Principle: If your lawyer makes more money off of your investors than he does from you, he’s not really your lawyer.
If someone made you an offer to buy your home, but suggested that you use their real estate agent in the process, you’d hopefully immediately notice a problem with such an arrangement. Most people would. That being said, here’s a very common scenario in the early stages of a startup:
Investor (to Founder): Hey, we’d love to work with you guys on a possible investment, but first you need to get your legal stuff cleaned up.
Founder (eager to get investment): Awesome. But I don’t know any good startup lawyers.
Investor: No problem, I know a great startup lawyer, [X]. We’ve worked with him on several deals. I’ll put you in touch.
Founder ends up hiring lawyer recommended by investor.
Sometimes the investor even sweetens the pot: “If you use X lawyer, we can close in Y weeks.” This is highly unethical.
There are a few reasons why this scenario is so common:
- A lot of founders, for understandable reasons (money), wait to engage a startup lawyer until they are already talking to investors (bad idea);
- A lot of founders are first-time entrepreneurs with no good way to assess the quality of a startup lawyer, so they rely on referrals from people whose judgment they trust (not a bad idea); and
- The Founder-Investor relationship feels a lot less adversarial than a buyer-seller relationship (because at the early stages, it is).
For the above reasons, founders presented with an investment opportunity often take the path of least resistance and hire the lawyer suggested by their lead angel/VC investor. But anyone who (i) has been to more than a few rodeos and (ii) is honest about it, will acknowledge that this can be a terrible idea. Nevertheless, you’d be surprised how many investors keep a well-groomed stable of ever-so friendly lawyers to send their portfolio companies to.
The Honeymoon Period
At the beginning of the founder-investor relationship, everything tends to be beers and high-fives. The Founders are excited about the injection of capital, and the investors are excited about the awesome business they just bought a piece of. Board meetings are upbeat and downright jovial. Tweets are so warm and fuzzy it’s almost cheesy. “Where on earth did the term ‘vulture capitalist’ come from?,” the founder asks. “These guys are my friends.”
This is why founders feel so safe using their lead investor’s lawyer.
And sometimes, for lucky founders, things never stray too far from this investor romance. If they kept expectations reasonable, execute on their plans, and you-know-what never hits the fan, why should they? Unless…
When the romance stops.
That big deal that was coming down the pipeline (or three) ends up falling through. The economy tanks. The CEO thinks the Company needs to take a big bet that breaks from the original business plan. Your VC’s portfolio ends up underperforming and she needs an exit to keep her partners happy, or she thinks someone else should be CEO. Or maybe a competing syndicate puts in a term sheet at better terms than your existing angel lead offers.
You can think of hundreds of scenarios that will cause the adversarial nature of the founder-investor relationship to rear its head; not because investors are bad people, but because their economic interests are just fundamentally different from those of the founders/company. And in those scenarios, this question becomes extremely important: who feeds your startup’s lawyer?
The Hand That Feeds
When the interests and desires of the Company become unaligned from its investors, the impartiality of the Company’s lawyer(s) is immensely important, particularly because of the attorney-client privilege on communications. It’s also essential in those scenarios when you need to play good cop/bad cop.
You interact with your investors on a much more personal, on-going basis than your lawyer does, so sometimes you may want (or need) something to be said, without you necessarily wanting to be the person to say it. Put bluntly, you need your startup’s lawyer to be unafraid to stand up, look someone in the eye, and say (in professional terms): “**** You.” Not that you shouldn’t do everything you can to avoid such a scenario, but the option absolutely needs to be there.
The point I want to drive here should be clear: if your startup’s attorney relies on your lead investor(s) for a significant portion of his/her business via referrals or direct representation on other deals, you better believe that he’s going to be tip-toing and curtsying around them whenever he has to say something they might not like. His relationship with them may actually be more valuable to him than his relationship with you.
I’m sure I ruffled a few feathers by writing the above, but young founders need to be aware of this dynamic. Attorneys who repeatedly play on both sides of the table will surely scoff and underscore their (air quotes) “zealous impartiality” in representing companies, despite relying on those companies’ investors for a lot of their business. Thankfully, this is my blog, and I can say this: they’re either lying to their clients, themselves, or both – and potentially violating rules of legal ethics.
Even people of the best intentions are susceptible to conflicts of interest. A (now) client of ours dropped another attorney (who was very close to that client’s VCs) when he suddenly realized that the VCs were aware of confidential facts that he never disclosed to them. Things just “slip out” after a few beers.
Startup ecosystems are relatively small communities. All experienced Texas startup attorneys have cordial, professional relationships with large investors, simply because it’s impossible to not run into each other on deals and at events. That’s a good thing. Knowing one another creates a level of trust that greases wheels a bit. Also, when a law firm is large and well-known enough, it is virtually impossible to avoid some small amount of representation on both sides of the startup table (investors and companies) at the firm level; there will be someone in the firm who represents investors.
The issue to be concerned about is not that any pre-existing relationship exists between your startup’s attorney(s) and your lead investors; the depth and degree of influence from that relationship is what matters. If the attorney or his/her firm represents your investors only once in a blue moon, or happens to be on a long list of attorneys/firms that the investor recommends to portfolio companies, that’s very different from being one of their “go-to” lawyers. If your lawyers represent 4 out of your lead’s past 5 investments, or if they peculiarly show up at all of his invite-only events, you may have a problem.
Nutshell: At the beginning of your relationship with a lead investor, it’s easy to see their advice as completely impartial and always in your best-interests, but it often won’t be. There will be scenarios in which your interests diverge, sometimes sharply, from theirs, and having an impartial attorney at that point is invaluable. So be careful if your lead investor and the attorney you’re considering seem to be BFFs. People (attorneys included) won’t bite the hand that feeds them: even when their client may need them to.