Top Ten Legal Mistakes Made By Entrepreneurs J. Matthew Lyons Andrews Kurth LLP 512.320.9284 mlyons@akllp.com April 2, 2014 Copyright 2014 Andrews Kurth LLP and J. Matthew Lyons. All rights reserved.
Andrews Kurth LLP Understand the ways in which the law is a constraint, but also the ways in which it is a tool to help you create and capture value. --Constance Bagley, Harvard Business School 1
1. Failure to Incorporate Soon Enough Establishes vehicle with limited liability Specifies relationship among founders, including share ownership Creates vehicle to hold IP, business plan / ideas Provides impetus to organize CONVERSE: Incorporating too soon 2
Selecting the Right Entity and Jurisdiction Limitation of liability for owners: Limited liability vs. unlimited liability Tax treatment of entity and owners Pass-through of profits and losses to owners Impact on exit strategies and liquidity options Formality and centralization of management structure and decision-making Choice of formation jurisdiction: Delaware vs. state of residence Choice will depend on expected investment source and exit strategy 3
Selecting the Right Entity and Jurisdiction Entity Type Sole Proprietorship General Partnership Liability Entity Level Taxation Management Unlimited No Direct Unlimited No Decentralized Limited Partnership Limited for LP, Unlimited for GP No Centralized Limited Liability Company Limited May elect Yes or No Either Corporation (C or S Corp) Limited Yes for C Corp, No for S Corp Centralized 4
Selecting the Right Entity and Jurisdiction Institutional investors prefer C corporations Investor familiarity with centralized management structure and formalities Many venture and private equity funds are precluded from investing in pass through entities for tax reasons Full range of exit strategies or liquidity options (e.g. stock for stock) not readily available to other entities types Lower organizational and ongoing administrative costs Institutional investors prefer Delaware Well-formed body of corporate law, including longestablished principles in case law and ease of filing Increased flexibility under Delaware law with respect to Board composition and corporate administration National understanding of Delaware law among practitioners 5
2. Failure to Subject Founders Shares to Vesting Vesting protects those who take venture forward Regardless of the reason for the departure, someone must be compensated to replace the departed founder 6
Structuring Company Ownership: Founder s Stock Founder s Stock Vesting General Structure o Four years on a monthly, quarterly or annual basis; one-year cliff o Can be shortened in certain instances o Buy back at cost upon termination of employment, death or marital dissolution prior to the end of the vesting period o 83(b) Election o Acceleration Issues: Termination & Change of Control Right of first refusal for sale to third parties The role of employment agreements 7
3. Creating Tax Issues with Equity Blowing the 83(b) election Founders cheap stock when sold below fair market value e.g., price sold to investors IRC 409A: Issuing discounted options Result: Employee suffers additional 20% income tax, at the time of vesting Company matching and withholding obligations and potential for lawsuits 8
4. Failure to Maintain Proper Documentation; Capitalization Errors Inadequate Capitalization Hygiene Too many promises ; too little documentation Promising a %, especially when non-dilutable Convertible note should not convert into a % interest, but rather a number of shares based on share price formula Failure to approve at Board / shareholder level Handshake deals Inadequate Recordkeeping Failing to maintain adequate organizational records Failing to track agreements (e.g. NDAs) CONVERSE: Too many agreements 9
Structuring the Company: Capitalization Plan Formation Series A Preferred ($5 Million Pre- Money $5 Million Invested) Series B Preferred ($15 Million Pre- Money $7.4 Million Invested) Series C Preferred ($30 Million Pre- Money $10 Million Invested) Shares % Shares % Shares % Shares % Common (Founders) 2,500,000 100% 2,500,000 25% 2,500,000 16% 2,500,000 11% Option Pool --- --- 2,500,000 25% 3,214,500 20% 4,000,000 18% Series A Preferred Series B Preferred Series C Preferred --- --- 5,000,000 50% 5,000,000 31% 5,000,000 22% --- --- --- --- 5,357,250 33% 5,357,250 24% --- --- --- --- --- --- 5,619,083 25% Total 2,500,000 100% 10,000,000 100% 16,071,750 100 % 22,476,333 100% 10
5. Failure to Adequately Protect IP Patents First to file rule harmonizes U.S. patent system with rest of the world; now more complex interplay between the dates of filing and of any pre-filing disclosures of the invention. Old U.S. rule: Filing required one year from public disclosure or sale International (PCT) filings Trademarks Failure to protect valuable brand Overinvesting in unprotected/unprotectable brand URLs, Facebook, Twitter, etc. accounts Bootstrapping with consulting services without adequate ownership of services/product delivered Copyrights: Must register CR before pursuing legal remedies against infringer. In the case of web software (e.g. iphone app), often costs less than $1,000. 11
6. Hiring Employees Without Regard to Prior Employee Obligations Non-competes, non-solicitation Trade secrets, inevitable disclosure Using inadequate or outdated forms Software code, open source Prior employer documents in possession No short cuts! 12
IP Issues and Hiring Employees Consider obligations to prior employer o Non-disclosure, non-compete, non-solicitation o Even without an agreement, common law trade secret obligations exist o Did you or another develop idea while employed? o Any employer files, documents, computers, smartphone, storage media, etc. spell trouble Beware of the Inevitable Disclosure doctrine o Under the Inevitable Disclosure Doctrine, a former employee of one company may be prohibited from working for a competitor of the previous employer based on the theory that the employee could not perform duties of the new position with the competitor without relying on trade secrets obtained from the previous employer o Application of the Doctrine does not require the former employee to have executed a non-compete agreement o Not all states apply the Doctrine 13
7. Inadequate Agreements with Employees and Contractors Employees Documented offer letters IP assignments, non-competes, non-solicits Contractors Misclassification when acting as employee IP assignments; restrictions on competition 14
