Startup Lawyer’s Poker: Fee Deferrals

Nutshell: Startup-focused law firms with well-developed client bases are able and willing to bet on (the 1% of) startups by deferring their fees, but founders should understand what they’re signing up for when agreeing to those arrangements.  In many cases, fee deferrals are just clever ways for firms to “lock in” already de-risked founders and have them ignore massively marked-up price tags on legal services.  Think before you drink the kool-aid. 

It’s no secret that one of the largest expenses that early-stage startups face from their very early days is the cost of hiring competent lawyers. The reason for this is simple: “cloud” economics don’t apply to people. Deploying a SaaS startup has become way cheaper than it was 10 years ago because of all the “X as a Service” that founders can leverage instead of having to invest significant amounts of capital on in-house technology.  But, unsurprisingly, developers still aren’t cheap. Being a good developer requires years of training and unique talent, and being human requires paying for stuff.  Good developers cost real money.  Good lawyers, like good doctors, cost real money.  Anyone suggesting otherwise is attempting to defy the laws of physics.

All that being said, readers of SHL know that there is a lot that smart founders can do to avoid over-paying for legal services:

  • Are you just one or two founders working on an MVP? – Use Clerky and/or, if you need a lawyer, hire a top-tier boutique firm that specializes in early-stage tech, and be careful with generalist solo lawyers.
  • Do you need specialist lawyers for things like trademarks, patents, or other specialty counsel? – Resist the firms that VCs try to force you to use, which are usually very large firms that over-charge clients by $200-300/hr in order to fund their pyramid structures, outdated bureaucracies, and bribes sponsorships of accelerators for funneling companies through them. If you think an extra $200 for every single lawyer hour won’t have a material impact on your runway, do the math again.

If I wanted to get cash-strapped founders to completely ignore the real cost of startup legal services and get them to pay my 2-3x inflated price tags, what would be a great way to accomplish that? Answer: defer my fees until they are less strapped for cash. 

PayDay Loan Meets No-Shop Clause

For many law firms, the fully transparent bargain in a fee deferral can be summed up as follows:

  • Assuming your bill doesn’t go above $X (often something like $25-50K), you don’t have to pay us anything for at least 6-12 months, or until you raise $Y (often a range of $100K-$500K).
  • In exchange, please ignore the fact that everything we charge you will be massively marked up. And we’d also like 1% of your common stock.
  • Also, don’t think about using other law firms for anything while our fees are being deferred – we can’t afford our deferrals if every client goes and hires those lawyers that left our firm 2 years ago and now work for $250/hr less than what we’re charging you for less experienced lawyers. If you do, the bill needs to get paid. This isn’t UNICEF.  The Life Time Value (LTV) isn’t there if all you’re using us for is a fixed-fee formation package.

If a major law firm has made this kind of offer to you, it’s likely because you’ve signaled to them that this “bargain“ is a good deal on their end. Usually, that means you’ve been accepted into a major accelerator, received interest from an investor, or have otherwise been “vetted.” You’ve been de-risked. Smart founders who are lucky to find themselves in this position should obviously ask: if I’m de-risked, is this actually a good deal for my startup?

Be Smarter About It

In startup law, successful late-stage clients cross-subsidize early-stage clients that can’t yet pay their bills. This economic reality ensures that, as long as small firms are stuck working with B-players, the firms with A-clients will always be able to win more A-clients by offering them fee deferrals that the smaller firms simply can’t match.  Startups that don’t want to be bankrupted by lawyers, yet also don’t want to be locked down by gilded handcuffs, really then have two options:

  • Find the efficient A-lawyers, and budget for their services. – Well run focused firms can be dramatically cheaper on early-stage services than traditional firms (and, frankly, better quality), particularly those small firms that regularly work with startups and have optimized their pricing structures for those kinds of companies.  Budget for their services just like you budget for anything else. The truth is you rarely need that much lawyer time before your seed round.
  • Find top-tier smaller firms that are willing to defer. – Remember, only firms with solid client bases can afford to defer their fees for good clients. Many small firms simply won’t do it, but some will.  The deferrals won’t be as large (because your LTV for them is smaller – they aren’t trying to do everything legal for you) but it doesn’t need to be, because the bills are lower.

The evolving law firm ecosystem that I’ve written about is increasingly moving up-market, working with higher-quality clients that once were too afraid to use anyone but the established law firm brands. That means those smaller, more nimble and efficient firms are increasingly able to offer their own “incentives” to attract top-tier clients, without the massive costs of shackling yourself to a single, large full service firm. 

