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Entrepreneurs need to learn some law

September 13th, 2009 | startups, venture capital

I recently wrote a post where I said entrepreneurs need to understand term sheets on their own, without the assistance of lawyers.  I got quite a bit of criticism for this, e.g.

@rafer Never ever sign a term sheet without your atty’s review. sry but thats crazy talk @cdixon http://bit.ly/UOgiC myreblog http://bit.ly/cJ9d0

I’ll agree that entrepreneurs, especially first timers, should have lawyers review everything they sign.  But I stand behind my main point:  you can’t outsource the understanding of key financing and other legal documents to lawyers.

Here’s just one of many examples of why.   A company I know was recently confronted with the following trade off.  Get a higher valuation with full ratchet anti-dilution or a lower valuation with weighted average anti-dilution.   The only way to assess this trade off is to understand what these terms mean and try to compute the expected value of the two offers.   In this particular case what matters is the likelihood of a future down round.  This is a business judgment, not a legal one, and the people best able to make it are business people.

You also need to consider your personal utility function.  For example, as a founder, I don’t care very much about anti-dilution provisions because I figure in the cases where it matters I will already have been fired and my equity crammed down.

My point is you can’t leave these judgements to lawyers.   They don’t have the expertise to make these expected value calculations nor do they understand how various scenarios affect the founders personally.

Another common mistake entrepreneurs make is let their lawyers argue over terms that don’t matter.  This puts deals at risk and costs money.  You need to understand what they are arguing over to decide when it matters and when it doesn’t.

You learn about these legal issues from experience, by talking to lawyers, by talking to experienced advisors, and by reading blogs and books (every entrepreneur should read The Entrepreneur’s Guide to Business Law).

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  • I'm a bit late finding this one but its 100% spot on Chris. I always tell entrepreneurs you cant outsource: legal knowledge (advice is different), fundraising or production (inc software development) if you want to be a game changer. You need this expertise in-house for sure
  • Thanks Chris. Been following your blog, learning a lot. The book reference is exactly what I need. The worst thing for me is not knowing what I don't know, which is exactly where I am when it comes to double clicking on term sheets. I'm also in the "I know my legal documents are awful" situation... but I figure I'll cross that bridge when I come to it. (Getting an investor interested first, is the higher order priority.) Thank you again, this is and will be exceptionally helpful, the book is on order.
  • Totally agree and would say your point applies to all situations where you use outsiders. As an entrepreneur you should delegate but not abdicate your responsibilities. I see this sometimes in my work with startups and make sure my founders understand every aspect of the deals we're working on
  • jeremy_freeland
    Chris - my experience as a business person / lawyer (i.e., in-house GC) is that the only way to understand these scenarios so as to be able to make an informed decision is to build a financial model to determine the outcomes, based upon different assumptions, e.g., round valuation and exit / next round valuation. The models are quite complex and require (in my experience) a joint effort between a financial analyst and a corporate lawyer, but the results are very instructive - not least because they differ from what one might instinctively conclude. In my experience, even though it can be resource intensive, it's the only way to be able to make an informed decision.
  • Great post, what blogs would you recommend?
  • brad feld has a great series on term sheets. http://www.feld.com/blog/archives/term_sheet/
    of course fred wilson is the master.
  • What you are trying to explain is sound. As explained to me last night, very late, by an IP Lawyer- Lawyers moral code is that we are your last, private resort to tell you you are screwing up. We got client privilege.

    Use the fact they have a code silence and weirdness. That's pretty much it.
  • What we all criticized was your assertion that founders could sign a term sheet without attorney overview (which you openly and elegantly backpedaled from, etc.). Founders absolutely need to be very schooled consumers of legal services in the way you suggest.

    One corollary to your assertion -- founders need to read the document as if it's two years later and life sucks. A tertiary problem we had at Lookery was that I'd unthinkingly dropped the standard weighted-average anti-dilution clause into our term sheet (which we wrote, not our investors). It wasn't necessary and became (one of our lesser) problems later.
  • Chris - I completely agree that entrepreneurs need to understand every term in detail. One problem in the entrepreneur / legal counsel relationship is that entrepreneurs way too often accept terms because their lawyers says "this is standard." I have seen WAY too entrepreneurs make mistakes because their lawyer told them it was "standard".

    Finally, in the course of this conversation I haven't seen one of the most valuable reasons to talk to your lawyer about a term sheet... and that is market information. Lawyers, especially if you have good ones, are seeing more deals than any other party in the transaction. They are in a great position to provide information to the entrepreneur about the market and what other deals recently have looked like. I am not suggesting that entrepreneurs should over weight this information, but this is important market information to have when making a set of business decisions.
  • Agree - getting market info from your lawyers can be good negotiating fodder. But as you say you shouldn't accept terms just because a lawyer/VC says it's "standard."
  • Chris – You are correct: “you can’t outsource the understanding of key financing and other legal documents to lawyers”; however, as a corporate lawyer for 15+ years, I cannot emphasize enough the importance of entrepreneurs’ retaining a strong transaction team, including an experienced corporate lawyer (see tip #2 of my post here - http://walkercorporatelaw.com/2009/09/07/doing-...).

