Chris Dixon

TechCrunch has a post today about TheFunded’s ideal first round term sheet.   I think what Adeo Ressi is trying to do with TheFunded is great, and he has clearly been a leader in exposing VC shenanigans and simplifying term sheets.

I looked through his ideal term sheet and from my summary reading the only thing I disagree with is full acceleration on single trigger (company is acquired).  The term I favor regarding single trigger is to have acceleration such that the founders only have a maximum N (say 12) months remaining. This seems to me a reasonable compromise so that 1) the founders only have to stick around at the acquirer for a maximum of N months (since they will probably be miserable at BigCo if they have to stay longer) 2) the acquiror gets some comfort that the founder will stick around long enough to integrate the startup into BigCo, thus getting the full value out of the acquisition.

I know some lawyers are telling entrepreneurs they shouldn’t have any acceleration on single trigger because it will make the company less attractive to acquirers.  Having been through a couple of acquisition negotiations on the business side (I know many lawyers will say they’ve been through many acquisitions but lawyers only see 10% of what really goes on in the process), what I learned is that acceleration on single trigger doesn’t hurt you from an acquirer’s perspective as long as founders are incented to stick around for some reasonable period of time (approximately 1 year, not 2-4 years).

Actually, the negotiation over acceleration on acquisition ends up pitting the founders against the investors, not the acquirer.  The way the (rational) acquirer figures it, they are going to agree to pay, say, $100M for a company with founders who have built incentives to stick around (some vesting left).  If the founders get full acceleration, then the acquirer figures they are going to have to set aside, say, $10M for future incentives, so will only pay $90M to buy the company, thereby leaving less for the investors. I didn’t understand this dynamic until I went through the process myself.

Of course a lot of this depends on the type of acquisition.  If it is a small trade sale the acquirer will probably want the founding tech team to stick around for as long as possible.  If it’s a profitable business then BigCo will probably want to put their own managers in charge and only need founders to stick around for 6-12 months.

I definitely support TheFunded’s full acceleration on double trigger (company acquired and founder is fired).  In fact – I think I might be alone on this one – I support double trigger for all employees.  I don’t see why only founders should have this basic protection.

I didn’t see any mention in the term sheet of initial vesting of existing founder shares (maybe I overlooked it…?).  I think that this is a very important term and that founders should vest over 4 years from seed funding or perhaps starting a few months before (for “time served” as they say).  In my experience, entrepreneurs way overestimate the odds that greater initial vesting will protect them from the VCs, and way underestimate the odds that less initial vesting will protect them from their co-founders.   I don’t care if your co-founder is the greatest person in the world, things happen in people’s lives, moods change, relationships get complex, etc. and founders leave startups.  Pretty often.  A better way to protect yourself from VCs is to only do deals with high integrity ones.

A friend asked me recently if I knew of any good guidelines for dividing up equity between founders, and specifically what to do in the case when a co-founder provides seed capital.

The truth is I don’t know of any great guidelines – this is seems to me a very case-by-case decison.

Obviously the main consideration should be the relative importance of each founder to the future prospects of the venture.  And, as in any negotiation, the alternatives each person has will also factor in.

Probably way too many founders divide things evenly just to avoid a difficult conversation.  Most likely, this will lead to a difficult conversation down the road (or worse).

(As an aside – you should also figure out titles early on.  When founders say “we are co-CEOs” or “we don’t have titles” that more often than not means there is a big fight looming.  Startups are little dictatorships for good reason.)

One thing I’ve also noticed is people tend to overvalue past contributions (coming up with the idea, spending time developing it, building a prototype, etc) and undervalue future contributions.  Remember that an equity grant is typically for the next 4 years of work (hence 4 years of vesting).  Imagine yourself 2 years from now after working day and night, and ask yourself in that situation if the split still seems fair.

Another consideration is if one founder has had greater career success and will therefore significantly improve the odds of getting financed at an attractive valuation.  One way to figure out how much this is worth is to estimate how much having that founder increases your valuation at the next financing and then, say, split the difference.  So if having her means you can raise $2M by giving away 30% of your company instead of 40% of your company, let that founder have an extra 5%.

If one founder had the idea for the company, it is sometimes reasonable to give that person additional equity.  If that idea involves a bona fide technology breakthrough, they could be entitled to considerably more equity, say 10-20% (or you may have to give some of that to a university or other IP owner). But if the idea is more abstract and doesn’t have real IP behind it (“User generated X” “A marketplace for Y”) that should only earn a few extra points of equity, if any.

