TL;DR: Whenever an influential organization publishes a “standard” financing document, important questions need to be asked about not just its specific terms, but also the entire concept of “standard” terms in general, and potential biases in their creation. In YC’s case, their decision to keep their “standard” TS very short (for speed purposes), and not address key economic/control issues, favors investors by deferring negotiation on those issues to a context (after signing) where common stockholders have less flexibility and leverage. YC’s default terms also give VCs substantial power that is hardly a “standard.” In the broader context (apart from YC), there are serious problems emerging in the startup legal market with how certain narratives around “standards”, closing fast, and the hiring of lawyers with deep conflicts of interest, are leading (and tricking) entrepreneurs & early employees into adopting legal strategies that hurt their long-term interests.
In Startup Law and financing, standardization and templates are often celebrated as noble, generous attempts at saving entrepreneurs money that they would otherwise “waste” on advisory fees. While it is definitely true that, to a point, creating uniform language improves efficiency, there are very real, and often dangerous, high-stakes issues that founders need to hear about regarding “standards,” but unfortunately they often don’t.
Take Y Combinator’s recent “Standard and Clean” Series A Term Sheet as just one example. YC has placed itself at the forefront of attempting to standardize early-stage fundraising docs for startups. The SAFE (Simple Agreement for Future Equity) has become in Silicon Valley a dominant instrument for seed fundraising, though survey data (and our experience) suggests it’s not nearly as dominant outside of California.
Given that the SAFE was, relative to other instruments used in the market (like convertible notes) a quite company-friendly agreement, YC established itself as offering very “founder friendly” standards in templates they create. So one would’ve expected that their “Standard and Clean” term sheet would follow the same trajectory. However, when we reviewed YC’s term sheet, our initial response – as lawyers who represent companies, and only companies (not their investors) – was “Uh oh.”
Short term sheets benefit investors
First, YC’s term sheet is remarkably short as far as equity term sheets go. The reason is somewhat reflected in their own blog post’s words:
“So don’t lose sight of the ultimate goal: closing fast and getting back to work.”
Short term sheets get signed faster than longer ones, because there’s less to discuss. Here’s the problem with short term sheets, though: once you sign a term sheet, two things happen:
A. You are now locked in with a “no shop” clause. That requires you to inform any other investors you were talking to that you are taking someone else’s deal. Good luck going back to them if this deal ends up not closing.
B. You start racking up legal fees with your own lawyers, which for a cash-limited startup puts pressure to close, and accept terms on the table, in order to pay those fees.
In other words, once you sign a term sheet, your leverage and flexibility dramatically go down. It becomes far easier for investors to pressure you with this or that language (which they will usually claim is also “standard”) than it would’ve been during the term sheet phase. So rushing to sign a short term sheet favors investors over startups. Slowing down and clarifying all material points at the term sheet phase also saves legal fees, because it reduces back-and-forth with the lengthier definitive documents.
Fair enough, you might say. YC favors moving fast anyway, because there can be benefits to moving fast for everyone. OK.
YC gives VCs full veto rights on equity financings
Here’s a second issue: as drafted, YC’s “standard and clean” terms give your VCs and other investors a complete veto right over all future equity financings, regardless of what the Board composition is. In other words, even if the common stock controls the Board (which shouldn’t necessarily be the case), and has a deal on the table with great terms, your VCs can block it simply because they, for whatever self-interested reason, don’t like it.
This is usually a point at which at least a few founders might be thinking “WTF?”
When you move to close an equity financing, there are at least two approvals that need to happen: Board and Stockholder votes. The Board vote is subject to fiduciary duties, but the stockholder vote isn’t, save for a few narrow circumstances. In a stockholder vote, you can block something for whatever reason you want, effectively. Yes, we have seen VCs block deals that common stockholders wanted, and with great terms; but because the VCs had self-interested reasons for favoring another deal, they refused to approve. This can give them remarkable power over what deals get done and don’t.
To be fair, YC points out this hard veto right in their blog post’s footnotes. Putting aside the fact that those footnotes won’t make it into a redline, probably their expectation is that good startup lawyers will always mention the issue to their clients, and negotiate if possible. In other words, their “standard” perhaps isn’t as big of a problem because it will be negotiated. And that brings us to a more important point in this post, which isn’t about YC specifically, but the entire concept of “standard” terms.
