Emerging Enterprise Center Blog : Boston Startup Lawyer & Attorney : Foley Hoag Law Firm : Startup Financing, Venture Capital

Sim Simeonov has a great post on founder agreements, which I have noted before. One of the classic issues (terminating an agreement with a "co-founder") came up for one of my clients last week. I was surprised that it was the first time for this particular client because it seems to me to be almost an obligation on the part of start up clients that they make clear promises to pay (money and equity) to people they heartily believe will perform some much needed function, write some much needed code, obtain much needed financing – whatever, and those people don’t perform but nonetheless seem to think they should be paid in full.

Outrage is the first reaction-- "I am not going to pay that SOB…" I sympathize, but legal action is not a solution. (It is like taking an overdose of chemotherapy.) You are a start up. The distraction and the cost are rarely worth it. Ignoring it is not the solution either. (Best case, you are going to have to explain the potential dispute to some investor. Worst case, it could cloud your IP rights (do you really own your software?). I promise it wont go away.)

In the end we negotiate these things away (almost always). While I don’t think this problem (the nonperforming co-founder or consultant or early hire) ever totally goes away, I think you can help yourself by being very clear about performance expectations up front. (You get paid against delivery; you vest upon delivery etc.) You can also help yourself by careful hiring. In the end, though, I am hard pressed to think of a start up client that has not hit that speed bump.

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Despite all the talk in the legal world about forms, and there is a lot of it, and despite the great success of the NVCA Series A documents project originally inspired by Sarah Reed, it took Fred Wilson’s recent blog post to create some interesting back and forth commentary on seed forms.

Good forms are a wonderful thing. They can save tons of time and cost – each of which is in short supply for early stage entrepreneurs. Now, not every shoe fits every foot, and sometimes work is needed and is appropriate.

At the risk of stating the obvious, if you are raising $400,000 (let alone a smaller amount) and you spend $20K on your counsel and $20K on investor’s counsel, you’ve blown 10% of your money right there. (Remember, you are also giving away a pile of equity to get that money in the door.) This is really expensive capital. Creativity and clever negotiating have a price.

Having said all that, I think it was T.S. Eliot who said with respect to literary criticism that "The only method is to be very intelligent." At some level, the same applies to your legal dealings. Forms are great, but they must be used thoughtfully.

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Yesterday’s WSJ carried a story about a legal skirmish between Google and, as the story implied, Microsoft.  IT Business Edge also has a post on this topic. The background is that Google was pursing a collection action against a small company in Ohio, I think, for about $350K. Apparently, Google filed a "normal" collection action, but the defendant hired a well known antitrust litigator from the Washington office of the venerable New York based law firm of Cadwalader, Wickersham & Taft. This fellow, and his firm, have Mircrosoft as an important client. The thing that rightly caught WSJ’s eye is that no one would ever hire Cadwalader to defend a collection case (certainly not one in which $350K is at issue). Cadwalader, on behalf of their client, counter attacked with a bunch of antitrust claims. Of course I think it is interesting that these two titans of the tech world are engaging in legal skirmishes. But the point I want to make here is more akin to the WSJ’s initial insight. Cadwalader will burn way more than $350K if this "collection" case goes to trial. This type of litigation is the sport of kings.

Most (all?) startups do not fit that category. I recall a litigation between two founders related to stock ownership, handled, on behalf of one founder, by my firm. The two hated each other to the point where there was no settling the matter, and it went all the way through trial. The cost, on our side, was in excess of $250K. Even modest litigations with small amounts at issue will run up costs that can far outweigh the benefits to any party.

Also, by the way, no investor wants to see his or her money frittered away in pursuit of a litigation. If the prospect for litigation is high, then prospect for obtaining new financing is correspondingly low. I am actually aware of one industry segment, in which a reasonably well funded company is pursuing a policy of suing all other players – including new entrants – for patent infringement. The merits of their position is unclear to me, but the fact of their strategy has made it impossible, as a practical matter, for companies with related technologies to get financing in New England.

Another thing to note about litigation, that is, apparently, true of the Google case I began with, is that once you start the process you can’t unilaterally undo it. Why? Because the adverse party will inevitably bring counterclaims. In Google’s case they initiated a simple collection case and are now stuck in an antitrust case. If you sue your co-founder he or she may counterclaim. If you then drop your claim, you will still be stuck defending the counterclaim.

My larger point here is that litigation can be a self-inflicted wound that kills your company. Litigation does have its place, but don’t think that even a seemingly great claim is as strong as it sounds.

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I can’t recall being asked about whether and how to maintain confidentiality of business plans and other information when interviewing possible attorneys whom one might want to retain until very recently, but I have been able to tell from my interactions with potential clients that may of them worry about what is OK to tell the attorney they are interviewing (and might or might not hire). 

Attorneys, as a general matter, have a professional responsibility to keep such information confidential, and reputable attorneys will abide by these rules. Having said that, not all attorneys always meet this standard, so don't take a risk that you don't need to. 

I don't think you need to get very deep into details of your business plan at an initial meeting with an attorney, and, in general, I would advise you not to. Also, don't leave a copy of the plan or your slide deck or other materials that contain sensitive information with any attorney, until you have selected one to work with and he or she has agreed to represent you. 

A general high level description of your business should suffice for the initial meeting. Once you have entered into a formal attorney/client relationship, the matter is different. Once you are in a formal relationship, you should be able to rely on your attorney's duty to keep client information confidential. Attorney's typically do not sign NDAs, and I would not ask for one.

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Sim Simeonov has a nice post on the subject of what is the best option vesting schedule. Options are a topic that has received a lot of attention in the blogosphere. A while back there was a lengthy discussion of options on Fred Wilson’s blog that, as I recall revolved around the need to think of option grants as percentages of the equity of the issuer (rather than in numbers of shares.  The EEC blog has many posts on options (and the related topic of restricted stock). All these posts tend to focus on some discrete aspect of options that came up in the author’s business. For a more general discussion, you can go to the Emerging Enterprise Center web site under "Ask the Start-up Lawyer." There you will find a general overview of the basics.

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My last post concerning structuring to meet the needs of your financing sources, has led me to think about how to handle contracts. Businesspeople are often willing to go “skinny”. That is to say they are willing to live with contracts that are not comprehensive or rigorous. They often rely on relationships and accepted business practices (or simply trust). In many ways, this is what makes the world go around. The mere creation of a thorough carefully drawn contract that covers every (almost every) contingency and the negotiation that implies may itself be an impediment to doing business. 

A lot of the time the sales guy writes up the contract, the CFO signs off on it and the world rumbles on. If the relationship works and no third party ever has to look at it – you are fine. But, what happens when a third party gets involved. I am thinking particularly about what happens when you go to sell the business and the buyer is a Fortune 50 company (or even a Fortune 2000 company) that does not have a strong “personal” relationship with your counterparty? Or, what happens if you go to a financing source such as a name brand VC?

