Post Category → Tech

Your Startup’s Legal Bill: The Printer & The Cartridge

A client of mine recently used an analogy to explain why he dropped another small, local law firm for MEMN: their printer is cheap, but their cartridges are really expensive.  That statement explains perfectly why many founders, because of their lack of understanding of basic law firm economics, can get really screwed by firms touting their low hourly rates as evidence of their “efficiency.” The core problem is this:

  • In the short term, your legal bill is a two-part equation: hourly rate * time spent. Naturally, that means that a lawyer billing $225/hr can generate a substantially larger bill than a lawyer billing $375/hr if the “cheaper” lawyer takes 3x the time to do the same task as the more “expensive” one.
  • In the long-term, “time spent” is itself a two-part equation: time spent to initially complete the task + time spent fixing mistakes (if the mistake is even fixable).  This should come to no surprise to a CEO who’s spent time interviewing and hiring developers. One developer wants a $60K salary, and the other wants $100k. Is the $60k one a bargain, or overpriced sh**?

The above two points should help make the analogy between printers and lawyers clearer:  a printer can seem like a great deal because the manufacturer locked you in with a low cost of adoption, but you should really pay attention to how much the cartridges cost, and how many you’ll have to use – and whether it flat out sucks. Because that’s where the real expenses are. It’s the exact same thing with lawyers: an exceptionally low hourly rate can seem like a great deal, but how many hours will this ‘bargain’ rate be multiplied by? And what exactly are you getting for that rate?

The “Hourly Rate” Issue

As mentioned above, it is absolutely the case that a lawyer billing $400/hr can produce a dramatically lower legal bill than a lawyer billing $225/hr; meaning that, under the right circumstances, you should be willing to pay more if the value is truly there.  But are there circumstances in which a lower rate does not mean lower quality? Yes, as I discussed in “When the A-Lawyers Break Free: BigLaw 2.0” a lot of clients are shocked to find out that when an attorney at a large firm bills them $675/hr, only maybe 20% (if she’s lucky) of that rate actually makes it to the lawyer (the talent). The rest goes to pay for all the background infrastructure necessary to support a firm full of dozens of different practice groups, offices, summer intern programs, etc.

Thanks to new technology and business models now viable because of that technology, a new breed of law firm is emerging that (unlike their predecessors who attracted attorneys by offering jeans, MacBooks, and a more relaxed atmosphere at the cost of lower compensation) can compensate their attorneys on par with and in many cases better than larger firms.  And those small, focused firms have dramatically lower overhead costs than larger firms. The end result is that, even with significantly lower hourly rates, the attorneys are still highly compensated.  Again, in law as in the world of developers, you get the talent you pay for.

Nutshell: make sure your hourly rate pays for legal talent, not an outdated delivery model.

The “Time Spent” Issue: The Problem with Generalists and Solo Lawyers

Moving to the second part of the equation: what allows a lawyer or law firm to do something more quickly, and with fewer mistakes, than another firm?  The first and most obvious answer is of course: better lawyers (and paralegals). No shocker there. Better, more experienced doctors work more efficiently and with fewer mistakes than crappier ones.  But there’s actually more nuance here than meets the eye.

Focus

You’ve developed a strange rash on your arm, and you need someone to help you treat it. Who do you suppose will be able to get it done more efficiently and effectively – a cardiologist or a dermatologist? It seems like a stupid question, but many people don’t understand the concept of legal specialization.  Focused repetition leads to specialized domain knowledge, which leads to higher quality and efficiency.

There are an endless number of business lawyers, corporate lawyers, even IP lawyers, running around touting themselves as startup lawyers. The reality is that they’ve spent 95% of their careers doing absolutely nothing related to the venture-backed startup space, but because they either stayed at a holiday inn express or because they know someone connected to startups, they’ve started to dabble in the area. How complicated could it really be? I’ll keep my answer short: get ready to be schooled.

Process and Technology

Being a generalist forces you to reinvent the wheel when specialists have already-developed forms, processes, and technology in place to minimize time burn.  A new client of MEMN recently said a prior firm charged $1700 to draft a form contract for hiring developers (which, btw, was garbage).  The startup lawyers who just read that are laughing because they know that a client who asks them for that kind of document gets billed literally 5% of that, if anything at all.

