Contracts v. Might Makes Right

TL;DR: When a first-time entrepreneur is navigating an environment full of entrenched players who all know and depend on each other, the difference between a balanced decision process and a shake down can come down to a contract. Take contracts, and the independence of the lawyers who help negotiate them, seriously.

Background reading:

A background theme of many SHL posts is the following: entrepreneurs enter their startup ecosystems, from the beginning, at a massive structural disadvantage relative to the various market players they are going to be negotiating with. Everyone else knows each other, has worked with each other over the years, and has already made their money. And then you show up.

Now assume that environment as the background, and then imagine you start striking deals with these people: for a financing, a partnership, participation in a program, etc., but assume there are no contracts or lawyers involved. What do you think will eventually happen? Here’s how it will play out: as long as you continue to deliver exactly what everyone wants from you, very little will happen. When everyone’s expectations and preferences are 100% aligned in the short term, the absence of contracts means very little. They’ll “let” you stay in the spot you’re in. 

Until things (inevitably) go sideways. A market shift suddenly means a change in strategy might be necessary, but there’s disagreement on how and when. A quarter comes in under projections, and there’s disagreement as to what that means. A potential outside investor expresses interest in making an investment, and there’s internal disagreement as to whether it should be pursued.

I focus here on the word disagreement, because in many situations on high-level strategic issues, the right answer isn’t always clear cut. The goal (grow the company, improve economics) may be clear, but the right execution strategy is far harder to see.  People will disagree, and where they stand on an issue often rests on where they sit. For example, “portfolio” players (institutional investors) will often be far more comfortable, and even insistent, on taking higher risk (but much higher reward) growth strategies than entrepreneurs and employees, who have only “one shot.”  See Common Stock v. Preferred Stock for a more in-depth discussion on the substantial misalignment between “one shot” players (entrepreneurs, employees), who usually hold common stock, v. portfolio/repeat players (investors), who usually hold preferred stock.

The core point of this post is this: in an environment of substantial disagreement, and where everyone other than the entrepreneur is a repeat player that knows and has economic ties to each other, the first-time entrepreneur (who speaks for the early common stockholders generally) will lose every timeunless contracts in place say otherwise. 

In the absence of laws and contracts, the law of the market is “might makes right,” and established, repeat players have all the might.  

Here is a scenario that I’ve encountered far too often (although increasingly less so as awareness has increased) that is almost comical when viewed objectively:

  • A financing has closed, putting in place a “balanced” Board of 2 VC directors, 2 common directors (one of which is a new CEO, the other a founder), and an “independent” director.
  • In attendance at the meeting are 6 people: the Board and company counsel.
  • The 2 VCs regularly syndicate deals with each other and have known each other for a decade.
  • The new CEO is a well-known professional CEO who has worked in several portfolio co’s of one of the VCs, and was “recommended” by that VC for the position.
  • The “independent” director is an executive well-known in the local market who also has worked with the VCs at the table for over a decade, both of whom recommended her for the position.
  • “Company counsel” represents 6 portfolio companies of the VCs at the table, and has represented them as investor counsel on as many deals, and is actually currently doing so for other deals. In fact, company counsel became company counsel because he came “highly recommended” by the VCs when they were first negotiating the deal with the entrepreneur.

So let’s summarize: there are 6 people at the meeting, and 5 of them have all worked with each other for over a decade, regularly send deals to each other, and in some cases (at least with respect to the lawyer and a VC) are currently working with each other on other deals not related to this company. And then there’s the entrepreneur.

Wow, now there’s one “balanced” Board, don’t you think? I’ve encountered entrepreneurs (whose companies are not clients) in this situation before. I let them know that, whatever they think their position at the company is or will be, they are simply leasing that position until their investors, who hold virtually all the cards and relationships, decide otherwise. It’s possible things turn out fine, as long as all goes as planned. It’s also very possible they won’t. But what’s absolutely clear is who decides, in the end.

Well-drafted contracts are, when negotiated in a transparent manner, a key mechanism for controlling the power of sophisticated repeat players who, absent those contracts, can simply force through whatever they want because of their political / economic leverage. What else might this reality tell us about negotiation dynamics in startup ecosystems?

