FOR COMPANIES THAT NEED TO RAISE FUNDS, it can be tempting hire legal counsel based on the lawyer’s ability to make introductions to funding sources. Not many CEO have the time to stay connected to those sources and the connections of their legal counsel can be viewed as a plus.
That’s all fine as long as the lawyers skills as a lawyer are vetted and the counsel engaged is savvy and experienced in the matters they are likely to be needed for, including venture funding documentation. And, while it may not be easy to fully vet the qualities of savvy or good judgment, you can inquire about past experience and reputation.
Confident lawyers will be happy to share names of CEO’s and others they work with who can provide firsthand information about what it is like to work with them. It is not enough to rely on the general reputation of a law firm a prospective lawyer works with. The careful CEO or CFO will get granular when investigating a legal hire.
Here is why it matters. Good lawyers with the right experience can save you from future headaches while helping you complete transactions on favorable terms.
Consider the following example involving something as mundane and detailed as notifying shareholders about their first refusal rights while completing a Series B financing. In our example, the prior Series A financing granted rights of first refusal to investors that entitles them to purchase a pro rata share of the Series B offering.
On the verge of closing a large Series B financing, the company sent out notices to the Series A shareholders telling them about the pending fund raise and giving them a fixed period to exercise their rights using a form they provided. The notice requests the Series A shareholders to either waive the first refusal right or purchase a full pro rata share. It also requests they either waive or elect to participate in buying a maximum share of first refusal shares not purchased by other Series A holders.
Simple enough and, superficially at least, all appears in order. But there are details unattended to and risks being taken by the company in following an all or none approach. The risks stem from the agreements used in the Series A financing and from the fact that shares are being offered for sale.
The investor rights agreement from the Series A financing grants a right to buy a pro rata share without explicitly saying whether the holder has to purchase all of the shares available or has the right to buy fewer shares. The term sheet, which preceded the investor rights agreements, and was disclosed to investors is clear that an investor can buy part or all of a pro rata share. Also, by way of background, options like this are usually interpreted absent express language to the contrary - to entitle a holder to buy less than all of the shares subject to the option.
The company and its lawyer, however, have chosen to interpret the agreement to grant rights to purchase all bu not less than all of the first refusal shares. Their notice and exercise form are so constructed putting the effectiveness of the notice at risk.
In addition, the first refusal agreement is unequivocal that the notice about exercising rights to buy first refusal shares not acquired by others must come later, after the company can determine how many shares are available. Failing to meet this requirement also puts the effectiveness of the company’s notice at risk.
Lawyer gobbledygook, right? What possible difference could any of this make? Technical deficiencies in the notice cannot make that much difference, can they?
Yes, the can. The problem is that if the notice is ineffective it can have expensive ramifications down the line for the company and other shareholders.
For example, if the company goes public in the next few years, lawyers for the underwriter will diligence the Series A documents and the notice. And they will care about whether the notice was effective. If it was not valid, the first refusal rights may still be effective which means they will need to be cleaned up or disclosed as part of the offering. This can create an expensive and time consuming headache for the company just when it is eager to finance.
A different, but equally annoying, set of problems can arise if the company wants to accept an offer of purchase later on. The buyer’s lawyer will do the same diligence and surface the same problem. In this context, the problem calls into question how many shares and rights to buy shares exist in the company being bought. The company will say the first refusal rights have expired. One or more Series A holders may say they still exist because the notice was defective, especially if the new share valuation is attractive. There are ways to resolve the issue but they can be expensive and time consuming to execute.
So, what would you want your lawyer to do under the circumstances? Issue the notice in the form it was or fix the timing issue and describe the purchase rights consistent with the clearer language in the term sheet to avoid creating issues in the future?
Most deal lawyers would not find this a difficult question to answer. But at the same time, most CEOs would not even be aware there is an issue without guidance from their lawyer on what probably feels like a minor detail.
Hence the admonition about hiring attorneys. The lawyer in this instance was hired in part because he had investor connections and he comes from a big firm. He may even be good at a lot of things but the this detail of a large funding is a mess, potentially a very expensive self inflicted mess.
Remember when hiring counsel: A good lawyer's primary value is in representing his or her client well with attention to details and a sensitivity to issues small and large that can impact the client. Connections can be a plus but they are dangerously not enough.
Look for more on lawyers in a later posts and check out our March 14 posting about the conflicts connected lawyers sometimes bring to their entrepreneurial clients. For more about fundraising and deal terms check out Richardson’s Growth Company Guide 5.0 – Investors, Deal Structures, Legal Strategies.
The venture moola blog comes to you from Atlanta, Georgia. Find it at readjanus.com. Copyright Clinton Richardson.
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Clinton Richardson, has been writing for decades. His critically acclaimed venture strategy books first appeared in 1987 and are now in their 5th edition. His Ancient Selfies is an International Book Awards Finalist and an eLit Award Gold Medal Winner. Ancient history and capturing photographic moments are among his passions. See his photo galleries at TrekPic.com.