Now that you have completed all of the important steps from the initial review to the due diligence process to signing a term sheet or commitment letter, it is time to bring in the lawyers. This may be the entrepreneur’s first exposure to a closing, so some “handholding” may be needed along the way. The lawyers for both sides should be competent in venture capital transactions. One of the most painful processes is to try to educate a new lawyer in venture capital financing. Avoid amateurs if at all possible.
As an investor, you will want your lawyers to draw up the legal documents for closing. They should follow the commitment letter very closely. When they are completed, copies for review should be forwarded to you, to the entrepreneur’s attorney, and to the entrepreneur. As an investor, you should read the legal document to determine whether it agrees with the business deal. The legal document should contain standard paragraphs—sometimes called boilerplate paragraphs—that lawyers need to put into these kinds of legal documents and that are not part of the commitment letter. Make sure the lawyer for the entrepreneur explains these boilerplate paragraphs so that the entrepreneur doesn’t think you are trying to pull something over on him or her. An example of legal documents with these boilerplate paragraphs is provided in Appendix B.
In this chapter we explore two types of closings: a loan with an option to own stock (warrants) and an agreement to purchase common stock.
It would be truly be wonderful if an entrepreneur could simply sign an IOU to an investor and get the money for the business. Unfortunately, neither party would be well served by such an approach. There must be adequate legal documentation before any investment can be closed and the proceeds disbursed. Any investor who puts up money before the legal documents that accurately reflect the deal are complete and signed by all parties has made a big mistake. Three fundamental legal documents are involved in a loan with an option to buy stock.
The loan agreement
The note
The stock purchase option
Each document has specific objectives, and each covers separate ground.
It is important for every investor to realize that these documents will govern the legal relationship between the entrepreneur and the investor. As the investor, read the legal documents carefully. There is nothing frightening about legal documents. They are written in English and not a foreign language. As you read them, make sure they state precisely what you and the entrepreneur had in mind. There can be only two reasons why they may not. Either the entrepreneur has changed his or her mind and has instructed the lawyer to make changes in the documents or there has been a mistake. In either event, you should discuss the changes with the entrepreneur and make sure that he or she is not trying to back out of the deal. This will head off an expensive argument between your lawyer and the entrepreneur’s lawyer.
Now let’s review the three basic legal documents of our first closing.
By far the largest document in this trio will be the loan agreement. It will contain 50–200 pages and possibly more if the investment is a complicated one. To some extent, the loan agreement will include the items in the commitment letter plus items standard for such loan agreements. A loan agreement contains ten sections, each of which is discussed below.
In this section, the lawyer will use specific language to describe the loan with all its terms and conditions. The lawyer also will describe the equity option with all its terms and conditions. This section will describe in detail the securities to be purchased and will specify the following:
The interest rate per annum
When repayment of principal will begin and over what period it will be repaid
Dates on which payments are to be made, such as the first day of each month
Delivery date of the funds by the VC
Description of the VC’s stock option
Ownership in the company by the VC
Cost of ownership
Also, this section will establish that the company has authorized and empowered its management to enter into the sale. It will discuss any other venture capital participants and the amount that they will be purchasing in your company.
This section will describe the collateral for the loan in great detail, and it will refer to a collateral security agreement that will be an exhibit to this agreement. Normally, the lawyer will describe each piece of collateral as set forth below:
A second mortgage on specific land and buildings
A third secured interest in machinery and equipment of the company
Personal guarantees of certain individuals
Assignment of certain leases
Assignment of life and casualty insurance
This section covers all the items the entrepreneur agrees to do as long as the loan or option to own stock is outstanding. The company will do the following:
Provide the investor with detailed financial and operating information on a monthly basis.
Provide the investor with any documents filed with the Securities and Exchange Commission or other government agencies.
Provide an annual budget by a specific date each year.
Advise the investors of any adverse changes in the company’s status.
Maintain certain current ratios, working capital amounts, or net worth amounts.
Maintain life insurance on certain executives of the company.
Maintain property and liability insurance in sufficient amounts.
Notify the representative of the venture capital company when board meetings will occur so that the venture capital representative may attend the meetings.
Provide access for the VC to the premises and to the books and records of the company.
Keep all equipment and property in good repair and in working order.