If one founder is providing seed capital, assuming there are no other investors involved, the best way to do this is a simple interest bearing (say 5% annual rate), non-convertible loan to the company. I did this once and just had my partner write an IOU on a single sheet of paper, without using lawyers.  When you raise further money the best thing is to have that loan convert into equity at the same terms as the rest of the investors (it looks a somewhat bad to investors to take their fresh capital and pay it right out to a founder – unless the founder is in dire financial straights).

The reason you want to avoid granting equity for a founder’s seed capital is 1) it would cost a lot more in legal fees and 2) you would have to come up with a valuation without a 3rd party, arms length offer.

If there are multiple seed investors, including non-founders, things get more complicated and you might have to resort to a convertible note or full blown equity round.

A frequent question entrepreneurs have when they are just starting their company is:  how secretive should I be about my idea?  My answer:  you should talk about it to almost anyone who will listen.  This includes investors, entrepreneurs, people who work in similar areas, friends, people on the street, the bartender, etc.

There are lots of benefits to talking to people.  You’ll get suggestions for improvements.  You’ll discover flaws and hopefully correct them.   You’ll learn a lot more about the sector/industry.  You’ll learn about competitive products that exist or are being built.  You’ll gauge people’s excitement level for the product and for various features.  You’ll refine your sales and investor pitch.  You might even discover your idea is a bad idea and save yourself years of hitting your head against the wall.

In terms of the risk of someone stealing your idea, there are at best a handful of people in the world who might actually drop everything and copy your idea.

First of all, most people will probably think your idea is stupid.  This does not mean your idea is stupid.  In fact, if everyone loves your idea, I might be worried that it’s not forward thinking enough.

People at large related companies almost always think they have already built or are in the process of building all the good ideas – so your idea is either something they are already building (which is a good thing to discover early) or else they will dismiss it as a bad idea.  (I have a personal diligence rule that when speaking to people at large companies, the facts that they tell you are very useful but their opinions about startup ideas no more valuable than any other smart person’s opinions).

In terms of speaking to other entrepreneurs, the vast majority are already working on something and are highly unlikely to drop everything and copy you.  Even if they are in the idea generation phase, high integrity entrepreneurs wouldn’t copy your idea anyways.

VC’s will either not like your idea, or else like it and possibly want to fund you.  They vastly prefer funding an existing team than taking an idea and building a team.  The one risk is if they have entrepreneurs they are working with in a similar area (see next paragraph).  Most VCs have enough integrity to disclose this and let you decide how much detail to go into.

The handful of people in the world who might copy your idea are entrepreneurs just starting up with a very similar idea.  You can probably just explicitly avoid these people, although by talking to lots of people your ideas will likely seep through to them.

Even if your idea gets in the wrong hands, they will probably just get the high level “elevator pitch” which isn’t worth much anyways. Hopefully by that time you’ve developed the idea much further and in much greater detail – by talking to as many people as possible.

A note about NDAs:  1) almost no experienced entrepreneurs/VCs will sign them (in fact, you asking them too is widely considered a sign of inexperience), 2) It’s not clear they have any real value – are you really going to spend years suing someone who signed an NDA?  I’ve personally never heard of it happening.

There’s a saying in artificial intelligence circles that techniques like machine learning (and NLP) can very quickly get you, say, 80% of the way to solving just about any (real world) problem, but going beyond 80% is extremely hard, maybe even impossible.  The Netflix Challenge is a case in point: hundreds of the best researchers in the world worked on the problem for 2 years and the (apparent) winning team got a 10% improvement over Netflix’s in-house algorithm.  This is consistent with my own experience, having spent many years and dollars on machine learning projects.

This doesn’t mean machine learning isn’t useful – it just means you need to apply it to contexts that are fault tolerant:  for example, online ad targeting, ranking search results, recommendations, and spam filtering.  Areas where people aren’t so fault tolerant and machine learning usually disappoints include machine translation, speech recognition, and image recognition.

That’s not to say you can’t use machine learning to attack these non-fault tolorant problems, but just that you need to realize the limits of automation and build mechanisms to compensate for those limits.  One great thing about most machine learning algorithms is you can infer confidence levels and then, say, ship low confidence results to a manual process.

