I thought I would write a couple of posts on legal issues start-ups should be aware of early in their lifecycle. In particular I wanted to cover some issues, that if not handled correctly, can have a detrimental impact at a later stage in the company’s life such as when they are looking for outside financing.
I recently met with Joe Milstone, partner and co-founder of Cognition LLP. Cognition is quite active in the start-up space in Toronto. They work with start-ups by offering a dedicated lawyer to act in the role of in-house counsel on a fractional, as-needed basis, and at a cost that is about a half to a third of a more traditional business law firm.
Craig: Joe, thanks for taking the time to talk with the StartupNorth readership today. Before we start, I guess we should get the formalities out of the way by stating everything we will cover today is meant as general information only and not meant to imply specific legal advice. For this post, I thought we would talk about intellectual property. From an investor standpoint, intellectual property can be a very strong factor in how an investor values a company and forms a big part of their decision in the company’s investment worthiness. When people think about intellectual property, the first thing that probably comes to mind are patents. However, there are many other aspects relating to the ownership of intellectual property that a start-up needs to ensure are in properly place, correct?
Joe: That’s right. Most start-ups will use their own employees, outside consultants, and external vendors to help create a product. Intellectual property ownership rights need to be clearly spelled out in all of these relationships to ensure when a company goes to file a patent, seek investment or often even to complete and comply with their own sales and marketing documentation, that there is no possibility that an outside entity can stake claim to their intellectual property. We work with companies when they are at the stage when they are looking for angel or VC financing and also when they are targets of acquisition. We know that investors or acquirers will look for this in their due diligence so we advise our clients to ensure they have a strong foundation from the start.
Craig: Ok, let’s start with employees. If you have an employee on payroll, doesn’t general law cover this off and give the employer rights to any intellectual property they may develop while employed?
Joe: That is correct as a broad and general proposition, however it is best practice to get an employment agreement in writing that will cover off this and other aspects that can have a determinant on the success of a company. For example, there are certain slippery residual rights that all inventors of intellectual property retain, whether they are employees or not, and that if not handled correctly, can impede what a company can do with the intellectual property. Also, without a specific employment agreement there will be more grey areas that everyone wants to avoid. Like what if one of their employees works on their own computer/equipment on their spare time – the employee may stake claim that some of the intellectual property is his or hers. Additionally, we have also run into situations where everybody in the company has an employment agreement except the founder. This covers the founder’s interests when he or she owns all of the shares, but when outside entities are looking to make an investment, they are obviously investing in the company as an entity, not the founder.
Craig: What about non-competes?
Joe: From a company’s standpoint, the knee-jerk reaction is to seek a broad non-compete clause if it ends a relationship with an employee. However, this is usually counterproductive, because courts believe fundamentally in the rights of people to work wherever they want. As a result, courts have a strong aversion to enforce almost any non-compete against an employee unless it is framed reasonably narrowly so as to address a specific business concern that can’t be protected in other ways. A company would be better off to have a very tailored and proportional non-compete clause that outlines specific timeframes, geographies, narrowly defined businesses, etc. Even better and more likely to be upheld is the use of other mechanisms to achieve generally the same results such as non-disclosure agreements and non-solicitation covenants with respect to employees, customers and even key suppliers of the company.
Craig: Start-ups often use flexible compensation structures in the early days when money is scarce (i.e. giving people below market salaries in exchange for equities). Any comments on legal aspects around this?
Joe: Ideally in those situations, there should be a cash component and the company should ensure that the market value of the overall compensation is sufficient to ensure that the employee has received adequate consideration in exchange for him or her agreeing to be bound by any non-competes, non-disclosure and IP assignments. The main thing is to get the relationship properly documented so both sides have a record of what kind of ownership is actually being provided and on what terms, and so the company can document and comply with corporate and securities legal requirements. Also, companies should ensure that the value of any services they receive is roughly equal to the fair market value of the shares that they grant in return. This is important from a corporate governance perspective as well as a tax perspective, and companies should avoid the temptation to entice an employee by back dating share grants to a period when the market value was lower.
Craig: Any other issues around the topic of employees / employment agreements?
Joe: The other thing would be around termination (either by the company or employee). Notice and severance period should be spelled out so both sides are clear on what their responsibilities are and so, from the company’s perspective, it can set and minimize its exposure. If the wrong language is used, the company can be exposed to a multiple of four or five times. If the employee has stock options, it should be carefully spelled out what happens to unvested options as well as the exercise of vested options. This can often vary depending on whether the notice period is or is not treated as part of the term of employment, and again there is careful language that has to be used to get it right.
Craig: Moving on to consultants and outside vendors, in today’s outsourced business model it is pretty common that start-ups will use outside entities in the development of their offerings. What should start-ups be aware of?
Joe: Dealing with intellectual property ownership is critical with outside entities such as consultants and vendors, because by definition they are separate business entities from the company offering their own distinct services and sometimes products. Each consultant or vendor contract needs to clearly spell out proper IP transfers , waivers and other cooperation and assistance. Unlike employees where the employer has default ownership of the intellectual property, this is not the case for vendors and consultants, so the scope and phrasing of the contractual inclusions is even more paramount.
Craig: Start-ups often hire people on as consultants vs. employees to reduce exposure to EI/CPP payments, wrongful dismissal, etc. Have you seen any issues with this?
Joe: The biggest issue is with the Canada Revenue Agency. They have published a guide as to how they will examine a situation to determine if a consultant is actually an employee, but the criteria often don’t point all in the same direction. Start-ups should ensure their consulting agreements and arrangements fit into the guidelines outlined by the CRA. Otherwise, simply calling someone a “consultant” won’t cut it. If a start-up has been using a consultant on a consulting basis that the CRA determines is actually an employee relationship, the start-up will be exposed to fines. The other issue is to realize that a true consultant is by law an “outside” entity, meaning that more tailored and elaborate IP provisions are necessary, and also that the company has to be mindful of such relationships when entering into non-disclosure agreements, joint ventures, privacy policies and the like, particularly where that consultant will be involved and will receive sensitive information. For example, a consultant will not be bound to a NDA that a company signs with another commercial party, meaning that those terms need to be properly “flowed through” to the consultant’s company and often the consultant individually too.
Craig: A lot of good information here, thanks again for taking the time today Joe. In my next post, I’ll be talking with Rubsun Ho, also from Cognition, to discuss term sheets from an entrepreneur’s point of view.
craig at mapleleafangels.com