Lawyer Equity – A Bad Idea (Part 2 of 2)

July 18, 2011

Paying Attorneys with Equity: Other Problems

In part one of this article, I brought up the issue that many start-ups will pay their attorneys with equity in the company rather than or in additional to paying them cash. I maintain that this is a bad idea. I described the main problem with this arrangement in the first part of this article – that such an arrangement creates a potentially harmful conflict of interest for the attorney. But there are many other reasons why this arrangement should be avoided as well.

Tendency to Over-litigate

I also get the sense that companies tend to over-litigate cases when they are not paying for them up front. The cost of attorneys fees is an incentive to try to avoid litigation and settle disputes. But if you are not paying the attorneys, you may feel that it makes sense to fight to the bitter end. That is still not the case. First, of course, you are still paying the attorneys. You are giving up some of your precious ownership interest in the company. Second, litigation is very distracting. You will end up spending valuable time on your litigation cases that you should be spending making your company successful. Third, litigation is a terrible way to resolve disputes. The judge who will decide your case will have very little time to get to know your case and will bring their own personal biases to the case. The end result is often a somewhat random decision. Do you really want to bet your company on the mood of a particular judge on a particular day? Better to settle the case and get back to building your company. You will have more incentive to settle if you are paying your attorney with cash instead of equity.

Failure to Value Legal Advice

The company may treat the attorney’s advice differently if the company is not paying for that advice. People tend to value advice in proportion to what they pay for it. When the attorney who is taking equity is giving what is in essence free advice, the company may not value that advice highly. If the company is paying its lawyer for advice, the company is more likely to take that advice seriously.

 I have seen this first hand. When I have offered my advice for free (what we attorneys call pro bono service), the client tends not to respect the advice.

Smart Money versus Dumb Money

There is a saying that smart money comes from banks and professional investors, and that dumb money comes from attorneys, doctors and friends and relatives. Banks and professional investors know about the risks of start-up businesses. They may not like it when they lose money, but they know and accept the risk. They also know about the ups and downs of business and will not be quick to pull the plug if they think the business idea still has merit. Dumb money people expect to get rich. They may cause trouble if they lose their money. And they may want to run at the first sign of trouble.

You may think that a lawyer who deals with start-ups all the time will not follow the dumb money pattern. That is true sometimes, but not as often as you would think. There is a reason why that person became an attorney and not an entrepreneur.

If You Need to Pay Your Attorney with Equity, Are You In Trouble Already?

One of the tests of whether a potential business idea has merit is whether the founders can raise capital. If you are having so much trouble raising capital that you need to in essence borrow money from your attorney, what does that say about the viability of your business plan? You may be too underfunded to start a business or your business plan may need adjustment. If your best source of money is your attorney, your company may have serious problems.

Lack of Attorney Choice

A start-up should be free to hire and ultimately to fire any legal advisors. But what if the current legal advisors are also shareholders in the company? Then there are problems. If you fire them, you may have to deal with disgruntled shareholders for the rest of the life of the company. That will influence whether you keep or fire them. This can lead to a messy situation. If you owe a former law firm money they are a creditor just like the rest of your creditors. But if they are shareholders instead, you are still partners with them, whether you like it or not.

Attorney Ethics Rules

Attorneys are governed by a set of ethics rules. These rules are imposed on a state-by-state basis, but the rules are very similar throughout the country. I do not believe that the rules prohibit an attorney from taking an equity stake in a client company. But they do impose conditions to protect the client, and those conditions are rarely actually met.

In Washington, where I practice, there are two rules that are directly on point. They are:

Ethics Rule 1.7 Conflict of Interest; Current Clients

… a lawyer shall not represent a client if the representation involves a concurrent conflict of interest …

and

Ethics Rule 1.8 Conflict of Interest: Current Clients: Specific Rules

(a) A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest adverse to a client …

There are exceptions to these rules. Basically it is permissible to represent a client or enter into a business transaction with a client where there may be a conflict of interest, if the client is fully informed of the potential conflict and the risks involved, has an opportunity to seek independent legal counsel concerning the relationship, and agrees in writing. This rarely happens in practice. Yet the client rarely seeks independent legal counsel. It just does not feel right to pay one attorney to review an arrangement to hire another attorney for free.

If you will be giving your attorney equity instead of cash, who will put together the deal and prepare the paperwork? Usually it is the attorney you have hired. That could create major problems. If you are negotiating an equity arraignment with an attorney who negotiates equity arrangements all the time, how can you be sure you are getting a fair deal, and not being taken advantage of? Is the attorney giving you the best representation possible, or is the attorney looking out for himself? Will the attorney fully disclose the nature of the deal in a way that you can actually understand?

There is a reason why attorneys are required to take many steps if they want to enter into a potential conflict of interest situation with a client. The fact that there are many steps is a sign that the relationship has serious potential problems. The fact that the required steps are not often followed is just a further warning sign that it is best to avoid this situation all together.

There is also an ethics requirement that the attorney’s fees be reasonable (In Washington see Ethics rule 1.5). What is a reasonable amount of equity to receive from a start-up given the enormous risks involved and the large potential reward? It is usually very hard to say.

There are some lawyers who will push the rules of ethics as far as they can. There are others who try to make sure they stay within the rules. Wouldn’t you rather that your attorney was one who made sure they stayed within the rules, at least when it comes to rules that are meant to protect you, the client?

What Do You Think?

Attorneys are pretty evenly divided on whether it is appropriate to take an equity stake in a start-up client. Many start-ups like the idea, but they may not be well informed on the subject. You now know what I think. What do you think?

(My thanks to fellow Seattle attorney Mason Boswell whose comments in an on-line discussion on this issue helped me focus my thoughts on the subject.)

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Lawyer Equity – A Bad Idea (Part 1 of 2)

July 18, 2011

Paying Attorneys with Equity: the Main Problem

 Start-ups are usually short on cash. They also usually need legal help. So, it is tempting for a start-up to offer attorneys equity in the company instead of paying them cash. Many attorneys will agree to this. In fact, some will insist upon it. But it is a bad idea.

