Post Category → Venture Capital

The Best Seed Round Structure Is the One that Closes

Nutshell: People with strong opinions can argue endlessly about whether founders should be structuring their seed rounds as convertible notes/SAFEs or equity. The problem is that the optimal structure for any type of financing is highly contextual, so anyone offering absolutes on the subject should just “Put that Coffee Down” in the Glengarry sense, before they hurt someone.  The X round that closes is better than the Y round that doesn’t.

Complete standardization of startup financing structures has been a pipe dream for over a decade. Every once in a while someone will produce a new type of security, or flavor of an existing security, and proclaim its superiority. The problem, of course, is very much like the problem faced by any product whose founders hopelessly believe that it will achieve market dominance on technical superiority alone: distribution channels, inertia, and human idiosyncrasies.  In the end, a financing is the act of convincing someone, somewhere, to give you money in exchange for certain rights that they value enough to close the deal.  Values are pesky, subjective things that don’t do well with uniformity.

Outside of Silicon Valley and a very small number of other markets, the people writing the early checks are usually not all rich techies in jeans and t-shirts debating the latest startup/angel investing trends on twitter. Even in Austin they aren’t. They’re successful individuals with their own backgrounds, culture, and values, and very often won’t give a rat’s ass about a blog post saying they should suddenly stop using X security and use Y instead.

So let’s start with the core principle of this post: The Best Seed Round Structure Is the One that Closes. That means priority #1, 2, and 3 for a group of founders is to get the money in the bank. Only from there can you work backward into what seed structure is optimal.

SAFEs are better than Notes? Many non-SV investors don’t care.

This was the same reasoning in a prior post of mine: Should Texas Founders Use SAFEs? To summarize my answer: unless a TX founder is absolutely certain that every investor they want in the round will be comfortable with a SAFE, it’s usually not worth the hassle, and they can get 99% of the same deal by just tweaking a convertible note. Yes, a SAFE is technically better for the Company than a convertible note, and YC has done a great thing by pushing their use. But the differences are (frankly) immaterial if they pose any risk of slowing down or disrupting your seed raise. Here’s what a conversation will often sound like between a founder (not in SV or NYC) and their angel investor:

Angel: Why do we need to use this SAFE thing instead of a familiar convertible note? I read the main parts and seems pretty similar.

Founder: Well, it doesn’t have a maturity date, in case we don’t hit our QF threshold.

Angel: So you’re that worried about failing to hit your milestones and hitting maturity?

:: long pause::

Put. That Coffee. Down.

Debt v. Equity? Do you really have a choice?

There are so many blog posts outlining the pluses and minuses of convertible notes/SAFEs v. equity that I’m going to stay extremely high-level here. The core fact to drive home on the subject is that the two structures are optimized for very different things, and that’s why people debate them so much. Your opinion depends on which thing you value, and that will depend on context.

Convertible Notes/SAFEs are built for maximal speed and flexibility/control up-front. Cost: Dilution, Uncertainty. You defer virtually all real negotiations to the future, save for 2-3 numbers, and note holders often have minimal rights. You can also change your valuation quickly over time, at minimal upfront cost, as milestones are hit. The price for that speed is you’ll usually end up with more dilution (because notes have a kind of anti-dilution built into them) and possibly more liquidation preference. See: The Problem in Everyone’s Capped Convertible Notes.  You’ll also pay a harsher penalty if your valuation goes south before a set of Notes/SAFEs convert than if you’d done equity from the start.

Equity rounds are built for providing certainty on rights and dilution. Cost: Legal Fees, Control, Complexity. An equity round is more inflexible, and slower than debt/SAFEs, but the key benefit is that at closing, you know exactly what rights/ownership everyone got for the money.  Those rights are generally much more extensive than what note/SAFEholders get. If the business goes south, or the fundraising environment worsens significantly, you’ll pay a lower penalty than if you’d done a note/SAFE. But for that certainty, you’ll pay 10x+ the legal fees of a note round (if you do a full VC-style equity round), and have 10x the documentation. That’s why you rarely see a full equity round smaller than $1MM.

