Monday, July 1, 2013

Expertorama Interview - Commonly Asked Startup Questions Answered

In April, when I was in Kiev for iForum, I gave an interview (in Russian) to Expertorama. Many of the questions that we covered in the interview, are questions that I answer all the time for new clients. For those who don’t read Russian and might find this material interesting, I am posting a translation of the interview, slightly reworked and reorganized.

ABOUT WHITE SUMMERS AND WORKING WITH LEGAL COUNSEL

Please tell me a little bit about yourself, your background, and what you do now?
I am a corporate and securities attorney based in Silicon Valley, California, specializing in representing startups and startup investors.

I obtained my JD from Berkeley Law in 2005 (it was then still called Boalt Hall). After law school I joined the Venture Law Group at Heller Ehrman, where I focused on documenting venture capital investments and working with startups. Heller Ehrman imploded in 2008, and my group joined the emerging companies group at Cooley. After Cooley, I worked briefly for Electronics for Imaging. However, I realized that in-house counsel work – only supporting one client, is not for me. I enjoy working with a number of clients at the same time. I hung out my own shingle, but quickly realized that solo practice did not provide the kind of scale that was needed to support my practice. To get better clients, I needed a bigger platform. Two years ago, I took my practice to White Summers, a boutique corporate and transactional law firm, with 10 attorneys. White Summers has offices in the Silicon Valley (Redwood City, California) and in the Pacific Northwest (Portland, Oregon) and specializes on structuring and formation of legal entities, financings, mergers and acquisitions, and commercial contracts.

Do you represent only U.S.-based startups?
The majority, though not all of our clients, are incorporated in the United States. Where they are physically located, however, is another matter. About half of my clients are headquartered in the CIS countries. One of my partners, Mark White, represents clients from Spain, and throughout Europe. An attorney is joining us, who will be developing the firm’s China practice. Even though many of our clients are located outside of the United States, they all inevitably have some to the U.S. jurisdiction – either they are incorporated in the United States, or they are raising money here, or their products and services target the U.S. market. A common characteristic among our clients is that they must face questions which require answers from a U.S. attorney.

When is the right time for a startup to engage legal counsel?
The best time to seek legal counsel is when the startup begins interacting with the outside world. There are four primary entry points:

Incorporation. When a startup consists of a single founder programming away in his proverbial garage without involving others, it can wait to talk to an attorney. But at a certain point, as the sole founder attracts team members and starts to actually do business, it becomes beneficial to form an entity with limited liability (usually a corporation). Of course, It is possible, even easy, to incorporate without working with a startup attorney, but will it be done right, in a manner most beneficial to the startup given its long- and short-term goals? At the point when a company is ready to form an entity for doing business, it is best to speak to an attorney to get advice on the best jurisdiction and time to incorporate as well as to get the other formation in place, such as stock issuance and transfer of intellectual property.

Commercial Agreements. Another time to seek legal counsel is when the startup is negotiating and about to enter into a commercial relationship. Whether this is a license of technology to or from the startup, a bank loan, or even an agreement with a consultant, it is best to consult a professional, who can review the contract terms, explain the risks associated with the particular agreement, and help to negotiate the best terms for the startup.

Term Sheet. Very frequently I am engaged by a startup that has been presented with a term sheet from an interested investor and needs advice on how to proceed. I provide an analysis of the term sheet and offer a negotiation strategy. My role is to identify the terms that do not conform to best practices in a way detrimental to the startup or the founder, and to review those with the startup. In most of these cases, the founders did not work with legal counsel previously, and are missing important documents. In those situations, I will do corporate cleanup, in other words, generate proper documentation that the investors’ legal counsel will require when they conduct diligence review.

Financing. Finally, sometimes I am engaged at a stage when the term sheet with investors has been signed and the company needs representation for documenting the financing itself.

INCORPORATION

What is the best jurisdiction for a startup to incorporate?
The answer to this question will vary significantly depending on the startup and on its particular plans. If a startup is planning on looking for funding in the United States, it will need, at the very least, to register a holding company in the United States because by and large American investors will not risk investing in a company registered in Russia or another foreign jurisdiction. They might, nonetheless, invest in a foreign business, but that business must be owned by a company incorporated in United States (and not in the Caymans or in BVI).

That said, not every startup intends to raise funding in the United States. A startup based outside the United States may look to investors locally or in other jurisdictions, such as Europe or Asia, where investors’ jurisdictional requirements are very different from those of U.S. investors.

