Tech startups: How law firms are getting their business

By Sandra Rubin – April 2014

Nick Catros was in talks with a startup for a position as its first in-house counsel when the company’s CFO made an unusual request.

He told Catros he had an existing relationship with George Takach, a senior partner at McCarthy Tétrault LLP in Toronto. He trusted Takach’s judgment and asked Catros to meet with him as part of the interview process. He didn’t come out and say it, but he wanted to give Takach a chance to kick the tires. Lexpert Cover

Even though Catros had been a deal partner at the former Goodman and Carr LLP for 15 years, then general counsel at CryptoLogic Inc., the two Toronto-based lawyers had never met. The conversation apparently went well enough and Catros got the job.

At CryptoLogic he’d had relationships with a few other firms. “McCarthys wasn’t one of them,” he says bluntly. Much as he liked Takach, once he got the job he had his own thoughts about which law firms his new company should – and shouldn’t – use.

“Going into this I expected to be moving away from McCarthys very soon. I understood that the CFO had a relationship, I understood McCarthys had helped them get through the period of time when there was no internal legal counsel, but my sense was that as a startup company our budget was limited. And McCarthys was a Cadillac firm.

“I felt we didn’t need that level of service and likely couldn’t afford it, so I suspected slowly but surely I’d move work away to other firms that better suited our needs and our economic circumstances.”

Guess what? Catros was so pleased with the quality of Takach’s advice and the financial accommodations a top-tier firm like McCarthys was willing to make for a cash-strapped startup that the legal work stayed put.

That was 2010, and the startup was Kobo Inc. Catros is its senior vice-president, business and legal affairs. Two major financings and a $315-million sale later, Kobo is not only paying full freight but has generated serious fees.

In the world of senior corporate lawyers and their most junior clients, this is as good as it gets.

The question is, who will be the next Kobo, and how far law firms are willing to go to get in on that business. The answer is anyone’s guess. There are thousands of wannabes. As for the law firms, are you kidding?

The new digital economy beckons.

Every Thursday afternoon, Robert Cowan, a corporate partner in the Halifax office of McInnes Cooper, spends two hours at a regional incubator and accelerator to meet with potential and existing startup clients. “They’re 10-, 15- or 20-minute meetings and I talk to them, answer questions, all without charging for it.”

Their questions range from HR issues to explaining how a stock-option plan works.

He’s not alone. Takach at McCarthys says he and a few other colleagues still pitch their services in the tech startup sector by hanging out at incubators and hubs that provide support to startups and tech companies. They stay close to venture capitalists, walk the halls of computer expos, reach out to engineering students — coaching and mentoring the most promising on the process of taking an idea to market.

Sounds like a business development strategy for an associate in the first few years at a firm. Takach says it’s anything but. “While many of them will fail at the early stages, many will succeed and when they do, they tend to do very well. Look at Shopify up in Ottawa, Desire2Learn in Waterloo, Hootsuite in Vancouver. These are all companies that started as startups but they’re meeting real needs in the market and they’re making real revenue.”

And there, in a nutshell, you have it.

From apps that measure our sleep cycles to 3D food printing, virtual shopping malls, video tweeting, using your phone to network or turn on your lights from the other side of the world, some days it seems like every element of our everyday life is being transformed by digitization.

The speed of change is eye-watering, fuelled by rapid changes to the building blocks of digital products and services.

Cloud computing means tech startups no longer have to buy a huge computer and incur steep hardware costs, sharply cutting the outlay on infrastructure. Document sharing and video conferencing mean they don’t really even need an office. Thanks to open-source coding, they can also acquire whole chunks of pre-written software code and just bolt it on to their idea instead of writing every last piece of programming themselves or paying someone else to write it.

“You’re still coding the real proprietary part – the secret sauce – but the print program, the basic payment module and a lot of the basic blocking and tackling you can now harvest from a whole field of offerings,” says Takach. “That keeps costs down and cuts time to market.

“It’s part of this ‘you can do it for not a whole lot of money’ thing. Instead of working in the salt mine secretly for two-and-a-half years on your prototype, you can bring it to market in three-and-a-half months.”

The result is that a whole new chapter of business legends is being written.

Fuelled by a new generation of digital success stories, from Zynga, Pinterest, Square and Spotify to Hailo, Snapchat, SmartThings and Ouya, a new generation of mostly young and entirely web-savvy entrepreneurs is racing to develop the next hot app or must-have cool thing.