Comply with all applicable laws and regulations.
Pay all taxes and other levies of taxes against the company.
Maintain its corporate existence and other business existences.
Give the venture capital firm the right of first refusal on new financings in the future.
Maintain a standard system of accounting in accordance with generally accepted accounting standards.
Notify the VC if the company is in default on any loans or leases.
The items above will be spelled out in separate paragraphs in the affirmative covenants section of the loan agreement. Be sure you understand each covenant because once you sign the agreement, this will be the only thing the entrepreneur must do to keep the loan out of default. If a new covenant is brought up as a “standard” covenant, discuss it with the entrepreneur, not the entrepreneur’s lawyer.
This section specifies what the entrepreneur agrees not to do. Some typical negative covenants follow:
There will be no change in control of the company.
Management will not sell, assign, or transfer its shares.
The company will not change the basic business it is in.
The company will not change its current business format; that is, change from being a corporation to a partnership.
The company will not invest in other companies or unrelated activities.
The company will pay no cash or stock dividends.
The company will not expend funds for capital improvements in excess of certain amounts.
The company will not pay or loan to any employee money in excess of a certain amount per year.
The company will pay no brokerage fees and the like in excess of a certain amount.
The company will not transact any business with members of the board of directors, management, or its officers or affiliated individuals.
The company will not dissolve, merge, or dispose of its assets.
The company will not change its place of business.
The company will sell no additional common stock, convertible debt, or preferred stock.
Each item above will be covered by a short paragraph in the legal documents. Violation of any of the above items will be considered a default, as set out below. Each item should have been discussed with the entrepreneur. If a new item appears, you need to discuss it with the entrepreneur because it will have an impact on the way you conduct business. If substantial new covenants appear in this section, you may have to meet with the entrepreneur to negotiate the terms in the legal documents.
This section describes items that will cause a default of the loan. A default may mean the company will have to repay the loan in full on the day of default. A default is usually called on any of the following items:
If the company does not carry out the affirmative covenants
If the company violates any of the negative covenants
If the representations and warranties made in the legal documents are not true
If the company does not make the loan payments on time
If the company does not pay other debts as they come due
If the company has any other loan called in default
If the company has any lease called in default
If a final judgment is rendered against the company by a creditor
If bankruptcy or reorganization of the company should occur
In this section, the lawyer will also specify what remedies are necessary to remove the default. As an example, suppose a default is called because the company has not made a payment; making the payment within ten days of written notice of the default may be the solution to remove the default. Some defaults can happen easily, as in the case of a payment that is not made on the due date. If the company misses the payment date by only one day, the investor can call the loan in default. A grace period should be provided in the legal documents. This refers to the amount of time the company has to correct a default once it is notified. In granting grace periods, remember that the longer they are, the worse it is for the investor.
Here the agreement may cover a wide range of items relating to the equity of the company, the equity of the investor or VC, or the option to own equity held by the investor or VC. These items include the following:
The right of the VC to force the company to register his or her shares in a public offering, free of charge
The right of the VC to include his or her shares in any registration of the company’s shares, free of charge
Any restriction on the transfer of the shares being received by the VC
A section referring to certain Securities and Exchange Commission regulations to which everyone must conform
An indemnification of the venture capital company against any violations on issuing of stock
Representations on the VC’s part about the number of shares and options outstanding
Any rights the VC may have to require the company to repurchase the shares held by him or her (this is the put)
Any rights the company has to repurchase the shares at a later date (this is the call)
This section covers all the equity rights that the investor will have. This part of the document should cover all matters that you and the entrepreneur have agreed upon with regard to the equity rights in the company. These equity rights are the mechanism whereby the VC will someday realize a profit on the equity position. It is the investor’s exit. Be sure you understand how you will realize a profit on this equity. This section is particularly critical to you. You want to exit from your deal someday, and these equity rights will be the mechanism for doing so.
This section constitutes a warranty from the company that the representations in the legal documents are true.
The corporation is in good standing.
The company is in compliance with all laws.
There is certain capitalization of the company.
There are no subsidiaries.
The financial statements are correct.
There have been no material adverse changes since the last financial statements.
There is no litigation going on, or if there is, a description and amount of potential payment is attached as an exhibit.
The company is in compliance with all government regulations.
