Post Category → Venture Capital

How Founders Lose Control Of Their Startups, Apart from Ownership

Summary: There are many ways, apart from ownership %, that founders slowly lose control of their companies. Some of the more obvious ones get spelled out in term sheets, but professional players in startup ecosystems know how to use more subtle mechanisms to erode founder control.

Seasoned founders and startup lawyers know that there are really two things that matter most in negotiating a term sheet: economics and control.  In other words, from the perspective of a founder, (1) what % of the Company will I own after the deal closes (and, more specifically, what % of exit proceeds do I get), and (2) whose permission is needed to make key decisions? Of the “control” terms, there are explicit ones, like protective provisions,  that competent founders know to focus on.  But there are more subtle aspects, like the composition of the Company’s advisors, and even who the Company’s lawyers are, that when ignored can significantly erode the ability of founders to maintain influence over their companies; particularly in high-stakes situations when there’s significant internal disagreement.

As I’ve written before, being an entrepreneur raising capital means learning to give up control. That’s a given. However, I’m very much a believer in transparency and having your eyes wide open. By educating yourself, you ensure you give up control at the appropriate time, and with fair terms; instead of with subtle power plays that slowly hand control to other people without you even noticing it.

The More Obvious Forms of Control

  • Voting Thresholds and Protective Covenants – These are typically spelled out in stockholder agreements and organizational documents. There are 1,000 ways to draft them, but they basically boil down to: you can’t do X without getting approval from stockholders holding Y% of the Company’s overall capitalization, or a specific % of various classes of stock.
  • The Board of Directors – Who is on the Board, and who has the ability to elect/remove people on the Board? The Board is the core governing body of the Company, which means nothing serious happens without their approval. In a 5-person board, whether founders (common stockholders) elect 3 directors or 2 dramatically alters the power dynamics of a startup.

The Often Overlooked, But Important Control Mechanisms

While voting power and board composition are definitely the most important issues, I always advise founders that maintaining control/influence over the companies they started is much more nuanced than what gets spelled out in a term sheet.

How “Independent” is Your Independent Director?

It’s very common for VC-backed boards to have an “independent” director – usually an industry expert that gets elected by both the common stock (founders) and preferred stock (investors).  However, it’s also fairly common for VCs to suggest that the “independent” director come from their own network of executives.  In judging whether their VCs recommended “independent” is the right person, founders should absolutely include the loyalty of that director to the VCs in the calculus.  He’s in their network, and knows that keeping them happy will mean more influential board appointments in the future. If a founder CEO is well-informed and connected in her startup’s own market, she likely has her own ideas for more independent directors. Put them on the table for discussion.

Board Observers – Who is at the Board Meeting?

Investors often will ask, in addition to a Board seat, for one or two board “observer” positions; meaning, at a high-level, non-voting people who can nevertheless attend board meetings and (usually) engage in discussion with the board. The presence of board observers matters and absolutely will influence discussion on board-level issues, even if they ultimately can’t vote. Don’t hand them out without understanding how they alter a founder’s influence at meetings.

Whom do your lawyers work for?

I’ve touched on this issue before here: Don’t Use Your Lead Investor’s Lawyers. There are hundreds of scenarios in which, in the middle of high-stakes decisions and disagreement among decision-makers on the right (or legal) course of action, founders will turn (protected by attorney-client privilege) to company counsel for advice – what’s legal?, what are the consequences?, what are my options?, what’s “market?” etc. etc..  Many times the “right” decision for the Company is one that won’t sit well, and even piss off, certain groups on the cap table.  You don’t want lawyers who work for those people.

“Don’t just go with the lawyer that the VCs insist upon. These lawyers will work with the VC on a hundred financings and with you on only one. Where do you think their loyalties lie? Get your own lawyer, and don’t budge.“ – Naval Ravikant, Lawyers or Insurance Salesman?

Despite arguments from certain investors and lawyers who claim that the above is a non-issue (you can imagine why), most founders immediately recognize the problem when this reality is described to them.

Where do your advisors and executives come from?

The theme of “pay attention to loyalties” carries on into a Company’s advisors and outside executive hires.  Where did they come from? Who got them this job, or their last job? Are they all part of the same investor group or business network? The conversations they have with you (the founders) will not be the only ones they’ll be having. Pay attention. Careers are long, much longer than the life of a single startup.  Advisors and executives, even those with strong ethics, pay attention to who can get them their next position when their current one exits.

Nutshell: Voting control matters, but it isn’t everything. Loyalties, particularly long-term loyalties, drive human behavior. Don’t be lazy and let every influencer (director, executive, lawyer, advisor) in your company come from the network of a single investor group. Smart ecosystem players know that’s one of the best ways to gain influence over a company without putting anything on paper. Leverage peoples’ contacts, and of course contacts will overlap, but make sure you ultimately have real diversity of perspectives to turn to.  Otherwise, when it really matters, a dozen back-end conversations will end up with really only one voice whispering in your ear.  