The Equity Arrangement

There are many variations on the attorney equity arrangement. The attorney can receive stock in lieu of payment. The attorney can offer a reduced rate and/or delayed payment of attorneys fees (until the next round of financing, for example) in return for equity. The attorney can obtain the right to purchase stock in the start-up at favorable rates, typically at the rate that the founders paid, or the rate of the most recent round of financing. The attorney can receive stock options instead of stock. Of course there are as many variations as there are attorneys. In any of these cases, the problems are the same.

The Main Problem – Conflict of Interest

The main problem is that if an attorney has an equity stake in the company, the attorney is no longer an unbiased professional. Attorneys are supposed to exercise independent professional judgment and offer unbiased legal advice to their clients. But the advice that the attorney gives the company may be affected by his or her ownership stake. This is called a conflict of interest – the attorney’s advice to the client may conflict with the attorney’s own personal interests. It is unrealistic to believe that the attorney will not take into account his or her personal financial interests while providing legal advice to the start-up, perhaps without even realizing that he or she is doing so.

Say that a company owes its attorney a lot of money for legal fees The company then comes to the attorney with a possible sale offer that would provide enough capital to pay the attorney’s fees. Isn’t the attorney faced with a possible bias of wanting the deal to close so he that can be paid? Would he still be expected to raise any red flags about the deal that he sees? Of course he would.

A company’s attorney should be working for and answer to the company, not to the individual shareholders of the company. Although I find that attorneys often fail to make this distinction, it is an important one to make. What is best for one shareholder may not be best for another, or for the company as a whole. (In my experience attorneys tend to favor the major shareholder, sometimes to the detriment of the company as a whole and/or to the minority shareholders.) When the attorney is one of the shareholders, who is the attorney representing – the company, the shareholders, or him or herself? The attorney should be answering to the company. The company is in turn answering to the shareholders. But if the attorney is one of the shareholders, then the attorney is in effect answering to him or herself, never a good situation.

A different perspective is to consider that the attorney who invests in the company is in essence acting as a venture capitalist. The interests of the venture capitalists are sometimes aligned with the interests of the company. but not always. For example, the venture capitalist’s interests may be very different than the company’s interests in negotiating a new round of financing, or deciding how to proceed with a company in financial distress, or dealing with a liquidation event. Often the start-up will be asking the attorney for advice dealing with venture capitalists. When the attorney’s financial interests are more aligned with the venture capitalists than with the start-up, it is impossible for the attorney to give truly unbiased advice.

There are also complex legal issues under securities laws for attorneys who own equity in their clients. That topic is beyond the scope of this article.

Having said that, I concede that attorneys taking equity would not be the only instance where an attorney would have a potential conflict with the client over money matters.

The attorney equity arrangement is somewhat similar to an attorney taking on a personal injury case on a contingency basis. Many attorneys will take large personal injury cases where instead of getting paid by the hour, the attorney gets a percentage, say 40%, of any money recovered. What if the other side makes a large settlement offer? The client asks the attorney’s opinion of whether he or she should settle. The attorney may have a bias towards taking the sure money, but is expected to advise the client on what is best for the client, not the attorney. Yet this is common practice and it is simply assumed that the attorney will always put the client’s interests first.

But I still can not shake the feeling that an attorney taking an equity stake in a company is different, and does interfere with the attorney giving his or her client unbiased professional advice. In addition to representing start-ups, I represent individual entrepreneurs in disputes with the companies they helped found. Sometimes these disputes end up in litigation. The company is usually represented by some large downtown Seattle law firm that has an equity stake in the company. I can’t help but feel that the attorneys are acting like their clients, with their clients perspective, when they should be unbiased legal professional advisors.

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A common and nasty trap for start-ups and how to avoid it – Forgetting to put founder’s IP licensing rights in writing

May 19, 2011

I said in an earlier blog that when you license technology, you should put everything in writing. Here is one trap that often gets start-ups in trouble. Founders often neglect to put licenses between themselves and their company in writing. They just assume that the company can use the technology they create. But what happens when they are no longer associated with the company? Can the company continue to use the technology? Can the founder?

We have a restaurant chain here in Washington called Ezell’s Fried Chicken. Late last year the company got in a fight with its co-founder and namesake Ezell Stephens. The headline in the local news read Founder Of Ezell’s Chicken Fired In Feud With Board.As I started reading the article I was pretty sure of what I would discover. Ezell’s the company and co-founder Ezell Stephens never had a written agreement as to who owned the Ezell trademark and their proprietary fried chicken recipe. Now they both claim ownership.

Mr. Stephens had recently started his own chain of restaurants, which he also called Ezell’s, claiming it was his name after all. And he used the same chicken recipe that Ezell’s Fried Chicken used. He claimed rights in the recipe because he had developed the recipe and it was based on an old family recipe that he had brought with him to Ezell’s Fried Chicken. (See his statement from his court filing at the end of this blog.) One can easily understand and sympathize with his emotional attachment to his own name and his own recipe.

On the other hand, Mr. Stephens stayed quiet for over 20 years while the company used the Ezell’s trademark and the Ezell family recipe. He did not object when the company applied for and obtained federal trademark registration for the marks Ezell’s Famous Chicken and Ezell’s Fried Chicken. He allowed the company to bring in outside investors. He profited from the company as an owner and an employee. Even if there were no written agreement, there had to be an implied agreement that the company owned the trademark and the recipe. Mr. Stephens allowed the other owners to invest in and work for the company all the time relying on that implied agreement.

In determining the terms of any implied contract, the court will not look at the subjective intent of the parties – what Mr. Stephens thought he was agreeing to. Rather the courts look to the objective intent of the parties – given the facts and circumstance, how would a reasonably prudent person in their situation interpret the contract. Using the objective standard, it should be clear that Mr. Stephens transferred any ownership interest he had in the intellectual property to the company.

I can understand how he feels. He lost the right to his own name and to his family recipe. But a startup is a business. He chose to make a business decision. It is too late now. He took the money. End of story.

