The purpose of this post is expand upon my answer to the question on Quora:

“What should you do as a startup when a Bay Area VC insists that you use their expensive legal counsel?”

Mark Suster, a VC at GRP Partners, has also written and spoken about how he likes to “share” his legal counsel with the startup in which he is investing.  My advice to entrepreneurs is clear: push back hard on this issue and choose your own strong, independent legal counsel – i.e., a law firm that’s going to work hard to protect you and watch your back.

Types of Conflicts of Interest

There are two types of conflicts of interests that need to be addressed when startups are pressured to use an investor’s law firm: ethical and business.

Ethics Rules.  Potential conflicts of interest that arise in the course of a law firm’s delivery of legal services are governed by applicable State Bar ethics rules, with which lawyers are required to comply.  As the Preamble to the ABA Model Rules of Professional Conduct provides in relevant part:

In the nature of law practice . . . conflicting responsibilities are encountered. Virtually all difficult ethical problems arise from conflict between a lawyer’s responsibilities to clients, to the legal system and to the lawyer’s own interest in remaining an ethical person while earning a satisfactory living.  The Rules of Professional Conduct often prescribe terms for resolving such conflicts. Within the framework of these Rules, however, many difficult issues of professional discretion can arise. Such issues must be resolved through the exercise of sensitive professional and moral judgment guided by the basic principles underlying the Rules.  These principles include the lawyer’s obligation zealously to protect and pursue a client’s legitimate interests, within the bounds of the law. . . .

In the event there is a potential conflict of interest between or among clients, most State Bar ethics rules require each client to consent in writing to the attorney’s representation — after full disclosure and consultation.  Indeed, each client must be able to appreciate the situation and have enough information to make a reasonable and informed decision as to whether or not the legal counsel can provide fair representation.  The consent of the client must also be entirely voluntary and not given under any pressure whatsoever, by the attorney or anyone else.

Business Conflicts.  Assuming that law firms are complying with the foregoing ethics rules, there is another issue that needs to be addressed: inherent business conflicts of interest.  This, to me, is the crux of the problem with entrepreneurs using law firms that also represent the investors.

As I noted on Quora, for many of the big Silicon Valley law firms, the venture capital firms are their gravy train and the big law firms need to play ball with them.  This is not to say that any lawyers at these firms are unethical (or that the law firms are not complying with applicable State ethical rules).  Instead, this is about the realities of the economics.

Let’s take a simple example:

Vinny VC meets with Eric Entrepreneur and gets very excited about Eric’s new venture; so excited, in fact, that a few weeks later Vinny presents Eric with a term sheet for a $750K seed financing.  Vinny advises Eric that this is his standard term sheet for seed financing and recommends that he retain Larry Lawyer at the ABC Law Firm to process the documents.  “Larry is great,” Vinny explains, “and we have some lightweight seed documents that we have put together with Larry’s law firm and used with other startups, which will make the process relatively quick and inexpensive.”

“Sounds good,” Eric says, and he meets with Larry Lawyer and signs an engagement letter (with the appropriate waiver of any potential conflicts of interest).  Now here’s the problem:

If Larry Lawyer and his firm are being sent a lot of work from Vinny VC and his firm, Larry is obviously not going to rock the boat and start pushing back on any key issues.  Why?  Because if he does, Vinny will just send his future work to the five other lawyers on his list.  This is not to say anyone is unethical here – this is just common sense.  Vinny wants his deals done quickly and cheaply (and on the forms that Vinny and Larry have created); and Larry wants Vinny to send him lots of legal work.

Accordingly, (i) Larry Lawyer is not going to suggest to Eric Entrepreneur that he talk to other investors and test the market prior to executing the term sheet; (ii) Larry is not going to raise issues such as doing convertible debt in lieu of a preferred stock financing; (iii) Larry is not going to push back hard if the liquidation preference includes some form of participation; (iv) Larry is not going to push hard to cut back on any of the protective provisions; and (v) Larry is not going to suggest that the company doesn’t need investor representation on the Board at this early stage.  In short, Larry is going to play ball because if he doesn’t, Vinny VC will stop calling.

