Every once in a while, I’m reminded just how harmful overlawyering can be.  I just finished preparing an operating agreement for 3 partners in a new venture.  They have a promising startup with a couple hundred thousand in seed capital, seeking to raise maybe a half million more to fund their initial operations.  I worked with them to prepare a detailed operating agreement, standard founder intellectual property (IP) assignments, and consulting agreements to govern their go forward work for the company.  That’s about all they need at this nascent stage.

All was good until one of the partners decided it would be a good idea to have their personal counsel look over the documents to protect their personal interest.  (After all, I’m company counsel, not founder counsel.)  Unfortunately for the company, founder’s counsel is what I’ll call an “Overlawyer”.  Next thing you know, I have a seven page memo of comments on the operating agreement.  And that’s not counting the four page tax memo that followed.   Or the three separate counsel phone calls I fielded on a completely standard founder IP assignment.

Mind you, most of the memo was written by a third year associate in his vast business experience (nice guy though, kind of sad to see him indoctrinated).  It was then reviewed by a senior corporate partner, and I’d estimate the combined hourly rate of these two lawyers at about $1,000 per hour.  Needless to say, many hours and thousands of dollars later, we are all “agreed”.  About 15 minutes’ worth of the input from Overlawfirm’s tax counsel was helpful.  Aside from that, what do I think was improved in partner’s “deal” as a result of their hiring Overlawyer to represent their interests?  Zero. Nada. Zilch.  The company will function exactly the same as it would have otherwise.

So everybody talks (complains) about the cost of Overlawyers in terms of dollars.  And the financial cost is ridiculous, no doubt.  But people rarely talk about the nonmonetary costs of an Overlawyer approach, which in my book are just as, or even more, detrimental to an entrepreneurial venture.  In the current founder situation, Overlawyer scared its founder client into worrying that certain benign document provisions were detrimental to founder (and somehow only to founder—odd, since they applied to all the founders equally).  That needlessly instilled in Overlawyer’s founder a certain degree of mistrust in both company counsel and in founder’s partners.  That’s a crying shame, because we all will be working together for years to come to build the business, and that’s not the right way to kick it off.

Worse, the business partners have just spent weeks negotiating with one another, rather than working together to advance the business.  The other partners who didn’t hire separate counsel were frustrated by the delay, and they aren’t happy that their partner sought out special protections for themselves rather than just doing what’s best for the company like everybody else.  These things take a toll on founder relations.

Finally, by incessantly prioritizing individual founder interest before the company’s operations, Overlawyer missed the forest for the trees.  Had I not put my foot down, founder would not have properly assigned their IP to the company, and the company’s decision making processes would have been held hostage to founder.  That would have made the company less investable, less functional, and quite likely, less successful.  Ultimately, what serves the founder’s financial interest in the startup context is a well functioning company, and that is a fundamental business truth that remarkably few Overlawyers grasp.

I’d like to say that this experience was unique, but it’s not.  While of course there are Overlawyers at firms of all sizes, I find almost an inverse relationship between the size of the law firm, and how prone they are to utter nonsense like the above.   There are structural reasons for this.  Many lawyers at big Overlawfirms have never done anything in their professional careers but practice law, and as a consequence have little ability to distinguish between salient business risks and theoretical legal issues.  Every business lawyer I’ve ever met likes to claim that he or she is a “practical lawyer,” and 90% of them are full of crap.  The inefficient approach is also inherent in the internal Overlawfirm financial model, which relies on leveraging young, inexperienced associates to enhance revenues at the top of the law firm pyramid.  Indeed, Overlawfirm’s business model depends on its lack of restraint; if every hour is billable, every issue, whether important or not, is revenue.

On a less cynical note, there are many honorable Overlawyers who are not trying to churn billable hours.  They truly (but falsely) believe that they best serve their clients’ interest by advocating for them in this way.  I would like to see law firms teach their corporate attorneys that their number one goal is to facilitate their clients’ businesses, while acting ethically and protecting against undue (not all) risk.  Instead, big Overlawfirms tend to drill into their attorneys that their number one priority is to avoid missing anything, always turn over every stone, never make a mistake.  Risk avoidance at all costs.  This leads Overlawfirms to the conclusion that overlawyering is good lawyering.  It’s not.  And it can be fatal to an entrepreneurial venture.  Whereas Overlawyers seek to avoid risk at all cost, the very essence of all business, and most certainly venture backed business, is calculated risk taking.   Shy away from too much risk, and you choke the opportunity.

