The Cost of “Staging” Your Startup Lawyers

An unfortunately common problem that successful startup entrepreneurs have to deal with is outgrowing their first law firm or lawyer.  The reason for this is two-fold:

  1. High-Growth – Unlike traditional “small businesses,” startups that seek angel/venture capital are by their nature meant to be very high-growth oriented: they start out simple and small with tiny legal budgets, but within a matter of a few years (sometimes months) they can be raising capital from sophisticated parties, striking complex commercial deals, developing valuable intellectual property, and otherwise requiring serious legal advice.
  2. Short-sightedness – Because startups start out so small and often with non-existent legal budgets, founders will often plan to go with an attorney or firm that markets itself as serving “small businesses” at very low rates. The problem, of course, is that a “startup” and a usual “small business” are not the same thing, because of the first point above.

My thoughts on the “go cheap at first” attitude are already articulated in another post. In a nutshell, I’m of the mindset that because of the high-quality DIY resources available online for startups, founders might often be better off going it alone, until they can afford real lawyers, instead of relying on a mis-matched provider whose mistakes can cost serious money to fix as the company scales.

But the goal of this post is really to emphasize a different, but related point: switching law firms can be a lot more expensive than you think.  Put differently, you might think you’re saving money by going with a “starter” attorney, knowing you’ll just “upgrade” if you’re successful, but make sure you understand the full cost of staging your legal providers in this way. It’s likely substantially higher than you expected. Here’s why.

Diligence Cost – What’s in that “other lawyer’s” contracts?

Startup-focused legal practices, particularly at large firms built to serve startups at all growth stages, will have their own set of contract/agreement templates that they regularly work with.  All of the attorneys at a particular firm will have deep experience working with those templates and know, without having to review them every time, what they do and don’t contain.  So if a new transaction ever comes up and an attorney ever has to make a decision or answer a question that depends on what a historical contract does or doesn’t contain, they won’t have to fully review (and hence you won’t be billed for) having to re-diligence all of the Company’s history.

Naturally, when you switch firms, you bring with you all of the legal foundation that you’ve built on someone else’s contract forms, but are now using attorneys who have no idea what those forms contain.  This means your new attorneys will need to fully review the work you’ve done in the past to be confident that the documents are kosher. On top of the cost of fixing any problems, this review process alone will carry a sizable bill.

Drafting Cost – Making everything fit.

On top of having standardized forms, properly run startup law practices draft their forms to integrate with one another. Defined terms, section references, and contract provisions are in sync between sets.  Formation docs -> Seed Docs -> VC docs -> Acquisition Docs, etc. This integration saves a startup money by allowing an attorney to pick up a set of, for example, venture capital deal forms knowing that it it’s designed from the get-go to sync with the Company’s previously signed contracts.  She can focus on the core deal terms instead of having to tinker with what should be standard language.

Introducing a foreign firm’s contracts into this “legal chain” produces a serious disturbance in “the force.” Everything on a going-forward basis will need to be tailored to fit the foreign legal docs that the Company executed with another firm.  And, unfortunately, that tinkering won’t be pro-bono.

Conflict Risk – Something lost in translation.

It’s also worth mentioning that by requiring your attorneys to engage in all this diligence and custom drafting that they otherwise wouldn’t have needed to do if you’d used them from the beginning, you are automatically taking on the risk that something will be messed up.  A provision in your old contracts might be missed (because your attorneys were working quickly to try to keep the bill low), or the “tailoring” to your old docs might not have been done perfectly (for similar reasons), and a straight conflict within your contracts will arise.  Hopefully it’s a small one. But it might not be. Just know the risk is there.

Think Ahead in Hiring Your Startup Lawyers

So how much can all of these “transition” costs add up to? It depends.  The longer you spend with your “starter” lawyer, the higher it will likely be, but it can easily reach 5-figures.  Keep that in mind when making decisions about how to provide for your startup’s legal needs.  For a successful startup that inevitably has to switch firms, the transition costs of staging, along with those of fixing the mistakes of “starter” lawyers, will likely eclipse what the startup would’ve paid if efficient and scalable legal counsel had been engaged from the beginning.

Form Your Austin Startup Yourself Before Hiring a Cheap Lawyer

Note to reader: Please share this with as many low budget startup founders (particularly in Texas) as you know. Friends don’t let friends waste money on crappy lawyers.

