Legal Issues That Can Affect the Value of Your Business
Laying proper legal groundwork might not be the sexiest aspect of a startup venture. But a failure to adequately address legal issues has real potential to negatively affect the value of your business down the road.
That’s why Rhonda Carniol, a partner at CSG Law, recommends getting a legal footing established for your company from the very outset.
As part of eCornell’s Entrepreneurship webinar series, Carniol joined Chris Wofford for a wide-ranging discussion of the legal issues that can affect startups. What follows is an abridged version of their conversation.
Wofford: Thanks for joining us, Rhonda. Could you start by telling us a bit about some of the work you do?
Carniol: Thanks, Chris. As a partner at CSG Law, I represent entrepreneurs from startup to exit. I find with my clients that it’s very important for their legal counsel to get an in-depth understanding of their business so they can advise them as to what sort of things they have to address that could really affect their business.
Wofford: Ideally you’d want to hit these people as they’re in the early phases of business development, right? Getting yourself legally established seems like kind of a no-brainer and maybe the first thing you should think about doing. On the other hand, it’s never too late, right?
Carniol: That’s so right. It’s never too late. The most important thing is to get yourself in great shape legally before you try to sell your business. It’s easier in the beginning, but even if you’ve been up and running for four or five years, I still think the things we’re going to discuss today are going to be helpful.
I’d like to start by talking about what makes a business valuable. For example, you’re solving a problem or you’re adding something new and innovative into the market. If you have something valuable, you need to protect your intellectual property. You also need to think about limiting your liability to your vendors or your customers. Additionally, you want to avoid disputes with your co-owners, your employees and your contractors. These conflicts take up time and energy.
The first thing to really talk about is protecting your personal assets. If you’re currently operating a business in your own name, you need to immediately stop. Why? Because your personal assets are at risk. But if you form a corporate entity, like a subchapter S corporation or an LLC, then your personal assets, in most instances, would not be at risk except for in fraud situations.
What type of entity should you form? Well, there are several choices. There’s a limited liability company, a subchapter S, a C corporation, and a benefit corporation. A limited liability corporation is usually what most people choose when doing a startup because it has the most flexibility. Owners of the company don’t have to be individuals and it’s easy to bring investors into the mix. It also has tax benefits because it’s a flow-through, unlike a C corporation.
Sometimes you might instead choose to form a subchapter S corporation. There are less expenses involved but it’s taxed the same way as an LLC. The hot new thing is a benefit corporation, in which you’re supposed to do something good for the community or for your customers or the environment. The problem with that is there are a lot of filing requirements and recordkeeping, so I find that most of my clients, although they may want to do good with their companies, don’t want to be bothered with that.
Wofford: How is a benefit corporation different from a 501(c)(3) nonprofit?
Carniol: Well, a benefit corporation is still being formed to make profits. But they can sacrifice some of those profits in order to do good. A nonprofit, of course, is not out to make a profit. So it’s a different type of entity.
Wofford: Okay, got it.
Carniol: What I really recommend is to get an agreement in place right away between the owners if there are multiple owners involved. As soon as possible. In an LLC, this would be called an operating agreement. In a corporation, it would be a shareholders agreement.
A lot of people say, “I don’t need an agreement. I worked with Tim for 20 years. We love each other.” Well, let me share a story. I recently represented someone who had worked with their co-owners for 10 years in various corporations. They waited a year and a half after they started a new business to do an agreement. They were almost ready to launch when they discovered that they had a lot of disagreements, even over how much of the business each person should own. So the cost to them was significantly higher than if they had sat down in the beginning and had the discussion initially. The thing that made them finally come to a decision was everyone’s worst nightmare, which was the creditors of the company coming forward and saying, “We’re going to put you in bankruptcy. You’re not paying your bills.” That’s not a situation I want to see anyone in. You need to sit down in the beginning, find out if you have any differences, find out if your visions are the same, and enter into an agreement.
I often see situations in which a company is about to be sold and it comes out that the assets of the company aren’t in the company’s name. Instead, they’re in the original owner’s name. This is a major problem. The assets then have to be transferred into the company and they may have significant value at this point and therefore pose tax issues.
