Life Science Network interviewed The Wagoner Firm’s Eric Leander to find out how startup founders can avoid common legal mistakes.
Eric Leander is a founding partner and head of the Emerging Ventures, and Corporate & Securities law practice groups at The Wagoner Firm PLLC, a full-service business law firm in New York. Eric’s personal practice focuses on working with startup / emerging growth companies and investors. The Life Science Network (LSN) editorial team caught up with Eric to find out how startup founders can avoid some common legal traps and mistakes. Here are his tips:
Protect Your Intellectual Property (IP)
You need to start with your founders. Make sure founders have agreements with the company that all the IP they have developed belongs to the company. Next if you are outsourcing work, it is critical to have a contract in place with “work-for-hire” provisions so that any work that is performed and any product or derivative of that work automatically becomes the property of the company. Those are two easy things that founders can do before looking at patents and trademarks.
There’s a lot more patentability in life sciences than in other tech spaces (e.g. software, SaaS, apps, social media). Do not disclose your technology until you have properly protected it (and in some cases never disclose it – i.e. protect things as “trade secrets”). Get your provisional patents filed early. There are timelines associated with patent applications so if you want to sell your product internationally, begin the international patent process at the same time as doing your US patents. If you don’t get the timing right, you may not have international protection for your IP. The problem is that it tends to be expensive to get multiple patents, so the best way to protect your IP without spending a lot of money on patents and patent lawyers is to keep it close to the chest – no public presentations about it until you have it firmly locked up. To the extent you may NEED to disclose details about your technology (e.g. to potential investors) do so ONLY after you have a solid Confidentiality / Non-Disclosure Agreement in place.
Incorporate in Delaware
Delaware law is the gold standard when it comes to corporate law in the US. Each state has its own corporate law. The Delaware corporate statutes provide a great deal of flexibility in the organization of a corporation and the rights and duties of board members and shareholders.
Not only is the Delaware corporate statute very business / management friendly, Delaware’s state level institutions are also specialized and responsive when it comes to corporations. The Division of Corporations at the Delaware Department of State is a very “user friendly” agency with a reputation for efficiency and a business forward attitude (it also helps that they embrace and deploy appropriate technology to meet the needs of their customer). In addition, Delaware has a responsive legislature that has historically prioritized corporate / business law matters and constantly refines and/or augments the corporate laws to accommodate changing markets, technologies and innovative business practices. The Delaware Court of Chancery stands-alone as a highly specialized court that focuses only on corporate law (with over 100 years or more of settled case law). So Delaware law provides consistency as far as an investor is concerned.
Lastly (and maybe leastly), most corporate attorneys are intimately familiar with Delaware business law. When law students study corporate law, mergers and acquisitions, and other business law courses, its usually Delaware law they are learning. For the same reasons that Angels / VCs and Investment Banks prefer Delaware law (and perhaps as a result thereof) most business attorneys prefer and are more comfortable with Delaware corporate law. This can lead to your attorney more efficiently and cost effectively assisting you if your company is incorporated in Delaware than if it is incorporated in another jurisdiction.
Have a Founders’ Agreement
It’s critical in my opinion that a Founders’ Agreement captures the general spirit of what you are trying to accomplish while also providing for specifics. A Founder’s Agreement should include both the general overarching duties and responsibilities of the founders as a group, but also the specific duties of each Founder on a position-by-position basis. It is important that each Founder has objectively measureable criteria and specific deliverables that they must hit so you can hold people accountable. Then you can say, “You were supposed to do this by this date and you didn’t do it” – then you can have that conversation on what to do about it. Maybe they have to give up some of their equity. A lot of people think, ‘Hey we’re all friends and we will be friends forever.’ But invariably people lose interest and stop pulling their weight but they still own a large chunk of the company. Investors generally don’t want to see companies with founders that are disengaged while still holding a significant stake of the company.
I think founders should always subject themselves to vesting to hold themselves accountable to each other and to make the company a more favorable investment. When investors come to the table, they often want to adjust pre-existing share agreements to include vesting. If you put together a reasonable vesting structure to begin with, you have a bargaining chip for investors. It shows that you’ve got your stuff together and you are a savvy group of founders. The more diligence you put into your corporate governance structure, the better you look to outsiders and the better you can function internally.
Become an LLC or C-Corp not an S-Corp
While an S-Corp is appropriate in a variety of circumstances (depending on the nature of the business you are trying to build), if you intend to take outside investment (i.e. from funds or institutions) it doesn’t make a lot of sense to elect to be an S-Corp because there are a variety of restrictions on your equity and capital structure. For example: 1) an S-Corp is limited to a maximum number of shareholders it can have; 2) Only natural persons, not business / legal entities, can own equity (so forget about investment from funds or institutional investors unless you drop the election); 3) S-Corps are only permitted to have a single class of stock (further limiting your likelihood of raising institutional investment as they often look for a preferred class of stock); and 4) essentially only US citizens / GreenCard holders can be a shareholder (so forget foreign money investment).
