Post Category → Venture Capital

Startups Scale. Solo Lawyers Don’t.

TL;DR: Freelancer marketplaces push solo lawyers as a way to keep legal costs down for startups.  But what they’re marketing is very different from what they actually deliver. Solo lawyers often can’t scale, and lack specialization. For high-growth startups, that is a big problem.

Background Reading:

In the landscape of options for getting legal covered for a tech company, there are generally speaking three types of providers, in order of largest to smallest: (i) BigLaw, (ii) Boutique firms, and (iii) Solo lawyers.  I’ve written quite a bit about the comparison between (i) and (ii), but this post is mostly about (iii).

Overhead

“Overhead” is a term often used to refer to everything that a lawyer’s rate has built into it that doesn’t directly go into compensation. Very large firms (BigLaw) have significant amounts of “overhead”; only about 20-25% of the $650/hr you pay for a top-tier BigLaw senior non-partner actually goes into her pocket.

But it’s far too simplistic to assume that all those resources are simply being burned for no reason. Large, fast-moving, complex transactions require collaboration among lots of different kinds of legal professionals, including different kinds of specialties of lawyers, paralegals, legal assistants, legal technology providers, etc. For the very top end of the market, good arguments can be made that the “overhead” of large, international firms is actually quite necessary. The idea that a bunch of freelancer lawyers/legal professionals could just team up to get a billion-dollar merger done efficiently and on-time is little short of delusional.

Boutique firms are the market’s response, enabled in part by new low-cost technology and infrastructure, to BigLaw’s overhead. Those deal lawyers who don’t cater to, and aren’t pursuing, the Ubers and Facebooks of the world, are acknowledging that while they do need institutional resources (overhead) to create strong teams that can close meaningful deals, those institutional resources don’t need to eat up more than half of revenue; certainly not with today’s technology. A $100MM acquisition, or even in many cases a $10MM financing, is sufficiently complex and fast-moving that, again, you are delusional if you think a bunch of freelancers working independently are going to get it done effectively; but a small integrated team of affiliated lawyers, or even a handful of boutique firms, can easily get it done outside of a 1,000 lawyer firm with offices on multiple continents.

Solo lawyers are on the opposite end of the overhead spectrum. They are the freelancers of the legal world. Their ‘overhead’ amounts to maybe a few SaaS subscriptions and a computer. E/N’s specialist network, in fact, has a fair amount of solo lawyers in various legal specialties. Their rates are naturally lower than lawyers in large or even small firms, due in part to overhead. You might conclude – and there are definitely solo lawyer marketplaces out there trying to drive this conclusion – that every early-stage startup should obviously be using solo lawyers, because they’re “cheaper.” But this overlooks certain key facts about the nature of startups, and about legal services, that call for a reality check.

Legal bills don’t correlate completely with hourly rates.

It’s not that complicated to understand that a well-structured team of lawyers billing $425/hr can easily produce a lower legal bill than independent solo lawyers billing at $275 if they have the right institutional resources – technology, team, knowledge, process (“overhead”) – in place. They’re also often supported by junior professionals/non-lawyers with dramatically lower rates to cover routine items. At very early stage, some of the legal tasks that startups need actually require very little lawyer involvement at all if the right infrastructure (‘overhead’) is in place. If you assume solo means cheaper, you’re often wrong.

Specialization drives efficiency.

What is a “startup lawyer”? That will take too long to fully explain in this post, but I can tell you what it’s not: a litigator, a small business lawyer, a generalist who dabbles in a little estate planning, real estate, and a few seed financings on the side, or a generalist corporate lawyer. I’ve been shocked by how many of these solo lawyer websites market lawyers as “startup lawyers” when they clearly, from their own bio descriptions, are nothing of the sort. Similar to the first point above, a lawyer at $425/hr who has done a project 50 times will be dramatically more efficient at it than someone at $275 who has done it once.

This is not rocket science. Smart founders know that developers with higher salaries often get far more done than 10 developers at lower salaries. The talent market dynamics of lawyers are not that different from those of developers.

