Why Founders Don’t Trust Startup Lawyers

“We received a term sheet from a competing VC syndicate, and if I go to our current lawyers, our existing investors will find out about it before I want them to.  Our law firm does a lot of work for our VCs.”

“Our VCs told us that if we used their preferred law firm, they’d close more quickly and even save us money by not hiring their own lawyers. But if we went with another firm, there ‘could be delays.'” 

“I went to my Board to disclose this highly confidential issue that only our lawyers and I knew about, and I realized that our VCs were already aware of it. No one but our lawyers could’ve disclosed it.”

“The lawyers that our investors connected us to said that the valuation in our term sheet was about market. It was only after closing that I found out we got totally hosed.”

The above are quotes or paraphrases of statements that we, as a firm, have heard directly from founders/executives as they explain their reasons for changing law firms. The unifying theme should be obvious, and it relates to the broader issue of why so many founders have such dim views of startup lawyers in general. In short, by playing fast and loose with conflicts of interest in the pursuit of maximizing short-term revenue, many startup lawyers and law firms have squandered their most valuable currency: trust.

Related Reading: How Founders Lose Control of Their Startups

What is Counsel?

No one who reads SHL or interacts with E/N’s tech practice would argue that our approach to the practice of law is “old school” in any sense of the term. The significant drivers of our growth include rethinking major facets of law practice, including organizational structure, compensation models, project management and technology adoption. However, while I am very much a tinkerer with respect to the delivery of legal services, I am quite old-school in my view of what lawyers fundamentally are, or at least should be: trusted counsel.

In a heated, high-stakes lawsuit or investigation, virtually everything you’ve ever said in writing to investors, to other executives, to friends and family, can be forced out into the open for everyone to review except for confidential communications with the Company’s lawyers (attorney-client privilege).  Take a moment to let that sink in. Nothing that you ever do or say as a company is more secure from forced disclosure than what you say to your lawyers.  That is, of course, unless the lawyers themselves disclose it.

Ask many founders whether they really trust the lawyers representing their company, and some will flat out say that, to them, their lawyers are just subject-matter experts there to paper deals and ensure the company doesn’t blow up from legal issues; highly-educated paper pushers and fire extinguishers.  Others will say that they do trust (in a sense) their lawyers, but when pushed into a serious, high-stakes situation in which total objectivity and confidence is paramount, the reality of their superficial relationship will surface.

  • Is the valuation they’re offering appropriate for our company, geography, and market?
  • Is this provision dangerous? Is it standard?
  • Some local people are pushing us to X accelerator, but we’re not sure it’s right for us. What should we do?
  • We need to make a major strategic shift that some of our stakeholders will want to block – what are our options?
  • My company is going under if I don’t get this deal done, but X investor says he will block it. Can he? What are my options?
  • We just got an acquisition offer, and I’m not sure whether it’s fair to me and my management team. What should we do?
  • One of our senior executives just got arrested. No one can find out about this until we know more. What do we do?

These are just a few of the kinds of questions that trusted counsel gets asked.  But trust, particularly the kind of trust we’re talking about here, carries a high price tag: independence and objectivity.  How can you trust my opinion about whether an acquisition offer is fair to the Company if the investors pushing you to sell have me on speed dial, and just sent me an invitation to their pool party? How can you trust me to give an honest assessment of a term sheet, or even a comparison of one term sheet v. another, if I’ve closed 20 deals for the VCs who submitted one of those term sheets, and have 3 more in the works? You are one deal. They are 25. Lawyers aren’t that bad at math.

Let’s be real: you can’t. Not possible. Founders know it, and in a world in which so many lawyers have given into the incestuous biz dev practice of playing both sides of the VC table, the result is a deep cynicism toward startup lawyers. Do I choose X firm or Y firm? Whatever. They’re all the same. I’ll just go with the cheaper one, or whatever one makes closing my financing easier. Some lawyers who regularly represent startups have even strategically made VC fund formation a core component of their firm. Smooth.

