Lessons from Elon Musk (Mistakes) for Startup Governance

Thou shalt have no other gods before Me.” – The 1st Commandment

This post is going to discuss certain high-stakes financial happenings with one of the great heroes of the Startup / Tech Ecosystem of recent decades, and indeed someone I deeply admire for his technical acumen (political opinions are more hit and miss): Elon Musk. Depending on your orientation, I might even be called a “fanboi” at times. I am particularly a big fan of his achievements at Tesla and SpaceX, as well as his efforts (however imperfect and ham-fisted) to reorient X fka Twitter toward a more free speech philosophy.

Elon Musk had his hand slapped big time by Delaware courts, having his >$50 billion Tesla compensation package annulled for lack of appropriate Board governance and process. He is now very angry and campaigning to have Delaware dethroned as the international destination of choice for corporate law. His view is that Delaware has treated him unfairly by overriding the choices Tesla’s Board, clearly controlled by him, chose with respect to determining Elon’s compensation package.

On numerous occasions I’ve heard Elon referred to, particularly among startup players, as a “god.” That is understandable, because his technical and business talents certainly get close to once-in-a-generation ultra ultra elite level. An apex Navy Seal of an entrepreneur.

For that reason, I included the 1st commandment above. Completely putting aside actual religious theology, the more intellectualized interpretation of the 1st commandment goes something like this: do not deify – in the sense of treating as infallible and therefore worthy of worship, even absolute power – something or someone that doesn’t deserve it; which is to say no one and nothing deserves complete worship like “God.” Everything and everyone, no matter how good in a particular context or domain, has limits and points beyond which they need to be constrained, lest very bad things begin to happen. Inarguably (I think) good advice.

As someone who’s worked for over a decade in various startup ecosystems, watching numerous companies rise and fall (for all kinds of reasons) either up close or from various distances, I’ve come to analogize entrepreneurial energy to something like uranium, gasoline, or the sun. All highly concentrated, tremendously powerful sources of energy. The core drivers of the economy. Immensely valuable and important.

And yet, used in the wrong way, without appropriate processes, checks and balances, they kill and destroy: explosions, cancer, apocalyptic painful fire. It takes an appropriate system to channel that energy into something productive and valuable. Our sources of entrepreneurial energy deserve tremendous respect and freedom – something which American culture is uniquely good at, but they’re not gods. They too need constraints, or they’ll kill us.

Notice the word system in the term startup ecosystem. What has turned the world of American venture-backed startups into an economic powerhouse that is envied by the world is not, and never has been, simply bowing to entrepreneurs wholesale, giving them 100% unconstrained power to build whatever and however they see fit. The actual startup ecosystem has never deified genius entrepreneurs. Instead, it has placed their energy and talent within a dynamic, evolving system of independent forces, each with their own guiding principles and incentives, that shapes and channels that energy into world-changing enterprises.

Professional venture capitalists – not the unbundled dumb money funds swirling the ecosystem in recent years but actual professionals with deep networks and expertise about startup and growth playbooks – are one example of a countervailing force on entrepreneurs. You will hear propaganda in the market suggesting that all VCs are useless and just waste time beyond their willingness to write checks, but this is patently and obviously false from even a half-hearted review of the history. Numerous household names in tech were deeply shaped by elite VCs coaching, guiding, and even constraining entrepreneurs when experienced judgment suggested doing so was necessary to keep the energy flowing in a productive direction.

That is not to overstate the role elite VCs have played in the ecosystem. They too are not gods, and absolutely need their own constraints and monitoring to avoid excesses. But they are a valuable and necessary part of the system that shapes entrepreneurial energy into our elite economy.

Other not-quite revered but still important forces in the ecosystem include lawyers – representatives of the democratic and court-determined legal system for protecting and aligning interests in a high-stakes economy of diverse players – and accountants (auditors) also play an important role. Employees as well. Accelerators, despite their overall decline, are also worth mentioning even if fundamentally they are just VCs of a particular flavor.

The startup ecosystem as we know it is built by setting these players – these forces – to interact, engage, and when appropriate constrain each other. Imagine a weather system with different forces constantly swirling around and engaging, pushing and pulling, mixing and unmixing. That’s kind of how an entrepreneurial ecosystem works. No single force – yes, not even ultra elite entrepreneurs – is so universally good and important that it should completely override all the other forces that have proven themselves time and time again as essential toward channeling all the energy toward a constructive, durable outcome.

Over centralizing such a dynamic ecosystem, allowing one set of forces to take over another, weakening the checks and balances, is usually bad for the market as a whole. One example of this would be venture capitalists controlling the lawyers who advise companies, biasing their advice on conflicted high-stakes issues. I’ve written about this quite a bit. Another example would be businesses hiring sycophants as legal advisors or accountants to misinterpret or misstate laws or financials, denying the open market the transparency and protections that the system has evolved to provide. We see this quite often as well.

