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.

Why VCs No Longer Require Warm Intros

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Once upon a time, the startup and VC ecosystem was a very opaque and fragmented place. Each non-SV market had at best a handful of meaningful check writers who were very geography-centric (local) in their funding. Even Silicon Valley had only a few dozen VCs, who very much expected you to move closer to them if they were going to fund you. Seed funds and accelerators were not a thing. The idea of a “pre-seed” round would be considered comical.

In that earlier, simpler time, much discussion revolved around the importance of the “warm intro.” So much so that I had to write posts like: “Why I (Still) Don’t Make Investor Intros.” Venture capitalists used the way that you were introduced to them as an important signal for a founding team’s chops. Candidly, this is not entirely unreasonable. A whole lot of what a founding CEO does is build relationships with key people in the market, and “sell” the vision so that other players will make an incentives-aligned contribution to the cause: join the team, buy the product, write a check, etc. There is some logic to the idea that if a CEO can’t convince anyone credible to introduce them to a VC, well, can they convince key employees, or key customers, or key commercial partners?

Times change. Now the image of elite VCs sitting in their gilded towers waiting for founders to jump through X or Y hoop just to be given 15 minutes to sit in a conference room chair seems… a bit dated. Sure, the go-go years of 2020-2021 have ended and we’re now in a bit of a reset of power dynamics between founders and funders, but nevertheless the whole process of how top founders get connected with VCs today looks very different from 10-15 years ago. In fact, at the high end of the market, it’s flipped. Rather than founders scrambling to get intro’d to VCs, it’s now VCs scrambling to get intro’d to founders. Multiple articles were written about “VC burnout” as VC partners and associates were, in some cases, under extreme stress trying to get access to good deal flow.

What changed? The Disney-fied story you’ll hear is something like “VCs have become more enlightened.” Relying on intro’s was too “good ol’ boys” chummy. It excluded talented people without connections. It reinforced biases and prejudice. Now our far more modern funding ecosystem is “open,” transparent, meritocratic, with a more level playing field.

Okay, perhaps. I won’t say that narrative is entirely false, but it’s most definitely incomplete. The bigger-picture reason is: competition, and a proliferation of alternative signals for team quality.

In How Angels & Seed Funds compete with VCs I wrote about how changes in the structure and timing of funding rounds produced an entire industry of check writers who preceded VCs in a company’s funding pipeline. Angel investors have been around for a long time, but as the SaaS revolution started dramatically dropping the cost of starting a startup, resulting in an explosion of people trying their hand at entrepreneurship, angels started professionalizing. You now had angel networks and syndicates that could collectively fund an entire round of millions of dollars. They were soon followed by “seed funds,” leaner, faster VCs who led rounds much earlier in a company’s life-cycle relative to more traditional VCs who typically dove in around Series A.

Parallel to the professionalization of angel networks and seed funds came startup accelerators, which were a result of the then-newly emerging seed ecosystem, but also a catalyst for its further evolution. The explosion of young startups who weren’t yet looking for millions of dollars, but for whom a few hundred thousand would make a meaningful impact, begged for a university-like talent sorting service provider that could apply a branded signal onto credibly vetted teams, thus helping them get later funding.

For a period of a few years, there was an elegant symbiosis between the “seed ecosystem” of accelerators, angel networks, and seed funds, on the one hand, and larger VC funds who showed up around Series A, on the other; much like how elite universities sort and credential students, for a price, and funnel them into top-tier employers.

We can pause for a moment here to recognize that this development alone significantly eroded the importance of the “warm intro.” Accelerators and angel networks rarely required warm intros. They had “open application” style ways of connecting with founders, which rarely required references or other connections. This meant a higher volume of applicants of more varied quality, but because the checks were smaller (less concentrated risk), and these orgs staffed themselves with people trained (in a way) to separate wheat from chaff, this significantly expanded the top of the funnel for startups entering the funding market.

At the tail-end of the seed pipeline, once you were accepted/funded by a top accelerator or angel network/seed fund, this served as a credible alternative to the less institutionalized “warm intros” of yesteryear. Someone had already put in effort to get to know you and filter you from the volume of B and C-players in the market, and so VCs grew more comfortable taking those meetings even if a classic introduction wasn’t part of the package.

But unlike centuries-old non-profit universities, the seed ecosystem was made up of dynamic businesses and service providers eager to claim more market share. And so they did.

Elite accelerators and other seed players started forming their own later-stage funds, or investing in VC funds much more tightly aligned with their own interests. If there was money to be made in later-stage rounds, why let some other fund make it? Seed players also started leveraging their control over the top of the funnel to exert pressure on later-stage VCs, requiring them to accept higher valuations, weaker governance rights, and other forms of limits on VCs freedom to operate. See: Startup Accelerators and Ecosystem Gatekeeping.  What had started as a nice complement to the business needs of VCs had now evolved into a direct competitor and gatekeeper.

