In my first installment (Part 1), I raised the topic of how cash-strapped start ups can afford quality professional services. The method I highlighted was providing services to these start ups in exchange for equity. The article then focused specifically on ethical considerations law firms should be aware of before engaging in this practice. This new installment will focus on what other professionals should consider before entering into this type of agreement.
Attorneys are not the only professional group that have imposed safeguards preventing them from consciously or subconsciously being affected by personal conflicts of interest in rendering their professional services to clients. For instance, before an accounting firm enters into this type of agreement, it should be aware of the potential consequences of obtaining equity in a client. The Securities and Exchange Commission (SEC) has imposed stringent regulations on auditors to ensure and enhance the independence of accountants that audit and review financial statements of companies. Specifically, the SEC determined that an accounting firm is not considered independent with respect to an audit client if a former partner, principal, shareholder, or professional employee of an accounting firm has a continuing financial interest in an audit client. As a result, an accounting firm considering this arrangement may be losing potential future work as an external auditor or violating an SEC regulation if the firm is providing external audit services in exchange for equity in one of its clients.
Another factor which should be given consideration is how your company may be affected by the fiduciary duty it will owe the start up after obtaining equity. To illustrate, design, engineering, and computer programmers may give pause before entering into this type of relationship if their professional service overlaps within the confines of the start up’s business practice. By doing so, you may risk breaching your newly minted fiduciary duty with the company as a result of directly competing with it. And even if you terminate your fiduciary relationship with the company, you may still face viable claims of breach afterwards. For example, in Illinois, a person is prohibited from using information gained during a fiduciary relationship for his or her own purposes even after termination.
Furthermore, in this day-and-age, good technical employees are hard to come by. By obtaining an equity stake in the start up, you will likely not be able to “steal” top-quality talent from it. Indeed, there have been several cases where a fiduciary duty prohibited a company from engaging in the practice of raiding employees or potential consumers from a company it held equity in.
Next, structuring the equity deal in itself may provide some potential headaches later on if your company obtains preferential stock or obtains seats on the start up’s board of directors. For example, In re Trados involved a dispute which arose from the sale of an initially venture capital (VC)-funded company. The VC investors received preferred equity in the company with liquidation preferences, along with board representation rights.
Eventually, the VC investors began looking for exit options. To allegedly help facilitate their exit, the Board voted to provide executive management of the company a management incentive plan (MIP), where the executives would receive a portion of the sale of the company, thus providing the executive board an incentive to align their interests in a sale of the company with that of the VC investors. A board-approved merger took place where the company was sold for approximately $60 million in cash and stock. Common stock shareholders received nothing from this sale as a result of the preferred stock liquidation preference held by the VC investors and the MIP. If the MIP had not been put into place, common stock holders would have received $2.1 million from the sale.
In this circumstance, the court determined that while the sale was not the product of a fair process, ultimately the sale price was fair, and therefore determined that the common stockholders could not recover anything from their breach of fiduciary duty claim. In contrast, there have been cases where a majority shareholder has been found in breach of its fiduciary duty as a result of favoring its personal interests. In Efron v. Kalmanovitz, a majority shareholder was held to have breached this duty when it organized a new entity, and sold the corporation’s assets to it on unfair terms to the other shareholders. These examples should serve as a valuable lesson of the additional considerations a company should mull over before agreeing to provide services for equity. It is not as simple of an arrangement as it may appear, and the consequences can span for great lengths of time.