How to Avoid “Captive” Company Counsel

TL;DR: Given the often substantial imbalance of experience between first-time entrepreneurs and the investors/VCs they are negotiating with, experienced startup/VC lawyers are often the most important “equalizer” at the negotiation table; both on deals and on high-stakes board-level issues. Smart repeat players (investors, accelerators) know this, and therefore often directly or indirectly push startups to hire lawyers (as company counsel) that they can manipulate with their leverage over ecosystem relationships/referrals. Those “captive” lawyers are, due to their conflict of interest and dependence on repeat players, incapable of representing the company and common stock objectively; and early common stockholders often get hurt long-term as a result. The market needs to stop tolerating and promoting this unacceptable mechanism of control.

This post is going to make some people uncomfortable. People who work with me know that I’m not the type who likes to irritate others just for the fun of it. But I’m always willing to say something that needs to be said, and I’ve always structured my business relationships and life in a way that I’m not prevented from saying it.

“It is difficult to get a man to understand something when his salary depends on his not understanding it.” -Upton Sinclair

“One Shot” Inexperience v. Seasoned “Repeat” Veterans

Founders, particularly inexperienced first-time founders, face enormous uncertainty and opacity as they build their companies. In that environment, they’re tasked with making complex long-term decisions, on behalf of themselves and other stakeholders, with very high-stakes implications; including distributional implications as to who gets what share of the limited pie.

More so, as founders raise capital, they engage with highly experienced, sophisticated, repeat player parties who have gone through the same process dozens of times; and know the numerous subtle ways of manipulating that process. Those parties (investors) are typically aligned with the common stock in the sense that they want the company to be a success, but there is significant misalignment in the fact that each side wants their share of the pie to be larger than the other, they often disagree on how to grow the pie, including how much risk to take in doing so, and each side also often disagrees on when it’s time to start eating. In the case of institutional investors, they have a legal obligation (to their own investors) to get as high of a return for their investment as possible; in other words, to get as much of the pie for themselves (and as large of a pie) as they can.

Repeat players (institutional investors) are highly experienced, wealthy, diversified, and have downside protection. “One shot” players (founders, early employees) have their net worth highly concentrated in one company, without downside protection; and they’re often highly inexperienced. The misalignment is obvious, never goes away, and feeds into numerous long-term disagreements regarding growth strategy, recruiting, financing, and exits. Very often, investors who were once entrepreneurs themselves will use their entrepreneurial histories as smoke and mirrors to get now new entrepreneurs to ignore how highly misaligned they are.

Counsel should level the playing field.

In this environment: inexperienced founders/management working with highly seasoned third-parties with significant misaligned financial motivations, founders/management have to rely on trusted advisors to level the playing field; to ensure that their inexperience is not leveraged unfairly to their detriment.

Without question, one of, if not “the” core advisor that startups turn to for leveling the playing field in interacting with highly seasoned investors, particularly at early stage, is Company Counsel; the lawyers hired to represent the company. Startup lawyers have a front-row seat to deals/activities in the market that cover a much broader, and larger, area than any particular investor sees, and they leverage that expertise to help startup teams navigate what, to them, is brand new territory.

Company counsel’s job is not to represent the founders personally – see A Startup Lawyer is Not a Founder’s Lawyer – nor the investors, but the entire company, including all of its stockholders as a whole. The best analogue I can think of is a family therapist, who doesn’t represent the parents or the children, but is looking for the well-being of the family unit. If someone is threatening the well-being of the family (the company), or trying to unfairly dominate it in a counter-productive way, the therapist (company counsel) helps address it. Sidenote: my job really does resemble that of a therapist sometimes.

The best company lawyers combine a “win-win” attitude (grow the pie) with a long-sighted, subtle skepticism over each individual actor’s motivations; monitoring how actions could result in unfairly taking one person’s part of the pie and handing it to someone else. They pay particular attention to how the more powerful and experienced players can, through numerous subtle tactics, take advantage of the most exposed and inexperienced stockholders on the cap table (early common stockholders, typically).

Many startup lawyers are “captive” to institutional investors.

