Law firms increasingly are turning toward high-risk, high-reward venture capital investing as a way to spur technology innovations to streamline functions like contract review and legal research.

Yet the investments are raising conflicts-related concerns among legal ethics experts and competing firms that have rejected the approach.

As clients demand better technology solutions from their law firms, some of the largest and most prestigious firms in the U.S. and U.K., including Dentons, Latham & Watkins, and Orrick, have turned to different forms of venture investing. That business model allows law firms—typically risk-averse operations compared with the players in Silicon Valley’s VC culture—to purchase equity stakes in legal tech startups.

But some see downsides to such investments, including the possibility that a law firm’s advice to clients on tech adoption issues could be tainted.

Rising Tide

Investments in legal tech companies exploded in 2018, from $233 million in 2017 to $1.7 billion last year, according to figures from the Legal Tech Sector Landscape Report by Tracxn Technologies.

Law firms provide a relatively small portion of total investing in this space. But firms increasingly are seeing the advantages of promoting legal tech startups directly through VC investments, and in other ways, to boost revenues and at the same time promote legal tech innovation that can benefit the entire industry.

“All of us are lifted by a rising tide,” said Dan Jansen, CEO and managing director of Nextlaw Ventures, the legal tech-focused venture capital operation whose first investment round was funded exclusively by Dentons. That tide is becoming a tidal wave, he said, as the number of legal tech companies has exploded over the last five years from 50 to about 1,500.

Some tech-forward firms like Perkins Coie have decided against opening their own venture capital operation for now—in part because of the concerns over the potential for conflicts.

“If you’re an investor, and you’re recommending the company you’re investing in to clients, conflicts can arise,” said Fiona Brophy, co-chair of the firm’s emerging companies and venture capital practice. “Our brand is providing trusted advice to our clients. We don’t want to be in a position where our advice is called into question.”

Writing Checks

Nextlaw Ventures is one of the biggest and oldest law firm VC operations. It made its first investment in late 2015—in ROSS Intelligence, an artificial intelligence-powered legal research platform. The Dentons-funded group invested in 10 legal tech startups in its first round, also including Qualmet, a tool that allows in-house counsel to collect data they can use to gauge the performance of their outside lawyers.

Nextlaw Ventures has written checks to fund each of the 10 startups—in some cases three times, Jansen said, as the companies have gone through the smaller “pre-seed” and “seed” investment rounds, and then in some cases a “Series A” round, investments typically worth $400,000 or more.

As a matter of course, 30 to 40 percent of these types of startups die before gaining traction, he said.

Jansen declined to say exactly how much Nextlaw Ventures has invested in its companies, other than to say that an average check to one of these startups is in the $200,000 range. In return, Nextlaw Ventures has received anywhere between 5 and 20 percent equity shares in the company.

Dentons’ backing of the operation remains strong, he said, as evidenced in the ongoing formation of Nextlaw Ventures’ second fund, which will include a larger group of companies.

It makes sense for law firms to use VC investments to promote legal tech, said Mike Bryant, operating partner with Knox Capital Holdings, a private equity firm—especially as firms face consistent pressures from the likes of the Big Four accounting firms, which are strong tech innovators growing fast in the legal space.

“When you look at the likes of Dentons and the others, the question is, why not?” said Bryant, who focuses on legal tech and services investments. “Why not diversify and make some bets on tech?”

Bryant warned, however, that firms need to commit to a VC investing philosophy. “It’s going to take a thick skin,” he said. “There are going to be winners and losers along the way.”

Legally Vetted

Nextlaw Ventures’ second fund will allow for investments not just from Dentons, but also from individual firm partners and outside companies as well, said Jansen.

The firm is doing all it can to avoid potential conflicts, he said. In part because he’s an entrepreneur and startup advisor—and not an attorney—he said he raised the issue when in discussions with firm leaders to join the operation. “They assured me that the structure was vetted legally, and is fully appropriate with what we’re doing,” he said.

The firm has not pressured partners to invest in the upcoming second fund, he said—in fact, the opposite is closer to the case: “Many partners have approached us.”

Law firms going down the VC path should be aware that legal tech investments could color advice to clients, said Kathleen Clark, a legal ethics professor at Washington University in St. Louis School of Law.

“The first thing that comes to my mind is the potential conflict of interest,” she said.

She explained that problems could come up in part because lawyers could steer clients toward companies that their firms have financial investments in—without fully disclosing that fact.

Yet firms should be able to resolve such issues, said Clark. And generally, there’s a significant upside to firms making VC bets on legal tech companies, she added, given that law firms historically have been technologically “backwards” compared to other industries.

Innovation Strategies

Firms are developing relationships with legal tech startups in a variety of ways.

Some have decided to make investments in individual companies and not groups, like British “Magic Circle” firm Slaughter and May’s funding of London-based document review company Luminance. Others are engaged in different types of collaborations with startups to develop specific products, like Baker McKenzie.

Firms such as Allen & Overy have set up legal tech “incubators,” which support legal tech companies through product development, and yet others have become “accelerators,” fixed-term arrangements through which they provide funding, connections, and sometimes mentorship. The Dentons-connected Nextlaw Labs, a sister group to Nextlaw Ventures, is one such accelerator.

Orrick has adopted a strategy somewhat similar to Dentons. But it’s taking a smaller-scale approach designed to mitigate risk, said Don Keller, the Silicon Valley-based leader of Orrick’s technology sector practice.

Orrick announced last November that it’s preparing to invest $250,000 in promising legal tech companies, said Keller. He expects to make about two such investments per year. One criterion is that the firm will invest in companies only after they’ve been validated by a larger round of funding from a more traditional VC shop.

“We are lawyers,” said Keller. “We understand the VC community, but we’re not as good at their job as they are.”

Sometimes lawyers make these types of investments as individuals.

Last June, for example, Hogan Lovells partner Neal Katyal invested in Everlaw, a cloud-based ediscovery and litigation platform.

In response to emailed questions, Katyal declined through a spokeswoman to say exactly how much he invested in the $25 million Series B funding round.

But the spokeswoman did say the investment had been approved by Hogan’s then-general counsel, and that Everlaw is not a firm client.

“Neal is an appellate lawyer, and has no need for trial management software (which is what Everlaw does) nor has Neal has ever recommended Everlaw to a firm client,” said Hogan Lovells spokeswoman Maria Woehr in a written statement on Katyal’s behalf. “He does not do trials and uses no document management software/platforms.”

‘The Missing Piece’

The legal tech app platform Reynen Court is using yet another venture-type model, the law firm consortium.

One month before Orrick’s announcement, a group of 12 major firms, including Skadden and Paul Weiss, unveiled Reynen Court, a new legal services automation platform, which will function as a kind of legal tech app store.

Reynen’s two lead firm investors, Latham & Watkins and Britain’s Clifford Chance, each invested $2.1 million into the Reynen startup, said its founder and CEO Andrew Klein, who said he put up $2.8 million of his own money through an affiliated company, Prins H LLC.

Reynen executives now have verbal commitments from 50 legal tech vendors to be a part of the group’s platform, Klein said, and are tracking the progress of another 200.

A Latham spokeswoman declined to comment. But according to a Clifford Chance spokesman, the platform being built by Reynen could be “the missing piece of the puzzle which can unleash a wave of innovation in law firms and clients for the benefit of the entire industry.”