In our “Startup Blog” series, How to Select New Counsel and Manage Legal Fees, we have been discussing the early stages of how to hire a lawyer for your startup. You should be aware that there are different payment methods available for legal fees. In this post we are going to focus deeper on deferred payment models.
One startup executive told us his story of shopping for legal counsel. He was so surprised and startled when a law firm offered him deferred billing that he decided to look for a different firm. He questioned the law firm’s motives since his startup was very capable of paying for its legal work. He wondered if the law firm was taking advantage of him and trying to make more money off of his company. Deferred payment models, including deferred billing, are not a deceptive practice and some startups should consider this alternative fee arrangement.
New Markets for Lawyers & Affordable Services for Startups
Deferred payment models provide startups access to legal services when they may not have the capital to afford legal services. Some startups require extensive legal work (such as complex intellectual property issues) before the startup has raised funds or is profitable. Deferred payment models also give lawyers access to a broader base of clients, and allow them to develop relationships with growing companies. There are a few deferred payment models that we will now discuss below.
A deferred billing model provides legal services with payment being deferred until a future date. The date could be a few months, or potentially longer. The fees may also increase or accrue interest as time passes. One advantage of deferred billing is that a startup does not have to give up any equity to a law firm. Also, law firms do not risk offending a startup by trying to gain an equity position.
Revenue Percentage Model
Some startups, such as social media companies, have relatively low costs. Therefore, they may be able to participate in a revenue percentage model and pay a monthly legal fee. Through the use of this model, a law firm will take a fixed percentage of the startup’s monthly revenue until the legal bill is fully paid.
Liquidity Event Model
Some law firms use a liquidity event model with startups. In this model, monthly legal invoices are issued but the startup does not pay legal fees until a liquidity event occurs (such as adequate financing is raised, a grant is secured, a buyout takes place or IPO is finalized). This model allows a startup to not pay legal fees until it has capital. However, this type of model may put pressure on a startup. Some startups have a long term view focused on product development without a big financial payoff in the near future (beyond monthly costs and salary). A liquidity event model may push the startup towards raising or taking money, resulting in a potential loss of strategic and operational control.
Another deferred payment model is an equity position. In this model, the law firm provides legal services in exchange for a percentage ownership of equity in the startup during the early stages of the company. Some startups may see the advantages of this model while others may view it as just “one more hand in their cookie jar” with another party receiving equity in their startup. This model can be especially risky for some law firms since they do not receive any monthly income from the startup and they risk receiving no future payment at all. Generally the equity position can be realized (cashed out) by the law firm during a buyout or IPO.
Venture or Incubator Model
Some startup groups and communities such as incubators, universities, non-profit cooperatives, innovation and technical centers, startup boot camps and accelerators may participate in a deferred payment model where basic legal and business services are freely provided to a group of startups by a law firm. In this model the law firm is able to decide which startups have the best ideas that the law firm wants to support and invest in long term. The selected startups would have to give the law firm an equity position in the startup for continued long term legal services.
Compliance with State and Federal Securities Laws and American Bar Association (ABA) Model Rules
It is important to ensure that any deferred payment model involving equity comply with both state and federal securities laws as well as American Bar Association (ABA) Model Rules. ABA Rules 1.5, 1.7(b) and 1.8(a) generally deal with legal fees being reasonable, fully disclosed in writing to the client in a way that can be understood, and the client being given time to consult with independent counsel on the transaction. There are differing viewpoints on whether taking an equity position in a startup is completely ethical and free from conflict of interest.