The Truth About Deferred Fees

I thought I'd share this great research piece by our new Head of Content, Courtney Cregan, posted on the UpCounsel blog this week.

Since the end of the “Great Recession,” tech-focused law firms have offered deferred fee billing arrangements to cash-strapped founders with increasing frequency.

In these arrangements, startups receive monthly bills but aren’t responsible for paying those bills until they receive money from a venture capitalist or private equity firm.

Traditionally, attorneys have sold this to founders as a way for them to allocate what little cash they have to growing their business instead of paying for legal fees.

In this symbiotic relationship, the bigger startups grow, the more law firms benefit – or so the pitch goes.

But, startup founders, beware: If this sounds too good to be true, it’s because it is.

Big Law Wins in Deferred Fee Arrangements

You have to consider that, by entering into a deferred fee arrangement, you could be putting unnecessary restrictions on – or even handicapping – the process of scaling your business. 

Here’s 10 reasons why you should take a closer look at these alternative billing arrangements:

1.) The legal advice you receive is biased. The question you really have to ask yourself (and one that we’ve asked many executives of small and large companies alike): Can you really trust legal advice to be unbiased when it comes from a party that stands to benefit from situations that aren’t beneficial to your business?

Law firms will tell you that this means that your interests are aligned, but your firm stands to make the most profit if you raise money quickly.

You have entered into a business transaction with your attorneys where the attorneys are now investors in your business.

Your attorneys may push you toward decisions that benefit shareholders like them – such as supporting an acquisition or sale – in order to get a bigger and/ or quicker payout.

“A lawyer’s legal skill and training, together with the relationship of trust and confidence between lawyer and client, create the possibility of overreaching when the lawyer participates in a business, property or financial transaction with a client, for example, a loan or sales transaction or a lawyer investment on behalf of a client.”
– ABA Model Rules for Professional Conduct

Take a hard look at these two questions from Professor Robert Peroni – who is Texas Law’s Centennial Chair for Faculty Excellence and has served as a visiting professor at NYU, UPenn, Georgetown and Northwestern University – and ask yourself if risking your business to defer legal fees is really worth it.

• How can lawyers exercise independent professional judgment and offer unbiased legal advice to their clients if they have an ownership interest at stake in the venture?  
• How can lawyers fulfill their function as gatekeepers of the securities laws if their personal equity interests in the venture will be injured by disclosure of negative information concerning the client? 

 Academics, the ABA and several attorneys alike have spoken out against deferred fees as undermining the ethical obligations of attorneys.

Law firms by nature are businesses, and as such, are accountable to a broad network of partners (AKA stakeholders). In other words, law firms care about making money. Do you really think a law firm with 100 to 1,000 partners cares about your business as much as they claim and are really looking out for your best interests instead of their own?

By entering into a deferred fee arrangement, you could be putting unnecessary restrictions on (or even handicapping) the process of scaling your business. 

2.) You may not get the quality of legal services you think you’re getting by going to a brand-name firm. Perhaps counterintuitively, the truth is that, if you decide to use a big, brand-name law firm, you may in fact be receiving lower quality legal services.

Here’s why:

• Billing rates for associates are much lower than those of partners, so in deferred fees arrangements, law firms typically rely heavily on associates so that partner time can be spent on legal services where payment is immediate. But law firms sometimes still charge for partner time.
• At Big Law, attorneys’ time is literally money and partners’ time will bring in the highest financial returns. Associates with the lowest billing rates are often fresh out of law school, so the quality of work you’ll receive is much lower. Take, for example, the account of a CEO at a mid-sized startup, who told us that he works with a well-known, tech-focused law firm. The work he receives from that law firm, he says, is often riddled with errors that he could catch – even though he’s not an attorney.
• Law firms typically put less effort into completing deferred fee work because there isn’t a guarantee they’ll get paid.

The alternative? Instead, you can find a freelance attorney, who has similar if not more experience than the one you’re paying top dollar for, and one who could potentially provide you with more attention, and higher quality legal services – at a better rate.

3.) Big Law slows startup growth. AdvanceLaw conducted a survey of 88 general counsel from large companies, including Lenovo, Shell, Google, NIKE, Walgreens, eBay, Panasonic, Nestle, Progressive, Starwood, Intel and Deutsche Bank.

More than half of general counsel indicated that Big Law attorneys are “less responsive” than other attorneys.

On top of that, your work is generally lower priority than the aforementioned large companies, because there’s no guarantee your lawyers will be paid.

What’s more, as mentioned above, associates straight out of law school are often handling the brunt of your legal work, new attorneys typically need more time to accomplish simple tasks. Increasing the firm’s turnaround time, associates’ work then (hopefully) has to be checked by a partner or a more senior associate.

More than half of general counsel indicated that Big Law attorneys are “less responsive” than other attorneys.  

4.) Law firms set their prices as high as they can safely get away with. Big Law billing rates are astronomical and on the rise. Citi Private Bank’s Law Firm Group found thatthe hourly rate of senior partners typically range from $1,200 to $1,300 per hour. The largest rates at big law firms are often more than $1,400 per hour.

This is in part because the law firm billable hour has to cover any overhead costs the firm incurs from day-to-day operations.