A corollary of all of the above is that it is very rare for startup companies to ever have a competitive advantage because of their machine learning algorithms.  If a worldwide concerted effort can only improve Netflix’s algorithm by 10%, how likely are 4 people in an R+D department in a startup going to have a significant breakthrough.  Modern ML algorithms are the product of thousands of academics and billions of dollars of R+D and are generally only improved upon at the margins by individual companies.

A large financial institution with access to virtually all venture capital returns data once did a study that determined that the vast majority of profits at each firm are generated by 1 or 2 partners.  In some cases it’s pretty obvious who these stars are- Mike Moritz at Sequoia, John Doerr at Kleiner, etc.  In many other cases it isn’t unless you are an industry “insider.”  So when someone tells you they just raised money from a top tier firm, a good follow up quesiton is “which partner?” since the non-star partners are probably as good at picking companies as a a tier B firm.

There is a big difference, of course, between being a VC who generates profits and being a VC that an entrepreneur should want to work with.  A star VC might be good at picking companies and winning deals, yet actually be a real jerk who doesn’t help the company at all.  But often star VCs do have better rolodexes, can be greater help raising follow on money, and are more influential within the firm if you need to do a “difficult financing.”

Another thing to understand is that who you are first introduced to within the firm is very important.  Why?   1) if you are intro’d to the wrong guy (and in VC unfortunately it is almost always men), that guy might reject you right away whereas another partner might have found your company interesting.  Once one guy dings you the other partners won’t give you a fair hearing for fear of offending the guy who dinged you.  2) VCs can be internally territorial, so if you are intro’d to one guy and he likes it, he might feel like it’s “his deal” when in fact you’d be better off with another partner (then you are stuck with the “roommate switch” problem if you recall that Seinfeld episode).

From my experience, picking the right partner is very important.  For example, in two companies I seeded, the same top tier VC firm invested in later rounds.  In one case the partner has been super helpful, and in the other case pretty much absent.  As I mentioned above, the partner’s influence within the firm also matters.  A influential partner can, for example, “pound the table” to do a follow on financing when you need it.  What stage the partner is in his career also matters.  Junior partners will typically work harder, but might also have “sharper elbows” when, for example, you are selling the company since he needs to prove himself by making the firm money.

So how do you pick the right partner?  Looking at their portfolio can help, but really this is where you need experienced advisors/seed investors who know all the people involved, their reputations etc and can make warm intros.

I believe that what I’m about to say is accepted by venture capitalists as fact, even trivially obvious fact, yet very few entrepreneurs I meet seem to understand it.

An option on a share of stock of an early stage company is (for all practical purposes) equal in value to a share in that early stage company.  Not less, as most entrepreneurs seem to believe (and god forbid you think “the VCs have the option to put in more money” is economically advantageous to you).

Here’s why.  Black and Scholes (and Merton) won a Nobel prize for inventing the Black-Scholes model, which was the first model that somewhat accurately modeled options pricing.  Using this model, and making a few reasonable assumptions (the option is “near the money,” the maturity is sufficiently far away), the key driver of an option’s value is volatility (in fact, if you listen to option traders talk, they actually talk about prices in “vols”).   In public markets, options are usually priced at some fraction of the share price.  This is because public stocks under normal circumstances have volatilities around, say, 20% (at least they used to 10 years ago when I was programming options pricing algorithms).

The volatility of the value of a seed stage startup is incredibly high.  I don’t know if any data exists for what volatility estimate would be good to use, but for an informal analysis suppose the average volatility of a seed stage startup is 300%.  Then try putting 300% into the volatility field of a Black-Scholes calculator:

So if your share price is $1, an option (European Call is a fancy word for options similar to what are given out in startups) is worth $0.9993 dollars.

This is good news for start up employees, directors, and advisors who are awarded stock options.  Their options are economically as valuable as stock but have better tax treatment.

Here’s the bad news.  At least since I’ve been observing early stage deals (since 2003), so-called financial innovation in venture capital has been all about creating new kinds of options for investors, each one more obfuscatory than the last.

- The first way they create options is by simply doing nothing – telling the entrepreneur “great idea, come back in a few months when you’ve made more progress.”  The logic is: why would you invest now when you could invest in, say, 3 months with more information? (as VCs say, why not “flip another card over”).  This is obviously perfectly within their rights and logical, but ultimately, in my opinion, penny wise and pound foolish.   While the VCs might be successful with this strategy on a specific deal, in the long run they are hurting themselves reputationally and also probably by letting some good deals slip away.

