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Failing Startups Leave Silicon Valley Lawyers Holding the Bag
The Recorder
April 03, 2009
When San Jose, Calif.-based Open Source Systems went bankrupt two years ago, it left Fenwick & West's David Bell with an unpaid bill of $125,534.16. That's something that, as the recession threatens to take down a whole slew of startups, Bell and other corporate lawyers are trying to avoid. But in Silicon Valley, attorneys are caught between their law firms' demands for revenue and the need to work agreeably with venture capitalists and serial entrepreneurs the lawyers hope to work with again.
"Even at the end of a startup's life, you know that these are people that are probably going to start up other companies in the future," Bell said. "All of what we do is about relationships: We represent companies, but it's people who hire us."
It's a fine line to walk when those clients' latest ventures are falling apart.
"You provide some help sometimes that you may not get compensated for," Bell said.
With more than one downturn under their belts, veteran startup lawyers have tried to figure out ways to handle the sticky situation as venture capitalists decline to venture any more capital in a crashed economy. Bell, who has his share of teetering clients, said he gets retainers for the end-of-life legal work. That work can include everything from advising on a fire sale of the company's assets to counseling boards on how to avoid liability for unpaid wages.
Lawyers also try to keep an eye on struggling clients.
"When the economy started to slide we instituted an additional layer of proactive oversight so that the accrual of legal fees in any one client does not go unnoticed," said Timothy Harris, a startup lawyer at Morrison & Foerster who has clients struggling through the recession.
But in spite of all best efforts, law firms could end up losing a lot of money on their startup clients during this downturn. John Murray, of Cupertino, Calif., bankruptcy firm Murray & Murray, said he's working for failing companies that owe big money to their law firms.
"I just got off a call where the referring law firm has a $2 million receivable," Murray said Thursday, declining to name the client or the firm.
Firms like Murray & Murray -- which specialize in winding down companies in or out of bankruptcy court -- are profiting during the downturn. Murray said his small firm has had 70 new engagements since the new year. Many of his referrals come from law firms owed enough money to now be creditors.
Companies that aren't law firms, like Sherwood Partners, also scoop up a lot of the work. They act as trustees in the out-of-court bankruptcy-type proceeding called assignment for the benefit of creditors under California law.
THE PRICE OF VIRTUE
Venture capitalists and entrepreneurs say they don't expect lawyers to work for free, but that "doing the right thing" will be rewarded down the road.
"There have been cases where company counsel is not made whole on billings due to a company winding down and yes, we try to be cognizant of that and reward those firms that still do the 'right thing' despite their lack of collections," said Jason Mendelson, a venture capitalist with the Foundry Group in Colorado. "Absolutely there is honor in sticking it out to the very end."
Mendelson, a former Bay Area lawyer who answered questions via e-mail, said he has continued to bring work to Cooley Godward Kronish's Eric Jensen for sticking it out till the end on certain occasions.
MoFo's Harris said he'll do about $5,000 to $10,000 worth of free work for a client that needs it at the end -- and he's already done it a couple of times this year. It usually comes in the form of advice on how to properly lay off employees, deal with the landlords and limit the personal liability of management and the board of directors. "The hope is that people will leave MoFo with a good taste in their mouth," said Harris.
But just how much leeway a client gets with Harris depends on the relationship.
"A long-term client who had come to us for three different companies currently in a distress situation, because he's been a client for 12 or so years, I have a huge limit for him," Harris said. "On the other hand, if there's an entrepreneur we've worked for for 12 months and it never really got off the ground, I might say here's five or 10 hours."
Even with the prospect of losing clients and never getting paid for some legal work, many startup lawyers are sanguine, saying it's just part of the business.
Like venture capital firms, law firms are now losing bets they placed on once-promising startups.
"That's just part of the Valley," said Fenwick's Bell.
