There’s a lot of discussion about “investor friendly” investment documents versus “founder friendly” or “startup friendly” investment documents. For example, an instrument with a repayment structure is considered more startup friendly, while one that has no repayment terms is considered more investor friendly.
This is because if a company takes an investment that has repayment terms that can be exercised at the startup’s discretion, the startup has the choice of cashing out the investor instead of converting them. If the startup increases in value quite a bit between the original investment and the conversion or cash-out event, the startup could be considered to give a raw deal to the investor by simply repaying the investment instead of converting them, since the investor’s potential equity stake would have grown quite a bit since their investment. This lets the startup preserve their equity by cashing out the investor.
Conversely, an instrument without repayment terms is often considered more investor friendly, because it removes the opportunity for a high-growth startup to cash out early investors, thus denying the investors the value growth of the equity in comparison to the original investment. Making conversion an obligation, and not an option, then preserves the investors’ position even if it becomes more preferable for the startup to cash them out.
These are concerns for good times, though, and good times are not always here. Sometimes things aren’t great for either startups or investors, and some of the more familiar good-time concerns need to be put aside, and more difficult conversations need to be had, especially when the investment market is more difficult.
Worrying over preference for startup friendly vs investor friendly is a nice gloss on a bad problem, namely, that both investors and founders are at significant risk of fraud and other criminal activity. And when the financing environment is more difficult, both parties have significantly increased risk that untoward behavior may be exhibited by either side of the deal.
The easy money climate from post-“Global Financial Crisis” in 2007-2009 led to a general diminishment of the awareness and level of concern as to how common of a risk fraud and other crime is in large-value transactions. Even selling a used car for a few thousand dollars presents an enormous opportunity for fraud and other crime, so why are we so quick to disregard issues when we’re talking about much larger figures? Most investors don’t desire to draw awareness to how at risk they are of being defrauded, or how much capacity they have to defraud and otherwise engage in criminal activities against their invested startups. And startups are often run by inexperienced first-time founders, or founders who were able to successfully navigate financing and reach an exit without ever experiencing fraud, and thus are somewhat ignorant of the risks and how to recognize, mitigate, or prevent them.
That most transactions occur without any criminal intent or activity on either side is not the point, because most of us go most of our lives without significant or major criminal experiences. Sure, most of us have had a bike stolen, or a car vandalized, or something minor of the sort, like a phone being stolen or broken. Maybe someone got punched at a bar. Sometimes people get threatened with guns. But crime to the tune of hundreds of thousands, millions, or tens of millions of dollars is an experience that most people, and therefore most founders, lack familiarity with.
Despite all of the PR and other marketing subterfuge to disguise the issue, the risk of fraud and other crime remains a huge concern for both investors and founders. Following the original .com crash back in ’99, there was a lot of talk about “vulture capitalists” who would impose onerous or exploitative deals on startups, and take advantage of the inexperience and naivete of founders. This resulted, in a circuitous way, in the adoption of “safe” investment structures that avoided many of the traps and other pitfalls built into more traditional convertible promissory notes, equity purchase-and-sale agreements, and other older methods.
Even with these newer methods, countless once-promising startups have risen and fallen due to the investors demands to constantly increase the investor’s profit-taking from the investment. And as the startup investment market grew, and started to draw in more VC firms taking money from pension funds, sovereign wealth funds, family offices, and other sources of capital of increasing questionable origins of the capital (1/3 of wealth is inherited, 1/3 of wealth is proceeds from crime, and only 1/3 of wealth is actually earned by its possessor), the risks and threats of startup investment on both sides has continued to grow, even if it’s downplayed by everyone involved.
