Metro Detroit's entrepreneur ranks are burgeoning. But startups are well advised to keep a legal-eye view on going into business. John Simon, attorney and partner at Foley & Lardner, LLP, gives the rundown of legal issues to which great minds must heed, such as corporate form and intellectual property protection.
The Legal-Eye View of Business Formation, Property Protection, and Meetings of the Mind
Detroit is in the midst of an entrepreneurial revolution that will continue to accelerate an economic recovery for not only the city, but all of Southeast Michigan. On a daily basis, early-stage local enterprises are announcing interesting and innovative new business pursuits in a variety of markets. These span the gamut from food production companies that are driving the latest market trends, to technology companies creating popular state-of-the art software, applications and internet tools, to investment firms that help support and finance other new local businesses and the growth we are experiencing.
Conditions are favorable for new businesses to start up or execute growth strategies. GM, Ford and Chrysler, and many of the large local companies that constitute their supply base, are back on their feet and humming, which is a tremendous boon as they constitute an essential part of the backbone of our local economy and thus generate demand for new products and services. Moreover, among its many strengths, the area enjoys a great number of highly-skilled workers and a reasonable cost of living – a very desirable combination for new companies to recruit and retain critical human capital. At the same time, many barriers to entry, such as real estate costs, are low. Furthermore, in recognition of the importance of new ideas and small businesses to our collective future and the principle that "a rising tide lifts all ships", local entrepreneurial networks are very strong and business owners routinely share insights with each other and collaborate to enhance each other's success. Critical commercial and residential mass and density are building downtown.
It is likely that the collection of new early-stage businesses that is growing right now, or waiting to be formed as the dreams of one of the countless soon-to-be leaders in our business communities, will take us to the next level. There is a palpable sense with all the positive entrepreneurial activity and energy buzzing in Detroit that the next Apple, Groupon, Heinz, or LinkedIn is right around the corner and will hatch not in Silicon Valley or New York City, but right here in the D.
At the same time, the failure rate for new businesses is very large. For a variety of reasons, many startups cease operating or file bankruptcy within just a few years after they commence operations. Failure can be an important learning tool for a new business or an entrepreneur – but from a legal perspective there is risk that can be managed to avoid future troubles. I'll be discussing some key legal issues that entrepreneurs should consider early in their new ventures to try to minimize risk and maximize the protection of their enterprises.
Corporate Form and Choice of Entity
One of the first decisions an entrepreneur will make is to choose and structure the entity for the business. Potential entities can include, among others, a sole proprietorship, corporation, limited liability company or limited partnership. Various considerations can drive the selection of the entity. For example, using a protective corporate form to hold the company's assets and operate its business can shield the owners from personal liability for the company's obligations. In the absence of a duly established and maintained corporate form (such absence including a sole proprietorship), the persons running the business can be held liable for the debts of or claims against the business without affirmatively guarantying those obligations, putting the entrepreneurs at risk personally. Therefore, if the business is going to take on debt or potentially face liability (for example, on contracts with others), it is advisable to consider the establishment of corporate protection by forming an entity that provides limited liability such as a corporation or limited liability company rather than a sole proprietorship.
The corporate entity structure can affect other aspects of the business as well, including tax treatment of the company and its investors/owners, the flexibility of the capital structure to facilitate future investment and financing, equity-sharing arrangements with employees and the marketability of interests in the business. For example, C corporations are subject to taxation at two levels – the corporate and the shareholder levels, while S Corporations, and limited liability companies and partnerships may receive "pass-through" tax treatment where the shareholders are taxed based on their pro rata ownership but not additionally at the corporate level. At the same time, a C corporation does have benefits in terms of enabling use of a wide variety of capital structures, including use of common and preferred stock, stock options, warrants and convertible securities to enable potential capital raising and exit and employee compensation strategies, whereas an S-corporation is limited, for example, to having one class of stock and a cap on the number of owners. Making the wrong decisions could inhibit the company's ability to generate meaningful returns after taxes or to achieve the exit or growth strategy sought at the outset and thus jeopardize its viability. An attorney should be consulted in reviewing the options.
In addition, in structuring their corporate form, if the entity has more than one owner, special consideration should be given to matters affecting corporate decision-making and sharing of the benefits and obligations encompassed by the business, and the corporate documents or agreements should reflect the parties' understandings. For example, the amount of each owner's contribution should be considered in structuring ownership percentages and voting control (including a process for resolving any deadlock), the roles that each owner will play and duration of those obligations should be established in writing, and the process for resolving potential arguments over matters such as sales of the business or a buyout of other owners (including matters requiring supermajority votes of owners) should be considered and addressed in advance to the extent possible. This will enable the company's owners and managers to focus on the business and its growth. Disputes on these types of matters can distract a business from its mission and cause serious harm.
Certain Intellectual Property Pitfalls
Intellectual property, such as patents, trademarks, copyrights and trade secrets, often constitutes the most important assets of a new business. This is especially true for small technology and manufacturing companies, whose advantage in the marketplace must be safeguarded by keeping their products free from copying by others. The failure to properly protect intellectual property can destroy the value of a new business and result in the company going out of business.
