Founders, leave the Legal Jousting for later (rounds)

If a man gets known by the startup he keeps, then a founder should be known by their legal professionals. Think about it, out of the vast sea of capable professionals available, the founder’s ability to separate the chaff from the wheat gets judged when they choose untested people to represent them in front of investors (or acquirers).

In a recent transaction, the partner of the law firm signed up our founder to protect them, but then the transaction was quickly hived off to an associate who was (at the time) working on their 2nd or 3rd term sheet. The “associate” relying on the legal knowledge taught in textbooks versus the knowledge gained from doing real transactions merrily redlined every single line of our term sheet. It was as though the associate was grading a college assignment.

The founder didn’t understand why there were so many redlines. They did not take the time to know whether the issues redlined were issues (for them) and forwarded the email to us. The entire episode made us reevaluate our assessment of the founder’s maturity.

Note to founders: When your legal help sends back term sheets with more than 10 red lines, you either have the wrong law firm or the wrong investor.

Founders erroneously expect their legal help to do three things that inherently have conflicts of interest:

• Represent the startup
• Represent you as a shareholder
• Represent you as an employee, i.e., CEO/CTO/etc

With three different vantage points to look from, which one should the legal professional put as first, but most importantly — which one comes last?

Whom an investor will want lock in their legal agreements can be explained by this diagram from a Pear.vc presentation:

In the early stages, your startup derives its value from your role as an employee. Your startup ties you in as an employee by providing you with a large chunk of equity as a shareholder. Therefore, the startup doing well is directly proportional to you doing well. If you (as an employee) do not perform, i.e., cannot execute on the business plan or leave the startup mid-way, then the large chunk of equity given to you must go back to the startup. Regardless of your involvement in your startup, the startup must continue to operate. It could mean that they must find someone who will execute the plan on which the startup got valued or end up liquidating.

Therefore, the valuing shareholders, i.e., the investors, will include caveats like vesting, lock-in, ROFR, etc., to protect the startup’s interest and its shareholders i.e. you. You must remember the investors are the ones that valued the startup based on your promise to execute the business plan. Any changes that negatively affect the startup’s value will get reprimanded seriously. It may not be in your best interest as an employee, but it is in the best interest of the startup and yours as a shareholder.

As the startup matures, the reliance on you will reduce, and the startup will justify its valuation with revenues, intellectual property, profits, etc. Most founders will move out of the daily affairs of the startup as running day to day operations get too structured for their innovative mindset. However, the startup will continue to flourish without them.

Now imagine that the startup is going an IPO. Would you (as the shareholder) and your startup have the same lawyer representing both of you? No, you would not. It would be unsound legal advice.

Therefore, just like hiring investment bankers to raise early rounds of capital is useless — so is hiring a law firm to negotiate early rounds. The law firm’s partner cannot justify spending their high per-hour legal charges on the nominal fees you can afford; therefore, your transaction will get managed by an associate looking at making a mark.

However, should your startup be the guinea pig for someone else’s career ambitions?

A better strategy is to self-educate on term sheets and shareholders’ agreements. Brad Feld’s Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist is a good start, although it specifically caters to the western ecosystems. You could sign up for TiE Mumbai’s workshops on Termsheets and Founder’s Agreements, which are helpful for you too. Here is a video from one of their sessions on valuation:

Therefore, instead of pushing off the problem onto your lawyer, who will push it off onto an associate who will eventually screw up your relationship with your investor. You, as a founder, get better served by knowing the monster you are dealing with and leaving the legal firms for rounds where the fees you payout are commensurate to the size of the round you are raising. Then you can demand that the partner personally looks at the documentation.

No one gets a free lunch. No one.

Originally published at https://showmedamani.com on September 18, 2020.