In a talent market, the cheap guy is usually cheap for a reason.

In an industry where results are driven by human, not just institutional, capital, you simply cannot hire whoever walks in the door and train them to produce A-level service; no matter how fantastic your resources are. As elitist as it may sound, most lawyers on the market simply lack the capacity and knowledge to correctly manage and close complex legal work. They may be very well suited for certain areas, but the moment you leave the minors and start playing in the majors, everything goes off the rails.

Serious talent requires serious compensation, which sets a floor on hourly rates; regardless of overhead. If that is too difficult to understand, good luck in business. It can be (and is) simultaneously true that the legal market is flooded with under-employed lawyers willing to discount and jump through hoops for work, and yet great lawyers who can manage and navigate specialized complexity/scale are in very high demand and short supply. 

Fast growth requires scalability. Switching lawyers is costly.

A startup can go from 2 founders needing to just incorporate to needing fast VC, employment law, tax, licensing, etc. support in just 1-2 years; sometimes sooner. You’ve got a VC term sheet on the table, 10 equity grants that need to get done in 2 days, a resolution to the issues with the VP you just fired, and assistance finalizing that LOI with the big customer that will help close your round; and you need all of this done this week. Virtually every single startup that has switched to E/N from solo lawyers has had the same universal complaint: they are SLOW.

Of course they’re slow. All that (air quotes) “unnecessary overhead” they cut out to get you that awesome hourly rate is precisely what could’ve funded the institutional resources that ensure legal work keeps moving: a well-trained team to collaborate with, technology (and training for technology) that streamlines unnecessary tasks, non-lawyer professionals to knock out checklist items while the lawyers focus on the big stuff. Scaling companies need legal teams, and max out a solo lawyer very quickly.  If a single solo lawyer happens to peculiarly have all the time in the world, please re-read my comments on talent markets.

And if you think it’s smart to go with the solo who is ‘cheaper’ and then switch quickly to a firm: again, a reality check. Switching lawyers/firms is costly. The new lawyers have to familiarize themselves with what the prior guy did, on forms that they (usually) aren’t familiar with. That takes time, and increases the likelihood of errors. Finding a firm that can scale-down for very early-stage, but then scale up when needed, all using its own forms and resources, is far smarter than taking an iterative approach with your legal team.

In short, the changing legal landscape available to tech companies is being driven very much by technology, and it’s been great not just for entrepreneurs, but also for lawyers looking for alternative platforms to work from.  I’m a big fan of how solo lawyer marketplaces are helping connect demand with supply in areas where the ‘overhead’ of firms really is unnecessary.

But be very careful about buying into any marketing suggesting that there’s this untapped market of great solo “startup lawyers” just waiting to fill your startup’s legal needs at unbelievably low rates.  Solo law works great for small businesses, who don’t scale fast;  and also for certain legal specialties where projects are very compartmentalized. But true startup/vc law requires institutional resources and well-trained, well-coordinated teams of lawyers/non-lawyers. The goal of tech startups is to scale quickly.  But solo lawyers can’t scale at all. That means that solo “startup lawyers” are, at best, a bad fit; and at worst, an oxymoron. 

Pre-Series A Startup Boards

It’s pretty well known that startups usually undergo a meaningful change in Board composition at their Series A round. At a minimum, the lead investor(s) of the round get Board seats; although they shouldn’t get Board control.

Less has been written about what startup boards tend to look like before a Series A round. Given that the time from formation to Series A has stretched out significantly for many companies in the market – due to pre-seed, seed, seed plus, seed premium, series seed, seed platinum diamond, whatever-you-want-to-call-not-Series A rounds. So here’s some info on what a board of directors tends to/should look like Pre-Series A.

