Post Category → Board of Directors

Replacing the Founder CEO

TL;DR: When an investor pushes to replace a Founder CEO, there are usually one of two motives behind it: performance or power. By keeping the process open and balanced, investors with strong reputations will demonstrate that the former, and not the latter, is at play.

Background Reading:

Here’s a story about two startups, each with struggling founder CEOs in need of a change, but with very different governance approaches, and very different outcomes. I’ve seen both of these fact patterns multiple times among my own client base, and I’ve made sure to strip any details that could be construed as too specific.

Company A:

Company A raises a small Series A round led by a well-known VC. During that round, no discussion ever occurred about what Company A’s management structure might look like in the next 5 or even 10 years. The VC and Founder CEO “hit it off” and closed the round, with the assumption simply being that the founder CEO would stay in charge of management.

Fast forward 18 months, and the Company is struggling. There’s been revenue growth, but not nearly enough to justify a serious uptick in valuation. One day the VC calls a meeting and informs the founder that they are getting a new CEO, and he’s already been identified. It’s a CEO the VC has worked with before, but whom the founder CEO has never met. His compensation package has already been finalized.

There had been no prior discussion of looking for a new CEO. The founders/common directors were never asked for input on who might be a good fit, or to interview candidates to ensure alignment. So naturally, the founder CEO goes into panic mode. He lashes out at his Board, starts reviewing his company contracts and talking to litigators, and some very lawyerly-sounding e-mails start getting fired off.

In the end, the founder CEO digs his heels and asserts at the next Board meeting that the new CEO candidate is not the right person, that as a Board member the fact that he was not consulted on the process was a violation of appropriate corporate governance, and that he will refuse to step aside at this time.

In order to avoid a full-blown dispute, and knowing that the founder’s threats could credibly create damage, the Board decides to slow down. The founder CEO stays in his position, and they work on a performance improvement plan. With trust being burned, they struggle to get aligned on the recruitment of new management. A year later, the company is still struggling.

Company B:

Company B also closes its Series A round led by an institutional VC. During the Series A negotiation process, however, the founder directly asks the VC about their philosophy on founder management, executive succession, and when they would expect professional management may be needed.  A candid discussion ensues in which the VC acknowledges that there will likely be an appropriate time to bring in more seasoned executives, but that such a process would be open, and the common directors/stockholders would be heavily involved in choosing the candidates.

As part of that discussion, the Founder CEO acknowledges that he himself is not interested in being in control forever, but that he does have a specific vision for how the Company might scale, and what its culture might look like through that scale. He also makes it clear that he expects to receive support in the form of a COO or other C-level support to scale his skillset before any definitive conclusions are drawn as to whether he can lead the company.

The VC makes a few comments about his own philosophy on how to approach management changes, but overall they are aligned. The founder CEO quietly verifies the VC’s answers by speaking with other teams who’ve worked with him before, confirming that is in fact how he operates.

The founders and VC also put in place a board structure that ensures the replacement of the CEO would require support not just from investors, but from an independent director, and they agree on what a fair process for recruiting that independent director would look like. With everything in place, they close the round.

Fast forward 2 years, and the Company has achieved some traction, but it’s stalling. After some hard discussions, the Board determines that it’s time to bring in some outside help. All directors, including the common directors and CEO, are invited to suggest candidates, and to be part of the open interview process. In the end, a CEO is chosen with the assistance of a 3rd-party recruiter, with both the support of the VC and the original management team. The founder CEO moves into the Chief Product Officer position, and remains on the Board. The company is doing much better.

As I’ve mentioned before, I’ve seen both of these fact patterns play out within my own client base. What can we learn from them?

Hard, but respectful conversations up front prevent much harder, and potentially more destructive, conversations later.

Lead investors are heavily incentivized to “sweet talk” a founder team, promising the sun, moon, and stars, in order to close the deal. VCs who overplay their “founder friendliness” are setting themselves up for drama in the future when reality pours cold water on everyone.

Smart founders and good VCs are open and honest about the issues that will inevitably come up in the future, and have candid conversations about them before docs get signed. They set realistic expectations, so that when a change is needed, there is much more alignment on how to effect that change.