To be honest, I’ve always viewed fee deferrals as an unfortunate, but necessary evil in the startup law space; a kind of smoke and mirrors to distract everyone from the very real problems that traditional law firms are unwilling to address. Does E/N do fee deferrals? Yes, unlike most firms our size, we defer for a small segment of our clients.  I’ve picked enough winners and turned down enough losers to trust my instincts on deferrals.  But if you ask me about deferring my fees, my initial response is always going to be “let’s talk first about how we’ve made top-tier startup law actually affordable.”

How Founders Lose Control Of Their Startups, Apart from Ownership

Summary: There are many ways, apart from ownership %, that founders slowly lose control of their companies. Some of the more obvious ones get spelled out in term sheets, but professional players in startup ecosystems know how to use more subtle mechanisms to erode founder control.

Seasoned founders and startup lawyers know that there are really two things that matter most in negotiating a term sheet: economics and control.  In other words, from the perspective of a founder, (1) what % of the Company will I own after the deal closes (and, more specifically, what % of exit proceeds do I get), and (2) whose permission is needed to make key decisions? Of the “control” terms, there are explicit ones, like protective provisions,  that competent founders know to focus on.  But there are more subtle aspects, like the composition of the Company’s advisors, and even who the Company’s lawyers are, that when ignored can significantly erode the ability of founders to maintain influence over their companies; particularly in high-stakes situations when there’s significant internal disagreement.

As I’ve written before, being an entrepreneur raising capital means learning to give up control. That’s a given. However, I’m very much a believer in transparency and having your eyes wide open. By educating yourself, you ensure you give up control at the appropriate time, and with fair terms; instead of with subtle power plays that slowly hand control to other people without you even noticing it.

The More Obvious Forms of Control

  • Voting Thresholds and Protective Covenants – These are typically spelled out in stockholder agreements and organizational documents. There are 1,000 ways to draft them, but they basically boil down to: you can’t do X without getting approval from stockholders holding Y% of the Company’s overall capitalization, or a specific % of various classes of stock.
  • The Board of Directors – Who is on the Board, and who has the ability to elect/remove people on the Board? The Board is the core governing body of the Company, which means nothing serious happens without their approval. In a 5-person board, whether founders (common stockholders) elect 3 directors or 2 dramatically alters the power dynamics of a startup.

The Often Overlooked, But Important Control Mechanisms

While voting power and board composition are definitely the most important issues, I always advise founders that maintaining control/influence over the companies they started is much more nuanced than what gets spelled out in a term sheet.

How “Independent” is Your Independent Director?

It’s very common for VC-backed boards to have an “independent” director – usually an industry expert that gets elected by both the common stock (founders) and preferred stock (investors).  However, it’s also fairly common for VCs to suggest that the “independent” director come from their own network of executives.  In judging whether their VCs recommended “independent” is the right person, founders should absolutely include the loyalty of that director to the VCs in the calculus.  He’s in their network, and knows that keeping them happy will mean more influential board appointments in the future. If a founder CEO is well-informed and connected in her startup’s own market, she likely has her own ideas for more independent directors. Put them on the table for discussion.

Board Observers – Who is at the Board Meeting?

Investors often will ask, in addition to a Board seat, for one or two board “observer” positions; meaning, at a high-level, non-voting people who can nevertheless attend board meetings and (usually) engage in discussion with the board. The presence of board observers matters and absolutely will influence discussion on board-level issues, even if they ultimately can’t vote. Don’t hand them out without understanding how they alter a founder’s influence at meetings.

Whom do your lawyers work for?

I’ve touched on this issue before here: Don’t Use Your Lead Investor’s Lawyers. There are hundreds of scenarios in which, in the middle of high-stakes decisions and disagreement among decision-makers on the right (or legal) course of action, founders will turn (protected by attorney-client privilege) to company counsel for advice – what’s legal?, what are the consequences?, what are my options?, what’s “market?” etc. etc..  Many times the “right” decision for the Company is one that won’t sit well, and even piss off, certain groups on the cap table.  You don’t want lawyers who work for those people.

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

Despite arguments from certain investors and lawyers who claim that the above is a non-issue (you can imagine why), most founders immediately recognize the problem when this reality is described to them.

Where do your advisors and executives come from?

The theme of “pay attention to loyalties” carries on into a Company’s advisors and outside executive hires.  Where did they come from? Who got them this job, or their last job? Are they all part of the same investor group or business network? The conversations they have with you (the founders) will not be the only ones they’ll be having. Pay attention. Careers are long, much longer than the life of a single startup.  Advisors and executives, even those with strong ethics, pay attention to who can get them their next position when their current one exits.

