Legal Debt is an Analogue of Technical Debt
Shortcuts in coding – not using DRY, not refactoring, not testing – are common sources of technical debt, which require additional effort, in the form of attention, thus time and money, to address. Shortcuts in the formation and operation of your startup create legal debt, which is analogous. Common sources of legal debt are not getting IP assignment agreements from everyone who works on your IP; not documenting equity issuances and splits with early founders; conducting an unsophisticated negotiation of fundraising documents with placement agents; making poorly understood tax elections; or failing to sign and maintain important documents.
When does the company repay this debt? There are two choices, one of which is mediocre and the other of which is positively bad.
If things go well, you will engage in corporate clean-up before pursuing a strategic financial transaction. You collect the due diligence materials you expect an investor or buyer to ask for; you provide them to your lawyers and any bankers; you pay to have everything reviewed to identify where those trouble spots are; and you pay to have them fixed in all the various ways we do that. (As an aside, the fix depends on the problem. Some problems can be whitewashed with a unanimous board and shareholder consent; others require complicated corporate transactions and valuation exercises to achieve the equivalent of unwinding a poor tax election decision; finally, some problems require the legal equivalent of a scorched-earth approach, where we take your old business and put it in its own little box and start a new clean company (the old problems are there, but now you’re not trying to ask investors to buy those problems).
If things don’t go well for you and you don’t or can’t take that path, you will solve these problems in the middle of a transaction, an investment or an M&A deal where you’re trying to sell the company. Why is this worse? Because you have lost the initiative, because the side with the money has all the leverage, and because you have often become emotionally invested in the deal and lost your BATNA. When an investor or buyer undertakes due diligence, they are using that information to confirm or test their assumptions about the deal. Ultimately, they do three things with any piece of troubling information: change the price, change the terms, or kill the deal. Venture capital funds will reprice deals when projections aren’t supported by well-founded assumptions; acquirers impose personal indemnity obligations on founders with capitalization table problems; and deals get killed when trust is lost, such as when one company turned over a new placement agent agreement every week for four weeks to prospective investors, or when the rationale for the deal doesn’t support the price, such as when one target had to reveal that it had no long-term contracts on which the buyer could rely to justify the investment.
One side note about how legal debt is paid for is described in this article on legal opinions in venture financings. Figuring out what’s been missed is expensive; clients new to a firm sometimes don’t even realize that they made this tradeoff years or months ago. The other important point on legal opinions, which are almost non-existent in early stage financings these days, is that perhaps the biggest benefit to the party seeking the opinion is that it all but guarantees that the company doing the deal will have a candid privileged conversation with their lawyer about risks that might not have been disclosed (for whatever reason). The lawyer then has an opportunity to address the matter in a way that protects both parties by allocating risk efficiently and can create a way to move forward instead of killing the deal or hiding the risk and simply hoping for the best.