We’ve seen a continuous escalation of expectations from investors; a Series A used to be a pre-revenue round, the first-money-in, to prove that a business concept was viable. But then the market “matured” and “became more sophisticated” (got older, wiser, and more comfortable and familiar with exploiting naïve founders), and the Series A was pushed up the line. Now you can’t raise a Series A as a proof-of-concept to fund the development of revenue. Startups introduced Seed to replace the role of the original Series A, only for Seed to get pushed up the line, and then Angel investments were developed to replace what used to be Seed and before that, Series A, and now Angel has pushed up the line too. People are talking about pre-Angel to Angel to pre-Seed to Seed to pre-A to A, and all the while, expectations from investors increase seemingly without relent.
Investors continue to demand more from startups while giving less, driving up the cost of startup capital requirements, and either driving up the base valuation of the startup or demanding that the founder team dilute themselves to such an extent they have little incentive to actually reach financial targets. This escalation in demands, expectations, and obligations on startups to get financed has resulted in an increasingly desperate situation for early-stage companies, especially ones that are more capital intense (e.g. the work they do is more fundamentally valuable than yet-one-more website) or take longer runways to get going (e.g. they’re working on innovations that require more inputs and time than just pasting together some existing codebases or APIs into a new app or website).
These dynamics have led to an emergence of blended funds that use both characteristics of VC funding and Private Equity, or PE, funding. PE funds by their nature are very exploitative and cold-blooded, historically dealing with mature companies and arms-length transactions. Investing in an existing mature company has a limited emotional or interpersonal investment, as the founders are generally long gone, and everyone is dealing with the business purely on business terms. This is not true for startups, where the founders are present and may be investing their life’s energy in making something new, which means the founders have a very personal and emotional tie to the business.
The introduction of cold-blooded, highly structured PE funds to startups creates a disparity of “sophistication” and experience that often results in extremely one-sided deals, resulting in PE-to-startup investments that are ripe for exploitation, abuse, and fraud. PE origin investors take the pretense this is “just market”, but it’s not, it’s intentional behavior on the part of the PE investor. They’re doing it because they want to, not because they don’t have a choice. They could choose not to demand harmful terms, but they won’t, and the entire reason they’re at a PE firm is because they’re happy to take advantage of people at every opportunity. There’s no such thing as a “startup friendly” PE firm. And when you combine this “profit at any cost” mentality with the emotional and personal ties of founders to a business, things can get very ugly, very fast.
What most people don’t understand, and the PE industry is very aggressive in keeping quiet, is that private equity as a concept was developed by criminals, specifically and intentionally to obscure and “legitimize” criminal enterprise. PE was essentially invented by Michael Milken in the early 1990s once he was released from Federal prison for securities fraud. Milken realized that he could steer investor capital into aggressive and exploitative deals that were technically legal, but intensely harmful to everyone except the PE firm.
When Rudy Giuliani “cleaned up” New York during his mayoral term in the 90s, people say that he “broke the Mob” or drove them out of New York. That’s not true. Giuliani moved the traditional Italian and Irish mobs out of street-level crime – prostitution, gambling, loan sharking, gunrunning, drug running, human trafficking, protection rackets, knee breaking, and other crimes you’d associate with mobsters, which are typically committed against individuals and private persons. This opened the street-level crime for the Russian mob, who had been backing Donald Trump since his visit to Moscow in the late 80s, and who became dependent on Russian money laundering following his Atlantic City bankruptcies. When the Russians and the Eastern Europeans took over the street level crime, the Irish and Italians moved on.
But the Irish and Italian mob didn’t go away, they just went “legit” by shifting from things that were overtly illegal and harder to hide, to things that may be questionably legal, but use the guise of business to shade and color their practices, while using the devil-in-the-details style contracts to take advantage of everyone that’s not “made”. The mobsters started, took over, or bought out private equity firms, investment banks, investment funds, and hedge funds using their ill-gotten gains, and shifted their crime from crimes against individual persons – who tended to speak out, or leave an actual physical body behind when murdered – and instead moved their crime to crimes against the imaginary corpus – the legal incorporation. Note that this wasn’t just in the finance industry, the same practices have been used in construction contracting and real estate development since the late 1800s at least. But once Giuliani cracked down on the Italian and Irish mob lineages in New York, these families shifted quite explicitly into the finance industry where they could run the same rackets with more profit and less risk.
