Alignment in Startup Governance: Conflict, Collusion, Corruption

Conflict

The source of governance conflict that gets the most attention in startups is the tension between founders and venture capitalists, particularly as it relates to power (who ultimately calls the shots) within a company. This power tension is real, but it’s not what I intend to write about here. There are plenty of other posts on this blog about that topic.

Aside from hard power, conflict can arise between founders/common stockholders and investors because of economic misalignment. As mentioned above, given their different positions in terms of affluence, risk-tolerance, and concentration of personal wealth, it’s not uncommon to encounter situations where founders or common stockholders want to pursue path A for a company, while investors are insistent on pursuing path B. In the worst circumstances, this can get into battles over voting power and Board structure. I’ve even seen situations in which investors attempt a “coup” by swiftly removing founders from a Board in order to force through their preferred agenda.

From a preventive standpoint, one of the best ways to avoid this sort of conflict is fairly obvious: ask the hard questions up front and get alignment on vision before anyone writes a check. Founders and investors should be candid with each other about their needs and expectations, and both sides should conduct diligence (reference checks, including blind ones if available) to verify that the answers they’re getting are in sync with past behavior.

Another tool for achieving better economic alignment between founders/common and investors/preferred is allowing the common stock to get liquidity in financings. Years ago the predominant view was that letting founders take money off the table was a bad idea, because everyone wanted them “hungry” to achieve a strong exit. The fear was that by letting them liquidate some wealth, they’d lose motivation and no longer push as hard. While this was a legitimate “alignment” concern, the general wisdom today is (for good reason) that it was actually getting the issue backwards.

More often than not, failing to let founders get some early liquidity is a source of misalignment with investors. Investors want to let the business continue growing and go for a grand slam, but founders (and their families typically) are impatient to finally realize some of the value that they’ve built. It can be very frustrating for a spouse to see a headline that a founder’s company is worth 8-9 figures, and yet they still can’t buy that home they’ve been eyeing and talking about for half a decade. Letting founders liquidate a small portion of their holdings (5-15%) – enough to ease some of their financial pressure but not enough that a later exit is no longer meaningful for them – can go a long way in achieving better alignment between the early common and the investor base. It makes founders more patient and thus better aligned with other stockholders with longer time horizons.

Today, I far more often see VCs and other investors be far smarter about founder and other early common stockholder liquidity. At seed stage it is still considered inappropriate (for good reason typically), and in most cases Series A is too early as well; though we are seeing some founder liquidity as early as higher-value Series As that are oversubscribed. By Series B it is more often than not part of a term sheet discussion.

But be careful. Relevant players should avoid any impropriety indicating that VCs are offering founders liquidity in exchange for better overall deal terms. That’s a fiduciary duty violation, because it benefits individual Board members while harming the cap table overall. For more on these kinds of risks, see the “corruption” part of this post below.

Collusion

Aside from destructive conflict in company governance, another concern is when various constituents on a cap table are able to consolidate their voting power in order to force through initiatives that may be sub-optimal for the cap table as a whole, but benefit the players doing the forcing.

One way in which this happens involves larger cap table players, with an interest in having their preferred deals approved, using quid-pro-quo tactics to convince other cap table holders to accept Deal A over Deal B because Deal A aligns more with the interests of the existing money players. For example, if a Series A lead currently holds a board seat and wants to lead a Series B, that VC has an interest in not only minimizing competition for that deal, but (assuming they don’t already have a hard block from a voting % perspective) also convincing other cap table players to go along with them.

All else being equal, an early seed fund investor should be more aligned with a founder than a Series A lead as to evaluating a Series B deal led by the Series A VC. They want the highest valuation, and the lowest dilution, possible. While the Series A VC is on both sides of the deal, both the seed and founder are only on one (along with the rest of the cap table). This is good from an alignment perspective. But all else isn’t always equal. For example, the seed fund and the Series A VC may have pre-existing relationships. The Series A lead and seed fund may share investment opportunities with each other in the market, and thus have an interest in keeping each other happy in a long-term sense despite their narrow misalignment on a particular company.

All it takes is for the Series A lead to invite the seed investor out to lunch, remind them of their extraneous relationships and interests, and now we have a collusion arrangement in which the seed fund may be motivated to approve a sub-optimal (for the company) Series B arrangement because of secondary benefits promised by the Series A lead on deals outside of this one.

