I long thought that litigation was the exclusive domain of lawyers, large companies and criminals. Who would want to pick on a poor, helpless start-up? The reality is, sadly, that our litigious society has entered the domain of the early stage company.
The disgruntled “friend,” collaborator or employee
I sometimes call this the “Social Network effect” after the Facebook movie. Usually, the litigant feels slighted and entitled to equity or cash. These cases are especially challenging because they become personal, rather than rational. The biggest sticking issue is equity, because often the litigant is seeking equity for some early collaboration (perhaps classmates that brainstormed an idea in their dorm room). While its generally understood that equity is for one’s forward-looking contributions, this principle can be hard to establish in a jury trial. This makes these cases especially tricky even when the company is 100% in the right. This should be a reminder to all founders to get stock allocations set and locked in the beginning to avoid future disagreements.
Perhaps inspired by patent trolls, I’ve seen an increasing number of larger companies sue any or all upstarts that threaten its core business. Given the number of very generic patents that have been issued over the past decade (many in software), it has become increasingly easy to demonstrate some sort of violation, especially to a less-than-sophisticated judicial system.
Smaller companies generally have only one product to sell, and without the ability to sell that product, have no business. Furthermore, most start-ups cannot afford the distraction and therefore, most boards advocate settling cases sooner than later.
Innovation ahead of regulation
This type of litigation is in the press seemingly everyday. Uber, a portfolio company, and Aereo are well-documented examples where municipalities or other groups sue the company for violation of certain regulations. The reality is that most regulation hadn’t taken into account the existence of new technologies (as in Uber or Aereo). Instead, protectionist politicians that wield significant influence try to shut down these new services before regulation catches up to innovation.
Representation selection signals to the other side a great deal about your view of the case. For example, if the start-up hires a large firm, the other party knows that high rates are being paid and thus may believe a higher settlement is likely. That said, if the start-up is fighting “bet the company” litigation, its advisable to use a big firm despite the signaling risks.
On the other hand, if you’re fighting a lawsuit that is a nuisance but doesn’t jeopardize the very being of the company, its advisable to use a smaller, less expensive firm. Remember that investor dollars are being used to fund litigation, which is among the worst ways an investor (or an entrepreneur) can envision spending his/her company’s capital.
I’ve seen our companies spend tens of thousands to over a million dollars in legal fees. Each case is unique, but my experience has been that the vast majority of cases settle close to the trial date. In these cases, generally hundreds of thousands have been spent. This isn’t altogether surprising given that it takes time for both parties to realign their expectations. If a case does go to trial, the costs almost certainly will be at or north of $1M for all fees leading up to and including trial.
Venture investors are increasingly familiar with litigation. The start-up founder/CEO needs to be transparent about the situation and the facts, and keep the Board closely updated on the process. Unfortunately, the wheels of justice turn slowly and often the biggest expense paid by the company is the time and distraction.