GPSolo Magazine - April/May 2004
A Piece of the Action:
The Promises and Perils of Taking an Interest in a Client’s Company
A potential client walks in your door with what she says is a great idea for a new product. You interview her and are impressed: She has done her marketing research, has a business plan, and has scraped together enough money to get production rolling on her widget, along with reasonable reserves for marketing and distribution.
Her only problem is that she doesn’t have enough left over to pay a lawyer for the services she knows she needs. She is interested in a long-term relationship with a lawyer and is wondering if you would be willing to represent her in exchange for an interest in her company.
If the potential client is another Martha Stewart (at least pre-indictment), an interest in the client’s business could prove extremely valuable. On the other hand, there is no question that such a transaction is doing business with a client, not only requiring a full disclosure that is difficult to draft, but also effectively making you a business partner of the client. So what do you do?
Lawyers contemplating an investment in a client’s business should approach the problem in two steps. First, the lawyer needs to address the wisdom of the investment as a part of the lawyer’s investment portfolio, which in turn depends on the lawyer’s attitudes toward risk. Only if the investment falls within the parameters of the lawyer’s investment profile should the lawyer consider whether the investment can be done ethically. Of the two, the first question is the hardest to answer.
Is the Investment Appropriate for the Lawyer?
Make no mistake: Taking a piece of the action in lieu of a fee is an investment. Moreover, it’s not a liquid investment like certificates of deposit or T-bills that can easily be converted to cash. At this stage of your career, you may not be ready to make such a long-term investment. Whether you are depends on your answers to the following questions:
• Do you know enough about the client’s business to assess the risks of your investment? If you aren’t reasonably expert in the industry, you are taking a big and stupid risk with little chance of an upside result. (See the sidebar below for a comparison of how large firms decide on taking an equity interest in lieu of a fee and note how you compare to them.)
• Can you survive without the billable time spent on the client’s matter to meet your present expenses? The only people who make money in investments are ones who can stay the course. If you need to be working every hour for every penny you can bring in, investing in the client’s business instead of getting an hourly fee is a sure-fire recipe for financial disaster . . . for you. Businesses take time to grow. If you need cash now, you have an immediate and obvious conflict. Stick to matters that will provide you with the cash you need.
• Can you afford to lose everything you’ve put into the investment? To answer this question, you first must determine what the probable time commitment is. If this client will take half of your time for the next eight months, will you have enough to make your payroll and rent? Can you afford to write off a third of your year’s potential billings if the business is unsuccessful? Unless you can, you shouldn’t be making the investment.
• Can you shrug off the thought that you might never see a dime from the client? This question measures your attitude toward risk. Some people love to gamble; others prefer only sure things. Investing with a client is at best a gamble. Some people don’t mind it if the return is great enough. If you can’t afford to lose your investment, stick to cases that pay cash and make your investments in government securities.
• Can you stand being in partnership with your client? Even though you are going to be acting as the client’s lawyer, you are effectively becoming a partner with the client in his business, even if your share is small. If the client shows any signs of being a difficult client or abusive manager, you need to factor that into your analysis of whether this investment is something you can tolerate.
Unless your answer to each of these five questions is an unequivocal “yes,” you have no business making an investment with your client. If a lawyer is worried about his or her investment, there is already the prospect of an actual conflict of interest. The real concern is to avoid any distraction to the lawyer in rendering legal services to the client. Only if the lawyer is comfortable with the risks can the potential conflict between client and investing lawyer be minimized.
Ethical Considerations of the Deal
If you determine that you can risk making an investment with your client, you have to ensure that the transaction complies in substance and form with the ethical requirements of your jurisdiction.
All states have some restrictions on lawyers investing in their clients’ businesses. Most follow Rule 1.8(a) of the ABA’s Model Rules of Professional Conduct in one form or another:
Model Rule 1.8(a): A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest adverse to a client unless: (1) The transaction and terms on which the lawyer acquires the interest are fair and reasonable to the client and are fully disclosed and transmitted in writing to the client in a manner which can be reasonably understood by the client; (2) The client is given a reasonable opportunity to seek the advice of independent counsel in the transaction; and (3) The client consents in writing thereto.