Family businesses (and my family used to have one, so I know) can operate at a level of informality that venture financed businesses just can’t ever get to. When IBM (or any other large buyer of companies) acquires your business, they want (need) to know that they will be inheriting the vendor and customer relationships. Assuring IBM that you and your customer have an understanding and are very simpatico just wont cut it. 

VCs get this, and they expect their portfolio companies to be set up for an exit. That means that informal arrangements (perhaps except for immaterial matters) are just not acceptable because they diminish the marketability of the portfolio company. If you are planning to get VC funding, you should assume that the VC will review your contracts (at the very least all the important ones) and a company with a squishy key contract may not be financeable (at least without an amendment to the contract).

Consider having to go from the easy squishy contract to the level of definition and tightness that IBM (or any other similar buyer) or a VC proposing a financing will want, under the pressure of a pending exit or pending financing. Your bargaining power just went out the window and your good will with the customer or vendor just went down the tubes. The moral to the story is that an ounce (or a several ounces actually) of prevention is better than an pound of cure.

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I once sat in on a meeting between a public company client and an investment banker, from whom the client wanted an underwritten offering. At one point in the conversation the CEO of my client said something like, “We intend to structure our business in accordance with the requirements of Wall Street.” Nobody twitched. But this is not going to be a post on the absurdity of taking unsound actions to appease Wall Street, it is a post about being realistic about how you cater to your financing sources. 

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David Wessel’s recent article in the Journal, “A Prozac Economy has its Costs,” asks: If we were able to invent the economic equivalent of Prozac – something that would take away the high-highs and the low-lows of our current economy (think the tech bubble of the late 90’s and the current recession) – would we elect for a prescription? Would we, given the choice between a dynamic, volatile economy with painful depressive phases, and a more mellow economy with fewer crises but a slower growth rate over the long term than its manic doppelganger, settle for a calmer existence? Though my understanding of economics is limited to my college-level macro and micro courses, from an entrepreneur’s and VC’s point of view, I think my answer would be: give me manic any day.

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Entrepreneurs are risk takers; lawyers risk managers. An inherent tension exists. Take too much risk or over-manage the risk and the results can range from unsatisfactory to disastrous. However, in every venture, there are manageable risks and uncontrollable risks. The trick is to realize which is which and deal with them accordingly. I have met some smart, innovative first-time entrepreneurs with thought-provoking business plans that illustrate foresight and a nuanced understanding of market forces. However, more often than not, these very same entrepreneurs are more than willing to lump all their risks in the “uncontrollable” category.

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There is an endless amount of advice on the subject of board composition out there, but the reality for venture financed companies and pre-venture companies is very different. The archetypal situation for venture financed companies is for each VC to have a seat on the board, the CEO to have a seat and perhaps one outside industry person. As successive rounds pile up, more VCs are added to the board. You can like it or not like it. You can think it is good or bad to have one or four VCs on your board. You can argue that you get the same input from all of them – so why hear it four times? But, in the end, they typically have big buck on the line; they own big portions of the business; and they have a right to be represented.

Having said that, with respect to companies that have not yet gotten venture financing, who you have on the board becomes more interesting, in part because you may have more flexibility. Sometimes if there is a large angel investor, this person goes on the board. Sometimes if there has been a financing raised from several accredited investors, the lead, or largest, investor goes on the board. But these are situations in which a majority of the Company is still owned by the founders. The founders can, and should, expect to be a majority of the board.

Also, in this circumstance, you may have more room to bring in outsiders than in the archetypal VC situation. In this case you can do more than just pay lip service to the idea that a board member should bring some expertise, contacts or other value to the board. It is great when you can find such a person. However, experience shows that big time industry luminaries are busy people. Even if you can get one on your board, you are not likely to get much bandwidth from him or her. Their big value add will be their name on the team slide in your deck. Frankly, I think this is a very overvalued contribution.

The best board members I have observed on early stage company boards have been successful industry players who do not fit the description of industry luminary. These folks typically do the job because they are older and more experienced than the entrepreneur and they like to mentor or because they get the vision and are believers in the business thesis or they have some other reason why they are willing to focus and give the entrepreneur time and energy. The ones who will really contribute are the ones you want. Choose wisely because you don’t have a lot of slots and you need to make progress.

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To follow up on comments on my post of a couple days ago and based solely upon our published numbers (which does not include all the transaction that we track),  77% of Series A investments tracked by us used the NVCA forms and 22% did not.   If I add unpublished data the adoption rate is slightly higher.  With respect to Series B and later stage investmens based solely upon our published numbers, 58% of transactions used the NVCA forms and 42% did not.  Again, if I add unpublished data the adoption rate becomes slightly higher.

The increase from 58% of Series B and later stage transactions to 77% of Series A transactions suggests that, at least in New England, the NVCA forms are gaining increasing acceptance. 

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Let’s start with an assumption: You are forming a company with the intention of obtaining venture financing within a year. (I will hold aside the probability of such a thing actually occurring.) If you followed my posts on Delaware franchise tax and par value you know that the number of shares you pick can affect your franchise tax – but it is not likely to have much of an effect if you use the so-called alternative calculation. Let’s also be clear with one definition. "Authorized shares" are all the shares a company may issue – not just the ones that are issued and not just the ones that are not issued. "Authorized shares" are all the shares.

One approach to the issue of how many shares could be to pick a number that kinda – sorta – looks like what you might have in the case of a venture financing. That might be something like ten million. When you have a large number of authorized shares, you can have a large number of issued shares and a large number of options.

Another approach might be to pick a small number to minimize franchise tax (under the basic calculation) and deal with changing later when you get financing. BTW, making a change in the authorized shares early in the life of a company is very straight forward. A stock split authorized by the holders of a majority of the shares is all that is needed.

Different strokes for different folks, but despite the fact that what is important is the percentage and not the number of shares, it sounds chintzy to give a new employee an option to buy one share – compared to, say, an option to buy 100,000 shares. Perception has a value. For this reason, despite the fact that it has no substantive effect on anything, most of my clients pick big numbers for authorized shares.

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When forming a company, you always have to pick a "par value" for the stock. If you read my post on Delaware franchise tax, you know that par value can affect the amount of tax you pay in Delaware. For this reason alone, you want to keep it low. This is why par value in venture financed companies is typically set a t $.001 (sometimes it is $.01 or $.0001). Beyond that, what is par value and why does anybody care?

In ancient times (long before I started practicing law) par value was the price below which an issuer agreed not to sell stock. This limitation provided purchasers some assurance that future investors would not be offered better terms than they got. Of course, if par value is $.01 or, better yet, $.001, this is not much of an assurance. So this function of par value is no longer of any importance. However, it does live on in corporate law. For example, stock that is issued for less than par value is referred to as "watered stock" and is not likely to be "duly and validly issued fully paid and non-assessable," an opinion that lawyers are required to give in connection with many transactions.

