Startups Scale. Solo Lawyers Don’t.

TL;DR: Freelancer marketplaces push solo lawyers as a way to keep legal costs down for startups.  But what they’re marketing is very different from what they actually deliver. Solo lawyers can’t scale, and lack specialization. For high-growth startups, that is a big problem.

Background Reading:

In the landscape of options for getting legal covered for a tech company, there are generally speaking three types of providers, in order of largest to smallest: (i) BigLaw, (ii) Boutique firms, and (iii) Solo lawyers.  I’ve written quite a bit about the comparison between (i) and (ii), but this post is mostly about (iii).

Overhead

“Overhead” is a term often used to refer to everything that a lawyer’s rate has built into it that doesn’t directly go into compensation. Very large firms (BigLaw) have significant amounts of “overhead”; only about 20-25% of the $575/hr you pay for a top-tier BigLaw senior non-partner actually goes into her pocket.

But it’s far too simplistic to assume that all those resources are simply being burned for no reason. Large, fast-moving, complex transactions require collaboration among lots of different kinds of legal professionals, including different kinds of specialties of lawyers, paralegals, legal assistants, legal technology providers, etc. For the very top end of the market, good arguments can be made that the “overhead” of large, international firms is actually quite necessary. The idea that a bunch of freelancer lawyers/legal professionals could just team up to get a billion-dollar merger done efficiently and on-time is little short of delusional.

Boutique firms are the market’s response, enabled in part by new low-cost technology and infrastructure, to BigLaw’s overhead. Those deal lawyers who don’t cater to, and aren’t pursuing, the Ubers and Facebooks of the world, are acknowledging that while they do need institutional resources (overhead) to create strong teams that can close meaningful deals, those institutional resources don’t need to eat up more than half of revenue; certainly not with today’s technology. A $100MM acquisition, or even in many cases a $10MM financing, is sufficiently complex and fast-moving that, again, you are delusional if you think a bunch of freelancers working independently are going to get it done effectively; but a small integrated team of affiliated lawyers, or even a handful of boutique firms, can easily get it done outside of a 1,000 lawyer firm with offices on multiple continents.

Solo lawyers are on the opposite end of the overhead spectrum. They are the freelancers of the legal world. Their ‘overhead’ amounts to maybe a few SaaS subscriptions and a computer. MEMN’s specialist network, in fact, has a fair amount of solo lawyers in various legal specialties. Their rates are naturally lower than lawyers in large or even small firms, due in part to overhead. You might conclude – and there are definitely solo lawyer marketplaces out there trying to drive this conclusion – that every early-stage startup should obviously be using solo lawyers, because they’re “cheaper.” But this overlooks certain key facts about the nature of startups, and about legal services, that call for a reality check.

Legal bills don’t correlate completely with hourly rates.

It’s not that complicated to understand that a well-structured team of lawyers billing $425/hr can easily produce a lower legal bill than independent solo lawyers billing at $275 if they have the right institutional resources – technology, team, knowledge, process (“overhead”) – in place. They’re also often supported by junior professionals/non-lawyers with dramatically lower rates to cover routine items. At very early stage, a lot of the tasks that startups need actually require very little lawyer involvement at all if the right infrastructure (‘overhead’) is in place. If you assume solo means cheaper, you’re often wrong.

Specialization drives efficiency.

What is a “startup lawyer”? That will take too long to fully explain in this post, but I can tell you what it’s not: a litigator, a small business lawyer, a generalist who dabbles in a little estate planning, real estate, and a few seed financings on the side, or a generalist corporate lawyer. I’ve been shocked by how many of these solo lawyer websites market lawyers as “startup lawyers” when they clearly, from their own bio descriptions, are nothing of the sort. Similar to the first point above, a lawyer at $425/hr who has done a project 50 times will be dramatically more efficient at it than someone at $275 who has done it once.

This is not rocket science. Smart founders know that developers with higher salaries often get far more done than 10 developers at lower salaries. The talent market dynamics of lawyers are not that different from those of developers.

In a talent market, the cheap guy is usually cheap for a reason.

In an industry where results are driven by human, not just institutional, capital, you simply cannot hire whoever walks in the door and train them to produce A-level service; no matter how fantastic your resources are. As elitist as it may sound, most lawyers on the market simply lack the capacity and knowledge to correctly manage and close complex legal work. They may be very well suited for certain areas, but the moment you leave the minors and start playing in the majors, everything goes off the rails.

