Taking Non-Accredited Money – Survival.

Imagine you’re walking through a desert. You haven’t had water for days, it’s 100 degrees, and you know if you don’t get a drink soon your time here is done.  Then you come across a mucky pool of stagnant water that is almost certainly infested with some kind of bacteria. What do you do? Pass on it, for fear of getting sick? Sh** no. You get yourself a drink.  Rule #1: survive.  

This is the decision many startups face when questioning whether they should accept money from “non-accredited investors.”  It also highlights how ridiculous it is for startup lawyers to tell founders that non-accredited money is never worth taking.  They clearly haven’t stepped down from their mahogany pedestal and planted their feet on the same ground as their clients.  Being the product of low-income immigrants myself, and seeing how many successful startups rely on pre-angel funding (a lot), the “if you don’t have rich friends and family, don’t bother” mindset really rubs me the wrong way.

I’m not going to get into the background of what accredited v. non-accredited investors are, or why you shouldn’t take their money.  Most likely you’ve already heard it repeated in 5 different ways.  Professional investors don’t like them, there are onerous disclosure obligations, they can prevent you from raising larger amounts of money, etc. etc. Let’s just take it as a given. Taking non-accredited money is a bad idea. We all know it is. But you know what’s a worse idea? Shutting down when there’s life-giving capital on the table.

Texas is not California.

Unlike startups raised in the land of milk and honey (Silicon Valley), where many angels really will fund an idea, a true MVP, or something with no revenue, in Texas (including Austin) it generally takes a lot of work and some traction (with zeros) to get to a point where angels will even consider writing you a check.  And while it’s true that bootstrapping should definitely be considered, it simply isn’t feasible for a lot of business models; unless you’ve got some deep pockets.  For that reason, the “friends and family” round – $25K, $50K, $100K, whatever, just enough to build something angels actually find attractive – is often the difference between startups that scale, and those that never get off the ground. And statistically speaking, most people’s friends and family are non-accredited.

How do I safely take non-accredited money?

As a startup that knows professional venture capital will be essential to scaling, taking non-accredited money is not “safe” in an absolute sense.  No matter how you structure it, having non-accreds on your cap table/balance sheet will raise questions and diligence from future investors.  The real question should then be, given that whatever consequence is better than shutting down, how do I raise non-accredited money as safely as possible.  Here are some principles for taking non-accredited money, while minimizing the chances that it’ll prevent professional funding:

  • Get help.  Work with an experienced startup lawyer to ensure that you comply with relevant regulations as closely as possible, and within budget, for the financing.  A misstep from a legal standpoint could create an unfixable problem down the road.
  • Limit the group.  Take money only from people you consider true friends and family who can afford to lose all of the money they give you, and who understand that losing the money is a real possibility. This means people who care about you, want you to succeed, and absolutely do not view this money as a lottery ticket to becoming rich. This is not crowdfunding.
  • Lenders; Not Investors.  View the non-accredited friends and family as lenders, not investors.  Make it crystal clear to everyone that their money is a loan, not an investment.  It will not convert into stock, and hence if you hit it big, they will not get a piece of all the upside.  Post-IPO, you can offer free rides in your Bentley and shower them with benjamins. Just don’t offer them stock today. If the company succeeds, the money will be paid back. Offer them a very high interest rate, and work with your lawyer to structure a non-convertible promissory note.  Anyone who will write you a check for $5,000, knowing that it is extremely high risk, and that there’s no chance of a 100x upside, must truly be in it just to help you succeed.

Important sidenote: If you have people who are willing to back you in the above way, you are rich – in a way that many people aren’t. Other people leverage their affluence. Leverage yours.

  • Long Maturity; Subordinated.  Set the repayment terms of the non-convertible note so that the debt does not become “due” until the Company has raised a significant amount of money, maybe $2 million+, and that the debt will be subordinated to all future debt issued to professional angel (accredited) investors.
    • The goal here is to allay any fear from angel investors that their money will be used to repay your non-accreds, instead of funding growth.  The money is not payable until a true VC round, and their debt is always senior to the non-accred debt.

Does following the above principles mean that having non-accredited money in your company won’t blow up a possible financing? No, it doesn’t.  But, in my opinion, it will significantly de-risk things for you.  When VCs or angels ask about your non-accreds, you can make it clear to them that (i) everyone knows that they are being paid back, will never be equity holders, and are subordinated to all other investors, and (ii) they are a highly vetted group of true friends/family who will be cooperative with whatever helps the founders succeed. Once they are paid back, they are a non-issue.

To be clear, I am not promoting the funding of startups with non-accredited money in a broad sense.  I tell founders the exact same things other experienced startup lawyers do: it’s a bad idea, it creates more disclosure obligations, and some investors might not touch you.  If you can avoid it, do so. But being alive yet uncomfortable is always preferable to being dead.  And my observation is that, at least in Texas, a F&F round is often a prerequisite for progressing far enough to where angels find you investable. Drink the mucky water, and live to fight another day.

 

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.

