Pre-Series A Startup Boards

It’s pretty well known that startups usually undergo a meaningful change in Board composition at their Series A round. At a minimum, the lead investor(s) of the round get Board seats; although they shouldn’t get Board control.

Less has been written about what startup boards tend to look like before a Series A round. Given that the time from formation to Series A has stretched out significantly for many companies in the market – due to pre-seed, seed, seed plus, seed premium, series seed, seed platinum diamond, whatever-you-want-to-call-not-Series A rounds. So here’s some info on what a board of directors tends to/should look like Pre-Series A.

A. Know the difference between a ‘Board’ of Advisors and a Board of Directors.

A lot of companies refer to their set of advisors as a ‘Board’ of advisors. That’s fine, even though they very rarely actually act like a board. There (usually) aren’t ‘Board of Advisors’ meetings where everyone gets on a conference call and talks shop. Instead, the company just has a loose set of individual advisors they work with on strategic matters, often in exchange for equity with a vesting schedule. Advisors often times are angel investors as well.

The important point here is that Advisors have no power/control over the company. They just advise. The Board of Directors, however, is the most powerful group of people in the Company, with the ability to hire and fire senior executives and approve (or block) key transactions. Big difference. Giving someone a seat on your Board of Directors is 100x more consequential to the company than naming them an advisor.

B. Know the difference between a Board Observer, Information Rights, and being a member of the Board of Directors.

Most angel investors writing small checks are buying the right to a small portion of the Company, and that’s it. They don’t expect to be very involved in day-to-day, and are happy to just receive whatever e-mail updates the Company intends to send out.

Angels / Seed Funds who write larger checks may want a deeper view into what’s going on in the company. They’ll often ask for different variants of ‘information rights’ – which can include delivery of regular financials, and notification of major transactions (like financings).

A step up from ‘information rights’ is a Board observer right. This means the investor has the right to observe everything that happens at the Board level, which includes hiring people, equity grants, approving major deals, etc. Do not dish out Board observer rights lightly. Having too many observers can make it difficult to keep confidential matters from being leaked to the market. It also can just be logistically cumbersome for a seed stage company to keep track of who gets to attend meetings, who has to be notified of what, etc.

Also, if you do give someone a Board observer right, ensure that it’s clear that they are a silent observer. This means that they can listen in on Board discussions, but they are not entitled to provide their thoughts/input, which can have legal ramifications and influence the true decision makers.

C. Giving seed stage investors Board seats is not the norm. Take it seriously.

The majority of companies we see have Founders only on the Board before closing their Series A. Sometimes it’s just the CEO; other times it’s 2 or 3 founders. That’s very much driven by the personal dynamics among the core team.

Occasionally a seed or VC fund writing a large seed check ($250K+) will request a Board seat for their seed investment. While not the norm, it’s also not terribly off market if a large check is being written. Founders should just understand that giving anyone a Board seat, even if they don’t control the Board vote, is inviting them to give their input on every single major strategic decision the Company will make. It is a very deep commitment, and should only be given to people you believe can deliver real value to the business, and whose values are aligned with the founder team. Otherwise you’re asking for unnecessary and distracting drama.

If the fund that wrote the large seed investment has deep enough pockets to lead a Series A, and is interested in leading your A, this adds even more layers of complexity to the decision. A *true* seed investor who only invests in seed rounds can be an asset in sourcing Series A leads, because those leads are a complement to their position. A VC who dabbles in seed investment for pipeline purposes, however, has opposite incentives; assuming you’re doing well, they may prefer to lock out other potential competitors and take the Series A round for themselves. Having a VC already on your seed-stage Board can make it harder to get term sheets from outsiders for your Series A.

This dynamic of committing early to a VC before you’re ready for a Series A is discussed somewhat in The Many Flavors of Seed Investor “Pro-Rata” Rights.  My experience has been that getting trustworthy VCs on your cap table pre-Series A is generally a very good thing, so long as their participation is not contingent on terms that effectively lock you into having them lead your Series A. That is the startup equivalent of getting married as a teenager, before you’ve had a chance to mature and really explore the market.

VCs who ask for board seats at seed stage, or who require that you guarantee them the right to a large percentage of your Series A (50%+) are trying to get you to lock yourself in early. You should want them to invest, but still ensure that they have to earn the right to lead your Series A.

D. Board composition should ‘reset’ at Series A.

If you’ve ended up giving a Board seat to a large seed investor in order to secure their investment, it is extremely important that it be clear between everyone that the seat is not guaranteed indefinitely. Boards can only be so large. If your seed investor who put in $250K is guaranteed a Board seat forever, it makes it a lot harder to make room on your Board for the people putting in millions, or even tens of millions of dollars.

