Nivi · December 10th, 2007
“C’mon—you have $500M and I am raising $1.5M and you want me to take the first $25K to pay your legal expenses for doing the deal? That’s like your dad giving you your allowance and then asking you to buy him a hot dog. When we were raising money for Flixster I thought that must be a trick—like if I agreed to that term they would pull the term sheet at the last second and say I failed the secret fiscal responsibility test.”
Summary: Venture capitalists don’t want to pay their legal fees for financings. Don’t fight this term—that’s a “big move on a little issue.” Instead, cap your contribution to the investor’s legal bill. And watch the legal bills in small financings: don’t spend a large portion of the investment on lawyers or give up a lot of equity for the privilege of paying your investor’s legal bill.
Venture capitalists don’t want to pay their legal fees for financings. We explain why in the appendix below.
So startups often pay their investor’s legal fee. An investor gives you money, you use some of the money to pay his lawyer, and the investor buys a little bit of your company with his legal bill!
Pay your investor’s legal bill.
Although paying your investor’s legal fee may fall outside the bounds of common sense, don’t try to remove this term. It’s an industry norm.
Norms are made to be broken, but this one isn’t worth it. You will do a lot of work to win this argument and you will gain very little. “Make big moves on your little issues and little moves on your big issues,” writes G. Richard Shell in Bargaining for Advantage. This is a little issue.
Also consider your investor’s perspective. In every other financing, their investee paid the fund’s legal fee. Are you really going to ask your investor to go to his partnership and say, “Hey, this deal is going to cost us $50K in cash money.”
Cap your contribution to the investor’s legal bill.
When you pay your investor’s legal bill, you’re paying their lawyers to negotiate against you. You’re paying their lawyers to make your deal worse.
You may have to pay your investor’s legal bill but you certainly don’t need to keep paying their lawyers until they run out of things to say. Put a cap on your contribution.
Without a cap, their lawyers will just keep arguing and collecting fees. With a cap, they’ll stop arguing once they hit the limit.
Propose a cap between $10K-$20K and let them make the case for a higher limit. Some investments require more legal work and some require less: in one rare case, we saw a top-tier investor do a large Series A financings ($10M) with no external counsel at all.
Many caps include the fees for both sides, i.e. the company shall pay no more than $X for the sum of the investor’s and company’s legal fees. It makes more sense to cap only your investor’s legal fee… but hey! this is venture capital, not math camp.
Watch the legal bills in small financings.
Don’t spend $20K on lawyers if you’re raising $50K. Not only are you spending a lot of the investment on lawyers, but you’re giving up a significant chunk of equity for the privilege of paying your investor’s legal bill. Investors recognize this issue and usually pay their own legal bills in debt financings.
If the investor’s expected legal bill is a large percentage of the investment, you could increase the investment to cover the bill and increase your pre-money to cancel out the dilution from the extra money. This makes sense but it’s also a “big move on a little issue.”
Instead, calculate your effective pre-money and do an apples-to-apples comparison to your alternatives. For example, if you raise $50K on a $50K pre-money and spend $10K of the investment on your investor’s legal fee, your effective pre-money is only $40K since your investor bought half the company and you got $40K. In general,
effective pre-money = pre-money × (investment – investor’s legal) ÷ investment
This is similar to calculating your effective pre-money in the option pool shuffle.
Appendix: Why investors don’t want to pay their legal bills.
Many people think investors don’t want to pay their legal bills because the money would come out of the investors’ own pockets. The argument goes like this: VCs pay their salaries from the fund’s management fee and if they had to spend the management fee on legal bills, they would have to reduce their salaries.
But investors already pay various expenses such as ongoing legal fees or accounting fees without touching their management fee.
And there are good reasons why investors and their limited partners may not want to pay legal fees out of the management fee: (1) legal fees are a variable expense so it’s hard to include them in a budget that justifies the management fee to limited partners, and (2) limited partners don’t want investors to feel like they’re taking money out of their own pockets to do legal diligence.
(Of course, all these issues are irrelevant for investors who are investing their own money.)
We don’t know how or why this became the norm, but there are several advantages and few disadvantages for the investor whose investee pays the legal bills. Paying the investor’s legal bill:
- Incents you to not argue too much or quibble over basic things that investors will never remove.
- Lets the investor buy a little piece of the company with his legal bill.
- Avoids discussion about how to split the bill among multiple investors.
- May slightly reduce the hurdle for the investor’s carry, depending on the investor’s agreement with his limited partners.
Image Source: University of Virginia.