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Rocky Mountain Startup Lawyer Posts

Why Colorado Startups Shouldn’t Use YC’s SAFEs

The “SAFE,” which is short for “Simple Agreement for Future Equity” was created by Y Combinator as a template document for seed financings. In its original form, the SAFE was essentially a convertible note without interest or a maturity date. 

In Silicon Valley, data shows that SAFEs took up a significant amount of market share for seed rounds. That’s not surprising, because SV is a world unto itself in terms of the density and level of competition of capital available for startups; and also far more inclined to a “billion or bust” growth culture among entrepreneurs than other parts of the country and world. That culture creates a “lottery ticket” dynamic in seed funding where hyper-standardization of terms and rapid closings are seen as a facilitator of broad portfolios. 

Put that many funds into such a small geographic area, and they will compete on who can be the most lenient in their terms. The original SAFE was about as lenient as an investor instrument could be. In SV, a significant portion of the investor community swallowed their concerns and funded SAFEs. But outside of SV, the dynamics are totally different. 

In the Denver/Boulder ecosystem, which due to its composition behaves much more like Austin or Seattle than Silicon Valley, the vast majority of investors rejected the original SAFE as too one-sided. As a firm that doesn’t represent tech investors (only companies), we tend to agree. Some asks from investors are perfectly reasonable, and if you try to avoid them, you can unintentionally signal that you don’t intend to actually deliver on your promises. 

We’ve seen convertible notes with low interest (2-5%) and a 2-3 yr maturity (plenty of time to use your seed funding to achieve a major milestone) become much more of a dominant seed structure than the original SAFEs. The maturity date serves as a basic accountability mechanism for investors to ensure that the company intends to eventually achieve a milestone that converts the notes to equity. Handing investors a SAFE, knowing that they are far more comfortable with more balanced convertible notes, can therefore send a bad signal.

Recently, YC updated their SAFE docs to make them far more company unfriendly than before in terms of economics/dilution. Without getting too “in the weeds” the SAFE templates now available on YC’s website are structured to have post-money valuation caps, instead of the original pre-money caps. This makes their economics far harsher than most seed structures, and so startups should exercise extra caution in adopting them. There’s a growing feeling that, as YC has grown and changed leadership, its investment posture is starting to look far more like an investor focused on maximizing returns than a (air quotes) “founder friendly” player. Their new post-money SAFE structure is a reflection of that.

In Colorado, convertible notes and seed equity are the main options for seed funding, which would typically be defined as $1.5MM or less of early money. While convertibles are far faster to close on, seed equity is still much leaner in terms of fees and time than a full VC-style deal, and can provide greater alignment between investors and the company. Work with advisors specialized in early-stage funding to sort out the appropriate structure that protects the company, while accommodating the expectations of your lead investors. 

If the original pre-money SAFE failed to become the “standard” for seed rounds outside of SV (including in Colorado), because investors felt it was too dismissive of their interests, the new post-money SAFE should similarly be rejected by companies for offering bad economics. 

For a deeper-dive into the recent SAFE changes, why startups should avoid SAFEs, and better structures for seed rounds from lawyers specialized in raising capital outside of SV, see: Why Startups shouldn’t use YC’s Post-Money SAFE. 

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A “standard” term sheet does not exist

Startup ecosystems are unique environments relative to most of the business world, in large part because of the substantial inequality of experience between the players involved. On a typical business deal, you have seasoned business people on both sides negotiating with each other, with appropriate advisors.

In the startup context, however, you very often have significantly inexperienced teams negotiating with investors who are, quite literally, 100x as experienced as they are at the types of transactions they are discussing. This is why first-time entrepreneurs often lean significantly on outside advisors, including lawyers, to “level the playing field” and ensure that a startup’s inexperience is not unfairly leveraged against them. 

Unfortunately, “this is standard” is perhaps the most common way in which sophisticated “repeat players” (investors) often dupe founders into accepting this or that term or document. The truth is that while there is some standardization at a very high level among early-stage tech documentation, there is still a wide diversity of acceptable high-stakes norms, any combination of which can be appropriate for a company’s unique context. 

