LawPivot is an online market for legal services. It’s a way for companies to confidentially obtain crowdsourced answers to their questions from lawyers and to also find lawyers to retain. Two lawyers with tech experience, Jay Mandal (formerly the lead mergers and acquisitions lawyer at Apple) and Nitin Gupta (formerly an intellectual property litigation lawyer at Townsend and Townsend and Crew) are the co-founders. In this post, I asked Nitin to answer the most common questions of high-tech entrepreneurs.
Q: Should I ask prospective investors to sign an NDA?
A: Although it would be nice for them to sign an NDA, investors, especially institutional ones like venture capitalists, typically do not. Investors run across many ideas and will resist creating obligations that may be hard to keep.
An investor who hears your investment pitch can learn about your idea, and potentially walk away and replicate it. However, if someone can replicate your idea based on a conversation, then you may not have a strong enough idea to defend it in the first place.
The risk of an investor taking your idea is probably minimal. But you should judge the above risk by looking into that investor’s prestige, public reputation, and other investments as well as your intuition as to his or her personal ethics. You can also check an investor’s portfolio of investments. If they have an investment in your space, they may be fishing for ideas as opposed to truly looking for an investment.
Q: What state should we incorporate in?
A: The state of residence is often the choice that many companies select to incorporate in, but the best choice may be Delaware. Many companies—particularly technology companies—have leaned toward incorporating in Delaware because its laws are corporation-friendly and the corporate law are more well-defined so there is greater legal certainty on issues.
Therefore, Delaware law has become the state of choice for those “in the know.” Delaware corporate law also tends to favor management (for example, stronger protections for officers and directors), and the Delaware Secretary of State is a well-oiled machine that rapidly facilitates corporate changes. Many companies that succeed often “reincorporate” into Delaware if they did not start there.
Q: Why can’t we create a company in the Bahamas or other offshore location?
A: You can incorporate your company in the Bahamas or Cayman Islands, but make sure that you have got a good reason (for example, a big tax advantage). If you do business in the United States (or other nations), you will need to create a corporate subsidiary in the U.S. (or in other nations you do business in). The main reasons companies may choose to incorporate a company offshore are: (i) it’s tax beneficial in the long-run and would be cost prohibitive to restructure in this manner in the future; (ii) it’s beneficial to have their intellectual property offshore; and (iii) the primary markets are overseas. However, an offshore incorporation requires thinking and expenditure on the structure at the front end. The cost of such a structure is large, and most startups conclude it is prohibitive at the early stage.
Q: So if we have a good reason and we’re willing to pay, venture capitalists will be okay with investing a Bahamas or other offshore company?
A: Venture capitalists generally invest in companies that are incorporated in the U.S., but if you have a good business reason to create a Bahamas or offshore company that you explain to venture capitalists, they should be okay with investing.
Q: Why do I need common and preferred stock?
A: Two classes of shares allow for different rights to represent different contributions by shareholders (e.g., money investors versus employees). Preferred stock is usually issued where a company is seeking outside investment. Otherwise, all the stock is common stock.
Typically, a company seeking outside investment provides investors preferred stock, which grants them rights in preference to common stock, such as: (i) rights in priority to common stock (for example, liquidation rights, rights to purchase company or founders’ stock, etc.), (ii) rights to block certain actions of the company (for example, sale of the company), and (iii) rights to have the company help them liquidate their holdings. Investors expect these preferred rights. Importantly, the two class structure also allows the company to offer common shares to employees at a relatively low price and preferred shares at a relatively high price.
Q: Since we own more than 50 percent of the company, we still control it, right?
A: The answer is not necessarily yes. If founders own over 50 percent of the company, the founders may not completely control the company if they have given away certain of their rights in their corporate documents. For example, the founders may have issued preferred stock of the company that has rights in preference to the founders’ common stock such as liquidation rights or has rights to block certain actions of the company such as the sale of the company. Additionally, the founders may have minority control of the board of directors, which governs major actions of the company, or the founders may have by agreement given away certain rights of the company to other parties such as control over its technology.