As I write this blog, the case is still active in court. The parties are fighting over who owns the Intellectual Property rights and over several agreements that the parties had entered into. I am not privy to all of the facts of the case, and do not know the details about the agreements, but as to the intellectual property rights, I would be very surprised if Mr. Stephens prevails.

For a similar take on the Ezell trademark issue, see fellow Seattle trademark attorney Michael Atkins’ Seattle Trademark Lawyer blog entry: Ezell’s Case Illustrates Need to Decide Who Owns Mark Before Dispute Arises.

The Ezell case reminds me of a story that I have heard several times from different sources. I have not been able to verify this story on the Internet and now believe it is apocryphal (being of questionable authenticity). But it could have happened and it illustrates my point very well.

The background story is true. Gene Roddenberry created the popular television series Star Trek, which aired in the 1960’s. Years later he helped produce a sequel television series, which was called Start Trek: the Next Generation. It was very successful. The Star Trek concept was also used in a series of successful movies and several other television series. Mr. Roddenberry had married an actress who was a regular in the first Star Trek show (she played Nurse Christine Chapel.)

Mr. Roddenberry died in 1991 while the Star Trek: The Next Generation show was on the air.

Now the story goes that Mr. Roddenberry owned the intellectual property rights to the Star Trek universe. Since he was personally involved with Star Trek: The Next Generation, no one thought that the television show needed a license to use the Star Trek universe. Supposedly, his wife was resentful of Star Trek because her husband spent too much time with Star Trek and not enough with her. When he died, she inherited the rights to the Star Trek universe. She initially refused to let Star Trek: The Next Generation continue to use the Star Trek universe. Without the Star Trek rights the show would have to shut down. Supposedly she was offered more money and a major recurring role in the show and she relented and the series was saved. (She did play the role of the recurring character in-your-face Betazoid Ambassador Lwaxana Troi. She appeared in every Star Trek television series that followed as well.)

Whether true or not, and I now think probably not, the point is still valid – make sure your company has valid written licenses for all of the intellectual property it uses, even if the you the founders brought that intellectual property to the company yourself.

——————

UPDATE: On October 18, 2011 the press reported that the parties had settled. Mr. Ezell agreed to give up the restaurant name Ezell but he can keep using his fried chicken recipe.

——————

From Mr. Stephens’ Answer and Counter-claim court filing:

3.9 Upon incorporation, Ezell Stephens retained all rights to his EZELL’S FRIED CHICKEN trademark; the Logo; and his recipes, procedures, and techniques.

3.10 Ezell Stephens also retained all rights to control the use of his name, voice, signature, photograph and likeness. These rights, along with the EZELL’S FRIED CHICKEN word trademark, the Logo trademark, and Ezell Stephens’s recipes, procedures and techniques are referred to collectively herein as “Ezell Stephens’s Intellectual Property.”

3.11 Ezell Stephens allowed EFC to use Ezell Stephens’s Intellectual Property without charge as long as he was involved with the day-to-day operations of the business. It was specifically anticipated and understood that Ezell Stephens would remain as an officer and director of the company that he founded, in order that he might control the quality of the goods and services provided in connection with the Ezell Stephens’s Intellectual Property.

3.12 Ezell Stephens did not intend to execute, and does not recall ever executing an assignment of Ezell Stephens’s Intellectual Property to EFC.

3.13 Ezell Stephens never intended, and has never agreed, that EFC could use Ezell Stephens’s Intellectual Property, including his name and photograph, after he was no longer involved with EFC’s business.

3.14 There are no written agreements that authorize EFC to use Ezell Stephens’s name or photograph.

3.15 There are no written assignments of any of the Ezell Stephens’s Intellectual Property to EFC.

3.16 The oral permission from Ezell Stephens to EFC to use Ezell Stephens’s Intellectual Property was also granted with the understanding that it was non-exclusive. In particular, Ezell Stephens retains, and has always retained, the right to use his name as a trademark in connection with separate restaurant businesses. Such rights have been recognized by EFC as part of its course of dealing with Ezell Stephens.

 

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Top Ten Legal Mistakes Entrepreneurs Make (and how to avoid them)

October 27, 2010

Here are my top ten legal mistakes entrepreneurs make and how to avoid making them, based on this author’s 26 years of experience providing legal advice to entrepreneurs. The focus is on how to avoid getting into legal trouble, rather than a checklist of specific legal documents that you might need. In my experience entrepreneurs often get into trouble when they do not follow this advice.

1. Failing to conduct your business to avoid litigation.

Of paramount importance when starting and managing a new company is to avoid ending up in litigation. Litigation is a terrible way to resolve disputes. It is very expensive, and even more importantly, it takes away your mental energy. While you are in litigation win or lose, your company will suffer. Much of the rest of this top ten addresses ways to avoid litigation.

2. Failing to put it in writing.

All of your major agreements should be in writing. It may sound obvious, but there are many types of agreements that often don’t get put in writing.

When a company has only a small number of owners, there should be a written shareholder or partnership agreement among the owners. Often people will tell me that they are good friends and they don’t need an agreement. They are wrong. Friendships sour, people change, and people die. Peoples’ priorities change when money is involved. It is far easier to put that agreement in writing now while you get along with each other rather than after you are already fighting.

Often founders of a company will bring technology, valuable trademarks, or other proprietary information that they have already developed, with them into the company. After the company is formed, who owns this intellectual property? There should be a written agreement that clarifies ownership.

When you start to work for a new company, or when your company hires a new senior person, the basic terms of employment should be in writing. These terms include salary, bonuses, stock options, job responsibilities, and term of employment. If the new hire has to move to take the new job, is there a minimum period of employment? Does the company pay moving expenses? Any stock related agreements should also be in writing (see # 6 below).

