Inside: Considerations before entering into an equity for professional services agreement (Part 1)

Model Rules to consider when debating whether to enter into this type of contract

America has a rich history of entrepreneurs who have changed the course of history with an invention or new business enterprise. This history continues, as a modern chapter is being written in the new millennium as the information technology boom has created a “start up” hysteria. More and more individuals have taken up the dream of “starting up” their own company.

In fact, it seems like every time that I pick-up a business magazine and flip through it, half of the content pertains to “start ups” or venture capital deals. Which has made me ponder, how are these fledgling, often pre-revenue companies footing their professional service bills? Assuredly, many of these companies require outside regulatory, business formation, and/or tax planning advice. This article considers the ethics of one approach of obtaining these professional services — a professional organization providing services in exchange for equity in the “start up”.

In this type of relationship, early stage businesses that are often cash-strapped are unable to afford necessary quality professional services. The arrangement works like this — a professional service provider swaps their traditional form of billing in exchange for an equity stake in the business venture. In the early 1990s, during the dot.com boom, this type of arrangement was actually quite popular, and a recent resurgence has been occurring. However, the practice is hotly debated.

Great rewards can be reaped from this exchange. For example, while not a professional service story, in 2005, a graffiti artist named David Choe was approached by Facebook to paint murals in the company’s first offices. He was offered $60,000 or the option of an undisclosed amount of stock in the privately held company. He elected to take the stock — a wise investment. Inversely, there are undoubtedly many stories that illustrate the financial risk of these arrangements as well. In terms of risk, financial risk is not the only thing professionals must consider before entering into this type of agreement. In the context of professionals, there must be some ethical considerations before entering into the agreement, or they may risk censure or potential liability. This article will address what businesses should be aware of when approaching a law firm with this type of arrangement.

Law firms

If you are a business and are considering this type of relationship in order to acquire outside legal services, it should be noted that this is an acceptable relationship. In a formal opinion in 2000, the American Bar Association stated that these types of relationships are not prohibited, so long as the attorney abides by the Model Rules of Professional Conduct. However, it then identified several rules which should be considered with caution.

Rules to consider

Rule 1.5(a) – Charging Reasonable Fees Requirement

An attorney is prohibited from entering into an agreement with a client where they are charging or collecting upon an unreasonable fee arrangement. In this circumstance, it is important to have a neutral party evaluate the worth of your business to determine a fair amount of equity interest that should be exchanged for the services a law firm will be providing. If this is not done, there is a possibility the law firm has violated this rule if they obtain an unreasonable amount of equity.

Rule 1.7 & 1.8 – Conflict of Interests

1.7 – Conflicts Between a Client and Attorney’s Personal Interests

A lawyer is not to represent a client if there is a concurrent conflict of interest between the client’s interest and the attorney’s personal interest. This is not an automatic preclusion; an attorney may represent a client if they reasonably believe that they can provide them impartial competent and diligent advice. In this circumstance, a law firm will be triggering this ethical rule, as they will gain a personal financial interest in the client’s business venture.

An additional consideration for a law firm is how this will impact their present and future dealings with other clients. The firm will likely check whether they will run into future conflicts with their clients, as this financial interest will be ongoing. For example, a law firm that represents a particular industry will likely not be as enticed by this opportunity because it may create conflicts with other clients who are competitors to the business that it has just obtained an interest in. This would preclude it from many potential clients, and could also increase the risk of a breach of ethics.

1.8(a) – Business Transactions with a Client

The ABA Model Rules specifically caution attorneys from entering into business transactions with a client in order to obtain an ownership or other pecuniary interest. In order to prevent an ethical breach, the rule sets out how an attorney can avoid misconduct: the transaction must be fair and reasonable to the client, and the terms must be fully disclosed in writing; the client should be advised in writing that they should seek independent legal counsel before entering into the transaction; and the client must give informed consent, memorialized in a writing signed by the client with the essential terms of the transaction.

Rule 2.1 – Candid Independent Advice

It is well-recognized that an attorney has a duty to provide clients candid independent advice. This may be difficult when an attorney also has an interest in the client’s business. The line of reasoning here is that because the attorney is gaining a financial interest in the business, their judgment may be impaired. This is perhaps the most worrisome rule for attorneys who are approached with this type of opportunity.

Final remarks

When lawyers engage in business transactions with clients, there is a well-established presumption of undue influence. If a business and law firm wish to enter into this type of agreement, it is important for the law firm to formally review all of the aforementioned ethical points covered in this article with their client.

Afterwards, the law firm should have the client sign a disclosure statement and conflict-of-interest waiver — moreover, it is advisable to inform the client that they should seek review from a neutral third-party attorney, and this suggestion should be made in writing. If a law firm is not providing you with these items or informing you of these duties, run away: You don’t want to be doing business with them. If an attorney cannot protect themselves from potential exposure to legal liability; assuredly, you likely do not want them advising you in your own legal affairs.

In my next article, I will provide an overview of how other professionals can be exposed to liability when entering into these types of agreements.

Contributing Author

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Jefferey Ogden Katz

Jefferey Ogden Katz is a partner at The Patterson Law Firm, LLC. He is a leading litigation attorney and has handled numerous professional liability cases...

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