There are no defaults on current borrowings.
The company is current on all taxes.
The company has rights to any patents that the entrepreneur owns.
Paragraph after paragraph of these types of representations and warranties can be expected in the legal documents. Each one has a specific focus and meaning. Your lawyer should be able to substantiate most of the claims. Read each one and be sure that on the closing date, all representations made by the company are the ones you expected.
This section will explain who pays the lawyers for drawing up the documents, who pays for filing any legal documents at local courthouses, who gets notices, and so on. Normally, the entrepreneur’s company will pay all the lawyers’ fees and closing costs.
In this section, the lawyers will define every technical or legal term appearing in the document. You should understand the definitions because they are an integral part of the entire document.
This last section includes items such as indemnification, waivers, notices, and addresses. In this section, too, the lawyers will list the conditions for closing. Condition-of-closing items are things such as the following:
Certificate of incorporation
Copy of bylaws
Certificate of incumbency
Opinion of entrepreneur’s lawyers
Certified audit
Certificates from Secretary of State
Copies of all corporate action taken by the company to authorize its execution of these documents
Copy of letter from senior lender consenting to this transaction
There will also be a final page for your signature, the entrepreneur’s signature, and the signatures of any guarantors.
This is a general overview of the loan agreement. You should find that the loan agreement follows closely the terms and conditions set forth in the commitment letter. If it does not, something is wrong.
Usually, the note will be written on one to five pages. The note will be an in-depth, detailed statement of the terms of the loan. It will specify the following:
How much money is being loaned
When it is to be repaid
The interest rate
What day of the month payments are to be paid
Guarantors
Conditions of prepayment of the loan
Collateral for the loan
Subordination of the loan to other loans
References to covenants in the loan agreement
A complete list of defaults
Waivers and amendments
The note will be signed by the president and, usually, the secretary of the corporation, as well as any guarantors of the note. The corporate seal will usually be affixed to the last page.
Finally, you can expect a four- to ten-page document describing the stock options to purchase stock in the company. It will provide details such as the following:
Duration of the stock option
Any covenants of the company during ownership of the stock option
The mechanism for surrendering the option in exchange for stock
The exact price that must be paid when the option is exercised
Adjustments to the exercise price (that is, the formula that will be used in case shares are sold at a low price or additional shares are issued by the company)
The availability of shares owned by the company to be issued if the option is exercised
Any written notices that must be given
A definition of common stock
Expiration date of the stock option
Transferability of the option
Normally, this option will be signed by the president and the secretary of the company on the final page of the stock purchase option.
Anywhere from five to ten exhibits will be attached to every financial agreement. Most of these were listed in our discussion of the sections of the loan agreement. Be sure you understand what each exhibit states because you will be agreeing that it is true and correct. Some typical exhibits listed for a closing are the following:
Security agreement describing the collateral security for the loan (be sure the collateral agreed upon has been given)
Financing statement that includes UCC-I forms that will be filed in the records of the courthouse (this statement will let all creditors know who has a claim on assets of the company)
Opinion of the company’s counsel on the validity of the transaction
Copy of all corporate actions taken by stockholders to effect the transaction
Copy of certificate of incorporation
Copy of the bylaws of the company
Certificate from the Secretary of State evidencing good standing
Copy of a certified audit from the accounting firm for the company
Any forms necessary for government-related financing
The description above is a simple overview of the documents and exhibits. Appendix B contains a set of documents from an investment made by a venture capital company. When you receive the real documents, you should read each one in detail to make sure you understand what you are signing. Not all investors read the legal documents. Some investors ask their lawyers whether everything is all right, and if the lawyers nod yes, the investors sign the legal documents without reading them. A lawyer’s nod means only that the legal documents are fine. It does not mean that the business deal is correctly presented in the documents. Only you can determine that. Some entrepreneurs do not read the legal documents. That is also a mistake. Be smart; read legal documents. Ask questions if you do not understand the legal descriptions.
The complexity of legal documentation has baffled American investors and business owners for decades. The simpler the legal documents are, the better they are for all parties. If there is a simple way to state something in a legal document so that everyone will understand it, that should definitely be the order of the day. Some lawyers are carried away with a great deal of verbage that many people call “legalese.” You should ask lawyers to refrain from following this practice. In legal documents, simple is good.