Savvy younger mobsters realized that corporations were better sources of cash, had a laundry list of reasons to keep quiet, and didn’t leave a physical body to stink or be buried when they were murdered. The mob shifted their crime to corporate targets via investment fraud and other scams, and made a shit load of money doing it. And that mob money is now the basis of a lot of existing Private Equity firms and other New York, Boston, Chicago, and Kansas City based PE firms, investment funds, brokerages, investment banks, hedge funds, and other financial institutions.
Once younger mobsters in private equity began shifting their targets to startups as easy marks post-GFC, trying to capture some of the wealth and thrill that VC firms kept to themselves (until the greedy VC firms shifted their targets too high up, and began overlapping with typical PE investment targets) the older efforts to rebalance the scales of power between VCs and startups became irrelevant. The PE firms have no relationship to maintain, no expectation of long-term growth to concern themselves with, they only want to make more money, right now, no matter what it takes or who they hurt. This may be true of VCs too, but at least most VCs don’t come from crime families, and try to maintain the guise of founder-friendly, even if that’s not usually true.
This mobster bleed-over into the finance industry, then PE, then PE firms investing in startups, has created a number of inscrutable and irrational practices by “investors” that naïve founders have no experience or basis of understanding to comprehend, but are easy to understand once you realize that the purpose of the activity isn’t to be a good investor who helps a company grow, but to engage in crime that hurts anyone and everyone necessary to ensure a benefit to the mobster-turned-PE-investor.
And at this point, most of these mobsters were never “real” mobsters anyway, but instead the children of mobsters who “went legit” 30 years ago, so lots of them may not even consciously realize that they’re engaging in overt criminal activity in the first place, because in their eyes, that’s “just how the industry works”. They’re not going to break your knees, hell they’re probably afraid of violence in the first place, so they’re just going to use finance scams to ruin your life. No hard feelings, right? “It’s just business.”
But it’s not business – it’s crime. We just don’t like to admit that crime exists in finance, no matter how many times it’s proven to be the case.
One of the most lucrative of these investment scams is called “greenmailing”. It’s like blackmailing, but more sophisticated. With blackmailing, you get some questionable evidence that will embarrass or harm someone, and you use it to squeeze them for cash until they’re dry. Maybe you use it to flip them into the scam and use them to bring in new victims. The same “catch, squeeze, repeat” happens with greenmailing, but instead of pictures of someone fucking someone they shouldn’t or snorting coke, or whatever it may be, greenmailing happens through contract scams that are, on the surface, legitimate. These mobsters pay a lot of money to maintain that pretense with expensive law firms. After all, lawyers never commit crimes, or help criminals commit crimes, right? How could a lawyer be crooked?
The premise is simple: A greenmailer makes a sizeable and superficially attractive investment in a startup or other company, but imposes onerous obligations on the company that are “just for protection” for the investor. Once the startup accepts the money, the greenmailer uses their contract agreement to begin making problems for the company, causing it to waste money, chasing away other investors, intentionally blocking or ruining deals, and basically forcing the company to fruitlessly expend time and effort to meet the investors’ demands without actually improving the startups business.
Eventually, often when the startup realizes that they’re being exploited and abused by the investor, and that the investors actions are actively undermining their business and harming the businesses’ potential and growth, the investor then demands an enormous payoff to go away, and begins overtly attacking both the persons and corporation to compel the company to surrender additional rights, and further increase their obligations, in exchange for more time to try to meet their original, impossible obligations.
This is resolved when either the company manages to raise enough money to pay the bribe to the investor, or the company is exhausted as a going concern, enabling the investor to take what products or IP remain and sell them off while excluding the founders, employees, or other investors from the proceeds of their own efforts.
