If I Lie To My Lawyer, Will It Save Me Money?

Not a chance. Even so, I occasionally find a client or prospect holding back important information, presumably because they think it will complicate the project and cost them more money. But that’s exactly why it should cost more money – because it makes things more complicated. Let’s see it in action…

First Call

Prospective Client: Hi, I’m working on a startup with a cofounder, and we are ready to move forward. We think the idea is viable. We formed an LLC about a year ago, and now we want to form a Delaware corporation. What will it cost to incorporate with two cofounders?

Lawyer 1: You’ll need to convert the LLC to a corporation. If you are lucky, and you formed the LLC in a state that allows conversion, forming a new corporation and converting the LLC into it will cost $2000, plus about $350 in filing fees. If you formed the LLC in a state that does not allow for conversion, we’ll have to do a merger. That will cost between $2500 and $3000, plus about $500 in filing fees.

Prospective Client: Wow, that’s a lot of money. We’ll have to discuss it and get back to you.

Second Call

Prospective Client: Hi, I’m working on a startup with a cofounder, and we are ready to move forward. We think the idea is viable. We want to form a Delaware corporation. What will it cost to incorporate with two cofounders? [Notice how the client left out that information about the existing LLC?]

Lawyer 2: It will cost you $1500 to incorporate, plus $150 in filing fees.

Prospective Client: Sounds good, let’s do it!

Now let’s flash forward 6 months, when the startup is trying to raise money from investors. They’ve signed a term sheet for an $800,000 investment, and the investors are doing their due diligence check on the company. During the due diligence, the investors discover that a year and a half earlier, the cofounders had formed an LLC, which they neglected to mention to Lawyer B. They also discover that there had originally been three cofounders, and one of them left on bad terms within the first 3 months. Now she’s moving around various hippy beach communities in Thailand, and doesn’t even have a cellphone. Even worse, it isn’t clear whether everyone signed intellectual property assignments, and Gone Girl happened to have developed the most important part of the code that is the startup’s product. Making a bad situation worse, the cofounders used Legalzoom to form their LLC, and even if they got an operating agreement, there isn’t a chance in Hell that it contains vesting provisions that would allow them to recapture Gone Girl’s unvested ownership interest in the LLC.

Here’s what it all adds up to:

  • The corporation doesn’t own most of the software code and other IP that is the core of the business. That belongs, at best, to the LLC, if everyone signed IP assignments.
  • If everyone signed IP assignments, that’s not going to help much, because they still need to convert (or merge) the LLC into the corporation. But they need Gone Girl’s approval to do so, and she was last seen on a beach in Bora Bora, smoking weed with an actor who may or may not have been in Titanic.
  • If there are no IP assignments, then it really doesn’t matter whether they can convert the LLC into the corporation, because Gone Girl owns the core of the business. And when word gets out that the business is worth $1.2 billion, guess who’s going to show up with some very mean lawyers in tow?

Of course, the truth of the matter is, that company will never be worth $1.2 billion, because the cofounders were too cheap to do things right. They thought that if they withheld important information from their lawyer, they could save a few hundred dollars. Instead, that little lie is going to cost them $5000 to $10000, at best, in legal fees to try and sort out the mess. At worst, the lie will cost these guys the $800,000 they were hoping to get from the investors, who are now walking away and looking to invest in a business run by someone with brains.

So the moral of the story is, keeping information from your lawyer will not save you money, it will cost you much much more.

Follow me on Twitter @PaulHSpitz

Clean House Before Your Financing

Admission: I don’t have a housekeeper, but if I did, I would have to clean my home before the housekeeper comes by, because I don’t want to reveal what a slob I am. Startups thinking about venture capital financing or mergers should adopt the same approach. Before closing the deal, there will be a due diligence process, during which the potential investor or merger partner will want to look at a long list of corporate documents. A certain amount of corporate housekeeping will be necessary to put together these documents, and if a startup has messy, incomplete books and records, it can easily derail the transaction. Scrambling to assemble all the needed records will delay the closing, at best, and poor record-keeping could have the undesirable effect of driving the potential investors to put their money elsewhere.
To avoid the problems involved in trying to organize your corporate records while trying to run the business and close the financing, it’s a good idea to start generating and organizing the records now, well before they are needed. Think of this as cleaning the house before the housekeeper shows up. This will reduce stress later, and is a good exercise for identifying where you might be missing a key document like an IP assignment agreement from a cofounder or license to do business as a foreign corporation. Take a look at this excerpt from a typical due diligence list for a venture capital financing, to get an idea of what kind of records you need to have:

a.     Articles of Incorporation and by-laws.
b.     Corporate minute books and stock transfer records.
c.      Federal and state tax returns and related reports.
d.     Shareholder agreements between the company and its shareholders.
e.     Documents imposing restrictions or conditions on stock transfer or merger, including any arrangements granting rights of first refusal or other preferential purchase rights.
f.      Third-party or governmental consent or authorizations required for merger or acquisition.
g.     Intellectual Property documents, including patents, patent applications, copyrights, trademarks, trademark applications, licensing agreements, etc.
h.     Office leases.
i.       Corporate policies concerning hiring, compensation, advancement and termination.
j.       Employment contracts, including non-competes and IP assignment agreements.
k.     Employee benefits documentation.
l.       Insurance policies.