3. Rushing into agreements.

Do not rush into agreements. Read all important agreements before you sign them. Have your attorney review all major documents. Too often, in the rush of making a business grow, entrepreneurs sign whatever is put in front of them, especially if it comes from someone they think they can trust, such as one of their partners or a venture capital firm. There is always time for review. You can and should look after your own interests. This does not mean that you are trying to kill the deal or be an obstructionist. Whoever drafted the contract took some time to prepare the document. You are entitled to take some time to review it and make sure it says what it is supposed to say, and treats you fairly (or at least as fairly as venture capitalists can treat entrepreneurs).

4. Not planning for the unexpected.

You may think nothing is going to go wrong. It is healthy to have that kind of optimism when starting a new company, and entrepreneurs are inherently optimistic people. You have to be to start your own company. But things do go wrong. You need to plan for the unexpected.

Go over your plan of action for your company and try to think what could go wrong and what would happen if it did. For example, what would happen if one of the founders died unexpectedly?

Anticipate that founders will have disputes. Fifty percent of all marriages end in divorce. The divorce rate among entrepreneurs is probably much higher. You may think that “even if the founders have a dispute or one of us leaves the company, we will be able to work out our differences. After all we are all reasonable intelligent people and we are friends. Nothing will come between that.” But it often does, especially when money is at stake. Plan for the unexpected now while you are still friends.

This is another reason to use attorneys. Clients rarely come back to their attorney to tell them the agreement worked exactly as planned; it is only when something goes wrong that they call their attorney. So attorneys are used to thinking about and planning for the unexpected. Your attorney can help you anticipate problems and prepare to avoid them or at least find a way to deal with them in an orderly non-litigation fashion.

5. Trusting people who say “You can trust me.”

If someone says “We don’t need the lawyers” or “We don’t need fancy contracts because you can trust me,” run, do not walk, and run away fast. Someone who can be trusted never has to say “trust me.” They have nothing to hide. They say, “Sure, we can put it in writing” and “Sure, have your lawyer review this.” and “What else do you need from me to assure you?” (For further discussion of this issue, see my blog entry Don’t Trust People Who Say You Can Trust Me.)

6. Using vague terms in agreements.

Try to use specific terms in any agreements you enter into. Watch out for vague almost meaningless terms like ‘profits’. The amount of profits in a venture is whatever the accountants want it to be. Don’t agree to giving or getting a percentage of profits, or any other subjective term. Use objective easy-to-measure terms instead, like ‘revenue’. Warner Brothers produced the highly successful Harry Potter movie series, with over a billion dollars in revenue. The company agreed to give a percentage of the profits from the movies to various people and companies. But according to the Warner Brothers accountants, these movies have not made any profit. (See STUDIO SHAME! Even Harry Potter Pic Loses Money Because Of Warner Bros’ Phony Baloney Net Profit Accounting.)

Specify stock options in detail. It is common in an offer letter that the company gives senior staff stock options worth around 3% of the company and that is all the letter says. At what price can you purchase the options? When do they vest? When do they expire?

Another vague term is ‘percentage of the company.’ What do they mean by 3% of the company; 3% of outstanding issued stock, with or without taking into account vested and unvested stock options; 3% at the time the letter is written, or at the time of vesting (after several diluting stock events) or when exercised (often after several more stock diluting events)? Be specific when offering or accepting stock or stock options.

7. Not having your own attorney.

Don’t expect venture capitalists (VCs) to look after your interests. When your company is ready to raise funds, the fund provider, usually a VC or two, will be represented by legal counsel. The VC will usually insist that the company hire a fancy law firm that has experience with corporate finance and securities. But who is representing the entrepreneur? Often, no one. You need your own independent legal counsel. You may be hesitant to hire an attorney because you do not want to kill the deal or seem like you are getting in the way. But a good attorney will look out for your interests in a way that does not hurt the company. The same is true if the company is going to be bought by another company.

But be sure to hire an attorney who is experienced in dealing with entrepreneurs and venture capitalists. Your family attorney or your friend’s divorce attorney will not be able to provide you with the counsel you need. Their poor advice will reflect back on how the VCs perceive you.

I remember reading once that the husband and wife founders of Cisco Systems, Inc. wished they had seen their own attorney before signing the documents presented to them by the venture capitalists. They say that they walked away with only 100 million dollars. (One article says before they left the company, they had also sold shares worth another 100 million dollars for a total profit of 200 million dollars.) That may not seem bad, but it is nothing compared to the billions the venture capitalists made.

Hiring your own attorney does not mean that you are causing trouble. It just means that you are looking after your own interests. I once represented an early founder who was no longer with the company, but still had a less than totally clear legal interest in the company. The company arranged to be bought by a larger company. My client was to receive very little of the sale proceeds. I stepped in on his behalf. But I made it clear that my client was not trying to kill the deal. Nor was he trying to be greedy and force the company to buy him off if they wanted the deal to happen. All he wanted was his fair share. Once the remaining founders understood that, we were able to negotiate an agreement quickly and the sale took place on schedule, and everyone was satisfied.

8. Not facing problem areas up front.

It is human nature to want to avoid conflict. There is the hope that if you delay a problem, it will go away. That does not work. The problem does not go away, it just gets worse. If there is a problem area in your future, try to deal with it now. Don’t kid yourself. The problem will come up, and if it comes up later, your options are more limited, and you are much more likely to be unable to resolve the dispute and end up in litigation, which is something you want to avoid; see #1 above.

Most startups are short on cash and on time. The founders can focus on only so many problem areas at once. Work with an experienced attorney who can help you anticipate problems and will advise you when you should take various legal steps. A good attorney will not tell you what to do–that is your job. Instead, the attorney will give you a risk assessment, tell you what kinds of problems can arise, what will happen if they do, and what you can do to prevent them. Then do not put off dealing with these issues because you think they will not happen or you can deal with them later when they do. Make sure that resolving problem areas sooner rather than later is part of your business strategy.