The best way for a first-time team to protect themselves is to work with trusted, experienced advisors, including lawyers without conflicts of interest with investors, to explain what is or isn’t appropriate for their context. And they should be extremely cautious with anyone – even someone with what appears to be a great reputation – suggesting certain financing terms are “standard.” “Standard” is often in the eye of the beholder, and incentives heavily influence their vision. 

For more on this topic, particularly as it relates to term sheets in Series A financing, see: The Problem with Standard Term Sheets (including YC’s)

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The Importance of “Friends and Family” Rounds

When people in startup ecosystems speak of “friends and family” rounds, they are typically referring to a very early round of financing – often the first round – of a startup in which all the people putting in money have very close, personal ties to the founders; which makes them more willing to take on a level of risk that a true investor may not.

Because so much of the wealth circulating in Silicon Valley was created in tech, “angels” in SV tend to be more more risk-tolerant relative to angels elsewhere in the country. They trust their ability to judge vision and team, independent of traction, and are therefore willing to invest much earlier. In other parts of the country, however, there is far less of that truly angelic angel money.  Much of the wealth available outside of SV for angel investment originated in non-tech industries, and the investors are therefore more conservative in their risk tolerance; often expecting more traction and milestones before they’ll invest.

That means that in ecosystems like Colorado, friends and family rounds are a vital part of helping entrepreneurs jumpstart their companies.  The most common F&F structure that we see is a convertible note, with a discount on a future funding round. The note should have a very long maturity date, like 3 years.

We advise that you avoid placing a valuation/valuation cap in a F&F note (most angel/seed convertible notes have valuation caps), however, because friends and family investors usually aren’t experienced enough to properly value the company. If you place it too high, you can create unrealistic expectations for the future. If you place it too low, it will “anchor” the valuation expectations of future investors, weighing the valuation down.

While we advise against putting valuation caps in F&F notes, we will include a provision giving your friends and family investors a discount (often 20%) on the future valuation or valuation cap that your angels/seed investors get. Say, for example, a year after your F&F round you do an angel/seed round at a $5 million valuation cap in a convertible note. This provision will amend your F&F notes to then give them a $4 million valuation cap; with the discount being the reward for additional risk they took on. And if your seed round is an equity round, the F&F note will simply convert into the seed equity, at a $4 million valuation.

This dual discount structure ensures that, whatever investment structure your seed investors get, your friends and family end up with the best deal, which they deserve because they invested the earliest.

Important point: There’s a common misconception among first-time founders that friends and family investors do not need to be accredited investors. This is incorrect. There is no such thing as a “Friends and Family exemption” from securities laws. To avoid serious problems down the road, startups expecting to eventually take on more experienced, institutional investors should steer clear of all non-accredited investment and only take money from people, friends and family or otherwise, who have sufficient income or assets to qualify as accredited investors.

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What Startup Accelerators Do

Background Reading:

When most people think of the core value of top-tier universities, they think it’s obviously to educate top students. While that may be true, there is a strong argument that education is actually secondary to top universities’ “sorting” function; in other words, by credibly filtering out and selecting the most elite among millions of students, universities help employers and other people find those students more easily.

Sidenote: there’s empirical evidence suggesting that students who get into the ivy league but don’t attend do just as well as those who do attend, lending backing to the idea that top universities are far more about sorting and finding talent than developing it.

Top-tier accelerators are the elite universities of startup ecosystems. As “doing startups” has become more of a thing and the number of entrepreneurs has gone up (correlating inversely with the drop in cost of starting companies), business ecosystems have become far more “noisy.” More pitches, more teams, more ideas, make it much harder for interested investors to sort through and find the cream. It’s the exact same problem employers have with students.

Here in Colorado, Techstars is clearly the most notable accelerator, although there are others here and throughout the country. Ask entrepreneurs about the value of the educational content of these accelerators, and feedback will vary; but almost universally founders will say that the top ones pay for themselves simply from the network they open up for you by putting their stamp on your startup; just like a Harvard or MIT.

