The Ethics of Representing Founders

Lawyers for startups typically serve as counsel to the new organization, with all of the complications that accompany representing an entity.  But consider those lawyers as they perform legal work for the enterprise before any organization exists.  Who are their clients?

Startup founders tend to be individuals.  Sometimes, the startup founders create an entity—an LLC, a subchapter S corporation, a subchapter C corporation, or some other structure—on their own, without seeing a lawyer.  In those instances, the eventual lawyer works with the “duly authorized representatives” of the established company, with the entity as the client.  But just as often, the founders retain lawyers to help select and establish the appropriate organization and to assure that the business begins on the right footing.  Those lawyers, who can end up doing a lot of work before an organization exists, must have someone as the client.  One would expect that the clients are the founders themselves, individually through a joint representation agreement.  That would be mostly right, but in a paper to be published next winter and available here, I explore the complexities of that assumption.  Surprisingly, not a lot has been written in the legal ethics world about this pretty common phenomenon.

There are three complicating factors to which lawyers working with founders must attend. The first is this: Those individual founders, whether they know it or not, often will qualify as partners within a partnership that arises by default.  But not always.  An inchoate business enterprise, without any real economic activity or ownership of assets, should not be deemed a partnership, and the lawyer will then represent some or all of the founders as individuals.  But a business that does have some identity, property, and commercial activity before its entity formation will qualify as a partnership under the Revised Uniform Partnership Act (RUPA), which represents the substantive law in just about all jurisdictions.  The lawyer who assists those founders in setting up the business needs to be clear with the founders, and in her retainer agreement, whether she will represent the partnership—an organization, separate from its constituents—or the individual partners.

That lawyer, of course, must discern which setting she and the founders are in.  Where the startup enterprise does appear to satisfy the RUPA standards and qualifies as a partnership, it would be unusual, and strategically puzzling, for the lawyer to opt to represent the individuals, and not the enterprise.

The second complication relates to the practical uncertainty about which persons qualify as founders, or as partners in the active business setting.  That challenge arises when the founders first approach the law firm, but it also reappears when founders move around.  And founders, as we know, do move around, and come and go.

Consider first the non-partnership enterprise, where the lawyer’s clients will be the individual founders.  It is easy to state that the lawyer will represent all of the founders collectively, which the Model Rules of Professional Conduct (like RUPA, but with more variation, the basis of the ethics rules in almost all United States jurisdictions) will generally permit with appropriate informed consent.  (The lawyer might choose to represent just one of the founders, and expressly not represent the others, but I conclude that such a choice is likely to be awkward and ineffective.)  But to suggest “all of the founders” begs the critical question of who qualifies as a founder.  Startups frequently emerge from the work of several collaborators who contribute to the enterprise in different, and often uneven, ways.  Some members of the team will easily be understood to be genuine founders; others, though, will be helpers whose participation is useful but not essential.  When crafting a retainer agreement with multiple individual clients, the law firm must make judgments about which of the team members will be on or off that representational bus.

If the enterprise qualifies as a partnership, the same difficulty arises, just with different labels, as the law firm aims to discern who among the team is a partner.  RUPA requires an ownership stake and, usually, responsibility for losses, along with some rights of control, to satisfy the partnership definition.  It will matter, and not only for purposes of the attorney-client privilege, which constituents possess partnership rights and which do not.

This uncertainty, in both settings, is only accentuated by the not-uncommon phenomenon I call “founder drift.”  Once the law firm has identified the individuals who will be clients (in the inchoate setting) or partners (in the active business setting), it will often have to respond to the happenstance that startup founders walk away from the enterprise.  This seems to be especially true in early-stage high tech startups, where the participants’ financial investments are less steep and the competing demand for savvy tech talent is high.

In the inchoate setting, a founder who leaves the group is still a former client to whom the lawyer owes some duties.  Ordinarily, the law firm can continue to represent the remaining clients, even if the founder who left moves to a similar business elsewhere.  The Model Rules, in the comments to Rules 1.7 and 1.9, imply that assistance to a former client’s competitor should not be a disqualifying adverse representation.  If the former founder has ownership rights in intellectual property important to the enterprise, though, the lawyer might have to send the remaining partners to a new law firm.

The effect of founder departure in the partnership setting is more complicated, at least conceptually.  Even under the more liberal RUPA doctrine (compared with its predecessor Uniform Partnership Act, or UPA), a partner’s exit from the partnership-by-default triggers a dissolution of the partnership.  The lawyer’s client disappears.  The remaining partners (along with the former founder’s replacement, perhaps) may form a new partnership, and the lawyer will then have a new, distinct client, so the RUPA implications might be more technical than substantive.  The former founder is not a former client of the law firm, so that helps, but the partners from the original enterprise most likely owe some fiduciary duties to one another, duties the lawyer must respect.  And the departing partner is entitled to an accounting and a buyout of her interests, which the lawyer will most likely oversee.

Sometimes the pre-incorporation departure will result from a shift in interest, or a better offer elsewhere, with little ill will.  Sometimes, though, the departure will result from serious disagreement about the enterprise or the participants’ relative shares of power or ownership, in which case the rancor could be greater.  The law firm can skate more easily through the former happenstance (with full attention to any mandatory duties, of course), but must be especially wary of the latter.  The firm may conclude that prudence warrants a withdrawal from any further representation if it is not sufficiently clear that the departed partner has no objections to the law firm’s continuing with the business it started with.

Finally, the third complication: All of the complexity just described will arise immediately when the lawyer first meets the founders (or, as is not unlikely in practice, meets some founders but not some others who can’t make the meeting).  To the extent that the lawyer recognizes potential conflicts of interest, as she would, for instance, if she concludes that her clients will be some individuals and not a partnership entity, she must counsel those persons to understand fully the implications of proceeding with one lawyer notwithstanding the risks of possible conflicts down the road.  She also must make clear to the participants in both settings that information she learns from any one of them will be shared with the others.  And her work with the founders or partners must be accomplished without favoring the interests of any one of them over the interests of the others.

This post comes to us from Clinical Professor Paul R. Tremblay of Boston College Law School. It is based on his recent article, “The Ethics of Representing Founders,” available here.