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.

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.

Standardization v. Flexibility in Startup Law

TL;DR: Standardization reduces time and fees, but at the cost of increased inflexibility. And sometimes, flexibility matters more.

Related reading:

Imagine you’re about to have a baby. You start asking your OBGYN about the facilities, preparations, etc., and the response you get is: “don’t worry about it, it’s all standard.”

Ok…, but your family has a history of certain unique hereditary conditions. Things can go wrong. You try to prod further. “Don’t worry, everything is going to be standard procedure.”

Are all people “standard”? Well, are all companies?

Standardization has its place, and certainly has its benefits. Those benefits include:

  • Lower Costs (at least upfront);
  • Faster execution, often enabled by technology;
  • Easier review.

In short, standardization makes things cheaper and faster. As great as that is, for any high stakes situation, a half-intelligent person will step back and ask: are speed and low cost really my top priorities here?

The purpose of this post is to discuss why the general push toward standardizing all financing (and other) documentation for startups, while clearly lowering up-front legal fees, is not always as “founder friendly” as the automation companies, investors, and other parties who also benefit from standardization, would have you believe. Nothing is free.

As I’ve written before a few times: “don’t ask your lawyers about this” sounds sketchy, and potentially raises red flags. If you want a novice team to simply move on and not ask questions, a real chess player will say “let’s save some legal fees.”

We’re negotiating over millions of dollars with potentially tens or hundreds of millions in long-term implications, but great, let’s save a few thousand in legal fees now by “streamlining” things. Right.

Who chooses the “standard”?

By far one of the most over-used phrases I hear in financing negotiations is “this is standard.” Says who? Do you have data? When you personally close dozens of financings a year across state lines, and have visibility into hundreds, like our lawyers do, it is very amusing when someone who makes maybe a handful of investments a year starts trying to lecture you on what’s “standard.”

The other day I heard a VC say that not having an independent director on the Board post-Series A is “standard,” and virtually everyone else in the room could smell the manure.

If you are looking to adopt market “standards,” make sure they are actually standards. Work with advisors with broad market experience to verify claims, and triangulate advice from multiple, independent advisors. Don’t let anyone simply dictate to you what the “standard” is. 

Serial players benefit from standardization. It’s not about saving companies legal fees.

Investors have portfolio incentives; meaning that they have their bets spread around a dozen or two dozen companies, sometimes much more if they’re a “spray and pray” kind of fund. For investors who look for unicorns, they expect most of their investments to fail, and just need 1 or 2 grand slams to make their returns. Unicorn investors demand very high growth, because even if such an approach can increase the number of failures, it will also maximize overall returns across the portfolio by turning up the juice on the 1 or 2 unicorns.

Entrepreneurs and their employees, on the other hand, have “one shot” incentives. Their net worth is concentrated in one company, and therefore the specific details, and risks, applied to their specific company matter a lot more to them.

The emphasis on very fast, very cheap financings benefits, above all else, large investors with broad portfolios who are looking to minimize their costs on any particular bet. It is not something developed out of beneficence toward companies; who often stand to gain more from adopting structures better suited to their specific circumstances. 

Standardization necessitates inflexibility, and when you’re fully invested for the long-haul in one specific company, flexibility may matter much more to you than simply moving as fast and cheaply as possible.

So who is standardization really for? The people who work in volume.

Lies about fixed legal fees.

One of the worst lies spread throughout some startup law circles is that fixed fees somehow “align” incentives between clients (companies) and lawyers. The argument is that, if lawyers bill by the hour, they will simply bill endlessly without reason. Thus, fixing their fees “solves the problem.”

Except it doesn’t.

Assuming all lawyers are principle-less economic actors who will do whatever maximizes their profits (cynical, but the general argument here is cynical), fixing legal fees does not align incentives between a client and the lawyer; it reverses them.

If Mr. Jerk Lawyer will run up the bill unjustifiably when the economics are hourly, he will, once you fix his fees, reverse course and do the absolute bare minimum necessary to complete the work; pocketing the difference. Why put in that extra hour or two to discuss a few nuances with potentially very material implications to the team, if it just hurts my fixed fee ROI? “This is fine and standard” is a much easier answer. Trust me, the minimum professional standards to avoid malpractice are very low. Close the deal, and move on to the next one.

Oh, but wait, the fixed fee proponent would retort: the fixed fee lawyer will still do a great job because he’s concerned about reputation. Response: (i) isn’t the hourly billing lawyer also concerned about reputation? (ii) you often don’t find out whether the lawyering you got was “good” or “bad” until years later. The difference between great counsel and bad counsel is in nuanced, long-term details not visible at closing. A-players and C-players can both close deals. I’ll let you guess which ones more often agree to fixed fees. 

There is a place for fixing legal fees when the work being done really is commoditized, and not of high strategic significance to a company in the long-term.  But anyone who thinks that fixed fees are some kind of magical solution to long-term lawyer-client relationships is, to put it bluntly, full of sh**. In attempting to solve one problem, they create other ones. So let’s all please stop pretending that when investors insist that you cap your legal fees when negotiating against them that they’re doing it to save you money. It’s a way to get your lawyers to stop talking to you. 

Our view is that clients definitely deserve some level of predictability in their fees, and we provide that by crunching data across our broad client base, and providing clients budget ranges based on that hard data. We also keep clients regularly updated on accrued billings, to avoid surprises. I promise to deliver transparency and data-driven predictability within reason, but I need, and smart clients want me to have, the flexibility to address unforeseen issues that, in my judgment, are material enough to fix, even if I could get away with ignoring them without anyone noticing for years.