The logic here should be that if the seed investor insisted on a Board seat at seed stage in order to ‘monitor’ things early on, they should be comfortable letting go of the wheel once they know larger, more experienced institutional investors are taking over. Their interests as an investor are more aligned with the new VCs investing in the Series A than they are with the Common Stock. It simply is not appropriate for a company who’s raised $5 million, $10 million, $30 million+ dollars of capital to still have someone who wrote a $250k-500k check taking up a board seat. Board observer rights should also terminate at Series A, or perhaps Series B, for similar reasons.

So, in a nutshell, founders should start with the assumption that no one will join their Board of Directors until a Series A happens, and someone writes a 7-figure check; as that is the norm. However, for large checks from investors with strong value-add and alignment with the founders, there can be a justification for giving them a seat at the table, as long as it’s structured in a way that will not cause any issues, or prevent competition, in Series A negotiations. For investors who want (and deserve) something ‘extra’ on top of their investment security, advisor equity, information rights, and silent observer rights should all be explored as alternatives.

Electing a Truly Independent Director

TL;DR Nutshell: There are few governance-related decisions with a more outsized impact on a company’s power structure than the selection of an independent director. Do not take that selection lightly.

Background Reading:

In assessing financing terms and interacting with their lead investors, most founders instinctively focus on two core things: economics and control. And, broadly speaking, that is correct.  But the devil is in the details, and too many teams overlook extremely important details. They’ll focus on high-level issues like valuation, liquidation preference, and board composition (# of seats), and then prematurely check out once a term sheet is signed. And that’s when sophisticated players start executing their playbook for maneuvering into a controlling position regardless of what the black-and-white text says.

I’ve already written extensively on how one part of that playbook is for investors to push companies to use their ‘preferred’ company counsel. Another classic maneuver is to push the company to elect an ‘independent’ director with whom investors have significant ties and influence. 

Independent Director as Tie-Breaker

Independent directors are, arguably, the most important people on Boards of Directors.  They are supposed to serve as an objective voice on what’s best for the Company overall; balancing the incentives of common stockholders (management/founders) and preferred stockholders (investors) that can often pull in different directions. They should have no reason to be driven by control or personal payout.

It is not unheard of for there to be significant disagreement between the common and preferred stockholders on how to approach an important issue, and the independent director serves as the key vote in deciding which path will be taken. Having a trustworthy independent director is a great deterrent to stockholder lawsuits, as his/her approval makes it that much harder for a disgruntled stockholder to claim foul play.

For real independence, dig deeper.

But what does “independent” really mean?

The wrong way to define “independent” is simply as “not an investor or employee.” That absolutely is part of the definition. But smart teams know that a person’s judgment and independence are heavily influenced by far more than just their front-facing professional status.

  • Does the candidate regularly invest in other startups alongside your investors, perhaps as part of a seed fund, accelerator network, or other group?
  • Is the candidate looking for other appointments, either as a director or a more-involved executive; potentially at companies where your lead investors could deliver access?
  • Does the candidate spend time in social / business circles where, if they were forced to make a hard decision that angered one side of the board, either members of management or the investor base could exert pressure out of retribution?

Sophisticated business players are masters at finding leverage in their social / business relationships to push a deal in the direction they want it to move. And some founders are quite good at it too. A truly independent director should be minimally exposed to the carrots or sticks that either side of the Board might use to sway a key decision in their direction.

Ideally, an independent director will be someone who has a relatively equal pre-existing relationship both with the founders and with the investors. But because founders often have significantly narrower networks than their lead investors (who are repeat players), that is easier said than done.

More often than not, VCs will propose someone from their preferred ‘roster’ of independent directors; people whom the founders (particularly first-time founders) don’t know at all, or only barely know. Given the loyalty and history that ‘roster’ will have to the VCs for dishing out serial appointments, those people should almost always be avoided. They’re not independent at all, no matter how much they might argue the contrary.

Specialized industry expertise is valuable.

If no viable candidates are available whom both sides can trust, then agreeing on a list of well-known industry players and pursuing their service together is often a very good idea.  Any arguments that an independent director must be local should be pushed back against if the right person is located elsewhere. Videoconferencing and teleconferencing are highly effective, as are airplanes.  If your independent director doesn’t ‘feed’ from your local ecosystem, that can be a good thing in the right context.  Skillset trumps geography.

Someone who not only has the necessary character to be independent, but has specialized knowledge that management and (often) generalist VCs do not, can be invaluable by opening up industry contacts, and helping overcome challenges that are unique to the market a company is engaging.

If you’re building a health tech, or energy tech, startup taking on a massively complex and entrenched market and no one on your board has engaged deeply with that market, that is usually a red flag that politics has trumped performance in determining the board makeup.

Avoid an empty seat.

