03 Apr How “captive” startup lawyers enable bad actors
Sponsored by Egan Nelson LLP
One unfortunate, and somewhat unique, aspect of startup ecosystems is that they have a large power/experience imbalance between parties doing business with each other. On the one hand, you have seasoned, well-connected investors who close multiple deals every year and have been doing so for years. They know the game inside and out.
On the other hand, you have (often) fresh entrepreneurs doing things for the first time. They can be extremely smart, but without the same experience that institutional investors have, they simply don’t know what they don’t know. Advisors, including lawyers who specialize in tech/VC financings, are supposed to level the playing field. If they have the right background and credentials, they see dozens of deals a year across city and state lines, and are able to use their expertise to help startups navigate their negotiations and relationships with VCs.
But there’s one very big problem that not enough people talk about. I’ve been talking about it for years, including on my Startup Law blog, Silicon Hills Lawyer. See: How to avoid “captive” company counsel.
Certain aggressive VCs, realizing that experienced startup lawyers can significantly improve founders’ ability to get fairer terms and assert themselves against bad behavior, have developed a strategy of making local startup lawyers “captive” to their interests. They send significant amounts of work to those lawyers, both directly and via referrals, with the understanding that the favor will be returned by keeping quiet when more independent counsel would speak up. Naval Ravikant touched on the topic in a blog post written years ago:
“Don’t just go with the lawyer that the VCs insist upon. These lawyers will work with the VC on a hundred financings and with you on only one. Where do you think their loyalties lie? Get your own lawyer, and don’t budge.” – Naval Ravikant, Lawyers or Insurance Salesman?
One of the jobs of company counsel (the lawyer who represents the startup) is to ensure that the startup’s Board of Directors is focused on creating value for all of the startup’s stockholders; instead of trying to enrich and empower a few investors at everyone else’s expense. But that doesn’t happen when the lawyer advising you on your term sheet has years of history working for the VCs who delivered you that term sheet, and gets referrals from them.
When virtually any savvy business person steps back and thinks about this serious conflict of interest, it seems almost obvious that smart entrepreneurs should be avoiding it. And yet it happens all the time and rarely gets talked about, because the arrangement benefits the people usually holding the microphone.
Founders navigating the VC environment for the first time need experienced, specialized VC lawyers, but they also need those lawyers to be independent from the people they are negotiating against. A few simple questions can help ensure that:
- What venture funds / investor funds do you personally (the lawyer you’re directly working with) represent as investor counsel, and how many deals have you done in the past 3 years for them?
- What about your law firm generally?
- How many of your firm’s clients are portfolio companies of X fund, and how did you become connected to those companies? May I reach out to the companies to confirm?
- Can I get your commitment to not pursue investor-side work for X fund while you are our company counsel?
Great VCs will unequivocally support a company’s ability to hire truly independent counsel. I interact with those kinds of VCs all the time, and thankfully they outnumber the jerks; at least on a national level.
Yes, finding startup lawyers who aren’t captive to local investors can take more time, and require more diligence. But doing so can mean the difference between throwing a bad actor off your Board and protecting your company/employees, or having them sink everything you’ve worked to build.
A few other posts that founders interested in this topic may find worthwhile:
Contributor: Jose Ancer, Technology & Venture Capital Partner, Egan Nelson LLP