Relationships and Power in Startup Ecosystems - Silicon Hills Lawyer

posted in Accelerators, Angels, Board of Directors, Ethics, Founders, Funding, Hiring, Long Essays, Power, Startup Law Firms, Startup Lawyers, Venture Capital

on February 18, 2019

by<br>ancerj

TL;DR : The highly unequal relationship and power dynamics in most startup ecosystems mean that what is visible publicly (on blogs, social media, etc.) is not an accurate representation of how the game is actually played, because few people are willing to speak honestly and openly for fear of being penalized by a well-connected gatekeeper. This makes off-the-record diligence, and watching loyalties of your most high-stakes relationships (including counsel), essential in order to prevent repeat "money" players (investors, accelerators) from dominating the voices of less influential "one shot" players (first-time entrepreneurs, employees) both on boards of directors and in the market generally. Hire and engage people without hidden dependencies on the money.

Background Reading:

Common Stock v. Preferred Stock

How to avoid "captive" company counsel

There are a few underlying themes that have been covered in a number of SHL posts and are relevant to this one:

First , in startup dynamics there is a fundamental divide and tension between inexperienced, "one shot" common stockholders and "repeat player" investor preferred stockholders (VCs, seed funds, accelerators) that feeds into all of the most high-stakes decisions around how to build and grow a company. It has nothing to do with good v. bad people. It has to do with core economic incentives.

Common stockholders (founders, early employees) typically have their wealth concentrated in their one company (not diversified), do not have substantial wealth as a backup in the event of failure, do not have the downside protection of a liquidation preference or debt claim on the company, and have almost no experience in the subtle nuances of startup economics and governance. This dramatically influences their perspective on what kind of business to build, how to finance it, whom to hire in doing so, and how much risk to take in order to achieve a successful outcome; including how to define "successful."

Preferred stockholders / repeat players (investors, accelerators) are the polar opposite of this scenario. No matter how "founder friendly" they are, or at least pretend to be via PR efforts (more on that below), their core economic interests are not fully aligned with one shot players. They are already wealthy, significantly diversified, have substantial experience with startup economics and governance, and have downside protection that ensures they get paid back first in a downside scenario.  In the case of institutional investors, they also are incentivized to pursue growth and exit strategies that will achieve rare "unicorn" returns, even if those same strategies lead to a large amount of failures; failures which hit common stockholders 100x harder than diversified, down-side protected investors.

And the fact that some of the repeat players are themselves former founders (now wealthy and diversified) is irrelevant to the fundamental economic misalignment; though investors will often use their entrepreneurial histories as smoke and mirrors to distract now first-time founders from that fact. They can probably empathize more with the common’s challenges, and help with execution, but they didn’t become wealthy by ignoring their economic interests. In fact, I would argue from experience that the moves/behavior of entrepreneurs-turned-investors should be scrutinized more, not less, because they’re almost always far smarter "chess players" at the game than the MBA-types are.

Second , apart from the economic misalignment between the common and preferred, there is a widely unequal amount of experience between the two groups. A first-time founder team or set of early employees do not have years of experience seeing the ins and outs of board governance, or how subtle deal terms and decisions play out in terms of economics and power.  The preferred, however, are usually repeat players. They know the game, and how to play it. This means that the set of core advisors that common stockholders hire to leverage their own experience and skillset in "leveling the playing field" is monumentally important; including their ability to trust that those advisors will help ensure that the preferred do not leverage their greater experience and power to muzzle the common’s perspective.

This second point relates to why having company counsel who is not dependent on your VCs / the money is so important; and it also highlights why repeat players go to such enormous efforts to either force or cleverly trick inexperienced teams into hiring lawyers who are captive to the interests of the preferred.  We’ve observed this in pockets of every startup ecosystem we’ve worked in: that aggressive investors work hard to gain influence over...