This exact kind of dynamic can happen between VCs and lawyers, by the way. See: How to Avoid “Captive” Company Counsel. Many VCs very deliberately build relationships with influential corporate lawyers in startup ecosystems, because they know very well that a lawyer who depends on a VC for referrals and other work isn’t going to push as hard for his or her client if that client happens to be across the table from said VC. Watch conflicts of interest.

The key preventive tactic here is: pay very close attention to relationships between people on your cap table, on your Board, and among your key advisors and executives. It is too simplistic to look at the %s on your cap table and assume that because no particular holder has a number-based veto majority that you are safe. The most aggressive and smart players are very talented at cap table politics. Diversify this pool of people by ensuring that they are truly independent of one another, preferably even geographically, so that they will be more motivated by the core incentive structure of your own cap table and deals, and not by extraneous factors that muck up incentives.

Corruption

Collusion involves simply coordinating with someone else to achieve a desired goal, but it doesn’t necessarily mean that collusion violates some duty you have to other people. A seed investor who doesn’t sit on your board has no fiduciary duty to you or anyone else on your cap table. So if they collude with your Series A lead to force through some deal that you don’t like, you may not like it, but you don’t really have any statutory legal right – aside from contractual rights you and your lawyers may have negotiated for – to make them do otherwise.

When collusion becomes corruption, however, someone is in fact going against their legal obligations, and trying to hide it. A common kind of governance corruption I’ve encountered is when VCs try to ensure that senior executive hires are people with whom they have long-standing historical relationships, even when other highly qualified candidates are available. Those executives will typically sit as common stockholder Board members, and have duties to pursue the best interests of the Company as executive officers. But because of background dependencies those executives have on specific VCs – those VCs may have gotten them good jobs in the past, and will get them good jobs in the future – they’re going to ensure the VCs always stay happy.

If as a founder you suddenly find out that your VCs know about certain private matters going on in the company that weren’t formally disclosed to them, there’s a very high chance there are background relationships and dependencies you were ignoring. While it’s always great for investors to bring their rolodexes and LinkedIn networks to the table when a portfolio company needs to make key hires, my advice is to generally ensure that there is still an objective process for sourcing high-quality, independent candidates as well. Also, build the pipeline process in a way such that no one gets the feeling that it was really a VC hiring them instead of the C-suite team or broader Board. Executives should not be reporting to VCs individually without the involvement and knowledge of the Board.

A more serious form of potential corruption – and an extremely clever one – that I’ve observed in the market in recent years involves VCs and founders. Imagine VC X is a high-profile VC fund that sees lots of high-growth angel investment opportunities. The ability to “trade” access to those opportunities is extremely lucrative currency, and VCs are experts at using that currency to build relationships and influence in the market.

VC X is an investor in Company A. Founder Y is a founder of Company A. Normally, as we’ve seen, the economic misalignment between Founder Y and VC X as it relates to Company A ensures that Founder Y will negotiate for as high of a valuation as possible because she wants to minimize her dilution. This puts Founder Y very much in alignment with other common stockholders on the cap table (employees) because they too want to minimize dilution. But obviously VC X would prefer to get better terms.

What if VC X offers Founder Y “access” to the angel investment opportunities it sees in the market? Suddenly we have an extraneous quid-pro-quo arrangement that mucks up the incentive alignment between Founder Y and other common stockholders. While on this company Founder Y may want to make VC X provide as good of terms as possible for the common stock, Founder Y now wants to keep her relationship warm with VC X outside of the company, because VC X is now a lucrative source of angel deal flow for Founder Y.

See the problem? Founder Y can make money by accepting worse terms for the company and cap table as a whole, because it benefits VC X, who rewards the founder with outside angel investment opportunities. The founder’s alignment, and fiduciary responsibility, to the rest of the common stock has been corrupted by outside quid-pro-quo.

I have seen founders co-investing in the market alongside the VCs who are currently the leads in those founders’ own companies. The VCs are not doing this to just be nice and generous. They’re using their deal visibility as a currency to gain favor with founders, potentially at the expense of the smaller common stockholders whom the founders should be representing from a fiduciary perspective.

This is an extremely hard governance issue to detect because it involves the private behavior of executives and VCs completely outside of the context of an individual company. It is unclear whether default statutory rules would ever require Founder Y and VC X to disclose the outside arrangements they have, given they aren’t true affiliated parties in the classic sense of the word. Frankly, it’s kind of a “cutting edge” problem, because while investors have forever traded deal flow with other investors to build collusive relationships, only recently has this strategy (very cleverly) been extended to founders.