Process and technology are at the core of why the hourly rate of a law firm or lawyer says very little about what you’ll end up paying.  I’ve seen solo lawyers and boutique firms talk about “overhead” as if it’s something to be absolutely kept to a minimum at all costs.  The problem, of course, is that if you don’t invest in technology, knowledge management resources, etc., it is 100% certain that you are going to be incredibly slow and inefficient compared to those firms who do, even if those firms have higher hourly rates.  This is the core problem with solo lawyers.  Yes, their hourly rate is low, but they practice like it’s 1995. And that’s expensive.

While we’ve done everything we can at MEMN to cut out fat and bloat, I have zero qualms about investing in technology that will enhance quality and efficiency. That’s not “overhead.” It’s called running a 21st-century business.  We also have an amazing espresso machine. Treat your talent well.

Conclusion: When you hire talent for your own startup, you don’t immediately go with the person asking for the lowest hourly rate. If you do, you’re a moron. Remember that lawyers and law firms are like printers (and developers).  What looks cheap could end up being the most expensive mistake of your life.

409A as a Service: Cash Cows Get Slaughtered

Background: 409A is a set of tax rules passed, in part, to stop companies from avoiding taxes through issuing underpriced (cheap) equity as compensation.  While well-intentioned, it spawned a cottage industry of third-party valuation firms/i-bankers who charge companies, including startups, thousands (sometimes tens-of-thousands) of dollars to get ‘409A valuations’ for their stock to avoid tax penalties in setting their stock’s Fair Market Value.

Anyone who deals with 409A valuations on a regular basis knows that they are the quintessential ‘cash cow’ for valuation firms and small i-bankers; evidenced by the number of those firms that are constantly inviting lawyers and influential tech players out to lunch in order to get referrals (btw, sorry guys, I’m blogging right now). And if they’ve dug a little deeper, they’ve found that, particularly at the early stage, these valuations are generated in an almost entirely automated fashion. Hence, cash cows: premium price, lots of hand-waiving to make them seem difficult to produce, but ultimately with a low marginal cost.

The Necessary Evil

In practice, startups have been advised by lawyers and their advisors to avoid a 409A valuation until a Series A. Pre-Series A there’s usually not much on the balance sheet and no arms-length price on the Company’s equity to generate a meaningful valuation, so startups just wing it.  Post Series A, however, the vast majority of startups pony up $3-10k to get their valuation, and it has to be refreshed (i) every 12 months, (ii) if there’s a material change in the startup’s financials, or (iii) if a new equity round is done; otherwise it goes ‘stale’ and no longer provides a safe harbor on FMV.

That can get expensive quickly, though any serious company looking to get acquired by a large company or eventually go public knows that the consequences of not doing this can be substantially more expensive.

409A-as-a-Service: The Slaughtering

Finally, eShares (the paperless stock certificate and capitalization tracking company) has pulled off something brilliant: 409A as a Service. Priced as a continuous service (which makes total sense given the on-going need for re-doing a valuation) and supported by well-known and established valuation firms, startups get continuous 409A valuation services at a monthly fee: $159/mo for a post-Series A startup – higher for later stage.

Doing the math, that’s $1,908/yr: easily a 40-50% discount on even the most ‘sweetheart’ deals offered by local valuation firms for post-Series A startups. If you need a refresh within a year, you’re in 90%+ discount territory. Add in the fact that (i) it’s done paperlessly via the web, and (ii) the valuation will be updated for major changes in capitalization or financials (no huge cost to avoid going stale), and we have ourselves a game-changer.

The pricing for Series B, Series C+ valuations is even more competitive relative to market rates for 409A services.  It’s also a brilliant feature for eShares because of how it ties in directly with their existing capitalization tracking platform.

Something tells me that this slaughtered cash cow is going to net eShares and Preferred Return a lot of steak dinners in the future.  The cottage i-bankers who’ve built practices off of milking 409A as much as possible? Not so much. The better i-bankers of course do higher-value things that justify their costs, so they have nothing to worry about. Yes, there are serious parallels to startup law here.

Nutshell:  Startups historically had to pay $3-10k for a valuation after closing a Series A in order to protect themselves from 409A issues, and they had to keep re-paying it on an on-going basis to keep it from going stale.  eShares has changed all of that by offering 409A valuations as a continuous service (as they should be) and pricing them in a manner that aligns more closely with what it costs to produce them.  Cash cows, particularly when visible to techies who like to disrupt things, eventually get slaughtered.

p.s. Like all of the other tools I recommend to startups for saving their capital, I have no financial interest in eShares.

