The Ultimate Guide to Startup Law
An Overview of Common Legal Challenges Founders Face – & How To Overcome Them
- Startup Entity Structure
- Startup Financing
- Intellectual Property for Startups
- Privacy Governance for Startups
- Wage Law Compliance for Startups
- Essential Legal Documents for Startups: A Checklist
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This eBook is intended to be for informational purposes only. This information does not constitute legal advice. The law is constantly changing, and the information may not be complete or correct depending on the date of the eBook and your particular legal problem. The use of information from this eBook does not create any type of attorney-client relationship. Please contact CGL with specific questions.
Startup Law Guide: Chapter 1
How Do I Legally Structure My Startup?
Tip from The Podcast
If you’re running your company right now, and you haven’t set up an entity yet, at the very least, I highly encourage you to set up a separate bank account for corporate funds
Choosing a Corporate Entity for Your Startup
The right corporate entity for your startup offers structure for your management team, operations, and ownership, while opening doors for the right kind of financing. The wrong corporate structure can cost you in taxes, missed opportunities, and compliance issues. Worse still, changing entity structure is expensive and time consuming, if it’s possible at all.
Unfortunately, there’s no hard or fast answer to the question “what’s the right entity structure for a startup?”. The answer is always: it depends.
It depends on who you want to own and operate your startup. It depends on whether you want to attract VC funding, or if debt funding will be sufficient. It depends on your other income sources, and your financial position generally. Here’s an overview of the typical entity structures:
Limited Liability Companies
What is an LLC?
Limited Liability Companies, or LLCs, are a hybrid entity type that share characteristics with corporations, partnerships, and sole proprietorships.
Like the corporate entity structure, LLCs limit the personal liability of business owners. This means LLCs can take on debt and other legal obligations as a legal ‘person’, which shields an owner’s personal assets while allowing for growth.
Unlike corporations, LLCs don’t need to hold special meetings or provide extensive corporate records, and the documentation requirements to set up an LLC are less onerous. There’s also flexibility in structuring management and operations, and for allocating profits.
Taxation Benefits of an LLC
In addition to the limited liability, flexibility, and streamlined filing process for LLCs, there are taxation benefits of the LLC entity structure. LLCs are not (usually) subject to separate federal taxes. This means the LLC’s profits and losses pass to the business owners and are then submitted by them via a personal tax return. The business owner only pays personal tax, thereby bypassing the double taxation experienced by corporations.
The exception here is if an LLC elects to be taxed as an S Corp or C Corp, in which case it will need to pay federal taxes. This election allows business owners to save money once they find themselves in a higher tax bracket.
Who Should Form an LLC?
LLC is a common entity structure for accounting, tax, and law firms. Manufacturers often choose it too, with some more prominent examples being Pepsi-Cola, Nike, Blackberry, IBM, Chrysler, and Crayola.
Startups seeking VC or angel investor funding might be better served by a different entity structure. LLCs are not the preferred entity for investors. That said, it isn’t possible to attract investment with an LLC. As always, it will depend on your circumstances.
The Various Types of Corporation
Corporations are legal entities separate from its owners. Business owners are shielded by limited liability and, as separate legal entities, each corporation has legal rights – including the rights to sue, be sued, buy and sell property, and sell ownership via company stock. There are multiple corporate structures to choose from:
C-Corporations (or C-Corps)
This is the default corporate form. It is owned by shareholders and preferred by investors, since it offers investors certainty about their rights as a shareholder and allows for flexibility in ownership by way of stock classes.
C-Corps are subject to double taxation, which means founders will need to pay taxation at the company level and then again as personal income when the company revenue is paid to them as wages, dividends, or bonus payments. Though, for young companies, the corporate income is usually quite low once salaries and expenses are paid.
S-Corporations (or S-Corps)
S-Corps are technically a tax designation and not a structure for a legal entity. In certain circumstances, C-Corps can elect to be treated as S-Corps under federal taxation law, which means the corporation can avoid double taxation.
The IRS outlines these requirements for corporations to qualify for S-Corp status:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Electing to become an S-Corp is fairly straightforward. You need to file a Form 2553 signed by all shareholders. The IRS has created this instruction guide to assist.
B-Corporations (or Benefit Corporations)
What’s a Benefit Corporation?
Benefit corporations are incorporated for the dual benefit of the public and its shareholders. This structure allows directors to contemplate broader community or environmental purposes in their decision making – instead of acting solely on the part of shareholders. You can read California’s Benefit Corporations legislation (AB-361) here.
Benefits of B-Corp Status
Beyond increased decision-making flexibility, benefit corporation status can provide a significant competitive advantage. Consumers are becoming increasingly conscious of the impact their purchasing habits has on the world. B-Corp status, especially when a B-Corp achieves Certified B Corporation status, makes a statement to the conscious public that your company cares about a particular social issue, generating additional investment and customer and staff loyalty.
A Final Note About Incorporating: Delaware isn’t always the best option
If you’re thinking of incorporating, you’ve likely heard Delaware is the place to do so. There are certainly perks to starting your company in Delaware. In fact, the benefits for big businesses have led to 66% of Fortune 500 companies being incorporated in Delaware. Corporate law is highly developed in Delaware, which means it offers greater certainty for founders and investors. However, there are financial considerations that may mean Delaware is not the right option for your startup – particularly if you aren’t headquartered or doing business in the first state.
