www.youtube.com/watch?v=6tWLqFmaNdQ

My blog post last week addressed angel financing and included five legal tips for entrepreneurs to help them through the angel financing process.  I had intended to post a part 2 (adding five more tips), but I thought I would try something different to break things up a little.  Accordingly, below is a brief video of three lessons that I learned in the big-firm trenches as a young corporate associate in New York City.  

Oddly enough, I actually look back with fondness on those eight years (including all the all-nighters and weekends working on deals) because of the solid training that I received – which I can finally appreciate practicing law out here in California.  Here are the three lessons: (1) do your due diligence; (2) watch-out using forms from other deals or off the web; and (3) create a competitive environment.  This is part one of an ongoing series.  (Note: videos are tricky and can put some people off; thus, I have also included below the substance of the video in written format.) 

www.youtube.com/watch?v=hqAmVCkSmhA

Lesson #1 – The Importance of Due Diligence

Let me set the scene very quickly:  I’m a second-year associate, and my firm is representing Sony in connection with its acquisition of CBS Records (a $2 billion deal).   I’m spending 15+ hours a day at Blackrock, the CBS Building in New York City, reviewing corporate documents as part of a legal due-diligence team of six other corporate associates.  We’re all young and inexperienced — and we really don’t know what we’re looking for.  But then we found so-called “change of control” provisions in the contracts for Michael Jackson, Bruce Springsteen and some other major artists, which provided that if there were a change of control – e.g., if Sony bought CBS Records – the contracts would automatically terminate unless the artists consented in writing.  Obviously, these provisions were very important to Sony – and the value of CBS Records would be much less if those artists did not consent.  So there was my first lesson: the importance of legal due diligence. 

If you’re buying a company or investing in a company (or if you’re selling a company and getting stock as part of the purchase price), you have to get the lawyers and business guys (and gals) to review the material contracts.  Entrepreneurs must understand this – and they also must understand that if they’re trying to raise capital, the prospective investors (including angels and VC’s) are going to conduct legal due diligence, and thus all their papers need to be in order; and contracts (such as IP assignments and employment arrangements) need to be buttoned down.

Lesson #2 – Watch Out When You’re Using Forms from Other Deals

Here it is a couple of months after the Sony-CBS Records deal closed, and I get tapped for another major acquisition; and the senior associate on the deal instructs me to take the first crack at the acquisition agreement.  Being a clever guy, I figured – OK, I’ll just take the agreement from the Sony-CBS deal I just worked on, and mark it up, plug in the new deal terms and change the names.  So I got a copy of the executed agreement, I mark it up, I give it my secretary and then send it to the senior associate for her review.  Little did I realize that I had included a number of pro-seller provisions that had been negotiated by Cravath, which is the prestigious law firm in New York City that represented CBS, the seller.  Boy did I get a chewing-out from the associate (luckily it wasn’t a partner).  The lesson, of course, is that you have to be very careful when you take agreements from other deals and start using them for your deal.  So when you are playing lawyer and pulling forms off of the Web, you better remember that the agreements are final, executed agreements, which have been negotiated often over many months and reflect input from both sides of the table.    

Lesson #3 – Create a Competive Environment

Now I’m a third-year associate and I have two deals on my plate: one is a divestiture – the sale of a division of a multinational corporation being auctioned by an investment bank – and the other is the sale of a private company to a competitor (with no bankers involved).  In both deals, my firm is representing the sellers, but as we worked our way through the negotiation process of each deal, we ended-up with two completely different agreements with respect to the material legal provisions.  In the auctioned deal, because the ibanker was able to play the prospective buyers off of each other and create a competitive environment, the final agreement was extremely seller friendly (including broad materiality qualifications, a huge basket and a cap on liability of 10% of the purchase price).  In the private-company transaction, there was only one prospective buyer, and he knew the seller was anxious to sell and thus was playing hardball.  Accordingly, in that deal, the deals terms ended-up being extremely buyer friendly, including a big escrow of the purchase price and a cap on the seller’s liability equal to 100% of the purchase price.  

The lesson I learned here, of course – which applies to all deals – is that you must create a competitive environment (or the perception of same) in order to have strong negotiating leverage.  (See tip #3 of my post “Doing Deals with the Big Boys: Ten Tips for Entrepreneurs.”)

httpvhd://www.youtube.com/watch?v=Kcty5PrNaxs

The Good 

Big law firms are very good in connection with billion dollar acquisitions, public offerings and any complex, bet-the-company type transaction (e.g., hostile takeovers).  Indeed, when money is not an issue and/or where the client needs lots of lawyers (i.e., lots of bodies), it may be prudent to retain a large law firm with strong experience to handle a particular corporate project.  I remember doing billion-dollar acquisitions as a corporate associate in New York, where we often had diligence teams of 10+ lawyers and transaction teams of 30+ lawyers.  Moreover, big law firms are also good (particularly in places like Silicon Valley) at making introductions for entrepreneurs to investors and the like. 

