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American Bar Association

ABA Section of Business Law

Business Law Today
January/February 2001 (Volume 10, Number 3)

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Top 10 legal mistakes of early-stage tech companies


Capital, talent and intellectual property are the steam, steel and barbed wire of the modern age. The most important job of lawyers for early-stage technology companies is preparing their clients so that they can attract, retain and protect those three essential assets of the new economy.

While the market will eventually separate the winners from the losers in the new economy without much comment from the legal profession, there is much that lawyers can do to prepare their clients for success in the early stages of their business ventures.

Central to the lawyer’s role is helping early-stage clients avoid some of the legal mistakes that will bedevil their ability to raise capital, prevent them from efficiently rewarding management talent, and keep them from obtaining and protecting important intellectual property. Although the list of potential errors and missteps is a long one, this article identifies 10 that are relatively common and easy to avoid.

Mistake No. 10: Creating a "cheap stock" problem.

In the new economy, grants of low-priced stock options and restricted stock have become indispensable tools to attract and retain talented employees. However, granting below-market stock options or restricted stock without careful planning can give rise to a "cheap stock" problem at the time of a company’s IPO.

"Cheap stock" problems arise when the Securities and Exchange Commission decides that a company has not properly charged against its earnings the fair market value of stock and option awards previously granted by it to officers and other key persons. The SEC may take this position if there is a significant difference between the value of the stock that the company has been using for purposes of calculating compensation expense and the price at which the company’s stock will be sold in the IPO.

In such circumstances, the SEC will demand that the company restate its earnings to reflect the higher level of compensation expense (and lower level of earnings) that the company would have incurred in earlier periods had the stock been properly valued. This demand can have a devastating effect on a company’s plans for an IPO.

Companies can guard against "cheap stock" problems by planning for them in advance. The key to avoiding or minimizing such problems is to carefully evidence the value of any stock or option grants at the time they are made and to be prepared to explain why that value increased prior to the IPO.

To evidence the value of equity compensation grants, companies should keep a careful record of any contemporaneous sales of the company’s stock to third parties. Appraisals by a qualified investment banker or valuation specialist are also good evidence of value, though appraisals made at the time stock or options are issued is generally more persuasive than those made in retrospect on the eve of an IPO.

Where companies cannot point to contemporaneous same-price purchases or appraisals, they must be ready with a credible explanation of any significant difference between the value attributed to the stock or option grants and the IPO price. Most will point to goals achieved or accomplishments made by the company between the time of the grants and the time of the IPO. Accomplishments might be meeting sales targets, entering into important contracts or obtaining patent or other legal protections for the company’s intellectual property.

Mistake No. 9: Failing to obtain good title to intellectual property.

Intellectual property is the primary basis of wealth in the new economy, much as bricks and mortar were the basis of wealth in the old one. Yet many early-stage technology companies pay scant attention to the legal formalities necessary to obtain ownership of that property in the first place.

Patents — Under the patent law doctrine of employee invention, the patent rights to an invention made by an employee belong to the employee, and not to the employee’s employer, even if the employee conceived and developed the invention in the course of his or her employment on the employer’s time and using the employer’s tools and materials. The employee may assign those rights to the employer, but such assignment must be by written document and supported by consideration. Continuation of employment alone may not alone be sufficient to support the assignment.

Some states also limit the circumstances under which an employer can require an employee to assign patent rights and may require the employer to make certain disclosures to the employee in connection with such assignments (such as, Section 2870 of the California Labor Code; the Illinois Employee Patent Act). Assignments of rights to employers that do not comply with these requirements may be void.

While an employer may be entitled to shop rights — a license to use the employee’s invention in the employer’s business — if the employee’s invention was made using the employer’s tools and materials, a shop right license is nonassignable and nonexclusive and generally a poor platform on which to base a business.

Copyrights — Copyright law also favors employee/creators over their employers. Under copyright law, title to a work initially belongs to its author, not to the author’s employer. Although the work-for-hire doctrine in the Copyright Act of 1976 may deem the employer to be the author of an employee’s work under certain circumstances, those circumstances are limited.

One of the prerequisites to application of the work-for-hire doctrine is that the creator of the work be an employee of the employer, as opposed to an independent contractor. Whether an employee is a true employee or a contractor is a fact-based question that is by no means entirely dependent on the employee’s title or even the assumptions of the parties. Factors that may distinguish employees from contractors include who controls the time and place of work, who owns the tools used to do the work, and who controls the creative process.