Should Your Startup Become a Corporation or LLC?
This will depend on your startup’s ownership structure and the type of investment you intend to attract in the future. There are pros and cons to both entity structures – and switching between the two can be complicated and costly if your state doesn’t offer a streamlined statutory conversion process. Delaware and California both offer these streamlined conversion processes.
If you’re uncertain, it’s best to seek help. Choosing the right structure for your entity is important – and getting it wrong can be costly in the short and long-term.
Startup Law Guide: Chapter 2
Startups typically access two types of financing: debt financing and VC financing. Which type you choose will vary depending on your stage of growth and, often, what’s available to you at the time you need it:
An Overview of Debt Financing:
Debt financing refers to financing provided when debt instruments are sold to investors. These debt instruments include loans from family and friends, bank loans, investor loans, convertible notes, short-term debt agreements, and hybrid debt/equity instruments like SAFEs and Convertible Notes.
Debt financing receives less publicity than venture financing and is considered to be a little less glamorous. But, when accessed intelligently, debt can help founders retain more ownership of the company – which is a significant perk.
Benefits of Debt Financing
Here’s a quick rundown of the other benefits of debt financing for startup founders:
- It doesn’t require founders to cede ownership or appoint particular persons to the board of directors.
- Interest payments may be tax deductible.
- You can improve your business credit.
- Debt obligations are (usually) predictable.
- Your lender typically doesn’t have a claim on future profits.
Drawbacks of Debt Financing
But, debt financing isn’t without its pitfalls. These are the most common drawbacks of debt financing for startups:
- You have to pay it back.
- While you retain ownership, you may sacrifice some control – especially where restrictive covenants are written into the loan document. It’s not uncommon to see loan agreements where startups need to consult with the investor before making business decisions, including whether to buy and/or sell assets.
- You may need to provide collateral, and that collateral might be your IP.
Common Types of Debt Financing Accessed by Startups
Startup Debt Financing: Family & Friends Loans
Family and friends financing, also referred to as a ‘family and friends round’ refers to loans from investors known to the founder(s). These loans are typically one of the first investment resources to be tapped by startup founders.
Knowing your investors personally doesn’t mean you should treat the loan informally. It’s important that you properly document the loans and sign formal loan agreements for each. These documents help set expectations with your family and friends and protect both parties if any disputes arise in the future.
Hybrid Financing: Convertible Notes & SAFEs
Convertible notes are a short-term debt instrument that converts to equity (in the form of preferred stock) if a seed round is completed before the loan is paid back.
Startups and investors are very comfortable with convertible notes. So much so that these documents come in template form across multiple websites. This is one of the major benefits of this type of financing. Another is that it typically provides one to two years of runaway upfront.
The main drawback to convertible notes, like with all debt instruments, is that you’ll need to pay the loan back if you don’t do an equity round within the agreed term. While this type of funding is fairly flexible, it will impact your startup’s decision making. Convertible notes, when paid back, are like a balloon payment. So, you’ll need to consider the payback timeline when making decisions about your startup’s finances.
SAFEs are relatively new and really only offered in Silicon Valley at the moment. In past years, founders would not need to pay the loan back if no equity round was undertaken. As a result, you’d have people who would use SAFE after SAFE without ever doing an equity fundraising round. To combat this practice, today’s SAFEs include repayment provisions with a triggering event other than equity rounds. Despite this, founders tend to prefer SAFEs over convertible notes where possible because they’re comparatively straightforward.
What’s the difference between SAFEs and Convertible Notes? And how do you choose?
SAFEs are streamlined documents designed to be simple. They don’t have maturity dates or interest rates. So, they tend to be preferred by founders. But they aren’t commonly used outside of Silicon Valley. Geography is often a deciding factor!
Traditional Debt Financing Basics: Formal Loans
Founders typically won’t get access to traditional debt financing until the company is a bit more established. Banks tend to be fairly risk averse and would want the company to be in a position to prove some financial stability, alongside holding assets that could be used as collateral.
This is why restrictive covenants are commonplace in traditional loan agreements for startups. Unfortunately, these terms can prevent founders from running the company in the way they’d like. Also rather unfortunately, many founders take the financial terms of the agreement at face value. They don’t look to the other terms which can contain these serious restrictions. These provisions in the agreement can restrict how you run your company and when and why you can buy or sell assets. In fact, they can restrict almost anything. This type of control with a loan agreement typically happens if you don’t retain an attorney.
Moreover, if you breach the loan agreements there can be serious consequences. Security may be taken for the loan which can include property and your equity interests in the company.
That’s why our top tip for founders looking to obtain a loan agreement either with a bank or another investor is to get an attorney. By retaining a lawyer, you have a professional on your side who can advocate on your behalf. Your attorney will have more experience handling these negotiations and will be more likely to return with an agreement that has more favourable terms for your startup.
That said, bank loans are typically a very cheap form of financing for startups – so long as you choose a reputable provider. This is a significant benefit and one that is often well worth accessing once your startup is in a position to do so.
