Early-Stage Legal Issues and Common Mistakes

Early-Stage Legal Issues and Common Mistakes How to Organize a Technology Business and Attract Capital 1 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Building Blocks • Capital Formation – Mistake: Creating an organizational structure that hinders the ability to attract investment capital • Talent – Mistake: Failing to protect your investment in people, or unwittingly creating exposure • Intellectual Property – Mistake: Failing to protect or obtain rights to critical IP 2 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Capital / Org. Structure • Many forms of business organizations • Some are more appropriate to attract venture capital or private equity than others • Don’t create an organizational structure that hinders the ability to attract investment capital 3 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Entity Formation • • • • • • • 4 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Sole Proprietor Partnership Limited Partnership Limited Liability Partnership Limited Liability Company Corporation (C-corp. v. S-corp.) Which One and Why? Entity Formation (cont’d) Sole Proprietor Simplest business form Features: 1. Owner can begin operating quickly with simple business licensing, and perhaps using a trade name (no filings with Sec. of State). 2. Owner can commingle assets, keep one checking account, account for taxes on personal return. 3. Personal liability for all debts of the business. 4. Sole means “no partners” – just debt. 5 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Entity Formation (cont’d) Partnership General Partnership, sharing of losses and profits, default business form for 2 or more people if not properly organized Features: 1. Simple to form under state law 2. Pass-through tax treatment 3. Generally no filings with Sec. of State required 2. Each partner is personally for all debts of the business 4. Dissolution at death 6 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Entity Formation (cont’d) Limited Partnership Partnership, sharing of losses and profits, with at least one general partner (others have limited liability) Features: 1. Pass-through tax treatment 2. Generally a certificate required to be filed with Sec. of State 2. One General Partner is personally liable for all debts of the business, other Limited Partners have limited liability 4. Dissolution at death 7 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Entity Formation (cont’d) Limited Liability Partnership (LLP) Partnership, sharing of losses and profits, with no general partner (partners have limited liability) Features: 1. Pass-through tax treatment 2. Generally a certificate required to be filed with Sec. of State or election recorded with County Officials 2. No General Partner personally liable for all debts of the business, Limited Liability Partners have limited liability 4. Dissolution at death 8 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Entity Formation (cont’d) Limited Liability Company (LLC) Hybrid like Partnership/Corporation, sharing of losses and profits – Managers and Members have limited liability Features: 1. Pass-through tax treatment 2. Generally a certificate required to be filed with Sec. of State 2. No Manager or Member required to be personally liable for all debts of the business, (Members have limited liability) 3. Managers can operate like a Corporation’s Board of Directors Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. 9 Entity Formation (cont’d) C-corporation (C-corp.) Legal entity and taxpayer, reports and pays taxes on earnings – Shareholders have limited liability Features: 1. No Pass-through tax treatment; Corporation is a taxpayer 2. Double taxation problem (corporate earnings and dividends) 3. Generally Certificate/Articles of Incorporation required to be filed with Sec. of State 4. Shareholders have limited liability - No shareholder required to be personally liable for all debts of the business 5. Flexible capital structure (several classes of stock permitted) Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. 10 Entity Formation (cont’d) S-corporation (S-corp.) Legal entity that reports (but does not pay) taxes on earnings – Shareholders have limited liability Features: 1. Pass-through tax treatment (shareholders pays taxes attributed to their interests like a partnership) 2. One class of stock and restrictions on number and type of shareholders 3. Generally Certificate/Articles of Incorporation required to be filed with Sec. of State 4. Shareholders have limited liability - No shareholder required to be personally liable for all debts of the business 5. Less flexibility in capital structure (rights looking like a second class of stock can terminate election) Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. 11 Entity Formation (cont’d) Which one and why? S-corp. or LLC Incorporate and file S election until a VC or private equity closing Features: 1. Institutional investors tend to prefer a convertible preferred security (requiring more than one class of stock) 2. Pass-through tax treatment to the founding shareholders who foot the losses in the early days/years and can take the losses against other income 3. Terminate the election at the closing, by the recording of an amended Certificate of Incorporation with preferences 4. If you choose the LLC, for more flexibility among the founders, statutory merger or other reorganization is possible to give the investors the preferences/capital structure they expect What next? 12 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Organizational Records • Maintain corporate formalities – Keep separate checking accounts – Don’t commingle assets – Hold regular meetings as required by organizational documents, memorialize actions taken 13 • Failing to maintain corporate formalities and organizational documents can result in unexpected personal liability Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Organizational Records (cont’d) • “Piercing the corporate veil” • Personal liability exposure for shareholders, members and partners (to claims of creditors of the entity) • Failure to properly maintain company’s organizational and equity ownership records – Unclear reflection of shares/options issued or outstanding, and who owns them – Representations, warranties, indemnities, escrow holdbacks Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. 