White & Lee, LLP

Facts: Johnny Tech and Lou Market have just left EDA Technologies Corporation, a company which designs and distributes EDA toolkits, to create Super EDA Technologies, a company which will attempt to design more advanced EDA toolkits. Johnny was a junior product design engineer at EDA and will design Super EDA's new products - while Lou was a Vice President of marketing at EDA and will under take the same function at Super EDA.

*Note: These illustrations are fictional and any resemblance with existing companies or persons is purely circumstantial.

Facts: Super EDA has no commercial products, though Johnny Tech is currently developing the toolkits. Fourteen months ago, while Johnny was employed by EDA, he made a presentation before the USA Computer Engineers Conference in which he disclosed several of the key technologies now being developed into the new Super EDA toolkits. Separately, Lou has tentatively selected the trade name "MasterTools" to designate the new software products to be marketed by Super EDA. The Company intends to market its products worldwide through authorized distributors.

Facts: Johnny is single with no other sources of income. Lou is married; his wife manages her own public relations firm - which has widely disparate fluctuations in profitability. Johnny and Lou expect the Company to incur significant early losses, with steadily growing profits after the first year. Both Johnny and Lou want to keep profits in the Company as working capital.

Facts: EDA has 2 founders, Johnny and Lou, neither of whom has any funds to support the Company. Funding will have to be raised from outside sources. Johnny has several friends in EDA and another competitive company which would like to work for Super EDA once it is funded. Two of these friends would work as developers, and two more as lower level administrative staff persons. All wish to receive stock in Super EDA as an inducement for them to leave their current positions.

Facts: Under California law, the Company must have at least 3 directors once it has 3 or more shareholders. Currently only Johnny and Lou are directors. With the issuance of incentive stock to the Company's new employees, at least one new member must be appointed to the Board of Directors.

Facts: Development of MasterTools, the Company's initial product, requires expertise which none of the Company's employees currently have. Harold Hacker has this expertise, but the Company does not expect that it will need Harold's services beyond initial product development. Johnny views MasterTools as his "baby" and plans on supervising carefully Harold's work. Harold insists on working primarily from his home and working at the Company's facilities only 2 days a week.

Facts:The Company has successfully beta-tested MasterTools, and now wishes to bring the product to market. Marketing Technologies Corporation has approached EDA about an early-stage investment in return for certain exclusive distribution rights. Vulture Ventures, a venture capital firm, has also approached Super EDA about an investment.

Facts: Marketing Technologies has just announced a staggering 3rd quarter loss and is no longer in a position to invest in the Company. Johnny's parents are comfortably retired and have volunteered to purchase $1 million of stock in the Company - representing half of their net worth. Lou has friends working in and outside of the EDA industry who have expressed an interest in investing in the Company. Many of these persons are "unaccredited" under the securities laws; however, Vulture Ventures, as mentioned, stands ready, willing and able to invest.

Facts:The Company is now fully funded and ready to roll-out the MasterTools product. This product is quite complex and will require extensive after-sale support. The Company has made no commercial sales to date.

Facts: The success of the MasterTools product has attracted enormous industry interest. Singapore Electronics has approached the Company about setting up an EDA joint venture company in Singapore to further develop these products, attempt to qualify for Singapore government grants available through the Economic Development Board, and market the products throughout the Pacific-rim region.

Scene One: Origination of Technology

Enforceability of Agreements:
- Non-Compete Agreements: Not enforceable in Calif; strong policy in favor of pursuit of livelihood; is enforceable in connection with sale of good-will, provided is limited in time and scope; also enforceable during the term of employment - and might be enforceable if Johnny and Lou continue as consultants (should make sure they are not).
- Proprietary Information and Non-Disclosure Agreement: Neither may use information that legitimately belongs to EDA.
  
