Top Ten Legal Mistakes Made by Entrepreneurs

Top Ten Legal Mistakes Made by Entrepreneurs

Published: March 3, 2003
Author: Constance Bagley

Executive Summary:

The life of a startup can be precarious, a wrong turn disastrous. Harvard Business School professor Constance Bagley
discusses the most frequent legal flops made by entrepreneurs,
everything from hiring the wrong lawyer to puffing up the business plan.

"I’ve heard many war stories," says Harvard Business
School associate professor Connie Bagley, reflecting on conversations
with former students who have started business ventures. To prepare
current students for the HBS Business Plan Contest, Bagley gives a
seminar in which she shares these war stories with the prospective
entrepreneurs, in the form of a list of "top ten" legal mistakes often
made by the unsuspecting. In addition, Bagley teaches the second year
elective course, "Legal Aspects of Entrepreneurship," which covers the
waterfront of issues typically faced by entrepreneurs in starting and
running a business, including securities and intellectual property law
issues.

Bagley’s teaching and research focus on legal aspects of
entrepreneurship and corporate governance. Before coming to HBS in
2000, she taught at Stanford Business School, and prior to that she was
a corporate securities partner in the San Francisco office of the law
firm of Bingham McCutchen. She is author or coauthor of several
textbooks, including the just-published second edition of The Entrepreneur’s Guide to Business Law.

Bagley recently met with Harvard Business School’s New Business
magazine, and talked about the legal issues commonly faced by
entrepreneurs, as well as her thoughts on how to successfully deal with
them.

In Bagley’s view, there is a tendency on the part of many
entrepreneurs to think that the lawyers can handle the legal issues and
to delegate too much to the attorney.

"While the language of the law can be intimidating, the concepts are
usually quite straightforward," she says. "Lawyers tend to be risk
averse, and if you delegate to them you will usually stay out of legal
trouble but can often compromise your business objectives. My goal for
the course—and for the coaching I give entrepreneurs—is to give them
sufficient comfort with the legal concepts to feel confident in driving
the process, to understand the ways in which the law is a constraint,
but also the ways in which it is a tool that can help you create and
capture value."

Lawyers who have no experience working with entrepreneurs and venture capitalists will most likely focus on the wrong things.
—Constance Bagley

# 10: Failing to incorporate early enough.
One problem that arises here is the so-called "forgotten founder": a
partner involved in starting the venture subsequently drops out. When
the venture gets financing or is ready to go public, this partner
returns, perhaps with an inflated view of what his or her contribution
was, demanding equity. This problem can be eliminated by incorporating
early and issuing shares to the founders, subject to vesting. As
partial consideration for their shares, each founder should be required
to assign to the new corporation all inventions and works related to
the company’s proposed business.

Incorporating early—before significant value has been created and
well in advance of any financing event that establishes an implicit
value for the shares—also helps prevent potential tax problems for
"cheap stock." Incorporating too late, and issuing inexpensive stock to
the founders at the same time that much more expensive stock is being
sold to investors, can create tax problems when the IRS argues that the
difference in stock price is actually income to the entrepreneur.

# 9: Issuing founder shares without vesting.
Simply put, vesting protects the members of the founding team who take
the venture forward. If people remain on the team and are productive,
their shares will vest. If they leave earlier, that stock can be
retrieved and given to whoever is brought in to replace them.

#8: Hiring a lawyer not experienced in dealing with entrepreneurs and venture capitalists.
Many venture capitalists say that they often rate the judgment of
entrepreneurs by their choice of legal counsel. Lawyers who have no
experience working with entrepreneurs and venture capitalists will most
likely focus on the wrong things while failing to recognize some of the
more subtle potential traps. It’s better to hire someone who has played
the game, who knows what’s standard and what isn’t, and who will get
the deal negotiated and closed promptly.

#7: Failing to make a timely Section 83 (b) election.
If the advice in #9 is followed, then shares will be issued, subject to
vesting, to the founders as well as new employees. If stock is acquired
and it’s subject to what the IRS calls a substantial risk of
forfeiture, then the IRS doesn’t view the purchase as being closed
until that risk goes away. When the stock vests, that risk evaporates,
so the IRS considers the deal closed. The IRS then calculates the
difference between the price paid at the outset and the fair market
value at that later date, then taxes this difference as ordinary
income. An 83 (b) election allows the tax computation to be made based
on the value at the time the shares are issued, which is often pennies
per share.

A no-name firm offering the highest valuation is often not the best source of equity.
—Constance Bagley

# 6: Negotiating venture capital financing based solely on the valuation.
Valuation is not the only thing one should consider when selecting a
venture capitalist or when negotiating the deal. There are many other
ways for venture capitalists to get compensated if they end up paying a
high price for shares. These include requiring participating preferred
with a high cumulative dividend, redemption rights exercisable after
only several years, and ratchet anti-dilution protection with no cap.

