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.


Top Ten Legal Mistakes Entrepreneurs Make (and how to avoid them)

October 27, 2010

Here are my top ten legal mistakes entrepreneurs make and how to avoid making them, based on this author’s 26 years of experience providing legal advice to entrepreneurs. The focus is on how to avoid getting into legal trouble, rather than a checklist of specific legal documents that you might need. In my experience entrepreneurs often get into trouble when they do not follow this advice.

1. Failing to conduct your business to avoid litigation.

Of paramount importance when starting and managing a new company is to avoid ending up in litigation. Litigation is a terrible way to resolve disputes. It is very expensive, and even more importantly, it takes away your mental energy. While you are in litigation win or lose, your company will suffer. Much of the rest of this top ten addresses ways to avoid litigation.

2. Failing to put it in writing.

All of your major agreements should be in writing. It may sound obvious, but there are many types of agreements that often don’t get put in writing.

When a company has only a small number of owners, there should be a written shareholder or partnership agreement among the owners. Often people will tell me that they are good friends and they don’t need an agreement. They are wrong. Friendships sour, people change, and people die. Peoples’ priorities change when money is involved. It is far easier to put that agreement in writing now while you get along with each other rather than after you are already fighting.

Often founders of a company will bring technology, valuable trademarks, or other proprietary information that they have already developed, with them into the company. After the company is formed, who owns this intellectual property? There should be a written agreement that clarifies ownership.

When you start to work for a new company, or when your company hires a new senior person, the basic terms of employment should be in writing. These terms include salary, bonuses, stock options, job responsibilities, and term of employment. If the new hire has to move to take the new job, is there a minimum period of employment? Does the company pay moving expenses? Any stock related agreements should also be in writing (see # 6 below).

3. Rushing into agreements.

Do not rush into agreements. Read all important agreements before you sign them. Have your attorney review all major documents. Too often, in the rush of making a business grow, entrepreneurs sign whatever is put in front of them, especially if it comes from someone they think they can trust, such as one of their partners or a venture capital firm. There is always time for review. You can and should look after your own interests. This does not mean that you are trying to kill the deal or be an obstructionist. Whoever drafted the contract took some time to prepare the document. You are entitled to take some time to review it and make sure it says what it is supposed to say, and treats you fairly (or at least as fairly as venture capitalists can treat entrepreneurs).

4. Not planning for the unexpected.

You may think nothing is going to go wrong. It is healthy to have that kind of optimism when starting a new company, and entrepreneurs are inherently optimistic people. You have to be to start your own company. But things do go wrong. You need to plan for the unexpected.

Go over your plan of action for your company and try to think what could go wrong and what would happen if it did. For example, what would happen if one of the founders died unexpectedly?

Anticipate that founders will have disputes. Fifty percent of all marriages end in divorce. The divorce rate among entrepreneurs is probably much higher. You may think that “even if the founders have a dispute or one of us leaves the company, we will be able to work out our differences. After all we are all reasonable intelligent people and we are friends. Nothing will come between that.” But it often does, especially when money is at stake. Plan for the unexpected now while you are still friends.

This is another reason to use attorneys. Clients rarely come back to their attorney to tell them the agreement worked exactly as planned; it is only when something goes wrong that they call their attorney. So attorneys are used to thinking about and planning for the unexpected. Your attorney can help you anticipate problems and prepare to avoid them or at least find a way to deal with them in an orderly non-litigation fashion.

5. Trusting people who say “You can trust me.”

If someone says “We don’t need the lawyers” or “We don’t need fancy contracts because you can trust me,” run, do not walk, and run away fast. Someone who can be trusted never has to say “trust me.” They have nothing to hide. They say, “Sure, we can put it in writing” and “Sure, have your lawyer review this.” and “What else do you need from me to assure you?” (For further discussion of this issue, see my blog entry Don’t Trust People Who Say You Can Trust Me.)

6. Using vague terms in agreements.

Try to use specific terms in any agreements you enter into. Watch out for vague almost meaningless terms like ‘profits’. The amount of profits in a venture is whatever the accountants want it to be. Don’t agree to giving or getting a percentage of profits, or any other subjective term. Use objective easy-to-measure terms instead, like ‘revenue’. Warner Brothers produced the highly successful Harry Potter movie series, with over a billion dollars in revenue. The company agreed to give a percentage of the profits from the movies to various people and companies. But according to the Warner Brothers accountants, these movies have not made any profit. (See STUDIO SHAME! Even Harry Potter Pic Loses Money Because Of Warner Bros’ Phony Baloney Net Profit Accounting.)

Specify stock options in detail. It is common in an offer letter that the company gives senior staff stock options worth around 3% of the company and that is all the letter says. At what price can you purchase the options? When do they vest? When do they expire?

Another vague term is ‘percentage of the company.’ What do they mean by 3% of the company; 3% of outstanding issued stock, with or without taking into account vested and unvested stock options; 3% at the time the letter is written, or at the time of vesting (after several diluting stock events) or when exercised (often after several more stock diluting events)? Be specific when offering or accepting stock or stock options.

7. Not having your own attorney.

Don’t expect venture capitalists (VCs) to look after your interests. When your company is ready to raise funds, the fund provider, usually a VC or two, will be represented by legal counsel. The VC will usually insist that the company hire a fancy law firm that has experience with corporate finance and securities. But who is representing the entrepreneur? Often, no one. You need your own independent legal counsel. You may be hesitant to hire an attorney because you do not want to kill the deal or seem like you are getting in the way. But a good attorney will look out for your interests in a way that does not hurt the company. The same is true if the company is going to be bought by another company.

