While more familiar in states like California, an attorney accepting an equity stake in a client in exchange for legal services rendered is neither new nor necessarily violative of ethics rules. The attorney needs to ensure that fees are reasonable, but there are no restrictions in the ABA Model Rules related to the form of payment.
Let’s survey the landscape and address recent opportunities that expand equity and equity-like investments for compensating legal services providers.
Attorney as Investor
A major question the attorney first must tackle is, what is the motivation for taking equity in lieu of fees? Typically, investors and early employees in a startup take equity or stock options because they intend to put personal and professional effort behind helping the company succeed, thus earning an outsize reward when the company experiences a liquidity event. These high-potential startups are a distinct category of new entity, characterized by an aggressive growth plan, a potential for investment rather than revenue supporting operations, and an expectation of an “exit” for a large sum of money over a relatively short time horizon. If this type of startup is a potential client, it is both more likely and more profitable to consider an equity stake in lieu of fees than most other business types.
If your clientele is more likely to bootstrap, have a slower growth plan, or perhaps continue to own and operate indefinitely the companies you help them form, taking equity makes less financial sense to both the founder and the attorney. There’s both a lower chance of a large upside or exit, and an expectation that revenue will cover expenses in the short term. In this situation, a contingent or deferred fee agreement, which functions more like debt, would probably meet the clients’ early-stage need to have low out-of-pocket expenses while compensating the legal service providers at market rates in the short term, if not right away.
Convertible debt at first blush appears to be an attractive option as well, where the attorney extends credit to a client with a date by which the debt is either repaid with interest, or it converts into equity in the underlying company. An acute problem here is the attorney is forced to choose at a future time, under as-yet-unknown circumstances, whether to cash out, forcing the client to pay, or become an equity stakeholder. If the company is struggling when the note is due to convert, the attorney calling in the debt could severely disadvantage the client. Worse yet, if the attorney lets the note convert, not only does this give the attorney an ownership stake in a failing company, it is essentially a write-off of all the fee for the attorney. This sets the attorney and client up for direct economic conflict and is not recommended. Conversely, if the company is thriving, the attorney faces the dilemma where holding on to equity could result in an outsize or “unreasonable” payment.
Another motivation to consider is taking equity in potential clients while expecting it to be a loss leader a large part of the time. In the startup capital of the world, Silicon Valley, a 2019 report valued the average annual legal services spent by a startup not involved in litigation or large intellectual property matters at $40,000. An attorney may find that helping many promising founders get off the ground for functionally low or no fees is a low-cost way to support the entrepreneurial ecosystem, build brand recognition among a high-potential population, and, perhaps sporadically, enjoy a windfall. But this attorney isn’t taking equity as an investment per se, and isn’t very concerned about the valuation discount rate or cap table. Instead, they are focusing on building a reputation and attracting a volume of a specific type of client. Then, as some of those clients grow and prosper, and still others experience challenges, they have already established a relationship with the attorney and can quickly identify who to turn to for help. To this end, the attorney may take a convertible note or a future interest such as a Simple Agreement for Future Equity (SAFE), but expect to write it off most of the time, foregoing either repayment or equity.
What if an attorney buys equity in a client’s company outright? Suppose the attorney so believes in the business model he or she pays out of pocket to invest in a client, unrelated to the provision of legal services? Depending on the size of the investment, the attorney may create a sticky problem. Perhaps the attorney participates in a Reg CF offering by the client, purchasing a handful of shares as a member of a crowd. The crowd of shareholders don’t have much influence over the business decisions of the company and are usually aggregated supporters of the executive team. Now suppose the attorney becomes a substantial investor with votes and potentially a board seat. At this point, the tension between roles as attorney, with a fiduciary duty to the client, and as shareholder – to whom the executive team bears a duty – becomes a challenge. A prudent attorney may set aside the client relationship at this time and continue on as an investor.
