Counseling Start-Up High Technology Companies

This article summarizes the presentation given by Randi Friedman, Esq. and the author at the First Annual Business Law Symposium on October 13, 2000. Given the time limitations in the seminar and the space limitations here, this is an extremely cursory overview of a topic that encompasses a large number of legal issues. We broke down the discussion into five parts: (i) a general overview, (ii) protection of intellectual property, (iii) creation of websites, (iv) employment relationships and compensation issues, and (v) venture capital financing. This article follows the same outline. We were joined by Alan Goldman, an investment banker, who shared some insightful comments on how investors review and evaluate these companies.

We began with a discussion of the so-called new economy and how it differs, if at all, from the old economy. My personal view is that, at least from a legal perspective, the changes are not as dramatic as some have suggested. For example, protection of intellectual property and trade secrets, non-competition agreements, licensing agreements, stock options and venture capital are not things that were created to deal with the internet, and they have a long history of presenting day-to-day issues for the business lawyer. Nevertheless, there are some differences. There is certainly an increased awareness and emphasis on these matters on the part of high-tech clients, who tend to be more sophisticated about these topics compared to budding entrepreneurs of just a decade or so ago. They certainly expect quicker responses and turnaround than old economy types might have, and they tend to need these matters dealt with at an earlier stage in their development than their predecessors. Of course, there are some issues that are new, such as website development and domain name protection. Nevertheless, established principles of contract law, employment law and the like continue to apply.

As in any new business, the choice of entity and the jurisdiction of formation are issues to be addressed at the outset. While limited liability companies offer a variety of advantages, the corporation is still the vehicle of choice for venture capital investors, so it is still commonly used by start-ups that expect to raise capital in that manner. Furthermore, the corporate form is virtually a requirement for companies to have an initial public offering. While an LLC can be converted to a corporation via a merger relatively easily, many start-ups choose to incorporate at the outset.

A related question is the state in which to form the entity. For a New Jersey based business, this typically means a choice between New Jersey and Delaware. There are differences between the two states’ laws, but not nearly as many as one might think when listening to certain Delaware proponents. Nevertheless, because of a decided preference for Delaware on the part of venture capital investors and their lawyers, and to a lesser extent by IPO underwriters and their advisors, the choice is often made to incorporate in Delaware. If that is done for a New Jersey based business, counsel should remember to qualify the new entity to do business as a foreign corporation in this state.

There are a number of provisions that can be included in a certificate of incorporation that will achieve certain desired results for a new corporation relating to management, restrictions on capital stock and similar matters. Two items in particular deserve attention for start-ups that contemplate venture capital or other third party financing.

The first is a provision to limit the personal liability of a corporation’s directors and officers for monetary damages for breach of any duty owed to the corporation or its shareholders, except for breaches of the duty of loyalty, not in good faith or involving a knowing violation of law, or resulting in an improper personal benefit. See N.J. Stat.Ann.§14A:2-7(3)(West). Delaware has a similar provision. Del. Code Tit. 8, §102(7).

The other provision is to authorize so-called "blank check" preferred stock. Generally, the authorization of a new class of capital stock requires an amendment to the certificate of incorporation. Because venture capital investments are often made in several stages of preferred stock, each having separate terms, it can be difficult to obtain shareholder approval each time. Thus, corporate statutes allow the certificate of incorporation to authorize a number of shares of preferred stock, to be issued in one or more series and having the rights, preferences and privileges designated by the Board of Directors for each particular series. Thus, only Board approval is needed to authorize and issue a new class or series of preferred stock, provided there is a sufficient pool of blank check preferred stock. See N.J. Stat.Ann. §14A:7-2 (West) and Del. Code Tit.8, §102(a)(4).

This is a topic of crucial importance to technology companies, the principal assets of which are often their technology and their key personnel. Counsel must first become aware of the distinctions among the various types if intellectual property protection: copyright, patent, trademark and servicemark registrations. The distinctions, as well as the steps to handle these matters, are beyond the scope of this article, but it is important that the company receive competent legal advice from an experienced professional on these matters.

The nature of many high-tech company’s business by definition involves the licensing of technology, whether as a licensor, licensee or both. When the company acts as a licensor, among the many other issues it must address are protecting its technology and its dissemination and use. Care should be taken in licensing agreements to require the licensee to limit the access to the technology or secrets to those who need such access to perform their functions. This is especially true for non-patented material. Non-competition, non-disclosure and non-solicitation agreements with a company’s employees are discussed below under Employment Agreements and Compensation.

This subject is not limited to high technology start-up companies. Many companies, as well as non-business organizations, have developed websites and continue to update and improve them. We first discussed contracting with website developers and pointed out that general contract law and the principles of contract negotiation apply here as they would, for example, to a contract to construct a building, manufacture a machine or write a software billing program. Thus, the contract must deal with the identity of the parties, the scope of the work to be performed, the time frame in which to perform, customer acceptance or approval of the website, customer input into its development, the rate of compensation and the schedule of payments and the remedies for defaults or breaches.