When no one is available locally whom both sides can trust in the independent director seat, companies will often be pushed to leave their independent director seat empty until after closing. I typically suggest that companies avoid a vacancy if they can, unless they’ve built such a strong level of trust/rapport with their VCs that they’re 100% confident a true independent will get selected, relatively quickly, post-closing.

If you are closing with a balanced board structure of 2 common, 2 VCs, and 1 independent, but your independent seat is empty, you are set up for a stalemate; and stalemates work (like a game of ‘chicken’) against the people with the most to lose; which means founders. By simply refusing (often with any number of excuses) to approve a key transaction, a key hire, or a new fundraise, investors can push founders into a corner to get their preferred independent director elected. Yes, this happens.

Agreeing on a ‘temporary’ independent director to take the seat at closing, to be replaced when a permanent one can be found, is sometimes a good idea. Not ideal, and you should still be very careful who gets chosen, but it is often better than an empty seat.  If you are stuck with an empty seat at closing, push hard to keep the selection of an independent director on the near term agenda, and call out delay tactics when you see them. Your leverage decreases proportionately with your bank balance.

It’s not cynicism. It’s experience.

If in reading the above, you feel the advice carries a perspective that is a tad too cynical and untrusting, I suggest that you go talk to multiple founder CEOs who have gone through rounds of funding with institutional investors.  They will educate you, off the record. Some stories will have happy endings. But others will teach you the value of a little preparedness and skepticism.

Trust is extremely valuable in business, and I always tell companies that if they’ve found people that they can really trust, and who have proven themselves to be trustworthy over time, hold onto those people with their lives. Make them directors, advisors, officers, your kids’ godparents. Surround yourself with people you can really trust. See: Burned Relationships Burn Down Companies.

But institutional investors have a job to do, and it’s not to be your BFF. It’s to make a lot of money by (1) getting into attractive deals (buttering up), and then (2) once inside, pushing companies to achieve lucrative exits as fast as possible (turning up the heat). Pay close attention to how the behavioral incentives at stage (1) and (2) are very different, and prepare for it, so you don’t end up as the cooked turkey.

The best analogy I’ve found for how companies should interact with their lead investors is that of foreign diplomats engaging in high-stakes trade negotiations. They have something you want, and you have something they want. And while you’re visiting, smile, crack jokes, share photos of your kids and focus on growing the pie together. Try as hard as you can to make the ‘partnership’ resemble something close to a friendship. But when you get back home, make sure the arsenal is well-oiled; just in case.

When all your eggs are in one basket, and you’re sharing that basket with money-driven people who are 10x more experienced than you are, a healthy dose of skepticism keeps you alive. Others will say to relax, let your guard down, and not be so cautious; but their net worth isn’t riding on one horse. Do your diligence, and then build a relationship that you can leverage for the success of your company. But never lose sight of where everyone’s incentives lead. The moment you do, the reality check will be costly and painful. 

Having a balanced power structure, instead of a founder-controlled or investor controlled one, is a great way to build trust and alignment. If your VC terms call for a balanced board, make sure what gets implemented is actually, not just superficially, balanced. Treat the selection process of your independent director as seriously as that of your company counsel, and don’t let anyone take it off the agenda.

Why Convertible Notes and SAFEs are Extra Dilutive

Background Reading:

Outside of Silicon Valley, Convertible Notes are the dominant form of seed round security. In SV, SAFEs are much more popular. The difference between the two effectively amounts to interest and a maturity date. For larger seed rounds, however, seed equity is another possibility.

The point of this post is not to debate the pluses and minuses of any of the above structures. The optimal one is, as mentioned in the above-linked posts, highly contextual. However, founders should understand that while SAFEs and Notes are faster and simpler to close on (usually), they come with a cost in the form of extra dilution relative to doing a seed equity round at an equivalent valuation. The math is as follows:

Dilution when raising seed as equity

Pre-Seed Capitalization:

You want to raise a seed round with the following terms:

  • Round size: $1.5 million
  • Valuation (cap or pre-money if equity): $6 million

You end up doing a seed equity round, with a 10% post-money pool, but with the pool top-up added to the pre-money (as it usually is). Post-close capitalization looks like:

Key to understanding what’s going on here is how the Seed Equity price gets calculated. $6 million (valuation) / (5MM Common + 714,219 pool) = $1.05.  So the seed investors paid $1.05 per share for their shares.

A year or two pass, and it’s time to do a Series A. The Series A economic terms are:

  • Round Size: $2.5 million
  • Pre-money: $10 million
  • Post-Close Available Pool: 15%

After you do the deal math (explaining that is not the point of this post), the post-close cap table looks like this:

So the above is what dilution looks like after both (i) a seed equity deal of $1.5MM at a $6MM pre with a 10% post-close available pool and then (ii) a $2.5MM Series A at a $10MM pre with a 15% post-close available pool.