And just as importantly, once those conversations occur, smart founders verify the answers they’ve gotten by speaking, off the record, to people who’ve worked before with those VCs. It is one thing to tell founders that you’ll be respectful, open and honest. It’s much more significant to have a portfolio full of teams that will confirm, without you looking over their shoulder, that it’s in fact how you work.

Commit to fair processes, but not specific outcomes. 

Good, litigation-preventing corporate governance always boils down to fair processes. No one ever knows at Series A who will be in the CEO seat at Series B, or Series C, but they can commit to what the process will look like for determining the final outcome.

Save for the very very small number of unicorns in which founders can keep strict control (think Facebook), reputable VCs will never tell a founder CEO that she/he will stay CEO as long as they want to. The job of a Board of Directors is to do what’s best for the all of the Company’s stockholders as a whole, even if that means making a founder CEO unhappy.

What really distinguished Company B from Company A wasn’t the outcome, but the process. By agreeing that executive succession would not be a surprise bomb dropped out of the blue, but a transparent process in which new executives are brought in with the honest support and vetting from all constituencies, Company B kept drama to a minimum.

In many situations where I’ve seen drama occur at the Board level, it’s started from one or two directors on the Board forgetting that there are other directors on that same Board – as well as outside stockholders to whom the Board has to answer – and thinking that they will successfully force through whatever they wish without having to answer to others.

It’s possible that in Company B the founder CEO may have not agreed that it was time to step aside. He may have even contemplated getting a little difficult, in the way that Company A’s founder CEO did. But by ensuring (i) open communication, (ii) a balanced recruiting process, and (iii) a voting procedure that included support not just from the investors, but from disinterested parties, the Board ensured that the founder would have had a much harder time creating drama; at least credible drama.

Excellent, thoughtful governance processes ensure that if anyone ever gets angry and wants to rock the boat, all they can really do is pound sand. Bad governance, however, effectively hands someone else a weapon to use against you.

Contracts enforce good process.

As I’ve written before in Don’t Rush a Term Sheet, anyone who doesn’t take the time to really understand what the material terms of their term sheet mean, not just in terms of economics, but in power structure and how hard decisions will be made, is in for an inevitable rude awakening at some point in the future.

If you have the tough conversations up front, and agree on what good, balanced process will look like, put that process on paper.

I’ve seen some investors sing wonderful songs about their principles and openness, but somehow try to insist that they *need* “simpler” decision-making processes on paper. Don’t worry about what the documents say, they’ll tell you. You can trust me. I’ll treat you right.

Cute.

There are two very different potential motives when investors insist that a startup needs to replace its founder CEO. The first is to improve the performance of the company, which benefits all stockholders and is consistent with the fiduciary duties of Board members. The second is to put in place someone that the investors can more easily control/influence, which is really about power and does not benefit all stockholders. By committing, contractually and reputationally, to balanced processes that include all Board members in executive recruitment, VCs can credibly demonstrate that shareholder value, and not power grabbing, are behind their actions. 

Great governance protects shareholder value.

There are plenty of institutional investors who follow solid corporate governance and still achieve fantastic returns. Yes, it takes more diplomacy and negotiation on the part of investors to build alignment and trust with other members of the Board and the cap table; instead of simply ramming through their agenda. But that is the investment culture and mindset that emerges when startup ecosystems mature from being captive to 1 or 2 funds toward more dynamic, competitive capital markets in which investors have to actually care about their reputation. See: Local v. Out-of-State VCs.   True ecosystems filter out bad actors by funneling deal flow toward those with the best reputations. 

For the most high-stakes decisions a company can make – like whom to raise money from, or whom to have in charge – speed should never be the top priority. Good processes and discussions take time up-front, but in the long-run they can prevent the kinds of disputes that destroy shareholder value, and can even destroy entire companies.

Ending note: Ensuring that company counsel is not “captive” to the investors is often important for maintaining balanced corporate governance, and protecting against hostile behavior. See: How to avoid “captive” company counsel.