Rushing through negotiations / contract drafting favors established players.

If the default market position gives power to established players, and contracts are a mechanism for controlling that power, the inevitable result is that those established players (at least the most aggressive ones) will try to get entrepreneurs to rush through contract negotiations.

“Let’s just go with what’s standard.”

“It’s all boilerplate.”

“Let’s save legal fees and put them toward building the business.”

“Time kills deals. Let’s get this closed.”

If someone is telling you that what the documents say doesn’t really matter, or that you should just stick to a template, it’s because, outside of the contract, they’re in control.  That doesn’t mean you should burn endless amounts of time negotiating every point, but take the material provisions seriously.

A market ethos of “relax, we’re all friends here” is designed to favor power players.

Old-school business folks know very well how large amounts of alcohol have often been used to seal business deals. In the startup world, alcohol may still be used, but just as effective is fabricating an environment suggesting to first-time entrepreneurs that everyone is just holding hands and singing kumbaya, and being independently well-advised isn’t necessary.

I’m all for having very friendly relations with your business partners. Life is too short to work with people you don’t get along with well.  But any time someone extends that thinking to the point of telling entrepreneurs that “everyone is aligned” and they should let go of the skepticism to focus on “more important things,” I call bullshit. Alcohol and kool-aid; stay sober in business.

“Billion or bust” growth trajectories mean contracts matter less. Outside of those scenarios, they matter more. 

Among emerging company (startup) lawyers, it’s always been well-known that the Silicon Valley ecosystem as a whole takes standardization, automated templates, and rapid angel/VC closings to an extreme relative to the rest of the country/world. I’ve pondered why that’s the case, and in discussing with various market players, concluded that it has a lot to do with the kinds of companies that Silicon Valley tends to target: billion or bust is a good way to summarize it. I wrote about this in Not Building a Unicorn. 

If the mindset of an ecosystem is significantly “power law” oriented in the sense that “winners” are billion-dollar companies, and everyone else will just crash and burn trying to be one of those billion-dollar companies, I can see why the finer details of deal negotiation may be seen as an afterthought. That environment, which is very unusual when compared to most of the business world, leaves a lot less room for the “middle” scenarios – things aren’t going terribly, and we’re clearly building a solid business. but neither is this a rocket ship, and there are hard questions to be decided – where the deep details of who has what contractual rights really matter.

In a heavily binary “unicorn” world, you’re either knocking it out of the park, in which case no one even reads the contracts and just lets you do your thing, or you’re crashing and burning, in which case the docs are just useless paper. As a law firm headquartered in Austin and structured for non-unicorns, we don’t work in that world, and actually avoid it.

For true “balance,” pay close attention to relationships.

In my opinion and experience, the best outcomes result when the power structure of a company (both contractual and political) doesn’t give any single group on the cap table the ability to force through their preferences, but instead requires some hard conversations and real “across the aisle” coalition building to make a major change.

Balanced boards are, on top of other contractual mechanics, a fantastic way of achieving this, when they are in fact balanced. The above-described scenario where everyone except for the entrepreneur knows and has strong economies ties to each other, including a company counsel “captive” to the VCs, is a joke; and sadly, a joke played on too many startups.

As I wrote in Optionality: Always have a Plan B, build diversity of relationships into your Board and cap table. Feel free to let “the money” recommend people, because their rolodexes are valuable, and are often part of the reason why you’ve engaged with them. But you should be deeply skeptical of any suggestion that the preferred stockholders should, alone, decide who the CEO is, who company counsel is, who the independent director is, etc. etc. Letting them do that certainly may get your deals and decisions closed faster, but unless you are successful in delivering a true rocket ship, you will ultimately regret it.

The common stock, including the founding team and early employees, need a strong voice at the table, especially given the power imbalance with repeat players. Well-negotiated contracts and independent, trustworthy company counsel are the way to ensure they have that voice.

How fake “Startup Lawyers” hurt entrepreneurs

TL;DR: Entrepreneurs need to be aware of the growing trend of lawyers from random backgrounds re-branding themselves as “startup lawyers,” despite having only the thinnest understanding of the subject.

Background reading:

There are two trends worth discussing in this post, both of which I’ve seen seriously hurt entrepreneurs and startups.