The Bad

The bad, of course, are the huge legal fees that big firms charge.  As I have discussed on the video on the home page of my website, there are lawyers at certain major national law firms billing out at $1,000 per hour; and there are first-year associates at big firms billing out at $300 per hour.  (Just to be clear: we’re talking about lawyers with no experience, fresh out of law school billing clients at a rate of $300/hr.)  The bottom line is that legal fees are through the roof. 

Now, in billion-dollar deals, legal fees are generally not an issue; indeed, they are just another line item in the list of transaction expenses (and generally pale in comparison to what the investment bankers are getting).  But in small deals or in connection with general corporate work, fees are often a significant issue to entrepreneurs.   

The Ugly

The ugly with respect to big law firms is pretty ugly from the entrepreneur’s perspective – and I’ve seen this over and over again.

The reality is that the smaller the client – the smaller the transaction — the further down the ladder the work gets pushed at the big law firms.  That’s the way these firms work.  The entrepreneur may meet the senior partner at the first meeting for his $15 million acquisition or $3 million financing, but that partner then goes back to his office, calls the assigning partner and gets some young associate to start cranking out the work.

I experienced this first hand as a young associate at a big, New York City law firm.  I can remember is like it’s yesterday: you get the call from the senior partner’s secretary to come up to the senior partner’s office; you run up the stairs or to the elevator; you bring your legal pad; you’re nervous and you sit down in the partner’s office (sometimes he’s on the phone and you’re sitting there for 10 minutes); and then if it’s a small deal that you’ve been tapped to handle, he either just flings a copy of the term sheet at you or just flies through the terms, hands you the form he wants you to use and then tells you to “go, get it done”; and as you’re leaving his office, he screams out “call me if you have any questions”  — which really means “don’t bother me with this little, bullshit deal — I don’t want to see you until the closing.”

 Conclusion

The takeaway here is that the big-firm template generally only works for the big deals and the big clients, and the entrepreneur needs to understand that.  I hope the foregoing was helpful.  If you have any questions or comments, please send them to me through the comments section of this post.  Thank you.

www.youtube.com/watch?v=lHtZY6kPq-w

Mistake #1 – The Failure to Diligence the Guys on the Other Side of the Table 

Whether the entrepreneur is doing a venture capital financing, a partnering agreement with another company or is selling his company to a private equity firm – he must investigate the guys on the other side of the table.  This means determining the reputation of both the company/firm (if it’s not a marquee name) and the particular individuals with whom he is dealing.  Who are these guys?  Are they good guys or are they jerks?  Can they be trusted?  When they say they are going to do something, do they do it?  Do they add value?  Remember, in certain deals (such as a venture capital transaction), the entrepreneur will be, in effect, married to these guys for a number of years.  Accordingly, at a minimum, the entrepreneur should get references and speak with other entrepreneurs or CEO’s who have done deals with the guys on the other side of the table in order to make an informed judgment as to whether they are guys with whom the entrepreneur should be doing business. 

Mistake #2 – The Failure to Build a Strong Transaction Team

Every successful entrepreneur knows the importance of building a strong team, yet they often ignore this rule when putting together a transaction team.  Now is not the time for the entrepreneur to being using his buddy the divorce lawyer or the attorney who wrote his will to negotiate his financing or acquisition; nor is it the time to use his bookkeeper to handle tax and accounting issues; nor is it the time for the entrepreneur to play lawyer and start pulling forms off of the Web.  As I learned first-hand in New York, the quarterback of the transaction team should be a strong, experienced corporate lawyer – he’s the guy who is going to drive the deal, watch the entrepreneur’s back and help the entrepreneur build-out his team.     

Mistake #3 – The Failure to Run the Negotiations Through the Lawyers

The entrepreneur should do what he does best — i.e., build companies — and leave the deal negotiating to a strong corporate attorney (or an investment banker in the acquisition context).  Entrepreneurs are generally no match for sophisticated venture capitalists or private equity guys or corporate development guys who do deals for a living.  Accordingly, a smart entrepreneur will stay above the fray and let his corporate attorney run the deal – and business issues can easily be handled at an all-hands meeting (whether in-person or via conference call).  Experienced deal guys on the other side of the table may try to do an end-run around the entrepreneur’s lawyers, but the entrepreneur must remain disciplined and simply advise the guys that all negotiations are being run through his lawyers. 

Mistake #4 – The Failure to Check Their Emotions and to Remain Disciplined

Entrepreneurs (particularly those who haven’t had much deal experience) often become emotionally wedded to a particular transaction and are unable to maintain their objectivity the further along they get in the process.  Too often, an entrepreneur will fall in love with a particular deal — like the first-time home buyer — which will lead to poor decision-making and risky positions.  As I saw first-hand in New York City representing big, successful private equity firms, the best deal guys are masters at taking their emotions out of transactions and being extremely disciplined.  Indeed, they will generally walk from a deal if they get out of their comfort zone (e.g., with respect to the risk profile, price, etc.) — regardless of how much time and money they have expended.  It is critical that the entrepreneur understand this dynamic — and that’s why it is so important to develop a game plan early on — because once the emotions start playing havoc, you have to stay disciplined and stick to your plan (your dealbreakers, etc.) and be willing to walk, if necessary. 

