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TEN THINGS I WISH MY LAWYER HAD TOLD ME ABOUT STARTING A TECH COMPANY

by
John F. Delaney, Esq.
Morrison & Foerster LLP
1290 Avenue of the Americas
New York, NY 10104-0050
Telephone (212) 468-8000
Telefacsimile (212) 468-7900
jdelaney@mofo.com
www.mofo.com

Summary of SAEC's "CEO Meet" Presentation
March 5, 2002

NOTE: The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

10. FORM A CORPORATE ENTITY!

  • Don't do business in your individual capacity -- form a corporation ("C" corporation or "S" corporation) or a limited liability corporation ("LLC") and do business through this corporate entity.
  • So long as corporate formalities are observed, you will generally be shielded from personal liability. For example, in general, your company's creditors will not be able to attach your personal property (e.g., your house or car) to satisfy the company's debts. However, if formalities are not observed or if there has been gross negligence a court could "pierce the corporate veil" and hold you personally liable.
  • It is important to consult an attorney or accountant regarding what type of entity is best for your needs. Also, get advice regarding in which state to incorporate.


9. AVOID HAND-SHAKE DEALS!

  • Get it in writing -- handshake deals can result in disaster, with disputes arising over what terms were agreed to by the parties.
  • Putting together a formal written agreement forces the parties to think through the issues involved -- whether its money, ownership, control, or allocation of risk.
  • If you get the better end of the deal, you will want to put it in writing -- or the other side may seek to back out when that fact becomes clear to him or her!
  • Potential investors can't review hand-shake deals! They demand to see written agreements.
  • If your business becomes successful, you will find it nearly impossible to go back and document the deal! At best, you will be "held up" for more money, renegotiated deal terms.


8. REFUSE TO SIGN ANYTHING YOU DON'T UNDERSTAND!

  • Flip-side to Rule No. 9.
  • If you don't understand a draft contract, have it reviewed by someone with relevant expertise who can explain it to you.

7. HAVE A "HEART-TO-HEART" TALK WITH YOUR CO- FOUNDERS UP FRONT!

  • Co-founders need to work through "worst-case scenarios" and memorialize how they want to handle those situations.
  • For example, if a co-founder walks away from the venture before funding, should he or she continue to own his or her same percentage in the company? If a departing founder is able to keep the same percentage, there is a risk that he or she will get a "free ride" on the efforts of his or her co-founders (especially in the case of an early-stage company where there is still a lot of hard work to be done).
  • Key: Discuss these issues while everyone is still friends -- and enter into the corporate version of a "pre-nuptial" agreement!


6. RAISE MONEY FROM RICH FRIENDS BEFORE RAISING MONEY FROM RICH STRANGERS!

  • Don't assume that you need a venture partner. Especially in this market, venture capital is essentially unavailable to early-stage start-ups. Also, remember that venture capital always comes at a price. A venture capitalist expects to have a say in your company, including its strategic direction and key issues like budget and compensation.
  • Try to fund early growth of your company from revenues. Approach friends and family for money before looking to angels. Approach angels before venture capitalists. Note that, with limited exceptions, you should only seek out "accredited investors" who meet certain income or net worth requirements established by the SEC. Generally, an "accredited investor" is someone who has individual net worth that exceeds $1 million, or a natural person with income exceeding $200,000 in each of the two most recent years and a reasonable expectation to earn the same in the current year. Raising money from non-accredited investors is significantly more costly from a legal perspective (perhaps requiring a full-blown disclosure document) and a bad idea generally (can non-accredited investors afford to buy into an early stage risky venture?).
  • When selecting a venture capitalist avoid the tendency to simply go with the one offering the highest valuation. Make sure you take into account the venture capitalist's reputation and the "value add" they can offer, including the depth of their expertise and whether they show a willingness to make a long-term commitment to your company.
  • Remember to begin your search for money at least six to nine months before you'll need it. Avoid the "I have to close by Friday to meet payroll" problem.


5. SECURE YOUR COMPANY'S NAME!

  • If you are going to spend money "branding" your company, make sure that you have rights in the "brand."
  • It is not sufficient to have secured your company's name through incorporation in a given state. It's essential to do a trademark search and, if the search reveals no problems, to register the trademark.
  • Trademark rights are established through actual use of the mark in commerce -- such use will not be reflected in state incorporation records. A party that has trademark rights can prevent others from using the same mark in the same "field of use"-- so, if your new Internet start-up is called "Apple Software," you've got a problem. In contrast, Apple Bank and Apple Computer can co-exist because they operate in different fields of use.
  • You can conduct a trademark search through companies like Thomson & Thomson for as low as $350 per mark searched. Filing an application to register the mark can cost as little as $1,500. Also, you can now file an "intent to use" application if you are not actually using the mark yet. If you are the first to file an intent to use application, once the application has matured to registration, you may be able to prevent others from using the mark after the application's filing date, even if their uses precede your first use of the mark in commerce.
  • Remember that in choosing a name for your company, fanciful and arbitrary names are better than descriptive names. Good examples include "Amazon.com" for an online bookstore; "Yahoo!" for an online portal. On the other hand, "Super Fast Software" for a software company is too descriptive. "Pets.com" is not a great name either.
  • Bottom line: If you are going to incur the expense of creating business cards, reserving a domain name and so forth, make sure you have the appropriate rights to use the name.


