Wednesday, September 2, 2009

Early Stage Tech Companies – When Should You Involve a Lawyer?

Early stage tech companies know that they need to hire lawyers. This post provides some help in figuring out when to spend the company’s hard earned cash on legal advice, and when it might be OK to do without. As with many things legal, there are no clear boundaries, but these are the guidelines I tend to use when working as general counsel with my own budget to manage.
General principles
Value and Risk Management. When I think about the need for legal involvement, I consider two primary drivers – value, and risk management.
Value. Value goes to the creation and preservation of value in the company. This may take the form of revenue generating transactions, or of events that will affect exit strategy.
It’s a surprisingly disregarded truism that businesses run on cash - if you’re going to be bringing revenue into the company, you need to make sure (a) you can collect, and (b) you can do so within the resource commitments you expected. If a deal or contract form is going to drive a lot of revenue, it makes sense to get your lawyer involved.
The inevitable precursor to most exits is “due diligence.” If you’re exiting in less than exuberant times, or if your revenues or page views don’t far exceed the norm, due diligence can become a mechanism by which your buyer will try to drive down the purchase price. Due diligence will turn up sloppy contract processes or poor protection of key intellectual property (IP), and you’ll be kidding yourself if you think you won’t be called upon to explain it. That having been said, not every issue will be a red-flag issue.
Risk Management. This one is easy to describe, but more difficult to assess: “What’s the likelihood of this event or transaction biting me, and how hard will it bite?” As a rule of thumb, I don’t get too worked up about transactions involving less than $35,000 – sad to say, this amount is seldom worth litigating, and I think resources are better spent on building a good relationship with the other party, so that difficulties can be handled in that context. I also think that many of these issues can be effectively managed by using good contract forms for your service providers. Many service providers to early stage companies are willing to work with the company’s forms.
Fairness. I’m a firm believer that acting fairly helps keep legal cost down. My preference is to avoid using one-sided contract forms, or taking positions that I’d reject outright if I were on the other side of the table. My experience is that taking fair positions helps builds trust, and makes negotiations more efficient. I’d encourage your lawyer to provide you with fair forms.
Categories of Legal Work
I categorize legal work as follows:
· Ownership and funding / entity formation
· Intellectual property
· Internal staffing / HR
· Suppliers / outside vendors
· Customers
· Marketing and channels / strategic relationships
· Mergers and acquisitions
· Litigation
Ownership and Funding / Entity Formation. To my mind this is one of the easiest areas to determine whether to use lawyers.
Equity and Convertible Debt. As a successful local CEO memorably told me: “Don’t f*ck with stock.”
You should treat any issue involving equity as a minefield. The securities laws are nothing if not arcane, and ensuring your compliance is a thing of joy to the lawyers who will subject you to their due diligence. Shareholder rights and your ability to issue stock can also quickly become complicated, especially if you raise money from angels or VCs. Managing a stock option plan is also something where you should work very closely with your lawyer – it’s very easy to mess up, and expensive, time-consuming and often embarrassing to fix. In summary, you should always involve your lawyer at the outset in any matter involving equity.
Conventional Debt. In my experience, the sad truth of trying to negotiate the legal terms of conventional debt agreements is simply that … you can’t. Most banks who are willing to lend you money are very reluctant to alter their loan agreement terms. This isn’t to say that you shouldn’t have your lawyer review the terms, but the review is more to let you know what you’ll be agreeing to and living with, as opposed to improving the deal. I do, however, recommend that you have your CFO / Controller carefully review the covenants and any related ratios to ensure that these are practical for you – there may be scope for negotiation here.
Formation. It’s possible to do this yourself, but you’ll spend twice as much again when you have to fix it when you raise your first round. Many firms in town will do this on a very reasonable fixed fee basis for you.
Intellectual Property. While customer acquisition and retention and staying ahead of your competition will likely have more practical effect on the value of your business, investors and buyers will want to know that you have clean title or all necessary license rights to any intellectual property that you use in operating the business.
Developing IP In-House. If you develop IP in-house, you should be able to restrict legal involvement to providing you with appropriate contract forms for employees, contractors and outside vendors. As long as you have all of these people sign those forms, you should be OK. If any of them want to change those forms, then I’d recommend that you get your lawyer involved. One word of warning – make sure your lawyer (or their firm) has real IP experience – general practice lawyers without good tech experience may not be sufficiently familiar with the issues.
Licensing IP In. If you acquire IP from third parties, I’d recommend you have your lawyer review the license agreement to ensure you’ll be able to use the IP the way you want to. Even though there may not be scope to negotiate the terms, the review can help ensure that you avoid any pitfalls or inadvertent infringement. This is also the case for open source licensing – as you’re probably aware, open source licenses such as GPL 3 can affect your ability to control distribution of key IP you combine with the open source. You can also save substantial legal fees down the line if, at the outset of your development work, you create and implement a process to track all third party code that you use in your technology, including files containing license terms, and attribution / liability mitigation terms required by the licensor.