Debt Financing is More Flexible Than You Might Think
Startups that are at the revenue stage are in a position to get very creative with their financing. There are creative instruments that allow for finance based on tertiary debt.
Accounts receivable financing uses your accounts receivable as collateral. These are typically used by companies with regular revenue but where that revenue is seasonal/time dependent. You can read more about it here.
Invoice factoring is the sale of accounts receivable to a third-party at a discount to accelerate the receipt of cash. This type of debt is relied on heavily in the tech/SaaS sphere, where startups can bring products to the market very quickly. The discount forms the fee payable to the buyer. And the amount of the discount changes based on the creditworthiness of the startup. You can read more about it here.
MRR lines of credit
This is a working capital loan, where the amount available is directly tied to monthly recurring revenue. The downside is that it’s bank debt – so it includes restrictions, including operational oversight. MRR lines of credit are almost exclusively for SaaS companies, specifically ones with low annual churn rates. Ideally under 5%, but certain economic conditions may allow for up to 15%. Subscription and membership-driven companies can also qualify, but should be breaking even, or very near it. As for ARR, it should be above $3M. Generally MRR lines of credit are for bridging larger fundraising efforts, primarily because the terms can be as little as a year. You can read more about them here.
Considerations for Startups When Taking On Debt
Generally speaking, startups will access these debt instruments as soon as they are available (and the need arises). Before you seek financing, you need to consider:
- How adverse are you to giving away equity in your startup right now?
- Will you be undertaking an equity financing round in the near future?
- Are you in a position to qualify for traditional debt financing?
- How important is it to you to know exactly how much you need to pay monthly on any debt instruments you obtain?
- Are you in a position to make these monthly payments?
- Do you have any collateral you’re comfortable providing to obtain a loan?
- What company assets do you intend to buy/sell for the duration of the loan?
Answering these questions will help you determine what financing avenues suit your startup – and whether it’s the right time. Though, we always recommend seeking professional advice from a finance expert before taking on debt.
Top Tips for Startups Taking On Debt
Always work with an attorney.
When dealing with investors, you’re (usually) dealing with highly sophisticated businesspeople. Having an attorney on your team means you have access to a professional who is sophisticated, familiar with these types of documents, and able to advocate on your behalf. You’ll get a better deal with an attorney.
Don’t seek debt financing when you’re desperate.
This will put you on a fast track to unfavorable terms. You should plan your financing to the largest extent possible.
Work with a finance advisor to manage your startup debt.
Living paycheck-to-paycheck is always stressful, but even more so when you have employees and business creditors to pay. You should consult with a financial advisor as early as you can afford it, and certainly before taking on any debt.
Pay attention to the small print.
Investors will always try to increase the favorability of the terms they are getting. Before signing off on any debt, you should question whether you’re okay with all the terms. If you don’t understand them, you shouldn’t sign anything until you do – again, it’s best to ask an attorney to take a look, advocate on your behalf, and explain the effects of the agreement to you.
Manage Your Spending.
Budgeting is key in any business, but even more so for startups with little disposable income. Only take on the debt that makes sense and only spend the money you need to spend
An Overview of VC Financing for Startups
VC financing. It’s competitive, idealized, and often seen as quite a sexy way to raise funds as a startup. But the reality is that it can be fraught with danger for founders – particularly if you don’t fully grasp the future consequences of ceding control in the early stages. You’ll always need to balance terms, conditions, & strings attached against the valuation being offered. Here are some common legal issues to consider when looking at VC financing:
What is VC Financing?
VC, or Venture Capital, is a type of financing that relies on private investors who pay funds into a startup in exchange for equity. In some cases, managerial assistance and expertise are also provided by the investors in exchange for equity, in lieu of an investment.
It is considered a fairly risky form of investment, but startups continue to attract VC financing through the potential for high returns.
The State of VC Funding in 2021.
VC funding saw a bit of a slump when the pandemic started but has since seen record levels of investment. Q1 in 2021 is estimated to be the largest quarter on record for non-traditional investor deal activity. While early and late stage fundings saw record high levels for valuations in Q4 2020.
Benefits of VC Funding
These are 5 common benefits of VC investment:
A good fund will invest in the next round.
If you secure early investment, you’re in a better position to raise funds the next time you need them. Good funds will invest in the next financing round, and they also provide social proof to other investors that your startup is worth investing in.
Your investors may provide support and expertise.
It’s in the best interest of your investors to support you. If your business doesn’t thrive, they lose their investment. Since they want to grow their portfolio, it’s in their interests to help guide your business towards success.
Investors often offer managerial support and expertise as an added benefit to accepting their investment. Depending on the investor, you may get access to office space, financial and legal teams, mentoring, administrative support, and IT infrastructure, amongst other things.
Increased access to networks.
Similar to the above point, professional investors will usually provide startups with access to their networks to help them succeed. This increases the opportunities available to the startup for further investment, as well as opening the door to a pool of potential clients.
It’s accessible for early-stage companies.
Early stage companies can’t always access traditional debt instruments, like loans from a bank or lines of credit. For these companies, VC investment is (comparatively) accessible.