VCs, being who they are (hardly tender souls afraid of competing), were not simply going to accept these seed-stage upstarts taking control of the ecosystem. The stakes are too high. VCs started evolving and competing, in many cases very successfully. See: Why Startup Accelerators Compete with Smart Money. The significant weakening of the “warm intro,” with many 7-figure check-writers openly inviting founders to send cold e-mails, is a result of this competition. If VCs didn’t want accelerators and seed investors choking them off from the entire pipeline of top startups, they had to get comfortable stepping out of their gilded towers a bit and spending more time filtering through the masses themselves.

Thus the erosion of the VC warm intro is less the result of a newly enlightened VC industry, and more a response to changing market dynamics requiring VCs to loosen up if they want meaningful deal flow. Making the warm intro merely optional is just one way VC is evolving. VC “scouts” – often very young people aligned with a VC fund and incentivized to identify early talent – are a kind of VC-aligned white-label of angel investors. See First Round Angel Track. Some VC funds are going further and creating their own accelerators. See Sequoia Arc.

My personal impression is that elite VC funds identifying and responding to competition from seed players, and themselves creating seed-stage arms of their funds, has been the nail in the coffin of the “golden era” of startup accelerators. It’s very true that some meaningful accelerators still exist, most notably Y Combinator, but it’s quite obvious now that accelerators no longer serve the central role in the seed ecosystem that they once did. It’s hard to imagine accelerators regaining their prominence among the very top tier of entrepreneurs without a significant revamp of their business models, including their pricing.

Ironically, elite startup accelerators once branded themselves as an alternative to a stodgy and antiquated university system, and yet now they themselves are seen, in some circles at least, as unnecessary and overpriced. The truth is accelerators are a service provider, with a relatively high price. It should surprise no one that the market responded by offering similar services (sorting, signals) at other price points. In the golden era of accelerators, a hustler would flaunt dropping out of Stanford or Harvard and joining YC or Techstars. I see a lot more elite founders today skipping accelerators entirely and just getting funded by a seed fund or nimble VC, accumulating a less centralized portfolio of signals, while saving significant dilution in the process.

This is not at all to suggest that the most elite startup accelerators are going away anytime soon. They absolutely have their place, particularly for founders in contexts where they struggle to acquire credible early signals; one key example being international founders in smaller markets. But all accelerators are facing credible competition and erosion of their pricing and brand power, as entrepreneurs at all levels, including those at the very top, realize that the value proposition of accelerators (signals for follow-on funding, a network, advisory) is often replicable at substantially lower levels of dilution.

At one level, the big picture story here is competition between different kinds of funders: angels, seed funds, accelerators, and VCs, all competing for each other’s turf, with different business models and price points. The number and variety of check writers grew significantly, changing power dynamics between founders and funders, and forcing the latter to become more flexible in order to access deal flow.

At a higher level, we see competition between signals. This post is ultimately about warm intros, which are one of many possible signals for the quality of a founder team. The “open application” style of accelerators and seed funds demonstrated that there were other ways to vet the quality of founder teams, and VCs eventually started integrating those other signals into their filtering repertoire.

We may be moving away from the warm intro as a central signal for startup quality, but we will never move away from the need for signals themselves. When people criticize the university system, they’re often criticizing its price, or its effectiveness, but they’re not criticizing the fundamental underlying “service” that elite universities and even standardized tests provide: talent sorting and signals. That service still needs to be provided somehow. The emerging theses are that there are ways of doing it better, cheaper, faster, etc. This is most definitely true, even if it’s also true that the older systems still have their place.

Developing alternative signals that produce results is legitimate improvement and market evolution. Competition between signals is not zero-sum. There’s room for more. But complaining about how existing signals are unfair or exclusionary without offering viable alternatives is (candidly) just whining. Not helpful. What we want to work and what actually works are two separate things.

Similarly, celebrating the weakening of the warm intro, much like celebrating the weakening of institutionalized education and testing, is not the same thing as pretending (delusionally) that we don’t still need effective + efficient talent sorting and signaling. Universities letting go of the SAT as a hard requirement does not mean some highly talented students won’t still use it as their preferred talent signal.

