Should Non-SV Founders Use SAFEs in Seed Rounds?

Nutshell: Because of the golden rule (whoever has the gold…), probably not – at least not for now.

Background Reading:

For some time now, there have been people in the general startup ecosystem who have dreamt that, some day, investment (or at least early-stage investment) in startups will become so standardized and high velocity that there will be no negotiation on anything but the core economic terms. Fill in a few numbers, click a few buttons, and boom – you’ve closed the round.  No questions about the rest of the language in the document. For the .1% of startups with so much pull that they really can dictate terms to investors (YC startups included), this is in fact the case.  But then there’s the other 99.9%, much of which lies outside of Silicon Valley.

Much has been written about how SAFEs were an ‘upgrade’ on the convertible note structure, and in many ways they are.  But anyone who works in technology knows that there’s a lot more to achieving mass adoption than being technically superior, including the “stickiness” of the current market leader (switching costs) and whether the marginal improvements on features make those costs a non-issue. And any good lawyer knows that when a client asks you whether she should use X or Y, she’s not paying you for theory. You dropped that sh** on your way out of law school.

This isn’t California

From the perspective of founders and startups outside of California, which are the focus of SHL, the reality is that going with a SAFE investment structure is very rarely worth the cost of educating/convincing Texas angel investors on why they shouldn’t worry and just sign the dotted line. The entire point of the convertible note structure, which by far dominates Texas seed rounds, is to keep friction/negotiation to a minimum.  Yes, there are many reasons why equity is technically superior, but that’s not the point.  You agree on the core terms (preferably via a term sheet), draft a note, they quickly review it to make sure it looks kosher, and you close.  You worry about the rest later, when you’ve built more momentum.  Professional angels know what convertible notes are, and how they should look. They also know how to tweak them.  In Texas, many of them still do not know what a SAFE is. 

And, in truth, many Texas angels and seed VCs who do in fact know what a SAFE is simply aren’t willing to sign one. The core benefit of SAFEs to startups is that they don’t mature, and hence founders without cash can’t be forced to pay them back or liquidate.  To many California investors, this isn’t a big deal, because they’ve always viewed maturity as a gun with no bullets.  But Texas investors don’t see it that way.  Many find comfort in knowing that, before their equity position is solidified, they have a sharp object to point at founders in case things go haywire. I’ve seen a few founders who rounded up one or two seasoned angels willing to sign SAFEs, only to have to re-do their seed docs when #3 or #4 showed up and required a convertible note to close. It’s not worth the hassle, unless you have your entire seed round fully subscribed and OK with SAFEs

Just Tweak Your Notes

The smarter route to dealing with the TX/CO/GA and similar market funding environment is to simply build mechanics into your notes that give a lot of the same benefits as SAFEs. A summary:

  • Use a very low interest rate, like 1-2%. – Many local angels tend to favor higher interest rates (seeing 4-8%) than west and east coast seed investors. But if you can get a very low rate, it’s more like a SAFE.
  • Use a very long maturity period, like 36 months. – 18-24 months seems to have become more acceptable in TX, which is usually more than enough time to close an equity round, or at least get enough traction that your debt-holders will keep the weapons in their pockets.  But if you can get 36 months, go for it.
  • Have the Notes automatically convert at maturity –  This gets you as close to a SAFE as possible, and we’ve seen many angels accept it. If you run out of time and hit maturity, either the angels extend, or the Notes convert, often into common stock at either a pre-determined valuation (like the valuation cap, or a discount on the cap), or at a valuation determined at the conversion time.

How successful you’ll be at getting the above is just a matter of bargaining power and the composition of your investor base. Austin investors, who think more (but not completely) like California investors, tend to be more OK with these kinds of terms.  In Houston, Dallas, or San Antonio, you’ll likely get a bit more pushback.  But that pushback will almost certainly be less than what you’d get from handing someone a SAFE.

