When Lawyers Become Venture Capitalists:
How to Structure Investments in Your Clients
J. Christopher Lynch
Partner, Wyrick Robbins Yates & Ponton LLP*
Silicon Valley’s Wilson Sonsini Goodrich & Rosati held stock in 35 companies that the firm shepherded through their IPOs in 1999. The firm’s shares for the top three of those IPOs were valued at over $93 million based on the closing prices of those IPOs on their initial trading days. Debra Baker, Who Wants to Be a Millionaire? 86 A.B.A. J., February 2000, 36. Anecdotal reports from another unnamed Silicon Valley law firm suggest that approximately one half of that firm’s 1999 income was derived from returns on equity investments in clients (effectively a doubling of the firm’s traditional fee-based revenue). One Silicon Valley firm actually has a policy of ceasing to represent its clients after their IPOs – it refers the clients to larger law firms in the area – so that the firm can take on more technology startups in which the firm receives equity. The equity party continued for the first quarter of 2000 before the Nasdaq Stock Market, which is the primary outlet for technology companies going public, suffered massive price drops in April, effectively closing the door on most technology companies’ IPO plans. Nevertheless, the opportunity to increase firm revenue significantly through returns on investments in clients has firmly taken hold of the legal profession’s attention.
Obviously, there are excellent reasons to consider equity investment opportunities in your clients, and not all the reasons are purely financial. However, as with any investment strategy, attorneys exposed to such opportunities need to consider the financial risks of such investments. Perhaps more importantly, the losses or gains from such investments put pressure on a very sensitive point for law firms – their compensation structure. The pressure can be magnified because of concerns about the allocation of (arguably) unearned revenues, unequal access to investment opportunities and the costs of funding the client investments. Other important concerns include a potential shift in allocation of attorney resources toward clients in which the firm has equity, and the need to comply with applicable securities laws in making these investments.
This article will address the issues by reviewing first the primary benefits and objectives to be served by a program involving attorney/law firm investments in clients, then the practical and structural issues faced by any attorney or firm in making such investments, followed by concerns unique to law firms, and finally the securities law compliance issues.
This article will not address to any significant extent the ethical issues under the North Carolina Revised Rules of Professional Conduct, as those issues are beyond the article’s scope. However, attorneys should note that taking equity in clients raises issues under several rules, including Revised Rules of Professional Conduct (1985) 1.5, 1.7 and 1.8, and that the attorney has the duties to ensure the transaction is fair to the client and that the client provides informed, written consent after disclosure of all relevant factors, including the client’s ability to seek separate counsel concerning the equity transaction. For further analysis of the ethical considerations involved, see Formal Opinion 00-418 issued by the ABA Standing Committee on Ethics and Professional Responsibility on July 7, 2000.
Why Take Equity in Clients?
The facts summarized in the first paragraph might make the answer to that question obvious, but a few more facts and observations are relevant. Most startup companies rely for some time on the founders’ personal assets for operations, making it difficult for them to pay for expensive consultants, including legal advisors. It has become common for many types of professional advisors (bookkeepers, business plan writers, employee recruiters and, yes, attorneys) to defer fees during this phase in exchange for equity in the startup. Thus the primary reason for taking equity might be that startup clients want and even expect you to do so. It has become standard practice in Silicon Valley for law firms representing technology-based startups to acquire a small percentage of the initial founders’ equity at little or no cost to the firms, other than deferring fee collection for some time, and the related risk that the deferred fees will result in receivable write-offs.
The opportunity to make direct venture capital investments is another powerful incentive for attorneys to invest in their clients. Many of us have gotten comfortable with routine investments in the public markets, and anyone can establish an online brokerage account to begin investing there. Yet, some of the most explosive growth potential of a company occurs before it becomes public, justifying the existence of the venture capital industry. Because venture capital firms do not accept most investors, investing in your privately held clients may be one of the few ways you can get exposed to the same types of investment opportunities.
Aside from the positive factors, you must recognize the increasingly powerful lure that startup companies have in using their equity to recruit attorneys as in-house counsel. In the accounting industry, this same practice causes horrible turnover problems for the accounting firms. For the law firm, this problem can be reduced by structuring client investments so that associates as well as partners have the opportunity to share in the equity. For the individual attorney or sole practitioner, this "problem" might appear to be an opportunity! However great the opportunity, though, going in-house to receive equity necessarily results in a concentration of financial risk. As we saw in 2000, some "sure thing" opportunities have turned into complete losses. On the other hand, maintaining your legal practice while developing a portfolio of client investments creates the opportunity for significant equity returns with the mutual-fund-like benefit of diversification.
