Series A: Making every day like Christmas for your lawyers
"Mr. A is trying to loan money to Mr. B. Your job is to grab as much of that money as you can on its way by."
As I gaze upon the list of documents my clients must prepare and negotiate at this early stage, it seems clear that this philosophy is alive and well. Investors' lawyers are consistently requiring investees to prepare and deliver documents that, in my view, are inappropriate and even unecessary in the context of a Series A transaction, raising legal fees by a significant factor without providing any significant additional benefit to the investors. The priciest of the lot? Requiring registration rights agreements and legal opinions.
A registration rights agreement gives certain investors the right to: (a) force an IPO (so-called "demand rights") , (b) require the Company to include the investors' shares in the IPO or any subsequent offering to the public markets ("piggyback rights"), and (c) post IPO, the right to demand that the Company sell its shares in a simple Form S-3 registration.
I do not always see eye to eye with Brad Feld on things like fashion (more on that soon) but he is absolutely correct when he says that this is one of the more heavily lawyered parts of any deal, and that it ultimately is one of the most irrelevant. First, demand rights are almost never used, so spending time and effort negotiating them is much like trying to negotiate an extended service warranty for your Edsel. Second, even if the company manages to make it to the IPO stage without being acquired, it is unlikely that the underwriters will allow the rights your investors spent your money putting in place to survive in their current form.
So why do Series A investors need to spend money on such matters now? Why can't parties instead provide an irrevocable commitment to provide those rights at some point in the future, and save some money and effort now? In my view, this would be no less vulnerable to the whims of a future investor or the underwriters than a more bloated approach. The response I usually get to this question from opposing counsel is a chagrined shrug.
Similarly, requiring legal opinions in a Series A deal is ordering caviar with truffles from the legal services menu. Surely a salad would have done. When I see this requirement in a term sheet, I start thinking about how great it would be if my name finally made it to the top of the waiting list for the Hermes birkin bag. I always tell my clients to double my bill at least if I am to deliver a legal opinion. Why?
Legal opinions are, in effect, legal guarantees that: (a) the shares were validly issued, (b) the issuance is exempt from prospectus requirements, and (c) certain resale restrictions apply to the shares. In addition, the opinions required usually ask that the company's lawyer certify: (a) that the company has the capacity and authority to enter into the investment, (b) that the deal documents are enforceable, and (c) that there are no circumstances in which a third party may seek to challenge the validity of the transaction. The time, effort and risk associated with providing an opinion mean that each of these items has to be investigated and reviewed, mostly in duplication to what the investors counsel have already done. Not to mention the added bonus of additional fees generated in the negotiation of the form of opinion.
Is it fair to ask for comfort on the above matters? From the company, absolutely. In fact, the company must warrant that each of the above items are true. It's also why investors hold the pen and prepare all of the deal documents - they wish to ensure the enforceability and validity of all of the constituent elements of the deal. It's why they have their own lawyers also review the corporate records of the company ahead of time, and even draft/approve the authorizing resolutions the directors and shareholders sign. In other words, a lot of salad is prepared. Given all of this sunk cost and effort (which the investee must pay for) what additional comfort does the investor get from a legal opinion?
None, in my view. At the Series A stage, most companies simply haven't been around long enough to have any significant operating history or issues. There aren't any complex capitalization matters that have occurred. In short, the risks in most Series A deals are investment risk, not legal ones. A legal opinion on top of all this salad does nothing except, perhaps, cause bloat.
As a lawyer, I'm all for bloating (see Birkin bag reference above). But as an advisor to my clients, I have to ask whether it is appropriate to try and fit a Series A deal into a format better suited to mature companies. I'd rather earn my Birkin through real value added legal work.