Post Category → Formation

Startup Lawyer’s Poker: Fee Deferrals

Nutshell: Startup-focused law firms with well-developed client bases are able and willing to bet on (the 1% of) startups by deferring their fees, but founders should understand what they’re signing up for when agreeing to those arrangements.  In many cases, fee deferrals are just clever ways for firms to “lock in” already de-risked founders and have them ignore massively marked-up price tags on legal services.  Think before you drink the kool-aid. 

It’s no secret that one of the largest expenses that early-stage startups face from their very early days is the cost of hiring competent lawyers. The reason for this is simple: “cloud” economics don’t apply to people. Deploying a SaaS startup has become way cheaper than it was 10 years ago because of all the “X as a Service” that founders can leverage instead of having to invest significant amounts of capital on in-house technology.  But, unsurprisingly, developers still aren’t cheap. Being a good developer requires years of training and unique talent, and being human requires paying for stuff.  Good developers cost real money.  Good lawyers, like good doctors, cost real money.  Anyone suggesting otherwise is attempting to defy the laws of physics.

All that being said, readers of SHL know that there is a lot that smart founders can do to avoid over-paying for legal services:

  • Are you just one or two founders working on an MVP? – Use Clerky and/or, if you need a lawyer, hire a top-tier boutique firm that specializes in early-stage tech, and be careful with generalist solo lawyers.
  • Do you need specialist lawyers for things like trademarks, patents, or other specialty counsel? – Resist the firms that VCs try to force you to use, which are usually very large firms that over-charge clients by $200-300/hr in order to fund their pyramid structures, outdated bureaucracies, and bribes sponsorships of accelerators for funneling companies through them. If you think an extra $200 for every single lawyer hour won’t have a material impact on your runway, do the math again.

If I wanted to get cash-strapped founders to completely ignore the real cost of startup legal services and get them to pay my 2-3x inflated price tags, what would be a great way to accomplish that? Answer: defer my fees until they are less strapped for cash. 

PayDay Loan Meets No-Shop Clause

For many law firms, the fully transparent bargain in a fee deferral can be summed up as follows:

  • Assuming your bill doesn’t go above $X (often something like $25-50K), you don’t have to pay us anything for at least 6-12 months, or until you raise $Y (often a range of $100K-$500K).
  • In exchange, please ignore the fact that everything we charge you will be massively marked up. And we’d also like 1% of your common stock.
  • Also, don’t think about using other law firms for anything while our fees are being deferred – we can’t afford our deferrals if every client goes and hires those lawyers that left our firm 2 years ago and now work for $250/hr less than what we’re charging you for less experienced lawyers. If you do, the bill needs to get paid. This isn’t UNICEF.  The Life Time Value (LTV) isn’t there if all you’re using us for is a fixed-fee formation package.

If a major law firm has made this kind of offer to you, it’s likely because you’ve signaled to them that this “bargain“ is a good deal on their end. Usually, that means you’ve been accepted into a major accelerator, received interest from an investor, or have otherwise been “vetted.” You’ve been de-risked. Smart founders who are lucky to find themselves in this position should obviously ask: if I’m de-risked, is this actually a good deal for my startup?

Be Smarter About It

In startup law, successful late-stage clients cross-subsidize early-stage clients that can’t yet pay their bills. This economic reality ensures that, as long as small firms are stuck working with B-players, the firms with A-clients will always be able to win more A-clients by offering them fee deferrals that the smaller firms simply can’t match.  Startups that don’t want to be bankrupted by lawyers, yet also don’t want to be locked down by gilded handcuffs, really then have two options:

  • Find the efficient A-lawyers, and budget for their services. – Well run focused firms can be dramatically cheaper on early-stage services than traditional firms (and, frankly, better quality), particularly those small firms that regularly work with startups and have optimized their pricing structures for those kinds of companies.  Budget for their services just like you budget for anything else. The truth is you rarely need that much lawyer time before your seed round.
  • Find top-tier smaller firms that are willing to defer. – Remember, only firms with solid client bases can afford to defer their fees for good clients. Many small firms simply won’t do it, but some will.  The deferrals won’t be as large (because your LTV for them is smaller – they aren’t trying to do everything legal for you) but it doesn’t need to be, because the bills are lower.

The evolving law firm ecosystem that I’ve written about is increasingly moving up-market, working with higher-quality clients that once were too afraid to use anyone but the established law firm brands. That means those smaller, more nimble and efficient firms are increasingly able to offer their own “incentives” to attract top-tier clients, without the massive costs of shackling yourself to a single, large full service firm. 

To be honest, I’ve always viewed fee deferrals as an unfortunate, but necessary evil in the startup law space; a kind of smoke and mirrors to distract everyone from the very real problems that traditional law firms are unwilling to address. Does E/N do fee deferrals? Yes, unlike most firms our size, we defer for a small segment of our clients.  I’ve picked enough winners and turned down enough losers to trust my instincts on deferrals.  But if you ask me about deferring my fees, my initial response is always going to be “let’s talk first about how we’ve made top-tier startup law actually affordable.”