Q: I have an invention and I would like to file a patent quickly. What are my options and what kind of patent should I file?
A: You should typically first file a provisional patent and then a non-provisional patent. A provisional patent allows you to file a patent without any claims, declaration or oath, and without any prior art disclosure. A provisional patent is valid for twelve months from the date you file the patent.
The main reason to file a provisional patent is to get an early effective date. You will eventually need to file a non-provisional patent before your provisional patent expires. However, for the non-provisional patent, you will still be able to secure the effective date of your provisional patent. A provisional patent can be filed with the USPTO.
Q: We are in the process of releasing a beta version of our software and plan to make it available to the public after six months. When is the deadline to file the patent application in this situation?
A: It depends if the release of the beta version of your software would be considered a public use. In this case, a public use is where the software would be available to your beta users, and there were no restrictions on whether they could disclose the software to others outside your limited pool of users. If it is a public use, you would have to file your patent within one year of the beta release.
On the other hand, you could require your beta users to sign a non-disclosure agreement and make them agree to keep it confidential. By having your beta users sign a non-disclosure agreement, the use of your beta software would not be considered a public use. As long as you keep the software confidential until your general release six months later, you will have one year to file your patent from the date of your general release.
Q: How long and how much will it cost to get a non-provisional patent?
A: After you submit your initial non-provisional application to the USPTO, a non-provisional patent typically takes anywhere from one and a half to three years to issue. After you submit your initial non-provisional application, you typically have to wait anywhere from six to 18 months before a patent examiner initially reviews your application.
After the initial review, there are typically back and forth communications between your patent attorney (or agent) and the patent examiner since your patent is usually not granted on your initial submission, and modification is needed to your patent. A non-provisional patent generally costs anywhere between $5,000 and $15,000 depending on the complexity of the invention.
Q: And once we do, we’re home free, right? Others will either be afraid to copy us or if they do, we can beat them in court, right?
A: Once a non-provisional patent is issued, it is ready to be enforced. Others may be afraid to copy you since the implications of knowingly infringing a patent may carry dire consequences. However, enforcing a patent could costs millions of dollars in litigation fees. Additionally, although a jury may find in your favor in a lawsuit, a winning judgment could be appealed thus delaying collection of any damages. This entire process could span over the course of several years.
That said, receiving a patent has many other benefits besides having the ability to enforce it. For example, a patent may increase the overall valuation of your company, attract investors, or be used as the backbone for lucrative licensing or partnership programs.
Q: The founders have been working on this for two years, why shouldn’t we get all our stock already?
A: In the investment marketplace, a founder is typically understood to earn his or her equity over a four-year vesting period (meaning they can lose shares if they don’t stay with the company through the end of the vesting period). Typical terms are that there is a one year “cliff,” after which one-forth of the stock vests, and the rest vests in increments of 1/48th of the original grant each month thereafter. The thinking here is that investors want to know that the founders still have incentive to remain at the company until their stock fully vests. Some investors invest as much in a team as they do in a business idea.
Q: Can I pay contractors with options?
A: In the early stages of a company, a company may choose to pay its contractors using stock options. You should make sure that you carefully consider the fair market value of the options and follow the rules of granting options. However, the big question is whether your contractors are willing to take stock options in place of monetary compensation. An easier sell if you can afford it may be to provide compensation partly in the form of stock options and partly as monetary compensation.
Q: My uncle doesn’t care about valuation, so why shouldn’t I take the money from him?
A: Beware of the pitfalls of “easy” money. For a company, you can take money from your uncle so far as he meets the minimum requirements of being an accredited investor, and he is someone you are willing to work with as an investor. If you think your uncle cannot tolerate a high-risk investment in a private company, and he would regularly bother you about his investment, you are better served to not take money from him. In addition, if you obtain a highly favorable valuation because your uncle does not care, this can box you into a valuation that causes downstream problems with investors who do care about valuation.