Finally, the client usually perceives an attorney’s investment, or willingness to take equity in lieu of fees, as a validation of the client’s business and an indication of the attorney’s desire to be a part of the "team." This factor helps reinforce a psychological bond that can lead to long and trusting client relationships.
How to Structure Equity Investments in Clients Generally
The Basics. Much of the discussion in this article relates to investment opportunities in technology-based startup companies, often with venture capital investors. Usually, these companies are corporations and, thus, their investors benefit from limited liability under applicable state law. However, attorneys and law firms might be presented with many different types of investment opportunities, including the opportunity to become a "partner" with a client. With the ease of creating limited liability entities under state laws, there is little, or maybe no, reason to invest in a partnership as opposed to investing in a corporation or limited liability company. Some startup companies will fail, and there is no reason for you to put your law practice or firm at risk, too.
Malpractice Insurance Issues. Some malpractice policies deny coverage for legal services performed for clients with which an attorney or law firm has some other business relationship. Presumably, an equity investment in a client would be considered a business relationship for this purpose. Attorneys may be able to avoid this coverage exclusion by forming separate investment partnerships to conduct all investing activities, but each attorney or firm should review its own policy and consult with its insurer for definitive guidance on this point, as policies vary from insurer to insurer, and the insurance markets change rapidly.
Fee Waiver, Fee Deferral or Cash. As noted earlier, many startups favor working with advisors who are willing to defer their fees. You might expect that clients would like it even better if the fees were waived rather than deferred. From the attorney’s perspective, swapping fees for stock generally is a bad idea. The tax code regards the receipt of stock for legal representation (property for services) as creating taxable income, even though the stock is not saleable, so a policy of taking stock for your fees could generate a large tax liability that must be satisfied with other sources of income. If instead you defer fee payment, you will be taxed only when the fees are paid (assuming you are a cash-basis taxpayer). In addition, if you defer fees, you would also be taxed on the value of any equity received from the client, unless you pay fair market value for the equity. The fair market value of the equity generally should be the same as the amounts other owners are paying for equity at the time. In many startups, the amount paid for the founders’ shares may be as little as $.001 per share, so it might be simplest to pay cash for any stock issued to the attorney or firm at that time.
Restrictions Associated with Founders’ Investments. If the attorney or law firm acquires shares at the same time as the founders, it might be appropriate for the shares to have restrictions similar to those that apply to the founders. For example, founders typically enter into shareholders’ agreements with respect to their shares, covering matters such as preemptive rights, co-sale rights and other transferability restrictions. These restrictions usually expire upon a public offering or acquisition of the company. The shares also might be subject to ratable repurchase by the startup if the founder’s or attorney’s services are terminated before some agreed-upon period, typically 3-5 years. This structure is comparable to the vesting structure for most employee stock options.
Founders’ Investments vs. Venture Capital Investments. The scenario described in the preceding two paragraphs outlines an acquisition of stock during the startup phase. But what about opportunities to acquire stock in an established client? Trading stock for legal services usually is not desirable from the attorney’s tax standpoint, for reasons described above. However, investing after-tax dollars in a client might be a great financial opportunity. As a practical matter, the most logical way to make this kind of an investment is when the client is raising funds from other sources, such as venture capital funds. If the attorney’s investment is small in relation to the funds raised generally, then the fairness concerns raised by RPC 1.8 (which imposes a duty on the attorney to see to the fairness of the arrangement) are minimized, especially where one or two major investors structure the investment on an arms’ length basis. In addition, investing at the same time and in the same manner as more professional investors should give the attorney greater comfort that the investment is promising – something that assumes greater importance when investing more cash than in the founders’ investment scenario. The venture capital investment is more purely financially oriented and is less likely to involve restrictions typical of founders’ investments.
Choice of Entity for Separate Investment Partnerships. Where an attorney or firm wishes to create a separate investment entity to make investments in clients, using a partnership or limited liability company as the investment entity usually will be the best choice. Ultimately, as with any investment, you make a client investment in the expectation that it will appreciate in value and generate cash or readily marketable securities that can be distributed to the owner(s) of the investment entity. Distributions of appreciated assets (shares in your client’s company) from a corporation – even an S corporation – will be taxable to the owners upon distribution based on the full amount of the appreciation. While using an S corporation will eliminate the "double taxation" burden associated with distributions from a C corporation, the distribution itself still will trigger a tax liability for the owners. By using a partnership or limited liability company instead, the owners usually may receive a distribution of appreciated assets without immediate taxation (subject to certain limitations under IRC Section 731 in the case of a distribution of publicly traded securities). Of course, a taxable event will occur upon each owner’s sale of the appreciated assets, but at least each owner will have the ability to control his or her own timing of taxation. Attorneys practicing law in the form of a Professional Association (PA) or Professional Corporation (PC) should bear in mind that PAs and PCs are corporations for tax (and other) purposes, so the reasons to form a separate investment partnership may be even more compelling than would otherwise be the case.
