Introduction

Suppose you are an inventor or a software engineer that has just developed a new product that is certain to appeal to the masses and achieve widespread popularity. You have the ability to generate substantial revenues with the opportunities such a product presents, but you cannot do it on your own. First, you will need capital to get your product off the ground. As they say, you need to spend money to make money, but this becomes a challenge when you have no money to spend. To fix this, you will need investors, likely venture capitalists, to finance your budding operations. However, you may not have the business or legal know-how to engage with such sophisticated financiers without fear of being taken advantage of.

Here is where the lawyers come in—you retain counsel to assist you in negotiating the terms of the prospective investment and to provide any other legal services you might need as you begin your entrepreneurial career. But plugging this hole only reopens another. Namely, if you cannot finance the humble beginnings of your new enterprise on your own, how can you expect to pay for the legal services associated with obtaining such financing? Luckily, your retained counsel offers to arrange an alternative fee structure until your goose lays its golden egg. In particular, your counsel offers to provide legal services not for cash, but instead for an ownership stake in your product. This arrangement benefits both parties: you now have access to the legal services necessary for the foundations and continuing operations of your enterprise, and the lawyers earn a stake in your business with the potential to pay significant dividends down the line—albeit for some risk.

This practice of “equity billing,” in which a law firm provides legal services in exchange for equity in their client’s company, proved to be extremely fruitful for firms located in Silicon Valley in the 1990s.[1] During this period, Silicon Valley firms developed these alternative fee arrangements in response to entrepreneurs in the high-tech industry facing dilemmas similar to the one illustrated above.[2] While potentially advantageous to both the lawyer and their clients, equity billing is an example of an alternative fee arrangement that could give rise to ethical issues and potential liability for lawyers who do not take the proper precautions.[3]

Legal Ethics Implications

Though the Model Rules of Professional Conduct do not prohibit the practice of equity billing outright, there are a number of rules that a lawyer who provides legal services in exchange for an ownership interest in a client must comply with in order to avoid raising ethical concerns.[4] In addition, a lawyer must ensure that they do not breach the fiduciary duties owed to their clients, beyond merely acting in compliance with the Model Rules.[5] Below is a summary of the rules and duties that lawyers must consider when taking an ownership interest in a client, along with guidance from the American Bar Association presenting the best practices to comply with each of these rules.

Model Rule 1.8(a)

Model Rule 1.8(a) governs business transactions in the lawyer/client relationship.[6] Specifically, it prohibits a lawyer from acquiring an ownership interest in a client unless:

(i) [T]he terms by which the lawyer acquires an investment in the client [are] fair and reasonable;

(ii) the terms of the transaction and all potential conflicts of interest [are] disclosed in writing to the client;

(iii) the client has a reasonable opportunity to seek the advice of independent counsel; and

(iv) the client consents to the transaction in writing.[7]

The fairness and reasonableness of the transaction turns to some extent on the satisfaction of Rule 1.5(a), discussed below.[8] The disclosure required by Rule 1.8(a) should be “detailed and comprehensive”[9] such that the lawyer is able “to explain the transaction and its potential effects on the client-lawyer relationship in a way that the client can understand it.”[10] Although actual consultation of independent counsel by a client is not required by Rule 1.8(a),[11] it is “the best protection the lawyer can have that [the arrangement] will actually be enforced.”[12] Only after each of these requirements has been satisfied can a client’s consent to grant the lawyer an ownership interest be enforceable.[13]

Model Rule 1.5(a)

Model Rule 1.5(a) requires that a lawyer’s fee for providing legal services be reasonable.[14] But a “reasonable” fee is more difficult to determine in the exchange of stocks, whose value fluctuates (unlike cash payments). By exchanging stock for legal services, the lawyer and client implicitly agree on the market value of the stock even though that determination may be a difficult one to make, especially if that determination later appears to be unreasonable in light of the client’s success.[15] The lawyer exposes themselves to the risk that the client may sue for return of excessive fees under Rule 1.5(a), or that the terms of the transaction were not fair and reasonable as required by Rule 1.8(a).[16] The lawyer may minimize this risk by first establishing a reasonable fee for their services and then accepting an amount of stock equal to the value of this fee, based on the valuation that other cash investors have assigned the stock around the same time.[17]

Model Rule 1.7

Model Rule 1.7 prohibits a lawyer from representing a client if their representation may be limited or adversely affected by the lawyer’s own personal interests.[18] Although a lawyer’s ownership of a client’s stock will typically be consistent with their legal services to the client, a conflict of interest may still arise in some situations, particularly where the lawyer’s ownership in a client constitutes a significant portion of their personal financial assets.[19] Lawyers should limit their investment in a particular client to a small, non-material portion of their total assets to avoid the appearance of being motivated by self-interest.[20]

Opinions on Equity Billing

The guidance from the ABA concerning compliance with each of the rules carries a cautionary tone directed at lawyers and law firms considering performing legal services for equity-based compensation.[21] However, some proponents argue that the practice of equity billing may actually benefit the lawyer-client relationship.[22]