The Board works for the Common Stock

TL;DR: Under Delaware law, the Board’s primary fiduciary duties are to the common stock; not the preferred. That includes Board members who are themselves investors. Keeping that in mind when interests between investors and common stockholders diverge is important for preventing lawsuits.

Background Reading:

Note: For purpose of this post, we’re going to assume Delaware corporate law, because the vast majority of startups are Delaware corporations. States like California, Texas, Colorado, etc. have different laws, although they are not that far off from Delaware (usually).

There are situations in which the “right” thing to do is a black and white, easy to identify issue. But in many other situations, contextual nuances, ambiguity, and human loyalties/incentives make finding an answer more opaque. In those situations, I’ve found that two questions can help provide clarity:

  • Whom do you work for?
  • (and related) Whom do you not work for?

Corporate governance is the broad term for how corporations should be “governed” in the best interests of their constituents. And under Delaware corporate law, it’s a well-known fact that a Board of Directors, which manages the Company at the highest levels, works for the stockholders. The job of a Board of Directors is to maximize value for the stockholder base. 

But which stockholders? Again, we have some ambiguity. Some of the stockholders are sophisticated, repeat player investors holding preferred stock, and the ability to fund (and negotiate) future financings. Other stockholders are first-time entrepreneurs, or employees, with far more of their net worth already sunk in the specific company, in the form of common stock.

Common v. Preferred

As I wrote in Common Stock v. Preferred Stock, anyone who speaks of Common Stockholders (founders, employees) and Preferred Stockholders (investors) as being fully aligned economically either has no idea what they’re talking about, or is deliberately obfuscating the facts, and the relevant case law on the subject. Investors are typically diversified, experienced, advised independently by personal counsel, and have contractual rights that allow them, in certain exit scenarios, to take 100% of exit proceeds. Common Stockholders are typically significantly less diversified, less experienced, reliant on company counsel for guidance, and lacking in contractual preferences on their equity.

In one sense, Common and Preferred stockholders are aligned in desiring for the Company to get as large of an exit as possible. But after that point is made, it has to be acknowledged that between them (distributionally), they conflict in terms of how much risk they are comfortable taking on to achieve that exit, what percentage of exit they will take, who else might join the cap table to share in that exit, when to go for an exit, and any number of other scenarios.

So again returning back to the point made earlier: a Board of Directors works for the stockholders. But there are conflicts between the stockholders. So whom does the Board work for?

Delaware courts give a clear answer: the Common Stock. For those interested, the most commonly cited case on the issue is called In re Trades Shareholder Litigation, although there’s a huge amount of other material available online on the subject.

Yes, all Board members work for the Common Stock; even the directors who are themselves investors and preferred stockholders. That means that, when deliberating on issues for the Company as Board members, directors are supposed to put aside their personal interests, and all the ways in which they might benefit themselves over other stockholders, and do what’s best for the common stock, as a class. And if they don’t, they are open to being sued by common stockholders.

The Job of Company Counsel

Delaware’s answer to whom the Board works for also illuminates what the job of company counsel is: to help the Board do what’s best for the common stock. That includes paying attention to circumstances in which investor directors may be, shall we say, distracted by personal interests in ways that aren’t beneficial to the overall stockholder base.

The job of independent company counsel is, in part, to help a Board of Directors remain mindful of their fiduciary duties to the company’s stockholders, particularly the common stockholders, and to avoid placing itself in situations where they’re exposed to fiduciary duty violation claims.

Because company counsel plays such a key role in corporate governance and keeping self-dealing in check, very aggressive VCs will maneuver to have the company engage lawyers who are “captive” to the interests of the lead investors. I’ve written about this extensively, including in How to avoid “Captive” Company Counsel. By “owning” the person most capable of noticing and raising a red flag when self-dealing is occurring, investors eliminate the largest check on their power.

If the job of the Board is to do what’s best for the common stock, and to avoid favoring the preferred, then clearly the last thing a well-governed Board would do is force the company to hire lawyers who have long histories working for the Company’s lead preferred holders, or who depend on them for referrals. In 80-90% of Boards I work with, this is seen as an obvious, plain as daylight fact; the Company should hire independent lawyers. Outside of the startup/VC world, it would be seen the same way by 100% of Boards.

