Forming Start-Up Companies: Who's My Client?

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Fordham Law Review




Consider the following scenario: three individuals—a magician, a baker, and a puppeteer—want to start a business that will run birthday parties for children. The magician will put up most of the money, the baker has extensive experience with children’s birthday parties, and the puppeteer, who has an MBA, will manage the business. They meet with a lawyer to help them form a company, including advising them on such issues as choice of entity and allocation of ownership and control. Before the lawyer agrees to the representation, she must ask herself: “who will I represent?”1

The author of this hypothetical, legal ethics expert Stephen Gillers, suggests that the issue is whether conflicts of interest prevent the lawyer from representing all three founders, in which case the lawyer would presumably represent only one of them.2 Addressing a similar hypothetical, another legal ethics expert, Paul Tremblay, agrees that the only plausible alternatives are “represent[ing] the founders as joint clients, most often with an explicit understanding that the firm would later represent any resulting business entity” or “represent[ing] only one of the founders.”3 However, Tremblay also suggests that, in some circumstances, the founders will already have formed a partnership by operation of law, or a “default partnership.”4 In these cases, the lawyer will likely represent the existing partnership entity in choosing to form an entirely new entity.5 Tremblay also notes that under “the rather quirky Jesse v. Danforth doctrine,” recognized in a few jurisdictions, the founders, “while apparently individual joint clients during the formation stage, retroactively convert to constituents of the entity— instead of former clients of the firm—after the entity has been established.”6 Whatever that means. And, to offer yet another option, mentioned by neither Gillers nor Tremblay, a State Bar of Arizona ethics opinion advises that a lawyer may form a business entity for multiple founders “and be counsel only for the yet-to-be-formed entity”—describing entity representation that is prospective rather than retrospective.7 What’s a lawyer to do?

Most jurisdictions have not yet addressed the question of whether some form of “entity” representation is available before a business entity has been created. As a result, one of this Article’s goals is to explore the advantages and disadvantages of doing so by considering both the “retroactive” and “prospective” options. In my view, courts should reject both of these options and insist on representation of one or more of the individual founders. But if some form of entity representation is deemed desirable, then I argue that it is the “prospective” rather than the “retroactive” option that should be recognized. As for “default partnerships,” I agree that representation of the existing entity appears to be at least a theoretical option, but I argue that such representation may raise more problems than it solves. As a result, I urge lawyers to choose to represent the partners jointly as individuals rather than the default partnership entity.

Part I of this Article examines early views of client identity in forming a start-up company. Although most courts and commentators assumed that entity representation was impossible because the entity had not yet been formed, one prominent commentator proposed reforming the ethics rules to permit lawyers to represent an incipient entity—but only when it was sufficiently “formed up” such that the group was the functional equivalent of a legally recognized entity. Part II addresses the formal adoption of a retroactive entity approach to preformation representation, including the lack of persuasive precedent for such an approach, as well as the weakness of the stated policy rationales. Part III discusses the concept of prospectively representing a yet-to-be-formed entity, concluding that while this is more attractive than a retroactive approach, it presents many of the same difficulties. Part IV directly addresses the policy concerns in answering the question of whether courts should permit lawyers to represent a yet-to-beformed entity. It concludes that the disadvantages of doing so outweigh any benefits to the founders and that any such benefits can just as easily be accomplished through joint representation of some or all of the founders. Finally, Part V acknowledges that, under certain circumstances, founders who have begun the process of developing a business become default partners. When this happens, there is indeed an entity that qualifies for client status; nevertheless, here, too, there are difficulties in determining both the identification of the appropriate decision makers and the need to keep all the partners informed. As a result, this Article concludes that the partners are better off when the lawyer represents them individually in a joint representation, where appropriate.

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