9. Expecting too much value in return for sweat equity.

Sweat equity is not worth much. Be aware that if you contribute sweat equity to a company, you may never be compensated. In many startups the founders forgo salary during the first year or two. They work hard for the company and expect to be compensated once the company is successful. This hard work is called sweat equity. Usually the salary accrues on the books as company debt. Meanwhile, investors have put up money and taken stock and/or stock options. Don’t expect to get paid for your sweat equity unless the company is really successful. Money always trumps sweat equity. The people who contribute the money will be able to dictate terms and will be sure that they are paid back first, before the founders are compensated for the time they have put into the company. I often see that the founders have not put their employment agreements in writing (see #2 above). Then, when the company folds and everyone is fighting over the assets, or the company is sold and everyone is fighting over the proceeds, the people who have worked hard for the company for a long time find that they are on the short end. No one wants to pay them for their past work.

Sometimes founders will avoid having to borrow money for a while and will build up accrued sweat equity compensation in the form of deferred salary and stock options. But even if you have this value on the company books, do not expect to ever see any of it. As soon as you need to raise money, the new investors will insist on erasing all of the sweat equity debt. They do not want to invest money in a company to pay for past performance. They will only want to invest in the future.

10. Failing to keep current on taxes and wages.

Timely pay the IRS and pay your employees or shut down. It is that simple. If you do not pay the IRS and some of your employees, you will probably end up personally liable for these debts.

Most entrepreneurs are optimists. They have to be to choose to be entrepreneurs. They always think that the company is on the verge of taking off and becoming successful. In many startups money is tight and gets tighter over time. Entrepreneurs have a strong temptation to forgo paying employee payroll taxes, and sometimes arrange not to pay their senior staff at all. They figure that they can make up these company obligations as soon as the product ships and sales take off. Instead they use the money that should have been spent on payroll taxes and employee wages to fund the development and marketing of the product. This is not a good idea.

Generally the company will be held liable for back taxes along with penalties and interest, and will also be liable for back wages. In many states including my home state of Washington, the company is liable for twice the amount of wages and any attorneys’ fees incurred collecting the wages. In many states including my home state of Washington, it is not a valid excuse that the company could not afford to pay the wages. If the company did not have the money to pay the employees, then the company should not have let them work and accrue wages; it should have laid them off instead.

But the real nasty surprise is that under the federal tax law, anyone who has any responsibility for writing checks and paying taxes will be held personally liable for unpaid taxes. In many states (perhaps all of them; I have not checked), these same people are also liable for unpaid wages, plus penalties and interest. I successfully represented two senior employees of a failed dot.com and obtained a large personal judgment against the founders of the company for back wages plus penalties and interest.

It is your responsibility to make sure that you do not ask people to do work that your company can not pay for. If the company does not have the money to pay wages and payroll taxes, then shut down before your employees do the work and you accrue company debt that you can and will be held personally liable for.

 Other Articles on this Subject

Here are two other good top ten lists with a different focus from my list. You may want to check them out too.

Top Ten Legal Mistakes Made by Entrepreneurs by Harvard Business School Professor Constance Bagley

Top Ten Legal Mistakes Made By Entrepreneurs, by J Mathew Lyons, Andrews Kurth, Austin, Texas

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Top Ten Intellectual Property (IP) Licensing Agreement Drafting Tips

October 1, 2010

Drafting an effective Intellectual Property (IP) Licensing Agreement is more difficult than it may seem. Here are some drafting tips to help you.

1. Draft Contract terms to avoid litigation.

Of paramount importance when drafting a contract is to avoid ending up in litigation. Draft contract terms with this goal in mind. Litigation is a terrible way to resolve disputes. It is very expensive, and even more importantly, it takes away your mental energy. While you are in litigation you will have difficulty focusing on work and on your home life. They will both suffer.

Litigation results are unpredictable and somewhat random. Lawsuits are a good way to get a final resolution of a dispute. But they are not designed to get the best possible resolution. Rather they focus on 1) getting a resolution so that both parties can go on with their lives, 2) getting that resolution in a somewhat timely manner, and 3) getting that resolution at a reasonable price to the taxpayers who end up paying the costs of running the courthouse. Litigation results are never satisfying to either party. What you often get is a vague ruling from a judge with a dollar figure attached that seems to come out of the air.

My personal opinion is that the better contract attorneys are also litigators or have been litigators in the past. They understand from first-hand experience the importance of drafting contracts to avoid litigation. [By way of full disclosure I am both a litigator and a contract attorney, so I may be biased.] Much of the rest of this top ten addresses ways to avoid litigation.

2. Put everything in writing.

All of the essential terms of your deal should be written down. A contract is a plan of action – what the parties will do for each other. Think of it as a specialized business plan. Until you put the steps of the plan in writing, it is hard to see if you have left anything out. Until you put the plan in writing, it is hard to know if you and the other side are actually talking about the same thing. People’s memories fade over time and people tend to remember agreements in their favor. But they can not argue with the written word.

Remember to put things in writing even if you are licensing IP from yourself. Many founders of companies have already created much of the IP that the company will use before the company was founded. Who owns that IP? Under what terms can the company use that IP? This should be clearly spelled out in writing.

3. Use attorneys to draft documents.

Do not try to draft complex IP contracts yourself. Experienced IP attorneys know how to draft IP contracts. They know what to include and what traps to avoid. They understand how to draft a contract that works. I have heard and seen too many horror stories of clients who do it themselves, often cutting and pasting from other licensing agreements. Several of my clients ended up in litigation because they tried to save a little money by writing the licensing agreement themselves. They did not do a very good job. When problems arose, they ended up paying me far more to solve the problem through litigation than if they had just let the attorneys write the contract in the first place.

Although I wish that you could just buy a form on-line or cut and paste from your last contract, it does not work. Imagine what would happen if your attorney tried to write a software program by cutting and pasting code from existing programs. It would be a disaster. Don’t try to do the attorney’s job with a cut and paste job either.

4. Face problem areas up front.

It is human nature to want to avoid conflict. There is the hope that if you delay a problem it will go away. But it does not work. The problem does not go away, it just gets worse. If there is a problem area between the parties, deal with it now. The time to discuss it and resolve the differences is at the beginning of the relationship. The problem will come up, and if it comes up later, your options are more limited, and you are much more likely to be unable to resolve the dispute and end up in litigation, which is something you want to avoid, see #1 above.