Closing Summary: There isn’t, and likely will never be, a national standard for seed investment documentation.  Every ecosystem has its nuances, and working with people who know those nuances will save you a lot of headaches. In Texas, the convertible note, however suboptimal, reigns supreme. Respect that reality, and work within it to get what you want.

The Tech Law Ecosystem vs. BigLaw; Except in Silicon Valley

Question: Why is it that, despite being the epicenter of championing innovative business models, dynamic markets, and the disruption of bloated institutions, Silicon Valley remains dominated by a handful of very large, expensive law firms built on century-old delivery models?

The Blunt Answer: Those large firms have dedicated biz dev people whose job is to write checks/cut deals with market players for referrals, and establish referral circles with investors who have heavy influence on the “pipeline.”  Referral pipelines rife with conflicts of interest have enabled BigLaw to entrench itself.

The entrenched firms deliberately seek out VCs (not just companies) as clients, who tacitly understand that, in exchange for the firms’ not pushing too hard on VC deals (when they represent companies), the VCs are supposed to act deeply concerned when they don’t see one of the good ol’ firms at the table; even if the lawyer they’re poo-pooing has impeccable credentials, experience, and even just left one of the very same firms on their ‘preferred list.’ Sound incestuous? It is. See Don’t Use Your Lead Investor’s Lawyers and Why Founders Don’t Trust Startup Lawyers.

It’s well known among the tech law community that no tech ecosystem –not Austin, Seattle, Boston, NYC, etc. – takes law firm “brand obsession” to levels anywhere near those of Silicon Valley, in large part for the above reasons.

History

The full answer is of course a bit more complicated. See: When the A-Lawyers Break Free: BigLaw 2.0.  Before the Cloud and SaaS, big firms truly were necessary to deliver the tier of legal counsel that top tech companies needed, and Silicon Valley’s early growth period occurred largely in that era.  But at some point technology changes things, and the rules of the game shift.  I’ve staked my career on the view that this shift has occurred, and is accelerating.  I left a large, full service firm designed around the traditional “one stop law shop” model for a smaller firm that leverages technology and an ecosystem of top solo lawyers, boutique firms, and other services to replicate “full service” in a much more efficient and flexible way.

A Summary of Why The Ecosystem is Emerging (Outside of Silicon Valley)

  • There have always been second and third tier small firms that (i) picked up clients top firms were not interested in, and (ii) employed lawyers who either never met the criteria of top firms, or dropped out of those firms because they were fine accepting less interesting work and lower compensation for a more easy-going life.  An alternative to going in-house, these lawyers call themselves “outsourced general counsel.”
  • Top, well-funded clients that reached scale (the kind that seek out and are willing to pay for top lawyers) inevitably required a large set of legal specialties: tax, executive comp, IP, tech transactions, trademarks, etc. to handle all of their legal needs.
  • Lacking an affordable, third-party collaboration infrastructure (like today’s Cloud/SaaS tools) to coordinate all of these different lawyers, keeping everyone (dozens of different specialties) under the same roof to share the high fixed overhead costs was historically essential to getting large deals done smoothly and as efficiently (for the time) as possible.
  • Hence, top paying clients gravitated to large firms that could serve them, and as long as those large firms paid the most, top lawyers (in all specialties) were willing to accept the astronomical overhead, convoluted structure, and inefficiency of their large employers.
  • But now, virtually every proprietary resource that large firms once had exclusivity on is available as a SaaS tool or outsourced service, along with very affordable and extremely effective collaboration tools.
  • Therefore, those top lawyers, once locked into large firms, are realizing that as long as they can wrestle away top clients from BigLaw, they no longer have to put up with taking home only a small percentage of their billings.  They can drop their rates significantly, take advantage of their small footprint to optimize for their practice area, and take home at least as much, and often much more, as they did in large firms.  A win-win for lawyer and client – but a loss for “The Beast.”
  • End-Result: A growing ecosystem of significantly smaller, more flexible law firms and solo lawyers that (i) are at the top of their field, well compensated, and have much better quality of life, and (ii) by collaborating with one another, replicate BigLaw’s “full service,” without its soul-sucking bureaucracy.