Dilution when raising seed as convertible notes or SAFEs

Now let’s replay the above steps, except instead of doing an equity round for the seed, let’s do a convertible note or SAFE round. We can ignore interest, which economically makes the SAFE and Note scenario exactly the same.

Pre-Seed Capitalization:

OK, now we do a $1.5 million convertible note or SAFE with a valuation cap of $6 million. Same numbers as the above seed round, except it’s structured as a convertible security instead of an equity round.

Because these are notes or SAFEs, there’s no dilution registered yet on the cap table. The dilution math is deferred until the Series A.

So after closing the $1.5MM, we’re now at the Series A round. Because we have notes/SAFEs, we’re required to do two calculations in this round: first we calculate the conversion price of the SAFE/Note seed round, and then we calculate the price of the Series A.

Repeating the terms of the Series A:

  • Round Size: $2.5 million
  • Pre-money: $10 million (VCs insist Note shares go in pre-money to keep their post-close % at 20%)
  • Post-Close Available Pool: 15%

After we run through the deal math, this is what the cap table looks like:

The conversion price for the Note/SAFE is calculated by $6MM (valuation cap) / (5MM Common Stock + 1,530,476 Pool) = $0.92.

Now let’s compare the Post-close Series A cap table between the Seed Equity v. the Seed Note/SAFE scenarios.

Seed Equity –> Series A:

Seed Note/SAFE –> Series A:

What’s different? The Series A got the exact same ownership, because that’s how VC’s approach deal math. They will adjust the numbers to ensure they get their %. However, the Common Stock has 1.56% less ownership, all of which went to the Seed round. And the reason for that is straightforward, the Seed got a lower price, because the larger pool (post-A instead of just post-Seed) was built into their conversion math. 

In this scenario, 1.56% is about $195K in Series A post-money terms. So the decision to do seed SAFEs/Notes instead of seed equity cost the common stock nearly $200K in Series A dollars. And that’s ignoring interest, which would put that past $200K if we’re talking convertible notes with interest. I also simplified the example by ignoring actual usage of the pool in-between rounds. A real-world example would’ve had a larger pool top-up at Series A, and therefore a larger dilution gap between seed equity and notes/SAFEs.

Conceptually the way to view this is that convertible notes/SAFEs, as currently structured, have a kind of strong anti-dilution protection built into them. And that’s apart from the more obvious anti-dilution aspect relating to valuation: that a valuation cap is just a cap, and the notes will convert at a lower price if your Series A is below the cap.

If I do a seed equity round, everything that happens to the capitalization afterward dilutes everyone, including the seed equity. There is a conventional form of (soft) anti-dilution protection (typically broad-based weighted average) in seed equity, but it is rarely triggered; only in down-round scenarios. When the Series A bargain for a larger pool and put that pool in the pre-money, the seed equity doesn’t benefit from it because their math already happened.

But in the note/SAFE scenario, the seed math is deferred to the Series A round. Anything that happens to the capitalization before that date gets built into the seed note/SAFE conversion math, so they’re protected from it. This is why the seed notes/SAFEs end up paying a lower price (92 cents) instead of the higher seed equity price ($1.05). The denominator in calculating their math is larger because of the larger pool. Lots of founders think that SAFEs/Notes only have harsh anti-dilution economics if there’s a “down round.” But that’s not entirely true. The scenario I described above was not a down-round scenario. SAFEs/Notes protect investors from dilution, much more so than seed equity, in every scenario.

If companies and investors, and in the case of SAFEs, Y Combinator, wanted to really make SAFEs and Notes more equivalent in economics to seed equity, they would allow for the capitalization, for purposes of calculating the conversion price, to be set in the security. In other words, at the time of issuing the SAFEs/Notes, we would say the capitalization is X, and that is the capitalization we will use for purposes of determining the conversion price, regardless of what the Series A negotiate for their option pool adjustment. That would not be hard to do at all.  The valuation would still float and be determined at Series A, as is part of the core “deal” of a convertible security, but that full anti-dilution aspect of SAFEs/Notes would be removed.

I have rarely seen this solution actually implemented in the market. Why? I’m not sure. A lot of people aren’t even aware of this economic disconnect between SAFEs/Notes and Seed Equity, so it could just be lack of awareness. Hopefully this post helps with that.  But it’s also possible that it’s just part of the “deal” that investors expect for taking convertible securities. If you ask them to move fast and take minimal protections/rights in exchange for their money, part of the price is extra dilution.

Whether or not founders think that price is fair will obviously depend on the circumstances of their company.  The goal of this post was not to give an opinion on SAFEs v. Notes v. Seed Equity, because my opinion is that they are all good for different circumstances. They all have their positives and negatives. All I wanted founders to understand is that there is an economic price to using SAFEs/Notes. Make sure it’s really worth paying.