Lawyer Metrics (case study 1)

Law professor learns the challenges of business planning

Introduction

Week 1 of Business Planning focused on Lysozyme Venture, a hypothetical business created by two co-founders, Robert Bender, a serial entrepreneur who is a longstanding client of the firm, and Albert Wise, a professor of biochemistry at a large public university.  Bender and Wise are cousins and recently reconnected at a family wedding, where a conversation about work evolved into a conversation about co-founding a business. Through his university research, Wise may have discovered a process that will make the antibacterial properties of lysozyme (a naturally recurring enzyme found in egg whites) more robust.  According to Wise, lysozyme has “dramatic potential” to revolutionize food storage by extending shelf life and reducing the need for refrigeration. See Memo to File, Breakdown of Bender’s and Wise’s Proposed Venture.

In effect, the Lysozyme Venture is the classic presentation of a co-founder who has developed some technology with commercial potential and another co-founder with financial capacity and business expertise. 

The Week 2 Lawyer Metrics Case Study has a similar frame, albeit with several technical co-founders and funding through a university alumni network of high net-worth professionals with business expertise.  The multiple technical co-founders create an additional layer of complexity. In addition, the network of funders is akin to angel and seed-round funding for venture capital, thus requiring compliance with federal and state securities laws. This type of venture is also going to require a detailed governance document. 

What is this case study about?

Lawyer Metrics was an applied research company formed in 2010 by Professor Henderson (and several other co-founders) with the expectation of significant additional funding from IU Maurer alumni, who would be investing for the substantial benefit of the Law School. It was sold to a large education nonprofit in late 2015. See Debra Cassens Weiss, “Law school nonprofit buys Bill Henderson’s Lawyer Metrics company,” ABA Journal, December 21, 2015; Marilyn Odendahl, “Access Group’s acquisition of Lawyer Metrics may help law schools, firms align goals,” Indiana Lawyer, January 12, 2016. 

This case study is organized into the following six sections:

1. Market opportunity: The market insights and the perceived market opportunity that motivated the company’s creation (focused on human capital).
2. Entity selection:  Why the company was formed as an LLC.
3. Getting “founders” and “funders” onto the same page:  The complexity of successfully recruiting additional co-founders; the incentive structure between “founders” and “funders” that formed the basis for the basis.
4. Raising money through a private placement:  How the company complied with state and federal securities laws, including how the private placement interacted with founder employment contracts, avoiding a potential dispute.
5. Important drafting decisions:  In hindsight, several important drafting decisions in governance documents, including the LLC operating agreements, founder employment agreements, and founder equity grant agreements, were crucial to avoiding conflict that could have escalated into costly and potentially fatal litigation.
6. Positioning company for sale:  Identifying a potential acquirer that would assign the highest possible valuation of the company.

The concluding section briefly discusses on the Lawyer Metrics experience deepened Professor Henderson’s understanding of business and the role of lawyers in the business planning process.

 1. Market Opportunity

The idea for Lawyer Metrics grew from Professor Henderson’s research on the legal profession, which began in 2004 when Henderson taught a course called “Law Firms as a Business Organization (B653).”  In the course of preparing for this course, Henderson started collecting and analyzing data on the AmLaw 200, which is a list of the nation’s 200 largest law firms based on revenue. 

One of his most surprising early insights was the finding that single-tier law firms (only equity partners) were significantly more profitable than two-tier firms (equity and nonequity partners), yet the market was moving rapidly to the two-tier structure.  Why was the less profitable structure becoming more pervasive?  This question was answered in one of Henderson’s first law review articles as a Maurer Law faculty member. See William D. Henderson, “An Empirical Study of Single-Tier Versus Two-Tier Partnerships in the Am Law 200,” 84 NC L Rev 1691 (2006) (positing that higher prestige can afford to run a longer and more selective tournament whereas less prestigious firms relied upon nonequity partners to increase leverage).  

A second insight occurred in the summer of 2007 when NALP published the below graphic on the distribution of the starting salaries for the class of 2006.

The most salient feature of the above distribution is that it is bi-modal, which is very unusual for a labor market. 

Presumably, employers are willing to pay more for higher-ability candidates.  Thus, we expect starting salaries to follow a standard distribution (bell curve) in which the mean (average), median (50th percentile), and mode (most frequently occurring value) all tend to converge on the same value.  In contrast, when a labor market has a bi-modal distribution, some combination of two things are happening: (1) employers are overpaying for entry-level talent, and (2) significant amounts of high-quality talent are available at bargain prices.  See Greg Mankiw, “Bimodality,” Greg Mankiw’s Blog, July 10, 2008 (famous Harvard economist commenting on law’s unusual bi-modal distribution).