That said, it is a highly competitive environment and finding an investor can be painstaking – particularly in the early stages.
You don’t need to pay investors back.
VC financing is given on the promise of equity – not payback. There’s no maturity date for VC financing. So if the investor doesn’t receive a return, it’s a loss for the investor – not (necessarily) a bankruptcy for you.
Drawbacks of VC Financing
But VC financing isn’t without its drawbacks. Here is a quick overview of some of the more common drawbacks of VC:
- The process of sourcing VC funding is lengthy and requires significant time investment. Founders need to develop business plans and agree upon long-term strategies.
- Highly competitive. For every dollar there is to invest, there are countless startups vying for it. This issue is compounded by the fact that startups want to attract the right investor.
- VC contracts may stagger funding. This often entails startups needing to meet certain milestones before additional funds are released.
- Small investors or angel investors can be more concerned about issues that arise along the way and may want to interfere in day-to-day management. You have to make sure that taking the investment, and allowing these investors into your business, is the right move for your startup.
Legal Pitfalls of VC Financing
Equity is more expensive than debt, but especially if you don’t fully understand your terms sheets.
The cost of equity is always going to be more expensive than debt. While you’re not paying the money out of pocket, you are promising to share your future revenue with your investors.
When you receive a terms sheet from an investor, it will be long, complex, and full of legalese.
The risk is that, at this point, founders are relatively inexperienced with VC funding and may not know what good terms, bad terms, and the usual terms look like.
To mitigate against this risk, you should partner with an experienced startup attorney. They can advocate on your behalf and shield you from future losses that inexperience may otherwise cause.
You don’t want to cede too much control, too early.
One of the key issues founders face during any VC round is what control is being given up.
While this is an issue that presents itself at every fundraising round, it is particularly critical in the early stages. The consequences of ceding too much control are severe. If too many rights are provided in the early stages, founders have little left to give away at the later stages if they want to retain majority ownership. This makes it difficult to attract further financing.
Founders need to have long-term plans regarding the key control terms, like control of the board – and how many seats are being given up – as well as retention of veto rights. When you seek investment, you do need to stick to those long term plans if you want to retain control over your startup.
You need to be conscientious when negotiating drag-along rights.
A drag-along right is a provision in a VC agreement that empowers a majority shareholder (or group of shareholders) to force the minority shareholders to sell or liquidate the company.
These provisions are non-negotiable for investors. But, for founders who want to retain their stake in the startup, drag-along rights can be tough to swallow. It is critical that founders negotiate drag-along right provisions intelligently in order to not be forced to sell in the future.
Founders can negotiate structural protections to limit investor power to force the sale of a startup, including:
- Require a ⅔ majority, instead of a 51% majority. This makes it more difficult for any investor to trigger the provisions.
- Negotiate timing on the provision. For instance, you can stipulate that the provision can’t be relied upon for the next 5 years.
- Outline that the drag-along rights are only granted to common stockholders, not the preferred stockholders.
- Require board approval of any sale (be Delaware aware: case law makes this tricky in the First State).
- Founders can try to stipulate a minimum sales price. Investors are unlikely to agree to this term, however.
Founders need to embed limitations on warranties, covenants, and representations.
Founders should also push for limitations on the warranties, covenants, and representations during the sales process. For instance, you should ask for several liability (instead of joint liability) to ensure that each founder isn’t held responsible for representations made by investors or other founders. These provisions essentially protect you from being held responsible for the actions (and words) of others. Consider materiality and knowledge qualifiers to limit the scope of the representations and warranties that you are making.
Get your agreements in writing.
Founders: ensure all your agreements are in writing, no matter how insignificant they might seem. Certainty is essential – and having agreements in writing promotes certainty.
Top 5 Tips for VC Financing Success
Plan for the long term, as best you can.
Business planning and strategy come into it, but you should know what your ultimate exit plan is by the time you start seeking investment. The answers to these questions should guide the type of investment you seek.
Find the right investment fit.
This can be tricky, given how competitive VC investment is. But, it is essential that founders and investors are working towards the same goal.
Hire a startup attorney, ASAP.
The difference legal counsel can make in slowing the dilution of control is staggering. Hiring a startup attorney means you have someone on your side to negotiate and advocate on your behalf. It also means having someone available to explain your legal obligations and to act as a sounding board for legal compliance.
Startup attorneys are experienced in managing startup issues on a startup budget. It’s best to find an attorney who has significant experience overcoming the hurdles startups face, particularly in the early stages.
Take time to understand your obligations.
You need to understand the small print and your obligations under VC contracts. It’s one thing to have an attorney advocating for you, but take time to understand what the impact of certain changes to the contract mean for your startup today and what it might mean in the future.
Remember that these documents are legally binding and can come with significant and expensive consequences if the agreements aren’t followed.
Focus on what you do best, outsource the rest.
Startup founders are increasingly encouraged to focus on their specific areas of expertise and should outsource the rest. Success follows focus. And focus may come easier if you surround yourself with a team who can take care of whatever you can’t.
Startup Law Guide: Chapter 3
Intellectual Property Law For Startups
For many startups, trade secrets and intellectual property (IP) will be amongst their most valuable assets, particularly early on. But drawing up the paperwork to protect these assets is not always a priority for busy founders, who would rather focus on developing the product and bringing it to market.