It’s precisely when the stakes are highest that a founder needs brutal honesty from advisors and counselors. And nothing ensures honesty like transparency and true independence of viewpoints. Make sure you don’t lose it. 

 

Should Non-SV Founders Use SAFEs in Seed Rounds?

Nutshell: Because of the golden rule (whoever has the gold…), probably not – at least not for now.

Background Reading:

For some time now, there have been people in the general startup ecosystem who have dreamt that, some day, investment (or at least early-stage investment) in startups will become so standardized and high velocity that there will be no negotiation on anything but the core economic terms. Fill in a few numbers, click a few buttons, and boom – you’ve closed the round.  No questions about the rest of the language in the document. For the .1% of startups with so much pull that they really can dictate terms to investors (YC startups included), this is in fact the case.  But then there’s the other 99.9%, much of which lies outside of Silicon Valley.

Much has been written about how SAFEs were an ‘upgrade’ on the convertible note structure, and in many ways they are.  But anyone who works in technology knows that there’s a lot more to achieving mass adoption than being technically superior, including the “stickiness” of the current market leader (switching costs) and whether the marginal improvements on features make those costs a non-issue. And any good lawyer knows that when a client asks you whether she should use X or Y, she’s not paying you for theory. You dropped that sh** on your way out of law school.

This isn’t California

From the perspective of founders and startups outside of California, which are the focus of SHL, the reality is that going with a SAFE investment structure is very rarely worth the cost of educating/convincing Texas angel investors on why they shouldn’t worry and just sign the dotted line. The entire point of the convertible note structure, which by far dominates Texas seed rounds, is to keep friction/negotiation to a minimum.  Yes, there are many reasons why equity is technically superior, but that’s not the point.  You agree on the core terms (preferably via a term sheet), draft a note, they quickly review it to make sure it looks kosher, and you close.  You worry about the rest later, when you’ve built more momentum.  Professional angels know what convertible notes are, and how they should look. They also know how to tweak them.  In Texas, many of them still do not know what a SAFE is. 

And, in truth, many Texas angels and seed VCs who do in fact know what a SAFE is simply aren’t willing to sign one. The core benefit of SAFEs to startups is that they don’t mature, and hence founders without cash can’t be forced to pay them back or liquidate.  To many California investors, this isn’t a big deal, because they’ve always viewed maturity as a gun with no bullets.  But Texas investors don’t see it that way.  Many find comfort in knowing that, before their equity position is solidified, they have a sharp object to point at founders in case things go haywire. I’ve seen a few founders who rounded up one or two seasoned angels willing to sign SAFEs, only to have to re-do their seed docs when #3 or #4 showed up and required a convertible note to close. It’s not worth the hassle, unless you have your entire seed round fully subscribed and OK with SAFEs

Just Tweak Your Notes

The smarter route to dealing with the TX/CO/GA and similar market funding environment is to simply build mechanics into your notes that give a lot of the same benefits as SAFEs. A summary:

  • Use a very low interest rate, like 1-2%. – Many local angels tend to favor higher interest rates (seeing 4-8%) than west and east coast seed investors. But if you can get a very low rate, it’s more like a SAFE.
  • Use a very long maturity period, like 36 months. – 18-24 months seems to have become more acceptable in TX, which is usually more than enough time to close an equity round, or at least get enough traction that your debt-holders will keep the weapons in their pockets.  But if you can get 36 months, go for it.
  • Have the Notes automatically convert at maturity –  This gets you as close to a SAFE as possible, and we’ve seen many angels accept it. If you run out of time and hit maturity, either the angels extend, or the Notes convert, often into common stock at either a pre-determined valuation (like the valuation cap, or a discount on the cap), or at a valuation determined at the conversion time.

How successful you’ll be at getting the above is just a matter of bargaining power and the composition of your investor base. Austin investors, who think more (but not completely) like California investors, tend to be more OK with these kinds of terms.  In Houston, Dallas, or San Antonio, you’ll likely get a bit more pushback.  But that pushback will almost certainly be less than what you’d get from handing someone a SAFE.

Closing Summary: There isn’t, and likely will never be, a national standard for seed investment documentation.  Every ecosystem has its nuances, and working with people who know those nuances will save you a lot of headaches. In Texas, the convertible note, however suboptimal, reigns supreme. Respect that reality, and work within it to get what you want.

The Many Flavors of Seed Investor “Pro-Rata” Rights

Nutshell: Taking seed investment from institutional investors is supposed to be akin to getting engaged; they’ve made a credible commitment to you, but your options are still open to walk if a better Series A partner shows up.  However, if you don’t read an investor’s “pro rata” terms carefully, you’ll find that you’re no longer the bachelor (or bacholerette) you thought you were.

Guiding Principles:

  1. Large seed round investors have an incentive to gain as much control over the composition of your Series A round as they can get – to maintain (or increase) their ownership % of the cap table, and to reduce competition from new outside investors, who might be better for your company.
  2. Founders’ interests, however, are completely the opposite – get large, influential seed investors on the cap table, but minimize their ability to control who leads the Series A.  The greater the flexibility in taking Series A term sheets, the more competition, the higher the valuation for the company.

