If I Lie To My Lawyer, Will It Save Me Money?

Not a chance. Even so, I occasionally find a client or prospect holding back important information, presumably because they think it will complicate the project and cost them more money. But that’s exactly why it should cost more money – because it makes things more complicated. Let’s see it in action…

First Call

Prospective Client: Hi, I’m working on a startup with a cofounder, and we are ready to move forward. We think the idea is viable. We formed an LLC about a year ago, and now we want to form a Delaware corporation. What will it cost to incorporate with two cofounders?

Lawyer 1: You’ll need to convert the LLC to a corporation. If you are lucky, and you formed the LLC in a state that allows conversion, forming a new corporation and converting the LLC into it will cost $2000, plus about $350 in filing fees. If you formed the LLC in a state that does not allow for conversion, we’ll have to do a merger. That will cost between $2500 and $3000, plus about $500 in filing fees.

Prospective Client: Wow, that’s a lot of money. We’ll have to discuss it and get back to you.

Second Call

Prospective Client: Hi, I’m working on a startup with a cofounder, and we are ready to move forward. We think the idea is viable. We want to form a Delaware corporation. What will it cost to incorporate with two cofounders? [Notice how the client left out that information about the existing LLC?]

Lawyer 2: It will cost you $1500 to incorporate, plus $150 in filing fees.

Prospective Client: Sounds good, let’s do it!

Now let’s flash forward 6 months, when the startup is trying to raise money from investors. They’ve signed a term sheet for an $800,000 investment, and the investors are doing their due diligence check on the company. During the due diligence, the investors discover that a year and a half earlier, the cofounders had formed an LLC, which they neglected to mention to Lawyer B. They also discover that there had originally been three cofounders, and one of them left on bad terms within the first 3 months. Now she’s moving around various hippy beach communities in Thailand, and doesn’t even have a cellphone. Even worse, it isn’t clear whether everyone signed intellectual property assignments, and Gone Girl happened to have developed the most important part of the code that is the startup’s product. Making a bad situation worse, the cofounders used Legalzoom to form their LLC, and even if they got an operating agreement, there isn’t a chance in Hell that it contains vesting provisions that would allow them to recapture Gone Girl’s unvested ownership interest in the LLC.

Here’s what it all adds up to:

  • The corporation doesn’t own most of the software code and other IP that is the core of the business. That belongs, at best, to the LLC, if everyone signed IP assignments.
  • If everyone signed IP assignments, that’s not going to help much, because they still need to convert (or merge) the LLC into the corporation. But they need Gone Girl’s approval to do so, and she was last seen on a beach in Bora Bora, smoking weed with an actor who may or may not have been in Titanic.
  • If there are no IP assignments, then it really doesn’t matter whether they can convert the LLC into the corporation, because Gone Girl owns the core of the business. And when word gets out that the business is worth $1.2 billion, guess who’s going to show up with some very mean lawyers in tow?

Of course, the truth of the matter is, that company will never be worth $1.2 billion, because the cofounders were too cheap to do things right. They thought that if they withheld important information from their lawyer, they could save a few hundred dollars. Instead, that little lie is going to cost them $5000 to $10000, at best, in legal fees to try and sort out the mess. At worst, the lie will cost these guys the $800,000 they were hoping to get from the investors, who are now walking away and looking to invest in a business run by someone with brains.

So the moral of the story is, keeping information from your lawyer will not save you money, it will cost you much much more.

Follow me on Twitter @PaulHSpitz

Three Things Your Startup Needs When You Hire

Most startups are narrowly focused on two key projects – developing the product and raising capital. All too often, however, startups neglect HR-related needs, which they see as less critical to the success of the enterprise. This oversight can get a company in trouble, so here are three HR-related things every startup needs once it moves beyond its founders and starts bringing on employees.

Employee Handbook

An employee handbook lays out a company’s policies for its employees, covering benefits, conduct in the workplace, and culture. While it may seem like overkill to have an employee handbook when the company consists of only two founders and one employee, the handbook can be an essential tool in establishing and maintaining the company’s desired culture. An employee handbook also communicates the company’s policy on key issues such as workplace discrimination and sexual harassment, when the failure to have a clear policy can have serious legal consequences. Of course, the employee handbook is a work in progress, too, and as the company grows in size and resources, the handbook can always be revised to reflect the company’s growth and development.

Bring-Your-Own-Device (BYOD) Policy

A growing trend among companies of all sizes is for employees to use their own laptops, tablets, and smartphones for business purposes. This is particularly widespread in the startup world, where a company may not have $10,000 sitting around to spend on laptops and smartphones to issue to employees. The problem with BYOD practices, however, is that all too often, no thought has been devoted to ownership and control of the data stored on the devices. An employee’s personal laptop could contain crucial intellectual property, customer information, or financial projections that belong to the company. A BYOD policy should outline what happens when an employee leaves the company, including whether the company has the right to remotely wipe data from the device. Another BYOD issue is technical support. If some employees use Apple laptops, while others use PCs, and you have some employees using iPhones and others using Android phones, there will be a lot of problems in supporting and maintaining all the different hardware, operating systems, and software. A third issue is security. Obviously, the company wants to ensure that any company information on the devices is secure from prying eyes. At the same time, employees will have their personal information on the same devices, and want to ensure that such information is not available to the company. I’ve written about BYOD in more depth here.