Mistake #5 – Blinking First

There comes a point in time in just about every deal where both sides have dug into certain positions and the question becomes which side will blink first; e.g., in a venture capital financing, perhaps the issue is the liquidation preference or, in an acquisition, perhaps the issue is carve-outs to the cap on liability.  Whatever the issue, the lesson for the entrepreneur is clear (albeit difficult to execute): in order to maintain negotiating leverage and credibility, the entrepreneur should not blink first.  Indeed, if the entrepreneur has flatly stated that “this issue is a dealbreaker,” but then blinks and nevertheless agrees to go forward with the transaction despite not getting what he asked for, he will have completely undermined his credibility and will have his clock cleaned with respect to any other significant issues.  Like poker, if your bluff gets called, it will be difficult to bluff again.  Which brings us back to the important tip in #4 above: run the negotiations through an experienced corporate lawyer (or an investment banker) who does this stuff for a living.

www.youtube.com/watch?v=NtSeN0wA598

Mistake #1 – Playing Securities Lawyer 

A company may not offer or sell its securities unless (1) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable state commissions; or (2) there is an applicable exemption from registration.  The most common exemption for start-up companies is the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933 and/or Regulation D, the safe harbor promulgated thereunder.  This is very complex stuff – and now is not the time for entrepreneurs to play securities lawyer.  Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.

Mistake #2 – Selling Stock to Friends and Family Who Are Not “Accredited Investors”

The rule of thumb in connection with private placements is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506 of Regulation D.  There are two significant reasons for this: (1) Rule 506 preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996 – which means, in general, that the issuer merely must file with the applicable state commissioners (i) a Form D, (ii) a consent to service and (iii) a filing fee; and (2) there is no prescribed written disclosure requirement if the investors are “accredited” – though it still may be prudent to furnish to investors a private placement memorandum (or at least a summary and a set of risk factors).  There are eight categories of investors under the definition of “accredited investor” – the most significant of which for entrepreneurs is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year.  Indeed, if a company offers or sells securities to non-accredited investors, it opens a Pandora’s box of compliance and disclosure issues, under both federal and state law.    

Mistake #3 – Advertising or Soliciting Investors 

Subject to certain limited exceptions, Regulation D of the Securities Act of 1933 prohibits issuers from “general advertising” or “general solicitation” in connection with a private placement.  These terms are not defined under the Securities Act, but have been broadly construed in SEC no-action letters.  “General advertising” includes any ad, article, notice or other communication published in a newspaper, magazine or similar media or broadcast over television or radio or on a website; “general solicitation” includes any solicitations via mail, e-mail or other electronic transmission, unless there is a “substantial and pre-existing relationship” between the issuer and the prospective investor.  That’s the test: there must be a “substantial and pre-existing relationship” – and there are a number of SEC no-action letters which discuss what that means; simply put, it means there must a business relationship that is in place prior to the offer sufficient for the issuer to determine that the offeree would be a suitable investor. 

Mistake #4 – Using an Unregistered Finder to Sell Securities 

Entrepreneurs often make the mistake of retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) to raise capital for them.  The problem is that finders must be registered with the SEC if they operating as a “broker,” which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others.”   If the finder is receiving some form of commission or transaction-based compensation (which is usually the case), he will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions.  If he is not registered and sells securities on behalf of an issuer, the private placement will not be valid (i.e., will not be exempt from registration), and the issuer will have violated applicable securities laws – and thus will be subject to serious adverse consequences (as noted in paragraph #1 above), including giving the securityholders the right of rescission. 

Two caveats: (1) In 2004, California enacted a law specifically addressing this issue, which provides for (i) an express right of rescission to any investor who purchases a security from a person or entity that acted as a “broker-dealer” but was not registered; and (ii) the right of the purchaser to sue the unregistered seller for money damages.  (2) In 2008, the SEC adopted a new Form D (which, as noted above, is the official notice of a private placement under Regulation D), which must include the identities of all brokers and/or finders engaged in the offering of securities of the issuer.  This will obviously result in increased scrutiny of finders that are not registered as broker-dealers.

Mistake #5 – Selling Preferred Stock to Angel Investors  

Unless a start-up is raising at least $750K for an angel financing, it may not make sense from a practical standpoint for it to issue preferred stock.  Indeed, preferred stock financing are complicated, time-consuming and expensive – plus the company would need to be valued, which could be extremely dilutive to the founders.  Accordingly, entrepreneurs are better served by issuing convertible notes to angel investors, which keeps the financing simple and inexpensive, defers the valuation until the Series A round and gives the investors a discount on the conversion price (or a warrant) as a sweetener.  Needless to say, if superstar angels are interested in investing in your company, but insist on preferred stock, bite the bullet and take the money; great partners trump all rules.