The Overlawfirm model is broken, period.  It works for few businesses at all, and almost never for entrepreneurial companies that must be nimble, practical and cost-efficient in their operations.  Entrepreneurs, if you find yourself with an Overlawyer, overfire.

In my last post I talked about the responsibilities that board members have to a company both before and after insolvency occurs. The list below provides some practical precautions for prudent directors in financially distressed companies to keep in mind.

Below are some practical precautions that a prudent director of a financially distressed company should keep in mind.

Financial Monitoring

1. Maintain vigilance over the company’s financial situation.
2. Convene board meetings as often as necessary to discuss important issues affecting the financial health of the company and consider alternatives to a particular course of action.
3. Avoid actions that benefit one creditor over another.
4. Place limitations on the company’s ability to incur further debt if the corporation is slipping into the zone of insolvency or it is unable to pay its debts when due.

Corporate Formalities

1. Maintain company formalities including holding scheduled meetings and keeping good corporate minutes of all actions taken by the board including the discussion of alternative courses of action that were considered and the advice of outside experts.
2. Ensure that all minutes reflect the attendance and active participation of directors.

Governance

1. If the board is considering entering into a significant transaction, such as a sale of assets, incurring substantial debt, a financial restructuring or any other transaction that could pose a substantial risk to company assets, seek legal and financial advice from outside experts which will also demonstrate that the board is considering independent, objective advice.
2. Before entering into a significant transaction of the type described above, consider seeking the advice and/or consent of major creditors.
3. Continue to act in the best interests of the company as a whole without favoring one corporate constituency over another, particularly any action that favors equity holders over creditors such as dividends or redemptions of stock.
4. Be aware that any action that benefits insiders including officers and directors will be subject to closer scrutiny and could be viewed as a breach of fiduciary duty or avoided as preferential or fraudulent payments.
5. Avoid increasing executive compensation out of the ordinary course of business unless it can be supported by the circumstances; consider obtaining outside advice to validate any decision.

Corporate directors of a financially healthy and solvent company have a fiduciary responsibility solely to the corporation and its stockholders and do not have a duty to creditors beyond the contractual duty owed by the company.

In today’s economy, many companies face unprecedented financial strains and, as the financial situation deteriorates and nears insolvency (aka zone of insolvency) directors must consider the impact of their decisions on the company’s creditors as well.  Once a company has passed the threshold of insolvency, the beneficiaries of a director’s fiduciary duties in many jurisdictions include the creditors of the company because, as courts have reasoned, the equity owned by its stockholders is worthless and the burdens of poor decision-making by management fall on the corporation’s creditors.

Generally, the fiduciary duties of a director are the duty of care and the duty of loyalty.  The duty of care requires a director to be fully informed of all material information reasonably available, acting with due care and consulting with officers, employees and outside experts as reasonably necessary to make informed decisions.  The duty of loyalty requires that a director act solely in the best interests of the company without personal or private motive, avoiding self-dealing and any conflict of interest that may compromise the director’s independent decision-making process.

Until fairly recently, the prevailing wisdom was to advise boards of directors that the shift in their fiduciary duties occurred once the company entered the zone of insolvency.  Recent case law in Delaware has rejected this premise, and, moreover, prohibited the rights of creditors to bring direct claims against directors for breaches of fiduciary duty even when the company is insolvent.  See North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.D.2d 92 (Del. 2007).  However, “creditors may nonetheless protect their interest by bringing derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim . . . that may be available for individual creditors.”  Id. at 94.  In Trenwick America Litigation Trust v. Billet, 906 A.D.2d 168, 175 (Del Ch. 2006), the court held that “so long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equity holders.  Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become residual claimants and the advancement of their best interests has become the firm’s principal objective.”

While these legal clarifications permit directors to focus on maximizing corporate value, the impact on creditors must be carefully considered as it remains difficult to assess when a company actually crosses the threshold of insolvency.  Under Delaware law, a company is considered insolvent if it fails one of several tests, including whether its total liabilities exceed its total assets, the so-called “balance sheet insolvency test” or whether the company is unable to pay its debts when due, the so-called “equitable insolvency test.”  Other states employ other tests.