In a thorough analysis, a recent ABA Journal article reminds us “the fundamental issue is whether the stake is sufficient to impair, or to create the appearance that it may impair, the attorney’s exercise of independent judgment on behalf of the client.” For some attorneys, a $15,000 investment is not sufficient to impair their independent judgment, that is, if the client later instructs the attorney to take legal action that could negatively impact the value of the attorney’s investment. In other circumstances, that $15,000 investment would absolutely erode the attorney’s impartiality, and put them in a conflict of interest. These rules are designed to protect clients and enforce the fiduciary duties of members of the bar, but it’s not to say a client cannot take advantage of or put an attorney in an untenable situation.
As an aside, despite being frequent needs of new businesses, patent and trademark prosecution are areas where it is historically unlikely to see equity in lieu of fees or other contingent fee agreements. The outcomes are relatively uncertain and often subject to forces outside either the attorney or client’s control. The duration between the work being performed and the transactions monetizing IP assets can span years and are difficult to predict at the time of the engagement. It is rare to find any patent practitioner who will consider working for equity only, rather than some type of hybrid deferred + contingent compensation or demand full value of services up front.
Another major concern is, to whom does the equity accrue? If to the firm, does the attorney get paid for services performed? If to the attorney, is a portion of the equity owned by the firm as a condition of fee-sharing between employer and employee? When there is a liquidity event, who between the attorney and he firm bears the tax burden? What if the attorney is no longer with the firm at the time of the liquidity event? These are less ethics concern relative to any client and more about general candor, fairness, and professional responsibility between attorneys, but the financial consequences for good or ill are not to be taken lightly.
Attorney as Broker
One area where attorneys can get into hot water without realizing it isn’t with attorney ethics boards, but with the Securities & Exchange Commission. Attorneys who are well-connected with an entrepreneurial ecosystem can often serve as informal business brokers, making introductions to potential investors, acquirers, or service providers that would help the founders grow. Rarely will you see the attorney wear the business-broker hat themselves in a formal sense, and it may be a conflict of interest for them to be compensated a contingent fee tied to their performance in negotiating the sale. ABA Model Rule 1.8(a) warns against entering into any business transaction with a client and requires that the attorney both inform the client they ought to consider consulting an independent attorney and the client waives the conflict in writing. However, when encouraging or support others to invest in a client, the attorney must tread even more lightly. Section 3(a)(4)(A) of the Securities Exchange Act of 1934 generally defines a “broker” broadly as “any person engaged in the business of effecting transactions in securities for the account of others.” This extends to “finders,” “business brokers,” and other individuals or entities that engage in the following activities:
- Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;
- Finding investment banking clients for registered broker-dealers;
- Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;
- Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;
- Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved); and
- persons that act as “placement agents” for private placements of securities.
This means if a person, attorney or otherwise, is not a registered broker-dealer with the SEC and a member of a “self-regulatory organization,” they are not allowed to accept payment for facilitating sales of equity on behalf of their clients. Today, the “finders” can be found to have criminal liability, the companies paying the success fees can be subject to fines, and, worse, court-ordered recission of tainted investments, meaning the company must attempt to pay back the investors.
In 2020, the SEC proposed a Conditional Exemption for Finders Assisting Small Businesses with Capital Raising, which would permit finders who meet certain disclosure requirements and other qualifications to receive “success fees.” This is an area the ABA has actively engaged the SEC for some time, as attorneys for startups are positioned in a unique nexus to be highly useful to clients seeking investment provided the constraints of Rule 1.8 are met.
Non-Attorney as Investor
Those states that permit non-lawyer ownership of law firms (Arizona and Utah, with task forces in place in several other states such as California), stand to bridge an interesting gap.
For years, incubators and accelerators have been a tool for startup founders trying to make “big” companies to access training, mentorship, professional connections, and service providers. The incubator itself typically makes a cash investment for equity in each portfolio company alongside these coaching services, and therefore is motivated to help it succeed. The incubators may have relationships with preferred providers, such a law firms, that offer services at a discounted rate to the portfolio companies, but they are typically independent and paid by the portfolio companies. There are sound business reasons to take on loss-leader type work when a high-growth-potential is at the earliest stages, and a few major firms handle much of this business even as the portfolio companies grow into massive entities that may even go public. The law firms stand to maintain long and profitable relationships if they catch an early-stage company on the upswing.