So, why not just go to no par stock? The reason is that under Delaware law, the directors must set the "stated" value of no par stock, and this "stated value" serves the same purpose as par, but it put a burden and responsibility on Directors that they don’t have if you just pick a really low par value. And, if that is not reason enough, giving the legal opinion noted above for no par stock requires that the attorney ascertain the stated value – just one more thing to do.

All in all, if you read this post, you have spent more time on par value than you should. Pick a really low number and go with it.

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That annual statement from Delaware is always a heart stopping experience. Clients often get statements indicating a franchise tax bill in the many tens of thousands. This is because when Delaware sends out their invoice, they calculate the amount owed based upon the number of shares authorized. But, there is an alternative calculation based upon gross asset value, that is very likely to lead to a much lower number. Below is what the Delaware Secretary of State has to say about calculating franchise tax.

HOW TO CALCULATE FRANCHISE TAXES

A domestic stock for profit corporation incorporated in the State of Delaware is required to pay annual franchise tax.  The minimum tax is $75.00 with a maximum tax of $180,000.00.  Corporations owing $5,000.00 or more make estimated payments with 40% due June 1st, 20% due by September 1st, 20% due by December 1st, and the remainder due March 1st.

The Annual Franchise Tax assessment is based on the authorized shares. Use the method that results in the lesser tax. The total tax will never be less than $75.00 or more than $180,000.00.

Authorized Shares Method

For corporations having no par value stock the authorized shares method will always result in the lesser tax.

·         5,000 shares or less (minimum tax) $75.00

·         5,001 - 10,000 shares - $150.00

·         each additional 10,000 shares or portion thereof add $75.00

·         maximum annual tax is $180,000.00

For Example

A corporation with 10,005 shares  authorized pays $225.00 ($150.00 plus $75.00)
A corporation with 100,000 shares authorized pays $825.00 ($150.00 plus $675.00[$75.00 x 9])

Assumed Par Value Capital Method

To use this method, you must give figures for all issued shares (including treasury shares) and total gross assets in the spaces provided in your Annual Franchise Tax Report.  Total Gross Assets shall be those "total assets" reported on the U.S. Form 1120, Schedule L (Federal Return) relative to the company's fiscal year ending the calendar year of the report.  The tax rate under this method is $350.00 per million or portion of a million.  If the assumed par value capital is less than $1,000,000, the tax is calculated by dividing the assumed par value capital by $1,000,000 then multiplying that result by $350.00.  

The example cited below is for a corporation having 1,000,000 shares of stock with a par value of $1.00 and 250,000 shares of stock with a par value of $5.00 , gross assets of $1,000,000.00 and issued shares totaling 485,000.

1.      Divide your total gross assets by your total issued shares carrying to 6 decimal places.  The result is your "assumed par".

Example: $1,000,000 assets, 485,000 issued shares = $2.061856 assumed par.

2.      Multiply the assumed par by the number of authorized shares having a par value of less than the assumed par.

Example: $2.061856 assumed par s 1,000,000 shares = $2,061,856.

3.      Multiply the number of authorized shares with a par value greater than the assumed par by their respective par value.

Example: 250,000 shares s $5.00 par value = $1,250,000

 

4.      Add the results of #2 and #3 above.  The result is your assumed par value capital.

Example:  $2,061,856 plus $1,250,000 = $3,311 956 assumed par value capital.

5.      Figure your tax by dividing the assumed par value capital, rounded up to the next million if it is over $1,000,000, by 1,000,000 and then multiply by $350.00.

Example: 4 x $350.00 = $1,400.00

NOTE: If an amendment changing your stock or par value was filed with the Division of Corporations during the year, issued shares and total gross assets within 30 days of the amendment must be given for each portion of the year during which each distinct authorized amount of capital stock or par value was in effect.  The tax is then prorated for each portion of the year dividing the number of days the stock/par value was in effect by 365 days (366 leap year), then multiplying this result by the tax calculated for that portion of the year.  The total tax for the year is the sum of all the prorated taxes for each portion of the year.

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Anyone who has hung around the tech community in Boston, knows that foreign nationals play a huge role in this ecosystem.   So it is worth focusing on some of the issues that are particular to foreign nationals.  Pritvi Tanwar of our firm has the following to say on this topic:

The New England Area and Boston in particular, through its universities and companies, attracts outstanding talent from around the world. It is no surprise then that many international students and other nonimmigrants go on to found or be founding members of companies in and around the Route 128 area. Starting a company as a foreign national in nonimmigrant status (a “Foreign National”) presents certain challenges and below are a few issues to be aware of:

1) Entity Choice – Many start-ups with two or more founders usually choose to incorporate as S-Corporations to benefit from the pass-through tax status of a partnership while still getting the limited liability protection afforded to corporations. However, all the shareholders of an S-Corporation must be citizens or permanent residents of the United States. This precludes the S-Corporation choice for start-ups where any of the founding members are Foreign Nationals. Also precluded are companies that plan to bring on Foreign Nationals in the early stages that they plan to pay with equity in the form of stock options. The logical choice for start-ups facing these challenges is a C-Corporation. Though this entity choice presents a double taxation issue, most technology start-ups are not profitable in the initial stages and any tax liability at the initial stages is usually minimal or non-existent. In addition, most VCs and investors will require any S-Corporation they fund to convert to a C-Corporation due to tax reasons (a topic for a different day). Hence, if you believe that your company fits the VC model of investment and you plan on approaching VCs for funding down the line you might be better off choosing the C-Corporation entity structure today.

2) Payment Schedules & Vesting – Another issue that often comes up for start-up founders and employees who are Foreign Nationals is the issue of employment. The U.S. Citizenship and Immigration Services’ (the “USCIS”) position is that “working” (i.e. providing services for compensation) without the requisite authorization violates the terms of the individual’s nonimmigrant visa and is potentially grounds for termination of the visa. Although the granting of founder’s stock at the inception of a company may not amount to “compensation”, the problem arises upon the vesting of any stock contingent on the founder or employee continuing to provide certain services to the company. The USCIS may interpret this as a situation where the individual is “working” and violating the terms of his or her nonimmigrant visa. Granted, this is gray area and this author does not know of any case where the USCIS has enforced a violation where the vesting of stock has been subject to an employee’s continued contribution to a start-up company, but it is a risk to be aware of and mitigate in the event that the USCIS changes its enforcement policy. Potential precautionary measures are entirely dependent on the individual factors of your start-up, the amount of risk you are willing to take and the enforcement policies of the USCIS – excellent reasons for you to have a three-way conversation with your start-up lawyer and an experienced immigration law attorney.

