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Legal Startups: All Chasm, No Revenue

Kenneth Adams over at Koncision wrote a blog post recently that caught my attention: The Perils of Innovation, about the challenges of true innovation in the corporate law field.  Take-home point:

Bringing innovation to the transactional world is like competing against a giant cartel. It’s like competing against faith. That’s what makes it so bracing, but it’s also why most people offering technology solutions to the transactional world will fail.

I started commenting on his post until I realized I was writing a mini-essay and that, given the relevance to other topics I cover, it made more sense to post here.  Ken talks about the recent shut-down of Ridacto, a little contract analysis tool that I came across – wait, now that I think about it, Ken was the one who introduced me to it, via Twitter – and found interesting, but a bit shy on execution. You uploaded a contract (more on that later), it ran an analysis, and then produced a proofing report that pointed out issues with defined terms, section references, etc. Much like a simpler version of Deal Proof, which my firm licenses but for some reason no-one used until I discovered it.  It’s highly imperfect, but has honestly saved my life as a junior associate, and has saved the clients I’ve worked with probably about 5-figures so far.

Here’s my comment to Ken’s post:

I’m pretty optimistic about the future of transactional legal tech, but I think that any startup trying to enter the space has to be incredibly strategic about how they build momentum.  I tried Ridacto – it seemed interesting, though the UI was a bit confusing.  But I think the real issue was that their approach to how they analyzed contracts would simply be a non-starter at a law firm of almost any size – hey, upload this contract for a private transaction that hasn’t occurred or been announced yet, we’ll analyze it for you, but we promise we’ll delete it afterwards!  Umm, yeah, good luck with that one.  I got my hand slapped by my IT overlords because Box, not Dropbox, but crazy-secure used by like the CIA Box, wasn’t secure enough for them.  Just suggesting Ridacto would get me laughed at.

Lesson: If you’re a legal startup, your customers, or at least those controlling their buying/use decisions, are pathologically paranoid about security and credibility.  You simply can’t be a $100K, bootstrapped, “lean startup” and expect to get any momentum in this space.  In some ways, you never get to truly enjoy the Early Adopter phases of most tech startups. You start out right in the middle of Geoff Moore’s famous “Chasm” – all the problems of a startup – burning cash, an un-proven business model or product + all the problems of a scaling tech co. that usually has revenue to rely on, like gaining credibility and convincing conservative customers.

The last sentence or two is a point I want to drive home.  The transactional legal field does have early adopters who love playing with new toys, myself included, but we’re (i) few and far between, (ii) usually at the junior level, and (iii) as a result, don’t control the purchasing decisions of our firms.  As a junior, I’ve recently been able to convince our firm of about 4-500 lawyers to trial two pieces of tech that can, and already are, transforming parts of our practice.   One of those is a true startup – BrightLeaf. But there are a number of factors that had to be in place before I could do that:
  • Price – low up-front cost, subscription based. If it doesn’t work out, we make a clean break, little money lost.
  • Trial Period/Demo – don’t expect any firm to consider your product unless you offer a trial, or at least a demo that they can play with.  Demos can be helpful where the firm would need to build in a bunch of of its own information to truly get a feel for the product.
  • Security – I’d have every single aspect of our firm in the cloud if I could, but I have to answer to IT people who get panic attacks at hearing the word “dropbox.”  If you’re handling anything with sensitive information, you need security credentials, and that isn’t cheap.
  • Credibility –  Hire ex-corporate lawyers that can sell – good luck finding them.  Network and get in contact with a single firm that (i) is an industry leader, (ii) has people who are willing to trial software – most likely tech-focused lawyers, and (iii) would allow you to mention their name in marketing materials.  Lavish them with attention.  Most law firms are sheep. Nothing perks the ears of a corporate partner better than “Well, X and X LLP are using it.”  That’s how legal language gets adopted. Same with legal tech.

Low up-front costs for customers and trial periods/demos, so not much revenue to rely on up-front – classic startup.  Security and credibility to convince conservative decision-makers that you’re legit, will make it past their IT people, and truly understand their problems – that’s the Chasm, and it costs money.  Usually a tech co. has some revenue from early adopters to rely on when its dealing with the Chasm, but not a legal startup.  You start out right in the middle of it.

Good luck being a true “lean startup” in this space.  Frankly, I think that an intrapraneur – operating with the brand and budget of a large Co., but with the freedom to innovate – has much better odds than a true entrepreneur running a legal startup. I know many VCs aren’t (yet?) pouring money into the legal space, but we’ll see.  We desperately need innovation, but it’ll take serious, well-funded risk-takers with a strong understanding of corporate law practice (not an easy combination to find) to make it happen.

Startup Law Hack: Get to Know Your Associate

One common gripe that you’ll hear around the startup community is that a startup using a large law firm will simply be “thrown to a junior associate.”  If you’ve read my post “In Startup Law, Big Can Be Beautiful” you’ll understand my perspective on this.

