Volume 18, Number 6
September 2001


Top Ten Legal Mistakes of Early-Stage Tech Companies

By James J. Greenberger

Mistake No. 10: Creating a "cheap stock" problem. "Cheap stock" problems arise when the Securities and Exchange Commission decides that a company has not properly charged against its earnings the fair market value of stock and option awards previously granted by it to officers and other key persons. To avoid or minimize these problems, carefully evidence the value of stock or option grants at the time they are made and be prepared to explain why that value increased prior to the IPO.

Mistake No. 9: Failing to obtain good title to intellectual property. The patent rights to an invention made by an employee belong to the employee, even if the employee conceived and developed the invention on the employer's time and using the employer's tools and materials. The employee may assign those rights to the employer by a written document supported by consideration.

Under copyright law, title to a work initially belongs to its author. The work-for-hire doctrine may deem the employer to be the author of an employee's work under certain limited circumstances. The creator of the work must be an employee, not an independent contractor. When a work is not a "work made for hire," an employer may obtain ownership of the copyright by an assignment supported by consideration.

Mistake No. 8: Failing to institute a trade secrets protection program. Every technology company should adopt a trade secrets protection policy of procedures and practices to protect confidential information that includes the following provisions:

  • Employees are informed of the importance of maintaining the secrecy of trade secrets.
  • Confidential information is available on a need-to-know basis.
  • Confidentiality agreements are obtained from employees and consultants.
  • Papers containing confidential information are locked up at night and all programs containing confidential information are password protected.
  • Departing employees must have exit interviews explaining their continuing obligation to protect the company's confidential information and requiring the return of company documents and programs.

Mistake No. 7: Not adopting an appropriate employee stock option plan. Under Internal Revenue Code § 83, an employee is taxed at the time the option is exercised, rather than when it is received. The tax is due and payable whether or not the employee sells the stock received on exercising the option.

If the employee does sell the stock at the time of exercise or at anytime thereafter, the employee is taxed again on the difference between the fair market value of the stock on the date he or she exercised the option and the sale price of the stock.

Qualified incentive stock option plans permit an employee to postpone recognizing income on exercising options until the employee actually sells the underlying stock and, thereby, has the cash to pay the taxes on the appreciation.

Mistake No. 6: Blowing the § 83(b) election. Mistake No. 6 is permitting employees, directors, and constituents of the company who receive awards of restricted stock to miss making an important tax election under Internal Revenue Code § 83(b) that permits recipients of restricted stock awards to elect to be taxed immediately on the receipt of the restricted equity, rather than on the lapse of the restrictions. The taxpayer pays tax on the difference between the fair market value of the stock and the purchase price.

Mistake No. 5: Selling securities to unaccredited investors. Regulation D imposes conditions on sales of securities to persons who are "unaccredited investors." An "unaccredited investor" is any individual who is not one of the following:
  • A director, executive officer, or general partner of the issuer or any general partner of the issuer, or
  • A person with a net worth, together with his or her spouse, of more than $1 million, or
  • A person who has had income in excess of $200,000 in each of the two most recent years or joint income with his or her spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

In offerings involving more than $1 million of securities, companies must provide unaccredited investors with written information about the company and its proposed sale of securities. Companies can easily make this type of technical securities law violation when selling stock to unaccredited investors, and it can come back to haunt them at the time of the IPO.

Mistake No. 4: Not properly maintaining organizational records. A court may ignore a corporate entity, and permit creditors of the corporation to assert their claims directly against the corporation's stockholders, if the court finds that the corporation lacks substance and acts as a mere alter ego for its stockholders. One factor that courts consider is whether the corporation has observed corporate formalities by maintaining proper corporate records.

A potentially more serious problem is a failure to maintain a careful record of equity ownership. A shareholders agreement can shape expectations and prepare the company for eventual sale. The agreement should specify who elects the board of directors and under what circumstances new third parties can be admitted as equity holders.

Mistake No. 3: Not conducting a timely trademark search. A company may be liable for infringing the trademark of another if

  • It uses a domain name or meta-tag that is similar to an existing trademark, and
  • The domain name or meta-tag identifies a website that either sells goods that may be confused with those of the trademark owner or interferes with the trademark owner's business.

A company may also be subject to criminal penalties under the Anti-cybersquatting Consumer Protection Act if it knowingly and improperly registers a domain name that infringes on an existing trademark. The existence of a similar trademark can leave a dot-com company vulnerable to "reverse cybersquatting" attack, whereby the owner of a weak or unenforceable trademark uses the private dispute resolution procedures of a domain name registrar to appropriate the domain name of another.

Mistake No. 2: Incautiously hiring former employees of a competitor. Before hiring an industry veteran, a company should investigate whether that person is subject to a restrictive covenant in favor of a former employer. A court's willingness to enforce a specific covenant may turn on the reasonableness of the covenant's terms and geographic restrictions, the burden of compliance on the former employee, and the cost to the public of enforcing the covenant.

Even if a new hire is not subject to a restrictive covenant, a company's ability to employ that person may be limited by the fact that the person has had access to a competitor's trade secrets. Courts have enjoined companies from hiring former employees of competitors where the court felt that the nature of the employee's new duties would inevitably lead to the disclosure of the former employer's confidences.

Mistake No. 1: Not properly licensing technology patented by others. Patent infringement is of particular concern to early-stage companies because patents give their owners broad legal protection. A patent can protect its owner's right, not just to a particular device, but to the entire process by which that device operates.

When a company discovers that one or more existing patents covers an element of its business, properly licensing those rights is crucial. Licensing less than all of the rights that a company needs to operate its business is a frequent error.

James J. Greenberger is a principal with Schwartz, Cooper, Greenberger & Krauss in Chicago, Illinois.

This article is an abridged and edited version of one that originally appeared on page 8 of Business Law Today, January/February 2001 (10:3).

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