Make sure EVERYONE (including all founders) is working under an employment agreement or a work-for-hire agreement that contains strong IP protection, often in the form of confidentiality and invention assignment provisions. This is probably the number one mistake we see with startups. Many entrepreneurs fail to realize that they are jeopardizing the value of their ultimate creation by working informally with friends, advisors, or consultants and only learn of their mistake too late when VC’s balk at the idea of investing in a company that does not have clean IP stacks.

Certain special situations may also necessitate a mutual nondisclosure agreement. These are generally appropriate for meeting with potential investors, potential strategic partners or potential service providers who have not yet joined the company and signed a full blown confidential information and invention assignment agreement. This will enable you to have fairly high-level discussions with third parties and share high level information about your company’s business plan and strategic direction.

If your company name, or the name you choose for your goods or services, will have any value to your business, you should consider federally registering them (including any logos you’ve designed) with the United States Patent and Trademark Office. You will also want to consider international protection of your trademark in any territories in which you sell (do business), manufacture or in which you fear piracy.

You need to ensure that you are complying with all business license and permit requirements. You should also review compliance with labor standards (from posting notices to employment policies regarding social media) as well as ADA requirements, inter alia.

Finally, your website should have proper copyright notices and should have both terms of service and a privacy policy, if applicable. These together serve two important functions: (1) they limit your company from unnecessary legal liability arising from user claims; and (2) document and demonstrate compliance with state and federal laws including “COPPA – the Children’s Online Privacy Protection Act of 1998.” These policies also delineate how your company collects and uses information collected through your website and other social media interactions—indeed, certain jurisdictions may have specific requirements regarding the disclosure of what information is collected and how it is used, e.g., California’s “Shine the Light” law.

This concludes our series “Starting Your Startup – Selected Legal Considerations.” There are, of course, countless other legal issues that arise during the course of a startup’s formation; however, we hope that these posts serve as a good starting point.

Documenting employment and independent contractor relationships is essential. Litigation commonly arises from a variety of avoidable circumstances in addition to the countless regulatory and tax pitfalls. Carefully delineating these relationships with written agreements is your first line of defense.

The reasons for considering issuing equity compensation range from preserving company cash flow/reserves and motivating employees by providing them an equity stake in the performance of the company as a whole. Increasingly, however, employees are looking for equity compensation packages as a feature of the overall employment marketplace and frequently compare notes on offers with friends and colleagues.

You may wish to consider using the following:

(a)        Employment Agreement. Long-form agreements are appropriate for your company’s CEO and other key executive officers. Shorter agreements may be appropriate your other employees, such as those employees who may be terminated “at will,” as opposed to executives who typically serve the company for defined periods of time (or terms) and may only be terminated for defined reasons (or cause).

(b)        Consulting Agreement/Work-For-Hire Agreement. This agreement is designed to be used for each of your company’s consultants, including both individuals and entities providing services to the company as independent contractors instead of employees. The distinction between independent contractors and employees is complex, requires careful analysis, and has important tax implications.

(c)        Stock Option Plan. As suggested above, many companies use employee stock options to compensate, retain, and attract employees. The Stock Plan is the general governing document containing the standard terms and conditions of the options to be granted. It also specifies how a given option plan qualifies for tax preferred treatment, if at all.

(d)       Option Agreement. Stock option agreements specify the individual options grants, vesting schedules, and other employee-specific information. Each grant of options will be documented by a separate option agreement.

(e)        Restricted Stock Purchase Agreement. These are to be used when equity grants under the Stock Plan are made as restricted stock awards rather than options. They include specifics regarding the repurchase right of the company and how it will lapse over time. These are not as common as options.

(f)        83(b) Election Form. Many founders, executives, and employees receiving options wish to make an 83(b) election in order to preserve possible future taxation benefits. A Section 83(b) election is an election to include in income the value of property that is subject to a substantial risk of forfeiture, such as a company repurchase right in the purchase agreement, which repurchase right lapses over time as a founder provides services to the company. Because the stock is subject to a substantial risk of forfeiture, the employee does not have to pay tax on his receipt of the stock until it vests. Often an employee may make a Section 83(b) election to pay tax on the value of the stock today because its value is lower than it is expected to be when the repurchase right lapses, or because the employee paid full value for it at the time of purchase so the Section 83(b) election incurs no additional current tax. The making of the Section 83(b) election also starts the employee’s capital gains holding period.