This malicious intent can be recognized, but is fairly well hidden under seemingly innocuous “protection” terms for the investor, whose inherent intent to malice and violence are only discovered later:
- Side letters granting specific rights and privileges to the investor that other investors don’t receive.
- Board observer rights that permit the board observer to influence, and even control, board outcomes, but without any fiduciary obligations to the startup or other investors.
- Repayment obligations that both the startup and the investor know are unlikely or impossible for the startup to be able to comply with.
- Performance targets that both sides know are unlikely or impossible for the startup to reach.
- Penalties and increasing obligations if the startup fails to meet the impossible targets.
- Short maturity periods (1-3 years) that permit the investor to exercise their rights at-will before a company ever has a reasonable chance to grow sufficiently to have a reasonable expectation that they can meet their obligations to the investor.
- Investor approvals for additional investment or the issuance of debt.
- Personal guarantees from founders.
The mobster-investor will provide assurances to the startup that “it’s just for our protection” and “we never actually exercise those provisions”. Imagine shoving a gun into someone’s ribs and saying “look, this gun is for my protection, I have no reason to use it as long as you do what I say.” That’s not protection, that’s malice.
These dangerous investors lie blatantly about their intentions and expectations, claiming to be interested in the company’s growth and success. They’ll claim to want to help organize new investment, contribute additional financing, finance assets or projects on the startups’ behalf, and demand commitments from the startup in exchange for these promises, but refuse to actually document their own commitments or obligations, claiming they need to see how things develop before they can provide specifics. The startup is made to commit to things immediately to get investment, but the investor doesn’t have to commit to any of their own promises, and can simply wait until later to make a decision.
In short, the “investor” commits fraudulent inducement to trick and beguile the startup into taking their money.
Once the startup has taken the money, the investor immediately begins forcing them to squander it through the exercise of their rights in the side letter and investment documents. These include things like unproductive hiring of both employees and vendors that do not enable a company to develop their products or generate revenue, focusing spending on appearances and pretenses instead of product development or revenue (for example, spending a lot of money on PR, marketing, and websites), attending events like conferences or other high-cost for participation experiences, and many more. Any expense that is not immediately related to getting a product to market, selling that product for revenue, or raising additional capital could be an unproductive expense that, all together with the other demands and obligations, put the startup completely at the mercy of the investor’s whims.
In short, the “investor” performs gross negligence with malice aforethought to continually reduce the startups options until they are completely dependent on the whims of the malicious investor.
If the startup confronts the investor about their obligate expenditures that do not produce useful momentum of the company, the investor then “pulls the ripcord”, exercising their cash-out option, and immediately obligating the company to pay out capital to the investor that the startup doesn’t have, that the investor knows, and knew well the entire time, that the startup doesn’t have, and cannot pay. This forces the startup to acquiesce additional control and influence over the startup to the malicious investor, unless they can immediately close on sufficient capital to pay the extortion so the investor leaves. Which, if the malicious “investor” is doing their job, is either impossible or nearly impossible.
Sometimes these investors will act as if they are the primary shareholder of the company, and immediately set about trying to force the company to sell itself to a competitor or other buyer in a self-serving deal that would profit the investor but screw the founder and their other investors.
The first thing to do for a startup founder to prevent this is to trust your gut. If someone strikes you as untrustworthy, a liar, or a scumbag, their money isn’t worth the particles of dog shit ground into the soles of your shoes. Money is only worth something to a startup if the people providing the money can be trusted. No amount of money, under any terms, is sufficient to pay the price of dealing with an untrustworthy or malicious person.
Trust your gut – your brain has 20 to 50 years of experience to draw from, but your gut has 5,000,000,000 years of experience with risks and dangers. Your ancestors survived a lot, and they passed those lessons down to you, and you feel them in your stomach when someone is dangerous. If someone makes you feel wary, believe that feeling, and walk the fuck away. Do not deal with anyone who gives you reason to pause or makes you suspect their motives. You can’t afford the risk.
