The Biggest Legal Mistakes That Startups Make – Part 2

by Scott Edward Walker on May 27th, 2011

Below is a video of the presentation I made a few weeks ago at CoLoft in Santa Monica (referred to in the tech community as “Silicon Beach”); it is part 2 of 2 of “The Biggest Legal Mistakes That Startups Make.”  You can watch part 1 here.  I hope you enjoy it.  Cheers, Scott

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For those of you who want to skip the video, here are the mistakes I discuss:

1.  83(b) Elections.  Some founders make the mistake of not making an “83(b) Election” in connection with the restricted stock (i.e., stock subject to forfeiture) issued to them.

Section 83(b) of the Internal Revenue Code permits the founders to elect to accelerate the taxation of restricted stock to the grant date, rather than the vesting date.  As a result, the founder would pay ordinary income tax rates on the fair market value of the stock at the time of the grant (which presumably would be quite low or would be equal to the purchase price if such stock were purchased), with any subsequent appreciation of the stock being taxed at capital gains tax rates upon its sale.   Such an election is made by filing a simple, one-page election with the IRS within 30 days after the grant/purchase date (no exceptions applicable).   I discuss this issue in detail in paragraph 3 of my blog post “Founder Vesting: Five Tips for Entrepreneurs.”

2.  Employment Issues.  Some startups make the mistake of not addressing employment-related issues with respect to new hires.

For example, if an employee is hired by a startup, he or she generally should be required to execute two documents: (i) an offer letter and (ii) a confidentiality and IP/invention assignment agreement.  The offer letter will set forth all of the employee’s respective rights and obligations, including position, compensation (including stock options and/or other incentive compensation), benefits and, most importantly, whether the relationship is “at will.”  The confidentiality and IP/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.  In addition, some startups make the mistake of hiring an employee and merely giving him or her “sweat equity” in lieu of any ongoing cash payment/salary.  Unfortunately, this is illegal in California and could lead to criminal liability.  I discuss these issues in paragraph 8 of my blog post “Launching a Venture: Ten Tips for Entrepreneurs.”

3.  Intellectual Property Issues.  Some startups make the mistake of not adequately protecting their intellectual property (or “IP”).

Indeed, for many start-ups, IP such as trademarks, domain names or patents is their most valuable asset.  Accordingly, a number of steps should be taken to protect IP assets, including (i) developing a comprehensive strategy for IP; (ii) establishing and implementing IP policies and procedures — e.g., concerning proper use of third parties’ IP; (iii) if appropriate for the business, filing patent applications and registering copyrights, trademarks and domain names; and (iv) as discussed above, requiring independent contractors and employees to execute confidentiality and IP/invention assignment agreements.  I discuss these issues in detail in my post, “What Are the 5 Biggest Mistakes that Startups Make Regarding IP?

4.  Stock Option Plans.  Some startups make the mistake of issuing shares of common stock (as opposed to stock options) to new employees.

This is a problem because of the potential tax liability.  Unless the employee purchases the shares for their fair market value, the issuance will be deemed compensation to the employee; and he or she will have to pay ordinary income tax at the federal and state level, and the company will have tax withholding obligations.  There are also tricky securities law issues. Accordingly, in order to attract and retain key employees (and to conserve cash), it usually makes good business sense for the company to establish a stock option plan.  I discuss these issues in detail in my post, “Issuing Stock Options: Ten Tips For Entrepreneurs.”

5.  Due Diligence.  Finally, some startups make the mistake of not diligencing the guys or gals on the other side of the table.

Indeed, whether a startup is doing a financing, a partnering agreement or some other transaction, it must investigate the other party.  This means determining the reputation of both the company/firm (if it’s not a marquee name) and the particular individuals with whom it is dealing.  Who are these guys?  Are they good guys or are they jerks?  Can they be trusted?  When they say they are going to do something, do they do it?  Do they add value?  Remember, in certain deals (such as an angel or venture capital financing), the startup will, in effect, be married to the firm and the individuals for a number of years.  I discuss this issue in detail in paragraph 1 of my blog post “Five Mistakes Entrepreneurs Make in Dealmaking – Part I.”


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