Serious talent requires serious compensation, which sets a floor on hourly rates; regardless of overhead. If that is too difficult to understand, good luck in business. It can be (and is) simultaneously true that the legal market is flooded with under-employed lawyers willing to discount and jump through hoops for work, and yet great lawyers who can manage and navigate specialized complexity/scale are in very high demand and short supply. 

Fast growth requires scalability. Switching lawyers is costly.

A startup can go from 2 founders needing to just incorporate to needing fast VC, employment law, tax, licensing, etc. support in just 1-2 years; sometimes sooner. You’ve got a VC term sheet on the table, 10 equity grants that need to get done in 2 days, a resolution to the issues with the VP you just fired, and assistance finalizing that LOI with the big customer that will help close your round; and you need all of this done this week. Virtually every single startup that has switched to MEMN from solo lawyers has had the same universal complaint: they are SLOW.

Of course they’re slow. All that (air quotes) “unnecessary overhead” they cut out to get you that awesome hourly rate is precisely what could’ve funded the institutional resources that ensure legal work keeps moving: a well-trained team to collaborate with, technology (and training for technology) that streamlines unnecessary tasks, non-lawyer professionals to knock out checklist items while the lawyers focus on the big stuff. Scaling companies need legal teams, and max out a solo lawyer very quickly.  If a single solo lawyer happens to peculiarly have all the time in the world, please re-read my comments on talent markets.

And if you think it’s smart to go with the solo who is ‘cheaper’ and then switch quickly to a firm: again, a reality check. Switching lawyers/firms is costly. The new lawyers have to familiarize themselves with what the prior guy did, on forms that they (usually) aren’t familiar with. That takes time, and increases the likelihood of errors. Finding a firm that can scale-down for very early-stage, but then scale up when needed, all using its own forms and resources, is far smarter than taking an iterative approach with your legal team.

In short, the changing legal landscape available to tech companies is being driven very much by technology, and it’s been great not just for entrepreneurs, but also for lawyers looking for alternative platforms to work from.  I’m a big fan of how solo lawyer marketplaces are helping connect demand with supply in areas where the ‘overhead’ of firms really is unnecessary.

But be very careful about buying into any marketing suggesting that there’s this untapped market of great solo “startup lawyers” just waiting to fill your startup’s legal needs at unbelievably low rates.  Solo law works great for small businesses, who don’t scale fast;  and also for certain legal specialties where projects are very compartmentalized. But true startup/vc law requires institutional resources and well-trained, well-coordinated teams of lawyers/non-lawyersThe goal of tech startups is to scale quickly.  But solo lawyers can’t scale at all. That means that solo “startup lawyers” are, at best, a bad fit; and at worst, an oxymoron. 

Luddites v. Tech Utopians: 409A and Legal

Background Reading:

TL;DR: Luddites pretend that technology can’t out-do them at anything. Tech utopians pretend tech can do everything. The truth lies in the middle.

In my sphere of the world, I interact with two profiles of people, both of whom I find somewhat obnoxious.

The first are luddites; often lawyers. These people cannot fathom the idea of clients wanting anything less than hand-crafted, white-glove attention to every legal matter. The compromises on quality and customization brought about by software and automation tools are an offense to their professionalism. They’ll walk you through 10 ways in which they can beat a piece of software, completely oblivious to the fact that 99.9% of the market doesn’t give a damn, if the software’s output is good enough.

The second are the opposite of luddites; what I’d call tech utopiansoften young founders or engineers. To these folks, effectively everything legal professionals do is hand-waiving non-sense, charging hundreds of dollars an hour to fill in forms.  Build a simple automation tool, or DIY checklist for them, and their eyes light up; enraptured with how ‘smart’ they are for not ‘wasting’ money on legal services. And I happily admit to a bit of schadenfreude when they end up paying 10x later for cleanup, as part of their education in the value of legal counsel.

Luddites are in self-denial regarding how much of their work can actually be done quite well, and sometimes better, by technology. Tech Utopians are in denial about how much work still requires, and will require for a very very long time, highly-trained, highly-intelligent people who can analyze and deliver things that even the most advanced technology cannot. And yes, those people are way more expensive than software.

