Post Category → Venture Capital

Don’t Ask Your Startup Lawyer for Investor Intros

Principle:  Nothing says “I can’t hustle” like a paid introduction.

A lot of young founders looking to raise seed funding for their startup go through the following thought process:

  • I need to get in touch with investors, but I don’t know any of them.
  • Well-known Startup Lawyers must know investors, and I need one anyway;
  • Therefore, I should ask the Startup Lawyer that I hire to make some investor intros for me.

The logic here isn’t bad. In fact, some startup lawyers emphasize their strong relationships with investors as a marketing pitch to companies.  Unfortunately, those relationships are sometimes too strong.

Yes, good startup lawyers do know many investors, and yes, they certainly can make investor intros.  The truth is, though, you shouldn’t want them to. Before I explain why, a bit of background facts:

  • Startup investors, particularly VCs, receive hundreds, maybe thousands of pitches every year.
  • There are very few areas of investing that carry as much uncertainty/risk as startup investing.
  • Therefore, investors rely on as many signals (shortcuts) as possible for filtering out founders that can’t build a successful business.
  • The ability to hustle (related to and including networking) is extremely important for a startup team, or at least the founder who will play the CEO/business role of the startup (investors will excuse a technical co-founder who sits in a closet all day coding); and
  • Finally, VCs often intentionally make themselves difficult to get ahold of as a way to test (find a signal for) the networking skills of founders.

As a sidenote: cold calling/e-mailing VCs almost never works, for the above reasons.

Hustle Deficiency

So here’s the big issue: if you type a well-known investor’s name into LinkedIn, there’s a 99% chance that you’ll find 100s of different “paths” to get an introduction to that investor. Twitter also often helps, as do AngelList, Accelerators, etc.  Now, of all those paths to a warm intro, what do you think it signals to the investor if the only person you could find to introduce you is someone you’re paying?  The first thing that will run through that VCs mind will be something like “huh, well, putting aside the actual business idea, the founder clearly sucks at networking.”  That’s not a first impression you want to make.

A second thought might be, “maybe they’re not bad at networking, but just couldn’t find someone to sincerely recommend them.” You get the idea. Having your lawyer introduce you to investors isn’t too far off from having your mom write you a reference for a job.

What good is my Startup Lawyer then for helping get investment?

Does this mean whom you hire as your Startup Lawyer is irrelevant as far as finding investors is concerned? No, it still matters, just in different ways.  A knowledgeable startup lawyer can help with (i) how to approach particular investors, (ii) making recommendations as to which investors would be better targets, and (iii) signaling to investors that there’s been some “adult supervision” in the Company’s development to avoid legal land mines.

Because reputable startup lawyers are (often) selective as to whom they represent, a good startup lawyer can also signal that, by representing you, he/she at least thinks your startup has good prospects.  Granted, a lawyer’s business judgment isn’t exactly on par with Warren Buffet’s or Paul Graham’s (obviously, he wouldn’t be lawyering if it was), but it’s something.

Nutshell:  Ask your Startup Lawyer for suggestions on whom you should seek intros to, and on how to do it, but don’t ask him for the intro itself.  It’ll just make an investor think that, because you resorted to a paid intro, the company lacks a competent hustler. Nobody wants to invest in a hustle-deficient startup.

Don’t Use Your Lead Investor’s Lawyers

Principle: If your lawyer makes more money off of your investors than he does from you, he’s not really your lawyer.

If someone made you an offer to buy your home, but suggested that you use their real estate agent in the process, you’d hopefully immediately notice a problem with such an arrangement.  Most people would.  That being said, here’s a very common scenario in the early stages of a startup:

Investor (to Founder): Hey, we’d love to work with you guys on a possible investment, but first you need to get your legal stuff cleaned up.

Founder (eager to get investment): Awesome. But I don’t know any good startup lawyers.

Investor: No problem, I know a great startup lawyer, [X].  We’ve worked with him on several deals. I’ll put you in touch.

Founder ends up hiring lawyer recommended by investor.

Sometimes the investor even sweetens the pot: “If you use X lawyer, we can close in Y weeks.” This is highly unethical.

There are a few reasons why this scenario is so common:

  • A lot of founders, for understandable reasons (money), wait to engage a startup lawyer until they are already talking to investors (bad idea);
  • A lot of founders are first-time entrepreneurs with no good way to assess the quality of a startup lawyer, so they rely on referrals from people whose judgment they trust (not a bad idea); and
  • The Founder-Investor relationship feels a lot less adversarial than a buyer-seller relationship (because at the early stages, it is).

