Ethical Issues When Working with Startups

What’s a Startup?

 Everyone has their own definition. Here’s mine.

 All businesses start as a startup.
 But they phase out when:
 >$50MM revenue (12 month, forward run rate);
 >100 employees; or
 >$500MM (on paper or otherwise).
What’s a Startup?
What’s a Startup?
 Startup Mentality

 Lawyers tend to think too much like, well, lawyers.

 Startups don’t really need lawyers.
 Most startups would list legal documents last on the list
of their priorities.
 Startup founders are DIY-ers.
 Startup founders play fast and loose with the rules.
 Startup Mentality

 Cash is king, queen, and the rest of the royal family.

 Lawyers as counselors and connectors.
 Startups want your help to raise money.
 Venture capital industry still relies on lawyers to introduce
founders to investors.
 Startup Mentality

 Entrepreneurs are usually a (toxic) mix of super

cocky and insecure.
 While confident, they usually hear “no” much more than
“yes.”
 They invest in their startup because they think they know
something that everyone else does not.
 Startups and Their Lawyers

 Traditional
 the lone (possibly unsophisticated) founder who turns to
a lawyer to assist in forming a company, protecting
intellectual property and obtaining funding from outside
investors
 Startups and Their Lawyers

 New Normal
 founders (often in groups) utilize form agreements and
software to set up companies and turn to lawyers later in
the process
 companies may obtain funding through crowd funding
websites or angel investors, often without the
involvement of counsel
 Lawyers and Then Some

 As a startup lawyer, you might end up doing quite a

bit of work that is not technically legal, but still adds
value.
 Reviewing pitch decks
 Making introductions
 Experiential advice
 Lawyers as Investors

 Investments of time and energy.

 Deferred fees plus everything you can to keep costs low.
 Some lawyers ask for warrants or options in the company
and my experience is that most startups find that request
flattering.
 If someone wants equity in a startup company, it’s
because they believe in the idea and the team.
Duties, Representation, and
Scope
 Duties as a Lawyer

 A lawyer owes certain duties to a client, including

duties of confidentiality, loyalty, communication,
and competence.
 These duties typically arise at the commencement
of an attorney-client relationship.
 When Representation Begins

 When the circumstances are relatively informal or

the commencement of the relationship is not clearly
defined, it can be difficult to determine exactly
when the representation began.
 The lawyer’s understanding of when that occurred
may be different than the client’s.
 When Representation Begins

 Attorney-client relationship can start well before any agreement is

reached between the attorney and client.
 Attorney-client relationship may be created either through an
express agreement or may be implied by the parties’ conduct:
 whether the attorney volunteered services;
 whether the potential client disclosed confidential information;
 whether the potential client reasonably believed he or she was
consulting the attorney in a professional capacity;
 whether the potential client sought legal advice;
 whether the attorney indicated that he or she was representing the
client; and
 the amount of contact between the two.
 When Representation Begins

 Payment of fees will be a factor supporting the

existence of the relationship, but a fee agreement is
not required to establish an attorney-client
relationship.
 However, a would-be client’s consultation of the
lawyer in a non-legal capacity (such as a consultant)
would not create an attorney-client relationship.
 When Representation Begins

 Discussing legal matters with startup founders or

entrepreneurs in relatively informal settings, including
through online contacts, should use caution.
 While an attorney may provide general information
without creating an attorney-client relationship, an
attorney’s detailed discussion of the legal implications of
a particular person’s (or company’s) situation or options
may be enough to create a relationship, depending on
the facts.
 When Representation Begins

 To minimize that risk, attorneys who provide online

resources such as formation documents or
financing templates should include disclaimers that
make clear that by providing the forms, the
attorney is not intending to create an attorney-
client relationship, is not providing legal advice, that
any use of the forms is at the user’s own risk, and
recommend that the user consult an attorney.
 Representation Scope

 It is ethically permissible for a lawyer to provide a

limited scope of representation.
 Assisting a startup client with intellectual property advice
but not assisting in corporate formation or stock
issuance.
 However, any such limitation on the scope of a
lawyer’s services must be reasonable and must be
clearly spelled out to the client.
 Representation Scope

