The Legal Side of Entrepreneurship

by John Vrionis, partner at Lightspeed Venture Partners

Lightspeed is in the business of encouraging entrepreneurship. This past summer, the Lightspeed Summer Fellowships program invited selected guests to provide aspiring entrepreneurs a perspective into all aspects of starting a new company. The program provides entrepreneurs the resources and mentoring they need to build their companies and develop their skills.

Craig Schmitz, a partner in the Technology Companies Group at law firm Godwin Proctor LLP who works on corporate, governance, board and fundraising issues, and Erika Fisher, an associate in the firm’s Business Law Department who deals with IP, fielded questions about the legal issues startups face. This article highlights their advice on issues ranging from financing to patent trolls:

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While startups may believe lawyers are too costly, working with one early on avoids potentially serious problems later. Law firms that focus on emerging technology companies understand their legal issues from multiple perspectives and offer excellent advice.

Financing.

Startups need to understand how to manage the seed money they receive from investors and VCs. Investors typically negotiate from a term sheet, which if not handled properly can create problems that can hurt or kill the startup’s chances when they do their Series A round of funding. Entrepreneurs need to hit a happy medium with backers, not giving away too much but not making overly aggressive demands.

They also need to decide whether to structure terms as an equity deal or a convertible security deal. “If you’re going to raise $1 million, my advice is to propose a convertible security, because you can get it done quickly and less expensively,” said Schmitz. “And if you have a valuation cap; a higher cap is always better than a lower cap.”

The Cost of Financing.

Startups bear the costs of their financing, from the first seed investment to the sale of Series A stock. In a Series A financing, companies must pay the investors’ lawyers as well as their own. Investors’ fees are capped, which influences what a startup will pay its own lawyers. Paying lawyers $50,000 when you are raising $500,000 doesn’t work. Lawyers should use standard forms, and investors should cap their lawyer fees at $7,500-10,000 for a seed round of this size. Even $15-20,000 is too expensive. These costs make it preferable to use a convertible security for a raise of this size and to structure as equity financing if you are raising closer to $2 million.

Convertible Securities.

Debt or convertible securities (e.g., a SAFE or KISS) provide a much simpler transaction with less terms to negotiate. The primary terms for these types of transactions are the valuation cap and the conversion discount. Debt also has a due date and interest rate to negotiate. Equity transactions are preferable from an economic certainty standpoint as they fix a price whereas convertible securities with a cap provide a ceiling on valuation but do not have a floor. “Investors won’t insist on complicated Series A terms if they are writing a check for $50,000, but if someone writes a $1 million dollar check and insists on an equity deal, I would take that deal and get the financing,” said Schmitz.

Incorporation.

Startups should incorporate as soon as they can; the expense is low. Lawyers can do it, but companies can do it themselves at websites such as Clerky or LegalZoom. Startups also must pay an inexpensive service fee for incorporating in Delaware. If high U.S. taxes are a company’s biggest worry, it might think about incorporating in the Cayman Islands or Ireland. However, the U.S. will collect taxes on sales in the U.S.

A major reason for incorporating is to have the founders assign their IP to the company; it is far easier for a business to contract with a startup when the IP is owned by one entity. In addition, investors will look to confirm the company they are investing in actually owns its technology assets. Incorporation also protects the founders from a liability standpoint.

Board and Stockholder Votes.

Two types of votes matter: board votes and stockholder votes. Things such as issuing equity and setting the compensation of officers are board-level votes. Even if one member of a three-person board holds half of the company, he can be outvoted by the other two. When it comes to issues such as electing board members, what matters is the number of shares the stockholder owns, not the number of stockholders. In Silicon Valley, most boards ultimately make decisions based on a consensus.

Patent Trolls.

Patent trolls purchase portfolios containing patents and sue companies for infringing them. “This is a shakedown,” said Schmitz. “When you raise millions in Series A funding you’re big enough to be interesting.” Depending on the claim, writing a check to settle and get rid of a troll may be worth it. On the other hand, it may encourage other trolls to visit. A startup may need to hire a lawyer to understand what the best strategy is given its particular technology space and to guard against being seen as an easy mark. “From a diligence perspective, trolling appears as a blemish on the company,” said Fisher. “You need to get a waiver and release of claims so the troll never comes to your doorstep again.”

Intellectual Property.

“The number-one thing that will kill a company is if the founders haven’t assigned their IP to it,” according to Schmitz. In semiconductors and other areas where hard IP really matters, investors highly value patents. Issues in software IP are nuanced and require a fairly high level of expertise to determine if the technology is patentable at all. However, depending on the technology, it can be a good idea to get some provisional patents on file to preclude others from filing similar patents. Fisher noted that, “If you can’t patent your technology or process, there are other legal protection strategies to leverage, such as copyright protection, trade secrets, and trademark protection.”

Use of Data.

“Startups need to remember that just because data is publicly available on a website does not necessarily mean they have a right to it,” said Fisher. Although the data is public, the startup may not have been able to manually aggregate that data on its own, or the owner of the website may expressly prohibit use of the data outside of the services the owner offers. The owner will want representations that a company one degree removed from the data will not do certain things with it.

With direct customers, personally identifiable data is of most concern. Most state laws require companies to tell users what they are doing with the personally identifiable data they collect, who they share it with, what their terms are, and the steps they take to protect data, as a leak may give users cause for action. Best practices dictates that a company provide the same explanation to end-users with regard to all data (not just personally identifiable data) collected through their products or services.

Domain Squatting.

If someone is squatting on a domain a company wants, the company can send a letter offering to buy the domain. If the squatter makes an offer in return, and the potential purchaser sends a letter acknowledging the offer, this is considered prima facie evidence of squatting. If the squatter doesn’t give up the site, the issue can be taken to court, and the squatter will have to show it is operating a business or maintaining a service. If a domain name is critical to a brand and the domain is not empty, the best course may be to find a new name.

A startup can also use a trademark to acquire a domain; if another party acquires the domain name after the startup received trademark rights that can be incredibly helpful. If someone violates the trademark by using a certain domain name, the startup could make claim in court.

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John Vrionis (@jvrionis) is a partner at Lightspeed Venture Partners who focuses primarily on early stage enterprise and consumer technology investments. In addition, John is the founder of Lightspeed’s Summer Fellowship Program. John holds an MBA from Stanford University Graduate School of Business, an MS in Computer Science from the University of Chicago and a BA from Harvard University.