As Antone Johnson, a smart startup lawyer, aptly points out in the comments to the Quora question:

My former firm ([Wilson Sonsini]) gets accused more often than any other of being in the pocket of the VCs, thanks to the “gravy train” alluded to in Scott’s answer.  It does have a vested interest in maintaining strong positive relationships with the VCs that feed it deal after deal.  I never met a lawyer there who wasn’t cognizant of his or her duties to represent the client zealously (meaning the company, not the investor), but I did feel there was a tacit understanding that pissing off the VCs would be a bad career move.

The M&A World

This inherent conflict of interest is not relegated to the VC world.  Indeed, I experienced it first-hand shortly after moving to California — when I got pulled onto an M&A deal at an LA law firm that I had just joined.

The managing partner of the firm was good friends with a middle-market investment banker, who recommended our firm to the client in connection with a complex leveraged buy-out.  I was tapped to quarterback the deal in light of my strong M&A experience in New York.

You have to understand that a middle-market i-banker’s entire year can be made or broken based on whether or not he can close one or two deals.  Indeed, he only gets paid if the deal closes.  Accordingly, like with the VC’s “recommended” or “preferred” legal counsel, we were supposed to play ball and make sure the deal closed so that the i-banker got paid.

Unfortunately, I’m not very good at playing this kind of ball – particularly when there were significant environmental issues that were not being adequately addressed.  The i-banker wasn’t too happy and, in fact, stuck his finger in my chest and warned:  “We’re going to get this deal done despite you fuck’n lawyers.”  He then vigorously complained to the managing partner that I was blowing-up the deal because I had retained special environmental counsel from my old New York City law firm and we were pushing too hard on the environmental indemnity.

Good work by the i-banker (and cheers to my former managing partner) for getting the deal closed by watering down the environmental indemnity: less than six months later our client’s company was indicted for significant environmental problems that it had assumed (by operation of law) as part of the acquisition.

Conclusion

Look – my goal here is not to point fingers and claim that anyone is being unethical or doing something wrong; this is the way business works.  There are inherent conflicts of interest in certain business relationships, and entrepreneurs need to have someone in their corner to point that out to them and to watch their back.  I am proud to play that role.

The Market Problem

As I tweeted a couple of days ago, I recently received three telephone calls over a three-day period from entrepreneurs looking for a new law firm because of the excessive fees of their current law firm.  Two of the three entrepreneurs advised me that they were reluctant to even call their lawyers with a question because of the fees.  I thought to myself:  I get it! 15 minutes = $125-175 for most partners (and those phone calls add up).

In fact, it can be worse than that.  Often clients can’t get ahold of the partner in charge so they’ll call the associate directly; and often the associate doesn’t know the answer so he’ll have to talk to the partner; and then the partner and associate will call the client back together; and here’s what the billing statement looks like for one question: 

Attorney     Date           Hours    Description of Services                  Rate               Fee

How do I know this?  Been there, done that.  Indeed, I worked for nearly 8 years at two major law firms in New York City.  This is how phone calls from clients often play-out.  The same inefficiency exists for the drafting of agreements: a junior associate spends a lot of time preparing the initial draft (pulling together different forms, learning on the job); a senior associate and/or partner reviews and revises the draft; the junior associate meets with the senior associate and/or partner to discuss the revisions; and then the junior associate finalizes the agreement and sends it out.

The bottom line is that the traditional law firm model – i.e., the billable hour – rewards inefficiency, overstaffing and padding.

The Solution

So what’s the solution to all this?

