Mar 122012

Is your startup ready to take on outside investors?  For many startups, the knee-jerk reaction is often “sure,” but be careful: sophisticated investors will want to take a rather invasive look through your company to make sure that they’re not investing in a dog. Prepare for an uncomfortable inquiry.

Before that inquiry happens, it’s well worth the effort to find and fix problems that are going to arise in that Due Diligence review anyway.  Not only will this make the process go faster, but it will mean that the investor is a lot less likely to write-off your company as a dog and move on. Besides, avoiding those problems means avoiding liability that can sink your company.

Here’s a dozen high-runner legal due diligence problems that I’ve seen in early-stage companies, in no particular order, with some take-away lessons on how to avoid them.

  1. Issuing more stock than is authorized by the corporate charter. A corporation’s Articles/Certificate of Incorporation always list the number of shares of stock that the company is authorized to issue. But, companies sometimes issue more shares than are authorized. The extra shares aren’t validly issued and may lead to a legal claim from the people who they were sold to. Lesson: keep a capitalization chart, showing the number of shares authorized, subtracting out the number that have been issued, and showing what’s left.
  2. Not having stock or option issuances approved by the board.  Section 55-6-21 of the North Carolina Business Corporations Act (or, in Delaware, Section 152 of the DGCL) specify that the Board of Directors authorizes the issuance of stock, and there are similar rules for stock options. The officers of many companies are sometimes loose with this formality, and issue the stock or options without the board’s approval. Lesson: Always have the board approve stock and option issuances.
  3. Not requiring restricted stock recipients to file an 83(b) election.  Section 83(b) of the Internal Revenue Code allows recipients of stock that vests over time to treat the stock as if it were all acquired on the day of the original purchase, instead of the dates on which it vests. For the employee, this is important, because it means that he only pays tax on the fair market value as of the date it was originally awarded, which will often be lower than the date it vested.  For the employer, it’s important, because the employer doesn’t want to have to be in the position of determining the value of the stock every month as it vests. To gain this advantage, though, the employee has to tell the IRS within 30 days, and they often forget. Lesson: require employees to file the 83(b) election as a condition of receiving the stock.
  4. Engaging officers as independent contractors. Section 3121(d) of the Internal Revenue Code (and other sections) requires officers of a corporation to be treated as employees, and not as independent contractors, except under a few very limited situations. As a result, companies can get into trouble for not withholding taxes on amounts paid to their officers. Lesson: for tax purposes, always treat a company’s officers as employees and both pay and withhold tax on them accordingly.
  5. Deferred compensation issues. Early-stage companies, perpetually short on cash, often make promises about future payments to their employees and other people who provide services to them.  Depending on the promise, these arrangements can fall afoul of Section 409A of the Internal Revenue Code, which regulated deferred compensation plans. (See this post for more information.) Failure to conform to 409A can lead to significant tax problems both for the employee and the employer.  The employee has to pay taxes on the deferred money, from the time it was deferred, in addition to interest and a 20% penalty. And, the employer may be liable for not properly withholding taxes. So, these arrangements should always be run by an attorney who’s familiar with 409A.  Lesson: Pay in cash or stock or consult a corporate attorney for help on paying your people in the future.
  6. Informal arrangements with employees and independent contractors.  For many start-up companies, their most valuable assets are intangible: computer code, know-how, data, etc…. So, it’s important to put formal agreements in place with people who create or come into contact with those assets, to ensure that those assets don’t go with you.  Among other things, that means that these people should (a) assign all their rights in company-related intellectual property to the company, (b) agree to protect the company’s secrets, (c) agree not to solicit company customers (or personnel) after leaving the company and (d) agree not to compete with the company. Lesson: have a standard agreement which all independent contractors and employees sign, covering at least those four things.
  7. Using IP belonging to a previous employer.  Company founders sometimes do the initial development of an idea while they’re working for somebody else, and then start a new company to commercialize the idea. This approach can be risky, especially if there was an agreement with the previous employer about intellectual property, since the old employer may think it owns the start-up’s core technology. (Or, even worse, they only decide that they own it once the new company is successful.)  Lesson: (1) get previous employers to agree that they do not own the new IP, or (2) at least stay out of the previous employer’s line of work, and don’t use its computers or equipment.
  8. Securities law violations. Many of us had the experience in middle school of putting together a mock company, selling “stock” to family members, running the business and paying them a dividend. Unfortunately, selling stock is actually a much more complicated process than this thanks to securities laws intended to protect investors.  As a general rule, all stock that a company sells has to be registered with the government, unless the sale is exempt from registration for some reason specified in securities law.  Unfortunately, it’s common to see companies who sold stock, completely oblivious to the securities laws.  And, that can create some serious liability for them down the road. Lesson: get the assistance of a corporate attorney who understands securities law to make sure you jump through the right hoops.
  9. Serious restrictions in license terms.  If you’re building on work that somebody else has done, then you probably have some sort of a license to their work. But, those licenses may be limited in time or in the scope of what you’re allowed to do.  Worse, they may be non-exclusive and allow others to compete with you.  Any of those may limit your ability to capitalize on your work.  Lesson: When negotiating licenses for core technology, be sure to read through and completely understand the terms of the license before signing.
  10. Over-reliance on employment agreements. Unless there’s some sort of other arrangement in place between an employer and an employee, the arrangement is considered to be “at will” — i.e. either party can end it, at any time, for nearly any reason (with some exceptions; can’t fire somebody because of their race, for example). But, that arrangement gets thrown out if there’s an employment agreement. In that case, the employment agreement spells out when the employee can be terminated. As a general practice, employment agreements are usually only appropriate for key people at the company. Using them with other people makes your company much less flexible.  And, remember, employment agreements are generally one-way.  It’s possible to sue the employee for damages, but there’s no way to force them to work for you — involuntary servitude died with Lincoln’s Emancipation Proclamation. Lesson: Only use employment agreements when they’re needed to retain the services of key personnel.
  11. Re-using forms from previous companies or from the Internet.  It’s tempting to avoid legal fees by re-using legal forms found someplace else, without having a good understanding of how the forms work. For example, any corporate attorney who’s been around for a while has heard the story of the do-it-yourself Delaware incorporation that incurred thousands of dollars in tax liability simply because they forgot to assign a “par value” to their shares.  Internet terms of service are another place where this happens — it’s all too common for websites to simply cut-and-paste terms from a different website. The end result can be a legal nightmare.  Lesson: consult an attorney before using forms that weren’t originally intended for you; the attorney can save you a lot of trouble and heartache down the road.
  12. Informality in decision making. Going back to #2, above, start-ups often do lousy jobs of ensuring that the correct people make decisions and of documenting those decisions. Some decisions must be approved by stockholders (amending the certificate of incorporation to add more shares, for example), some decisions must be approved by the board (issuing more stock, for example), and other decisions can be delegated by the board to the officers. Unfortunately, when a company skips those requirements, it may end up having taken an action that it was never authorized to take.  Lesson: document all board and shareholder actions in meeting minutes and/or written consents, and ensure that officers know what authority has been delegated to them by the board.

You’ve probably noticed that a lot of those suggestion involve “see an attorney” in some form.  Yes, that can sometimes get expensive, but there are ways to keep the cost down, some of which I’ll describe in a later post.

End Note: Please don’t blindly apply these lessons to your company without consulting your own lawyer. After all, every situation is different, laws change, the laws where you live might be different and, heck, I might just be wrong. And, if you do happen to be one of my clients,  please check with me.