Admittedly, that can be easier said than done, especially when a startup badly needs money, or the investor is very good at pretending to be a legitimate, non-malicious person. And these are the exact circumstances that make this behavior so incredibly dangerous. “I can’t believe he was a murderer, he always seemed so nice!” Except for that tent made of human skin he kept in his closet, I guess.
If you fail to heed your gut, and start the diligence process with someone, there’s a lot of signs to watch out for that malicious investors will require but non-malicious investors wouldn’t dream of asking for. Like carrying a knife or a gun, it may be described as “for your own protection”, but someone can’t use a dangerous implement if they don’t have it in the first place. Nobody with good intent pulls a gun on you “for their own protection”, and nobody with good intent as an investor demands things that endanger you. So do not give investors, even “legitimate” ones, these “sophisticated” (exploitative) deal terms, no matter how they sweet-talk you about why they “need” to be able to screw you over at a moment’s notice, just because they feel like doing so.
Before we get in, keep in mind these things will reduce the number of investors that will invest in you. That is specifically and emphatically the point. These things are existentially dangerous, and if refusing them means that malicious people won’t deal with you, you have accomplished your objective.
Let’s take a closer look at some of these dangerous deal terms and structures and discuss alternatives:
- Promissory Notes or Convertible Promissory Notes.
These documents are treated like debt, and generally have an established repayment period and structure, or are at-will. Both approaches are dangerous to a startup that cannot forecast its cashflow or cash on hand into the future with any certainty. If the investor calls the note and the note cannot be repaid, then the investor has the ability to force the company into bankruptcy or impose additional obligations on the company to avoid being forced into bankruptcy.
If the Company is not prepared to immediately issue units (LLC) or shares (C-corp) to the investor, the Company should use a market-standard KISS, SAFE, or SAFER instrument that is specifically and explicitly not a Promissory Note or Convertible Promissory Note, and thus is neither a debt instrument, nor is callable by the investor. The biggest risk of a KISS or SAFE is that you’re forced to issue shares at maturity, whether you want to or not, at a pre-structured valuation. But the biggest risk of a promissory is that… your company no longer exists. Which risk is worth taking, the potential for a bad price, or death?
- Making corporate bankruptcy at the consent or demand of the investor.
If the investor requires consent to go bankrupt, or is able to demand that the company go bankrupt, the investor has the ability to force the company into Chapter 7 liquidation bankruptcy, which would allow the investor to seize control of the company or its property. Since most modern startups only have intellectual property, and maybe some software assets, the investor forcing a Chapter 7 liquidation can effectively take the only thing of value a startup has exclusively to itself, screwing the founders, employees, and other investors.
Contrast this with a company’s voluntary Chapter 11 bankruptcy, where the courts force the company’s creditors to renegotiate liabilities so that the company can survive as a going concern. A Chapter 11 is in the company’s favor, and would potentially wipe out the difficult investor, while a Chapter 7 would wipe out the company and favor the difficult investor. Which is better for the startup? And what non-malicious investor is going to ask you to let them decide if your company will continue to exist or not?
Do not permit the investor to obligate that any bankruptcy action, whether Chapter 7 or Chapter 11, is at the investor’s discretion. Further, do not sign an instrument with the investor that would enable them to even take any action that would force the company into bankruptcy, such as a Promissory Note or Convertible Promissory Note. Use a KISS, SAFE, or SAFER instead, which eliminates these issues.
- Investment documents written by the investors’ attorneys.
Only use deal documents written by your own attorneys, or standard documents that do not require significant attorney costs to use.
Using your own attorneys ensures that all the documents are exactly the same for all of your investors, and enables you to control your legal costs. If an investor says that they need $30k in legal costs for paperwork, ask questions. If they have a track record of investments, why don’t they have paperwork already? (Because billing you legal costs can be part of the scam, and controlling the documents is part of it too.) If your attorneys write the documents, you know that they’re not going to include dangerous provisions, and you can also monitor the actual cost of the legal services.