In some instances, the law firms will accept equity in lieu of payment; however, this brings several challenges. First, per ABA Model Rule 1.5, the fee must be reasonable, by a multifactor analysis. Different states have different refinements on the reasonableness of fees, but the common thread is that it must be pegged both to the time, skill, and labor work performed and the market rate in the locality for similar services. A startup attorney considering accepting equity is faced with the perplexing position of performing relatively low-priced work early on for a client that has a potential for an outsized return.
Assuming an average $10,000 price tag for entity formation and startup services in a major urban market, what amount of equity is fair? A conservative $100,000 valuation for a nascent startup would give the attorney a whopping 10% ownership stake in the client – nearly per se unreasonable for the amount of work performed setting up the entity. Suppose the attorney agrees to a 1% stake, which is taking a 99% pay cut, and further suppose that in a few years, the startup is valued at $1 million and the attorney’s stake is now equal to $10,000 but it isn’t yet liquid. Does the attorney continue to hold the equity, or ask to cash out? This decision itself could compound the looming conflict of interest contemplated in ABA Model Rule 1.8: if the attorney gets out now, their fee is clearly reasonable and they end their business transaction with a current client. However, if the attorney continues to hold the stake, they could stand to make more money if the valuation is higher later; or they could lose it all. At this point, business decisions by the client may directly impact the attorney’s financial interest in the client, potentially coloring the advice the attorney provides, if any. A prudent investor may decide to terminate the attorney-client relationship in lieu of remaining on the cap table as an investor.
Y Combinator, notably, established the SAFE, a standardized convertible note that allows equity investment without locking the company into a valuation too early. This tool is endemic in the angel and early-stage venture capital investment space, because it contains predictable boilerplate and only a few variables related to pricing the investment.
In those states that have recently permitted non-attorney ownership of law firms, what changes? These rule changes are quite new, and Arizona releases quarterly reports of any complaints lodged against licensed alternative business structures (ABSs). As of August 31, 2021, eight entities have been licensed as ABSs, providing largely estate planning and tax services.
Here, there is no clear limitation on a company issuing equity in lieu of fees to a legal services firm owned by non-attorneys. Insofar as attorneys have a fiduciary duty to clients, non-attorney owners of ABSs, as in Arizona, do as well, under the oversight of the State Bar of Arizona. The discipline for a violation of, for example, ABA Model Rule 1.8 as explained above, could extend to the ABS having its license revoked or suspended, a public reprimand or admonition, probation or monetary fines. Likewise, the designated Arizona-admitted ABS Compliance Lawyer could face discipline.
It stands to reason that this highly regulated environment with regular public disclosures adjudicated openly and being the subject of national interest as the first state to attempt such deregulation, may lead to a low rate of ethics rules violations by ABSs. It will be interesting to compare the operational ethics of ABSs compared to established law practices, which may not have contemporary procedures in place to screen for economic conflicts of interest, and are not subject to comparable public disclosures.
The rigorous oversight of ABSs may increase a client’s confidence that these entities are clear on the rules put in place to protect clients. Accordingly, it may be a seamless path, much like an incubator, to have ABSs take equity stakes in clients in exchange for provision of services, potentially companies other than high-potential startups.
A company may sell equity, within SEC regulations, to nearly anyone. A client further retains the option to consent to an economic conflict of interest with its attorney and will do so at its own risk – this arrangement commonly ends uneventfully. If the business is successful, all parties enjoy a windfall, or are at least made whole. If the business is run into the ground, not much is left to fight over. The more likely scenario is that “professional discipline in the context of fee arrangements is very rare, particularly where competent business clients are involved.” The dearth of case law on clients suing their attorneys over improper or improperly waived conflicts of interest resulting from co-investment or equity in lieu of fees may be an indication of attorneys closely hewing to the disclosure and waiver guidance, but more likely an indication of how unlikely it is that the attorney acts contrary to the business judgment of the client, thus creating economic loss worth litigating. The biggest risk may be to the attorney herself, who ultimately does not enjoy a payout, let alone a windfall, due to the high rate of new business failures. According to the Small Business Administration, about 50% of new businesses do not survive past five years of operation.