Investment Issues Unique to Law Firms
Founders’ Investments vs. Venture Capital Investments. The most striking difference between a founder’s investment in a client and a later, venture-capital investment is that the latter requires the investment of substantial, after-tax dollars, while the former can be viewed as, essentially, "free stock," plus the firm’s express or implied commitment to perform services for a client that may not be able to pay its bills. For reasons described below more fully, the fundamental nature of this difference suggests that the two types of investments be handled by creating two different investment partnerships for firms that make both types of investments.
Determining Who Participates and Allocating Returns. Some firms allow attorneys to make direct investments, others allow investments only by the firm (or a partnership affiliated with the firm), and others permit a combination of both. For venture capital investments, some firms even require that the sponsoring attorney fund a portion of the investment individually, in order to minimize the likelihood that an attorney will encourage the firm to make unwise investments as a way to generate a larger billing book. In a way, the prospect of the potentially huge returns from investments in client equity can be destabilizing to a firm if participation in the opportunity is not handled thoughtfully.
For example, if individual attorneys are allowed to make investments directly, with no firm involvement, and the individuals make millions from such an investment, surely other firm attorneys will resent the outcome. The situation could be viewed as comparable to that of a plaintiff’s attorney winning a large contingent fee case and taking the position that the attorney’s firm should not share in the fee award. Accordingly, firms should consider adopting a policy that all client-related investment opportunities should be offered to the firm at some level. As with other firm compensation issues, however, a firm must be careful not to de-motivate those who generate revenue opportunities. Law firms typically provide greater compensation to attorneys who generate new clients and/or high levels of collections. The same principles probably should be applied to some degree in allocating returns from profitable client investments. Otherwise, attorneys who generate such opportunities will be less motivated to seek them out or, worse, may consider leaving the firm for another firm where such attorneys would receive greater compensation.
Determining the best way to allocate equity returns must be handled on a firm-by-firm basis, taking into account the firm’s existing compensation philosophy. At a high level, though, there are two basic approaches to such allocation decisions. One approach is to wait until the returns are realized and then make subjective decisions about how to allocate the proceeds. The other is to develop a formula for participation that recognizes different attorneys’ contributions to developing and maintaining clients in which the firm has equity: (a) "finders" (originating attorneys); (b) "minders" (attorneys responsible for managing a client’s work); (c) "grinders" (more junior attorneys who bill time to the client); and (d) other firm attorneys. Most firms probably will develop allocation mechanisms that are not at either extreme but reflect a balancing of some predetermined formulas with some room for subjective allocation after the fact. Exhibit A to this article illustrates the model adopted by the author’s law firm for founders’ investments.
One important question is whether to allow participation by anyone other than a firm’s partners. The opportunity to participate in a firm’s equity programs, if reserved solely for partners, could provide a strong incentive for associates to remain with a firm and to become a partner. However, firms increasingly delegate substantial client responsibility to associates and probably will be at greater risk for losing talented associates if the associates cannot participate in equity made available to the firm by clients for whom the associates perform work. Perhaps a harder question is whether to allow nonattorney staff to participate in equity programs. Firms addressing this issue will have to balance the economic issues against the intangible morale benefits of permitting nonattorney staff to participate.
A firm’s decision on participation probably will differ for the two types of investments. With a founders’ investment, the firm has lesser reasons to exclude associates or nonattorney staff because the equity is almost "free." However, venture capital investments require a more or less substantial cash outlay. A firm wishing to allow associates or other to participate in a venture capital investment would either have to collect cash from the other participants or provide the cash as an additional employee benefit. Unlike a Section 401(k) plan contribution, however, a firm’s contribution on behalf of an employee to a firm-sponsored investment partnership would not be tax-deferred to the employee, so the contribution would trigger taxable income to the employee. Given the extreme risk and illiquidity of venture capital investments, and the near-term tax liability, employees may not truly appreciate the value of this type of contribution. Thus, firms engaging in both founders’ investments and venture capital investments should probably establish separate investment partnerships for these two types of activities.
