Ten Questions with Fred Greguras of Fenwick and West

Fred Greguras is a partner at the Silicon Valley law firm of Fenwick and West. He is also a buddy of mine, and I asked him to answer the most common questions of newbie entrepreneurs. His clients have included BioMarker Pharmaceuticals, Excite, Kintana, and Speedera Networks. It’s very important to make the right decisions in these areas at the start of a company, so I hope you’ll heed his answers.

1. Question: Can I start a technology company in the same business as my current employer?

   Answer: Working completely outside of an employer’s premises and not using an employer’s trade secrets or other resources may not be enough to avoid a taint on your technology and intellectual property (“IP”) for the new business. Investors will examine the creation of IP very carefully in such a situation as they don’t want to buy into a law suit. While California law favors employee mobility it also protects employers in Labor Code Section 2870 which is part of most employee invention assignment and confidentiality agreements you sign before you begin employment with a company.

   Basically, 2870 states that an employee owns an invention that he/she developed entirely on his or her own time without using the employer’s equipment, supplies, facilities, or trade secret information except for those inventions that either relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or result from any work performed by the employee for the employer.

   The taint to the new business can come from the founder who is trying to continue work with his/her current employer while trying to create technology and IP for a new business or from a consultant who is “moonlighting” from a business in the same space. Some business sectors such as EDA software are notorious for litigation against departed employees who try to start a new business in the same space.

2. Question: When should I incorporate?

   Answer: The first step in starting a business is to test the business concept with prospective customers and to look carefully at potential market size to see if there really is a business opportunity. Timing of incorporation will be driven by the need to document the founders’ ownership of the business, to secure ownership of pre-existing intellectual property, to enter into contracts with customers, to grant stock options and to accept investment. You usually don’t want to delay incorporating until just before a Series A financing round because such timing could cause tax problems for founders who want to buy their shares at a nominal price as compared to the valuation of the corporation at the time of the financing.

3. Question: Why don’t I use a Limited Liability Company (“LLC”) since it is cheaper to start?

   Answer: An LLC is often used for consulting and smaller businesses, but not often for an operating business that will seek venture capital. You can decide whether to be taxed as a corporation or partnership when your business organization is an LLC. Losses and gains of the business flow through to the shareholders individual 1040 tax return when taxed as a partnership. Venture capitalists won’t invest in an LLC, you can’t grant stock options to employees and other service providers in an LLC, and an LLC can’t be acquired tax-free in a stock acquisition exit.

4. Question: Why does everyone incorporate in Delaware?

   Answer: I still see some entrepreneurs use California corporations because they want to keep their costs as low as possible. Delaware incorporation advantages are venture capitalist preference, ease of dealing with regulatory authorities, flexibility in the law (such as the number of board members) and more helpful precedent on corporate law. Disadvantages are the corporation being taxed by and subject to two states regulatory requirements.

   You can’t avoid California taxes if the corporation is operating in California. California advantages are lower cost and being subject to only one state’s regulatory requirements, if the corporation is operating here. One major disadvantage of using California is the difficulty of dealing with regulatory authorities on corporate filings in a financing or other situation when articles of incorporation need to be amended. If a business has been incorporated in California, the VCs will often want it to be reincorporated in Delaware as part of a round of financing.

5. Question: Should we incorporate as an S corp or C corp?

   Answer: “S corp” and “C corp” are tax statuses rather than a type of corporation you would form in California or Delaware. An S corporation is taxed like a partnership. Gains and losses flow through to the shareholders so it can provide tax advantages if, for example, there is a long product development period with significant expenses that would flow through to individual tax returns.

   There are restrictions on the number (100) and types of shareholders in an S corp. Shareholders must be U.S. citizens or residents and natural persons not entities. Also, while you can make a decision at the end of a calendar year to switch to a C corp, you can’t decide to turn S corp status off when ever you want to do so. A preferred stock financing will terminate S corp status because an S corp may not have more than one class of shares outstanding.

6. Question: Should I incorporate offshore since my business will focus on China/India?

   Answer: This decision is driven by the likely exit strategy and the type of investors most interested in your business. Exit alternatives such as an IPO on the Indian or Hong Kong stock exchanges are not possible if you are a U.S. corporation. Some global investors will invest only in an offshore corporation such as a Cayman Islands exempted company while some domestic U.S. venture capitalists will still only invest in a U.S. corporation.

   You can reincorporate from one state to another, i.e., California to Delaware, on a tax-free basis but you can’t reincorporate outside the U.S. without tax consequences. Reincorporation offshore almost always will cause the corporation to remain subject to U.S. taxes under Internal Revenue Code Section 7874. If you initially incorporate offshore you can reincorporate into the U.S. on a tax free basis so if in doubt, start offshore at the outset.

7. Question: Can I have everyone in my startup be contractors or consultants (“1099 services”) rather than employees?

   Answer: Many startups label and engage service providers as consultants rather than employees prior to a round of financing to try to avoid employer obligations such as income tax withholding and unemployment taxes. This status depends on facts, however, not a label in an agreement. The basic test is the degree of control over the individual.