Are accelerators necessary for startup founders to succeed? Absolutely, positively not. The large majority of successful companies we work with never touched an accelerator. But for entrepreneurs lacking strong connections to investors and other key players early on, they can dramatically accelerate a startup’s ability to find capital, advisors, etc.; and should be strongly considered.

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Why the “independence” of a Startup Lawyer matters.

Background Reading:

There are two general types of work that a corporate lawyer (startup lawyers are corporate lawyers) provides: strategy and execution. Very experienced, senior executives who’ve been in the game for a very long time tend to use their lawyers much more for execution than strategy. They know how to navigate the environment themselves, and how to negotiate, and just want good lawyers to paper things properly.

First-time entrepreneurs, however, are not seasoned executives. They’re often entering an environment of total opacity, where lots of the people they’re dealing with (investors, partners, etc.) have 10-20x more experience and connections than they do, and very misaligned incentives. In this context, entrepreneurs lean on their startup’s lawyers – who have very broad visibility into the market, and broad experience on a variety of deals – not just for execution, but for deep strategic guidance: how and what to negotiate, how to navigate the ecosystem, what to push back on, how to protect themselves, etc.

Unfortunately, because startup lawyers play such a pivotal role in helping entrepreneurs negotiate with and protect themselves from bad actor investors, those investors often make it a point to gain significant leverage over the lawyers in their local ecosystems: by sending deals in their direction, working with them on deals, etc. This is a huge problem.

If you are an entrepreneur working with a lawyer to negotiate a term sheet, how on earth can you trust the objectivity / impartiality of that lawyer’s advice when the people who sent you the term sheet have employed him on 20 other deals, and will do so in the future? Fact: you can’t. The conflicts of interest are simply too high. For that reason, one of the core questions any startup founder needs to ask a prospective lawyer is: what investors do you work for? Do not hire lawyers with deep ties to people you expect to raise money from.

Well-negotiated and fair deals result when both sides are represented by experienced, independent counsel. No matter what anyone else in the ecosystem tells you about how a certain set of lawyers will help you close on money, if you don’t take their independence from the money seriously, you will regret it in the long run.

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Must Colorado startups hire lawyers in Denver or Boulder?

Background reading:

In short: no, and anyone who says otherwise is simply lying in order to cut off competition from potentially better fit lawyers with broader geographic footprints.  Virtually every serious corporate lawyer (startup lawyers are corporate lawyers who specialize in early-stage) with a well-deserved brand has clients across city and state lines.

Because the vast majority of startups are incorporated in Delaware, Delaware corporate law governs 99% of the issues they’ll deal with. The 1% will be labor/employment issues, which will typically be governed by the location of their employees (often multiple states), and local labor boutiques are easily engaged for that. 

In fact, when you’re navigating negotiations with potentially influential local investors whose ‘reach’ covers a lot of the local legal market, there can be benefits to having counsel from someone more detached from the local community. See: How to avoid “captive” company counsel. 

Go through the above-linked checklist to ensure you are engaging counsel that is the right fit for what you’re building – in terms of specialization, cost structure, culture, etc. – regardless of where they are physically located. 

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Formation options for Colorado Startups

Background reading:

The following are a few points that any startup entrepreneur needs to keep in mind in terms of forming their company from a legal perspective.

First, formation is not the same thing as incorporation.

Incorporating a company is literally the act of filing a document in Delaware (or another state). It achieves 1% of what needs to happen in a proper startup formation. A full formation involves forming a Board of Directors (or if an LLC, Managers), issuing equity with vesting schedules, assigning IP, forming an equity plan, and a number of items. When comparing offerings from different firms, pay very close attention to what is actually included in a package, because it’s easy for firms to leave things out in order to appear to offer a lower price.

Second, don’t assume you want a “standard” Delaware C-Corp.

If you read info from Silicon Valley – and most content out there is from SV – you’d think 100% of tech startups are C-Corps. That’s not true. Yes, most are, but your particular business model and growth trajectory may make it a less obvious choice. See: More Tech Startups are LLCs. 