With respect to a firms’ venture capital investment partnerships, some firms require mandatory participation from all eligible participants. In one Silicon Valley firm, the participation levels are mandatory for all partners based on the partners’ proportional cash compensation. The stated justification for this mandatory participation is the concern that the decision by a risk-averse participant to have a low participation would cause significant friction if and when large payouts are distributed to everyone else.
The Power of Client Equity as a Retention Tool. An earlier part of this article referred to the phenomenon of attorneys being recruited by startups with the lure of potentially valuable stock options. The ability of a firm to make investments in clients and then share returns with associates should help reduce the lure of the startups. The retention power will be increased if the nature of partners’ and associates’ participation is communicated in advance, rather than waiting for an investment to mature and then making discretionary allocations. Another option to consider is vesting of associates’ (and partners’) interests in these programs. Briefly, vesting programs attempt to provide greater participation benefits to those who have worked longer at a firm. Firms also should consider whether a participant leaving the firm should be able to take all or any part of his or her interest upon departure. The rule might vary depending on whether the attorney simply retires or leaves to practice with another firm.
Investment Management. In any investment partnership, the investment managers take on the responsibility of deciding when to invest and when to dispose of liquid investments. With respect to investment decisions, firms should recognize that attorneys with day-to-day responsibility for generating new clients and supporting existing clients will face pressures (sometimes self-imposed) to support investments in those clients. With venture capital, cash investments, these decisions should require approval by some other attorneys. Even with fee-deferred, founders’ investments, where no significant cash is required, the firm still is providing credit to a business that probably would not be credit-worthy in other circumstances. Thus, the same process of approval by other attorneys is warranted.
On the happy day when a firm investment becomes liquid, the investment managers must decide how long the firm should continue to hold the investment. This decision may have significant economic consequences to some participants depending on what vesting restrictions the firm has established. For example, if an attorney has announced a plan to leave a firm that requires departing attorneys to forfeit their interests in the investment partnership, what should happen if a firm investment generates a significant return before the attorney leaves? Each firm must decide its own policies on these issues, but the rules should be clearly articulated in advance to avoid disputes later.
Securities Law Issues
In recent years, the Securities and Exchange Commission has begun objecting to private placements where large numbers of attorneys participated through some of the Silicon Valley law firms, on the grounds that some of the participants were not accredited, and no apparent exemption from registration would have been available. The SEC’s objections have been raised during its review of the companies’ initial public offering documents and can result in delay of the public offering effort. These problems can be avoided by proper planning and structuring of law firm investments through investment partnerships that qualify for available registration exemptions, rather than permitting direct attorney ownership of client stock.
Obviously, the attorney must be sure that any investment made by the attorney or law firm does not violate applicable federal and state securities laws. The timing requirements and related costs of securities law registration efforts usually dictate that startup companies conduct their securities offerings pursuant to exemptions from applicable federal and state securities laws. Clearly, then, the attorney or law firm who wishes to participate in such an offering must ensure that the attorney’s or firm’s participation will not preclude reliance upon an exemption that would otherwise be available to the client.
Most startup securities offerings are structured so as to be exempt from federal and state registration requirements under Regulation D promulgated under the Securities Act of 1933, as amended. Generally speaking, Rule 506 under Regulation D permits offerings to an unlimited number of "accredited investors" (Rule 501(a)) provided that the issuer complies with other requirements of the Regulation. In turn, accredited investors include:
(5) Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;
(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year; … and
(8) Any entity in which all of the equity owners are accredited investors.
The bases for qualification as an "accredited investor" identified above would permit a firm’s investment partnership to qualify only if all participants met the relatively high income or assets tests referred to in subsections (5) and (6) of Rule 501(a) under Regulation D. However, depending on the nature of a firm’s work with a client, a firm might be able to qualify as an accredited investor pursuant to subsection (2) of Rule 501(a), which refers to:
(2) Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940[.]
The definition of a "private business development company" is not terribly clear, but it is a definition relied upon by many venture capital partnerships to conclude that they are accredited even if some of their owners are not themselves accredited. This is frequently the case for partnerships composed of "friends and families" of a venture capital fund. Any firm wishing to rely upon this definition to establish that its investment partnership is accredited should consult with experienced securities law counsel to sort through the definitions but, generally, they require that the purported private business development company "provide significant managerial assistance" to portfolio companies and limit investments to smaller, nonpublic companies. See Sections 202(a)(22) of the Investment Advisers Act of 1940, as amended, and Sections 2(a)(46)-(48) of the Investment Company Act of 1940, as amended.