   If he/she is tightly supervised and on the company’s premises during regular working hours, the individual is really an employee. It is very hard for a startup to properly structure a contractor relationship in a startup because of the way the company must operate. For example, many times the company provides a “contractor” with business cards identifying them in an employee position such as “VP, Sales” which is not the right thing to do legally but is what the company believes it needs to do to be successful.

8. Question: How can I grant stock options to employees and consultants?

   Answer: Your start-up should adopt a stock option plan at the time of incorporation that satisfies federal and state tax and securities laws requirements. In California, the plan is often referred to as a “25102(0) plan” based on the California Corporations Code provision. Adopting such a plan will enable the corporation to grant tax favorable options (“incentive stock options”) and avoid securities law violations because the plan will have a securities law exemption under state and federal law. If the plan is not created in accordance with securities laws, granting an option to an employee or other service provider requires the individual to qualify for the same type of securities law exemption as for an investor (“accredited investor”).

9. Question: How does the corporation obtain ownership of the technology and IP from each of the founders which was developed before we incorporated?

   Answer: Founders will usually assign ownership of technology and IP as payment for their shares of common stock of the corporation. This is documented in their founders stock purchase agreement. Investors will almost always want technology and IP to be a transfer of ownership rather than a license in which the founders “hedge” on their commitment to the new business. Ownership provides more value to the business than a mere license. Ownership of technology and IP created after the corporation is established occurs through invention assignment agreement or consulting agreements.

10. Question: Can I hire people away from my former employer?

    Answer: Your employee invention assignment agreement with your former employer will likely have a restriction on soliciting employees, usually for a period of 12 months. The restriction usually doesn’t cover non-solicited hiring of your former employer’s employees but proving who solicited whom may be difficult. Even if the non-solicitation period has expired, you still need to be careful to make sure the new hire does not use trade secrets of your former employer while working for you.

11. Question: Can I file a provisional patent application myself?

    Answer: You can but you need to be very careful to describe the invention and the best mode of practice as required by patent law. A patent attorney may be needed to help draft “claims language” because of increasing litigation over whether a provisional application covered these elements. The provisional patent application must contain a written description of the invention, and “of the manner and process of making and using it, in such full, clear, concise, and exact terms as to enable any person skilled in the art to which it pertains, or which it is most nearly connected, to make and use the same.”

12. Question: If we have been issued a patent, won’t that stop a Microsoft from copying us?

    Answer: You cannot enforce a patent until and if it is issued and the costs to enforce a patent can be staggering – literally millions of dollars. Whether someone is infringing your patent usually isn’t a 1 or 0 case. The other party may claim it is not infringing your patent or that your patent is invalid, for example, because it is based on a defective provisional application. There may be good arguments on both sides that require a court to make a decision after a lengthy and expensive trial.

13. Question: Shouldn’t prospective investors sign non-disclosure agreements (NDAs) so that they don’t rip off our ideas?

    Answer: Venture capitalists won’t sign NDAs before hearing your pitch because they see so many companies that may be in the same business segment and overlap in what they are doing. NDAs with investors patent counsel are usually feasible later during IP due diligence for a financing when, for example, investors counsel needs to review an unpublished patent application. I recommend “peeling the onion” in making disclosures to investors and others whenever feasible. This means disclosing only as much as you need to for the purpose of the meeting. This isn’t helpful in many businesses such as Internet where what you are doing may be obvious.

14. Question: If my buddies and I own more than 50% of the corporation, don’t we control it?

    Answer: You may if it is prior to a VC financing and you also control the Board of Directors of the corporation. Both the board of directors and shareholders have a right to approve key decisions of the corporation. Board decisions are made on the basis of one person, one vote rather than on a percentage of ownership so you need to be careful with the size and composition of the board. The preferred stock holders in a VC financing will have what are called protective provisions which give them “veto rights” over key decisions like a new round of financing or selling the corporation without regard for their percentage of ownership of the corporation.

15. Question: Why should founders vest—we’ve already been working on the business for two years?

    Answer: Vesting among founders avoids the “free rider” problem, where a founder gets shares and then leaves the corporation and the other founders continue to make contributions. I recommend vesting schedules whenever there is more than one founder to try to make sure all founders continue to contribute. While the investors may renegotiate vesting schedules for founders at the time of a financing, providing some upfront vesting is appropriate when founders have been working on the business for a while. The balance is between maintaining the “stickiness” of the founder and recognizing prior contributions. I usually tell founders to err on the side of more stickiness.

16. Question: Why does it cost $50,000 or more to do a round of financing?

    Answer: The corporation receiving investment pays the legal fees of both its legal counsel and the investors counsel. The total tends to be higher than $50,000 in most Series A financings because of the number and complexity of the financing documents and the rate structures of the large law firms that tend to represent both sides in these deals.

    You can manage these costs to a certain extent by having a clear and complete financing term sheet that covers all key points. The business people on each side should address the “tough” issues (such as founders vesting and option pool size) at the term sheet stage and make decisions on such issues rather than have lawyers argue over business issues which increases legal fees. A vague term sheet may avoid confrontation for the moment but it is likely to cause larger legal fees.