The bottom 25% of most professions is probably dead in the water relative to software; think TurboTax and LegalZoom. As AI becomes more sophisticated, that will probably move up to something closer to 50%. This is quite visible in law as lower ranked schools (many of which are a racket) are getting sued by debt-saddled graduates who can’t find jobs, and the credentials of lawyers at well-paying firms edge up each year.  To some extent, it’s never been better to be an elite lawyer. It’s never been worse to be any other kind.

Tech-Enabled Lawyers

The truth about almost every profession, at least when you move beyond the lower rungs, is that technology is a supplement, not a replacement, for people. It’s a tool. And a very powerful one for those who can figure out how to leverage it.

MEMN’s recruiting process is designed to systematically filter out luddites. That’s because, not only do I simply not have the time or desire to waste hours of my life trying to train them, but technology (automation, machine learning, communication tech, project management, etc. etc.) is so deeply integrated into our workflows that to add anyone who doesn’t ‘get it’ into the mix would cause a total breakdown. Before I look at emotional or analytical intelligence, or communication skills (all of which are important), I want to know what kinds of technology this person already uses in her/his life.

When lawyers from other firms ask how they might operate and scale leanly like MEMN, my answer is as swift as it is depressing: “first, you have to fire half of your payroll.” They usually start laughing, until they see the dead serious look on my face. The legal profession is full of luddites, everywhere; even among the younger generation and in firms that service tech clients. And there’s no room for them in tech-enabled law firms. “Get it” or get out.

And yet with all of the technology that we leverage, I tell every single MEMN client that we are not cheap, and never will be. Cheaper than our true competitors, certainly. And dramatically more responsive. But talent costs money.

409A: Trim that fat

When I wrote 409A as a Service: Cash Cows Get Slaughtered a few years ago, highlighting how eShares was using their own technology to trim the fat in an industry that (in my opinion) really was in many cases extorting startups, the response from the luddites was predictable. “Here are 10 reasons why you can’t automate a 409A valuation.”

Over the years, eShares as a platform has grown (as I knew they would), and many of our clients have been thrilled to take advantage of their service. Tech-enabled 409A; not fully automated. They recently published a blog post called The art and science behind an eShares 409A breaking down how automation is used in their reports, and how it’s not.

The future of professional services belongs to people who embrace technology and let it do what it does best, without diminishing the areas where human intelligence and creativity are superior, and will continue to be so for a very long time. Not tech-less. Not tech-only. Tech-enabled. 

How to Avoid “Captive” Company Counsel

Background Reading: Why Founders Don’t Trust Startup Lawyers

This post is going to make some people uncomfortable. People who work with me know that I’m not the type who likes to irritate others just for the fun of it. But I’m always willing to say something that needs to be said, and I’ve always structured my business relationships and life in a way that I’m not prevented from saying it.

“It is difficult to get a man to understand something when his salary depends on his not understanding it.” -Upton Sinclair

Inexperience v. Seasoned Veterans

Founders, particularly inexperienced first-time founders, face enormous uncertainty and opacity as they build their companies. In that environment, they’re tasked with making complex long-term decisions, on behalf of themselves and other stakeholders, with very high-stakes implications; including distributional implications as to who gets what share of the limited pie, and who gets to decide when the pie gets eaten.

More so, as founders raise capital, they engage with highly experienced, sophisticated, repeat player parties who have gone through the same process dozens of times. Those parties (investors) are typically aligned with founders/management in the sense that they want the company to be a success, but there is significant misalignment in the fact that each side wants their share of the pie to be larger than the other, and each side often disagrees on when it’s time to start eating. In the case of institutional investors, they have a legal obligation (to their own investors) to get as high of a return for their investment as possible; in other words, to get as much of the pie for themselves (and as large of a pie) as they can.

Counsel should level the playing field. 

In this environment: inexperienced founders/management working with highly seasoned third-parties with significant misaligned financial motivations, founders/management have to rely on trusted advisors to level the playing field; to ensure that their inexperience is not leveraged unfairly to their detriment. 

Without question, one of, if not “the” core advisor that startups turn to for leveling the playing field in interacting with highly seasoned investors, particularly at early stage, is Company Counsel; the lawyers hired to represent the company. Startup lawyers have a front-row seat to deals/activities in the market that cover a much broader, and larger, area than any particular investor sees, and they leverage that expertise to help startup teams navigate what, to them, is brand new territory.