One issue that should be addressed separately in website development agreements is the issue of ownership of the finished product and its components. Under the work for hire doctrine in copyright law, the ownership and right to copyright the webpage belongs to the customer, or party that retained the developer, absent anything to the contrary in the agreement. A developer may agree to this in general, but needs to be careful not to give the page-owner exclusive rights to ideas that the developer used in the past or may wish to use in the future. There are a number of gray areas here and the drafter of a website development agreement, representing either side, needs to be sensitive to them.

Another issue of concern is domain name ownership. A domain name is one’s internet address. In 1999, the Lanham Act, the federal trademark statute, was amended by the Anticybersquatting Consumer Protection Act. This Act lowers the threshold for establishing infringement of a trademark or servicemark in the use of a domain name. The Act creates liability on the part of a domain name holder who has a bad faith intent to profit from a registered trademark or servicemark and registers, traffics in or uses a domain name that is either (i) identical or confusingly similar to a distinctive mark or (ii) identical, confusingly similar to or dilutive of a famous mark. The owner of the registered mark must only prove similarities between the registered mark and the domain name, not the consumer confusion that a trademark owner must demonstrate under traditional trademark infringement analysis.

Owners of web pages should be concerned about liability arising from the operation of a website, particularly those that create links to other sites. Thus, it is wise to include disclaimers on the webpage to attempt to limit liability for places to which the web page might send a user. Similarly, if the page owner is selling products via the webpage, whatever terms and conditions of sale it would put on a standard sales order (e.g., limitation of a warranty of merchantability), should be posted on the website. Similarly, the page owner should at least attempt to establish jurisdiction for any disputes arising from a web-based transaction (i.e., "Any disputes relating to the sale of products through this website will be governed by the laws of the State of New Jersey and be resolved solely by the state and federal courts sitting in New Jersey.") The enforceability of such provisions is questionable in many jurisdictions given the global reach of the internet.

A well drawn employment agreement can protect the rights of both the employer and the employee, or at least create a clear set of rules that govern the employment relationship. A primary issue is the terms of employment and the employer’s ability to terminate the relationship, either with cause or without cause. The definition of cause is frequently a topic of significant debate. Of course, salaries, bonuses, and perquisites should be spelled out in the agreement.

Other than perhaps establishing an employment-at-will relationship in writing, the key benefit to an employer from an employment agreement is the type of restrictions that can be imposed on the employee as a condition of employment. These include (i) covenants not to compete both during and for a period of time after employment, (ii) non-disclosure of trade secret and other confidential information agreements, and (iii) non-solicitation of key employees and customers agreements.

An employment agreement should also require the employee to acknowledge that anything he or she invents or creates during employment, and for some period thereafter, is the property of the employer. The agreement should explicitly assign all right, title and interest in such inventions to the employer, and obligate the employee to assist in prosecuting any patent applications that the employer chooses to make with respect to those inventions. The obligation to assist should survive the term of employment, albeit for per diem compensation.

The foregoing topics apply as well to agreements with independent contractors. Companies that choose to retain individuals on this basis rather than as employees should be aware of the payroll tax withholding and other issues this raises.

Stock options are a key element of compensation in many cash-strapped start-up companies. An option is the right to purchase a number of shares of the employer’s stock at a certain price over a certain period of time. Generally, these rights vest in stages over a period of years after the options are granted, with vesting contingent on the employee’s continued employment. There are a number of securities and tax issues that need to be considered with respect to stock options but are beyond the scope of this article.

As with each of the prior topics, this subject could merit an entire book, and in fact many have been written about this. Typically, venture capital investments are made in the form of preferred stock that is convertible to common stock, at the holder’s option, at some fixed rate or based on some type of formula. As noted above, companies attempting to raise venture capital should have a charter provision authorizing blank check preferred stock so that the Board of Directors can establish the terms of several series of preferred stock to be issued from time to time. (In reality, the investor generally establishes the term and the Board approves them if it wants to obtain the investment.) The terms address issues such as voting rights, dividends, conversion rights and terms, liquidiation preferences, Board representation, put and call rights and anti-dilution protection.

The company needs to focus on the securities laws in these transactions, and counsel needs to be aware of the available exemptions from securities law registration, both under federal and state law. The principal exemptions relied upon under the Securities Act of 1933, as amended, are found in Regulation D, Rules 501-508, and under the New Jersey Uniform Securities Act are found in N.J. Stat. Ann. §§ 49:3-50(b)(9) and (12)(West).

Our seminar concluded with Alan Goldman’s presentation as to what investors look for, and among other things he stressed a well conceived business plan and a high quality management team.

In summary, the seminar highlighted the wide range of issues and legal disciplines that are impacted by the representation of start-up businesses, particularly in the high technology area. While it is probably not realistic for any one attorney to have expertise in each of these areas, he or she should at least be aware of the issues in order to properly advise clients and direct them to the appropriate specialists.