The Main Issue

No one covers the entire issue of why prorata rights are important to seed investors better than Mark Suster: What all Entrepreneurs Need to Know About Prorata Rights. Because of the economics of seed investing, the ability of seed investors to secure follow-on positions in their “winners” is critical to their portfolio returns.  Also, institutional VCs will typically only write seed checks if they have a reasonable shot at securing a substantial position (15-20%+) in a Series A round.  For these reasons, seed investors will often require, as a condition to their investment, the right to make follow-on investments in future rounds.  These are usually called “pro rata” rights because, on a basic level, the investor gets the right to purchase her “pro rata percentage” of future rounds.  But the point of this post is that how “pro rata” is defined can have substantial consequences in future financings.

While seed investors’ requiring some form of pro-rata is understandable (I’ve found California seed investors demand it much more often than Texas investors), Founders need to be aware that the more follow-on investment rights they grant in their seed, the less flexibility they have in bringing in large, potentially better VCs in the Series A round.  That “bigger fish” that wasn’t around for your seed round will expect at least 15-20% of the Company in the A round, or it won’t “move their needle.”  Getting that VC to this threshold becomes very hard if you’ve already promised your existing investors a huge portion of the A-round.

Being too relaxed about your seed investors’ follow-on investment rights will either (i) force you to give away a very large percentage of your company in the Series A (to “feed” everyone), and/or (ii) give your existing investors the ability to block a term sheet from that outside investor you really want. 

The Flavors

Pro Rata of Fully Diluted – The Classic Engagement.

By far the most common (and company favorable) definition of “pro rata” in seed rounds is pro rata of the Company’s fully diluted capitalization.  This means that the denominator by which the particular investor’s ownership is divided (to determine their pro rata %) is the entire capitalization of the Company, including outstanding shares, options, warrants, and shares reserved but unissued under the Company’s equity plan.  So, for example, if Investor X paid $50K for 100,000 shares, and the total fully diluted capitalization is 5,750,000 shares, then his pro rata percentage is about 1.74% (100K/5.75MM).  If you do a new $1 million round, Investor X has the right to purchase 1.74% of that round.

But a very important wrinkle is that, if the seed round in which the rights were granted is a convertible note round (it almost always is), the investor’s ownership percentage isn’t set yet; so there’s no easy way to calculate the formula.  The note needs to be converted (or at least assumed converted) to arrive at a %.  Without getting too much in the weeds, there are a lot of variables here that can influence what % the investor eventually gets:

  • Does the pro rata right only kick in once the note is converted? If so, then the Company can raise more note rounds (without having to offer pro-rata to existing investors), and those notes will convert alongside Investor X’s note, shrinking his pro-rata %.
  • Do we assume conversion before it actually happens? If so, do we assume it as of the date of issuance (fixed pro-rata), or the date in which the pro-rata right is being calculated (variable, potentially diluted by new rounds)?

The devil is in the details, and the details heavily influence what % an investor is ultimately entitled to.

Pro Rata of the Existing Round – The “You’re Really Married” Version.

On the other end of the spectrum is a significantly less common definition of “pro rata” that nevertheless pops up on occasion in seed rounds: pro rata based on the existing round.  Here, the denominator for the formula is not the fully diluted capitalization, but the round in which Investor X invested – a substantially smaller denominator, and hence a much larger percentage. Example: if Investor X made a $50K investment in a $500K seed round, her “pro rata” under this formula is 10% ($50K/$500K).

Did you see what happened? A tiny variation in the pro-rata language increased Investor X’s pro rata % nearly 6-fold.  And if you’re really paying attention, you’ll realize that, if everyone in your $500K seed round got these pro-rata rights, you’ve just given your seed investors first dibs on your entire Series A. While it’s not as crazy to give your Series B investors first dibs on your entire Series C, since they’re likely deep-pocketed VCs whom you already have a long-term commitment to, giving your seed investors that kind of control of your Series A is dangerous.  It’s the startup equivalent of getting married when you’re 16, before you’ve had a chance to mature and find “the one.”  Be careful.

Other Follow-on Rights

We sometimes encounter other variations of follow-on investment rights that aren’t quite pro-rata rights, but they’re worth mentioning because investors are requesting them for the same reasons.  Warrants granting the right to purchase a fixed $ amount in the Series A are sometimes requested.  I’ve also seen side letters stating flat out that Investor X gets first dibs on Y% of the Series A.  Obviously, like any provision, it ends up being about leverage and the type of investor you’re negotiating with.

The guiding principle for founders should always be to put a limit on their seed investors’ follow-on investment rights.  I personally believe that straight pro-rata of fully diluted is fair and reasonable, but anything above that is overreaching by seed investors trying to control the A round.  By all means keep your seed investors interested and informed, and ensure they are offered the opportunity to lead your Series A.  That’s why they bet on you in the first place.  But the opportunity to lead the Series A is very different from the right to lead the A. If someone demands the latter, it’s time to get serious, because you just got a marriage proposal.