So the founders-investor relationship is inherently imbalanced in favor of the seasoned, experienced investors at the table, and company counsel is supposed to play a strong role in correcting the imbalance. Clearly then, any factors that raise doubts as to the independence of company counsel; factors that might make him/her ‘captive’ to the interests of the money at the table, are cause for serious concern.

In “Why Founders Don’t Trust Startup Lawyers” I described how the business development practices of certain startup/vc lawyers give companies every reason to be worried that their company counsel is inherently incapable of providing that ‘balance’ that they are supposed to rely on. Many lawyers know that if they can win a relationship with a VC fund or accelerator, that relationship can be worth dozens of deals/clients to them in a manner of just a few years; far far more efficient biz dev than going after companies one by one. So building economic ties with those investors becomes a major source of business for lawyers, including lawyers who act as company counsel.

I don’t waste any breathe or time trying to actually convince anyone that this scenario is a serious conflict of interest problem; certainly not lawyers. See the Upton Sinclair quote above. I simply explain to founders/management in very clear terms how things in fact work, and let smart people arrive at their own conclusions. Sunshine is a great disinfectant.

Chess: Losing the negotiation before it starts.

Negotiation strategy and psychology is a fascinating area to study. Winning a negotiation and getting what you want in a deal is, to those who are observant, an intricate game of human behavioral chess. To get what I want, I could simply negotiate very aggressively at the negotiation table. That can work. But there’s a cost to it. It spends social capital that I’d prefer to keep. I come off as overly self-interested, when as a long-term player I’d prefer to be seen as a friendly, trustworthy guy; in line my PR/marketing efforts.

A much more effective strategy is to win by preventing the negotiation altogether. A simple checkers player wins by brute force negotiation. But a ‘chess player’ in business wins by controlling the environment of the negotiation, and the people involved, and in many cases preventing negotiation entirely. Ensure companies are using my preferred lawyers, swell guys that they are, and who I know won’t step out of line with the financial ties I have on them. Then deliver an (air quotes) “standard” term sheet. The founders then take that term sheet to those lawyers, maybe there’s a little back-and-forth for good measure, and we move forward, with ‘our guys’ on the inside long-term.

By convincing founders/management to use captive company counsel, investors can get what they want – both in a financing and long-term – without even having to negotiate much for it. When requesting certain terms, making certain decisions, or engaging in certain behaviors, independent company counsel will properly advise the team on how to respond or defend themselves; but captive counsel will just say it’s all normal and standard, lest he anger the people really funding his salary.

I know some people will try to stop me right there. I’m being overly cynical here, they’d say. This is just how the business works. Surely no serious investor would actually use their influence over company counsel to push things unfairly in their favor.

Oh really? Many VC lawyers, including myself personally, have observed situations in which a negotiation is not going in the direction an investor would like, and off-the-record phone calls to company counsel get made. “We’re hoping to preserve our long-term relationship here, beyond just one deal.” “Our fund is actively seeking firms to partner with long-term.” “If this deal goes *as hoped*, we’d love to explore other opportunities to work together.” To a lawyer who plays both sides of the table, you are one deal, while a VC fund’s “favor” can mean many, many deals. Don’t delude yourself into thinking that favor is free.

I am happy to have a discussion about the issues I bring up here, and to be clear, there are many well-respected investors who respect the appropriate boundaries. But please don’t try to feed me or companies candy-coated bullshit about the angelic “professionalism” of business parties when 7, 8, 9 figures are on the line, and a few easy phone calls and veiled threats (or bribes) can ensure they stay in the ‘right place.’ If your investors would never make those phone calls, then there shouldn’t be a problem with selecting company counsel with which they can’t make those phone calls. When you respond to investors that, while you appreciate their recommendations, you prefer to select your own independent company counsel, a common response is that you are perhaps not being “trusting” enough, or too “adversarial.” There is no tension between being a friendly, “win-win” person in the business world, while insisting that your backside is covered with trustworthy advisors. Anyone claiming otherwise is simply trying to disarm you, with “friendliness” as an excuse for adopting a strategy that gives them substantial power.