Because of the subjective nature of these insolvency tests, the board of a distressed company exercising its fiduciary duties must remain cognizant of the impact of its decisions on the corporation’s creditors.  In next week’s post, I’ll outline some of the concrete steps and precautions that a director of a financially distressed company can take.

Patents, trade secrets, know-how, copyrights, and trademarks can be crucial to your business. Managing this intellectual property can make the difference between fortune and failure. This brochure presents ten recommendations for protecting what belongs to you. In the spirit of David Letterman, here’s my Top 10 List.

#1

Obtain written assignments of all inventions and copyrights from employees and third-party vendors including consultants, advertising agencies, and photographers, and have these assignments reviewed by your attorney.

#2

When adopting anything new, such as technology, a trademark, or software, contact your attorney about conducting a right-to-use study to avoid infringement.

#3

Assume that any disclosure to a third party, including a customer, a vendor, a consultant, or a competitor, will not remain confidential. Confidentiality agreements offer some degree of protection, but they are not guarantees against improper disclosure.

#4

Discussing an idea in the presence of others, such as actual/prospective customers, vendors, or consultants, can result in a claim of co-ownership of your idea. Avoid this situation by listening to the challenge presented, and then by conducting your problem-solving in private.

#5

When negotiating an agreement, avoid terms that may limit your ability to compete. Terms that require careful scrutiny include:

- An agreement stating that ownership of an invention does not belong to you
- A software or website development agreement that does not explicitly provide for your ownership of the software
- Prohibitions against reverse engineering by you
- Confidentiality clauses
- Unreasonable restrictions on the use of deliverables
- Continuing obligations to use the vendor, e.g., for software modifications or hosting
- Limitations on the other party’s indemnification obligations, e.g., no indemnification for infringement of patents, copyrights, or trade secrets

#6

Protect your inventions by documenting all improvements and promptly disclosing potentially patentable inventions to your patent attorney. Do not offer to sell the improvements and do not publicly disclose them until your attorney has considered the feasibility of patent and trade secret protection.

#7

Protect your copyrights by using a proper notice on all copyrightable works, including software, advertisements, brochures, and artwork. Check with your attorney to determine if the copyrights should be registered.

#8

Before adopting a trademark or service mark, have a search conducted to make certain that the mark, and the corresponding domain name, are available. If the mark is available, register the mark and use it properly. Do not allow third parties to use your mark without a written license agreement.

#9

If you have a claim against another party, proceed promptly. If you delay, you could lose your rights.

#10

Contact your attorney promptly if you receive a cease and desist letter. Your attorney may lessen the possibility of a lawsuit being filed against you, and failure to consult with your attorney may expose you to increased damages for willful infringement. If actually sued, contact your attorney promptly. Failure to timely respond to a lawsuit can have serious, and costly, ramifications.

Intellectual property litigation can be the death knell of a startup.  Not only is the litigation costly, it distracts the company founders from operating and growing the business, and  it makes it a lot it harder (if not impossible) to raise capital.  If the litigation turns out really badly, an injunction can be issued that shuts down the business and there can be a substantial damages.

It’s impossible to completely protect a new business against an intellectual property lawsuit.  However certain steps can be taken, including:

1. Have trademark clearance searches conducted on all trademarks adopted, the name of the business, and the domain name used.

2. Have a right to use study conducted for any new products and methods.

3. Confirm ownership of all intellectual property of the business.

Even if these steps are taken, litigation can still result.  The diagram below can be helpful and gives you a rough overview of what happens if litigation occurs in a Federal Court. Hopefully this graphic also provides good incentive for avoiding it. I also have a good summary that compares patents, trademarks, copyrights and trade secrets, Send me an email at info@pasadenaangels.com if you’d like a copy.

So you’ve just started your company, and as with most entrepreneurs, you have very limited money for service providers of any sort.  That said, you have heard in the past that it is always best to get a lawyer involved in the company sooner rather than later, especially if you’re looking to raise capital in the near future.  You’ve decided to bite the bullet and hire a lawyer, but you want to spend wisely. Lawyers can provide a large portfolio of services, but for the entrepreneur on a limited budget here are some suggestions for targeting your legal dollars:

1. STOCK OPTION PLAN.  In order to attract and retain the best executives and key employees, particularly in the technology industry, you will need to be able to offer attractive equity packages.  Potential hires respond to offers of cash for sure, but if that’s in limited supply, giving an equity stake in the future success of the company will make an offer more attractive.  However, if not done properly under an option plan, grants of equity are fraught with pitfalls for the unwary—unintended ambiguities in the grant language, failure to implement vesting, a lack of compliance with securities laws, unintended tax consequences to the company and its employees, and the list goes on and on.  These issues often lead to costly disputes.  At an extreme, they can make a company unfinanceable, for investors will rarely put money into situations where the capitalization of a company is unclear or in dispute. A properly drafted stock option plan is money well spent.