For the above reasons, founders presented with an investment opportunity often take the path of least resistance and hire the lawyer suggested by their lead angel/VC investor.  But anyone who (i) has been to more than a few rodeos and (ii) is honest about it, will acknowledge that this can be a terrible idea. Nevertheless, you’d be surprised how many investors keep a well-groomed stable of ever-so friendly lawyers to send their portfolio companies to.

The Honeymoon Period

At the beginning of the founder-investor relationship, everything tends to be beers and high-fives.  The Founders are excited about the injection of capital, and the investors are excited about the awesome business they just bought a piece of.  Board meetings are upbeat and downright jovial.  Tweets are so warm and fuzzy it’s almost cheesy. “Where on earth did the term ‘vulture capitalist’ come from?,” the founder asks. “These guys are my friends.”

This is why founders feel so safe using their lead investor’s lawyer.

And sometimes, for lucky founders, things never stray too far from this investor romance.  If they kept expectations reasonable, execute on their plans, and you-know-what never hits the fan, why should they? Unless…

When the romance stops.

That big deal that was coming down the pipeline (or three) ends up falling through.  The economy tanks.  The CEO thinks the Company needs to take a big bet that breaks from the original business plan.  Your VC’s portfolio ends up underperforming and she needs an exit to keep her partners happy, or she thinks someone else should be CEO. Or maybe a competing syndicate puts in a term sheet at better terms than your existing angel lead offers.

You can think of hundreds of scenarios that will cause the adversarial nature of the founder-investor relationship to rear its head; not because investors are bad people, but because their economic interests are just fundamentally different from those of the founders/company.  And in those scenarios, this question becomes extremely important: who feeds your startup’s lawyer?

The Hand That Feeds 

When the interests and desires of the Company become unaligned from its investors, the impartiality of the Company’s lawyer(s) is immensely important, particularly because of the attorney-client privilege on communications.  It’s also essential in those scenarios when you need to play good cop/bad cop.

You interact with your investors on a much more personal, on-going basis than your lawyer does, so sometimes you may want (or need) something to be said, without you necessarily wanting to be the person to say it. Put bluntly, you need your startup’s lawyer to be unafraid to stand up, look someone in the eye, and say (in professional terms): “**** You.”  Not that you shouldn’t do everything you can to avoid such a scenario, but the option absolutely needs to be there.

The point I want to drive here should be clear: if your startup’s attorney relies on your lead investor(s) for a significant portion of his/her business via referrals or direct representation on other deals, you better believe that he’s going to be tip-toing and curtsying around them whenever he has to say something they might not like.  His relationship with them may actually be more valuable to him than his relationship with you.

I’m sure I ruffled a few feathers by writing the above, but young founders need to be aware of this dynamic.  Attorneys who repeatedly play on both sides of the table will surely scoff and underscore their (air quotes) “zealous impartiality” in representing companies, despite relying on those companies’ investors for a lot of their business. Thankfully, this is my blog, and I can say this: they’re either lying to their clients, themselves, or both – and potentially violating rules of legal ethics.

Even people of the best intentions are susceptible to conflicts of interest.  A (now) client of ours dropped another attorney (who was very close to that client’s VCs) when he suddenly realized that the VCs were aware of confidential facts that he never disclosed to them.  Things just “slip out” after a few beers.

Caveats

Startup ecosystems are relatively small communities. All experienced Texas startup attorneys have cordial, professional relationships with large investors, simply because it’s impossible to not run into each other on deals and at events.  That’s a good thing.  Knowing one another creates a level of trust that greases wheels a bit.   Also, when a law firm is large and well-known enough, it is virtually impossible to avoid some small amount of representation on both sides of the startup table (investors and companies) at the firm level; there will be someone in the firm who represents investors.

The issue to be concerned about is not that any pre-existing relationship exists between your startup’s attorney(s) and your lead investors; the depth and degree of influence from that relationship is what matters.  If the attorney or his/her firm represents your investors only once in a blue moon, or happens to be on a long list of attorneys/firms that the investor recommends to portfolio companies, that’s very different from being one of their “go-to” lawyers.  If your lawyers represent 4 out of your lead’s past 5 investments, or if they peculiarly show up at all of his invite-only events, you may have a problem.

Nutshell: At the beginning of your relationship with a lead investor, it’s easy to see their advice as completely impartial and always in your best-interests, but it often won’t be. There will be scenarios in which your interests diverge, sometimes sharply, from theirs, and having an impartial attorney at that point is invaluable.  So be careful if your lead investor and the attorney you’re considering seem to be BFFs.  People (attorneys included) won’t bite the hand that feeds them: even when their client may need them to.

