Sea turtles have a tough life. The first thing a sea turtle will see after they hatch and crawl out of the sand is a flock of birds picking them off like dive bombers as they sprint for the sea. Once safely in the water, they are met with hungry fish - with mouths agape. If they can make it to deep water, they have a very good chance of returning someday to the sand to lay eggs. As you might guess, few of them make it back.
Startups are like that. They are confronted with business and legal challenges from the day they are born, often exacerbated by the lack of a legal budget and fueled by the ready availability of do-it-yourself legal solutions. What follows is my list of the top 10 legal mistakes that startups often make and how to avoid them.
1. Claims by current or former employers. This is the age of the side hustle, and many startups start as a nights and weekend type endeavor. The startup founder with a day job must ensure that his big idea does not belong to his employer. California law has a very employee favorable rule on this issue, and it is found in Section 2870 of the California Labor Code. At a high level, Section 2870 provides that, notwithstanding any contrary provision of an employment or other agreement, the employee owns his inventions if they were (i) developed on the employee's time, (ii) without using the employer's facilities or trade secret information and (iii) do not relate to the employer's business or research or development or result from any work performed by the employee for the employer. The flip side of this coin is if the employee signed an invention assignment with his or her employer assigning any inventions that do not meet these requirements to the prior employer. This is an easy mistake to make, and to avoid, and one with serious consequences since the employee will be done before they start if they do not own the invention they seek to commercialize.
2. Lack of documentation. Handshake deals are risky because memories fade and relationships sour. But startup founders often delay papering their agreements until they have a financier or customer in sight. If they do not agree on important terms, such as equity ownership, the financier may not be interested in funding what may seem to be a legal battle. The first and most fundamental legal relationship to document is to share ownership among the founders. After percentage ownership, common disputes are: vesting, the characterization of cash contributions as loans or equity investments, and ownership trade secrets. On the last point, many promising companies have fallen apart in due diligence over a failure to prove ownership of their trade secrets.
3. No vesting restrictions. Closely related to failing to document is failing to impose vesting. "Vesting" refers to the right to retain shares of stock of a company after terminating service. Typically, founders are expected to vest in their stock over three to five years. Thus, if a founder has three year vesting, and terminates service with the company after one year, the company would have the right (often automatically exercised) to repurchase one-third of the founder's shares at cost (which will be little in the typical case). The remaining two-thirds of the shares would not be subject to a repurchase right. Failing to impose a vesting restriction can be fatal to a company, since if a founder leaves a company holding a large amount of unvested shares, the company may not have enough common stock to replace the founder. Also, the remaining founders might not feel incentivized to continue working for an absentee founder.
4. Choosing the wrong tax entity. Here in Silicon Valley, where I practice, us tax lawyers must regularly fall on our swords on tax matters. The default choice for startups is the double taxed C corporation, not the (usually) more efficient single taxed S corporation, or LLC taxed as a partnership. The reason for that is driven by the needs of the venture capital investors, who are usually prohibited from investing in anything other than C corporations. In 2017, the Tax Cuts and Jobs Act reduced the federal corporate rate of tax from 35% to 21%, which lessens the disparity between C corps and passthroughs, but does not necessarily make them equal. Thus, unless the startup is destined for venture capital money, a little thought should go into the choice of entity decision.
5. Qualified small business stock treatment. Sections 1202 and 1045 of the Internal Revenue Code of 1986, as amended, provides a huge benefit to investors in qualified small businesses. If a shareholder holds QSBS for five years, any gain on the sale of the stock may be exempt from federal tax up to the greater of $10 million or 10 times basis. If the holder does not meet the five-year holding period, they may still roll their gain over into a new QSB and defer tax. The requirements are technical and potentially complex, and sometimes require modelling to optimize the after-tax results of an investment in QSBS. The QSBS status is also fragile, and may be lost through redemptions, distributions or simple timing. An awareness of these rules on the front end of a stock issuance may be a tax saver.
6. Noncompliance with employment laws. California's labor laws have always been challenging for employers. When even large companies with full time human resources departments stumble over byzantine wage and hour rules, what chance does a cash starved startup have? This is especially true as the economy moves to newer models that just do not fit the older laws. As a general rule, nonexempt employees must be paid at least minimum wage, in cash, and currently. Federal law exempts an employee who owns at least a 20% equity interest in the employer and is actively engaged in its management from the requirement of being paid a cash wage. California law, however, does not have the same exemption, even though it is a rare early stage startup that pays its founders cash wages. The venture capital market understands and accepts that risk as a cost of doing business in California. The risk that the market will not take, however, is the consequence of misclassifying employees as independent contractors. An employee misclassification problem can easily break a company, and regularly does, due to the possibility of: a class action wage and hour lawsuit, the employer's liability for income taxes that should have been withheld and payroll taxes, unpaid workers compensation (which also has criminal law implications) and collateral effects on benefit plans, to name a few issues. California's recent codification of the Dynamex Operations West v. Superior Court, 4 Cal. 5th 903 (2019), decision with Assembly Bill 5 has increased awareness among everyone including, unfortunately, potential plaintiffs and governmental agencies. For gig economy businesses trying to do business in California, AB 5 may be their biggest obstacle. For any other business, due to the factual nature of the inquiry and the disconnect between employment law and business practices, misclassification has to be near the top of the list of potential company killers.