One must ask, what’s the reputation of this firm? Do they have a
history of standing by the entrepreneur if the entrepreneur stumbles?
Do they have good contacts in the industry? In trying to build
alliances, do they know the big players? A no-name firm offering the
highest valuation is often not the best source of equity.

#5: Waiting to consider international intellectual property protection.
Patents are granted on a country-by-country basis (with a single
application available for the European Union). In the United States, if
an invention is sold or made public, there’s a year’s grace period to
file a patent application. Everywhere else, if the invention is sold or
publicized prior to filing the patent application, the invention is
unpatentable in that country. For example, if the invention is publicly
disclosed to a Japanese national visiting a tradeshow in the United
States, then under Japanese patent law, if no patent application has
been filed, that disclosure makes the invention unpatentable in Japan.
The same is true with trademarks. A tremendous amount of money might be
spent in developing a brand in the United States, yet when the product
is shipped overseas it could violate trademarks of companies dealing in
similar goods outside the United States. One must make intelligent
choices of where they think their markets are, and how much money to
spend at an early stage in order to insure that the brand is available
in those markets.

#4: Disclosing inventions without a nondisclosure agreement, or before the patent application is filed.
If patent protection hasn’t been obtained, or in cases where a patent
is not available, the only protection is to maintain something as a
trade secret. To do so, one must show that they’ve taken reasonable
steps to keep it secret from competitors.

Is it wise to get potential venture capitalists to sign a
nondisclosure agreement? In the best of all worlds, yes, but most
won’t. Before disclosing to anyone, one must learn who has a reputation
for integrity in the industry. In dealing with most people, it’s wise
to require them to sign nondisclosure agreements. It needn’t be
elaborate, but it should say that they acknowledge they may be exposed
to trade secrets, and they agree not to use or disclose them without
permission.
Business plans should expressly state on the cover page that they are
confidential and proprietary. That’s not as strong as a nondisclosure
agreement, but laws in some states suggest that if a person knows they
have been exposed to a trade secret, they can’t use it or disclose it
without permission from the owner.

Can entrepreneurs be sued by their funders for fraud? Yes.
—Constance Bagley

#3: Starting a business while employed by a potential competitor,
or hiring employees without first checking their agreements with the
current employer and their knowledge of trade secrets.

The law is clear that if someone is currently working for a company,
particularly if her or she is a key employee, they cannot operate a
competing business. Even just incorporating may spark a lawsuit from
the current employer. Would-be entrepreneurs should first go to their
current employer and either resign or tell them what they’re doing and
ask them if they’d be interested in investing. Amazingly, that’s often
a very smooth way of ending that relationship. Under no circumstances
should they misrepresent the nature of the new business.

Even after leaving the current employer, one still cannot use or
disclose the company’s trade secrets. Under the so-called inevitable
disclosure doctrine, if someone has been exposed to trade secrets at
their job and leaves to work for someone else, and if their
responsibilities in the new job are sufficiently similar, some courts
will conclude that it’s inevitable that they will use the information
that they had from the earlier position. They could face an injunction
prohibiting them from working for the new employer until a number of
months go by and whatever trade secrets they had are stale.

It also helps to know whether potential recruits are subject to
covenants not to compete. States vary in terms of how enforceable they
are, but one shouldn’t assume they are not. One should also check to
see what assignments of inventions might have been signed. Personnel
files should be reviewed, and recruits should check theirs, to be
certain that a covenant not to compete or an assignment of inventions
wasn’t tucked into a signed non-disclosure agreement.

#2: Promising more in the business plan than can be delivered and failing to comply with state and federal securities laws.
If someone promises to do something and knows that they can’t perform
that promise, that’s considered fraud. In a business plan, one must
make an honest appraisal of what’s doable and set forth their
assumptions, so the person putting up money can judge whether they are
realistic. Can entrepreneurs be sued by their funders for fraud? Yes.
Trying to squeeze out a little extra valuation by fudging the numbers
erodes credibility, makes investors less trusting, and ultimately
impairs the ability to get subsequent rounds of financing.

Finally, anyone selling stock or other securities must comply with
both the federal and state securities laws by either registering the
securities (rare for a start-up) or meeting all the requirements for an
applicable exemption. Ignorance of the law is no excuse. As one judge
put it in a decision upholding criminal convictions for violating the
securities laws: "No one with half a brain can offer ‘an opportunity to
invest in our company’ without knowing that there is a regulatory
jungle out there."

#1: Thinking any legal problems can be solved later.
There’s a tendency to think, "Once I get my funding, once I’m up and
running, then I’ve got time to hire the lawyers; right now, I’m running
as fast as I can to get my business plan done and raising money." This
is shortsighted logic. Many of the points made here are problems that
can’t just be patched up later. Does that mean that one should devote
all of their time, effort, and money to the legal issues? No. That’s a
good reason to hire a competent lawyer. Excellent legal talent can be
retained for relatively little money up front at the early stages. It
will cost much less to get it right at the beginning than to try to
sort it all out later and correct it.

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