3) Enforceability of NDAs and Assignment Clauses - Your co-founder and/or founding employee might one day decide to head back to their home country for personal or business reasons. Departing with them could be your start-up idea and possibly detailed knowledge of the technology that you are implementing. You probably already have NDAs with the relevant IP assignment clauses executed by all the founders and employees – but are these enforceable in a foreign country? Not if the governing law is based in the United States. Making your NDAs applicable in foreign jurisdictions is complicated and expensive and perhaps not the best use of resources for a cash-starved start-up. One possible approach to this scenario is to postpone this process until your start-up’s business and technology grows to the point where you are undermining yourself by not addressing the risks presented in your particular case. Also, keep in mind that actual enforcement in some countries can be a logistical and financial nightmare. Once again, there is no one-size-fits-all answer and a discussion with you start-up counsel is the best starting point to understanding the risks that your start-up faces.

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There are certain questions that I get over and over again. One of them is “Why shouldn’t I just use one of the many internet services to incorporate? It’s cheap; it’s easy…” Well, it turns out that there is a reason. First, let me note that you can get a perfectly effective incorporation over the internet. If you use one of the many services, you will actually have a company and you can get the benefits of incorporation. For many purposes it will serve just fine. Having said that, in each case where I have had occasion to review one of these incorporations, there has been an issue of one form or another. One example of an issue that seems to arise with some frequency is that the certificate of incorporation does not contain certain optional provisions (indemnification and exculpation of officers and directors) that under some circumstances can have real value. (For the sake of clarity (a phrase after which you know something completely opaque is about to be written), under Delaware law you can include in your certificate of incorporation provisions permitting the indemnification of officers and directors and limiting their liability to the company – under some circumstances. Sophisticated investor will insist on the inclusion of these provisions.) Another issue that sometimes arises is around the creation of preferred stock. Sometimes I see a class of preferred stock but no terms and no provision allowing the board of directors to set the terms. Never having used one of these services, I can’t tell if these problems arise because of the limitations of the service or because the users don’t really know what to do. Are these issues fatal? Probably not. Also when you finally do go to sophisticated counsel or get a sophisticated investor, they will note these issues and they will be changed/fixed. But, on the one hand, I think (and I am curious what anyone out there thinks) the real problem is that having these kinds of glaring issues in so basic a document makes you look amateurish. On the other hand, sophisticated investors are going to be able to evaluate your level of sophistication whether or not you incorporate on line. The result is that you pay the online people and then later you pay someone to fix the issues. (All in it will be more expensive, but you can put off some of the cost to a later date.)

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Prithvi Tanwar, an associate at Foley who does a lot work with us at the EEC, recently had occasion to consider the General Public License in the context of start-ups.  This resulted in the following comments which I thought would make a useful post.

A start-up wants to develop its online application using scripts licensed under the GNU General Public License (“GPL”). What are the potential ramifications? Any modifications and works derived from a script or product that is licensed under the GPL must themselves be licensed under the terms of the GPL when distributed to third parties (they must be made available in source code, at no additional cost, to anyone to whom you distribute the modifications or derivative works).

There are two questions a start-up building software derived from scripts under the GPL needs to ask: (i) Do we plan to distribute the software? and, (ii) How much of the software do we plan to develop using the GPL scripts? If your business plan requires the sale/distribution of software to customers - move to question two. If however, you plan on providing a service using your web application, where all your software sits and runs on your servers and users access these servers through their computers (be it desktops or smart phones) you might not trigger the distribution requirement under the GPL license. If you are distributing software, the next step of the analysis is to determine whether your product “as a whole” is a derivation of the script under the GPL. If this is the case you might very well have to disclose the source code for your entire product and not just the portion you developed by modifying the GPL script. Not the route you want to take if you view your product as proprietary. Unfortunately, the question of what constitutes “as a whole” is difficult and requires a case-by-case analysis. This might be a good time to call your IP Counsel to get an idea of how much risk you plan on taking using open source software in your development process.

Your choice of a software distribution vs. service provider model will also affect investment and exit events in the future. Using GPL scripts in the development of your website application will raise concerns for potential investors and buyers. If a potential acquirer or investor views your product as the main asset, to be distributed and marketed as a closed-source proprietary product, they might balk at your use of GPL scripts. If however, the buyer or investor view you as a services company where your main asset is your customer base and market presence, the use of GPL scripts might not be a problem. Executing a software development process in tandem with your business plan and still having room for flexibility is a difficult process, but is key to avoid boxing yourself into a corner over the long run.

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We had a great kickoff to the new "season" of programs at the EEC on Tuesday night, when we hosted the IEEE Boston Entrepreneurs' Network (ENET) September meeting "Launching Your Successful Company."  There are many more upcoming events of interest to entrepreneurs at the EEC in September, so check out our events calendar.

The slides from the presenters will be posted to the ENET website shortly, so I won't try to summarize them in full, but some interesting take aways from the three presenters:

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Issues around the dating of stock certificates do not often come up because they are usually prepared for a closing or a specific transfer and the dating is clear. But, sometimes for a number of possible reasons, time passes and stock certificates need to be prepared for transfers that occurred some time in the past. Our firm’s practice, and I believe the practice of most firms is to date the stock certificate when it is prepared by the paralegal or secretary who makes up the certificate itself. Our view is that anything else may lead to confusion in the stock records of the company and that the date on the certificate does not control things like the determination of the holding period for tax purposes. A common problem with backdating (holding aside any discussion of fraudulent behavior) is that if there are other intervening issuances, the company could end up with a stock certificate bearing a later number in the sequence of certificates in the ledger having an earlier issue date than a stock certificate with an earlier number in the sequence ledger. This is a very bad idea since it is likely to cast doubt upon the accuracy of the stock ledger.

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As I have noted on many occasions, one of the most common structures for angel investments is a note that converts into shares of a future round at a discount to the price in that round. While this has the advantage, among other advantages, of putting off the moment when a valuation of the company must be agreed to, one client has recently pointed out the flip side to this benefit is that it caps the investor’s upside during the period from the angel investment to the moment of conversion into the future round at an amount equal to the relevant discount. While few angels ever worry about this issue, the point is well taken, especially if you believe that the future investor will require your angel investor to give up some (all?) of her discount in connection with the new round. One possible way to work around the issue of a capped upside is to issue low priced warrants to the angel investor. For some reason, venture investors have less of a tendency to bother with warrants than they do with discounted conversions. Needless to say, using warrants raises a lot of issues including how to price them both in terms of actual dollars and as a percentage of the equity of the company. They also introduce another piece of documentation and therefore complexity and expense, which may be OK or not OK depending in part on how much angel money you are raising.

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One thing that happens in the law business (I imagine any business) is that you become too familiar with the subject matter. As a result, you may start to take it for granted that your clients see the world the same way you do. This thought was sparked because I had a start up client ask a bunch of great questions about angel notes into a future financing. At Foley we deal with these kinds of angel notes all the time. For any given client, however, each note is likely to be a unique experience. Anyway, it is nice to be caught up short and look at some of the issues inherent in these notes afresh.