What is “standard”?
What exactly do we mean when we say something is “standard”? Whose data are we using?
Given that investors are on one side of a deal, and entrepreneurs (and other employees) on another, might we be a little cautious in letting investors be the ones telling the market what the “standards” are?
When YC, with its prominent brand, places the label of “standard” on giving VCs unilateral veto rights on future financings, that influences the market, even if unintentionally, in favor of VCs. Now lawyers representing the interests of startups/common stockholders (like us) have to negotiate not just with investors across the table, but against a now so-called “standard.”
We’ve closed many, many deals where we don’t give VCs this kind of broad veto right, and soften it significantly to make it more balanced. But now when we push back on giving VC’s these veto rights, their response is going to be: “Look at YC’s term sheet. Giving us a hard veto is the market standard.”
Which leads to another question: what is the appropriate threshold for something becoming “standard”? 75%? More than 50%? If 49% of deals don’t have a provision, or even 10%, there are good arguments that there are in fact multiple “standards.” But when some “standards” favor repeat players with microphones and dominance over startup ecosystems, while other “standards” favor “one-shot” players (like first-time entrepreneurs and employees), which ones do you think get publicized? Taking a 75% standard, as an example, and then prominently publicizing it as the “standard” can be a way to move the market to 100%, with “efficiency” as a weak excuse for eliminating flexibility on such a high-stakes provision.
Even if we had perfect objective data, at what point should startups place more weight on their own priorities, unique context, and leverage for the permanent, highest-stakes economic and power terms of their company’s governance, instead of aggregated, anonymized data covering a huge diversity of companies?
One could argue that the publication by investors of their own so-called “standards” is a kind of assertion of market power, and a way to influence long-term the data that is then used to justify those same standards. Do common stockholders have the ability to do the same and ensure balance? No, they don’t. They depend on individual lawyers to represent their interests and help make up for the power inequality. And that finally brings us to an even bigger problem.
The “own the advisors” game.
Let me paint a picture of a “game” of sorts for you. The game has two broad sets of players: “one-shot” players and repeat players.
The “one-shot” players are first-time entrepreneurs and early employees; common stockholders. They are usually not diversified, which means their wealth is concentrated in their one company. They also typically lack significant personal wealth, and don’t have downside protection on their equity, further magnifying their “skin” in this “one-shot” that they have. Finally, not having played the game before, they rely on experienced, trusted (hopefully) outside advisors (like lawyers) to help them not get taken advantage of.
The “repeat players” (investors, accelerators) are in the polar opposite situation. They are wealthy, diversified, downside protected (liquidation preference or a debt claim), and they’ve played the game many, many times. In the case of the largest repeat players, they’re also incentivized to take significant risks in order to “swing for the fences” and go after risky big prizes, even if doing so increases the number of total failures; failures which hit the one-shot players far harder because they aren’t diversified across a portfolio juiced for “power law” returns.
There is a fundamental misalignment here that never goes away, and feeds into many high-stakes decisions (and disagreements) in a company’s history around recruiting, risk, fundraising, exits, etc. Both sides want to make money, but they are often misaligned in their perspectives on how to do so, whom to raise funding from (and on what terms), and what level of risk is acceptable. The repeat players have 100x the experience of the one-shot players, but the one-shot players hope their advisors can help “balance” the inequality as they navigate this misalignment.
Now, let’s say I’m a very smart repeat player – a “chess player” of sorts – and I’d prefer that this “balancing” not really happen. I make more money, and keep more control, if I can somehow get in the way of the lawyers helping the one-shot players. But at the same time, if I look too visibly aggressive in doing so, the one-shot players won’t want to play with me at all. So as an investor I want to win, but in a way that preserves a public image of selflessness so that inexperienced players keep coming to me, and preferably with minimal defenses. What’s a good multi-step strategy?
Here’s a suggestion.
1. Create “standards” for the game, based on limited data, and with microphones, that the one-shot players can’t see or influence. Publish these so-called “standards” while emphasizing how much money they’ll “save” everyone by using them. Talk a bit about how you were once yourself a one-shot player (former entrepreneur), so you’re really doing this out of selfless empathy for the new folks; even if now you’re highly misaligned.