The Economic Deflation of Startup Law

News.  Two big issues have been floating around the startup law space lately. First, Yokum Taku introduced “convertible equity” in an attempt to address the potential downsides (for entrepreneurs) of convertible debt, which set off a debate that Antone Johnson spectacularly Storified. More interesting to me, however, was AngelList’s announcement that seed rounds can now be closed, soup-to-nuts, on their platform.  The real news there, for lawyers at least, is that Wilson Sonsini will close those rounds for free.  Yes, as in nothing.

Startup Law – Deflation Accelerating

Much has been written about the “deflationary economics” concerning startups and the web, with Mark Suster’s post probably being one of the best articulations that come to mind.  Not as much has been written about the indirect effects that industries experiencing economic deflation can have on other sectors they interact with.  Wilson Sonsini’s AngelList pronouncement is, in my opinion, the clearest sign that the portion of the legal sector working with technology startups is itself experiencing rapid deflation — and not because lawyers have suddenly shed their luddite tendencies and read ‘The Innovator’s Dilemma’ (though they should).

What’s happened, essentially, is that with literally every other service used by their clients becoming radically cheaper, and the resulting downsizing of investment rounds, startup lawyers simply couldn’t maintain their usual fees and keep a straight face.  This deflation started out with what you might call Stage 1 deflation, with standardized docs emerging, fixed fee packages, etc.  Startup Law was just efficient at this stage, especially compared to other areas of the law.  But with free, dynamically generated documents from high-end firms available online, and now with one of the best firms in the country saying they will close seed rounds for free, I’d say its reached Stage 2, where commoditized is the more appropriate adjective.  And I’d argue that this has some serious implications going forward.

How We Got Here

First, it’s worth reflecting on the different steps that startup law firms have been (or should be) taking in order to compete in this deflationary environment.  I’d break those steps into 3 categories: contractual, technological, and operational.  These steps could also serve as a model for other parts of the legal field that, while not as aggressively deflationary as startup law, will likely eventually follow a similar path.

Contractual. 

  • Standard Firm Docs – In order to make contract drafting more efficient, firms started modularizing the language of their own documents.  If an investor gets a 1x participating liquidation preference with a 3x cap as opposed to the 1x non-participating currently in the document, ‘drafting’ involves mostly cutting and pasting bracketed language, with minimal tinkering.  While this cut down on internal drafting, it still left room for bickering about language with the other side of the deal.
  • Universal Standard Docs – Going one step further, standardized investor docs like the Series AA and the NVCA Model docs emerged, allowing for parties on both sides to have a common language framework to work from.

Technological.

The contractual efficiencies developed in startup law still required the usual process of opening a word document, filling in blanks, moving around language in a very straight-line fashion, and then proofing to make sure everything is coherent.  Closing required creating signature packets, then tracking signatures and assembling them back into fully executed copies.  But then technology emerged to streamline a lot of this process.

  • Proofing Software – A significant amount of time on a transaction used to be spent by junior attorneys flipping through pages to make sure names are properly spelled, commas are in the right place, and defined terms are properly in place.  Software like Deal Proof emerged that can scan a document and generate a proofing list for an attorney, cutting down on that proofing time by anywhere from (my estimate) 50-75%.
  • Document Automation – Companies like Brightleaf have emerged to turn the cut-paste-and-proof process of working with form docs into one of simply clicking certain options in a form.  Want that 1x participating LP w/ 3X Cap? Just click the right box in your template, and the language will get filled-in automatically, and every other area of the document that is impacted will also be modified. No need to proof.
  • Electronic Closing.  –  With multiple parties often signing dozens of documents, the usual closing process involved creating “signature packets” where you PDF’ed the signature pages of each contract, and created single files containing all the pages that each individual party had to sign.  Without doing this, mistakes would be inevitable.  With electronic signature software like Docusign, this process is largely removed.  Put the ‘Sign Here’ tabs for each person in the appropriate places, and Docusign will (1) guide them to where they need to sign, and (2) generate fully executed documents.

Operational.

One obvious end-result of the contractual and technological developments has been that drafting simply takes a lot less time, which naturally means less money billed.  But what they’ve also done is made the drafting and closing process a lot simpler.  To modify a vesting schedule or a liquidation preference, you don’t really need to understand the actual mechanics of the language. Just click the box.  And to get a deal signed up, you don’t need to create complicated signature packets and coordinate signatures.  Just drop the Docusign tags in the right place, and it’ll do the rest.

