I’ve started three companies in my career (Soleil Network Technologies, KiraCom and Commuter Products) and like all founders, I’ve stumbled through plenty of challenges at each one. One of the critical lessons I’ve learned over time is to pick key advisors who are independent of my investors.
Having a great attorney or banker who specializes in start-ups is just as critical to your success as having great board members. But most entrepreneurs lack the contacts we need to find appropriate advisors in the banking or legal industries. We might turn to our friends or to people we know who practice general law for recommendations. Most often, we turn to our investors for such referrals.
But there is a potential problem built into the last scenario.
Chances are, most of the service providers your investors recommend to you will be on their short list because the law firm or bank in question already has your investor as a client, at one (or many) of their other portfolio companies. It works the other way, too: lawyers will take you on as a client, help you get your business plan together, and then begin introducing you to VCs or Angels whom they think can fund your company.
On its face this would seem common, and harmless, enough. After all the start-up business is “references” trade and we’re all greatly aided by whom we know. Plus, conventional wisdom has it that if a reputable VC connects you to a lawyer already retained by his firm, the guy must be good, right?
The truth is that there is an inherent “conflict of interest” in this scenario.
If your lawyer has or currently “works with” your investor, this really means your lawyer has or does work for your investor. Now, a pre-existing relationship between your lawyer and your investor may be fine. But in the unfortunate event that the founders’ interests diverge from the investors’ interests, it can spell major problems.
I learned this the hard way.
In one of my companies, one of our attorneys restructured our company after we had incorporated. He changed some of our ownership conditions and told us that we needed to do it because “the VCs will require it anyway”. (That should’ve been a red flag.) What our lawyer didn’t tell us was that we were also giving away an important point of leverage for our term sheet negotiation. To be fair, I’m not saying that our lawyer wasn’t doing his job—it’s just that he was looking out for the interests of his other client first. My co-founders and I were too inexperienced to challenge this. We found out later that the “restructuring” had needlessly weakened our negotiating position in favor of the very investors who happened also to be our lawyer’s clients. We blindly trusted our lawyer, who gave us a four-year vesting schedule for our post-valuation equity, a full year longer than it needed to be. (Translation: a longer window of opportunity for the VCs to oust us!)
Again, I’m no Pollyanna. It makes sense that the lawyer-investor relationship often takes priority: law firms funnel prospective portfolio companies to investors; and a VC firm or angel represents many potential clients to a lawyer. This means, lawyers stand to make more money off serving one investor well, than from serving any individual company – no matter how much they like yours. But this doesn’t mean we founders can’t protect ourselves.
The Lesson: founders must take care to ensure that our advisors or service providers do not have competing interests with our own.
How do we do this? The best way that I’ve found is to keep one, and if possible, two degrees of separation between your advisors and your investors.
Make sure any attorney you hire does not also represent your funders. The next time an investor refers you to a “great lawyer’ ask yourself, and the lawyer, if there is a pre-existing business relationship between the lawyer and the VC or angel. If there is, cite this with the lawyer (your due diligence will impress!) and ask him or her for a referral to a third party—ideally an attorney (s)he respects at a separate firm. Then do your due diligence again.
So the Valley is clubby, which means you may need to go to smaller firms to find a truly independent person. But this is OK. Remember that your priority is to find an advisor who will put your interests first. Maintaining a degree or two of separation between your investors and your other advisors is the only way I know of to guarantee that your interests will be protected at critical moments in the life of your company.
One last word of advice: If you find a pre-existing relationship between your investor and a lawyer but you decide to move ahead anyway, the law firm may ask you to sign a “Conflict of Interest” waiver showing that you’re aware of their working relationship with the VC or Angel. Consider yourself warned.