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Perspectives on entrepreneurship, startups and venture capital from K9 Ventures.

Investors should pay their own legal expenses

By Manu Kumar | September 20, 2018

Legal
Legal by Nick Youngson CC BY-SA 3.0 Alpha Stock Images

There, I said it; right there in the title of the blog post. And I’ll repeat it again: Investors should pay their own legal expenses.

I’ve never understood why the norm for someone putting money into a company comes with the company bearing the cost of the legal diligence and the transaction. The work performed by investor counsel protects the interests of the investor, not the company. But, investors routinely put a clause in the term sheet for the financing that says “Company will pay, at the Closing, reasonable legal and due diligence expenses of Investors in an amount not to exceed $30,000,” or, “Company to pay investor counsel fees, not to exceed $30,000,”, or even in the form Series Seed documents: “Company to reimburse counsel to Purchasers for a flat fee of $10,000.”

This practice feels like a vestige of the days when the balance of power was in the favor of investors and not founders. VC funds have the ability to pay for their own expenses. They already do so for things like backoffice, operations, accounting, and audit. There is no reason why these funds can’t pay for their own legal expenses.

As noted above, investor counsel represents investors interests, not the company’s interests, but they are being compensated by the company. So the company is paying for someone who isn’t looking out for the company’s best interest? How does that make any sense?

Most founders acquiesce to this clause because it is a small amount in the grand scheme of things on a percentage basis. If you’re raising several million dollars from someone are you really going to go argue with them over the amount of the legal fees? Probably not. But, I do. Everytime. Because it just rubs me the wrong way.

For most VCs once a term sheet is signed, getting through diligence and legal is a chore, and not the most fun part of the job. So they’re easily convinced to hand things off to their law firms to take care of it. However, their lawyers have absolutely no incentive to keep costs in check. I have yet to ever see a deal where the investor counsel expenses came in significantly lower than the agreed to cap in the term sheet. Somehow, magically, the cost for investor counsel always seems to come in just a few dollars below the cap, or sometimes even exceeds the cap and is then “discounted’ back down to the cap amount. And this happens even for the simplest transaction.

Company counsel is usually doing more work than investor counsel in early stage deals: preparing the deal documents, disclosure schedules, diligence folders, pro-formas, filing the charter, issuing the stock (hopefully now on Carta!), and more. And of course company counsel is going to see the amount agreed to in the term sheet for investor counsel and feel like, “Hey, I’m doing most of the work here so shouldn’t I be getting paid more than the investor counsel?” And right there, the legal cost of a simple financing transaction balloons out of control.

It is not unusual for company counsel to say that their cost will be 1.5x-2x of the investor counsel. After all they need to be responsive to all the investor counsel requests that help them reach their cap, and that creates even more work for company counsel. So if the investor counsel cap is at $30K, you can easily see the legal cost for the transaction coming in at around $75-$90K, even when there is no reason for it to be this high.

VCs are doing their companies and the entire ecosystem a disservice by creating an incentive structure that hurts their own portfolio companies with excessive legal bills. If a VC firm was paying for its own legal diligence and transaction costs, they would be more inclined to ensure that costs don’t balloon out of control for silly reasons, and that the transactions get completed in a efficient and timely manner.

The invoice a company receives from investor counsel is usually not itemized. That’s logical since itemizing the invoice would potentially leak privileged information between the attorneys and their client — the investor. But this means that companies have absolutely no idea what they’re paying for. There is a complete breakdown of checks and balances.

K9 Ventures has invested in 36 companies since 2009. I’m pleased to say that K9 has *never* charged a company for legal expenses. K9 uses the Series Seed document set for all investments that we lead and it’s easy enough to look at the redline changes proposed by company counsel to the form Series Seed documents. This situation is a little unique to K9 though since we’re investing so early in the life-cycle of the company that there is very little history, and therefore not a lot of legal diligence work. Our standard term sheet, so far, has been a variation of the Series Seed term sheet, where I’ve changed the language to say: “Company to reimburse counsel for K9 Ventures for a flat fee of $2,000, only if counsel is retained by K9 Ventures in connection with the transaction.” The latter half of that sentence has never been triggered. Going forward, the entire expenses section of K9’s term sheet will simply be eliminated, or be replaced with “Each party shall bear its own legal costs.”

Massive props to Satya Patel and Hunter Walk at Homebrew, where they have always paid their own fees and believe that charging back legal expenses to companies is crazy. I agree 100% with them.

Founders *should* question their investors on what their policy is with regards to investor legal expenses, and should pushback on any VC firms that charge companies for their legal costs. This is a ridiculous practice and it’s time to change it.

Update: There was a suggestion to include a list of firms that either have not or will not charge companies for the investor counsel legal expenses. If your firm should be listed below, please let me know on Twitter at @ManuKumar and I can add you to this list (listed in alphabetical order):

* Update 09/30/2019: A reader pointed out that in a recent transaction Spark Capital paid the first $25K of the investor counsel legal fees, and the company paid the amount over $25K.