14 Organizational Records (cont’d) Revisions to Article 8 of the Uniform Commercial Code – Eliminated requirements that contracts to sell securities be in writing – Offer letters or oral promises of stock/options can create significant problems 15 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Organizational Records (cont’d) Issuance of stock must be: – legal – in accordance with organizational documents and – for the types of consideration specified in organizational documents 16 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Organizational Records (cont’d) Shareholders’ Agreement may address: – Restrictions on the right to transfer stock (S-corp. election) – Rights to buy back (death, disability, retirement, termination of employment) with terms – Who elects the Board of Directors – What circumstances new third parties can be admitted as equity holders – Drag-along or come-along provisions 17 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws • It’s a private business, how could we violate securities laws? • What is a security? • Presumption of registration • Applicable exemptions • Burden of proof 18 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws •Private businesses are subject to the securities laws also •Violation of federal and state securities laws (perhaps unintentionally), is still a violation. 19 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Securities 1. Except in the case of a general partnership, the investment interests purchased by the investors generally will be deemed to be “securities” for federal and state law purposes. 2. Securities are subject to federal and state laws concerning the manner of offer and sale to investors. a. securities for sale either must be registered with the SEC and State Securities Commissioner or qualify for an exemption from registration. b. state registration exemptions differ dramatically from state to state, and a federal exemption does not guarantee a state exemption (or vice versa), nor does an exemption in one state mean that a comparable exemption will be available in another state. 20 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Exemptions and Planning a “Private Offering” – There are a number of private offering exemptions from registration at the federal and state level – The exemptions have a variety of conditions applicable to them, and one cannot assume that an exemption applies – The Issuer has the burden of proof to show registration or an applicable exemption – Most of the federal exemptions require compliance with state law as well (federal law does not preempt state regulation generally) – Plan ahead with experienced securities law counsel 21 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws General Requirement: Prohibition against general solicitation or advertising 1. Exemption from registration under Section 4(2) and Rule 506 (that preempts state regulation), as well as most state securities law exemptions, requires a precondition that the securities cannot be offered or sold by any form of “general solicitation or general advertising.” 2. The issuer may not advertise, engage in a mass mailing, conduct information meetings with potential investors or issue a press release that discusses the existence of the private placement until after the offering has been concluded and all sales have been finalized [Note: website can be general solicitation]. 3. All potential investors should be people with whom the issuer has a pre-existing business relationship. 22 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Intrastate Exemption (the “Neighbor” Exemption”) Elements 1. Issuer is incorporated in the state. 2. A substantial portion of issuer's business is from within the state. 3. Each offeree is a state resident. 4. Each purchaser is a state resident. 5. Offering proceeds are used within the state. 6. Securities "come to rest" within the state. 23 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Intrastate Exemption Advantages • No offeree or purchaser qualifications other than residence. • No limitations on the manner of offering, except offers must be limited to state residents. • No prescribed disclosure format. • No ceiling on the amount of securities offered. • No filing or reporting requirements. • No resale limitations except to nonresidents of the state. 24 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Absent the Neighbor Exemption: • To accomplish a private placement that would permit raising unlimited funds without registering the securities with the SEC, the issuer must conduct a “private placement” either: – under the statutory provisions of Section 4(2) of the Securities Act of 1933 (the "Securities Act"), or – under Rule 506 of Regulation D. Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. 25 Securities Laws Rule 504 of Regulation D Simplest exemption for offerings up to $1 Million Features: 1. No disclosure format requirements, although disclosure is advisable as protection against anti-fraud liability. 2. No general advertising or solicitation limitations, although state exemption requirements will continue to apply (states usually prohibit it). 3. No limitations on resales. 4. No offeree or purchaser qualifications. 