Standard documents have been developed to reduce or eliminate legal fees for everyone involved. This is a good idea in nearly all cases. The two most common, the KISS and SAFE, were developed by Cooley Law in San Franscisco for 500 Startups and Y-Combinator respectively. These instruments are market standard documents developed by one of the most experienced startup-finance legal firms in the nation. The use of a KISS or SAFE does not need any, or hardly any, modification by the counterparty attorney, and as such using these instruments is essentially free.
Your investors attorneys are not working for you, and do not have your best interests in mind. Under nearly all conditions, there is no benefit, and significant risks, to permitting the investor to author the documents of the investment. Also, consider that if they are experienced investors, you should be asking why they don’t already have standard documents that they use, or have an existing preference for using an existing standard document. That they would roll their own documents raises questions by itself. Even the most “sophisticated” investors’ attorneys are unlikely to be as experienced and comprehensive for startup investment concerns as a firm like Cooley, so permit the prevailing authority in startup investment to act as a prevailing authority, and use known-good, cost-free, safe (no pun intended) investment documents.
There is a newer version, called a SAFER, developed by NextWave Partners and Polsinelli LP, that is intended to go even further in startup-friendly anti-dilution terms, but this document is new as of 2023 and as such not widely used as of yet. However, its benefits are obvious (go read it) and it is likely to become a very well used document in the future.
Some investors reject KISS and SAFE because the investor is old, and is not willing to gain familiarity with a new instrument. These parties will be bad investors even if they are not actively malicious, simply because old people are less likely to understand new things, or the current state of the world. And malicious investors will not use KISS or SAFE instruments because they are not able to engage in their fraudulent behavior under the terms of the KISS or SAFE.
Do not accept documents written by the counterparty, and do not fund counterparty legal expenses, with the exception of a very small ($5k or less) dispensation for the cost of their attorney to review the KISS or SAFE to ensure it has not been modified by your own startup’s legal counsel in ways that would impair its traditional use.
- Callable investment terms
Do not permit the investor to recall their investment at their leisure. This enables malicious behavior by enabling the investor to wait until the startup is in a tight spot, and then demand money the startup doesn’t have. This puts the startup in the position of having to sign new and ever-more onerous agreements with the investor to get them to back off and let the startup have time to return the investment. And when that happens, it gets harder and harder for the startup to raise money as the investor demands increase. The inevitable outcome of a callable investment is that the investor owns the company and all its assets, and the founders and other investors get nothing.
- Callable on demand without negotiation of repayment terms
Everything about this deal term is a disaster waiting to happen for the startup. What if you refuse to take the uninformed, ignorant, or dangerous advice and direction from an investor? They can kill your company just because you upset their ego. What if the investor keeps demanding you to do things you don’t agree with? What if they want you to take money from bad people? There’s nothing good about this provision, it can only hurt you, and never benefit you.
If the investor demands that they be able to call their investment, the startup should walk away. If the startup is not willing or able to walk, it must include two requirements: 1) Call by mutual consent, that is, the investor can only call the investment if the startup agrees to permit it to be called. This enables both parties to walk away amicably if there’s irreconcilable differences. 2) The terms of the repayment must be negotiated in good faith at the time that both parties agree that the investment may be called. This ensures that the startup is able to negotiate terms for repayment that it can live with, and refuse if the terms are intolerable.
- Side letters granting specific rights and privileges to the one investor.
Side letters should be rejected out of hand. No investor should receive preference over other investors for the same class and investment phase. This is why KISS and SAFE instruments have a “most favored nation” clause that says that any new rights granted to one investor are received by all investors – this approach creates a mass of non-malicious investors who have the same rights, and can thus block or override the malicious investors’ intent.