I’ve lost count of how many common stockholders have told me that they closed a so-called “standard” deal, and with a very light review of their history any independent lawyer can identify numerous terms and actions they’ve taken that were hardly “standard” in many meaningful sense of the word, but they were sold as “standard” to the inexperienced common stockholders by lawyers and investors taking advantage of their inexperience. See: The Problem with “standard” term sheets. Convincing entrepreneurs that closing fast and signing so-called “standard” terms is in their best interests (often claiming it “saves” fees and time) has become a dominant strategy for sophisticated repeat players to get their way, while appearing to be generous.

Cost control as sleight-of-hand.

Notice the subtleness in how certain investors (including some blogs) talk about lawyers and legal fees. Why can’t we just close a deal for a few thousand dollars? This stuff has become so standard, let’s just keep the negotiations “between the business parties” and close this thing quickly.

Yes, let’s move fast (read: not discuss the terms much) and keep it “between the business parties”; where one side is inexperienced and doing it for the first time, and the other side has done it 50 times. That’ll keep it “fair.”

We’re negotiating and discussing transactions where even small changes could mean millions of dollars in one pocket or another, but let’s “control the legal fees” to save $10-20K right now. Yeah, gotta watch the legal budget. Really appreciate your (air quotes) “concern” there, champ.

If you are building a company on a trajectory to be worth at least a comfortably 8 or 9-figure exit (which if you are talking to serious tech investors, you are), the idea that you should minimize time spent working with counsel, because it’s all just boilerplate and you’re better off keeping the legal fees for something more valuable, is a mirage set up to keep teams ignorant of what they’re getting into, and how they can properly navigate it. Telling a company “don’t ask your lawyers about this” sounds suspicious. “Let’s save some legal fees” sounds much better. But there’s no difference. You are being played.

Balanced, but also competent.

Stepping back a bit, it’s important to also clarify what I am not saying in this post. I am not saying that investors and other stakeholders in a company should not have an interest in ensuring that company counsel is competent and trustworthy. Founders do occasionally engage lawyers, typically for affordability reasons, that simply do not understand the market norms of venture capital financing. Using those types of lawyers ends up being a disaster, because they will slow down deals and offer all kinds of comments that aren’t about ensuring fairness and balance, but are simply the result of their not knowing how these types of deals get done. That will drive the legal bill through the roof, with little benefit.

Company counsel should have strong experience in venture capital deals. Sometimes when investors request a change in company counsel, they have valid concerns about that counsel’s competence. Assess the merits of those concerns. However, it is one thing for your investors to say “this lawyer won’t work,” and then leave it to the company to find new, independent counsel. It is a completely different, and far more questionable, thing for them to insist that you use their preferred lawyer.

Avoiding captive counsel.

Here are a few simple questions to ask a set of lawyers to ensure they can be relied upon as company counsel to fairly represent a VC-backed company, particularly one with inexperienced founders:

What venture funds / investor funds do you personally (the lawyer you’re directly working with) represent as investor counsel, and how many deals have you done in the past 3 years for them?
What about your law firm generally? (for very large firms, this is less important)
How many of your firm’s clients are portfolio companies of X fund, and how did you become connected to those companies? May I reach out to some of those companies’ early common stockholders to confirm?
Can I get your commitment to not pursue investor-side work for X fund while you are our company counsel, and to not pursue a referral relationship with them?
Are there any other financial ties to VC funds that would potentially compromise your ability to represent and advise us fully in negotiating with those VCs?

Larger ecosystems and larger law firms are generally less prone to this problem, because it is harder for individual players to really throw their weight around as a percentage of a larger firm’s revenue. That is to say, if the lawyer you’re working with doesn’t personally represent/rely upon X fund, but some other lawyer in the large law firm does, it’s less likely that company counsel can be “squeezed” (pressured into not fully advising/negotiating) by the money. Although even in Silicon Valley and NYC BigLaw I’ve seen situations in which a fund will ‘nudge’ a set of founders to their preferred partner at a large firm. 100% captive.

