Getting Funded: Step 5, The Legal Grind

Term sheet signed, due diligence complete, now it’s time to head into the last stage of the funding process — the closing.  I don’t mean to use the title terms “legal grind” negatively. But, for most VCs and for most entrepreneurs, getting through the legal paperwork required to complete a round of financing tends to be much less exciting than building companies.  However, the legal process that caps the funding is important and should be taken seriously.  Often, mistakes made at this stage can cost dearly later in the company’s life.

You should…

  • Get a good attorney.  You may have a family friend or someone you met on the plane who is a lawyer.  That’s great, and they may be suited for the job, but if you’re not sure, don’t take the risk.  While there is nothing overly complicated about venture financings, especially early ones, there is a cadre of legal professionals that not only know the law behind getting a deal done but also know what the expected behavior of the legal team should be.  They know what points to focus on and which ones are less relevant.  They know how to negotiate with the other side without pissing them off and potentially wrecking the deal.  They have done these deals before and plan to do many more with the same sets of investors, so they come into the game knowing what to expect and what is anomalous.  There are a handful of law firms in Silicon Valley (compared to the total number) that top tier VCs use for their representation — and they do so for a reason.  VCs maintain a continuous relationship with the same firms and the same attorneys.  If you, as a startup, get one of those firms to represent you, the deal will go smoother and move quicker.
  • Don’t stress too much over the costs.  For me, seeing my first real “legal bill” was a shock.  Yes, these people charge more for sending a fax that you used to make in an hour during your first part-time job.  However, attorneys do not charge the entrepreneur for a financing until the deal is done done and, therefore, get paid with the money that goes into the company as an investment.  Your attorney will have another watchdog — the VC that’s funding you.  As I mentioned already, VCs and attorneys have a symbiotic relationship.  The last thing your attorney wants to do is to be seen as gouging his clients.  VCs talk, VCs refer, and VCs know what things should cost.  If you are dealing with an experienced firm, costs may be high, but they tend to be within a normal range.  It is much better to pay a bit more for an experienced attorney than to get bargain representation.  But…
  • Always get a cap on legal fees.  You should know and be comfortable with what they lawyer will charge.  This is really important for your sanity and comfort.
  • Focus on getting the deal done.  You should make this perfectly clear to your legal counsel from the very beginning.  “Your job is not to out-lawyer the opposition.  Your job is to watch out for anomalies in the deal, explain the risks, explain the probabilities associated with the risks, but, most importantly to get the deal done. We want to do this, our VCs want to do this, so make sure it’s done.”  It is your lawyer’s job to help make the deal happen.  You will have agreed on the basic terms and they should not be the ones to torpedo the whole thing unless there’s damn good reason to do so.
  • Ask your lawyer to explain things.  This may be your first financing, or you just may have never cared that much about legal terminology (like me during my first few financings).  You should have your attorney walk you through all the “interesting” parts of the document (and only the interesting parts) and explain what they mean to you and your company in plain English.  Do not permit your attorney to use terms like “pari passu” without asking him “WTF is that?” and getting a simple answer.  You shouldn’t be surfing the web for definitions when you have a professional by your side.
  • Honor the no-shop.  Your term sheet will have a no-shop agreement somewhere in the text.  While there is little legal recourse that VC can take if this promise is broken (you don’t have any money, that’s why you’re getting the financing), there is a huge risk of damaging your reputation as a company and as an entrepreneur if you violate this clause.  If your promises are, indeed, like pie crusts — made to be broken, your chances of getting another round done or getting another company funded drop dramatically.  VCs talk and reputations persist.  Keep your word, even if it causes some minor discomfort, even if it means not chasing the two pretty birds in the bush.
    Talking to other VCs is OK during this period if you are trying to put together a syndicate for the investment, but you should always check with your lead investor first.  And, if you jump ship because another offer is too good, be aware of the consequences… they are not pleasant.
  • Stick to the terms you negotiated prior for the term sheet.  During the legal process, some nuances may get tweaked.  Even the valuation may be adjusted for some reason (such as letting a strategically important partner into the deal), but, you should not change the terms dramatically after the deal has gone to the attorneys.  Don’t come in saying that your friend told you that the option pool should be smaller and so you want to change it.  Don’t agree to form your company in Delaware and then decide, in the eleventh hour to base it in Chihuahua, Mexico for tax reasons.  Just as with a no-shop violation, no one will take you or other agreements you make in the future seriously.
  • Demand a closing schedule from your VC.  Usually, early stage deals close in four to six weeks.  You should confirm the expectations of the closing date, have a plan and a set of milestones by which you can gauge if the deal is on track.  If your VC’s attorney is planning a vacation, you should know about it and insist on a backup.  The period of closing the deal is very unproductive for your company.  You want to make that period be as short as it possibly can be.
  • Always provide full and honest disclosure.  If there is anything that is material to the legal aspects of the financing, especially if it is explicitly asked for, you should be thorough and honest with your disclosures.  If your founder is not committed to moving to a new city, if your former boss feels that you stole code from his company, if you really have 5,000 and not 8,000 customers — now is the time to tell the truth if you haven’t already.  By not being honest here, you are not just irrevocably damaging your reputation, but also risk a catastrophic rift with your investors down the road (and a lawsuit to boot).
  • Remember, your lawyer is your ally, but they work for you.  You call the shots and you set the schedule.  You insist on points that need to be made and you chose to ignore ones.  The attorneys are there to get the deal done and they work for you.  However…
  • …trust your legal team and not get distracted.  You should have an attorney whose opinion you value and trust.  Chances are, they will have done many more of these deals that you and when they say something is important, it probably is.  Good ones are upfront about prioritization and are not there to book hours by digging into unnecessary details.  Your ears should perk up when your lawyer says: “listen, I’ve seen many of these, and this part is bullshit.”  or “trust me on this one, this part is important.”  Being your employee, your attorney should want to see your company get funded and feel like he is on your team.
    You should not be reading blog posts for legal advice during this process and brining up points that some blogger mentioned.  Not the right time.

We should….

- **Focus on getting the deal done.**  Just as the entrepreneur wants to start building his company, we should want him to get going as soon as possible.  Our first goal should always be to close the deal on the terms everyone agreed on.  Additional diligence requests, unless absolutely necessary, more meetings and conference calls should be avoided.  All that should be behind us and we should be focused on the prize. - **Use standard, familiar agreement forms.**  We should not forget that most entrepreneurs are neither lawyers nor care that much about the cleverness of the legal language used in funding documents.  As I write this, I am looking at a series of bound “trophy” books holding the documents of all my earlier financings and acquisitions during my life as an entrepreneur.  Guess what?  I haven’t read them.  And most entrepreneurs don’t care to read them.  Use standard forms and standard agreements without any linguistic trickery.  The simpler the better. - **Be reasonable.**  If there’s a misunderstanding or a valid request to change something, we should do it.  The changes shouldn’t be material or frequent, but mistakes do happen.  The term sheet, after all, is a non-binding agreement and we don’t want to get a bad reputation just as much as the entrepreneur doesn’t. - **Stick to a schedule.**  We should offer the entrepreneur a closing schedule and try, in every way possible, to stick to that schedule.  No vacations, no “emergency board meetings.”  We should keep our promise and get the deal done on time. - **Avoid conflict.**  If we are assholes during your first interaction with the company, it won’t be a pleasant experience for the next five years.  We should minimize clashes, explain things patiently, try to compromise, and, in general be nice.
*This concludes my six-part “Getting Funded” series.  I plan to put the links to posts  on a separate page for easy reference.  Stay tuned for the next series “Seven Deadly Sins of Venture Capital”.*
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