The best legal documents are those that you never refer to after the closing. If during your relationship with the entrepreneur you never have to look at the legal documents, the deal has worked well. If you or the entrepreneur are constantly referring to the legal documents and questioning the meaning of every word, something is wrong. This is a signal that you and the entrepreneur have a problem.
You would think that the purchase of stock would be a simple transaction—that an investor could write a check and the company would issue the investor some stock certificates. As it turns out, that is far from the truth. There will not be a stock option (unless options are an additional part of the stock purchase), but there will be a fairly lengthy stock purchase agreement. An example of a stock purchase agreement is given in Appendix B. The stock purchase agreement will be similar to the loan agreement described above, but let us discuss the points again from the perspective of a stock purchase.
The stock purchase agreement has 10–12 sections. Many of the sections will be similar to the ones covered below.
In this initial section, the lawyer will describe the sale of stock and the price being paid, as in the corresponding section of the loan agreement above.
Many of the affirmative covenants that were covered above in the loan agreement will be set forward in this section.
Again, many of the same negative covenants will appear in this section for the sale of stock.
In this section, the lawyer will carve out the liquidation rights of the stock:
Are the shares being sold to the investor on the same basis or do the shares get preference in liquidation?
What dividends do they receive?
What rights do they have to elect directors?
It is typical for the VC to have the right to elect one to three directors, as long as he or she does not elect a majority. Although the VC may have the right to elect as many as three directors, he or she often elects only one. This single director will follow the company, attend the board meetings, and if things become critical, will ask the company to elect two additional directors who will then have more to say about the operation of the business. Often, however, VCs retain a majority ownership through the equity of the business from the outset.
Covered in this section are the many equity rights of the VC, including the right to register his or her shares in any public offerings and the right to require registration of shares free of charge. These equity rights are the primary exit for the VC. Be reluctant to change any of these equity rights.
A full set of representations and warranties similar to the ones in the loan agreement will appear here.
Again, this section explains who will pay all the legal fees; usually, it is the seller of the stock.
Some restrictions may be placed on the entrepreneur’s operation of the company. The entrepreneur may have to operate under certain guidelines as long as the VC owns shares. This section will describe any operating restrictions.
A voting trust may be involved in a sale of stock. If so, this section will discuss the voting trust in detail. Here is how a voting trust works. Usually, a trust is set up at a bank trust department with a bank trust officer as trustee. Shares of the entrepreneur and the shares of others are put in the trust. The venture capital firm controls the voting trust, but only under certain conditions can the venture capital firm vote the shares in the trust. This section will give the precise details on the voting trust.
Many times, the venture capital firm will want to ensure that key employees continue to work for the company—at least for a specific period of time. The VC may therefore ask key employees to sign one-way employment contracts ensuring that they will be with the company as long as the VC is an investor. As part of the agreement, key employees may be asked not to reveal confidential company information if they are permitted to leave the company.
The employment agreement can be turned around, of course, to the advantage of the entrepreneur. It can ensure that the entrepreneur’s job is secure during a period in which the venture capitalist firm may have an opportunity to take over the company. Usually, this security is overshadowed by the one-sided nature of the contract.
A VC told us of three young MBAs who signed employment contracts. The contracts provided that these gentle souls be paid a reasonable sum despite their brief experience in the business world. However, the contracts were for five years. As fate would have it, the business failed. Among the “assets” of the business were the three employment contracts. The institutional investor who had invested the funds foreclosed on all the assets of the business and picked up the employment contracts of the three MBAs. For the remaining four years of their contract, these men were virtually the slaves of this corporate giant.
Many venture capital firms play an active role in the management the company in which they invest. They may help the company establish marketing or financial controls or address any number of problems that may arise in a new or small, growing company. They want compensation for the time and attention their consultants take to help the new business get off the ground. Compensation is usually arranged through a contract with the venture capital firm for management consulting services. This agreement will describe the services to be rendered and the terms and amount of payment that will be made to the venture capital firm for these services.
Many lawyers will take it upon themselves to tell a client not to enter into a business arrangement because it is a bad business deal.