Reputation plays a huge role in keeping legal fees reasonable. You’ll go much further diligencing a set of lawyers, asking their clients whether they feel they keep their bills honest, instead of adopting some nonsense idea that fixing/capping fees will magically produce the outcome you really want.

Standardization and Flexibility need to be balanced.

All good startup lawyers adopt some level of standardization, as they should. There is a lot of room for creating uniform practices that save time and money, without damaging quality and flexibility. But any attempts to pretend that complex, high-stakes law can be “productized” should raise serious skepticism, at least from entrepreneurs who view their company as something more than just another cookie-cutter number in someone else’s portfolio.

If I refuse to fix all of my legal fees, it’s because the reality of serious startup law does not fall along some neat bell curve; not when you represent a diverse client base, with diverse goals beyond simply getting as big as possible as fast as possible. There is far more qualitative nuance to strategic lawyering than there is even in healthcare, where the goals are much cleaner, quality is more easily evaluated, and the base structure of each “client” (biology) is more uniform. Business goals are subjective, and the right outcome for one client may look totally different for another, requiring totally divergent, and unpredictable, levels of work. That requires flexibility, both in process and pricing.

Where the final outcome really matters, speed and low cost are not the top priorities. Leave room for flexibility and real strategic guidance, or you’ll move very fast and very cheaply right into a brick wall.

When a Startup Lawyer can’t scale.

TL;DR: If you’re building a scalable business, your main lawyer(s) need scalable infrastructure to ensure projects/deals can get handled correctly, promptly, and cost-effectively. Hire a startup lawyer who can’t scale, and when you need them most, they’ll be unavailable.

Background reading:

When I talk to seasoned founders about what they really want out of their company counsel, their responses largely boil down to 3 things: quality, responsiveness, and cost-effectiveness. Any good, single lawyer can at some point in time deliver all 3 of those, but not consistently, and not at scale. To do that it takes what I call, broadly, “infrastructure.” If you hire a lawyer who doesn’t have infrastructure — no matter how good they may be — you can expect a world of pain at the very moment that you need him/her most.

Law firm infrastructure includes:

  • Paralegals / Professional staff (like word processing) to handle necessary tasks that you don’t want a lawyer billing hundreds of dollars an hour for (like signature collection, option grants, state filings, etc.);
  • Technology and institutional knowledge, like automated templates, form libraries, etc. to streamline standardized processes to ensure lawyer time is spent on higher-value work;
  • Junior attorneys and appropriate training/compensation infrastructure for them, to keep work moving that is too complex for paralegals/staff, but not cost-effective for Partners to manage;
  • Other partners/senior attorneys to keep work moving when the main partner isn’t available (on another deal, on vacation, sick, etc.);
  • Access to niche specialists (IP, Tax, Employment, Commercial, etc.) to ensure answers on complex issues get the right subject matter expertise, though they don’t need to be within the same firm;
  • Experienced M&A (Mergers & Acquisitions) attorneys who specialize in high-stakes exit transactions, which require different expertise from venture capital/angel financing experts.

The clearest symptom of a startup lawyer who can’t scale is slowness, and as anyone with experience in the startup game knows, time kills deals. To a lawyer who’s seen hundreds of deals, your $500,000 seed financing may seem like just another small deal.  But to you it’ll feel like life and death, and you can’t wait weeks for your lawyer to get on it because he’s on vacation, out sick, or stuck in another deal without the right support infrastructure to ensure yours gets handled as well. 

I’ve known lawyers who dramatically underestimate how time consuming and expensive it can be to build and maintain legal infrastructure. They think they’ll just wait until they get busy enough and “just find someone.” It always blows up in their faces. Hiring specialized, highly qualified staff and attorneys is hard in any specialty area. Building a compensation structure that works mathematically but will attract and retain the people you need is even harder. Many lawyers can’t actually afford it. There is a world of difference between a single lawyer handling his own little portfolio of clients v. building a real firm that can handle hundreds of clients, day in and day out, with minimal hiccups. 

Even within very large firms, you might run into lawyers who are, effectively, solos. By this I mean that they lack the relationships/connections within their large firm to really ensure their clients will get served properly. Again, the clearest symptom is slowness. If clients are regularly having to follow up with a lawyer, solo or within a firm, because stuff is not getting done, that is a clear sign that you have a startup lawyer who can’t scale.

An easy way to vet a startup lawyer for whether she/he can scale is: 

  • Analyze their website: are there other lawyers/professionals with similar experience on their roster? Some solo lawyers, sensing that smart clients know they can’t scale, will brand themselves as a firm, when really their “firm” is nothing more than… a website.
  • Ask them: when you’re not available, who else do you have quick access to for ensuring my work gets done? Ask for names, and diligence.
  • Talk to their clients: find out what companies in your network already work with them, and ping them for feedback (on your own).

Small businesses who may need their lawyer for one non-urgent thing every year or so don’t need to worry about their lawyer’s scalability. But tech startups are, by nature, high-growth and need regular, consistent, and sometimes urgent legal bandwidth. And changing lawyers/firms can be a serious pain, and lead to mistakes.

Hire a startup lawyer that can scale to the level you expect your company to be within the next 5 years, or you’ll regret it.

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. In 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% 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, 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.