Why Startup Founders Should Hire Lawyers When They Deal With Venture Capital Firms
Earlier this week at DealBook, in a post about how “In Venture Capital Deals, Not Every Founder Will Be a Zuckerberg,” professor Steven Davidoff cites to research showing that “the dirty secret of venture capital is that the dream can be dashed as the venture capitalists make millions in a sale, leaving the founders with nothing.” Davidoff also references a study by Brian Broughman and Jesse Fried that found, in Davidoff’s words, “that founders who negotiated greater control rights ended up receiving on average $3.7 million more.”
I don’t doubt that’s true, and as I’ve explained on this blog before, despite strange claims by conservatives to the contrary, corporations put profits before everything else, and corporate executives and board members tend to put their interests before shareholders’ interests. The idea that venture capitalists are out to make money, including at the expense of startup company founders, really shouldn’t surprise anyone. If you want to make money from a corporation, you need control. Venture capitalists know that. Startup founders should know that.
But how do startup company founders maintain control of their company? They could spend a couple hours at night teaching themselves the finer points of fiduciary duties in Delaware and then try to outwit the investors (and their lawyers) who have done this a hundred times, or they could shell out their own money to pay for their own personal lawyers.
Two years ago, venture capitalist Fred Wilson wrote on his blog “A Challenge To Startup Lawyers,” complaining that “The legal fees for [a seed round funding] transaction were $17,000,” and challenging lawyers to bring their fees down lower, given how they “just signed the standard documents which were tweaked to reflect the round size, share price, and board provision in the term sheet.” I posted a reply, explaining how legal work isn’t piecemeal, and how a lawyer becomes responsible for everything related to the transaction.
That only explains why the lawyer costs so much; what I didn’t go into detail about was the value you get out of that.
Davidoff’s column began by referencing a recent lawsuit filed by the founders of Bloodhound Technologies — who received a mere 0.0004364% of the company’s value when it was sold — against the venture firms that invested in the company. The case, as summarized thoroughly in the opinion written by Vice Chancellor J. Travis Laster (of the Delaware Chancery Court) denying the venture capitalist’s motion to dismiss the case, is a perfect example of why startup founders want their own lawyer, not some lawyer for the investors, not some lawyer for the company, and not some “lawyer for the situation,” looking at the deal.
As alleged, the Bloodhound Technologies lawsuit wasn’t just an example of the venture capitalists extracting a better deal for themselves, it was a textbook freeze-out and dilution case. You could teach a law school class on corporations with it. Importantly for my point here, there were ample signs of a problem years before the eventual sale, and several strategies the founders could have undertaken to protect themselves — if they had had an attorney on their side. Let’s pull some quotes from the opinion:
The venture capitalists‘ first move was to ease Carsanaro out of the top spot. According to the complaint, the venture capitalists convinced the board that “hiring a CEO with additional Healthcare domain experience would make [Bloodhound] more marketable to potential acquirer.” …
[T]he venture capitalists convinced the board that Bloodhound should raise “one last round of financing for the Company, in the form of a new round of Series C convertible 5 preferred stock.” …
The size of the board was increased from five to six…
[The venture capitalists] then reopened the terms of the Series C Preferred. [The founders] were excluded and not kept informed. …
[T]he size of the board was increased again…
[The original founder and CEO] was asked by the board “to resign as a director, officer, and employee of the Company …”
All of that happened in six months, and it only got worse from there, as the venture capitalists allegedly entered in multiple deals in which they “raised capital” from themselves, thereby further diluting the value of the founders’ shares until, by the time the company was sold for $82.5 million, the founders owned less than 1% of the company.
If you’re a startup founder who is considering or who already has venture capital funding, you owe it to yourself to read pages 1-15 of Chancellor Laster’s opinion. As Chancellor Laster summarizes the complaint, the scheme looks so clear; so, how come the founders didn’t know they had been rooked until a decade later when the company was sold? Part of it is the benefit of hindsight, but another part — in my opinion, a larger part — is that the founders now have lawyers to identify and to frame these issues appropriately.
If the founders had had lawyers at the time, they could have taken steps to preserve their control and ownership of the company (like staggering board elections, or fixing the size of the board, or prohibiting further insider equity investments), even while meeting the investors’ claimed needs, like bringing on a more experienced CEO. Going back to Fred Wilson’s example, $17,000 sounds like a lot to shell out for a lawyer giving a thumbs’ up to a deal — and, frankly, I know there are plenty of young, smart lawyers out there who could do the same for much less than the big corporate law firms charge — but it sure beats getting only $36,000 when the company you founded is sold.