- Next there is tranching – this is pretty literally an option.  Even if the pre-negotiated future valuations are higher, the option has basically the same value as a share at the current price.  Try the Black-Scholes calculator but changing the strike price to 10 (simulating the idea that the seed round is $1M pre and future valuation is $10m pre):

The point is with the super high volatility of startups, you can structure the option in almost any way and it’s still like giving someone shares.  (I discuss the problems with tranching in more detail here.)

- Next there was “warrant coverage.”  This is perfectly legitimate in many cases (e.g. as a “kicker” in a venture debt round, as part of an important strategic partnership), as long as the entrepreneur understands 1 warrant basically equals 1 share.  One mistake entrepreneurs often make is to focus so intently on nominal valuation that they don’t realize their “effective valuation” with warrants is much lower.  For example, if the valuation is $10M pre and you give 100% warrant coverage, the valuation is really $5M pre.

- Over the past few years with big VCs starting “seed programs” we’ve seen the emergence of situations where there is no contractual option but the signaling value of the VC’s potential non-participation gives them option-like value.  I discuss why I dislike these deals here.  (This might be one point on which Fred and I disagree…?).

- Super pro rata rights.  This is a new term that’s popped up lately.  Pro-rata rights are options, but seem like reasonable ones.  If as an investor I bought 5% of your company, pro rata rights give me the right to invest 5% in the next round.  They are arguably a reasonable reward for taking a risk early on.  Super pro rata rights mean if I buy 5% of your company now I have the right to invest, say, 50% of the next round.  This is a really expensive deal for the entrepreneur.  If an investors puts in $250K for 5% of your company now with super pro rata rights on 50% of the next round, I’d just for simplicity assume you sold ~20% (assuming the next round sells 30% and the VC does half of that) of your company for $250K.  (The actual analysis of the value of super rata rights seems tricky – maybe some finance PhD will figure out how to price them at some point).

Good VCs don’t mess around with this stuff.  They realize that real value is created when you invest in great people and innovate around technology, not finance.

My last 2 posts were about things to avoid, so I thought it might be helpful to follow up with something more positive.  Having been part of or observed about 50 early stage deals, I have come to believe there is a clearly dominant set of deal terms.   Here they are:

- Investors get either common stock or 1x non-participating preferred stock.  Anything more than that (participating preferred, multiple liquidation preferences) divide incentives of investors and the entrepreneurs.  Also, this sort of crud tends to get amplified in follow on rounds.

- Pro rata rights for investors.   Not super pro rata rights (explaining why this new trendy term is a bad idea requires a separate blog post).  This means basically that investors have the right to put more money in follow on rounds.  This should include all investors – including small angels when they are investing alongside big VCs.  There are two reasons this term is important 1) it seems fair that investors have the option to reinvest in good companies – they took a risk at the early stage after all 2) in certain situations it lets investors “protect” their investments from possible valuation manipulation (this has never happened to me but more experienced investors tell me horror stories about stuff that went on in the last downturn – 2001-2004).

- Founder vesting w/ acceleration on change of control.  I talk about this in detail here.   If your lawyer tries to talk you out of founder vesting (as some seem to be doing lately), I suggest you get a new lawyer.

- This stuff is all so standard that there is no reason you should pay more than $10K for the financing (including both sides).  I personally use Gunderson and think they are great.   Whoever you choose, I strongly recommend you go with a “standard” startup lawfirm (Gunderson, Wilson Sonsini, Fenwick etc).   I tried going with a non-standard one once and the results were disastrous.  Also, when you go with a standard firm and get their standard docs it can expedite later rounds as VCs are familiar with them.

- A board consisting of 1 investor, 1 management and 1 mutually agreed upon independent director.  (Or 2 VCs, 2 mgmt and 1 indy).  As an entrepreneur, the way I think of this is if both my investors and an independent director who I approved want to fire me, I must be doing a pretty crappy job and deserve it.

- Founder salaries – these should be “subsistence” level and no more.  If the founders are wealthy, the number should be zero.  If they aren’t, it should be whatever lets them not worry about money but not save any.  This is very, very important.  Peter Thiel said it best here.  (I would actually go further and say this should be true of all employees at all non-profitable startups – but that is a longer topic).