2. Build relationships with lawyers that the one-shot players hire for advice, by hiring those same firms on the much larger volume of deals you control, and also referring other people to them from your broad network as a repeat player. This ability to refer lots of work to said lawyers is a “currency” that the inexperienced one-shot players always lack.
3. Recommend to the one-shot players that they hire these same awesome lawyers that you (the repeat player) prefer, because of how “efficient” and “high quality” they are, and how well they know the “standards.” You know that those lawyers view you as a source of 50x as much “deal flow” as any one-shot player, and would never do anything to jeopardize that deal flow. Emphasize how much money will be “saved” by using “familiar” lawyers.
4. Tell the one-shot players that, given everything is “standard” anyway, they should focus on “closing fast” and saving fees. In fact, they should hire the lawyers on a flat fee, which ensures that the faster the lawyers move (the less time they spend advising the inexperienced startup and negotiating on its behalf), the more money those lawyers make. You can have two sets of lawyers who charge the exact same end-price, but those charging a “flat fee” (as opposed to billing by time worked) are actually rewarded for doing less work, with an improved margin.
5. With the “standard” (that repeat players created) in hand, the lawyers (that repeat players control) “close fast” (earning a better margin on their flat fee), with minimal discussion or negotiation, so everyone can move on and not “waste money” on unnecessary advisory.
6. The repeat players, very happy with how “high quality” and “efficient” the captive lawyers were at closing on their standard, refer them more work; regardless of how well it served the one shot players who, on paper, were the client.
7. Rinse and repeat over many iterations. Now we have market data that validates the “standards” that the repeat players created, further entrenching it.
Does this game sound familiar to anyone? We bet it does to startup lawyers.
The core point is this: there is a structural problem with how certain startup ecosystems have evolved to approach “legal” and the hiring of lawyers. It’s the result of a significant imbalance of power between “one shot” startups and the repeat player investors/accelerators they work with, the latter of which have found many (not all) startup lawyers quite eager to flout conflicts of interest in order to generate business for themselves.
“One shot” common stockholders (entrepreneurs, employees) and “repeat player” investors (including accelerators) are not fully aligned in terms of economics and incentives, given the above-described differences as it relates to diversification, wealth, experience, and downside protection. Repeat players, through their ability to operate as brokers/gatekeepers of referrals, have increasingly pushed founders to hire law firms that are ultimately “captive” to investors, and even then sometimes insist that those law firms adopt billing practices (like flat fees) that actually reward lawyers for rushing work and under-advising inexperienced startups.
And all of this is done under the pretense of wanting to help founders “save” money. In this game, the appearance of “founder friendliness” is often a marketing tool to help lull first-timers into forgetting how misaligned they are from the money players, and then taking advice from those same money players that ends up, unsurprisingly, being an “own goal.” Former entrepreneurs-turned-investors are often the most skilled at using their pasts (as entrepreneurs) as smoke and mirrors to get now first-time entrepreneurs and early employees to forget their misalignment, and take their advice as gospel.
In fact, if you look around the market and find startup law practices that have grown at an abnormally fast, seemingly non-organic, pace, what you’ll often find is lawyers willing to juice this conflict of interest-driven game as far as possible, to a point getting preciously close to meriting litigation. We’ve seen at least one threatened law suit already.
We see the negative consequences of this game all the time around the country, as inexperienced “one shot” common stockholders (including entrepreneurs) are duped into signing (air quotes) “standard” deals, and taking certain “standard” actions, while having no real clue as to what the long-term consequences are because everyone was celebrating how great of an idea it is to “close fast” and keep it “standard.” When the long-term consequences of the “standard” docs and actions play out, it becomes clear no one ever actually explained to the inexperienced common stockholders and the company what the real implications were, or how they could’ve been negotiated for more balance; because everyone capable of doing so was ultimately incentivized to favor the interests of the money.
So not only are we increasingly pushing so-called “standards” that are themselves biased and questionable, we’re depriving the most inexperienced and exposed people in the ecosystem, the new entrepreneurs and early employees, of the right to even be truly independently advised in assessing those “standards.” And we’re selling it all as noble and well-intentioned because it purportedly “saves” them fees, even if the long-term negative consequences for them far exceed whatever fees they “save.”
