As startup culture has spread to more U.S. cities, a growing number of law firms are offering specialized services to startups, including midsize and boutique firms that are tailoring their business models to entrepreneurs’ needs.
But there’s a reason Silicon Valley fetishes both success and failure: For every breakthrough venture, many more companies fizzle out in early stages, are acquired or operate successfully for a time before encountering financial troubles and going out of business. And that means special risks for their outside counsel.
Philadelphia-based CloudMine serves as a recent example. Founded in 2011, the medical data storage company was successful for several years, raising millions in capital and working with well known clients in the Philadelphia area. But CloudMine filed a Chapter 7 bankruptcy petition Nov 5.
Among the company’s listed creditors were Morgan, Lewis & Bockius and Baer Crossey McDemus, a business and technology boutique in Philadelphia. The amount owed to each of these firms in bankruptcy filings was listed as “unknown.” Morgan Lewis declined to comment for this story, and Baer Crossey did not respond to requests for comment.
Gregory Seltzer, who leads the emerging growth and venture capital group at Ballard Spahr, said it’s uncommon for a business to exist for as many years and financing rounds as CloudMine did and end up filing for bankruptcy. But the pitfalls associated with new ventures are many.
Law firms take on “a great deal of risk” when choosing to represent startups, he said, regardless of their size. In managing that risk, firms should view their client roster like a traditional stock portfolio, he said, with a combination of large-cap, middle-market and small-cap companies.
“If we look at the law firm as a business, it should have economic diversity in the size of its client base,” he said. At larger firms, he noted, that may require different rate structures for different stages of clients, which requires some pricing work.
“We’re sensitive to when the companies get paid,” said Matthew McK. Mohn, who leads Reed Smith’s U.S. emerging growth and venture capital practice. “They aren’t making money in any meaningful way for sometimes 18 months to two years. … We’re very accommodating from that perspective.”
So startup clients aren’t necessarily expected to pay monthly bills as quickly as an established business would be. And when a company does appear to be encountering financial difficulties, Mohn said, there’s an extra effort to provide the needed services as efficiently as possible.
“With companies like this, if we know that they’re struggling … we are very careful about limiting the amount of time in those kinds of instances,” he said.
David H. Feinberg, a founding partner at Boston-based Feinberg Hanson, had a different perspective when it comes to managing financial risk with startup clients. Feinberg’s main goal in starting his firm was to represent entrepreneurs. Its services have become broader as the clients have grown, he said, but he and his colleagues still work with a lot of seed-stage startups.
“We do it more out of love for the space, and the whole spirit of entrepreneurship,” he said. “Of course there are times when we get left with unpaid bills.”
Bankruptcies are “very rare” in this space, he said—in 25 years he’s seen maybe three or four. When companies are unsuccessful, it usually happens earlier and there are simpler ways to wind down the business, he said.
Like Mohn, Feinberg said it’s no secret to his firm if a startup client is hurting financially. And when that happens, there should be a lot of planning around the next steps. As part of that, he said, the law firm should make sure it’s working with a retainer fee in place.
And his firm keeps in touch with clients about the bills, which go out monthly, Feinberg said. Sometimes they don’t have the cash to pay right away, but may have it shortly thereafter. ”We try to get a sense when we take on a client of what their financing is,” he said.
Thinking Like Investors
Of course, like with any client relationship, due diligence on the front end can help to mitigate or avoid financial problems and extensive write-offs down the line.
A lawyer just starting out in the emerging businesses space will often “take on anybody,” Mohn said, but should look to reduce risk as their client list grows.
“As your practice develops, you’ll get to the point where you can be a little more picky, a little more choosey,” Mohn said. “It’s not about that first year. It’s about year three, year five-plus.”
Lawyers should evaluate the founder’s entrepreneurial history, whether they have any financial backing to start with, and whether there appears to be the start of a good lawyer-client relationship, he said.
“They’re not going to have an inside lawyer. They’re going to be calling you at least every week if not every day,” Mohn said. “It’s got to be someone you want to work with and want to support.”
Feinberg echoed that sentiment, stressing that the relationship must be strong, but he said his approach to establishing that relationship is different from an investor’s. To mitigate financial risk, he said, he assesses how serious the founder is about making the business work. But the evaluation is more about the entrepreneur than the product or service, he said.
“We vet clients because we want to make sure they are honest people, and we want to make sure they don’t have bad relationships with prior lawyers,” Feinberg said. “We have clients that are rocketship successful, and we have more clients that have to struggle through. We try to help, because even if a particular client isn’t successful, the man or woman behind the client may go off and do something else.”
But Seltzer said his practice enters into startup representations much like an investor would, carefully analyzing the leadership of the company, and the technology the business is built on, before choosing to commit. He said he often will consult with Ballard Spahr’s IP lawyers to assess the technology side of a potential client.
Some firms will “volume onboard” startup clients, he said, and that can lead to more written-off fees for companies that don’t go the distance. Being selective, Seltzer said, makes for less of that, but doesn’t totally eliminate risk.
When a client falls on hard times, “we’re not going to bail on people. We’re prepared to go down with the ship,” he said. “It can be financially painful, but I see that as our obligation.”
Still, he noted, “The success stories fully outweigh the negative stories.”