IP Assignment Agreement

A third essential item is an IP assignment agreement. This is an agreement that every employee should sign, stating that any work done for the company belongs to the company, regardless of whether that work is performed during normal working hours (whatever those are!) or in the evenings or on weekends. A good IP assignment agreement also should state that any IP developed that is related to the company’s business belongs to the company, even if the employee did not create such IP as part of his or her specific, assigned duties. If you’ve seen The Social Network, or are familiar with the dispute between Facebook and Mark Zuckerberg, on the one side, and the Winklevoss brothers on the other side, you should understand why having a good IP assignment agreement is important. Having such agreements in place for each founder, employee, and contractor also will be required when the company starts to seek outside funding.

While it may seem like HR issues aren’t critical areas for a startup to focus on, these three items can be essential building blocks for the startup as it grows.

Follow me on Twitter @PaulHSpitz 

Startup Checklist

In previous posts, I have provided a lot of information on various aspects of getting a startup company established. I thought it would be useful to put a lot of that information in one post, as a startup checklist. So here we go…

1. Review your employment agreement – before doing any substantial development work, founders who are maintaining their day jobs should review their employment agreements (and this could include employee handbooks, etc.) to ensure that there are no conflicts with the startup. In particular, a startup founder wants to make sure that any IP she develops will belong to her startup, and not to her day job. It’s a good idea to have a lawyer take a careful look at employment agreements and policy statements.

2. Decide how you will split the equity among the founders – while equal shares might seem easy and uncontroversial, it may not be the best, fairest way of splitting the equity.

3. Form a corporation – if you have any aspirations of seeking angel investments or venture capital funding, form a corporation, not an LLC. And form it in Delaware. You might think forming an LLC is cheaper or easier, and you will be wrong. You will end up needing a corporation anyway, and will waste time and money fixing things that should have been done right the first time.

4. Adopt bylaws – once you have filed your certificate of incorporation, you will need to adopt bylaws to govern the management of your new company.

5. Appoint a Board of Directors – You will need one or more directors to oversee management of your company. The directors can now approve various resolutions to get the company operating.

6. Enter into a shareholders agreement with vesting and buyout provisions, and issue stock – you will want to have vesting provisions in place from the start, in case any founders leave the startup. Otherwise, you will have an ex-founder wandering around outside the company with fully-vested shares. Also, make sure each founder receiving shares files an 83(b) election with the IRS at the time you issue shares. Let me repeat that in boldface, because it is really important: make sure each founder receiving shares files an 83(b) election at the time you issue shares.

7. Assign IP to the company – at the time of issuing shares, make sure that all founders assign to the startup any IP they are creating. This will be part or all of the payment for their shares, depending on the situation.

8. Qualify to do business – You will need to qualify to do business in whatever state your principal location is located in, unless you are located in Delaware (see number 3). This is fairly easy to do; you just file some paperwork and pay the state a fee.

9. Stock options – do not issue stock options until you have a proper stock option plan in place, approved by the board of directors, with a Section 409(A) valuation of the stock options. This doesn’t necessarily have to be done at the outset, but there are advantages to doing it before entering into negotiations with VC’s over a Series A round.

10. Employment/consulting agreements — if you are going to hire employees or use outside developers, make sure they sign agreements specifying that any work they do for the startup is the property of the startup.

11. Comply with securities laws – just because you are not a public company does not mean that you are exempt from the securities laws. This is a complex area, with many risks and pitfalls. Definitely consult a knowledgeable lawyer in advance, and preferably each step of the way. Only seek funding from accredited investors; it will make your life much easier. There are no friends-and-family exemptions from the securities laws.

All of the above items are essential to making sure that your startup has a smooth path to growth. If you omit any of the above items, you jeopardize the well-being of the startup, and create many headaches and costs downstream.

Follow me on Twitter @PaulHSpitz

Moonlighting – Check Your Employment Contract

Often during the early stages of a startup, founders will keep their existing jobs while working on the startup in their spare time. This enables them to pay their bills and live during the period before the startup obtains outside funding. There is a pitfall here for technical people, like hardware and software developers. What if the intellectual property being developed for the startup does not actually belong to the startup? It could happen.

Companies often require tech workers to sign an “invention assignment agreement” as part of their employment. When they do that, the tech workers are agreeing that any intellectual property that they are working on will belong to their employer. If the invention assignment agreement is narrow, it will specifically apply to IP directly related to the products and services of the employer. A broader invention assignment agreement might sweep in marginally related or even unrelated IP.

So, the problem is that the IP the person is developing for the startup might actually belong to his day-job employer, even if he or she is working on that IP at home, in the evening. The closer the relationship between the startup’s business and the day-job’s business, the greater the likelihood of a problem. A day job has an even stronger claim to ownership of the IP if the employee was using a company-issued computer to develop the IP. Before getting too far into developing any IP for the startup, therefore, a founder needs to review any employment agreements and invention assignment agreements he may have with his current employer. Then he can determine what his obligations are, and whether there is a risk that his new venture won’t even own the IP he is developing for it. In addition, the founder needs to ensure that he uses his own computer when developing any IP.

The flip side of this is that the startup needs to secure its ownership of any IP being developed for it. Founders should incorporate the startup as early as possible, and assign their IP to the startup in exchange for their equity. The startup needs to make its developers enter into IP assignment agreements. The startup can pay for this IP using either cash, if it has any, or equity in the startup, but it needs to pay something.