Another messy situation can arise in a multi-owner deal. If one person owns the patent, for example, then that individual has considerable negotiating power going into any deal – much more than the other owners. The easiest way to avoid these things is to move your assets over to the company at the outset. If you’ve already started a business and your assets aren’t with the company, move them over now.
Wofford: This goes back to your earlier point about doing all you can to avoid disputes.
Carniol: Exactly. That’s also why I can’t stress enough the value of a contract.
You should also always have a contract with your independent contractors that includes enforceable ownership language and confidentiality protections. You want to protect your customer list, your contacts, your vendors, your unique processes and your way of providing products. If you don’t have a confidentiality agreement, these things could skip right out the door with an independent contractor or a departing employee.
Wofford: Are these contracts something that should be drawn up by individuals? Do they need to involve highly complex legal language? Would you craft an NDA, for instance, without legal counsel?
Carniol: I know there are templates online, but you should not have an NDA without legal counsel. This is a really inexpensive document for your lawyer to draft. They will draft it geared to what’s important for your business. I don’t suggest just doing it yourself because you just may not protect what you need to.
Ideally, you should have a separate agreement for your employees and another for your independent contractors. If you’re further along in the process – let’s say a private equity firm is starting to look at you – you will need a different type of confidentiality agreement. Sometimes you’re going to have confidentiality provisions even in your customer agreements. But they won’t be as big as what you put in your independent contractor agreement because you don’t want to scare the customer away.
There are some other things that you might think of putting in the independent contractor agreements. You might include indemnities. If you get sued by a third party because of something the independent contractor did, you want them to step up and indemnify you. Of course, there are things that are standard in the industry so you cannot be too far-reaching, or the vendor is going to tell you to go take a walk.
You may also want to think about including an anti-competition provision. Sometimes this is appropriate and sometimes it is just not. You cannot stop someone from running their business but in some situations, you may want to prohibit them from making the same product as you, at least for a short period. You just need to evaluate it and this is a good time to call a lawyer to find out what the standard in the industry is and what is reasonable.
Wofford: What about contracts and agreements with your own employees?
Carniol: Your employees will probably become your most valuable assets, so you need them to sign confidentiality and ownership agreements. Without an agreement, an employee who conceives of an invention typically owns the patent rights, not the company. So, think about how this is going to look when you try to sell your business or get an investor. The best way to deal with this is to put it in an agreement.
Depending on your particular business, you may also want to consider whether non-competes and non-solicitation agreements are needed with your employees. In some industries, requiring a non-compete would mean you could not successfully hire anyone, but you at least want to establish a non-solicitation of your customers and definitely a non-solicitation of your other employees because this will prevent a group of employees from leaving and forming a competing business.
Since your employees are such valuable assets, you may also want to consider allowing them to have a stake in the success of the company. Consider whether certain employees should have an ownership interest or a phantom interest in the business. This is also something you would definitely need to talk to an attorney about because a lot of it depends on how far along you are in the process of building your business.
Wofford: Obviously, giving employees ownership encourages them to work hard for your company and to remain loyal.
Carniol: Absolutely.
I’d like to now talk a little bit about customer agreements, which are often needed in the business-to-business market and even in the consumer market. In the consumer market, if you have a web platform up, you will usually see an acceptance agreement that most people click without reading. Even though most people won’t read it, you should have an agreement that people must accept in order to do business with you, in order to protect yourself. Of course, the type of agreement you are going to have depends on your product, industry standards and your customer base. It needs to be tailored to your business.
In the business-to-business market, let’s say you are providing software that another company is going to use to operate and it is integral to their business. You want to limit your liability, because one lawsuit could put you out of business before you have even started. You also want to make sure that it is clear that you own everything and you are not giving ownership to the other company.
Another thing that is really important is to clarify payment terms. You have to specify in these agreements when the customer has to pay you. You do not want to have to get into a lawsuit situation as a startup, so having these kinds of provisions is going to help you avoid disputes and litigation.