We will use Model Rule 1.8(a) in this article, but you should check your local ethics rules since there is considerable variation among American jurisdictions.
Model Rule 1.8(a) has substantive and procedural elements. The procedural elements are easy to meet. You must make appropriate disclosures about the risk in writing. The client must have a reasonable opportunity to review the risks and seek independent counsel. Finally, the client must consent in writing after written disclosure is made. You must comply with each of these requirements. Making a disclosure orally doesn’t cut it. Getting the client’s OK over the telephone doesn’t comply. The disclosures and the client consent must be written. This is the easy part to comply with; don’t try to cut corners, as there’s no saving argument if you do.
The real problems in making the disclosure are substantive. Regardless of the form of the disclosure, the transactions and terms must be “fair and reasonable” to the client. Furthermore, these terms must be fully disclosed (i.e., you need to tell the client of all the things that can go wrong). Neither of these substantive issues is easy to analyze or communicate to a client.
Fair and reasonable terms. The drafters of the Model Rules believed that “fair and reasonable” is an obvious, objective standard. Whether this is a correct conclusion is a matter of some debate. Rule 1.8 doesn’t define “fair and reasonable”; for guidance, you need to refer to Rule 1.5 to determine the factors that make a fee “fair and reasonable”:
• The time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly;
• The likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer;
• The fee customarily charged in the locality for similar legal services;
• The amount involved and the results obtained;
• The time limitations imposed by the client or by the circumstances;
• The nature and length of the professional relationship with the client;
• The experience, reputation, and ability of the lawyer and lawyers performing the services; and
• Whether the fee is fixed or contingent.
Determining whether the transaction is “fair and reasonable” is thus not easy to do and will vary widely depending on the circumstances. (This is yet another reason that you really have to know the industry your client is working in.)
Full disclosure. The second substantive part of Rule 1.8(a) requires that the transaction and its terms be “fully disclosed” to the client in writing. In practice, this means disclosure of everything that possibly could go wrong in the transaction. Most lawyers have at one time or another drafted a waiver of potential conflicts between multiple clients who want the lawyer to represent them simultaneously. Those disclosures are difficult to make effectively, but they are simple in comparison to the disclosures you have to make to the client if you are taking a piece of the action. If you aren’t spending the better part of a day describing the long list of horribles that could happen, you probably aren’t taking enough time to analyze and document the potential problems.
Even if you’ve drafted a brilliant disclosure letter that fully complies with Rule 1.8(a) and the client signs off on it, you’re not yet out of the woods. Your agreement may comply with all the ethical requirements and still run afoul of the substantive corporate law of your jurisdiction. For example, many states do not consider a promise for future services to be adequate consideration for shares in a corporation. If your state has such a requirement, the fact that you have drafted the perfect disclosure letter to the client will not help you if you have not provided adequate consideration under state law. If you ignore the substantive corporate law, you will not have ethical or malpractice problems, but your agreement to take stock in exchange for services may not be enforceable or may be subject to rescission.
Conclusion: To Take or Not to Take?
Determining whether to take a piece of the action of a client’s business is not an easy question to answer. The lawyer is effectively being asked to waive the fee in lieu of obtaining an ownership interest in an ongoing business and will probably not be able to see much of a return on that investment for some time. Only the lawyer who can afford long-term deferral of income and who can tolerate the prospect of significant risk should consider taking an ownership interest in the client’s business.
Even for such unusual lawyers, the disclosure requirements are complex. The rules are easy to state but difficult to apply, and the lawyer should anticipate being second-guessed, particularly if the investment is unusually successful.
