Choose Your Legal Advisors Carefully

We’ve been asked why we mention attorneys so frequently in the CapGenius blog posts. The simple reason is that attorneys can have a significant impact on topics we cover such as capitalization, taxation and accounting for stock and equity financing. We’ve seen great attorneys have a hugely positive impact, and have unfortunately seen weak ones cost companies and founders significant amounts of time and money for what on the face of it might seem like “minor details” or “afterthoughts” (both phrases we have heard weak attorneys use in discussing some of these topics).

Note for Attorneys: Some of the articles posted here may be viewed as being harsh by our attorney friends. We are only intending to be harsh on bad attorneys. If you are an attorney reading the CapGenius articles and chafing at the stupid things we say attorneys often do, and agree they are absurd, then don’t worry, you are not a bad attorney. That said, even you have to admit there are some bad attorneys out there!

Corporate counsels are a necessary evil for any Company. Evil because were it not for the legal mess that is United States Corporation’s you would need them a lot less and spend less on them. Necessary because they have important roles to play and the actions they take can either set your Company on a better course to success, or inadvertently throw up future unseen obstacles that can really slow you down.

Suffice to say that selecting the right attorney and law firm is a very important decision and one that (if possible) you should make before you incorporate your business.

Given that, we wanted to provide a list of a few things to consider as you begin to evaluate legal advisors. You will notice that with the exception of this and the next paragraph, we do not mention fees, billable hours or billing rates. If we were helping select a skydiving outfit we would not recommend you go with the cheapest based on price alone, and we likewise recommend you not choose your attorney based on who charges less per hour. This is a very myopic view for selecting someone who will be a key advisor to your business.

Weak attorneys charge less per hour because they have to in order to get clients. However, being weak attorneys, they will make costly mistakes and you will end up paying them a lot of money over time to fix the stuff they screwed up (note: you will not know they screwed up because they will not tell you this). “Expensive” attorneys (on an hourly basis) are often expensive because they are in high demand, and as a result can charge higher rates. They are in high demand because they are good at what they do. They will get things right the first time, will make smart recommendations that save you time, money and headaches down the road, and can be a valuable resource for your business. As such, we highly recommend you narrow your list of attorneys down to two or three where you feel you’d be comfortable working with any of them, and only then would we recommend you focus on fees and billing rates. When you get to this point, ask to meet the associate who will be assigned to your Company, interview this person and make sure you know their billing rates as well. Associates will do a lot of the legal work on your business so you want to make sure you are comfortable with the one they plan to assign to you. If you are not, ask for a different associate. Finally, don’t be afraid to ask for a fixed price for your near-term work (company formation, fundraising, option pool, etc.), and offer to given them equity or warrants in return (more on this below).

With that out of the way, here are a few things to think about when selecting an attorney:

(1)   They are there for LEGAL advice. Don’t expect them to overstep this role, and be wary of the attorney who frequently does so. You should select your attorney based on whether or not they are good at their profession. It is rare that they are also truly knowledgeable about founding a company, raising capital, investment banking or your particular market. While it is likely they will have been exposed to each of these on a regular basis, they generally only focus on the legal side of these things. If you need advice on other topics, find advisors who are experts in those areas to help out (note: in the same vein, investment bankers are not lawyers and you should not rely on them for legal advice).

(2)   Even with what we wrote in Point #1, the best corporate legal advice comes from a business point of view. Avoid hiring a lawyer who understands the complexity of the various legal and regulatory codes but has no real sense of how businesses work and how legal decisions should factor into running your Company. Legal decisions are important, and you do not want to misstep, but they rarely contribute to sales growth, so prioritize accordingly. Sometimes the best “legal” decision is not the best “business” decision. You should weigh the legal considerations, but these should not block out the business logic.

