“Ask the Attorney” – Formation Issues (Part II)

by Scott Edward Walker on February 3rd, 2010


This post is part of a new series entitled “Ask the Attorney,” which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”  This post is a longer, more-comprehensive version of the VentureBeat post.

The goal here is two-fold: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain english (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott


Two former classmates and I are launching a new venture.  Unfortunately, we don’t have enough money to hire a lawyer.  I found a lot of articles on the web, but I’m still not sure what kind of entity we should form and where.  I also was wondering if there are any other legal issues we should be worrying about?


Thank you for your questions.  This is part II of my answer.  Last week (in part I), I addressed the issues of (i) choice of entity, (ii) place of formation, (iii) equity issuance, (iv) vesting restrictions and (v) prior employment.  Below are five more issues that should be on your radar.  Again, it would be prudent for you to retain a good, reasonably-priced attorney to assist you and watch your back (see our FAQ’s).  If you don’t have the money, some lawyers will defer their fees and/or take equity if you can get them excited about your venture.

1.  Management Issues.  You and your two co-founders should sit down and agree on how the company will be managed — e.g., who will be on the Board of Directors and what position each founder will hold.  Whatever you decide should be reflected in a written agreement (commonly referred to as a stockholders’ agreement or voting agreement), which should also address certain other significant issues, including: (i) rights of first refusal with respect to the sale of any shares by a founder (sometimes addressed in the founders stock purchase agreements); (ii) whether any founders will have veto rights with respect to certain extraordinary company actions (e.g., the sale of the company, borrowing in excess of a certain amount, the issuance of additional shares, etc.); and (iii) whether founders will have so-called “drag-along” rights (i.e., the right to “drag” other stockholders in the event of the sale of a certain percentage of the equity of the company) and/or “tag-along” rights (i.e., the right of a founder to “tag-along” in the event of such a sale).

The importance of a written agreement to address these issues cannot be over-emphasized.  Indeed, Simeon Simeonov, the founder and CEO of FastIgnite, recently wrote an excellent post on VentureHacks (one of the best websites for startups) entitled “When to fire your cofounders,” in which he discusses the issue of getting rid of an unwanted co-founder.  From a business perspective, it may sound pretty easy; from a legal perspective, it is not — particularly if the founder in question is the CEO (who reports to the Board of Directors).  In short, there must be appropriate documentation in place — such as a stockholders agreement and perhaps an employment letter agreement – otherwise the co-founders may not have the legal authority to terminate another co-founder.

2.  IP Issues.  For many start-ups, particularly technology companies, intellectual property (IP) is their most valuable asset.  Accordingly, certain steps must be taken to ensure that your company owns the IP and protects it.  First, if any technology/IP were developed prior the company’s formation, you must do two things: (i) as noted last week (see #5), confirm that none of the founders’ prior employers has rights to the technology/IP because of prior agreements or applicable law (e.g., because a founder was “moonlighting” while previously employed); and (ii) make sure ownership to the technology/IP is transferred from the applicable founder(s) to the company in writing.  Once the company has been formed, the ownership of the technology/IP should be protected by requiring all of the Company’s employees and consultants to execute confidentiality and invention assignment agreements (as discussed in #4 below).

There are also a number of other IP issues that generally need to be addressed.  Indeed, as startup guru Steve Blank notes in his outstanding post “Someone Stole My Startup Idea – Part 3: The Best Defense is a Good IP Strategy”: “You need a plan for trademarks, copyright, trade secrets, contracts/NDA’s and patents before you get funded.”  Moreover, as Brad Feld (a smart investor) recently tweeted and blogged, you can learn more about IP issues by checking-out the new blog by IP attorney Jill Hubbard Bowman (see, e.g., her post “Ten Smart Reasons to Learn about IP Law”).

3.  Securities Laws.  As I have previously discussed, a company may not offer or sell its securities unless (i) the securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (ii) there is an exemption from registration.  The most common exemption used by start-up companies is the so-called “private placement” exemption.  As the term implies, a private placement is a private offering to a small number of purchasers – like a few founders.  The SEC and each of the State securities commissions have their own set of rules regarding private placements, and it is imperative that they be complied with.  Non-compliance could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

If you are interested in learning more about some of the common mistakes entrepreneurs make relating to securities laws, you can watch my brief video on YouTube: “5 Mistakes Entrepreneurs Make in Raising Capital.”

4.  Employment Issues.  If any employees are hired by the company, they should be required to execute two documents: (i) an offer letter agreement and (ii) as noted above, a confidentiality and IP/invention assignment agreement.  The offer letter agreement will set forth the employee’s rights and obligations, including position, compensation, benefits and, most importantly, whether the relationship is “at will.”  The confidentiality and invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any IP developed by the employee is legally owned by the company.

Non-competition and non-solicitation provisions may also be included; however, such provisions are generally unenforceable in California other than in the context of the sale of a business (though California courts will generally enforce provisions that prohibit employees from soliciting the company’s employees provided they are reasonable in scope and duration).  Consultants and Board advisors should also be required to execute (i) a written agreement, setting forth their rights and obligations, and (ii) a confidentiality and invention assignment agreement.

In addition, you need to be very careful about classifying workers as “independent contractors” when in fact they are “employees” in order to avoid paying payroll taxes and otherwise complying with applicable law.  California governmental authorities are particularly concerned about this issue and expressly note on the Department of Industrial Relations website that: “In handling a matter where employment status is an issue, that is, employee or independent contractor, [the the Division of Labor Standards Enforcement] starts with the presumption that the worker is an employee. . . . The most significant factor to be considered is whether the person to whom service is rendered (the employer or principal) has control or the right to control the worker both as to the work done and the manner and means in which it is performed.”

5.  Stock Option Plan.  Finally, in order to attract and retain key employees (and consultants) and to conserve cash, it would make good business sense for your company to establish a stock option plan or other form of equity compensation plan.  As I mentioned last week, the goal is to issue any equity (including options) as soon as possible when the value of the company is as low as possible; and, as noted above, because options are “securities” their issuance must comply with applicable federal and state securities laws.  The SEC and most State securities commissions (including California) have created an exemption from registration for any offer or sale of securities pursuant to certain plans and contracts relating to compensation.  If you would like to learn more about stock options and some of the tricky issues relating to their issuance, you should check-out my post “Issuing Stock Options: Ten Tips for Entrepreneurs.”


I hope the foregoing is helpful.  If you have any questions about this post or any other legal issues, please ask them in the comments.  Thanks.

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2 Responses to ““Ask the Attorney” – Formation Issues (Part II)”

  1. You have covered almost all the topic. nice work.