Thrown to the juniors.

First, one reason many entrepreneurs are dropping very large law firms for more “right sized” boutiques is that those law firms have become so unaffordable for almost any early-stage company that entrepreneurs end up working almost exclusively with very young, junior lawyers. I touched on this issue briefly in The Problem with Chasing Whales.  One partner in our firm worked on a seed financing in which his BigLaw counterparty literally said on their phone call “I only have 15 minutes to spend on this deal; otherwise I start having to write off time.”

The firm you engage may have a marquee brand, but if to that firm you are small potatoes, you will end up working with that firm’s B or C-team, which will put you much worse off than having hired a set of lawyers that take your company more seriously.

Junior professionals absolutely have a place in law, but that place is not working directly with CEOs on their most strategic decisions, no matter the size of the company. It’s working mostly in the background, with real senior level involvement and oversight. When an entrepreneur is thrown to junior lawyers, it reflects how the firm has prioritized (or not) that work, even if to the entrepreneur the project is extremely important.

Fake “startup lawyers.”

But the title of this post is really about a second, even more troubling, trend. I’ve been seeing an increasing number of litigators, real estate lawyers, patent lawyers, and lawyers with all kinds of backgrounds who have suddenly decided to brand themselves as “startup lawyers.” A little tweak to the website, read a few blog posts, perhaps host a free session at a co-working space or two, and voila, now they’re ready to help entrepreneurs.

Holy crap is this dangerous. Imagine if you were talking to a doctor about a potentially serious heart condition, inquired about their experience, and then got back the following response: “well, I’ve been a dermatologist for the past 5 years, but after reading a few blog posts I decided I’d try my hand at cardiology.” Walk out the door, fast.

In the “thrown to the juniors” case, at least those juniors have some accurate, up-to-date institutional infrastructure (templates, checklists, internal firm training, partner review, etc.) to rely on as they try to help startups. But these random re-branded lawyers are essentially training on early-stage companies, while relying on extremely generalized resources (like this blog) as guidance. We see mistakes everywhere, often because we get hired to clean up the mess.

In every serious law firm with a real reputation for representing emerging companies, lawyers who call themselves “startup lawyers” are corporate/securities specialists with a strong understanding of early-stage financing, tax, commercial, IP, M&A, and labor law as they typically relate to early-stage companies. They have the depth and breadth of expertise to properly serve as an early-stage company’s “outside general counsel,” of sorts, while relying on deeper subject matter specialists when needed. 

But a litigator or patent lawyer who read a few blog posts and stayed at a holiday inn express? Disaster. As I’ve written many times before, “startup law” is largely built on contracts, and the entire point of contracts is that they are permanent unless everyone involved agrees to “fix them.” There’s no “v1.1” update to fix bugs. That means the iterative, “move fast and break things” “we can fix it later” culture of software development is the last approach anyone in their right mind will apply to legal issues.

Stop treating entrepreneurs like suckers.

Ultimately, what these developments reflect is an underlying mindset among lawyers (and other market players) that “startup” is synonymous with “little shit companies.” First-time entrepreneurs may be very smart, but they don’t know what they don’t know, and they rely on their ecosystems and advisors for guidance in almost every area. It’s the same problem that leads them to get pushed to hire captive lawyers who really work for their investors, instead of hiring independent counsel that will actually do its job. 

Just throw a junior, or a random lawyer who managed to maneuver into a few referrals, to them; they’ll figure it out. They’re just a tiny company anyway. Whatever.

So my request to the broader ecosystem is: please, stop referring entrepreneurs to your random, local lawyer friend who decided to take a stab at this “startup law” thing. That’s not how this works, and you are hurting real people, building real companies with long futures built on the foundations put in place by these fake advisors.

And to entrepreneurs: be careful out there, and do your diligence. Many of us know that you wouldn’t quit your job for, or pour your life savings into, a “little shit company,” so align yourself with an inner circle of people who think accordingly.

Flexibility in Choice of Counsel

TL;DR: A flaw in the “one firm for everything” law firm model is that companies are often pushed to specialist lawyers that they aren’t a good fit for, or simply don’t like. The boutique law firm ecosystem delivers far more flexibility for startups to work with specialist lawyers better suited for their specific cultures and needs.