Austin’s “Cut the BS” Culture: The Ecosystem Grows

In my opinion and based on observations from interacting with players in various ecosystems, Austin’s legal market is at the forefront of this emerging lawyer ecosystem.  Here the quality of attorneys outside of BigLaw – multi-specialty small firms, single-specialty boutiques, and even solos  – is extremely high and increasing, because the client base here isn’t anywhere near as brand-obsessed as in Silicon Valley.  We still have our own cronyism, but our strong “be authentic” cultural bent helps keep it in check.

At MEMN, we connect clients on a regular basis with experienced, top-tier corporate, tax, trademark, litigation, executive comp., patent, etc. attorneys outside of BigLaw, all with better credentials than the lawyers BigLaw throws to startups, and at rates often below inexperienced junior lawyers at large firms.  And, as far as I know, none of us took a pay-cut in leaving BigLaw.  I am fully convinced that this ecosystem will continue to gain traction, and we have every intention of pushing that traction outside of the Texas market, including connecting with firms in other markets doing the same.

How BigLaw Will Respond

Of course BigLaw is responding, but it’s important to keep in mind that “BigLaw” is a set of many different players, each with their own perspectives on the old model.  The big winners of the traditional law firm model were (i) the many layers of in-house administration and management needed to coordinate dozens of specialties and hundreds of different kinds of lawyers, and (ii) the power rain-makers sitting atop the pyramid extracting a significant amount of billings from lawyers doing the work, including all the specialists. These constituencies will absolutely do everything they can to protect the old model.

The main marketing message that will emerge from these groups will be one of “integration.”  They will argue that keeping everyone under a single structure provides benefits that make up for the overhead and inertia. In other words, they’ll try to portray themselves as the “Apple” of law.  Expensive and huge, but “worth it.” I love my iPhone 6.

Without getting stuck on this topic because this post is long enough, anyone who thinks about it will be skeptical of an analogy between software-hardware integration and the ‘integration’ of lawyers in dozens of different specialties, especially as technology continues to erode the friction in cross-firm collaboration.  A better analogy would be something like the Mayo Clinic, but of course that would mean that BigLaw must accept that only the absolutely most complex transactions (think billion-dollar, multi-national mergers) truly require its “integration” – and The Ecosystem would be more than happy to unburden BigLaw (which would then not be nearly so big) of the other 99.9% of the market.

While management and top rain-makers will work to protect The Beast, the rest of the BigLaw pyramid will, over time, come to realize that The Ecosystem is more of a liberator than a competitive threat.  Finally, a way to practice your specialty much more effectively, do interesting work, get paid well for your talent, and not have the significant majority sucked up to pay for “stuff” that doesn’t enhance your work.  Much like how technology has created an explosion of interesting, well-paying work outside of large organizations in many “knowledge worker” industries, The Ecosystem is simply an extension of that process to law.

A Message to BigLawyers

Ask yourself: if you’re billing $625/hr at a large firm and have developed strong relationships with clients, what will those clients say if you tell them you can do the exact same work for them, but charge $400/hr instead – the only real change being the signature block on your e-mails? Certainly The Beast, including the deal lawyer who ‘controls’ the relationship, will do everything it can to push the work to another $625/hr attorney in the firm. But what will the Client say?

Viewed this way, BigLaw today can be accurately described as a mechanism by which rain-makers who (lower-case c) “control” client relationships force the “labor” lawyers to stay in one large firm, accepting only a small percentage of the value they produce in exchange for “deal flow.” And by having the talent pool controlled in this way, clients who need top lawyers have to pay the higher rates to feed The Beast and the rainmakers.  The Ecosystem, and the fact that no one really controls clients (who won’t be forced to pay $625/hr when they can find the same lawyer for $400), throws a wrench in this structure.

A Message to Lawyers Building The Ecosystem

  • Collaborate;
  • Optimize;
  • Don’t fall back on generalism, but resist artisanal lawyering;
  • And absolutely do not underestimate ever the importance of branding and marketing.