Nutshell: Voting control matters, but it isn’t everything. Loyalties, particularly long-term loyalties, drive human behavior. Don’t be lazy and let every influencer (director, executive, lawyer, advisor) in your company come from the network of a single investor group. Smart ecosystem players know that’s one of the best ways to gain influence over a company without putting anything on paper. Leverage peoples’ contacts, and of course contacts will overlap, but make sure you ultimately have real diversity of perspectives to turn to.  Otherwise, when it really matters, a dozen back-end conversations will end up with really only one voice whispering in your ear.  

It’s precisely when the stakes are highest that a founder needs brutal honesty from advisors and counselors. And nothing ensures honesty like transparency and true independence of viewpoints. Make sure you don’t lose it. 

 

Should Non-SV Founders Use SAFEs in Seed Rounds?

Nutshell: Because of the golden rule (whoever has the gold…), probably not – at least not for now.

Background Reading:

For some time now, there have been people in the general startup ecosystem who have dreamt that, some day, investment (or at least early-stage investment) in startups will become so standardized and high velocity that there will be no negotiation on anything but the core economic terms. Fill in a few numbers, click a few buttons, and boom – you’ve closed the round.  No questions about the rest of the language in the document. For the .1% of startups with so much pull that they really can dictate terms to investors (YC startups included), this is in fact the case.  But then there’s the other 99.9%, much of which lies outside of Silicon Valley.

Much has been written about how SAFEs were an ‘upgrade’ on the convertible note structure, and in many ways they are.  But anyone who works in technology knows that there’s a lot more to achieving mass adoption than being technically superior, including the “stickiness” of the current market leader (switching costs) and whether the marginal improvements on features make those costs a non-issue. And any good lawyer knows that when a client asks you whether she should use X or Y, she’s not paying you for theory. You dropped that sh** on your way out of law school.

This isn’t California

From the perspective of founders and startups outside of California, which are the focus of SHL, the reality is that going with a SAFE investment structure is very rarely worth the cost of educating/convincing Texas angel investors on why they shouldn’t worry and just sign the dotted line. The entire point of the convertible note structure, which by far dominates Texas seed rounds, is to keep friction/negotiation to a minimum.  Yes, there are many reasons why equity is technically superior, but that’s not the point.  You agree on the core terms (preferably via a term sheet), draft a note, they quickly review it to make sure it looks kosher, and you close.  You worry about the rest later, when you’ve built more momentum.  Professional angels know what convertible notes are, and how they should look. They also know how to tweak them.  In Texas, many of them still do not know what a SAFE is. 

And, in truth, many Texas angels and seed VCs who do in fact know what a SAFE is simply aren’t willing to sign one. The core benefit of SAFEs to startups is that they don’t mature, and hence founders without cash can’t be forced to pay them back or liquidate.  To many California investors, this isn’t a big deal, because they’ve always viewed maturity as a gun with no bullets.  But Texas investors don’t see it that way.  Many find comfort in knowing that, before their equity position is solidified, they have a sharp object to point at founders in case things go haywire. I’ve seen a few founders who rounded up one or two seasoned angels willing to sign SAFEs, only to have to re-do their seed docs when #3 or #4 showed up and required a convertible note to close. It’s not worth the hassle, unless you have your entire seed round fully subscribed and OK with SAFEs

Just Tweak Your Notes

The smarter route to dealing with the TX/CO/GA and similar market funding environment is to simply build mechanics into your notes that give a lot of the same benefits as SAFEs. A summary:

  • Use a very low interest rate, like 1-2%. – Many local angels tend to favor higher interest rates (seeing 4-8%) than west and east coast seed investors. But if you can get a very low rate, it’s more like a SAFE.
  • Use a very long maturity period, like 36 months. – 18-24 months seems to have become more acceptable in TX, which is usually more than enough time to close an equity round, or at least get enough traction that your debt-holders will keep the weapons in their pockets.  But if you can get 36 months, go for it.
  • Have the Notes automatically convert at maturity –  This gets you as close to a SAFE as possible, and we’ve seen many angels accept it. If you run out of time and hit maturity, either the angels extend, or the Notes convert, often into common stock at either a pre-determined valuation (like the valuation cap, or a discount on the cap), or at a valuation determined at the conversion time.

How successful you’ll be at getting the above is just a matter of bargaining power and the composition of your investor base. Austin investors, who think more (but not completely) like California investors, tend to be more OK with these kinds of terms.  In Houston, Dallas, or San Antonio, you’ll likely get a bit more pushback.  But that pushback will almost certainly be less than what you’d get from handing someone a SAFE.

Closing Summary: There isn’t, and likely will never be, a national standard for seed investment documentation.  Every ecosystem has its nuances, and working with people who know those nuances will save you a lot of headaches. In Texas, the convertible note, however suboptimal, reigns supreme. Respect that reality, and work within it to get what you want.