Unfortunately, the consequences of failing to protect or misusing IP can be catastrophic. Investors will likely be reluctant to invest if your IP ownership isn’t in order. Worse, you could be sued if the idea behind your startup is considered someone else’s property. This chapter will outline how your startup can protect and properly use its IP:
What are Trade Secrets and Intellectual Property?
Broadly speaking, trade secrets and intellectual property are ideas and/or information that hold value for a startup. In fact, trade secrets are a category of IP. But there are key differences between trade secrets and other categories of IP that are worth noting.
Defining Trade Secrets:
The United States Patent and Trademark Office defines a trade secret as information that:
- Has either actual or potential independent economic value by virtue of not being generally known,
- Has value to others who cannot legitimately obtain it, and
- Is subject to reasonable efforts to maintain its secrecy.
You must ensure that your trade secrets meet all three of these criteria on a continuing basis to protect your trade secrets. While these elements exist, your startups will enjoy strong protections offered by federal trade secrets legislation (The Defend Trade Secrets Act).
The Growing Popularity of Trade Secrets
Facebook, Google, Bumble, and even McDonalds all protect their ‘secret sauce’ using trade secret protections. There are significant advantages to trade secrets, including that the protections are indefinite (as long as the three elements above are maintained) and companies don’t need to disclose the information publicly to protect it (unlike with patents).
Defining Intellectual Property
Trade secrets are a type of IP, alongside copyright, trademarks, and patents. These categories are all legal constructs designed to protect intangible assets derived from human ‘intellect’. Without delving too far into the legal definitions for each category, they can broadly be described as follows:
- Copyright: protects creators’ original works of authorship. These protections are used by artists, authors, musicians, and illustrators but also apply to common business materials such as articles, ad copy, websites, and software code.
- Trademarks: protect identifying branding elements, including logos, names, and slogans.
- Trade Dress: protects the appearance, characteristics and overall “look and feel” of a product or its packaging or design. Like trademarks, trade dress is designed to prevent others from using elements that are the same or confusingly similar to the elements you use to identify your business to the public.
- Patents: protect inventions, including “any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof” (35 U.S.C. 101). To qualify, inventions must be novel (the first of its kind), useful, and not obvious.
- Trade secrets are defined above. It is worth noting that trade secrets may be patentable in some cases. Determining whether to retain the information as a trade secret or to patent it will be a business decision.
Protecting Your Startup’s Intellectual Property
Your First Steps: Ensure Trade Secrets and Intellectual Property Are Owned by Your Startup
To begin with, you will need to define your startup’s IP. You should ensure this is documented in writing and add to this list over time. Your IP is much easier to protect when you know precisely what it is. From there, you must ensure that the IP you’ve defined is owned by your startup:
Don’t misuse IP owned by others.
Startups should be careful not to use trade secrets and IP owned by others – particularly IP owned by a company that the founders worked for previously. This error can result in part or all of the IP being deemed to belong to that company, much like the storyline of the film, The Social Network.
Your employment contract (with any employer outside of the startup) likely assigns the rights to any trade secrets or IP you generate during your employment to your employer. This means your ideas could belong to your employer, depending on the circumstances.
If you developed your idea using any of your former employer’s technology, tools, time, or trade secrets, there is a good chance that your former employer can claim the idea was developed “in the course of your employment” and that they own it.
If you’re uncertain whether your idea belongs to you or your employer, it’s worth seeking early legal advice. The financial burden of developing an idea and bringing it to market to then have a former employer claim ownership is devastating, not only emotionally but also financially.
Founders should assign the IP to the startup.
At the same time, founders should be careful to assign ownership of the trade secrets and IP they develop to the startup. Innovation and ideas usually come about before the company is legally formed. It is important that founders (and any other IP contributors) assign their rights to the IP to the startup and agree on what they get in return for that assignment very early on. We cannot overstate the importance of making these agreements in writing. Investors will be looking for these agreements to be in place before they contribute any funds. Beyond that, it’s just good practice to ensure a disgruntled founder or early employee can’t jeopardize the future of your business.
Next: Carefully Protect Your Startup’s Intellectual Property
Once you have defined and determined ownership of your startup’s IP, you need to carefully guard it. As we outlined above, trade secrets are only afforded legal protection if you make reasonable efforts to protect it. This means that you can lose these essential protections if you’re reckless with your trade secrets.
A non-disclosure agreement (NDA) is a legal document that prohibits people from disclosing trade secrets and other IP. All founders, freelancers, employees, candidates and anyone else with whom the information is shared should ideally sign either:
- a non-disclosure agreement (NDA), or
- confidential or proprietary information and invention assignment agreement (CIIAA), depending on their role at the startup.
We say ideally because, in reality, investors and sometimes even contractors aren’t going to want to sign an NDA early in the relationship – and asking can sometimes hurt your relationship with them. Moreover, you aren’t likely to have the resources to enforce the NDA if it is breached.
To protect your trade secrets in practice, you should create a ‘sliding scale’ of information to share with venture capital investors. Work out how you can talk about your idea without going into significant technical detail about execution. Over time, you can share more about your idea and, once you’ve established a relationship, you can ask for your NDA.