Start talking to each other and sharing work.  Being solo has many inefficiencies, and for many specialties the “optimal” structure will likely be more focused firms that effectively leverage their institutional knowledge with targeted, efficient tools and processes.

Take advantage of your small footprint to experiment and iterate on process, technology, pricing, etc. that was never possible under a large firm – you are a startup.  Resist the urge to price yourself as a generalist who does boring, cheap work, but also don’t design your firm in a way that is so “high-touch, high-end” that it can’t scale.  If you’ve hit on something that works, scale it and liberate more BigLawyers.

And absolutely never, ever pretend that all it takes to succeed is to simply “be a good lawyer.”  Clients care about brand and prestige, including the deal lawyers who connect you to clients. No one can find you if you don’t know the slightest thing about marketing yourself. Serious companies won’t want to hire you if your website looks like it was built overnight by a middle schooler. Learn.

The Ecosystem will be built by the most entrepreneurial of BigLaw, including those who are confident enough in their personal brand to break free from The Beast. Once a path has been laid, the more timid will follow.

And a Message to the Gatekeepers

So you say that you’re all about disruption and transparent markets, yet you continue to hand out referrals to firms that write you checks and send attractive blondes offering steak dinners.  I’m not mad at you.  I know how the game works.  Upstanding doctors fall prey all the time to Big Pharma’s biz dev tactics, so I totally understand your inability to resist being a hypocritical little sh**.

Thankfully, every ecosystem (Austin included) has enough gatekeepers who believe in true meritocracy.  The Ecosystem is growing and will continue to grow. Companies will find a much more vibrant, dynamic legal market.  Top lawyers will find interesting, well-paying work in non-soul-sucking settings, and the most innovative will be rewarded with scale.  I’m not pretending to be Mother Theresa and absolutely have an economic dog in this fight.  But knowing all the benefits that accrue both to startups and to lawyers (my people) from it, supporting The Ecosystem is absolutely part of my mission.

Taking Non-Accredited Money – Survival.

Imagine you’re walking through a desert. You haven’t had water for days, it’s 100 degrees, and you know if you don’t get a drink soon your time here is done.  Then you come across a mucky pool of stagnant water that is almost certainly infested with some kind of bacteria. What do you do? Pass on it, for fear of getting sick? Sh** no. You get yourself a drink.  Rule #1: survive.  

This is the decision many startups face when questioning whether they should accept money from “non-accredited investors.”  It also highlights how ridiculous it is for startup lawyers to tell founders that non-accredited money is never worth taking.  They clearly haven’t stepped down from their mahogany pedestal and planted their feet on the same ground as their clients.  Being the product of low-income immigrants myself, and seeing how many successful startups rely on pre-angel funding (a lot), the “if you don’t have rich friends and family, don’t bother” mindset really rubs me the wrong way.

I’m not going to get into the background of what accredited v. non-accredited investors are, or why you shouldn’t take their money.  Most likely you’ve already heard it repeated in 5 different ways.  Professional investors don’t like them, there are onerous disclosure obligations, they can prevent you from raising larger amounts of money, etc. etc. Let’s just take it as a given. Taking non-accredited money is a bad idea. We all know it is. But you know what’s a worse idea? Shutting down when there’s life-giving capital on the table.

Texas is not California.

Unlike startups raised in the land of milk and honey (Silicon Valley), where many angels really will fund an idea, a true MVP, or something with no revenue, in Texas (including Austin) it generally takes a lot of work and some traction (with zeros) to get to a point where angels will even consider writing you a check.  And while it’s true that bootstrapping should definitely be considered, it simply isn’t feasible for a lot of business models; unless you’ve got some deep pockets.  For that reason, the “friends and family” round – $25K, $50K, $100K, whatever, just enough to build something angels actually find attractive – is often the difference between startups that scale, and those that never get off the ground. And statistically speaking, most people’s friends and family are non-accredited.

How do I safely take non-accredited money?

