Not following the rules early on will haunt a promising startup for years to come. By Jennifer A. Post, Esq. (Founder, Post Law Group, PC)
Last week I had the pleasure of speaking to the Beverly Hills Bar Association on the topic of Counseling Technology Startup Companies. Whenever I speak about the legal and business challenges facing a startup company, I am reminded about the many questions entrepreneurs ask as they take their first steps into the adventure of launching a new company. Based on my experience, here are the top five (or six!) legal questions frequently raised by entrepreneurs and the advice they need to hear — but love to hate.
Q: "I'm going to keep working at my job until my idea is perfect, then I'm going to quit and start my company. Doesn't that make the most sense?" A: Well, it might make sense economically in the short term, but it will cause some concern — and possibly a full-blown legal dispute — over who owns that perfect idea. Without describing all of the various state law and common law principles at play, suffice it to say that if an entrepreneur uses an employer's computers, desks, resources, email accounts, etc. to create her ideas, the employer probably owns whatever was created.
Ideally, it would be best to completely separate from the employer first before setting pen to paper on the business plan or technology framework. But failing that possibility, entrepreneurs should do everything they can to avoid "cross pollinating" any aspect of their employer's work and materials with their startup ideas.
For investors, any lack of clarity on the ownership of intellectual property (IP) can be a deal killer. Investors want to know for sure that startups own — outright and without possible claims of third parties — their critical IP assets.
Q: "I'm going to pay everyone with equity until I raise money. I can do that, right?" A: Yes and no, but why would you? Setting aside the maze of securities law problems (and possible employment law problems) in doing that, startups have to be careful not to give away the store early on. While I can appreciate that cash is tight, giving away equity is generally not a good idea. Also, when vendors say they will do something for free (such as write code) in exchange for equity — well, that isn't free at all! When startups load up their capitalization tables with vendors, contractors, minor employees, etc., those persons stay in the cap table long after the value of such goods/services is gone. Moreover, the pie is only so big, and when investors come to the table and take their very generous slice, there isn't going to be as much left for the founders/entrepreneurs.
Founders should grant equity only to people who are critical to the company's success. Later on, when things settle down, it might be appropriate to expand a stock incentive plan to rank and file employees. But let's face it: no one wants to start a company only to find out they are building equity for lots of other people and not for themselves. Be aware that experienced investors generally don't want to make investments with unsophisticated stockholders. Having a stream of cats and dogs as shareholders creates the need to "re-capitalize" the company when investors come to the table, which is not a good use of scarce funds. At the end of the day, going without might be more beneficial than giving away equity to short-term vendors or contractors.
Q: "Do you think it is ok to show my business plan to lots of people to see if they think it's a good idea?" A: That is not a good idea, actually. Sharing the "secret sauce" without a having a Non Disclosure Agreement (NDA) in place is as good as giving your ideas away. Of course, even an NDA cannot protect a company from a person’s intent to steal technology or concepts. Some forms of IP can be protected by statute, so it is safer to disclose those registered properties — but at the early stages of business, most startups have not completed (or even started) such a registration process. (And, the reality is that many companies opt not to file for patent or other IP protection since such rights can quickly become obsolete as technology advances at a faster and faster pace.)
Also, by law, companies cannot disclose "trade secrets" if they intend to maintain the status of such information as, well, secrets. While everyone wants feedback on their ideas before they take the plunge, rest assured — any experienced investor that reviews the business plan will have plenty to offer. Also, it should be noted that many venture capital firms do not sign NDAs since they see hundreds or thousands of deals per year and can't log information obtained at every pitch. The best advice for early feedback is to develop a group of trusted advisors (financial, legal, industry, etc.) to meet with and discuss your ideas under a well-drafted NDA.
Q: "I can sell stock on the internet now, right?" A: Not yet and not exactly. This question was posed even before the JOBS Act was passed into law. The JOBS Act does provide a pathway for small companies to find investors by crowdfunding on the Internet. However, there are a number of requirements (some of which are yet to be fully developed by the SEC) that companies need to be aware of. Such requirements include utilizing a "portal" owned and operated by a registered broker-dealer and posting financial and business information about the company on that portal (talk about confidentiality problems!). There are limitations on amounts of capital that can be raised (generally up to $1M in any 12 month period). And while most anyone roaming around on the Internet can qualify to be an investor under the new rules, there are strict limits on the amount that the general public can invest, which means the investments will likely come in very small increments.
