Lawyer Equity – A Bad Idea (Part 2 of 2)

July 18, 2011

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 …

and

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.)

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Lawyer Equity – A Bad Idea (Part 1 of 2)

July 18, 2011

Paying Attorneys with Equity: the Main Problem

 Start-ups are usually short on cash. They also usually need legal help. So, it is tempting for a start-up to offer attorneys equity in the company instead of paying them cash. Many attorneys will agree to this. In fact, some will insist upon it. But it is a bad idea.

The Equity Arrangement

There are many variations on the attorney equity arrangement. The attorney can receive stock in lieu of payment. The attorney can offer a reduced rate and/or delayed payment of attorneys fees (until the next round of financing, for example) in return for equity. The attorney can obtain the right to purchase stock in the start-up at favorable rates, typically at the rate that the founders paid, or the rate of the most recent round of financing. The attorney can receive stock options instead of stock. Of course there are as many variations as there are attorneys. In any of these cases, the problems are the same.

The Main Problem – Conflict of Interest

The main problem is that if an attorney has an equity stake in the company, the attorney is no longer an unbiased professional. Attorneys are supposed to exercise independent professional judgment and offer unbiased legal advice to their clients. But the advice that the attorney gives the company may be affected by his or her ownership stake. This is called a conflict of interest – the attorney’s advice to the client may conflict with the attorney’s own personal interests. It is unrealistic to believe that the attorney will not take into account his or her personal financial interests while providing legal advice to the start-up, perhaps without even realizing that he or she is doing so.

Say that a company owes its attorney a lot of money for legal fees The company then comes to the attorney with a possible sale offer that would provide enough capital to pay the attorney’s fees. Isn’t the attorney faced with a possible bias of wanting the deal to close so he that can be paid? Would he still be expected to raise any red flags about the deal that he sees? Of course he would.

A company’s attorney should be working for and answer to the company, not to the individual shareholders of the company. Although I find that attorneys often fail to make this distinction, it is an important one to make. What is best for one shareholder may not be best for another, or for the company as a whole. (In my experience attorneys tend to favor the major shareholder, sometimes to the detriment of the company as a whole and/or to the minority shareholders.) When the attorney is one of the shareholders, who is the attorney representing – the company, the shareholders, or him or herself? The attorney should be answering to the company. The company is in turn answering to the shareholders. But if the attorney is one of the shareholders, then the attorney is in effect answering to him or herself, never a good situation.

A different perspective is to consider that the attorney who invests in the company is in essence acting as a venture capitalist. The interests of the venture capitalists are sometimes aligned with the interests of the company. but not always. For example, the venture capitalist’s interests may be very different than the company’s interests in negotiating a new round of financing, or deciding how to proceed with a company in financial distress, or dealing with a liquidation event. Often the start-up will be asking the attorney for advice dealing with venture capitalists. When the attorney’s financial interests are more aligned with the venture capitalists than with the start-up, it is impossible for the attorney to give truly unbiased advice.

There are also complex legal issues under securities laws for attorneys who own equity in their clients. That topic is beyond the scope of this article.

Having said that, I concede that attorneys taking equity would not be the only instance where an attorney would have a potential conflict with the client over money matters.

The attorney equity arrangement is somewhat similar to an attorney taking on a personal injury case on a contingency basis. Many attorneys will take large personal injury cases where instead of getting paid by the hour, the attorney gets a percentage, say 40%, of any money recovered. What if the other side makes a large settlement offer? The client asks the attorney’s opinion of whether he or she should settle. The attorney may have a bias towards taking the sure money, but is expected to advise the client on what is best for the client, not the attorney. Yet this is common practice and it is simply assumed that the attorney will always put the client’s interests first.

But I still can not shake the feeling that an attorney taking an equity stake in a company is different, and does interfere with the attorney giving his or her client unbiased professional advice. In addition to representing start-ups, I represent individual entrepreneurs in disputes with the companies they helped found. Sometimes these disputes end up in litigation. The company is usually represented by some large downtown Seattle law firm that has an equity stake in the company. I can’t help but feel that the attorneys are acting like their clients, with their clients perspective, when they should be unbiased legal professional advisors.

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