Early Stage companies require capital, people, and often the need to protect intellectual property. Some common errors can be avoided that otherwise will inhibit or prevent companies from achieving success.

Some of the most common and significant lessons to learn are:

Properly Maintaining Organizational Records
The doctrine of "piercing the corporate veil" is well established in the corporate law of most states. Under that doctrine, a court may ignore a corporate entity and permit creditors of the corporation to assert their claims directly against the corporation's stockholders, if the court finds that the corporation is under capitalized and acts as a mere alter ego for its stockholders. One factor that courts consider in such cases is whether the corporation has observed corporate formalities by maintaining proper corporate records.

Another serious problem is the failure to maintain a complete record of equity ownership. Nothing will impair an IPO or venture financing more than confusion about how many shares of a company are outstanding and who owns them. The Uniform Commercial Code eliminated the requirement that contracts to sell securities be in writing. As a result, companies that make careless oral or e-mail promises to sell stock or grant options are creating serious future problems.

Practical Solution: All promises of stock options must be signed and in writing. All Corporate records must properly reflect share ownership.

"Securities Act"). Regulation D imposes particularly stringent conditions on sales of securities to persons who are "unaccredited investors." In the SEC's view, unaccredited investors tend to be less sophisticated investors who require special protection when buying stock. An "unaccredited investor" is any individual who, generally, is NOT one of the following:

• A director, executive officer or general partner of the issuer;
• A person with a net worth of more than $1,000,000; or
• A person who has had income in excess of $200,000 in each of the two most recent years (or joint income with his or her spouse in excess of $300,000 in each of those years) and has a reasonable expectation of reaching the same income level in the current year.

In offerings involving more than $1,000,000 of securities, Regulation D requires that companies provide unaccredited investors with specific written information about the company and its proposed sale of securities.

While Regulation D does not prohibit selling securities to unaccredited investors, it makes doing so more complicated than selling securities only to accredited investors. This complexity increases the chance that a company will make a technical mistake in the offering.

Technical securities law violations can strike back at the company at the time of its IPO or if the company later fails and the investors determine to seek redress directly from those behind the offering. In connection with the IPO, the SEC will carefully study all prior issuance of stock by the company and demand that it take immediate action to cure any past violations of securities laws. Those remedial actions can delay, stall or even kill the IPO. 

Practical Solution: Either avoid selling securities to unaccredited investors in early rounds, if possible, or do a full and complete offering circular. Investor questionnaires must be completed from each investor in order to verify their accredited status.

"Cheap Stock" Problems
Grants of low-priced stock options and restricted stock have become indispensable tools to attract and retain talented employees. However, granting below-market stock options or restricted stock without careful planning can give rise to "cheap stock" problems.

"Cheap stock" problems arise when the SEC decides that a company has not properly charged against its earnings the fair market value of stock and option awards granted. The SEC may take this position if there is a significant difference between the value of the stock that the company has been using for purposes of calculating compensation expense and the price at which the company's stock will be sold in an IPO. In such circumstances, the SEC will demand that the company restate its earnings to reflect the higher level of compensation expense (and lower level of earnings) that the company would have incurred in earlier periods had the stock been properly valued. This demand can have a devastating effect on a company's plans for an IPO and the tax consequences to the stock recipient can be enormous. If the fair market value at the time of grant was higher than the option or grant price, the stock recipient could be personally liable for ordinary income taxes on the value received, which tax liability is payable immediately even though no cash is available for payment.

To evidence the value of equity compensation grants, companies should keep a careful record of any contemporaneous sales of the company's stock to third parties. Appraisals by a qualified investment banker or valuation specialist are also good evidence of value. Appraisals made at the time stock or options are issued are generally more persuasive than those made in retrospect on the eve of an IPO.

Where companies cannot point to contemporaneous same-price purchases or appraisals, they must be ready with a credible explanation of any significant difference between the value attributed to the stock or option grants and the IPO price. Most will point to goals achieved or accomplishments made by the company between the time of the grants and the time of the IPO. Accomplishments might be meeting sales targets, entering into important contracts or obtaining patent or other legal protections for the company's intellectual property.

Practical Solution: Make sure the value of the stock granted reflects its fair market value at the time of grant by contemporaneously reflecting in the minutes the justification for the price.

Employee Stock-Option Plans
A company must adopt a stock-option plan prior to granting stock options to employees. Failure to do so can result in the loss of significant tax benefits and the imposition of tax liability on key employees.