If there is a desire to enter the American market or to work with American investors, then at least one of the companies in the family of companies that constitutes the business must be incorporated in the United States, preferably in Delaware. In fact, the vast majority of startups that are incorporated in the United States, are incorporated in Delaware.

Why Delaware specifically?
The United States legal system is based on precedent. So the more that cases of a certain type are adjudicated in a jurisdiction, the more established and clear the law is relating to those kinds of cases in that jurisdiction. Historically, Delaware was the state of choice for large corporations and remains the state of choice for publicly-trading companies in the United States. Perhaps this was because of the business-oriented administrative system in place, or because Delaware has a separate court, the Chancery Court, that specializes in corporate and securities matters. Regardless of the original causes, the fact remains that over many years Delaware has acquired a very established body of corporate law and a judicial system that is competent in these matters and reasonably predictable.

But that’s history. Bottom line is that investors are familiar with Delaware. They understand how the Delaware laws affect their rights are shareholders. For investors who have large portfolios, investments in 30 to 50 companies or more, it would be an impossible task, having to track their rights across 15 or 20 jurisdictions. Delaware is the industry-standard, and while you don’t have to always adhere to the industry-standard, if you don’t, you should have a very good reason for swimming against the current. Are there any benefits to incorporating in a local jurisdiction (outside the U.S.)?

When we are talking about global business, we have to talk about families of companies. Thus, having a legal entity in the jurisdiction where a company is actually located can be very convenient for its operations. For example, it is easier for a company incorporated locally to enter into contracts with employees or to obtain a lease for office space.

For foreign startups that are targeting the U.S. for investment, the local company will typically be a wholly-owned subsidiary of a U.S. corporation. For startups that are looking to U.S. as a market for its products or services, the U.S. company may be a subsidiary or a sister-company. In either case, the relationships between the family of companies that constitute a business can (and should) be documented by commercial agreements.

Is it true that one should put off incorporating a venture until it begins generating revenue?
I would say that waiting to incorporate until a business generates revenue is waiting too long and exposing the founders to too many risks and potential liability. Many startups don’t begin generating revenue for one to two years, or even longer. During that time, they have developers working on valuable intellectual property, officers are meeting with prospective customers, and presumably there is investment being made into the company that is supporting its operations.

If a startup has not incorporated and does not have a corporate bank account, how is it going to take money from investors? It is, of course, always possible to shake hands and accept a suitcase full of cash under the table. However, this is not a good business practice. If something goes very wrong, the founders will be subject to personal liability because they will be found to have been operating as a common law partnership. To minimize liability and make it easier to conduct business, ventures should be incorporated when they business outgrow the embryonic state and begin to have relationships with the outside world, whether it’s taking investment, uploading a mobile application to the AppStore, or hiring engineers.

As I mentioned in the discussion about engaging counsel, if a startup consists of a single founder, that founder can exist for quite a while on his own, without incorporating. However, if there are multiple founders involved and the company is not incorporated, the company structure becomes volatile.

By way of example, let’s say that five founders are working together on a startup without documenting their relationship. By the time an investor enters the scene, only three founders are still working on the project and the remaining founders incorporate the business.

But what about the two founders who left? Because of the lack of proper documentation, we are faced with many questions the answers to which depend on who you ask. Do the founders who left own a share of the company? If so, is it clear what their share is? Is it proportionate to their contribution? Is intellectual property that they created being used by the company? If so, does the company actually have the right to use it? Do the founders have the right to use it as well in a competing venture?

More often than not, an investor will not want to get involved in this type of situation because the risks are too high. Investors require that the cap table and IP ownership be clear and unambiguous. And this kind of a situation is exactly the type of issue that investors worry about uncovering when they conduct legal due diligence of a company.

This is why, the more people that are involved in a project, the more important it is to structure and document everything correctly and in a timely manner. Then, if something does not go according to plan, which is often the case, it’s a minor hiccup that does not derail the entire venture.

GETTING READY TO TAKE INVESTMENT

What types of documents should an entrepreneur have in place before talking to investors?
Technically, you don’t need anything to talk. It is always possible that the investor will be so excited about the investment opportunity that he will offer you a term sheet even when the startup is not incorporated or does not have all the right documents in place.