What “Alignment” Really Means

To the majority of lawyers (outside of the startup space) and investors (outside of the startup space), the above views are totally uncontroversial.  Make sure your own lawyers are independent and objective? Umm, yeah, thanks Captain Obvious. And even within the smaller sphere of startup/VC work, I know several investors and lawyers who draw a hard, ethical line to ensure that their reputation is not muddied in the pursuit of short-term revenue. If their investor-client is investing in a startup, they don’t shimmy over to the other side of the table with a smile on their face and a conflict waiver in-hand. They insist that the startup get their own lawyers. Trusted counsel.

But then there are the other people. “Deals get done faster” – “Startups save money on legal fees” – and (my favorite) “We’re all really aligned here, so why do we need two sets of lawyers?” Seriously?

I like to take complex issues and distill them into very simple statements totally free of B.S., so here’s one for you: when someone buys your startup for $200MM, there’s ultimately two places that money can go: in your pocket (and of your co-founders, team, etc.), or the pocket of your investors.

What was that about “alignment” again? And to be clear, the price tag gets negotiated in the acquisition, but guess where the % distribution between Pocket A and Pocket B gets largely negotiated? Financings. 1% of $200MM is $2 million.  So you’re negotiating whether millions of dollars in an exit will go into founders’ pockets or VCs pockets, and you’re telling founders they should just use the VC’s lawyers to close the round – because it saves maybe $10-20K in legal fees? Right. Thanks for ‘looking out’ on the legal budget.

Founders and their investors have shared interests in building a highly successful, profitable company. That much is doubtlessly true. But anyone who uses “alignment” as a justification for founders not worrying about the independence of their company’s lawyers is either (a) totally lying or (b) laughably lacking in even a basic understanding of human nature. 

This is not to say at all that founder-investor relations should be viewed as adversarial. Clearly not. I’m all for honesty, respect, transparency, and the like in company-investor relations.  It’s an important long-term relationship.  However, healthy relationships are built on reality. And the reality is that VCs have limited partners for whom they are legally obligated to maximize returns. It doesn’t at all make them bad people. It just means that they, like the rest of us, have a job to do. They are not your best friends, they are not your mom, and they are most certainly not fully “aligned” with the company’s economic interests. Hire your lawyers accordingly.

Drawing a Firm Line

In Austin, you frequently hear the mantra “be authentic.” No, not authentic in some anti-corporate, hipster sense, but “be who you say you are. do what you say you’re going to do.” Don’t hide behind excuses like “this is how it’s always been done before,” or “this is how the game has to be played.” Change the game. Rewrite the rules.

A while back the tech/vc attorneys at E/N sat down together over lunch to discuss the above issue. We’ve all dealt with it at prior firms we worked at, and there was no possible way of doing anything about it there. But there’s a funny thing about leaving big, corporate environments for smaller, focused firms (like startups) – it’s much easier to establish a set of firm principles, infuse them into the group’s culture, and protect them as the group grows.  And here we are: E/N, as a firm, does not and will not play both sides of the Tech VC table.

Everyone here understands it, is committed to it, and anyone who wants to join the firm will have to as well. And many of our clients are well aware of high-profile early-stage investors whom we’ve, politely, chosen not to represent as a result of this policy. Loss in short-term revenue? Sure.  But this is a long-term play. Rather than following other lawyers and firms in chasing anyone who will write us a check, we believe deeply in preserving our clients’ trust, and have chosen to bet on it.  If you want a paper pusher, I’m happy to make some recommendations. We provide legal counsel.

Early Hires: Options or Stock?

Nutshell:  While the conventional equity path of a startup is to issue (i) common stock to founders and (ii) options to employees, early hires concerned about taxes will often insist on receiving stock as well. Voting power, along with other political factors, present a few tradeoffs for founders to consider in that scenario.