At the time, Henderson suggested that the market for “elite” talent was overheating, with demand outstripping supply.  In effect, the second mode was moving to the right because virtually all large law firms used selection criteria based on grades and law school prestige. At the time, Henderson observed, “All these firms want Harvard, Columbia, Chicago graduates, etc. and, if necessary, Illinois (top 25%), Indiana (top 15%), Marquette (top 10%), etc.  If legal education worked like any other market, Northwestern would be merging with Cardozo, exploiting Cardozo’s capacity and location and leveraging Northwestern’s brand.  But law schools are maximizing prestige, not output or profit.”  See Bill Henderson, “Distribution of 2006 Starting Salaries: Best Graphic Chart of the Year,” ELS Blog, Sept 4, 2007. 

During this same time period, two researchers at the University of California-Berkelely began releasing preliminary findings of a major study that identified and measured 26 effectiveness factors among practicing lawyers.  Further, the study documented that LSAT scores and law school grades predicted a relatively small subset of effectiveness factors. In contrast, other psychometric tools (associated personality and biodata) were much better predictors of nearly all measures of lawyer effectiveness. See Marjorie M. Shultz & Sheldon Zedeck. Final Report – Identification, Development, and Validation of Predictors for Successful Lawyering (January 30, 2009).

Thus, Henderson and Dean Lauren Robel began discussing the possibility of empirical research that could benefit Indiana Law, both in improving student placement and developing commercially viable products and services.  In 2009, this resulted in the funding of a working group (Human Asset Development Project, or HAD) that included alumni with relevant expertise and outside consultants specializing in human capital, lawyer development, and statistics. Eventually, the working group concluded that private commercial business was the best road forward, with IU Law alumni investing the equivalent of venture capital funding for the financial benefit of the Law School. 

Similar to the Bender/Wise problem, this required clarification of the University’s right to any associated intellectual property. Fortunately, the University’s General Counsel concluded that what would become Lawyer Metrics was outside the scope of the University’s Intellectual Property Policy. See Indiana University IP Policy (adopted May 2, 2008).

In early 2010, as plans for Lawyers Metrics began taking shape, several law firms were interested in participating in low-cost pilot studies.  One of them resulted in a “Moneyball” study where we used resumes collected at the time of hiring associate resumes (collected at the time of hiring) to predict performance at midlevel associates. That study, which was conducted for a few thousand dollars (our internal cost), resulted in the following two-by-two matrix:

The top right box (blue) contains factors that are likely to be ignored by law firms yet are associated with above-average associate performance.  Conversely, the bottom left box (box) lists several factors that law firm generally value yet are not associated with strong future performance.  In fact, the factors in red (Undergraduate Honors and Law Review) were negatively correlated with mid-level associate performance.

By the fall of 2010, when Lawyer Metrics was considering organizing itself as a venture capital-based business, it formulated a detailed set of current and future product offerings that were responsive to known law firm pain points. See Lawyer Metrics Products and Services, Sept 2010.

2. Entity Selection

The potential for running law firm pilots (and collecting data) necessitated the creation of a separate business entity.  In March 2010, Lawyer Metrics was formed as an Indiana Limited Liability Company. See Lawyer Metrics Certificate of Organization, Indiana (March 25, 2010).

Although Professor Henderson was initially the sole member and owner, it was anticipated that several alumni connected to the working ground would become investors with the intent of benefiting the law school.

In this situation, an Indiana LLC was a relatively obvious choice.  The rationale included four reasons:

1. Limited liability, making it a better option than a sole proprietorship or partnership.
2. Pass-thru taxation, as we anticipated some initial losses. Using a C-Corporation would have created the possibility that such losses could be permanently locked inside a failed business entity.  See Dwight Drake, Business Planning: Closely Held Enterprises (5th ed 2018) at 47 (“Losses sustained by a C Corporation are trapped inside the corporation. They may be carried backward or forward [to affect the tax liability of the entity], but they will never be passed through to the shareholders.”).
3. Flexibility in ownership structure, as we wanted to create the equivalent of different classes of stock for founders (those active in the business) and funders with different business objectives (benefiting Indiana Law versus seeking a venture capital return). This type of structure is unavailable with S-Corporations, which precludes more than one class of stock. See IRC §1361(b)(1)(D).
4. Flexibility in governance, as a manager-managed LLC could be structured to mirror a traditional board of directors. 