But there’s still that 10-20% of funds (bad actors) who use any number of excuses for putting captive lawyers in the counsel seat. And yes, I have seen lawsuits, both against investors and against lawyers, result from parties playing those kinds of games. Piss off the wrong stockholder with sufficient assets to litigate with, and leave enough evidence, and you won’t like the outcome. 

When Boards don’t do their job

It’s one thing to say that the Board’s job is to represent the best interests of the common stockholders, and not take actions to enrich the investor base at their expense, but ensuring that it actually gets done is a whole other issue. Again, there are many funds out there who care deeply about their reputation, and try hard to fulfill their fiduciary duties. But every serious corporate lawyer knows of the tactics that bad actors will use to push through their agendas, often with thinly veiled arguments about why they are best for the company. Some examples:

  1. Telling management that they should not be talking to outside investors (who might offer competing terms, or more competitive valuations), because it is “distracting” and they should “focus on the business.” Or that they simply “aren’t ready” for fundraising yet, despite the fact that the company will run out of cash without getting talks going.
  2. Making up reasons why their preferred lawyers / firm will offer favorable economics (lower cost) to the Company if they are engaged, and using cost savings as a reason why it’s best for the company.
  3. Running executive recruitment processes without the involvement of founders/existing management who are Board members, citing that they prefer not to distract them. The end result being that their loyalists end up getting hired, and not other candidates.
  4. Insisting that their preferred “independent” director choice be elected, despite clear loyalty issues, and holding up other key decisions until they are put in place.
  5. Using made-up data to impose onerous budget constraints on the Company, unless management “gives” on other issues they want.

Unfortunately, once you’ve allowed an asshole onto your Board, it takes constant vigilance and offense/defense to counter the many tactics they might use to push the Company in directions that increase their power and ownership, without actually benefiting the company overall.  Sometimes you have no choice but to go down that path.

But without a doubt, the best thing a team can do to ensure their Board stays aligned with its fiduciary duties is to avoid bad actors altogether, and that takes diligence before any checks are written. All money is green, but some of it is rotten.

As I wrote in Local v. Out of State VCs and Ask the Users, as startup ecosystems become more transparent and open, relying less on one or two dominant funds, the value of diligencing the reputations of investors goes up significantly.  VCs rely heavily on their reputations for deal flow, and there are many good players in startup ecosystems who will use reputational information to either push more deal flow toward VCs who play by the rules, or penalize bad actors. 

I have seen companies go deep into talks with Fund A, and then choose to go with Fund B primarily based on very negative feedback they received, off the record, from entrepreneurs and other market players who know how Fund A worked. Reputation is powerful. Use it.

Key takeaways to wrap this up:

  • The job of a Board of Directors is to do what’s best for the common stockholders of the Company by maximizing shareholder value for the aggregate stockholder base, and not enrich or empower themselves at the common’s expense.
  • Even with that fact, bad actors will use shady tactics and excuses to push companies to do things that favor the VCs over the remainder of the stockholder base.
  • Your best defenses are (i) do diligence to find out who the bad actors are, and avoid their money if you can, and (ii) hire independent advisors who will hold their ground against bad actors during Board meetings.

Negotiation and Inexperience

TL;DR: Having access to trusted advisors, and the time to consult with them, is essential for anyone negotiating terms with which they have very little experience. Don’t accept someone’s argument that you must negotiate important issues live. It’s simply untrue, and a tactic for gaining unfair leverage.

Background Reading:

A recurring theme of SHL posts is that entrepreneurs, particularly first-time entrepreneurs, need to be extremely mindful of the imbalance of experience between themselves and the many sophisticated, repeat players they’re going to be negotiating with as they build their companies. It’s obviously common for entrepreneurial personalities to be more comfortable (than most) with risk, and to go head-first into negotiations and activities without proper backup. But for really big, irreversible decisions, it will backfire, and others will happily use it against you.

One of the most overused phrases for getting naive negotiators to give in on issues they should push back on is “this is standard.” When you have no historical or market perspective – what’s normal, what’s fair, what are the risks, how will this play out in 5 years? – you can be easily manipulated into all kinds of bad outcomes. I’ve been at more than my fair share of board meetings or negotiations where someone at the table makes a completely biased, nonsensical claim that something is “standard,” at which point I’ve had to step in to set things straight, and gladly offer up data or a quick market survey.