Basically, the client asked one of the questions I have addressed from time to time: What is normal? Are there usual and customary standards for --- you fill in the blank. She wanted "practice" guidelines for (1) What happens if there is not a future financing? (2) Are angels ever cashed out when the contemplated next financing happens? (3) Is there any way to translate the note into a percentage ownership in the company? (4) Is there a standard discount?

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California has long had a statute making employment related noncompetition agreements illegal. There has been for some time now in Massachusetts a movement to make these agreements illegal here as well. An article in xconomy has this to say on the subject:

The alliance, founded last year by partners at Boston’s Spark Capital, argues that the non-compete clauses imposed by many Massachusetts employers stifle innovation by preventing entrepreneurs with good ideas from setting up new businesses that might be seen as competing with those of their former employers. Such agreements are unenforceable in California—a fact that may aggravate brain drain from New England to the West Coast, in the view of many people active in the local entrepreneurial scene.

Noncompetition agreements are also a topic on which Mike Rosen, one of my partners, writes with some frequency. 

I don’t have an opinion whether these agreements actually stifle innovation nor do I know how such a thing would be measured. I can safely say that I have not heard anyone make the case with any conviction that noncompetes promote innovation by protecting investment in new companies. But, noncompetes are a “standard” part of the employee package at any venture funded company here in Massachusetts. They are typically (universally ?) one year agreements – in the venture funded world. Once you get outside the venture funded world they get longer and longer. I have seen employers ask for as much as five (count them – five) years.

Having said all this, there are other agreements that are part of the “standard” package including, for example, non-solicitation of employees, non-hire provisions and non-solicit of customers. My understanding is that these provisions are just as legal in California as they are in Massachusetts. Employers can get much (most? all?) of what they might in a noncomp from these provisions. If you agree with that last sentence, it is going to be really hard to determine what, if any, benefit there will be from making noncompete’s illegal.

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This is a theme to which I keep returning – email (and other electronic records) is forever. At this point everyone has a horror story about the email that got sent to the wrong person or that had some embarrassing statement. The observation that email seems to inspire people with a freedom to say – whatever, has been made so many times that it can’t possibly bear repeating, can it? Well, despite the well know phenomena of misdirected email, embarrassing statements and etc., all these email faux pas seem to continue unabated.

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Negotiation can be about a lot of things. A great attorney that I know, he is now retired, once said that the most difficult thing to overcome in a negotiation is a good reason for something. A good reason – one that can be articulated so that the other side recognizes it as self-evidently rational – will often (very often) trump the power, the money and the clever posturing.

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I have already tried to attack the delicate subject of the use of legal forms once. Certainly one of the more abused "forms" is the nondisclosure agreement or NDA. Clients often like to get a "standard" NDA which they then apply in all sorts of circumstances. Some clients are very savvy about NDAs and really know the issues and how to edit and negotiate them. Some clients have themselves developed a set of very sophisticated NDA forms covering the universe of business circumstances with which they deal. For may reasons, it is really nice to have clients who can and do deal with their own NDAs. For one, the need for an NDAs tends to come up fast and clients sometimes do not want to slow down a deal to negotiate one. This is especially true if getting their lawyer involved will mean the other party gets their lawyer and soon cycle times start going up. But, if you are not one of those clients that knows, you can make missteps. Here is an example:

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Clients often ask for a standard form of NDA or a standard set of representations or some other "normal" agreement. You know, "the usual thing…" A corollary to this request is the request that the lawyer turn (sometimes the word is "spin") the document instantly. The problem with this approach to legal documentation is that in the legal world, facts are critical and context is king – not that "standard" forms are not useful, but their utility depends upon the facts and circumstances of their use. So here is one example to make the point:

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One of o the issues that has plagued directors of all sorts of companies is the potential for personal liability. Over the last several decades, Delaware has enacted provisions in its corporate law that can limit the liability of directors and permit a corporation to provide indemnification to directors. One thing that has always been a “hole” in these protections has been that they depend upon having and keeping in place certain bylaw and charter provisions. To put a fine point in it, Delaware corporations have been able to change existing bylaw and charter protections to deny them to directors, who thought they were protected. Delaware has made an important change (effective August of this year) to improve the protection of directors. See our firm’s client alert on this topic which says in relevant part: “The statute now explicitly prohibits the elimination or impairment of any indemnification and advancement rights provided in the corporation’s charter and by-laws once the act or omission in question has occurred. Indemnification and advancement rights could only be eliminated or impaired retroactively where the by-law or charter provision, existing at the time of the act or omission in question, expressly authorized such elimination or impairment.”

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The other day an entrepreneur asked what par value was and why pick such a low number (referring to the $.001 that was proposed). Well this is a dry topic, if ever there was one. It involves a little bit of a history lesson for background, and, as a practical matter, par value of more significance to attorneys than it is to you as an entrepreneur. A couple of clarifications, I am writing about par value of stock and more particularly common stock and even more particularly common stock issued by Delaware corporations. Having said that, here goes:

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I spend this past Saturday judging the 13^th annual HBS business plan competition. I am not sure that I have judged every one of them, but it is pretty close. I always enjoy it. In part it is that I run into people I know but don’t often see. In part it is the plans. The competition seems to be an inexhaustible source of energy, creativity, ambition and insight into human behavior. Perhaps not surprisingly, this year the competition attracted a lot more entrants than in prior years. In addition, the plans I saw seemed both surprisingly doable and, in many cases, they were in fact well into the execution stage. More than that, however, this year’s plans reminded me of some of the things that make a good business, not necessarily a venture fundable technology business, but a good business: simplicity and an understanding of human behavior.

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Recently there seems to have been a spate of clients looking to convert from LLC status to regular “C” corporation status. I think of this as the other end of the funnel. Someone formed an LLC, usually on the advice of their accountant (but not always) or they asked a question along the lines of “how hard is it to change later?” To which the answer is “Not very.” They expected to get the tax benefits of a pass through entity (see my prior blog on this topic). And that may be as much thought as went into the process. Well the evil day finally arrives and it is time to convert, what exactly do you have to do and how much will it cost?

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When confronted with an optimistic point of view on the economy, one entrepreneur had this to say:

One of the other silver linings is the insane amount of work that an entrepreneur can get done with very little money today. I have 6 unpaid interns …One is a PhD student …. and four are computer science majors that could have gotten great paying summer jobs 2 years ago. I also have a CFO that put together professional financial documents for us on deferred cash, and over $XXX,XXX in programming being done on deferred cash. None of that would have happened two years ago.

Entrepreneurs are finding a way to get their businesses off the ground without angels or VCs.

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A signature is worth a thousand words

“Sally is calling all our customers.”

“Does she have a noncompete?”

“Yes.’

“Does the noncompete say she can’t call our customers for one year after she leaves?”

“Yes”

"Ok, let's call the lawyer."

Silence...

“Did she sign the noncompete?”