Section 83 of the Internal Revenue Code (the "IRC") governs the taxation of employees who receive stock options in exchange for services.  Under Section 83, an employee is taxed at the time he exercises an option, rather than at the time it is granted to him, if the price of the option is equivalent to the fair market value of the stock. The tax is assessed at ordinary income rates on the difference between the fair market value of the underlying stock on the date of exercise and the exercise price of the option, which price may be very low. This tax will be due and payable, whether or not the employee sells the stock he receives, upon the exercise of the option. If the employee does sell the stock, at the time of exercise or at anytime thereafter, he will be taxed again on the difference between the fair market value of the stock on the date of option and the sales price of the stock. This tax will be assessed at capital gains rates if the employee held the stock for more than 12 months following the exercise of the option, or at ordinary income rates if not.

Qualified incentive stock option plans ("ISO"), can provide a way for companies to reduce the tax burden of options on themselves and their employees. ISOs permit an employee to postpone recognizing income on option exercises until the time the employee actually sells the underlying stock. By postponing taxation of that income, an ISO relieves the employee of the need to find the cash necessary to pay taxes on the stock appreciation until the time he actually sells the stock and has the cash available to pay the tax.

Practical Solution: Adopt an ISO, which must:

• Be in writing.
• Be approved in writing by the shareholders of the company within 12 months before or after the plan is adopted by the company's board of directors.
• Provide that options be granted within 10 years following approval of the plan by the shareholders and expire within 10 years following the date of the grant (five years if the options are granted to persons holding 10 percent or more of the company's stock).
• Provide that options are granted only to persons who remain employees of the company (but not directors or consultants) until not more than three months prior to exercise (or one year in the event of death or disability).
• Ensure that options have a set exercise price at no less than 100 percent of the fair market value as of the grant date (or 110 percent of the fair market value if the option holder is a 10-percent shareholder).
• Limit the amount of option stock that can vest to an option holder in any calendar year to $100,000 (based on the grant date value).
• Prohibit the transfer of options, except by will or the laws of descent and distribution.
• Establish an appropriate vesting schedule.

The Section 83(b) Election
Employees, directors and contractors of the company who receive awards of restricted stock need to make an important tax election under Section 83(b) of the IRC. Restricted stock awards are a form of equity compensation that is used as an alternative or supplement to grants of stock options. Awards are restricted

in that the recipient cannot transfer the stock he receives, and the company will have the right to repurchase the stock for a below-fair value price if the recipient terminates his employment. These restrictions generally lapse over time as the stock vests. 

Section 83 provides that as the stock vests, the recipient must recognize income equal to the difference between what the recipient paid for the stock and the fair market value of the stock on the vesting date. Where the value of the restricted stock has appreciated substantially between the date of grant and the vesting date, the tax liability can be substantial. Moreover, since the now unrestricted stock may still be illiquid (e.g. because of the lack of a market for the stock), the recipient may have no ready source of cash from which to pay the tax.

Section 83(b) is intended to relieve the tax burden that the vesting of restricted stock places on award recipients. Section 83(b) permits recipients of restricted stock awards to elect to be taxed immediately upon the receipt of the restricted equity, rather than upon the lapse of the restrictions.

Practical Solution: Make the Section 83(b) election so that tax will be paid at the time of receipt of an award of restricted stock on the difference, if any, between the fair market value of the stock and the purchase price paid. Since the fair market value of stock in early stage companies is usually very low, the recipient will likely owe little if any tax upon receipt of the restricted stock. The recipient will only owe additional tax upon his sale of the stock, and then potentially at favorable capital gains rates.

Failing to Obtain Good Title to Intellectual Property
Many early stage technology companies pay little attention to the legal formalities necessary to obtain ownership of intellectual property. 

Patents
Under certain patent law doctrines of employee invention, the patent rights to an invention made by an employee belong to the employee (and not to the employee's employer), even if the employee conceived and developed the invention in the course of his employment on the employer's time and used the employer's tools and materials. The employee should assign those rights to their employer by a written document which must be supported by consideration. Continuation of employment alone may not suffice.

Some states also limit the circumstances under which an employer can require an employee to assign patent rights and may require the employer to make certain disclosures to the employee in connection with such assignments (see Section 2870 of the California Labor Code). Assignments of rights to employers that do not comply with these requirements may be void. 

Copyrights
Under copyright law, title to a work belongs to its author upon creation of the work, not to the creator's employer or the person paying for the work. Although the work-for-hire doctrine in the Copyright Act may deem the employer to be the author of a work under certain circumstances, those circumstances are limited and not applicable to third party contractors.

In a work-at-home, use-your-own-laptop, project-based environment, the answer of whether a worker is an employee or contractor can sometimes be surprising. When a work is not a "work made for hire," an employer may still obtain ownership of the copyright to works created by its employee -- but only by obtaining written assignment of the work from the employee that is supported by consideration.