While in the traditional workplace these factors led to fairly predictable results, in the work-at-home, use-your-own-laptop, project-based new economy, the results can be complex and surprising. When a work is not a "work made for hire," an employer may still obtain ownership of the copyright to works created by its employee — but only by a separate written assignment supported by valuable consideration.

Mistake No. 8: Failing to institute a trade secret protection program.

Trade secrets are among the most valuable forms of intellectual property in the new economy. To be subject to protection as a trade secret, confidential business information must generally satisfy three criteria:

• the information must have limited availability,

• its restricted availability must give it economic value, and

• its owner must take "reasonable precautions" to keep it secret.

An error often made by early-stage technology companies is not taking the "reasonable precautions" necessary to turn its confidential business information into legally protectable trade secrets. What constitutes "reasonable precautions" is a subjective question, the answer to which depends on a variety of circumstances.

However, one precaution that every technology company should take is to adopt a formal trade secrets protection policy. The policy should establish standard procedures and practices that the company and its employees and consultants will follow to protect the company’s confidential information. Most policies will include at least some of the following provisions:

• employees should be informed in writing of the importance of maintaining the secrecy of the company’s trade secrets,

• confidential information should be made available to employees only on a need-to-know basis,

• written confidentiality agreements should be obtained from all employees and consultants,

• papers containing confidential information should be locked in safes or desks at night and all programs containing confidential information should be password protected, and

• departing employees should have exit interviews in which their continuing obligation to protect the company’s confidential information is explained and the return of all documents and programs owned by the company is required.

While many companies at least nominally require that their employees sign nondisclosure agreements, that is often the extent of their trade secret protection efforts. The danger these companies face is that when they try to enforce those nondisclosure agreements, a court may find that because the company did not take other "reasonable precautions" to protect the confidentiality of the information the agreements sought to protect, that information did not constitute protectable trade secrets. The confidentiality agreements are therefore unenforceable. To guard against this possibility, every technology company should institute and adhere to a formal, written trade secret protection policy.

Mistake No. 7: Not adopting an appropriate employee stock option plan.

Mistake No. 7 is granting stock options or other equity-based compensation to employees before adopting a proper stock option plan. Companies that commit this error risk losing significant tax benefits and imposing unexpected tax liability on their key employees.

Section 83 of the Internal Revenue Code governs the taxation of employees who receive property, including stock options, in exchange for services. Under Section 83, an employee is taxed at the time he or she exercises an option, rather than at the time he or she receives it. The tax is assessed at ordinary income rates (up to 39.6 percent) on the difference between the fair market value of the underlying stock on the date of exercise and the exercise price of the option. This tax will be due and payable whether or not the employee sells the stock received on exercising the option.

If the employee does sell the stock, at the time of exercise or at anytime thereafter, he or she will be taxed again on the difference between the fair market value of the stock on the date he or she exercised the option and the sales price of the stock. This tax will be assessed at capital gains rates (generally 20 percent) if the employee held the stock for more than 12 months following the exercise of the option or at ordinary income rates if he did not.

Qualified incentive stock option plans (ISOs), adopted according to Sections 421 and 422 of the code, can provide a way for companies to reduce the tax burden of options on themselves and their employees. ISOs permit an employee to postpone recognizing income on exercising options until the time the employee actually sells the underlying stock.

By postponing taxation of that income, an ISO relieves the employee of the need to find the cash necessary to pay taxes on the stock appreciation until the time he or she actually sells the stock and has the cash available to pay the tax.

In addition, if the employee holds the underlying stock for at least one year following the exercise of the option and for at least two years following the date the option was granted, the employee’s entire gain on the sale (the sales proceeds of the stock less the exercise price of the option) will be taxed at capital gains rates. If the stock is sold earlier than these anniversaries, the difference between the fair market value on the date the option was exercised and the exercise price will be taxed as ordinary income, with the balance taxed as capital gain.

Generally, ISO plans must:

• be in writing,

• be approved in writing by the shareholders of the company within 12 months before or after the plan is adopted by the company’s board of directors,

• provide that options be granted within 10 years following approval of the plan by the shareholders and expire within 10 years following the date of the grant (five years if the options are granted to persons holding 10 percent or more of the company’s stock),

• grant options only to persons who remain employees of the company (but not directors or consultants) until not more than three months prior to exercise (or one year in the event of death or disability),

• set the exercise price of options at no less than 100 percent of the fair market value as of the grant date (or 110 percent of the fair market value if the option holder is a 10 percent shareholder),

• limit the amount of option stock that can vest to an option holder in any calendar year to $100,000 (based on the grant date value), and

• prohibit the transfer of options except by will or the laws of descent and distribution.