Silence….

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To a large extent, but not exclusively, whether to be a “C” corporation or an “S” corporation or a limited liability company (and “LLC”) is a tax issue. LLCs and “S” corporations are so-called pass-through entities. That is to say that the entity itself is not taxable; its tax attributes (profits and losses) are passed through to the owners of the entity, and they pay tax in accordance with their particular tax situation (often at the highest marginal rate for individuals – assuming they are well-to-do). (Most LLCs and “S” corporations distribute cash to enable their owners to pay these owner-level taxes.)   Distributions or dividends that an LLC or “S” corporation pays to its owners are then free of a second level of tax.  Profits of a “C” corporation, on the other hand, are subject to double tax: first, the entity itself is taxed, and the shareholders are taxed on any dividends paid to them.

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There must be millions of NDAs out there. How controversial can they be? One of my clients and I recently put together a form of NDA that was specifically designed to be easy to sign. We made it simple, one page; we took out a lot of the legal boilerplate; we did not take any aggressive positions (tried to make it completely evenhanded). 

So far, she has sent it to two companies and neither has signed it. In one case, we got back a revised draft that, in effect, put back all the provisions we took out. All but one of these “new provisions” are favorable to my client. So, we plan to agree to them. One example is they lengthened the duration of the NDA. 

Why would they do this? Who knows? The ways of lawyers are often mysterious. One lesson might be don’t bother trying to short cut the process because there is a good chance that your short cut will make for a long delay.

A couple of things to be aware of in NDA:. First, the duration – should it be infinite or for a stated number of years or some other period (and if for a specified period how long)?  At a minimum it should be long enough to protect confidential information for however long you think it will have value as a result of being confidential. Second, identification of what is and what is not confidential. Does the stuff have to be physically marked confidential or is it enough that one should know (or something in between)? Third, when does stuff cease to be confidential? When it enters the public domain? When it is generally known? Consider also what state you want to enforce the NDA in. There is a lot more that goes into these agreements, but if you think through these items, you have a good start.

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I have been out of the country and not watching the blog scene as carefully as I should, but as I sit here in Beijing waiting for my delayed flight, a friend has brought two postings to my attention, and they are both good posts.

Data on the startup/venture industry:

Techcrunch has posted its exec summary (or a portion thereof) for its first year in review.  In an industry where good data (let alone information) is hard to come by, this promises to be a welcome new source.  Congratulations. 

With respect to antidilution:

Fred Wilson has a post on "Founder Dilution -- How Much is Normal."  It is followed by something like 62+ comments almost all of which are worth the read if dilution concerns you.  There are also a number of links that may also be of interest. 

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Further to my last entry on noncompetes, one of our Partners, Michael Rosen, writes a blog entirely devoted to noncompete issues, and he has written much on the subject of pending legislation to prohibit noncompetes in certain situations in Massachusetts.

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In the context of venture financed technology companies, a one year post employment noncompete is standard stuff, at least here in Massachusetts. California, famously, passed a statute making employment related noncompete agreements illegal in that state. That statute has led to a few sticky issues for companies that start out in other states, such as Massachusetts, and then open operations in California. For example, what do you do when you have a long standing Massachusetts employee and you relo him or her to California? Or, what about requiring some employees to sign noncompetes and not others? By the way, California permits nonsolicitation agreements, nonhire agreements, confidentiality agreements and the like. So, how significant is it really that you can’t have a traditional noncompete? Acutally, I am heading down the wrong path California noncompetes, blue sky laws and etc. are going to be the topic for another day.

I recently met with the first employee of a start up client (located here in Massachusetts) who told me, quite sincerely, that he was unwilling to sign a noncompete because he objected to them on philosophical grounds. While I can imagine a lively debate on this subject, it would be completely impractical. Professional investors will require all employees (especially key technical people) to sign them or they wont invest. Savvy founders know this and, whatever their private thoughts may be, will insist that their employees sign standard forms of noncompete (ditto invention agreements and confidentiality agreements). If you are of the philosophical persuasion that noncompetes are a bad idea, that is fine; don’t let it get in the way of your signing one.

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The frequently asked question is whether to incorporate in Delaware or Massachusetts (since I practice in Massachusetts) but it could be Delaware versus any other jurisdiction. 

The main reason to incorporate in Delaware is that most VCs will insist on it before making an investment. The reason VCs like Delaware is that many many many companies are incorporated there, it has a very well developed and cutting edge corporate law, and the Delaware Court of Chancery is one of the most active (the most active?) forum for the resolution of disputes relating to corporate law. As a result, there is a high degree of certainty around what the rules of corporate governance are and how disputes will be resolved. Also, most (all?) firms that regularly represent VCs, consider themselves experts in Delaware corporate law. The cost of incorporating in Delaware is not materially different than incorporating in other states – so, the cost of incorporation is not a factor. As a result of all these factors, Delaware has become the jurisdiction of choice for venture financed (and other) companies. 

However, if you incorporate in Delaware and you are in fact headquartered in Massachusetts (or some other jurisdiction), you will have to qualify to do business in Massachusetts (of the other jurisdiction). This qualification is an additional annual cost of several hundred dollars. So, if it is just you, and you don’t plan to get professional investment money, go public or have other special reasons to worry about corporate law, you can save yourself some money by incorporating where you are conducting business. 

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Even though it is not much money, incorporation costs money. So, when should you incorporate? It does not need to be the first thing you do. But, you should certainly incorporate before you enter into any contractual agreements with third parties or, if there is more than one of you, when you start building up some value in terms of intellectual property or other assets.

When you enter into a contract with another person or company, you are likely to want that contract to be between your company and the other person. If this is not the case, it is likely that you will have personal liability under the contract. Personal liability is almost always a bad idea. Before you sign a lease, a license, or incur obligations to consultants, accountants, attorneys or enter into any other agreement, incorporate and have the company sign the contract or incur the obligation. When you start to build up assets, such as IP, you may want to make sure the assets are owned by the company. This is particularly true if there is more than one founder. For example, if Harry writes a lot of code, the company can’t own the code until (a) it exists and (b) Harry transfers the IP to the company. It may not matter much if Harry is the sole entrepreneur, but if he has a co-founder, that person is likely to be toiling away with the assumption that both she and Harry are contributing value to the enterprise. In that case, it is time to create a company, move the IP into the company and have everyone work on behalf of the company. 

Look at it this way:  when you have something of value and you are ready to deal with third parites such as co-founders, investors, customers, suppliers etc. then you need to have your corporation.  By the way,  you may not want a corporation -- you may want a limited liability company, a limited partnership or some more obscure form of entity.  How to incorporate will be the subject of another post.

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Incorporation may seem so obvious that it hardly bears mention. Nevertheless, at the risk of being boring, you want to incorporate because: (1) if you do it right as a general proposition, you get protection from personal liability for the obligations of the business, (2) the company (or LLC or limited partnership) is a vehicle that can be financed, and (3) it greatly facilitates many mechanical aspects of the business, such as hiring people, holding assets such as IP but other assets as well. 