All clients want to know whether something is wrong from a legal perspective, but most businesspeople become upset by lawyers who jump into the business fray in order to “save” their clients from signing a bad business deal. Some good lawyers are certainly good businesspeople. However, very few practicing lawyers are good entrepreneurs or VCs. It’s difficult for anyone to carry on two professions successfully. Every VC can tell you about a lawyer who killed a business deal because the lawyer felt that his or her client was not getting a good deal.
You should encourage your lawyer to refrain from trying to renegotiate the deal for you. If your lawyer tries to renegotiate the deal, the entrepreneur will assume that you have directed your lawyer to do so. The entrepreneur will believe you are trying to change the deal or find a way to get out of it. Needless to say, this will take the entrepreneur’s attention away from closing the deal and may start the relationship off on a sour note. Be very careful before you instruct your lawyer to negotiate openly with the entrepreneur. If there is something you do not like about the legal documents, go to the entrepreneur and negotiate yourself. Do not use a surrogate who is not familiar with the business deal.
A lawyer experienced in drawing up legal documents for venture capital investments is worth a ton of gold. A lawyer trying to bluff through this type of investment agreement will destroy your chances of a quick and successful closing.
Be economical in your use of lawyers; they are expensive. Usually, you will be better off having your lawyer complete the first draft of the proposed legal documents and then letting the entrepreneur’s lawyer review it. If you start with your lawyer, the document will have all the things you need in it, and you will not have to argue with the entrepreneur’s counsel to put language in the agreement. This method can save significant time and expense.
One of the main factors that slows down the legal process is the lack of time that lawyers have to work on legal closings. Legal documents sent by a VC’s attorney to the entrepreneur’s attorney can sit on the desk of the entrepreneur’s lawyer for weeks before the lawyer gets around to reviewing them. Tell the entrepreneur to remind his or her lawyer daily, if necessary, that there can be no closing until the lawyer reviews the documents. Do not let the entrepreneur put you in charge of riding herd over the entrepreneur’s lawyer.
You may not realize it, but your lawyer may incur liability by not performing quickly and reasonably. Any lawyer who does not close a deal that should have closed could be held liable for whatever damages are caused. Certainly, a lawyer who does not act on legal documents sent to the lawyer for review within five days is courting disaster.
When you get the first draft of the legal documents, be sure to read it very thoroughly. Too many people do not read the legal documents. Read the legal agreement for the basics of the deal, not for the meaning of every word. Compare your commitment letter with the legal documents. Make sure each point in the letter is covered in the legal document. Lawyers sometimes make mistakes.
Legal fees are rarely low. In fact, of all the fees that businesspeople complain about, legal fees probably top the list. The question is not whether legal fees are too high but whether a specific legal fee is fair in view of the work that has been performed by the lawyer. Some attorneys are unethical in their billing practices. They think nothing of padding a legal bill with 10 or 20 hours of work, and then mailing the bill to the client without a great deal of explanation. Most legal bills consist of a single line—“for services rendered”—followed by a dollar amount.
Because legal bills have become such a large part of business life, most businesspeople are attempting to manage the fees. The most common method of managing legal fees was introduced by large corporations: They all now require a detailed legal bill. The bill must include hours worked, the specific project on which the time was carried out, the billing rate of the individual working on it, and the name of the individual authorizing work on the project. In addition to these detailed bills, many smaller businesses are requiring law firms to give them advance estimates of the time it will take to complete a project. They ask the lawyer to call them once he or she reaches a certain amount of time expended. By doing this, the small business keeps track of the law firm’s hours and does not let it run up a big bill.
If the small business has agreed to pay the legal fees for both your lawyer and its lawyer, it is incumbent upon you to help the small business manage the legal fees. This means contacting your lawyer and discussing fees. You must discuss the procedure for working on your deal and how the bill will be rendered. Do not let yourself be surprised when you arrive at the closing table and see the legal bill. If you are surprised by the amount of the legal bill, you have not been managing your lawyers very well. All too often, entrepreneurs receive a shock at the closing table. As an investor, you may be in a poor position to help the small business negotiate fees. If your lawyer is a close friend, you will have a hard time questioning him or her about legal fees, even if they seem too high. Although an investor cannot be expected to manage the small business legal fees, it is important that you manage all your own legal fees so you are satisfied with the amount that is being charged at the closing table.