The fact of the matter is that Elon had a kind of kangaroo Board of Directors, including his own divorce lawyer, his brother, and supposed “independent” directors who in fact owed much of their wealth to Elon and even vacationed with him; something which may seem innocuous in smaller cases but is material when the executive in question is one of the world’s wealthiest people and can fund some really nice vacations.

Thus when Elon’s compensation package and the process for determining it were reviewed, it was a joke. Amateur hour of the highest order, inappropriate for a Series B startup let alone a public company like Tesla. There was not even a feigned attempt at a professional process. Elon thought himself a god who didn’t need to listen to the legal system or lawyers. The Delaware Chancery Court, a global force in corporate law with tremendous gravitation pull, just gave him a reality check.

While Elon is understandably not happy about that, in the bigger picture it actually reinforces why the American business economy – and Delaware law specifically – is so respected internationally. Nothing says “rule of law” (music to the ears of high-stakes economic players entrusting enormous amounts of money to complex governance systems) like overriding the (in this case arrogant) wishes of the wealthiest person on earth to enforce the rules.

To be very clear, this is not to say that laws are all important. Sometimes laws should be changed, even fudged. Uber is a great example of a company that thoughtfully broke some laws in order to improve them. Incidentally, it’s also an example of an entrepreneur ultimately getting out of hand and smart VCs + lawyers playing a constructive role to get the business back on track.

Laws are, in many respects, like speed limits. We can always assume they’re going to be fudged on the margins, and yet where you set them still plays an important role for determining how far the fudging goes. Elon clearly went too far, pushing (metaphorically) 150mph in a 75 zone. However special of a person he may be, and however important his achievements, there is always a point at which the system simply cannot tolerate anyone setting such reckless behavior as an example.

The lessons here for startup governance are straightforward. Legal advisors should not be sycophants – they should not be beholden to the VCs or the entrepreneurs wholesale. The most aggressive players on either side of the table will very often try to hire gladhander advisors so desperate for the work that they’ll rubberstamp whatever, and yet somehow independent professionals with actual backbones need to be allowed into the room.

Founders sometimes misinterpret my writings about corporate governance and “independent” company counsel as suggesting that I’m going to just be a founder CEO’s lap dog. Being independent from the VC’s so that company counsel can properly represent the common stock as a constituency is not the exact same thing as working for a particular founder.

Independent directors should be meaningfully independent, not the CEO’s or the VC’s BFF. Credible processes for setting very high-stakes compensation matter. And no, simply getting a fragmented stockholder vote at the end to “cleanse” an otherwise horrible process is unlikely to be sufficient, particularly in cases fraught with time constraints, information asymmetries, and coordination problems among the stockholders.

This is also not to say that Elon did not deserve to be extremely handsomely rewarded for his spectacular performance as Tesla’s leader. I’m sure his compensation will still be very very juicy. It just means that even Elon should have respected the process – the system – in which he was operating. He chose not to, and the system pushed back in a language that, short of imprisonment, even someone like Elon can definitely read and learn to respect: lots and lots of money lost. That kind of pushback is exactly what ecosystems must do in order to stay durable, dynamic, and not beholden to any single fallible, imperfect, definitely not a god player.

Corporate governance isn’t everything, but it matters, requiring constant monitoring and calibration to prevent conflict, collusion, and corruption. It has proven itself to serve a very important function in the startup ecosystem. Take it seriously, even if you’re an aspiring Elon Musk.

The (Real) Problem with Carta for Startups

TL;DR: Carta has forever sold itself as friction-reducing “infrastructure” for the startup ecosystem. What this recent debacle around shady secondary sales pitches reveals is that “reducing friction” often comes at a cost of over-centralizing the market. We need to think more broadly about whether keeping the startup ecosystem a bit more decentralized, even if that may seem “inefficient,” is actually a net positive in terms of trust and security for startups.

Carta, the cap table tool and self-proclaimed “infrastructure” for startup ecosystems, was all over the news recently in startup circles, because of the following:

In short, it appears that sales people for Carta’s secondary liquidity platform (for selling early startup shares to interested later-stage investors) were accessing cap table data, including investor contact info, of startups using Carta and directly pitching investors as to liquidity opportunities – all without (importantly) the knowledge of CEOs or Boards. A clever (in a mercenary sense) revenue-building strategy, but a spectacular breach of trust. No CEO or Board wants to be worrying about potential huge shifts in their cap table because their cap table software is out trying to get their angels/seed investors to sell their shares.

After a lot of back-and-forth, including some peculiarly aggressive accusations by its CEO, Carta eventually decided to exit the secondary market entirely; a smart move in my opinion even if it’s criticized by some as too reactive. 