7. Failing to protect intellectual property. For a technology company, intellectual property protection goes to the heart of their value. Their IP will usually include patents and trade secrets. The most common patent mistake that startups make is not registering the patents early enough. In 2013, the America Invents Act changed the priority rule to provide that the applicant who first files their patent application receives priority. Patents are expensive, and that fact may deter a startup from filing. However, an inventor can file a provisional patent at a relatively low cost. If the applicant files a non-provisional patent application within one year, he or she will obtain the benefit of the early filing date. A provisional application includes a specification but does not require formal patent claims, inventors' oaths or declarations, or any information disclosure statement.
Many startups rely heavily on trade secret protection and, or instead of, patent protection. We now have a federal trade secrets law -- the Defend Trade Secrets Act of 2016. For federal law purposes, a trade secret includes many forms of protection if the owner has taken reasonable measures to keep the information secret and the information derives value from not being generally known. California similarly defines trade secret to mean information that derives independent economic value from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use, and is the subject of efforts reasonable under the circumstances to maintain its secrecy.
Breaking this down, for information to be trade secret, it must be valuable, rarely known and the owner must try to keep it secret. It is that last prong (the "reasonable steps") that requires the most effort. At a minimum, that probably requires a startup utilize an NDA. The well advised startup will also have practices and policies in place that documents its reasonable efforts to keep its trade secrets secret.
8. Failing to protect trademarks. Companies often underestimate the value of trademarks and neglect to protect their rights to names and marks. Many companies in our new economy build value based on users and the promise of continued growth. That user base and expectation of growth is often inexorably tied to its marks and logos. Losing the right to use a name or logo would be devastating to a company that relies heavily on its marks. The process for most startups should be (after the usual google search) to conduct a pre filing or "knockout" search of its mark with the U.S. Patent and Trademark Office. That search covers the wording in the mark as opposed to design and graphic elements, and assesses the risk of a challenge by a trademark examiner. The next step would be a federal trademark registration.
Many startups confuse the secretary of state's registration of a company's name with trademark protection. Federal trademark law operates independently of state corporate formation, and a company that forms under a particular name may be prevented from using it if that name violates a trademark. The more prudent course of action would be to clear the name (and trademark it) before investing money into securing rights to it, or building value around it.
9. Violating Section 409A. Section 409A of the Internal Revenue Code applies whenever there is a "deferral of compensation," so an employee has a legally binding right to compensation that is or may be payable in a later taxable year. If 409A applies, the payments must meet specific election, timing and distribution requirements to avoid immediate taxation, along with a 20% penalty and interest. A stock option is a deferral of compensation, but a safe harbor exempts common stock options from 409A's requirements provided that the options are granted at fair market value as of grant. A safe harbor allows a company to avoid 409A penalties if that valuation is established by an independent appraisal (among other means).
An early stage company is hard to value, even for a professional, if it has no operations, IP or earnings, but still wants to grant stock options. The company might thus be tempted to "guess" at a value and grant options anyway. That would be a risky strategy, since the company would be outside the safe harbor and if it has guessed wrong, may be subjecting its employees to tax and penalties. The company would also create a due diligence issue for itself when a financier or acquirer reviews the company. A better approach is to defer the grant of the option until it can have a valuation, or (but less desirable) to sell restricted stock to service providers.
10. Failure to comply with securities laws. Startups need money, and they will sell stock and securities to get it. The sale of securities is highly regulated by both the federal and state governments, and the penalty for violating securities laws can be severe, from rescission and personal liability by promoters, to criminal sanctions. Securities law compliance can be a complex and tie up sensitive matter. Notwithstanding the seriousness and complexity, noncompliance with securities laws has never been easier. Entrepreneurs can easily go online and download investment documents and use them to raise money. The accelerator Y Combinator makes its "SAFE" (simple agreement for future equity) available for download by anyone. In addition, the JOBS Act of 2012 ushered in an era of web-based crowd-finance platforms, making it much easier to raise money from strangers. The securities law exemption from registration under Rule 506(c), for example, is widely used for accredited only investments and allows advertising and solicitation. Left on their own, startups might not understand the need of only accepting (and sometimes, verify) accredited investors, appreciate the importance of disclosing material facts to investors, or figure out how to timely comply with federal and state blue sky notice filing requirements (if an exemption even applies). Developments in technology and business practice have made mistakes easy in this area of law.