BizSpark Phoenix – Legal Issues for Startups

On May 13, 2009 Garland Brown, an attorney with Greenberg, Traurig, LLP presented a well-rounded overview of some of the core legal issues facing startups. I have included his presentation in this post but I also wanted to share my personal notes on some of his key points for technology startups.

Before doing that, let me also mention that Garland has a unique background that should make anyone interested in this area eager to reach out to him for advice.  He started out as a software developer working for a certain large software company headquartered in Redmond, Washington. At one time he lead the team responsible for the Encarta web-based encyclopedia series.  He also has worked as an independent software developer toiling away on his own to bring ideas to life as salable products.  Somewhere along the line he entered the legal arena and spent considerable time trying to work out aspects of Microsoft’s relationship with the European Union (talk about global perspective)!  He is now focused almost exclusively on startups and early-stage technology companies.

Locally, Garland is a big fan of the Microsoft BizSpark initiative and has personally devoted many hours to assisting startups engaged in the program. He is also an angel investor and a member of ATIF (Arizona Technology Investor Forum).

Presentation Notes:

Organizing Concepts

An obvious but overlooked fact is that you don’t have to do ANYTHING to organize a startup. Many jump to the conclusion that they MUST be at least an LLC, LLP, C Corp, S Corp or whatever before even settling on what their product or service is. The entity you choose is important and has tax and liability considerations but the reality is that if you never develop that great idea in the first place, the organization of the company is moot.

If you do choose to organize right away, many software entrepreneurs choose LLC (limited Liability Company) as the entity of choice. Garland points out that choosing a Delaware based LLC is a good idea in that there is a large body of (pro-business) law around Delaware-based LLC’s.

More important, in Garland’s opinion, is to engage an Advisory Board of at least 3 members. This group will serve as your sounding board and sanity check.  Composition can vary but should consist of at least one person with business expertise (especially in the domain you are trying to reach), a financial person and a technologist familiar with your industry. They don’t have to be local but it should be an odd number to aid in making decisions.

Funding Issues

Debt vs. Equity is a critical area for startups and Garland had some strong opinions here. In the debt arena this was the first time I heard of the Three F’s as sources – Friends, Family & Fools!  (ouch!) The reality is that you need to get to a revenue stream or large user base as soon as possible. Angels and early stage investors are reluctant to engage with just an idea that has no one else validating it.

If you are funded by an angel, expect three things – A schedule, regular meetings and results. Think 10-15X results!

Equity is a particularly challenging area in that it’s so difficult to assign percentages where there is no solid valuation (which will change over time anyway). Garland’s view is that the VC sets the valuation no matter what you might think. And yes, each VC has a different set of variables and methods to assess valuation for equity distribution.  An additional note of concern is high initial valuations.

If you have an excellent advisory board expect to reward them with an equity stake. Be careful with employees. Giving away too many equity positions can dilute the company too quickly.  Think hard about how critical or essential someone is to the operation before conferring equity positions. An emerging rule of thumb is reserve 15% of the equity for employee stock options and/or grants.

In the middle of the road between debt and equity is Convertible Debt Financing. This is usually a note that accrues interest but can be converted to equity. No payments are made until conversion.

Intellectual Property

Garland zeroed in on the patent issue as similar to the obsession with getting the organization structure in place before getting real work done. Patents have their place but are too often seen as the anchor for funding an idea.  The reality is that a patent can expose your technology to a broad set of competitors that can infringe almost immediately and potentially outlast you legally and financially. This is an area for deep consultation with competent legal counsel.

A Trade Secret on the other hand is very helpful in that it lasts indefinitely. Just remember to keep it secret and avoid divulging even components of the idea.

Copyright is unique in that as soon as the work is created it IS copyrighted. Software code is intrinsically copyrighted by the fact you uniquely create it. A Registered Copyright is one where you send the material to the the copyright office for registering.  You can request that the the office not expose the source material.

For background reading Garland recommends Competing in Internet Time.