Background Reading:

The core value proposition behind what we’ve been building at E/N over the past several years is this: new legal technology has removed the hegemony once held by large, all-purpose law firms over the high-end of the legal market; enabling an ecosystem of specialized boutiques to replicate the kind of full service that 500-1,000 lawyer firms provide, yet far more flexibly and efficiently.

Parsing that out requires a bit of backstory:

Scaling technology companies have always needed many different kinds of lawyers: corporate, commercial, tax, employment, litigation, patent, data privacy, etc. Historically, getting all of those lawyers to effectively share information and collaborate was virtually impossible without having all of them under the same firm. The cost of building and running a law firm was simply too high in terms of infrastructure, and cross-firm collaboration carried a lot of friction.

Unneeded Infrastructure

So in that old world, if you were building any kind of serious tech company, you effectively had to go to BigLaw. Running a BigLaw firm is extremely expensive: high-end real estate with top shelf furnishings, file rooms, libraries, in-house IT, lavish summer intern programs, layers of administrative staff, etc. When you have a BigLaw attorney $750+/hr, maybe 20-25% of that is paying for the attorney. The rest is funding all the infrastructure of the firm.

E/N’s position is that a very large portion of the tech ecosystem does not, and very likely never will, need that “infrastructure,” and therefore should not be paying for it. So we take the partners and other attorneys from those firms, cut their rates by hundreds of dollars an hour, and put them on a significantly leaner platform. The end-result is that, on average, early-stage/middle-market companies get better lawyers, at lower rates, and with much better responsiveness.

Flexibility in Specialist Selection

But while efficiency and responsiveness are a big part of E/N’s value prop, flexibility is another that is worth emphasizing, because it touches on a problem that companies often run into when choosing to work with a very large firm.

If you hire a “startup lawyer” (corporate) at a large firm, that firm’s business model is premised on cross-selling all of its specialties. So if while working with your corporate lawyer, a labor law issue, or a patent law issue, comes up, he/she is almost certainly going to refer it internally within the same firm. We’ve seen time and time again that this dynamic causes major headaches for many entrepreneurs.

Why? Because lawyers are people (not software), and law firms are service businesses (not product companies). Once you move past the template-ized aspects of very early-stage legal, the individual personalities, culture, and processes of the lawyers you work with have a very large impact on the end-product you get. You can have half a dozen patent lawyers, all with impeccable credentials and similar academic backgrounds, and yet the way that they each work and interact with clients is fundamentally different. And because lawyers are so different, there is every reason to expect that your particular company may simply “fit” better with one, and not “fit” at all with another.

So a fundamental flaw with the “one firm for everything” law firm model is that it very often pushes startups to work with lawyers that they simply don’t like, or aren’t a good fit for. Not only do entrepreneurs often hate this approach, but many startup lawyers hate it too, because they themselves would prefer their clients find appropriate specialists. When I was in BigLaw, I saw first-hand how startups often got pushed to patent lawyers (just as an example) who made absolutely no sense – from a pricing and technical background standpoint – for a particular company, but the startups nevertheless felt stuck with the lawyers they were sent to.

At E/N, we get exactly zero kick-backs / referrals fees when we connect one of our clients to an outside lawyer via our heavily curated specialist network. Sticking to the patent lawyer example, when a client needs patent assistance, we (i) first emphasize that we don’t do patents and don’t want to (we’re focused), and (ii) provide a list of options that, based on the company’s stage, culture, and type of technology, would be a good fit for them, and then we either make a referral or let the company conduct their own diligence, if they want to. 

Flexibility + Focus maximizes quality and “fit”

Many specialist lawyers (including in BigLaw) can be quite entrepreneurial, but by being part of firms that service 25+ different practice areas, they are institutionally constrained to a minimal level of focused optimization; in the exact same way that large conglomerate companies end up being mediocre at a lot, and excellent at very little.

How do startups take on companies 100x their size? By picking a specific segment / product offering and owning it.  That’s precisely what the boutique law firms in E/N’s specialist ecosystem are doing. By narrowing their focus, building targeted infrastructure and cutting out the irrelevant, they’re able to optimize for companies that need exactly what they deliver, and ignore everyone else. And by connecting with lawyers like those at E/N, they get merit-based referrals to ensure the companies they work with are a good “fit” for them.