But it’s something everyone, including counsel, should keep their eye on. It may even be worth considering creating new disclosure requirements regarding anyone purporting to represent the common stock on a Board (founders included) and co-investment or investment referral relationships with key preferred stockholders. We certainly want founders and VCs to be aligned on maximizing the value of a particular company. But this (trading deal flow outside of the company as quid-pro-quo favors) is not that. The losers are the employees and smaller investors whose interests aren’t properly being looked after, because founders as common board members may be favoring particular VCs on the cap table over other outside offers that have better (for the company’s stockholders) terms but don’t come with juicy personal investment opportunities on the side.

It’s somewhat ironic that ten years ago company-side startup lawyers (I don’t represent investors) had to think a lot about overly aggressive “asshole” VCs who mistreated founders, in many cases to the detriment of a company. But today it’s much harder for VCs to play that game because the ecosystem has become so much more competitive and transparent reputationally. Now we instead need to have a conversation about the exact reverse: “founder friendliness” getting so out of hand that it’s now potentially generating fiduciary duty issues and harming smaller cap table holders. Unsurprisingly, Silicon Valley is, from my observation, where things have flipped the most.

When the stakes and dollar values are very high – and in top-tier startup land they very often are – incentives drive behavior. Understand how the incentives align and misalign among the key constituencies on a cap table, and use that knowledge to achieve outcomes that maximize value not just for particular “insiders,” but for all stockholders who’ve contributed to the company.

A Fix for Post-Money SAFEs: The Math and a Redline

TL;DR: The default language of a Post-Money SAFE has the worst possible economics for founders in the vast majority of seed round contexts, because any future convertible rounds (that aren’t equity) force dilution entirely on the common stock (seed investors aren’t diluted at all – YC benefits significantly from this language in its own investments). A very small tweak to the language can save founders/common stockholders millions of dollars, and make the Post-Money SAFE fairer to the cap table.

Background reading: Why Startups Shouldn’t Use YC’s Post-Money SAFE

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

First, a very quick review of the high-level economic problem with the Post-money SAFE structure that YC promoted a few years ago; and which is only in recent quarters becoming more visible to founders as their seed rounds start to convert:

The stated value proposition of the post-money SAFE, relative to the traditional pre-money SAFE, was that it delivered investors far more clarity over how much of the cap table they were buying. If they put in $1 million on a $10 million post-money SAFE, they were buying 10% of the company today, regardless of what the current cap table looks like. This is actually a good thing. Clarity is great.

The hidden value proposition for investors of the post-money SAFE, and which has cost founders enormously by not understanding its implications, was an extreme level of anti-dilution protection built into the post-money SAFE. Any SAFEs or notes that you issue after the post-money SAFE round, but before a Series A, do not dilute the investors; they dilute only the common stock (founders and employees). This is the case even if the 2nd or 3rd round of SAFEs is an up-round with a higher valuation cap.

This was and remains crazy, and totally unnecessary in light of the stated purpose of post-money SAFEs; which was for investors to know what they are buying on the day of their closing. When you buy equity you are able to calculate the ownership you are purchasing at closing, but equity rounds virtually never, not even in the most investor-slanted deals, have full anti-dilution protection for post-closing investment. Why should Post-Money SAFEs give investors that? They shouldn’t, and this was an egregious (but in my opinion, deliberately obfuscated) over-step in startup financing template design.

We posted here a very simple redline (in track changes) of what needs to be edited on YC’s post-money SAFE to eliminate the terrible anti-dilution mechanics. Again, it’s worth emphasizing that this redlined safe still gives investors the stated benefit of the post-money structure, which is to know what % of the cap table they are getting as of their closing. What it changes is that it makes post-closing issuances proportionately dilutive to both founders and investors, just as they would (and should) be in any other kind of financing structure.

There are numerous different ways someone could draft a “fix” to this problem. I’m just posting a simple public redline so founders, lawyers, and investors understand the problem, and can either go with this solution, or craft a variant that works for their context.

A colleague of mine also designed a very helpful model (in Google Sheets) breaking down the mathematical (economic) differences between a typical pre-money SAFE, post-money SAFE, and our suggested redlined post-money SAFE. We know engineers in particular love seeing the numbers.

