Startup Accelerator Anti-Dilution Provisions; The Fine Print

TL;DR Nutshell: All major startup accelerators have uniquely strong anti-dilution protection in their stock purchase agreements.  These provisions are serious, can have a material impact on cap tables, and founders should be aware of what they mean. Many of them are also structured in ways that really don’t make sense economically, and are unfair to founders. Some better approaches are out there and worth considering.

It used to be common knowledge in startup circles: no one, not the CEO, not your first big investor, not even your grandma got full anti-dilution protection.  Maybe they got that watered-down weighted average stuff that is common in VC rounds, but the idea of guaranteeing someone X% of the cap table was a non-starter… until accelerators showed up. On top of receiving their % of the cap table (anywhere from 2-8%, depending on the accelerator), the vast majority have provisions requiring you to “top up” their shares if they experience any kind of dilution pushing their ownership below the % they originally purchased.

Granted, the protection typically expires at a seed equity or Series A round (called a ‘qualified financing’ in the docs).  Full anti-dilution forever would be non-sense.  But these provisions are still a big deal and can materially impact the capitalization distribution of the Company, and even impact how a company might go about structuring seed rounds.  While we definitely haven’t seen every accelerator’s anti-dilution provisions, we’ve seen enough, certainly most of the top accelerators’, to say that most fall into the following categories:

A. Protection from only additional Founder issuances – The most company/founder favorable anti-dilution protection, but unfortunately not the most common; though at least one very elite accelerator uses it.  In short, the accelerator is protected only if the founders issue themselves new equity, or otherwise somehow increase their ownership %s, after issuing the accelerator shares.  If stock, warrants, notes, etc. are issued to outsiders, like for services or for investment, no “top up” is required.

B. Full protection until a qualified equity round – This is the least company/founder favorable, and is unfortunately the most common; including among some top brand accelerators.  Basically, no matter the reason for issuing additional securities – services, investment, etc. – you must top-up the accelerator completely until the company raises $X in an equity round.  That last point is extremely important, and I will discuss it further below, given the fact that convertible notes/SAFEs (and not stock) have become by far the predominant form of raising seed rounds.

C. Full protection until a qualified equity or debt/SAFE round – This is a middle-ground provision that is less common than “B” above, yet at least is more agnostic as to its impact on seed round structures. If, after issuing the accelerator shares, you raise a round of $X of equity or convertible notes/SAFEs, the anti-dilution protection stops.

The “C” anti-dilution category is a little tricky, because even if the “tolling” of the anti-dilution stops at raising, for example, $250K in convertible notes (assuming that’s the qualified financing threshold), you still have to provide a top-up when those $250K in notes eventually convert.  While that’s still free shares to the accelerator, it ends up being far fewer top-up shares than there would be under the “B” (more common) type of anti-dilution protection.

Example: 

  • StartCo issues Accelerator 6% of stock as part of the program.
  • After the program, the Company (in sequence) (i) issues stock to several employees, (ii) raises $2MM in convertible notes @ various caps, (iii) issues some more options, and then (iv) eventually closes a $4MM Series A round.
  • The “qualified financing” threshold in the accelerator’s stock agreement (for purposes of ending anti-dilution protection) is $250K.

If StartCo had attended an accelerator with “A” type anti-dilution, they wouldn’t have had to top-up the accelerator at all – no free shares. As long as no equity was issued to the original founders, the accelerator continued to be diluted by future issuances just like the founders themselves were.

If StartCo had attended an accelerator with “C” type anti-dilution, they would’ve had to “top up” (or “true up,” however you want to call it) the accelerator for (i) the stock issued before the note round(s), and (ii) only for the first $250K in notes of the seed round. Once the $250K in notes was issued, anti-dilution stopped, though some top-up shares would need to be issued in the Series A round once it’s known exactly how many shares those $250K in notes convert into. While this scenario is worse for the company/founders than scenario “A,” it’s not nearly as bad as “B.”

If StartCo had attended a “B” category accelerator, which remember is the most common, including among some top accelerators, every single issuance before the Series A, including often (i) option pool shares reserved in connection with the Series A and placed in the “pre-money” and (ii) (in the worst variants of this category) all $2MM in notes, would require anti-dilution top-ups. That’s A LOT of free shares to the accelerator.

Accelerator A asked for 6% only on Day 1. Accelerator C asked for 6% on Day 1 and for maybe 3-6 months. Accelerator B asked for 6% for possibly 1-2 years. 6% is not just 6%. The details matter. A lot.

And perhaps more interestingly, “B” type anti-dilution is relevant to how founders structure their seed (pre-A) rounds.  If StartCo had raised $250K in seed equity, it could’ve cut off the accelerator’s anti-dilution immediately. But by raising seed money as notes and putting off equity for a Series A round (which is extremely common), it let the accelerator’s anti-dilution drag-on. Does it really make sense for accelerator anti-dilution to favor one type of seed round structure over another?