(g)        25102(o) Notice. Companies issuing stock options must comply with state and federal securities laws. Non-compliance can lead to lawsuits by investors and civil or even criminal prosecution by government agencies. Frequently the stock option grants are structured to fit within exemptions to the laws that generally require registration of the securities. A common exemption for Stock Plans for option issuances in California is found in Section 25101(o) of the California Corporations Code.

Inexperienced entrepreneurs must be cautious not to raise money in violation of state or federal securities laws. Often, this means qualifying as a “private offering” under Regulation D of the Securities Act of 1933 (“Reg D”) and applicable state securities laws. Although the details of Reg D are beyond the scope of this post, in general the company will need to prepare a formal Private Placement Memorandum (“PPM”) that sets forth a complete and fair disclosure of all “material” facts about the offering, the issuer, and the issuer’s business, finances, management, operations, and most significantly, the risks associated with its business, finances, management, and operations. Information is “material” if a reasonable investor would consider the information important in making an investment decision.

In addition, if the issuer intends to sell securities to one or more non-accredited investors under a Rule 506 exempt offering, Rule 502(b) of Reg D requires that the PPM include certain specific information that must be delivered to all purchasers. In all such offerings, whether to accredited or non-accredited investors, the investors also must be provided with the opportunity to ask questions and receive answers about the offering and to obtain information reasonably obtainable by the issuer to verify the information furnished. To keep things simple we recommend only raising funds from “accredited investors” and NEVER pay anyone a “commission” or other fee for raising funds unless that person is a registered broker-dealer.

Founding shareholders should work out all of the details between them as early on as possible. Issues that should be considered include: What is the contribution of each shareholder? Must each work full-time? Can a shareholder leave the company to pursue other matters and still retain ownership? What happens if there is a dispute, or a shareholder dies or becomes incapacitated? Can one shareholder sell his shares freely or are there restrictions, like rights of first refusal, to limit the transferability of his shares? Furthermore, care must be taken not to run afoul of Federal and state securities laws.

Documents that address these issues include:

(a) Common Stock Purchase Agreement (with or without Vesting). This agreement allows the founders to document their initial ownership in the company, including securities law transfer restrictions and any vesting provisions with respect to their shares.

(b) Shareholders Agreements. These agreements typically provide for restrictions on transferability of shares and co-sale, drag-along and first right of refusal rights. They may also provide for specific voting restrictions, such as providing for election of specific individuals as directors of the corporation.

(c) Buy-Sell Agreements. The purpose of this agreement is to provide for an orderly transition of ownership interests on the occurrence of specified events. A carefully drafted buy-sell agreement will anticipate potential conflicts that may upset the functioning of a small, closely held entity when an owner desires or is forced to sell his or her interest in the entity. Typically, a buy-sell agreement controls the circumstances under which an owner may sell his or her interest, who is a permitted buyer, and how the price will be determined.

(d) 25102(f) Notice. Companies selling stock must comply with state and federal securities laws. Non-compliance can lead to lawsuits by investors and civil or even criminal prosecution by government agencies. Frequently the offering is structured to fit within exemptions to the laws that generally require registration of the securities. A common exemption for securities sold to founders in California is found in Section 25102(f) of the California Corporations Code.

We are starting a multi-part series of blog articles entitled “Starting Your Startup: Selected Legal Considerations.”  The series is not mean to be, and could not possibly be, an exhaustive list of all of the legal issues that arise for startups.  Instead, it is intended to assist entrepreneurs, legal practitioners, and other professionals alike in thinking about many of the important issues that startups must consider.  We will posting sections periodically in addition to our other blog articles, so be sure to check back every so often.

Business Entity Selection

Form a limited liability entity – this may be a C-corporation, and S-corporation or an LLC. There are advantages and disadvantages to each and the correct choice will depend on a number of factors, including the type of venture you are pursuing, the amount of capital you intend to raise, and type of investor you intend to approach.

It is a frequently cited principal that seed and angel investors prefer investing in corporations as opposed to LLCs. Among the reasons for this preference is avoiding the income tax consequence that arises from equity ownership of pass-through entities such as LLCs. On the other hand, the same pass-through income tax treatment is frequently more tax efficient overall. These considerations need to be carefully balanced.

If you decide to form a corporation (for example, in Delaware), you will need the following core formation documents:

(a) Certificate of Incorporation. This document sets forth the company’s initial authorized capitalization, among other things. This must be filed with the Delaware Department of Corporations, and will need to be amended and restated to create additional classes of stock, for example, certain types of preferred shares, to facilitate successive rounds of investment.

(b) Bylaws. The Bylaws provide the procedural mechanics required by Delaware law, including establishing the number of authorized directors.