(3)   Try to hire an attorney who also has a MBA (JD/MBA or both degrees separately). There are plenty of people out there who have both, so look around. Having a MBA shows that the person has a true interest in business and has at least an educational background studying business (you will often find they have worked in companies as well, which is an added plus). Attorneys with a MBA will be more likely to put the legal issues in a business context. In other words, they are more likely to speak your language. We have also found that these folks are much better at understanding where the legal work fits in the overall pecking order and are less likely to “lawyer things up”.

(4)   Pick someone you like and trust. You will be seeing this person on a regular basis for a very long time, so make sure it is someone who will not be afraid to tell you when they have a concern or disagree with what your are doing, and someone who will not irritate you when they do this. Consider letting an attorney buy a small amount of equity, but make sure they understand they are in the board meeting as a service provider, not a shareholder (the downside to equity is that attorney’s sometimes forget their role and overstep bounds into the realm of an investor during the board meetings). No all shareholders are invited to board meetings (obviously) and they should not be confused about why they are invited to attend.

(5)   Get their commitment on a few things. Ask them to commit to attending your board meetings personally with rare exceptions. If you want them to be there you need to include them in the scheduling process for meetings, and you should understand that the partner on your deal cannot be there every time, but they should be making an effort to attend regularly and when they cannot attend they should be sending the same associate each time who should understand they are there to listen and take notes, not check their Blackberry. Also, you should assume (but still confirm) that they will not charge you for the time spent attending board meetings. If this is not their defacto practice, select a different attorney as that is a bad sign. If so, take advantage of the free legal time with your attorney, and understand you will be charged for the meeting minutes, which is perfectly reasonable. Also ask them to commit to making some introductions for you. This could be to investors, strategic partners or other entrepreneurs – don’t be afraid to ask for access to their network of contactss.

(6)   Don’t worry (much) about conflicts of interest. Top attorney’s and law firms will have conflicts of interest with large corporations (and possibly your competitors), as well as angel and venture investors. They have conflicts because they are good attorneys and are sought out for their legal expertise by smart people. Law firms that have no potential conflicts are either not looking carefully enough, or are not very good since no one who matters is seeking their advice. Understand that if your law firm represents Google, and Google sues you or tries to acquire you, it is unlikely the law firm will be able to work with you on that particular matter. They will help you find alternative legal help, and you should take comfort knowing there is a strong likelihood the fact the conflict exists and you are a client will actually be helpful to you in dealing with the matter at hand. If the conflict of interest exists with investors, ignore it, especially if you are in Silicon Valley. These conflicts are commonplace and should not be a concern unless the attorney and the investor happen to be personal friends. Top law firms are excellent at handling these conflicts and if you trust the attorney, these should not be a concern for you. All that said, you should have an open and frank discussion about conflicts of interest and how the attorney and his/her firm handles them before you decide which attorney to hire. If you do not feel comfortable after this discussion, refer back to Item #4 (pick someone you trust).

A (few) word(s) on Deferred Legal Fees

It is fairly common for start-up companies in Silicon Valley to structure fee arrangements with their attorney’s that defer or waive legal fees from the inception of the business until some later date, typically the closing of a meaningful financing round. This deferral or waiver is compensated in part by a small amount of early equity or warrants being issued to the law firm, and sometimes to the specific partner (we recommend trying to do a bit of both, but the law firm will likely have pre-set rules for this). The fee deferral/waiver concept is attractive to start-ups because it pushes out or eliminates a meaningful early expense which allows the business to get more done for less early on.

We are generally in favor of this approach assuming the structure of the arrangement is a good one. That said, it is important that as an entrepreneur you remember that deferring legal fees is the equivalent of Wimpy (from Popeye) promising “I’ll gladly pay you Tuesday for a hamburger today”, with the difference being you will actually have to pay when Tuesday (or more likely the Series A) arrives. Think of it as the first debt (long term payable) in your business, and make sure it is not forgotten when doing your cash budgets.