Be aware of fully automated options.

There are fully automated and safe options like Clerky, if you are comfortable with no customization and a very standard structure. If keeping legal costs to an absolute minimum is a top priority, Clerky is far safer than a DIY project with templates.

LegalZoom and RockeyLawyer are not appropriate for a startup, because they are designed for small businesses, which have much simpler/less complex needs.

Most startups hire law firms. Hire one right-sized for what you’re building in the next 5 years.

See: Checklist for Choosing a Startup Lawyer and Why Startups hire law firms, not a lawyer.   Most startup-specialized firms have fixed fee packages for formations that will allow for more flexibility/customization (and guidance) than a fully automated approach, without incurring excessively high costs.

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Why startups hire law firms, not a lawyer.

Background reading: When a startup lawyer can’t scale. 

When navigating startup legal issues, it’s very important to learn the distinction between “startup” and “small business,” because it’s not always clear, given that both start out small.

When someone says “small business” they are referring to something like a coffee shop, or a restaurant. For the first several years, the customers will be geographically local. If it takes any investment at all, it will likely be 1-2 local “partners” putting in money. Equity likely isn’t used much for compensation purposes, because the much slower growth of its value means it won’t incentivize employees as much as cash will.

“Startup” on the other hand, refers to a company that (naturally) starts out small, but whose customer footprint will likely be more national and international, and is likely to scale faster than a small business. Startups still differ in their types of growth trajectories, with Silicon Valley being well-known for building / emphasizing hyper-growth “Unicorn” startups. See: Not Building a Unicorn for our perspective on how smaller startup ecosystems often build companies that behave differently from what SV produces.

But the main point here is that startups face much more complex legal issues, and a higher volume of them, than small businesses do. And that requires a different type of legal infrastructure to get the work done.

The legal market can be separated largely into 3 categories: solo/tiny firms, boutique firms, and very large firms (BigLaw). BigLaw is structured for billion-dollar companies, and startups on that path; and is priced accordingly. Solo/tiny firms are well-designed for small businesses, including small apps likely not looking for much scale.

Boutique firms are designed for the “middle market” – higher complexity and volume than small biz, but much leaner and lower overhead than BigLaw. E/N (our firm) is a boutique firm. 

At any given time, a seed or Series A stage client of mine will have a commercial agreement being drafted, a few option grants in process, an NDA to be reviewed, and perhaps 1-2 other projects in play. If they were waiting on me, personally (a Partner) to handle all of it, they would be waiting far longer than they can afford to. Expecting a Partner (who has many clients) to do all of that work is also ridiculous and inefficient; the law equivalent of asking a Neurologist to check your temperature, treat a cold, and give you a simple vaccine. Overkill.

So firms designed for scaling startups have paralegals, junior lawyers, senior non-partners, word processing professionals, and technology – an infrastructure to get different levels of work done efficiently and on time, with Partner oversight. That’s necessary for startups, who often operate on compressed timelines, and can’t wait very long. 

If you’re a startup, and not a small business, make sure you hire a firm with the right infrastructure to get things done efficiently and promptly. Otherwise, when you need your lawyer most, you’ll be faced with a several week (or month) wait that could kill a crucial deal.

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Colorado startup seed financing structures.

Background reading:

In terms of how a typical emerging tech company (startup) raises seed capital, there are 3 options that from our experience make up 95+% of rounds: Equity (Preferred Stock), Convertible Notes, and SAFEs (Simple Agreement for Future Equity).

If you want a deeper dive into their pluses and minuses, read the above-linked posts. At a high-level, equity (stock) is more complex to negotiate, draft, and close, but has the benefit of greater certainty. Larger rounds tend to be closed as equity. “Seed equity” is a subset of equity financing using slimmed down, very template-ized documentation that can be closed much more quickly (with lower legal fees) than a full VC-style equity round. When rounds below $1.5-2 million are to be closed as an equity round, we see Seed Equity being increasingly utilized as an option.