A. Know the difference between a ‘Board’ of Advisors and a Board of Directors.

A lot of companies refer to their set of advisors as a ‘Board’ of advisors. That’s fine, even though they very rarely actually act like a board. There (usually) aren’t ‘Board of Advisors’ meetings where everyone gets on a conference call and talks shop. Instead, the company just has a loose set of individual advisors they work with on strategic matters, often in exchange for equity with a vesting schedule. Advisors often times are angel investors as well.

The important point here is that Advisors have no power/control over the company. They just advise. The Board of Directors, however, is the most powerful group of people in the Company, with the ability to hire and fire senior executives and approve (or block) key transactions. Big difference. Giving someone a seat on your Board of Directors is 100x more consequential to the company than naming them an advisor.

B. Know the difference between a Board Observer, Information Rights, and being a member of the Board of Directors.

Most angel investors writing small checks are buying the right to a small portion of the Company, and that’s it. They don’t expect to be very involved in day-to-day, and are happy to just receive whatever e-mail updates the Company intends to send out.

Angels / Seed Funds who write larger checks may want a deeper view into what’s going on in the company. They’ll often ask for different variants of ‘information rights’ – which can include delivery of regular financials, and notification of major transactions (like financings).

A step up from ‘information rights’ is a Board observer right. This means the investor has the right to observe everything that happens at the Board level, which includes hiring people, equity grants, approving major deals, etc. Do not dish out Board observer rights lightly. Having too many observers can make it difficult to keep confidential matters from being leaked to the market. It also can just be logistically cumbersome for a seed stage company to keep track of who gets to attend meetings, who has to be notified of what, etc.

Also, if you do give someone a Board observer right, ensure that it’s clear that they are a silent observer. This means that they can listen in on Board discussions, but they are not entitled to provide their thoughts/input, which can have legal ramifications and influence the true decision makers.

C. Giving seed stage investors Board seats is not the norm. Take it seriously.

The majority of companies we see have Founders only on the Board before closing their Series A. Sometimes it’s just the CEO; other times it’s 2 or 3 founders. That’s very much driven by the personal dynamics among the core team.

Occasionally a seed or VC fund writing a large seed check ($250K+) will request a Board seat for their seed investment. While not the norm, it’s also not terribly off market if a large check is being written. Founders should just understand that giving anyone a Board seat, even if they don’t control the Board vote, is inviting them to give their input on every single major strategic decision the Company will make. It is a very deep commitment, and should only be given to people you believe can deliver real value to the business, and whose values are aligned with the founder team. Otherwise you’re asking for unnecessary and distracting drama.

If the fund that wrote the large seed investment has deep enough pockets to lead a Series A, and is interested in leading your A, this adds even more layers of complexity to the decision. A *true* seed investor who only invests in seed rounds can be an asset in sourcing Series A leads, because those leads are a complement to their position. A VC who dabbles in seed investment for pipeline purposes, however, has opposite incentives; assuming you’re doing well, they may prefer to lock out other potential competitors and take the Series A round for themselves. Having a VC already on your seed-stage Board can make it harder to get term sheets from outsiders for your Series A.

This dynamic of committing early to a VC before you’re ready for a Series A is discussed somewhat in The Many Flavors of Seed Investor “Pro-Rata” Rights.  My experience has been that getting trustworthy VCs on your cap table pre-Series A is generally a very good thing, so long as their participation is not contingent on terms that effectively lock you into having them lead your Series A. That is the startup equivalent of getting married as a teenager, before you’ve had a chance to mature and really explore the market.

VCs who ask for board seats at seed stage, or who require that you guarantee them the right to a large percentage of your Series A (50%+) are trying to get you to lock yourself in early. You should want them to invest, but still ensure that they have to earn the right to lead your Series A.

D. Board composition should ‘reset’ at Series A.

If you’ve ended up giving a Board seat to a large seed investor in order to secure their investment, it is extremely important that it be clear between everyone that the seat is not guaranteed indefinitely. Boards can only be so large. If your seed investor who put in $250K is guaranteed a Board seat forever, it makes it a lot harder to make room on your Board for the people putting in millions, or even tens of millions of dollars.

