Post Category → Angels

Don’t Use Your Lead Investor’s Lawyers

Principle: If your lawyer makes more money off of your investors than he does from you, he’s not really your lawyer.

If someone made you an offer to buy your home, but suggested that you use their real estate agent in the process, you’d hopefully immediately notice a problem with such an arrangement.  Most people would.  That being said, here’s a very common scenario in the early stages of a startup:

Investor (to Founder): Hey, we’d love to work with you guys on a possible investment, but first you need to get your legal stuff cleaned up.

Founder (eager to get investment): Awesome. But I don’t know any good startup lawyers.

Investor: No problem, I know a great startup lawyer, [X].  We’ve worked with him on several deals. I’ll put you in touch.

Founder ends up hiring lawyer recommended by investor.

Sometimes the investor even sweetens the pot: “If you use X lawyer, we can close in Y weeks.” This is highly unethical.

There are a few reasons why this scenario is so common:

  • A lot of founders, for understandable reasons (money), wait to engage a startup lawyer until they are already talking to investors (bad idea);
  • A lot of founders are first-time entrepreneurs with no good way to assess the quality of a startup lawyer, so they rely on referrals from people whose judgment they trust (not a bad idea); and
  • The Founder-Investor relationship feels a lot less adversarial than a buyer-seller relationship (because at the early stages, it is).

For the above reasons, founders presented with an investment opportunity often take the path of least resistance and hire the lawyer suggested by their lead angel/VC investor.  But anyone who (i) has been to more than a few rodeos and (ii) is honest about it, will acknowledge that this can be a terrible idea. Nevertheless, you’d be surprised how many investors keep a well-groomed stable of ever-so friendly lawyers to send their portfolio companies to.

The Honeymoon Period

At the beginning of the founder-investor relationship, everything tends to be beers and high-fives.  The Founders are excited about the injection of capital, and the investors are excited about the awesome business they just bought a piece of.  Board meetings are upbeat and downright jovial.  Tweets are so warm and fuzzy it’s almost cheesy. “Where on earth did the term ‘vulture capitalist’ come from?,” the founder asks. “These guys are my friends.”

This is why founders feel so safe using their lead investor’s lawyer.

And sometimes, for lucky founders, things never stray too far from this investor romance.  If they kept expectations reasonable, execute on their plans, and you-know-what never hits the fan, why should they? Unless…

When the romance stops.

That big deal that was coming down the pipeline (or three) ends up falling through.  The economy tanks.  The CEO thinks the Company needs to take a big bet that breaks from the original business plan.  Your VC’s portfolio ends up underperforming and she needs an exit to keep her partners happy, or she thinks someone else should be CEO. Or maybe a competing syndicate puts in a term sheet at better terms than your existing angel lead offers.

You can think of hundreds of scenarios that will cause the adversarial nature of the founder-investor relationship to rear its head; not because investors are bad people, but because their economic interests are just fundamentally different from those of the founders/company.  And in those scenarios, this question becomes extremely important: who feeds your startup’s lawyer?

The Hand That Feeds 

When the interests and desires of the Company become unaligned from its investors, the impartiality of the Company’s lawyer(s) is immensely important, particularly because of the attorney-client privilege on communications.  It’s also essential in those scenarios when you need to play good cop/bad cop.

You interact with your investors on a much more personal, on-going basis than your lawyer does, so sometimes you may want (or need) something to be said, without you necessarily wanting to be the person to say it. Put bluntly, you need your startup’s lawyer to be unafraid to stand up, look someone in the eye, and say (in professional terms): “**** You.”  Not that you shouldn’t do everything you can to avoid such a scenario, but the option absolutely needs to be there.

The point I want to drive here should be clear: if your startup’s attorney relies on your lead investor(s) for a significant portion of his/her business via referrals or direct representation on other deals, you better believe that he’s going to be tip-toing and curtsying around them whenever he has to say something they might not like.  His relationship with them may actually be more valuable to him than his relationship with you.