What I want to write about on this post is that this whole debacle reveals something concerning about Carta’s long-stated aspirations as it relates to the startup ecosystem. What does it really mean when Carta repeatedly states that it wants to become foundational “infrastructure” for startup equity, and that it seeks to reduce “friction” in startup equity markets? Being a great cap table tool – what Carta originally was – has always been an obvious positive for startups, even if Carta has repeatedly been criticized for being overpriced and too complicated and has since started receiving more heated competition from leaner alternatives; particularly Pulley.

But should founders, VCs, and other startup ecosystem players actually want a centralizing tool to maximally unify the ecosystem and reduce so-called “friction,” as Carta has repeatedly pursued, or is there something about the decentralized nature of the startup market that is actually good? Is it possible that some “friction” in how the startup ecosystem functions is desirable and positive for founders and startups?

Analogies to the decentralization philosophy of crypto, and perhaps also open source software, are appropriate here. Crypto gets lambasted for all the energy that is expended in maintaining blockchains, but the regular response is that “inefficiency” is worth the added security of not having any centralized node that market participants need to trust to behave “nicely.” Friction is a price that is sometimes worth paying in high-stakes situations where trust and security are paramount.

You see similar concerns when discussing proprietary v. open source approaches to various forms of software and hardware. Yes, there is some benefit in some contexts to relying on proprietary “infrastructure” – scale economies, data aggregation, etc. – but obviously concerns about monopolistic rent extraction loom large and very often push markets toward decentralized or even open source standards.

I’ve raised my own concerns about conflicts and interest in startup ecosystems, when self-interested players with broad brands pretend to be helping founders but are in fact using their market power to effectively extract rent from the market. For example, I wrote about how YC’s Post-Money SAFE is actually a horrible instrument (economically) for many startups, and many founders don’t get advised about how to make its terms more balanced. YC has made a ton of money from pushing the Post-Money SAFE as a “standard.”

But the selling point of YC’s templates has always been “efficiency” and “reducing friction.” Again, we see a trade-off: trusting a self-interested party (in this case an influential investor) to set so-called “standards” may in some sense reduce “friction,” but the cost of that friction reduction is significantly more dilution to startup founders. Friction reduction, and trusting a centralized party to provide it, is not a free lunch. We need to assess the full costs before determining that it’s actually a good idea.

I’ve advocated for a more open source approach to startup financing templates, where we don’t pretend anything is a “standard” that shouldn’t be negotiated, but still allow for a github-like repository of well-known starting points for negotiation. This allows for some measured benefit of standardization, while maintaining decentralized adversarial players who negotiate and ensure each deal truly makes sense for the context.

I’m also an advocate for open source cap table templates. I think automated cap table tools have over-sold themselves, particularly at the earliest stages, and founders would be wise to understand that Excel is perfectly fine (and free) until perhaps Series A, or at least post-Seed.

I’ve also written about the tendency for startup law firms to flout conflicts of interest with the VC community. They’ll build deep relationships with VCs, while parlaying those relationships into representing the companies those same VCs invest in. The founders are often told that these counsel<>investor ties will “help” them – it will reduce “friction” because the lawyers know the VCs well – but it’s complete nonsense and even contradictory to the entire point behind rules around conflicts of interest in law.

You simply can’t trust lawyers to advise you properly in negotiating with a VC if that same VC regularly sends work to those same lawyers. This is why we designed Optimal to be a company-focused firm, and we regularly turn down VCs who ask to work with us. That has a cost in terms of limiting our revenue opportunities, but not unlike Carta’s decision to exit secondaries, it’s about preserving client trust. It’s a bet that the market needs and wants a player, in our case a law firm, offering trusted advocacy above what more conflicted players can provide.

All of this suggests that friction, though sometimes spoken of exclusively in negative terms, often serves a purpose. Negotiation is friction. Diligence (including of a VC’s reputation) is friction. Competition and independent review (even if redundant) is friction. Having multiple sets of advisors representing different parties instead of everyone mindlessly trusting one conflicted group is friction. Assessed holistically, sometimes friction is worth it when interests are fundamentally misaligned. 

So my advice as a VC lawyer watching how this has all played out with Carta is: the outcome here is good. It’s good that the ecosystem spoke its voice, and Carta acknowledged a fundamental problem with its business model. But let’s not miss the much broader lesson here as it relates to the many other situations in which some influential ecosystem player will promise startups “less friction” in exchange for trusting them perhaps far more than they really deserve.

I like Carta as a cap table tool, even if I think it needs to simplify itself and lower costs. I am, and have been, much more deeply skeptical of Carta as centralized “infrastructure” for the entire startup ecosystem, promising all of these wonderful benefits so long as we trust it with enormous amounts of power and data. This most recent debacle (I think) shows why others should be a bit more skeptical too.