The logic here should be that if the seed investor insisted on a Board seat at seed stage in order to ‘monitor’ things early on, they should be comfortable letting go of the wheel once they know larger, more experienced institutional investors are taking over. Their interests as an investor are more aligned with the new VCs investing in the Series A than they are with the Common Stock. It simply is not appropriate for a company who’s raised $5 million, $10 million, $30 million+ dollars of capital to still have someone who wrote a $250k-500k check taking up a board seat. Board observer rights should also terminate at Series A, or perhaps Series B, for similar reasons.

So, in a nutshell, founders should start with the assumption that no one will join their Board of Directors until a Series A happens, and someone writes a 7-figure check; as that is the norm. However, for large checks from investors with strong value-add and alignment with the founders, there can be a justification for giving them a seat at the table, as long as it’s structured in a way that will not cause any issues, or prevent competition, in Series A negotiations. For investors who want (and deserve) something ‘extra’ on top of their investment security, advisor equity, information rights, and silent observer rights should all be explored as alternatives.

Electing a Truly Independent Director

TL;DR Nutshell: There are few governance-related decisions with a more outsized impact on a company’s power structure than the selection of an independent director. Do not take that selection lightly.

Background Reading:

In assessing financing terms and interacting with their lead investors, most founders instinctively focus on two core things: economics and control. And, broadly speaking, that is correct.  But the devil is in the details, and too many teams overlook extremely important details. They’ll focus on high-level issues like valuation, liquidation preference, and board composition (# of seats), and then prematurely check out once a term sheet is signed. And that’s when sophisticated players start executing their playbook for maneuvering into a controlling position regardless of what the black-and-white text says.

I’ve already written extensively on how one part of that playbook is for investors to push companies to use their ‘preferred’ company counsel. Another classic maneuver is to push the company to elect an ‘independent’ director with whom investors have significant ties and influence. 

Independent Director as Tie-Breaker

Independent directors are, arguably, the most important people on Boards of Directors.  They are supposed to serve as an objective voice on what’s best for the Company overall; balancing the incentives of common stockholders (management/founders) and preferred stockholders (investors) that can often pull in different directions. They should have no reason to be driven by control or personal payout.

It is not unheard of for there to be significant disagreement between the common and preferred stockholders on how to approach an important issue, and the independent director serves as the key vote in deciding which path will be taken. Having a trustworthy independent director is a great deterrent to stockholder lawsuits, as his/her approval makes it that much harder for a disgruntled stockholder to claim foul play.

For real independence, dig deeper.

But what does “independent” really mean?

The wrong way to define “independent” is simply as “not an investor or employee.” That absolutely is part of the definition. But smart teams know that a person’s judgment and independence are heavily influenced by far more than just their front-facing professional status.

  • Does the candidate regularly invest in other startups alongside your investors, perhaps as part of a seed fund, accelerator network, or other group?
  • Is the candidate looking for other appointments, either as a director or a more-involved executive; potentially at companies where your lead investors could deliver access?
  • Does the candidate spend time in social / business circles where, if they were forced to make a hard decision that angered one side of the board, either members of management or the investor base could exert pressure out of retribution?

Sophisticated business players are masters at finding leverage in their social / business relationships to push a deal in the direction they want it to move. And some founders are quite good at it too. A truly independent director should be minimally exposed to the carrots or sticks that either side of the Board might use to sway a key decision in their direction.

Ideally, an independent director will be someone who has a relatively equal pre-existing relationship both with the founders and with the investors. But because founders often have significantly narrower networks than their lead investors (who are repeat players), that is easier said than done.

More often than not, VCs will propose someone from their preferred ‘roster’ of independent directors; people whom the founders (particularly first-time founders) don’t know at all, or only barely know. Given the loyalty and history that ‘roster’ will have to the VCs for dishing out serial appointments, those people should almost always be avoided. They’re not independent at all, no matter how much they might argue the contrary.

Specialized industry expertise is valuable.

