News

The Right Lawyer for a Smart Startup

When the time comes to negotiate with VCs, expect them to suggest an attorney. Thank them politely — and then go out and get your own expert

By Gabor Garai Business Week Online

You’ve received a list of terms from a VC group committing the $4 million in first-round funding you were seeking for your technology company. There are a few items you don’t fully understand, and several others you’d like to change. You have been given the name of a general practice lawyer from a neighbor, but you’re uncertain if this individual has any experience in smaller-company financings. The venture capital (VC) firm has offered a few "suggestions," but you’re a tad uncomfortable because you’re not sure you want to use a lawyer with connections to the investors. What do you do?

In my view, the entrepreneur’s instincts are right on target in this not-uncommon situation. Entrepreneurs who convince VCs to invest in their companies don’t gain access to the cash until they have negotiated the actual terms of the investment — and that negotiation process is far from trivial. It involves important items covering the terms of investment, along with the VC’s ongoing involvement in the your business.

THANKS, BUT NO THANKS. Because VCs invest regularly, they have attorneys who are highly expert in such negotiations. But who should represent the entrepreneur, who has likely never before negotiated such an agreement?

The lawyer friend recommended by a neighbor is unlikely to be the best person to consult, since agreements with VCs tend to be highly specialized. The idea of using the VC firm’s recommendation is less clear cut. The VCs invariably tell an entrepreneur: "We prefer that the companies we invest in be represented by top-notch professionals. So we would like you to use one of the attorneys we use for our other portfolio companies because we have experience with them and they’re the best."

Before saying yes to the VCs suggestions — and occasionally, insistence — think about all the issues that come up in negotiating investment terms, the issues that will impact the company and its founders for many years to come. In addition, think about the many day-to-day and strategic issues arising after the completion of the financing. You will want a trusted adviser to recognize and advocate your interests. Here are some of the most common challenges:

• The power position of the VC firm. Key among power issues is the VC outfit’s role on the board of directors. For example, will it be controlled by the VCs or will they have just a single seat on the board? What of other possible arrangements?

• Antidilution protection. VCs often seek legal protection to prevent their shares from being diluted by subsequent investments. This isn’t automatic, however, nor is it black-and-white. Different formulas exist, depending on which stage the startup has reached, and the mood of the investor market. But bottom-line is this: The more protection against dilution that VCs receive, the more equity that is being given up by the founders long-term.

• Stock incentive provisions. Various decisions are required about stock set-aside for founders and employees: vesting periods, possible acceleration of investing if the company is sold, whether to hand out options or restricted stock. The VCs may have different views than the founders. Whose view prevails?

• Management team employment agreements. Obviously there are conflicting interests at work here. Executives want nonrestrictive noncompetes and generous severance arrangements, and the VCs are going to want the opposite.

• Ongoing management decisions. The startup’s entrepreneurs are likely to have a longer-term view on things like licensing and other partnership agreements than the VCs, who may want to exit in three or four years. How closely will the VCs get to look over the entrepreneurs’ shoulders on such matters?

• Exit strategies and acquisitions. The time horizon and return-on-investment expectations of VCs may be very different from those of the entrepreneur. An acquisition or other strategic move may have enormous long-term value to a company and its founders. Yet, such a step could defer the date when the company could be sold or taken public, to the detriment of the investors. As entrepreneurs evaluate strategic moves, the lawyer at their side should be expert in mergers, acquisitions, and corporate strategies.

These kinds of decisions make the choice of a lawyer far more important than many entrepreneurs realize. Thus, I recommend that entrepreneurs avoid hiring any of the lawyers used by the VCs. Even though such lawyers will be paid by your startup, at some level they also will be aware that the referral came from the VCs and, more important, that future referrals are likely from the same source.

On a related note, I highly recommend choosing legal counsel who represent startups and technology companies on a regular basis. Using someone who represents VCs is also a good idea — as long as those VCs aren’t investors in your outfit. After all, the greatest value that a lawyer can contribute to an emerging company is his familiarity with the ever-changing VC landscape.

ASK AROUND. Entrepreneurs need their lawyers to be knowledgeable about the VC-entrepreneur marketplace and, equally important, to be truly beholden to the company’s best interests. This means finding a lawyer who can strategize not just about the negotiating issues, but also their implications for the startup’s management. For example, developing a strategy for handling stock-incentive provisions will invariably lead into a discussion about tactics for motivating and rewarding the management team and other employees. In other words, the lawyer should have good business judgment as well as be technically expert.

How should entrepreneurs go about finding such a lawyer? Networking is usually the best approach. Ask other entrepreneurs who have received VC backing whom they consulted for legal advice and where the referral came from. Professionals like bankers and accountants are other sources. Don’t be afraid to interview two or three candidates — the stakes are high enough to warrant careful selection.

Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.

http://www.businessweek.com/smallbiz/content/nov2003/sb20031110_7465_sb020.htm

News Catrgory Sponspor:


Dorsey & Whitney - An International business law firm, applying a business perspective to clients' needs in Missoula, Montana and beyond.

Leave a Comment

You must be logged in to post a comment.