That list is just a small subset of the full range of documents that an investor or merger partner will be requesting. A quick search on “due diligence document list for venture capital” will generate several free examples of comprehensive lists to guide you.

Another lawyer that represents startups wrote that the most valuable piece of equipment a startup can buy is a good document scanner. While you will want to have hard-copy originals of certain documents, other documents can be maintained exclusively as digital copies. In addition, every document should be scanned and kept in digital form too, as a backup. Scanning can be a time-consuming process, which is why it is good to start now, and do a manageable amount every day.

It’s pretty easy to organize these digital documents into subject areas, with appropriate folders and labels. For example, you would create a digital folder labeled “Employment,” and digital copies of all employment contracts, non-competes, and employee handbooks would go into that folder. Another folder can be created for Intellectual Property, with subfolders for non-disclosure agreements, patents, trademarks, copyright, logos, IP assignment agreements, etc. A third folder will contain your articles of incorporation, bylaws, and minutes of shareholder and board meetings. When the time comes to hand over copies of these various documents as part of due diligence, you will already have them in digital format, well-organized, and ready to copy to a disk. Your closing process will go more smoothly, you will save a little on attorney fees (theoretically), and your investor or merger partner will be impressed by how organized and prepared you are.

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Five Keys To Working With Investors

If you are a startup founder and you are looking for outside investment, here are five keys to working with angel investors and venture capital funds.

Investigate Your Investors

Potential investors are going to put a lot of money into your company, and they will investigate your company thoroughly. You should do the same with your investors. After all, you will be in a close relationship with these investors over a period of several years, and you will be giving up a great deal of equity and control to them. Consequently, you need to be comfortable with how they operate, and you need to know what they bring to the table. Talk to other startups that these investors have put money in. Are they easy to deal with? Do they respect the founders and employees? Are they accessible? Do they pepper the founders with 3 AM phone calls? What kind of business background do they have? Do they have good contacts?

Create a Competitive Environment

You will have greater leverage in negotiating favorable terms if investors have to compete with each other for a chance to invest in your company. If your startup is hot, if it has good buzz, there will usually be more than one angel or VC eager to invest. Creating a competitive environment, or even the appearance of a competitive environment, can be crucial to getting more favorable terms. You have to be careful with this, however, because if you go too far in playing one investor off against another, you could drive them all away and be left with nothing.

Be Cold-Blooded

Your startup is your baby, but to the investors, it is just another company they might invest in. They aren’t being emotional when dealing with you, and you need to avoid becoming emotional as well. Be prepared to walk away if the terms aren’t good. This is especially hard when you have already put a lot of time and effort into closing a deal. Establish reasonable deal-breakers in advance, and stick to them.

Understand the Deal

Even if this is your third startup and you have been through a couple of financings before, your investors do this for a living, and you don’t. As a result, they will always have a greater facility with the deal terms than you. I recall sitting in a meeting with a VC a few months back, and the guy was speaking at about 90 mph. He was rattling off numbers, terms, and formulas at far too rapid a clip for his audience to keep up with him. He may have been speaking total nonsense, but it was all going by so quickly who could tell? The point is, he was completely comfortable dealing with these complex terms and ideas, while many in the audience were hearing it for the first time. It is crucial, therefore, that founders put the time into understanding each and every part of the deal. Rely on advisors, rely on lawyers, but make sure you read every word and ask questions. That leads us to our fifth key…

Get Your Own Lawyer

An angel financing or Series A financing is no time to go it alone. You cannot rely on Legalzoom to help you here. And you absolutely should not use your investor’s lawyer, or even a lawyer recommended by your investor. Your investor’s lawyer cannot represent you and the investor at the same time; it is a honking big conflict of interest. If it comes down to you or the investor, guess which one of you will get screwed? The same applies to a lawyer recommended by the investor. He is going to rely on the investor to continue to recommend him to clients, so he isn’t going to push that hard on your behalf. The risk of cutting off those referrals is too great, compared to the small amount he will make from you on this one transaction. You need to get your own lawyer, and you need someone who understands these kinds of transactions. The guy who does your patent applications or your parents’ will generally is not going to have sufficient expertise and experience in this area. Remember, the investors do this every single day. You need an experienced, strong corporate lawyer who can explain the deal to you, and negotiate hard to make the terms more favorable to you.