Donald Langevoort argues that contrary to the tone of ABA guidance, taking an equity stake in a client may evidently bolster a lawyer’s ability to render objective legal services in some respects.[23] While the introduction of financial incentives from a lawyer’s equity stake in a client into the lawyer-client relationship can admittedly compromise the lawyer’s objectivity, this analysis would not be complete without properly considering the other incentives affecting a lawyer’s objectivity in practice.[24] A lawyer’s equity stake in a client could function to mitigate other influences adversely affecting a lawyer’s objectivity in practice.[25] In particular, Langevoort notes that lawyers (as well as other professionals) tend to subconsciously overestimate the value and even necessity of the services provided to their clients.[26] A lawyer’s self-serving inferences will lead them to believe that the services provided are more valuable to their clients than they actually are, causing them to overwork, and thus overbill, to the client’s detriment.[27] However, if the lawyer also has an equity stake in their client, their focus shifts from billing hours to ensuring that their services are adding value to the client.[28] Though the introduction of a financial stake in a client can impair objectivity in theory, it may indeed have the opposite effect when viewed in light of other influences.[29]

Kevin Miller also argues that exchanging equity for legal services aligns the interests of the lawyer and client better than any other fee arrangement.[30] Like Langevoort, Miller argues that lawyers who exchange their legal services for equity will be more focused on adding value to their client’s company.[31] Additionally, Miller illustrates how an ownership interest in a client aligns the interests of the lawyer and their client in the litigation context.[32] Lawyers who litigate claims subject to contingent fees face agency costs, whereby the lawyer is disincentivized from thoroughly pursuing a claim due to the fact that part of the benefit of their efforts will be realized by the client, preventing them from enjoying all of the fruits of their labor.[33] By introducing additional an equity interest in the client, the interest of the lawyer and the client align in pursuing the proper course of action.[34] Suppose a lawyer has a choice to settle a client’s claim or bring it to trial and that the expected recovery at trial is higher for the client than the settlement amount.[35] Although it is in the best interest of the client to bring the claim to trial, the lawyer would prefer to settle if the cost of going to trial is greater than the increase in their expected payout, creating a conflict of interest.[36] However, if the lawyer also owned an equity interest in their client, there would be a stronger incentive for the lawyer to bring the claim to trial if the meritorious litigation were also expected to result in an increase in the client’s stock price.[37] Conversely, if the pursuit of such a claim would result in publicity that would negatively impact the stock price of the client, an ownership interest in the client would incentivize the lawyer to consider what course of action would be in the best interest of the client beyond the context of that particular dispute.[38]

However, Miller also notes that there are some circumstances, such as initial public offerings (IPOs), in which owning an equity interest in a client could drastically motivate a lawyer to act against the interest of the client.[39] In preparation for an IPO, a lawyer with an equity interest in their client may be motivated to engage in some form of nondisclosure or misrepresentation to artificially inflate the value of the client’s business.[40] Once the lawyer has realized a short-term gain from their efforts to increase the stock value, they can exit their ownership position and leave the remaining shareholders to deal with the long-term consequences.[41] Though this type of situation represents a clear conflict of interest between the lawyer and their client, the potential for malpractice or negligence liability may suffice to dissuade lawyers from engaging in such conduct.[42]

Equity Billing in Practice

Though the practice of equity billing is not without controversy, it is obvious that an investment in a client startup could prove to be immensely fruitful for a law firm as the business grows. Though public information regarding how law firms invest in their clients is limited,[43] some reports demonstrate the practices that have been used in the past. One such Silicon Valley law firm that notoriously took equity positions in its startup clients during the 1990s was Venture Law Group (VLG).[44]

As required by the Model Rules of Professional Responsibility, VLG would require their clients sign a “Conflict Waiver and Consent of the Company” statement before taking an equity position in the client.[45] This statement served to satisfy each of the requirements of Rule 1.8(a): it informed the clients of the potential conflicts of the investment, advised them that it may seek the advice of independent counsel, and stated that the client consents to VLG’s ownership in the company while also serving as its legal representative.[46] Additionally, VLG would require the lawyer responsible for bringing in the client to personally invest in a certain portion of the ownership interest offered to VLG, with the remaining partners investing in the balance on a pro rata basis.[47] This requirement served to solidify the foundations of a long-term relationship with the client and also to incentivize partners to thoroughly investigate the investment risk of a prospective client before bringing them in.[48] Interestingly, the ABA advises against allowing individual attorneys to personally invest in their clients, noting that the more an attorney has personally invested in a client, particularly in proportion to their overall wealth, the greater the danger that their objectivity will be impaired.[49]

Regardless of the perceived riskiness of the particular practices used by VLG, their investment in their clients proved to be lucrative. In one instance, VLG turned a profit of about $990,000 following a clients IPO after an initial investment of $15,000 just two years prior.[50] Though the potential upside for an investment into a client’s startup is clear, so is the potential that the client’s enterprise, hence the equity received in exchange for legal services, ultimately becomes worthless.[51]

The exchange of legal services for client equity has apparently quieted down since the startup craze of the 1990s, but the practice of law firms investing into their clients is still alive and well.[52] Though times of economic prosperity typically mitigate the risk of malpractice claims,[53] lawyers and law firms who invest in their clients would be wise to ensure that they are following the best practices so as not to expose themselves to potential liability or undue financial risk.