Vocabulary:

  • “Option Pool” – a portion of the company’s capitalization set aside (after founder stock is issued) for equity issuances to employees, consultants, advisors, etc., and subject to a special “plan” designed to comply with complex tax rules.  Even though it’s referred to as an “option” pool, properly designed equity plans will allow for direct stock issuances under the pool as well; not just options.
  • “ISO“ – Incentive Stock Option – a tax-favored type of option issuable only to employees, if certain requirements are met. The main benefit is that upon exercise, the difference between the exercise price and the fair market value on the stock at the time of exercise is not taxed as ordinary income. However, it is subject to the Alternative Minimum Tax (AMT), which can hit certain people depending on their tax situation.
  • “Restricted Stock” – For purposes of a private startup, just another way of saying Common Stock. The same security that founders get, except for non-founder employees it’s usually issued from the “pool” (under the Plan) using different form documents.
  • “Early Exercise Options” – Conventional options issued to employees are not exercisable until they vest; meaning until the recipient has worked long enough to “earn” the right to exercise them.  Early exercise options have modified vesting/exercise provisions so that they can be exercised from Day 1 – with the underlying shares becoming subject to the vesting schedule.  From the Company’s perspective, early exercise options are very similar to restricted stock issuances. The only real difference is that the recipient has the option to exercise and receive the Stock on Day 1, or sit on it and exercise later.

Convention.

The conventional path of a Company’s equity issuances goes something like this:

  • Founders receive direct issuances of Common Stock (not options)
  • Non-Founder employees receive ISOs (options)
  • Consultants, advisors, etc. receive NSOs (options)
  • Investors receive Preferred Stock, or SAFEs/Convertible Notes that convert into Preferred Stock

Backround:  

  •  The value of restricted stock is taxable as ordinary income on the date of issuance, unless its fair market value (FMV) is paid in cash.
  • Options, both ISOs and NSOs, however, are generally not taxable on the date of grant, as long as their exercise price is equal to the FMV.
  • So, you would normally expect employees to prefer receiving options over stock. No tax > Tax. And this is the case when the stock’s FMV is relatively high. That’s why later hires (usually after a Series A) almost always receive options, without question.
  • Stock gets to vote on stockholder approvals. Options do not (until they’re exercised for stock).

The Issues: Early employees want to minimize tax. Companies want to avoid giving away voting rights/complicating stockholder votes too early.

  • However, in the very early days of a startup’s life, avoiding tax on restricted stock is easy because of how low the FMV of the stock is (fractions of a penny): write a check for a few dollars (the full FMV), or just pay the tax on the few dollars of ordinary income.  You therefore get the “no tax on grant” benefit of options, without worrying about paying tax later on an exercise date.  Receiving stock also gets the clock running on long-term capital gains treatment.
  • Therefore, very early hires, when they do their homework, tend to insist on receiving restricted stock (or early exercise options) over conventional options. Better to deal with tax when the stock is worth (at least to the IRS) virtually nothing, instead of years later upon exercising the option when the tax bill could be much greater (ordinary income for NSOs, or AMT (for some people) for ISOs).
    • Sidenote: Conventional equity plans also have a 90-day post-termination exercise period, meaning, when an employees leaves a company (voluntarily or involuntarily) they have to exercise their options within 90 days, or they then get terminated – even if vested. Paying the exercise price isn’t an issue for an early hire in that scenario, because it’s very low (the fractions of a penny FMV), but if the AMT comes into play it can hit them with a tax bill.  This doesn’t come up in a Restricted Stock scenario.
  • The tradeoff from the Company’s perspective is that, just like founders, those hires that receive restricted stock will have full voting rights (including seeing whatever is submitted for stockholder votes) for all of their stock on Day 1, before they’ve vested in anything.  When only one or two people are in question, this may not be a big deal. It can be a way of making early employees feel like a part of the core team, because their equity is being treated just like founders.  When there are more than a handful of hires, however, it can get unwieldy fast. The number of people to consult for stockholder votes can go from 2-3 to 10, 15, 20. If there are consultants and advisors in the picture, they may start to ask why they aren’t getting the same tax benefits as early hires. And then at some point you have to draw a line and start granting options. Is the first optionee not as special as the restricted stock people? Politics. 