When deciding between becoming an LLC or a C-Corp, the first question is ‘Do you need or realistically expect to take money from third party investors and, if so, when are you going to do it?’ A typical benefit of being an LLC is that they are usually taxed as “pass-through” entities; meaning you can write off any losses against your personal income. So if you are bootstrapping for 18-24 months, and making money from another job, this might be the right choice for you
Another item to consider when choosing an LLC or C-Corp is whether you want to utilize equity incentives for key hires / personnel (equity compensation, stock options etc.). The tax aspects of LLC’s can get funky (make sure you have a good CPA / tax advisor) and deploying equity incentives in LLCs can be extremely difficult (and/or a tax quagmire). If you want to do equity compensation or stock options, you’re probably much better off simply starting as a C-Corp.
Pro-Tip: If you do decide to begin with an LLC, Delaware is the place to do it. The Delaware LLC statute (and the fine folks at the Delaware Department of State), make it extremely simple to convert from an LLC to a Corporation with a simple set of filings (and because it is deemed to be the same entity post-conversion, there is generally not a tax realization event that accompanies the conversion). If you form an LLC in a state that doesn’t provide for this “statutory conversion” (ex. New York), transitioning from an LLC to a Corporation requires extra leg-work (typically a “cross-species” merger or an “interests-over” transaction), extra documentation, extra filings, and extra costs.
Don’t publicly ask for investment (especially from “non-accredited” investors)
When you ask for investment, you are engaging in an “offer for the sale of securities” which subjects you personally, and your company to both state and federal securities laws. So don’t stand in front of a room full of non-accredited investors and say, “We are raising money” or “we’re looking for investment.” By doing so, absent an applicable exemption, you’ve now made a “public offering.” While hyper-technical, it is a violation of securities law unless of course you’ve gone to the effort of registering your stock / offering with the SEC and appropriate state regulators (which you haven’t). Securities law is a very technical area of law and there are a lot of ways for you to raise capital, but there are also many traps for the unwary and a lot of ways to make critical errors that could cost you in the long-run. Talk to a lawyer before you start pitching – they can help guide you on what to do and what not to do (and ALSO what to say and what NOT to say).
Don’t try to raise too much money too early
Many startups try to raise too much money too fast and they end up giving away too much of their company. The amount of money you raise shouldn’t be your measure of success. You need a strategic growth / business / fundraising plan ahead of time. Nothing you do should be “from the hip.” Generally speaking, as you meet more milestones and build value, your company is worth more money, so any investor money you take on has a smaller dilutive effect later than they would earlier. So before taking any money, entrepreneurs should first stop and plan out what you need the money for, how much money you need and you need to establish specific milestones. Then only ask for the money you need and a small buffer. If you take all the money at Point A before you have hit your milestones, you will give away a lot more of your company.
Be careful with your term sheet
Make sure that you are not giving away the store in the first round. Whatever terms you have in your first round, assume you will have to give away even more the next round. People want more and more each round because they are getting less return. If you start out by giving people great terms because they are your friends (and most early investors tend to be friends and family), that will end up biting you later. You need to separate what’s right for the company from what’s right for investors and have a structure for what is fair and a reasonable return.
Get professional advice
People need to be realistic. Entrepreneurs tend to want to DIY everything but you can make a lot of mistakes that render your company unfinanceable or, in the case of life sciences, compromise the value / integrity of your IP, potentially compromise things like FDA approvals, and other things that may very well stop a med-tech or pharma company from acquiring you or licensing from you. You have to bring professionals in and consult with them. Ask a lot of questions. You need to break from this habit of ‘I can do everything myself’. Rely on advisors and focus on what you are good at.
You need a good CPA, attorney and insurance person that you can trust. Those three professionals can help you head off most of the major problem you are going to have.
Eric M. Leander, Esq. is an attorney with The Wagoner Firm PLLC (www.TheWagonerFirm.com) in Albany and NYC, New York. Eric is also the Managing Partner of Square Peg Ventures (a small investment group – currently fully deployed) and a Co-Founder of Unboxed Ideas LLC (a business support and consultancy company). Eric is an advisory board member of the Tech Valley Center of Gravity (a non-profit maker space in the Albany NY area), and is a frequent instructor for the “Small Enterprise Economic Development” (SEED) program offered by the SUNY Albany Small Business Development Center. You can find Eric on LinkedIn and on twitter @LeanderEsq. The information presented in this article is general information intended for informational and educational purposes only. The information and opinions expressed herein are not legal advice or a legal opinion on any specific circumstances or facts. No attorney-client relationship or privilege should be expected or inferred. Before acting on any of the materials presented here, you are advised to consult an experienced attorney concerning your particular factual situation and any specific legal questions you may have.