Deferred Compensation = Accelerated Dilution

Richard Komaiko

Richard Komaiko

by Richard Komaiko, Cofounder of AttorneyFee

A few weeks ago I met a really promising seed stage team at a Hackers and Founders event.  Out of sheer curiosity I asked them whether they had gone through all the legal formalities associated with starting a company.  They said that they had just met with an attorney, and were planning on hiring him the next day.  “How much did he quote you for the incorporation?” I asked.  “He said it would be $2,500.”

I was unable to hold back my reaction: “Wow!”  My new friends asked, “Wow that’s a lot, or wow that’s a little?” I responded, “Wow that’s about 10 times higher than average.”   They could hardly believe it, but the average price to hire an attorney for corporate formation documents in California is only about three hundred dollars.

“That’s ok,” they assured me, “because this attorney is working on deferred compensation.”  Deferred compensation is an arrangement where you pay nothing until you raise a funding round, at which point the law firm collects all of the fees that have been accruing in the background, and typically takes a sliver of equity as well.

I cautioned them against this mentality.  “Deferred compensation doesn’t mean it’s free, and it’s not an excuse for overpaying 10x.  Deferred compensation is just another form of credit.  This particular form of credit, however, has the potential to force you to make certain business decisions that might not necessarily be in your best interest.”  If you rack up enormous legal bills, you might have to raise more money than you actually need, and relinquish more ownership than you would otherwise desire.  The consequences are very real, but all too often, entrepreneurs fail to appreciate them.  Perhaps if the practice were called accelerated dilution, people would take it a little more seriously.

This conversation sparked my curiosity, so I decided to conduct a survey of companies in the current class of YC and 500 Startups.  The survey had two questions: (1) how much debt have you accrued so far in deferred compensation legal fees, and (2) what services did you get for that money?  The results of the survey are shocking, and were recently published in VentureBeat.

In the mean time, I have two bits of advice for founders.  First, buying fancy legal services does not magically transmogrify your idea into a business.  Building your product, failing fast, and iterating to find the right product-market fit is the magic process by which you become a business.  Ask yourself, if you had only $1,000 to spend, would you rather spend it on product development or legal formalities that won’t become relevant unless you’re successful anyway?  If your answer is that you would rather spend the money on product development (which is the right answer), then how could it possibly be rational to go into debt so that you can also buy fancy legal services?

Second, corporate formation documents are like flan.  The difference between mediocre flan and world class flan is almost imperceptible, and certainly not worth paying a premium for.  That’s not to say that first class legal services are never worth the money, it’s just to say that you should be selective about which services are so nuanced as to require first class service.  If you’re raising a series A round, it’s probably worthwhile to loosen the purse strings and hire a top tier law firm.  But things like corporate formation, convertible debt notes, and employment agreements are not rocket science, and almost anyone with a JD can provide equally satisfactory services.

In conclusion, if legal services are required to take your company to the next level, make certain to shop around to determine the ‘market price’, be selective about which issues require first class service, and think twice before accelerating the dilution of your company by taking on massive amounts of deferred compensation debt.

Richard Komaiko

Richard is a cofounder of AttorneyFee, a Bay area startup that aims to make the cost of legal services more transparent.

@RichardKomaiko

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