Dear Entrepreneurs: Choose Your Own Legal Counsel

by Scott Edward Walker on September 8th, 2010

Introduction

The purpose of this post is expand upon my answer to the question on Quora:

“What should you do as a startup when a Bay Area VC insists that you use their expensive legal counsel?”

Mark Suster, a VC at GRP Partners, has also written and spoken about how he likes to “share” his legal counsel with the startup in which he is investing.  My advice to entrepreneurs is clear: push back hard on this issue and choose your own strong, independent legal counsel – i.e., a law firm that’s going to work hard to protect you and watch your back.

Types of Conflicts of Interest

There are two types of conflicts of interests that need to be addressed when startups are pressured to use an investor’s law firm: ethical and business.

Ethics Rules.  Potential conflicts of interest that arise in the course of a law firm’s delivery of legal services are governed by applicable State Bar ethics rules, with which lawyers are required to comply.  As the Preamble to the ABA Model Rules of Professional Conduct provides in relevant part:

In the nature of law practice . . . conflicting responsibilities are encountered. Virtually all difficult ethical problems arise from conflict between a lawyer’s responsibilities to clients, to the legal system and to the lawyer’s own interest in remaining an ethical person while earning a satisfactory living.  The Rules of Professional Conduct often prescribe terms for resolving such conflicts. Within the framework of these Rules, however, many difficult issues of professional discretion can arise. Such issues must be resolved through the exercise of sensitive professional and moral judgment guided by the basic principles underlying the Rules.  These principles include the lawyer’s obligation zealously to protect and pursue a client’s legitimate interests, within the bounds of the law. . . .

In the event there is a potential conflict of interest between or among clients, most State Bar ethics rules require each client to consent in writing to the attorney’s representation — after full disclosure and consultation.  Indeed, each client must be able to appreciate the situation and have enough information to make a reasonable and informed decision as to whether or not the legal counsel can provide fair representation.  The consent of the client must also be entirely voluntary and not given under any pressure whatsoever, by the attorney or anyone else.

Business Conflicts.  Assuming that law firms are complying with the foregoing ethics rules, there is another issue that needs to be addressed: inherent business conflicts of interest.  This, to me, is the crux of the problem with entrepreneurs using law firms that also represent the investors.

As I noted on Quora, for many of the big Silicon Valley law firms, the venture capital firms are their gravy train and the big law firms need to play ball with them.  This is not to say that any lawyers at these firms are unethical (or that the law firms are not complying with applicable State ethical rules).  Instead, this is about the realities of the economics.

Let’s take a simple example:

Vinny VC meets with Eric Entrepreneur and gets very excited about Eric’s new venture; so excited, in fact, that a few weeks later Vinny presents Eric with a term sheet for a $750K seed financing.  Vinny advises Eric that this is his standard term sheet for seed financing and recommends that he retain Larry Lawyer at the ABC Law Firm to process the documents.  “Larry is great,” Vinny explains, “and we have some lightweight seed documents that we have put together with Larry’s law firm and used with other startups, which will make the process relatively quick and inexpensive.”

“Sounds good,” Eric says, and he meets with Larry Lawyer and signs an engagement letter (with the appropriate waiver of any potential conflicts of interest).  Now here’s the problem:

If Larry Lawyer and his firm are being sent a lot of work from Vinny VC and his firm, Larry is obviously not going to rock the boat and start pushing back on any key issues.  Why?  Because if he does, Vinny will just send his future work to the five other lawyers on his list.  This is not to say anyone is unethical here – this is just common sense.  Vinny wants his deals done quickly and cheaply (and on the forms that Vinny and Larry have created); and Larry wants Vinny to send him lots of legal work.

Accordingly, (i) Larry Lawyer is not going to suggest to Eric Entrepreneur that he talk to other investors and test the market prior to executing the term sheet; (ii) Larry is not going to raise issues such as doing convertible debt in lieu of a preferred stock financing; (iii) Larry is not going to push back hard if the liquidation preference includes some form of participation; (iv) Larry is not going to push hard to cut back on any of the protective provisions; and (v) Larry is not going to suggest that the company doesn’t need investor representation on the Board at this early stage.  In short, Larry is going to play ball because if he doesn’t, Vinny VC will stop calling.

As Antone Johnson, a smart startup lawyer, aptly points out in the comments to the Quora question:

My former firm ([Wilson Sonsini]) gets accused more often than any other of being in the pocket of the VCs, thanks to the “gravy train” alluded to in Scott’s answer.  It does have a vested interest in maintaining strong positive relationships with the VCs that feed it deal after deal.  I never met a lawyer there who wasn’t cognizant of his or her duties to represent the client zealously (meaning the company, not the investor), but I did feel there was a tacit understanding that pissing off the VCs would be a bad career move.

The M&A World

This inherent conflict of interest is not relegated to the VC world.  Indeed, I experienced it first-hand shortly after moving to California — when I got pulled onto an M&A deal at an LA law firm that I had just joined.

The managing partner of the firm was good friends with a middle-market investment banker, who recommended our firm to the client in connection with a complex leveraged buy-out.  I was tapped to quarterback the deal in light of my strong M&A experience in New York.

You have to understand that a middle-market i-banker’s entire year can be made or broken based on whether or not he can close one or two deals.  Indeed, he only gets paid if the deal closes.  Accordingly, like with the VC’s “recommended” or “preferred” legal counsel, we were supposed to play ball and make sure the deal closed so that the i-banker got paid.

Unfortunately, I’m not very good at playing this kind of ball – particularly when there were significant environmental issues that were not being adequately addressed.  The i-banker wasn’t too happy and, in fact, stuck his finger in my chest and warned:  “We’re going to get this deal done despite you fuck’n lawyers.”  He then vigorously complained to the managing partner that I was blowing-up the deal because I had retained special environmental counsel from my old New York City law firm and we were pushing too hard on the environmental indemnity.

Good work by the i-banker (and cheers to my former managing partner) for getting the deal closed by watering down the environmental indemnity: less than six months later our client’s company was indicted for significant environmental problems that it had assumed (by operation of law) as part of the acquisition.

Conclusion

Look – my goal here is not to point fingers and claim that anyone is being unethical or doing something wrong; this is the way business works.  There are inherent conflicts of interest in certain business relationships, and entrepreneurs need to have someone in their corner to point that out to them and to watch their back.  I am proud to play that role.

Tags: conflicts of interest, entrepreneur, entrepreneurs, ethics, investment banker, investors, legal counsel, M&A, startup, term sheet, vc