All in all, the practice of investing in clients presents clear potential for substantial profit and the legal community would be naïve to ignore it, albeit in the face of risk. Lawyers and law firms wishing to make a quick profit from client equity should limit their investments to clients that they truly believe will succeed, particularly with their legal support. Conducting thorough due diligence would be wise in order to avoid investing in clients that may be doomed from the start, as these clients will be the most eager to cling to malpractice claims in the event of their failure.

 

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[1]  Merri A. Baldwin, Put Your Money Where Your Mouth Is: Ethical Guidelines for Lawyers Investing in Clients, Bus. L. News, Summer 2024, at 20.

[2]  Kevin Miller, Lawyers as Venture Capitalists: An Economic Analysis of Law Firms That Invest in Their Clients, 13 Harv. J. L. & Tech. 436, 438 (2000).

[3]  See Anthony E. Davis & Susan J. Lawshe, Investing in Clients the Latest Trend in Conflicts of Interest, American Bar Association, (Mar. 8, 2021), https://www.americanbar.org/groups/professional_responsibility/policy/ethics_2000_commission/bhealey2/ [https://perma.cc/6P8V-3ZZM].

[4]  ABA Comm. on Ethics and Pro., Formal Op. 00-418, 1 (2000) (Acquiring Ownership in a Client in Connection with Performing Legal Services) (hereinafter “ABA Formal Opin. 00-418”).

[5]  Davis, supra note 3.

[6]  Model Code of Prof’l Conduct R. 1.8(a) (2018) [hereinafter Model Rules].

[7]  Davis, supra note 3.

[8]  ABA Formal Opin. 00-418 at 3.

[9]  Davis, supra note 3.

[10]  ABA Formal Opin. 00-418 at 6.

[11]  Id. at 8.

[12]  Davis, supra note 3.

[13]  Id.

[14]  Model Rules R. 1.5(a).

[15]  ABA Formal Opin. 00-418 at 4–5.

[16]  Davis, supra note 3.

[17]  ABA Formal Opin. 00-418 at 5.

[18]  Model Rules R. 1.7.

[19]  ABA Formal Opin. 00-418 at 9–10.

[20]  Davis, supra note 3.

[21]  See generally id.

[22]  See generally Donald C. Langevoort, When Lawyers and Law Firms Invest in Their Corporate Clients’ Stock, 80 Wash. U. L. Q. 569 (2002); Miller, supra note 2.

[23]  Id. at 570.

[24]  Id. at 575.

[25]  Id. at 577.

[26]  Id. at 574.

[27]  Id. at 577.

[28]  Id. at 577.

[29]  Id. at 580.

[30]  Miller, supra note 2, at 463.

[31]  Id. at 457 (noting that law firms with equity stakes in their clients “will have an incentive to do what is in the best interest of the client, at least in terms of maximizing the client’s stock value”).

[32]  Id. at 458.

[33]  Id. at 461, (quoting Richard A. Posner, Economic Analysis of Law § 21.9, 625 (5^th ed. 1998)).

[34]  Id. at 461.

[35]  Id. at 461.

[36]  Id. at 461–62.

[37]  Id. at 462.

[38]  Id. at 462.

[39]  Id. at 453.

[40]  Id. at 453.

[41]  Id. at 453.

[42]  Id. at 457.

[43]  Id. at 439 n. 3.

[44]  Id. at 440. Because Venture Law Group later merged with Heller Ehrman White & McAuliffe in 2003, see John Cook, Venture Law Group agrees to merger, Seattle Post-Intelligencer, (Sept. 2, 2003), https://www.seattlepi.com/business/article/venture-law-group-agrees-to-merger-1123185.php [https://perma.cc/JQB9-Q77L], information about the long-term sustainability of its equity billing practice is limited.

[45]  Id. at 441.

[46]  Id.

[47]  Id. at 440 (quoting D.M. Osborne, When is a Law Firm Not a Law Firm?, Inc., May 1998, at 87.).

[48]  Id.

[49]  Davis, supra note 3.

[50]  Miller, supra note 2, at 441. VLG also owned 100,000 shares of its client, Yahoo!, Inc., at the time of its IPO in 1996, which was one of the most sought-after public offerings to date. Id. at 442.

[51]  Id.

[52]  Baldwin, supra note 1, at 20 (noting that “[t]wo decades on, lawyers and law firms continue to invest in clients”).

[53]  Davis, supra note 3.