Company counsel’s job is not to represent the founders personally – see A Startup Lawyer is Not a Founder’s Lawyer – nor the investors, but the entire company, including all of its stockholders as a whole. The best analogue I can think of is a family therapist, who doesn’t represent the parents or the children, but is looking for the well-being of the family unit.  If someone is threatening the well-being of the family (the company), or trying to unfairly dominate it in a counter-productive way, the therapist (company counsel) helps address it. Sidenote: my job really does resemble that of a therapist sometimes.

The best company lawyers combine a “win-win” attitude (grow the pie) with a long-sighted, subtle skepticism over each individual actor’s motivations; monitoring how actions could result in unfairly taking one person’s part of the pie and handing it to someone else.

Many startup lawyers are “captive” to institutional investors. 

So the founders-investor relationship is inherently imbalanced in favor of the seasoned, experienced investors at the table, and company counsel is supposed to play a strong role in correcting the imbalance. Clearly then, any factors that raise doubts as to the independence of company counsel; factors that might make him/her ‘captive’ to the interests of the money at the table, are cause for serious concern.

In “Why Founders Don’t Trust Startup Lawyers” I described how the business development practices of certain startup/vc lawyers give companies every reason to be worried that their company counsel is inherently incapable of providing that ‘balance’ that they are supposed to rely on.  Many lawyers know that if they can win a relationship with a VC fund, that relationship can be worth dozens of deals/clients to them in a manner of just a few years; far far more efficient biz dev than going after companies one by one. So building economic ties with those VCs becomes a major source of business for lawyers, including lawyers who act as company counsel. 

I don’t waste any breathe or time trying to actually convince anyone that this scenario is a serious conflict of interest problem; certainly not lawyers. See the Upton Sinclair quote above.  I simply explain to founders/management in very clear terms how things in fact work, and let smart people arrive at their own conclusions. Sunshine is a great disinfectant.

Chess: Losing the negotiation before it starts. 

In my school days before becoming a lawyer, I found negotiation strategy and psychology to be a fascinating area to study. Winning a negotiation and getting what you want in a deal is, to those who are observant, an intricate game of human behavioral chess. To get what I want, I could simply negotiate very aggressively at the negotiation table. That can work. But there’s a cost to it. It spends social capital that I’d prefer to keep. I come off as overly self-interested, when as a long-term player I’d prefer to be seen as a friendly, trustworthy guy; in line my PR/marketing efforts.

A much more effective strategy is to win by preventing the negotiation altogether.  A simple checkers player wins by brute force negotiation. But a ‘chess player’ in business wins by controlling the environment of the negotiation, and the people involved, and in many cases preventing negotiation entirely. Ensure companies are using my preferred lawyers, swell guys that they are, and who I know won’t step out of line with the financial ties I have on them. Then deliver a “fair” term sheet. The founders then take that term sheet to those lawyers, maybe there’s a little back-and-forth for good measure, and we move forward, with ‘our guys’ on the inside long-term.

By convincing founders/management to use captive company counsel, investors can get what they want – both in a financing and long-term – without even having to negotiate much for it. When requesting certain terms, making certain decisions, or engaging in certain behaviors, independent company counsel will properly advise the team on how to respond or defend themselves; but captive counsel will just say it’s all normal and standard, lest he anger the people really funding his salary. 

I know some people will try to stop me right there. I’m being overly cynical here, they’d say. This is just how the business works. Surely no serious investor would actually use their influence over company counsel to push things unfairly in their favor.

Oh really? Many VC lawyers, including myself personally, have observed situations in which a negotiation is not going in the direction an investor would like, and off-the-record phone calls to company counsel get made. “We’re hoping to preserve our long-term relationship here, beyond just one deal.” “Our fund is actively seeking firms to partner with long-term.” “If this deal goes *as hoped*, we’d love to explore other opportunities to work together.”  To a lawyer who plays both sides of the table, you are one deal, while a VC fund’s “favor” can mean many, many deals.  Don’t delude yourself into thinking that favor is free.

I am happy to have a discussion about the issues I bring up here, and to be clear, there are many well-respected investors who respect the appropriate boundaries.  But please don’t try to feed me or companies candy-coated bullshit about the angelic “professionalism” of business parties when 7, 8, 9 figures are on the line, and a few easy phone calls and veiled threats (or bribes) can ensure they stay in the ‘right place.’ If your investors would never make those phone calls, then there shouldn’t be a problem with selecting company counsel with which they can’t make those phone calls. 

Cost control as sleight-of-hand. 

