First time founders and the trouble with founder friendly terms

Disclaimer: I am a first time founder, not an investor. My data is based on discussions with dozens of other early stage, software startup founders on the east coast. My experience could simply reflect the difference in investing climate between east and west coasts.

I recently had a twitter conversation with Mark Suster and Arlo Gilbert about Mark’s recent post regarding Convertible notes.

This is the main point, in my words, that I took from the post:

Founders should not do a convertible note deal with investors who will not agree to language limiting liquidation preference overhang

Implementing language like this would be fair for investors and fair for founders. Here is the rub: every investor knows about liquidation preference overhang and many of them bank on it being how they make their money. In fact, the angels and seed stage VCs that we have talked to, all explicitly state that this is how they benefit from early stage deals. In their words, the valuation jump from from seed to A round is their payoff from taking such risks early on

Having been through only one very small, but critical round of funding I can tell you that we fought against term sheet markups with multiple preferences and ratchets. Our well respected and high priced lawyers told us that multiple preferences were standard on a seed convertible note and that most of these terms didn’t really matter in a first seed round. Having done my homework I pushed against those and we ended up getting good terms that everyone seemed happy with — but that doesn’t mean they weren’t going to try.

This gets to my larger point that first time, or early stage founders do not have the leverage or funding options to push back on terms that are not friendly. Often the BATNA for these folks is, take out a personal loan. So when I read the following quote I had to think that it doesn’t understand the funding environment that we are in.

So here’s what every entrepreneur should add immediately to any convertible note they are trying to raising money against and run from any angel who won’t agree to this.

Run where? When I talk to my fellow early stage east coast founders, the majority aren’t beating away founder friendly term sheets. Even seed stage companies with revenue and traction raising relatively small amounts are giving away board seats and agreeing to multiple preferences because they have nowhere else to go. For founders, these deals can be make or break. For investors they can hold out and the only downside is slightly lower yield. So there is asymmetry in needs which means founders have little leverage.

And please don’t let any angel try to convince you they deserve more for the early risk. The early risk is why they get a cheaper price.

This is exactly what a lot of them say though, and early founders don’t have the history or credentials to fight them on it (aside from pointing to posts like Mark’s). So the options in many cases are, close up, or take worse terms.

The immediate response to these points is always some mix of “well then you aren’t good enough” or “go back to bootstrapping till you get better terms” or something that points to the founders or the company not being ready for good terms. Granted there are a lot of those, but I am talking specifically about trends I have seen with more than one startup who have bootstrapped themselves to traction/revenue and have teams comparable with those well funded elsewhere.

The bottom line here for me is that for first time seed stage founders, most don’t seem to have the leverage or the network to be able to push back on terms that aren’t particularly friendly. To say to these founders that all we need to do is fight back on them, is ignoring the ecosystem that they find themselves in. Given the startup to investor ratio, many of us only have personal connections to a few, and if none of them are willing to agree to language that is friendly then we end up being stuck.

We need something better than pointing to a handful of (very valuable) blogs if we are going to be able to push back against terms unfriendly to founders. I don’t really know how else to prevent taking bad terms other than falling back to a defensive position and hoping you can squeeze enough juice out to not need any outside money before shutting down.