Firms have taken advantage of this simplicity by pushing work down to junior attorneys and even paralegals, who bill a lot less per hour.  Where it might have previously required an experienced attorney to draft and close a seed financing, an innovative firm might have a paralegal do 95% of the work, with zero drop in quality.  A partner or senior attorney might spend a few minutes discussing very high-level issues with the client, but that’s it.

The Next Step: Deal Platforms

I have zero doubt that Wilson Sonsini is taking advantage of all three of the above categories.  But the key to really get the kind of deflation reflected in the free AngelList closings is the next step of legal technology: Deal Platforms.  Rather than just the initial drafting of docs being automated, with negotiation over terms and language to follow, the automation becomes bilateral.  If the investor wants a better liquidation preference, he simply fills in a field or checks a different box, and if the Company disagrees, they uncheck that box.

Contract language becomes completely secondary – commoditized – on a deal platform.  One can easily envision a time in which the negotiation of a full venture deal, not just a convertible note financing, involves nothing more than checking boxes and filling in a few fields, with full documents automatically generated and then electronically signed.  The chances of closing such a deal for free are practically zero, but all that automation could make a ~$10K legal bill for a full institutional venture capital financing a reality, which would be about a 50-80% cut on current rates.

Takehome: Nobody should be myopic enough to expect AngelList-like automation to stop at the seed deal stage.  Again, The Innovator’s Dilemma, legal version.  See below from AngelList’s Q&A.

Does Docs support Series A rounds?

No. Docs only supports seed rounds right now. (emphasis added)

Implications: Freemium Startup Law

There are a number of ways that this rapid deflation has and likely will impact the structure of startup law practices.  One result of the already-occurring deflation has been the growth of boutique firms competing with BigLaw by offering similar, albeit more limited, services at lower billable rates.  I wrote about this previously: ‘In Startup Law, Big Can Be Beautiful.‘

The economic advantage of a boutique practice is that firms can avoid the high billable rates necessary to sustain the breadth and overhead of large law firms, while still offering their experienced attorneys comfortable salaries.  That works well in an environment where the demand is for cheaper seed financings and venture deals. But what happens when free or practically free becomes the dominant expectation?

Cross-subsidize.  As Wilson Sonsini’s move has made absolutely clear, large firms have their own economic advantage with respect to legal fees: cross-subsidizing low-end work with profits from larger deals.  Large firms don’t just handle formations, seed financings, and venture deals, they also handle cash cow M&A and IPO transactions that are not experiencing anywhere near the kind of deflation going on at the low end.  Those deep pockets make offering free startup work a lot easier, provided enough of the loss-leaders generate big deals down the pipeline.

This model of offering a lot of stuff for free and profiting off of the high-end users should look very familiar to techies: it’s the freemium model, applied to law.  And it distinctly favors large, brand-name firms.  Boutique firms lack the institutional capacity to handle the large transactions that a larger firm can use to cross-subsidize free work.  Without more radical change, their only hope is to make up for deflation with volume.  But [insert large number] * free doesn’t pay the bills.  Commoditized deal work favors the cross-subsidization of large firms over the lower labor costs of boutique practices.

Conclusion: Move Fast, Move Up, or Move Out

At this point (when deal platforms become ubiquitous), I see smaller startup law practices having to either (A) get used to operating at much lower margins, or (B) find a way to move up-market and take a piece of the larger deals.  I wrote previously about the possibility of boutiques using technology to scale for large transactions here: The Ad-hoc Law Firm? Granted, I don’t have much visibility into how boutique practices are doing, though I’d love to hear from other attorneys or knowledgeable people on how they see the future panning out.

As for large firms operating in this space, the choice is much more straight-forward: either become radically efficient with your commoditized startup work in order to keep the pipeline flowing, or get out.  I’ve seen firms here in Austin completely exit startup work for exactly this reason.  Thankfully, we’re going with the other option.

Post-script (years later): AngelList’s experiment failed, and no “deal platforms” have emerged. Why? Flexibility and coordination. The diversity of options for even early-stage rounds, and their different appropriateness depending on context, makes full standardization and automation an impossibility. And the subjective preferences of various investors (and companies) also serves as significant resistance. Automation and flexibility are fundamental tradeoffs, and the market has chosen flexibility for high-stakes deals.

Legal Startups: All Chasm, No Revenue

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

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

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

Here’s my comment to Ken’s post:

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

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

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

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

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

Startup Law Hack: Get to Know Your Associate

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

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

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

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

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