The Truth Behind Deferred Legal Fees
How a Deferred Fee Deal Works
Here’s how a deferred fee deal works. For selected clients, the venture law firm defers some or all fees billed on the client’s work in exchange for the promise to pay the fees at a later time and “warrant coverage,” or equity in your company. This sounds OK, but the fees are due and collectible at a later time, the equity collateralizes the fee debt (which is tough to explain to smart investors), and often you are giving the law firm your equity for free. In some cases, the law firm may ask in addition that the company’s assets including intellectual property be put up as collateral for the fees.
How You End Up Paying More
Often, law firms who offer deferred fee deals bill hourly at middle range to very high rates. Since you are not paying the fees right now, it doesn’t hurt much, and you don’t ask for the discounts you otherwise might. Also, you don’t account for projects on a per project basis, or ask for flat fees where they are possible to get. As a result, your overall fees are ultimately higher. Furthermore, there is a great deal of legal work to do in any start-up, because almost nothing is done yet. So in prioritizing what to do first, and how much ultimately to do, if you have a deferred fee arrangement, it is easy to instruct your lawyers to do everything that is “needed,” or to say “yes” to calls and emails suggesting more work that could be done. As a result, unnecessary work is completed unnecessarily early in the company’s existence, and the legal fees mount quickly. For example, when the company is deciding upon which name to use for itself or its products, a typical venture law firm might suggest filing trademark applications before the company has settled upon the name it will ultimately use, or when the company will not ultimately sell products or services into the public marketplace, so might not need a trademark in the first place. Also, investment term sheets might be written (or even a full set of investment documents) using “the standard terms,” long before the founders have zeroed in on any real investors, or know the general terms to which such investors might be willing to agree. Then when real investors do materialize, new term sheets and new investment documents need to be written, not to mention costly edits to the company’s corporate documents to take the new terms into account. Finally, in the early stages of any company, organizational structures and solid procedures have not been established. As a result, if 5 people are working in a room, or from various rooms, more than one may send work to the lawyers without any real management review of what work has been sent, or why. …so the legal bill just keeps running up.
How Much More
In deferred fee arrangements billings often mount up to between $20,000 and $200,000 within a year or two of engagement, depending upon how much work is needed or completed on behalf of an early stage company. This might sound like a lot, but it is easy to understand if you consider that the legal work may include company formation and corporate documentation, financing documents, SEC filings and compliance work, trademark and patent filings and other IP work, independent contractor and employment agreements with multiple founders and employees, vendor agreements, licensing deals, form agreements the company may rely on for revenue and of course, “big deals,” or company-making arrangements with impressive industry players.
When Are Deferred Fee Arrangements Good?
Deferred fee arrangements are a great value if: 1) Your business raises a lot of money or produces exponential returns, or 2) your business fails (as long as the law firm does not obtain from you a personal guarantee for fee payment, or there is no IP or other value left in the company for them to attach). If, however, you succeed only in building a good company with respectable revenues, or you have to get successive rounds of financing to execute on your business model, your deferred legal fee arrangement ends up being a large debt you must disclose to potential investors and ultimately pay off.
So What’s the Better Way
- Sign with a firm that is experienced with early stage companies
- Clarify with the firm which work they recommend be done, and work with them to prioritize what you really need first
- Get the firm to do work for flat fees where possible
- Keep legal work broken out into separate projects and monitor each one separately
- Document with the firm that they must obtain authorization before starting work on any project
- Establish a single contact through whom all legal work is assigned and managed
Steven Masur (2010)