Which accelerator’s anti-dilution makes more sense?

As someone on the company side and at a firm that (deliberately) doesn’t represent accelerators, I’m obviously partial to the “A” approach of accelerator anti-dilution.  But stepping back and trying to assess things objectively, it also just makes more sense.  What exactly should an accelerator’s anti-dilution protection be “protecting” for? If the concern is that a set of founders with low ethics will immediately dilute the accelerator post-program by issuing themselves more equity, then “A” anti-dilution protects for that.

Perhaps, for economic reasons and much like the qualified financing threshold in a convertible note/SAFE, the accelerator doesn’t want its ownership % to be cemented until a serious financing round has occurred that prices the company’s equity. If (and I do mean if) that is the intent, it’s not clear why it should matter whether the seed round is debt/SAFEs or equity, as long as it’s large enough to be considered a real seed round. Plenty of VCs/seed funds who are more than capable of pricing companies (via caps) are signing notes/SAFEs.  The logic for “B” and “C” type anti-dilution must be, fundamentally, about grabbing a larger share of the cap table; not “protection.” 

If accelerators insist on “protection” for more than just self-interested equity issuances, then they should at least modify their anti-dilution provisions to stop favoring equity seed rounds over debt/SAFE rounds, given how much more prevalent the latter have become. And founders should be aware that if a particular accelerator is asking for 6% w/ “B” anti-dilution, that could be equivalent to 10%+ on Day 1 (much more than simply 6%), after accounting for all the free shares that must be given to fulfill long-term anti-dilution obligations. 

Kudos to the few accelerators who’ve moved toward the most company/founder favorable (and justifiable) type of anti-dilution; the “A” category above.  As for those preferring the “B” and “C” categories, which includes some very well-known brands, it would be great to hear some thoughts on why you think they are a more reasonable structure.  If I were a founder in one of those accelerators, I’d be interested in hearing those thoughts as well.

Splitting Founder Equity: Avoid “Grunt Funds”

TL;DR Nutshell: If you plan on building a scalable, VC-backed company, you need to learn (early on) to have hard conversations. Fact. Your first hard conversation may involve figuring out the equity split among founders. A few people (who are good at SEO) are pushing a concept called “Grunt Funds” in which founder equity, instead of being negotiated and set from the beginning, continues to change month-by-month according to some overly complex formula.  I’ve never seen it work well in the context of high-growth tech startups. Have the hard conversation. If you can’t figure out how to split founder equity, good luck building a company. 

Negotiating the “equity split” among a pair or group of founders is an extremely important part of a startup’s formation process, and there is a lot of good web content available providing guidance on how to get it done. Below is a list of a few articles worth reading. I don’t necessarily endorse all of what they say, but it’s your job as CEO/Founder to read, make your own judgments, and act on them. Advisor Whiplash is part of the job.

Another piece of relevant reading on how to document founder splits: SHL: How Founders (Should) Break Up

The point of this post is to make one thing clear: if you are building the type of startup that will raise angel and VC money, stay away from “Grunt Funds” or anything that attempts to create a variable, constantly changing founder equity split. 

Figure Out the Numbers. Don’t Hide Behind Formulas. 

I’m not going to link to any articles promoting the “grunt fund” concept to avoid giving it any more air time on Google than it already has. The origin is a book called “Slicing the Pie.” Basically, instead of figuring out founder equity %s like a normal company, “grunt fund” founders set up a formula with half a dozen metrics that are measured on a monthly basis to gauge “performance,” “contribution,” whatever, and founder equity is accumulated over time based on those metrics. It is tedious, ends up costing more in legal fees in the long-run, and in my experience never survives scrutiny from investors. It has, every time I’ve encountered it (thankfully, a significant minority of cases) ended up being a waste of founder time and money.

Good Founder Docs Are Already Flexible

The core driver behind the desire for an always-changing equity split among founders can be boiled down to one question: “what if things change?” What if one person turns out to be a dud, and another unexpectedly a rockstar? What if someone’s personal life causes them to leave? What if the business changes and a particular founder’s skills are no longer valuable?  These are absolutely valid questions, and they require that founder equity have built in mechanisms to allow equity to be readjusted if needed.

Thankfully, there already is such a flexible mechanism in well-known, standard startup formation documents: it’s called a vesting schedule. If one person is no longer valuable to the startup, then they can leave, forfeiting their unvested equity. Or if they refuse to leave, they can be fired, also giving up their unvested equity.  Or if one person knows they’ve turned out to be more valuable than the % they got, they can force a hard discussion, with a credible threat to walk. If they are in fact as valuable as they think they are, the other founder(s) will change their %.