In smaller firms, which are significantly more exposed to this problem due to their size, you’ll sometimes find that a single fund accounts for a massive percentage of that firm’s pipeline revenue. Those lawyers will slap their mothers if the fund asks them to, and companies are wise to avoid using them as company counsel.

The costs to companies of having captive counsel can be severe. Rushed, unfair sales because a particular fund’s LPs suddenly decided they need liquidity. Refusals to pursue other potential investors because the ‘right’ term sheet from ‘friendly’ investors has been delivered. Executive changes installing ‘friendly’ new management without an objective recruiting or vetting process. Early firing of founders without reasonable opportunities for coaching. The list goes on.

This is not theoretical. When company counsel is captive, their passivity will allow the preferences of a portion of the cap table to dictate the trajectory of the entire company, without the checks and balances that a properly governed company should have. And yet the sad fact is that inexperienced founders often don’t even have the frame of reference to know it is happening, or that it wasn’t supposed to happen that way. Many just assume, wrongly, that “this is how these things work,” when really that’s only how it works when you hire advisors who can’t, no matter how much they protest basic facts of human behavior, be objective.

“Don’t just go with the lawyer that the VCs insist upon. These lawyers will work with the VC on a hundred financings and with you on only one. Where do you think their loyalties lie? Get your own lawyer, and don’t budge.” – Naval Ravikant, Lawyers or Insurance Salesman?

This issue is not about labeling one group of market players as ‘good’ and the other as ‘bad.’ Hardly. There are many, many investors in the market who are phenomenal people with deep ethics. They should have nothing to worry about in ensuring their portfolio companies hire competent, independent counsel. And the best companies always maintain transparent, friendly relationships with their investors. It’s the investors who act deeply concerned when you communicate a preference for hiring independent company counsel – who can objectively represent the common stock without being incentivized to rush negotiation or condone nonsensical “standards” desired by the money across the table – that are signaling their reliance on a strategy of leveraging entrepreneurs’ inexperience against them.

This issue is about acknowledging that no one in any tech ecosystem has more “skin” in a company – financially or emotionally – than first-time entrepreneurs and their earliest employees – not even close. And yet at the same time, their inexperience means that their closest advisors play an outsized role in helping them navigate the various relationships and risks that they are exposed to. Pushing startups to use their investors’ preferred lawyers as company counsel is, plainly, an unjustifiable mechanism of control; one that anyone who supports entrepreneurship and tech “ecosystems” should not tolerate.

People with far more experience and power than tech entrepreneurs will demand that their company counsel be independent and objective, because the fairest outcomes result when everyone at the table is well-advised. Ignore all attempts to argue the contrary. Founders should demand the exact same for their companies.

Protect Your Angel Investors

Background Reading:

A lot of writing, including my own, breaks the world of startup funding “players” into 2 broad categories: founders and investors. While that is helpful, it’s also important for founders to understand that within the investor category, there’s an important distinction between angel investors and institutional investors; in terms of incentives, behavior, and their overall relationship with the company.

Institutional investors are sophisticated (… usually), repeat players who are working with large amounts of other people’s money; and those other people expect (demand) great returns. They have their own lawyers (and therefore usually negotiate harder), have much deeper pockets, and usually invest much later in the game than true angels; when the company is a much more attractive investment from a risk-adjusted perspective.

Angel Investment: faster, easier, but more exposed.

Angel investors are investing their own money. Seed funds / angel groups do work with a broader pool of money, but they are more accurately described as an organized group of angels than a true institutional fund. Angels often do not utilize their own lawyers in executing deals (because the check sizes don’t justify it), which means they rely more on trust in the team, and on standardized, more lenient terms. Their money goes in much earlier in the stage of the company, so at a point where the company is much riskier. Angels are accurately described as betting as much on a founder team as they are on the business. Prominent angels also regularly serve as “social proof” for gaining the interest of VC funds.

Because angels invest much earlier in a company (than VCs), usually without lawyers, and usually on standard documents with minimal investor protections, their relationship with founders/management is often much more informal and trusting, and less about “the numbers,” than the founder-VC fund relationship. Accelerators usually also fall in the same category. This is all very much a good thing. It’s what allows seed investments to move quickly, at a time where the company doesn’t need or want to spend a lot of hours going back and forth on deal nuances when they could be building the foundation of the business. But it also means that angel investors are exposed to gaming by later investors (or, sometimes, bad actor founders) who take advantage of key inflection points to push the angels’ investment away from the “deal” they thought they were going to get.