 Additionally, even in a limited-scope representation,

the attorney has a duty to advise the client of
reasonably apparent legal problems, even if outside
the narrow scope of the services the lawyer has
agreed to provide.
 Startup Representation

 Two founders may want to hire one attorney to form

the corporation, draft a shareholder agreement
between them and review a lease that the corporation
is about to enter into.
 That makes for three clients, each of the founders and
the corporation.
 Even if all interests are aligned at the moment, conflicts
between the parties could arise at any point in time.
 Startup Representation

 Lawyers representing startups need to be very clear

from the outset whom they represent, and to make
expressly clear the client’s identity to those involved
in the matter.
 If the lawyer represents the company, the lawyer’s
duties are owed to the company and not to
individual constituents such as officers or directors.
 Startup Representation

 This concept may not be clear to a founder who

closely identifies with the company, has hired the
lawyer and has been the primary contact with the
lawyer.
 For that reason, lawyers need to make the identity
of the client explicit from the outset, including in the
representation agreement and other initiation
documents.
 Startup Representation

 The lawyer should explain whenever appropriate

that the client is the organization and not the
founders (or anyone else).
 A lawyer has an obligation to explain the identity of
the client when, in dealing with constituents of the
organization, it becomes apparent that the
organization’s interests may become adverse to the
interests of the constituent.
 Startup Representation

 If a lawyer decides to represent more than one client (for example, joint
representation of founders, or a company and its investors), it is very
important that the clients are fully informed of the risks of such joint
representation, and consent to those risks.
 In the formation stage of a startup, the people involved may not
understand that they have at least potentially conflicting interests,
especially when they believe that they have a shared vision for the new
company.
 It is important to make clear to such clients that in fact their interests
potentially conflict, especially with regard to shareholder plans,
allocation of shares and options, and agreements that govern
management and control, and they may want separate legal advice to
best protect their own individual interests.
Equity in a Startup
 Why Take Equity?

 In 1999, the well-known Silicon Valley law firm Wilson Sonsini

Goodrich & Rosati took stock as part of its compensation for legal
services rendered in connection with the initial public offering
transactions of thirty-three of the fifty-three companies that the
firm represented in IPO transactions that year.
 Wilson Sonsini’s holdings in twenty-four of those fifty-three
companies were valued in excess of $1 million each at the close of
the first day of trading.
 This investment practice is not limited to Wilson Sonsini. Indeed,
Wilson Sonsini’s cross-town rival, Cooley LLP, also reportedly
made lavish returns on its equity investments in law firm clients.
 Why Take Equity?

 Bill Fenwick of Fenwick & West, who turned down

shares in Apple Computer's IPO:
 [W]e incorporated Apple Computer and represented them
exclusively for a number of years. At one point, at a very
young point in their development, they wanted us to take
$50,000 off of our fees in stock. And, quite frankly, I had come
from the East and . . . there are a host of problems you've got
to deal with if you're going to do that. Well, that $50,000 that
they wanted us to take in stock was worth $12 million when
they went public, so that is a pretty humbling experience.
 Equity Positions in Startups

 Under certain circumstances, lawyers may have opportunities to invest

in their startup clients.
 For example, lawyers may take a stake in the venture in lieu of their fees,
since the client may be cash-strapped but in need of legal services.
 Similarly, lawyers may take an ownership stake in a patent or other
intellectual property in lieu of fees, a practice expressly allowed under
the newly adopted USPTO rules of professional conduct. See USPTO
Rule 11.108(i), 37 C.F.C. §11.108.
 Some law firms may invest in their clients by purchasing shares or
options on the same terms as other “insider” investors; this may be
done through an investment entity or venture fund formed by the law
firm.
 Equity Positions in Startups