Generally speaking, the decision to give restricted stock v. options to very early hires is a practical/political one.  While the tax-favored nature of ISOs means that most early employees won’t see much of a tax difference between receiving ISOs v. restricted stock, the prospect of an AMT hit in the ISO scenario does make restricted stock, on net, better for recipients.  That needs to be balanced, on the company’s side, against the early voting power/information rights given away when an employee receives stock instead of options, and how it will play out with all of the company’s other hires.  

My general advice to founders is to be aware of the tradeoffs, and to consciously treat the early voting power and tax benefits associated with restricted stock as currency not to be wasted.  If there’s a very early superstar that you deliberately want to single out as a key player, use the currency.  If not, then make the decision based on all the other factors. Company culture will likely factor greatly into the calculus.  Many, many founders prefer to avoid the politics/complications and simply draw a line at the founder (stock)/non-founder (option) division.  Others are more selective. There’s no magic formula.

A few separate issues worth addressing:

  • The 90-day post-termination exercise period (after which unexercised options, vested or not, are terminated) often gets criticized as being unfair to employees, and there’s some justification for that criticism. The view is that the employee shouldn’t be forced to “use it or lose it” if they did their time (their option vested) and are now moving on to a new company.
    • The actual 90-day number comes from tax rules requiring that ISOs be exercisable only within 90 days of termination.  If an option is exercisable after that, it automatically becomes an NSO for tax purposes. But there’s nothing in the tax rules requiring that the option be terminated at 90 days. That’s largely meant (i) as a deterrent (frankly) to people quitting, and (ii) a way to clean up the cap table for people who didn’t want to pay their exercise price, allowing that portion of the pool to then be re-used for new hires.
    • While the 90-day period is still convention, key executives/hires will often either negotiate for an extended exercise period for their own grants, or the Company will as a gesture of good will, decide on its own to selectively extend the period when someone leaves on good terms.

Obligatory Disclaimer: This post contains a lot of fundamentals and generalizations on tax rules, but it’s obviously not intended to be an exhaustive statement of those rules. Circumstances vary, and you should absolutely not rely on this post without consulting your own attorney and/or tax advisors.  If you do, don’t blame me when it blows up in your face.  You’ve been warned.

How Founders (Should) Break Up

Nutshell: There are two ways for founders to break up. One preserves everything those founders built together, including a chance of a successful outcome. The other can bring everything crashing down, ruining months, even years, of hard work, and damaging lives in the process. Simple decisions made at the beginning of the relationship dramatically influence which outcome you end up with.

Worthwhile reading:

First off, like any good lawyer, let’s get our definitions straight. I’m talking about Founders (capital F) in this post – meaning the people who were there at the beginning of a startup, or at least well before it became something investors wanted to buy a part of. For better or for worse (probably worse), the term “founder” has become just another title that gets negotiated by early hires to help artificially build their street cred. If you showed up to a startup with your own lawyer, or with data on compensation packages, you’ve gone through very different dynamics from actual founders.

The Honeymoon Period – Setting the Foundation.

Know and trust each other. 

It sounds sappy, but it’s unquestionably true: starting a startup with a cofounder is about as close (emotionally) to starting a family with a spouse as you’ll ever get, without actually starting a family with a spouse. CEOs refer to their startups as “their baby,” and they’re not kidding.

You have to go in totally trusting the other person, and committed to the good of the startup as something separate and higher than your own self-interest. If you don’t, you’re demented and asking for a world of pain.  I look at our portfolio of startup clients, and the vast majority (but not all) of the top ones were started by either (i) two or more cofounders who are real friends, or (ii) a single founder with total control. In each case, minimal time is spent arguing over equity %s or vesting schedules. It doesn’t mean everything is lollipops and sunshine, but everyone knows their role. Founders who are mere ‘business partners’ generally underperform compared to founders with a strong, personal relationship.

Paper it.

Different people have different approaches to marriage. Some are big on prenups, and others aren’t. But for founders, sign some damn contracts. Standard ones that shouldn’t take startup lawyers very long to produce. They should have:

  • Clear language regarding the Company’s ownership of all IP;
  • A vesting schedule (~4 yrs), with a cliff (~1 year);
  • Non-solicits and (depending on the state, but def. if you’re in TX) non-competes;
  • Language about returning all company property on termination; and
  • No ambiguity as to what happens if/when a founder leaves voluntarily or involuntarily.