- If small angels are investing alongside big VCs, they should get all the same economic rights as the VCs but no control rights.  Economics rights means share price, any warrants if there are any (hopefully there aren’t), and pro-rata rights.  Control rights means things like the right to block later financings, selling the company etc.  I once had to track down a tiny investor in the mountains of Italy to get a signature.  It’s a real pain and unnecessary.

- Option pool – normally 10-20%.  This comes out of the pre-money so founders should be aware that the number is very important in terms of their dilution.  Ideally the % should be based on a hiring plan and not just a deal point.   (Side note to entrepreneurs – whenever you want to debate something with a VC, frame it in operational terms since it’s hard for them to argue with that).

- All the other stuff (registration rights, dividends etc) should be standard NVCA terms.

- Valuation & amount- My preference is to keep all terms as above and only negotiate over 2 things – valuation and amount raised.  The amount raised should be enough to hit whatever milestones you think will get the company further financing, plus some fudge factor of, say, 50% because things always take longer and cost more than you think.  The valuation is obviously a matter of market conditions, how competitive the deal is etc.   One thing I would say is if you expect to raise more money (and you should expect to), make sure your post-money valuation is one that you will be able to “beat” in your next round.  There is nothing more dilutive and morale crushing than a down round.

In venture capital, tranching refers to investments where portions of the money are released over time when certain pre-negotiated milestones are hit.  Usually it will all be part of one Series of investment, so a company might raise, say, $5M in the Series A but actually only receive, say, half up front and half when they’ve hit certain milestones.  Sometimes something similar to tranching is simulated, for example when a VC makes a seed investment and pre-negotiates the Series A valuation, along with milestones necessary to trigger it.

In theory, tranching gives the VC’s a way to mitigate risk and the entrepreneur the comfort of not having to do a roadshow for the next round of financing.  In practice, I’ve found tranching to be a really bad idea.

First of all, the entrepreneur should realize that the milestones written in the document are merely guidelines and ultimately the VC has complete control over whether to fund the follow on tranches.  Imagine a scenario where the entrepreneur hits the milestones but for whatever reason the VC gets cold feet and doesn’t want to fund the follow on tranche.  What is the entrepreneur going to do – sue the VC?  First of all they have vastly deeper pockets than you, so at best you will get tied up in court for a long time while your startup goes down the tubes.  Not to mention that it would effectively blacklist you in the VC community.  So just realize that contracts are the right to sue and nothing more.  The only money you can depend on is the money sitting in your bank account.

Here are some other reasons both entrepreneurs and investors should dislike tranching:

1) Makes hiring more difficult: Hiring is super critical at an early stage.  A very reasonable question prospective employees often (and should) ask  is “How many months of cash do you have in the bank?”  How do you respond if the money is tranched?  In my first startup, our full round gave us 18 months of cash but the first trance only a few months.  Should I have said what I had in the bank- just a few months – and scare the prospective hire?  Or should I have tried to explain “Oh, we have 18 months, but there is this thing called tranching, blah blah blah, and I’m sure the VCs will pony up.”  Not very reassuring either way.

2) Distracts the entrepreneur:  The entrepreneur is forced to spend time making sure she gets the follow-on tranches.  In many cases, she even has to go present to the VC partnership multiple times (each time requiring lots of prep time).  Also, savvy entrepreneurs will prepare multiple options in case the VC decides not to fund, so will spend time talking to other potential investors to keep them warm.  So basically tranching adds 10-20% overhead for the founders that could otherwise be spent on the product, marketing etc.

3) Milestones change anyways:  At the early stage you often realize that what milestones you originally thought were important actually were the wrong milestones.   So you either have to renegotiate the milestones or the entrepreneur ends up targeting the wrong things just to get the money.

4) Hurts VC-entrepreneur relations.  Specifically, it encourages the entrepreneur to “manage” the investors.    One of the great things about properly financed early stage startups is that everyone involved has the same incentives – to help the company succeed.  In good companies, the investors and entrepreneurs really do work as a team and share information completely and honestly.  When the deal is tranched, the entrepreneurs has a strong incentive to control the information that goes to the investors and make things appear rosy.  The VC in turn usually recognizes this and feels manipulated.  I’ve been on both sides of this and have felt its insidious effect.

There are better ways for investors to mitigate risk – e.g. lower the valuation, smaller round size.  But don’t tranche.

