. That included how certain lawyers with deep relationships with VC firms were somehow also representing the companies those VC firms invest in; and acting as if there wasn’t anything wrong with inexperienced entrepreneurs relying on counsel with conflicts of interest. Articles got shared, word got around, people seemed to notice.

Over time we grew to, depending on whom you ask, one of or *the* top recognized boutique practice in emerging companies and VC (startup) law. We had phenomenal colleagues and clients, and a deep emphasis on early adoption of legal tech, work-life balance initiatives, and a remote-centric culture; long before distributed teams were “cool.”

We were recruiting from, and negotiating with, all of the top ECVC BigLaw brands 100x our size; and unlike most boutiques, we had a great recruiting pipeline with top law schools. We were thriving, while giving elite lawyers a refuge from the (in my opinion) dysfunctions of the broader industry. And we achieved all of this, profitably, at rates $300-400+ per hour below the firms right across the table from us.

Within the span of about 10 years into my career, at 35, I found myself leading, managing, and recruiting a nationally recognized elite ECVC law group I was proud of. In many (but certainly not all) ways it was a very fun run. The adventure was a success, not just in terms of helping change a segment of the legal industry, but in building lasting relationships with colleagues, CEOs, and other great people along the way.

A few weeks ago that chapter in the book of my career closed. I’m thinking about writing a separate blog post explaining in depth why and how it closed, given the numerous inquiring minds in my network who have reached out. There are definitely some lessons that could be drawn for the benefit of other lawyers, recruiters, and people in the market. But for now, I have bigger immediate priorities.

After the closing of this nearly decade-long chapter in my career, as I was contemplating new possibilities, several of my closest (and highly capable) Partner colleagues approached me with an idea: why not build a new pirate ship together – this time entirely our own – with trusted colleagues committed to the core vision? Why not take it all to the next level? And thus a new chapter begins.

I’m thrilled to have just recently accepted an invitation to help build out Optimal Counsel LLP (“Optimal” for short), as a Partner and legal CTO. I could not have imagined a more stellar set of Partners and associates to serve as the “founding team” of this new boutique firm that I am joining.

Lean, Modern, and Elite is our mantra. Unapologetically tech-driven, remote-first (I’m still closing top VC deals while hiking the mountains in Colorado), and with the high standards our clients have always expected from us. Loudly asserting that elite legal talent can deliver the goods while still having the autonomy, lifestyle, and top-of-market compensation it deserves.

This is not “BigLaw lite,” with a thin veneer of newness attached to the same stale operating model and backward firm culture. We are not a firm for lawyers who romanticize about industry tradition, “face time” in an overpriced office, and the good ol’ boys of the good ol’ days. The overwhelming loyalty of Optimal clients and lawyers is evidence that we are built for a different kind of lawyer, working for clients who are fundamentally tired of the legal industry’s baggage.

How far can we go with even more freedom and flexibility to push the envelope in the legal industry? My last chapter started with me taking a leap mostly on my own. This one starts with a tribe of extremely talented, ambitious lawyers with a unified vision and purpose. I’m looking forward to seeing what we can achieve in another 10 years.

Cheers to a new adventure,

J