(c) Action by Written Consent of Incorporator. This document appoints the initial Board of Directors and adopts the Bylaws of the company.

(d) Initial Organizational Resolutions of the Board of Directors. This document completes the organization of the company by appointing the Officers and authorizing the issuance of shares to the Stockholders, among other things.

(e) Indemnification Agreement. Indemnification agreements are often provided to a company’s directors and officers to minimize potential personal liability for actions taken in their capacity as directors and officers.

Entity Jurisdiction

The entity jurisdiction decision depends on the type of business venture, where the principal office is located, where your product is manufactured, and where sales and service income will be generated.

**For most tech startups that desire VC funding, we recommend forming a Delaware C-corporation because VC funds often prefer the business-friendly legal environment Delaware has developed through its business statutes and case law. We then qualify that Delaware corporation to do business in the state where its principal place of business is located – e.g., we file a Statement and Designation by Foreign Corporation form with the California Secretary of State’s Office if the principal place of business is in California.

The foundation of the deceased abstract painter Sam Francis is serving as lead plaintiff in a class action filed in early November against nine art galleries in California.  The complaints, filed in Los Angeles and San Francisco Superior Courts, allege that the galleries “failed and refused” to pay a royalty to the foundation and others similarly situated pursuant to the California Resale Royalty Act of 1976 (similar lawsuits also relying on the California law have recently been filed in New York against Sotheby’s and Christie’s auction houses, and in San Jose against Ebay).

The unfamiliar and seldom-enforced California Resale Royalty Act of 1976 provides artists a royalty of five percent (5%) of the sales price of artworks under certain conditions, including if they are resold in California for more than $1,000.  The royalty is based on the sale price, not the profit and extends to artists’ heirs for 20 years after the artist’s death.  The law only applies to the sale of fine art, which is defined as an “original painting, sculpture, or drawing, or an original work of art in glass.”

Many believe that California’s law conflicts with the federal Copyright Act of 1976 (the “Copyright Act”) because it is preempted by the federal law; however, earlier this year, one federal judge held that the California law did not offend the Copyright Act and did not violate the Constitution.

The California law was signed into effect by Governor Jerry Brown in 1976.   California is the only state in the United States that provides artists with a resale royalty for visual art.  The legislative intent of the law was to ensure that artists would participate in the economic appreciation of their works, just as artists in France enjoy under France’s equivalent “droit de suite,” but critics believe that if the law is held to be enforceable, that it will force galleries to move to other states that don’t require payment of the resale royalty.

One of the interesting quirks of U.S. trademark law is the manner in which priority rights are assigned to parties utilizing the same or similar marks.  In the United States, priority rights are given to the first party to use the mark in commerce and not to the first party to file for registration of the mark.  This is in stark contrast to most of the world whereby priority among conflicting mark holders is assigned to the first party to register the mark.  As a result, for U.S. mark holders that desire to expand their brands overseas, the date of registration can become critical.  That’s where the Paris Convention comes into play.

The Paris Convention is an intellectual property treaty that addresses the issue of setting uniform trademark registration dates.  It works as follows:  the date on which a U.S. entity files a U.S. trademark application triggers a six-month period during which time it is possible to file corresponding trademark applications outside of the United States in countries that are signatories to the Paris Convention—e ach of which is treated as if it had been filed on the date that the U.S. application was filed. Given the importance of obtaining an earlier registration date, the benefits of utilizing the Paris Convention are critical, especially in “first to file” jurisdictions.

Although it is always advisable to file foreign registrations within the six-month window, it is important to note that missing the six-month due date does not necessarily mean the applicant has lost the chance to obtain trademark protection outside of the United States; it  means that an application filed outside of the United States will only enjoy its own filing date and will not enjoy the filing date of the U.S. application.

Congratulations to Blake Mycoskie, Founder and Chief Shoe Giver of Bonfante Steinbeck client TOMS Shoes, on the launch of his book “Start Something That Matters” (www.startsomethingthatmatters.com).   In his book, Mycoskie tells his story of how he came to form TOMS Shoes and what inspired him to develop the company’s One for One™ mission—for every pair of shoes a consumer buys, the company gives a pair of shoes to a child in need somewhere in the world.  Last year, the company reported that, with assistance from charities and other organizations, TOMS had given away more than a million pairs of shoes.  What is more, through his own story and others that motivated him, Mycoskie presents a how-to blueprint to developing like-minded companies for socially-conscious entrepreneurs. (www.TOMS.com)

[Graphic provided courtesy of TOMS Shoes]