4. IDENTIFY AND PROTECT YOUR IP RIGHTS!

  • If your company is a technology company, much of its value will be tied to intangible intellectual property. At a minimum your company should set up a system to consistently identify, manage, and protect its intellectual property assets, including establishing policies and procedures to be followed by employees.
  • COPYRIGHTS protect expression, not underlying ideas. Examples: Software, manuals, drawings, schematics, memos, reports, articles, advertising and promotional materials. Although copyright protection now attaches upon creation, you should nonetheless use the copyright notice on your copyrighted works and register the copyright in such works with the U.S. Copyright Office. For more information see the U.S. Copyright Office's website at http://lcweb.loc.gov/copyright/
  • PATENTS protect inventions -- that is, ideas -- so long as they are useful, novel and non-obvious. Examples: Machines, devices, processes, and business methods. Unlike copyrights, patent rights do not attach upon creation -- rather, the U.S. Patent and Trademark Office decides whether your invention qualifies for a patent. Beware of statutory bar issues: a patent will not be granted on your invention if you have sold (or offered for sale) your invention or disclosed it to the public, in a publication or otherwise, more than one year prior to filing the patent application. Provisional patent applications are now available-- by making this simplified (and generally less expensive) filing you can establish an early priority date. Filing a provisional patent application gives you a full year to assess the invention's commercial potential before committing to the higher cost of filing and prosecuting a non-provisional application. For more information on patents see the U.S. Patent and Trademark Office's website at http://www.uspto.gov/main/patents.htm.
  • TRADEMARKS protect names, words, symbols, logos, and sounds used to identify the source of good or services. Trademark rights can attach upon use of the mark in commerce, but prudence dictates that you should conduct a search and register your mark prior to investing time or money in the mark. Use the "TM," "SM" or "R" notices as appropriate. In order to avoid forfeiture of your rights, it is important to impose quality-control restrictions when licensing the mark for use by others. For more information on trademarks see the U.S. Patent and Trademark Office's website at http://www.uspto.gov/main/trademarks.htm.
  • TRADE SECRETS are confidential and proprietary information that give your company a competitive advantage. Examples: Manufacturing processes; source code; technical and marketing "know-how"; customer lists; formulas (e.g., Coca Cola formula); market research; and so forth. Trade secret protection lasts only as long as the information is kept confidential. So your company must set up procedures to maintain the confidentiality of its trade secrets! For example-- consistently mark your company's confidential materials with a "Confidential & Proprietary" legend; have employees and consultants sign confidentiality agreements; and keep trade secrets in secure areas.


3. JUST BECAUSE YOU PAID FOR IT DOESN'T MEAN YOU OWN IT!

  • Be cautious when using consultants -- just because you are paying for them to create something for you doesn't mean that you own the IP rights in what they create!
  • Indeed, the law is counterintuitive -- generally speaking, if a consultant creates software, marketing materials, or other work for you, and there is no signed agreement assigning IP rights to you, the consultant retains ownership rights in the work!
  • Example: Cybration/ICUII, a supplier of online video software, hired a programmer for work related to Cybration's core product. Though Cybration paid the programmer $300,000, there was no written contract at all between the parties, and therefore no assignment of rights from the programmer to the company. The parties eventually settled-- but not before Cybration had to expend financial and other resources in filing a lawsuit to force resolution of the matter. Result: Serious set back to Cybration's business. See Tara Copp, Local Startup in Court Battle, CORPUS CHRISTI CALLER-TIMES, June 7, 2000, at C7.


2. PAY ATTENTION TO THE TAX ASPECTS OF YOUR ACTIVITIES!

  • For example, as noted above, your choice of corporate entity can have a dramatic impact on your bottom line.
  • Another example is the "83(b) election." In the case of restricted stock, which is typically granted early in the life of the company, failure to file an 83(b) election can have negative tax consequences for the recipient of the stock if the stock subsequently increases in value.
  • Tax issues are too complicated to explore in detail here -- but make sure that your attorney or accountant are helping you to identify these issues.

1. PAY ATTENTION TO EMPLOYEE ISSUES!

  • There are more lawsuits against start-ups generated by current and former employees than any other source!
  • The law doesn't allow you to run your company like a frat house party! Educate yourself on what the law considers to be inappropriate behavior within the workplace, and set up mechanisms within the company to prevent inappropriate behavior from occurring.
  • Have all new employees sign offer letters characterizing the relationship as an "at will" relationship. This ensures that the "at will" status of a relationship is not jeopardized by any oral representations to the contrary.
  • Address the ownership of any works and inventions created prior to the establishment of the company. Make sure you get IP assignments up front, before the employee begins work -- otherwise, disaster can result! The last thing a startup needs is to become embroiled in costly litigation (even the threat of litigation can scare away investors).
  • Make sure you correctly characterize personnel working for the company as either independent contractors or employees -- you'll want to avoid facing tax liabilities and penalties if your "independent contractor" is actually an employee in the eyes of the IRS. Even Microsoft made this mistake -- and it cost the company millions to correct it!
  • Don't use an "off-the-shelf" employee stock option plan -- a stock option plan needs to be tailored to your particular needs -- potential buyers have walked away from companies with ill-considered stock option plans. For example, a buyer is most likely to balk at option plans that call for acceleration of existing options upon a change of control. Work with an expert to develop a plan that suits your company's needs.
  • Never make promises regarding benefits that are not subject to the terms of the plan under which the benefits are provided. The terms of a plan, for example, will typically specify that the employer retains the right to amend or change the benefits.
  • Establish standard practices with respect to hiring and firing employees. Appropriate entry procedures can help ensure that new employees are all "on the same page" with respect to company policies. Exit procedures can be used to remind employees of any continuing obligations (e.g. confidentiality) and to confirm the return of company property.

* This is a summary of a speech given by John Delaney, Partner, Morrison & Foerster LLP (http://www.mofo.com/) for SAEC's "CEO Meet" on March 5th, 2002.

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