Should I form my Austin startup in Texas or Delaware?

Note: The DE-related info in this post is really applicable to startups based in any state, but I’m speaking mostly to Texas entrepreneurs, particularly in Austin, in writing this.  Because of the depth of startup activity in California, which might translate to more sophisticated case and statutory law, forming a non-DE startup there might make more sense than it would in Texas.

The default incorporation state in forming a company is always the state in which the company operates, but there are several reasons why a Texas startup (or any startup outside of California) might consider DE instead:

  • Well-Established, Business Friendly Statutory and Case Law – Because DE is the legal home of (by far) the largest number of large corporations in the country, you’ll find the least amount of ambiguity in DE as far as corporate governance practices, contractual interpretation, etc. are concerned.  And DE Chancery judges are by far the most knowledgeable in complex business matters of any judges in the country.  Virtually every corporate lawyer in the country who operates a serious practice will be familiar with DE law, so if you call him/her up with a random question about whether a certain transaction is kosher, or how a particular provision would be enforced in court, you’re 10x more likely to get a quick answer if you’re a DE corporation.  For a Texas entity, the answer will often be “I’m not sure,” which leads to “Let me research that for you,” and that research won’t be pro-bono.
  • Sophisticated Investors will expect Delaware – Because of the above, institutional venture capital firms that manage large funds will (very) often refuse to invest in a Texas startup that isn’t a Delaware corporation.  Angel investors are more likely to be OK with Texas, but we’ve encountered a fair amount of professional angels who either insist on DE before making their investments, or at least expect a conversion to a DE entity before the Company’s first venture capital equity round.
  • Protective of Officers and Directors – Delaware courts have a history of deferring to the business judgment of the officers and directors of a Company, meaning that without evidence of gross self-dealing or negligence, they’re unlikely to use hindsight to second-guess business decisions. This makes finding reputable executives and directors easier, for obvious reasons.
  • Response Time – Ever needed to close that bridge financing in the next 2 hours in order to make payroll? I’ve seen it plenty of times, but surely that would never be your company. Ever. Well, just in case, DE has an amazingly well-greased system for filing legal documents.  For extra fees, you can get guaranteed 24-hour, 2-hour, and even 1-hour response times. Suriname should really consult with the Delaware Secretary of State to up its game.
  • Converting Later is More Expensive – When you’re starting out fresh, there are no contracts to review, consents to get signed, etc. You just form the Company where you want to form it. But as time progresses, and you get shareholders, sign contracts, hire employees, etc., the amount of diligence involved in ensuring that you can convert to a DE entity grows exponentially. Pay now, or pay more later.

The Downsides to DE:

  • Fees (Cost): This is really the only reason why a Texas startup that intends to eventually raise professional venture capital will consider not incorporating in DE.  By forming a DE entity that operates in Texas, you’ll have to file a form to qualify to do business in Texas as a “foreign” (non-Texas) entity. This costs about $750. You’ll also need to maintain a “registered agent” in DE, which will run you about $125 a year. Finally, you’ll have to pay franchise taxes in both DE and TX, although the added cost until your startup becomes profitable is likely to only be a few hundred dollars a year.

So the decision to incorporate in TX or DE really boils down to two questions:

Do you ever intend to raise professional venture capital?

If not, then unless you just find Delaware’s sophisticated business-friendly environment really appealing, you’re probably well-served by sticking with a Texas/home state entity.  A lot, if not most, startups will fall into this category. Save your money and use it to build a great product.

If you do intend to raise professional venture capital, are you willing to incur the additional cost of forming a DE entity?

At formation, the up-front cost differential between a DE v. a Texas entity is likely to be about $1,000, with a few hundred extra a year for registered agent services and franchise taxes.  As time progresses, the cost of converting to DE will increase in terms of legal diligence and logistics as you execute contracts, pick up shareholders, etc. While numbers obviously vary, you can probably expect about $5K-10K in fees in converting your TX entity to DE pre-Series A.

Most of our clients bite the bullet and pay the extra ~$1K to form in DE from the beginning. That’s because (1) we don’t really serve startups that don’t intend to raise professional capital, because they don’t need us, and (2) it sends a signal from the beginning that the Company intends to operate in the big leagues. Still, a handful take the approach that 5-10x in fees is fine down the road if, at least at that point, they’ve found investors or a good revenue stream to help pay the costs.  I generally say that, if you’re really that worried about losing $1,000 in a startup that you seriously think will pursue venture capital, perhaps you should reconsider entrepreneurship altogether.  But it’s ultimately a personal judgment call.