As a startup that knows professional venture capital will be essential to scaling, taking non-accredited money is not “safe” in an absolute sense.  No matter how you structure it, having non-accreds on your cap table/balance sheet will raise questions and diligence from future investors.  The real question should then be, given that whatever consequence is better than shutting down, how do I raise non-accredited money as safely as possible.  Here are some principles for taking non-accredited money, while minimizing the chances that it’ll prevent professional funding:

  • Get help.  Work with an experienced startup lawyer to ensure that you comply with relevant regulations as closely as possibleand within budget, for the financing.  A misstep from a legal standpoint could create an unfixable problem down the road.
  • Limit the group.  Take money only from people you consider true friends and family who can afford to lose all of the money they give you, and who understand that losing the money is a real possibility. This means people who care about you, want you to succeed, and absolutely do not view this money as a lottery ticket to becoming rich. This is not crowdfunding.
  • Lenders; Not Investors.  View the non-accredited friends and family as lenders, not investors.  Make it crystal clear to everyone that their money is a loan, not an investment.  It will not convert into stock, and hence if you hit it big, they will not get a piece of all the upside.  Post-IPO, you can offer free rides in your Bentley and shower them with benjamins. Just don’t offer them stock today. If the company succeeds, the money will be paid back. Offer them a very high interest rate, and work with your lawyer to structure a non-convertible promissory note.  Anyone who will write you a check for $5,000, knowing that it is extremely high risk, and that there’s no chance of a 100x upside, must truly be in it just to help you succeed.

Important sidenote: If you have people who are willing to back you in the above way, you are rich – in a way that many people aren’t. Other people leverage their affluence. Leverage yours.

  • Long Maturity; Subordinated.  Set the repayment terms of the non-convertible note so that the debt does not become “due” until the Company has raised a significant amount of money, maybe $2 million+, and that the debt will be subordinated to all future debt issued to professional angel (accredited) investors.
    • The goal here is to allay any fear from angel investors that their money will be used to repay your non-accreds, instead of funding growth.  The money is not payable until a true VC round, and their debt is always senior to the non-accred debt.

Does following the above principles mean that having non-accredited money in your company won’t blow up a possible financing? No, it doesn’t.  But, in my opinion, it will significantly de-risk things for you.  When VCs or angels ask about your non-accreds, you can make it clear to them that (i) everyone knows that they are being paid back, will never be equity holders, and are subordinated to all other investors, and (ii) they are a highly vetted group of true friends/family who will be cooperative with whatever helps the founders succeed. Once they are paid back, they are a non-issue.

To be clear, I am not promoting the funding of startups with non-accredited money in a broad sense.  I tell founders the exact same things other experienced startup lawyers do: it’s a bad idea, it creates more disclosure obligations, and some investors might not touch you.  If you can avoid it, do so. But being alive yet uncomfortable is always preferable to being dead.  And my observation is that, at least in Texas, a F&F round is often a prerequisite for progressing far enough to where angels find you investable. Drink the mucky water, and live to fight another day.

 

The Texas Startup Ecosystem: Curated & Connected

Nutshell: You can’t build a startup alone. Find your city’s startup “watering hole,” and start drinking.  But remember: that watering hole is not a charity.

In a world of abundance, including abundance of noise, curation becomes incredibly valuable.  Few people have the time to sort through hundreds of duds (products, information, people) before finding something or someone that they truly need. Curation is actually one of the main points of this blog; particularly the Learn the Essentials section. Undercapitalized Texas founders need information on basic startup law and finance.  That information has historically either been locked up in expensive silos (law firms), or spread out over the web alongside loads of crap.  I help them avoid the noise.

If you (just) build it, they won’t come.

When I run into very green founders, my first piece of advice is always simple and direct: get plugged in. By that I mean find people who “do” startups: either as  founders, developers, investors, advisors, etc. – and start making connections. It’s great to rely on your friends and business associates for general advice, but unless they work specifically in startups, it will not be good enough.  The challenges you encounter as a founder of a tech startup (business, legal, financial, etc.) will be very different from those that people outside of that space have experienced.  You need specialized advice, and that means specialized people.

