editione1.1.4
Updated September 15, 2023You’re reading an excerpt of The Holloway Guide to Raising Venture Capital, a book by Andy Sparks and over 55 other contributors. A current and comprehensive resource for entrepreneurs, with technical detail, practical knowledge, real-world scenarios, and pitfalls to avoid. Purchase the book to support the author and the ad-free Holloway reading experience. You get instant digital access, over 770 links and references, commentary and future updates, and a high-quality PDF download.
controversy In addition to paying their own lawyers for work done related to negotiating a term sheet, the vast majority of venture capital funds require the startups they invest in to pay for a portion of the investors’ legal bills. Investors’ legal fees, if not paid for by the startup, come out of investors’ management fees. A small group of venture capital firms, including K9 Ventures, Afore Capital, Bloomberg Beta, Homebrew, and Spark Capital, believe investors should pay their own legal expenses. Critics believe these firms are employing a marketing tactic akin to “founder-friendly religious activity,” saying that who pays legal expenses is a minor point in the scale of an investment deal, and over-negotiating on the bill is ultimately a waste of energy.
At the very least, founders can manage the legal fees by putting a cap on them. In early-stage deals, a cap of $10K–$25K should be acceptable. Caps on legal fees can be powerful when founders are negotiating with a syndicate, as it motivates the investors to coordinate the legal activity rather than throwing a gaggle of lawyers into the negotiation.
For most financings, the majority of the legal costs come from legal diligence and corporate records cleanup, not the back-and-forth between lawyers arguing over the terms of a term sheet or the stock purchase agreement in the long-form docs.
danger Even if you’ve negotiated a cap on the portion of your investors’ legal fees you’re responsible for covering, your counsel’s fees can get out of control if you aren’t careful. If your lawyers are arguing about anything meaningful, you should tell them to bring it to you before it goes back and forth between different legal teams more than once.
Alex McCaw, co-founder of Clearbit, offers an alternative strategy to keeping fundraising bills low in chapter 26 of The Great CEO Within, by Matt Mochary. McCaw proposes founders set up a four- to eight-hour meeting with the decision-makers and lawyers from both the company and the venture firm. In this meeting, lawyers are only allowed to speak when advising their client on the meaning of a specific term. Once terms are agreed to, lawyers agree on wording for each term in the meeting, and one side’s counsel draws the final documents up from there. After you’ve signed a term sheet, there shouldn’t be much left for lawyers to go back and forth on beyond wordsmithing, diligence, and corporate cleanup.
Definition Pro rata rights (or pro rata) in a term sheet or side letter guarantee an investor the opportunity to invest an amount in subsequent funding rounds that maintains their ownership percentage.
Pro rata is Latin for “in proportion.” Most people are familiar with the concept of “pro rating” from dealing with landlords: if you’re entering into a lease halfway through the month, your rent may be “pro rated,” where you pay an amount of the rent that is in proportion to your time actually occupying the property.
Almost all investors try to negotiate for pro rata rights, because if a company is doing well they want to own as much of it as possible. After all, why not double down on a winner than use that same money to invest in a newer, unproven company? In the 2018–2019 fundraising climate, though, it’s safe to say we’re at “peak pro rata.” Everybody wants pro rata, even those who don’t entirely understand how it works or affects companies.