What does this all mean for entrepreneurs right now? It is still not legal to publicly advertise your stock for sale on the Internet. Also, when the crowdfunding floodgates do open, entrepreneurs will have to ask themselves if they really want hundreds of tiny (unsophisticated) shareholders in their company. As above, managing a large capitalization can complicate things early on, especially when institutional investors come to the table.
Q: "The rules related to issuing stock are making it impossible for me to raise money. Can't I just take money from people willing to give it to me and fly under the radar for now?" A: No, no, no, no, no! It's not worth the risks. I know, I know. I'm a securities lawyer and I might be a little extra sensitive about this one. But in my experience, not following the rules early on will haunt a promising startup for years to come. For example, if a company doesn't properly issue stock to persons qualified to be investors, regulators at the federal and state level can require that it return the money and take back the stock — what’s known as a rescission offering.
Or, it may be that there is a risk that the shareholders have a right to demand rescission (since the stock was not properly issued to them). If that is the case, a company has to disclose that risk to every investor that it ever takes money from. (Think "The Scarlet Letter": A big "R" for rescission embossed on your company's logo.) Investors don't like risks like that.
Also, it sends the message that the founder is not running a tight ship — that she cuts corners or doesn't have a regard for the legal process. While that may seem a little stuffy, investors are willing to place bets on technology, management teams, and markets; they don't place bets on legal compliance. Finally, if an entrepreneur invites investors in who are not qualified to invest in her company (meaning she ran out and sold stock to anyone who would buy it — a clear violation of securities regulations), she is making it harder to eventually sell her company.
If a company has shareholders who really shouldn't be shareholders at the time the company is being sold, their presence can derail the sale for the following reason: The shareholders are probably not qualified to be shareholders of the buyer, either.
Let me break it down for you: If your company is being acquired for stock, the buyer has to be able to issue that stock to your shareholders in compliance with law or buy your company for cash. If buyer can't or won't come up with cash, you may lose your deal. Suffice it to say there is nothing to be gained over the long term by avoiding compliance with state and federal securities laws. I'm not saying it is easy to raise capital. It never is. But as the saying goes: An ounce of prevention is worth a pound of stock, or something like that.
Q: "I met a guy that said he can find money for my company if I cut him in on the deal. How much should his cut be?" A: Zero, and while you’re at it, run for the hills. These characters call themselves "finders." Unless your finder is a registered broker-dealer (and why would he call himself a finder if he is licensed?), he is operating outside of the law. Only broker-dealers are licensed to find capital, structure transactions, explain deals to potential investors, help draft offering documents, and get paid for all that. Finders, who are really nothing more than persons acting within a very narrow exception to the broker-dealer registration requirements, can do nothing more than make an isolated introduction of a company to a potential investor. And that's it. If a person does that repeatedly, or holds himself out as having a business of putting financing deals together, he needs to be registered as a broker-dealer.
So, what's the big deal if the company gets money, the investors are happy, and the finder takes a cut? Well, for starters, if you use a finder, you will be looking at your old friend the rescission right again. If you were careful enough to follow other securities laws in the transaction, all that compliance may be lost once the SEC or state regulators get involved. You will not be able to obtain a legal opinion for the transaction (or future transactions) even if one of the investors requires it. And, as above, institutional investors simply won't take the risks of working with companies that have a potential black eye on their compliance history. Finders seem to be everywhere and they certainly can find money. However, if you hope to work with high caliber partners, investors, and advisors, you would be advised to "find" another way to raise the money.
While lawyers sometimes give advice that entrepreneurs hate, lawyers should be as creative and as driven as their clients are in helping entrepreneurs reach their goals - not just stand in the way.
If you could change something about the style or advice of your lawyer, what would it be and why?
Editor’s note: Got a question for our guest blogger? Leave a message in the comments below. About the guest blogger: Jennifer Post is Founder of Post Law Group, PC. She is a corporate and securities attorney based in Los Angeles, California. Her firm works with entrepreneurs, startup companies and investors in private securities offerings, venture capital financings, secured lending and M&A transactions. Her practice represents US and foreign companies and investors. She takes a proactive role as outside general counsel to her emerging growth clients offering both legal and business strategy advice.