This article was originally published in the FOCUS: Venture Capital section of the Indus Business Journal – June 2003
While experienced entrepreneurs are familiar with the proper role of attorneys in first-time venture capital financings, first-time founders are often unsure what to expect. Some believe that certain attorneys can guarantee access to capital, or expect that hiring one law firm over another will give them dramatically greater leverage in negotiations. Neither supposition is completely true. But hiring the right attorney can make a big difference in important aspects. Knowing what to expect an experienced attorney to be able to do will help set expectations within realistic boundaries, as well as ensure that an entrepreneur can get the most out of legal counsel.
Perhaps the most important thing that an experienced venture capital attorney can bring to the process is the knowledge of what an entrepreneur can and can’t get. Examples include how current valuations are running and what types of deal terms to expect. For example, attorneys that see many deals and who have been in the business for a long time will know that current valuations are not very different than they were ten years ago. They can also explain why the values of the Internet bubble years can’t work for investors in normal financial times.
Similarly, deal terms, which are easily refused at a point in time when investment competition is high, may be quite common at a time when money is tight. One example is the “liquidation preference” than an investor requires in a deal. During the bubble years, many VCs were content to ask for “simple” liquidation preference — meaning that on a sale of the company, they could choose to either get their money back first (the right choice if the sale is for a low amount), or take the percentage of the company that their stock ownership represents (the correct choice if the sale is for a high amount). Currently, with money much harder to get and investors smarting from severe losses in their Internet company investments, many VCs are demanding preferences that entitle them to get several times their money back before the entrepreneur (or even earlier investors) see a penny.
The reason that knowing how terms are running is so important is that there tends to be a high degree of uniformity of offers within the VC community. Pushing for something that will be impossible to get wastes time, increases legal costs, extends the process (raising the possibility that something may kill the deal entirely) and can sour a relationship in the beginning that must work well for many years. The fact is, many terms, which seem “unfair” when they are first encountered, will appear in every offer from every VC firm. Understanding why some of these terms are necessary to make the deal work for an investor — as well as learning that it is a waste of time fighting them — is something that its better to find out at the outset. For some entrepreneurs, learning what terms to expect can lead to adopting a boot strap approach, and avoiding a long and potentially disastrous learning experience.
An experienced lawyer can also tell a fair set of documents when she sees one. Where experienced attorneys are representing both the investor as well as the entrepreneur, there should be very little negotiation between them over the documentation, since there is a very high degree of uniformity in documentation among firms, and its more likely that the first drafts will be “down the middle.”
An experienced lawyer should also help an entrepreneur do everything right from the start, encouraging simplicity in structure and the use of option, non-disclosure, non-competition, vesting and other agreements from the outset that venture capital investors will find acceptable. Otherwise, costly delays will hold up a financing, while employees (and, worse, prior employees), need to be persuaded to sign new agreements as a precondition to a financing.
A good VC lawyer should also be able to function as a valued business advisor. Experienced startup lawyers help an entrepreneur look over the horizon to anticipate — and head off — future problems that will not only impede the likelihood of raising capital, but succeeding in the venture at all. There are many aspects of a business, from developing licensing strategies to adopting a funding plan, that an experienced attorney will have been involved in with scores, if not hundreds, of prior clients.
Finally, a good lawyer can indeed facilitate getting funding. He/She can help determine whether the company’s business plan is likely to be funded, and advise on how it should be changed in order to become fundable. However, an entrepreneur must be under no illusions about the role of a lawyer extending much beyond that. An investor wants to invest in the management team, and not an outside provider. Knowing that the startup has a good lawyer that was confident enough in the team and the plan to take the client on is helpful, but there’s a long road between hiring a lawyer and closing an IPO. On the other hand, a recognized VC lawyer can help open a door, but the VC wants to see the entrepreneur walk through that door alone — and not with a lawyer in tow.