Should I Use My Investor’s Lawyer?by Scott Edward Walker on August 31st, 2011
This post was originally part of the “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs). Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998 (San Francisco) or 310-288-6667 (Los Angeles). Thanks, Scott
We’re a startup based in Palo Alto, and we just received a Series A term sheet for a $725,000 investment. The investor is kind of insisting that we use his lawyer at a big Valley firm to represent us. He said that he doesn’t need a lawyer, and this will save us a lot of money. We’re first time entrepreneurs, and we don’t know if this is standard practice and what we should do. Any advice would be appreciated.
Welcome to the world of the Silicon Valley! This is not uncommon, but I still cringe when I hear it (probably because I was trained at two big law firms in New York City and this kind of stuff typically doesn’t happen there).
I think a good startup lawyer has two important roles: (1) to watch his client’s back – that is, to make sure his client is protected from a legal standpoint and doesn’t get blind-sided; and (2) to act as a consigliere – that is, to provide strong, disinterested business advice (to the extent necessary).
As the late, great attorney Craig Johnson wrote in the book The Silicon Valley Edge: A Habitat for Innovation and Entrepreneurship:
Although start-up lawyers in Silicon Valley draft documents and follow form books . . . , they usually play a much larger role in the businesses being started. They are often dealing with people with very limited or no business experience. These people need help in defining and pursuing their business goals. . . . How should the founders divide the initial stock ownership? Who should be on their board of directors? Which financing sources should they consider? At what valuation and on what terms?
Accordingly, in the context of negotiating your term sheet, a good startup lawyer will sit down with you and walk you through all of the key legal provisions in the term sheet to make sure you fully understand their ramifications. For example, he will explain to you how the liquidation preference works and run spreadsheets, if necessary, to show you how much money you will receive based on different sale scenarios; he will explain to you how the option pool works, including the founders’ significant dilution; and he will discuss what protective provisions are and other tricky legal terms, such as drag-along rights and anti-dilution provisions.
But more importantly, a good startup lawyer will also discuss with you the business terms, including the structure of the deal. Because this is only a $725K investment, a good lawyer will recommend structuring the investment as a convertible note or a “Series Seed” financing, rather than a full-blown Series A. Indeed, this is what will save you money on legal fees. Moreover, he will impress upon you the importance of talking to other investors (if you haven’t already done so) in order to create a competitive environment.
He will also help diligence the investors to make sure you choose the right partner for your startup. Not to mention pushing back hard on unreasonable terms, such as “exploding” term sheets or certain redemption rights.
Simply put, how is the investor’s lawyer going to play this role? From a business perspective, he is beholden to the investor. If he doesn’t play ball and get the deal done on the investor’s terms, the investor will obviously stop sending him work. This is not to suggest that there’s anything nefarious or unethical going on; it’s just common sense.
There is too much at stake for entrepreneurs not to be represented by a smart, unbiased lawyer, who has no vested interest in the closing of a proposed financing. As I learned in New York, no matter what an investor tells you, at the end of the day it’s all business. And if an investor can convince you to use his lawyer, it’s good for his business — not yours.
Tags: anti-dilution provisions, convertible note, drag-along rights, exploding term sheets, investor, lawyer, liquidation preference, New York, option pool, protective provisions, redemption rights, Series A term sheet, series seed, silicon valley, startup lawyer