Notice the subtleness in how certain investors (including some blogs) talk about lawyers and legal fees. Why can’t we just close a deal for a few thousand dollars? This stuff has become so standard, let’s just keep the negotiations “between the business parties” and close this thing quickly.

Yes, let’s move fast (read: not discuss the terms much) and keep it “between the business parties”; where one side is inexperienced and doing it for the first time, and the other side has done it 50 times. That’ll keep it “fair.”

We’re negotiating and discussing transactions where even small changes could mean millions of dollars in one pocket or another, but let’s “control the legal fees” to save $10-20K right now. Yeah, gotta watch the legal budget. Really appreciate your “concern” there.

If you are building a company on a trajectory to be worth at least a comfortably 8 or 9-figure exit (which if you are talking to serious tech investors, you are), the idea that you should minimize time spent working with counsel, because it’s all just boilerplate and you’re better off keeping the legal fees for something more valuable, is a mirage set up to keep teams ignorant of what they’re getting into, and how they can properly navigate it. Telling a company “don’t ask your lawyers about this” sounds suspicious. “Let’s save some legal fees” sounds much better. But there’s no difference. You are being played. 

Balanced, but also competent. 

Stepping back a bit, it’s important to also clarify what I am not saying in this post. I am not saying that investors and other stakeholders in a company should not have an interest in ensuring that company counsel is competent and trustworthy. Founders do occasionally engage lawyers, typically for affordability reasons, that simply do not understand the market norms of venture capital financing. Using those types of lawyers ends up being a disaster, because they will slow down deals and offer all kinds of comments that aren’t about ensuring fairness and balance, but are simply the result of their not knowing how these types of deals get done. That will drive the legal bill through the roof, with little benefit.

Company counsel should have strong experience in venture capital deals.  Sometimes when investors request a change in company counsel, they have valid concerns about that counsel’s competence. Assess the merits of those concerns. However, it is one thing for your investors to say “this lawyer won’t work,” and then leave it to the company to find new, independent counsel. It is a completely different, and far more questionable, thing for them to insist that you use their preferred lawyer. 

Avoiding captive counsel. 

Here are a few simple questions to ask a set of lawyers to ensure they can be relied upon as company counsel to fairly represent a VC-backed company, particularly one with inexperienced founders:

  • What venture funds / investor funds do you personally (the lawyer you’re directly working with) represent as investor counsel, and how many deals have you done in the past 3 years for them?
  • What about your law firm generally? (for very large firms, this is less important)
  • How many of your firm’s clients are portfolio companies of X fund, and how did you become connected to those companies? May I reach out to the companies to confirm?
  • Can I get your commitment to not pursue investor-side work for X fund while you are our company counsel?

Larger ecosystems and larger law firms are generally less prone to this problem, because it is harder for individual players to really throw their weight around as a percentage of a larger firm’s revenue. That is to say, if the lawyer you’re working with doesn’t personally represent/rely upon X fund, but some other lawyer in the large law firm does, it’s less likely those “phone calls” could be effectively made. Although even in Silicon Valley and NYC BigLaw I’ve seen situations in which a fund will ‘nudge’ a set of founders to their preferred partner at a large firm. 100% captive.

In smaller firms, which are significantly more exposed to this problem due to their size, you’ll sometimes find that a single fund accounts for a massive percentage of that firm’s pipeline revenue. Those lawyers will slap their mothers if the fund asks them to, and companies are wise to avoid using them as company counsel.

The costs to companies of having captive counsel can be severe. Rushed, unfair sales because a particular fund’s LPs suddenly decided they need liquidity. Refusals to pursue other potential investors because the ‘right’ term sheet from ‘friendly’ investors has been delivered. Executive changes installing ‘friendly’ new management without an objective recruiting or vetting process. Early firing of founders without reasonable opportunities for coaching. The list goes on.

This is not theoretical. When company counsel is captive, their passivity will allow the preferences of a portion of the cap table to dictate the trajectory of the entire company, without the checks and balances that a properly governed company should have. And yet the sad fact is that inexperienced founders often don’t even have the frame of reference to know it is happening, or that it wasn’t supposed to happen that way. Many just assume, wrongly, that “this is how these things work,” when really that’s only how it works when you hire advisors who can’t, no matter how much they protest basic facts of human behavior, be objective. 

Don’t just go with the lawyer that the VCs insist upon. These lawyers will work with the VC on a hundred financings and with you on only one. Where do you think their loyalties lie? Get your own lawyer, and don’t budge.” – Naval RavikantLawyers or Insurance Salesman?