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 land grab dynamic here, in 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).

Many entrepreneurs and startup teams in particular have lost huge amounts of equity and money by being misled into signing inflexible contracts that they thought were “standard,” but really aren’t. The smallest bit of tweaking and negotiation can produce enormous differences in financial outcomes.

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 and Scalar have lean 409A-only (no extra software) offerings.  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.

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.

Related reading:

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, 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-$45K assuming the round is $4-6 million-ish raised. A larger round closer to $10M+ or higher may be closer to $50K due to more legal work demanded by the VCs, and will look more like a Series A. Again, BigLaw’s rates will drive that higher if you go that route. Often 2x. 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.

We also published The Open Startup Model for founders who (understandably) want to avoid the cost of a third-party capitalization tool entirely until later in their company’s trajectory. A lot of lean companies get by just fine during seed stage, and sometimes even Series A, relying on a simple but well-organized excel model.

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. Also consider just leaning on an Excel-based cap model.

Good luck.

Post-Money Valuation Cap Convertible Note Template

Link: Post-Money Valuation Capped Convertible Note Template

See also: Seed Round Template Library

Post-money (as opposed to conventional pre-money) valuation caps have become more of a thing in early-stage startup convertible rounds. The primary benefit of a post-money cap is that it makes it clearer to investors what percentage of the cap table they are purchasing as of the day of their investment, because the “all-inclusive” valuation cap incorporates all SAFEs and/or Notes the company has raised, even if they haven’t been formally converted or modeled on the cap table. In pre-money caps, what you are buying is more ambiguous.

The extra transparency of post-money caps can be a very good thing. But as I’ve written before, and many others have pointed out, the default post-money SAFE that YC published a few years ago had a very anti-founder “gotcha” built into it. Not only did it commit to a specific % of the cap table today, but it also gave investors aggressive anti-dilution protection for any future dilution from more SAFES or Notes, all the way until an equity round in which everything converts. Tons of companies have gotten burned by this, not understanding that YC’s Post-Money SAFE structure forces the common stock alone to absorb all dilution until SAFEs convert. This is way worse economically than other financing structures for early-stage.

Frankly, YC’s decision to make its SAFE instrument so investor friendly was surprising, even acknowledging that they, as investors, surely have benefited financially from it. Giving post-closing anti-dilution protection to SAFE investors isn’t necessary at all to give them the real primary benefit of a post-money cap, which is clarity as to what they are buying today. If I’m investing into a company that already has raised some SAFEs or Notes, I surely would like a hardened commitment as to what post-money valuation I’m paying for today, but I don’t see why I should expect protection from future dilution. For that reason, we published a “fixed” post-money SAFE template. With a few added words (clearly reflected in track changes for transparency), it “fixes” this anti-dilution problem in the YC template.

Acknowledging the benefits of even a “fixed” post-money SAFE, the truth is a lot of investors around the world, and in the U.S., still aren’t comfortable with SAFEs. They think SAFEs generally skimp too much on investor protection. For example, particularly in a down market like today, some investors would prefer the debt treatment of a convertible note. Even in 2023, we still see quite a few deals closed on convertible notes instead of SAFEs. I represent exactly zero VCs or tech investors, and what I’ll say on this topic is that in reality the differences between SAFEs and Notes are not super material; and never worth losing funding over them. Go with whatever works, and just make sure you have good advisors to protect you on more material points.

Most convertible notes I see today still use the older-style of pre-money valuation cap. There’s no reason why founders, in choosing to raise on a convertible note, should be stuck only with pre-money valuation caps, given that, as I described above, there can be very good reasons for using a post-money structure.

For that reason, I’ve taken the convertible note template that’s historically been publicly available here on SHL, and made a post-money valuation cap version. The benefits of a post-money valuation cap’s clarity, but under a convertible note structure. Just one more potential template to leverage in closing an early-stage round. Importantly, it does not have YC’s harsh anti-dilution mechanisms built in. The purpose of this post-money cap is to reassure investors as to what they are investing in today. There is no promise of anti-dilution for future fundraises because, in my opinion, there shouldn’t be.

The usual disclaimers apply here. This is just a template, and it is intended for use with experienced counsel. I am not recommending that founders use this template on their own without experienced advisors. If you choose to do so, do not blame me for any negative consequences.

Related recommended reading: Myths and Lies about Seed Equity. As useful as SAFEs and Convertible Notes are for simple early-stage fundraising, my impression is that they tend to get over-used, sometimes in contexts when an equity round really makes a lot more sense. Make sure you understand the full pros and cons of an equity round, including potential “seed equity” structures that are simpler and cheaper to close than full “NVCA” equity docs. A lot of the over-use of Notes and SAFEs stems from myths and falsehoods often shared in the market about equity deals.