26 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Rule 505 of Regulation D Permits Offerings up to $5 Million Restrictions: 1. No more than 35 purchasers, excluding accredited investors. 2. Fixed disclosure obligations, depending on the amount of the offering. 3. No general solicitation or advertising allowed. 4. Rule 505 securities are "restricted" and may not be freely resold or transferred. 27 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Rule 506 of Regulation D • Safe Harbor – Preempts State Regulation (other than notice and fee) • Requirements – Issuer’s reasonable belief that there are no more than 35 purchasers, excluding “accredited investors” and foreign investors – Issuer’s reasonable belief in the sophistication of each of the non-accredited purchasers – No general advertising or solicitation Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. 28 Securities Laws Antifraud Provisions 1. Even if securities are not required to be registered with the SEC, the issuer must comply with federal and state antifraud provisions. 2. Failure to comply with the provisions of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as well as the lesser known Section 12(2) of the Securities Act can result in civil liabilities (i.e., money damages). 3. Liability for violating the antifraud provisions can be personal as to corporate officers, directors, principal shareholders, promoters, and others associated with the offering. 4. The antifraud provisions collectively prohibit any person in connection with the purchase or sale of any security from misrepresenting or omitting a material fact or engaging in any act or practice that constitutes a "fraud" or deceit upon any other person. 5. Fraud, for securities law purposes, includes omissions in disclosure (sometimes even unintentional ones), rather than just deliberate misrepresentations, and therefore, regardless of whether a person intends to defraud an investor, the person will nevertheless be liable if he or she fails to disclose a material fact. 29 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Private Placement Memorandum 1. Prepare private placement memorandum (PPM) to satisfy the disclosure requirements and to comply with antifraud provisions. 2. Used as marketing tool to sell securities 3. Protects issuer and principals from liability if investment is unsuccessful 30 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Form D • Should be filed with SEC within 15 days after first “sale” of securities • Failure to timely file Form D does not affect the availability of the exemption 31 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Management Controls • Establish internal procedures and checklists that make it easier to remain in compliance with the rules concerning the conduct of the offering and the information sent to and received from prospective investors. • Control of the PPM. • Each copy of PPM should be numbered and given only to specifically designated persons • Copies of the PPM for internal use also should be numbered, and a list of each person to whom a copy of the PPM has been sent should be maintained, 32 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Investor Remedies Nature of the Remedies 1. Penalty for violating the registration or antifraud provisions, at a minimum, that the investors can rescind their purchase and receive a refund of their investment. State and federal regulatory agencies have enforcement rights and, under certain circumstances, may fine the issuer and its principals and enforce criminal penalties. Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. 2. 33 Securities Laws Investor Remedies Rescission 1. The first rule of securities law is that investors never sue when they make money, only when they lose it. 2. Rescission never sounds threatening to clients because all clients believe their deal will succeed. Without that belief, you would not pursue the offering. Nevertheless, it is when things go wrong, frequently for reasons the issuer failed to predict or could not control, that regulators or disappointed investors may seek remedies. 3. The right to rescind based on a technical failure to comply with the securities laws may be unrelated to the real reason why an investor wants his or her money back. 4. If remedies are sought, it usually will be when the issuer and its principals can least afford to fulfill the demands. 34 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Best approach to sell securities only to “accredited investors” • SEC Rule 501 of Regulation D defines an “accredited investor” as: – a director, executive officer or general partner of the issuer or any general partner of the issuer; or – a person with a net worth, together with his or her spouse, of more than $1 million, or – a person who has had income in excess of $200,000 in each of the two most recent years or joint income with his or her spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year. 35 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Securities Laws Regulation D – Offerings involving > $1 million of securities, require company to provide specific written information to unaccredited investors – Makes the sale of securities to unaccredited investors more complicated and increases the risk of making a technical mistake in the offering – If an error is revealed, the SEC will carefully review all prior issuances of stock and demand immediate action to cure discrepancies 36 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Employees • Hiring employees of competitors without caution and proper diligence (“noncompetes”) • Incautiously hiring former employees of a competitor with access to confidential information or trade secrets (may be buying a lawsuit) 37 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Employees • Enforceable restrictive covenants from employees are generally limited: – In scope of activity – In duration – In territory (geographic area) • Balancing the legitimate business interests of the employer with the public policy interests of the community 38 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Employees Before making hiring decisions: • Investigate whether that person is subject to a restrictive covenant in favor of a former employer – Covenants of noncompetition (nonsolicitation of customers) – Covenants of nondisclosure • Doctrine of inevitable disclosure – Duties of new position would inevitably lead to disclosure of the former employer’s protected information Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. 