“If you’re looking to raise money from VCs and Angels, …they’re going to want to see that every single person who works at the company and has ever worked at the company or consulted for the company signed an NDA. That’s how critical IP is in this world.”
In addition to ensuring that founders assign their IP rights to the startup, you want to be sure that you have IP assignment clauses in your agreements with all employees, independent contractors, and any other individual or company you engage to create work product for your startup. Critically, you want to be sure that the employee or independent contractor agrees to assign any IP rights arising out of their services to the company.
You do not necessarily need to register your IP to protect it. In fact, you acquire certain rights in a trademark simply by using it. This is because copyright protection applies the moment a work is fixed in tangible form; and you can prevent others from making or selling your invention by simply keeping it secret.
However, this type of protection can be vulnerable. Your rights may be geographically limited and difficult to enforce and if your invention becomes public, it’s no longer protected. Registering your IP gives you extensive rights and protections. It also puts others on notice that you own the IP which can deter competitors from infringing on your rights.
Intellectual Property Protection Hygiene
Defining and maintaining your startup’s IP doesn’t need to be a lengthy or expensive process. But the fallout from poor IP hygiene will almost certainly be lengthy and expensive. It is worth developing and establishing good IP protection processes in the early stages of your startup.
Startup Law Guide: Chapter 4
Privacy Governance for Startups
For startups, privacy law can seem overwhelming. You may need to parse and comply with the laws that exist wherever your customers, and even website visitors, live. Those laws can be complex and they’re constantly changing. Despite this, startups don’t need enormous budgets for privacy to thrive.
If you’re not familiar with privacy for small businesses, we recommend reading our feature article on Business.Com: The Essential Small Business Guide to Data Privacy. This guide provides an in-depth overview of the major privacy considerations for startups.
Basic Tenets of Privacy Law
Compliance with privacy law looks different around the world, but the laws being enacted and developed today center around certain recurring themes including the following:
- Be transparent with your customers about your data practices;
- Give your customers power over the data you collect, store, use, and sell;
- Develop safe data sharing practices; and
- Notify customers if their personal information is accessed by someone who shouldn’t have accessed it.
Compliance for California-based Startups
The California Privacy Right Act (CPRA) is the legislation that California startups need to first consider. In November 2020, Californians voted to replace the California Consumer Privacy Act (CCPA) with a new and expanded law, the CPRA. The CPRA will go into effect on January 1, 2023 and [CGL1] applies to businesses that:
- Have annual gross revenue in excess of $25 million in a calendar year, or
- Buy the personal information of 100,000 or more California-based consumers or households annually (this is a slight change – up from 50,000 under the CCPA); or
- Derive 50% or more of its annual revenue from selling or sharing California consumers’ personal information.
This threshold may not apply to all startups. But that doesn’t mean that startups can ignore questions of privacy.
Benefits of Good Privacy Governance for Startups
Beyond your legal obligations, there are numerous business benefits to developing good privacy governance at your startup, including these benefits outlined by CPO Magazine:
- Competitive advantage;
- Increased customer loyalty and trust;
- Improved brand value; and
- Mitigated risk of reputational and financial damage from a data breach.
We propose one additional (and very significant) benefit: it works to future-proof your startup.
Growth is unpredictable. You can lay outside of the requirements one day then meet them six months later. Proactively preparing to meet the privacy requirements of the CPRA, European data protection laws , and similar laws in other jurisdictions you fall under ensures you don’t need to implement expensive band-aid solutions down the line.
Initial Privacy Steps for Startups
We strongly encourage startup founders to ensure you understand the following:
- How you are collecting information from individuals,
- What type of information you are collecting,
- What you are using it for,
- Where you are storing it, and
- Who you share it with.
Having a firm handle on your data ecosystem is a good practice that will set you up for future compliance with any other state or federal law. It is a foundational step that allows you to create up-to-date and accurate privacy notices, identify gaps and inconsistencies in your current approach, and determine what types of internal policies and security controls are reasonable for your business. It will also ensure your business handles personal information in line with consumer expectations, which can minimize the risk of reputational damage.
Notice of Collection
Like many privacy laws, the CPRA has provisions around notice, specifically about the notice you must provide to users about what types of information you collect, what purposes you use that information for, and with whom you share that information. Being transparent with your customers about your data collection and usage is a good business practice, even if you don’t currently fall under the CPRA.
“Sensitive” or “Special” Data
Certain categories of data may be considered “sensitive” or “special” under the law and may be subject to stricter obligations. Be sure to consider whether any of the data you collect carries a particularly high risk – either because it relates to particularly vulnerable populations such as children or because the data is highly personally identifiable and cannot be easily changed such as Social Security numbers or biometric data. The consequences for failing to safeguard this type of data can be severe. For instance, the CPRA includes increased fines for the misuse of children’s data.
Good Vendor Management
Develop formal policies and procedures early to handle engaging and overseeing vendors and service providers. Think of vendors and service providers like your employees – you hired them, so you are responsible for them. In general, there are three elements to good vendor management:
- Conducting due diligence before you engage a vendor;
- Implementing contractual protections that lay out your expectations for how the vendor will treat the data you share with them; and
- Monitoring or periodically reviewing your vendor’s performance and compliance with their contractual obligations.