The broad context in which this happens is fairly simple: an angel round has been closed for a while – usually convertible notes or SAFEs, but sometimes seed equity – and the company is raising a Series A. After negotiation and modeling, the parties have not aligned on numbers. The VC doesn’t like the terms that the angels are ‘getting’ in the round (from their notes/SAFEs), because after accounting for his own share, too much of the cap table is taken. So he makes his check contingent on the founders going back to their angels and convincing them to accept modified terms.

The angels, not happy about it, are exposed because their money is already sunk, and much worse things could happen if the deal dies. So they cave; accepting worse terms so that, effectively, the new money can get better ones. Requiring earlier seed money to raise their valuation caps is a common way to make lower Series A valuations more swallowable.

But to be totally honest here, sometimes the gaming is not led by the VCs, but by the founders. They see what the angels are getting in the deal, and might collude with the new money to force a change. I’ve never had one of my personal clients play that sort of game, but I have seen it happen.

There are situations, of course, in which terms simply need to be re-negotiated; usually because the company’s path took a number of unexpected negative turns, and things just won’t work if a reset doesn’t happen. Those situations should be distinguished from the ones in which a deal really can close, but someone is just using the exposure of angels to get more of the pie.

Reputation is capital. Don’t waste it.

The job of company counsel is not to do whatever founders / management want; it’s to advise on what is best for the company and all of its stockholders long-term. On a whole host of issues, people who’ve seen the life cycles of companies play out over time (like VC lawyers) can bring a long-term perspective that a fresh team may not understand intuitively.

My advice to founders, which I put down in Burned Relationships Burn Down Companies, is that relationships matter. A lot. Especially with your early money, which often acts both as your cheerleaders in the market, and as a safety net if things get rough. Putting aside the purely ethical aspects of gaming angel investors (which are important, mind you), burning your early investors is bad for the company. It’s also just bad for founders personally, whose relationships can mean a soft landing if their company fails, or support for their next venture.

As a startup and new team, you don’t have buckets of money, or a rock-solid reputation, to insulate you from everything that can go wrong with a company. Your reputation and social capital are some of your most valuable assets; don’t waste them. If anyone is asking you to hurt your social capital, stand your ground. They’re asking you to incur a cost, but for their benefit.

In fact, real chess players sometimes want to burn your other relationships, because it reduces your optionality, which increases their leverage. Always think multiple steps ahead.

Pro-rata rights are core economics.

And on a final note, it’s important for founders to understand that when angel/seed funds request “pro rata rights” for future rounds, those rights are not a nice-to-have that is independent from the economics of their existing investment. Successful angel investment depends on the ability to double down on winners (put in additional investment), because the vast majority of an angel’s investments are losers. That’s the core economics of angel investment. If you deny angels their pro-rata in a Series A, you are taking away a part of their deal that allowed them to invest in you in the first place. The long-term consequences for a company and a founder team are usually not worth the near-term benefit.

Founder Education

TL;DR: Accelerators have emerged as elite universities of sorts for tech entrepreneurs. But they offer a bundled value proposition at a price (in terms of time and equity) that doesn’t work for everyone. For those teams in need of just the educational aspects of an accelerator, other (quality, but lower cost) offerings are starting to be developed that should be considered.

I’m a huge proponent of curation and leveraging the knowledge of trustworthy domain experts to avoid burning time; time that could otherwise be spent running a company.

The value of curation in the lives of founders is perhaps reflected best, above all else, in the rise of accelerators. Accelerators’ core value proposition to founders is that, in exchange for (i) several weeks of their time, (ii) an equity stake, and (iii) rights to invest in future investment rounds, founders in accelerators gain virtually immediate access to significantly curated resources: investors, mentors, other founder teams, prime office space, educational content, etc.