I’m sure I ruffled a few feathers by writing the above, but young founders need to be aware of this dynamic.  Attorneys who repeatedly play on both sides of the table will surely scoff and underscore their (air quotes) “zealous impartiality” in representing companies, despite relying on those companies’ investors for a lot of their business. Thankfully, this is my blog, and I can say this: they’re either lying to their clients, themselves, or both – and potentially violating rules of legal ethics.

Even people of the best intentions are susceptible to conflicts of interest.  A (now) client of ours dropped another attorney (who was very close to that client’s VCs) when he suddenly realized that the VCs were aware of confidential facts that he never disclosed to them.  Things just “slip out” after a few beers.

Caveats

Startup ecosystems are relatively small communities. All experienced Texas startup attorneys have cordial, professional relationships with large investors, simply because it’s impossible to not run into each other on deals and at events.  That’s a good thing.  Knowing one another creates a level of trust that greases wheels a bit.   Also, when a law firm is large and well-known enough, it is virtually impossible to avoid some small amount of representation on both sides of the startup table (investors and companies) at the firm level; there will be someone in the firm who represents investors.

The issue to be concerned about is not that any pre-existing relationship exists between your startup’s attorney(s) and your lead investors; the depth and degree of influence from that relationship is what matters.  If the attorney or his/her firm represents your investors only once in a blue moon, or happens to be on a long list of attorneys/firms that the investor recommends to portfolio companies, that’s very different from being one of their “go-to” lawyers.  If your lawyers represent 4 out of your lead’s past 5 investments, or if they peculiarly show up at all of his invite-only events, you may have a problem.

Nutshell: At the beginning of your relationship with a lead investor, it’s easy to see their advice as completely impartial and always in your best-interests, but it often won’t be. There will be scenarios in which your interests diverge, sometimes sharply, from theirs, and having an impartial attorney at that point is invaluable.  So be careful if your lead investor and the attorney you’re considering seem to be BFFs.  People (attorneys included) won’t bite the hand that feeds them: even when their client may need them to.

SAFE: How Founders Should Paper Their Own Investments in Their Startups

YCombinator has made a splash over the fast few weeks regarding its new SAFE (Simple Agreement for Future Equity) security that it will be using for investments in YC startups. It accomplishes everything convertible notes do, without the “hammer” of a maturity date (i.e. the money coming due if another financing never happens). Open question how far the document goes in the broader investment community. It seems everyone took to their blogs to comment on SAFE’s provisions, so I’m not going to repeat that here. Instead, here are some links:

I’d like to establish a point that (I think) hasn’t been touched upon by the startup bloggerati: that, regardless of whether SAFEs get much traction with investors/startups broadly, SAFE appears to be the perfect way for founders to paper their own capital investments in their startups.

Background Reading: SHL – Founder Convertible Notes

  • At the inception of a startup, founder stock should generally be issued at a very low per share value: typically $0.00001 per share.
  • Issuing the stock at a higher per share price (for, say, a founder’s investment of $20,000) potentially establishes a Fair Market Value of the stock that will make it much more expensive for future employees to receive equity in the company, which negatively impacts hiring.
  • “Founder Notes” are a way to (i) issue founder stock cheaply, but (ii) still paper a founder’s investment of serious money (aside from sweat) in her/his startup. And (in my experience) later investors like to see the extra “skin in the game” from a founder.  They’re not happy about it being reflected in a debt instrument, but it’s usually a net-plus for the founder.
  • But one downside is that, in the case of multiple founders, by issuing founder notes you’ve just handed a co-founder a very sharp object to use against the Company (and other founders) if things don’t go as planned and the note never gets converted. Founders sometimes end up hating each other. Better to keep the weapons in the closet.

Solution: SAFE – The “Discount, No Cap” Version

  • 20% Discount should be fair
  • I suggest the uncapped version because founders shouldn’t be setting capped valuations at the formation/early stages of the Company.
  • SAFE is also a bit more digestible to those Angels who may have a problem with Founders having a debt claim on the Company.

