Ask the Attorney: What issues do I need to consider when forming a start-up?

(Editor’s note: “Ask the Attorney” is a VentureBeat feature allowing start-up owners to get answers to their legal questions. Submit yours in the comments below and look for answers in the coming weeks. Author Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs.)

Question:  Two former classmates and I are launching a new venture.  Unfortunately, we don’t have enough money to hire a lawyer.  I found a lot of articles on the web, but I’m still not sure what kind of entity we should form and where.  I also was wondering if there are any other legal issues we should be worrying about.

Answer: Last Monday, I looked at some of the issues surrounding this question, including the choice of entity, place of formation, equity issuance, vesting restrictions and prior employment.  Below are five more issues that should be on your radar. With issues this critical, though, it’s worth reiterating that it would be prudent for you to retain a good, reasonably-priced attorney to assist you and watch your back.

1.  Management Issues.  You and your co-founders need to sit down and agree on how the company will be managed (e.g., who will be on the Board of Directors and what position each founder will hold).  Whatever you decide should be reflected in a written agreement, referred to as a stockholders’ agreement or voting agreement. This should also address other significant issues, including: (i) rights of first refusal with respect to the sale of any shares by a founder; (ii) whether any founders/stockholders will have veto rights with respect to certain extraordinary company actions (such as the sale of the company or borrowing in excess of a certain amount); and (iii) whether founders/stockholders will have so-called “drag-along” and/or “tag-along” rights.

2.  IP Issues.  For many start-ups (particularly technology companies), intellectual property (IP) is the most valuable asset and, accordingly, certain steps must be taken to ensure that the company owns the IP.  First, if any technology/IP were developed prior the company’s formation, you must do two things: (i) as noted last week, confirm that none of the founders’ prior employers have rights to the technology/IP because of prior agreements or applicable law (i.e., because a founder was “moonlighting” while still employed); and (ii) make sure ownership to the technology/IP is transferred from the applicable founder(s) to the company in writing.  Once the company has been formed, protect the ownership of the technology/IP by requiring all of the company’s employees and independent contractors to sign confidentiality and IP/invention assignment agreements (see #4 below).

3.  Securities Laws.  As I have previously discussed, a company may not offer or sell its securities unless (i) the securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (ii) there is an exemption from registration.  The most common exemption used by start-up companies is the so-called “private placement” exemption.  As the term implies, a private placement is a private offering to a small number of purchasers – like a few founders.  The SEC and each of the State securities commissions have their own set of rules regarding private placements, and it is imperative that you follow them to the letter.  Non-compliance could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

4.  Employment Issues.  If any employees are hired by the company, insist that they sign two documents:  an offer letter agreement and, as noted above, a confidentiality and IP/invention assignment agreement.  The offer letter agreement will set forth the employee’s rights and obligations, including position, compensation, benefits and, most importantly, whether the relationship is “at will.”  The confidentiality and IP/invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information – and to ensure that any IP developed by the employee is legally owned by the company.

Non-competition and non-solicitation provisions may also be included; however, such provisions are generally unenforceable in California other than in the context of the sale of a business (though California courts will generally enforce provisions that prohibit employees from soliciting the company’s employees provided they are reasonable in scope and duration).

5.  Stock Option Plan.  In order to attract and retain key employees (and consultants) and to conserve cash, it would make good business sense for your company to establish a stock option plan or other form of equity compensation plan.  As I mentioned last week, the goal is to issue any equity (including options) as soon as possible when the value of the company is as low as possible; and, as noted above, because options are “securities” their issuance must comply with applicable federal and state securities laws.  The SEC and most State securities commissions (including California) have created an exemption from registration for any offer or sale of securities pursuant to certain plans and contracts relating to compensation.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  The author and his firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.

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