39 Trade Secrets Protection Common Mistake: Failing to institute a trade secret protection program 40 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Trade Secrets Protection • A trade secret is basically any information that's unique and valuable to your business but isn't known to people outside of your business. • Trade secrets can be protected under state and federal law. 41 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Trade Secrets Protection In order to classify and protect a trade secret, there are five key factors that should be present (rules to follow): 1. trade secrets must really be secrets 2. use a warning label (to give notice of the proprietary nature) 3. restrict physical or electronic access to your trade secret information 4. Continue to require that everyone sign confidentiality agreements 5. Follow all the rules outlined above 42 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Trade Secrets Protection Most policies will include at least some of the following provisions: – confidential information should be made available to employees only on a need-to-know basis; – written confidentiality agreements should be obtained from all employees and consultants; – papers containing confidential information should be locked in safes or desks at night and all programs containing confidential information should be password protected; and – departing employees should have exit interviews in which their continuing obligation to protect the company's confidential information is explained and the return of all documents and programs owned by the company is required. 43 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Intellectual Property Common Mistake: Failing to obtain “good title” to intellectual property (including, licensing technology owned by others) 44 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Intellectual Property • • • • • Title to intellectual property rights Patent rights Copyrights Licensing Who owns it and how do you know 45 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Intellectual Property Patents • Generally, patent rights to an invention belong to the inventor/employee and not to the employer • The right may be assigned by the employee in writing and supported by consideration • An employer may have shop rights, if the invention was made using employer’s tools and materials 46 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Intellectual Property Copyrights • Title to work initially belongs to its author, not to the employer (works for hire) • Distinguish employee from independent contractor – who controls the time and place of work – who owns the tools used to perform work – who controls the creative process 47 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Trademark Protection • Failure to conduct a timely trademark search • Failure to complete trademark search before selecting a domain name • Failure to conduct proper searches and protect marks before making an investment in the mark (advertising, etc.) 48 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Trademark Protection Trademarks • Any word, name, symbol, design or any combination used to distinguish the goods of a company • Ownership of a trademark precludes other companies from using names/marks that are confusingly similar • Registering trademark will give additional rights to the owner 49 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Trademark Protection • Trademarks are protected by: – federal law – state law – common law 50 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Trademark Protection A company could be sued/liable for infringing the trademark of another if – it uses a domain name or meta-tag that is similar to an existing trademark and – the domain name or meta-tag identifies a Web site that either sells goods that may be confused with those of the trademark owner or interferes with the trademark owner’s business. 51 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Technology Common Mistake: Failing to properly license technology patented by others 52 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Technology Proper licensing of patent rights – – – – Exclusive Non-exclusive Right to sublicense the patent rights or not All patent rights that a company needs to operate its business should be owned or properly licensed 53 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Website Conduct • Common Mistake: Failing to properly review and monitor the company website for compliance issues 54 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Website Conduct Legal concerns that arise from the use of company related website fall into several categories: – – – – – 55 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide. Contract Securities Intellectual Property Advertising / False claims Privacy More Information Preston C. Delashmit Epstein, Becker & Green, P.C 945 East Paces Ferry Road, NE Atlanta, Georgia 30326 Phone: (404) 869-5325 Fax: (404) 869-5425 Email: pdelashmit@ebglaw.com 56 Copyright 2005, Epstein Becker & Green, P.C. All Rights Reserved Worldwide.