That can happen even when we are talking about savvy investors. For example, about six months ago we closed a deal in which our client received funding from Khosla Ventures, a top-tier venture fund. Vinod Khosla met the founder at a conference and he believed in the team and the technology. At that time, the company was formed as an LLC. There was nothing else done; it was an empty shell company. The client received a term sheet and we prepared the proper formation and financing documents.

In other words, there is no minimum set of documents that a startup is required to have to engage with investors, if there is a sufficiently high level of interest from the investors. But some investors might see a complete lack of corporate documentation as evidence of a lack of commitment by the founders. After all, if the founders have not been willing to invest even the small amount of their own funds necessary to properly set up the company, they must not have a lot of faith in the success of the project. But, ultimately, the importance that is placed on proper corporate documentation pre- first investment is going to be individual to the investor and to his interest in the company.

If you were to do things “by the book” so to speak, you would form a Delaware corporation, distribute Common Stock to the founding team, impose vesting on the shares, transfer all technology and other intellectual property created by the founders pre-incorporation to the corporation, and enter into agreements with everyone generating intellectual property for the company that make this intellectual property the property of the corporation from the time of creation. That’s the basics. Of course, if the company has any operations, you would properly document those as well.

Are investors to be trusted? Or will they include terms in a term sheet that take away the founders’ rights in some sneaky way that founders will likely miss without the help of an attorney?
It depends on how familiar the founder is with the terminology. I would say that on the whole, investors aren’t trying to purposefully mislead the founders or hide something unpalatable in the term sheet. Investors will include those terms and conditions in the term sheet that are important to them. Founders are expected to understand each term (whether on their own or with the help of an attorney). It is not enough to look at the company valuation, though that is certainly an important term. If a founder is experienced, understands common industry practices and terminology, and has already sold three companies, he can probably handle negotiations with the investor himself. But these types of founders are the exception.

Legal services can come with a hefty price tag. If the investors are performing due diligence, who pays the bill?
Often in an investment transaction, the startup pays not only for its own attorney, but also for counsel for the investors. This is a very standard practice in the U.S. Sometimes if the investment amount is fairly small ($25,000-$100,000) both parties will agree to pay for their own counsel, or more likely, the investor will not engage counsel in the first place.

Of course, if we are talking about a very small investment amount, we work with the company to create minimalistic (yet sufficient) documentation, where the legal fees will make sense in the context of the transaction. Usually, a small investment can be documented as a bridge financing using a convertible promissory note that we’ll prepare for the company, based on the investment terms that it would like to offer to its investors. (For more information about convertible promissory notes, see my blog post on the topic.)

On the other hand, if we are talking about a financing in excess of $500,000, U.S. investors will expect the startup to pay their legal fees. Depending on the transaction, the cost of services of an attorney from the investor side is usually limited to $10,000 -$35,000. Since the attorney for the startup performs the majority of the work in an investment transaction, the cost for company counsel’s fees averages 1.5 to 2 times the cost of legal services for the investor (assuming comparable law firms with comparable rates on both sides of the transaction).

LEGAL PITFALLS

What are some legal difficulties that a startup might face at different stages of its life?

Legal difficulties often arise when something that needs to be documented is put off for later. Then suddenly it becomes too late, and it’s no longer an item at the bottom of a long to-do list, but a mistake which carries a cost and needs to be fixed. Some mistakes can be fixed afterwards, but it is typically more expensive than doing it right the first time.

Misunderstandings between counterparties also potentially create legal difficulties. If an agreement was rushed, it is possible that it was not thought through fully. After the fact, it may turn out that one party had meant one thing, and the other something else. Sometimes, when documentation wasn’t sufficiently well thought through, the plain text of the contract may not be enough to provide guidance on a point of contention.

Bottom line, good communication between the parties about their expectations with respect to their relationship will help to minimize many potential conflicts and legal difficulties.

Are there issues with startups being sued, for patent infringement among other things?
We do not run into this problem very frequently. In my practice, I have yet to see a single contract that I’ve drafted litigated. Generally speaking, the documents that we generate are meant to set expectations between counterparties. Even if things don’t go according to plan and one of the parties is dissatisfied with the performance of the other, it does not make a lot of sense to go to court for resolution. Litigation is both a very expensive endeavor and a disruptive one for business. The majority of my clients are not yet at a stage where it makes sense for someone to sue them or where they have the resources to sue someone. Fortunately, patent infringement claims have not been brought against my clients either. Possibly for the same reasons listed above, but also because, even if their technology potentially infringes a patent, the patent holder simply wouldn’t know about it. Since my clients’ products and services aren’t household names quite yet, someone has to look pretty hard to find them. And then again, there are no deep pockets, so what will a lawsuit, even a successful one, get them? The company will shut down and everyone loses.