To be sure, not every team gets hurt by the emergent “close fast and keep it standard” dogma; in much the same way that not everyone who smokes gets cancer. Some teams manage to protect themselves in other ways, regardless of what the docs say, or are lucky to work with lawyers who fully do their job. But the issue is so pervasive, and there is enough damage occurring to inexperienced players, that it needs to be, at a minimum, discussed out in the open by people not incentivized to dismiss or downplay it.
We believe that startups are more than capable of making their own decisions as to how they want to hire advisors, including counsel, once they’ve heard the full story and potential implications. Part of the problem is how little open and honest discussion occurs on the topic, and how much market pressure to use captive lawyers is applied quietly in the background, precisely because the market is dominated by repeat player perspectives; many of which are cleverly spun and publicized as “friendly.”
Negotiating the YC “Standard and Clean” Term Sheet
To be crystal clear, this broader diagnosis of the market is not about YC at all. YC is a great organization, and many of our firm’s clients (including YC companies) have fantastic things to say about their program. We have no idea what YC’s arrangements are in terms of referring companies to certain conflicted or non-conflicted law firms, or the kinds of economic arrangements they promote with those firms. For all we know, YC legitimately believed that they could post this “standard,” and then expect truly independent, non-captive lawyers to then do their job and produce fair outcomes.
But while we have your attention, given that this “standard and clean” term sheet is already out there, a few suggestions that we would give to companies and common stockholders before signing it:
A. Soften the veto. Build some “boundaries” around the veto right on future financings. For example, if the valuation is a certain amount above the current price (not a down round), perhaps a Board vote should be sufficient. The Board is subject to fiduciary duties, which can constrain bad actors. Maintain some kind of “path” to a value accretive financing, even if the current money gets hostile and tries to reduce competition, or force a deal with their “friends.” There should also typically be some kind of ownership threshold below which all VC vetoes go away.
B. Clarify the shadow preferred’s economics. Be clearer about the economics of the “shadow preferred” referenced for Notes/SAFEs. What are their liquidation preferences? Term sheets are a good opportunity to address any liquidation overhangs if the Notes/SAFEs themselves don’t address them.
C. Clarify the common stock’s board voting rights. Do the common stockholders have to be employees in order to vote for the common stock’s board seats? This has significant power implications long-term, because there can be any number of reasons why early common stockholders might leave the company (or be forced out), and still want a voice (even if not control) in governance; and for good reasons. When there’s a power shift, common stockholders remaining on payroll are usually far more beholden to the money, and because their equity was often issued later (at a higher price), their economics and incentives are more aligned with later investors. Make VCs explain in full just why exactly it’s so important that all common directors be service providers, or be elected by service providers, to the company. Listen closely enough, and you’ll understand how the arguments are often thinly veiled power plays.
Also, does one common director have to be the CEO? This is usually (but not always) the case. Discuss it and spell it out in the term sheet. Just like the previously mentioned point, given that the CEO position often eventually gets filled by a later common stockholder recruited by the Board, with different priorities and incentives from early common stockholders, this has control implications long-term. Again, tying common director positions (and the voting in their elections) to being on payroll is often a subtle power move to eventually exclude (as a company scales) early common stockholders from having visibility and a say in company governance; because they’re the people most likely to disagree with later-stage investors on how to scale, when to exit, and how much risk is acceptable.
Provide a “yes” or a “no” to these questions. Silence means shifting negotiation post-term sheet, where the common have less flexibility. Be mindful of how some players will spin this discussion into a caricature of founders not wanting to give up control. Control and a voice/visibility are two completely separate issues. There are many constituencies on a cap table with various incentives and interests. There are good arguments for why, as a company scales and the stakes get higher, early common stockholders – who are the most exposed to dilution and risk – should still have some say and visibility (even if not control) in company governance, to voice concerns around risk, financing strategy, recruiting, exits, etc. Conflating the narrow context of a founder unwilling to share control with the far broader, and far more legitimate reality that early common stockholders and investors have very different incentives and perspectives on company growth, is a common straw-man tactic for obfuscating the issue. Both sides deserve to have un-muzzled voices in governance.
D. Clarify the anti-dilution exceptions. Be clearer about the exceptions to anti-dilution adjustments, instead of engaging in a post-signing “battle of the standards.” While not always an issue, these can sometimes be ways for the preferred to squeeze the common by refusing to waive anti-dilution unless they “give” on something. Spell them out in the term sheet.