There are two main things that I tell all companies to focus on in this regard:

  1. Have a group of experienced, trusted advisors that you can quickly communicate with on serious issues.
  2. Do not let yourself be bullied into a setting where your inexperience puts you at a substantial disadvantage.

Trusted Advisors

When I speak of trusted advisors, I’m not referring necessarily just to your Company’s “advisory board,” which serves a broader purpose of helping you on long-term strategic, business, and technological issues. I’m referring to people you can call or e-mail for specific, tactical guidance on more pressing matters; your “inner circle.” Seasoned entrepreneurs, mentors from accelerators, lawyers (who are independent from your lead VCs), and trustworthy angel investors often make up this group for most CEOs I work with. The most important thing is that they (i) have visibility into the broader market, to help you actually understand what is acceptable, and (ii) will be direct and honest with you when you most need them to.

Imbalanced Negotiation Settings

While it is far less common in the tech world than in other areas, you occasionally still encounter people (particularly VCs) who insist that the only appropriate way to “really” negotiate is live, and in person. And let me tell you: this is bullshit.

Of course, live discussion is important for communication and relationship-building; it has its place. But more often than not, attempts to force entrepreneurs and company executives to negotiate key issues live, or under a very tight deadline, is a tactic to gain unfair leverage from their inexperience. Of course the guy who’s done this type of deal 30 times wants you to agree to terms live, face to face, away from your set of advisors. It has zero to do with business norms. Plenty of high-stakes deals are negotiated asynchronously. 

How you push back and (respectfully) assert yourself in negotiations with other business parties will set the tone for your long-term relationship. If you allow them to force you into circumstances that favor them, they will do it indefinitely. There is nothing wrong with responding, diplomatically, that while you of course would love to grab beers and meet up in person for more casual matters, for real business, you expect time to consult with advisors.

If you’re working with people whom you should want to build long-term relationships with, they will respect your request.  In fact, I’ve known some great VCs and other business people who are very upfront about the experience imbalance with new entrepreneurs, and insist that companies work closely with key advisors.  Those are people playing a long game, and who know that their reputation in the market matters more than short-term opportunism.

If the person you’re negotiating with rejects your request, and dictates to you the medium of negotiation, then at a minimum you’ve gained some key information on what the relationship is going to really look like if you choose to move forward.

Common Stock v. Preferred Stock

TL;DR: Beyond the technical differences between Preferred Stock and Common Stock, there are deeper differences in their composition, incentives, and risk exposure that play out in the course of a company’s history. Understanding the tension between those differences is important.

Very quick vocabulary lesson:

Common Stock is the default equity security of a corporation. It’s what founders, employees, advisors, and other service providers get.

Preferred Stock (Series A, Series B, etc.) is “preferred” because it has extra privileges / rights layered on top of it relative to the Common Stock, including a liquidation preference, rights to block certain things, etc. Preferred Stockholders are almost always investors.

Why don’t investors (usually) buy Common Stock? Short answer: why be common when you can be “preferred”?

Longer answer: they want the downside protection that a liquidation preference provides (they get their money back before anyone else), and they want various contractual privileges that separate them from the “common” holders; like the right to elect certain directors. Also, another argument often made is that by having investors buy Preferred Stock, the “strike price” of options (which buy common stock) used as service compensation can be lower (when a valuation occurs). The logic is that common stock at the time is less valuable due to its lower rights and status on the liquidation waterfall.

So if your investors pay $1 for Preferred Stock with a liquidation preference and other rights, you can still issue your employees options at 20 cents per share (or whatever your valuation reflects) without busting tax/equity compensation rules. The options are for Common Stock, which lacks the bells and whistles of Preferred Stock, and therefore the “fair market value” exercise price is lower. If the investors had paid $1 for Common Stock, your employee options would’ve been much more expensive.

Interesting corporate law factoid: between the Common Stock (founders, employees, etc.) and the Preferred Stock (investors), which group does the Board of Directors owe greater fiduciary duties to in the event of a conflict?

