Businesses raise capital in a few general ways: selling shares of their company (equity), retaining earnings, and taking on debt. A publicly traded company must comply with strict disclosures to the public and comply with other SEC regulations. Many companies want to avoid the costs and exposure of disclosing detailed financials and sell equity in private placements restricted to a smaller pool of potential investors who meet specific income and net worth requirements (accredited investors).
Crowdfunding is a way for businesses to raise operating capital in small increments from many people, normally not restricted to accredited investors. This means of raising capital has increased dramatically since the promulgation and revision of Regulation Crowdfunding (Reg CF) starting in 2012. To raise Reg CF money, a company lists promotional information on one of the more than 70 FINRA-regulated online portals, which verify the company’s and potential investors’ information, and handle executing the investment transaction and recordkeeping. In 2020 alone, over 1,000 companies raised nearly $525 million, a 91% increase over 2019. There iaboves no minimum to raise through a Reg CF offering, and the average raise per company has been $275,000.
Different types of businesses, from e-commerce to venture capital funds, have used crowdfunding to share ownership with many minority investors. In addition to allowing small businesses to raise up to $5 million in capital with lower costs and disclosure burdens, crowdfunding permits anyone to invest in private companies. The most enthusiastic investors are typically customers or those with a strong conviction the founders will be successful. By sharing ownership with members of a supportive community, a crowdfunded business can share profits or dividends with shareholders.
Unlike most businesses, most states regulate who can own a law firm, and often require that they be specific entities like a PC or PLLC. Historically, all states save the District of Columbia have prohibited nonlawyers from having ownership stakes in law firms. The idea is that a law firm ought to be bound to the same fiduciary duties that bind each individual attorney. The reason for this limitation is that the state bar has no power to discipline nonlawyers if they harm clients, and they fear that profit motive untethered to a fiduciary duty could undermine zealous advocacy of clients.
This leaves law firms fewer options to raise capital. Many law firms use debt to finance operations, litigation, or other business needs. However, because a law firm’s biggest asset is typically intangible and contingent, namely, future earnings on matters it may not win nor be paid for, traditional financing can be a challenge. Litigation financing is often limited to a single specific case, such as a large class action against a major company with a strong probability of collecting substantial fees. This type of loan would not work for renovating an office or hiring more marketing staff to promote the attorneys’ services.
Utah and Arizona recently diverged from the ABA Model Rule 5.4, which prohibits sharing legal fees with nonlawyers under most circumstances. California, Florida, and North Carolina have also formed task forces to evaluate whether the restriction on ownership and fee-sharing can be removed or revised.
Beyond the state prohibitions on fee-splitting with nonlawyers, nothing in the federal regulations prevents a U.S.-incorporated law firm from offering securities under Reg CF. For a law firm seeking to raise more than $5 million, Reg A is the appropriate exemption to consider; above $20 million, Reg A+ is suitable. Both of these operate similarly to a very small IPO and are not restricted to FINRA-regulated online portals. A profitable law firm can be an investment vehicle for shrewd investors, and new types of ownership and services offerings will quickly appear in those states now permitting them.
A likely first foray will be combining professional services, such as collocating accounting and legal services or combining medical evaluations with personal injury case evaluations in a single business entity. The initial nonlawyer investors in standalone law firms are likely to be similar to angel investors and venture capitalists, looking for outsized near-term returns. An investor of this type will be attracted to either high-volume litigation practices or boutiques that specialize in high-value claims, expecting to reap outsized returns on attorney fee awards. Another path is private equity investment, where nonlawyer investors provide capital and advice to jumpstart a law firm expansion and share in the resulting profits. A simpler model would be dividend-driven, where a nonlawyer investor would get a portion of firm profits.
Crowdfunding a business can also create social impact customized to the community. In states that permit nonlawyer ownership, crowdfunded law firms can also share profits with shareholders. Spreading the risk of operating a law firm in a lower-income community could increase access to justice in underserved communities. A law firm could crowdfund operational costs that permit attorneys to deliver services without charging clients, much like pro bono services work now. Or, communities could support operations of a law firm satellite office in a remote area that may not otherwise attract attorneys.