What we do see sometimes are trademark disputes. Here’s how that usually goes:

These days, it can be difficult to invent a relevant and interesting company name for which a domain name is still available. But entrepreneurs are creative people, and eventually find a name and a domain. During the name selection process, they will usually run a Google search for their desired name to see if it’s already being used. If the search does not produce relevant hits, or if the only relevant hit is a chicken farm in New Zealand, they proceed with the name.

The problem is that trademark infringement is broader than using the exact name that another company is using in the same space. The test is “likelihood of confusion” so a company with a similar, not identical name, may have a legitimate claim against a newcomer. Without conducting a thorough trademark search, it is hard to catch those similar but not identical names.

Proceeding with our example, sometimes it turns out that there is, in fact, another company, with a similar but not identical name, that has the resources to do trademark policing. This company will start a cease and desist letter campaign against what they perceive as a violator of their trademark.

The first letter is generally from the company that owns the trademark, and reads something like, “We’ve invested a lot of money in our trademark and you are violating our rights! Stop it, immediately.” Then the “offending” company has to go to their attorney and the attorney will write a response explaining how there is actually no trademark violation and that the marks are sufficiently dissimilar that there could be no likelihood of confusion.

The next letter will typically come from a heavy-hitter law firm hired by the trademark holder. It will say something like “You are violating the rights of our client. Stop immediately or we will sue you.”

Whether there truly is infringement, is largely a matter of opinion and interpretation, and any question of opinion or interpretation can be resolved in court – that’s what courts do. But that’s a very expensive way to get an answer. If the dispute is between a small startup and an established company with a budget allocated specifically towards IP rights enforcement, the startup will have a difficult decision to make. One option is for the startup to change its name. But that means they would have to come up with another, non-infringing name that’s just as good, find a domain name that’s available, and wave goodbye to the time and money spent on developing this brand. Another option is to continue the letter exchange and hope that the other company is bluffing when they say they’ll sue. That’s a big risk, calling their bluff!

To reduce the risk of facing this situation, prior to definitively committing to a name, (1) have your attorneys conduct a thorough trademark search for it, and, if it comes back clear (2) register a trademark for it.

GENERAL ADVICE

What advice can you give to new/novice entrepreneurs?
The most important piece of advice that I can give is to do what you love! The right motivation to become an entrepreneur is that you cannot do anything else, not because you don’t have the skills, but because you have identified an important problem, and have a solution to that problem that is far superior to what’s out there now. Being an entrepreneur, running a startup, you’ll work harder than you ever have in your life. It's certainly not for everyone, and if you’re going to take the plunge and go for it, be sure you are ready and that this is right for you.

Second, you need to be running a continuous assessment of what you bring to the venture. You have to keep track of the components you need for success and be honest about what’s missing. Sometimes, entrepreneurs will start a project on their own and develop a strong personal attachment to it. It is theirs and theirs alone. They don’t want to bring on additional founding team members because they don’t want to share the equity or have to listen to other opinions. That kind of an approach can work for some founders, but it can backfire as well. Two heads are better than one and it is good to be challenged, even if it’s not as comfortable as being king in your own little kingdom. Working alone results in a skewed, one-sided vision.

Founders should seek out other talented like-minded people who will also become obsessed with the project. The more people that are excited about your idea, the more chances you have of persuading clients, customers, investors and business partners to be excited about it as well.

Don’t be paranoid that someone will steal your idea. Don’t be reluctant to seek advice from experts or to issue an equity stake to your partners. Running a startup is a collaborative process. All successful companies are developed by a team. No matter how brilliant an entrepreneur is, he cannot run a successful startup without a team. There will inevitably be gaps, and a strong team can fill those gaps. Every successful entrepreneur I have talked to has said “hire people smarter than yourself to be on your team”! Lastly, I would say, constantly check and recheck whether the project you are working on is relevant! Does it provide a solution to a real problem? Solving a fictional problem is truly a thankless task.

Happy company making!

Inna


White Summers  Inna Efimchik, a Partner at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.
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3 comments:

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  2. The best advice for new, young entrepreneurs is not to think that a 40 hours week is good enough. 40 hour weeks is just a part-time job in the entrepreneurial world.

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