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Stephen Ma was quoted in Alfred Lee’s article titled “Link to Website Windfall Splits Lawyers,” which appeared in the Los Angeles Business Journal. The full article can be found below:

Few L.A. companies in recent years have grown as quickly as Swagbucks.

The El Segundo consumer rewards website saw revenues rocket more than 4,000 percent in five years, to $53 million last year – before taking on a single outside investor.

And its sudden rise hasn’t just benefited its founders. Enjoying an unexpected windfall is the company’s law firm, Davis Shapiro Lewit Grabel Leven Granderson & Blake.

While Swagbucks’ sales took off, its outside attorneys held on to a 10 percent stake in its parent company, Prodege. The stake was granted in exchange for legal services during its early days, when cash was tight. Ten percent wasn’t worth much then, but now could be valued at more than $12 million.

Taking equity instead of fees is a practice that has come into vogue in Los Angeles with the emergence of the tech sector. Pioneered by Silicon Valley law firms decades ago, equity as compensation has been attractive to firms here looking to find the next Apple or Google.

But it also has led to problems. Davis Shapiro’s increasingly lucrative stake in its client has been the subject of internal wrangling at the firm, leading to the ouster of its managing partner and years of fighting over which attorneys get to share in the profit.

Daniel Hayes, an L.A. attorney and former managing partner who departed the Beverly Hills office of the New York firm in 2012, claims he was the attorney who originally brought Swagbucks to the firm. Two years later, he remains locked in a fight over his claims that the 10 percent stake should be his.

Peter Zeughauser, a Newport Beach law firm consultant, said that despite the practice’s rising popularity in Los Angeles, only a handful of firms have mastered the tricky art of making equity stakes pay off – and doling them out properly.

“A lot of the firms that have done them wouldn’t do them again if they were starting over,” he said. “These things are not so simple to administer. … The likelihood of success of having a startup exit strategy that pays out is small and there are a lot of spats over who should get how much.”

Prodege declined comment. Representatives of Hayes and Davis Shapiro did not provide comment.

Growing company

Prodege was co-founded in 2006 by entrepreneur Josef Gorowitz and concert photographer Scott Dudelson. The two met through mutual friends and launched a company that provided custom search engines for non-profit organizations, which could then raise money every time someone used the search engine.

“I had previously co-founded a honey export business out of Argentina and realized that while I was worrying about the movement of physical commodities from one location to another, companies like Google were making money simply on clicks,” Gorowitz told the Business Journal in 2011.

In 2008, Prodege launched Swagbucks. Users can collect reward points – known as swag bucks – for watching Internet videos or playing games, then redeem them for gift cards, prizes and discounts. Swagbucks earns a small referral fee when people use its site to search online, make a purchase or other actions. It also sells targeted advertising on its site.

Swagbucks generated $1.2 million in revenue in its first year, and has exploded since then. Revenue grew roughly tenfold in its first two years; executives have said that the company has been profitable since 2010. It has placed on the Business Journal’s annual ranking of fastest-growing private companies in Los Angeles in each of the last three years, peaking at third in 2011. Today, the company has about 110 employees in its El Segundo office.

Its success has drawn the attention of investors. Last month, Swagbucks announced a $60 million investment by Palo Alto’s Technology Crossover Ventures for a “significant minority stake.” Chuck Davis, a venture partner at Technology Crossover, replaced Gorowitz as chief executive. The deal valued the company at more than $120 million and marked the first time Gorowitz and Dudelson said they had taken an outside investment.

But quietly holding a stake all along was Davis Shapiro, then known as Davis Shapiro Lewit & Hayes. The New York entertainment boutique, founded by Fred Davis, son of music mogul Clive Davis, is known for representing startup clients including Spotify and MySpace Music. It has also occasionally taken equity stakes in clients, according to court documents.

The practice was popularized by Silicon Valley firms such as Cooley and Wilson Sonsini Goodrich & Rosati, which reaped big gains cashing out on stakes in clients including Google Inc. and VA Linux. Not everyone was a winner: Silicon Valley firm Brobeck Phleger & Harrison declared bankruptcy following the dot-com bust, which destroyed the value of the stakes it had taken in clients.

In Los Angeles, the practice has caught on amid the recent tech boom. Cooley opened a Santa Monica office in 2012 and invests in clients through partnerships that are formed annually by partners who choose to participate in a given year.

In general, firms have taken the lessons of the dot-com bust to heart and are less likely to do deals that are purely equity in lieu of fees. More common is a hybrid arrangement in which a firm might accept a small retainer fee or defer fees for the first year and take a smaller percentage of equity.

West L.A.’s Manatt Phelps & Phillips has gone as far as launching a digital ventures arm distinct from its law practice. The firm declined to comment, but told the Business Journal in April that it has made investments ranging from $25,000 to $500,000 in about 10 companies, including Encino YouTube network DanceOn and MovieLaLa, a social network for movie fans.

Dispute

Davis Shapiro’s stake in Prodege dates back to at least 2008. The firm received equity in lieu of fees, though it’s unclear whether it received other compensation. Hayes, then a partner in the firm’s Beverly Hills office, claims he brought the client in.

In 2008, a simple trip with the client bumped up the firm’s ownership by 5 percent.

“Thanks in large part to Peter (Lewit’s) offer to go to London with this client, we have increased our equity stake from 5 percent to 10 percent,” Hayes wrote in an email, included in court documents, to his partners that year. “They are really gaining momentum and we can help push it over the top.”

Davis left the firm in late 2009 to start an investment bank and Hayes took over as managing partner. But as the company grew, the relationship between Hayes and his partners frayed. In 2012, friction arose when a third party expressed interest in a potential acquisition of Prodege that valued the company at around $60 million, according to court documents.

“What appears to have fundamentally altered the relationship among these three partners was the prospect that a sale of Prodege might occur and that a 10 percent ownership interest could produce compensation dwarfing what any one of the partners had previously generated,” William F. Cavanaugh Jr., an arbitration judge who heard the case, wrote in a court filing.

Hayes’ former partners, Steven Shapiro and Peter Lewit, claim that a dispute broke out in 2012 when they asserted that the Prodege stake was a partnership stake and not Hayes’ alone, ultimately resulting in them terminating him as partner in November 2012.

In an affidavit, Hayes attributed the dispute instead to his refusal to issue advance payments to partners due to the firm’s dwindling finances, as revenues had dropped by more than half between 2008 and 2012; Shapiro and Lewit denied the claims.

The fight entered arbitration. In April, a panel ruled in favor of Davis Shapiro, granting the firm the 10 percent stake and ordering Hayes to pay his old firm $59,000 unrelated to the Swagbucks stake.

But the arbitration didn’t bring an end to the dispute. On May 30, Hayes wrote a letter again demanding rights to the Prodege interest, prompting Davis Shapiro to sue him in Los Angeles Superior Court this month. It is unclear if the stake was sold off or not in early May as part of the investment by Technology Crossover.

Stephen Ma, an attorney who reviewed the case for the Business Journal, said a 10 percent equity stake in a legal client is on the high side, as percentage stakes have been trending lower. Wilson Sonsini, for example, doesn’t take stakes larger than 1 percent these days. He added that he expected a settlement could be reached and that the case would hinge on the particulars of the contract.

“It’s ultimately a contract case. What does the contract say and how did the parties intend it?” he said.

Source: Los Angeles Business Journal