E. Clarify how all Board voting will happen. Are there specific Board actions that, aside from a Board majority, the investors expect for their own directors to have veto over? If not, say so. If so, list them. VC docs often have a section, apart from stockholder veto rights, that give the preferred directors veto (at the Board level) over certain key actions. If you’re silent about this issue, instead of making it clear that a majority governs all the time, investors will often claim that it’s an open point for negotiation in the docs. Silence is not your friend.
If YC truly wants their term sheet to serve as a balanced (and not biased) reference point for Series A deals (and I believe they do), they should prominently address at least these core economic and control issues; not in a passing blog post reference, but squarely in the document with appropriate brackets so as not to signal a “default” and therefore not slant negotiations. Having public templates as starting points, like the NVCA has done for some time, can be helpful, and we utilize them regularly to streamline negotiation and save fees. But it’s a big responsibility and needs to be done carefully; with input from people on the other side of the table whom the money can’t “squeeze” if they speak honestly and openly.
The general theme here is that you should be clear in the term sheet on all material issues. Nothing is more material than economics and control. Keeping it short, and glossing over things by referencing a nebulous “standard,” or simply not addressing a point at all, favors investors because it transfers negotiation to a context where the company has less optionality and flexibility. We’ve closed deals that land, after transparent discussion and negotiation, in any number of places on these above-mentioned points. The real point we’re trying to emphasize in this post isn’t about pushing deals to go in one direction or another – that depends on the context – but highlighting just how often these issues aren’t even discussed with startup teams because of games that investors and lawyers are playing, and their incentives to “close fast.”
Some people argue that you should “sign fast” on a term sheet because if you negotiate, you might “lose the deal.” We don’t see that actually happen in practice, and can’t think of a clearer signal that you might not want to take someone’s money than being told that the deal will die if you try to clarify even a few material points. This, again, is the kind of sleight of hand rhetoric that sounds like it’s advice to help entrepreneurs, when in fact it helps investors. In reality, spending more time to achieve alignment on a more detailed term sheet expedites drafting and closing once the term sheet is signed.
Start asking the right questions.
In a game of the inexperienced v. the highly experienced, moving very fast, and not taking the time to ask important high-stakes questions, favors the experienced. Great startup lawyers prioritize deals because they know they deserve urgency, but show us lawyers who act as if speed should be a founder team’s top priority in a financing, and we’ll show you lawyers who are captured by money players. In too many cases, startup entrepreneurs’ cultural inclination toward speed and automation – which in the right contexts is a good thing – has been hijacked by misaligned but very clever repeat players in order to dupe the inexperienced into adopting legal strategies that actually hurt their interests.
Wrapping this topic up, as counsel, our job isn’t to always provide startup clients direct answers, but sometimes to simply ensure they, in their inexperience and unequal power in the market, are asking the right questions. Questions like:
- What do we really mean by “standard”? Can the data be manipulated?
- Whose “standard” is it, and are they biased? Can their “founder friendliness” be a marketing tactic instead of full reality?
- How much should I even care whatever “standard” means, at least as it relates to my most high-stakes terms, if I’m building a unique company with its own priorities, context, leverage, etc.?
- Might it be a bigger problem (than my investors will acknowledge) if my company counsel is far more motivated, via referrals and other economic ties, to keep my investors happy instead of the inexperienced common stockholders whose skin is entirely in this one company?
- Is “moving fast” and rewarding my company’s lawyers for minimizing their involvement (with flat fees) really in my best interests, or is “saving money” a clever excuse to keep me ignorant and not properly advised of what I’m getting into, so that more experienced players can then take advantage of the imbalance?
We don’t pretend to have universal answers for these questions, because there aren’t any. Where you land depends on the context, the people involved, their unique priorities, and the kind of relationship they expect to have going forward. You know, a lot like term sheets.
Jose Ancer (@ancerj) and Jeremy Raphael (@jraphs) are Emerging Companies Partners at Egan Nelson LLP (E/N), a Lean, World Class Law Firm delivering top-tier, scalable legal counsel to leading startups, without the unnecessary overhead costs associated with traditional firms.