A Lawyer’s Take on Doing Deals in a Downturn
One of my clients said it best:
“Complications kill time and time kills deals.”
And that’s especially true now as a major recession looms on the horizon.
The best way to avoid deal-killing complications is to get your legal ducks in a row BEFORE you start serious negotiations with a major investor, including:
Running your checklist of key legal documents and issues
Filling in the gaps (because you’ll undoubtedly have some, if not many)
Getting your data room sorted out sooner rather than later.
And while I don’t want to sound like every other finger-pointing pundit telling you that you need to get experienced counsel on board early, in this case, it really is true.
Ideally, you should do all of the above with experienced counsel at your side. They’ll know exactly what closets are likely to get opened in the negotiating process.
Here’s what else you need to know so you can get your legal ducks in a row early and pave the way for a quick and smooth deal process.
Why You Should Work with a Lawyer Earlier, Not Later
In their zest to be cash efficient, a lot of startup founders hesitate to spend money on legal matters unless they are already in the middle of negotiating their financing round. The rationalization is simple: why spend that time, effort, and money unless we have to?
But waiting too far along in a deal to secure the help of counsel can be a big mistake, especially in a challenging economy.
Here’s why.
While every deal is different, you can almost always count on investors – or more accurately, their lawyers – (a) requesting copies of standard types of legal documents as part of their due diligence and, (b) you having to make legally binding statements and affirmations about the state of the company that have huge implications down the road. So there really is no advantage to waiting to enlist counsel to prepare for these things.
Negotiating a deal is hard enough without giving the other side’s lawyers a reason to complicate things. Very often investors themselves don’t care about negotiating the legal minutiae of a deal. But they simply have no incentive to tightly manage their legal team. Or they just love their lawyers and go with whatever they say. So you should fully expect the other side’s lawyers to poke and prod into all your legal closets and corners. If you aren’t prepared for this by having your legal house in order before you start, you risk major deal delays and even worsening deal terms as your lead investor’s lawyers work to account for all the actual and potential legal landmines you have.
Even if your lead investor doesn’t have a problem with you getting your legal house in order during the deal process, it will inevitably end up taking up time, money, and bandwidth that neither you nor your law firm can really afford to spare in the middle of closing a deal.
And this can also be a real nightmare when you discover problems mid-deal that require you to go back to vendors, ex-employees, and others for permissions, consents, agreements, waivers, and whatnot – third parties who don’t need to move at your pace or schedule.
Having your legal house in order goes to the core health of your company. Making sure that important agreements, like key IP ownership and equity arrangements, are in place shows that you have your priorities straight and have set a good foundation for your business. Early-stage investors are investing in the founders more than anything, so having all your core legal matters already properly worked out shows them that you have what it takes to run your business well and give them a good return on that investment.
Run Your Checklist of Key Legal Documents and Issues
Before you begin raising money, a good place to start is by understanding what any significant investor is thinking about and what they are likely to ask for in terms of information, agreements, and other documents.
The range of requested items may vary by the industry you’re in, what stage your company is at, what your investor’s lawyers are used to asking for, and other factors. But a lawyer experienced with deal negotiations will be able to help you sort out what’s most likely to be asked for in your particular situation.
That said, a company will almost always be asked about the following:
Core governance documents like your certificate of incorporation and bylaws
Board and shareholder meeting minutes or written consents
All ownership and stock option-related documentation
Any litigation or potential litigation
Documents showing that you own or have all the licenses you need for your business’ important IP
Employee and contractor matters
Important customer, supplier, and vendor arrangements
Fill In the Gaps
Running your checklist of key legal documents and matters isn’t just an exercise in checking the boxes. And to be clear, I’m also not saying that you need to have any and every document accounted for.
The key here is to not give other people—like employees, contractors, vendors, and co-founders—a way to make your life difficult or turn something simple into a source of argument later on. In running through your checklist, it’s inevitable that you’ll discover things that are missing or are legally problematic—especially when your company has a lot of history, personnel, and/or moving parts. The list of seemingly simple but often forgotten legal agreements and documents that I’ve seen in working with clients could go on endlessly and has often included things like:
● Forgetting that your most important client requires you to have $5 million in cybersecurity insurance and can terminate your contract at any time if you don’t
● Finding out that you don’t have agreements in place that give you ownership rights in the software being developed for you by your outsourced developer in Vietnam or Ukraine.
● Realizing that you forgot to actually issue shares of the company to yourself and other co-founders.
● Not having agreements with your employees and consultants to assign the IP they develop on your behalf to the company
● Not having non-competes in place for certain members of your VIP team
The takeaway here is that if anything important is missing, get the responsive documents and arrangements you need in place, especially anything involving giving away an ownership stake in your company, important IP, and/or key vendor agreements and client contracts.
While You’re At It…Assemble Your Data Room in Advance
If you’re not familiar with the term, your data room is an online data repository, usually in Dropbox or something similar, where you will need to upload all of the documentation requested by an investor’s lawyers. While not every investor will want exactly the same things, most law firms representing professional investors have the same kind of information and documentation requests.
A lot of companies are surprised to find out how much time it takes to get their data room set up. But it can be very time-consuming, granular, and frustrating work for both your law firm and your business team—hunting through files and email accounts for information and documents to find everything you’re supposed to share. And then having your lawyer check the documents you’ve assembled to make sure there are no seriously unpleasant surprises for investors to discover.
The last thing you want to be doing in the middle of actually trying to negotiate the raise itself AND do everything else to keep the business running is to be pulling up hard-to-find documents at the last minute. It’s much easier to have these items prepared and loaded in advance rather than starting from scratch in the middle of negotiations.
Conclusion
When the next promising investment opportunity comes your way, will you be the startup that comes to the deal with complications that need explanations and papering over? Or will you be prepared for a quick but intelligent close?
We are entering a tough VC deal environment. Deals are slowing down and people are looking for ways to buy time and make excuses for changing their minds. The best time to prepare is now. Enlist the help of counsel early, run your legal checklist, and take care of complications before it’s too late.
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