I’m not bearish on BigLaw at all; at least not the truly high end portion of it. Billion-dollar companies doing complex cross-border deals needing 10 different kinds of lawyers to collaborate on a single project very quickly are almost certainly in BigLaw’s sweet spot, and that’s not going to change any time soon. At the same time, we’re seeing a growing exodus of non-unicorns toward the more flexible, efficient, and focused boutique ecosystem that is better designed for their needs. We’re enjoying being near the center of it. 

Announcing E/N Alpha

I’m very excited to announce the launch of E/N Alpha, a flat-fee subscription program ($500/mo) that our firm has launched for high-potential very early-stage startups.

The details are available on the linked page, and should be fairly straightforward. In particular, I think it’s important to read the section describing what it’s not, because it reflects our firm’s thought-out response to what we see as a lot of failures / nonsense in the legal market where firms, for marketing purposes, pretend to deliver efficiency, when what they’ve really done is watered down their service so much to the point of no longer being useful.

Not software – Readers of SHL and E/N clients know I love legal tech and that we’re always integrating new tools into our practice, but as I wrote in Lies About Startup Legal Fees, there is simply too much BS floating around startup ecosystems that some magical automation tool or piece of AI will dramatically cut legal spend long-term for startups. Significant automation requires significant standardization and inflexibility, which in the world of high-stakes legal work for scaling tech companies negotiating with sophisticated parties, most smart Founders and executive teams are not willing to accept.

Yes, you can automate formations and a few very early things, but complexity increases exponentially beyond that (like a code base), and the value of software automation tapers off fast.

Not paralegals and junior attorneys – I have lost count of how many startups have switched to us from firms that talked a good efficiency game, when their main tactic was to force CEOs to get on the phone with paralegals and junior attorneys whose expertise ends the moment you go off script or deviate from a checklist. I love paralegals and juniors, and we have and train them. But if you think a founder wants to talk to your paralegal about structuring their seed financing, or making that key first or second hire, you don’t understand founders; at least not the smart ones.  See: The problem with chasing whales for what happens when founders end up having to deal with a firm’s B or C team.

Not “everything legal for one price” – Oh man, I came across a firm promising this the other day. “We’ll do everything legal you need for one flat monthly price.” Right. See: Standardization v. Flexibility in Startup Law, for an explanation of what really happens when a firm is forced to work under a ridiculous fixed fee. Fixed fees are great for low-stakes, routine work with a well-defined scope, or for high-volume projects that (again) are well-defined in scope, but the idea that you can map all of the legal needs of scaling emerging tech companies onto some bell curve and peg a number, like an insurance company, without dramatically impacting quality or flexibility, is some straight-up ghostbusters nonsense.

The only possible way it works is if you limit your client base to companies that basically all look and act the same, and have virtually all the same expectations and needs within a narrow range. That’s not how we work, nor how any serious law firm I know works. Analogies to healthcare’s move into fixed-fee pricing don’t hold water without accepting the “narrowly tailored client profile” point, because human biology is 1000x more “standardized” (bell curves) than the corporate structures, investor expectations, growth trajectories, legal obligations, and company values of tech companies.

Not the only way to work with us – This is simple. E/N Alpha is an option for startups looking to lock-in price certainty on a specific scope of work they are sure to need within their early years. But it is not the only way to work with us.

Fundamentally, what we want E/N Alpha to reflect is that E/N is a lean, flexible, high-end boutique law firm built from the ground up to address the many dysfunctions we’ve seen in the emerging tech / startup legal market. Entrepreneurs hire us because they know they need serious, specialized, trustworthy lawyers to address complex, high-stakes issues, and they need some way of affording that; particularly in the early days.

Everything else: tools, low-level professionals, and all the other ways a law firm can optimize itself should stay in the background. They aren’t, and shouldn’t be, the end-product.

 

Checklist for choosing a Startup Lawyer

A friend mentioned to me the other day that, as much great content as there is on Startup Law, there isn’t a simple list of things a founder team should assess in choosing their own company counsel. So here it is, leveraging past SHL posts in a distilled form.

