pic-asher.jpgCONTRIBUTED BY
Asher Bearman

Our first installment in our newest series Understanding VC Financing terms addresses a hot issue at the moment – transaction costs and attorney fees.  Much has been written about this topic in recent months.  For example, with respect to seed round financings, Fred Wilson recently called for attorney fees to be $5,000 for such deals.  Bill Carleton responded with his thoughts on GeekWire.  In typical series priced round of newly issued preferred stock (i.e., Series A, B, C, etc.), however, the transaction agreements are more complex and it’s almost always the case that a VC firm will want to perform some level of legal diligence.  For example, before investing a few million dollars in a tech company, a VC typcially will want to confirm that the company owns its intellectual property, which can require patent searches, open source code analysis, review and invention assignment agreements, and/or more.  Accordingly, the costs of these preferred rounds tend to be much greater than the costs of doing a seed round.

The Sinking Dollarphoto © 2008 Reuben Whitehouse | more info (via: Wylio)It is customary for the company to pay for the legal costs incurred by VCs in a series financing, so entrepreneurs are often sensitive about both their own counsel’s fees for a preferred financing as well the possible fees of the investor’s counsel.  Often, this can be stated as the “reasonable” costs; however, the distinction is not much different in practice.  What is important is that often the parties negotiate a cap – or a maximum amount – that the company must pay.  In our experience, the range can be dramatic.  For example, a follow-on round with little diligence and few changes to the existing agreements can be done for $15,000-$25,000 if everyone is on the same page throughout in terms of keeping the process streamlined.  Alternatively, I’ve also seen complicated financing deals that were heavily negotiated throughout that cost $40,000-$50,000 and, in cases where the diligence was particularly extensive or turned up problems that had to be cured prior to the closing, the amounts can easily exceed $100,000 (all the more reason to spend a little up front to make sure that your documenation is in order before going into a financing).

Drivers of Costs – Continued Negotiation, Diligence and ‘Clean Up’

A vague or hurried term sheet can often result in increased deal costs.  To avoid this, entrepreneurs and investors are both smart to involve their counsel early in the term sheet process.  This may create a little more cost up front, but usually pays for itself in the long run by limiting the chance for vague terms in the term sheet that result in legal or business confusion when the documents are being drafted.  This also is the best time for lawyers to value-add on fundamental business points – again, investors and entrepreneurs are smart to leverage the market expertise of their lawyers at this stage to best understand whether proposed terms are ‘normal’ or ‘market’.  I may seem biased here but, in my experience, the additional costs of involving attorneys on either side early (before the term sheet is signed) is cheap insurance. 

In a preferred round, investors generally will undertake a significant amount of due diligence and, in many cases, there must be a legal ‘clean up’ of various issues in order for a VC to complete their investment, which can include (depending on the context):

  • Confirmation of proper entity formations and corporate governance (if the company’s records are not in order, often the company’s lawyers must scramble the jets to get everything cleaned up, which can create a significant amount of additional cost and could threaten or delay closing)
  • IP diligence, including confirmation that the company owns all necessary IP, there are no open source or similar issues, that all current and former employees/consultants have signed invention assignment agreements and, where applicable, applying reverse vesting to common stock held by key employees
  • Employee diligence, including ensuring key empoyees have signed noncompetition/nonsoliciation agreements (assuming enforceability in the applicable jurisdiction)
  • Stock option diligence, which can result in changes to the price per share if an increase to the pool is contemplated on a “pre money” basis (including legal diligence to ensure that all stock option grants were properly approved and 409A compliant)
  • Litigation diligence to ensure that there are no pending or threatened suits against the company that could materially reduce its value
  • Tax and other liability diligence to ensure the company is current on all obligations
  • Requiring key person insurance
  • Requiring D&O insurance coverage and director indemnification agreements acceptable to investor representatives that will take a board seat

Ideally, the appropriate cap on fees will also consider other applicable factors such as which counsel is primarily responsible for drafting the agreements, the extent to which existing agreements must be revised, the amount of legal diligence that may be involved, etc. 

Trap for the Unwary

One additional trap for the unwary entrepreneur – whatever the cap may be, make sure that the firm representing the investor(s) bills the lesser of their actual fees or the cap.  When I’m representing investors, I love to be able to come in under the cap and look like a rock star.  It doesn’t always work out and I do often end up billing the cap, but my goal is to keep it under.  Some well-known law firms in the space, however, have a standard practice of billing the cap amount (seemingly without regard to the relative complexity or simplicity of the deal or the actual time spent).