A few days ago, Simeon Howard posted an article that had some great suggestions about minimizing problems when using freelance contractors. Simeon provided some good insights and as I read his article, it made me think of some related issues that a successful startup should consider.
As a technology lawyer, I get a lot of calls from companies that are developing and launching new products and services. In fact, most of my clients are small startups and emerging technology companies, some of them literally working out of a garage. Usually, these companies are looking for some help with a legal question and I can typically give them some helpful answers. However, sometimes they have made some pretty serious mistakes that make it difficult, if not impossible, for me to help them.
To avoid some of the more serious legal issues that I see on a fairly regular basis, here are some things you should consider. These issues don’t always come up, but you should be on the lookout for them so you can avoid them if at all possible.
1. Lawyers and Contracts Are Important. Really. Many individuals and small companies think that because they’re “small” they don’t need and/or can’t afford to use things like lawyers and contracts. Wrong. Contracts can save you a lot of time and trouble, if handled correctly. A solid contract has saved many of my clients when disputes and arguments come up. On the other hand, if you mess this up, it can mean the demise of your company.
Don’t let the word “contract” scare you. A contract doesn’t have to be 50 pages long to get the job done. Sometimes, all you need is a short, simple agreement that spells out the obligations and responsibilities of the people signing the contract. However, don’t make the mistake of thinking you can just go out on the Internet and “grab” a contract that will do the job. There are some very good contracts out there and some really bad ones as well.
Unless you speak fluent “legalese” you’ll want to make sure the contract fits your specific needs. You may think you need a non-disclosure agreement when, in fact, you need an assignment of rights agreement. If you have any doubts, spend a little money and check it out with an attorney before you sign a contract. Don’t be the guy who calls me up after you’ve signed a contract to find out what it means because I may not be able to help you.
If you look around, you should be able to find a lawyer who works with startups and small companies. Try to find one that knows your industry and market. Get references and talk with people that you trust. They can tell you what attorneys they use. Interview the attorney and find out if they have experience working with small companies. Ask them what they know about your industry and your competitors.
Attorneys at large law firms in plush offices usually charge more than sole practitioners so shop around. While you don’t necessarily want the cheapest attorney in town, you can get high quality legal help without breaking the bank. Ask them about their billing rates and policies. Get it in writing. Many attorneys will quote a “flat fee” for a project if they understand the scope. This can be a good way to control your costs while avoiding unexpected legal expenses.
Important Safety Tip – The most important part of any contract is “How do I get out of it?”
2. Don’t Slosh Your Equity Around. It’s Messy. I’ve worked with many small startups that are using the ownership interest in their company like some kind of piggy bank. They fund every project and development effort using stock, stock options, or LLC membership interests. They use equity interests in their company to pay contractors and other third parties for services. This is often a big mistake and here’s why.
The biggest potential problem is that if you do it wrong, you may be in violation of the Securities and Exchange Commission (“SEC”) securities laws. You probably don’t even know what a “security” is and you may not think it matters. It does. There are some pretty serious consequences for issuing stock or membership interests in violation of the SEC rules. You may think it’s a “loan” or a “license” when in fact you are issuing securities. If you get this wrong, you may have to give any investment money back and, in some cases, you may be hit with a fine. In addition to the SEC rules for issuing stock, most states have “blue sky” laws that govern how you can issue stock and securities so you need to be aware of those potential issues as well.
Lesser problems include losing control of your company or creating such a convoluted mess that serious investors or potential partners will walk away from your equity structure to find simpler deals. If a potential investor looks into your company’s capitalization table and sees that there are 30-40 shareholders who all own .5% – 5%, they may view that as a seriously negative situation and move on to the next opportunity.
Another problem is the early grant of equity can create problems when someone is no longer associated with your company or development effort. Do you really want some disgruntled web developer running around out there with a 3% ownership interest in your company? Probably not.
Finally, depending on the nature of the transaction, it’s possible that whoever receives the stock or LLC equity interest may owe taxes on the value of what they’ve received. This could come as a very unpleasant surprise for everybody involved in the transaction.
Important Safety Tip – You Don’t Know What You’ve Got ‘Til It’s Gone
3. Intellectual Property Protection. Don’t Screw It Up. If you are starting up a new company or launching a new product, you are almost certainly creating intellectual property. The problem for many new businesses and companies is that they don’t know anything about intellectual property and may not even know what qualifies as intellectual property. Do you have a patentable product? Can you or should you register your name/logo/slogan? What trade secrets have you developed? How do you keep someone from stealing your intellectual property?
While you may have a basic understanding of patents, trademarks, and copyrights, you probably don’t know how easy it is to compromise or destroy your intellectual property rights.
For example, did you know that you could lose your patent rights if you offer to sell your invention to someone more than one year prior to filing your patent application?
Did you know that your web designer may own your website content if you don’t have the right kind of contract in place?
Did you know that your freelance software developer owns your software unless you have the right kind of contract in place?
Is your non-disclosure agreement protective enough?
If you know all about these issues, you’re definitely smarter than the average entrepreneur, so congratulations to you. If you don’t know about these issues, you’re pretty much like most other people out there trying to figure things out as you go along. Don’t be that guy (or gal). Get some help from a qualified professional before it’s too late. Figure out what your sustaining proprietary advantage is, protect it every way you can, and then use it to build some serious value.
Important Safety Tip – Protect Your Stuff.
4. Bottom Line. Legal issues can be complex and somewhat intimidating. Just remember. You don’t have to be an attorney, but don’t be afraid to talk to one. Your future company valuation is hoping that you do.
*Disclaimer and Notice. This article is not legal advice but is provided for educational purposes only. Your unique circumstances and situation will likely require individualized advice. If you have legal questions, you should seek the counsel of a qualified legal representative who is familiar with the laws where you are located and doing business.