Wofford: What other legal angles are essential to consider?
Carniol: Once you have your agreements in place, the most important thing is to develop and protect your brand. This is what differentiates you and makes your business unique. The example I like to give is toothpaste because it’s so boring. Even so, most of us have a favorite brand of toothpaste. Everyone has brand loyalty and that’s why you have to take care of your brand. Trademark your name, your logos and your designs. Doing a trademark only costs about $2,000, and it’s money well spent. You don’t want to start operating your business and then have another company come in and say, “Hey, you can’t operate under this name because I’m using it in the same business.” One of the most important things at the outset of starting a business is avoiding disputes.
Wofford: But a $2,000 layout in the early stages might seem like a lot to people, right?
Carniol: Well, a trademark adds value to your business because you own the intellectual property. You now have a name when you go to sell your business or when you’re looking for investors.
If you have the opportunity to do trademarks to protect your business and your assets, it makes your company more valuable when you go to sell because you have something that makes you unique. Plus, if you have a good idea and you’ve got a patent or a copyright or a trade secret, it slows down anybody else who wants to copy your idea.
Of course, not every idea can be protected. Establishing a trade secret isn’t easy because, generally speaking, for a company to be considered the owner of a trade secret, it usually must be shown that the subject matter has economic value. On top of that, you’ve got to use reasonable precautions to maintain the privacy of it. One famous trade secret is the recipe for Coke and they’ve maintained the confidentiality of that forever.
But you can also use contracts to protect the disclosure of confidential information. Ask people to sign a confidentiality agreement. The only time that this is really a problem is when you approach potential investors and venture capital. Often, they will not sign a confidentiality agreement because they hear so many ideas. Once you’re an established company, it’s different. You can get investors in private equity to agree to limited confidentiality agreements.
Wofford: What about the process of establishing copyright?
Carniol: Filing for copyright allows you to seek statutory damages. However, filing copyrights all the time isn’t realistic. If your business is about updating content constantly or you have a lot of content, you’re just not going to do this. It’s going to slow you down. And not everything you create can be copyrighted.
For instance, facts can’t be copyrighted. If you’ve done a lot of research and you’ve accumulated a lot of facts and data, that’s great — but you can’t copyright it.
The next thing I want to talk about is patents. Getting a patent is the most expensive process — it costs more than getting a trademark or a copyright. But again, not every product can be patented. And for those that can, the patent office has to approve it and that is a long process. Even when you get the patent, you can face lawsuits trying to claim that your patent is invalid. In your filing to the Patent Office, you also have to have to publicly disclose much of your invention and a lot of times, you won’t want to do that. You could do that disclosure and not get the patent and then your secret sauce is out there.
Patents also have a limited life. They last between 18 and 20 years. Once the patent’s life is over, you can’t license what you patented anymore and get money for it.
Wofford: That’s a lot to consider.
Carniol: It is, and it all goes back to doing an initial analysis. What is the goal? Do you want your business to go on for 40 years with a product that you can continue to license or is it something you’re constantly going to be innovating and updating?
Wofford: As we wrap up, I want to ask how much legal stuff can be sorted out by individuals on their own or would you always advise people to seek legal counsel one way or another?
Carniol: Yes, I think you should seek legal advice. I’m sure people are going to walk away from this going, “Wow there’s a lot to do. This is going to cost me a fortune.” It’s actually not going to cost that much.
Even if you don’t hire a lawyer, there is a lot of free advice out there from universities and other organizations for startups. There are accelerator programs where you can get free legal advice. Of course I’m biased because I’m a lawyer but I think that when you start out, you should at least have an initial conversation with a lawyer and find out what is important and what isn’t. Then you can spend your dollars wisely and not waste money on things that aren’t important.
Wofford: I think this conversation was very useful to our audience. I appreciate it, Rhonda.
Carniol: Thanks, Chris.
Want to hear more? This article is based on Rhonda Carniol’s live eCornell WebSeries event, Six Legal Issues That Can Affect the Value of Your Business Subscribe now gain access to a recording of this event and other Entrepreneurship topics.