When considering a fee deferral, it is important to think about the other side of the equation – why would an attorney agree to defer fees for a poorly funded start-up that might never be able to pay the bills? There are two primary reasons attorney’s will do this:

First, and usually the primary reason, is that they realize small companies cannot afford the fees prior to raising a financing round, but that once an attorney is selected, it is next to impossible to unseat them. So, if they don’t start working with a start-up early on, they will have a hard time getting the business later.

Second is that the equity may have some value down the road. Don’t be confused – this is a SECONDARY factor for most attorneys, with fee generation being the first. Don’t be lulled into thinking otherwise. If they tell you equity matters more than the fees, ask them to take a bit more equity and to WAIVE fees until you close your Series A (or B) instead of deferring fees. See how they respond to the request (90% will offer an excuse that they need some billings to show their partners, etc.. A handful will accept, and you should seriously consider working with them as this is a powerful signal about their belief in you and your idea).

You will be fortunate to find an attorney who is more focused on Reason #2 than #1. Even better, if they say they’d like defer or waive fees AND invest at the same time, you can feel comfortable they want your business in large part because they believe in you and your company, and while generating legal fees is an important thing for them, they see meaningful upside in the equity as well.

We have seen a disturbing trend in the market related to fee deferrals. In the past, attorneys would defer fees with two key things clearly understood: (1) They needed to keep billings to a minimum during the early startup phase, and (2) Sometimes start-ups fail.

This seems to be changing as we are hearing about attorneys who rack up huge deferred fees that they eagerly wait to collect when a financing round of sufficient size comes together. To avoid this, make sure to ask for detailed monthly statements during the deferral period and challenge every item you do not understand. DO NOT wait until the end of the deferral period as you will have a harder time getting any disputes resolved. Also, before you accept a deferred fee arrangement, make sure it is clear what they will and will not be working on, what the total range of billings is likely to be during the deferral period. Also make sure you understand exactly when they expect to be paid.

You should request a fixed cap on legal fees during the deferral period, and negotiate this cap within the context of the work you have agreed they will be doing for you. If at any point the attorney complains about the amount of work being more than they had expected, remind them of three things: (1) They agreed to the fee amount, (2) They got equity in the business, and (3) You selected them at least in part because of the deferral agreement. If they had asked for a higher cap on the work they might not have gotten your business to begin with and if they persist in asking for more they might still lose it.

Another trend we see but do not like is that when an early-stage business does not work out, and there is nothing available to pay fees, attorneys used to be the easiest “creditors” on the books as they understood that long-term relationships are important and that sometimes failures happen. They would get out of the way from a creditor perspective and still provide legal help (effectively pro bono) to handle the wind down. This seems to be changing as (some) attorneys are lining up with creditors to get paid and refusing to do the shut down work until they do get paid. This is of course dependent on the partner and firm, but before engaging an attorney for deferred work, ask for some references of clients they have done this with before (both successful outcomes and failures).

Fee Waivers – We include the fee waiver concept along with deferrals because we have seen them done before, and seen them work well for both sides. The structure was that the attorney waived all fees over $15,000 from inception through the first $1 million financing round. They were paid $15,000 for their work on forming the business and completing an angel financing round. In return they received 1% of the founders stock in the business and the right to invest $50,000 in the angel round. We have seen fee waivers done twice across the companies we have been involved with (making it an uncommon occurrence). In one case the law firm made over $1 million on their equity when the company was acquired less than two years after it was formed. The other one is ongoing. 1% of the founders stock to a law firm is a hefty amount, but given the amount of work they did it was much cheaper from a dilution standpoint than paying their fees from the angel round, and because they held founders stock, the firm and partner had a vested interest in the success of the Company. Fee Waivers are not common, but this should not prevent you from asking. More likely you will settle for deferred fees, which if structured correctly can provide an early boost for your startup.

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We may provide a future post with some questions to ask potential legal counsel during interviews, but don’t hold your breath waiting for it – it is a bit off our target path. We put this post up at the request of a couple of entrepreneurs, so if we see comments requesting a Q&A checklist we’ll work on putting it together. If not, we’ll assume this post will suffice and get back to dealing with equity-related matters.

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