    Of course, this may sound self-serving, but I have a different perspective than you: more than one-third of my work is spent cleaning-up the legal mess entrepreneurs have created for themselves by playing lawyer and/or by retaining an inexperienced lawyer. Recent examples include: (i) having to effect a rescission offer in a certain State because the entrepreneur sold stock to non-“accredited investors” without complying with applicable State securities laws and received a Cease and Desist order from State authorities; (ii) having to bring in litigators to sue a major investor who was selling his 75% interest in my client’s venture to some bad guys and the agreement that the entrepreneur negotiated without a lawyer had no veto rights, tag-along rights or any other rights to protect him; (iii) having to try to re-negotiate the terms of an angel investment in which an inexperienced lawyer gave the investors preferred stock and half the company for a $250K investment.

    I recognize that a lot of entrepreneurs get frustrated dealing with lawyers (and the huge legal fees); however, there is a big distinction between (i) an entrepreneur understanding key legal documents and (ii) an entrepreneur having a strong, experienced corporate lawyer watching his back.

    Thank you – and keep up the good work.

    Scott Edward Walker
  • Totally agree that entrepreneurs should hire experienced startup lawyers. I tried skimping once on startup docs and I had to redo everything because even I could tell they were awful. That doesn't change the fact that entrepreneurs need to understand the details of term sheets, employee agreements, option plans, etc.
  • A really good lawyer will be able to give you the following experince:
    My ex is a lawyer. Because of a wide age gap and a distance issue, for some reason, it worked out that I shadowed him in his office, in a Vault 100, one day. By the end of that day I understood some basic facts of what he was working on, with some explination taken aside, because I was sitting there.

    If your lawyers can't be able to explain to you what they are doing when you sit and watch them, you have a bad lawyer. If they can, you have a good one. (He is very good at what he does). If that lawyer can't explain corporate law on a level for you need to know (My ex called this being "people friendly"), you should not retain that lawyer.

    End of story. I would give you my ex's number, but alas, he does international tax @ MOFO. Not until much later in many stages do startups ever worry about international tax.
  • Greg George
    Precisely - under no circumstances should you allow any lawyer to make or influence business decisions that are your responsibility - I can write a book on these client horror stories. Lawyers are not trained in business, period. Lawyers are trained to advise you of the law. Ask the right questions and use them only as a tool, as you would you accountant, war time Consigliore or other advisor.

    Regarding term sheets and others matters of business, keep your own counsel.
  • Color me idealistic/naive but most of this tension arises from investors insisting on a different class of shares than the founders. If everyone held common stock, interests would automatically be aligned. Key protections could go into simpler shareholder agreements.
  • I think with straight 1x preferred you get (nearly) aligned interests as well.
  • Nope. The Pro Rata changes everything. Investors have incentive for the company to consume capital that the founders don't.
  • Rafer - I agree investors have an incentive for the company to consumer capital faster than the founders, but I don't think this has to do with preferred vs common shares or pro-rata rights. I think it has to do with the way VCs are paid. Carry fees encourage them to "shoot the moon" and management fees encourage them to "put money to work." See http://www.cdixon.org/?p=443. Getting you to the end of your cash also gives them more options, see http://www.cdixon.org/?p=259. (I think you have the impression I'm ultra pro-VC - I think if you read my older posts including the ones I cite you'll see I'm actually not).
  • Sorry, until I looked you up a few weeks ago, I assumed you actually were a VC. At least half of the issue is me. I'm in the "VC is broken" camp, and your efforts to heal it from within don't move me. Over the next decade, software VC will move to angels and strategics.

    RE: pro rata. Management fees and 'shooting the moon' are certainly relevant, but the math on it only works because the Preferred has complete control over its own dilution. The Common doesn't, even in profitable companies.
  • "Another common mistake entrepreneurs make is let their lawyers argue over terms that don’t matter. This puts deals at risk and costs money. You need to understand what they are arguing over to decide when it matters and when it doesn’t."

    I think VCs fall into this trap as well. That's why i really like the Gunderson & Fenwick folks. They get it in my experience.
  • I actually never allow lawyer to lawyer discussions without me being present. I don't expect the VC to be on every call or e-mail but as company CFO, I insist on being there so I can make those judgment calls. Lawyers are not there to make deals, they are there to represent their client's individual interests
  • Ropes and Gray keeps Oren Michels out of that soup as well. A good lawyer can differentiate between a legal and business issue, though that's the the Startup 101 version, as we've discussed.
  • Totally agree.
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