To give a high-level idea of the economic implications, assuming the following:

SAFE Round 1: $5M pre-money cap or $6.5M post-money cap ($1.5M invested)

SAFE Round 2: $10M pre-money cap or $12M post-money cap ($2M invested)

Series A round: $25M pre-money, $31M post-money ($6M new money), 10% post-available pool.

In Series A dollars (company value as of Series A closing), common stockholders lose $912,000 in moving from the traditional pre-money SAFE to YC’s preferred post-money SAFE. Fast-forward to an exit years later, and you’re talking easily millions or even tens of millions of dollars in lost value from simply changing the template.

Again in Series A dollars, common stockholders gain appx. $1.2 million in using the redlined post-money SAFE relative to YC’s post-money SAFE. The addition of just a few extra clarificatory words (which eliminate the hidden anti-dilution protections for investors) shift $1.2 million in Series A value from investors to the common stock; which again could easily be >$10 million by exit. All with just a few tweaks of language.

If this isn’t clear already: the stakes here are extremely high. And anyone suggesting that mindlessly using an investor or accelerator’s preferred templates is “saving” founders money (by reducing legal fees) is either hilariously uninformed, or lying out of their teeth. Tread carefully, and stay well-counseled.

Disclaimer: The model presented above is purely a hypothetical based on general math mechanics of SAFE and Series A rounds. The specific outcome in your company’s case will be dependent on the facts and circumstances, and you should always use experienced, trusted advisors to avoid missteps.

Early v. Late-Stage Common Stockholders in Startup Governance

TL;DR: While the preferred v. common stock divide gets the most discussion in startup corporate governance, and for good reason, the early v. later-stage common stock divide is also highly material. Given their different stock price entry points, early common stockholders (like founders and early employees) are not economically aligned with common stockholders added to the cap table in Series B and later rounds. This has important power implications as to who among the common stock gets to fill the Board’s common stock seats, or vote on other key matters. Clever investors will often put in subtle deal terms that allow them to silence the early common stock in favor of later-stage common stockholders who are far more likely to agree with the interests of the money.

Background reading: The Problem with “Standard” Term Sheets

The Common Stock v. Preferred Stock divide is the most important, and most discussed, concept in corporate governance as it relates to startups. The largest common stockholders are typically founders, followed by employees. Preferred stockholders are investors. Sometimes in growth rounds investors will dip into the common stock via secondary sales, which muddies the divide, but for the most part the divide is real and always worth watching.

Investors (preferred) are diversified, need to generate high-returns for their LPs, prefer to minimize competition in rounds where they have the ability to lead, and have downside-protection in the form of a liquidation preference. Common stockholders, particularly founders and early employees, are far more “invested” in this one company, want to maximize competition among potential investors to increase valuations, and don’t have downside protection. That creates fundamental incentive misalignments.

This divide becomes extremely important when discussing the two key “power centers” in a company’s corporate structure: (i) the Board of Directors, and (ii) veto rights at the stockholder level. The latter usually takes the form of overt veto rights (often called protective provisions) spelled out in a charter, but there are also often more subtle veto rights that can have serious power implications; like when a particular party’s consent is needed to amend a contract that is essential for closing a new financing.

When founders (and their legal advisors) actually know what they’re doing, they’ll pay extremely close attention in financing terms to how the Board composition is allocated between the common v. preferred constituencies, and whether either group is given “choke point” veto rights that could be utilized to exert inappropriate power over the company. Unfortunately, because founders are often encouraged (usually by clever investors) to mindlessly rush through deals, and even sign template documents produced by investors, extremely material nuances get glossed over, with the far more experienced VCs benefiting from the rushing. It gets even worse when the lawyers startups use are actually working for the VCs.

As just one example, founders will often focus exclusively on high-level Board composition, because it’s the easiest to understand. They’ll say something like, “well, the common still controls the Board, so everything else doesn’t matter.” But that’s simply not true. You may have control over your Board, but if your preferred stockholders have a hard veto over your ability to close any future financing – if the preferred have to approve any amendments to your charter, you can’t close new equity – then your investors are really in control of your financing strategy. The Board is important, but it’s not everything.

The purpose of this post is to highlight another important “divide” among constituencies on the cap table: early-stage common stockholders (founders and employees) v. later-stage common stockholders (later hires, C-level execs who replace founders). While less relevant Pre-Series A, this divide becomes much more important in growth-stage financings, and plays into the power dynamics of company governance in ways that early-stockholders are often poorly advised on.