Apart from equity, there are convertible securities, with convertible notes and SAFEs being the 2 dominant forms. Convertible securities are much easier to draft (lower fees) because they defer a lot of the hard issues/negotiations to the future.  But the cost is more uncertainty, and also somewhat more dilution. 

A convertible note is effectively a debt instrument that intends to convert into equity in the future, when a larger financing occurs. It has a maturity date (like a loan) that sets a deadline on the company reaching that milestone financing, or else a discussion/re-negotiation with the investors needs to happen.

SAFEs are basically convertible notes without a maturity date. They also convert into equity in the future, but there is no “deadline” of a maturity date, which is much more company favorable, and investor unfavorable.

A recent survey of seed financing structures reveals that in California, where the volume and density of seed investment (and competition among investors) is magnitudes higher than the rest of the country, SAFEs are well on their way to becoming a dominant seed round instrument. SAFEs were originally created by Y Combinator.

A key takeaway from that survey, and which I’ve emphasized several times before, is that entrepreneurs in Colorado, Texas, and other ecosystems should be very careful to not extrapolate trends in Silicon Valley into their companies, because the norms of their local investor community are likely different. Among convertible security seed rounds, convertible notes are far more preferred by seed investors here than SAFEs.

I don’t represent a single tech investor, for reasons I’ve written about in How to Avoid “Captive” Company Counsel, so I can speak with total impartiality in saying that SAFEs are extremely company friendly to the point of being somewhat ridiculous in many cases.

The “deal” between an investor and company in a convertible note round is that the investor will accept fewer rights upfront (which is risky for them), but the maturity date and debt aspect of the investment provides them some protection. A SAFE basically tells an investor to accept all of those downsides (fewer rights upfront), and yet let go of that protection. Hope for the best.

It’s no surprise that SAFEs came from YC. Already within California, there is much more competition among investors to get into the top startup rounds, so terms in general are more company friendly. YC is the elite of Silicon Valley in many respects, so YC companies by default are able to dictate terms much more easily to investors than a typical startup.

Still, as the data shows, SAFE rounds outside of Silicon Valley do happen. We certainly close them. But the core point here is to not get too hung up on them. We too often see founders try starting out with a SAFE, and then have to change course mid-round (which is more costly) because a serious investor gave them a reality check. Better to focus on convertible notes, if you’re doing a convertible round. As long as the maturity date is far off enough (2-3 years), get the money and move forward.

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How Colorado startups are often different from Silicon Valley startups

Background reading: Not Building a Unicorn. 

The growth path you intend to take for your company dramatically impacts the legal structure you implement on Day 1.

Silicon Valley is known for serving as a magnet for entrepreneurs going after huge, billion-dollar markets, and the entire ecosystem there – including Silicon Valley startup lawyers and firms – has been built around those kinds of companies. In smaller ecosystems like Denver-Boulder, Austin, etc., there are also many firms with great “business lawyers,” but who lack the specialized knowledge of technology and venture capital that startups need.

Hiring a small business lawyer to work on a “true” startup raising angel and eventually venture capital will produce huge errors and long-term cleanup costs, due to that lawyer’s lack of knowledge of both market norms and legal precedent to work from. 

We’ve felt this “bifurcation” of the market – small business or billion-dollar unicorn path – has a huge gaping hole. What about startups for whom a $50 million or $100 million exit is a perfectly acceptable goal? “Small business” people can’t scale for them, but the unicorn ecosystem is overkill. 

The truth is that Colorado emerging tech startups usually look a whole lot more like that (successful, but deliberately not unicorns) than the kinds that Silicon Valley builds and promotes.

The fact that states like Colorado, Texas, and Washington produce a lot more successful, but non-unicorn, startups means that the legal structures of those companies often look very different from the “standard” Silicon Valley approach. This includes:

Colorado entrepreneurs need to ensure they’re getting advice that works in their particular context. That often means working with people, including lawyers, advisors, and investors, who aren’t necessarily in the same city, but also aren’t dominated by Silicon Valley’s unique way of doing things. 

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