Almost every new business faces unexpected complex issues that need to be resolved. Below are five legal issues for small business owners to consider.
1. Contracts Between Founders
No matter the trust level, co-founders of a startup should always have a very clear understanding of their expectations of each other. Creating meaningful contractual relationships will help set up your venture to survive when one or more founder moves on.
Honest and frank discussions about what level of commitment will be required is a good first step. These talks can cover issues such as the time commitment each founder will devote to the venture, how long one can devote to the venture prior to a funding event occurring before that person will necessarily need to depart, what each founder’s specific role and responsibilities will be, and perhaps even a methodology for resolving contentious situations.
Specific actions to consider are:
- Entering into written employment agreements specifying roles and responsibilities.
- Creating contractually binding “vesting” arrangements with respect to founder stock, typically over a four-year vesting period.
- Having a clear understanding as to if and under what circumstances early founders will may off the board of directors or out of senior management roles as the company grows.
- Creating a shareholders’ agreement to cover issues such as voting for a board of directors, restrictions on transfer of founder shares (buy-sell, co-sale, drag-along rights and rights of first refusal, among other issues), and other transfer issues such as death, disability, divorce, and dispute resolution among shareholders.
2. Intellectual Property
Properly documenting the creation, contribution to, modification and protection of intellectual property is crucial.
Your intellectual property begins the day you start thinking about and planning your venture, and taking steps to get patented and filing for trademarks is important for protecting yourself and your business.
Though intellectual property protection like a patent filing or a trademark registration can be costly for an early-stage venture, you can review publicly available resources, such as the U.S. Patent and Trademark Office (USPTO) website, before investing significant effort in branding your business. Patents protect inventions, original designs, and novel processes. Applicants must file for a U.S. patent at the U.S. Patent and Trademark Office. A trademark is a symbol, sound, and/or words legally registered as representing your company or product. The full trademarking process is complex, so–as with a patent–hiring an attorney to guide you through both processes can be a worthwhile investment
Some other things to watch out for: failing to properly transfer existing intellectual property into the business venture, not documenting or ineffectively documenting the contribution of independent contractors, failing to implement proper employee protocols, and investing effort in a brand without fully understanding its availability.
If you raise money for your venture, investors will perform diligence on your company and expect to see that you have properly protected all of your intellectual property from inception. If the venture starts off with intellectual property that existed prior to the formation of the venture (perhaps existing assets of one or more of the founders, or assets that were created prior to the creation of the legal vehicle), make sure those assets are properly transferred and/or assigned to the business venture.
This process should also be coordinated with the issuance of equity to the founders (see discussion below), as these intellectual properties can often serve as the basis for the issuance of equity and can create tax issues for the founders if not properly transferred.
It is critical that independent contractors sign a written agreement prior to the commencement of any efforts on behalf of the company. Contributions to your intellectual property can also include other, less obvious things such as questions, comments, ideas, images, writings, music, sounds, audiovisual works or effects, artwork, design elements, graphics, suggestions, concepts, notes or other materials.
Without a written agreement, any of these types of contributions that are created by an independent contractor (i.e. someone who is not an actual employee) are often viewed legally as being owned by the author and not by the company–absent a written agreement to the contrary.
Similarly, although an employer generally owns the results and proceeds of intellectual property created by its employees, in some cases there may be a number of tricky issues relating to employee development that should also be covered in a written agreement. These documents are typically referred to as Employee Proprietary Invention Agreements and should be executed by every employee, including the founders, prior to commencement of employment.
Entrepreneurs frequently pick a brand because of a convenient URL and sometimes find later that a potential trademark-infringement claim forces them to entirely re-brand their business. With a little bit of guidance at the front end, these problems can be avoided.
3. Issuing Securities (or Promising to Do So) Without Proper Documentation
The issuance of equity securities (i.e., any ownership interest in your business) is regulated by both the federal government and state regulatory agencies. It is essential that the initial issuance of “founders” shares and every subsequent issuance of equity securities be properly documented and comply with regulatory requirements.
4. Understand Your Cap Table
Every transaction in the company’s equity (including transactions in convertible or derivative instruments like convertible notes and stock options) impact the cap table, so it’s important to have a thorough understanding of how it works. Cap-table issues may occur when equity transactions are offered, discussed, and/or documented without precision.
5. Clarity Around Convertible Notes
One way entrepreneurs raise capital is via an instrument commonly referred to as “convertible notes.” Convertible notes are frequently used as a way for a company to take in investment without having to deal with valuing the company at a stage of its development where doing so is impossible. Convertible notes have a great deal of complexity in how they’re used, so professional guidance is usually advised. Among other things, the parties agree that the amount invested will convert into future equity of the company at a valuation negotiated with investors at the time of the more-recent investment, subject to a discount on conversion (typically in the 20% to 25% range) to compensate the early investor for taking on additional risk.
Negotiation is often one of the most difficult aspects of raising money through convertible notes, and there should be a reasonable compromise between what would be a very low actual valuation at the time of the convertible note and a meaningful guess as to what a reasonable pre-money valuation might be when the company achieves what it is intending to accomplish with the proceeds of the convertible-note financing.
By understanding these and other legal considerations of your business, you can make sound decisions and take practical steps to protect yourself and your company