Non-Disclosure Agreements. If you are relying on a trade secret program (most likely, you will be), then I do recommend using NDAs with third parties where you are likely to disclose confidential information such as technical information, roadmaps, pricing, your financial condition or marketing analyses. Ask your lawyer to provide you with a fair form of mutual NDA. Most NDA legal reviews and negotiations take an experienced tech lawyer less than 10 minutes – good value for your legal spend in my mind. Don’t expect VCs to sign NDAs.
Branding. If branding is important to your business, then I do recommend working with a trademark lawyer. To save money, focus on a single core brand and logo, and use that to qualify each subsidiary brand. Your trademark attorney should be able to provide you with a budget and timeline for their work, and advise you on an efficient strategy for your money. I’d encourage you to work with a lawyer whose primary practice is trademarks – the extent to which they’re familiar with the Patent and Trademark Office (PTO) procedures and personnel will affect the time it takes them to get your application registered. Although you could complete the PTO forms to register a trademark yourself, I don’t recommend it – the key value in a trademark is that you should be able to litigate successfully to preserve the goodwill you’ve established in the brand. If you cut corners with your application, it will probably become apparent in litigation, and may affect the enforceability of your mark.
Patents. Whether you choose to patent your IP is very much an “it depends” issue. Suffice to say that you should engage in a thorough cost benefit analysis before doing so.
Copyright Registration. If the value of your IP is embodied in source code, then it’s very affordable to register copyright in the source code. Registration puts you in a stronger position to enforce your copyright and obtain damages awards. It’s possible to register your source code without significantly disclosing it – consult your IP attorney to find out how.
Internal Staffing / HR.
Paperwork. Your law firm should be able to provide you with templates for standard terms of employment and generic workplace policies, intellectual property assignment and confidentiality agreements, and offer letters. They should also be able to provide you with a services agreement form for independent contractors and bodyshops. You should be able to use these without too much legal involvement.
However … I recommend having your lawyer review any offer letter or services agreement before it’s finalized in any of the following circumstances:
· Offer letters for any member of your executive team
· You describe option awards, warrants, restricted stock arrangements, or commission arrangements outside of your standard arrangements
· You want to provide a contractor with equity for services
· You provide loans, refundable advances or contingent signing bonuses to the employee
· You provide change of control rights such as vesting acceleration or cash payments
· You provide parachutes or deferred compensation
· You’re having a vendor develop IP for you outside the US
HR Issues. My experience is that exposure to most employee claims can be avoided by treating your employees decently – treat employees as you’d like to be treated yourself. Most likely you’ll want to create that culture anyway, to help attract and retain good talent. That having been said, I recommend contacting your lawyer in advance (so far as practicable) in the following circumstances (as with all things in this article, this is a non-exhaustive list – if in doubt, bite the bullet and make the call):
· Prior to any termination of an employee by the company
· If you suspect any discrimination or harassment, or the prospect of a claim
· Workplace violence or the possibility of workplace violence
· If you want to reduce one or more employees’ compensation
· Reductions in force / layoffs
· If there is any chance that you won’t be able to make payroll (ideally, well before you have anyone work when there’s a possibility they won’t get paid).
· If you’re bringing on employees outside the U.S.
Service Providers. Your law firm should be able to provide you with form services agreements for you to use with service providers. You will typically need to generate a statement of work to describe the services and compensation arrangements. In particular, the form should address IP ownership assignment and license rights, the vendor’s use of open source, and the vendor’s obligations to provide regular source code updates. If the IP development effort is significant, if you’re spending a chunk of change, or if the service provider insists on using their own form, I’d have your lawyer review the documents. I’d also consider milestone payments and an acceptance testing mechanism for these kinds of transactions.
Licensors. If you’re licensing in a third party’s IP, then you should have your lawyer review the docs. I’d typically agree to work with the licensor’s paper.
Marketing, PR and Headhunters. Marketing, PR and headhunter firms tend to insist on using their own contract forms – in my experience, they typically do a poor job of protecting the customer. Rather than have your lawyer review the provider’s forms, insist on using the form of services agreement your lawyer provided, and take care with the statement of work. I’d take care (and at least consider legal review) to ensure that you can terminate on short notice, that the payment arrangements are clear and fair to both parties, and that you won’t have to pay for poor performance.
Real Estate. I think that a cost benefit analysis is appropriate here to determine if legal review is appropriate, but I’d typically ask a real estate attorney to do a quick review of the docs and let me know if there are any truly awful provisions I should try to change. A lot will depend on how comfortable you are with your non-lawyer real estate professional.
Internet Companies (e.g. social networks). For the most part, internet companies’ legal interactions with their customers or users take place via Terms of Use (TOU), a Privacy Policy, and any payment terms. I do think you should get legal review for these items, but because this work tends to be pre-revenue, I’d work with your lawyer to figure out the most efficient way to get them involved. I’m increasingly of the view that it makes sense to prepare these forms on a fixed fee or capped basis.