When working with law firms, it can also be difficult to predict the budget of your legal projects. For example, don’t be surprised to receive an exorbitant bill for what you thought was just a 15-minute phone call and some quick legal advice.

5.) You’ve given away ownership in your company for free. You’ve given your law firm equity, but you must still eventually pay the firm for the legal services you receive on top of that.

6.) If your company is sold for little to no money or folds, you still have to repay your law firm. As a creditor, your law firm gets paid first. By the time your law firm and any other investors are paid, you and your employees typically don’t benefit financially at all. In addition, founders who have taken on personal debt now must dip into their personal bank accounts.

7.) Big Law attorneys may be less innovative. More than 40 percent of big law partners are in their 50s and 60s, according to American Lawyer, and we can speculate that they may not be open to change when they've been conducting business the same way for several decades.

If your company is sold for little to no money or folds, you still have to repay your law firm.

8.) You’re opening the door to insider trading. While you hopefully would never have to deal with something like this, it’s worth keeping in mind that your attorneys own stock in your company and have access to inside information about how your company is performing.

9.) Venture Capitalists will scrutinize how any funding will need to cover repayment of your legal fees. In the long run, wouldn’t it be better for your business (and in the eyes of potential investors) if you’d already taken care of legal bills or gotten a better cost for services?

10.) Exercising your right to fire your law firm is problematic when that firm owns stake in your company. This is true whether you do or don’t have cause to end your relationship.

Listen, it’s understandable that your company wants to work with a brand-name law firm – one that has a track record of working with companies like Oracle. We’ve all been in situations where we’ve chosen the brand-name product (i.e., the more expensive one) over a cheaper alternative, because we expect the product quality to be that much higher.

But at the end of the day, whether it’s a product or a service, customer satisfaction is not always correlated to any prestige associated with a brand.

Read These 10 Rules if you do use Deferred Fees 

If you do decide to go down this path, before signing any agreements, follow these guidelines to make sure you get a fair deal:

1.) Don’t take on any personal debt. Your law firm is now a creditor. The firm you engage will get the first bite of the apple if your company fails or is acquired for little to no money or folds.This is probably the most important rule: founders should do everything in their power to avoid taking on any personal debt. If you’ve taken on any debt and your company performs poorly, your debt to your law firm could bankrupt you.

2.) Carefully review the engagement letter. This is an obvious one. Take note of how much equity you’re giving away and how the firm will be repaid if your company folds or is acquired for little to no money.

If you’ve taken on any debt and your company performs poorly, your debt to your law firm could bankrupt you.  

3.) Do not offer warrant coverage. The firm can convert these warrants into shares by paying $20,000. The number of shares the firm gets is determined by the price of the warrant. Let’s say a law firm defers $100,000 in fees with 20 percent warrant coverage. This means that the firm gets $20,000 in warrants.

 If you set the price of the warrant too low, you’ll find yourself giving away a lot of your company. You might consider giving stock options instead, but you run into the same problem. It’s very complicated to figure out how to price warrants and stock options. Plus, they can clutter up your capitalization table, making future financings more complex.

4.) Negotiate fixed fees. Ask the firm to do work on fixed fees for each service. This means that you won’t be at the mercy of the billable hour when a complication arises that is unexpected and/or time consuming. A good law firm will be able to come up with a fixed fee based on previous similar engagements.

5.) Make sure the amount of equity you hand over is ethical. There is an ethical limit to how much equity law firms can take in your business. To quote the ABA’s 2000 Ethics Opinion, attorneys who take stock in any client must comply with the below requirements.

• The investment and its terms must be fair and reasonable to the client;
• The terms of the investment must be fully disclosed in writing to the client in a manner that can be reasonably understood by the client;
• The client must be advised in writing that the client may seek the advice of independent counsel of the client’s choice and the client must be given a reasonable opportunity to do so;* and
• The client gives informed consent in a signed writing to the essential terms of the investment and the lawyer’s role in the investment transaction.

6.) Review the firm’s work closely. As I mentioned in deferred fee arrangements, law firms typically rely heavily on associates to handle the work. Partners should always review the associates’ work with a fine tooth comb, but this isn’t always the case so review, review, review.

7.) Consider the value add of any legal services in developing the equity agreement. Most founders considering deferred fees are receiving legal services for a startup that doesn’t yet have a valuation.

8.) Deferring fees doesn’t mean you don’t need to figure out how much each legal project will cost you. At the outset, ask the firm to list the legal services they recommend for the next year. Your attorneys should be able to tell you why these are the most important priorities, and you can value each service based on this information.

9.) Create strict rules to handle conflicts of interests. Founders and their attorneys should put in writing procedures to handle actual and any long-range potential conflicts of interest that may arise as the company scales and becomes profitable.

10.) Work with experienced attorneys. If you’re going to pay astronomical billing rates, make sure the attorneys you choose have well-reviewed experience shepherding early-stage companies to the next level. Attorneys who have taken clients from seed or a Series A financing to late-stage financings or an IPO likely offer the best legal services, because this means the client chose to stick with them. Also, ask your attorney to be clear about how much of the work will be performed by associates and the experience level of each associate.

Lastly, Charles Dickens is famous for this advice: “never do to-morrow what you can do today.” So, even if you choose not to listen to me, academics and the ABA, for Pete’s sake, at least listen to good ole Chuck!