  Johnny will have a more difficult time as generally clear what belongs to the prior employer - Johnny can take what he has learned, what he took into the Company; the gray area is methodology, process and systems - though this may be proprietary, it may also be an essential business tool which the employee cannot carve out. Note also that Johnny is a lower level person, and he may not have been exposed to high-level information - or get the scrutiny he might otherwise receive.
  Lou is a high-level person, and even though customer lists and data base information might be obtained from other sources, he must be careful.
- Employment Agreements: Johnny and Lou may each unilaterally terminate their agts; timing question generally - don't want to start with new venture until this is done. Should expect that there will be no wind-down period, and must immediately return materials belonging to EDA. Will want to comply strictly.
- Vesting Stock Agreements: Stock stops vesting on termination date - so may wish to time for maximum vesting; no exercise period as with options; vested stock cannot be taken away.
- Option Agreements: Must generally exercise on vested options within 30 days of termination - take care of immediately; timing may be a question if exercise price is not avble (or with NQO tax on exercise).
Information:
- with most value: hard to say; technology could be most valuable but can't use it as higher risk; marketing is more acquired from public sources; depends on how Company defines its business; usually with early-stage technology companies the marketing information is not valuable at the outset - except to the extent that gives credibility to management downstream.
- most protectable: the technology as clearly definable (what it is), usually able to determine origin and more layers of Intellectual Property protection (patent, copyright, trademark); marketing information is in a gray area (but see Restatement of Torts Sec 757 defining customer lists as trade secrets).
Where Products Designed:
- during period of employment? - no problem under California Labor Code.
- with EDA workstation? - problem, but no determinative; look at tools used, location, during whose time, etc.; factual analysis.
- to address general industry user needs? - depends if in a fiduciary relationship with EDA, as might constitute a business opportunity (reason why not to sit on related company Boards?)

Scene Two: Protecting Intellectual Property

How to best protect Software?:
Patent best as protects the idea itself, and not just manifestation of idea; rqrmts include novelty, utility and non-obviousness; utility protection for 17 years - monopoly on any use that infringes patent claims - need not be "substantially similar"; must file a patent application - takes 15-18 months with prosecution - costs $6,000-$9,000.
Copyright is embodied in the work; must be original and fixed in a tangible medium; corporate protection for the shorter of 75 years from publication or 100 from creation; common-law rights if don't register, but registration recommended as (a) pre-emptive defense - takes away innocent infringers defense, (b) prerequisite to bringing suit for infringement, (c) award of statutory damages and attorneys' fees from the date of registration, and (d) creates a presumption of validity in the copyright; can have copyright as well as patent protection - when patent runs out, the copyright remains; can register with the Copyright office - few dollars - with source code file the first and last 25 pages; as statutory damages for infringement only from the date of registration unless register within three months of first publication - should register within three months.
Trade Secret will be lost with publication of the patent, but 17 years more than sufficient for software; necessary to restrict disclose all the same to maintain copyright protection.
Patent Protection. Should file in primary markets first, ie: US, major European and Asian markets; 1 year after publication to file in the US - have a 1 year grace period in most foreign countries which reverts back to the US filing date under the Paris Convention - certain countries are not members, such as Taiwan; common to file under the Patent Cooperation Treaty - 57 countries members, simplifies the patent search and evaluation process - however each country reviews the application under its own standards; benefit is reduction in initial costs, and reserves priority for 20 months equals more time to test product in critical markets before incurring significant expense.
No "publication" resulting in a loss of novelty if oral disclosure with executed Non-Disclosure Agreements; typically inventions disclosed in general terms, preserving the essence of the discovery; written materials distributed anywhere in the world may destroy novelty; if blow the publication may still be able to file on other protectable aspects (build protection around the publicized technology).
Trademark. MasterTools might be descriptive mark; can't to establish secondary meaning when mark hasn't yet been used in commerce; can file an "intent to use" registration - no reason not to, except expense if product is not successfully developed; explain process.

Protection in Foreign Countries:

Copyright - have reciprocal protection under the Berne Convention; no need to separately file; get same rights as in country where are registered; covers major European and Asian markets.

Patent - must file separately in each country; have a 1-year grace period dating back the filing of the US application; if limited funds, can rely on copyright - but lose the more global protection given to patents; go after primary markets if cost not a concern.

Trademark - absolutely must file in primary markets, as most are "first to file" jurisdictions; count on 15-18 months and $1,500/each.