Privacy by Design
One framework that startups can use to build a culture of privacy is the ‘Privacy by Design’ framework. The Privacy by Design framework embeds privacy into the design and operation of IT systems, networks, and business practices. It promotes a culture of privacy which, in turn, helps startups make future-focused decisions about website development and data collection practices, amongst other things.
The 7 Principles of Privacy by Design
There are 7 principles behind privacy by design as outlined by former Information and Privacy Commissioner for Ontario, Canada, Ann Cavoukian, in her article ‘Privacy by Design: The 7 Foundational Principles’:
Privacy should be proactive, not reactive.
Once lost, consumer trust is difficult to regain. By approaching privacy risk with a proactive, not reactive, attitude across your network and technologies, internal processes, and physical security measures, you demonstrate a commitment to high standards of privacy.
Privacy as the default setting.
This principle envisages a setting where “if an individual does nothing, their privacy still remains intact. No action is required on the part of the individual to protect their privacy – it is built into the system, by default.”
To achieve this, startups are encouraged to:
- Outline why personal information is collected, used, retained, and disclosed in a consumer-facing policy;
- Collect personal information fairly and lawfully;
- Minimize data collection to purposes where it’s strictly necessary – and then minimize the identifiability, observability, and linkability of any collected data, wherever possible; and
- Use, retain, and disclose data in limited circumstances and ensure data is securely destroyed when it is no longer needed.
Privacy needs to be embedded into design.
Your IT and network infrastructure and planning should be built from the ground up with privacy in mind. Privacy, when embedded into the core functionality of your systems and processes, becomes significantly more robust.
Privacy impact assessments are a useful tool in this regard. You can read more about PIAs here.
A quick note: there is plenty of emphasis on the importance of data privacy and cyber security, but physical security measures are essential too. Wherever you store personal information physically, make certain that there are measures in place to protect it.
Full functionality means positive-sum, not zero-sum.
A system which requires trade-offs between privacy and full functionality is likely not an optimized system. Privacy can be embedded into your systems in such a way that you achieve the multi-functionality you need to meet your business goals and consumer expectations.
End-to-end security – full lifecycle protection.
Privacy should be protected by robust means throughout its entire lifecycle before being securely destroyed. Cybersecurity is an essential component of this. The NIST Framework is a useful resource for startups looking to manage cybersecurity risk.
Visibility and transparency – keep it open.
Visibility and transparency are critical to establishing and maintaining accountability and trust. Founders who have engaged in data mapping can quite easily make data practices visible for consumers which, in turn, offers business benefits over time.
Respect for user privacy – keep it user-centric.
User empowerment should be kept front and center where personal information is concerned. Consent, accuracy, access, and compliance are key. They can be integrated by startups by developing strong privacy defaults, appropriate notice policies, and user-friendly functionality (and by avoiding dark patterns).
Privacy is complex. We’ve created a compliance checklist to help you navigate it.
Startup Law Guide: Chapter 5
Wage Law Compliance for Startups
Most startups follow a common route when establishing a work force:
First, startups rely on work by the founders – who may or may not still be employed elsewhere and running the startup as a side hustle.
Then, freelancers start to perform contract work. At this stage, it is not (usually) financially feasible for the startup to hire employees.
Finally, non-founding employees are brought in once funding arrives.
You need to use caution at every stage when determining how to engage an individual to provide services to the company (e.g. whether as a contractor or an employee). They must be correctly classified and paid in line with their classification to minimize risk of claims for unpaid wages. And these risks exist at every stage.
Common Pitfalls in Worker Classification for Startups
Founders as Employees
Founders can be considered employees of the startup. If they are, they will need to receive minimum wage for their contributions.
Relying on equity payments for founders in California is a route that’s fraught with legal risk. Federal law exempts founders with 20% or more equity from the requirement to receive minimum wage. But some states don’t allow this – California included.
We often see startups skirting the minimum wage rules relying on the mentality that founders aren’t likely to make a claim against their company for not receiving minimum wage. This is true – if the relationship between the founders stays intact. (Potentially expensive) Issues can arise if a disgruntled founder leaves or is removed and they make a claim for minimum wage. If this happens, the start-up cannot rely on a defense that the founder agreed to receive sweat equity in lieu of wages. There is no defense of consent in employment law and payroll records will show the founder was not paid proper wages.
Legal issues aside, investors are alert to warning signs that you haven’t been compliant with wage laws for founders. You may lose the interest of investors if you haven’t been paying your team correctly.
Contractors as Employees
Startups may be tempted to prolong the use of the ‘contractor’ classification, particularly in the early stages where the future is less certain. This can result in startups running into issues related to worker classification and claims for unpaid wages.
Federal Classification: Employee vs Independent Contractor
At the federal level, you need to grapple with the definition of an employee vs a contractor under the Fair Labor Standards Act (FLSA) and the IRS classification standards.