One solution is the advice given by Bram Cohen, a smart entrepreneur, in the comments section of my post on VentureHacks entitled Top Ten Reasons Why Entrepreneurs Hate Lawyers:

“Associates doing work is a real problem. I’ve found that insisting that all work be done by partners results in better work for less money in the end, even though the nominal hourly rate is much higher, because an associate will bill for several hours researching a subject which the partner already knows off the top of their head.”

That’s great advice – and that’s why my firm has no associates and each attorney on my team has 10+ years’ experience, was trained at big law firms and has stellar academic credentials.  But even that advice doesn’t completely solve the inherent problem of the billable hour model because inefficiency is still rewarded: the longer the project drags on, the more the law firm is paid.

There’s only one solution: fixed fees – i.e., the law firm and the client agree beforehand how much the project will cost.  This is the dagger to the billable hour model.

No more incentive for the law firm to be inefficient.  No more overstaffing.  No more associates banging the file to meet their annual minimum billing requirements or bonus targets.  And the best part from the client’s perspective: no more surprises at the end of the month when the invoice arrives.

Conclusion

It’s time to destroy the billable hour.  If entrepreneurs cannot call their lawyer with a question, there’s obviously a problem in the marketplace.  The solution is easy: a fixed fee (which includes unlimited phone calls and emails).  That’s what we’re doing – and that’s why entrepreneurs love us.

www.youtube.com/watch?v=Kcty5PrNaxs

The Good 

Big law firms are very good in connection with billion dollar acquisitions, public offerings and any complex, bet-the-company type transaction (e.g., hostile takeovers).  Indeed, when money is not an issue and/or where the client needs lots of lawyers (i.e., lots of bodies), it may be prudent to retain a large law firm with strong experience to handle a particular corporate project.  I remember doing billion-dollar acquisitions as a corporate associate in New York, where we often had diligence teams of 10+ lawyers and transaction teams of 30+ lawyers.  Moreover, big law firms are also good (particularly in places like Silicon Valley) at making introductions for entrepreneurs to investors and the like. 

The Bad

The bad, of course, are the huge legal fees that big firms charge.  As I have discussed on the video on the home page of my website, there are lawyers at certain major national law firms billing out at $1,000 per hour; and there are first-year associates at big firms billing out at $300 per hour.  (Just to be clear: we’re talking about lawyers with no experience, fresh out of law school billing clients at a rate of $300/hr.)  The bottom line is that legal fees are through the roof. 

Now, in billion-dollar deals, legal fees are generally not an issue; indeed, they are just another line item in the list of transaction expenses (and generally pale in comparison to what the investment bankers are getting).  But in small deals or in connection with general corporate work, fees are often a significant issue to entrepreneurs.   

The Ugly

The ugly with respect to big law firms is pretty ugly from the entrepreneur’s perspective – and I’ve seen this over and over again.

The reality is that the smaller the client – the smaller the transaction — the further down the ladder the work gets pushed at the big law firms.  That’s the way these firms work.  The entrepreneur may meet the senior partner at the first meeting for his $15 million acquisition or $3 million financing, but that partner then goes back to his office, calls the assigning partner and gets some young associate to start cranking out the work.

I experienced this first hand as a young associate at a big, New York City law firm.  I can remember is like it’s yesterday: you get the call from the senior partner’s secretary to come up to the senior partner’s office; you run up the stairs or to the elevator; you bring your legal pad; you’re nervous and you sit down in the partner’s office (sometimes he’s on the phone and you’re sitting there for 10 minutes); and then if it’s a small deal that you’ve been tapped to handle, he either just flings a copy of the term sheet at you or just flies through the terms, hands you the form he wants you to use and then tells you to “go, get it done”; and as you’re leaving his office, he screams out “call me if you have any questions”  — which really means “don’t bother me with this little, bullshit deal — I don’t want to see you until the closing.”

 Conclusion

The takeaway here is that the big-firm template generally only works for the big deals and the big clients, and the entrepreneur needs to understand that.  I hope the foregoing was helpful.  If you have any questions or comments, please send them to me through the comments section of this post.  Thank you.