And on the flip side, great accelerators are able to attract quality resources by promising the people who provide those resources access to a curated set of startups; saving them time from having to sort them out in the general marketplace.

Of course, the value of those resources and their curation varies wildly depending on the quality of the accelerator. Top accelerators have proven invaluable to many young, inexperienced founder teams who’ve saved countless time searching, networking, vetting, etc. by tapping into an accelerator’s network and resources. Lower quality accelerators, however, are often a time suck, and much like the “Top Startups to Watch” lists we all see get thrown around, can serve as a damaging and distracting vanity metric.

But as much of a fan as I am of great accelerators, the reality remains that accelerators offer a bundled value proposition. And not every founder team needs, or is willing to ‘pay’ for, the entire bundle. Some founders have already arrived at a successful business model showing strong traction, and are good in the advisor department, but just need connections to Series A investors. Other teams are well-funded, and already have their own office space, but could really use some guidance on the ‘fundamentals’ of recruiting, managing a scaling company, etc. It shouldn’t surprise anyone if resources are developed in startup ecosystems to address these types of companies for which a typical accelerator isn’t the right fit.

Every now and then I use SHL to spread awareness about new resources in the market that I feel are really adding something differentiated and high value for founders relative to what’s currently available. Years ago I wrote about Clerky and how it filled a void in the market of startups that just need a super-fast, totally standard incorporation and corporate organization, and due to capital constraints are willing to go through it without a lawyer. I also wrote about how eShares was using a SaaS model to liberate early-stage startups form burning money on 409A valuations. I later wrote about how services like Bad Ass Advisors can help companies connect with specialized advisors/mentors beyond the limited roster of people available in their local market.

Today, I’m writing about another topic: Founder Education; meaning how founders can get access to the wisdom/pattern recognition of people who’ve observed dozens, or even hundreds, of startups. It includes best practices on topics like starting a company, finding advisors, finding product-market fit, using advisors, compensating people with equity, targeting investors, understanding metrics, building sales/distribution channels, etc. etc. Books and blogs are great, but they can only go so far, and sorting gold from garbage gets hard. Top accelerators have developed internal curriculums for these sorts of topics, but (remember) they come bundled with a lot of other resources, and at a price, that don’t necessarily work for all companies.

In Austin, I was recently introduced to Founders Academy; an educational curriculum designed for tech founders. It’s run by Gordon Daugherty, a very well-known and respected (including by me, and SHL readers know I’m jaded from experience) startup advisor in Austin who’s had a front seat for some time at one of Austin’s best known accelerators, Capital Factory. Gordon’s built Founders Academy into a packaged, structured curriculum for new tech founders; offered both as a set of online videos that you can buy, and also as an in-person course (taught by Gordon over a few days) that founders can sign up for.

I got some feedback from a few teams that participated in the in-person course, and they all said it was extremely valuable for the price of a few hundred dollars. I’ve reviewed much of the material myself, and have also interacted with Gordon enough, to say that he knows what he’s talking about, and because his background is in Austin / Texas, his curriculum will resonate well with founders operating in markets that aren’t Silicon Valley.

As I’ve written about before on: Bad Advisors: The Problem with Localism, many tech entrepreneurs operating in second and third-tier ecosystems run into a serious problem when they limit their pool of advisors to their city’s geographic boundaries: they get bad (sometimes really bad) advice. Founders Academy, and other programs like it (if you know of them, leave comments please) thankfully help solve that problem by scaling the wisdom of domain experts (advisors who aren’t charlatans) in ways that are more structured and digestible than just blog posts or books.

Education means leveraging the wisdom of others, so you can avoid the mistakes that they made. For tech entrepreneurs who don’t have time or money to waste, the right kind of education is invaluable. And while top accelerators have emerged as the elite universities of the tech startup world, they clearly aren’t for everyone. It’s great to see quality educational resources popping up to fill the void.

p.s. Like Clerky, eShares, and Bad Ass Advisors, I don’t have any ownership interest in Founder Academy. The mention was entirely earned.

Silicon Hills Lawyer

A top-tier Startup Lawyer helps Startups and Founders safely navigate high-stakes legal and financing issues, while keeping VCs honest.

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