The Internet has democratized their chances of succeeding. In the old days (the old days being a few years ago) a tech entrepreneur would have to raise between $500,000 and $1 million just to get a beta stereotype before potential investors. Nowadays it’s closer to $100,000 and they have access to a whole new model of bringing ideas to market.

“You can print a physical prototype of your product using your 3D printer, then go to a website where you can market it and people can make a future purchase for when it turns into a product, which gets you investors much earlier,” says Andre Garber, Director of the Startup Program at Dentons Canada LLP.

“There are so many different things facilitating the development of products and services that allow you to get to market faster than you traditionally could that it’s giving people this newfound energy to go out and start up their own business. It’s a completely different landscape. There is a real explosion of excitement around this new type of anyone-can-do-it type of technology company.”

Take Pebble, one of the earliest producers of a smartwatch. In 2012 after pitching and being turned down by traditional venture capital sources, Pebble, developed by a Canadian engineer who graduated from the University of Waterloo, launched a Kickstarter campaign to raise US$100,000.

Buyers who pre-bought a Pebble at US$115 would receive a US$150 smartwatch when they became available.

The company met its goal within two hours of going live.

Within six days, with 30 days left in the campaign, Pebble had raised more than US$4.7 million, becoming the most funded project in the history of Kickstarter. When the campaign did close, 68,928 people had pledged to buy a Pebble, raising US$10.3-million and confirming the fledgling company had a commercially saleable idea.

“You can definitely validate your product much faster by going out and raising funds for it,” says Garber, who has clients who have used crowdsourcing.

Garber himself is emblematic of the new-economy startup clients pushing their way through to the top. Where many large corporate law firms like to have grey hair at the head of their practice groups and programs, he is still in his twenties. He’s a self-described tech geek. His clients wear jeans? He wears jeans. He knows all the new apps.

“I enjoy being a young guy working with really senior advisors that counsel these startups with me. I’m really interested in this space. Since formally starting this program in the fall, a few of our startup program companies have already been accepted into the new cohort of Y Combinator, a world-class accelerator [in Silicon Valley]. We’re really excited about them coming back to Canada. It’s a great time for some of these early-stage companies.”

Thanks to securities regulators, it could be about to get even better.

For those who don’t work in the so-called collaborative economy, crowdsourcing and crowdfunding are different animals when it comes to raising money. While both entail accepting funds from strangers on the Internet, crowdsourcing typically involves a promotion or pre-purchase: You contribute early, as with Pebble, and you get a discount or special promotion when the product comes to market.

Crowdfunding, on the other hand, allows strangers to invest directly as shareholders through a similar Internet platform. With no exemption to the prospectus requirements, it has been strictly verboten under securities laws.

The Ontario Securities Commission is among the provincial regulators taking a hard look at changing that, and has included crowdfunding in a package of proposed prospectus exemptions. South of the border, the U.S. Securities and Exchange Commission recently issued a proposed federal crowdfunding exemption.

If and when regulators give the final all-clear and crowdfunding explodes onto the scene, it promises to trigger a paradigm shift because if you take crowdsourcing out of the equation, many startup companies are still facing challenges raising enough money to get their product to market.

“It’s been tougher these days and it’s not just accessing capital, it’s also in the terms attached to it when you do,” says Paul Amirault, a partner at Norton Rose Fulbright Canada LLP in Ottawa.

Whether it’s the after-effects of the dot-com bubble or the credit crisis, Amirault says startups have had to be creative and flexible in raising financing and are willing to try a range of methods, from self-funding or bootstrapping at one end to venture capital or private equity at the other. “The in-between options can include small-business loans from banks, raising equity from friends and family or angel investors.”

Amirault is not the only one to talk about financing as an issue. Lawyers around the country say that thanks to incubators, accelerators, increasing funding from the federal and provincial governments, players like the National Research Council Canada and the Business Development Bank of Canada, and the advent of angel syndicates, the angel investing is there.

But many say next-stage financing – venture capital, small business loans or private-equity money – in the $5-million to $15-million range is more problematic.

“It’s mostly equity capital, what we would traditionally refer to as the VC money,” says Valerie Mann, managing partner of Lawson Lundell LLP in Vancouver. “Banks still don’t really touch technology companies until they’re far enough along that they’ve got cash flow and real assets. A lot of these companies don’t have a tremendous amount of real assets so banks will lend, but they certainly don’t lend to very early-stage [startups] and you have to be far enough along with presence and positive cash flow that they’ll be interested in you.”