Raising only $250K at X valuation and planning to raise another $500-750K at a higher valuation soon, before your A round, because you’re super optimistic about the next 6-12 months? Note/SAFE probably. Raising a full $1.5MM round all at once that will last you 12-18 months, with a true lead? Probably equity.

Seed Equity is a nice middle ground, but if your investors won’t do it, it’s just theoretical. Series Seed, Series AA, Plain Preferred, etc. Seed Equity docs are highly simplified versions of the full VC-style equity docs used in a Series A. They are still about 2-3x the cost of a convertible note round to close in terms of legal fees, but dramatically faster and cheaper than a full equity set. They are a valuable middle ground for greater certainty, but minimal complexity and cost.

But after pondering the nice theoretical benefits of seed equity, we’re back to reality: will your seed investors actually close a seed equity deal? I can’t tell you the answer without asking them, but I can tell you that I know a lot of seed investors in TX and other parts of the country, including professional institutionals, who would never sign seed equity docs.

There is an obvious tradeoff in the convertible note/SAFE structure that has become culturally acceptable for both sides of the deal. Founders get more control and speed up-front, and investors get more downside protection and reassurance that in the future they will get strong investor rights negotiated by a strong lead.

With seed equity, investors are (like with Notes) being asked to put in their money quickly with minimal fuss, but without the downside protection of a note/SAFE, and with significantly simpler investor rights. Many seed investors see that as an imbalanced tradeoff. Whether or not they are right isn’t a question that lends itself to a single answer. It’s subjective, which means the Golden Rule: whoever has the gold makes the rules.  Can they beef up those protections in the next large round? Sure, but many don’t see it that way, and good luck ‘enlightening’ them when every delay brings more reasons for why the round may never close.

I think seed equity is great, and am happy to see founders use it as an alternative to Notes or SAFEs for their seed raise. But that doesn’t change the fact that for every 10-15 seed deals I see, maybe 1 is true, simplified seed equity. And those usually look far more like Friends and Family rounds – where the investors are so friendly that they don’t care about the structure – instead of a true seed with professional seed money.

When it comes down to getting non-SV seed money in the bank, most founders only really have 2 choices for their seed structure: convertible notes or a full equity round. If you’re lucky enough to get a SAFE or seed equity, fantastic. Go for it. But don’t let the advice of people outside of your market, with minimal knowledge of your own investor base, cloud your judgment with theories. When a team debates what type of product to build, the starting point isn’t which one is technically superior, but which one their specific users will actually pay for. Seed round structuring (like coffee) is for closers.

Burned Relationships Burn Down Companies

TL;DR Nutshell:  Success in building a company most often requires a founder team who can not only find great investors, advisors, employees, and other stakeholders, but build deep relationships with those people in a way that leads them to be emotionally, not just financially, invested in the success of the company.  Short-sighted founders focus on the costs of those relationships, ‘transactionalizing’ them in a way that weakens loyalty. The smarter ones realize that those costs are an investment in an invaluable safety net that will support the company when it hits rough waters.

A brilliant phrase that I learned a while back, and which I’ve often used in suggesting to founder CEOs how they should approach building their “roster” (not just employees, but investors, advisors, lawyers, and other stakeholders) is to never be the person who “knows the cost of everything and the value of nothing.”

If you approach every relationship from the perspective of maximizing your gains and minimizing your costs – get the highest valuation possible, keep as much control as you can, minimize the equity package, minimize the salary, discount the bill –  you may think you are doing what’s best for yourself and your company, but in reality you’re just isolating yourself from the people whom you should most want on your team. 

Talent cares about relationships.

The most successful and talented people in any market/industry – venture capital, angel investing, design, programming, law, sales, PR, etc. – very very rarely get to where they are because they were chasing money. They often do what they do because they, in some sense, enjoy it. It may not be fun in the same way that going fishing or on a great vacation is fun, but work is something much deeper to them than just work. This is not at all, however, to say that money is irrelevant to them, but getting paid well is often more about respect for their talent – a moral acknowledgement of the value they provide – than about their actually needing the dollars themselves.