Update: If you’re looking for DIY-ish startup formation options, this is another viable alternative: Clerky

So you’re starting a company with virtually no budget for legal fees, and you just found a guy in Austin who’s willing to help you out on the cheap. He even bills $175/hr and seems to come well-recommended by other entrepreneurs. Awesome, right? For me it is.

It’s difficult to overstate just how often clients end up paying our firm more to close a transaction, sometimes substantially more (think 5-6 figures), because we have to clean up a mess created by some cheap local lawyer with “startup friendly” (read: questionably low) rates.  Garbage sold at a low price is just expensive garbage.  There’s one solo practitioner in particular who’s done work for two people I know, separate companies, and screwed up big time on both of them (2/2).   One ended up closing a VC round at 2-3x the usual fees in order to clean up the disaster he created. Cheap is awesome until real investors hire real lawyers to actually read the documents your cheap lawyer drafted… or failed to draft.

I’ve previously articulated my views about going alone on startup legal issues, including a discussion on the growing number of DIY tools available online.  There are so many multi-specialty legal issues that come into play in forming, growing, and financing a company, that I highly advise against trying to do things yourself, at least if you expect to raise professional venture capital and scale your business. The stakes are simply too high.

But, the reality is that no matter what every lawyer with a blog says, founders will keep trying to form their companies on their own.  Given this reality, here’s my suggestion to all of Austin’s startup founders with zero funds budgeted for legal fees (and who can’t find a decent attorney who will be flexible):  meet Docracy, read this post, and follow everything very carefully.

Lawyerless > Crappy Lawyer

The beauty of quality DIY online resources is that, while they will never provide the level of service that an experienced, quality attorney will provide, they sure as hell are better than relying on a crappy one.  With the right contracts available for free online (via Docracy), the right guidance (via blogs, articles, etc.), and the patience to seriously read the instructions, you can stand a much better chance of not screwing your company up by doing things yourself versus hiring an incompetent attorney, trusting him to do things correctly, and then finding out two years later that he didn’t.

So here’s my free guide for using the power of the internet to form your own Delaware C-Corp based in Texas. If you are forming an LLC instead of a C-Corp, then for the love of all things good and holy, please get a competent lawyer.  And again, let me reiterate: I do not think you should try to form your startup on your own. My desire here is to simply provide a helmet and a flashlight for those who are going to do it anyway, so that if they are ever able to afford a real attorney and raise serious funding, their legal history won’t be a complete nightmare.  You will screw some things up, but hopefully the clean-up costs will be much smaller than those caused by Austin’s crappiest lawyers.

DIY Startup Formation – Powered by Docracy, Orrick, and “the Internets”

Background Reading:

Requisite Formation Docs:

Steps (Order is important)

  1. Read all of the Background Reading – very very carefully.
  2. Figure out your Founder Common Stock distribution and Vesting details
  3. Execute and File the Charter in Delaware
  4. Execute the Action by Incorporator
  5. Execute the Board Consent (Make sure you designate at least a CEO and Secretary)
  6. Execute the Common Stock Purchase Agreements for each Founder, including all exhibits. – Set
  7. File your 83(b) Election immediately
  8. Fill out Common Stock Certificates
  9. Execute the Stockholder Consent
  10. Have the Secretary execute the Bylaws
  11. Did you file your 83(b) election yet? (30 days within Stock Issuance, or your toast)
  12. Apply for an EIN at the IRS Website
  13. Have officers and directors execute Indemnification Agreements
  14. Have all founders execute a Confidential Information and Inventions Assignment Agreement
  15. Register as a Foreign Entity in Texas.
  16. Keep digital copies of everything in a safe place.

Useful Forms to Possibly Use Later:

The above does not cover granting options to employees via a formal option plan, because, frankly, by the time you are granting equity to non-founders you’re insane for not having hired a lawyer – and the legal issues around options are complicated – real complicated.

Disclaimer: As I said before, you will screw some things up. And yes, trying this yourself is silly and irrational – much like a lot of things entrepreneurs tend to do.  The above steps and documents might not even be the right ones for your startup’s context.  I did not draft the above-referenced documents, nor do I vouch for their legal enforceability. You absolutely should hire a lawyer before trying to form your startup. But, putting all that side, if you read carefully and follow the above instructions, you will be probably be on better legal footing than 99% of the startups formed by terrible lawyers.

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.