That’s what makes crowdfunding so potent. Regular people could have the chance to invest early in the next Shopify, now valued at more than $1 billion, the next Zynga, which has a market capitalization of more than US$3 billion and has gone public, or the next Spotify, which is valued north of US$4 billion.

The effect promises to be the equivalent of mainlining steroids into the veins of the startup economy.

Consultants and private-equity firms estimate between US$5 billion and $6 billion was raised last year just through crowdsourcing alone. There are 84 active Canadian crowdfunding platforms, portals and service providers at the ready once securities regulators open the doors, according to the National Crowdfunding Association of Canada. And there are hundreds, if not thousands, more in the larger global online community.

Think about it. We are looking at the disintermediation of angel investors, venture-capital funds and even bankers in early to mid-level rounds of financing. But they will all still need lawyers.

You better believe law firms are ready.

Startups have long been an essential part of the business plan at LaBarge Weinstein LLP, says Deborah Weinstein. In fact, she believes her firm does more startup work than any law firm in Canada.

Startups may not represent the largest percentage of the firm’s revenues, she says, but only because companies don’t start paying significant fees until they are more mature. They do represent the great majority of new file openings.

“We do hundreds, or even thousands, of startups every year,” she says from her office in Ottawa. With offices in Waterloo, Vancouver and Toronto, LaBarge Weinstein stays close to major startup clusters and has a payment policy designed to attract skittish would-be entrepreneurs.

For “qualifying startups” (those that have passed the firm’s informal due diligence, Weinstein says), clients are provided with startup kits and fees are deferred until the new business can pay, which is either when they’ve raised some money through a financing or started to generate some revenue.

Clients determine what they’re comfortable paying and LaBarge Weinstein starts billing them at that rate. How do the partners know for sure when revenues start coming in? Weinstein says they don’t. They rely on their clients to be honest. How long will the firm wait for repayment? “Years, if necessary,” she says. “Many never come to fruition and we have to write off those accounts. We just hope the person will call us for their next startup.”

If the venture is successful and the client sells the business, closes a major financing or decides to move to another law firm, LaBarge Weinstein only asks them to pay the accrued fees interest free.

Waiving the interest if a client moves to a competitor seems a little mind-boggling at first blush.

“Why?” asks Weinstein. “It means they’re not happy with us, so that’s fine. We’re completely different from your average law firm. National firms try to compete this way and they really can’t. We’re 21 lawyers, and we’re all on the phone together once a week to deal with these issues.

“We look at it very simply: Many companies come in to us, some work and some don’t. Some we get to bill and some we don’t. But it’s amazing what happens when you align yourself with a client who has no money, and you take a very small risk. Relative to my business one client is a very small risk but relative to their business it’s a very big thing I’m doing for them. So we end up having clients for life.

“I can think of two clients, for example, who came to me after the tech bubble burst, about 13 years ago. I worked with both of them for over a year before I ever saw a single dollar. One of them is still my client today and paying bills. The other one is BelAir Networks, and I sold to Ericsson for a lot of money.”

Takach does not agree with Weinstein when she says national firms like his can’t compete in this area. He says they can and do make accommodation for startups.

In fact, he takes on about 12 startup clients a year “and I do my homework.” Kobo is not his only or even his biggest success story. In 1994, Constellation Software was one of the chosen. Today the company has a market capitalization of roughly $5 billion and is a big user of legal services.

In Atlantic Canada, energized by local success stories like the US$326-million sale of Radian6 and Ocean Nutrition for $540 million, the startup economy is growing, says McInnes Cooper’s Rob Cowan.

Cowan estimates about 90 per cent of his work is with startups, mainly tech and life sciences companies. He says his firm generally uses bundling and fixed fees to keep costs down for early-stage clients and works to keep the internal cost of delivery efficient. “We would not have all partner time,” he says from Halifax. “We’d have associates and paraprofessionals involved so that our cost, in terms of work in progress, in terms of an hourly rate, we’re not losing money.

“If I spent a lot of time drafting documents each time for an early-stage company, my hourly rate would rack up very quickly and it would be far more than we would actually charge clients. So what we’ve tried to do is prepare a relatively standard set of documents that we tailor for individual circumstances.”

Any firm approached by an early-stage entrepreneur has to start by doing some due diligence. Regardless of region, when an early-stage startup client walks through the door they need a lot of legal work and likely have no money to pay.