I’ve often heard founders say something like “we don’t have VCs yet, so we don’t need vesting schedules.” Totally wrong reasoning.  The vesting schedule is there to ensure that if someone walks away before a meaningful milestone (especially if they walk away angry), they can’t take with them any chance of the Company’s ever succeeding.  Try raising VC money with 40% of your cap table held by an inactive founder.   The cliff serves a similar purpose – it puts in black ink what everyone should already understand: this is a long-term project, and if you’re not in it for the long-term, you shouldn’t be signing up.

Papering this kind of arrangement among a good group of founders should not be controversial.  If I start seeing founders bickering over vesting schedules, or random contingencies in their founder docs, my views on their long-term prospects are automatically dropped several notches.  I’m also not a fan of founders negotiating “single trigger acceleration” among themselves – “if you fire me, I get X% of my vesting schedule accelerated”.  If you’ve chosen the right founders, no one should be getting fired unless it’s the right decision for the startup. And if it’s the right decision for the startup, you shouldn’t be walking away with more than what you actually earned.

When the Honeymoon’s Over – A Clean Break.

I’ve said it before, and it’s worth repeating: Contracts Aren’t for the Honeymoon; They’re for the Divorce.  While there are hundreds of reasons why a founder might break away from a startup, if the proper foundation was set, there should be minimal legal ambiguity as to what happens to the startup when that founder is gone.  IP stays, as do all unvested shares. The departing founder keeps what she vested. Deliver everything to the company relating to the startup – hardware, code, login credentials (which should be changed after the departure), etc. Don’t try to take any employees with you, or build a competing product. Move on.  

A simple letter stating the definitive termination date should be delivered by the Company to the departing founder, spelling out what the post-termination equity holdings will be, and delivering the small amount of money needed to repurchase the unvested shares.  It’s also often considered a best practice to give a departing founder a small “sweetener” – a few extra shares, or a little cash, in exchange for signing a full waiver and release of all claims, including a non-disparagement clause (you can’t start insulting everyone on twitter).  Hopefully there aren’t any real claims to waive, but when VCs diligence the company and see an exit of a major founder, it gives them a bit of comfort to see that release signed.  Founder lawsuits have a way of creeping up once a few zeros are added to the valuation.

Emergency Maneuvers.

Not everyone is so lucky to have a clean founder breakup.  Sometimes angry founders refuse to return company property, or refuse to sign documentation relating to their departure.  I’ve even seen situations in which founders are caught maliciously hacking into servers.  Prepare yourself.

If the proper legal foundation was set early on, a refusal to sign anything shouldn’t be a serious problem. Good founder docs are drafted so that simply e-mailing a termination notice, along with a check, gets everything material done. Signatures on termination docs is nice, but not essential. As to other things like refusing to return property, usually the first step is to have some personal conversations about how small startup ecosystems are, and that reputations take a long time to rebuild. A nastygram from your corporate lawyers can help too.  If all that fails, it may be time to get other lawyers (litigators), or other authorities, involved. Hopefully it never gets there.

But if you didn’t do what you were supposed to do when the founders first got together, and now you have an angry, defiant founder who perhaps still owns rights to company IP, or has walked away with half the cap table… well, you fu**ed up. Is this the end of your company? Not necessarily, but it definitely could be. Talk to your lawyers. Maybe there’s enough of an e-mail trail making it clear that IP was intended to be transferred. Maybe a recapitalization (a ‘recap’) is possible to wipe out everyone’s equity and start fresh. Maybe you can eventually convince them to sign the right docs now.  Maybe. Regardless of the outcome, you’re going to be paying your lawyers a lot more (like 20-100x) to clean it up than you would’ve paid to do it right on day one.

Only idiots start families with people they don’t trust, or truly understand. Founders who start companies with people they don’t trust, or who think it’s unnecessary to paper things properly, aren’t much smarter. Find the right cofounder, and then sign some damn contracts. Then hope you never have to read them again, and start building.