Employee and Contractor Agreements Obtain a signed proprietary information and invention assignment agreement before (or immediately upon) commencing employment o Don t ignore any carve-outs have someone technical review them o Get it as of Day 1 prior to disclosure of company confidential information o Consider appropriate, enforceable non-compete/non-solicitation (note state by state enforceability) o Beware of contractors who become employees good time to clean-up IP ownership Obtain agreements (assignment and NDA) from each consultant and advisor Trademarks, URLs and pre-formation IP assignments 15
8. Failure to Seek or Receive Adequate NDAs Can lose patent/trade secret protection without NDA or other reasonable steps to protect Watch out for termination dates, residuals, concurrent development clauses Failure to police Using inadequate or outdated forms Business plans and offering memorandums At least include confidentiality statement VCs will not sign choose carefully before sending 16
9. Angel/Friends & Family Financings Sales to non-accredited investors Often overpriced Creates barriers to future rounds Dilution and disappointment Dumb money Option pricing issues when common stock sold Inadequate resources to continue to invest and protect prior investment Administrative hassles Expensive to administer and may deter VCs Complex Structures for small dollars 17
10. Institutional Fundraising Errors Seeking institutional capital too early Soliciting the wrong type of investor for the venture Choosing the wrong VC Selecting a strategic in the first round Must do your diligence on the investors Take too much money or too little money with regard to next value inflection point 18
Bonus: Choosing Wrong Attorney for Venture (or not using one) Expertise, experience, personality must be a match Relationships; understands terms, market, process Make the complex simple Avoid doing too much, too early Focus on right things, avoid subtle traps Pay me (a lot less) now, or (a lot more) later... IF it can be fixed Not being involved in the legal process Not using AK Fixed Fee Startup Package 19
AK Startup Package (www.akstartup.com) Incorporation, Organization and Qualification Reservation of corporate name Preparation and filing of Delaware Certificate of Incorporation Preparation of Bylaws and Certificate of Secretary Preparation of Action by Incorporator Preparation of Organizational Board Consent regarding various organization and corporate governance matters Preparation and filing of Form SS-4 Application for Employer Identification Number Preparation and filing of qualification to do business as foreign corporation Preparation and organization of corporate records and minute book Preparation of Stockholder Consent Preparation of form Indemnification Agreements for directors & officers Capitalization Matters Entry of capitalization data and corporate records into capitalization tracking software and corporate records database Preparation of Founder s Restricted Stock Purchase Agreement for up to four Founders Preparation of Stock Certificates for up to four Founders Preparation of Memorandum re 83(b) Elections for Founders Preparation and filing of state securities filings for stock issuances to Founders Preparation of Stock Option/Stock Issuance Plan Preparation of forms of Early and Standard Exercise Stock Option Agreement Preparation of form of Stock Issuance Agreement Preparation/filing of Form U-2 Uniform Consent to Service of Process 20
AK Startup Package Employment and Consulting Matters Preparation of form of At-Will Employment Offer Letter Preparation of form of Proprietary Information and Inventions Agreement Preparation of Form of Independent Contractor Services Agreement Intellectual Property Matters Preparation of form of Unilateral Nondisclosure Agreement Preparation of form of Mutual Nondisclosure Agreement Preparation of Assignment of Intellectual Property from Founders to the company Preparation of Memorandum re Trademark Matters for a new company Consultations One hour of advice on employment matters One hour of advice on employee benefits matters One hour of advice on protecting intellectual property One hour of advice on venture capital term sheets 21
Q&A Thank You! Open Discussion / Q&A 22
A Focus on Emerging Growth ANDREWS KURTH LLP Technology & Emerging Companies Practice Growth Andrews Kurth is a leading law firm for entrepreneurs, public and private emerging growth companies, and venture capital and private equity firms. Our Technology and Emerging Companies Practice Group comprises a dedicated team of attorneys providing focused representation to public and private emerging growth companies and entrepreneurs as well as the venture capital and private equity firms that finance them. We take pride in having a practical, business-like approach to advising our clients, and we share their entrepreneurial spirit and drive. Our client service teams combine relevant experience with an understanding of a client s business and markets to provide efficient legal services and solutions with an outstanding degree of responsiveness. We thrive in the fast-paced entrepreneurial world by combining flexibility and speed with the experience that comes from taking billions of dollars in new ventures from inception to IPO and beyond. The materials included herein provide a general description of certain legal and business matters and should not be construed as providing specific legal advice or establishing an attorney-client relationship. MATT LYONS phone: (512) 320-9284 fax: (512) 320-9292 email: mlyons@akllp.com Matt Lyons is a partner with Andrews Kurth, where he specializes in representing private and public emerging growth companies and entrepreneurial interests. He advises on all aspects of forming new businesses, raising capital, M&A, and securities laws & regulations. He also regularly counsels companies and their boards on corporate governance and executive compensation. Matt represents and maintains relationships with a number of prominent venture capital, private equity and investment banking firms. Matt has consistently been named as one of the leading lawyers in Texas for the area of Technology: Corporate and Commercial in the Chambers USA Rankings. He also has been Martindale-Hubbell "Peer Review Rated" for Ethical Standards and Legal Ability. Matt has been named a "Texas Rising Star" in the area of Securities and Corporate Finance by Texas Super Lawyers and Texas Monthly Magazine. Matt received his undergraduate and law degrees from the University of Texas at Austin. 23
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