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Anatomy of a Term Sheet – Conditions to Closing

Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth. 

We’ve gone through the charter terms that involve changes to the startup’s certificate of incorporation, and now we are working on the Stock Purchase Agreement section of the model Term Sheet. In a Series A investment transaction, the startup is issuing preferred stock to the investors. As part of the transaction, the startup and the investors sign a contract called a stock purchase agreement, which contains a variety of terms application to the transaction. In the last installment, we looked at the reps and warranties that each side makes to the other. Today we look at conditions to closing and counsel/expenses. 

Conditions to Closing

This is what the closing conditions term looks like in the model term sheet:

Standard conditions to Closing, which shall include, among other things, satisfactory completion of financial and legal due diligence, qualification of the shares under applicable Blue Sky laws, the filing of a Certificate of Incorporation establishing the rights and preferences of the Series A Preferred, and an opinion of counsel to the Company. 

The financial and legal due diligence can be a time-consuming process, as the investors will want to thoroughly investigate the company’s business. In addition, if the company has been sloppy in its corporate housekeeping, time must be spent cleaning up the corporate records.

Qualification of the shares under Blue Sky Laws means ensuring that there is an applicable exemption from registration under federal and state securities laws. Rule 506(c) of Regulation D under the federal Securities Act provides an exemption for private placements, so long as the startup business offers the securities only to accredited investors. There is no limit on the size of the investment, and the prohibitions against general solicitation and advertisement do not apply. In addition, Rule 506(c) largely preempts state securities laws; the company only has to do a notice filing on Form D, consent to service of process, and pay a filing fee.

The company will have to file an amended Certificate of Incorporation, containing the new class of preferred stock and outlining the rights and preferences of the holders of the preferred stock. If the company had been set up as an LLC, it will have to convert to a C corporation, which can delay the closing and raise the legal costs. This is why startups that are thinking about raising venture capital money should incorporate as a C corporation from the outset.

Finally, the investor may require the startup’s lawyer to provide an opinion letter stating that (a) the company is validly existing, in good standing, and authorized to do business where located; (b) the company has the authority to enter into the various agreements involved in the transaction, and that they are enforceable against the company; (c) the performance by the company of the transaction, including the issuance of the preferred stock, will not violate state of federal law; (d) the capital structure of the company is as described; (e) all shares are validly issued; and (f) there is no litigation threatening the transaction. Since the startup’s lawyer is incurring potential liability in issuing the opinion letter, the lawyer will have to conduct some due diligence on the company before signing off. There can be problems when the investors try to push their own due diligence obligations onto the startup’s counsel, to save money.

Counsel & Expenses

Venture capital financings are unusual, in that the startup company pays not just its own attorney fees, but also the investors’ legal fees:

Company to pay all legal and administrative costs of the financing [at Closing], including reasonable fees (not to exceed $[_____])and expenses of Investor counsel[, unless the transaction is not completed because the Investors withdraw their commitment without cause].

One reason for this is the capital structure of venture capital firms. If the VC firm paid its own attorney fees directly, the money would come out of the VC firm’s management fee, reducing the income to the VC partners. Another reason is to create an incentive for the startup company not to negotiate too vigorously over terms that the investor will not remove or change. If there are multiple investors, it also saves them from having to argue about how to split the legal bill among them.

In any case, it has become an industry standard for the startup company to pay the investor’s legal fees out of the financing proceeds. Rather than trying to change this, the best option for the startup is to try to cap the amount of investor legal fees it will pay. Since you are paying the investor’s lawyers to negotiate against you, putting a cap on their fees gives them an incentive to be more reasonable, rather than argue until they are blue in the face. It is typical to set the cap between $10,000 and $20,000.

In some deals, the startup company is also responsible for drafting all the documents. This is another odd duck term, because in typical transactions (leases, acquisitions, mergers, etc.), the party with greater leverage drafts the documents. Usually, the first draft is going to be more favorable to the party that prepared the draft. While having the startup’s lawyers draft the documents will raise the startup’s attorney fees, keep in mind that nobody is drafting these documents from scratch. There are numerous model documents that provide a starting point, including the NVCA documents we have been using in this series.

That is it for the Stock Purchase Agreement terms. Next time we will dive into the Investor Rights Agreement terms, including registration rights, among other important terms. Thanks for reading!

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