Seller Beware

SNAPCHAT (NOW SNAP) COMPLETED ITS IPO ON MARCH 2ND,
Seller Beware 1
and despite its success its founder Evan Spiegel pointed a spotlight on how venture capital funding can lead to difficulties for founders down the road if they don’t pay attention to the fine print of how the deal is structured and they don’t have the right legal counsel advising them of their position or rights. In The New York Times article on February 23rd, the Snap founder tells the cautionary tale of how the first institution to invest in the now multi-billion dollar company, had certain control over the future of Snap from the outset. Venture capital firms often require investment terms that provide some level of control over the companies they invest in. Without the right advice and representation, that level of control could become a real burden for founders and/or the Company.

In the anatomy of early-stage venture capital funding rounds, the VCs often communicate deal structures and terms as ‘standard’ and term sheets offered by many venture capital firms lack sufficient detail for founders to understand whether or not their investor’s idea of ‘standard’ is the same as their own. Start-ups at this point in their lifecycle can be desperate for investment to ensure the viability of their company and may move forward without truly understanding the agreements required in a venture capital investment transaction if they are not getting the right legal advice. Such was the case with Snap, whose ‘standard’ deal gave its first investor considerable power over additional investment, making it unattractive to some other investors and a large distraction for the company. (Though the investors who passed on Snap early on must be regretting that decision now considering the return multiples the early-stage investors are expecting!)

In the words of Evan Spiegel, ‘standard means either
the
person taking you through the documents doesn’t understand
them
or you could be getting taken advantage of.

Founders rarely if ever have their own personal counsel separate from company counsel representing their point of view from the outset. It is important for founders to understand that company counsel is exactly that: company counsel. If a start-up doesn’t already have company counsel, a venture investor may recommend lawyers from one of the main Silicon Valley firms to ensure a smooth and ‘standard’ deal. This gets dangerously close to a conflict of interest in that one usually doesn’t bite the hand that feeds. In the words of Evan Spiegel, ‘standard means either the person taking you through the documents doesn’t understand them or you could be getting taken advantage of.’

Those same lawyers won’t necessarily be driven to bargain for a liquidity event for the founders at the Series C round, or argue against the non-competes or non-solicitation restrictions the founder is agreeing to. It’s the reason founders who are asked to stand aside from the company they created realize they were simply at-will employees, there at the whim of the board, they will often lack rights to severance, perhaps not even a Good Reason clause. Their stock holding, while valuable, is illiquid and not tradable on public exchanges, and it is nearly always subject to sale restrictions even if a buyer can be found.

Success in negotiating for liquidity rights, severance
or
exit payments, board seats and other controls over future
investors
and the company’s destiny will vary based on facts,
timing
and most importantly leverage.

Like all negotiated arrangements, there can be a big difference between ‘standard’ and ‘optimal’ especially for founders who, at the time of funding may lack leverage and the understanding of the documents, which investors deal with frequently. Success in negotiating for liquidity rights, severance or exit payments, board seats and other controls over future investors and the company’s destiny will vary based on facts, timing and most importantly leverage.

Ultimately investors often seek the best protections to maintain some level of control over their investments and may not be looking out for the best interests of founders. This is why Founders should carefully consider whom they engage as company counsel and may wish to consider having competent and truly independent counsel to represent their personal interests.

By Allan Rooney – Founding Partner

These materials are for informational purposes only. Nothing herein is intended nor should be regarded as legal advice. The distribution of this article to any person does not establish an attorney-client relationship with our firm. Rooney Nimmo assumes no liability in connection with the use of this publication. This bulletin is considered attorney advertising under the applicable rules of New York State. Rooney Nimmo UK is regulated by the Law Society of Scotland and Rooney Nimmo US by the New York Rules of Professional Conduct. All Attorneys and Solicitors listed in this firm stipulate their jurisdictional limitations. Rooney Nimmo in the USA is a law firm registered as a New York State Professional Corporation.Seller Beware 2

 

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