It’s the same with the warm intro. Sure we can talk about how it’s unfair and exclusionary, and that it’s a good thing that there’s a broader menu of signals available, but the fact is for many teams it still works. In fact, given how much bigger the market has become, with a larger diversity of credible intro sources (respected founders, senior executives, and angels being the best options), the warm intro today is arguably much less “chummy” than it was in the tighter, narrower networks of a decade ago. If you can get a strong warm intro (note: lawyers are not strong warm intros), I highly recommend you use it. In a crowded market, anything that can credibly differentiate you is worth using.

The wheat will somehow get separated from the chaff. That’s a fact. More ways of doing that (a wider variety of effective signals) is a good thing. But I would caution anyone from turning this story into some kind of “you can be whatever you want, if you try” warm-and-fuzzy narrative. Startup entrepreneurship is still brutally competitive and meritocratic (albeit imperfectly); exclusionary by design, just like any high-stakes industry or sport. Some barriers, like the warm intro requirement, have been loosened. But that’s meant the number of entrants has multiplied 10-fold.

The competition among funders has gotten much more intense, but so has the competition among entrepreneurs. The strongest teams will always use credible, unambiguous signals to differentiate themselves from weaker players in an increasingly crowded and noisy market. Some of those signals will be elitist, because the entire point is to identify the elite.

End-note: The topic of intros and signals often gets understandably lumped into discussions of “diversity” in the startup ecosystem. If you’re interested in my candid thoughts (as a latino from a low-income background) on that topic, see: Diversity in Startups: Whining, Warring, Winning. 

Milestone-Based Valuation Caps for SAFEs and Convertible Notes

TL;DR: When it’s difficult to get aligned with investors on the appropriate valuation cap in your Convertible Note or SAFE, having a tiered milestone-based valuation cap can be a reasonable compromise. If you hit the milestone, you get the better (for the company) deal. If you don’t, investors get the better deal. But avoiding ambiguity in the language is key.

Related Reading:

Equity rounds, including simplified/leaner seed equity, have always been preferred by founders for whom “certainty” over their cap table is a key priority. Equity allows you to lock in a valuation and certain level of dilution, which is often an optimal strategy in boom times when valuations are very juicy; though of course over-optimizing for valuation alone, to the exclusion of other factors (like liquidation preferences, governance power, investor value-add, etc.) is never a good idea.

But as of right now (December 2022), we are definitely not in boom times. The startup ecosystem has seen a dramatic contraction in financing activity, and uncertainty over valuations has taken over; with investors demanding that they move lower, and entrepreneurs struggling to accept the new reality.

Convertible securities (Notes and SAFEs) have always had the benefit of being more “flexible” and simple than equity. They have their downsides for sure, but in many contexts when speed-to-closing is important, and fully “hardening” a valuation is not possible, they make a lot of sense. But in times of maximal uncertainty, like now, even agreeing on an appropriate valuation cap can be tough. You believe you deserve more, but the investors, often citing all the apocalyptic data, say you’re being unrealistic.

A milestone-based valuation cap can be a good way of getting alignment on a valuation cap, especially if you’re highly confident in your ability to hit that milestone, but you have no credible way of getting an investor today to share your confidence. Investors tend to like valuation caps because they are asymmetrically investor-friendly – if the company performs well, the cap limits the valuation, but in a bad scenario, investors get downside protection (lower valuation at conversion). A milestone-based cap is a way of making the cap’s “flexibility” a bit more symmetrical, with upside for the company if it outperforms.

A milestone valuation cap would say something like (paraphrasing): “If the Company achieves X milestone by Y date, the Valuation Cap will be A. If it does not, the Valuation Cap will be B.”

Simple enough, but as always the devil is in the details. When using a milestone valuation cap, you want to minimize ambiguity and the possibility of disagreement in the future as to whether the milestone was in fact achieved.

Bad milestone language: “The Company successfully launches an alpha product to market.”

What do you mean by “successful”? In whose opinion? By what date? What constitutes a “launch”?

Better milestone language: “The Company’s product/service achieves at least 10,000 daily active users by [Month + Year], with such metric to be calculated and reported in good faith using a consistent methodology determined by the Board of Directors in its reasonable discretion.”

Not 100% air-tight – it can often be unproductive to over-engineer the language, and too much distrust between investors and management as to calculating the milestone is a bad sign – but still far clearer and less subject to disagreement than the first one.

If you find yourself cycling in discussions with investors over what the “right” valuation is for your seed round, consider committing to a milestone-based structure as a way of (i) getting alignment as to what “success” looks like post-close, and (ii) bridging the “confidence gap” between the founding team and the money.

Startup Governance Choke Points: Protective Provisions

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

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

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

The hidden VC “block” on future fundraising. 

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

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

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

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

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

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

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

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

Preventing / Negotiating this Choke Point

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

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

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

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

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

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

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

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

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

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