There has been a lot of debate on the legal costs associated with financing rounds for startups. Fred Wilson’s challenge to startup lawyers called for legal costs to be reduced to $5,000.00 for a seed financing round. The issue, brought up by many lawyers is this: (1) large firms are not going to drop their rates from $17k+ to $5k because their costs are too high based on the army of associates working on each piece of the matter; (2) startup focused firms aren’t well known enough to VCs but they could get the work done in between $5K-$10k because they are lean and understand the startup world because they themselves are startups.
To understand what drives legal fees (aside from an army of associates) during a financing round, it’s important for startups, especially those going through their first few rounds, to understand why a transaction costs more than a few hundred dollars. It’s also important to understand why choosing a firm that’s a good fit for a startup matters in these rounds.
Few things can hurt a startup more than a vague or hurried term sheet that will result in increased costs down the road. To avoid these problems, smart entrepreneurs and investors involve counsel early on in the term sheet process to make it as smooth as possible. For entrepreneurs, they need to understand that a VC’s counsel is not the startup’s counsel and that they absolutely need their own counsel as well. It’s like buying an insurance policy that will cost your startup much less than potential future problems stemming from vague term sheets.
Involving attorneys from the get go also allows lawyers to provide increased value-add through market knowledge; entrepreneurs and investors can leverage that knowledge and experience for their own benefit. For startups, they can also discuss with their lawyers what is “normal” or “market-value” and what safeguards they should be pushing for, and what they can be more lenient on. Lawyers have a knack for seeing what can cause a potentially massive lawsuit down the road, but clients need to involve them early on to leverage such knowledge.
Understanding Due Diligence
In most funding rounds, costs start increasing due to due diligence required by investors before a deal is closed. This means due diligence on the following (if not more) subjects:
(1) Litigation Diligence: Investors want to ensure that there are no pending or threatened suits against the startup that could materially reduce its value (they cannot just take your word on this).
(2) Tax and Liability Diligence: Investors need assurance that the startup is up to date on all taxes and potential obligations.
(3) IP Diligence: The assurance that each IP the startup claims as its own really belongs to the startup and not anyone else. This also includes review of whether there are any open source or similar issues, that all former/current employees/consultants/contractors/founders have legally and properly assigned rights to any IP to the startup, and if reverse vesting of common stock held by key employees is necessary.
(4) Employee Diligence: Ensuring that employees/contractors/consultants/founders have signed properly drafted non-compete, non-disclosure and non-solicitation agreements. Also ensuring thatemployees & contractors are properly classified to avoid potential liabilities.
(5) Corporate Governance Diligence: Investors want to ensure that theentity is properly formed and corporate governance matters have been properly followed (i.e. startup’s corporate records must be in order; if they are not, lawyers and the startup must go into overdrive conducting a “cleanup” to ensure that everything is up to date, properly documented, and ready for inspection – this can add significant costs and often can be delay, or kill, a deal closing).
(6) Stock Option Diligence: Legal diligence to ensure that all stock option grants were properly approved and 409A compliant; this may also result in a change to the price per share if contemplated on a “pre-money valuation” basis.
(There are more aspects that can drive up the costs, but those listed above can be some of the most time-consuming).
Setting a Cap
Anytime a startup (or an investor) hires counsel, they should ask for a cap on the legal fees; SLF works to ensure that in closing deals such as early financing rounds, our legal bill comes under the cap, however other firms have been known to bill at the cap regardless of complexity or simplicity of the deal.
If an attorney or firm does not want to talk in terms of a cap on the legal fee, it may be prudent to search around a little more.
For more information on startup legal services, email us at firstname.lastname@example.org or join us for a class taught by Sheheryar Sardar.