Cash? Equity? How should a startup pay its attorneys?

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

A reader asks: We’re a bootstrapped startup that’s starting to attract interest from angel investors.  We haven’t incorporated or done anything else from the legal side, but we started interviewing different law firms.  A few of them are offering to defer fees for equity, and we were wondering if that’s common practice and if there are any issues with that.  Any input would be appreciated.

Answer: This question is close to my heart (and wallet) as I’ve thought quite a bit about the compensation issue since launching my own firm a couple of years ago. I should note before progressing, though, that my position is not the norm (particularly in Silicon Valley).

The bottom line is there are only four ways you can compensate your attorneys: cash, credit (aka deferred fees), equity or a combination of the foregoing.  Let’s look at each one in reverse order.

Equity.  I get calls all the time from entrepreneurs asking me to represent them for equity.  The obvious business problem is that I’m a lawyer, not a VC. The less obvious, but more significant problem is that it creates an inherent conflict of interest.  I would be wearing two hats: stockholder and lawyer.

To get around this conflict of interest, many Silicon Valley law firms do two things: They establish separate funds (controlled by the law firms) to hold the equity and they require the startup to execute a waiver (usually as part of the engagement letter), relinquishing any conflict claims and expressly consenting to the law firm’s representation despite the conflict.

Needless to say, these law firms made a fortune in the late 1990’s taking equity stakes in their clients.  It’s a business model that can work, but I don’t think it’s always in the best interest of the clients.

Credit/Deferred Fees.   Some Silicon Valley firms justify their equity stake (usually about 1 percent) in return for deferring fees (usually capped at $15,000-$20,000).  The problem with this is the fee deferral is just that – a deferral.  It simply pushes-off the due date of the invoice until later – generally the closing date of the initial financing.

This, however, creates another inherent conflict of interest: If the financing doesn’t close, the law firm doesn’t get paid.  This is akin to a success fee – and we all know the problems success fees create with middle-market investment bankers.

How hard will the lawyers push with respect to key issues (particularly if it’s a small firm or a solo) if pushing could blow-up the financing?  For example, are the lawyers going to suggest to the startup that they test the market prior to executing the term sheet? Are they going to raise issues such as doing convertible debt in lieu of a preferred stock financing?  Are they going to push back hard if the liquidation preference includes some form of participation?  Are they going to push hard to cut back on any of the protective provisions?

Cash. Obviously, startups are trying to conserve the little cash they generally have.  That being said, cash is king and makes the above issues go away.  I started my career at two major law firms in New York City, and, to my knowledge, none of the big New York firms takes equity stakes in their clients.  This is a Silicon Valley invention.

I think the most important role the startup lawyer plays is to watch his or her client’s back – to protect the client.  Most first-time entrepreneurs cannot appreciate all of the potential legal pitfalls (and potential liability) in connection with launching a venture and executing the business model.  To the extent the relationship between the lawyer and his client is muddied by inherent conflicts, it undermines that role.

In short, any time a service provider is willing to accept something other than cash for services, there’s some sort of trade-off.

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.