Junior associate can mean someone who is truly clueless about what they are doing.  But with the right firm, it can also mean someone who:

  • has been assigned tasks appropriate for their skill level, with senior-level oversight
  • has access to other more experienced (read: expensive) attorneys when they’re actually needed
  • has access to institutional knowledge and resources within the firm to efficiently handle most of your basic needs, and
  • because they are early in their career, will be much easier to get ahold of than a senior attorney managing dozens of much larger clients.

Much like how properly-run hospitals efficiently distribute work, with the assistance of technology, between specialists, general practitioners, nurse practitioners, etc., you won’t find any problem with being assigned (not dumped) to a junior associate if the firm you’re working with knows what its doing.  You’ll get better service because of it.

The logical conclusion of this is, when you approach a firm, you should care just as much about the junior associate assigned to your company as you do about the partner/senior attorney.  Research their junior associates, and don’t be afraid to request one.  This will probably surprise the firm a bit, but there’s nothing wrong with making sure you are well served both at the senior and junior level.  Within any firm, there can be wide variance between associates who are there just trying to earn a paycheck and pay off debt, and those who love working with entrepreneurs and have the credentials to show it.

The Need for a Seed Lead

Over the past several months the issue of signaling risk in seed investments has gotten a fair bit of attention. Here’s a break-down of the concern:

  • Because of the “deflationary” economics around running a startup, (i) seed rounds have gotten smaller such that investment amounts are below what would normally move the needle for an early-stage VC, and (ii) the number of startups has increased as a result.
  • VCs can manage only a fixed number of investments if they’re to avoid letting their attention be stretched too thin, lest they become a mere commoditized source of cash with no value-add.
  • Normally when a VC invests in a company, they’ve done their diligence, reserved a fixed amount of their dry powder for follow-on investments, and someone’s reputation is on the line for the success of that investment.
  • Some early-stage VC funds, in order to stay in on the action, have purportedly turned to a “spray and pray” investment strategy, through which they make lots of tiny investments with minimal diligence at the seed stage; so many in fact that there’s no way they could do follow-on investments for all of them.
  • But with tons of small investments, the claim is that these companies are viewed merely as options, not as portfolio companies that a VC would be more committed to, and the VC is therefore much less likely to participate in the next round.
  • Problem: Because later-stage investors will see this early-stage VC on the Company’s cap table and know that they have the cash to make a follow-on investment (not necessarily the case for an angel), they will understandably become suspicious of why that VC isn’t continuing to invest. This is the negative signal.
  • Theoretical Nutshell: Taking on real VC money at the early-stage is therefore risky because that VC may (i) just view you as an option, (ii) therefore really isn’t all that into you, and (iii) if he/she decides to end the relationship early, could make it a lot harder to find a dance partner for the Series A.

To be honest, I don’t have a dog in this fight. I can’t really because I’m too young and haven’t seen enough deal flow to say whether this happens or not.  I do know that some very well respected people are of the mindset that it does happen, and other well-respected people (and here) think it’s just hot air.  The takeaway that I’ve gotten from a lot of the discussion is that, most likely, some early-stage VCs really do screw entrepreneurs in this way.  But others are sensitive to the signaling issue and are committed to their seed investments. So do your homework.

I recently came across a very interesting post by Roger Ehrenberg over at IA Ventures that talks about the trend of what he calls “party rounds” in which founders, out of a fear of losing control early on, deliberately structure their seed round so that nobody is really a lead investor – lots of small checks.  The crux of his concern is as follows:

What if things don’t happen according to plan?… Isn’t this the time that the deal lead steps up to lead a bridge round assuming management is executing well but simply needs more time? Yes. But wait, we have no deal lead. We don’t have an investor with enough skin in the game to care…. By not having a lead, a partner who takes the long view and has the resources to back it up, the founders have placed themselves in a very risky situation.

What’s fascinating about his point is how, rather than early-stage VCs treating seed investments as options out of some reckless plan to keep their hands in lots of cookie jars, founders are, out of a bit of paranoia, turning themselves into options by not letting anyone write a large enough check.  This is an extremely important perspective to add to the whole signaling debate: there are huge advantages to bringing in a committed high roller at the seed stage.

The worst-case scenario would be to let institutional money into your seed round, but not let them put in real money.  Then you’ve loaded up on signaling risk, while making it virtually costless for them to write you off.

Assuming you’ve found a reputable early-stage VC who is sensitive to signaling issues and willing to take the reins (of the funding, not your company) and grab a large chunk of your seed round, realize that their deep pockets could be a potential lifeline when you hit some road bumps along the way.  And a lot of us know that the Series A is where you’re likely to find road bumps.  There are of course other benefits, like having the VC’s network opened up to you early on.  Regardless of how often founders get screwed by signaling, Roger’s advice is tangible enough to bypass theoretical debate.  Keep it in mind if you’re in the (fortunate) situation of having to choose whom to take seed money from.