Over the years, I’ve spent a lot of time with lawyers and staring at legal bills. In probably 90 cases out of a 100, out of control bills are a direct and measurable result of client disorganization. Essentially, business people fail to agree on exactly what the specific deal terms are in combination with the ‘what if’ scenarios. It is the ‘what if’ scenarios that a) the legal folks are supposed to help (Cha Ching!)with and b) they are the least thought about by the clients before the lawyers start trading documents.
Here’s an example.
Let’s say that an investor and a founder agree to a two stage funding scenario. This isn’t me, by the way, just an example I’m making up as I type this. Chunk one on closing, chunk two based on milestones. Now, typically, both sides will know they need to create the measurable milestones which would be the added to the financing documentation. Both sides agree on language with respect to obligation or right but not obligation, etc. Then, off to the lawyers.
The smart lawyers all start with the what if questions. What if the investor doesn’t want to fund. What happens if only one of the seed guys fund and not the other 3? What happens to board seats, the founders equity, etc. When both sides have their own legal teams, it gets expensive fast because each side is walking their client through what if scenarios and why one flavor is better or worse for their side. Lawyers push back, a little posturing, yadda yadda and eventually you and the investor get a punch list and walk through the issues to varying degrees of compromise. This is expensive and that punch list should be done upfront.
Having lived through this more than once, I’ve taken a slightly different approach.
First, the folks working on my 1st round and I have spent a bunch of time mapping out each bullet item (board composition, anti-dilution provisions, etc) and getting to an agreement in business language with the what if scenarios defined as best we can. They are then mapped out within a business language (not legal language) agreement.
Another (made up) example:
If you have an investor that is going generally own a big chunk of your company you are going to have that world famous “matters requiring special (re:investor) approval” section in your documents. In my (non-VC) opinion, 90% of that stuff isn’t really all that important. Like who cares if there is a $50,000 limit on a capital expense. If the business needs it, you get it approved, big deal. The sale of the company, on the other hand, you do care about. Or changing the board composition or whatever is important to you (and it’s not the laundry list!).
So for example on a sale issue, go through the specifics and agree on the ‘what if’ possibilities around the company sale. If an investors says to me, I’m good with a 3x return and I say, I’m good as well, we create specific language that says, in effect, for a sale, below a 3x return on a cash in basis, both the founders and the investors have to agree but at a 3x or greater, either party can drag the other. And this is regardless of whatever else in is the agreements (a save and except clause).
In this case, we’ve both said what we think is fair and even if they see more upside but I want to cut and run, I can. And the reverse is true, they want to call the patient 3x, okay, we’re done. No surprises; we’ve agreed to a set of specific cases where it is mapped as business language. The lawyers paper all of this and don’t go back and forth with their own set of issues.
My point of these examples is not to debate my examples rather to get you to think about doing as much as you can with all the variations and ‘what about this’ stuff before you get the lawyers involved. Once each of these items are discussed and agreed upon, the business language of agreement gets written down, reviewed, and agreed to by you and your investors. Then, call in the legal guys.
Give them tight directions to paper what you’ve agreed to (or better/cheaper still, modify some boilerplate they’ve done a million times before). Good lawyers will still ask have you thought about questions if you haven’t covered them all but at that point, in my opinion, you are now getting specific and excellent council which is directly related to what you’ve papered.
If you find yourself saying, gee, didn’t think of that, spend more time before you go to your lawyers. If, after you’ve done a detailed review with the other side as business issues, you are still getting a question or two; you’ve got great council looking out for you as they should.
The legal bill for my little adventure is going to be 20% of what the bill was for a deal of equal size recently done. It’s due to amazingly smart lawyers as well as smart investors spending the time with me up front. It makes a difference in the wallet.
Food for thought, you mileage may vary.
Bonus Item: If you’ve never done this before and/or have no idea what a drag-n-tag, weighted average with a full ratchet mocha decafe non-fat participating pref share is, spend $150 and buy one hour of a lawyers time to take you through a set of standard documents (Shareholders agreement and subscription agreement being two of note), explaining every paragraph and their thoughts on them. If you are in Toronto, Rob Hyndman or Suzie Dingwall Williams are excellent choices for getting up to speed as they live this everyday working with startups.
Do this before you even think about discussing this stuff with your investor. You can also get a whole pile of sample documents, annotated terms sheets, etc, in a zip file from me or on the NVCA’s web site.
Extra Bonus Item: Another good reason why you should spend all this time up front is getting to know who you are marrying before honeymoon night. Hiding behind the lawyers is a great but ultimately expensive tactic. Sorry, my legal guys are insistent is utter nonsense, they work for the client. Get to know how they negotiate face to face with no ‘I’ll ask the lawyer stuff’ in the way.
It just sucks to find out after the deal closes, they are pencil pushing, spreadsheet driven, non-technical knobs. Not that there are any of those in the VC business today. I’m just saying….