Answer: the Common Stock. And yes, that means even the directors elected by preferred stockholders, even if the director is a VC. Ask your corporate lawyer if you don’t believe me. The Delaware case law is pretty clear.  All the more reason to avoid “captive” company counsel, to help the Board actually do its job.

Kind of ironic. The investors get “Preferred” stock, but the Board is actually legally required to “prefer” (in a way) the Common Stock.

Apart from the technical differences between Common Stock and Preferred Stock, it’s important to keep in mind the different characteristics of the people who make up the two groups.

A. Common Stockholders are much less “diversified” than Preferred Stockholders. This is their “one shot.” 

As I wrote in Not Building a Unicorn, venture capitalists and founders/management often have very different incentives when it comes to setting out a growth and exit strategy for a company; especially when the VCs are the type that look for “unicorns” (larger funds).

Most startup investors (preferred stockholders) have a portfolio of investments. If a few go bust, their hope is to more than make up for it with a grand slam from another. For a less diversified common stockholder, like a first time founder: going bust is really going bust.

Imagine, for simplicity, you have 2 potential growth/exit strategies: Option A and Option B. Option A has a 50% chance of success, and would result in the Company exiting at a $80MM valuation. Option B has a 10% chance of success, but would result in a $1B exit.

Now imagine a portfolio of 10 companies, each with an Option A and an Option B. The Preferred Stock are invested in all 10 of those companies, but the Common Stock are exclusive to each company.

Do you think the Common Stock and Preferred Stock are always going to see eye to eye on which option to take? Hell no. With downside protection (liquidation preference) and diversification, preferred stockholders are far more incentivized to take much bigger risks than common stockholders are.

The Common Stock v. Preferred Stock divide is very real, and that matters from a corporate governance perspective.

B. Common Stockholders are typically less “sophisticated,” and don’t have their own lawyers. 

Part of the idea of fiduciary duties is that someone more sophisticated, informed, or influential is given responsibility to look out for the best interests of someone who is less sophisticated, informed, and influential. That’s why the Board of Directors, which has the most power in the corporation, has fiduciary duties to all the smaller stockholders who can’t see everything that’s going on.

Naturally, because many institutional investors are diversified, they are by definition “repeat players,” which makes them more sophisticated at the complexities of financing, corporate governance, etc. In negotiating transactions with the Company (like financings), they also often have their own lawyers to negotiate directly on their behalf.

Common Stockholders rarely involve their own lawyers when they are getting their equity from the Company. They rely much more on the norms of how the Company treats all of its equity recipients. And, frankly, they just have to trust that they will be treated fairly.

It’s worth noting that, at least in this regard, individual angels are a lot more like common stockholders than institutional venture capitalists. They too often sign standardized docs, with little negotiation or personal lawyer involvement, and they also often don’t have visibility into Board decisions. They are usually more trust driven in their dealings with their investments. This is why founders will often feel more “aligned” with angels than with VCs. That’s because they are usually more aligned.

Even founders, with much bigger stakes than a typical employee, often do not involve personal lawyers in dealings with the Company; not until the later stages when the cap table and board composition are very different. They rely much more on company counsel to advise on what’s best for the Company as a whole, which indirectly means what’s best for the common stock.

In short: Common Stockholders, broadly, (i) are less diversified, and therefore more exposed to risk in this specific company, (ii) have less downside protection, (iii) are less wealthy and sophisticated, and (iv) usually don’t have their own lawyers to review and negotiate things on their behalf. This is, to a large degree, why the case law puts such an emphasis on fiduciary duties to common stockholders.  Because the bigger Preferred Stock players can negotiate contractually for their rights and protections, Corporate Law says officers and directors should focus on what’s best for the Company as a whole, with special care toward the interests of the common stock.

ps: should Company Counsel own equity in the Company? Usually they don’t, but sometimes they do. After reading the above, it should be crystal clear what type of security they should own, and why letting your lawyers buy preferred stock can, in many circumstances, be a very bad idea.

Do my startup’s lawyers need to be local?