A patent is essentially the government-granted right to exclude others from using, making, copying or selling an invention for a period of time. The patent laws allow a new business that has invented a product to control the revenue from it by protecting it from the competition or deriving income from licensing others to use it. Patent protection increases a company's value by providing certainty that its inventions will inure to its exclusive benefit. So, at the outset, a company with inventions should ensure that it has processes in place to ensure that (i) it is not infringing on other companies' patents and (ii) it is properly obtaining protection for its own patent portfolio.
Patent infringement claims can easily destroy a growing company. If a company invests scarce resources and time into an invention, only to find out that the invention is already patented, it might never recover on the investment. A party with superior patent rights might seek an injunction from a court to force the company to stop making or selling the relevant product (or one which uses the allegedly infringing patent). This could destroy a key revenue source. The litigation can also result in damages for lost profits and a reasonable royalty for the sales of the infringing product thus far, as well as potential punitive triple damages for willful infringement and attorneys' fees. To avoid this, an inventor entrepreneur can have a product clearance investigation performed and patent attorney opinion provided to supply the company with an analysis of the risk of infringement. This review can also provide the company with insight on how it might change the product slightly to avoid patent infringement issues. At a minimum, having an opinion of patent counsel can support an argument that future infringement, if any, was not willful (thus justifying punitive damages).
A company that creates new inventions should also have policies in place for obtaining protection of their patents. To be patentable, an invention must be new, non-obvious and useful. Recent changes to the U.S. patent law will, once effective, mean that all things being equal, the first inventor to file for patent production (rather than the first to invent) will be entitled to protection. So, a company should have a process that allows it to quickly recognize when it has a patentable invention. Confidentiality of the invention is even more important. Also until the new law imposes the "first-to-file" standard, a company should continue to have rules in place to note when inventions are publicly used, offered for sale or described in publications so it is aware of the one-year deadline to file an application, and keep lab notebooks to ensure support of the date of a conception and reduction to practice of any invention.
Trademarks are words, names, symbols or designs that are used by a company to identify its goods and distinguish them from those created and sold by others. Perhaps the simplest example of essential intellectual property that must be protected is the name of the company, which is a trademark that will convey to the marketplace the entire brand. This allows a company to build brand recognition and loyalty. Even the most basic business enterprise will want to make sure the domain name for its name is available and have the trademark records searched for identical or confusingly similar names at an early stage to ensure that it does not need a drastic name change after it has already built up a following for its product. Also, a new company should consider seeking a federal trademark registration, which can provide many benefits including: (i) preventing innocent infringement by other companies; (ii) enabling the company to seek injunctive relief (i.e. forcing others to cease and desist from using the trademark) and punitive damages and attorneys' fees in infringement actions; and (iii) the marketing advantage of being able to use the ® symbol in connection with the trademark. These protections all add and protect value to the enterprise.
A trade secret is commonly defined as a formula, pattern, device or compilation of information used in one's business that allows a company to gain an advantage over a competitor that does not know or use the secret. Trade secret is a method for a company to protect intellectual property that might not be patentable. Generally, for a trade secret to be protected, it must not be widely known in the public, it must be somewhat valuable to the company and courts look to whether the company took reasonable steps to protect it. So, to try to protect trade secrets, it is important that the company have systems in place to keep the information confidential. Steps to be considered include requiring written confidentiality agreements before information is shared with third parties, restricting access of personnel to confidential information, and restricting departing employees from disclosing information
Contracts, whether for the supply of goods from an important vendor or for the sale of goods to a customer or for the employment of key employees, are often critical to a new enterprise's success. Significant matters such as the timing and quality of goods, and the extent of any warranties, should be understood and established in contracts of the company. The company should also consider formulating form purchase order terms and conditions, in consultation with counsel, to ensure that the company's purchases are made on terms that are expected, rather than terms that are unilaterally imposed by a supplier.
With respect to employees, employee contracts or policies should maintain "at will" employment, allowing for termination at any time for any reason and without guaranteeing any employment, and should also contain provisions to protect the enterprise. These include confidentiality and non-disclosure requirements, non-solicitation and non-compete provisions (which should be tailored with advice of counsel to be enforceable), and, to protect the intellectual property of the company, provisions pursuant to which the employees agree that any intellectual property created in their work is "work for hire" assigned to the company.
Lastly, assuming a new company has protected itself on the corporate formation and governance, intellectual property and other contract angles, and is performing successfully, it will be tempted to grow quickly. Surprisingly, rapid growth is actually often a key cause for many companies' bankruptcy filings. For example, a common business failure story involves a company securing a new and large customer contract, for which the business must invest extensive capital and other resources in research and development, personnel, equipment and space. Then, at some time leading up to launch, or after launch, the opportunity falls apart or underperforms, leaving the company with more obligations and flat (or sometimes even less) revenues. Growth and acquisition of debt should be managed carefully in this regard. Through careful planning and contracting, a company can try to minimize its exposure in these situations by addressing uncertainties in advance.
As entrepreneurial activity continues to accelerate in Detroit, I hope these brief pieces have provided some guidance and insight on legal issues that new businesses should consider in starting up and protecting and enhancing their growth.