This issue is not about labeling one group of market players as ‘good’ and the other as ‘bad.’ Hardly. There are many, many investors in the market who are phenomenal people with deep ethics. They should have nothing to worry about in ensuring their portfolio companies hire competent, independent counsel. And the best companies always maintain transparent, friendly relationships with their investors.

This is about acknowledging that no one in any tech ecosystem ever has more skin in the game, financially and emotionally, than first-time entrepreneurs; not even close.  And yet at the same time, their inexperience means that their closest advisors play an outsized role in helping them navigate the various relationships and risks that they are exposed to. Pushing startups to use their investors’ lawyers as company counsel is, plainly, an unjustifiable mechanism of control; one that anyone who supports entrepreneurship and tech “ecosystems” should not tolerate. 

People with far more experience and power than tech entrepreneurs will demand that their company counsel be independent and objective, because the fairest outcomes result when everyone at the table is well-advised. Ignore all attempts to argue the contrary. Founders should demand the exact same for their companies.

Don’t Rush a Term Sheet

TL;DR: No matter how many blog posts and books are out there (many of which I recommend) attempting to explain the mechanics of VC term sheets in simple terms, the reality is that VC term sheets are complicated, both in terms of how their math works and in how the various control-related provisions will impact a founder team over time. Take time to understand them, and don’t rush to sign, even if investors make you feel like you have to.

Background Reading:

Similar to the ‘automation delusion’ that I’ve written about in Legal Technical Debt, which has led some very confused founders to think that most of what startup lawyers do is getting eaten (as opposed to supplemented) by software, there’s a sentiment among parts of the founder community that VC deals have become so standardized that the only kind of analysis needed before signing a term sheet should look something like:

“$X on a $Y Pre?”

“5-person Board, with 2 common, 2 Preferred, and 1 Independent?”

“Great, here’s my signature.”

Take this approach, and you are going to get a lot of ice cold water splashed on your face very quickly, and not at all in a good way. I’ve seen it many times where founders run through a VC deal, so excited about how awesome their terms were, only to realize (sometimes at closing, sometimes years later when things have finally played out) that there were all kinds of “Gotcha’s” in the terms that they failed to fully appreciate. Having solid, independent, trustworthy advisors to walk you through terms before signing is extremely important, and it needs to be people whose advice you take seriously. See: Why Founders Don’t Trust Startup Lawyers and Your Best Advisors: Experienced Founders. 

Some simple principles to follow before signing a term sheet are:

A. Fabricated Deadlines Should be Pushed Back On – It is very common for a term sheet to end with something like “this term sheet will expire on [date that is 48 hours away].” That deadline is very rarely real. It’s just there to let you know that the VC expects you to move quickly.

It is unreasonable to sit on a VC’s term sheet for weeks without good reason. By the time they’ve offered you a term sheet, they’ve likely put in some real time diligencing your company, and the last thing they want is for you to take their term sheet and then “shop” it around to their competitor firms to create a bidding war.  Doing so is not how the relationship works, and will almost certainly burn your deal. So expecting you to move somewhat quickly in negotiating and then signing is fair, but if a VC is pressuring you with anything remotely like “this needs to be signed in 24/48 hours, or the deal’s gone,” what you have there is a clear picture of the kind of power politics this VC is going to play in your long-term relationship.

Move quickly and be respectful, but make sure you’re given enough time to consult with your advisors to fully grasp what you are getting into. It should be in everyone’s interest to avoid surprises long-term.

B. Model The Entire Round – VC Lawyers are usually the best people to handle this because they see dozens of deals a year and will be the most familiar with the ins-and-outs of your existing capitalization, but having multiple people running independent models is always a good idea, to catch glitches. You want to know exactly what % of the Company your lead VC expects for their money, before agreeing to a deal.

I have seen many situations where founders get distracted by a ‘high’ valuation, but when everyone is forced to agree on hard numbers they realize that the VC’s definitions were very different from what the founder team was thinking.  This is absolutely the most crucial when you have convertible notes or SAFEs on your cap table, because how they are treated in the round will significantly influence dilution. The math is not simple. At all.