With respect to personal liability, as everyone knows, companies get sued for many reasons, often contractual disputes or employment related disputes.  Companies are separate legal persons (different from their owners), and companies are legal actors.  So, companies (as distinct from their owners) enter into contracts, and companies are obligated to perform those contracts.  If the counterparty to a contract is disappointed for some reason, recourse is to the company that entered into the contract, not the owner of the company.  Now, this is not the case if you don't respect the legal entitiy by doning things like keeping appropriate books and records, not commingling funds with your personal account, signing documents personally (rather than on behalf of the company -- this has to do with how signature lines appear on documents) and the like.  Also, there are certain kinds of claims (including torts) where the individual actor (in addition to the corporate actor) will have liability.  Nevertheless, by incorporating you protect yourself from many potential sources of liability.l

Financing is really a subset of dealings with third parties, but it merits its own mention.  Perhaps it is sufficient to say that no VC will write you personally a check for $XX.  These investors expect to sit on boards, own an known percentage of a company etc.  This is all achieved by investing in a corporation (or LLC or limited partnership).

A separate question is when to incorporate.  This will be the subject of another post.

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What on earth is “traction”? One entrepreneur and client, told me the other day, that she has done a lot of pitches (and she has). Her company is addressing a large niche in a hot space (mobile advertising). It seems like everyone has some level of interest, but they all tell her to come back when she has “traction.” When asked what would be evidence of traction, one wag is reported to have said, “I’ll know it when I see it.”

The elusive traction is particularly important to web based businesses, but is not limited to some measure of unique visits or eyeballs. Non-web businesses are being confronted with requests for evidence of “market traction.” If you have 1000 hits per day, traction is more than that; if you have a $10 million annual run rate, traction is more than that. Webster’s defines traction as:

(1) the act of drawing : the state of being drawn ; also : the force exerted in drawing (2): the drawing of a vehicle by motive power ; also : the motive power employed (3) (a): the adhesive friction of a body on a surface on which it moves “the traction of a wheel on a rail” (b): a pulling force exerted on a skeletal structure (as in a fracture) by means of a special device “a traction splint” ; also : a state of tension created by such a pulling force “a leg in traction”

Judging from this definition, traction is being used as an analogy suggesting the need for sufficient friction to prevent wheels from skidding while pulling a heavy load. However, the practical reality is that I have never heard an entrepreneur report being told that they had “traction” – whatever its meaning. 

You may be familiar with Xeno’s paradox. The gist of it is that if you always get half way to your goal, you never actually reach your goal. You may also be familiar with the myth of Sisyphus. The gist of it is that Sisyphus is condemned to pushing a rock up a hill and, just as he gets near the top, the rock rolls down and he has to begin again. 

So, I think “traction” means credible evidence that you can get to the end -- to an exit with a reasonable return within a reasonable time frame (for the relevant investor) (or that you can get the rock to stay at the top of the hill). In other words, when an investor says the “T” word, it sounds like they are trying to eliminate execution risk. 

Since execution is often the last hurdle before an exit, if you hear the “T” word, you are probably talking to an investor who wants a sure bet not someone who is going to take a risk on your business.

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One of the regular questions we get from entrepreneurs relates to this apparent conflict. On the one hand, they want to talk up their innovations to potential investors, team member candidates and other audiences. But they are told that disclosure of the invention can ruin their chance to get a patent protecting it.

In a nutshell, this is because a patent is a reward given to an inventor by the government, in the form of a temporary monopoly on the invention, for teaching the world how to practice the invention. Thus, patentability requires, among other things, that the invention be “novel” when you file for protection. If people already know how to practice the invention, there is no reason for the government to reward you for showing them. So any “public disclosure” of your invention makes it, literally, old news, or in patent terms, “prior art.”   The effect of public disclosure differs by country. The U.S. is actually one of the jurisdictions more forgiving of early public disclosure. Europe, commonly seen as an important territory to protect, is probably the toughest.

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Clean energy technology entrepreneurs might seem to have reason to be more optimistic these days than their counterparts in other fields such as software and technology. After all, most VCs and industry observers maintain that quality clean energy startups remain good candidates for funding even in this challenging environment. However, promising clean energy startups can get caught in the dreaded funding gap between proof of concept in a lab setting and the establishment of commercial viability that might attract venture capital.

This is where state support can be crucial. In Massachusetts, the SEED funding program administered by the Massachusetts Technology Collaborative’s Renewable Energy Trust has brought almost $5,000,000 to early-stage clean companies, mostly in the form of convertible debt, in deals up to $500,000 matched by other debt or equity investment.

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In the rogue’s gallery of investor protective provisions that come out of their cave in bad times, the multiple X preference is among the first. A preference is a provision that gives an investor a return in the event of a sale of the business before any money goes to the common stockholders. So, in a typical (and very commonly seen in good times as well as bad) 1X participating preferred, the investors get a payment in an amount equal to their investment plus accrued and unpaid dividends before the common get anything. After receiving this payment, the investors participate with the common on an as converted basis. My article on antidiluton, has a detailed description of the effect of this provision. However, just imagine the effect on the common stockholders of a 3X or, God forbid, a 5X preference. After the dotcom bust, these things appeared like mushrooms after rain. Try to resist these things. Having said that, it may be the only way to get financed, so be realistic. It may be possible to negotiate capped preferences in which the investor gets his or her preference but only up to some limit. In any event, do the math at various exit values. It could turn out that a multiple X preference makes working for someone else rather than starting a venture financed business look good. 

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Bad times may well cause this beast to come out of its cave. Full ratchet antidilution is a provision that protects investors to the max from low priced issuances. The gist of this provision is that the conversion price of a security (usually preferred stock, but not necessarily) will be reduced to the lowest price at which a company sells any shares of its common stock. So, if you have 1,000,000 shares of preferred outstanding with a conversion rate of $1.00, these shares will convert into 1,000,000 shares of common stock. However, if these shares have a full ratchet antidiluton provision and you issue one share of common stock for $.10, then the conversion rate will drop to $.10, and the preferred stock will convert into 10,000,000 shares. You can imagine the dilutive effect on other stockholders. 

For the reason outlined above, full ratchet is rarely used. However, it does have its place when there is a disagreement about valuation. If you can’t bridge the valuation gap, you might end up saying something like “OK, if I have to raise money next year at a lower valuation than you are getting, I will adjust you to that valuation.” In a world where money is very hard to come by and investors are very nervous about valuation, I predict we will start seeing more of these provisions.