TL;DR: No. Most top startup lawyers have clients in many different cities, and lawyers specializing in emerging tech/startup work usually exist only in denser tech ecosystems. Familiarity with your ecosystem, and the expectations of its participants, matters more than being physically local.

Background Reading:

If you live in a small town/city and need specialized (not general practice) medical care, you most likely need to look to a larger city to find that specialist. Any kind of service provider needs some minimal user base to build a viable practice. Larger cities have a higher concentration of patients, and therefore a higher number of patients needing a particular specialty, which is what enables the development of specialist doctors.

This is why cardiologists generally don’t live in farm towns, at least not during their working-week. They live in larger cities. And neonatal cardiologists (even more narrowly specialized) generally only live in the very largest cities.

For localized work, specialization requires density.

It’s also why true startup lawyers – corporate lawyers with a focused practice in emerging tech and venture-backed companies – generally exist only in cities with dense startup ecosystems. Even with modern technology that enables casting a wider net for your market reach, most professionals rely significantly on a local client base. If that local base doesn’t exist, they move to where one does, or they change their practice to mirror the local market. Houston has among the world’s top energy lawyers, but slim pickings for technology/vc lawyers. Boston has among the world’s top healthcare lawyers, but slim pickings for entertainment lawyers (many of which are in Los Angeles). No surprises there.

So to the extent work has a heavily local component (like healthcare, and to a lesser extent law), if you need a particular kind of specialized service, you are smart to look for it in places that have a real density of users for that service. Otherwise you will end up with sub-par local providers, which can be fine if the stakes are low, but disastrous when they aren’t.

Startup Law really isn’t that localized.

It may come as a surprise to people that, for a significant portion of my client base, I have never met the principals in person; and likely never will. Videoconferencing and teleconferencing serve just fine (in addition to other tech tools). That is actually the case for a lot of lawyers with specialized practices. Most serious startup/VC lawyers that I know have clients in multiple cities. In my case, about half of my clients are in Austin (reflecting the need for a dense local base to usually build a specialized practice), and the other half are not (confirming that being local isn’t required at all).

Unlike a cardiologist, I don’t need to physically examine anyone to do my job, which makes geography largely irrelevant. Because most startups generally incorporate in Delaware for reasons discussed throughout the startup blogosphere, local state law only plays a small role in most of the legal issues that startups deal with (usually local employment law); and for those issues, most startup lawyers collaborate with local employment lawyers. The corporate issues generally require very little understanding of local state law. I have quite a few clients with lawyers in half a dozen different cities, none of which are the city where the company is headquartered. And it works just fine.

More important than truly local lawyers is lawyers who are familiar with working in ecosystems that look like your own. The norms of Silicon Valley financing and governance are very different from those of Denver and Atlanta, as an example; both what some would call “2nd tier” ecosystems.  But a Denver lawyer would be quite comfortable with Austin norms, and visa versa.

Local v. foreign specialized lawyers is about tradeoffs.

Silicon valley startups generally use silicon valley startup lawyers. Austin startups generally use Austin startup lawyers. And in both cases, that works very well, because there isn’t a cost to ‘going local.’ Being able to meet up once in a while in person with your service providers is obviously nice from a relationship standpoint. There is some benefit also to your investors being familiar with company counsel, although that issue is usually exaggerated for reasons that I’ll discuss more below.

So if you can get the nice benefits of having someone local, without many costs, going local is usually a good idea as long as you can find someone local who isn’t captive to local investor interests. And sometimes you can’t. See: “How to avoid ‘captive’ company counsel.” There is no set of advisors for whom a founder/management team should care more about their independence than company counsel.

For startups with less dense ecosystems than Silicon Valley or Austin, however, the cost to going local can be much higher. The reason VC or Angel-backed startups in Houston, San Antonio, Dallas, Atlanta, Miami, New Orleans, Phoenix, Salt Lake City, and similar cities often hire startup lawyers who aren’t local is that they (correctly) recognize that their local ecosystems (generally) lack the density to support truly specialized, scalable startup/vc law practices. Each of those cities has fantastic, very smart corporate lawyers who likely have some tech clients, but startup/vc law as a specialization is more difficult to find; although there are exceptions.