Besides the unethical padding mentioned above, watch for the many methods employed either intentionally or unintentionally to run up your legal fee. Listed below are five of them.
Your lawyer or perhaps even the small business lawyer will often disagree on many points. This means that the lawyers will have to spend innumerable hours discussing these points and working each one out to their satisfaction. Remember that when these two lawyers disagree, you are paying the bill on both sides of the table, even as they argue about minuscule points. There is a fairly simple way to cure this problem. When your lawyer has reviewed the papers drafted by the small business lawyer, tell him or her to mark each item in the documents seen as a problem. Before discussing these points with the small business’s lawyer, ask your attorney to discuss each one of them with you. Many of them may have no material business significance; therefore, you will be willing to let the small business lawyer put them into the agreement. Each time you knock out one of these small points for discussion, you save legal fees.
Some lawyers increase their fees by rewriting sections of the documents over and over again. Suppose the small business’s lawyer presents a written version of the document. Your lawyer may rewrite the documents completely, running up secretarial and drafting time in order to redo entire sections. You should instruct your attorney from the beginning that there is to be one writer of the documents and one commentator on the documents. Your lawyer should be the writer and the small business lawyer should be the commentator. This arrangement will reduce legal fees.
Often, lawyers will disagree vehemently over points of law. The disagreement will send them scurrying to the library or to other research sources to clarify various points of law. This research can burn up many hours of time. Each lawyer is trying to show which one is the best legal scholar. You should instruct both lawyers that you do not wish them to research various points of the law without your permission and that you will not pay for such research.
Lawyers will correct each other on usage, style, grammar, and even spelling. They will use up your time for the purpose of “clarifying the language.” Tell the lawyers that you are not interested in matters of style. Stress that you want a clear document and that is all.
Most lawyers are by nature argumentative. They spend three years in law school arguing points back and forth. Once they enter the real world, they continue to argue with one another. You should remember that you are paying for all of these arguments. If you have two lawyers arguing with each other and they are each billing you at the rate of $350 an hour, you are paying $11.66 per minute to hear them eloquently debate the merits of a legal point. Act as a moderator and get to the heart of the argument. Ask your lawyer what the consequences will be if you agree to the words being proposed. If these consequences are quite modest or if the consequences are extremely unlikely, you may wish merely to sign the document rather than fight to remove the words. On the other hand, if the consequences appear to be drastic, you must adjourn the legal meeting and call a business meeting with the entrepreneur partner to iron out the problem.
When you are dealing with a syndication of investors, each investor’s lawyer may want an opportunity to review legal documents. There should be only one fee—for the lead investor’s lawyer, not for each participant’s lawyer who wants to look at the documents. If the small business agrees to pay for all the lawyers and if four or five investors’ lawyers look at the documents, the small business is opening up the cash register. When you let the lawyers take out what they need to cover their time in reviewing the documents, the “review” may go on indefinitely.
Some lawyers tell a story about the young lawyer who began working in his father’s law firm right out of law school. His father took a much-needed vacation to Europe and left his son behind to continue the legal practice. The first case the young lawyer worked on was a railway right-of-way case. The young lawyer noted that his father had been working on the case for almost 20 years. In several days, the young lawyer assembled the parties in a room and negotiated a settlement. The case was closed. When the father returned from his vacation, the young lawyer explained with glee that he had settled that long-outstanding railway right-of-way case. Needless to say, the father was extremely upset as he explained to his son that the railway case sent all of the young lawyer’s brothers and sisters to college and the annual fees from the case had even sent the young lawyer himself to law school.
Remember, lawyers receive fees while cases are open. They do not receive fees from cases that are closed. Another factor to watch for in syndications is the tardiness with which other investors’ lawyers may review the documents. Invariably, one of the lawyers will be slow and not get around to the documents for days. You must obtain the names of all the lawyers and constantly put pressure on each lawyer to submit his or her comments so that closing can take place. You can help manage this process. The lead investor needs to lead the lawyers to a closing.