I recently met an entrepreneur who was raising money for his startup.  Six months prior, he had raised seed money (<$1M) from one of the increasingly popular seed programs big venture firms are offering (big venture firms = roughly $100M fund and larger).  As a potential investor, the first question I asked him is “is the big venture firm following on?”  The answer was no.  What this means is the entrepreneur is going to have a *really* tough time raising any more money at all, because what all potential investors think is “if this top VC that has hundreds of millions of dollars and knows this company the best doesn’t want to invest, why would I?”   What the entrepreneur didn’t realize is that when you take any money at all from a big VC in a seed round, you are effectively giving them an option on the next round, even though that option isn’t contractual. And, somewhat counterintuitively, the more well respected the VC is, the stronger the negative signal will be when they don’t follow on.

Even in the good scenario when the VC does wants to follow on, you are likely to get a lower valuation than you would have had you taken money from other sources of funding (angels, micro-VCs like Y-combinator).   This isn’t obvious if you haven’t done follow on fundraising before, but I’ve observed it first hand many times.  The reason is you won’t have the freedom to go out and get a true market valuation for your company.  Suppose you have venture firm X as a seed investor and they offer you, say, a $6M pre money valuation for your follow on round (usually called the Series A).  Suppose furthermore that if you were free to get a competitive process going that the “true valuation” for your company would be more like $10M pre.  If you now go to another firm, Y, and pitch them, one of the first questions is going to be “Is X investing?”  You say yes, X has made you an offer.  Now what Y is thinking is either 1) “I should call up X and offer to co-invest at $6 pre,” thereby keeping you at an artificially low valuation, or 2) if that’s not an option (e.g. because you already have 2 VCs in the deal, because X doesn’t think Y is a high quality enough firm to co-invest with, etc) Y is going to hesitate to offer you a term sheet, for fear of being used as a stalking horse.  This is industry lingo for when the entrepreneur uses firm Y to get a higher priced term sheet which X then matches and excludes Y.  VCs really don’t like to be used as stalking horses.  So what having a big VC in as a seed investor does is prevent you from getting a competitive dynamic going that gets you a true market valuation.

Why are big VCs doing this?   If you have a, say, a $200M fund, spending, say, 5% of your fund to get options on 50 companies is a great investment.  You could look at this from an options valuation perspective (seed stage startups have super high volatility – the key driver of options price in the Black-Scholes valuation model).  More simply, just think of it as “lead gen” for venture capitalists.  Basically big VCs are spending 5% of their budget generating captive leads for their real business:  investing $10M into a companies at the post-seed stage.

These seed programs are relatively new so we are only starting to see the wreckage they will eventually cause.  I predict in a few years, after enough entrepreneurs get burned, what I’ve said above will be conventional wisdom.  Unfortunately there are a lot of good companies that will die along the way until that happens.

Disclosure:  I sometimes compete with big VCs for investments, so I am not disinterested here.

A popular option in seed round financing is a convertible note instead of setting a valuation in an equity financing.  A convertible note is basically a loan where the investors convert the debt into equity in the next round of financing at a step up.  A common step up is 20%, which means for every dollar the investors lend, they get $1.20 worth of shares in the subsequent round.

The appeal of convertible notes is 1) it defers the negotiation about valuation to the next round 2) it is often much cheaper in terms of legal fees (~$5k versus $20-40K).

Here’s why a lot of seed investors don’t like convertible notes:

1) Most importantly, they split the entrepreneur’s and investors’ incentives – for the subsequent round, the entrepreneur benefits from a higher valuation, the investor from a low one.   Most investors work hard despite this to help the company, but nevertheless the note creates friction between people who should be working in tandem.

2) On more than a few occasions VCs in subsequent rounds have said “I don’t want to give the seed investors a 20% step up.”  Sure, the step up is in a contract, but the investor in the subsequent round can always make their investment contingent upon modifying that contract.  In the end, it ends up pitting seed investors who wants their step up versus entrepreneur who wants to get the financing done, and the seed investor is forced to choose between getting the step up they deserve and being “the bad guy” who spoils the financing.

One increasingly popular compromise is to do a “convertible with a cap.”  What this mean is that you set a cap of $N million dollars valuation and a step up of M%, and on the subsequent round the seed investor gets the better of the two.  If the cap is low enough, this mostly rectifies #1 above since the investor has the economic incentive to increase the valuation above the cap.  It doesn’t rectify #2, however, but does have the benefit of being significantly cheaper in terms of legal fees than a proper equity financing.   There is nothing worse than spending 5%-10% of your seed round on lawyers.