If you’re going to be taking payments from your users or customers, then I strongly recommend outsourcing this function to a reputable payment processor. While the primary benefit is to reduce your risk around PCI compliance and storage and processing of personal data, you’ll reduce the need for your lawyer’s involvement in the contract and payment processes.
Product / Service Companies (e.g., enterprise software, SaaS). I would work with your lawyers to create a set of customer contract forms that reflect your technology and business model. I’d be very wary of your lawyers taking a one-size-fits-all approach. Your contract forms should be reflective of your business processes (not the other way round). You should also consider the tone you want to strike with your customers, and what kind of review you’ll get from customers’ procurement and legal teams. Many standard forms for early stage tech companies are, in my opinion, overly defensive, which only encourages push-back from customers. Not only does this interfere with the efficiency of your sales cycle, but it can lead to increased legal costs in negotiating changes to your contracts, and just as often to you and your lawyers having to work with the customer’s standard form contracts, which are generally very customer-favorable.
A Word About Purchase Orders (POs). Many tech customers and some resellers will want to make purchases just on the basis of their purchase order terms. This is a superficially attractive option, because all that’s needed from the customer is budget approval for the purchase, and you can avoid legal review of contract terms. However, almost without exception, PO terms suffer from two defects from a tech seller’s perspective: (1) they are generally geared to the purchase of goods and services, and not technology licensing; and (2) they contain terms which are very, very onerous for the seller.
For example, most POs will include provisions assigning title to products and services deliverables to the buyer – these terms often extend to the underlying IP rights. You really, really don’t want to assign ownership of any of your IP to your customers (and if you do, you want to be sure that you will never need to re-use it, and that your customer pays a premium for it). Also, most POs will have lengthy warranty periods, and very customer favorable acceptance and payment clauses. Not only does this cause revenue recognition issues, but it can leave you leave in the position where, realistically, you’re relying on the customer’s goodwill to get paid, without an easily enforceable contract.
Marketing and Channel Relationships; Strategic Relationships.
Market Partners and Channels (a.k.a. referral deals and resellers). You can deal with many of these relationships with a good set of form agreements. These should be driven by your business model, and should be a collaborative work between the VP running the program, your CFO/Controller and your attorney. It’s very important not to let the legal forms drive your process – you need to have the forms reflect the process that’s going to work for you. I think this is an area where you want your lawyer to have a lot of hands-on channel experience, because their practical advice can be very valuable.
If your potential partners push back on the form agreements, I’d involve your lawyer in resolving the differences. The legal structure for these deals can be surprisingly complicated, and there are pitfalls for the unwary.
Strategic Relationships. Strategic relationships tend to involve a significant commitment of company resources, and often a fair amount of new IP development, some exclusivity or limits on competition, and occasionally some equity element. For all of these reasons, you should be involving your lawyer. As with the channel deals, I’d make sure your lawyer has hand-on experience of these kinds of deals. The paperwork for these deals is usually complicated; although you and other members of your exec team (and board members) will be anxious to get the deal finalized as quickly as possible, you can make the process much more efficient (which includes lower legal fees) if you run your initial rounds of negotiation off a term sheet. You should involve your lawyer in the term sheet preparation from the outset. If you can’t get your proposed partner to commit to a term sheet then, in my experience, you’re likely spinning your wheels in trying to negotiate full agreements. Either you’ll open the door to your partner’s legal team negotiating business terms (shudder), or you may find that the people you’re dealing with don’t have sufficient authority to push the deal through the way they’ve sold it to you, if at all.
Mergers and Acquisitions.
This is an easy one - get your lawyer involved early in the process, even if only to get their strategic input on the way the deal is shaping up. Make sure they have plenty of experience in M&A work in your sector.
No question – unless you can very, very quickly resolve the dispute at an executive level, you need to bring your lawyer in. Even then, I think there’s much to be gained (and pitfalls to be avoided) by getting your lawyer involved early – if they have experience of the kind of dispute in question, their strategic advice can be very helpful in resolving the dispute efficiently, and without shooting yourself in the foot.
Knowing when to involve lawyers is a learned skill. Just as important is understanding how you can use your lawyers efficiently. I find that many early stage companies shy away from calling their attorney because of cost concerns. If you’re paying your lawyer based on time spent, you’ll find that calls for strategic advice tend not to run too expensive. Things don’t generally get expensive until time consuming activities such complex document drafting or review begin. There are many occasions when involving your lawyer sooner rather than later will cut down on your legal fees. For example, it’s less generally less expensive to pay your lawyer to help you avoid a dispute than it is to pay them to help you resolve it.
You’ll have seen that a key theme of this post is that you should be working with a lawyer who has significant experience of the matter for which you want their advice. While it makes sense to have one key lawyer with whom you coordinate most of your legal activities (be it your primary corporate lawyer or an outside general counsel), you’ll get more bang for your buck on specific matters if your lawyer can provide strategic advice that reflects their experience of seeing how similar matters have panned out for other companies.