Any party’s “entry point” on the cap table has an extremely material impact on their outlook for financing and exit strategy. If I got my common stock in Year 1, which is the case with founders and early employees, the price I “paid” for that stock is extremely low. But if I showed up at Year 4, I paid much more for my stock, or I have an option exercise price that is substantially higher.

Fast-forward to Year 5. The company’s valuation is tens or hundreds of millions of dollars. The Y1 common stockholder is sitting on substantial value in their equity. Multiples upon multiples of what they paid for their stock. They’ve also been grinding it out for years. The Y4 common stockholder, however, is in a very different position. They only recently joined the company, and their equity is only worth whatever appreciation has occurred in the past year.

Now an acquisition offer for $300 million comes in. Put aside what investors (preferred stockholders) think about the offer. Do you think the “common stock” are all going to see things in the same way? Is the Y1 common stockholder going to see the costs/benefits of this offer in the same way that the Y4 common holder will? Absolutely not. Later-stage common stockholders have far less sunk wealth and value in their equity than early-stage common stockholders do, and this fundamentally changes their incentives.

Now apply this early-stage v. late-stage common stock divide to Board composition. Simplistically, founders often just think about “common stock” seats. But who among the common stock gets to fill those seats? Investors who want to neutralize the voice of the early common stock on a Board of Directors will put in subtle deal terms that allow them long-term to replace early common stockholders with later-stage common stockholders on the Board, because the later-stage holders (often newly hired executives) will be more aligned with later-stage investors who want to pursue “billion or bust” growth and exit strategies. A Y1 common stockholder has far more to lose in turning down an exit offer, and instead trying for an even bigger exit, than a Y4 common stockholder does.

The most popular way that this shows up in terms sheets / equity deals is language stating that only common stockholders providing services to the Company get to vote in the common’s Board elections, or in approving other key transactions. Once you’re no longer on payroll, you lose your right to vote your stock, even if you still hold a substantial portion of the cap table.

Through the natural progression of a company’s growth, founders and early employees will usually step down from their positions, or be removed involuntarily. Whether or not that should happen is entirely contextual. However, it is one thing to say that an early common stockholder is no longer the right person to fill X position as an employee, but it is an entirely different thing to say that such early common stockholder should have no say at the Board level as to how the company should be run. Whether or not I am employed by a company has no bearing on the fact that I still own part of that company. The entire point of appropriate corporate governance is to ensure that the Board is properly representing the various constituencies on the cap table. Early common stockholders are a valid constituency with a valid perspective distinct from executives hired in later stages by the Board.

Deal terms that make a common stockholder’s voting rights contingent on being employed by the company are usually little more than a power play by investors to silence the constituency most likely to disagree with them on material governance matters, and instead fill common Board seats with later-stage executives who will toe the line. Importantly, aggressive investors will often rhetorically spin this issue as being simply about “founder control,” to make it easier to dismiss as self-interested, but that is flatly inaccurate. Many Y1 or Y2 common stockholders are not founders, but their economic incentives are far more aligned with a founder, who also got their stock very early, than with an executive hired in Y5+.

Yes, the largest early common stockholders will often be founders, but the reason for giving them a long-term right to fill Common Board seats is not about giving them power as founders, but as representatives of a key constituency on the cap table that is misaligned with the interests of investors and later-stage common holders. This isn’t “founder friendliness.” It’s balanced corporate governance.

The message for early common stockholders in startups is straightforward: don’t be misled by simplistic assessments of term sheets and deal terms. It’s not just about the common stock v. preferred, but whether all of the common stock gets a voice; not just the common holders cherry-picked by investors.

The Carta SAFE for Seed Rounds

Background reading:

As I’ve written in various places (see above), a significant problem that has emerged in startup ecosystems involves certain investor organizations pushing startups to adopt their preferred financing templates. Predictably those templates are often riddled with issues that favor the interests of the money. Of course these organizations are far too clever to come out and state transparently, “we want you to use this document because it makes us and other investors more money,” so they spin other narratives about saving founders time, or reducing legal fees; even though the “cost” to founders is often orders of magnitude higher than whatever they might be “saving” by mindlessly signing the templates.