Is this set-up totally flexible? No, it’s not meant to be. Is it as egalitarian as a grunt fund? Maybe not, but nobody said successful startups are democracies. Brilliance is rarely built by committee. See Mark Suster on “The Importance of Benevolent Dictators.” Founder in-fighting probably ruins at least as many companies as flawed business fundamentals.

Smart Founders Figure it Out.

In my experience, successful startups are generally built either by a single founder or by founders who, more or less, know their place in the hierarchy. They have a common vision, often have strong, trusting relationships (friendships), and have a pretty good feel for whose skills really are more valuable to the startup than others. The CEO is the CEO, and the other founders know exactly why he/she is CEO. They have the tough conversations early-on, and if circumstances warrant a change from the original split, they figure it out. Ultimately, a solid founder group cares far more about building a successful company than about burning time in nonsensical formulas every month trying to see whose % went up.

I’ve seen all kinds of equity splits: 50/50 (generally a bad idea, but not always), 60/40, 33/33/33, 51/49, 80/20, all kinds of iterations. The “right” split is highly circumstantial. But in the end, the founders figure out the numbers, paper them with solid docs, and move on.

Does this mean “grunt funds” don’t work for anyone? No, I didn’t say that.  I work with the segment of the startup space that goes after scale and (usually) large amounts of outside investment needed to reach that scale. Founders jumping on that train know from the beginning that they are in for a very bumpy ride, and that anything short of complete trust and unity of vision among the team will result in a train-wreck. I’m sure GFs work in some contexts, just not in high-growth tech startups.

Have the hard conversation, avoid tedious formulas, and then get to work.  

How Startups Burn Money on Lawyers

TL;DR Nutshell: There’s a lot of bad advice floating around startup ecosystems about how lawyers work, and how founders should go about minimizing their legal burn. Much of that advice, which is given without ever actually consulting lawyers, ends up costing founders more in legal fees in the long run.  Below are some thoughts (from someone who actually knows how startup law works) on how to not burn money on legal, while also not blowing up your company.

First off, let’s go ahead and get this out of the way: I am a startup lawyer.  Some would claim that this discredits me in writing about startup legal fees, because clearly I’m just going to write whatever maximizes my compensation. Right? Never mind that I spend 90% of my time on SHL writing about how startups can or should, for example:

If your attitude is that all lawyers are money-grubbers with no ethics beyond maximizing legal bills, then (i) this blog is not for you and please don’t ever e-mail me, (ii) I’m 99.9% confident that you’ve never actually built anything successful in business, and are not likely to, which is why you’ve never known good lawyers, so again please (iii) never contact me.

Now that we have that out of the way, here is a starting fundamental principle: when you put aside the issue of institutional overhead (which is a massive issue), the economics of lawyers closely aligns with the economics of developers: great developers, and great lawyers, expect great pay. If you’ve come to accept the reality that building a company on quality, scalable, durable software code requires paying the money to bring in great developers, it should not stretch your imagination to grasp why building a company on quality, scalable, durable contract drafting (which, when you think about it, is a lot like software code) requires paying the money to bring in great lawyers. And lest you forget, it does not cost $250,000 in education to become a software developer, but sadly (very, very, deeply sadly) that’s the going rate of top-tier law schools. :: deep sigh ::

Software code may determine whether your company ever makes money, but legal code determines whether you ever make money. That’s why founders who actually know what they’re doing hire great developers and great lawyers. 

With all of that in mind, the startups who burn money on lawyers fail to follow these basic rules:

1. Hire an actual Startup Lawyer, early.

Not an M&A lawyer. Not an oil & gas corporate lawyer. Not an IP lawyer. And certainly not the schmuck hanging around your coworking space or incubator who, because he’s friends with someone, decided to re-brand himself as startup lawyer without ever having seen a real VC deal. If you have a heart issue, you call a cardiologist. If you’re building a startup that will raise venture capital, you hire a lawyer who specializes in (guess what?) startups and venture capital.

There is a very simple test for determining whether the lawyer you’re talking to is actually a startup lawyer, notwithstanding what his LinkedIn profile says:

  • A. What were the last 3-5 Series A deals you closed, as the lead lawyer?

If the lawyer doesn’t pass the above test, you will never forgive yourself after going through the world of pain he will bring to your company.

And separately, cleaning up the mess of a bad lawyer ALWAYS costs 10x what it would’ve cost to have it done correctly on Day 1. You are not being capital efficient by letting your “lawyer friend” handle your formation, with plans to get a real lawyer when you’ve raised a little seed funding. You’re just accepting a smaller legal bill early on for a much much larger one a bit later.

