01/03/01

Introduction

1. Will the Law Firm Accept Equity? 
2. How Can I Convince the Law Firm to Accept Equity?
3. Should I Pay With Stock or Stock Options?
4. Will the Law Firm Have a Conflict of Interest?
5. Do I Want the Law Firm Exercising Control Over My Business?
6. Is Transferring Equity a Good Business Decision?

Introduction

            The affordability of securing expert advice from professionals, including law firms, has always presented challenges to early-stage enterprises.  The traditional cash-for-services model remains to this day the predominant method of compensating law firms.  Recently, however, entrepreneurs have begun to pay for legal services, either in whole or in part, by transferring equity interests in the new companies to law firms.

            What follows is a checklist of the key issues and questions that an entrepreneur should consider before transferring equity to a law firm as payment for legal services.

1. Will the Law Firm Accept Equity?           

            A logical question to ask a law firm before retaining its services is whether the firm would consider accepting some equity in the enterprise as compensation.  Some law firms will not accept stock as payment for services as a matter of policy, while others may insist on traditional payment for their services but be willing to make a direct investment in the company either through individual partners or via an internal venture fund.  If you receive an affirmative answer, you might also want to ask the law firm how it has structured fee arrangements in the past, and how frequently it has agreed to such alternative fee arrangements.  Each client's arrangement will be structured differently, and no current benchmark exists among the legal industry mandating that a specific percentage of fees should be paid in the form of equity, or in cash.

2. How Can I Convince the Law Firm to Accept Equity?

            Perhaps the most difficult challenge facing any entrepreneur who wishes to pay either all or a portion of his fees in the form of equity, lies in convincing the law firm that the equity transferred has a cash value equivalent to the legal services performed.  Because enterprises at the earliest stages of development face the realistic prospect of eventual failure, it is incumbent upon the entrepreneur to arrive at a fair value for the equity which is being exchanged for services, which is typically supported by the company's business plan or performance to date.

3. Should I Pay With Stock or Stock Options?

            The client must also decide whether to offer actual stock or stock options as payment, a decision that will often have tax implications for the law firm.  As a general matter, taxes are deferred on stock options until the options are exercised, while the receipt of stock requires the recipient to report income immediately.  Additionally, if you offer stock options, the law firm may demand certain terms, such as a required payout if various conditions occur before the law firm exercises its options.

4. Will the Law Firm Have a Conflict of Interest?  

            Entrepreneur clients should also be aware of the potential conflicts of interest that might arise when a law firm becomes an owner of the enterprise.  The law firm's role as objective counselor and advisor to a company can potentially conflict with the law firm's role as a financial stakeholder in the enterprise.  A committee of the American Bar Association takes the position that there is nothing illegal or unethical about law firms accepting equity as payment for legal services rendered.  According to the committee, however, any such transaction between the law firm and the client must be fair and reasonable to the client, the terms of the transaction must be fully disclosed to the client, the client must consent in writing to the arrangement, and the client must be given a reasonable opportunity to seek a second legal opinion on the matter.  The ethical guidelines on this issue are still a bit unclear and few cases exist on this issue which are helpful in structuring the arrangement to avoid conflicts.

5. Do I Want the Law Firm Exercising Control Over My Business?

            Entrepreneurs must also evaluate the implications on management before transferring an ownership interest in the enterprise to a law firm.  Although some entrepreneurs might welcome the prospect of outsiders holding some decision-making power, others might not be comfortable with such an arrangement.  Before agreeing on any fee structure with a law firm that involves the transfer of equity, an entrepreneur should carefully evaluate how the transfer might affect both day-to-day management and the overall business philosophy of the enterprise.  Another difficult example is where a transaction may be pending, such as a round of venture capital financing or an acquisition, where the law firm will be performing legal services but may also be influenced by their own pecuniary interests in the outcome of the transaction.  This cloud on objectivity is not likely to be helpful to the company or its shareholders.

6. Is Transferring Equity a Good Business Decision?  

            Avoiding the payment of cash for legal services might seem quite tempting at first, because it helps preserve needed funds for operations and other purposes.  Entrepreneurs must consider the long-term implications of such a decision, however.  If the transfer of equity to a law firm would mean compromising core principles of the enterprise, or putting at risk the health and potential growth of the company, soul-searching and self-assessment may be in order.  An entrepreneur must look at both the short-term and the long-term consequences before deciding to transfer equity to a law firm.

* Benjamin L. Krein, an Associate with the law firm of McDermott, Will & Emery, made significant contributions to this article.