Because lawyers with ample business experience formed Lawyer Metrics, we did not spend any time deliberating the choice of entity.  For a reliable overview of the above analysis and relevant factors, see Dwight Drake, supra, Chapter 3 (“The Choice-of-Entity Challenge”).  See also Clifford R. Ennico, Advising Small Businesses (Thomson Reuters June 2023) at § 2.37 (listing advantages and disadvantages of LLCs). 

Lawyer Metrics operating agreement–the critical governance document for an LLC–reflected these choices. See Lawyer Metrics LLC Operating Agreement. Before that document could be put into effect, however, the founders and funders had to agree on the material economic terms–i.e., the type of things that bargain back and forth when creating a term sheet. See Investopedia, Term Sheets: Definition, What’s Included, Examples and Key Terms, July 31, 2023 (“A term sheet is a nonbinding agreement that shows the basic terms and conditions of an investment. The term sheet serves as a template and basis for more detailed, legally binding documents.”) For background on a manager-managed LLC, see Ennico, Advising Small Business at § 7.22.

Relevant forms for future use:

• For a manager-managed LLC form agreement with practice notes, see Ennico, Advising Small Business: Forms at § 7.11.  
• For checklists of the pros and cons for all business entities, see Ennico, Advising Small Business: Forms at § 2.4.

3. Getting “Founders” and “Funders” on the Same Page

One of the most distinctive features of this case study was the relatively large number of technical personnel (five) who were part of the initial founders group. Areas of expertise included legal labor markets (Henderson), law firm recruiting, IO psychology, lawyer training, and statistics. In addition to this substantial brain power, Lawyer Metrics would need substantial seed funding ($800,000 to $1 million) from outside investors. Cf  Memo to File, Breakdown of Bender’s and Wise’s Proposed Venture (two founders with one providing financing). 

In effect, before the business could be launched, two levels of negotiations needed to reach a successful conclusion:

1. Allocation of decision-making, financial rewards, and control between funders and founders, and
2. Division of labor, level of commitment, decision-making, and financial rewards among co-founders.

Obviously, founder-funder terms (#1) would affect the range and desirability of intra-founder terms–something that was not necessarily obvious to the five initial Lawyer Metrics co-founders. 

In September of 2010, the “founders” and “funders” met on-site for two days in Boulder, Colorado. The lead funders were several IU Law alumni with substantial experience as business lawyers, operators, and investors.  To start the negotiations, the founders were presented with a term sheet that, among other features, proposed a 15-85% split of profits and 30-70% of capital gains upon selling the business. See Proposed Term Sheet for Lawyer Metrics (Sept 7, 2010). In exchange for their financial investment, funders would receive either A or B Units, which had the same economic and voting rights yet signaled whether they were investing for themselves or to benefit the Law School.  In exchange for their labor and ideas, founders would receive C Units, which were profit interests that vested over time.

The 85/15 split of profits in favor of the funders was generally not contentious because it was presumed that all profits would be put back into the business in order to maximize an eventual sale price, which had a more favorable 70/30 split. However, the biggest challenge with the 30% split was an allocation of 6% per founder, assuming a pro rata distribution.  The majority of the founders felt this was too little upside to make a deal possible.  This issue was resolved by creating additional ownership interest (D Units) which entitled founders to 40% of the sale price of the company for any amount excess of an internal rate of return (IRR) of 25% until the end of 2017 (first six years) and 10% IRR per annum thereafter. 

To illustrate: If the company had $800,000 in invested capital, the threshold IRR would be met if the company was sold for $1 million at the end of Year 1, $1.25 million at the end of Year 2, $1,562,500 at the end of Year 3, $1,953,125 at the end of Year 4, and $2,441,406 at the end of Year 5. Thus, if the company were sold for $5 million at the end of year 4, the proceeds would be allocated as follows:

Thus, the funders would receive $2,521,250 (including their $800,000 in capital invested) while the founders would receive $2,478,750. In contrast, if the company were sold for $1.5 million in year 4 (below the 25% IRR), funders would only receive $210,000 (30% of a $700,000 return on capital). 