2. Hire a law firm (not a solo lawyer), but not one too big (unless you plan to be a unicorn).

Now I’m ruffling some feathers, but SHL is not about making friends. Background reading:

Hire a solo lawyer, and you will (i) end up paying for a massive amount of inefficiency that an intelligently structured law firm would’ve avoided by adopting the appropriate technology, processes, and staffing, and (ii) max them out quickly. A $200/hr rate is not efficient if it’s multiplied by 3x the number of hours. If you are building a small company for which maybe a 6 or 7-figure exit is the end-game, a solo lawyer can be a great, even optimal fit. But companies going after big exits outgrow solo lawyers very quickly, and switching lawyers is very expensive.

Hire a very large firm, however, and you will pay for an enormous amount of bureaucracy and overhead that will not add a single bit of value to your company.  You’ll pay $600/hr, and $150 will make it to the lawyer, if she’s lucky. The fundamental principle requires paying for lawyers, not a bunch of unnecessary fluff. Modern software/SaaS has rendered the institutional structure of large firms completely unnecessary.

And be careful with referrals w/o your own verification. Out of hundreds of people I interact with, there are only a handful whose opinions on referrals for various services I actually trust as objective and based on merit. There are so many side-deals, “I scratch your back, you scratch mine” arrangements, and general cronyism in startup ecosystems that should lead you to be skeptical of any particular person’s lawyer recommendations. See also: Why Founders Don’t Trust Startup Lawyers. 

Sidenote: there is an exception here for companies truly on a billion-dollar track. BigLaw, with its extremely high rates, is designed for massive scale. If you legitimately see yourself as the next unicorn, then perhaps BigLaw really does make sense.

3. Use Specialists.

Background reading:  Startups Need Specialist Lawyers, But Not “Big Firm” Lock In

If a single lawyer says he can form your startup, close your seed financing, draft your real estate lease, draft your provisional patent, and apply for your trademark, run like the wind. This should be self-explanatory.

4. Do your homework, but don’t pretend that you can DIY.

If your startup law firm offers some very early work (like a formation) on a fixed fee (and they should), they are not doing it out of the kindness of their charitable heart. They are doing it because it (hopefully) makes economic sense for both sides. If you expect your lawyers to spend hours explaining to you the ins-and-outs of vesting schedules, IP, how convertible notes work, etc. etc., and yet somehow magically fit it all into an affordable fixed fee, you’re only going to select for crappy lawyers who have no choice but to accept such an unprofitable arrangement. Remember the fundamental principle.

The best founders I work with do their homework, and when they come to me with a request, they have already developed a working grasp of 75% of the concepts. Reading startup/vc law blogs, books, articles, etc. is to building a startup what reading WebMD is to being a medical patient. You will save money, make fewer mistakes, and get an overall much better end-result.

But the flip side of this is – accept that, no matter how much startup law might seem totally simple, even easily automatable, this is some complicated sh**. Very very smart people hire smart lawyers because they are smart enough to know what they don’t know.

You may think “I just want to issue some stock. That’s simple, right?” without having any clue as to all the steps that need to be taken, questions that need to be answered, and processes that need to be followed to actually accomplish that goal in a way that doesn’t create huge regulatory or contractual problems.  If you’ve hired the right lawyer(s), trust them to do their job. You will mess it up. 

5. Be Organized, and Make Clear Requests.

Related to “do your homework,” go to your lawyer(s) w/ clear action items or, at a minimum, clear questions that will help you arrive at clear action items.  You will burn a lot of legal funds asking your lawyer for one thing on Monday, changing the request on Wednesday, and then asking for tweaks on Thursday, than if you’d just waited until you knew exactly what needed to get done before making the request.

6. Be Realistic.

Good developers try everything they possibly can to avoid clients/CEOs whose views on how much time it actually takes to accomplish a task are totally detached from reality.  Good lawyers do the exact same thing with clients.  If (i) you have vetted your lawyer(s) and determined that they are trustworthy, efficient, and highly knowledgeable, then (ii) you should not be badgering them every month about why the bill is higher than you wanted it to be. It could backfire.  It would be ridiculous for me to walk into a company and tell the CEO how to run it, with zero domain expertise. Don’t be just as ridiculous with your lawyers and their practice.

Newsflash: you will ALWAYS pay more for lawyers than you want to pay. Remember the fundamental principle.

Hire an actual startup lawyer, at a firm that isn’t too big. Use specialists. Do your research, but trust your lawyers. Stay organized, and stay realistic.  Follow these principles and you will not get that Series A financing for $5,000 like you always wanted, but you will easily save 6-7 figures in legal fees over the life of your startup, and have a much healthier relationship with some of your closest advisors.