 Investing in clients provides a competitive edge for a law

firm. “From the client’s perspective, the lawyer’s willingness
to invest with entrepreneurs in a startup company frequently
is viewed as a vote of confidence in the enterprise’s
prospects.” (“ABA Formal Opin. 00-418”).
 Further, a law firm’s willingness to invest in an enterprise
may provide an additional boost of capital for the firm (if the
law firm is investing cash as opposed to providing services
in exchange for stock) or as a way to provide legal services
the client could not otherwise afford.
 Equity Positions in Startups

 The most significant ethical concern created by attorneys

investing in clients is the potential conflict between the
lawyer’s financial interest and the client’s interests:
 transactions must be “fair and reasonable to the client,” with the
terms fully disclosed in writing in a manner which the client
reasonably should understand;
 the attorney advise the client of the right to seek the advice of
independent counsel, and give the client a reasonable opportunity
to do so; and
 the client thereafter consent in writing.
 Equity Positions in Startups
 ABA Formal Ethics Opinion 00-418 looked at the ethics of attorneys investing in
clients. The opinion set forth certain conditions that must be satisfied in a stock-
for-fees scenario. The lawyer must:
 explain the transaction so that the client can understand its terms as well as its potential
effect on the lawyer-client relationship;
 describe the scope of services to be performed in exchange for the stock, and must set
forth whether the lawyer may retain the stock if the attorney-client relationship ends before
all the agreed-upon services are performed;
 disclose to the client that conflicts could arise that could affect the lawyer’s exercise of
independent professional judgment, including where the lawyer’s desire to protect the
value of the stock may conflict with the client’s goals;
 inform the client that, because of these conflicts, the client should consult an independent
lawyer concerning whether to enter into the transaction; and
 that should conflicts arise after the stock is issued, that the disclosing lawyer may need to
withdraw.
 Equity Positions in Startups
 The question of the fairness of the transaction is one that requires attention and possible
documentation.
 Under both sets of rules, the fairness of a transaction between a lawyer and a client is
determined as of the time that the transaction was entered into.
 In some cases, it may be hard to value the stock (or other interest) at the time it was exchanged.
 If the value significantly increases over time, the lawyer may have difficulty later proving the
fairness of the deal.
 ABA Opinion 00-418 recommends that the lawyer establish a reasonable fee for her services and
accept stock that at the time of the transaction is worth the reasonable fee. If possible, the stock
should be valued at the amount per share that cash investors agreed to pay about the same
time the stock was issued to the lawyer or law firm. If that is not possible, “the percentage of
stock agreed upon should reflect the value, as perceived by the client and the lawyer at the time
of the transaction, that the legal services will contribute to the potential success of the
enterprise.”
 Equity Positions in Startups

 In certain instances, the required level of disclosure for informed written

consent may differ, depending upon the experience and knowledge of
the client.
 If the law firm pays for stock at the same terms as are offered to other
investors, the fairness of the transaction may be presumed.
Axiomatically, in such instances, since the firm is not exchanging services
for its shares, there is no need to value those services.
 Depending on the type of investment vehicle (a separate venture fund,
for example) the potential conflicts of interest may be muted,
particularly if the investment represents only a small percentage of the
total equity of the company or a small percentage of the lawyer’s or law
firm’s holdings.
 Equity Positions in Startups
 Law firms may further minimize ethical risks by adopting guidelines that, for
example, limit investment in any one client. Other factors such guidelines should
address include:
 whether to allow individual lawyers to invest or whether to limit investments to the firm as a
whole;
 whether the firm should make any investments directly or whether the firm should set up a
separate partnership or other entity (such as a venture fund) to make the investments;
 who should make investment decisions; and
 whether to take investment decisions out of the hands of the lawyers doing the work for the
client. Of course, law firms should also adopt policies that minimize the risk of insider
trading.
 The firm should confirm that its investment will not affect its malpractice
coverage.
 Lastly, the firm should ensure that a sound process is in place to obtain informed
written consent from clients, as applicable.
 Thank You.
Jordan Walbesser, Hodgson Russ LLP
jwalbesser@hogsonruss.com; @jordanwalbesser; 716.848.1663