My non-Austin clients have concluded that it’s much better, and more efficient, to collaborate with lawyers in another city who’ve seen the exact issues they’re dealing with dozens of times, and have the resources to address them quickly, relative to someone who may be easier to grab beers with, but hasn’t. CEOs need to exercise their own judgment for their own circumstances.

Be careful with localism, and localist incentives.

“Localism” is a term I’ve started using to refer to the underlying, subtle incentives among ecosystem players that push them to promote local people onto a set of founders, sometimes at a very high cost to the company; discussed in the links at the beginning of this post. Ask any experienced founder, and they’ll tell you about so-called “advisors” or “mentors” in their local ecosystem who, while fun to hang around as cheerleaders, unfortunately don’t actually deliver much real advice or mentorship. There are some great advisors/mentors out there, but also a lot of duds.

There are, broadly speaking, 2 ways (not mutually exclusive) in which service providers (venture capitalists, lawyers, accelerators, accountants, advisors, etc.) build their portfolios: (A) being actually good (objectively) at their service, and (B) building relationships and generating referrals from those relationships. Most A-level people rely on both (because the first leads to the second).  But there are a whole lot of people in every business community who are quite mediocre at the actual service they provide, but are exceptional at marketing themselves and building referrals.

If my social capital is the primary way that I get business, then I’m heavily incentivized to refer to people within my personal, local social circle, even if I know that objectively, someone better may be in another city. That “someone better in the other city” has his own social circles she/he belongs to that aren’t as inter-connected (or dependent) on my own. Sending business to them makes it less likely that it’ll come back to me, unless there’s some objective reason for the referral.

I don’t mean to sound cynical about all of this. It is how a lot of good people build their practices and reputations in the business world, and it’s just fine. But it’s important for every team to to be aware of these dynamics in their raw form, and correct for them as needed. And believe me I get the “farmers market” “go local” “support the LOCAL ecosystem” aspects of promoting local people as well, even if I believe the more self-interested dynamics underly a lot of that; at least as it relates to service providers. 

There’s something noble in that, but not when it comes at the expense of founders – who are putting their entire livelihoods on the line – getting shit service. As I’ve written before, nothing builds an ecosystem more than great companies, and great companies aren’t built with mediocre people. 

Watch out for ‘captive’ local counsel.

Circling back quickly to the issue of captive company counsel is a good place to close this out. For many people in startup ecosystems, localism is driven either by self-interested referral circles, or ecosystem cheerleading.  But for the most influential players in a particular ecosystem, it can also be driven by control. Thankfully the transparency of the web is weakening this dynamic, but institutional investors with heavy local influence often like to see local VC lawyers in the company counsel seat because they’ve strategically built leverage over those lawyers by (i) being their clients, and/or (ii) pushing portfolio companies to use them as company counsel. In other words, they’re company counsel, but… not really. 

Obviously you’ll never hear anything like this stated flat out in a board meeting. What you’ll more often hear is discussion about credentials, or familiarity, or experience, etc. etc. “I’m not sure those lawyers have the right experience” or “We’re more comfortable with these guys.” As I’ve written before, sometimes those concerns have merit. Take them seriously, and if you need to upgrade, go through the process yourself to find independent counsel. But also understand how these comments are usually veiled attempts at pushing companies to engage lawyers who are captive to the investors’ interests, and unable to fully represent the company.  If your lead investors seem peculiarly interested in your using a particular set of lawyers, that’s often a good indication of whom you should avoid.

Yes, there’s some reduction of “friction” when company counsel is familiar with the norms/expectations of investors across the table. But its value shouldn’t be overstated. Sometimes what investors call “friction” is just your lawyers doing their damn job. In this regard, we have seen companies from smaller ecosystems choose to engage foreign company counsel not because local VC specialists weren’t available, but because the founder team viewed them all as captive. Sometimes (but not always) they are right. 

There’s no right answer for all companies on this issue. Specialization is important. Local can be helpful at times, but also costly in specific circumstances. But you’ll arrive at a much better decision by weighing all the variables, instead of just assuming that “going local” is a requirement. It most certainly is not.