This article is part of our “Business Startup Guide” – a curated list of our articles that will get you up and running in no time!
Picking the right attorney in your startup is as important as picking the right business partner. You can’t underestimate the importance of selecting an attorney who “gets” your business model, your market opportunity, and most importantly, your fundraising and exit strategy.
My business partner and I made many mistakes in our first tech startup, and so many of them were the result of choosing a lawyer who was a terrible fit.
Let me paint the picture for you: We were about two months into our startup idea. We had stars in our eyes and excitement in our bellies. Both my business partner and I were “green”—meaning, this was our first startup venture, and we had no idea what we were about to get ourselves into on that warm fall day when we walked into the office of our soon-to-be attorney…
The attorney was, in fact, a business attorney, but what we later discovered was she had never before worked with a tech startup with high growth ambitions, the need to raise multiple rounds of financing over the next two years, and the goal to exit/sell the company in a five- to seven-year timeframe.
We were targeting raising around $3 million from investors. We had personally invested $70,000 of our own money at this point, and we were hoping to raise at least another $250,000 to help us hire a team, launch our company, and begin to build our product.
We shared all of this with our attorney before she helped us write our Operating Agreement (OA), so we assumed we were in good hands. The agreement seemed to have all the things business partners would need in order to professionally launch and run a company together (i.e., team roles and responsibilities, ownership percentages, “what if” scenarios, etc.).
We set off to raise our money. We developed a kick-ass investor pitch and we started pitching it to family, friends, angel investors, and even venture capitalists for feedback. We knew we were too early for VC money, but it was nice to get the chance to pitch to VCs early in our startup and learn what milestones we needed to accomplish to become “venture-ready.”
We soon got interest from an angel investor, and he wanted to invest $300,000 in our startup. My business partner and I were elated. After a couple of due diligence meetings with the investor and our attorneys, he gave us the check.
The deal we made with him was he’d get 30% of our company in exchange for the $300K, and my business partner and I each diluted from 50% ownership down to 35% each. So far it sounded like a fair deal, considering we didn’t yet have a product developed—only a pitch deck, a business plan, a fleshed-out idea, and some user interface (UI) designs of what we thought our online product would look like.
However, the deal we made with this investor was not in the best favor of the company’s growth—we just didn’t know it at the time.
What we’d signed was an agreement that the investor could keep his 30% ownership and never dilute.
Now, if you’re a savvy investor or entrepreneur, I’m sure your jaw just dropped as you read that. Maybe you even shouted some profanities out loud. For those of you who don’t understand the implications of an investor this early in a deal never diluting his shares: That kind of a deal is unheard of and extremely detrimental to any future fundraising.
When fundraising for a startup, all investors dilute as additional investors join in on the deal. This should be clearly spelled out in your Capitalization Table, or “Cap Table” as it’s commonly called. A Cap Table shows who owns the company, what the ownership shares are, and what the owners have invested in exchange for that share.
Our attorney updated our operating agreement to include a “non-dilution clause” for this investor, and my business partner and I later found out how much this would cost our company—both financially and otherwise.
Now, let’s fast-forward about nine or ten months into the growth of the company. We had a beta product launched, 20 beta testers, and lots of interest from different investor groups. One group of angels was interested in investing up to $500,000 in our company, and another was willing to match those funds if the first group invested. We even won $65,000 from an angel investor pitch competition in the form of a convertible note.
We were on a roll.
That is until one very savvy investor from the interested angel group asked for a copy of our operating agreement. We gladly handed it over to him as part of the due diligence process. A few days later, he asked to schedule a call with us. This is when we found out just how devastating it was to have that “non-dilution clause” as part of our OA.
The investor said, “We can’t invest in you unless this clause is removed from your operating agreement.”
It didn’t seem like too big of a deal to ask our first angel investor to agree to us removing the clause. But when we asked him he was livid that we had “gone back on our deal.” We explained to him and his attorney that this clause was harmful to our growth, and that interested investors were stipulating that we remove it. We even explained that it’s not common to have this clause in an OA for startup companies—especially tech startups.
Neither he nor his attorney grasped this concept. His attorney was convinced he was protecting his client’s investment, when in fact he was harming his investment because the non-dilution clause was not allowing other investors to fund our growth.
That $300,000 investment, which had initially made us so happy, was what we later learned is endearingly called “dumb money.”
Our attorney should have known.
At this point in our startup’s saga, a mentor suggested we hire another attorney—someone with experience in technology startups that raise multiple rounds of financing and desire founder exits within five to seven years. It felt awkward going to another attorney without telling our first attorney (we were advised not to do so), but we decided it was important for the health of the company. So we hired another firm to help us facilitate the removal of this clause.
We eventually got the clause removed, but it took several months and tens of thousands of dollars. It also cost me, as the CEO of the company, time away from additional fundraising and selling, since both my business partner and I spent too much time on expensive legal meetings trying to convince our only investor that he was harming the future of our company, and ruining his own investment by blocking others from coming in.
By the time the clause was removed from our OA, the Great Recession was in full swing. The housing debacle was ramping up, and the angel investor group that had been interested in investing in us had moved on, and invested their funds in another startup. We lost the opportunity and had to raise funds from our friends and family to help sustain us for a few more months. Ultimately, we ran out of money and had to dissolve the company.
Success is a terrible teacher
This was a terrible—but also great—lesson to learn at that stage in my startup career. Mind you, my business partner and I didn’t blame the failure of our company on that one investor because we did make a series of other mistakes, but I can tell you that the experience hurt us at a critical time during our company’s launch.
I now say that “success is a terrible teacher,” and I strongly believe in that statement. Life’s best lessons come from failure. What’s important, though, is to learn from those failures and share those experiences with others, in the hopes of helping them avoid making the same mistakes.
I hope I can help you avoid making the same mistakes we made.
It’s important to conduct due diligence on anyone that comes into contact with your company—especially your attorney.
Below is a quick checklist of ten questions that will help you select the right attorney for your startup. Please add to it in the comments if you have other tips for entrepreneurs!
10 questions to consider when interviewing an attorney for your startup:
- Has the attorney ever worked in your industry before? Do they understand the startup lingo in your industry, and do they understand your business model?
- How much time do they have for you?
- Who else in their firm can help you if they are unavailable for some reason?
- Have they worked with companies who have raised multiple rounds of financing to start or grow?
- Can they create and advise on a Capitalization Table?
- Do they (or does the firm they work for) have experience creating compensation packages for key employees, including stock options for all employees?
- Do they (or does their firm) have experience with intellectual property and patents?
- Have they worked with companies that have a global footprint?
- Do they have experience with mergers and acquisitions, including how to set up the company for successful exit scenarios?
- Are they willing to share a few references from other startup companies they’ve helped?
After our company failed, I took several weeks and interviewed angel investors, venture capitalists, and other founders who had experienced failed startup ventures and investments. As a result of my research, I compiled a presentation titled “The Top 10 Reasons Startups Fail.”
I’d love to hear your startup failure stories. Tweet me @iamcarolina.
Best of luck to you in your startup venture!
Editor’s note: This article originally published in 2014. It was updated in 2019.