This dynamic was most visible with YC’s announcement of the Post-Money SAFE, which implemented economic concepts exorbitantly favorable to seed investors (including YC of course), but was marketed as a way to (air quotes) “help” founders have more “clarity” about their cap table. YC, their long list of positive impacts on the ecosystem notwithstanding, is still an investor with lots of mouths to feed. No one should’ve been surprised that it would use its brand leverage to push a more investor-favorable document onto startups, particularly now that, with its brand having significantly matured, it no longer needs to rely as much on “founder friendliness” to attract startups.

Carta, the incumbent capitalization SaaS used by startups, recently announced that it is enabling automated SAFE financing on its platform. Interesting news, and I’m sure it’ll save teams planning on closing SAFE financings a bit of hassle. But automated SAFE closings have been available on other platforms, like Clerky, for some time, and realistically the technology behind it is hardly earth-shattering. Given that SAFEs are utilized far more in California than in the rest of the market, that’s probably where the automation will have the most impact.

What I find much more interesting, and relevant to topics I write about, is that Carta chose to tweak the YC SAFE docs and create a “Carta SAFE.” Companies can still close on YC’s Pre-Money or Post-Money SAFE templates, but they also have the option of a Pre-Money or Post-Money “Carta SAFE.” The changes themselves are fairly innocuous, but helpful and balanced. More importantly, I think it’s worth recognizing the valuable role that an organization like Carta could play in promoting various template financing structures to startups.

YC is a venture capitalist, and thus highly biased in the terms it purports to offer as “standard.” They lost tremendous credibility among the legal and startup community – although surely gained favor among VCs – with their 180 on the Post-Money SAFE. They absolutely deserve respect for their track record of picking successful startups, but lines have been crossed with respect to any facade of “founder friendliness” in their template standards.

Carta, however, is a technology company that (as far as I know) is not investing in dozens of startups every year. Carta has far less reason to favor an investor-biased document, and thus potentially has far more credibility in swaying market “standards” in a more balanced direction. This is visible in how they’ve implemented their automated seed financings and templates, relative to how YC pushed out the Post-money SAFE.

Go to YC’s website, and you can’t even find the old pre-money SAFEs with more company-favorable economics and terms. All you have is the new (profoundly investor-biased) Post-Money docs for download. This simple fact has actually caused huge confusion among inexperienced founders, who often aren’t even aware that YC dramatically changed their forms and economics, and thus (thinking they are doing themselves favors) simply download and execute the forms on YC’s site. YC could’ve very easily offered up the new Post-Money SAFEs, while leaving the old forms also available for download, with clear prompting to founders to work with advisors to decide which form they prefer. Instead, YC consciously chose to promote only the new forms, signaling a clear desire to change the market “standard” in favor of investors.

Contrast that with Carta. The Pre-Money v. Post-Money distinction is front and center in their UI, with both types of forms easily accessible to startups, and with helpful tools for comparing dilution from the different structures. This is a far more honest and transparent way for helpful templates to be offered to startup teams, without shady gimmicks or marketing spin to nudge them in favor of the money. It should be applauded.

Of course, I’m not going to wrap up this post without acknowledging that Carta still has bias. Who doesn’t? As an automation tech company, they are obviously biased toward automation and templates that enable automation. There are countless ways in which financing documents can (and often should) be negotiated and tweaked to make them a better fit for the unique context of a particular company raising money from particular investors. Sometimes convertible notes of various flavors make more sense. Other times seed equity. Other times the full suite of NVCA equity docs.

Despite growing traction among public templates, an enormous amount of investors and startups still take advantage of flexibility and customization in their deal docs, because the stakes are so high, the context and people involved so nuanced, and the terms so permanent, that it’s worth doing a bit of negotiation. If a few thousand dollars of legal fees can save you a few million in the long-run on your cap table, it doesn’t take advanced calculus to arrive at a decision.

In saying that, I’m obviously reflecting my own bias as company counsel to startups (and not investors). My job is to ensure startup teams are aware of all the options on the table for their financings and corporate governance. That of course includes bringing up when an automated template might make sense. Sometimes it does, often times it doesn’t. We can all stop pretending that serious lawyers are in any way threatened by tools like Carta or Clerky. I love these tools, because the last thing I enjoy spending my time on is shuffling cookie-cutter forms. Use the cookie-cutter when it makes sense, but make sure you really understand the tradeoffs and limitations, because a lot of very smart teams decide to put the cookie-cutter down and take a more “custom fit.”

