How Paying Your Lawyer With Equity Works
I get asked a lot about whether I accept equity for legal services,as I’m sure many other startup lawyers do. Many law firms accept equity in addition to or in lieu of cash as payment for their services. In this article, we explore the equity-for-legal-services phenomenon by looking at how it came to be, why it’s used and how it works.
Many of the firms that accept equity would disagree with my statement above that they accept an equity stake in lieu of payment. They would argue that they accept equity as a way to offset risk and not as a form of payment. I’ll let you decide how credible you think this argument is. But how did this argument even come to be?
Equity in lieu of cash was designed and implemented mostly by large firms to attract clients, mostly early stage startups, who couldn’t afford the high hourly rates that these firms charged for their services, services that were mostly intended for Fortune 500 companies who could afford them. In moving upstream to serve the startup market, these large law firms’ high overhead service models didn’t exactly fit with the lean startup movement. So, they came up with this model and started aggressively marketing it as an alternative fee arrangement. While equity for services may have been around a long time, it wasn’t always referred to as an “alternative fee arrangement.” This is pretty much a recent development and is where things stand now — these firms dangle the carrot of decreased initial cash outlay required for a lawyer to do a lot of the company formation and organization work in exchange for taking a small equity stake in the company, most of the time ranging from 2-5%. So far, so good, right?
Lawyers, perhaps as a startup’s most trusted adviser, can’t afford to be in a situation where their advice and integrity is questioned
Here’s an example of how the whole equity in lieu of cash system works that illustrates the pros and cons of this model: You’re planning on launching a new tech company but don’t have the cash to pay to hire a lawyer to help you. Enter a law firm that offers to accept equity to do the work in lieu of cash. This seems reasonable to you, so you go for it. Eighteen months down the line, your company is prospering and you get an offer from Google to buy you out. This means cashing out your company’s shares, a good thing for you, as well as all the shareholders. So, you go to your lawyer and ask him what you should do. Selling means his firm gets paid; standing pat means no pay day now or perhaps ever since these offers don’t come around all the time. So, your lawyer says “sell,” but you’re wondering whether you received the best advice. Did he tell you to sell because it’s best for you and your company or because the firm gets paid? This example illustrates how you arrive at a juncture where you might begin to question your lawyer’s motives. Lawyers, perhaps as a startup’s most trusted adviser, can’t afford to be in a situation where their advice and integrity is questioned and that’s why accepting equity in lieu of cash up front creates an inherent conflict of interest.
There are quite a few firms that accept equity, but they have put in place structures intended to eliminate this ethical dilemma. The question is do they eliminate the lingering suspicions in the back of founders’ minds? Here’s what’s been done: Law firms create separate funds, similar to a venture capital fund, that make these “investments” and hold them separate and apart from the law firm generating operating accounts. These funds are managed by non-lawyers, mostly experienced investment managers, but they ultimately report to the firm’s management who are lawyers (lawyers are not ethically permitted to report to non-lawyers or fee split with non-lawyers). This creates a form of “chinese wall” that permits the fund to manage the investments while permitting the lawyers to manage the clients. At the end of the day though, the firm benefits when the startup in which they hold a stake is sold. What’s an absolute fact in all this is that there is an extra infrastructural layer that costs these firms money to operate, which also pushes up their overhead, which pushes up their hourly rates, which causes a greater need to continue accepting equity. It’s a self-feeding cycle.
The ultimate question to ask in assessing these equity in lieu of cash models, as well as any other alternative fee arrangement model is does it serve the best interests of clients? If the answer to this is no or maybe, equity should not be accepted and should be eliminated altogether. If the answer is yes, then it’s worth exploring. And as you explore keep in mind that granting equity to your startup company’s attorney is a business transaction for which you are entitled to independent and objective legal advice. If you are not advised to seek this independent legal advice, know that you should seriously consider doing so. Don’t be penny wise and pound foolish.
Personally, I do not believe that there is any level of structure that can be put in place to mitigate the suspicions and lingering questions that may arise in agreeing to accept equity. As a lawyer, I have an unequivocal obligation and ethical duty to do what is in the best interest of each and every one of my clients; it is a position of high trust. I don’t take the obligations I have to my clients lightly and I want all my practices, including my billing practices, to reflect this. My integrity is not for sale. So, I refuse to do anything that will bring it or the trust my clients have in me into question. Obviously, accepting equity in lieu of cash works for many lawyers and firms and that’s great. It just doesn’t work for me and hopefully this article highlights some of the reasons why.