I negotiated a contract where the other side agreed to a contract term regarding the payment of licensing fees from existing licenses. My client knew that the actual payment according to this term would end up being over one million dollars, while the other party thought it would be around $100,000. I insisted that my client disclose this fact up front and redraft the contract term. They gave up their legal claim to one million dollars, but the other side was never going to pay that amount anyway. Instead they negotiated a fee that both sides thought was fair, and they avoided litigation

5. Plan for the unexpected.

A contract should be a plan of action. But a contract should also deal up front with what will happen if the unexpected happens. What if things do not go according to plan? How should the parties deal with the unexpected? It is far easier to come to agreement on how to deal with the unexpected at the start of the relationship then after the unexpected has already happened.

A client of mine drafted his own license agreement against my advice. He was to distribute the other party’s software. Both sides were counting on the other party releasing a major upgrade to the software shortly after the agreement was signed. My client made a major investment in setting up his business in anticipation of the major upgrade. I asked him what would happen if the major upgrade did not happen. He insisted that it would and he did not have to worry about that, and he refused to plan for the unexpected. Three years later when the upgrade had still not been released, he came back to me and we ended up litigating the issue of what happens now.

Go over your plan of action and try to think what could go wrong and what would happen if it did. This is another reason to use attorneys. We see lots of cases when things have gone wrong, and we are used to thinking that way. Clients rarely come back to their attorney to tell them the agreement worked exactly as planned. It is only when something goes wrong that they call their attorney. So attorneys are used to thinking about and planning for the unexpected.

6. Make the terms fair.

If the contract terms are fair and reasonable, you are far less likely to have a dispute. You certainly want to try to negotiate a contact that is in your favor. But if the contract terms are too one-sided in favor of one party, the other party is less likely to want to perform, and you are more likely to end up in a dispute. Do you want to be in the IP licensing business or the litigation business? If you want to be in the IP licensing business, then draft a contract with reasonable terms so that both sides are able and willing to perform. That way you are not likely to end up in litigation.

There is a difference between a contract that is a good deal for you, and one that is a totally in your favor. Many attorneys try to get the most one-sided contract that they can. They are not doing their clients any favors. They are just setting their clients up to end up in litigation.

When possible, build incentives towards compliance. Don’t just say that a new product version is due by a certain date, say that there is an extra payment if the project is done on time, and the payment goes down if the new version is late.

7. Be wary of multiple agreements and/or attachments.

Sometimes a deal consists of multiple agreements and/or an agreement with attachments and schedules. If so, then think through how they will work together. Too often the agreements are negotiated as separate contracts even though together they constitute one deal. Attachments are often added as an afterthought, after the negotiations are finished. Do all of the documents make sense together? Are they consistent? What happens if one of the deals falls apart, and the others do not? One way to avoid potential problems is to make separate deals that stand on their own whenever possible.

I had a client who wanted to sell her IP to another company. She got a small lump sum payment and a favorable employment agreement with the new company, with salary bonuses tied to the success of the IP. She considered her new job to be part of the compensation for selling the IP. I told her that these deals did not work well together. She should sell the IP for what it is worth, and sign an employment agreement for what she is worth. She did not take my advice. She did not last long at the new company, and is now suing them to them to get her IP back.

8. Say it in plain English.

There is no need for a contract to use secret lawyer language that no one else can understand. Say it in plain English. If you don’t know what it means, ask. There are plenty of times when I read something prepared by an attorney, and I have no idea what it means, so I ask them to rewrite it.

Define technical terms, even if the parties know what they mean. It is fine to use acronyms, abbreviations, and initials in an early draft of a contract. But the final version of the contract should make sense to anyone, not just those in the know. First, there is less agreement on those shorthand terms than you may realize. Second, if there is a disagreement about the contract, the legal standard is what it would mean objectively to a normal person reading the contract, not what it means to the tech people. You never know who will be reading the agreement and trying to understand how it works. Remember that if you end up in litigation the ultimate arbiter will be a Judge, and most Judges have very limited technical knowledge.

The clearer a document is, the more likely both sides will understand it, and the more likely both sides will be able to honor the terms of the contract, and the less likely that there will be misunderstandings and litigation.

9. Make sure you are agreeing to the same terms.

When you think you have finished negotiating and you have come to an agreement, make sure you and the other party have agreed to the same terms. In the very old days, invoices and purchase agreements would fly back and forth by mail or personal delivery. A while back faxes would fly back and forth. Today it is usually emails and email attachments. It is very easy to think you have agreed to the same terms, when you are actually each referring to a different version of the contract. This type of misunderstanding happens more often than you might think. Make sure that you know what version you are agreeing to. When you think you have an agreement, pull all the contract terms together in one document and make it clear that this is the version you are all agreeing to.

10. Make sure the contract fits your particular needs.

      Keep in mind what you are trying to accomplish with your new agreement. Too often clients and their attorneys jump right in and start to write the standard contract, whether it fits what the client needs or not. I always try to start with asking my client “what are trying to accomplish here?” Then I draft a contract that fits the client’s needs.

There are times when a creative solution is better than that standard boilerplate. My favorite example is a telephone company with commercial clients. The telephone company would often end up in billing disputes over $3,000 to $5,000 dollars with its customers. This was not enough money to justify litigation. Besides, the company did not want to alienate its customers. So the telephone company wrote into its contract that there was mandatory arbitration of billing disputes. The result of the arbitration was only binding on the telephone company. If the customer did not like the result, the customer could still file a lawsuit. The customers were more than willing to go along with this contract term. It turned out that customers rarely took their claims to court even when they lost. The client really just wanted to have a voice, a chance to have their say. The telephone company had a fast and inexpensive way to resolve its dispute and keep its customers satisfied.

Write a contract that is easy to understand, fits your needs, is reasonably fair to both sides, and is likely to avoid litigation.

