J. Matthew LyonsAndrews Kurth LLP

512.320.9284mlyons@akllp.com

April 20, 2016

Top Ten Legal MistakesMade By Entrepreneurs

Presented to

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“Understand the ways in which the law is a constraint, but also the ways in which it is a tool to help you create and capture value.”

--Constance Bagley, Harvard Business School

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• Establishes vehicle with limited liability• Specifies relationship among founders, including share

ownership• Creates “vehicle” to hold IP, business plan / ideas• Provides impetus to organize• CONVERSE: Incorporating too soon OR forming the

wrong entity (or entities) for the venture in the wrong state for the venture

1. Failure to Incorporate Soon Enough

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• Limitation of liability for owners: Limited liability vs. unlimited liability

• Tax treatment of entity and owners• Pass-through of profits and losses to owners• Impact on exit strategies and liquidity options• Formality and centralization of management structure and

decision-making• Choice of formation jurisdiction: Delaware vs. state of

residence• Choice will depend on expected investment source and

exit strategy

Selecting the Right Entity and Jurisdiction

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Selecting the Right Entity and Jurisdiction

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• Institutional investors prefer C corporations– Investor familiarity with centralized management structure and formalities– Many venture and private equity funds are precluded from investing in

“pass through” entities for tax reasons– Full range of exit strategies or liquidity options (e.g. stock for stock) not

readily available to other entities types– Lower organizational and ongoing administrative costs– Little if any advantage to forming as LLC or S corporation to harvest tax

“losses”; usually just move expense and jeopardize IRC 1202 treatment.• Institutional investors prefer Delaware

– Well-formed body of corporate law, including long-established principles in case law and ease of filing

– Increased flexibility under Delaware law with respect to Board composition and corporate administration

– National understanding of Delaware law among practitioners– Beware LLCs and Texas and California Corporations

Selecting the Right Entity and Jurisdiction

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• Vesting protects those who take venture forward• Difficult to compensate for prior service (because

investors only care about future value creation)• Regardless of the reason for the departure, someone

must be compensated to replace the departed founder

2. Failure to Subject Founders Shares to Vesting

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• Founder’s Stock• Vesting – General Structure

– Four years on a monthly, quarterly or annual basis; one-year cliff

– Can be shortened in certain instances– Buy back at cost upon termination of employment,

death or marital dissolution prior to the end of the vesting period

– 83(b) Election– Acceleration Issues: Termination & Change of Control

• Right of first refusal for sale to third parties• The role of employment agreements

Structuring Company Ownership: Founder’s Stock

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• Blowing the 83(b) election• Founders “cheap stock” when sold below “fair market

value”– e.g., price sold to investors

• IRC §409A: Issuing “discounted” options– Result: Employee suffers additional 20% income tax,

at the time of vesting• Company matching and withholding obligations and

potential for lawsuits• Blowing IRC 1202 (qualified small business stock) status• Not much sense in trying to “optimize” taxes in a startup

beyond an 83b election or with stock gratuity efficiency

3. Creating Tax Issues with Equity

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• Inadequate Capitalization Hygiene– Too many “promises”; too little documentation

• Promising a %, especially when non-dilutable• Convertible note should not convert into a %

interest, but rather a number of shares based on share price formula

– Failure to approve at Board / shareholder level– “Handshake” deals

• Inadequate Recordkeeping– Failing to maintain adequate organizational records– Failing to track agreements (e.g. NDAs)

• CONVERSE: Too many agreements

4. Failure to Maintain Proper Documentation; Capitalization Errors

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Structuring the Company: Capitalization Plan

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• Patents– ‘First to file’ rule harmonizes U.S. patent system with rest of the world;

now more complex interplay between the dates of filing and of any pre-filing disclosures of the invention.

– Old U.S. rule: Filing required one year from “public disclosure” or sale– International (PCT) filings– Freedom to operate

• Trademarks– Failure to protect valuable brand– Overinvesting in unprotected/unprotectable brand

• URLs, Facebook, Twitter, etc. accounts• “Bootstrapping” with consulting services without adequate ownership of

services/product delivered• Copyrights: Must register CR before pursuing legal remedies against infringer.

In the case of web software (e.g. iphone app), often costs less than $1,000.– Copyrights require to file source or other code, so be cautious

5. Failure to Adequately Protect IP

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• Non-competes, non-solicitation• Trade secrets, inevitable disclosure• Using inadequate or outdated forms• Software code, open source• Prior employer documents in possession• No short cuts!

6. Hiring Employees Without Regard to Prior Employee Obligations

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• Consider obligations to prior employer– Non-disclosure, non-compete, non-solicitation– Even without an agreement, common law trade secret obligations

exist– Did you or another develop idea while employed?– Any employer files, documents, computers, smartphone, storage

media, etc. spell trouble• Beware of the Inevitable Disclosure doctrine

– Under the “Inevitable Disclosure” Doctrine, a former employee of one company may be prohibited from working for a competitor of the previous employer based on the theory that the employee could not perform duties of the new position with the competitor without relying on trade secrets obtained from the previous employer

– Application of the Doctrine does not require the former employee to have executed a non-compete agreement

IP Issues and Hiring Employees

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• Employees– Documented offer letters– IP assignments, non-competes, non-solicits

• Contractors– Misclassification when acting as employee– IP assignments; restrictions on competition– Failure to get a signed agreement (with IP assignment)

from everyone

7. Inadequate Agreements with Employees and Contractors

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• Obtain a signed proprietary information and invention assignment agreement before (or immediately upon) commencing employment

