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.