C. Understand The Exclusivity Provision – Most term sheets will have a no-shop/exclusivity provision “locking you up” for 45-60 days, the amount of time it typically takes to close a deal after signing a term sheet. This is reasonable, assuming it’s not longer than that, to protect the VC from having their terms shopped around. But it also means that if you are talking to other potential VCs, the moment one term sheet arrives, everyone else should be told (without disclosing the identity or terms of the TS you have in hand) that it’s time to put forth their terms, or end discussions. Because once signed, your job is to close the signed term sheet.

D. Focus on Long-Term Control/Influence Over Decision-Making – Thinking through the various voting thresholds, board composition, and consent requirements is extremely important. Will the board be balanced, with an ‘independent’ being the tie breaker? Then being extremely clear on who the independent is, and how they’ll be chosen, is crucial. Will one of the common directors have to be the CEO at all times? Then understanding exactly how a successor CEO will be chosen is crucial, because usually at some point it’s not a founder.

If X% of the Preferred Stock is required to approve something, then you need to know (i) what %s of the Preferred will each of your investors hold, and (ii) who will the other investors be? Usually the Company gets discretion as to what money gets added to the round apart from the lead’s money, ensuring there are multiple independent voices even within the investor base, but some VCs will throw in a provision requiring that only their own connections fund the round. That heavily influences power dynamics.

There will be many situations in the Company’s life cycle where everyone on the cap table doesn’t agree on what’s the best path for the company. Ensuring balance on all material decisions, and preventing the concentration of unilateral power, is important, and yet not simple to understand without processing terms carefully. 

E. Shorter Term Sheets are Not Better – There is debate within the VC/VC Lawyer community as to whether shorter, simpler term sheets are better than longer, more detailed ones. I fall squarely in the camp that says you should have clarity on all material terms before signing and locking yourself into exclusivity; not just the economic ones.  That means any sentences like “the Preferred Stock will have ‘customary’ protective provisions” (meaning they will have the right to block certain company actions) should be converted into an exact list of what those provisions will be. I can guarantee you your counsel’s perspective on what’s ‘customary’ is going to differ from their counsel’s.

The view among those who prefer shorter term sheets is that you should sign as soon as possible, to avoid ‘losing the deal’ (as if VC investment is that ephemeral). I don’t buy it. The moment you sign a term sheet, you are going to start racking up legal fees, and you are now bound by a no-shop/exclusivity. That means your leverage has gone down, and you are much more exposed to being pressured into unfavorable terms to simply ‘get the deal closed.’ Politely and respectfully negotiate a term sheet to make it clear what all of the core economic and control terms are. The alignment and lack of surprises on the back end is well-worth the extra time on the front end. 

In short, the core message here is know what you are signing. Make sure your VCs know that you are committed, and aren’t going to play games by shopping their terms. But also make sure you are talking to the right people to ensure that the deal you think you’re getting is in fact the one in your hands.

Why Your [Specialist] Lawyer Sucks

TL;DR Nutshell: A common complaint from startups about their law firms is that, while they like their corporate counsel, the ‘specialists’ (patent, employment, benefits, export, etc.) that they end up working with suck. The core reason for this usually has to do with the incentives of large, outdated law firms to cross-sell their poorly-fitted specialists, even when better suited alternatives can be found elsewhere.

Background Reading:

Here are some very common complaints I’ve heard from funded startup founders about their law firms:

  • The patent lawyer I got connected to knew nothing about the background technology of our product. I spent half a day explaining the basic tech/science, and frankly had to do all the legwork myself.
  • The benefits/ERISA lawyer I spoke with took me through all kinds of corner cases/issues that seem far more relevant to a large company than to my startup, when all I want is an off-the-shelf equity plan and to grant a basic employee option.
  • I e-mailed the employment law specialist they referred me to about a time-sensitive executive termination issue, and it took 5 days to get a response, and it ended up being a junior lawyer they ‘throw’ to companies at my stage.
  • My TOS needed to cover some touchy healthcare privacy issues because of the nature of our (med-tech) product, but the guy my lawyer sent me to could barely tell me the basics of HIPAA.

Specialists and Sub-Specialists

One of the most important concepts founders need to understand in interacting with lawyers is that lawyers, just like doctors, have specialties and even sub-specialties; at least the good ones do. Corporate law is a specialty. Startup/VC Law is a sub-specialty of corporate law. There are also energy-focused corporate lawyers, healthcare-focused corporate lawyers, etc. The sub-specialties available in a city mirror the types of industries that dominate the local economy. That’s why Houston startups often use Austin tech/vc lawyers, and Austin energy companies often use Houston energy lawyers.