Reserve an Option Pool; Not an Ocean.

TL;DR  The larger the pool reserved at formation, the more dilution founders are shouldering that would otherwise be shared with employees and investors. Take it seriously.

Here’s how much discussion usually goes into determining a startup’s option pool size at formation:

Attorney: What size of an option pool do you want to reserve?

Founder: I don’t know, what’s the usual size?

Attorney: 20%

Founder: Ok, let’s go with that.

The reason so little thought goes into it is partially due to the fact that startup formations have (for good reason) become very standardized.  Neither founders nor attorneys are interested in delving into any nuances beyond the core questions about equity distribution and founder dynamics.  The founders want to focus on their product.  The lawyers don’t want to burn time on a fixed-fee transaction.

But here’s why failing to take the time to think through your initial option pool size is a problem: reserving too large of a pool, even if it’s never used, means you’re giving away a larger amount of the company to future hires/investors than you want to.

“That can’t be!”, the founder says. How can an unused pool impact my dilution? Whatever doesn’t get used just gets canceled at an exit, right?  While technically correct, this misses a very important issue: future employees and investors will rely on the term “fully diluted capitalization” in determining how much of the Company they want to ask for in the hiring or investment process. And “fully diluted capitalization” includes the unused part of the option pool.

The Hiring Example

You’re negotiating a compensation package for a rockstar developer, and they say they want 5% “of the Company.” What does that mean? The vast majority of the time it means 5% of the “fully diluted capitalization,” which means all outstanding equity AND all reserved but unused equity in the option pool.

Think this through a bit.  5% means having to give them more shares if your option pool size is 20% instead of 10% (because the pie is larger), even if none of the pool is in use.  If you end up getting a good exit in a year without having used much of the pool, the unused pool will get canceled, but the “5%” shares the developer received won’t be reduced proportionately.  The pie shrinks, but his slice stays the same size – which means yours shrinks.  The 5% hire ends up with a much higher percentage of the cap table.

Nutshell: The larger pool you reserve, even if none of it is in use, the more shares you’ll have to give to early hires to get them to a % they feel comfortable with.  Those extra shares mean, if the pool is unused at an exit, those hires own more of the Company than the % they bargained for.

Incubators-Accelerators also base their equity requests on a “fully-diluted” basis (%-based), so by having an excessively large pool, you’re giving them too many shares.

The Investment Example

This is a bit more nuanced, and I suggest you read the excellent Venture Hacks post: The Option Pool Shuffle.

Background:

  • Convertible Notes with caps generally use “fully diluted capitalization” (remember, that includes an unused pool) in determining the conversion price. So a larger pool means the investor gets more shares to get them to the right %, producing the same issue as with employees: if the pool is unused at an exit, they end up with a larger chunk.
  • In a Term Sheet, VCs generally make you “top up” the option pool to have a certain % of availability post-closing, but they make the pre-money cap table absorb all the dilution from it.  The ask will look something like this:

“the total post-Closing available option pool (excluding granted options) represents 15% of the fully diluted shares of the Company.“

The Venture Hacks article gives a mathematical example, but the most important point is this: the higher % the VCs require as available (unused) post-closing option pool, the lower the price they are paying for their shares, and the more dilution the founders are absorbing.

How does this relate to the point of not going overboard in reserving your original option pool? The pool you reserve before your first VC financing will set the baseline for negotiating how much of an option pool “top up” VCs make founders absorb.  If you have a 16% available pool pre-funding, it makes it look a lot more benign for a VC to demand a 15% post-money pool than, for example, if your pre-funding pool was only 5%.  Getting from 5% pre-funding to 15% post-funding will require a very large increase in the pool size.

By having a smaller pool before your funding, it reveals a much bigger “hit” on the founders when the financing is modeled and the VCs post-funding pool “ask” is reflected.  When both the VCs and the founders see the substantial dilution resulting from the pool increase, it forces a deeper discussion about what the post-funding pool should really look like. And that’s where the Venture Hacks wisdom comes in: have a hiring plan and a solid argument for how much of a pool you really need, and make the VCs argue for theirs.

Nutshell:  By keeping your pool size small before funding, it requires a much larger pool increase to get to a VC’s desired post-funding unused pool, all of which is borne by the pre-financing cap table.  This forces a necessary discussion with the VCs about what the appropriate pool size really is, instead of just accepting whatever number they pull out of thin air.

So what is the right formation pool size?

It depends. How many founders are there? Whom are you likely to need to hire in the next 12 months? These are details to discuss with your attorney.  Whatever you do, don’t just accept 20% without thinking about it.

Conclusion

As a founder, your ownership is set at formation.  Everything afterward is dilution.  By reserving an unnecessarily large pool, you’re basically protecting future hires and investors from dilution, while absorbing it all yourself.  It’s not that hard to increase your pool size if you run out of room, and when you do so, at least everyone on the cap table will absorb the dilution with you.  By keeping your pool smaller, you’ll also make VCs think twice about casually dumping an unnecessarily large pool size on their term sheets in order to drive their share price down.

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.