Need legal representation for your company? (Genesis 37 has something to tell you.)

Lawyer marketing frequently emphasizes — what else? — the importance of hiring lawyers. As someone who has himself stood in the shoes of the cash-conserving entrepreneur, however, I understand the reluctance to use precious startup capital on legal fees. It is possible to significantly overspend on legal services — either by buying too many services or buying the services from a firm whose pricing is too high for your company’s stage of life. The real question is, what are the issues that truly require legal attention early on — and what is a cost-effective way to address them?

Let me provide a couple of examples, illustrating how getting legal advice up front might have prevented loss and heartache, or just saved some time and effort.

A client (I’ll call him Joe) developed an idea for a company, started the company, and brought in his two best childhood friends, who were like brothers (let’s call them Reuben and Judah — is this story seeming familiar yet?), to run it as equal co-founders. Joe found one of the many startup legal document sets that are available online, and drew up the Company’s certificate of incorporation, bylaws, stock purchase agreements, and IP assignment docs. He thought he had covered the bases pretty well on his own.

Ownership divided into thirds is, however, inherently unstable because any two stockholders can form a majority and act to the detriment of the third. The temptation to do so can be powerful, particularly when cutting out the third person means taking back his equity. Lo and behold, this came to pass: Reuben and Judah got together, decided that they no longer needed Joe, and fired him. The legal documents Joe had put together contained standard time vesting of the founders’ stock, but no provision for acceleration of vesting upon a termination without cause. Thus, Joe stood to lose not just control of the company he founded, but nearly all of his one-third ownership as well.

A lawyer experienced in these matters might have suggested steps at the outset to prevent a sad situation like this from developing: a different allocation of ownership or a stockholders agreement that would have maintained Joe’s control, compulsory buy-sell arrangements to create orderly exits if ever the founders wound up at odds, and vesting accelerating provisions to protect the equity of anyone terminated without good cause.

I am sure that (like Joseph in Genesis 37), Joe will rise to new heights in his future ventures (and perhaps even have the opportunity to show mercy to his brethren). Still, he’s unintentionally learned a painful lesson about the consequences of not adequately protecting oneself at the outset of a new venture. I would advise anyone who is starting a company with co-founders, or considering accepting a position with a company where employment and equity terms are on the table, to identify and get advice from good legal counsel. Find someone who has relevant experience, and whose rates and approach to legal practice are a good fit for you. (I know a guy.)

Another common situation in which good legal advice up front can be quite worthwhile is the negotiation of term sheets. Term sheets are short documents, typically (but not always) non-binding, laying out the key agreed-upon deal points of a proposed transaction. They are commonplace in private investment and M&A transactions. Negotiating a term sheet is a worthwhile exercise because it ensures that the parties are in fundamental agreement before they invest significant time and energy in reaching a final deal.

Sophisticated parties who are repeat players in transactions (e.g., investment fund principals or angel investors) often understand the process well, and don’t necessarily require legal advice each and every time. But for everyone else, it’s a good idea to have experienced counsel review a term sheet. A lawyer can make sure that you understand all of the terms and nuances, and that you have covered all of the key points that are sure to arise during negotiations over the final agreements.

In a recent deal in which I participated, my client retained me after the term sheet had already been signed. The results were not catastrophic as in Joe’s story above, but I believe that my lack of involvement at that stage resulted in some misunderstandings between the parties on deal terms and therefore more bumps on the road to closing. Again: when you are about to be involved in an important business transaction, talk to a lawyer sooner rather than later. You can always decide to defer legal services, but make that decision after educating yourself on the risks, the services you might obtain, and how much they would cost. It may not be as costly as you think — nor as costly as the mistakes you would otherwise make.

———

UPDATE 12-18-13: Needless to say, while ownership divided into thirds is perhaps the most risky, 50-50 ownership splits present their own issues, such as deadlocks. Good advice is needed, regardless of the split.

Categorised as: Entrepreneurship, Startup Stuff