The improved 70/30 founder split (above the 25% IRR) ultimately proved satisfactory for all five co-founders.  However, the next hurdle was negotiating individual employment contracts for all five co-founders. In addition to salary and vesting terms for founder equity, this required the co-founders to agree on how to allocate C and D units.  Henderson proposed giving slightly more C units to the founder slated to become President, as this person would bear the burden of daily management duties. However, he advocated an even distribution for D units, as exceeding the 25% IRR would require immense teamwork among all co-founders.

Ultimately, one co-founder dropped out because he thought the equity allocation and vesting schedule did not fit the timing of his biggest contribution, which he felt would occur in the first year of operations.  A few months later, during the course of Lawyer Metrics’s funding raising efforts, discussed below, a second co-founder dropped out when it became clear that he would need to relocate his family in order to stay in compliance with the governance documents, including his employment contract. 

4. Raising money through a private placement

In many start-up businesses, the initial capital “is acquired chiefly through the personal resources of the owner or his immediate relations, and investor-related debt.” Dwight Drake, supra, Ch 6, Capital Sourcing Challenges at 166 (discussing options like personal assets, home equity loans, direct investments from friends and family, and personal guaranteed on bank loans).  However, when the amount of start-up capital is relatively substantial, the most common and likely source of funding is external equity investment.  

The Lawyer Metrics business plan required between $800,000 and $1 million in start-up capital. Why did the company require this amount of capital?  Primarily to provide enough financial runway to enable two of the co-founders to work full-time in the business for a period of at least two years, as it would take substantial time to develop, sell, and deliver the company’s new products and services. See See Lawyer Metrics Products and Services, Sept 2010. In effect, the purpose of the start-up funding was to de-risk (at least partially) the career changes of uniquely qualified co-founders. 

Any time a business seeks out external investment (debt or equity), it raises the specter of state and federal securities laws.  See Dwight Drake, Ch 6, Capital Sourcing Challenges, supra, at 180 (noting that compliance with securities law is necessary any a business seeks to raise external capital).  Under federal securities laws, any offer or sale of a security must either be registered with the SEC or meet an exemption. Because only a tiny fraction of businesses would ever consider enduring the initial and ongoing expense of issuing a registered security, the exemptions are key to the financing of many closely held business entities.

Under the Securities Act of 1933, there are two potential statutory exemptions. 

1. Section 4(2), which exempts from registration any “transactions by an issuer not involving a public offering.”  Section 4(2) commonly referred to as the “private offering” or “private placement” exemption.
2. Section 3(a)(11), which exempts from registration securities offered and sold only to residents of a single state by an issuer who is a resident of and doing business within the same state. Section 3(a)(11) is commonly referred to as the “intrastate offering exemption.”

To reduce uncertainty among issuers, the SEC has published rules that set forth specific standards for meeting the exemptions. Rules 504 and 506 of Regulation D describe two private offering exemptions available under Section 4(2); SEC rules 147 and 147A deal with the intrastate offering exemption under Section 3(a)(11).

Among these exemptions, the most commonly used is Rule 506. See “The Most Common Exemption–Regulation D Rule 506,” Capital Law Group, May 3, 2023 (noting that Rule 506 accounts for more than 90% of exempt offerings).  Not surprisingly, this was also the provision relied upon by Lawyer Metrics.

The major advantage of Rule 506 is that it preempts all state securities law registration requirements, see Ennico, Advising Small Business at §16.5 (noting that the National Securities Markets Improvement Act of 1996 preempted state blue sky laws for any offering under Rule 506 of Reg D), which saves a great deal of time and expense when investors reside in multiple states.  It also has no cap on the amount of money raised.  The major limitation of Rule 506 is that investors must qualify as accredited investor under U.S. Securities law, which is generally determined by net worth (>$1 million) and income (>$200,000 per year) combined with professional criteria associated with the ability to access and evaluate relevant information about the business.  

To ensure compliance with Reg D, Lawyer Metrics prepared a detailed private placement memorandum (PPM) that included: a summary of the offering (pp 1-5), including the personnel involved; a detailed listing of risk factors (pp 6-9); use of proceeds (p 10); discussion of the business (pp 11-15); Background and description of the management team (pp 16-20); terms of the offering and plan of distribution (pp 21-23); who should invest (pp 24-25); description of ownership units and operating agreement summary (pp 26-31); Federal Income Tax and ERISA considerations (32-41). PPM exhibits included reviewed 2010 financial statements (Exhibit A), cash flow projections (Exhibit B), amended and restated operating agreement (Exhibit C), and the subscription agreement (Exhibit D).  

