Six legal tips every startup founder should read

Silicon Valley | BCBusiness
A scene from HBO’s comedy series Silicon Valley.

It’s cheaper to build a solid legal foundation from the get-go than to fix a structurally unsound one later

Starting a business is challenging, especially for new entrepreneurs. But a few simple maxims can help any startup set down legally sound foundations to support future growth.

1. Know your responsibilities. Before starting a new venture, entrepreneurs should ascertain their duties to current and former employers. If the idea for a startup was developed or worked on while an entrepreneur was employed by another business, there may be specific legal issues to consider.

Pursuant to the federal Copyright Act, unless there’s an agreement to the contrary, an employer is the primary owner in copyright of the work produced by its employees during the course of their employment. Moreover, some employment contracts contain intellectual property (IP) provisions that assign all works produced by an employee, even those produced outside work hours. As such, it’s imperative for entrepreneurs to consider what legal obligations they have to their current or former employers.

Startup founders should also recognize that they owe a common-law duty to maintain the trade secrets and confidential information of their employers. Such information should not be used or disclosed for the purposes of advancing a new startup. This is especially the case if the startup will be a competing enterprise with a former employer.

Founders may also be subject to non-compete and non-solicitation clauses in their employment contract. While many employers try to draft these to be as restrictive as possible, the clauses may be unenforceable if they are too broad.

2. Draft a founders’ agreement. Once it’s determined that a new venture does not conflict with duties to former employers, the savvy entrepreneur should pick her co-founders carefully.

It’s not uncommon for pre-incorporation founders to fall off the map before the startup becomes profitable. What’s more likely is for a deadbeat co-founder to come out of the woodwork to collect profits if the startup takes off. Drafting a founders’ agreement can be helpful in dealing with a feckless co-founder.

Aside from regulating the relationship among the founders and ensuring that all IP is appropriately assigned, a founders’ agreement typically contains reverse vesting provisions, ensuring that founders who continue to contribute to a company are entitled to the shares issued to them in the company, while those founders who decrease their contributions, or stop contributing altogether, have less of or no stake at all in the company—thus allowing productivity to be rewarded and non-contributing founders to be cast aside.

In addition to protecting the interest of the company and preventing non-contributing founders from free-riding, some sophisticated investors will require a vesting agreement as a condition of their investment.

Another vital document that should be crafted carefully is a shareholders’ agreement. That said, most startups that are seeking external funding may rely on a founders’ agreement until their first major round of financing, as the terms of a shareholders’ agreement will typically be heavily negotiated by the major investors.

3. Protect your startup’s name. It could be one of the company’s most valuable assets. As a point of reference, the top three most valuable brands in the world are Apple, Microsoft and Google with brand values alone being US$124.2 billion, $63 billion and $56.6 billion, respectively.

Many startups operate under the mistaken assumption that a corporate name reservation is the only thing they need to protect their business name. But if the name is not registered as a trademark, it will only be enforceable under the common law of passing-off, which is often difficult to establish. That’s why it’s good practice to obtain trademark protection for the startup’s business name.

Depending on where a startup intends on doing business, it may make sense to make similar trademark registrations globally. After all, even if a name is reserved and protected by trademark here in Canada, it will not be protected in other countries. If a startup has any ambitions to go global, it’s best to invest in a little due diligence and make sure that the name it selects is available globally.

4. Protect your startup’s intellectual property. In addition to protecting the business name, founders should implement an intellectual property strategy to monitor the use and disclosure of their intellectual property from day one.

One of the most common pitfalls that entrepreneurs fall into is the exposure of their intellectual property by (1) communicating confidential information to various people without non-disclosure agreements and other safeguards to secure their trade secrets and intellectual property, or (2) the use of inadequate non-disclosure agreements that were shared by a friend (or found on Google). Non-disclosure agreements should be drafted with the particular circumstances of the disclosure in mind and ought not to be treated as a basic boiler-plate document. 

Additionally, the public disclosure of IP rights without advanced planning may compromise a company’s ability to secure a patent. One of the requirements to patent an invention is that the invention must not have been publicly disclosed anywhere in the world before the patent application is filed. Canada and the U.S. provide a one-year grace period for public disclosure to file a patent application, but such a grace period may not exist in other jurisdictions that the startup intends on doing business. Hence, it’s important for a growth-stage company to have a sound intellectual property strategy that contemplates potential business it may have internationally, before making any public disclosure of patentable technology.

5. Draft a consulting agreement and be cautious about giving equity compensation. Once the startup is ready to retain the services of independent contractors, it’s vital to enter into a consulting agreement with such contractors. Many startups retain the services of independent contractors without any written agreement. This could lead to big problems. Unlike an employment relationship, IP developed by an independent contractor will typically belong to the independent contractor absent a clause in a contract to the contrary. Therefore, startups should use consulting agreements that stipulate the terms of the contract and assign any IP developed during the course of the contract to the company.

Furthermore, startups should be cautious about giving equity compensation to contractors as contractors tend to have nomadic tendencies, jumping around from one company to the next. Three potential collateral consequences from giving away equity to contractors: they may walk away from a project before it’s finished; too many shares or options may be given away, thereby giving rise to minority rights and creating apprehension for potential investors; and finally, the share capital of the startup is diluted.

While compensation plans are a business decision, startups should be cautious about issuing equity to contractors and should only do so pursuant to vesting mechanisms (discussed above) or a carefully drafted stock-option plan.

6. Retain appropriate legal counsel. The pitfalls outlined above could be averted if the entrepreneur retains appropriate legal counsel at the outset. Unfortunately, many founders view lawyers as an expense rather than an investment in the company’s success. Startup founders often think it’s better to focus on developing the business and raising funds before investing in its legal foundations. But it’s much less expensive (and less dangerous) to build a skyscraper properly than to fix a structurally unsound one later.

Consult a corporate lawyer who acts for startups and has appropriate industry knowledge. This means a savvy founder shouldn’t turn to her “accountant friend” or “generalist lawyer friend” to do her incorporation. Businesses that rely on professionals who are insufficiently qualified tend to be blemished with problems down the road.

At best, if the startup ever takes off it will have to pay more to clean up its legal affairs. At worse, directors may be in breach of corporate law, the shareholders’ stake in the company may be exposed and the title to the IP of the business may be compromised.

Parham Peiroo is a business lawyer at Zargar Lawyers & Business Strategists. Parham provides strategic advice to growth-stage companies, angel investors, venture capital firms and private lenders. The contents of the above article are for informational purposes only and are not to be construed as legal advice. Readers should take specific advice from a qualified professional.

This article originally appeared in The Globe and Mail on January 21.