Background Reading: Startup Lawyers – Explained.

Are they actually a “startup lawyer”?

The number of lawyers over the years who have attempted to re-brand themselves as startup lawyers – meaning corporate lawyers with a heavy specialization in early-stage technology and venture capital – has gone up significantly. Law has numerous specialties and subspecialties, much like healthcare, and you want to ensure that, if you’re building an early-stage technology company looking to raise outside capital, your main lawyer(s) has deep experience in exactly that.

See: Startups Need Specialist Lawyers. The last thing you want to end up with is a litigator, patent lawyer, or small business lawyer who thinks that, because he stayed at a Holiday Inn Express, he suddenly knows startup law.

Ask for their AngelList profile, or a list of deals they’ve closed in the last 6 months.

Do they have access to other specialist lawyers that you’ll need?

In line with the above, the first lawyer you’ll need is a startup lawyer, but once the business gets going, you’ll quickly need others, including commercial/tech transactions lawyers, tax lawyers, data/privacy lawyers, patent lawyers, trademarks, litigation, etc. They do not need to be under the same firm (and you often benefit if they aren’t), but a serious startup lawyer who represents scaled companies must have direct access to these kinds of specialists to provide responsive counsel to their clients.

A simple “yes, we have access” is not enough. Ask for names, info on how they normally engage, and do your diligence.

Is their infrastructure / cost structure right-sized for what you’re building?

Be realistic about what your company will look like over the next 5 years if things go as planned, and hire a lawyer/firm that can serve that company, without scalability problems. Are you building a narrow app for which a successful exit would be a few million dollars? A solo lawyer would probably be a good fit for you.

Do you legitimately see yourself as on a potential IPO or >$500MM exit track, and targeting a $10-20+MM Series A in a year or two? Law firms that represent “unicorns” may be a good fit for you, even if they’re much more expensive.

Are you realistically on more of a $3-10MM Series A, and $50-300MM exit path; or maybe you’re more interested in scaling on revenue alone? You’re going to get too big for a solo, fast, but “unicorn” firms are probably overkill for you. Try a boutique law firm.

See: When a Startup Lawyer can’t scale and Lies about startup legal fees.

Are they familiar and aligned with the norms / expectations of your likely investors?

In line with the idea of hiring a right-sized law firm, if you’re not on the unicorn track, you will run into problems if you hire lawyers who generally represent (and target) companies who are.

We see this often when, for example, law firms from Silicon Valley represent a tech startup raising local money in, say, Texas or Colorado. Ecosystems of different sizes often have very different norms and expectations, and you can run into cultural or even process conflicts when your lawyers simply don’t speak the same language as your investors, or other stakeholders. The largest deals in the largest tech ecosystems – SV and NYC – have much closer market norms, and smaller/mid-size deals in smaller ecosystems like Austin, Boulder, Seattle, etc. often behave similarly among themselves.

See: The problem with chasing whales.

Are they not conflicted with investors you’re likely to raise money from?

Entrepreneurs, and especially first-time entrepreneurs, lean heavily on their startup lawyer(s) for core strategic guidance in navigating negotiations / issues with their main investors. Ensure that the lawyers you hire do not have deep ties to, or dependencies on, the people who are likely to write you checks, or the lack of true independence of the advice you get can burn you in the end.

See: How to avoid “captive” company counsel. 

Finally, do they “not suck”?

After all of the above, do these folks actually answer their damn e-mails quickly enough? Do they have good technology / processes in place to make your life easier and work efficiently? Do they give real strategic advice, and not make tons of costly mistakes that you end up having to pay for in the long run?

See: Lawyers and NPS.

There are lawyers who will check all of the above boxes, and yet after you talk to their clients, you’ll find that they just suck to work with. Do your homework / research on the more objective checklist items, but in the end never forget to choose lawyers who actually care about doing all the subtle human-oriented things that result in good service.

post-script: A few questions that don’t belong on the checklist:

  • Is the lawyer in my city? – Nothing about local city law applies to startup lawyering. Think regionally, or focus on their client base resembling what you’re building.
  • Can they introduce me to investors? – See: Why I (still) don’t make investor intros.  There are far more effective ways to get connected to investors than through intros from a law firm.