Background reading: How to avoid “captive” company counsel.
There’s a game that, as Startup/VC lawyers, we’ve seen played out across many ecosystems. We’ll call it “own the lawyers,” and because it benefits repeat players (professional investors, service providers) at the expense of first-time founders – and the former are usually the people controlling the microphones – it rarely gets discussed publicly.
To summarize, the game goes like this:
- First-time entrepreneurs are at an enormous disadvantage, in terms of experience, in negotiating against sophisticated, repeat player investors who’ve been doing deals and building their network for years. Let’s call this the “experience inequality” of Startup-VC relationships.
- Experienced Startup/VC Lawyers, who see far more deals than even most investors, have the ability to level the playing field by bringing their expertise and skill set to the table in negotiating deals, and managing high-stakes governance issues, for startups. This has negative economic implications for VCs, so many of them would much prefer to somehow preserve the inequality.
- Startup Lawyers and law firms need clients, and like any rational business actor, their priorities and behavior will be heavily influenced by who can get them more business, and who they do the most work for. VCs see/influence a lot of potential clients, and regularly need to hire lawyers themselves; an order of magnitude more “deal flow” than a single set of founders can provide.
- So by using their broad reach over large quantities of deals, and funneling them to specific law firms, VCs can “own” those firms. No matter who their client is on paper, those captive lawyers understand what hand feeds them the most, and will ensure it stays happy and loyal.
- Finally, by convincing their portfolio startups to overlook the obvious conflict of interest and use those captive lawyers as company counsel, VCs can preserve the experience inequality by “owning” one of the startup’s most important advisors; who otherwise might have helped the team (and common stock) negotiate better, and protect itself, on high-stakes issues.
Of course, bring this issue up to those VCs and their favored lawyers, and you’ll get predictable responses: “We would (emotional emphasis) NEVER attempt to influence company counsel inappropriately.” “My legal advice would NEVER be biased by my relationships with your VCs.”
Anyone who seriously thinks this deep of a conflict of interest does not heavily influence the advice that lawyers give (or fail to give) is either lying, delusional, or simply hasn’t spent enough time in the market.
Sidenote: not all VCs play this game, nor do all startup lawyers. We’ve known several high-integrity VCs who will openly call it out and insist that a startup get independent lawyers. But enough people play the game that it needs to be discussed out in the open for what it is: an unethical way to prevent young startups from getting a level playing field on which to navigate the many areas where they will be misaligned with their VCs.
In the extreme cases, the game is played overtly and aggressively: “you *must* use these lawyers, and sign this conflict waiver, if you want the deal.” But the smarter “chess players” use carrots instead:
- The deal will move faster because these lawyers “know us” well, and you’ll save on fees. It’s all “standard” language anyway.
- This law firm has “access” to lots of investors, and can help make important introductions.
- We’re all “aligned” here. Using these lawyers will ensure things go “smoothly.” They’ll be more “efficient.”
Yes, using a law firm “owned” by your VCs will make the deal move faster… but why? Because they won’t fully advise you; lest they push a button their real clients won’t like. We’re talking about high-stakes, high-dollar issues with permanent long-term economic and power implications, with a massive imbalance of experience between the business parties involved. Speed should hardly be the top priority, unless your real goal is to ensure no one asks any hard questions.
The idea that serious lawyers are all just checking boxes and filling in templates, and therefore deals should just close as fast as possible, is a mirage set up by repeat market players to preserve the experience inequality in deals. “Don’t ask your lawyers” sounds sketchy. “Let’s move fast and save some legal fees” sounds much better, but it’s the same message, just more cleverly packaged.
And yes, captive law firms can make investor intros, but is it really worth it? The entrepreneurs with the best instincts say absolutely not. Are there not many other ways to get intro’ed to investors without compromising one of your most important strategic advisors; especially in the golden age of LinkedIn, AngelList and accelerators? Of course, there are, and honest advisors will tell you that intros from people you aren’t paying (like respected founders and angels) are far better signals (more “warm”) to potential investors than intros from service providers.
Just don’t expect certain law firms to stop selling their (air quotes) “special access” to VCs – and their ability to “expedite” closings – as a reason to hire them.
It’s easy to mischaracterize all this advice as being overly adversarial, but that’s just obfuscation of the core issue. Good startups (and their lawyers) always try to maintain friendly, transparent relationships with investors. Why have it any other way? But openness and transparency are not even close to the same thing as letting go of your right to be independently well-advised. Oftentimes the best safeguard against large conflict is ensuring all parties, not just the more well-connected and influential ones, have a means of correcting a player who steps out of bounds.
As much of a supporter as we are of startup culture and the more “friendly” ethos it often promotes, the non-naive know that investors are here to make money, and themselves would never buy into the sort of candy-coated BS suggesting that everyone is “fully aligned” and therefore lawyer loyalties don’t matter. If your VCs seem peculiarly interested in you using a particular set of lawyers out of the entire universe of options, now you know exactly whom you shouldn’t be hiring.
For a short list of questions to ask when conducting diligence on potential lawyers for your company, see: Checklist for hiring a Startup Lawyer. One of the most important ones is: “What conflicts of interest does your firm have with investors I might raise money from?” The lawyers and firms with the best real value propositions have built their brands on the quality of advisory they deliver; not with questionable marketing tactics that grow revenue by pushing startups to rely on shills for their VCs.
Entrepreneurs and their early employees pour their lives into their companies, and deserve unbiased, trustworthy strategic legal advisory on their most high-stakes negotiations. They should ignore any and all arguments, and half-baked incentives, suggesting the contrary. Every honest person knows that business relationships are more balanced and fair when everyone is independently well-advised, which is why repeat players know that “owning” your lawyers is a fast-track to eventually owning you.
“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 Salesmen?
Jose Ancer (@ancerj) and Jeremy Raphael (@jraphs) are Emerging Companies Partners at Egan Nelson LLP (E/N), a Lean, World Class Law Firm delivering top-tier, scalable legal counsel to leading startups, without the unnecessary overhead costs associated with traditional firms.