Once the lawyers have drawn up and examined the documents and once the businesspeople have ironed out the business problems, a big pile of legal documents will be ready for signing. Normally, three to ten copies of each document will have to be signed. The closing usually takes place in a conference room. Every closing seems to have its crisis. Usually, the entrepreneur’s lawyer will bring some documents, such as incorporation papers or life insurance, that are not in the proper form. If all of the required documents are not present at closing, your lawyer will not be able to close the investment. In large deals, the lawyers will get together the day before the closing date to see whether all the papers are in order and whether it is possible to close the investment; this is called a “dry closing.” An inexperienced lawyer for the entrepreneur or VC may try to have a closing without reviewing all the documents beforehand. To simply pick a date and show up unprepared for a closing is almost a sure way to abort the closing.
A closing is an extremely exciting moment because it is the moment when the VC parts with money and the entrepreneur’s business gets an infusion of capital. However, the physical process can take hours and be extremely boring. Documents are signed, shuffled around the table, and looked at and verified by lawyers. It is, to say it most simply, the lawyers’ environment.
You can always expect last-minute changes. Generally, these are minor items, but occasionally, they are material. Our recommendation to you as an investor is not to waive any major items. This is the only time the entrepreneur will be fully motivated to get everything done. Once the deal is closed and you have invested your money, the items you needed at the closing are less urgent. The entrepreneur will then have more pressing things to do. Don’t waive the life insurance requirement at a closing. The entrepreneur may seem to be in no rush to get the policy. What if four weeks after you invest, he or she has a heart attack, but there is no insurance policy? Be tough at a closing. Do not waive material items.
Lawyers can spend considerable time on the actual closing itself. Many hold a preclosing the day before the actual closing. This dress rehearsal, as well as the actual event, can be costly. Envision the lead VC’s lawyer, the lawyer of the bank giving a loan, as well as the lawyer for the small business. These three lawyers may charge $750 per hour each. On top of these fees are those of the junior attorneys, paralegals, and secretaries, which can run from $80 to $150 per hour. All in all, the deal is probably being billed at the rate of $3,000–$6,000 per hour.
If the deal is extremely large and complicated and involves additional people, that figure can be multiplied by two or three. But for the moment, assume that the minimum is $2,000 per hour. If the lawyers spend five hours in preclosing and seven hours in the actual closing, this is a total of 12 hours. Twelve times $2,000 is $24,000, just for the preclosing, and is quite apart from what you will pay for the drafting, research time, and other document gathering.
There is only one way around the expense of closing, and that is to be absolutely ready when a closing date is set. Your lawyer should have reviewed all the documents in detail with the small business lawyer to ensure that when closing occurs and everyone is sitting around the table, everything that is needed to close will be at the table. There will be no last-minute scurrying for any documents and there will be no last-minute changes. If you can impress upon your lawyer that you do not want the closing set until everyone is absolutely ready, you will be doing yourself a big favor. Do not go to the closing table prematurely. It will cost a lot of money if you do. What is worse, you will have to do it over again if the investment does not close.
You should remember that lawyers are merely specialists in a specific area and have knowledge of an area in which you do not—namely, the laws that govern business activities. Remember, too, that they are providing a service and that you hire them just as you hire any other employees or advisors. Tell them what you want them to do and you will have a satisfactory relationship with your attorneys.
Also remember that lawyers make money by charging for time and that they are disposed to spend a great deal of time working on something. Most of the problems lawyers work on are not legal problems. They are simply problems that businesspeople have left to them to solve. Many business problems turned over to lawyers can easily be solved by two business-people in a head-to-head discussion.
Before you try to solve a problem from a legal standpoint, be sure you have exhausted all other remedies. Legal solutions are expensive. In one case in New York City, a VC lost $150,000 when the lawyer, who was a member of one of the large prestigious law firms in New York, had been negligent in his closing of the loan and clearly was open to suit. When the venture capital firm looked into suing this lawyer, it found that it would probably have to pay at least $150,000 to do so. The VC was told that he would be lucky if he recouped any of his legal fees, much less the $150,000 that the lawyer had lost for the venture capital firm.
Also remember that the number of lawyers in the United States is higher than ever before. By many counts, there is a surplus of lawyers. If you do not like the lawyer you are working with, find a new one. There are hundreds of good lawyers seeking work with good investors.
Your lawyer should supply you with a complete original of all the documents collected at the closing. The documents should be packaged by the lawyer into an indexed file that will become the basis of your legal relationship with the company. Make sure your lawyer delivers this file as soon as possible after closing.