But be sure to hire an attorney who is experienced in dealing with entrepreneurs and venture capitalists. Your family attorney or your friend’s divorce attorney will not be able to provide you with the counsel you need. Their poor advice will reflect back on how the VCs perceive you.

I remember reading once that the husband and wife founders of Cisco Systems, Inc. wished they had seen their own attorney before signing the documents presented to them by the venture capitalists. They say that they walked away with only 100 million dollars. (One article says before they left the company, they had also sold shares worth another 100 million dollars for a total profit of 200 million dollars.) That may not seem bad, but it is nothing compared to the billions the venture capitalists made.

Hiring your own attorney does not mean that you are causing trouble. It just means that you are looking after your own interests. I once represented an early founder who was no longer with the company, but still had a less than totally clear legal interest in the company. The company arranged to be bought by a larger company. My client was to receive very little of the sale proceeds. I stepped in on his behalf. But I made it clear that my client was not trying to kill the deal. Nor was he trying to be greedy and force the company to buy him off if they wanted the deal to happen. All he wanted was his fair share. Once the remaining founders understood that, we were able to negotiate an agreement quickly and the sale took place on schedule, and everyone was satisfied.

8. Not facing problem areas up front.

It is human nature to want to avoid conflict. There is the hope that if you delay a problem, it will go away. That does not work. The problem does not go away, it just gets worse. If there is a problem area in your future, try to deal with it now. Don’t kid yourself. The problem will come up, and if it comes up later, your options are more limited, and you are much more likely to be unable to resolve the dispute and end up in litigation, which is something you want to avoid; see #1 above.

Most startups are short on cash and on time. The founders can focus on only so many problem areas at once. Work with an experienced attorney who can help you anticipate problems and will advise you when you should take various legal steps. A good attorney will not tell you what to do–that is your job. Instead, the attorney will give you a risk assessment, tell you what kinds of problems can arise, what will happen if they do, and what you can do to prevent them. Then do not put off dealing with these issues because you think they will not happen or you can deal with them later when they do. Make sure that resolving problem areas sooner rather than later is part of your business strategy.

9. Expecting too much value in return for sweat equity.

Sweat equity is not worth much. Be aware that if you contribute sweat equity to a company, you may never be compensated. In many startups the founders forgo salary during the first year or two. They work hard for the company and expect to be compensated once the company is successful. This hard work is called sweat equity. Usually the salary accrues on the books as company debt. Meanwhile, investors have put up money and taken stock and/or stock options. Don’t expect to get paid for your sweat equity unless the company is really successful. Money always trumps sweat equity. The people who contribute the money will be able to dictate terms and will be sure that they are paid back first, before the founders are compensated for the time they have put into the company. I often see that the founders have not put their employment agreements in writing (see #2 above). Then, when the company folds and everyone is fighting over the assets, or the company is sold and everyone is fighting over the proceeds, the people who have worked hard for the company for a long time find that they are on the short end. No one wants to pay them for their past work.

Sometimes founders will avoid having to borrow money for a while and will build up accrued sweat equity compensation in the form of deferred salary and stock options. But even if you have this value on the company books, do not expect to ever see any of it. As soon as you need to raise money, the new investors will insist on erasing all of the sweat equity debt. They do not want to invest money in a company to pay for past performance. They will only want to invest in the future.

10. Failing to keep current on taxes and wages.

Timely pay the IRS and pay your employees or shut down. It is that simple. If you do not pay the IRS and some of your employees, you will probably end up personally liable for these debts.

Most entrepreneurs are optimists. They have to be to choose to be entrepreneurs. They always think that the company is on the verge of taking off and becoming successful. In many startups money is tight and gets tighter over time. Entrepreneurs have a strong temptation to forgo paying employee payroll taxes, and sometimes arrange not to pay their senior staff at all. They figure that they can make up these company obligations as soon as the product ships and sales take off. Instead they use the money that should have been spent on payroll taxes and employee wages to fund the development and marketing of the product. This is not a good idea.

Generally the company will be held liable for back taxes along with penalties and interest, and will also be liable for back wages. In many states including my home state of Washington, the company is liable for twice the amount of wages and any attorneys’ fees incurred collecting the wages. In many states including my home state of Washington, it is not a valid excuse that the company could not afford to pay the wages. If the company did not have the money to pay the employees, then the company should not have let them work and accrue wages; it should have laid them off instead.

But the real nasty surprise is that under the federal tax law, anyone who has any responsibility for writing checks and paying taxes will be held personally liable for unpaid taxes. In many states (perhaps all of them; I have not checked), these same people are also liable for unpaid wages, plus penalties and interest. I successfully represented two senior employees of a failed dot.com and obtained a large personal judgment against the founders of the company for back wages plus penalties and interest.

It is your responsibility to make sure that you do not ask people to do work that your company can not pay for. If the company does not have the money to pay wages and payroll taxes, then shut down before your employees do the work and you accrue company debt that you can and will be held personally liable for.

 Other Articles on this Subject

Here are two other good top ten lists with a different focus from my list. You may want to check them out too.

Top Ten Legal Mistakes Made by Entrepreneurs by Harvard Business School Professor Constance Bagley

Top Ten Legal Mistakes Made By Entrepreneurs, by J Mathew Lyons, Andrews Kurth, Austin, Texas