And founders absolutely need to dispel any “if you build it, they will come” (just focus on the product) thinking. No, they won’t come. You probably don’t know how to build it in the first place. And even if you do, distribution matters.  You or someone working for your startup needs to be out there building relationships. Every startup needs at least one hustler. 

The Noise

Naturally, the number of these specialized “startup people” is a tiny fraction of the general business community in any particular city; especially in large cities with relatively small (but growing) startup communities.  But as startups have become much more of a “hot” topic (evidenced by political campaigns and a boom in angel investing among non-tech people), everyone and their mother has suddenly decided to bill themselves as a startup consultant, mentor, advisor, founder, whatever.  You see this in the legal field, where lots of general business lawyers have suddenly become ‘startup lawyers’ overnight. There are also a lot of business executives trying to mentor startups, with zero experience having actually worked with one.

So knowing that they need to find good startup advice, but there are a lot of duds out there, what are founders to do?

People, Curated

As the Texas startup ecosystem continues to mature, in each major city we’re seeing startup “hubs” emerge: places where the signal-to-noise ratio of real, valuable startup experience v. ‘everything else’ is orders of magnitude better than throughout the rest of the city. They’re like watering holes for the founderati. Startup people, curated for you. You’ll find far more jeans and sneakers than slacks and loafers in these places.  That’s a very good thing.

To help Texas founders get plugged in , I’ve created lists for Austin, Houston, and San Antonio (cities where the majority of our client base is) of the key startup locations, events, and even people in each city.  While every incubator, meetup, and person that I list on those pages is a great resource, there are stand-out “core” places that, in my opinion, any new founder should use as a starting point for plugging in – by following their posts, attending events, etc.

In Austin, Capital Factory has by far emerged as the largest “hub” of the startup community. Tech Ranch, while somewhat less well known, is also an important player. While not physical spaces, Austin Open Coffee and Austin Lean Startup Circle are also regular meetups whose attendees pack a significant amount of startup experience.

In San Antonio, Geekdom is hands-down the epicenter of the startup community. I’ve yet to encounter a serious startup out of San Antonio that has not connected with Geekdom in some way.  SA New Tech, a regular meetup, also has a solid attendance.

In Houston, the Houston Technology Center (HTC) appears to be evolving into a core of Houston’s startup community. Not exactly a cultural/social hub (yet) the way CF is for Austin or Geekdom is for SA, but an important player. The Houston Lean Startup Circle  is also very well attended by experienced startup folks.

Dallas is noticeably absent from this list. I frankly don’t work a lot with Dallas startups, and I only write about what I know. Also, there are a lot of very important players in these cities that I didn’t mention (accelerators, investors, etc.) simply because the point of this list is to emphasize how very early-stage founders should get ‘plugged in’ to their startup ecosystem. A brand new founder shouldn’t be “plugging in” to accelerators or investors.

Eyes Wide Open

Texas founders benefit enormously from the above institutions.  The connectedness and collaboration that result from their “dense” environments of startup activity are absolutely essential to a thriving Texas startup ecosystem.  All that being side, founders need to understand that these are not charities, and the people running these organizations (while great) are not Mother Teresa.

A number of the “startup hubs” in any city are either for-profit themselves, or connected to/run by very for-profit investors. The density that they provide is not strictly for the public good: it’s a way to pool resources and systematically reduce the search costs for (i) investors looking to invest in great startups, and (ii) executives looking to join startups on the rise.

There’s certainly nothing wrong with this. Doing well by doing good is awesome. I “do well” by this blog just the same. But founders should avoid becoming naively enamored and approach these institutions for what they are: very useful players in a profitable market for influence.  That market is competitive (incubators, accelerators, co-working spaces, etc. are in competition), and the players are incentivized to do and say things that maintain their influence, but aren’t always in the best interest of founders.  Founders should absolutely plug themselves in, but keep their eyes wide open in doing so.

 

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.