– Don’t ignore any carve-outs – have someone technical review them

– Get it as of “Day 1” – prior to disclosure of company confidential information

– Consider appropriate, enforceable non-compete/non-solicitation (note state by state enforceability)

– Beware of contractors who become employees – good time to clean-up IP ownership

• Obtain agreements (assignment and NDA) from each consultant and advisor

Employee and Contractor Agreements

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• Can lose patent/trade secret protection without NDA or other reasonable steps to protect

– Watch out for termination dates, residuals, concurrent development clauses

– Failure to police– Using inadequate or outdated forms

• Business plans and offering memorandums– At least include confidentiality statement– VCs will not sign – choose carefully before sending

8. Failure to Seek or Receive Adequate NDAs

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• Sales to non-accredited investors• Often overpriced

– Creates barriers to future rounds– Dilution and disappointment– “Dumb money”– Option pricing issues when common stock sold

• Inadequate resources to continue to invest and “protect” prior investment

• Administrative hassles– Expensive to administer and may deter VCs– Complex Structures for small dollars

• Crowdfunding

9. Angel/Friends & Family Financings

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• Seeking institutional capital too early• Soliciting the wrong type of investor for the venture• Choosing the “wrong” VC• Selecting a “strategic” in the first round• Must do your diligence on the investors• Take too much money or too little money with regard to

next value inflection point

10. Institutional Fundraising Errors

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• Expertise, experience, personality must be a match• Relationships; understands terms, market, process• Make the complex simple

– Avoid doing too much, too early– Focus on right things, avoid subtle traps

• Pay me (a lot less) now, or (a lot more) later... IF it can be fixed

• Not being involved in the legal process• Not using AK Fixed Fee Startup Package

Bonus: Choosing Wrong Attorney for Venture (or not using one)

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Incorporation, Organization and Qualification • Reservation of corporate name• Preparation and filing of Delaware Certificate

of Incorporation • Preparation of Bylaws and Certificate of

Secretary • Preparation of Action by Incorporator• Preparation of Organizational Board Consent

regarding various organization and corporate governance matters

• Preparation and filing of Form SS-4 Application for Employer Identification Number

• Preparation and filing of qualification to do business as foreign corporation

• Preparation and organization of corporate records and minute book

• Preparation of Stockholder Consent• Preparation of form Indemnification

Agreements for directors & officers

Andrews Kurth Startup Organization Package - akstartup.com

Capitalization Matters• Preparation of Founder’s Restricted

Stock Purchase Agreement for up to four Founders

• Preparation of Stock Certificates for up to four Founders

• Preparation of Memorandum re 83(b) Elections for Founders

• Preparation and filing of state securities filings for stock issuances to Founders

• Preparation of Stock Option/Stock Issuance Plan

• Preparation of forms of Early and Standard Exercise Stock Option Agreement

• Preparation of form of Stock Issuance Agreement

• Preparation/filing of Form U-2 Uniform Consent to Service of Process

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Employment and Consulting Matters• Preparation of form of At-Will Employment Offer Letter• Preparation of form of Proprietary Information and Inventions

Agreement• Preparation of Form of Independent Contractor Services

Agreement

Intellectual Property Matters• Preparation of form of Unilateral Nondisclosure Agreement• Preparation of form of Mutual Nondisclosure Agreement• Preparation of Assignment of Intellectual Property from

Founders to the company

Andrews Kurth Startup Organization Package - akstartup.com

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• We think like entrepreneurs• Leading law firm for entrepreneurs, public and

private emerging growth companies and venture capital and private equity firms

• Dedicated team of attorneys providing focused representation to public and private emerging growth companies and entrepreneurs as well as the venture capital and private equity firms who finance them

• Practical, business-like approach to advising our client

• Share entrepreneurial spirit and drive with our clients

• Client service teams combine relevant experience with an understanding of a client’s business and markets to provide efficient legal services and solutions with an outstanding degree of responsiveness

Technology and Emerging Companies Practice

Industry Breadth• Clean Technology• Computers and Networking• Consumer Products• Defense Technology• eCommerce• Education Technology• Energy Technology• Internet and Social Media• Life Sciences and

Biotechnology• Marketing and Email Service• Marketplace• Medical Device• Nanotechnology• Renewable Energy• Semiconductor• Software• Software-as-a-Service• Telecommunication• Transportation• Wireless Communication

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Technology and Emerging Companies Practice

Scope of Practice• Nationally recognized as one of

the leading securities and transactional law firms to public and private domestic and international companies

• Top-ranked national Corporate/Securities and M&Apractices

• A leading firm servicing emerging growth and energy technology companies throughout the United States

• Representation of leading companies in the technology industry

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From technology-driven organizations to startup accelerators, Andrews Kurth values the importance of a community network and utilizes our partnerships to better serve our clients with an abundance of resources

Andrews Kurth Involvement

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Matt represents public and private companies, venture and private equity funds, emerging growth companies, and entrepreneurs in public and private offerings, mergers, acquisitions and divestitures, and issues related to business formation, operation, executive compensation and corporate governance.

He received his J.D. in 1993, with honors, from The University of Texas School of Law and his B.A., with high honors, from The University of Texas in 1990.

Matt’s complete biography may be found at the following link: http://www.andrewskurth.com/assets/pdf/bio_JMatthewLyons.pdf

Team Lead: Matt LyonsPartner111 Congress Avenue, Suite 1700Austin, Texas 78701mlyons@andrewskurth.com512.320.9284

Profiled as one of the leading Technology lawyers in Texas, Chambers USA:

America's Leading Business Lawyers

(2006-2015)

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Thank You!Open Discussion / Q&A

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