If you work with a generalist lawyer who dabbles in a little real estate, corporate law, litigation, and maybe does a few tax returns on the side, you’re asking for a world of pain if you’re building a scale-seeking tech company. But even if you work with a general corporate lawyer, failing to work with one who focuses on technology and venture capital (sub-specialty), you will waste time and money.

In the end, it’s all about incentives. 

OK, so now you understand that depending on the issue, you need corporate, tax, patent, trademark, employment, etc. etc. specialist lawyers. The question then is: which one should you use? Large, traditional law firms (BigLaw) always have the same answer: “use ours!” Nevermind that the benefits lawyer I’m sending you to spends 95% of her time talking to billion-dollar companies and will take 10 days to respond to your itty-bitty (to her) issue. Nevermind that “my patent guy” has a BS in chemical engineering and still uses a Blackberry, and you’re trying to patent a piece of consumer hardware. Nevermind that the lawyer I just sent you to keeps (as compensation) only 20% of the $650/hr he charges you, and there are far smarter lawyers in his specialty at a boutique charging half his rate.

Two law firm concepts: “origination credit” (I make money off of the lawyers in my firm that you use) and “cross-selling” (my firm expects you to use our firm’s specialists) are at the core of why so many startups end up wasting time, energy, and money dealing with specialist lawyers who (for startups) suck; because they are either over-kill, not responsive enough, or simply unnecessarily expensive.

Ecosystem v. BigLaw

You would think that, as a startup/VC lawyer at a boutique law firm, I would always tell companies that they should avoid BigLaw and choose focused boutiques instead (the “ecosystem” I write about). You’d be wrong. No matter how much disruption occurs in healthcare, pushing medicine out of hospitals and closer to the patient, you will always need the Mayo Clinics of the world. In that sense, BigLaw still “works” very well in a very specific context, and that context is very large, complex M&A transactions and IPOs.

We regularly tell clients that, while our senior partners have closed and managed $750MM, even billion-dollar deals as partners in BigLaw, boutique firms are institutionally not designed for fast, complex, very large transactions requiring armies of lawyers and other staff who can be rapidly deployed onto a large deal. That being said, the vast majority of startups, even successful ones, will never, not even in their exit transaction, need those kinds of resources. 

Right-Sized Lawyers. 

The “max out” size of boutique firms varies with their structure and the credentials of their attorneys (particularly partners, who manage the large deals). At MEMN, we say about $400MM is where our model usually stops making sense, and we’ll even assist a client in finding successor counsel to handle that size of deal. At that point, you’re probably not worried too much about your legal bill as a proportion of the overall transaction proceeds, and the players you’re working with (particularly I-Bankers in IPOs) will often require you to use a short list of brands simply for marketing and insurance purposes.

But a $100MM acquisition? $200MM? With the right boutique corporate partners running the deal (trust me, you want real partners running your exit; read bios), and the right specialists chosen for the project, wherever they are, that is not (and has not been) a problem. The newly emerging ecosystem of top-tier boutique law firms can easily thrive while still being totally honest about its limitations. It cannot represent Uber. Uber needs BigLaw. But there are plenty of successful tech companies who aren’t Uber but still need serious legal counsel.

If you have decided that you want and need BigLaw, my completely honest suggestion to you is that you go all-in and choose one of the very small number of Silicon Valley based brands that regularly represent the tech unicorns of the world. While you will still deal with several of the “poor fit” issues that plague young startups using over-sized law firms, those firms are the most likely to at least have specialists and sub-specialists who understand issues faced by technology companies, and they at least try to work well with startups.  You’re “locked in,” but at least you’re locked into a place with lawyers who can competently address your needs.

Choosing a BigLaw firm that is not one of the top tech brands will be like going on your once-in-a-lifetime luxury off-roading trip in the mountains, and buying a $200K Ferrari for the task. Your friends (who aren’t morons) will show up in souped-up Range Rovers. If you’re going big on bling, at least do it correctly.

For the rest of the world’s founders who need serious legal counsel, but honestly don’t see themselves needing the institutional resources of BigLaw any time soon, the emerging boutique ecosystem (which is thriving outside of Silicon Valley) offers a serious answer to the “my specialist lawyers suck” problem: well-compensated, top-tier, responsive lawyers at right-sized firms, chosen not because of background economic incentives, but because they are the right lawyers for the job.