Many potential benefits could come from a law firm that is partially owned by the community. Programs such as legal aid offices and public defenders are either government services or charities, vital services that are supported by taxes or donations. However, many clients who don’t qualify for legal aid find their civil claims too small to be attractive to law firms that accept contingent fees. A crowdfunded “midsized claims” practice could help community members assert their rights when there isn’t a headline-grabbing case alongside.
Beyond criminal defense and civil torts, this could also support community artists or entrepreneurs. Creators and founders can get basic help from a nonprofit or a few pro bono hours from an expert, but they may be priced out of appropriate levels of support for breakout success. A law firm could offer a crowdfunded department where services are subsidized by crowdfunding. If the art, music, or startup becomes successful, the crowdfunded department has a great client, and the community gets a “win.” Promoting these themes on a platform can also attract social impact investors from far afield. This could entice skilled attorneys to serve historically underserved areas, while keeping rates accessible and give underrepresented creators their best chance at success.
These ideas will be tested in the states currently loosening the restrictions on law firm ownership. Effective January 2021, Arizona repealed the ban on nonlawyer law firm ownership. Arizona is boldly asking legal innovators to try new ideas—not merely a test-drive or evaluative sandbox, but as a full commitment to the theory that a more competitive market brings better prices and solutions for consumers. As of May 2021, three entities had registered as “Alternative Business Structures,” or law firms with nonlawyer ownership interests.
Arizona needs to increase access to legal services for its residents. Arizona ranks second-to-last in actively licensed lawyers per capita, with about half the number of attorneys by population (24 per 10,000) as the national average (40 per 10,000). The acute need for innovative legal services makes this a prime target for a Reg CF offering by a law firm.
Likewise, Utah has less than half the population of Arizona, and around 8,000 lawyers. The 2019 Report and Recommendations from the Utah Bar Association’s Work Group on Regulatory Reform details the access to justice gap in lower-income communities. Effective August 2020 through August 2027, the Utah Supreme Court Office of Legal Services Innovation created a “regulatory sandbox,” soliciting alternative delivery systems and ownership structures for law firms. In its first seven months of operation, the Utah Supreme Court has authorized no less than 28 entities with varying degrees of nonlawyer ownership or fee sharing to operate in the sandbox. The Office of Legal Services Innovation monitors each of these entities and reviews consumer complaints when they arise. The rush to bring in nonlawyer-owned legal services business to Utah is promising – will the first crowdfunded law firm appear here?
Conversely, California has over 12.6% of currently licensed attorneys in the United States. A primary recommendation from the state bar’s 2020 Task Force on Access Through Innovation of Legal Services Final Report is to modify the Rule 5.4 prohibition on fee-sharing with nonlawyers to include nonprofit organizations. The task force went so far as to declare: “Rule 5.4 has been identified as a significant inhibitor of innovation that could be provided by nonlawyer entities, including individuals, organizations, and technologies,” and urged further study into a “regulatory sandbox” much like that underway in Utah. If California permits nonlawyer firm ownership, it would be an attractive target for investors.
Crowdfunded law firms will look different in different markets. Some may focus on social enterprises, underwriting part of the operational cost of low-cost legal services in areas of great need, out of a sense of “double bottom line” investment. Better access to justice helps us all, even if it’s not profitable. Crowdfunding would give members of the community ownership of a service they may someday need, bridging the gap between those who need legal representation and those who desire to provide legal services, but cannot afford to work for free.
Will equity investment in law firm drive prices down, increasing access to legal services for more consumers? Arizona and Utah support nonlawyer ownership. Let’s see who will share the dividends.
About the Author
Elana Bertram is an assistant professor for Hawai’i Pacific University College of Business, teaching business ethics, corporate finance, and international strategic management. She is also a partner at Parlatore Law Group LLP, focusing on intellectual property and regulatory compliance for startups and small businesses.