Scene Three: "C" v. "S" Corporation Status

Principal Differences. "S" corp provides corporate shield from liability, and is taxed as a partnership - resulting in a single layer of tax; best if corporate losses can be passed through against other sources of personal income, or if - with profits - little will be kept in retained earnings. Advantage of "C" corp is ability to build up retained earnings without pass through of tax to shareholders.
Requirements: "S" corporation requires less than 35 shareholders, 1 class of stock, and no corporations, partnerships, or non-US residents as shareholders; must file with the IRS and California Franchise Tax Board within 75 days of the later of incorporation or the formation of company; Board and each then-existing shareholder must approve the election; are a "C" corp by default if not filed as an S corp.
Tax Effects on Founders. Company will probably have early losses, and will need working capital for product development or marketing; if early losses, the working capital concern is not significant.
Johnny will want "C" corp status as (a) he cannot use any corporate tax losses, (b) corporate tax should not be a big issue early on if - with the small profits expected - any gain is used to pay reasonable salaries to employees, and (c) to the extent that profits are kept in the Company as retained earnings - Johnny will not want to pay tax on profits not being distributed out to him.
Lou will want "S" corp status so he can write off losses against his wife's income when filing jointly; as wife's income is variable, he can use a tax loss carry-forward.
Tax Effect on Shareholders.Venture investors will blow S status as partnerships. Private investors may find "S" status to be a principal attribute of investment in an early-stage company - as usually are high net-worth individuals; they must purchase Common Stock (valuation question with earlier issued Founder stock) and will want an understanding with management that the Company will refile as a "C" corp with profitability (as then they would be taxed on prorate profits at a time when no distributions are made on the stock).
S status may dis-incentivize employee shareholders, as they may be buying into tax liability - and presumably with losses, they cannot write this off against other sources of income.
Result: "S" status best for early-stage companies which expect losses which can be used by high-net worth shareholders; real problem is building up retained earnings for future capital needs.

Scene Four: Early Stage Capital Structure

Typical Capital Structure. Large number of authorized shares, say 15m total/10m common/5m preferred; permits low stock price, marketability, stock issuances to lower-level staff; blank check preferred is a place holder, doesn't blow S status as long as don't issue stock - no real reason to have it unless shows investors that Company is planning ahead.
Stock Issuances.Founders, as a group, should get 1 to 2 million of the authorized shares (assuming 10m of Common Stock; want a high number to lock in ownership when private investment comes into the Company; though it is a numbers game - gives leverage with VCs as they know Founders expectations.
Companies typically carve out 10-20% of issued stock for employees; actual number increases to keep percentage pool in this range; allocation among key employees/managers varies by value to the Company. Expensive to set up option plan at outset ($1,500-$2,000), so might try vesting stock or NSQO's outside of plan; securities outside of plan must comply with 25102(f) ie: sophisticated, pre-existing relationship with officers/directors or business; best if developers get vesting stock over 4 yrs - options outside of plan more complex to administer, and tax hit on exercise which can avoid with vesting stock; admin people can be brought into plan later - don't want to give away stock too freely, as then sets precedent for new employees coming in.
Pricing. At Board's discretion; typically should attempt to keep as low as possible (avoid "pride of ownership" problem - this won't set valuation for the VCs); must have some basis in reality - therefor hard assets must be correctly valued; can allocate high asset value between equity and debt; ratio of 3:1 is typical; don't want to make too high as gives Founders a liquidity preference over new investors coming in = a balancing act; also, if debt/equity ratio too high (ie. too much debt) the IRS may recharacterize the debt as equity; general concern here about thinly capitalized companies which may cause loss of the corporate shield - sufficient capitalization can be achieved through debt or equity infusion.
When to Offer Incentive Compensation. Depends on employee; probably necessary to lure key technology and management employees; should have no problem qualifying under 25102(f); always be aware of total employee pool - ultimately coming out of Founders pockets (which may be OK).
Securities to Outside Investors. Preferred Stock with liquidity and dividend preference to justify price difference; price usually set by investors - but Company should preempt with its own valuation; best valuation set by discounted cash flow method over 3-5 years; critical is definition of the market, competition and capitalization requirements; better valuation if track record of some sort - product/market development obviously helps; depends on need of immediate resources, whether working under a "window of opportunity" which rqrs immediate funding; also might be better to get the management expertise/market access that VCs or corporate investors can provide from the outset. Generally better to get money from the outset; real question is whether seed funding is available - no harm is initiating relationships early.

