Transparency in Startup Investing: A Response

Let me start by saying I have tons of respect for YC and their amazing track record, and for their incredible transparency and their seemingly endless contribution of startup writing and podcasts, and the Macro itself which I continue to learn a lot from on a regular basis as an early-stage investor. But I disagree with the premise and conclusion of one of their recent posts.

Earlier this week Geoff Ralston published a post on YC’s The Macro calling on founders to help their angel investors who have invested in their startups via convertible notes, to figure out what the heck is happening to them at the next round when their notes convert. He writes:

I propose that a simple way to improve upon this is to send all investors a concise summary of what has happened in the deal, along with all the documents needing their signature. This will give the investors sufficient information to know what their rights are going forward and how their share price was calculated.

As an early stage investor myself I disagree. I think the founders are busy enough running their startups and, more importantly, the onus is on us, the early-stage investors, in this regard. I’d further argue that if an angel investor needs this type of help “to figure out what has happened” (Ralston’s words) at the next round, then they shouldn’t be in this game — or, alternatively should choose to invest via securities that lock in the rights they so cherish but risk getting “trampled on” and losing.

My responses to some of Geoff’s points in-line below:

In many ways it is easier than ever for startup founders to raise seed financing, and it’s easier and more convenient than ever for angel (a.k.a seed) investors to find and choose where to place their bets.

Ah, the beginning of the problem. Lots of people playing in the sandbox who shouldn’t be in the sandbox, due to bright shiny exits and easier-than-ever access.

Nowadays the earliest investors in startups usually invest via convertible securities.

Correct. This has been blogged about at length but let’s briefly review why we early-stage investors do that, when what we really want is equity with gobs and gobs of rights rather than holding debt in the startup. Two main reasons: a) we’re cheap — we don’t want to fund a company with a $100k CLA and have $10k go right out the back door to lawyers to document our rights, and b) we’ll rarely agree with the founder on valuation so we kick that can down the road to the Next Round (as defined), hopefully protected by a valuation cap (best tweet I ever saw: “A fool and his money are soon parted — via a non-capped CLA”).

In other words, this is a choice made by the investor — as if to say, “I’m willing to risk the further investors setting my rights, because I don’t want to, or can’t agree on the rights documents right now.” In other words we are consciously leaving our rights to be determined by the Next Round investors because in return they are willing to a) pay for the docs and b) slug their terms out with the founders and their lawyers. It’s a conscious trade-off that has its risks. The countering benefit of course is that we get in earlier, at a lower valuation, and hopefully the Next Round investors don’t strong-arm the founder into screwing us or imposing harsh demands re: shareholder rights.

Angel investors almost never have a seat at the table while all of this takes place. This means there is no guarantee that rights they gained in their financing are preserved.

Again, this is a choice. I like to re-invest in the next round when I can, so I can get a seat at the table. If I’ve chosen not to re-invest, well then I’ve left others at the table to negotiate my rights, haven’t I?

It is probably true that in most every case small investors simply go along with the terms negotiated by others irrespective of whether their rights are being egregiously trampled upon.

Again this makes the Next Round investors sound very evil — sometimes they are, believe me. But if I’ve invested in only 3% or less of the company, and I’m chosen not to invest again, and I’ve used a convertible doc because I didn’t want to pay for or negotiate a full set of rights documents….. have I not in some way accepted the risk of getting “trampled on,” much the same as I’ve accepted myriad other risks related to this startup (e.g., will this startup even survive to a Next Round, will the founders fight, will the product flop etc.) in return for an early position at a low valuation?

When a financing as described above is nearly complete, seed investors are sent the financing documents to sign, and often asked to do so with little time for review…..The only way for those investors to know exactly what has transpired during those negotiations is to carefully read — or have a lawyer read — all of those documents and to dig into the Excel file to figure out how share prices were determined.

This part got me a little miffed, I must say. Yes, the only way to understand a serious investment of serious money is to “carefully read” legal documents — or if you can’t, have a lawyer read them. If neither of those options appeals to or is available to you, then I’m sorry, I go back to my first point that you shouldn’t be in the sandbox. This is not meant to be insulting or offensive or elitist. I’m just saying that early-stage investing is not a game, it’s a business, you’ve made a business investment governed by current and future legal documents, and yes, I’m sorry to break it to you that you or someone qualified on your behalf should read them. (Disclosure: I happen to be a former corporate lawyer, which certainly helps me understand these docs, but most of my colleagues in the space have no formal legal training yet are perfectly and equally proficient at reading and understanding these docs and their implications.)

Furthermore- these agreements are pretty standard. There hasn’t been dramatic innovation in “Next Round” (Series A or Series Seed) investment documents over the past few years. or decades even. Once you or your lawyer has seen a few of them you (or he/she) should be able to identify the nuances and implications of the various moving pieces negotiated by the Next Round investors that impact your prior investment. Again, if you can’t figure these out, you should probably find somewhere else to allocate your high-risk capital bucket.

In short, early stage investing looks sexy and exciting but it’s a business like any other and has its inherent risks and its generally pretty standard legal documents. If you want to be an early stage investor at very low valuations, and don’t want to or can’t negotiate your own rights, and can’t understand the Next Round documents and their implications relatively quickly — then you probably should reconsider the investment category.