Venture capitalists, together with Startups, are biased in favor of their own bank statements. Automation tech companies, like Carta, are biased in favor of hyper-standardization and automation. And high-end ECVC (Startup) lawyers, like me, are biased in favor of flexibility and customization. There’s no need to hide any of this. Every party has an important role to play in the ecosystem, and the interaction of all the moving parts ensures we all arrive at a reasonable equilibrium. All of that being said, I’m glad an organization like Carta has entered the template financing arena, because a well-branded but less biased player was sorely needed.

Moving (Too) Fast and Breaking Startup Cap Tables

The Race to the Bottom in Startup Law

As I’ve written many times before, the “move fast and break things” ethos, which makes absolute sense in a software environment where fixing “bugs” is quite easy and low-stakes, becomes monstrously expensive and reckless when applied to areas where the cost of a mistake is orders of magnitude higher to fix (if it’s fixable at all). Silicon Valley got a very visible and expensive (to investors in terms of capital, and founders in terms of legal errors and terrible legal advice) lesson in this reality a while back with a very well-funded (but ultimately failed) legal startup heavily promoted as enabling (via over-hyped vaporware) startups to “move faster” and save significant costs. That legal startup was, perhaps unsurprisingly, controlled by money players with all kinds of reasons to profit from startups (that they invest in) getting weak legal and negotiation guidance. No one wants an in-experienced founder to move fast and mindlessly do what investors want more than… those investors.

That fundamental point is one that inexperienced founders need to keep their eye on throughout their entire fundraising and growth strategy. Notice how, for example, certain Silicon Valley groups adamantly argue that SV’s exorbitant rents and salaries are nevertheless worth spending capital on, and yet simultaneously they will howl about how essential it is that startups minimize their legal spend (a small fraction of what is spent on rent and salaries) in fundraising, and move as quickly as possible; usually by mindlessly signing some template the investors created? Why? Because they know that the one set of advisors most capable of “equalizing” the playing field between inexperienced startup teams and their far more seasoned investors is experienced, independent counsel. Aggressive (and clever) investors say they want you to adopt their preferred automation tools and templates because they care so much about saving you money, but the real chess strategy is to remove your best advisors from the table so that the money can then, without “friction,” leverage its experience and knowledge advantage.

At some obvious level, technology is an excellent tool for preventing errors, especially at scale when the amount of data and complexity simply overwhelms any kind of skilled labor-driven quality control mechanism. But there is a point at which people who sell the technology can, for obvious financial incentives, over-sell things so much that they encourage buyers to become over-dependent on it, or adopt it too early, under the delusion that it is far more powerful than it really is. This drive to over-sell and over-adopt tech for “moving really fast” is driven by the imbalance in who bears the cost of fixing “broken things.”

Ultimately the technology seller still gets paid, and puts all kinds of impenetrable CYA language in their terms of service to ensure that no one can sue them when users zealously over-rely on their products in ways clearly implied as safe by the tech’s marketing. Founders and companies are the ones who pay the (sometimes permanent) costs of a poorly negotiated deal or contract, or in the case of cap tables incorrect calculations and promises to employees or investors.

In the world of cap tables, automation and tracking tools like Carta (the dominant player, justifiably, by far) are enormously valuable, and doubtlessly worth their cost, in helping the skilled people who manage the cap tables keep numbers “clean.” In the early days of Carta’s growth (once called eShares), there was a general understanding that cap tables rarely “break” before the number of people on the table exceeds maybe 20-30 stakeholders as long as someone skilled at managing cap tables (in excel) is overseeing things. That last part about someone skilled is key.

There are in fact two broad sources of cap table errors:

Using Excel for too long, which creates version control problems as the number of stakeholders grows; and
Management of cap tables by people who are simply too inexperienced, or moving too quickly, to appreciate nuances and avoid errors.

Technology is the solution to the first one. But today it’s increasingly becoming the cause of the second one. The competitive advantage of technology is speed and efficiency at processing large amounts of formulaic data. But the advantage of highly-trained people is flexibility and ability to safely navigate nuanced contexts that simply don’t fit within the narrow parameters of an algorithm. In the extremely human, and therefore subjective and nuanced, world of forming, recruiting, and funding startups in complex labor and investor markets, pretending that software will do what it simply can’t do – delusionally over-confident engineers notwithstanding – is a recipe for disaster. The combination of new software and skilled expertise, however, is where the magic happens.