Having said that, if you are constrained to agree to full ratchet, you need to consider negotiating some parameters around it. By way of example, try to exclude options issued under the option plan, try to exclude small issuances of warrants to equipment lessors, try to limit the time period in which the full ratchet operates to some period (perhaps one year). Consider other issuances that you might make and try to negotiate exceptions for them. Also, consider a range inside of which you don’t have to make the adjustment. For example, consider trying to negotiate a provision the gist of which is that the full ratchet will only operate if you raise more than $X at a valuation that is less than 90% of the preferred.

Full ratchets have another negative effect, they cause the next investor to want one too. Consider negotiating a termination upon closing of the next round.

I predict that the next year will see an increase in full ratchet provisions.

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Right now I am 30,000 feet over Africa yet client challenges are still on my mind. Every start up  company  needs a name, and it is surprisingly hard to find a good one, not so much because these companies  (not to mention lawyers) are unimaginative, but because so many  names are taken. One start up client of mine recently had more difficulty than usual, and their travails have inspired me to write this blog.  

Rule Number 1: Google the name.

This should go without saying: pick a name that you don’t think is in use by someone else. Do an Internet search for the name you think you want. If someone else is using the name for a business similar in any way to yours, move on. Uses in other industries may not be a problem, and if you love the name go to Rule Number 2.

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I spend a lot of time with entrepreneurs explaining how restricted stock and Section 83(b) or the tax code work. It was the subject of a prior blog entry. However, it comes up so often and different people absorb the concept in different ways, so I thought it might be worth attacking again in a different way. Restricted stock can have some very material tax benefits when compared with options, especially in the early stages of any venture. So, here is how restricted stock works. I will compare it to options later.

You may want to incent employees by giving them stock. Here is an example. Easy Company decides to incentivize one of its employees by giving her a stake in the company. It then grants to Jane 100,000 shares (assume for the purposes of this example that the shares have a fair market value of $.01 per share). Two things follow. First, Jane owns the stock and, in our example, has no particular incentive to stay of the sort associated with vesting. Second, Jane has income equal to the value of the shares of stock she has been given. In this example she has income of $1,000. Easy Company must report (and withhold taxes for) this income on Jane’s Form W-2  for the year in which she was given the stock, and Jane must pay tax on that income. Now, $1,000 of income does not seem like much, but if the stock had a fair market value of $1.00 per share, Jane would have $100,000 of income on which she would owe tax. If her marginal tax rate is 40%, then she has to pay $40,000 of tax to the feds.

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With the economy dropping off the edge of a cliff, personal liability is becoming a frequent topic of advice with clients and board members; see my prior blog on the subject of liability of officers and directors.   Right now, I want to make a note on personal guarantees because either clients are worried about having to make good on them or because creditors are asking for them to shore up a risky situation.

You may remember the three rules of real estate:  Location, location, location.

The three rules of personal guarantees are:  Don't, don't and don't. 

When someone asks you to sign one, use the Nancy Reagan defense:  Just say "no."  This is, of course, easy advice to give without any situational context.  If you choose to ignore it, be aware that these contracts are generally speaking enforceable obligations and they are often open ended in the sense that you may be guaranteeing recovery of costs such as the creditor's legal bill (in addition to the underlying obligation).  If guaranty you must, try to get a cap on the amount.  At least that way you know what the maximum liabiltiy is.  Also, get your attorney to read the guaranty -- who knows what a creditor might put in there?

Also, consider that there is often a personal dimension.  A claim for payment can put a lot of pressure on you personally (unless you can comfortably afford to pay up).   Think about explaining to your spouse that you have to write a big check to a landlord, bank, equipment lessor or someone else.

If you already have a guaranty in place, you may find that it limits your range of motion in any negotiation you may have with creditors.

Unfortunately, in this climate, we are likely to see personal guarantees asked for and called upon.

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Since Sequoia's 56 slides of gloom and doom, a lot has been written on surviving the downturn.  Don Dodge has captured 11 items of advice from John Doerr of Kleiner Perkins.  This focus on what you need to do to survive the downturn seems healthy to me because it assumes that you can and, with some grit and determination, will survive the downturn.  And, I think most start-ups will survive.  Having said that, some will experience a lot of pain and find themselves in dire straights.  And, yes, some will get into real trouble.  By real trouble, I mean bankruptcies and personal financial disasters.  To prevent these situations from becoming worse than they need to be, you need to understand where your personal liability begins and ends.  There has not been a lot of blog advice that I have seen on these points.  You can look at one thing I have written  Liability of Officers and Directors.  Item 6 of Doerr's list is "Renegotiate all contracts including rent. You will be surprised what can be renogitated for a lower price of better terms."  I agree with this item, but you need to be forward thinking about it.  Don't avoid the landlord or the bank -- deal with them up front in a realistic way.  For example, if you promised a payment on a day -- make it.  If you can't then communicate early so the lender is not surprised.  When dealing with creditors in these circumstances you need all the credibility you can get.  Also, raising and dealing with issues early (before the landlord has so many defaults that he gets panicked) will maximize the amount of flexibility that you get from the creditor.  By way of contrast, dodging phone calls and avoiding will just annoy the lender and may lead to inflexibility.

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I recently have had the misfortune of having to counsel a client on the general subject of closing down a business including the duties and liabilities of directors and officers who find their companies in this circumstance. Depressing as it sounds, I have the sense that there may be more of this in the near future. So, below is a punch list (not comprehensive or detailed) of some of the things you should be aware of, if you find yourself in this horrible situation.

Here are the disclaimers:  

The content of this blog posting is in no way an adequate substitute for actual legal advice. The laws governing these topics are detailed and complex, and the brief descriptions below are not adequate synopses of these laws. The content of this blog posting is taken from memoranda prepared by our firm in connection with advice to clients operating under specific circumstances and may not be applicable to your particular circumstances. If you find yourself involved as an officer, director or otherwise with an insolvent company, consult an attorney knowledgeable in this discipline.

Credit for the research and writing of memoranda from which I have taken most of the below belongs other attorneys at Foley Hoag LLP, particularly Mark Clark whose carefully written, thoroughly researched, and detailed memorandum I have grossly butchered in an effort to provide readers of this blog post with the gist of the most important concerns applicable to officers and directors of insolvent companies. To the extent that errors and inaccuracies have crept into this information, they are, of course, my sole responsibility.

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A question that comes up with some frequency is how many options to grant to an advisory board member. One of my partners advises his start up clients not to issue more than 1% of a company’s equity to the entire advisory board. I think this is a pretty good goal. My experience, however, is that some advisory board members should be paid more than others because they ad more value, either because they undertake to do more than others or because they bring more visibility and credibility than others. One advisory board member that I know insists on half of a percent for her commitment, but she is a rock star in her industry and agrees to make phone calls and provide introductions. In effect, she adds more value than simply her good advice. So, those are some guideposts, but when considering a new advisory board member you should consider the contribution that is expected as well as the dilutive effect of the option grant.

11/04/08 update -- One of my start-up clients just faced this issue and settled on a pool of 1.5% for all advisory board options.

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