VCs & Tech Lawyers: Innovate, Automate, Simplify

Funding deals are only as complex and formal as the parties choose to make them.

The world of VC fundings, for example, is almost surreal in its complexity and formality. A typical deal starts with a term sheet from the VC's lawyers that tells the company it will have to slog through the standard range of (typically) preferred stock issues and will need, by the way, to reimburse the VC for its lawyer fees along the way (a typical price tag: $25K to $35K). This is then followed by "definitive documentation" that is fairly stacked against the company and from which the company needs to have its own lawyers work backwards to bring it to a more balanced state. This in turn causes the company to incur its own set of lawyer fees, often amounting to something akin to the amount it is reimbursing to the VCs. The net result: a small startup raises a few million dollars and spends $60K or $70K in processing costs for the privilege of having it properly documented. Of course, this is for a standard Series A-style funding. It only gets worse in later rounds, where potentially intricate rights may need to be adjusted among different classes of preferred shares or where downrounds may be involved or where internecine fights among disparate company factions may color large aspects of the terms finally negotiated. In such cases, when it comes to complexity and cost, we arrive at a stage that might even be called byzantine.

Now that is the working model that is so often criticized and about which so many ask, "Isn't there a better way?"

The answer is yes and no.

With VC deals proper, simplicity will never become the norm because the investor goals will always be animated by a strong desire to impose control and formality upon the target startup. There is a reason why all those seemingly oppressive terms are in the deal in the first place. And such terms do require elaborate documentation and lots of back and forth to sort through.

Given that simplicity in deal terms is not really achievable in this sort of deal, the answer often sought at this level is to push for the widespread use of "standard" documentation in hopes of streamlining these deals and limiting their costs. The model legal documents of the National Venture Capital Association represent this sort of effort. These are well-drafted documents that are highly useful in their own way.

Model forms, however, only go so far. In the working model described above, after all, the VC lawyers begin every such deal with the equivalent of model forms used by the particular law firm and those deals go down a path where they invariably generate much process and attendant large fees. Anyone who has been around awhile in such situations knows that a lot is gained by having skillfully drafted paperwork with which to begin a deal. But this does not in itself lessen the costs in any material way. Such model forms are in effect already part of the standard process, then, and it is no answer to the issues of complexity and cost to say that adopting such forms in some super-standardized way and putting them in some central online location will materially reduce costs by standardizing the deals. All this is another way of saying that high levels of complexity, and costs, are an inherent part of such deals.

Of course, it is theoretically possible to simply have companies sign "standard" paperwork prepared by the VC groups in its unaltered form and this might give us a sort of LegalZoom for funding documentation. But to view this sort of deal in this fashion is to ignore reality. When presented with such paperwork, companies do need to negotiate to bring balance to the documentation and, if they don't, they will find themselves often signing on to highly unfavorable terms.

As with every deal, there is really no such thing as "standard" paperwork unless one wants to accept potentially loaded terms.

In my judgment, when it comes to VC deals, some improvements can be made in terms of process but inherent complexity will always remain. There is too much money at stake, and too many varied interests, for the parties simply to sit down and sign without slogging though a whole variety of issues, many of them inherently complex. Yes, by all means, use graphs when it will help explain things. Use standard forms to start the process. Make them widely available for all parties to use. Put them online so people can log in to see and manipulate them in one location. Yes, do all this and more, and in the end you will still wind up with a complex process that cannot be automated beyond the superficial process level.

When one gets beyond the VC deal, and turns to angel-style funding, then the potential to simplify funding documents (and the funding process) is very real. It is possible to do a simple funding round for up to $1M or so with processing costs that do not exceed $5K or so. Series A or Series AA fundings can be documented with pretty vanilla terms (standard 1x liquidation preference, balanced anti-dilution protection, a few basic protective provisions, some investor participation in management such as one Board seat). The key to such simplified terms is having "friendly" investors who are content to accept basic protections but who also do not want to push for control.

Of course, only early-stage deals will fit this category but that is my point: the complexity of a deal is directly tied to what the parties are trying to accomplish - if you have simple, friendly terms, you can have simple, friendly process and paperwork and, if you don't, you can't. None of this will change by calls to "automate" or to "get with it" concerning modern technology. It is not a technology issue. It is a people issue. If there is a will toward simplicity by friendly parties, there is a way. If there is an inherent adversity, and a lot of money involved, simplicity will only exist in idealized discussions having little to do with real-world deals.

I think McClure is pointing out an opportunity for law firms that exists for both startup and established customers. One of the major barriers to lower the friction in the process is defining the value based on billable hours. What you really want from your attorney is a risk assessment and recommendations. The value of which is proportional to the size of the opportunity you are contemplating and the likely effect of the risk mitigation strategies offered. You have to change the business model to effect a transition to some of the technologies that McClure is talking about.

Some suggestions:

o Subscription models for legal services and cloud storage of all of the relevant documents might convert much of the due diligence process into a "configuration management" problem where you are always ready for a transaction because you maintain your relevant agreements and contracts in a known (and hopefully good) state to minimize the need for a fire drill before a transaction.

o Subscription models for advisory services would encourage attorneys to use more secure IM, document generators, cloud storage...We need to move beyond a billable hour model.

o for public agreements like privacy policies and terms of services there is an opportunity for a subscription service to monitor changes in posted policies, and perhaps for an additional fee provide customized interpretation of the significance. I had suggested this to the Legal River folks for their http://privacy-policy-generator.legalriver.com/ and http://terms-of-service-generator.legalriver.com/ that it might be as useful to classify the existing agreements already posted on the net. This would extend what EFF is doing with http://www.tosback.org/ (in itself a valuable service).

There is an event coming up Wed-Mar-3 at Churchill Club on "Innovation & Change, a "New Normal" for the Legal Industry?" (see http://www.churchillclub.org/eventDetail.jsp?EVT_ID=853 ) that explores what Cisco has done to leverage current technology and new business models in managing legal work (internal and outsourced). Hopefully some of these techniques trickle down to the startup world as they gain more acceptance in Fortune 500 / AmLaw 100 relationships.

George Grellas makes some excellent points in http://news.ycombinator.com/item?id=1090615 that the more adversarial the negotiation the less impact technology can have on cutting costs.

someone needs to build a web app that asks a few basic questions, gives you some check boxes to click and then generates all the standard PDFs you need for seed funding, employee agreements, etc.

Note: 2007 - not much has happened in 3 years, has it...