by Small-Cap Institute
This is part of a continuing series where SCI speaks with experienced, small-cap investors and executives “off the record” about a variety of capital markets, corporate finance, and boardroom issues.
There is one fact pattern that is almost always bad for small-cap shareholders, and it involves lawyers.
The situation is framed by this investor: “There are so many small-caps without in-house lawyers, and most of them led by people without legal backgrounds. There’s a constant of either hiring the wrong lawyers, paying way too much for them, or both.”
As SCI stated in Don’t Have In-House Counsel? It’s a Serious Added Risk for Investors, “After the financial crisis, belt tightening in the small-cap realm recast in-house lawyers as ‘nice to haves’ instead of ‘must haves.’ Investors will tell you that’s not a positive development, because the cost savings aren’t worth it.”
But that doesn’t mean that small-caps which elect to operate without in-house counsel can’t still improve the way they hire, manage, and pay for lawyers.
The good news is that the law business continues to be a buyer’s market. What started in the wake of the financial crisis as extreme sensitivity to fees has expanded to clients of all sizes simply rejecting the status quo. While iconic and highly specialized attorneys still regularly fetch between $1,000 and $2,000 per hour for their time, the overall legal services marketplace has become a lot more competitive. With large law firms looking to shed office space in a post-pandemic world, it’s possible that decreasing overhead could usher in even more pricing pressure.
For example, one of the most dramatic changes to the law firm model is a shift away from hourly billing to alternative fee arrangements (AFAs) like flat fees. According to Bloomberg, 40 to 50 percent of large law firms now utilize AFAs; this would have been unthinkable prior to the financial crisis. The evolution away from traditional hourly fee billing is a net-positive for small-caps, since that billing ecosystem was susceptible to self-evident conflicts of interest.
But many small-caps aren’t benefitting from AFAs for two reasons: (1) they don’t know it’s a possibility; and (2) especially when it comes to clients with less legal experience, law firms still do their best to construct flat fees which aren’t demonstrably different than historic hourly fees when all is said and done.
A former large firm lawyer and in-house counsel told SCI: “Practicing lawyers aren’t quick to admit this, but when you see a small public company with no in-house lawyers and management who lack legal experience, it’s certainly an advantageous billing situation. Every lawyer knows that no matter how smart the CEO/CFO are, they are going to overpay – pure and simple. These are usually people who have no refined understandings of how much time various tasks should take. It’s the quintessential ‘they don’t know, what they don’t know.’ In a perfect world, those companies wouldn’t get taken advantage of. We don’t live in a perfect world.”
Here are three common circumstances where small-caps can hire smarter and pay less.
One of the most impactful problems a small-cap company can create is by hiring the wrong attorneys to represent the company in connection with a capital raise – particularly structured financings. Since so many small-cap companies are repeat capital raisers, it’s a common occurrence and the damage can be appreciable. There are steps management can take to avoid this pothole.
- Company counsel. While it’s reasonable to believe that the company’s existing outside counsel is the most logical choice to represent the company in a financing, they are only the right choice if they have extensive, recent experience representing similarly situated companies, in similar financings. Company counsel might be a good choice, but they could also be a terrible choice – particularly when financings involve convertible instruments. For some perspective, the hedge funds that are going to be investing in most small-cap financings are represented by lawyers who likely do little else other than represent institutional investors in small-cap financings. In other words, they have done dozens, if not hundreds, of financings. Accordingly, the fact that outside counsel is a trusted advisor and knows the company well is helpful on the one hand, but useless on the other hand if they aren’t experts in small-cap financings. Key point: you shouldn’t select existing company counsel to represent the company in a financing out of loyalty or convenience; company counsel is only the right choice – if they are the most qualified.[i]
As one fund manager said: “In structured financings, some issuer’s counsel have no chance against most hedge fund deal lawyers. It’s not even a fair fight.”
- Large law firms. CEOs are susceptible to assuming that they can’t possibly go wrong selecting a large international corporate law firm to represent the company in a financing. The mistake lies in the assumption. The largest law firms in the world predominantly represent large private and public companies. As it pertains to corporate finance, the lawyers in those firms could well have experience navigating some of the most complex finance transactions ever undertaken. Yet, if they don’t have significant experience representing small-cap companies – particularly in structured private placements – then their other experience is likely inapplicable.
- Actual attorney. Irrespective of the size and type of law firm, it’s critical for CEOs to confirm that the actual attorney who is going to represent the company has extensive, recent experience representing similarly situated companies, in similar financings. It’s not sufficient if the firm itself, or an attorney’s partner has such experience. Rather, the actual attorney representing the company is the person who needs to have the relevant experience. As is the case with all professional service providers, the firm is only as good as the person within the firm that’s doing the lion’s share of the company’s work.