A larger law firm that wishes to establish a separate equity investment partnership might have special structural concerns under the securities laws, in that having 100 or more participants could require the firm investment partnership to comply with Investment Company Act rules. Some law firms already are seeking an exemption from the participant limit, but the SEC has not yet responded publicly. Using the law firm itself as the investment partnership probably would avoid this compliance problem, though.
Attorney investments in clients carry risks but offer the potential for great rewards, including closer ties between attorneys and their clients. The following checklist is intended to help attorneys approach these opportunities with foresight so that the potential risks can be minimized.
1. Develop a form of engagement letter that discloses the nature of the proposed equity arrangement with the client and that otherwise complies with NC RPC 1.7 and 1.8.
2. Obtain clear guidelines from your malpractice insurer concerning any limitations on coverage and consider these limitation in structuring your investment arrangements.
3. Obtain the client’s informed written consent to the representation and the equity arrangement.
4. Invest only in a corporation’s stock or the membership interests of a limited liability company.
5. Develop a policy on whether you will take stock in companies that cannot pay the bills at first and, if so, how: fee deferral, or fee waiver.
6. For venture capital investments, decide how much money to make available per year and what investment sizes are appropriate per client. (Remember, you will be investing after-tax dollars and will need other dollars to pay your taxes.)
7. Make sure your investments will qualify for a Regulation D exemption, preferably because the investor is an "accredited investor" under Regulation D.
8. For law firms:
Sample Memorandum to Firm
M E M O R A N D U M
To: All Attorneys
From: The Partners
Re: New Policies and Benefits Concerning Firm Equity in Clients
As some of you already are aware, the Firm has been seeking opportunities to acquire equity in certain of our clients as part of our representation. There are two primary reasons we have embarked on this course: (a) it strengthens the bond between the Firm and the client, and encourages the client to think of us as key members of their "team," similar to other key employees of the client; and (b) it creates the opportunity for us to benefit financially from the client’s success.
The purpose of this memorandum is to outline the Firm’s recently adopted, standard practices in: (a) undertaking new client representation involving equity; (b) rewarding those who create equity opportunities for the Firm; and (c) sharing the wealth when we are lucky enough to make good choices in this area!
Engagement Letter. Whenever a law firm enters into a business relationship with a client, ethics rules require that the proposal be clearly articulated in advance, and that the client be advised of its right to seek separate counsel on the matter. While it is desirable to use engagement letters even in instances where we do not seek equity, it is mandatory for any client where we will have an equity stake.
Screening by New Business Committee. In order to make the best use of our time and to avoid collecting worthless stock in lieu of cash, all new clients on this program will have to be approved by a New Business Committee. The New Business Committee currently is the same as the managing partners of the [Firm] Founders Fund (_____, _____ and ______). Approval of any two members of the New Business Committee will be sufficient to engage a new client.
Terms of Equity. We generally seek ____% to ____% of a startup’s founder’s equity whenever possible. ____% is more appropriate for a deal that is already funded or that is very near to receiving venture funding; ____% is more appropriate for an entrepreneur with a raw idea and nothing more. Our deal with a new client will be reflected in the engagement letter. Our preferred model calls for us (through an investment vehicle named "[Firm] Founders Fund") to purchase founder’s stock together with the stock purchased by a startup’s founders. Typically these shares would have a nominal purchase price (approximately $100). In some cases, the shares may be subject to ratable repurchase by the startup if our services terminate before some agreed-upon period, typically ____ to ____ years. (This structure often is referred to as "vesting.") For example, if our services terminated 2 years into a 4-year vesting term, the startup would have the right to repurchase ½ of our founder’s shares at a nominal price, even if our services were terminated without cause. This structure is comparable to the vesting structure for most employee stock options.
Benefits to the Client. In return for this stock, the Firm would offer fee deferral, up to a prenegotiated cap of $______, until the startup’s first funding in excess of $_______.
Investment Management. [Firm] Founders Fund shares will be held until converted to cash or readily marketable securities or longer, in the discretion of the managing partners, who currently are ______, ______ and ______. The objective generally would be to release shares upon any liquidity event. However, no attorney would have a vested interest in the shares held by the [Firm] Founders Fund unless and until the managing partners make a decision to distribute the proceeds, even if the partnership assets are already liquid.
Allocation of Proceeds (summarized on Attachment A).
The [Firm] Founders Fund should not be confused with the partners’ annual investment partnership that occasionally makes companion investments alongside investments made by venture capital funds. The partners’ investment partnership is a passive investment fund in which partners make actual cash investments in some companies, usually our clients. Returns on this fund are allocated only among the partners according to their investment amounts.
Model for [Firm] Founders Fund