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How much proprietary technology information can employees take with them from one company to another? [Case Study: HP v. Oracle]

September 20, 2010

When a high-level employee leaves one high-tech company for another, how much proprietary technology information can he take with him? Actually, quite a lot.

In a case from the current news, Hewlett-Packard Co. (HP) filed a lawsuit against its former CEO Mark Hurd on September 7, 2010. Hurd was forced out of HP recently due to allegations of improper claims on expense reports and a sexual-harassment investigation. He was given a separation package worth up to $40 million. A month later he joined one of HP’s rivals, Oracle. HP claims that he can not possibly perform his job at Oracle without revealing HP’s proprietary technology information to Oracle. He also appears to be in clear violation of the written terms of his separation agreement which prohibits him from working for a competitor.

The law appears to be squarely on HP’s side. An employee is free to take general knowledge with him when he leaves a company, along with any job skills he has developed. But he can not take information that was unique to his job and was treated as proprietary information. Often it is hard to draw a distinction between what is protectable information and what is not. In this case, it seems pretty clear. Hurd helped develop HP’s strategy on how to compete with Oracle. He also had detailed knowledge of HP’s products. This information should be proprietary.

Hurd did not just walk away from HP. He took a large separation package with him and signed a written agreement. His written agreement clearly states that for a period of twenty-four months after separation, he “will not provide services to a competitor that would involve conflicting business activities.” He seems to be in clear violation of his separation agreement.

(At least for now, HP’s complaint, along with the exhibits that consist of the contracts he agreed to, is available here.)

But Hurd probably still has the upper hand. Courts are very reluctant to keep employees from working in their chosen field. This policy makes sense when the employee is the little guy fighting against the big corporation. But in this case, Hurd is hardly suffering by having to forgo work for two years in return for about $40 million. That is a deal most of us would be very happy with. But judges can not really comprehend that kind of money. And they do not want to have to say that some employees are entitled to protection, and some are not. Where would they draw the line? A judge will probably treat Hurd the same way the judge treats other employees and just give him a slap on the wrist. The court is likely to say that while at Oracle, Hurd can not work on matters that are designed to compete with HP. That order will be mostly for show. How could anyone possibly enforce that order? Will HP be allowed to post one of its employees in Oracle’s executive washrooms? Of course not.

And HP can hardly claim to be the innocent victim. Just last year for example, HP did the same thing it is now claiming that Oracle has done. It hired away data storage chief David Donatelli from competitor EMC. EMC sued and this case was quickly resolved in court. The court allowed Donatellit to go to work for HP but barred him from working on data storage matters for one year. Anything HP said in that lawsuit in defense of hiring Donatelli can and will be used against it in a court of law by Oracle.

If a court wants to side partially with HP, it can order Hurd not to work for Oracle for say six months. That would be considerably less that the 24 months that Hurd originally agreed to. But this might be an effective approach. In the fast moving high-tech industry, how much information is really valuable after six months?

I am surprised that HP did not try to sue Oracle as well for what we lawyers call intentional interference with a business relationship or expectancy. Oracle induced Hurd to break his contract with HP. Hurd promised HP he would not work for a competitor and would not reveal HP’s secrets. Oracle induced him to come work for them, a competitor of HP, and it is hard to imagine that the executives at Oracle are not interested in finding out what Hurd knows about HP’s internal strategy and other proprietary information. Oracle interfered with HP’s contractual business relationship with Hurd.

This type of claim was used very successfully against news outlets and other companies that tried to get former tobacco company employees to expose the lies their bosses told about the health risk of cigarettes. The most famous case involved the prime time TV news show 60 Minutes. In 1993 a tobacco company fired one of its research scientists. He had been claiming within the company that nicotine is addictive and that the tobacco companies were intentionally trying to make their cigarettes even more addictive through the use of additives. He had signed a non-disclosure agreement with the tobacco company that prohibited him from revealing its propriety information. Shortly after he was fired, executives of the major tobacco companies testified before Congress that nicotine is not addictive. The scientist wanted to tell his story on 60 Minutes. The show was glad to have him. Shortly before the segment was to air, the tobacco company threatened to sue CBS, the owner of the show, for interference with its business relationship with the scientist. CBS backed down and ordered 60 Minutes to heavily edit the proposed segment.

Practice Tip: If you are the company hiring the ex–employee you should be very careful, especially if you are a small company that can not afford a major legal battle. Learn what separation agreement he or she has with the former employer and if you encourage the new hire to breach that agreement you do so at your own risk.

The most extreme case that I can remember of an employee leaving one high-tech company for another and taking propriety information with him was the Borland-Symantec case. In late 1992 Eugene Wang, a vice president of Borland’s computer languages division, left Borland to go to work in a similar capacity for competitor Symantec. Borland claimed he took its proprietary information with him. He denied the claim. Then Borland examined his work computer and discovered about a dozen emails that Wang had sent to Symantec CEO Gordon Eubanks in the days before resigning from Borland. Wang discussed the secrets he would share with Eubanks. Along with these emails Wang had sent a number of internal Borland documents that were labeled “Borland Confidential”. You can not get more blatant proof than that.

Based on these emails, Borland was able to convince the police to seize Wang’s personal computers from his home. On these computers they found even more incriminating evidence. Much of this evidence had been erased. But the police were able to un-erase the files using one of Symantec’s most popular products of the time, Norton Utilities. Wang does not come across as a very sophisticated computer expert.

So what happened? Nothing. Borland sued Wang and Symantec of course. Wang and Eubanks were indicted on criminal charges of conspiracy, trade secret violation and receiving stolen property. Many years later the criminal charges were dropped. About seven years after the civil case was filed, the parties settled. It appears that they just dropped the lawsuit completely. By that time many of Borland’s witnesses now worked for Symantec, and many of Symantec’s witnesses now worked for Borland. Wang only stayed with Symantec for three yeas and was long gone. And the information he had taken with him from Borland had long ago lost any value.

Executives change companies all of the time. And they take with them whatever knowledge they have been exposed to. And it is nearly impossible to stop them.