When the A-Lawyers Break Free: BigLaw 2.0

Nutshell: The world of transactional tech law used to be divided into A-Player lawyers earning the gold at large firms and everyone else making a decent living at second-tier small firms. SaaS eliminated that world, and small can now mean better, faster, and more lucrative; which means A-Lawyers are breaking free.

No one who operates in the startup space needs to be told that bigger does not always mean better.  In fact, the opposite is often the case. Being large often makes you slower, more bureaucratic, and inefficient. Just try getting a piece of new technology adopted at a major law firm, or getting a secretary to learn that technology.  I’ve been there.

Big Was Better

If bigger leads to better performance, there must be something about the nature of the product or service in question that requires a large organization.  In law, that “something” was historically (i) expensive, proprietary resources to properly service clients (barriers to entry), (ii) the need for collaboration among multiple specialties, and (iii) high amounts of friction in effecting that collaboration.

Before the days of SaaS and Secure Cloud Storage/Collaboration, top-tier transactional law required at a minimum (i) a law library, (ii) internal word processing, (iii) teams of administrative support and attorneys, and (iv) dozens of legal specialties under the same roof.  Without that, you would be slow and inefficient.  In that world, choosing a small firm usually meant, as a fact, that you were dropping down a tier in quality.

And then things changed. Your “library” is now a subscription SaaS service. Word processing you can outsource by the hour. Same thing for admin support.  People working remotely often collaborate more easily than people working within the same law office, if they use the right tools. When BigLawyers step back from their billing timer and realize this, two very important thoughts come to mind:

  • Why are you all here? – Why do we (all kinds of different lawyers working in different areas that require different processes) need to still work under the same structure? I’m tired of having to justify to a bunch of litigators or IP lawyers that some software that I NEED for MY practice needs to be put into the budget. Why can’t I come to work in jeans if my clients don’t care? Why do I even have to come in to work today? All I do is stay in my office anyway.
  • Where the f*** do all my billings go? I bill $600 an hour. I take home like 20% of that. Wait, you mean all of this obsolete, bloated, bureaucratic infrastructure is the reason 80% of what my clients pay disappears? They hired me, not your brand. Why am I here?

Focus Always Wins

Every variable that once made the large, full service law firm necessary and optimal has been turned on its head by the web, SaaS, and the cloud. Now, a corporate lawyer at a small firm can staff a deal just as quickly, if not more quickly, utilizing a network of smaller, more focused, more efficient and (yes) better lawyers and law firms. It doesn’t take a Harvard MBA to understand why a top trademark lawyer operating out of a trademark boutique that does nothing but trademarks is going to be vastly superior at (guess what?) trademarks than a lawyer who works alongside dozens of other types of lawyers. Focus trumps being a generalist; and that applies equally to lawyers and law firms. 

But the reality of how SaaS has changed the landscape isn’t exactly news, at least not to people who follow these topics. Why then has it still seemed as if large firms have a lock on the best lawyers?

Money

In every profession, the best expect to be paid according to their talent. This is not rocket science, nor is it surprising. A-Lawyers have stayed in BigLaw for one very simple reason: it paid the most. Notice the past tense.  When big really did mean better, the better clients went big, and that means big paid more.

But it was only a matter of time that enough top lawyers started asking themselves “where the f*** do my billings go?” and realized that BigLaw’s overhead and bloat leaves an enormous amount of room to cut out fat, charge less, and still take home WAY more.  Yes, my friends slaving away in BigLaw trying to hit your 2000-2150 billables quota so you can earn that nice little bonus amounting to 3% of your billings, the cat’s out of the bag. Many of us at small firms earn more than you do. A lot more. And we do it with better technology, a more flexible schedule, and often working from wherever we want. All while our clients pay a lot less. Who, long-term, do you think is going to win at attracting talent?

You know what’s better than profits-per-partner? Profits in your wallet.

Networked Law: BigLaw 2.0

Examples of specialists we (corporate lawyers at a small firm) use to staff deals (i) a former silicon valley BigLaw tech transactions partner (head of his group) now operating a solo practice, (ii) a T100 in Texas trademark lawyer operating out of a trademark boutique, (iii) one of the country’s leading open source specialists operating a solo practice, and (iv) a veteran venture capital paralegal working virtually from Palo Alto. Everyone bills 40-60% less on an hourly basis than they would at a major law firm, which doesn’t even account for their ability to optimize pricing, process, technology, and staffing for their practice area. And, yes, everyone takes home more than they would in BigLaw.

You know what that’s called? D-i-s-r-u-p-t-i-o-n.  I don’t use that word lightly. This is not a piece of software that large firms can ultimately pay a consultant to help them adopt, but a fundamental restructuring of how top-tier transactional law operates.

The Future

Small firms are not just for the mickey mouse club anymore. The A-Lawyers are asking “Why are you all here?” and “Where the f*** do all my billings go?” and are doing something about it. Focused, faster, efficient, networked, and now with much bigger paychecks. Small law has been around for a while. But BigLaw 2.0 is just beginning to ramp up. As more A-Lawyers set themselves free, most of BigLaw will have to face the reality that all the branding in the world can’t save a bloated, overpriced, and now completely unnecessary delivery model.

p.s. We’re hiring.