Paying Attorneys with Equity: Other Problems
In part one of this article, I brought up the issue that many start-ups will pay their attorneys with equity in the company rather than or in additional to paying them cash. I maintain that this is a bad idea. I described the main problem with this arrangement in the first part of this article – that such an arrangement creates a potentially harmful conflict of interest for the attorney. But there are many other reasons why this arrangement should be avoided as well.
Tendency to Over-litigate
I also get the sense that companies tend to over-litigate cases when they are not paying for them up front. The cost of attorneys fees is an incentive to try to avoid litigation and settle disputes. But if you are not paying the attorneys, you may feel that it makes sense to fight to the bitter end. That is still not the case. First, of course, you are still paying the attorneys. You are giving up some of your precious ownership interest in the company. Second, litigation is very distracting. You will end up spending valuable time on your litigation cases that you should be spending making your company successful. Third, litigation is a terrible way to resolve disputes. The judge who will decide your case will have very little time to get to know your case and will bring their own personal biases to the case. The end result is often a somewhat random decision. Do you really want to bet your company on the mood of a particular judge on a particular day? Better to settle the case and get back to building your company. You will have more incentive to settle if you are paying your attorney with cash instead of equity.
Failure to Value Legal Advice
The company may treat the attorney’s advice differently if the company is not paying for that advice. People tend to value advice in proportion to what they pay for it. When the attorney who is taking equity is giving what is in essence free advice, the company may not value that advice highly. If the company is paying its lawyer for advice, the company is more likely to take that advice seriously.
I have seen this first hand. When I have offered my advice for free (what we attorneys call pro bono service), the client tends not to respect the advice.
Smart Money versus Dumb Money
There is a saying that smart money comes from banks and professional investors, and that dumb money comes from attorneys, doctors and friends and relatives. Banks and professional investors know about the risks of start-up businesses. They may not like it when they lose money, but they know and accept the risk. They also know about the ups and downs of business and will not be quick to pull the plug if they think the business idea still has merit. Dumb money people expect to get rich. They may cause trouble if they lose their money. And they may want to run at the first sign of trouble.
You may think that a lawyer who deals with start-ups all the time will not follow the dumb money pattern. That is true sometimes, but not as often as you would think. There is a reason why that person became an attorney and not an entrepreneur.
If You Need to Pay Your Attorney with Equity, Are You In Trouble Already?
One of the tests of whether a potential business idea has merit is whether the founders can raise capital. If you are having so much trouble raising capital that you need to in essence borrow money from your attorney, what does that say about the viability of your business plan? You may be too underfunded to start a business or your business plan may need adjustment. If your best source of money is your attorney, your company may have serious problems.
Lack of Attorney Choice
A start-up should be free to hire and ultimately to fire any legal advisors. But what if the current legal advisors are also shareholders in the company? Then there are problems. If you fire them, you may have to deal with disgruntled shareholders for the rest of the life of the company. That will influence whether you keep or fire them. This can lead to a messy situation. If you owe a former law firm money they are a creditor just like the rest of your creditors. But if they are shareholders instead, you are still partners with them, whether you like it or not.
Attorney Ethics Rules
Attorneys are governed by a set of ethics rules. These rules are imposed on a state-by-state basis, but the rules are very similar throughout the country. I do not believe that the rules prohibit an attorney from taking an equity stake in a client company. But they do impose conditions to protect the client, and those conditions are rarely actually met.
In Washington, where I practice, there are two rules that are directly on point. They are:
Ethics Rule 1.7 Conflict of Interest; Current Clients
… a lawyer shall not represent a client if the representation involves a concurrent conflict of interest …
Ethics Rule 1.8 Conflict of Interest: Current Clients: Specific Rules
(a) A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest adverse to a client …
There are exceptions to these rules. Basically it is permissible to represent a client or enter into a business transaction with a client where there may be a conflict of interest, if the client is fully informed of the potential conflict and the risks involved, has an opportunity to seek independent legal counsel concerning the relationship, and agrees in writing. This rarely happens in practice. Yet the client rarely seeks independent legal counsel. It just does not feel right to pay one attorney to review an arrangement to hire another attorney for free.
If you will be giving your attorney equity instead of cash, who will put together the deal and prepare the paperwork? Usually it is the attorney you have hired. That could create major problems. If you are negotiating an equity arraignment with an attorney who negotiates equity arrangements all the time, how can you be sure you are getting a fair deal, and not being taken advantage of? Is the attorney giving you the best representation possible, or is the attorney looking out for himself? Will the attorney fully disclose the nature of the deal in a way that you can actually understand?
There is a reason why attorneys are required to take many steps if they want to enter into a potential conflict of interest situation with a client. The fact that there are many steps is a sign that the relationship has serious potential problems. The fact that the required steps are not often followed is just a further warning sign that it is best to avoid this situation all together.
There is also an ethics requirement that the attorney’s fees be reasonable (In Washington see Ethics rule 1.5). What is a reasonable amount of equity to receive from a start-up given the enormous risks involved and the large potential reward? It is usually very hard to say.
There are some lawyers who will push the rules of ethics as far as they can. There are others who try to make sure they stay within the rules. Wouldn’t you rather that your attorney was one who made sure they stayed within the rules, at least when it comes to rules that are meant to protect you, the client?
What Do You Think?
Attorneys are pretty evenly divided on whether it is appropriate to take an equity stake in a start-up client. Many start-ups like the idea, but they may not be well informed on the subject. You now know what I think. What do you think?
(My thanks to fellow Seattle attorney Mason Boswell whose comments in an on-line discussion on this issue helped me focus my thoughts on the subject.)