How Should a Startup Compensate its Attorneys?

by Scott Edward Walker on December 1st, 2010

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.  Please shoot me any questions you have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

 

Question

We’re a bootstrapped startup based in Palo Alto, and we’re getting some serious traction with our site and interest from angel investors.  We haven’t incorporated or done anything else from the legal side, but we started interviewing different law firms.  A few of them are offering to defer fees for equity, and we were wondering if that’s common practice – and if there are any issues with that.  Any input would be appreciated.  Thanks!

Answer

This question is close to my heart (and wallet).  Indeed, I have thought about the compensation issue quite a bit since launching my own firm a few years ago, and my position is not the norm — particularly in Silicon Valley.

The bottom line is that there are only four ways you can compensate your attorneys: cash, credit (i.e., deferred fees), equity or a combination of the foregoing.  Let’s look at each one in reverse order.

Equity.  I get calls all the time from entrepreneurs asking me to represent them for equity.  The obvious business problem is that I’m a lawyer, not a VC. The less obvious, but more significant problem is that it creates an inherent conflict of interest.  I would be wearing two hats: stockholder and lawyer.

To get around this conflict of interest, many Silicon Valley law firms do two things: first, they establish separate funds (controlled by the law firms) to hold the equity; and second, they require the startup to execute a waiver (usually as part of the engagement letter), waiving any conflict claims and expressly consenting to the law firm’s representation despite the conflict.

Needless to say, these law firms made a fortune in the late 1990’s taking equity stakes in their clients.  That’s their business model – and it’s big business.  But I don’t think it’s in the best interest of the clients.

Credit/Deferred Fees.  The Silicon Valley firms justify their equity stake (usually about 1%) in return for deferring fees (usually capped at $15,000-$20,000).  The problem with this argument is that the fee deferral is just that – a deferral.  It just pushes-off the due date of the invoice to a later date – generally the closing date of the initial financing.

This, however, creates another inherent conflict of interest.  Why?  Because if the financing doesn’t close, the law firm doesn’t get paid.  This is akin to a success fee, and we all know the problems success fees create with middle-market investment bankers.  Let me share a simple example (which I discuss in my post “Dear Entrepreneurs: Choose Your Own Legal Counsel”):

Shortly after moving to California 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.

As noted above, the investment banker only gets paid if the deal closes.  Accordingly, we were supposed to play ball and make sure the deal closed so that the 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 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 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.

Accordingly, the issue is how hard will your lawyers push with respect to key issues (particularly if it’s a small firm or a solo) if pushing could blow-up the financing and thus prevent them from getting paid?  For example, are the lawyers going to suggest that you test the market prior to executing the term sheet? Are they going to raise issues such as doing convertible debt in lieu of a preferred stock financing?  Are they going to push back hard if the liquidation preference includes some form of participation?  Are they going to push hard to cut back on any of the protective provisions?

Cash. Obviously, startups are trying to conserve the little cash they generally have.  That being said, cash is king and makes the foregoing issues go away.  I started my career at two major law firms in New York City, and none of the big New York firms takes equity stakes in their clients.  This is a Silicon Valley invention.

I think the most important role the startup lawyer plays is to watch his or her client’s back – i.e., to protect the client.  Most first-time entrepreneurs cannot appreciate all of the potential legal pitfalls (and potential liability) in connection with launching a venture and executing their business model.  To the extent the relationship between the lawyer and his client is muddied by inherent conflicts, it undermines that role.

Conclusion

I hope the foregoing is helpful.  Remember: any time a law firm or other service provider is willing to accept something other than cash for services, there has to be a trade-off.

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