For the past decade, a large number of startup businesses around the world have been formed, capitalized, successfully turned their thoughts into action, entered the public markets (or chosen to remain privately held), and had major disruptive effects across numerous industries. By a recent count, there are now 22 decacorns (businesses that, at their last valuation, exceeded $10 billion) and an additional 391 unicorns ($1 billion+) from 25 countries on six continents. Venture capital funds continue to hold enormous amounts of “dry powder” (uncalled capital commitments from limited partners) available for investment—a recent estimate suggests there is $243 billion still to be deployed.
The dream to create the next great business is alive, well and thriving. But can entrepreneurs pay the bills, particularly the cost of counsel? The answer should be “yes,” and this short article sets out a few specific conclusions.
We first set the stage: Founders and leadership teams of new startup businesses see the success stories of their friends and classmates. They know, or learn quickly, after forming their business (frequently through digital providers) that they need to raise significant equity capital over an extended period of time, to fund growth in their business. First, there is typically an initial round from angel or other early-stage investors, which may take the form of a Simple Agreement for Future Equity (SAFE) or convertible note. Frequently within a year, the company goes back to the capital markets to raise Series Seed or Series A capital. With continued success, a company will return for Series B and other lettered capital rounds approximately every 18 to 24 months thereafter as its business generates significant revenue. We do not attempt to cover venture debt, traditional credit products or alternative listings in markets outside the United States to fund the business in this article.
We expect in 2020 a continuing trend of modest legal costs for a company’s first financing. Y Combinator, through its introduction, advocating and backing of SAFE financing documents, has successfully driven the legal spend for financings on these forms to be pennies on the dollar. Founding teams can literally fill in three or four blanks in form documents and close their rounds, typically with only minimal involvement of outside counsel or compliance firms to take care of required securities filings. There are very few business terms to negotiate involving SAFEs, and entrepreneurs often quickly become skilled in what decisions to make. We also see little, if any, legal diligence involving outside counsel. For a typical SAFE round raising $1.5 million to $2 million for a business, expenses should be minimal for outside counsel. In recent years, the “plain vanilla” SAFE financing round for a company meeting these parameters starts at $5,000 for company outside counsel but then varies upwards depending on specific needs and particularized facts and circumstances.
Convertible notes, as opposed to SAFEs, require more involvement of outside counsel given their additional components. There are “forms” used by large law firms that are similar but not identical and, typically, there is a level of engagement with outside counsel and investors (and their counsel) when funds are raised using convertible notes. On the same parameters used for the hypothetical SAFE instrument from the prior paragraph—$1.5 million to $2 million raised—the “plain vanilla” note raise in 2019 for tech startups normally begins at the cost of $15,000 for company outside counsel. This cost presupposes skilled counsel on both sides of the transaction handling a straightforward convertible note. Law firms can deliver more precise pricing varied based on individual situations (depending on the business vertical, geography, number and type of investors, and other key factors). Law firms with dedicated emerging companies and venture capital lawyers, like Morrison & Foerster, are astute at providing a sensible budget to companies that serves their needs based on their particular facts and circumstances.
The cost of outside legal counsel gets higher, not surprisingly, when businesses are ready for priced rounds and the legal complexities increase. The key driver for cost at the Series Seed and Series A stages initially turns on the form of documents. Just as Y Combinator greatly simplified the earlier financing rounds with its SAFE form, so, too, did the National Venture Capital Association (NVCA) serve the industry, very productively, by developing standard forms for venture financing. If the company raising capital and its lead investor can agree on forms to be used at the outset, the legal budget can be determined relatively easily.
We support using the NVCA model documents at the earliest possible stage. The forms are clear, relatively well-balanced and regularly updated. They can be quickly customized by outside counsel for a particular business. The forms are certainly complex—traditionally five “primary” documents and four to eight additional “ancillary” documents (including an opinion of counsel) for a standard venture financing round. However, experienced outside counsel can generate the paperwork and negotiate terms quickly. In addition to the forms of documentation, by this stage of a company’s life cycle, it is also expected that investors will conduct thorough due diligence on the company’s business. The company will set up a virtual data room and upload responsive documents at the request of investors. The diligence inquiry is likely to include a thorough review of standard corporate matters, commercial contracts, intellectual property, employment matters, litigation and a range of other topics depending on the nature of the company’s business.
When the NVCA forms are used, the related important questions concerning the legal budget for a Series A or Series Seed financing are typically specific to the company itself: its business, location, investors and other factors. With that caveat, for law firms sophisticated in the startup space, it’s not uncommon for company outside counsel fees for the corporate work in connection with raising Series Seed and Series A capital to start at around $50,000. It is typical, in 2019, for outside counsel fees to be paid at the closing of the financing transaction. In addition, companies raising capital should be aware that it is common for the fees of the lead investor’s outside counsel to be paid by the company at the close of the financing. The amount of those fees to be reimbursed by the company is traditionally negotiated on a term sheet that is agreed to by the issuer and the lead investor before proceeding with definitive documents.
Looking ahead to 2020, there remain a few unknowns that may have a material effect on cost. We observe that the pricing analysis for outside counsel is made more complicated by the location of the investor and the underlying business. Changes in the laws and regulations relating to the Committee on Foreign Investment in the United States (CFIUS), beginning in 2018, require a thoughtful analysis of mandatory and voluntary filings for many startup businesses if investors are outside the United States. Further CFIUS-related legal developments are anticipated to occur in the first quarter of 2020, as regulations are finalized. For now, startup businesses should keep CFIUS on their radar screen.
In addition, again depending on the underlying business raising capital, there are new laws coming into effect that could impact diligence and documentation. A new privacy law in California coming into effect in 2020, the California Consumer Privacy Act (CCPA), will potentially require analysis. If applicable, counsel for the company and investors working on a transaction will expend effort to ensure compliance.
Our advice for issuers is to have a candid discussion at the outset of a financing of the anticipated legal fees. A productive discussion frequently permits the company and its counsel and other advisors to allocate tasks and ensure as smooth a process as possible. Wise management teams often act proactively with potential investors, at or before the inking of term sheets, to identify and resolve issues. Management can direct counsel about what to negotiate on requested document changes. We find that experienced counsel are always open to these discussions, believing that, in the long-term, partnering with the company to close a financing round promptly and efficiently will yield long-term business success.