These comments apply only to situations where a high-level employee leaves one existing company for another. Things are a little different when the high-level employee leaves a company to start a new company. I hope to address that situation in a future blog.

UPDATE: Just as I was about to post this blog, HP announced that it had settled with Hurd. The details are not entirely clear yet, but it appears that Hurd can work for Oracle, and he promises not to reveal any of HP’s secrets but there are no specific restrictions on his employment. Hurd also retains the approximately $10 million in cash he received in his severance package but gives up his claim to about $30 million in HP stock that was also in his severance package. This seems like a good practical solution to the problem.

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Our Vanishing Right of Privacy

September 14, 2010

An issue came up recently where a man was upset that people in his condominium complex were using the pool and Jacuzzi late at night. He wanted to take pictures of their activities to document their behavior in his complaint to the condo board. Can he do that?

The law recognizes a limited right to prevent other individuals from invading your privacy. There is a legal doctrine that there is no right of privacy for activities that are conducting in “open view.” If this person can see the activity from a window of his condo with an ordinary camera, I do not think there is any reasonable expectation of privacy. What if he can not see them from his window, but he can walk right up to them in a common area open to all condo owners. Is that still an “open view”? Does it matter what they are doing? Is there a difference between a group of friends just partying, and a couple making love? I would not think so.

My favorite case on this subject comes from the Woodstock movie. For those of us old enough to remember, in the movie about the original Woodstock festival there is a scene where a man and a woman are running through a field of tall grass, peeling off all of their clothes, and falling down together presumably to make love. One of the stage cameras had been turned around and the operator used his high powered zoom to capture this scene which actually took place behind and far from the stage in a field where no one else was around.

Well it turns out that a man had gone to the Woodstock festival but his wife could not make it. He came home and raved to her about how wonderful the festival was. When the movie about the festival came out he insisted that they go see it together. There they were sitting in the movie theater watching the movie when up popped the image of him running through the field with some other young woman. The wife divorced him. He sued the movie producers. The court held that he had no expectation of privacy. There may have been some anti-hippie bias in that ruling.

Back to our example with the condo person. What if he had to use special equipment, a high powered zoom lens or some special night vision lens to take his pictures. Would that matter? The answer is not clear.

In a more recent case, actress Jennifer Aniston was sunbathing topless in her own backyard surrounded by a fence. A photographer standing on the public sidewalk found that if he stood  in one particular spot, using a high powered zoom lens, he was able to get a picture of her which he intended to sell to some sleazy magazine. She threatened to sue. I believe he backed down and withdrew the picture. But it would have made for an interesting case.

Nowadays, satellite images are readily available on any personal computer. For example, many aerial details can be seen by using Google Maps. Does that change our reasonable expectation of privacy? An environmental group took a series of aerial photographs of the California coast, including the yard and house belonging to Barbra Streisand. She had chosen to live in a house set far back from the highway to maintain her privacy. She sued for invasion of privacy (and other claims) and lost. That type of photography is now readily available in Google Maps. Does that mean that we no longer have any right to privacy in our backyards?

That is why I love this area of law. There are no clear rules. And with advances in technology, the law is constantly changing. One of the effects is that the amount of our lives that is protected by the right of privacy is constantly shrinking. What do you think?

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Don’t Trust People Who Say You Can Trust Me

September 11, 2010

I am preparing a list of my version of ‘the top ten mistakes entrepreneurs make’ for a later blog entry. The very first piece of advice is do not trust people who say you can trust me. In my experience, if someone says to you “You can trust me”, you should run away from them as fast as you can. Otherwise, you may end up with legal problems.

 People who can really be trusted do not have to say “You can trust me.” They say “You can trust me, and I will prove it to you. You want me to put it in writing, sure. You want references, sure. You want to talk to your attorney first, sure. No problem. What else do you need? I have nothing to hide.”

 But a person who is just saying “you can trust me” does not mean it. If they come up with an excuse not to put it in writing, there is a reason. They do not want you to know what they intend to do, or they want the option of changing the deal later, in their favor of course.

 A variation on the same theme is the statement “We don’t need lawyers”, or “I hate lawyers, let’s not waste our money on them.” True, there are plenty of bad lawyers who will make deals far more complicated than they need to be or even kill a good deal over minor legal concerns. But a blanket refusal to use lawyers usually has a bad reason behind it. The person making the claim does not want his deal examined too closely. Again, they probably do not want you to know what they intend to do, or they want the option of changing the deal later, in their favor of course. And they know involving lawyers will force them to put their intentions in writing and have their intentions examined by a third party.

Another variation is “We don’t have time to put it in writing. You can trust me. Let’s just proceed.” It is rarely the case that this is true. Usually it is just a negotiating tactic. It is a way of putting pressure on you to not put the deal in writing. Insist that there is time. If the deal is worth doing, it is worth doing right. And it is worth putting in writing.

 Once in a while, there is a valid reason to trust someone and not to put something in writing, but even then, it is not a good idea. I had a client who wrote a book with another person. The other person had agreed that he would write material that my client could use in her book and she would pay him half of the royalties. He was a very respected elder American Indian. He would not put their agreement in writing. He said that his word was his bond. This feeling came from a long tradition. So she agreed. He died before the book was published and his heirs, who then owned his property, including his writings, tried to stop the publication of the book, claiming there had been no deal. She had a major problem proving that he had wanted her to use his writings. Her problem could have been prevented if instead of trusting him, she had insisted on putting their deal in writing. Even if you really think you can trust the person, don’t. Get more information, put it in writing, and when it is about something that really matters, have your attorney look it over too.

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Hello world!

September 10, 2010

Welcome to my blog, Marshall2Law. In this blog I will be commenting on issues involving law, business, the Internet, society, and social responsibility.  My primary target audience is socially conscious business entrepreneurs. Entries will range from business and legal tips to brief insights into major social issues. I welcome comments, suggestions and an open discussion. You can also find my blog on facebook at Law Offices of Gary Marshall.

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