Scene Five: Board Membership

Board Membership. Typically start out with a range of 3-5, initially set at 3 - avoids going back to Shareholders to revise Bylaws; don't want to pack w/ friends yet want control = a balance; should select persons with needed expertise from outside company, critical vendor or customer to lock-in? (but may set a bad precedent); should avoid an even number of members to prevent dead-lock.
Directors are elected by the Shareholders at annual meeting of the Shareholders; are appointed by the Board to fill vacancies until next meeting of the Shareholders or when the seat filled by appointed is next up for election.
VC Seat. OK for the Board to act with vacancies for a short period; depending on when the venture financing is expected to occur - better to have a temporary vacancy than to file with a member not really needed and have to add a new seat.

Scene Six:Independent Contractors v. Employees

Advantages/Disadvantages. The Company will have greater flexibility with independent contractors - ie. easier to end relationship (based on completion of project or breach of contract - not termination); more control, however, over employees; the costs of hiring an independent contractor v. employees will vary, and must be examined on a case-by-case basis. Basic distinction between the two is determined based primarily on the Company's control over the work of the developer - including supervision of work, where the work is performed, the tools used, provision of training and support, the method of payment, work hours and development schedule - and similar factors (20-factor test used by the IRS in Rev. Ruling 87-41, 1987-1 Cum Bull 296).
Potential Penalties. Potential penalties include: (a) payment of withholding tax never paid (personal liability for the responsible officers of the Company), (b) payment of FICA (social security contributions), (c) failure to cover workers' compensation may result in personal liability for job-related injury, (d) potential effect on non-discrimination requirements under employee benefit plans - resulting in tax on highly compensation employees, (e) potential liability for health coverage of employee under COBRA, and (f) back wages for over-time pay due under Dept of Labor regulations.
What Is Harold? Possibly an employee given Johnny's close supervision of Harold; better if Harold were to work only at his office/home - but 2 days/weeks for reporting and software testing purposes would be OK.
Effect of a Contract. Courts will look to the actual nature of the work relationship between the parties; an agreement may, however, set out the indicia of the independent contractor relationship which developers, such as Harold, are expected to practice.

Scene Seven: Initial Funding - Financing v. Corporate Partnering

Mgt. Control. Mktg Tech will probably own less of the Company (less than 20% to avoid consolidated reporting) and be primarily interested in use of the Company's technology in its markets - not overall direction of the Company; Super EDA may, however, want mgt participation to help identify and exploit new mkts.
Industry Contacts. Mktg Tech provides better access to the markets in which it is currently marketing its own products - VCs might provide introductions in a variety of other markets/industries, which may be more important to overall Company valuation - requires thorough review of strengths of each.
Timing. No money typically comes in a very short period; VCs must be nurtured - good to meet early on - typically 6 - 12 months, or 3-4 months for an unusually attractive opportunity; Marketing Technology might be longer, depending on the commitment being made - companies move at different speed, again depending on market opportunity. Best to pursue both and see where the money comes in; an LOI with Marketing Technology at outset may set a limit on when a closing will occur.
Follow-On Funding. More likely to get support from VCs, as maturing the Company to liquidity in their interests; Marketing Technology may not support Company to that extent, and prefer simply to buy out the technology if the Company itself is no longer viable - each, however, will support the Company to get out what they put in - Marketing Technology funding may also value the Company artificially high - which may cause it difficulty in accepting a lower valuation later.
Job Security. VCs are more dangerous here - but Johnny and Lou should not be concerned about this; if have a good equity stake in the Company and not doing their jobs, they should be replaced - if better for the Company, brings it closer to liquidity and payoff for the Founders - most likely the VCs will want to tie Johnny and Lou into the Company, so should not be a concern.