2. FOUNDER ARRANGEMENTS.  Preparing the appropriate arrangements between the company and the founder is an important step and should be done before capital investment is made.  These arrangements typically include the purchase of founder’s equity, assigning intellectual property from the founder to the company, documenting founder loans to the company, and putting in place a founder employment agreement with the company.  Often, founder’s stock is subjected to vesting similar to stock options.  Investors like to see vesting for founder’s stock because this gives the investors comfort that the founders will be around for awhile or at least until their stock is fully vested.  It is also important to put in place legal arrangements amongst multiple founders.  Fact is, it is the rare management team that is 100% the same from inception to exit event.  How will you feel if your 50% partner leaves the company but keeps his stock while you continue to build the company’s success?  Co-founders need to put in place legal arrangements, most typically either through a simple vesting schedule or else through a more detailed buy-sell agreement, setting forth what will happen to the equity of the company in the event the co-founders’ participation in the business changes over time.

3. EMPLOYEE AND INDEPENDENT CONTRACTOR AGREEMENTS. Clarifying in writing the terms of employment and contractor relationships is one of the best ways to ensure your company is protected and avoids disputes and litigation down the road.  Ask your lawyer for a form employee offer letter and a form independent contractor agreement.  Particularly if you are a technology company, you also want a form employee proprietary information and inventions agreement (see intellectual property below).  The forms you use should be geared toward entrepreneurial companies and therefore include appropriate language for making stock option grants and covering other issues unique to emerging growth companies.

4. INTELLECTUAL PROPERTY ARRANGEMENTS.  Any intellectual property created by one or more of the founders should be properly transferred and assigned to the company such that the company now owns that intellectual property.  With respect to employees and contractors, it is important to document terms such as confidentiality and the assignment of intellectual property developed by the employee or contractor while working for the company, including those of any founders that are also employees.  Any future investors or potential buyers will want to have assurance that the intellectual property of the company is in fact owned by the company and not by one of the employees or contractors.  Accordingly, preparing the documents to evidence such terms is one of the most important steps in “getting your ducks in a row.”   Likewise, if you hire software developers or others to help you code, you need appropriate legal arrangements to ensure that the end product will be 100% owned by the company.

5. FINANCING TERM SHEET.  Experienced emerging growth attorneys have seen hundreds if not thousands of financing term sheets.  What likely looks like a foreign language to you is actually standard fare for your lawyer.  Your lawyer can walk you through an Angel or VC term sheet to help you understand where the risks and areas of opportunity for negotiation are.  This is time well invested.  It does take some time for new founders to come up to speed on this stuff, and you are best to begin your education regarding financing terms in advance of negotiations with potential investors.  With a solid foundation of the impact of various terms, and the knowledge of the range of what comprises market, you will be able to negotiate a financing deal that emphasizes the terms that are most important to you and also is reasonable and attractive to investors.

In my next post I’ll talk about the top five worst uses!

As promised in my last post, here’s a brief checklist and some rules of thumb to determine if a patent is right for your business. Before you go through the time and expense of filing a patent application, go through the following checklist and honestly answer the questions.

Question 1:  Is the invention (product or process) different in any way from information that has been available to the public for more than a year (e.g., described in a printed publication, offered for sale, used to produce a product)?

Significance:  “The public” means anyone who does not have a confidential relationship with you.  The information can be in any form, for example a product, a written publication (including for example, a U.S. or foreign patent, a scientific or trade journal, or a trade brochure), a publication on the Internet, or a display at a trade show.  A sale, or offer for sale, of the new product, or of a product of the new process is also “information”.

Question 2:  Does the invention provide us a competitive advantage?

Can it do something not done before?

Can it do it cheaper?

Can it do it better?

Significance:  If the answer is no, it’s not worth filing since a competitor can practice an equally good option.

Question 3:  How large is the potential market?

Significance:  If the market is less than $50,000 per year, then it is possible no one will compete.