Lawson Lundell’s Valerie Mann says when she is approached, she conducts an informal vetting process to make sure she understands the business idea, then talks to people at incubators and in the venture and angel communities, “to get a feel for the people and what they’re doing, to get a little bit of comfort.

“But I couldn’t tell you whether whatever technology widget they’ve come up with is going to be the thing that’s going to hit it out of the park. I wish I could.”

It’s a risk. If a startup fails, which many do, law firms often end up among their largest creditors. But the bigger risk is missing out on the next Dropbox.

Mann, who’s chair of her firm’s technology group as well as managing partner, says estimates show Vancouver has about 8,000 early-stage technology companies, “of which I’d guess 85 per cent of them have fewer than five employees.

“Clearly most startups are stretched. Their challenge is they have a whole bunch of things to do up front and they don’t have any cash. At the time they come to us for legal advice, they don’t want to spend their first dollar on legal services so we have various ways of accommodating them.”

Like other firms, Lawson Lundell provides them with a startup package that generally includes a standard non-disclosure agreement, a template shareholders’ agreement, incorporation documents, and employee and independent contractor agreements that address issues like assignment of intellectual property rights. They also provide the documents for seed-round term sheets and licence agreements.

Mann says that’s not what makes someone a client for life. “We can get them through the documents – and just about any law firm in town can do that – but a lot of what they need is really more advisory.

“The difficulty from a cost-management point of view is that the tendency for a firm is to say it’s a startup, ‘so I’ll give it my two-year call and they’ll run with it. It’s great experience for them.’ That’s not really what the startup needs. What the client needs and wants is access to somebody who’s got a little more wisdom, a little more experience, someone who can say ‘I’ve seen this before and here’s what you should consider.’”

“The real help comes in walking them through their priorities and their issues and risks, understanding their business, and we will do that but we have to give them concessions up front. So often we provide the advisory component for little or no money. It catches up at a financing.”

If anyone’s in a position to talk definitively about what creates a client for life, it’s Nick Catros, who started working with George Takach at his CFO’s request, fully intending to move Kobo’s legal work away from McCarthys. “I started to work with George to get an idea of the kind of stuff that he was helping the company with, and George was very proactive. I think he probably had some idea what I was thinking.” Asked later, it turns out he did not.

Takach took the time to map out for Catros what he had mapped out for CFO (now also COO) Greg Twinney, “which was: ‘Look, I’m prepared to make an investment in Kobo and that investment is going to be in providing my time at reduced or even zero rates, and providing non-legal advice where I can without all the billable hours associated with that.

“And as Kobo evolves from a very mature company to a more mature company, I think I can help put in place some of the pieces you need to take the next steps. I recognize that you’re constrained financially and paying my full freight is not an option, so you’re going to get my stuff at a startup price. Don’t worry, I’ll make sure you can afford it.’”

Catros says that’s not what made him a convert because, in terms of business pitches from law firms, it’s far from unique. He says it was the quality of the work and the advice in the face of financial concessions that made him a convert.

“Oftentimes when you get into a situation like that, the way the lawyer manages it is to assign you the service of a student or a very junior lawyer. The actual relationship partner you’re dealing with is going to get involved very infrequently. At the end of the day, that’s not really getting value.

“What George offered allowed him the opportunity to show me the value he could bring to the table. Even though he was charging us the preferred rate it didn’t change the quality of the service, he was very intimately involved in everything we were doing. He didn’t push us off to students or juniors unless it was appropriate. That gave him the chance to prove he’s worth the much higher rates he usually charges.”

Having gone through a couple of rounds of financing and a sale to a very large Japanese e-commerce company, Kobo is no longer a startup. It generates hundreds of millions of dollars in annual revenues around the world. Takach is no longer giving them reduced rates.

Catros says other law firms, colleagues from past relationships, still try to pitch for Kobo’s business. They strike out.

“Had George not been so sensitive to the realities of the startup, had he not been so forward thinking in terms of being so flexible on fees and making a real investment in our company that way, I would have gone to a cheaper option fairly quickly because I assume everyone I call on a legal matter is going to give me competent legal advice. That’s not a differentiator.

“It’s all those things that wrap around the legal advice: the pragmatism, the problem-solving, the ability to give good business advice, to understand what any particular circumstance requires and work though that.

“George showed me very early on what he brings to the table and I’ve seen through the process of working with him that he’s worth it. He’s got a loyal customer for life.”

And for anyone advising startup clients, that is a story you want your client to tell.

Sandra Rubin is a Toronto-based writer and strategic consultant.

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