At the time of writing, the FLSA relies on an assessment of the total activity or situation that controls. The US Supreme Court has outlined 7 factors relating to the relationship that should be considered when determining whether a worker is an employee or a contractor. In May 2021, this will change to a test that considers two core factors as being the most probative, namely the nature and degree of control over the work and the worker’s opportunity for profit or loss. There are other guiding factors that will be considered too. You can find the 2021 Final Rule here.
The IRS considers the degree of behavioral control and financial control the startup has over the contractor, as well as how each party perceives their relationship.
The different tests create confusion for companies. You should consult your attorney if you are uncertain about your employment classifications.
State Classification: Employee vs Independent Contractor
You’ll also need to contemplate any state standards. California, Connecticut, Delaware, Illinois, Indiana, Massachusetts, Nebraska, Nevada, New Hampshire, New Jersey, Vermont, Washington, and West Virginia, for instance, have stricter independent contractor requirements than the federal standard. The exact application differs in each state and the list above is not intended to be exhaustive.
In California, pursuant to AB5, with a few limited exceptions, a company must satisfy three requirements to prove that a true contractor relationship exists. The company must show that the individual:
1. Is free from the direction and control of the hiring company;
2. Provides services that differ from the ordinary business of the company; and
3. Has and operates an independently established business of the same nature as the work performed.
Your contractor agreement plays a crucial role in outlining the scope of a contractor’s services – and will be used as the starting point in proving proper classification of a contractor. To minimize the risk of assessed penalties and past wages for misclassifying a contractor, companies should strongly consider including the following points in any contractor agreement:
- Has the right to set his or her own working hours;
- Controls where and how the work will be completed;
- Will be paid based on the completion of a project (preferably based on milestones, not an hourly rate); and
- Is responsible for costs incurred in the performance of the work.
You can read our FAQs about independent contractor status in California here.
If you’re not absolutely certain about your obligations, you should contact your lawyer.
There are no exceptions for startups under federal and state labor laws and penalties for unpaid wages and misclassification of employees can be expensive. You must pay your employees, including founders, what they’re entitled to or risk being liable for unpaid wages. If you’re uncertain about the classification of your workforce, spending a little money on legal guidance here is often less costly in the long run.
Non-Founding Employees & Equity
We see startups using the promise of equity to lure employees (again, particularly in the early stages). In terms of wage compliance, you will need to pay them in line with minimum wage laws in the state they live in.
Additionally, you want to be certain that the contract reflecting your agreement with each employee is crystal clear.
Startups may consider using the template form of option agreement, form of exercise agreement, and equity incentive plans available online – but only if you are very clear about how they work. If not, find the template then book a consultation with your attorney to check everything is in order.
Equity is one of the most valuable assets your startup has. It is not worth risking giving away too much – and if you don’t completely grasp the future consequences of equity arrangements with early employees, you may experience reduced investor interest or need to engage in (potentially expensive) buyouts in the future.
A Checklist of Essential Legal Documents for Startups
In the very early stages, you should ensure your startup creates the following documents:
- Company’s identifying information.
- Company structure.
- Authorized number of shares (for a corporation)
- Management interest, if the company is an LLC.
- Decision-making rights.
- Voting rights, including tiebreaker rules.
- Corporate Governance, including establishing the Board of Directors and setting annual meetings of the Company.
- Titles of Officers of the Company, including responsibilities.
- Initial capital contributions (and additional capital contribution requirements), if the Company is an LLC.
- Finance Management, including whether one or more founders need to sign off on expenses and whether founders will be reimbursed for expenses.
- Transfer Restrictions, with respect to Company shares or membership interests.
- Dispute resolution processes.
- Founder exit.
- Founder removal.
- Company dissolution, including winding up and distribution of any assets.
- Action by Written Consent of the Incorporator, appointing the Board of Directors and adopting the Company’s Bylaws.
- Organizational Resolutions, appointing officers of the Company and approving issuance of stock, among other things.
- Vesting Schedule, if the shares are subject to vesting.
- Section 83(b) Election.
Next, you should develop the following documents:
- Non-Disclosure Agreement
- Independent Contractor / Consulting Agreement
- Intellectual Property (IP) Assignment of Rights
Finally, as the need arises you should create:
- Offer Letters & Employment Contracts, including Employee Confidential Information and Inventions Assignment Agreements.
- Equity Incentive Plan.
- Indemnification Agreement.
If you only take one thing away from this eBook, we want it to be this:
Fixing legal mistakes is significantly more expensive than being compliant from the outset.
Building a relationship with a law firm experienced in navigating the challenges faced by founders is key to your success. It is worthwhile reaching out to find an attorney to work with as you grow. Experienced startup attorneys have experience navigating legal issues for startups on a budget. They can provide tailored, future focused advice based on your budget. When you have this relationship, you can trust your attorney to advise you on what costs you must incur, what you should consider, and what you leave until later.
If you need help navigating legal compliance as a founder, reach out. We have significant experience working with startups at all stages. And we’re here to help you too.
The materials available at this website are for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem. Use of and access to this website or any of the e-mail links contained within the site do not create an attorney-client relationship between CGL and the user or browser. The opinions expressed at or through this site are the opinions of the individual author and may not reflect the opinions of the firm or any individual attorney.