ISO plans do have some limitations. In certain very high growth situations, the alternative minimum tax liability that ISOs can impose on option recipients may make their use undesirable. However, for most early-stage technology companies, properly adopting and implementing an ISO plan can have significant tax advantages both for the company and its key employees.

Mistake No. 6: Blowing the Section 83(b) election.

Mistake No. 6 is permitting employees, directors and constituents of the company who receive awards of restricted stock to miss making an important tax election under Section 83(b) of the code. Restricted stock awards are a form of equity compensation that is used as an alternative or supplement to grants of stock options.

Awards are restricted in that the recipient cannot transfer the stock received and the company will have the right to repurchase the stock if the recipient terminates his or her employment or if some other triggering event occurs. These restrictions generally lapse over time as the stock vests.

Section 83 provides that as the restrictions on the stock lapse and the stock award vests, the recipient must recognize income equal to the difference between what the recipient paid for the stock and the fair market value of the stock on the date that the restrictions lapse, which is done incrementally as vesting occurs, so the impact is magnified over time.

Where the value of the restricted stock has appreciated substantially between the date of grant and the date the restrictions lapse, the tax liability can be substantial. Moreover, since the now unrestricted stock may still be illiquid (such as, because of the lack of a market for the stock or other restrictions on transfers including stockholder agreements), the recipient may have no ready source of cash from which to pay the tax.

Section 83(b) is intended to relieve the tax burden that the vesting of restricted stock places on award recipients. It permits recipients of restricted stock awards to elect to be taxed immediately on the receipt of the restricted equity, rather than on the lapse of the restrictions.

A taxpayer who makes a Section 83(b) election will pay tax at the time he or she receives an award of restricted stock on the difference, if any, between the fair market value of the stock and the purchase price paid. This apparent tax burden can be a substantial tax benefit. Since the fair market value of stock in early-stage companies is usually very low, the recipient will likely owe little if any tax on receipt of the restricted stock. The recipient will only owe additional tax on sale of the stock, and then at favorable capital gains rates (generally 20 percent if held for more than one year).

Section 83(b), however, comes with a catch: A recipient of restricted stock must file a written election with the Internal Revenue Service within 30 days following receipt of the restricted stock. The filing is simple and straightforward. Yet employees of technology companies and counsel to the companies blow this requirement with amazing regularity.

Unfortunately, the IRS takes a decidedly low-tech view of Section 83(b) elections: If a restricted stock recipient misses the 30-day deadline, he or she loses the opportunity to make a Section 83(b) election forever. No extensions are allowed. Recipients of restricted stock awards who blow the election miss out on potential tax benefits and may receive a large and unexpected future tax bill when their restricted stock awards vest.

Mistake No. 5: Selling securities to unaccredited investors.

Securities law missteps while raising early rounds of equity financing are another problem that can come back to haunt early-stage companies. A typical misstep involves technical errors in how securities were sold to "unaccredited investors."

In raising equity capital from private investors, most early-stage companies will try to comply with federal securities law by following the rules on nonpublic stock offerings set out in Regulation D to the Securities Act of 1933. Regulation D imposes particularly stringent conditions on sales of securities to persons who are "unaccredited investors." In the SEC’s view, unaccredited investors tend to be less sophisticated investors who require special protection when buying stock.

Rule 501 of Regulation D defines an "unaccredited investor" as any individual who is not one of the following:

• a director, executive officer or general partner of the issuer or any general partner of the issuer, or

• a person with a net worth, together with his or her spouse, of more than $1 million, or

• a person who has had income in excess of $200,000 in each of the two most recent years or joint income with his or her spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

In offerings involving more than $1 million of securities, Regulation D requires that companies provide unaccredited investors with specific written information about the company and its proposed sale of securities. The types and amounts of required information vary depending on the size of the offering. But, for larger offerings, the required disclosures are extensive and complex and similar to those required in a public offering of stock.