Put slightly differently, the highly talented people whom you want supporting your company’s success will very often have “F.U. Money” or “F.U. Skills” or both. They’ve already mastered the bottom rungs of Maslow’s hierarchy of needs and are looking for respect, involvement, trust, engagement, etc in their work and investments. They are looking for real relationships. Build and nurture those relationships, and the long-term returns will be massive, either for your company or you individually. Burn those relationships, and you’re fu**ed. 

Don’t Transactionalize People.

Obsessed with maximizing your valuation/control and minimizing dilution? You’re going to end up with shitty VCs; the kind who add no value, are always whining about performance, and will replace you in a heartbeat for not producing the results that they can’t help you achieve. Insisting on keeping equity packages as small as possible? You’ll end up with shitty employees who will drive you insane with the amount of oversight, correction, and overall time sucking they require. Focused on keeping those legal bills to an absolute minimum? You’ll end up with shitty lawyers who are unresponsive, incompetent, and accruing legal technical debt that you’ll pay for later. The examples go on and on.

Watch the bottom line and the cap table intelligently, but let good people make good money. When you push too hard against talent, they will either (i) pass  entirely on you for someone who values them more, or (ii) register in their mind that their relationship with you is purely transactional. The qualitative difference between a transactional relationship and a deeper one sounds small, but in a high-risk, low resource business it can be everything.

If you hit a funding snag and need a bridge to get to your next round, investors with whom you’ve built real relationships may put in some money to keep you going. Investors who view you as just another number in their portfolio will not. Need to cut compensation temporarily, or stretch payments on a bill, to get through that bridge period? You better hope your employees and service providers actually give a damn about your business for reasons beyond their paycheck.

Healthy long-term business relationships are built on a mutual sense of fairness; that it’s OK to take into account leverage and context in negotiations, but that everyone should in the end leave a little on the table as a statement that the relationship is there for something bigger than just money.

Mistrust Burns Money.

Trust – meaning a feeling that you have a solid understanding of a person’s authentic character and that they’ll treat you fairly and respectfully – is not just some teddy bear “kumbayah” lets-all-love-each-other buzz word. It is currency that makes doing business long-term significantly, dramatically, more stable and less costly. If you frame it purely in terms of a risk-reward analysis, if I feel like I can trust someone, I automatically feel like working with them is less risky. And if it’s less risky, the threshold of reward that I need (my compensation) to make the relationship worthwhile goes down significantly. Mistrust is spectacularly expensive.  As a startup, you can’t afford for people to not trust you.

The end-conclusion here is a straightforward one: all of the data on business executives confirms that emotional intelligence – the kind of ‘people skills’ that enable you to connect and build trusting relationships with others – is a foundational trait for successful founders, particularly founder CEOs. People are born with varying degrees of those skills, but everyone should work on improving them.

Very very very few teams succeed purely on the momentum of their business. Study the histories of successful teams, and you’ll see a network of valued relationships being built and nurtured over time, propelling founders forward and often protecting them from hitting rock-bottom.  Don’t be the guy who knows the cost of everything and the value of nothing. He’s lonely, unsuccessful, and poor.

The Fiduciary Duties of Founders

TL;DR Nutshell: The moment someone is added to a startup’s cap table, founders (as majority stockholders, directors, and officers) becomes fiduciaries of that stockholder. This means that, regardless of how much control founders may have over a company, corporate governance law draws a hard line on how that control can be used. Crossing that line can result in a lawsuit.

This is one of those “core concepts” posts that, to lawyers and professional investors, will seem laughably basic; and yet the topic is something that I regularly see first-time founders get very wrong. And like most SHL posts, I’m going to explain things without referencing statutes or complicated terms. Founders need to understand the concept of Fiduciary Duties. The details they can learn from their lawyers or on-the-job.

State Corporate Law

Most Angel/VC-backed startups are Delaware corps. If they are not Delaware corps, they are usually incorporated in their home state and will be required by institutional investors to become Delaware corps if/when they ever are offered a check.  Whether you are a Delaware corp or not, your state certainly has corporate governance rules giving founders (as directors and majority stockholders) varying degrees of fiduciary responsibility to minority holders in their company. The concept is the same.