Founders now have a standardized security to paper their personal investments in their startups, (A) without screwing with the Company’s FMV and, more importantly, (B) without giving disgruntled co-founders a way to blow up the Company at a “maturity date.” 

Nutshell: Founder Notes were a way to paper a founder’s investment of personal funds without messing with a startup’s FMV, but “maturity” created a problem in a multiple founder context. SAFE resolves that problem. While it’s an open question how much SAFEs will be utilized by investors, they should be strongly considered for papering founder investment.

Why experienced entrepreneurs hire better lawyers.

There are goods and services for which quality is apparent to the consumer from the beginning, and then there are those where what you actually got for your money can take years to figure out.  Transactional lawyering is decidedly in the latter category, although it often takes a client some personal seasoning (or good advice) to figure that out.

Fundamentally, there are two “jobs” that a client will typically hire outside corporate counsel for in a transaction. The first is getting the transaction done. This is the job that all clients are aware of, no matter how much experience is under their belt.  As long as the client gets his/her desired economic terms, papers get signed, and wires get initiated, all seems to have gone as planned.

But the more experienced entrepreneurs (and unfortunately that experience often isn’t pleasant) know that good legal counsel will serve a second function. While not as simple to define as the first, let’s call it transactional insurance. Some illustrations would be helpful here.

Formation. You have a great startup idea, got together with some co-founders, and want to make it official. You incorporate, issue some founder stock, perhaps authorize an equity plan, and you’re good to go. Put the papers away and forget about them. No worries here, right?

  • What if one of the founders later claims that some of the Company’s IP is his/hers and not the Company’s?
  • What if some of that founder’s work was done on a prior employer’s time/hardware, and that employer now claims ownership of the IP?
  • What if one of the founders dies? Where does their stock go?
  • What if one of the founders gets divorced. Where does their stock go?
  • What if a founder decides to leave the Company after  a year? Where does their stock go?
  • What if someone sues the Company and you personally?
  • What if the IRS comes back 4 years from now and says you owe them a bunch of $ on your vested stock?
  • What if it turns out that a founder had a non-compete agreement with a prior employer with deep pockets, and working at your Company violates it?
  • Insert 3 dozen other scenarios here.

VC/Angel Financing: Everyone signed the papers and sent you checks. Awesome. No worries, right?

  • What happens if we decide to sell the Company early?
  • What happens if we want to raise a new financing, but not all of our current investors are on board?
  • What if an investor decides 5 years from now that he wants his money back?
  • What happens if the IRS claims 3 years from now that we issued stock at too cheap of a price and tax is owed?
  • What happens if an angel investor sues the Company claiming that we fraudulently withheld information from them?
  • What happens if the SEC claims that we sold stock illegally to unqualified investors? Wait, what does college football have to do with this?
  • Insert 3 dozen other scenarios here as well.

The quality of the process and legal drafting that took place in the above scenarios will determine whether a resolution could be as simple as (i) pulling up a document, (ii) pointing to Section 2.3(a)(i), and (iii) getting back to work, or something that could destroy years of hard work in an instant.

From the perspective of a lean entrepreneur who just wants Minimum Viable Lawyering, signing some papers provided for free or a few hundred bucks felt like success.  But experienced entrepreneurs typically have a better sense of the nightmare they may be inheriting by going with the attorney or firm who claims to do the exact same thing as the “overpriced” guys, but at a substantial discount.

Granted, there is a lot to be said for Job #1, and there’s no shortage of movement in the legal industry toward getting the transaction done quickly and cost-effectively.  That topic is the subject of perhaps 80% of my blog posts.  But something is only truly cost-effective when it efficiently accomplishes all of the tasks that you hired it for – not when it provides the trappings of a job-well-done, but kicks any number of disasters down the road.  

I can’t tell you how much time we spend cleaning up the work of bad lawyers who looked, at the time, like a bargain. Experienced entrepreneurs hire efficient lawyers. Inexperienced entrepreneurs hire cheap ones.