💡 Be smart: the most cost-effective attorney at a large law firm is an associate with more than 5 or 6 years of tenure that has yet to make partner. They have already been identified by their firms as high performers who are likely to make partner, and they are typically billed out at a substantial discount to partners. For most corporate matters, you want them to be doing > 70 percent of the work. In pre-trial litigation situations, it’s the same thing, except that you’d also like to see senior paralegals do as much as possible as well. The moral of the story is: don’t ever pay for lawyers with less than 5 or 6 years of experience, and in most day-to-day situations the hours billed by partners should be < 20 to 30 percent of the total in any period.
’34 Act Reporting Fees
Far too many small-cap companies still pay law firms more than necessary for basic ’34 Act reporting work.
- Flat fee. Small-caps should strongly consider negotiating flat fees for basic ’34 Act reporting in lieu of continuing to pay hourly fees. In addition, when soliciting bids for this work, management should try to add in ancillary items like reviewing related press releases, and perhaps even attendance at a fixed number of board meetings.
💡 Be smart: most large law firms view basic corporate work to be “loss leaders” in today’s law business. They do that work on a flat fee basis with very little margin with the hopes of having much larger fee generators like M&A, financings, etc. Accordingly, don’t hand a large law firm a profit they’re not even expecting.
- Billable work. SCI asked some experienced in-house counsel for some suggestions about how management without legal backgrounds can keep fees as low as possible in hourly billing situations.
- Ask for the form. When it comes to common corporate tasks like drafting registration statements, stock purchase agreements, merger agreements, stock option plans, etc., remember that large law firms have highly refined “form” documents they start with. At the beginning of the process, ask counsel to send you the relevant form. Thereafter, you’ll be in a position to compare what was done, and counsel will be on notice that you’re monitoring the actual work that was done.
- Always ask for an estimate. Prior to any substantive corporate work, ask counsel how many hours they believe will be expended. Then ask them to contact you by phone or email when 75 percent of the forecasted time has elapsed, and let you know how they are proceeding. While you might not know whether the forecast was reasonable to begin with, you’ll be sending a message that you’re monitoring the time, and it will often encourage greater efficiencies.
- Don’t start with non-lawyer drafts. Some companies feel like they will save money by having experienced executives (read: non-lawyers) take a first shot at drafting corporate documents. The thinking is that “editing” is cheaper than “drafting.” Unfortunately, this is rarely true. It’s almost always going to be cheaper for an attorney to edit a form they are comfortable with, than to rework a document they’ve never seen.
- Location. Given the advent of email and Zoom, the physical location of company counsel has become less and less important. Too many small-cap companies still unwittingly pay a premium to have counsel located proximate to the company. CEOs should be aware that both flat and hourly fees (and expenses) are often demonstrably less at branch offices of large law firms which are located outside of major markets.
When it comes to having counsel attend board meetings, don’t be penny wise and pound foolish. You definitely should have counsel present at all physical/virtual board meetings, and they should participate telephonically for all other meetings. This is one of the easiest public company axioms, because there are… no exceptions.
Though there are countless helpful resources regarding litigation theory, strategy, and management, many of them omit or under emphasize an important reality – the costs and outcomes of litigation often pose existential threats for small-cap companies. Consequently, CEOs should consider keeping these two things in mind:
- If your company is sued. Real litigation (versus nuisance type matters) is often a costly nightmare in the best of circumstances. CEOs should strongly consider hiring a seasoned litigation attorney as a consultant to assist with, among other things, selecting attorneys, negotiating fees, reviewing strategy, and managing the process. In the vast majority of circumstances, the consultant’s fee will be paid for several times over with the resulting savings. The key point here for CEOs is that attempting to preside over all aspects of litigation with limited or no litigation experience is an unnecessarily risky proposition for shareholders.
- If your company is the plaintiff. The company should consider negotiating a contingent fee or a blended contingent fee agreement with counsel instead of paying straight hourly fees. Previously only the province of small specialty plaintiff’s law firms, much larger law firms now regularly take cases utilizing alternative fee structures.
Investors would definitely prefer that your company have experienced in-house counsel, but if you don’t there are still myriad ways for your company to hire the right lawyers while paying less. As one CFO told SCI: “The problem is believing it’s not a problem. By the time you realize you have the wrong lawyers or are overpaying for legal services, it’s always too late.”