In the volatile world of venture capital, it isn’t just the financiers who take on risk. Lawyers also make a calculated gamble, given that about 75 percent of venture capital-backed companies fail.
“A lot of times [law firms] see start-ups before venture investors do, so we have to make the decision: Is this worth our time? Is it worth deploying resources, associate hours and incurring costs?” said Nathaniel Gallon, a partner in Wilson Sonsini’s office in Palo Alto, Calif. “In some sense, we are making the same kinds of bets that venture capitalists are, but in smaller dollar amounts, namely legal fees.”
Gallon was part of a panel discussion on “California Venture Capital,” hosted last month by the USC Business Law Society. He was joined by three other speakers representing different parties that might be involved in a venture capital deal: Bill Elkus, founder and managing director of Clearstone Venture Partners, with offices in Santa Monica and Palo Alto; Chris Shoff, a founding partner of Cooley LLP’s Los Angeles office; and Andy Wilson, founder and CEO of Graphight and three other companies that have gone public. The event was moderated by USC Gould School of Law Professor Donald Scotten.
Venture capital firms are financial intermediaries, gathering funds from one group of people, investing them in another group and trying to help grow the companies they invest in, Elkus said.
“Typically, the investors in venture capital funds are institutional investors that can afford to take a great deal of risk,” he said, pointing to university endowments, state pension plans, sovereign wealth funds and some wealthy families. “They usually invest less than 5 percent of their total assets in venture as an asset class.”
Venture capital firms make their money by charging a management fee and securing a share of the profits, usually about 20 percent.
Companies pursuing venture capital generally do so after they’ve gotten “seed stage” funds from family, friends and possibly “angel investors.”
“There are fairly well-known rules of thumb” for what Elkus’ firm looks for when deciding whether to invest in a company, he said.
“We certainly look for a product or service that’s transformational or groundbreaking. You look for a market that’s growing; you look for entrepreneurs who have prior success or at least prior experience; you do diligence on the individuals.”
This round of funding is known as “Series A,” when a professional investor gets behind the fledgling company — which typically has zero sales at that point. Series B and other rounds follow, in which the price increases, but risk and stake in the company decrease.
“The end of the game is that the company has an exit,” Elkus said. “Exit” can be an IPO (to monetize the value of the stock), purchase by another company or a merger and acquisition.
Lawyers work with entrepreneurs from the beginning of the process, Shoff said.
“We help get the company formed, working out the details of who’s going to own what percentage of the company, and get their IP protected,” Shoff said. “The goal is to make sure that the documents and the company [are] formed in a way that will make it easy to find investment, whether it’s angel investment or friends and family investment.”
When launching a business and securing financing, entrepreneurs must carefully discern who will provide their legal representation, Wilson said.
“There’s one thing that’s always true about entrepreneurs: You never have as many resources as you’d like. The last place you want to spend money is on lawyers,” Wilson said. “Good lawyers will understand this and determine the “necessary amount of lawyering you want to do to make sure not that it’s perfect, but that it’s not wrong.”
A lawyer’s experience can also make a huge difference for an entrepreneur when it comes time to negotiate.
“If … you have someone who hasn’t done venture representing on the other side, the negotiation process can be very protracted because not only [is the lawyer] educating the entrepreneur, but [the lawyer is] educating the other side,” Wilson said. “The effectiveness of lawyers, and part of the value … in having good counsel is them having experience and good relationships with other lawyers who can kind of work things quickly — because remember, as the entrepreneur, you’re paying for this stuff. So getting to the right answer quickly is usually valued.”
Wilson’s advice dovetailed with that from Dean Robert K. Rasmussen, who opened the event.
“The thing you have to learn first as a lawyer is, we work for other people,” Rasmussen said. “We have to provide value. We have to get in their heads. We have to know, first of all, the process they’re involved in, the structure of their industry and what counts as success.”
“And you’re actually paying for both sides,” Shoff added, noting that the company will pay for its own lawyer and for the investors’ lawyers.