Note that the subscription agreement was specifically written to safeguard compliance with Rule 506.  Finally, Lawyer Metrics filed Form D with the Securities & Exchange Commission.  See Lawyer Metrics SEC Form D (dated Feb 11, 2011). 

Relevant forms for future use:

• Ennico, Subscription agreement—Long form, Advising Small Businesses: Forms at §17.3 (form compliant with Rules 505 and 506 under Reg D).
• Ennico, Prospective investor questionnaire, Advising Small Businesses: Forms at §17.4 (for use in connection with an offering under Rule 505 or 506 of Reg D).

5. Important drafting decisions made in the formation documents

Similar to other start-up ventures, the key governance and strategy decisions were ultimately embedded inside several contracts, including the LLC operating agreement, individual employment agreements, and grant agreements for C and D units.

In hindsight, two drafting decisions proved to be especially important in controlling the impact of management personnel changes and intra-founder conflict. 

5.1 Avoiding the stranded equity problem

The first decision dealt with the possibility that the private offering would take significant time and, to ensure full alignment of incentives, require a reallocation of founder equity.  In chronological terms, the operating agreement was amended and restated employment in early January 2022, followed by the signing of founder employment agreements and equity grants in January and February of 2011, and filing of Form D with the SEC, which commenced the private offerings. However, each founder’s employment agreement included a term which stated:

In addition, all the grant agreements contained the following provision:

Without the above provision, the Company was at risk of stranding equity with co-founders despite a material change in their ability to contribute to the business. Not only would this situation dull incentives for the other co-founders, the stranded equity would likely require an update to the offering documentation and make it more challenging to raise the required funds during the 12-month offering period.

As it turned out, one of the co-founders had become reluctant to relocate his family from another country.  Thus, Lawyer Metrics exercised its right to terminate the co-founder’s employment agreement (and revert C and D Units back to the company) while simultaneously making clear to the co-founder that the company was very open and willing to negotiate terms that better fit his family and professional situation.  Because of these contractual terms, Lawyer Metrics was spared complex and potentially harmful negotiations over co-founder’s separation from the company.

As it turned out, the original group of five co-founders had now been winnowed down to three.

5.2 Containing the risks of an intra-company dispute

Internal conflict in closely held companies is common, particularly among co-founders.  In some cases, these disputes will escalate to the point where one or more co-founders decide to exit the business.  As a result, during the formation stage, the goal is to create a set of incentives that reduce the likelihood that the business will be permanently and irreparably harmed. 

Approximately two years after launching, the Lawyer Metrics co-founders were at loggerheads over strategy.  Although the company had no problem obtaining meetings with many of the world’s largest law firms, the sales cycle was proving to be, at best, extremely long.   To conserve limited cash reserves, one co-founder wanted to target medium-sized law firms (AmLaw 100-200 and the bottom of the NLJ 250), as these firms had fewer layers of decision-makers. Following the Moneyball analogy, the smaller firms were more akin to the Oakland Athletics–i.e., the lack of financial resources necessitated that they be more open to new ideas. The counter argument, of course, was that all baseball teams eventually adopted the Moneyball approach–and that by landing the equivalent of the New York Yankees or Boston Red Sox as clients, the rest of the market would rapidly follow. 

Regardless, the co-founders could not agree on a compromise. When the board was unable to broker a compromise, one co-founder decided to leave the business. 

In terms of business planning, the key point of this section is that Lawyer Metrics (or any small start-up with limited funds) could not survive an intra-founder dispute that resulted in either a lawsuit or a large cash payout.  Yet, when parting ways, both sides will necessarily want to interpret agreements and obligations in ways that are most generous to them.  One way to keep a disagreement from escalating into a lawsuit is to include a fee-shifting provision in all formation documents. For example, below is the language from Lawyer Metrics LLC operating agreement:

Similar language was included in all employment contracts and well as equity grant agreements. The consequence of this language is that if and when an intra-organizational dispute occurs, the cost of pleadings and discovery does not necessarily become a source of additional settlement leverage that effectively ends the company.  Instead, because the cost of litigation is likely more than the dollar value of the underlying dispute. the parties are strongly incentivized to consider less drastic, and likely more reasonable, alternatives. 

For many small start-ups, the above approach would be a simple and effective way to mitigate a common and foreseeable event.

6. Positioning company for sale

Conclusion (this should be your “Connections to other parts of the course.