Attorney as Co-Founder
Last, the thorny issue of the relationship between co-founders and the relationship between an attorney and a client is not addressed by the ABA Model Rules. The common advice to non-attorney founders is it is uneconomical to offer equity to service providers, and it should be preserved for individual contributors who will continue to add value to the startup over time. From the founders’ perspective, it’s better to find ways to pay service providers for limited scope work and save equity allocations or options for longer-term relationships. This advice, however, doesn’t fully capture the issues a founder who is also an attorney may face, nor the synergy possible when a legal services provider is a long-term participant in the startup’s success.
Let’s walk through a few potential pratfalls for an attorney co-founder. Imagine a circumstance where an attorney and a friend want to start a business together. So long as that business is not providing legal services and does not break laws, it has no professional responsibility implications for that attorney. Suppose it is a personal training business – the attorney handles some paperwork and operational “back end,” but mostly her contribution was startup capital for the qualified personal trainer who delivers the services to clients. Years later, the business is thriving, and now the co-founders are preparing to franchise.
As the franchise grows, the co-founding attorney is made full-time GC and draws a salary. Now, as in-house counsel, the company is the attorney’s client. The co-founders argue about franchise fees, and the friend insists on raising the royalties owed from franchisees over the attorney’s objections. Does the attorney now have a conflict of interest? In the attorney’s estimation, the business decision will negatively impact the revenue for the firm and possibly damage the franchise’s reputation, driving down the value of her ownership stake. The Comment for ABA Model Rule 1.13, however, instructs “When constituents of the organization make decisions for it, the decisions ordinarily must be accepted by the lawyer even if their utility or prudence is doubtful. Decisions concerning policy and operations, including ones entailing serious risk, are not as such in the lawyer’s province.” As an owner, the attorney may have some ability to persuade the friend to act otherwise, but as an attorney, she is stuck between executing something against her own perceived self-interest and honoring the client’s request.
If an attorney never takes the role of attorney in their own company, the conflict is avoided. However, as many attorneys who serve on boards of directors well know, it’s challenging to bring their full skills and expertise to bear on business problems without relying on legal advocacy. To fully avoid a conflict as co-founder, the company should consider hiring outside counsel.
The speed and ease with which startups are formed and launched, and money can be moved to support them, makes all the above issues arise faster and with more intensity. Attorneys are competing for clients who expect same-day service and demand full-service business services at a discount. When Wilson Sonsini first disclosed it took equity stakes in its IPO clients in the early 2000s, earning $1 million payouts 35 times over in one year, the time to consummate a financial transaction was days, not minutes; clients rarely attempted to pay with credit cards or any means other than a check or wire transfer; and clients were certainly not broadly savvy about price-shopping for business attorneys on the internet.
Today, not only does business move faster, but it feels more competitive. Law firms are competing against each other as well as legal services providers who unbundle or specialize in low-cost, low-customization services. Startup clients are more educated about the minimum necessary to get started, relying on non-attorney mentors and advisors who have experience with the legal processes necessary to launch a business and aren’t afraid to cut corners. Much critical education about starting businesses that may have once been the purview of a trusted attorney advisor is available free on the internet – often set to music. Novel vehicles for financing businesses, from crowdfunding to peer to peer lending to coin offerings, may appear attractive to both founders and their advisors and service providers. Almost all of them are accessible to motivated founders without an attorney as a gatekeeper. To continuously prove our value to clients, it’s not enough to sound expert and have a pleasantly appointed office. Attorneys may be expected to support startup clients in new and untested ways, but we must always be mindful of the essential fiduciary duty to put our clients’ interests before our own.
While regulatory agencies like the SEC and disciplinary bodies including the ABA and state bars, with notable leaders among Utah and Arizona, strive to update their rules to reflect current technology and client demands, it is incumbent on the attorney to focus on the client-protecting purposes of the ethics rules as they exist today when they stand to profit.
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 Of Counsel to SRD Legal Group, LLC, focusing on intellectual property and regulatory compliance for startups and small businesses.