The Carta folks have been at this game long enough to have seen how often over-dependance on automation software, and under-utilization of highly trained and experienced people in managing that software, can magnify cap table problems, because it creates a false sense of security in founders that leads them to continue flying solo for far too long. Sell your cap table software as some kind of auto-pilot, when the actual engineering behind it doesn’t at all replace all the things skilled experts do and know to prevent errors, and you can easily expect ugly crashes.

That’s why Carta very quickly stopped promoting itself as a DIY “manage your cap table by yourself and stop wasting money on experts” tool and evolved to highly integrate outside cap table management expertise, like emerging companies/vc law firms and CFOs; who spend all day dealing with cap table math. They realized that the value proposition of their tool was sufficiently high that they didn’t need to over-sell it as some reckless “you can manage cap tables all by yourself!” nonsense to inexperienced teams who’ve never touched a cap table before. The teams that use Carta effectively and efficiently see it as a tool to be leveraged by and with law firms, because startup teams are rarely connected to anyone who is as experienced and trustworthy (conflicts of interest matter) in managing complex cap table math better than their startup/vc law firm.

But as is often the case, the cap table management software market has its own “race to the bottom” dynamics – but a better name may be the “race to free and DIY.” If I’m a company like Carta, and I know that truthfully very few companies need my tool before maybe a seed or Series A round (excel is perfectly fine, flexible, and simple until then), I’m still extremely worried that someone will use the time period before seed/Series A to get a foothold in the market and then squeeze me out as their users grow. That someone is almost always a “move fast and break things” bottom-feeder that will, once again, over-sell founders on the idea that their magical lower-cost DIY software is so powerful that founders should adopt it from day 1 to save so much money by no longer paying for expertise they don’t need.

Thus Carta has to create a free slimmed down version, and they did. But they’ve stuck to their guns that cap tables are extremely high-stakes, and even the best software is still extremely prone to high-cost errors if utilized solely by inexperienced founders. That’s why Carta Launch has heavy ties to a network of startup-specialized law firms. It’s free as in beer, but honest people know that it still needs to be used responsibly by people who fully understand the specific context in which it’s being used, and how to apply it to that context.

But the bottom-feeders of cap table management are of course showing up, with funding from the same people who were previously happy to impose costs (errors, cleanup) on inexperienced teams as long as their software gets adopted and their influence over the ecosystem therefore grows. The playbook is tired and predictable.

Why are you using that other (widely adopted and respected) technology that still relies (horror of horrors) on skilled humans? It’s 2020, you need :: something something automation, machine learning, AI, etc. etc. :: to stop wasting money and move even faster. Our new lower-cost, whiz-bang-pow software lets you save even more time and manage your cap table on your own, like the bad ass genius that you are.

We know where this is going. Many of us already have our popcorn ready. While before I might run into startups who handled only a formation on their own, and show up with a fairly basic and hard-to-screw-up cap table, I’m increasingly seeing startups who arrive with seed rounds closed on a fully DIY basis, and totally screwed up cap tables involving investors and real money. They also often have given up more dilution than they should’ve, because no independent, skilled expertise was used to help them choose and negotiate what funding structure to use. Clean-up is always 10x of what it costs to have simply done it right, with a thoughtfully chosen (responsible) mix of technology and skilled people, on Day 1.

Technology is wonderful. It makes our lives as startup/vc lawyers so much better, by allowing us to focus on more interesting things than tracking numbers or inputting data. The stale narrative that all VC lawyers are anti-technology really gets old. We were one of the first firms to adopt and promote Carta, along with numerous other legal tech tools. Not a single serious law firm views helping their clients manage cap tables as a significant money driver. But that’s like saying no serious medical practice views X or Y low-$ medical service as a significant money driver. Something can be a small part of a professional’s expertise, and yet still way too contextual, nuanced, and high-stakes to leave to a piece of software pretending to be an auto-pilot.

When the cost of fixing something is low, move as fast as you want and break whatever necessary. But that’s not contracts, and it’s not cap tables. In those areas, technology is a tool to be utilized by still-experienced people who regularly integrate new technology into their workflows, while maintaining skilled oversight over it. Be mindful of software companies, and the clever investors behind them, who are more than happy to encourage you to break your entire company and cap table as long as you utilize their half-baked faux-DIY tool. Their profit is your – often much larger than whatever money you thought you were saving – loss.

Silicon Hills Lawyer

A top-tier Startup Lawyer helps Startups and Founders safely navigate high-stakes legal and financing issues, while keeping VCs honest.

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