Finally, any transaction between a client and a lawyer will raise red flags. Any investment with a client will receive the closest of scrutiny, and a lawyer acquiring an interest in the client’s business must show full compliance with Rule 1.8(a) and Rule 1.5(a). This is not a game for the faint of heart or the sloppy. To avoid malpractice and ethical problems, you must understand the long-term nature of the investment and make all the required (and difficult) disclosures.
Joseph M. Hartley is a trial lawyer in Santa Monica, California, specializing in legal malpractice cases. He can be reached at email@example.com.
How the Big Firms Do It
Some large law firms have made fortunes by taking stock in exchange for services, particularly in the high-tech industry. They bring to the investment several features unmatched and unmatchable by small firms.
Typically, large firms that will take a piece of the action in exchange for fees have a specialized committee to determine whether the firm is willing to take a chance on a start-up. Although the committee will not be limited to persons familiar with the industry, the committee will draw upon the expertise and knowledge of other members of the firm who know the industry intimately. They rarely take more than 5 percent of the outstanding shares in a company, and the committee usually has an exit strategy to dispose of the shares based on established, written guidelines. They also try, to the extent possible, to keep a diversified portfolio to minimize risk.
This is a more institutional approach than a sole or small-firm practitioner is likely to have, but it has a number of advantages. The shares benefit the firm as a whole, not just the lawyer or lawyers who are working on the client’s business. If the client’s business succeeds, there is less of a sense of a windfall. If the firm instead decides to sell the interest, it is done pursuant to well-established guidelines that can be explained to the client. Indeed, the lawyers working on the client’s business can truthfully say that the decision to sell the interest is simply not in their hands. Thus, the possibility for client displeasure is to some extent mitigated, and it certainly cannot be focused on the lawyers who are actually performing the work for the client.
Consider the industries where lawyers taking a piece of the action have statistically proved profitable. The most common are in high-tech start-ups, sometimes in patents, and with entertainment clients.
These areas are characterized in large part by industries where the product is largely intangible: patents, intellectual property, or reputation. Law firms making such investments typically have a large portfolio of similar ventures and can average out the risk. They do not need the investment to produce the money for this month’s office rent, staff salaries, and partner draws.
Does this describe your firm and the industry in which your client is operating? If your client has in fact invented a better mousetrap, the world just might beat a path to her door. But if your client is opening a restaurant (90 percent of which fail within the first year) or a local grocery store (with profit margins of less than 1 percent of sales), the prospects for your investment becoming a major source of income for your retirement are not good.
Even a bad prospect doesn’t mean you shouldn’t take on a matter. The key to successful representation of any client is to make sure that any pro bono you do for a deserving client is planned, not forced upon you by a downturn in the client’s fortunes.
Diminished Expectations Are Not All Bad
Most law firms you read about in the Wall Street Journal that become rich by taking interests in client businesses are big players themselves. They often have access to venture capital or other resources that makes entrepreneurs willing to give up some ownership interest in order to tap the law firm’s contacts and resources.
Most clients who are likely to offer you a piece of their action will not be in that league. This is not to say that taking an ownership interest in their business may not be profitable in the long run or that it should not be done. Just don’t expect most clients to be able to make you rich beyond your dreams.
A Contingency Fee or a Piece of the Action?
What is a contingency fee, after all? It is a fee that is paid only in the event that a contingency happens. In litigation, the contingency is easy to predict: the case is either won or settled. Drafting contingency fees in a non-litigation context is less common but often is easier and less risky than taking a piece of the action.
To have a contingency fee that works, you therefore need to have a contingency that will bring something of value to the company. Not all start-up companies have such a prospect, and for them the choice may be taking them as a client and accepting a piece of the action as a deferred fee, or declining representation. But if a client is likely to be coming into significant money, the lawyer and the client may be better served by structuring the fee agreement as a contingency fee, particularly if the lawyer’s services are related to realizing the contingency. Remember, however, that the fee still has to be reasonable using the criteria of Rule 1.5(a).