Practical Solution: Have all contractors and, as appropriate, employees, sign an agreement transferring all of their right, title and interest in the intellectual property created to the company as a condition of initial employment.

Trade Secret Protection Program
Trade secrets are among the most valuable forms of intellectual property. To be subject to protection as a trade secret, confidential information must have economic value and its owner must take "reasonable precautions" to keep it secret.

Early stage companies often err by not taking the "reasonable precautions" necessary to turn their confidential business information into legally protectable trade secrets.

Practical Solution: Adopt a formal trade secret protection policy. The policy should establish standard procedures and practices that the company, its employees and third party contractors must follow to protect the confidential information. Policies should include at least some of the following provisions:

• Employees should be informed in writing of the importance of maintaining the secrecy of the company's trade secrets.
• Confidential information should be made available to employees only on a need-to-know basis.
• Written confidentiality agreements should be obtained from all employees and consultants.
• Material containing confidential information should be locked in safes or desks at night and all programs containing confidential information should be password protected.
• Departing employees should have exit interviews in which their ongoing obligation to protect the company's confidential information is explained and the return of all documents and programs owned by the company is required.

Trademark Protection
Branding is a driving force behind many early stage companies. However, registering a domain name or using a meta-tag in a Web site before thoroughly confirming the availability of the corresponding trademark can have serious consequences.

The owner of a trademark may preclude others from using names which are similar to its mark and that are likely to cause confusion in the minds of consumers. To acquire trademark rights to a name or symbol, a company need merely use the trademark in commerce. Registration is not required.  

A company may be liable for infringing the trademark of another if it uses a domain name or meta-tag that is similar to an existing trademark and the domain name or meta-tag identifies a Web site that either sells goods that may be confused with those of the trademark owner or interferes with or diverts the trademark owner's business.

A company may also be subject to criminal penalties under the Anti-Cybersquatting Consumer Protection Act, if it knowingly and improperly registers a domain name that infringes upon an existing trademark.

Practical Solution: Conduct a full and complete trademark search before selecting a domain name.

Licensing Technology Owned by Others
Companies must pay careful attention to the exact scope of the rights they are licensing. Licenses may be exclusive, often with quota requirements, or non-exclusive. They may include a right to sublicense the rights or allow for third party contract manufacturing, or not. They should allocate responsibility for prosecuting those who infringe and for defending against claims of infringement that may be brought by other patent holders.

The consequences of patent infringement can be severe. A court may enjoin an infringer from using the patented process and, in cases of intentional infringement, may award damages to the patent owner of up to three times its actual losses from the infringing use. Infringing upon a patent, either out of ignorance or as the consequence of an inadequate licensing agreement, can be expensive and disruptive to the business of an early stage company. 

Practical Solution: Hire experienced intellectual property counsel to make sure the company gets what it needs and understands what it may not have.

Hiring Former Employees of a Competitor
Where new employees have had access to the trade secrets of a competitor, problems may arise.

The company should inquire whether the person is subject to a restrictive covenant in favor of a former employer. Restrictive covenants generally fall into two categories: Covenants of non-competition and covenants of non-disclosure. State laws vary substantially in their treatment of non-competition covenants. In California they are void, unless tied to the sale of a business. In other jurisdictions, a court's willingness to enforce a specific covenant may turn on factors such as the reasonableness of the covenant's term and geographic restrictions, the burden of compliance on the former employee and the cost to the public of enforcing the covenant. Covenants of non-disclosure of trade secrets are more readily enforceable, though the question of what information they may rightfully protect from disclosure can be contested.

Using a relatively new legal principle known as the doctrine of inevitable disclosure, several courts have recently enjoined companies from employing former employees of competitors where the court felt that the nature of the employee's new duties would inevitably lead to the disclosure of the former employer's trade secrets. Companies hiring former employees of competitors should carefully tailor the job responsibilities of such new hires so as to minimize the chances of a former employer bringing an inevitable disclosure claim.

Practical Solution: Query all new hires on whether they are subject to any restrictions regarding their former employment.

These issues are always present in early stage companies. Carefully managing through them often determines a company’s success or failure. The axiom that an ounce of prevention is worth a pound of cure is particularly true for new organizations.

About Paul R. Katz
Paul R. Katz is a shareholder in the Los Angeles office of Greenberg Traurig, a national law firm comprised of over 800 lawyers and focuses his practice on internet, e-commerce, convergent media, intellectual property and information technology matters. He provides services to emerging companies as well as to larger organizations procuring technology and can be reached at katzp@gtlaw.com.