While Regulation D does not prohibit selling securities to unaccredited investors, it makes doing so more complicated than selling securities only to accredited investors. This complexity increases the chance that a company will make a technical mistake in the offering. Although companies can legally sell securities to unaccredited investors outside of Regulation D — pursuant to the not-involving-a-public-offering exemption contained in Section 4(2) of the Securities Act — such sales are an inexact science and ask for trouble if the company later decides to go public.

Technical securities law violations of the type that a company can easily make when selling stock to unaccredited investors can strike back at the company at the time of its IPO. In connection with the IPO, the SEC will carefully study all prior issuances of stock by the company and demand that it take immediate action to cure any past violations of securities laws. Those remedial actions can delay, stall or even kill the IPO.

As a general rule, early-stage technology companies should avoid selling securities to unaccredited investors in early rounds, if possible. When a company sells securities in nonpublic offerings, it should obtain investor questionnaires from each investor in order to verify their accredited status.

Mistake No. 4: Not properly maintaining organizational records.

One of the most common mistakes of early-stage companies is failing to maintain proper records of the company’s organization and equity ownership. Poor record keeping can, among other things, expose shareholders, members and partners to personal liability for the claims of the entity’s creditors.

The doctrine of "piercing the corporate veil" is well established in the corporate law of most states. Under that doctrine, a court may ignore a corporate entity, and permit creditors of the corporation to assert their claims directly against the corporation’s stockholders, if the court finds that the corporation lacks substance and acts as a mere alter ego for its stockholders. One factor that courts consider in such cases is whether the corporation has observed corporate formalities by maintaining proper corporate records.

A potentially more serious problem, which relates to all forms of legal entities, is a failure to maintain a careful record of equity ownership. Nothing will impair an IPO or venture financing more than confusion about how many shares of a company are outstanding and who owns them. In the absence of a formal record of stock and option issuances, that confusion is quite possible.

A 1995 revision of Article 8 of the Uniform Commercial Code, which eliminated the requirement that contracts to sell securities be in writing, adds to the potential for trouble. Early-stage companies that make carelessly oral promises to sell stock or grant options may be creating serious future problems.

Companies must take care that their issuance of stock is legal and in accordance with their organizational documents. The corporate laws of some states limit the types of consideration for which stock may be issued. Issuances of stock and promises of options in excess of authorized capital are embarrassing at a minimum and a virtual guaranty of serious legal problems.

Even where the equity interests of investors, founders and employees in an early-stage company are clear, the relative rights of those equity interests may not be. A good shareholders agreement can go a long way to shaping expectations and preparing the company for eventual sale. The agreement should specify who elects the board of directors and under what circumstances new third parties can be admitted as equity holders (by buying shares from existing equity holders or otherwise).

A drag-along provision, which permits a controlling shareholder to compel all other shareholders to sell their shares to a third party at the same time and on the same terms as the controlling shareholder, can also be a useful tool for facilitating a sale of the company at a later date without interference from dissident minority shareholders.

Mistake No. 3: Not conducting a timely trademark search.

The use of an exciting or catchy domain name is a driving force behind many early-stage companies. However, registering a domain name or using a meta-tag in a Web site before thoroughly confirming the availability of the corresponding trademark can have serious consequences.

A trademark is any word, name, symbol or design, or any combination, that is used to distinguish the goods of one company from those of its competitors. The owner of a trademark may preclude others from using names that are similar to its mark and that are likely to cause confusion in the minds of consumers. To acquire common law trademark rights to a name or symbol, a company need merely use the trademark in commerce. The owner of a trademark may obtain additional rights by registering the mark in the U.S. Patent and Trademark Office.

A company may be liable for infringing the trademark of another if

• it uses a domain name or meta-tag that is similar to an existing trademark and

• the domain name or meta-tag identifies a Web site that either sells goods that may be confused with those of the trademark owner or interferes with the trademark owner’s business.

A company may also be subject to criminal penalties under the Anticybersquatting Consumer Protection Act if it knowingly and improperly registers a domain name that infringes on an existing trademark.

The existence of a similar trademark can also leave a dot-com company vulnerable to "reverse cybersquatting" attack. In reverse cybersquatting, the owner of a weak or unenforceable trademark uses the private dispute resolution procedures of a domain name registrar (such as Network Solutions Inc.) to appropriate the domain name of another. This tactic exploits the fact that the rules of certain private dispute-resolution procedures do not permit a defendant to question the strength of the plaintiff’s trademark or to raise many of the other defenses that are available to defendants in trademark infringement lawsuits.