Scene Eight:Private Funding

Johnny's Parents. Appear to be accredited, so minimal disclosure rqrd to comply with securities laws - avoid cost of private placement memo; give up no control and probably no affirmative covenants (rights of first refusal, registration rights and redemption/co-sale rights) or negative covenants (separate class vote); personal concerns with getting family involved? Also, parents can only provide money - is this enough?
Lou's Friends. Minority shareholder concerns (fiduciary duty); also, to extent these persons are in competitive companies, concern about confidentiality - shareholders have the right to Company's books and records to extent material to their investment; will need extensive disclosure document for the unaccredited investors - costing the Company $15,000 - $30,000 in legal fees.
Generally, for offerings of up to $1 million under Rule 504 of Securities Act of 1933 and accredited investors only - no formal disclosure document required, however still subject to anti-fraud rules (10b-5) and - for this reason - disclosure document required; above $1 million or for unaccredited information requirements of Regulation D apply; also subject to Blue Sky regulations in each state in which securities are sold.
Venture Investors. Looking for return of 10 times investment over 5 years - or market revenues of $100m in 10 yrs; willing to take technology risk - not market risk; will value Company on multiple of earnings at year 5 or cash flows over 5 years discounted to the present at a desired rate of return of perhaps, 10%; will want (a) liquidation and dividend preferences, (b) redemption/co-sale/reg. rts for exit strategy, (c) anti-dilution protection (event and price based), and (d) separate class vote (sale of new class of stock, merger/acquisition, sale/license of technology, etc.); disclosure documentation - none, except business plan used to sell VCs in first instance - and Schedule of Exceptions to representations in Stock Purchase Agreement; subscription docs and Articles with terms of stock heavily negotiated.

Scene Nine:Marketing Roll-Out

Marketing Strategies. There are several ways to bring the Company's products to market. The Company could sell directly to the end-user by tele-marketing, direct sales - or both. Representatives who find customers and are paid a commission could be hired. Distributors who purchase and resell packaged goods could also be set up to market the Company's products. Other distributors who have the right to copy from a master diskette might also make sense. OEM distributors, or VARs who add substantial value to the products are another possibility.
Company Marketing Responsibilities. Marketing policies and strategies should be decided by the Company; the implementation of these policies can be decided by others.
Foreign Markets. Requires special adaptations/localizations of the product for the local market - such as language etc. Substantial after-sale support necessitates that this be provided by the foreign distributor. Note also that local laws in the EEC and certain other countries make it difficult to terminate distributors - so they should be selected carefully.
Anti-Trust Concerns.Vertical price restraints are prohibited - and distributors/resellers must be free to set their own prices; royalties can be tied to a percentage of retail sales with a "floor" price per unit; restrictions can be placed on the sale of competitive products during the term of a license agreement; for concerns about price maintenance, the Company might reserve the right to sell direct to the end-user as a means of under-cutting distributors who are selling at too high a price.

Scene Ten:Marketing Joint-Venture

When JV Makes Sense. Isolates risk outside of partners' main line of business; build value in new enterprise for separate market appreciation/liquidity (not likely); dedicated management and resources for market opportunity which cannot otherwise be captured. Here makes sense to qualify for Singapore tax credits - or to give comfort to off-shore investors; manufacturing off-shore may have additional advantages such as costs savings, logistics and minimize import duties/quotas in primary markets.
Effect.
-Technology Ownership:owned by JV; dilutes value of contributing Company (but may be offset by success of JV)
-Marketing: Should only be pursued if will eliminate barriers in primary markets; must consider in advance.
-Valuation/Liquidity: Should not look to the JV for liquidity - primarily a product development or market orientation which helps the contributing partners; should only be formed if no other way to achieve objective.
Joint Venture Issues.
- Business Form. Partnership best for tax loss pass-through; liability of each corporate partner is limited; as mentioned, liquidity generally not a concern - however, corporate structure generally is understood and easy to work with.
-Management Control. Can spell out specifically in the Partnership Agt or Bylaws; critical is distinction between JV autonomy and what the corporate partners vote on.
-Technology Ownership. Must be agreed to by the parties in advance; critical to both - no different issue from that faced in a direct Product Development Agreement between the parties; may provide for a buy-out formula and delay to the time of dissolution.
-Contribution. Initial and on-going contribution, and in what form; possibility of bringing in third parties? - question of autonomy; should be something in the form of a "Buy-Sell Agreement" if one of the partners wants to get out.