A San Francisco friend related that he sees or reviews pitches from 15 companies per week and he only invests in 4 companies annually. (A couple of his VC’s investments have been notable — Atrium and Snap.) However, he did remark that even getting to the level of term sheets, things can go wrong to dissuade his VC firm from closing a deal. And that is why he mentioned his experience in reviewing and negotiating with startups.
In my previous blogs, I have addressed valuations and term sheets. However, to quote Yates, “Many a slip between the cup and the lip” that suggests that, even during this final term sheet negotiations, things can go wrong!
My VC friend relates that one fairly prevalent problem is having the counterparty’s attorney stretch out negotiations by nitpicking every element of the term sheet. He believes that the problem stems from inexperienced lawyers. I disagree. From personal experience as an attorney and General Counsel, I have dealt with many attorneys who believe that the best way to impress a client is to look at every angle, every word and bringing out any blemish as another negotiating point. The more edits the lawyer notes on a contract seem to suggest that the lawyer is earning his high bills, Even though, in reality, the changes in the draft might be legally superfluous or marginally important. There is a fine balancing act between counterpunching changes with the opposing party and relenting on legal or transactional points that are unlikely to occur or have little incremental costs.
And I have met so many attorneys who actually follow this technique. I recall one in-house corporate attorney, who had worked previously in government, sought every way to slow down the review and edits for a multimillion-dollar telecom contract. The company’s business manager approached me to tell me that the contractual delays had a severe impact on the company’s bottom line costing hundreds of thousands of dollars. Yet, this corporate attorney sought different changes, other excuses why the contract could not be finalized. Actually, he needed to impress his boss, also a lawyer/manager, when he allegedly found many faults with the contract. I myself reviewed the telecom contract and failed to see all the issues he was referring to. I even questioned whether he carefully read the contract. Weeks went by until the contract was sent to outside counsel to review and negotiate when complaints rolled in. This review change added more to the timeline and costs.
Maybe the problem stems from the fact that, since attorneys are paid by the hour, it behooves them to stretch out negotiations just to pad their billable hours. And, from what I read in the business journals, many law firms are now seeking to bill more and more in a climate with fewer clients and far less legal work. I would not be surprised that, in this macro-legal-environment, we will see more of this excessive billing of additional hours in the near future.
So going back to my VC friend, he related that he would go back to his inventory of over 750 startups and find another startup with far, fewer headaches. The economic irony is that the startup is obligated to pay the investor’s legal fees as well as its own attorney. (By the way, this is also true even for the IPO process.) So, when the opposing lawyers and the startup’s counsel keep adding hours to the negotiations, the startup will have less money to finance operations and marketing. Intuitively, my friend knows this and sees that the capital he initially dedicated to this startup is being eaten up by legal expenses. Hence, his philosophy is to look for another deal.
How to resolve this from the startup’s point of view? As a startup GC, I was particularly sensitive to legal expenses and I undertook a proactive approach to handling negotiations and all other legal matters. The first approach is to set a deadline — if you give a lawyer one month to negotiate a contract, he will do it in a month. He can also do it in a week. And the bill would be substantially smaller. The second step is to prepare every material paperwork needed to close the negotiations so that the process is not slowed down for lack of documentation.
Here, my legal experience played a role that whenever my company had a new round of investors, I already prepared every piece of paper needed to close the deal. Indeed, a Fortune magazine article mentioned that a previous employer was able to lock up investments every month quickly. My proactive legal management approach played a substantial role in the expeditious investments in the company. And, when I left, a former colleague from the company mentioned that legal expenses skyrocketed to several hundred percents after my departure.
Another observation from a CFO from a publicly traded company applies here. He commented that most lawyers are “deal breakers” — pushing negotiations ad infinitum. He preferred to work with a “business man’s lawyer” who clearly understood that closing the deal is more important than negotiating arcane issues.
The reality is that the startup during the term sheet negotiations should “not count its chickens until they hatch.” The term sheet phase can be improperly handled by a thoughtless attorney and the startup might still walk away empty handed. Handling the term sheet process must be carefully monitored and completed efficiently with the least legal exposure and expenses.