Conducting a complete trademark search before selecting a domain name is a critical step for technology companies. Trademark searches are deceptively complex. A domain name need not be identical to a trademark in order to infringe on it, let alone to give rise to reverse cybersquatting vulnerability. A proper trademark search will need to review several different databases because trademarks are protected not just by federal law, but by state and common law as well.

Mistake No. 2: Incautiously hiring former employees of a competitor.

The work force of the new economy is highly mobile. As a consequence, hiring individuals who may have previously worked for a competitor is a common if not nearly inevitable practice in some industries. In most circumstances, those hires will be unremarkable. However, where a new employee may have had access to the trade secrets of a competitor, problems may arise. By taking a few precautions, companies can substantially reduce their chances of being sued successfully by a competitor smarting over the loss of talent.

The most important precaution a company can take before hiring any industry veteran is to investigate whether that person is subject to a restrictive covenant in favor of a former employer. Restrictive covenants generally fall into two categories: covenants of noncompetition and covenants of nondisclosure. State laws vary substantially in their treatment of noncompetition covenants.

Although covenants of noncompetition are legally enforceable in most jurisdictions, a court’s willingness to enforce a specific covenant may turn on factors such as the reasonableness of the covenant’s term and geographic restrictions, the burden of compliance on the former employee, and the cost to the public of enforcing the covenant. Covenants of nondisclosure are more readily enforceable, though the question of what information they may rightfully protect from disclosure can be contested (see Mistake No. 8).

Even if a new hire is not subject to a restrictive covenant, a company’s ability to employ him or her may be limited by the mere fact that the person has had access to the trade secrets of a competitor. Under the common law of many states, employees have a continuing duty to maintain the confidence of their former employer’s trade secrets, even after the termination of their employment.

Using a legal principle known as the doctrine of inevitable disclosure, several courts have recently enjoined companies from hiring former employees of competitors where the court felt that the nature of the employee’s new duties would inevitably lead to the disclosure of the former employer’s confidences.

Courts applying that doctrine have noted that a new employee should not be placed into a position where fiduciary obligations to a new employer are placed at odds with fiduciary obligations to a former employer. Companies hiring former employees of competitors should carefully tailor the job responsibilities of such new hires so as to minimize the chances of a former employer bringing a successful inevitable disclosure claim.

Mistake No. 1: Not properly licensing technology patented by others.

Mistake No. 1 on the Top 10 list is not properly licensing patent rights that are owned by others. This is a growing problem, particularly among Internet-based businesses, as recent developments in the law concerning software and business-methods patents have increased the use of and reliance on patents by many businesses.

Patent infringement is of particular concern to early-stage companies because patents give their owners broad legal protection. A patent can protect its owner’s right, not just to a particular device, but to the entire process by which that device operates. By comparison, a copyright protects only a form of expression, but not its underlying concept.

For example, a company that is barred by a copyright from using a certain software program can legally develop or purchase another program that performs exactly the same function without violating the copyright. Likewise, in the case of a domain name that conflicts with an existing trademark, the selection of an alternate name is limited only by imagination.

When a company discovers that one or more existing patents covers an element of its business, properly licensing those rights is crucial. Licensing less than all of the rights that a company needs to operate its business is a frequent error.

Licensing patent rights can be complex. Companies must pay careful attention to the exact nature of the rights they are licensing. Licenses may be exclusive or nonexclusive. They may include a right to sublicense the patent rights or not. They may allocate responsibility for prosecuting those who infringe, and for defending against claims of infringement that may be brought by other patent holders.

Licensees should ensure that their purported licensors actually have the right to license the technology or business methods that they are purporting to license.

The consequences of patent infringement can be severe. A court may enjoin an infringer from using the patented process and, in cases of intentional infringement, may award damages to the patent owner of up to three times its actual losses from the infringing use. Accordingly, infringing on a patent, either out of ignorance or as the consequence of an inadequate licensing agreement, can be expensive and disruptive to the business of an early-stage technology company.

To succeed in the new economy, technology companies must be able to raise capital, attract management talent and protect their intellectual property assets. How a technology company deals with a number of legal issues in the early stages of its development may have a profound influence on its long-term ability to develop those assets.

Lawyers can play an essential role in structuring early-stage companies for success and in helping them avoid the Top 10 mistakes that may make that success elusive.

Greenberger is a principal with Schwartz, Cooper, Greenberger & Krauss in Chicago. His e-mail is: jgreenberger@scgk.com.


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