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Starting a business is fraught with many perils, some business, some personal and some legal. I have listed below the most important legal pitfalls to avoid based on my perspective in working with a large number of start-up companies over the last fifteen years. Falling into any one of these traps can mean the difference between success and failure or the ability to attract money to fund the growth of the business.
1. Failure to protect intellectual property. For high-tech start-up companies, the worth of the business is based largely upon its intellectual property and the talents of the people in the company. Intellectual property provides barriers to entry by competitors and consequently provides the high profit margins that produce high valuations as a private company and as a public company. It is imperative, from the very beginning, to discuss intellectual property protection with patent counsel, if there is potentially patentable technology, and to explore protecting other intellectual property, such as copyrights, trademarks and trade secrets.
In addition, properly worded non-disclosure agreements for contractors, suppliers and financing sources as well as employees are essential to protect the intellectual property of the business. Every employee, whether a clerical employee, an engineer or a software developer, should execute a non-disclosure agreement.
2. Failure to execute a shareholders’ agreement. A shareholders’ agreement governs the relationship between the initial founders of the company. It dictates what happens if one founder voluntarily leaves, is terminated, dies or becomes disabled. In most cases, the company is interested in buying back the stock and the terminated shareholder is interested in having liquidity for those shares. I cringe every time I meet with a group of founders that tell me they have no need for a shareholders’ agreement because they are all "friends." This is almost always the death knell for a business relationship and I can count on their being back in my office in a couple of years to deal with the issues of "corporate divorce."
The shareholders’ agreement should clearly spell out the triggering event, whether the terminated shareholder is obligated to sell, whether the corporation is obligated to buy or merely has an option to buy, and what the purchase price is or the method by which the purchase price will be determined. The shareholders also need to discuss funding for the company’s obligation to purchase shares upon the death or disability of a shareholder through life or disability insurance or by having the departing shareholder hold financing for the company by accepting a note payable over a number of years.
3. Failure to read contracts. Believe it or not, people do sign agreements that they don’t read. I recently dealt with a company that had signed a contract with one of its major competitors and the competitor had slipped into the agreement a clause that providing that the company would not hire any of the competitor’s employees for a period of five years. Needless to say, the company was surprised and mortified that no one had read thoroughly the contract. Although an executive may not be able to read every contract he or she signs, someone in the company or its outside legal counsel should read the contracts and advise the company as to the risks associated with the various provisions.
4. Failure to exercise caution in leaving your former employer. As I always advise clients, litigation is not a business strategy that will be funded by any outside investors. You should exercise extreme caution in leaving your former employer to start a business that may be compete with that employer. I am always amazed at the number of people who do not know whether they have executed a non-disclosure, non-solicitation of employees or non-competition agreement with their current employers. Of course, if you ask the personnel department for a copy of these documents, red flags will immediately go up and the word will be out that you are thinking about leaving the company. It is very important that, when you sign these documents, you retain copies for you own personal file.
The attorney working with you in starting a new company should carefully review these documents to ensure that none of these provisions are likely to generate litigation against the company and you by your former employer. Often, this will mean you will have to sit on the "side lines" for a period of months and perhaps years, because of a non-competition agreement or start your company outside a restricted territory. It also may mean that you may not be able to hire key people from your former employer for a number of years because of a non-solicitation provision.
I always advise people not to sign anything at the time of leaving their employment until it has been reviewed by an attorney. You should only take your personal possessions and should be very careful that anything belonging to the former employer stays in the office. This means the Rolodex on your desk stays! You should also remember that any action that you take within the last few months prior to leaving will be judged in hind sight. If decisions arise in the last few months that you are working for your former employer that might raise questions about your impartiality, you should always try to get someone else involved in making these decisions so it is not your decision alone.
5. Failure to provide for stock or option vesting. One of the purposes of awarding restricted stock or stock options is to ensure that the key individuals will remain employed with the company for a certain period of time. To accomplish this, the stock is often subject to vesting requirements and the options are subject to exercisability requirements. In the case of restricted stock, if the individual does not stay for the full period of vesting (usually 3 to 5 years), any unvested stock is subject to repurchase by the corporation at the price paid for the stock by the individual, regardless of the fair market value of the stock at that time. In the case of stock options, the options only become exercisable upon accomplishing certain performance milestones or upon the passage of time. If the individual leaves, then the unvested stock will repurchased and the unexercised options will be forfeited.
Outside investors, especially venture capitalists, will often insist on these provisions as an additional assurance that the key members of the company will remain committed to the company and will not leave early, taking valuable stock with them that may be needed later to recruit other members of management. Although founders often want fully vested stock, it is just as important that founders have restrictions on their stock in the event that they should die, become disabled or simply lose interest in the company.
6. Undercapitalization. Raising capital is the hardest thing that start-up companies have to do. The amount of capital required and the time to raise it are almost always underestimated by a factor of at least two. It generally takes three to six months of intensive effort to raise capital for a start-up company. During this time the key management members must be devoted almost exclusively to fundraising. It is very difficult trying to start a company and hit the technology window, while at the same time taking valuable time to raise capital. Very few people have a knack for raising capital quickly and in most cases it takes a number of months before the fundraising can be successfully completed.
7. Failure to use the North Carolina tax credit. North Carolina has a very advantageous tax credit for passive individual investors in companies with less than $5 million in revenues. However, in order to qualify for the qualified business venture tax credit, the company must be registered with the North Carolina Department of Commerce before funds are invested by outside investors. A number of companies simply do not realize that this tax credit is available. You should strongly investigate this provision and, if the company might qualify for the tax credit, file an application to register as a qualified business venture. If you do qualify, then your investors will qualify for a 25% credit against their North Carolina income tax liability subject to certain limitations, in the year following the year in which the investment is made. This is incredibly important in getting private individuals to invest in early stage, high risk ventures.
8. Failure to keep good records. A number of entrepreneurs think that record keeping is not important. Our experience is that record keeping must be done on a continuing basis and that it costs considerably more to clean up than if it had been done on a continuing basis. Good record keeping is often a test used by investors as to the quality of the company. They expect to find a company that has kept good minutes and is in good standing in all states in which it is registered or qualified to do business. More importantly, with respect to employee options, poor records may result in disputes as to who was granted options and how much they were for and how long they were to last. If good records are not kept, it can be a massive job prior to public offering in getting the corporate records straight.
9. Keep it simple. Companies become very complicated very quickly, especially when there are outside investors. At an early stage keep it simple with one class of stock until you raise capital from outside investors. We do see companies using the LLC form, which is very advantageous in certain situations. We find it much easier in raising capital for companies, to use the "tried and true" C corporation form (or an S corporation in a few instances). Investors know C corporations and they know their rights as shareholders and makes it a lot easier in raising capital when structuring a company in this fashion.
The key to all of this is being conscientious and alert and seeking good outside advice about the legal issues facing an emerging growth company.
This article was published in the March 2002 issue of the Triangle TechJournal.