At the most fundamental level, to say that founders have fiduciary duties to their stockholders means that they cannot, without seriously risking a lawsuit, unfairly enrich themselves at the expense of other people on their cap table. They can certainly get rich by making everyone on the cap table rich; by growing the pie. But they can’t, without some kind of very credible case that it is necessary for the well-being of the entire business, improve their part of the pie at the expense of the rest of it. 

Hypothetical: Founders X and Y hired Employee A and gave her 5% of the Company that, because of some big contributions she made, was 40% fully vested on the date of issuance (meaning 2% of the Company’s equity, of her holdings, is fully vested). After a few months after the issuance, they have a big dispute and the founders fire Employee A, which they are certainly entitled to do. Under the Stock Issuance Agreement terms, 3% worth of the Company gets returned (because it wasn’t vested yet), and Employee A walks away with the 2% she had vested.

But Founders X and Y are pissed off that Employee A has that 2%. “She doesn’t deserve it. She totally ruined the product” they say. Then the light bulb switches on. “We control the Board and the stockholder vote! We’ll just dilute the hell out of her by issuing ourselves more shares!” they say.

Sorry, dudes. If it was that easy to screw minority stockholders, no one would ever invest in a company.

Delaware and other states have rules around “Interested Party Transactions.”  Without getting in the weeds, Interested Party rules boil down to:

  • A Board of Directors has a duty (a fiduciary duty) to do what’s best for the company and all of its stockholders taken as a whole, without unfairly enriching its own members.
  • Any transaction in which the Board members themselves are specific beneficiaries – meaning they are getting something that others are not – is inherently suspect. It is an “Interested Party Transaction” and is open to claims by minority stockholders (the people who didn’t benefit from the transaction) that it was a fiduciary duty violation.
  • In order to “cleanse” (so-to-speak) the transaction and, in some cases, give it a safe harbor protection from lawsuits, extra steps must be followed to ensure the transaction really was fair. Those steps usually are (i) obtaining approval by the disinterested members of the Board (if any) and/or (ii) obtaining approval by the disinterested stockholders of the company. The disinterested people are the ones who aren’t getting the special benefits.

Put the above 3 bullets together, and it’s clear that Founders X and Y (i) are planning an Interested Party Transaction and (ii) without getting a “cleansing” vote of that transaction, are assuming a very serious risk of a lawsuit. If there were 5 people on the Board, and the planned dilutive issuance to X/Y was approved by the rest of the Board, then the risk profile of the transaction would be very different. Similarly, if there are other people on the cap table besides Founders X/Y and Employee A, then if their votes make up a majority of the stock not held by X/Y (the disinterested stockholders) and they approve the dilutive new stock, we’re again in much safer territory.

The key is that, in an interested party transaction, you need to get a majority of the people who aren’t getting the ‘special benefits’ to approve the deal. If you can’t, then you’re asking for pain. 

If the entire cap table is X, Y, and A, then X & Y are just asking for trouble and (frankly) deluding themselves by thinking that they can dilute A (without her consent) in a legally air-tight manner. I’ve seen founders throw out a phrase like “let’s just do a recap” (short for recapitalization) as if recaps are a magical get-out-of-fiduciary-duties card. I think that idea was spread by ‘The Social Network,’ but I’m not entirely sure. Recaps are complicated, and you still have to worry about fiduciary duties to get them done properly.

Corporate Governance is Real

The overarching umbrella of the rules, processes, etc. that govern how corporate directors and officers interact with stockholders is called ‘corporate governance.’ Founders sometimes think it’s all silliness reserved for when they go IPO, but it’s not. From Day 1, corporate governance matters. Yes, it becomes more formalized as you grow as a company and the stakes get higher, but it’s the same rules at Seed v. at Series D, just being applied differently. You better believe it matters the moment a VC is on your cap table.

Fiduciary duties do not mean that you always have to do what your minority stockholders want. That would be impossible. It just means that, as a director/officer, you have to do what’s best for the Company (the whole pie), and not just for yourself. If there’s a financing coming up that some of your stockholders don’t like, you should be safe if disinterested parties approve it as something that is the best move for the entire company. I say should, because the rules, the process, and even the language in your board resolutions matter. They can be (and often are) the difference between moving forward knowing that your decisions can’t be challenged v. handing disgruntled stockholders a loaded gun to use against you when you least want them to.