Talk to any Silicon Valley lawyer who takes on a start-up company as a client, and you might mistake him for a venture capitalist or perhaps an angel investor.
It’s common knowledge that attorneys in the San Francisco/San Jose area tend to go well beyond their standard legal duties, often assisting companies with business plans, introducing entrepreneurs to potential investors and helping establish relationships between various business clients who can benefit from one another. It also is known that almost all Silicon Valley law firms with a significant high-tech practice create funds that invest in their clients’ businesses, putting up $25,000 to $50,000 per company.
While the question of an attorney/client conflict of interest might arise, the practice is hardly new – Silicon Valley lawyers and a few outside the region have simultaneously functioned for decades as advisers, financial matchmakers and investors in young companies. The sheer number of young companies being formed today – and their eye-popping valuations at the time of an IPO or acquisition – has made the multi-purpose lawyer somewhat standard in the Bay Area, and that has caught the attention of attorneys outside the Valley.
The keenest attention is focused on private equity investment funds for lawyers. Indeed, Silicon Valley law firms such as Venture Law Group (VLG) often receive calls from other firms in developing technology hot spots such as Austin, Texas seeking advice about setting up such vehicles for their own attorneys. The Los Angeles firm of O’Melveny & Myers recently launched a fund that will make equity investments in technology companies, but the firm has released very little details about the vehicle. Current guidelines issued by the American Bar Association (ABA) do not prohibit lawyers from investing in their client’s companies. The California State Bar has rules for such transactions, including that lawyers must set fair and understandable terms for an investment, inform clients they can seek outside counsel and get written consent from a client for the investment.
As part of a larger effort to review its conflict-of-interest guidelines, the ABA is studying such transactions between lawyers and clients and will release a report next year. While the ABA has no regulatory authority, state bars do have enforceable regulations, and those organizations often base their rules on ABA guideliness.
More Than Meets the Eye
At first glance, an attorney’s world might seem less risky than that of a venture capitalist, but lawyers working with start-up companies know nascent clients often lack the resources to write big checks for legal bills. So, to one day get paid, attorneys must carefully choose clients likely to win eventual VC backing. Most Silicon Valley attorneys defer billing, with many offering a discount for the opportunity to invest in a client’s company through a law firm’s fund. Attorneys also try to limit the work they do for a business before it receives its first round of institutional financing.
Mario Rosati, a member of the Silicon Valley law firm Wilson Sonsini Goodrich & Rosati who oversees the firm’s investment vehicle, WS Investments, estimates that he represents about 25% of the entrepreneurs who seek his counsel, after evaluating their track records, prior work experience, educational backgrounds and the technologies they are developing. Rosati says he prefers to work with Bay Area companies because they can more easily obtain funding than far-flung enterprises.
VLG founder Craig Johnson says his law firm turns down about 90% to 95% of its would-be clients, accepting only those who rank high on the firm’s “fun and opportunity matrix” – companies that are enjoyable to work with and that provide an advantage, such as an enterprise that could allow a young lawyer to develop an industry expertise. “Opportunity,” however, also can mean a chance to take an equity stake in the business. And the selectivity has paid off – the firm chooses such winner clients that it must write off only 1% of its client fees a year.
A VLG board decides whether to take on new clients and Johnson says the grueling process has been compared to an interrogation by former White House Independent Counsel Kenneth Starr. VLG directors and senior attorneys may work with as many as three companies at a time that have yet to receive venture backing. “We call those three-dog nights.”
Once a Silicon Valley law firm signs on with a start-up, attorneys must take care of the usual legal chores such as incorporation and intellectual property protection, but that is not the biggest part of their job. Lawyers are among the first “service providers” entrepreneurs contact, as company founders often latch on to them before seeking angel or seed capital to help their business hone a strategy, establish ties with other key industry players and prepare the start-up for introductions to investors.
“In many ways, having an experienced law firm that’s used to working with start-ups could really function very similarly to … an angel investment round,” says David Makarechian, senior associate at the law firm Brobeck, Phleger & Harrison L.L.P. “We absolutely provide strategic advice to companies, we clean them up, we advise them on the process, we help them with term sheets, and it’s a role that … The venture capital community, the angel community and the companies rely on us for. We provide, in many ways, the structure that facilitates the process.”
In exchange for accepting the risks and extra work, lawyers want part of the upside so firms create investment funds that take modest stakes in their client’s companies. At some law firms, only partners can invest in the funds while at others, associates also can get in on the action. Some law practices establish investment trusts solely for the benefit of associates.
A partner or group of partners act somewhat akin to general partners for the law firms’ funds, reviewing investment opportunities introduced by other attorneys in the firm and deciding whether to take equity stakes.
Law firms use the investment funds as an enticement to keep savvy young attorneys from jumping ship to join start-ups that can offer stock options and the excitement of building a new enterprise. In addition, lawyers sometimes individually invest in their client’s businesses with the law firm’s permission.