Question 4:  How long will the market exist?

Significance:  If the market will not exist two years from now, patent protection may not make sense since it generally takes at least two years to get a patent.

Question 5:  How likely is it that there will be competitors in the market?

Significance:  If there will be no competitors, there is no reason to file.

Question  6:  Can I contractually prevent all customers from doing it themselves or purchasing from a competitor?

Significance:  If the answer is yes, there may be no reason to file.

Question 7:  Is this an invention that can be licensed to third parties?

Significance:  If the answer is yes, then most likely file since royalty rates are generally higher for a patented invention.

Question 8:  Can I protect this as a trade secret?

Would it take considerable effort to reverse engineer the invention?
Will disclosure to the customers be unnecessary for them to use the invention?
Will disclosure to the government be necessary (which may destroy trade secret protection)?
Does anyone already know the invention such as consultants or university researchers (which may destroy trade secret protection)?
Can I protect the invention from ex-associates and partners and ex-spouses?

Significance:  If the answer is yes, trade secret protection may be the way to go.  An option is to file a patent application, and reserve the trade secret vs. patent decision for later.

Question  9:  Will filing a patent application and satisfying the “best mode” requirement require disclosure of valuable trade secrets

Significance:  A “yes” answer may mean no filing.

Question  10:  Can I protect this with a copyright or trademark or trade dress rights?

Significance:  If the answer is yes, there may be a cheaper and easier way to obtain protection than through a patent.  Consult an attorney regarding these options.

Question  11:   Is this invention unobvious compared to what came before it?

How different is the invention from the prior art?
How long have people been trying to solve the problem?
How much effort and time did it take to solve the problem?

Significance:  To actually receive a patent, it is necessary that the invention be unobvious.  However, I recommend that a patent application be filed for any commercial product that is “different”, even if “obviousness” is problematic.  The “patent pending” notation generally slows down competitors enough to more than justify the cost of a patent application.

Question  12:  Has anyone who does not have to assign his or her rights to me contributed to the invention?

Significance:  If third parties will have the right to practice the patented invention, it may not be worth filing.

Question 13:  Can I obtain an enforceable patent? Can I detect if someone is infringing?

Significance:  If the patent is not enforceable, there may be no reason to file.  For example, if the invention is a new process for making a product, but the product is indistinguishable from products made by the old process, it may not be possible to detect infringement.

There are multiple types of applications for patent protection that are available.  Two of the more common are Utility (Provisional and Regular) and Design.  The difference between design patents and utility patents is that design patents only protect the non-functional appearance of a product, while utility patents cover how your invention works.  For some products both patent types may be available.  The main advantage of design patents is they are relatively inexpensive to obtain.  The main disadvantage of design patents is the scope of protection is generally narrow – they only cover the appearance of the product shown in the drawings, and not the product’s function.

If a utility patent is appropriate for your invention, then you need to decide whether to file a regular application or a provisional application. Because of their lower initial cost, provisional patents can be more attractive to start ups. Some of the more significant pros and cons of filing a provisional patent include:

ADVANTAGES OF A PROVISIONAL APPLICATION

1. Slightly Lower Initial Cost. The initial cost of preparing and filing a provisional patent application generally is lower than that of preparing and filing an actual patent application. This is because of the lower PTO filing fees and the more limited requirements of a provisional application.

2.  Delay of Examination Costs. Since a provisional application is not examined by the PTO, examination costs are delayed during the pendency of the provisional application.

3.  Shift of Patent Term. The end of the patent term can be shifted one year into the future, an important advantage for inventions, such as drugs, whose commercial value may be at the end of the patent term.

DISADVANTAGES OF A PROVISIONAL APPLICATION

1.  Delay in Issuance of a Patent. A provisional application cannot result in a patent— an actual application will eventually have to be filed.  Accordingly, the initial filing of a provisional application, instead of the immediate filing of a regular application, necessarily delays the issuance of any resulting patent.

2.  Higher Total Cost. The overall cost of initially filing a provisional application and then following up with the filing of an actual application will necessarily be more than the immediate filing of a regular application.

3.  Accelerated Foreign Filing Costs. Filing a provisional patent application starts the one-year period within which foreign patent protection must be applied for.

In next week’s post I’ll provide an entrepreneur’s checklist for determining if a patent application is required (or appropriate for your product or invention.