If no viable candidates are available whom both sides can trust, then agreeing on a list of well-known industry players and pursuing their service together is often a very good idea.  Any arguments that an independent director must be local should be pushed back against if the right person is located elsewhere. Videoconferencing and teleconferencing are highly effective, as are airplanes.  If your independent director doesn’t ‘feed’ from your local ecosystem, that can be a good thing in the right context.  Skillset trumps geography.

Someone who not only has the necessary character to be independent, but has specialized knowledge that management and (often) generalist VCs do not, can be invaluable by opening up industry contacts, and helping overcome challenges that are unique to the market a company is engaging.

If you’re building a health tech, or energy tech, startup taking on a massively complex and entrenched market and no one on your board has engaged deeply with that market, that is usually a red flag that politics has trumped performance in determining the board makeup.

Avoid an empty seat.

When no one is available locally whom both sides can trust in the independent director seat, companies will often be pushed to leave their independent director seat empty until after closing. I typically suggest that companies avoid a vacancy if they can, unless they’ve built such a strong level of trust/rapport with their VCs that they’re 100% confident a true independent will get selected, relatively quickly, post-closing.

If you are closing with a balanced board structure of 2 common, 2 VCs, and 1 independent, but your independent seat is empty, you are set up for a stalemate; and stalemates work (like a game of ‘chicken’) against the people with the most to lose; which means founders. By simply refusing (often with any number of excuses) to approve a key transaction, a key hire, or a new fundraise, investors can push founders into a corner to get their preferred independent director elected. Yes, this happens.

Agreeing on a ‘temporary’ independent director to take the seat at closing, to be replaced when a permanent one can be found, is sometimes a good idea. Not ideal, and you should still be very careful who gets chosen, but it is often better than an empty seat.  If you are stuck with an empty seat at closing, push hard to keep the selection of an independent director on the near term agenda, and call out delay tactics when you see them. Your leverage decreases proportionately with your bank balance.

It’s not cynicism. It’s experience.

If in reading the above, you feel the advice carries a perspective that is a tad too cynical and untrusting, I suggest that you go talk to multiple founder CEOs who have gone through rounds of funding with institutional investors.  They will educate you, off the record. Some stories will have happy endings. But others will teach you the value of a little preparedness and skepticism.

Trust is extremely valuable in business, and I always tell companies that if they’ve found people that they can really trust, and who have proven themselves to be trustworthy over time, hold onto those people with their lives. Make them directors, advisors, officers, your kids’ godparents. Surround yourself with people you can really trust. See: Burned Relationships Burn Down Companies.

But institutional investors have a job to do, and it’s not to be your BFF. It’s to make a lot of money by (1) getting into attractive deals (buttering up), and then (2) once inside, pushing companies to achieve lucrative exits as fast as possible (turning up the heat). Pay close attention to how the behavioral incentives at stage (1) and (2) are very different, and prepare for it, so you don’t end up as the cooked turkey.

The best analogy I’ve found for how companies should interact with their lead investors is that of foreign diplomats engaging in high-stakes trade negotiations. They have something you want, and you have something they want. And while you’re visiting, smile, crack jokes, share photos of your kids and focus on growing the pie together. Try as hard as you can to make the ‘partnership’ resemble something close to a friendship. But when you get back home, make sure the arsenal is well-oiled; just in case.

When all your eggs are in one basket, and you’re sharing that basket with money-driven people who are 10x more experienced than you are, a healthy dose of skepticism keeps you alive. Others will say to relax, let your guard down, and not be so cautious; but their net worth isn’t riding on one horse. Do your diligence, and then build a relationship that you can leverage for the success of your company. But never lose sight of where everyone’s incentives lead. The moment you do, the reality check will be costly and painful. 

Having a balanced power structure, instead of a founder-controlled or investor controlled one, is a great way to build trust and alignment. If your VC terms call for a balanced board, make sure what gets implemented is actually, not just superficially, balanced. Treat the selection process of your independent director as seriously as that of your company counsel, and don’t let anyone take it off the agenda.