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.
Topics Lawyers
I always thought it had something to do with the taxation of the corporation versus that of the venture partnership.
There is one reason that they do this:
Because they can.
Do you think that Facebook paid their legal fees? Doubt it. Why? Because Facebook had so much leverage.
The statement “Most caps include the fees for both sides” is not accurate. Term sheets typically only say that the company will pay reasonable legal fees of investors’ counsel, capped at $X. (I also disagree with $10K – $20K as a reasonable cap to propose with straight face for investor counsel.) Of course, you can try to discuss a fee cap with company counsel, but almost all competent counsel will not agree to a cap. However, most experienced counsel can provide estimates based on actual data from previous similar transactions. Companies often have neglected corporate cleanup that needs to be fixed in connection with a financing (similar to not going to the dentist for years and paying the price later). In addition, there are always things that occur in financings that are difficult to predict (such as arguments among founders). Finally, capping company counsel fees is a disincentive to provide services after the cap is exceeded.
I get busy for a few months, and what happens? You go and post things that prompt replies that make me crazy.
Yokum is right – if you’ve done enough Series A deals, counsel are more than capable of committing to an estimate as a cap on fees. Where he and I differ is on quantum. Investors’ counsel should not charge more than $10 – 15k in legal fees for a Series A deal. Period. There is no shortage of pro bono time that has been spent by the NVCA working groups creating model Series A documents. Virtually nothing is written from whole cloth by VC lawyers for a Series A round, and the legal due diligence requirements are modest. VC counsel generally generate the bulk of fees from their VC clients through fund formation and LP management, anyhow. Fund work gives VCs more than enough leverage to enforce a fee cap at the Series A stage.
I have no problem with committing (as company counsel) to a cap on company legal fees, either. If I am asked by my client to take a haircut on my fees, I will, if : (a) I secure a commitment to all future legal work for a meaningful period of time, and (b) I believe that the business has high-growth potential. This isn’t a new approach: in fact, I learned it from Yokum’s firm at the height of the dot-com boom.