Today – surprise! – a hardcore legal topic: legal opinions in venture capital investment rounds. We will discuss what they are (and aren't); why they matter (sort of); and why you, as an entrepreneur, should care (but usually don’t).
The legal opinion in the spotlight is given to investors by the company’s law firm at the closing of an investment. Most of the specific issues opined on are among the company’s own representations and warranties to the investors in various other closing documents. By offering their own opinions on those matters, the firm issuing the opinion not only verifies the diligence of the company, but it also becomes another guarantor of sorts for any damages suffered by the investors if the opinions are faulty.
A critical preliminary point. These legal opinions say nothing about the underlying business merits of the company or of an investment in the company. They speak only to various legal matters related to the company, and the transaction that can be impact the company’s ability to conduct its business as presented to the investors.
So, what are those legal matters?
Opinions usually cover a broad range of very and not-so-very significant, mostly housekeeping, matters. The laundry list typically includes, for example, the due incorporation and qualification to do business of the company; the due authorization, execution, and binding nature of the various financing documents as to the company; whether the company is involved in any litigation, or is in violation of any of its material agreements (or would be if the transaction closes); and, the capital structure of the company.
Several of the specific matters covered in an opinion may contain exceptions/exclusions, just as the “Schedule of Exceptions” to the company’s own representation and warranties found in most investment Purchase Agreements highlights exceptions/exclusions to the company’s own assertions regarding various matters. The opinion is what lawyers call a “disclosure document,” which is to say (in law school-speak) an “issue spotter,” designed as much to highlight problematic matters as fix them. Further, while friends, family, and other seed and pre-seed rounds seldom involve legal opinions (or sometimes even lawyers – which is a topic for another day), when institutional venture investors arrive on the scene, opinions are usually de rigueur.
If this all sounds like something entrepreneurs can leave to their lawyers to figure out, they (too) often do. But they probably should at least know what is going on, for several reasons.
First, legal opinions force startups to step back, if only for a moment, and make sure that in the rush and confusion of building their startup they have taken care of the little things that can, when neglected, cause big problems. Being “duly incorporated and validly existing” may seem like legal trivia, but it is a “t” that, if left uncrossed, can have serious, costly, and even potentially fatal consequences. And as it turns out, the “backup” for the opinion – the routine the law firm goes through to make sure that its opinions are correct – often uncovers an uncrossed “t” or undotted “i” or two. Think of the process as insurance against future legal “gotchas.”
Second, legal opinions can be expensive. It’s not uncommon for the added cost of the legal opinion to reach $5,000, and now and again $10,000 or more. While it rarely goes much beyond that in a routine venture capital round, I was once involved in a complex venture capital recapitalization round (two simultaneous rounds, actually) where the legal opinion accounted for close to $50,000 in fees, as investor and company counsel argued about what was/was not something that should be in the opinion, or even was of a nature that could be opined on. And, the company pays for the cost of the opinion, even if in effect out of the proceeds of the financing. Although, like most other transaction fees the costs of legal opinions have come down over time, they can sometimes become material.
A key insider trick about legal opinions is that there are some lawyers who are downright fascinated by them. Probably because opinions are among the purest distillations of the legal art – being as they are documents that mostly involve crisp, knowable legal niceties, and what can be said about them. (Arguing about what is knowable in a legal, rather than a practical, sense is now and again central to intra-lawyer negotiations of opinion form and substance.) Firms that issue opinions usually have “Opinion Committees” that lawyers, who sign an opinion on behalf of the firm, must clear the opinion with before signing.
Understanding the dynamics of legal opinions gives entrepreneurs at least some control over the likely expense of a legal opinion in any given transaction. How so? By encouraging the entrepreneur to support their counsel in the opinion negotiation. More particularly, while the actual negotiation of the legal opinion is between the respective counsel of the company and investor counsel, where that negotiation kicks off – which is to say which side offers the first draft of the opinion – can make a difference.
As the company counsel is giving the opinion, it makes sense for the company counsel to produce the working draft: even if investor counsel is drafting most or all of the other deal documents. That’s because any draft offered by company counsel will already be approved by the issuing firm’s Opinion Committee. Which means that, even if changes are made to that draft, those changes will be the only things the Opinion Committee will need to pass on in the final opinion. In contrast, when a draft is produced by investor counsel, you will end up with a final document that needs a de novo review by the Opinion Committee – at some added cost in time and money.
It should also be noted that, while lawyers sometimes get excited about the back and forth of opinion negotiations, in fact, in most transactions everyone pretty much knows where they will end up when all is said and done. And, more will have been said than done. In this respect, it never hurts for investors to encourage their counsel to stick to the nitty-gritty on opinion matters, and to not even ask for “non-standard” stuff unless there is a compelling reason peculiar to the deal. Ditto entrepreneurs should instruct counsel not to be stingy about the opinion except to the extent that there is good reason. Opinions are one of those cases where “good enough” should be good enough for everyone, even if everyone goes away thinking they left something on the table.
Fortunately, legal opinions for venture financings have become more standardized in recent years thanks to the inclusion of a form of legal opinion being included as part of the NVCA model legal documents. While there is inevitably negotiations on the required assumptions and qualifications required to provide the substantive legal opinions, the appropriate scope of the legal opinions are less negotiated than they have historically been.
Finally, lest all of this talk suggests opinions are something less than mission critical, here’s a real world example where a botched opinion resulted in a very expensive – time, distraction, and money – legal disaster for a young company with much better uses for its time, attention, and money.
One year, the company in question went public. About a year later, they filed for a secondary offering. The stock price was down a bit but things were looking okay, and, well, they needed the money. In the run-up to closing the secondary, the firm’s new counsel (the company had changed counsel after the IPO) went about backing up its capitalization opinion and discovered that the shares issued in the IPO … had never been created. They had been appropriately authorized, and seemingly sold, but did not legally exist.
Suffice to say, this discovery led to a lot of trouble for a lot of people, as well as the aforesaid costs in time, distraction, and money for the company. Live and learn. Opinions may not be the entrepreneur’s friend, but they sure can cause entrepreneurs problems.