“They’ve figured out you don’t want to get paid by the hour, so their investments” are like lottery tickets, says Sevin Rosen General Partner Steve Dow, referring to a lawyer’s equity participation in a company.
Attorneys point to the small sizes of their investments when asked whether their equity stakes constitute a conflict of interest with clients. One concern that arises is whether as investors, a lawyer’s interests would more closely align with other investors rather than with the company he’s representing, thereby hampering the lawyers’ ability to act on the clients’ behalf. Conversely, there are worries that a lawyer would no longer be fit to give independent advice if his investment resulted in his own interests being too tightly aligned with the company’s.
Wilson Sonsini, for example, generally limits its investments to $25,000 to $50,000 and about 1% of the founders’ stock. The firm has taken stakes in companies under its wing including Juniper Networks Inc., Brocade Communications Systems Inc., E-loan Inc. and bamboo.com Inc., Rosati says. “We intentionally keep ownership small to avoid any appearance that our equity participation may affect our legal advice or our legal judgment.”
VLG invests some $30,000 to $35,000 per round of financing, which, comparatively speaking, isn’t that much as a portion of a $5 million round. Plus, the profits from that investment will be divided among the firm’s attorneys, not giving any individual much of stake, Johnson notes.
But to Jim Caleshu, any investment by a law firm in one of its client’s companies creates a problem. The lawyer chairs the steering committee of Legal Services for Entrepreneurs of the San Francisco Bay Area, a non-profit organization that provides free legal services to start-ups and emerging businesses in low-income communities.
“There’s a serious compromise of professional ethics when a lawyer takes an equity stake in a client,” Caleshu says. The prospect of making an “untold fortune” by investing in a client raises two issues: First, the public might perceive the attorney as not being free of bias, and secondly, the investment might actually corrupt the attorney’s legal judgment. It is enough to have one’s fees at risk when working with young, not-yet-funded companies, Caleshu argues, and an equity holding adds another burden to an attorney’s professional objectivity.
“Law firms are not venture capitalists; that’s not our primary business, and, therefore … I think we have to be very careful about how big the investments get both from the standpoint of our client relationship, but also from the standpoint of relationships with venture capitalists,” observes Hank Barry, who recently left his attorney post at Wilson Sonsini to become a venture capitalist at Hummer Winblad Venture Partners (see story page 30).
By and large, venture capitalists are not bothered by lawyers investing in their clients because the sums are so small compared to the million dollar plus investments made by other investors. Some venture capitalists also see such investments as beneficial to their portfolio companies because lawyers will be motivated to work extra hard for their clients. Even those VCs who dislike the practice must eventually accept it or be forced to bypass Silicon Valley’s most sought after law firms to represent their portfolio companies.
Alloy Ventures General Partner Craig Taylor acknowledges the potential for conflicts of interest between young companies and their lawyer-investors, but he has yet to run into a real life problem. The key seems to be the modesty of the size of the investments, he says.
Alta Partners Managing Partner Jean Deleage echoes Taylor’s argument, but was nevertheless shocked to learn about the practice when he came to in the United States in 1976 from his native France.
Stewart Alsop, a general partner at New Enterprise Associates sees no reason to frown upon lawyers investing in the start-ups they counsel. He does think, however, that a law firm should avoid representing a company and its competitor. Although some law firms are simply too large to avoid this situation, they should make an effort to ensure that different lawyers work on each company to avoid any problems, he says. Alsop views investment opportunities by lawyers as a means of engaging them with their companies – a key ingredient to getting the job done efficiently.
Indeed, VCs are more concerned with lawyers giving sufficient attention to their portfolio companies rather than a possible conflict of interest arising from attorneys’ investments.
With so much activity in terms of companies being formed, rounds of financing, as well as the numbers of IPOs and mergers and acquisitions, Silicon Valley lawyers – like VCs – have a lot on their plates.
Deleage routinely hears from a portfolio company wanting to switch from one law firm to another to get more attention. Then Deleage gets a call from a second portfolio company wanting to switch from the second law firm to the first for the same reason.
Nevertheless, he does not envision start-ups avoiding big-name law firms to get more attention from less prominent firms with little knowledge of new companies.
Despite the risk of having to write off fees for start-ups that never get funded, Silicon Valley lawyers see long-term profits from the potential of continued service to the company once it grows into a powerhouse. Alternately, a law firm could represent a hot, young concern in a sale or IPO, benefiting both from the transaction and an investment in the company.
Brobeck, for example, has represented computer networking giant Cisco Systems Inc. from its infancy, and the company today is a very lucrative client. Brobeck represented Cisco in its recent acquisition of telecommunications-equipment company Cerent Corp. for $6.9 billion. “We have to view everybody we can as the next (potential) Cisco,” Makarichian explains.
VLG sat at the other side of the table in the Cisco/Cerent deal, representing the company that was acquired. When VLG invested in the company, it was valued at about $10 million, said VLG’s Johnson. “Let it be said we did just fine on our investment.”